Stock Idea Sector: Banks & Finance November 18, 2020 AU Small Finance Bank

Tomorrow’s rising star

Powered by Sharekhan’s 3R Research Philosophy AU Small Finance Bank Tomorrow’s rising star Stock Idea Stock Powered by the Sharekhan 3R Research Philosophy Banks & Finance Sharekhan code: AUBANK Initiating Coverage

3R MATRIX + = - Summary

Right Sector (RS) ü Š We Initiate Coverage on AU Small Finance Bank (AUSFB) and find it an attractive player operating in a niche space, having strong metrics and a promising long-term outlook. Right Quality (RQ) ü Š The bank caters to the niche below-radar borrower segment (low competition andblue sky growth potential), has stable NIMs, and well-maintained asset quality. Right Valuation (RV) ü Š At the CMP, AUSFB is available at 4.7x/3.7x its FY2022E/FY2023E ABVPS, given its strong track record and secured nature of book due to which we believe valuations + Positive = Neutral - Negative are justified. Š We Initiate Coverage with a Buy rating and a price target of Rs. 1,060.

Reco/View We Initiate Coverage on AU Small Finance Bank (AUSFB) and view it as an attractive player operating in a niche space (with long-term growth potential) having strong fundamentals today and a promising outlook. The bank caters to the niche below- Reco: Buy radar borrower segment (low competition and blue-sky growth potential), has stable NIMs, and well-maintained asset quality, which make for a strong foundation CMP: Rs. 894 today. AUSFB mainly competes with NBFCs (in the lending segment); and by virtue of being a small finance bank (SFB), AUSFB has a structural advantage of access to low-cost funds (Retail + CASA at 54% of total), which provide cushion to its NIMs Price Target: Rs. 1,060 (attractive at 5%) and the opportunity to scale up (LCR at 140%, Tier 1 at 18.3%). We view the pricing power that AUSFB commands being twin-fold – firstly, it comes from the nature of its borrower segment (under-penetrated geographies and below- radar client profile etc.) and secondly, due to good traction in building a robust Company details retail-focused deposit franchise (low cost and sticky). AUSFB has had a long and successful history (since being an NBFC and now as a bank) in credit underwriting Market cap: Rs. 27,400 cr quality mainly in the under/un-banked self-employed customers segment that lacks formal income documentation, which we believe indicates the management’s 52-week high/low: Rs. 1,217/366 quality as well as underlying strength of business franchise. We find SME and granular retail lending opportunity as an attractive space, providing a long runway NSE volume: 6.9 lakh for growth for small finance banks and believe AUSFB has the potential and is well (No of shares) on way to become a strong player in the medium to long term. We believe once the business momentum picks up again, near-term pressure on NIM due to excess BSE code: 540611 liquidity will abate. We expect NIMs to remain at ~5.0% on a steady state basis.We Initiate Coverage with a Buy rating and a price target (PT) of Rs. 1,060. NSE code: AUBANK Our Call Free float: 21.8 cr Valuation – We Initiate Coverage on AUSFB with a PT of Rs. 1,060: We expect (No of shares) AUSFB to generate superior return ratios along with good asset quality in the long run, given its strong risk management framework and robust growth prospects. At the CMP, AUSFB is available at 4.7x/3.7x its FY2022E/FY2023E ABPVS.We believe AU SFB is likely to sustain its premium valuations due to its strong asset quality mix, Shareholding (%) superior return ratios, a long runway for growth along with high promoter ownership. As the bank achieves its vision of becoming a full-scale retail focused bank, we Promoters 29.0 believe the valuation premium is likely to sustain.d. We expect ROA/ROE to improve to 2%/20% in FY2023E from 1.8%/17.9% in FY2020 with visible improvement in asset- FII 40.8 quality outlook along with improving collection efficiency, moderation in opex, and credit cost. We value AUSFB at 4.5x its FY2023E P/ABV, given the secured nature of DII 15.6 its lending book (98% of the loan book is secured), robust collection, underwriting mechanism, efficient risk management capabilities, and long runway for growth. The Others 14.7 stock has corrected ~36% from its highs. We believe risk reward is favouring long-term investors. We Initiate Coverage with a Buy rating and a PT of Rs. 1,060, implying a ~19% upside. Price chart Key Risks 1400 A prolonged delay in pickup in economic activity will impact growth and profitability 1200 of the bank. Further, the bank has high exposure to the informal/SME segments, which 1000 may be vulnerable if economic recovery is delayed. 800 600 400 Valuation Rs cr 200 Particulars FY19 FY20 FY21E FY22E FY23E 20 19 20 20 - - - - Net Interest Income 1,342.6 1,908.9 2,448.9 2,866.6 3,218.5 Jul Nov Nov Mar PPOP 721.9 1,197.2 1,683.2 2,190.3 2,692.8 PAT 381.8 674.8 915.0 1,277.2 1,635.1 Price performance EPS (Rs.) 13.2 22.8 30.1 42.0 53.8 (%) 1m 3m 6m 12m ABVPS (Rs.) 92.6 126.2 150.0 191.1 242.4 P/E (x) 67.9 39.2 29.7 21.3 16.6 Absolute 16.4 26.4 57.7 3.4 P/ABVPS (x) 9.7 7.1 6.0 4.7 3.7 Relative to 7.7 10.9 18.8 -4.0 Sensex ROE (%) 14.0 17.9 17.4 19.7 20.3 ROA (%) 1.5 1.8 1.7 1.9 2.0 Sharekhan Research, Bloomberg Source: Company; Sharekhan estimates

November 18, 2020 2 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Executive Summary

3R Research Positioning Summary Valuation and return potential

n Right Sector: Š We believe valuations are justified given its We believe the largely underpenetrated market strong track record and secured book. segment is an attractive space with a large Š The stock has corrected ~36% from its highs; we headroom for growth. believe risk reward is now favourable. n Right Quality: Š We Initiate Coverage with a Buy rating and price India’s largest private small finance bank player target of Rs. 1,060 (19% upside). with strong growth prospects and attractive metrics.

n Right Valuation: At the CMP, AUSFB is available at 4.7x/3.7x its FY2022E/FY2023E ABVPS, given its strong track record and secured nature of book due to which we believe valuations are justified.

