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Bank of India ABN Jul07[1]

Bank of India ABN Jul07[1]

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Bank Of India
Bank Of India

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Monday 30 July 2007

Change of target price

Bank of India Ride the rally...
Bank of India's earnings visibility is high compared with its peers. FII holdings in the stock are below the regulatory maximum of 20%. We believe its premium valuation will be sustained. We stay at Buy with a revised target price of Rs303.5.

Buy
Absolute performance

n/a
Short term (0-60 days)

Neutral
Market relative to region Banks

India
Price

Key forecasts
FY06A Reported PTP (Rsm) Reported net profit (Rsm) Reported EPS (Rs) Normalised EPS (Rs) Dividend per share (Rs) Normalised PE (x) Price/book value (x) Dividend yield (%) Return on avg equity (%)
Accounting Standard: Local GAAP Source: Company data, ABN AMRO forecasts

Rs254.00
Target price

FY07A 15328.0 11231.0 23.0 23.0 3.50 11.0 1.98 1.38 20.6

FY08F 18711.5 13098.1 26.8% 26.8% 4.50& 9.47& 1.78 1.77 20.3%

FY09F 23444.8 15825.2 26.9 26.9 5.00 9.44 1.38 1.97 17.7

FY10F 27346.5 18458.9 31.4 31.4 5.00 8.09 1.20 1.97 15.9

Rs303.50

(from Rs264.00)

9156.8 7014.6 14.4 14.4 3.00 17.7 2.49 1.18 14.8

Market capitalisation

Rs123.99bn (US$3.05bn)
Avg (12mth) daily turnover

Rs181.92m (US$4.08m)
Reuters Bloomberg

BOI.BO

BOI IN

year to Mar, fully diluted

Ride the rally, maintain Buy; valuation rolled forward to FY09 BOI has been the best performing stock in our PSU banks coverage universe over the past three years. We believe the stock will sustain a premium valuation given the high earnings visibility and quality of earnings. We maintain our Buy rating, rolling forward our valuation to FY09 and, consequently raise our target price to Rs303.5. At our target price the stock would trade at 1.8x FY09F adjusted book value and 11.3x FY09F earnings. Earnings normalisation ahead; ROE set to remain high The better-than-peer stock performance from FY05 to FY07 was due to an improvement in core operating earnings. We believe the recent improvement in operating parameters will normalise in FY08. We expect ROA to remain stable around 0.9% up to 2010. We expect ROE to average 18% over FY08-10. Calibrated growth is the key positive BOI has enjoyed moderate loan growth with little recourse to bulk deposit markets and maintains a de-risked treasury portfolio. Improving asset quality on the back of control over incremental defaults and aggressive provisioning have also been positive triggers. Equity dilution ahead; FII ownership is below the maximum limit We postpone our forecast for the equity dilution of 100m shares from FY08 to FY09, based on management guidance. As of June 2007, BOI had foreign ownership of 16%. Our valuation methodology assigns a 10% premium for the open FII limit. Excluding the premium, our fair value would be reduced to Rs276, equating to 10.3x FY09F earnings and 1.6x FY09F adjusted book value.

Price performance (1M) Price (Rs) Absolute % Rel market % Rel sector %
Aug 04 300 250 200 150 100 50 0 BOI.BO Aug 05

(3M) (12M) 195.4 30.0 18.6 22.4
Aug 06

220.5 15.2 9.1 10.7

108.4 134.2 65.1 97.0

Sensex

Stock borrowing: Difficult Volatility (30-day): 41.29% Volatility (6-month trend): ↓ 52-week range: 276.20-101.60 Sensex: 15234.57 BBG AP Banks: 182.50
Source: ABN AMRO, Bloomberg

Researched by
ABN AMRO Institutional Equities Team
Priced at close of business 27 July 2007. Use of %& indicates that the line item has changed by at least 5%.

www.abnamrobroking.co.in

Mafatlal Chambers – C Wing, Ground Floor, N.M. Joshi Marg, Lower Parel (E), Mumbai 400 013, India. Tel : +91 022 6754 8411 Fax : +91 022 6754 8420

