Archive for the ‘Industry analysis’ Category.

 

As an armchair investor, I usually analyze companies and their economic models through their annual reports and other published documents. This is a top down approach and does not involve any grass roots analysis or any kind of investigation at the ground level. At the end of the day, it has a virtual feel to it.

I recently met a distant relative, who is in the transportation business – mainly long distance trucking and started talking with him about the economics of his business. He mentioned a few key points of his business

          The pricing in the business is very volatile in nature. He was able to get good pricing (rate per tonne) during the 2004-2008 period. The rates collapsed during the 2008 -2009 period. Rates have recovered since then, but are still not anywhere near the peak levels.

          The current rates are slightly above break even. He is able to make good profits in a few months, but ends up giving back (looses money) part of it in the other months.

          He had contracted with large companies via fixed rate contracts and got killed by these contracts during the downturn due to low utilization (A truck under a fixed rate contract cannot be hired out). At present, he has inflation related pricing clauses, but is unable to enforce them due to severe competition.

          The trucking business is driven by vehicle finance from banks and NBFCs. Large companies like TCI are able to negotiate rates and payment terms with them. However as a small operator, he is unable to do so.

          The current ROC in the business is an anemic 10-13% of capital. At the same time there is a lot of stress. Due to these factors a lot of small operators are exiting the business and he is planning to do the same.

I started thinking about the economics of the business and did a mental exercise of applying the porter’s five factor model to the business to see how the facts fit the model

  1. Entry barriers: This business has low to nonexistent barriers to entry. A typical truck costs around 22-29 lacs (total cost) and one can easily get a loan of around 20 lacs. So anyone can enter this business with a starting capital of 7 lacs. In addition, one does not need any specialized skills in this business (beyond a driver’s license and a transport permit). Finally, there is an open market for trucking service (via brokers) and any operator can contract out his vehicle (if he accepts the offered price)
  2. Buyer power: Buyer power is quite high in this industry, especially with large companies. A large cement or steel companies drives a hard bargain with the transport operator as trucking, atleast at the small scale is a commodity product.
  3. Supplier power: Supplier power is quite high too. A small transport operator has to deal with large banks or NBFC for finance and with Tata motors or Ashok Leyland for the trucks. It is easy to see the lack of leverage in this unequal relationship. Fuel is the biggest variable cost, which also is priced by the government.
  4. Substitute product: Although there is not much substitution for road transport, multi-modal transport is now becoming a viable alternative. Large operators like GATI, concor or gateway distriparks now offer a combination of road and rail transport and thus provide a cheaper option. This has now started to hurt the smaller operators
  5. Competitive intensity: This is very high in the industry. As it is easy to add capacity (does not take much to buy trucks or divert it to a more profitable routes), pricing is driven by demand and supply. Due to the highly fragmented nature of the industry, most of the small operators are price takers and are not able to earn an attractive return on capital

It is also clear that the industry is now consolidating with the exit of the smaller players. In a commodity industry, the pricing is driven by the lowest cost operator. In the trucking industry the large operators (especially multi-modal transporters) have some leverage with the suppliers and are able to drive costs down (due to scale) and thus earn an attractive return on capital.

One added reason for doing this mental exercise is that I did a short project with Tata motors in their heavy vehicle business as a management student in the late 90s. The economics for the small operator had started deteriorating then and has now become worse due to the entry of multi-modal transport operators.

At the end of the conversation, I did not want to advise my relative that he should exit this business as it would seem presumptuous (what would an armchair investor know?). However, I am guessing that he has arrived at the same conclusion without using the fancy models and would be exiting it soon.

In the end, I think it was a good learning experience for me. The trucking business reminds me of the following quote by warren buffett

‘When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact’

 
 

I  have discussed about the various factors or parameters in analyzing a bank in some earlier posts (see here and here). In this post, I will use these parameters to evaluate a real example.

A warning before I proceed – The wieghtage given to each factor and conclusions derived depend heavily on the temperament and biases of an individual. If you are an investor who likes growth and are ready to take some risks to get a multi-bagger, you may overweight the topline and bottom line growth and pick a bank which is growing rapidly.

On the other hand if you are conservative in nature, you may overweigh the CAR ratio and  may actually get nervous if the bank is growing too rapidly. I personally prefer a middle path – I would prefer a conservatively managed bank which is growing at 1.5-2 times the GDP growth rate and hence is likely to give a 15-20% growth rate.

In my world a 15-20% growth rate is adequate, if it can be sustained for 5-10 years. I am not looking for shooting stars.

I am taking the example of Axis bank for this post to demonstrate the process I  go through when evaluating a bank. I do not have any position in the stock.

Profitability and its source

The first factor I would look at for in any company is the Return on capital (ROE in case of banks). Any company earning below the cost of capital (over the business cycle) is out of contention. The bank or the company should have an average ROE in excess of 15% over the last 10 years. Axis bank has had an ROE of around 23% over the last 10 years. The ROE has dropped from 32% in 2001 to around 20%, but has generally been maintained above 18% during the entire time period.

I am also interested in understanding the source of the above average returns. In case of a bank, the ROA (return on asset) is an important number. A number in excess of 1.3% is considered good. Axis bank has improved its ROA from 0.8% in 2001 to around 1.6% in 2011.

