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Can Fin Homes Ltd

Buy Rs.480/-. Duration: - 18 to 24 months or more for multiple 16th

Oct, 2014

While the Indian economy has come a long way in the last few decades, not all the states are

equally placed in this transformation story. Some regions, despite being rich in natural

resources are at the lower most rungs on the ladder of development. While others, based on

education and job creation opportunities, have raced well ahead. A case in point is South

India - the region that houses one of the most urbanized states (Kerala); one of the most

developed state (Andhra Pradesh) and is a house to Asia's fastest growing cosmopolitan city

(Bangalore). The education and job opportunities in the IT sector in South India have drawn a

highly mobile educated workforce further fuelling the housing demand.

At a time when the Indian economy is witnessing a turnaround, the businesses that cater to

the basic needs of the growing population in these regions are likely to ride the overall

economic growth wave better than others. One such need is the demand for housing. And

while we would not suggest you to expose yourselves to real estate companies that are

laden with huge debts and dicey track record, investing in companies in the housing

finance business can be a good proxy play to participate in the story of the booming

housing demand.

One can guess the potential from the fact that the country has shortage of 19 million housing

units. And as compared to other emerging economies, the housing loan/mortgage is just 9%

of the GDP. With a huge demographic dividend and rising urban migration and affordability,

the growth of the housing business across India can hardly be questioned. However, as far as

stability and risk aspect of growth is concerned, no other region can be more reassuring that

South India.

However, high growth prospects breed competition. And housing finance sector even in

South is no exception to this. Almost all players in the segment want to grab larger market

share and this is getting well reflected in their valuations. As far as investing is concerned, to

benefit from this opportunity, investors should focus on companies that are operating in the

niche segments - based on the ticket size, regional exposure or the class of borrowers they are

exposed to. And there are enough such companies in the small cap segment that not just

enjoy huge growth potential, but being relatively small and less tracked, also offer strong

valuation upsides for the investors.

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Key Management Personnel

Shri C. Ilango- Managing Director, has been the Managing Director of Can Fin Homes Ltd.

since April 29, 2011. He has served as Deputy General Manager of Canara Bank and is a

senior banker with over 31 years of commercial banking experience having served across

India. He is a Post Graduate degree holder in Agricultural Science viz., M.Sc., (Agriculture)

and a CAIIB.

Shri K. N. Prithviraj - Chairman, is a rank holder in M.A.(Economics) and CAIIB. He was

also a Fellow of Research in the Department of Economics, University of Madras. He has

more than 38 years of experience in the banking industry. Earlier, he was the Chairman &

Managing Director of Oriental Bank of Commerce, Executive Director of United Bank of India

and General Manager of Punjab National Bank. He was a Government Nominee Director for

Oriental Insurance Company for two years.

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A stock investment as good as buying a second home

"If you had sizeable investible surplus, what would you do?"

An average middle-aged Indian homeowner would probably say, "I would buy a second

property."

Property is deemed to be the safest and most lucrative of investment assets in India. And why

not! It is a solid, tangible asset with limited downside risk... It is a good hedge against

inflation... And it has delivered solid returns over longer time periods...

While buying a second home may be a good idea, it requires a big capital commitment. And if

you're living in a big city or a metro, you will agree that property prices have gone through

the roof. And while investing in smaller cities and towns may be more lucrative, very few

have the time and money to identify the right investment opportunity.

What if we were to tell you that there was indeed a way to participate in the housing boom in

India's rural and semi urban markets? After a management meeting in Bangalore last month,

we were thoroughly convinced that we had indeed found a stock that was almost as good as

buying a second home. A company that could be your proxy investment in thousands of

homes...

The company that we are referring to is Can Fin Homes Ltd - our Hidden Treasure

recommendation for the month. Promoted by Canara Bank in 1987, Can Fin Homes is a

Bangalore-based deposit taking housing finance company with a focus on rural and semi-

urban markets. The company has pan-India presence with 103 branches in over 15 states.

While predominantly a South India-focused housing finance company, Can Fin has been

expanding its presence in non-southern markets which now account for about 30% of the

company's loan book.

