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a substantial discount to our conservative
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Financial / Business performance “IDFC Bank
Limited” from an investment perspective

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RC Capital Management IDFC Bank Limited

Company Analysis: IDFC Bank Limited


Posted on 29th Jan 2016

Background

IDFC ltd was an old holding for us. You can find the analysis of the company here. We exited the
position in Mid 2014 after it was announced that the company was being granted a banking
license. I gave a detailed reason for the exit here. I would recommend reading this note to get a
background on this new position.

Since then, the company has gone through the process of getting ready to launch the bank, clean
up the loan books and put the necessary infrastructure in place. The bank was formally launched
in Oct 2015 and the then shareholders of the company received 1 share of the bank for each IDFC
share held.

A different investment idea

This is quite a different idea from the all the others we have invested in till date. The first
difference is that this is closer to a new start-up and hence we do not have a full operating history
of the bank. I will however detail out why that is not entirely the case, though the market seems
to be treating the bank in that fashion.

The second difference is that we have used the market momentum in our favor. The IDFC bank
demerger was an arbitrage play for a lot of investors based on the sum of the parts (SOTP)
valuation of the bank and the rest of the finance company. To be fair, IDFC was selling at a good
discount to its SOTP valuation prior to the demerger. However, I have realized in the past
(painfully after losing money), that such de-mergers often do not result in an immediate
unlocking of the value (it does work out in the long run)

After the de-merger there is usually some level of selling pressure as arbitrage players exit the
stock, which tends to suppress the stock prices of the split entities far below their fair value. This
creates a buying opportunity if you are interested in buying the company for the long term. We
started our initial position as the selling pressure peaked out.

Finally, as I will explain further in the note, the market has been overly focused on the previous
quarter numbers where IDFC took a large write off on its loan books and basically wiped the slate
clean (or maybe even more than clean)

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RC Capital Management IDFC Bank Limited

The key points

I have not published a note on the bank till now as I did not have any concrete numbers to share
till the maiden quarter was announced. At the same time, the management has given sufficient
hints in terms of the expected profitability and plans for the future to make a decision. Let’s look
at some of the highlights

 The bank has a loan book of close to 43000 Crs which makes it the 6-7 th largest private
bank right out of the gate. So we are not talking of blank page here as it has been the case
with several new banks.
 The bank identified almost 18% of its loan books as stressed assets and took a 50% charge
on it. This meant that IDFC showed a loss in the last quarter. This charge may not sound
much until you consider that the worst of the PSU banks have declared a 10% stressed
asset ratio and have not provisioned adequately for it. IDFC bank on the other hand has
gone ahead and declared that they have worst loan book in the country and have
provisioned far in excess of the regulatory requirement. I personally think (it’s my guess)
that they have taken a very cautious stance on their loan book to ensure the success of the
bank
 If the above provisioning was not enough, the bank is accruing income on a cash basis for
the stressed loan book. This means that they are accounting only the cash income as they
receive it. In contrast every other bank calculates income on an accrual basis and stops it
only if the payment becomes overdue beyond 90-180 days. So we have a very conservative
approach to calculating income too.
 IDFC ltd started the investments in the bank when it was given the license 18 months back
and has been taking the hit to its P&L since then. As an investor we will get the benefit of
the same without paying the penalty to the earnings
 The bank has started off with 24 branches with plans to expand it to 50 by the end of the
year. They have also launched the retail banking operations in the month of January
 The bank has an ongoing relationship with several corporates and plans to use the same
to expand beyond the infrastructure loans in the near term

The key negatives

 For starters the bank is going to incur a continuing cost of setting up the retail operation
for the next several years which is going to penalize earnings. As a result, we are not likely
to see a high ROE. This could limit the valuation upside for the bank (higher the ROE,
higher the valuation)
 The competitive pressure in the banking space is rising with new banks and payment
companies. In addition, RBI has declared that, in the future, these licenses will be available
on the tap. This means that the competitive pressure on the industry will remain high and
an inefficient player will not be able to make a high ROE.

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RC Capital Management IDFC Bank Limited

 Further disruption in the banking and financial services space from new technologies such
as mobile based payment systems, peer to peer lending and other financial innovations.
This could pressure the other income (non-lending) for all the banks.
 Possibility of further deterioration of the loan book, though I think that is very low.

