hsbc 09-10-13 india diversified financial services

8/13/2019 HSBC 09-10-13 India Diversified Financial Services

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Niche consumer NBFCs still attractive,

despite macro slowdown, rising ratesPrefer sectors that are cash flow and

price sensitive: rural and housing financePrefer HDFC and LICHF, both OW rated;

upgrade SHTF to OW from N; downgrade

IDFC and PFC to N(V) and REC to N

Niche retail NBFCs remain attractive:Non-banking financial

companies (NBFCs) continue to be a space worth looking at,

despite a tough macro-environment and rising rates, as niche

consumer segments are still growing well. Two key sectors

rural and housing finance remain attractive. Urban housing

demand is steady due to affordability, income stability and

urbanisation and demand remains largely price and income

sensitive. Likewise, rural demand remains healthy, benefitting

from good monsoons, improving consumer cash flows, rising

income, and the wealth effect. Both segments have low interest

rate sensitivity. However, the commercial vehicle (CV) cycle

continues to be sluggish, while infrastructure issues, mainly

power, remain unresolved.

Little incremental impact on margins:NBFCs have

effectively managed their funding costs in 2Q, despite the

RBI raising the marginal standing facility (MSF) rate by

200bp. With the RBI reversing 125bp of this hike within the

quarter, NBFCs funding costs will ease. However, we

maintain our estimate of a 0-30bp margin decline for our

NBFC universe as the RBI has started hiking repo rates.

HDFC and MMFS best placed: HDFC (housing) and

MMFS (rural) are both well-positioned in their respective

sectors, with healthy profitability, good management and

conservative risk policies. LICHFs profitability has largely

bottomed out, while SHTF could see lower profitability due

to declining margins and rising asset quality risks. IDFC,

PFC and REC continue to be affected by the slow resolution

of power sector issues. A potential banking license could be

a further drag on IDFCs profitability.

Preferred picks: We continue to prefer HDFC, followed by

LICHF and SHTF (value buy). We remain N on MMFS,

whose strong fundamentals are offset by a rich valuation.

We downgrade IDFC and PFC to N(V) and REC to N as we

await the full resolution of power sector issues.

FIG

India Diversified Financial Services

India NBFCs

Remain selective

Indian NBFCs - Ratings and target prices

Company Bbg CMP* Rating(New)

Rating(Old)

TP(New)

TP(Old)

Potentialreturn **

HDFC HDFC IN 802 OW OW 1029 1007 30.0%LICHF LICHF IN 198 OW OW 236 243 21.1%Mahindra &Mahindra Fin

Services

MMFS IN 264 Neutral (V) Neutral 285 250 9.4%

ShriramTransport

SHTF IN 571 OW Neutral 706 723 25.2%

IDFC IDFC IN 95 Neutral (V) OW 101 129 9.8%Power Fin POWF IN 134 Neutral (V) OW 134 130 5.4%RuralElectrification

RECL IN 193 Neutral OW(V) 205 251 12.1%

**Potential return equals the percentage difference between the current share price and the target price, plusthe forecast dividend yieldSource: Company data, HSBC estimates, * prices as of 3rd October 2013,

9 October 2013

Tejas Mehta *

Analyst

HSBC Securities & Capital Markets (India) Private Limited

+91 22 2268 1243 [email protected]

Sachin Sheth *

Analyst

HSBC Securities & Capital Markets (India) Private Limited

+91 22 2268 1224 [email protected]

Todd Dunivant *

Head of Banks Research, Asia Pacific

The Hongkong and Shanghai Banking Corporation Limited

+852 2996 6599 [email protected]

View HSBC Global Research at: http://www.research.hsbc.com*Employed by a non-US affiliate of HSBC Securities (USA) Inc,and is not registered/qualified pursuant to FINRA regulations

Issuer of report: HSBC Securities and Capital Markets (India)Private Limited

Disclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of it


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Valuation and risk factors

PE PE-based PB PB-based DCF Wghtd TP ___________________________________ Risks ____________________________ multiple TP multiple TP value (INR) Upside risks Downside risks

Weights 20% 50% 30%

MMFS 12.5 321 2.4 289 253 285 Improvement in asset quality Higher slippages due to monsoon vagaries,regulatory uncertainties, interest rateuncertainties

SHTF 9.0 664 1.7 772 624 706 Rigidity, higher slippages, regulatory risks

Weights 50% 20% 30%

HDFC 23.5 1147 4.5 999 853 1029 - Increase in competitive pressures couldslow business growth or impact margins;

Asset quality riskLICHF 8.2 248 1.4 245 208 236 Asset quality deterioration and prolonged

suppressed spreads

Weights 100%

PFC 0.6 134 134 Earlier than expected capex revival,lesser than expected asset quality issues

Increase in slippages, decline in margins

REC 0.9 205 205 Earlier than expected capex revival,lesser than expected asset quality issues

Increase in slippages, decline in margins

Weights 20% 50% 30%IDFC 8.0 100 0.9 100 102 101 Earlier than expected capex revival,

lesser than expected asset quality issuesWorse than expected asset quality andgrowth outlook

Source: HSBC estimates

Sector-wise analysis and outlook

Sectors Growth drivers Growth outlook Customer sensitivity Risks Rank

Housing Growing salaried middle class,increasing nuclearisation of families,rising incomes, home aspirations,increasing urbanisation, property prices

Growth has remained secularirrespective of the macro slowdown;Outlook remains steady with demandstill buoyant, buying behaviour ismore linked to prices and job securitythan interest rates

High sensitivity to prices andincome stability, lowsensitivity to interest rates

Low risk as 95%+ customers are stillfirst time home buyers; asset qualityremains one of the best among allsectors; however, its a AAA-equivalent lending and therefore lowyield, leading to lower RoAs

1

Rural vehicles Rising incomes, rising employment,growing wealth effect of gold and realestate, last mile connectivity resulting in

shift from savings to consumptioneconomy; leading to higher creditpenetration and higher sales of vehicles

Rural growth largely remainsdecoupled from macro slowdown,supported by ever-growing food

demand, higher MSPs andemployment schemes; growth invehicles likely to remain buoyant

Highly cash flow sensitiveand sentiments highlycorrelated to the monsoons

and agriculture, althoughdirect monsoon linkedbusiness is smaller

Monsoon risks remain every year asit affects not just incrementaldemand, but increases risks to

existing book asset quality; however,slippages are generally temporary

2

CV Industrial activity for large fleetoperators;Cash and carry consumables demandfor small operators

Faltering GDP and IIP growth andban on mining activities havesignificantly slowed down MHCVsales, where volumes have beendeclining for past few quarters;however, cash and carry related CVdemand and last mile connectivityrelated LCV sales are still growing

First time users and SmallRoad Transport Operatorsare borrower cash flowsensitive, however, largefleet operators are interestrate and IIP growth sensitive

Cyclical in nature and therefore,dependent on economic cycles; assetquality could see moderatedeterioration during downturn as peopleget out of business; however, chancesof subsequent recovery are good

3

Power India is a power starved country withannual supply shortfall at ~8-10%;however, generation capacity addition,fuel linkage and ability of state discomsto buy power are key drivers for the

sectors growth

Given India has one of the lowest percapita power consumption amongBRIC nations, long term growthoutlook remains promising; however,near term generation growth could

suffer due to coal and gas linkageissues, which will take time to sort out

Highly interest rate sensitivegiven the high leverageneeded to set up powerinfrastructure

Almost all recently operationalised andupcoming gas based projects arelikely to be restructured due to noresolution on gas supply; also thermalprojects could face coal supply issues

either due to shortage of supply fromCoal India or no PPA signed with thediscoms, which could lead torestructuring and some write-offs

4

Source: HSBC


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Stock scorecard

Growth Margins Asset quality Profitability Transparency, stability,visibility andmanagement quality

Valuations Verdict

HDFC Positive: Home salesremain buoyant, which willkeep HDFC's loan growthintact at 18-20% YoY;growth supported fromhome sales beyondmetros

Neutral: Likely to remainsteady at 2.2-2.4% rangewith support from a goodliability and asset mix anda well-matched ALM

Positive: Robust assetquality trend to continueaided by goodaffordability, first timehome and conservativecredit culture; GNPLs at0.7-0.8%

Positive:Expect RoA tocontinue in 2.7-2.8%range and ROA in 21-23%range over FY14-15e

Positives:One of the bestmanaged companies witha quality top management,prudence riskmanagement, stronggrowth and earnings'visibility

Trading at 4.1x PB and19.3x PE 12-monthforward; ex-subsidiaryvalue, trading at 2.4x PBand 11.3x PE inline withhistorical range; premiumustified considering stronggrowth and earnings'visibility

