Bandhan and Gruh Merger Valuation

This blog post has two sections – In the first section, we value Gruh Finance separately (before merging into Bandhan). We have analysed and valued Bandhan separately here (in our previous blog post). In the second section, we value the merged entity and estimate the value of synergy to assess if Gruh’s pricing as per the deal was justified.

1. Gruh Valuation (just prior to acquisition by Bandhan)

Loan Asset Profile

As of Jun’19, Gruh operated primarily in the rural and semi-urban areas of Gujarat and Maharashtra, which together comprised 63% of the outstanding portfolio

Period	10Y	5Y	3Y	2Y	1Y	31/3 – 30/9
Outstanding Loans CAGR	24%	20%	16%	15%	12%	5%

Although, Gruh has done well with outstanding loans demonstrating good growth over the past 10 years, but with increasing base from concentration in the West, growth rate has shown a decline as shown in table above.

As of Jun’19, GRUH’s outstanding home loans to individuals of 14,665 crore constituted 83% of the total outstanding loans. Loan Against Properties (LAP) of Rs. 1,820 crore and other loans to individuals for non residential premises (NRP) of Rs. 343 crore constituted 10% and 2% respectively of the outstanding loans. The outstanding loans to developers of Rs. 876 crore constituted the remaining 5% of outstanding loans.

Though, cumulative disbursements as at March 31, 2019 stood at Rs. 33,392 crore with a CAGR of 14% over FY14 – FY19, but the loan disbursement decreased from Rs. 5,259 Cr (in FY18) to Rs. 4,936 in (FY19) for the 1st time in this period. In FY19, Gruh disbursed home loans to 37,599 families (previous year 43,473 families) and the average home loan to individuals increased to Rs. 9.59 lakhs from Rs. 9.40 lakhs in previous year

Liability Profile

	FY15	FY16	FY17	FY18	FY19	Jun-19
Outstanding borrowings	8216	10244	12018	14046	16584	18430
Banks/NHB	67%	77%	67%	55%	63%	69%
NCDs	8%	9%	20%	29%	26%	20%
Public Deposits	16%	14%	13%	10%	9%	9%
CPs	9%	0%	0%	5%	1%	2%

Commercial Paper (CP) is a short term cheap source of funds. Since the IL&FS and DHFL crisis, Gruh has reduced its reliance on CPs as a source of funding.

Regulatory Constraint and Equity Profile

	FY10	FY11	FY12	FY13	FY14	FY15	FY16	FY17	FY18	FY19	Jun’19
CAR	16.6%	13.2%	14.0%	14.6%	16.4%	15.4%	17.8%	18.3%	18.9%	20.3%	20.3%

Recently, NHB has proposed a gradual increase in the capital adequacy ratio (CAR) from the current 12% to 15% by 2022. Since FY14, Gruh has maintained CAR of over 15% and it has consistently increased from 15.4% in FY15 to 20.3% in FY19.

CAR = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets, where Tier 1 is the core bank capital, which comprises of equity and disclosed reserves. Tier 1 can absorb losses without requiring the bank to cease operations and Tier 2 capital on the other hand can absorb losses in the event of liquidation. (We have described CAR and how does it impact growth and valuation of an FI in our previous blog post on the analysis and valuation of Bandhan Bank).

We observe that return on equity (ROE) has decreased consistently from 31% in FY15 to 26% in FY19 (and 24% in Jun’19). Since capital comprises of equity, a CAR ratio which rises over time with decreasing return on equity denotes that the FI is not using capital effectively to grow. This is further corroborated by declining loan growth.

	FY10	FY11	FY12	FY13	FY14	FY15	FY16	FY17	FY18	FY19	Jun-19
D/E	8.8	9.3	9.9	10.0	10.7	11.5	12.3	10.8	9.0	8.7	8.8

As of Jun’19, borrowings were 8.8x of equity (from highs of 12.3 in FY16), which was higher than most of its listed peers. Please note that in FIs, capital is defined as including only equity (not debt), while debt or borrowing is viewed as raw material.

Asset Quality

Non Performing Assets – An asset is marked as NPA if the interest or principal instalment is overdue for 90 days. Gruh reported NPA of 0.95% in Jun’19 up from 0.66% in Mar’19. Historically, reported NPAs have remained below 1% expect in FY10.

