Yes Bank YES IN
February 14, 2018 - 8:05pm EST by
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2018 2019
Price: 330.00 EPS $0.28 $0.35
Shares Out. (in M): 2,338 P/E 18 14
Market Cap (in $M): 11,800 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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Description

Elevator Pitch 

YES is a small private bank in India that should yield ~85% valuation upside over the next 3yrs given ~65% EPS increase and expansion in P/E to ~16x from ~14x today, driven by:
 
-Expansion in Net Interest Margin (NIM) to ~4% (vs. 3.4% today) as YES continues to build its CASA ratio (Current & Savings Account deposits) to ~40% (vs. 30% today), and brings down its cost of Savings Accounts (SA) from 7% to 4% in line with other private banks today.
 
-Increased mix of retail loans to ~35% (vs. ~20% today) which should lead to expansion in valuation multiples, narrowing the gap between where Yes Bank and other retail banks are valued.
 
-25-30% annual loan growth – outpacing other private banks in India given Yes Bank’s relatively small loan book (low base effect) and recent launch of a full retail loan product portfolio.
 
YES is controversial amongst the investor community as many believe their non performing loans are understated. My research makes me believe Yes Bank’s strong asset quality track record is credible, hence why I believe this investment opportunity exists.
 
Background / Context
 
India’s banks had been mostly nationalized in the 1960s. In the 1990s, India faced a balance of payments crisis and began a program of economic liberalization in order to secure an emergency loan from the IMF. Six licenses to set up private banks were subsequently issued over the course of 15 years in order to encourage efficiency and better service standards. A further two bank licenses were issued in 2015.
 
India’s entire banking system has credit outstanding of ~INR75Trill (~$1.1Trill). ~22% market share is with the private banks, ~4% share is with foreign banks, and the remaining ~74% is with nationalized banks (of which the largest is State Bank of India with ~16% domestic market share).
 
The new generation private banks are HDFC Bank (~INR4.9Tr loan book), ICICI Bank (~INR4.5Tr), Axis Bank (~INR3.5Tr), Kotak Mahindra Bank (~INR1.3Tr), Yes Bank (~INR1.1Tr), IndusInd Bank (~INR1.0Tr).
 
Yes Bank was launched in Aug 2004 by Rana Kapoor & Ashok Kapur after obtaining one of the rare licenses to set up a private bank in India. Both had previously founded a corporate finance / investment banking firm in India on behalf of Rabobank (Netherlands). Rana Kapoor was previously head of Bank of America’s wholesale banking business.
 
Yes Bank’s vision is to become a comprehensive retail & commercial bank in India. The initial years were focused on wholesale banking (large loans / deposits from corporations) given the prior experience of the promoters. Yes Bank hired a new head of retail banking from HDFC Bank in 2012, and is now heavily focused on growing this business.
 
Yes Bank has been unpopular / controversial with many investors given disbelief in their extremely strong asset quality metrics, high exposure to stressed corporations, and wholesale funding base.
 
Yes Bank has a very strong track record thus far and yet still have the greatest room for performance improvement going forward
 
Yes Bank’s financial performance historically has been very strong. ROE has been >20% since FY08, despite many instances of equity dilution. ROA has also increased steadily to 1.73% (within range of the larger private banks) – there was a drop in ROA in FY11 as Yes Bank curtailed lending and chose to build a bond portfolio as they believed the lending environment was too risky (in retrospect this was a good decision). Loans have grown faster than the combined loan book of the six private banks every year other than FY12 & FY14 (India’s macro situation was very weak in FY14). Operating costs as % assets are the lowest amongst private banks (1.8% average over past 5yrs). However, non interest income as % assets has been low at 1.7% (average over past 5yrs), though this is the same as HDFC Bank whereas other private banks generate >2%. Mgmt say they have reduced many fees to win retail business which they expect to increase over time.
 
Yes Bank has also navigated successfully through three major storms in the banking sector over the past decade.

