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Anand Rathi Financial Services, its affiliates and subsidiaries, do and seek to do business with companies covered in its research reports. Thus, investors should beaware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in makingtheir investment decision. Disclosures and analyst certifications are located in Appendix 1.
Anand Rathi Research Ind
India I EquitiesFinancial Services
Sector Report
Parag Jariwala+9122 6626 6707
Clyton Fernandes+9122 6626 6744
24 August 2010
Non-Banking Finance Companies
Opportunities galore
OverweightNifty/Sensex: 5531/18402
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Anand Rathi Financial Services, its affiliates and subsidiaries, do and seek to do business with companies covered in its research reports. Thus, investors should beaware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in makingtheir investment decision. Disclosures and analyst certifications are located in Appendix 1.
Anand Rathi Research Ind
India I EquitiesFinancial Services
Sector Report
Parag Jariwala+9122 6626 6707
Clyton Fernandes+9122 6626 6744
24 August 2010
Non-Banking Finance Companies
Opportunities galore
We see strong business prospects for select large NBFCs owingto likely huge investment in Infrastructure and latent demand onaccount of improving rural economy. We expect NBFCs to bebetter-placed than banks in their respective domains, given theirniche expertise and regulatory advantages. We prefer REC andMMFS, on higher growth opportunities, strong earnings
visibility and better profitability, vis--vis peers.
Opportunity unlimited.We expect IDFC, PFC and REC tobenefit from likely large investments in Infrastructure and lead to
funding requirements of`2.3trn in FY11e and`2.8trn in FY12e.STFC could benefit from up-tick in economic activity, higherfreight movement and subsequent demand for used-CV loans.MMFS is poised to reap rewards of an improving rural economy,led by better monsoons and higher rural disposable income.
Niche expertise, regulatory benefits. Niche expertise, adequatecapital, high credit rating and hence lower cost of funds, better
asset-liability management and lower operating costs place ourcoverage NBFCs at an advantage over banks. The RBI recentlyawarding IFC status to IDFC and PFC is positive for bothbusiness growth and margins. For our coverage universe, weexpect robust loan growth (+25% CAGR over FY10-13e), aheadof banks (~20%).
Top picks REC and MMFS.We prefer stocks with highergrowth opportunities, strong earnings visibility and betterprofitability vis--vis peers and, hence, favour REC and MMFS.
Risks. i)Slowdown in economic growth; thereby, infrainvestments/rural income could impact business growth and assetquality; ii) high dependence on non-retail borrowings could hurtspreads, if interest rates sharply rise.
OverweightNifty/Sensex: 5531/18402
RoA vs PBV for our coverage NBFCs
REC
IDFC
PFC
MMFS
STFC
1.0
1.5
2.0
2.5
3.0
2.0 2.5 3.0 3.5 4.0 4.5
RoA
PBV
Source: Company, Anand Rathi Research
Sector valuation matrixRating Price ( ) Target ( ) M cap (US$bn) PE (x)* PBV (x)* RoE*
REC Buy 327 425 6.9 10.0 2.2 23.4
PFC Buy 333 408 8.2 11.2 2.1 20.4
IDFC Buy 183 219 5.9 17.6 2.3 13.9
MMFS Buy 595 748 1.2 10.5 2.4 23.9
STF Buy 769 934 3.7 11.3 2.8 27.9
Source: Company, Anand Rathi Research (* FY12e)
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Investment Argument & Valuation
We see strong business prospects for select large NBFCs owing tolikely huge investment in Infrastructure and latent demand onaccount of improving rural economy. We expect NBFCs to be
better-placed than banks in their respective domains, given theirniche expertise and regulatory advantages. We prefer REC andMMFS, on higher growth opportunities, strong earnings visibilityand better profitability, vis--vis peers.
Opportunity unlimited
Infrastructure Finance
IFCs are set to benefit from the likely huge investment in the infrastructuresector. As per the Planning Commissions revised estimates (as on Mar10), infrastructure investments for FYP XI (FY08-12) and FYP XII
(FY13-17) stand at US$514bn and US$1,025bn respectively. This implies~2.3x and ~4.5x increase versus actual infrastructure investments in FYPX (US$227bn).
As per the study conducted in Jul 10 by the RBI on infrastructurefinancing, debt requirement is estimated at`2.3trn and`2.8trn for FY11eand FY12e respectively, with limited debt funding in both years. The debtfunding gap is estimated at`734bn over the next two years (`341bn in
FY11e and`392bn in FY12e). Total funding gap for FYP XI is estimatedat`1.6trn.
We expect strong disbursements growth for IFCs on account of hugefunding requirement and banks having almost reached their internal
exposure limits for infrastructure lending. Banks have funded ~50% of thetotal investment in Infrastructure in the first three years (i.e., FY08-10) ofFYP XI. Banking funds will be limited going forward owing to sectoral cap(Infrastructure accounts for ~12% of total credit) and asset liability profile.
Transport Finance
We expect the transport industry to benefit from higher GDP and betteragriculture growth in FY11e vis--vis FY10. Due to weak connectivity inrural areas, freight capacity is expected to grow faster than GDP. Higherdisposable income of rural population will drive auto demand in ruralIndia. We expect strong loan growth for auto financing companies.
While we expect STFC to benefit from an up-tick in economic activity,higher freight movement and subsequent demand for used-CV loans,MMFS is poised to reap rewards of an improving rural economy, led bybetter monsoons and increasing rural disposable income.
Niche expertise, regulatory benefits
Over time, NBFCs have developed niche expertise in their respectivefields, which has resulted in better understanding of business and strongcustomer relationship in rural India. Higher government holdings (RECand PFC), enhanced capital adequacy (IDFC and STFC) and strongparentage (MMFS) have led to higher credit rating.
Shortage of funds for infrastructure
projects is estimated at`734bnover FY10-12e
Rural prosperity to drive transportindustry
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Better asset liability profiles
IFCs fund long-term infrastructure projects that entail similar maturity ofliabilities (duration gap between assets and liabilities is not more than 1year). STFC and MMFS have negligible duration gap; STFC has higherduration of liabilities than assets (and is the only NBFC with positive
duration).Lower operating cost
IFCs have lower operating cost compared with banks due to absence ofliability franchises, concentrated lenders and smaller employee base.Economies of scale have resulted in lower operating cost for STFC andMMFS as against banks.
Well-managed asset quality
Delinquencies in infrastructure financing are considerably low to negligible.Credit cost is almost nil for REC, PFC and IDFC. STFC and MMFS havegradually developed sound methods of evaluating loan proposals and
assets as well as collection. This has helped them keep credit cost undercheck.
Regulatory benefit
To ensure adequate funding to infrastructure projects, the government hastaken various initiatives. These include granting IFC status that will helpincrease exposure limits, which, in turn, will drive: i) business growth, andii) lower cost of funds due to infrastructure bonds and higher ECBs.
Further, to take care of the huge funding requirement, government has setup India Infrastructure Finance Company (IIFCL) and initiated theconcept of an Indian infrastructure debt fund (fund size is likely to be~`500bn).
RBI recently granting IFC status to IDFC and PFC is positive for bothbusiness growth and margins. Further, REC is likely to be granted IFCstatus by end-Sep 10.
Strong loan growth and sustainable superior return ratios
Huge opportunity for loan growth and superior model combined withstrong pricing power is likely to translate into higher return ratios forNBFCs. We expect a strong loan growth (+25% CAGR over FY10-13e),ahead of banks (~20%). NBFCs RoA is likely to be higher than banks 2.5-4% for NBFCs versus 1-1.5% for banks.
ValuationWe have used the two-stage dividend discount model (DDM) to arrive atour target price (SOTP for IDFC, with its core lending business based onthe two-stage DDM), as we expect higher asset growth than RoE (postdividend) for our NBFC universe.
Our assumptions for normalised RoE are based on the RoE that NBFCscan generate on a long-term sustainable basis. Our assumption for risk freerate (Rf) and market risk premium (Rm) are 7.5% and 6.5% respectively.
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Fig 1 NBFCs DDM assumptionsREC PFC IDFC MMFS STF
Terminal growth (%) 5.0 5.0 5.0 5.0 5.0
Risk free rate - Rf (%) 7.5 7.5 7.5 7.5 7.5
Risk premium - Rm (%) 6.5 6.5 6.5 6.5 6.5
Beta 1.0 0.9 1.3 1.2 1.0 CoE (%) 14.0 13.4 15.8 15.3 14.0
EPS CAGR FY11-FY16e (%) 22.3 22.0 29.3 23.9 23.5
EPS CAGR FY16-FY20e (%) 11.2 12.2 15.9 13.1 13.1
Target Price (`) 425 408 219 748 934
BV FY12 (`) 150 158 79 249 273
Implied target P/BV (x) 2.8 2.6 2.8 3.0 3.4
Value of subsidiaries (`) - - 34 - -
Recommendation Buy Buy Buy Buy Buy
Source: Anand Rathi Research.
Risks
Slowdown in infrastructure investments could result in lower assetgrowth for IFCs. Slower economic growth and a below-normalmonsoon could impair rural cash flow, thereby impactingdisbursements growth for STFC and MMFS.
REC and PFC have higher exposure to state electricity boards (SEBs),the financial health of which is a concern. Although interest paymentsare secured against the cash flow, any further increase in losses ofSEBs is likely to impact asset quality.
STFC and MMFS lend to riskier asset classes. Economic slowdowncan increase the delinquency rate and, subsequently, increase creditcost.
Unlike banks, NBFCs depend on non-retail borrowing. Tighterliquidity scenario would not only increase the cost of funds, but alsoimpact growth prospects (due to shortage of funds).
