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Auto NBFCs

Aadesh Mehta, [email protected]: +91 22 3043 3239

October 2015

BANKS

RBI

RBI

NBFCNBFC

BANKS BANKS

NBFC

RBI

NBFC

NBFC

Analysts:

Auto NBFCs' Multiple Headaches

Pankaj Agarwal, [email protected]: +91 22 3043 3206

Ravi [email protected]: +91 22 3043 3181

NBFC

Auto NBFCs

October 08, 2015 Ambit Capital Pvt. Ltd.

CONTENTS

Auto NBFCs - Multiple Headaches …........................................................... 3

Auto financing – A `2.3trn opportunity …………………………………………….4

Cyclical turnaround – Still some way away ………………………………………..7

Structural headwinds could be disruptive………………………………………...12

So what’s the way forward for NBFCs? …………………………………………..23

Valuation and recommendations …………………………………………………29

COMPANIES

Cholamandalam Finance (BUY) …………………………………………………………..31

M&M Financial Services (SELL)…………………………………………………………. …..57

Shriram Transport (SELL) …………………………………………………………………….65

Magma Fincorp (BUY) ……………………………………………………………………….71

Sundaram Finance (NOT RATED) ………………………………………………………….77

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Multiple Headaches

Slowing GDP growth and a severe slowdown in the rural economy mean that cyclical headwinds for auto NBFCs haven’t subsided yet. Also, higher competition from banks, closing regulatory arbitrage with banks, decreasing proportion of low-cost funding and consolidation in the CV industry mean that auto NFBCs are structurally on a weak footing. In the medium term, Cholamandalam Finance is best placed on our framework to deliver superior profitability; we initiate with a BUY. Cyclical pressures are not over yet for M&M Finance (SELL) due to its rural-heavy loan book and a slowing rural economy. Shriram Transport’s (SELL) profitability is under pressure both cyclically and structurally due to increasing competition in its core used CV segment, asset quality pressure on its CE/CV book and the decreasing proportion of low cost funding.

Cyclical recovery some time away Whilst falling interest rates (125bps decline in repo rate in CY15) and falling fuel prices (22% decline over the last 12 months) are incrementally positive for auto NFBCs, cyclical woes are not over yet for auto NBFCs, as a full-fledged recovery is still some time away. A weakening economy (GDP growth of 6.8% in FY16 vs 7.3% in FY15), no recovery in mining & manufacturing activities and a slowing rural economy (due to falling subsidies and a weak monsoon -15% below normal) mean that the worst is not over yet for NFBCs in terms of growth and profitability. Structural changes to impact growth and profitability Even in the case of a cyclical recovery, we expect growth and profitability for auto NBFCs to be structurally weak vs historical trends due to: (i) Increasing competition from PSU and private sector banks; (ii) NBFCs losing their regulatory advantages to banks due to a changing regulatory regime; (iii) Decrease in proportion of low-cost priority sector borrowings from banks; and (iv) Consolidation in the fleet industry resulting in fewer opportunities for NBFCs.

Cholamandalam Finance and Magma: our only BUYs Given the positioning of NBFCs in the segment vs banks, it is difficult to be structurally positive on NBFCs. However, on a mid-term basis, Cholamandalam Finance (CIFC IN) is the best placed amongst auto NBFCs to deliver superior profitability due to improvement in NIMs owing to its strong presence in lucrative but high entry barrier business of LCV financing and old CV financing. Valuations at 2.4x FY17E P/B have further scope to rerate as CIFC delivers 20% EPS CAGR over FY15-18E driven by 19% AUM growth and ~30bps improvement in RoAs to ~2%. We initiate with a BUY and a target price of `740 (15% upside). Whilst Magma’s RoEs continue to lag its peers, we believe that Magma offers the best risk-reward as its RoEs would improve not only from declining credit costs but also from: (i) Operating leverage due to internal structuring; and (ii) NIMs improvement due to change in the asset mix towards high yield assets and declining cost of funds. RoE expansion from ~11% in FY15 to 13% in FY17E, may lead to a meaningful rerating from current valuations. We retain BUY on MGMA. M&M Financial Services and Shriram Transport: reiterate SELL Given the rural slowdown, we expect MMFS’ profitability to further deteriorate with average RoE of 14.9% in FY16-17E (vs 17.8% in FY14-15). Hence, valuations at 1.8x FY17E P/B are expensive and we retain our SELL on MMFS. With increasing competition in the used CV segment and continuous asset quality pressure in its CE/CV loan book, we expect SHTF’s average RoEs in FY16-17 to remain weak at 13.5% (vs an average 14.5% in FY14-15). Hence, valuations at 1.8x FY17E P/B are expensive and we retain our SELL on SHTF.

THEMATIC October 08, 2015

Auto NBFCsNEGATIVE

BFSI

Recommendation Cholamandalam BUY

Upside (%): 15

M&M Finance SELL

Downside (%): 4

Shriram Transport SELL Downside (%): 20

Magma Fincorp BUY

Upside (%): 53

Sundaram Finance NOT RATED

Rankings of lenders as per framework Particulars SUF SHTF MMFS CIFC MGMA

AUM Growth

Margin resilience

Operating leverage

Credit costs

Blending ranking

Source: Ambit Capital Research

CIFC is best placed in our framework with reasonable valuations

Source: Ambit Capital Research; Note: Bubble size is one year forward RoE (%)

Analyst Details

Aadesh Mehta, CFA +91 22 3043 3239 [email protected]

Pankaj Agarwal, CFA +91 22 3043 3206 [email protected]

Ravi Singh +91 22 3043 3181 [email protected]

SHTFMMFS

SUF

MGMA

CIFC

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Ranks as per Ambit framework

Note: - Strong; - Relatively Strong;

- Average; - Relatively weak.

Auto NBFCs


Auto financing – A `2.3trn opportunity Auto financing is a `2.3trn opportunity in India and has reported a robust CAGR of ~16% over the last ten years backed by strong auto sales growth in India over the last decade. Moreover, this segment has been a more profitable segment for lenders with specialised auto NBFCs and for banks with heavy auto loan portfolios due to higher yields.

Exhibit 1: Vehicle loan growth vs banking system loan growth

Source: RBI, Ambit Capital research.

Exhibit 2: RoAs of auto NBFCs and banks

Source: Company, Ambit Capital research; Note: Auto NBFCs included in this analysis are SHTF, MMFS, SUF, CIFC and MGMA.

Going through a downturn However, the growth and profitability of auto financiers have been under pressure over the last four years. Auto loan growth for the industry has declined from 25% in FY11 to 2% in FY15 and average RoEs of auto NBFCs have declined from 20% in FY11 to 15% in FY15, indicating lower profitability in the segment.

Exhibit 3: Auto loan growth has declined for the industry

Source: RBI, Ambit Capital research

Exhibit 4: Declining RoEs of auto NBFCs…

Source: Company, Ambit Capital research. Note: NBFCs included in this analysis are SHTF, MMFS, SUF, CIFC and MGMA

A weak economic environment, which has impacted construction/economic activity across segments and geographies, is the primary reason for the lower growth and profitability for auto financiers. Increased fuel prices and high inflation (leading to higher manpower costs) have also adversely affected the profitability of fleet operators in both the passenger and goods segments.

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Auto NBFCs


Exhibit 5: Primary sales have slowed down in various auto categories

Source: SIAM, Ambit Capital research

Whilst auto financiers have faced pressure on loan growth and profitability over the last couple of years, specialised auto financing NBFCs have faced higher pressure than banks in this segment on all key parameters such as loan growth, NIMs and asset quality.

Exhibit 6: NBFCs have grown slower than the top-5 banks

Source: Company, Ambit Capital research. Note: Top-5 NBFCs include SHTF, MMFS, MGMA, SUF and CIFC. Top-5 banks refer to HDFCB, ICICIBC, KMB, IIB and SBIN.

Exhibit 7: Asset quality deterioration for NFBCs have been sharper than for banks in the auto segment

Source: Company, Ambit Capital research. Note: Top-5 NBFCs include SHTF, MMFS, MGMA, SUF and CIFC. Banks refer to HDFCB, KMB and IIB.

Exhibit 8: NBFCs’ NIMs have declined due to multiple headwinds on yields and cost of funds

Source: Company, Ambit Capital research; Note: NBFCs include SHTF, MMFS, MGMA, SUF and CIFC

Exhibit 9: RoEs of auto NBFCs have meaningfully declined

Source: Company, Ambit Capital research; Note: NBFCs include SHTF, MMFS, MGMA, SUF and CIFC

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NBFCs - NPAs Banks - NPAs

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NBFCs - NIMs

14%

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Average RoEs - NBFCs

Auto NBFCs


NBFCs have suffered more than banks The loan growth and profitability of auto NBFCs have suffered more than banks in this downturn because of the following reasons:

Sharp slowdown in the rural economy (where NBFCs have a higher presence than banks) due to: (a) declining government spending in rural areas and (b) multiple crop failures due to weak monsoons and unseasonal rains in some parts of India;

More competition from banks in some of the traditional segments of NBFCs due to: (a) slower growth in corporate segment, (b) increasing branch network and (c) evolution of credit bureaus which is helping banks to reach and appraise customers better;

Regulatory changes around priority sector guidelines, securitisation guidelines and tougher NPA regulations have impacted the loan growth, NIMs and provisioning costs of NBFCs, thereby depressing RoEs.

Key questions we seek to answer In the following sections, we have focused on answering the following four questions:

Have cyclical headwinds bottomed out for NBFCs?

How are NBFCs structurally placed in the auto financing segment vis-à-vis banks amidst the closing regulatory gap with banks and changing nature of the auto financing market?

What could be the potential earnings growth and RoEs of NBFCs in the medium to long term based on the structural changes and cyclical trends in the sector?

Which NBFCs provide favourable risk-reward ratio for investors at current valuations?

Auto NBFCs have suffered more than banks in the downturn due to a combination of rural slowdown, higher competition from banks and regulatory changes

Auto NBFCs


Cyclical turnaround – Still some way away Declining wholesale rates have aided the margins and declining fuel prices have given a breather to the asset quality of NBFCs. However, lack of pickup in the mining and construction activities imply that recovery is still some time away. Nevertheless, we see a recovery in the HCV segment, driven by replacement demand rather than fresh capex. We believe, such recovery is unlikely to be emulated in other auto segments, with PVs outperforming the rest of the segments.

As discussed in the earlier sections, cyclical headwinds had taken a toll on auto NBFCs’ growth, NIMs and asset quality over the last 3-4 years. The slowdown in the overall economy and more specifically in rural geographies has impacted the growth and asset quality of these NBFCs. Moreover, a relatively elevated interest rate environment over the last 3-4 years has also impacted the NIMs of these NBFCs.

That said, some headwinds are abating for NBFCs, which is positive for their growth and profitability.

Some headwinds are abating #1: Funding scenario is improving

Interest rates are turning benign, thereby helping the margins of auto NBFCs. Banks’ base rates as well as wholesale market bond rates have been declining over the last one year, which has helped NBFCs improve their cost of funds and NIMs.

Exhibit 10: Movement of base rate vs 3-year AAA and AA bond yields

Source: Company, Bloomberg, Ambit Capital research

Exhibit 11: Cost of funds has been declining for NBFCs and hence their NIMs have been improving over the last few quarters

Source: Company, Ambit Capital research

NBFCs have been able to lower their funding cost also due to the shift from bank borrowings to bonds borrowings. Abundant liquidity has led to bond rates falling very sharply over the last 12 months vs the fall in base rates and treasury yields. This has helped NBFCs swap their expensive bank borrowings with less expensive bond borrowings, thereby reducing their funding cost. Note that the decline in NIMs in 1QFY16 vs 4QFY15 has been due to seasonal factors.

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Auto NBFCs


Exhibit 12: Difference between average base rates and average AAA bond rates* have expanded

Source: Bloomberg, Company, Ambit Capital research; *We have taken all tenors between 3months to 10 years for the bond rates

Exhibit 13: Premium for corporate bonds over treasury bonds have declined

Source: Bloomberg, Ambit Capital research

Exhibit 14: Bond/CP borrowings as a percentage of total borrowings have increased for NBFCs over the last one year

Source: Company filings, Ambit Capital research.

#2: Declining fuel prices have reduced pressure on asset quality

Moreover, declining fuel price (22% fall in last one year) over the last 12 months is also a positive for fleet operators, as it has reduced the input cost pressure on fleet pressure at the time when they are not in a position to pass it on to consumers due to weak demand. Fuel costs are ~50% of the total operating cost of a fleet operator.

Exhibit 15: Decline in fuel prices over the last 12-18 months

Source: IOC, Ambit Capital research

0.63%

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Difference between average base rates and bond rates* 1.16%

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Diesel Price / liter in metro cities (Rs)

Bond/CP borrowings as a percentage of total borrowings have increased for NBFCs over the last one year

Auto NBFCs


However, a broader recovery remains elusive Despite tailwinds from benign interest rates and lower fuel prices, we believe that the cyclical stress is not over yet for auto financing NBFCs. A slowing overall economy coupled with a severe slowdown in the rural economy means that the pressure on the growth and asset quality of auto NBFCs is not over yet.

#1: Overall slowdown in the economy

From an overall economic growth prospective, our Economy team has a bearish view on economic growth and expects GDP growth in FY16 to be lower at 6.8% vs 7.3% in FY15. This will have a bearing on the growth and asset quality of all lenders including NBFCs.

#2: Core manufacturing/construction/mining activities remain weak

Moreover, even other economic indicators that have a bearing on auto NBFCs are still not showing any signs of improvement and are likely to remain weak, as per our Economy team.

Exhibit 16: Manufacturing and mining IIP have improved only marginally

Source: CEIC, Ambit Capital research

Exhibit 17: Construction GDP continues to languish

Source: CEIC, Ambit Capital research

#3: Rural cash flows remain stretched

Moreover, even the data-points that tell us about the health of the rural economy are not showing any signs of improvement. The growth in government spending in the rural economy has been declining over the years in terms of lower growth in MSPs and lower growth in subsidies.

Exhibit 18: Growth in MSPs remains flattish

Source: Ministry of Agriculture, Ambit Capital research

Exhibit 19: Government subsidies are declining

Source: Union Government budget documents, Ambit Capital research

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Auto NBFCs


Moreover, the monsoon this year has been less than ideal, with a 14% YTD deficit in rainfall. More specifically, two major states, Maharashtra and UP, have seen deficient rainfall this year. These states are also the states which saw unseasonal rains in April, which damaged major crops in these two states. Maharashtra and UP contribute to ~20% auto NBFCs’ loan book and the current situation will continue to impact the overall asset quality of NBFCs even if the situation improves in the rest of the states.

Exhibit 20: Weak monsoon distribution in India

Source: IMD, Ambit Capital research

Selective recovery in certain pockets Replacement and urban demand uptick drive MHCVs and cars recovery Whilst a full-fledged recovery in auto sales has still not materialised, MHCVs and cars are showing better growth trends as compared to tractors, utility vehicles and LCVs. However, our channel checks with auto-dealers and branches of few NBFCs suggest that demand in MHCVs is driven by replacement demand from large fleet operators and not by broad-based demand.

Exhibit 21: Sales growth (YoY) is recovering in MHCVs and PVs


Hence, NBFCs have not been able to grow their CV loan books in line with the MHCV volume growth. Moreover, the growth in passenger vehicles is also largely coming from urban centres, as growth remains weak in rural centres, as per various management commentaries.

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MHCVs PVs

HCVs and cars are showing better growth trends as compared to tractors, utility vehicles and LCVs

Auto NBFCs


Outlook in other auto segments remains negative

Overall, given that we expect economic growth to remain weak (with further deceleration in the rural economy), our Auto analyst does not expect auto sales to recover in FY16, with MHCVs and cars performing better than the other sub-segments.

Exhibit 22: Macro heat map – Cyclical headwinds not yet over

Drivers Metrics Trend Outlook on different auto segments

MHCVs LCVs PVs Tractors

Manufacturing Manufacturing IIP Neutral Neutral Neutral NA NA

Construction and infra Construction GDP Negative Negative NA NA Negative

Mining Mining IIP Negative Negative NA NA NA

Rural cash flows

MSPs Negative NA Negative Negative Negative

Rural spends by Govt. Negative NA Negative Negative Negative

Monsoons Neutral NA Neutral Neutral Neutral

Urban consumer Sentiment

Consumer confidence

Positive NA NA Positive NA

Hiring trends Positive NA NA Positive NA

Overall outlook Positive Negative Neutral Negative

Whilst the key drivers of CV sales are weak, CV demand has recovered due to replacement demand from fleet operators. The NBFCs would only benefit when the overall economy recovers with an uptick in infrastructure and construction activities.

LCVs are more sensitive to semi-urban/rural cash flows given their last mile connectivity; pressure on rural cash flows should imply that LCVs should still see some headwinds, before finally rebounding.

Slowdown in rural geographies implies that PV sales in rural areas will remain muted. However, rural geographies account for only 30% of the PV industry sales, and with urban sales doing well for PVs, we believe the worst is over.

Tractors are dependent primarily on agriculture cash flows and rural spends of the government in the form of construction work. With both key drivers being muted, we believe that the headwinds for tractors are not yet over.

Source: Ambit Capital research

Our recent discussions with the management teams of auto NBFCs also suggest that the NBFCs are still not witnessing any recovery in their loan growth and asset quality and the risk of further deterioration in asset quality still remains high. Moreover, despite the sharp increase in delinquencies and credit costs for NBFCs over the last four years, asset quality stress is still lower than the worst these NBFCs have seen in the past. Hence, if the economy does not improve any time soon, there is further scope for deterioration in the asset quality of auto NBFCs.

Exhibit 23: MMFS’s asset quality troubles have not peaked yet


Exhibit 24: SHTF’s asset quality troubles have not yet peaked yet

Source: Company, Ambit Capital research. On-book credit costs refer to those provisioning charge on the AUM excluding the off-book assets.

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Auto NBFCs


Structural headwinds could be disruptive Whilst a delayed cyclical recovery would resolve some of the immediate concerns of NBFCs, we believe that the loan growth and profitability of auto financing NBFCs could be disrupted by select structural trends, such as: (i) increasing competition from banks; (ii) closing regulatory arbitrage; (iii) lower availability of cheaper PSL-based funding and; (iv) consolidation in the fleet industry.

In the section below we highlight how each of these structural concerns could disrupt the business models of auto-financing NBFCs.

#1: Increasing competition from banks – This time it’s different

A walk through the decadal turf wars…

Up to the late 1990s, vehicle financing was dominated by NBFCs. However, new private sector banks (which began operations in 1994) sensed this opportunity and entered the segment in a big way in the late 1990s.

Car loans: From a blue ocean to stormy waters Up to the 1980s, car leasing was more prevalent than financing in India. Foreign banks (Citi Bank, HSBC, etc) started offering car loans in the late 80s, followed by NBFCs. With foreign banks having limited reach, NBFCs were the dominant players in the segment until the late 90s – Anagram, Kotak Prime, Apple Finance and Gujarat Lease Finance being the key NBFCs in the segment. As demand for cars outstripped supply in the 1990s, some auto finance companies made mass purchases and sold them at a meaningful premium. However, the entry of new manufactures (GM, Ford and Daewoo Motors in the early 2000s led to higher supply of cars and led to the end of the premiums charged by the NBFCs. This period also saw the entry of Indian banks (especially PSU banks) in the segment, marginalizing NBFCs in the segment (as yields declined sharply in the segment). This led to various NBFCs exiting the segment and those that survived were either: (a) backed by banks (e.g. Kotak Prime); or (b) able to find their own niches in used cars, the self-employed and the rural segment (e.g. M&M Finance); or (c) backed by OEMs to cater to the segments where banks were not comfortable lending.

CV loans: Multiple rounds of consolidation Up to 1997, CV financing was highly fragmented and was dominated by NBFCs followed by PSU banks, co-operative banks and the unorganised sector. However, the economic downturn between 1997 and 2002 led to a sharp increase in delinquencies and a severe slowdown in the segment, leading to various NBFCs (20th Century, Gujarat Leasing and Anagram) closing down during this period. Soon after, private banks entered the segment in a big way, with ICICI Bank and HDFC Bank being the dominant players. NBFCs which survived in the segment either: (a) had very low cost of funds and long relationships with fleet operators (E.g. Sundaram Finance); or (b) ventured into used CV financing (e.g. Shriram Transport); or (c) were backed by OEMs (Tata Motor Finance) to cater to segments where banks were not comfortable lending.

Hence, with competition increasing from banks, some NBFCs ventured into segments which were not catered by banks (such as old CV financing and financing of SRTOs i.e., small road transport operators) and the NBFCs were able to establish themselves in these segments.

With NBFCs not being new to competition from banks, many of them have survived and thrived by reinventing themselves. However, NBFCs are now facing a fresh round of new competition with: (i) PSU banks becoming more active in the auto segment; (ii) private sector banks increasing their thrust in rural/semi-urban geographies by increasing the number of branches in search of higher growth and yields; and (iii) the advent of credit bureaus over the last 7-8 years, which has made it easier for banks to target segments that were hitherto served by NBFCs.

NBFCs were the dominant players in the auto loans until the late 90s; however, the entry of banks marginalised NBFCs

Competition led to various NBFCs exiting car loans and those that survived were either: (a) backed by banks; or (b) able to find their own niches; or (c) backed by OEMs

NBFCs that were once dominant in CV financing are now mostly operating in the small fleet operator and used CV financing segment

NBFCs are now facing a fresh round of new competition with: (i) PSU banks becoming aggressive; (ii) private sector banks increasing their thrust in rural/semi-urban geographies; and (iii) the advent of credit bureaus

Auto NBFCs


PSU banks – The giants awaken

Whilst PSU banks always had an advantage over NBFCs due to their wide branch network and lower funding costs, they scarcely used it to gain market share in auto loans. However, lack of opportunities in the corporate segment, thin capital base and intense scrutiny on corporate loans mean that PSU banks are incrementally focusing more on retail loans. Apart from home loans, auto loans are another segment where PSU banks have started focusing more in the recent past. Our channel checks and data trends show increased focus of PSU banks on auto loans in terms of better products, pricing, reach and service quality.

Exhibit 25: Dominance of PSU banks in key states (branch count in respective states) Top 5 Banks MAH GUJ TN AP UP BIHAR

Bank 1 1,476 (SBIN) 1,254 (SBIN) 1,210 (IOB) 1,071 (SBIN) 2,134 (SBIN) 971 (SBIN)

Bank 2 1,198 (BOMH) 1,003 (BOB) 1,042 (SBIN) 902 (ANDB) 1,309 (PNB) 584 (PNB)

Bank 3 891 (BOI) 600 (DBNK) 971 (INBK) 399 (SBOH) 1,142 (BOB) 450 (CBOI)

Bank 4 643 (CBOI) 394 (BOI) 825 (CBK) 381 (SNDB) 960 (ALBK) 340 (BOI)

Bank 5 620 (ICICIBC) 339 (HDFCB) 416 (ICICIBC) 251 (CBK) 932 (UNBK) 236 (ALBK)

MMFS 97 56 93 116 74 37

Source: RBI, Company, Ambit Capital research

Exhibit 26: Increasing focus on PSU banks in auto loans “Car loans, in the first six months (of FY2015) grew slowly because there were certain policy decisions that were taken in the previous year to make eligibility more stringent and we were also re-tweaking our system of appraisal. We decided that towards the second half of the year we will go ahead and do a much more aggressive campaign.”

