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Equitas Small Finance Bank, with a well-diversified asset mix and steadily improving liability franchise (CASA ratio at 34%), is likely to emerge as a preferred player to play on India’s financial inclusion story with economic formalisation as the key driver. We initiate with BUY rating and target price of Rs92, valuing the stock at 2.5 FY23E P/BV.

Journey from commencing CV financing in 2011 under its NBFC avatar to convert into SFB in 2017 has been encouraging and reflective of management’s ability to respond to market realties in a most effective manner. It trimmed unsecured lending to 17% in FY21 from 76% in FY13.

Delivering its highest RoA (since commencement of SFB operations) at 1.7% and RoE at 12.5% in FY21 despite covid-related challenges speaks of its business resiliency. While near-term asset quality concerns persist amid resurgence of covid cases and its high exposure to self-employed segment, lower restructuring pool at ~2.4%, provision buffer at 90bps, and calibrated lending (MFI book fell 11% YoY in FY21) reinforces our view that Equitas would navigate the current cycle more effectively than peers.

* Carving out a niche in financing ‘underserved’ self-employed segment. An early (2011) NBFC foray by entering into CV financing space provided a headstart in underwriting individual loans and with decade-plus experience, Equitas built a robust proprietary credit model to underwrite ‘underserved’ small business owners mostly in tier 3-6 cities. Further, as a prudent lender, it preferred the organic way of doing business – right from sourcing (no DSA sourcing) to underwriting (including vehicle inspections, valuers, site visit for SBL loans) to collection. With >14% asset yields, average credit cost of ~150bps between FY13-FY21 speaks of its asset franchise. A huge untapped market, adequate capital (tier-1 at 23%), and diversified asset mix, underscore its ability to deliver industry-leading growth going forward. We estimate 19% / 24% AUM growth in FY22E/FY23E respectively.

* CASA at 34% speaks for its strong liability franchise. Differentiated ‘value for money’ banking products and services, deep distribution and targeted approach enabled Equitas to emerge as a strong alternative for customers banking with a traditional regional bank in their locality, and build strong retail liability franchise. Its C/D ratio touching ~100% within 4 years of SFB operations reflects its successful execution of liability strategies. The early (FY17-FY18) capex on building liability-focused branches helped the company building trust in local communities, and the same helped it build strong 34% CASA by FY21-end, one of the highest within the SFB space. While it offers high SA rate at 7%, hence raises questions on stickiness of CASA deposits if it start cutting rates, our view is that CASA customers are less interest-rate sensitive if compensated by differentiated product offering. We have seen similar trend playing out for one of the large private sector banks.

* Operating leverage and normalisation of credit cost to remain key RoA driver. Equitas delivered its highest RoA since SFB conversion, at 1.7% and RoE at 12.5% despite elevated credit cost at 170bps (vs historical average of 120bps) due to covid challenges. However, benefits arising from operating leverage, cost/income ratio at lowest level of ~60%, enabled it to deliver highest profitability. Its continued focus on cost optimisation, no intent to expand branch network over next 2 years, and likely normalisation of credit cost from FY23E onwards is likely to drive RoA to >2% and RoE >18% going forward. Key risks: A) stress unfolding higher than anticipated, and B) delay in loan growth recovery.

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