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Introduction

ICICI Bank Limited (NYSE: IBN) is the largest private sector bank in India. ICICI Bank’s (ICICI) equity shares are listed in India on the Bombay Stock Exchange (BOM:532174) and the National Stock Exchange of India Limited (NSE:ICICIBANK) and its American Depository Receipts (ADRs) are listed on the New York Stock Exchange (NYSE). One ADR equals two equity shares.

ICICI Bank’s ADR just made a new 52-week high and our view is that this stock is being buoyed more by systemic reasons than by idiosyncratic reasons. Considering its historical exposure to the ‘Infrastructure and Energy Related’ plays and ongoing changes to Reserve Bank of India’s (RBI) guidelines on Non-Performing Assets (NPAs), our opinion is that the Bank’s NPAs will continue to rise. This will, without a doubt, hurt earnings and hence earnings growth expectations. We are putting ourselves in the precarious position of calling a top on this stock.

Source: Seeking Alpha

Why IBN Just Made A New 52-Week High!

In our view, there are two primary reasons, both of which are systemic in nature and nothing to do with what’s really happening at ICICI, and they are:

  1. A near universal recognition of strong relative demographics in India. India is one of the few places on earth where the ratio of young to old people is still very heavily skewed in favor of the younger demographic. India has a population of about 1.3 billion, roughly 50% of it is in the 20-59 age group and by 2020 the working age group is expected to reach 64% of the total population.
  2. The euphoria surrounding Mr. Modi’s resounding victory, which marked India’s first political governance by a center-right, pro-business, political party.

ICICI just happened to be at the right place at the right time. The stock has risen to its yearly highs mainly on the coattails of a secular Indian-growth story; to quote one of the most quoted, Mr. Warren Buffett: “Only when the tide goes out do you discover who’s been swimming naked.”

Thesis – Short ICICI Bank

In our view, there are two main reasons why ICICI’s common stock is a sell:

  1. Heavy exposure to Infrastructure and Energy related plays, where NPAs are the highest according to RBI, and changing RBI guidelines on how NPAs should be calculated will continue to keep NPAs at elevated levels.
  2. Extremely high EPS growth expectations bound to be disappointed. While ICICI has grown its EPS at an average growth rate of 13% on a 5-year look back, looking out over the next 5-year period, analysts expect the company to see its earnings go up by 22% per annum.

There are a few other secondary reasons we like this as a short:

  1. Maturity Pattern of Assets And Liabilities indicates that nearly 37% of assets and 39% of liabilities mature in 1 year or less.
  2. Maturity Patterns of Deposits indicate that nearly a third of all deposits mature in one year or less.
  3. Foreign Institutional Investors (FIIs) Reducing Stake. Between 2015 and 2016, FIIs reduced their ownership by 5%. This could be the beginning of a trend, we don’t have confirmation of it yet but we will continue to watch this data point.
  4. Strong Shareholder Base – a dual edged sword. The top 6 shareholders constitute over 45% of total shares of the company. Deutsche Bank (NYSE:DB) trust holds over 25% of the shares.

Large Exposure to Infrastructure and Energy Related Plays – NPAs to keep rising

In a country dominated by nationalized banks (both my parents worked for two, different, such nationalized banks for over three decades) ICICI grew through demonstration of much better quality of service and efficiency. Nationalized banks in India are under strict guidance to adhere to the Government’s guidelines on advances; the ministry of finance decides which sectors of the economy need funding, and in what quantities, and set quotas for these banks to follow through. So, the advances-portfolio of a nationalized bank is more a reflection of the government’s policy designs rather than prudent lending.

ICICI, being a private bank, has always enjoyed a much greater say on its advances-portfolio and has championed its growth primarily via lending to the retail segment. The disparity between its allocation of loans to the retail segment versus almost any other segment is blatantly obvious from all the annual reports it has published from 2011 to 2016. But if you re-categorize the same information by adding together all Infrastructure and Energy related plays into one basket, then a different picture emerges. ICICI has been very actively lending in this space; on average, about 30% of its advances portfolio has had exposure to this sector since 2011, this is what concerns us.

