Kotak Mahindra Bank (KMB IN) Dial 811 for growth

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1 INSTITUTIONAL EQUITY RESEARCH Kotak Mahindra Bank (KMB IN) Dial 811 for growth INDIA BANKING Initiating Coverage Financialisation of savings is a big structural change in India s economy. Some banks took asset quality shocks, making them risk averse, which led to a shift in loan market share to a few strong private banks. The financial ecosystem created by Kotak is well poised to capture the benefits of this financialisation. Its digital strategy of 811 has seen early success with c6 growth in its total customer base. Strong customer acquisition on the liability side in a cost effective manner should enable the bank to augment its low cost deposits even further to 58% by FY21 from 51% at present. Kotak is well positioned to capture loan marketshare and the rising interest rate environment bodes well for it as it has a high proportion of low cost deposits. Its superior underwriting skills, strong monitoring of portfolio, and cost optimisation should lead to enhanced return ratios we see RoA by FY21 (1.7% in FY18). Our Buy rating is based on the following: 58% CASA ratio by 2021: Kotak s customer base has increased by c.6 in FY18 to c.13mn, up from 8mn in March We estimate that c.7 of its new customers came from 811 (digital banking); 811 will continue to provide strong traction in terms of customer growth, resulting in high growth in savings deposits. Kotak s savings deposit base should more than double over the next three years with market share increasing to 3.1% from 1.8% in March 2018; as a result, its CASA should touch 58% by NIM to see uptrend: We estimate NIMs to rise from here mainly on: (1) Rising yield: 10 year government bond yield has increased by 55bps since March 2018; we believe this will push up asset yield (as 6 of loan book is floating), leading to an uptick in NIMs, (2) increasing lending towards high yielding assets (increased focus towards CV/CE), and (3) shifting funding mix towards a low cost deposit base. Overall, we expect NIMs to increase by c.19bps over FY Loan growth momentum to continue: Kotak restarted its growth engine in FY18 after successful integration of ING. Loan book grew by 2 yoy mainly driven by CV/CE and corporate segments. The market remains conducive for the CV segment and Kotak should continue to capture share in corporate. Accelerated customer acquisition through 811 will also provide opportunities for cross selling retail loan products. We estimate a loan CAGR of 2 over the next three years (management s guidance is 2 loan growth in FY19). Positive on cost; asset quality stable: We believe cost synergies from the ING merger have already started to flow through; Kotak s cost to income ratio declined from 5 pre merger (FY15) to 48% in FY18. Its digital investments are also expected to bring in further operating efficiency. We expect cost to income ratio to continue falling to 44% by FY21. Kotak also has one of the best asset qualities in the industry, mainly due to its diversified portfolio, efficient risk monitoring, and control. We see no downside to asset quality from here (in fact, we expect it to remain strong). Subsidiaries to benefit from a shift in the savings market: The share of financial savings in India as a % of total household savings increased to 41. in FY16 from 31.1% in FY12. In FY17, investment in shares & debentures increased to 1 from 2.7% in FY16. Kotak s subsidiaries, which provide services across products (from insurance to asset management to securities) are likely to be key beneficiaries of this shift. A large part of the customers of its subsidiaries (4 for securities, 5 for insurance) are acquired through Kotak Bank; hence, an increasing customer base will provide higher cross selling opportunities. Recommendation and valuation: We expect earnings CAGR of 28% over FY19 21, resulting in a FY21 ROA of 2.0x. Based on the SOTP method, we arrive at a target of Rs 1,545, translating into an implied P/adjusted BVPS of 3.7x FY21 (adjusted BVPS of Rs 292). We initiate coverage on Kotak Mahindra Bank with a Buy rating. 20 June 2018 BUY CMP RS 1320 TARGET RS 1545 (+17.) COMPANY DATA O/S SHARES (MN) : 1906 MARKET CAP (RSBN) : 2533 MARKET CAP (USDBN) : WK HI/LO (RS) : 1396 / 515 LIQUIDITY 3M (USDMN) : 39.3 PAR VALUE (RS) : 5 SHARE HOLDING PATTERN, % Mar 18 Dec 17 Sep 17 PROMOTERS : FII / NRI : FI / MF : NON PRO : PUBLIC & OTHERS : PRICE VS. SENSEX Jan 17 Jul 17 Jan 18 Kotak Bank BSE Sensex KEY FINANCIALS Rs bn FY18 FY19E FY20E Pre prov ROE (%) 20.7% 22.7% 24.9% Pre prov ROA (%) % Net Profit % growth 19.7% 33.7% 25.4% EPS (Rs) Adj BVPS (Rs) ROE (%) % 14.9% P/E (x) 40.0x 30.0x 24.0x Adj P/BV (x) 4.5x 4.0x 3.4x PC ESTIMATES VS CONSENSUS FY19E FY20E NII PPP 2.4% 3.7% PAT 3.6% 4. Source: PhillipCapital India Research Est. PhillipCapital India values your support in the Asiamoney Brokers Poll We appreciate your vote. Sujal Kumar ( ) skumar@phillipcapital.in Manish Agarwalla ( ) magarwalla@phillipcapital.in Page 1 PHILLIPCAPITAL INDIA RESEARCH