So what is it about the company that makes us say that it seems as good as buying a second

home? Here are the reasons.

The company has a highly secured home loan book with over 88% of the borrowers belonging

to the salaried class. Of these, 50% borrowers are PSU employees where job security is usually

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quite high. Moreover, the company has a loan to value ratio of 75% of registered value of the

property as against the market value of the property. This is a fairly conservative approach. It

is because of these reasons that the company has been able to maintain impeccable asset

quality over the years. For instance, the company's gross non-performing assets (Gross NPA)

have been continuously on the decline and stood at merely 0.2% as of March 2014. What is

more, the company has had zero net NPAs over the last five years.

If this has already got you interested, let us tell you that this is just half the story yet. One of

the biggest game changers for the company was when it got a new management team in

FY11. The new management team, led by Managing Director Mr C Ilango, revamped the

housing finance business by centralizing the system. It increased staff strength, expanded

branch network and also started sales through agents.

The post-FY11 financial of the company are a

testimony to the new management's thumping

success. Let us see how the company has performed

in the period up to and after FY11. Between FY07

and FY11, the company's loan disbursements grew

at a tepid 1.5% compounded annual growth rate

(CAGR). Compare this with a whopping growth

rate of 75.3% CAGR in the period from FY11 to

FY14! As of March 2014, the company's loan book

stood at Rs 58.44 billion.

Even the branch network which had stagnated around 41-odd branches till FY11 has now

expanded to 103. It is worth noting that the average branch break-even period for the

company is just 4 to 12 months. One of the unique selling propositions of Can Fin Homes that

the management claims is its shortest loan turnaround time of about 7 days. Moreover,

hassles over documentation are less.

Given the strong structural growth drivers for the housing finance industry, the company's

robust business model and well-focused management team, we believe that Can Fin Homes

has the right ingredients that offer both safety and growth. It is noteworthy that the company

has a track record of consistent dividends since its listing in 1991.

Growth without compromise in asset quality

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More about Can Fin Homes Ltd

Can Fin Homes Ltd is a 26-year old institution registered as a deposit taking Housing Finance

Company (HFC) with the National Housing Bank (NHB). The company was listed in 1991

and is promoted by Canara Bank which has 42.38% stake in the company. The company is

headquartered in Bangalore and has 103 branches across India in over 15 states. The

company's loan book has grown at an average annual rate of 38% over the last three years,

with 70% share coming from South India. The average loan ticket size stands at Rs 16 lakh

and majority of individual loans are towards salaried class, while the average age of

individual borrower is around 35 years. At the end of March 2014, the share of non housing

loans stood at 8.04%. The capital adequacy ratio for the company at the end of March 2014

stood at 13.8% while net interest margins in FY14 came at 2.7%.

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How Can Fin Homes Ltd will boost its fortunes...

1. Strong promoter backing

Can Fin Homes Limited is promoted by Canara Bank which is one of the largest

nationalized banks in India in association with reputed financial institutions including

HDFC and UTI. With Canara Bank's 42.4% shareholding in Can Fin Homes, the

company benefits largely from the bank's huge brand image and the goodwill it enjoys

in South India. Moreover, a rich legacy and experience of the promoter always serves

as a strong backup for the company.

2. Healthy funding mix backed by superior credit rating

Can Fin Homes by the virtue of strong credit

ratings and National Housing Bank (NHB)

refinance support has been able to maintain

healthy and low-cost funding mix. Superior

ratings from the top two rating agencies have

ensured Can Fin Homes to set competitive

rates in the market. And the NHB funding to

the extent of 41% (as at the end of FY14) has

been the icing on the cake. This has enabled

the company to create its own niche in the

southern states of the country and has enabled it to keep costs in control thereby

supporting margins.

