Allahabad Bank is one of the cheapest public sector banks in India, trading at 5.0x earnings and 75% of book value. ALBK is the oldest public sector bank in India. It was privatized by the government in 2002 and currently operates close to two thousand branches across the country with a concentration in northeastern India (Uttar Pradesh and West Bengal primarily). The government still owns 55% of the bank, more on this later. For a good overview of the Indian banking sector see sunny329’s Punjab National write-up from March 7th, 2004.

 

ALBK has 520bn rupees in total assets: 290bn in loans, 185bn in investments, and 45bn in other. These are supported by 485bn of deposits (40% of which are low cost) and 35bn of equity. The loan portfolio consists of the following: 41% corporate, 41% “priority sector” (including 19% agricultural), and 18% retail. The majority of the investment portfolio (~85%) is comprised of government securities. Reserve Bank of India requires all banks to hold 25% of their liabilities in government of India securities. ALBK must also comply with government guidelines stipulating that 40% of their loans be in the “priority sector” including 18% of their loans to agriculture.

 

Over the last several years the bank has had mid-20s percent loan and deposit growth and high-20s percent return on equity. These results are despite historical inefficiencies due to ALBK’s status as a public sector bank. They were very slow to introduce technology (even ATM’s were a very recent development) and they were generally unable to achieve layoffs and other cost saving measures. Lately ALBK has stepped up efforts to modernize the bank although they are still a far cry from private sector peers. One of the things we like about ALBK is that their focus on the most rural areas insulates them to some extent from the fiercest (private sector) competition-- ALBK is actually the only bank in many of its villages.

 

We like to adjust ALBK’s reported financials in order to get a more accurate picture of economic book value and earnings.

 

Book value adjustments:

We decrease the book value by the amount of bad loan provisions needed to bring after tax net NPAs to zero.

 

We attempt to mark to market the bond portfolio (Indian GAAP does not require mark to market for held to maturity OR available for sale securities). ALBK had significant mark to market gains historically as interest rates declined (remember they held significant gov’t securities). However with the recent uptick in interest rates ALBK tells us that there is very little gain left in the bond portfolio (so no mark to market adjustments currently needed).

 

Income statement adjustments:

We back out all of the securities gains on sale

 

We add back all of the provisions, then provision for loan loss based on 2% of new loans (this is very conservative – they use 25bps and historical loan losses are well below 1%). They also provision for “depreciation on investments,” basically if the value of any of their investment securities declines they mark it down and run it through the income statement – obviously not an operating expense and hopefully not a recurring one.

 

                                                            3/31/04            3/31/05            3/31/06

pre-tax income                                      5,634              5,958              10,242*

less: gain on sale                                   (5,047)             (3,474)               (1,390)

add: provisions                                       4,263              4,756 

less: normalized provisions                       (560)             (1,162)               (1,582)

adjusted pre-tax income                         4,290              6,078                7,270

tax (33%)                                             (1,416)             (2,006)               (2,399)

adjusted net income                                2,874               4,072                4,871

average shares                                          347                   347                   440

eps                                                          8.28                11.74                11.07

p/e                                                            6.8x                 4.8x                   5.1x

 

*profit before provisions

 

The 3/31/06 annual report has not been released yet, but based on the summary financials they disclosed the company earned 15.50 per share in FY2006, yielding a p/e multiple of 3.6x.  Adjusting for the proper level of provisioning, normalized taxes, and gain on sale they earned 11.07 per share or a p/e of 5.1x. Also please note that we are taxing them at the full tax rate of 33% while in reality their tax rates have been closer to 10-15%. The low tax rate is due to certain tax benefits associated with agricultural and other priority sector lending. We expect the tax rate to increase over time. The eps is lower in 2006 vs. 2005 due to an equity offering that they completed in May 2005 which increased shares outstanding but has not yet been fully reflected in earnings.

 

The stated book value is 81.45 per share. Adjusting this for the after-tax net NPAs and the recent dividend of 4 rupees, the book value per share is currently 74 rupees, putting the stock at 75% of (tangible) book.

 

ALBK is targeting 25% growth in loans and deposits in the next 12 months. On the automation front, they hope to get half of their branches on the central banking system by the end of the year with all of their branches being computerized by mid 2006. They also plan to roll out an additional 250 ATMs. Given the overall growth in the Indian economy and especially the banking sector, we expect Allahabad to grow its balance sheet at least 15% for the next several years.

 

Public sector banks have a government imposed cap on the level of foreign ownership – when foreign ownership hits the cap (20%) you can only buy stock from another foreigner, which trades at a premium. Allahabad is one of the only banks that is not at its foreign ownership limit (it’s at roughly 16% last we checked). Therefore Allahabad’s stock price is actually representative of what you, as a foreign holder, would have to pay to own the stock, unlike SBI, PNB and others which currently trade at 8-15% “foreign premiums.”

 

A potential catalyst for the public sector banks would be the government’s divestment of its stakes. It is hard to tell when this is likely to occur -- many of the analysts in India hold differing views on the topic. However to the extent that Allahabad (and others) continue to grow at the current rate they will certainly need more capital. Allahabad has already done one secondary offering since the initial privatization and can’t do another of any significant size without either diluting the government below 50% or with the government’s pro rata participation -- which the government has said it won’t do.