Non-Banking Finance Companies - Opportunities Galore - AR

8/8/2019 Non-Banking Finance Companies - Opportunities Galore - AR

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Anand Rathi Financial Services, its affiliates and subsidiaries, do and seek to do business with companies covered in its research reports. Thus, investors should beaware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in makingtheir investment decision. Disclosures and analyst certifications are located in Appendix 1.

Anand Rathi Research Ind

India I EquitiesFinancial Services

Sector Report

Parag Jariwala+9122 6626 6707

[email protected]

Clyton Fernandes+9122 6626 6744

[email protected]

24 August 2010

Non-Banking Finance Companies

Opportunities galore

OverweightNifty/Sensex: 5531/18402


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Anand Rathi Financial Services, its affiliates and subsidiaries, do and seek to do business with companies covered in its research reports. Thus, investors should beaware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in makingtheir investment decision. Disclosures and analyst certifications are located in Appendix 1.

Anand Rathi Research Ind

India I EquitiesFinancial Services

Sector Report


[email protected]


[email protected]

24 August 2010

Non-Banking Finance Companies

Opportunities galore

We see strong business prospects for select large NBFCs owingto likely huge investment in Infrastructure and latent demand onaccount of improving rural economy. We expect NBFCs to bebetter-placed than banks in their respective domains, given theirniche expertise and regulatory advantages. We prefer REC andMMFS, on higher growth opportunities, strong earnings

visibility and better profitability, vis--vis peers.

Opportunity unlimited.We expect IDFC, PFC and REC tobenefit from likely large investments in Infrastructure and lead to

funding requirements of`2.3trn in FY11e and`2.8trn in FY12e.STFC could benefit from up-tick in economic activity, higherfreight movement and subsequent demand for used-CV loans.MMFS is poised to reap rewards of an improving rural economy,led by better monsoons and higher rural disposable income.

Niche expertise, regulatory benefits. Niche expertise, adequatecapital, high credit rating and hence lower cost of funds, better

asset-liability management and lower operating costs place ourcoverage NBFCs at an advantage over banks. The RBI recentlyawarding IFC status to IDFC and PFC is positive for bothbusiness growth and margins. For our coverage universe, weexpect robust loan growth (+25% CAGR over FY10-13e), aheadof banks (~20%).

Top picks REC and MMFS.We prefer stocks with highergrowth opportunities, strong earnings visibility and betterprofitability vis--vis peers and, hence, favour REC and MMFS.

Risks. i)Slowdown in economic growth; thereby, infrainvestments/rural income could impact business growth and assetquality; ii) high dependence on non-retail borrowings could hurtspreads, if interest rates sharply rise.

OverweightNifty/Sensex: 5531/18402

RoA vs PBV for our coverage NBFCs

REC

IDFC

PFC

MMFS

STFC

1.0

1.5

2.0

2.5

3.0

2.0 2.5 3.0 3.5 4.0 4.5

RoA

PBV

Source: Company, Anand Rathi Research

Sector valuation matrixRating Price ( ) Target ( ) M cap (US$bn) PE (x)* PBV (x)* RoE*

REC Buy 327 425 6.9 10.0 2.2 23.4

PFC Buy 333 408 8.2 11.2 2.1 20.4

IDFC Buy 183 219 5.9 17.6 2.3 13.9

MMFS Buy 595 748 1.2 10.5 2.4 23.9

STF Buy 769 934 3.7 11.3 2.8 27.9

Source: Company, Anand Rathi Research (* FY12e)


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24 August 2010 Non-Banking Finance Companies - Opportunities galore

Anand Rathi Research 3

Investment Argument & Valuation

We see strong business prospects for select large NBFCs owing tolikely huge investment in Infrastructure and latent demand onaccount of improving rural economy. We expect NBFCs to be

better-placed than banks in their respective domains, given theirniche expertise and regulatory advantages. We prefer REC andMMFS, on higher growth opportunities, strong earnings visibilityand better profitability, vis--vis peers.

Opportunity unlimited

Infrastructure Finance

IFCs are set to benefit from the likely huge investment in the infrastructuresector. As per the Planning Commissions revised estimates (as on Mar10), infrastructure investments for FYP XI (FY08-12) and FYP XII

(FY13-17) stand at US$514bn and US$1,025bn respectively. This implies~2.3x and ~4.5x increase versus actual infrastructure investments in FYPX (US$227bn).

As per the study conducted in Jul 10 by the RBI on infrastructurefinancing, debt requirement is estimated at`2.3trn and`2.8trn for FY11eand FY12e respectively, with limited debt funding in both years. The debtfunding gap is estimated at`734bn over the next two years (`341bn in

FY11e and`392bn in FY12e). Total funding gap for FYP XI is estimatedat`1.6trn.

We expect strong disbursements growth for IFCs on account of hugefunding requirement and banks having almost reached their internal

exposure limits for infrastructure lending. Banks have funded ~50% of thetotal investment in Infrastructure in the first three years (i.e., FY08-10) ofFYP XI. Banking funds will be limited going forward owing to sectoral cap(Infrastructure accounts for ~12% of total credit) and asset liability profile.

Transport Finance

We expect the transport industry to benefit from higher GDP and betteragriculture growth in FY11e vis--vis FY10. Due to weak connectivity inrural areas, freight capacity is expected to grow faster than GDP. Higherdisposable income of rural population will drive auto demand in ruralIndia. We expect strong loan growth for auto financing companies.

While we expect STFC to benefit from an up-tick in economic activity,higher freight movement and subsequent demand for used-CV loans,MMFS is poised to reap rewards of an improving rural economy, led bybetter monsoons and increasing rural disposable income.

Niche expertise, regulatory benefits

Over time, NBFCs have developed niche expertise in their respectivefields, which has resulted in better understanding of business and strongcustomer relationship in rural India. Higher government holdings (RECand PFC), enhanced capital adequacy (IDFC and STFC) and strongparentage (MMFS) have led to higher credit rating.

Shortage of funds for infrastructure

projects is estimated at`734bnover FY10-12e

Rural prosperity to drive transportindustry


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Better asset liability profiles

IFCs fund long-term infrastructure projects that entail similar maturity ofliabilities (duration gap between assets and liabilities is not more than 1year). STFC and MMFS have negligible duration gap; STFC has higherduration of liabilities than assets (and is the only NBFC with positive

duration).Lower operating cost

IFCs have lower operating cost compared with banks due to absence ofliability franchises, concentrated lenders and smaller employee base.Economies of scale have resulted in lower operating cost for STFC andMMFS as against banks.

Well-managed asset quality

Delinquencies in infrastructure financing are considerably low to negligible.Credit cost is almost nil for REC, PFC and IDFC. STFC and MMFS havegradually developed sound methods of evaluating loan proposals and

assets as well as collection. This has helped them keep credit cost undercheck.

Regulatory benefit

To ensure adequate funding to infrastructure projects, the government hastaken various initiatives. These include granting IFC status that will helpincrease exposure limits, which, in turn, will drive: i) business growth, andii) lower cost of funds due to infrastructure bonds and higher ECBs.

Further, to take care of the huge funding requirement, government has setup India Infrastructure Finance Company (IIFCL) and initiated theconcept of an Indian infrastructure debt fund (fund size is likely to be~`500bn).

RBI recently granting IFC status to IDFC and PFC is positive for bothbusiness growth and margins. Further, REC is likely to be granted IFCstatus by end-Sep 10.

Strong loan growth and sustainable superior return ratios

Huge opportunity for loan growth and superior model combined withstrong pricing power is likely to translate into higher return ratios forNBFCs. We expect a strong loan growth (+25% CAGR over FY10-13e),ahead of banks (~20%). NBFCs RoA is likely to be higher than banks 2.5-4% for NBFCs versus 1-1.5% for banks.

ValuationWe have used the two-stage dividend discount model (DDM) to arrive atour target price (SOTP for IDFC, with its core lending business based onthe two-stage DDM), as we expect higher asset growth than RoE (postdividend) for our NBFC universe.

Our assumptions for normalised RoE are based on the RoE that NBFCscan generate on a long-term sustainable basis. Our assumption for risk freerate (Rf) and market risk premium (Rm) are 7.5% and 6.5% respectively.


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Fig 1 NBFCs DDM assumptionsREC PFC IDFC MMFS STF

Terminal growth (%) 5.0 5.0 5.0 5.0 5.0

Risk free rate - Rf (%) 7.5 7.5 7.5 7.5 7.5

Risk premium - Rm (%) 6.5 6.5 6.5 6.5 6.5

Beta 1.0 0.9 1.3 1.2 1.0 CoE (%) 14.0 13.4 15.8 15.3 14.0

EPS CAGR FY11-FY16e (%) 22.3 22.0 29.3 23.9 23.5

EPS CAGR FY16-FY20e (%) 11.2 12.2 15.9 13.1 13.1

Target Price (`) 425 408 219 748 934

BV FY12 (`) 150 158 79 249 273

Implied target P/BV (x) 2.8 2.6 2.8 3.0 3.4

Value of subsidiaries (`) - - 34 - -

Recommendation Buy Buy Buy Buy Buy

Source: Anand Rathi Research.

Risks

Slowdown in infrastructure investments could result in lower assetgrowth for IFCs. Slower economic growth and a below-normalmonsoon could impair rural cash flow, thereby impactingdisbursements growth for STFC and MMFS.

