City Union Bank Ltd - Edelweiss GWM unique competitive advantages compared with key peers on the yield, cost of funds and operating expense front, allowing it to Edelweiss Investment

Shivaji Thapliyal

Research Analyst

[email protected]

+91 (22) 4272 2159

Date: 3rd July 2017

Edelweiss Investment Research Insightful. Independent. Decisive.

City Union Bank Ltd “This CUB Has Teeth”

1 GWM

Edelweiss Investment Research

City Union Bank (CUB) is a mid-sized private sector bank with a INR24,112cr loan book and a distribution network comprising 550 branches. It possesses

unique competitive advantages compared with key peers on the yield, cost of funds and operating expense front, allowing it to deliver sustainably higher

risk-adjusted return ratios. Given reasonable valuation for forecast return ratios, we recommend a ‘BUY’ Rating on the stock.

Loan book re-orientation largely over, CUB can revert to long term risk-managed growth trajectory

Jewel Loan de-focusing is largely behind CUB with exposure having fallen from 22% in FY13 to 9% in FY17 which allows CUB to grow without this drag going

forward. Further, over FY1995-2016, CUB has displayed an average growth differential of 5% with the industry while displaying the prescience to pull back prior

to key crises viz. global tech slowdown, the Great Recession and China slowdown, earmarking CUB as the bank stock to own over the long term cycle.

Under-penetrated home market, market share gains and high operating leverage to further aid growth

CUB’s South/Tamil Nadu focus is adequate for fueling balance sheet growth over the next 4-5 years. (1) Its Q3FY17 branch share in Tamil Nadu is 3.5%

compared with 67% for PSU Banks and 28% for Private Sector Banks, indicating significant under-penetration. (2) CUB stands to gain market share from PSU

Banks due to superior service levels. (3) Competition from large private sector banks is not significant as CUB operates in the INR 25 lacs – 1 cr loan ticket size

MSME sub-segment whereas the former focus on much larger ticket sizes (4) CUB remains under-leveraged from a business per branch perspective with their

FY17 Deposits per branch at INR 55 cr compared with INR 58-145 cr for key peers.

Well-managed funding profile, prudent asset-liability management lend significant cost of funds comfort

CUB’s FY17 Cost of Funds stood at 5.9% compared with 6.5-7% for key peers. This is driven by (1) lower dependence on Borrowings which were 1.7% of FY17

Deposits and Borrowings compared with 3.1-19% for key peers (2) lower dependence on Bulk Deposits which are 5% of total deposits compared with 15-23%

for key peers (4) prudent reluctance to participate in Saving Account interest rate competition with SA rate at 4% compared with key peers at 4-7.1%.

High exposure to MSME loans and higher loan granularity result in yield leadership for CUB

CUB’s FY17 Yield on Advances stood at 12.1% compared with 11.3-12% for key peers which, in turn, is driven by (a) higher loan exposure to high-yielding

MSME segment at 48% compared with 12-35% for key peers and (b) higher loan granularity with Top 20 borrowers accounting for 5.3% of loan book

compared with 8.1-14% for key peers.

Non-IBA bi-partite employee settlement and best-in-class digital franchise drive major opex benefits

City Union Bank’s FY17 Cost to Income Ratio stood at 41% compared with 45-60% for key peers. This is led by (1) lower Cost per Employee of INR 6.1 lacs

compared with INR 6.2-9.1 lacs for key peers which, in turn, is driven by (a) Non-IBA bi-partite employee settlement (b) low average employee age of 27

years (2) 85% of transactions now via non-branch channels compared with c.60% 2 years ago. (3) Further, we looked at ATM, POS, Card and Android

platform data and note that City Union Bank is in the top 2 across all parameters, indicating superior digital franchise, a key idiosyncratic advantage.

City Union Bank’s headline asset quality seems middling but underlying credit book indicates no undue risks

City Union Bank’s gross total stress (GNPA Ratio + Std. Restructured Assets) stood at 3.4% as of H1FY17 compared with 1.5-6.6% for key peers. We note that (1)

City Union Bank’s exposure to key stressed sectors stood at 20.7% of H1FY17 credit compared with 17-22.9% for key peers whereas (2) Metals and Infra

exposure stood at 5.6% compared with 2.6-14.3% for key peers, indicating no incremental underlying credit risk compared with peers. Broad underlying

macro risk for lumpy corporate NPA accretion is low with Large Corporate exposure low at 7% of FY17 loan book, avoidance of long-gestation project

financing with Working Capital loans 65% of loan book and Consortium lending at c.1% of loan book.

Valuation and Rating: Initiate with BUY, PT of Rs 220. CUB undervalued on comprehensive metrics

We use Residual Income Model to arrive at a Price Target of Rs 220 for City Union Bank, at which the stock trades at 2.7x FY19E book value. We initiate with

BUY Rating with our PT providing 25% upside to CMP. The stock currently trades at a P/B of 2.2x FY19E book value for an FY18E-20E RoE of 16%-17%.

(INR cr) FY16 FY17 FY18E FY19E FY20E

Net Interest Income 981 1199 1452 1701 2008

Total Income 1391 1683 1994 2309 2710

Profit After Tax 445 503 639 748 922

Basic EPS 7.4 8.4 10.7 12.5 15.0

P/E 23.8 21.0 16.6 14.2 11.8

Book v alue per share 51 60 69 80 104

P/B 3.5 3.0 2.6 2.2 1.7

Return on Av erage Equity 15.5% 15.2% 16.6% 16.8% 16.3%

Shivaji Thapliyal

Research Analyst

[email protected]

+91 (22) 4272 2159

Bloomberg: CUBK:IN

52-week range (INR): 170/ 95

Share in issue (cr): 59.8

M cap (INR cr): 10,759

Avg. Daily Vol.

BSE/NSE :(‘000): 832

Date: 3rd Jul 2017

Public, 100.0

60

80

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180

200

Jan

-16

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-16

Ma

r-1

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Ap

r-1

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v-1

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-17

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CUB Sensex

City Union Bank Ltd

This CUB Has Teeth

CMP INR 177 Target INR 220

Rating: BUY Upside: 25%

City Union Bank Ltd.

2 GWM

City Union Bank: Well-managed funding profile + Granular high-yielding loan book + Bipartite employee settlement = Higher sustainable RoE

City Union Bank is expected to deliver a best-in-class RoE of 16-17% over FY18E-20E. Healthy sustainable RoE is delivery is expected on the back

of high net interest margin and structurally low opex with low reliance on leverage.

City Union Bank’s FY17 Cost

of Funds is 5.9% compared

with 6.5-7% for key peers

City Union Bank’s FY17

Yield on Advances is

12.1% compared with

11.3-12% for key peers

City Union Bank’s FY17 Cost

to Income Ratio is 41%

compared with 45-60% for

key peers

FY15 FY16 FY17 FY18E FY19E FY20E

NII 807 981 1199 1452 1701 2008

Other Income 404 410 484 542 608 702

Opex 519 558 689 795 929 1056

PAT 395 445 503 639 748 922

At CMP, FY19E P/B is

2.2x

At Target Price,

FY19E P/B is 2.7x

Upside of

25%

FY18E-20E RoE of

16-17%

FY15 FY16 FY17 FY18E FY19E FY20E

RoAA 1.49% 1.50% 1.51% 1.69% 1.72% 1.82%

RoAE 16.7% 15.5% 15.2% 16.6% 16.8% 16.3%

PB Multiple FY19E BVPS CMP / Target

2.2x (CMP) 80 177

2.7x (Target) 80 220


3 GWM

Price Target INR 220

We use the Residual Income Valuation Model to value CUB. We assume a long-term risk-free rate of 7% for India, a

Beta of 1.05 for CUB and an India Equity Risk Premium of 6% and arrive at an overall Cost of Equity of 13.3% for CUB.