The Basics
Key assumptions
We forecast loan growth of about 18.5% for FY08-10, with stable net interest margins of about 3.0% and core fee income at 0.5% of average assets. We also expect intermediation costs to fall and operating expenses as a proportion of average assets to decline to 1.7% in FY10F from 2.2% in FY07A. Over the same period, we expect the operating expenses to core income ratio to decline from 53% to 45%. Provisions for bad loans are expected to stay at 1.0% of average loans and tax incidence is expected to rise from 27.9% in FY07A to 32.5% in FY09-10F. We expect the interplay of these factors to result in net profit growth of 16.6% in FY08, 20.8% in FY09 and 16.6% in FY10.
Key events
Date Event

Versus consensus
EPS (Rs) 2008F 2009F 2010F ABN AMRO 26.8 26.9 31.4 24.9 30.4 n/a Cons % diff 7.6% -2.3% n/a

Source: Bloomberg, ABN AMRO forecasts

How we differ from consensus
Our FY08F EPS is 7.6% higher than the Bloomberg consensus estimate and our FY09 EPS estimate is 2.3% lower. We believe the FY07A performance has not yet been factored into consensus estimates. The consensus EPS estimate of Rs24.9 for FY08 is only 7% higher than the FY07 EPS figure.

July 2007 RBI's quarterly review of the annual policy
Source: RBI

Valuation and target price
Our 12-month target price of Rs303.50 is arrived at using the Gordon Growth Model. We estimate BoI’s sustainable ROE at an average of 16.8% for FY09-10 and apply a long-term growth rate of 7.0% and a cost of equity of 13.0%. This gives us an implied price to book multiple of 1.6. We assign a premium of 10.0%, factoring in that the FII holding is below the regulatory cap of 20.0%, which allows interested foreign investors to acquire the stock, and arrive at a target price to book of 1.8x.

Forced ranking*
Company Andhra Bank PNB Bank of India OBC HDFC Bank Canara Bank SBI ICICI Bank UTI Bank Rec Upside / downside Buy Buy Buy Hold Buy Hold Buy Hold Sell 34% 27% 19% 16% 12% 9% 3% 2% -6%

Catalysts for share price performance
We expect the following factors to drive the stock price towards the target price: Moderate loan growth, with stable net interest margins; Low loan loss provision charges that should sustain profitability; and, Relatively low FII holding and strong fundamentals which should sustain a premium valuation.

* by difference to target price as at time of publication. Recommendations may lie outside the structure outlined in the disclosure page Source: ABN AMRO forecasts

Risks to valuation and target price
Key risks to our target price, investment case and forecasts are: A deceleration in economic activity, particularly industrial demand and investment activity; Rapid increases in domestic interest rates, particularly long bond yields; Sudden changes in the asset quality cycle and a deterioration in the quality of existing assets and, consequently, higher-than-estimated loan loss provisions; Higher-than-estimated capital infusion for the life insurance business which could put pressure on scarce resources; and, Fall in net interest margins accompanied by stronger volume growth which would put pressure on capital adequacy and bring forward capital raising plans.
Volatility (30-day)
120 % 100 % 80 % 60 % 40 % 20 % 0% Jul Jun 02 03

Mar Jan 04 05

Nov Sep 05 06

Jul 07

Source: Bloomberg

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Key assumptions and sensitivities
Table 1 : Key assumptions
FY06 Credit (% growth yoy) Deposits (% growth yoy) Interest bearing funds (% growth yoy) Interest bearing liabilities (% growth yoy) Net interest margin (% of avg funds) Fee and Other income (% growth yoy) Operating expenses (% growth yoy) Provision for bad loans (% of avg. credit) Provision for Invst depr (% of avg. invst) Provision for tax (% of pre-tax profits)
Source: Company data, ABN AMRO forecasts