REC and PFC have higher exposure to state electricity boards (SEBs),the financial health of which is a concern. Although interest paymentsare secured against the cash flow, any further increase in losses ofSEBs is likely to impact asset quality.

STFC and MMFS lend to riskier asset classes. Economic slowdowncan increase the delinquency rate and, subsequently, increase creditcost.

Unlike banks, NBFCs depend on non-retail borrowing. Tighterliquidity scenario would not only increase the cost of funds, but alsoimpact growth prospects (due to shortage of funds).

Recommendations

Rural Electrification Corporation (Buy; Target price: `425/share)

REC is well placed to reap the benefit of the huge capacity addition andinvestment in T&D. It enjoys strong pricing power as it is a key lender toSEBs. We expect REC to register earnings CAGR of 26% over FY10-13eon the back of strong loan growth and stable margins (due to strong

pricing power and likely IFC status).

We estimate that RECs RoA and RoE would remain high at +3% and+23% respectively, over FY10-13e. Our target price of`425/share isbased on the two-stage DDM (CoE: 14%; Beta: 1; Rf: 7.5%). At our targetprice, the stock will trade at PBV of 2.8x in FY12e and 2.4x in FY13e.

Power Finance Corporation (Buy; Target price: `408/share)

PFC is likely to see huge benefit from the likely massive investment inpower capacity over FY10-13e. Capital raising in FY11 would supportbusiness growth. The companys IFC status, high productivity and lowcredit costs would result in 21% EPS CAGR over FY10-13e.

PFC offers a fine combination of resilient growth and value. Our targetprice of`408/share is based on the two-stage DDM (CoE: 13.4%; Beta:


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0.9; Rf: 7.5%). At our target price, the stock will trade at PBV of 2.6x inFY12e and 2.2x in FY13e.

IDFC (Buy; Target Price: `219/share)

We are positive on IDFC, as it is poised to benefit from the infra-lending

opportunity, backed by its credible risk-management skills, high capitaladequacy and low leverage. Further, the IFC status is beneficial both forbusiness growth and for protecting spreads.

Management targets growing its balance sheet 3x in the next three years,led by the existing infrastructure lending opportunity. We expect 33% loanbook CAGR over FY10-13e. Now classified as an IFC, IDFC will enjoyenhanced single/group borrower limits and higher exposure limits forbank-borrowings, enabling robust balance-sheet growth. Also, lower risk

weights for its funding, easier access to ECBs, ability to issue tax-freebonds and its recent equity issue are likely to be positive for spreads.

Our SOTP-basedvaluation gives us fair value of`219/share; we value thelending business at `185 (2.3x FY12e BV, based on the two-stage DDM;CoE: 15.8%; Beta: 1.3; Rf: 7.5%) and other businesses and investments at`34/share. Risks are drastic slowdown in infrastructure spending andfailure to mobilise resources for the AMC business.

M&M Financial Services (Buy; Target Price: `748/share)

MMFS is well placed to tap the strong rural demand backed by its nichepresence in rural markets. Its strong parentage and diversified branchnetwork is likely to support business growth. We expect NIM to sustain at+11.5% over FY10-13e owing to the companys strong pricing power.High NPA coverage of 82% and stable credit costs (~3%) are likely tokeep RoA at +4% over FY10-13e.

MMFS is a resilient play on Indias growing rural prosperity. Given itsstrong business growth and superior return ratios, we believe that the stock

has potential of re-rating. Our target price of`748/share is based on thetwo-stage DDM (CoE: 15.3%; Beta: 1.2; Rf: 7.5%). At our target price, thestock will trade at PBV of 3x in FY12e and 2.5x in FY13e.

Shriram Transport Finance Company (Buy; Target price: `934)

STFC is well poised to capitalise on the up-tick in economic activity andfreight movement. Its business model is structurally superior to peers anddifficult to replicate.

Over FY05-10, STFC traded at ~2x PBV and average RoA of ~3%. Webelieve these valuations will sustain, as we expect STFC to maintain RoA at+4% over FY10-13e led by strong loan growth, improving margins andstable asset quality. Our target price of`934/share is based on the two-stage DDM (CoE: 14%; Beta: 1; and Rf: 7.5%). At our target price, thestock will trade at P/BV of 3.4x in FY12e and 2.7x in FY13e.


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Fig 2 Non-banking finance companies ValuationsREC PFC IDFC MMFS STFC

Current price ` 327 333 183 595 769

`bn 323 382 274 57 173 Market Cap

US$ bn 6.9 8.2 5.9 1.2 3.7

Target price ` 425 408 219 748 934 Upside % 30.0 22.4 19.7 25.7 21.4

Recommendation Buy Buy Buy Buy Buy

FY10-13e EPS CAGR 26.0 21.4 25.9 24.9 29.4

FY11 2.5 2.5 2.6 2.9 3.6

FY12 2.2 2.1 2.3 2.4 2.8 PBV (x)

FY13 1.9 1.8 2.1 2.0 2.2

FY11 12.6 13.6 21.7 13.1 14.2

FY12 10.0 11.2 17.6 10.5 11.3 PE (x)

FY13 8.1 9.1 14.5 8.5 9.2

FY11 3.3 3.0 3.0 4.3 4.1

FY12 3.3 2.9 2.9 4.3 4.3 RoA (%)

FY13 3.2 2.9 2.8 4.2 4.4

FY11 21.5 19.5 14.3 23.1 28.1

FY12 23.4 20.4 13.9 23.9 27.9 RoE (%)

FY13 24.9 21.3 15.0 24.4 27.2

FY11 129 135 73 205 216

FY12 150 158 81 249 273 BV (`)

FY13 176 186 91 303 343

FY11 25.9 24.4 8.7 45.6 54.3

FY12 32.6 29.9 10.7 56.5 68.0 EPS (`)

FY13 40.5 36.6 12.9 69.8 83.9

Dividend yield (%) FY11 2.4 1.5 0.9 1.5 0.0

FY11 0.0 0.0 0.4 7.0 3.1

FY12 0.0 0.0 0.4 7.1 3.3 Gross NPAs (%)

FY13 0.0 0.0 0.4 7.3 3.5

FY11 0.0 0.0 0.2 1.0 0.6

FY12 0.0 0.0 0.1 1.0 0.6 Net NPAs (%)

FY13 0.0 0.0 0.1 1.1 0.6

Source: Bloomberg, Anand Rathi Research.


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Opportunity unlimited

We expect IDFC, PFC and REC to benefit from likely largeinfrastructure investments, leading to funding requirements of

`2.3trn in FY11e and `2.8trn in FY12e. While we expect STFC tobenefit from an up-tick in economic activity, higher freightmovement and subsequent demand for used-CV loans, MMFS is

poised to reap rewards of an improving rural economy led by bettermonsoons and increasing disposable income.

Infrastructure Finance

FYP XI and FYP XII infrastructure spend targeted at US$514bn and US$1trn, which is2.3x and 4.4x of FYP X spend respectively

As per the Planning Commissions revised estimates, Infrastructureinvestments for FYP XI (FY08-12) and FYP XII (FY13-17) stand atUS$514bn and US$1,025bn respectively. Total investment in Infrastructureis expected to increase to 7.6% and 9.95% of GDP, implying increase of~2.3x and ~4.4x during FYP XI and FYP XII respectively. This is asagainst increase of 5.1% of GDP during FYP X, entailing actualinfrastructure investments of US$227bn during FYP X.

Fig 4 Infrastructure spend to touch US$1trn (~10% of GDP) by FYP XII

227

514

10255.55

8.20

9.95

0

200

400

600

800

1,000

1,200

FYP X FYP XI FYP XII

0

2

4

6

8

10

12

Infrastrcture investment % of GDP (RHS)

(US$ b) (%)

Source: Planning Commission, Anand Rathi Research.

Power accounts for 32% of the total investment in Infrastructure, followedby roads & bridges at 14%. Investments have mainly increased (FYP-on-FYP) in Power (up 128%), Roads (116%), Telecom (150%), Railways(127%) and Irrigation (126%). These together contribute ~90% of theplanned investment in Infrastructure under FYP XI.

Infrastructure spend to account for~10% GDP by FYP XII


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Huge debt-funding requirement

Total infrastructure investment over FYP XI is estimated at`21trn. Ofthis, 52% will be funded via non-debt fund and 48% through debt fund. Asper a study conducted in Jul 10 by the RBI, on infrastructure financing,debt requirement is estimated at`2.3trn and`2.8trn in FY11e and FY12erespectively.

Fig 9 Infrastructure spend and debt funding requirement` bn FY08 FY09 FY10 FY11 FY12 FYP XICentre 1,126 1,283 1,485 1,721 2,040 7,656

State 795 990 1,250 1,602 2,072 6,709

Private 782 943 1,157 1,468 1,847 6,196

Total 2,703 3,216 3,893 4,791 5,959 20,562

Non-debt 1,386 1,659 2,019 2,495 3,122 10,681

Debt 1,317 1,557 1,883 2,296 2,837 9,880

Source: RBI, Anand Rathi Research.

Shortage of debt fund

Debt fund availability will be limited in FY11e and FY12e to`1.9trn and

`2.4trn as against likely debt requirement of`2.3trn and`2.8trn

respectively. The debt funding gap is estimated to be`734bn over the nexttwo years (`341bn in FY11 and`392bn in FY12). Total funding gap for

FYP XI is estimated at`1.6trn, which is 16-17% of total available debt

funds.

