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  • Stock Recommendation | Karur Vysya Bank - ADD - Target price : 110

    Publish date: OCTOBER 25, 2018

    Slippage concerns ease; overall business performance weak. KVB reported ~11% yoy earnings growth on the back of significantly slower business growth. Loans grew 9% yoy but NII growth was weak at 4% yoy. Gross NPLs increased marginally but slippages dropped sharply and net NPLs declined sequentially, the only key positive development for the quarter. SME slippages have slowed, which is comforting. Valuations are not demanding but RoE recovery is likely to be gradual. Maintain ADD (TP at ₹110, unchanged).

    KVB reported modest earnings growth of 11% yoy led by drop in revenues at 4% yoy. NII growth was low at 4% yoy and other income declined sharply by 24% yoy. Rise in cost of deposits and flat yields led to NIM (calculated) compression by 7 bps qoq to 3.3%. Non-interest income was down owing to treasury losses of ₹210 mn and muted fee income (up 9% yoy). Provisions were lower by 34% yoy (credit cost down 150 bps qoq to 1.8%). Loan growth of 9% yoy was led by healthy growth in retail (28% yoy) while SME loans grew slower at 10% yoy; large corporate loans were flat yoy. Cost-ratios deteriorated (cost-income ratio up 700 bps qoq and 660 bps yoy to 52%) on the back of moderate increase in operating expense at 10% yoy while revenues declined yoy. The bank incurred previously deferred provisions for investment depreciation worth ₹301 mn in 2QFY19 (₹465 mn deferred over 2HFY19E). Deposit growth was muted at 3% yoy; lower than industry average. CASA ratio was flat qoq at 30%.
    Headline gross NPLs increased marginally by ~25 bps qoq to 7.7% while net NPLs declined ~10 bps qoq to 4.4% of loans. Slippages for the quarter have fallen sharply and are below average trends at 1.6% of loans, which is a key positive in this quarter’s results. This quarter has given greater comfort on the SME portfolio as this was the key portfolio that deteriorated in the previous quarter. However, we do note that the recovery from the SME loans that slipped in the previous quarter has been negligible and we need to see a recovery in this portfolio to feel more comfortable. Issue on the large corporate book is declining as the bank has been aggressively recognizing the pain. Share of loans under SDR, S4A, 5:25 is quite negligible.
    Our broad thesis remains unchanged and valuations are suitable post recent price correction (down 17% in past three months). Performance of the SME segment, execution acumen of the current team and trajectory towards RoE improvement remain the key monitorables. We maintain our positive view given the favorable valuations. At our RGM-based TP of ₹110 (September 2020E), we value the bank at 1.4X (adjusted) book and 9X FY2020E EPS for RoEs that can move closer to ~14-15% in the medium term.

    Muted loan growth due to slower growth in SME book and flat loan growth in corporate segment
    Loan growth was muted at 9% yoy in 2QFY19. The drop in advances growth was driven by sharp slowdown in the SME segment and muted corporate growth partly offset by robust retail growth, which maintained momentum of previous quarters. Retail loan growth has been strong since 3QFY18. The share of retail loans increased 120 bps qoq and 280 bps yoy to 18.4%. Within retail, growth was primarily driven by home loans and LAP. Personal loans and vehicle loans maintained moderate growth on a low base. Home loans increased 24% yoy, similar to previous quarter whereas growth in LAP stood at 3% yoy. Growth in vehicle loans was lower than 1QFY19 at 7% yoy whereas personal loans recovered to 9% yoy in 2QFY19. Education loans continued to drop (down 8% yoy).
    SME loan growth dropped to 10% yoy from 15% yoy in 1QFY19. The company had seen increase in stress in this segment last quarter and probably maintained a cautious stance this quarter. We await further clarity from the management on the drop in SME loan growth. Growth in the agriculture segment was low at 7% yoy while corporate growth was flat yoy. Slowdown in the corporate segment has been the primary reason for slow loan growth over the past few quarters. The share of corporate loans has dropped 110 bps qoq and 280 bps yoy to 30%.
    We expect modest net advances growth at 13% CAGR over FY2018-21E driven by growth in retail and SME loans; this will pick pace going ahead. KVB is aggressively pushing to convert its large retail customer base to asset customers. The company has rolled new branch/individual sales incentive scheme to improve origination. There has been further investment on the technology side to garner new customers. The bank has recently launched ‘KVB Next’ (a series of digital products for retail and business customers) and ‘KVB Dlite’ (all-in-one upgraded mobile banking app).

    Lower recoveries lead to rise in GNPL ratio by ~25 bps qoq to 7.7%
    Reported GNPL increased 26 bps qoq to 7.7%. Gross slippages were the lowest in the past 8 quarters (down 520 bps qoq and 340 bps qoq) at 1.6% of advances. Net slippages were mainly from the commercial/SME segment (2.4% of SME loans). The company had seen spike in slippages from this segment in the previous quarter (5.2% net slippages in 1QFY19). The company saw sharp improvement in net corporate slippages (down to 0.9% from 7.2% in 1QFY19). Asset quality maintained robust performance on the retail and agriculture space. Recoveries were lower in 2QFY19 at 0.4% compared to ~1.5-2.5% in the past few quarters mostly led by lower recoveries from granular SME slippages in 1QFY19.
    2HFY19E will see volatile movement in NPLs as it is difficult to estimate the further spike in SME slippages and the company will have higher recovery and write-offs as well since it has quite a few large corporate exposures that are in various stages in the NCLT process. Loanloss provisions are likely to remain higher going ahead as the bank still needs to catch up on coverage ratio (excluding technical write-off), which is quite low at 44.7%. Provision coverage ratio (including technical write-off) was up 200 bps qoq to ~58.5%. We forecast GNPL ratio to be in the range of 1.5-2.5% over FY2019-21E.
    Cost ratios deteriorate in 2QFY19
    Growth in operating expenses was moderate at 10% yoy in 2QFY19 driven by 11% yoy growth in employee expenses and 9% yoy growth in other expenses. Cost-to-income ratio increased 700 bps qoq and 660 bps yoy to 52% in 2QFY19. Growth in non-staff expense reflects investments in business expansion and digital initiatives.
    We expect cost-income ratio to further increase to 48% by FY2019E from 44% in FY2018 (up 370 bps yoy) and further elevate to 49% by FY2021E. Our views are guided by (1) investment in digital initiatives, (2) increase in employee base and (3) continued investment in branch expansion (though expected to slow down going forward).
    Other highlights in the quarter
    ₹ Deposit growth remained muted at 3% yoy, a trend similar to the previous quarter. CASA growth was robust at 11% yoy driven by moderate SA at 12% yoy. Term deposits were flat yoy. We forecast 14% CASA CAGR in FY2018-21E with CASA ratio at 31% by FY2021E.
    ₹ Non-interest income saw a sharp drop by 24% yoy in 2QFY19 driven by high decline in treasury gains (treasury losses worth ₹210 mn) and muted growth in fee income at 8% yoy. Fee income is expected to traverse on a stiff growth trajectory going ahead as the company also plans to focus on distribution of insurance and other financial products.
    ₹ Calculated margins dropped 7 bps qoq and 17 bps yoy to 3.3% on the back of rise in cost of deposits while yields were flat qoq. There was pressure from cost of deposits, which increased 6 bps qoq to 6.1%. NIM is expected to witness marginal compression to 3.5% by FY2021E from 3.7% in FY2018 on the back of drop in yields, a likely result of change in loan mix towards higher share of low-yielding retail products.
    ₹ Tier-1 ratio was comfortable at 13.7% with CAR of 14.2%.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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