IDFC Bank-Capital First merger: Gains for both justify the deal premium

But, growing deposit base will be the real test

Shares of IDFC Bank and Capital First hit their respective 52-week highs on Friday on increased buzz of the two entities being merged. Much to the Street’s expectations, they agreed to a merger on Saturday. Under the deal, IDFC Bank will issue 139 shares for every 10 shares of Capital First. Given that shares of IDFC Bank closed at Rs 67.65 on Friday and Capital First’s at Rs 835.9 on the BSE, 10 shares of Capital First, therefore, are valued at Rs 8,359, while the value of 139 shares of IDFC Bank works out to Rs 9,403, indicating a premium of about 10 per cent for Capital First shareholders. Consequently, some analysts believe the IDFC Bank stock may correct a bit on Monday, with some investors also wanting to benefit from the arbitrage opportunity. 

However, there are others who believe that despite the premium for Capital First, there is potential for the two stocks to rise on Monday and thereafter, given the long-term gains on the business front and due to benign valuations so far for IDFC Bank. “IDFC Bank is trading at a significant discount to its peers. This valuation gap should reduce if the deal closure happens within slated timelines (two-three quarters),” says an analyst from a foreign brokerage. 

“The merger is positive for IDFC Bank in terms of diversification of lending book. Also, valuation multiple in terms of price-to-adjusted book value for the merged entity would be still at a significant discount as compared to other large private banks,” says G Chokkalingam, founder & MD, Equinomics Research & Advisory.

The confidence of experts emerge from reasonable synergies the merger could fetch for both companies. For IDFC Bank, the immediate one will be a well-diversified loan book. Currently, about 47 per cent of IDFC Bank’s loan book is skewed towards infra. Incorporating the Rs 185-billion loan book of Capital First, it will reduce the stickiness of IDFC Bank’s infra loans to an estimated 34 per cent (based on Q2 numbers). With the share of legacy loans inherited about two years ago reducing, investors can expect IDFC Bank’s asset quality to improve as the loan book seasons further. “The merger gives the much-needed impetus to building a reasonable retail franchisee, a process that could be difficult for the bank to execute on its own,” says Asutosh Mishra of Reliance Securities. Capital First’s loan book is quite diversified with a bulk of it in the loan against property (LAP) segment, while a reasonable bit comes from two-wheeler loans, consumer loans and loans to small businesses. These segments are expected to remain the focus areas for retail lenders. 

Capital First’s ability to keep bad loans in check despite its dependence on LAP (gross NPA ratio of 1.7 per cent in Q2), stands testimony to its asset quality. Analysts say Capital First’s management team folding into IDFC Bank is an intangible advantage to the bank. “Vaidyanathan has a history of successfully scaling up a bank’s retail assets (he was with ICICI Bank earlier). His turnaround with Capital First is well-established. Thus, his leadership at IDFC Bank is a major positive,” says the analyst quoted above. 

For Capital First, its founder and Chief Executive V Vaidyanathan has in the past expressed the advantages of operating as a bank. But now, the deal is struck at the right time. Increasing competitive intensity has not been a trouble for this NBFC so far. But, it could start pinching from here on, as cost of money is already on the rise. Maintaining profitability (margins) at over 8-9 per cent in a rising bond yields scenario could be stretched for Capital First. As banks come with the natural advantage of low cost of funds, the merger is a blessing for Capital First. The customer base of the combined entity would stand expanded to over 5 million; IDFC Bank’s current base is 2 million and Capital First at 3 million. Organic growth of such a scale could be otherwise challenging for Capital First and IDFC Bank.

Though these positives appear to justify the deal valuations, there is still a major concern, particularly for IDFC Bank. Much as the bank needs to broad base its assets, the need of the hour is to grow its liability franchisee at a faster rate. After two years of operations, IDFC Bank’s deposit base is just Rs 390 billion, with the share of low-cost Casa deposits at 8.2 per cent. Unless Casa ratio increases, the benefit of low cost of funds may not accrue for the bank. 

How effectively the bank’s combined assets will boost its liability profile (or deposit base) needs to be seen. This is in fact the real test of the merger. Mishra of Reliance Securities believes that as the dynamics of merger with Capital First is better than the earlier proposal (Shriram group merger), chances of success is fairly high. “If the deposit base doesn’t increase substantially in 12-18 months, investors might once again shy away from IDFC Bank,” says an analyst from a domestic brokerage.