The board of IndusInd Bank and Bharat Financial Inclusion (erstwhile SKS Microfinance), approved the merger of the two entities, in an all-stock transaction. Shareholders of Bharat Financial Inclusion (BFIL) will get 639 shares in IndusInd Bank for every 1000 shares held. The share swap ratio implies 11-12 per cent premium to the BFIL’s current price and a multiple of over 6 times its book value as of June 2017 quarter. Kotak Mahindra Bank and IDFC Bank acquired microfinance businesses at 1.9-2.0 times trailing book to value. This makes IndusInd’s acquisition of BFIL an expensive one, leaving very little upside in the near term for IndusInd shareholders; BFIL shareholders, though have been handed a sweet deal.

But expensive acquisition aside, the success of the deal rides on the potential earnings synergies, which we believe is riddled with long term challenges and risks. While IndusInd would benefit from BFIL’s dominant market position and higher yielding loan book, it exposes itself to the vagaries in the MFI space; the underlying structural risks withiin the industry became pronounced post demonetisation.

Given that IndusInd Bank on a standalone basis itself, is trading at a steep valuation of 4.4 times one year forward book, upsides will be limited in the stock over the medium term.

Headwinds in MFI business

While BFIL is the largest MFI in terms of gross loan portfolio (Janalakshmi Financial Services which was the largest MFI, recently received final licence to set up a small finance bank), growth challenges that have emerged post-demonetisation within the MFI industry is a cause for worry. BFIL’s gross loan portfolio stood at ₹9,631 crore as of the June 2017 quarter, a growth of 14 per cent year-on-year. In the same quarter last year, BFIL had registered 76 per cent YoY growth.

Post demonetisation, cash crunch and rising defaults have impacted growth for MFIs. While the sector is slowly limping back to normalcy, it may not return back to high growth of 50 per cent levels anytime soon. Many of the MFIs that have transitioned to small finance banks have been trying to diversify away from MFI lending, given the risks within the portfolio.

BFIL recognises more than 8 weeks overdue loans as NPAs (against RBI’s 90-day norms). In the June quarter, GNPA stood at 6 per cent of loans. While the company has been conservative on provisioning and the management has stated that it has taken much of the hit in the June quarter itself, returning to pre-demonetisation levels of GNPAs looks unlikely.

Acquiring an MFI business, when the sector is facing headwinds could weigh on IndusInd Bank’s earnings.

Many ifs and buts in synergies

Microfinance forms about 2.5 per cent of IndusInd’s loans, which would inch up to about 7 per cent of loans, according to the management. The increase in IndusInd’s market share in microfinance should boost its overall growth. IndusInd’s decision to transfer BFIL’s employees and operations into a wholly owned subsidiary, making it a captive business correspondent, is also a positive. BFIL has a cost to income ratio of around 52 per cent (as of June 2017), higher than that of IndusInd’s at 45-odd per cent. Hence keeping physical assets in a separate entity, makes sense. Lower risk-weights for MFI portfolio in IndusInd (75 per cent) as against BFIL’s 100 per cent, should also free up some capital.

But earnings synergies could be long-drawn and weighed by structural risks.

Key benefits of the merger touted by market players are improvement in yields, margins and hence return ratios. BFIL’s gross yield as on June 2017 stood at 19.7 per cent as against IndusInd’s 11.5 per cent (11.2 per cent as of September 2017). Hence there would be an improvement in yields post-merger. There could also be a fall in cost of funds (by 3 per cent as indicated by the management).

But the cost to comply with cash reserve (CRR) and statutory liquidity (SLR) requirements, could eat away some of the margin gains. BFIL’s weaker asset quality would also increase the cost of provisioning.

One of the biggest arguments in favour of the merger, has been the leveraging of BFIL’s large customer base for deposits. But mobilising deposits from existing MFI customers will be a tall task, given the weak savings pattern within this segment. Other MFI players transitioning into small finance bank such as Bandhan etc. have faced similar challenges. Incremental cost savings could accrue if IndusInd, is able to raise lower cost bulk deposits to replace BFIL’s current borrowings, which would be long-drawn.

Also, IndusInd has been growing its loan book by 25-30 per cent over the last couple of quarters. Funding BFIL’s loan book through its existing customer deposit base would be difficult.

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