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Lehman Coverage on PNB + Canara + BOB + UBI + IOB

Lehman Brothers equity research has initiated coverage on Goldmines of the Indian Capital Market, PSU banks. Lehman has a OVERWEIGHT rating on Punjab National Bank, Canara Bank, Bank of Baroda, United Bank of India and Indian Overseas Bank.
Expect a positive delta in operating metrics vis-a-vis the trend seen in the past three years, supported by a benign operating environment. These banks are currently trading at a material discount to SBI, which we think is unjustified. Note that this valuation gap has emerged only since April 2007. These Public sector banks are trading at an unjustified discount to private sector banks which is unjustified.

Over the medium term, we believe regulatory moves will be a key driver for the sector and especially public sector banks. Going by recent developments, expect regulatory moves to be benign for public sector banks. Peaking of interest rates provides a favourable background for stock performance, in our view. A turnaround in the interest rate environment will act as a trigger for stock performance.

Punjab National Bank:
Forecast high profitability driven by a 44% Current and Savings Account (CASA) ratio and strong fee income growth. Expect weak margins to rebound to 3.9% in FY08E as credit demand picks up and high-cost bulk deposits are re-priced. PNB runs a structurally sound franchise business characterized by a high CASA ratio and a strong fee income revenue stream. Near-term dampeners such as uptick in fresh slippages and drop in margins are likely to wear off over the next few quarters, in our view. Lehman expects the bank to report a 20% earnings CAGR on a 21% CAGR in advances over FY07-FY10E. On estimates, the bank will generate 18% ROE in FY10E. At 1.6x FY09E ABV and 8.2x FY09E earnings, current valuations are not demanding. Initiate coverage of the stock with a Overweight rating and a 12-month price target of INR720

Canara Bank:
Current weakness in margins has been driven by a low incremental C/D ratio in 1HFY08, but with no contraction in spreads. With credit growth likely to pick up strongly, we believe margins have bottomed, and we expect the bank to post healthy core earnings for 2HFY08. At 1.0x FY09E adjusted B/V and 6.4x FY09E earnings, current valuations are attractive, in our view.

Lehman expects Canara bank to report an EPS of Rs 34.6 and Rs 42.6 for FY08 and Fy09 respectively. Based on dividend discount model (DDM) and adding INR10 for value of investments in NSE and NCDEX, Lehman arrives at a 12-month forward fair value of INR340, at which price the stock would trade at 1.2x FY09E adjusted B/V and 8.0x FY09E earnings.

Bank of Baroda:
Bank of Baroda's current profitability is one of the lowest among its peers, expect some improvement, driven by rising cost and capital leverage. Estimate an ROE of 16% in FY10E, up from 11.5% in FY07. BOB offers potential higher reward, based on the valuations of 25% - owned UTI Asset Management Company (UTI AMC), which is seeking an initial public offering (IPO) in late FY08.

Despite factoring in lower profitability, believe Bank of Baroda's current valuations offer a favorable risk reward. Initiate coverage with a 1-Overweight rating and a 12-month PT of INR430, based on 1.2x FY10E adjusted B/V and 7.8x FY10E earnings, which are still at discounts to our valuations of other public sector banks, thus capturing the lower profitability of the bank.

United Bank of India:
Profitability is contingent on calibrating loan growth given the low Casa ratio. However, management's focus on profitability rather than growth is a positive.Reserve Bank of India (RBI) guidelines, which allow banks to shore up their tier-1 ratio through non-cumulative preference shares, is a big positive given the bank's capital constraint.

Building in a sustainable return on equity (ROE) of 14.5%. However, at 1.3x FY09E adjusted B/V, we believe current valuations are attractive even after factoring in lower profitability for the bank. Based on dividend discount model (DDM) methodology, arrive at a 12-month forward fair value of INR230; at which price the stock would trade at 1.5x FY10E adjusted B/V and 7.4x FY10E earnings.

Indian Overseas Bank:
Structural factors such as sector-leading NIMs, a low cost/income ratio and efficient capital utilization drive current profitability. Despite the high core profitability, the stock is yet to see any material re-rating and continues to move in a band with other public sector unit (PSU) banks on P/B multiples.

The stock is a strong candidate for re-rating. Based on dividend discount model (DDM), arrive at a 12-month price target of INR200. Based on the target price, the stock would trade at 1.5x FY10E adjusted B/V and 6.2x FY10E earnings.

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