Idbi Corporation Bank Possible Merger Analysis

J

2008

Neev - Anschluss Case Deliverables Proposed IDBI Bank-Corporation Bank Merger

Team Bizczars Ankur Rohtagi Raman Goyal Mohit Jain FORE School of Management New Delhi

Anschluss Case Deliverables 2008

RBI in their recent report „Current and Finance 2008‟ has laid down the major issues/challenges for the banking sector in near future. These are: (i)

Mobilizing resources to sustain & accelerate the current economic growth momentum.

(ii)

Implementation of Basel II norms by foreign banks in India and Indian banks having operational presence abroad from March 31, 2008 and by other scheduled commercial banks by March 31, 2009.

(iii)

Issues involved in for entrance of foreign banks is due for review in April 2009.

Amidst opposition from sections against mergers in the banking sector, the Reserve Bank of India (RBI) has made a clear case for consolidation among banks. In a latest study of banking mergers in the post reform era, the RBI said that the banks have registered significant gains in efficiency and profitability after mergers. Further, the four public sector banks have made greater efficiency gains than their private sector peers, the RBI said, after analyzing seven merger cases of relatively large banks. In the case of the Punjab National Bank, the Union Bank of India, the Oriental Bank of Commerce and the Bank of Baroda, change in the average return on assets (ROA) during the post- merger period over pre- merger period was positive and statistically significant. As in the case, IDBI bank has shown keenness in acquiring another bank either in public or private sector as a part of their strategy for increasing their branch network, customer base, improved technology usage and product portfolio. Corporation Bank having wide branch network, superior technology usage and wide product base appear as a suitable target for the acquisition.

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Anschluss Case Deliverables 2008

Financial Statement Analysis of Acquiring IDBI Bank and Target Corporation Bank „CAMEL‟ model is used for the quantitative analysis to determine the financial and competitive position of the two banks. „CAMEL‟ is banking supervisory and evaluation model comprises of analysis of various ratios under the heads of „C’apital Adequacy, „A’sset Quality, „M’anagement Efficiency, „E’arnings and „L’iquidity. Ratios are also determined for 25 other listed public sector banks along with IDBI and Corporation Bank to determine their sector position under various heads. Results of the analysis are as follows:

Capital Adequacy Corporation

Ratios

Bank

IDBI Bank

Score

Rank

Score

Rank

Capital Adequacy Ratio (%)

12.09

13

11.95

16

Debt/Equity (times) 1

0.69

4

6.46

27

Advances/Asset (%)

58.82

21

62.9

4

G-Sec/Investment (%) 2

85.6

14

71.04

26

Group Rank

11

24

Asset Quality Corporation

Ratios

Bank

IDBI Bank

Score

Rank

Score

Rank

Net Non Performing Asset/Total Assets (%) 3

0.19

5

0.83

24

Net Non Performing Assets/Net Advances (%) 4

0.32

5

1.32

24

Total Income/Total Assets (%)

24.79

4

25.1

5

Change in Non Performing Assets (%) 5

-10.57

6

50

25

Group Rank

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1

22

Anschluss Case Deliverables 2008

Management Efficiency Corporation Bank Score Rank

Ratios

IDBI Bank Score Rank

Total Assets/Total Deposits (%)

70.7

14

112.62

1

Profit Per Employee (Crores)

0.07

2

0.08

1

Business Per Employee (Crores)

8.39

3

18.09

1

Return on Net Worth (%) 6

15.14

17

7.83

25

Group Rank

6

7

Corporation Bank Score Rank

IDBI Bank Score Rank

Earnings Quality Ratios Operating Profit/Average Working Funds (%) 7

2.2

6

1.19

26

37.09

7

15.73

20

Net Interest Margin (%) 9

3.04

10

0.65

27

Profit After Tax/Average Assets (%) ` 10

1.23

6

0.62

24

Interest Income/Working Funds (%)

7.95

18

7.18

26

Profit After Tax Growth (%)

8

Group Rank

8

27

Corporation Bank Score Rank

IDBI Bank Score Rank

Liquidity Ratios Liquid Assets/Demand Deposits (%)

101.14

27

177.38

4

Liquid Assets/Total Deposits (%)

19.17

2

17.66

4

G-Sec/Total Assets (%)

21.22

21

17.83

27

0.17

20

0.01

26

15.95

1

9.86

26

Approved Securities/Total Assets (%) Liquid Assets/Total Assets (%) 11 Group Rank

