Macquarie Research:: Buy Rural Electrification: Valuations factor in negatives; target Rs309

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Rural Electrification: Valuations factor in negatives
Event
 Retain OP: REC reported 3Q11 PAT of Rs6.6bn, up 40%YoY and 6% above
our estimates. A strong showing on margins offset weakness in transmission
& distribution lending. We retain our Outperform rating as we believe current
valuations are undemanding, even as we cut our target multiple and target
price from Rs460 to Rs309 to factor in slower growth.

Impact
 Strong margins become better. REC’s very healthy NIMs got even better in
3Q11 as the large low cost yen borrowings had their full impact. NIMs were up
17bp QoQ to 4.56% compared to our expectations of margin contraction. This
tallies with PFC’s 3Q11 results, where higher foreign borrowings have helped
NIMs. Management had raised lending rates by 25bp in January. However we
are building ~ 25bp QoQ NIM compression for 4Q11 to factor in increase in
cost of ordinary bonds.
 T&D a laggard but mitigating factors present. Overall loan growth of 20%
YoY was much below our expectations, as T&D (which constitutes 52% of
loan book) grew by only 14%YoY versus 40% growth in generation loans.
Given the continued slowdown in T&D, our earlier loan growth estimate of
30% YoY is unlikely to be achieved. We have accordingly cut our growth
estimate to 20%YoY. We believe there is limited downside risks to these
growth estimates because of the following reasons:
The much faster growing generation segment is likely to become
increasingly important vs T&D. Around 53% of recent sanctions have
been to generation compared to 41% of T&D.
Management focus on private borrowers, who are expected to drive bulk
of capacity generation.
FY12 likely to see higher execution activity, being the last year of the
current Five Year Plan.    
Earnings and target price revision
 We have increased FY11 EPS by 1% and cut FY12E and FY13E EPS by 7%,
and 13% driven by lower loan growth. We have cut our target multiple from 3x
to 2x FY12E BVPS on lower RoE. Our TP reduces by from Rs460 to Rs309
Price catalyst
 12-month price target: Rs309.00 based on a Gordon growth model
methodology.
 Catalyst: Revival in loan growth, sustaining margins
Action and recommendation
 Valuations factor in negatives, maintain OP- .We believe current valuations
of 1.6x FY12E BVPS are attractive, given the attractive ROE and RoAs of the
stock despite growth slowdown. Among specialist power lenders we prefer
PFC over REC, given its better growth visibility


Valuation
 We have cut our TP multiple from 3.0x to 2.0x FY12 BVPS. Our TP reduces to Rs309 from Rs460
earlier. The cut in multiple is mainly driven by (i) lower sustainable ROE from 21.5% to 19.0%, as
we factor in credit charge of 0.5% of average assets and (ii) to a much smaller extent from
increase in cost of equity to factor in increased volatility from higher foreign borrowings.
 We use a two stage Gordon growth model for valuing REC, where P/BV = RoE *{(p(1+g) * (1-
(1+g)n/(1+r)n)) + (pn(1+g)n(1+gn))/((r-gn)(1+r)n)}, where g=growth rate for the first n (high-growth
period) years, p=payout ratio in the first n years, gn=perpetual growth rate,pn=perpetual payout
ratio.

Fig 2 Two stage GGM
RoE 19%
g (initial growth) 11%
r (CoE) 13.5%
gn (perpetual growth rate) 4%
n (initial growth period, yrs) 10
P/BV (FY12) 2.0x
Target price (rounded off) 309
Source: Company data, Macquarie Research, February 2011