Kotak Mahindra Bank: BUY

The year has been full of challenges for the banking sector, having to deal with slowing loan growth, muted deposit mobilisation, rising pressure on asset quality and lower profitability.

Against this backdrop, Kotak Mahindra Bank has managed to deliver balanced loan growth and drive operational efficiency.

By consciously avoiding exposure to risky sectors, the bank has been able to maintain asset quality.

Given the increasing delinquency in the commercial vehicle and construction equipment (CV/CE) segment, the bank has been winding down its exposure to this business. This may cause the bank’s loan growth to slow down from 24 per cent in 2012-13 to around 15 per cent in 2013-14.

While lower growth may moderate return on equity, the bank’s long-term fundamentals remain strong. This is thanks to its well-capitalised position, strengthening deposit base, efficiency gains and sound asset quality.

The bank plans to use its more-than-comfortable capital adequacy of 18 per cent to double its branch strength and bolster deposit base in the next three years.

Aside from its core banking business, the bank’s strong subsidiary businesses such as asset management, insurance and broking lend value of around Rs 170 a share.

At the current price of Rs 745, the stock trades at three times one-year forward its consolidated book value. Industry leading margins and return on asset and a well capitalised balance sheet, will continue to see the stock trade at a premium to its peers as in the past.

Hence, investors with a two-to-three year horizon can buy the stock at current levels, as the lending as well as subsidiary businesses will deliver significant returns once the economy turns around.

Retail push

After obtaining banking license in 2003, Kotak Mahindra Group was the first non-banking finance company to become a bank. But it was only from 2007-2008 that Kotak Bank shifted focus from capital markets to the core lending business.

Currently, core lending contributes 82 per cent of the consolidated net profit, a significant increase from 40 per cent in 2007-2008. This helped the bank grow earnings at 18 per cent annually over the last five years, despite a subdued capital market. The bank has been building a diversified loan portfolio over the years. The loan book has grown 25 per cent annually over the last five years, higher than the industry growth of 18 per cent.

Beginning with retail exposure, the bank gradually increased its share from the corporate segment, which now contributes 29 per cent to the bank’s lending, from 17 per cent in 2007-2008.

However, since the start of 2012-13, the corporate as well as the commercial vehicle segments have been witnessing moderation in growth. With growing stress in the corporate segment, the bank’s focus has been largely on medium-term finance and working capital.

The management continues to remain cautious on the infrastructure and project financing business. This seems to be a prudent strategy at this juncture to mitigate risk.

Cautious on the stressed CV/CE segment, the bank has reduced its exposure to this segment as well.

The retail segment has been driving the loan growth in recent quarters with robust momentum across sub-segments such as small personal loans, home loans and business banking. The expected loan growth of 15 per cent in 2013-14 will be driven by the retail segment.

Savings deposits to grow

Kotak Bank has been relatively less aggressive on the branch expansion front compared to most of its mid-tier peers such as YES Bank and IndusInd Bank. During this period, the bank’s branch network increased by 260 branches, compared with more than 320 branches added by YES Bank and IndusInd Bank. In spite of this, the bank has built its low-cost deposit base, primarily due to the robust growth in the savings deposit which has grown by 48 per cent annually over 2011- 2013.

After the de-regulation of savings deposit rates from October 2011, Kotak Bank as well as YES Bank took the opportunity to offer higher rates, thus building their savings deposits base.

The bank now aims to double its branch network from the current 500 to 1,000 in the next three years. This will further strengthen its low-cost deposit base.

Operational efficiencies

In spite of an aggressive branch expansion plan, the management expects to maintain operational efficiencies and contain its cost-to-income ratio within 50 per cent.

The improvement in savings deposit base should offset cost pressure arising from expansion plans. This should help sustain margins at around at around 4.5 per cent, amongst the best in the industry.

Stable asset quality

After de-risking its loan portfolio by reducing exposure to unsecured loans in 2009, Kotak Bank was able to bring down its gross non-performing assets from 2.3 per cent to the current 1.1 per cent.

The total secured loans now contribute 86 per cent of the total loans. It also remains cautious on other stressed sectors such as infrastructure, airlines and diamonds. This should help prevent erosion in asset quality.

While Kotak Bank has a relatively lower ROE of 15 per cent vis-à-vis its peers, it is also has a low leverage of 7.5 per cent.

With sufficient capital cushion the bank can increase its leverage to scale up its ROE. In any case the return on asset is amongst the best in the industry at 1.9 per cent.

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