Equitas & Ujjivan: A worthy long-term pick

Micro finance lenders like Equitas and Ujjivan that had converted to small finance banks faced twin headwinds of soaring delinquency in the micro finance book in the aftermath of demonetisation and higher operating expenses on account of conversion into a bank. The erstwhile highly profitable businesses reported losses in certain quarters of FY18 and ended the fiscal with sharply lower profitability on account of higher credit cost that they had to provide on account of toxic micro finance assets.

However, the books are now largely provided for. The worst of asset quality issues are behind, although some lurking fears in the minds of investors cannot be wished away in a pre-election year. The managements’ endeavour is to diversify and de-risk its asset book that was erstwhile dominated solely by micro finance lending is underway.

On the liability side, retail low-cost deposit accretion is the focus. This should partially cushion margins as the asset yield falls with more secured lending.

Stock prices have already taken cognisance of the positive changes. However, acceleration in earnings going forward or any inorganic development along with probable re-rating of valuation multiples make Equitas and Ujjivan worth exploring for the long-term.

Ujjivan and Equitas both have provided for/written-off their troubled micro finance book. For Ujjivan, the portfolio at risk, which touched a high of 10 percent, has now fallen to four percent. Gross and net non-performing assets (NPAs) have fallen to 3.6 percent and 0.7 percent at the end of FY18 from a high of 6.2 percent and 2.3 percent, respectively, three quarters back, with a handsome provision cover of 81.5 percent.

Equitas too, saw its gross and net NPAs falling to 2.72 percent and 1.44 percent at the end of FY18 from a high of 5.8 percent and 2.8 percent two quarters back, respectively.

Source: Company

Both entities are moving away from a complete unsecured micro lending business model. Equitas, in particular, has come a long way and managed to pare down its micro finance book from 46 percent to 28 percent and unsecured lending from 47 percent to 33 percent in the past one year.

Source: Company

Ujjivan too is de-risking its portfolio and is targeting one-third share of its portfolio from secured lending in the next three years. In fact, the share of micro and small enterprises (MSE) and affordable housing, which was three percent of the loan book at the end of FY17, improved to seven percent at the end of FY18.

Source: Company

Conversion to a bank has opened vistas for non-interest earnings from lending, liability franchise, third-party product distribution and selling of priority sector lending certificates (PSLC).

Source: Company

The spike in operating expenses, due to rapid rollout of bank branches, coupled with muted interest earnings resulted in a sharp spike in the cost-to-income ratio. The managements of both Ujjivan and Equitas feel that the bulk of capex is behind it and effective sweating of infrastructure and improved productivity would gradually bring down the cost-to-income ratio.

Diversification of the asset book in favour of secured lending comes with a risk of lower yielding assets. The only lever to protect margin is to lower cost of funds. Hence, access to such deposits becomes a critical differentiator.

Both Ujjivan and Equitas have identified low-cost deposits as a core focus area. Equitas has so far done a better job in garnering a higher proportion of low-cost deposits. This has helped it reduce its cost of deposits to 6.5 percent from 7.8 percent at the end of last year and overall cost of borrowings to 8 percent from 9.2 percent.

Ujjivan too has seen an 80 bps reduction in the cost of borrowings during the year gone by but was reliant mostly on wholesale deposits. With a minuscule share of current and savings account (CASA) it has enough headroom to grow its low-cost deposits base to pare down its cost of borrowings to a more competitive level.

Credit costs for Ujjivan and Equitas had shot up to 400 basis points and 252 bps FY18, respectively. With the toxic book of micro lending post demonetisation largely provided/written off, credit cost normalisation should propel earnings growth from FY19 onwards.

Both Equitas and Ujjivan are extremely well-capitalised and would take care of growth for the next couple of years without any risk of imminent dilution. Ujjivan has a capital adequacy ratio of 23 percent. Equitas has a Tier I capital adequacy of 27.1 percent, with total CAR of 29.6 percent.

Shares of Equitas and Ujjivan have rallied 17 percent and 15 percent, respectively, over the past couple of months. While these stocks looks expensive compared to the bottom valuation in the midst of the micro finance crisis, post demonetisation, they are nevertheless quoting a discount to the premium valuation enjoyed prior to the crisis, albeit with the prospect of lower return ratios (RoA).

However, with a pan India presence and relatively high yielding book, they remain attractive acquisition candidates by relatively larger entities. Seen in this context, the stock has enough headroom to re-rate, if one considers the deal valuation between Bharat Financial and IndusInd Bank (3.8 times FY19e book). Investors should definitely look at these two small finance banks, as the worst is certainly behind.