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15

24

Anschluss Case Deliverables 2008

Synergies of the Merger These are the various Quantitative as well as Qualitative synergies, which the IDBI can leverage upon post me rger with corporation bank. Positives: (Superscripts below refers to CAMEL ratios) (1) Improved Debt to Equity ratio after merger thereby decrease gearing on its balance sheet1 (2) Reduced exposure to market by investing more in G-Secs or risk free securities2 (3) Lowering of NPA‟s in the basket of IDBI

3,4

(4) Utilization of better recovery mechanism of NPA‟s 5 (5) Increase in the net-worth of the bank 6 (6) Better utilization of the working funds 7 (7) Surge in Net Interest Margin (NIM) and hence Improved Profits 8,9 (8) Improved Return on Assets 10,11 (9) Significant Improvement in the Rural Branch Network from existing 10.5% to 16% (Annexure I) which will lead to better penetration of already existing Agri Business product portfolio.

Negatives: (1) Corporation Bank has poorest Advances to Assets Ratio. (2) Business per Branch of the merged entity to be decreased by 45% in case of no foreclosures of branches. (3) Business per Employee to be decreased by 25% in case of no lay-offs. (4) Assets per Branch of merged entity to be decreased by 49% (5) Assets per Employee to be decreased by 29%. (6) Profits per Branch of merged entity to be decreased by 32% For Detailed Analysis refer Annexure II

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Anschluss Case Deliverables 2008

Legal Hurdles of the Merger The regulatory framework for M&A‟s in the banking sector is laid down in the Banking Regulation (BR) Act, 1949. The Act provides for two types of amalgamations, viz., (i) voluntary and (ii) compulsory. For voluntary amalgamation, Section 44A of the BR Act provides that the scheme of amalgamation of a banking company with another banking company and is required to be approved individually by the board of directors of both the banking companies and subsequently by the two-thirds shareholders (in value) of both the banking companies.

The statutory framework for the amalgamation of public sector banks, viz., nationalized banks, State Bank of India and its subsidiary banks, is, however, quite different since the foregoing provisions of the BR Act do not apply to them. As regards the nationalized banks, the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 and 1980, or the Bank Nationalization Acts authorize the Central Government under Section 9(1)(c) to prepare or make, after consultation with the Reserve Bank, a scheme, inter alia, for the transfer of undertaking of a „corresponding new bank‟ (i.e., a nationalized bank) to another „corresponding new bank‟ or for the transfer of whole or part of any banking institution to a corresponding new bank. Unlike the sanction of the schemes by the Reserve Bank under Section 44A of the BR Act, the scheme framed by the Central Government is required, under Section 9(6) of the Bank Nationalization Acts, to be placed before the both Houses of Parliament.

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Anschluss Case Deliverables 2008

Valuation of the Deal 1. Three Stage Dividend Discount Model: It is the most general of the models because it does not impose any restrictions on the payout ratio and assumes an initial period of stable high growth, a second period of declining growth and a third period of stable low growth that lasts forever. Figure below graphs the expected growth over the three time periods

Implicit Assumption: Only dividends are paid. Remaining portion of earnings is invested back into the firm, some in operating assets and some in cash & marketable securities.

Strengths of the DDM:

The dividend discount model's primary attraction is its simplicity and its intuitive logic. After all, dividends represent the only cash flow from the firm that is tangible to investors. Estimates of free cash flows to equity and the firm remain estimates and conservative investors can reasonably argue that they cannot lay claim on these cash flows. Limitations of the Dividend Discount Model:

The dividend discount model‟s strict adherence to dividends as cash flows does expose it to a serious problem. Many firms choose to hold back cash that they can pay out to stockholders. As a consequence, the free cash flows to equity at these firms exceed dividends and large cash balances build up. In the dividend discount model, we essentially abandon equity claims on cash balances and under value companies with large and increasing cash balances. 7|P a g e

Anschluss Case Deliverables 2008

We have given the explanation of Corporation Bank below. Similarly on the same model, we have calculated the value of IDBI Bank as Rs92.37 and is shown in the excel sheet. Below is the explanation of the sheet.