Good combination ofdefensive with returns

LICHF Positive:LICHF will alsocontinue to benefit fromthe steady home salesgrowth; we expect 20-22%

loan growth over FY14-15e

Neutral:Spreads atlowest level of 1.1%, havemostly bottomed out, evenafter considering higher

funding cost, marginalrecovery likely if MSFrates soften further

Positive:Robust assetquality trend to continuesupported by goodaffordability, first time

home purchases andconservative creditculture; GNPLs at 0.7-0.8%

Neutral:Expect low RoAof 1.3-1.4% and ROA of17-18% to continue, butlargely bottomed out as

margins have bottomedout

Positives:Presence inthe right sector, goodasset quality;Negatives:Poor earnings'

visibility due to uncertainmargins; averagemanagement

Trading at 1.24x PB and7.6x PE 12-monthforward, much lower thanhistorical averages,

probably reflectingmargins and earnings'uncertainty; upturn inmargins is the key catalystto rerate the stock

Value buy

MMFS Positive:Growing ruraleconomy coupled withhealthy monsoons thisyear to boost ruralspending; MMFS directbeneficiary of this; expectloan growth of 24-26%over FY14-15e

Neutral:High cash flowsensitivity of customersand low privatecompetition helping MMFSto pass on the rise infunding costs; however,imbalance in ALM tomarginally affect FY14NIM

Positive:Diversified loanbook across vehiclesegments coupled withgood monsoons, ruralspending by governmentand good cash recoveryefforts to support healthyasset quality; GNPLs at3.3-3.6%

Positive:RoA to declinemarginally from peak 4%levels to 3.7-3.8% due toslight margin decline andhigher credit cost; ROA toremain at 21-23% overFY14-15e

Positives:Presence inrural sector, strong topmanagement, prudencerisk management, stronggrowth and earnings'visibility for FY14,transparencyNegatives:Visibility linkedto monsoon vagaries

Trading at 2.6x PB and12.5x PE 12-monthforward, which are peakvaluations, investors havefavoured given strongearnings' outlook; webelieve stock is fullyvalued

Good defensive stock, butpriced to perfection

SHTF Negative:SHTF has beencautious on growth due toCV cycle slowdown overthe past few quarters;

growth mainly in theyounger used vehicles,growth to remain stable at15-17% levels

Neutral:FY14 to be thelast year of margin declineat 7.5-7.7% as SHTF isincrementally shifting to

high yielding older usedCVs; also with MSF ratereducing, fundingpressures have reduced,continue to price 20-25bpsmargin decline for FY14

Negative:Stressincreasing mainly in theindustrial category towhich SHTF has 20%

exposure; expect creditcost to rise in current fiscal

Negative:RoA to declineto ~3% from 3.3% due todecline in margins andhigher credit costs, but

likely to stabilise at thatlevel; ROA also likely todecline to 18-19% range

Positives:Niche businesssegment, marginsbottoming out, decentearnings' visibility

Negatives:CV cycleslowdown, slow growth,rising asset qualityconcerns, change inmanagement, somedoubts on riskmanagement

Trading at 1.4x PB and8.0x PE 12-monthforward, valuationslanguishing at Dec-11

lows, when mining issueoccurred, probablybuilding in rising NPLs andweaker profitability; webelieve asset qualityshould be broadlymaintained, given most ofits customers are in cash-n-carry business

Reasonably valued, someupside remain

IDFC Negative:IDFC hasclearly opted formaintaining asset qualityat the risk of slow growth.With capex revival stillsome time away andrefinancing opportunitieslimited , growth will largelyby muted FY14 - 15e

Negative:Lowerincremental disbursementsimply limited incrementalfunds requirement, whichwill limit the impact onmargins of rising rates.However with lowerflexibility on transmittingcosts, margins will declineby 15-20 bps over FY14-15e

Negative:GNPL hasremained fairly stable at0.32%; However, withinfra sector issues still farfrom resolution, defaults /restructuring will rise; Weexpect its GNPL to rise to2-2.5% over FY14-15e,especially from its gasbased exposure (2% ofthe loan book)

Negative:IDFCsprofitability is likely to beunder stress with pressurefrom all fronts growth,margins and asset quality;expect ROA to decline to2.5-2.6% and ROA to 12-13% - one of the lowestamong covered NBFCs

Positives:Good topmanagement,conservative risk cultureand good reportingtransparencyNegatives:weakeningvisibility and stability ofearnings' growth

Trading at 8.1x PE and0.9x PB , closer to all timelows; Capex revival andresolution of impedingissues in the infrasegment would be key forre-rating of the stock;Banking license could bea further drag on the stockin the medium term

Cheap valuations, butmany sector and bankinglicense uncertaintiesprevail

PFC Negative:Ex-TFM,disbursements growth hasslowed down significantly;State sector growing well,but private and centralsector growth slowingdown; We expect 5-7%disbursals growth and 15-16% loan growth overFY14-15e

Neutral:Expect risingrates to have limitedimpact on margins of ~25-30bps; PFC managingfunding costs through tax-free bonds (INR11.2bn in2Q) and cash-creditfacilities (INR 50bn in 2Q)from the banks and hasraised lending rates by50bps

Negative:Slow progresson reforms leaves a hostof pending issues to beresolved, increasing assetquality risks for PFC;outstanding restructuredbook at INR c120 bn ofloans to the IPPs

Negative:We expectROA to decline to 2.3-2.4% over FY14-15e,impacted by slowinggrowth, asset quality risksand unhedged forexexposures; ROA is likelyto remain at ~20%; Poorrisk managementpractices reduces comfortof reported earnings

Positives:Low exposureto IPPsNegatives:exposure toIPP growing; Poor riskmanagement practices,slowing growth, poorearnings' visibility;Uncertain growth strategyof former Chairman;Recent change ofChairman

Trading close to all timelow multiples of 0.6X PBdue to continuinguncertainties on powerreforms; Change ofChairman recently furtherfuelling uncertainty; Fullresolution of sector issuesand clear managementstrategy would be the keycatalysts for re-rating

Low valuations, but mayremain low due to lowcomfort on reportedearnings and sector notout of the woods

REC Negative:Ex-TFM, REC'sgrowth also likely toslowdown to mid teenswith growth largely comingfrom state sector gencosand discoms

Negative:Margins declineto be limited at ~20-25bpsas REC has raised INR35bn via the tax freebonds at 8.5% -8.7% andutilised the cash credit

facility from banks as wellas raised lending rates by50bps to limit the impactof spike in costs in thewhole sale market

Negative:Slow progresson reforms leaves a hostof pending issues to beresolved, increasing assetquality risks for REC;outstanding restructured

loans at cINR230 bn

Negative:We expectROA to decline to 2.6-2.7% over FY14-15e,impacted by slowinggrowth and asset qualityrisks; ROA is likely to

remain at ~22-23%; Poorrisk managementpractices reduces comfortof reported earnings

Positives:Low exposureto IPPs

Negatives:exposure toIPP growing; Poor riskmanagement practices,slowing growth, poorearnings' visibility;Uncertain growth strategyof former Chairman;Recent change ofChairman

Trading close to its all timelow of 0.9x PB , thoughhigher than its PFC due toclarity on growth strategy,hedged forex liabilities andbetter margins

Low valuations, but mayremain low due to lowcomfort on reportedearnings and sector notout of the woods

Source: HSBC


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Summary 5Focus on housing, rural 9Our stock picks 18Company write-ups 24HDFC (HDFC IN) 25LICHF (LICHF IN) 29MMFS (MMFS IN) 33

SHTF (SHTF IN) 37IDFC (IDFC IN) 41PFC (POWF IN) 46REC (RECL IN) 50Disclosure appendix 57

Disclaimer 60

Contents


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NBFC some niches deserveconsideration despite macroheadwinds

Indias macro environment remains challenging.With inflation stubborn and rates again on the

upswing, risks to growth have increased further.

Against this backdrop, we review NBFC stocks

under our coverage to identify if there are any

investment opportunities among these wholesale-

funded entities. We conclude that while growth,

margins and asset quality risks are increasing,

NBFCs that are focused on sectors where customers

are more sensitive to prices and own cash flows

and not sensitive to interest rates will outperform.

Rural finance from a savers to a

spenders economy

Indias rural economy has outperformed in the past

five years, amid the slowdown in the countrys

overall growth. Rising minimum support prices and

rural employment schemes have lifted rural

incomes, while rising gold and land prices have

spurred a wealth effect. The overall improvement

in sentiment has continued to boost rural spending.Going forward, a good monsoon this year and

national elections next year will further boost rural

consumer cash flows, which will continue to drive

demand. Rural customers are also more sensitive to

their own cash flows than interest rates, which

imply it has decoupled in the current macro

environment. Lastly, while asset quality risks are

high, in the current context, we believe these risks

are much less.

Housing finance still the best

In our view, housing finance remains the best

sector to be in due to its apparent immunity to the

macro slowdown; affordability and job security,

along with property prices, are the key growth

drivers here, not interest rates. Increasing growth in

first and second tier cities further supports growth

in this segment. This sector also has the lowest

asset quality risks as most customers are first-time

buyers and the credit culture remains conservative.

