Is there an Upside in the Speculative Kotak Bank - Federal Bank Merger?

The past six months have been a roller coaster ride for the Indian stock markets. Hovering around 52,000 in March 2022, the BSE Sensex touched an all-time of 60,611 in the first week of April 2022.

However, it nosedived by 15% in June 2022 and was back to 51,000 levels, only to jump back to 60,000 come August 2022.

While the broad market return averaged around 12%, the best bank stocks in India took charge and outperformed the BSE Sensex.

The banking index averaged 20%, outperforming the broad markets by 8%. This performance comes on the back of higher business growth, rising rates that are aiding margins, and a period of mild asset quality.

If history tells us something, it's that some of the best returns in banking stocks have come after a bank undergoes a merger.

And so, this brings us to the highly speculated merger between Kotak Mahindra Bank and Federal Bank.

Even though Federal has denied media reports suggesting it is in talks with Kotak for a merger and Kotak hasn't denied or confirmed, we look into how value accretive this merger can be.

A good start is to look at the total asset and liabilities the merger will bring to the table.

• Generally, banks face stiff competition for customer deposits, with more than 30 lenders serving about 80% of Indians who have access to basic savings accounts. But Kotak has always struggled to grow organically.
  
  So, acquiring/merging another business will be a big positive for the private lender. The potential merger could double Kotak's total deposit base. This will make Kotak an indomitable player in the banking space. The proposed new entity will rank number three in the Indian private banking space.
• Kotak enjoys rich valuations. So, any merger, especially with a regional player like Federal bank, can add more value to the business. Moreso, in this case considering Federal's southern exposure. However, any value that may accrue to its shareholders will be a function of the merger swap ratio decided by the banks.
  
  While Kotak has 30% of its branches in the southern region, Federal has over 69% of its branches there. Post the merger Kotak will enjoy a widespread network across the country.
  
  Federal Bank's current branch count will add 75% to Kotak's total count. While Federal Bank operates 1,300 branches, Kotak operates around 1,700.
  
  However, technological advancement has rendered physical banking redundant. With physical banking taking precedence, this measure for deciphering value accretion is of little use.
• A better way to judge is to analyse the combined capacity of the two banks. The bank's capacity to not just lend, but to lend responsibly.

Return Ratios and Asset Quality

	Kotak Mahindra Bank	Federal Bank
Capital Adequacy Ratio %	23.7%	15.8%
Net NPAs (non-performing asset)	0.7%	0.9%
Return on Equity %	13.4%	10.9%

Data source: Annual Report 2022

While both companies boast healthy return ratios and maintain a sufficient capital buffer, Federal Bank's NPAs are higher than Kotak's. On the off chance this number rises, the proposed merger can be at risk.

How do we know that a merger is value accretive for the minority investor?

A glance at recent history provides all the proof we need.

If you look at the mergers and acquisitions of private banks, you will notice how much value they have created for the shareholder.

• HDFC Bank - Times Bank in 2000
• HDFC Bank - Centurion Bank of Punjab in 2008
• ICICI Bank - Bank of Rajasthan in 2010
• Kotak Bank - ING Vysya 2014

Most of these mergers have boosted returns for their shareholders within two years. Hence proving that mergers have yielded better shareholder returns in the banking sector.

In conclusion

When it comes to mergers and acquisitions in the banking sector, the number of branches or employees does not matter.

What matters is whether the strength of the banks is complementary and if together they can boost shareholder returns.

While the strengths of the two banks are complimentary, the merger could be value accretive for the shareholders of the banks over the long term.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.