A 200% surge in share price since Sep13 has meant that Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) stocks are now trading at their historical mean valuation; further re-rating in our view needs to be backed by an improving fundamental story. Though the near-term outlook remains strong (and we expect EPS growth of >20% in FY15), the spreads may not be sustainable over the medium term if the much talked about power sector reforms were to finally ensure financial stability for SEBs (state electricity boards) . Hence, we expect the ROEs—return on equity—of >20%) to moderate for these companies over the longer duration and with stocks already trading above mean valuations we downgrade PFC (to Neutral from Buy) and REC (to Sell from Neutral).
Power financiers have significantly re rated: Since September 2013 the stock of both the power financiers have significantly re-rated on the back of reform expectations in the power sector. PFC has been one of our top picks in the infra finance space to date as we did not expect any big defaults to happen and also in our opinion this was the only space where we expected growth in loan book and expansion in margins. We think that these power financiers can still grow at more than 20% in the near term (over the next two years), but believe structural headwinds don’t bode well for both PFC and REC.
Operating performance could remain strong over the next two years given: Loan book growth remains high: Since PFC and REC are sitting on a sanctioned and not disbursed pipeline of almost 80% of their portfolio, loan growth may not be a problem for them. Also, the main customers of PFC & REC, i.e. the SEBs, will remain money hungry as profitability is still a long way off for SEBs and they also need to upgrade their capacity.
However in the recent past the quality of growth has not been very healthy as growth has mostly come from refinancing of loans for PFC and REC, hence visibility for future growth will be a function of new project approvals.
Spreads/NIMs may remain strong: PFC and REC have remained one of the few lenders in the power sector and sole lenders for SEBs for last couple of years given high uncertainty in the sector. As a result, the companies have been able to charge higher interest