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Suresh Krishnamurthy

Dena Bank has had a chequered history having to set-off large accumulated losses against its reserves twice in the past decade. It has, however, returned to profitability in the past two years.

AN investment in the public offer of Dena Bank need not be considered, as the potential for the stock to deliver gains appears limited. There are a number of stocks that are better placed to take advantage of the growth opportunities in the banking sector.

In this context, even as the stock could deliver near-term appreciation (market price of the stock is now Rs 36) and appears to be a good candidate to flip (buy in the public issue and sell after listing), chances are high that the stock would be an under-performer over a longer term.

A public sector bank, Dena Bank generates a substantial proportion of its business from the western region. The bank has had a chequered history having to set-off large accumulated losses against its reserves twice in the past decade.

Turnaround for real

There has been an impressive turnaround in the fortunes of Dena Bank in the past two years. The appreciation in the value of its investment portfolio helped the bank considerably. That, however, is only half the story. There has been a perceptible improvement in its operations. Steady business growth, recovery from assets classified as non-performing earlier, and control on expenditure did almost as much to boost profitability.

Contribution of treasury profits to profit growth was also limited. A substantial proportion of such profits was used to increase the amounts set aside (provisions) to offset assets classified as bad loans. In contrast, advances rose 10 per cent in FY-03 and FY-04.

In addition, cash recoveries of Rs 175 crore and Rs 225 crore were made in these two financial years. The proportion of operating expenses to net interest income (excess of interest earned over interest paid) also declined. This, however, may not prove to be enough, given that the operating environment has become challenging.

Challenging changes

The rapid change in the interest rate outlook has clouded the prospects for relatively weaker banks such as Dena Bank. Given the profits generated in the past two years and the capital that will be raised from this public offer, Dena Bank's ability to grow will not be affected. The bank would, however, find it challenging to grow the profits in line with its peers.

This is mainly because of two reasons. The bank would need to set aside profits to cover bad loans. Even as Dena Bank was able to reduce the proportion of bad loans in the past two years, the NPA still remains a high 7.85 per cent. Doubtful loans account for about 70 per cent of the total bad loans. Provision for bad loans could as such remain high in the next two years, constraining profit growth. Dena Bank, like other public sector banks, also needs to provide for the increase in its wage Bill following the agreement with trade unions. This, too, would contribute to the decline in profits in the following year.

Not strong

Dena Bank does not have strong credentials on a number of other parameters. The advances growth of about 10 per cent in the past two financial years is much below that of industry average. Even in the first half of FY-2005, when industry participants were able to register growth in advances of about 5 per cent, Dena Bank reported only a 3 per cent growth in advances.

Dena Bank's spreads too are under pressure. Spreads (the difference between the rate at which funds are borrowed and that at which they are lent) declined for Dena Bank in FY-2004. Only a few public sector banks reported a decline in spreads during that year. That Dena Bank's spreads were below 3 per cent when stronger banks enjoyed spreads in excess of that figure compound the matter.

The relatively low spreads is probably linked to the low advances growth. The low spread makes profit growth even more sensitive given that the outlook is for higher volumes at lower margins.

Valuation not attractive

Considering these issues, the valuation of the stock is not attractive. The bank's net worth after the offer would be about Rs 1,009 crore. If this is adjusted for the net non-performing assets of Rs 763 crore, the book value of the stock declines to about Rs 9 per share. The offer price discounts the earnings for the 12-month ended September 2004 by about 3.5 times. The offer price of Rs 27, thus, does not appear attractive when the valuation of peer banks is considered. Shareholders, too, can consider selling the stock.

The Dena Bank management, however, believes that the year following FY-05 would be better for a number of reasons. In that year, Dena Bank's provisions for wage arrears, voluntary retirement scheme and bad loans are expected to be much more moderate than in FY05. The management also feels that low capital adequacy constrained advances growth in the previous years and hopes for better performance in the years ahead. The management suggests that bad loan provisions reduced the spread in the previous years. It is also reporting a higher level of recoveries of loans classified as bad in the earlier years.

These are valid reasons and the outlook for 2006 may be better. The moot point, however, is whether the bank can generate return on net worth that is better than that of its peers as only that can make the stock attractive from a valuation perspective. Investors can keep an eye on the expected improvement in the performance of Dena Bank, while staying away from the stock for now.

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