Vikas Khemani

One of the frameworks which has served me well over the years in generating extraordinary returns is to identify companies where one can capture a high-growth phase and re-rating in valuation. There can be many circumstances which lead to this kind of occurrence. The primary condition is that it should be a good business but should also have a catalyst that can propel the business into a new growth phase. The catalysts could be owing to several reasons, including a change in management or change in the industry structure.

When a good business pivots into a new growth orbit, magic happens. A stock, typically, gets into its golden period and, in my experience, this phase, typically, lasts anywhere between three and ten years, depending on the company and the sector. Britannia, Aarti Industries are some stocks which have experienced such a phase.

I would like dwell on one such stock which, I think, is pivoting to a new orbit and, that is, ICICI Bank.

Weathering The Storm

ICICI Bank is one of the leading private sector banks with a huge customer franchisee and brand equity. It has a balanced business mix of retail as well as corporate franchise. However, it has been going through a difficult phase over the past decade, delivering 6% growth in PAT, while the stock clocked 3% CAGR return since 2008. During this phase, the bank was caught in a bad asset quality cycle partly because of the environment and partly owing to its own internal issues. The bank spent most its energy repairing rather than building. Despite the challenges, its customer franchisee didn’t fritter away and remained strong, not just at the bank but also at its subsidiaries.

The bank’s CASA ratio at 49.3% as of December 2018 is one of the best in the industry and retail credit growth has been reasonably robust, two very strong indicators of a robust customer franchise. All its subsidiaries witnessed robust growth and maintained leadership across the financial services spectrum — life insurance, general insurance, asset management and capital markets. Since fiscal 2016, the bank has unlocked more than Rs.140 billion of capital in its subsidiaries, demonstrating the value created in these businesses. Also, the aggregate market capitalisation of the three listed subsidiaries is now about Rs.1 trillion. On the corporate credit front, the damage of asset quality cycle is mostly behind it, both owing to adequate provisioning and a change in economic sentiment.

Today, with a supportive macro environment, a new management and a change in the asset quality cycle, I feel the bank stands at the cusp of growth and a consequent re-rating. The bank’s capital position continues to be very strong with Tier-I adequacy at 15.92%, and total adequacy at 18.42%, as of March 31, 2018, well above the regulatory requirement.

India’s macro for private sector banks remains robust than ever before, especially for a large incumbent player. There is growth in savings, increasing formalisation of the economy and the rapid digitisation across the economy. Along with this, the growing entrepreneurial zeal and aspirations of Indians are driving demand as well as innovation in the market for financial services. 

State-owned banks are continuing to lose market share to private banks. Besides, the cost of building a new bank and brand gives significant advantage to large incumbent banks, while the changes in the NBFC space is reducing competitive intensity. Not to mention the robust growth in savings and credit demand creating a huge tailwind.

Better Times

The new leadership has consistently worked towards getting the bank into a growth mode with huge focus on core operating profitability and better risk management practices. As part of a major transformation process, the bank is planning to move away from hierarchy-based designations to role-based designations, while business verticals have been given profit targets instead of the traditional growth-based targets, which will also reflect in the performance appraisal system. Early signs of that are already visible in core operating profit rising 17% YoY in Q3FY19 to Rs.56.67 billion. The new management approach seems to be conservative on risk but moderately aggressive on growth.

The asset quality cycle, which has been major drag on the bank, is behind with net NPA declining to 2.58% — the lowest in the past 12 quarters. If growth returns without any incremental slippage, then this ratio will keep going down, thus, making the bank more robust. The bank’s corporate stress pool-watchlist now stands reduced to Rs.188 billion (3.1% of the loan book). As per management commentary, 32% of the bank’s power exposure (8.2% of loans) has already been recognised as stressed, while of the residual 68%, 55% is private sector loans, the bulk of which is rated A- and above. The bank has improved the proportion of highly-rated corporates in its portfolio — reducing the concentration with incremental lending under a revised risk framework, and lowered exposure to key sectors under stress. Besides, the implementation of the Insolvency and Bankruptcy Code is making banks more empowered and is a very big step to guard against a repeat of such asset quality cycle in future. Resolution of many cases will be the icing on the cake.

The risk-reward of that is beginning to fall in place and, as a result, most banks are beginning to look to grow their corporate credit portfolios. This is important as with credit growth, asset quality improves as well. Retail is also going strong. The bank’s retail business grew by 22% YoY in Q3FY19, with its share now at 59% of loans. It is expected go past 60%, thus leading to better margins. 

Importantly, in the near-term, there is the possibility of a huge return on equity (RoE) kicker. As the RoE heads towards the 17-18% range over the next two-three years, the stock can not only deliver 18-20% earnings growth, but will also be ripe for a re-rating. At its current price of Rs.392, the valuation is quite reasonable at 1.5x estimated FY20 price to book (core).

For ICICI Bank to get these return ratios, it doesn’t have to get too many things right, and as the valuation is very reasonable, I believe the stock offers a significant upside with a favourable risk-reward ratio. As an investor, you won’t lose much if the hypothesis goes wrong but stand to make 2-3x return if the hypothesis indeed plays out.

The author has a position in the stock