Amid this broad sell-off, investors seem to be overlooking individual merits and focusing on the sector’s overall risk. Notably, small finance banks (SFBs) within the microfinance space are bearing the brunt, with their struggles standing out as they face heightened financial pressures and operational challenges.
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In the June 2024 quarter, SFBs recorded the highest percentage of unpaid microfinance loans (MFI) in the 30-180 day overdue category, surpassing other types of players in the sector.
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Two key factors could explain this trend. First, SFBs tend to have a higher average ticket size compared to non-banking financial companies (NBFCs) and MFIs. Second, SFBs’ microfinance portfolios may be more concentrated in regions currently exhibiting financial stress, according to Sadaf Sayeed, CEO of Muthoot Microfin.
This reflects in the valuations of SFBs.
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While NBFCs & NBFC-MFI peers such as CreditAccess Grameen, Arman Financial, and Muthoot Microfin trade at price to book value range of 1.14 – 2.09, SFBs trade in the range of 0.7-1.4.
While almost all small finance banks started as microfinance institutions, the likes of Equitas SFB have moved away from microfinance over the years.
Infact, as of Q2 FY25, only about 16% of the total loan book is exposed to microloans. Ujjivan, its closest comparable peer in the SFB space, has an MFI portfolio of nearly 50%. Yet, both are down 30% in the last year.
Could the market still be viewing Equitas SFB primarily as a microfinance player, despite its limited exposure to the segment?
Equitas SFB not only has a modest share in microfinance but also holds robust provision buffers. Addressing concerns over microfinance highlighted in the Q2 FY25 earnings call, the management detailed two significant adjustments to its provisioning policy.
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Provisions are buffers that banks and lenders create to absorb future or expected losses, from current profits.
1. Upfront Provisioning: CEO and MD P.N. Vasudevan noted that the bank has increased provisions for loans overdue between 90 and 180 days from 50% to 75%. Additionally, loans overdue beyond 180 days now have a 100% provision, compared to the previous threshold of 360 days. This approach, seen as conservative by investors, signals the bank’s proactive stance on potential credit risks.
2. Buffer Provisioning: Beyond these changes, Equitas SFB created an additional buffer of Rs. 100 crore for standard microfinance assets.
The MFI book provisions now total around Rs. 370 crore, or 7% of the total MFI portfolio, against a gross non-performing asset (GNPA) ratio of 4.83%, indicating substantial risk protection. While this doesn’t rule out challenges over the next two quarters, it demonstrates the bank’s prudent approach to the segment.
The downside, however, is a temporary hit to profitability. From an FY24 return on equity (ROE) of 14.4%, Equitas SFB reported an ROE of just 1.3% in H1 FY25—a short-term impact of its conservative provisioning stance.
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According to the management, current stress in the microfinance segment is expected to persist for another two quarters. The loans in question are two-year tenures, and with stress already evident for the past 2-3 quarters, the situation will likely resolve or result in these borrowers slipping into non-performing assets (NPAs) within the next two quarters.
This indicates that profitability for Equitas SFB is likely to remain subdued in the short term.
Additionally, operating costs are expected to stay high as the bank invests in new product lines such as personal loans and credit cards. These offerings require significant upfront investments, and their returns are expected to materialise gradually over time.
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These products will also substitute the relatively riskier microloans and Equitas expects to bring down the MFI loan book to under 10% in the medium term.
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Essentially, this means there is near-term pressure on profitability. However, long-term investors may view this situation differently, particularly when considering the bank’s valuation metrics, such as its P/B ratio.
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Considering the current valuations, this stock may be a good addition to your watchlist. However, it’s important to stay vigilant about potential risks that could impact its performance in the future.
For more such analysis, read Profit Pulse.
Note: We have relied on data from www.Screener.in and www.tijorifinance.com throughout this article. Only in cases where the data was not available, have we used an alternate, but widely used and accepted source of information.
The purpose of this article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your advisor. This article is strictly for educational purposes only.
Rahul Rao has been Investing since 2014. He has helped conduct financial literacy programs for over 1,50,000 investors. He helped start a family office for a 50-year-old conglomerate and worked at an AIF, focusing on small and mid-cap opportunities. He evaluates stocks using an evidence-based, first-principles approach as opposed to comforting narratives.
Disclosure: The writer and his dependents do not hold the stocks/commodities/cryptos/any other asset discussed in this article.