3. Business turnaround on the back of branch expansion and buoyant demand

Until FY11, the business of the company stood dormant in terms of negligible credit

and branch network expansion. Post the new management team that took charge in

FY11, the fortunes of Can Fin Homes' business started improving drastically and it

witnessed a complete overhaul of its business model. Centralization of the processes,

strengthening of the employee base, sales through agents and most importantly rapid

expansion of branch network set the ball rolling for the company's business. And then

there was no looking back. The loan book for Can Fin Homes grew annually at

staggering rates of 21.1%, 51.6% and 45.9% for FY12, FY13, and FY14 respectively.

New management since 2011 boosts growth

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This was fairly commensurate with the branch network growth of 26.8%, 32.7% and

20.3% for FY12, FY13, and FY14 respectively. The incremental loan growth for the

company largely emanated from the increased branch network. This coupled with a

strong marketing network enabled the company to penetrate deeper and enhance the

level of business significantly. Besides, the company's major thrust on the expansion of

retail loan portfolio continues to drive the credit off-take. While 90% of the loan pie

comes from housing finance portfolio, merely 10% emerges from the risky non-

housing segment.

It is also noteworthy that the branch network grew 100% in a short span of just three

years. Moreover, we believe that the company is poised to maintain the growth

momentum in the coming years. Thus, stable interest rates, increasing demand for

housing loans and subsequent strong growth in disbursements supported by rapid

branch expansion would enable Can Fin Homes to maintain healthy growth

momentum in its loan book going forward. Moreover, the company continues to bank

upon the growing buoyancy in the southern property market that would aid the

aggressive credit expansion target. We envisage a conservative 16.6% CAGR in total

loans at the end of FY18 and reckon that the company could surprise us positively on

this count.

4. Shortest turnaround time supports the loan growth too

Despite the prevalent higher interest rates, Can Fin Homes continues to witness

increasing demand for loans. And that's purely because the loan turnaround time is

among the shortest. And that also becomes the unique selling proposition (USP) of the

company's lending business. Shortest turnaround time of 7 days and lesser

documentation hassles backed with expertise over housing loan finance segment set

the company apart from the competition.

5. But no compromise on quality

Aggressive loan book expansion has not deterred the quality of the loan book by any

means. In fact, the improvement in asset quality has been directly proportional to the

loan growth for the last three years. The gross non-performing assets (NPAs) that stood

at 1.1% in FY10, reduced sharply to 0.2% in FY14 despite the aggressive loan book

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expansion in the recent years. Interestingly, of the Rs 63.55 billion loan book (at the end

of quarter ended June 2014), a meager amount of Rs 0.12 billion account for non

performing assets (NPA). Also, with 100% provisioning policy, the net NPA has

remained nil over the last five years.

That's primarily because the company lends

to the secured salaried class that forms almost

88% of the total customer base. And what

more, 50% of this salaried customer base is

employed with public sector units that all the

more ensure a regular flow of loan

repayments. Thus, only remaining 12% of the

borrowers are self-employed which is one of

the biggest reasons that the company has

been able to maintain impeccable asset

quality over the years. Not just that, the loan-to-value ratio for housing loans stands at

75% of the registered value of the property and 50% for the mortgage loans. This

conservative strategy has also helped the company to keep the NPA additions at bay.

6. Secured loan portfolio and operating efficiencies support the earnings growth

Buoyant loan growth expansion backed by secured mix coupled with improving cost

efficiencies have led to superior earnings growth for the company post the business

turnaround. Despite aggressive network expansion, the cost-income ratio at 28.3%

(FY14) has remained under control and in fact has declined on annual basis.

Moreover, stable risk-free loan yields and costs benefits have ensured stable average net

interest margins (NIM) of 3.4% for past three years.

Consequently, the three-year compounded annual growth rate (CAGR) for earnings has been

21.7% (FY11 to FY14) and is expected to remain healthy in the coming years. Thus, consistent

credit growth, stable NIMs and superior asset quality have led to healthy return ratios. We

expect the company to clock average return on equity (ROE) of 17.4% and average return on

assets (ROA) of 1.3%-1.4% over the next 4-year period.

