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Repco Home Finance Ltd (RHFL) Buy at Rs.400/- 10th Oct,2014

The fortunes of the banking and finance sector are very dependent on the overall state

of the economy. When the economy is doing well, loan growth tends to be robust.

Moreover, the repayment capacity of the borrowers also remains strong. But when the

tide turns, financial institutions come under pressure not only to grow their business but

also to maintain their asset quality.

Before we go any further let us understand what asset quality is and why it matters to

shareholders. By asset quality, we mean the creditworthiness of a loan. The most

common parameter to assess the asset quality is non-performing assets (NPAs). This

indicator shows the quantum of loans that have been non-recoverable and therefore

would have to be written off by the banks.

As you know, the Indian economy has been facing a series of challenges. And this has

severely impacted the medium term prospects of the banking sector. Borrowers have

been hit hard by high interest rates and the poor business environment. This, in turn,

has resulted in a sharp increase in the quantum of bad loans. The end result is lower

profitability for the lender and poor shareholder returns.

Let's delve a bit more into the causes of bad loans. One major reason, as we discussed

above, is the poor business environment. Factors such as slowdown in demand, excess

capacity, regulatory hurdles, project delays, etc. tend to adversely impact the financial

health of a business and their capacity to service their loans.

Another reason for bad loans could be poor risk management and credit appraisal

systems followed by banks. There tend to be cases wherein banks fail to understand the

risks associated with a certain project or borrower and hence, end up burning their

fingers.

Among the banks that have been victims of wilful default, there is this one bank

called United Bank of India (UBI). The entity has been in the news recently after it

suspended its lending activity for an indefinite period following capital adequacy

concerns. As of December 2013, the bank's Gross NPA ratio was staggeringly high at

10.82% (as per company's 3QFY14 presentation), the worst level in the industry. The

state-run bank has also been under the scanner of the Reserve Bank of India (RBI) for

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alleged dubious lending practices. Having said that, there are several small private

sector lenders too that are in RBI's watch list for poor credit assessment.

It goes without saying that investors in small cap lending businesses are at the

maximum risk of exposure to value traps.

So what we typically look for in lending businesses are:

Managements that are more concerned about the quality of lending than growth

in loan book

Businesses that are keener to preserve lending margins than chase growth

Entities that have historically been very proactive in provisioning policies and

have adequate capital support

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The 'Gruh Finance' of the South

Have you ever wondered how tough it is for a small town, self-employed, non-

professional to seek a home loan? The worries magnify further if the individual is not

salaried and if he hails from a semi-urban or rural area. That is because banks and large

housing finance companies (HFCs) have very limited credit history for such markets.

Therefore, for the under-served rural populace, buying a home with borrowed finance is

more of a dream.

Interestingly, despite housing finance being a relatively safer asset class, not many

entities have ventured into this space for the semi urban and rural regions. The reasons

being longer tenure of loans, difficulty in assessment of borrowing capacity and

possibility of asset liability mismatch. Needless to say, entities like Gruh Finance that

have successfully proven the business model in this space are much sought after!

The good news is that, we recently came across one entity that is ideally positioned to

advantage of the latent demand for home loans in rural areas of South India. Not just

that...it enjoys the parentage and goodwill of a small government owned bank that has

been in existence since 1969.

Not many would be familiar with Repco Bank, a south based regional bank with

prominent presence in Tamil Nadu. Due to its cooperative society structure and distinct

laws that govern cooperative societies, the entity had to set up a subsidiary to tap the

growth potential in the housing finance market.

Repco Home Finance Ltd (RHFL), the subsidiary of Repco Bank, was established in 2000.

The entity provides low ticket mortgage loans in semi urban and rural areas. It has a

balanced loan mix of salaried (46%) and self-employed (54%) individuals. The loans

schemes of RHFL comprise of home loans, home makeover loans, mortgage loans, plot

loans, commercial construction loans, NRI loans etc.