Commercial vehicle finance slowing

Although the CV space does not face any

particular structural issues, its cyclical nature and

close linkage to industrial activity make it more

vulnerable to the economic slowdown. Given the

current industrial slowdown and mining ban,demand has come off significantly in the past few

quarters and it is probably at its lowest point in

Summary

Niche consumer NBFCs remain attractive, despite tough macro

conditions; housing and rural finance stand out

Rising rates to have limited impact on margins of most NBFCs;

HDFC and MMFS best placed fundamentally

We prefer HDFC, followed by LICHF and SHTF (value buys) and

MMFS; our least preferred stocks are IDFC, PFC and REC


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recent history. The exception has been LCVs,

where demand remains healthy due to growth in

last-mile connectivity in the hinterlands. In terms

of sensitivity, first-time users (FTUs) and small

road transport operators (SRTOs) are more cash

flow sensitive than large fleet operators, which are

likely to be more sensitive to interest rate and

industrial activity. In terms of asset quality,

NBFCs catering to the cash-and-carry CV

operators are less prone to credit risks, than those

financing fleet operators.

Power sector issues unresolved

The infrastructure space, especially power, remains

our least preferred sector, as structural issues there

are unresolved. While some progress has been

made on coal supply issues (tariff revisions by

distribution companies (discoms), fuel supply pass-

through to name a few), speedier resolution to

power sector problems has yet to be seen. Issues

like PPA signing by discoms and FRP signing bystate governments have not progressed and

continue to get delayed, thereby leading to poor

visibility on growth, asset quality and earnings.

Not only is incremental growth likely to slow

drastically, the asset quality of upcoming and

recently completed projects is also under question.

The infrastructure space is also largely interest rate

sensitive as most projects are built with a substantial

debt burden. Ongoing delays in the execution of

projects are leading to a substantial increase in

interest cost burden for many private sector players.

Given the problems related to coal supply, gas

supply, fuel cost pass-through and PPAs not

signed, we expect c.19GW of projects could be

restructured, of which 20% could eventually be

written off due to low capacity utilisation. In

addition, c.32GW of projects are under

Comptroller and Auditor General (CAG) scanner

and at risk of default.

Similarly, discoms total historical loss of

INR1.2trn is yet to be restructured under the

Financial Restructuring Package (FRP) package,

leading to significant uncertainties on asset quality.

HFC and rural finance best

sectoral play

Overall, on the parameters of growth, sensitivity

and risk, the housing finance sector stands out

given end-customers (a salaried class with c95%

first-time home buyers) secured nature ofcollateral lending and secular growth witnessed

historically. Rural buoyancy, amid a good

monsoon, bumper harvest and increasing income

levels, makes rural financing our next most

preferred pick. Risks to growth, asset quality and

sensitivity to interest rates make infra financing

the least preferred.

HDFC and MMFS, best stocksfundamentally

On growth, prefer HDFC, LICHF and

MMFS

HDFC and LICHF have seen steady secular

growth in the past decade through economic

cycles, and we believe they will continue to do

reasonably well over the next few quarters.

MMFS, a rural play, has also grown well and

diversified its loan book. With a good monsoon

and stable rural incomes, MMFS should continueto do well in the next few quarters.

SHTF has seen slower growth amid the slowdown

in the overall CV demand cycle, although its

AUM are still growing 15-17% annually as it is

focused on used CVs, which are achieving better

sales than new CVs. This growth level should

continue in the near future.

IDFC has seen and will likely continue to see a

significant slump in growth due to a lack of newcapex, extreme management caution and a lack of

refinance opportunities. PFC and REC should also


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see barely single-digit growth in disbursements, as

private sector disbursements slow, well-rated

central Public Sector Utilities (PSUs) migrate to

banks and power sector issues remain unresolved.

On margins, most do well, despite

recent spike in rates

Most NBFCs have managed to limit the impact of

the recent spike in rates by using their cash-credit

limits and liquidity on the balance sheet, while

IFCs have also raised tax-free bonds to managefunding costs.

HDFC remains the most insulated on margins,

given its superior Asset Liability Management

(ALM) structure, good asset mix and balanced

liability profile.

MMFS has also largely limited the impact of

margins, though with the RBI starting to raise

repo rates, it could see a 25-30bp impact on

margins in the current fiscal year.

LICHFs margins remain subdued at 1.1% and are

likely to remain so in the current fiscal year due to

funding cost pressures, though they could improve

slightly in the next fiscal year.

SHTF has seen margins slide from 8.5-9% to

7.8%, and we expect them to slide further to 7.5%

in the current fiscal year, though incremental

growth in the older used CVs will lift yields,

which will protect incremental margins.

IDFC should see 10-15bp margin decline due to

rising funding costs, though low incremental

growth should limit funding requirements and

therefore margins. PFC and REC have seen their

margins remain resilient, though we expect a

marginal drop given they are at historical high

levels and rates in the system are rising.

Asset quality avoid IFCs

HDFC and LICHFs asset quality remains strong

by virtue of the segments that they cater to. Our

view on their outlook has not changed, while

MMFS should see relatively stable asset quality as

the rural economy continues to do well. SHTF

could see some rise in NPLs as the CV demand

cycle remains weak.

IDFC, PFC and REC are most at risk of ongoing

issues in the power sector and therefore, risk to

earnings is significant for these stocks.

Overall, HDFC and MMFS remain fundamentally

the best NBFCs with quality management,

transparency, prudence, growth and earnings

visibility. SHTF and LICHF come next, while

IDFC ranks poorly on fundamentals, though it has

a good management team, in our view.

Rankings based on key performance metrics

HDFC LICHF MMFS SHTF IDFC PFC REC

RoA 3 7 1 2 5 5 3ROA 1 6 1 4 7 4 1Prudence 1 4 1 3 5 7 6Transparency 2 5 1 4 3 6 7Earnings

visibility

1 4 2 3 5 6 7

Earningsstability

1 4 2 3 5 6 7

Managementquality

1 5 2 3 4 6 7

Points 10 35 10 22 34 40 38Overall rank 1 4 2 3 5 7 6


Valuations: Prefer HDFC,LICHF

We prefer HDFC (OW); valuations (19.3x PE and

4.1x PB, 12-mth forward) remain in line withhistorical multiples and fundamentals. This is

followed by LICHF (also OW) at a 7.6x PE and

1.2x PB, where margins and therefore earnings

have bottomed out and growth remains healthy.

While fundamentals are not likely to improve this

year, we expect margins to start rising next year,

which should act as a catalyst for LICHF to rerate

from its current low valuations.

At an 8.0 x PE and 1.4x PB, we believe SHTF has

corrected more than what is warranted by its

fundamentals. Recently, the stock has also reacted


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negatively due to the resignation of its CEO. We

believe the current stock price is a good entry

point for long-term investors. We therefore

upgrade our rating to OW, but reduce its EPM

value after lowering growth forecasts.

We like MMFS from a fundamental point of view

but consider the stock fully valued at a 12.5x PE

and 2.6x PB. However, given the likely strong

harvest and stable rural incomes, we think it is a

good defensive stock. We raise our targetmultiples to 12.5x PE and 2.4x PB, but remain

Neutral, adding the volatility flag.

IDFC has corrected significantly, especially after

the Board recently reduced the FII limit.

However, given its low growth and drag on

profitability over the medium term, in case it gets

the banking license, we do not expect its multiples

to rerate much from current levels. We therefore

downgrade the stock to N(V).

As for PFC and REC, although some progress is

being made on power sector reforms, a host of issues

still need to be resolved. We note a lack of clarity on

reform implementation. We do not think the stocks

will rerate until power sector issues are resolved. We

downgrade PFC to N(V) and REC to N.

Overall HDFC, LICHF and SHTF remain our

preferred picks and MMFS is a good defensive

play. IDFC, REC and PFC remain least preferred.

Indian NBFCs - Ratings and target prices

Company Bbg CMP Rating (New) Rating (Old) TP (New) TP (Old) Pot return

HDFC HDFC IN 802 OW OW 1029 1007 30.0%LICHF LICHF IN 198 OW OW 236 243 21.1%Mahindra & MahindraFin Services

MMFS IN 264 Neutral (V) Neutral 285 250 9.4%

Shriram Transport SHTF IN 571 OW Neutral 706 723 25.2%

IDFC IDFC IN 95 Neutral (V) OW 101 129 9.8%Power Fin POWF IN 134 Neutral (V) OW 134 130 5.4%Rural Electrification RECL IN 193 Neutral OW(V) 205 251 12.1%

Source: Company data, HSBC estimates; Prices as of 3 October. Potential return equals the percentage difference between the current share price and the target price, plus the forecast dividendyield


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A reality check

With the economy slowing further in 1Q, inflation

still elevated and interest rates up significantly,

NBFCs have been a tough space to be in, giventhat most are niche players and wholesale funded.

In light of this, we attempt to identify the

preferred investment themes among rural,

housing, CVs and infrastructure (mainly power)

and pick stock winners within the NBFC space

based on the relative strength of the sectors and

stock-specific fundamentals.

