ICICI Bank Investment Thesis

Published on 04/28/21 | Saurav Sen | 3,448 Words

The BuyGist:

  • This thesis was originally posted on December 10th, 2019. 
  • We go through the company's competitive advantage, durability of competitive advantage, and its management quality. 
  • Since we wrote this, a lot has changed. We regularly revisit our thesis to see what we got right and what we got wrong.

Thesis Summary

Has mostly shifted towards Retail lending, largely cleaned up its loan book, digitized, expanded its reach, and is positioned to remain a dominant player in a cleaner Indian Banking system – our conduit to invest in the rising Indian Consumer.

Competitive Advantage: The Castle

  • Core Competency? Retail & Corporate banking in India.
  • Products – Better or Cheaper? Better. Scale & Reach Advantage. Better Technology.
  • Historical Growth? Good Revenue and Cash Flow growth in last 12 months.

Durability of Competitive Advantage: The Moat

  • Competition? Heavy. HDFC Bank, Axis, Kotak. And some government banks.
  • Economic Moat? Digitization, combined with Scale and Reputation.
  • Cash Flow Volatility? Volatile due to impact of Loan Loss Provisions, not competition.

Management Quality: The General

  • Strategy & Action? Good. Been applying the HDFC Bank playbook: Vanilla Retail loans.
  • Return on Equity? Low. May improve over next 12 months. 15% target by 2020.
  • Sustainable Free Cash Flow? About $3 billion. Translates to roughly $18.3 per share.

Competitive Advantage: The Castle

Core Competency? Retail & Corporate banking in India.

This is pretty simple. ICICI Bank – the main unit of the consolidated holding company – lends money to businesses and people. Nothing mysterious here. But its legacy has been in corporate lending, and that has hurt them over the last few years. We’ve gone over the travails of the Indian Banking industry in detail before, and most recently over here. ICICI was one of the culprits – they lent money to questionable government-backed infrastructure projects and to questionable corporations that had no intention of paying it back. This was a systemic issue. Our other Indian Banking idea – HDFC Bank – came out of it unscathed because they played it safe. ICICI didn’t. And they suffered. But over the last 12-18 months, ICICI has been mimicking their big rival by shifting their loan book towards people rather than corporations. And this seems to have served them well. Take a look at this loan-book transition:

But, right off the bat, let me point out the main RISK in the ICICI story: About 50% of its Retail Loan Book is in Home Loans. That’s a big chunk of ICICI’s assets exposed to one sector – Housing. To  

With a stronger Central Bank oversight, new bankruptcy laws, a more retail-oriented loan book, ICICI appears to come out of the Indian Banking crisis cleaner and stronger. At The Buylyst, we are bullish on India and on Indian consumers over the long-run. And a clean, plain-vanilla, easy-to-understand private bank is a good way to harness this tailwind.

Products – Better or Cheaper? Better. Scale Advantage. Reach Advantage. Better Technology.

I’ve said this before, and I’ll say it again: Fintech is Finance – there is no “Fin” without “Tech” anymore. This is true of Retail Banking than any other form. Our interaction with our money is becoming increasingly digital. As with anything else – like shopping and watching movies – we want everything done with the click of a button. Banking is no exception. ICICI has had to invest heavily in smartphone apps to make lending easier to the vast number of newly-banked people in India.

Ironically, this investment in cutting-edge tech is more effective when you’re a big player. At the moment, vast portions of the Indian population are still unbanked. The way to bank them is to offer a potent combination of old-fashioned customer service involving humans, backed by easy-to-use apps. India, for the most part, is still a “high-touch-point” country when it comes to customer service, which means that human involvement is almost necessary to sell anything. Banking is not an impulsive purchase. Banks need a large physical footprint across the country to not only reach more people in semi-urban and rural areas but to also have an appearance of scale and stability.