2 Kotak s profitability and RoA to improve from here We see its RoA at 2. by 2021 from 1.7% in FY18. Digital banking initiatives (especially 811), rising yield, and declining cost to income ratio will be major drivers Kotak s share price has risen 309% in the last five years, outperforming the Bank Index by 173%. However, in the same period, Kotak s RoA declined to 1.7 in FY18 from 1.8 in FY13. The decline was predominantly driven by integration related issues and a fall in NIMs (4.4% in FY18 from 4.6% in FY13), which was somewhat offset by a lower cost to income ratio (48.1% in FY18 from 52. in FY13). Kotak Bank: RoA movement over FY13 18 Kotak Bank: RoA movement over FY % 0.1% 0.1% % 0.1% % % 0.1% 0.1% % 0.1% RoA (2013) NII Non NII Opex Provision Other RoA (2018) RoA (2018) NII Non NII Opex Provision Other RoA (2021) We estimate Kotak s profitability to increase from here and believe it can generate a RoA of 2. by Major drivers for increased profitability: 1) Digital banking initiatives to drive growth: Kotak increased its customer base by c.6 in FY18 to 13mn. We believe c.7 of these new customers were acquired through 811 accounts (zero balance digital bank accounts that it launched in April 2017). Traditionally, Kotak has targeted mass affluent customers for its deposit base. With 811, it will be able to tap mass customers without investing a significant amount in establishing physical infrastructure. We believe that as they mature, these new 811 customers will also provide huge cross selling opportunity for Kotak. We expect momentum in its fee income to continue, driven by higher cross sell opportunities to a growing customer base. 2) Deposit growth to drive up CASA ratio to 58% by 2021: Kotak s savings deposits have more than doubled since FY16 to Rs 655bn in FY18 and they were up by 58% in FY18, mainly on strong customer growth due to 811. By 2021, we expect Kotak s savings deposits to once again more than double to Rs 1,510bn; resulting in a CASA ratio of c.58%, up from 51% in FY18. 3) NIMs to start uptrend: Kotak s net interest margin declined to 4.37% in FY18 from 4.77% in FY14 mainly due to softening of interest rates, resulting in lower yields and merger related issues. However, NIMs should see an upturn from here, as the funding profile continues to shift towards low cost deposits and increasing lending towards higher yielding assets. KMB has increased its 6M MCLR by 15bps during current fiscal. We model a 19bps NIM increase over the next three years. 4) Cost growth to be slower than revenues: We believe merger related synergies have started to flow in, and Kotak is now operating at an efficiency that is even better than its pre merger operating efficiency. Cost to income ratio should continue to fall; we model 44% CIR in FY21. Page 2 PHILLIPCAPITAL INDIA RESEARCH

3 811 will strengthen Kotak s liability franchise further Kotak s savings deposit base more than doubled to Rs 655bn in FY18 over FY16; we believe growth will continue. Savings deposits will increase by 2.3x over the next three years, with CASA ratio reaching 58% in FY21 Kotak s strategy for deposit growth and market share has primarily revolved around offering higher deposit savings rates vs. competition. The strategy has worked well until now; in the 10 year period ending FY15, Kotak s deposit base saw 33% CAGR. Growth declined to c.14% in FY17, mainly due to integration related issues, but rebounded in FY18 to 21%. Kotak has been able to improve its CASA ratio to 51% in FY18 (from 29% in FY13) backed by strong deposit growth. The key question now is will Kotak be able to grow its deposit base at a similar pace ahead? We believe the answer is yes. Our reasons are listed below. Deposit growth (Rs bn) 4,000 3,500 3,000 2,500 2,000 1,500 1, Pre Merger CAGR of 33% Integration Phase14% 1,386 1,574 Post Integration 2 1,926 2,349 2,877 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19e FY20e FY21e 3,516 CASA as a % of total deposits 6 51% 5 44% 4 36% 38% 3 29% FY13 FY14 FY15 FY16 FY17 FY18 Increasing focus on mass customers for growth Traditionally, Kotak has been targeting mass affluent customers for its deposit base. As of March 2013, it s CASA and TDs above Rs 50mn were 41% of its total deposits however, it has since diversified its customer base, and this ratio has declined to 23% as of March More of Kotak s branches (c.66%) are in metro or urban areas, compared to overall private banks (5). It has also one of the highest per customer CASA deposits in India, suggesting that a large portion of its deposits is from urban mass affluent customers. Foreign banks, with c.94% of their branches in urban locations, have a strong hold in the HNI segment their average savings deposit per client is over Rs 194,000. CASA and TDs above Rs 50mn as a % of total deposits 4 41% 4 37% % 2 23% Jan 13 Jan 14 Jan 15 Jan 16 Jan 17 Jan 18 Deposits landscape of Indian banks Avg Savings Deposit Per account f Kotak Private Banks 20 SBI Nationalised Bank % of Branch in Metro and Urban > Foreign Banks (Rs 194 k, Page 3 PHILLIPCAPITAL INDIA RESEARCH

4 Savings deposits growth for metro and urban geographies (key markets for Kotak) seems to be moderating. As shown in the chart below, during the five year period ending March 2016, average savings deposit growth in metro + urban locations was c.12.4% vs. average growth of c.19 2 from Growth spiked in 2017, mainly due to demonetisation, but for the nine months ending December 2017, savings deposit growth again slowed down to c.. We believe Kotak will need to expand its branches/reach to semi urban locations to fuel the next phase, as deposit growth in its primary markets (metro and semi urban locations) matures. Savings deposit growth in metro + urban geographies 3 Kotak: Product coverage across customer segments Avg: 19.1% Avg: 2 1 Avg: 12.4% 1 Mar/01 Mar/02 Mar/03 Mar/04 Mar/05 Mar/06 Mar/07 Mar/08 Mar/09 Mar/10 Mar/11 Mar/12 Mar/13 Mar/14 Mar/15 Mar/16 Mar/17 9M Dec 17 Source: Company, RBI, PhillipCapital India Research 811 as a cost effective alternative: 811 will help Kotak to tap into the semi urban and rural markets, in our view, without investing significant amounts in creating physical infrastructure. As of March 2018, 6 of 811 customers were from top 20 cities, suggesting that the mass market in semi urban areas is still largely untapped, providing a huge opportunity for Kotak to grow its deposit base. Branch strategy: With 811 in place, Kotak believes that it does not need a large network of branches to acquire customers; hence, it need not expand its branch network aggressively. However, this does not mean that the bank would not have to invest in branches, as these are required for cross selling and to serve digital customers. Branches are also needed to perform a full KYC for 811 acquired customers, which is the key for Kotak, as it would want to convert these customers to full time customers and start cross selling to them. Kotak currently offers 811 accounts only to customers residing in c.6,700 (out of over 19K pin codes) pin codes in India. As it opens more branches and brings more pin codes into its serviceable area, the reach of 811 will also increase. 811: A customer acquisition engine 811 was launched in March 2017 as a part of Kotak s strategy to acquire customers in a cost effective way, targeting the mass segment. Through 811, Kotak offers a savings account that can be opened by downloading the bank s app and authenticating with Aadhar credentials via OTP. With this, Kotak has strengthened its presence in all customer segments. Key features of 811 are: Zero balance savings account Zero charges for all digital transactions 6% interest rate offered on savings account balances > Rs 100,000 and < Rs 100mn Virtual debit card Page 4 PHILLIPCAPITAL INDIA RESEARCH

