Sector Analysis: ICICI Bank (IBN) is India’s largest private sector bank - it belongs to the International Banking group. Oflately, fortunes of international banks have been tied to the US financial sector; IBN’s correlation to Financials SPDR (XLF) in the past six months is 0.86. In simple terms, IBN traded in-line with the US financial sector for the past six months and dropped by 50%; underperforming India’s BSE Sensex which fell by 15% during the same period.
There are many reasons for IBN’s decline but a major influence has been the issues facing the US banking sector. So, the obvious question that investors have regarding banking stocks is: “what if the story of US banks' asset write downs and earnings losses is repeated in emerging markets such as India?” However, there are a few subtle differences between Indian banks and their US counterparts that make Indian banks less likely to follow the same path.
First, Indian banks have very low exposure to structured finance investments in the US market. IBN’s Q2 2008 report didn’t have any materially significant losses from structured investments in US and the management doesn’t expect that to change anytime in the future. Secondly, home loans that banks originate in the Indian market are of better quality than US mortgages. At this point, it is important to understand the difference between a US home loan versus a Indian home loan.
A US home loan is typically pooled as an MBS and sold to investors leaving the risk of default with the MBS investors, (a group of financial institutions) while the originating bank only services it. The loan doesn't appear on the lender banks’ balance sheet nor is it liable in case of default; hence it has little to no incentive in checking the ability of the borrower to repay the loan. To make matters worse, the originator bank is paid for originating the loan which means that the banks are incentivized to originate as many loans as possible without checking the credit quality of the borrower.
This is not true in case of Indian home loans; they are originated, serviced and carried on the lender’s balance sheet as well as accounted for in NPA estimation. It is this subtle variation that makes all the difference in the quality of home loans issued by Indian banks. Here, the originator (Indian bank) is liable for default and thus has an incentive to check the ability of the borrower to repay the loan.
Growth Catalysts: Various segments of IBN’s business are,
a) Commercial & Retail Banking (ICICI Bank) forms the largest chunk of revenues and is the most important part of the business. It recorded a 35% growth in savings deposits in the June quarter on a y-o-y basis. India has a savings-to-GDP ratio of about 35% while China is at 50%. However, 69% of India’s savings are from the household segment while the bulk of Chinese and Korean (about 80%) savings are from the corporate and government segment. Obviously, a higher savings ratio in the household segment bodes well for ICICI Bank. India maintains a high savings rate inspite of high inflation since social security is almost non-existent which means the high savings rate should persist in the near future. IBN has a network of 1,388 branches while India’s largest nationalized bank, State Bank of India, has a network of 13,000+ branches. Private sector banks such as ICICI have grown rapidly at the expense of nationalized banks since the latter were not quick enough to adapt to changing customer needs; we don’t see a reversal in this trend in the anytime soon.
b) ICICI Securities: ICICI is the largest retail stock brokerage franchise in India and it also offers online trading. Stock market turnover has grown at a CAGR of 60% per annum in the last five years and stock trading at ICICI securities (in terms of daily turnover) has grown at a CAGR of 114% in the last four years.
c) ICICI Life Insurance: Life insurance industry was privatized in 2000 and since then it has grown at a CAGR of 40% pa. ICICI Life insurance has grown at a CAGR of 77% in the last five years and in the quarter ending June 30 2008, ICICI Life increased its market share from 12.7% to 13.8% while new business premium grew by 46% during the same quarter. India has low penetration of life insurance and we believe ICICI Life will continue to grow with the market.
d) ICICI General Insurance: India has one the lowest penetrations of Insurance amongst the Bric nations with premiums at 0.6% of the GDP; Brazil (1.6%), Russia (2.3%), China (1%) have higher insurance premium-to-GDP ratios and so the growth potential in the Indian market certainly exists. ICICI General Insurance’s gross premiums increased at a CAGR of 18% in the last four years. In the quarter ending June 30 2008, ICICI General Insurance increased its market share from 11.9% to 13.3%.
Overall, ICICI is well positioned to grow in an underserved market and has an excellent track record of above average performance in every business segment.
Valuaton: A DCF valuation of IBN yields a price of $51/ADR; at a current stock price of 29.35 it has an upside potential of 73%. DCF valuation is extremely sensitive to sustainable beta values and the reason I have used a sustainable beta of 1.65 is because it’s a large private sector bank and its volatility will fall in-line with the market as it continues to grow. Moreover, using a beta of 1.65 we get a sustainable cost of equity of 14% which is an appropriate discount rate for a large cap bank in a country with high inflation rates. The model uses a long term revenue growth rate of 4% and a conservative sustainable net profit margin of 19%; IBN’s TTM net profit margin is at 24%.
A scenario analysis with short term revenue growth and variable sustainable net margin shows that IBN’s current stock price reflects low short term revenue growth at 10% or a low sustainable net profit margin of 11%. A low sustainable net profit margin was a possibility if IBN had recorded massive structured finance losses; however, given the low probability of such losses, IBN is undervalued by 73%.
Crisis in the US Banking sector is certainly the largest influence on IBN’s stock decline but there are a couple of other issues that have contributed to IBN’s recent fall:
a) Inflation Control: The Indian government faces a general election in the first half of 2009 and historically inflation is a major issue during the elections; the government will use all the levers available to control inflation before the opposition can topple the government on this issue in 2009. In an attempt to control inflation, the reserve bank is reducing liquidity in the system and has increased CRR 7 times in the last 14 months. CRR (cash reserve ratio) is the percentage of bank deposits that a bank must have on hand as cash. Overall, a reduction in liquidity will negatively affect GDP growth. However, the government might soon run out of options on the liquidity front and we might be at the tail end of CRR increases.
b) Subsidiaries: IBN’s fast growing insurance subsidiaries continue to burn cash and negatively affect its bottom line. These losses are due to the special treatment of policy writing and one-time acquisition costs by Indian GAAP. In the life insurance business, most companies amortize one-time customer acquisition commission and policy writing costs over the term of the policy, however, Indian GAAP doesn’t allow amortization of these costs and so, as the insurance business grows it negatively affects IBN’s bottom line. In the long run, these policies do generate significant earnings and this is just a short term issue.
IBN’s stock has taken a beating due to the US banking crisis and some short term issues we discussed above; in the long run, IBN has a proven business model, a good franchise with a strong management team and high growth prospects.
Disclosure: At the time of write up, the analyst and his company had a long position in ICICI Bank.