Description

This is a simple idea that requires a little dash of faith. So I’ll keep it brief.

Overview of Business

Jammu & Kashmir bank is the dominant bank in Jammu & Kashmir state, on the very northern end of India and bordering on Pakistan. The state government owns a 53% stake so the float is small (less than USD$400 million). The cap is about USD$790 million. 

J&K is a relatively poor, mountainous, and sparsely populated state (11 million people). Main industries are agriculture and tourism. Given the geopolitics of the area, there’s also a heavy military presence which helps the economy. Furthermore, for the same geopolitical reasons, the region receives a significant amount of transfers from the central government. The economy has actually been growing rather well, though the state remains much poorer than India as a whole.

The geographical isolation and small size of the local economy has one silver lining – J&K Bank is a virtual monopoly in the state. The bank has something like 80%-90% market share – both deposits and loans. The state seems to be beneath the notice of the other larger banks, even as India liberalizes the banking sector. Indeed, I consider J&K bank to have one of the finest deposit franchises among Indian banking, with near best in class CASA ratios.

For the last 15 years, India’s banking sector has expanded significantly, and so has J&K Bank. Because of its local dominance, the bank actually earns extremely attractive returns in the state (I estimate 6% NIMs and 20-30%+ ROEs depends on how you count). For the bank as a whole, ROEs in the last decade averaged in the high teens.

The business is simple. It’s a plain old lending bank that depends almost wholly on net interest income. Being an old public sector bank, its pretty stodgy, behind in technology, and not super well managed. Most years though, the fact that it's a monopoly bails it out. 

Current Problems

The problem, however, that the local economy does not contain as much loan demand as needed to absorb all the deposits. Therefore, ironically, the bank is a significant exporter of credit to the rest of India. In the last quarter, although 73% of deposits are from within Jammu & Kashmir, 52% of loans are made outside of the state (in part funded by higher cost wholesale deposits). Even worse, the bulk of these loans are to crappy Indian corporates & infrastructure projects as part of larger lending syndicates / consortiums. It’s fair to say that these country bumpkins got screwed. J&K’s pan-India portfolio is afflicted with the disease currently plaguing all large India public sector banks. (This is well documented, and you can find out a lot more via a quick Google search. Suffice to say that the situation is not pretty).

To add on top of that, the situation within J&K state, which over the last decade offered rich economics and good credit quality, deteriorated thanks to devastating floods in late 2014. We’ve seen a rash of NPLs / restructuring due to this tragedy (though assistance from the central government should perhaps alleviate the stress in the next several quarters).

The confluence of these two issues has cut the stock price in half from its highs. The P/B ratio is now 0.9x, the cheapest since the financial crisis (the only other time which it dipped below 1x).

Provisions in the last year have been massive. Gross NPLs are currently Rs. 26 billion, 5.6% of gross loans.

Future Developments

Frankly, asset quality might get worse before it gets better. I get the feeling that the entire public banking sector is still in an “extend and pretend” situation. Indeed, J&K is actively restructuring loans (this rising 27% YOY to Rs. 18 billion). Some previously restructured loans have already returned as NPAs. NPL coverage is only 51% -- which totally blows and hints at elevated further provisions going forward.

Thankfully, the bank is actively retrenching from its pan-India business. Both loans and deposits outside of J&K are falling. And hopefully newly written loans are of a better quality.

Rebuilding from the floods, along with pretty good economic growth is expected to drive growth inside Jammu & Kashmir. Thus, business mix should improve somewhat through the next year. Small consolation though given the situation today.

Balance Sheet, Valuation, and Earnings Power

The good news here is that the balance sheet is quite manageable despite elevated provisions. Tier 1 capital under Basel III is 11.4%. There are no liquidity problems.

But the real draw to me is the bank’s substantial pre-provision, pre-tax profits. This year, this should be around Rs. 16 billion – against Rs. 26 billion in NPAs, Rs. 18 billion in restructured loans, and Rs. 6 billion in YTD provisions. PPOP is 3.7% of net loans outstanding.

To me, it seems very improbable that this bank could fall into distress. The underlying earnings power combined with existing equity base should be sufficient to tide the company through the next several years. (Indeed, despite a massive spike in provisions, the bank remains GAAP profitable).

Therefore, if you believe the bank has a certain amount of franchise earnings power, stemming from its Jammu & Kashmir monopoly, this should be a good investment over the next several years.

The earnings power is not terribly hard to estimate. Using a reasonable range of “long term sustainable ROE”, the stock is trading ~3-5x earnings 3-5 years out. They'll likely pay a reasonable dividend while you wait.

Risks

If asset quality is a MAGNITUDE worse than it currently appears.

A massive natural disaster (earth quake, massive flooding, etc)

War with Pakistan (or China). That would really suck.

Catalyst

Wait for credit quality to stabilize