City Union Bank (CUB) - A well run Frachise at attractive valuation

City Union Bank (CUB)

- A cub that can compound into a tiger. A well run Franchisee that is available at fair valuation !!

Content Index

• City Union Bank – Investment Snapshot :- Slide #3

• Our Research Head’s Investment Note on the Stock :- Slide #5

• City Union Bank – Company Overview :- Slide #12

• City Union Bank – Financials :- Slide #32

• Concerns & Reasoning :- Slide #37

• Conclusion :- Slide #39

“ Specialists in discovering Multibagger stocks “

City Union Bank – Investment Snapshot (as on September 9, 2014)

Recommendation :- BUY

Maximum Portfolio Allocation :- 3%

Investment Phases & Buying Strategy

1st Phase (Now) of Accumulation :- 80%

Current Accumulation Range :- 75 to 85 Rs

2nd Phase (can increase allocation based upon the execution of the company) :- 20%

We would expect Investors to continue accumulating the stock on any dips.

Core Investment Thesis :

City Union Bank (CUB) is one of the well run regional banks that has a strong history of generating healthy return ratios and shareholder wealth creation on a consistent basis. At the current elevated market prices, we would like to play safe by buying well run businesses at decent valuations instead of chasing the high growth stocks. CUB fits the bill perfectly, offering investors superior risk-adjusted returns.

Current Market Price – 80 Current Dividend Yield – 1.25 % Bloomberg / Reuters Code –CUBK IN/ CTBK.BO BSE / NSE Code – 532210/ CUB Market Cap (INR BN / USD Mn) – 46.89 /768 [1 USD – Rs. 61] Total Equity Shares [Mn]– 586.2 Face Value – Rs. 1 52 Week High / Low – Rs.82 / Rs.42 Promoter’s Holding – 0 % FII - 33.4 % DII - 10.17 % Other Holdings - 56.40 %


Elevator Investment Pitch


[HBJ CAPITAL - CITY UNION BANK (CUB) MULTIBAGGER] September 1, 2014

Dear Members of Multibagger,

We at HBJ Capital have been focused on investing in scalable businesses run by credible and competent Management teams. We

have consistently scouted for companies that are leaders in new emerging spaces from Multiplex operators to Sanitary ware

companies. Most of these bets have been taken with a 5-10 year view, in which we believe that these companies are capitalizing on a

secular growth opportunity in a capital efficient manner, delivering magnified returns for investors. Fortunately, we have been

successful so far in identifying and investing in such good Small Cap/ Mid cap businesses with strong fundamental characteristics.

However increasingly - there has been strong Investor interest in these spaces (they were unloved a couple of years back) and prices

of these quality Small Caps/ Mid Caps (Secular growth businesses with strong ROE characteristics) have been bid up heavily. As we had

written several times in our earlier Investment newsletters - the long consolidation phase in Indian markets over the last few years has

resulted in transfer of shareholding of such good companies from weak hand to strong hands. With the positive election results,

Investors have once again started viewing India as a 10 year story and are pumping money into buying the secular growth businesses.

The decreased supply of equity in such stocks as a result of the long consolidation phase combined with a strong demand post the

Election results, has resulted in huge supply-demand imbalance. This scarcity premium for quality stocks has resulted in several of them

multiplying in value over the last few months. The average P/E multiple on several of these stocks has exceeded 35X. While we still don't

see it as a bubble, we definitely believe that froth is getting built in these names with huge expectations and little margin of safety. Even

though we are happy to HOLD on to our winners at higher prices, we are not comfortable deploying incremental capital in these ideas.

In such a scenario, it becomes important for an Investor to do the tough job of finding the few outliers - Stocks which are still quoting

at attractive valuations, despite strong fundamentals and structural growth opportunity. We believe that our Multibagger Idea for this

month - City Union Bank (CUB) is one such outlier in which an Investor can earn superior risk-adjusted returns over a 5 year+ time

frame. Before we get into the details of our Multibagger idea, it's important to understand the benefits of investing in a quality financial

stock, even if it is priced at a huge premium compared to a sub-standard finance business. Look at the example below,


Investors in HDFC Bank have made far better returns with much lower volatility than investors in SBI, despite the entry valuations

being hugely divergent (50 P/E Vs 5 P/E). Staying with quality stocks works well for long term investors despite premium valuations.

While this trend can be seen in stocks across the board, it is more prevalent in Financial stocks. Financial businesses are leveraged

entities and also are derivatives of the broader economic cycle. They are also regular equity capital issuers (dilution at higher Price/ Book

is a strong driver for higher returns of quality stocks) as sustained growth requires regular capital infusion. Hence, the difference in

returns of investing in quality Financials Vs Non-Quality financial franchisees is more pronounced.

As Financials/ Banks are commoditized businesses with only differentiation in terms of discipline and execution - the culture of the

financial institution is of paramount importance to an Investor. As a well known saying goes - "the best predictor of future behavior is


past behavior". Look at the track record of City Union Bank and it's easy to understand as to why we believe that CUB is among the best

managed financial franchises in India. The 10 year Business track record and Investor wealth creation history is simply amazing.