We arrive at a price target of INR220, at which the stock will trade at 2.7x FY19E book value.

Bull

3.4x 2019E BPS INR 274

Our bull case assumes that CUB will continue to win market share at a fast pace from PSU Banks, have no impact

from GST and display very good opex control implying an EPS level 5% higher than our base case resulting in an

FY17-20E EPS CAGR of 23%.

Base

2.7x 2019E BPS INR 220

Our base case assumes that CUB will continue to win market share at a reasonable pace from PSU Banks, have a

minimal negative impact from GST and display good opex control implying an FY17-20E EPS CAGR of 21%.

Bear

1.4x 2019E BPS INR 113

Our bear case assumes that CUB will continue to win market share at a moderate pace from PSU Banks, have

moderate negative impact from GST and display moderate opex control implying an EPS level 5% lower than our

base case resulting in an FY17-20E EPS CAGR of 17%.


4 GWM

Focus Charts

Average Daily Turnover (INR cr) Stock Price (CAGR) Relative to Sensex, CAGR (%)

3 months 6 months 1 year 1 year 3 years 5 years 10 years 1 year 3 years 5 years 10 years

1.84 1.05 0.73 59% 33% 32% 28% 39% 26% 19% 11%

Bu

sin

ess

Va

lue

Driv

ers

Nature of Industry

Industry loan growth has slowed to 5% in FY17 but there is great divergence among individual banks. While PSU Banks are challenged on

the growth and asset quality front, Private Sector Banks are growing faster with superior asset quality. Within Private Sector Banks, banks

with higher loan book exposure to large corporates, especially to stressed sectors like Metals and Infra, are worse off compared with

banks with higher exposure to retail and / or retail-like small-ticket MSME loans.

Opportunity Size

CUB has a Q3FY17 branch share of 3.5% in its home state of Tamil Nadu compared with 65% for PSU Banks, from whom CUB continues to

win market share. From an overall perspective, CUB has a market share of only 0.30% of the banking system’s loans as of FY17. Hence,

CUB has significant headroom for growth both within its home state and from an overall perspective. Furthermore, MSME is a major long-

term thrust area for the Indian government and MSME / Trade loans are a focus area for CUB with 48% loan book share as of FY17.

Capital Allocation

CUB has focused on the higher-yielding MSME segment resulting in high Net Interest Margin of 4.2% (FY17). CUB stands very well

capitalised with a Tier 1 Capital Ratio of 15.4% as of FY17.

Predictability

Predictability is high since CUB has very low exposure to Large Corporate Loans (7% of FY17 loan book) from where large lumpy NPA

accounts usually emerge. Further, CUB’s exposure to consortium lending is very small at c.1% of loan book providing similar comfort.

Sustainability

In its key home state of Tamil Nadu, CUB is winning market share from PSU Banks, fending off competition effectively against key Tamil-

Nadu focused listed rivals, Karur Vysya Bank and Lakshmi Vilas Bank, which have significant asset quality issues while larger private sector

rivals operate in significantly higher MSME ticket size range compared with CUB, which has an average MSME ticket size of c. INR 33 lacs.

Disproportionate Future

At present, CUB does not plan to expand rapidly outside its home state of Tamil Nadu, where it has significant headroom. However,

management is acutely aware of the importance of long-term growth delivery for investors and hence, we think the bank would

ultimately start to focus outside Tamil Nadu, particularly on the loan book side.

Business Strategy &

Planned Initiatives

CUB will continue to focus on the high-yielding MSME segment, particularly on retail-like small-ticket MSME loans. Cost control to be

maintained on the back of favourable employee settlement and further enhanced with technology initiatives including robust digital

strategy and robotics.

Near Term Visibility

While there is concern regarding the impact of GST on the overall MSME space, CUB will be impacted minimally since it largely operates

within an MSME portion that is already tax-compliant. Any slowdown due to onerous compliance requirements will be short-lived.

Long Term Visibility

CUB has high long-term visibility as it is a bank with deep expertise in small-ticket MSME lending, high client retention, improving cost

control on the back of technology leadership, prudent liability management and best-in-class credit appraisal approach.


5 GWM

Focus Charts – Story in a nutshell

CUB to grow sans drag as de-focusing of Jewel

Loans largely behind us

CUB’s South-focus adequate given high

op. leverage, among other reasons

Low dependence on Borrowings and Bulk

Deposits results in lower CoF

Small-ticket loan exposure results in high-yielding

loan book

Non-IBA employee settlement and digital

franchise drive lower opex

Underlying credit risk for CUB not concerning

Source: Edelweiss Investment Research

22%

18%

14%

10% 9%

FY13 FY14 FY15 FY16 FY17

Je

we

l Lo

an

s a

s a

% o

f Lo

an

bo

ok

55 58

74 76

145

City Union

Bank

Lakshmi

Vilas Bank

DCB Bank Karur

Vysya

Bank

RBL Bank

FY

17 D

ep

osi

ts /

Bra

nc

h (

INR

cr)

5.9%

6.5% 6.7%

7.0% 7.0%

City Union

Bank

Karur Vysya

Bank

Lakshmi

Vilas Bank

DCB Bank RBL Bank

FY

17 C

ost

of

Fu

nd

s

12.10% 12.03%

11.34% 11.29% 11.25%

City Union

Bank

DCB Bank Karur Vysya

Bank

Lakshmi

Vilas Bank

RBL Bank

FY

17 Y

ield

on

Ad

va

nc

es

41%

45%

51% 53%

60%

City Union

Bank

Karur

Vysya

Bank

Lakshmi

Vilas Bank

RBL Bank DCB Bank

FY

17 C

ost

/ I

nc

om

e R

atio

2.6%

5.6% 6.6%

10.7%

14.3%

DCB Bank City Union

Bank

RBL Bank Karur Vysya

Bank

Lakshmi

Vilas Bank

As

a %

of

H1FY

17 c

red

it

Metals Infra


6 GWM

I. Jewel loan book de-focusing over, CUB poised for growth

without drag Post FY13, City Union Bank de-focused its Jewel Loan book and this had

proved to be a material drag on overall loan growth since then. However,

most of this process seems to be behind CUB and the incremental drag on

loan book growth due to this reason will be significantly lower going forward.

Evolution of loan book proportion for City Union Bank– FY13-FY17


Agri 16% 19% 17% 16% 18%

MSME 26% 30% 34% 34% 30%

Large Industries 14% 8% 6% 7% 7%

Retail Traders 8% 7% 5% 5% 4%

Wholesale Traders 11% 11% 12% 13% 14%

Commercial Real

Estate 5% 5% 5% 5% 5%

JL Non Agri 9% 5% 2% 1% 1%

Housing Loans 5% 5% 6% 7% 7%

Other Personal Loans 2% 2% 3% 3% 3%

Loans coll. by Deposits 2% 2% 2% 2% 2%

Infra 1% 1% 1% 1% 1%

NBFC 1% 1% 1% 1% 1%

Others 2% 3% 5% 5% 7%

Jewel Loan* 22% 18% 14% 10% 9%

Source: Company data; *Including Agri Jewel Loan

Jewel Loan exposure has fallen from 22% in FY13 to 9% in FY17

We note that, in FY13, the total Jewel Loan book was 22% of total loan book

and this has since fallen to 9% of total loan book, as of FY17. It is clear that CUB

had taken a strategic decision to de-focus its Jewel Loan as it was then not

willing to keep gold loan risk on its balance sheet. This has no readacross for

CUB’s gold loan underwriting standards as this was largely an industry-wide

phenomenon wherein several banks have withdrew from gold loans whereas

focused gold loan NBFCs such as Manappuram Finance and Muthoot Finance

have grew AUM in this area during the same period.

