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Brief history of Ujjivan Financial Ltd
Samit Ghosh, a career banker retired as the head of Bank of Muscat (India) at the age of 54. He started a NBFC for furthering financial inclusion – Ujjivan Financial Ltd which was into microfinance. They lent money for income generation activities to women using the Joint Liability Group (JLG) model popularized by Nobel Laureate Mohammad Yunus of Grameen Bank (Bangladesh).

Ujjivan Financials stated in 2004 with an equity capital of Rs 2 Cr and today, it has an equity base of Rs 3000+ Cr. Ujjivan SFB today lends to 37 lac borrowers and has a total customer base of 59 lac customers.

Brief Financials:

Ujjivan has grown over the years and matured as an organization with 16,000+ employees and 575 bank branches across India. And of course,

“Lending is the easy part; loan recovery is tough work and shows the skill of the banker.”

What is the investment thesis – Ujjivan Financials (CMP Rs 136)?

1. Reverse merger arbitrage
   Assuming prices don’t change, parent company (Ujjivan Financials) will appreciate by 60% once the reverse merger is executed.
   (Because the holding company discount will vanish)
   
2. Improving microfinance scenario
   Economy has opened up, collections are improving, so asset quality should improve from here.  The asset book has also started growing. With 1 or 2 good quarters, I expect the Ujjivan SFB stock to double to approx. Rs 40 (from Rs. 19).

If things work out in the next 12-18 months, Ujjivan Financials (parent) could become
1.5 X 2 = 3X returns.
That’s the investment thesis.

What does my investment thesis NOT rest on?

Some miraculous performance by Ujjivan SFB
Banking is a tough business. There are very few lending organizations which are consistently able to do a good job at loan recovery. HDFC Bank, Kotak Bank, Chola Group, City Union, Bajaj Finance are some of the names that come to mind, out of the hundreds of lending institutions, which have been able to do a fantastic job at loan recovery and containing NPAs over a long period of time.

However, I don’t need Ujjivan to achieve the miraculous performance that HDFC bank does every year. I just need normal /average times to return back for me to make money in this opportunity. And all the industry and company-specific signs are pointing to a return to normalcy after the Covid 2^nd wave hit us hard in April-2021.

Whenever a shock hits the economy, the microfinance segment is the first to get affected. It is also the first to recover once normalization starts.

Also,

• In this borrower segment, willingness to pay is not such a big issue especially as compared to ability to pay.
• The bank cannot keep hiding the NPAs too much because these are short tenure (24 months), unsecured loans.

If we read the conference calls of a diverse set of microfinance institutions viz. Bandhan Bank, CreditAccess Grameen, Arman Financials, Satin Credit, Equitas etc., three things seem obvious – collections are improving, credit demand is back, asset quality recovery is happening.
Now, who will do a better and to what extent cannot be ascertained, but the direction which the industry and all players in it are taking is clear – things are improving.

I expect Ujjivan to do an average job with collections, asset recovery, loan growth etc. Given the 17 yr history of Ujjivan, it is definitely a better than average player in the industry.
Things just coming back to normal is what I need for my investment thesis to work out – I don’t need any miracles to happen.

Why do I think Ujjivan is at least an average or better than average lending institution?
This is a matter of opinion and judgment. Only numbers don’t speak the entire truth. However, I will point you to a few things to help you build your own judgment & conviction.

1. MD’s Letters from 2007
   These letters are a masterclass in lending/banking. It is a reflection of the founder’s clarity, conviction and dexterity in building an institution.
2. Ujjivan was one of the few institutions which bypassed the Andhra crisis of 2010/11 because when Samit Ghosh started the business, he realized/estimated that Andhra Pradesh market is getting over-heated and this generally ends in a disaster.
3. A similar foresight helped Ujjivan contain the Assam microfinance crisis to a certain extent. Samit Ghosh had kind of estimated in Dec-19 itself that Assam may probably go the Andhra way and it did to an extent partly aided in that direction by Coronavirus.
4. Right since early days, Samit Ghosh was clear in his vision that he does not want to stop by just giving loans to the poor, he wants to take the full gamut of banking services to them. He started with microfinance lending and then converted to a bank and there is more to come.
5. Ujjivan weathered the demonetization storm better than most of its peers. They did a better than average job at containing credit costs.

Going through the last 17 years history of the organization, I think Ujjivan is at least an average / above-average organization. It will come out of the current NPA crisis.