What has helped RHFL defy the odds of the financial sector is its presence in a niche

segment and ability to leverage the strengths of the rural market. The semi-urban and

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rural areas have witnessed robust and steady increase in disposable incomes. Led by

government incentives, easier accessibility, greater connectivity and increase in food and

vegetable prices, these pockets have flourished like never before. Banking on the rural

story, RHFL has been tapping the non-salaried and non-professional segment based out

of Tier II/III cities.

RHFL enjoys a very low cost structure in terms of client acquisition and branch set-up

vis-à-vis its larger peers. With this lean branch model and strong branch network

expansion plans in place, RHFL's loan book is poised to generate significant growth

consistently going forward. Moreover, the expected increase in average ticket size of the

loan from current Rs 1 m to Rs 1.5 m places the company on a surer footing.

Given the company's small size, unique business model and scalability we believe that

RHFL is a stable long term player in the home financing space. Moreover, the

company's sustainable margin profile is among the best in the industry.RHFL's focus on

higher yielding loan segment (loans to self employed individuals) coupled with lower

costs of funds, helps it maintain net interest margins above 3.5% levels. Add to this

robust risk management systems and conservative lending metrics (loan to value ratio)

which can ensure good asset quality. That the total loan write-offs since inception has

stood mere 0.08% of total disbursements is indicative of the same.

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More about Repco Home Finance Ltd.

Repco Home Finance Ltd or RHFL is a professionally managed housing finance

company headquartered in Chennai, Tamil Nadu. Incorporated in April 2000 as a wholly

owned subsidiary of the Repatriates Co-operative Finance and Development Bank

Limited (Repco Bank Limited) to tap the growth potential in the housing finance

market. RHFL is registered as a housing finance company with the NHB. Repco is

focused on providing home loans in tier II and tier III cities with an average ticket size

of around Rs 9.5 lakh. The branch network of the company boasts of 102 brnaches and

satellite centers with 90% located in Southern Inida. The company has successfully

raised Rs. 2700 mn in March 2013. The company intends to focus on diversified resource

funding mix to strengthen balance sheet and optimize costs.

Key Management Personnel

T S Krishna Murthy, Chairman: With over 50 years' experience, he has served as Chief

Election Commissioner of India, Chief Commissioner of Income Tax. He also sits on the

boards of Shriram Life, Edelweiss ARC, DSP Blackrock Trustee and RRB Energy.

R Varadarajan, Managing Director: With over 35 years' experience, he was with

Syndicate Bank for 23 years and thereafter with Repco Bank. He is responsible for the

strategic decisions of the company.

V Raghu, Executive Director: He has over 32 years of experience. He has worked earlier

as GM with NHB and also with Reserve Bank of India (RBI) and State Bank of India

(SBI).

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How Repco Home Finance Ltd will unlock its growth potential?

Niche business focus with balanced loan mix

RHFL has created a niche for itself by focusing on the self-employed segment in

Tier II/III and peripheries of Tier I cities. The self-employed segment constitutes

75% of the total workforce in the region. This leaves considerable opportunities

for smaller housing finance companies like RHFL to focus on non-salaried and

Tier II/III markets. Moreover, these markets are largely under-served by banks

and large HFCs as they preferably focus on the salaried segment that forms 25%

of the total workforce due to ease in credit appraisal.

With lesser focus on highly competitive salaried segment (46% of loan book) and

highest exposure to the fast-growing self-employed (54% of loan book) category,

the company is positioned favorably to reap the benefits of improving rural

demographics. The company reaches out to the customers directly through

localized advertising, loan camps and word of mouth referrals. This direct

marketing avoids agents or intermediaries thereby reducing costs and ensuring

greater transparency and efficiency.

To add to this, RHFL boasts of a low-cost branch model operating at lower rentals

in Tier II/III cities. With mere three to four employees per branch that ensure

lower costs, they are equipped with strong local knowledge and understanding of

customer needs. Further, centralized credit approval system ensures lower

administrative expenses. Therefore, the company has succeeded in maintaining

lower cost-income ratio that range between 17%-18% and is expected to remain at

these levels going forward.