The investment thesis

I think the bank offers a good long term opportunity for the following reason

 The management of the bank has run IDFC ltd for 15+ years and have been very conservative
in their lending. In spite of being in the infrastructure space, which has been the epicentre of
the credit crisis, the team has ensured that the credit cost (NPA) has been lower than 1% per
annum even if you consider the 10% charge off taken recently.
 The management has indicated a growth plan of around 20% per annum and I think this is
fairly doable as the bank already has an ongoing relationship with a lot of corporate customers
and can now go beyond the infra lending space.
 The bank has a CAR of around 20% which is the absolute highest in the industry. As we
discussed earlier about the quality of the asset book, the actual ratio could be even higher as
the management seems to have over provisioned the stressed loans
 The management shared in the recent conference call that they have started growing the
investment book (mainly bonds) and are borrowing from the market to do the same. This will
help them to arbitrage the interest rate gap and also play the downward trend in the interest
rates. The management is thus using a creative approach to expand the balance sheet in the
short term till the advances pick up
 The bank was able to earn around 250 Crs in the quarter, resulting in an ROE of 7%, ROA of
1.2% and a minimal bad debt expense. I think the net profit is likely to be higher in the coming
quarter as it becomes operational in the retail sector and expands further on the corporate
side.
 Finally, the bank is selling at around 1.2 times book value which mean that market is valuing
it lower than all the other private banks and much closer to the PSU banks (think book
adjusted of bad debts and not reported book values)

Conclusion

This investment idea is not entirely driven by numbers, though as I have shared we are not
building castles in the air without a basis on current performance.

If we leave aside the label of a bank, this is a financial institution which was able to borrow only
from the debt market and lend in the infrastructure space. The company has now been given an
opportunity to borrow at cheaper rates (CASA deposits) and lend across the spectrum, thus
reducing the lending risk.

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RC Capital Management IDFC Bank Limited

The company also has a clean slate to setup an infrastructure in terms technology, people and
branches which is not constrained by any legacy issues. This would enable the bank to take full
advantage of all the new technologies and innovations in lending and distribution to setup a
lower cost banking operation.

One final point – The recent results of several banking companies have been down right horrible.
Due to the recent RBI mandate, a lot of banks are finally coming clean and provisioning further
for their stressed assets. As a result, the performance of banks has been quite depressed in the
current quarter. This has rubbed off on IDFC bank and its stock price, though it does not fall in
the same bucket (having taken the provisions already).

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RC Capital Management IDFC Bank Limited

Q4 – 2016 Results Review


Posted on 10th May 2016

The bank was operationalized in Oct 2015 and as a result is a semi-start-up rather than a fully
operational entity. The semi-start-up tag is an important one to keep in mind for the following
reasons

 The bank demerged from IDFC limited and has carried forward the assets (infra loans). The
top management of IDFC has also moved over to the bank. Due to these assets, the bank has
been able to generate interest income and profits right from inception.
 The start-up part of the tag is due to the fact that IDFC was an infrastructure institution and
the new entity is a retail bank. As a result, IDFC bank is now investing in setting up a retail
network from scratch. I have covered all these points in detail in the previous note on IDFC.
 As the bank is a relatively new entity, we do not have any prior numbers as the current quarter
is the second one, since the formation of the bank. As a result, it makes sense to look at some
of the lead indicators of performance to get a sense of the future
 The no.1 driver of performance – net advances, grew by 5% q-o-q or around 20% annualized.
This matches with the targets which have been shared by the management
 The second critical factor is the NPA numbers. The management took a large provision on its
stressed assets of around 8800 Crs before the demerger and indicated that this provision
would be adequate in the future. In the current quarter we can see that the new provisions
were minimal and the provisioning seems to be adequate. The Gross NPA numbers seems to
have doubled, which is more of a technical change of assets from the stressed to NPA bucket
and will not impact the profitability or book value as the required provisions have already
been taken

In terms of building the retail bank, the following are the key indicators which we will continue
to track in the future

 New branch: 35 new branches (rural and urban) were added taking the total to 60
 CASA/ low cost funding: the company has paid down its high cost bond borrowing
(along with liquidation of some investments) and replaced it with lower cost FD and
CASA accounts. CASA ratio now stands at around 9.5% and should increase with the
expansion of the branch network
 CAR ratio: The CAR ratio increase from 19 to 22% due to the drop in investments and
lower borrowings. The high CAR ratio means that the bank can grow for quite some time
without requiring any equity funding
 Cost to income ratio: this has now crept up to 44% and is likely to go up further to 50%
levels next year as the management continues to expand the branch network and hire
people to expand the operations
Future expectations

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RC Capital Management IDFC Bank Limited

The bank is earning around 6-7% ROE due to high levels of capital on the book. This number will
expand going forward as the bank expands its balance sheet and reduces the cost of funding via
deposits and CASA accounts.

We should however not expect the ROE to expand rapidly as the bank will continue to invest
heavily into the retail network and technology backbone.