DDM Valuation of Corporation Bank: Corporation Bank reported a return on equity of 17.52% for FY08 and paid out dividends per share of Rs 10.50 year (on reported earnings per share of Rs 52.33). We will assume that its bigger asset base build over by high debt will allow the bank to maintain its current return on equity (low by industry standards) and retention ratio for the next 7 years, leading to an estimated expected growth rate in earnings per share of 10%: Payout Ratio = Dividend per share/ Earning per share = 10.5/52.33= 20.06% Expected Growth rate = Retention ratio * ROE = (1-0.2006)* 17.52% = 14.00% Analysing & then normalizing the normal EPS growth rate we found, that actual growth rate is 10.02% and not 14% as calculated for the annual one. Growth rate in EPS is calculated on the historical overall performance of the stock EPS Growth rate

2004 32.2

2005 23.42 -27.27

2006 25.9 10.46

2007 29.4 13.45

2008 Avg. Growth 42.1 43.44 10.02

The cost of equity for the high growth period is estimated using a beta of 1.16 for Corp. bank (based upon the return of stock on index and returns on index), the Indian rupee risk free rate of 8% (i.e. yield of 10 year Govt. Bonds) and a market risk premium of 8.21% (calculated using last 8 year returns of NIFTY from Apr01-Mar31 every year and it comes out to be 16.21%, thereby “market premium= market return- Risk free rate” i.e. 16.21%-8%=8.21%) Cost of equity in high growth using CAPM Model= 8% + 1.16(8.21%) = 17.52% After year 7, we will assume that the beta will decline towards 0.8 in stable growth (which will occur after the 15th year) and that the risk premium for India will also drop to 5% (reflecting our assumptions that India will become a more stable economy). Cost of equity in stable growth = 4% + 0.8 (5%) = 8.00% We will assume that competition will pick up after year 9, pushing the return on equity down to the stable period cost of equity of 12.00% by the 15th year. The payout ratio in stable growth can

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Anschluss Case Deliverables 2008

then be estimated using the stable growth rate of 5% and using industry averages for ROE to be 12%: Stable period payout ratio = 1- Expected Growth rate/ ROE = 1- 8%/17.5% = 58.33%~ 60% Table below summarizes the assumptions about payout ratios and expected growth rates and also shows the estimated earnings and dividends per share each year for the next 9 years: Expected Growth Rate 10.00% 10.00% 10.00%

Earnings per share 57.56 63.32 69.65

Payout ratio 20.06% 20.06% 20.06%

Dividends per share (DPS) 11.55 12.70 13.97

Cost of Equity 17.52% 17.52% 17.52%

Cumulative Cost of Equity 1.175236 1.38117966 1.62321205

Present Value of DPS 9.83 9.20 8.61

4 5 6 7

10.00% 10.00% 10.00% 10.00%

76.62 84.28 92.71 101.98

20.06% 20.06% 20.06% 20.06%

15.37 16.91 18.60 20.46

17.52% 17.52% 17.52% 17.52%

1.90765724 2.24194747 2.63481737 3.09653223

8.06 7.54 7.06 6.61

8 9

9.67% 9.00%

111.83 121.90

22.72% 28.05%

25.41 34.19

17.16% 16.42%

3.62775348 4.22338997

56.89 7.00 8.10

10 11 12 13 14 15

8.33% 7.67% 7.00% 6.33% 5.67% 5.00%

132.06 142.18 152.13 161.77 170.94 179.48

33.37% 38.70% 44.02% 49.35% 54.67% 60.00%

44.07 55.02 66.98 79.83 93.46 107.69

15.68% 14.95% 14.21% 13.47% 12.74% 12.00%

4.88571888 5.61593451 6.41392736 7.27807323 8.20504357 9.1896488

9.02 9.80 10.44 10.97 11.39 11.72

Years 1 2 3

Present value of dividend in high growth phase

Present value of dividend in transition phase

78.44

During the transition phase, all of the inputs change in equal annual installments from the high growth period values to stable growth period values. Since the costs of equity change over time, the cumulated cost of equity is used to calculate the present value of dividends. The terminal price at the end of year 15 can be calculated based upon the earnings per share in year 15, the stable growth rate of 5%, a cost of equity of 12.00% and the payout ratio of 60.00%

Terminal Price= [179.48* (1.05)* (0.60)]/ (0.12-0.05) = Rs1615.32

To get the present value, we divide by the cumulated cost of equity in year 15 by terminal value to get Rs 175.78: The components of value are as follows:

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Anschluss Case Deliverables 2008

Present Value of dividends in high growth phase: Rs 56.89 Present Value of dividends in transition phase: Rs 78.44 Present Value of terminal price at end of transition: Rs. 175.78 Curre nt Fair Value of Corporation Bank stock: Rs. 311.11.

2. EV/EBITDA Multiple: Enterprise value (EV) is total company value (the market value of debt, common equity, and preferred equity) minus the value of cash and investments. Also, EV= Market Capitalization+ Market Value of Debt- Cash & near Cash Numerator is enterprise value, EV/EBITDA is a valuation indicator for the overall company rather than common stock the analyst can assume that the business's debt and preferred stock (if any) are efficiently priced.

