Bank of Baroda - Under a cloud due to high COE

BOB will likely find itself behind a cloud in the prevailing challenging environment. We raise our loan growth and fee income estimates but also increase our cost of equity estimate to 15.0%, leading to the cut in our target price. We retain our Buy recommendation.

Low profitability relative to peers is a liability in a challenging scenario
Bank of Baroda's (BOB) NIM declined from 2.83% in 4Q08 to 2.76% in 1Q09 and is now among the lowest in the peer group. The bank's FY08 return on average assets of 0.92% is also low relative to peers. We consider this a liability in a rising rate scenario, as reducing margins could lower profitability even further. Return on equity in 1Q09 was only 14.97%, even though leverage was high, represented by a low tier-1 CAR of 7.89% as of June 2008.

However, the performance in 1Q09 was generally encouraging
Except for the decline in net interest margins, BOB's performance in 1Q09 was encouraging. Core fee income grew strongly, with fees rising by 45% yoy, the cost-to-income ratio fell and the share of the low cost deposits in total deposits increased. These helped offset the rise in provisions due to mark-to-market losses. However, overall profitability (ROAs) came in at only 0.81%.

We raise loan growth and fee income estimates but margins concern us
BOB's loan growth of 42.1% appears exaggerated because of base effects - qoq growth in loans was 4.2% compared with the industry average of about 2.6%. We believe, however, that loan growth will sustain its momentum and we revise our FY09 loan growth estimate from 18.4% to 22.3%. We also increase our fee income estimate by 12.2% for FY09 and 12.5% for FY10. However, we believe a NIM of about 2.5% will not be materially different from that of FY08. The cut
in our net interest margin estimates leads us to cut our FY09 profit estimates by 6.8%.

A hike in the cost of equity reduces our target price to Rs281.50
The sensitivity of BOB's target price to changes in the cost of equity is high, given its low return on equity. The hike in cost of equity to 15.0% from 13.0% thus pulls down the target price-to-book multiple from 1.4x FY09F adjusted book value to about 1.04x. At our new target price, the stock would trade at 6.6x FY09F EPS.