We expect strong growth/high profitability at AUSFB, given its: a) focus on the underpenetrated small business financing segment, b) early growth stage, c) strong credit underwriting, d) good track record, and e) experienced management. AU Small Finance Bank offers secured small loans primarily to the vehicle and the underpenetrated MSME (micro, small and medium enterprise) and SME segments in western India. It has a track record of strong growth and high risk-adjusted loan yields, driving high profitability. AUSFB is one of India’s smallest banks. We expect its primary focus, the MSME loan segment, to emerge as one of India’s fastest-growing financial segments over the next decade (see our 26-Sep-17 blue paper, India’s Digital Leap – The Multi-Trillion Dollar Opportunity), helped by: a) improving underwriting ability, as data availability expands; and b) reduction in servicing costs, given digitization. Further, AUSFB is entering a number of newer loan segments (eg, home, gold, agriculture, business banking), in the wake of its conversion to a small finance bank from an NBFC in April 2017.
While bank transition costs will likely dent F18 profitability, we expect RoE to recover quickly, to 16%/20% in F19/F20, mainly helped by: a) a highly profitable product mix (high yields); b) strong growth / operating leverage; c) funding cost reduction as deposits replace high-cost borrowing; and d) stable asset quality. AUSFB is trading at 44x our F19 / 27x our F20 EPS estimates. While this is not cheap relative to the SENSEX multiples, we expect such premium valuations to persist, given: a) a strong growth outlook; b) strong underlying profitability; c) balance sheet strength; and d) strong record of managing asset quality in a relatively riskier segment. Our price target is `725, which implies a valuation of 33xF20 earnings.