Advantages for using EV/EBITDA: • EV/EBITDA may be more appropriate than P/E for comparing companies with different financial leverage (debt), because EBITDA is a pre- interest earnings figure, in contrast to EPS, which is post- interest. Drawbacks for EV/EBITDA: • EBITDA is overestimating cash flow from operations as working capital grows. • EBITDA also ignores the effects of differences in revenue recognition policy on cashflow from operations.

Calculations provided in the spreadsheet under the sheet multiples valuation reflect the current market scenario (Low Market Capitalization) of equity thereby giving depressed valuations for both the banks (IDBI: Rs53.48 & Corp.: 209.60). Both the values are eroding the net worth of the company and does not justify the real worth of both the set of companies.

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Anschluss Case Deliverables 2008

MERGER VALUATION OF IDBI & CORPORATION BANK:

Considering the credit crisis in the global financial markets, among the various modes by which IDBI may finance the deal would be through all swap deal. The reasons being: 1. IDBI having a very high gearing of almost 6.46 (D/E) makes it incapable of raising any cash from the market. Hence, it would not be possible to go for all cash deal. 2. With the current credit crisis, it will be almost near impossible for IDBI bank to create an Leverage buyout. Further, traditionally govt. banks in India, they have never followed these methods. Jounal 3. An all swap or swap-cash deal is more then possible thereby maintain regulatory requirements of over 50% Govt. holding in any scenario. 1. Swap Ratio calculated based on book value method

Valuation IDBI Bank Corp. bank

Shares in Cr. 72.34 14.34

Face value Rs 10 Rs 10

Latest Book Equity(Subscribed Reserve value Book Swap in Cr.) (Cr.) (Cr.) value/share ratio 14.34 6655.7 6799.1 93.99 72.34 3559.82 4283.22 298.69 3.18

NOTE: Swap ratio taken into Consideration is 3.18:1 i.e. 3 IDBI share for 1 shares of Corp Bank 2. Swap ratio Calculated using DDM valuation Prices obtained for banks Valuation IDBI Bank Corp. bank 3.

Swap Ratio on valuations

Price By DDM 92.37 311.11

3.368

For All Swap Deal Average of swap ratio by two methods

3.27

4. Changes in Shareholding Pattern Change in the number of shares No. of shares to be received by shareholders of Corp. Bank from IDBI Existing shares of IDBI Bank After merger with IDBI total shareholders Increase in the number of shares of Corp. Bank In IDBI Bank by 39.35% 11 | P a g e

In Cr. 46.94 72.34 119.28 =(46.94/119.28)=39.35%

Anschluss Case Deliverables 2008

5. Deal Size by Calculation: DEAL SIZE Shares allotted to Corp. Bank IDBI Share Price as per DDM Valuation Amount paid: IDBI merger

Value in Cr. Except Share Price 46.94 92.37 4335.40

6. Conclusion: According to us an all swap deal will allow IDBI to use the client as well as asset base in a better way, also by having Corp. Bank, it will be able to deleverage itself in the current credit crisis scenario where most leverage banks fall the fastest. The all swap deal will give approximately Corp. bank a share of 39.35% in IDBI Bank. The swap ratio of 3.27 being calculated above using both the Book Value as well as DDM prices. The approximate deal size obtained on the basis of the Nov14 ,2008 current prices is 4335.4 Crores.

.

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Anschluss Case Deliverables 2008

Annexure I

Branch Network Metro IDBI Bank % Total Corporation Bank % Total Merger Entity % Total

Urban

Semi-Urban

Rural

Total

178

172

99

53

35.46%

34.26%

19.72%

10.56%

294

253

183

171

32.63%

28.08%

20.31%

18.98%

472

425

282

224

33.64%

30.29%

20.10%

15.97%

502

901

1403

Annexure II

Rs in crores

IDBI Bank

Corporation Bank

Merged Entity

Pecentage Increase

PAT (FY08) Assets Deposits Advances

745.88 130694 72998 82213

750.52 66598 55424 39186

1496.4 197292 128422 121399

100.62% 50.96% 75.93% 47.66%

Business (Advances + Deposits) Branches (No.) Employees (No.) Business/Branch Business/Employee Assets/Branch Assets/Employee PAT/Branch PAT/Employee

155211 502 9,324 309.19 16.65 260.35 14.02 1.49 0.08

94610 981 10,722 96.44 8.82 67.89 6.21 0.77 0.07

249821 1483 20,046 168.46 12.46 133.04 9.84 1.01 0.07

60.96% 195.42% 114.99% -45.52% -25.13% -48.90% -29.79% -32.09% -6.68%

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