Fig 8 - Funding pattern FYP XI

Budgetarysupport

45%

FDI8%Equity

6%

ECBs6%

Insurance Co4%

NBFC (incl.IIFCL)10%

CommercialBanks21%

Source: RBI, Anand Rathi Research

Fig 7 Share of sources of debt in infrastructure debtCentral government

InternalGeneration

22%

Borrowings

52%

Central Budget26%

State governments

States Budgets66%

Borrowings

24%

InternalGeneration

10%

Private sector

InternalAccruals/Equity

30%

Borrowings70%



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Fig 10 Infrastructure debt funding Requirement versus availability` bn FY08 FY09 FY10 FY11 FY12 FYP XIDomestic bank credit 498 632 801 1,016 1,289 4,237

NBFCs 239 315 416 549 724 2,242

Pension/insurance company 91 100 110 121 133 554

ECBs 196 218 242 269 299 1,223

Total debt resources 1,024 1,264 1,569 1,954 2,444 8,255

Debt requirement 1,317 1,557 1,873 2,296 2,837 9,880

Debt requirement (US$ bn) 33 39 47 57 71 247

Funding Gap 293 293 305 341 393 1,625

Funding Gap (%) 29 23 19 17 16 20

Funding Gap (US$ bn) 7 7 8 9 10 41


Banks close to reaching internal limits on infra lending

Infrastructure projects require long-term financing for being cost effectiveand sustainable. However, debt financing for infrastructure projects has

been largely confined to banks that have difficulty in providing long-termdebt due to asset-liability mismatch. Banks have funded 45% of the totalinvestment in Infrastructure in the first three years (i.e., FY08-10) of FYPXI. We expect strong disbursement growth for IFCs on the back of hugefunding requirement and banks almost reaching their internal limits forinfra lending.

Fig 11 Infrastructure funding mix

0

10

20

30

40

50

60

FY08 FY09 FY10 FY11 FY12 11th plan

Domestic Bank Credit NBFCs Pension/Insurance Co ECBs Source: RBI, Anand Rathi Research.

Availability of bank finance to infrastructure projects is likely to face

various constraints going forward, as:

1. many state-owned banks have already reached sector cap (12-15% oftotal credit) for Infrastructure;

2. also, higher lending to the infrastructure segment in FY09 and FY10 isrelated to slowdown in credit off-take by other sectors; with economicrecovery back on track, banks lending to the corporate/retail segment(better margins with low asset-liability mismatch) is likely to increase.

3. Bank lending to infrastructure is currently ~13% of outstanding loans.Banks exposure to other long-term funding, such as housing andeducation loan, is also high. Overall, ~33% of banks assets are currently in

the form of long-term loans, while the average maturity of banks liabilitiesis less than two years. Such asset liability mismatch would prevent furtherexposure of banks to infrastructure.


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Fig 12 Bank credit to Infrastructure as a percentage of industrial bank credit

0

5

10

15

20

25

30

35

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

Feb-10

May-10

(%)


Fig 13 Share of Power in overall bank infrastructure credit

0

10

20

30

40

50

60

70

F

Y98

F

Y99

F

Y00

F

Y01

F

Y02

F

Y03

F

Y04

F

Y05

F

Y06

F

Y07

F

Y08

F

Y09

(%)

Source: RBI, Anand Rathi Research.Transport finance

Increased focus on rural connectivity by government

In India, more than 60% of cargo (goods) is transported via road. Betterconnectivity in rural areas results in increase in economic and socialbenefits for rural population i.e., enhanced growth, employment, educationand healthcare opportunities. A nation-wide network of all-weather roadsin rural areas is critical for economic progress in rural India.

The government is investing heavily in developing better roads for higherconnectivity of villages and small towns, with the Central government setto build ~0.15m km of roads across India. This will lead to strong demandfor goods vehicles (especially small and mid-size CVs).

Freight capacity addition to be higher than GDP growth

Higher connectivity in rural India will boost industrialisation in villages andraise demand for increased transportation. Following the past trend, weexpect freight capacity to grow faster than GDP due to lower base andhuge requirement.

Economic recovery leads to enhanced auto demand

Better economic condition is the key demand driver for the auto industry.Over Oct 08-Sep 09, the auto industry witnessed a downturn owing toeconomic slowdown. Since then, improved economic activity has placed


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auto demand back on track. Revival in auto demand will act as a boon forauto finance companies.

Fig 14 Revival in auto demand

0

50

100

150

200

250

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

-50

0

50

100

150

200

Passenger Vehicles (PVs) Commercial Vehicles (CVs)

PV yoy growth (RHS) CV yoy growth (RHS)

('000) (%)

Source: SIAM, Anand Rathi Research.

PVs and CVs saw 34% and 63%growth respectively over

Apr-Jul 10


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Niche expertise, regulatory benefits

Niche expertise, adequate capital, high credit rating and hence lowercost of funds, better asset-liability management and lower operatingcosts place our coverage NBFCs at an advantage over banks. The

RBI recently awarding IFC status to IDFC and PFC is positive forboth, business growth and margins. For our coverage universe, weexpect robust loan growth (+25% CAGR over FY10-13e), ahead ofbanks (~20%).

Niche expertise based on vast experience

All NBFCs in our coverage universe have over a decade of experience intheir respective niche segments. They have, hence, developed a betterunderstanding of the business and healthy & long-lasting customerrelationships. They have also developed better procedures for loangeneration and valuation of underlying assets, which keeps delinquencies

under control. These NBFCs have presence across the value chain andprovide other ancillary services to their customers, thereby becoming theone-stop-shop for them.

Fig 15 NBFCs Niche expertiseName Year of Incorporation Experience (years) Positioning

REC 1969 40 - Operating under ministry of power, Navratna PSU- Enjoys strong relationship with Central and state governments- One of the few lenders to SEBs, thus strong pricing power- Nodal agency for RGGVY

PFC 1986 24 - Operating under ministry of power, Navratna PSU- Enjoys strong relationship with Central and state governments utilities (~90% of loan book)- Nodal agency for UMPPs (huge lending potential) and R-APDRP

IDFC 1997 13 - One of the few private players in infrastructure lending

- Presence across the value chain- Diversified lending (unlike REC, PFC) to mitigate segmental risk- Well capitalised to tap huge lending potential

STFC 1979 31 - Specialised in used-CV financing, with 20-25% market share- Expertise developed over the years for loan generation, asset valuation and collection- more than 450 branches and 1m loyal customers

MMMFS 1991 19 - Rich experience in and better understanding of rural auto financing- Strong brand name of the parent helps gain customer confidence- more than 400 branches and 1m loyal customers

Source: Company, Anand Rathi Research.


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Regulatory differences in favour of NBFCs

IFC status to reduce cost of funds

The RBI, in its circular dated 12 Feb 10, created a separate category forNBFCs IFCs comprise infrastructure financing and are non-deposit-taking systematically important (i.e., NBFC ND-SI). The other threecategories of NBFCs are asset finance companies (AFCs), loan companiesand investment companies.

Criteria for classification are:

Minimum of 75% of total assets should be deployed in infrastructureloans

Net owned funds of Rs3bn or above Minimum credit rating 'A' or equivalent by CRISIL, FITCH, CARE,ICRA or equivalent rating by any other accrediting rating agency CAR of 15% (with minimum tier-1 capital of 10%)

Fig 16 Regulation Key highlightsNorms Banks AFCs IFCs

CAR CAR requirement of 9%Tier 1 CAR of 6%

CAR requirement of 12%Tier 1 CAR of 6%

CAR requirement of 15%Tier 1 CAR of 10%

SLR requirement 25% of NDTL - 20% of deposits accepted frompublic- STFC and MMFS have 6-7% of

total borrowings via FDs

NA

CRR requirement 5% NDTL NA NA

Low cost fundingadvantage

- Banks has significant cost advantage due to higherCASA- CASA in the range of 30-35% for major banks

NA NA

- Currently, banks are allowed to lend:1) 15% (20% for infra) of owned funds to single

borrower2) 35% (50% for infra) of owned funds to group of

borrowers

- Currently NBFCs allowed to lend:1) 15% of owned funds to single

borrower2) 35% of owned funds to group

of borrowers

- Under IFC status, NBFCs are allowed tolend:

1) 25% of owned funds to singleborrower

2) 50% of owned funds to group ofborrowers

Relaxedconcentration/exposurenorms REC and PFC are being granted

exemption from concentration/exposurenorms (25% or 50%) for Central/stategovernment utilities or SEB lending

Standard asset provisions - RBI requirement of 0.4% of loans- Some banks prudently provide for higher provisions

- RBI does not require provisioningfor standard assets- STF and MMFS prudently

provides for future delinquencies

- RBI does not require provisioning forstandard assets- No provisions by IFCs

State guaranteed loans Risk weight = 100% Risk weight = 100% Risk weight = 20%- currently, REC and PFC have ~25% and~18% of loans guaranteed by state- lower CAR requirement, therefore moreleverage (higher return ratio)

NA NA - Companies are allowed to issueinfrastructure bonds under chapter VI A ofthe IT Act

- IFCs will issue ~Rs20bn each in FY11and FY12- Cost of borrowing ~150-200bps lower

than commercial borrowing rate

Infrastructure bonds

- Infrastructure bonds are exempt fromcredit rating- Lower cost of borrowings

ECBs Not allowed under automatic route Not allowed under automatic route - Companies can borrow up to 50% oftheir net worth under the automatic route- ECBs (partly hedged) cost will be 100-150bps lower



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As per these guidelines, PFC and IDFC have already been awarded IFCstatus (NBFC-ND-IFC). REC is likely to get IFC status by end-Sep 10.

