Citi Group : Hold Axis Bank (formerly known as UTI Bank)

(BSE: 532215 | NSE: UTIBANK | ISIN: INE238A01026)

Company description :Axis Bank is India ‘s third-largest private-sector bank after the significantly larger ICICI Bank and HDFC Bank. It is more than twice the size of the next largest private-sector bank. The top three private-sector banks collectively account for almost 9.6% market share, while private-sector banks as a group are about 18.6% of the system. Axis Bank is a small player in the broader banking sector; its market share is less than 2% in terms of loans and deposits. Axis Bank was started by the erstwhile Unit Trust of India (UTI) in 1994, along with LIC and GIC, two government-owned insurance companies. UTI’s stake is now held by UTI-I, a government-owned entity, with a 28% holding. LIC and GIC together own 16.3%, and collectively, these government-owned shareholders own approximately 44% of the bank.

Investment thesis :Axis Bank is one of the few clean (in terms of asset book), rapidly growing,profitable, and competitive private-sector banks in India ; thus we think it will be a major beneficiary of the favorable banking environment. The Indian banking sector is in a sweet spot: consumer and corporate lending is strong, asset quality is improving and fee-income opportunities are growing. We expect this favorable environment to continue in the medium term but recognize that a key challenge for banks will be funding growth. Looking at its profile, we believe Axis Bank stands to gain disproportionately from existing opportunities in the sector. The bank has strong technology and products, an expanding distribution franchise, adequate scale, a strong service culture, and management enterprise – features that should help it stay ahead of the dominant government banks to win market share.

Raising target price to Rs675 — UTI Bank has now formally changed its name to Axis Bank. We also make changes, raising our target price to Rs675 (Rs560), on the back of a) new capital and rolling forward valuation benchmark valuations to FY09 (FY08); b) revised earnings (up 5%-2% FY08E-FY09E); c) relatively higher loan and fee growth momentum; and d) possible upsides, from proposed new business initiatives.

New name – new game? More growth, more businesses — AXIS BANK is currently establishing its new identity; in the marketplace; its high visibility advertising campaign goes with the byline, "new name, same bank." Our sense is that there is a little more to the bank: a) higher asset growth momentum and b) broader business mix, through new initiatives in credit cards, international, wealth, distribution businesses and forays in private equity and institutional broking. Effectively, Axis Bank should be a slightly broader-based version of UTI Bank.

Does the large capital raising necessarily add value? In the opportunity context, probably yes —AXBK is more than doubling its capital base; but will it add value? – Returns on shareholder equity – No. Returns to shareholders – given high market growth and opportunity, regulatory protection from international competition (medium term), its own track record of leveraging up capital and returns, and a competitive perspective; our sense is Yes.

Maintain Hold/Low Risk — While Axis Bank has pulled back after a sharp 44% move over the quarter and capital raising, we see moderate returns over the next 12 months; maintain Hold/Low Risk (2L), with a Rs675 price target.

Raising target price We are raising our target price for AXIS Bank – as we do the following.

  • a) incorporate new capital;
  • b) revise earnings to incorporate new capital and most recent operating performance;
  • c) continue to use the our EVA methodology and PBV multiples as benchmarks – roll over benchmarks to FY09 from FY08 previously; and
  • d) factor in slightly higher asset and fee growth rates; given Axis Bank’s own business momentum, as also the relatively sustained growth outlook that the market appears to offer. Our new target price is Rs675, 20% higher than our previous target of Rs560.

We highlight earnings, returns and growth estimates that we have revised, factoring in capital raising, 1Q08 performance and growth expectations. Does the large Capital raising necessarily add value? Returns on Shareholder equity will dip There are negatives: a) ROEs take a dip – we estimate AXBK’s ROE in FY09 – the first full year of capital use – will dip to about 14.2% – just above its cost of capital, and substantially lower than the 21% we were forecasting prior to the capital raising; b) earnings are unlikely to be affected – our estimates suggest a 2% earnings accretion in FY09E, given the relatively high valuations capital is being raised at; and c) there is an implicit pressure on management to leverage up this capital quickly, to raise ROEs on equity, which could also suggest higher levels of risk, along with a more muted return profile. Usually, markets are a little cautious with capital raising – given the pressure they exert on ROEs, as well as the surplus stock they bring to the market.

