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Superior incremental unit economics demonstrates business potential

We initiate coverage on IDFC FIRST Bank (IDFCFB) with BUY recommendation and target price of Rs73 (assigning 1.9x multiple to FY23E book). The bank’s evolution is unique in a sense: on getting license, it was created out of demerger of infrastructure financing business followed by merger of erstwhile Capital First. Stress build-up and franchise investment resulted in a weak return profile (net worth erosion) during the transition phase. However, the new bank, with a new Board, new management and renewed focus, has made significant strides in retailisation and granularisation of its business.

Current return profile is dragged by high-cost structure, low fee income and elevated credit cost. Nonetheless, its marginal unit economics is superior and incremental retail disbursements have potential RoE of >20%. Going forward, key triggers for RoE improvement would be normalisation of cost to income ratio, retail fee income scale-up, and steady improvement in NIM trajectory. Key risks would be sustenance of cutting edge execution of stated strategy and elevated ‘cost to income’.

* Remarkable transition in asset and liability profile post the merger:

IDFC FIRST Bank followed a structural path towards retailisation of assets as well as liabilities. After having rolled out a 5-year strategic roadmap towards targeted RoA and RoE of 1.4-1.6% and 13-15% respectively, it has made significant strides on most operating parameters: 1) retailisation of assets (>30% CAGR over FY19-FY21, now constituting 63% of assets); 2) granularity of deposits – average CASA deposits surged to ~50% and deposits of 5% (>7% for retail), GNPAs rose to 4.15% (from 2.6% in FY20). Retail GNPAs at 4.01% are higher by 175bps from the pre-covid average. Restructured pool is equivalent to 1.3% of retail assets. Despite the incremental stress in FY21, credit cost was contained at 250bps for FY21 supported from adequately covered and write-back in wholesale portfolio. Coming from a high-growth phase in retail (>25% in FY21), the impact of covid second wave disruption needs to be closely monitored.

* Investment in franchise comes at a cost; efficiency key to drive RoAs:

Bank has actively invested in people, processes, products, infrastructure and technology to put together all the necessary building blocks towards a stronger foundation essential for a long-term sustainable growth engine. However, this has come at a cost, and the cost structure hovers much higher compared to peers (IDFCFB’s ‘cost to income’ at >70%). However, cost efficiency and containment will be a key RoA driver going forward.

* RoE profile currently low; incremental unit economics superior:

IDFC FIRST Bank’s current return profile is dragged by higher ‘cost to income’, lower fee income, and elevated credit cost. Nonetheless, its far superior incremental unit economics is encouraging (incremental retail disbursements have potential RoE profile of >20%). As we see a steady and sustainable transition in favour of retail assets/liabilities, we expect return profile to improve (to >8%/11% by FY23E/FY24E) on the back of normalisation of ‘cost to income’, retail fee income scale-up, and steady improvement in NIM trajectory.

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