Catalysts Earnings and Balance sheet highlights Long-term triggers � With visible improvement in asset quality, given • Strong collections and underwriting mechanism to strong collection mechanism, moderation in opex provide earnings visibility. and credit cost, we expect ROA/ROE to improve to • Potential for long-term growth due to low 2%/20% in FY2023E from 1.8%/17.9% in FY2020. competitive intensity in the target segment. � AUSFB’simproving retail liability with Retail + Medium Term Triggers CASA at 45% of totalprovides cushion to its NIMs • Improving loan book traction as the economy (attractive at 5%). recovers. � With LCR at 140% and Tier 1 at 18.3%, AUSFB has • Regulatory and government support for MSME/ the ability to scale up without requiring capital in SME sector to support growth/asset quality. the near term. Key Risks • Delayed pick-up in economic activity. • Rising inflation may cause increase in cost in funds and therefore impact profitability

November 18, 2020 3 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Table of Contents Pages Right Industry 5 Š Financial Inclusion saw Bank accounts opened, rise in Credit penetration next 5 Š Industry growth and outlook for SFBs 6 Š SFBs have an opportunity to address the Target audience 6 Š Evolution of SFBs 6 Š SMALL FINANCE BANKS- Gaining Market Share 6 Š SFBs growth to continue, be led by diversification 8 Š Technology is an enabler for Financial Inclusion & SFBs 8 Š Growth drivers: Sizeable market opportunity and credit at affordable rates 8 Š Factors driving growth for the SFB Industry 9 Š Market share gains expected for well capitalized banks and SFBs 10 Š Profitability of SFBs is expected to improve now that the transition phase over 11 Š Small Finance Banking Industry 11 Š Regulation 11 Right Company 12 Š Why we like AU Small Finance Bank 12 Š AUSFB – Comparative landscape 12 Š Focus on Retail segment, well diversified, high-yield secured portfolio to lead growth 12 Š Strong geographical presence with niche borrower profile provides sustainable long-term 14 growth opportunities Š AUSFB’s pricing power seen in its ability to maintained stable NIMs 15 Š Liability franchise gradually improving, with share of deposits picking up 16 Š Asset quality to continue to remain strong 16 Š High capital adequacy will support growth without necessitating dilution 18 Š Collection efficiency and customer activation trends nearing pre-COVID-19 levels 19 Š Moratorium book manageable; and fully secured 20 About the Company: AU SMALL FINANCE BANK AT A GLANCE 21 Š Diversified Loan Portfolio 22 Š Financials in charts 25 Š Financials 26 Outlook & valuations 27 Š Outlook 27 Š Valuation 27 Š One-year forward P/BVPS (x) band 27 Š Peer Comparison 27 Company background 28 Š Company background 28 Š Investment theme 28 Š Key risks 28 Š Key management personnel 28 Š Top 10 shareholders 28 3R Philosophy definitions 29

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Why we like the Small Finance Bank Industry – Offers large headroom for growth While financial inclusion (in terms of deposits, bank channels and services accessibility) has reached a significant penetration level in India, we believe credit delivery and accessibility still lags for the non- salaried as well as non-urban centre clients. Therefore, there exists a large market that can be effectively catered to by special entities such as small finance banks (SFBs). We believe SFBs have a structural advantage of access to low-cost retail deposits (and opportunity for asset growth as well) compared to NBFCs, which enables them to sustain margins and have sustainable growth. We believe the largely underpenetrated market segment is an attractive space with a large headroom for growth. Financial inclusion opened bank accounts; Rise in credit penetration next: According to World Bank’s Global Findex Database 2017, India’s financial inclusion level has improved significantly with the adult population’s bank accounts rising from 53% in 2014 to 80% in 2017 on account of various government initiatives, institution support, and increased usage of mobile phones as a medium for distributing financial services.

Adults having bank accounts (% of Population)

90%

80%

70%

60%

50%

40%

30%

20%

10%

0% 2011 2014 2017

Source: World Bank’s Global Findex Database 2017

As per CRISIL Inclusix, the index that measures the financial inclusion across 666 districts in India, financial inclusion score of 58.0 was reported in Fiscal 2016, having increased from a score of 50.1 in 2013 and 35.4 in 2009.

Industry growth and outlook for SFBs

1600

1400

1200

1000

800 1433 600

400 733 514 200 370 444

0 FY16 FY17 FY18 FY19 FY22P

Source: Company, Sharekhan Research November 18, 2020 5 Powered by the Sharekhan 3R Research Philosophy Idea Stock

SFBs have an opportunity to address the target audience: SFBs aim to cater to the low-income segment and have an opportunity to offer them with various products and services. Further, unlike NBFCs, which expand horizontally with a special focus product, SFBs have the chance to expand vertically and horizontally, which will enable them to have a good range of medium and low-value customers and, as a result, help in increasing their business. However, factors such as lack of awareness of financial services, illiteracy, and poverty will result in a challenge for SFBs from the demand side. Although SFBs will fare better in terms of product and service quality due to their focused approach, SFBs will have to create convenient touchpoints to initiate customers into saving regularly and invest in human capital to equip their staff into mobilising savings. While financial inclusion (in terms of deposits, bank channels and services accessibility) has reached a significant penetration level in India, we believe credit delivery and accessibility still lags for the non-salaried as well as non-urban centre clients. Therefore, there exists a large market that can be effectively catered to/ captured/ serviced by special entities such as SFBs. The micro, small and medium enterprise (MSME) sector in India is key to India’s economic growth. Around 75 million MSMEs contribute to about one-third of the GDP and 45% of the manufacturing output of the country. These companies also provide employment to more than 110 million Indians. The sector’s sustained growth and health are important to achieve India’s GDP growth targets. The sector is currently seeing a huge credit gap. According to industry reports and estimates, only 16% of MSMEs in India receive formal credit, leaving more than 80% of these companies under-financed or financed through informal sources. Informal credit ends up being much more expensive than formal debt, making it difficult for MSMEs to address accumulated debt burden.The World Bank estimates the current credit gap for MSMEs in India to be at $380 billion (around one- third of existing credit book). We believe this credit gap today can be addressed by lenders with continued digitisation efforts and improved regulatory norms for data security and protection. Evolution of SFBs Despite various measures taken by the government to increase financial penetration in India, a significant percentage of India’s population does not have access to basic financial services. In 2013, the Reserve Bank of India (RBI) constituted a committee that recommended differential licensing in the form of payment bank and SFB. Accordingly, on November 27, 2014, the RBI released guidelines for a new class of banking entity, ‘small finance banks’, to cater to the diverse needs of the low-income group. The objective of SFBs is to extend banking services to the underserved and unserved population through savings instruments and providing credit to small business units, small and marginal farmers, micro and small industries, and other unorganised sector. Operations of SFBs are technologically driven to reduce the cost of operations and ensure faster reach to the untapped market. Small Finance Banks - Gaining Market Share: Small Finance Banks (SFBs) were introduced by the RBI with the intent of driving financial inclusion for the unbanked and under-banked sections of the economy. In their three years of existence, SFBs have made their presence felt, growing their market share in both loans and deposits.

November 18, 2020 6 Powered by the Sharekhan 3R Research Philosophy Idea Stock

SFBs - Already growing in prominence (Market share; Offices)

FY2019 FY2020 2.8 1.5 0.9 0.6 0.5 0.3

Deposits Credit Reporting Office

Source: Company, RBI

We believe these early trends are encouraging and offer further testimony to the significant untapped opportunities in the informal/semi-formal sectors. In terms of outlook, we believe there remains significant scope for growth in several underserved segments. Further, as branches mature and visibility for SFBs improves, benefits from improving operating leverage will improve core profitability, going ahead.

SFBs - Market share split evolution

FY15-FY16 FY18-FY19

36% 47%

53% 64%

Top three SFBs Other seven SFBs Top three SFBs Other seven SFBs

Source: Company, Sharekhan Research

SFBs have been gaining market share in loans and witnessed a CAGR of 26% from FY2015-FY2016 to FY2018- FY2019 and should continue to gain market share in the medium term. Notably, the share of the top three SFBs (AUSFB being one of them) increased from FY2015-FY2016 to FY2018-FY2019 within total SFB assets under management (AUM) as it recorded a CAGR of 34% for the period.