The improvement in ROA was driven by higher net interest margins and better other income, resulting in higher net profit margins which have gone up from around 1.8% to around 3.7% . So in effect the bank has improved the profitability, both from lending and  fee based sources.

Asset Quality

A bank may be very profitable and showing great results, but may have very risky loans on its books. Asset quality is an important factor in evaluating the quality of the earnings of the bank. Unfortunately there is no easy and direct way of doing it.

I typically look at the NPA number, the level of provisioning of the NPA and profile of the assets. It helps to review the distribution of credit risk by industry in the notes to account, to confirm that there is not too much concentration of lending to any specific industry or borrower.

The truth of the matter is that one cannot get a perfect read of the asset quality and has to trust the management. This is the main reason why a long term track record and culture of the bank is important. If the bank has a past history of conservative lending over the business cycle, then one can expect the same to continue.

I am a bit concerned on this count with Axis bank. The bank has been expanding rapidly, especially on the home loans and other retail assets. One cannot be sure if the bank has been conservative in lending.

Safety

The next factor I would look at is the safety or capital cushion of the bank. The ratio to look for is the CAR (Capital adequacy ratio). The bank has on average maintained a CAR of 12.5% and may need to raise more capital to fund future growth.

The next factor to evaluate the sustainability of the earnings is the gross/ Net NPA and level of provisioning. The bank has a gross NPA of around 1% and net NPA of around .26%. The bank was provisioned around 68% in 2010, which means that 32% of the NPA have not been provided for (and could hurt the profitability if these loans cannot be fixed).

The NPA number is very crucial for the banks. It is difficult to be sure about the true NPA of the bank as a bank can play a lot of games to modify this number and thus come up with a desired profit number. One has to just trust the numbers, based on the overall feel of the management.

Growth

If I am satisfied with the profitability and safety of the bank, I would move on to the growth in topline and net profit for the bank. In case of Axis bank, both the numbers have increased in excess of 30%. Clearly the bank is in a lot of hurry to grow.

In addition to the income and profit, the bank has grown its branch network from 139 to 1390 in 2011 and the ATM network from 490 in 2002 to around 6270 in 2011. The bank is thus expanding the retail network which is healthy growth as it helps the bank on the liability side (gather low cost deposit) and also lend to the retail segment (in the form of home loans, personal loans etc).

Cost analysis

Cost is an important factor in the analysis of any industry and more so in the case of the bank. The two crucial cost elements are the cost of funds and the overhead costs.

The cost of funds in case of axis bank has dropped from around 7.5% to around 5%, due to the increasing current and savings deposits. This is a good trend and has enabled the bank to earn a decent net margin (3.7% currently).

The cost to income (or overhead) ratio has gone up from 30% to around 40% level mainly due to the cost of new branches and other such investments. If this ratio is up due to expansion of the branch network, then I am all for it. Axis bank is clearly investing in expanding the branch and ATM network and is benefiting from this expansion too

Competitive advantage

It is also crucial to evaluate the strength of the bank’s competitive advantage and if the bank is working on enhancing it. The competitive advantage comes from the following factors

          Brand : Axis bank is now a well know brand, especially in the urban areas and is constantly being strengthened through advertising and promotion

          Customer Lockin : The bank is improving the lockin by increasing the number of branches, ATM and by providing a wide range of products. The bank can keep increasing the customer lockin by constantly improving the service levels and adding new products.

          Production side advantage : The bank has been able to expand the branch network and increase the number of customers. This provide the bank, economies of scale in gathering deposits (and lower cost of funds) and reduce the per customer cost of servicing them.

          Entry barrier: There is certain level of entry barrier as RBI does not issue new licenses easily (which may change now). As a result the private banks have been shielded from relentless competition and have been able to grow rapidly and achieve scale. Any new banks will to incur years of investment to achieve the same scale.

Management quality

This is the most important and the most difficult factor to evaluate. In the case of axis bank, I can offer a few view points, but these are just that – views or impressions. Each one of us will come up with their own impressions.

I find the management quite aggressive in expanding growing the bank. In some ways, the bank looks like a version of ICICI bank when it was in the growth phase. Some of you may find that comparison unfair as ICICI grew too rapidly and then had to fix the asset quality issues. I am not implying that axis bank has the same issues, but one cannot sure in cases where the growth has been rapid. 

The disclosure levels of the bank are quite adequate and the bank provides a lot of detail about asset profile and distribution.

Overall the management is definitely doing the right things and has strengthened the balance sheet and increased its competitive advantage over the years.

Conclusion

I have covered how I would evaluate a bank based on the various factors. As you can see, there is no checklist or points system where if the bank scores well on most of the factors, then at the end of the exercise you would have neat conclusion to buy or sell.

I find the bank passes most of the checkpoints in terms of fundamental analysis, except for my concern on asset quality. The key reason for not pulling the trigger is price – I find the price higher than what I would like to pay.

 
 

I recently started analyzing financial institutions such as brokerages, banks and HFC (housing finance companies). I wrote about brokerage firms here and here.

In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.

Key factors
Return on equity – This is a critical factor in analyzing a bank.  A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.

An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.

CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.

The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)

Net/ Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books.  A low number is always good.  An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA

This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.

Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.

The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.

Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits.  The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.

An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.

Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .

NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.

This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)

 NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.

There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t  agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.

Next post :  More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.