Why are there 2 listed companies with the name Ujjivan?
Ujjivan Financials started as a NBFC. Samit Ghosh was very clear from the start that only lending to the poor does not constitute financials inclusion. He wanted the poor to take benefit of the full gamut of bank services including deposits/investments/insurance etc.
When RBI announced regulations for granting new licenses for small finance banks, Ujjivan applied and was amongst the 10 institutions that got the license to start the small finance bank in 2015.
One of the conditions for granting an SFB (small finance bank) license was that the promoter of the bank should hold at least 40% stake in the bank for the first 5 years.

The organization had grown exponentially in the last 11 years since starting operations in 2004. Ujjivan Financial had raised equity capital multiple times from multiple institutional investors, most of whom were foreign entities.
RBI also required the promoter of the bank to be an Indian entity i.e. registered in India with at least 51% shareholding held by Indian people / institutions.

Ujjivan had to migrate to a different corporate structure.

Ujjivan incorporated the following 2 changes

1. Transfer the entire microfinance business to a subsidiary (Ujjivan SFB) and take the banking license in the name of the subsidiary.
2. IPO the parent company (in 2016) – Ujjivan Financials, so that foreign shareholding can be reduced from 77% to below 49%.

In my opinion and in the opinion of the Ujjivan management, this was the correct thing to do because a banking license provides both a certain stability and longevity to the business model.

However, RBI had its own quirky rules.
RBI required the SFB to also be listed within 3 years of commencing operations.

Ujjivan SFB started operations on 04.02.2017. This meant the SFB had to be listed by 03.02.2020.
Ujjivan Financials (parent) petitioned RBI to allow reverse merger with the already listed parent company and thus fulfill the condition to list the SFB. However, this would mean that

Ujjivan SFB would not have any promoter and the condition of maintaining a minimum of 40% promoter holding for the first 5 yrs of operations would be violated. Though this condition did not make much sense since Ujjivan Financials (parent) had no other business and also did not have a promoter (diverse shareholding).
Because of this stubbornness of RBI, Ujjivan SFB had to be listed on the stock exchanges in Jan-20. In fact, Equitas had a similar problem to Ujjivan and delayed the listing of Equitas SFB by more than a year in the hope that RBI will change its mind.

RBI did change its mind on the listing requirement of SFBs on 26.09.2021 and extended the time period of compulsory listing from 3 years to 8 years.
6 of the 10 small finance banks will now be able to take benefit of the relaxation in the listing timelines. Four of them have already listed – Ujjivan SFB, AU SFB, Equitas SFB, Suryodaya SFB.

So, we have a situation where there is only one business of the Ujjivan entity – a small finance bank, but 2 listed companies.
Obviously, the holding company suffers from a holding company discount and Ujjivan Financials trades at an approx. 60% of the valuation of Ujjivan SFB.

Reverse Merger arbitrage between Ujjivan Financials (parent) and Ujjivan SFB

Ujjivan Financials (parent) holds 83.32% shares of Ujjivan SFB
Ujjivan Financials holding is worth 83.32%*3370 = Rs 2772 Cr
However, market-cap is only Rs 1653 Cr
Thus, there is a potential upside of 2772 / 1653 = 67% in in Ujjivan Financials once the reverse merger is executed.

The board of directors of both the companies have already notified to the exchanges about their specific intent to execute the reverse merger.
In fact, Ujjivan Financials Board of Directors have announced a share swap ratio of 115 shares of Ujjivan SFB for every 10 shares of Ujjivan Financials held by the investor.
This means an upside of 59% for the Ujjivan Financials shareholders once the reverse merger gets executed.

However, given that the Ujjivan Financials share price is still trading at a discount even after the announcement of the share swap ratio, clearly the market does not believe that the reverse merger will take place.
In fact, Equitas Holding and Equitas SFB are in the exact same boat as the Ujjivan twins and the market seems to be believing that the reverse merge of Equitas will go through. The share price discount of Equitas Holding vis-à-vis Equitas SFB has reduced in line with the swap ratio announced.

Typically, such a scheme of arrangement takes 12-15 months to get executed.
Let us look at the process in detail to understand as to why the market is indicating that the reverse merger of Ujjivan will not happen.

Scheme of Amalgamation – Process and possible bottlenecks
There are basically 5 steps in the amalgamation process.

