Description

Equitas provides an opportunity to invest in an Indian bank that will have the high growth and return profile of an NBFC like financial institution but without the downside/risks associated with the NBFCs.  Equitas, historically a micro-finance institution (MFI) was awarded the small finance bank (SFB) licence by RBI (Reserve Bank of India) in 2015, and is currently in the early days of transitioning from an MFI to a bank. While conversion of an NBFC/MFI to a bank is ROA dilutive, Equitas will benefit from many factors that will help scale – new loan products, non-interest income opportunities, and stable and lower funding sources. After the initial gestation period of operating as a bank, the benefits will easily outweigh the banking costs, and Equitas should see a U-shaped recovery. I expect the book value to grow by 2x in 3 (max 4) years, followed by 15%+ steady state ROE. Equitas should provide a 65-100% return in ~3 years based on where the stock is currently trading.

Note:

• All numbers are in Indian Rupees unless stated. 1USD = ~65 rupees.

• Fiscal year ends on March 31st.

• Equitas is probably 1-2 quarters away from seeing the bottom before we see the u-shaped recovery – the stock could see short term correction before seeing long-term appreciation (Note for those who like to time the market)

Why does the opportunity exist?

Indian private banks are currently trading at 3.2x price-to-book and the NBFCs are trading at 3.5x. 3-year average trading multiple for the private banks and NBFCs are 3.2x and 3.5x book, respectively. In comparison, Equitas is currently trading at 2.4x book, when the bank probably has one of the best chances to grow its loan book and book value in the next 3+ years. There are a few good reasons why Equitas is trading at current levels, including:

• ROA and ROEs have come under pressure in the last few quarters

• Loan book growth has slowed down in the last 1 year, and

• NPAs have started to balloon

The first two issues faced by Equitas are short-term mostly since the bank is currently in a transition phase. The third issue is partly due to the regulatory differences between previous MFI reporting and current small bank’s reporting requirements. Additionally, NPAs have increased for most financial institutions (especially NBFC/MFI) in India in the last few quarters due to the demonetisation effort by the Indian government (demonetisation effort scrapped ~86% of the currency in circulation). Most of the retail NPAs are good loans and Equitas has more than adequate coverage on these loans. I have explained each of these issues in more detail below.

Why Equitas?

1)     Huge potential to grow its loan book: Equitas’ loan book increased by ~3x in 3 years between FY14-FY17. While Equitas has grown its loan book quickly, in the last 4 quarters its book has stayed flat. Equitas has slowed the loan book growth since the bank has been trying transition into its banking role. Equitas has also been trying to reduce its MF book and grow its non-MFI book; MF book is down from being 54% at end of FY16 to 42% of total book to 1Q18 (quarter ending June 2017).    

I would expect the no-growth or modest-growth for the next 3-4 quarters as Equitas works on transitioning its branches and get through the initial gestation period. But once the company’s operations stabilise, Equitas will not have any problems in growing its loan book. Its current AUM base is very small (little over $1bn) and with over 600 branches the incremental advances to double the loan book every year will be easy (less than $2mm of incremental loans per branch).

2)      Equitas will have a well-diversified AUM portfolio mix after full transition and initial gestation period: MF lending can be very lucrative as the yields are very high (~20% area) but the segment is prone to many risks – i) highly cyclical (micro and macro factors can unexpectedly impact the credit demand cycle), and ii) MF lending institutes are easy political target that can increase delinquencies in the short term. For example, last few quarters, the MF industry was dramatically impacted by demonetisation effort by the government, which has not only reduced credit demand but also increased NPAs due to cash crunch.

The best way for a MFI to scale is by diversifying its assets. While the yields on some of the products are not quite as attractive as MF yields, there are number of other benefits like longer tenure, bigger ticket sizes, lower credit risk profile lending, and not politically sensitive. I would expect the company’s exposure to MF to be in 20-25% area in the next 3years, with the remaining being evenly split between vehicle financing, MSE and SME financing and housing financing.

3)   Non-interest income expansion opportunity: Non-interest income is a big opportunity for Equitas. Previously, Equitas had very limited non-interest income as it was not a bank and had restrictions on generating income from selling third-party products. With Equitas converting to a bank and having formal agreements with third-parties, they have a good opportunity to increase this part of their business. Sources of non-interest income include selling third-party investments, insurance and other products. Already, the bank’s non-interest income has increased from under 2% of AUM previously to 4.6% in 1Q18. Equitas has been running as a bank for only a year now and most of its branches are not yet converted into bank branches (only 335 out of 617 converted).

4)      Lower funding cost, stable funding source, and better match of assets-liabilities:  The biggest benefit of transitioning to a bank is access to deposits, where the funding cost can be substantially lower than borrowings. Equitas’ cost of funding is already seeing the benefit of being a bank as its funding cost has been dropping. Over the last 2 years, its funding cost has dropped by around 300bps (from 11.8% in 1Q16 to 9.2% in 1Q18). The current deposits to total funding ratio is about 35% from 0% a year ago. This is just the beginning and there is more room for the funding costs to go down as deposit ratio increases. Funding cost should drop to 7-8% in the next 1-2 years.

