AI #04: The scorned Indian bank set for a 75% rebound

Nowhere in emerging markets is the growth potential more obvious than in banking and finance. Just take a look at the chart below which shows mortgage debt as a percentage of gross domestic product across the world.

As you can see, there's a huge amount of room for lending to grow in countries such as China and India before it's even on a par with the rest of emerging Asia - let alone the developed world.

And of course, it's not just in mortgages. Or car loans. Or credit cards. Insurance, investment and a huge range of other financial services will flourish as these countries become richer.

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It's a powerful investment story - but investors need to be selective. China clearly has huge potential as a banking market. But as an investment, it ticks all the wrong boxes for me. The major banks are all state-controlled and take direction from the government as to which sectors they should be lending to. That makes then a poor prospect for investors, since they'll always be forced to put national interests first.

On the other hand, India is much further ahead with developing a modern financial system. Yes, there are a large number of state-controlled banks from the country's socialist period.

But there's also a thriving, fast-growing private sector that are taking the lead in modernising Indian finance - especially in consumer sectors. These banks are reasonably free of government interference. And they are likely to deliver very attractive returns for shareholders over the next decade. I'm very keen to add an Indian banking play to the portfolio.

Today I want to recommend a seriously underappreciated Indian bank one that I think could make you a 75% return on your money.

Why big Indian banks will thrive over the next decade

I'm taking a slight detour with the recommendation I'm making today. With Asia Investor my recommendations usually range from small to medium-sized companies. The kind of stocks that are usually overlooked by emerging market investors. In most industries, I think these have the best long term potential. But that approach doesn't make a lot of sense with banking.

Over time, size tends to win out in banking. The big firms can take advantage of economies of scale and their extensive branch networks to outcompete smaller firms. The industry tends to consolidate into a few larger groups. And in India, with almost 100 commercial banks, 200 regional ones and many local co-operatives, there's likely to be a lot of consolidation in the years ahead.

So today's recommendation is a relatively large firm that you may well have heard of already. It operates in a sector which I believe has strong growth prospects. It's a leader in its field. And it's surprisingly cheap on a long-term view, for reasons we'll see in a minute.

So if you don't know it already, let me introduce you to ICICI Bank

The explosive growth in consumer lending across India

ICICI is India's largest private sector bank. It's the leader in retail lending, with around 30% market share across the whole consumer finance segment. The majority of its consumer loans are mortgages and vehicle loans (see below), but it also has a corporate division and several international business, most significantly the UK and Canada.

There are also subsidiaries in other areas of financial services, such as life insurance, general insurance, stockbroking and asset management, although their current contributions to profits are small.

All this makes it a promising play on the development of the Indian financial system. It has broad exposure while being rooted in consumer finance, the most promising segment of all over the next few decades.

That's because consumer finance is a relatively new segment. The chart below shows the breakdown of loan books at Indian lenders in 1996 and 2008. Don't worry too much about all the details - some of the categories are pretty arcane. But notice the huge growth in mortgages as a share of lending over little more than a decade. And see how new categories such as education and credit cards are cropping up.

As the first half of the chart suggests, lending in India used to be almost exclusively to companies. Until a couple of decades ago, commercial banks weren't allowed to make residential mortgages.

Today that's changed. The government relaxed the rules, a wealthier middle class emerged demanding new financial products and services and the whole shape of the economy changed. So did banking, with ICICI in the forefront of the revolution. But as that tiny mortgages/GDP ratio in the first chart at the top of this issue suggests, there's still a very long way for it to grow

With a commanding foothold in the Indian banking sector, you would expect ICICI to be thriving as the Indian economy recovers. But that hasn't been the case. In fact for the last year, ICICI has been all but left behind by its competitors. Let me explain exactly why.

How ICICI became India's least favourite bank

ICICI did not have a great Financial Crisis. During the boom of the last decade, the bank got somewhat carried away. It was the most aggressive in expanding in India, which for a bank almost inevitably means that you end up with a sharp rise in bad loans when the economy turns down.