- B Sriram, Managing Director and Group Executive, SBI (March’2015) "In view of the credit growth, which had been subdued during FY'15, the focus of the bank had been on retail growth. We will see the retail growth numbers also, but to give a boost to retail business, bank has waived full processing chargers for home loans and car loans and 50% for the traders loan that is the mortgage loans again for the business purposes. Bank has opened one more retail loan factory taking the number to 61 from the 60 existing one. Streamline this scheme for housing loans, loans to pensioners and strengthened its Lending Automation Processing System, LAPS for efficient and faster processing of the proposals."

- Narang Vidyasagar, General Manager (Planning), Bank of Baroda (July’2015)

"The strategy of tie-up arrangement with diverse reputed auto manufacturers like Maruti Suzuki, Tata Motors, Hyundai Motors, Mahindra and Mahindra and ICML continues to provide healthy retail leads to augment Vehicle Loan portfolio."

- Mrs. V R Iyer, MD & Chairperson, Bank of India (May’2015)

Source: Company, Media reports, Ambit Capital research

Aggressive pricing/products from PSU banks

The increased focus of PSU banks in auto loans is visible in the pricing and products offered by PSU banks in this segment. For example, the largest PSU bank, SBI, is charging only 60bps over its base rate for car loans vs a spread of ~300bps in FY11. The aggression of PSU banks is limited not only to SBI but also to other PSU banks. Also, the aggression has now extended beyond pricing (and into higher tenors, higher LTVs and waiving processing charges).

Exhibit 27: SBI’s spreads in car loans* have declined over FY10-15

Source: Company, Ambit Capital research; Note: * Over the base rate

2.95% 3.00%

2.25%

1.25%0.75% 0.75% 0.60%

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Jun-

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SBI - Interest spreads in car loans

Our channel checks and data trends show increased focus of PSU banks on auto loans in terms of better products, pricing, reach and service quality

Auto NBFCs


Exhibit 28: Aggressive product features of PSU banks

Bank Features

SBI

SBI is offering 7-year tenor loan with 85% LTV on on-road pricing which is the highest tenor product in the segment.

SBI had eased eligibility norms for car loans in October 2014, allowing the salaried with a minimum annual income of ₹300,000 from ₹400,000 earlier. For self-employed, the minimum net annual income or PAT had been lowered to ₹400,000 from ₹600,000.

SBI also partnered with taxi aggregator OLA to give OLA drivers tailor-made loans.

PNB Waived documentation and processing charges.

BOB BoB is offering low processing fees (0.50% for car loans and 2% for two wheelers), zero prepayment charges, concession rates for liquid collateral and 25bps reduction in auto loans rates for home loan customers with good track record.

UNBK Waiver of processing charges, no prepayment penalties if paid from own sources.

Source: Company, Media reports, Ambit Capital research

Exhibit 29: SBI’s disruptive product features

Source: Media, Ambit Capital research

Exhibit 30: Bank of Baroda is offering a turnaround time of two days


Auto NBFCs


Exhibit 31: PNB is offering loans at 100% LTVs


Improving service quality/reach

PSU banks’ aggression in the segment is limited not only to pricing and is visible in increasing reach and service quality. Earlier, PSU banks generated auto loans mostly from branches and generally lent to their existing customers. However, this is changing now and PSU banks are now adding delivery channels for their auto loans. Our channel checks suggest that PSU banks are now deploying executives at

the auto dealers’ premises. This is not only helping them in higher originations but is also decreasing the turnaround time for the customer and the auto dealer.

PSU banks like SBI are also tying up with fleet car aggregators like Ola. It uses such tie-ups to approve the loan within 24 hours at 10% down-payment. The repayment of loan is trip-wise with some portion of the earnings of every journey going towards loan repayment. Such repayment mechanism also helps in early detection in case of default.

Our channel checks also indicate that PSU banks have meaningfully improved on turnaround time as well.

Exhibit 32: Primary data suggesting that PSU banks are achieving operating efficiency

The turnaround time of PSU Banks has improved considerably. They are no more inactive players in this segment as they used to be earlier.

- Branch Manager of one of the largest auto NBFC Turnaround time of ‘XYZ PSU Bank’ has improved from 3-4 weeks to 1-2 weeks. Pressure from top management of the bank has driven select regional heads to be aggressive and improve turnaround time

- Regional head of auto finance NBFC Most customers expect banks to connect the dots between online and offline options to deliver convenient and consistent service. The average loan-processing time has been squeezed to 22 days from 35 days earlier. Moreover, in home loans where there are builder tie-ups, it can come down to seven days. Banks are enabling customers to digitally access all banking services through the internet and mobile phones, thereby, also speeding up the loan process and reducing branch banking.

- Arvind Kapil, Senior Executive Vice-President & Business Head, SBI (August’2015) Source: Company, Media reports, Ambit Capital research

The increased focus of PSU banks in the segment is visible in their growth rates as well. Whilst data is not available for the auto loan portfolio of all PSU banks, SBI’s data is clearly showing this trend. Such aggression by SBI has resulted in it growing faster than private sector banks and NBFCs.

The increased focus of PSU banks is visible in their faster growth rates as compared to private sector banks and NBFCs

Auto NBFCs


Exhibit 33: SBI has gained market share from private banks and NBFCs in auto loans

Source: Company, Ambit Capital research.

Private banks – Increasing thrust in rural/semi-urban areas With increasing competition in urban/prime segments from PSU banks, many large private banks are now moving to semi-urban and rural areas for their next leg of growth and in search of higher yields. The management commentaries of many private banks show such strategic intent.

Exhibit 34: Strategic intent of large private sector banks to move deeper into semi-urban and rural areas

HDFC Bank

“About 60% or 65% of India still lives in semi-urban and rural and 54% of the bank’s distribution network and branches are in these regions. We are one of the few banks that are on the lending side of the balance sheet in these areas. Incrementally, the proportion coming from semi-urban and rural network is growing every month. … We are happy that we have gone into virgin territory both in terms of distribution and on the asset side. We want to substitute the moneylender. Over the next three to four years, more than a fourth of the loan book would emerge from these territories because these areas are growing much faster than urban India is. .. But we have been doing this over three or four years, we changed our methods of selling, operations, products and now we have a very viable model….Here we are substituting the moneylender very substantially and we are creating a brand; Revenues from semi-urban and rural areas is currently 15 per cent of the total revenues. It will be 30 -35 per cent in the next five years.”

- Aditya Puri, MD, HDFC Bank (March’2015) ICICI Bank

“More than 50 percent of our branches are in rural and semi-urban areas. A lot of our recent increase in branches—in fact over 60 percent—is in rural areas, and in unbanked villages we have almost 450 branches. We’re present in about 15,000 villages. So all this, in terms of scope and scale, makes it pretty large. From here on, to build values in the transaction… that takes some time, but that’s the next step of the journey.” - Chanda Kochhar, MD, ICICI Bank. (February’2014) “We believe that the next growth drive will come from the rural India and the small towns,"

- Rajiv Sabharwal, ED, ICICI Bank. (January’2014) IndusInd Bank

“The first priority will be bringing scale while retaining our profitability. We plan to double our branch network and our customer base. Then the two new frontiers will be digital banking and rural banking...”

- Romesh Sobti, MD, IndusInd Bank. (December’2014) Source: Company, Media reports, Ambit Capital research

Increasing rural thrust of private sector banks

The strategic intent of the banks to increase their presence in semi-urban/rural areas is also visible in the branch expansion strategy of these banks. Over FY12-14, five of the largest private sector banks have opened around ~2,400 branches in rural and semi-urban geographies, 3.2x the branches opened by auto-financers during the same period.

21%

13%

1%

10%

21%

35%

13%15%

26%30%

12%

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FY12 FY13 FY14 FY15

Growth in auto loans (%, YoY)

Top 4 pvt banks SBI Top4 NBFCs

With increasing competition in urban/prime segments from PSU banks, many large private banks are now moving to semi-urban and rural areas for their next leg of growth and in search of higher yields

Private sector banks’ reach in rural and semi-urban areas is improving which is visible in rapid branch expansion in these areas over FY12-14

Auto NBFCs


Exhibit 35: Five of the largest private banks are penetrating deeper into semi-urban and rural areas

Source: RBI, Company, Ambit Capital research

Our channel checks suggest that this expansion has helped some of these banks to venture into products, like tractors, semi-urban/rural car loans and LCVs, which were hitherto dominated by NBFCs. Banks are essentially acquiring the creamy layer customers of NBFCs in semi-urban and rural areas (i.e. salaried segment, large-ticket segments and customers with better track records).

Access to credit scores would increase competition

For a long period, India lacked credit bureaus, which made it difficult for banks to enter into the retail loans segment. Hence, banks relied mostly on their limited internal databases to make credit decisions which were of limited use. Nevertheless, NBFCs were able to tap these customers based on the soft information and feet-on-street collection team. However, the increasing penetration of credit bureaus has made it relatively easier for banks to tap into these customer segments. The penetration of credit bureaus has increased from 10% in FY10 to 22% in FY15.

Exhibit 36: Increasing penetration of credit bureaus in India

Source: World Bank, Ambit Capital research

Moreover, many NBFCs were not sharing the credit history of their customers with credit bureaus, fearing poaching of their customers by other lenders. Hence, these traditional NBFC customers remained under the radar of banks. However, a RBI circular issued in January 2015 has made it mandatory for all banks and NBFCs to share their customer data with credit bureaus. This should give banks access to the track records of NBFC customers in rural/semi-urban geographies and hence should help banks enter into the traditional NBFC segments which they were not able to break into due to lack of creditor history.

1,515

457

2,357

744

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500

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Bank branches (Top 5 pvt) - Semi-urbanand rural

Auto NBFC branches

Branch additions

FY10-12 FY12-14

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FY10 FY11 FY12 FY13 FY14 Jun-14

Credit bureau coverage (% of adults)

Increasing coverage of credit bureaus is making it easier for banks to penetrate into segments which were earlier dominated by NBFCs

The new regulations issued in January 2015 made it compulsory for NBFCs to share the credit history of their customers with credit bureaus; this would make credit appraisal relatively easier for banksin the traditional NBFC segments

Auto NBFCs


With increased competition from banks, we believe NBFCs would find it difficult to maintain their historical profitability and growth. Our channel checks suggest that increased competition from banks is already resulting in higher pricing pressure in almost all auto financing segments for NBFCs, including tractors. This is evident from the fact that yields of almost all of the NBFCs have hardly improved despite the proportion of higher-yielding assets (like small LCVs and used assets) increasing in their book.

#2: Closing regulatory arbitrage to depress RoEs NBFCs have traditionally enjoyed regulatory advantages vis-à-vis banks in the form of relaxed NPA provisioning norms, higher ability to leverage and no regulatory requirements like CRR/SLR investments. These regulatory advantages increased the competitiveness of NBFCs (vs banks) and also helped them generate higher RoEs.

No SLR, CRR and PSL requirement: Unlike banks, NBFCs do not have regulatory requirements like investing a large portion of their resources into SLR, CRR and priority sector loans. These exemptions give an advantage to NBFCs over smaller banks that do not have large low-cost deposits. Consequently, NBFCs with superior ratings (such as Sundaram Finance and M&M Finance) have been able to compete with smaller regional banks.

Higher ability to leverage: Loopholes in the securitisation guidelines and lower tier-1 capital requirement meant that NBFCs were able to leverage their balance sheet significantly up to FY11.

180 day NPA recognition: NBFCs were allowed to recognise NPAs at 180 day delinquencies (vs 90 days for banks) which gave them more flexibility to operate in segments (such as tractors, used vehicles and LCVs) where payments from the borrowers were erratic.

However, since 2011, the RBI has been gradually closing the regulatory arbitrage between banks and NBFCs and has already closed two out of three arbitrages mentioned above.

Exhibit 37: The RBI has closed the regulatory arbitrage between banks and NBFCs

Key parameter Before regulation After regulation Impact

Capital Adequacy (FY11/15)

Minimum CAR of 12%; Tier-1capital of 7.5%

Minimum CAR of 15%; Tier-1 capital of 10% Decreased the leverage capability of NBFCs

Credit enhancement on assignments (FY13)

Credit enhancement was given 100% risk weight

Credit enhancement to be deducted from capital funds Decreased the leverage capability of NBFCs

Asset provisioning (FY15) 180dpd NPA; Standard asset provisioning of 0.25%

90dpd NPA by FY18; Standard asset provisioning of 0.40%

RoEs could decline by 0.2-2.5% due to decline in yields and increase in credit costs


Moreover, the current RBI governor, Mr Raghuram Rajan, at various forums has mentioned that the RBI wants regulations to be institutional-neutral and it would close all regulatory arbitrage between different institutions going forward. Hence, there could be more regulations for NBFCs which could further impact their profitability.

Increasing competition from banks would structurally impact growth and profitability of NBFCs

NBFCs have traditionally enjoyed regulatory arbitrage over banks in terms of high leverage, lax NPA recognition norms and no regulatory requirements like CRR/SLR

However regulatory arbitrage between banks and NBFCs is diminishing with changing regulations

Auto NBFCs


#3: Lower availability of low-cost funding Indian banks are required to lend 40% of their loans to the weaker sections of society; these loans are called priority sector loans (PSL loans). However, prior to FY12, banks were able to classify their direct loans to auto NBFCs as part of their priority sector lending (PSL) requirement. Also, banks buy securitised pools from NBFCs to meet their PSL requirement.

The penalty for not meeting the priority sector requirement was very high for banks, as they had to invest the shortfall in very low-yielding NABARD bonds (5-6% lower than normal lending rates). Hence, banks were happily lending to NBFCs under the priority sector at much lower rates vs the prevailing lending rates; for example, banks were lending to NBFCs at rates as low as 7% when they were lending at ~10-11% to similar rated other corporates, as the yield on NABARD bonds was 6%.

However, various regulatory changes around priority sector lending guidelines and securitisation rules over the last 3-4 years have led to a decrease in the availability of low-cost funds for NBFCs from banks under the priority sector. This has structurally increased the funding costs for various NBFCs.

Exhibit 38: Regulatory changes that impacted low-cost PSL funds for NBFCs

Year Regulatory change Impact on NBFCS

FY12 Direct lending to NBFCs was removed from the priority sector

Reduced the availability of on-balance-sheet low-cost borrowing for NBFCs

FY13 Introduction of 8% spread cap above the base rate of the lending bank for PSL loans

This reduced the amount of assets available with NBFCs for securitisation under PSL given high yield on their loans

FY13 Minimum holding period of 3-12 months before securitisation vs no requirement earlier

This reduced the amount of assets available with NBFCs for securitisation (for example, gold loan NBFCs were forced out of the securitisation market because of this rule given the low tenure of their loans)

FY13 Beneficial interest of 5-10% in the securitised pool, vs no requirement of beneficial interest earlier

This reduced the amount of assets available for PSL funding up to 3-4 percentage points for certain NBFCs

FY15 Legacy RIDF bonds counted under PSL obligations of banks, vs not being counted earlier

This reduced the demand for PSL loans originated by NBFCs by up to 50% over FY15-16

FY15

New norms have added large-ticket-sized loans given to the agricultural infrastructure, social infrastructure, medium enterprises and renewable energy sector to the PSL category

This could further reduce the demand for PSL loans originated by NBFCs

Proposed

The draft rules have proposed that banks that are over-achieving priority sector targets can issue PSLCs to under-achieving banks for a market-driven fee. The draft guidelines have excluded NBFCs from this arrangement. Final guidelines are still awaited.

This could further reduce the demand for PSL loans originated by NBFCs as over-achieving banks could meet the requirements of under-achieving banks


This has structurally increased the funding costs for various NBFCs, as the proportion of low-cost off-balance-sheet funding for auto financing NBFCs has decreased for auto NBFCs over the last four years.

Exhibit 39: Average securitised assets for all auto NBFCS have declined over FY11-15


65.8%

49.7%44.5% 43.7%

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Securitised assets as % of total AUM

NBFCs were preferred vehicles for banks to meet their priority sector lending requirements, ensuring abundant lower-cost funds for NBFCs; however, changing regulations on priority sector lending and securitisation are depleting this low-cost funding source for NBFCs

Auto NBFCs


#4: Consolidation in the fleet industry could marginalise NBFCs Both the passenger vehicle and commercial vehicle fleet industry in India is fragmented. As per some estimates, ~75% of commercial vehicles in India are owned by operators who own less than 5 trucks. The passenger vehicle industry is even more fragmented with no large operators in this industry.

The fragmented nature of the fleet industry in India is beneficial for NBFCs, as reach, credit appraisal and collections become difficult for banks in a fragmented segment. NBFCs have survived the competition from banks by funding:

(i) Small vehicle operators or driver owners, which banks find difficult to reach or do not find attractive to lend to due to lack of credit history or higher collection costs.

(ii) Medium or smaller vehicles, as single truck owners find it difficult to buy more expensive large vehicles.

Even the funding pattern of banks and NBFCs clearly shows that all large fleet operators borrow from banks, with NBFCs only left with individual and small operators. Hence, consolidation in the fleet industry could be a negative for NBFCs as and when it happens.

Whilst it is too early to pass some definite judgment, some early trends are pointing towards a consolidation in the industry.

Increasing size of vehicles could marginalize NBFCs

Over FY08-15, sales of vehicles on tonnage basis is increasingly getting polarised to heavy commercial vehicles (25 tonnes and more) and light commercial vehicles (sub-7.5 tonnes). Especially, the share of >25 tonne vehicles in total tonnage sold has gone up from 18% in FY08 to 48% in FY15.

The increasing share of high tonnage trucks in sales has been driven by increasing widening of highways from 2 lanes to 4 lanes. Thus, operating bigger trucks upon interstate routes has become more viable, due to: (i) reduced transportation time due to lesser number of trips; (ii) lower costs per tonne, such as toll and road tax, driver wages, fuel etc.

Moreover, increasingly stricter enforcement on a nationwide overloading ban in certain states has also led to increasing demand for larger tonnage vehicles.

Exhibit 40: Increasing share of bigger trucks in CV freight


7% 10% 11% 9% 11% 15% 17% 12%

74% 73% 65%55% 48%

49% 48%41%

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FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Sub 7.5 tonnes > 7.5 tns & <= 25 tns > 25 tonnes

Smaller ticket sizes and a fragmented customer base are the best combination for NBFCs to thrive, as banks find it difficult to reach and profitability serve this segment

Hence, increase in share of bigger vehicles in commercial vehicles sales is a negative for NBFCs

Auto NBFCs


Exhibit 41: With highways moving to more than four lanes…

Source: CRISIL, Ambit Capital research

Exhibit 42: …goods traffic composition has also polarised to HCVs and LCVs

Light Goods Vehicle (%)

2/3 axles trucks (%)

Multi-axle vehicle (%)

Section of NH71A 2011 20.9 56.8 22.3

2014 22.1 37.9 40.0

Section of NH18 – AP 2010 20.3 74.4 5.3

2014 15.3 56.8 27.9

Section of NH5 – 2011 12.7 73.7 13.6

2014 14.7 55 30.3

Source: Technical Note by V R Techniche Consultants Pvt. Ltd, Ambit Capital research

The target segments of NBFCs are individual truck drivers or small operators, who find it relatively unaffordable to buy and operate large trucks due to: (i) Heavy down-payment for such heavy tonnage vehicles (down-payment of `200,000-400,000 for a truck of `20mn); (ii) High loan EMIs, which implies the need for freight visibility which a SRTO may not have. Fleet operators enjoy greater advantages on pricing due to larger vehicles, which give them more economies of scale.

That said, increasing share of LCVs in CVs also means that NFBCs that are strongly positioned in the LCV segment should benefit going forward.

GST would accelerate further polarisation…

The introduction of Goods and Services Tax (GST) could further accelerate the polarisation of CV sales to HCVs and LCVs. This is because the currently fragmented logistics network will adopt the hub-and-spoke model:

(1) Currently, manufacturers and wholesalers have fragmented warehousing facilities spread amongst different states. This is primarily to circumvent taxes like CST (Central States Tax) given that goods warehoused in the state of sale would not be charged with CST. Whilst this has led to savings on tax, this has also made the logistics supply chain very fragmented and inefficient. (2) However, GST will eliminate the need for such tax planning, as it will make CST redundant. Consequently, the logistics chain will consolidate to different hubs and spokes based purely on economies of scale and efficiency.

Exhibit 43: Savings on CST on state-level warehousing has resulted in very fragmented logistics chain…


Exhibit 44: However, post GST, the logistics chain will evolve to the hub-and-spoke model


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FY09 FY13

Four/Six/ Eight Lane Two Lane One Lane

Introduction of goods and services tax could further increase the share of bigger vehicles in CV sales,negatively impacting NBFCs

Auto NBFCs


With the hub-and-spoke model coming in, CV sales could get further polarized as HCVs will be more preferable to MCVs in interstate movement of goods for hub transfers, and LCVs will be more preferable for short haulage spoke transfers. Both these segments would grow at the cost of MCVs.

(3) Whilst MCVs (medium commercial vehicles) would be the preferred mode of transport for intra-state transfers between the hub and spoke, their growth would be more than offset by their loss of market share in interstate/intra city haulages routes towards HCVs/LCVs.

Stringent regulations could lead to consolidation

SRTOs sustain their business on overloading. Whilst overloading has been strictly banned in India since 2005, its implementation has been strictly enforced only by few states or geographies. Stricter implementation of the overloading ban could result in many of the SRTOs becoming unviable (http://goo.gl/yyNdsm).

Taxi aggregators could lead to consolidation in passenger segment

The advent of fleet taxis (such as Meru Cabs and Tab Cabs) and taxi aggregators like Uber and Ola could lead to banks finding it easier to fund these customers, as it becomes easier for them to predict the cash flows and collect money from the operators via the aggregators. A case study in point is SBI’s tie-up with Ola, which it utilises to approve the loan within 24 hours at 10% down-payment. The repayment of the loan is trip-wise, with some portion of the earnings of every journey going towards loan repayment. Such a repayment mechanism also helps in early detection in case of default.

Stringent regulations on overloading could decrease profitability of small operators and could marginalise them

Taxi aggregators like Uber and Ola are making it easier for banks to fund the hitherto fragmented commercial passenger vehicle industry

Auto NBFCs


So what’s the way forward for NBFCs? No clear answer By nature, NBFCs are opportunistic lenders in niche segments with no material sustainable competitive advantages. Either banks enter these niches (car loans and new CVs loans in the prime segment) and take market share away from NBFCs or the NBFCs become dominant in the segment to the extent that there is no further scope for growth (SHTF in used vehicle financing). Now based on increasing competition from banks, lack of regulatory advantages and the changing nature of the auto industry, NBFCs are structurally on a weak footing. Going forward, we expect the growth and profitability of NBFCs to be lower than the historical levels.

