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Suresh Krishnamurthy

SHAREHOLDERS can subscribe to the rights offer of Karnataka Bank. The offer price of Rs 20 is at a substantial discount to the prevailing market price of Rs 82. Shareholders are entitled to subscribe to two shares for every one held.

Failure to subscribe to the offer will lead to a sharp decline in the value of the investor's holdings.

Karnataka Bank is a regional outfit with 252 out of its 371 branches located in Karnataka. The bank has been in existence since 1924, but its regional character has impeded growth in the past. Thus, the bank continues to be smaller than many of its peers. This is despite its growing at a faster pace compared to the industry trends over the past decade.

According to the bank, the rights offer is to strengthen its capital base. The capital adequacy ratio is well above the regulatory minimum level. The offer to mobilise Rs 160 crore would, however, still be useful considering the expected growth in advances and changes in regulation relating to capital adequacy norms.

Weaker than peers

In 2003-04, the bank reported improvement in almost all parameters. Advances growth was better than that of industry. While the net interest income expanded sharply, the proportion of bad loans declined significantly. These factors have led to a significant expansion in profitability. The bank has also reported progress on the technology front.

Despite such progress, Karnataka Bank is still considerably weaker than several of its peers. Its net interest margin (the spread between the rate at which funds are borrowed and lent) of just above 2 per cent is one of the lower spreads in the industry. Most public sector banks enjoy spreads of 3 per cent-plus. The reasons are not far to seek. The proportion of low-cost deposits is only about 20 per cent. At about 5 per cent, the proportion of bad loans is also relatively high.

A consequence of this poor return on assets is the below-average return on its net worth even between 2002 and 2004 when the industry situation was favourable. At about 21 per cent, it is not impressive especially considering its private sector status.

Targeting growth

There is, however, potential for improvement from this state. The bank is targeting advances growth of nearly 28 per cent in 2004-05 while aiming for profits of Rs 150 crore. Both targets appear achievable. That would have a salutary effect on the proportion of bad loans.

The bank reported profits of Rs 105 crore in the nine months ended December 2004 and the target of Rs 150 crore is, thus, within reach. This would be achieved despite the significant increase in provisions for depreciation in the value of government securities. As a portion of this provision (a substantial part of which is likely to be for non-recurring nature) would be largely absent in the following financial year, there is also the prospect for robust growth in profits.

The situation is also favourable for improving the net interest margin, given the increase in interest rates in the economy. This, along with the decline in provisions for bad loans, would raise the return on net worth. This would, however, need the bank to sustain 20 per cent plus growth in business.

Valuation

The offer, which is being made at a considerable discount to the market price, has also had the intended effect of improving the stock valuation. The stock's price-to-earnings multiple has increased from about 4.5 just after the announcement, to 6.5 now. This PE multiple is almost on a par with the discounting commanded by most public sector bank stocks.

The Karnataka Bank stock appears attractive even at this price. If the bank generates a return on net worth of about 20 per cent on the post-issue net worth of about Rs 1,000 crore in 2005-06, the profit growth that year would be about 33 per cent. The possibility of above-average business growth and improvement in the proportion of bad loans suggest maintaining a return on the net worth of 20 per cent, if not higher, is possible. The rosy industry situation is another positive factor.

Private sector banks are also targets for acquisition. A degree of acquisition premium is likely to get built into these stocks over the next couple of years, especially if the Budget makes pronouncements favourable to foreign direct investment in the banking sector. Investors can, thus, consider accumulating the stock.

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