1. RBI approval for reverse merger
   {RBI has come out with a policy paper which allows for companies like Equitas, Ujjivan, IDFC to collapse their holding company structure and reverse merge with the subsidiary bank}
2. Approval from SEBI for 2 things
   1. Waiver of minimum lock-in for promoter which is 3-yr lock-in from IPO
   1. Approval to achieve minimum public shareholding criteria by way of reverse merger
      (Not granted – SFB will have to go for a QIP / rights issue)
3. No Objection from Stock Exchanges
   {Routine Matter}
4. Approval for Scheme of Arrangement by the public shareholders of both Ujjivan SFB and the parent – Ujjivan Financials
   {This is the most crucial approval – all power is with the minority shareholders}
5. Sanction of NCLT
   {Routine Matter}

On Point 1 –> On 26^th Nov-21, RBI has accepted the recommendations of the Internal Working Group on the corporate structure of the Indian private banks. In this document, recommendation 23 allows for banks like Ujjivan SFB to exit the holding company structure.
This clears the way for reverse merger of Ujjivan Financials (parent) with Ujjivan SFB.
Of course, RBI has to specifically approve this reverse merger and on a case-to-case basis, RBI may refuse to approve the reverse merger.

On Point 4–>The minority shareholders of both Ujjivan Financials (parent) and Ujjivan SFB have to approve the reverse merger. The Ujjivan Financials (parent) have been waiting for the reverse merger for a long time, so they will definitely approve it.
However, the merger ratio does not leave much incentive for the minority shareholders of Ujjivan SFB to approve the reverse merger.
In my view, there are no negative consequences of reverse merger for the minority shareholders of Ujjivan SFB. In fact, public shareholding will increase post reverse merger and the parent will not be able to exercise excessive control on the bank.

On Point 2b à Let us look at who all have raised money in the last 20 months?
(Dec-21) – Muthoot Microfin raises money from Private Equity Firm General Pacific
Private Equity Fund – General Pacific Capital picked up 14% in Muthoot Microfin for Rs 375 Cr valuing the entire company at approx. Rs 2,700 Cr.
Total AUM of Muthoot Fin stands at Rs 5,200 Cr – so this translates to 50% of AUM.

(Aug-20) – Satin Credit Care raises Rs 120 Cr via rights issue
Loan book of Satin Credit Care stood at Rs 6,750 as of Sep-20.
Price to book value was approx. 0.4
The company still managed to raise money (via rights issue) at these cheap valuations.

(Dec-21) – Florintree to invest Rs 100 Cr in preferential issue by Satin Credit
Satin Credit raises Rs 225 Cr through preferential allotment.
Rs 100 Cr comes from Florintree Advisors – an AIF, Rs 25 Cr from NRI investors.
Rs 100 Cr is being infused by the promoters
Even though money is being raised at cheap valuations (P/B = 3), Satin Credit is still able to raise money to shore up their networth and consequently Capital Adequacy Ratio

(Oct-20) – CreditAccess Grameen raises equity via QIP
After the 1^st wave of Covid, CreditAccess Grameen raised Rs 800 Cr via a QIP.
Multiple institutional investors including both Indian and foreign funds invested in this QIP – T. Rowe Price Group, Kotak India Midcap Fund, Tata AIA life Insurance, Nomura Trust, HDFC Life insurance, ICICI Prudential Mutual Fund.

(Oct-20) Equitas SFB raises equity via IPO
Equitas small finance bank raised Rs 517 Cr via an IPO just after the 1^st Covid wave.
Several institutions also participated as anchor investors including ICICI Prudential, HDFC Life Insurance, Mirrae Asset, Sundaram MF etc.

(Mar-21) Suryodaya SFB raises equity via IPO
Suryodaya SFB raises Rs 520 Cr in Mar-21 just before the 2^nd Covid wave hit us hard.
There was enough demand from institutional investors for the Suryodaya IPO both as anchor investors and institutional subscribers to the IPO.

Bottom line is there is enough demand for equity of good companies in this microfinance sector even when they are facing strong near-term headwinds.

What went wrong with Ujjivan Financials between 2016 and 2021?

The stock of Ujjivan Financials has fallen from a high of Rs 511 in Jul-16 to a low of Rs 141 in Dec-21. This is a -73% decline. Investors have lost a lot of money in the Ujjivan Financials stock. What has gone wrong?
In 2016, Ujjivan Financials was priced for perfection, we were in a bull market and financials were doing well. Then came the first blow

1. Demonetization in Nov-16
   Microfinance businesses like Ujjivan suffered a lot. It took about 15 months to put the damaged caused by demonetization behind.
2. IL&FS crisis in Sep-18
   Though Ujjivan had already converted to a bank and did not suffer too much, the valuations definitely took a big hit
3. Listing of Ujjivan SFB (sometime in 2019)
   When it became clear that RBI will not allow reverse merger ahead of time and the bank will also have to be listed, Ujjivan Financials (parent) suffered a de-rating and a holding company discount of 40% for built into the stock price.
4. Coronavirus pandemic (Mar-20)
   All hell broke loose. Unsecured lending businesses like Ujjivan’s suffered a big blow
5. Wave 2 Coronavirus pandemic (Apr-21)
   Though the 2^nd wave was shorter, its impact was more intense and devastating

The bad stock returns of Ujjivan in the last 5 years are the precise reason why I think not many new institutional investors or for that matter new retail investors are interested in the Ujjivan stock. If investors want to play out the opening up theme in microfinance businesses, there are better companies to invest in including Bandhan Bank.