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SFB growth to continue, led by diversification: SFBs have registered a CAGR of 26% from Fiscal 2016 to Fiscal 2019 in terms of AUM. The top three SFBs accounted for 64% of the total SFB AUM in Fiscal 2019 compared to 53% in Fiscal 2016. These top three SFBs recorded a CAGR of 34% from Fiscal 2016 to Fiscal 2019. Further, it is expected that the loan portfolio of SFBs will register a CAGR of approximately 25% in the near term due to support from (i) significant market opportunities in the rural segment; (ii) new product offerings and cross-selling opportunities with the ability to cross-sell products on the liability side and asset side to improve customer stickiness and loyalty; (iii) higher presence of informal credit channels; (iv) geographic diversification; (v) ability to manage local stakeholders; (vi) access to low-cost funds; and (vii) loan recovery and control on NPAs. In the past three years, SFBs have shifted their focus from microfinance to other products, but the core customer focus is not likely to change owing to regulatory norms. Going forward, SFBs will have to focus on small ticket-size lending to financially underserved and unserved segments (loans below Rs 2.5 million have to form at least 50% of the loan book). MFIs that converted into SFBs are expected to further diversify and expand their loan book beyond microfinance loans by focusing on allied segment loans such as MSME loans, affordable housing finance, gold loans, commercial vehicle/noncommercial vehicle loans, and two-wheeler loans. Technology is an enabler for financial inclusion and SFBs: The overall improvement of the financial inclusion score is primarily driven by the ‘JAM’ trinity, i.e. Jan Dhan Yojana, Aadhaar and mobile. Technology improvements help in financial penetration; however, the primary challenge for SFBs is still the ability to generate low-cost deposits. While there exists a significant opportunity, SFBs will need to be innovative further in terms of introducing customised and flexible offerings to target the untapped market and move toward becoming universal banks. Increased use of technology has enabled lenders to provide customised product offerings to their target customer segments with much lower turnaround times. Further, availability of multiple data points facilitates lending decisions by firms within a few minutes by using data-driven automated lending models. These models help in the supply of credit to small business units and the unorganised sector at a low cost. The use of technology is expected to also help such players in expanding their reach to underserved population and areas at a lower operating cost. Growth drivers: Sizeable market opportunity and credit at affordable rates Due to the size of India’s population and the lack of formal banking services for a significant section of India’s population, driving financial inclusion has been a key priority for the government. The banking system and PSL have been the most popular channels to bring the majority of India’s population under formal credit institutions. The size of the Indian market (in terms of financially excluded households) offers scope for sustainable credit to the poor at affordable rates to drive growth for SFBs in India.

Credit opportunities for lenders in India’s MSME space

Banks/Devlopment Banks/SFBs/NBFCs/Co-op Microfiance Institutions Institutions Banks More then Rs 25 lakh Rs 2 lakh-Rs25 lakh Up to Rs 2 lakh

Š Organised sectors Š Un Organised sectors Š No financials Š Corporate Entity Š Cash basis accounting Š General need of funds Š Organised financials Š Composite laon requirments Š Cash Flow analysis Š Project specific laons

Source: Company, Sharekhan Research

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The growth outlook for this segment is quite encouraging due to the size of the opportunity and several reforms such as implementation of GST, extension of the credit guarantee fund scheme to NBFCs, and lower tax rates, which will incentivise lenders and improve transparency. These and several other focused initiatives aim to increase the sector’s contribution to GDP to over 50%, as the nation aspires to be a Rs. 5 trillion economy.

Demand supply gap

40 Demand supply gap ( in Rs lakh -crore) 36.7 35 Potentially Addressable Credit Gap 30 25.8 Micro-8.0 25 Small-16.8 Medium-1.0 20

15 10.9 10 8.8 5 1.5 0.6 0

SCB NBFC's Other Banks/Govt Total of Supply Total Addressable Institutions Demand

Source: Company, Sharekhan Research

The opportunity size for financiers is significant – an IFC study (November 2018) pegs the addressable credit gap at Rs. 25.8 lakh crore, which is more than 2.5x the current size of formal credit to this sector, with the bulk of it in the micro and small segments.

Factors driving growth for the SFB Industry

Source: Company, Sharekhan Research

November 18, 2020 9 Powered by the Sharekhan 3R Research Philosophy Idea Stock

SFBs to gain from expanding Middle Class

Target market for SFB

Source: Company, Sharekhan Research

Market share gains expected for well-capitalised banks and SFBs: Going forward, non-banks are expected to lose their market share to well-capitalised banks and SFBs amid ongoing crisis ofconfidence and consequent liquidity crunch. NBFCs are heavily reliant on banks for funding, which has led to rise in cost of funds. However, access to deposits, resulting in lower cost of funds, will allow SFBs to compete with NBFCs on pricing in the underpenetrated region and take away some share from NBFCs, thus resulting in overall business growth for SFBs. Overall deposits base of SFBs grew by 109% y-o-y in Fiscal 2019; A key differentiator vis-à-vis NBFCs SFBs have a sizeable growth opportunity as most of them were previously functioning as NBFCs/MFIs. In the past one year, all SFBs have been focusing on increasing their deposit base immediately after commencement of their operations. Overall deposit base of SFBs has grown by 109% to around Rs. 555 billion in Fiscal 2019. However, CASA deposit has reduced from 24% in Fiscal 2018 to 20% in Fiscal 2019.

Deposits to grow at a robust pace

2500

2000

1500

2272 1000

500 555 265 0 FY18 FY19 FY22P

Source: Company, Sharekhan Research

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Profitability of SFBs likely to improve now that the transition phase is over Newly converted SFBs had a challenging beginning in Fiscal 2018, as many players experienced a decline in profitability due to losses in the second half of the financial year on account of stressed microfinance accounts. The main reason for the sharp increase in non-performing assets in the microfinance portfolio of SFBs was the dual impact of demonetisation and loan waivers. Profitability revived in Fiscal 2019 as credit costs on loans disbursed post demonetisation was much lower. Further, due to rapid growth in deposit base and a consequent reduction in cost of funds, net interest margins also increased in Fiscal 2019 compared to the previous year. Profitability, however, remains partly constrained by high operating expenses, representing approximately 7% of average assets. Profitability is expected to improve moderately going forward on account of further reduction in operating expenses as players gradually scale up their banking operations with the aid of digitisation. However, reduction in operating expenses may not be consistent across the board, as it depends on the ability of SFBs to keep branch establishment and employee costs at stable levels, and scale up their deposit and income base from these branches. Additionally, the ability to maintain sound asset quality in new segments, while managing growth and profitability across economic cycles, remains to be seen. SMALL FINANCE BANKING INDUSTRY The Indian banking industry has seen several changes in recent years to promote financial inclusion. NBFCs, such as Bandhan and IDFC, received permission to set up universal banks. Further, a few microfinance companies, local area banks, and NBFCs have received the permission to set up SFBs. SFBs are allowed to take deposits, which provide them an edge of having lower cost of funds in comparison to NBFCs. MFIs turned into SFBs are now diversifying their advances mix and are focusing on other retail and corporate lending businesses.

