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Suresh Krishnamurthy

Kotak Mahindra Bank: Buy Sundaram Finance: Hold Cholamandalam Finance: Buy

THE financial industry is on the threshold of something spectacular. Penetration of financial services — both at the retail and wholesale levels — is a fraction of the potential. Increased penetration of services is, however, inevitable. Changes in the structure of the financial system over the past few years have ensured that.

The big players such as the SBI, ICICI and HDFC are at the vanguard to take advantage of the emerging opportunities. Jostling for space with such giants are some smaller, niche players with a brand to reckon with. Specifically, Kotak Mahindra Bank, Sundaram Finance and Cholamandalam Finance have shown the dynamism to stake their claims.

Over the past few years, these firms too have managed to grow their businesses. The size of the opportunity is so large that such mid-sized and smaller players too, can aspire to create wealth for their shareholders.

At present, the return on net worth of these firms is not too attractive. They are only about 15 per cent when most banks and financial services firms have been able to step it up beyond 20 per cent over the past couple of years. The consolidated profits of these firms, however, are showing signs of traction. They rose at a robust rate in 2003-04 and the growth rate is likely to be sustained in this financial year. They are planning to up the ante further over the next few years. The industrial growth and expansion in retail finance would help these firms to achieve that. These firms bank on a combination of fund-based business (hire-purchase of commercial vehicles, auto loans, housing finance and personal finance) and fee-based business (asset management, insurance, financial product distribution and securities broking).

Except auto loans, all the other segments are witnessing growth in demand accompanied by prospects for healthy profitability. This is despite increased competition from public sector banks, which have the twin advantage of access to low-cost funds and extensive branch networking.

To address the opportunities, one of them — Kotak Mahindra with assets of about Rs 8,000 crore — has converted itself into a bank and emerged as the front-runner capable of growing in size. Kotak Mahindra considers that conversion into a bank will help it leverage the balance-sheet better and, consequently, expand the return on net worth. The other two firms have not seriously considered turning into banks.

Until now, they have so far considered associated costs — a larger low-return SLR portfolio, lower tax benefits, and higher regulatory costs — as outweighing the benefits. Being associated with business groups, obtaining a banking licence may also prove tougher for these non-banking financial services firms.

Kotak is also into financial services in a much more comprehensive manner and is present in almost all spheres except general insurance. Sundaram Finance, with assets of about Rs 4,000 crore, for instance, is not into life insurance and securities broking. Cholamandalam, with assets of about Rs 1,500 crore, is into securities broking but has only a minor stake in insurance and that too in a general insurance firm.

Kotak Mahindra: Buy-and-hold

Mr Uday Kotak, MD, Kotak Mahindra Bank

The stock of Kotak Mahindra trades at a price-to-earnings multiple of less than 20 times its earnings for the 12-month period ended September 2004.

Considering the potential for growth and the aggressive management, investors can consider buying into the stock now. They however, may need to have the patience to hold it for a long period before the returns turn attractive.

Kotak Mahindra is a strong player in retail financing, securities broking and investment banking business. It is, however, striving to make its mark in asset management and life insurance. These two businesses, where Kotak is challenged by a number of established and substantially stronger players, are the future engines of growth.

Business growth in asset management and life insurance has been strong since 2002. It is also expanding its branch network aggressively. This will help Kotak lower funding costs and achieve greater retail penetration.

Earnings for the half-year ended September 2004 were affected because of a 28 per cent decline in earnings on its treasury portfolio.

Apart from holding of Government securities in the bank, Kotak also runs a primary dealer that necessarily has to participate in government auctions. This has hit profitability.

Otherwise, profits of the other businesses have grown rapidly. Specifically, securities broking and asset management have registered significant growth. If this is maintained over the next 12 months, the share price appreciation may happen sooner rather than later.

Sundaram Finance: Strong franchise value

Mr T. T. Srinivasaraghavan, MD, Sundaram Finance

The stock of Sundaram Finance trades at a price-to-earnings multiple of nearly eight times its consolidated earnings per share for the year ended March 2004 adjusted for the merger with associate firm Lakshmi General Finance. Investors need not consider buying into the stock now at the ruling valuations, as a larger stock such as State Bank of India is trading at a comparable valuation. Shareholders can continue to hold the stock, considering the strong franchise value enjoyed by Sundaram with its customers. Sundaram Finance is also bigger than some of the private sector banks.

The performance of the financing business of Sundaram Finance in the half-year ended September 2004 was not impressive. Net interest income (difference between interest income and interest expenses) dipped by about 3 per cent. This is only to be expected, given the stiff competition especially in the auto loans business. Kotak's car financing business reported a 17 per cent dip in profitability.

Sundaram Finance reported a marginal rise in profitability. The performance of two its major subsidiaries — Sundaram Home Finance and Sundaram Asset Management — should have improved given the favourable operating conditions.

Cholamandalam: Attractive yields

Mr M. Anandan, MD, Cholamandalam Investement and Finance Company

From an investor's perspective, Cholamandalam appears the least well-placed among the three to combat the onslaught of competition in the financial services arena. It would, however, be a folly to turn away from this company. It has its niche clientele and managed to achieve business growth over the past few years.

The lower probability of Cholamandalam scaling up massively in size is also reflected in the stock price. The stock trades at price-to-earnings multiple of about seven times its earnings per share for the 12-month period ended September 2004. The valuation does not factor in the profitability of its subsidiaries in securities broking, financial products distribution and insurance advisory business. The dividend yield of nearly 7 per cent is also attractive and suggests that the market is valuing the stock as pure-play non-banking finance company.

Investors can consider taking small exposures in this company, which has a market capitalisation of less than Rs 300 crore. If the contribution of subsidiaries keeps rising, then returns would be commensurate with the risk.

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