Description

Summary

The Indian banking sector is one of the most structurally attractive in the world. GDP growth, increasing credit penetration as a percentage of GDP, and private banks gaining market share from state run institutions should provide years of above average loan and deposit growth at solid returns. We highlight Axis Bank in this writeup in particular given its improving company-specific fundamentals, exposure to the abovementioned favorable trends, and a reasonable valuation. We think the stock should double over the next 2-3 years and compound at a mid-teens rate after that.

Backdrop

India has grown over any recent five-year period going back to 2005 at between 11-15% nominal and ~7% real rates. While the next year should trend above these rates due to a lower base, it isn’t unreasonable to expect relatively strong growth over the next few years. Growth should be driven by a stil-high level of agricultural workforce (~40%), a high rural population (~66%), and a younger demographic (54% less than 24 years old). In addition, India has enacted several favorable incentives for manufacturing in India to gain export share (~1.7% share of world merchandise exports - comparable with Poland, Thailand, and Vietnam). Of note, India has a large domestic economy that should provide additional incentive for manufacturing activity that seeks to diversify away from China and its increasing wages. As we will outline below, even sub-par growth should be adequate for this investment.

Credit Penetration and Industry Structure

Credit penetration in India is comparatively low. India’s total credit to the private non-financial sector stands at about 56% of GDP compared to 68% in Brazil, 117% in Thailand, 134% in Malaysia, 151% in the United States, 193% in Korea, and 195% in China. Further, recent credit growth has been cyclically low following an expansionary phase in 2010-2014 driven by capacity expansion. 

Important to this thesis is the industry structure in the banking sector. In 2019, about 61% of loans outstanding were made by public sector banks. Notably, the country is undergoing a slow and steady privatization of the banking sector as privately-run banks continue to gain loan and deposit share. In 2016, private banks held about 25% of loans outstanding at 21% of deposits. In 2019, that share had increased to 34% of loans and 30% of system deposits. Capital constraints, recurring loan losses, lack of investment, and poor service levels should continue to see share move to private sector banks. Assuming this trend continues and private banks approach 50% share over the next 10 years, even a 5-10% nominal growth in system credit should result in 11-16% growth for private bank loans. Of course, given mid-single digit inflation, 5-10% loan growth is reasonably low. A scenario where GDP growth is mid-high single digits in real terms, inflation is mid-single digits, and where credit as a percentage of GDP grows, could result in system loan growth approaching 12-15%. In such a scenario, private bank loans could grow at ~20% per annum. It is this favorable backdrop that serves as an important driver of growth whilst providing margin protection (most of the larger private banks can gain share in a relatively disciplined fashion).

Private Banking Industry Structure

The four largest private sector banks in India by assets are (1) HDFC Bank, (2) ICICI Bank, (3) Axis Bank, and (4) Kotak Mahindra Bank. Given that all the private sector banks account for ~30% of the system, even the largest players have single-digit market shares. In 2019, HDFC Bank had ~7% deposit share, ICICI Bank had ~5% share, and Axis Bank was the number three player at about 4% share. Notably, the incremental share of deposits for each of these banks was far higher than current market share - HDFC at ~12-13% and Axis and ICICI at ~8-9% incremental share in 2019. 

Apart from the competitive advantages relative to the state run banks mentioned above, at this point the private sector banks have amongst the lowest cost of deposits in the banking system. This is remarkable given that state-run banks carry an implicit government guarantee. In practice, the Indian government has not allowed depositors to get hurt even in situations where private banks have gotten themselves into trouble (witness Yes Bank a few years ago). As a result, HDFC Bank, Axis Bank, and ICICI Bank have the lowest cost of deposits in the system. This is a marked change for banks like Axis and ICICI Bank versus 10+ years ago and allows them to earn adequate returns without excessive risk taking.

