New banks are a rare breed in India. IDFC Bank (IDFCBK), carved out of its parent, infrastructure lender IDFC Ltd, a year ago, starts life with a distinct set of advantages and disadvantages. The market prefers to look at the negatives, which centre on meeting near-term regulatory targets for loans to priority sectors. We believe India’s long-term macro story, opportunities for growth in the banking sector and the reduction in competition in recent quarters will allow IDFCBK to create a profitable long-term business.
Competitive strengths: IDFCBK begins its long journey as a fully-fledged bank with a quality management team, high corporate governance standards and a robust balance sheet, which will complement its differentiated business model. The bank is using technology innovations such as micro-ATMs — a portable “bank in a box” that allows it to have a variable cost business model, rely less on branches, yet increase its reach multifold, thereby transforming itself from an infrastructure lender into a mass retail bank.
Profitability, catalysts: The return on assets (RoA) is currently low at 1.1% and will probably stay at this level until FY18e. We expect IDFCBK to follow the early growth path of private banks in India, with RoA improving to 1.4% by FY21e. This should be driven by diversifying the loan book, expanding corporate relationships and establishing a retail franchise. We also see several medium-term catalysts: (i) it is wholesale funded, so declining rates should benefit margins; (ii) the bank has the option to offer differential savings deposit rate, which would be positive for the retail franchise; (iii) by FY18e, there is a possibility of write-backs of provisions made against infrastructure loans; and (iv) greater investment by foreign investors by September 2018 due to the regulatory requirement for parent IDFC Ltd to reduce its stake.
Initiate with a Buy rating and a TP of R92: Even with the recent strong share price rally, IDFCBK still trades at a 1.75x 1-year forward AB, well below the 3.0x for private banks we cover and 2.3x during the early stage of their growth cycle. We think it deserves a better multiple. Using a single-stage Gordon Growth Model, we value the stock at 2.1x 1-year forward P/AB, based on a sustainable RoE of 15.3%, COE of 12.5% and long term growth rate of 10%. For FY17e and FY18e, we are 12% and 4% above consensus earnings. The main downside risks are prolonged structural change, lower-than-expected leverage of the technology model, and weaker-than expected long-term profitability if the retail franchise disappoints.
IDFC Bank, India’s newest listed private bank, opened its doors for business on 1 October 2015. A year on, we think this was good timing. The economy has picked up in the last few quarters, inflation and interest rates have fallen, the first good monsoon in three years is helping to revive the rural economy and there’s sufficient liquidity in the banking system. While the near-term outlook is improving, we believe the long-term story also remains attractive. India is one of the most under penetrated credit markets, with a credit/GDP ratio of just 56%, which suggests there is significant scope for credit growth over the next few years.
At the ground level, competition in the banking sector has eased, which partly explains why credit growth is at a multi-year low. We think PSU banks are likely to remain on the backfoot at least for the next two years as they clean up their balance sheets. This gives us reason to believe that there is a large gap to be filled in the market and we believe IDFCBK fits perfectly.
The stock has underperformed the private bank index and broader markets since listing in November 2015, although the price has recovered in the last two months. IDFCBK, which is in the very early stage of its growth cycle, is trading at a 1.75x 12-month forward P/AB, well below the 3.0x for private banks we cover. While its ROE is low at 7.5% due to its special situation and high equity base, we believe this is not the right metric to value the stock.