Four big banks, State Bank of India, Punjab National Bank, Bank of India, and ICICI Bank, accounted for over 37 per cent of total gross NPA and five sectors: 1) infrastructure, 2) mining, 3) iron & steel, 4) textiles and 5) aviation – accounted for over 50 per cent of total stressed assets.

– RBI’s report on financial stability.

ICICI’s Advances Portfolio: 2011 to 2016

Source: Rigel Mercantile Limited

‘Where there is smoke, there’s fire.’ If you look at ICICI’s composition of NPAs by sectors between the years 2011 and 2016, you will notice that for all years until 2014, the biggest contribution to NPA’s came from the retail segment, but starting from 2015 the contribution from infrastructure and energy related plays dramatically shot up to the point that around 50% of the total NPAs in FY 2016 came from this sector alone.

ICICI’s Allocation of Gross NPAs: 2011 to 2016

Source: Rigel Mercantile Limited

Rajya Sabha – the upper house of Indian Parliament, an impediment to Modi’s plans

During Modi’s campaign, infrastructure rebuilding was a major theme and huge hopes were built of a new connected India. Well, almost three years in, the governing party’s super majority in the lower house has not been able to get the all important ‘land acquisition bill’ passed in the upper house.

We are just realizing in the United States that infrastructure rebuilding is easier to talk about than getting done. In a recent White House town hall it was openly mocked about, as to how cumbersome it is to start any infrastructure project and how long the list of regulatory approvals and sanctions required is to start anything at all. Imagine what it must be like in India. Building roads, bridges and other infrastructure projects in one of the most populous countries in the world requires significant land acquisitions from mostly farmers and residents of rural areas. Modi won the 2014 elections on the basis of massive infrastructure spending but so far one of the key bills essential for this, the land acquisition bill, has consistently failed in the upper house of India’s parliament.

In our view, the Indian markets which were hyped up on Modi’s victory, his business friendly policies, and his infrastructure pledges have begun to realize that without a strong majority in the upper house, not much can be achieved by Mr. Modi and his friends. The National Democratic Alliance (NDA), which is the ruling alliance, has an absolute majority in the lower house, 339 out of 545 seats, but it is short quite a bit in the upper house.

Here’s what the upper house currently looks like:

Source: The Wire

Factoring in BJP’s recent, astounding, win in Uttar Pradesh and extrapolating those results for elections to be held in 2018 and 2019 (assuming no major surprises in the state elections to be held), here’s what the upper house could look like in 2020:

Source: The Wire

The NDA will still be a few seats short of an absolute majority but let’s assume that it will manage to get those few extra seats and establish a majority in the upper house. That’s still only by 2020, which means that there is very little chance of Modi’s land acquisition bill passing the upper house any time before then.

Revised NPA Guideline – Reserve Bank of India

Under RBI’s guidelines, an asset has to be classified as a NPA if any amount of interest or principal remains overdue for more than 90 days. In addition the RBI has guidelines for restructured assets. Until March 31, 2015, a fully secured standard asset could be restructured by rescheduling principal repayments and/or the interest repayments with a disclosure that it was a restructured asset and the loss in the fair value of the restructured loan measured in present value terms, had to be either written off or a provision had to be made to the extent of the diminution involved. Loans restructured after April 1, 2015, however, have to be classified as an NPA as soon as there is any restructuring involved. Infrastructure is an exception to the new guidelines.

As per RBI’s guidelines for classification of loans, a loan for an infrastructure project is classified as non-performing only if it fails to commence commercial operations within two years from the documented date of commencement. The fact that ICICI has just started recording a higher NPA for the infrastructure play, starting in 2016, indicates to us that there is much more pain to come from this sector.

