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 rates and pass on the increase in cost of funds and thereby improve NIMs (net interest margins). We expect a slight moderation in NIMs as (a) the company resets lending rates on an annual basis and (b) other financial institutions are still shying away from the sector.
Credit quality to remain strong: Our analysis of past global PPP projects suggests the absolute credit losses in the sector will be limited. In addition to this, PFC and REC has more than 85% of loan book exposed to central or state utilities which provides comfort on credit quality.
Structural headwinds pose risks: PFC and REC have gone through a big re-rating in the past six months, with stock prices moving up 88% and 68%, respectively. While we expect robust results in the near term, the long-term prospects of these stocks may not be in line with the market expectations which seems to have gone from very bearish to very bullish in nine months.
Near-term numbers look good: Given the pipeline created over the last five years PFC/REC still have sanctioned, but not disbursed, loans accounting for c.80% of their current AUM (asset under management). Thus both companies will be able to show AUM growth of more than 15% for the next couple of years. Also, the spreads i n the near term will remain high as R15 bn in new loans were disbursed at 12.5% yield in FY14. We do not expect any default from the state governments and with most SEB loans going through the restructuring process big credit losses in the near term are unlikely. We expect c.15%-20% EPS (earnings per share) growth for the next couple of years.
However,current profitability may moderate: Profitability of power finance companies increase in bad markets as those willing to lend to SEBs then are few, allowing PFC and REC to charge higher rates despite state government guarantees. However, if the much-talked about power sector reforms are implemented and financial health of SEBs were to improve then we may see cost of funding for SEBs come down as more financiers (like banks) will be willing to finance them; the downside to this would be lower loan growth and decline in margins for PFC and REC. Also, their back book, i.e. sanctioned but not disbursed loans, has come down from c120% to 80% of AUM in past couple of years as a majority of the loans disbursed in the past couple of years were for refinancing, which means future growth is dependent on new investments in the power sector.
Valuation: PFC and REC are trading at 1.0x and 1.2x FY16e BVPS (book value per share) respectively, which is close to their mean historical valuations. At current valuation levels, we see limited re-rating potential given structural headwinds. We downgrade PFC REC with revised FVs (fair values) of R300 (from R177) and R310 (from R188).