ICICI Bank’s second quarter 2015 earnings were up 15% over the prior year period, broadly in line with our five-year growth estimate of 14.8%. Net interest income grew strongly (up 15%) as net interest margins (NIMs) expanded to 3.4% versus 3.3% last year, and total loans grew by 14% ahead of the 11% loan growth in the economy. The main growth driver is the bank’s retail loans, comprising 40% of its outstanding loans. While retail loans increased 25 % over the prior year, corporate loans experienced much slower growth of 5%. The margin expansion trend at ICICI is similar to most other private banks, where higher yielding retail loan growth has outstripped the corporate advances.
Non-interest income grew by 26%, aided by higher trading income and dividends from ICICI’s insurance arms. Fee-based income grew 5.5% over the prior year, with the retail segment accounting for 60% of all fees generated, growing by 20%. We believe there is considerable work the bank could do to make the fee component of its non-interest income line more robust across business cycles, by moving towards non-trading fee based services. On the expense front, the bank continues to monitor provisions and operating expenses closely. While there were specific loan provisions made during the quarter on the corporate side, the trailing twelve month provision-to-loan ratio for the bank as of 30 September, 2014 stood at a healthy 0.9%. As a result, we have reduced our 2015 forecast for provisions to 1.1% from 1.3%. We are also expecting higher loan growth in 2015 of 14% versus 13% previously assumed. As a result of these changes, we increase our valuation of ICICI Bank by a modest 3% to INR 1,403 per share of USD 46 per ADR. As ICICI just about begins to generate ROEs of above 14%, we look for sustainability of these returns before reviewing our current no-moat rating on the bank.
Economic Moat Rating
We give ICICI Bank an economic moat rating of "none," as it fails to perform well on a few key cost metrics that we use to judge cost advantages across all financial services firms. While evaluating ICICI Bank on the four cost pillars of banking: (1) low cost of funding, (2) low loan losses, (3) low operating costs, and (4) high fee-based income. We recognize that the bank’s consolidated performance on each of these parameter’s is heavily influenced by the insurance business. We highlight what the performance would be with and without insurance included in the business.
Firstly, ICICI's deposit/loans ratio stands at about 95%, providing little room for loan book growth, despite having the largest branch network and the largest deposit base amongst private banks in India. This pales in comparison to HDFC Bank’s and SBI's deposit-to-loans ratio of 1.2 times. As a result, the NIMs from the standalone Indian bank averaged at 2.8% (between 2010 and 2014) and consolidated NIMs have averaged 2.4% over the same period. Both these margin figures are much lower than Axis Bank’s 3.4%, and SBI’s 3.3%. We anticipate that NIMs will remain at 3% in 2014, after posting a margin moderately above 3% in fiscal 2013.
Secondly, the bank's underwriting seems relatively sound with consolidated provisions/ loans averaging 1% over the last five years--in line with SBI’s 1.1% and Axis Bank's 1% over the same period. On a standalone basis, however, provisions were slightly higher at 1.3% on average for its Indian business, and we would like to see the bank perform more consistently across all geographies.
Thirdly, we see a large contribution from fee income to bank’s overall revenues as a big plus. On digging deeper into this aspect, we see that even without insurance revenues the fee-income earned by ICICI Bank is quite strong. On a consolidated basis, 70% of the bank’s revenues have been fee-generated over the last five years. However, on a standalone basis, after removing insurance and international businesses, 36% of revenues are non-interest or fee-based. This still compares favorably to most other Indian banks where fees account for a third of total revenue.
Lastly, on the operating costs front, insurance business ratchets up the five-year historical efficiency ratio to 70% on average on a consolidated basis, versus 42% on a standalone basis. This is mainly due to the upfront nature of lumpy expenses needed to set up an insurance business. Now that both the life insurance and general insurance arms have reached break-even, we anticipate further scale expansion to drive costs down at a consolidated level in the coming five years.
ICICI Bank performs well on its underwriting skills and diversification towards more fee-based revenue streams. However, we believe deposit growth and operating cost reductions (linked to profitable expansion of its insurance business) remain works in progress. While the consolidated entity has not crossed our threshold of 14% ROEs in the past, when we remove one-time regulatory charges on the insurance business of INR 6.85 billion in 2012 and INR 1 billion in 2013, we see that the consolidated ROEs cross our estimated 14% COE benchmark. On a standalone basis, however, the bank fails to reach 14% ROEs in any of the past five years. This goes to show, that while the bank’s insurance arm is pressuring operating expenses over the short-run, in the long-run this business will be the key to ICICI Bank generating higher profitability on a sustained basis. In conclusion, until the bank sustainably crosses our 14% COE, we contend that ICICI does not have an economic moat.