Recommendations
Rural Electrification Corporation (Buy; Target price: `425/share)
REC is well placed to reap the benefit of the huge capacity addition andinvestment in T&D. It enjoys strong pricing power as it is a key lender toSEBs. We expect REC to register earnings CAGR of 26% over FY10-13eon the back of strong loan growth and stable margins (due to strong
pricing power and likely IFC status).
We estimate that RECs RoA and RoE would remain high at +3% and+23% respectively, over FY10-13e. Our target price of`425/share isbased on the two-stage DDM (CoE: 14%; Beta: 1; Rf: 7.5%). At our targetprice, the stock will trade at PBV of 2.8x in FY12e and 2.4x in FY13e.
Power Finance Corporation (Buy; Target price: `408/share)
PFC is likely to see huge benefit from the likely massive investment inpower capacity over FY10-13e. Capital raising in FY11 would supportbusiness growth. The companys IFC status, high productivity and lowcredit costs would result in 21% EPS CAGR over FY10-13e.
PFC offers a fine combination of resilient growth and value. Our targetprice of`408/share is based on the two-stage DDM (CoE: 13.4%; Beta:
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0.9; Rf: 7.5%). At our target price, the stock will trade at PBV of 2.6x inFY12e and 2.2x in FY13e.
IDFC (Buy; Target Price: `219/share)
We are positive on IDFC, as it is poised to benefit from the infra-lending
opportunity, backed by its credible risk-management skills, high capitaladequacy and low leverage. Further, the IFC status is beneficial both forbusiness growth and for protecting spreads.
Management targets growing its balance sheet 3x in the next three years,led by the existing infrastructure lending opportunity. We expect 33% loanbook CAGR over FY10-13e. Now classified as an IFC, IDFC will enjoyenhanced single/group borrower limits and higher exposure limits forbank-borrowings, enabling robust balance-sheet growth. Also, lower risk
weights for its funding, easier access to ECBs, ability to issue tax-freebonds and its recent equity issue are likely to be positive for spreads.
Our SOTP-basedvaluation gives us fair value of`219/share; we value thelending business at `185 (2.3x FY12e BV, based on the two-stage DDM;CoE: 15.8%; Beta: 1.3; Rf: 7.5%) and other businesses and investments at`34/share. Risks are drastic slowdown in infrastructure spending andfailure to mobilise resources for the AMC business.
M&M Financial Services (Buy; Target Price: `748/share)
MMFS is well placed to tap the strong rural demand backed by its nichepresence in rural markets. Its strong parentage and diversified branchnetwork is likely to support business growth. We expect NIM to sustain at+11.5% over FY10-13e owing to the companys strong pricing power.High NPA coverage of 82% and stable credit costs (~3%) are likely tokeep RoA at +4% over FY10-13e.
MMFS is a resilient play on Indias growing rural prosperity. Given itsstrong business growth and superior return ratios, we believe that the stock
has potential of re-rating. Our target price of`748/share is based on thetwo-stage DDM (CoE: 15.3%; Beta: 1.2; Rf: 7.5%). At our target price, thestock will trade at PBV of 3x in FY12e and 2.5x in FY13e.
Shriram Transport Finance Company (Buy; Target price: `934)
STFC is well poised to capitalise on the up-tick in economic activity andfreight movement. Its business model is structurally superior to peers anddifficult to replicate.
Over FY05-10, STFC traded at ~2x PBV and average RoA of ~3%. Webelieve these valuations will sustain, as we expect STFC to maintain RoA at+4% over FY10-13e led by strong loan growth, improving margins andstable asset quality. Our target price of`934/share is based on the two-stage DDM (CoE: 14%; Beta: 1; and Rf: 7.5%). At our target price, thestock will trade at P/BV of 3.4x in FY12e and 2.7x in FY13e.
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Fig 2 Non-banking finance companies ValuationsREC PFC IDFC MMFS STFC
Current price ` 327 333 183 595 769
`bn 323 382 274 57 173 Market Cap
US$ bn 6.9 8.2 5.9 1.2 3.7
Target price ` 425 408 219 748 934 Upside % 30.0 22.4 19.7 25.7 21.4
Recommendation Buy Buy Buy Buy Buy
FY10-13e EPS CAGR 26.0 21.4 25.9 24.9 29.4
FY11 2.5 2.5 2.6 2.9 3.6
FY12 2.2 2.1 2.3 2.4 2.8 PBV (x)
FY13 1.9 1.8 2.1 2.0 2.2
FY11 12.6 13.6 21.7 13.1 14.2
FY12 10.0 11.2 17.6 10.5 11.3 PE (x)
FY13 8.1 9.1 14.5 8.5 9.2
FY11 3.3 3.0 3.0 4.3 4.1
FY12 3.3 2.9 2.9 4.3 4.3 RoA (%)
FY13 3.2 2.9 2.8 4.2 4.4
FY11 21.5 19.5 14.3 23.1 28.1
FY12 23.4 20.4 13.9 23.9 27.9 RoE (%)
FY13 24.9 21.3 15.0 24.4 27.2
FY11 129 135 73 205 216
FY12 150 158 81 249 273 BV (`)
FY13 176 186 91 303 343
FY11 25.9 24.4 8.7 45.6 54.3
FY12 32.6 29.9 10.7 56.5 68.0 EPS (`)
FY13 40.5 36.6 12.9 69.8 83.9
Dividend yield (%) FY11 2.4 1.5 0.9 1.5 0.0
FY11 0.0 0.0 0.4 7.0 3.1
FY12 0.0 0.0 0.4 7.1 3.3 Gross NPAs (%)
FY13 0.0 0.0 0.4 7.3 3.5
FY11 0.0 0.0 0.2 1.0 0.6
FY12 0.0 0.0 0.1 1.0 0.6 Net NPAs (%)
FY13 0.0 0.0 0.1 1.1 0.6
Source: Bloomberg, Anand Rathi Research.
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Opportunity unlimited
We expect IDFC, PFC and REC to benefit from likely largeinfrastructure investments, leading to funding requirements of
`2.3trn in FY11e and `2.8trn in FY12e. While we expect STFC tobenefit from an up-tick in economic activity, higher freightmovement and subsequent demand for used-CV loans, MMFS is
poised to reap rewards of an improving rural economy led by bettermonsoons and increasing disposable income.
Infrastructure Finance
FYP XI and FYP XII infrastructure spend targeted at US$514bn and US$1trn, which is2.3x and 4.4x of FYP X spend respectively
As per the Planning Commissions revised estimates, Infrastructureinvestments for FYP XI (FY08-12) and FYP XII (FY13-17) stand atUS$514bn and US$1,025bn respectively. Total investment in Infrastructureis expected to increase to 7.6% and 9.95% of GDP, implying increase of~2.3x and ~4.4x during FYP XI and FYP XII respectively. This is asagainst increase of 5.1% of GDP during FYP X, entailing actualinfrastructure investments of US$227bn during FYP X.
Fig 4 Infrastructure spend to touch US$1trn (~10% of GDP) by FYP XII
227
514
10255.55
8.20
9.95
0
200
400
600
800
1,000
1,200
FYP X FYP XI FYP XII
0
2
4
6
8
10
12
Infrastrcture investment % of GDP (RHS)
(US$ b) (%)
Source: Planning Commission, Anand Rathi Research.
Power accounts for 32% of the total investment in Infrastructure, followedby roads & bridges at 14%. Investments have mainly increased (FYP-on-FYP) in Power (up 128%), Roads (116%), Telecom (150%), Railways(127%) and Irrigation (126%). These together contribute ~90% of theplanned investment in Infrastructure under FYP XI.
Infrastructure spend to account for~10% GDP by FYP XII
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Huge debt-funding requirement
Total infrastructure investment over FYP XI is estimated at`21trn. Ofthis, 52% will be funded via non-debt fund and 48% through debt fund. Asper a study conducted in Jul 10 by the RBI, on infrastructure financing,debt requirement is estimated at`2.3trn and`2.8trn in FY11e and FY12erespectively.
Fig 9 Infrastructure spend and debt funding requirement` bn FY08 FY09 FY10 FY11 FY12 FYP XICentre 1,126 1,283 1,485 1,721 2,040 7,656
State 795 990 1,250 1,602 2,072 6,709
Private 782 943 1,157 1,468 1,847 6,196
Total 2,703 3,216 3,893 4,791 5,959 20,562
Non-debt 1,386 1,659 2,019 2,495 3,122 10,681
Debt 1,317 1,557 1,883 2,296 2,837 9,880
Source: RBI, Anand Rathi Research.
Shortage of debt fund
Debt fund availability will be limited in FY11e and FY12e to`1.9trn and
`2.4trn as against likely debt requirement of`2.3trn and`2.8trn
respectively. The debt funding gap is estimated to be`734bn over the nexttwo years (`341bn in FY11 and`392bn in FY12). Total funding gap for
FYP XI is estimated at`1.6trn, which is 16-17% of total available debt
funds.
Fig 8 - Funding pattern FYP XI
Budgetarysupport
45%
FDI8%Equity
6%
ECBs6%
Insurance Co4%
NBFC (incl.IIFCL)10%
CommercialBanks21%
Source: RBI, Anand Rathi Research
Fig 7 Share of sources of debt in infrastructure debtCentral government
InternalGeneration
22%
Borrowings
52%
Central Budget26%
State governments
States Budgets66%
Borrowings
24%
InternalGeneration
10%
Private sector
InternalAccruals/Equity
30%
Borrowings70%
Source: RBI, Anand Rathi Research.