The stock has delivered around 80X returns over the last 15 years. While some of it was due to valuation re-rating, the bulk of the

returns was due to strong earnings growth. The bank in fact was one of the stars of the 2003-07 Bull run with CAGR returns of around

50+% during this time frame. While strong past returns doesn't secure good future returns - we believe that the Bank's fundamentals

are surely in place (in fact strengthened) for the stock to continue outperforming the Index. We certainly believe that the next decade

is going to be even more exciting for CUB than the previous one.

One of the major reasons for the bank's strong performance is its focus on MSME segment (over 30% of its outstanding book). We

are extremely bullish on the SME lending opportunity that is set to unfold in India over the next decade. Shift from unorganized capital

sources (local money lenders who charge very high rates) to organized Banks & NBFC's will strengthen going forward. We are extremely

bullish on this entire space and that is the reason Shriram City Union Finance continues to be one of our preferred picks in the NBFC

space. With several policy impetus to encourage manufacturing MSME's ("Make in India") along with consistent opening up of global

trade, we believe that the next decade would offer strong growth opportunities. Our understanding is that MSME lending will continue

to be a specialized lending segment in which there would be a few big winners. Only institutions with the right execution skills, culture

and focus would be able to capitalize on this opportunity.

CUB has a strong small business lending franchise in its focus regions (South India, primarily Tamil Nadu). I, having come from a

Industrial town in Tamil Nadu and having been CUB's customer for many years, can certainly vouch for the loyalty and stickiness it

commands with its clients. CUB's deep understanding of MSME segment, lending discipline, well capitalized balance sheet, wide

customer base and strong focus would enable the bank to ride this huge tail wind profitably. Since CUB has been able to lend to this

segment without higher delinquencies and since these loans generate higher yields - the bank has a strong track record of maintaining

high NIM's (consistently hovering around 3+% for 10 years). CUB is especially strong in Working Capital loans for MSME's that are

secured. Hence, we believe that higher ROA's and ROE's are sustainable for CUB going forward too.


CUB also has a strong branch network and a healthy retail liability franchisee. In fact the bank has zero reliance on high cost funds

such as Certificates of Deposit and Corporate Bulk Deposits. Management has ramped up the branch network strongly over the past few

years and are planning to end this year with around 500 branches. With trends improving on all fronts - MSME growth, Strength to

gather low cost deposits and lend to higher yielding working capital loans and Rebound in overall Macro economic climate in India -

we certainly believe that CUB would be able to perform strongly over the next decade.

The current Management team headed by Mr. Kamakodi has done a fantastic job of building on the bank's strengths in MSME

lending while staying away from Infrastructure loans and Consortium loans during the previous credit cycle. We believe that the Bank

has an inherently conservative culture that can be seen from low average NPA's, despite the bank lending to a difficult segment.

Fortunes of MSME's are closely linked to the overall economy and despite the economic slowdown of the last few years, the bank's gross

NPA's has peaked around 1.7% and is expected to decline over the next 2 years (Slide - 35). While the current provisioning of around

62% is on the lower end, Management has consistently guided that the provisioning would improve going forward. They have also

indicated that all accounts are adequately collateralized and the recovery rates would be in line with the historical rates of 75-80%.

At a time when majority of Indian Banking system (PSU Banks) is devoid of capital to fund credit growth of over 20%, we believe

that CUB is well capitalized with its recent QIP issue. With CAR of around 16%, the bank is well positioned to take advantage of the

strong economic rebound that we foresee over the next 2 years. More importantly, the quality of Investors who invested in this QIP

issue is top notch with several extremely long term investors (Slide - 30) participating in this issue. The QIP issue that came around the

current price levels was subscribed by over 3.3X, indicating the preference for the bank among good investors. The quality of our Co-

Investors in this stock gives us a lot of comfort.

We believe that there are a lot of margin levers for the bank going forward such as Interest rates reversal, Lower provisioning

charges, Improved Cost/ Income ratio on back of healthy growth, Strong treasury income from lowering Bond yields etc. We believe that

the bank should be able to do at least 480 Cr Rs of profits by FY-16 on a conservative basis (Slide - 34). While the lower gearing would


decrease ROE's for sometime in the immediate future, we believe that ROE's would eventually go back to the bank's historical average of

around 20% over the next few years. We also believe that ROA's can be sustained in the range of 1.5-1.8% over the next many years.

Despite the geographical risks (Slide - 37) associated with a regional bank, we believe that the current FY-15 estimated valuations of

around 1.7X Price/ Book and 11.3X Price/ Earnings is cheap for a bank of CUB's quality that can sustainably grow at >3X India's GDP

growth and generate ROE's of around 18-20%. In addition to this there can be an added bonus of - increased Merger & Acquisitions in

the banking space on the back of new banking licenses from RBI can make CUB an attractive target for bigger banks, leading to price

acquisition at a much higher premium to the current valuations.