5 Notably, the account has a maximum balance limit of Rs 100,000, but customers can undergo full KYC within a year to avail higher balances and other services. Several other banks have also launched similar offerings, but we believe Kotak provides the best features. Digital accounts offered by various banks in India KOTAK DBS AXIS SBI ICICI RBL STAN Account 811 DigiBank ASAP Yono Pocket Abuscus SC Digital Account Avg Monthly Balance Zero Zero Zero Zero Zero - Age (18-25) 5,000-Age (25 +) Interest Rate Less than 1 Lakh: Between 1 Lakh to 1 Cr: 6% Over 1 Cr: in Savings Account Over 10K in TD account: 7.1% % Features 1) Zero Balance 1) Zero Balance 1) Zero Balance 1) Zero Balance 1) Debit Card 1) Debit Card 1) Debit Card 2) Virtual Debit Card 2) Investments 2) Virtual Debit Card 2) Ru Pay Card 2) 10 Leaves checkbook 2) Fixed Deposit 2) Investments 3) Book FD & RD Online 4) Online Shopping 5) Investments 3) Instant Personal Loan 4) 24X7 Virtual Assistant 3) Auto Sweep FD 4) Online Shopping 5) Investments 3) Instant Loan 3) Recurring Deposit 3) Investments Documents Required 1) Aadhar 2) PAN 1) Aadhar 2) PAN 1) Aadhar 2) PAN 1) Aadhar 2) PAN 1) Aadhar 2) PAN 1) Aadhar 2) PAN 1) Aadhar 2) PAN How to Open Mobile App Mobile App Mobile App Mobile App Mobile App Online Online App: No of Downloads 10+ Million 1+ Million 10+ Million 5M+ 5M+ 100k+ 500k+ App: Rating (Google) Source: Company, Phillip Capital India Research Accelerated customer growth at a lower acquisition cost. Kotak has been able to acquire customers at a faster pace with c.8 lower cost compared to the past with its 811 franchise. Since the launch of 811, Kotak has been acquiring c mn customers per quarter on an average compared to customer additions of c mn per quarter before the ING merger. As a result, Kotak increased its customer base by c.6 in FY18 to c.13mn. The bank has a target of doubling its customer base to 16mn by September 2018; at its current customer acquisition run rate of c.1.5mn per quarter, the bank will be able to exceed this target easily, in our view. Assuming that customer acquisition through the traditional channel was similar to the pre merger run rate (c.0.25mn per quarter), we estimate that c.7 of new customers acquired since March 2017 have come from 811. Kotak s customer acquisition quarterly run rate (mn) Pre ING Merger After 811 Launch Total customer growth (mn) Traditional Customer 811 Customer Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 1Q18 2Q18 3Q18 4Q18 0 4QFY17 1QFY18 2QFY18 3QFY18 4QFY18 Page 5 PHILLIPCAPITAL INDIA RESEARCH

6 can lead to doubling of deposit base over the next three years We believe successful execution of 811 can lead to significant accretion of Kotak s deposit base. We estimate total CASA deposits almost doubling over the next three years, with a CASA ratio touching 58% based on the following assumptions: 1) Out of 8mn customers as of March 2017, c.6 were pure savings customers. 2) Assuming 1 of new customers acquired are pure asset side customers. 3) Kotak will continue to increase its traditional customer base at a pre 811 run rate. 4) 1 of 811 customers are likely to drop out within the first year (in FY19), which will taper to a dropout rate in FY21. 5) As Kotak penetrates mass customers in tier 2 and tier 3 cities, average balance of new customers declines. 6) Average savings account balance per customer (traditional customers) will increase by c.1 per year. Based on the assumption above, we estimate average balance for 811 customers is currently likely to be around Rs 10 11,000, but this should increase as customers mature. We estimate average balance of 811 customers to increase at a CAGR of 7% over the next three years. Kotak 811 and traditional customer progression Opening Customers (mn) FY18e FY19e FY20e FY21e Comments Savings (Traditional) Assuming c.6 of 8mn customers in March 2017 were savings account customers Total Net New Customer (mn) Savings (Traditional) Acquisition run rate for traditional customer to remain the same. Dropout rate for 811 customers to be 1 in Total FY19 declining to in FY21 Closing Customer (mn) Savings (Traditional) Total Avg SA Per Customer (Rs) Savings (Traditional) 1,05,030 1,15,533 1,27,087 1,39,795 Assuming average customer balances to increase ,175 10,802 11,570 12,559 overtime Total SA (Rs mn) Savings (Traditional) 6,19,679 8,08,734 10,43,382 13,33, ,611 71,934 1,17,658 1,76,539 Total SA (Rs mn) 6,55,290 8,80,668 11,61,040 15,10, as a % of SA 5.4% % 11.7% CASA ratio 51% 54% 56% 58% Page 6 PHILLIPCAPITAL INDIA RESEARCH