We expect these companies to benefit, notwithstanding the increase incapital adequacy requirement.

Impact of higher CAR to be negated by reduced risk weight on state-

guaranteed loans for REC and PFC

Higher CAR requirement (minimum of 15% for IFCs compared with 12%for other NBFCs) will reduce leverage. REC and PFC will be able tonegate the higher CAR on the back of reduced risk weight on state-guaranteed loans. Central/state governments guarantee ~25% and ~18%of loans for REC and PFC respectively.

Fig 17 CAR calculation under IFC status (%)REC PFC

Loans NBFC status IFC status NBFC status IFC status

1) state-guaranteed 25 25 18 18

2) Others 75 75 82 82

Risk weights

1) state-guaranteed 100 20 100 20

2) Others 100 100 100 100

Total risk-weighted assets 100 80 100 86

CAR requirement (%) 12 15 12 15

Capital required 12 12 12 13


Will absence of CASA deposits impact NBFCs?

Banks have significant advantage over NBFCs, in terms of low-costdeposits. Through their large branch network, banks can mobilise higheramount of CASA (saving deposits rate: 3.5%; current account rate: nil) andretail deposits. This entails lower cost of funds for banks compared withIFCs and AFCs (6-6.5%).

Factors negating lower cost of funds are:

A bank has to place 6% of NDTL with the RBI in the form of CRR,on which it does not earn any interest

Yield on SLR portfolio is in the 6.5-7.5% range, considerably lowerthan yield on overall portfolios of IFCs (11-11.5%) and NBFCs (15-18%)

Yield on loans for banks is 10-11%, which is ~100bps lower than yieldon loans for IFCs and much lower than AFCs.

NBFCs are likely to negate any pressure on spread (due to absence of lowcost deposits) via strong pricing power and no regulatory requirement tokeep 31% of funds (CRR and SLR) in low/no-return generating assets (Fig18).

Reduced risk weights on government-guaranteed loans to negate higher

CAR requirement


19/94



Fig 18 Spreads (FY11e) NBFCs versus Banks

Yield on earning assets

0

2

4

6

8

10

12

14

16

18

20

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)

Cost of funds

0

2

4

6

8

10

12

14

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)

Spreads

0

2

4

6

8

10

12

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)


Superior yield on overall assets due

to absence of CRR and SLRrequirement and strong pricing

power

High cost of funds due to absence ofCASA, but high credit rating

keeps cost of funds under control

Higher yields on portfolio tosupport overall superior spread


20/94



Fig 19 NIM (FY11e) NBFCs versus Banks

0

2

4

6

8

10

12

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)


High capital adequacy

Infrastructure finance

IFCs are required to maintain capital adequacy ratio of 15% (tier-1: 10%;and tier-2: 5%). Currently, CAR for REC and PFC stands at 17-19%(constitutes only tier-1) and for IDFC at ~26% (high, due to recentdilution of 12.2%). Higher capital will ensure dilution-free growth for RECand IDFC over the next 2-3 years. PFC is planning to raise capital by end-FY11.

Both REC and PFC have room for financing growth through tier-2 capital(up to 5% under their IFC status). This will increase leverage and, hence,lower dilution for equity shareholders.

Transport finance

CAR for STFC and MMFS is much higher than the regulatory requirementof 12%, which will ensure adequate capital for growth. SFTC has CAR of23% (tier-1 of 16%) and MMFS of 17.4% (tier-1 of 15.4%), as of 1QFY11.

Fig 20 Tier-1 CAR (FY11e) NBFCs versus banks

0

5

10

15

20

25

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)


Higher NIM on better spreads andlower leverage

Higher tier-1 better for assetquality in an economic downturn


21/94



Better asset liability management


Inherently, infrastructure financing has a long gestation period, which mayextend to over 10-15 years. Tenure is generally higher for road and power

projects, which may even extend to over 20 years. Banks are usuallyunwilling to lend beyond 5-10 years due to lack of adequate long-termliabilities.

This asset liability mismatch for banks gives an edge to IFCs such as PFC,REC and IDFC as they boast of long-term liabilities. Better asset liabilityprofiles mitigate interest rate risk (lending long by borrowing short).

Transport finance

Both STFC and MMFS have negligible duration gap. STFC has higherduration of liabilities than assets (the only NBFC with positive duration asset duration of three years and liabilities of ~4 years). Both companies

have reduced interest-rate risk by fixed-rate borrowing for lending to fixed-rate assets (no fixed-floating mismatch).

High credit rating and, hence, lower cost of funds


PFC and REC enjoy AAA credit rating due to high government stake(which results in low default risk) and lower leverage compared with otherNBFCs and banks. The AAA status enables these companies to borrow atrelatively lower rates, thereby reducing the cost of funds.

IDFC was downgraded by CRISIL to AA+/Stable from AAA/Stable in

2QFY10 due to fear of higher leverage going forward. Change in creditratings is applicable only on incremental borrowings. However, both ICRAand Fitch have reaffirmed AAA rating for the company. IDFC uses ratingof ICRA and Fitch for its incremental borrowings and, hence, borrowingcost continues to be lower.

Transport finance

STFC and MMFS both lend to the riskier asset class (used-CVs and rurallending). However, over the years, these NBFCs have demonstrated abilityto minimise risk and, thereby, improve return ratios. Their asset qualityremains superior (provision coverage ratio of >70% and net NPAs of


22/94



lower operating cost for them as against banks. STFC and MMFS havecost-to-income of 22-25% and 25-30% respectively.

Fig 21 Cost-to-income (FY11e) NBFCs versus Banks

0

10

20

30

40

50

60

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)


Impeccable asset quality for IFCs and stable credit

cost for STFC and MMFS

IFCs

Delinquencies in infrastructure financing are substantially low-to-negligible.Most infrastructure project loans are backed by government guarantee orsecured against cash flow of the particular project; for example, tollcollections in case of road projects and tariff revenue in case of SEBs.Hence, REC and PFC enjoy ~100% recoveries. Credit cost is almost nilfor REC, PFC and IDFC.

Transport finance

Both STFC and MMFS lend to the riskier asset class (used-CVs and rurallending). Over the years, both companies have developed sound methodsfor evaluating loan proposals, asset valuations and collection. This hashelped them keep credit cost under check. We remain conservative due totheir exposure to riskier asset class and keep our credit cost stable at 1.5%of AUMs for STFC and 3% of loans for MMFS.

Fig 22 NBFCs have superior asset quality (FY11e)

0.0

0.4

0.8

1.2

1.6

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)


Cost-to-income below 30% forNBFCs as against +40% for

banks

Net NPA less than 0.4% forIFCs and less than 1.5% each for

STFC and MMFS


23/94



NBFCs better placed to tap huge potential

Huge opportunity in infrastructure and rural lending combined with abetter business model is likely to place NBFCs ahead of banks. We expectNBFCs loan book to grow faster than similar-size banks with stable

margins.We estimate IFCs (REC, PFC and IDFC) loan book to witness 25-30%CAGR over the next 2-3 years. STFC and MMFS are expected to grow~25% over FY10-12e.

Fig 23 Loan growth (CAGR FY10-12e) NBFCs versus Banks

0

5

10

15

20

25

30

35

40

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)


NBFCs have healthier return ratios than banks

A structurally superior model (low operating cost, high CAR) with strong

loan growth and strong pricing power will result in a much healthier RoAthan banks (2.5-4% for our NBFC universe versus 1-1.5% for banks).However, low leverage (better for asset quality in bad times) will keep RoEunder check.

Fig 24 RoA (FY11e) NBFCs versus Banks

0

1

2

3

4

5

REC

PFC

IDFC

MMFS

STF

SBI

PNB

BOB

BOI

Canara

ICICI

HDFCBK

Axis

(%)



24/94



Company section


25/94

Anand Rathi Financial Services Limited does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investmentdecision. Disclosures and analyst certifications are located in Appendix 1

Anand Rathi Research

India Equities

India I Equities


[email protected]


Clyton [email protected]

Key financials

Year End 31 Mar FY09 FY10 FY11e FY12e FY13e

Net interest income (`m) 17,776 25,348 33,337 42,014 53,011

Net profit (`m) 12,721 20,014 25,581 32,169 40,036

EPS (`) 16.4 20.3 25.9 32.6 40.5

Growth (%) 50.6 23.3 27.8 25.8 24.5

PE (x) 19.9 16.1 12.6 10.0 8.1

PABV (x) 3.9 2.9 2.5 2.2 1.9

RoE (%) 22.0 23.2 21.5 23.4 24.9

RoA (%) 2.7 3.4 3.3 3.3 3.2

Dividend yield (%) 1.4 2.0 2.4 3.1 3.7

Net NPA (%) 0.0 0.0 0.0 0.0 0.0


Financial Services

Initiating Coverage

24 August 2010

Rural Electrification Corporation

Propelled by capacity add and investment; initiate with Buy

We initiate coverage on REC with a Buy recommendation andtarget price of`425/share. REC is well placed to reap the benefitof huge capacity addition and investment in T&D over FY10-13e.Its strong pricing power, likely IFC status and low operatingcosts would sustain +23% RoE and +3% RoA.

