Sell IndusInd Bank Ltd For Target Rs. 830 By Elara Capital Ltd
Bottom falls out; a lot left unanswered
IndusInd Bank (IIB IN) has highlighted deficiencies in derivatives accounting and estimated an impact of ~2.4% of 9MFY25 net worth of ~INR16bn post tax and~INR21bn pre-tax. Given the impact assessment, this leads to uncertainty in context of lower-than-expected tenure extension of MD & CEO Sumant Kathpalia and the exit of CFO Gobind Jain earlier. While the timing of this event is strange, coming on the heels of the lower tenure extension, there is a lot left unanswered: 1) Why was this not highlighted earlier, 2) How is such a lapse possible despite concurrent audits, 3) Why did the auditors not share any qualifications, 4) Are there any additional challenges, and 5) How did this issue go undetected for more than five years? This poses a series of questions on lapses in terms of processes and sanctity of book value. Beside the one-year extension of MD & CEO and key management positions, there are likely to be key transitions in the next couple of years, adding to more uncertainty. We expect further stock correction, but the question remains what comes next? We believe this event will shake investor confidence on franchise value. While valuation look low, book value sanctity is under question. We are yet to cut earnings estimates, given a pending external report, but earnings downgrade is imminent. We downgrade to Sell from Accumulate with a lower TP of INR 830 from INR 1,020
The question is only one or one of many? IIB has highlighted issues in derivatives accounting. Interestingly, this accumulated over some time and amassed to INR 21bn (pre-tax). This benefitted NII and Other income, and thus reversal (which needs to pass through P&L) would hurt profitability. IIB has appointed an external agency to look into deficiencies and assess the impact. The question is whether the worst is over or is there is still more in store. Given the recent events, we are finding it difficult to make an assessment, and, thus, the bank is staring at significant risk of an earnings downgrade.
What happened? The bank internally hedged forex borrowers by entering internal derivative contracts with its trading desk. The trading desk then hedged this exposure externally in the market. External trade was marked to the market, meaning its value fluctuated with market rates, negatively affecting P&L. The internal trade was accounted for using swap cost accounting or swap valuation, affecting asset book instead of P&L. External trades moved with the market, but internal ones followed swap valuation, which might not reflect market movements. This mismatch could temporarily bolster reported NII while suppressing actual trading losses. But external hedge was MTM, and this created mismatch in income recognition. Over time, if internal trade diverged significantly from external market movements, the real impact surfaced when the trade was unwound or matured.
Downgrade to Sell with a lower TP of INR 830: The past year has been challenging for IIB. The outcomes have been less than desired and marred by event risks. This was reflected in price movement with more than 30% correction in the past six months. We have yet to prune our earnings estimates, but this event does create challenges around potential downside revision. Given the uncertainty, we downgrade IIB to Sell from Accumulate with a lower TP of INR 830 from INR 1,020 based on 0.8x (from 1.0x) FY27E P/BV.
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SEBI Registration number is INH000000933
