In this blog post, we have assessed the key fundamentals of Bandhan Bank just prior to its merger with Gruh Finance. Using Discounted Cash Flow valuation with latest reported numbers from Sep’19, we have estimated an intrinsic value of Rs. 495 per share, making the Bank slightly overvalued before the impending merger. We have also posted our analysis and valuation of Gruh Finance. We have estimated the value of synergy arising out of its merger into Bandhan and assessed if the deal was priced to be a bargain.
Loan Asset Profile
Bandhan Bank constituted ~20% (Rs. 39,061 Cr) of the outstanding micro loan portfolio in the industry (Rs. 1,90,684 Cr), which itself formed ~25% of the total micro loan potential in the country (as of Jun’19)
| In Cr.
Unless otherwise stated | FY17 | FY18 | FY19 | Jun’19 | Sep’19 (as per investor presentation) | CAGR (FY17-19) |
| Outstanding Advances (including IBPC) | ₹23,642 | ₹32,389 | ₹44,776 | ₹45,420 | ₹45,927 | 37.6% |
| Microcredit % | 69.6% | 87.1% | 84.6% | 86.0% | ||
| Microcredit | ₹16,457 | ₹28,211 | ₹37,889 | ₹39,061 | 51.7% |
Overall outstanding advances have increased at a CAGR of ~38% over FY17 – 19. Although, this growth is commendable, but the Bank has high concentration in the East with West Bengal forming 46% of the loan book last year.
RBI has mandated Priority Sector Lending (PSL) of 40% of advances for all the Banks. For Bandhan, ~85% of the outstanding advances over FY18 and FY19 have come from PSL by issuing loans to micro customer. Bandhan was able to sell PSL certificates worth 58% and 76% of its PSL loans in FY18 and FY19 to other banks which fell short of their PSL target. These certificates are akin to social credits with no underlying risk and asset transfer. Bandhan earned 151 Cr and 309 Cr (income close to 1% of the PSLCs sold) by selling these certificates to other banks un FY18 and FY19 respectively. This looks good since with the microcredit focus, Bandhan can earn ~1% extra income on the portion of its PSL loans which it can sell as PSL certificates.
Moreover, focus on micro credit coupled with loan growth allowed Bandhan to sell loans in the form of Inter Bank Participation Certificates (IBPC). Such certificates can we viewed as similar to securitization which provide liquidity (cash flow) by selling less liquid loan assets. Bandhan earned interest income of Rs. 318 Cr and Rs. 201 Cr in FY18 and FY19 from IBPC sales.
Liability Profile
Debt comprises of both Current Account Savings Accounts (CASA) and term deposits. CASA deposits provide a stable source of low-cost funding, which formed 36% of their total deposits as of Jun’19 (Sept’ 19 CASA % not reported separately from Gruh) . On the other end, ~85% of their lending is to microfinance borrowers which earns them relatively high yields of 18.40%. Bandhan has maintained a Net Interest Margin (NIM) of over 10%, which is a characteristic of FIs which have CASA as a low cost source of funding.
| FY17 | FY18 | FY19 | Jun’19 | |
| CASA | 29% | 34% | 41% | 36% |
| D/E | 5.5 | 3.6 | 3.9 |
Bandhan has the lowest debt to equity ratio in the industry. Please note that in Financial Institutions, debt is viewed as raw material and capital is defined as including only equity.
Asset Quality and Risk Factors
Financial institutions have increasingly been opaque when it comes to reporting loan asset quality. It is very challenging to get a true picture of asset quality from annual reports, investor presentations and reports from credit rating agencies. In the past (case in point DHFL) credit rating agencies have not been great at indicating a looming credit crisis on the horizon.
Nonetheless, we have compiled the following to form a view about Bandhan’s asset quality
- Increase in loans to NBFCs / MFIs and increase in Non Productive loans – Although, Non Priority Sector (which includes loans to NBFCs/MFIs) forms a small % of Bandhan’s portfolio, but loans to this sector have almost doubled over the past 5 quarters (FY19-Q1 to FY20-Q1). Moreover, as displayed in the exhibit above 75% (1759/2356) of loans are personal loan, which are non-productive. In a stressed economic environment, this class of loans are very susceptible to becoming bad loans since people are less likely to pay for discretionary things. In FY19, such loans (although small % of the portfolio) had an NPA of 1.97% which is very high when compared to PSL NPA of 1.06%
- Business has grown with heavy concentration in the East – As per the investor concall transcript from Jul’19, 55% of Bandhan’s customers have been with them for more than 3 loan cycles. These repeat customers have an outstanding loan ticket size of ~Rs. 49,000 and represent 65% of the total loan value as of Jun’ 19. The first 3 cycles of loans constitute newer customer with a ticket size of Rs. 29,000. Point to note here is that a customer traverses through cycles only if they are making timely payments else the relationship with the customer is discontinued. Moreover, loan sizes are increased as Bandhan feels more confident when a customer has matured beyond 3 cycles. While, this gives comfort but Bandhan is very concentrated in the East. They certainly have seemed to have developed a good relationship with customers in the East since the time they were a MFI. The challenge will be replicating a similar model in other parts of the country where Bandhan is aggressively foraying into.
