In search of velocity

When Polali Jayarama Bhat secured a first rank in MSc (chemistry) from Mysore University in 1972, he never imagined that he would end up a career banker. But as fate would have it, after dabbling for three months as a lecturer in a government college, Bhat got a break in Karnataka Bank as a probationary officer in 1973. And it seems the chemistry has since worked well for the 62-year-old, who after spending close to four decades is today at the helm of the bank, overseeing assets around ₹66,000 crore. Incidentally, Karnataka Bank, which went public in 1995, has the unique distinction of being the only listed private sector bank from the South Kanara region — the rest have either been nationalised or merged. Interestingly, Karnataka Bank itself has a history of M&A, taking over three regional banks in the 1960s. Today, after 90 years of its existence, the bank boasts of 561 branches, a lending book over ₹27,000 crore and deposits of close to ₹39,000 crore. 

However, over the past decade or so while the bank’s net profit has grown at 8%, the absence of a dominant shareholder and its strong regional presence have occasionally kept rumour mills active about the bank either being merged or acquired. Can the bank then hold on to its independent legacy? The question is particularly pertinent given that for a whole host of conglomerates and non-banks eagerly waiting to grab new bank licences, strong regional players such as Karnataka Bank make for a suitable match. For Bhat, though, selling out is clearly not an option. “I have said in various forums that we are not a bank to be acquired. We are resisting anybody’s efforts to acquire our bank and it is not possible also as the shares are widely held,” says Bhat stoically, sitting out of the bank’s soberly decorated regional HQ in Mumbai.

But as it turns out, in the case of Karnataka Bank, things may be coming to a point where a potential merger may simply become inevitable. If and when that comes through, it will be a welcome change for investors who have got nothing out of the bank except stable dividends. Over the past 10 years, the bank’s share price has remained stagnant. While the bank has given an average dividend of 38% over the past 10 years, its current yield amounts to 4%. The past decade might have been miserable for investors but lets delve into why Karnataka Bank really matters.

Perfect match

Bereft of funding from the government which nationalised banks had access to, Karnataka Bank has largely been a regional bank. Of its 561 branches, 434 are in the south with 346 in Karnataka alone. Even with respect to future branch expansion, Bhat is clear that 50% out of the total branches proposed to be opened will be in Karnataka state to capitalise on its strong brand equity. The local nature of its business has ensured strong goodwill not only among borrowers but depositors as well. UR Bhat, founder, Dalton Capital Advisors and until recently, director on the board of the bank, says, “The bank competes with public sector banks such as Canara, Syndicate, Corporation, Vijaya and State Bank of Mysore. One would expect a private bank like them to pay a higher interest rate to garner deposits but their goodwill ensures they can do so — in quite a few maturity buckets — by paying the same or even lower interest rates.” Even more, 98% of Karnataka Bank’s funds come from retail deposits signifying almost zero reliance on wholesale deposits (See: Sticky money). That stickiness in deposits gives the bank enormous opportunity to monetise its liability (deposit) franchise, but there is a challenge, too, says Sweta Sheth, analyst, Stewart & Mackertich Wealth Management, “Bigger old generation private banks such as Karur Vysya and ING Vysya pose significant competition.” 

Changing gears

The management isn’t unaware of the challenges. That’s why the bank embarked on re-engineering its business processes to accelerate growth. Along with targeting aggressive growth in low-cost deposits or CASA (current account saving accounts), it is also relying on its wide network of ATMs to act as a profit centre. Every November to February, it runs an increase CASA campaign. Last year it added 500,000 new accounts and has garnered another 400,000 this year. Bhat says, “Our aim is to increase CASA from 24.7% to 26% by end-FY14 and achieve around 30-35% over the next five years.” 

The management is also banking on increasing debit card penetration to cut costs. Currently, its debit card penetration is 40% and an ATM uptime of 99.5% not only ensures high footfalls from its customers but a sizeable number of acquired transactions as well. Bhat understands branch transactions are costly. It works to about ₹40-45 per transaction compared with ₹15 for an ATM transaction, he acknowledges. “We are opening many off-site ATMs so the services of our staff can also be deployed for other productive business,” he adds. From the current 612 ATMs, Bhat wants to take the number to 700 by March 2014. 

Led by this aggressive retail push, the bank is aiming to increase its mix of retail assets from the current 51% to 60%. Sheth expects this to boost the bank’s return ratios, which have seen a downward trend, of late. RoE has fallen from 13.67% in the quarter ended December 2012 to 10.36% in the latest quarter ending December 2013 and RoA has dipped from 0.97% to 0.71% over the same period. “Many bankers are very cautious in the current environment. They prefer maintaining asset quality rather than aggressively growing the loan book. If the book doesn’t grow and the profits are eaten away by provisioning, RoE and RoA are definitely going to be hit,” mentions Sheth.

