Mushtaq Ahmad had never seen such devastation in his entire life. The recent flash floods in Jammu & Kashmir that swept through 20 of the 22 districts in the state have wiped out over 5,700 villages and uprooted over 15 lakh families, besides destroying hundreds of livelihoods and business establishments. Ahmad has not lost anything personal, but as the chairman and CEO of the state’s biggest lender, J&K Bank, the pain is official.
The reason: the 75-year-old bank, in which the state government holds a 53% stake, has 45% of its commercial advances tied to establishments in the state. Besides, two of its big corporate clients — REI Agro and HDIL — have turned out to be NPAs, a big reason why the stock fell out of favour with the Street since the development was leaked by a local newspaper last May. The market’s fears have not been unfounded, as the gross NPA has increased from 1.7% as of FY14 to 4.2% as of June 2015.
Thanks to all this stress, profits declined 58% to ₹130 crore in the first quarter of the current fiscal. In a triple whammy, rating agency Crisil downgraded the bank’s fixed deposits from ‘AA+/stable’ to ‘AA/negative’ in the wake of the stress in the asset quality and its fallout on the bank’s profitability.
The bank enjoys high employee productivity compared with its peers
Since the adverse turn of events that began early last year, the stock has fallen 34% to ₹137 as on November 10. But these adverse developments have led deal-hungry investors to pile on to the stock, which is now trading at 1X its book value and 6X its current year estimated earnings. In fact, if one invests at the current market price, the dividend yield alone works out to 3.5%. Not surprising, then, that contrarian value investors fancy the stock. Apart from several renowned mutual funds, Parag Parikh’s Long-Term Value Fund among them, well-known US-based value investor Mohnish Pabrai holds a 2.56% stake, valued at ₹174 crore, through Pabrai Investment Fund. Pabrai’s stake was noticed for the first time in the September 2014 quarter, during which the stock traded in the range of ₹141 to ₹147 per share. If market sources are to be believed, even reticent investors such as Fortuna Capital partner Sanjoy Bhattacharyya have bought the stock.
According to Bhattacharyya, the odds are in favour of investors given the attractive valuation. He believes that despite the uncertainty, the bank has managed to expand its dominant market share and improve interest margins. That apart, he admires its low-cost operating model, which has a 20% growth in business volumes without compromising capital adequacy or taking on excess leverage.
Operating in Jammu & Kashmir since 1939, J&K Bank has grown its revenue and profits at an annual rate of 16% and 26%, respectively, over the last decade. Along with its long operating history and capable management, operationally, too, the bank is attractive. It has strong operating margins (a net interest margin of 3.8%), return on equity of 22%, huge operating cash flows and minimal capex. Despite the stress in the balance sheet, it has strong NPA coverage ratio (87% in FY14) and a well-capitalised balance sheet (capital adequacy ratio of 12.7% in FY14), with a net worth of close to ₹6,000 crore.
Despite the presence of reputed investors, the Street’s concerns revolve around the bank’s list of NPAs thanks to big defaulters such as REI Agro, Bhushan Steel and HDIL. The bank has already declared slippages of close to ₹1,100 crore in Q1FY15 in two accounts — REI Agro and HDIL. Though this gives cause for worry, the bank is well-placed in terms of risk to its books as these three accounts — with a total exposure of about ₹1,500-1,600 crore — only account for about 3.5% of its total loan book of ₹46,000 crore and about 25-27% of its net worth.
That apart, these risks have already been identified and provided for in the past quarter, so apart from any slippages from Bhushan Steel — so far considered a standard asset (normal because of payments) by the bank — the incremental pain should be very less. In fact, the bank has got more than its share of leeway in subsequent months: the HDIL account has since turned standard (earlier considered to be an NPA because of operational issues) and the ₹45 crore-65 crore provision made by the bank in the previous quarter is set to be written back. Similarly, the REI Agro account, which was earlier considered to be an NPA, has been restructured in recent months, bringing some relief for the bank in terms of provisioning.
Apart from these three clients, a larger worry for the bank seems to stem from the possible impact of the recent floods in Jammu & Kashmir on its loan book, especially in the agriculture, SME and trade segments. Though this could certainly have huge implications for the bank, numbers suggest a silver lining here as well. For instance, as of Q1FY15, the bank’s loan book stood at ₹46,000 crore, out of which only 45% — or about ₹20,700 crore — is in Jammu & Kashmir.
However, as only 75% of the area under the state has been affected by the floods, theoretically, only 75% of J&K Bank’s ₹15,500-crore book could stand to be at risk. If one further assesses the damages based only on the most impacted segments such as agriculture, trade and SME, which together account for 47% of its loan book, risky loans could be in the region of about ₹7,000-8,000 crore, which is about 15-17% of its total loans and about 1-1.3X its net worth. This number is still big enough to wipe out the bank’s net worth but only if all of its borrowers fail to pay up.
Still, no one expects all of the bank’s loans to turn into NPAs, as any default will also impact the creditworthiness and borrowing ability of the borrowers in the future. Analysts expect any sort of stress due to slippages, willful defaulters and the inability of certain borrowers to pay to also be felt gradually, giving the bank enough time and an opportunity to deal with the same. “Though we believe that there will be some regulatory easing when it comes to these loans, providing J&K Bank incentives in terms of priority sector requirements, target requirements and NPA recognition, its balance sheet will no doubt be impacted for the next two quarters,” says Pritesh Bumb of Prabhudas Lilladher.