FY07 30.3% 27.5% 27.1% 27.3% 3.0% 26.9% 22.5% 1.0% 0.7% 26.7%

FY08F 18.4% 14.9% 14.2% 14.3% 3.0% 5.7% 7.2% 1.0% 0.7% 30.0%

FY09F 18.4% 14.6% 16.5% 14.3% 3.0% 14.0% 10.0% 1.0% 0.6% 32.5%

FY10F 18.6% 17.7% 16.3% 16.4% 3.0% 14.2% 10.0% 1.0% 0.6% 32.5%

16.4% 19.3% 18.1% 18.5% 2.9% 9.7% 6.6% 1.0% 1.1% 23.4%

Table 2 : Sensitivity to net profits
FY06 Sensitivity to 1% change in NIM Sensitivity to 1% change in fee income Sensitivity to 1% change in personnel cost Sensitivity to 1% change in operating costs Sensitivity to 1% change in prov. for bad loans
Source: Company data, ABN AMRO forecasts

FY07 2.4% 0.4% 1.0% 1.7% 0.5%

FY08F 2.3% 0.4% 0.9% 1.5% 0.5%

FY09F 2.2% 0.4% 0.8% 1.3% 0.5%

FY10F 2.2% 0.4% 0.8% 1.3% 0.5%

3.1% 0.6% 1.4% 2.3% 0.7%

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I N V E S T M E N T

V I E W

Ride the rally
Bank of India’s earnings visibility is relatively high in comparison with many of its state-owned peers. FII holding is also below the regulatory maximum, of 20%. We believe the stock’s premium valuation will be sustained.

Ride the rally… maintain Buy
Bank of India’s stock has performed consistently well over the past three years. The stock now trades at a premium to most of its peers. Earnings quality and visibility remain high. We see the stock sustaining this premium valuation and therefore stay at Buy.
Chart 1 : Absolute stock price performance (1 year, 2 years and 3 years)
450% 400% 350% 300% 250% 200% 150% 100% 50% 0% -50% ANDB BOB BOI CBK CRPBK HDFCB ICICIB OBC PNB SBIN UNBK UTIB

BOI has been the best performing PSU bank, on the back of improving core earnings

Absolute - 1yr
Source: Bloomberg data as on 27 July 2007, ABN AMRO

Absolute - 2yr

Absolute - 3yr

The past was great, but we expect earnings to normalise
The improvement in core earnings was behind the near continuous re-rating of the stock seen over the past three years. Going forward, we do not foresee further expansion in profitability. We expect ROA at 0.9% between FY08 and FY10. Key highlights of past performance: Net Interest Margins expanded from 2.73% in FY05A to 2.97% in FY07A. Operating expenses as a proportion of assets came down from 2.34% in FY05A to 2.16% in FY07A. Gross NPLs declined from 5.6% in FY05A to 2.5% in FY07A, thereby increasing the proportion of interest earning loans. This led to a sharp improvement in profitability. The return on assets rose from 0.39% in FY05A to 0.91% in FY07A.

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Chart 2 : ROE vs leverage
25.0 30.0 25.0 20.0 15.0 15.0 10.0 10.0 5.0 5.0 0.0 FY 08F FY 09F FY 10F FY 98 FY 99 FY 00 FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 FY 07

20.0

0.0

Leverage = Avg. Assets / Avg. Equity
Source: Company data, ABN AMRO forecasts

RoAE (%)

We postpone equity dilution to FY09F, as per management guidance
We expect fresh equity to be issued in FY09, as the Bank’s tier-1 capital was already low at 6.66% at the end of June 2007. Though we had earlier built an equity issue into our FY08 estimates, in accordance with management guidance we have now factored this issue into our FY09 estimates. We foresee equity dilution to the extent of 100m shares. Bank of India is one of the few state-owned banks to be well placed on this aspect with the government holding about 69.5%. Post the expected dilution of 100m shares in FY09, we estimate that the government of India’s (GOI) stake will fall to 57.7%, higher than the minimum requirement of 51% and thus providing adequate headroom for additional equity dilution to fund loan growth, should it be needed.
Chart 3 : Shareholding pattern – GOI vs Other (%)
100%

Despite, the expected dilution of 100m shares in FY09, the GOI stake would remain at a comfortable 57.7%

75%

50%

25%

0% FY 07 FY 08F GOI holding (%)
Source: Company data, ABN AMRO forecasts

FY 09F Others (%)