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Fig 10 Infrastructure debt funding Requirement versus availability` bn FY08 FY09 FY10 FY11 FY12 FYP XIDomestic bank credit 498 632 801 1,016 1,289 4,237
NBFCs 239 315 416 549 724 2,242
Pension/insurance company 91 100 110 121 133 554
ECBs 196 218 242 269 299 1,223
Total debt resources 1,024 1,264 1,569 1,954 2,444 8,255
Debt requirement 1,317 1,557 1,873 2,296 2,837 9,880
Debt requirement (US$ bn) 33 39 47 57 71 247
Funding Gap 293 293 305 341 393 1,625
Funding Gap (%) 29 23 19 17 16 20
Funding Gap (US$ bn) 7 7 8 9 10 41
Source: RBI, Anand Rathi Research.
Banks close to reaching internal limits on infra lending
Infrastructure projects require long-term financing for being cost effectiveand sustainable. However, debt financing for infrastructure projects has
been largely confined to banks that have difficulty in providing long-termdebt due to asset-liability mismatch. Banks have funded 45% of the totalinvestment in Infrastructure in the first three years (i.e., FY08-10) of FYPXI. We expect strong disbursement growth for IFCs on the back of hugefunding requirement and banks almost reaching their internal limits forinfra lending.
Fig 11 Infrastructure funding mix
0
10
20
30
40
50
60
FY08 FY09 FY10 FY11 FY12 11th plan
Domestic Bank Credit NBFCs Pension/Insurance Co ECBs Source: RBI, Anand Rathi Research.
Availability of bank finance to infrastructure projects is likely to face
various constraints going forward, as:
1. many state-owned banks have already reached sector cap (12-15% oftotal credit) for Infrastructure;
2. also, higher lending to the infrastructure segment in FY09 and FY10 isrelated to slowdown in credit off-take by other sectors; with economicrecovery back on track, banks lending to the corporate/retail segment(better margins with low asset-liability mismatch) is likely to increase.
3. Bank lending to infrastructure is currently ~13% of outstanding loans.Banks exposure to other long-term funding, such as housing andeducation loan, is also high. Overall, ~33% of banks assets are currently in
the form of long-term loans, while the average maturity of banks liabilitiesis less than two years. Such asset liability mismatch would prevent furtherexposure of banks to infrastructure.
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Fig 12 Bank credit to Infrastructure as a percentage of industrial bank credit
0
5
10
15
20
25
30
35
FY98
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
Feb-10
May-10
(%)
Source: RBI, Anand Rathi Research.
Fig 13 Share of Power in overall bank infrastructure credit
0
10
20
30
40
50
60
70
F
Y98
F
Y99
F
Y00
F
Y01
F
Y02
F
Y03
F
Y04
F
Y05
F
Y06
F
Y07
F
Y08
F
Y09
(%)
Source: RBI, Anand Rathi Research.Transport finance
Increased focus on rural connectivity by government
In India, more than 60% of cargo (goods) is transported via road. Betterconnectivity in rural areas results in increase in economic and socialbenefits for rural population i.e., enhanced growth, employment, educationand healthcare opportunities. A nation-wide network of all-weather roadsin rural areas is critical for economic progress in rural India.
The government is investing heavily in developing better roads for higherconnectivity of villages and small towns, with the Central government setto build ~0.15m km of roads across India. This will lead to strong demandfor goods vehicles (especially small and mid-size CVs).
Freight capacity addition to be higher than GDP growth
Higher connectivity in rural India will boost industrialisation in villages andraise demand for increased transportation. Following the past trend, weexpect freight capacity to grow faster than GDP due to lower base andhuge requirement.
Economic recovery leads to enhanced auto demand
Better economic condition is the key demand driver for the auto industry.Over Oct 08-Sep 09, the auto industry witnessed a downturn owing toeconomic slowdown. Since then, improved economic activity has placed
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auto demand back on track. Revival in auto demand will act as a boon forauto finance companies.
Fig 14 Revival in auto demand
0
50
100
150
200
250
Apr-09
May-09
Jun-09
Jul-09
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
-50
0
50
100
150
200
Passenger Vehicles (PVs) Commercial Vehicles (CVs)
PV yoy growth (RHS) CV yoy growth (RHS)
('000) (%)
Source: SIAM, Anand Rathi Research.
PVs and CVs saw 34% and 63%growth respectively over
Apr-Jul 10
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Niche expertise, regulatory benefits
Niche expertise, adequate capital, high credit rating and hence lowercost of funds, better asset-liability management and lower operatingcosts place our coverage NBFCs at an advantage over banks. The
RBI recently awarding IFC status to IDFC and PFC is positive forboth, business growth and margins. For our coverage universe, weexpect robust loan growth (+25% CAGR over FY10-13e), ahead ofbanks (~20%).
Niche expertise based on vast experience
All NBFCs in our coverage universe have over a decade of experience intheir respective niche segments. They have, hence, developed a betterunderstanding of the business and healthy & long-lasting customerrelationships. They have also developed better procedures for loangeneration and valuation of underlying assets, which keeps delinquencies
under control. These NBFCs have presence across the value chain andprovide other ancillary services to their customers, thereby becoming theone-stop-shop for them.
Fig 15 NBFCs Niche expertiseName Year of Incorporation Experience (years) Positioning
REC 1969 40 - Operating under ministry of power, Navratna PSU- Enjoys strong relationship with Central and state governments- One of the few lenders to SEBs, thus strong pricing power- Nodal agency for RGGVY
PFC 1986 24 - Operating under ministry of power, Navratna PSU- Enjoys strong relationship with Central and state governments utilities (~90% of loan book)- Nodal agency for UMPPs (huge lending potential) and R-APDRP
IDFC 1997 13 - One of the few private players in infrastructure lending
- Presence across the value chain- Diversified lending (unlike REC, PFC) to mitigate segmental risk- Well capitalised to tap huge lending potential
STFC 1979 31 - Specialised in used-CV financing, with 20-25% market share- Expertise developed over the years for loan generation, asset valuation and collection- more than 450 branches and 1m loyal customers
MMMFS 1991 19 - Rich experience in and better understanding of rural auto financing- Strong brand name of the parent helps gain customer confidence- more than 400 branches and 1m loyal customers
Source: Company, Anand Rathi Research.
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Regulatory differences in favour of NBFCs
IFC status to reduce cost of funds
The RBI, in its circular dated 12 Feb 10, created a separate category forNBFCs IFCs comprise infrastructure financing and are non-deposit-taking systematically important (i.e., NBFC ND-SI). The other threecategories of NBFCs are asset finance companies (AFCs), loan companiesand investment companies.
Criteria for classification are:
Minimum of 75% of total assets should be deployed in infrastructureloans
Net owned funds of Rs3bn or above Minimum credit rating 'A' or equivalent by CRISIL, FITCH, CARE,ICRA or equivalent rating by any other accrediting rating agency CAR of 15% (with minimum tier-1 capital of 10%)
Fig 16 Regulation Key highlightsNorms Banks AFCs IFCs
CAR CAR requirement of 9%Tier 1 CAR of 6%
CAR requirement of 12%Tier 1 CAR of 6%
CAR requirement of 15%Tier 1 CAR of 10%
SLR requirement 25% of NDTL - 20% of deposits accepted frompublic- STFC and MMFS have 6-7% of
total borrowings via FDs
NA
CRR requirement 5% NDTL NA NA
Low cost fundingadvantage
- Banks has significant cost advantage due to higherCASA- CASA in the range of 30-35% for major banks
NA NA
- Currently, banks are allowed to lend:1) 15% (20% for infra) of owned funds to single
borrower2) 35% (50% for infra) of owned funds to group of
borrowers
- Currently NBFCs allowed to lend:1) 15% of owned funds to single
borrower2) 35% of owned funds to group
of borrowers
- Under IFC status, NBFCs are allowed tolend:
1) 25% of owned funds to singleborrower
2) 50% of owned funds to group ofborrowers
Relaxedconcentration/exposurenorms REC and PFC are being granted
exemption from concentration/exposurenorms (25% or 50%) for Central/stategovernment utilities or SEB lending
Standard asset provisions - RBI requirement of 0.4% of loans- Some banks prudently provide for higher provisions
- RBI does not require provisioningfor standard assets- STF and MMFS prudently
provides for future delinquencies
- RBI does not require provisioning forstandard assets- No provisions by IFCs
State guaranteed loans Risk weight = 100% Risk weight = 100% Risk weight = 20%- currently, REC and PFC have ~25% and~18% of loans guaranteed by state- lower CAR requirement, therefore moreleverage (higher return ratio)
NA NA - Companies are allowed to issueinfrastructure bonds under chapter VI A ofthe IT Act
- IFCs will issue ~Rs20bn each in FY11and FY12- Cost of borrowing ~150-200bps lower
than commercial borrowing rate
Infrastructure bonds
- Infrastructure bonds are exempt fromcredit rating- Lower cost of borrowings
ECBs Not allowed under automatic route Not allowed under automatic route - Companies can borrow up to 50% oftheir net worth under the automatic route- ECBs (partly hedged) cost will be 100-150bps lower
Source: RBI, Anand Rathi Research.
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As per these guidelines, PFC and IDFC have already been awarded IFCstatus (NBFC-ND-IFC). REC is likely to get IFC status by end-Sep 10.
We expect these companies to benefit, notwithstanding the increase incapital adequacy requirement.
Impact of higher CAR to be negated by reduced risk weight on state-
guaranteed loans for REC and PFC
Higher CAR requirement (minimum of 15% for IFCs compared with 12%for other NBFCs) will reduce leverage. REC and PFC will be able tonegate the higher CAR on the back of reduced risk weight on state-guaranteed loans. Central/state governments guarantee ~25% and ~18%of loans for REC and PFC respectively.