Regulation

The following table sets forth certain key features of the RBI’s regulations in relation to SFBs: Scope of Activities • Basic banking activities such as acceptance of deposits and lending to underserved and unserved sections of the society. • Financial services such as distribution of mutual funds and insurance products with prior approval from the RBI. • Prior approval required from the RBI for branch expansion of SFBs in the initial five years; after stabilisation period of five years, the RBI may liberalise the prior approval requirement and scope of activities. • SFBs cannot be a Banking Correspondent (BS) to other banks; however, they can have their own BC network. Prudential Norms • Requirement of maintaining CRR and SLR as applicable to the existing commercial banks. • 75% of ANBC should be given to sectors eligible under PSL as per the RBI; 40% as per PSL prescriptions and remaining 35% under the PSL, where the SFB has a competitive advantage. • Minimum 50% of loan book to constitute loans of ticket size up to Rs. 2.5 million that can be relaxed by the RBI after a period of stabilisation of five years. Capital • Minimum paid up capital Rs. 1 billion. requirement • Minimum tier-1 capital: 7.5% of RWA; minimum capital adequacy ratio of 15% of RWA. Shareholding • Initial shareholding of the promoter in the bank should be brought down to 40% within the first five years, which should be further bought down to 30% within 10 years and further to 26% within 12 years from the commencement of operations. • Mandatory listing requirement of SFBs within three years of reaching net worth of Rs 5 billion. • FDI as per the FDI policy for private sector banks, amended from time to time. Branch • Required to have 25% of their branches in rural unbanked centres (population shall be less than requirement 10,000) within one year of commencement of operations. SFBs are given three years to align their existing branches with this requirement, but 25% of all new branches opened in a year should be in URCs. Source: Sharekhan Research

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Why we like AUSFB – India’s largest private SFB player with strong growth prospects and attractive metrics AUSFB has had a long and successful history (since being a NBFCs and now as a bank) in credit underwriting quality mainly in the under/un-banked self-employed customer segment that lacks formal income documentation. AUSFB is predominantly present in underpenetrated states such as Rajasthan and Madhya Pradesh (~42% and 16%% of its AUM, respectively), which have significantly low credit and deposit penetration and have lower competitive pressures from banks and NBFCs. We believe AUSFB’s presence in these states provides the bank the competitive edge to pursue growth, along with its niche customer profile with low competition from peer banks and NBFCs. Management has indicated a positive asset-quality outlook (with only 5.5% exit moratorium levels in August, of which 2.5% has paid the September/October EMIs), which implies ~3% of customers (manageable) in the stress pool. We expect H2FY2021 to record reasonable growth, helped by revival/near normalisation of the rural/semi-urban based markets, and disbursements too picking up gradually. However, going forward, we estimate with a revival in Indian economy and demand pullback, AUM’s growth trajectory to hold at 15%-17% over the next 3-5 years.

Operating efficiencies

Opex comparison 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY17 FY18 FY19 FY20 Q2 FY21

AU SFB Equitas Ujjivan SFB

Source: Company, Sharekhan Research

SFB - Loan Book (As on March FY2020)

30,000

25,000

20,000

15,000

10,000

5,000

- Ujjivan SFB Equitas SFB AU SFB

Loan Book

Source: Company, Sharekhan Research

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SFB - CASA % (As on March FY2020)

25.0% 21.4%

20.0%

14.5% 15.0% 13.5%

10.0%

5.0%

0.0% Ujjivan SFB Equitas SFB AU SFB

Source: Company, Sharekhan Research

SFB - GNPA, NNPA % (As on March FY2020)

3.0% 2.7%

2.5%

2.0% 1.7% 1.5% 1.5%

1.0% 1.0%

0.5%

0.0% Bandhan bank Ujjivan SFB Equitas SFB AU SFB

Source: Company, Sharekhan Research

SFB - Cost / Income (%) (As on March FY2020)

80%

70% 67% 66%

60% 54%

50%

40%

30%

20%

10%

0% Ujjivan SFB Equitas SFB AU SFB

Source: Company, Sharekhan Research November 18, 2020 13 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Focus on the retail segment, well-diversified, high-yield secured portfolio to lead growth: In the near term, we expect AUSFB to continue with its used vehicle financing and opportunistic lending in the smaller secured retail products. However, for the long term, we expect growth to be driven by retail lending with a focus on the auto segment (wheels) and the underpenetrated MSME portfolio. We expect AUM to register a ~15% CAGR over FY2020-FY2023E.

Loan book breakup

Bsuiness Banking (BB: Cash Credit, WC, LC-BG limits Agri SME NBFC etc) Reg 3% 5% 3% 2% Vehicle Loans 36% SBL – SME (Small and Mid Corp Assets) 14%

OD Against FD 2% Gold Loan, Consumer Durable Loan and Personal Loan 1% Housing Loan 2% SBL – MSME 32%

Source: Company, Sharekhan Research

We believe the diversified book also provides AUSFB with the ability to withstand and recoup faster from contingencies like the present pandemic-led disruption. The bank’s asset mix consists of high-yielding retail portfolio across used and new vehicles, commercial vehicles, Home Loans, MSME/SME Loans. The bank has recently also forayed into retail products such as home loans, gold and personal loans (still small proportion). The bank’s mid and small corporate book is spread across agri SME loans, NBFC, and real estate financing. Retail assets form 84% of the total AUM, and we expect the focus of the bank to continue in the retail, granular portfolio on a normalised course of business. Even though we expect disbursements to remain muted in H1FY2021, leading indicators for the economy as well as management commentary indicate toward a gradual revival in credit demand, with some uptick expected in Q4FY2021. We expect H2FY2021 to record reasonable growth, helped by revival/near normalisation of the rural/semi- urban based markets, and disbursements picking up gradually. We expect disbursements to decline by ~24% during FY2021E and expect a multi-year low AUM growth of high single digits in FY2021E. However, going forward, we estimate with a revival in the Indian economy and demand pullback, AUM’s growth trajectory is expected to hold at 15%-17% over the next 3-5 years. Strong geographical presence with niche borrower profile provides sustainable long-term growth opportunities: Continuing since its NBFC days, AUSFB has had a long track record of successfully underwriting credit to the under/un-banked areas catering to self-employed customers who do not have formal income documentation etc. AUSFB is predominantly present in states such as Rajasthan and Madhya Pradesh from where it sources 58% of its AUM (42% and 16%, respectively). These states of Rajasthan and Madhya Pradesh are characterised by significantly low credit and deposit penetration, thereby offering little in terms of competition from other banks and NBFCs. Hence, we believe, AUSFB’s dominant position in these states provides the bank with