Reinvention a must – expect move towards higher yield and lower opex models However, history has shown that many NBFCs have been reinventing themselves over the years to survive the changing regulatory regime and the changing business environment. Many NBFCs have survived many cycles. Examples include: (i) SHTF emerging as a used vehicle financier by making the drivers owners of the vehicles; (ii) Cholamandalam realigning its business mix towards LCV loans, mortgages and used vehicle loans and moving away from personal loans and MHCV loans; (iii) Magma moving towards tractor loans, mortgages and SME loans and away from CV/CE loans and passenger vehicle loans.

Companies that could not evolve with the changing situations have ceased to exist. Examples include Apple Finance, Anagram Financial Services and Gujarat Leasing, which were very prominent auto financiers in the early heydays of the sector.

NBFCs that keep on evolving with the changing times would continue to deliver decent profitability and loan growth despite all the structural challenges. So NBFCs that would keep aligning their businesses to the lending segments where banks are not present or/and develop low-cost operating models in the existing segments to compete with banks would continue to exist and perform reasonably well.

… but how would NBFCs fare in the mid-term? We have analysed five auto financing NBFCs in this note: Shriram Transport Finance (SHTF), M&M Finance (MMFS), Cholamandalam Finance (CIFC), Magma Fincorp (MGMA) and Sundaram Finance (SUF). Given that all the five NBFCs analysed in this report have been in existence at least 20 years, it would be safe to assume that all of these NBFCs have been able to evolve with the changing times. Hence, rather than evaluating these NBFCs on their structural strengths, we have ranked these NBFCs on their ability to generate superior profitability and growth in the medium term based on their positioning in the changing regulatory regime and trends in the auto industry.

Growth - High growth days are behind us The credit growth of NBFCs in the medium term would depend on: (1) the growth rate in the segments where individual NBFCs are strong; (2) change in the level of competitive intensity in these segments; and (3) NBFCs’ current market share in these segments. In this context, whilst NBFCs that are exposed to MHCVs and cars seem to be the biggest beneficiaries (given better growth trends in the near term), NBFCs’ AUM growth in some of these segments could be slower than the historical averages given increasing competition from banks in these segments. Moreover, the used CV segment is relatively less competitive than other segments but lower growth vs the historical trends coupled with increased competition from other NBFCs and SHTF’s high market share in this segment means that SHTF’s growth might remain anaemic going forward. Moreover, the sectors which have are less competitive (LCVs and tractors) are facing a cyclical downturn, impacting growth in these segments.

Increasing competition, changing regulatory regime and consolidation in the fleet industry mean that NFBCs are structurally on a weak footing in the auto financing segment

Hence, like what they have done in the past, NBFCs would have to keep on evolving to survive in the auto financing segment

NBFCs that would keep on evolving and realigning their business modes to keep pace with changing regulatory and competitive regime should survive and do well going forward

High growth days of NBFCs are over and they would have to settle for lower growth rates going forward; NBFCs with higher exposure to CVs and cars are better placed on near-term growth prospects

Auto NBFCs


In the exhibit below, we have provided our expectation of growth for individual NBFCs assuming that these NBFCs would not take the unnecessary risk to achieve growth.

Exhibit 45: AUM growth – CIFC is best placed

Particulars FY13-15 AUM CAGR

FY15-17E AUM CAGR Ranking Comments

SHTF 9% 15% Uptick in old and new CVs as well as PVs should result in increase in SHTF’s growth, given high exposure of its book to MHCVs and PVs (92% of AUM).

MMFS 15% 11%

Despite an uptick in auto sales (ex-tractors), we expect MMFS’s AUM growth to continue to be muted at 11% CAGR over FY15-17E. Lower growth in its UV and tractors portfolio (collectively ~50% of MMFS’s loan book) would be driven by: (i) Loss of market share and muted rural UV sales; and (ii) Rural slowdown and lack of increase in infra spending posing a challenge to the tractors book.

SUF 4% NA With high exposure to CVs and cars (83% of AUM), SUF stands to enjoy strong visibility to growth.

CIFC 16% 19% We expect 19% CAGR in CIFC’s AUM over FY15-17E, driven by uptick in the CV, PV and old CV segments.

Magma 10% 8% Despite the uptick in CVs and PVs, we expect a muted ~8% AUM CAGR in FY15-17E, as Magma realigns exists its low profitable products and geographies.

Source: Ambit Capital research. Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

Margin resilience – CIFC is best placed Whilst the high margins of auto financiers are facing competitive and regulatory headwinds, tailwinds in the form of declining funding costs, change in the liability mix and ALM mismatch can help some of the NBFCs improve their NIMs from hereon. CIFC is the best placed in our framework of: (i) ability of an NBFC to face a pricing war from banks; (ii) exposure to regulatory headwinds of 90day NPA norms and lower demand for securitisation; (iii) ALM mismatch; and (iv) headroom for liability mix from banks

Exhibit 46: Chola is best placed to maintain its margins

Particulars SUF SHTF MMFS CIFC MGMA

Pricing power Negative impact of regulations on NIMs Positive impact ALM mix Ability to change liability mix to improve funding cost

Overall Positioning

Source: Ambit Capital research. Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

#1: Pricing power amidst intense competition – CIFC well placed

Despite competitive pressures in auto financing segments like new CVs and new PVs, certain segments have been relatively unscathed by the pricing pressure from banks such as used CVs, used PVs and LCVs. This is because banks lack the collection expertise for such segments. NBFCs that are well positioned to grow in these segments should be in a stronger position to maintain their yields. In our framework, CIFC and MMFS emerge as the best NBFCs in terms of their ability to withstand pricing pressures from banks, with 50% and 41% of their AUMs exposed to the above-mentioned segments. Note that whilst 92% of SHTF’s AUM should qualify as a segment with pricing power, as per our definition, we have excluded the used MHCVs portion, as SHTF would face pricing pressure from NBFCs, if not banks, in both the new and used MHCV financing space.

Exhibit 47: Auto financing segments – LCVs, tractors and used assets would be the key target of NBFCs Particulars MHCVs LCVs PVs Tractors Used MHCVs Used LCVs Used PVs

FY15 financing market (` bn) 392 139 1,149 145 214 131 131

Yields 10.5%-14% 12.5%-18% 10.5%-16% 14%-21% 18%-25% 18%-25% 20%-26%

Credit costs 1%-3% 2%-4% 1%-3% 2%-5% 2%-6% 2%-6% 3%-5%

NBFCs positioning vs banks Weak Strong Weak Strong Strong Strong Strong


NBFCs with a presence in the segments with higher pricing power, lower exposure to securitisation, higher floating rate liabilities and higher headroom to change liability mix towards lower-cost liabilities are best placed to protect their margins

CIFC and MMFS have better pricing power due to their higher presence in segments like LCVs, tractors and used vehicles

Auto NBFCs


Exhibit 48: Which NBFC will maintain its pricing power?

% of AUM SUF SHTF MMFS CIFC MGMA

Used CVs and PVs 12% NA 13% 19% 12%

LCVs 11% NA 10% 24% 0%

Tractors 3% NA 18% 7% 18%

Total 26% 35% 41% 50% 30%

Relative strength

Source: Ambit Capital research; Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

#2: Regulatory headwinds – NIMs of SHTF most exposed

Regulatory changes such as 90day NPA provisioning and declining supply for low-cost securitisation funding should compress the NIMs of the auto financiers. SHTF and MMFS are the most exposed on this front.

Exhibit 49: SHTF’s and MGMA’s NIMs are the most exposed to regulatory challenges Impact of regulations SUF SHTF MMFS CIFC MGMA

90 dpd NPA migration Declining Securitization Overall

Source: Ambit Capital research; Note: - Strong; - Relatively Strong; - Average;

- Relatively weak.

i) 90dpd NPA provisioning – Migration to 90day NPA provisioning implies that there would be lesser assets available to recognise interest income on and could result in a ~2-33bps decline in yields across auto financiers. Our analysis assigns a high score to those auto financers whose yields would be the least impacted due to the above-mentioned changes.

Exhibit 50: MMFS is most impacted from 90dpd NPA provisioning Particulars SUF SHTF MMFS CIFC MGMA

Impact on yields 0.02% 0.25% 0.33% 0.11% 0.07%

Rank


- Relatively weak.

ii) Declining securitisation – The classification of legacy RIDF bonds into PSL loans and the broadening of definition of PSL loans over FY14-15 have led to a decline in demand for non-agri-based PSL loans, which auto loans are predominantly classified as MMFS and CIFC, whose funding is less dependent on securitisation and that have a higher proportion of a much-sought after agri PSL on their loan book, would be the least impacted due to this regulatory change. Note that, to calculate exposure to agri loans, we have accounted for tractors and LCVs as a percentage of AUM.

Exhibit 51: Impact of declining securitisation on auto financiers


Securitization (% of liabilities) 13% 18% 6% 14% 35%

Agri PSL (% of AUM) 16% 17% 28% 25% 18%

Total


- Relatively weak.

SUF would be least impacted on yields because of a change in regulations

Auto NBFCs


#3: Asset-liability mismatch – MMFS are best placed

NBFCs with net higher duration should stand to benefit more in a declining rate environment, as their liabilities price faster than their assets. MMFS and MGMA have better scores on this metric relative to other NBFCs primarily due to the higher asset duration of their books owing to their significant exposure to tractor financing which is a longer tenor product as compared to other financing segments.

Exhibit 52: Impact of declining interest rates on auto financiers

ALM Mix SUF SHTF MMFS CIFC MGMA

Asset duration – A 1.90 1.67 2.30 1.90 2.10

Liability duration – B 1.50 1.91 1.29 1.23 1.34

Equity (% of AUM) – C 18% 15% 16% 11% 8% Leverage adjusted duration Gap – A-B(1-C) 0.68 0.05 1.22 0.80 0.87

Ranking


- Relatively weak.

#4: Mix change from banks to wholesale market – CIFC best placed

Auto financiers have additional levers to manage their cost of funds by realigning their bank borrowings to relatively cheaper wholesale borrowings. In fact, wholesale borrowings can be relatively cheaper by ~55-115bps across NBFCs, depending on their credit rating and risk aversion in bond markets. Magma and CIFC are best placed in this metric due to a combination of high proportion of bank borrowings in their liabilities and higher differential of cost of funding.

Exhibit 53: Impact of declining interest rates on auto financiers


Banks (% of liabilities) 8% 29% 43% 55% 42% Differential between bank and wholesale rates 0.90% 0.55% 1.00% 0.75% 1.15%

Headroom available to lower cost of funds by lowering contribution of banking funds*

NA 0.05% 0.23% 0.26% 0.26%

Blended ranking Source: Ambit Capital research; *Note – Assuming banks would be ~20% of NBFCs liability mix on a sustainable

basis. - Strong; - Relatively Strong; - Average; - Relatively weak.

Operating leverage – MGMA/CIFC is best placed

Given the pricing pressure in the auto financing space, the ability of the NBFCs to improve their operating efficiency would help improve their profitability. Operating efficiency could come either through internal cost-cutting measures, utilisation of excess capacity or introduction of low-opex products like LAP. Our ranking of the auto financing NBFCs on the three metrics indicates that CIFC and MGMA are best placed to demonstrate operating leverage during an upcycle.

Exhibit 54: MGMA and CIFC are best placed to benefit from operating efficiency


Internal cost-cutting measures Utilisation of excess capacity Total

Source: Ambit Capital research; Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

MMFS and MGMA have the best ALM mix to benefit from a declining rate regime

CIFC and MGMA have the biggest headroom to change their liability structure towards lower-cost liabilities

MGMA and CIFC have the highest operating leverage

Auto NBFCs


#1: Internal cost-cutting measures – Magma is best placed

Internal cost-cutting measures could include: (i) Reduction of origination fees – through increased direct sourcing by avoiding DSAs and increased cross-selling; AND/OR (ii) Restructuring business model – Re-aligning of employee incentives with performance, cutting the flab in the employee structure, improved use of technology and exit from non-profitable geographies and/or products. Our bottom-up analysis along with management discussions reveal that Magma is best placed on this metric.

Exhibit 55: MGMA is best placed in terms of internal cost-cutting measures


Origination fees (% of AUM) 0.28% 0% 0.50% 0.77% 0.69% Scope for reduction in origination fees Scope to restructure the business model

Total


- Relatively weak.

#2: Utilisation of excess capacity – CIFC is best placed

Two operating models exist for NBFCs to manage their sales, credit and recovery functions:

Customer-centric model, wherein the NBFC employee is responsible for origination, appraisal and collection from the customer. Whilst this is a cost efficient way of doing business on a small scale, it is susceptible to underwriting of riskier customers and hence higher asset quality risks. For the model to be successful, strong internal controls and employee incentive structure are required. NBFCs like SHTF, MMFS and SUF follow this model.

Function-centric model, wherein the origination, appraisal and collection process for a single customer is spread across employees. Whilst such a model would minimise the asset quality and fraud risks, this model is a costlier way of doing business on a low scale and especially during a downturn as excess employee capacity in their sales vertical remains under-utilised. NBFCs like CIFC and MGMA follow this model.

Hence, during a period of recovery, NBFCs following the function-centric model should enjoy greater operating leverage as compared to customer-centric model.

MGMA and CIFC are best placed on this metric, as they have the lowest AUM/employee which is indicative of excess capacity currently sitting in their cost structures.

Exhibit 56: MGMA is best placed in terms of utilisation of excess capacity


Function centric model AUM/employee (` mn) 46 34 26 19 19

Overall excess capacity


- Relatively weak.

MGMA and CIFC are working towards improving their operational efficiency

MGMA’s and CIFC’s operating model is best suited during times of recoveryand higher growth

Auto NBFCs


Credit costs – Regulatory changes and rural stress would offset cyclical improvement Whilst a generic economic improvement should lower the delinquency levels of auto financiers, regulatory headwinds (90dpd NPA provisioning and 40bps standard provisioning) along with high exposure to a stressed rural India could hamper the decline in credit costs in the upcycle.

We use the following parameters in our framework to assess the asset quality risks of auto financiers:

(i) Regulatory impact: This would include one-time additional credit costs due to migration to 150/120/90 day NPA norms by FY16/17/18, as the NPAs go up by 30-40% are each of the subsequent buckets. Moreover, credit costs would also be structurally higher for the auto financiers, as NPAs structurally inch up relative to their historical 180dpd-based classification. MMFS and SHTF are the most exposed on this due to high delinquencies in the 90-180 day bucket.

(ii) PCR adjusted for 90dpd NPAs: Whilst NPAs of auto financiers would increase on migration to 90dpd norms, auto-financers also have levers to manage their credit costs by lowering their provisioning coverage ratio. We evaluate the headroom that each NBFC has towards lowering their provisioning coverage and find MGMA to be the most exposed on this metric due to its lowest provisioning coverage.

(iii) Troubled exposure: Whilst an economic recovery should help improve asset quality, we believe certain segments will suffer from the ongoing stress. These segments would be tractors (more exposed to rural spending and monsoons), CE (lack of rural infra spending) and LAP (declining property prices). CIFC and MGMA are the most exposed on this parameter.

Exhibit 57: Quantifying the impact on NBFCs from an increase in credit costs


90dpd NPAs – recurring impact (% of AUM) 0.07% 0.72% 0.89% 0.38% 0.32%

90dpd NPAs – one time impact (% of AUM) 0.01% 0.11% 0.13% 0.06% 0.05%

PCR – adjusted for 90dpd NPAs 49.3% 39.7% 30.5% 22.2% 16.0%

Troubled exposure (Tractors +CE+LAP) 11% 10% 25% 37% 38%


Exhibit 58: Relative ranking – SUF is least vulnerable to an increase in credit costs Particulars SUF SHTF MMFS CIFC MGMA

Regulatory impact PCR – adjusted for 90dpd NPAs Troubled exposure Total


- Relatively weak.

Overall, Sundaram Finance fares the best in our framework on asset quality risks.

Based on overall parameters, we find that CIFC is best positioned to display earnings growth based on its positioning on all the key parameters of profitability growth.

Exhibit 59: Chola is best placed to preserve its earnings growth Particulars SUF SHTF MMFS CIFC MGMA

AUM Growth drivers Margin resilience Scope for operating leverage Scope for improvement in credit costs Blended ranking


- Relatively weak.

We expect SUF to show the best trends in terms of asset quality going forward

Auto NBFCs


Valuation and recommendations Despite under performance of most of the auto NBFCs, their valuation multiples are yet to reflect their current sub-par profitability. SHTF, MMFC and Magma have been trading at a discount to their historical average valuations and much lower than their historical peak valuations due to pressure on profitability at present. CIFC is trading at a premium to historical valuations given the sharp improvement in its growth and profitability over the last 3-4 years. Sundaram Finance has been rerated significantly over the last couple of years and is trading at its peak multiples despite pressure on profitability.

Exhibit 60: Relative valuations

Company Mcap Price Reco. TP Up/

down P/B P/E EPS CAGR ROA ROE

US$bn Rs

Rs FY16E FY17E FY16E FY17E FY15-17E FY16E FY17E FY16E FY17E

Shriram Transport 3.4 930 SELL 745 -20% 2.0 1.8 17.3 12.8 25% 2.0% 2.1% 14.5% 15.3%

M&M Finance 2.1 233 SELL 225 -3% 2.0 1.8 15.2 11.8 11% 2.2% 2.5% 13.1% 15.1%

Sundaram Finance 2.6 1,515 NA NA NA 5.2 4.5 34.2 29.5 9% 2.8% 2.9% 16.9% 17.2%

Magma Fincorp 0.3 87 BUY 133 53% 0.9 0.8 11.0 6.3 25% 0.9% 1.5% 9.4% 13.3%

Cholamandalam 1.5 642 BUY 740 15% 2.8 2.4 22.0 15.6 17% 1.6% 1.9% 14.7% 16.8%

Average

2.6 2.3 19.9 15.2 18% 1.9% 2.2% 13.7% 15.6%

Source: Bloomberg, Ambit Capital research; Note* Based on Bloomberg consensus estimates

If we compare the relative rank of each of these NBFCs with their current valuation multiples, SHTF and SUF look overvalued and MMFS looks fairly valued. CIFC looks attractive due to its better positioning in the segment and Magma looks attractive due to its lower valuations.

Exhibit 61: CIFC is best placed in our framework with reasonable valuations

Source: Bloomberg, Company, Ambit Capital research; Note: Bubble size is one year forward RoE (%)

Cholamandalam Finance (BUY, 15% upside): CIFC fares the best in our framework in terms of its positioning to maintain its earnings growth despite regulatory and competitive challenges. CIFC enjoys not only mid-term positive catalysts of declining cost of funds and improving operating leverage to sustain its current RoAs, but is also well positioned to sustain its profitability and growth owing to its competitive strengths in LCV and old CV financing. Valuations at 2.4x FY17E P/B have further scope to rerate as CIFC delivers 20% EPS CAGR over FY15-18E driven by 19% AUM growth and ~30bps improvement in RoAs to ~2%. We initiate with a BUY and a target price of `740 (15% upside).

Shriram Transport (SELL, 20% downside): Whilst SHTF enjoys greater visibility to its growth as compared to its struggling peers, it lacks levers to improve its RoEs from current levels of ~12%, due to regulatory challenges (90dpd NPA norms, lower securitization levels), competitive headwinds (pricing pressure and loss of market share in old CV financing) and stress in its construction equipment subsidiary. Valuations at 1.8x FY17E P/B are expensive in the context of muted RoEs of 12%/15% over FY16/17E and a tepid 10% EPS CAGR over FY14-17E.

Shriram TransportM&M Finance

Sundaram Finance

Magma Fincorp

Cholamandalam

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Auto NBFCs


Magma Fincorp (BUY, 53% upside): Despite the much-awaited improvement in its NIMs, Magma’s RoEs (~10%) continue to lag its peers due to increase in operating and credit costs. This along with the prospects of lower AUM growth due to restructuring are adequately captured in the valuations of 0.8x FY17E P/B and 6.2x FY17E P/E, which are at a 50% discount to the peer average. However, Magma’s RoEs are likely to expand from ~11% in FY15 to 13% in FY17E, as: (i) its operational efficiency will improve, due to the ongoing business realignment, which would find further support from an eventual economic recovery; and (ii) its NIMs will expand due to change in the portfolio mix towards high-yield assets and change in the liability mix towards low-cost liabilities. This could lead to a significant rerating from current valuations of 1.3x FY17E P/B, making the risk-reward highly skewed in favour of an investor at current valuations.

MMFS (SELL, 4% downside): MMFS enjoys distinct competitive advantages in rural auto financing due to its parent’s dominance in tractors and UVs, and access to lower cost of funds. However, MMFS’s profitability would be structurally lower than the historical averages in the medium term due to a battery of headwinds such as: (i) a stressed rural economy; (ii) increasing competition in rural space; (iii) migration to 90day NPA norms; and (iv) parent’s (M&M’s) loss of market share in UVs. Whilst the stock has de-rated from 3x one-year forward P/B to 1.8x one-year forward P/B, its valuations are still factoring in robust earnings growth over FY15-17E. Consequently, we believe that more disappointments are likely in the near term for MMFS, due to lack of positive catalysts amidst a challenging regulatory and competitive environment.

Sundaram Finance (NOT RATED): In stark contrast to other NBFCs, SUF focusses on prime customers and directly competes with banks (only ~20% of its collections are in cash vs ~40-60% for its NBFC peers). Our analysis indicates that Sundaram Finance (SUF) could see its RoEs compressing due to: (i) pricing pressures in CV and car segments (~83% of AUM) where its directly competes with banks; (ii) absence of further levers to further lower its funding costs; and (iii) lack of availability of any operating leverage to offset such headwinds. The stock has significantly rerated over FY13-15 to 4.5x trailing P/B despite earnings CAGR slowing down to 1% during this period (vs 13% CAGR over FY08-15). With slower growth than peers and risks to sustainability of RoEs, it remains to be seen whether it can return to its historical growth trajectory and sustain its premium valuations.


The challenger Cholamandalam Finance (CIFC) enjoys not only mid-term positive catalysts of declining cost of funds and improving operating leverage to sustain its current RoAs, but is also well positioned to sustain its profitability and growth owing to its competitive strengths in LCV and old CV financing. Given the multiple structural and medium-term tailwinds, we expect CIFC to deliver 20% EPS growth over FY15-18E, driven by 19% AUM growth and RoAs improving by ~30bps to 2%. Our excess return based valuation of `740 implies 2.8x FY17E P/B and 17x FY17E P/E. We initiate with a BUY implying 15% upside.