Growth rates (yoy) of loan book components for City Union Bank– FY14-FY17


Agri

29% -2% 12% 28%

MSME

23% 25% 20% -2%

Large Industries

-39% -13% 27% 23%

Retail Traders

-9% -9% 10% -5%

Wholesale Traders

13% 23% 21% 20%

Commercial Real

Estate 13% 10% 20% 7%

JL Non Agri

-41% -49% -40% 15%

Housing Loans

24% 32% 27% 15%

Other Personal Loans

5% 50% 20% 20%

Loans coll. by Deposits

57% -3% 7% 3%

Infra

-3% -25% -10% 62%

NBFC

-8% -1% 22% 13%

Others

42% 120% 26% 56%

Total Loans

6% 11% 17% 14%

Jewel Loan*

-13% -16% -18% 4%

Loans ex Jewel Loan

11% 18% 23% 14%

Source: Company data; *Including Agri Jewel Loan


7 GWM

Jewel Loans de-growth from smaller base and slower place has already translated to lower drag

We note that CUB overall loan book growth was 6%, 11% and 17% in FY14, FY15 and FY16, respectively, whereas loan book excluding Jewel Loans grew 11%, 18%

and 23% in FY14, FY15 and FY16, respectively. This differential has narrowed significantly in FY17 with total loan book growing 13.5% whereas loan book ex Jewel

Loans grew 14.5%. This is because the Jewel Loan book is now (a) a small portion of overall loan book and therefore does not move the needle as much as it

used to and (b) de-growth of -13%, -16% and -18% yoy for the Jewel Loan book in FY14, FY15 and FY16 has given way to modest growth of 4% in FY17.

RBI Notification capping cash disbursal of Gold Loans at INR 20,000 an incremental positive

The relatively recent RBI Notification capping cash disbursal of Gold Loans at INR 20,000 (i.e. loans with ticket size exceeding INR 20,000 will have to be disbursed

through non-cash means e.g. cheque, etc) has, on balance, improved the regulatory setup somewhat in favour banks making loans against gold compared

with specialised gold loan NBFCs.

While Gold Loans of ticket size exceeding INR 1 lacs were already being disbursed through non-cash means (primarily cheque), now Gold Loans of ticket size

between INR 20,000 and INR 1 lac would have to be disbursed through non-cash means. What this means for specialised Gold Loan NBFCs is that they would

have to encourage borrowers falling in this bracket to develop a banking habit, which exposes these customers to being poached by banks.

It may be noted that, for Manappuram Finance, c.50% of loan book is to borrowers of loan ticket size exceeding INR 1 lac wheras, for borrowers below INR 1 lac

ticket size, the average ticket size is c.INR 15,000 indicating that most of such borrowers fall below the INR 20,000 threshold. Hence, for Manappuram, a relatively

lower c.10-15% of disbursals are potentially exposed to the poaching threat. For other specialised Gold Loan NBFCs, however, this sort of loan book skew (of very

large and very small ticket size loans) is not quite witnessed and hence, the vulnerability is higher. It may noted that the addressable NBFC universe (for poaching)

for banks engaged in Gold Loan business goes beyond just the well known players in this segment such as listed specalised Gold Loan NBFCs (Muthoot Finance,

Manappuram Finance), unlisted specialist Muthoot Fincorp and listed diversified NBFCs (IIFL, SCUF) as the number of players engaged in the Gold Loan business is

very large.

Furthermore, it may be noted that a bounce-back in the Gold Loan book, which has just taken root on a moderate scale in FY17, will also be yield-accretive for

CUB.

Slowdown in loan growth in FY17 is mainly on account of the transient impact of Demonetisation

De-monetisation has impacted certain components of the loan book viz. MSME, Retail Traders and Commercial Real Estate (comprising 39% of total loan book as

of FY17). We do not think the impact of De-monetisation would sustain as the economic activity linked to the aforementioned portion of the loan book is driven

by cash availability, which we believe would normalise soon given cash withdrawal limits have been completely removed.

It is worth noting that, if the growth rate of the affected portion of the loan book would have been the same as that in FY16, then the overall FY17 loan growth

(yoy) would have been significantly higher at 22% as opposed to the observed 13.5%. It may be noted that CUB did sell some PSLC backed by their MSME loans

and bought PSLC in the Agri segment. However, suffice to say that Re-monetisation is going to have a salutary impact on CUB loan growth going forward.


8 GWM

II. Ultra-long term advances trend underlines CUB as growth

engine with prudent risk management

We go as far back as FY96 and examine CUB and banking system advances’

growth trend since then. There are some interesting insights to glean from this

and overall, it establishes CUB as possessing judicious risk management

expertise while delivering higher growth than the system.

Advances growth (yoy) and Growth Differential – City Union Bank – FY96-FY16

Source: RBI, Ace Equity

We note that CUB delivered an Advances CAGR of 23% over FY1995-2016

compared with banking system Advances CAGR of 18.6% over the same

period. The average differential of growth rate of CUB compared with the

system is 5% and the average multiple of growth rate of CUB compared with

the system is 1.3x.

CUB has displayed the prescience to pull back prior to key financial crises

Further, we note that the growth rate differential steadily contracted from

FY1996 to FY2000, turned significantly negative in FY2006 and then, again in

FY2014. We note that these prudent relative growth pullbacks on the part of

CUB happened prior to key financial crises. It may be noted that the FY2000

crisis was led by the global tech slowdown, the FY2007-2008 crisis was the most

debilitating global financial crisis since the Great Depresssion and FY2015-2016

was a phase in which a China slowdown caused great stress to the Indian

Banking sector. In each of these cases, CUB has displayed great prescience

and slowed down lending to levels even lower than the system. This sense of

counter-cyclicality and general risk management prudence displayed by CUB

earmarks it as a prime bank name to be owned over the long-term cycle.

42%

24% 21%

16% 15% 14% 15%

20%

27% 30%

27%

31%

36%

24% 21%

35%

31%

26%

6%

12%

17%

-20%

-10%

0%

10%

20%

30%

40%

50%

FY

96

FY

97

FY

98

FY

99

FY

00

FY

01

FY

02

FY

03

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

FY

15

FY

16

City Union Bank Differential with System


9 GWM

III. South/Tamil Nadu focus adequate for growth over medium term

CUB currently does not have the intention to rapidly become a significantly pan-

Indian bank and its South/Tamil Nadu focus is adequate for fueling growth over the

next 4-5 years.

Market share gains expected at the expense of PSU Banks

The market share of PSU banks in the key Southern state of Tamil Nadu is significantly

high and eating into their share remains one of CUB’s key growth drivers. Loss of

share for PSU banks is an overarching mega trend on account of their comparably

inadequate service levels.

Competition from large private sector banks not intense for CUB

Competition from large private sector banks is also not a pressing concern since

these banks’ focus is on higher MSME ticket sizes (c. INR5cr), whereas CUB focuses

more on the INR25lacs –1cr segment. The average ticket size for the bank in the

MSME segment is c. INR33lac. Consequently, large private sector banks are unable

to match CUB’s service levels for smaller-ticket MSME clientele.

Home state of Tamil Nadu as yet under-penetrated from CUB’s perspective

Branch share breakdown—Tamil Nadu (9m17-end)

Rural Semi

Urban Urban Metro Total

State Bank Group 12% 12% 15% 17% 13%

Other Public Sector Banks 54% 49% 55% 50% 52%

Private Sector Banks 25% 33% 29% 32% 30%

Regional Rural Banks 10% 6% 1% 0% 5%

Foreign Banks 0.0% 0.0% 0.2% 1.1% 0.2%

Source: SLBC Tamil Nadu

We evaluated the branch presence breakdown data for Tamil Nadu

from the State Level Banking Committee and note that PSU banks

account for 65% of branches, indicating their significant penetration in

the state. Private sector banks account for 30% of branches in the state.

