BUY: Bank of Baroda

I had recommended BOB in my last post on recommendations of my fund manager. Now I see that it is a wider circle. BRICS has put a BUY on Bank Of Baroda.

Broking house, Brics PCG is bullish on Bank of Baroda, BOB. It has recommended a “BUY” rating on the stock with a target price of Rs 276.

The Brics PCG report on Bank of Baroda:

“Bank of Baroda is amongst the largest banks in India, with the biggest overseas presence after State Bank of India. Under the new management, BOB has successfully addressed its earlier concerns of slow credit growth, an unhedged investment portfolio, laggardly technology implementation and low growth in fee-based income.”

“Now, having tackled these issues head on, the bank is embarking on a robust growth path. We expect BOB to post strong business growth in FY07, armed with an adequate capital base to sustain growth. While the numbers do not reflect the improving performance of the bank as yet,
we believe this will definitely change in the coming quarters.

Investment rationale

Accelerated credit growth with improved asset quality, BOB has turned around in FY06, recording a 38% growth in advances. This was achieved via a greater focus on retail, agricultural and other priority sector lending, and was funded through liquidation of excess SLR securities. Credit growth in FY07 is expected to stand at around 25%. Net NPAs of the bank declined to 0.9% at the end of FY06 and the incremental slippage is expected to be around 1% for FY07.

Strong capital adequacy base

Of the total capital adequacy ratio, CAR, of 13.65%, Tier-I capital constitutes around 10%. With enough room to raise Tier-II capital and the option to raise Tier-I capital through hybrid instruments, CAR would not pose a constraint to business growth.

Credit growth coupled with improving yield to drive NII Increase in the PLR rate, the realignment of the interest rate of the sub-PLR credit portfolio, and a higher proportion of CASA deposits and retail assets will drive NII growth.

Investment portfolio protected against interest rate risk

After the recent transfer of securities to the HTM category, the AFS segment is cushioned against an interest rate movement of up to 8%.

Key concern – Poor return ratios

The lower return on equity is a major valuation constraint for BOB. The bank’s ROE of 12.3% at the end of FY06 is significantly lower than peers. However, this is expected to improve, going forward, on the back of improved operational performance. The management expects the
sustainable ROE to be around 15%.

Valuation

At the current P/ABV of 1x, BOB appears to be a cheap stock. Employing the dividend discount model, DDM, we arrive at a target price of Rs276. We have assumed a sustainable ROE of 15%, risk-free rate of 7.75% and premium rate of 6.75%. At the targeted price the P/ABV works out
to 1.1x, which appears to be reasonable. We thus recommend a Buy on the shares of BOB at this target of Rs 276, which is an appreciation of 21% over the current price.