	FY10	FY11	FY12	FY13	FY14	FY15	FY16	FY17	FY18	FY19	Jun’19
NPA	1.11%	0.82%	0.52%	0.32%	0.27%	0.28%	0.32%	0.31%	0.50%	0.66%	0.95%

Asset Liability Mismatch – We have described ALM in the blog post on Bandhan Bank’s valuation. ALMs can pose a greater threat to HFCs than to companies primarily focussed on microcredit financing since microcredit loans are relatively short term.

Gruh had no negative cumulative mismatches in the up-to one-year bucket which indicates an adequate liquidity profile

Again, we will mention that of late FIs have not been very transparent in reporting out bad loans. We can rely on some key credit indicators like NPAs, ALM, LCR etc and also reports from credit agencies to form a picture of their asset quality. An investor needs to do a very thorough analysis to assess the management quality of any company to build trust on what is being reported.

Management

As of Jun’19, promoter HDFC Bank owned 47.4% of Gruh Finance. Mr. Sudhin Choksey is the MD and he has been with the company since 1996. Gruh’s stock price traded at close to Rs. 11 towards the end of FY10 and shot up beyond Rs. 300 in FY19. EPS increased 6.5x over the same period. Over this period, Gruh has declared dividends with a payout ratio of above 30% every year. This indicates that the management has been sharing the fruits of its good performance with the shareholders. If we look closer an investor would observe that the management has rewarded itself handsomely over public shareholders. Of the 73 cr shares market float before the impending merger, 7.3% of the shares (including the effect of the two bonus issues) have been created by allotment of Employee Stock Options, which lets the management increase its shareholding at a cheaper price than the prevailing market price. Stock options are aimed at incentivizing the management to work hard towards increasing business performance. An investor notices that after the merger announcement (on 7th Jan’19) the management called for a special resolution on 22nd Apr’19 to allot 90 lacs stock options, which is 2.6x of the yearly average of allotting 34 lacs options over the last 10 years. It seems the management handsomely incentivized itself since as per the terms of the merger, Gruh shareholders were supposed to receive 568 Bandhan shares for 1000 shares of their own.

DCF Valuation of Gruh Finance (just prior to merger with Bandhan)

Value of equity is the present value of its future Free Cash Flows to Equity (FCFE). Click here to look at how we have estimated future FCFE for this financial firm and discounted them to present using Cost of Equity (COE) to arrive at the equity value.

Gruh does not look like it was priced to be a bargain. We have at arrived an intrinsic value of Rs. 80 per share as against its market price of Rs. 312 before the deal. We have outlined the assumptions and guiding principles in the exhibit below. ROE set at a mean of 25% (max 26%, min 24%) over the next 5 years and then declines to a mean of 20% (max 22.5%, min 17.5%) as the firm transitions to stable growth. 100 Monte Carlo simulation trials are run with ROE oscillating between min and max values (We would have liked to run 100x more simulations, but we have not purchased any software which lets us do that. We have used just excel’s inbuilt NORM() and RAND() functions to run 100 manual trails). We have assumed a growth in loan assets to be 12% over the next 5 years which tapers to 10% when the firm reaches stability. This may seem low, but our assumption is based on the back of Gruh’s declining growth in the last 5 years. On bumping up the growth expectations to 20% every year over the next 10 years, the intrinsic value that we get is Rs. 125 per share, which still makes it massively overpriced.

The over pricing is further corroborated by doing a reverse DCF*. We find that only 16% of Gruh’s market cap of Rs 23, 320 cr was justified by its current performance (non growth perpetuity) and the rest 84% is the value market believed that Gruh will generate from future growth. *Reverse DCF is nothing fancy – All one needs to do is take the profit after tax Rs. 468 Cr (or preferably net operating profit after tax for non financial firms) and divide it with cost of equity 12.5% (or preferably cost of capital for non financial firms). The Rs. 3,744 Cr value that you get is the value that is justified by company’s current performance assuming no growth in perpetuity. This value formed 16% of Gruh’s market cap before its merger.

Market seems to have rewarded Gruh’s good performance exorbitantly. The stock was trading ~50x earnings, which is high relative to its peers.

2. Valuation of the merger

We have valued Bandhan Bank separately just before it acquired Gruh Finance. The analysis and valuation is presented here.

