Both POWF & RECL have corrected by 32% and 20% in last 12m, but we still don’t see any reason to own these stocks. In the best case, we expect the stock to deliver returns just ahead of its cost of equity with a mean P/B of 1.2-1.3x, though normalised conditions are too far out and too tough to predict. Cut PT and continue to retain UNPF on both.

Business structure

In substance, these companies are off-balance sheet entities for the government, lending primarily to state-owned power utilities (85%), most of which are loss making at an operating level. Pseudo sovereign identity allows them to borrow at relatively cheaper rates vis-a-vis their fundamental financial health would otherwise justify, making for relatively higher margins. As a result, private investors make money out of taxpayers owing to the arbitrage in the business model where owner & principal borrower remain effectively the same: the government and we can’t come around with any reason to accept this as a great story to push. NIMs have been falling for both players owing to yield compression. We build in 3.3% and 3.1% NIMs in FY19 and FY20 for both the companies.

Power sector stress

Burdened by high AT&C losses, DISCOMs continue to be under financial stress even after two years of UDAY implementation. Impacted by their inability to purchase power, the generation sector has also not been able to enter longer-term PPAs for power supply. Owing to the distressed condition of the DISCOMs, Ministry of Power has directed both Power Finance Corporation (POWF) and Rural Electrification Corporation Ltd (RECL) to restrain from lending further to DISCOMs with AT&C losses greater than 15% until they come up with a satisfactory roadmap to reduce the losses. Total stress stood at 22.3% and 11.5% as on Q3FY18 for POWF & RECL respectively.

Further growth challenges

Both POWF & RECL had reported somewhat better loan growth in Q3FY18 (10% and 11% respectively) although on a low FY17 base. While loan approvals are better (20% and 40% y-o-y), disbursal growth remained muted at 9% and 5% for 9MFY18 respectively. The recent lending restraint will further add on to growth challenges in the sector. Factoring this, we cut FY17-20e loan growth estimates to 6.6/6.7% for POWF & RECL respectively.

Estimate change

On the back of lower asset growth, compressing margins and higher credit costs, we cut our EPS estimates by 25.4/29.7% in FY19/20e for POWF and 12.1/8.0% in FY19/20e for RECL. We assume a 70% haircut in private sector power exposure, although we have generously assumed ‘zero’ losses on state sector loans. Near term news flow will remain weak, as we expect downgrades in asset quality as some of the generation capacities slip into NPLs. Moreover, NPL in this sector can be always lumpy and hence credit costs will remain volatile until the overall sector revives — several years out.

Valuation

POWF & RECL trade at 1.0x adj. BV (Mar’18e) and 4.7x and 5.2x EPS (12m to Mar’19e). We value POWF at Rs 79 implying 0.9x Mar’19e adj. BV, 4.1x EPS (12m to Mar’20e) vs. 5 year average of 0.8x and 5.0x respectively. We value RECL at Rs 113 implying 0.85x Mar’19e adj. BV, 4.3x EPS (12m to Mar’20e) vs. 5 year average of 0.9x and 4.7x respectively. Risks: NIM stability, better loan growth and improvement in asset quality.