IDFC First Bank: The Next Kotak or the Next Yes Bank?

Are you aware of the Warren Buffett hamburger story?

In his 2001 letter to shareholders, Warren Buffett opined that he likes hamburgers and he's going to buy hamburgers for the rest of his life.

So, they love it in the Buffett household when the hamburger price goes down. Buffett even joked that they start singing the 'Hallelujah Chorus'. But when hamburger goes up in price, they start weeping.

Buffett then argued that for most people, it is the same with everything in life they will be buying - except stocks.

When stocks go down and you can get more for your money, people don't sing the 'Hallelujah Chorus'. They get dejected.

I'm wondering how investors reacted to the 5% fall in the IDFC First Bank share price on Thursday. Were they singing the 'Hallelujah Chorus' or were they sad and dejected?

Like Hamburgers, should they be buying more of IDFC First Bank or should they head for the exits?

Let's try and help them out by taking a deeper look at the stock...

First things first. IDFC First Bank cracked 5% on Thursday because of valuation concerns raised by a prominent brokerage house. The brokerage says the stock may have run up too fast, too soon, and may therefore take a breather over the next 12-15 months.

As a matter of fact, most brokerages feel this way. Their target price for IDFC First Bank is quite close to its current share price.

However, should one sell a stock just because it seems overvalued by a few percentage points?

This is justified if your holding period is 1-2 years. But what if one is playing a long-term game of 5-10 years?

Should investors with such a time horizon also move out of the stock and get back in when the price falls by a few percentage points in the near future?

I don't think so. If your time horizon is truly long term then a slight overvaluation from a near term perspective shouldn't matter at all.

In fact, having a long-term investing perspective is one of your best chances to outperform your fellow investors whose time horizon doesn't extend beyond a year or two.

Therefore, once you get into a good quality stock with strong growth potential, the idea should be to hold on to it for the long term. You should stay put at least till the business quality is intact and not worry too much about near term valuations.

Is IDFC First Bank one such stock? Is it capable of generating long term wealth for investors even at these levels when it is already up close to 3x in the last one year?

Well, there's no better to way to find out than to head straight to the bank's annual reports of the past few years. And this is exactly what I did.

Although I started reading the bank's annual report from the year FY16, it is the annual report of the year FY19 where I finally found my 'Aha moment'.

This was the year where there was a change of guard. Rajiv Lall, the bank's founder MD and CEO had passed over the baton to V. Vaidyanathan, the new M.D. and CEO.

The more I read that year's annual report in general and Mr V. Vaidyanathan's achievements in particular, the more I was convinced that he seemed like a great fit. And come to think of it, Vaidyanathan's appointment wasn't even in the scheme of things initially.

You see, when IDFC First Bank approached the RBI for a banking licence, it was a dedicated infrastructure financier and had a loan book that was dominated by infrastructure projects.

However, in its new avatar as a bank, it knew it had to reduce its dependence on infrastructure financing and also retailise its balance sheet as fast as possible. In fact, the bank was not averse to going the inorganic route as well to fast track the process.

So, an agreement was signed with the Shriram Group to see if something can be worked out between certain businesses of the group and IDFC First Bank. Unfortunately, the deal did not go through due to differences in valuation.

This is where, Vaidyanathan and his company, Capital First Ltd came into the picture.

In hindsight, Rajiv Lall must be happy that the deal with Shriram Group didn't happen. For he seemed mighty pleased with the strengths that Capital First possessed and its dynamic CEO, Vaidyanathan.

Here's Lall in his own words...

• We then worked out a proposition for a merger with Capital First as it met all our strategic requirements and in fact turned out be a better cultural fit for the bank.
  
  In fact, the added bonus of pursuing a merger with Capital First was that we were also getting a strong leader with a terrific track record to take the institution forward.

Indeed. Mr Vaidyanathan did have a stellar track record at Capital First.

On his watch, the NBFC went from strength to strength, growing retail loans from just Rs 1 bn to a whopping Rs 184 bn by March 2017.

It became a strong name in the consumer financing segment with asset quality that was pristine through all these years. What's more, the company's market cap jumped 10X from Rs 7.8 bn to over Rs 78 bn between March 2012 and March 2017.

And mind you, it was not a cakewalk for Vaidyanathan by any stretch of imagination.

When he took charge of Capital First, it was a loss-making entity. Therefore, in a way, he did not start from ground zero but from a basement. And then came a whole litany of challenges.

He was forced to shut down unrelated businesses, raising funds proved to be an uphill task, the macro environment, especially the interest rate cycle turned non-conducive and fund raising through QIP failed. In fact, there came a point where he didn't know where to spend his time.

