Ideas for profit|Q3 review: DCB posts strong result on operating efficiency; can buy-on-dips

-Significant improvement in operating efficiency

-Comfortable assets quality and efficient utilisation of capital

-Valuation premium but will sustain with levers of return improvement in place

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DCB Bank, a small-sized private sector bank, reported strong performance in Q3 FY19 with net profit increasing by 51 percent YoY aided by healthy loan growth and controlled expenses.

DCB is a retail,  SME and MSME focused bank and stands out for its comfortable asset quality in the sector marred by high non-performing assets. Bank has witnessed gradual but steady improvement in the return ratios since last year which makes it worth a consideration in an environment where a large part of the banking system has been rendered weak and NBFCs are stepping back following the liquidity crunch.

Key positives

DCB's advances growth was healthy at 23 percent YoY and higher than the industry average, albeit on a smaller base. The growth in loan book was even better at more 25 percent YoY if we exclude corporate banking which is not a focussed area for the bank. Net interest margins remained almost same as last quarter at 3.83 percent.

The highlight of the quarter was significant improvement in operating efficiency and was one of the key driver of profits. Thanks to the contained growth in operating expenses at 5 percent YoY, the cost to income ratio improved to 55.2 percent in Q3, declining by 710 bps YoY. DCB had earlier guided to achieve the cost-to-income ratio of 55 percent by Q4 FY19. It is heartening to see bank delivering on the target in Q3 itself.

DCB’s asset quality is relatively better compared to peers. The bank reported gross non-performing assets (GNPAs) at 1.92 percent as at end December which inched up slightly on a sequential basis. The lender encountered a fraud in its commodity funding segment which led to higher slippages and consequently slightly higher provisions in Q3. Nevertheless, bank’s net NPA remained almost stable at 0.71 percent in Q3. Additionally, bank’s low restructured advances (0.32 percent), high provision coverage ratio (77 percent) and policy to maintain floating provisions provides lot of comfort.

Bank is efficiently utilising the capital as it is focussing to grow segments attracting a risk weight of less than 100 percent. Management’s efforts is well reflected as growth in risk weighted assets  at 15 percent YoY was much lower compared to overall advances growth at 23 percent YoY.

DCB usually ends up with priority sector lending at 50-55 percent of total lending which exceeds the regulatory requirement of 40 percent. As a result, bank earns fee income by selling the additional priority sector lending certificates (PSLC).

Problem areas

DCB is targeting loan book growth of around 22-24 percent per annum. The target is modest considering bank’s small loan book size which is less than 1 percent of overall banking system advances.

The bank’s funding profile remains average, with a low share of CASA deposits at 24 percent, much lower than the industry average of around 35 percent.  However, we draw comfort from the share of retail term deposits (including NRI deposits) which stood at 54 percent of total deposits as at end December and lends stability to the bank's resources profile.

Bank’s core fee income was weak at 5 percent YoY.

Other observations

DCB intends to add 15-20 branches next year. The bank targets to double its loan book in 3 to 3.5 years which roughly translates to loan book growth of 22-24 percent per annum.

Outlook

DCB had earlier guided to achieve RoA (return on assets) of 1 percent and RoE of 14 percent by Q4 FY19. Bank almost achieved it in Q3, earlier than the targeted timeline which is very encouraging.

Going forward, we see a sure, but moderately paced improvement in return ratios for DCB primarily driven by balance sheet growth and operating leverage. The bank’s ability to maintain its margins and stable asset quality as it grows its book will be crucial. Slippage on any of these variables will make bank’s journey more arduous.

On the valuation front, the stock is currently trading at 1.8x FY20e price-to- book which is premium to many of its peer old private sector banks. However, the current valuation will sustain with levers of profitability improvement in place. Capital raising can be a key catalyst in medium term. With not much room for valuation re-rerating, the upside to stock price in near term will be in tandem with earnings growth. Nevertheless, long term investors should utilise the weakness in stock price, if any, as an opportunity to accumulate the stock.

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