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Robust capital base, strong asset quality, and healthy retail deposit makes AU a good long term bet

Company profile AU Small Finance Bank (formerly Au Financiers (India) Ltd) – AU SFB was incorporated in 1996 as an NBFC, promoted by Mr. Sanjay Agarwal, with 28+ years legacy of being a retail focused institution. AU SFB has an established market position in Rajasthan, and has expanded operations to Maharashtra, Gujarat, and other states over the years. The bank's main focus is a retail asset-financing segment, primarily in the vehicle financing segment (around 32% of gross loan portfolio as on March 31, 2025), alongside Micro Business Loans (24.2% of gross loan portfolio as on March 31, 2025). Other segments include housing, gold loans, personal loans, overdraft, and commercial banking products. AU SFB’s liability product offerings include the entire gamut of current account, savings account, recurring and term deposits, transaction banking, bouquet of third-party mutual funds, and insurance covers. As of March 31, 2025, AU SFB had established operations across 2456 banking touchpoints while serving ~113.4 Lakh customers in 21 States & 4 Union Territories with an employee base of around 50,946 employees.

Investment Arguments

Adequate Capitalisation & Sustained Deposit Growth AU SFB maintains adequate capitalisation, supported by steady internal accruals and a strong ability to raise capital when needed. The bank’s net worth rose to Rs 17,166 crore as of March 31, 2025, up from Rs 12,560 crore on March 31, 2024, and Rs 10,977 crore a year prior. This increase was partly due to the Fincare merger. Capital raising included Rs 2,000 crore via QIP and Rs 500 crore through Tier II bonds in FY23. As of March 2025, the overall capital adequacy ratio (CAR) stood at 20.1%, with Tier 1 CAR at 18.1%, both comfortably above the 15% regulatory requirement. The bank has demonstrated steady deposit growth over the past three years, with an increasing share of retail deposits, including CASA and retail term deposits under Rs 2 crore. For the year ended March 31, 2025, deposit growth for the merged entity was 27% YTD, taking total deposits to Rs 1,24,269 crore. This improvement reflects a deepening retail deposit franchise and greater funding stability.

Cost of Funds and Deposit Mix Alongside deposit growth, the bank has focused on sourcing low-cost funds through retail deposits and institutional refinancing. Despite this, the average cost of funds rose to 7.07% in FY25 from 6.4% in FY24 due to the prevailing high interest rate environment. Maintaining a competitive cost of funds while continuing to increase the share of retail liabilities will be a key factor to monitor over the medium term.

Resilient Asset Quality The bank has demonstrated a track record of maintaining better-than-average asset quality metrics. AU SFB's GNPA remained below 3% until March 2020. Although GNPAs and NNPAs rose during the pandemic to 4.3% and 2.3% in June 2021, they declined to 1.7% and 0.5% by March 31, 2024. However, they slightly increased again to 2.28% and 0.74% by March 31, 2025, primarily due to stress in unsecured loans and seasonal impact in the vehicle and agri segments.

Low Restructured Book & Diversified Portfolio The bank’s standard restructured book declined to just 0.3% of gross advances as of March 31, 2025, from 2.1% in June 2022. The loan book is well-diversified across Wheels (31.7%), MBL/MSME (24.2%), Commercial Banking (20.9%), Home Loans (8.7%), MFI (7.9%), and Gold Loans (1.6%). While loan growth has been strong, the longer tenure of the portfolio means asset quality trends here will be closely monitored.

Stable Profitability Metrics AU SFB reported a PAT of Rs 2,106 crore (RoA of 1.5%) for FY25 and Rs 1,535 crore (RoA of 1.5%) in FY24. Net interest income has been rising since FY23, aided by growth in business volumes and the Fincare merger, though higher funding costs had some offsetting impact. Recoveries from written-off accounts also supported earnings. Credit cost rose to 1.3% in FY25 from 0.4% in FY24, driven largely by stress in the unsecured segment.

