Description

Central Bank of India (CBI) represents compelling value at its current price of Rs. 156.  The stock is down by almost 40% from its high of Rs. 249 in November, and is trading at 4.6x earnings for the fiscal year ending next month, and just 1.1x book value.  ROE is about 24%, and earnings should grow at perhaps 15%-20% annually for the next few years (though EPS growth in the fiscal year which will begin in April will be stunted by a rights issue which is imminent; more on this later).  It is also trading well below its public sector bank peers.  I believe the stock has the potential to provide a return of 150% to 325% over the next three to five years.  Importantly, at the current valuation I think that the downside risk is very limited.

Background

CBI is a "public sector" Indian bank; the government owns 80.2% of the shares in the company.  The remaining shares are publicly traded on the Indian stock exchanges.  The bank was founded in 1911 and has over 3,600 branches throughout India.  It is among the top ten public sector banks in the country.  (To celebrate its centennial year, the government issued a CBI postage stamp.  Try imagining Citibank on a U.S. postage stamp.)

Financial Performance

A new CEO took over CBI three years ago, and has aggressively pushed since then to improve the profitability of the bank.  The results have been dramatic, as can be seen from the table above.  One example: return on assets (ROA) increased from 0.43% three years ago to 0.89% in the most recent quarter, and the CEO has publicly pledged to increase ROA to at least 1%, which alone will boost net profits by another 12%.

One component of the reason for the growth in profits in recent years has been the improvement in asset quality at the bank.  Gross NPAs declined from 7.16% at the end of FY 2006 to 2.33% at the end of FY 2010, while Net NPAs dropped from 2.59% to 0.69% over the same four-year period.  Another reason is the improvement in the net interest margin (NIM) in recent years.  Large amounts of high cost bulk deposits raised a few years ago were not renewed by management, in order to bring down the bank's cost of funds.  In addition, the bank has gradually shifted its loan portfolio mix by increasing the share of higher-yielding retail loans.  This should continue to improve the NIM over the next few years.

Valuation Comparison with other Public Sector Banks

The table below compares Central Bank of India with its largest public sector bank competitors.  It is clearly the cheapest stock in the group based on earnings multiple, and is the second cheapest based on price to BV; the only cheaper stock by that measure is Indian Overseas Bank, which earns a far lower ROE than CBI.

Punjab National Bank was recommended on VIC by sunny329 in March 2004 when the price was Rs. 250.  PNB is a larger competitor of CBI.  The thesis of that recommendation had similarities to this write-up: PNB was trading at 6x earnings (compared with 4.6x for CBI today), and was at a modest premium to BV.  The ROE in both cases was in the low-to-mid 20s.  Expected earnings growth in both banks was similar, perhaps 15-20% EPS growth annually.  PNB's market cap was $1.5 billion seven years ago; CBI is at $1.4 billion today.  PNB has worked out well: it is trading at Rs. 1,100 today (4.4x the price at which it was recommended), having hit a high of almost Rs. 1,400 (5.6x) less than four months ago.

If you find my CBI recommendation interesting, I encourage you to read sunny329's PNB writeup.  He provides good background information on the Indian banking sector, which, for the most part, is as relevant today as it was seven years ago.

Dividends

CBI pays out less than 10% of its profits as dividends, and the dividend yield is modest at about 1.5%.  Because it has tremendous growth opportunities, it chooses to retain the vast majority of its profits.

Rights Issue

In order to strengthen its balance sheet and capital ratios and to provide capital for future growth, CBI is planning a rights issue to raise about Rs. 25 billion in equity.  This is expected to happen very soon, likely within the next month.  The rights issue price has not been determined, but is likely to be at a modest discount to the stock price.  I estimate that the number of shares outstanding could increase from 404 million now to perhaps 580 million after the rights issue is completed.  The good news is that any shareholder who subscribes for his portion of the rights issue will not be diluted; he will continue to own the same percentage of the company as he did pre-rights.  The bad news is that the number of shares will increase meaningfully, and this will affect EPS growth in the coming year.  Given the bank's ability to invest the additional capital rapidly and to deploy it fully over time by growing the balance sheet, I estimate that EPS will be roughly flat or down a little in the coming year before resuming growth of maybe 15% to 20% annually.

Looking out four years to fiscal 2015, EPS should increase to perhaps Rs. 48 to 55.  With a multiple of between 8x and 12x EPS, this translates into gains of 150% to 325% over the four years.

To supplement my research, I have had extensive discussions with two of India's most highly regarded value investors about the company.  They are very bullish on the company's prospects and consider the stock to be ridiculously cheap at the current price.  My belief is that the Indian stock market's recent decline, combined with the impending rights issue, have created a rare opportunity to purchase a decent company at a very attractive price.

Catalyst