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Sunday, November 04, 2001












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Does debit to ICICI mean credit to ICICI Bank?

Recommendation:

ICICI Bank: Hold

ICICI: Switch to ICICI Bank

Suresh Krishnamurthy

INVESTORS in ICICI should consider selling out and switching to ICICI Bank.

Considering the swap ratio, this may not produce arbitrage profits after the transaction costs. But it may be better to remain invested in ICICI Bank rather than in ICICI for a few reasons.

First, if the ICICI Bank price remains at the present level when the merger is consummated, the relative under-valuation of the ICICI stock will be transferred to the stock of ICICI Bank. Thus, holding the ICICI Bank stock may be better than ICICI and waiting for the conversion of shares to take place.

Also, if the merger were to fall through due to any reason, it would be considered a positive for ICICI Bank and negative for ICICI. Holding the ICICI stock could prove detrimental.


In the case of exposure in ICICI Bank, the positive factor is the swap ratio. Prima facie, it looks favourable for ICICI Bank. In any case, the relative under valuation of the ICICI stock will be translated into shares of ICICI Bank after the merger. In such a case, the future profit growth or growth in dividends required by the company to justify the valuations would be even less than 10 per cent.

However, there are other issues as well: It is not clear if the swap ratio fully factors in the problem loans of ICICI. Second, the regulatory response to the reverse merger is crucial. The terms the RBI sets may have a bearing on the value created by the reverse merger.

On balance, the ICICI Bank shareholders can hold on to the stock. Further, post-merger, the stock price needs to be marked up over the present value, theoretically.

Suitability: The ICICI Bank stock has been more volatile compared to a few other stocks in the banking sector. However, as the valuation of the stock is now at relatively low levels, the downside risk from the present levels will be limited.

Universal banking dream

The reverse merger of ICICI with ICICI Bank is a culmination of the aggressive push ICICI has been making towards universal banking. However, even the Reserve Bank of India has, in its report, said that the empirical evidence on economies of scope and scale is not categorical.

Financial institutions such as ICICI may benefit from cost-efficiency factors as they would be able to access low-cost deposits. Importantly, a universal bank would also be able to channel its borrowings into various sectors depending on the trends in the economy. Potentially, the volatility in earnings can be reduced.

In addition, the RBI itself has been stating that FIs should either transform themselves into banks or non-banking finance companies. ICICI's move to transform itself into a universal bank has to be viewed in this backdrop. It had to happen eventually.

However, the benefits of the merger would depend on the response of the regulator. The regulator is likely to specify a transition path and a period for the merger. It remains to be seen if the regulator would allow the merger to go through before ICICI transforms itself into a bank or only after. The implications for the latter course of action could be seen as being adverse.

Becoming a bank....

Following are the salient issues spelt out by the RBI to be addressed in the conversion of an FI into a bank.

* Reserve requirements;

* Nature of subsidiaries and equity investments;

* Priority sector lending.

According to Mr K. V. Kamath, Chief Executive Officer, ICICI, the merged entity would need around Rs 18,000 crore to comply with the reserve requirements. Since ICICI raises some Rs 45,000 crore each year, this is not likely to pose a problem. However, Rs 18,000 crore would have to be deployed at particularly low interest rates in government securities and with the RBI. To that extent, the benefits flowing from the merger would be reduced.

Another issue is of priority sector lending. There are no indications that the infrastructure loans of ICICI would be considered as priority sector lending. In this backdrop, if the merged entity is asked to meet priority sector lending targets applicable for banks, there could be a problem.

In any event, the period within which the targets are to be achieved would be quite crucial. One, it may require ICICI to divert a large portion of its borrowings into the priority sector. This will have a bearing on the profitability of the merged entity as incremental funds may have to be deployed in a sub-optimal manner to fulfil regulatory requirements.

In contrast, the regulator's response to ICICI's subsidiaries and its equity investments may actually prove positive. Banks are allowed to invest only up to 5 per cent of their advances in equity.

For ICICI, equity investments are not much higher than 5 per cent. However, ICICI may have to divest a large portion of its stake in companies such as ICICI Infotech, ICICI Knowledge Park, ICICI Web Trade, ICICI Econet and a few others. In addition, ICICI is likely offload the holdings of around 10.21 crore shares in ICICI Bank in 2003. These divestitures would lead to inflow of capital for the merged entity.

This apart, taxation is likely to emerge as an important issue. ICICI, which now enjoys special tax treatment available for companies engaged in financing long-term projects, is likely to lose that status when it merges with ICICI Bank. This will lead to increased incidence of taxation in the case of long-term finance business.

The impact of this move will be lower only if ICICI de-emphasises long-term financing after the merger. However, considering that long-term financing is still a major portion of the business, the impact is likely to be adverse. The higher incidence of taxation can work out to 10-12 per cent of the profits earned from long-term finance.

Challenges galore

Overall, ICICI is likely to face several challenges, pre- and post-merger. The benefits that universal banking are likely to spawn will take effect only after these challenges are addressed. Importantly, the regulatory constraints can slow the growth rate of the merged entity - to considerably lower levels than what ICICI Bank has managed since its inception and may have done for some more years without much problem.

Constant emphasis by the management on the benefits that universal banking is likely to produce creates the impression that these challenges are being glossed over. Essentially, ICICI is now in uncharted waters.

In addition, it may take a while for these challenges to be addressed. What kind of costs the merging entities will have to absorb for tackling these challenges over a period will be known only after the regulator has spoken on this issue. Till such time, there is no need to be either euphoric about the development or view it categorically as negative.

In the case of shareholders, those invested in ICICI have reason to feel aggrieved (see accompanying story on merger valuation). As for the shareholders of the merged entity, the ever-present question mark over the asset quality of ICICI may haunt them even after the merger.

However, if the merger is taken as an opportunity to mark down the value of non-performing loans considerably, its adverse impact after the merger can be reduced to size. In any case, with such enormous uncertainties, fresh investments in the two stocks need not be considered now.

Related links:
ICICI, Bank merger swap at 2:1
ICICI, bank reverse merger an acid test
ICICI's key is integration


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