Operating Efficiency & Profitability Outlook. Operating costs have remained stable, ranging between 4.2% and 4.4% during FY24 and FY25. Going forward, the bank expects net interest margins to improve based on its strong positioning in core geographies and product categories, which allow for effective risk-based pricing. Operating expenses are expected to stay stable as there are no significant expansion plans in the medium term. Sustaining profitability while scaling operations in segments like MSME and Commercial Banking will be vital. Managing credit risk in the unsecured segment remains a key factor for long-term performance. The bank's ability to maintain high asset quality and continue growing its low-cost deposit base will be essential to support profitability and ratings stability.

Q4FY25 Financial Performance FY25 has been challenging for the bank due to high interest rates, tight liquidity, and elevated stress in unsecured retail loans, leading to increased credit costs. While Q4 earnings had accelerated provisioning, primarily in unsecured segments, the Provision Coverage Ratio (PCR) improved significantly. Despite sequential improvement in asset quality with a decline in slippages, the overall slippage levels remained elevated. The management expects profitability to improve in FY26, especially in the second half, driven by lower repo rates and normalization of credit costs, with growth guidance maintained at 20–25%. Net interest income for Q4 stood at Rs 2,094 crore, up 57% year-on-year and 4% quarter-on-quarter, though Net Interest Margins (NIMs) declined ~6 bps q-o-q to 5.79%. Core fee income increased 20% y-o-y and 15% q-o-q due to stronger forex, distribution, and processing fee income, while treasury gains rose to Rs 103 crore from Rs 46 crore last quarter. Operating expenses grew 27% y-o-y and 9% q-o-q, leading to a 95% y-o-y and 7% q-o-q growth in PPoP to Rs 1,292 crore, with core PPoP up 3% q-o-q. Provisions surged 379% y-o-y and 27% q-o-q, pushing annualized credit cost to 1.7%. PAT came in at Rs 504 crore, up 36% y-o-y but down 5% q-o-q, falling short of estimates due to higher provisions. Advances rose 8% q-o-q, deposits grew 11%, with CASA and retail term deposits both up 5%, though total retail deposit share dropped to 62% from 65%. Asset quality improved, with GNPA/NNPA at 2.28%/0.74% versus 2.31%/0.91% q-o-q, and PCR increased to 68%. The restructured book was stable at 0.3%, while gross and net slippages declined to 3.3% and Rs 530 crore, respectively. SMA for MFI fell to 3.7% from 4.4%. About 16% of the MFI book is impacted by MFIN 2.0 guidelines. Credit costs were high in credit card (11%) and MFI (7.75%) segments, and the bank made an accelerated provision of Rs 150 crore in Q4 to strengthen coverage. With improving collections and resolutions in March, slippages in unsecured loans appear to be peaking. Policy support, easing liquidity, and lower rates should aid recovery, and return ratios are expected to improve.