What went wrong with Ujjivan in August 2021?
Since Samit Ghosh turned 70 yrs in Nov-19, he had to retire from the position of MD&CEO of Ujjivan SFB. This was the same reason that Aditya Puri retired from HDFC Bank after turning 70 yrs of age.

As part of the succession planning, Nitin Chugh (head of digital at HDFC Bank) joined Ujjivan SFB as the MD&CEO. This, at that time in Nov-19, looked like a good decision which takes care of the future sustainability of the bank.
However, Coronavirus hit and the entire microfinance industry went through massive problems with NPAs increasing to more than 10% across the industry. Nitin Chugh had a fallout with the founder Samit Ghosh and the ugly board room battle ended in Nitin Chugh leaving Ujjivan SFB.
There also has been massive attrition in mid and lower management of the bank and the NPA situation as on date is not at all encouraging (GNPA = 11.8% with 68% loan book being unsecured).

I don’t know who is right between Samit Ghosh and Nitin Chugh. My investment thesis also does not rest on finding out who was right.
With Covid 2^nd wave, GNPAs increasing and the exit of Nitin Chugh (MD&CEO), the Ujjivan stock price fell to levels seen during the Mar-20 at the peak of the Coronavirus fear.

Optically speaking, financials of NBFCs like Arman & CreditAccess Grameen look much better than Ujjivan SFB.

What is happening?
There are two reasons for this

1. Difference in the way banks and NBFCs report NPA numbers
2. Payment Holiday during wave 2

If a loan remains unpaid for 90 days, both NBFCs and banks (including SFBs) report that particular account as NPA.

The difference between a NBFC and a bank is in the way they regularize the account after the customer starts paying.
For example, if a NPA customer after missing to pay 3 loan instalments (90 days overdue) comes and pays 1 single EMI, technically she becomes 60 days overdue. Now, NBFCs like Arman immediately regularize the account and remove the customer from the list of NPA customers. However, banks and SFBs are not allowed to remove the customer from the NPA list unless she pays all the 3 EMIs – both interest and principal in full.
So, even though headline NPA numbers for NBFCs is looking much better than that of banks, the scenario for these two types of institutions is not really too different.

In fact, being alarmed that NBFCs may not report the correct GNPA numbers, RBI came out with a circular instructing NBFCs to upgrade a NPA customer only after she pays the entire overdue amount (all 3 EMIs) just as the banks do.

Also, Ujjivan SFB did not give any payment holiday during April to June 2021 – during the 2^nd covid wave. They chose to restructure some of the accounts in Q2FY22 after the covid wave had subsided.
However, Arman Financials gave a 1 to 3 months payment holiday to 100% of their customers during the covid 2^nd wave. So, technically 100% of their loans are restructured even though they do not call it restructuring. It will only be evident in the next 6 to 9 months as to what happens to the asset quality in the Arman loan book.

How do Q1FY22 & Q2FY22 look like?
Let us look at the asset quality and provisioning data

As discussed above, NBFCs are optically reporting lesser GNPA figures than banks, but clearly the NBFCs expect more GNPA because they have provided more than their GNPAs. Provisioning coverage is more than 100%.
The NPA situation of equally bad for most of the microfinance companies.

Now let us look at the collections trend of Ujjivan looks something like this

The collections data for Ujjivan looks very encouraging. The fact that same month billing is hovering around 95% inspite of a 11.8% NPA levels means several of their NPA customers are also paying up.
If we compare the collections data with some of their peers

Actually, all these companies have their own unique ways of calculating the percentage collections. One cannot really decipher purely based on the collection numbers.
Eg. Though Ujjivan collection figures are much higher than that of Arman, the GNPA levels and provisioning levels of Ujjivan are higher than that of Arman.
Absolute collection figures matter less than the trend in the collections.

And the trend is clear, the industry as a whole is recovering.