We do not possess, strictly speaking, market share data for Tamil Nadu

and business per branch would alter the market share for a given branch

share. However, our understanding is that PSU banks have a somewhat

lower market share than their branch share, while the opposite holds true

for private sector banks. Moreover, brach share is a reasonable indicator

of the penetration of the respective banks.

Branch share in Tamil Nadu—CUB versus peers (9mFY17-end)

Source: Company data, SLBC TN; LVB, DCB numerators are as at H1FY17-end, FY16-end

CUB’s branch share in Tamil Nadu stands at 3.51%, Karur Vysya Bank’s at

3.63% and Lakshmi Vilas Bank’s at 2.49%. From these numbers, we get a

sense of the under-penetration of these smaller-sized TN-focused banks.

The differentiation among the 3 banks lies in the extent to which each

has sweated its branch network, which we discuss in the next section.

3.63% 3.51%

2.49%

0.16% 0.08%

Karur Vysya Bank City Union Bank Lakshmi Vilas

Bank

RBL Bank DCB Bank


10 GWM

IV. CUB’s branch network as yet under-leveraged from a business

per branch perspective

Advances per branch (INR cr / branch) – FY17 - City Union Bank vs Key peers

Source: Company data; LVB data is for H1FY17

We note CUB’s advances per branch is INR44cr compared with peers’ INR44-

124cr.

Deposits per branch (INR cr / branch) – FY17 - City Union Bank vs Key peers

Source: Company data; LVB data is for H1FY17

CUB’s deposit per branch stands at INR55cr compared to peers’ INR58-145cr.

Thus, CUB remains significantly under-leveraged compared to key peers from

a business per branch perspective. Hence, we believe there is significant

upside for the bank from an operating leverage perspective.

44 44

57 58

123

0

20

40

60

80

100

120

140

Lakshmi Vilas

Bank

City Union Bank DCB Bank Karur Vysya Bank RBL Bank

FY

17 A

dva

nc

es

/ B

ran

ch

(IN

R c

r)

55 58

74 76

145

0

20

40

60

80

100

120

140

160

City Union Bank Lakshmi Vilas

Bank

DCB Bank Karur Vysya

Bank

RBL Bank

FY

17 D

ep

osi

ts /

Bra

nc

h (

INR

cr)


11 GWM

V. City Union Bank possesses Cost of Funds advantage over key

peers

CUB has a lower cost of funds compared to key small private sector banks. This

feeds directly into higher net interest income for a given balance sheet size,

implying higher net interest margin, ceteris paribus.

Cost of funds—CUB versus peers (FY17)

Source: Company data; DCB, RBL figures are simple averages of 4 FY17 quarters

Lower dependance on borrowings compared to peers

The bank has employed prudent approach and superior asset liability

management to keep its cost of funds on the lower side. One of the aspects of

this approach is low dependence on borrowings in comparison with deposits, the

former being generally higher cost than the latter.

Borrowings as % of Deposits and Borrowings—CUB versus peers (FY17)

Source: Company data; *Figure for LVB is calculated

CUB’s proportion of borrowings as a percentage of total deposits and borrowings

as of FY17 is 1.7% compared with key peers at 3.1-18.7%.

Lower dependence on high-cost bulk deposits compared to peers

Another key aspect of CUB’s funding mix is low dependence on high-cost

bulk deposits. There is no exposure to corporate bulk deposits and

certificates of deposit. Moreover, dependence on other bulk deposits at

c.5% of deposit book is also low

Bulk Deposits as % of Total Deposits – CUB versus peers (FY17)

Source: Company data; KVB figure is Bulk Term Deposits to Total Term Deposits

The dependence of key private sector peers on bulk deposits at 15-22.5% of

total deposits is materially higher than CUB’s. Bulk deposits are typically

higher cost deposits that banks lean on to fulfil their asset-liability

management requirements.

5.9%

6.5% 6.7% 7.0% 7.0%

City Union Bank Karur Vysya Bank Lakshmi Vilas Bank DCB Bank RBL Bank

FY

17 C

ost

of

Fu

nd

s

1.7% 3.1%

5.5% 6.2%

18.7%

City Union Bank Karur Vysya Bank Lakshmi Vilas Bank DCB Bank RBL Bank

5.0%

15.0%

18.0%

22.5%

City Union Bank Karur Vysya Bank Lakshmi Vilas Bank DCB Bank


12 GWM

CASA ratio for CUB is broadly comparable with peers

CUB’s FY17 CASA ratio of 23.4% is broadly comparable with key peers whose

CASA ratio ranges between 19.1% and 27.7%. Hence, even from a headline

CASA ratio perspective, this is neither a material negative or positive for the

bank from a cost of funds perspective for CUB.

CASA ratio—CUB versus peers (FY16, H1FY17, FY17)

Source: Company data

City Union Bank not participating in Savings Account interest rate competition

We note that City Union Bank offers a Savings Account (SA) interest rate of 4%

across accounts and hence, the headline CASA ratio needs to be viewed in

the context of SA interest rate competition, which City Union Bank is not

participating in. Consequently, CUB’s cost of SA deposits will be concomitantly

lower compared with banks that are participating in this rate competition.

Highest SA interest rate—CUB versus peers


We note that Lakshmi Vilas Bank and RBL Bank offer higher SA interest rates of

6.5% and 7.1% p.a., respectively, on certain savings account offerings.

27.7%

24.0% 23.4% 22.0%

19.1%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Karur Vysya Bank DCB Bank City Union Bank RBL Bank Lakshmi Vilas

Bank

FY16 H1FY17 FY17

4.0% 4.0% 4.0%

6.5%

7.1%

City Union Bank DCB Bank Karur Vysya Bank Lakshmi Vilas Bank RBL Bank


13 GWM

VI. City Union Bank has higher Yield on Advances compared

with key peers

CUB has a higher Yield on Advances compared with key small private sector

bank peers. This feeds directly into higher net interest income for a given

balance sheet size, implying higher net interest margin, ceteris paribus.

Yield on advances—CUB versus peers


Small-ticket MSME expertise of CUB feeding into higher Yield on Advances

We note that CUB is an small-ticket MSME specialist on the lending front.

Small-ticket MSME loans are higher-yielding assets leading to superior yield

on advances for the bank compared to peers.

Advances breakdown—CUB versus peers (FY17)

Source: Company data, Edelweiss Investment Research

We note that CUB’s MSME exposure is 48% of FY17 loan book compared to key

peers at 12-35%. Total small-ticket loans (SME + Retail) are 68% of loan book

compared with 30-64% for key peers. To arrive at the advances breakdown, we

have made certain reasonable assumptions / approximations to enable an

apple-to-apple comparison across these companies. We are well into the MCLR

regime and CUB has sustained its yield and maintained its margin leadership.

CUB’s Loan book granularity positive for Yield on Advances

Granularity of CUB’s loan book is significantly higher compared to peers. This

results in higher loan yield for the bank since higher granularity implies that it

operates in a higher yield bracket from a target client and ticket size

perspective.

Top 20 borrowers as a % of loan book—CUB versus Peers (FY16)


We note that the share of Top 20 Borrowers as a proportion of FY16 loan book

stood at 5.3% for City Union Bank compared with 8.1%-14% for key peers,

indicating higher granularity for City Union Bank and concomitantly higher yield

bracket (lower ticket size). Higher granularity also implies lower loan book risk,

ceteris paribus, due to lower concentration risk.

City Union Bank’s Net Interest Margin higher compared with peers

Consequent to its Yield and Cost of Funds leadership, CUB delivers higher NIM

compared with key peers, implying higher RoE, ceteris paribus.

