A few weeks back I replicated the screen developed by Prof Damodaran on Bank Nifty stocks and found 5 of them to have values less than the median Price to Book. Of the 5 stocks IDFC First Bank seemed appealing. Based purely on numbers, the operations metrics like NIM and CASA Ratio were better than the median for the group. The percent of securities held to maturity was lower – an agreeable indicator. However, Gross NPA was higher, ROE barely there. These were based on FY22 numbers. I updated the table for FY23 and found IDFC Bank had shown major improvement on all metrics. However, it would be good to bear in mind that FY23 has been kind to almost all banks.
I followed up with a DCF valuation to assess if IDFC First offers a buy opportunity. It looks like a steal.
History
IDFC Bank, in its current avatar, is fairly new on the block. Since its set up in late 2015, the bank has seen major changes. What stands today has little in common with the bank that was set up post RBI’s approval for banking license about 10 years back. Led by the redoubtable V Vaidyanathan, the Bank is on the fast track of growth. Mr. Vaidyanathan is an old hand at banking, having been in this industry since 1990. With close to 2 decades in Citibank and ICICI Bank and then a stint in NBFC – Capital First, Mr. Vaidyanathan is probably the right person to lead IDFC First. He recently increased his stake in the Bank to 1.23%. Per RBI regulations, he has another decade at the helm to build on his vision of “world class bank”. Given the current landscape – the nifty small finance banks, payment banks, other private banks – he has his job cut out for him. And he recognizes it. There is something endearing about a CEO requesting for patience in an annual report.
Business Model / FY23 numbers
IDFC First Bank has its roots in infrastructure finance and corporate bank. Through merger with Capital First in 2018, it stepped into the profitable, low-risk world of retail banking; and MSME financing. It is in this space that the Bank sees growth in the next decade, driven primarily by focusing on digital and analytics-led decision making. Given the profit pools within the retail banking universe, these two are no longer a differentiator and has been/is being used successfully by most of the players.
So far, the Bank has diligently followed its long-term strategy. The two entities IDFC Bank and Capital First merged in Dec 2018. Since then, the bank has remained focused on reducing infrastructure loans and corporate financing while continuing to grow its books in retail, MSME and rural banking. The proportion changed, with almost perfect symmetry, between FY18 and FY23.
The bank aggressively increased retail deposits during COVID-related lockdown and touched 50% CASA ratio within 2 years of merger and has maintained at that level since. Higher share of CASA in overall deposits bodes well due to low cost nature of CASA deposits. The bank also used these deposits to pay off high-cost wholesale deposits and Certificate of Deposits.
In the last 5 years the bank has taken time to introduce assets – a few at a time, giving itself the space to formulate and execute the strategy for product features, target segment, pricing, and marketing in the highly competitive space where the scope for product differentiation is limited. Starting with launching credit card and wealth management in FY21 to secured loans in FY22, the patience was rewarded in form of an increase in operating profit that grew a whopping 44% to Rs 2,700+ cr in FY22. The bank kept up the momentum in FY23 raising deposits worth Rs 43,000 + crore and growing loan book by 24% y-o-y to cross Rs 160,000 + cr. During this time the bank also entered the fast growing education loan segment and launched credit products for farmers.
The strategy of the bank, beyond the customer first and ethical org part, appears conservative – maintain adequate levels of capital (in excess of regulatory requirement), maintain strong liquidity levels (in excess of regulatory requirement), keep the wholesale and retail loan book adequately diversified, migrate to safer categories of credit within each customer segment, continue to maintain focus on risk management through strong underwriting practices and continuous portfolio monitoring. On the liability side, the Bank aims to keep CASA ratio between 40% and 50% and have a diversified portfolio of deposits in order to reduce the volatility that comes from few large deposits.
The focus on MSME sector may well drive the next level of growth for the bank. There are some mind-numbing projections on the demand for credit to exceed $570 billion in the next 5 years. On a different note, the corporate capex cycle fell two quarters in a row. According to data from Motilal Oswal Financial Services corporate investments “likely” fell 6.2% Y-o-Y in Q1 FY24 (quotes mine). However, this is not in line with RBI’s report on “Private Corporate Investment” which sounded bullish. These two factors – demand for capital in MSME and “perceived slowdown” in corporate capex – may yield results for IDFC First which has less than 5% of loan book coming from the corporate sector.
Risk Management
The Bank’s GNPA in FY23 was at 1.65%. However, with Mortgages (25%), Consumer Loans (12%) and Vehicle Financing (9%) together accounting for 46% of the loan book, the Bank will need to monitor and manage the GNPA of these 3 businesses closely. GNPA for LAP (2.79%), Consumer Loans(1.84%) and Vehicle Financing (1.83%) pulled up the average GNPA across businesses in FY23.
On the bright side, the Bank’s sustained focus on managing risk in Wholesale Banking has had significant effect in reducing both corporate book and infra financing portfolio. The exposure to top 20 single borrowers and top 5 industries has also seen significant drop in the last 5 years, helping in much needed risk reduction and adding diversification to the bank’s portfolio. In addition, the provision coverage ratio has seen a steady increase.