However, despite all these odds he persisted and maintained a laser sharp focus on his target customer. The efforts finally paid off as the company was able to raise funds through private equity.

Then one by one, things started falling into place, ultimately culminating into the merger with IDFC Bank which later became IDFC First Bank.

It will be fair to say that had it not been for the merger, Vaidyanathan would have left no stone unturned in turning Capital First into a commercial bank. That has been his dream right from the beginning.

So when IDFC Bank came calling, a banking licence and a well-built banking platform in tow, Vaidyanathan was more than happy to oblige.

The value proposition was straightforward for both IDFC as well as Capital First. IDFC Bank needed to retailise the loan book away from infrastructure. This would shore up margins and profitability.

Capital First got access to the banking licence it always wanted. It's no wonder that as soon as the merger was completed, Vaidyanathan and his team got down to business.

In fact, here's the plan that he outlined in the FY19 annual report of the company, to be achieved over the next 5 years.

• Grow CASA % from 10% to 30%
• Grow retail deposits (CASA + TD) as percentage of total borrowings from 10% to 50%
• Grow the retail loan book as percentage of total loan book from 35% to 70%
• Reduce infrastructure loans from 22% to 0%
• Reduce the cost to income ratio from 80% to 55%
• Grow branches from 200 to 800
• Grow NIM from 3% to 5%

Well, I have with me the bank's latest presentation for the year FY23. So, let's see where it stands with respect to all the goals.

• Grow CASA % from 10% to 30% (Achieved, it currently stands at an impressive 50%)
• Grow retail deposits (CASA + TD) as percentage of total borrowings from 10% to 50% (Achieved, the ratio is 52%)
• Grow retail loan book as percentage of total loan book from 35% to 70% (Achieved, it currently stands at about 70%)
• Reduce infrastructure loans from 22% to 0% (Almost there, it currently stands at 3%)
• Reduce cost to income ratio from 80% to 55% (Not achieved, the ratio stands at 72%. But it’s expected to come down as branches scale up)
• Grow branches from 200 to 800 (Achieved as it currently has 809 branches)
• Grow NIM from 3% to 5% (Achieved as the NIMs currently stand at 6.1%)

As you can see, except for the cost to income ratio, the bank has really done well to achieve its goals and that too, ahead of time.

When Vaidyanathan took charge in FY19, a slew of research reports came out and cast serious doubts about the future of IDFC First Bank.

'IDFC has one of the weakest liability franchises', said one research house. 'The issue of low CASA will be hardest to fix', said another. 'Large infra book related issues', said still another.

Well, fast forward to today and we very well know who's having the last laugh.

Vaidyanathan and his team were aware of the challenges the bank was facing. They went all out in meeting them and coming out ahead. This is a commendable achievement in my view.

You know, in 2004, when the RBI announced two new bank licences for Kotak Bank and Yes Bank, Vaidyanathan was with his colleagues had joked that even they should go to the central bank and ask for a bank licence.

Well, almost 20 years later, of the two, only Kotak Bank survives, thanks to a vice like grip on risk control. Vaidyanathan and his team would do well to keep this lesson in mind and not let asset quality slip in order to chase growth.

Kotak Bank has averaged a price to book value multiple of close to 4.5x over the last many years. IDFC First Bank on the other hand is currently trading at just half of that.

Therefore, there seems to be enough potential upside over the long term if IDFC First Bank manages to not only grow but keep its balance sheet pristine.

Does this mean that we are endorsing the bank? No, far from it.

In this editorial, we have just laid out the facts to assist you in making an informed judgement on the stock. Only time will tell if it goes the Kotak Bank way or implodes like Yes Bank.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)

Rahul Shah co-head of research at Equitymaster is the editor of (Research Analyst), Editor, Microcap Millionaires, Exponential Profits, Double Income, Midcap Value Alert and Momentum Profits. Rahul has over 20 years of experience in financial markets as an analyst and editor. Rahul first joined Equitymaster as a Research Analyst, fresh out of university in 2003 but left shortly after to pursue his dream job with a Swiss investment bank. However, he quickly became disillusioned working for the 'financial establishment'. He learned first-hand the greedy stereotype of an investment banker is true and became uncomfortable working for a company that put profit above everything else. In 2006, Rahul re-joined Equitymas ter to serve honest, hardworking Indians like his father, who want to take control of their financial future - and not leave it in the hands of greedy money managers. Following the investment principles of Benjamin Graham (the bestselling author of The Intelligent Investor) and Warren Buffet (considered the world's greatest living investor), Rahul has recommended some of the biggest winners in Equitymaster's history.