Indian banks in best shape in a decade, says Nomura; picks IndusInd, ICICI & Axis Bank as top picks

Global brokerage Nomura believes that the Indian banking sector is in the best shape in a decade and is ripe for picking for the mid-to-long term. The investment thesis for Indian banks is as solid as ever, as per the brokerage.

"Indian banks are in a sweet spot, in our view. They are well-capitalized, the credit cycle is benign and profitability is at its highest level in a decade. We believe they are at the cusp of a multi-year credit cycle, notwithstanding any near-term demand disruptions arising from an uncertain macro. Sector valuations are attractive, and we expect strong 17% RoEs (returns on equity) across the sector over FY23-25F," said the brokerage.

Nomura prefers banks that have a strong liability franchise and RoA outlook. Based on this, it has listed ICICI Bank, Axis Bank and IndusInd Bank as its top picks in the space with up to 20-23 percent upside potential. However, it has downgraded AU Small Finance Bank to ‘Reduce’ from ‘Neutral’.

Retaining it positive view on the space, the brokerage noted that NPLs (non-performing loans) are near decade lows, with bank capitalization levels and provision coverage at or near all-time highs. It also pointed out that sector RoAs are also at their best levels in a decade, which Nomura believes is sustainable over FY24-25F.

However, Nomura stated that sector P/B valuations are still slightly below their 10-year averages and it also offers a secular market share gain story, from PSU banks to private, which continues to play out. While the demand outlook in an uncertain global macro backdrop is a key near-term concern, the brokerage believes the sector is ripe for picking from a medium to long-term perspective. Further, the credit cycle is benign and profitability is at its highest level in a decade – which means banks are at the cusp of a multi-year credit cycle, added Nomura.

While Nifty Bank has strongly outperformed the benchmark in the last one year, up 30 percent versus an 18 percent gain in Nifty. This same trend has not been seen in 2023 YTD on the back of overall weakness and volatility in the market sentiment. In the current calendar year, Nifty Bank has added a little over 2 percent as against a 4 percent rise in benchmark Nifty.

Investment Rationale

On a strong footing

The brokerage notes that the supply constraints previously weighing on Indian banks (arising from high corporate NPLs, and low capital) have eased sharply over the last three years. From a demand perspective, both Indian corporates and end-consumers are relatively under-leveraged compared to the rest of the world, and in a solid shape, it added.

"While interest rates have picked up sharply over the past year, rates across product segments are not significantly higher than pre-Covid levels. Historically, the Indian banking sector’s credit growth has stalled primarily on NPL-related concerns (and not rates, in our view), and asset quality continues to be robust," it explained.

Nomura expects sector credit to record a healthy 13 percent CAGR over FY23-25F, with private banks registering a strong 18 percent CAGR, adding that a broader revival in corporate capex (which has remained elusive for a decade) provides further optionality.

However, the key near-term challenge for the sector is deposit mobilization, and this too is showing signs of a sustainable revival, aided by recent rate hikes in term deposits, it warned.

NIMs – higher for longer; prefer banks over NBFCs

The brokerage further pointed out that NIMs (net interest margins) of Indian banks have expanded sharply over the past year and may already be near peak levels. However, Nomura's analysis shows that NIM moderation will only be gradual, with support from upward re-pricing of non-repo linked loans (that is yet to largely play out).

It also clearly prefers banks over NBFCs, where it expects higher NIM pressure and lesser comfort on valuations on average.

Nomura sees banks to report 16 percent/ 13 percent core PPoP growth over FY24/25F. Banks’ strong contingent provision buffers as well as potential upside from treasury gains should still support RoAs at 1.8 percent (15 percent PAT CAGR over FY23-25F), in its view.

The brokerage also noted that its PPoP and PAT estimates for ICICI Bank, Axis Bank and SBI are 3-4 percent ahead of Bloomberg consensus led by higher NII.

"Our sensitivity analysis also shows that if we were to assume a sharp 50bp rate cut towards the end of FY24F, the impact on RoAs for large private banks could be limited to 10 bps in FY25F," it forecasted.

Top picks

Nomura said that it prefers banks with strong liability franchises (in an environment where deposits are a relative challenge) and a strong RoA outlook, adjusted for valuations. Thus, ICICI Bank and Axis Bank are its top picks while IndusInd Bank is its key alpha idea, as a rare RoA expansion story going into FY24F, that is also well-hedged against possible interest rate cuts.

Meanwhile, it downgraded AU Small Finance Bank to a non-consensus Reduce from Neutral. AU Bank is the most expensive stock with the lowest RoE outlook in coverage, it said.

It also prefers ICICI Bank and Axis Bank over HDFC Bank, which has a high ask rate on deposit growth (and hence opex).

Nomura also likes Bandhan Bank to play the late-cycle RoA recovery in microfinance. Likewise, it likes the State Bank of India for its RoE delivery but noted that it would require a sustainable pick-up in capex activity for further re-rating. However, Kotak Mahindra is relatively less preferred for its lower RoE outlook and impending management transition, said the brokerage.

Nomura has a ‘buy’ call for IndusInd Bank with a target price of ₹1,600, indicating a potential upside of 27 percent. Meanwhile, it sees a 20 percent upside for HDFC Bank, ICICI Bank and Axis Bank each with a ‘buy’ call and target prices of ₹1,895, ₹1,120 and ₹1,160, respectively.

It also has a 'buy' rating on Bandhan Bank with a target price of ₹325, suggesting an upside of 40 percent.

On the other hand, it is 'neutral' on the Kotak Mahindra Bank with a target price of ₹2,040, an 11 percent upside, and it has a price target of ₹650 for AU Small Finance Bank, indicating a downside of 12 percent.

Among PSU banks, it has ‘buy’ calls on State Bank of India and Bank of Baroda with a target of ₹680 and 230, respectively.