City Union Bank: Banking on the South - Buy

Even as public sector banks continue to be weighed by weak credit growth and poor asset quality, a few small regional private banks that continue to deliver healthy growth in loans and earnings offer a good opportunity for investors. City Union Bank that has a strong foothold in South India has been able to deliver healthy traction in loans, driven by the MSME (micro and small and medium enterprises) and wholesale and retail traders segment. These high yielding segments constitute a little over half of the bank’s portfolio. The bank’s focus on secured lending, cautious approach to corporate lending, improving margins and strong capital base are key positives.

Investors with a two to three years time horizon can invest in the stock. It trades at 2.2 times its one year forward book value, higher than its three-year historical average of 1.6 times. However, the valuations of most private banks have gone up sharply in the past year, a typical case of too many investors chasing too few opportunities.

Nonetheless, expected earnings growth of about 20 per cent over the next two years, sound return ratios — return on asset of 1.5 per cent and return on equity of 15-16 per cent — and strong capital position still offer good upside for investors.

City Union Bank’s strong presence in South India, particularly in Tamil Nadu, where more than half its branches are present, has helped it build a strong SME (small and medium enterprises) client base. This along with the traders segment has kept the bank’s loan growth in good stead over the last couple of years.

In the latest June quarter, the bank continued to deliver strong loan growth of 19 per cent year-on-year. Itssteady growth in loans is encouraging and its cautious stance on the corporate segment lends comfort. The management is not in favour of pursuing aggressive growth in loans at the cost of compromising asset quality. The bank’s focus on working capital loans (65 per cent of loans) and secured loans (99 per cent of its loans) also mitigates risk.

The bank is well capitalised for growth over the next two years. Its Tier I capital ratio stood at 14.76 per cent as of June 2016. The management expects 15-18 per cent growth in loans in the coming year, and will look at growing at a faster pace once the economy improves.

Aside from healthy traction in loans, notable improvement in margins has also kept earnings in good stead. Over the past year or so, the rate easing by the RBI has led to a fall in both lending and deposit rates. But for City Union Bank, the fall in yield on advances has been lower than the reduction in the cost of deposits. This has aided margins.

The bank’s strong retail deposit base has also aided margins. The net interest margin (NIM) improved from 3.4 per cent in 2014-15 to 3.8 per cent in 2015-16. In the latest June quarter, the NIM inched up further to around 4 per cent. The margin may contract over the long run as competition builds up. But it should remain within the 3.5-3.7 per cent band.

With the stress in the banking system, City Union Bank saw its bad loans inch up from 1.8 per cent of loans in 2014-15 to 2.4 per cent in 2015-16.

However, the slippage ratio (additions to bad loans as a percent of loans) has been moderating in recent quarters and the trend is likely to continue. The management expects the slippage ratio to remain in the 1.75-2 per cent range for 2016-17; in 2015-16, the ratio stood at 2 per cent and in the latest June quarter it was 1.8 per cent (annualised).

The management has indicated though that it is facing challenges in liquidation of collaterals. This is expected to improve as the economic cycle picks up.

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