Axis Bank Ltd. (ABL)Qualitative aspects:

Positives One of the largest three private sector banks (HDFC, ICICI are other two); Strong leadership team; Pan-India Franchise - Technology Driven Product Bouquet; Stable Funding Profile Strong Deposit Franchise; Operating Costs Range-Bound (last four years); Good asset quality management through cycles good underwriting and risk management; Strong Earnings Diversity Robust Fee Franchise.

Concerns - Higher risk appetite as seen from concentrations at Assets (Pl refer to slide No 20 in company ppt Q1, FY13) and potential shift to SME and car loans; Precedence to growth over liability structure in the past.

Quantitative aspect:

Positives - Robust Earnings backed by Strong Income Diversity First Line of Defense; Good Funding Profile and above-average capital cover Second Line of Defense; High NIMs, High fee based revenues.

Concerns Ability to raise capital to sustain growth and comply with BASEL III requirements; Ability to refinance debt.

Detailed Description

Background: The bank was incorporated in 1994 as UTI Bank Limited. The bank underwent rebranding in 2008 and is now Axis Bank Ltd. Although, ABL was promoted by government owned institutions, it has fostered the efficiencies of a private bank.

Liability configuration:

Current Tier-1 capital of the bank is 9.45% and demands capital raising to sustain the growth momentum. Bank had last raised capital in 2QFY2010 when its tier-I CAR was 9.4%. Probably, second round of equity funding would be required to comply with Basel III norms within next few years.Bank has high proportion of (around 40%) stable current and savings account (CASA) deposits. Creation of strong liability franchise through expansion of branch network (as shown in the picture below) is a conscious strategy bank has adopted over last several years.

Deposits, as of now, stand at around Rs. 2,00,000 Cr. Given the total deposits of banking sector around Rs. 60,00,000 Cr., Axis Bank accounts for around 3% of total banking deposits in the country.

In context of CASA, following points must be kept in mind:

1. Banks are offering products like Auto-sip to term deposits from saving account beyond a specific balance with facility to anytime withdrawal (one savings and term deposit account).2. I would imagine banks to slowly move to one account concept of a customer (both assets and liabilities). Banks would be drawn by competitive forces to this concept even though it is detrimental to the overall P/L of the banks.3. Freeing of interest rate on Savings Account by RBI and corresponding high rate offering by some banks like Yes bank etc.4. CASA, traditionally, has been chased by every banker as a cheap source of funding. Competition becoming too tough there. 5. Awareness among customers on opportunity cost of funds lying in their Current and Savings Bank account driving them to allocate cash to better earning avenues.6. Banks may start offering interest even on Current Accounts to attract the liabilities (at present, there is no interest at all, though).

Based on above points, think, CASA would diminish as value differentiator for banks over a period of time and banks would need to explore other stable fee based revenues (distribution of financial products, services like cash and trade, charges for other services they offer to the customers etc.) to sustain profit margins, Return on Assets and growth.

Asset configuration:

Existing breakup of loan book is as follows:

Focus of Bank is to grow retail and SME franchise. Management intends to increase the retail portfolio from the current 22.1% (19.5% in FY11) to ~30% over the next 3 to 4 years; the SME book is targeted to reach 18-20% from current 14.0%. Further, at present, the retail book is dominated by home loan products (~75% of the retail book), followed by auto loan (13.0%). The management intends to grow the share of auto loans with incremental focus on New CV Financing. Share of home loan to decline to 6065% going ahead. Home loans, while earn less, are much less venerable to any systemic shocks. Similarly, SME means higher risk. This change in the product and segment focus with increasing balance sheet means higher risk bank is intending to take though with higher profitability (low ticket and high margin business. Cost of generating the business also goes up quite substantially). Would bank be able to price its products in a very competitive environment (competition not only with banks but other NBFCs as well) to compensate itself for the risk, it is taking. Credit cost to go up significantly.