Gruh was priced at Rs. 23,599 Cr [= 565.92 * (73.4 Cr Gruh shares * 568/100)] as per the terms of deal with Gruh shareholders receiving 568 Bandhan shares per 1000 Gruh shares. The merger came into effect on 17th Oct, 19.

Bandhan came out with the consolidated numbers (Bandhan and Gruh combined) in its FY20-Q2 investor presentation. They have stated growth, cost and transformational synergies as the motive behind the deal besides promoter stake dilution (synergy motive of the deal posted in the snippet below). Two entities come together with the motive of synergy when it is believed they will be able to do things that they could not have done as separate entities

Value of equity is the present value of its future Free Cash Flows to Equity (FCFE). Click here to look at how we have estimated future FCFE for this financial firm and discounted them to present using Cost of Equity (COE) to arrive at the equity value. 

Based on Sep’19 data, the intrinsic value we have estimated is Rs. 415 per share based on base case assumptions outlined in the valuation exhibit above. This makes the merged entity overpriced as of this writing. (Bandhan was trading at ~Rs. 555 immediately following the merger and slid to Rs. 515 on 13th Dec).

In our valuation of Bandhan, we have considered a growth in loan assets to be 25% over the next 5 years which tapers to 20% when the firm reaches stability. We extrapolate the same growth rate to overall merged entity with the belief that Gruh will be able to expand further through Bandhan’s existing branch network (refer Synergy snippet above) and moreover Bandhan will be able to tap on Gruh’s network as well. These assumptions reflect my perception of future growth potential.

ROE is set at a mean of 23.75% (max 25%, min 22.5%) over the next 5 years and then declines to a mean of 20% (max 22.5%, min 17.5%) as the firm transitions to stable growth. 100 Monte Carlo simulation trials are run with ROE oscillating between min and max values.

Moreover, we have estimated Rs. 1907 Cr as the value of synergy (which is under 3% of the estimated intrinsic value of the merged entity) in our base case valuation (please refer valuation exhibit). However, we see that Gruh’s pricing of Rs. 23,599 Cr. as per the deal is 2.9 times Gruh’s intrinsic value (Rs. 6,029 Cr.) combined with synergy.

We go onto run 100 simulation trails to get a range of synergy values. We observe that 65 of the trails show a positive value indicating that Gruh and Bandhan coming together will create more value than they could have as separate entities. However, 93% of those trails indicate that Gruh was acquired at a premium. (At the risk of repeating ourselves, we reiterate that we would have liked to run 100x more simulations, but we have not purchased any software which lets us do that. We have used just excel’s inbuilt NORM() and RAND() functions to run 100 manual trails)

Conclusion

Our base case valuation and the simulation trails we ran corroborated that Gruh was not priced at a bargain and Bandhan paid a high premium for the acquisition. This is not hard to conclude since the merger was priced based on a share swap and we saw in the first section of this blog post that Gruh was massively overpriced. (Again, please bear in mind that DCF is subjective and is as good as the underlying assumptions. Our assumptions are based on our perception of future growth potential, which we have outlined in the blog post above. Infact, we stretched the growth parameters in our valuation of Gruh and still found it overpriced). Moreover, the intrinsic value of the merged entity we have estimated is Rs. 415 per share based on base case assumptions. This makes the merged entity overpriced as of this writing. (Bandhan was trading at ~Rs. 555 immediately following the merger and slid to Rs. 515 on 13th Dec). Post the acquisition of Gruh, the intrinsic value of Bandhan dropped by Rs. 80 (from Rs. 495 to Rs. 415)

We do see (in 65 of the 100 simulation trails we ran) that both of the entities coming together will create more value than they could have separately. However, a great deal has to go right for Bandhan to break even on the deal.

With the acquisition of Gruh, it remains to be seen how Bandhan delivers on the growth synergies due to geographic complementarity. An investor needs to closely track the loan asset quality and also loans given to non-priority sector including exposure to Construction. Moreover, an investor needs to keep tabs on new ESOPs that may be issued to assess if the management is not overly compensating itself over common shareholders.

Thanks for reading!

Gautam

Disclaimer – Currently, I do not own any stock of this company. This analysis should not be misconstrued as a buy / sell recommendation. Moreover, any opinion expressed in this blog post is solely my own and does not represent views of my employer.