5)      Low leverage and high capital adequacy ratios provides opportunity to easily grow its loan book: Equitas has been maintained a low leveraged book historically, which is a prudent thing to do in MF lending. Historically, Equitas has maintained a leverage ratio of ~3.5x (3.2x in 1Q18) versus private banks in the 8-10x area.  Equitas’ current capital adequacy ratio (CAR) is around 35% versus the required 15% for small finance banks. In MF lending the assets could face unexpected short-term high delinquencies or the liabilities could suddenly dry up when the macro conditions are weak and financial institutions stop lending. But the transition to a bank solves both the asset as well as liability issues and Equitas can easily increase its leverage.

The low leverage ratio means that even if Equitas were to double its loan book today (without any increase in equity) the leverage ratio would still be manageable and the CAR would be in close to 20%, well above the required 15% required. Hence, loan book growth is not contingent upon fresh earnings or equity capital infusion.

6)   Professional management: Management team is especially critical and execution is paramount when the company is going through a transition phase. Equitas is run by a professional management team. It’s founder, Vasudevan P.N, is currently the CFO but does not even sit on the board. Board has only 1 non-independent director (its CEO). In Indian context, this is highly unusual, which conveys that the founder is not a control freak. Rest of the team are qualified professionals who have been at the firm for a long time and seen the different industry credit cycles. Management is focused on growth but is conservative in its lending practices (seen in recent quarters).

Few considerations:  Short-term pain

1)      Increase in banking costs: The transition towards a full-fledged bank will be a painful process with some one-time and additional ongoing expenses that will increase their cost-to-income ratios above historical averages.  Prior to the transition, the C/I ratio was about 53% (FY15 and FY16) but in the last few quarters the ratio has increased to over 75%. In currency terms, the operating cost in 1Q18 had increased by about Rs. 1.1bn or 102% YoY. In the 2-3 years, the C/I ratio should drop down to mid 50% as the bank branches mature and operating leverage kicks-in.

2)      NPA and credit cost issue: NPAs and credit cost have increased in the last year for mainly two reasons, i) regulatory accounting changes for banks versus MFI. For MFI, the NPAs were recorded when payments were due on 150/120days but for banks it is recorded at 90days, ii) demonetisation (Nov 2016) by the government created a cash crunch, especially impacting the low income individuals the most (typical MF lenders), which resulted in the spike in NPA ratios. Equitas currently has 50% provision coverage ratio (PCR) on total loans and ~60% on MF loans and hence is adequately covered. The credit cost was around 2% of loans last year and 3% in 1Q18. The credit cost should peak in the next 1-2 quarters and then should drop to historical levels (sub 2%).  

3)      Slowdown in loan book growth, high net banking expense and higher credit costs have drastically impacted the ROA/ROEs: Historically, when Equitas was mostly an MF business, its ROA and ROEs were in the 3% and 12-13% range. In FY17, the ratios dropped to 2% and 9%, respectively and in 1Q18 the ROA and ROE were merely 0.7% and 2.8%. The returns are definitely giving short term investors a pause from investing but for long-term investor this creates an opportunity to play the upswing in returns.

4)      Geographical diversification: While Equitas has operations in over 12 states (most states expect east India), about a third of its branches are suited in one southern state, which is generally well banked.  

Valuation:

The stock is currently trading at 2.4x book value or 34x last years earnings. In contrast, Indian private banks are currently trading on average of 3.2x book (3 year average, low, high of 2.9x, 2.1x, 3.8x). Similarly, NBFCs in India are currently trading at 3.5x book (3 year average, low, high of 3.0x, 2.1x, 4.7x).  Given, the transition nature of the business, one will need to see the Equitas’ book value and earnings power post the transition and initial gestation period. After the initial transition period of 1-2 years, the book should quick grow and double in 3-4 years (2020). If we assume the stock trades at 2x book then, the stock would imply a 65% return; 2.5x book would imply 100% return.  

Brief company overview:

Equitas started as a MF company over a decade ago catering to individuals with limited access to formal financing channels. Currently MF is about 42% of its loan book with the rest non-MF (vehicle finance, MSE, SME and housing finance, etc). The company’s AUM has increased rapidly in the last few years owning to the low base and the underpenetrated market factors (AUM increased from Rs. 14.8bn in FY13 to Rs. 71.8bn in FY17).  

The bank has over 600 lending branches across India of which 335 have been converted into full-fledged bank branches. According to the regulatory requirements Equitas is required to convert all of their branches into bank branches within 3 years of start of banking operations.

Small Finance Bank (SFB) – History and regulatory requirements:

In October 2015, RBI granted small bank licenses to 10 financial institutions, with Equitas being one of them. The rationale behind RBI’s decision to provide banking licenses to these banks was to improve banking (savings vehicle) in the underserved parts of the country and also to make credit available to them. On the other hand, the small banks benefit from access to cheap and stable funding source (ability to collect deposits), wider customer base, diversified product mix and non-interest income opportunities.

Useful links:

https://rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=10636

http://www.equitas.in/sites/default/files/PR693F994665BD79442A084C623CC527F9EFB.PDF

http://www.equitas.in/node/277

http://www.sebi.gov.in/filings/public-issues/apr-2016/equitas-holdings-limited_32403.html

Catalyst

completion of bank branches conversion (1-2 qtrs); NPA drop; signs of loan book growth