Key Conference Call Takeaways

• Elevated interest rates during the year impacted both funding costs and credit demand, yet AU Small Finance Bank delivered strong performance with 27% YoY growth in deposits and over 20% growth in advances. Despite challenges in unsecured lending, especially in the MFI segment, branch-level profitability improved, with 29% of branches breaking even, up from 25% the previous year. Growth was led by secured loans, which maintained strong asset quality, while the unsecured book declined due to MFI-related issues. However, collections are improving and the issue is nearing resolution. The bank continues to rely on the CGFMU scheme to mitigate risks when lending to underserved segments and has recalibrated its credit card portfolio, which declined 19% YoY but is expected to become profitable in 1–2 years, contributing to fee income.
• The bank’s retail lending strategy remains focused on fixed-rate products, and it is preparing to open 70–80 new branches in FY26 across new cities. Commercial and MFI operations are transitioning to Mumbai, while Jaipur will focus on back-end processes. The credit card business is being restructured with stricter underwriting norms, reducing spending by 50%, and new leadership is now in place. Meanwhile, the bank is also leveraging Fincare’s expertise to build its gold loan portfolio. Despite pressure on CASA, the overall deposit franchise remains strong, supported by bulk deposits. The bank is actively engaging with the RBI on securing a universal banking license and expects progress within the current calendar year.
• Cost controls have led to improved efficiency, with the cost-to-income ratio falling to 57% in FY25. An additional INR 1.5 billion provision was made to raise the PCR to 68%. RoA dropped to 1.53% due to accelerated provisioning, but credit costs on total assets are expected to fall from 1.3% in FY25 to 85bp in FY26 and 75bp in FY27. NIMs may remain under pressure in the near term due to the changing business mix and elevated funding costs, but are expected to benefit from lower interest rates in 3Q and 4Q of FY26. About 30% of the loan book is linked to repo rates, which could lead to some yield pressure. Nevertheless, macroeconomic trends are improving, and the policy environment appears more growth-oriented and aligned with government priorities.
• The credit card business is projected to break even by FY27E and become profitable by FY27–28. The REG portfolio, constituting 3% of total assets, remains stable and is not targeted for aggressive growth. The bank believes it can maintain 25% YoY growth in advances until it reaches an asset base of INR 3–4 trillion, after which growth may moderate to around 20% YoY. Tractor and used vehicle financing showed healthy traction in 4QFY25, though demand for 2-wheelers remained subdued. Secured lending grew 23% YoY while unsecured lending declined 17% YoY. MFI lending grew from 6% to 10%, but achieving a 40% CAGR is not the bank’s current objective. The bank remains PSL-compliant, with 50% of the SMF book in FY25 derived from MFI lending.
• Term deposit rates were cut by 25bp, though the cost of funds increased 7bp QoQ due to fewer calendar days and a change in the business mix, impacting NIMs by 5–7bp. The MFI book is entirely group-based (JLG) and will evolve gradually. Credit costs will be the main lever of performance in FY26, and the bank is prepared for a declining rate cycle. Management expects a 30–40bp improvement in credit costs in FY26 versus FY25, with provisions expected to normalize to 85bp in FY26 and fall to 75bp in FY27. The MFI segment should stabilize within two quarters, with most recent stress concentrated in Karnataka, which is already showing signs of recovery.
• Collection efficiency continues to improve across all segments and is expected to sustain its momentum into FY26. Approximately 70–80% of the incremental MFI book is covered under the CGFMU scheme, which offers significant protection. The vehicle finance portfolio saw strong asset quality performance in 4Q, and the bank intends to maintain 3% coverage on the MFI portfolio. Credit card credit costs should normalize to 6–7% by 2HFY26, and no special provisions are anticipated. Elevated costs in 1HFY26 should ease significantly in the second half. March showed positive trends in collections and credit costs, reinforcing confidence for improved performance in FY26.
• Slippages improved significantly in 4Q, though management remains cautious about declaring a peak. FY26 is expected to be better on this front. The small vehicle finance segment saw a recovery in collections after being affected in 3QFY25. Home loan NPLs were marginally higher and will be a focus area for operational improvement. On the operational expense front, the bank is tightly managing costs even as it continues integrating Fincare and making tech-related investments. It aims to keep the C/I ratio below 60% while expanding its technology and distribution capabilities.
• Capital-raising plans will be evaluated after the bank secures its universal banking license. The revised LCR guidelines are more favorable than previously anticipated, and the bank expects to maintain an LCR of around 120%. Management remains cautiously optimistic for FY26, with anticipated easing in credit costs, normalization in unsecured segments, and supportive macro policies driving more stable and profitable growth.