7 We believe Kotak has significant potential to increase its deposit base, as: 1) It continues to pay higher interest on savings products vs. competition. 2) Incremental customer acquisition through 811 strategy. 3) Increase in average balance as new customers mature. KOTAK MAHINDRA BANK INITIATING COVERAGE Kotak s savings deposit base grew by 58% in FY18 (after the launch of 811) and its market share increased to 1.8% as of 4QFY18 from 1.3% in 1QFY18. We estimate its deposit base growing at an average of 23% in FY19 21 and its savings account market share increasing to 3.1% by Kotak s savings account (Rs bn) growth and market share 1,800 1,600 1,400 1,200 1, % Savings deposits 1.6% 1. Market Share % % 1, % 1, QFY18 2QFY18 3QFY18 4QFY18 FY19e FY20e FY21e Source: Company, RBI, PhillipCapital India Research 0....followed by revenue growth The customer profile of 811 mostly young, technology savvy, and with very low brand loyalty provides limited initial revenue opportunities. As shown in the chart below, retail loans per customer has declined by c.2 over the year, suggesting that there is low penetration of loan products among newly acquired customers. However, we believe that better engagement with these customers will help Kotak to cross sell its asset side products, providing revenue opportunities ahead. Customer profile: 811 Retail loan per customer (Rs 000) 811 key highlights 44% of 811 customers Salaried employees 9 Customers between years of age 6 of 811 Customers come from top 20 cities QFY17 1QFY18 2QFY18 3QFY18 4QFY18 As 811 customers are more digitally savvy than others and therefore less branchintensive, catching them young will provide the bank with long term revenue opportunity at much lower cost. Page 7 PHILLIPCAPITAL INDIA RESEARCH

8 Digital bank opportunities in India: DBS case study Successful execution of a digital strategy will be a key driver for growth for all businesses. In this report, we have looked at various aspects of digital banking, the opportunities in India, and for Kotak Mahindra Bank in particular Way back in 1994, Bill Gates said that Banking is necessary, but banks are not and this seems to be coming true. Technological developments and shifting demographics are changing consumers preferences. The new generation of millennials prefer banking on the go and avail services through online and social media based platforms instead of coming to banks. Globally, banks are responding to these change and moving rapidly to embrace digital technologies. They are making substantial investments in creating digital infrastructure with an aim to provide banking services through digital platforms such as mobile, tablets, and the internet. Another key driver for this shift towards digital adoption is higher estimated profitability through lower cost and higher customer engagement. As per McKinsey, setting up of a digital bank takes substantially lower capex (about 2 of the traditional) and operating expenditure (about 5 of the traditional) per customer, compared with traditional banks. This lower cost is a result of: (1) absence of physical branches, (2) simplified product offerings, and (3) streamlined processes. Any cost incurred for creating digital infrastructure is likely to be offset by operating efficiency achieved by using integrated channel strategy. As shown in the chart below, the cost of transaction through mobile is around 50 times lower than via branches and around 10 times lower than via ATMs. Hence, any shift in banking transactions from the high cost channels (branches and call centres) to low cost channels (mobile and ATMs) should result in significant cost saving for banks. IT cost: Digital banks takes lower capex and opex (USD mn) Relative transaction cost per channel Depreciation Opex Branch 10 Call Center 94% IVRs 31% ~ ~5 ~15 Traditional Digital Traditional Digital Capex IT Maintainance Opex and Depreciation ATM Online Mobile 4% 21% Source: McKinsey (Building a digital banking business), Tower Group, Fiserv/M Com DBS case study: Digital vs. Traditional bank Though it is difficult to exactly quantify the benefits of moving to digital banking, DBS, in its 2017 investor day, constructed a Digital vs. Traditional P&L for its consumer/sme bank of Singapore and Hong Kong. This gives us some indication about the profitability of digital banking. According to DBS, digital customers generate higher income per customer (2x) at a lower cost (20pp lower CIR) compared to traditional customers, thus generating a higher RoE of 27% vs. 19% for traditional customers. In this exercise, DBS identified a digital customer based on three behavioural criteria: 1) Product purchase via digital channels 2) > 5 of on going financial transactions through digital channels 3) > 5 of non financial transactions are digital Page 8 PHILLIPCAPITAL INDIA RESEARCH

9 Customers were reviewed on a rolling 12 month basis to re qualify as digital vs. traditional. Based on its criteria, DBS separated a total customer base of 5.9mn (2017) into 3.6mn traditional and 2.3mn digital customers. As shown in the charts below, income generated per digital customer of SGD 1,306 is more than 2x that of a traditional customer of SGD 568. Cost to income for the digital P&L comes to around 34% vs. 5 for traditional customers. Overall, digital customers generate an ROE of 27%, much higher than traditional customers 19%, suggesting that changing mix towards digital customers should improve per unit revenues, reduce cost income ratio, and drive up ROE. DBS: Traditional vs. digital P&L (SGD bn) Income Per Customer % CIR % DBS: Traditional vs. digital RoE 3 RoE % 19% 19% % 27% Traditional Digital Traditional Digital Source: DBS Digital Investor Day Presentation DBS Digibank (India) DBS launched a mobile only Digibank in India in April 2016, with a target of acquiring 5mn customers and a deposit base of Rs 500bn by With this launch, it planned to diversify its customer base to mass customers from affluent customers. As of October 2017, the bank had already acquired 1.5mn customers using just onefifth of the resources required by a traditional bank setup. As shown in the chart below, cost per acquisition for 2017 (YTD) was SGD 23 and the target is to move this to SGD 18 by Further, average balances increase over time, as customers become more engaged. Digibank: Reducing cost of acquisition Average balance based on vintage Source: DBS Digital Investor Day Presentation Page 9 PHILLIPCAPITAL INDIA RESEARCH

10 Digibank s growth was helped by demonetisation and UPI, as shown in the chart below, number of transactions has increased 25x since the launch and major push was due to demonetisation and UPI launch. Value of transactions per month has also increased by around 11x since launched. Digibank: No. of transactions per month (3M moving avg) Value of transaction per month (3M moving average) Source: DBS Digital Investor Day Presentation We believe successful customer acquisition achieved by DBS, with limited branches, bodes well for Kotak which has a more comprehensive branch network and better brand recognition in India. Digital banking opportunities in India Through its initiatives such as Digital India, Aadhar, UPI, Bharat Bill Pay, and GST the Indian government has created a robust digital ecosystem, providing huge opportunity for digital banking in India. 365mn potential customers: In its digital strategy investor day in November 2017, DBS estimated around 100mm affluent and 265mn emerging affluent consumers for its Digibank franchise in India thus, a total market size of 365mn customers. While digital banking penetration for affluent customers was estimated to be c.2, digital penetration around emerging affluent was higher at 4, resulting in c.140mn addressable digital population, which is likely to increase with increasing penetration. Digital banking opportunity in India Source: DBS Digital Investor Day Presentation Digital banking growth in India, in our view, will depend of three main factors: 1) Digital infrastructure 2) Favourable regulatory framework 3) Willingness of customers to adopt digital technologies Page 10 PHILLIPCAPITAL INDIA RESEARCH