Competitive position: STRONG Changes to this position: STABLE

Structural drivers in place to sustain its RoAs and growth CIFC is well positioned to capture profitable and structural growth in LCV financing by virtue of its competitive strengths of lower origination costs (0.5% of disbursement vs ~2% for peers as per our channel checks), lower delinquencies (NPAs at 2.8% vs 5.9%/16% for MMFS/TMF) and efficiencies of scale. Moreover, it should continue to gain market share in the used CV financing space (32% FY11-15 AUM CAGR vs 18% for SHTF) due to its strength in collections and a captive customer base for cross-selling. Such strengths in LCV and used CV financing should insulate CIFC’s profitability and growth from intense competition from banks in the prime segments of auto financing.

Medium-term levers to help improve current RoAs Despite competitive and regulatory headwinds, CIFC is likely to improve its RoAs by 30bps over FY15-18E to 2% as the company’s cost of funds is likely to reduce by ~80bps due to migration to cheaper wholesale market funding coupled with a systemic decline in interest rates – we expect ~75bps cut in policy rates by Mar’16. Also, operating efficiency (opex/AUM) would improve by ~50bps as uptick in growth utilises the idle sales force and reduces collection costs.

Safer LAP amongst its peers Whilst CIFC’s LAP book (29% of AUM) is vulnerable to declining real estate prices, increase in credit costs might not be substantial, as its collateral is more liquid than its peers due to lower-ticket-sized loans (average ticket size of `5mn vs industry average of `12mn) and a higher share of self-occupied residential properties (89% exposure vs industry average of 70%).

Valuations reasonable in light of sustainable growth and RoEs We expect CIFC to deliver 19% AUM growth over FY15-18E, with RoAs improving to 2%. Improving NIMs (6% to 6.3%) and improving operating leverage (from 3.1% to 2.8%), should offset marginally increasing credit costs (from 1.3% to 1.5%) over FY15-18E. Our excess return based valuation of `740/share implies 2.8x FY17E P/B and 17x FY17E P/E. We initiate coverage with BUY (15% upside from CMP). Key risk: Higher-than-expected delinquencies in LAP.

Cholamandalam Finance BUY

INITIATING COVERAGE CIFC IN EQUITY October 08, 2015

BFSI

Recommendation Mcap (bn): `101/US$1.5 6M ADV (mn): `31.8/US$0.5 CMP: ` 642 TP (12 mths): ` 740 Upside (%): 15%

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: GREEN

Catalysts Pick-up in LCV sales in 2HFY16

Performance


Analyst Details




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Key financials (` mn, unless specified)

FY14 FY15 FY16E FY17E FY18E

Total income 14,917 17,308 19,907 23,380 28,073

PAT 3,640 4,351 4,920 6,798 8,124

Dil. EPS (`) 25.4 30.0 32.5 43.2 51.6

BVPS (̀ .) 160.0 184.1 238.6 267.4 313.0

ROE (%) 17.1 17.5 15.7 17.4 17.8

P/E (x) 25.3 21.4 22.0 15.6 10.8 P/BV (x) 4.0 3.5 2.8 2.4 2.0 Source: Company, Ambit Capital research

Cholamandalam Finance


Snapshot of company financials Profit and Loss statement Year to March (̀ mn) FY16E FY17E FY18E

Net interest income 17,185 20,363 24,626

Fee based and other income 2,722 3,016 3,446

Total Income 19,907 23,380 28,073

Total expenses 8,187 8,987 10,144

Operating and other expenses 5,814 6,520 7,578

Employee Cost 2,373 2,467 2,566

Pre provision profit 11,720 14,393 17,929

Provisions 4,377 4,247 5,804

Profit before tax 7,343 10,146 12,126

Tax 2,423 3,348 4,001

PAT 4,920 6,798 8,124

Balance Sheet Year to March (̀ mn) FY16E FY17E FY18E

Networth 36,102 42,106 49,281

Borrowings 263,873 318,868 392,551

Total liabilities 299,975 360,974 441,832

Fixed assets 751 826 909

Investments 743 817 898

Loans and Advances 291,253 350,684 429,608

Cash and Bank Balance 3,748 4,122 4,535

Net working capital 3,480 4,525 5,882

Total assets 299,975 360,974 441,832

Company background

Incorporated in 1978, Cholamandalam (CIFC) is the NBFC arm of the Murugappa Group operating from over 534 branches, with an AUM of `254bn. Predominantly, CIFC is a vehicle financier, but it also has a presence in home loans, home equity loans, SME loans, investment advisory servicesand stock broking.

Timeline of events Year Event

1979 Commenced equipment financing business

1992 Commenced vehicle finance business

1995 Started stock trading business

1997 Started asset management business

2001 Started Chola Distribution for distribution of wealth management products

2006 JV with DBS Bank Singapore; commenced consumer finance

2007 Commenced home equity business

2008 Raised ~`2bn of incremental capital through rights issue

2009 Exited consumer finance business

2010 Sold asset management business; shifted focus on secured products such as vehicle finance and home equity

2011 AFC status JV with DBS terminated; raised ₹2.5bn of incremental capital

2012 Raised ₹2.1bn of incremental capital; Launched tractor and gold loans

2013 Capital infusion of `3bn through QIP

2014 Exited gold loan business

2015 Raised `5bn by issuing cumulative convertible preference shares; also applied for payment bank licence through its subsidiary

AUM growth over FY08-15

Key Ratios Year to March FY16E FY17E FY18E

AUM growth (%) 14.4 20.4 22.5

Dil Consol EPS growth (%) 8.5 32.8 19.5

Net interest margin (NIM) (%) 6.3 6.3 6.3

Cost to income (%) 41.1 38.4 36.1

Opex (% of AAUM) 3.0 2.8 2.6

Gross NPAs (%) 4.2 3.5 3.6

Credit costs (% of AAUM) 1.60 1.32 1.49

Provision Coverage (%) 39.7 43.0 50.0

Capital adequacy (%) 20.8 19.5 18.5

Tier-1 (%) 14.8 14.0 13.0

Leverage (x) 8.9 8.5 8.8

BVPS (̀ .) 238.6 267.4 313.0

Dil. EPS (`) 32.5 43.2 51.6

ROA (%) 1.8 2.1 2.0

ROE (%) 15.7 17.4 17.8


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From a rough ride to a dream run Incorporated in 1979, Cholamandalam Finance (CIFC) is the NBFC arm of the Chennai-based Murugappa Group. CIFC was focussed on vehicle financing; however, in FY06, it forayed into unsecured products like consumer/personal loans after entering into a joint venture with Singapore-based DBS Bank. The company faced some turbulent times during FY08-11 when its unsecured retail loan segment was under stress. However, from FY09 onwards, the thrust has been more on diversifying its loan book towards secure products like vehicle financing and mortgages. At present, ~69% of CIFC’s AUM consists of auto loans and ~29% is loan against property. CIFC clocked RoEs of 17.5% in FY15 primarily driven by 24% RoEs in its home equity segment, which was offset by weak RoEs of ~13% in the auto finance segment.

Exhibit 1: Synopsis of CIFC’s key business segments

Loan Product As a % of portfolio* IRR (%) Year of

introduction AUM CAGR

(FY13-15) Ticket size

range Estimated

RoA Major competitors

Vehicle Finance 69% 11% Tractor 7% 18-20% 2012 43% `0.5mn ~2-3% MMFS, LTFH, HDFCB, KMB, MGMA

HCV 9% 12%-14% 1992 7% `21mn ~1%-2% IIB, HDFCB, SHTF, ICICIBC, KMB

LCV 18% 14-17% 1992 -3% `0.5mn ~2%-3% TAMOFIN, MMFS, HDFCB, SUF

Car & MUV 10% 14-15% 1992 52% `0.8mn ~1%-2% HDFCB, SBI, ICICIBC, KMB, MMFS

3 Wheelers & SCVs 6% 14-16.5% 1992 -6% `0.2mn ~2%-3% TAMOFIN, MMFS, HDFCB, SUF

Old Vehicles 19% 16.5-21% 2006 13% `0.36mn ~2%-3% SHTF, MMFS, SUF, MGMA

Home Equity 29% 14-15% 2007 30% `3-5mn ~1%-2% HDFCB, ICICIBC, PSU Banks, BAF, foreign banks

Business Finance / Others 2% 15% 2006 35% `1mn ~1%-2%

Source: Company, Ambit Capital research. Note: * Portfolio as of March 2015.

Exhibit 2: Estimated profitability of different segments of CIFC (%) as of FY15

(as a % of AUM) Home equity Vehicle financing Blended

NIMs 5.4% 7.5% 6.8%

Opex 1.3% 3.6% 3.0%

Operating profits 4.1% 3.9% 3.9%

Losses and Provisions 0.5% 2.0% 1.3%

PBT 3.7% 2.0% 2.6%

Tax 1.2% 0.7% 0.9%

PAT 2.5% 1.3% 1.7%

Leverage(x) 9.8 9.8 10.2

RoE 24.3% 13.1% 17.5%

AUM growth ( YoY % change – FY15/FY14) 24% 3% 9%


The turnaround During FY06-09, CIFC ran into a rough patch due to an increase in bad assets in its recently-expanded unsecured personal loan book. Over FY06-10, credit costs increased from 1% in FY06 to 2.9% in FY10, leading to RoE declining from 10% in FY06 to 2.6% in FY10. CIFC almost went bust during this distressed period. CIFC navigated through the crisis only when the promoters came to the rescue of the company in FY09 by infusing `3bn of cumulative convertible preference shares to enable CIFC to write off losses in its loan portfolio.

Also, in FY10, the promoters bought out the 37.5% stake held by DBS in the company. CIFC discontinued its unsecured business after that and instead started focusing on growing its secured business like vehicle financing and home equity.

CIFC went through a rough phase over FY08-10 due to high delinquencies in personal loans



Exhibit 3: RoEs declined during FY07-10 due to surge in credit costs


Since then, the company has significantly turned around its business. During FY10-15, the company’s RoEs have increased from 2.6% in FY10 to 17.5% in FY15, with 76% EPS CAGR during this period. Loan book CAGR of 30% supported by improvement in asset quality and operating efficiencies led to this robust EPS growth and RoE improvement.

The strong profitability has resulted in strong stock price returns as well, with the stock rerating from 1.0x in FY10 to 2.4x one-year forward P/B at present.

Exhibit 4: CIFC has hit a purple patch over the last five years after a rough period

Particulars FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Total Income 6.3% 7.1% 9.2% 7.9% 6.5% 7.9% 6.9% 7.1% 7.1% 7.1%

Opex 2.9% 4.4% 5.3% 4.1% 3.1% 4.2% 3.9% 3.5% 3.1% 3.1%

Operating Profit 3.5% 2.7% 3.9% 3.8% 3.4% 3.7% 3.0% 3.5% 3.9% 4.0%

Provisions 1.1% 1.2% 2.3% 3.6% 2.9% 2.2% 0.2% 0.8% 1.3% 1.3%

Pre-Tax RoAs 2.4% 1.5% 1.6% 0.3% 0.4% 1.3% 2.6% 2.8% 2.6% 2.7%

Taxes 0.6% 0.5% 0.6% -0.4% 0.2% 0.5% 1.0% 0.9% 0.9% 0.9%

RoAs 1.8% 1.0% 1.1% 0.6% 0.2% 0.8% 1.5% 1.9% 1.7% 1.8%

Leverage 6.3 9.6 12.6 12.9 13.6 10.3 9.1 9.6 9.9 9.8

RoEs 11.4% 9.7% 13.4% 8.2% 2.6% 8.0% 13.9% 18.1% 17.1% 17.5%

PAT growth (%) 3% -12% 91% -28% -71% 401% 178% 78% 19% 20%

Diluted EPS growth (%) 1% -16% 60% -44% -74% 217% 154% 59% 11% 18%

AUM Growth (%) 30% 84% 77% -12% 9% 33% 47% 41% 22% 9%


Exhibit 5: CIFC’s fully diluted EPS CAGR …


Exhibit 6: … has led to a rerating of the stock


0%2%4%6%8%10%12%14%16%18%20%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Credit costs as a % of AUM (LHS) RoE (%, RHS)

1.8

5.7

14.4

22.8 25.4

30.0

-

5.0

10.0

15.0

20.0

25.0

30.0

35.0

FY10 FY11 FY12 FY13 FY14 FY15

Diluted EPS

0.5

1.5

2.5

Sep-11

Dec-1

1

Mar-12

Jun-12

Sep-12

Dec-1

2

Mar-13

Jun-13

Sep-13

Dec-1

3

Mar-14

Jun-14

Sep-14

PB Avg. PB -1 SD +1 SD

CIFC’s RoEs have increased from 2.6% in FY10 to 17.5% in FY15

76% CAGR



Is this outperformance sustainable?

With the stock already significantly re-rated, the key question is whether CIFC can sustain its growth and profitability not only in the near term but also over the long term. In the following sections, we have delved deep into CIFC’s business model and its competitive advantages to see if the company’s current growth and profitability is sustainable in the near term and long term and whether the risk-reward is favourable for investors at current valuations.

Exhibit 7: CIFC’s SWOT analysis

Strengths Weaknesses

CIFC is one of the largest non-captive/dealer-linked financiers, which enables it to participate in the sales growth of vehicles without taking undue risk on asset quality.

It has a well-diversified loan book across products (HCVs, cars, PVs, LCVs and old CVs), OEMs and geographies.

CIFC’s presence in both HCV and LCV segment through OEM tie-ups gives it an opportunity to source customers for its growth in old CV financing.

CIFC has received support from the Murugappa Group, which not only helps its raise money during periods of distress, but also opens additional growth opportunities (like agri-based lending).

CIFC’s cost of funds is higher compared to its peers by ~80bps due to lower credit rating, which is driven by the baggage of its debacle in personal loans.

CIFC’s business model involves high operating cost due to segregation of sales, appraisal and collection functions. Its opex /AUM in vehicle financing is at 3.6% compared to ~3.1% for its peers.

Opportunities Threats

Consolidation of the logistics sector into a hub-and-spoke model would drive increased sales of LCVs, which is CIFC’s key driver of profitability. The advent of GST could be a key catalyst for further sustainable growth of ~20-25% CAGR over FY16-17.

CIFC has an opportunity to lower its funding costs by ~20bps by moving away from expensive bank-based borrowings to cheaper wholesale borrowings.

CIFC’s business model enjoys high operating leverage, which can flow through the earnings when growth increases. Opex/AUM can improve by ~30bps over FY15-17E.

CIFC can leverage additional growth opportunities in agri-based lending through Murugappa Group companies like Coromandel, Carborundum and Eid Parry’s.

CIFC has been facing competition from banks on pricing (HDFC Bank) in its key product segments like LCVs (MMFS and TAMOFIN). Consequently, its pricing and asset quality would be dependent on actions taken by these players.

Migration to 90 day NPA recognition norms could structurally compress CIFC’s RoEs by ~110bps, driven by an 11bps decline in yields and a 6bps increase in credit costs.

Declining property prices could threaten CIFC’s profitability and growth in its highly profitable home equity portfolio (29% of AUM).




Vehicle financing – Waiting for the uptick Vehicle loans contributed to 69% of CIFC’s total AUM as at FY15. CIFC’s vehicle financing book is well diversified across products (HCVs, LCVs, SCVs, used CVs, cars and UVs), across OEMs (Original Equipment Manufacturers) and across geographies, with no state contributing more than 12% of the loan book.

Exhibit 8: Vehicle loan book diversified across products


Exhibit 9: A geographically well-diversified branch network

State As a % of AUM

Maharashtra 12%

Rajasthan 10%

Tamil Nadu 9%

Chattisgarh 8%

Madhya Pradesh 7%

AP and Telangana 7%

Gujrat 6%

Punjab 6%

West Benal 5%

Uttar Pradesh 5%

Karnataka 5%

Other states 21%


Strengths in key segments to sustain its profitability Whilst competition is heating up in prime customer segments of HCV and car financing, our channel checks and analysis indicate that CIFC should broadly be able to maintain its RoEs and growth in the vehicle financing segment, as the mix of LCVs and used CVs continues to grow in its loan mix.

LCV financing: LCV sales growth currently remains muted due to cyclical pressures; however, LCV sales might grow structurally due to the evolution of the hub-and-spoke model, which could be further accentuated once GST is implemented. CIFC will be well positioned to capture profitable growth in the LCV financing segment by virtue of its competitive strengths of lower originating & credit costs and scale efficiencies. Its originating costs are lower by virtue of: (i) high repeat customers; (ii) lower dealer payouts; and (iii) OEM tie-ups.

CIFC’s credit costs are lower in the segment as compared to its peers due to: (i) lower OEM pressure; (ii) access to borrower credit history; (iii) loan loss participation from select OEMs; and (iv) diversification. Structural growth in LCV sales should provide ample opportunities for CIFC to clock in ~20-25% CAGR in the segment in the medium term.

Used CV financing: CIFC’s market share gain (FY11-15 CAGR of 32% vs 18% for SHTF) in the used CV financing space is underpinned by its competitive strengths in collections and a captive HCV/LCV customer base to cross-sell. CIFC’s growth in the highly-profitable used CVs segment will insulate its RoEs and growth from competition from banks in prime segments.

In the following sections, we articulate CIFC’s key strengths in each of the segments.

10%

13%

26%

15%

8%

28%

Tractor

HCV

LCV

Car & MUV

3 Wheelers & SCVs

Old Vehicles



LCV financing – The non-captive champion Whilst growth in LCV sales currently remains muted due to cyclical pressures, LCV sales should grow structurally due to the evolution of the hub-and-spoke model, which will be further accentuated by GST implementation. CIFC will be well positioned to capture profitable growth in the LCV financing segment by virtue of its competitive strengths of lower originating & credit costs and efficiencies of scale. Its originating costs are lower by virtue of: (i) high repeat customers; (ii) lower dealer payouts; and (iii) OEM tie-ups. CIFC’s credit costs are lower than its peers due to: (i) lower OEM pressure; (ii) access to borrower credit history; (iii) loan loss participation from select OEMs; and (iv) diversification. Structural growth in LCVs sales should provide ample opportunity for CIFC to clock in ~20-25% disbursement CAGR over FY15-17 in the segment.

Originally a financier of HCVs and PVs, CIFC started focusing on LCV financing in FY03, as increasing competition in HCVS and PVs started impacting its yields in these segments. Moreover, LCV was relatively a new and growing segment, with no major competition from large CV players in the segment, which helped CIFC expand in this segment. However, slowdown in LCV sales and stress in asset quality in LCV financing over the last two years have led to a decline in CIFC’s LCV loan book over FY14-15. LCVs currently form 34% of CIFC’s vehicle financing portfolio vs 50% of its auto loan portfolio in FY11.

Tough to penetrate = Higher yields Whilst yields have come off in LCV financing over FY12-15, they remain higher than other auto financing segments. The smaller size of the segment, high operating costs and high credit costs have resulted in yields in the segment remaining higher than other auto financing segments:

Small size of the segment: Lower ticket sizes imply that LCV financing is a relatively smaller financing opportunity than other auto financing segments. Its current annual financing potential is only ~`162bn in contrast to ~`435bn for MHCV financing and `1.5tn for PV financing. This keeps many financiers away from this market.

High operating costs needs scale: Ticket sizes of LCV loans at ~`0.4mn are much lower than other segments (`2.1mn for MHCVs and `0.8mn for PVs). Moreover, LCV financing is also characterised by high fragmentation of its customers (the maximum number of vehicles that a fleet operator in the LCV segment has is ~20 vehicles vs more than 500 vehicles in HCV segment). Smaller ticket sizes and a highly fragmented customer base result in higher operating and collection costs for the lender in the form of higher loan processing costs and a robust collections team. Hence, scale is important to be profitable in this segment, which has kept many financiers away from this segment.

Higher competition from captive financiers: Given that LCV financing is a relatively new segment with sub-prime profile of borrowers and high operating costs, most lenders have avoided this segment. Consequently, financing this product was entirely left to captive financiers. Some of these captive financiers indulged in risk-based competition (100%+ LTVs, lower customer profiles, financing on invoice value, etc) to boost sales of their parent company, which worked as an entry barrier for new entrants in this segment.

Small size of the segment and higher competition from captive financers are the difficulties in financing the LCV segment



How did CIFC penetrate this segment? Notwithstanding the challenges of lending in this segment, CIFC has been successful in garnering a meaningful market share in the LCV financing space, due to the following reasons:

Early mover advantage: CIFC started focussing in this segment in 2003, when most financiers were averse to lending in this segment. Early entry in the segment helped CIFC establish relationships with dealers, customers and OEMs much ahead of its peers.

OEM support: Partnering with an OEM gives a financier dealer connect and thus helps it originate new customers. Moreover, OEM tie-ups also help the financiers to become eligible for loss subvention and thus compensate for loan losses to a certain extent. Our channel checks suggest that CIFC was a preferred financier for OEMs, as:

- CIFC is not linked to a competitor: OEMs generally avoid entering into tie-ups with the NBFCs having strong linkages with rival OEMs due to the fear of targeting of customer leads. For example, Ashok Leyland will be wary of entering into tie-up with MMFS, as it fears that its customers could be diverted by the MMFS field executive to the MMFS dealership. CIFC, being an NBFC without any strong linkage to an OEM, is able to garner a lot of confidence with the OEMs in this regard.

- CIFC has an OEM-focussed sales architecture: CIFC has a unique organisational structure wherein not only the sales function is separated from the rest of the functions, but even the sales persons are segregated on the basis of the OEMs and products, having variable pay linked to the sales of the respective OEM. Thus, an executive tagged to M&M will be incentivised to fulfil the targets of M&M and not divert his leads to other OEMs like Tata Motors. Such architecture enables CIFC to focus on meeting the targets of the OEM with which it has entered into tie-ups with. Moreover, such OEM-specific employee incentive also makes the OEMs confident that CIFC’s executives will not refer their customer leads to other OEMs.

- CIFC helped OEMs in strategising approaches in micro-markets: CIFC has the best reach amongst non-captive NBFCs; it has maximum coverage of multiple micro-markets, across various products and OEMs. Thus, partnering with CIFC enables an OEM to get perspective of the various micro-markets especially the ones where the OEM is weak. This adds a lot of value to the OEM in terms of strategising their products and sales in various micro-markets.

Superior dealer service: Our channel checks reveal that CIFC offered better service than few captive NBFCs in terms of turnaround times and post-disbursement servicing. Dealers of few OEMs do not prefer their captive NBFCs, as they are slower in turnaround times (TAT) and also ask dealers to take care of the documentation. Captive NBFCs behave in such a way because they have traditionally enjoyed superior bargaining power over the dealers due to lack of other financing options.

CIFC has been successful in LCV segment by virtue of early mover advantage, OEM support and dealer servicing.



