AU Small Finance Bank is entering the primary market on Wednesday 28^th June 2017 with an offer for sale (OFS) of 5.34 crore equity shares of Rs. 10 each by 4 PE investors (Warburg Pincus, International Finance Corp, Chrys Cap, Kedaara), and promoters, in the price band of Rs. 355 to Rs. 358 per share. Representing 18.79% of the post issue paid-up share capital, OFS will raise Rs. 1,913 crore at the upper end of the price band and close on Friday 30^th June. Listing is expected on 10^th July.

Jaipur based AU Small Finance Bank, formerly AU Financiers, has transitioned from an asset financing NBFC providing loans for vehicle purchase, MSMEs and SMEs (split 50:30:20, of Rs. 10,734 crore AUM as of 31-3-17) to a small finance bank (SFB) effective 19^th April 2017, having 269 branches and 121 asset centers (31-5-17) across West and Central India, mainly in Rajasthan, Gujarat, Maharashtra, Madhya Pradesh, Chhattisgarh, with focus on low income and middle income group (LIG and MIG) customers. Business is concentrated in its home geography, with 54% of gross AUMs in single state of Rajasthan. In June 2016, company sold its lucrative, high-growth, and current investor favourite mortgage (home loan) business, of Rs. 1,500 crore AUM, for approximately Rs. 950 crore, to enable its transition to SFB.  

In FY17 (NBFC till then), company’s total income grew 36% YoY to Rs.1,430 crore as disbursements soared 20% YoY to Rs. 6,730 crore, while net interest income (NII) grew 41% YoY to Rs. 917 crore. After accounting for provisions and write-offs of Rs. 77 crore and exceptional gains of Rs. 670 crore (Rs. 517 crore post tax) on sale of housing finance and other smaller businesses (insurance broking, micro finance), company reported PAT of Rs. 843 crore. Adjusting for this one-time gain, FY17 PAT rose 32% YoY to Rs. 326 crore, resulting in EPS of Rs. 11.74, up from FY16’s Rs. 9.28.

On borrowings of Rs. 7,071 crore, company is well capitalized, with capital adequacy ratio of 23.21%, vis-à-vis regulatory requirement of 15%. Net interest margins (NIM), at 9.67%, are strong, which will contract going forward, once banking norms of CRR and SLR become applicable. Return on Net Worth (RoNW) of 21.7% and Return on Assets (RoA) of 3.4% are also healthy. However, the asset book is not the best in the business, with gross NPA at 1.61% and net NPA at 1.05%, at 120 days past due, as of 31-3-17. 

As of 31-3-17, equity stood at Rs. 284.25 crore, post 5:1 bonus in Oct 2016 and warrant conversion by promoter and senior management in Jan 2017. Company’s net worth was Rs. 2,000 crore, having doubled from Rs. 1,000 crore (31-3-16) on sale of housing business, leading to BVPS of Rs. 70, as of date. Promoters hold 36.03% stake, which will shrink to 32.87% post OFS, while combined holding of 4 PE investors (Warburg Pincus, International Finance Corp, Chrys Cap, Kedaara) participating in the OFS will decline from 47.4% to 31.7%. Company’s other shareholders include ICICI Pru Life (1.7%), SBI Life (1.7%) and Motilal Oswal Financial Services (1.2%), who are not participating in the OFS.

At Rs. 358, company will have a market cap of Rs. 10,176 crore, which is nearly as much as its 31^st March 2017 AUM of Rs. 10,734 crore. On historic performance of FY17, valuation multiples at PBV of 5.1x and PE of 31x are quite stretched. Based on FY18E performance too, these multiples at 4.2x and 24x respectively are extremely aggressive. Below is the comparative analysis of listed NBFC peers:  

Financial data for FY17, NA: Not Available

Shriram Transport Finance, India’s largest asset financing NBFC specialising in used CV segment, with Rs. 79,000 crore loan book, is ruling at PBV multiple of 1.8x and PE of 16x, while M&M Finance, providing vehicle loans to rural India through a nationwide network of 1,200 branches and Rs. 42,000 core loan book is trading at PBV and PE multiples of 2.5x and 18x. 1,000 branches strong Shriram City Union, three-fourth of whose Rs. 23,000 crore AUM comprises of SME and 2wheeler loans, is ruling at PBV of 2.7x while another vehicle financer Cholamandalam Investment is trading at PBV of 3.4x, despite much larger loan portfolio of Rs. 29,000 crore.    

Capital First, specialising in SME loans with AUMs of Rs. 20,000 crore, promoted by Warburg Pincus (same investor in AU) having current ownership of 36%, has long term credit rating of AAA (versus AU’s A+, which is four notches lower), higher growth rates (reported NII and PAT growth of 65% and 44% respectively in FY17 as against AU’s 41% and 32%), enjoys better asset quality (net NPA of 0.30% vis-à-vis AU’s 1.05%) with listed track record of nearly one decade, is available much cheaper, at PBV multiple of 2.6x and PE of 21x.

Bajaj Finance is the only NBFC ruling at a higher PBV of 6.5x which is justified by its 44% YoY PAT growth (32% for AU in FY17) and AUM growth of 36% on huge base of Rs. 44,000 crore (31-3-16) to Rs. 60,000 crore (31-3-17), versus AU’s AUM growth of 31% on much lower base of Rs. 8,000 crore (31-3-16). Moreover, Bajaj Fin’s asset quality is significantly better, with net NPAs of only 0.4% in relation to AU’s 1.05%. Well, both size and asset quality matter and AU has a lot of catching up before it can join the premium big league of the likes of Bajaj Finance!

While AU is an asset finance NBFC to start SFB operations, listed peers who have started SFB are Equitas and Ujjivan, being micro finance institutions, and ruling at nearly half of AU’s asking valuation. Equitas, operating its SFB since Sept 2016, is ruling at PBV of 2.2x, while Ujjivan, which launched SFB operations in Feb 2017, is trading at PBV of only 1.9x, with both having comparable AUMs of Rs. 6,000-7,000 crore. What also comes to light from the experience of these 2 companies is as SFB business expands, cost of operations rise, straining P&L for a few quarters, especially when serving unbanked areas (regulatory requirement of minimum 25% of total braches to be located there). Hence, AU will also see pressure on its P&L in FY18.  

From the above, one can thus conclude that in relation to (practically all) NBFCs operating in vehicles and SME lending space, AU’s IPO is grossly overpriced.

While it will be futile to compare AU with banking heavy-weights, such as Indusind, Kotak, Yes or even HDFC Bank, in existence for so many years while AU is a new entrant yet to prove its mettle as a bank, different set of RBI regulations govern the two - take for example, priority sector lending at 40% versus 75% for small finance banks. The above four banks are all currently ruling at PBV multiples of less than 4 times, FY18 book. Despite all the investor fancy and spectacular run-up in share price, even RBL Bank, with Rs. 49,000 crore balance sheet, is ruling at PBV of 3.8x on FY18E BVPS, which fades away AU’s pricey valuation.

In short, by all parameters, AU Small Finance Bank IPO is expensively priced.

Benjamin Graham, revered in the investment community as the father of value investing, who has also mentored the most-admired-investor-of-our-times Warren Buffett, has, in his book The Intelligent Investor, said ‘A great company is not a great investment if you pay too much for the stock’. The above applies perfectly in case of AU Small Finance Bank. One wonders what prompted the company and merchant bankers to adopt such steep pricing!

While the company is good, posting strong growth, albeit with regional presence, pricing of the issue is very aggressive, making it an avoid.

Disclosure: No Interest.