11 Digital infrastructure: We believe India has well developed digital infrastructure in place. It has one of the largest populations of mobile phones and internet subscriptions, which is expected to grow further. According to Nasscom s The Future of Internet in India report, by 2020: 1) Internet users will double to 730mn from 350mn 2) Around 7 of new connections will come from rural areas 3) 7 of new users would consume data in local languages 4) Smartphone users will grow significantly to 702mn 5) 7 of ecommerce transactions will be through mobile phones 6) India will remain the fastest growing internet market Mobile phone subscribers (mn) Internet subscribers (mn) Aadhar enrolments (mn) 1, ,400 1,200 1, ,200 1, , , Source: TRAI Performance Indicator, UIDAI Regulatory environment: One of the major regulatory hurdles for digital banking in India was the cumbersome KYC process. However, with Aadhar enabled e KYC, this has become quite easy. Banks and fin tech firms are now using OTP based KYC through Aadhar. Almost all mobile only banks use e KYC to save both cost and time (vs. the tedious paper heavy process). Willingness to adopt fin tech: According to EY, India s fin tech adoption rate is second only to China at 5, which means that Indian consumers are quite open to newer technology and innovation. This augurs well for digital banking adoption. In terms of business category, adoption is more concentrated towards payments & transfer, insurance, and savings & investments businesses. We believe that once the customer acquisition phase is over, advance analytics initiatives will help banks to cross sell their products, and adoption rates for lending and financial planning businesses will increase going forward. Fin tech adoption rate Fin tech adoption by category China India UK Brazil Australia Spain Mexico Germany South Africa US Hong Kong South Korea Switzerland France Netherlan Ireland Singapore Canada Japan BE & LuX Payments & Transfer Financial Planning Savings & Investments Borrowing Insurance 1 China (83%) China (2) China (58%) China (46%) India (47%) 2 India (7) Brazil (21%) India (39%) India (2) US (43%) 3 Brazil (6) India (2) Brazil (29%) Brazil (1) China (38%) 4 Australia (59%) US (1) US (27%) US (13%) South Africa (3) 5 UK (57%) HK (13%) HK (2) Germany (1) Germany (31%) Source: EY FinTech Adoption Index Page 11 PHILLIPCAPITAL INDIA RESEARCH

12 Kotak s digital banking strategy Kotak began its digital journey with the launch of its mobile app in April Since then, it has been investing considerably in building its digital franchise. It has made significant progress towards digital transformation across all its major activities including lending, deposit, automation, sales force effectiveness, and process automation. It has developed a comprehensive digital offering over the years, across internet and mobile platforms in order to accelerate its customer acquisition and achieve deeper engagement with existing customers. We believe Kotak is well positioned to ride the digital wave with cost effective customer acquisition and cross selling a wider range of products on its digital platform to satisfy customers' needs. The table below lists a few of the major initiatives that Kotak has taken in its digital transformation journey. Kotak s digital initiatives timeline (not exhaustive) Time Digital Initiative Details April 2013 Mobile app Launched March 2014 Kotak Jifi First of its kind social bank account, combining the power of social media with conventional banking March 2014 Hashtag Banking Using Twitter to offer 23 banking services including Mobile and DTH recharge Oct 2014 KayPay World s first any bank to any bank funds transfer platform via Facebook powered by a bank Dec 2014 Mail & Message Money First bank to launch and mobile number based fund transfers Jan 2015 Kotak Jifi Saver Accounts Account managed via customers Twitter and Facebook pages June 2015 Bharat Banking App India's first internet free multilingual banking app to provide mobile banking services to the unbanked 2016 mstore Integrating ecommerce into Kotak s digital offering June 2016 TAB Banking Automation of the savings account on boarding process for corporate salaries (2 of corporate sourcing through TAB) LMS Mobile App Mobile based lead management cum activity tracker April Instant A/c opening anytime and anywhere in five minutes 2017 Kotak Digital Branch 24X7: State of the art lobby and customer friendly layout WIFI, digital signage, quick service tablets 3Q17 Biometric Authentication Introduced facial authentication (under biometric) in its mobile banking app; both facial and fingerprint available Q India s first Bi Lingual Voicebot, Keya, at customer care centres To help customers navigate quickly, Keya speaks both English and Hindi Kotak s digital banking strategy: Kotak has basically adopted a four pronged digital strategy, focusing on: 1) Acquiring customer: Scale acquisition at an efficient cost Kotak launched 811 (digital savings accounts) in April 2017 in order to ramp up its customer acquisition with a target of doubling its customer base to 16mn in September 2018 from 8mn in March ) Customer experience: Look at differentiated customer service Kotak offers more than 100 features through its mobile app, including managing financial transaction, money transfer through NEFT, IMPS, RTGS, shopping via Flipkart, booking movies tickets, flights, etc. 3) Efficiency: Making internal business operations more efficient Kotak continues to invest in technology to improve its banking operations and efficiency, and to reduce errors arising out of manual intervention. 4) Cyber security: Enhancing cyber security and data protection framework, including fraud prevention Cyber security is one of the key risks for digital banking. Inadequate security measures might result in cyber fraud and thefts, leading to reputation damage for Kotak. We believe enhanced security measures are one of the key drivers for the bank s digital strategy success. Page 12 PHILLIPCAPITAL INDIA RESEARCH

