Banks: Impact of equity issuances

It has been pouring in this fiscal and will continue for some time! We are referring to the downpour of issuances in the equity markets. Besides the flurry of IPOs in the primary issuances, markets will be witness to secondary issuances including ADRs, GDRs and QIPs (qualified institutional placements).

Equity issuances in FY08E   Rs bn Dilution ICICI Bank 203.1 24.4% SBI 45.0 8.5% HDFC Bank 42.0 15.0% UTI Bank 46.0 26.3% Yes Bank 8.6 7.1% HDFC 31.1 7.1% IDFC 21.0 14.7%

While so far the non-banking companies have satiated their inorganic growth appetite by raising ECBs and FCCBs in the overseas markets, financial entities being partially handicapped in terms of foreign debt raising, have lined up their equity issues. Banking entities and financial institutions have already been the frontrunners in terms of secondary equity issues so far and there are a couple of more to come. The total amount of the issuances is estimated Rs 396 bn (US$ 9.7 bn) of new equity and these offerings would dilute their equity capital at end of FY07 by 7% to 26%.

The need...
Sustenance and growth of market share: There is no precedent for such large issuances. The aggregate issue of new equity by these banking entities, over the preceding decade, is estimated to be less than Rs 180 bn. However, Indian banks that have been more active in issuing additional equity have, naturally, been more successful in expanding their market share. In the past five years, ICICI Bank, HDFC Bank and Axis Bank (erstwhile UTI Bank) have added a combined 4% to their market share of non-food credit, raising it to 15.1%. They also raised Rs 137 bn of fresh equity, leading to dilution of 13% to 47% in their equity books, over the last five years.

The growth history created by the said banks in the last two fiscals is also unprecedented and will be a challenge to sustain across interest rate cycles. Besides their own growth, financial conglomerates like HDFC, SBI and ICICI Bank also need capital to fund the growth of their subsidiaries before separating them to unlock value. In fact, a large part of the funds raised in the equity issuances this fiscal will be routed to subsidiaries.

Capital Adequacy Ratio in FY07   Tier I Tier II Total CAR ICICI Bank 7.4 4.3 11.7 SBI 8.0 4.3 12.3 HDFC Bank 8.5 4.6 13.1 UTI Bank 8.0 3.8 11.8 Yes Bank 8.2 5.4 13.6 HDFC 7.6 5.3 12.9 IDFC 16.1 4.2 20.3

Regulatory compliances: Banks have estimated the application of Basel-II norms by FY09 to have an impact of 1% to 1.5% on the capital adequacy ratios (CAR). None of the banks have reported sufficient details of the credit profile of their assets to enable accurate assessment of the impact. It is also possible that some banks may enjoy a release of capital arising from a superior credit quality. FY07 results of Indian banks under our coverage indicate that most have total CAR of at least 11%. However, banks that are short of capital or carry the risk of lowering their Tier-I CAR below 6% (statutory requirement) due to higher risk weightage, are de-risking themselves by accumulating additional capital to meet the exigencies.

The impact...
The classical explanation for a decline in return on equity (ROE) would be the lag between the inflow of new equity and the time when it is fully geared. In the interim, the bank may be relatively under leveraged, which could depress the ROE temporarily. The 11-year trend in ROE of HDFC Bank depicts such peaks and troughs. The long-term trend of decline may be explained by a secular decline in profitability. We believe the strongest influence on this trend is the sustained competition that tends to drive down all elements of revenue.

Banks that are expanding market share do not seem to be spared from the broader trend of declining asset profitability. There are two opposing forces that act on the return on asset (ROA) of a bank that is expanding market share by leveraging new equity. An aggressive chase of new business could depress margins and the ROA. Substitution of high-cost deposits by equity could, in the near term, shall improve margins.

Whether valuations justify?
The equity issuance would definitely poise the banking stocks attractively on the price to book value parameter due to addition to their net worth. Having said that, this should not be the sole guidance of their future prospects. There has been considerable convergence between the operations of the state-owned banks and new private sector banks on four important dimensions - loan growth, cost of intermediation, asset quality and profitability.

A logical approach to estimation of fair values would therefore need to be based on most of these parameters. Also, sustenance of higher margins (NIMs), higher profitability (with fee income support) and retention of market share in fund as well as non-fund based income streams are imperative factors that should guide investors' evaluation of banking sector stocks.