Why a merger won’t fix AU’s woes
Investor response to AU Small Finance Bank Ltd's optimistic management commentary at a recent analyst meeting has been lukewarm. The bank has ambitious plans to nearly double its balance sheet to ₹2 trillion by the close of FY27 from ₹1.17 trillion as of December 2023, following its merger with Fincare Small Finance Bank.
This objective necessitates an annual growth rate of about 20% over the next three years.
Given AU’s historical performance, which includes a 37% compound annual growth rate (CAGR) in balance sheet size up to FY23 over the past five years, achieving this target seems plausible.
In fact, rapid growth is the reason why AU Small Finance was a preferred choice among investors until recently. The stock has surged by 97% over the last five years.
However, this aggressive expansion strategy has shown its downside, particularly with asset quality deteriorating in the December quarter (Q3FY24) results, leading to a nearly 5% drop in net profit to ₹375 crore.
This decline was mainly due to an increased provision for bad loans, particularly for credit cards, which rose to ₹159 crore from ₹33 crore in the previous year.
As a result, the bank's stock value has diminished by about 20% since the Q3 results. The bank is targeting a return on assets (RoA) of 1.8% by FY27, up from 1.22% for the nine months ended December 2023 (9MFY24).
RoA is profit after tax as a percentage of balance sheet, or total assets, where the asset base is calculated taking average of the last two years. Achieving a ₹2 trillion asset base with a 1.8% RoA would imply a net profit of ₹3,300 crore for FY27, considering the average asset size for FY26 and FY27.
After accounting for the issuance of 70 million shares to Fincare's shareholders, the price-to-earnings ratio for FY27 is estimated at 13 times, which is high compared to peers like Federal Bank, which is at 10 times based on FY23 figures.
The merger with Fincare, whose balance sheet is roughly 15% the size of AU’s, offers limited immediate diversification benefits due to Fincare's smaller scale. Despite Fincare’s higher net interest margin (NIM) of 10% compared to
AU’s 6% in Q3FY24, the overall impact on NIM post-merger will be minimal.
Unless there is a system wide decline in interest rates led by RBI’s loosening of monetary policy, the cost of funds is likely to rise for the bank. The incremental cost of funds at 7.7% is higher than average of 6.7% for 9MFY24. The management has already admitted the challenges in raising deposits. In addition to higher cost of funds, profit is likely to be impacted by merger integration costs.
Nonetheless, the merger will address AU’s issue of regional concentration, reducing its presence in western India from 64% to 40% of its touch points, while expanding its footprint in southern India to 28%.
It’s anticipated that operating costs will decrease as the network of branches and business associates effectively doubles, reaching 1,049 touch points and expands customer base to 10 million. However, these financial advantages have already been factored into the projected 1.8% RoA for FY27.
History shows that the initial enthusiasm for merger benefits, such as synergies, often diminishes over time.
This pattern holds true for AU, with its stock price falling below ₹669 per share on 31 October, the first trading day following the merger announcement, reflecting skepticism over the merger’s long-term impact on resolving the bank’s fundamental challenges.