Fig 17 CAR calculation under IFC status (%)REC PFC
Loans NBFC status IFC status NBFC status IFC status
1) state-guaranteed 25 25 18 18
2) Others 75 75 82 82
Risk weights
1) state-guaranteed 100 20 100 20
2) Others 100 100 100 100
Total risk-weighted assets 100 80 100 86
CAR requirement (%) 12 15 12 15
Capital required 12 12 12 13
Source: Company, Anand Rathi Research.
Will absence of CASA deposits impact NBFCs?
Banks have significant advantage over NBFCs, in terms of low-costdeposits. Through their large branch network, banks can mobilise higheramount of CASA (saving deposits rate: 3.5%; current account rate: nil) andretail deposits. This entails lower cost of funds for banks compared withIFCs and AFCs (6-6.5%).
Factors negating lower cost of funds are:
A bank has to place 6% of NDTL with the RBI in the form of CRR,on which it does not earn any interest
Yield on SLR portfolio is in the 6.5-7.5% range, considerably lowerthan yield on overall portfolios of IFCs (11-11.5%) and NBFCs (15-18%)
Yield on loans for banks is 10-11%, which is ~100bps lower than yieldon loans for IFCs and much lower than AFCs.
NBFCs are likely to negate any pressure on spread (due to absence of lowcost deposits) via strong pricing power and no regulatory requirement tokeep 31% of funds (CRR and SLR) in low/no-return generating assets (Fig18).
Reduced risk weights on government-guaranteed loans to negate higher
CAR requirement
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Fig 18 Spreads (FY11e) NBFCs versus Banks
Yield on earning assets
0
2
4
6
8
10
12
14
16
18
20
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Cost of funds
0
2
4
6
8
10
12
14
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Spreads
0
2
4
6
8
10
12
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Source: Anand Rathi Research.
Superior yield on overall assets due
to absence of CRR and SLRrequirement and strong pricing
power
High cost of funds due to absence ofCASA, but high credit rating
keeps cost of funds under control
Higher yields on portfolio tosupport overall superior spread
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Fig 19 NIM (FY11e) NBFCs versus Banks
0
2
4
6
8
10
12
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Source: Anand Rathi Research.
High capital adequacy
Infrastructure finance
IFCs are required to maintain capital adequacy ratio of 15% (tier-1: 10%;and tier-2: 5%). Currently, CAR for REC and PFC stands at 17-19%(constitutes only tier-1) and for IDFC at ~26% (high, due to recentdilution of 12.2%). Higher capital will ensure dilution-free growth for RECand IDFC over the next 2-3 years. PFC is planning to raise capital by end-FY11.
Both REC and PFC have room for financing growth through tier-2 capital(up to 5% under their IFC status). This will increase leverage and, hence,lower dilution for equity shareholders.
Transport finance
CAR for STFC and MMFS is much higher than the regulatory requirementof 12%, which will ensure adequate capital for growth. SFTC has CAR of23% (tier-1 of 16%) and MMFS of 17.4% (tier-1 of 15.4%), as of 1QFY11.
Fig 20 Tier-1 CAR (FY11e) NBFCs versus banks
0
5
10
15
20
25
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Source: Anand Rathi Research.
Higher NIM on better spreads andlower leverage
Higher tier-1 better for assetquality in an economic downturn
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Better asset liability management
Infrastructure finance
Inherently, infrastructure financing has a long gestation period, which mayextend to over 10-15 years. Tenure is generally higher for road and power
projects, which may even extend to over 20 years. Banks are usuallyunwilling to lend beyond 5-10 years due to lack of adequate long-termliabilities.
This asset liability mismatch for banks gives an edge to IFCs such as PFC,REC and IDFC as they boast of long-term liabilities. Better asset liabilityprofiles mitigate interest rate risk (lending long by borrowing short).
Transport finance
Both STFC and MMFS have negligible duration gap. STFC has higherduration of liabilities than assets (the only NBFC with positive duration asset duration of three years and liabilities of ~4 years). Both companies
have reduced interest-rate risk by fixed-rate borrowing for lending to fixed-rate assets (no fixed-floating mismatch).
High credit rating and, hence, lower cost of funds
Infrastructure finance
PFC and REC enjoy AAA credit rating due to high government stake(which results in low default risk) and lower leverage compared with otherNBFCs and banks. The AAA status enables these companies to borrow atrelatively lower rates, thereby reducing the cost of funds.
IDFC was downgraded by CRISIL to AA+/Stable from AAA/Stable in
2QFY10 due to fear of higher leverage going forward. Change in creditratings is applicable only on incremental borrowings. However, both ICRAand Fitch have reaffirmed AAA rating for the company. IDFC uses ratingof ICRA and Fitch for its incremental borrowings and, hence, borrowingcost continues to be lower.
Transport finance
STFC and MMFS both lend to the riskier asset class (used-CVs and rurallending). However, over the years, these NBFCs have demonstrated abilityto minimise risk and, thereby, improve return ratios. Their asset qualityremains superior (provision coverage ratio of >70% and net NPAs of
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lower operating cost for them as against banks. STFC and MMFS havecost-to-income of 22-25% and 25-30% respectively.
Fig 21 Cost-to-income (FY11e) NBFCs versus Banks
0
10
20
30
40
50
60
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Source: Anand Rathi Research.
Impeccable asset quality for IFCs and stable credit
cost for STFC and MMFS
IFCs
Delinquencies in infrastructure financing are substantially low-to-negligible.Most infrastructure project loans are backed by government guarantee orsecured against cash flow of the particular project; for example, tollcollections in case of road projects and tariff revenue in case of SEBs.Hence, REC and PFC enjoy ~100% recoveries. Credit cost is almost nilfor REC, PFC and IDFC.
Transport finance
Both STFC and MMFS lend to the riskier asset class (used-CVs and rurallending). Over the years, both companies have developed sound methodsfor evaluating loan proposals, asset valuations and collection. This hashelped them keep credit cost under check. We remain conservative due totheir exposure to riskier asset class and keep our credit cost stable at 1.5%of AUMs for STFC and 3% of loans for MMFS.
Fig 22 NBFCs have superior asset quality (FY11e)
0.0
0.4
0.8
1.2
1.6
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Source: Anand Rathi Research.
Cost-to-income below 30% forNBFCs as against +40% for
banks
Net NPA less than 0.4% forIFCs and less than 1.5% each for
STFC and MMFS
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NBFCs better placed to tap huge potential
Huge opportunity in infrastructure and rural lending combined with abetter business model is likely to place NBFCs ahead of banks. We expectNBFCs loan book to grow faster than similar-size banks with stable
margins.We estimate IFCs (REC, PFC and IDFC) loan book to witness 25-30%CAGR over the next 2-3 years. STFC and MMFS are expected to grow~25% over FY10-12e.
Fig 23 Loan growth (CAGR FY10-12e) NBFCs versus Banks
0
5
10
15
20
25
30
35
40
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Source: Anand Rathi Research.
NBFCs have healthier return ratios than banks
A structurally superior model (low operating cost, high CAR) with strong
loan growth and strong pricing power will result in a much healthier RoAthan banks (2.5-4% for our NBFC universe versus 1-1.5% for banks).However, low leverage (better for asset quality in bad times) will keep RoEunder check.
Fig 24 RoA (FY11e) NBFCs versus Banks
0
1
2
3
4
5
REC
PFC
IDFC
MMFS
STF
SBI
PNB
BOB
BOI
Canara
ICICI
HDFCBK
Axis
(%)
Source: Anand Rathi Research.
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Company section
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Anand Rathi Financial Services Limited does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investmentdecision. Disclosures and analyst certifications are located in Appendix 1
Anand Rathi Research
India Equities
India I Equities
Parag Jariwala+9122 6626 6707
Clyton Fernandes+9122 6626 6744
Clyton [email protected]
Key financials
Year End 31 Mar FY09 FY10 FY11e FY12e FY13e
Net interest income (`m) 17,776 25,348 33,337 42,014 53,011
Net profit (`m) 12,721 20,014 25,581 32,169 40,036
EPS (`) 16.4 20.3 25.9 32.6 40.5
Growth (%) 50.6 23.3 27.8 25.8 24.5
PE (x) 19.9 16.1 12.6 10.0 8.1
PABV (x) 3.9 2.9 2.5 2.2 1.9
RoE (%) 22.0 23.2 21.5 23.4 24.9
RoA (%) 2.7 3.4 3.3 3.3 3.2
Dividend yield (%) 1.4 2.0 2.4 3.1 3.7
Net NPA (%) 0.0 0.0 0.0 0.0 0.0
Source: Company, Anand Rathi Research
Financial Services
Initiating Coverage
24 August 2010
Rural Electrification Corporation
Propelled by capacity add and investment; initiate with Buy
We initiate coverage on REC with a Buy recommendation andtarget price of`425/share. REC is well placed to reap the benefitof huge capacity addition and investment in T&D over FY10-13e.Its strong pricing power, likely IFC status and low operatingcosts would sustain +23% RoE and +3% RoA.
Robust loan growth visibility. RECs loan pipeline is strong,with outstanding sanctions of +`1trn (1.6x of loan book), offeringgood visibility for business growth. The huge capacity additionand investment in T&D over FY10-13e is likely to lead to 28%loans CAGR over FY10-13e.
Strong pricing power, likely IFC status to protect margin.REC enjoys strong pricing power as it is a key lender to SEBs. Re-pricing of loans (`100bn in FY11e; `150bn in FY12e), likely IFCstatus and hence low cost infrastructure bonds and easier access toECBs is likely to protect its margins at ~4%.