Net interest margin—CUB versus peers (FY17)

Source: Company data; LVB figure is avg. of quarterly figures

12.10% 12.03%

11.34% 11.29% 11.25%

City Union Bank DCB Bank Karur Vysya Bank Lakshmi Vilas

Bank

RBL Bank

FY

17 Y

ield

on

Ad

va

nc

es

48%

12%

35%

12% 20%

20%

52% 15%

20% 10%

0%

20%

40%

60%

80%

100%

CUB DCB KVB RBL LVB

MSME Retail Agri Corporate

5.3% 8.1%

9.8% 11.4%

14.0%

City Union Bank DCB Bank Karur Vysya Bank Lakshmi Vilas Bank RBL Bank

4.17% 4.04% 3.70% 3.50%

2.85%

City Union Bank DCB Bank Karur Vysya Bank RBL Bank Lakshmi Vilas Bank


14 GWM

VII. City Union Bank has lower Cost to Income Ratio compared with

key peers

City Union Bank has a lower Cost to Income Ratio compared with key small

private sector banks. This feeds into higher Profit after Tax for a given Total

Income, implying higher Return on Equity, ceteris paribus.

Cost to income ratio—CUB versus peers


We note that CUB’s cost-to-income ratio stands at 41% compared to 45-60%

for key peers.

Lower cost per employee one of the key drivers of lower cost-to-income

ratio

One of the key drivers of lower cost-to-income ratio compared to peers is

the bank’s lower cost per employee

Cost per employee (INR lacs) —CUB versus peers (FY17)

Source: Company data; CUB excl. one-off ex-gratia provision; LVB is FY16 figure

CUB’s cost per empoyee at INR 6.1lacs is significantly lower than peers’ INR 6.2-

9.1lacs. There are 2 key reasons for this:

CUB has successfully negotiated the bi-partite settlement between

management and staff union officers’ association. This is not related to the

settlement negoatiated by Indian Banking Association (IBA) on behalf of banks

that agree to IBA negotiating on their behalf.

It is to be noted that CUB employees were granted a significant wage revision in

FY17, which is expected to stand for the medium term. This implies that the INR

6.2 lac cost per employee for FY17 is now at an increased level (INR 4.7 lac for

FY16) which would rise only at a moderate pace in the coming years, keeping

employee cost under control.

The second reason is that CUB has a prudent human resource strategy and has

worked to maintain a young workforce, implying lower employee cost, ceteris

paribus. The average age of its employees is 27 years, indicating a young

employee base.

Moreover, the bank’s business acquisition cost is on the lower side. It has a

focused approach for MSME clients due to which client retention is higher and

business acquisition costs are concomitantly lower.

High proportion of transactions through non-branch channels also lowers opex

materially

CUB has been able to successfully transfer its branch transactions to non-branch

channels. 2 years ago, c.50-60% of transactions happened via non-branch

channels but this has now moved up to c.85% thereby reducing cost.

Furthermore, this also releases branch personnel to focus on business promotion

activities. City Union Bank’s thrust on technology is typified by its investment in

robotics as its was able to introduce India’s first banking robot ‘Lakhsmi’ in

November 2016. (We expand further on the efficacy of City Union Bank’s digital

strategy in the next section).

41%

45%

51% 53%

60%

City Union Bank Karur Vysya Bank Lakshmi Vilas

Bank

RBL Bank DCB Bank

FY

17 C

ost

/ I

nc

om

e R

atio

6.1 6.2

7.8 8.2

9.1

City Union Bank DCB Bank Lakshmi Vilas

Bank

Karur Vysya Bank RBL Bank

(IN

R la

kh

)


15 GWM

City Union Bank’s best-in-class digital strategy a key factor driving lower opex

We compare the digital strategy outcomes of City Union Bank and note that it

is the only bank in our set of key peers that is in the top 2 on all parameters.

Monthly ATM transaction value (Oct 2016) as a % of deposits—CUB versus

peers

Source: RBI, Company data

We compare the monthly ATM transaction value for October 2016 as a

percentage of deposits (H1FY17-end) and note that this is 3.2% for CUB with

only Karur Vysya Bank higher at 4.5%; balance 3 peers are at 0.6-1.2%.

Monthly POS transaction value (Oct-16) as a % of deposits—CUB versus peers


We also compare the monthly POS transaction value for October 2016 as a

percentage of deposits (H1FY17-end) and note that this is 0.22% for CUB with

only Karur Vysya Bank higher at 0.25%; balance 3 peers are at 0.07-0.16%.

Monthly ATM transaction value (Oct-16; INR) per card—CUB versus peers

Source: RBI

We also compare the monthly ATM transaction value per card for October

2016 and note that this is INR5,752 for CUB compared with INR2,919-5,682 for

key peers.

Monthly POS transaction value (Oct-16; INR) per card—CUB versus peers

Source: RBI

We also compare monthly POS transaction value per card for October 2016

and note that this is INR398 for CUB with only DCB Bank higher at INR779;

balance 3 key peers are at INR170-380.

4.5%

3.2%

1.2% 1.2%

0.6%

KVB CUB LVB DCB RBL

0.25%

0.22%

0.16%

0.07% 0.07%

KVB CUB DCB LVB RBL

5752 5682 5628

2988 2919

CUB KVB DCB RBL LVB

(IN

R)

779

398 380 313

170

DCB CUB RBL KVB LVB

(IN

R)


16 GWM

Debit cards as a multiple of deposits (Oct-16; per INR cr)—CUB versus peers


We also compare the number of Debit Cards at the end of October 2016 as a

multiple of Deposits at H1FY17-end and note that this is 55 cards / INR cr for

City Union Bank with only Karur Vysya Bank higher at 79 cards / INR cr with the

remaining 3 key peers at 18-42 cards / INR cr.

Android downloads as a multiple of deposits (Oct-16; per INR cr)—CUB versus

peers

Source: Google Play Store, Company Data

We also compare the number of downloads on the Android platform cards as

of October 2016 as a multiple of deposits at H1FY17 end. It stands at 3.5

downloads / INR cr for CUB with only Lakshmi Vilas Bank higher at 3.7

downloads / INR cr; balance 3 peers are at 1.8-2.8 downloads / INR cr.

Thus, we note that CUB is in the top 2 among key peers across all parameters

considered, implying greater traction for its digital strategy compared to key

peers. This implies lower opex cost for CUB, ceteris paribus, compared to peers.

N.B. We looked at October 2016 as the period for this analysis as we wanted to exclude the partly

transient impact of Demonetisation.

79

55

42

21 18

KVB CUB LVB DCB RBL

(IN

R c

r)

3.7 3.5

2.8

1.9 1.8

LVB CUB DCB KVB RBL

(IN

R c

r)


17 GWM

VIII. City Union Bank has middling asset quality and is not a

major concern

CUB’s asset quality is of middling nature and is not a major concern in absolute

terms.

Gross total stress—CUB versus peers (FY17)

Source: Company Data; LVB data as of Q3FY17

While CUB’s headline GNPA ratio (as of FY17) is 2.8% compared to 1.2-3.6% for

key peers, its gross stock of total stress (the sum of GNPA ratio and Standard

Restructured Assets Ratio) stands at 3.4% compared to peers’ 1.5-6.6%.

Notably, Standard Restructured Assets Ratios for Karur Vysya Bank and Lakshmi

Vilas Bank at 2.0% and 3.8, respectively, are significantly higher than CUB’s

0.6%.

Management commentary in the Q4FY17 results conference call with regard

to asset quality has been significantly positive, particularly on the recovery

front. Recovery in Q4FY17 was INR 56cr, which is the highest and 3 years and

this momentum, if it continues, could result in the bank making up for the lower

trading profit on high FY17 base. Recovery rate, at the portfolio level, has been

c.80% and this is expected to continue going forward.