Possible weak links
Multiple products/customer segments – The bank’s offering currently covers possibly the entire gamut of products and customer segments (from retail to MSME) in true spirit of being a Universal Bank. The loan book is diversified across 20 businesses per the Annual Report FY23. This level of diversification may be difficult to build upon for a bank of IDFC First’s size. The resources and processes required for seamless execution of services is expected to be considerable.
Cost of maintaining or acquiring CASA / fixed deposits – in the midst of the war for deposit mobilization, this remains a sticky area.
Migrating to safer categories of credit within each customer segment – though a sound plan, execution of this strategy may well be a challenge. With the ease of access of credit bureau data and lower degree of product differentiation, this sub-segment of customer has universal appeal. Within the retail banking world, this sub-segment is spoilt for choice. It is difficult to understand what IDFC First brings to the table that is unique and will be effective in acquiring and retaining this segment.
Strong focus on risk management – The approach of the bank, based on the assessment of annual report, appears conservative. Risk management seems to be at the center of decision making. The trouble is low risk customers aren’t profitable. And they are actively pursued by almost all banks with targeted campaigns. Risk-based pricing works when the cross-section of customers is representative of varied risk profile. Profitability of a banking institution often requires a delicate balance between sub-optimal customer segments and risk management.
Gross NPA rates for the 3 largest businesses – Mortgages, Consumer Loans and Vehicle Financing are driving up the GNPA for the business. This requires close monitoring.
The Banking Sector Snapshot – FY23
The BCG Banking Sector Roundup Report – FY 23 considers 35 banks in all – 12 PSU, 10 Private (new), 9 Private (Old) and 4 Small Finance Banks (SFBs). The report is adequately detailed, and I am basing this section on that report (URL at the end).
The overview for growth in business (deposits and advances), profitability (Income and PAT), key ratios (ROA, CASA, NPA) all show an impressive uptick Y-o-Y except for CASA and Cost-Income ratio. This is not news. FY23 has been kind on banks – almost all of them. The chart below captures a few metrics (as percentage of average assets)
In the midst of the rate hikes from RBI, Banks were able to transmit the higher rates in lending products (on which they earn interest) in comparison to deposit products (on which they pay interest). The graph below is particularly illuminating. On an average banks maintained an interest rate delta of ~3%
A few points that caused much cheer
Credit growth (Y-o-Y) at decadal high of 18%, a tad tempered by deposit growth at 11%
Retail segment (21%) grew fastest, followed by MSME (18%), Agri (16%) and Corporate (13%)
Strong asset quality – GNPA, bounce rates, provision coverage ratio – better than before
Digital Banking transactions cross 200 billion with the share of UPI at 41% possibly cutting into debit card spends (my hypothesis) while credit card and personal loan portfolios continue to grow impressively. Digital Banking is also being used effectively across products – sourcing of savings account/ FDs, issuances of credit card/ personal loans to bring down the cost and time of acquisition.
Within the loan book, there emerged 2 distinct segments of growth – MSME and Retail. Banks that can leverage these two segments would stand the gain the most.
Within the private banking (new) segment, IDFC First stood out as one of the top performers on the back of big gains in Net Advances, Deposits and ROA Y-o-Y and one of the highest CASA Ratios in FY23.
Valuation:
I use DCF to value IDFC First Bank. Based on FY23 numbers in annual report, I project cash flow for the next 10 years. The bank paid no dividends in FY23, and I assume this trend to continue another 3 years as the bank builds on its current base. During this period, I also assume that the bank grows its earnings at 40% each year before declining linearly to a stable growth rate of 12% in year 10. From year 4 onwards I assume the Bank will start paying dividends. The payout ratio is based on achieving a RoE of 14.5% and growth of 12%. These are assumptions and are based on the last 10-year numbers reported by IndusInd Bank and Kotak Mahindra Bank.
Risks to Valuation
IDFC First is a young bank and probably still working on its DNA. It is possible that the bank moves from conservative approach to a risk-based approach, based on the trend in banking. In which case the valuation will not hold.
Beta is an important component to compute the cost of equity. It is assumed that the bank, in year 10, has a beta of less than 1.0 keeping in line with its conservative DNA.
ERP is assumed to fall 1.33% in year 10 from its current value of 8.33%. This assumption is based on the hope that in 10 years, as India’s economy grows, its rating will improve, default spread will narrow, and country risk premium will fall.
A few metrics used in projections has been benchmarked against Kotak Mahindra Bank and IndusInd Bank. This assumes that IDFC First will tread the mid-path between these two. A clear swing to either side will impact the valuation.
Disclaimer
I don’t hold any investment in IDFC First Bank
For this research report, I have used the audited numbers in annual report in good faith.
All my research is sourced from internet (attribution below) and I have not interacted with the Bank in any manner, shape or form
While my valuation shows a clear case of buy, not all buys are suitable for all investor profiles. Please consult with a SEBI registered Investment advisor before making any decision.
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Good catch