CLSA: Rural Electrification - OUTPERFORM

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REC: Power building
REC is set to report a 26% loans Cagr over FY10-13, after diversifying
into power-generation project financing and the private sector. We expect
its topline to post a 23% Cagr in the same period, driving a 21% earnings
Cagr. Its asset quality is robust with gross non-performing loans (NPL) at
just 3bp, but surprises on quality and spread contraction are key risks.
We initiate coverage with an Outperform rating and Rs430 target based
on 2.7x forward PB.
Healthy loan growth, mix to change
Over the next five years, we estimate US$250bn in power-sector investment,
as India scales-up generation, transmission and distribution infrastructure.
Private-sector generation capex will dominate investment and REC should
benefit from strong credit demand and its move into power-project financing
with a focus on the private sector. We expect REC’s loans to grow by 26%
Cagr over next three years with private-sector forming 16% of total loans.
Diversification to reduce concentration risk
We believe that the change in REC’s loan mix will cut its exposure to state
electricity boards (SEB), which generally have weak financial positions. While
its asset quality is strong, with a 3bp gross NPL ratio and low likelihood of
slippages from SEBs, it is important to reduce concentration risks. We assume
rise in gross NPLs and loan loss provisioning costs in the context of loan
growth, chunky nature of loans and rising share of private borrowers.
Earnings to post a 21% Cagr
We forecast a 21% core-earnings Cagr over FY10-13 led by strong net
interest income (NII) growth. Contribution from fees to income will remain
low. We assume a 22bp spread contraction to 2.7% in the same period, in
line with the FY08-09 trend, due to higher interest rates and a lower capital
gain-bond share. REC may be able to mitigate spread pressure by raising
lending rates and its share of external commercial borrowings (ECB).
Recommend Outperform
Current valuations reflect REC’s growth trajectory and superior profitability.
Compounding of book value will drive stock-price appreciation. We base our
Rs430 target on 2.7x forward PB, assuming a 22% sustainable ROE. REC may
raise equity over the next year to drive growth plans. Key risks are assetquality
deterioration and lower spreads. We rate the stock an Outperform.