Asset quality stress seems to have peaked; operating efficiency set to improve
Banking stocks have significantly outperformed the broader market in the current calendar year (CY22). The Bank Nifty is up 10 percent year-to-date (YTD) while the NIFTY has remained almost flat in the same period. The rally in the banking stocks has been fueled by strong earnings performances. Most private banks have beaten Street expectations in term of profits in the quarter gone by (Q1 FY23). Their earnings have been enhanced by a healthy pickup in loan growth, better asset quality, and a significant decline in credit costs/provisions even as treasury income was muted. While margins showed mixed trends, the trajectory is likely to be upward as the full effect of the interest rate hikes kicks in.
It is worth noting that most of the earnings uplift and the price up-move have been seen in the stocks of large-cap private banks. Should investors expect the rally to spill over to mid- and small-cap banking stocks? The banking sector tailwinds may not turn out to be “a rising tide lifts all boats” kind of scenario, making it important to assess each bank separately.
Amid this backdrop, we analyse DCB Bank (CMP: 96; Mcap: 3,000 crore), a small-sized private bank, to understand its future potential.
DCB’s performance in recent years has been lacklustre. The bank’s asset quality has deteriorated sharply, leading to elevated credit costs and weaker profitability levels. Despite a performance, which is not so impressive, we are positive on the stock. This is because the bank has multiple levers to improve return ratios over medium to long term.
First, there has been a pickup in business activities as seen in the Q1 FY23 performance. The management intends to double the balance sheet in the next 3-4 years.
Second, the asset quality should improve in FY23 on the back of higher upgrades and recoveries, leading to lower credit costs. The collection trends from the segments at the bottom of the pyramid have been very encouraging as indicated by the earnings of microfinance companies. Moreover, in the case of DCB, the overall book is well collateralised, enhancing the recovery chances.
Last but most important, the valuation of the bank is very compelling as it is trading much below the book value. Precisely for this, we see a reasonable upside to the stock price supported by business growth and earnings in FY23.
Advances growth to accelerate
Historically, DCB Bank’s net advances have grown at a strong pace, recording a year-on-year (YoY) growth of over 20% between FY12 and FY18. However, growth moderated to 16 percent in FY19 on the back of a cautious approach undertaken by the bank because of a slow economic environment and a reduction in the corporate book (12 percent contraction in FY19). The weak growth in the last two years was due to the pandemic-induced economic crisis, which necessitated DCB to shift focus from growth and instead preserve capital, manage portfolio stress, reduce cost, and maintain adequate liquidity for the near term.
With the improvement in the macroeconomic environment, the advances growth has improved 18 percent YoY in Q1 FY23, albeit on a lower base.
DCB has established market position in the small and medium enterprise (SME) segment, which along with the mortgage (42 percent) segment, constituted over 50 percent of the loan book as on June 30, 2022.
Going by the management guidance, the loan book is likely to increase by a compounded annual growth of 20-25 percent over the next 3-4 years.
Weak but improving funding profile
DCB Bank’s funding profile is average with the share of low-cost CASA deposits at 28.6 percent as of June, much lower than its peer banks. However, we draw comfort from the fact that the bank has improved the granularity/composition of the deposit base. This is evident from the fact that the share of its top-20 depositors in total deposits has reduced to 6.2 percent in June from 15 percent in FY18. This is encouraging as it lends stability to the bank's resources profile. Additionally, the share of bulk deposits (deposits greater Rs 2 crore) has reduced progressively.
The net interest margin (NIM) in Q1 FY23 stood at 3.61 percent. As per the management, the NIM is expected to stabilise in the 3.65-3.75 percent range. Lower slippages in the future will reduce interest reversals and will help improve margins.
Operating cost to remain elevated
DCB Bank saw a YoY increase of 32 percent in operating costs, which, along with lower treasury income, pushed the cost-to-income ratio to 64 percent in Q1 FY23. Going forward, costs are likely to remain elevated as the bank expands the branch network, adds to the headcount, and invests in technology. However, as the business gains momentum and the balance sheet expands, the operating leverage will help reduce the cost-to-income ratio and the cost to average assets ratio to 55 percent and 2.4 percent respectively over the next 4-5 quarters. The FY23 earnings will thus get some support from the improvement in operating efficiency.
Asset quality vulnerable, provisions set to decline
DCB’s asset quality deteriorated in the past two years with gross non-performing assets (GNPA) touching 4.2 percent as of June ’22, having increased from 2.5 percent in March ’20. Moreover, the overall restructured book remained high at 7 percent of standard advances as of June. The weakening in the asset quality was partly due to the bank’s customer profile, mainly comprising small-ticket borrowers in the self-employed segment that was more severely impacted by the pandemic.
While the GNPA has declined from the peak of 4.8 percent in December ’21, the asset quality is vulnerable as a significant portion of the book is under moratorium, indicating high potential stress. The performance of the restructured portfolio will be a key factor to monitor as the moratorium period ends.
That said, recoveries and upgrades have been very strong in the past couple of quarters and, if the trend is maintained, the GNPA will decline even if slippages remain high.
The credit cost for the bank seems to have peaked. With the asset quality stress easing in recent quarters, credit cost is likely to decline which will be key driver for earnings in FY23. DCB’s credit cost in FY22 stood at 1.5 percent and the management expects it to improve to 0.5-0.6 percent over a period of time.
Valuation pricing in most concerns
Going forward, the improvement in return ratios for DCB Bank hinges on balance sheet growth, operating leverage and improvement in asset quality. We see slippages and provisions to moderate driving profitability in the near term. But over the medium term, operating efficiency will be the key profit driver.
DCB’s stock is now trading at 0.7 times FY24 estimated book, which is very compelling and prices in growth as well as asset quality concerns. A substantial valuation re-rating above 1 time book value is unlikely till the ROA (return on assets) improves above 1 percent on a sustained basis. However, with multiple positive triggers, the valuation can inch closer to one time book, which will drive the meaningful stock upside in the near to medium term. Long-term investors should buy the stock.
