Kotak Mahindra Bank looks strong to achieve high growth in ROE and Market Capitalisation by FY25.

Summary

We believe KTKM is positioned for an earnings upgrade cycle; estimate growth by 7%/13% for FY23E-FY25E on higher margins and lower loan-loss provisions. We expect Kotak Mahindra Bank to achieve market capitalisation of US$100Bn by FY25E.

KTKM is well-positioned this cycle to put capital to work, and successful execution of its retail asset strategy to drive the MCap to US$100bn by FY25E.

We believe KTKM is positioned for an earnings upgrade cycle; estimate growth by 7%/13% for FY23E-FY25E on higher margins and lower loan-loss provisions. We expect core operating profits to grow at a 22% CAGR (vs. <15% CAGR in FY19-22) and net profits to grow at an 18% CAGR in FY22-25E.

KTKM looks strong given its: (1) beneficial position in a rising interest rate environment; (2) sustainable loan growth at a +20% CAGR on utilization of excess capital (500bps v/s PVT banks) and realize operating leverage aided by its digital platform (“811”); (3) best in class PPOP-ROA; and (4) limited dilution risk as promoter’s stake already at RBI limits, leading to an improvement in ROEs of 200bps in FY22-25E. 

Kotak Bank could join the ranks of banks with US$100bn in market cap by FY27E as this cycle it has all the factors in place for it to deliver sustainable and strong volumes and operating profit growth as it puts its excess capital to work (500bps vs. other PVT banks). Consequently, we believe it can deliver a +20% CAGR for PAT driven by: 

A strong customer franchise (cumulative customer base of 33mn v/s HDFC Bank’s 70mn customers) that allows the bank to also scale up its deposits while its digital platform (8-11) also scales up (30% of deposits in 4QFY22 came from 8-11 platform). 

• Low-cost deposits which translated to a best-in-class cost of deposits at 3% in FY22 (lower than HDFC Bank/ICICI Bank by 30bps). 
• Significant investments in distribution network with the addition of employees while also investing heavily in digital architecture as seen in non-employee expenses rising by a 19% CAGR in FY17-22 vs. the PVT sector bank average of 15%. 
• Improvement in productivity ratios, which currently appears less impressive particularly in retail assets, given banks’ investment in adding resources which, as they mature, will drive operating leverage and translate into best-in-class ROAs. 
• This, coupled with the limited scope of dilution given the promoter’s shareholding is already at the RBI minimum - one of the main reasons for capital-raising in the past, in our view, will also allow the bank to put to use excess capital, translating into higher leverage over time. We expect this to drive ROEs up from 13% in FY22 to 19% in FY26.

Kotak has delivered a slower core PPOP growth at a FY19-FY22 14.5% CAGR (3.7 ppt lower than the avg. of ICBK and HDBK) as loan growth slowed down due to rising stress in the retail segment (Commercial retail particularly) driven by subdued macro and an increase in bad loans (25% yoy increase in bounce rates 1yr prior to the pandemic). It retained its focus on mortgage loans which it views as necessary as it pivots to become a consumer-retail bank. 

However, over the last few years, it scaled up its liability franchise with a strong CASA ratio and retail deposits and has been putting in place the enabling infrastructure to scale up the retail loans especially in consumption-oriented products such as home loans and is now diversifying to unsecured products such as personal loans and credit cards, which would also enable it to deliver an all-round retail franchise with higher products per customer. This will lead to a more sustainable loan growth. 

KTKM has strengthened its liability franchise particularly the current account franchise which has grown at an 18.5% CAGR over FY19-22 (to 21% of deposits vs 15% for PVT banks) compared to an average 15% CAGR for PVT banks. As a result, the cost of funds has consistently declined to levels below the larger banks (the gap has widened to 30bps partly on better mix driven by CA deposits). We believe this allows Kotak to improve its rate offering and accelerate market share gains particularly in the savings deposit; although this has seen a slowdown as the bank reduced the interest rate sharply to slow down the growth in its loan book and moderate its loan-deposit ratio to a healthy level of 87%. 

Improvement in productivity ratio:

Kotak’s cost to income ballooned to 47% (amongst the highest vs peers) as it ramped up investments to tackle competition from peers, fintechs and also to scale up its retail asset franchise. However, if we look at the productivity gains (savings/retail deposits per lagged branch), while the bank has seen healthy traction in deposits productivity partly supported by higher interest rates, revenue momentum (fee income) and asset creation (retail loans) have been comparatively weaker. We attribute this to capacity build up on the employees and digital side which is evident from the fact that Kotak added 57% more employees (including contractual employees) over FY17-21 vs 19%/38%/42% for ICBK/AXBK/HDBK. The growth in non-employee expenses has been far higher (even the non-employee per branch expenses have been much higher) than peers. Our recent meeting with the VC & MD indicated that the bank would continue the growth momentum. We believe the infrastructure build out in this cycle coupled with excess capital, strong provisioning coverage, and a best-in-class liability mix enhances the visibility of sustainable growth momentum. As the investments start to pay-off, we see cost to income ratio peaking out in FY23E and thereafter moderating and improving by 120bps by FY25. 

Increase in Market Share:

Over the last three years, the bank has gained market share specifically in savings and current account deposits by 30bps and 40bps, respectively. We believe the bank still has scope (given the differential between deposit rates) to accelerate the market share particularly in savings deposit as it has the scope to offer higher savings deposit and retain customers (executed well during the FY19-22 period). On the other hand, within retail, the bank has gained market share in mortgage loans between FY19-22 by 70bps to 2.8% which is a key product to scale up the retail lending business for the bank. We believe with capacity building, a healthy credit environment with clean up being done in the household segment during the COVID period in the system (as seen in consistent improvement in bounce-rates on retail loans in the system and lower delinquencies), Kotak is well positioned to gain market share further, though we note that the competition will be high as well from the larger PVT banks.