– The IPO is to comply with regulatory requirements
– Better to play the journey of this bank through the IPO than bet on UFSL
– Growing and diversified assets
– Liability profile improving
– Asset quality stabilising
– Moderation in cost to income ratio a kicker for earnings
Ujjivan Small Finance Bank (USFB) started off as a microfinance non-banking financial services company. The entity eventually got a Small Finance Bank licence and commenced operations in February 2017. The holding company of this SFB got listed in the bourses in 2016 in the name of Ujjivan Financial Services (UFSL). So, why is the same business getting listed under a different entity now?
The one line answer: to comply with a regulatory diktat that says a Small Finance Bank has to get listed within three years of commencing operations. This regulatory requirement had a telling impact on the UFSL stock, despite the company’s steadily improving financial performance. The stock touched a low of Rs 181 in October last year. However, it is now hovering around the Rs 327 mark with a market capitalisation of Rs 4117 crore.
Should one consider UFSL to play the theme?
Post listing of Ujjivan SFB, UFSL will still hold 83 percent stake in USFB and at the upper end of the price band, the value of this stake works out to Rs 5311 crore. Even with a holding company discount, the derived value of UFSL (from the listing of USFB) works out to Rs 4249 crore, a small premium to its current price. So does it pay to play the upside of this Small Finance Bank through the holding company, where there is still an arbitrage in terms of the valuation discount?
The answer is no. There are too many uncertainties that are yet to get addressed. For instance, as per the current guidelines, the promoter’s stake in the Small Finance Bank has to go down to 40 percent in five years, which could further erode value for UFSL shareholders. Although the management says the promoter stake can technically come down to zero at the end of five years, which could pave the way for a reverse merger between UFSL and USFB, that is in the realm of conjecture.
We would therefore strongly recommend investors to avoid such uncertainties and play the upside of this Small Finance Bank through the IPO of Ujjivan Small Finance Bank.
The initial public net offer (after the pre-IPO placement) is close to Rs 750 crore in the price band of Rs 36 to 37 per share. Of this, Rs 75 crore is reserved for UFSL shareholders at a discount of Rs 2 per share. The QIB (qualified institutional buyer) tranche is 75 percent of the net issue, non-institutional investors 15 percent and the remaining 10 percent is for retail. At the upper end of the price band, the market capitalisation of USFB would be close to Rs 6,399 crore.
Growing and diversified loan book
Ujjivan Small Finance Bank (USFB) has seen steady growth and diversification of its asset book in the past three years. At the time the bank started, close to 97 percent of assets were from micro lending which is now down to 83 percent with the addition of secured lending products.
The asset book is also diversified geographically, spanning 24 states and Union Territories and the top two states are the southern states of Tamil Nadu (16.5 percent share) and Karnataka (15.6 percent). USFB has one of the lowest state concentration risks amongst Small Finance Banks.
Improving liability profile
Despite addition of relatively lower yielding secured assets, USFB hasn’t seen much deceleration in its interest margin, thanks to the improvement in the liability profile with steady addition of deposits, which have a relatively lower cost compared to borrowings. The share of deposits in the total funding mix that was 6 percent in Q1 FY18 and used to fund only 6 percent of assets is now 75 percent and funds 79 percent of assets. While CASA (low cost current and savings accounts) is still minuscule at 13 percent, the steady acceleration of deposits and CASA remains a long-term driver of stable margins.
Recovered well from asset quality shock
Asset quality faced headwinds post demonetisation that saw its gross non-performing assets spiking to 6.2 percent of total advances. Since then, asset quality has exhibited tremendous resilience and as on September 2019, the gross and net NPA of the bank stood at 0.9 percent and 0.3 percent respectively. It has a healthy provision cover of 61 percent.
Moderation in costs
Like most of its peers, USFB also had up-front costs in terms of network, people and technology since the inception of the bank, resulting in a spike in the cost to income ratio that stood as high as 76 percent at the end of FY19. While the Small Finance Banking model by design is a high cost and high yielding asset framework, as the business scales up, investments are sweated effectively resulting in a moderation of the cost to income ratio and provides a significant kicker to earnings.
We expect earnings’ compound annual growth rate (CAGR) of close to 40 percent in the coming couple of years and feel that the valuation at 1.8 times FY21 estimated book value is reasonable compared to peers. We therefore recommend subscribing to the issue.
Key investment risks
A severe economic slowdown could impact asset growth as well as asset quality. Steep hike in cost of funds and a liquidity shortage could result in margin erosion and slowing down earnings growth.