13 Key digital highlights Among top 5 banks in mobile transactions both in terms of value and volume. Kotak s market share in mobile transactions is 8.4% by value and 4. by volume for July November 2017, corresponding to 1.6% share of deposits and 2.7% share of loan. Mobile transaction market share (Jul Nov 2017) Deposits and advances market share % 14% 17% 16% 14% 1 14% 19% Value Volume % 24% Deposit Loan 1 8% 1 ICICI AXIS SBI HDFC 3% 1% 4% 1% Kotak Indusind Citi BoB RBL Yes 1 SBI 6% 9% HDFC BoB BoI 6% 4% 6% ICICI CAN AXIS 3% 1% 1% 3% Kotak Indusin d Yes Source: RBI, Company, PhillipCapital India Research Highest digital active customers: Kotak has one of the highest percentages of digitally active customers. As of March 2018, 66% of the bank s active customers were digitally active, compared to 58% for Axis Bank. We estimate ICICI and SBI to have around 31% and 16% digitally active customers. Digital active customers as a % of total customers 7 66% 6 58% % 1 SBI ICICI Axis Kotak One of the highest digital acquisitions: As of 2017, c.7% of Kotak s total liability acquisition was through the digital channel; 88% and 69% of Kotak s recurring and fixed deposits (retail) were sourced digitally as of 4QFY18, up from 6 and 5 in 2QFY17. Asset side growth was also picking up with 3 of salaried personal loan sourced digitally in 4QFY18 vs. 13% in 2QFY17. Page 13 PHILLIPCAPITAL INDIA RESEARCH

14 Liability side growth Asset side growth (salaried personal loans sourced digitally) Recurring Deposit Sourced Digitally Fixed Deposit Sourced Digitally % 63% 69% 59% 77% 66% 83% 6 88% 69% % 1 19% 21% 29% Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 Leading bank in digital sales: According to a global benchmarking survey conducted by Finalta in on 100+ banks, Kotak was one of the leading banks in India in terms of digital sales. Out of every 1,000 active customers, it acquired 133 customers through digital sales vs. an India average of 80 and global average of 74. In terms of 90 day digital activity level changes, Kotak saw an activity level increase of 8.1% compared to an India average of 3.9% and global average of 3.6% Leading bank in digital sales Digital activity growth 133 Public Site Secure Site Mobile App Digital Mobile Kotak India Avg Global Avg Aus/NZ Kotak India Avg Global Avg Aus/NZ Page 14 PHILLIPCAPITAL INDIA RESEARCH

15 Loan growth gathering momentum Corporate banking book to grow at an average 2 in FY19 21, CV/CE book CAGR of 2, business banking to slowly pick up from FY20 Kotak s loan book CAGR was c.3 (to Rs 662bn) over a 10 year period ending March 2015 (before the merger with ING in FY16). Integration challenges and demonetisation resulted in loan growth falling to 1 in FY17. After a successful ING integration, Kotak s restored its growth (in FY18) with loan book rising by 21%. Merger synergies helped Kotak to grow its corporate loan book, resulting in corporate book exposure increasing to 59% of total loan book in FY18 vs. 56% in FY16. Kotak loan book (Rs bn) 3,500 3,000 2,500 2,000 1,500 Pre Merger CAGR of 3 Integration Phase 1 1,187 1,361 1,697 Post Integration 2 2,084 2,571 3,118 1, FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19e FY20e FY21e Loan book mix Segment wise loan breakup (March 2018) 10 8 Retail Corporate 56% 59% Small Business, PL & Credit Cards, 1 Others, Corporate Banking, 31% 6 4 Home Loans and LAP, 19% 2 44% 41% CV/CE, 9% FY16 FY18 Business Banking, 11% Agriculture division, 14% A substantial part of loan book growth over the past two years has come from corporate and CV/CE books, mainly due to Kotak s focus in the last months on growing these segments. As shown in the chart below, Kotak s CV/CE book grew by 38% and 4 in FY17 and FY18 respectively compared to a system loan growth of 11% and 1. Corporate loan book increased by 2 and 2 in FY17 and FY18 compared to flat system level growth. Loan books of small business, PL, and credit card and home loans also grew faster than the sector. Page 15 PHILLIPCAPITAL INDIA RESEARCH

16 However, loan book for business banking has been relatively flat over past two years, with no significant growth in either turnover or working capital requirement on the SME side due to demonetisation and GST implementation. Kotak: Segment wise loan book growth vs. sector (yoy) % Kotak Sector % 11% 1 1 8% 21% 3% 1% 14% 1 24% 16% 13% % 1 8% 8% FY17 FY18 FY17 FY18 FY17 FY18 FY17 FY18 FY17 FY18 FY17 FY18 FY17 FY18 Corporate banking CV/CE Agriculture division Business banking Home loans and LAP Small business, PL and Credit card Total Gaining market share Increased lending in corporate and CV/CE books has helped Kotak to capture market share in these categories. As shown in the chart below, market share gain is particularly strong in the CV/CE segment, where banks have increased market share to 12. as of FY18 from 7.9% in FY16. Market share of the corporate book increased to 2.3% in March 2018 up from 1. as of March Loan book growth by category (Rs bn) Corporate Banking Home Loans and LAP Small Business, PL& Credit Cards Mar 16 Mar 17 Mar Agriculture division Business Banking 79 CV/CE 152 Market share movement by category % Corporate Banking 3.1% Mar 16 Mar 17 Mar % Home Loans and LAP 1.1% 1.4% Small Business, PL& Credit Cards Agriculture division 3.7% 3.8% Business Banking 7.9% CV/CE 12. Management has guided for a 2+ loan growth for FY19. We list the key catalysts for loan book growth ahead Corporate banking: Kotak s corporate loan book CAGR was 23% over the past two years, and as of March 2018, it comprises 31% of total advances. Growth has mainly come from market share gains, as slow corporate credit off take in the economy over the past few years provided an opportunity to acquire some of the quality clients from PSU banks. As shown in the chart above, Kotak s market share in corporate lending has increased to 2.3% as of March 2018 from c.1. in March Kotak s corporate book is also well diversified with top 10 sectors contributing only 5 of total book, with loans to banks, CRE, and NBFCs comprising 11%, 7% and 6% of the total Loan book respectively. As shown in the chart below, lending growth over Page 16 PHILLIPCAPITAL INDIA RESEARCH