The yield on advances was impacted by an increase in non-performing assets during fiscal 2016, as interest income is not accrued on non-performing assets. The yield on domestic advances decreased by 78 basis points from 11.85% in fiscal 2015 to 11.07% in fiscal 2016 primarily due to the above.”

ICICI Annual Report 2016.

Sky-high EPS growth expectations – Analyst coverage

This stock has a near universal buy rating in the local Indian Analyst community except for one divergent view by Jefferies.

Heavy exposure to Infrastructure and Energy related plays at a time when this sector is contributing the highest NPAs to India’s gross NPAs, coupled with an ongoing revision to NPA calculations by the RBI, will force ICICI to recognize higher NPAs for years to come. We believe that fresh NPAs, which have already increased by 109.7% in 2016 relative to 2015 levels, will continue to rise at a much faster pace than what the bank, and/or the market, is accounting for. Profit after tax for FY 2016 has already taken a hit and is for the first time in many years lower on a year-over-year basis. The extremely high EPS growth expectations, of 22% per annum, are unrealistic.

Stresses showing up – Rising NPAs

In fiscal 2016, ICICI’s total provisions and contingencies went up to Indian Rupees (INR) 116.6 billion from INR 39 billion in 2015, a rise of 198%.

Source: Rigel Mercantile Limited

Total NPAs increased from INR 152.42 billion in 2015 to INR 267.21 billion in 2016, an increase of 75.3%. Fresh NPAs rose from INR 79.7 billion in 2015 to INR 167.1 billion in 2016, an increase of 109.7%. Total write-offs went from INR 16.96 billion in 2015 to INR 29.6 billion in 2016, an increase of 74%. Total provision for NPAs increased from INR 31.41 billion in 2015 to INR 72.16 billion, an increase of 130%.

Source: Rigel Mercantile Limited

First decrease in after tax profit in many years:

Source: FY 2016 ICICI Annual Report

Plateauing Net Interest Margins:

Source: FY 2016 ICICI Annual Report

Rising Non-Performing Assets – a trend emerges

Source: Rigel Mercantile Limited

Source: Rigel Mercantile Limited

Source: Rigel Mercantile Limited

Source: Rigel Mercantile Limited

The bleeding continues in fiscal 2017

ICICI’s gross NPA ratio continued to move higher after a brief dip down in Q3 2016.

Source: ICICI Q3 2017 Report

Source: Rigel Mercantile Limited

Maturity Pattern of Assets And Liabilities – a potential yellow flag

Source: Rigel Mercantile Limited

The widest asset-liability mismatch is in the 6 months to 1-year range.

Source: Rigel Mercantile Limited

Source: Rigel Mercantile Limited

Maturity Pattern of Deposits – a potential yellow flag

In 2008, ICICI faced a severe solvency crisis. Customers were lining up on the streets forcing a bank run and the RBI had to step in to rescue ICICI. If NPAs continue to rise at these rates, ICICI’s solvency might come into question, forcing another bank run. The reason we do not think this bank is headed toward a solvency crisis in the near future is because while today roughly 33% of total deposits mature within the 6 month to 1 year range, back during their 2008 solvency crisis, this number was around the 65% range.

Source: Rigel Mercantile Limited

FII’s Reducing Stake – a potential yellow flag

Between 2015 and 2016, FIIs reduced their ownership by 5%. This could be the beginning of a trend, we don’t have confirmation of it yet but we will continue to watch this.

Please refer to page 68 of ICICI’s FY 2016 Annual Report: ICICI FY 2016 Annual Report

Strong Shareholder base – a dual edged sword

ICICI enjoys a strong shareholder support. The top 6 shareholders constitute over 45% of total shares of the company. Deutsche Bank trust holds over 25% of the shares.

Please refer to page 51 of ICICI’s FY 2016 Annual Report: ICICI FY 2016 Annual Report

Concentrated shareholder base and large shareholdings might lead to disruptive price moves if any one of the large shareholders is forced to liquidate.