Robust loan growth visibility. RECs loan pipeline is strong,with outstanding sanctions of +`1trn (1.6x of loan book), offeringgood visibility for business growth. The huge capacity additionand investment in T&D over FY10-13e is likely to lead to 28%loans CAGR over FY10-13e.

Strong pricing power, likely IFC status to protect margin.REC enjoys strong pricing power as it is a key lender to SEBs. Re-pricing of loans (`100bn in FY11e; `150bn in FY12e), likely IFCstatus and hence low cost infrastructure bonds and easier access toECBs is likely to protect its margins at ~4%.

High RoA and RoE to sustain. We expect REC to registerearnings CAGR of 26% over FY10-13e on the back of strong loangrowth and stable margins. This would lead to high RoA andRoE, of +3.3% and +23% respectively, over FY10-13e.

Valuations and risks.At our target price, the stock will trade atPBV of 2.8x FY12e and 2.4x of FY13e respectively. Our targetprice is based on the two-stage DDM (CoE: 14%; Beta: 1; Rf:7.5%). Risks: Slowdown in power sector investment, regulatorychanges and poor health of SEBs

Rating: Buy

Target Price: `425

Share Price: `327

Key data RECL IN /REC.BO

52-week high/low `339/`188

Sensex/Nifty 18402/5531

3-m average volume US$13.1m

Market cap `281bn/US$6.9bn

Shares outstanding 987.5

Free float 33%

Promoters 67%

Foreign Institutions 19%

Domestic Institutions 6%

Public 8%

Relative price performance

REC

Sensex

175

200

225

250

275

300

325

350

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Source: Bloomberg


26/94

24 August 2010 Rural Electrification Propelled by capacity add and investment; initiate with Buy


Quick Glance Financials and Valuations

Fig 1 Income statement ( m)

Year end 31 Mar FY09 FY10 FY11e FY12e FY13e

Net interest income 17,776 25,348 33,337 42,014 53,011

NII growth (%) 37.1 42.6 31.5 26.0 26.2

+ Non-interest inc 2,663 2,767 2,677 3,149 3,806

Total income 20,439 28,115 36,014 45,163 56,818

- Op. expenses 1,208 1,620 1,904 2,269 2,713

Operating profit 19,231 26,495 34,110 42,893 54,105

- Provisions 34 3 2 2 2

PBT 19,197 26,492 34,108 42,891 54,103

- Tax 6,476 6,478 8,527 10,723 14,067

PAT 12,721 20,014 25,581 32,169 40,036

+(AssociatesMinorities) - - - - -

Consolidated PAT 12,721 20,014 25,581 32,169 40,036

PAT growth (%) 47.9 57.3 27.8 25.8 24.5

FDEPS (` /share) 14.8 20.3 25.9 32.6 40.5

DPS (` /share) 4.5 6.5 8.0 10.0 12.0


Fig 2 Balance sheet ( m)Year end 31 Mar FY09 FY10 FY11e FY12e FY13e

Share capital 8,587 9,875 9,875 9,875 9,875

Reserves & surplus 53,314 100,929 117,267 137,882 164,054

Borrowings 449,360 559,482 736,071 955,970 1,213,953

Current liab & prov 38,737 25,149 30,179 39,232 51,002

Deferred tax liabilities 9,567 (74) (74) (74) (74)

Total Liabilities 559,564 695,361 893,318 1,142,886 1,438,810

Advances 513,814 664,526 855,897 1,098,816 1,395,348Investments 10,049 9,099 9,554 10,031 10,533

Cash & Bank Bal 18,860 13,903 19,301 24,696 22,769

Fixed & Other Assets 16,841 7,833 8,567 9,343 10,160

Total Assets 559,564 695,361 893,318 1,142,886 1,438,810

No. of shares (m) 859 987 987 987 987

Borrowing growth (%) 31.1 24.5 31.6 29.9 27.0

Loans growth (%) 30.7 29.3 28.8 28.4 27.0Source: Company, Anand Rathi Research

Fig 3 RatiosYear end 31 Mar FY09 FY10 FY11e FY12e FY13e

Interest spread (%) 3.1 3.2 3.2 3.2 3.1

NIM (%) 4.1 4.3 4.2 4.2 4.1Other inc / Total inc (%) 13.0 9.8 7.4 7.0 6.7

Cost-Income (%) 5.9 5.8 5.3 5.0 4.8

Provisions / Loans (%) 69.6 60.0 60.0 60.0 60.0

Dividend Payout (%) 35.5 35.2 36.1 35.9 34.6

Borrowings-loans (%) 87.5 84.2 86.0 87.0 87.0

Gross NPA (%) 0.1 0.0 0.0 0.0 0.0

Net NPA (%) 0.0 0.0 0.0 0.0 0.0

BV (`) 83.2 112.1 128.7 149.6 176.1

Adj BV (`) 83.1 112.1 128.7 149.6 176.1

CAR (%) 13.9 20.8 18.6 16.8 15.6- Tier 1 (%) 13.9 20.8 18.6 16.8 15.6Dividend Yield (%) 1.4 2.0 2.4 3.1 3.7Source: Company, Anand Rathi Research

Fig 4 PE Band

REC

3x

6x

9x

12x

0

50

100

150

200

250

300

350

400

M

ar-08

M

ay-08

Jul-08

S

ep-08

N

ov-08

J

an-09

M

ar-09

M

ay-09

Jul-09

S

ep-09

N

ov-09

J

an-10

M

ar-10

M

ay-10

Jul-10

Source: Bloomberg, Anand Rathi Research

Fig 5 Price-to-Book Band

REC

0.5x

1.2x

1.9x

2.6x

0

50

100

150

200

250

300

350

400

Mar-08

May-08

Jul-08

Sep-08

Nov-08

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10


Fig 6 Bankex versus REC

REC

Bankex

175

200

225

250

275

300

325

350

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Source: Bloomberg


27/94




We initiate coverage on REC with a Buy rating and target price of`425/share. The company is well placed to reap the benefit of hugecapacity addition and investments in T&D over FY10-13e. Its strong

pricing power, likely IFC status and low operating costs wouldsustain +23% RoE and +3% RoA over the next three years.

Robust loan growth visibility

RECs loan pipeline remains strong, with outstanding sanctions of >`1trn(1.6x of 1QFY11 loan book). During the past eight quarters (2QFY09-1QFY11), REC sanctioned loans worth `966bn (average quarterlyadditions to sanctions were `120bn).

Higher sanctions in the past eight quarters are likely to get converted todisbursements over the next two years. Total disbursements over the next

two years are estimated at`

624bn (`

274bn in FY11e and`

350bn inFY12e), which is 65% of the sanctions made in the past eight quarters. Weexpect loans CAGR of 28% over FY10-13e.

Strong pricing power, likely IFC status to protect

margin

REC enjoys strong pricing power as it is the one of the few lenders to theSEBs and is the nodal agency for RGGVY and ultra mega transmissionlines.

We estimate loans worth `100bn to get re-priced in FY11e (`150bn inFY12e) at ~50bps higher than average yields on loans in FY10. We expectREC to issue low-cost infrastructure bonds worth `20bn each in FY11,FY12 and FY13, under Chapter VI A of the Income Tax (IT) Act. Thesebonds are likely to be priced at 150-200bps lower than the average cost ofborrowings in FY10 and account for ~7% of incremental borrowings inFY11 (~5% in FY12e and FY13e).

With IFC status, companies will be allowed to borrow up to 50% of theirnet worth via ECBs (through the automatic route). We expect incrementalborrowings under ECB to be `45bn (16% of incremental borrowings) inFY11e and `9-10bn (3.5% of incremental borrowings) over FY12-13e.Infrastructure bonds and ECBs are likely to negate any pressure onmargins due to higher borrowing cost from other sources of funding and

lower contribution from REC capital gain bonds. We remain conservativeand expect spread to sustain at +3% and NIM at +4% over FY10-13e. In1QFY11, spreads and NIMs stood at 3.4% and 4.6% respectively for thecompany.

High RoA and RoE to sustain

We expect earnings CAGR of 26% over FY10-13e on the back of strongloan growth (28% CAGR over FY10-13e) and stable margins at +4% overthe same period. Operating costs are expected to see CAGR of ~20%over FY10-13e and credit cost to remain negligible. RoA and RoE arelikely to remain superior, at +3% and +23% over FY10-13e.

Margins to remain superior at +4%over FY10-13e

Healthy loan pipeline to supportloan CAGR of 28% over

FY10-13e


28/94



Valuations

REC is a long-term bet on Indias growing power sector investments. Itcurrently trades at PBV of 2.2x FY12e BV and 1.9x FY13e BV. Withstrong earnings visibility and superior return ratios, we believe the stockhas potential for re-rating. We initiate coverage on REC with a Buyrecommendation and target price of`425/share, which is at 30% upside;

we favour it as our top pick in the IFC space. Our target price is based onthe two-stage DDM (CoE: 14%; Beta: 1; Rf: 7.5%).

Risks to our target price

REC is a dedicated power finance company. Any slowdown in powersector investments will hurt loan growth

Any regulatory changes as regards SLR/CRR requirements,maintenance of standard provision coverage on loan book etc, cannegatively impact profitability.

REC has a higher exposure to SEBs. Any default by SEBs due to theirpoor financial health can impact profitability


29/94




RECs loan pipeline is strong, with outstanding sanctions of >`1trn(1.6x of loan book), offering good visibility for business growth. Thehuge capacity addition and investment in T&D over FY10-13e is

likely to lead to 28% loans CAGR over FY10-13e.