Exposure to stressed sectors within peer range

We compare CUB’s exposure to key stressed sectors of the Indian economy

and note that it is well within the peer range, indicating no significant

concern from an underlying asset quality perspective on this metric.

Credit exposure* to stressed sectors – H1FY17 - City Union Bank vs Key peers

Source: Company Data; *Loan book + Credit substitutes

I

1.2% 1.6% 2.8%

3.6% 2.8%

0.3% 0.3%

0.6%

2.0% 3.8%

RBL Bank DCB Bank City Union Bank Karur Vysya Bank Lakshmi Vilas Bank

GNPA Ratio Std. Restr. Ratio

17.0% 17.8%

20.7%

22.6% 22.9%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

DCB Bank RBL Bank City Union Bank Lakshmi Vilas Bank Karur Vysya Bank

Metals Construction Gems & Jewellery Infra Mining Textiles Engineering


18 GWM

We drew up a list of key stressed sectors of the Indian economy as follows:

Metals, Construction, Gems & Jewellery, Infra, Mining and Textiles. We note that

CUB’s credit exposure to these stressed sectors stands at 20.7% of credit (loan

book + credit substitutes) compared with 17-22.9% for key peers, indicating that

CUB is not undertaking any meaningful incremental risk from an underlying

sector perspective.

We do note that the relative stress of each sector is not identical. Furthermore,

we also acknowledge there would be differences across individual banks in

credit appraisal standards to the same sector. Additionally, credit risk across

projects within the same sector would also vary. Nevertheless, a sum of

respective exposures to these stressed secors gives us some sense of the

potential gross underlying stress for a given bank.

We further note that among the selected sectors, in terms of concentration risk,

City Union Bank’s exposure is the highest to Textiles at 10.3% of credit, which is

expected given its main area of operation is Tamil Nadu.

Most importantly, we also note that City Union Bank’s credit exposure to the

two most stressed sectors of the Indian economy viz. Metals and Infra is lower

than peers, barring DCB Bank. (Power and Telecom are subsumed in Infra

exposure.)

Credit exposure* to Metals and Infra—CUB versus peers (H1FY17)

Source: Company Data; *Loan book + Credit substitutes

We note that City Union Bank’s credit exposure to Metals and Infra is 5.6% of

credit with DCB Bank at 2.6% and the remaining 3 key peers higher at 6.6-

14.3%. The nature of Infra exposure, particularly expsoure to Power

Generation and Distribution, across peer banks considered may vary but this

exposure data was not available across banks and we have made the

apple-to-apple comparison based on data available.

From a 30,000 feet view, it is important to appreciate that CUB carries very

little of the loan book risk that has arisen in the wider banking sector from

exposure to large corporates (7% of FY17 loan book) in riskier sectors, project

financing of long-gestation projects (Working Capital Loans are 65% of loan

book) and concomitant consortium lending (c.1% of loan book). We shall

discuss these aspects and more in detail in the subsequent section. Hence,

to that extent, the possibility of the accretion of large lumpy corporate NPA

is low for CUB.

2.6%

5.6% 6.6%

10.7%

14.3%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

DCB Bank City Union Bank RBL Bank Karur Vysya Bank Lakshmi Vilas

Bank

Metals Infra


19 GWM

IX. CUB’s water-tight credit appraisal and lending approach also

indicates sound underlying asset quality

We looked deeply into CUB’s credital appraisal process and overall approach

to lending and note that they follow a fairly conservative process which

precludes an outsized accretion of bad loans.

CUB requirements for making an MSME loan point to a water-tight credit

appraisal method

(1) Income Tax Return filing of the last 3 years – While this may not be stressed

upon by lenders and NBFCs operating in the MSME space, IT Return filings

for last 3 years are viewed as critical by CUB. This enables CUB to make a

more informed decision about a businessman’s earning capacity and

analyse better the plausibility of cash flow projections of his business. The

proportion of SME borrowers who submit IT Return filings are as much as

c.80%.

(2) Immovable propety as collateral – CUB has a strong preference for

immovable property as collateral as opposed to movable property and

shares. Hence, the quality of collateral is superior for CUB loan assets.

Usually, the immovable property in question is residential property. Not

only does immovable property provide sound value as collateral, its value

to the borrower also acts as a deterrent and reduces the latter’s

probability of defaulting. Nearly all of the secured loan book is

collateralised by immovable property. The average recovery rate for CUB

is c.85% which compares very favourably with the national average of

India at 26% (as per World Bank statistics).

(3) Project report (business plan) – This includes a description of the business

and estimation of cash flows for the business going forward. While, as a

standalone document, this would be of lesser value, when analysed in

conjunction with the last 3 years’ Income Tax Return filings, it enables the

credit appraisal team to take a more informed decision about the

business proposal.

(4) CIBIL score – This is invariably downloaded from the relevant third-party

source on the basis of identity proof (PAN) submitted to CUB. A poor or

non-existant credit history translates into a low CIBIL score, which is not

viewed positively by the bank’s credit appraisal team

(5) Additional document – Any additional document that provides useful and

incremental knowledge about the business is also considered for credit

appraisal. For example, stock (inventory) report for the business.

(6) Existing bank account – If a potential borrower already has an existing

bank account (savings / OD) with CUB, it is considered as an additional

input for the credit appraisal team. Such a bank account can provide

valuable information about the businessman’s cash flow profile in the past.

Other factors in CUB’s overall lending approach provide underlying asset

quality comfort

(1) Focus on secured lending - It may be noted that as much as 99% of CUB’s

lending is collateralised.

(2) Use of Personal Guarantee – CUB also often obtains personal guarantee

along with collateral. This also acts as a deterrent reducing a borrower’s

probabiliy of defaulting, ceteris paribus.

(3) Single banker relationships – CUB generally avoids consortium lending and

opts for single-banker relationships instead. This helps them arrive at a

better understanding of their clients’ cash flows and liquidity position and

thereby, take more informed lending decisions. Consortium lending cases

amount to only about c.1% of total loan book.

(4) Higher granularity in loan assets – The average ticket size of MSME loans is

c.INR 33 lacs as opposed to c. INR 5 cr for larger private sector bank peers.

This means their MSME exposure is ‘retail-like’ in nature and possesses a

different risk profile compared to larger ticket MSME exposure, which

carries greater macro risk

(5) Focus on Working Capital lending – 63% of loan book is Working Capital

loans. This means that the macro risk present in term loans made during

long-term project lending is low for CUB.


20 GWM

(6) Streamlined, centalised loan approval structure

a. All loan proposals are placed at the branch level.

b. The loan proposals are then analysed by 10 loan processing centers. If

the proposal is rejected, then no further action is taken. If approved,

the proposal is forwarded to the respective regional DGM, which is a

very senior level functionary in CUB hierarchial nomenclature.

c. Importantly, the regional DGM (each of whom may handle upto 50-75

branches) is located at the Head Office. This, in effect, means the loan

approval is highly centralised in nature.

d. An intranet software is in place that enables seamless exchange of

information across the organisation.

e. All loans others than Loans collateralised by Deposits (2% of Q3FY17

loan book) and Jewel Loans (9% of loan book) required centralised

approval meaning 89% of loan book has undergone centralised

approval.

(7) Low exposure to Large Corporate Loans

a. The only loan exposure truly in the nature of Large Coporate Loans is

the 7% exposure (as of Q3FY17) to Large Industries. The ‘Large

Industries’ classification followed by CUB is as per the MSMED Act 2006

and classifies loans to companies with investment in plant and

machinery in excess of INR 5 cr as under Large Industries.

b. Furthermore, consortium lending cases amount to only about c.1% of

total loan book.

c. The 5% Commerical Real Estate exposure is mostly to contractors with

ticket size usually ranging between INR 20-50 lacs. Builders are usually

not the category being lent to though there is some exposure to

builders with ticket sizes usually not exceeding c.INR 5 cr and going up

to INR 10 cr at the most.

d. The Infra exposure of 1% of loan book is mostly legacy exposure to SEB.

e. The NBFC expsoure of 1% of loan book consists of exposure to Mutual

Benefit Fund and other NBFC exposure.

f. We note that, in the Indian credit market, the macro risk in Large

Corporate loan exposure is comparably higher than in other segments.