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Scalable business backed by growth

RHFL today stands on the cusp of a growth trajectory. Deepening geographic

presence, consistent loan growth trajectory and superior margins make RHFL's

business extremely scalable. While loan book growth is the major catalyst for the

steady business growth of RHFL, new customer additions, expansion of branch

network and increase in the average loan size remain the key drivers

The average ticket size of the loan book that stands today at Rs 1 m has grown at

CAGR of 11.9% from FY10 to FY13. The company expects to expand this average

ticket size to Rs 1.5 m over the next three years. Further the credit growth for the

company would get a further boost with the increase in share of loan against

property (LAP) segment that stands as 17% of the total book at current levels.

Consistent expansion in existing distribution network is the second biggest driver

for the loan traction for RHFL. The company expects to add around 15 new

branches every year with two-third of the network located in southern states and

the rest in the non-southern region. Also, the branches start adding up to the

business and profitability in less than one year of their establishment.

Robust risk management system and controlled asset quality

Despite the higher loan exposure to the risky self-employed category, the asset

quality of the company remains under control. While the erratic cash flows of

self-employed borrowers tend to temporarily push up the bad loans for the

company during few quarters, these are not willful defaulters. That the total loan

write-offs since inception have stood at merely 0.08% of total disbursements are

indicative of the same. Also, with consistent recoveries in place, it is unlikely that

the company may witness severe pressures on credit quality.

Additionally, the company has adopted conservative lending practices by

maintaining average loan-to-value (LTV) ratio of 60-65% and income to

installment (IIR) of 50% in FY13. Besides, the zero exposure to the

rather risky developer loan segment also helps maintain asset quality for

the company. The gross non-performing assets (NPAs), therefore,

have remained below 2% levels as at the end of March 2013 and the provision

coverage has improved from lower levels of 22% in FY11 to 34% in FY13.

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Robust earnings profile, capital sufficiency

The company's borrowing mix stands pretty diversified with 50% of the

borrowings flowing from banks, another 37% from NHB and 12% from the

promoter, the Repco Bank. Owing to the low ticket size of the loan book, RHFL

stands eligible to access refinance at cheaper rates from NHB. Furthermore, the

banks provide reasonable rates to RHFL as these loans qualify for priority sector

loans for banks. Besides, owing to the floating nature of the loan book, the

company is able to pass on the cost to customers, thereby pushing up the margins

higher. Moreover, the effective loan book composition of high yielding self-

employed segment and less riskier salaried segment would enable the company

to report yields at 12%+ levels.

The company boasts of a higher capital adequacy of 24.5% as at the end of

December 2013. This entirely comprises of Tier I capital. With capital sufficiency

much above the regulatory limits provides the company with comfortable

headroom for growth for the next three years. The company also plans to tap the

non-convertible debentures and commercial paper market to raise resources in

near future.

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Key challenges for Repco Home Finance Ltd.

Regulatory changes

Any adverse changes in regulatory stance are highly likely to impact the overall

business and financial profile of the company. Changes with respect to caps on

spreads, risk-weights or higher provisioning could possibly mar the profitability

of the company. Therefore, this risk cannot be ignored.

Asset quality pressures

Given the sizeable exposure to the self-employed segment with volatile cash flows

and lower provisioning coverage of RHFL, the entity's asset quality remains

vulnerable to economic cyclicality. Moreover, certain pockets such as the Andhra

Pradesh belt which is clouded with political issues might also add to the bad loans

of the company. Therefore, any further increase in gross NPAs could result in

increased provisioning, which might prove detrimental to the earnings profile of

the company.

Macro turbulences

The continued economic slowdown and the consequent impact on the real estate

sector may hamper the business prospects of the company. Under prolonged

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phase of downturn, the company might face higher default rates. Additionally,

the higher interest rate scenario may also weigh down on the demand for

housing loans, thus stagnating credit growth for the company.

Risk Analysis

Regulatory Risk

Some businesses are subject to regulations by external government agencies.