Strong sanction pipeline

During FY05-10, disbursements witnessed CAGR of 23%. From FY08 toFY10, REC sanctioned loans worth ~`1.3trn. During the past eightquarters (from 2QFY09 to 1QFY11), REC sanctioned loans worth `966bn(average quarterly additions to sanctions stood at `120bn).

Higher sanctions in the past eight quarters are likely to get converted intodisbursements over the next two years (typically, disbursement growthcomes with a lag of 10-12 months). Total disbursement over the next two

years is estimated at`

624bn (`

274bn in FY11e and`

350bn in FY12e),which is 65% of sanctions made in the past eight quarters. We expect 27%CAGR in disbursements (on a higher base) over FY10-13e. Loans arelikely to witness CAGR of 28% over FY10-13e and likely to cross the`1-trn mark by FY12e.

Fig 7 Sanctions and disbursements ( bn)

163188

329

452 454

74 75107

130

172211

274

350

404434

FY05

FY06

FY07

FY08

FY09

FY10

FY11e

FY12e

FY13e

Sanctions Disbursements Source: Company, Anand Rathi Research.

Fig 8 Trend in loans ( bn)

217 253321

393

1,099

1,395

514

665

856

0

200

400

600

800

1,000

1,200

1,400

1,600

FY05

FY06

FY07

FY08

FY09

FY10

FY11e

FY12e

FY13e

CAGR of 28% overFY10-13e

( bn)`


Higher sanctions during FY08-10

to drive disbursement growth inFY10-13e


30/94


31/94



Strong pricing power, likely IFC status

to protect margin

REC enjoys strong pricing power as it is a key lender to SEBs. Re-

pricing of loans (`100bn in FY11e; `150bn in FY12e), low costinfrastructure bonds and easier access to ECBs is likely to protect itsmargins at ~4%, in a rising interest-rate scenario.

Margin pull down by:

Lower share of REC capital gain bonds in overall borrowings expected to reduce to 12% in FY12e from 18% in FY10.

Change in asset mix in favour of generation projects, which entaillower margins.

Margin push up by:

IFC status ECB and infrastructure bonds under Chapter VI A of theIT Act to ensure lower cost of funds.

Re-pricing of loans (`100bn in FY11e and `150bn in FY12e) Loansare likely to be re-priced ~50bps higher than current yield on loans.Compared with this, borrowings worth `30bn are likely to re-price at ahigher rate.

Issue of deep discount bonds worth `7-8bn with a tenure of 7-10years is likely to be priced 40-50bps lower than similar interest-payingbonds.

Share of capital gain bonds to decline, to pressure

borrowing costs

RECs reported spreads remained high at +3.3% as the company enjoyslower funding cost owing to bonds under Section 54EC of the IT Act.

These are three-year bonds with average cost of ~6% as againstcommercial borrowing rate of ~8%. Going forward, share of such bondsis likely to reduce, which will increase RECs cost of funds. The bonds,

which raised >`73bn in FY07, have been re-paid in FY10, reducing theirproportion to 18% in FY10 compared with 32% in FY09.

Additional borrowing through this route is likely to be limited due to othermodes of tax savings made available by the government over the past two

years. We expect REC to borrow`9-10bn in FY11 and `4.5-5.5bn overFY12-13e. Share of capital gain bonds in overall borrowings is expected tofall to 15% in FY11e, and further to 12% and 10% in FY12e and FY13erespectively.

Capital gain bonds to account for~10% of borrowing by FY13e


32/94



Fig 11 Share of Section 54EC bonds in overall borrowings to decline (%)

46 4543 41

3835

32 31

22 2118 19

1512

10

44

1QFY08

1QFY08

1QFY08

1QFY08

1QFY09

2QFY09

3QFY09

4QFY09

1QFY10

2QFY10

3QFY10

4QFY10

1QFY11

FY11e

FY12e

FY13e


Asset mix to change in favour of generation projects

Increased emphasis by the government and private sector on expandinggeneration capacity has led to higher sanctions to generation projects.

Yield on generation project loans is lower as: i) the lender can have chargeof the physical assets and ii) there is less chance of default due to powerpurchase agreements and prior supply linkages that give revenue certaintycompared with transmission projects.

Over the past three years, REC has been able to negate any pricingpressure owing to the increasing share of generation loans.

Fig 12 Share of generation projects (%)

25.7

34.1 36.1

60.353.3 53.0

FY08

FY09

FY10

in loan book in sanctions Source: Company.

IFC status and re-pricing of loans to ease pressure on

margins

ECBs through the automatic route

With the IFC status, companies will be allowed to borrow up to 50% theirnet worth via ECBs (through the automatic route). We expect incrementalECBs to be `45bn (16% of incremental borrowings) in FY11e and `9-10bn (2-3% of incremental borrowings) over FY12-13e.

High share of generation projects insanctions (53%) as against loans

(36%)

Low cost borrowings to account for22-25% of overall borrowings over

FY10-13e


33/94



Infrastructure bonds under Chapter VI A of the IT Act

We expect REC to issue low-cost infrastructure bonds worth `20bn eachin FY11, FY12 and FY13, as per Chapter VI A of the IT Act. These bondsare likely to be priced 150-200bps lower than average cost of borrowingsin FY10 and account for ~7% and 5.5% of incremental borrowings for

FY11e and FY12e respectively. However, benefit of infrastructure bondsis likely to be limited in FY11e as the first tranche of infrastructure bondsis likely to be issued in Oct 10 (`10bn) and the second in Feb 10 (`10bn).

Share of low-cost borrowings for REC could increase to 26% in FY11efrom 22% in FY10 (but, benefit will be limited due to year-endborrowings). Low cost borrowing is likely to account for 24% and 22% inFY12e and FY13e.

Fig 13 Share of low cost borrowing in overall borrowings

17.814.7

11.89.8

-2.7

4.24.9

3.78.9

7.97.0

FY10

FY11e

FY12e

FY13e

REC Capital gains bonds Infrastructure bonds ECB/foreign currency Borrowings Source: Company, Anand Rathi Research.

Re-pricing of loans to offset increase in wholesale

borrowing cost

A large part of REC loans (~75%) are covered by a re-set clause of threeyears. We expect loans worth `100bn and `150bn to be re-priced in FY11eand FY12e respectively, ~50bps higher than current yield on loans. Asagainst this, borrowings worth `30bn will be re-priced at a higher rate.

Deep discount bonds

REC is expected to issue deep discount bonds worth `7-8bn (~3% of

incremental borrowings) with maturity period of 7-10 years. These bondsare generally priced 40-50bps lower than the regular interest-paying bonds,owing to tax benefit. Deep discount bonds are non-interest paying andtaxable as capital gains (10% or 20%, depending on the tenure andindexation) and not as income from other sources (30% on interest paid).

Spread to remain at 3.2%; margins at 4.2%

We remain conservative and expect spread to remain at 3.2% and NIM at4.2%. In 1QFY11, REC spreads and NIMs stood at 3.4% and 4.6%respectively. We expect RECs margins to remain protected owing to:i) regular re-set of loans being in line with re-set of borrowings; ii) strongpricing power, which is on account of large scale of operations and it beingone of the few lenders to SEBs, thereby ensuring spread of ~3% and NIMof ~4%.

Deep discount bonds will be priced

40-50bps lower

Loans worth`100bn and`150bnwill be re-priced in FY11e and

FY12e (15% and 17% of openingloans)


34/94



Fig 14 Trend in yields, cost of funds and spread (%)

10.110.6 10.7

11.811.1 11.0 11.0 11.2 11.1 11.0 11.2 11.3

7.8 7.8 7.8 8.0 8.1

3.4 3.2 3.2 3.2

6.77.2 7.8

8.67.6 7.7 7.7

3.3 3.4 2.9 3.23.5 3.4 3.3 3.4

1QFY09

2QFY09

3QFY09

4QFY09

1QFY10

2QFY10

3QFY10

4QFY10

1QFY11

FY11e

FY12e

FY13e

Yield on loans Cost of funds Spread Source: Company, Anand Rathi Research.


35/94



High RoA and RoE to sustain

We expect REC to post earnings CAGR of 26% over FY10-13e on theback of strong loan growth and stable margins. This would lead tohigh RoA and RoE, of +3.3% and +23% respectively, over FY10-13e.

REC enjoys superior cost-to-income owing to lower operating cost (nobranches and lower employee base) and large ticket-size of disbursements.

We expect operating costs to witness CAGR of 20% over FY10-13e.Credit costs are expected to remain negligible on the back of robust assetquality. Hence, strong loan growth backed by stable margins is likely todrive PAT CAGR of 26% over FY10-13e. RoA and RoE would remainsuperior at +3% and +23% respectively in FY13e.

Fig 15 Trend in operating cost and cost-to-income

500

1,000

1,500

2,000

2,500

FY06

FY07

FY08

FY09

FY10

FY11e

FY12e

FY13e

4.0

4.9

5.8

6.7

7.6

8.5

Operating cost Cost-to-income

(%)( m)`


Fig 16 Negligible credit cost

0

100

200

300

400

500

FY07

FY08

FY09

FY10

FY11e

FY12e

FY13e

(0.02)

0.00

0.02

0.04

0.06

0.08

0.10

0.12

Provisions for NPAs Credit cost (RHS)

(%)( m)`


Operating cost to grow at a CAGRof 20% (versus NII CAGR of

28%)


36/94



Financials

We expect 28% CAGR in NII over FY10-13e on account of strongloan growth and stable margins. We estimate PAT CAGR of 26%(lower than NII growth due to lower other income) over the same

period. RoA and RoE would remain superior at 3.3% and 22-23%respectively.

