Why Kotak Mahindra Bank is unlikely to be top investors’ choice among large lenders despite strong Q2

Kotak Mahindra Bank’s standalone loan book grew 19% year-on-year to ₹5.5 trillion, excluding the twin impact of the acquisition of Kotak Mahindra Investments’ loan portfolio and loans against FCNR(B) deposits worth ₹16,110 crore.

Kotak Bank took over Kotak Mahindra Investments’ loan portfolio of nearly ₹9,600 crore at the beginning of Q2 to comply with the Reserve Bank of India’s directions requiring the elimination of overlapping, non-specialized lending structures within a banking group. Since only the advances of Kotak Mahindra Investments were transferred to Kotak Bank, and not the liabilities, the bank is likely to have earned interest income of about ₹200 crore. Adjusting for this, net interest income (NII) growth would be about 13% year-on-year, versus 15.7%.

Kotak Bank’s net interest margin (NIM) for Q2 was 4.31%, down 22 basis points (bps) sequentially, with FCNR(B)-related funds accounting for the bulk of the decline at 15 bps. The balance was due to quarter-specific day-count variation, as Kotak Bank reports NIM based on the number of days rather than the number of months. Core pre-provisioning operating profit (PPoP) growth was robust at 20% year-on-year to ₹6,115 crore, attributable to a 21% increase in fee and service income to ₹2,926 crore.

Margin pressure

The bank declined to provide guidance for NIM in Q3. However, the full impact of FCNR(B) deposits could exert significant downward pressure on margins, as nearly 45% of incremental deposits in Q2 came from this source. Reported deposit growth was 23% year-on-year, but would have been much lower, at 13%, excluding FCNR(B) deposits.

To be sure, some of the adverse impact on NIM may be eased, albeit to a smaller extent, by the recent 25 bps hike in the repo rate. Kotak Bank’s loan book is nearly 65-70% floating-rate, with most of it linked to the repo rate.

The near-term credit-cost outlook is positive, as fresh slippages, or additions to gross non-performing assets (NPAs), fell 25% year-on-year and 7% quarter-on-quarter to ₹1,230 crore in Q2.

However, the long-term outlook appears challenging. Bank management has indicated that credit costs could rise by 12-15 bps as a percentage of advances once expected credit loss (ECL)-based provisioning norms come into effect from FY28. Based on a likely loan book of nearly ₹6 trillion at the end of FY28, the estimated incremental credit cost could be ₹720-900 crore for the year. This could pull down net profit growth. It should also be noted that higher credit costs under ECL are likely to be an industry-wide phenomenon, rather than specific to Kotak Bank.

Returns and valuation

Despite its healthy Q2FY27 performance, Kotak Bank continues to trail ICICI Bank and HDFC Bank on return on equity (RoE). Kotak Bank’s reported RoE was 11.6% in Q2, versus 16.6% for ICICI Bank and 13.5% for HDFC Bank, despite the latter two having larger asset bases.

Relative to its RoE, Kotak’s valuation appears rich compared with those of its two larger rivals. The bank trades at a price-to-earnings multiple of 15, based on Motilal Oswal Financial Services’ earnings estimates for FY27, versus 13 for ICICI Bank and 10 for HDFC Bank, after adjusting for the valuation of their respective subsidiaries.

Kotak will have to improve its performance and RoE considerably over the long term to justify its valuation premium over rivals.