All in all, we believe CUB is a good franchisee to BUY at current valuations. Investors can certainly hope to earn superior risk

adjusted returns for the next 5+ years on the stock. We will continue to track the Bank's progress and keep you updated on our views

through our quarterly Multibagger Flashback reports. Hope the CUB compound overtime to become a big Tiger.

Regards,

Gokul Raj. P - Director & Head : Investments.


City Union Bank – Company Overview


CUB – Historical Highlights


CUB – Focused Business Model


CUB – Healthy Branch Network


Good Independent Board & Good Corporate Governance


10 Year Financial Track Record


Healthy Spreads


Strong NIM’s & ROA’s


Good Productivity


Strong Overall Business Growth


Strong focus on secured Lending


Robust Risk Management


Strong NPA Management


Well Managed Lending Book


Strong Investment Book


Healthy Profitability


Lowering share of Gold Loans – Healthier Book


Relatively Cheap Valuations


Investors who participated in recent Fund Raising



Strong Institutional Shareholding

City Union Bank - Financials


City Union Bank – Balance Sheet


City Union Bank – Profit & Loss Statement


City Union Bank – Key Financial Metrics


Concerns & Conclusion


Concerns & Reasoning


1.) Geographical Concentration Risk :

Tamil Nadu continues to contribute around 75% of CUB’s overall business. This amount of concentration beings in a lot of geographical risks. Any climate issues, Political crisis etc can dampen the Bank’s profits severely. While this is a important risk, we believe that the Management’s cautious lending approach and Tamil Nadu being a developed state decreases the risk to an extent. While the bank has diversified a bit over the last decade, we still believe that the bank would continue to be a Tamil Nadu based bank for the foreseeable future (which is not necessarily a bad thing). 2.) Increased Competition from new entrants :

Indian private sector banks have had a strong run over the last few decades as competition has been limited by lower banking licenses. With RBI focused on increasing competition by introducing several newer forms of banking, we certainly see the possibility of increased pressure on banking industry ROA’s and ROE’s. We also believe that Employee costs could shoot up and older private sector banks may risk losing key personnel with increased completion. 3.) Re-Investing risk in case of Acquisition :

We believe that acquisition by a larger bank will improve the value to shareholders in the near term but the long term returns would need to be re-evaluated. Another risk could be increased Equity dilution to prevent a hostile takeover. While this is a risk, we believe that CUB has an independent board that would take decisions in the long term interest of its shareholders.

Price Chart

• CUB has broken out after a long period of consolidation over the last 3-4 yeas. The stock is currently trading near its all time highs. • The shareholding of the Bank is very widespread with literally no promoter group. This makes the bank an ideal acquisition target for the larger banks. • Institutions (FII’s & DII’s) have increased their shareholding in the bank significantly over the last many quarters at the expense of retail shareholders.


Share Holding %

June Mar Dec Sept

2014 2014 2013 2013

Promoters 0 0 0 0

FII 33.4 32.23 21.54 21.74

DII 10.17 9.79 8.43 7.48

Others 56.45 57.9 70.03 70.78

Conclusion

Indian private sector banks from the older generation (CUB, SIB etc) to newer ones (Indusind, ICICI, HDFC etc) have created substantial wealth for shareholders. They have continuously gained market shares from the laid back PSU banks and this is a trend that is expected to continue going forward too. The new government’s focus on increased Financial Inclusion is another large tail wind that would benefit the overall banking industry. We believe that a large part of the unorganized lending industry would become formalized over the next decade, leading to Win-Win benefits for capital savers and capital raisers. Financial stocks are always the best proxy to invest in a nation’s economic recovery. There are enough indications to believe that Indian GDP growth is expected to accelerate from the current 5% levels to around 7-8% over the next few years. This improvement along with the peaking of Indian interest rates would ensure a fertile growing ground for well managed Banks. A look into the past Bull Markets clearly show that banking is always an outperformer in good markets. In fact, several technical analysts point to the fact that Bank NIFTY shows the trend of real NIFTY just as DOW Transportation does it for DOW index in USA. Indian markets are currently quoting at an average of around 16X forward earnings. In such a scenario, CUB’s current valuations of less than 12X Price/ Earnings is a unwarranted discount to the overall market valuations. This is very low for a bank that is well managed and can give long term investors in the stock peaceful night sleeps. We believe that CUB is a cheap and rewarding way to play the big Indian growth story. We estimate CUB to deliver around 9.5 Rs of EPS over the next 3 years. The overall Book Value is expected to increase to around 61 Rs by FY-17 on very conservative estimates. Based on the stocks historical valuation, we certainly believe that the stock can quote at over 2X Book Value and over 14X earnings. We expect to make healthy profits on this stock on the back of both Earnings growth and Valuation Re-Rating.



THANK YOU