This is an important point: After the recent scandals in the Indian Banking industry, the Indian public is increasingly looking for STABILITY in their banks. I’ve pointed out before that deposit insurance laws in India are woefully inadequate. Only the equivalent of about $1,500 per account is insured. This means that most people need to spread out their savings across many banks. What they want is to be reasonably confident that their bank won’t fail, and their deposits are safe. ICICI has had some troubles with their management, their image, and bad loan decisions in the recent past. But over this past year, they’ve cleaned up their act on multiple fronts. They’ve always been #1 or #2 in terms of size and reach. Now, with the reputation mostly back on track, they can market themselves as the big, stable candidate amongst a sea of small, risky competitors. More on this in the competition section.

Here’s the bottom-line: ICICI has what it takes to be the big, stable bank with cool technology – much like it’s more successful rival HDFC Bank. The point about Stability depends on the bank’s Risk Management qualities, and this differentiator is a common must-have among both customers and investors.

So far this year, they’ve improved on the Stability front.

Historical Growth? Good Revenue and Cash Flow growth in last 12 months.

Almost all trends – numerically – look good. Revenue has been increasing at a good clip. Cash Flow has been proportionately increasing. Credit quality is better. Here are some convincing charts:

Based on this evidence, it appears that ICICI management has improved its credit risk management capabilities considerably. Will this newfound sense of risk management remain steadfast? We don’t know. We can’t. But it’s logical to bet Yes.

However, despite better credit risk management, some risks are hard to hedge out completely. Considering this is India, the risk of political instability causing economic instability is always present. Banks will always be sensitive to macro-economic shocks. Currently, ICICI’s biggest risk exposure is the India Housing Market. About 30% of ICICI’s loan book is exposed to this macro risk. What is the risk, specifically? We’ve discussed this in some detail here but the gist is this: Unemployment rates have increased in India and if the Modi government doesn’t step in to boost that somehow, there could be more delinquencies, especially in the Housing market. If that happens, ICICI NPA’s could increase.

Apart from this, the biggest risk in the ICICI story is old skeletons peering from the proverbial closet. This last quarter, ending September 30th, 2019, saw some other loan assets in (as clarified by Management in the last earnings call) the Construction and Infrastructure industries were downgraded to below-investment-grade. This was surprising in the face of overall improvement in the bank’s credit risk profile. And these were, no doubt, related to loans made 2, 3 or 4 years ago when the bank went on a commercial lending binge. Management mentioned that more downgrades should be expected. But they comforted analysts by saying the impact on cash flow should be immaterial.

Overall, ICICI’s loan book should grow along with the bottom-line – cash flow. However, credit quality may worsen somewhat, which could have an offsetting impact, albeit a small one.

Durability of Competitive Advantage: The Moat

Competition? HDFC Bank, Axis, Kotak. And some government banks.

Competition is stiff but limited. The other biggies in India also have formidable footprints and a complete suite of smartphone apps. When it comes to product offering or technology or geographical footprint, ICICI faces strong competition in each category. But taken together, in totality, ICICI stands out along with HDFC Bank. They’re the top 2 private-sector banks, with Axis being a distant third. Kotak has other offerings, like investment research and brokerage accounts – categories in which they have a more established presence compared to HDFC Bank or ICICI.

If we zoom out, the reality is that private-sector banks have been taking share from public-sector banks, which have traditionally ruled Indian banking. And as that movement has taken place, the biggest private banks have gained. ICICI, over the last 12 months, has seen deposits grow by more than 20%. That’s in line with their biggest competitors, if not better. As the banking industry mess gets resolved, people seem to be coming out of it demanding scale, stability and snazzy tech. ICICI has all 3. If it can keep its credit risk under control (also known as stability), it’s right up there to grab more share from the big public-sector banks.

Economic Moat? Digitization combined with Scale and Reputation.

