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PSU banks: Valuations steadily turning less attractive

The current benign credit environment has supported asset quality for PSU banks and early warning indicators give us no reason to worry. Profitability has been further boosted by provision reversals and revenue recovery from bad loan resolutions. While these recoveries will likely hold up in FY2025E as well, a steady decline is inevitable thereby impacting profitability. Given the swift re-rating of valuation multiples, we downgrade Canara (REDUCE) and PNB (SELL), while retaining ADD rating on BOB and Union Bank.

Credit cost likely to decline for Tier-2 PSU banks in FY2025E

Steady resolution of stress from the corporate NPA cycle has resulted in a significant improvement in asset quality for PSU banks over the past few years. These banks have also been able to limit the impact from the Covid pandemic, contrary to expectations of many. Slippages have declined across most segments for all PSU banks and early warning indicators are benign as well. At the same time, net NPA ratio has also declined closer to ~1.0% for the Tier-2 PSU banks, thereby reducing the requirement for incremental provisions. This drives our expectation of a meaningful decline in credit cost in FY2025E.

Bad loan recovery supporting revenues, but it will eventually decline

PSU banks currently carry a large pool of bad loans (~Rs10.6 tn) across GNPA and technically written-off (TWO) accounts. This pool has served as a source of steady recoveries resulting in provision reversals as well as significant revenue contribution (across both interest income and non-interest income). Exhibit 4 shows that revenue from recoveries has contributed 15-50% of PPOP for some Tier-2 PSU banks in recent quarters. While bad loan recoveries are unlikely to decline sharply in FY2025E, they will decline eventually as the pool of bad loans ages and declines. This will inevitably put pressure on profitability, thereby making it difficult for the Tier-2 PSU banks to sustainably deliver better return ratios than SBI. 

Prefer SBI among PSU banks; downgrade Canara (REDUCE) and PNB (SELL)

As highlighted in our previous report, Tier-2 PSU banks have seen a sharp valuation re-rating over the past two years, resulting in a swift convergence in the valuations of all PSU banks closer to SBI. As a result, making an investment case for Tier-2 PSU banks has become challenging given that SBI has demonstrated a superior franchise across all key metrics: through-the-cycle credit cost, liability franchise and asset franchise. We continue to prefer SBI (retain BUY) as our preferred stock within the PSU bank space, while retaining an ADD rating on BOB and Union Bank. We downgrade Canara Bank to REDUCE and PNB to SELL. We have incorporated the recent equity capital raise by Union Bank in our model and tweaked estimates marginally. We value the PSU pack as follows: SBI (~1.4X), BOB (~1.1X) and the rest (Canara, Union and PNB) at ~1.0X FY2026E BVPS (adjusted) while maintaining the same pecking order.

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