These companies are subject to regulatory risk since they do not have the liberty

to operate in a free environment. Excessive regulations can create bureaucratic

hassles and impede growth. Thus, higher the regulation, higher is the risk for any

business. The housing finance sector is subject to various regulations imposed by

the Reserve Bank of India and National Housing Bank in terms of capital

adequacy, lending norms, provisioning requirements etc.

Cyclicality Risk

An industry cycle is characterized by an upturn as well as downturn. Businesses

whose fortunes typically swing with industry cycles are known as cyclical

businesses. Cyclical businesses do well during an industry upturn and vice versa.

On the other hand, there are some businesses based on consumption stories that

are non-cyclical. These businesses are immune to industry cycle changes and

have less risk. In short, if the business is cyclical higher is the risk. The housing

finance sector is extremely cyclical and is in fact a reflection of the macro

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economy. The sector typically witnesses average credit growth at 1.5 times GDP

growth.

Competition Risk

Every industry is characterized by competition. However, some industries where

entry and exit barriers are typically low have higher competition risk. Low

barriers means more players can enter into the industry thereby intensifying

competition. Low product differentiation also intensifies competition risk. The

Indian housing finance sector is already very competitive with most banks and

NBFCs offering mortgage finance. Plus the entry of new banks is expected to

intensify competition in the coming years.

Income growth

Over the eight year period (actual history of past 5 years and explicit forecast for

the next 3 years) Repco Home Finance's income CAGR is 23.1%.

Net Profit Growth

Over the eight year period (actual history of past 5 years and explicit forecast for

the next 3 years) the net profit CAGR is 20.6%.

Net interest margin

Net interest margin (NIM) is a measurement of the spread that the financial

entity makes on its average earning assets (typically loans, investments and

balance with other banks). Banks that are able to fetch sufficient low cost funds

and lend them with a good spread or invest in high yielding assets have steady

NIMs. The higher the NIM, the easier it is for financial entities to tide over

volatility in interest rates. The average NIM for Repco Home Finance over the 8

year period (actual history of past 5 years and forecast for the next 3 years) stands

at 4.5%,

Net profit Margins

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Net profit margin is a measurement of what proportion of a company's revenue is

left over after paying for all the variable and fixed costs inclusive of interest and

depreciation charges. Net margin is the final measure of profitability. It reflects

the total profits the company takes home. Higher the margin, better it is for the

company as it indicates better pricing power and effective cost management. The

average net margins over the 8 year period (actual history of past 5 years and

explicit forecast for the next 3 years) stand at 18.2%.

Return on net worth (RoNW)

RoNW is an important tool to assess a company's potential to be a quality

investment by determining how well the management is able to allocate capital

into its operations for future growth. A RoNW of above 15% is considered decent

for companies that are in an expansionary phase. The average RoNW over the 8

year period (actual history of past 5 years and explicit forecast for the next 3

years) stands at 17.8%.

Cost to income ratio

This ratio helps assess the operating cost efficiency of a financial entity. It

primarily takes into account the operating cost for the company vis-à-vis income

by way of net interest earned and other income. Financial entities that are lean in

terms of cost to income ratio manage to retain a healthy profit margin across

cycles. The average cost to income ratio for Repco Home Finance over the 8 year

period (actual history of past 5 years and forecast for the next 3 years) stands at

16.7%.

Transparency

Transparency is the key to any business. Transparency can be gauged by

assessing the past dealings of the company with various stake holders be it the

customers, suppliers, distributors or shareholders. The easiest way to gauge the

same is checking the level of disclosures in the company's quarterly financial

updates and communication with minority shareholders. Most importantly, the

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management's willingness to explain its stance if there is a negative development

in the company or stock shows its forthrightness. Transparent managements

would get a higher rating. The management of Repco Home Finance has been

reasonably transparent in its operations. However there is room for improvement

in the disclosure of financial information.

Capital allocation

Apart from honesty, capital allocation skills are equally important in assessing

management quality. By capital allocation we mean how the management

chooses to deploy capital in the business or across businesses. Managements that

have in the past destroyed shareholder wealth by diversifying in unrelated,

unviable businesses or make expensive acquisitions would rank low on this

parameter. Further managements that focus on capital intensive growth at the

cost of profitability would also fetch a low rating. The management of Repco

Home Finance has a good track record in terms of capital allocation. The

company is standing on a growth trajectory and is well geared to take up organic

and inorganic route.