ABLs exposure to vulnerable industry segments (commercial real estate, textiles, power and gems & jewellery) remains slightly higher as seen from the following table (taken from ppt of the Bank itself):

About ~10% of the bank total loan book (incl non-fund base) is exposed to the power Sector. Management says that a majority of it is towards private sector companies. About ~30% of the exposure is to operational projects and rest is to under-construction projects, of which 25-30% projects are likely to be commissioned in FY13, 50% in 2014, and remaining in 2015. The management expects restructuring may happen in FY14 if the fuel linkage issue is not sorted out. How much would be non-funds based support/commitments to corporates please. It means around 17,000 Cr. of say 1,70,000 Cr. loan book (funded assets) is towards power. Of which, around 70% viz around 12,000 Cr. is towards under-construction projects. Assuming 25-50% of it goes for toss, it could be quite a lot for the bank to hold/address on its equity.

GNPA and NNPA improved from 1.21%/ 0.63% in FY07 to 0.94%/ 0.25% respectively in Mar. 2012. However, Asset quality suffered during the last quarter (June 2012) with GNPA (1.06% vs. 0.94% in FY12) increasing 15.8% QoQ and NNPA (0.31% vs. 0.25%) increases 28.0% QoQ.

On Mar., 2012, PCR stood at 81%. Rise in delinquencies (61.2% CAGR FY07-12) was nullified by strong recoveries and up gradation (CAGR 66.3% CAGR). In June 2012, Coverage ratio stood at 79% vs. ~81% in FY12. Fresh slippages for the quarter stood at Rs 4.56bn, but recoveries/ up-gradation were on lower side at mere Rs 620mn.

The bank restructured assets Rs 6.28bn during the quarter (June 2012), taking the total restructured book to ~Rs 38.3bn (2.2% of o/s advances vs. 1.8% in FY12) of which Rs ~8.2bn (~21% of restructured asset) cumulatively has slipped into NPA. Are there some provisions made for the restructured assets please. Any thought/experience/study on performance of restructured assets in the past.

At the start of FY12, the management had budgeted credit cost of 7075 bps and ended with 55 bps NPA provision. The management has budgeted higher credit cost of 85 bps for FY13. The average for past five years stands at 91 bps. Are provisions made by the bank are enough to absorb the potential losses given the change in focus to SME segment and Auto loan product and exposure of venerable sectors like commercial real estate, textiles, power and gems & jewellery in Balance Sheet.

Credit growth to be around 20%.

Income configuration:

NIM is around 3% on consistent basis. Conscious move to reduce the bulk deposits and beef up CASA through expanding branch network has strengthened the deposit franchise and improved NIM over a period of time.

Breakup of non-interest income of bank is as follows:

Growth in retail banking and corporate debt syndication fee income has remained robust for Axis and its total fee income/total operating income is consistently around 30%.

The banks fee income (~75% of the total non-interest income) grew at a brisk pace (44% CAGR FY07-11). Despite the slowdown in project financing, fee income grew 29.3% in FY12. A large chunk (36.1% in FY12) of fee income comes from corporate fees followed by fee income from the retail book.

Bank is expanding non-interest bearing income franchise brokers business, treasury income, financial products distribution network etc. Do you think banking is focusing on non funds based fee focused franchise. If yes, what are the focus areas of bank here.

Strong liability franchise (reflected in strong NIMs) and fee income support ABLs return on asset. High ROA creates greater tolerance for the absorption of higher credit costs under stressed conditions.

Ownership issue:

One problem with Axis Bank seems to be its split ownership between - LIC, GIC, New India Assurance, Oriental Insurance, United Insurance, & Specified Undertaking of UTI (SUUTI). In past, Government had to intervene when most of the partners protested LICs bid to take over the stake of SUUTI. Are owners moving in cohesive manner for best interest of the bank. Is the leadership of Ms. Shikha able to drive all of them in a focused manner towards common goal of growth.

