Kotak Mahindra Bank: An efficient, successful capital allocator

Investors who have a penchant for investing in companies that announce generous and consistent dividends would probably shy away from Kotak Mahindra Bank (KMB). The bank’s dividend payout over the last decade has been a mere 2% of profits. This is far lower than the industry average of 12%. But there is a logic to this. As legendary investor Warren Buffett himself suggests, companies can create value for their shareholders by reinvesting profits in businesses and taking initiatives that remunerate capital instead of payoffs in the form of dividends.

KMB has created more investor value even with a low dividend payout. It has instead redeployed capital in businesses to strengthen its moat and generate higher returns. To put things in perspective, the bank has cumulatively paid an overall dividend of Rs 572 crore on profits of Rs 23,000 crore. Had the bank not paid a dividend, this would have been worth Rs 2,400 crore based on current market capitalisation of the bank at five times its book value. The benefits would have been even higher had the impact of tax been accounted for.

Nevertheless, this is just one of the wisest things that Uday Kotak-led bank is known for. Its capital allocation across verticals and segments could be a case study in itself for the banking sector. No wonder the 15-year old bank commands a market capitalisation (MCap) exceeding that of State Bank of India (SBI), which has been in existence for over two centuries.

Art of allocation 

During 2007-17, KMB’s profits grew 23% annually. Interestingly, 97% of these profits were ploughed back (at an average RoE of 16% over the last 10 years) in the business, growing shareholders’ networth by 24% annually. This has mirrored growth in MCap at 30% (FY07 till date).

Is it an art or simple financial engineering? Raamdeo Agarwal, Co-Founder, Motilal Oswal, who has studied many such wealth creators in the past, said KMB has built franchisees and remained grounded in terms of its business activities. “Public sector banks by virtue of their imprudent decisions and weak fundamentals have been left starved for capital. In contrast, KMB, after securing a banking licence, has demonstrated capital efficiency, thus bringing it on par with the some of the finest capital allocators such as HDFC Bank and Asian Paints. Be it acquisition of ING Vysya Bank or taping any other opportunity, Uday Kotak has demonstrated wise capital allocation.”

Always backing the right opportunity

KMB strengthened its balance sheet to strike the right opportunity. Around mid-2014, the bank acquired 15% stake in MCX, whose share prices had fallen to around Rs 600 a share, after parent Financial Technologies was accused in the National Spot Exchange (NSEL) fraud case. Post the acquisition, the MCX counter hit a high of Rs 1,400 in 2016 and currently trades at about Rs 800 a share.

While MCX was an investment, the acquisition of ING Vysya Bank was a good case in point. Instead of cash, the idea of merging the bank through a share swap deal (790 shares of KMB for every 1,000 shares held in ING Vysya Bank) turned out to be an attractive deal. At the time of acquisition, ING Vysya Bank was trading at about 1.7 times its book value compared to 4-5 times for KMB. Without shelling out a single rupee, KMB secured ready excess to ING Vysya Bank’s branches and customers. It was strategic as it helped the promoters pare down their holding in the bank to meet the deadline set by the Reserve Bank. It gave KMB ready access to 573 branches of ING Vysya Bank taking KMB’s total branch count to 1,214.

Act like an investor

By retaining capital and earnings, the bank has created huge scale, which it has now leveraged to fund growth. Recently, KMB raised Rs 5,803 crore by selling a mere 6.2 crore shares at Rs 930 a share via a qualified institutional placement (QIP). This is supposed to be the second largest QIP in India in terms of value. The timing is interesting as the last time the bank raised funds through the QIP route was 2007 just before the market peak out. This time around (in May 2017), equity markets peaked just after the bank raised funds. Timing is crucial while raising equity as higher valuations mean a lower dilution. The last QIP resulted in 3.2% dilution in equity. Moreover, the amount raised is huge even at the current leverage ratio of about eight times. This could translate in dissemination of an additional about Rs 45,000 crore in loans. This offers it in a huge advantage in a market starving for capital.

Focus on building a moat

Sanjay Bakshi, adjunct professor at Management Development Institute, Gurugram, sees right capital allocation widening the business’ moat and paying off in the long run. “Most investors forget to look at capital allocation within the businesses. If capital is allocated to well deserving activities or segments with an aim to widen the moat and to reap long-term payoffs, it should certainly create wealth”.

KMB has selectively allocated capital towards building capabilities. Acquisition of ING Vysya Bank, which had a 38% exposure to SMEs as against 10% for KMB, benefitted the bank. In FY17, it acquired 99.5% stake in BSS Microfinance in an all-cash deal by paying Rs 139.2 crore. This acquisition helped the bank tap bottom of the pyramid customers by giving it access to a customer base of 2.17 lakh and a network of 78 branches.

KMB has been instrumental in building great business in the past. Today, many of these businesses that were started a few years back like Kotak Securities, Kotak Mahindra Capital (investment banking) and Kotak Mahindra Asset Management (mutual funds) are leaders in their respective categories.

Since FY14, the bank has invested an additional Rs 4,000 crore in key subsidiaries (See table: Subsidiary performance) whose networth stood at Rs 11,524 crore. The same accounts for 30% of the bank’s consolidated equity capital. Cumulatively, these subsidiary profits have grown at 16% annually, reporting an average return on equity (RoE) of 13%. Kotak Securities and Kotak Mahindra Investments have reported a 441 and 928 basis points improvement in RoE, respectively.

While some subsidiaries continue to bleed, their contribution is not significant. Of the total 18 reported subsidiaries, five are incurring losses with a cumulative loss of Rs 43 crore. This seems shallow when compared to the cumulative profits of Rs 1,582 crore earned by 13 subsidiaries.

“Great capital allocators do not hesitate in allocating capital towards business initiatives that will create long-term value, even though such initiatives will penalise near-term profits. Withdrawing capital from unproductive activities and redirecting them to other activities will improve its bond with customers and create loyalty, which is also a capital allocation decision,” Bakshi added.

The management has maintained its sharp focus on areas and businesses that grow while protecting capital at the same time. Aalok Shah, Banking Analyst, Centrum Broking, said KMB’s non-performing asset numbers and asset quality have been much superior that state run peers like SBI. “The management has allocated most of its resources and capital in relatively less risky commercial, rural, and retail loans segments. It has invested heavily in upgrading its technological infrastructure while periodically introducing convenience banking features periodically.”