Description

Ujjivan Financial Services (UFSL) is an event-driven investment opportunity with an upside of over 60% which can be expected to be realized over the next 1-2 years. In simplistic terms, the investment thesis involves UFSL (Holdco), to reverse merge into Ujjivan Small Finance Bank (USFB), the OpCo entity, which would collapse the holdco discount. The board has clearly stated that the reverse merger is its primary objective, and so the only uncertainty remains with respect to the timing of the reverse merger, which will depend on some regulatory approvals that we will discuss.

History of the bank, holdco and opco structure:

Ujjivan started as a micro-finance company in 2005 and was founded by the current chairman of UFSL Samit Ghosh and his friends. Ujjivan became one of the best micro-finance success stories in India over the next 10 years as the company expanded its network across India.  

In 2015, RBI gave a few microfinance institutions (including Ujjivan) licenses to convert to Small Finance Banks (SFB) with a condition that the bank formed would require to have a promoter. The promoter of the bank was then required to own minimum ownership of 40% in the bank for a mandatory period of 5 years since the formation of the bank.

Ujjivan received the in-principal approval from RBI in Oct 2015 to set up the SFB. Ujjivan then set out to form its SFB subsidiary and transferred its business to the SFB entity and commenced operations from Feb 1, 2017. In the meantime, UFSL (the holdco entity) IPO’d in 2016 to reduce the foreign holding below 50% (another RBI requirement to form SFB). The opco entity USFB also went on to IPO at the end of 2019 to again meet another RBI requirement (a financial entity with capital in excess of INR 500crs is required to IPO within 3 years). So now we have both UFSL and USFB listed with UFSL owning just a stake in USFB and no other operating assets. UFSL currently owns 83% stake in USFB and its 5 year mandatory lock-in period will expire on Feb 1, 2022.    

What is the value unlocking potential – investment upside?

USFB currently trades at Rs 23/share or 1.2x its book value. UFSL owns 83% stake in USFB and trades at Rs 162/share, which would imply a holdco discount of 40%. While holdco discounts in India can exist much higher than 40%, they are justified when the shareholders of the holdco do not get to fully participate in the upside of the opco entity. But in the case of UFSL, the shareholders can expect the structure to collapse and receive proportionate shares in the opco, thereby collapsing the entire holdco discount.

There is also an upside from the potential stock appreciation of USFB. The USFB stock has recently been under pressure due to management issues at the bank. USFB had recruited an outside talent Nitin Chaugh to run the operations of USFB in 2019 and to take over the role of MD and CEO from Samit, as he wanted to take a step back from running the bank. Nitin had an impressive background having worked at HDFC Bank for 18 years and being the group head of the digital banking business at HDFC Bank. At USFB the vision was to use Nitin’s experience to transition the bank into a new-age digital bank, but soon after his appointment as CEO in Dec 2019, covid happened. Nitin was not experienced with running a microfinance bank that required a different skillset of managing operations at ground level especially during a crisis like covid. This led to asset quality deterioration and high attrition at all levels of the organization. Eventually, Nitin resigned as CEO in Sept 2021 and the company bought back the old management to run the bank. The new changes include the appointment of Carol Furtado (who had been with Ujjivan since inception) as interim CEO until the next CEO is identified and also the addition of four directors on the board including Samit Ghosh (common director with the holdco) and Sudha Suresh (ex CFO/CEO of the holdco). The new managements’ near-term goals include i) hiring senior management members to replace members who left during Nitin’s tenor,  ii) stabilizing the asset quality, and iii) putting the bank back on growth trajectory.  

There is a big valuation difference between Ujjivan and Equitas, which trades at over 2x book value. Both these banks were considered to be of similar quality before Nitin’s tenor. If the current management of USFB is able to put the bank back on the right track, the stock could rerate and trade between the current valuation of 1.2x book and closer towards 2.2x book, where Equitas trades.  

Next steps and expected timeline:

In July 2021, RBI announced that it would permit Ujjivan (along with Equitas and IDFC) to apply for the amalgamation of the holding company with the SFB. The holdco can apply for this approval three months prior to the 5th anniversary of the bank, subject of course to the entities complying with the all regulatory prescriptions. For Ujjivan the 5-year period would expire on Feb 1, 2022 and so they can apply for the reverse merger from Nov 1, 2021 onwards.

Post the RBI approval, Ujjivan would also require approvals from SEBI, NCLT and shareholders of both the holdco and opco. SEBI approval is required given the promoter of the SFB is required to lock-in at least 20% stake for three years after the IPO of the SFB.  However, Equitas has already received this approval from SEBI and I expect Ujjivan to receive this approval soon. According to UFSL’s latest annual report that came out in early September (after the RBI permission to reverse merge), management believes that the reverse merger could take over a year from receiving all the approvals. I believe that the entire process would take 1-2 years but the holdco discount will keep narrowing as the company keeps completing its milestones.   

Pros and cons of other similar trade opportunities:

The Reserve Bank of India (RBI) has recently given approvals for 3 Holdco entities (UFSL, IDFC Ltd, and Equitas Holdings) permission to apply to reverse merge into their opco entities, whereby which the holdco entities will cease to exist. So a similar event-driven opportunity exists in all the 3 companies but each has its own nuances and so the risk-reward is different. Below are my thoughts on the 3 opportunities:

• Equitas Holdings: The situation is very similar to Ujjivan.

• Pros: From a timing perspective, Equitas is a few months ahead of Ujjivan since the SFB was incorporated in Sept 2016 (6months before Ujjivan) and so they can already apply to reverse merge (vs Ujjivan can only apply from Nov 2021). Equitas has already started the reverse merger process and announced the equity swap ratio. They have also received their SEBI approval to be exempt from the shareholding requirement. Additionally, the bank is better managed than Ujjivan (especially in the last 2 years) and so trades at a premium to Ujjivan SFB

• Cons: the holdco discount is the lowest at 25% since they are ahead in the reverse merger process, so the upside is lower. Additionally, the bank trades at 2.2x book so Opco is prone to higher rerating if markets correct.   

• IDFC Ltd: IDFC trade idea was written on VIC by Sandrokottos in Nov 2019 and you can read the write-up for all the details there.

• Pros: Holdco discount is the highest of the 3 ideas with over 45% discount (depending on how much value one offers to their AMC business). Additionally, the underlying bank IDFC First bank is available in the F&O market and so investors can hedge their position by shorting the bank and derisk the volatility from the bank’s stock price movement.  

• Cons: the holdco structure is complicated since the holco owns other businesses (AMC, JV in foundations) outside the banking opco entity. Holdco will require to divest the AMC and foundations first before they can start the reverse merge process and so from a timing perspective, this will take the longest time to complete.

• Ujjivan Financial Services:

• Pros: Offers attractive upside due to the 40% holdco discount. The holdco structure is simple to reverse merge and will have precedents from Equitas which will be running the process with a few months of a head-start. Additionally, the underlying bank trades at 1.2x book value, which is the lowest of the 3 banks.

• Cons: the underlying bank has been facing fundamental operational issues but with the old management back in the realm they should be able to stabilize the asset quality and put the bank back on its growth track.

Catalyst

Approvals from RBI, SEBI and shareholders. Improvement in fundamentals of underlying bank.