Kotak Mahindra Bank (KMBL) ended Q2’09 with declining profitability across most businesses. The standalone Bank recorded a 36.5% y-o-y decline in net profit and most subsidiaries saw shrinkage in volumes.
The present economic turmoil is affecting virtually all businesses of the Group. The standalone banking business is likely to be affected by the expected deterioration in asset quality.
The present loan book consists of a large proportion (36.4% at the end of Q2’09) of high-risk assets such as real estate and personal loans. All these segments carry a high risk of default which in turn may further increase on account of the present economic slowdown, marked by job cuts and falling asset values.
However, KMBL is expected to reduce its exposure to these segments and shift its advances mix towards low-yield and less risky segments such as corporate banking. This, in turn, is expected to reduce the net interest margin.
The asset management business is also likely to see a decline in profitability as the downturn in equity markets may lead to more subscriptions in debt funds which command a lower fee vis-à-vis equity funds.
The investment banking and brokerage businesses too are not likely to show any recovery in the near term as the stock markets are expected to be weak and volatile in the near future. This will keep both retail and institutional investors away from the market, thus adversely affecting both the investment banking and broking businesses.
However, despite a fall in profitability across several businesses, we still see value in businesses such as stock broking and investment banking which are likely to perform well on the reversal of the prevalent trends in the equity markets.
As we are confident about the long-term prospects of Indian economy, we expect equity markets are likely to reflect the strength of the economy in the medium-to-long term.
Kotak has a strong investment banking division, which has participated in several of the key IPOs in the previous few years. The stock broking division also enjoyed a large market share during the upswing in the market.
Certain features of insurance, such as tax-saving and safety of returns, coupled with the company’s growing geographical expansion and focus on Bancassurance channel is likely to play a role in future growth of this business.
Our FY09 target price of Rs467 for Kotak Mahindra Bank has been calculated by using the sum-of-the-parts valuation methodology.
The standalone banking business has been valued by using the Discounted Equity Cash Flow model. Assuming a sustainable RoE of 16%, we have arrived at a terminal growth rate of 12.39%. Cost of equity has been assumed at 15.75%. This gives the standalone bank a valuation of Rs125.
As our target price of shows an upside of about 20% from the current price level, we upgrade our rating on the stock from Hold to BUY.