17 the past two years has mainly come from lending to Banks and NBFCs. Kotak also has significant exposure to the CRE sector. With a strong balance sheet, the management is targeting 20 2 growth in this segment. We estimate the corporate banking book to grow at an average 2 in FY Exposure to top 10 sectors (Rs bn) Banks 225 CRE 144 NBFCs Automobiles (inc ancilliaries) 88 Wholesale Trade FY16 FY17 FY18 Engineering 83 Food Processing 66 Iron & steel 61 Drugs & Pharma Logistics & Auxillary transport MHVC sales growth vs. Kotak loan growth (yoy) MHVC Sales Kotak CV/CE Loan Growth 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 Commercial vehicle/construction equipment: Kotak has almost doubled its CV/CE book over the past two years to Rs 152bn as of March 2018 from Rs 78bn in March The increase in loan disbursement was mainly driven by higher demand for commercial vehicles led by BS 4 transition in April Key catalyst for future growth opportunities in this segment: BS 6 transition April 2020: BS 6 norms are expected to come into force by April 2020; as a result, demand for commercial vehicles should remain high as fleet operators are likely to advance their buying decisions before prices increase under BS 6. Demand for higher tonnage trucks to increase due to GST: With the implementation of GST, companies have now started moving towards larger warehouses. This, in addition to stricter enforcement of overloading across the country, has resulted in more demand for higher tonnage trucks. Voluntary Vehicle fleet Modernisation Programme (V VMP) proposes to bring under its purview vehicles bought on or before March This will see medium and large fleet operators replacing their fleets, thereby spurring demand. Good monsoon and government spending in the infrastructure sector will continue to drive strong demand in tractor sales and in the CE industry. We estimate CV/CE book CAGR of 2 for FY Business banking: Kotak extends facilities to SMEs in the form of working capital finance and foreign exchange related requirements through its Business Banking Unit. Growth in this unit remained muted over the past two years mainly due to: (1) integration challenges as a significant portion of the current business banking loan book came from ING, and (2) demonetisation and GST implementation resulting in a drop in demand. Kotak had maintained a cautious stance towards SME lending and is waiting for the GST dust to settle. However, as shown in the chart below, credit exposure to MSMEs has recovered to pre demonetisation levels, and we believe that as growth starts Page 17 PHILLIPCAPITAL INDIA RESEARCH

18 picking up, Kotak will find lending opportunities in this space. We estimate growth to slowly start picking up in this segment from FY20. We estimate a 3% loan growth in FY19 increasing to 1/1 in FY20/21. Indexed credit exposure Source: MSME Pulse Report, Transunion Cibil Page 18 PHILLIPCAPITAL INDIA RESEARCH

19 NIM to turn around from here NIM will return to pre merger levels because of rising yield, loan mix changing towards high yield assets, good loan and deposit growth, and lower deposit costs Kotak s NIM declined to 4.37% in FY18 from 4.77% in FY14, mainly due to declining loan and investment yield and integration related issues. The impact was somewhat offset by considerable change in its liability profile due to strong growth in low cost deposits. The CASA ratio increased to 51% in FY18 from 3 in FY14. NIM has fallen since the merger Declining cost of funds, offset a drop in yields 4.8% 1 Cost of Funds Yield on Loans 4.7% 4.6% % 4.3% % FY13 FY14 FY15 FY16 FY17 FY18 FY13 FY14 FY15 FY16 FY17 FY18 NIM is likely to see a turnaround from here and go back to pre merger levels. We believe key catalysts for NIM expansion are: Rising yield: 10 year government bond yield is up 55bps since March end at 7.94% vs. 15bps MCLR hike by Kotak since March We believe this will also lead to higher asset yields for banks (as 6 of the loan book is floating) Loan mix changing to high yielding assets: Kotak has been focusing on growing its high yielding loan book (CV/CE) over the past few years. We expect loan yield to inch upwards as loan book shifts towards these high yielding assets. High loan growth: Management has guided for 2 loan growth in FY19. We estimate loan book CAGR of 2 for FY19 21, resulting in NIM expansion. NIM drivers FY18 FY19e FY20e FY21e Opening NIM 4.53% 4.37% 4.39% 4.53% Impact of Asset Yield 0.63% 0.31% 0.39% 0.01% Impact of Asset Mix Shift % 0.16% 0.04% Impact of Cost of SA % 0.01% 0.0 Impact of Cost of Term Deposit % 0.0 Impact of Borrowing Rate % 0.07% 0.0 Leverage % Others 0.07% % Closing NIM 4.37% 4.39% 4.53% 4.56% Deposit growth: Kotak s savings deposit growth increased by 58% in FY18. We believe deposit growth will continue to grow with 811. Shifting of liability profile towards low cost CASA deposits also supports NIMs. Lower cost of deposit: As mentioned earlier, a significant portion of deposits in FY18 came from 811 customers, and this is likely to increase going forward as customers mature. Kotak offers interest rate to customers whose average balance is less than Rs 100,000 (vs. its blended cost of deposit of 5.57%), Since a large majority of 811 customers belong to this category, their increasing share in the total deposit mix will bring down cost of deposits. Overall, we estimate NIM to increase by c.19bps over FY Page 19 PHILLIPCAPITAL INDIA RESEARCH