Promoter Pledging

Promoters typically pledge their shares to take a loan which is generally infused

in the company. This exercise is generally resorted to when all other sources of

external liquidity dry out. The risk with this strategy arises when share price falls.

This triggers margin calls. If management is unable to provide some sort of a

collateral to the lending party from whom the money is borrowed that party may

sell the shares to recover its money. This accentuates the share price fall. Hence,

higher the promoter pledging higher is the risk.

Net NPA to advances

A good asset quality is the hallmark of good lending practice of a financial entity.

Financial entities that tend to have high non-performing assets (NPAs) during

periods of economic stress deserve a lower rating. Ones that have average net

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NPA ratio in excess of 1.5% are particularly risky. The average net NPA to

advances ratio for Repco Home Finance over the 8 year period (actual history of

past 5 years and forecast for the next 3 years) stands at 0.9%. However given the

high propensity of slippage on account of higher exposure to risky assets.

Capital adequacy ratio (CAR)

This is one of the most important factors that are used to judge the soundness

and sustainability of a financial institution's business over the longer term. It

shows the ratio of capital to assets financed. The RBI has stipulated a minimum

CAR of 15% for NBFCs as per Basel II and 12% minimum CAR is stipulated by

NHB. Since Repco Home Finance's CAR at the end of December 2013 stood over

25%.

Comparative Valuations

FY13 RHFL Gruh Finance

Return on assets 2.40% 2.90%

Return on equity 17.10% 33.30%

Net interest margin 4.00% 4.40%

Net NPA/Advances 1.00% 0.10%

Cost/income 17.30% 19.00%

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Business per employee (Rs m) 87 47

Business per branch (Rs m) 361 183

Profit per employee (Rs m) 2.1 2.8

Valuations (FY14)

Price to adjusted book value 3.2 7.6

Dividend yield 0.40% 1.20%

Valuations (Rs m) FY13 FY14E FY15E FY16E FY17E FY18E

Revenue (Rs m) 1,401 1,695 2,141 2,729 3,403 3,849

PAT (Rs m) 800 901 1,096 1,403 1,753 1,987

EPS (Rs) 12.9 14.5 17.6 22.6 28.2 32

Adj. book value (Rs) 96.8 107 122.3 143.2 169.6 200.2

Price to earnings (x) 24.2 21.5 17.7 13.8 11.1 9.8

Price to adj. book value (x) 3.2 2.9 2.6 2.2 1.8 1.6

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Financial at a glance

Consolidated (Rs m) FY13 FY14E FY15E FY16E FY17E FY18E

Net Interest Income 1,401 1,695 2,141 2,729 3,403 3,849

Net Interest Income growth (%) 20.20% 21.00% 26.40% 27.40% 24.70% 13.10%

Net Interest Margins (%) 4.00% 4.40% 4.20% 4.20% 4.20% 3.90%

Operating profit margin (%) 28.60% 25.30% 25.20% 26.60% 27.60% 26.20%

Net profit 800 901 1,096 1,403 1,753 1,987

Net profit margin (%) 19.70% 16.20% 15.40% 16.30% 16.90% 16.00%

Balance Sheet

Loans and advances 33,206 44,484 57,342 72,224 89,511 109,652

Fixed and other assets 4,638 5,110 5,804 7,001 8,832 11,515

Investments 81 81 81 81 81 81

Total Assets 37,924 49,674 63,227 79,305 98,424 121,247

Current liabilities 5,415 5,956 4,646 4,785 4,799 4,799

Net worth 6,345 7,166 8,175 9,491 11,156 13,056

Borrowings 20,638 30,148 45,266 59,740 77,160 98,339

Other liabilities 5,527 6,405 5,140 5,289 5,308 5,053

Total liabilities 37,924 49,674 63,227 79,305 98,424 121,247