- Asset Liability Mismatch – There was a point in time until last year that everything was so hunky dory with MFIs/NBFCs, the institutional investors were so bullish until Mr. Market made everyone look at one of the most fundamental and crucial principle in Finance – Asset Liability Mismatch (ALM). Let’s try to understand what does it mean in simple terms. When FIs engage in short-term borrowings (liabilities) to give long-term loans/advances (assets) to its customers then what happens is that the FI may not be able to pay off its creditors since the money is stuck in long term loans that they have made to their customers. Typically, FIs roll over their short term borrowings i.e. make another borrowing to fulfill a short term borrowing, but if they are not able to do so then they face a severe liquidity crunch which is called ALM. Now the question arises why do FIs engage in short term borrowings at all? the answer is that such borrowings are cheaper than the longer term borrowings (long term borrowings have a higher interest rate since the providers of capital want to be compensated with a premium for bearing more risk which stems from a longer term loan).
Regulatory Constraint
As per RBI requirement, Bandhan is required to maintain a Capital Adequacy Ratio (CAR) of 10.875%. Please note that in Financial Institutions, capital is defined as including only equity (not debt). While a low ratio denotes that the FI is not adequately capitalized, a ratio which rises over time denotes that the FI is not using capital to grow. (CAR = Tier 1 + Tier 2 Capital / Risk Weighted Loan Advances) 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. Tier 2 capital on the other hand can absorb losses in the event of liquidation. Even though growth in equity has exceeded the growth in advances, but the CAR has decreased recently.
| FY17 | FY18 | FY19 | Jun’19 | Sept’ 19 | |
| Tier 1 Cap | 24.8% | 31.5% | 27.9% | 25.8% | |
| Tier 2 Cap | 1.6% | 1.2% | 1.3% | 1.3% | |
| CAR | 26.4% | 32.7% | 29.2% | 27.0% | 25.1% |
In the snippet below, the CFO explains the decrease in CAR. Since FIs operate under a regulatory capital constraint, it can be argued that these firms have to reinvest in regulatory capital in order to grow in future. Portion of PAT which does not get paid out can be viewed as reinvestment since it gets added to the equity capital. We have forecasted the change in regulatory capital and used these as reinvestments to estimate Free Cash Flow
Management
Erstwhile Bandhan Financial Services Pvt. Ltd. (BFSL) was the largest NBFC-MFI in India and the first entity to receive an in-principle universal banking licence from the Reserve Bank of India. Bandhan Bank was established following the transfer of BFSL’s business to the bank and it commenced operations in August 2015.
Bandhan Bank was incorporated as a wholly-owned subsidiary of Bandhan Financial Holdings Limited (BFHL). BFSL holds 100% equity in BFHL
As per the RBI’s New Bank Licensing Guidelines, a bank is required to reduce its promoter’s stake to 40% within three years of the commencement of its business (August 23, 2015). Subsequently, BBL’s IPO in March 2018 helped pare the promoter’s stake to 82.28% as on June 30, 2018 from 89.76% as on December 31, 2017
Upon completion of merger with GRUH, Bandhan Financial Holdings Limited – BFHL, the non-operative financial holding company (NOFHC) was able to reduce its stake to 60.96% from 82.26% earlier, but it remains higher than the 40% requirement as per the banking license requirement of RBI. In Sep’ 18, because of this noncompliance RBI has restricted Bandhan from opening of new branches without prior approval from RBI and also frozen the remuneration of its CMD Mr. Chandra Shekhar Ghosh.
CMD’s total compensation remained Rs 2.04 Cr in FY18 and FY19. He made up for the no increase in compensation by exercising 50,000 (of the 200,000 granted to him) options at a strike price of Rs. 180 (i.e. bought 50,000 shares at Rs. 180) on Feb 14th, 2019 when the shares were trading at Rs. 479. Had he sold the shares around that time frame, he would have made a profit of Rs. 1.5 Cr on an investment of Rs. 90 lakhs (180 * 50,000). This is a perfectly legal way for risk-free gains made possible by the magic of employee stock options.
