YES Bank's Painful course correction begins. :: Kotak Securities

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YES Bank (YES) Banks Painful course correction begins.
Yes Bank reported a loss led by high provisions (9X yoy) and 38% yoy decline in operating profits. The new business strategy, similar to other private banks, has begun. Near term high credit costs (upward revision risks exist) for the back book, weak RoEs, low CET-1 (8.5%) would make this transition painful in the medium term. This makes is too risky to back today even if the new strategy is acceptable. SELL remains. TP revised to `170 (from `210 earlier).


Balance sheet and P&L saw a steep and swift deterioration Yes Bank reported a loss of `15 bn in 4QFY19 led by elevated credit cost and a steep decline in non-interest income. Four key numbers for the quarter: (1) Loan book deteriorated with loanloss provisions at 5.6% of loans led by a sharp rise in provisions(GNPL up 110 bps qoq to 3.2%) and contingent provisions. (2) Non-interest income declined ~65% yoy due to reversal in corporate fees. (3) NII growth slowed to 16% yoy and NIM declined 20 bps qoq. Loan growth was at 18%. (4) CET-1 declined ~60bps qoq to 8.5%. Surprisingly, Yes Bank declared a dividend. Stressed loans at 4% of loans; 20% provisions made in 4QFY19 and 125bps for FY2020 Yes Bank reported a new stress book that is ~4% of current loans, a surprise noting the clean chit given by the RBI for FY2018. As per management, this is not a kitchen-sinking exercise but an unexpected negative outcome post the IL&FS crisis and coincidental to management change. These loans are in real estate, infrastructure and entertainment. The bank has built a contingency provision of 20% of the stressed book in FY2019 and this could result in 125bps provision for FY2020 as there is a high probability of default in these loans in the short term. The bank defended its exercise but did not rule out any further increase in the stress book. Management candid about weakness of its current model; long and painful recovery journey We have been cautious on the extant business model of YES that relied on excessive dependence on fees or structuring in corporate loans that was strong on collateral but not necessarily backed by cash flows exposing the balance sheet to risks. The new MD highlighted these risks; acknowledgment of the same is a positive. Strategy of the new MD is similar to peers, which we believe would pay off in the long term. The management is guiding for a 1% RoA by the end of the third year suggesting near term weak performance. Maintain SELL with fair value of `170; downside risk exists to fair value and earnings We maintain our SELL rating with fair value revised to `170 (from `210 earlier) valuing the stock at 1.8X March 2021E book for weak RoEs in the medium term but likely to improve gradually. However, clear risks to fair value and earnings exist as we need to see the progress of capital adequacy (dilution could happen at lower-than-expected multiples) and stressed portfolio (upward revision to stressed book exists).

Key takeaways from the analyst meet and conference call  The management highlighted that there would be a four-pronged strategy:  Granularise business. A three pronged approach which would include (1) improving the liability franchise, (2) expanding the retail/SME portfolio and (3) focusing a lot more on the transaction banking business on the corporate side. Structured finance is a bespoke business and a challenging business to scale. There is a need to build other lines of business.  Culture change.(1) Liability led as compared to the asset led focus in the recent years, (2) regulatory compliance given what the bank has seen in recent years and (3) uncompromising governance.  Digitalize. (1) Digitalization, (2) monetization of data given the strong data that is moving through their network like UPI, (3) ecosystem banking.


 Risk management. (1) Segregation of credit approval and risk oversight functions, (2) reduce portfolio concentration, (3) prudent accounting norms, (4) stricter early warning systems and proactive countercyclical provisioning.  Medium term objective is to ensure that growth can move back to 20-22% and RoAs is at 1.5%.  Only 30% of the branches are currently profitable. The bank would look to improve this ratio over the next few years (80% by FY2023 and 100% by FY2025). There is greater devolution of authority and there would be more feet-on-street to give strength to the liability business.  Moving from centralized team to a more decentralized business with greater authority at the regional level to drive local strategies. High focus on fees, which the management said was like running on a treadmill, resulted in behavior change in lending and less focus on other retail products. Our reading: need more quarters before we get an understanding of progress The new MD & CEO is taking the right decisions to take the bank forward. However, we would still want to wait before we turn positive on the bank for a few reasons.  Clarity on peak of bad loans is yet to emerge. The management has highlighted that the total stressed loans, as per their internal study, is ~`100 bn (~4% of loans). On the face of it, it does not appear to be too high given that the balance sheet has the ability to absorb this stress. The management has alluded that it is mostly in real estate, infrastructure and entertainment. We have seen this many times in the past, where managements have increased their guidance on stressed loans in subsequent quarters as some of the planned exit strategies, on corporates which are not classified as stress today, do not fructify or there is a tendency to remain optimistic on the potential cash flows of a few large exposures which do not materialize. It is quite likely that the loss given default for Yes Bank is lower, but the bank would still need to make higher provision in the interim to meet the regulatory requirements and this could have an impact on tier-1 ratios.  Risk could be elsewhere as well, such as in the bond portfolio. The management highlighted that the stress that was reported is only in the loan book and not in the bonds as the bank would be taking MTM against any changes that happen to that portfolio. In 4QFY19, the bank provided `2.4 bn for MTM losses and in our view, it would be prudent to have additional provisions for this portfolio as well in FY2020.  Strategy is all-too-familiar but there are risks in execution. Our reading of the strategy is that it is not something that we are not familiar with. Nearly all the frontline private banks have a broadly similar strategy of granularisation of deposits and loans and reducing existing concentration of business. We believe that it is in the right direction. However, building a liability franchise is not as easy as it is made out to be. We have seen that adding branches or employees does not ensure its success and it is a continuous and rigorous exercise that only the frontline banks have achieved. Ability to build a retail loan portfolio is challenging especially when the bank has a negligible customer base where it can cross sell and reduce its costs and lower credit risks.  Management changes need more clarity. We also need to understand the management strength in this phase of the cycle. There could be exits of good employees and hiring could be a challenge as the bank may not be in a position to give them freedom to build business as it does not have comfortable capital levels or liability profile. Unlike Axis Bank which has been able to get senior management relatively easily, we see Yes Bank taking a more conservative approach. At this point the changes in senior management are a lot fewer and address some of the critical gaps in the system.