High RoA and RoE to sustain. We expect REC to registerearnings CAGR of 26% over FY10-13e on the back of strong loangrowth and stable margins. This would lead to high RoA andRoE, of +3.3% and +23% respectively, over FY10-13e.
Valuations and risks.At our target price, the stock will trade atPBV of 2.8x FY12e and 2.4x of FY13e respectively. Our targetprice is based on the two-stage DDM (CoE: 14%; Beta: 1; Rf:7.5%). Risks: Slowdown in power sector investment, regulatorychanges and poor health of SEBs
Rating: Buy
Target Price: `425
Share Price: `327
Key data RECL IN /REC.BO
52-week high/low `339/`188
Sensex/Nifty 18402/5531
3-m average volume US$13.1m
Market cap `281bn/US$6.9bn
Shares outstanding 987.5
Free float 33%
Promoters 67%
Foreign Institutions 19%
Domestic Institutions 6%
Public 8%
Relative price performance
REC
Sensex
175
200
225
250
275
300
325
350
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Source: Bloomberg
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24 August 2010 Rural Electrification Propelled by capacity add and investment; initiate with Buy
Anand Rathi Research 25
Quick Glance Financials and Valuations
Fig 1 Income statement ( m)
Year end 31 Mar FY09 FY10 FY11e FY12e FY13e
Net interest income 17,776 25,348 33,337 42,014 53,011
NII growth (%) 37.1 42.6 31.5 26.0 26.2
+ Non-interest inc 2,663 2,767 2,677 3,149 3,806
Total income 20,439 28,115 36,014 45,163 56,818
- Op. expenses 1,208 1,620 1,904 2,269 2,713
Operating profit 19,231 26,495 34,110 42,893 54,105
- Provisions 34 3 2 2 2
PBT 19,197 26,492 34,108 42,891 54,103
- Tax 6,476 6,478 8,527 10,723 14,067
PAT 12,721 20,014 25,581 32,169 40,036
+(AssociatesMinorities) - - - - -
Consolidated PAT 12,721 20,014 25,581 32,169 40,036
PAT growth (%) 47.9 57.3 27.8 25.8 24.5
FDEPS (` /share) 14.8 20.3 25.9 32.6 40.5
DPS (` /share) 4.5 6.5 8.0 10.0 12.0
Source: Company, Anand Rathi Research
Fig 2 Balance sheet ( m)Year end 31 Mar FY09 FY10 FY11e FY12e FY13e
Share capital 8,587 9,875 9,875 9,875 9,875
Reserves & surplus 53,314 100,929 117,267 137,882 164,054
Borrowings 449,360 559,482 736,071 955,970 1,213,953
Current liab & prov 38,737 25,149 30,179 39,232 51,002
Deferred tax liabilities 9,567 (74) (74) (74) (74)
Total Liabilities 559,564 695,361 893,318 1,142,886 1,438,810
Advances 513,814 664,526 855,897 1,098,816 1,395,348Investments 10,049 9,099 9,554 10,031 10,533
Cash & Bank Bal 18,860 13,903 19,301 24,696 22,769
Fixed & Other Assets 16,841 7,833 8,567 9,343 10,160
Total Assets 559,564 695,361 893,318 1,142,886 1,438,810
No. of shares (m) 859 987 987 987 987
Borrowing growth (%) 31.1 24.5 31.6 29.9 27.0
Loans growth (%) 30.7 29.3 28.8 28.4 27.0Source: Company, Anand Rathi Research
Fig 3 RatiosYear end 31 Mar FY09 FY10 FY11e FY12e FY13e
Interest spread (%) 3.1 3.2 3.2 3.2 3.1
NIM (%) 4.1 4.3 4.2 4.2 4.1Other inc / Total inc (%) 13.0 9.8 7.4 7.0 6.7
Cost-Income (%) 5.9 5.8 5.3 5.0 4.8
Provisions / Loans (%) 69.6 60.0 60.0 60.0 60.0
Dividend Payout (%) 35.5 35.2 36.1 35.9 34.6
Borrowings-loans (%) 87.5 84.2 86.0 87.0 87.0
Gross NPA (%) 0.1 0.0 0.0 0.0 0.0
Net NPA (%) 0.0 0.0 0.0 0.0 0.0
BV (`) 83.2 112.1 128.7 149.6 176.1
Adj BV (`) 83.1 112.1 128.7 149.6 176.1
CAR (%) 13.9 20.8 18.6 16.8 15.6- Tier 1 (%) 13.9 20.8 18.6 16.8 15.6Dividend Yield (%) 1.4 2.0 2.4 3.1 3.7Source: Company, Anand Rathi Research
Fig 4 PE Band
REC
3x
6x
9x
12x
0
50
100
150
200
250
300
350
400
M
ar-08
M
ay-08
Jul-08
S
ep-08
N
ov-08
J
an-09
M
ar-09
M
ay-09
Jul-09
S
ep-09
N
ov-09
J
an-10
M
ar-10
M
ay-10
Jul-10
Source: Bloomberg, Anand Rathi Research
Fig 5 Price-to-Book Band
REC
0.5x
1.2x
1.9x
2.6x
0
50
100
150
200
250
300
350
400
Mar-08
May-08
Jul-08
Sep-08
Nov-08
Jan-09
Mar-09
May-09
Jul-09
Sep-09
Nov-09
Jan-10
Mar-10
May-10
Jul-10
Source: Bloomberg, Anand Rathi Research
Fig 6 Bankex versus REC
REC
Bankex
175
200
225
250
275
300
325
350
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Source: Bloomberg
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Anand Rathi Research 26
Investment Argument & Valuation
We initiate coverage on REC with a Buy rating and target price of`425/share. The company is well placed to reap the benefit of hugecapacity addition and investments in T&D over FY10-13e. Its strong
pricing power, likely IFC status and low operating costs wouldsustain +23% RoE and +3% RoA over the next three years.
Robust loan growth visibility
RECs loan pipeline remains strong, with outstanding sanctions of >`1trn(1.6x of 1QFY11 loan book). During the past eight quarters (2QFY09-1QFY11), REC sanctioned loans worth `966bn (average quarterlyadditions to sanctions were `120bn).
Higher sanctions in the past eight quarters are likely to get converted todisbursements over the next two years. Total disbursements over the next
two years are estimated at`
624bn (`
274bn in FY11e and`
350bn inFY12e), which is 65% of the sanctions made in the past eight quarters. Weexpect loans CAGR of 28% over FY10-13e.
Strong pricing power, likely IFC status to protect
margin
REC enjoys strong pricing power as it is the one of the few lenders to theSEBs and is the nodal agency for RGGVY and ultra mega transmissionlines.
We estimate loans worth `100bn to get re-priced in FY11e (`150bn inFY12e) at ~50bps higher than average yields on loans in FY10. We expectREC to issue low-cost infrastructure bonds worth `20bn each in FY11,FY12 and FY13, under Chapter VI A of the Income Tax (IT) Act. Thesebonds are likely to be priced at 150-200bps lower than the average cost ofborrowings in FY10 and account for ~7% of incremental borrowings inFY11 (~5% in FY12e and FY13e).
With IFC status, companies will be allowed to borrow up to 50% of theirnet worth via ECBs (through the automatic route). We expect incrementalborrowings under ECB to be `45bn (16% of incremental borrowings) inFY11e and `9-10bn (3.5% of incremental borrowings) over FY12-13e.Infrastructure bonds and ECBs are likely to negate any pressure onmargins due to higher borrowing cost from other sources of funding and
lower contribution from REC capital gain bonds. We remain conservativeand expect spread to sustain at +3% and NIM at +4% over FY10-13e. In1QFY11, spreads and NIMs stood at 3.4% and 4.6% respectively for thecompany.
High RoA and RoE to sustain
We expect earnings CAGR of 26% over FY10-13e on the back of strongloan growth (28% CAGR over FY10-13e) and stable margins at +4% overthe same period. Operating costs are expected to see CAGR of ~20%over FY10-13e and credit cost to remain negligible. RoA and RoE arelikely to remain superior, at +3% and +23% over FY10-13e.
Margins to remain superior at +4%over FY10-13e
Healthy loan pipeline to supportloan CAGR of 28% over
FY10-13e
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Valuations
REC is a long-term bet on Indias growing power sector investments. Itcurrently trades at PBV of 2.2x FY12e BV and 1.9x FY13e BV. Withstrong earnings visibility and superior return ratios, we believe the stockhas potential for re-rating. We initiate coverage on REC with a Buyrecommendation and target price of`425/share, which is at 30% upside;
we favour it as our top pick in the IFC space. Our target price is based onthe two-stage DDM (CoE: 14%; Beta: 1; Rf: 7.5%).
Risks to our target price
REC is a dedicated power finance company. Any slowdown in powersector investments will hurt loan growth
Any regulatory changes as regards SLR/CRR requirements,maintenance of standard provision coverage on loan book etc, cannegatively impact profitability.
REC has a higher exposure to SEBs. Any default by SEBs due to theirpoor financial health can impact profitability
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Robust loan growth visibility
RECs loan pipeline is strong, with outstanding sanctions of >`1trn(1.6x of loan book), offering good visibility for business growth. Thehuge capacity addition and investment in T&D over FY10-13e is
likely to lead to 28% loans CAGR over FY10-13e.
Strong sanction pipeline
During FY05-10, disbursements witnessed CAGR of 23%. From FY08 toFY10, REC sanctioned loans worth ~`1.3trn. During the past eightquarters (from 2QFY09 to 1QFY11), REC sanctioned loans worth `966bn(average quarterly additions to sanctions stood at `120bn).