Further, FIIs hold around 27% of the bank. Their purchase and sale decisions may trigger significant upside/downside in the stock.

International Presence

Branches at Singapore, Hong Kong, DIFC - Dubai and Colombo Representative offices at Shanghai, Dubai and Abu Dhabi Axis U.K. Ltd. incorporated as a subsidiary Total assets overseas amounted to US$ 6.15 billion as compared to US$ 4.85 billion as at and June11, a growth of 27% YOY. Overseas assets constituted 12% of total assets as at end June 2012.

Corporate Banking, Trade Finance products, Debt Syndication and Liability businesses

Acquisition:

Axis Bank entered a deal in November 2010 to buy the investment banking and equities units of Enam Securities for $456 million. Axis Securities, the equities arm of Axis Bank, will merge with the investment banking business of Enam Securities. As per the deal, Enam will demerge its investment banking, institutional equities, retail equities and distribution of financial products, and non-banking finance businesses and merge them with Axis Securities. How do we see the impact of this acquisition on financials over next 5 yrs.

Financial snapshot (from angel broking):

Competition:

HDFC Bks performance consistently superior to that of peers Progress achieved under ICICIs consolidation efforts is noticeable both for assets and liabilities Axiss move to improve funding profile while balancing growth is positive

Funding profiles of these three banks along with the important risks on the assets are captured in two slides below (data source Fitch report on private sector banks):

Valuation:

Few minutes to the table below are quite insightful (taken from money control on Aug. 9, 2012):

NameLast PriceMarket Cap.(Rs. cr.)Net InterestIncomeNet ProfitTotal Assets

HDFC Bank604.35142,482.1327,286.355,167.07337,909.49

ICICI Bank956.90110,332.7533,542.656,465.26473,647.09

Axis Bank1,087.9545,081.1721,994.654,242.21285,627.79

While Axis is catching up with HDFC on Net Interest Income, Net profit and Total Assets, there is a sizable difference between the market cap of both the banks. Market Cap of Axis bank is ~31% of that of HDFC. Question to mind is what do we attribute this to

May be 20% over this 31% may be attributed to the size of HDFC business being bigger.May be next 20% over this 51% may be attributed to the quality of assets, earnings and better brand of HDFC over Axis

But, what about remaining 30% difference (we know above stated 20% for two cases are also theoretical but, logical).. It may mean that market is either overpricing HDFC or underpricing Axis. This needs a bit more work and discussion with market participants (analysts, bankers and credit rating guys) to ascertain what may be correct.and, needless to say that will be only our understanding of the pricing. ParametersAxisHDFCICICI

MARKET CAP (RS CR)44,929.93142,411.41110,177.09

*P/E10.0925.8915.86

*P/C9.3723.5714.74

*PRICE/BOOK1.974.761.82

Can we dive deep in what the Axis Valuation parameters vis a vis that of HDFC communicating to us. Either there is something more about Axis that we dont know or market is pricing it wrong.

Do we think, Axis is trying to mimic HDFC and can acquire the quality, profile and brand name similar to that of HDFC over a period of time. At least, market valuations dont seem to believe that.

Where do we see business 5 yrs down the line and Valuation:

Next 5 yrs thought would be as follows:

Bank will continue growing (on higher base) say @ 15-20%. Would need capital soon. Hopefully, bank will be able to raise capital close to the current market price and so exercise would be marginally book value additive to the existing shareholders. However, immediate effect on the earnings would be negative. There is structural change in liability proposition of Axis (focus on casa through branch expansion) but bank has to build strong fee revenues from multiple channels to sustain ROCE (ROA) and ROE. There is structural change in Asset proposition more SME and retail focused (small ticket but less sensitive to rates, more sticky business etc.). This would also mean more risk on the assets. Kind of stress banks faces on its existing asset portfolio is another thing which would determine valuations of the bank going forward. We know this is a dark horse and we would not be able to do any work here with significant confidence level.