Valuation – words are eloquent but how do you put a price tag on this thesis?

As of the most recent quarter, the total advances portfolio of ICICI was around INR 4.6 trillion. Gross NPAs were at INR 380 billion and net NPAs (less of cumulative provisions) were at INR 201 billion. So, the gross NPA to Advances ratio stood at around 8% and the net NPA to Advances ratio stood at around 4%.

If a bank’s net NPAs to advances ratio is 4%, this is straight forward: this means that the bank is likely to lose about 4% of its total advances. So, in a realistic sense, then, about 4% of total advances must be assumed to be of zero value. This one-two punch on the company’s balance sheet and its income statement will force earnings lower and with it force valuations down to more realistic levels. We will evaluate several scenarios including ones in which valuations stay constant.

Extrapolating EPS growth using Bank’s results for 9 months ended to Dec-2016

FY 2015 FY 2016 FY 2017 – forecast
Operating profit 197.20 238.63 284.99
Provisions 39.00 80.67 164.00
Profit before CCRR and tax 158.20 157.96 120.99
Collective contingency 36.00
Profit before tax 158.20 121.96 120.99
Tax 46.45 24.70 17.17
Profit after tax 111.75 97.26 103.81
Outstanding Shares 5,842,092,456.00 5,840,224,893.00 5,840,224,893.00
EPS 19.13 16.65 17.78
EPS Growth -12.94% 6.74%

If we use the quarterly reports as a guide and extrapolate FY 2017 results using 9-month ended results as of Dec-2016, we get a year-over-year EPS growth of 6.74%, nowhere close to market expectations of 21% per annum.

We built a model to forecast the impact of NPAs on ICICI’s balance sheet and income statement.

Our Balance Sheet Model:

Our Income Statement Model:

Using our EPS estimates, we created a constant P/E model, assuming no changes in multiples, and a dynamic P/E model, assuming a 10% worsening of multiples every year, to forecast the possible paths for the stock’s price over the next three years.

Constant P/E Model:

Source: Rigel Mercantile Limited

Dynamic P/E Model:

Source: Rigel Mercantile Limited

Considering that our entire argument has been about sky high valuations, we reject the constant P/E model and instead accept the dynamic P/E model. The results from our dynamic P/E model suggest that if we were to initiate a short position at these levels, our expected return over a 1 – 3 year horizon would be around 30%, net of dividend yield.

A look at Technical Analysis of the price chart

While the stock recently made a new 52-week high, a long-term price chart reveals that the stock is barely inching up to its long-term moving average. From a technical analysis stand point, the area above current levels should act as strong resistance, which should allow the stock to consolidate for a while, giving us plenty of time to build a short position.

Conclusion

Rising NPAs resulting from past high exposures to the infrastructure and energy related plays coupled with revisions to RBI’s guidelines on NPA calculation will continue to keep ICICI’s NPAs at elevated levels for the next few years. In such a scenario, the high EPS growth expectations of 22% per annum, which implies that in FY 2019 expected EPS is around 30, are bound to be disappointed. Based on our analysis, we think that a more realistic expectation is for the EPS to be at 14.19 in FY 2019, which represents a decline of around 15% over the next three years. We think the market will come around to seeing this and eventually lower its valuations on ICICI as well. Declining EPS and a valuation-rethink should guide this stock lower.

Disclaimer: Rigel Mercantile Limited specializes in Macro Research and Systematic Trading. The views expressed above are our discretionary ideas that we have arrived at using discretionary analysis and therefore are limited to our discretionary portfolios only. Our systematic strategies may or may not have a position (long or short) in the securities mentioned above. Under no circumstances should the information contained herein be used or considered as an offer to sell, or a solicitation of an offer to purchase, any security or investment service. The information presented herein is presented in summary form and is, therefore, subject to qualification and further explanation.

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Disclosure: I am/we are short IBN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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