Calibrated loan growth is the key positive
From a fundamental perspective we continue to like the business. We still believe that banks with stable business growth would be in a better position than peers to maintain their margins. We expect BOI to pursue modest business growth with a focus on sustaining margins. So far, it has pursued growth with little recourse to bulk deposits as well as maintained a de-risked treasury portfolio. We estimate loan growth to stay at about 18.5% in FY08-10. On the back of such moderate business growth, we expect lowB A NK O F I N D I A

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cost deposit ratios to remain stable. That will help in sustaining NIMs at about 3% between FY08F and FY10F. Furthermore, we expect the return on assets to remain flat at 0.9% between FY08 and FY10.
Chart 4 : Loan mix (Rs bn, March 2007)
Loans to NHBs and HFCs Commercial 4.2% Others real estate 0.2% 3.6%

Loan book remains fairly diversified, but exposure to SME and Agriculture is high
Export credit 7.3% Infrastructure finance 7.9%

Residential mortgages 9.7%

Auto finance 0.6% Education loan 1.0%

International advances 23.3%

Agriculture 15.6%

Small & Medium Enterprises 26.6%

Source: Company data, ABN AMRO

Increase in loan loss provisions a key downside risk, in our view
The stable earnings growth story is however predicated on a benign asset quality environment. Consistently strong recovery and upgradations of bad loans over FY0507 have helped BOI keep a lid on them. Due to aggressive provisioning and bad loans write-off, provisions for bad loans stayed at about 1% of average loans in both FY06 and FY07. Going forward, we expect provision charges to remain at about 1% of advances. If however asset quality slips further, its effect on profit growth would be magnified, as loan loss provisions could be higher than we estimate. It remains the key downside risk, in our view.
Table 3 : Movement of gross non-performing loans (Rs m)
FY03 Beginning Balance Add : Inflows from good loans % of average loans Less : Upgradation of NPLs Less : Recoveries of NPL Less : Write-offs Gross NPLs (closing) Gr. NPLs / Gr. Adv (%)
Source: Company data, ABN AMRO

FY04 38040 12041 2.7% -1090 -5880 -5770 37,341 8.1%

FY05 37341 7565 1.5% -2020 -8040 -3290 31,557 5.6%

FY06 31557 7090 1.2% -1420 -7210 -5230 24,787 3.8%

FY07 24787 9469 1.3% -1326 -7520 -4410 21,000 2.5%

37220 12260 3.0% -2010 -3640 -5790 38,040 8.9%

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Chart 5 : Gross, net and incremental default rates (%)
12% 10% 8% 6% 4% 2% 0% FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 FY 07 FY 08F FY 09F FY 10F

Incr NPLs to Avg loans (%)
Source: Company data, ABN AMRO forecasts

Gr.NPLs / Gr.Adv (%)

% Net NPLs / Net Adv

Life insurance foray…
Bank of India has planned a foray into the life insurance business in partnership with Dai-Ichi Mutual Life of Japan and Union Bank of India. Bank of India is to be the dominant shareholder with a 51% stake. It would have to invest about Rs750m to start with. However, the life insurance business is intensely competitive and prudential capital requirements are high. It will have to infuse capital at regular intervals and this may put a strain on the bank’s resources. However, at the same time it could prop up BOI’s valuation on a sum-of-the-parts basis. Hence, at this stage we believe it is premature to value the life insurance business.

Marginal change in earnings estimates; FII ownership is low
We have not changed our earnings estimates for FY08 significantly: our profit after tax estimate is only 2% higher than before, while EPS is up to Rs26.8 from Rs21.9. This is because we had earlier factored in equity dilution in FY08, which we now assume in FY09, as per management guidance. We have factored in earnings normalisation in our valuation estimate. Our implied price to book target is now 1.8x FY09F. The 20% limit for FII investment in stateowned banks is creating a scarcity value for state-owned banks in which FIIs can invest. Bank of India, in which FIIs hold 16%, is one such stock benefiting from the low FII holding. We factor in the open FII limit by building in a premium of 10% to our target price to book multiple. The target price, arrived at by using the Gordon growth model, stands at Rs303.50, from Rs264. Devoid of this premium, the target price drops to Rs276, implying 10.3x FY09F EPS and 1.6x FY09F adjusted book value.

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