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NBFCs
India
Resetting expectations at attractive valuations. We believe that the
recommendations of RBI’s working group on NBFCs, if implemented, will pose the next
set of challenges for asset finance and infrastructure NBFCs. After the recent price
correction, we believe infrastructure NBFCs already factor in the impact of regulatory
changes and stress-case business scenario. We remain selective in the asset finance
segment; we believe that issuance of new bank licenses will likely be a long-drawn
process; even as asset finance companies (Shriram Transport and Mahindra Finance) are
better placed to procure the same. Upgrade IDFC, PFC and REC to BUY from ADD.
RBI NBFC report: Lower leverage, higher provisions, silent on securitization guidelines
We believe that the report by RBI’s working group on NBFCs, if implemented, will increase the
provisioning cost for most NBFCs. With negligible gross NPLs and large excess provisions, IDFC is
best placed in this scenario. We find about 2-3% medium-term EPS impact on infrastructure
NBFCs (PFC and REC) and about 7-10% on asset finance companies (Shriram Transport and
Mahindra Finance) due to higher provisions, if the guidelines are implemented.
The RBI report has proposed a minimum Tier I capital adequacy ratio (CAR) to 12% from 10%
earlier. In order to maintain a high investment grade credit rating, NBFCs generally maintain about
12-14% Tier I CAR. However, we find more pressure on leverage if RBI imposes restrictions on
loans sold by NBFCs to banks. Notably, the guideline on priority sector recognition for loan sold by
NBFCs to banks will be reviewed by another committee of bankers.
Bank licenses: A longer wait
RBI has clarified that the Government will need to make a couple of amendments to the Banking
Regulation Act before inviting applications for new branch licenses; the revised bill will shortly
placed in the Parliament. Thus, we would likely need to wait longer for new bank license
issuances. In the draft guidelines, RBI continues to look at companies (NBFCs or otherwise) who
can focus on financial inclusion and have reasonably strong promoters. Thus, asset finance
companies like Shriram Transport Finance, Mahindra Finance and L&T Finance stand a good
chance.
Infrastructure NBFCs provide attractive risk-return trade-off
We are upgrading our rating on IDFC to BUY from ADD retain target price of Rs150). We upgrade
our rating on PFC to BUY from ADD with a revised price target price of Rs225 from Rs240 earlier
and on REC to BUY from ADD retain target price of Rs240). All three infrastructure NBFCs (PFC,
IDFC and REC) are trading close to historic low valuation multiples after a 40-50% correction in
the recent past. Asset quality remains a risk though we believe that the price already factors in a
stress scenario and likely impact of the working group committee recommendations. Notably, IDFC
and PFC have demonstrated a track record of maintaining low NPLs across business cycles, a trend
that appears to be ignored by the street.
We believe Shriram Transport Finance is one of the best candidates for procuring new bank
licenses. However, macro headwinds in the CV industry, coupled with likely regulatory issues
(more stringent NPL recognition norms, change in regulations for priority sector recognition of
loans sold by NBFCs to banks) will likely pressure stock price performance. We retain our REDUCE
rating with a price target of Rs675 (down from Rs700 earlier).
RBI NBFC report: Higher provisions, lower leverage
Higher provisions. We believe the report by RBI’s working group on NBFCs, if
implemented, will increase provisioning cost for most NBFCs. The committee has
recommended that the NPL provisioning guidelines for NBFCs should be in line with those of
banks. Currently, banks follow the NPL recognition norm of 90 days-past-due, while NBFCs
follow a 180-day norm. Thus, NPLs of NBFCs will likely increase considerably in case NBFCs
follow the banking rule. Banks are required to have a higher standard and specific NPL
provisions (exhibit 1). With negligible gross NPLs and large excess provisions (Rs6.5 bn), IDFC
is best placed in this scenario. We find about 2-3% medium-term EPS impact on
infrastructure NBFC and about 7-10% on asset finance companies (stress case in Exhibits 2-
6).
Infrastructure NBFCs (REC and PFC) will likely have a higher impact due to standard asset
provisions. In our scenario analysis, we have modeled the impact from the first year
(2012E) even as RBI will likely provide leeway of a couple of quarters to comply with the
guideline. In the second scenario, outlined in Exhibits 2 and 3, we have stressed earnings
to lower loan growth and higher NPL provisions. Even in a stressed case, valuations
appear attractive, close to book value. Earnings are likely to be volatile if 10% provisions
have to be made in one quarter, especially given that these are large ticket loans.
Asset finance companies have a higher gross NPL ratio and hence the impact on specific
NPL provisions in case of migration to 90 days from 180 will likely be higher. In Exhibits 4
and 5, we estimate the impact of increase in gross NPLs to 4.5% from 2.7% for Shriram
Transport Finance and 6.5% from 5% for Mahindra Finance. Notably, Shriram Transport
Finance follows the norm of 180-days-past due dates for NPLs while Mahindra Finance
follows the 120-day norm. More aggressive recoveries or a change in provision coverage
ratio can provide significant sensitivity to our estimates in the stress scenario.
