IndusInd Bank BUY. Announces BHAFIN merger we like the deal. 15 October 2017 India Private Sector Banks Company Update

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1 15 October 2017 India Private Sector Banks Company Update IndusInd Bank BUY Announces BHAFIN merger we like the deal IndusInd Bank (IIB), over the weekend, announced that it will acquire Bharat Financial Inclusion Ltd (BHAFIN, Unrated) for a consideration of INR 1,118 per share (i.e. swap ratio of 0.639) valuing BHAFIN at ~INR 155bn, a premium of 11.4% over the last closing price. The transaction values BHAFIN at 6.4x trailing BVPS and 4.2x P/BV (consensus) and will entail dilution of 14.8%. In addition, promoters of IIB will infuse capital in to the bank (through equity warrants) to keep their economic interest intact at 15% taking total dilution to 17% for existing shareholders. Notwithstanding the premium paid, we like the transaction given the multiple benefits that it brings to IIB. In our view, the transaction is unique given the upfront benefits that accrue to the bank. We see IIB s RoA expanding above 2.2% by that can potentially be best-in-class. A NIM level comfortably above 4.25%, Tier1 above >15% and earnings growth of over 25% sustainably. We believe these are ingredients that should drive IndusInd to rerate higher. We are upgrading our earnings for / by 3%/22% factoring the merger and introduce our estimates with an EPS of INR 108/ share. We value IndusInd at 4.5x P/BV (which is now largely in-line with our HDFC Bank s P/BV multiple) and raise our target price to Rs2,120 per share, 21% upside. IndusInd continues to be one of our top picks in the sector and would be buyers of the stock on any declines. Large opportunity on the anvil, gets overnight presence in a large market: The deal gives IIB an overnight presence into significantly underpenetrated market with an opportunity to cross-sell asset as well as liability products. IIB s combined customer base will exceed 16mn with presence across 100K locations with nearly 2600 branches. As IIB has already cracked the livelihood finance model through its vehicle finance loans, it should be able to leverage this large opportunity to cross-sell its liability (CASA), loan book (longer tenor loans : home loans, vehicle finance, personal loans) as well as fee-based products (microinsurance, micro- MFs etc). Financial benefits upfront, synergies could surprise: The merger is accretive for IIB from day 1 on multiple fronts: a) BFIL is well-capitalised, and with further capital unlocking on risk-weight reduction, would help IIB shore up tier 1 by over 100bps, b) c.3% reduction in cost of funds on BFIL s portfolio post-merger would add c.70bps to IIB s NIMs, c) BFIL s entire loan book is PSL compliant and can be used to generate c.1.5% fee income through PSLCs. While we build conservative improvement in opex and credit costs, we believe they provide further headroom for RoA improvement over FY18-20E. Sameer Bhise sameer.bhise@jmfl.com Tel: (91 22) Jayant Kharote jayant.kharote@jmfl.com Tel: (91 22) S Parameswaran s.parameswaran@jmfl.com Karan Singh CFA FRM karan.uberoi@jmfl.com Tel: (91 22) Nikhil Walecha nikhil.walecha@jmfl.com Tel: (91 22) Bunny Babjee bunny.babjee@jmfl.com (+91 22) Recommendation and Price Target Current Reco. BUY Previous Reco. BUY Current Price Target (12M) 2,120 Upside/(Downside) 21.1% Previous Price Target 1,650 Change 28.4% Key Data IIB IN Current Market Price Market cap (bn) INR1,750 INR1,048.1/US$16.1 Free Float 91% Shares in issue (mn) Diluted share (mn) 3-mon avg daily val (mn) INR1,888.0/US$ week range 1,818/1,037 Sensex/Nifty 32,433/10,167 INR/US$ 64.9 Price Performance % 1M 6M 12M Absolute Relative* * To the BSE Sensex Valuations should get richer; BUY: We are changing our estimates to factor in the merger and raise our earnings by 3-22% in /. We believe IIB s RoA can now potentially breach 2.2% by with a stronger margin profile, diversified asset mix, high CASA and high capitalization levels. We are now building IIB s sustainable RoEs at 23%. We believe IndusInd can now rerate higher and thus raise its target price to Rs2120 per share, which is 21% upside from CMP and maintain our BUY rating. Financial Summary (INR mn) Y/E March A A Net Profit 22,864 28,679 38,091 56,836 75,748 Net Profit (YoY) (%) 27.5% 25.4% 32.8% 49.2% 33.3% Assets (YoY) (%) 25.4% 27.6% 33.7% 26.3% 24.9% ROA (%) 1.8% 1.8% 1.8% 2.1% 2.2% ROE (%) 16.6% 15.3% 15.7% 18.6% 20.9% EPS EPS (YoY) (%) 13.4% 24.8% 13.6% 49.2% 33.3% PE (x) BV BV (YoY) (%) 50.4% 16.5% 18.9% 17.2% 19.4% P/BV (x) Source: Company data, JM Financial. Note: Valuations as of 13/Oct/2017 JM Financial Institutional Securities Limited JM Financial Research is also available on: Bloomberg - JMFR <GO>, Thomson Publisher & Reuters S&P Capital IQ and FactSet Please see Appendix I at the end of this report for Important Disclosures and Disclaimers and Research Analyst Certification.

