Ujjivan Small Finance Bank has come out with its initial public offering, proposing to raise ₹ 750 crore through fresh issuance of shares. The issue also includes a reservation of up to ₹75 crore for subscription by eligible shareholders of Ujjivan Financial Services.

While Ujjivan Small Finance Bank is well capitalised, with tier I capital ratio at 18.2 per cent as of September 2019, the IPO mainly aims to meet the RBI’s listing norms. Ujjivan Financial Services, which got listed in May 2016, is the holding company of Ujjivan Small Finance Bank. The RBI’s norms requires a banking subsidiary to be listed within three years (January 31, 2020) from the date of commencement of business.

The double-listing of the holding company and the small finance bank would exert pricing pressure at the holding company level. To ease the blow, the company has sought the RBI’s approval for the merger of Ujjivan Financial with Ujjivan Small Finance Bank upon completion of five years from the commencement of business.

But the RBI has clarified that the merger proposal will be taken up at the relevant time (January 2022).

For now, investors need to consider the value proposition offered by the public issue of Ujjivan Small Finance Bank. At the upper band of ₹36-37, the IPO is priced at around 2.2 times its book as of September 2019 (post issue). Healthy loan growth, good geographical diversification, strong return ratios and capital are key positives for the bank. However, challenges on the deposits front (in particular CASA - current and savings account), high share of MFI (micro-finance) loans, and some observations made by the RBI recently on operational/compliance lapses, are dampeners that need a close watch. Against this backdrop, the IPO is not cheap. The asking price appears to have priced in most of the positives, and there could be limited upside for investors in the near term.

While the bank has sound fundamentals and growth opportunities, investors with a long- term perspective can wait to see how the challenges around deposit growth and compliance issues play out before investing.

Existing investors in the holding company — Ujjivan Financial Services — can, however, sell their shares and subscribe to the IPO (discount of ₹2 per share) as investing directly in the small finance bank makes better sense.

Business performance

Ujjivan launched its small finance bank in February 2017. Demonetisation led to lower collection efficiencies and rise in GNPAs (gross non-performing assets). In FY18, the company’s focus was to contain losses and improve quality of loan book.

In FY19, coming out of the demonetisation blues, the bank’s loan book grew by a strong 46 per cent, and its profitability improved significantly. Between FY17 and FY19, Ujjivan’s loan book has grown 32 per cent CAGR, led by growth in non-MFI segments. While MSE and affordable housing have been ramping up rapidly, new offerings such as personal loans and two-wheeler loans are still in a nascent stage.

In the latest September quarter, Ujjivan’s loan growth was a robust 55 per cent to ₹12,864 crore. While the share of MFI loans has come down significantly to 79 per cent as of September 2019 (from 98 per cent in March 2017), it is still high. Loan diversification will be important, but an aggressive growth in non-MFI can impact earnings due to lower yields on non-MFI portfolio. Also, the asset quality in the non-MFI portfolio will need watching.

So far, Ujjivan has been able to maintain its asset quality, post the demonetisation shock. GNPA, which went up to 3.65 per cent in FY18, fell to 0.92 per cent in FY19 and further to 0.85 per cent in September. However, given the inherent risk in the MFI business and the uncertainty over risk from its non-MFI portfolio, asset quality will have to be monitored.

Deposits, a challenge

Garnering low-cost retail deposits has been critical for small finance banks to bring down cost of funds and cushion profitability. But this has been a challenge. For Ujjivan, too, while it has been able to ramp up its deposit base significantly, the share of its low-cost CASA deposits is still low at 11.9 per cent of total deposits. Scaling up low- cost deposits could remain a challenge, weighing on earnings.

Currently, the bank’s return ratios are healthy — ROA (return of assets) of 1.7 per cent in FY19.

RBI’s observations

During a recent inspection of the bank conducted for fiscal 2018, the RBI made certain observations on the bank’s business and operations which will need a watch. Among them are lack of a system to tag PSL (priority sector lending) advances, miscategorising of PSL advances, lack of a rating methodology to assess borrowers, high proportion of bulk deposits, concentration in the top 20 depositors, lack of a fraud management system, and lack of an independent compliance department.

While the management has stated that they have responded to the observations and addressed them, how this pans out needs to be seen.