Stock Recommendation | Cholamandalam - ADD - Target price : 1,425

Chola has reported 31% growth in loan book to ₹477 bn on the back of 38% loan growth in vehicle finance business to ₹354 bn. High growth in CVs followed by SCV and used vehicles were the key drivers. A higher base and rising borrowing costs will likely put pressure on NII from this segment. We expect Chola’s management to focus on other drivers to maintain its earnings momentum: (1) In the past, management had guided that reduction in operating expenses will be one of the key drivers of FY2019E earnings growth; the company reported 600 bps yoy improvement in operating expenses to loan ratio in 2QFY19—this will likely continue in the near term. (2) Recovery will likely remain strong—this was a focus area in FY2018. (3) Home equity business has started to look up—pre-tax RoA of the home equity business inched up to 3.2% from 2.4% in 2QFY18. Management had guided for a pipeline of recoveries in 2HFY19 as well.

We are tweaking our estimates by 1% to factor FY2018 Ind-AS financials, recent business trends and our medium-term business outlook. Post the revision, we expect Chola to deliver 25% EPS CAGR during FY2019-21E and 21-22% RoE. Current challenges in debt market will put pressure on NIM though liquidity may not be an issue for the company due to its long track-record, parentage of the Murugappa group and high credit standing. We continue to like the multi-product model of Chola that ensures stable growth and profitability; it remains one of our core holdings in the NBFC sector; retain ADD with RGM-based TP of ₹1,425 (3X FY2020E book).

Vehicle loans at peak

▶ AUM growth at 31% yoy in 2QFY19. Chola reported AUM growth at 31% yoy in 2QFY19 on the back of sharp spike in vehicle AUM at 38% yoy. Disbursements increased 26% yoy. The share of vehicle loans in the overall portfolio increased 390 bps yoy to 74%. Vehicle finance disbursements were up ~30% yoy but declined 2% qoq on the back of sluggish sales due to increase in fuel prices. Home equity witnessed low growth at 11% yoy, though better than previous quarters. Growth momentum of business loans moderated a bit (up 37% yoy compared to 47% in 1QFY19) as effect on low base gradually faded off.
▶ Vehicles finance disbursements moderate a bit qoq. Chola delivered ~30% yoy growth in vehicle disbursements. However, vehicle disbursements declined 2% qoq on the back of increasing fuel prices and high base. The strong business momentum in CVs from 2HFY18 moderated a bit in 1QFY19 and further in 2QFY19. The company marginally increased its market share in HCVs to 4.6% from 4.2% qoq. LCVs disbursements increased 36% yoy and mini LCV/ 3-W disbursements were up 94% yoy (on a low base). Construction equipment disbursements continued to grow at a steep pace on a low base (up 115% yoy).
▶ AUM growth moderates but remains healthy at 21% CAGR. We forecast Chola’s loan growth to moderate to 23% in FY2019E, down from 31% in 1HFY19, followed by 20% CAGR in FY2020-21E.
■ Vehicle loans will likely see 23% yoy growth in FY2019E; down from 38% in 2QFY19 and 19% AUM CAGR over FY2020-21E. We expect CV loans to moderate from the current high base. Other segments will continue at a steady pace. Management’s focus segments will be tractors, used vehicles and refinance.
■ Home equity will see improvement going ahead as the company focuses on increasing penetration in tier-III and tier-IV cities. Currently the company plans to open ~18-20 branches per quarter in this space.

NIM compression yoy
▶ NIM shrink 80 bps yoy to 6.3%. Chola’s NIM dropped 80 bps yoy to 6.3% in 2QFY19 on the back of sharp drop in NIM in the vehicle finance segment; reported margins compressed 90 bps yoy in vehicle finance business. As a result, NII growth at 14% yoy lagged AUM growth. The company has been rapidly expanding its share of low-yielding HCVs in overall vehicle finance mix. NIM declined 40 bps qoq, due to assignment gains in the base quarter. Adjusting for the same, NIM was flat qoq.
▶ Moderate yield expansion. We expect overall yields in vehicle finance to inch up largely on the back of change in AUM mix towards high yielding products (used CV, older vehicles and tractors) and rise in lending rates. The company has raised lending rates in the home equity segment; the rise in vehicles finance interest rates will likely be more gradual due to competition from banks.
▶ Rising borrowing cost will put pressure on NIM. We expect Chola’s NIM to compress by 20 bps between 1HFY19 and 2HFY19E due to rise in borrowing cost. The company has average funding requirement (disbursements – repayments + redemption of existing borrowings) of about ₹30 bn/month, i.e. ₹180 bn in 2HFY19. It has already raised ₹50 bn in last week of September (from undrawn lines of credit) and will need to raise additional about ₹150 bn or so (30% of FY2019E borrowings). On assuming about 50-60 bps rise in funding cost between 1H and 2H, the impact would be about 15-20 bps on its NIM.
▶ Well-placed on liquidity. Exhibit 6 shows the ALM statement as on September 2018. The company has surplus in all buckets up to 1st year. It has CP of ₹46 bn. Management believe that based in its asset profile, it can have short-term borrowings (CP and bank CC) of up to 20%; it has maintained the ratio at 10-15%; the company proposes to bring down the ratio to 10%.

Improvement in asset quality trends
Chola reported 46% yoy decline in provisions in 2QFY19. All asset quality parameters show improvement in recoveries.
▶ GNPL declined to 2.8% from 4.5% in 2QFY18 and 3% in 1QFY19.
▶ Chola reported net provision recovery of 0.6% in 2QFY19 in the home equity business.
▶ Stage 3 loans declined to 3.4% from 5.1% in 2QFY18 and 3.6% in 1QFY19. Coverage on stage 3 loans increased to 36.8% from 33.2% in 2QFY18 and 36.5% in 1QFY19 likely due to a lower base.
▶ Overall outstanding ECL provision was down 2% qoq to ₹9.4 bn. We expect the positive collection trends to continue over the next few quarters. While NPLs in the vehicle finance business have almost bottomed out, we find scope of improvement in the home equity business. The company is in the process of auctioning repossessed properties, which will lead to lower net provisions. We forecast GNPLs at 3% in FY2019E with 80 bps coverage on stage 1 and 2 loans and 37% on stage 3 loans.

Cost ratios to further improve in medium term
▶ Cost-to-average AUM dropped 50 bps yoy. Cost-to-average AUM dropped 50 bps yoy to 2.5% on the back of modest growth in operating expenses at 8% yoy in 2QFY19. Employee expenses remained stable yoy. Slowdown in business expansion is helping to keep costs under control.
▶ Cost pressure to further reduce in medium term. We forecast operating expenses to grow at 15% CAGR over FY2018-21E and cost-loans ratio to moderate to 2.5% by FY2021E from 3% in FY2018. Slowdown in expansion and cost efficiencies resulting from increase in per branch productivity is the primary driver.

Definitions of ratings

BUY	-	We expect this stock to deliver more than 15% returns over the next 12 months.
ADD	-	We expect this stock to deliver 5-15% returns over the next 12 months.
REDUCE	-	We expect this stock to deliver -5-+5% returns over the next 12 months.
SELL	-	We expect this stock to deliver

Our target prices are also on a 12-month horizon basis.

Other definitions

Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

Other ratings/identifiers

NR	=	Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
CS	=	Coverage Suspended. Kotak Securities has suspended coverage of this company.
NC	=	Not Covered. Kotak Securities does not cover this company.
RS	=	Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
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