Indian Old Private Banks: Southern vintage

Old generation private banks are strong regional plays, with niche operations and loyal customer bases. Over the last few years, they have implemented contemporary technology, put in place superior HR practices, capitalized themselves, and have become more aggressive in their domain areas. Strong growth in home state economies coupled with rising per capita income has helped them to report strong financial performance. Further, these banks are ideal takeover candidates post FY09, once RBI allows foreign banks and corporate houses to acquire Indian banks. Given the high earnings visibility, clean asset book and superior return ratios, we believe that current valuations offer significant upside.

Robust growth backed by buoyant home state economies: Old private banks have a strong presence in South India, and have been the larger beneficiaries of the buoyancy in home state economies and rising per capita income. Strong relationships with customers built over several decades of existence, niche areas of operations, and expanding branch network are their key strengths, which would enable them to sustain higher growth. They have developed strong technology platforms (100% CBS) and have in place skilled manpower to take on the competition head-on. Risk management systems have improved significantly, leading to robust asset quality.

Stronger fundamentals than state-owned banks: Following structural transformation in their areas of operations, the old private banks have reported healthier financials than their state-owned counterparts. Average margins for these banks are 3.1%, higher than an average of 2.7% for state-owned banks. They are cost efficient, with cost to income ratio at ~42% (~50% for state-owned banks). Except for South Indian Bank, these banks enjoy high RoAs of 1.3%+ (higher than an average of 1%+ for state-owned banks).

Valuations attractive; option value from possible M&A: We believe that valuations are attractive at 0.8-1.3x FY10E BV, with RoEs of 15-20%. While these banks are a play on earnings growth (we expect their earnings to grow at 22% CAGR over FY08-10), possible M&A post FY09 could bring in significant option value. Recently, HDFC Bank acquired Centurion Bank of Punjab (CBoP) at market cap/branch of ~Rs285m and market cap/customer of ~Rs45,000. Old private banks are trading at an average market cap/branch of ~Rs58m and average market cap/customer of Rs7,250. We initiate coverage on City Union Bank, Karur Vysya Bank and South Indian Bank with a Buy rating and maintain our Buy rating on Federal Bank and Karnataka Bank.