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Tuesday, May 20, 2014

Value Pick: J&K Bank - Returns of 65% in 10 Months

Dear Reader,

Unlike, any other manufacturing or service company, a bank’s accounts are presented in a different manner (as per the banking regulation). The analysis of a bank’s accounts differs significantly from any other company due to their structure and operating systems. Those key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank. Therefore, we have attempted to throw light on some of the key ratios (picked up from various websites), which are unique for banks and determine the financial stability of a bank.

Key parameters for evaluating operating performance and financial stability of banks are as under:

1. Net interest margin (NIM) – For banks, interest expense is their main cost (similar to cost of raw materials for companies) and interest income is their main revenue source. The difference between interest income and expense is known as net interest income. It is the income, which the bank earns from its core business of lending. Net interest margin is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call.

Net interest margin (NIM) is an indicator of the ability of a bank to generate returns. Higher the NIM, the more profit a bank can earn from a given pool of funds. There is no benchmark number which is considered as an ideal level to maintain, however NIM above 3.5% is considered very good.

2. Non-performing assets (NPA) – When a customer defaults on a loan (interest is outstanding for more than 90 days), the bank writes it off from its books and the loan is termed as a Non-Performing Asset (NPA). There are 2 forms of NPAs:

Gross NPA – The amount outstanding against the borrowers account (with the outstanding interest)
Net NPA – Gross NPA – (Provisions made on the loan + Recoveries made on the loan + other adjustments)

NPAs are a reflection of the healthiness of a bank’s loan portfolio book. Higher ratio reflects rising bad quality of loans.

3. Provision coverage ratio (PCR) – When a bank does not expect a customer to repay the loan, it sets aside a certain sum of money for the expected loss. This is known as a provision.

The key relationship in analyzing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a faster clip).

4. CASA ratio – This is the ratio of current account and savings account deposits to the total deposit base of the bank.

The bank pays out much lower interest rates on savings accounts and current accounts than other types of deposits such as fixed deposits. Raising money this way is also cheaper than loans from other sources like RBI, money market or other banks. Hence for a given sum of money, higher the ratio more profitable is the bank.

5. Capital adequacy ratio (CAR) – Capital adequacy ratios are a measure of the amount of a bank’s capital expressed as a percentage of its risky loans. It is a measure of how well capitalized a bank is, i.e. how easily it can withstand losses. Applying minimum capital adequacy ratios serves to protect depositors and improve the stability and efficiency of the financial system. The RBI specifies the minimum capital adequacy ratios that all banks have to maintain. As investors, we have to expect more than just the minimum.

The higher the CAR, the safer are the depositors’ funds. Considering that banks have been expanding their operations very aggressively, it is important to keep an eye out for whether they are adequately capitalized.

6. Credit to Deposit ratio (CD ratio) – This ratio is indicative of the percentage of funds lent by the bank out of the total amount raised through deposits. Higher ratio reflects ability of the bank to make optimal use of the available resources.

The regulator does not stipulate a minimum or maximum level for the ratio. But, a very low ratio indicates banks are not making full use of their resources. And if the ratio is above a certain level, it indicates a pressure on resources.

7. Return on Assets (ROA) – Return on asset ratio is the net income (profits) generated by the bank on its total assets (including fixed assets). The higher the proportion of average earnings assets, the better would be the resulting returns on total assets. Similarly, ROE (return on equity) indicates returns earned by the bank on its total net worth (shareholder’s funds).

The above are some of the important parameters one should evaluate his/her banking stock on, however banks being highly leveraged entities, the margin of error is very small and we therefore believe that the most important aspect from an investor’s perspective is the asset quality and the provision coverage policy of the management.

In July 2013, RBI has taken few measures to curb liquidity which was expected to adversely impact the whole banking system of the country in coming quarters, hence we have seen all banking stocks going through correction with steep fall in stock prices during that period. However, RBI has clarified that these are temporary measures taken for controling Rupee depreciation. We believe that banking stocks may not see sharp rise or strong bounce in their prices but there are few stocks where valuations are very attractive and have potential to reward medium to long term investors (1.5 to 3 years).

Considering all above important ratios and key fundamentals, our team recommended Buy for Jammu & Kashmir Bank on 31st July at price of Rs. 1122 for target of Rs. 1550 in 12 - 18 months. We informed our members that J & K Bank can deliver decent return on your investment if holded for period of 1.5 to 2 years.

Suggested Buying Strategy (31st July 2013): 60% allocation at CMP - Rs. 1122 & 40% allocation in the range of Rs. 1020 - 1050 (in case of any further fall in stock price)

J&K Bank has recently announced its results for the quarter and year ending Mar’14 and the key highlights of the same are as below:

i) Net interest income of the bank is up by 10.67% YOY at Rs 701.18 crores while for the whole year the net interest income is up by 15.91% at Rs 2684 crores.

ii) The Gross NPA is up marginally from 1.62% at the end of Mar’13 to 1.66% at the end of Mar’14 while the Net NPA has moved up from 0.14% to 0.22%. 

iii) De-growth in other income is 46.82% resulting in 3.58% de-growth in total operating income (net interest income + other income) at Rs 812 crores. Last year in Mar’13 quarter, there was one time other income of 72 crores from sale of stake in MetLife. Operating expenses have increased by 8.72% driven largely by provisions for ensuing wage revision, higher depreciation on account of branch expansion and other expenditures.

iv) The net profit is flat at 250 crores, however on excluding the impact of MetLife stake sale; it’s up by around 20-25%

v) The provision for bad and doubtful debts, standard advances and depreciation on investments is lower in comparison to Mar’13 resulting in profit before tax being higher by 17.06% at Rs 420.87 crores. 

Since Mar’13, the deposits of the bank have grown by 7.97% (10.59% in J&K state) and the gross advances have grown by 18.12% (23.73 in J&K state). As per the management, they will continue to focus on increasing the proportion of business from J&K as they derive much higher profitability in J&K in comparison to rest of India. For FY 15, management have guided for around 18-20% growth in advances (~25% growth in J&K state) and around 15% growth in deposits (~20% growth in J&K state).

Today, J & K Bank is trading at Rs. 1850 giving returns of 65% in period of 10 months. As overall bank performance is good with better asset quality in comparison to other banks and reasonable valuations of 7.4 times earnings and 1.55 times book value, we suggest our members to continue holding this stock in their portfolio with medium to long term perspective.

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Team - Saral Gyan.