IDFC: BUY. There’s much to bank on

The shareholders of Infrastructure Development Finance Company (IDFC) recently approved the demerger of the company’s financial undertaking into a wholly-owned step-down subsidiary — IDFC Bank.

With this, the company has gone a step further in setting up a bank (from October 2015). The stock offers a good opportunity for long-term investors looking to bet on the banking space over the next two to three years. A strong management team, healthy capital base and relatively attractive valuation are key positives for the stock.

IDFC’s recent move is in line with the RBI’s norms for new banks to be set up through a financial holding company and to segregate all banking-related businesses to the new bank. IDFC will transfer its related businesses of financing, project finance, fixed income and treasury assets and liabilities to IDFC Bank. In October 2014, the scheme was approved by the company’s board. According to the scheme, IDFC will issue one equity share of IDFC Bank for every share held in IDFC. Post-demerger, IDFC Financial Holding — a 100 per cent subsidiary of IDFC — will hold 53 per cent stake in IDFC Bank and 47 per cent will be held by the shareholders of IDFC.

The demerger provides good headroom for foreign investors to increase their stake in the new bank. Foreign institutional investors currently hold about 47 per cent stake in IDFC. In the new bank, foreign investors’ holding will be about 23 per cent. This is lower than most of the other private sector banks.

IDFC is a leading lender in the infrastructure space. The company’s profitability in the near term will be impacted by the costs incurred to meet the statutory requirements of a bank and branch expansion. Over the long run, however, benefits of low-cost deposits and reducing exposure to one single segment — infrastructure — will be a positive.

Also, the RBI issued a number of guidelines last year, in the form of flexibility in loan structuring and refinancing, and allowing banks to raise funds specifically for lending to the infrastructure sector without regulatory requirements, such as CRR, SLR and Priority Sector Lending targets. This benefit will also be extended to the new bank being set up by IDFC. Hence, 30 per cent of the outstanding infrastructure loans in 2015-16 will be eligible for such exemptions, if they are funded through long-term infrastructure bonds. This can cushion the erosion in the company’s profitability to some extent.

The return on assets currently at 2 per cent could go down to 1.2-1.4 per cent over the next three to four years, and thereafter stabilise at 1.7-1.8 per cent, in line with its peers in the private banking space. The stock has rallied 83 per cent since our previous buy recommendation last February. But it still trades at 1.6 times one-year forward book value. This implies a discount of almost 50 per cent to most private banks. As the new bank expands, this valuation is likely to narrow over the coming years.

IDFC remains a good play on a recovery in the infrastructure space. One of the leading project lenders in India, the company grew its loan book by 28 per cent annually during 2009 to 2013. However, challenges in the last two years have significantly impacted the company’s pipeline of loans.

As of the December quarter, the total loan book stood at ₹54,004 crore, almost flat over the previous year.

Over the past year, the government has been taking steps to clear roadblocks in the infrastructure space by expediting clearances. Auction of coal blocks and rolling out spectrum for telecom players are also some of the recent initiatives. Given the company’s proven track record in the infrastructure financing space, it is well placed to benefit from an expected improvement in the investment cycle over the next one to two years.

IDFC’s gross non-performing assets as a proportion of loans are at 0.7 per cent.

As on December 2014, the net restructured loans stood at 6.1 per cent of loans, of which almost 87 per cent related to energy sector and within that 31 per cent to gas-based power projects.

So, the company’s asset quality in future will depend a lot on the fate of the gas-based power projects. Given the uncertainties in the gas sector, the company has been making higher provisioning in the last few quarters. Total provisions are 3.9 per cent of loans, half the total stressed assets — this should help avoid negative surprises.

The company’s Tier-I capital ratio was a strong 23 per cent as of December quarter.

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