Description

SOUTH INDIAN BANK – SIB IN

I believe South Indian Bank (SIB) shares represent great value – combining a strong chance for a double (or more) with a remote possibility of any permanent loss of capital.

SIB is likely to benefit from both a return to operating income growth and a dramatic reduction in loan loss provisioning in the coming two years. The combined impact should mean a FY20 (March year-end) EPS of INR ~5.5 (FY18e EPS is INR 1.9 according to bberg consensus). At the current market price of ~32, that implies a normalised P/E of less than 6x. In a normalised world in 12-18 months, you will have: (1) a bank with ROA of 1%+, (2) growing at 15-20% (primarily through retail/SME loans), (3) with sufficient capitalisation and (4) the troubles from a botched adventure in syndicated project finance lending firmly in the past. What is the right multiple for this? Banks with a similar profile in India (Federal Bank, DCB Bank, Karur Vyasa Bank) trade at 14-20x forward P/E or 2x+ book value. Taking a conservative 12x P/E on the INR 5.5 EPS gives us our double in 12-18 months (once the market starts factoring in FY20 numbers).

Some background:

SIB is a 90 year old private sector bank (note not state owned) headquartered in Kerala in South India. The bank has a pan India network of 850+ branches but is concentrated mainly in the South (~70%). For most of its history, SIB concentrated on retail and SME loans. However, it went away from this around FY10 to FY14 – and aggressively financed mega project loans as a junior partner in several banking consortiums. In a typical case, a large bank such as ICICI Bank or the State Bank of India would be the lead banker in financing green-field projects (e.g. a power plant) and arrange for further banks such as SIB to chip in and spread the risk. For a while, and probably with a dose of crony capitalism, all went well. However, predictably, the situation proved too good to be true. Loans started going bad and almost the entire banking system got dragged in to the mess (apart from the best in class HDFC Bank, Kotak Bank etc. that kept discipline). It is quite a fascinating episode, and one from which the Indian banking system is only just emerging.

SIB recognised the problem around 2014/2015 and pulled back on corporate lending. It has completely stopped project financing, and large corporate loans in general. They have also provisioned fairly aggressively, written off some bad loans and sold some further problem loans to Asset Reconstruction Companies (ARCs) at a discount. I believe the bank has now almost emerged from the mess and can focus again on its core retail/SME market – where a steady 15-20% growth is rather normal and doesn't require any genius (for example, India’s mortgage market is growing at 16-17% and government owned banks are bleeding market share). 

1/ The numbers:

Most of my numbers are a simple extension of management guidance in conference calls. They seem sensible to me, and are probably more likely to be conservative than aggressive. In my view, sell-side numbers are plain wrong. They seem to have just hit “copy right” on excel, especially for other income, provisions, tax  rates and share count dilution. It is certainly possible that they know better than management on topics such as provisions and taxes but it is highly unlikely. This is probably a combination of lazy modelling and a case of “show me”… given the below par operating performance of the bank for the past few years. 

The bank has guided for (FY19 and FY20 annually):
-18-20% loan growth (vs. 15-18% in FY18)
-25% growth in fee/other income (FY18 run rate)
-NIM of ~2.9% (same as current run-rate of 2.9% last Q)
-Provisions of between INR 4,000 to 5,000m (vs. ~11,000m likely in FY18e)
Tax rate 32-33%
ROA of 1%+ by FY20 and 1% annualised by Q3 or Q4 of FY19. Note that the bank did have 1% ROA in the years prior to their FY12-13 adventures – it is not unchartered territory. I think of it more as a reversion to the mean.

Just plugging in these numbers in a simple model throws out PAT of INR 10,0000 to INR 12,000cr by FY20. The bank has said they will raise institutional capital in the coming quarters and issue ~200m shares, which will raise share count to 2,000m. That implies INR ~5.5 in EPS in FY20.

I do not think anything in this guidance is controversial. They grew the book at 16% in the December quarter already. From FY19 onwards, with management focused on growth again (after 3-4 years of firefighting bad loans) this is highly likely. Federal Bank, which is also Kerala based and South India focused, and is about 12 months ahead of SIB in the clean-up process is now routinely growing at 20-23% (22% in Dec-17 Q). SIB does not need to try too hard to grow at 18-20%. Note that 90% of their deposit customers do not have any loan product with SIB – there is huge untapped potential sitting right at home.

Fee income growth of 25%: already growing fee income at 25-30% consistently (grew 46% yoy in Dec Q). Note that treasury income in FY17 and FY18e has been exaggerated and is unlikely to be repeated.

NIMs have not dipped below 2.7% for the past 7 quarters, and given SIB’s push in growing their deposit franchise, I do not see a danger of NIMs dropping below 2.8-2.9%.

