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Power finance corporation Ltd
Concerns overdone; valuations
attractive; resume at Buy
„Buy for EPS upgrades (consensus); attractive risk-return
We resume coverage on PFC with a Buy rating (and PO of Rs260) and revised
earnings estimates, post the follow-on offering. The positive catalyst will likely be
earnings upgrades by the consensus (Mle at +4/6% higher for FY12/13), as
structurally power financing remains a focused priority for the govt. and PFC itself
has +6x sanctions to its annual disbursements. Moreover, PFC’s valuations
remain very attractive (trades at 1.2x FY12 book; RoEs of ~18%) and the stock is
trading at a +15-25% discount to its peers (REC, IDFC) despite better risk-profile
Finally, we believe asset quality issues are overdone (detailed below).
Concerns on asset quality overdone
We believe concerns on asset quality are overdone. PFC is more exposed to
lower-risk generation business. (~85% of loans). While PFC has +67-68%
exposure to SEBs, its exposure to ‘working capital’ to state electricity boards
(SEBs) as % of total loans is <4-5% and total exposure to private sector is <8-9%.
EPS growth of +8/24% in FY12/13, but profit growth high
Post rights issue, we estimate earnings growth of +8/24% for FY12/13, but net
profit growth of +24% in FY12/13. Earnings to be driven by loan growth of +24-
25% in FY12 and margins rising (by ~15-20bp yoy) owing to low-cost funding
sources (tax-free bonds, infra bonds, ECBs, etc) and leveraging capital. More so,
we now also are building in 20bp credit costs going forward (vs. nil so far). Key
risks are: large scale default by SEBs, which could hurt PFC’s earnings growth
Buy for EPS upgrades; attractive valuations
We resume coverage on PFC with a Buy rating (and PO of Rs260) and revised
earnings estimates, post the follow-on offering of US$780mn recently. Besides
govt. focus on power sector to drive GDP growth in India, we believe there are 5
reasons why one should buy PFC:
„ Above consensus earnings estimates to drive upgrades: While modest,
but we are +4/6% ahead of consensus for FY12/13 pre-tax earning
estimates. We expect consensus to raise their earnings for FY12/13, as we
believe PFC will deliver above average / higher FY12 (yoy) margins (NIMs)
driven by 1) higher share of fixed rate liabilities (~66% fixed rate) vs. loans
(~8% fixed rate’ +83% re-set with 3 year clause); 2) ability to raise cheaper
funding (tax-free bonds, ECBs, retail infra. bonds, etc) and; 3) leveraging
recently raised capital.
„ Positive on volume growth momentum: We remain positive on PFC
delivering on volume growth of +24-25% for FY12-13, as PFC has a pipeline
(sanctions) that are +6x its annual disbursements and structurally, power
financing remains a focus area for govt, with debt requirements of
~US$200bn in 12
th
five-year plan (FY12-17).
„ Compelling valuations; attractive risk-return: Valuations remain
compelling with stock trading at 1.2x FY12 (1.0x FY13 book) book with RoEs
of ~18% for FY12/13. Moreover, with its peer group, the stock is trading at
+15-25% discount to its immediate peer group, despite PFC having a better
risk-profile (~85% exposure to generation business) vs. REC (40%
generation) and vs. IDFC (+35-40% capital market linked businesses).
Furthermore, compared to its 5 year historical trading range (one-year
forward), the stock is trading at +30-35% discount.
„ Asset quality issues appear to be overdone: The sharp discount to its
five-year average trading band, as well as to its peers is partly owing to asset
quality concerns, which we clearly believe are overdone.
o PFC is more exposed to lower-risk generation business. (~85%
of loans). While PFC has +67-68% exposure to SEBs, its
exposure to ‘working capital’ to state electricity boards (SEBs)
as % of total loans is <4-5% and total exposure to private
sector is <8-9%.
o While NPL worries have been there over the past 6-8 months,
the underlying (state electricity boards losses) have been a
reality for the past 8-10 years and there have been no defaults
to date. We draw some comfort from checks and balances in
place since the last defaults / restructuring (2003) in the form of
escrow / state guarantees, etc. and stringent risk practices put
in place prior to disbursements.