And it let its international ambitions grow out of control. In FY2008 net new loans at overseas branches grew by 96% compared with growth of 15% for the overall group. But margins in these were much lower than in its home market.

What's more, to support its rapid growth at home and abroad, it funded itself with expensive and fickle wholesale borrowings rather than stable deposits from retail customers. That's broadly the same mistake that many Western banks made and paid heavily for it. All this was well known, so it's no surprise that at the peak of the crisis, text messages and internet postings were making the rounds claiming that ICICI was on the edge of collapse.

It wasn't while it may have overstretched itself, the underlying business was solid. Still, the legacy of that too-fast growth is that non-performing loans doubled as percentage of assets, as the chart below shows.

And as the bank deals with those, return on equity has collapsed from high historic levels. In the past year, ICICI had a return on equity of 9.5%, compared with 16-19% at private sector rivals like HDFC Bank and Axis Bank.

But it won't lag behind for long. The last year has prompted an enormous response by the banks management a fact that has so far gone unnoticed by investors.

ICICI is primed for a spectacular rebound

In the last year, ICICI's management has battered the business back into shape. The loan book has been shrunk, especially in areas such as credit cards and personal loans where the biggest problems turned up. Operating costs have been cut. Now as these measures take effect as provisions for bad loans tail off, profitability should rebound strongly to be more in line with peers.

Credit growth should resume in FY2011 - management are expecting the loan book to grow by 15-20%. But this will be done in a more prudent way under a more focused strategy. The bank has focused on building up a low-cost deposit base, with current and savings accounts (CASA) now accounting for 41.7% of deposit, up from 28.7% in 2009.

CASA deposits attract lower rates of interest, meaning that a higher CASA ratio pushes up the bank's net interest margin (the difference between what the bank pays for its funds and what it earns on loans). ICICI's net interest margin is below that of peers; as this changes, profitability will improve.

The company plans to grow its network of 2,000 branches the largest among private-sector lenders and to use the infrastructure more effectively to source deposits and sell to customers. To this end, it recently announced a takeover of the Bank of Rajasthan, a troubled lender with major governance issues (to put it politely) from the northwest of India.

ICICI certainly seems to be paying a full price for BoR based on the bank's current level of business. But the deal will add more than 450 branches to ICICI's network and is the only target of its kind available in the region. On a per branch basis it doesn't look so expensive and so should make long-term sense if ICICI makes full use of the expanded network.

Meanwhile, consumer lending will focus more on mortgages and vehicle loans, with much tougher standards on credit cards and personal loans. And indiscriminate growth in the international business has been abandoned. Instead, ICICI says it will focus on serving the large non-resident Indian population and on lending to Indian businesses abroad, which makes sense it's in a good position to dominate this niche.

So management seem to be moving in the right direction quickly and decisively. However, it could take two-three years for the effects of this to filter through and profitability to return to a stronger level.

So despite having every chance to be one of the dominant financial groups in a huge market in the long run, ICICI is somewhat out of favour with investors right now. Instead, the spotlight is on peers, who are showing much more impressive results. To me, this looks exactly the kind of opportunity that rewards the patient investor prepared to look past a few weak quarters of earnings.

Three risks to consider

ICICI is unusual in that it is one of the few major Indian companies not controlled by a founder or one of the country's business dynasties or by a foreign multinational. Founded as the Industrial Credit and Investment Corporation of India in 1955 to provide foreign currency loans to Indian businesses, it set up a retail banking division in the 1990s as India began to liberalise its financial sector.

The firm has been listed in the US as an American Depository Receipt since 2000. An ADR is essentially a certificate giving you rights over share traded abroad in this case India. We're investing via ADRs because most foreigners aren't allowed to invest directly in the Indian markets.

The biggest single direct shareholder is Life Insurance Corporation of India, a government-owned firm that is the country's largest insurer. Singaporean sovereign wealth fund Temasek is also an investor, followed by smaller holdings from a number of institutions.

