City Union Bank: Steady performer; buy on dips

FY18 earnings at glance
CUB reported net profit growth of 18% year-on year (YoY) for FY18. Net interest income increased by 19% YoY driven by 17% growth in advances and margin improvement.  The net interest margin (NIM) expanded by 25 basis points in FY18 to 4.42% as the fall in cost of funds was sharper than the fall in yields on advances. The strong growth in core fee income of 18% YoY was partially offset by fall in treasury income. Consequently, non-interest income growth was subdued at 10% YoY.

Though declining, CUB’s asset quality is relatively better compared to peers with gross non-performing assets (GNPAs) at 3.03% as at end March 2018. The bank’s slippage ratio to NPA remained stable at 2% in FY18. However, recovery and upgradation to standard assets was slightly better as compared to FY17. The loan loss provisions increased by 25% YoY improving the calculated provision coverage ratio (PCR) to 45%.

CUB enjoys robust capitalisation; its tier-I capital adequacy ratio (CAR) stood at 15.79% and overall CAR was at 16.22%.

High regional concentration
City Union bank is a regional focussed bank with Tamil Nadu comprising 63% of its advances and 78% of its deposits as on March 31, 2018. Also, 69% of the bank’s 600 branches are in Tamil Nadu and 90% in south India. The bank will continue with its calibrated branch expansion strategy and intends to further grow its branch network in its home state, Andhra Pradesh and Telangana. Though regionally concentrated, we see immense growth opportunity for the bank as some of the public sector banks operating in the region are are fast losing their relevance in the financial system.

Robust margins despite modest funding profile
CUB's funding profile is average, with a low share of CASA deposits and cost of borrowings in line with the industry average. CUB's CASA deposit at 24% was much lower than the industry average of around 35% as on 31 March 2018. However, we draw comfort from the share of retail deposits (retail term deposits and savings banks deposits) which is between 70-80%, during the past few years, lending stability to the bank's resources profile.

The bank’s superior asset profile more than compensates for its average liability profile. Bank’s lending focus is more on working capital loans which constitutes around 66% of the advances as at end March 18. Moreover, it targets lending to trading and MSME segments in small ticket sizes.

Hence, the bank enjoys relatively high yields on advances mainly driven by (1) small ticket loans to small and medium enterprises with limited access to organised finance that command higher pricing, and (2) product-mix tilted towards large working capital facilities that earn relatively high yields compared to term loans.

Sound asset quality
CUB’s asset quality is reasonable in spite of presence in high yielding segments. Though the GNPA has inched up in the recent years, the bank’s miniscule restructured book at 0.03% of advances with no exposure to any restructuring categories (such as SDR or S4A) for which dispensation was revoked by RBI in February 2018 gives lot of comfort. Moreover, 99% of its loan book comprises secured lending.

CUB’s outstanding in security receipts (SRs) stood at Rs 341 crore as on March 31, 2018, accounting for 1.2% of the advances as on that date. CUB has already made provisions amounting to Rs 82 crore against the SRs in FY18. With outstanding provisions towards SR at Rs 132 crore, the bank has followed prudent provisioning to take care of any probable shortfall in future realisation of security receipts.

CUB’s asset quality has showed immense resilience during previous downturn in credit cycles. This was on the back of bank’s ability to quickly pull back growth from riskier segments prior to major crises. The bank’s prudence is evident from the reduced exposure to jewellery loans from 22% of its loan book in FY13 to 8.3% in FY18.

Outlook and Valuation
We expect CUB to maintain its strong profitability. Though margins may come under slight pressure due to increased competition and rising rates, we don’t see significant downside as around 95% of the loan book is on a floating rate basis. Frequent re-pricing of floating loan book reduces interest rate risk and will help sustain margins in future as well.

On the operating front also, we don’t see any significant upside risk. Following a bi-partite settlement between the bank and the staff union in FY17, the employees of the bank received a significant wage revision in FY17. Hence, we expect modest growth in future employee cost. This along with bank’s calibrated branch expansion strategy will keep operating expenses under control.

The receding asset quality pressures with negligible restructured accounts on books negates the risk of high provisioning as well.

So, we expect overall profitability to be maintained with bank delivering ROA of more than 1.5%. The big lever can come from accelerated loan book growth. While strong capital adequacy can support potential high loan book growth, but for the bank’s conservatism, investors can expect gradual but steady improvement in ROE over next two years.

On the valuation front, the stock is currently trading at 2.4x FY20e price-to- book, which is significant premium to many of its peer old private sector banks. We believe the bank’s consistency and conservatism justifies the premium at a time when banking sector is grappling with asset quality woes and weak performance.

We see the premium valuation sustaining given the strong return profile with levers of improvement in place. With not much room for valuation re-rerating, the upside to stock price will be in tandem with earnings growth. Investors looking for consistent earnings growth may look to utilize adverse market volatility, if any, as an opportunity to add the stock.

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