The Hindu Business Line : ICICI Bank — Bankable for the long term

There is scope for good medium/long-term returns, given the prospects for the core banking business, strong brand value and possible contributions from the insurance subsidiary.

MR K. V. KAMATH, MD and CEO... The bank has been a leader in leveraging technology.

An investment in ICICI Bank's follow-on public offer may only suit those with a three-four-year investment horizon. Such investors may bid at the cut-off price. Those looking for gains over the short term would be better off not participating in the offer, as there is a possibility of the stock offering better entry points in the market at the issue closes.

Medium/long-term prospects

But there is scope for good medium/long-term returns. The business is bound to benefit from the bright prospects for the core banking business in a growing economy, the prominent position and the brand value acquired in the banking space, as well as the possible improvements in the profitability of the (insurance) subsidiaries.

The life-insurance business, by its very nature, takes time to break-even and the red on the balance-sheet appears magnified during high growth phases. ICICI Prudential Life, for instance, recorded a 60 per cent growth in premium income in FY-07 and this has naturally led to high actuarial provisions (which are based on the liabilities the insurer contracts on policies issued).

Besides, any future re-alignment in the Foreign Direct Investment policy relating to insurance (even if it appears remote at present) could have a bearing on the banking company's valuations. ICICI Bank may then be in position to encash or monetise, with capital gains, the investments it has made in the subsidiaries. The bank's investments in its subsidiaries — the material ones being the two insurance subsidiaries — amount to around Rs 2,300 crore. The value of the core banking franchise would automatically become more critical in a scenario where the bank's stake in the other financial businesses is brought down.

Value of subsidiaries

The re-organisation of ICICI Bank's subsidiaries has turned out to be almost co-terminus with the bank's fresh capital-raising programme. The reported pricing on the shares to be issued by the proposed new subsidiary (ICICI Financial Services) — a 5.9 per cent stake at Rs 2,650 crore — values the new subsidiary at approximately Rs 45,000 crore which is more than half of the current market capitalisation (around Rs 82,000 crore) of the parent bank itself. This has naturally raised the question if the parent stock now needs to be revalued. Other investors indeed seem to have placed a high valuation on businesses — mainly life insurance — that are still a net drain on the consolidated financials and may continue to be so for some time to come. The life-insurance subsidiary's net loss for 2006-07 at Rs 650 crore is one-fifth of the bank's (standalone) PAT (profit-after-tax) of Rs 3100 crore.

Short-term investors to wait

Short-term investment prospects in the stock though may not be that attractive. A possible moderation in economic activity in the near term could prove a drag on the earning prospects. The reported slow down in the growth of the bank's flagship lending product — housing loans — attests to this. The near-term financials may also be impacted by the pressures on the funding side brought over from the interest rates tightening of the past two-three quarters. Apart from bank-specific risk, overall systemic risk in the form of a possible rise in risk aversion (particularly towards emerging markets) may also affect near-term valuations. Therefore, investors with a holding period horizon of six months to one year can possibly wait to pick up the stock at lower levels.

Factors that bear watching

Quality of core bank financials

The core banking business and the associated financials will possibly come under greater investor scrutiny now that the hiving off of the investments in subsidiaries has been accomplished.

Such a study of the financials of the core bank point to a number of areas which, if acted upon, could lead to better long-term valuations for the stock.

Given its prominent position in the industry, its size and the reputation it has built up in the market, one would have imagined that the overall balance-sheet would present a structure that is intrinsically capable of optimally managing diverse interest rate environments. ICICI Bank, though, has relied on a kind of regulatory forbearance to insulate itself from interest rate shocks which otherwise may have seen its earnings under greater pressure.

Among financial intermediaries, ICICI Bank possibly stands out for the low level of interest rate risk it is carrying on its balance-sheet. Almost 40 per cent of its total assets as of March 2007 — Rs 1,35,000-1,40,000 crore on a balance-sheet of Rs 3,45,000 crore — is not subject to interest rate risk. This has been accomplished mainly through two mechanisms.

The bank has placed almost its entire statutory liquidity ratio (SLR) portfolio (25 per cent of its demand and time liabilities) — comprising investments in government securities — amounting to around Rs 60/65,000 crore in the "held to maturity" (HTM) category. The value of investments held in this category need not be adjusted to reflect current (and changing) market interest rates.

To give a perspective, based on its current balance-sheet and the growth in its liabilities base in the last four years, the bank may need to invest Rs 25,000-28,000 crore in SLR securities in FY-08 (assuming the CAGR of 45/50 per cent in the deposit base recorded in the past four years is maintained). Assuming this entire incremental SLR investment is not categorised as HTM, a rise in interest rates by say 0.50 percentage points, could possibly increase provisioning requirements (and lower profits) by as much as Rs 500 crore. (This assumes a "duration" or weighted average time to maturity of four for the portfolio — a higher "duration" would mean larger losses). Compared to that, the bank's increase in provisioning for investments in 2006-07 was only around Rs 60 crore even as investments in government securities increased by around Rs 17,000-18,000 crore and interest rates also stiffened by close to 0.50 percentage points.

Secondly, the bank's flagship lending product — home loans — which at Rs 64,000 crore in March 2007 constituted 30 per cent of the total advances, is largely in the form of floating rate loans. This transmits the risk of rising interest rates entirely to the borrower.

The point to be noted here is that the bank carries a fairly large interest rates derivatives trading book. While it operates in the interest rates derivatives markets as a proprietary trader, it has not found or used that market as a platform to engage in financial intermediation in the strict sense of the term. As of March 2007, the outstanding notional principal of its interest rate derivatives trading book was around Rs 2,80,000 crore. And this book is positioned to benefit from rising interest rates. A 1 percentage point rise in rates would increase the value of the trading portfolio by around Rs 70 crore.

Using the interest rate derivatives markets to offer better interest rate solutions to borrowers could have a direct impact on the quality of the loan portfolio and in turn on provisioning/earnings.

So far the quality of the housing loan portfolio does not seem to have been adversely affected — gross and net NPAs in the collateralised loan book, which is mainly housing loans, were 1.3 per cent and 0.7 per cent respectively at March 2007. But this is one parameter to be watched as the bank has reiterated the critical role of the housing loan business in its overall strategy.

From a valuation perspective, such immunity in the balance-sheet, obtained either because of regulatory forbearance or market imperfections may not be optimal. For when the interest rate cycle turns, there could be opportunity losses in sticking to book value accounting for a major part of the balance-sheet.

Overall prospects

Overall, the medium/long-term investment prospects for the stock appear good. The chinks in the armour, as can be seen from the company's balance-sheet, are capable of being removed. The company could build on its position and the growth it has recorded in many banking parameters — deposits, advances, market share and the so far muted impact on loan portfolio quality despite rapid business growth. Non-interest income at around 20 per cent of the total and the steady performance on this front indicate a buffer available for the earnings stream. The bank also has been a leader in leveraging technology to provide a range of services — particularly in the retail segment. This provides considerable earnings cushion. Risks to this outlook emanate from the pressure that has been seen on interest margins, the slide in overall returns on equity/assets and a reasonable probability of such pressure continuing in the ensuing period.

Offer details: ICICI Bank's follow-on public offering in the price band of Rs 885 to Rs.950 is set to raise Rs 8750 crore. Retail investors have the option of paying Rs 250 on application, Rs 250 on allotment and the balance on call. The offer is open from June19-22.

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