Higher sanctions in the past eight quarters are likely to get converted intodisbursements over the next two years (typically, disbursement growthcomes with a lag of 10-12 months). Total disbursement over the next two
years is estimated at`
624bn (`
274bn in FY11e and`
350bn in FY12e),which is 65% of sanctions made in the past eight quarters. We expect 27%CAGR in disbursements (on a higher base) over FY10-13e. Loans arelikely to witness CAGR of 28% over FY10-13e and likely to cross the`1-trn mark by FY12e.
Fig 7 Sanctions and disbursements ( bn)
163188
329
452 454
74 75107
130
172211
274
350
404434
FY05
FY06
FY07
FY08
FY09
FY10
FY11e
FY12e
FY13e
Sanctions Disbursements Source: Company, Anand Rathi Research.
Fig 8 Trend in loans ( bn)
217 253321
393
1,099
1,395
514
665
856
0
200
400
600
800
1,000
1,200
1,400
1,600
FY05
FY06
FY07
FY08
FY09
FY10
FY11e
FY12e
FY13e
CAGR of 28% overFY10-13e
( bn)`
Source: Company, Anand Rathi Research.
Higher sanctions during FY08-10
to drive disbursement growth inFY10-13e
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Strong pricing power, likely IFC status
to protect margin
REC enjoys strong pricing power as it is a key lender to SEBs. Re-
pricing of loans (`100bn in FY11e; `150bn in FY12e), low costinfrastructure bonds and easier access to ECBs is likely to protect itsmargins at ~4%, in a rising interest-rate scenario.
Margin pull down by:
Lower share of REC capital gain bonds in overall borrowings expected to reduce to 12% in FY12e from 18% in FY10.
Change in asset mix in favour of generation projects, which entaillower margins.
Margin push up by:
IFC status ECB and infrastructure bonds under Chapter VI A of theIT Act to ensure lower cost of funds.
Re-pricing of loans (`100bn in FY11e and `150bn in FY12e) Loansare likely to be re-priced ~50bps higher than current yield on loans.Compared with this, borrowings worth `30bn are likely to re-price at ahigher rate.
Issue of deep discount bonds worth `7-8bn with a tenure of 7-10years is likely to be priced 40-50bps lower than similar interest-payingbonds.
Share of capital gain bonds to decline, to pressure
borrowing costs
RECs reported spreads remained high at +3.3% as the company enjoyslower funding cost owing to bonds under Section 54EC of the IT Act.
These are three-year bonds with average cost of ~6% as againstcommercial borrowing rate of ~8%. Going forward, share of such bondsis likely to reduce, which will increase RECs cost of funds. The bonds,
which raised >`73bn in FY07, have been re-paid in FY10, reducing theirproportion to 18% in FY10 compared with 32% in FY09.
Additional borrowing through this route is likely to be limited due to othermodes of tax savings made available by the government over the past two
years. We expect REC to borrow`9-10bn in FY11 and `4.5-5.5bn overFY12-13e. Share of capital gain bonds in overall borrowings is expected tofall to 15% in FY11e, and further to 12% and 10% in FY12e and FY13erespectively.
Capital gain bonds to account for~10% of borrowing by FY13e
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Fig 11 Share of Section 54EC bonds in overall borrowings to decline (%)
46 4543 41
3835
32 31
22 2118 19
1512
10
44
1QFY08
1QFY08
1QFY08
1QFY08
1QFY09
2QFY09
3QFY09
4QFY09
1QFY10
2QFY10
3QFY10
4QFY10
1QFY11
FY11e
FY12e
FY13e
Source: Company, Anand Rathi Research.
Asset mix to change in favour of generation projects
Increased emphasis by the government and private sector on expandinggeneration capacity has led to higher sanctions to generation projects.
Yield on generation project loans is lower as: i) the lender can have chargeof the physical assets and ii) there is less chance of default due to powerpurchase agreements and prior supply linkages that give revenue certaintycompared with transmission projects.
Over the past three years, REC has been able to negate any pricingpressure owing to the increasing share of generation loans.
Fig 12 Share of generation projects (%)
25.7
34.1 36.1
60.353.3 53.0
FY08
FY09
FY10
in loan book in sanctions Source: Company.
IFC status and re-pricing of loans to ease pressure on
margins
ECBs through the automatic route
With the IFC status, companies will be allowed to borrow up to 50% theirnet worth via ECBs (through the automatic route). We expect incrementalECBs to be `45bn (16% of incremental borrowings) in FY11e and `9-10bn (2-3% of incremental borrowings) over FY12-13e.
High share of generation projects insanctions (53%) as against loans
(36%)
Low cost borrowings to account for22-25% of overall borrowings over
FY10-13e
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24 August 2010 Rural Electrification Propelled by capacity add and investment; initiate with Buy
Anand Rathi Research 32
Infrastructure bonds under Chapter VI A of the IT Act
We expect REC to issue low-cost infrastructure bonds worth `20bn eachin FY11, FY12 and FY13, as per Chapter VI A of the IT Act. These bondsare likely to be priced 150-200bps lower than average cost of borrowingsin FY10 and account for ~7% and 5.5% of incremental borrowings for
FY11e and FY12e respectively. However, benefit of infrastructure bondsis likely to be limited in FY11e as the first tranche of infrastructure bondsis likely to be issued in Oct 10 (`10bn) and the second in Feb 10 (`10bn).
Share of low-cost borrowings for REC could increase to 26% in FY11efrom 22% in FY10 (but, benefit will be limited due to year-endborrowings). Low cost borrowing is likely to account for 24% and 22% inFY12e and FY13e.
Fig 13 Share of low cost borrowing in overall borrowings
17.814.7
11.89.8
-2.7
4.24.9
3.78.9
7.97.0
FY10
FY11e
FY12e
FY13e
REC Capital gains bonds Infrastructure bonds ECB/foreign currency Borrowings Source: Company, Anand Rathi Research.
Re-pricing of loans to offset increase in wholesale
borrowing cost
A large part of REC loans (~75%) are covered by a re-set clause of threeyears. We expect loans worth `100bn and `150bn to be re-priced in FY11eand FY12e respectively, ~50bps higher than current yield on loans. Asagainst this, borrowings worth `30bn will be re-priced at a higher rate.
Deep discount bonds
REC is expected to issue deep discount bonds worth `7-8bn (~3% of
incremental borrowings) with maturity period of 7-10 years. These bondsare generally priced 40-50bps lower than the regular interest-paying bonds,owing to tax benefit. Deep discount bonds are non-interest paying andtaxable as capital gains (10% or 20%, depending on the tenure andindexation) and not as income from other sources (30% on interest paid).
Spread to remain at 3.2%; margins at 4.2%
We remain conservative and expect spread to remain at 3.2% and NIM at4.2%. In 1QFY11, REC spreads and NIMs stood at 3.4% and 4.6%respectively. We expect RECs margins to remain protected owing to:i) regular re-set of loans being in line with re-set of borrowings; ii) strongpricing power, which is on account of large scale of operations and it beingone of the few lenders to SEBs, thereby ensuring spread of ~3% and NIMof ~4%.
Deep discount bonds will be priced
40-50bps lower
Loans worth`100bn and`150bnwill be re-priced in FY11e and
FY12e (15% and 17% of openingloans)
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Fig 14 Trend in yields, cost of funds and spread (%)
10.110.6 10.7
11.811.1 11.0 11.0 11.2 11.1 11.0 11.2 11.3
7.8 7.8 7.8 8.0 8.1
3.4 3.2 3.2 3.2
6.77.2 7.8
8.67.6 7.7 7.7
3.3 3.4 2.9 3.23.5 3.4 3.3 3.4
1QFY09
2QFY09
3QFY09
4QFY09
1QFY10
2QFY10
3QFY10
4QFY10
1QFY11
FY11e
FY12e
FY13e
Yield on loans Cost of funds Spread Source: Company, Anand Rathi Research.
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High RoA and RoE to sustain
We expect REC to post earnings CAGR of 26% over FY10-13e on theback of strong loan growth and stable margins. This would lead tohigh RoA and RoE, of +3.3% and +23% respectively, over FY10-13e.
REC enjoys superior cost-to-income owing to lower operating cost (nobranches and lower employee base) and large ticket-size of disbursements.
We expect operating costs to witness CAGR of 20% over FY10-13e.Credit costs are expected to remain negligible on the back of robust assetquality. Hence, strong loan growth backed by stable margins is likely todrive PAT CAGR of 26% over FY10-13e. RoA and RoE would remainsuperior at +3% and +23% respectively in FY13e.
Fig 15 Trend in operating cost and cost-to-income
500
1,000
1,500
2,000
2,500
FY06
FY07
FY08
FY09
FY10
FY11e
FY12e
FY13e
4.0
4.9
5.8
6.7
7.6
8.5
Operating cost Cost-to-income
(%)( m)`
Source: Company, Anand Rathi Research.
Fig 16 Negligible credit cost
0
100
200
300
400
500
FY07
FY08
FY09
FY10
FY11e
FY12e
FY13e
(0.02)
0.00
0.02
0.04
0.06
0.08
0.10
0.12
Provisions for NPAs Credit cost (RHS)
(%)( m)`
Source: Company, Anand Rathi Research.
Operating cost to grow at a CAGRof 20% (versus NII CAGR of
28%)
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Financials
We expect 28% CAGR in NII over FY10-13e on account of strongloan growth and stable margins. We estimate PAT CAGR of 26%(lower than NII growth due to lower other income) over the same
period. RoA and RoE would remain superior at 3.3% and 22-23%respectively.
Strong NII growth
We expect 28% NII CAGR over FY10-13e on the back of strong loangrowth (28% CAGR in loan growth) and stable margins (~4%).