Strong NII growth

We expect 28% NII CAGR over FY10-13e on the back of strong loangrowth (28% CAGR in loan growth) and stable margins (~4%).

Fig 17 Trend in net interest income ( bn)

68

13

18

53

25

33

42

0

10

20

30

40

50

60

FY06

FY07

FY08

FY09

FY10

FY11e

FY12e

FY13e

CAGR of 28% overFY10-13e

( bn)`


Non-interest income to be slower

We expect non-interest income to marginally decline in FY11 owing toone-offs in FY10 (write-back of excess provisions and income-tax refundof`433m). Processing fee charged by the company and interest on excessmoney parked in banks/mutual funds is the only source of other incomefor the company. Hence, we remain conservative and estimate lowergrowth (~20%) in non-interest income (excluding one-offs).

Fig 18 Other income and other income as a percentage of operating profits

1.0

1.5

2.0

2.5

3.0

3.5

4.0

FY08

FY09

FY10

FY11e

FY12e

FY13e

5

7

9

11

13

15

Non-interest income % to operating prof its (RHS)

(%)( bn)`



37/94



High return ratios

RECs strong pricing power would translate into superior NIMs. Loweroperating cost coupled with negligible credit cost would result in RoA of+3% and RoE to range at +23%, despite lower leverage.

Fig 19 Superior return ratios

1.0

1.5

2.0

2.5

3.0

3.5

FY06

FY07

FY08

FY09

FY10

FY11e

FY12e

FY13e

15

17

19

21

23

25

27

RoA RoE (RHS)

(%) (%)


Fig 20 DuPont Analysis (%)REC FY08 FY09 FY10 FY11e FY12e FY13e

Interest income 8.9 10.1 10.8 10.9 11.2 11.4

Interest expenses 5.4 6.2 6.5 6.6 6.9 7.1

Net Interest Income 3.5 3.9 4.3 4.4 4.3 4.3

Other Operating Income 0.0 0.2 0.2 0.2 0.1 0.1

Other Income 0.4 0.4 0.3 0.2 0.1 0.1

Total Income 3.9 4.4 4.7 4.7 4.6 4.5

Operating expenses 0.3 0.3 0.3 0.2 0.2 0.2

Operating profits 3.6 4.2 4.5 4.4 4.4 4.3

Provisions 0.1 0.0 0.0 0.0 0.0 0.0

PBT 3.5 4.2 4.5 4.4 4.4 4.3

Taxation 1.2 1.4 1.1 1.1 1.1 1.1

RoA (incl DTL) 2.3 2.8 3.4 3.3 3.3 3.2

Leverage (x) 8.0 8.0 6.9 6.4 7.2 7.8

RoE (incl DTL) 18.6 22.2 23.3 21.5 23.4 24.9


RoA and RoE to remain healthy at+3% and +23% over FY10-13e


38/94



Fig 21 Income statement ( m)Y/E 31 March FY09 FY10 FY11e FY12e FY13e

Interest Income 46,649 64,309 83,916 109,726 141,441

Interest Expended 28,873 38,961 50,580 67,712 88,430

Net Interest Income 17,776 25,348 33,337 42,014 53,011

Growth (%) 37.1 42.6 31.5 26.0 26.2

Non-interest Income 2,663 2,767 2,677 3,149 3,806

Total Income 20,439 28,115 36,014 45,163 56,818

Non-interest income / Total Income (%) 13.0 9.8 7.4 7.0 6.7

Operating Expenses 1,208 1,620 1,904 2,269 2,713

Employee Expenses 872 1,171 1,382 1,658 1,990

Other Expenses 336 449 522 611 723

Pre-provisioning profit 19,231 26,495 34,110 42,893 54,105

Growth (%) 42.1 37.8 28.7 25.8 26.1

Provisions 34 3 2 2 2

Profit Before Tax 19,197 26,492 34,108 42,891 54,103

Taxes 6,476 6,478 8,527 10,723 14,067

Tax Rate (%) 33.7 24.5 25.0 25.0 26.0

Profit After Tax 12,721 20,014 25,581 32,169 40,036

Growth (%) 47.9 57.3 27.8 25.8 24.5

Number of shares (m) 859 987 987 987 987

Earnings per share (`) 14.8 20.3 25.9 32.6 40.5


Fig 22 Balance sheet ( m)

Y/E 31 March FY09 FY10 FY11e FY12e FY13e

Share Capital 8,587 9,875 9,875 9,875 9,875

Reserves and Surplus 53,314 100,929 117,267 137,882 164,054

Net Worth 61,901 110,803 127,142 147,757 173,929

Borrowings 449,360 559,482 736,071 955,970 1,213,953

Deferred tax liabilities 9,567 (74) (74) (74) (74)

Other Liabilities & Provisions 38,737 25,149 30,179 39,232 51,002

Total Liabilities 559,564 695,361 893,318 1,142,886 1,438,810

Loans 513,814 664,526 855,897 1,098,816 1,395,348

Investments 10,049 9,099 9,554 10,031 10,533

Cash & Bank Balances 18,860 13,903 19,301 24,696 22,769


Total Assets 559,564 695,361 893,318 1,142,886 1,438,810



39/94



Company background & Management

Rural Electrification Corporation (REC) is a Navratna PSUincorporated in 1969, with the main objective to finance and promoterural electrification projects across the country. REC came out with

an initial public offer in Mar 08. The company is managed bydirectors appointed by the government of India in consultation withthe Power Ministry.

Company background

REC is a Navratna PSU, incorporated in 1969 under the Ministry ofPower with the main objective to finance and promote rural electrificationprojects across India. REC came out with an IPO in Mar 08 and a follow-on offer in Feb 10. The government holds 66% stake in the company atpresent. REC enjoys international credit rating equivalent to sovereignrating of India from international credit rating agencies Moodys and Fitch,

which is Baa3 and BBB- respectively.

Fig 23 Shareholding pattern

Public and

others, 8%

DIIs, 6%

FIIs, 19%

Promoters, 67%

Source: Company

Management

Fig 24 Key managementName Designation Background

JM Phatak Chairman andManaging Director

IAS officer with 32 years of service withstate/central governments

Holds Masters in Management and PublicAdministration from Harvard University

HD Khunteta Director (Finance) More than 30 years of experience in Finance;Served as ED (Finance) in NHPC

Guljit Kapur Director (Technical) In-charge of technical and operation aspects ofvarious project;More than 35 years of experience with variousSEBs

Source: Company

REC is a Navratna PSU, in whichthe government holds 66% stake


40/94

Anand Rathi Financial Services Limited does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investmentdecision. Disclosures and analyst certifications are located in Appendix 1

Anand Rathi Research

India Equities

India I Equities


[email protected]


[email protected]

Key financialsYear end 31 Mar FY09 FY10 FY11e FY12e FY13e

Net interest income (`m) 18,875 27,983 35,471 44,060 54,291Net profit (`m) 19,700 23,572 28,022 34,271 42,042

EPS (`) 17.5 20.5 24.4 29.9 36.6

Growth (%) 54.4 16.6 19.3 22.3 22.7

PE (x) 19.4 16.2 13.6 11.2 9.1

PABV (x) 3.3 2.9 2.5 2.1 1.8

RoE (%) 17.8 19.0 19.5 20.4 21.3

RoA (%) 3.2 3.1 3.0 2.9 2.9

Dividend yield (%) 1.2 1.4 1.5 1.7 2.1

Net NPA (%) 0.0 0.0 0.0 0.0 0.0


Financial Services

Initiating Coverage

24 August 2010

Power Finance Corporation

Long-term play on Power; initiate with Buy

We initiate coverage on Power Finance Corporation (PFC) withBuy and target price of`408/share. PFC is likely to see hugebenefit from the massive investment in power capacity overFY10-13e. Capital raising in FY11 would support businessgrowth. The companys IFC status, high productivity and low

credit costs would result in 21% EPS CAGR over FY10-13e.

Robust loan growth visibility. PFCs loan pipeline remainsstrong, with outstanding sanctions of`1.4trn (1.7x of loan book).Huge capacity addition and vast investment in power capacity islikely to drive 26% loans CAGR over FY10-13e.

IFC status and capital raising to support business growth.Now classified as an IFC, PFC will enjoy enhanced single/groupborrower limits and higher exposure limits for bank-borrowings,enabling robust balance-sheet growth. PFC is likely to raise capitalby end-FY11 to support its business growth prospects. This willfurther strengthen its capital adequacy (17.3% in Jun 10).

Low costs to aid profitability. Likely stable margins of ~3.7%,high productivity (cost-to-income: ~3.5%) and negligible creditcosts would drive net profit CAGR of 21% over FY10-13e.

Valuation.At our target price, the stock would trade at PBV of2.6x FY12e and 2.2x FY13e. Our target price is based on the two-stage DDM (CoE: 13.4%; Beta: 0.9; Rf: 7.5%). Risks: Slowdownin the power sector and regulatory changes.

