Why investors should ride on this bank’s growth despite expensive valuation

- High growth targeted in the coming years before converting into universal bank

AU Small Finance Bank had a strong start to the year and has been a consistent performer ever since its listing. In troubled times like now, discerning investors should stick to high quality. AU’s journey to become a universal bank gives an opportunity to participate in a high growth story with quality that very few can afford to miss.

The stock has had a lacklustre performance in the past one year despite superlative execution due to its premium valuations. It is trading at a discount to the price at which Temasek had picked up stake in the bank last year.

While the macro environment is turning challenging by the day, the balance sheet of AU is still relatively small, suggesting that there is enough headroom for growth without getting impacted by broader macro headwinds. Given the strong management team, diversified asset book, focus on garnering low-cost liability and earnings potential from moderation in cost, we see AU as a good long-term play that is likely to outperform most competitors in the medium term.

The granular retail focussed loan book

AU is attempting to build a high quality granular asset book without compromising on growth. In the past two years, growth in assets under management was 54.3 percent (compounded annual growth rate) driven by significant growth in lending to MSME as well as small and mid corporates, in addition to a steady performance of its core product – wheels loan.

In the quarter gone by, growth in AUM was in the order of 44 percent. While the core products of wheels and MSME were healthy, the superlative performance (on a small base) came from newly introduced products such as home loans, gold loans and consumer durable loans.

Even in terms of disbursement that grew by 40 percent YoY in Q1 FY20, the key drivers were the new products. It is interesting to see that the bank has stepped up its presence in the used vehicle segment to counter the slowdown in new vehicle sales and has witnessed strong traction there.

Source: Company

The asset book is getting increasingly granular and diversified in terms of products and geographies. The share of retail assets is close to 79 percent and the bank intends to maintain this high share of retail.

Source: Company

The strong growth in the asset book has not led to on-boarding of additional risks with the ratio of risk weighted assets to total assets falling to 58 percent from 91 percent two years ago.

Building a robust deposit franchise

While the asset growth has been robust as the book diversifies, the key to maintaining high profitability lies in garnering lower cost liabilities. In the past eight quarters, the addition to incremental deposits is 1.2x the addition to assets under management. So, the growth in new business has been funded solely by deposits.

Source: Company

The share of deposits in total funding has risen to 63 percent now from 48 percent a year ago. The bank is focusing on a strategy to build a granular retail-focused liability book and the emphasis is on garnering retail term deposits. In view of the relatively high yielding asset book, this strategy works well. The share of retail savings and term deposits is close to 46 percent of total deposits. The share of CASA stood at 19 percent at the end of June 2019, and the bank is targeting a CASA ratio in the twenties.

With its initiatives on the technology front, geographical expansion and diversification as well as differential rates, the bank is likely to build a robust liability franchise in years to come.

Sustaining a very decent interest margin

The bank has succeeded in improving its interest margin sequentially to 5 percent in the quarter gone by, thanks to a slight rise in yield on assets and softening in the cost of funds despite the rather challenging funding environment in recent times. Given that the yield on the incremental assets is trending up and cost of funds moderating, we do not expect any imminent pressure on interest margin.

Pristine asset quality

Asset quality has shown no apparent deterioration with reported gross and net NPAs at 2.1 percent and 1.3 percent respectively. The level of gross and net NPA has been steady around this level for the past several quarters. The strong asset quality is on the back of complete in-house sourcing, strong referral flows, repeat customers and emphasis on customer equity.

Likely moderation in costs

The bank had been reporting a relatively high cost-to-income ratio as it had upfronted expenses on conversion into a bank from an NBFC. With the benefits of operating leverage, the cost-to-income ratio is expected to decline, which should be a kicker for earnings growth. The bank is increasingly relying on technology, smaller branches and business correspondents, a model that should lead to further moderation in costs.

Risks

The macro slowdown poses a risk to any lender. Close to 13 percent of the bank’s AUM comes from NBFCs and real estate. The exposure to real estate is close to 3 percent of AUM and has a gross NPA ratio of 2.8 percent. While the sourcing is selective, nevertheless, the book warrants close monitoring. The NBFC book is diversified across asset financing, housing finance, gold loan and fintech (financial technology) clients with 88 percent of the portfolio above investment grade rating. So far, the book has zero delinquency.

Outlook

With a largely retail focused asset as well as deposit book, the bank is building a granular business backed by a robust technology infrastructure that can navigate the challenging macros relatively better. With adequate capital in place (capital adequacy ratio at 18.6 percent), the bank is looking at growing its asset book by close to 30-35 percent in the foreseeable future. It is targeting to become a universal bank after five years of inception, that is by 2022.

But is the growth journey coming at a high premium for investors?

AU (Current market price: Rs 674, market cap: Rs 19,749 crore) is down 3 percent from the level at which Temasek had picked up equity in the company last June. The valuation at 4x FY21e book looks expensive. If the growth journey continues, the stock is likely to mimic the earnings trajectory, which we expect to be at least 30 percent in the next couple of years.

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