Exhibit 10: CIFC’s market share* in LCV financing

Source: Company, Ambit Capital research. Note: *Market share derived by triangulating Ambit Capital estimates with industry discussions

Exhibit 11: Yields* are resilient in LCV financing

Source: Company, Ambit Capital research. Note: * Based on industry discussions

High market share reflects competitive strengths

The LCV financing segment has gone through a lot of stress of late due to increased delinquencies. However, we find that CIFC has relatively performed better than its peers in terms of profitability.

i) Lower origination costs: CIFC enjoys lower origination costs as compared to its peers due to the following reasons: High repeat customers: CIFC’s early entry into the segment in 2003

resulted in it gaining the upper hand in originating many first-time customers. It was successful in retaining these customers, as its employees were directly in touch with the customers through the early deployment of technology and analytics rather than through DSAs. This has led to CIFC garnering an estimated ~15% market share in LCV financing. CIFC’s management highlights that 20-30% of the incremental business in LTV financing is from repeat customers. Consequently, it does not pay origination fees on the business it generates on repeat customers, which would be ~20-30% of its existing customer base.

Lower dealer payouts: CIFC’s unique organisational architecture wherein it has segregated sales personnel for different OEMs helps foster a direct connection with the customer. Our channel checks indicate that CIFC pays lower origination fees to the dealers due to the direct relationships with most of its borrowers through its dedicated sales team.

OEM tie-ups: As CIFC is a preferred financing partner of the OEM, CIFC has a lot of visibility with the dealers, resulting in lower dealer payouts during select schemes in the festival season. In addition, select OEMs also support CIFC by offering loss subvention fees, which can be up to 0.3% of the disbursements.

ii) Lower credit costs: CIFC enjoys lower credit costs as compared to its peers. Lower OEM pressure: Unlike captive financiers, CIFC’s credit decisions are

not influenced by OEMs or dealers and hence fewer bad decisions are made by CIFC.

Superior appraisal due to access to borrower credit history: Given CIFC’s high market share in LCV financing, it has access to historical customer behaviour data in this segment and is thus able to price a customer appropriately with adequate safeguards. For instance, our channel checks suggest that whilst CIFC was forced to offer LTVs north of 100% as a result of risk-based competition from some captive financiers, it was able to avoid bad customers by virtue of its access to customers’ track record. CIFC offered such high LTVs mostly to its repeat customers with good track records.

CIFC, 15%

IIB, 14%

MMFS, 9%

TMF, 8%SUF, 5%

Others/Cash, 49%

15-21%

14-18%12-18%

10-14% 10-14%

8%

10%

12%

14%

16%

18%

20%

UsedVehicles

LCVs Tractors MHCVs PVs

Yields (%)

CIFC enjoys efficiencies of scale, lower originating costs and lower credit costs in LCV financing compared to peers.



Loan loss participation from select OEMs: Loan loss participation can be up to 50% of the crystallised loan losses from select OEMs on certain models. This helps CIFC lower its ultimate credit costs.

Diversified exposure across OEMs and geographies: CIFC’s loan book is diversified across OEMs and geographies, hedging it against any geographical risks and OEM product quality risks. We find that CIFC has solved the problem of bad cases by not overtly depending on a particular OEM or geography and by meeting its targets through lower volumes across its dealerships.

iii) Efficiencies of scale: In LCV financing, scale is of paramount importance due to the high operating costs involved in servicing a small-ticket and fragmented customer base. Any new competitor seeking to enter this segment would need to operate at high volumes to compensate for the high operating costs involved related to maintaining the collection force and branches. Given that CIFC had already scaled up much ahead of its peers, CIFC enjoys significant cost benefits as compared to its peers.

Exhibit 12: Our channel checks reinforce CIFC’s strengths in LCV financing

Banks Captive financer CIFC Other

NBFCs Remarks

Origination

Dealer relationship Chola’s focus in this segment has resulted in consistent and superior dealer servicing. This has helped it penetrate deeper. MMFS and TMF also enjoy dealer penetration as they are captives.

OEM tie-ups Chola’s superior OEM tie-up comes from its ability to underwrite a high number of borrowers, given its well-diversified network as compared to a few OEMs.

Turnaround time Our channel checks indicate that CIFC has the fastest turnaround time (TAT) amongst the customers and dealers in the LCV given its faster verification and appraisal process. Some captives are slower in TAT because they have superior bargaining power over the dealers.

Appraisal

Non-captive independence

CIFC enjoys better asset quality than its captive peers, as it is able to appraise its customers independently, with much lower pressure from OEMs as compared to captives. Moreover, its sourcing and origination team is separate.

Analytics CIFC is able to appraise its customers better because 20-30% of its customers are repeat customers and it is way ahead of its peers in deploying analytics for cross-selling.

Collections Strength of collection team

CIFC and MMFS have higher on-field employees for collections as compared to other lenders.

Total


Higher LCV sales to increase financing opportunity CIFC has seen a slowdown in its LCV financing segment (AUM declining at a CAGR of 3% over FY13-15), primarily due to the slowdown in LCV sales (decline of 16% CAGR over FY13-15) and deterioration in the asset quality in the segment.

Exhibit 13: LCV sales are correlated with CV sales

Source: SIAM, Ambit Capital research.

-60%

-40%

-20%

0%

20%

40%

60%

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

YoY sales growth (%)

MHCV Goods LCV Goods



However, as discussed in the earlier section, the evolution of the Indian logistics space from a fragmented model to a hub-and-spoke model could drive robust growth in LCV sales. We believe that the likely implementation of GST could also accelerate the evolution of the logistics space into the hub-and-spoke model, and thus be a key catalyst for an uptick in LCV sales and hence LCV financing. Whilst competitive intensity has increased with the entry of banks like HDFC Bank in this segment, growth in LCV sales should provide ample opportunity for CIFC to demonstrate ~20-25% disbursement CAGR in the segment.

Exhibit 14: LCV financing is a much smaller financing opportunity as compared to others…


Exhibit 15: …but robust sales in LCVs could increase the financing opportunity by 20% CAGR

Particulars LCVs financing segment

Units sold/available (mn) 0.4

Avg. Ticket Size (` mn) 0.4

Turnover (` bn) 170

LTVs (%) 95%

Financing potential (` bn) 162

Current financing penetration 95%

FY15 financing market (` bn) 153

FY15-18E financing penetration 95%

FY15-18E market growth estimate 20%

FY18E financing market (̀ bn) 265

FY15-18E growth estimate 20%


1,532 1,306

435 428 263 207 162

- 200 400 600 800

1,000 1,200 1,400 1,600 1,800

PVs

Use

d PV

s

MH

CVs

Use

dM

HC

Vs

Use

d LC

Vs

Trac

tors

LCV

s

FY15 financing potential (Rs bn)



Used CV financing – The challenger CIFC’s market share gain in the used CV financing space (FY11-15 CAGR of 32% vs 18% for SHTF) is underpinned by its competitive strengths in collections and captive customer base to cross-sell. CIFC’s growth in the highly-profitable used CV segment will insulate its RoEs and growth from competition from banks in prime segments.

A challenging but sustainable growth opportunity

Used CV financing offers a sustainable growth opportunity for NBFCs like CIFC, with a market size of `428bn. It is a relatively tougher financing opportunity for banks to penetrate as compared to other auto financing segments. Mainstream lenders have typically found it challenging to lend in this segment due to the smaller ticket sizes of the transaction, difficulties in valuing the asset and a collection-intensive model owing to riskier customer segments. However, NBFCs like SHTF has dominated this segment due to their ability to value the old CVs and due to their scale of operations in terms of collections.

Exhibit 16: Opportunity* in used CV financing is as big as new CV financing

Source: Company, Ambit Capital research. Note: * Ambit Estimates

CIFC has been focussing on growing its used vehicle financing business since FY06. CIFC has mitigated the challenges of lending in the old CV space by deepening customer engagement by: (1) increasing cross-selling amongst its customers through CRM and analytics, (2) mitigating valuation risks through independent appraisers, and (3) increasing on-field employees for collections. Consequently, CIFC’s exposure to this segment has grown from 0% in FY08 to 13% of AUM in FY15.

Set to gain market share in used CV financing Our channel checks highlight that CIFC is best placed to gain market share in used CV financing.

1. A huge collection team is an entry barrier in this business, which has led to players like Sundaram Finance and banks restricting themselves to refinancing to only large fleet operators or larger customers. Note that CIFC is the only auto financier to match SHTF’s collection capabilities, with ~19 employees/branch compared to SHTF’s ~22 employees/branch. CIFC is able to afford this large collection team because of a dominant LCV business which requires a large collection team.

2. Captive LCV/HCV customer base to cross-sell: CIFC’s LCV borrowers are low-hanging candidates for CIFC to cross-sell its used CV loans. This minimises CIFC’s customer acquisition costs. Moreover, CIFC is also entering into tie-ups with select OEMs for HCV financing. CIFC replicating its LCV financing success in HCV financing could throw the doors open for cross-selling opportunities in financing of used HCVs as well.

1,532 1,306

435 428 263 207 162

0

300

600

900

1,200

1,500

1,800

PVs

Use

d PV

s

MH

CVs

Use

dM

HC

Vs

Use

d LC

Vs

Trac

tors

LCV

s

FY15 financing potential (Rs bn)

CIFC is best placed to gain market share in used CV financing driven by strengths in collections and a captive customer base to cross-sell.



CIFC’s focus in this segment has resulted in it gradually gaining a respectable market share in old CV financing. This is demonstrated by the fact that CIFC is the second-largest old CV financer after SHTF.

Exhibit 17: CIFC is the only auto financier that matches SHTF in terms of field force

Source: Company, Ambit Capital research; Note: Magma has been excluded in this analysis as it has a very low number of branches.

Exhibit 18: CIFC has the second-highest market share in used CV financing


Exhibit 19: CIFC has gradually gained market share in used CV financing

Particulars Market share – Used assets AUM CAGR (%)

FY11 FY15

CIFC 5.4% 7.5% 32%

MMFS 2.7% 6.9% 50%*

MGMA 2.1% 3.6% 39%

SHTF 89.8% 82.0% 18%

Source: Company, Ambit Capital research; Note: Market share has been calculated relative to CV financing; *MMFS’s market share appears high, as it has more used cars financing and less used CV financing

HCVs – Strategic to growth of used CV financing Whilst HCV financing accounts for 6% of CIFC’s AUM, it occupies a strategic importance in CIFC’s growth strategy, as the company can use these HCV financing customers to cross-sell its more profitable used CV financing proposition. CIFC focusses predominantly on the SRTO segment in HCV financing, where yields are ~14-16%, and it originates all of its HCV financing customers in-house. Whilst this segment has been less profitable of late for lenders due to high credit costs, it is seeing some uptick in terms of growth and curtailment of bad lending practices (lenders have minimised lending at 100% LTVs).

22

19

13

6

0

5

10

15

20

25

SHTF CIFC-VF MMFS SUF

Employee/branch CIFC, 7%

MMFS, 2%

SHTF, 70%

MGMA, 3%

SUF, 4%

Cash/unorg.

lenders, 14%



LAP – Relatively better than its peers CIFC, like any other LAP lender, is vulnerable to macro headwinds of declining real estate prices and increasing delinquencies. However, any increase in credit costs should not be substantial due to the lower ticket sizes of its loans (average ticket size of `5mn vs industry average of `12mn) and higher share of self-occupied residential properties (89% exposure vs industry average of 70%).

Launched in FY06, LAP is CIFC’s most-profitable segment, generating RoAs of 2.5% vs blended RoAs of 1.7% as of FY15. CIFC’s clocks in yields of ~13-14% in this product, by focussing exclusively on lower-ticket LAP (median ticket size at `3mn vs industry median of `1.2mn). CIFC has improved its RoAs in this product from 1.9% in FY11 to 2.5% in FY15 due to scaling up of the loan book, which led to increase in operating efficiency.

Exhibit 20: Profitability profile of CIFC in LAP

Particulars FY10 FY11 FY12 FY13 FY14 FY15

NIMs 6.6% 5.8% 5.5% 5.6% 5.6% 5.4%

Opex 2.9% 2.4% 2.0% 2.0% 1.6% 1.3%

Operating profits 3.6% 3.4% 3.5% 3.6% 4.0% 4.1%

Losses and Provisions 0.4% 0.5% 0.3% 0.3% 0.2% 0.5%

PBT 3.3% 2.9% 3.1% 3.3% 3.8% 3.7%

Tax 1.1% 1.0% 1.0% 1.1% 1.3% 1.2%

PAT 2.2% 1.9% 2.1% 2.2% 2.5% 2.5%

Leverage 13.6 10.3 9.1 9.6 9.9 9.8

RoE 30.0% 19.9% 18.9% 21.2% 25.3% 24.3%

AUM growth (%) 98% 49% 42% 41% 35% 24%


Expect marginal uptick in credit costs… CIFC, like any other LAP lender, is vulnerable to macro headwinds of declining real estate prices and increasing delinquencies. This is especially considering the fact that ~30% of its AUM is exposed to the National Capital Region (NCR) region where property prices are relatively under more stress This is also visible in CIFC’s asset quality deterioration in this segment in FY15. We expect CIFC’s 180 dpd delinquencies to increase by ~30bps in this segment over FY15-17E, as the slowdown in real estate continues.

…but resilient to major stress Whilst CIFC’s LAP book should see some increase in credit costs, we expect it to be resilient to any major stress as compared to its peers due to:

Lower ticket sizes than its peers: CIFC’s median ticket size is `3mn and average ticket size is `5mn. This compares with median ticket size of `12mn for its peers. In a scenario of default, lower-ticket-sized exposures would enable swift liquidation of the property with relatively lower hair-cuts as compared to larger-ticket-sized exposures.

Higher share of self-occupied residential properties (SORP): CIFC’s early entry in this segment in 2007 meant that it has been in the market in the previous 2007-09 cycle as well, when it experienced a steep decline in real estate prices of commercial properties. Consequently, it has been vary of funding against collateral of commercial properties and has actively increased its exposure to SORP in the LAP book to de-risk its portfolio from a similar decline in real estate prices. The share of SORP has increased from 80% to 89% over FY11-15 as compared to the average peer group exposure of 70% (as per CRISIL estimates). A higher share of SORP implies a safer book due to the emotional attachment of the borrower towards his/her residence.

CIFC’s LAP book is safer than its peers due to lower ticket sizes and higher share of SORP.



Our channel checks also highlight that is a conservative player in this segment and hence we see lesser risk for CIFC in this segment vs other NBFCs/HFCs.

Exhibit 21: CIFC is seeing an uptick in credit costs in the LAP segment


Exhibit 22: But CIFC has lower ticket sizes in the industry as compared to its peers

Source: Company, Ambit Capital research; Note: Ticket sizes are as of FY15

Exhibit 23: CIFC has consciously increased its proportion of SORP…


Exhibit 24: …leading to higher share of SORP as compared to its peers

Source: Company, CRISIL, Ambit Capital research

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

0.1%

0.2%

0.2%

0.3%

0.3%

0.4%

0.4%

0.5%

0.5%


CIFC - credit costs Industry - 90dpd NPAs (RHS)

22.5

17.6

9.67.0 6.8

5.02.9 2.5 2.3 2.0 1.3 1.2 0.6 0.5

12

0

5

10

15

20

25

BAF

RELG

CA

PF

RCA

P

IBH

F

CIF

C

MG

MA

LIC

HF

HD

FC

REPC

O

CA

NFI

N

DH

FL

SCU

F

GRU

H

Avg Ticket Size (Rs mn) Industry Median (Rs mn)

80% 83% 83% 87% 89%

20% 17% 17% 13% 11%

0%

20%

40%

60%

80%

100%


Composition of CIFC's LAP book

Others SORP

89%70%

11%30%

0%

20%

40%

60%

80%

100%

CIFC Industry

Commercial Property Self occupied residential property



Steady RoEs + Higher loan book growth = Robust earnings growth CIFC delivered a robust 30% AUM CAGR in FY10-15, with RoEs improving from 3% in FY10 to ~17.5% in FY15. The combination of higher loan growth coupled with improvement in RoEs helped the company deliver 76% EPS CAGR in FY10-15. The improvement in RoE was primarily driven by improvement in operating efficiencies (opex/AUM down from 3.8% in FY11 to 3% in FY15) and decline in credit costs (down from 2% in FY11 to 1.3% in FY15).

We expect CIFC to deliver a robust 20% EPS CAGR over FY15-18E. Our expectations are driven by two factors:

Higher loan growth at 19% CAGR over FY15-18E.

RoAs improving by ~30bps to ~2.0% in FY18E, as improving margins and operating efficiency more than offset marginal increase in credit costs.

Consequently, we expect RoEs to improve to ~18% in FY17E after dipping to ~16% in FY16 due to infusion of equity share capital on conversion of cumulative convertible preference shares in 2QFY16.



Loan growth to gain momentum Over FY10-15, CIFC has recorded an AUM CAGR of 30% driven primarily by home equity (35% CAGR) and vehicle finance (38% CAGR). However, growth has decelerated at 16% CAGR over FY13-15, as the vehicle financing book slowed down. We expect loan book growth to expand at 19% CAGR over FY15-18E, as:

Vehicle financing expands: Vehicle financing has shown green shoots after a tepid FY15, with higher disbursements in HCV, LCV and old CV financing. We expect growth in vehicle financing to continue its upward momentum, as:

HCV/PV financing grows due to higher HCV/PV sales. Our Auto analyst expects 20% CAGR in domestic CV sales and 10% CAGR in domestic PV sales over FY15-17. We also expect growth in LCV financing to improve from FY17, as this segment grows with a lag after strong MHCV sales in FY15 and FY16.

We expect CIFC to continue gaining market share in old CV financing due to its strength in collections as well as a huge captive LCV/HCV customer base to cross-sell.

Overall, we expect 16% CAGR in CIFC’s vehicle financing loan book over FY15-17E vs 21% CAGR in FY12-15.

Growth in LAP slows down: We expect CIFC’s growth in LAP to taper off from 33% CAGR over FY12-15 to 22% CAGR over FY15-17E due to challenges such as: (i) increasing competitive intensity in the segment due to entry of various players; and (ii) slowdown in real estate prices. However, the roll-out of the product in the rest of the branches (currently offered only in 15% branches) should offset the above-mentioned challenges to a certain extent.

Exhibit 25: Robust AUM growth…


Exhibit 26: …driven by vehicle finance and home equity


71 63 69 91 135

190

233 255

77%

-12%

9%

33%

48%41%

22%

9%

-20%-10%0%10%20%30%40%50%60%70%80%90%

-

50

100

150

200

250

300

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

` bn

AUM (Rs bn) AUM Growth (YoY, %, RHS)

28%

54%63%

46%

19%3%

98%

49% 42% 41% 35%24%

41%53%

-37% -40%

12%

63%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%


Vehicle Finance Home Equity Others



Operating efficiency to kick in High opex driven by multiple factors

CIFC lags its peers on opex (as a % of AUM) primarily due to a higher employee base (vis-à-vis its vehicle financing AUM) vs its peers. This is due to the following:

Dedicated functional team: CIFC has a dedicated functional team for each of its functions i.e. sales, collection and credit. CIFC’s organisational structure is in sharp contrast to other NBFCs wherein the sales person doubles up in collections also. To illustrate, ~34% of CIFC’s employees are exclusively involved in sales and ~45% in collections, in contrast to other NBFCs that have 60-70% of their employees dabbling in sales as well as collections. This results in a lower AUM per employee for CIFC.

Small ticket sizes: It is focused on small CVs and LCVs wherein operating costs are higher due to lower ticket sizes and requirement of deeper presence for collections. These products together account for 16% of CIFC’s AUM.

High collection costs: The company increased its focus on collections in the economic downturn, when collection efficiency dropped. CIFC had the highest employee growth during the downturn (at 24% CAGR over FY11-15).

Exhibit 27: CIFC has higher opex vs peers …


Exhibit 28: …primarily due to higher employee strength relative to AUM and disbursements


Exhibit 29: CIFC’s segregated vertical for sales and collection results in higher on-field employees


Exhibit 30: CIFC has invested the most in employees as compared to its peers


3.8%3.6%

3.0%

2.5%

1.9%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

MGMA -VF CIFC-VF MMFS SUF SHTF

Opex/AUM 54

29 34

20 26

12 19

10

19

9

0

10

20

30

40

50

60

AUM/Employee (Rs mn) Disb/employee (Rs mn)

SUF SHTF MMFS CIFC - VF MGMA - VF

38% - Sales 34% - Sales

69%, Sales +Collection

62% - Sales +Collection

45% -Collections 46% -

Collections

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Magma CIFC MMFS SHTF

24%

17%

13%

7%

-1%

-5%

0%

5%

10%

15%

20%

25%

CIFC MGMA MMFS SUF SHTF

Employee count - FY11-15 CAGR



Opex efficiency to improve as growth increases CIFC’s focused and segregated organisational structure may be a liability in a period of low disbursement growth during a slowdown, due to under-utilisation of the sales team. However, it offers operating leverage and scalability in a period of economic turnaround, as the currently idle capacity in the sales team (which is focused only on sales and not on collections, unlike other NBFCs) would help CIFC to demonstrate a higher disbursement growth without a corresponding increase in employee hiring, as the growth increases. This is especially true for CIFC’s low-ticket loans for LCVs.

Consequently, we are factoring in employee expense CAGR of 5% over FY15-18E, which is lower than AUM CAGR of ~19%. We believe CIFC’s opex/AUM could decline by ~50bps over FY15-18E to ~2.6% of AUM.

Exhibit 31: Opex improvement in CIFC over FY15-18E


56% 50% 44% 43% 41% 38% 36%

3.9% 3.5%3.1% 3.1% 3.0% 2.8%

2.6%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

30%

35%

40%

45%

50%

55%

60%

FY12

FY13

FY14

FY15

FY16

E

FY17

E

FY18

E

Cost to income (%) Opex (% of AUM, RHS)



NIMs to improve marginally Over FY11-15, CIFC’s NIMs have been resilient at ~6% despite a ~200bps increase in cost of funds. This can be explained by: (i) increasing proportion of higher-margin off-balance-sheet assets (from 8% of AUM to 14% over FY11-15); (ii) improvement in yields of ~190bps; & (iii) leverage decreasing from 11.3x to 10.2x over FY11-15.

Exhibit 32: NIMs have been resilient over FY11-15 due to increasing proportion of off-balance-sheet assets…


Exhibit 33: … as increase in yields was offset by increase in cost of on-balance-sheet borrowings


We expect CIFC’s NIMs to improve marginally to ~6.3% over FY15-18E, as a ~55bps decline in yields would be offset by a ~80bps decline in funding costs.

1. Decline in cost of funds: We expect a ~80bps decline in CIFC’s cost of funds over FY15-17E due to: (i) reduction in systemic interest rates by more than 50bps over FY15-17E, which will result in a ~40bps decline in CIFC’s cost of wholesale borrowings and a ~55bps decline in the cost of bank borrowings; and (ii) Migration of CIFC’s borrowing mix from bank borrowings to more wholesale-market-linked NCDs/CPs given increasing appetite amongst institutional investors for corporate bonds in the recent times. CIFC has the highest proportion of bank borrowings amongst its peers, and thus we expect this to come down from 55% of its liabilities in FY15 to 35% in FY17E, which could lower its cost of funds by a further 20bps.

