Kotak Mahindra Bank Transformation gathers steam::Macquarie Research,

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Kotak Mahindra Bank
Transformation gathers steam
Event
 For 2Q FY3/11, Kotak reported 23% YoY growth in net profit to Rs3.6bn,
below our estimate of Rs3.9bn, mainly on account of a loss in AMC business.
We increase our TP by 25% to Rs580 due to an increase in banking business
(including auto finance) value by 39% to Rs418. Maintain Outperform.
Impact
 Focus continues to shift more towards banking business: We believe the
market is not yet cognizant of Kotak’s changing business model, where
banking (including auto finance) business now contributes more than 70% of
the total value and profits. In our view, this change is encouraging, as it lends
more stability to earnings growth and return ratios. From a mere 19% five
years ago, banking business now contributes nearly 75% of the total profits
(70% for 2Q FY11). The core bank and auto finance profits grew 55% YoY
compared to 23% for the consolidated entity.
 Credit costs could decline materially: Current credit costs of 66bp are
primarily due to the requirement to meet the 70% NPL coverage norm. We
have factored around 60bp in credit costs for FY11. Upside to our estimate
exists if the current track record of slippages continues.
 MTM hit taken on liquid funds in AMC business: Kotak decided to take the
MTM hit on 90-day-plus liquid funds whose NAV was hit due to the sharp rise
in interest rates. As a result, AMC business posted a loss this quarter.
 Expense ratios to remain high: The increase in the cost-income ratio to
75% from 70% is mainly due to salary hikes, higher bonus provisions (mainly
in capital markets business), higher commissions to loan agents and higher
advertising expenses. The bank intends to take the branch network to 320 by
the end of FY11. We expect expense ratios to remain high, as the bank is
investing in rapid scale-up of its banking business.
 Insurance business returns to profitability: After posting a loss last
quarter, insurance business increased to Rs134m. The company cut costs
about 20% QoQ, and the reduction is likely to continue.
Earnings and target price revision
 We made modest changes to our consolidated earnings estimates despite
sharply raising core banking earnings forecasts by 10–15%, as we factor in
higher opex the consolidated entity (mainly due to higher bonuses in
nonbanking businesses). We raise our TP by 25% to Rs580, mainly to reflect
our increase in the multiple for the banking business to 3.5x from 2.7x.
Price catalyst
 12-month price target: Rs580.00 based on a Sum of Parts methodology.
 Catalyst: Continued momentum in banking business, strong earnings growth.
Action and recommendation
 Reiterate Outperform: We believe that the bank’s lesser dependence on
volatile income streams is likely to result in more consistent earnings growth
and return ratios. We maintain our Outperform with a higher TP of Rs580.