We are downgrading SKS to a Sell (3M) with Rs 605 target price. We also reduce our earnings by 41-52% over FY11-13e, factoring in lower NIMs (net interest margins), slower loan growth and higher credit costs. While we do not make a bearish case on the fundamentals of the business itself, we believe the improvements will likely be gradual and will require modifications of SKS? business model as well adjustments by its large customer base.
The stock has corrected sharply over the last couple of months, but we believe that the current regulatory changes will have a meaningful impact on its operations (earnings, growth, asset quality and funding) even if there is a relatively quick resolution. In case of further delays, the impact could be higher. In sum, we see risks to the downside as greater than possible medium-term upsides to the stock.
Microfinance operations in AP are in the process of bootstrapping and, after a period of a near halt of operations, are slowly limping back to some semblance of normalcy. We believe however that the process will be slow, and will take at least two-three quarters even in the best case (assuming the regulatory impasse is resolved quickly). However, the broader picture remains blurred for microfinance operations in India (especially in AP which is the largest exposure) as regulatory pressures are likely to remain in place. We expect this scenario to be clearer by end FY11 post-RBI?s Malegam committee report on MFIs and the government?s focus on financial inclusion initiatives.
We believe that SKS is better positioned relative to its peers given: (i) Recent capital raising, which reduces its leverage (total assets/equity) to 3.2x (Sep ’10); and (ii) a geographically more diverse loan portfolio, with Andhra Pradesh contributing only 28% of its loan book (Sep ’10). This will likely be relatively beneficial for SKS when the dust settles on the sector, but the benefits will likely show through gradually and there will be some more pain to endure before that.
We are reducing our target price on SKS to Rs 605 per share, based on our EVA (economic value added) model (and benchmarked off 2x FY12Ee P/BV?price-to-book value), factoring in: a 41-52% reduction in earnings; lower growth prospects over the medium term (30-40% loan growth medium term); and higher asset quality risks over the next two-three quarters.
We recently went on a field trip near Hyderabad with SKS to meet end customers and understand the on-the-ground impact of the AP regulations. While our sample set was very small to be representative of its entire customer base, there were a few takeaways which could be generalised.
Operations have started to normalise gradually. SKS has started to hold centre meetings in more areas and more frequently (while a weekly meeting is still not being held) and disruptions have largely ceased. Attendance at the centre meetings is however still relatively low (around 60% on average). No fresh lending is being done by most MFIs in AP, including SKS.
Customers seemed to be aware that this is largely due to the AP Ordinance. Most customers we met believed that a monthly repayment model would not be conducive for them and they would prefer to continue with a weekly repayment model. Customers said that availability of timely credit is more important than interest rates charged .
The AP Microfinance Bill was ordinanced on Oct 15, 2010 and has recently been tabled by the state Assembly (the Bill has since been passed) . We believe that, if enacted, there will be several implications for the MFI sector, including:
Net interest margins: While the ordinance does not talk about interest rates as such and has capped repayments at 100% of principal, some MFIs (most notably SKS) have come forward and reduced lending rates. Access to bank funding for MFIs has become significantly tighter and costlier. This is likely to impact NIMs negatively for the sector. We believe loan spreads can fall by at least 2-3% (from over 15% earlier) over the medium term due to the combination of lower lending yields and higher funding costs.
Loan growth: Most MFIs have stopped fresh disbursements in AP and have slowed down, if not stopped, even in other states. The current MFI Bill talks about reducing the extent of over-leveraging by borrowers and intends to limit an individual to loans from 1SHG (self-help group)+1MFI only. This will be a further dampener to growth in the state as currently there are multiple MFIs lending to individual borrowers. We believe loan growth for the sector is likely to reduce sharply from the over 100% growth rates seen over the last couple of years.
Asset Quality: Collections for MFIs in AP have come down sharply due to (i) MFIs’ inability to contact borrowers, pending registration with AP government, (ii) inability to hold centre meetings due to disruptions/protests, (iii) changing of collection frequency to monthly from weekly and (iv) borrower reluctance to repay. We believe that unless there is a quick resolution to the current situation and there are orderly meetings held by MFIs, the losses are likely to increase significantly.
Also, the shift in the repayment model to monthly from weekly entails higher repayment risks.
Access to Funding: Most banks have become risk-averse while lending to the MFI segment and prefer to wait till there is more clarity on the operations of the companies. Most banks have reduced lending to the sector significantly. We believe that access to funding (debt and equity) will remain tight for the sector and will also cost significantly more than what has been available before.
?Citi