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SKS Microfinance
Underweight
SKSM.BO, SKSM IN
Pressures intensifying - Cutting EPS and PT
• We reiterate our Underweight rating on SKS, and cut our PT by
21% to Rs550 (2x FY12E BV) and EPS by 34/72/35% for
FY11/12/13E. We believe the AP situation is now quite intractable, and
a de facto loan waiver seems to be in place. The stock is still not cheap
at 2.4x P/BV, and we think there is more downside.
• AP impact on growth, NPLs: The Andhra Pradesh microfinance
ordinance became permanent law in Dec 10. This has been accompanied
by an Opposition campaign to “waive” microfinance loans, creating a
large moral-hazard problem. We are now factoring in a ~25% loss on the
AP portfolio over the Dec 10 – Sep 11, with 4Q11 bearing the brunt.
• Return ratios ratcheting down: The secondary impact of the AP issue
is margin pressure. SKS’ voluntary yield cut is a straight hit to margins,
especially as this has coincided with tight liquidity and the high cost of
wholesale funds. The absence of future securitization is a further ROE
drag, and we see normalized ROEs dipping to ~16-17%.
• Some positives in the medium term: Concerns that bank funding could
dry up completely have been addressed. Also, we see no further bad
news on the regulatory front (assuming other states don’t follow AP’s
footsteps). Finally, bank support for MFIs is not impossible, given the
criticality of this sector in meeting weaker section targets. However,
near-term earnings destruction could overwhelm these positives.
• Not cheap enough: We are cutting our earnings estimates by 30-70%
for FY11-13 to factor in slower growth and higher credit costs. Our new
Dec-11 PT, based on our three-stage Gordon Growth Model, is Rs550,
down from our previous PT of Rs700. Given the pressures on
profitability and the adjustment to a new ROE (and growth) regime, we
think 2.4x PBV is too rich for a troubled business. We maintain
Underweight.
Unfavorable risk-reward
Still not cheap: SKS microfinance has corrected by ~40% from issue levels but we
believe that the contraction in return ratios expected still does not justify current
prices. We expect ROEs to contract to 15-16%, down from our ~17-21% expectation
earlier, and thus valuations at 2.4x FY12E look expensive, especially given the
uncertainity on asset quality, particularly on the AP book. With higher uncertainity
and lower return ratios than private banks we believe current valuations do not factor
in all the risks.
Lack of earnings visibility: There is a lot of near term uncertainty on asset quality
as the AP situation has still not stabilized and credit losses can be higher than what
we have factored in. We have factored in ~25% of credit losses from a shrinking AP
book. Given low collection levels, credit losses could be substantially higher with
high losses expected in the next 2-3 quarters.
Management indicated that it would change the NPA recognition norms from a
weekly basis to a monthly basis, and hence 3Q11 could be protected, but we expect a
significant increase in Gross NPAs and credit costs in 4Q11 from the AP book.
Sustainable ROEs unlikely to cross upper teens, given pricing pressures: We
believe sustainable ROEs will not only be affected by the near-term pressures on the
AP book, but margin pressure will also continue. Not only would interest rate cuts
across states need to be taken sooner, but funding costs would also inch up. Any net
offset from cost synergies would also be difficult to come by as we expect growth
rates to moderate from >40% to 30% in FY12-13.
Worst case, BV at risk: Assuming the situation is not improving in AP, SKS
Microfinance would need to take large write-downs in for their AP book. Currently
we factor in a 20-25% writedown in the AP book, but if the situation is further
exploited by politicians and recovery rates are only 50%, we estimate a loss in FY12
and book impact of 15% (pre-tax).
AP impact on growth, NPLs
The Andhra Pradesh microfinance ordinance became permanent law in Dec 10. This
has been accompanied by an Opposition campaign to “waive” microfinance loans,
creating a large moral-hazard problem. We are now factoring in a 25% loss on the
AP portfolio over the Mar 11 – Sep 11, with 4Q11 bearing the brunt.