Of the total 22.2 lakh options (granted in FY18), 4.1 lakh have been granted to senior management personnel including the CMD. It seems rest of the 18.1 lakh options have been granted to mid level management employees. This is good since the higher management does seem to be keeping the free gains to themselves alone.
Live options are a double whammy for the common shareholders since not only they reduce the value of equity, but also provide free gains to the promoter group and employees holding them. It becomes important to value them and assess the degree of impact they have on the overall value of equity for common shareholders. At the end of FY19, there were 18.57 lakh options outstanding, which have a negative drag on the value of equity. The reason is that the employees holding the outstanding options represent another claim on equity (besides that of the common stockholders) and the value of this claim has to be netted out of the value of equity to arrive at the value of common stock. I have estimated this negative drag at around Rs. 82 Cr using the Black Scholes Model for pricing options. We will see in the valuation section that this value of options seem to have a very low impact on Bandhan’s value of common equity.
Another point to assess the management quality is to look at related party transactions. It seems that the promoter group (BFSL and holding company BFHL), the key management group (KMP) and their relatives make deposits in the bank and in return earn interest. An investor needs to assess the interest% on such deposits and see that it does not exceed the interest% that the bank offers to its customers for specific maturities. Moreover, the huge difference between the maximum outstanding deposits and outstanding deposits at the end of the financial year are also indicative of the fact that a significant chunk of these deposits are short term in nature. The proportion of maximum outstanding deposits to overall deposits by related parties was ~2% in FY19. It could be that the intention is to inject liquidity, in that case we need to ascertain if the bank experiences funding challenges in short-term.
DCF Valuation of Bandhan Bank (just prior to Gruh acquisition)
Value of a firm is the present value of its future cash flows. So it becomes important to estimate the future cash flows to value any entity. Buffet says that he eliminates a company from consideration upfront if he cannot roughly estimate a business’s key economic characteristics 5–10 years out.
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.
(Please bear in mind that DCF can be very subjective and is as good as the underlying assumptions. One of my favorite people from the Finance world, Prof. Sanjay Bakshi humorously describes future cash cash flows in a spreadsheet as “mungeri lal ke haseen sapne”. We can’t agree more :-). We have tried not to be too “haseen” and not overly “badsurat” in our future estimates 🙂 ) Bandhan was trading under Rs. 500 per share in early part of Oct’ 19, but then the stock shot up well above 500 reflecting market optimism right before the impending merger with Gruh Finance
Bandhan was trading at Rs. 584 (as of 16th Oct, 19 just before the merger), which is the highest value we get in our simulation. On doing a reverse DCF*, we find that 30% of Bandhan’s market cap of Rs 69,670 cr (as of 16th Oct,19 just before the merger) was justified by its then current performance (non growth perpetuity) and the rest 70% is the value market believed that Bandhan will generate from future growth on the back of positive sentiments regarding the merger with Gruh.
*Reverse DCF is nothing fancy – All one needs to do is take the profit after tax and divide it with cost of equity 12.5%. The value that you get is the value that is justified by company’s current performance assuming no growth in perpetuity. This value formed 30% of Bandhan’s market cap before the merger.
Conclusion
Bandhan Bank has demonstrated good growth and constitutes 20% of outstanding micro lending portfolio in the industry. The additional income from selling PSL certificates augurs well for Bandhan. The bank reaches micro loan customers largely through an extensive network of low cost doorstep service centers (DSC) with a cost-to-income ratio of 32.6%. The bank gets a most of its business (65% of value) from repeat customers. Bandhan is very concentrated in the East, which formed 46% of its loan book as of FY19. The challenge will be replicating this model in other parts of the country and building customer relationships (the way it has done in the East) in an industry which has become increasingly competitive. With the acquisition of Gruh, an investor needs to track how Bandhan delivers on the growth synergies due to geographic complementarity (post on the merger with Gruh is up next). An investor needs to closely track the loan asset quality and also loans given to non-priority sector with the limited arsenal of quality indicators (NPA, ALM mismatch, productive/non-productive loans and reports from credit rating agencies) at their disposal. Moreover, an investor needs to closely watch any new ESOPs that may be issued (to see if the management is not overly compensating itself over common shareholders) and also assess deposits made by promoters and interest earned.
Prior to the acquisition of Gruh, Bandhan looked slightly over valued. In our next blog post, we have analyzed and valued Gruh Finance. We have also valued both Bandhan and Gruh together to estimate the value of synergy (which has been outlined as the motive of the deal besides dilution in promoter stake). We then go on to assess if Gruh’s intrinsic value combined with synergy justifies Gruh’s pricing as per the deal.
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.