Rural Electrification - Increasing concerns on asset quality ::Macquarie Research,

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Rural Electrification
Increasing concerns on asset quality
Event
 We cut our earnings and TP for REC to reflect the increased risks on the book
and downgrade it to Neutral from Outperform. Our new TP is Rs190 versus
Rs290 previously.
Impact
 Concerns on the book - both on the SEB side and private side. We
believe ~50% of REC’s exposure to loss making SEBs and ~40% of private
loan exposure may be at risk of restructuring; some of it may slip into NPLs.
We believe REC may have to accordingly make provisions of up to 2.5% of
assets over FY12-14E. This is likely to result in a squeeze on the ROE from
the current ~22% to ~16%.
Exposure to SEBs - While positive noise has been made on the policy
front to raise tariffs for the states, the process may be drawn out and tariff
revisions may be insufficient in scope. The exposures are unlikely to slip
into NPLs and eventual losses are unlikely to be large here. However,
given the size of the book – 83% of REC’s loans is to SEBs – provisioning
alone on the restructured assets is likely to be large.
Exposure to private sector- Our analysis of large private projects
showed that ~40% of the exposure is likely to be restructured. Given that
there is no implicit or explicit government guarantee, some of the
exposure may slip into NPLs. We are building in for 30% private
exposures to be restructured, with another 10% slipping into NPLs. Given
that loans to the private sector are only 11% of the loan book, credit costs
here are unlikely to be very large.
 Building in general provisioning - We are also building in Rs4bn of
standard asset provisioning as suggested by RBI’s working group on NBFCs.
Earnings and target price revision
 We are cutting our FY12, FY13 and FY14 earnings forecasts by 19%, 24%
and 26% to take into account higher provisioning. Our TP reduces to Rs190
from Rs290 following the cut in earnings and multiple - from 1.8x to 1.2x. Our
earnings are 30% below consensus and our TP is 24% below.
Price catalyst
 12-month price target: Rs190.00 based on a Gordon growth model
methodology.
 Catalyst: Upside risk is a material change in SEB tariffs and their financial
status, also actions on policy front to de-bottleneck project execution.
Action and recommendation
 Downgrade to Neutral from Outperform. Given the ROE of ~16% likely in
FY12-14E, the current valuation seems fair. Material steps both at the state
and central government levels to raise tariffs, improve SEBs’ financial status
and improve project execution are likely to make us positive on the stock

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