2. Decline in yields: We expect yields to decline by ~55bps over FY15-17E due to: (i) Rising competitive intensity: We expect a ~40bps steady decline in yields over FY15-17E due to a ~100bps decline in the LCV and home equity segment, which account for 47% of CIFC’s AUM; and (ii) Migration to 120/90 day norms by FY16/17, which will impact yields by ~10bps (as CIFC will have lower interest earning assets to recognise interest on).

Exhibit 34: CIFC’s borrowing mix


Exhibit 35: CIFC can move away from expensive bank borrowings


8% 9%

13%

18%

14%6.0%

5.1%

5.5%

5.7% 6.0%

0%

5%

10%

15%

20%

5.0%

5.5%

6.0%

6.5%

FY11 FY12 FY13 FY14 FY15Off-balance sheet (% of AUM, RHS)NIM (% on AUM, LHS)

8.5%

10.2%10.6% 10.6% 10.4%13.1%

13.9%14.2% 14.1% 14.1%

12%

13%

14%

15%

8%

9%

10%

11%

12%

FY11 FY12 FY13 FY14 FY15Cost of funds (%) Yield on AUM (RHS, %)

55%

3%

17%

11%

14%Bank Term Loans

Commercial papers

Debentures

Tier II Capital

Off-balance sheetfunding

55%42% 43%

29%7%

20%

14%34%

40%

54%

0%

50%

100%

CIFC MGMA MMFS SHTF SUF

Banks Mkt borrowings FDs Off-balance sheet Others



Credit costs to increase marginally CIFC’s credit costs increased over FY12-15, driven by increasing delinquencies in both its vehicle financing and home equity book; credit costs have increased from 20bps to 130bps over FY12-15. Whilst we expect asset quality improvement in its vehicle financing book as the economy gains momentum, we expect CIFC’s credit costs to increase marginally by 20bps, as:

Credit costs in its home equity business will remain elevated due to challenges in the segment; we factor in NPAs in its home equity book to remain elevated at ~1.4% in FY15-18E.

Migration to 90 day NPA provisioning norms by FY17 could result in additional credit costs of 30bps/40bps over FY16/17.

Exhibit 36: CIFC’s gross NPAs and credit costs have increased of late…

Source: Company, Ambit Capital research; Note: FY15 numbers are on 150dpd basis

Exhibit 37: …driven by increasing credit costs in its vehicle financing and home equity book

Source: Company, Ambit Capital research; Note: All numbers are on 180dpd basis

Exhibit 38: Credit cost increase to be marginal as provisioning coverage is lowered


5.5%

2.6%

0.8% 1.0%

1.9%

3.1%

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%5.5%6.0%


Gross NPA (%) Credit costs as a % of AUM

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Credit costs

Vehicle Financing Home equity

69% 87% 69% 80% 63% 35% 40% 43% 50%

2.9%

2.2%

0.2%

0.8%

1.3% 1.3%1.6%

1.3%1.5%

0%10%20%30%40%50%60%70%80%90%100%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

FY10 FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E

Provisioning Coverage ratio (%) (RHS) Credit costs as a % of AUM (LHS)



Key assumptions and estimates Exhibit 39: Key assumptions and estimates (` mn unless specified)

Assumptions FY16E FY17E FY18E Remarks

YoY AUM growth (%) 14.4 20.4 22.5 We expect 19% CAGR in CIFC’s AUM over FY15-18, driven by uptick in the CV, PV and old CV segment.

NIMs on AUM (%) 6.3

6.3

6.3

Despite decline in yields, we expect CIFC to marginally improve its margins due to shifting of its liabilities mix from banks to wholesale markets.

Opex (as a % AAUM) 3.0

2.8

2.6

Higher growth in the LCV and used CV segment will result in operational efficiency.

Credit costs (% of avg loan book) 1.6

1.3

1.5

Whilst we expect asset quality improvement in CIFC’s vehicle financing book as the economy gains momentum, we expect its credit costs to increase marginally by 20bps due to elevated credit costs in its home equity business and migration to 90 day NPA provisioning norms by FY17.

Net revenues (` mn) 19,907 23,380 28,073 FY15-18E CAGR of 17% vs FY12-15 CAGR of 23%.

Operating profit (` mn) 11,720 14,393 17,929 FY15-18E CAGR of 22% vs FY12-15 CAGR of 31%.

Net Profit (` mn) 4,920 6,798 8,124 FY15-18E CAGR of 23% vs FY12-15 CAGR of 19%.

Diluted EPS (`) 32.5 43.2 51.6 FY15-18E CAGR of 20% vs FY12-15 CAGR of 15%.

Adjusted BVPS (̀ ) 239 267 313 FY15-18E CAGR of 19% vs FY12-15 CAGR of 12%.

RoE (%) 15.7 17.4 17.8 RoEs would improve from current levels.


Ambit vs consensus Our FY16/17 earnings estimates are lower than consensus estimates, as we expect operating leverage to play out slower than consensus expectations due to a slower-than-expected recovery in the economy.

Exhibit 40: Ambit vs consensus

Particulars Ambit Consensus Divergence

Total Income (̀ mn) FY16E 19,907 20,163 -1%

FY17E 23,380 23,859 -2%

PAT (̀ mn)

FY16E 4,920 5,394 -9%

FY17E 6,798 6,902 -2%

EPS (̀ mn) FY16E 32.5 34.7 -6%

FY17E 37.6 44.3 -15%




Valuations reflect sustainability We have valued CIFC using the excess return to equity model which is ‘net profit – (cost of equity x average net worth)’ for all the future years discounted back to the present using cost of equity.

We have explicitly forecast net profit for FY15-18E based on the assumptions in Exhibit 39.

We have assumed 22% CAGR in loan growth for FY18-23, and have faded it to an average 17% over FY23-35.

We have assumed an average sustainable RoA of 1.95% and sustainable RoE of 20% from FY18 onwards, as margins and operating efficiencies would improve from the current levels on a cross-cycle basis.

We have assumed cost of equity of 15% and terminal growth of 5%.

Based on these assumptions our excess return model values CIFC at `740/share (implied FY17E P/B of 2.8x and implied FY17E P/E of 19x), implying 15% upside from current levels.

Exhibit 41: Excess return valuation profile of CIFC

Particulars (in mn) ̀ mn, unless mentioned

Current Net worth (Sep’15) – A 37,844

Excess return – B 62,704

Total Fair Value - C = A+B 100,548

Shares in issue - D 157

Implied fair value per share - E=C/D 639

Cost of equity of the company – F 15.0%

One year forward Target price - E*(1+F) 740


Cross-cycle valuations at a premium as ROEs have structurally improved CIFC’s current 12-month forward P/B of 2.4x and 12-month forward P/E of 16x are at a 35% premium and 50% premium to their cross-cycle averages driven primarily by improvement in RoE over the last five years. We expect current valuation multiples to sustain in the future, as CIFC’s RoEs would sustain at current levels and as it would deliver 20% EPS CAGR over FY15-18E.

Exhibit 42: CIFC is trading at a ~35% premium to its one-year forward P/B

Source: Bloomberg, Ambit Capital research.

Exhibit 43: CIFC is trading at a ~50% premium to its one-year forward P/E

Source: Bloomberg, Ambit Capital research.

0.5

1.0

1.5

2.0

2.5

Sep-11

Dec-1

1

Mar-12

Jun-12

Sep-12

Dec-1

2

Mar-13

Jun-13

Sep-13

Dec-1

3

Mar-14

Jun-14

Sep-14


5

8

10

13

15

Apr-11

Jul-11

Oct-11

Jan-12

Apr-12

Jul-12

Oct-12

Jan-13

Apr-13

Jul-13

Oct-13

Jan-14

Apr-14

Jul-14

Oct-14

PE Avg. PE -1 SD +1 SD



Fairly valued relative to its peers CIFC commands a marginal 9-12% premium on P/B to its peer-set for a 9%-10% premium to peer RoEs. We believe that CIFC’s premium over its peers should widen, as: (i) CIFC has higher visibility in its loan book growth relative to its peers due to its well-diversified business; and (ii) CIFC can sustain RoEs through multiple levers such as declining cost of funds and improving operating leverage.

Exhibit 44: Relative valuation snapshot

Company Mcap Price Reco TP Up/

down

P/B P/E EPS CAGR ROA ROE

US$bn Rs Rs FY16E FY17E FY16E FY17E FY15-17E FY16E FY17E FY16E FY17E

Shriram Transport 3.4 930 SELL 745 -20% 2.0 1.8 17.3 12.8 25% 2.0% 2.1% 14.5% 15.3%

M&M Finance 2.1 233 SELL 225 -3% 2.0 1.8 15.2 11.8 11% 2.2% 2.5% 13.1% 15.1%

Sundaram Finance 2.6 1,515 NA NA NA 5.2 4.5 34.2 29.5 9% 2.8% 2.9% 16.9% 17.2%

Magma Fincorp 0.3 87 BUY 133 53% 0.9 0.8 11.0 6.3 25% 0.9% 1.5% 9.4% 13.3%

Average 2.5 2.2 19.4 15.1 18% 2.0% 2.2% 13.5% 15.3%

Cholamandalam 1.5 642 BUY 740 15% 2.8 2.4 22.0 15.6 17% 1.6% 1.9% 14.7% 16.8% Premium/(Discount) to above 12% 9% 13% 3% -17% -13% 9% 10%

Source: Bloomberg estimates

Key catalysts for our BUY stance Recovery in LCV volumes: CIFC will be a key beneficiary of an uptick in LCV volumes, as it commands a high market share in LCV financing. LCV financing is one of CIFC’s highest yielding products, with high operating costs involved due to the small-ticket nature of the transactions. Consequently, higher LCV volumes will not only improve CIFC’s yields but also its operating leverage. Industry experts highlight that an uptick in LCV volumes is felt in HCV volumes after a lag of 12-18 months, which should materialise in 2HFY16.

Risks to our BUY stance Higher-than-expected stress in LAP segment: Ever-increasing property prices have helped in the growth of the LAP segment and have also led to better asset quality for lenders, as distressed borrowers were able to refinance their loans. We expect CIFC’s NPAs in this segment to be broadly in check and increase only marginally from 1.4% in FY15 to 1.7% in FY17E, as: (i) our analysis suggests that CIFC has been more prudent in the LAP segment vs its peers; and (ii) the recently-available SARFESI protection should aid in its recovery process. With 29% of CIFC’s AUM concentrated in this segment, higher-than-expected delinquencies in this segment could have a meaningful impact on CIFC’s growth and asset quality.

Forensic accounting Exhibit 45: CIFC is clean on all parameters

Segment Score Comments

Accounting GREEN CIFC has an average rank amongst its peers on RoA impact of migration to 90-day NPA norms; the impact on CIFC would be 11bps vs peer range of 4-31bps. That said, we believe that its accounts are a true representation of the accounts of the company.

Predictability GREEN CIFC has reported fairly stable earnings growth and has also met its guidance. The company’s disclosures provide adequate granularity on the business on a quarterly basis.

Earnings Momentum GREEN Consensus downgrades (FY16/17 EPS estimates) have been immaterial over the past six months.




Income statement [` mn]


Net interest income 12,116 14,640 17,185 20,363 24,626

Interest income 29,827 34,244 38,368 45,230 55,029

Interest Expense 17,711 19,604 21,184 24,867 30,403

Other income 2,801 2,668 2,722 3,016 3,446

Total Income 14,917 17,308 19,907 23,380 28,073

Total expenses 6,582 7,489 8,187 8,987 10,144

Operating and other expenses 4,707 5,272 5,814 6,520 7,578

Employee Cost 1,875 2,217 2,373 2,467 2,566

Pre provision profit 8,335 9,819 11,720 14,393 17,929

Provisions 2,833 3,247 4,377 4,247 5,804

Profit before tax 5,502 6,572 7,343 10,146 12,126

Tax 1,862 2,221 2,423 3,348 4,001

PAT 3,640 4,351 4,920 6,798 8,124


Balance Sheet [` mn]


Networth 22,947 26,733 36,102 42,106 49,281

Borrowings 221,806 235,234 263,873 318,868 392,551

Total liabilities 244,753 261,967 299,975 360,974 441,832

Fixed assets 729 683 751 826 909

Investments 824 675 743 817 898

Loans and Advances 232,535 254,525 291,253 350,684 429,608

Cash and Bank Balance 8,008 3,407 3,748 4,122 4,535

Net working capital 2,657 2,677 3,480 4,525 5,882

Total assets 244,753 261,967 299,975 360,974 441,832


Key Metrics


AUM growth (%) 22.4 9.5 14.4 20.4 22.5

Dil Consol EPS growth (%) 11.2 18.1 8.5 32.8 19.5

Net interest margin (NIM) (%) 5.7 6.0 6.3 6.3 6.3

Cost to income (%) 44.1 43.3 41.1 38.4 36.1

Opex (% of AAUM) 3.1 3.1 3.0 2.8 2.6

Gross NPAs (%) 1.9 3.1 4.2 3.5 3.6

Credit costs (% of AAUM) 1.34 1.33 1.60 1.32 1.49

Provision Coverage (%) 63.2 35.5 39.7 43.0 50.0

Capital adequacy (%) 17.2 21.2 20.8 19.5 18.5

Tier-1 (%) 10.5 13.0 14.8 14.0 13.0

Leverage (x) 10.4 10.2 8.9 8.5 8.8


Valuation parameters


BVPS (̀ .) 160.0 184.1 238.6 267.4 313.0

Dil. EPS (`) 25.4 30.0 32.5 43.2 51.6

ROA (%) 1.6 1.7 1.8 2.1 2.0

ROE (%) 17.1 17.5 15.7 17.4 17.8

P/E 25.3 21.4 22.0 15.6 10.8 P/BV 4.0 3.5 2.8 2.4 2.0 Dividend yield (%) 0.5 0.5 0.5 0.8 1.1 Source: Ambit Capital research



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Limited prospects of a turnaround

M&M Financial Services’ stock has de-rated from 3.1x to 1.8 one-year forward P/B over the past 18 months and is now trading at an 18% discount to the historical averages. However, we believe the stock is not cheap enough at 1.8x one-year forward P/B to take a leap of faith, as the company’s profitability will be under pressure due to a stressed rural economy and regulatory changes. Moreover, structural factors like increasing competition in the sector and M&M’s loss of market share in UVs mean that profitability could be structurally lower than the historical averages. We marginally cut our TP to `225 (implied 1.7x FY17E P/B). SELL. Competitive position: STRONG Changes to this position: NEGATIVE Cyclical stress is not over yet MMFS is still cyclically challenged owing to: (i) the continuing economic slowdown with no uptick in construction and infrastructure activities; (ii) below par monsoons and unseasonal rains earlier this year further battering the already stressed rural and agricultural economy; (iii) continued slowdown in tractor sales (18% of AUM) due to lack of rural spending by the Government and deficient rainfall. Hence, we expect loan growth to be muted at 11% CAGR in FY15-17E (vs 26% CAGR in FY11-15). With high early delinquencies and lower provisioning coverage, credit costs will remain elevated at ~280bps/250bps in FY16/17E (vs 90-250bps in FY12-15). Competition and regulations are making things worse Despite the uptick in auto sales in India in FY15, MMFS’s AUM growth has been under pressure due to: (a) M&M losing market share in UVs (31% of MMFS’s AUM) and (b) market share loss in the car segment (23% of AUM) due to increasing competition from banks. Moreover, migration to 90 day NPA norms by FY18 would also structurally impact MMFS’s profitability due to higher credit costs (structurally up by ~13bps) and lower NIMs (structurally down ~20-30bps). Regulatory and competitive pressures would drive NIMs decline MMFS enjoys multiple tailwinds to aid its NIMs such as declining base rates, scope to shift away to bond borrowings and a favorable ALM profile. However, we still expect its margins to decline by ~30bps in FY15-17E due to: (i) lower growth in higher-yield products like tractors and UVs; (ii) competitive pressure on yields in cars and UVs (~53% of its AUM) and even in tractors in some cases; and (iii) lower proportion of interest-earning assets due to a shift to 90 day NPA provisioning by FY18, that could erode its NIMs by ~33bps. The stock is not cheap enough to take a leap of faith Whilst the stock has de-rated from 3.1x one-year forward P/B in Dec’13 to 1.8x one-year forward (18% discount to the historical average P/B), it is still not cheap, given FY16/17E RoEs of ~13/15% and our expectations of structural pressure on RoEs and growth of the sector (due to the reasons mentioned above). Hence, the stock should trade at a discount to the historical multiple even if earnings recover cyclically. Moreover, we believe that cyclically the scenario will become worse before it improves. We marginally cut our target price to `225 (implied 1.7x FY17E P/B) and retain our SELL stance.

COMPANY INSIGHT MMFS IN EQUITY October 08, 2015

M&M Financial Services SELL

BFSI

Recommendation Mcap (bn): `133/US$2.0 6M ADV (mn): `368.4/US$5.6 CMP: `233 TP (12 mths): `225 Downside (%): 4%

Flags Accounting: GREEN Predictability: RED Earnings Momentum: RED

Catalysts Continued disappointing results over

FY16/17 due to higher-than-expected credit costs

Prolonged slowdown in rural India over FY16/17

Share price performance (%)


80

90

100

110

120

130

Sep-

14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-

15

Sep-

15

MMFS IN SENSEX

Analyst Details

Aadesh Mehta, CFA +91 22 3043 3239

[email protected]

Pankaj Agarwal, CFA

+91 22 3043 3206 [email protected]

Ravi Singh +91 22 3043 3181

[email protected]

Key financials

` mn FY13 FY14 FY15 FY16E FY17E Total Income 23,402 27,651 30,880 33,079 35,751 PAT 9,270 9,580 9,129 8,731 11,193 Dil. EPS (`) 17.2 16.8 16.1 15.3 19.7 BVPS (̀ .) 80.5 93.1 104.5 116.2 131.2 ROE (%) 23.8 18.6 15.5 13.1 15.1 P/E (x) 13.5 13.9 14.5 15.2 11.9 P/BV (x) 2.9 2.5 2.2 2.0 1.8


M&M Financial Services


Exhibit 1: Industry auto sales (ex-tractors) revived slightly in FY15…


Exhibit 2: …however, MMFS’s disbursements remain on a downward trajectory


Exhibit 3: M&M is losing market share in UVs


Exhibit 4: Growth in car loans has been muted for MMFS


Exhibit 5: Pricing pressure has increased in car loans…

Source: Company, Ambit Capital research; Note: Spreads refer to spreads over base rate

Exhibit 6: …with banks aggressively growing their reach

Source: Company, RBI, Ambit Capital research

-25%

-15%

-5%

5%

15%

25%

35%

45%

55%


Tractor CVs UVs Cars

-25%

-15%

-5%

5%

15%

25%

35%

45%

55%

FY13 FY14 FY15

Tractor CVs UVs Cars

47%

55%53%

55%

48%

42%

37%

30%

35%

40%

45%

50%

55%

60%

FY09

FY10

FY11

FY12

FY13

FY14

FY15

M&M Market share in UV segment

35%

47%

17%21%21%

29%

7%4%4%

19%23%

11%

0%

10%

20%

30%

40%

50%

MMFS IIB HDFCB KMB

FY13 FY14 FY15

3.0% 3.0%

2.3%

1.3%0.8% 0.8% 0.6%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Jun-

10

Nov

-10

Apr

-11

Sep-

11

Feb-

12

Jul-

12

Dec

-12

May

-13

Oct

-13

Mar

-14

Aug

-14

Jan-

15

Jun-

15

SBI - Interest spreads in car loans

1,515

457

2,357

744

-

500

1,000

1,500

2,000

2,500

Bank branches (Top 5 pvt)- Semi-urban and rural

Autofinancer branches

Branch additions

FY10-12 FY12-14



Exhibit 7: Decrease in growth in MSP prices could signal slowdown in cash flows

Source: Ministry of Agriculture, Ambit Capital research

Exhibit 8: Credit costs are yet to peak


2%

12%

4%4%

9%

4%

0%

2%

4%

6%

8%

10%

12%

14%

FY00-07 CAGR FY07-14 CAGR FY14-15 (YoY)

MSP - Paddy MSP - Wheat

7.4%7.8%8.1%

6.8%

4.8%5.5%

7.6%

8.7%

6.4%

4.0%

3.0%3.0%

4.4%

5.9%

0%

10%

20%

30%

40%

50%

60%

70%

0%1%2%3%4%5%6%7%8%9%

10%

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

Gross NPA (%) AUM growth YoY (RHS, %)



Key assumptions and estimates Exhibit 9: Key assumptions and estimates (` mn unless specified)

Assumptions FY15 FY16E FY17E Remarks

YoY AUM growth (%) 8% 8% 14%

Despite an uptick in auto sales (ex-tractors), we expect MMFS’s AUM growth to continue to be muted at 11% CAGR over FY15-17E. Lower growth in its UV and tractors portfolio (collectively ~50% of MMFS’s loan book) would be driven by: (i) Loss of market share and muted rural UV sales; and (ii) Rural slowdown and lack of increase in infra spending posing a challenge to the tractors book.

NIMs on AUM (%) 9.2% 9.1% 8.9%

Whilst falling interest rates bode well for the NIMs of a fixed rate lender like MMFS, we do not expect MMFS’s margins to decline by ~30bps by FY17E due to: (i) lower growth in higher-yield products like tractors and UVs; (ii) pressure on yields in multiple product segments driven by higher competition; and (iii) lower proportion of interest-earning assets due to a shift to 90 day NPA provisioning by FY18.

Opex (as a % AAUM) 3.0% 3.1% 3.1% We expect a stable opex-to-AUM ratio in FY15-17E for MMFS.

Credit costs (% of avg loan book) 2.5% 2.8% 2.5%

Slowdown in the rural segment and migration to 90 day NPA recognition, coupled with a high level of early delinquencies and low provisioning coverage, suggest that credit costs would remain elevated at ~250-280bps in FY15-17E (vs 90-170bps in FY12-14).



Profit after tax - standalone (` mn) 8,318 7,809 10,006 FY15-17E CAGR of 10% vs FY12-15 CAGR of 10%.

Profit after tax - Consolidated (` mn) 9,129 8,731 11,193 FY15-17E CAGR of 11% vs FY12-15 CAGR of 12%.

Standalone Diluted EPS (`) 14.6 13.7 17.6 FY15-17E CAGR of 10% vs FY12-15 CAGR of 7%.

Consolidated Diluted EPS (`) 16.1 15.3 19.7 FY15-17E CAGR of 11% vs FY12-15 CAGR of 9%.

Adjusted BVPS (̀ ) 104.5 116.2 131.2 FY15-17E CAGR of 12% vs FY12-15 CAGR of 21%.


We downgrade our PAT estimates primarily to factor in higher credit costs in FY17.