Around 28% of the shares are held as ADRs. Liquidity on the ADR is very good, at around 2.45 million shares per day on average over the past year. Note that in this case, the ADR gives the holder rights over two underlying shares in ICICI, so the price of the ADR should be equal to twice the price of the India-listed shares.

As usual, let's take a look at the risks. In addition to the usual Asia Investor risk warnings, let me flag up the following:

First, banking is a cyclical business. You make more loans when times are good and then watch them turn down when growth slows. That makes ICICI different to most of the stocks that will be in the Asia Investor portfolio. Over the long run, growth should be very strong, but it will be more sensitive to the economic cycle than my usual recommendations.

Second, it's easy for banks to overstretch themselves while expanding, generally through relaxing lending standards too much in the pursuit of growth. ICICI did that; its peer HDFC Bank, on the other hand, was more conservative and sailed through without trouble.

That's a clear error of ICICI's management and strategy. But they should have learned a hard lesson from it and hopefully won't make the same mistakes next time. This is something I'll be keeping an eye on as the cycle develops.

Third, I mentioned earlier the structure of India's banking system and how foreign banks are restricted. In the case of ICICI and HDFC Bank, because more than 51% of their equity is controlled by foreigners, they were recently classed as foreign-owned Indian-controlled companies. There has been some speculation that this could restrict their ability to invest in certain sectors where there is a cap on foreign investment.

However, the latest statements from government officials are that they will not be treated any differently to other Indian-owned. So there appears to be no threat here at the moment. Still, it emphasises the fact that India's rules on foreign investment are quite restrictive and often arcane, some it's possible that ICICI's new status could cause trouble in future. That said, given the size, importance and obvious "Indian-ness" of the firm, I consider it unlikely.

ICICI's governance at the top of the firm seems good, reflected in the fact that it has a full sponsored ADR listing and has to comply with strict SEC disclosure regulations. But in an emerging market like India, there is always a risk of problems suddenly emerging at lower levels.

In particular, the Indian press sometimes features headline-grabbing accounts of recovery agents for defaulted loans behaving unethically, harassing borrowers and even turning violent. This is not uncommon as financial systems develop, but sometimes leads to tighter regulation although generally the biggest organisations benefit from this in the long run, because more regulation often makes it hard for smaller firms to compete. More generally, financials are always subject to the risk of regulation and government intervention, although this seems less likely to be on the rise in India than in most developed markets.

Finally, there seems a high chance that the bank will discover major issues at the Bank of Rajasthan post takeover and have to spend some time sorting them out. However, at 4.5% of ICICI's total assets, the impact is unlikely to be significant - and as noted, ICICI is buying the firm for its branch network and franchise rather than the loan book.

Why you could make 75% as this bank rebounds

ICICI is rather different to my usual recommendations. Often, we're looking at stocks where there will be no broker coverage or they might be number 20 out of 20 on the coverage list for some very overworked junior analyst. But ICICI has 45 analysts covering it, so it's scarcely a hidden gem whose prospects remain under-researched. I'm adding it to the portfolio not because I believe that I know something about the company that the market doesn't, but because in my view its medium-term value is being overlooked because of its weak short-term profitability relative to its peers.

As the table below shows, earnings growth picked up in FY2010 after the problems of 2007-2009, but has only just passed its 2006 peak. Analysts' consensus forecasts are for Rs45/share in FY2011 and Rs57/share in FY2012.

But I'm more interested in the point a year or so beyond that. At that point, net interest margins should be rising, loan loss provisions should have dropped and efficiency should have improved. So profitability should be starting to rise back towards the same levels as its peer group, which as I mentioned earlier is around 16-19%.

I'm going to take a fairly basic top-down approach to this and in my base case, I'd assume that return on equity rises to around 15% in FY2013 (from around 10% next year and 12% the year after). That would point to EPS of around Rs80/share.