November 18, 2020 14 Powered by the Sharekhan 3R Research Philosophy Idea Stock the competitive edge to pursue growth, armed with local knowledge and client history, especially given its customer profile being under/un-banked customers and low competition from most other banks and NBFCs. Most of AUSFB’s competition is having a stronghold in Southern India, and while they are now looking to expand their geographical footprint, the first-mover advantage continues for AUSFB with a long history of clients and local knowledge. Hence, we expect AUSFB’s competitive advantage in its key geographies to sustain for the next 3-4 years. AUSFB’s pricing power seen in its ability to maintain stable NIMs: AUSFB caters to the below-radar segment of customers (new to credit/low access to formal sources of credit etc.), where there is low competition, except in the few geographies of the country. This segment offers significant pricing for players such as AUSFB, which we believe will be sustainable for growth as well as margins for the long term. AUSFB has a long history of catering to this segment; and as an SFB, it now has the added advantage of deposits apart from traditional borrowing sources as an NBFC (NCDs, term loans, commercial paper, subordinated debt etc.), which are of higher cost. However, with transitioning into an SFB, AUSFB has now access to lower cost of funds via the low cost CASA deposits and term deposits, which also provide opportunity for cross-sell of products. We believe as the bank achieves scale and the proportion of deposits to total borrowing increases (along with benefits from lower cost of borrowing), there is a potential of NIMs to improve led by a further drop in cost of funds.

NIMS

12

10

8

6

4

2

0 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21E FY22E FY23E

Source: Company, Sharekhan Research

NIMs for the SFB have shown distinct phases of pre-SFB phase having higher margins, but post grant of banking license, they have been slightly depressed as yields have seen a dip due to regulatory requirements (SLR/CRR/LCR requirements) and reduction in yields (due to pass through of CoF benefit to customers). While in FY2020, margins began to improve, the impact of COVID-19 has resulted in the bank taking a conscious decision to maintain higher liquidity, which weighed on NIMs (investment yields are substantially lower at 5%-6% versus advances yields of 12%-15%). The bank had maintained ~Rs. 7,000 crore of liquidity at the end of Q1FY2021. In the long term, we expect NIMs to sustain at current levels and range between 5.5%-6% on a steady state basis, which will be attractive for a bank.

November 18, 2020 15 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Liability franchise gradually improving, with share of deposits picking up: Transitioning into a bank gave AUSFB access to deposits and, of late, the bank has been able to manage good traction in its deposits. Deposits currently stand at ~70% of total borrowings at the end of Q1FY2021. We expect deposits as a proportion of total borrowings to reach 80+% by the end of FY2023E. The bank’s primary focus at present is on growing the share of retail deposits in both term and savings deposits, which provides it with cheaper funds and more sticky customer base.

CASA %

25%

20%

15%

10%

5%

0% Q2 FY2020 Q1 FY2020 Q2 FY2020

Source: Company, Sharekhan Research

Asset quality to continue to remain strong AUSFB started off as a commercial associate of HDFC Bank to source vehicle loans for the bank. The bank’s capability to underwrite credit and maintain asset quality have evolved over the years with a long track record and experience gained with its association with the top private sector bank in the country. The bank (earlier NBFC as well) has over the years developed strong credit screens and effective underwriting ability, which have resulted in a robust asset-quality picture.

Asset Quality trajectory

3

2.5

2

1.5

1

0.5

0 FY16 FY17 FY18 FY19 FY20 FY21E FY22E FY23E

Gross NPA NET NPA

Source: Company, Sharekhan Research November 18, 2020 16 Powered by the Sharekhan 3R Research Philosophy Idea Stock

The bank also has a strong collection and recovery team of 2,500 collection agents and has put in place separate credit teams for each of its business verticals.

Robust business process

Sourcing Credit Appraisal

Direct Sourcing In -depth Field No DSAs Investigation

Local Strong Referral Employees In Channel Field

Repeat Touch & Feel Customers

Customer Asset quality Equity in Alignment Absolute Terms

Source: Company, Sharekhan Research

The credit team evaluates business needs, cash-flow based income generation capabilities, and analyses the borrower’s ability to repay the loan. Stringent credit screens have helped AUSFB contain GNPAs at sub- 2% levels till FY2020, despite having faced unprecedented events such as demonetisation in FY2017 and COVID-19 in FY2020.

Credit Cost trajectory

700 2.50%

600 2.00% 500

1.50% 400

300 1.00%

200 0.50% 100

0 0.00% FY2014 FY2015 FY2016 FY2017 FY2018 FY2019 FY2020 FY2021E FY2022E FY2023E

Provisions COVID 19 Provisions Credit Cost

Source: Company, Sharekhan Research

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AUSFB has had a strong emphasis on asset quality, which is witnessed in the relatively low slippages seen over the years with slippage ratio maintained below 2% due to robust and comprehensive credit and risk management framework, which has evidenced since its NBFC times and continues even now. With Provision Coverage Ratio (PCR) at 71.1% and improving collections efficiency, we believe the asset-quality outlook has improved and with the secured nature of the book the outlook is positive. High capital adequacy will support growth without necessitating dilution Healthy CRAR of 21.5% and a Tier 1 ratio of 18.3% (as on September 2020), which is not only comfortably above regulatory requirements, enables AUSFB to grow without necessitating capital over the medium term. The bank as consistently maintained high capital ratio over the year.

Capital Adequecy

23 21.5 22.0 19.3 19.3 18.4 18.4 17.1 16.0 13.7

FY16 FY17 FY18 FY19 FY20

Capital Adequacy Ratio Tier 1

Source: Company, Sharekhan Research

The asset quality had seen some impact due to the pandemic for the near term. GNPA/NNPA in Q2FY2021 stood at 1.5%/0.5%. Going forward, we expect GNPAs to be in the range of sub 3%. The cautious lending approach and strong underwriting practices will help the bank maintain its asset quality in the long term.

NPA Trajectory

3.0 2.5 2.5 2.2 2.0 2.0 2.0 2.0 1.9 1.7 1.5 1.5 1.5 1.3 1.3 1.3 1.3 1.2

1.0 0.8 0.5 0.5

0.0 FY18 FY19 FY20 Q1FY21 Q2FY21 FY21E FY22E FY23E

Gross NPA Net NPA

Source: Company, Sharekhan Research

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Collection efficiency and customer activation trends nearing pre-COVID-19 levels: Collection efficiency for AUSFB was at 96% for Q2FY2021 and is now at near pre-COVID-19 levels of ~98% (Q2FY2020). However, collection efficiency would also include more than billed receipts from some customers (past over-dues) as well and, thus, may take time to stabilise. Looking at customer activation rates, the same has increased to 78% (full payment) and 4% part-payments as of September 2020, which is close to pre-COVID-19 levels of 80% and 5%, respectively, and indicate a healthy revert to normalised business traction and are much improved if compared to figures for June. For June, customer activation was at 67% for full and 8% for part-payments, respectively. Wheels continued to lag overall collection activation at 72% and 5% full and part-payments, respectively.