Cost/Income ratio down despite growth in FY14

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Key challenges for Can Fin Homes

1. Lower income growth in smaller towns

Players like Can Fin Homes are largely focused on garnering business in smaller towns

and cities where banks and larger housing finance companies do not have sufficient

reach. In the past few years, the per capita income and consumption growth have kept

pace with that in the metros thus offering a very healthy momentum to financiers like

Can Fin. However, in the event of economic slowdown, the incremental growth of

smaller mortgage financiers can certainly take a hit.

2. Stiff competition from other housing finance companies and banks

Since Can Fin Homes largely caters to the salaried class, most of them being PSU

employees, nearly all banks (particularly PSU ones) and housing finance companies

are its competitors. This is because, the kind of credit appraisal and documentation

that Can Fin adheres to is very similar to that of any other mortgage lender. In fact, its

own parent Canara Bank can be its key competitor. The addition of new banks or

consolidation of PSU banks could also cannibalize the market share of mortgage loans

of smaller players.

3. Rise in provisioning costs

As mentioned earlier, Can Fin Homes has shown a very conservative approach in its

provision policy and has consistently improved its NPA ratios over the past 3 years.

However, given the fact that the company got aggressive in expanding its loan book

only since FY11, it is too early to say that such impeccable asset quality will be

sustained. Hence the risk that the company may have to provide more for NPA risk in

the coming years is real. We have accounted for this risk and have accordingly given

the company discounted valuations compared to the best housing finance companies.

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Risk Analysis

1. Regulatory Risk

Some businesses are subject to regulations by external government agencies. These

companies are subject to regulatory risk since they do not have the liberty to operate in

a free environment. Excessive regulations can create bureaucratic hassles and impede

growth. Thus, higher the regulation, higher is the risk for any business. The housing

finance sector is subject to various regulations imposed by the Reserve Bank of India

and National Housing Bank in terms of capital adequacy, lending norms, provisioning

requirements etc.

2. Cyclically Risk

An industry cycle is characterized by an upturn as well as downturn. Businesses

whose fortunes typically swing with industry cycles are known as cyclical businesses.

Cyclical businesses do well during an industry upturn and vice versa. On the other

hand, there are some businesses based on consumption stories that are non-cyclical.

These businesses are immune to industry cycle changes and have less risk. In short, if

the business is cyclical higher is the risk. The housing finance sector is extremely

cyclical and is in fact a reflection of the macro economy.

3. Competition Risk

Every industry is characterized by competition. However, some industries where entry

and exit barriers are typically low have higher competition risk. Low barriers means

more players can enter into the industry thereby intensifying competition. Low

product differentiation also intensifies competition risk. The Indian housing finance

sector is already very competitive with most banks and non-banking finance

companies (NBFC) offering mortgage finance. Plus the entry of new banks is expected

to intensify competition in the coming years.

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4. Income growth

Over the nine year period (actual history of past 5 years and explicit forecast for the

next 4 years) Can Fin Homes income CAGR is 18.8%.

5. Net Profit Growth

Over the nine year period (actual history of past 5 years and explicit forecast for the

next 4 years) the net profit CAGR is 15.6%.

6. Net interest margin

Net interest margin (NIM) is a measurement of the spread that the financial entity

makes on its average earning assets (typically loans, investments and balance with

other banks). Banks that are able to fetch sufficient low cost funds and lend them with

a good spread or invest in high yielding assets have steady NIMs. The higher the NIM,

the easier it is for financial entities to tide over volatility in interest rates. The average

NIM for Can Fin Homes over the 9 year period (actual history of past 5 years and

forecast for the next 4 years) stands at 3.1%, which is in-line with the average NIMs of

housing finance companies (HFC).

7. Net profit Margins

Net profit margin is a measurement of what proportion of a company's revenue is left

over after paying for all the variable and fixed costs inclusive of interest and

depreciation charges. Net margin is the final measure of profitability. It reflects the

total profits the company takes home. Higher the margin, better it is for the company

as it indicates better pricing power and effective cost management. The average net

margins over the 9 year period (actual history of past 5 years and explicit forecast for

the next four years) stand at 15.7%.

