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UBS Investment Research
India Banking & Finance Sector
Liquidity pangs
„ Tight liquidity conditions have impacted NBFC price performance
Non-banking financial company (NBFC) stocks have corrected 5-36% over the
past three months on tight liquidity conditions. Our study of past cycles suggests
strong outperformance by the segment when liquidity eases. While liquidity
tightness might continue, the deficit should fall, easing concerns about growth and
margins.
„ Valuation opportunity opening up; stocks slightly above five-year averages
Current valuations are slightly above five-year averages, which we think are
justified, as we expect ROE to be 200-400bp higher than in the last cycle. UBS’s
economic growth forecast for FY12 is 8%, which predicates a healthy growth and
profitability outlook for the sector.
„ Risk: high foreign ownership, oil spike, aggressive monetary tightening
Foreign institutional investor ownership in these stocks has increased multifold,
representing a risk to our view until the situation stabilises. High oil prices could
lead to higher inflation, prompting the Reserve Bank of India (RBI) to act
aggressively. Inflationary pressure could lead it to maintain tight liquidity, in spite
of the pick-up in spending. These risks could cap near-term upside for the segment.
„ Prefer NBFCs with pricing power; top pick SHTF
We prefer companies that have strong pricing power, face less competition from
banks, and have a strong funding base. Our top pick in the segment is Sriram
Transport Finance (SHTF), a UBS Key Call, while our least preferred pick is LIC
Housing Finance (LICHF). We lower our price target for Rural Electrification from
Rs415 to Rs350 on our lower earnings estimates for FY11 and FY12.
Executive summary
We believe near-term challenges are increasing for the NBFC segment because
of tight liquidity, high interest rates and rising inflationary pressure. These
concerns, together with the strong performance in 2010 and high foreign
ownership, could weigh on NBFC share price performance near term. However,
valuations have corrected 5-36% in the past three months, suggesting some of
these concerns are reflected in the share prices. UBS’s India economist, Philip
Wyatt, expects inflation of 6.5-7% in the next couple of months and economic
growth of 8% in FY12, which should support a healthy growth and profitability
outlook for the segment in the medium term. Philip believes liquidity conditions
are ‘as tight as it gets’; this should help stabilise expectations. While the risk of
inflationary pressure remains, we believe valuations are becoming attractive.
Our top pick in the segment is SHTF, our least preferred is LICHF.
Tight liquidity conditions have impacted prices
Tight liquidity conditions have been the bugbear for Indian financials, with the
UBS NBFC Index down 10% since November 2010, and most leading financial
stocks down 5-36% in the past three months. We think liquidity conditions will
have a bearing on the margin trend and expect it to decline from cyclical highs
for most NBFCs in H2 FY11 and FY12. However, we think 1) this decline will
be gradual over next two to three quarters rather than immediate; 2) structural
demand factors for growth remain in place for infrastructure, power, vehicles,
and mortgages, helping NBFCs’ pricing power and stabilising their margins.
In the near term, improvement in liquidity conditions (which is our base case),
could act as a catalyst for share price performance. Based on our growth and
profitability outlook, we believe valuations, though still at a premium to
historical averages, are becoming attractive after the recent correction.
Based on available historical data, we have identified six instances of tight
liquidity conditions and studied the price performance of NBFC stocks during
these phases. Contrary to general perception, our study suggests NBFCs have
outperformed/market performed the Sensex in most instances, except once, in
January 2006-July 2006, when they underperformed the Sensex by 23% (in line
with banks). We have documented the performance of NBFCs against the
Sensex and the banks over from January 2004 to March 2009, when there were
four instances of tight liquidity conditions (a full business cycle).
Our study also shows that as conditions move from tight to normal liquidity, the
segment tends to outperform the market by a wide margin.
Stocks have corrected and valuations are
slightly above 5-year average P/BV multiples
NBFCs have corrected 5-36% over the past three months, following which the
UBS NBFC Index (comprising HFDC, SHTF, REC, PFC, IDFC and LICHF) is
trading at a five-year average valuation multiple. However, given UBS’s
economic growth forecast of 8% for FY12 based on investments, we believe the
outlook on loan growth, asset quality and NIMs remains favourable and we
expect stocks to trade above their five-year average. Additionally, the rolling
over of estimates to FY13 in the next six months or so should provide additional
cushion to multiples, in our view
Reliance on short-term funds is low but liquidity
important for growth outlook
The charts on the following page support our view that NBFCs’ NIM
compression is likely to be gradual rather than immediate, due to efficient asset
liability management (ALM). As seen in charts 3 and 4, the maturity of
liabilities percentage is low for most NBFCs (except IDFC) and proportion of
floating assets is higher than liabilities (except for PFC). Therefore, we think an
immediate increase in the average cost of borrowings is unlikely; however,
prolonged tight liquidity conditions can impact these companies’ ability to grow.
In Table 2, we summarise our estimates of the impact of tight liquidity
conditions on our earnings estimates, assuming the NBFCs have to borrow at
75bp above our assumption—the risk to FY11 earnings will not be more than 2-
6%.
Risk: high foreign ownership in the sector
There has been strong foreign interest in the NBFC segment, mainly because
they are cheaper and more liquid proxies in the financial sector than banks,
which have ownership restrictions. As a result, FII ownership in most of these
stocks has increased multifold (except for PFC), presenting a near-term risk until
the situation stabilises, in our view.
Recommendation summary
Our recommendations for the sector are:
Shriram Transport Finance (Buy, PT Rs1000, estimated 40% upside)
We like SHTF for its strong competitive positioning and superior return ratios.
Its valuation of 2.6x FY12E P/BV and 10x FY12E PE are at slight premiums to
its five-year average, but we think it could re-rate further due to its strong
business outlook. SHTF is a UBS Key Call.
Rural Electrification (Buy, PT Rs350, estimated 31% upside)
We lower our price target for REC from Rs415 to Rs350 on our 4% and 9%,
lower earnings estimates for FY11 and FY12, respectively, due to lower-thanexpected disbursements. However, at 1.8x FY12E P/BV, we believe this is
largely priced in. We maintain our Buy rating.
Power Finance (Buy, PT Rs360, estimated 24% upside)
Our price target is Rs360. We think at the current valuation of 1.8x FY12E
P/BV, we believe lower NIM expectations are largely priced in. We maintain
our Buy rating.
LIC Housing Finance (Sell, PT Rs160, estimated 6% downside)
We maintain our Sell rating on LICHF, as we believe its pricing power in
mortgages is weak due to intense competition. While it could maintain high
growth (30%) in loan book in the near term, we think it will likely fall over the
medium term because of the change in management and likely change in
strategy.
IDFC (Neutral, PT Rs180, 10% estimated upside)
We maintain our Neutral rating on IDFC. We expect strong growth but think
margin compression will weigh on share price performance. Our sum-of-theparts based price target is Rs180.
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