Collection Efficiency - Returning to normalcy Product Q2FY20 Q1FY21 Q2FY21 SBL 98% 72% 105% Wheels 99% 62% 89% NBFC 100% 86% 105% Business Banking 84% 82% 105% Real Estate Group (REG) 87% 49% 109% Agri 85% 84% 119% Home Loan 99% 83% 112% SME 88% 51% 106% Personal Loans 97% 65% 88% Gold Loan 96% 84% 114% Consumer Durable 99% 70% 84% Others 99% 100% 100% Grand Total 98% 68% 96% Source: Company, Sharekhan Research

Customer Activation –Returning to normalcy % of Gross Advances Product Sep-20 Total Gross Advances Full Part (Rs Cr) SBL 11,248 82% 5% Wheels 9,549 72% 5% NBFC 1,492 100% 0% Business Banking 1,210 94% 2% Real Estate Group (REG) 727 86% 9% Agri 745 94% 2% Home Loan 707 92% 4% SME 526 78% 8% Personal Loans 165 81% 5% Gold Loan 57 72% 5% Others 686 100% 0% Total 27,110 78% 4% Source: Company, Sharekhan Research

November 18, 2020 19 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Moratorium book manageable and fully secured The bank is tracking the moratorium portfolio closely and 2.5% of borrowers (by gross advances) from this portfolio have paid at least 1 EMI in September/October FY2021. This book is 100% secured with small ticket loans with low EMIs backed primarily by self-owned residential and commercial properties/income-generating assets.

Granular understanding on the Complete moratorium book

5.5% of growth book

Business Banking REG PL & others 1% 1% 1% Agri SME 5%

Wheels SBL 50% 42%

Source: Company, Sharekhan Research

The main impacted segments are schools/academics, Travel and tourism, and hospitality and associated businesses like catering etc. In most of the affected segments, while there is short-term demand destruction, we do not envisage permanent damage to the underlying businesses and, with each passing quarter, the bank is seeing improvement. Improving activity levels, supportive measures (deferment, ECLGS, Restructuring, Interest on interest waiver) should also help tackle the pandemic’s impact on borrowers. Because of the above factors, we believe that while there will be interim slippages from this book, eventual credit cost is likely to be lower; AUSFB currently holds Rs. 278 Crore in COVID-related provisions and would continue to monitor the trends for future course of action. The moratorium numbers have reduced significantly as well, and from 11.5% loans under moratorium (no EMIs paid since March) in June month, the moratorium amount has reduced to 5.5% as of August end and a further 2.5% of this portfolio has become active in September-October (at least paid 1 EMI). The bank remains watchful of the remaining 3% portfolio and expects restructuring to largely happen within this pool.

November 18, 2020 20 Powered by the Sharekhan 3R Research Philosophy Idea Stock

About the Company: AUSFB AT A GLANCE AUSFB is a scheduled commercial bank headquartered in Rajasthan. As on March 31, 2020, the bank had ~647 touch points operational across 11 states and 1 Union Territory of North, West, and Central India with a team of 17,112 people.

Well-diversified Geographically

Geographical split - Retail AUM

CG + Haryana +HP + Goa + Punjab rest 5% 6% Delhi 7% Rajasthan 43% Gujarat 11%

Maharashtra 11%

Madhya Pradesh 17%

Source: Company, Sharekhan Research

Break up of branches

Source: Company, Sharekhan Research

While several NBFC peers are strong in financing similar segments as that of AUSFB, most of them have a strong presence in Southern and Western India and have comparatively low penetration in key geographies, which are strongholds of AUSFB (namely Rajasthan and Madhya Pradesh). Therefore, we believe with a long history and local knowledge base, a first-mover advantage and minimal competition from both banks or NBFCs, the key states of operations, viz. Rajasthan and Madhya Pradesh, continue to remain less crowded and largely under-penetrated and provide adequate opportunities for both credit and deposit growth for AUSFB.

November 18, 2020 21 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Diversified Loan Portfolio

Focused on retail with a diversified portfolio

Gross AUM of Rs 30,893 Crore

Small & Mid- corporate 16%

Wheels-42% SBL-MSME-37% Retail Assets HL-2% 84% Others-3%

Source: Company, Sharekhan Research

Wide array of business channel touch points

Source: Company, Sharekhan Research

November 18, 2020 22 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Diversified product portfolio (FY2020)

Wheels-Used+New (Mix:42%) ATS-Rs3.1 Lakhs Yield-15.7%

MSME(Mix:36.5%) ATS-Rs 10.5 lakhs Yield-15.5% Retail Portfolio(Mix:84%) Avg .Yield-15.6% Home Loans(Mix:2.0%) ATS-Rs 10.7 Lakhs Yield -13.2%

Other Loans(Incl Gold Loans,Personal Loans)(Mix:3.4%) ATS-Rs 1.27 lakhs AU SFB'sProduct Portfolio Real Estate (Mix:2.7%) ATS-Rs.262.9 lakhs

NBFCs(Mix:6.0%) ATS-Rs996.7 Lakhs Small & Mid Corporate Portfolio (Mix:16%) Avg Yield-15.2% SME (Mix:4.0%) ATS-Rs 49.7 laKHS

Buisness Banking(Mix:3.5%) ATS-Rs 55 Lakhs

Source: Company, Sharekhan Research

AUSFB has a fairly long and stable track record in lending small ticket, secured, retail loans primarily to unbanked and under-banked self-employed individuals for purchasing assets that will generate income. The bank’s retail asset segment includes three key focus products – vehicle Loans, small secured business loans to MSMEs, and housing loans. The bank also includes gold loans, consumer durable loans and personal loans, along with overdraft (OD) on fixed deposits (FD). Vehicle loan: Vehicle loan has been a key product since its inception and is the most seasoned book in AUSFB’s portfolio. Despite sluggish growth in the overall automobile sector, its vehicle loan AUM recorded growth of 27% y-o-y and stood at Rs. 12,985 crore, comprising 42.0% of its total AUM during FY2019-FY2020. Wheels disbursements grew 16% y-o-y to Rs. 7,799 crore during the reporting year. Average ticket size (ATS) for this product was Rs. 2.4 lakh for FY2019-FY2020. The bank offers a wide product range in the industry and extends credit for two-wheeler to 22-wheeler vehicles for personal and commercial use. The bank offers loans for new and pre-owned vehicles and for refinancing of vehicles across several categories, including cars, Multi-Utility Vehicle (MUV), Sports Utility Vehicle (SUVs), Light Commercial Vehicle (LCV), Medium and Heavy Commercial Vehicle (MHCVs), Construction Equipment (CE), tractors, two and three-wheelers. The bank finances vehicles for personal as well as commercial use. In the commercial space, AUSFB serves First-Time Buyers (FTBs), First-Time Users (FTUs), Small Road Transport Operators (SRTOs), and captive users.