We believe the relative outperformance of the

sectors is driven by:

Growth drivers and outlook

Customer sensitivity to borrowing

Risks to asset quality

Rural the most buoyant

Rural finance shift from savings to

consumption economy to drive growth

Rural has been the single most important sectorand has remained buoyant over the past five years.

While urban centres and industrial activity have

shown slowing growth, rural buoyancy has been

an important driver of consumption growth due to

rising incomes and the wealth effect. Factors such

as consistently rising Minimum Support Prices

(MSP) and rural employment schemes (e.g.,

Mahatma Gandhi National Rural Employment

Guarantee Scheme) have increased rural incomes.

Rural wages on the rise The income effect

1%

5% 6%8%

11%

16%

18%20%

18%

0

50

100

150

200

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

0%

5%

10%

15%

20%

25%

Average daily wage rate in rural India for men(INR)

y-o-y growth(RHS)

Source: RBI, HSBC

Focus on housing, rural

We conduct a cross-sectoral review, attempting to rank most-to-

least preferred sectors, followed by top NBFC picks

Rural and housing sectors continue to promise good growth and

profitability; CV cycle at the bottom, but visibility low

Power sector, though in better shape than last year, has

unresolved issues


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MSP on the rise = Rural buoyancy and income effect

0

500

1,000

1,500

2,000

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Paddy MSP Wheat MSP Coarse Cereals MSP

Source: CIEC, HSBC

Similarly, our channel checks suggest that rising

prices of gold and land the two core assets that

rural people own have led to the wealth effect,

making rural people feel richer and improving the

broader rural sentiment, which has induced people

to shift from savings to consumption.

Gold prices have risen exponentially = Wealth effect

0

10,000

20,000

30,000

40,000

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Gold prices (INR)

Source: CIEC, HSBC

Growth outlook for rural sector

Along with the above, we believe two additional

factors will keep the rural economy buoyant for

FY14-15:

Good monsoons this year along with higher

MSP will further boost rural incomes

General elections by May 2014 will further

boost spending in rural regions, which will

drive consumption

Overall, the rural theme is relatively decoupled

from domestic and global macro uncertainties and

therefore remains an attractive space. Gold loans

and vehicle finance are two sub-sectors that one

could consider in terms of the rural theme.

High cash flow sensitivity

Spending behaviour in the rural segment is more

linked to income and wealth levels and sentiment

(which is a function of agricultural production

levels) than to changes in interest rates. High

interest rates in a year with a good monsoon will

not deter rural people from borrowing for an asset

purchase. In essence, they are more cash flow

sensitive than interest rate sensitive.

Backed by rising income and wealth levels, auto

sales, one of the largest assets purchased in rural

areas, have shown significant buoyancy in the

past five years. As a proxy to this, below we show

a chart of Maruti car sales over the past few years

in rural areas. Similar buoyancy can been seen in

FMCG sales, which have been considerably more

in rural areas than urban centres and LCV demand

from last mile connectivity (as per our channel

checks). All of this points toward higher

sensitivity of demand to the customers cash flow

than interest rate movements.

Tractor sales jump in 1QFY14 - leading indicator of ruralhealth

-40%

-20%

0%

20%

40%

60%

1Q09

3Q09

1Q10

3Q10

1Q11

3Q11

1Q12

3Q12

1Q13

3Q13

1Q14

Tractor sales (YoY)

Source: SIAM, HSBC


11/61

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Maruti sales growth in rural centres outstrips urban growth

0%

20%

40%

60%

80%

100%

FY09

FY10

FY11

FY12

FY13

-50%

0%

50%

100%

150%

Rural sales Non Rural Sales

Growth Ex Rural (RHS) Growth - Rural (RHS)

Source: Company data. HSBC

Asset quality seasonality

associated, but no imminent risk

Rural businesses are cash flow dependent, which

in turn is seasonal in nature. The asset quality

cycle follows a similar trend a case in point is

the asset quality of MMFS, which deteriorates in

1H and then improves in 2H every year.

Asset quality MMFS

0%

2%

4%

6%

8%

10%

12%

Q207

Q407

Q208

Q408

Q209

Q409

Q210

Q410

Q211

Q411

Q212

Q412

Q213

Q413

Gross NPL Net NPL

Source: Company data, HSBC

Thus the performance on the asset quality front is

more closely linked to the patterns of cash flow

and income generation than to activity on the

macro front. In the current environment, with

above-average monsoons and bumper harvest

expectations, the cash flow cycle is expected to

remain robust, which suggests improving asset

quality in the latter half of the year.

Housing finance seculargrowth continues

Indias housing finance sector has historically

shown resilience in the face of economic

upheavals. Increasing urbanisation, a rising

middle class, rising income and the increasing

comfort of borrowers to take on debt have been

long-term growth drivers for this sector. With the

housing loans to GDP ratio in the vicinity of 10%,

we believe the potential for growth in this sectorremains intact.

Housing loan growth still resilient

0%

10%

20%

30%

40%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Hom e L oan Grow th S CB Loan Gro w th - HDFC

Loan Grow th LIC HF Sy stem Credit grow th


While the economic slowdown, combined with

high property prices, has slowed sales in metro

areas significantly, especially Mumbai and the

National Capital Region (NCR), our discussions

with the banks/NBFCs suggest smaller,

underpenetrated centres are doing well as the

slowdown has not yet threatened the job security

of the salaried class, who make up the majority of

home loan seekers. Also, most of the demand has

been driven by a large base of government

employees, as well as the IT, financial and other

service sectors. Most of these have remained

healthy, barring some job losses in the financial

sector. Further, our channel checks suggest that

the first and second tier cities are becoming more

important in driving overall growth. The IT sector

has started witnessing a rebound, thereby

improving sentiment in this segment. Overall we


12/61

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expect housing finance growth to remain resilient

at 15-17% as buying behaviour is driven more by

property prices and job security than interest rates.

Asset prices more sensitive than

interest rates

Purchasing a property is a long-term, possibly

once-in-a-lifetime, event for many so its demand

is driven more by prices and affordability than the

borrowing rate to finance the purchase. Below we

see very little correlation between the change ingrowth rates versus the change in repo rate (the

proxy of prevailing interest rates).

Growth vs repo rates Very low correlation

0%

10%

20%

30%

40%

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

Hom e L oan Grow t h SC B Loa n Gr ow th - H DF C

Loan Grow th LIC HF Repo Rate (RHS)


Home loan growth has remained fairly stable over

the past few years, despite rates moving

significantly in both directions. Therefore,

financiers with a diversified presence across India,

like HDFC and LICHF, could sustain current

growth over the coming years.

Asset quality as good as ever

With collateral-based lending, a relatively

conservative credit culture and 95% of home sales

being to first-time buyers, housing finance is the

least exposed to asset quality risks. The strong

asset quality of HDFC and LICHF over the years

reflects the relatively low risk nature of lending inthis sector is, albeit at lower returns.

Gross NPLs No spikes

0.00%

0.50%

1.00%

1.50%

2.00%

FY08

FY09

FY10

FY11

FY12

FY13

HDFC LICHF


Despite property price rise, affordability has remained constant on the back of rising disposable income

5. 3 4.7 4. 3 4.7 5.0 5.1 5.1 4.5 4.7 4.8 4.6 4.75.1

0

510

15

20

25

30

35

40

45

50

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

0

2

4

6

8

10

12

P rope rty C ost (INR La cs) A nnu al In com e (IN R Lacs ) R HS Afforda bility

Source: HDFC FY13 company release, Affordability = Property Prices/ Annual income


13/61

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CVs heading toward thebottom but LCV still bright

Demand for MHCVs is closely correlated to

growth in the economy in general and to industrial

activity more specifically (see chart below). So it

is no surprise then that MHCV sales declined 23%

y-o-y in FY13. However, within this segment:

Passenger vehicle (i.e., buses) sales have not

been affected.

Goods transporting vehicle sales have not

slowed down much.

Most of the slowdown has been seen in the

infrastructure and construction related segment

and this is mainly due to the mining freeze.

IIP vs CV sales Close correlation

-40%

-20%

0%

20%

40%

Mar-09

Jul-09

Nov-0

9

Mar-10

Jul-10

Nov-1

0

Mar-11

Jul-11

Nov-1

1

Mar-12

Jul-12

Nov-1

2

Mar-13

Jul-13

-20%

-10%

0%

10%

20%

CV sales (MoM growth) IIP (MoM growth) RHS

Source: Bloomberg, SIAM, HSBC

Banks and NBFCs believe mining activity will

resume over the next few months, which couldrestart demand for MHCVs in 2HFY14. But this

is still uncertain.

LCV sales are holding onto growth, in the mid-

teens compared to a 2% decline in overall CV

sales in FY13. LCV demand continues to be

driven by last-mile connectivity in rural regions,

mainly for cash-and-carry and FMCG and for

ferrying rural people to nearby areas due to lack

of a public transport system.

Moreover, we note that the rural economy has

been doing well for the past five years, essentially

decoupling from the greater economy. With

industrial activity not likely to pick up any time

soon and the rural segment aided by the monsoon,

we expect LCV sales to continue to grow steadily,

while visibility on MHCVs will emerge only in

2HFY14.

