Punjab National Bank (“PNB”) is one of the largest banks in India, with the third largest balance sheet (assets of approximately US$20BN), the second largest branch network in the country (almost 4,000 branches) and over 40MM customers. PNB was formed in 1895, was nationalized in 1969, and was publicly listed in 2002. PNB is 80% owned by the government of India and the remaining stake is publicly traded on two exchanges in India. Unlike many ideas posted on VIC (including the majority of my ideas), PNB is highly liquid—average daily trading volume between the two exchanges has been approximately $22M/day over the past six months.
The banking sector itself is divided into two sectors, the public sector, which consists of banks partially owned by the government, and the private sector banks, which came into being about ten years ago when the industry was deregulated. Of the public sector banks, State Bank of India (SBIN.IN), Canara Bank (NCBK.IN) and Punjab National Bank are the largest but there are a handful of smaller, less liquid banks as well. Most foreign investors who have taken a stake in Indian financial services companies have chosen to invest in private sector banks such as HDFC, HDFC Bank and ICICI Bank. While these investments will likely prove highly profitable over a long period of time, I believe that buying PNB allows investors to participate in the very positive secular growth trend that is currently occurring in India at a price that is significantly below liquidation value even though the bank not only will not be liquidated, but will thrive over the next few years. While private banks such as the ones mentioned above have proven very successful in building enviable franchises over the past decade, the state-owned banks, which include the largest bank in the country, State Bank of India, have been around for far longer and have built large, profitable, defensible branch networks.
The current business environment in India should be nirvana for banks, and the valuations of the private sector banks reflect this reality. ICICI Bank (generally considered lower quality) and HDFC Bank (the highest quality bank and management team in the country) are trading at 2.0x and 3.0x forward book values and 11x and 16x forward earnings, respectively. PNB, however, is trading at 1.1x forward (FY 2005 ending March 31, 2005) book value on an Indian GAAP basis and approximately 77% of it true economic (and U.S. GAAP) forward book value. The disparity between Indian GAAP book value and economic book value lies in a large unrealized gain on PNB’s securities portfolio, which I will address later in this write-up. PNB is trading at 5.1x FY 2005 projected earnings. I expect these earnings to grow by 15% - 20% per year for the next few years. So where is the hair on one? I will address that as well, although I believe that the “hair” on PNB is overly discounted by the market and intrinsic value is about 100%-200% higher than the current trading price.
Foreign investors have historically ignored the state-owned banks in India because they were viewed as deficient in their application of technology and saddled with non-performing loans. Moreover, these banks were forced by the government to fund infrastructure and other projects that did not provide an adequate risk-adjusted return. However, in recent years these banks have dramatically reduced their bad loans and implemented technology throughout their organizations (PNB being among the most advanced in technology upgrades). Moreover, the ruling party in India since 1999, the Hindu-nationalist BJP, is very business-friendly and has stopped most of the value-destructive activities of prior administrations. The BJP recognizes that the state-owned enterprises must be managed to compete with private sector organizations. Since coming to power in 1999, the BJP has privatized state assets in telecommunications, energy and the automobile sectors. In the coming weeks, the government plans to sell stakes in the country's largest oil exploration firm and five other companies to raise around $3 billion to meet its privatization target for fiscal 2003-2004. Jagdish Shettigar, economic adviser to the prime minister, recently commented in an interview that if the BHP is to win elections in April/May (they are predicted to win by a wide margin), it may totally divest or at least reduce the government's holdings in public sector banks, which we view as a huge opportunity for investors (a free option at the current prices).
Brief Macro on India
Over the last few years, the BJP has shown a strong willingness to implement the reforms necessary to drive strong economic growth in India over the next decade. The BJP is committed to making India a more efficient place to do business for foreign investors and plans to relax labor laws, which currently make it hard for companies to retrench or fire workers, and speed investment approvals. With strong secular trends such as outsourcing, a rejuvenated Indian consumer, and a government that is more pro-business than any other prior administration, it is not unreasonable to expect that India will continue to outperform most economies in the world. India’s GDP has been growing and is projected to continue to grow at rate of approximately 8%.
