RoA of merged entity may lag standalone Kotak Bank in the near to medium term
Kotak Mahindra Bank
Kotak announced on November 20 that it is set to acquire ING Vysya Bank at a share swap ratio of 725:1000, subject to requisite approvals. This implies a valuation of R160 bn for Vysya Bank, equating to 1.9x FY16e (estimates) consensus book and an 11% premium to the closing price on the day prior to the announcement. A strong presence in the south and a CASA (current account savings account) franchise is what Vysya Bank offers to Kotak in the pending deal.
Pro forma fair value range: Our sensitivity analysis examines the fair value range of the merged entity (Kotak-merged) after factoring in the potential costs and benefits of the pending acquisition, of R1,188-1,484 per share. Based on a pro forma fair value between our bull and bear case (R1,364) the difference to our target price would be 18%.
Potential synergies: The two most significant synergies we expect include fee income potential and cost savings on branch expansion, both adding 15 bp to RoA (return on assets) by FY17e, or about 10-15% of Kotak Bank’s standalone earnings and even higher over the medium term after completion of the integration process. Other synergies include the potential for higher savings account deposits and a potentially higher mix of retail loans.
Acquisition challenges: Upfront costs of the merger (legal, rebranding, technology, etc.) are likely to weigh on near-term profitability. The impact of higher provisioning on Vysya’s book and higher costs of savings deposits will likely peak in FY16e (with the latter partly offset by a higher SA mix), resulting in an adverse impact of 10 bp of assets—10% of Kotak Bank’s earnings. Cultural differences may impact productivity as well.
Change in shareholding pattern: We would expect the pending acquisition to help reduce promoter stakes from 40% to 34%. While the total foreign ownership in KMB will increase from 42.5% to 47.0%, FII ownership will dip from 34.6 to 33.6%. ING Groep has voluntarily agreed to hold its stake (6.5%) in the merged entity for a year.
Valuation: KMB (standalone) now trades at a 12-month forward P/AB (price-to-book ratio) of 4.7x versus its five-year average of 3.1x. Based on a sustainable RoE (return on equity) of 23.4%, we arrive at a target multiple of 4x using a single-stage Gordon growth model. Our TP of R1,253 includes a value of R339 per share for the subsidiaries.
Downside risks to our view are continuing weak macro and low leverage.
Vysya Bank would be merged into Kotak once the companies have obtained all requisite approvals, which could take until the end of FY15 per management. In the scenario of the merger taking place we have attempted to take a look at the merged entity (Kotak-merged) after factoring in potential costs and benefits due to the merger to get a better sense of the impact on RoA arising from the union. Our analysis suggests that the pro forma fair value range of the Kotak-merged could lie between R1,188-1,484 per share.
P&L impact: We describe below the incremental impact of the merger on key parameters based on our scenario analysis for Kotak merged.
Margins: Re-pricing of existing Vysya Bank savings account deposits could negatively impact margins but also would be partly offset by both higher SA in funding mix as well as higher retail loan mix (tractor loans in which KMB has a significant presence).
Other income (fees): We expect the merged entity to benefit from a wider customer base, distribution network and product suite, which would translate into higher cross-selling of Kotak’s products. We see some incremental impact in FY16 itself, and we expect more gains to kick in the medium term post-merger.
Opex: We expect upfront costs related to merger (stamp duty, re-branding, technology integration, etc) to be offset by slower branch expansion as we see a lower need for KMB to grow organically post-acquisition. On an average Vysya Bank branches have a vintage of six years, which would already be contributing to the bottom line versus a new branch which would take two-four years to contribute. As per our discussion with the management, the average cost incurred in setting up and operating a new branch could be R70-80m over four-five years (or R15m per branch/year on an average) after which the branch would break-even. We estimate that 75% of this amount or R11m per branch/ year on average could be the cost savings per branch and result in cost savings. For instance, if Kotak-merged halves its (Kotak’s) earlier plan of opening 150-200 branches per year, the cost savings from opening 75 less branches in FY15 could be R0.8 bn in FY15 based on current estimated costs.
Credit costs: Per our calculations, factoring in a 100% coverage ratio for Vysya Bank’s unprovided NPLs (non-performing loans) in FY16, we see an incremental impact (R0.85 bn) on the merged P&L (profit & loss account) which translates into an incremental 4bp (pre-tax) impact on FY16 RoA for Kotak-merged. We have been conservative here, but believe that the management will also take the conservative route in estimating NPL costs.
Profitability: Overall, we expect to see synergies to make RoA marginally accretive in FY16e. However, we do not see RoA of the merged entity reaching the levels of standalone Kotak Bank pre-merger in the near to medium term.
Challenges: We see challenges in terms of integration of two different banking cultures. Of the 10,000 employees of Vysya Bank, around 3,000 are unionised and come under the wage structure of IBA (the Indian Banks Association). While the salary levels are similar to the remaining employee base, wage increases would be determined by negotiation with the unions. Productivity too would be a challenge. Taking a leaf out of the previous merger of HDFC Bank and Centurion bank, where HDFC Bank had to write-off some assets from the acquired entity post-acquisition, a similar situation cannot be ruled out for this acquisition.
Shareholding pattern: We expect the pending deal to help reduce promoter stakes from 40% to 34%. Promoter stakes include Uday Kotak (which has the largest stake, at 39.7%), with family etc. holding the remaining 0.3%. Per RBI, promoter’s stake in KMB has to be reduced to 30% by Dec-16 and 20% by March 18. This all share deal significantly contributes in moving towards this goal. Total foreign ownership in Kotak-merged will increase from 42.5% to 46.9%, of which the FII ownership will be 33.6% (down from 34.6% for Kotak). ING Group has voluntarily agreed to hold their stake (6.5%) for one year from the date of deal execution and this would be counted in the FDI category for the merged entity.