Despite the inherent riskiness of its business and high provisions, the stock has its merits.
The Indian IPO market has seen increased activity over the last four months (July – October 2023). A total of twenty-eight IPOs, to be exact, occurred during the period: a lively market when compared to the nine IPOs that occurred during the first six months of the year. The IPO of ESAF Small Finance Bank which is currently open for subscription is the first mainboard IPO of November 2023. The ₹463 crore IPO closes for subscription on November 7, 2023.
ESAF Small Finance Bank, as the name suggests, is a small finance bank based in Thrissur, Kerala with its business predominantly concentrated in South India, particularly Kerala and Tamil Nadu. Of its 700 banking outlets, the shares of Kerala and Tamil Nadu were 43.43 percent and 13.86 percent. The share in gross advances from Kerala and Tamil Nadu stood at 43.45 percent and 22.14 percent, respectively, whereas the share of deposits from these two states stood at 80.04 percent and 3.36 percent.
ESAF mainly provides micro-loans – these are small-size loans provided to individuals without being secured by any collateral: 74.70 percent of ESAF’s advances are micro-loans, and 75 percent of loans are unsecured. These kinds of loans are inherently risky with high default rates, and hence, carry high interest rates. The inherent riskiness of these loans is evident from the high level of provisions and non-performing assets present in the industry.
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Banking is largely a commoditised business, and therefore, firms with lower costs will be the ones with a strong competitive position. ESAF’s cost of funds (%) as of 31 March 2023 was 6.00 percent – 10 basis points lower than the median cost of funds for the five listed small finance banks. The lower the cost of funds, the better.
However, as high provisions are a regular feature of small finance banks, it is sensible to include provisions in calculating the cost of funds. ESAF’s cost of funds with provisions rises to 9.50 percent – 60 basis points higher than the median for the five listed SFBs. So, provisions are a major drag on ESAF’s finances and competitive position.
| Company | Cost of funds (%) | Cost of funds with provisions (%) |
| ESAF SFB | 6.00 | 9.50 |
| Ujjivan SFB | 6.10 | 7.70 |
| Utkarsh SFB | 6.80 | 9.80 |
| Suryoday SFB | 6.10 | 9.70 |
| Equitas SFB | 6.50 | 8.90 |
| AU SFB | 5.60 | 6.50 |
We can infer from the above table that AU Small Finance Bank is in the strongest competitive position among the lot, followed by Ujjivan SFB, and ESAF could rise to their level if it can rein in its ‘provisions for non-performing loans.’
ESAF’s latest yield on advances (%) stood at 16.50 percent: 90 basis points higher than the median ‘yield on advances’ for the five listed SFBs. The net interest margin (NIM) – another common analytical metric for banks – for ESAF was 10.60 percent: 90 basis points higher than the median for the five listed SFBs. But, if provisions are included in calculating NIM, then ESAF’s NIM gets reduced to 7.20 percent, still 30 basis points higher than the median NIM for the five listed SFBs. The higher the yield on advances and NIM, the better.
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It is a common observation among companies coming out with an IPO to see a marked improvement in certain of their principal business parameters – growth, profitability, asset quality – in periods closer to the IPO date. However, in periods after the IPO, these parameters are found to deteriorate back to earlier (pre-IPO) lower levels. The same trend can be observed in ESAF’s case too. The asset quality of ESAF made a significant improvement closer to the IPO with gross NPA (%) declining to 2.49 percent in FY23 compared to 7.83 percent in FY22 and 6.70 percent in FY21. Here, rather than being gullible to the reported numbers, we should perceive ESAF’s asset quality improvement with a certain amount of scepticism.
We said earlier that lower costs provide a competitive advantage in a commoditised business like banking. The market seems to recognize this fact too. The shares of AU Small Finance bank, which we found to have the lowest cost among the SFBs, trades at a price-to-book value (PBV) of 4.06, against the median PBV of 2.11 for other SFBs. Therefore, going forward, ESAF SFB should strive to maintain, and if possible, reduce its cost of funds. Any rise in the cost of funds will hamper its competitive position and is cause for concern.
Now we come to the most appealing feature of this IPO: an attractive valuation. The price band for the issue is ₹57 – ₹60 per share. At the upper end of the price band, the stock will have a price-earnings (PE) ratio of 8.28 and a price-to-book value (PBV) of 1.46. Considering the volatile nature of ESAF’s recent earnings figures, a valuation based on its book value rather than earnings would provide a more truthful estimate of its intrinsic value.
The five listed small finance banks have a median PBV of 2.11. The most competitively strong among them – AU SFB and Ujjivan SFB – trades at PBVs of 4.06 and 2.63, respectively. In comparison to them, ESAF’s PBV of 1.46 gives us an alluring impression.
There are two major concerns regarding ESAF SFB: One is the inherent riskiness of the ‘micro-loans’ business, and the other is its relatively high provisions for bad loans and asset quality concerns. Despite these concerns, after AU SFB and Ujjivan SFB, ESAF SFB is the most competitively positioned firm in the small finance bank sub-sector. An investor with a medium-to-high risk tolerance and a long-term investment horizon may consider the stock for his/her portfolio.
The issue is expected to be heavily subscribed due to the small size of the IPO, reasonable quality of the issue, and attractive valuation. Hence, getting shares allotted through the IPO is highly unlikely. The investor who fails to get shares allotted in the IPO could consider buying shares from the secondary market post-listing. Here too, the valuation matters and should be given due concern. Any price below two times book value – i.e., below ₹80 per share – seems fair enough.
The performance of recent IPOs has been satisfactory. All trade at a price higher than their respective issue price, except Yatra Online. Certain stocks like Signature Global, JSW Infrastructure, RR Kabel, and Jupiter Life Line Hospitals have given superior returns.
The prevailing market sentiments, whether positive or negative, will surely influence an IPO’s subscription and listing gains. The current market sentiment is slightly subdued. Nifty50, after hitting an all-time high in the middle of Sept. 2023, has lost 4.76 percent in value since then. However, such subdued markets’ adverse influence, if any, on an IPO may sometimes act as a boon for long-term investors by providing them opportunities to gobble up shares from the secondary market at reasonable prices.
AMN CAPITAL 