2 Transaction structure and timeline: BFIL s operations to continue as a business correspondent (BC) of IIB While BFIL s books will be fully integrated with that of IIB, the employees and operations will be transferred into a new subsidiary (to be incorporated post-merger) which will act as business correspondent (BC) for IIB. Thus, the improvement in financial metrics will start flowing from day1 without any disruption to BFIL s business operations. While there will be no change in the board of IndusInd bank, BFIL will find representation on a new MFI advisory committee to be constituted post-merger. Tentative timelines indicate an 8-10 month period for the merger process to be completed. Hence, post-merger synergies are expected to meaningfully accelerate from itself. Exhibit 1. IIB BFIL merger structure Exhibit 2. IIB - BFIL merger tentative timelines Source: JM Financial, Company JM Financial Institutional Securities Limited Page 2

3 Dilution impact on existing shareholders The merger will result in a two-fold dilution impact for existing shareholders arising from: (a) shares issued to BFIL shareholders (swap ratio : 0.639) and (b) subsequent infusion of capital in the form of preferential warrants from promoters as their stake in IIB falls by nearly 2% post-merger. This results in an overall book accretive dilution of 16.9% for existing shareholders as shown in the table below: Exhibit 3. Dilution to existing shareholders IIB No. of shares (Pre-issue and Pre-merger) (mn) BHAFIN Current shares o/s (mn) 138 Swap Ratio No. of shares to be issed by IIB (Rs m) 88.5 No. of shares post- merger (mn) Post merger dilution to existing shareholders 14.8% No. of shares held by promoters (mn) Current promoter stake in IIB 15.0% Promoter stake post BFIL merger 13.0% Additional dilution from promoter infusion 1.9% No of share to acquire additional stake (mn) 13.2 No. of shares after merger + promoter infusion (mn) Total dilution to existing shareholders 16.9% The merger is highly accretive to IIB s tier 1 capital as well. BFIL is well capitalized, with a tier 1 capital ratio of 31.8% (as of 1QFY18). This, coupled with the release in capital from the subsequent reduction on risk-weights on MFI loans (75% weightage for the bank vs 100% for BFIL) can result in c.102bps accretion to tier 1 capital for IIB as shown below. Exhibit 4. Impact on Tier 1 capital As of 1Q18 Tier 1 capital (INR mn) RWA (INR mn) Tier 1 (%) IIB Tier 1 capital 227,366 1,452, % BFIL Tier 1 capital 24,515 77, % Total merged entity (after RWA weightage adjustment) 251,881 1,510, % Tier 1 capital accretion (%) 1.02% JM Financial Institutional Securities Limited Page 3

4 Valuation and 12M TP Exhibit 5. IIB: Revision of estimates Pre-merger estimates Post-merger estimates BVPS (INR) EPS (INR) RoE 17.0% 18.4% 15.6% 18.7% RoA 1.9% 1.9% 2.1% 2.2% We value IndusInd Bank on a two-stage Gordon Growth Model. Our assumptions are as follows: Exhibit 6. IIB: Valuation summary Initial no of years 10 Growth rate for the first 10 years (%) 20.5% Pay out ratio for the first 10 years (%) 7% Perpetual growth rate (%) 4.4% Perpetual payout ratio (%) 80.0% K K Fully adjusted BVPS (Rs) 469 Target P/BV (x) 4.5 Fair value (rounded off) 2,120 Exhibit 7. IIB : One year fwd P/BVPS IIB Fwd. P/BV (x) SD+1 SD-1 Average Exhibit 8. IIB: One year fwd P/EPS IIB Fwd. P/E (x) SD+1 SD-1 Average Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12 Oct-13 Oct-14 Oct-15 Oct-16 Oct-17 Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12 Oct-13 Oct-14 Oct-15 Oct-16 Oct-17 JM Financial Institutional Securities Limited Page 4