We consider the demographics of India to be exceptionally favorable for financial institutions. Firstly, the population is massive (1.1BN) and growing quickly – approximately 3.4% p.a. Secondly, India’s consumer population has extremely low leverage – household debt/GDP is just 2% in India (vs. 77% in the US and 66% in Korea). The combination of a large growing population, which is generally underleveraged combined with a low interest rates environment (by historical standards), suggests that Indian banks are likely to enter a period of massive balance sheet growth, which of course implies rapidly growing earnings.
Consumer lending (primarily mortgages), which has been growing at rates exceeding 30%, has been the primary contributor to loan growth over the past few years. Corporations have had excess capacity and therefore have not invested in capital expenditures. All banks (private and public) are required to hold 25% of their assets in government bonds but virtually all of the banks currently hold substantially more than 25% due to the anemic corporate loan growth and attractive interest rate environment for fixed income. These securities holdings may soon be converted into loans as all signs indicate a substantial, near-term pick-up in corporate borrowing due to 1) improving business confidence, 2) rising capacity utilizations, and 3) lasting political stability. Sectors such as steel, petrochemicals, refineries and cement are running at capacity utilizations of around 90%.
We believe that PNB has a superior franchise in India. Geographically, PNB is focused on the Northern States of India, particularly the area surrounding the capital New Delhi, which has a number of benefits. The benefit of operating in this region of the country is that the banking industry competition in this region of the country is significantly less intense than it is in the western regions of India (around Mumbai) where the vast majority of publicly listed Indian banks operate. Additionally, within this geographic footprint, PNB has a superior branch network, with over 4,000 branches, and over 40MM accounts. This superior franchise leads to what we consider to be a superior balance sheet. Our view is driven by the fact that of all the Indian banks (including private sector), PNB has the highest ratio of low-cost deposits (e.g. savings and checking accounts) as a percentage of total deposits. Low cost deposits drive earnings at a bank, as they represent the cost of goods sold on the income statement. PNB uses virtually no wholesale borrowings to fund its assets, as the rest of its funding is comprised of retail generated CDs. PNB’s low cost deposit mix drives the lowest cost of funding amongst all the Indian banks, which in turn drives the highest net interest margin in the sector.
We believe that PNB’s franchise underpins not only a strong deposit base and superior margins, but also drives superior loan and balance sheet growth. Over the last five years, total loans have grown at approximately 20% p.a. at PNB, vs. 14% at the State Bank of India and Bank of Baroda at 13%. Retail loans, which comprise 16% of PNB’s total loans, grew at a 38% rate year over year in the most recent quarter. The remaining loan book primarily consists of corporate loans, with approximately 13% of total loans coming from the agricultural sector. Given the large percentage of corporate loans, PNB’s loan growth should accelerate in the likely event of a pick-up in corporate capital expenditures and borrowing. PNB’s management team has indicated to us that the company should sustain high-teens loan growth into the foreseeable future (absent a significant pick-up in corporate borrowing), which would drive earnings growth in the 15-20% range assuming some net interest margin compression.
Indian banks have benefited significantly from the fall in interest rates in India over the past few years, and are carrying large unrealized gains on securities on their balance sheet. PNB has a huge unrealized bond gain on its balance sheet. While banks are not required to report their unrealized gains on a quarterly basis, PNB management has told us that the unrealized gains on the bank’s balance sheet are approximately 50 billion rupees, close to the company’s market capitalization of 66.75 billion rupees and unadjusted (unadjusted for unrealized gains) book value of approximately 50 billion rupees.
