Bharat Financial deal – IndusInd Bank unlikely to overpay

Madhuchanda Dey
Moneycontrol Research

IndusInd Bank (IIB) has signed an exclusive agreement with micro-finance lender Bharat Financial Inclusion (BFI) to explore a possible merger.

Market has been abuzz with talk about an impending deal between the two companies, and has rewarded both stocks equally this year so far.

Chart 1

The standalone micro-finance model appears to be facing challenges in recent times. BFI undoubtedly will be a profitable addition to IIB’s portfolio, but the latter is unlikely to overpay. For long-term investors, it makes sense to stay invested in IIB.

Why is it important for Bharat Fin to find a partner in a bank?

BFI has been experiencing stress in its books post demonetisation and the spate of loan waivers has made matters worse. Higher provisions led to a loss of Rs 235 crore and Rs 37 crore, respectively in the final quarter of FY17 and first quarter of FY18. Collection efficiency has improved, but is yet to return to pre-demonetisation levels.

RBI, in line with income tax regulations, has prescribed a limit of Rs 20,000 for loan disbursements or repayments in cash. This is initially applicable for gold loan disbursement, though we expect it will eventually apply to all categories for NBFCs. So the road ahead has speed-breakers for BFI and scaling up the business without compromising on the quality of earnings may not be easy.

Micro finance companies operate with several restrictions – on loan size (loan amount not to exceed Rs 60,000 in the first cycle and Rs 1,00,000 in subsequent cycles), category of borrowers (family income capped at Rs 100,000/Rs 160,000 per annum for rural/urban) and indebtedness (less than Rs 100,000 per borrower). Not more than two MFIs can lend to a borrower at a time; the loan processing charge is capped at 1 percent and finally there is a spread cap of 10 percent above the cost of borrowings.

The operational flexibility post conversion to bank along with the reduction in excess liquidity (which is required in day-to-day operations and for first loss margins for off balance sheet), should boost margins.

chart 2

What it brings to IIB?

IIB already has a business correspondent arrangement with Bharat Financial. With a tiny micro finance loan book of Rs 3000 crore, the ambition to scale up this high-yielding book is understandable.

The return on assets (ROA) in the MFI business historically has been much higher than that in traditional banking. The acquisition gives IIB access to priority sector lending (PSL) assets, and the bank can earn fees by selling PSL certificates as well.

The access to the largely non-urban pan-India network of 1252 branches opens up significant cross-selling opportunities for IIB.

Finally, MFI assets are classified under retail attracting a lower risk weight of 75 percent compared to lending to non-banking finance companies where the risk weight is 100 percent, thereby boosting the capital adequacy ratio (CAR).

The increase in share of MFI book to above 8 percent will marginally change the risk perception of the retail book as this piece is unsecured lending and risk of default is much higher. Though Bharat Financial follows a conservative 60-days overdue NPL (non-performing loan) recognition norm compared to 90 days overdue for most banks, collection efficiency number remains a key monitorable given the recent experience of stress in this pocket.

chart 3Valuation – the known unknown?IIB has maintained that any deal of interest to the bank will have to be value-accretive from day one. Given the performance divergence between IIB and BFI in recent times, albeit the intrinsic value of BFI’s highly profitable and high yielding book, it is extremely unlikely that IIB will overpay. As our scenario analysis suggests, the deal value could range from 5.7X-6.2X BFI’s trailing adjusted book (a premium to IIB’s valuation at 5X book).

Chart 4However, if one were to weigh the earnings accretion against the impending equity dilution, it is evident that the deal will be almost neutral to earnings in FY18 and earnings accretive from FY19 onwards as synergy benefits kick in and lower cost of funds for BFI gives a boost to overall margin.

Chart 5Hence, we do not see much of an arbitrage opportunity arising out of the swap ratio for BFI’s shareholders. Under the most optimistic scenario, where IIB pays a significant premium (6.2X trailing book of BFI), it suggests a stock upside of 9 percent for BFI shares.

The deal, nevertheless, adds another feather to the cap of the well-run IIB. Shareholders of the bank should stay invested and reap long-term benefits of a perfect execution strategy of a capable management team.

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