Stock Recommendation | Shriram City Union Finance - ADD - Target price : 1,875

While SCUF reported strong business growth in 1HFY19, we expect business momentum in 2H to be a bit weak; we are reducing our loan growth estimate to 15% from 23% for FY2019E. A couple of reasons—(1) festive demand to date appears to be weak and 2W sales will likely decline in 3QFY19, (2) SMEs will likely face challenges in case drying up of liquidity for NBFCs affects their cash flows. Many smaller NBFCs including fintech companies operate in the SME loan ecosystem though may not directly overlap with SCUF; SCUF has already started reducing its portfolio in the high-ticket SME loan segment that may be more vulnerable and (3) challenges in the debt markets may prompt SCUF to stay focused on liquidity over growth; higher cost of funding will also discourage growth in low-yields segments. Market sources suggest that funding costs for AA+ rated companies have increased by 75-100 bps over the last one month.

We are revising our estimates by -8% to +2%. While we factor in lower growth on the back of recent liquidity challenges, we expect NIM to remain strong due to (1) lower competition in the market leading to higher pricing power and (2) cherry picking of higher-yield loans. Post the revision in estimates, we expect the company to deliver 15-17% medium-term RoE and 15- 16% earnings CAGR during FY2019-21E. We are revising down our TP to ₹1,875 (1.7X book FY2020E) from ₹2,120 to reflect lower medium-term growth. Challenges in debt markets keep the business under pressure, driving our ADD rating despite high upside to our TP. We prefer Shriram Transport Finance over SCUF in the current environment.

AUM growth strong at 18% yoy in 2QFY19
▶ Strong growth in AUM at 18% yoy. SCUF reported strong growth in AUM at 18% yoy to ₹298 bn in 2QFY19 driven by sharp rise in AUM on business loans (MSME), twowheelers and personal loans (on a low base).
▶ MSME disbursements were modest at 13% yoy in 2QFY19 compared to 21.5% yoy in 1QFY19 even as loan growth was up 23% yoy. Disbursements have been in the range of 25-29% in the past two quarters but slowed down in 2QFY19 indicating some sign of weakness. Repayment rate in business loans increased to 58% from 47% qoq due to closure of one account worth ₹4 bn from South India.
▶ Two-wheeler loans witnessed steep disbursements growth of 20% yoy leading to a 27% yoy growth in AUM. While growth remain strong in the sector, rise in upfront payment and hike in fuel prices have dampened demand. Management guided that 3QFY19 will likely see a lower demand on yoy basis though the festive season might lead to an upward push.
▶ Personal loans continued to grow at a fast pace (up 36% yoy on a low base) to AUM of ₹25 bn. The share of personal loans to overall AUM has increased 42 bps qoq and 108 bps yoy to 8.4% of overall AUM. Management expects to increase the share of personal loans to >10% by FY2020E. Disbursements were high at 33%yoy in 2QFY19; slightly lower than previous quarter. The company is increasingly focusing on crossselling loans to existing customers with sound repayment records and this is expected to drive growth going ahead (leads to cost benefits). Almost 80% of all personal loans sourced in the past 2 years are via the cross-selling model of business origination.
▶ Gold loans continued to drag loan growth (down 10%) owing to problems related to cash disbursements and shift in customer base towards personal loans as a substitute for gold loans. Disbursements in this pace have slightly picked pace on a sequential basis; albeit down 17% yoy. The company is currently operating from 5 states in this space and expects to drop share of gold loan to overall loan going ahead.
▶ We expect growth to moderate in the near term. We expect loan growth to moderate to 15% in FY2019E from 18% in 1HFY19 as the company goes slow in the current environment. It has raised lending rates by 25-200 bps on various products; high rise in large ticket business loans to encourage exits from its portfolio. Gold loan will see marginal revival in growth in the medium term (10% AUM CAGR over FY2019-21E) on the back of higher prices.

Rise in rates across specific product classes led to NIM expansion
▶ Margin expansion in 2QFY19. Reported NIM compressed 31 bps yoy to 13.8% on the back of 31 bps drop in yields while borrowing cost was flat yoy at 6.7%. The likely drop in yields was a result of change in AUM mix towards higher share of low yielding products. On a qoq basis, the company saw 66 bps NIM expansion on the back of rise in yields; a likely impact of rise in rates across select product classes in recent months. Rise in cost of funds was low at 20 bps on qoq basis. The company has high share of bank borrowings (55%). The share of market borrowings has increased to 30% in 2QFY19 from 19% in 2QFY18.
▶ We expect medium-term NIM compression. We expect SCUF’s NIM to compress over the medium term as banking competition increases and funding may not be as comfortable as in FY2018. Exit of smaller NBFCs, improvement in pricing power and cherry picking of high yield loans will likely aid NIM in the near term.

Asset quality broadly stable qoq
▶ Gross stage-3 loans up 17 bps qoq. Asset quality was stable qoq with Gross stage-3 showing marginal increase by 17 bps qoq (yoy numbers are not comparable as the company made a transition in recognition of stressed loans from 120 dpd to 90 dpd in 4QFY18 to 10%. The rise in GNPL was witnessed in auto loans while all other segments saw an improving asset quality trend. GNPL in the auto segment at 11.1% is higher than others. Credit cost (calculated) increased to 3.4% versus 3% qoq (2.8% yoy) as the company increased provisioning on stage-1 and 2 assets (ECL coverage on stage-1 and 2 assets were up 20 bps qoq to 2.5% in 2QFY19).
▶ Gradual reduction in credit costs. We expect total ECL for SCUF to decline to 5.8% of loans by FY2021E from 7.4% in FY2019E (7.5% in 2QFY19) to reflect the improving trends in asset quality. Gross stage-3 loans are expected to improve by 60 bps over FY2019-21E to 8% driven by improvement in collections. The company has increased focus on improving collections and is devoted towards taking initiatives to improve asset quality at a swift pace. We build in improvement in provision coverage on stage-1 and 2 loans to 2% by FY2021E from 2.5% in 2QFY19.

Marginal improvement in cost ratios
▶ Cost-income ratio dropped 60 bps qoq (down 120 bps yoy) in 2QFY19 to 38.1% largely led by slowdown in infrastructure investments. The company has been trying to improve productivity of existing branches, which has led to strict cost control. Operating expense growth at 16% yoy was led by sharp rise in employee expenses at 25% yoy while other expenses growth was low at 6% yoy.
▶ We expect ~17% CAGR in operating expenses over FY2019-2021E driven by 18% CAGR in employee expenses and 16% CAGR in other expenses. The company is investing in business expansion, digital initiatives and analytics giving rise to jump in employee expenses. Cost-to-average AUM ratio will drop 20 bps over FY2019-2021E to 5.1%.

Shriram Housing Finance – AUM growth on track; rise in NPLs arrested
▶ AUM growth at 20% yoy based on Ind-AS. AUM increased 20% yoy (5% qoq) in 2QFY19 compared to 12% yoy in 1QFY19. Disbursements were up 1.6X yoy in 2QFY19. The AUM mix is more inclined towards retail loans and hence is gradually reducing focus on the construction finance space. The share of retail loans real estate loans dropped 100 bps qoq to 10% of overall portfolio. While share of high yielding loans decreased qoq, rise in home loans was the most likely reason for improvement in NIM.

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.
NA	=	Not Available or Not Applicable. The information is not available for display or is not applicable.
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