The question is can the bank really lend profitably in an environment where other banks are playing it safe? Nishid Shah, president, Ambika Fincap and a long-time investor in Karnataka Bank thinks so. “HDFC Bank and Axis Bank have been growing around 27-30% year-on-year. So there is no reason why Karnataka Bank can’t to do it. Their total size is ₹66,000 crore, advances and deposits put together and in three years they should cross ₹120,000 crore.” That might come through but for now there is a more pressing problem at hand, that of deteriorating asset quality. 

Book problem

Currently, the bank has gross NPAs of 3.65% and net NPA of 2.23%. “We want gross NPAs below 3% and net NPAs below 2%. Once we achieve that, provision will get released which will increase the net profit,” points out Bhat. That could work out in a best-case scenario and if it does not, the bank simply can’t wish away its bad loans. And for a bank of its size, its net non-performing loans form a sizeable part of its tier-1 capital of ₹2,819 crore (see: Worry wart). 

While the bank has been meeting its operating profit projections, provisions and contingencies have eaten into FY14 profits. Even for the final quarter of FY14, the management has guided that restructured loans will be to the tune of ₹200 crore. While Bhat mentioned in the investor conference call that net restructured loans in the last quarter could be around ₹100 crore owing to recovery in some previous bad loans, investors are clearly taking a wait and watch approach. “At the beginning of FY14, management had a gross NPA target of 2.5% and net NPA of below 1%. Seeing the current situation I doubt if they would be able to reach that target,” opines Sheth.

No wonder, the bank continues to trade at a discount. For FY14, the book value will be closer to ₹172, while the stock currently trades at ₹95. The management itself has made some cardinal mistakes in the past that has eroded value. Historically, the bank has raised capital through rights issues below book value. Shah adds that people who argue that right shares at a discount is not dilutive as it is given to all the shareholders miss a major point that all the shareholders may not have cash to subscribe to the rights shares. “A good bank will try and ensure that equity dilution enhances the book value by issuing shares at a premium; at HDFC, Axis and ICICI — almost all equity dilution has enhanced book value. In case of Karnataka Bank, it has been book value dilutive.”   

Nudge to merge

The time of reckoning may be near. Existing investors are an unhappy lot, the NPA problem persists despite management efforts to rein in non-performing loans, and the prevailing economic environment as well as the competitive landscape is only leading to a situation where the bank will find it extremely difficult to raise capital. 

While the going may get tough for Karnataka Bank, it may turn out to be a plum picking for a potential suitor. It’s not just its strong regional presence and sticky deposits that make it a perfect match for someone wanting to grow their presence in the south — the bank also has substantial monetisable assets — it owns most of its regional office premises, it also has many company flats for its officers in Bengaluru and Mumbai. In India’s financial capital alone, it has more than 100 flats. 

The real question is will the management relent. It seems unlikely, for now. “Our bank will continue to be run by a professional board as it has been for many years now,” mentions Bhat, further adding that it will be difficult for anyone to acquire control “because of a large number of shareholders holding less than 1,000 shares.” He mentions that foreign investors are holding their stakes for investment purpose and are interested in seeing the market price move closer to or cross the book value.

For a bank that has seen its share price languish below book value for many years, that cross-over could materialise with an ownership change. Institutional investors, who are holding a 25% stake, may really not care what triggers that change. Usually, they are quick to tender shares when they see quick money on the table. Although it’s not a big deal for a deep-pocketed acquirer to line-up about ₹1,000 crore — that’s the theoretical price tag for a 50% stake at the current market price — a potential suitor may simply not take that route. Often, a hostile bid triggers a run in the stock price that ends up hurting the buyer. More importantly, an outright buyout also comes with the additional complication of an eventual reduction in the promoter’s stake to less than 10% in line with the central bank diktat. UR Bhat feels if the potential acquirer is a bank or a NBFC controlled by a promoter it is very unlikely that RBI will allow it to happen as it is against its avowed objective. “However, if the potential acquirer is a widely held company or bank with no identifiable promoter, it is possible that the RBI may consider. Then, there also has to be enough willingness on the part of the Karnataka Bank management and shareholders to go ahead.”

Whichever way, with a less than 1 % stake that the management commands, and the little goodwill that the bank may have with its investors for its diligent dividend pay-outs, the management may hardly wield the power to resist a potential merger if the situation arises. Currently, the stock trades at ₹95, down 63% from its all-time high of ₹259 reached in the January 2008 frenzy. A new buyer could well help unlock the value embedded in the bank. But, what if this really does not work out? 

It’s quite possible that the bank’s efforts to grow organically and reduce bad assets may yield results, but that is not the only thing you can count on as an investor. The trigger to buy the stock is the fact that the stock trades even at a discount to adjusted book value — with a very good chance of a friendly merger unlocking value — and has a minimal downside even if status-quo is maintained.