„ Recent capital dose a booster for growth / exposures: Besides increasing
stock liquidity, which was abysmally low owing to high govt. share (90% vs.
78% post money), PFC’s capital has gone up to +19-19.5%, which should
provide a big boost to growth (volumes) for PFC in FY12/13. Moreover, the
added capital will also allow PFC to lend more to single / group borrowers.
Valuations: risk-return attractive
As highlighted in the past, we traditionally value banks/NBFCs based on Gordon
model metric (P/B-ROE/ COE), as we believe this best captures the risk-return
trade-off. The ROE-P/B relationship, however, is unlikely to be linear as ROE
expands beyond COE. Typically, a company is likely to receive a premium to its
P/B as it generates a higher ROE or is better positioned to capitalize on growth
opportunities in India. We value PFC using the growth-adjusted P/B method with
the following key assumptions: Forecast ROE: average of around 18% over
FY11-13E and cost of equity at 13.5%
YTD, PFC has underperformed the most (~30%), as highlighted, owing to
concerns on its exposure to PSU power companies and volume / margin worries.
PFC has had structurally high RoAs (at +2.7%) driven by high margins and low
operating cost structure (cost-income ratio at ~3%) and obviously near-zero credit
costs. While it may not be adequate, we are also building in 20bp credit costs
going ahead, as a buffer. Subsequent to factoring in credit costs, we still believe
PFC can deliver +2.7% RoAs.
Hence, we assign a 25% premium PFC to their theoretical book multiples to
arrive at our fair multiples of ~1.6x, which is still a 10% discount to PFC’s fiveyear average multiple. We think PFC will get re-rated, as it will deliver on earnings
/ growth and more importantly, asset quality concerns ebb, which have been a
focus of attention lately, as we believe that State governments will likely support
loss making SEBs and simultaneously may even push for tariff hikes.
Accordingly, our PO now stands at Rs260, a +30% potential upside.
Earning growth / drivers
Estimate net profit growth of +24% for FY12/13
While we estimate earnings growth of +8/24% for FY12/13, profit growth should
be higher for FY12 at +24% yoy. Lower earnings growth has to do with PFC’s
recent capital raising (US$780mn FPO). Subsequent to the capital raising, PFC’s
total CAR is up at +19-19.5% allowing not only room for growth but also
enhancing single / group borrower limits (owing to higher net worth).
We highlight below the key drivers for profit growth going ahead:
Volume growth of +24-25% should sustain through FY13
More importantly, recently there has been a lot of debate on sustainability of
volume growth for PFC. While there is no doubt that the power sector is going
through a rough phase owing to lack of reforms at T&D level and coal availability,
environment and land acquisition issues, we believe PFC can continue to grow its
loan book by +24-25% yoy for the next few years, as 1) outstanding sanction
pipeline remains strong (+6x of PFC’s annual disbursements) and 2) there is
~US$200bn spending opportunity in the 12
th
five-year plan (FY13-17), almost
double that of the 11
th
five-year plan.
Margins likely to be ~20bp higher yoy in FY12; flattish (yoy) in FY13
While spreads are likely to expand by +12-15bp in FY12, we expect margins to
increase by ~20bp in FY12 and remain flat yoy in FY13.
The key spread drivers are:
„ While today re-pricing gap (ALM) has narrowed for PFC for FY12 (Rs40bn of
assets and Rs39bn of liabilities re-price), the average duration works in its
favor. Average duration on assets is 6.4 years and liability is 5.2 years.
„ More importantly, of the total borrowings, ~66% is fixed, while of the loans
~92% are at floating rate of which ~83% is with reset clause of three years,
which benefits PFC’s margins.
