Ujjivan, Equitas: Investors shouldn't rush

Back in October 2015, when the Reserve Bank of India (RBI) announced the list of non-banking financial companies (NBFCs) eligible to operate as small finance banks (SFBs), there was much cheer on how this opens up a new platform to serve the underserved in a structured banking format. But after two years, as investors look back to assess the progress made by the marquee names — Equitas and Ujjivan — some amount of disappointment seems justified.

Equitas Holdings was the first to hit the bourses in April 2016. The share of microfinance loans was much more than 50 per cent when the SFB rolled out its public offering. Since then, the share of microfinance loans to the overall assets under management (AUM) has reduced to 36 per cent in the September 2017 quarter (Q2). Demonetisation was a blessing in disguise. Even as the credit costs (loan losses) for microfinance loans peaked to 3.6 per cent in the December’16 quarter, the event fast-forwarded the SFB’s efforts to diversify its AUMs. Currently, the non-microfinance book is spilt between business loans, loans to the agriculture segment, gold loans and corporate loans. The pace of loan growth in the non-microfinance segment exceeds that of the microfinance loans and Equitas plans to reduce the dependence on microfinance to 25 per cent by FY19. 

Illustration by Ajay Mohanty

Yet, all this comes at a cost. In the process of aligning its business to the SFB model, return ratios have gone for a toss. From 14 per cent return on equity (ROE) in June 2016, the number plunged to about two per cent in Q2 of FY18, because of high provisioning costs and operating expenses incurred in the process of SFB conversion. As the financier shrunk the microfinance book in Q2, AUM grew at just 3.5 per cent year-on-year. But, as much of the demonetisation related pain is well-absorbed in the financials, analysts at Edelweiss believe Equitas is adequately capitalised to rein in execution risks. “Franchise investment, elevated cost and higher provisioning would lead to decline in earnings in FY18, but benefits will accrue from FY19 onwards,” the analysts said. 

The path charted by Ujjivan Financial Services is also not too different, though it has relatively been a laggard in terms of increasing the share of its non-microfinance portfolio. Consequently, Ujjivan was hit harder by demonetisation, with its credit costs remaining elevated at 4.8 per cent, even for the microfinance portfolio, in Q2FY18. The event also slowed down the pace of diversifying the SFB’s AUMs. Consequently, Ujjivan continues to derive 85 per cent of its AUMs from microfinance loans, while the rest is unsecured loans to individuals, housing loans and loans to small and medium businesses. Yet, return ratios have significantly deteriorated in the past year as the troubled microfinance portfolio continues to account for the bulk of its loan book. But, there are some positive too. Analysts at Axis Capital believe the improvement in operating metrics after demonetisation has been much faster for Ujjivan and they expect a return to normalcy by FY19.

Nonetheless, shedding a few points on the return profile appears imminent for the SFB business at least in the early years of operations. Even the latest entrant, AU Small Finance Bank, wasn’t spared in Q2 and foreign brokerage Morgan Stanley expects the financier’s ROE to plunge from 20.4 per cent in FY17 to 12.4 per cent in FY18.

In light of the plunging return ratios, how should investors look at these stocks? 

Equitas has been a non-performer and the past one year is a reflection of its poor financials. Therefore, trading at 2x FY19 price-to-book (P/B), the stock appears fairly priced within the financial services sector. But, Ujjivan trading at 2.8x FY19 P/B, doesn’t fully address the concerns relating to its fundamentals. Diversification of its loan book could entail high costs in the medium-term. Investors may, hence, be better off gauging how well the SFBs fulfil their promise in the next 6-12 months, though in the long-term, they make for attractive investments.