If the bank continues to grow at 20% levels and achieve a 12%+ ROE, the valuations of the bank
should approach that of the other top private sector bank. However, this would take at least 2-3
years and hence in a way this idea is quite similar to Piramal enterprises (circa 2011) where in the
management invested into the business for a long time (without any visible numbers).

However, we kept track of the various lead indicators of performance and made sure that the
company was heading in the right direction. Once the numbers have become visible to the
market, we are seeing a re-valuation of the stock (Piramal enterprise)

If the bank management continues to execute to the plan, the stock should follow suit, though we
are not likely to see the same happen in the short term.

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RC Capital Management IDFC Bank Limited

2016 - Annual Results Review


Posted on 7th July 2016

Key risks and their current status

NPA risk – The main short to medium risk for the bank is an increase in NPAs leading to higher
provisions and lower profits. I personally think that this is unlikely as the management had
identified close to 20% of assets as stressed and took a 50% provision against them before the
launch of the bank. In comparison, the worst of the PSU banks have reported around 10% of their
total assets as stressed and are provisioning around 30% against them. So we can assume that the
management took a fairly aggressive stance prior to the launch of the bank so that they would
not be distracted by this issue and can focus on building the bank.

The last two quarters have a borne this out as new provisions have been minimal. On the contrary
if the power sector does get revived (even partially), then some these provisions could get
reversed.

Technology and regulatory changes – I covered this point in the update for Shriram transport. I
think this is a far more important risk or even an opportunity for the bank. The entire banking
sector in India is now undergoing substantial change due to new regulations, which have reduced
the entry barriers into banking. On tap licenses, payment and small banks and other new entrants
mean that we will have higher competition in this space.

In addition to the above, we now have technology led change which is causing all kinds of non-
financial players (telecom, mobile wallets etc.) to enter into various parts of the financial
ecosystem. This is likely to increase the competitive intensity further.

The net impact of an increase is that the ROE for the sector is likely to reduce over time. These
changes however are both a threat and an opportunity for IDFC bank. As banking and financial
services move online and to the mobile, the bank can expand rapidly in the retail space without
an extensive branch network. The key competitive barrier in the retail space is changing from a
physical distribution network to a technology driven, online platform.

Key assumptions (valuations) and current status

The bank is currently selling at around 1.1 times book value or roughly 20 time earnings. The
reason for this wide difference between the two valuation measures (cheap on book basis, but
seemingly fairly valued on earnings) is due to the low ROE of the bank.

This low ROE is in turn due to low levels of loans in comparison to the equity. The bank has a
CAR ratio of around 22% and even higher if one eliminates the investment book. As a result, the
bank can grow its loan book quite rapidly (with higher debt) and earn a better ROE.

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RC Capital Management IDFC Bank Limited

Let’s do a thought experiment – Let’s say IDFC bank has been operational for last 10 years and is
now operating similar to other Pvt sector banks. So the bank is able to operate with a CAR ratio
of around 16% and can earn a NIM of roughly 3% on its loans. Due to the higher leverage (lower
CAR ratio), the bank easily supports an additional loan book of around 40000 Crs on its balance
sheet.

This additional loan book would equate to around 1200 Crs of pre-tax income or in other words,
the bank could be earning twice the current level of net profits if it was operating as any other
bank. By the way, this would translate to an ROE of 12.5% which would still on the lower side
compared to the other private banks.

If you look at it in this manner, then the bank is selling at around 10 times earnings.

So in effect the market is valuing the bank based on its current earning/ profitability and ignoring
the fact that it could very easily raise its earning and ROE by operating like any other bank. We
are not even considering the impact of other income in this assumption

To be fair, this change is not going to happen overnight. The bank needs to expand its lending
(the easier part) and grow the retail business which will take time and add to the costs in the
interim. So in effect at the current price, we are not paying for the transition of IDFC from a
focused lending institution (in the infra space) to a universal bank.

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RC Capital Management IDFC Bank Limited

Q1-2017 Results Review


Posted on 2nd August 2016

This was a good quarter in terms of the progress made by the bank in building its retail
operations. As the bank was operationalized in Oct 2015, it is still in an investment and build out
phase and has yet to complete the first year of operations.

The bank reported an operating income growth of 28% on a q-o-q basis. Net profit grew by 60%
during the same period. I would not read too much into these numbers as the bank recently
started operations and hence these numbers are likely to bounce around from quarter to quarter.