Additionally, Nitin Chugh is gone, and the entire old guard is back at the helm of Ujjivan SFB –

• Ittara Davis has been appointed as the MD&CEO of Ujjivan SFB for a term of 3 years
• Carol Furtado is back as the Chief Operating Officer
• Samit Ghosh is the Chairman of the holding company – Ujjivan Financials
• Several of the old board of directors (including independent ones) are back

After the ouster of Nitin Chugh, the new management does not have any incentive to hide the full extent of problems. In my opinion, the current management is incentivized to put out all the problems in the open and deal with them so that the effort to clean-up is more effective. I do not expect big negative surprises on the asset quality side.

What about 3^rd wave?
No one knows. But I have a few stipulations to make

1. In my opinion, India has realized the severe economic costs of strict lockdowns. The government will try to keep the economy going even after the 3^rd wave arrives
2. Discovery of Omicron variant probably signals the end of Coronavirus – because the virus has mutated so much, it has become far more contagious and much less lethal. We may see increase in cases, but drastic reduction in hospitalizations and deaths.
3. With the stock prices across the microfinance sector so depressed, maybe the bad scenario is already priced in.

What will make me lose money?

1. Gross NPA numbers go up further i.e. credit costs increase significantly from here
   (Sep-21 GNPA is 11.8%)
2. Reverse merger does not happen
3. There is a run on the bank – depositors start withdrawing money

My estimate of the situation

Point 1 –> Things industry-wide are improving, the direction is UP

Point 2 –> Reverse merger has already been announced, RBI has also accepted the recommendations of its internal committee to allow companies like Ujjivan, Equitas, IDFC to exit the holding company structure. In my opinion, its just a matter of time.

Point 3 –> We are 20 months into the Coronavirus pandemic. There has not been a run on any of the Indian banks. I do not foresee why it should happen to Ujjivan SFB. In either case, if it happens my investment thesis completely breaks down and I will lose a lot of money.

When will I sell?
I do not think this is a “multi-bagger” stock that I wish to hold for 5/10 years.
I also think that 1/2 good quarterly results and the Ujjivan SFB stock will get re-rated.

I will sell if

1. Both Dec-21 and Mar-22 quarterly results are good and still the bank stock price does note move up.
2. After I make a 3X return in today’s price

Some other points which should find mention in this article

• Ujjivan Financials is widely held by institutions. Any one large institutional shareholder deciding to sell its stake in Ujjivan Financials will result in a dramatic fall in the share price. This happened in early Sep-21 when Government of Singapore and CX Partners (Alena Private Ltd) sold their stake in Ujjivan.

• RBI has appointed one of its employees – General Manager, RBI regional office (Bengaluru) as an additional director on the board of Ujjivan SFB.
  I honestly do not know what to make of this. Generally, RBI using its powers to appoint someone on the board of a bank means not all is well with the bank. However, we already know that Ujjivan SFB is in trouble with 11.8% NPAs. Also, there was no negative price impact of this news on the Ujjivan SFB in the next week, so it seems the market does not believe that this is a negative surprise – something that is already priced in.

• On 24^th Sep-21, after the old guard took charge at Ujjivan, the company had come out with a business update. The management has talked about a credit cost of Rs 1100 Cr to Rs 1200 Cr in FY22. Bank has provided for Rs 887 Cr till Sep-21.
  So, the pain on NPA provisions is still not over and the cleaning may take 1/2 quarters more
• The logic I am using for investing in Ujjivan also applies to Bandhan, Credit Access Grameen, Suryodaya, Satin Credit, Arman Financials, Spandan Spoorthy and several other companies in the microfinance industry. If the credit quality indeed improves quickly, it will improve for almost everyone in the industry. I do not have a good reason to justify why not invest in Bandhan or CreditAccess Grameen instead of Ujjivan Financials.

However, I think the reverse merger arbitrage is unique to Ujjivan and provides additional safety margin. Also, because Ujjivan is not an obvious choice or the best choice for the microfinance turnaround investment thesis, it is relatively ignored by the institutions. With a higher threshold to withstand pain, I think I will end up making good money in Ujjivan Financials.

To summarize the entire article and the investment thesis, is Ujjivan SFB the IndusInd bank (60 bagger between Apr-09 and Apr-18) of this decade? – I do not know.
But, if the reverse merger goes through and normal times return back to the microfinance industry and to Ujjivan, the holding company – Ujjivan Financials can easily become a 3 bagger within a 12-18 month time frame.

Disclaimer:
Please do not consider this article as a stock recommendation. The article is an illustration of the kind of analysis that goes into fundamental research and equity investing.
The author Amey Kulkarni (@amey_candor) is a SEBI registered Investment Advisor.

Investment Advice:
Ujjivan Financials is a stock we hold in the Candor Investing SmallCase.
If you are looking for investment advice, check out our smallcase at https://candorinvesting.smallcase.com/