One element of the company’s balance sheet management over the last four years that we particularly like is that the management aggressively taken securities gains (see item A in the table below), and used those gains to increase their reserves for loan losses (item B), as opposed to sending those gains to the bottom line to inflate earnings. Note that gross NPLs represent total non-performing loans/total loan book while net NPLs represent (total non-performing loans – reserves for non-performing loans)/total loan book. Net NPL ratios do not consider collateral values, which if considered would substantially reduce the risk of loan losses. Figures in the table below are in billions of rupees; also note that FY 2003 ended in March 2003:
Improvement in Reserves
F2000 F2001 F2002 F2003
Gain on Sale of Securities (A) 2,149 2,163 3,797 6,022
Net Reserve Additions (B) 722 3,792 7,409 11,233
Gross NPLs 13.15% 11.68% 11.28% 11.40%
Net NPLs 8.49% 6.68% 5.27% 3.80%
As of December 2003, the Net NPL ratio had been further reduced to 2.2% of loans through further aggressive provisioning. In our discussions with management we believe that they are likely to continue to aggressively realize their bond gains in order to boost reserves and that they will be able to have zero NPLs by March 2005. The only other Indian bank to have a target of zero NPLs (Oriental Bank) trades at a significant premium to the other state banks.
We consider the valuation of PNB to be extremely compelling. On an Indian GAAP basis, the stock is currently trading at approximately 1.15x projected March 2005E stated and tangible book value of 220 rupees per share, and approximately 5x March 2005E earnings. However, we believe that there are two major adjustments to book value which should be made to reflect the real economic book capital of the company. Stated book value should be adjusted to include the massive after-tax unrealized bond gains that the company has on its balance sheet because of securities purchased in higher rate environments. Under Indian GAAP, a bond portfolio is not marked to market, and hence unrealized bond gains are not reflect in the value of equity. However, under US GAAP, bonds which are available for sale are marked to market, and hence equity is effectively increased to the value of unrealized bond gains. We believe that this adjustment is reasonable, given that the bank could at any time realize these bond gains, and substantially increase the value of the balance sheet (although it would take a significant hit to net interest margin as the higher yielding securities sold would have to be replaced with lower coupon securities). Additionally, we believe that stated book value should also be reduced by the value of the net non-performing loans on the balance sheet (gross NPLs are greater than reserves, thus net NPLs are positive). As noted above, we believe this treatment of NPLs for valuation purposes is conservative given that it gives no weight to collateral values. When these adjustments are made, we believe that true economic book value at the company will be closer to Rs 325 per share (see table below) at the end of fiscal year 2005 – which would suggest that the stock is currently trading at about 79% of forward economic book value – i.e if the company were shut down, and the existing business has no value, the investor would recognize a 25%+ return. Note that this analysis gives no consideration to the value of real estate on the bank’s balance sheet either. It is impossible to quantify, but we have been told that the branch network alone is worth a fortune in terms of the market value of real estate.
PARAMETERS (Rs million)
Y/E MARCH FY04 FY05
Current Mkt Price 250 250
Equity 2,653 2,653
Net Worth 46,929 58,336
Net NPAs 9,435 7,601
Unrealised Gains 50,000 50,000
Mkt Cap (Rs million) 66,325 66,325
Mkt Cap ($ million) 1,458 1,458
Net Profit 11,089 12,733
Growth Rate (%) 31.7 14.8
PPP 21,058 23,209
EPS (Rs) 41.8 48.0
Bookvalue (Rs) 176.9 219.9
ABV for NPAs (Rs) 153.8 201.3
ABV for NPAs and Bond Gains (Rs) 276.3 323.8
ROE (%) 24.5 22.8
ROA (%) 1.2 1.2
Net NPA (%) 2.0 1.4
Cost to Income Ratio (%) 43.5 49.5
Dividend (Rs per share) 4.5 5.5
P/E (x) 5.98 5.21
P/Book (x) 1.41 1.14
P/ Ad. Book (NPAs) (x) 1.63 1.24
P/ Ad. Book (NPAs and Gains) (x) 0.90 0.77
P/ PPP (x) 3.15 2.86
Dividend Yield (%) 1.80 2.20
Risks/The Bear Case