Provisions: accelerated provisioning and a one-off write-down of value of security receipts mean that they have provisioned INR 9,500m already in the first 9 months of FY18. Q4 FY18 will likely see additional INR 2,000m provisioning according to management. Post Q4, the elevated provisioning is likely to stop given they do not have any further stressed corporate loans to provision for. My back of the envelope numbers give me a similar number of INR ~4,500-5,000m in “clean” provisioning that they will be required to do in FY19. This is admittedly a difficult number to predict without granular loan-level detail but is my best guess given their annual report disclosure on bad loans ageing, and assuming any slippages in the retail/SME book is as per historical trends.

Note that ROA of 1% in FY20 assuming 15% growth in income earnings assets in FY19 and FY20 implies PAT of roughly INR 10,000m (EPS of INR 5 on the increased share-count).

2/ Non Performing Assets (NPA) and capital position:

NPAs have been steady for the past 3 quarters now and are trending down (see page 40 of the Dec Q presentation). Corporate NPAs have all been recognised – management has repeatedly said that they do not have any large stressed corporate account now in danger of slipping into NPA. Provision coverage ratio currently stands at 49% (vs 60%+ historically). Management has guided for ~60% coverage ratio in the coming 2-3 quarters. Capital adequacy stands at 12.5% and the company intends to raise ~11% additional equity capital to fund further growth. At the end of the day, banks are black boxes and one can never really tell what makes up the granular loan book but it does seem to me that there aren’t any hidden bombs here. The worst is over (their kitchen sink quarter was March 2017) and provisions have remain elevated in the past 3 quarters. March 2018 will likely be the last elevated quarter for provisioning.

3/ Management:

I think the “management” case is fairly robust. Having interacted with them on a few occasions now, they do not come across as overly excitable. For what it is worth, to me they actually seem conservative in their tone. The CEO, VG Mathew joined in January 2014 and became CEO in October 2014. He has spent most of his time at SIB firefighting the bad loans (he wasn't around during much of the go-go project lending years). Mr. Mathew does not come across as someone who will put out unrealistic targets publicly. They have recently hired Sanchay Sinha to head their Retail banking operations. He comes with good pedigree: having worked with HDFC Bank and IndusInd Bank in the past (HDFC Bank is the gold standard in Indian banking). Note that management has recently been granted more options in December 2017 (total 4.5m shares or 0.25% of the total capital). Management ownership is not huge but is rising incrementally. At the end of the day, a bank is a bank. Much of my thesis relies on the management being at least partially honest – especially with regards to the legacy NPA issues being resolved.

4/ Other shareholders:

One of India’s best bank/financials investors, Ashish Dhawan (founder of Chrys Capital), has a 6.5% stake in SIB. He owns 1.6% personally and 4.9% through Lavender Investments, a connected fund. He has a great track record in the space, having been an early investor in Axis Bank and Shriram Transport in the early 2000s (both spectacular multi-baggers). He has consistently increased his stake in SIB over the past year or so. His presence in SIB can only be positive. SIB is under-owned by Indian mutual funds (or foreign funds), especially compared to its Kerala cousin, Federal Bank. If the operating numbers come in as expected, there is likely to be strong incremental interest in SIB.

5/ Further thoughts:

The bank (and the stock) has had 3-4 “lost” years. They have worked hard to get past the problems created by their corporate misadventures. I think there is finally light at the end of the tunnel now. The market still views this more or less as a basket case, which is why I think the risk of permanent capital loss is minimal (status quo is priced in). If nothing works, the company still probably earns INR 3-4 in FY20 (it earned INR 3.2 back in FY11 and the BV is up ~175% since then). INR 3.5 EPS implies a 9x multiple at today’s price, around half of the Indian index and certainly cheaper than any private Indian bank that I know of. On the other hand, good things could happen (higher growth, even lower provisioning, treasury income, higher multiple). Might the market pay 15x for INR 6.5-7.0 in EPS in FY2021 to get a INR 100 stock in 2 years? Quite possible I think. There is a lot more detail I can put in here but it is probably best if interested people just read through the quarterly presentation and conference calls. In today’s market, I do not see too many opportunities with similar risk/reward characteristics.

December Q presentation:

https://www.southindianbank.com/UserFiles/file/SGA_SIB%20Investor%20Presentation_Q3%20FY18.pdf

FY17 annual report:

https://www.southindianbank.com/UserFiles/file/SIB%20AR%202016-17.pdf

Catalyst

Earnings recovery through higher growth, lower provisioning 

Clean loan book visibility and corporate NPA issues fully resolved

Upcoming capital raise