„ Today, PFC has the ability to raise low-cost funding in the form of tax-free
bonds, infra bonds and ECBs, which in today’s context has relatively lower
costs than domestic debt (bonds / bank loans).
„ Lastly, the recent capital raising will obviously play a positive role in margin
expansion owing to which margin expansion is estimated to be higher than
spread expansion.
Concerns on asset quality overdone
While there are underlying issues with PSU power companies, especially state
electricity boards (SEBs), given old technology being used, inadequate tariff hikes
and political interferences, the issue is overdone, in our view. PFC’s ‘working
capital’ exposure to state electricity boards (SEBs) as % of total loans is <4-5%
and total exposure to private sector is <8-9%; PFC is more exposed to generation
business. (~85% of loans). While it may not be adequate, we are also building in
20bp credit costs going ahead, as a buffer vs. almost nil so far.
NPLs unlikely; restructuring may be a possibility
Given the importance of the sector, we do not believe that the exposures of
lenders will turn into NPLs. However, a massive restructuring could be on the
anvil given the quantum of losses financed. While loans to ailing SEBs may not
necessarily be treated as NPLs and consequently may not require entire 70%
provisioning against them, lenders’ profitability may get impacted to the extent of
NPV loss arising from the restructuring package. Since the problem that we
currently face is huge in terms of its sheer size, scope and the likely impact that it
will have on the power value chain, restructuring is the only way out in the short
term. We do not expect any interest restructuring, if any, only an extension of
principal payments might be undertaken.
Why there are no SEB defaults since 2003
Post the restructuring in 2003, State utilities were asked to ensure payment of
current bills through Letters of Credit and any default amount would be recovered
through adjustment against releases due to the respective state governments on
account of plan assistance states' share of central taxes and any other grants or
loans given to the states by debiting their respective accounts. Furthermore, in
our view, the current health of state finances is much better than it was in 2003.
Hence, it would be easier for the states to contribute to the funds required for the
one-time settlement.
Tariff rationalization is the key to end SEBs’ woes
The obvious solution to the financial woes of the SEBs, in general, is to increase
the blended realization per unit of power sold to enable the distribution utilities to
cover the increase in costs. Though independent electricity regulators have the
nominal right to set tariffs, they have not been able to overcome political
considerations.
Most states in India heavily subsidise the power for agricultural use by charging
higher rates to industrial users. For the large states, ~30% of the energy sold is
used for agriculture. However, revenue from agricultural customers forms only 8%
of the total revenue. Industrial customers contribute ~45% of total revenues
against their share of 34% of total energy sold. Moreover, the race among states
to position themselves as attractive destinations for investment is resulting in
limited increase in tariffs for industrial consumers as well. Blended tariffs have to
increase by ~25% for SEBs to break-even. If Coal India increases coal prices for
utilities by ~20%, another ~5% increase in overall tariffs would be required to
break-even. We remain hopeful that SEBs will progressively and proactively raise
tariffs to bridge the annual losses.
Price objective basis & risk
Power finance corporation Ltd (PWFEF)
We rate PFC as a Buy with PO of Rs260. We maintain Buy (target P/B of 1.6x, a
10% discount to five year average multiple, with a potential upside of +30% as we
reckon: 1) Est. operating earnings to grow +30% in FY12 led by 25% volume
growth and margins risiing by 20bps on leveraging capital, 2) RoAs sustaining at
2.7% and RoEs at around 18%, 3) comfort on asset quality and, 4) recent fall in
stock (+30% YTD) captures the downside risks. Our PO is based on Gordon
model theory of RoE and CoE, wherein RoE estimated at 18% and CoE at 14%,
hence we assign a 25% premium to Gordon theory to capture the continued
growth momentum and comfort on asset quality. Growth (volume) is likely to
sustain at +25% especially as PFC remains a direct play on financing of power
projects in India (key govt. focus area). Risks are higher defualts that could lead
to asset quality issues.
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