 Revenue profile to slowdown to reflect changes to business model. As highlighted by the management, the focus to get a more granular loan book and remove the concentration risks that are currently present in the model. This would result in a sharp slowdown or decline in revenues in the medium term unless loan growth is quite strong. In our view, it is quite likely that the loan book does not grow in the medium term as the bank looks to replace this highly concentrated book with a low risk book. Further, there would an impact on NIM and fee income as this business is not as high yielding or fee accretive as its structured finance book.  Management is highlighting increased expenses to build a higher feet-on-street business. With only 30% of its branches profitable today and the intention to take it to 80% by FY2023 and 100% by FY2025, the management highlighted that it would ramp up its employee base to get more feet-on-street employees as part its objective to granularise its franchise. In our view, this could increase the costs which given the weak revenue profile could further increase the pain to deliver better RoEs.  Buffer on capital too thin and weak liability franchise makes it difficult to turn positive. The weak tier-1 ratio of ~8.5% and liability franchise (less granular deposits) make it difficult to turn positive this early in the cycle of the bank. Risk of dilution at lower multiples and very thin buffer to absorb large losses at a time when the balance sheet has limited scope for growth make it difficult to turn positive. Sharp deterioration in asset quality  GNPL increased 110 bps qoq to 3.2%. Reported gross NPL increased 53% qoq to `79 bn (up 2X yoy) to 3.2% of loans (up 110 bps qoq). The rise in GNPL was driven by higher slippages (gross slippages at Rs35 bn). Two accounts worth Rs11 bn slipped into NPLs in 4QFY19. One of these accounts is from the aviation sector (Rs5.5 bn) which was performing as of March 31, 2019 while the other is a stressed infrastructure conglomerate (IL&FS). Net NPL increased 56% qoq on absolute terms to `45 bn with NNPL ratio at 1.9% of loans (up 70 bps qoq). Total stressed assets (GNPL+standard restructured security+security receipts+SMA-2) increased 190 bps qoq to ~5%. SMA-2 book is low at 1% of loans (up from 0.2% qoq). ~2% of overall SMA-2 is from the commercial real estate space. The share of BB and below rated corporate assets saw a steep spike in 4QFY19 by 460 bps qoq to 7.1%. The bank made contingent provision on this book worth Rs12 bn in 4QFY19 which led to a spike in credit costs (coverage on the BB and below book increased 20% as a result). Provision coverage ratio (calculated) decreased 110 bps qoq and 690 bps yoy to 43%.  IL&FS recognition broadly complete. The company has total exposure of `26 bn (including non-fund based exposure) to a few accounts under IL&FS group. Out of this, `24 bn has been classified as NPL as of 4QFY19. Out of the remaining exposure, ~`1 bn is non-fund based exposure and `0.9 bn is classified as standard. The company maintains a coverage of 25% of IL&FS fund based NPLs and 15% of the fund based standard exposure.  6.4% of overall advances are towards NBFC/HFC lending. The company has 3.5% of overall exposure towards HFCs while 2.9% is towards NBFCs. Out of the total lending to NBFCs, 70% is rated A or better while 88% are rated A or better for the exposure towards HFCs. There has been a deterioration in the rating profile of this book as, out of the total lending to HFCs, 96% borrowers were rated AA or better as of 3QFY19 and 91% borrowers were classified A or better for lending to NBFCs. The company has 7% exposure to the commercial real estate sector and 0.27% of this book is in SMA-2. ~70% of this book is towards residential lending. Management continues to see stress in luxury residential projects.

 Sharp rise in BB and below rated assets. The share of BB and below pool saw a sharp increase by 460 bps qoq to 7% in 4QFY19. Management took a prudent decision to provide contingent provisions for this book worth Rs21 bn in the current quarter. Real estate, media and entertainment and infrastructure comprise majority share of the BB and below rated pool.  Maintain cautious stance on asset quality. The bank has a high exposure towards a few stress sectors like power and real estate with negligible or nil NPLs currently. Additionally, they have been rapidly expanding the corporate book including sharp expansion in the EPC sector (up 210 bps in FY2019 to 10% of overall advances). We would take a more constructive view over the next few quarters as some of the risk of default from some of these sectors is still quite high.