As I wrote in the previous update, I prefer to look at some lead indicators and drivers of
performance which should translate to better ROE and growth numbers in the future. Let’s
look at how the bank performed on those variables

 The no.1 driver of performance – funded credit, grew by 4% q-o-q or around 18% annualized.
This matches with the targets shared by the management. On the conference call, although
the management was not explicit, it seems that this growth rate is likely to trend higher in the
future.
 The second critical factor is the NPA numbers. The NPA numbers dropped slightly during
the quarter. As the management has already taken a high provision, we may even be
surprised by the ultimate recovery from these stressed assets. A case in point – the interest
income grew by 25% versus a 5% growth in advances as the bank was able to get interest
income from stressed assets which are not part of the regular advances.
 In terms of building the retail bank, the following are the key indicators which we will
continue to track in the future

Distribution: The number of branches have expanded to 65. In the past, the number of
branches was a key driver for any bank to develop its retail operations. However, this is
changing rapidly now. With the introduction of JAM and new technology platforms, banks
like IDFC are successfully experimenting with new concepts like micro ATM to acquire
customers at a lower cost. The bank has added 300 micro ATM in the quarter and plans to
expand the same to 1000 by the end of the year.

These micro ATMs are being installed in regular kirana stores and have thus added a new
point of distribution for basic banking at a much lower cost. In addition to this newer form of
distribution, the BC (business correspondent) system has been opened up by RBI which is
enabling the bank to acquire customers and provide basic banking services at a lower cost
and also to scale rapidly.

CASA/ low cost funding: The lower cost deposits including CASA are growing rapidly and
grew by 60% for quarter. This will continue to rise as the bank builds its retail operations.

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RC Capital Management IDFC Bank Limited

CAR ratio: The CAR ratio has dropped from 22% to around 20.4% as the bank has added to
its investment book to take advantage of the excess liquidity on its book. This will enable the
bank to earn trading income even as it continues to build its loan book.

Cost to income ratio: The cost to income ratio dropped to around 39% during the quarter. This
number is likely to move around and remain high as the bank continues to invest in building
its retail and corporate business.

Future expectations

The management has shared the detailed strategy of the bank for the medium and long term. It
is quite a detailed document and I would encourage you to have a look at it. The management
has articulated a clear and crisp approach and shared precise goals for FY 17.

As part of the strategy for expanding the reach, the management has acquired an MFI (micro
finance institution) called Gram Vidiyal (GVMFL) at the cost of 2X book value. The MFI has
around 1.1 MN customers, ROA of 3% and ROE of around 30%. The purchase price seems to be
reasonable, though we will know the true worth over time as the loan book matures.

The above acquisition allows the bank to expand its reach via 300 branches of GVMFL and thus
achieve a step change in its long term plans. The management is open to more acquisition as part
of its long term strategy.

If the management can execute to its strategy and achieve what it has set for itself, the ROE and
growth numbers will follow and so will the stock price

A note on the MFI frenzy

A few of you may have noticed the frenzy around the NBFC and especially the MFI space. The
buying frenzy is not fully irrational.

The Indian household debt at around 9-10% of GDP is among the lowest in the world and there
is a huge pent up demand in the retail / MSME segment. The introduction of Adhar, regulatory
changes and several new technology tools is now allowing the NBFC segment to reach new
customers at a much lower cost and achieve rapid growth.

We are now seeing growth in excess of 40% in this space. This is further aided by the fact that
PSU banks and to a certain extent some Pvt sector banks, are not capable or interested in serving
these customers.
So we have a confluence of factors coming into play here – A new regulatory and technology
platform which allows companies to reach out to a large set of under-served customers at a time

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RC Capital Management IDFC Bank Limited

when the dominant players in the ecosystem, namely banks, are not in a position to take
advantage of these opportunities.

We are seeing this playout in the entire financial services space – Home loans, NBFC, Auto finance
and even structured finance (such as that of Piramal enterprises). This is likely to continue for the
next 2-3 years.

There is however a dark side to this whole opportunity – A growth of 30%+ may lead to poor
lending practices and weak credit underwriting in several cases. This may be even more true in
the case newer institutions which lack the experience and management bandwidth to manage
this growth (and later collect the bad debts).

We may not see the impact of these practices for the next 2-3 years, but if poor decisions are being
made, the chickens will eventually come home to roost. We have seen that in the past in the sub-
prime mortgage crisis in the US and the bad debt problems of the PSU banks now.

The time to be cautious is now and not when the poor lending practices lead to a blow up in the
future. In other words – tread with caution and be sure what you are buying.

We are already around 18% of our model portfolio in financials via four companies. These
companies operate in different segments of the financial ecosystem and I believe that the
management of each of these companies is competent and has seen multiple cycles in their
respective businesses. At the same time, if the frenzy continues and our concentration in this
business segment continues to grow, I will start reducing the position size.

For now, we are not there yet and hence I am not taking any action for now.

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