Moral hazard issue
The conversion of the ordinance to an act in Dec 10 is an incremental negative - there
were some hopes that the AP government would soften its stance. The political
scenario has, in fact, got worse for the MFI sector – given the main opposition leader
in the state is on a hunger strike to highlight farmers’ issues. There are also reports
that some of the opposition parties are campaigning for the MFI loans to be waived
and exhorting borrowers not to repay till the RBI formalizes a view on the sector. We
think this is creating a large moral hazard issue for this sector.
Impact on NPLs
SKS reported 43% collections in November, and the December number is awaited.
The pressures on NPLs are coming from multiple fronts: a) the moral hazard problem
highlighted above b) SKS has been forced to switch to a monthly, rather than weekly,
collection format will lead to higher NPLs as its out of sync with borrowers' cash
flows and c) we are not convinced that SKS field officers are getting unfettered
access to the centers, given the groundswell of political opposition.
We are factoring in a 25% loss in AP over the next year, which is slightly above what
was reported in November. This, we think, is an optimistic estimate, given the moral
hazard issue. We will continue to monitor but this remains the greatest area of
concern.
Growth takes a beating
The secondary impact of the AP issue is on growth. We think it will be impossible
for SKS to continue to grow at historical growth rates (>50%). In the near term the
AP book would shrink substantially as no new disbursements are happening and
given ~28% exposure in AP impact on overall growth would be significant in the
near term. Even outside AP, a lack of funding would force a slowdown in
disbursements, and we expect a slower growth in non-AP states as well. We estimate
that in the near term there could be a contraction in AUMs in the Dec-10 quarter and
given write down and repayments and hence loan growth would be significantly
impacted in FY12 and stabilise at lower growth levels in FY13-14.
Return ratios ratcheting down
The secondary impact of the AP issue is margin pressure. SKS’ voluntary yield cuts
is a straight hit to margins, especially as this has coincided with tight liquidity and
high cost of wholesale funds. The absence of future securitization is a further ROE
drag, and we see normalized ROEs dipping ~16-17%.
Voluntary yield cuts: SKS has taken voluntary yield cuts in AP (from 26.7% to
24.6% effective yield) and also reduced lending yields in other states with yield in
the near term to reduced to 24.6%. Also a move to monthly installments from weekly
installments in AP (28% of current book) would also lead to NPV loss of interest
yield for SKS.
Cost of funds: Banks have frozen funding to the sector and incremental funding we
believe would come at higher levels. Also the current tight liquidity situation would
further impact borrowing costs. With lower lending yields and higher cost of funds
we believe margin would be impacted substantially with ~250bp margin contraction
expected over FY10-13.
Impact of lower securitization: Given the AP situation we believe securitization
would be much lower than ~30-35% done earlier. Also now given the higher risks
associated with microfinance loans margins in securitizing portfolios would also be
lower than earlier.
Some positives in the medium term
Concerns about bank funding have been addressed. Also, we see no further bad news
on the regulatory front (assuming other states don’t follow AP’s footsteps). Finally,
bank support for MFIs is not impossible, given the criticality of this sector in meeting
weaker section targets. However, near-term earnings destruction could overwhelm
these positives.
No further bad news assuming no spillage into other states – Bengal remains a
risk: The AP situation currently has not slipped into other states and according to the
management recoveries in ex-AP loan book is currently at historical levels of 98-
99%. Thus if the AP situation does not percolate to other states then we expect return
ratios to bounce back in FY13 post write down in AP book in FY12. West Bengal
contributes ~16% of SKS's portfolio currently and there could be risks from that part
of the portfolio.
Critical for banks – weaker section –targets – huge penalties: We believe that
MFI loans are very critical for banks meeting the mandatory exposure for the Priority
section especially for the weaker sections (10% of their loan book).Even if banks
meet their PSL target and not weaker section sub target they would be required to
lock in funds in RIDF bonds which yields <5.0%.
Cut EPS by 30-70%, PT by ~20%
We cut our EPS estimates by ~30-70% for SKS given the increase in credit costs and
slower growth expected. We expect a maximum impact in FY12 when credit costs
are likely to jump due to write-downs in the AP book and settle beyond FY12. On a
steady-state basis we believe ROEs will remain below 17-18% post FY12E leading
to a ~35% cut in earnings for FY13E. Our new Dec-11 PT is Rs550, based on our
three-stage Gordon Growth Model, down from our previous PT of Rs700.
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