In 2008 during GFC liquidity dried up in the banking system with investors fearing a run on Yes Bank given they were mostly wholesale funded and hence depositors could withdraw rapidly. Yes Bank was unaffected as they had strong relationships with their large wholesale depositors, while there was a run on ICICI Bank from retail depositors. 

In 2013 during the US Taper Tantrum short term interest rates suddenly rose 300bps and the market believed Yes Bank could become insolvent given the bank was mostly short term wholesale funded and NIMs were <3%. The impact on Yes Bank was minimal as they ran a matched asset & liabilities book – hence loans repriced in line with deposits. 

In 2015 during the RBI’s Asset Quality Review the regulator mandated banks to recognize loans to 150 large corporate borrowers as non-performing, leading to fears Yes Bank would suffer large write downs. However Yes Bank emerged with minimal impact while other corporate lenders suffered surges in non-performing loans. 

 

Yes Bank has proven their capabilities over the past 12yrs, and what is very exciting is they are the bank which still has most room to improve & enhance value going forward. YES has the opportunity to grow faster than other banks given they are small and only now entering into much of the retail banking space (YES has achieved ~25% earning assets growth over the past 5yrs vs. 14-21% for the larger private banks). YES has the opportunity to grow NIM (currently 3.4%) whereas other banks are already at high levels (4%+). YES has the opportunity to grow non-interest income as % assets given they are lowest of all banks. Yes Bank also has the opportunity to enhance its valuation ratios through building retail loan mix. 

 

Yes Bank should expand NIM to 4.0% by FY20 

YES currently has the lowest Net Interest Margin (NIM) among the six private banks at 3.4% (vs. ~4%+ for other banks on their domestic loan books). This is a result of Yes Bank having a higher cost of funds (COF) given a low proportion of CASA deposits relative to peers (currently ~30% of total deposits, vs. peers at 40%+), and a higher cost of SA deposits as YES hiked SA rates to 7% in 2012 in order to win market share

 
YES has made significant progress on improving NIM in recent years. In FY11, YES generated 2.9% NIM, given CASA ratio was just 10%. Growth in CASA since then has been a result of expansion of branch network (214 branches in FY11 vs. c.1000 branches today), increase in SA rates to 7%, far better service quality relative to public sector (PSU) banks enabling share gains, effective targeting of large depositors (e.g. trusts), heavy investments in brand building (e.g. sponsored Indian Premier League in 2012), and strengthened leadership (hired a new head of retail from HDFC Bank in 2012).
 
Yes Bank is targeting 4% NIM by FY20, a 60bps improvement from current level (50bps was achieved over the past 5yrs). My financial analysis shows that a 40% CASA ratio and a drop in SA rates to 4% will result in 4% NIM.

I believe a 40% CASA ratio is a very reasonable target for Yes Bank to achieve as they continue to roll out their branch network and improve CASA per branch. YES are targeting 2500 branches by FY20 – a very reasonable target given HDFC & ICICI Bank have ~4500 branches each today, Axis Bank has ~3000 and these banks continue to expand. Branches are also becoming smaller and require less staff given increased share of digital transactions (mgmt say branches today are only required to give customers a psychological comfort that if they need to access a branch they can do so easily – the actual usage of branches by customers is low). With 2500 branches, YES would require ~INR480M of CASA deposits per branch in order to achieve a 40% CASA ratio by FY20 – which again seems very reasonable given Axis Bank today has ~INR580M, HDFC Bank has ~INR520M. 

Yes Bank has started to reduce their SA interest rates over the past year (7% has been reduced to 6%), and plan to reduce to 4% once they reach 40% CASA ratio. The controversy is whether SA deposits will flow out in response to rate cuts. Yes Bank’s experience so far has not shown significant loss of customers in response to rate cuts – though this could be because YES is still paying the highest rate of any bank. Mgmt say the high interest rate on SA was a great way to win customers whom YES is now selling loans / other financial products to, which creates barriers to switching and hence customer stickiness is high. There is also no incentive for a customer to switch to another bank which is offering the same interest rate, and other banks may cut SA rates to 3% given the current low interest rate environment. IndusInd and Kotak Mahindra are the only banks who also offer a rate higher than 4% currently, both of whom have done so in order to raise CASA and both have also begun to reduce rates.