CV financing is cash flow sensitive

CV segment uptake is fragmented in terms of end

use, with LCV demand driven more by last-mile

connectivity and growing cash-and-carry business

volumes. This, plus increasing freight rates, has

ensured steady cash flows, which can boost

demand for LCVs.

In contrast, MHCV sales, which are driven by

industrial activity, have faltered due to weak IIP

leading to weakening cash flows despite freight

rates rising steadily. In general, FTUs and smallroad transport operators (SRTOs) are more cash

flow sensitive than large fleet operators, which are

likely to be more sensitive to interest rates and

industrial activity.

Freight rates are a significant driver of

profitability and thus asset quality

Asset quality in the CV segment is dependent on

the profitability of the fleet operators while the

FTUs and SRTOs are more cash flow sensitive.Though diesel prices have been on the rise and

thereby increasing the cost of operations for the

LCV most resilient

-40%

-20%

0%

20%

40%

60%

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

CV LCV MHCV

Source: SIAM, HSBC


14/61

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FIG


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fleet operators, freight rates have risen in line to

compensate for the increasing cost, keeping the

operators profitable.

Freight rates

1.49

1.51

1.53

1.55

1.57

1.59

Dec-0

9

Mar-10

Jun-1

0

Sep-1

0

Dec-1

0

Mar-1

1

Jun-

11

Sep-1

1

Dec-1

1

Mar-12

Jun-1

2

Sep-

12

Dec-1

2

Mar-13

Jun-1

3

(Rs/tkm)

A verage freight rat es

Source: Crisil, HSBC

However, as industrial activity slows, business

volumes could shrink, thereby increasing the risk

of large fleet operators facing stress. Hence the

segment could witness a moderate deterioration in

asset quality

Infra finance structuralbottlenecks

While the long-term growth potential of the

infrastructure sector remains promising with a

need to add more power generation capacity to

address the chronic power deficit and the

requirement for better road and other physical

infrastructure, the near-term outlook for the sector

(especially power) is clouded by structural

bottlenecks. See our reportIndian Power and

Banks: Progressing towards value discovery,

dated 12 July 2013. Delayed clearances, problems

in acquiring land, lack of coal supplies for power

production, lack of gas, and the financial ill health

of the state discoms are among a host of issues

that have stunted the sectors growth.

Over the past 12 months, there has been progress

with the central government trying to resolvevarious issues, including restructuring discoms

debt, expediting clearances for projects, securing

coal supply through fuel supply agreements

(FSAs), creating new bidding guidelines, and

introducing tariff relief for low-tariff PPAs. Also,

the discoms have been raising tariffs regularly for

a couple of years now to reduce financial losses.

Progress made, but much remains to

be done

The recent Cabinet Committee on Economic

Affairs (CCEA) ruling allows projects with coal

linkage from Coal India with PPAs to pass-through increased costs by allowing them to raise

tariffs. This is likely to benefit about 5.5GW of

power projects. However, loans to projects where

PPAs have not yet been signed (8,335MW) are at

risk of impairment amounting to an estimated

INR348bn.

However, the decision regarding the pass-through

mechanism for power producers using imported

coal with PPAs being signed still needs to be

resolved. The Central Electricity Regulatory

Commission (CERC) has appointed a panel

headed by HDFC Chairman Deepak Parekh to

make a recommendation on tariff increases.

Should these projects be allowed to raise tariffs,

then we would expect their positive returns,

however small, to be sufficient to service debt.

The bulk of these projects have PPAs signed.

For the projects without PPAs signed (totalling

2,940MW), we estimate impaired loans of

INR141bn. There is a risk that the arbitration

panels decision could lead to litigation, thus

delaying relief for even those projects with PPAs

in place. Projects which use both domestic and

imported coal and have not signed a PPA are

expected to remain in limbo as we do not expect

any fresh signing of PPAs.

Gas-based projects most at risk

Total private sector gas-based capacities are about8GW. These projects are close to completion, but do

not have sufficient gas supply to operate and, even


15/61

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FIG


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where gas is available for operational plants, they

face difficulty in selling power since their average

tariff is expected to go up significantly after the new

natural gas pricing policy. The future of these

projects is uncertain. In fact, most developers have

suspended their unfinished gas projects regardless of

how close to completion they are.

Overall, we estimate c.19GW of power capacity is

at risk of restructuring or defaulting over the next

couple of years. In addition, the CAG-related coalblock allocations could put at risk another

upcoming 33.2GW of power capacity.

Power projects at risk

At risk (MW) Probabledisbursals

(INRbn)

Domestic coal-based projects withpartial PPAs and no fuel pass-through

8,335 348

Imported coal-based projects withpartial or no fuel pass-through

2,940 141

Gas-based projects at risk 7,968 273CAG related risk exposure 370Risky exposures of PFC and REC 143Total 19,243 1,275


Uncertainty over discoms continuing

The revenue gap carried by discoms has been a key

area of concern, with average sale prices not

enough to meet the average cost of supply. This has

led to total losses of about INR1.2trn with major

losses coming from the discoms of the seven key

states Uttar Pradesh, Tamil Nadu, Rajasthan,

Andhra Pradesh, Haryana, Punjab and Madhya

Pradesh. However, in the last two years,

incrementally, the situation has improved after

almost all states raised tariffs in FY13. To tackle

the losses, the central government has finalised a

FRP for these states, whereby short-term debt up to

31 March 2012 will be restructured, with 50% to be

taken up by state governments by issuing bonds

and the balance 50% to be restructured by banks.

However, barring Tamil Nadu and Rajasthan,

other states have yet to sign the FRP. Banks

funding will likely remain low and incremental

PPAs are unlikely to be signed by the states as

they are still not out of woods. In such a scenario,existing generation capacities will operate at sub-

optimal levels, while IPPs will slow the pace of

commissioning new projects, which could lead to

significant restructuring by banks and IFCs over

the next few quarters. Also, many large promoters

like Lanco, GMR and GVK are sitting on

significantly leveraged balance sheets, which

increases the risk of default if the government

does not resolve the issues in time.

Given these issues in the power sector, we expect

new capex will be postponed, which is already

resulting into muted sanctions growth, implying

slowing disbursements growth going forward. All

this suggests that the revival of the sector is some

time away, though we are moving in that direction.

Pro forma impact of risky power sector exposure

(INRbn, FY13) PvtGencos

SEB Total Pvt Genco% of totalexposure

(FB+NFB)

Risky /power

exposure

Total riskyexposure

Write-off/Total

exposure*

Write-off/PAT

(tax adj)

Write-off/BV

REC 166 - 166 13% 40% 5% 0.70% 24% 6%PFC 193 - 193 12% 40% 5% 0.70% 24% 5%

Source: HSBC estimates , *Write-off assumed at 20% of risky exposure


16/61

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High interest rate sensitivity

The capex-intensive nature of infrastructure

projects places a substantial debt burden on the

project owners. Interest cost, therefore, is a

significant determinant of the profitability and

viability of a project. The interest cost has

assumed greater significance in the current

environment given power projects are

underutilized, which hurts their profitability. The

decade-low interest coverage and fixed asset

coverage ratios and high debt/equity ratio for

some of the biggest names in infrastructure (GVK

Power, JP Associates and GMR Infrastructure) is

a clear indication of stress. High leverage, coupled

with rising borrowing costs, raises financial risks.

Interest coverage at all-time low for major infra players

0

12

3

4

5

FY07

FY08

FY09

FY10

FY11

FY12

FY13

LANC O INFR A GM R INFRA

G VK POWER & IN FR JP Associate

Source: Bloomberg, HSBC

Embroiled in asset quality worries

Infrastructure projects are most exposed to asset

quality risks owing to multiple issues, including:

delays in project execution, underutilization and

fuel shortages. The key ratios, like debt/equity and

fixed asset coverage, for some of the infrastructure

companies point to acute financial stress.

Debt/equity ratio on the rise

0

2

4

6

8

10

FY07

FY08

FY09

FY10

FY11

FY12

FY13

LANC O INFR A GMR INFRA

GVK POWER & IN FR JP Asso ciate


A significant number of projects is likely to come

up for restructuring in the power sector over the

next few quarters.

Overall, the nature of lending (secured), and

clientele make housing finance the least exposed to

asset quality risks. In the current scenario of vibrant

agri and rural growth, the rural financiers should see

improvement in asset quality and remains our

preferred sector after housing finance. Infrastructure

finance is most exposed and least preferred with a

higher potential for defaults and restructuring.


