The following are excerpts from the recently-issued Stock Analyst Report on IDFC, published by Morningstar Analyst Suruchi Jain. Registered Morningstar Members gain exclusive access to our full IDFC Analyst Report (PDF), including fair value estimates, consider buying/selling prices, bull and bear breakdowns, financial and company overviews, and risk analyses. Not a Registered member? Get these reports immediately when you sign up with Morningstar for free.
Thesis
Unlike most Indian banks under our coverage IDFC is a non-deposit taking financial services firm or an NBFC which limits its ability to access low cost funding through public deposits. Furthermore, its status as an IFC, a specialized NBFC offering infrastructure loans, limits the amount by which it can grow its loan book beyond its equity base as IFCs have a minimum capital adequacy requirement of 15% (versus Indian banks that have 9%).
In our opinion, these are the primary reasons why IDFC’s returns on equity (ROE) are unable to surpass its cost of equity (COE) supporting our view that the company does not have a moat. To continue to grow its asset base, IDFC will necessarily have to raise more equity through public or private markets as it has done in the past, which will continue to put pressure on its ROEs in the future, supporting our stable trend outlook.
IDFC’s non-deposit taking status limits its ability to establish the sticky relationship that banks have with their customers. Not only are deposits the cheapest method of funding for a financial services firm, but also most banks are able to cross-sell profitable fee-based products to deposit customers as there are high switching costs associated with customers moving banking relationships.
IDFC lacks this switching cost advantage as its NBFC license does not allow it to gather public deposits. Therefore, for its funding IDFC typically raises equity or issues public debt. The other central disadvantage for the company is its IFC status which confines the amount by which it can grow its loan book as compared to its equity capital. The gearing restriction on this front as well limits the size of its loan book and as a result the size of the overall company.
Despite low ROEs, return on assets (ROA) is high, primarily due to the equity-to-assets or leverage ratio being low. The high ROA reflects excellent management and successful execution namely, low loan losses, low operating costs, and high net-interest margins. The firm has low loan losses with provisions at 0.7% of all loans (much lower than State Bank of India’s (SBI’s) 1.1% and HDFC Bank's 1.2% over the same period), which confirms our view that IDFC’s underwriting skills are reasonable and that it has a healthy loan book despite lending to the infrastructure sector--which typically has lumpy capital expenditure requirements and projects with long gestation periods.
Low provision losses reflect the bias towards financing operational projects versus projects under construction, as well as those power projects that already have the necessary access to sufficient fuel. On the operating expense front, IDFC has an impressive efficiency ratio (non-interest expense/revenue) that averaged 22% over the last four years and is likely to remain low due to the lack of a brick-and-mortar branch network that typifies most banks. IDFC does not need a widespread retail branch network due to its status as a non-deposit-taking institution.
Although IDFC offers its infrastructure clients ancillary services such as private equity, asset management and broking, the company’s fee based revenues are on the decline with fee income at 34% of its total income in fiscal-year 2012 compared to an average of 44% over the last 4 years (which used to compare favorably with SBI’s 40% and HDFC Bank’s 30% on average). This further confirms that IDFC does not hold a competitive advantage when it comes to lending relationships as all banks and most NBFCs can also lend to the infrastructure sector.
Overall, we believe IDFC efficiently runs its lending business producing superior ROAs, however, the company is limited by its IFC guidelines and forced to maintain low leverage thereby unable to enhance ROEs much beyond COE. In our opinion, the firm’s competitive advantages will be significantly enhanced if it applies for and receives a banking license. With that, IDFC will be able to shore up its equity balances by gathering public deposits instead of constantly raising public equity. Furthermore, under a lower capital adequacy regime it will be able to grow its loan book to a larger size even with the same amount of equity.
Risk
We believe the main risk faced by IDFC is its increasing dependence on the infrastructure lending business. The revenue contribution from this business was 83% in fiscal 2013, versus a smaller figure of 76% for fiscal 2012. Under a severe economic downturn infrastructure projects and capital investments in India will be severely impacted, which may cause large defaults on IDFC’s loan book. We believe diversifying the company’s revenue stream to grow other fee-based offerings would be efforts well spent.
Financial Health
IDFC’s capital adequacy ratio of 22.1% (and Tier 1 at 19.8%) as at 31 March, 2013 more than fulfills the current minimum requirement of 15% (and Tier 1 of 10%) for all Infrastructure Finance Companies (IFCs). We think IDFC is presently adequately capitalized. While IDFC is more than likely to raise more equity in the future to fund its growth, we expect this will be moderately dilutive for current shareholders as we anticipate the shares will be issued at a significant premium to book value, as has been the case in past capital raises.
Valuation
Our fair value estimate for IDFC stands at INR 113 per share, which represents 1.1 times book value per share, and 9 times our fiscal 2014 (which closes in March) earnings estimate. In the event that IDFC receives a banking license and begins accepting public deposits, we foresee a significant upside to our valuation. However, in our base-case scenario, we expect that IDFC's net interest margin (net interest income/interest-earning assets) will average 3.9% and its non-interest revenue will grow at 11% annually over the next five years to form 22% of net revenues in fiscal 2018.
Overall, we model net revenues to grow at 15% per year and also assume the company will be able to control both its operational and credit costs. In our opinion, IDFC will maintain an efficiency ratio (noninterest expense/net revenue) of less than 15% for each of the coming five years and believe that net charge-offs will continue to remain low at 0.8% of loans, as the company continues to keep its bad debts low. Despite good underwriting, careful cost management and strong topline growth, we believe IDFC will earn ROEs just meeting its estimated 14% cost of equity, averaging 14.3% over the next five years as the company keeps its gearing (equity/assets ratio) high at an average of 19% and hence needs to raise capital in order to grow in double digits.