Such exposure is lower for CUB compared with key peers.

g. We also note differences in classification where, in contrast, for

example, RBL Bank classifies companies with turnover exceeding INR

1500 cr under C&IB (Corporate and Investment Banking) and

companies with turnover between INR 250 and INR 1500 cr under

Commercial Banking. The MSME piece falls under Branch and Business

Banking (which also contains loans to individual consumers) and this

consists of MSME players with turnover lower than INR 250 cr. This implies

that even the small headline exposure of 7% to Large Industries of CUB

is of a different (lower risk) nature than alternate classifications of the

nature discussed above.

CUB’s credit appraisal process gives us comfort that it will tackle the GST

situation admirably

We think that CUB will remain largely unscathed from the impact of GST

implemention on the MSME sector given that it largely operates in that portion

of MSME that is already tax-compliant. A small portion of the bank’s MSME

borrowers may, as per a certain hypothesis, see a moderate margin shrinkage

but this is not likely to lead to significant incremental NPA accruals. There can,

however, be a significant impact on disbursement to the MSME sector since

the borrowers may become preoccupied with onerous compliance

requirements but we believe that this is likely to be transient and not persist

with materiality beyond H1FY18.


21 GWM

X. Higher capital levels implies lower dilution compared with peers

CUB raised its Tier-1 capital to 16.03% in FY15 and has since maintained higher

capital levels than peers.

Tier 1 Capital ratio—CUB versus peers (FY15-FY17)


We evaluate Tier 1 Capital Ratio for comparison instead of Total Capital Ratio

(CRAR) since the regulator emphasises on the former and there is a separate

minimum level for the same.

Higher Tier 1 Capital Ratio of 15.4% for CUB compared with 8.7-12.5% for key

peers implies lower dilution of existing shareholders going forward, ceteris paribus,

compared with those for key peers.

Key financial indicators

FY16 FY17 FY18E FY19E FY20E

Net Interest Income 981 1199 1452 1701 2008

Other Income 410 484 542 608 702

Total Income 1391 1683 1994 2309 2710

Operating Expenses 558 689 795 929 1056

Pre-Provisioning Operating Profit 833 994 1200 1380 1654

Provisions excl for Tax 231 301 336 370 408

Profit Before Tax 603 693 863 1010 1246

Profit After Tax 445 503 639 748 922

Basic EPS 7.4 8.4 10.7 12.5 15.0

P/E 24 21.0 16.6 14.2 11.8

Book value per share 51 60 69 80 104

P/B 3.5 3.0 2.6 2.2 1.7

Provisions on Average Advances 1.2% 1.3% 1.3% 1.2% 1.1%

GNPA Ratio 2.41% 3.10% 2.70% 2.40% 2.30%

NNPA Ratio 1.53% 1.97% 1.71% 1.52% 1.46%

C/I Ratio 40% 41% 40% 40% 39%

Yield on Avg Advances and Investments 11.4% 10.7% 10.7% 10.8% 10.9%

Cost of Average Deposits and Borrowings 7.6% 6.8% 6.5% 6.7% 7.0%

Net Interest Margin 3.8% 4.1% 4.4% 4.4% 4.4%

Return on Average Assets 1.50% 1.51% 1.69% 1.72% 1.82%

Return on Average Equity 15.5% 15.2% 16.6% 16.8% 16.3%


15.36%

12.54% 11.87%

11.40%

8.75%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

City Union Bank Karur Vysya Bank DCB Bank RBL Bank Lakshmi Vilas Bank

FY15 FY16 H1FY17 FY17


22 GWM

Valuation

We use the Residual Income Valuation Model to value CUB. We assume a

long-term risk-free rate of 7% for India, a Beta of 1.05 for CUB and an India

Equity Risk Premium of 6% and arrive at an overall Cost of Equity of 13.3% for

CUB. We arrive at a price target of INR220, at which the stock will trade at 2.7x

FY19E book value.

Valuation metrics

FY16 FY17 FY18E FY19E FY20E

Basic EPS 7.4 8.4 10.7 12.5 15.0

EPS growth 9% 13% 27% 17% 20%

P/E 23.8 21.0 16.6 14.2 11.8

Book value per share 51 60 69 80 104

P/B 3.5 3.0 2.6 2.2 1.7

Return on Average Equity 15.5% 15.2% 16.6% 16.8% 16.3%


At CMP, CUB trades at P/B of 2.2x FY19E book, which we believe is attractive

given FY18E-20E RoE of 16-17%. Consequently, we believe the multiple of 2.7x

implied by our price target of INR 220 is reasonable.

The stock trades at P/E of 11.8x FY18E EPS for FY17-20E EPS CAGR of 21%.

Hence, we conclude that CUB is attractive from P/E basis as well.

Is CUB a multiple re-rating candidate? We believe so

We carry out a multi-layered analysis to understand whether CUB deserves a

re-rating and find that a valuation gap exists between CUB’s FY19E P/B

multiple and what it should logically trade at.

The (P/B, RoE) pair indicates undervaluation for CUB

The (P/B, RoE) pair encapsulates all aspects of a bank’s internals and,

theoretically, is sufficient to judge the bank’s valuation as long as the P/B is

calculated accurately and the RoE represents the accurate structural and

sustainable long-term RoE (the long-term growth rate of the “book” in the P/B

ratio).

We use the average FY17-19E RoE as a proxy for the sustainable long-term

RoE for a bank and then compare the P/B multiples for a relevant private

sector banks’ universe.

P/B vs RoE—CUB versus expanded set of private sector peers

Source: Edelweiss Investment Research, Bloomberg

We note that that all banks in our expanded universe which have an RoE of 14%

or higher, trade at a P/B of 3.2-3.6x except for City Union Bank, Yes Bank and

Lakshmi Vilas Bank, which trade at 2.2x, 2.3x and 1.6x, respectively. We examine

RoA and implied Financial Leverage to get a clearer picture.

The (P/B, RoA) pair also indicates undervaluation for CUB

Since the average FY17-19E RoE is a period average, its value as a proxy for

sustainable long-term RoE is not necessarily all-encompassing. Hence, it is

necessary to look at RoA, which indicates a bank’s underlying ability to sweat its

assets to generate bottomline. When RoE is viewed in conjunction with RoA, we

get a better sense of the sustainability of the former, since an RoE achieved with

high financial leverage indicates higher generic balance sheet risk and

concomitantly lower sustainability of RoE.

P/B vs RoA—CUB versus expanded set of private sector peers


3.6 3.5 3.4 3.2 2.3 2.2 2.2 1.8 1.7 1.6 1.5 1.4 1.1 1.0

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23 GWM

We note that all banks in our universe which have an RoA of 1.6% of higher,

trade at a P/B of 3.2-3.6x except for City Union Bank and Yes Bank. Lakshmi

Vilas falls significantly short of this RoA threshold with an RoA of 0.9% implying a

high Financial Leverage of 16.2x calling into question the sustainability of its RoE

of 15%. As for Yes Bank, it is unique in the banking universe as far as trading at

its valuation for its return metrics. This has mostly to do with, among private

largecaps, (a) the highest exposure to large corporate loans as a percentage

of loan book (68%) (b) high exposure to Infra and Metals sectors (c.12% of

H1FY17 credit) (c) the widest divergence with RBI with regard to NPA

recognition.

