Moneycontrol
Jan 17, 2018 06:21 PM IST | Source: Moneycontrol.com

Capital First merges with IDFC Bank — Should investors buy into the weakness?

Then it tried to punch above its weight by eyeing a merger with Shriram Group. The attempt failed, prompting questions about IDFC Bank’s growth path. The decision to merge Capital First with itself was therefore well timed. The premium paid (close to 12.5%) is a small price for salvaging a brand like “IDFC”.

Madhuchanda Dey
 
 
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IDFC’s conversion into a bank was accompanied by a stark realisation that growing the retail book (to balance out the corporate heavy legacy balance sheet) was a Herculean task in a hyper competitive environment. It seemed relatively easier to grow the retail book by acquiring other lenders. The first signs of an acquisition-driven growth strategy was visible when IDFC Bank acquired a small micro finance entity called Grama Vidiyal.

Then it tried to punch above its weight by eyeing a merger with Shriram Group. The attempt failed, prompting questions about IDFC Bank’s growth path. The decision to merge Capital First with itself was therefore well timed. The premium paid (close to 12.5%) is a small price for salvaging a brand like “IDFC”.

Prima-facie, it seems shareholders of Capital First stand to gain more from the merger. So, how should long-term investors look at the current weakness in IDFC Bank?

Contours of the merger

The boards of the two institutions have agreed to a swap ration of 139: 10 (139 shares of IDFC Bank for every 10 shares of Capital First) which will result in 40 percent equity dilution.

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What’s important to understand is the visibility that shareholders of IDFC Bank are getting in return.

Why is the deal a win-win?

For IDFC Bank, the asset mix still skewed towards corporate changes in one shot from 80:20 in favour of corporate and retail to 55:45. The combined entity will gain access to 5 million customers (3 million from Capital First) to sell retail assets as well as liability products.

The combined entity will have significant distribution footprint - close to 250 branches, 2200 dealership of Capital First and will have well entrenched pan-India presence through over 350 dedicated BC (business correspondent) outlets and over 9,100 micro-ATM points.

On the asset side, it will have presence across different ticket sizes of loans across SME (small & medium enterprises) and MSME (micro, small & medium enterprises). The product mix of Capital First – loan against property, SME loans, 2-wheelers, Consumer durable financing, etc. will have good complementarity with IDFC Bank.

Not only did IDFC Bank find growing retail asset difficult, but it also lacked the right leadership to drive the business. In Mr. V. Vaidyanathan (current CEO of Capital first who will head the combined entity) who has a proven track record, IDFC shareholders will find the right leadership to drive the retail business.

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Finally, as per RBI’s directive, the parent of IDFC Bank i.e. IDFC Ltd has to reduce its stake from the present 52.8 percent to 40 percent by October 2018. The merger achieves the same in one stroke, by bringing down the parent’s stake to 37.8 percent. IDFC has expressed its intention to mop up shares from the market to take up its stake to 40 percent that should provide downside support to the stock.

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For Capital First there will be close to 100 basis points reduction in cost of funds as their short-duration liability matures. In addition, the non-banking finance company will get enhanced visibility under a banking platform and access to a retail liability base.

The near-term speed breakers

However, the merger in addition to the regulatory approvals might face speed breakers in the form of the combined entity having to meet Priority Sector Lending (PSL) requirements and SLR/CRR (statutory liquidity ratio/cash reserve ratio). The management sounded confident about meeting the overall PSL norm (but not the sub-categories under PSL).

As of now, only 4.9 percent of IDFC’s asset book is funded by low-cost liabilities (CASA). For the combined entity it will be even lower at 3.6 percent. For IDFC Bank, to improve margin and return ratios, the ramp up in deposits especially low-cost deposits remain key.

While Capital First gives IDFC Bank access to retail assets, the onus of garnering retail liabilities will depend on the team’s ability to cross sell liability products successfully to the clientele.

Alongside some of these regulatory costs, there could be merger synergies (that are not yet quantified) which could offset some of the above mentioned drag on earnings.

Long-term – on track execution can re-rate the stock of IDFC Bank

The combined entity will be well-capitalised to grow without diluting for the next couple of years. In the new avatar, IDFC Bank expects to grow in twenties once the merger is fully consummated.

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While the near-term earnings outlook may not be exciting, investors with a long-term investment horizon should buy into the weakness, as strong execution will gradually reduce the huge valuation gap between IDFC Bank and its peer group.

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