IPO: ESAF Small Finance Bank

In a nutshell

• Quality: It reported a three-year average ROE of 10.8 per cent. Moreover, it achieved an average net interest margin of 9.4 per cent in the last three financial years.
  
• Growth: Over the last three years, it grew its AUM (assets under management) by 39.2 per cent annually and its PAT by 69.4 per cent annually.
  
• Valuation: The stock will be priced at a P/E and P/B of 9.5 and 1.4 times, respectively, compared to its peers' median and average of 14.1 and 2.2 times.
  
• Overview: Rural areas are not only relatively less competitive but also have higher growth potential due to lower penetration. As of March 31, 2023, rural centres, which accounted for 47 per cent of GDP, received just 8 per cent of the overall banking credit, which shows the vast market opportunity for banks and NBFCs to lend in these areas. The company aims to gain from this opportunity.

About ESAF Small Finance Bank

ESAF Small Finance Bank is an SFB with a focus on rural and semi-urban centres. As of June 30, 2023, its gross advances to its customers in rural and semi-urban centres (combined) accounted for 63 per cent of its gross advances, and 72 per cent of its banking outlets were located in rural and semi-urban centres (combined). Its advances comprise of (a) microloans, which comprise microfinance loans and other microloans; (b) retail loans, which include gold loans, mortgages, personal loans, and vehicle loans; (c) MSME loans; (d) loans to financial institutions; and (e) agricultural loans.

Strengths of ESAF Small Finance Bank

• A higher share of retail deposits: ESAF SFB had the highest retail deposits(low-cost funds) as a percentage of total deposits at 89 per cent as of June 30, 2023, in comparison to its peers.
  
• Strong capital adequacy ratio (CAR): It maintained a CAR of 20.6 per cent as of June 30, 2023, against the regulatory requirement of 15 per cent.

Weaknesses of ESAF Small Finance Bank

• Rising competition: While the rural segment has been relatively less competitive, In recent years, there has been a significant rise in small finance banks catering to these areas. Besides, big banks such as HDFC Bank have also been actively opening branches in tier-3 and tier-4 cities. Rising competitive environments could pose a threat to the company's growth going forward.
  
• It caters majorly to the unsecured category : As of June 30, 2023, 75 per cent of its advances (net of provisions) were unsecured advances. Microfinance, in general, is a risky segment and can quickly go south if there is any adverse event. During the pandemic, NPAs in small finance banks shot up significantly due to the nature of the borrowers they cater to.

Risk report

Management

• Is ESAF Small Finance Bank free from regulatory penalties?
  Yes, the management is free from regulatory penalties.
• Does the SFB provide for its non-performing assets (NPAs) adequately? Specifically, is the provision-to-gross NPAs ratio more than 50 per cent?
  Yes, its provision coverage ratio stood at 74 per cent as of June 30, 2023.
• Do the top five managers have stock as a significant part of their compensation (more than 50 per cent)?
  No. While ESOPs have been offered in the past, stock-based compensation does not form a significant part of the top five managers' income.

Financial strength and stability

• Does ESAF Small Finance Bank have a fresh slippage-to-total advances ratio of less than 0.25 per cent? (fresh slippages are loans that became NPAs in the last financial year)
  No, the ratio stood at 6.43 per cent for the year ended FY23 and 0.87 per cent for the quarter ended June 30, 2023.
• Did the SFB generate a current return on equity (RoE) of more than 12 per cent and a return on assets (RoA) of more than 1 per cent?
  Yes, the SFB reported an ROE and ROA of 19.4 and 1.6 per cent, respectively, in FY23.
• Has the ESAF Small Finance Bank increased its loan book by 20 per cent annually over the last three years?
  Yes, the SFB increased its loan book by 39 per cent annually between FY21 and FY23.
• Has the SFB increased its net interest income (NII) by 20 per cent annually over the last three years? (Net interest income is the difference between the revenue that is generated from an SFB's assets and the expenses associated with paying out its liabilities).
  Yes, it achieved an annualised growth rate of 41 per cent in net interest income between FY21 and FY23.
• Is there a direct relationship between the increase in the loan book and the increase in net interest income (NII)?
  Yes, higher advances have translated into higher net interest income.
• Is the ESAF Small Finance Bank's capital adequacy ratio more than 15 per cent?
  Yes, it reported a capital adequacy ratio of 20.56 per cent as of June 30, 2023.
• Can the SFB run its business without relying on any external funding in the next three years?
  Yes, its capital adequacy ratio stood at 20.56 per cent as of June 30, 2023. The financial strength, coupled with the IPO proceeds, would ensure the sustainability of business operations without external help.
• Did the SFB generate an average net interest margin (NIM) of over 3 per cent in the last two years? (Net interest margin or NIM denotes the difference between the interest income earned and the interest paid by an SFB or financial institution relative to its interest-earnings assets like cash).
  Yes, its average three-year net interest margin (NIM) stood at 9.4 per cent.
• Is the SFB's average gross NPA ratio (Gross NPAs/Total advances) over the last three years less than 1 per cent and the average net NPA ratio (Net NPAs/Total advances) less than 0.5 per cent?
  No, it reported an average gross NPA of 5.7 per cent and an average net NPA of 3 per cent in the last three years.
• Does the SFB have a cost-to-income ratio of less than 50 per cent?
  No, it reported a cost-to-income ratio of 57.9 per cent in FY23.

Growth and business

• Will ESAF Small Finance Bank be able to scale up its business?
  Yes, as rural centres have lower financial inclusion compared with urban areas, and there is thus less competition for banking services in rural centres compared with urban centres, the company's future prospects look bright.
• Does the SFB have a loan book of more than Rs 1,00,000 crore?
  No, it reported an AUM of Rs 17,204 crore as of June 30, 2023.
• Does the SFB have a recognisable brand truly valued by its customers?
  No, there are many Banks, NBFCs and SFBs lending to the MSME and retail segment.
• Does ESAF Small Finance Bank have a credible moat?
  No, it operates at a small scale in a commoditised market.
• Is the level of competition faced by the SFB relatively low?
  No. While it was relatively low before, competition has been rising with the entry of not only new small finance banks but also big banks that are trying to take a crack in the rural segment.

Valuations

• Is ESAF Small Finance Bank's price-to-earnings ratio lower than its peers' median level?
  Yes, it will trade at a price-to-earnings ratio of 9.5, lower than its peers' median level of 14.1.
• Is the SFB's price-to-book ratio lower than its peers' average level?
  Yes, it will trade at a price-to-book ratio of 1.4, lower than its peers' median level of 2.2.

Disclaimer: This is not a stock recommendation. Do your due diligence before investing.

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