Fig 17 Trend in net interest income ( bn)
68
13
18
53
25
33
42
0
10
20
30
40
50
60
FY06
FY07
FY08
FY09
FY10
FY11e
FY12e
FY13e
CAGR of 28% overFY10-13e
( bn)`
Source: Company, Anand Rathi Research.
Non-interest income to be slower
We expect non-interest income to marginally decline in FY11 owing toone-offs in FY10 (write-back of excess provisions and income-tax refundof`433m). Processing fee charged by the company and interest on excessmoney parked in banks/mutual funds is the only source of other incomefor the company. Hence, we remain conservative and estimate lowergrowth (~20%) in non-interest income (excluding one-offs).
Fig 18 Other income and other income as a percentage of operating profits
1.0
1.5
2.0
2.5
3.0
3.5
4.0
FY08
FY09
FY10
FY11e
FY12e
FY13e
5
7
9
11
13
15
Non-interest income % to operating prof its (RHS)
(%)( bn)`
Source: Company, Anand Rathi Research.
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Anand Rathi Research 36
High return ratios
RECs strong pricing power would translate into superior NIMs. Loweroperating cost coupled with negligible credit cost would result in RoA of+3% and RoE to range at +23%, despite lower leverage.
Fig 19 Superior return ratios
1.0
1.5
2.0
2.5
3.0
3.5
FY06
FY07
FY08
FY09
FY10
FY11e
FY12e
FY13e
15
17
19
21
23
25
27
RoA RoE (RHS)
(%) (%)
Source: Company, Anand Rathi Research.
Fig 20 DuPont Analysis (%)REC FY08 FY09 FY10 FY11e FY12e FY13e
Interest income 8.9 10.1 10.8 10.9 11.2 11.4
Interest expenses 5.4 6.2 6.5 6.6 6.9 7.1
Net Interest Income 3.5 3.9 4.3 4.4 4.3 4.3
Other Operating Income 0.0 0.2 0.2 0.2 0.1 0.1
Other Income 0.4 0.4 0.3 0.2 0.1 0.1
Total Income 3.9 4.4 4.7 4.7 4.6 4.5
Operating expenses 0.3 0.3 0.3 0.2 0.2 0.2
Operating profits 3.6 4.2 4.5 4.4 4.4 4.3
Provisions 0.1 0.0 0.0 0.0 0.0 0.0
PBT 3.5 4.2 4.5 4.4 4.4 4.3
Taxation 1.2 1.4 1.1 1.1 1.1 1.1
RoA (incl DTL) 2.3 2.8 3.4 3.3 3.3 3.2
Leverage (x) 8.0 8.0 6.9 6.4 7.2 7.8
RoE (incl DTL) 18.6 22.2 23.3 21.5 23.4 24.9
Source: Company, Anand Rathi Research.
RoA and RoE to remain healthy at+3% and +23% over FY10-13e
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Fig 21 Income statement ( m)Y/E 31 March FY09 FY10 FY11e FY12e FY13e
Interest Income 46,649 64,309 83,916 109,726 141,441
Interest Expended 28,873 38,961 50,580 67,712 88,430
Net Interest Income 17,776 25,348 33,337 42,014 53,011
Growth (%) 37.1 42.6 31.5 26.0 26.2
Non-interest Income 2,663 2,767 2,677 3,149 3,806
Total Income 20,439 28,115 36,014 45,163 56,818
Non-interest income / Total Income (%) 13.0 9.8 7.4 7.0 6.7
Operating Expenses 1,208 1,620 1,904 2,269 2,713
Employee Expenses 872 1,171 1,382 1,658 1,990
Other Expenses 336 449 522 611 723
Pre-provisioning profit 19,231 26,495 34,110 42,893 54,105
Growth (%) 42.1 37.8 28.7 25.8 26.1
Provisions 34 3 2 2 2
Profit Before Tax 19,197 26,492 34,108 42,891 54,103
Taxes 6,476 6,478 8,527 10,723 14,067
Tax Rate (%) 33.7 24.5 25.0 25.0 26.0
Profit After Tax 12,721 20,014 25,581 32,169 40,036
Growth (%) 47.9 57.3 27.8 25.8 24.5
Number of shares (m) 859 987 987 987 987
Earnings per share (`) 14.8 20.3 25.9 32.6 40.5
Source: Company, Anand Rathi Research.
Fig 22 Balance sheet ( m)
Y/E 31 March FY09 FY10 FY11e FY12e FY13e
Share Capital 8,587 9,875 9,875 9,875 9,875
Reserves and Surplus 53,314 100,929 117,267 137,882 164,054
Net Worth 61,901 110,803 127,142 147,757 173,929
Borrowings 449,360 559,482 736,071 955,970 1,213,953
Deferred tax liabilities 9,567 (74) (74) (74) (74)
Other Liabilities & Provisions 38,737 25,149 30,179 39,232 51,002
Total Liabilities 559,564 695,361 893,318 1,142,886 1,438,810
Loans 513,814 664,526 855,897 1,098,816 1,395,348
Investments 10,049 9,099 9,554 10,031 10,533
Cash & Bank Balances 18,860 13,903 19,301 24,696 22,769
Fixed & Other Assets 16,841 7,833 8,567 9,343 10,160
Total Assets 559,564 695,361 893,318 1,142,886 1,438,810
Source: Company, Anand Rathi Research.
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Anand Rathi Research 38
Company background & Management
Rural Electrification Corporation (REC) is a Navratna PSUincorporated in 1969, with the main objective to finance and promoterural electrification projects across the country. REC came out with
an initial public offer in Mar 08. The company is managed bydirectors appointed by the government of India in consultation withthe Power Ministry.
Company background
REC is a Navratna PSU, incorporated in 1969 under the Ministry ofPower with the main objective to finance and promote rural electrificationprojects across India. REC came out with an IPO in Mar 08 and a follow-on offer in Feb 10. The government holds 66% stake in the company atpresent. REC enjoys international credit rating equivalent to sovereignrating of India from international credit rating agencies Moodys and Fitch,
which is Baa3 and BBB- respectively.
Fig 23 Shareholding pattern
Public and
others, 8%
DIIs, 6%
FIIs, 19%
Promoters, 67%
Source: Company
Management
Fig 24 Key managementName Designation Background
JM Phatak Chairman andManaging Director
IAS officer with 32 years of service withstate/central governments
Holds Masters in Management and PublicAdministration from Harvard University
HD Khunteta Director (Finance) More than 30 years of experience in Finance;Served as ED (Finance) in NHPC
Guljit Kapur Director (Technical) In-charge of technical and operation aspects ofvarious project;More than 35 years of experience with variousSEBs
Source: Company
REC is a Navratna PSU, in whichthe government holds 66% stake
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Anand Rathi Financial Services Limited does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investmentdecision. Disclosures and analyst certifications are located in Appendix 1
Anand Rathi Research
India Equities
India I Equities
Parag Jariwala+9122 6626 6707
Clyton Fernandes+9122 6626 6744
Key financialsYear end 31 Mar FY09 FY10 FY11e FY12e FY13e
Net interest income (`m) 18,875 27,983 35,471 44,060 54,291Net profit (`m) 19,700 23,572 28,022 34,271 42,042
EPS (`) 17.5 20.5 24.4 29.9 36.6
Growth (%) 54.4 16.6 19.3 22.3 22.7
PE (x) 19.4 16.2 13.6 11.2 9.1
PABV (x) 3.3 2.9 2.5 2.1 1.8
RoE (%) 17.8 19.0 19.5 20.4 21.3
RoA (%) 3.2 3.1 3.0 2.9 2.9
Dividend yield (%) 1.2 1.4 1.5 1.7 2.1
Net NPA (%) 0.0 0.0 0.0 0.0 0.0
Source: Company, Anand Rathi Research
Financial Services
Initiating Coverage
24 August 2010
Power Finance Corporation
Long-term play on Power; initiate with Buy
We initiate coverage on Power Finance Corporation (PFC) withBuy and target price of`408/share. PFC is likely to see hugebenefit from the massive investment in power capacity overFY10-13e. Capital raising in FY11 would support businessgrowth. The companys IFC status, high productivity and low
credit costs would result in 21% EPS CAGR over FY10-13e.
Robust loan growth visibility. PFCs loan pipeline remainsstrong, with outstanding sanctions of`1.4trn (1.7x of loan book).Huge capacity addition and vast investment in power capacity islikely to drive 26% loans CAGR over FY10-13e.
IFC status and capital raising to support business growth.Now classified as an IFC, PFC will enjoy enhanced single/groupborrower limits and higher exposure limits for bank-borrowings,enabling robust balance-sheet growth. PFC is likely to raise capitalby end-FY11 to support its business growth prospects. This willfurther strengthen its capital adequacy (17.3% in Jun 10).
Low costs to aid profitability. Likely stable margins of ~3.7%,high productivity (cost-to-income: ~3.5%) and negligible creditcosts would drive net profit CAGR of 21% over FY10-13e.
Valuation.At our target price, the stock would trade at PBV of2.6x FY12e and 2.2x FY13e. Our target price is based on the two-stage DDM (CoE: 13.4%; Beta: 0.9; Rf: 7.5%). Risks: Slowdownin the power sector and regulatory changes.