Historical Backdrop for Axis Bank

Historically Axis Bank lent money to large and medium sized Indian corporates. They lacked a strong branch network, had a relatively higher cost of funds, and lacked the ability to make retail loans. The corporate loan business in India has been highly cyclical. The lack of an established bankruptcy code (introduced only in August 2016), led to perverse incentives to borrow too much and repurchase debt at a discount later. As a result, following the credit expansion of 2010-2014, corporate loans soured at high rates with gross non-performing loans for the entire banking system at >11% of gross advances. Industrial sectors like metals, cement, and mining experienced 30-40% of impaired loans. As a bank with a reasonably large corporate loan portfolio, Axis Bank’s Gross Non-Performing loans reached 8-9% in 2017-2018. It is noteworthy that despite the high loan losses during the cycle, Axis Bank managed to grow book value per share and was able to raise capital at above book value (market participants recognize the favorable backdrop for the sector and are willing to provide capital at terms that are not overly damaging to existing shareholders).

Bain Capital, Management, and Business Improvements

During this cycle, Bain Capital recognized the strong underlying fundamentals and improved funding and industry positions of the private banks in India. They invested $1 billion in Axis Bank in December 2017 and joined the board. Further, India enacted bankruptcy reform improving incentives in corporate lending. Equally importantly, Axis Bank continued to build its branch network, improve its funding position, and built a robust retail franchise (now ~55% of the loan portfolio). Finally, the bank improved its management team following the 2016 cycle. New management has focused on improving the risk culture and underwriting throughout the bank. These improvements can easily be seen in the bank’s credit metrics and loan composition. For example, almost 90% of corporate slippages historically came from the BB and below loan pool. Over the last four years, 92-95% of new corporate loans have been made to borrowers rated A- and above (~90% of the current corporate loan book is rated A- or above). Despite Covid, gross non-performing assets are ~3% of loans. More importantly, net non-performing assets are just 0.9% of loans outstanding. Net loan slippages in recent quarters have been about 50bps on an annualized basis. Further, the bank is well-provisioned for both Covid and business-as-usual losses as reflected in these figures and a coverage ratio of 130% of GNPA including buffer provisions. Today, the bank is better managed, more diversified with both retail and corporate loans, has better rated-loans, and is adequately provisioned. In short, there is nothing that constrains it from prudently participating in the opportunities that lie ahead. 

Future Prospects

We’ve tried to make the case for a favorable industry backdrop that should drive much of the growth going forward. We’ve also tried to outline the improved management and business position of Axis Bank today relative to 2015-2016. Despite significant challenges in India from Covid, the Indian private sector banks, including Axis, reported both positive earnings and growth in book value. Further, Axis and the other private banks strengthened their balance sheets by increasing provision coverage to >100% of gross non-performing loans and by raising growth capital at reasonable valuations for existing shareholders. While current year earnings (fiscal year ending 3/22) are depressed on account of the Covid provisions (ROE ~12%), we think Axis has a clean balance sheet, strong capital position, and is well positioned to return to strong growth and normalized returns over the next few years.

At today’s price of Rs. 752 (~$10 per share) and a book value per share on 3/22 of about Rs. 375, the bank trades at ~2x current year book value. While loan growth will depend on the factors discussed above, we think ~15% loan growth per annum for the next 3-years is a reasonable expectation. Management expects to target an 18% ROE, though we think that will require some work to get to. With reasonable assumptions on costs and normalized credit losses, we have ROE’s of between 14-16% over the next three years leading to book value of ~Rs. 675 by 3/26. At a 17% ROE, that equates to earnings of >Rs. 100/share. At 15x, those earnings, the stock should double over the next 3-years. Should macroeconomic factors lead to stronger than expected loan growth in India, multiples could easily be higher. For a bank approaching a 20% ROE with structurally favorable medium-term drivers of growth, 3x+ book does not strike us as being an unreasonable valuation. Either way, we think returns over the next three years should be strong. Further, returns beyond that should continue to be good. While very bearish markets and fears about loan losses (e.g. Covid) can cause stocks to approach book value, we don’t see that risk given the current setup. In any event, those have been historically terrific opportunities to add to or initiate investments. Given the information we now have about the effects of Covid and the stronger balance sheets, the risk/reward over the next few years strikes us as attractive.

Catalyst

Recovery from Covid and continued loan growth.