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Summary of state discoms financial health and our analysis of their ability to call for new bids and initiate a capex programme

State ____ Outstanding loans (INRbn) _____Revenue gap

(INRbn)Revenue gap Case I Capex likely

FY11e FY12e FY13e FY14e exists Bids likely

1 Andhra Pradesh na na na 0 No Yes possible Possible2 Bihar 101 111 122 3.5 Yes No No3 Chhattisgarh 19 35 55 4.6 Yes Not likely4 Delhi 41 46 54 NA NA Not likely5 Gujarat 24 30 33 0 No Not likely Yes6 Haryana 150 184 222 0 No Not likely No7 Jharkhand na na na 0 No Yes possible Yes8 Karnataka 48 53 59 0 No Yes possible Yes9 Kerala 11 17 19 4.1 Yes Not likely Yes10 Madhya Pradesh 111 149 199 0 No Not likely No11 Maharashtra 82 117 157 0 No Yes possible Yes12 Punjab 168 179 200 0 No Not likely No13 Rajasthan 31 54 112 12.8 Yes Not likely No14 Tamil Nadu 241 300 388 NA No Yes possible No15 Uttar Pradesh 243 270 300 0 No Not likely No

Total 1,268 1,543 1,921 25

Source: HSBC


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Having looked at various sectors, we compare stocks

under our coverage based on growth, margins, asset

quality, profitability, and valuations.

Growth HDFC, MMFS andLICHF emerge as winners

Most sectors saw reasonable growth up to FY12.

However, with macro and industrial activity

faltering post FY12, along with the mining ban in

FY12, sectors like CV have slowed significantly.

Accordingly, SHTF has consciously reduced its

growth since FY13. Also, emerging structural

issues in the power sector meant that whiledisbursements were continuing against pending

sanctions, incremental sanctions have reduced.

As a result, IDFC has already seen a significant

slowdown in growth, while PFC and RECs

growth has been cushioned by state sector capex.

Incrementally, we expect disbursements to grow

at a single-digit rate for PFC and REC, which will

slow growth to a mid-teens rate over FY14-16e.

Compared with these stocks, HDFC and LICHFs

growth has remained resilient and should remain

so in the foreseeable future. MMFS is the bestway to play the rural theme, which remains one of

the key growth sectors. Over the past five years,

MMFS has not only grown well, it has done so

with diversification and reduced direct linkage

with agriculture. Going forward, the growth

outlook for MMFS looks fairly buoyant, with the

exception of CV and to some extent cars.

Our stock picks

HDFC, LICHF and MMFS set to see resilient growth; others to see

slower growth due to cyclical and structural issues

We see a limited impact on margins due to rising rates for most

NBFCs; HDFC, LICHF and MMFS best placed on asset quality

Overall HDFC and MMFS score better than others although

MMFS is fully valued; we prefer LICHF; IFCs are trading cheap,

but structural weakness makes them relatively unattractive

Growth

-50%

0%

50%

100%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

HDFC LICHF MMFS SHTF

IDFC PFC REC

Source: Company data, HSBC estimates


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Asset quality HDFC andLICHF key winners

Housing finance has had among the most resilient

asset quality over the years. Factors like first-time

purchases, rising income levels, sentimentality,

and a prudent credit culture in India have helped

financiers keep asset quality healthy and minimize

credit costs. Not surprisingly, both HDFC and

LICHF have had credit costs as low as 15-20bp in

the past few years.

On the other hand, given the rural market is

fragmented with physical cash recovery as a

repayment mechanism, it is a high risk segment.

Though MMFS usually has high credit cost, this

has been built into loan pricing and profitability,

helping it to maintain high profitability even with

high credit cost. Also, MMFS has significantly

improved its gross NPL levels since 2008 from

c.10% levels to 3% as of FY13 by diversifying to

various vehicle categories and reducing direct

linkage to agriculture activities. Going forward,

MMFS is likely to maintain stable asset quality in

FY14, buoyed by good monsoons and as a

possible beneficiary of election spending.

However, SHTF, being the largest player in used

CVs, could see some rise in delinquencies as 20%

of its loans are linked to industrial activity.

Therefore if IIP remains weak, it will eventually

impact cash flows of the truck operators.

On the infrastructure front, IDFC, REC and PFC

have seen very low NPLs and credit costs as most

of the growth in the past five years was due to

disbursements toward new capex in the power

generation sector by the private sector. However,

with issues continuing to plague the sector,

coupled with leverage on promoters balance

sheets, despite positive steps taken by the central

government in the past year, we think there is a

good chance of large-scale restructuring and

eventual write-off of a few assets. Nearly all gas-

based capacity is at a serious risk of being written

off over the next couple of years. See our report

Indian Power and Banks, published 12 July.

PFC and REC have made about 85% of their

loans to state and central sector utilities and may

therefore continue to report low NPLs. However,

their private sector exposure is increasing, which

could be a source of concern.

Gross NPLs

-6%-4%

-2%

0%

2%4%

6%

8%

10%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

HDFC LICHF MM FS SHT F

IDFC PF C REC


Margins HDFC stands out

Margins vary significantly across NBFCs

depending on the segment that each is serving and

the required business model for the same.

However, given the current volatile rate

environment, their margins could be at risk as

they are wholesale funded. Having well-matched

ALM, along with matched repricing of assets and

liabilities and the ability to change asset mix

incrementally, is crucial in managing margins

under the current conditions.

Post RBI monetary action to increase the MSF

rate by 200bp to 10.25% in addition to other

measures on 15 July and 23 July, borrowing rates

have jumped across tenors with the short end

moving up 200-250bp from 8.5% to 11% and the

long end moving up by about 100bp from 9% to

10%. This has inverted the yield curve and

tightened liquidity, which could have a serious

impact on NBFCs margins till the measures are

reversed and liquidity eased.


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We have found that most NBFCs have tried to

manage spreads by:

Maintaining sufficient liquidity on the

balance sheet, which can be used during

tough times like these

Borrowing in surplus in 1Q, when money is

available more cheaply at 8.25-8.5%, which

they have lent in the current quarter

Using their committed cash-credit lines with

banks, which were available at a lower rate

than market

PFC and REC have also raised tax free bonds

Many have increased lending rates by 25-50bp

On 20 September, although the new RBI Governor

reversed 75bp of the 200bp hike on the MSF, he

simultaneously increased the repo rate by 25bp,

making the rate hike more permanent, though in

small amounts. This implies that while short-term

rates will come off from current high levels, they

will remain above the pre-15 July levels. With the

RBI further reducing the MSF rate by 50bp to 9%

now, short-term funding costs will decline further

and ease funding cost pressures for NBFCs.

However, we maintain our estimate for a 0-30bp

margin decline for our NBFC universe as the RBI

has started hiking repo rates.

In this context, HDFC stands out with steady

spreads in the 2.2% to 2.4% range or margins in the

3.4% to 3.6% range. HDFC has a well-matched

ALM book, which when combined with its ability

to incrementally change its asset mix between

wholesale and retail, helps it to maintain steady

spreads. In the current quarter, given the jump in

interest rates, HDFC has been able to maintain

spreads by pre-empting surplus borrowing at lower

cost in 1Q, while steadily building up a retail

deposit base and minimizing reliance on bank loans

(under 10% of liabilities). Also, it is likely to have

increased its exposure to wholesale borrowers,

which is a high yield segment.

LICHF has seen significant margin compression

in the past few quarters, with FY13 spreads

dropping to a low of 1.1% versus the peak of

1.7%. Mismatch in its ALM and around 97%

retail loans in the overall loan book affected its

spreads significantly as rates increasedsignificantly in FY13. However, in the current

fiscal year, LICHF seems to be managing the

spreads well with 1Q spreads improving to 1.2%.

Also, like HDFC, it borrowed in surplus in 1Q

when money was available cheaply, which it is

now using to disburse incremental loans. Also, it

recently introduced new products at higher rates,

which can partially offset higher funding costs.

So, while it is likely to make spreads of 1.2-1.3%

in 1H, spreads can shrink to 0.9% in 2H asincremental new borrowing cost is likely to be

about 10%, while incremental lending yield is at

10.9%. Overall for FY14, spreads should remain

stable at 1.1% at best. Accordingly, while spreads

are close to the lowest levels, earnings could

remain weak till the spreads improve.

MMFS has been able to reduce the impact to a

large extent by using cash-credit lines and raising

lending rates for new borrowers. However, with

almost 100% of assets at fixed rates vs. 50% fixed

rate liabilities, a sudden rise in funding cost will

Yield curve pre and post 15 July 2013

6%

7%

8%

9%

10%

11%

ON

rates

1M

CD

3M

CD

6M

CD

12M

CD

AAA1Year

AAA

3Year

AAA

5Year

15-Jul 15-Sep 30-Sep



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take time to pass on to borrowers. As a result,

MMFS is expecting a 20-30bp margin contraction

for FY14 over FY13, without much impact on

growth. However, 30bp in the context of a 10%

average margin is not much.

SHTFs margins have declined from a peak of 9%

in FY11, when it resorted to aggressive

securitization, which boosted margins to 7.8% in

FY13, when securitization levels fell along with

the loan book shifting to the 1-4 year-old used-vehicle category, where yields are lower.

According to SHTFs management, the last two

months have not had much impact on margins as

it maintains sufficient liquidity. SHTF has always

been a high cost borrower in the market and

securitized INR10bn in 2Q. The company is

replacing the 1-4 year-old vehicle segment with

older high yielding vehicle segments, which will

help to maintain margins.