But returns to shareholders? So far, pretty good Historically, AXBK has returned handsomely to investors; it has raised capital form – 65%pa over 2002-2007, and 35%pa over 2005-2007, in its two rounds of capital raising over the past. More important, however, the reasons it raised capital in the past are as real, if not more heightened now, than on the previous occasions. These are

a) The growth opportunity: India ‘s loan market is growing 22-24% (has stepped down from the 30% + levels), and we believe it has the legs to maintain this momentum over the medium term. AXBK – as one of the more aggressive private sector players is likely to continue to gain market share, and grow faster. Capital is a necessity if AXBK is to participate and capture its disproportionate share, of this growth.

b) Regulatory opportunity: The regulatory environment in India ‘s banking system currently is tilted in favor of the private sector banks. On the one hand, it is closed for acquisitions by foreigners (This is expected to be re-looked at in 2009). And foreign banks are inherently constrained from very rapid organic growth, as branch licensing is restricted. On the other hand, the relatively dominant and incumbent government-owned banks are somewhat constrained for capital – there is a minimum government shareholding level, which limits the amount of capital these banks can raise, and is a fundamental impediment to their medium-term, and more crucially longer-term, growth. In effect, AXBK and its private sector peers are in a privileged regulatory spot – their competition is handicapped – while they have both the domestic market opportunity and access to global capital. We believe aggressive capital raising – to bolster the capital base and build market position – furthers the competitive and defensive positions of the private sector banks, when and if the restrictions on its competition is lowered.

c) Track record in leveraging capital – AXBK itself has a good track record in leveraging its capital. On the two previous occasions it has raised capital, it has run the cycle of raising capital, seeing its ROEs dip, but then leveraging rapidly and profitably enough to get its ROEs back to the 21% levels before re-entering the market. It should, however, be recognised that as the scale of new capital raising has increased – the slower has been the ROE ramp-up. We would believe given the substantially enhanced scale of capital raising this time around (133% of existing capital), the drop in the ROE will be sharper, and the pullback to the 20% level will be slower.

d) Operational and competitive necessity: We also believe this capital raising is also a necessity for AXBK. It needs capital to continue to grow (Tier 1 is down to 6.42%), increased regulatory capital requirements will pressure the base, and
equally important, it does require a certain level of cushion given the high growth rates of the past, and the fact that the asset environment, healthy as it is, is slightly more uncertain than over the last few years.

We also believe there is a competitive reason. Peer private banks and financial companies have raised over $8b over the last two months; being relatively thin on capital would potentially be a competitive disadvantage, from a funding perspective ( particularly as they go offshore, but there could be some slowdown on account of the current ECB guidelines), on the scale of lending, and in the ability to take risk.

But is this too much capital?? Potentially, yes – it is over 130% of its current capital base, is substantially more than it has raised in the past (proportionate to capital and asset size), and is also proportionately more than any of its peers have raised. Management suggests this capital should last at-least 3.5-4 years; and should provide greater operational flexibility. But it has its downsides – the pressure to leverage and build aggressively will be higher (risks could be higher – and asset and liability pricing power could be lower), returns on shareholder returns will be lower, and if the business and the stock were to do well, it could well be a case of the existing shareholders getting diluted out too early.

We also believe the significant capital raising in the broader banking sector could well touch $10b before the year end and could create a level of surplus capital across the sector. This is particularly so in the context of a) broader loan growth showing numerical as well as anecdotal signs of slowing down; b) asset risk perceptions are a little higher now (on our part, we sense reasonable asset quality comfort); and c) the pressure to aggressively leverage the large capital that has been raised across the system – this could lower asset yields, raise funding costs, and effectively hurt margins across the sector. These risks, stand-alone or more ominously in combination, could well be a drag and potentially a risk, on stock returns.

How is Axis positioned relative to peers, what is changing along with the name?AXBK is a more plain vanilla bank than its closest peers, ICICI Bank and HDFC Bank. On the a) asset side – its product mix is a little more limited (smaller retail spread, somewhat narrower credit focus); b)liabilities – it has a relativelysimpler product profile, with hitherto only modest emphasis on retail term deposits; c) liability distribution, it has been slower on the wealth management and product distribution side of the business (launched insurance distribution only last year); and d) financial services – has so far not forayed into this space (ICICI Bank is substantially ahead, HDFC Bank has an institutional securities business).

This does suggest that there are parts of the broader banking/financial services business, where Axis Bank lags it peers. Our sense is that it potentially also offers the opportunity for AXBK, at the margin, to grow more rapidly, and aggressively than its peers, if it executes well. Some of this has been represented over the last 18 months; AXBK’s fee growth momentum has been higher, its expansion of its low-cost deposits has been more rapid and consistent, and its asset portfolio mix possibly more balanced (or less concentrated in retail).