The biggest tailwind in the banking industry, globally, may be digitization. Why? It makes credit risk analysis more systematic. Over time, more sophisticated AI tools may improve the process. In my view, stringent human oversight will always be necessary because all these lending algorithms or models – AI-infused or not – are “garbage-in-garbage-out”. But what digitization does best is to take out bias and moral hazards. If you’ve noticed here, many scandals in Indian Banking have been results of moral failures. Digitization should help with that going forward.

I mentioned earlier that the combination of Scale (Reach) + Reputation (Stability) + Good Tech differentiates ICICI as it stands now. If it can repair the Reputation part a bit more, even better. I’ll add a fourth dimension here: Retail Lending. Here’s why:

The combination of Scale (Reach) + Reputation (Stability) + Good Tech (easy-to-use Apps that collect credit data to be used in lending algorithms) + RETAIL LENDING widens the Moat between ICICI and smaller competitors. Retail Lending and Digitization go hand-in-hand. Unlike commercial lending (to companies, infrastructure projects, non-bank financials etc.), data and analytics on Retail Lending (to regular folks like you and me for homes, cars, credit cards etc.) are more freely available. There is enough data that it can be automated. Scale gives more data, Reputation increases Scale, more Scale provides more data for Good Tech, which makes the Tech even better – and all of them together increase profitability in the Retail loan book. It can be a virtuous loop. ICICI (along with HDFC Bank) stands tall to be able to create this loop. Once it’s in motion, it’s hard for small, regional banks to compete. Look at how much more oligopolistic banking in the US has become, a far cry from the fragmented industry it was in the pre-internet era.

The 4 variables mentioned above amplify each other. If ICICI can set the loop in motion, it’s Moat should widen considerably.

Cash Flow Volatility? Volatile due to impact of Loan Loss Provisions, not competition.

ICICI’s cash flow is volatile. They do have a line of fee-businesses like Life Insurance but that’s not enough to offset the volatility from Credit Risk in its banking business. The main volatile variable is loan losses and loan loss provisions. I mentioned earlier that ICICI’s main risk is loan losses arising from remaining skeletons in the closet, related to bad loans in Construction & Infrastructure.

But the main point is that cash flow volatility will be more a function of lending prudence as opposed to ceding ground to HDFC Bank or Axis based on snazzier apps or product variety. Of course, as I mentioned earlier, bad lending decisions impacts stability (and the image of stability), which can lead to market share loss.

ICICI’s cash flow volatility should reduce if management can keep improving the bank’s credit risk profile.

Management Quality: The Generals

Strategy & Action? Good. Been applying the HDFC Bank playbook: Vanilla Retail loans.

ICICI has recently been through a major Management scandal. Storied CEO Chanda Kochhar was allegedly involved in orchestrating a major loan to an electronics company, which had on its board Kochhar’s husband. I’ve written a bit more about this scandal here. She was replaced, and the current management team is headed by CEO Sandeep Bakshi and CFO Rakesh Jha. Qualitatively, I don’t know much about them. The only sense I get is that they know what they’re doing – I say this based purely on hearing their earnings calls. CFO Jha, especially, seems to have an iron grip on the various businesses of the bank while CEO Bakshi has remained consistent on big-picture issues such as the shift to Retail Lending and the drive to improve their Risk Ratings.

Numerically, I must give them full marks. They’ve steered the bank away from that crisis in credibility towards a pathway to stability. The big shift has been this: lend more to Retail clients rather than Commercial clients. This has been their biggest rival’s playbook – HDFC Bank has stayed clear of all the banking scandals around them by “sticking to their knitting” (as their CEO Aditya Puri puts it). This shows in the numbers. ICICI’s management team should get a special bonus if this trend continues (or even stabilizes) for the next couple of years. If management can keep credit risk under control, they can unleash that virtuous loop of Scale + Reputation + Apps. And “sticking to their knitting”, especially with Retail Lending via digitization, is the way to go. At least on the earnings calls, they seem to be in agreement.

Return on Equity? Low. May improve over next 12 months. 15% target by 2020.