The impact of rate volatility on margins is also

likely to be minimal for PFC and REC this

quarter, as they too have utilized their cash-credit

limits and raised tax-free bonds to fund growth

and reduce dependence on NCD and bank term

loans. Both PFC and REC have also raised their

incremental lending rates by 50bp to minimize the

impact of higher funding cost.

By contrast, IDFC has resorted to tapping the

market at higher cost and become extremelycautious on expanding the loan book. Refinancing

opportunities have also shrunk, as PSU banks like

SBI have been aggressive in refinancing this year.

Accordingly, IDFC will see only a limited margin

impact in the current quarter.

Going forward, with the RBI hiking repo rates, we

believe most of the NBFCs will start hiking prime

lending rates as they head into the busy 2HFY14.

Overall, HDFC, MMFS, SHTF, PFC, and REC

should be able to minimize margin loss, without

sacrificing much growth. However, IDFC could

see margin stress, while LICHFs margins will

remain low at an estimated 1.1% for the current

fiscal year.

Net interest margins

0%

5%

10%

15%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

HDFC LICHF MMFS SHTF

IDFC PFC REC


Liability mix (FY13)

0%

20%

40%

60%

80%

100%

HDFC

LICHF

MMFS

SHTF

IDFC

PFC

REC

Loans from Banks Other Institutional loansDepos its DebenturesCP BondsOthers

Source: : Company data, HSBC

Borrowings split (FY13)


Loans fromBanks

10% 30% 51% 38% 25% 16% 3%

OtherInstitutionalloans

1% 4% 0% 0% 0% 2% 3%

Deposits 33% 1% 11% 4% 0% 0% 0%Debentures 50% 61% 22% 45% 72% 0% 0%CP 6% 0% 0% 0% 2% 0% 1%Bonds 0% 4% 3% 12% 1% 76% 78%Others 0% 0% 12% 1% 1% 6% 15%



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Not just about profitabilityMost NBFCs deliver healthy returns, with ROA

ranging between 2.5% and 4% and ROA ranging

between 14% and 22%.

We believe that along with profitability, the

stocks should be assessed based on their credit

risk management, reporting transparency,

earnings visibility and earnings stability.

HDFC and MMFS stand out for their steady

growth in loans and earnings, healthy

profitability, high reporting transparency,

prudent credit risk management and good

earnings visibility.

LICHF comes next with healthy loan growth,

and prudent risk management. But with

margins declining significantly over the past

two years, profitability has dipped significantly,

though ROA is reasonable at 17-18%. A lack of

transparent reporting of its balance sheet has

considerably reduced earnings visibility in the

current volatile rate environment.

SHTF follows, with healthy profitability,

reporting transparency, good earnings

visibility and prudent risk management, but

has seen loans and earnings growth decline

over the past two years due to a CV demand

cycle slowdown. Profitability has declined

and is likely to continue to decline modestly,going forward.

Our least preferred IFCs are PFC, REC and

IDFC, as issues in the power sector continue

to plague earnings visibility. While IDFC has

seen steady profitability, high reporting

transparency and reasonably prudent risk

management, loan growth has been faltering

and asset quality risks increasing, implying

that profitability is likely to decline over

FY14-15. Given its low equity leverage, ROA

is likely to decline to about 12-13% over

FY14-15e, which would be the lowest among

all covered NBFCs. PFC and REC have

shown steady loan and earnings growth, but

asset quality risks on their private sector

exposure is increasing. Also, they have been

the least prudent in credit risk management,

historically. Therefore, transparency in their

practices remains low, leading to much lower

comfort in and confidence on their reported

earnings and book value.

ROA

1%

2%

3%

4%

5%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

HDFC LICHF MMFS SHT F

IDFC PFC REC


ROE

10%

15%

20%

25%

30%

35%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

HDFC LICHF MMFS SHT F

IDFC PFC REC



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ROA DuPont analysis as % of total assets

___ HDFC ___ __ LICHF ____ ___ MMFS ___ __ SHTF ____ ___ IDFC ____ ___ PFC ____ ___ REC ____FY13 FY14e FY13 FY14e FY13 FY14e FY13 FY14e FY13 FY14e FY13 FY14e FY13 FY14e

NII 3.40 3.44 2.10 2.10 10.16 9.90 8.58 8.17 3.88 3.73 4.15 3.69 4.47 4.18Fee income 0.13 0.13 0.16 0.13 - - - - 0.65 0.49 0.12 0.11 0.11 0.11Other income 0.46 0.42 0.11 0.10 0.17 0.15 0.57 0.45 0.73 0.81 0.13 0.11 0.15 0.14Optg revenue 3.99 3.99 2.37 2.32 10.33 10.05 9.15 8.62 5.26 5.03 4.40 3.92 4.73 4.43Opex 0.30 0.29 0.39 0.37 3.37 3.18 2.05 2.02 0.80 0.75 0.34 0.31 0.31 0.27Operating profit 3.69 3.70 1.99 1.94 6.96 6.87 7.10 6.61 4.46 4.28 4.06 3.60 4.42 4.16Total Provision 0.08 0.05 0.11 0.15 1.29 1.38 2.10 2.17 0.53 0.76 0.05 0.13 0.11 0.22PBT 3.61 3.65 1.88 1.80 5.81 5.49 5.00 4.43 3.93 3.52 4.02 3.48 4.25 3.88Tax 0.95 0.97 0.48 0.46 1.80 1.81 1.63 1.44 1.14 0.99 1.01 0.98 1.11 1.05PAT 2.66 2.69 1.40 1.34 4.01 3.68 3.38 2.99 2.79 2.53 3.00 2.50 3.14 2.83


Ranking


RoA 3 7 1 2 5 5 3ROA 1 6 1 4 7 4 1Prudence 1 4 1 3 5 7 6Transparency 2 5 1 4 3 6 7Earnings' visibility 1 4 2 3 5 6 7Earnings' stability 1 4 2 3 5 6 7Management quality 1 5 2 3 4 6 7Points 10 35 10 22 34 40 38Overall rank 1 4 2 3 5 7 6



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Company write-ups


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Robust growth set to continue

As one of the largest home financiers in India,

HDFC continues to benefit from the steady,

secular growth in home sales that we have beenseeing for years through economic cycles. The

trend continues even now with property buying

decisions still mainly driven by home prices and

income stability. While first tier cities have done

well, the pace of growth in second tier and third

tier cities has improved, which will continue to

support steady growth for HDFC. We expect it to

deliver 18-20% loan growth over FY14-15.

Superior liability structure andcost transmission to aid NIM

HDFC has a well-matched ALM book. That, along

with its ability to change its asset mix between

wholesale and retail, helps it to maintain steady

spreads. In the current quarter, given the jump in

interest rates, HDFC has been able to maintain

spreads by pre-empting surplus borrowings at lower

cost in 1Q, while steadily building up its retail

deposit base and minimizing its reliance on bank

loans (under 10% of liabilities). Also, it is likely tohave increased its exposure to the high yielding

wholesale borrowers segment. Among the NBFCs,

HDFC has the best liability structure with c.33% of

borrowings in the form of deposits, which is stable

funding. With c.30% of its liabilities likely to

reprice upward in the current fiscal year, HDFC

recently increased its prime lending rate by 25bp to

protect its margin.

Stable asset quality willcontinue to aid returns

HDFCs gross NPL ratio has been less than 1%

for the last 18 quarters and has shown a steady,

continuous improvement currently at 0.77%.

With credit cost remaining low at 15-20bp, we

expect it to continue to deliver ROA of 2.7-2.8%

and ROA of 22-24% over FY14-15.

Retain OW

HDFC trades at a 4.1x PB and 19.3x PE 12-month

forward. Ex-subsidiary value, it is trading at an

11.3x PE and 2.4x PB. We maintain our target

multiples of 24x PE and 4.5x PB. But after rolling

forward earnings (September 2015 base), we arrive

at a new target price of INR1,029 (INR1,007).

Under our research model, for stocks without a

volatility indicator, the Neutral band is 5ppts above

and below the hurdle rate of 11% for Indian stocks.

HDFC (HDFC IN)

Best play in the NBFC space on all measures and biggest

beneficiary of resilient housing growth with credible management

Margins least vulnerable to volatile rate environment; prudent risk

management helps maintain healthy profitability

Reiterate OW with a revised target price of INR1,029 (previously

INR1,007); our preferred stock in the NBFC space


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Our target price of INR1,029 implies a potential

return, including dividend yield, of 30%, which is

above the Neutral band; therefore, we are

reiterating our OW rating. Potential return equals

the percentage difference between the current share

price and the target price, including the forecast

dividend yield. HDFC remains our preferred pick

in the NBFC space.