5 Benefits galore for the merged entity: Distribution network to double BFIL has over 1400 branches, with c.237,000 Sangam centres. The customer base of the merged entity will be in excess of ~16mn (10mn for IIB as of 2QFY18) vs (9mn for KMB, 40mn for HDFCB). Exhibit 9. BFIL: Operating parameters Particulars As of 1QFY18 Branches 1,408 - Centers (Sangam) in non-ap States 237,372 Employees 15,284 - of which, Loan officers 9,251 Members (customers) in non-ap States ( 000) 6,847 Active borrowers in non-ap States ( 000) 5,152 No. of loans disbursed ( 000) 1,894 The merger will aid IIB to improve its distribution network more-than two fold to 2,618 touch points across India (excluding CFD outlets) and gives it access to BFIL s 6.8mn customers spread across c.100,000 villages. Access to these underbanked areas across the country will help IIB cross-sell its liability (CASA), loan book (longer tenor loans : home loans, vehicle finance, personal loans) as well as fee-based products (micro-insurance, micro- MFs etc). Exhibit 10. Quantum leap in distribution network 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, ,727 3,385 2,618 1,408 1,210 AXSB HDFCB IIB + BFIL MFI loans to push up loan book yields Currently, MFI loans form only 2% of IIB s loan book which will go up to nearly 10% postmerger. MFI loans fetch high yields (17-18%) as compared to 11.3% yields of IIB s current loan book. Even with slight reduction in lending rates on the MFI book (as IIB aims to maintain BFIL s leadership position in lending rates), the book will remain substantially margin accretive. At the current growth rate for BFIL and IIB s loan books, MFI loans are likely to remain in the 8-10% range over the near term and thereby contribute meaningfully to loan book yields of the merged bank. Also, IIB s continuous focus on rebalancing of portfolio towards higher proportion of non-vehicle retail loans will offset some part of yield decline coming on the corporate side. We build an overall 45bps expansion in the loan book yields of merged entity by. Exhibit 11. BFIL s AUM split as of 1Q18 AUM and Balance sheet (Rs. bn.) 1Q17 4Q17 1Q18 YoY (%) QoQ (%) Loans 62,270 71,760 77, % 7.4% Assigned loans O/s 22,360 19,740 19, % -2.6% AUM 84,630 91,500 96, % 5.3% Source: JM Financial, Company JM Financial Institutional Securities Limited Page 5

6 Exhibit 12. IndusInd Bank loan book as of 1QFY18 Loan Book Composition (Rs bn) 1Q17 4Q17 1Q18 YoY (%) QoQ (%) Consumer Finance Comm. Vehicle Loans % -0.2% Utility Vehicle Loans % 3.6% Small CV (Incld 3Ws) % 0.3% 2Ws loans % 0.0% Car loans % 3.3% Tractor % 14.5% Equipment Financing % 6.3% Credit card % 14.1% LAP % 3.6% Others (Home, Personal) % 13.0% Total % 3.4% Corporate & commercial Banking Large corporates % 5.0% Mid size corporates % 2.0% Small corporates % -1.8% Total % 2.6% Total Advances , , % 2.9% Loan Mix (%) Consumer Finance Comm. Vehicle Loans 14.8% 13.8% 13.4% -1.4% -0.4% Utility Vehicle Loans 2.2% 2.1% 2.1% -0.2% 0.0% Small CV (Incld 3Ws) 2.3% 2.1% 2.0% -0.2% -0.1% 2Ws loans 3.3% 2.9% 2.8% -0.5% -0.1% Car loans 4.4% 4.1% 4.1% -0.2% 0.0% Tractor 1.3% 1.6% 1.8% 0.5% 0.2% Equipment Financing 3.7% 3.6% 3.8% 0.1% 0.1% Credit card 1.3% 1.5% 1.7% 0.3% 0.2% LAP 6.0% 6.2% 6.3% 0.3% 0.0% Others (Home, Personal) 2.0% 2.3% 2.5% 0.5% 0.2% Total 41.2% 40.3% 40.5% -0.7% 0.2% Corporate & commercial Banking Large corporates 29.2% 27.8% 28.4% -0.8% 0.6% Mid size corporates 18.3% 19.6% 19.5% 1.2% -0.2% Small corporates 11.4% 12.3% 11.7% 0.3% -0.6% Total 58.8% 59.7% 59.5% 0.7% -0.2% Total Advances 100% 100% 100% Exhibit 13. IIB s 1QFY18 loan book mix (%) 2% Exhibit 14. Post-merger loan book mix (%) 10% 30% Vehicle retail Non-vehicle retail 28% Vehicle retail Non-vehicle retail 57% 10% Corporate and commercial banking Microfinance 53% 10% Corporate and commercial banking Microfinance JM Financial Institutional Securities Limited Page 6

