Kotak Mahindra Bank - 1Q12: Bank continues to be strong ::JPMorgan

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Kotak Mahindra Bank Overweight
KTKM.BO, KMB IN
1Q12: Bank continues to be strong


 Kotak reported net profit of Rs3.7bn up 14% y/y (ex insurance) which
was 7% below estimates. Weaker than expected capital markets business
led to the profit miss in spite of better than expected profitability for the
lending business. We maintain OW on Kotak as growth and asset quality
continues to remain robust but strong stock performance since May-11
and disappointments on flow business could cap near-term upside.
 Very strong quarter for the lending business: PAT for standalone
bank and Prime was up +32% y/y driven by strong loan growth and
almost no credit costs. Loan growth at ~10% q/q surprised driven by
~20% q/q growth in the corporate book. Sweet spot in asset quality
continues with just ~10bps of credit costs and with asset quality trend
expected to sustain, we believe credit costs could undershoot our 50bps
assumption in FY12.
 Margins come off but ROAs improve: Margins have been moderating
over the last 6 qtrs with ~30bps q/q contraction in 1Q12, but low credit
costs and opex improvement (opex/assets down 25bps y/y) has led to
ROA improvement. ROAs have moved up from <1.5% in FY09 to
~1.9% and we expect ROAs to sustain at 1.9-2.0% inspite of moderating
margins for standalone bank.
 Capital market disappoints relative to muted expectations: PAT for
the non-lending business was down ~55% y/y with significantly lower
profitability reported by the capital market businesses (KMCC +
securities). We expect weak trends to continue in the near term til cash
volumes improve materially and industry sees some consolidation.
 Strong recent performance could limit near term upside: Kotak
lending business profitability has continued to surprise and possible
earnings upside in the lending business could offset weak capital markets
profitability. But post the ~20% outperformance over the index since
May-11, current valuations at 18x FY12 consol EPS (adjusted for
insurance) is at a premium to peers and could limit near term upside.




Standalone bank: Key highlights
 PAT for standalone bank at Rs2.5bn up 34% y/y was marginally higher than
our estimates. Margins were lower than estimates but higher than expected
other income led to the PAT beat.
 Loan growth surprised with ~10% q/q growth primarily driven by ~21%
q/q growth in corporate loan book. With standalone loan growth now at
~40% y/y we see limited risk to our 29% consolidated loan growth estimate
for FY12.
 Margins contract higher than expected: Processing fees is now reported
in fee income v/s interest income till FY11and this has impacted prior
period margins by ~30bps (FY11 margins now at 5.2% v/s 5.5% reported
earlier). This was the primary reason for the large divergence in trends in
reported margins and calculated margins. Adjusted for processing fees, our
calculated margins was down ~40bps q/q which was higher than expected
as cost of funds increased sharply by ~100bps q/q.
 Strong fee income momentum: Adjusted for the processing fees, core fee
income growth was very strong at >40% y/y growth driven by sharp jump in
non fund based revenues (LCs/guarantees).
 Asset quality continues to remain robust with credit costs at just ~10bps
reflective of the sweet spot in asset quality. Management continues to see
healthy asset quality trends across most retail products.
 ROA continues to improve for the standalone business: Margins have
been steadily trending lower over last 6 qtrs but ROAs have improved to
>2.0% from 1.85% in FY10 for the lending business primarily due to lower
credit costs and also lower opex/assets.


Flow business performance remains subdued:
 Capital market businesses: Overall PAT for non-lending business was
down ~55% y/y. Though moderation was expected, profitability of Kotak
securities and KMCC has been below expectations.
 Kotak securities PAT was down ~50% y/y as proportion of options
volumes increase. Kotak securities is staying away from competing in the
options market due to very low yields and hence that has impacted market
share over last 2 qtrs. Management expects muted performance to continue
over next 2-3 qtrs.
 International subsidiaries reported a loss of Rs30mn but this was
primarily due to a MTM losses on FCCBs held.