Lower leverage. The RBI report has increased the minimum Tier I capital adequacy ratio
(CAR) to 12% from 10% earlier. The proposed ratio is significantly higher than about 6%
for banks; we are not very clear about the reason for increase in CAR.
In order to maintain a high investment grade credit rating, NBFCs generally maintain about
12-14% Tier I CAR. Most NBFCs currently have about 18% Tier I and may not have any
immediate need to raise capital. However, a higher regulatory CAR will reduce the leeway of
these companies if rating agencies increase comfort on leverage. We find more pressure on
leverage if RBI imposes restrictions on loans sold by NBFCs to banks.
We expect some medium-term capital pressure on all asset finance companies:
Shriram Transport. Adjusted for first and second loss provisions on loans securitized to
banks, Tier I CAR was 14.5% as of March 2011
Muthoot Finance. High gold prices will likely buoy loan growth; Tier I CAR will decline to
8% by March 2012E (13.4% in base case) in case all gold loans are retained in the books
of the NBFCs
Mahindra Finance. We are modeling 25% yoy loan growth in 2012E despite 12% qoq
loan growth in 1QFY12. If the pace of growth remains higher than expected, the
company will need to raise equity.
Await guidelines on loan securitization. Last week, RBI constituted a committee of
bankers to comprehensively review the guidelines of priority sector loans. The committee will
discuss issues relating to priority sector classification for loans sold by NBFCs to banks.
Other proposals
Government-owned NBFCs. The committee has highlighted that prudential guidelines
for NBFCs should be applicable to Government-owned NBFCs as well. In this backdrop,
we would like to highlight that PFC and REC would find it challenging to comply with
single party exposure norms of other NBFCs (maximum single party exposure at 15% of
net owned funds) due to their large exposures to state utilities.
Capital market linked lending. The committee proposes higher risk weights on equity
market linked loans and commercial real estate.
Private placement of NCDs. The committee has also expressed concerns regarding
private placement of NCDs by non-deposit accepting NBFCs; this will likely impact the
gold loan NBFCs.
We find infrastructure NBFCs attractive at this price
PFC, IDFC and REC are trading close to historic low valuations after 40-50% correction in
the recent past (Exhibits 7-9). While the risk of asset quality performance remains a concern,
a stress scenario (as highlighted above) is already factored in the price.
REC’s current stock price offers attractive dividend yield of 5.9% for FY2012E, PFC is trading
at dividend yield of 3.6% for FY2012E and IDFC at 2%.
Is the market ignoring the positives of infrastructure NBFCs?
Macro challenges in the power sector pose significant risks to the asset quality performance
of the lenders, a key reason for the decline in infrastructure NBFC stocks. In this backdrop,
we would like to highlight the following:
Buffers on IDFC’s balance sheet. IDFC has maintained reported gross NPL in the range of
0.2% and 1.1% since 2002 (Exhibit 10). As of June 2011, only about 30% of IDFC loan
book (about Rs110 bn) was exposed to project completion risk. The company has followed
an aggressive provisioning policy and currently has a buffer of Rs6.5 bn on its balance sheet.
If we assume a 10% loss given the default on NPLs, the current excess provisions can absorb
impact of about 50% NPLs in its non-operating assets.
PFC’s strong asset quality performance track record. PFC has reported gross NPLs in the
range of 0.02-1% between FY2003 and FY2011, Notably, NPLs have been low even at the
nadir of the previous crises. In 2003, SEBs restructured their dues to power/fuel suppliers
(like NTPC); loans for capex to PFC continued to be current. Key reasons:
PFC was a nodal agency for several schemes operated by the central Government. The
company has been working closely with the Ministry of Power
Default to PFC may be construed as default to Central Government by the auditors of the
state Government. PFC offers a discount for timely payment and hence interest rates move
up by 25 bps in case of delinquencies
Low exposure to private sector is a positive. We believe the lack of adequate fuel supply
arrangements will affect the prospects of private power producers. PFC has just 8%
exposure to private sector. Generation remains a large contributor at 85% of overall loan
book as of March 2011
REC’s has reported high NPLs in FY2003, i.e., in the previous downturn. The company
primarily focused on rural electrification projects and did not fund generation projects
(primary focus segment of PFC) in the past. REC has improved its asset protection
mechanism; the company offers a small rebate (25 bps) for timely repayment of loans
(like PFC) and secures its cash flows from escrow mechanism. The management has
highlighted that it has an exclusive escrow charge on select distribution circles and other
lenders (banks and State Governments) may not have access to such a facility. Exposure
to the private sector is only 10% of overall loans.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
NBFCs
India
Resetting expectations at attractive valuations. We believe that the
recommendations of RBI’s working group on NBFCs, if implemented, will pose the next
set of challenges for asset finance and infrastructure NBFCs. After the recent price
correction, we believe infrastructure NBFCs already factor in the impact of regulatory
changes and stress-case business scenario. We remain selective in the asset finance
segment; we believe that issuance of new bank licenses will likely be a long-drawn
process; even as asset finance companies (Shriram Transport and Mahindra Finance) are
better placed to procure the same. Upgrade IDFC, PFC and REC to BUY from ADD.
