State Bank of India stock rating: 'Buy'

State Bank of India's (SBI) Q3FY11 profit after tax was up 14% YoY at Rs 28.3 bn (10% higher than our estimate). Performance on operating parameters was significantly better than we had anticipated. Some of the positive surprises are: margin improvement of 18 bp QoQ (vs our estimate of 10 bp decline), lower than expected opex (13% lower than estimated), and stable asset quality.

NIM (net interest margin)for the quarter improved by 18 bp (basis points) QoQ to 3.6%, leading to 43% YoY (+12% QoQ) growth in NII (net interest income) to Rs 90.5 bn (8% higher than estimated). Healthy growth in CASA (current account,savings account) deposits and elevated CD (credit deposit) ratio aided margin expansion. Interest income included Rs 2.3 bn of interest under income tax refund vs Rs 3.7 bn a year ago and Rs 1.2 bn a quarter ago, adjusted for which NII grew 10% QoQ and 48% YoY. Yield on loans for 9M(nine-month)FY11 were at 9.58% vs 9.5% in H1FY11 and 9.8% in 9MFY10. In our view, yield on loans improved 4 bp QoQ for Q3FY11 (9.74%) vs Q2FY11 (9.7%).

The full impact of (i) 25 bp increase in BPLR (benchmark prime lending rate) and 10 bp hike in base rate in Q3F11, and (ii) 40 bp hike in base rate and 25bp in PLR in Q4FY11 will aid margin performance. Cost of deposits declined marginally to 5.20% in 9MFY11 vs 5.25% for H1FY11. Cost of deposits declined 13bp QoQ (Q2FY11 at 5.23% and Q3FY11 at 5.1%) as 70% of the incremental deposits were CASA deposits and some of the old high cost TD (term deposit) re-priced at a lower rate. Cost of deposits have bottomed out and will see moderate increases now. The management has guided that NIM will improve by 10 bp in Q4FY11, led by rise in base rate and PLR at the beginning of the quarter.

In absolute terms, GNPA (gross non-performing loan) remained flat sequentially at Rs 234 bn. PCR (provision coverage ratio), including technical write-offs, increased to 64% vs 62.7% a quarter ago. The bank has to comply with 70% PCR requirement by the end of September 2011. Incremental provisioning required for 70% PCR is Rs 20 bn, to be amortised over three quarters. Reported slippages for the quarter were at Rs 31.5 bn (annualised slippage ratio of 2.5%, down from 2.6% (core) in H1FY11). During the quarter, the bank reduced Rs 7.7 bn of URIPY (unrealised interest of previous years) balance from GNPA, resulting in higher adjusted slippages of Rs 39 bn. Balance under URIPY was fully provided; thus, there should be a proportionate increase in write-offs.

In our view, write-offs should be Rs 22.5 bn (vs reported level of Rs 14.5 bn). The bank made provisions of Rs 20.5 bn during the quarter, including MTM (mark- to-market) provision of Rs 2.1 b. NPA provisions stood at Rs 16.3 bn, which also include additional provisions made to improve coverage ratio. Total restructured loans stood at Rs 327.5 bn, which includes Rs 184 bn restructured under RBI scheme. Of the total restructured portfolio, assets worth Rs 44.2 bn have slipped as NPAs. Under the RBI scheme, slippages are Rs 29 bn (15.7% of restructured portfolio). During Q3FY11, Rs 20 bn of loans were restructured, which included Rs 16 bn of loans to Kingfisher.

Loans grew 21% YoY while deposits were up 14% YoY. On domestic operations, CD ratio was 77% vs 75% in Q2FY11. Large corporate loans grew 28% YoY and 14% QoQ, led by infrastructure and petroleum. Reported CASA ratio improved 92 bp QoQ and 577 bp YoY to 48.7%, the highest after HDFC Bank. Growth in savings deposits was impressive at 30%, leading to 28% growth in CASA deposits.

Non-interest income (ex-treasury) grew 6% YoY to Rs 31 bn. While fee income grew 13% YoY, forex income and other miscellaneous income dropped 17% YoY. In Q3FY10, change in accounting for ATM intercharge fee had led to excess income recognition of Rs 2.2 bn (for 9MFY10 in Q3FY10 itself). Adjusted for this, growth in fee income was higher at 21%. Trading profits were at Rs 2.2 bn vs Rs 2 bn in Q2FY11 and Rs 4.4 bn in Q3FY10.

Operating expenses were up 11% YoY but declined 3% QoQ (13% lower than our estimate).

Cost to core income (ex-trading profits) ratio was down at 46% vs 48% in Q2FY11 and 55% in Q3FY10. With an increase in benchmark yields, guidance towards gratuity liability has been revised downwards by Rs 3 bn to Rs 19 bn. During the quarter, the bank provided Rs 1.4 bn towards gratuity, taking the cumulative provision in 9MFY11 to Rs 15.4 bn. Pension liability provisions are without considering the ninth bipartite agreement and are being provided as per eighth bipartite agreement. We wait for details on the shortfall on this account.

For Q3FY11, consolidated NII grew 40% YoY (7% QoQ) to Rs 123 bn while other income improved 5% YoY to Rs 76 bn. Opex increased 15% YoY to Rs 110.2 bn. SBI?s subsidiary banks reported operating profit growth of 18% YoY, led by strong NII growth of 35%. However, increased provisions led to lower PAT growth of 15% YoY. Provisions for Q3FY11 were Rs 6 bn v/s Rs 5 bn in Q2FY11. Including technical write-offs, consolidated PCR stands at 68%. SBI Life reported PAT of Rs 3 bn for 9MFY11, up 51% YoY.

Adjusted for life insurance valuation, SBI trades at 1.5x FY12e consolidated BV (book value) of Rs1,657 and 9.1x FY12e consolidated EPS (earnings per share) of Rs 273. Standalone RoE (return on equity) will be 18-19% in FY12-13. The stock has corrected 25% from its peak on concerns relating to margins and asset quality. We believe valuations are attractive. We expect RoA (return on asset) to improve from 0.9% in FY10 to 1% in FY11 and 1.1% in FY12-13. RoE is likely to improve from 15% in FY10 to 18-19% by FY13 (without assuming capital raising). The Rs 200 bn rights issue should happen shortly, once government approval comes.

State Bank of India stock remains our top pick in the sector with a target price of Rs 3,600 (1.8x FY13e consolidated BV + Rs127 for insurance). Key risks are higher pension liabilities, RBI?s further monetary policy stance and any risk to industrial growth at macro level, which can impact potential loan growth in FY12.