The stocks of Equitas Holdings and Ujjivan Financial Services rallied in the past few weeks – up 11 and 16 per cent, respectively since close of July 9. This was following a go-ahead from the RBI, permitting these holding companies to apply for a downstream reverse merger with their subsidiary small finance banks (SFB). The scheme of amalgamation submitted by the companies, is subject to approvals from RBI and SEBI. Besides, at this point RBI has not extended the timelines for complying with the SFB licensing norms, which include the impending promoter stake dilution.

What’s changed

Previously, these holding company stocks were under pressure due to regulatory diktat. At first RBI’s mandate to list their banking subsidiaries came as a bummer. Then came the blow of a heavier holding company discount with clear price discovery (of subsidiary), followed by the impending need for promoter stake dilution in the banks . These publicly held holding companies enjoy an 82 (Equitas) and 83 (Ujjivan) per cent stake in their banking subsidiaries. This has to be brought down to 40 per cent by September 2021 for Equitas SFB and to the same levels by January 2022 for Ujjivan SFB.

However, the RBI has now permitted the holding companies to apply for a reverse merger, which can help achieve two objectives with one stroke – eliminating the need for having two listed entities (that essentially just represent one small finance bank) while also resulting in a complete exit of the promoter with no dilution for existing shareholders .

Following this, the holding company discounts are expected to narrow further (already narrowed by 8-10 percentage points since the announcement), and the likely reverse merger deals could hold value for the investors of the holdcos (will receive shares of small finance banks). Besides, for Equitas Holdings with healthy prospects in the subsidiary SFB we expect the company to see the best of both worlds – value appreciation in subsidiary coupled with narrowing holding company discount. Trading at a 27 per cent discount to its holding in the SFB (market capitalization), Equitas Holdings seems like an attractive bet for long term investors.

In the case of Ujjivan Financial Services while further narrowing of holding company discount is imminent, the near term stress in the SFB’s financials can be a drag. Ujjivan SFB is currently reeling under pressure owing to its exposure to micro finance (72 per cent of the bank’s loan book) and higher-than-peers credit costs (3.9 per cent of AUM in FY21, compared to 1.5 and 2.5 per cent for Equitas SFB and Suryoday SFB, respectively), which have dragged its return ratios as well--- ROA dropped to 0.04 per cent in FY21 from 2.2 per cent in FY20. Factoring in the near term weakness, Ujjivan Financial Services, now trades at a 33 per cent discount to its holding in the SFB.

Hence, in our view, while fresh entry into Ujjivan Financial Services at this point might not yield healthy returns for long term investors, due to the recent run up in the stock, existing investors can continue to hold the stock, in a bid to unlock value from the proposed demerger.

Overhangs eliminated

In our previous buy call on Equitas Small Finance Bank (in May 2021), we had stated two risks – one its geographical concentration in States with heightened covid cases and two the impending dilution for shareholders, following the mandated dilution of promoter holding in the bank (https://tinyurl.com/EqSFB). While the former continues to be a stress factor, despite its capital adequacy of 24.18 per cent and provision coverage of 71.9 per cent providing some comfort, the latter is expected to be addressed with the reverse merger. Equitas SFB now trades at 2.19 times its book value and may see further re-rating with more clarity emerging on RBI’s intentions on this front. This could lead to further upside in the stock of the holding company too.

Last week leading private lenders – HDFC Bank and Bajaj Finance posted higher than usual delinquencies in their retail book in the June 2021 quarter, in the absence of any regulatory ban on stress reporting, as was the case in the corresponding quarter last year. This could help gauge the havoc wrecked by the second wave of the pandemic in retail households. The impact of the same could only be more intense for the target segments of the SFBs.

Equitas SFB had reported a drop in its billing efficiency (percentage of EMIs collected for that month) in April 2021 itself --- to 88.12 per cent, compared to 94.46 per cent in March 2021. Ujjivan SFB too reported a drop in its collections from 94 per cent in March 2021 to 89 per cent in April 2021. In the ensuing lockdown months, the collection ratios could have dipped further. In this backdrop, among the two, Ujjivan SFB with its heightened unsecured exposure (73 per cent of loan book in FY21) is at higher risk.

While the restructuring framework 2.0 announced by the RBI could help ease the pain on NPA front, mandatory provisions could continue to drag profits—especially for Ujjivan SFB that witnessed a 2 per cent drop in its overall loan book in June 2021 quarter (provisional numbers reported in an exchange filing). The bank’s net interest margins could suffer due to higher interest reversals (on account of NPAs) and likely drop in overall yields (due to 13 per cent y-o-y drop in high yielding microfinance book)—despite being offset by a savings in cost of deposits (CASA inched up by 7 percentage points in the first quarter of FY22, compared to corresponding quarter last year).