Rating: Buy

Target Price: `408

Share Price: `333

Key data POWF IN /POWF.BO

52-week high/low `345/`202

Sensex/Nifty 18402/5531

3-m average volume US$3.9m

Market cap `382bn/US$8.2bn

Shares outstanding 1147.8m

Free float 10%

Promoters 90%

Foreign Institutions 4%

Domestic Institutions 3%

Public 3%

Relative price performance

PFC

Sensex

200

230

260

290

320

350

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Source : Bloomberg


41/94

24 August 2010 Power Finance Corporation Long-term play on Power; initiate with Buy


Quick Glance Financials and Valuations

Fig 1 Income statement ( m)

Year end 31 Mar FY09 FY10 FY11e FY12e FY13e

Net interest income 18,875 27,983 35,471 44,060 54,291

NII growth (%) 17.2 48.3 26.8 24.2 23.2

+ Non-interest inc 2,448 3,248 3,245 3,263 3,705

Total income 21,323 31,230 38,716 47,323 57,996

- Op. expenses 1,382 1,096 1,303 1,578 1,889

Operating profit 19,941 30,135 37,413 45,745 56,106

- Provisions 36 - 50 50 50

PBT 19,905 30,135 37,363 45,695 56,056

- Tax 205 6,562 9,341 11,424 14,014

PAT 19,700 23,572 28,022 34,271 42,042

+(AssociatesMinorities) - - - - -

Consolidated PAT 19,700 23,572 28,022 34,271 42,042

PAT growth (%) 63.2 19.7 18.9 22.3 22.7

FDEPS (`/share) 17.5 20.5 24.4 29.9 36.6

DPS (`/share) 4.0 4.5 5.0 5.5 7.0


Fig 2 Balance sheet ( m)Year end 31 Mar FY09 FY10 FY11e FY12e FY13e

Share capital 11,478 11,478 11,478 11,478 11,478

Reserves & surplus 103,601 121,130 142,438 169,323 201,965

Deposits 521,602 671,084 840,022 1,074,607 1,358,976

Borrowings 44,851 43,612 46,315 51,570 55,528

Minority interests 555 470 470 470 470

Total Liabilities 682,086 847,774 1,040,722 1,307,447 1,628,417

Advances 644,290 798,560 1,000,026 1,264,243 1,580,204Investments 359 314 330 347 398

Cash & Bank Bal 3,922 13,943 3,763 4,519 5,768


Total Assets 682,086 847,774 1,040,722 1,307,447 1,628,417

No. of shares (m) 1,148 1,148 1,148 1,148 1,148

Deposits growth (%) 28.3 28.7 25.2 27.9 26.5

Advances growth (%) 24.9 23.9 25.2 26.4 25.0


Fig 3 RatiosYear end 31 Mar FY09 FY10 FY11e FY12e FY13e

Interest spread (%) 1.6 2.0 2.2 2.2 2.2

NIM (%) 3.6 3.6 3.7 3.7 3.7Other inc / Total inc (%) 11.5 10.4 8.4 6.9 6.4

Cost-Income (%) 6.5 3.5 3.4 3.3 3.3

Provisions / Loans (%) 53.8 53.8 53.8 53.8 53.8

Dividend Payout (%) 27.3 25.6 24.0 21.6 22.4

Borrowings-loans (%) 81.0 84.0 84.0 85.0 86.0

Investment-Deposit (%)

Gross NPA (%) 0.0 0.0 0.0 0.0 0.0

Net NPA (%) 0.0 0.0 0.0 0.0 0.0

BV (`) 100.7 115.9 134.5 157.9 186.4

Adj BV (`) 100.7 115.9 134.5 157.9 186.3

CAR (%) 17.2 19.3 16.5 15.3 14.0- Tier 1 (%) 17.2 19.3 16.5 15.3 14.0Dividend Yield (%) 1.2 1.4 1.5 1.7 2.1Source: Company, Anand Rathi Research

Fig 4 PE Band

PFC

3x

7x

11x

15x

0

50

100

150

200

250

300

350

400

450

Feb-07

May-07

Aug-07

Nov-07

Feb-08

May-08

Aug-08

Nov-08

Feb-09

May-09

Aug-09

Nov-09

Feb-10

May-10

Aug-10


Fig 5 Price-to-Book Band

PFC

0.8x

1.3x

1.8x

2.3x

0

50

100

150

200

250

300

350

400

Feb-07

May-07

Aug-07

Nov-07

Feb-08

May-08

Aug-08

Nov-08

Feb-09

May-09

Aug-09

Nov-09

Feb-10

May-10

Aug-10


Fig 6 Bankex versus PFC

PFC

Bankex

200

230

260

290

320

350

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Source: Bloomberg


42/94




We initiate coverage on PFC with a Buy recommendation and targetprice of`408/share. PFC is likely to see immense benefit from themassive investment in power capacity over FY10-13e. Capital raising

in FY11 would support business growth. The companys IFC status,high productivity and low credit costs would result in 21% EPSCAGR over FY10-13e.


PFCs loan pipeline remains strong, with cumulative outstanding sanctionsof`1.4trn as on 1QFY11 (1.7x of loan book). During the past eightquarters (from 2QFY09 to 1QFY11), PFC sanctioned loans worth `1.2trn(average quarterly additions to sanctions were `155bn).

Higher sanctions in the past eight quarters is likely get converted to

disbursements over the next two years, estimated at`

717bn (`

317bn inFY11e and `400bn in FY12e), which is 60% of sanctions. We expect loansCAGR of 26% over FY10-13e.

IFC status and capital raising to support business

growth

Now classified as an IFC, PFC will enjoy enhanced single/group borrowerlimits and higher exposure limits for bank-borrowings, enabling robustbalance-sheet growth.

With the IFC status, PFC is required to maintain the capital adequacy ratio(CAR) of 15% as against 12% required for other NBFCs. Rapid growth inloans (26% CAGR over FY10-13e) in excess of RoE (20-21% over FY10-13e) will burn capital faster. PFC will require capital for maintainingcurrent growth rate. CAR, as on 1QFY11, is 17.3% as against themandatory 15%. We expect PFC to raise capital by end-FY11.

Low costs to aid profitability

PFC is the nodal agency for UMPPs that entail huge investment. Itcommands pricing power as it is the lead lender for such projects.

Margins to sustain at 3.7%

Margins in generation projects are lower compared with T&D projects,owing to higher charge on assets (due to lower risk) and better revenue

visibility (due to purchase agreements and lower losses).

PFC has been awarded IFC status by the RBI. Thereby, we expect PFCscost of funds to reduce due to issue of low cost infrastructure bonds(`20bn each in FY11e, FY12e and FY13e, which is 4.4%, 3.4% and 2.8%of incremental borrowings) and ECBs (`38bn, `11bn `13bn i.e., 8.4%,1.8% and 1.9% of incremental borrowings respectively).

Infrastructure bonds and ECBs will lower any pressure on margins due tohigher borrowing cost from other source of funding. However, a largepart of PFCs loan book (`200bn, which is 25% of FY10 loan book) will

be re-priced at the ongoing rate (10.75-11%). This will cap upwardmovement in yields on loans. Overall, we expect spreads to remain stableat 2.2% and margins at 3.7% over FY10-13e.

Higher sanctions to drive loanCAGR of 26% over FY10-13e

IFC status to support loan growthand stable margins


43/94



Earnings to witness CAGR of 21% over FY10-13e

Strong loan growth backed by stable margins (~3.7%), lower cost ofoperations (cost-to-income: ~3.5%) and negligible credit cost (remainednil/negative over FY06-10) will drive PAT CAGR of 21% over FY10-13e.

ValuationPFC is a long-term bet on Indias expanding power sector investments. Itoffers a good combination of strong growth and value, and trades at PBV2.1x FY12e and 1.8x FY13e. With strong earnings visibility and higherreturn ratios, we believe the stock has potential of re-rating. We initiatecoverage with a Buy recommendation and target price of`408/share. Ourtarget price is based on the two-stage DDM (CoE: 13.4%; Beta: 0.9; Rf:7.5%).

Risks to our target price

PFC is a dedicated power finance company. Any slowdown in powersector investments will hurt loan growth

Any regulatory changes as regards SLR/CRR requirements,maintenance of standard provision coverage on loan book etc, canhave negative impact on profitability

Good combination of growthvisibility and value


44/94


45/94



Loan book skewed towards generation projects and

state/central governments

The generation segment accounts for 82% of the total loan book, followedby T&D projects at 12%. Higher share of the generation segment augurs

well for asset quality as loans are secured by charge on assets (turbines etc)and lower probability of losses as in the case of transmission projects (dueto distribution losses).

Fig 9 Break-up of loan book 1QFY11 (as per segment)

Others

6%Distribution

4%

Generation

82%

Transmission

8%

Source: Company

Central/state governments account for 85% of the loan book. PFC isexpected to benefit from this as it enjoys strong relationship with state andcentral government utilities, which comprise more than 80% of the loanbook. Sustained increase in power-sector spending by the government

augurs well for strong loan growth.

Fig 10 Break-up of loan book - 1QFY11 (as per borrower)

Central PSUs

19%

State

66%

Joint Sector

8%

Private

7%

Source: Company


46/94



IFC status and capital raising to

support business growth

Now classified as an IFC, PFC will enjoy enhanced single/group

borrower limits and higher exposure limits for bank-borrowings,enabling robust balance-sheet growth. PFC is likely to raise capitalby end-FY11 to support its business growth prospects. This willfurther strengthen its capital adequacy (17.3% in Jun 10).

IFC status to support business growth

PFC has been awarded IFC status by the Reserve Bank of India (RBI).This will enhance single/group borrowing lending limits by 5% and overall(

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