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8. Return on net worth (RoNW)

RoNW is an important tool to assess a company's potential to be a quality investment

by determining how well the management is able to allocate capital into its operations

for future growth. A RoNW of above 15% is considered decent for companies that are

in an expansionary phase. The average RoNW over the 9 year period (actual history of

past 5 years and explicit forecast for the next 4 years) stands at 16.0%.

9. Cost to income ratio

This ratio helps assess the operating cost efficiency of a financial entity. It primarily

takes into account the operating cost for the company vis-a-vis income by way of net

interest earned and other income. Financial entities that are lean in terms of cost to

income ratio manage to retain a healthy profit margin across cycles. The average cost

to income ratio for Can Fin Homes over the 9 year period (actual history of past 5 years

and forecast for the next 4 years) stands at 27.8%.

10. Transparency

Transparency is the key to any business. Transparency can be gauged by assessing the

past dealings of the company with various stake holders be it the customers, suppliers,

distributors or shareholders. The easiest way to gauge the same is checking the level of

disclosures in the company's quarterly financial updates and communication with

minority shareholders. Most importantly, the management's willingness to explain its

stance if there is a negative development in the company or stock shows its

forthrightness. Transparent managements would get a higher rating. The management

of Can Fin Homes has been reasonably transparent in its operations. However there is

always room for improvement.

11. Capital allocation

Apart from honesty, capital allocation skills are equally important in assessing

management quality. By capital allocation we mean how the management chooses to

deploy capital in the business or across businesses. Managements that have in the past

destroyed shareholder wealth by diversifying in unrelated, unviable businesses or

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make expensive acquisitions would rank low on this parameter. Further managements

that focus on capital intensive growth at the cost of profitability would also fetch a low

rating. The management of Can Fin Homes has a good track record in terms of capital

allocation. The company is standing on a growth trajectory and is well geared to take

up to next level.

12. Promoter Pledging

Promoters typically pledge their shares to take a loan which is generally infused in the

company. This exercise is generally resorted to when all other sources of external

liquidity dry out. The risk with this strategy arises when share price falls. This triggers

margin calls. If management is unable to provide some sort of a collateral to the

lending party from whom the money is borrowed that party may sell the shares to

recover its money. This accentuates the share price fall. Hence, higher the promoter

pledging higher is the risk. With none of the promoters' equity being pledged.

13. Net NPA to advances

A good asset quality is the hallmark of good lending practice of a financial entity.

Financial entities that tend to have high non-performing assets (NPAs) during periods

of economic stress deserve a lower rating. Ones that have average net NPA ratio in

excess of 1.5% are particularly risky. The average net NPA to advances ratio for Can Fin

Homes over the 9 year period (actual history of past 5 years and forecast for the next 4

years) stands at 0.02%. Given that the asset quality of the company stands one of the

best in the industry and is expected to remain stable (despite being conservative with

future projections).

14. Capital adequacy ratio (CAR)

This is one of the most important factors that are used to judge the soundness and

sustainability of a financial institution's business over the longer term. It shows the

ratio of capital to assets financed. The RBI has stipulated a minimum CAR of 15% for

NBFCs as per Basel II and 12% minimum CAR is stipulated by NHB. Since Can Fin

Homes CAR at the end of March 2014 stood over 13%.

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Why Is the Stock Worthy Of Investment

Under the leadership of the new management team since FY11, Can Fin Homes has

transformed into a strong player in the retail housing finance market over the last three years.

With a well-crafted business strategy focusing on quality growth the company is poised to

tap the affordable housing finance market potential. The company boasts of a rich dividend

payout since its early years. Niche lending business, faster turnaround time for loans and

secured loan book backed by prudent risk management practices makes Can Fin Homes the

preferred choice for the home loan borrowers in the semi-urban and rural markets.

What more, the strategic branch locations serving customers of relatively small size (average

loan ticket size of Rs 16 lakh) have enabled the company to carve its own niche in the highly

competitive housing finance market. Moreover, the company's huge customer base typically

comprising of salaried class ensures healthy loan book for the company. Besides, the growing

branch network with faster break-evens would continue to aid robust loan book expansion

going forward.

