Union Bank - calibrated growth

Union Bank's calibrated growth and high leverage have maintained its profitability. The bank's NIMs and investments portfolio are vulnerable to rate hikes, in our view, but improving low-cost deposits offer some relief. We hike our COE but retain our Buy recommendation.

Calibrated growth, high leverage boost ROE
Union Bank has been pursuing calibrated growth. The moderate growth in loan book with a traction in low-cost deposit mix led to stable NIM on a qoq basis at 2.63% in 1QFY09. In FY09, management expects NIMs to be flat yoy at 2.8%. We, however, reduce our NIM estimate for FY09 from 2.70% to 2.62%, given the tight liquidity situation (2.69% in FY08). However, we also note that Union Bank's low tier-1 capital leads to increased leverage, which results in higher ROE than its peers.

MTM losses drag profits lower, but asset quality appears good
As at end June 2008, Union Bank had 32.6% of its investments in the available-for-sale category, the duration of which was 2.72 years. With short-term yields expanding about 170bp qoq, the bank had to book a mark-to-market loss of Rs3.39bn in 1QFY09. Asset quality appears good with incremental delinquency declining from 1.93% in FY06 to 1.23% in FY08 and further to 0.85% in 1QFY09. We estimate the provision charges (loan loss and mark-to-market provisions) in FY09F will increase from our earlier estimate of 0.73% to 1.0%.

Low capital adequacy is a constraint
Union Bank is capital efficient but also capital constrained to an extent. Therefore, it will likely benefit from any banking law amendment that allows public sector banks to issue non-voting shares. Alternatively, the government will have to subscribe to the shares in rights issue. We believe this will likely alleviate capital adequacy concerns. We estimate Union Bank's tier-1 CAR will be a low 7.3% by March 2009.

We retain our Buy rating but cut our earnings estimates and target price
We marginally cut our FY09-10 earnings estimates and have changed our estimates for profitability (ROA). The cut in our target price is due to an increase in the cost of equity from 13% to 15%. We retain our Buy recommendation but with a new target price of Rs172.40 (from Rs215.4). At our new target price, the stock would trade at 6.8x FY09F earnings and 1.3x FY09F adjusted book value.