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Year to 3/2013a 3/2014e 3/2015e 3/2016e

P&L summary(INR m)

Net Interest Income 61,829 73,686 88,899 105,906Non-interest Income 10,739 11,768 13,107 14,661

Processing fees & other income 2,413 2,848 3,360 3,965Income from investment 7,962 8,539 9,346 10,275Misc income 363 381 400 420

Total Operating income 72,567 85,454 102,006 120,567Operating expense 5,389 6,196 6,893 8,038

Staff costs 2,462 2,856 3,313 3,843Other oper expense 2,927 3,340 3,580 4,195

PPOP 67,178 79,258 95,113 112,529Provisions 1,450 1,015 1,137 1,273HSBC PBT 65,728 78,243 93,976 111,256Exceptionals - - - -Profit-before tax 65,728 78,243 93,976 111,256Taxation 17,245 20,705 24,869 29,441PAT 48,483 57,538 69,108 81,815

Minorities + pref dividend - - - -Attributable profit 48,483 57,538 69,108 81,815HSBC attributable profit 48,483 57,538 69,108 81,815Balance sheet summary (INRm)

Total assets 1,960,061 2,325,547 2,764,421 3,290,099Customer loans (net) 1,700,462 2,039,328 2,447,151 2,936,937Investment assets 136,135 143,363 151,253 159,876Other_assets 123,465 142,855 166,017 193,286

Total Liabilities 1,710,061 2,043,338 2,443,861 2,923,910Customer deposits 519,328 643,967 775,980 935,056Debt securities issued 1,068,953 1,260,274 1,509,203 1,808,916Other liabilities 121,780 139,097 158,678 179,937

Total capital 250,000 282,209 320,560 366,190Ordinary equity 250,000 282,209 320,560 366,190Minorities + other capital

IEA (avg) 1,808,431 2,132,206 2,535,952 3,017,901

IBL (avg) 1,489,778 1,746,261 2,094,712 2,514,578Capital adequacy (%)

RWA (INRm) 1,534,347 1,425,431 1,684,669 1,994,155Core t ier 1 13.9% 17.2% 16.8% 16.5%Total t ier 1 13.9% 17.2% 16.8% 16.5%Total capital 16.4% 20.0% 19.3% 18.7%

ROAA deconstruction

Net interest income 3.40 3.44 3.49 3.50Total interest income 11.03 10.94 10.76 10.83Total interest expense 7.63 7.50 7.26 7.33

Income from investment 0.44 0.40 0.37 0.34Other income 0.15 0.15 0.15 0.14Operat ing income 3.99 3.99 4.01 3.98Operat ing expenses 0.30 0.29 0.27 0.27

Staff costs 0.14 0.13 0.13 0.13Other oper exp 0.16 0.16 0.14 0.14

PPOP 3.69 3.70 3.74 3.72Provisions 0.08 0.05 0.04 0.04Non-op items - - - -PBT 3.61 3.65 3.69 3.68Taxation 0.95 0.97 0.98 0.97PAT 2.66 2.69 2.72 2.70

Year to 3/2013a 3/2014e 3/2015e 3/2016e

Growth (YoY %)

Net interest income 18.4 19.2 20.6 19.1Non-interest income 10.1 9.6 11.4 11.9Operating expense 19.3 15.0 11.2 16.6PPOP 16.9 18.0 20.0 18.3Provisions 81.3 (30.0) 12.0 12.0PBT 16.0 19.0 20.1 18.4PAT 17.6 18.7 20.1 18.4

Customer loans (net) 20.7 19.9 20.0 20.0Total Assets 16.7 18.6 18.9 19.0RWA 18.4 (7.1) 18.2 18.4Customer deposits 43.1 24.0 20.5 20.5

Ratios (%)

NIM 3.42 3.46 3.51 3.51Gross yield 11.10 10.99 10.80 10.86

Cost of funds 9.32 9.20 8.83 8.82Spread 1.78 1.79 1.97 2.04

NPL/gross loans 0.7 0.7 0.8 0.8Credit cost 0.09 0.05 0.05 0.05Coverage 106.3 133.3 129.0 129.7NPL/RWA 0.8 1.1 1.1 1.1Provision/RWA 0.1 0.1 0.1 0.1Net write-off/RWA - - - -NPL/NTE 4.8 5.4 5.9 6.2Net loans/total assets 86.8 87.7 88.5 89.3RWA/total assets 78.3 61.3 60.9 60.6

Avg IEA/avg total assets 99.4 99.5 99.6 99.7Avg IBL/avg total liab 81.9 81.5 82.3 83.1

Cost/income 7.4 7.3 6.8 6.7

Non-int income/total income 14.8 13.8 12.8 12.2ROAA (including goodwill) 2.66 2.69 2.72 2.70ROAE (including goodwill) 22.0 21.6 22.9 23.8Return on avg tier 1 26.7 25.2 26.2 24.9Leverage (x) 8.3 8.1 8.4 8.8

Valuation data

PE (diluted EPS) 25.6 21.6 18.0 15.2P/PPOP 18.5 15.7 13.0 11.0P/BVPS 5.0 4.4 3.9 3.4P/NTE 5.0 4.4 3.9 3.4Dividend yield (x) 1.6 1.7 2.1 2.5P/Asset 0.6 0.5 0.4 0.4

Price relative

543

593

643

693

743

793

843

893

943

993

2011 2012 2013 2014

543

593

643

693

743

793

843

893

943

993

HDFC Rel to BOMBAY SE SENSITIVE INDEX

Source: HSBC

Note: price at close of 3 October 2013

Financials & valuation HDFC

Per share data (INR)

EPS reported (fully diluted) 31.4 37.2 44.7 52.9HSBC EPS (fully diluted) 31.4 37.2 44.7 52.9DPS 12.5 14.0 17.0 20.0NAV 161.7 182.5 207.3 236.8NAV (including goodwill) 161.7 182.5 207.3 236.8


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HDFC chartsLoan growth Disbursement growth

10%

15%

20%

25%

30%

35%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

Loan Grow th (YOY%)

0.00%

10.00%

20.00%

30.00%

40.00%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

Disbursemen t Growth

Source: Company data, HSBC estimates Source: Company data, HSBC estimates

Margin Gross NPL

2.8%

3.0%

3.2%

3.4%

3.6%

3.8%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

Margin

0.60%

0.65%

0.70%

0.75%

0.80%

0.85%

0.90%

0.95%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

GNPL


ROA/ROA Rolling PE PB 12-mth fwd

2.2%

2.4%

2.6%

2.8%

3.0%

3.2%

3.4%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14e

FY15e

FY16e

15%

20%

25%

30%

35%

HDFC ROA HDFC R OE (RHS)

0x

10x

20x

30x

40x

Sep-

92

Sep-9

5

Sep-9

8

Sep-0

1

Sep-

04

Sep-0

7

Sep-1

0

Sep-1

3

0x

2x

4x

6x

8x

Rolling P/E Average 5 year

Rolling P/B (RHS) Av g 5 y r PB (RHS)



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Steady loan growth to continue

Housing finance remains fairly buoyant, despite

economic growth faltering and interest rates rising,

as property buying decisions are more dependent

on prevailing property prices and job creation than

on interest rates. Also, while Mumbai and the NCR

have seen slower growth, first and second-tier cities

continue to grow at a steady pace. Demand from

the government sector as well as service sector

continues to support healthy demand. Accordingly,

we maintain our loan growth estimate of 20-22%

for LICHF over FY14-15. The developer segment

should remain muted.

Spreads at the bottom, but

difficult to improve

At 1.1%, LICHFs spreads are near the bottom

given that its average funding cost is c.9.75%

against an average lending yield of 10.9%. LICHF

also borrowed in surplus in 1Q at c.8.5%. In the

current quarter, given the sharp rise in funding

costs, LICHF has avoided borrowing at higher

rates, by using the surplus funds as well as raising

10-year money at 9.5-10%. Going forward, while

near-term rates will come off slightly post reversal

of RBI measures, they will remain high enough

that will not allow LICHF to improve its spreads

much from current levels.

Profitability at the lowest point,but likely to continue

With steady loan growth and robust asset quality,spreads are the single most important driver of

LICHFs ROA. Therefore, with spreads not likely

to improve much above 1.1%, ROA is likely to

taper off at 1.3-1.4% levels, one of the lowest

among NBFCs and leading to ROA of 17-18%.

Retain OW

As returns are unlikely to improve in the near

term, the current trading multiples of 1.2x PB and

7.6x PE are probably pricing in the worst-caseearnings scenario. This makes us constructive at

the current price. We maintain our target

multiples of 1.4x PB and 8.2x PE. With an

extended period of low spreads we cut our EPM

value to INR208 (previously INR251). This

combined with a roll-forward of earnings

(September 2015 base) arrives at our new target

price of INR236 (INR243). Under our research

model, for stocks without a volatility indicator,

the Neutral band is 5ppts above and below the

hurdle rate of 11% for Indian stocks. Our target

price of INR236 implies a potential return,

LICHF (LICHF IN)

Expect loan growth to remain stable at 20-22%

Spreads and ROA have bottomed out at 1.1% and 1.3%,

respectively; improvements likely from next year onward

Reiterate OW with a revised target price of INR236 (previously

INR243); current price factors in worst-case margin scenario


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