Exhibit 10: Change in estimates (` mn unless specified)

New estimates Old estimates Change

FY16E FY17E FY16E FY17E FY16E FY17E

Net revenues (` mn) 33,079 35,751 33,079 35,827 0% 0%

Operating profit (` mn) 21,857 23,243 21,857 23,320 0% 0%

Standalone PAT (̀ mn) 7,809 10,006 7,809 10,327 0% -3%

Consolidated PAT (̀ mn) 8,731 11,193 8,879 11,821 -2% -5%

Standalone diluted EPS (`) 13.7 17.6 13.7 18.2 0% -3%

Consolidated diluted EPS (`) 15.3 19.7 15.6 20.8 -2% -5%

Adjusted BVPS (̀ ) 116 131 116 132 0% -1%


Exhibit 11: Ambit vs consensus (standalone) ` mn Ambit Consensus Divergence. Comments

Net Revenues

Consensus has downgraded its earnings estimates by 8% over the past three months primarily due to lower expectations on growth and asset quality. Nevertheless, our estimates are materially lower than consensus estimates due to lower growth and higher credit cost assumptions.

FY16E 33,079 33,876 -2%

FY17E 35,751 38,606 -7%

PAT

FY16E 7,809 8,965 -13%

FY17E 10,006 11,122 -10%

EPS (̀ )

FY16E 13.7 15.7 -13%

FY17E 17.6 19.4 -9%




Valuations factor in a recovery Whilst the continued disappointing results have led to the stock underperforming by 15% over the last 12 months, the stock is still not expensive in absolute terms due to the weak RoEs. We have valued MMFS using the two-stage excess return to equity model which is ‘net profit – (cost of equity x average net worth)’ for all the future years discounted back to the present using cost of equity.


We have assumed 20% CAGR in loan growth for FY19-24 and 18% CAGR in FY25-35.

We have assumed an RoA decline of 5bps every year over the next 20 years due to increased competition in the segment, resulting in RoAs falling from 2.7% in FY18 to 2.3% in FY26 and sustaining at such levels until FY34.

We have assumed cost of equity of 15% (based on risk-free rate of 8%, equity risk premium of 7% and a beta of 1.0).

We have assumed terminal growth of 5% and this is applied from FY34. Based on these assumptions, our one-year forward target price for the stock is `225/share (implied one-year forward P/B of 1.8x and one-year forward P/E of 12.8x), implying 5% downside from current levels. Note that we have cut our target price to `225/share (vs `230/share earlier), as we have cut our FY17 earnings estimates.

Exhibit 12: Excess return valuation profile of MMFS Particulars (in mn) ̀ mn, unless mentioned

Current Net worth (Sep'15) – A 59,427



Shares in issue - D 563

Implied fair value per share - E=C/D 197


One year forward Target price - E*(1+F) 225


Slight discount to cross-cycle valuations The continued disappointing results have led to MMFS’s RoE decreasing to ~15% in FY15 from 24% in FY13. This has led to the stock getting de-rated from 3.1x one-year forward P/B in FY13 to 1.8x one-year forward now, an 18% discount to its cross-cycle one-year forward P/B and a 13% premium to the cross-cycle P/E. Not so depressed valuations despite stressed current profitability imply that current valuations are already building in some recovery in profitability for the company. With the company still being cyclically stressed and with cyclical pressure on profitability, the discount to cross-cycle valuations is justified.



Exhibit 13: MMFS is trading at an 18% discount to its historical average P/B


Exhibit 14: MMFS is trading at a 15% premium to its historical average P/E


Key risks to our investment thesis

Our SELL stance on the stock revolves around our assumption that the continued slowdown in the rural economy would lead to a slowdown in loan growth and higher credit costs for MMFS. However, the following scenarios could result in better-than-expected earnings growth for MMFS:

Increase in government spending in rural areas, especially in rural infrastructure projects like roads.

Sharp uptick in tractor sales and UV sales.

It’s parent M&M regaining its market share in UVs post the new launches.

Forensic accounting scores Exhibit 15: Explanation for our flags on the first page


Accounting GREEN Annual report disclosures on NPAs, provisioning coverage, expenses, accounting policies and related party transactions and comparing them with peers gives us comfort that the reported numbers of MMFS are a true reflection of the profitability of the company.

Predictability RED MMFS’s earnings have been volatile and unpredictable in the recent past and with increasing asset quality risks and declining growth, the financial performance of MMFS would remain volatile in the near term.

Earnings Momentum RED Consensus has downgraded its earnings estimates by ~8-10% over the quarter primarily due to negative surprises on growth and asset quality. We expect consensus earnings estimates to trend downwards as the year progresses.


1

2

3

Mar-06

Dec-0

6

Sep-07

Jun-08

Mar-09

Dec-0

9

Sep-10

Jun-11

Mar-12

Dec-1

2

Sep-13

Jun-14

Mar-15

PB Avg. PB

7

9

11

13

15

17

Mar-06

Dec-0

6

Sep-07

Jun-08

Mar-09

Dec-0

9

Sep-10

Jun-11

Mar-12

Dec-1

2

Sep-13

Jun-14

Mar-15




Income statement (` mn) FY13 FY14 FY15 FY16E FY17E


Interest Income 38,567 49,217 55,361 58,826 63,787


Fee based and other income 1,023 314 486 535 589

Total Income 23,402 27,651 30,880 33,079 35,751

Total expenses 7,419 9,135 10,068 11,222 12,508


Employee Cost 2,234 2,973 4,591 5,117 5,703


Provisions 3,191 5,058 8,275 10,087 8,162


Tax 3,965 4,586 4,219 3,961 5,075

PAT - Standalone 8,827 8,872 8,318 7,809 10,006

Profit from Subsidiaries 547 691 871 1,068 1,373

Minority interest (104) 7 (60) (146) (186)

PAT - Consolidated 9,270 9,580 9,129 8,731 11,193


Balance Sheet (` mn) FY13 FY14 FY15 FY16E FY17E

Net worth 44,546 50,942 56,694 62,428 69,776

Borrowings 188,594 239,293 262,538 276,557 319,770


Fixed assets 1,068 1,195 1,101 1,193 1,363

Investments 5,610 9,052 8,537 8,537 8,537

Loans and Advances 240,380 296,170 329,300 350,976 405,047


Deferred tax assets 2,382 3,151 4,153 4,153 4,153

Net working capital (19,754) (24,866) (28,652) (31,072) (35,492)

Total assets 233,140 290,235 319,232 338,986 389,546


Key Metrics FY13 FY14 FY15 FY16E FY17E

AUM growth (%) 35.1 21.3 8.3 8.4 14.2

Dil Consol EPS growth (%) 39.3 (2.6) (4.4) (4.4) 28.2


Cost to income (%) 31.7 33.0 32.6 33.9 35.0

Opex (% of AAUM) 3.2 3.1 3.0 3.1 3.1

Gross NPAs (%) 3.0 4.4 5.9 7.7 6.3




Tier-1 (%) 17.0 15.5 15.5 16.2 15.9

Leverage (x) 5.8 6.2 6.1 5.8 5.9


Valuation parameters FY13 FY14 FY15 FY16E FY17E

BVPS (̀ .) 80.5 93.1 104.5 116.2 131.2

Dil. EPS (`) 17.2 16.8 16.1 15.3 19.7

ROA (%) 3.9 3.0 2.5 2.2 2.5

ROE (%) 23.8 18.6 15.5 13.1 15.1

P/E 13.5 13.9 14.5 15.2 11.9

P/BV 2.9 2.5 2.2 2.0 1.8

Dividend yield (%) 1.5 1.6 1.5 1.4 1.7




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Past its prime

Shriram Transport Finance’s RoEs and AUM growth are under structural pressure, due to: (i) Regulatory changes on priority sector borrowings, (ii) tougher NPA recognition norms, and (iii) increasing competition in used auto financing. Muted economic growth and high delinquencies in its CV and CE portfolio mean that even the cyclical pressure on profitability is not over yet. We cut our FY16/FY17 consolidated EPS estimates by 13%/8% and our target price to `745/share (vs `921/share earlier). We retain SELL.

Competitive position: STRONG Changes to this position: NEGATIVE Cyclical challenges to continue unabated SHTF is still cyclically challenged both on growth and asset quality, due to: (i) continuing slowdown in the economy, (ii) increasing stress in the rural economy, (iii) no broad-based recovery in CV/auto sales, and (iv) still high (and increasing) delinquencies in its loan book (40% loans in CEs and ~6% loans in CVs are 150+ day delinquent). We expect consolidated credit cost to remain elevated at 270bps in FY16E (vs 200bps in FY15), with consolidated RoE of 12% in FY16E (vs 23% in FY11-14). Our FY16 EPS estimate of `54 is 13% below consensus. Regulatory changes to structurally impact profitability Various changes in the priority sector lending and securitisation guidelines over the last 3-4 years have structurally compressed SHTF’s NIMs. Also, migration to 150/120/90 NPA recognition over FY16/17/18 is likely to structurally decrease its NIMs by ~22bps (due to lower proportion of interest-earning assets). Hence, a declining interest rate environment would only marginally boost SHTF’s NIMs by 13bps over FY15-17E. Also, migration to 90 day provisioning would structurally increase provisioning cost by ~11bps, and hence, we expect average credit cost of 222bps in FY16-17E vs ~200bps in FY11-15. Structurally on a weak footing; ownership change adds to uncertainty Increasing competition in the slow-growing used CV market, increasing reach of banks and credit bureaus, and prospects of consolidation in the fleet industry are few structural challenges that SHTF will have to face even if it comes out of cyclical stress. Moreover, SHTF’s future strategy is uncertain due to the changing nature of ownership, whereby the effective stake of Piramal Enterprises is now higher than the original promoters. Structurally lower profitability to reflect in lower valuations SHTF’s stock price has declined 32% over the last one year and is now trading at 1.7x one-year forward P/B, a 25% discount to the historical average. Whilst the valuation looks cheap vs the historical average, SHTF’s RoEs and growth have structurally decreased vs historical trends and are yet to fully reflect in the valuations as SHTF is at least a year away from recovering from cyclical stress. We cut our TP by 19% to `745, as we factor in sub-par profitability in the near term, due to a 13%/8% cut in our FY16/17 PAT estimates.

COMPANY INSIGHT SHTF IN EQUITY 08 October, 2015

Shriram TransportSELL

BFSI

Recommendation Mcap (bn): `211/US$3.2 6M ADV (mn): `731.2/US$11.2 CMP: `930 TP (12 mths): `745 Downside (%): 20%

Flags Accounting: AMBER Predictability: RED Earnings Momentum: RED

Catalyst

Elevated credit costs in FY16

Market share loss in old CV financing over FY16-17E

Muted RoEs of 12%/15% in FY16/17E

Performance (%)

Source: Bloomberg, Ambit Capital Research

8090

100110120130140150

Sep-

14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-

15

Sep-

15

SHTF IN SENSEX

Analyst Details




Key financials ` mn FY13 FY14 FY15 FY16E FY17E Total Income 36,464 38,134 41,836 47,952 55,889 PAT 14,635 13,588 10,284 11,990 16,148 Dil. EPS (`) 65 60 46 54 72 BVPS (̀ .) 316 365 400 454 518 ROE (%) 22.1 17.4 11.7 12.4 14.6 P/E (x) 14.4 15.5 20.2 17.3 12.8 P/BV (x) 2.9 2.5 2.3 2.0 1.8


Shriram Transport


Exhibit 1: SHTF is losing market share in the old CV space…

Particulars Market share – Used assets AUM CAGR (%)

FY11 FY15

CIFC 5.4% 7.5% 32%

MMFS* 2.7% 6.9% 50%

MGMA 2.1% 3.6% 39%

SHTF 89.8% 82.0% 18%

Source: Company, Ambit Capital research; Note: Market share has been calculated relative to CV financing; * MMFS’s market share appears high, as it is involved more in used cars financing and less in used CV financing.

Exhibit 2: …resulting in an moderate uptick in SHTF’s growth vs historical levels


Exhibit 3: Lower securitisation volumes imply that margin improvement will not be meaningful…


Exhibit 4: …and credit costs would remain elevated


Exhibit 5: RoAs will be capped…


Exhibit 6: …leading to muted RoEs


0%

10%

20%

30%

40%

50%

60%

70%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

E

FY17

E

AUM Growth (YoY, %)

10%

15%

20%

25%

30%

35%

40%

45%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

E

FY17

E

Securitised assets as a % of avg AUM (RHS)Calculated NIMs (% on AUM)

1.7%1.6%

1.3%

1.6% 1.6%

2.0%1.9% 2.0%

2.3%

2.1%2.0%

1.0%

1.2%

1.4%

1.6%

1.8%

2.0%

2.2%

2.4%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

E

FY17

E

Credit costs as a % of AUM

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

E

FY17

E

RoA (%)

0%

5%

10%

15%

20%

25%

30%

35%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

E

FY17

E

RoE (%)

Shriram Transport


Key estimates and forecasts Exhibit 7: Key assumptions and estimates (` mn unless specified)


YoY AUM growth (%) 11 18 17 Increased competition should result in market share loss for SHTF. This should result in SHTF mirroring moderate AUM growth.

NIMs on AUM (%) 7.4 7.5 7.5

Despite anticipating a ~50bps decline in systemic interest rates over FY15-17, we expect only a ~13bps improvement in SHTF’s NIMs over FY15-17E due to: (i) lower proportion of low-cost securitisation funding due to reclassification of legacy RIDF bonds as PSL loans; (ii) pricing pressures due to competitive forces; and (iii) lower proportion of interest-earning assets, as SHTF moves to 90 days NPA over FY15-18E.

Opex (as a % AAUM) 1.9 1.9 1.9 We expect a stable opex-to-AUM ratio in FY15-17E.

Credit costs (% of avg loan book) 2.3 2.3 2.2

Despite anticipating a dramatic recovery in its used CV financing business, we expect improvement in SHTF’s consolidated credit costs to remain marginal due to: (i) continued slippages in its CE book, wherein gross NPAs are ~25% and would continue to rise, as early delinquencies are still high; and (ii) migration to 150/120 day NPA recognition norms over FY16/17, which should result in an incremental ~20bps surge in credit costs. We expect consolidated credit costs of ~260/230bps in FY16/17E vs ~200/270bps over FY14/15.



Profit after tax - Standalone (` mn) 12,378 14,005 16,925 FY15-17E CAGR of 17% vs FY12-15 CAGR of -1%.

Profit after tax - Consolidated (` mn) 10,284 11,990 16,148 FY15-17E CAGR of 25% vs FY12-15 CAGR of -8%.

Standalone Diluted EPS (`) 56 63 76 FY15-17E CAGR of 17% vs FY12-15 CAGR of -1%.

Consolidated Diluted EPS (`) 46 54 72 FY15-17E CAGR of 25% vs FY12-15 CAGR of -7%.

BVPS (̀ ) 400 454 518 FY15-17E CAGR of 14% vs FY12-15 CAGR of 15%.

Consolidated RoE (%) 11.7 12.4 14.6 Source: Ambit Capital research

We downgrade our FY16/17 consolidated PAT estimates by 13%/8% to factor in higher credit costs from its equipment financing segment post the ongoing merger process. This has resulted in a 19% cut in our target price.

Exhibit 8: Change in estimates (` mn unless specified)

Estimates – ̀ mn Old New Change


Net revenues 47,952 55,889 47,952 55,889 0% 0%

Operating profit 35,536 41,521 35,536 41,521 0% 0%

PAT - Standalone 14,005 16,925 14,005 16,925 0% 0%

PAT - Consolidated 13,822 17,610 11,990 16,148 -13% -8%

Diluted EPS - Consol (`) 62 79 54 72 -13% -8%

Consolidated RoE (%) 14.3 16.0 12.4 14.6 -13% -8%

TP 921 745 -19%


Exhibit 9: Ambit vs consensus ` mn Ambit Consensus Divergence. Comments

Net Revenues

Our FY15-17 estimates are lower than consensus estimates due to higher credit cost assumptions vs consensus on SHTF’s equipment financing subsidiary.

FY16E 49,136 47,952 -2%

FY17E 57,232 55,889 -2%

Dil EPS - Standalone (̀ ) FY16E 63.2 62.8 -1%

FY17E 78.6 75.9 -3%

Dil EPS - Consol (̀ )

FY16E 60.5 53.8 -11%

FY17E 76.4 72.4 -5%


Shriram Transport


Valuations unreflective of declining profitability SHTF is trading at 1.7x one-year forward P/B and 11.4x one-year forward P/E on consensus estimates, a 25% discount and 6% premium to its cross-cycle averages respectively. With RoEs coming down to ~12-15% in FY15-17E vs average of ~25% in FY07-14, we believe that the valuation multiples are unlikely to expand from hereon and in fact they could contract over the next couple of years.

Exhibit 10: One-year forward P/B at a ~25% discount to cross-cycle averages


Exhibit 11: One-year forward P/E at a ~6% premium to cross-cycle averages


In absolute terms, we have valued SHTF using the two-stage excess return to equity model which is ‘net profit – (cost of equity x average net worth)’ for all the future years discounted back to the present using cost of equity.


We have assumed 17% CAGR in loan growth for FY18-34.

We have assumed average RoA of 2.2% between FY18-24

We have assumed cost of equity of 15% (based on risk-free rate of 8%, equity risk premium of 7% and a beta of 1.0).

We have assumed terminal growth of 5% and this is applied from FY34 onwards. Based on these assumptions, our one-year forward target price for the stock is `745/share (implied one-year forward P/B of 1.5x and one-year forward P/E of 12.1x), implying 9% downside from current levels. Note that we have downgraded our target price to `745/share (vs `921/share earlier), as we factor in lower RoEs on a consolidated basis due to the stress in the equipment financing subsidiary.

Key risks to our investment thesis Our SELL stance on the stock revolves around our assumption that weak economic growth would continue to put pressure on SHTF’s asset quality and growth over the next 12 months. A sharp economic recovery leading to sharp improvement in asset quality is a key risk to our negative stance on the stock.

1.0

1.5

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Shriram Transport


Forensic accounting scores Exhibit 12: Explanation for our forensic accounting scores


Accounting AMBER Compared with its peers that have migrated to 120-150 NPA recognition, SHTF still recognises NPAs at 180 days. Besides this, we did not come across anything unusual in the accounts of the company and we believe that its accounts are a true representation of the accounts of the company.

Predictability RED SHTF’s earnings have been volatile and unpredictable in the recent past. With exposure to rural India, the mining sector and the overall economy, SHTF’s financial performance remains unpredictable in the near term. Moreover, the management failed to guide the street on the upcoming losses in the equipment financing subsidiary.

Earnings momentum RED

Lack of higher infra spending by the Government and stress in its equipment financing subsidiary imply that its consolidated RoEs would remain muted in the near term. Besides this, consensus has downgraded its earnings estimates by 25% over the past six months. We expect consensus earnings estimates to trend downwards as the year progresses.


Shriram Transport


Income statement (` mn)

FY13 FY14 FY15 FY16E FY17E

Net Interest Income (inclu. Securitisation) 34,579 36,479 41,091 47,092 54,878

Other income 1,885 1,655 745 860 1,011

Operating income 36,464 38,134 41,836 47,952 55,889

Operating expenditure 7,808 9,561 10,783 12,416 14,368

Pre-provisioning profit 28,614 28,573 31,054 35,536 41,521

Provisions 8,451 10,293 12,630 14,691 16,329


Tax 6,556 5,638 6,046 6,840 8,267

PAT - Standalone 13,607 12,642 12,378 14,005 16,925

Net Contribution from subsidiaries 1,033 946 -2,092 -2,015 -777

PAT - Consolidated 14,635 13,588 10,284 11,990 16,148



Networth 71,947 82,732 90,846 102,951 117,580

Borrowings - on balance sheet 310,025 359,300 442,800 466,866 551,111

Borrowings - off balance sheet 182,322 166,284 98,811 173,886 204,220


Fixed assets 601 1,017 988 1,087 1,196

AUM 496,760 531,021 591,082 695,545 816,881

Cash and equivalents 100,304 98,112 68,769 80,923 95,040

Net Current Assets (33,371) (21,834) (28,383) (33,852) (40,205)

Total assets 564,294 608,316 632,457 743,703 872,912



AUM growth (%) 23.5 6.9 11.3 17.7 17.4

Dil Consol EPS growth (%) 11.7 (7.2) (23.0) 16.6 34.7

NIM (%, on AUM) - Calculated 7.8 6.9 7.4 7.5 7.5

Cost to income (%) 21.4 25.1 25.8 25.9 25.7

Opex (% of AAUM) 1.8 1.8 1.9 1.9 1.9

Gross NPAs (%) 3.2 3.9 3.8 3.2 3.0




Tier-1 (%) 16.7 15.7 14.3 15.2 14.7

Leverage (x) 7.8 7.4 7.0 7.2 7.4


Valuation parameters FY13 FY14 FY15 FY16E FY17E

BVPS (̀ ) 316 365 400 454 518

Diluted EPS (`) 65 60 46 54 72

ROA (%) 2.9 2.2 2.0 2.0 2.1

ROE (%) 22.1 17.4 11.7 12.4 14.6

P/E 14.4 15.5 20.2 17.3 12.8

P/BV 2.9 2.5 2.3 2.0 1.8

Dividend yield (%) 0.8 0.7 0.7 0.8 0.9



Levered to growth

Despite improvement in NIMs, Magma’s RoEs continues to lag to its peers due to increase in credit and operating costs. However, Magma offers the best play in a period of economic recovery as its RoEs would improve not only from decline in credit costs but also from: i) Operating leverage - its best placed amongst its peers in our framework; and ii) NIMs improvement - due to AUM mix shift towards high-yield assets and shift in liability mix towards low-cost liabilities. We expect its RoEs to expand from ~11% in FY15 to 13% in FY17E, which w lead to a meaningful rerating from current valuations. We reiterate BUY with a revised TP of `133/share (vs `143/share earlier). Competitive position: MODERATE Changes to this position: STABLE Restructuring and eventual growth to improve operating efficiencies Magma’s opex/asset ratio is the highest in the industry at 3.5%, which is compressing its RoEs. However, Magma has started focusing on improving operational efficiencies by scaling down operations in low-RoA products/geographies, employee rationalisation, increased cross-selling and reduction in DSA payouts through higher direct origination. Moreover, improvement in loan growth and asset quality would aid further operational efficiencies as it will be able to better use its idle sales capacity and also lower its collection costs. We expect the opex/asset to improve by ~20bps in FY15-17E. Higher-quality fresh origination to result in asset quality improvement With continued stress in the economy and lower provisioning coverage, Magma’s credit costs would remain elevated at ~200bps/140bps in FY16/17. However, Magma’s asset quality should improve beyond FY17, due to better quality fresh originations owing to: (i) the company exiting from some geographies with higher credit costs; (ii) increased direct sourcing of customers; and (iii) alignment of employee incentive structure towards asset quality. Also, Magma has already moved to 120 day NPA recognition, implying that the incremental impact on Magma from moving to 90 day NPA recognition will be limited and will not meaningfully impact the profitability. Steady yields, lower funding costs & capital raise to improve NIMs Despite headwinds of declining low cost securitization funding and pricing pressure from banks, we expect Magma’s NIMs to expand by ~70bps over FY15-17E, as: (i) Realignment of AUM mix realigns from highly competitive and low yielding segments like cars and CVs/CEs towards high-yielding segments will support yields; (ii) cost of funds declines by ~40bps due to lowering of base rates by banks and shift to wholesale market borrowings; and (iii) equity capital infusion of ~`5bn, which would aid NIM expansion by ~30bps. Valuations not reflecting the turnaround Magma’s RoAs and RoEs are well positioned to expand, not only due to external factors such as an eventual economic recovery and also by internal restructuring of its operations. We expect RoE improvement from ~11% in FY15 to 13% in FY17E to drive the rerating of the stock. Our EVA-based TP of `133 implies 1.2x FY17E P/B for a stock that is currently trading at 0.8x FY17E P/B and ~6x FY17E P/E, a 50% discount to its peers.

