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Sunday, September 17, 2006

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Hindu Businessline - Investment World

IDBI-United Western Bank merger

The amalgamation of United Western Bank (UWB) with IndustrialDevelopment Bank of India is likely to change the rules of the game inthe banking space on the issue of valuation of shares.

The merger is markedly different from takeover of GlobalTrust Bank and Nedungadi Bank by healthier rivals. In both the cases,shareholders went away without any consideration for the sharessurrendered.

Apart from synergies to the participating banks, the IDBI-UWB merger is likely to be a positive for old private sector banks.

As the wave of consolidation is likely to gather momentum overthe next year or so, old private sector banks may see their valuationsimprove.

Investment in the IDBI stock can be considered with a long-term perspective.

The stock is available at a price-to-book multiple of 0.8 and aprice-to-earnings multiple of about eight times its trailing 12 monthsearnings.

Accepting the offer at Rs 28 per share appears an appropriate strategy for the UWB shareholders.

A good fit for IDBI

The amalgamation of UWB with IDBI is likely to add value to thelatter over the long term. The merger is likely to help IDBI expand itsretail presence, though its size may not increase substantially.

Of the several benefits the deal brings, we believe access tothe branch network is most significant. IDBI, with a balance-sheet sizeof Rs 81,700 crore, has a network of 181 branches now. It scores poorlyon this parameter compared to like-size peers. The merger would giveIDBI immediate access to the 230-branch network of UWB, therebywidening its deposit franchise.

For IDBI, growing at 25 per cent over the past two years, additionof branches would help sustain the momentum. Deposits may expand byover 20 per cent and the asset base by about 10 per cent. The ReserveBank of India's (RBI) strict licensing norms that restrains opening newbranches has placed a scarcity value on branches. The merger would,therefore, give IDBI access to a ready physical infrastructure,enabling it to mobilise low-cost funds.

Second, the merger with UWB is likely to help IDBI diversifyits credit profile. Dominant in industrial financing, IDBI should getexposure to agriculture credit through UWB;nearly half the number ofUWB its branches is in semi-urban and rural areas, and shouldcomplement IDBI's loan book.

The third aspect relates to the benefit of an improved depositmix for IDBI. As it manages its transformation from a financialinstitution to a commercial bank, it finds about 60 per cent of theliabilities in the form of long-term borrowings. Low-cost deposits arejust about 9 per cent of the total. This perhaps explains IDBI's lownet interest margins (0.5 per cent versus industry average of three)and the high cost of funds (6.5 per cent versus the industry average offive). In this backdrop, the access to UWB's low-cost deposit baseshould prove advantageous for IDBI in the long run.

Inexpensive acquisition?

IDBI has offered to pay Rs 28 per share to the UWBshareholders. The purchase consideration, at this price, works out toabout Rs 150 crore. The price-to-book multiple for the acquisitionworks out to about 1.9. Although this appears slightly high, we believethe price factors in the takeover premium attached to UWB's business.Further, UWB has a positive net worth (about Rs 115 crore). Its capitaladequacy ratio had turned negative mainly because of technicalprovisions such as for depreciation in the value of investments.

Even with a mere 10 per cent recovery rate and no furtherslippage in the asset quality, the acquisition would be a valueproposition for IDBI. Being a big bank with a high capital adequacy(14.8 per cent), it is likely to see larger volumes per branch.

Key challenges

On the face of it, an outflow of Rs 150 crore may appearinexpensive. But if one were to consider the hidden costs in the formof bad loans and the likely slippages in the quality of existingassets, the effective cost is likely to go up by another Rs 100 crore.

Considering IDBI's size, this may still be a small sum.Post-merger, its level of net non-performing assets is likely toincrease to 1.4 per cent from about one per cent now. As such, managingand containing the level of bad loans remain a challenge for IDBI.

In the short term, the IDBI stock is unlikely to deliversignificant value. Its management has said that UWB would be kept as astrategic business unit in the near term.

While this may make the balance-sheet look attractive in theshort term, the impact of the synergies that will flow from the mergerwill be visible only over the long term.

Integration of UWB with itself is likely to be a key challengefor IDBI. UWB has an employee base of over 3,200, which is about 70 percent of IDBI's.

Going by the draft amalgamation scheme, IDBI is required toabsorb the entire workforce, a move that is likely to push up its wagecost and make integration a tricky exercise.

The boards of the two banks have been given time tillSeptember 27 by the RBI to discuss the amalgamation scheme and placetheir objections/suggestions before the central bank.

As such, the possibility of another bank/institutionpresenting a better offer to take over UWB cannot be ruled out, thoughthe chances appear slim at the moment.

Despite the concerns, the downside risks associated with themerger appear minimum, making the IDBI stock attractive as a long termproposition.

Attractive bailout for UWB

The UWB shareholders can accept the offer, priced at Rs 28 pershare. That the shareholders of the transferor bank are beingcompensated is in itself a big improvement over the previous suchcases.

Poor asset quality and deteriorating financials had cast agloomy picture of UWB's future. IDBI, with enough capital at itsdisposal to absorb the business of UWB, is confident enough to lendsuccour to the ailing bank.