20 Faster customer adds to keep driving fee income A large part of its fee income comes from traditional banking and wealth management, making it sustainable Kotak s fee income increased at an average c.31% per year over the last five years, faster than its balance sheet growth. As shown in the chart below, fee income as a % of core operating income increased to c.26% in FY18 from c.17% in FY11. Kotak generates its fee income mainly from four sources: 1) Traditional banking fees: A large part of fees (c.16%) comes from third party distribution in insurance or mutual funds. Traditional banking fees also include retail fees, letters of credits, etc., which are expected to grow with the loan book. Third party distribution income as a % of total fee income 18% 16% 14% 1 1 8% 6% 4% Insurance Mutual Funds % 9.1% 7.6% 7.6% 6.9% ) Wealth management fee: Kotak is one the leaders in wealth management services in India, with over Rs 2,250bn in relationship value. We believe fees generated by wealth management services are sustainable, as these are based on well established relationships with clients. 3) Syndication fee: Kotak also participate in various debt market deals, domestic and forex loan syndication. 4) Forex advisory: Fees generated for forex advisory and other services. As a large part of the fee income comes from traditional banking and wealth management, we believe its growth is sustainable and expect its momentum to continue, driven by higher cross selling opportunities to a growing customer base. Fee income as a % of core operating income % 24% 24% % 1 26% 27% 27% 27%.fee income growth vs. balance sheet growth 9 Balance Sheet Fee Income Page 20 PHILLIPCAPITAL INDIA RESEARCH

21 Cost synergy flowing in; asset quality stable Cost ratios to continue falling as benefits of merger synergies escalate KOTAK MAHINDRA BANK INITIATING COVERAGE Before Kotak s merger with ING, its cost to income ratio was 51% while ING s was 5. For the merged entity, this ratio jumped to 59% in FY16 due to integrationrelated costs. However, with the completion of integration, this ratio has fallen to 48% in FY18. We believe that integration pains are now over and cost synergies have started. Kotak is now operating at an operating efficiency that is better than what it was before the merger. As shown in the chart below, employee and other costs are 1.3% and 1.6% of total assets in FY18 vs. 1. and 1.8% in FY14. We expect this ratio to continue falling and merger related cost synergies to continue. We model a cost toincome ratio of 44% for FY21 in our base case scenario, down from 48% in FY18. Cost to income ratio Employee and other costs as a % of assets % 5 59% 5 48% 46% 4 44% 4% Employee Cost/ Avg Asset Other Cost/ Avg Asset 3.9% 3.6% 3.6% 3.4% % 3.1% 2.9% 2.9% 2.8% 2.8% Kotak (1H15) ING (1H15) FY16 FY17 FY18 FY19e FY20e FY21e 3% 1% 1.9% 1.7% 1.6% 1.8% % 1.6% 1.6% 1.6% 1.7% 1.8% % % 1.9% % 1.3% 1.1% 1. FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19EFY20EFY21E Asset quality Good quality, to remain steady Kotak has maintained best in class asset quality compared to peers, as shown in the chart below. Gross NPA and net NPA were at 2. and 1. as of March 2018, compared with GNPA of 6.8% and 8.8% for Axis and ICICI. Kotak s GNPA jumped in FY16 driven by higher GNPA for the industries segment, mainly coming from ING s books. GNPA and NNPA (FY18) 1 GNPA NNPA 10.4% 1 8.8% 8% 6.8% 5.6% 6% 4.8% 4% 3.4% % 1.3% % 0.6% 1. IIB HDFC Yes Kotak Axis ICICI SBI Segment wise GNPAs 4% 3% 1% 1.3% 1.7% % Agricultural and Allied Activities 1.1% 4.1% 4.1% FY15 FY16 FY17 FY18 1.3% 1.4% 1.4% 1.3% 0.9% 1.4% 1. Industry Services Personal Loans and others 1.9% 2.4% 2.6% 2. Total Page 21 PHILLIPCAPITAL INDIA RESEARCH

22 We don t see any downside to asset quality from here as the management has put in an efficient risk monitoring and control process and only lends to high quality customers. Moreover, Kotak has a well diversified loan book with top 10 Industries contributing c.5 of the exposure. Corporate exposure by industry Banks, 11.1% CRE, 7.1% NBFCs, 6.3% Others, 5 Auto, 5. Trade, 4.3% Engineering, 4.1% Logistics, 2.8% Source: MSME Pulse Report, Transunion Cibil Drugs & Pharma, 2.9% Food Processing, 3.3% Iron & steel, 3. Overall, we model 45bps of credit cost for FY19 21 compared to average credit cost of 44bps over FY Page 22 PHILLIPCAPITAL INDIA RESEARCH

23 Subsidiaries benefit from a shift to financial assets Kotak s subsidiaries contribute 34% of its net profit KOTAK MAHINDRA BANK INITIATING COVERAGE The Indian consumer is going through a fundamental change in behaviour household savings are increasingly shifting to financial assets from physical assets. As shown in the chart below, the share of financial savings as a proportion of household savings increased steadily to 41. in FY16 from 31.1% in FY12. This growth is spread across asset classes. Investment in shares & debentures increased to 10. in FY17 vs. an average of 1.8% over FY We believe these change in savings pattern and improved economic conditions is likely to provide strong growth opportunities for Kotak s subsidiaries. Increasing share of financial savings (Rs tn) Growth across financial asset classes (Index to 100) % 6.4 Financial Savings Financial Savings as a % of Household Savings 32.9% % FY14 FY15 FY16 FY17 FY FY12 FY13 FY14 FY15 FY16 0 Equity Market ATDO MF AUM Insurance Premium Source: ICICI Securities Presentation, PhillipCapital India Research As shown in the charts below, Kotak s subsidiaries contribute 34% of its net profit. They leverage on customers acquired by Kotak to sell their products, while the bank acts as a main customer acquisition engine for the group. We believe strong customer growth at the bank (through 811) will provide strong tailwinds for Kotak s subsidiary growth. Entity wise net worth (FY18) Entity wise net profit (FY18) Kotak Life Insurance 4% Others 8% Kotak Life Insurance 7% Others 9% Kotak Securities 7% Kotak Securities 9% Kotak Prime 9% Kotak Mahindra Bank 7 Kotak Prime 9% Kotak Mahindra Bank 66% Page 23 PHILLIPCAPITAL INDIA RESEARCH