India's Digital Push Will Squeeze Margins In Small Finance Banks

Key Takeaways

• Rising fintech and large bank competition, along with digital product gaps, threaten AU's customer growth, margins, and overall market share.
  
• Aggressive lending, higher credit risks, and funding disadvantages create persistent pressure on profitability and long-term financial stability.
  
• Expansion into new markets, digital investments, and a strong focus on secured retail lending position the bank for steady growth, resilience, and improved profitability.

Catalysts

Engages in the provision of various banking and financial services in India.

• Growing competition from digital-first fintech platforms and payment providers is expected to steadily bypass traditional small finance banks such as AU, leading to a long-term decline in new customer additions, stagnating deposit growth, and margin compression as the company loses share in core segments.
  
• As Indian consumers become more financially literate and increasingly seek lower-cost or more comprehensive digital banking products, AU Small Finance Bank's inability to match the scale or cost efficiency of large banks and fintechs will likely erode its customer base, putting ongoing pressure on both loan and deposit growth.
  
• Aggressive lending in historically underserved or informal segments and rapid geographic expansion are expected to lead to structurally higher credit costs and an ongoing risk of non-performing assets, curbing net margin expansion and creating long-term instability in earnings.
  
• The company's relatively weak CASA (Current Account, Savings Account) ratio and persistent funding cost disadvantage compared to major competitors imply that net interest margins may remain structurally depressed, especially as the low-cost deposit mobilization continues to lag sector peers.
  
• Increased regulatory scrutiny and potential tightening of lending norms for small finance banks are expected to constrain AU's ability to profitably grow its loan portfolio, while required heavy investments in digital infrastructure to remain competitive will further sap profitability and impede improvements in the cost-to-income ratio over time.

AU Small Finance Bank Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on AU Small Finance Bank compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming AU Small Finance Bank's revenue will grow by 26.7% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 24.5% today to 23.4% in 3 years time.
• The bearish analysts expect earnings to reach ₹42.4 billion (and earnings per share of ₹57.02) by about July 2028, up from ₹21.8 billion today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 16.2x on those 2028 earnings, down from 25.1x today. This future PE is greater than the current PE for the IN Banks industry at 12.6x.
• Analysts expect the number of shares outstanding to grow by 0.27% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 14.58%, as per the Simply Wall St company report.

AU Small Finance Bank Future Earnings Per Share Growth

Risks

• Robust long-term secular trends such as the rising formalization of the Indian economy, expanding digital adoption, and sustained MSME, retail, and affordable housing sector growth are likely to fuel strong, sustained loan and deposit growth for AU Small Finance Bank, driving up top-line revenue and earnings over the coming years.
  
• The continued geographic expansion and branch roll-out into new markets, especially through leveraging the Fincare merger, will widen AU's reach and likely result in higher loan portfolio growth and improved overall profitability in the long run.
  
• Heavy investment in digital and tech-driven banking infrastructure is enhancing operational efficiency and productivity, leading to improved cost-to-income ratios and supporting stable or rising net margins over time.
  
• AU's high mix of retail and secured lending particularly in wheels and mortgages, which have historically demonstrated relatively resilient asset quality is likely to underpin consistent net interest margins and limit earnings volatility, especially as economic cycles stabilize.
  
• Supportive government and regulatory policy towards financial inclusion and differentiated license status is expected to protect AU from direct competition with large universal banks, enabling market share gains and providing a stable environment for steady revenue, margin, and earnings improvement.

Valuation

• The assumed bearish price target for AU Small Finance Bank is ₹610.0, which represents the lowest price target estimate amongst analysts. This valuation is based on what can be assumed as the expectations of AU Small Finance Bank's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of ₹979.0, and the most bearish reporting a price target of just ₹610.0.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be ₹181.2 billion, earnings will come to ₹42.4 billion, and it would be trading on a PE ratio of 16.2x, assuming you use a discount rate of 14.6%.
  
• Given the current share price of ₹736.75, the bearish analyst price target of ₹610.0 is 20.8% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.