Union Bank reported better-than-expected NII in 3QFY11. Management guided for improvement in asset quality, going forward. We believe, a combination of stable operating earnings ratios and lower provisions will lead to higher ROAs. The stock price correction offers an opportunity, in our view. Upgrade to Buy.

3QFY11: NIM expansion continues on the back of improving liability mix
Net interest income (NII) grew a robust 48% yoy (+5% qoq) higher than the 25% yoy loan growth driven by 67bps yoy (+23bps qoq) improvement in net interest margins (NIMs) to 3.44% in 3QFY11. But, core fee income remained sluggish at +7% yoy in 3QFY11 (+8.3% yoy in 9MFY11). Deposits grew about 24% yoy as of December 2010. However, the low-cost deposits (CASA, current and savings account) grew 27% yoy. CASA proportion increased by about 100bps yoy to 33.3% as of December 2010 and partly contributed to about 80bps yoy decline in cost of deposits. According to management, the pension liability is about Rs24bn, to be provisioned off in five years (Rs3.6bn provided in 9MFY11). The gratuity liability is about Rs2.5bn to be fully provisioned in FY11F (Rs1.9bn in 9MFY11F)

Management guides for sharp improvement in asset quality in FY12
Gross slippages fell to 70bps of loans (on one-year lag basis) in 3QFY11 compared to about 120bps slippage in 2QFY11. The management stated that slippages will likely come down to 100-125bps of loans in FY12 vs 250-260bps in FY11. Consequently, it expects the provision charge for bad loans to come down from 110bps in FY11 to about 50bps in FY12. Our estimates factor 20bps yoy decline in credit costs to 74bps, in FY12-13.

Higher core earnings and lower provisions to reflect in higher RoAs in FY12F
Given the improved liability mix, we expect Union Bank to be able largely to maintain NIMs in the current macro economic environment. But, moderate growth in operating costs and a lower provision charge for bad loans will show in higher bottom line and, so, higher RoAs in FY12F. We factor in 15bps yoy improvement in RoAs to about 1.2% in FY12.

Recent stock price correction offers an opportunity; upgrade to Buy
Union Bank's stock price has corrected by about 14% since 1 November 2010 compared to falls of about 7% in broader market indices (Sensex and Nifty). We upgrade to Buy, as the stock now trades at 1.2x FY12F book value and 5.6x FY12F earnings. A sharp rise in cost of funds and a worse-than-expected asset quality environment remain the key risks to our investment argument.