At that point, I think the company is likely to trade on a price/earnings ratio of at least 20. In most markets, that's high for a cyclical like a bank, but it's at the lower end of historic valuations for ICICI and its peers and seems fundamentally justifiable given its enormous long-term potential.

That would point to a share price of Rs1,600 in 2013, giving potential upside of around 75% from the current level. Discounting Rs1,600 back at a minimum required rate of return of 15% gives a current buy limit of Rs1,050.

At the current exchange rate, Rs1,050 translates to $22.2. Each ADR gives the holder rights over two shares in ICICI, so this translates to a current buy limit on the ADR of $44.4, although this will change if the INR/USD exchange rate moves substantially.

A more bullish case might see ROE get up to around 18%. If that happened by 2013, that could point to a share price in the Rs1,900 region but that would be an optimistic scenario and I think it would be likely to take longer.

In terms of balance sheet strength, it's important to be aware that bank balance sheets are highly complex. If the global crisis taught us anything, it's that that apparently healthy numbers can conceal huge problems

That said, the Indian banking system came through with few problems and is generally regarded as pretty solid. The Reserve Bank of India is a capable, conservative and prudent regulator and its rules helped prevent any firms from getting into serious trouble. On a company-specific level, ICICI made big mistakes, yet the underlying business was still solid enough for it to come through.

The core measure of a bank's financial strength is its tier one capital ratio, which is the measure of equity capital to assets. This is intended to provide the buffer to absorb unexpected losses. By international standards, Indian banks are generally well-capitalised. And with a tier one capital ratio of 12.92%, ICICI is well above average for the overall sector.

The one area in which the firm may look disappointing by international standards is the dividend, where the yield is around 1.33%. That reflects the fact that in India, banking is very much a growth business, rather than a utility-type industry in the developed. So for now, payout ratios will be lower because the banks need to retain capital for expansion. In due course, the dividend is likely to rise significant.

As mentioned earlier, we'll be investing in ICICI through American Depository Receipts. These are listed in New York and quoted in US dollars, but entitle us to the full rights of an India listed share.

Recommendation

Buy: ICICI Bank (American Depository Receipts)

Ticker: IBN

Exchange: New York

Market cap: $21.2bn

Bid/mid/offer prices: $37.95/$37.96/$37.97

Buy limit: $44.4

52-week low/high: $28.53/$45.95

Yearly change: 2006 +36%; 2007 +45%; 2008 -67%; 2009 +91%; 2010 (to date) -5%

For UK readers, ICICI will not be eligible to be held in an ISA. Although the New York Stock Exchange is a recognised stock exchange under HMRC rules, for ADRs the underlying share must also be traded on a recognised stock exchange and no Indian exchanges currently qualify as such.

Updates

A couple of quick updates on the portfolio this week. First, Silverlake Axis announced a strategic tie-up with HNA Group, a Chinese conglomerate that signed software and services contracts with it earlier in the year. HNA will purchase a stake of up to 11.6% in Silverlake from the company's controlling shareholder, Goh Peng Ooi.

Silverlake says that this relationship is intended to lead to further business with HNA and opportunities to sell its products and services to other firms in China. Obviously, this could be a positive in the long run, but for now theres; no way to know it will make a difference.

Meanwhile, Eredene Capital announced a £7.3m investment in an Indian port services firm. The company's results will be out by the next issue of Asia Investor, so I'll look into progress on its portfolio and how this deal fits into the strategy in a fortnight's time.

That's it from me for this issue. As ever, if you have any questions, please email me on asiainvestor@moneyweek.com. I'll be back with another investment idea in two weeks.

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources for information in this report: Bloomberg terminal, Citigroup Global Markets, Angel Securities, The Hindu, Reserve Bank of India, World Bank, Banco Central do Brasil, ICICI Bank 2008 2010 Annual Reports, presentation 2010 results and website, Silverlake Axis, Eredene Capital

www.fsa.gov.uk/register/home.do