 

Yes Bank should grow mix of retail loans to 35% by FY20 which should lead to multiple expansion 

Retail loans currently make up just 21% of Yes Bank’s loan book, of which 13% is branch business banking and just 8.5% is consumer loans (this was close to zero in FY14). This is very low relative to other private banks, who have 40-55% retail mix, given YES chose to build their commercial banking business first. 

Retail loans have been growing very rapidly for Yes Bank (65% CAGR over past two years), driven by rollout of Yes Bank’s branch network and launch of a full consumer product portfolio. YES launched auto loans, mortgages and loans against property ~18months ago, and within the past 6months launched unsecured personal loans and credit cards.
 
YES are targeting 20-25% consumer loan mix by FY20, driven by continued cross-selling into their large captive customer base they have obtained through building a strong CASA franchise over the past 5yrs, as well as continued rollout of new branches. YES have built an incredibly strong retail team, with ~80% of the senior management coming from HDFC Bank – which is reputed as the best bank in India given consistent growth & asset quality across economic cycles, they are the largest of all private banks, and have mostly high- yielding retail loans (they do not hold mortgages on their books which are low-yielding). HDFCB achieves the highest valuations of any bank with average P/B of 3.9x over the past 7yrs (with the foreign shares often trading at a 20% premium).
 
Retail Banks achieve higher valuations given extremely long runway for growth in consumer banking (similar to consumer goods companies in India), higher ROAs given lower credit costs, and more granular loan book which reduces volatility and susceptibility to economic shocks. HDFCB & IndusInd are valued at ~3.5x P/B or ~20x P/E (last 7 yrs average of both banks) vs. Yes Bank at ~2.4x P/B and ~12x P/E. ICICI Bank / Axis Bank have averaged ~2x P/B and 14x P/E – however both have much of their retail book in low-yielding mortgages, and have many stressed loans on their corporate loan book which investors have anticipated will lead to significant write-downs in book value. Other than ICICI Bank, all banks have averaged 17-20% RoE over the past 7yrs.
 
Assuming Yes Bank achieves 35% retail mix by FY20 (vs. ~50% for HDFCB / IndusInd), implies valuation should rise to 16x P/E [= (20x + 12x) / 2] or 2.95x P/B [= (3.5x + 2.4x) / 2]. Or thinking about the retail & commercial businesses individually, assuming a 25x P/E for the retail book (in line with other consumer goods companies in India) or 4x P/B, implies the market values Yes Bank’s commercial book at ~10x P/E or 2.1x P/B (since overall valuation has averaged 12x P/E and 2.4x P/B over the past 7 years for an average 15% retail loan mix). Applying these multiples to 35% retail mix yields overall 15x P/E and 2.75x P/B. Averaging the two approaches yields 15.5x P/E and 2.85x P/B.
 
Yes Bank has the best asset quality, and their track record seems credible
 
Banks are highly leveraged businesses (10x+ leverage) which generate low ROA (<2%). Asset quality is therefore imperative to a bank’s success given a few % of loans defaulting can lead to write-offs which could wipe off the bank’s entire book value. Lending money to borrowers is relatively easy, but ensuring that money gets repaid is more difficult. Collections therefore distinguishes a well run bank from others.
 
Since inception, Yes Bank has had the lowest non-performing loans ratio of any bank in India. This has been met with disbelief amongst much of the investor community, many of whom believe they under-report bad loans somehow.
 
However, I believe their asset quality track record is credible. As an illustration, there are so many examples of loans where Yes Bank recovered its money while other banks lost / underwent restructuring.
 
