We retain our positive stance on Muthoot Finance in the light of attractive valuations, significantly higher-than-industry business traction and high RoE (return on equity). Muthoot has reported strong loan growth largely on the back of new client acquisitions; the recent rally in gold will further buoy its business. We raise estimates by 5-14% to factor in higher growth and somewhat better-than-expected NIM (net interest margins); raise price target to R230 (from R220).

We believe that rising gold prices will support business growth for Muthoot. Higher gold prices raise Muthoot?s ability to increase the loan ticket size. Gold prices have increased by 25% since April (20% since June). On a year-on-year basis, gold prices are up about 45%. Muthoot?s growth is driven by more customers. In Q1FY12, Muthoot reported 96% y-o-y growth in loan book?of this 72% was driven by an increase in customers and the balance (24%) in average loan size (representing rise in gold prices). On a quarter-on-quarter basis, the average ticket size was up only 3% q-o-q even as gold prices increased by 6% q-o-q.

We believe that the average ticket size will eventually catch up with the average rise in gold prices. Thus, the company is well-placed for higher growth. We are raising our loan growth estimates by 10% in FY2012e (estimate). We now model 58%, 25% and 13% loan growth in FY2012e, FY2013e and FY2014e, respectively as compared to over 100% growth in the past two years.

Muthoot?s loans are not linked to daily gold prices but to a ‘benchmark gold price’. The management has highlighted that during periods of sharp rises in gold prices (like the current scenario), they would wait for prices to stabilise before revising the ?benchmark gold price?. Thus, a sharp rise or fall does not affect the company in the near term; the price-rise needs to sustain in order to drive loan growth.

Despite fears of adverse regulations for gold loan NBFCs (non-banking finance companies), RBI?s committee on NBFCs regulations did not have any specific proposals for the gold loan business. We find limited risk to earnings of Muthoot Finance if RBI?s proposed NBFC report is implemented. The committee proposes to reduce regulatory arbitrage between banks and NBFCs; it proposes to implement the 90-day NPL (non-performing loan) recognition norm for NBFCs as compared to 180 days currently. Muthoot?s gross NPLs are currently low at 0.3%, which will likely rise to about 0.8% if NBFCs move to the 90-day NPL recognition norm. This poses about 4% risk to base-case estimates.

We believe that Muthoot will need to raise capital if its growth is stronger than expected. Gold loans (from NBFCs) cannot be classified as priority sector loans for banks; we hence expect the share of loans outside the balance sheet to decline to 10% by March 2012e from 26% in March 2011. According to the management, banks have appetite for buying out gold loans despite the removal of the priority sector classification. We, however, believe that the demand will be considerably lower. Slowdown in credit from the industrial sector will likely prompt banks to resume focus on retail segments?as such, banks? demand for gold loans will likely rise in Q2FY12e. We believe that Muthoot?s Tier-I CAR (capital adequacy ratio) will decline to 11.5-12% levels in the next few quarters if the company cannot sell down loans to banks.

Banks currently require licences from RBI to open new branches while NBFCs have no such restrictions. The NBFC committee report is also silent on this issue. As per the current regulations for banks, about 25% of incremental branches need to be in Tier 3-6 cities. Most NBFCs are focused in smaller towns or lesser-banked/un-banked areas and hence, such a regulation may not pose a challenge. Muthoot had a massive expansion drive over the past few years?branches rose to 2,733 in March 2011 from 985 in March 2009. Typically, a branch requires about three years to achieve optimum scale; hence, even if RBI imposes restrictions on new branches, Muthoot?s existing branches can drive healthy growth in the medium term.

Government?s drive to unearth black money can affect gold-backed lending As per the recent income tax notification, purchase of gold above R0.5 m requires the buyer to quote his PAN. We believe this is aimed to restrict the use of black money invested in the sector. In this backdrop, high-value gold loans disbursed in cash may be restricted. Notably, the average ticket size of gold loans is low at R34,000.

We believe that increase in competition and pressure on NIM is the biggest risk to gold loan companies. We expect Muthoot?s spread to decline to 8.9% by FY2014e from 10.9% in FY2011 and 13.1% in FY2007. However, better operating leverage ratio (on the back of optimum utilisation from recently set up branches) will support RoA (return on assets). We believe that better service proposition (lesser documentation, faster turnaround time, neighbourhood branches, longer working hours) will enable NBFCs focused on the gold loan business to earn somewhat higher yields. We expect the gold loan business to remain a small-ticket business thereby requiring high operating leverage.

?Kotak Institutional Equities