This is also the reason why the market does not expect a major increase in NPAs right away. “Though it is hard to predict the actual impact, our internal calculations suggest that because of these issues and the recent floods, we could see J&K’s NPAs going up by another 2-3%,” says Vallabh Kulkarni, who tracks the bank at Motilal Oswal Securities. With historical NPAs at about 2%, J&K Bank is considered as one of the most efficient banks around. In the current environment, however, it might have to bear additional NPAs, which could result in its NPA ratio going up to 4-5% of its loan book.
Even in such extreme circumstances, the possibility of the bank making losses and reporting an erosion of its net worth is remote. In FY14, the bank made profits before NPA provisions of ₹1,900 crore, 15X higher than its provisioning for NPAs, indicating that the bank has more than enough cushioning. Even if the Street’s predictions of NPA provisioning going up to ₹400 crore-450 crore in FY15 — as against ₹127 crore in FY14 — come true, analysts remain optimistic as they estimate a profit of close to ₹1,100 crore for the bank in FY15.
Though the bank has the ability and financial strength to deal with the recent spate of negative developments, the impact of these events can only be managed, controlled and minimised. Some part of the stress will certainly show up on the bank’s books and spill over to the next three-four quarters. “We met J&K Bank chairman and CEO Mushtaq Ahmad recently to understand the bank’s outlook on business growth, profitability and asset quality. We think that growth could be moderate in the wake of recent floods in Jammu & Kashmir and other asset quality issues. While slippages in the agri and horticulture books might rise in the near term, damage to the commercial book is likely to be limited. We expect return ratios to be under pressure in the near term but at 1X FY16 estimated book value, valuations largely factor in the negatives,” says Kulkarni of Motilal Oswal Securities.
What's on the books
Personal and corporate loans form a chunk of J&K Bank's advances
So, what could really go wrong at the bank and how far can these events impact its financials? First of all, because of higher NPAs, provisioning for the same will go up and profits will be affected.
That apart, the Street is expecting the bank’s cost of funds to jump and margins to shrink because of the pressure on yields as a result of restructuring and slippages in some of its accounts. This combined knockout punch of lower margins and higher provisioning could together impact the bank’s profits.
Though the bank might show a marginal 5-7% decline in profits in FY15 as compared with the ₹1,182 crore it made in FY14, lower profits will mean the bank will generate lower return on equity, which is estimated to fall from 22.3% in FY14 to 17-18% by the end of FY15. However, even under these conditions, book value will keep growing — albeit at a slow pace — to the extent of retained earnings, which will help in protecting its stock price.
Moreover, the bank is currently exploring the idea of selling its 5% stake in MetLife Insurance; it had last jettisoned 5 crore shares in the company, amounting to a 6.26% stake, at Rs 36.5 per share for a neat ₹182.5 crore.
“We have already decided that we will exit MetLife, in which we hold a 5% stake; most of the formalities have been completed in this regard. I think that should fetch us a very good return and I’m sure we will end the year with an unusual growth in profits and the overall business. When you judge the performance of a bank, you need to focus on medium to long-term results instead of getting disappointed with the results of just one quarter,” Ahmad said while addressing an analyst call in August this year. This time around, the bank is expecting a better valuation for its stake in MetLife all thanks to an improvement in the profitability of the venture and positive policy developments such as the hike in the FDI limit in insurance.
Though word on the street is that the bank may net ₹700 crore for its stake, even if the realised amount is less than that, that gives the bank significant leeway in terms of good coverage for future slippages in its loan accounts. That apart, when the recovery takes place, people and businesses will both need money, this time to recoup their losses, which can be nothing but good news for banks like J&K that will gain business and an improvement in profitability. The bank, too, is confident of returning to its past glory once some of the issues highlighted in the past are resolved.
“I am sure once these two accounts (REI and HDIL) are addressed and issues rectified, our NPA levels will again be around 2%. We have witnessed a credit growth of 24-25% in Jammu & Kashmir and I am very confident that we will maintain this figure in the state and keep credit growth going at 15% even outside the state, funding top-rate government of India undertakings and fundamentally sound business houses,” added Ahmad.
Though NPAs have seen a sharp rise, the bank has a high coverage ratio
For now, the bank continues to maintain its focus on its high-growth home state, keeping a tab on the kind and quality of clients it currently services. Though its long-term prospects have not been hurt yet, near-term headwinds have had sufficient implications on the bank’s finances.
Though the markets have already factored in a large element of this risk, incremental news flows could have some bearing on share prices as the bank announces its results. Consequently, J&K Bank could see its quality of earnings deteriorating for some time along with its falling return ratios.
Yet, when compared with regional players such as South Indian Bank (trading at 9X its earnings) and PSUs such as State Bank of India (trading at 14X its earnings), J&K Bank is relatively cheaper, being available for investors at 5X its earnings. In terms of price-to-book value as well, J&K Bank is trading at a 30% discount compared with South Indian Bank and SBI.
Perhaps now is a good time for investors to see merit in the logic of value investors and back the stock of the beleaguered bank.