Ambit: Regional Banks:The search for a pan-India franchise

The search for a pan-India franchise
Regional banks have differentiated themselves from PSU banks on
asset quality and now trade at a premium to PSU banking stocks. Their
profitability and valuation differential to large private sector banks
has, however, persisted, owing to higher cost of funds, low fee income
generation and higher cost to income. The improvement on all these
three parameters, we find, is related to the quality of the liability
franchise, for which geographical diversification is the only lasting
solution. The evolution of ING Vysya Bank (IVB) also proves the
significance of geographical diversification. Even as Federal Bank (FB),
Karur Vysya Bank (KVB) and South Indian Bank (SIB) manage their
asset quality risks, their operating performance would remain
constrained due to their liability franchise. City Union Bank (CUB), on
the other hand, has done better under similar constraints and looks
likely to outperform its peers on growth and profitability.
Improving the liability franchise is key: A comparison of large private
sector banks and PSU banks with regional banks shows that regional banks
have been able to differentiate themselves from PSU banks on asset quality
(FY13 credit costs of ~60 bps vs PSU banks’ 114bps); however, they continue
to lag large private sector banks on the cost of funds (due to lower CASA), fee
income generation and operational efficiency. Given that primary banking
relationships deliver 2-3x more business than secondary banking relationships
in India and given that the liability relationship (rather than the lending
relationship) is the determinant of a primary banking relationship, the
improvement in the quality of the liability franchise would be a key driver for
regional banks to bridge the profitability gap vis-à-vis large private banks.
Geographical diversification proving to be a necessary evil:
Geographical diversification is crucial for regional banks if they are to improve
their liability franchises. IVB has set a good example in this regard, but the
other regional banks remain laggards on this metric and this affects their
operational performance. Regional banks’ operating profits have recorded
15% CAGR (in FY11-13) vs large private banks’ 22%.
Asset quality is a key near-term risk: The asset quality outlook for these
banks is rather bleak, with rising delinquencies and higher credit costs
looming large. Our scenario analysis shows that IVB and FB are better
cushioned on provision coverage and capital ratios.
Recommend BUY on IVB, FB and CUB, SELL on KVB and SIB: We initiate
coverage with a BUY stance on IVB (due its proven competitive advantages).
We retain our BUY stance on CUB (due to its strong growth and profitability
trends) and FB (as structural concerns on operating performance seem
discounted). We initiate coverage with a SELL stance on KVB and we change
our stance to SELL on SIB due to pressure on their profitability ratios from
deterioration in operating performance as well as due to asset quality risks.

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Summary of stock-specific investment
cases
ING Vysya Bank (VYSB IN, Mkt Cap US$1.1bn, BUY)
ING Vysya Bank differentiates itself from other regional banks based on its: (1)
strength of the liability franchise, which supports healthy margins, (2) better asset
quality trends and larger buffer in provision coverage and capital ratios, which
help it to withstand asset quality shocks, (3) superior fee income generation, and
(4) the branch network, which supports a moderation in its cost ratios. We expect
the decline in the opex/assets ratio to 2.22% in FY15 from 2.51% in FY13 to drive
a RoA improvement to 1.3% in FY15 from 1.2% in FY13. The recent correction in
the stock price means that the stock is trading at a 16% discount to its historical
average 12-month forward P/B multiple. We initiate coverage with a BUY
stance and a target price of `626 (50% upside).
Federal Bank (FB IN, Mkt Cap US$0.6bn, BUY)
We have been toning down our expectation on Federal Bank (FB)’s operating
performance even, even as there has been a tangible improvement in the bank’s
asset quality, particularly for retail and SME books. Our analysis of FB’s
geographical concentration and its impact on FB’s liability franchise, fee income
generation and cost efficiency show that any improvement from hereon would be
gradual, and the process could test the management’s and investors’ patience.
However, in the last three months, the stock has underperformed the Bankex by
11% and current valuation of 0.63x FY14 BV seems to discount these long-term
structural concerns. Our target price of `312, valuing FB at 0.75x FY14 BV,
implies 21% upside. The 47% drop in our valuation is driven by a ~25%
downward revision in our EPS estimates. The reduction in earnings estimates is
driven by lower loan book growth, lower NIM and higher cost-to-income estimates
as compared to our earlier estimates. Our downbeat expectations on an
improvement in profitability due to structural challenges on liability franchise also
lead to a lower valuation multiple.
Karur Vysya Bank (KVB IN, Mkt Cap US$0.5bn, SELL)
Karur Vysya Bank’s (KVB) RoAs have declined to 1.3% in FY13 from an average of
1.6% over FY06-11, due to constraints on its liability side, rising cost ratios and
increasing credit costs. KVB continues to seek growth amidst a slowing macroeconomic environment. We believe unabated pressure on margins, cost ratios and
asset quality would lead RoAs to decline further. The stock is trading at inexpensive
valuations of 1.0x FY14 BV but near-term positive catalysts are scarce. We initiate
coverage with a SELL stance and a target price of `320 (3% upside).
South Indian Bank (SIB IN, Mkt Cap US$0.4bn, SELL)
South Indian Bank (SIB) has a plateful of challenges, with little diversification
outside its home state Kerala, a weak liability franchise, no improvement on fee
income generation, slowing asset growth and rising credit costs. The bank has a
57% exposure to corporate loans and a coverage ratio of 29%. Hence, it has very
little room for error on asset quality. We expect SIB’s financial performance to be
volatile and we expect RoAs to fall below 1% in the near term. We change our
stance to SELL with a target price of `20 (3% upside) vs `29 earlier. The 31%
drop in our valuation is driven by lower loan growth expectation (from above 30%
growth earlier to 18-19% loan CAGR) and subdued expectation of any recovery in
the bank’s profitability in the near term.

City Union Bank (CUB IN, Mkt Cap US$0.3bn, BUY)
City Union Bank (CUB) emerges as one of the most robust regional bank
franchises in our analysis. Its strong income generation (NII and fee income to
assets of 4.6% vs peer average of 4.2%), controlled cost base and healthy asset
quality more than offset the weakness on the liabilities side. Hence, superior RoAs
of 1.5-1.6% are the best among regional banks and are closer to the new private
sector banks. In the near term, we expect the bank to maintain its margins in the
current tight liquidity environment, given that the duration of the loan book is
lower than the duration of its borrowings. CUB would deliver net profit CAGR of
20% in FY13-15. The stock is trading at 1.1x FY14 BV, which is an attractive entry
point. We retain our BUY stance with a target price of `66 (59% upside).
Development Credit Bank (DCB IN, Mkt Cap US$0.1bn, NOT RATED)
Following unbridled loan book growth in FY07-08 (48% CAGR), particularly in the
unsecured personal loans and CV/CE segments, with sub-par risk management,
credit losses shot up in FY09-10. As the bank then shrunk its balance sheet, the
bloated cost base led to the bank sliding into the red. A new management team
took charge in FY10 and initiated a recovery plan under regular monitoring by the
RBI. The new management team has steadied the ship and focused on de-risking
the balance sheet, cementing its niche (of western India-based MSME/mortgage
lending), strengthening its liability franchise and bolstering risk management.
These efforts, along with a controlled cost base, have resulted in the RoA
improving from -1.31% in FY10 to 1.03% in FY13. With the ingredients for a scale
up in place, operating leverage could kick in and drive RoA expansion. Instances of
other similar management-driven turnaround stories in the sector suggest that a
rerating should follow as evidence emerges of a sustained improvement in
profitability and asset quality.
NOTE: Ambit currently owns 4.43% of DCB’s outstanding shares.