Synergies Of Merger Make IDFC First Bank A Good Bet

IDFC First Bank

"IDFC Bank was looking to diversify its loan book from infrastructure. The bank was looking for a merger with a retail finance institution that had an adequate scale, strong financials and specialized skills. Meanwhile, Capital First was looking to attain the commercial banking licence in order to access a large pool of funds for growth and access to lower cost of funds."

About the Merger

IDFC First Bank was founded by the merger of erstwhile IDFC Bank and the erstwhile Capital First on December 18, 2018. IDFC Bank was founded in 1997 to finance infrastructure, focusing primarily on project finance as well as mobilisation of capital for private sector infrastructure development. IDFC Bank provided financial intermediation for infrastructure projects and services, value addition via innovative products to the infrastructure value chain or asset maintenance of existing infrastructure projects. Capital First has stayed consistent with the theme of financing self-employed entrepreneurs, MSMEs and consumers through the platform of technology and has grown the retail franchise. The company achieved a diversified portfolio across 600 industries and over 70 lakh customers. Retail loan assets stood at 91 per cent of the overall loan assets. Capital First provided financing to select segments that are traditionally underserved by the existing financing system because due to their small ticket sizes, credit evaluation and collections are difficult and business is unviable due to high operating and credit costs. Capital First would have run into problems as institutional funding lines, which were the company’s main source of liabilities, could be constrained.

IDFC Bank was looking to diversify its loan book from infrastructure. The bank was looking for a merger with a retail finance institution that had an adequate scale, strong financials and specialized skills. Meanwhile, Capital First was looking to attain the commercial banking licence in order to access a large pool of funds for growth and access to lower cost of funds. In January 2018, IDFC Bank and Capital First announced that they would merge with each other and the shareholders of Capital First would be issued 139 shares of the merged entity for every 10 shares of Capital First. The shareholders of both IDFC Bank and Capital First approved the merger with votes in favour by an overwhelming 99.98 per cent and 99.9 per cent, respectively. This was also the first merger between an NBFC and a commercial bank. The merged entity has loan assets of Rs. 104,660 crore. The retail segment constituted 34.62 per cent of loans in the retail segment. Margins for the company stood at 3.3 per cent post-merger. The merged entity has a diversified asset profile and a large retail customer base of more than 70 lakh live customers, including 30 lakh rural customers. The net worth of the merged entity increased by Rs. 3600 crore due to the merger and stands at Rs. 18376 crore as of Q3FY19, as against Rs. 14776 crore for the erstwhile IDFC Bank in Q2FY19. 

The Road Ahead

On the assets side, the bank plans to increase its retail asset book to Rs. 1,00,000 crore over the next 5-6 years. The bank plans to cut exposure to the infrastructure segment as and when the loans mature. The company’s exposure to the infrastructure segment stood at Rs. 22,710 crore as on December 31, 2018. The bank will look to continue growing its non-infra corporate loan book based on the available opportunities. The bank plans to increase its retail book composition to over 70 per cent of its total loan book in the next 5-6 years. It intends to expand its housing portfolio and it will be one of its key offerings. The company intends to increase its gross yield to 12 per cent over the next 5-6 years from 9.2 per cent at present, through growth in the company’s retail loan assets.

On the liability side, the bank will channelise its focus on increasing the CASA (current accounts and savings account) ratio to 30 per cent over the next 5-6 years from 10.3 per cent as of December 2018. Diversified liabilities in favour of retail deposits (incl. CASA) are important for the bank. CASA and retail term deposits are expected to increase to over 50 per cent in the next 5 years from 10.5 per cent at present. In order to increase its retail deposits and CASA, the bank will open 600-700 more branches over the next 5 years. The bank has 206 branches at present. 

On the profitability front, as retail contribution as a percentage of total assets moves closer to 70 per cent, the bank plans to expand net interest margins to 5.5 per cent in the next 5-6 years due to an expected increase in gross yield and lower cost of funds due to lower CASA ratio. It plans to reduce its cost to income ratio to 55 per cent over the next 5 years, significantly lower than 80 per cent in December 2018. With the expected improvement in NIM and cost to income ratio, the bank remains hopeful of achieving a return on assets (ROA) of 1.4-1.6 per cent and a return on equity (ROE) of 13-15 per cent. The management from its experience with the erstwhile Capital First remains confident that once a stable business model is established and profitability is scaled up consistently, then sustained increase in ROA and ROE would be achievable.

A large part of the bank’s retail loan book comprises loan book of Capital First, which has conducted high levels of due diligence while underwriting loans. For the large ticket sized loans, including loan against property, several checks including cash flow evaluation, credit bureau and reference checks are conducted before loans are sanctioned. Over 40 per cent applications were rejected due to inadequate cash flows to service the loan. This has helped Capital First to maintain stable asset quality. Capital First also encountered several periods of stress such as demonetisation, implementation of GST, increasing interest rates between 2010 and 2014. However, the bank’s GNPAs and NNPAs remained at approximately 2 per cent and 1 per cent, respectively.

Challenges

Although the self- employed and MSME credit space remains underpenetrated in India, the lack of sustainable cash flows often makes this space vulnerable to defaults. The quality of underwriting is of utmost importance. As the opportunity in this space is lucrative, IDFC First Bank could face competition from other banks if too many entities enter this space and use newer technologies for customer outreach.

Financial Performance

IDFC First Bank is a new entity and its results are not comparable with those of either IDFC Bank or Capital First. The company reported a net interest income (NII) of Rs. 1445 crore for the quarter ended December 2018. The company’s total operating income (net of interest cost) came in at Rs. 1449 crore as of December 2018. The net interest margin (NIM) for the quarter stood at 3.27 per cent for the company. The cost to income ratio for the quarter stood at 78.75 per cent. The profit before tax for the company stood at Rs. 95 crore. As a result of the merger, the goodwill amount of Rs. 2599 crore arose on the books of the company. Under Indian GAAP, this goodwill can be amortised over a period of five years.

 However, the company has opted to be prudent by accelerating the amortisation of goodwill to the profit and loss account. Simply put, the amount paid to Capital First shareholders (as per agreed swap ratio between the two companies) included a premium component over the fair value of net assets. This resulted in the creation of goodwill on the balance sheet. Thus, the company posted a loss of Rs. 1538 crore in its first quarterly results. The normalised profit for the company would have been Rs. 153 crore, which includes Rs. 72 crore because of certain tax write-back items. The non-performing loans for the quarter increased to Rs. 1671 crore from Rs. 895 crore. This was on account of the merger of Capital First’s loan book. The book value per share of the merged entity is Rs. 38.43 post the merger.

"On the profitability front, as retail contribution as a percentage of total assets moves closer to 70 per cent, the bank plans to expand net interest margins to 5.5 per cent in the next 5-6 years due to an expected increase in gross yield and lower cost of funds due to lower CASA ratio."

Conclusion

The opportunity in the banking, self-employed, MSME space remains extremely underpenetrated. IDFC First Bank’s aggressive expansion plans, strong underwriting history, large liability franchise because of CASA puts the bank in an advantageous position to tap the opportunity. By virtue of the above factors, we recommend a BUY.