While Financial Leverage captures the overall potential generic balance sheet

risk but to provide further colour on balance sheet risk, one needs to adjust for

the quality of underwriting standards of banks.

P/AB vs RoE—CUB versus expanded set of private sector peers


The adjustment for the quality of underwriting standards is achieved by

adjusting the book balue for Net NPA and Standard Restructured Assets book.

We adjust for 100% of Net NPA (since Net NPA has not been provided for) and

25% of Standard Restructured Assets.

We note that that all banks in our expanded universe which have an RoE of

14% or higher, trade at a P/AB of 2.4-3.8x except for City Union Bank, Yes Bank

and Lakshmi Vilas Bank, which trade at 2.4x, 2.4x and 2.1x, respectively. We

note again that the analysis here does not account for the risk of high financial

leverage whereas an RoA-only analysis would have ignored the greater

significance of RoE, the direct driver of shareholder value.

P/AB+ (with incremental adjustment for unrecognized loan book stress)

indicates undervaluation for CUB

While the total stress recognized, measured as the sum of NNPA and Standard

Restructured Assets, is a reasonable measure of the quality of underwriting

standards, we must also provide for unrecognized stress. We do this by looking

at the credit exposures to two key stressed sector viz. Metals and Infra.

P/AB+ vs RoE—CUB versus expanded set of private sector peers


We adjust the book value further by 10% of Metals credit exposure and 5% of

Infra credit exposure and designate the same Adjusted Book Value+ (or AB+).

We understand the limitation of this exercise as headline Metals exposure

across banks may not be similar but this is done as best approximation. We treat

this as possible incremental recognition that is not currently part of recognized

stress and, to that extent, there is no overlap.

The P/AB+ is the valuation mutiple of the respective bank having adjusted for

recognized and certain unrecognized stress. We note that that all banks in our

expanded universe which have an RoE of 14% or higher, trade at a P/AB+ of

3.4-3.9x except for City Union Bank, Yes Bank and Lakshmi Vilas Bank, which

trade at 2.5x, 2.5x and 2.4x, respectively. Given that Lakshmi Vilas Bank’s

implied financial leverage of 16.2x is prohibitively high and Yes Bank has

idiosyncratic issues, we find that CUB is the most undervalued bank in our

choice set on the basis of the our comprehensive set of valuation metrics as

laid out in our extended analysis above.

3.8 3.6 3.4 3.3

2.4 2.4 2.3 2.1 2.1 1.9 1.9 1.8 1.3 1.2

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P/AB (FY19E) Avg RoE (FY17-19E)

3.9 3.7 3.5 3.4

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P/AB+ (FY19E) Avg RoE (FY17-19E)


24 GWM

Financials

Income Statement (INR cr) Balance Sheet (INR cr)

Year to March FY16 FY17 FY18E FY19E FY20E As on 31st March FY16 FY17 FY18E FY19E FY20E

Interest income 2,944 3,174 3,604 4,232 5,067 CAPITAL AND LIABILITIES

Interest charges 1,963 1,975 2,151 2,531 3,058 Share Capital 60 60 60 60 63

Net interest income 981 1,199 1,452 1,701 2,008 Reserves and Surplus 2,992 3,510 4,068 4,735 6,479

Other income 410 484 542 608 702 Deposits 27,158 30,116 34,550 40,212 46,567

Net revenues 1,391 1,683 1,994 2,309 2,710 Borrowings 113 531 531 531 531

Operating expense 558 689 795 929 1,056 Other Liabilit ies & Prov isions 929 1,054 1,054 1,054 1,054

- Em ployee exp 214 299 359 430 495 Total 31,252 35,271 40,263 46,592 54,694

- Depreciation / am ortisation 52 54 54 62 71 ASSETS

- Other opex 291 336 382 436 490 Cash and Balances with RBI 1,363 1,484 1,633 1,796 1,975

Preprovision op. profit 833 994 1,200 1,380 1,654 Balances with Banks & Call Money 1,238 1,395 1,534 1,688 1,856

Provisions 231 301 336 370 408 Investments 6,324 7,031 7,693 8,420 9,220

PBT 603 693 863 1,010 1,246 Advances 21,057 23,833 27,884 33,740 40,488

Taxes 158 190 224 263 324 Fixed Assets 218 215 247 284 327

PAT 445 503 639 748 922 Other Assets 1,053 1,313 1,272 664 827

Extraordinaries 0 0 0 0 0 Total 31,252 35,271 40,263 46,592 54,694

Reported PAT 445 503 639 748 922

Basic number of shares (cr.) 59.8 59.8 59.8 59.8 61.3 RoAE Decomposition

Basic EPS (INR) 7.43 8.40 10.68 12.50 15.03 Year to March FY16 FY17 FY18E FY19E FY20E

Diluted number of shares (cr.) 61.2 61.2 61.2 61.2 62.7 Net Interest Income / Assets 3.3% 3.6% 3.8% 3.9% 4.0%

Diluted EPS (INR) 7.27 8.22 10.44 12.22 14.70 Other Income / Assets 1.4% 1.5% 1.4% 1.4% 1.4%

Net Revenues / Assets 4.7% 5.1% 5.3% 5.3% 5.4%

Growth Ratios Operating Expense / Assets 1.9% 2.1% 2.1% 2.1% 2.1%

Year to March FY16 FY17 FY18E FY19E FY20E Provisions / Assets 0.8% 0.9% 0.9% 0.9% 0.8%

NII growth 22% 22% 21% 17% 18% Taxes / Assets 0.5% 0.6% 0.6% 0.6% 0.6%

Net Revenues growth 15% 21% 19% 16% 17% Total Costs / Assets 3.2% 3.5% 3.6% 3.6% 3.5%

Opex growth 7% 24% 15% 17% 14% Return on Assets 1.5% 1.5% 1.7% 1.7% 1.8%

PPOP growth 20% 19% 21% 15% 20% Assets / Equity 10.3 10.0 9.8 9.7 8.9

Prov isions growth 26% 31% 12% 10% 10% Return on Average Equity 15.5% 15.2% 16.6% 16.8% 16.3%

PAT growth 13% 13% 27% 17% 23%

Valuation Metrics

Operating Ratios Year to March FY16 FY17 FY18E FY19E FY20E

Year to March FY16 FY17 FY18E FY19E FY20E Basic EPS 7.4 8.4 10.7 12.5 15.0

Yield on Average Advances and Investments 11.4% 10.7% 10.7% 10.8% 10.9% EPS growth 9% 13% 27% 17% 20%

Cost of Average Deposits and Borrowings 7.6% 6.8% 6.5% 6.7% 7.0% Book value per share 51 60 69 80 104

Spread 3.7% 3.9% 4.2% 4.1% 4.0% Basic P/E 23.8 21.0 16.6 14.2 11.8

Net Interest Margin 3.8% 4.1% 4.4% 4.4% 4.4% Price - to - Book 3.5 3.0 2.6 2.2 1.7

Cost to Income Ratio 40% 41% 40% 40% 39%

Tax Rate 26% 27% 26% 26% 26%


25 GWM

Edelweiss Broking Limited, 1st Floor, Tower 3, Wing B, Kohinoor City Mall, Kohinoor City, Kirol Road, Kurla(W)

Board: (91-22) 4272 2200

Vinay Khattar

Head Research

[email protected]

Rating Expected to

Buy appreciate more than 15% over a 12-month period

Hold appreciate between 5-15% over a 12-month period

Reduce Return below 5% over a 12-month period

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City Union Bank 5 years price chart

Disclaimer

26 GWM

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27 GWM

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28 GWM

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Documents

City Union Bank Ltd - Edelweiss GWM unique competitive advantages compared with key peers on the yield, cost of funds and operating expense front, allowing it to Edelweiss Investment