RBI NBFC report: Lower leverage, higher provisions, silent on securitization guidelines
We believe that the report by RBI’s working group on NBFCs, if implemented, will increase the
provisioning cost for most NBFCs. With negligible gross NPLs and large excess provisions, IDFC is
best placed in this scenario. We find about 2-3% medium-term EPS impact on infrastructure
NBFCs (PFC and REC) and about 7-10% on asset finance companies (Shriram Transport and
Mahindra Finance) due to higher provisions, if the guidelines are implemented.
The RBI report has proposed a minimum Tier I capital adequacy ratio (CAR) to 12% from 10%
earlier. In order to maintain a high investment grade credit rating, NBFCs generally maintain about
12-14% Tier I CAR. However, we find more pressure on leverage if RBI imposes restrictions on
loans sold by NBFCs to banks. Notably, the guideline on priority sector recognition for loan sold by
NBFCs to banks will be reviewed by another committee of bankers.
Bank licenses: A longer wait
RBI has clarified that the Government will need to make a couple of amendments to the Banking
Regulation Act before inviting applications for new branch licenses; the revised bill will shortly
placed in the Parliament. Thus, we would likely need to wait longer for new bank license
issuances. In the draft guidelines, RBI continues to look at companies (NBFCs or otherwise) who
can focus on financial inclusion and have reasonably strong promoters. Thus, asset finance
companies like Shriram Transport Finance, Mahindra Finance and L&T Finance stand a good
chance.
Infrastructure NBFCs provide attractive risk-return trade-off
We are upgrading our rating on IDFC to BUY from ADD retain target price of Rs150). We upgrade
our rating on PFC to BUY from ADD with a revised price target price of Rs225 from Rs240 earlier
and on REC to BUY from ADD retain target price of Rs240). All three infrastructure NBFCs (PFC,
IDFC and REC) are trading close to historic low valuation multiples after a 40-50% correction in
the recent past. Asset quality remains a risk though we believe that the price already factors in a
stress scenario and likely impact of the working group committee recommendations. Notably, IDFC
and PFC have demonstrated a track record of maintaining low NPLs across business cycles, a trend
that appears to be ignored by the street.
We believe Shriram Transport Finance is one of the best candidates for procuring new bank
licenses. However, macro headwinds in the CV industry, coupled with likely regulatory issues
(more stringent NPL recognition norms, change in regulations for priority sector recognition of
loans sold by NBFCs to banks) will likely pressure stock price performance. We retain our REDUCE
rating with a price target of Rs675 (down from Rs700 earlier).
RBI NBFC report: Higher provisions, lower leverage
Higher provisions. We believe the report by RBI’s working group on NBFCs, if
implemented, will increase provisioning cost for most NBFCs. The committee has
recommended that the NPL provisioning guidelines for NBFCs should be in line with those of
banks. Currently, banks follow the NPL recognition norm of 90 days-past-due, while NBFCs
follow a 180-day norm. Thus, NPLs of NBFCs will likely increase considerably in case NBFCs
follow the banking rule. Banks are required to have a higher standard and specific NPL
provisions (exhibit 1). With negligible gross NPLs and large excess provisions (Rs6.5 bn), IDFC
is best placed in this scenario. We find about 2-3% medium-term EPS impact on
infrastructure NBFC and about 7-10% on asset finance companies (stress case in Exhibits 2-
6).
Infrastructure NBFCs (REC and PFC) will likely have a higher impact due to standard asset
provisions. In our scenario analysis, we have modeled the impact from the first year
(2012E) even as RBI will likely provide leeway of a couple of quarters to comply with the
guideline. In the second scenario, outlined in Exhibits 2 and 3, we have stressed earnings
to lower loan growth and higher NPL provisions. Even in a stressed case, valuations
appear attractive, close to book value. Earnings are likely to be volatile if 10% provisions
have to be made in one quarter, especially given that these are large ticket loans.
Asset finance companies have a higher gross NPL ratio and hence the impact on specific
NPL provisions in case of migration to 90 days from 180 will likely be higher. In Exhibits 4
and 5, we estimate the impact of increase in gross NPLs to 4.5% from 2.7% for Shriram
Transport Finance and 6.5% from 5% for Mahindra Finance. Notably, Shriram Transport
Finance follows the norm of 180-days-past due dates for NPLs while Mahindra Finance
follows the 120-day norm. More aggressive recoveries or a change in provision coverage
ratio can provide significant sensitivity to our estimates in the stress scenario.