COMPANY INSIGHT MGMA IN EQUITY October 08, 2015

Magma FincorpBUY

BFSI

Recommendation Mcap (bn): `21/US$0.3 6M ADV (mn): `26.9/US$0.4 CMP: `87 TP (12 mths): `133 Upside (%): 53%

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: AMBER

Catalysts

Improvement in growth in FY17

Improvement in operational efficiencies over FY16-17

Share price performance (%)


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MGMA IN SENSEX

Analyst Details




Key financials

` mn FY13 FY14 FY15 FY16E FY17E Total Income 7,752 9,404 11,526 13,130 14,795 PAT (adj.) 1,246 1,391 1,687 1,866 3,280 Dil. EPS (`) 6.6 7.3 8.8 7.9 13.9 BVPS (̀ .) 73.5 79.1 87.1 98.2 110.4 ROE (%) 10.0 9.6 10.7 9.4 13.3 P/E (x) 13.3 11.9 9.8 11.0 6.3 P/BV (x) 1.2 1.1 1.0 0.9 0.8


Magma Fincorp


Exhibit 1: Magma’s RoE gap with peers has narrowed in FY15


Exhibit 2: Normalising for 90dpd, Magma’s RoE gap with peers is much lower


Exhibit 3: Magma’s operating costs are the highest amongst peers…


Exhibit 4: …due to a high employee base relative to AUM and disbursements


Exhibit 5: As Magma’s operating efficiencies improve…


Exhibit 6: … RoEs will also improve


19.7%

16.2%18.6%

17.1%

9.6%

16.9%

11.7%

16.2%17.5%

10.7%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

SUF SHTF MMFS CIFC MGMA

RoEs

FY14 FY15

18%

15%17% 17%16%

14%12%

10%11%9%

0%

4%

8%

12%

16%

20%

Reported Adjusted for NPAs at90dpd

FY1

5 R

oEs

CIFC SUF MMFS SHTF MGMA

3.7%

3.1% 3.0%

2.5%

1.9%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

MGMA CIFC MMFS SUF SHTF

Opex/AUM 54

29 34

20 26

12 19

10

19

9

0

10

20

30

40

50

60

AUM/Employee (Rs mn) Disb/employee (Rs mn)

SUF SHTF MMFS CIFC - VF MGMA - VF

2.8%

3.3% 3.3%

3.7%

3.4% 3.4%

2.7%

2.9%

3.1%

3.3%

3.5%

3.7%

3.9%

FY12 FY13 FY14 FY15 FY16E FY17E

Opex/AUM (%)

7.4%

10.0% 9.6%10.7%

9.4%

13.3%

2.7%

4.7%

6.7%

8.7%

10.7%

12.7%

14.7%

FY12 FY13 FY14 FY15 FY16E FY17E

RoEs (%)

Magma Fincorp


Key estimates and forecasts Exhibit 7: Key assumptions and estimates (consolidated)


AUM growth (%) 9% 1% 15% We expect ~8% AUM CAGR in FY15-17 driven by recovery in FY17.

NIM (%) 5.6% 6.1% 6.3%

We expect a ~70bps improvements in NIMs over FY15-17E, as: (i) yields would remain steady at current levels due to continued realignment of mix to higher-yielding products like tractors, SME loans, old CVs and low-ticket mortgages; (ii) cost of funds decline by ~40bps due to lowering of base rates by banks and shift to wholesale market borrowings; and (iii) equity capital infusion of ~`5bn in Mar’15 would expand NIMs by ~30bps.

Opex/avg AUM (%) 3.7% 3.4% 3.4%

We expect opex to improve over FY15-17E due to internal and external levers. Internally, Magma has been focusing on improving operational efficiency and realignment to higher RoA products. Externally, uptick in growth will also result in Magma’s idle sales capacity being used and reduction in its collection costs, due to its cross-functional architecture.

Credit costs (% of avg loan book) 1.27% 2.02% 1.44%

We expect credit costs to remain high over FY15-17 despite the economic recovery, as we expect the coverage ratio to increase to 70%.

Estimates



Profit after tax (` mn) 1,807 1,941 3,350 FY15-17E CAGR of 36% vs FY12-15 CAGR of 34%.

Diluted EPS (`) 8.8 7.9 13.9 FY15-17E CAGR of 25% vs FY12-15 CAGR of 35%.

Adjusted BVPS (̀ ) 87 98 110 FY15-17E CAGR of 13% vs FY12-15 CAGR of 15%.

RoAA (%) 0.9% 0.9% 1.5%

RoE (%) 10.7% 9.4% 13.3%


We downgrade our FY16/17 PAT estimates, as we increase our credit costs estimates.

Exhibit 8: Change in estimates (` mn)

New estimates Old estimates Change


Net revenues (` mn) 13,130 14,795 13,304 13,304 -1% 11%

Operating profit (` mn) 6,357 7,546 6,391 7,505 -1% 1%

Profit after tax (` mn) 2,012 3,473 2,322 3,574 -13% -3%

Diluted EPS (`) 7.9 13.9 9.0 14.1 -12% -2%


Exhibit 9: Ambit vs consensus (consolidated)

` mn Ambit Consensus % divg. Comments

Net Revenues FY16E 13,130 12,763 3% Our FY16 PAT estimates are lower than

consensus due to expectation of higher credit costs. FY17E 14,795 14,991 -1%

PAT FY16E 1,941 2,160 -10% However, we are materially ahead of consensus

expectations on FY17 PAT due to expectations of higher operating leverage. FY17E 3,350 2,911 15%


Magma Fincorp


RoE expansion to drive valuations At a valuation of 0.8x FY17E P/B (post dilution), Magma is trading at a discount to its peer-set due to its relatively lower RoEs. However, given the scope for improvement in its RoEs in the medium and long term, the valuation discount should eventually converge. We have valued Magma using the two stage excess return to equity model which is ‘net profit – (cost of equity x average net worth)’ for all the future years discounted back to the present using cost of equity.


We have assumed 17% CAGR in loan growth for FY18-24 and a 16% CAGR in FY23-34.

We have assumed RoAs gradually improving to 1.8% up to FY34.

We have assumed cost of equity of 15.5% for Magma based on risk-free rate of 8.5%, equity risk premium of 6.5% and a beta of 1.0.

We have assumed terminal growth of 5%. Based on these assumptions, we cut our one-year forward target price for the stock by 7% from `143/share to `133/share (FY17E P/B of 1.2x and FY17E P/E of 9.6x), implying 53% upside from current levels. Note that Magma’s cost of equity is higher (by 50bps) than other NBFCs in our coverage, as we assume a higher equity risk premium due to the execution risk involved in simultaneously increasing the share across many product categories.

Exhibit 10: Excess return valuation profile of Magma Particulars (̀ mn, unless mentioned)

Net worth (Jun'15) – A 21,870



Shares in issue post dilution – D (mn) 236

Implied fair value per share - E=C/D (`) 115


One-year forward share price - E*(1+F) (`) 133


Magma Fincorp


Premium to cross-cycle valuations to increase On consensus estimates, Magma’s current 12-month forward P/B of 1x is at a 10% discount to its cross-cycle average P/B, and its 12-month forward P/E of 7.8x is broadly in line with its cross-cycle 12-month average forward P/E. With RoEs improving to ~14% over FY17E vs ~11% in FY15 driven by 25% EPS CAGR, we expect Magma’s valuation multiples to rerate over the next couple of years.

Exhibit 11: One-year forward P/E is broadly in line with its cross-cycle average P/E


Exhibit 12: One-year forward P/B is at a ~10% discount to cross-cycle average P/B


Key risks to our investment thesis Our BUY stance revolves around the assumption of an economic recovery in FY16, limited increase in credit costs and marginal improvements in operational efficiency. Consequently, a weak economy and an elevated interest rate environment should lead to lower NIMs and higher credit costs for the company. Further, higher-than-expected credit cost in newer and riskier segments, like tractors, used CVs and SME loans, is also a key risk.

Forensic accounting scores Exhibit 13: Explanation for our flags on the first page


Accounting GREEN

Magma is one of the most-prudent recognisers of NPAs at 120 days past due and its standard asset provisioning is at 30bps. Based on annual report disclosures on NPAs, provisioning coverage, expenses, accounting policies and related party transactions and comparing them with peers gives us comfort that the reported numbers of Magma are a true reflection of the profitability of the company.

Predictability AMBER With elevated rural stress, the asset quality and growth outlook is hazy. We are building in credit costs of 200bps in FY16.

Earnings Momentum AMBER With expectation of a muted AUM growth in FY16, improvement in RoEs would be delayed up to FY17.


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Magma Fincorp




Net Interest Income 7,177 8,743 10,486 11,934 13,419

Non- Interest Income 575 661 1,040 1,196 1,376

Total Income 7,752 9,404 11,526 13,130 14,795

Operating expenditure 4,662 5,586 6,847 6,773 7,249

Pre Provisioning Profit 3,091 3,818 4,679 6,357 7,546

Provisions 966 1,841 2,444 4,030 3,205


Tax 675 381 362 315 869

Profit after tax 1,449 1,596 1,873 2,012 3,473

Adjusted Profit after tax 1,246 1,391 1,687 1,866 3,280



Networth 13,974 15,038 16,549 23,198 26,097

Preference Capital 1,970 1,498 1,326 850 850

Borrowings 167,834 180,496 180,464 176,762 204,422


Loan Book 162,400 178,770 195,665 197,963 227,459

Other Assets 21,378 18,262 2,674 2,847 3,910

Total assets 183,778 197,032 198,339 200,810 231,369



AUM growth (%) 34.9 10.1 9.5 1.2 14.9

Dil Consol EPS growth (%) 84.0 11.6 20.9 (10.7) 75.8


Cost to income (%) 60.1 59.4 59.4 51.6 49.0

Opex (% of AAUM) 3.3 3.3 3.7 3.4 3.4



Tier-1 (%) 10.6 11.5 11.1 15.6 15.2

Leverage (x) 13.2 13.1 12.0 8.7 8.9




BVPS (̀ ) 74 79 87 98 110

Diluted EPS (`) 6.6 7.3 8.8 7.9 13.9

ROA (%) 0.8 0.7 0.9 0.9 1.5

ROE (%) 10.0 9.6 10.7 9.4 13.3

P/E 13.3 11.9 9.8 11.0 6.3

P/BV 1.2 1.1 1.0 0.9 0.8

Dividend yield (%) 0.9 0.9 0.9 0.8 1.4



Long-standing champion Sundaram Finance (SUF) is the oldest CV financier with a track record of strong profitability and growth. SUF has delivered average RoEs of 19% over FY08-15, due to lower operating and credit costs by virtue of focusing on prime customers. The stock has significantly rerated over FY13-15 to 4.9x trailing P/B despite its earnings CAGR slowing down to 1% during this period (vs 13% CAGR over FY08-15). With increasing competition from banks, it remains to be seen whether SUF can return to its historical growth trajectory and sustain its premium valuations.

Competitive position: STRONG Changes to this position: NEGATIVE

Oldest auto financier; strong focus in southern India

Incorporated in 1954, Sundaram Finance (SUF) is a part of the Chennai-based Sundaram Group of companies. It is one of the oldest auto financiers in India with a presence in housing finance, general insurance and asset management. SUF’s is strongly focused in southern India, which accounts for 63% of its loan book. Its auto loan book is dominated by CVs and cars, which account for 46% and 37% of its AUM respectively. In stark contrast to other NBFCs, SUF focusses on prime customers and directly competes with banks.

Superior RoEs driven by lower operating and credit costs

Over FY08-15, SUF has delivered consolidated EPS CAGR of 14% and BVPS CAGR of 18%, driven by average RoEs of 19% and AUM CAGR of 11%. Relatively lower funding costs, operating costs (average of 240bps) and credit costs (average of 40bps) have helped SUF to deliver average RoEs of ~19% despite lower lending yields. SUF’s lower operating and credit costs are driven by its focus on prime customers; in direct competition to banks (only ~20% of its collections are in cash vs ~40-60% for its NBFC peers).

Structural issues could test expensive valuations

SUF’s earnings growth has moderated over the last two years, with EPS CAGR slowing down to 5% over FY13-15 vs 14% over FY08-13. Counterintuitively, during the same period, the stock has re-rated to 4.9x trailing consolidated P/B from 2.5x two years ago and it is trading at a premium of 80%/100% to its historical averages/peers. As cyclical stress is still not behind the company and as the structural issues mentioned earlier are weakening the competitive positioning of NBFCs, including Sundaram Finance, it remains to be seen whether the company can return to its historical profit growth trajectory and sustain its current valuation multiple.

Sundaram Finance NOT RATED

VISIT NOTE SUF IN EQUITY October 08, 2015

Key financials (` mn, unless specified)

` mn FY11 FY12 FY13 FY14 FY15

Total Income (Standalone) 7,426 8,755 10,496 11,502 12,015

PAT (Standalone) 2,952 3,555 4,101 4,425 4,541

PAT Consolidated) 3,889 4,579 5,640 5,811 5,759

Dil. EPS - Consolidated (`) 35.0 41.2 50.8 52.3 51.8

BVPS (̀ .) 163 195 235 277 337

ROE (%) 20.8% 21.4% 21.2% 19.7% 16.9%

P/E (x) 43.3 36.8 29.8 29.0 29.2

P/BV (x) 9.3 7.8 6.4 5.5 4.5


BFSI

Recommendation Mcap (bn): `168/US$2.6 6M ADV (mn): `46.8/US$0.7 CMP: `1,515

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: AMBER

Performance


Analyst Details




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SUF IN SENSEX

Sundaram Finance


Key charts Exhibit 1: SUF’s AUM mix has shifted to car loans


Exhibit 2: SUF’s AUM mix is strongly focused on south India


Exhibit 3: SUF’s liability breakup is heavily dependent on wholesale borrowings


Exhibit 4: Auto financing contributed to 79% of consolidated profit in FY15


Exhibit 5: SUF has kept its operating costs in control

Source: Company, Ambit Capital research; * Ratios are unadjusted for the netting of depreciation on operating lease and origination costs in the total income.

Exhibit 6: SUF’s productivity has plateaued


52% 50% 45% 46%

33% 35% 38% 37%

7% 7% 7% 7%4% 5% 5% 5%4% 4% 5% 6%

0%

20%

40%

60%

80%

100%

FY12 FY13 FY14 FY15

CVs Cars CEs Tractors Others

South, 63%

North, 18%

West, 15%

East, 4%

Debentures, 48%

Securitisation, 17%

CPs, 15%

Deposits, 13%

Banks / Others, 8%

Auto Financing,

79%

Housing Finance,

13%

Asset Manageme

nt, 3%

Others, 5%

2.3%

2.4%

2.5%

2.6%

2.7%

35%

36%

37%

38%

39%

40%


Cost to income (%) Cost to assets (%) (RHS)

500

510

520

530

540

550

560

570

580

100120140160180200220240260280300


Branches (RHS) AUM/Branches (Rs mn)

Sundaram Finance


Exhibit 7: SUF’s yields and cost of funds


Exhibit 8: SUF’s NIMs have been broadly stable


Exhibit 9: SUF’s asset quality has worsened over FY12-15


Exhibit 10: SUF’s credit costs have increased…


Exhibit 11: … resulting in declining RoEs over FY11-15


Exhibit 12: Historical trends in tier 1 and leverage


12.0%

13.0%

14.0%

15.0%

16.0%

17.0%

18.0%

7%

8%

9%

10%

11%


Cost of funds (%) Yield on advances (%) (RHS)

6.60%

6.70%

6.80%

6.90%


Net interest margins (%)

50%

60%

70%

80%

90%

0.5%

0.8%

1.0%

1.3%

1.5%


Gross NPAs (%) Provisioning Coverage (%) (RHS)

0.5%

0.3%

0.5% 0.5%

0.6%

0.00%

0.30%

0.60%

0.90%


Credit Cost (%)

16%

18%

20%

22%

2.4%

2.5%

2.6%

2.7%

2.8%


RoA (%) RoE (%) (RHS)

5

6

7

8

9

10

12%

14%

16%

18%


Tier 1 (%) Leverage (x) (RHS)

Sundaram Finance


Exhibit 13: Historical YoY AUM growth


Exhibit 14: Standalone and consolidated EPS growth


Exhibit 15: SUF is trading at a 70% premium to its historical cross-cycle average P/B*

Source: Company, Ambit Capital research; Note: *On standalone basis

Exhibit 16: SUF is trading at a 90% premium to its historical cross-cycle average P/E*

Source: Company, Ambit Capital research; Note: *On standalone basis

Forensic accounting scores Explanation for our forensic accounting scores


Accounting GREEN Being already at 120dpd NPA recognition, SUF is a step ahead of the 90 dpd NPA recognition norms of its peers, some of whom are still at 180 days. Besides this, we did not come across anything unusual in the accounts of the company and we believe that its accounts are a true representation of the accounts of the company.

Predictability GREEN SUF’s superior underwriting and conservative approach to growth have resulted in stable asset quality even in challenging times. This has prevented any shocks and unpredictability in the financial performance for SUF.

Earnings momentum AMBER 83% of SUF’s book is exposed to cars and CV loans, a segment which is growing relatively better than other segments like tractors and LCVs. However, stiff competition from banks has resulted in SUF growing slower than the primary sales of vehicles.


0%

5%

10%

15%

20%

25%

30%


AUM Growth (%)

-60%

-40%

-20%

0%

20%

40%

60%


Standalone EPS growth (%)Consolidated EPS growth (%)

0

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2

3

4

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6

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Apr-15

Oct-15


5

10

15

20

25

30

Mar-10

Sep-10

Mar-11

Sep-11

Mar-12

Sep-12

Mar-13

Sep-13

Mar-14

Sep-14

Mar-15

Sep-15


Sundaram Finance





Interest income 13,702 16,987 20,630 22,155 22,547


Other income 802 604 688 984 1,144

Total Income 7,426 8,755 10,496 11,502 12,015

Total expenses 2,688 3,284 3,841 4,298 4,528


Employee Cost 1,123 1,454 1,619 1,813 1,959


Provisions 443 349 729 737 975


Tax 1,342 1,567 1,825 2,041 1,971

PAT (Standalone) 2,952 3,555 4,101 4,425 4,541

PAT (Consolidated) 3,889 4,579 5,640 5,811 5,759


Balance Sheet (` mn)


Net-worth 15,293 17,879 20,867 24,049 29,781

Borrowings 110,693 126,178 145,113 148,565 148,887


Fixed assets 2,341 2,944 3,319 3,466 3,109

Investments 9,928 7,640 10,443 14,473 15,215

AUM 108,064 135,080 151,480 156,980 162,610


Net working capital (5,169) (5,898) (8,006) (9,053) (9,033)

Total assets 125,987 144,057 165,980 172,614 178,668


Key Metrics


AUM growth (%) 21.7% 25.0% 12.1% 3.6% 3.6%

Dil Consol EPS growth (%) 36.3% 22.7% 20.5% 14.4% 4.2%

Net interest margin (NIM) (%) 6.7% 6.7% 6.8% 6.8% 6.8%

Cost to income (%) 36.2% 37.5% 36.6% 37.4% 37.7%

Opex (% of AAUM) 2.7% 2.7% 2.7% 2.8% 2.8%

Gross NPAs (%) 0.8% 0.6% 1.0% 1.2% 1.4%

Credit costs (% of AAUM) 0.4% 0.3% 0.4% 0.4% 0.5%

Provision Coverage (%) 74.8% 84.2% 57.5% 63.5% 64.1%

Capital adequacy (%) 16.2% 16.3% 17.9% 18.2% 21.4%

Tier-1 (%) 12.6% 12.9% 13.4% 14.5% 17.2%

Leverage (x) 8.1 8.1 8.0 7.5 6.5




BVPS (̀ .) 162.6 194.8 235.3 277.2 337.5

Dil. EPS - Consolidated (`) 35.0 41.2 50.8 52.3 51.8

ROA (%) 2.6% 2.6% 2.6% 2.6% 2.6%

ROE (%) 20.8% 21.4% 21.2% 19.7% 16.9%

P/E 43.3 36.8 29.8 29.0 29.2

P/BV 9.3 7.8 6.4 5.5 4.5

Dividend yield (%) 0.9 1.0 0.6 0.7 0.7


Sundaram Finance


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Abhishek Ranganathan, CFA Retail / Mid-caps (022) 30433085 [email protected]

Achint Bhagat, CFA Cement / Roads / Home Building (022) 30433178 [email protected]

Aditya Bagul Consumer (022) 30433264 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Kushank Poddar Technology (022) 30433203 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar, CFA Metals & Mining (022) 30433223 [email protected]

Prashant Mittal, CFA Derivatives (022) 30433218 [email protected]

Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Oil & Gas / Chemicals (022) 30433242 [email protected]

Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Krishnan V India / Asia (022) 30433295 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Shaleen Silori India (022) 30433256 [email protected]

Singapore

Pramod Gubbi, CFA – Director Singapore +65 8606 6476 [email protected]

Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola - CEO Americas +1(646) 361 3107 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

Sundaram Finance


Shriram Transport Finance (SHTF IN, SELL)


Mahindra & Mahindra Financial Services (MMFS IN, SELL)


Magma Fincorp Ltd (MGMA IN, BUY)


0200400600800

1,0001,2001,400

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SHRIRAM TRANSPORT FINANCE

050

100150200250300350400

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MAHINDRA & MAHINDRA FIN SECS

020406080

100120140

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MAGMA FINCORP LTD

Sundaram Finance


Cholamandalam Investment (CIFC IN, BUY)


Sundaram Finance Ltd (SUF IN, NOT RATED)


0100200300400500600700800

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CHOLAMANDALAM INVESTMENT AND

0200400600800

1,0001,2001,4001,6001,800

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SUNDARAM FINANCE LTD

Sundaram Finance


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock

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Disclosure 26. Ambit and/or its associates have financial interest in M&M Financial Services and Magma Fincorp

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