Now, it means:

On Asset base of Rs. 2,00,000 Cr., 20% growth would mean expansion of B/S by around 40,000 Cr. each year.With profit base of Rs. 4,000 Cr. and Div. payout of ~20%, bank will add ~3000 Cr. to equity in B/S. With this addition, it would have say capacity to add deposits of ~Rs. 27000 (9 times). Mean, additional liability of Rs. 30,000 Cr.There is clearly a gap between credit growth and liability growth and would demand equity infusion to sustain credit growth nos.

If our required rate of capital is around 15% and business is also going to grow with around 15-18%, we are purely banking on P/E and P/BV expansion for us to make money here. In addition, we have with potential credit risk on assets of the bank (always a dark horse), which with the high leverage of banking, can be very detrimental to our positions.

Would think that P/E of around 7-8 and P/BV of close to 1.25-1.5 would provide us with required margin of safety in this business, given the existing quality/quantity. It would demand around 20% - 25% fall in the price of the business. We may track it and when prices go to that kind of level, we should quickly get to drawing board to decide on this.

Important points from the call with Mangesh the other day on Axis are:1. Would need to raise capital at least 2 times in next 3-4 yrs.1. Going forward, Asset profile would change to higher risk and higher margin.1. Questions on the assets are Quantity and quality of unfunded exposure (it is around 25% of total exposure as per Fitch ppt); Stress on funded exposure specially in power, infrastructure, jewellery etc.1. At present, Axis is in phase of integration with Enam. IB, Broking, Asset Mgmt business of the Enam would add to the fee based income of Axis.1. Axis is trying to follow HDFC Bank footprints.

Here are notes from call with Saswata of Fitch Ratings on Axis Bank on Sep. 4th, 20121. Given the track record of the bank, bank would be able to raise capital. However, given the requirement for the entire banking sector in the context of Basel III, banks would have to plan well. Otherwise, there would be too much competition for capital between 2016-18.1. Axis traditionally has been running tight on equity capital level and that is also reflected in higher ROEs of the bank.1. Funding structure (CASA) would continue to be key aspect in the banking lower the cost of funding and higher pricing power. 1. Major source of fee based income of private sector banks is off balance sheet items Bank Guarantees, Performance guarantees, LCs, Derivatives etc. While fee based income is critical for the banks, what kind of capital would be demanded in context of Basel III for these off Balance Sheet items is yet to be seen going forward. Sense is that as all these transactions would demand capital allocation and corresponding returns, funding aspects of banks would become more important in that scenario (CASA based franchise).1. Bank has been talking about increasing SME and Retail assets for quite long time. But, risk aversion/conservatism is there in the bank at each level.1. Bank has been aggressive on debt fund raising side. In pursuit of building relationships, it probably is taking exposures on B/S. and then selling down large part of it with some kind of performance guarantee. Large part of unfunded commitment to corporate assets is coming from this side of business.1. Marking of NPAs is being done as per regulatory guidelines. So, there is comfort on that side.1. Restructuring exercises, more so in the public sector banks, has been at quite high level and is clearly uncomforting. Even RBI has been raising voice on the subject again and again. There are no standardized disclosures on the subject. However, around 85% of the restructured assets in 2008 did bounce back. We have to also make a distinction between cyclical assets/businesses and permanent damage of assets, while looking at restructured assets. Public sector Banks have shown lesser prudence on the subject but private sector banks are quite vigilant and prudent in their approach..1. If an asset comes to restructuring for the second time, it is automatically treated as NPA.1. In the entire banking system, NPAs are around 2.9% and Restructured assets are around 3-3.5%. it means around 6% of the assets are under stress. Fitch estimates that this level could go to around 10% by 2013.1. For Axis bank, these nos. are NPAs around 1% and Restructured assets around 2%.1. Private Banks would see a lot more lesser stress on assets if there is systematic down side in the entire economy.1. Private Sector banks do have higher risk appetite but, they also have stronger risk management systems.