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Factoring in near-term pain! Steady RoA recovery; growth to drive medium-term stock performance

* Equitas Small Finance Bank (EQUITASB) has demonstrated a strong business growth trajectory with a 26% CAGR in its loan book and 38% CAGR in deposits from FY22-FY24. This growth has improved the bank's CD ratio from 102% in FY22 to 86% currently, and increased the retail deposit mix to 69%.

* The ongoing stress in the MFI segment has impacted profitability, but MFI business exposure has reduced to ~17% from 19% in FY22. The bank’s ability to recover from credit cycles suggests potential asset quality improvement from 2HFY25 onwards.

* EQUITASB’s stock price, which peaked at INR115 in January 2024, has corrected by 29%. We believe sustained loan growth estimated at 23% CAGR and improvement in RoA to 1.7% by FY26E will enable improvement in stock performance, particularly as confidence in asset quality improves.

* We have adjusted our earnings estimates for EQUITASB by incorporating higher credit costs, which would result in an 11%/12% reduction for FY25/26E. Despite this, we project a strong earnings recovery in FY26, with RoA/RoE improving to 1.7%/14.7%

* We, thus, find the stock’s current valuation attractive at 1.3x FY26 BV, a 51% discount to AUBANK. We maintain our BUY rating with a revised TP of INR100 (based on 1.6x FY26E ABV).

Growth outlook steady; business mix shifting toward secured products

EQUITASB reported a robust 20% YoY loan growth in FY24, fueled by strong performances in Small Business Loans, Vehicle Finance, and Housing Finance, which grew 30%, 19%, and 46% YoY, respectively. However, in 1QFY25, growth moderated to 16% YoY, partly due to a cautious approach and a 16.7% YoY decline in disbursements to INR39.6b. The bank is strategically shifting toward secured products and reducing the microfinance loan concentration to ~17% of AUM. While new CV growth is expected to align with industry trends, demand recovery in the SBL segment, especially micro-LAP, is anticipated to drive overall growth. The management remains confident in achieving a 25% growth for FY25. We estimate a 23% CAGR in loans over FY24-FY26, reaching INR468b by FY26.

Robust liability franchise; mix of retail deposits growing steadily to 69%

EQUITASB has significantly scaled up its liability franchise, achieving a 30% CAGR in total deposits over the past four years. Although the CASA ratio has declined sharply to 31% YoY due to customers favoring higher-rate term deposits, the retail deposit mix remains strong at 69%. The bank's focus on the mass affluent and high-networth segments has helped retain and grow its customer base, as it adjusts savings account rates. With deposit growth outpacing advances, the CD ratio (after reducing refinance borrowings from advances) has improved from 90% in 1QFY24 to 83% in 1QFY25, positioning the bank well to sustain healthy margins and a stable savings account profile. We estimate deposits to grow at a 23% CAGR over FY24-FY26.

Pace of NIM moderation to ease; potential turn in rate-cycle to aid margins

The bank has reported a 64bp decline in margins over FY24. During 1QFY25, NIMs further declined 20bp QoQ to 7.97%, affected by a continued rise in funding costs and a shift in asset mix from high-yield MFI business to secured products. However, a stabilizing cost of funds, CD ratio reaching the comfortable range of 85-86%, and lever to moderate SA rate as the rate cycle turns will help the bank maintain steady margins. We, thus, estimate NIMs to sustain at ~7.6% for FY25. The fixed-rate nature of the loan book (~85% being fixed rate) will support margins particularly as the interest rate cycle turns.

Estimate C/I ratio to maintain in mid-60s and recover to ~64% by FY26

The bank has consistently been investing in its business by adding new branches and building digital infrastructure and capabilities, which has kept operating expenses elevated. As a result, the bank’s C/I ratio increased to ~64.5% in FY24. With continued investments in the business, technology, and employees, we expect the C/I ratio to maintain in the mid-60s and recover gradually to ~64% by FY26.

Asset quality showing weakness; credit cost to remain elevated in FY25

EQUITASB experienced a rise in the GNPA ratio to 2.7% in 1QFY25, driven by increased slippages in MFI (INR850m) and vehicle finance (INR1.5b), pushing the overall slippage ratio to 4.5% and surpassing the management's 4% comfort level. MFI stress is widespread across multiple regions, mainly driven by over-leveraging issues in the industry; however, with the bank successively reducing the MFI mix to 17% and anticipated recovery in vehicle finance, we expect slippage run-rate to ease from 2HFY25 onward. We estimate 2Q to remain weak for most MFI players as the forward flows begin to pick up during 1Q, driving the NPA formation over 2Q/3Q. We, thus, expect the overall credit cost to stay elevated at 1.8% for FY25. However, as the vehicle business regains its asset quality and MFI slippages also improve from 2HFY25 onwards, we expect credit costs to moderate to 1.3% by FY26.

Valuation and view

EQUITASB has demonstrated robust growth with a 26% CAGR in its loan book and a 38% CAGR in deposits from FY22-FY24, significantly improving its CD ratio from 102% to 86% and increasing the retail deposit mix to 69%. Despite current challenges in the MFI sector, where its contribution has decreased to ~17%, the bank's ability to rebound from credit cycles with controlled credit cost suggests potential asset quality improvement from 2HFY25. The stock has corrected 29% from its January 2024 peak. However, with sustained growth expected, a projected improvement in RoA to 1.7% by FY26, and a current valuation of 1.2x FY26 BV, EQUITASB remains an attractive long-term investment. We reiterate a BUY rating with a revised TP of INR100 (based on 1.6x FY26E ABV).

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