7 Incremental CRR/SLR cost to be negligible Impact of statutory costs like CRR/SLR are also expected to minimal given that, a) BFIL s entire INR96bn book is eligible for cheaper refinancing which is exempt from CRR/SLR requirements and b) BFIL already hold c.inr 3.6bn in margin money deposits against its INR19.2bn securitized loan portfolio. Hence, assuming a conservative 40% portolfio refinancing by bodies like SIDBI etc, the net impact of incremental CRR/SLR cost is <Rs0.6bn (less than 0.5% of NII of merged entity). Margins to improve substantially over FY18-20E BFIL s c96bn MFI loans (as on 1Q18) will immediately gain from a nearly 300bps reduction in cost of funds which will push the book s margins near the 12% mark. IIB s cost of funds will also benefit from the immense cross sell ability for tapping into the 6.8mn customer of BFIL across c.100,000 locations. We believe even with an average Rs50mn of deposits per branch of BFIL by, c.inr 80bn of deposit accretion can happen from these branches. This will stabilise the merged bank s CASA and consequently, its cost of funds over FY18-20E. In the recent times, Bandhan bank, one of the largest MFI lenders that received a banking license has displayed encouraging results in raising deposits (c.inr 230bn over 2 years, with c. INR 68bn in CASA) after converting to a bank. IIB has already run a pilot with 100 branches of BFIL for IIB s liability products. Overall, adjusting for slight reduction in lending rates for MFI loans, we expect margins to expand by c70bps from current levels by. Exhibit 15. IIB movement of deposit costs and yield on loans (%) 16% 14% 12% 10% 8% 6% 4% 2% 0% 12.1% 13.8% 14.1% 13.3% 12.5% 11.8% 11.4% 12.0% 11.9% 11.8% 6.0% FY11 8.0% 8.3% 7.6% 7.7% 6.8% 6.3% FY12 Yield on advances (%) Cost of Deposit (%) FY13 FY14 FY15 5.9% 5.7% 5.6% Exhibit 16. Margin and spread movement (%) 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 3.6% 3.4% 3.5% 3.1% FY11 3.7% 3.6% 3.8% 2.8% 2.8% 3.0% 2.9% 3.1% FY12 FY13 NIM (%) Spread (%) FY14 FY15 4.0% 3.3% 4.4% 3.7% 4.6% 4.7% 4.0% 4.0% Fee income to gain from higher PSLCs IIB s currently meets its PSL target as c42% of its loans are PSL compliant. Incrementally, entire 100% loan book of BFIL will be eligible for PSL loans leading to a nearly 10% surplus of PSL loans for IIB. These loans can be used to generate additional fee income from Priority sector lending certificates (PSLCs) which make lucrative fees for the bank (c1.5% of the amount). Coupled with the cross-sell potential of other fee items at BFIL s branches (microinsurance, micro- MFs etc), overall core fee/assets for IIB is expected to improve even on an increased asset base. JM Financial Institutional Securities Limited Page 7

8 Exhibit 17. Core fee growth to improve from PSLC gain (%) Core fee income (Rs bn) Core fee income growth (%) FY12 FY13 FY14 FY15 Exhibit 18. Core fee/ assets to improve on a higher asset base (%) 2.6% 2.5% 2.4% 2.3% 2.2% 2.1% 2.0% 2.21% 2.45% Core fee Inc /Assets 2.51% 2.45% 2.47% 2.49% 2.52% FY14 FY15 Opex and credit cost remain further levers for ROA improvement Under its PC-4 cycle, IIB is already aiming to bring down its Cost-to-income by 200bps through optimizing size and headcount of the new branches as well as better utilization of current workforce. BFIL too has been on a steady cost optimization path to achieve its medium term target of 40% CI ratio (51% as on 1QFY18 Vs 61% in FY15). Hence, with no near term pressure on costs, CI ratio for the merged entity will gain from higher income over FY18-20E. Credit costs too have peaked for IIB in and BFIL has provided for nearly all of the affected loans from demonetisation period. On the loans disbursed post Jan 17, BFIL has collections in excess of 99.6% indicating normalization of leftover impact of demonetisation or farm loan waivers. Disbursements are likely to further pick up in the second half of the year for MFI loans. While we build an improvement of c280bps in CI ratio over FY18-20E and avg. 80bps credit cost over FY19 and for the merged entity, we believe trends in both of these can be better than expected and thus, remain an important lever for further RoA improvement in to 2.3%. Exhibit 19. CI ratio set remain on improving trajectory (%) 50% 48% 46% 44% 42% 46% 48% 47% C-I Ratio 47% 48% 46% 45% Exhibit 20. Cost/assets trends (%) 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 2.7% Cost / Assets (RHS) 2.9% 2.9% 3.0% 3.2% 3.2% 3.2% 40% FY14 FY15 0.0% FY14 FY15 JM Financial Institutional Securities Limited Page 8

