First,a disclosure. IDFC constitutes approx 10% of my portfolio. Since my portfolio is highly(too) diverse with >2% in approx 30 stocks, it remains a large bet in my portfolio. My average purchase price is around 125, bought between Sep 2013 and Sep 2014.
Second Disclosure: My investment horizon is 10 years+, and my return expectation is a CAGR in the high teens. This is something I decided apriori, not something which I have discovered after the tepid rise in the stock price.
First the negatives:
a) IDFC is a primarily infrastructure lending organization. This means that growth has been tepid to zero in the last 2 years. This contrasts with the 15-20% growth of other NBFCs during the last 2 periods.
In addition to low growth, there are also problems in its loan book. Approx 3% is lent to Gas Based Power Plants, and we all know that this may have to be written off. (Though they do have some provisions against that). In general, you cannot have been lending to power and roads and not have problems.
b) Once they convert to a Bank, the profits will almost certainly fall, as all costs related to the Bank (CRR, SLR, extra employees, IT costs, Branch Costs), will be immediately applicable, while the bank will take its time to increase NII and revenue.
c) IDFC has made a horrendeous bet on Gsecs, trying to play the interest rate cycle. This bet is going to mean a big profit downturn in the last quarter results.
d) Lots of people think of HDFC Bank when they think of IDFC becoming a bank. However, in a straight sense the scenario is quite different. When Kotak, HDFC, IndusInd, Axis, and ICICI became banks in the 1990ās their primary competition was PSU Banks, which were run in an abysmal fashion. Today, when IDFC Bank needs to get market and mind share, it is by competing against these new banks, rather than the PSU banks. This is a much more difficult task. So the going is not going to be easy at all.
e) Post the demerger, IDFC Ltd will be left with its IDF, AMC and PE Fund. No one can predict the holding company discount on the Bankās share, but since DDT is 18%, it is fair to assume that it will be at least that much. In addition, there will never be additional FII investment in the holding company, since they will be pretty much at the limit.
Now the investment thesis:
a) The price: Current price of IDFC is < 1.5 times book. This compares very favorably with other Private sector banks with similar management quality.
b) FII Holdings: In the demerged bank entity, FII investment will be 25%, and this can increase to 49%, It stands to reason that this will get filled up quickly.
c) The Opportunity: I think this is the single biggest reason to invest. While it is true that Private sector banks today are very well run and have large CASA and network moats, it is also true that technology is upending the entire banking business model. The need for an elaborate branch network, the need for lots of employees, the need for elaborate relationship models, is fast evaporating. The use of mobile banking, banking correspondents, payment banks, and the overall influx of technology means that banks which are saddled by legacy branches and employees can be seriously affected by a bank which remains technology invested, but has no investments in a branch network or does not require anyone to visit a bank, ever. It is true of PSU Banks for sure, but is also true of a lot of Private sector Banks. Everything I have read or heard of from IDFC management in their public comments makes me reasonably certain that they understand this, and this is the business model they intend to follow.
Now, it may be that they are early, that the market is not ready for a technology oriented bank, and that it will take a while for customer awareness and adoption. In which case, IDFC Bank will remain a has been. But even in that case, the price provides excellent margin of safety.
In summary, an investment in IDFC remains an investment in the future of technology enabled banking. It is clearly not a short term play, but in the short term, the low price does provide a margin of safety. But you must weigh it against the opportunity cost of waiting for the price to reflect improved performance in the future. It seems good for a passive investor like me, who would like to buy something and then only occassionally reflect on whether the investment thesis is playing out.