We believe the transition from UTI Bank to Axis Bank probably provides an opportunity to transition beyond just the name. In part, it’s the scale. In larger measure, it would be the opportunity to expand its product offering; banking products, as well as the financial services space. Management has recently spelt out fairly specific ambitions in these areas – credit cards, wealth management, and its international initiatives are already under way, and we would expect a further acceleration, as well as some level of contribution, over the new to medium term.

In addition, management is seeking to foray into the private equity business; it is setting up an infrastructure fund, for which the management team is on board. It is also exploring the option of entering the institutional broking space, as a business opportunity in itself, and to further its distribution strength in thecorporate market. These are both businesses that broadly tie-in with itscorporate business – an if executed value, could add value, as also round off this business.

We do see these initiatives expanding Axis Banks’ business platform; though the primary operating and investment look of the new entity will continue to be that of a private bank aggressively and profitably tapping into the broader corporate and retail opportunity in India .

We believe some of management’s proposed initiatives, if effectively executed, could well add incremental value. This would be in some of its more recent initiatives – credit cards, wealth management and Insurance distribution, on the retail side. The potential to leverage in this space remains substantially large – in particular because AXBK has a very strong branch network/platform, which we believe could be substantially leveraged for these products. On the institutional side, management is seriously exploring opportunities in the private equity and institutional equities space. While these would need to be independent ventures, if executed and leveraged on the banking platform, they
could well add to value

Business has been OK . . . . 1Q08 a little mixedAXBK had an OK 1QFY08 – will profits were up a strong 30%, though pre-provisioning profit expansion (ex-trading gains), was a more modest 11%. A key driver of profitability has been strong trading gains; historically a key strength of the bank. Operating profitability growth though was a step down over its last few quarters, and lower than some peers. It was also characterized by a relatively sharp fall in qoq margins; somewhat seasonal in their case, but a little lower than expectations. Management does suggest these margins should bounce back as some of its lower yield assets run off – this has been the case in the past, and management has historically pulled back margins from 1Q lows.The key pressure point, however, has been costs; up almost 75% yoy, and well ahead of expectations. While this does reflect the continued investment into the business, and industry-wide cost pressures, the pace of expansion is high. We do believe this rapid cost expansion will need to be either moderated, or the investments need to generate returns quickly; otherwise costs could be a potential drag on profitability.The loan book continues to grow rapidly, up almost 59%yoy, and sustaining the well above industry average growth rates AXBK has had. Asset quality also remains OK – there is some level of deterioration, but not meaningfully ahead of loan expansion. Overall asset quality also remains comfortable; net NPAs at under 0.6% suggest little overall asset quality pressures.

Valuation We set our Rs675 (previously Rs560) target price using an EVA-based methodology. EVA is our preferred valuation methodology. Our target price is based on an EVA methodology because it takes into account (1) longer-term earnings and growth of the bank, (2) an improving mix of earnings, and (3) asset quality control. We assume the following: a) a risk-free rate of 8%; 2) a long-term asset loss expectation of 100bp; and 3) higher longer-term margins (+25bps) and fee income growth (+100bps) consistent with the expectation of a reduction in SLR requirements. Our secondary valuation methodology is based on P/BV, which we use to value all banks in our coverage universe. We expect private-sector banks to trade at a premium to the sector on a P/BV basis, reflective of their longer-term prospects, competitiveness and management. We value Axis Bank at 2.5x FY09E PBV or Rs701 (Previously 3.4X FY08E) based on a discount to HDFC Bank. Our PBV target multiple is lower than previously set, as post large capital raising, we expect an FY09E ROE of under 15%, which is substantially lower than the 20% factored in prior to capital raising. We prefer the EVA based methodology, on the grounds of consistency, rather than the PBV based valuation which gets distorted over shorter times frames, by capital raising.

Risks We rate Axis Bank shares as Low Risk based on our quantitative risk-rating system, which tracks historical share price volatility. Key upside risks to our target price include: (1) stronger-than-expected margins, (2) higher-than- expected fee income levels, and (3) any corporate activity including mergers and acquisitions. Key downside risks that could impede the stock from reaching our target price include: (1) mid-market credit focus; (2) a large share of wholesale funding; (3) aggressive trading orientation; and (4) the role of key shareholders.

Other Info: Corporate Announcements | Board Meetings | Financial Results | Corporate Actions
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