Kotak Mahindra-ING Vysya Bank merger at reasonable valuations

November 21,2014 The Street has given a thumbs up to the ING Vysya Bank-Kotak Mahindra Bank merger, expected to create multiple synergies for the combined entity. Talks on the merger, which the Street had sensed even before news of the deal came in, saw the two stocks rise about seven per cent each on Thursday.

The deal was announced after market hours on Thursday.

The valuations and share-swap ratio are reasonable, analysts say. In fact, the share-swap ratio of 725 Kotak Mahindra Bank shares for every 1,000 shares of ING Vysya Bank entails 15 per cent dilution for Kotak, lower than Street expectations of about 20 per cent dilution.

The deal values ING Vysya Bank at Rs 790 a share, or about twice its FY15 estimated adjusted book value, lower than expectations of 2.2 times. "With Kotak Mahindra Bank trading at four times the FY15 estimated book, ING Vysya Bank's acquisition, at 2.2 times, will be highly EPS (earnings per share)- and book-accretive; at these valuations, the deal will be seven-eight per cent EPS-accretive and more than 10 per cent book-accretive," Adarsh Parasrampuria of Nomura said in a pre-deal note.

Past mergers and acquisitions in this sector such as the HDFC Bank-Centurian Bank of Punjab merger(2008) and the ICICI Bank-Bank of Rajasthan merger (2010) took place at higher price/book value multiples of 2.4 and 5.4, respectively. As such, analysts believe the Kotak Mahindra Bank stock could rally further on Friday. Both the Kotak Mahindra Bank and ING Vysya Bank stocks recorded new highs on Thursday, in anticipation of the deal.

Operationally, too, the deal offers multiple synergies. First, the combined entity will be the fourth-largest private bank in India, in terms of branch network. Currently, Kotak Mahindra Bank is fourth, while ING Vysya Bank is eighth. The combined entity will have 1,214 branches, against Kotak Mahindra Bank's current branch strength of 641. Kotak Mahindra Bank has a target of 1,000 branches by 2016; the deal will accelerate this process.

Second, Kotak Mahindra Bank, which has a strong footing in west and north India (these regions account for 80 per cent of its total branches), will achieve significant presence in South India, too, given 64 per cent of ING Vysya Bank's branches are in this region. For the two banks, the advances and liabilities profile, as well as the urban/metro and rural branch composition, are also somewhat similar, analysts say. The merger will also enable loan-book diversification and increase Kotak Mahindra Bank's presence in the small and medium enterprise (SME) segment, which currently accounts for only eight per cent of its loans. The SME and business banking segments account for 38 per cent of ING Vysya Bank's loan book. The merger will also boost Kotak' Mahindra Bank's fee income, as ING Vysya Bank offers multiple trade finance and foreign exchange products.

In a pre-deal note on Thursday, Sri Karthik Velamakanni of Espirito Santo Securities India said, "Given ING NV's parentage, through the past several years, ING Vysya Bank has ramped up its forex and trade finance products. These are some of the missing links for Kotak Mahindra Bank, which could help it boost its fee income and deploy capital to more 'off-balance sheet' fee income-generating activities."

While the combined entity will still have a strong capital adequacy ratio of 16.5 per cent (against Kotak Mahindra Bank's 17.6 per cent currently), its return ratios are likely to see some pressure in the short to medium term. This is because ING Vysya Bank's return on assets (RoA) and return on equity (RoE) ratios are much lower than those of Kotak Mahindra Bank - against Kotak Mahindra Bank's RoA and RoE of 2.2 per cent and 14.3 per cent, respectively, ING Vysya Bank has RoA of 1.1 per cent and RoE of 8.9 per cent. The combined entity will have RoA of 1.8 per cent and RoE of 12.8 per cent, according to Kotak Mahindra Bank. The management of the bank is confident of gradually improving these ratios.

At the end of September this year, ING Vysya Bank's savings account deposits stood of Rs 7,288 crore; its savings deposit rate was four per cent. Kotak Mahindra Bank provides six per cent interest on savings deposits. Upon the merger, the rates will have to be adjusted to offset any increase in interest expenses. But if ING Vysya Bank's savings bank customers are given six per cent interest, the annual hit on the profit will be to the tune of Rs 140-145 crore. Kotak Mahindra Bank will have to find ways to improve the net interest margin of ING Vysya Bank's operations, which stood 3.46 per cent against Kotak Mahindra Bank's 5.05 per cent. ING Vysya Bank's cost-to-income ratio is 340 basis points higher than Kotak Mahindra Bank's. If Kotak Mahindra Bank has to raise the profitability of the merged entity to its current levels, these factors will have to be looked at.

While there are bound to be short-term aberrations leading to some impact on the financials on a quarterly basis, once the deal is consummated, the longer-term gains should outweigh these.

The transaction is expected to be completed by April 1 2015, after which Kotak Mahindra Bank's promoter holding will fall from 40 per cent to 34 per cent; ING Vysya Bank's promoters will be second-largest shareholder in the combined entity, with a 6.5 per cent stake. Meanwhile, ING Vysya Bank's promoters have agreed for a post-merger lock-in period of a year --- implying they will not reduce their stake further during this period. This implies supply in the stock will be restricted to that extent.