Event:

ICICI bank has approved an in principle merger with Bank of Rajasthan (BoR). The bank has entered into agreement with certain shareholders of BoR consenting to the share swap ratio of 25:118 (25 shares of ICICI Bank for 118 shares of BoR), subject to necessary regulatory approvals. The Tayal group is a dominant shareholder in BoR the bank with a declared stake of ~28% as of Mar-10.

What's in it for ICICI Bank?

·         Access to a large branch network - ~25% of the present

The merger of ICICI Bank and BoR will augment the network of the combined entity to ~2,463 (~25% increase in ICICI Bank's present branch network) further consolidating its position as largest private sector bank by branches. The access to such a large and wide branch network augurs well for ICICI Bank as it enters a growth phase in FY11. 

·         Merger strengthens presence in northern region

While BoR has pan-India presence, its network is significantly stronger in the northern states like Rajasthan, Punjab, Haryana and Delhi (~73% of total branches in these states). We expect the merger to strengthen ICICI Bank's presence in these areas.

·         Limited impact on asset profile

BoR's balance sheet is significantly small with respect to ICICI Bank (~5% of total assets). Consequently, we see insignificant impact of this merger on overall advances profile of ICICI Bank.

·         Immense scope for productivity improvement with limited investments

BoR has 463 branches, which is significant for the present balance sheet size of the bank. However, there is significant scope for improvement in utilization of the branch network, as branch/ employee productivity is still way below that for the peer group. We see huge opportunity for productivity improvement for BoR, which would be a medium term positive for ICICI Bank.

Additionally, ICICI Bank and BoR have implemented the same software platforms, which we believe would enable smoother integration with limited investments in infrastructure.

·         BoR's asset quality

BoR's asset quality has remained relatively healthy over 9mFY10 with Gross NPAs increasing by ~Rs714m in absolute terms (~0.9% of advances). We believe that this increase is a reflection of the phenomenon witnessed across the industry in the aftermath of the downturn and not specifically a reflection of bank's credit quality. Going forward, with revival in the economic environment, asset quality concerns are likely to recede. 

Valuations and view

Given the regulatory hurdles, lack of access to growth capital (Tier-I at 6.19% as of Mar-09) had constrained BoR's growth trajectory in FY10 (~5% advances growth over 9mFY10) and had resulted into to an underleveraged franchise. The merger provides ICICI Bank a lucrative opportunity to eke out productivity gains and create value over the medium term.

Currently announced swap ratio imputes BoR's valuation at ~Rs30.4bn (4.8x book value as of Dec-10), translating into a per share price of ~Rs188.3 – a premium of ~89% over the CMP. An attempt to value the CASA franchise of BoR offers a plausible explanation for the valuations offered by ICICI Bank. Assuming a nominal growth in CASA deposits (in line with GDP growth), the interest gains made by ICICI Bank would result into a PV of ~Rs26-33bn, which amounts to over 85% of BoR's valuation.  Moreover, we believe, creation of such a wide branch network (with a CASA/branch of ~Rs91m) would have consumed significant time and management bandwidth.

While the merger is expected to be marginally earnings dilutive (by ~3%) in the near-term, we see a significant value creation opportunity over the medium-term as the bank leverages BoR's underutilized network of ~463 branches (~25% of ICICI Bank's present branches) in the northern and western regions of the country.

We remain convinced of ICICI Bank's medium term earnings trajectory and believe that the bank is now ready to execute the next phase of its strategy to deliver high profitability while accelerating balance sheet growth. We would revert with our revised earnings estimates for ICICI Bank as further clarity emerges on this front. Maintain Outperformer