The primary argument against the state-owned banks is no longer that their technology is antiquated. PNB has computerized branches comprising 89% of its business, installed 353 ATMs and is implementing a core banking solution networking all of its branches. The primary argument against owning the banks centers on their inability to take bond gains when rates inevitably rise (real rates are negative in India). Moreover, given the high yield on state-owned banks’ securities portfolios, the argument is that their NIM and profitability measures will collapse when they have to reinvest bond sale proceeds at the prevailing lower rates. First, it is important to note that PNB has taken provisions for NPLs in excess of bond gains every year. So, while bond gains may slow in a rising rate environment, so will provisioning as PNB approaches zero NPAs. PNB only has 12.7 bn rupees of Net NPAs, so PNB could eliminate all net NPAs by realizing only 25% of its bond gains. The duration on PNB’s portfolio is approximately 5 years and they intend to hold the vast majority of bonds till maturity, so the chance of a collapse in NIMs anytime soon is minimal. In fact, PNB’s NIM has been remarkably stable over time. The lowest it has been in the last 10 years is 3.45% and it has been as high as 4.25%. This variance in NIMs is similar to a bank in the U.S., yet investors still fret about the securities portfolios. If rates were to rise, PNB’s NIM would benefit due to the high proportion of low-cost deposits. Moreover, in a rising rate environment, they have substantial cushion against a write-down in the value of their bond portfolio given the amount of unrealized gains. If rates were to fall, PNB’s securities portfolio would become even more valuable. As PNB’s margin holds up over the next few years, it is likely that investors will continue to re-rate PNB and the other state-owned banks.
Finally, investors are very concerned about a potential merger that was recently announced. PNB notified investors that it is considering an acquisition of some of the assets of IFCI. IFCI is state owned lender whose business is, by government mandate, largely focused on the project finance business. IFCI currently has assets of approximately $3BN, and has negative equity. Structurally, IFCI is an extremely challenged and disadvantaged business model. IFCI is unable to take deposits, and hence is basically funded by wholesale borrowings. A significant portion of these borrowings are fixed at extremely high rates (up to 17%), and as interest rates have declined in India and globally in recent years, IFCI has endured a massive margin squeeze as asset yields have declined. Secondly, IFCI has suffered enormous credit losses in recent years, and many of its borrowers defaulted on high fixed rate loans. Historically, IFCI has been largely focused on the social purposes of the business as opposed to profit motives.
The Government has asked PNB to acquire IFCI, and PNB has conditionally and conceptually agreed to make an offer to the government for the business. The market is quite skeptical of this merger given that no details have been given and IFCI is such a poor performing institution. However, our conversations with bankers in India lead us to believe that IFCI will be acquired on terms that are at worst fair, and potentially advantageous to PNB. Our understanding is that IFCI will be separated into “good” and “bad” assets, and that the bad assets will be transferred to a “work-out” company owned by the government before PNB acquires IFCI. PNB will only acquire the performing assets of IFCI. We have also been informed that any acquisition will be subject to substantial due diligence before PNB will be required to enter a bidding price for the business. Finally, the government has indicated that it will provide PNB with large tax benefits as a result of the merger. These preconditions to an acquisition lead us to believe that the acquisition of IFCI will probably be a positive for the bank and even if it is neutral to shareholder value, the stock will likely react favorably as the cloud of uncertainty dissipates. We believe that the acquisition of IFCI will be beneficial to PNB as PNB will be able to grow its loan book significantly (allowing PNB to realize even more bond gains without sacrificing earnings) and improve IFCI’s margins by replacing high-cost borrowings with low-cost deposits.
The government needs to divest state-owned assets to raise funds and is very pro-business in general. It is not in the government’s interests to saddle one of their largest banks with non-performing assets so that you take one problem and magnify it into a bigger problem that affects the security of public deposits. We will know more regarding the details of the merger in the coming months.
1. zero net npls in a year
2. clarification of the terms of the IFCI merger
3. margin and profit resilience in a rising rate environment