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Secured Business Loans (SBL) Secured business loans MSME (SBL-MSME) is a key product within the retail assets segment and comprised 36.5% of the total AUM (as on March 31, 2020). Key clients are MSMEs with annual turnover between Rs. 40 lakh and Rs. 10 crore, having at least a few years of track record in such businesses, generating cash flows at high frequency and having limited or no formal documented income proofs (for example grocery/kirana stores, dairy/cattle rearing, and hotel/restaurants). Such loans are then secured by immoveable property, and the uses include working capital needs, expansion, purchase of machines/equipment, and infrastructure requirements. AUSFB has developed understanding of its customers’ business and their future requirements to arrive at the loan amount that can be offered to them. The bank also caters to larger businesses in terms of turnover, which have more formal and documented income proofs. The bank targets small and medium-size enterprises (SMEs), including traders, wholesalers, distributors, retailers, manufacturers, and self-employed professionals; and these loans are meant to meet their needs for expansion, working capital, and purchase of equipment. Gross AUM for its SBL business increased by 44% y-o-y to Rs. 11,287 crore as on March 31, 2020. SBL disbursements grew by 32% y-o-y to Rs. 4,865 crore in FY2019-FY2020. Average ticket size for this product was Rs. 9.4 lakh for FY2019-FY2020. Home loans AUSFB also provides a range of home loan products (self-construction, purchase of flat/house, extension/ renovation and takeover/top-up), with a focus on the affordable housing segment. Ticket size wise, the bank offers loans from Rs. 2 lakh to above Rs. 50 lakh for a maximum 30-year tenure for salaried customers; and 20 years for self-employed, non-income proof/self-employed income-proof profile customers. The bank’s customers can apply for loans at any of its branches.

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Financials in charts

Return Ratios (%) Yields and Cost Movement

22.0 3.5 8.0 20.00 21.0 7.0 20.0 3.0 15.00 19.0 6.0 18.0 2.5 5.0 10.00 17.0 16.0 2.0 4.0 5.00 15.0 3.0 14.0 1.5 2.0 0.00 13.0 12.0 1.0 FY18 FY19 FY20 Q1FY21 Q2FY21 FY17 FY18 FY19 FY20 FY21E FY22E FY23E NIM Margin (%) Average Cost of Borrowings(%) RoE(%) RoA Yield on AUM(%) Source: Company, Sharekhan Research Source: Company, Sharekhan Research

Asset Quality Business traction

3.0 35000 6000 2.5 30000 5000 2.5 2.2 2.0 2.0 2.0 25000 1.9 4000 2.0 1.7 1.5 1.5 20000 1.5 1.3 1.3 1.3 1.3 3000 1.2 15000 0.8 2000 1.0 10000 0.5 0.5 5000 1000

0.0 0 0 FY18 FY19 FY20 Q1FY21 Q2FY21 FY21E FY22E FY23E Q1FY19 Q3FY19 Q1FY20 Q3FY20 Q1FY21

Gross NPA Net NPA Gross AUM Deposits Disbursment Source: Company, Sharekhan Research Source: Company, Sharekhan Research

Share of Retail in Savings Account (SA) Profile of Deposits spread across segments

11% 9% 18% 15% 19% 14% 35% 36% 36% 41% 41% 49%

22% 22% 19% 21% 21% 86% 89% 91% 14% 82% 85% 81% 10% 11% 12% 8% 8% 7%

27% 27% 30% 26% 26% 25%

4% 4% 4% 4% 4% 5% Q1FY20 Q2FY21 Q3FY21 Q4FY21 Q1FY21 Q2FY21 Q1FY20 Q2FY21 Q3FY21 Q4FY21 Q1FY21 Q2FY21

Retail SA Bulk SA TASC Corporate Govt Banks Individual +HUF+Sole Proprietor Source: Company, Sharekhan Research Source: Company, Sharekhan Research Note: TASC - Trust, Association, Societies and Club

November 18, 2020 25 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Financials

Income Statement (Rs Cr) Particulars FY19 FY20 FY21E FY22E FY23E Interest earned 2,949.1 4,285.9 5,427.5 6,546.1 7,768.0 Other income 461.9 706.1 581.7 674.8 803.0 Total Income 3,411.0 4,992.0 6,009.2 7,220.9 8,571.0 EXPENDITURE Interest expended 1,606.5 2,376.9 2,978.6 3,723.5 4,662.2 Net Interest Income 1,342.6 1,908.9 2,448.9 2,822.5 3,105.8 Operating expenses 1,082.6 1,417.9 1,347.4 1,351.1 1,328.8 Pre Provision Profits 721.9 1,197.2 1,683.2 2,146.3 2,580.1 Provisions 141.8 283.2 438.3 452.6 468.2 PBT 580.1 914.0 1,244.9 1,693.7 2,111.8 Provision for Tax 198.3 239.2 329.9 448.8 559.6 Reported PAT 381.8 674.8 915.0 1,244.9 1,552.2

Balance Sheet (Rs Cr) Particulars FY19 FY20 FY21E FY22E FY23E CAPITAL & LIABILITIES Capital 292 304 304 304 304 Money received against Share Warrants 175 - - - - Employees stock options outstanding 43 52 52 52 52 Reserves & Surplus 2,653 4,021 4,900 6,096 7,587 Networth 3,163 4,377 5,256 6,452 7,943 Deposits 19,422 26,164 33,752 43,202 55,299 Borrowings 8,613 10,335 12,402 14,883 17,859 Other Liabilities and Provisions 1,424 1,267 1,343 1,424 1,509 Total Liabilities 32,623 42,143 52,753 65,961 82,610 ASSETS Cash and Balances with Reserve Bank of India 811 1,050 1,354 1,733 2,218 Balances with banks and Money at Call and 929 2,320 8,655 13,111 18,141 Short Notice Investments 7,162 10,668 13,762 17,615 22,548 Advances 22,819 26,992 27,802 32,251 38,378 Fixed Assets 447 448 475 503 534 Other Assets 455 665 705 747 792 Total Assets 32,623 42,143 52,753 65,961 82,610

November 18, 2020 26 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Outlook and Valuation n Sector view - Improving outlook for SFBs While financial inclusion (in terms of deposits, bank channels and services accessibility) has reached a significant penetration level in India, we believe credit delivery and accessibility still lag for the non-salaried as well as non-urban centre clients. Therefore, there exists a large market that can be effectively catered to by special entities such as SFBs. We believe SFBs have a structural advantage of access to low-cost retail deposits (and opportunity for asset growth as well) compared to NBFCs, which will enable them to sustain margins and have sustainable growth. We believe the largely underpenetrated market segment is an attractive space with a large headroom for growth. n Company outlook - Long track-record of robust performance, improving outlook with growth opportunity AUSFB has had a long and successful history (since being an NBFCs and now as a bank) in credit underwriting quality mainly in the under/un-banked self-employed customer segment that lacks formal income documentation. AUSFB is predominantly present in underpenetrated states such as Rajasthan and Madhya Pradesh (~42% and 16%% of its AUM, respectively), which have significantly low credit and deposit penetration. We believe AUSFB’s presence in these states provides the bank the competitive edge to pursue growth, along with its niche customer profile with low competition from peer banks and NBFCs. We believe business outlook is improving with disbursements normalising and CASA improving sharply to 21% of deposits. Collection efficiency trends are stable at 96% (including multiple EMIs) and customer activation at 82% (including full/partial EMI payments) was only marginally lower to pre-COVID-19 levels of 85%. Management has indicated a positive asset-quality outlook (with only 5.5% exit moratorium levels in August; of which 2.5% has paid September/October EMIs), which implies ~3% of customers (manageable) in the stress pool. We expect H2FY2021 to record reasonable growth, helped by revival/near normalisation of the rural/semi-urban based markets, and disbursements too picking up gradually. However, going forward, we estimate with revival in the Indian economy and demand pullback, AUM growth trajectory would likely hold at 15%-17% over the next 3-5 years. n Valuation - Initiate with a Buy rating, with a PT of Rs. 1,060 We expect AUSFB to generate superior return ratios along with good asset quality in the long run, given its strong risk management framework and robust growth prospects. At the CMP, AUSFB is available at 4.7x/3.7x its FY2022E/FY2023E ABPVS.We believe AU SFB is likely to sustain its premium valuations due to its strong asset quality mix, superior return ratios, a long runway for growth along with high promoter ownership. As the bank achieves its vision of becoming a full-scale retail focused bank, we believe the valuation premium is likely to sustain.d. We expect ROA/ROE to improve to 2%/20% in FY2023E from 1.8%/17.9% in FY2020 with visible improvement in asset-quality outlook along with improving collection efficiency, moderation in opex, and credit cost. We value AUSFB at 4.5x its FY2023E P/ABV, given the secured nature of its lending book (98% of the loan book is secured), robust collection, underwriting mechanism, efficient risk management capabilities, and long runway for growth. The stock has corrected ~36% from its highs. We believe risk reward is favouring long-term investors. We Initiate Coverage with a Buy rating and a PT of Rs. 1,060, implying a ~19% upside.