Lower leverage. The RBI report has increased the minimum Tier I capital adequacy ratio
(CAR) to 12% from 10% earlier. The proposed ratio is significantly higher than about 6%
for banks; we are not very clear about the reason for increase in CAR.
In order to maintain a high investment grade credit rating, NBFCs generally maintain about
12-14% Tier I CAR. Most NBFCs currently have about 18% Tier I and may not have any
immediate need to raise capital. However, a higher regulatory CAR will reduce the leeway of
these companies if rating agencies increase comfort on leverage. We find more pressure on
leverage if RBI imposes restrictions on loans sold by NBFCs to banks.
We expect some medium-term capital pressure on all asset finance companies:
Shriram Transport. Adjusted for first and second loss provisions on loans securitized to
banks, Tier I CAR was 14.5% as of March 2011
Muthoot Finance. High gold prices will likely buoy loan growth; Tier I CAR will decline to
8% by March 2012E (13.4% in base case) in case all gold loans are retained in the books
of the NBFCs
Mahindra Finance. We are modeling 25% yoy loan growth in 2012E despite 12% qoq
loan growth in 1QFY12. If the pace of growth remains higher than expected, the
company will need to raise equity.
Await guidelines on loan securitization. Last week, RBI constituted a committee of
bankers to comprehensively review the guidelines of priority sector loans. The committee will
discuss issues relating to priority sector classification for loans sold by NBFCs to banks.
Other proposals
Government-owned NBFCs. The committee has highlighted that prudential guidelines
for NBFCs should be applicable to Government-owned NBFCs as well. In this backdrop,
we would like to highlight that PFC and REC would find it challenging to comply with
single party exposure norms of other NBFCs (maximum single party exposure at 15% of
net owned funds) due to their large exposures to state utilities.
Capital market linked lending. The committee proposes higher risk weights on equity
market linked loans and commercial real estate.
Private placement of NCDs. The committee has also expressed concerns regarding
private placement of NCDs by non-deposit accepting NBFCs; this will likely impact the
gold loan NBFCs.
We find infrastructure NBFCs attractive at this price
PFC, IDFC and REC are trading close to historic low valuations after 40-50% correction in
the recent past (Exhibits 7-9). While the risk of asset quality performance remains a concern,
a stress scenario (as highlighted above) is already factored in the price.
REC’s current stock price offers attractive dividend yield of 5.9% for FY2012E, PFC is trading
at dividend yield of 3.6% for FY2012E and IDFC at 2%.
Is the market ignoring the positives of infrastructure NBFCs?
Macro challenges in the power sector pose significant risks to the asset quality performance
of the lenders, a key reason for the decline in infrastructure NBFC stocks. In this backdrop,
we would like to highlight the following:
Buffers on IDFC’s balance sheet. IDFC has maintained reported gross NPL in the range of
0.2% and 1.1% since 2002 (Exhibit 10). As of June 2011, only about 30% of IDFC loan
book (about Rs110 bn) was exposed to project completion risk. The company has followed
an aggressive provisioning policy and currently has a buffer of Rs6.5 bn on its balance sheet.
If we assume a 10% loss given the default on NPLs, the current excess provisions can absorb
impact of about 50% NPLs in its non-operating assets.
PFC’s strong asset quality performance track record. PFC has reported gross NPLs in the
range of 0.02-1% between FY2003 and FY2011, Notably, NPLs have been low even at the
nadir of the previous crises. In 2003, SEBs restructured their dues to power/fuel suppliers
(like NTPC); loans for capex to PFC continued to be current. Key reasons:
PFC was a nodal agency for several schemes operated by the central Government. The
company has been working closely with the Ministry of Power
Default to PFC may be construed as default to Central Government by the auditors of the
state Government. PFC offers a discount for timely payment and hence interest rates move
up by 25 bps in case of delinquencies
Low exposure to private sector is a positive. We believe the lack of adequate fuel supply
arrangements will affect the prospects of private power producers. PFC has just 8%
exposure to private sector. Generation remains a large contributor at 85% of overall loan
book as of March 2011
REC’s has reported high NPLs in FY2003, i.e., in the previous downturn. The company
primarily focused on rural electrification projects and did not fund generation projects
(primary focus segment of PFC) in the past. REC has improved its asset protection
mechanism; the company offers a small rebate (25 bps) for timely repayment of loans
(like PFC) and secures its cash flows from escrow mechanism. The management has
highlighted that it has an exclusive escrow charge on select distribution circles and other
lenders (banks and State Governments) may not have access to such a facility. Exposure
to the private sector is only 10% of overall loans.
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