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India’s largest public sector bank is about to get even bigger. In a move that could herald the long-awaited consolidation of India’s banks, the State Bank of India Ltd (Rs.70.50) has just taken the first step towards merging its five associate banks. The result will be a new banking behemoth with assets worth Rs.37 lakh crores – one-fifth the size of India’s gross domestic product.

This will bring all of SBI’s associate banks under its fold – the bank has already merged with two of them – State Bank of Indore and State Bank of Saurashtra in the last decade.

For long, experts have pointed towards the need for bank consolidation at a time when financial inclusion is rapidly expanding and small entities often don’t prove viable to execute bigger projects. Even as the bank insists that the effort is “purely exploratory” at this stage, there are signs that this might indeed turn out to be the moment of reckoning for India’s banking sector. Finance Minister Arun Jaitley hinted at it a few weeks ago when he asked reporters to “wait for a few days” on being asked about banking consolidation.

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Moreover, the Reserve Bank of India has regularly stressed upon the need to consolidate non-performing entities and cleaning up of balance sheets to reform the banking sector. If the approval goes through, the newly set up entity will turn out to be more than five times the size of the country’s second largest lender ICICI Bank which has a total business size of about Rs 7.2 lakh crores.

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SBI itself has more than 17,000 branches across the country and about 200 offices in foreign countries. These branches do a total business of about Rs.29 lakh crores as of now having advances of Rs.13.91 lakh crores and Rs.16.71 lakh crores worth of deposits as of December last year. These five additional banks will also bring in an additional Rs.12 lakh crores of business with them.

SBIN and its Associated Banks (AB's) board has provided an in-principle approval to proceed for a merger creating a behemoth with a quarter of assets. SBI will also usurp the two-year old Bharatiya Mahila Bank (FY15: Profit Rs.290 m, Assets:Rs.185 bn). AB merger would entail higher employee costs given the difference in pension/gratuity calculation between ABs and SBIN— approx. Rs.7 bn per bank or in aggregate about 2.2% of consol equity. The greater challenges are in employee redundancies, HR/Operations, Branch and ATM rationalization, etc. Technology and accounting are similar.

We see a potential of risk-arbitrage between the listed-cubs—State Bank of Bikaner & Jaipur (SBBJ IN, Rs 507, NC), State Bank of Mysore (SBMS IN, Rs 424, NC) and State Bank of Travancore (SBTR IN, Rs 403, NC) —and SBIN. We see this as the first of many reports on which ink will be spilt as we proceed closer to the eventual merger. To begin that journey, we do a deep-dive of the annual performance of the five associate banks.

Valuation/risks:

SBIN trades at 1.3x consol trailing BV (Mar 16) and 5.1x EPS (12 m to Mar 17e). We value SBIN at Rs.280, implying P/B & P/E multiples of 1.4x (Mar 17e) and 6.4x (12m to Mar 18e). This compares with 10-year averages of 1.5x and 9x, respectively. 

Key risks: Weak asset quality, weak loan growth.

Cubs—important for growth & asset quality: SBIN’s associate banks (five smaller banks or cubs) aggregate to ~26% of the standalone loan. In terms of total assets, it’s about 20% of consol assets. However, over time their contribution to the consol profits has come off to ~10% in FY16e versus >30% in FY11. However, the cubs’ contribution in slippages as compared to the standalone bank’s slippage has been significantly higher in the last two years. The net profit and ROE profile of the cubs has not diverged materially from the parent, except in the December 2015 quarter.

Growth consolidation to improve slippages over time: As we had highlighted in an earlier report, the growth consolidation at the cubs continued in FY16 as well, with aggregate loan growth coming in at 3.1% against an industry average of 10.7%+. We understand the cubs had an explicit direction from the parent bank to limit risk-weight asset (RWA) growth to 12% in FY16. While slippages have increased, we expect the trend to reverse over time.

Asset Quality—accelerated recognition: The key takeaways from the full year asset quality data of the cubs are as follows —

* Slippages are elevated this year, especially in Q4—a potential indicator that SBIN too could recognise larger NPAs

* Aggregate stressed asset has come off to 9.3% from 11%, implying accelerated recognition through classification of restructured accounts as NPA

* Most SDR accounts are either restructured or have already become NPA

* The only possible underreporting could come from 5/25 refinancing on which we have no data points.

It is possible that conversion of restructured DISCOM loans to bonds have also aided the fall in the total stressed assets, although we cannot ascertain the impact of this at present.

Restructured assets have declined: Restructured assets for cubs in aggregate declined to 5.8% in FY16 versus 8.4% in FY15, aided by lower fresh restructuring post removal of forbearance on asset quality from April 2016, and higher slippages of restructured assets to NPA (12.2% in FY16 vs. 11.3% in FY15). Conversion of DISCOM loans to bonds may have played a role in this too.

Conclusion: The scrip of SBI has more or less bottomed out at the CMP of Rs.170.50. Therefore, BUY the Shares of State Bank of India Ltd at Rs.170.50, for a short term target of over Rs.200. Keep a SL of Rs.167 (sell 50%)--164 (exit) for any short term trade. However, the long term investors should buy and keep holding.