Guidance

• Profitability is expected to improve in FY26, especially in H2FY26, supported by lower repo rates and normalization of credit costs.
• Growth guidance remains unchanged at 20–25% YoY.
• Return ratios are expected to improve, with RoA likely expanding by 20–30 bps over FY25–27.
• The credit card portfolio, currently under recalibration, is expected to turn profitable in 1–2 years and contribute meaningfully to fee income.
• AU SFB plans to open 70–80 new branches in FY26, targeting expansion into new cities.
• The credit card business is projected to break even by FY27E and become profitable by FY27–28.
• Management believes 25% YoY growth in advances can be sustained until the bank reaches an asset base of INR 3–4 trillion, after which growth may moderate to ~20% YoY.
• Credit costs are expected to decline from 1.3% in FY25 to 85 bps in FY26 and 75 bps in FY27.
• NIMs, though under near-term pressure, are expected to benefit from lower interest rates in 3Q and 4QFY26.
• MFI segment stress is expected to stabilize within two quarters; Karnataka, a key stress region, is already showing signs of recovery.
• Credit card credit costs are expected to normalize to 6–7% by 2HFY26.
• Elevated costs in 1HFY26 are expected to ease significantly in the second half.
• FY26 is expected to be better in terms of slippages, with further improvement in collection efficiency.
• The bank plans to maintain 3% coverage on the MFI portfolio.
• The C/I ratio is targeted to be kept below 60%, even as the bank continues tech investments and Fincare integration.
• Capital-raising plans will be assessed after securing a universal banking license, which is expected to progress within the current calendar year.
• Revised LCR guidelines are favorable; AU SFB expects to maintain an LCR around 120%.
• Management remains cautiously optimistic for FY26 with macro and policy tailwinds expected to support more stable and profitable growth.

Key Risks & Concerns

Weak CASA Profile and Deposit Mix Challenges CASA, while improving, remains low relative to larger private banks and continues to be a structural weakness for AU SFB. The CASA ratio declined from 38.4% in March 2023 to 30.6% in December 2024, driven by rising competition for deposits and an industry-wide slowdown in deposit mobilization. Although the combined share of CASA and retail term deposits was stable at 65% as of December 2024 (vs. 64% in March 2024), it has slipped from 69% in March 2023. The bank still has a relatively high proportion of bulk deposits, which, though 49% non-callable, are rate-sensitive and less sticky. This poses challenges for asset-liability management, especially in a tight liquidity environment. While AU SFB managed past disruptions in the banking sector without prolonged impact, building a more granular deposit base with a higher share of CASA will be essential over the medium to long term. Sustained CASA improvement remains a critical rating sensitivity.

Growth, Margin, and Asset Quality Risks Lower-than-expected growth in advances, particularly if demand from core customer segments slows or competition intensifies. Additionally, pressure on net interest margins due to rising funding costs or inability to pass on rates could hurt profitability. Higher-than-expected credit costs, especially in the unsecured loan and MFI segments, where delinquencies remain elevated, could also adversely impact earnings. The ability to manage these risks while maintaining balance sheet strength and delivering consistent returns will remain crucial to sustaining investor confidence and valuation.

Outlook & Valuation

AU Small Finance Bank reported a resilient quarterly performance, underpinned by strong loan and deposit growth that outpaced the industry, despite a drag on profitability from one-time provisions. AU SFB has had a long and successful history (since its days as an NBFC and now as a bank) in secured credit and its underwriting quality, mainly in the under-/unbanked self-employed customer segment that lacks formal income documentation. The bank has strong skill sets and a deep experience in its core secured segments. It entered the unsecured business to enhance its product offering/ geographic reach and use it as a key tool to accelerate and retain customer liability. However, its execution track record in scaling the unsecured portfolio has remained subpar so far, warranting a course correction. Management acknowledged the challenges and initiated corrective measures to improve performance. We believe profitability/ return ratios have broadly bottomed out. The bank is reasonably confident that improvement will be largely seen in H2FY26 led by lower policy rate and normalization of credit cost. Guidance on growth remained intact at 20-25%. Management has indicated that the Net Interest Margin (NIM) is expected to face continued pressure, projected at 5.8% for Q4 FY25. However, a 25 basis points reduction in the savings deposit rate in April 2025, along with lower interest reversals due to an improved outlook on asset quality for FY26, and approximately 70% of the asset portfolio being fixed-rate, present significant upside risks to the NIM forecast. Additionally, management anticipates that credit costs will decrease to 75–85 basis points in FY26, compared to 1.3% in FY25, suggesting an enhancement in asset quality performance in the upcoming quarters. We believe AU SFB, with a robust capital base, strong asset quality, and healthy retail deposit franchises, is well-placed to capture long-term growth opportunities. At CMP of Rs.688, the stock is trading at P/BV of 2x FY27E. We recommend a BUY rating on the stock.