To put into numbers, the loan book for Can Fin Homes has grown at a compounded annual

growth rate of 38.5% for the last three years (FY11-FY14). Both net interest income and

profitability have grown at a compounded average growth rate (CAGR) of around 26.2% and

21.7% respectively over the last three years. Superior earnings profile has also translated into

higher return ratios for the company. The return on equity (ROE) and return on asset (ROA)

have stood at over 17.9% and 1.5% respectively as at the end of FY14.

Strong parentage, sound financial, impeccable asset quality, robust return ratios and healthy

dividend payout makes the stock worthy of investment. Moreover, it a value play riding the

theme of the promising housing finance market that is poised to grow with the improving

economic prospects and the government thrust on housing and developing smart cities.

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Rationale for valuation

The banking and mortgage finance sector is dependent on credit growth, which comes from

both corporates as well as retail. This is in turn a function of how well the economy is

performing. Unlike other sectors, a mortgage finance company's asset is cash and the ability

to grow the top line is therefore, largely dependent on the capital base (net worth in a broader

sense). Therefore, more than the price to earnings ratio, the adjusted price to book value

(P/BV) is relevant while valuing a mortgage finance company stock. By adjusted P/BV, we

mean reducing net non-performing asset from the net worth and then, dividing it by the

number of shares.

Considering the economies of scale that the business model of Can Fin Homes provides on

account of niche positioning, robust fundamentals, superior growth prospects backed by

strong capital sufficiency, we value it at price to adjusted book value multiple of 1.0 to 2.0

times estimated FY18 adjusted book value. Owing to the entity's short financial history and

small size of the asset book, we have chosen to value the company at a discount to its peers.

Nonetheless, we remain confident of the promising business prospects of the company in the

long-run.

Comparative Valuations

FY14 Can Fin Homes Repco Home Finance

Loan growth (%) 45.9 34.0

Net interest margins (NIMs, %) 3.1 5.5

Net NPA/ Net advances* (%) - 1.2

Return on Equity (%) 17.9 17.8

Return on Assets (%) 1.5 2.8

Valuations (FY14)

Price to adjusted book value (x) 2.1 4.1

Dividend yield (%) 1.4 0.3

* Can Fin Homes Ltd had nil net NPAs in FY14

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Financials at a glance

(Rs m) FY13 FY14 FY15E FY16E FY17E FY18E

Net Interest Income 1,095 1,550 1,779 2,036 2,367 2,721

Net Interest Income growth (%) 20.8 41.6 14.8 14.5 16.2 14.9

Net Interest Margins (%) 3.3 3.1 2.7 2.6 2.6 2.6

Operating profit margin (%) 18.8 19.3 16.3 15.4 14.6 13.7

Net profit 541 759 860 973 1,116 1,254

Net profit margin (%) 13.8 13.1 11.1 10.2 9.7 9.0

Balance Sheet

Loans and advances 39,955 58,306 72,039 84,851 98,596 114,181

Fixed and other assets 556 662 781 950 1,258 1,813

Investments 159 149 152 155 160 164

Total Assets 40,670 59,117 72,972 85,957 100,014 116,158

Current liabilities 5,366 6,731 9,087 6,906 2,693 2,693

Net worth 3,922 4,523 5,215 6,020 6,968 8,054

Borrowings 30,730 46,947 56,304 68,715 83,864 102,351

Provisions 652 916 2,366 4,316 6,489 3,060

Total liabilities 40,670 59,117 72,972 85,957 100,014 116,158

Valuations

(Rs m) FY13 FY14 FY15E FY16E FY17E FY18E

Revenue (Rs m) 1,095 1,550 1,779 2,036 2,367 2,721

PAT (Rs m) 541 759 860 973 1,116 1,254

EPS (Rs) 26.4 37.0 42.0 47.5 54.5 61.2

Adj. book value (Rs) 191.4 220.8 253.8 293.0 338.0 389.7

Price to adj. book value (x) 2.4 2.1 1.8 1.6 1.4 1.2

Price to earnings (x) 17.7 12.6 11.1 9.8 8.6 7.6