However, I do believe Yes Bank has had the advantage of being small which has enabled them to be selective on lending – an advantage that will fade with time – hence I am assuming credit costs normalize in line with other banks going forward. Yes Bank’s average loans loss provisions as % assets over past 5yrs has been 31bps vs. 45bps for HDFC / IndusInd (retail-oriented banks) and 79bps for Axis / ICICI (corporate-oriented lenders). My financial model assumes Yes Bank increases to 55bps in FY20. I would anticipate 60-65bps credit costs as a long-term average beyond FY20 (average of other retail & corporate oriented banks currently).

 

Fundamentals of banking industry are attractive – system should grow 10-20% over mid-long term with private banks growing faster 

 

India’s banking system has a very long runway for growth, given leverage levels are low and the economy continues to grow. Household debt is ~9% of GDP – one of the lowest levels of all comparable developing economies (Mexico ~15%, Indonesia ~17%, Russia ~20%, Brazil ~25%, China ~36%). Credit to the private sector is also relatively low at 53% of GDP. Recent political initiatives in India have also created a vast opportunity for growth in the banking sector – the Prime Minister’s financial inclusion drive and recent demonetization scheme has led to ~400M people entering the banking system.

Banking credit typically grows 1-2x nominal GDP growth. Over the past 4yrs it has been closer to 1x as loans to industry have fallen off in response to the weaker economy and hence lack of investment by the private sector in new projects, though this has been offset somewhat by consumer credit which continues to grow strongly at ~20% annually. The government is also trying to kick-start private sector investment through public sector spending on infrastructure.

It is reasonable to assume India’s real GDP should grow 6-8% p.a. over the medium term. The government is targeting inflation of 2-6%, which implies nominal GDP should grow 8-14%. The mid-point is 11%, but assuming a lower 10% and applying the 1-2x from above implies the banking system should grow 10-20% annually over the medium term. There are downside risks to this estimate (for example corporates have been increasingly tapping the bond markets recently), but there are tailwinds which can offset this such as acceleration of growth in consumer lending given low penetration and the governments recent initiatives.

Private banks should grow faster than the overall banking system. Public banks have been losing share for many years, a trend which has accelerated since FY15 given the public banks are dealing with a high level of non-performing loans and are running low on capital. Assuming 50-60bps of annual share gains for private banks continue, with the banking system growing at 15% p.a. on average, private banks should grow ~18% while other banks should grow ~14%. Note other banks also include foreign banks (just 4- 5% market share) which have been pulling out of India post GFC to preserve capital and focus more on their home markets.

 

Very experienced & stable management team, strongest alignment of incentives with shareholders

CEO, Rana Kapoor, is also the founder / promoter of Yes Bank and holds ~11% of shares outstanding. His deceased brother-in-law’s family also own ~11%. This is the only bank in India, other than Kotak Mahindra Bank, which is managed by such a large shareholder – providing heavily aligned interests with shareholders. He is a relatively young promoter at 59 years and hence likely to remain in place for many more years. Prior to founding Yes Bank in 2004, he spent 5yrs launching an investment banking / corporate finance firm in partnership with Rabobank, two years working at ANZ Grindlays Investment Bank as Country Head, and 15 years with Bank of America where he was head of the wholesale banking business.

CFO, Rajat Monga: was also a founding member of Yes Bank, and has been CFO since 2004. Prior to this he was working with Rana Kapoor at Rabobank. He currently owns 0.21% of shares outstanding (worth ~$16M at today’s share price, while his annual salary is ~$1.2M).

Head of Retail, Pralay Mondal: joined Yes Bank in 2012 after spending 12yrs with HDFC Bank where he was Head of Retail Assets (no details on compensation).

Yes Bank has ~20M stock options outstanding (5% of market capitalization). 

 

Valuation – base case yields ~85% upside from current share price

YES should grow EPS at ~22% CAGR until FY2020, after factoring in dilution due to equity raises (assuming $500M equity raised before FY20). Applying 15.5x P/E (discussed above) yields  ~85% upside over ~3yrs. Valuing using 2.85x P/B (discussed above) yields similar returns. 

Downside is limited on a 3-yr view since lower growth assumptions removes the need for a further equity capital raise in FY20, providing downside protection to EPS. 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

No specific short term catalyst - is a long term idea.

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