Mid-cap NBFCs remain a hope story; valuations rich despite underperformance: In 2015, earnings disappointed materially. Loan growth remained sluggish while NPL (non-performing loan) formation and credit costs continued to rise. There was some respite from lower funding costs. In 2016, we are building a moderate earnings recovery against the backdrop of extended sluggishness in the economy, which is only gradually picking up, and two consecutive years of weak monsoon. We expect more consensus earnings downgrades in 2016.
Reported earnings could be further impacted by a shift to aggressive NPA (non-performing assets) recognition norms during F16-18 (not in our numbers). The impact could be uglier than expectations due to the weak economy. In addition, concerns about competition from upcoming small finance banks are likely to intensify later in 2016 as there is more clarity on their business plans. Still, valuations are expensive across NBFCs. We remain UW (underweight) on STFC (Shriram Transport Finance Company) and MMFS (Mahindra & Mahindra Financial Services). We are EW (equal weight) on SCUF (Shriram City Union Finance) mainly on better profitability, growth, and a strong capital position that gives the option of an acquisition (SCUF has said it is open to investment opportunities as it is carrying excess capital).
HFCs: Sweet spot behind us; competition, uncertainty, risks ahead. Prefer HDFC. Home loan disbursements growth for LICHF (LIC Housing Finance Ltd) and IHFL (Indiabulls Housing Finance Ltd) has slowed quite sharply in F1H16, even as banks appear to be gaining market share. Trends in property prices and transactions growth have been weak. Incremental spreads should moderate as base rates fall more than funding costs. We see risk of new base rate computation rules potentially triggering sharply lower home loan yields over the next year. For the LAP segment , we expect slower loan growth and lower profitability—i.e., either credit costs start rising on property market weakness, or loan yields suffer from greater competition if the portfolio behaves well. We prefer HDFC (OW) given a better asset and liability mix and valuation close to 1 S.D. below the mean. We are EW on LICHF and IHFL.
Microfinance: Upgrade SKS to OW on strong medium-term earnings visibility amid a tough environment; long-term uncertainty due to SFB licence miss remains: RBI recently doubled loan limits for shorter-tenor loans; this should drive higher loan growth and operating efficiency at SKS. Hence, while long-term uncertainty remains, due to it not receiving a small finance bank (SFB) licence, we see very strong earnings growth in the near to medium term (MSe ~55% EPS CAGR F16e-18e). This, in the context of weak earnings growth in the rest of the group, should drive stock performance.
2015 Roundup and 2016 Outlook
* NBFCs have underperformed benchmark indices in 2015, while HFCs (Housing Finance Companies) and microfinance (SKS) have done relatively well. This is largely in line with revisions in consensus earnings’ expectations over the year.
* While consensus remains positive toward an earnings rebound at NBFCs, we are less sanguine and expect to see further consensus downgrades.
* Further, NBFC valuation multiples remain rich relative to their earnings growth. We think downside risks to asset quality are higher at NBFCs, and reported earnings could be even weaker owing to a shift to accelerated NPA recognition norms. Also, we expect the debate about competition from SFBs to intensify in 2H16 as there is more clarity on their business plans, likely resulting in further pressure on valuations. Hence, we expect continued underperformance in 2016.
* We prefer HDFC (OW) in the HFC space given its attractive valuation, and upgrade SKS to OW on strong near to medium term earnings visibility.
Key changes to earnings forecasts
We cut 2016-18 EPS forecasts by 7-15% at SCUF and 3-12% at MMFS on higher credit costs. NPL formation has kept rising, contrary to our expectations of some moderation, and hence we now forecast asset quality to improve at a more gradual pace than previously.
We raise EPS forecasts by 7%-20% for SKS, driven by higher AUM growth and better operating efficiency, following doubling of the cap on ticket size for shorter tenor loans.
Concerns around competition from upcoming SFBs is likely to intensify later in 2016 as there is more clarity on their business plans. We think the SFBs are likely to start competing in segments (higher yielding, under-served) traditionally the domain of NBFCs. The concern we see is that SFBs could disrupt pricing and underwriting standards in some of the NBFC segments in the medium term, even if not sustainably. As the debate intensifies, the sustainable growth and RoE (return on equity) assumptions embedded in NBFC valuation multiples could come under pressure, resulting in further valuation derating.