IDFC First Bank Limited

I don’t think it’s an act of attacking the guy after a quarter or two of bad performance. I can assure you that I have been very patient. However, this is definitely a case of ‘the straw that broke the camel’s back.’ Maybe your “back” is stronger than mine (just joking). For me, the last straw was the FY27 cost-to-income ratio at 65%.

You may think I’m obsessed with the cost-to-income ratio from my first post. Let me explain. To set the groundwork, bear with me as I give a brief explanation of how a bank works. (Most of you might already know this, but let me explain again to highlight its importance.)

For simplicity, I’m assuming a capital adequacy ratio (CAR) of 10%. (In reality, CAR is around 12%.) Assume I start a bank with Rs 10 as my capital (by issuing 10 shares of Rs 1 each). With the assumed CAR, I can only take Rs 100 as deposits. According to RBI rules, because the CAR is 10%, I cannot accept more than Rs 100 in deposits, even if someone is willing to give me more. This is because if a bank’s capital is Rs 10, it can only take on business risks proportional to Rs 10. This acts as a limit on the loan book and deposits. Naturally, since I have deposits of Rs 100, my loan book will also be Rs 100.

Now, if my bank generates Rs 2.5 as profit after a year of operations (an ROE of 25% because our bank made Rs 2.5 profit on the initial Rs 10 it started with), my capital becomes Rs 12.5. So, in the second year, I can take Rs 125 in deposits, and my loan book will increase to Rs 125.

Conversely, if my bank only makes Rs 1 on Rs 10 (an ROE of 10%), to increase the loan book to Rs 125 for the next year, it has to raise an additional Rs 1.5 from somewhere else (because the bank has Rs 10 initial capital and Rs 1 profit, totaling Rs 11). By issuing Rs 1.5 in new shares, the equity is diluted by 15% (there will now be 11.5 shares instead of 10). In effect, the market capitalization of the bank increases by 15%. If this happens over five years, the original shareholding is diluted by about 50%. This is a significant number.

I’ve seen comments from people wanting Bajaj Finance-like growth. I’m afraid that’s not possible because Bajaj Finance has an ROE of 22-25%. Why? It has a net interest margin (NIM) of around 9% and a cost-to-income ratio of 35-40%. The business builds itself, and there isn’t much need for dilution. That’s when real value creation happens for existing shareholders.

I would recommend everyone read HDFC Bank’s annual reports from 1996 to 2005. You’ll understand what growth means. Even though they had to build new branches, start new business lines, and attract deposits, they had good ROE and grew their book with minimal dilution. That’s when value creation happens for the shareholder.

Now, finally, to explain why I’m so disappointed with IDFC First.
By Q1 FY25, all the issues from the IDFC Bank days are resolved. Their bad loan book is written off, high-cost borrowings are repaid, and most branches have been operational for 2-3 years. The current loan book is entirely created by V Vaidyanathan and his team, with no legacy IDFC issues remaining. There’s good momentum in deposits, and the brand is established.

The bank is now in a position similar to my example of starting a bank with Rs 10 capital. Everything needed has been built over the last five years. So, my assessment now is focused solely on the future, not on what happened since 2018. I will credit them for reaching this stage, but my analysis is only about the future.

If, after three more years, the cost-to-income ratio still remains at 65%, the ROE will likely still be around 10-13%. Now, please calculate the dilution for three years with the bank growing deposits at 25 %.
This is just unacceptable in my view. If IDFC First cannot generate a good ROE from FY25 onwards, shareholders cannot expect good returns. I hope my explanation clarifies why I’m so concerned about the ROE not improving substantially until FY27, which is three years from now.
This is in no way a comment about what tech they are using or how the customers feel about the bank. It is just an investor point of view.

Disclosure: I had a good investment in IDFC Ltd until Q1 FY25. I made good money too. I genuinely wanted them to succeed. Please don’t misunderstand me as being overly negative. I’m just sharing what I’ve learned.