V. Vaidyanathan, the managing director and chief executive of IDFC First Bank Ltd, and his team have outdone themselves.
For the previous 22 quarters, the bank has staged a turnaround that is nothing short of remarkable. The team has delivered on almost every metric it set out to achieve in December 2018. And yet, the stock price continues to disappoint.
If you bought the IDFC First Bank stock in November 2018, you would have expected Vaidyanathan to orchestrate a turnaround like he did at Capital First, which was merged with IDFC Bank to form IDFC First Bank. Instead, you got a 12% compound annual growth rate over 5 years.
This is a disappointing outcome. It’s disappointing for long-term investors because the bank hit every milestone it aimed for at the time of the merger in December 2018, and yet that has not shown up in the stock price.
Over the last five years, the bank has lagged even the Nifty 50.
So, what explains this dichotomy?
IDFC First Bank needed to build a strong deposit base. It also had to replace IDFC’s high-cost borrowings with cheaper deposits. Check.
It needed to run down its old infrastructure book. Check.
It needed to build an asset base. Check. It did that by introducing more than 20 new lines of businesses.
It also grew it loan book from around ₹32,000 crore in the first half of 2018-19 to about ₹2 trillion in 2023-24.
IDFC First needed to maintain respectable asset quality. Barring FY21 and FY22 and the impact of covid-19, it has maintained gross non-performing assets at under 2.2%. GNPA reflects what percentage of the loans given by the bank are not being paid in time.
IDFC First also communicates with exceptional clarity and candidness with shareholders.
And yet, it trades at 1.6 times its price/book. In comparison, the NIFTY Private Bank Index trades at an average of 2.6x. Is this valuation justified?
For context, IDFC First grew its deposits by 41.9% year-on-year in FY24. The system deposit growth was 13% during the period. This is even higher than the deposit growth of small finance banks (red line)—a remarkable achievement in a time when banks are struggling to raise deposits.
IDFC First was also one of a few banks to grow its loan portfolio by 25% in FY24. This matches the credit growth of small finance banks. During this period, credit growth of India’s banking system was 14.9%.
However, credit growth is a double-edged sword. A very high growth rate can be alarming. After all, most banking mishaps happen at the tail end of rapid credit growth. Luckily, IDFC First is cognisant of not making this mistake. According to a Jefferies Report in April, IDFC First’s credit growth is expected to be 22% over the next two fiscal years.
Also, IDFC First has a superior net interest margin profile. NIM is like gross margin (sales-cost of goods sold) for banks. At 6.4%, IDFC First has the highest NIMs among larger private banks. This means for every ₹100 of loans provided, IDFC First can generate 6.4% as gross margin.
For more such in-depth analyses, read Profit Pulse.
A simple comparison with peers suggests that a higher NIM is better, all else held constant. But all else is rarely held constant. Higher NIMs could result from lending to risky customers at higher yields. This could lead to higher NPAs in times of stress. In good times, however, it shows up as higher return on equity (net profit/book value), an important measure of bank profitability.
Another factor is that IDFC First’s asset quality has been superb. Since March 2019, its GNPA has stayed below 2.2 except during the covid-19 period.
Currently, at 1.38% GNPA, its asset quality is second only to that of HDFC Bank Ltd.
This is impressive. But IDFC First’s new retail book needs to be tested over multiple cycles. In a cushy credit environment, the entire Indian banking sector is reporting decade-low NPAs. In this context, IDFC Bank’s sub-2.2% GNPA is impressive but has relatively lower significance.
Without a doubt, IDFC First Bank has some top industry metrics. But it falls short on what really matters. Profitability.
According to the Jefferies report, IDFC Bank’s current and forward ROE for FY25 is estimated to be on the lower end of the spectrum as compared to large as well as smaller peers.
This raises an interesting question. IDFC First’s NIM is better than that of its peers, and its NPAs are second only to HDFC Bank’s. So why is its ROE so low?
The simple answer lies in the cost-to-income ratio. IDFC First Bank is barely 6 years young. It has had to build everything from the ground up since 2018. All the front-loaded investments (branches, IT and technology systems, employee productivity) are yet to show up at the ROE level. At a cost-to-income ratio of 73%, the bank has a long way to go.
Also, since the merger in December 2018, the bank’s book value per share (BVPS) has grown at just 3.6% CAGR. The balance 7% price return over the last 5-6 years is due to a P/B re-rating. Its P/B was re-rated from around 0.9 in December 2018 to around 1.6 as on 13 September 2018 on a consolidated level. This reflects the fact that the turnaround has not gone unnoticed. Marquee investor GQG Partners holds 2.22% in IDFC First Bank, down from 2.35% in the previous quarter.
But the fact is that without adequate BVPS growth, hoping for higher price returns remains just that, a hope.
No wonder IDFC First trades on the lower end of the valuation spectrum compared to large private banks. And at median valuations compared to smaller peers.
But there’s a silver lining. There are three major factors that can help the bank achieve a 13-15% ROE over the next two to three years.
These levers include expected asset (loan) growth of over 20%. IDFC First Bank has grown deposits by 42% year-on-year in a tight liquidity environment. If this is indeed a signal of impending deposit growth trends, credit growth will not be affected by lower deposit growth as is the case for larger peers. This is likely to be a significant advantage for the bank.
Rate cuts are likely to be a positive for the bank too. Since 60% of IDFC Bank’s book is fixed, a cut in rates will likely expand NIMs. The bank also has nearly ₹13,600 crore of legacy IDFC Ltd borrowings, which are higher cost. More than 50% ( ₹7,200 crore) are due this financial year. Low-cost deposits will replace high-cost borrowings. This will reduce interest expenses. These factors should boost NIM marginally, assuming the current yield profile remains the same.
Then there’s the cost to income. This is the single biggest factor that can impact profitability. For FY25, a 1% decline in the cost to income ratio should result in around 6% increase in earnings. Over the next 3 years (FY24-27), according to the same Jefferies' report cited above, the CI ratio should come down by 7%.
GQG Partners is most likely betting on the same. If the 13-15% ROE materializes, IDFC First Bank’s about 2.7 million shareholders will have much to cheer.
Note: The purpose of this article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your advisor. This article is strictly for educational purposes only.
Rahul Rao has been investing since 2014. He has helped conduct financial literacy programmes for over 1,50,000 investors. He helped start a family office for a 50-year-old conglomerate and worked at an AIF, focusing on small- and mid-cap opportunities. He evaluates stocks using an evidence-based, first-principles approach as opposed to comforting narratives.
Disclosure: The writer and his dependants do not hold the stock(s) discussed here as per SEBI guidelines.
