Our first NBFC bet
Updated: Apr 11, 2020
While over the past few years we rigidly shy-ed away from NBFCs and Banking as a sector. Since in India banking has usually only been retail and corporate loans. Now, business loans as we look at it are equal to selling put options on businesses. If the business performs the bank earns a nominal interest rate, however in case the business fails the banks stand to lose most of the loan amount and might even have to spend more in legal filings and compliance. In banks like HDFC and KOTAK, the due diligence and risk management systems made sure that loans would rarely default. Even they deposit rates they offered has always been low, giving them the advantage of a high Net Interest Margin. But all of these factors make sure these institutions rarely trade cheap. Moving on to housing and home finance. The concept that a house is sold on abnormally high premiums initially that they would be sold in case the loan defaults never quite made much sense to us.
In the case of a company like DIWAN HOUSING (DHFL) we observed that the company was working on a very thin Net Interest Margin of 4-5%. While the interest income on home loans is a long term commitment, the company can't really change the interest rate throughout the cycle while the customers can always choose to benefit from better interest rates. Companies like Capital First etc never quite made sense to us majorly because their chunk of the loan books was dedicated to white goods. Would I really trust a person who asks for a loan to buy a mobile phone? Initially, this business seemed attractive due to higher interest rates, lower defaults and smaller token sizes. Would you continue to repay a loan you take on a mobile phone you lose?
The many uncertainties always kept us super sceptical in this space and the recent correction taught us "it is a good idea to fear uncertainty".
We love the insurance space and sector and so does Rakesh Jhunjhunwala, he did buy a majority stake in STAR LIFE recently. But getting to our originally topic of NBFCs.
We have recently initiated coverage on the finance subsidiary of a hundred-year-old institution.
Incorporated as the Financial Services wing of the Murugappa Group in 1978, today Chola Finance has grown to an AUM of Rs. 47,700 Cr operating across all major Tier II/ III cities from its strong network of 885 branches.
While we discourage high dividend yield companies, we love that virtue in finance and commodity stocks. Chola has recently paid 65% of PAT as dividend. Chola works with a 20% ROE and the chunk of their loan book has continued to be vehicle loans. Recently they have started diversifying into home equity and the capital markets. The company's capital markets division has been making consistent profits and is targeting a nichè clientele (viz.- HNI and Institutions). The company claims to have an NNPA of 1.7% (according to its 20th July' 2018) presentation and has recently been upgraded to AA+ by ICRA. Rating improvement for a financial institution implies they can borrow at cheaper rates while they may continue to lend at the same rates as before. We would not want to flaunt the PBT growth across 2013- 2018 of 45% CAGR since we can not comment on the consistency of the same. The company has consistently grown EPS PAT and Cashflow from Profits each year since March' 2010 till March' 2018.
While even Chola would take a hit due to the slump in auto sales, we don't see the slowdown last longer than a few more months. We have maintained a very bullish outlook on the auto sector as a whole. India has one of the lowest penetration among emerging markets. Infra spending and a more dense network of roads in India now than ever before should soon trigger a boom in the sector.
Increasing fundamentals and panic in markets make the company a sound bet on this sector opening our portfolio to a new industry, but let's show you if it actually is as cheap as we think it is.
Ratio and Financial Metrics
Current Market price @ 1190/- and Market Capitalisation at Rs. 18,483 Cr.
With companies in the finance sector, we very carefully look at ROE, Dividend Payout and PE. Chola fits well on all three with a 20% ROE, 65% DPR and a PE of 16x which lower than its 3/5/10 year historical average PE.
Considering the company stops growing and is valued ceteris paribus- at current prices it would have to move up 22% to reach that value. However, a 3.21x BV is something we could be slightly sceptical about.
Elaborate research on the same coming soon on our research page - The LGHC Reports