9 Exhibit 21. GNPLs and NNPLs to remain under control (%) FY Gross NPLs (%) Net NPLs (%) Coverage (RHS) (%) FY13 FY14 FY Exhibit 22. LLP costs may surprise on the positive side (%) FY FY FY FY15 LLP (%) RoAs to touch 2.25% and RoE nearing 21% by Driven by improved margins, better fee income profile and controlled operating & credit costs, merged IIB s RoA is expected to improve from 1.9% currently to 2.24% in with cost levers providing further headroom to touch 2.30%. Though equity base is set to increase with capital infusion from the promoters, RoEs too are expected to improve significantly and touch c.21% by. Exhibit 23. On track for Industry leading RoAs and RoEs (%) 25% 20% ROE (RHS) 1.82% 1.80% 1.83% ROA (LHS) 2.11% 2.24% 2.5% 2.0% 15% 10% 5% 17% 15% 16% 19% 21% 1.5% 1.0% 0% 0.5% JM Financial Institutional Securities Limited Page 9

10 Financial Tables (Merged) Profit & Loss (INR mn) Y/E March A A Net Interest Income 45,166 60,626 86, , ,881 Profit on Investments 1,453 2,769 3,000 2,500 2,500 Exchange Income 8,370 9,195 10,601 12,290 14,274 Fee & Other Income 23,147 29,751 40,759 54,834 71,061 Non-Interest Income 32,969 41,715 54,360 69,624 87,835 Total Income 78, , , , ,715 Operating Expenses 36,721 47,831 67,277 87, ,902 Pre-provisioning Profits 41,414 54,510 73, , ,814 Loan-Loss Provisions 6,141 10,506 13,943 14,050 17,368 Provisions on Investments Others Provisions , Total Provisions 6,722 10,913 15,779 14,800 18,168 PBT 34,693 43,597 57,714 86, ,646 Tax 11,828 14,918 19,623 29,279 39,898 PAT (Pre-Extraordinaries) 22,864 28,679 38,091 56,836 75,748 Extra ordinaries (Net of Tax) Reported Profits 22,864 28,679 38,091 56,836 75,748 Dividend paid 3,522 4,320 5,714 8,525 11,741 Retained Profits 19,343 24,359 32,377 48,311 64,007 Balance Sheet (INR mn) Y/E March A A Equity Capital 5,950 5,981 6,995 6,995 6,995 Reserves & Surplus 167, , , , ,991 Deposits 930,003 1,265,722 1,620,124 2,106,162 2,674,825 Borrowings 221, , , , ,871 Other Liabilities 72,186 89, , , ,580 Total Liabilities 1,396,762 1,782,738 2,383,327 3,009,906 3,760,262 Investments 312, , , , ,033 Net Advances 884,193 1,130,805 1,559,410 1,980,451 2,515,173 Cash & Equivalents 121, , , , ,410 Fixed Assets 8,746 9,606 12,680 16,137 19,032 Other Assets 70,561 89, , ,910 93,615 Total Assets 1,396,762 1,782,738 2,383,327 3,009,906 3,760,262 Key Ratios Y/E March A A Growth (YoY) (%) Deposits Advances Total Assets NII Non-interest Income Operating Expenses Operating Profits Core Operating profit Provisions Reported PAT Yields / Margins (%) Interest Spread NIM Profitability (%) Non-IR to Income Cost to Income ROA ROE Assets Quality (%) Slippages Gross NPA Net NPAs Provision Coverage Specific LLP Net NPAs / Networth Capital Adequacy (%) Tier I CAR Dupont Analysis (%) Y/E March A A NII / Assets Other Income / Assets Total Income / Assets Cost / Assets PBP / Assets Provisions / Assets PBT / Assets Tax rate ROA RoRWAs Leverage ROE Valuations Y/E March A A Shares in Issue EPS (INR) EPS (YoY) (%) PER (x) BV (INR) BV (YoY) (%) ABV (INR) ABV (YoY) (%) 50.2% 16.4% 18.9% 17.1% 19.4% P/BV (x) P/ABV (x) DPS (INR) Div. yield (%) JM Financial Institutional Securities Limited Page 10

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