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Building strong foundation for sustainable growth

RoA to remain suppressed in near term

* AUBANK has historically delivered healthy RoAs; however, this has seen compression over FY24, primarily due to a decline in margins and an uptick in credit costs. The merger with Fincare SFB will enable AUBANK to achieve sustainable growth, while stronger return ratios for Fincare will boost profitability in the coming years, particularly as operating leverage improves.

* Post-merger, the AUBANK will also gain presence in high-yielding MFI and Gold loan segments, while its positioning in SBL and the Housing vertical will be strengthened. Moreover, Fincare's robust presence in southern India complements AUBANK's stronger presence in the North, thus helping AUBANK significantly expand its geographical foothold.

* While the merger is BV and RoA accretive, aided by stronger return ratios in MFI, Gold, and SBL loan portfolios, the intense competition for liabilities and integration costs will largely offset any near-term benefit. However, we estimate RoA to gradually improve to 1.7% by FY26E as the bank benefits from operating synergies, while moderation in funding costs also enables an improvement in margins.

* Furthermore, as Fincare is a rural-focused SFB with 85% of its advances meeting the PSL criteria, the merger will enable AUBANK to fulfill its PSL target without compromising on growth.

* We believe that the bank’s execution capability will play an important role in maintaining robust growth, asset quality while delivering healthy RoA to its stakeholders. We are optimistic about smooth execution, given the management’s execution prowess and track record over the past couple of decades. We reiterate Buy on the stock with a TP of INR720 (2.7x FY26E BV).

Estimate loan CAGR of ~25% post-merger

The merger with Fincare SFB will augment AU Bank's loan book by ~16%. We estimate the combined entity to deliver robust growth at a 25% CAGR, thus resulting in balance sheet size surpassing INR1.5t by FY25E. This will be led by improved geographical footprint, addition of new product lines, and an expansion in customer base. Loan book is thus likely to cross ~INR1tn in FY25E, driven by ~20% YoY growth in key existing business lines and an accelerated 30% YoY growth in newer segments. The bank expects steady ~20% growth in VF and SBL, while Commercial, HL, and MFI segments are likely to grow at a faster ~30% runrate.

Business mix to diversify; new product lines to open up growth avenues

The distinct asset composition of AUBANK (Wheels, SBL, Housing, and Commercial) and Fincare SFB (MFI, SBL, and Gold) complements each other and bridges the gap in the bank’s product offerings. The wider product suite not only presents avenues for growth, but also augments the merged entity's leadership positioning in the SFB sector. Post-merger, the overall business mix of the bank is thus poised to become more diversified, with the concentration of wheels reducing to 27.4% from 32%, and the new segments of MFI/Gold constituting 7.5%/1.6% of the combined loan book. AUBANK strategically aims to keep the MFI mix below 10% vs 7.5% post-merger. The merger thus not only widens opportunities for expansion into new geographical areas and product segments, but also addresses Priority Sector Lending (PSL) requirements, including the more stringent Small and Marginal Farmer (SMF) segment, through high-yielding products such as MFI, SBL, and Gold.

Geographical mix to improve; touchpoints to more than double

Through merger, AUBANK aims to more than double its touchpoints to 2,334, with the bank further planning to add another 150 touchpoints by the end of FY24. AUBANK is yet to establish any meaningful presence in the southern region and the merger will facilitate AUBANK to significantly strengthen its geographical diversification, leveraging Fincare's strong presence in the southern region. The bank is thus poised to extend its reach to nine states from four states with each having over 100 touchpoints as opposed to only four states currently.

Funding cost pressures to dilute near-term margin performance

The sharp rise in rate environment and intense competition for garnering deposits has resulted in elevated competition for liabilities in the banking sector. This has exerted huge pressure on funding cost. AUBANK has thus reported NIM compression of ~60bp over the past three quarters to ~5.5% currently and the bank expects continued cost pressures and suggests further 30-40bp rise in the cost of funds over the coming months. Alongside a rise in funding costs, AUBANK has witnessed moderation in lending yields, primarily due to a change in business mix even as disbursement yields across segments increased at a calibrated pace. AUBANK has thus guided NIMs to sustain at ~5.5% over FY24E, while the NIMs are likely to hold flat over FY25E despite merger, as the ongoing rise in funding cost dilutes the margin benefit, which was anticipated post-merger.

Cost-ratios to stay elevated; operating leverage to improve gradually

AUBANK strategically invests for sustainable growth by leveraging technology, streamlining processes, and expanding the branch network. AUBANK will incur an upfront stamp duty expense of INR800m, covering banking and lawyer fees. Further integration, personnel, and tech migration costs are estimated at INR2-2.25b with 70% expected in Year 1 and 30% in Year 2 post-merger. Cost-ratios are thus likely to stay elevated at 63-64% in FY25E. The merger with Fincare is expected to enhance revenue growth through cross-selling opportunities, robust distribution income, and potential benefits from the AD-1 license. The potential turn in the rate-cycle and gradual moderation in funding cost is also anticipated to aid margin improvement, which will drive healthy NII growth. This coupled with improved investment yields and benefits from potential capital raise will create a flywheel effect and enable gradual moderation in cost-ratios from FY26E onwards.

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