Rating: Buy
Target Price: `408
Share Price: `333
Key data POWF IN /POWF.BO
52-week high/low `345/`202
Sensex/Nifty 18402/5531
3-m average volume US$3.9m
Market cap `382bn/US$8.2bn
Shares outstanding 1147.8m
Free float 10%
Promoters 90%
Foreign Institutions 4%
Domestic Institutions 3%
Public 3%
Relative price performance
PFC
Sensex
200
230
260
290
320
350
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Source : Bloomberg
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24 August 2010 Power Finance Corporation Long-term play on Power; initiate with Buy
Anand Rathi Research 40
Quick Glance Financials and Valuations
Fig 1 Income statement ( m)
Year end 31 Mar FY09 FY10 FY11e FY12e FY13e
Net interest income 18,875 27,983 35,471 44,060 54,291
NII growth (%) 17.2 48.3 26.8 24.2 23.2
+ Non-interest inc 2,448 3,248 3,245 3,263 3,705
Total income 21,323 31,230 38,716 47,323 57,996
- Op. expenses 1,382 1,096 1,303 1,578 1,889
Operating profit 19,941 30,135 37,413 45,745 56,106
- Provisions 36 - 50 50 50
PBT 19,905 30,135 37,363 45,695 56,056
- Tax 205 6,562 9,341 11,424 14,014
PAT 19,700 23,572 28,022 34,271 42,042
+(AssociatesMinorities) - - - - -
Consolidated PAT 19,700 23,572 28,022 34,271 42,042
PAT growth (%) 63.2 19.7 18.9 22.3 22.7
FDEPS (`/share) 17.5 20.5 24.4 29.9 36.6
DPS (`/share) 4.0 4.5 5.0 5.5 7.0
Source: Company, Anand Rathi Research
Fig 2 Balance sheet ( m)Year end 31 Mar FY09 FY10 FY11e FY12e FY13e
Share capital 11,478 11,478 11,478 11,478 11,478
Reserves & surplus 103,601 121,130 142,438 169,323 201,965
Deposits 521,602 671,084 840,022 1,074,607 1,358,976
Borrowings 44,851 43,612 46,315 51,570 55,528
Minority interests 555 470 470 470 470
Total Liabilities 682,086 847,774 1,040,722 1,307,447 1,628,417
Advances 644,290 798,560 1,000,026 1,264,243 1,580,204Investments 359 314 330 347 398
Cash & Bank Bal 3,922 13,943 3,763 4,519 5,768
Fixed & Other Assets 33,515 34,957 36,603 38,339 42,046
Total Assets 682,086 847,774 1,040,722 1,307,447 1,628,417
No. of shares (m) 1,148 1,148 1,148 1,148 1,148
Deposits growth (%) 28.3 28.7 25.2 27.9 26.5
Advances growth (%) 24.9 23.9 25.2 26.4 25.0
Source: Company, Anand Rathi Research
Fig 3 RatiosYear end 31 Mar FY09 FY10 FY11e FY12e FY13e
Interest spread (%) 1.6 2.0 2.2 2.2 2.2
NIM (%) 3.6 3.6 3.7 3.7 3.7Other inc / Total inc (%) 11.5 10.4 8.4 6.9 6.4
Cost-Income (%) 6.5 3.5 3.4 3.3 3.3
Provisions / Loans (%) 53.8 53.8 53.8 53.8 53.8
Dividend Payout (%) 27.3 25.6 24.0 21.6 22.4
Borrowings-loans (%) 81.0 84.0 84.0 85.0 86.0
Investment-Deposit (%)
Gross NPA (%) 0.0 0.0 0.0 0.0 0.0
Net NPA (%) 0.0 0.0 0.0 0.0 0.0
BV (`) 100.7 115.9 134.5 157.9 186.4
Adj BV (`) 100.7 115.9 134.5 157.9 186.3
CAR (%) 17.2 19.3 16.5 15.3 14.0- Tier 1 (%) 17.2 19.3 16.5 15.3 14.0Dividend Yield (%) 1.2 1.4 1.5 1.7 2.1Source: Company, Anand Rathi Research
Fig 4 PE Band
PFC
3x
7x
11x
15x
0
50
100
150
200
250
300
350
400
450
Feb-07
May-07
Aug-07
Nov-07
Feb-08
May-08
Aug-08
Nov-08
Feb-09
May-09
Aug-09
Nov-09
Feb-10
May-10
Aug-10
Source: Bloomberg, Anand Rathi Research
Fig 5 Price-to-Book Band
PFC
0.8x
1.3x
1.8x
2.3x
0
50
100
150
200
250
300
350
400
Feb-07
May-07
Aug-07
Nov-07
Feb-08
May-08
Aug-08
Nov-08
Feb-09
May-09
Aug-09
Nov-09
Feb-10
May-10
Aug-10
Source: Bloomberg, Anand Rathi Research
Fig 6 Bankex versus PFC
PFC
Bankex
200
230
260
290
320
350
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Source: Bloomberg
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24 August 2010 Power Finance Corporation Long-term play on Power; initiate with Buy
Anand Rathi Research 41
Investment Argument & Valuation
We initiate coverage on PFC with a Buy recommendation and targetprice of`408/share. PFC is likely to see immense benefit from themassive investment in power capacity over FY10-13e. Capital raising
in FY11 would support business growth. The companys IFC status,high productivity and low credit costs would result in 21% EPSCAGR over FY10-13e.
Robust loan growth visibility
PFCs loan pipeline remains strong, with cumulative outstanding sanctionsof`1.4trn as on 1QFY11 (1.7x of loan book). During the past eightquarters (from 2QFY09 to 1QFY11), PFC sanctioned loans worth `1.2trn(average quarterly additions to sanctions were `155bn).
Higher sanctions in the past eight quarters is likely get converted to
disbursements over the next two years, estimated at`
717bn (`
317bn inFY11e and `400bn in FY12e), which is 60% of sanctions. We expect loansCAGR of 26% over FY10-13e.
IFC status and capital raising to support business
growth
Now classified as an IFC, PFC will enjoy enhanced single/group borrowerlimits and higher exposure limits for bank-borrowings, enabling robustbalance-sheet growth.
With the IFC status, PFC is required to maintain the capital adequacy ratio(CAR) of 15% as against 12% required for other NBFCs. Rapid growth inloans (26% CAGR over FY10-13e) in excess of RoE (20-21% over FY10-13e) will burn capital faster. PFC will require capital for maintainingcurrent growth rate. CAR, as on 1QFY11, is 17.3% as against themandatory 15%. We expect PFC to raise capital by end-FY11.
Low costs to aid profitability
PFC is the nodal agency for UMPPs that entail huge investment. Itcommands pricing power as it is the lead lender for such projects.
Margins to sustain at 3.7%
Margins in generation projects are lower compared with T&D projects,owing to higher charge on assets (due to lower risk) and better revenue
visibility (due to purchase agreements and lower losses).
PFC has been awarded IFC status by the RBI. Thereby, we expect PFCscost of funds to reduce due to issue of low cost infrastructure bonds(`20bn each in FY11e, FY12e and FY13e, which is 4.4%, 3.4% and 2.8%of incremental borrowings) and ECBs (`38bn, `11bn `13bn i.e., 8.4%,1.8% and 1.9% of incremental borrowings respectively).
Infrastructure bonds and ECBs will lower any pressure on margins due tohigher borrowing cost from other source of funding. However, a largepart of PFCs loan book (`200bn, which is 25% of FY10 loan book) will
be re-priced at the ongoing rate (10.75-11%). This will cap upwardmovement in yields on loans. Overall, we expect spreads to remain stableat 2.2% and margins at 3.7% over FY10-13e.
Higher sanctions to drive loanCAGR of 26% over FY10-13e
IFC status to support loan growthand stable margins
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Earnings to witness CAGR of 21% over FY10-13e
Strong loan growth backed by stable margins (~3.7%), lower cost ofoperations (cost-to-income: ~3.5%) and negligible credit cost (remainednil/negative over FY06-10) will drive PAT CAGR of 21% over FY10-13e.
ValuationPFC is a long-term bet on Indias expanding power sector investments. Itoffers a good combination of strong growth and value, and trades at PBV2.1x FY12e and 1.8x FY13e. With strong earnings visibility and higherreturn ratios, we believe the stock has potential of re-rating. We initiatecoverage with a Buy recommendation and target price of`408/share. Ourtarget price is based on the two-stage DDM (CoE: 13.4%; Beta: 0.9; Rf:7.5%).
Risks to our target price
PFC is a dedicated power finance company. Any slowdown in powersector investments will hurt loan growth
Any regulatory changes as regards SLR/CRR requirements,maintenance of standard provision coverage on loan book etc, canhave negative impact on profitability
Good combination of growthvisibility and value
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24 August 2010 Power Finance Corporation Long-term play on Power; initiate with Buy
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Loan book skewed towards generation projects and
state/central governments
The generation segment accounts for 82% of the total loan book, followedby T&D projects at 12%. Higher share of the generation segment augurs
well for asset quality as loans are secured by charge on assets (turbines etc)and lower probability of losses as in the case of transmission projects (dueto distribution losses).
Fig 9 Break-up of loan book 1QFY11 (as per segment)
Others
6%Distribution
4%
Generation
82%
Transmission
8%
Source: Company
Central/state governments account for 85% of the loan book. PFC isexpected to benefit from this as it enjoys strong relationship with state andcentral government utilities, which comprise more than 80% of the loanbook. Sustained increase in power-sector spending by the government
augurs well for strong loan growth.
Fig 10 Break-up of loan book - 1QFY11 (as per borrower)
Central PSUs
19%
State
66%
Joint Sector
8%
Private
7%
Source: Company
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IFC status and capital raising to
support business growth
Now classified as an IFC, PFC will enjoy enhanced single/group
borrower limits and higher exposure limits for bank-borrowings,enabling robust balance-sheet growth. PFC is likely to raise capitalby end-FY11 to support its business growth prospects. This willfurther strengthen its capital adequacy (17.3% in Jun 10).
IFC status to support business growth
PFC has been awarded IFC status by the Reserve Bank of India (RBI).This will enhance single/group borrowing lending limits by 5% and overall(