One-year forward P/BVPS (x) band

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

- 19 19 19 20 20 20 19 20 18 19 19 20 19 19 20 20 19 20 18 19 19 19 20 20 20 ------Jul Jul Jan Jan Jun - Jun - Oct Oct Apr Apr Feb Sep Feb Sep Dec Dec Aug Aug Nov Nov Nov Mar Mar May May

PBV 3-yr Avg +1 sd -1 sd

Source: Sharekhan Research

Peer valuation CMP (Rs P/BV (x) P/E (x) RoA (%) RoE (%) Particulars / Share) FY21E FY22E FY21E FY22E FY21E FY22E FY21E FY22E AU Small Finance Bank 894 5.2 4.2 29.7 21.3 1.7 1.9 17.4 19.7 Ujjivan Small Finance Bank Ltd 35 1.9 1.7 21.7 14.2 1.5 2.0 8.9 12.5 Spandana Sphoorty 628 1.2 1.0 9.3 5.6 3.3 4.6 13.2 11.9 HDFC bank 1408 4.0 3.4 27.2 22.0 1.7 1.8 15.5 16.6 Source: Company, Sharekhan Research November 18, 2020 27 Powered by the Sharekhan 3R Research Philosophy Idea Stock

About company AU Small Finance (AUSFB) is a small finance bank that transitioned from a prominent, retail-focused non- banking finance company (NBFC), which primarily served low and middle-income individuals and businesses that have limited or no access to formal banking and finance channels. AUSFB received a license from the RBI to set up an SFB on December 20, 2016, and commenced its SFB operations from April 19, 2017. The bank’s liability product offerings include current accounts, savings accounts, term deposits, recurring deposits, and collections and payments solutions for MSME and SME customers. The bank aims to be a retail focused, preferred trusted SFB offering integrated and tailored solutions to its customers. At the end of FY2020, AUSFB has total AUM of Rs. 30,893 crore, spread across vehicle finance, SME, MSME, and other high-yielding products (including OD against FDs, gold loans, and personal loans etc). At the end of Q2FY21, the bank operates through 686 branches, with 63% of its branches in the rural and semi-urban areas. Rajasthan, Maharashtra, Madhya Pradesh, and Gujarat are the key geographies from where AUSFB sources 72% of its AUM and 68% of its total deposits.

Investment theme AUSFB has expanded and strengthened its business model to offer a diverse suite of banking products and services by leveraging its asset-based lending strengths, NBFC customer base, and cost-efficient, technology- driven hub-and spoke branch operating model to successfully operate its small finance bank. In addition to its vehicle finance, MSME and SME offerings, the bank’s asset product offerings include working capital facilities, gold loans, agriculture-related term loans, Kisan credit cards for farmers and loans against securities. The liability franchise has shaped up well with deposits, presently forming ~70% of the total borrowings. Of the same, deposits are dominated by retail deposits, forming ~43% of the mix and low-cost CASA deposits form 14.5% of the deposit base.

Key Risks A prolonged delay in pickup in economic activity will impact growth and profitability of the bank. Further, the bank has high exposure to the informal/SME segments, which may be vulnerable if economic recovery is delayed.

Additional Data Key management personnel Mr.Sanjay Agarwal Managing Director/CEO Mr.Uttam Tibrewal Whole Time Director Mr. Vimal Jain Chief Financial Officer Mr.Deepak Jain Chief Operating Officer Source: Bloomberg

Top 10 shareholders Sr. No. Holder Name Holding (%) 1 Agarwal Sanjay 18.52 2 Redwood Investments Ltd 6.84 3 CAMAS INVESTMENTS 4.71 4 Capital Group Cos Inc/The 4.13 5 AGARWAL SHAKUNTALA 3.86 6 AGARWAL JYOTI 3.86 7 Kotak Mahindra Asset Management Co 3.76 8 Nomura Holdings Inc 2.89 9 Motilal Oswal Asset Management Co 2.32 10 MYS HOLDINGS PVT LTD 2.17 Source: Bloomberg

Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a position in the companies mentioned in the article.

November 18, 2020 28 Powered by the Sharekhan 3R Research Philosophy Idea Stock

Understanding the Sharekhan 3R Matrix Right Sector Positive Strong industry fundamentals (favorable demand-supply scenario, consistent industry growth), increasing investments, higher entry barrier, and favorable government policies Neutral Stagnancy in the industry growth due to macro factors and lower incremental investments by Government/private companies Negative Unable to recover from low in the stable economic environment, adverse government policies affecting the business fundamentals and global challenges (currency headwinds and unfavorable policies implemented by global industrial institutions) and any significant increase in commodity prices affecting profitability. Right Quality Positive Sector leader, Strong management bandwidth, Strong financial track-record, Healthy Balance sheet/cash flows, differentiated product/service portfolio and Good corporate governance. Neutral Macro slowdown affecting near term growth profile, Untoward events such as natural calamities resulting in near term uncertainty, Company specific events such as factory shutdown, lack of positive triggers/events in near term, raw material price movement turning unfavourable Negative Weakening growth trend led by led by external/internal factors, reshuffling of key management personal, questionable corporate governance, high commodity prices/weak realisation environment resulting in margin pressure and detoriating balance sheet Right Valuation Positive Strong earnings growth expectation and improving return ratios but valuations are trading at discount to industry leaders/historical average multiples, Expansion in valuation multiple due to expected outperformance amongst its peers and Industry up-cycle with conducive business environment. Neutral Trading at par to historical valuations and having limited scope of expansion in valuation multiples. Negative Trading at premium valuations but earnings outlook are weak; Emergence of roadblocks such as corporate governance issue, adverse government policies and bleak global macro environment etc warranting for lower than historical valuation multiple. Source: Sharekhan Research

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