The reason ICICI never made the cut at The Buylyst last year was because their ROE is appallingly low at <5%. We don’t normally look at companies that have single-digit ROEs. But the potentially exciting combination of the “dual cleanup”- of ICICI itself and the Indian Banking industry at large – made us take a closer look. Returns come from the future, not the past. And for all the reasons mentioned in the sections above, we think that in ICICI’s case, the probability of a good future outweighs the probability of a troubled one.

ICICI’s management has targeted an ROE of 15% by mid-2020. This is aggressive. I doubt they’ll get there in 2020. But even if they get to 10%, it will be a massive success. That can happen if margins improve. They can improve if their loan book grows even at, say a 10% clip (they’ve been growing at 20%). And then if management can keep cost of funding low with plain-vanilla deposits, their net interest margin should look better. They can attract more deposits if they can unleash that virtuous loop mentioned above: Scale + Reputation + Apps. And to unleash this loop, management must focus maniacally on credit risk. And management can do that if it lends more to retail. If it does, the main risk in this whole story is macroeconomic. If businesses start hiring lesser people, unemployment rate increases. If that happens, delinquencies could increase and, consequently, ICICI’s credit risk could increase.  But if management has designed the right lending algorithm to the Retail sector, credit risk should be muted. The big variable, as I mentioned earlier, is the Housing sector. I would implore ICICI management to reduce its Housing exposure.

If the virtuous loop is unleashed and if there’s no meaningful pressure on the Housing market going forward, ICICI should achieve its ROE target of 15% - maybe not in 2020 but maybe by 2021.

Sustainable Free Cash Flow? About $3 billion. Translates to roughly $18.3 per share.

Here are the assumptions:

  1. Revenue: Assumed no increase over the last 12 months. 
    1. We expect expansion in the ICICI’s balance sheet – loans and deposits – in tune with their experience over the last 12 months. Their loan book has been growing at a clip of 20%. But there may be some economic headwinds in India over the next 12 months, which could slow loan growth. We’re being conservative.
  2. COGS and Operating Costs: COGS include Interest Expense attributable BOTH to deposits and to long-term debt. 
    1. All Operating Costs booked under “R&D and Cost of Labor”.
  3. EBITDA: Assumed same margin as last 12 months.
  4. Capital Expenditure: Assumed all Capex is Maintenance. Assumed same as last 12 months.
  5. Working Capital: No positive swing assumed. Assumed Changes in Working Capital will normalize to $0 over the next few years. This is an important assumption!
    1. Remember: Loan Loss Provisions in the Income Statement is a non-cash charge.
    2. The last few months have seen a lot of Working Capital positive swings because of extra allocation to Loan Loss Provisions. This show up as an increase in Operating Liabilities in the Cash Flow Statement, when adjusting Accounting Profit towards Cash Flow from Operations. I expect this trend to reverse.
    3. The NPA (nonperforming asset) % has decreased over the last few quarters. This will – sooner or later – result in lower loan loss provisions. This will reverse the working capital swing.
  6. Cash Interest: Already included in COGS.
  7. Cash Taxes: From Cash Flow Statement.

The big takeaway is this: Assuming NO GROWTH in revenue, and assuming that Management hangs on to its newfound control on Credit Risk, there seems to be considerable upside to the ICICI story. The MAIN RISK is that about 30% of its loan book is in Home Loans. It’s a Macro risk that’s hard to quantify. It depends on the employment situation in the country and, consequently, on overall stability of wages. We’ve put out our views on it here. But if ICICI’s current credit quality profile – as per internal ratings - is to be believed, then the impact of “bad loans” in this sector should be muted. About 94% of its loan book is rated A- or higher. This is a significant improvement over the last 2 years.

All things considered, this seems to be a decent long-term bet on the Indian Consumer and on the resurgence of the Indian Banking Industry, after a massive, much-needed clean-up effort by the country’s Central Bank and – by extension – the ICICI management. The bet is that most of the skeletons in the closet have been cleaned out.

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