Stock Recommendation | Bajaj Finserv / Bajaj Finance - ADD / REDUCE - Target price : 5,650/1,950

Post the sharp stock price correction (23-24% in the last three months) for both Bajaj Finance and Bajaj Finserv, we upgrade both the stocks by a notch. We revise the rating of Bajaj Finserv to ADD from REDUCE with TP of Rs5,650 (down from Rs6,100) and Bajaj Finance to REDUCE from SELL with TP of Rs1,950 from Rs2,000. We value Bajaj Life at 1.4X EV, Bajaj General Insurance and Bajaj Finance at 4.5X book FY2020E. We expect Bajaj Finance to deliver 37% EPS CAGR and 22-24% medium-term RoE. We believe that Bajaj Finance, given its strong parentage and robust performance will be well placed on the liquidity front though may moderate its growth momentum a bit from its current high levels. Focus on profitable segments and improving productivity will ensure superior earnings growth.

Bajaj General: Combined ratio rises yoy but remains lower than peers
Bajaj General Insurance reported muted 6% growth in net earned premium in 2QFY19 due to a lower quantum of crop insurance written in the quarter owing to unfavorable pricing in the Kharif season. Adjusting for the impact of the same, net earned premium was up 20% yoy. Gross written premium was up 23% yoy in 2QFY19 (adjusted for crop insurance) largely from motor (52% of gross written premium in 2QFY19 adjusted for crop insurance) business generated during the quarter.
Combined ratio saw a sharp rise in 2QFY19 to 97.2% largely owing to high claims (₹629 mn) from the unfortunate occurrence of floods in Kerala. Adjusting for the impact of the same, combined ratio was up 480 bps yoy to 93.6%; this ratio still remains superior to the rest of the industry. Claims ratio (un-adjusted for impact of Kerala floods) increased to 68.2% in 2QFY19 from 67.9% in 1QFY19. The rise in claims led to a 37% yoy drop in earnings.
We expect the business to deliver 19-20% net premium growth, about 96-97% combined ratio and 22-25% RoE over the medium term.
Bajaj Life: Individual business picked pace
Bajaj Life Insurance reported 24% growth in individual APE in 2QFY19 while overall new business premium was down 5% yoy. The company has been shifting focus to traditional policies-share of par increased (35% of individual APE in 2QFY19 from 23% yoy) while ULIP was down (61% of individual APE from 72% yoy). Ticket size saw an increase of 37% yoy in 2QFY19 to ₹54,636. While growth has been muted, persistency has seen an uptrend in the first three buckets. 13th and 37th month persistency ratios improved by ~500 bps and 400 bps on a yoy basis to 78% and 49% respectively in 1HFY19 while the improvement was maximum in the 25th month bucket (up 1,100 bps yoy to 64%)

Strong loan growth and robust cost control led to sharp rise in earnings
Bajaj Finance reported 54% growth in earnings as per Ind-AS in 2QFY19. Robust NII growth and strong cost control were the key drivers. NII growth was driven by strong AUM growth at 38% yoy to ₹1tn and marginal improvement in NIM (calculated) to 11.1% in 2QFY19 from 10.65% in 2QFY18. NIM was however down on qoq basis (30 bps) owing to rise in cost of borrowings. Operating expenses growth was low at 25% yoy leading to improvement in cost to average AUM by 25 bps qoq and 37 bps yoy to 4.1% in 2QFY19.
Asset quality performance deteriorated marginally. Reported stage-3 loans were up 10 bps qoq to 1.5%. Total slippages in 2QFY19 were ₹4.8 bn in 2QFY19 compared to ₹3.8 bn in 1QFY19. The company has 86 bps coverage on stage-1 and 2 loans as compared to 89 bps in 1QFY19. The coverage ratio for stage-3 loans dropped 400 bps qoq to 65%. The company has Rs2-2.25 bn exposure to a lumpy infrastructure account; the loan is current but Bajaj has made provision of 10% on the same.
Robust growth across all businesses; expect some moderation in 2H
Bajaj's high loan growth was contributed by almost all business segments-consumer businesses (38.6% of total loans) were up 39% yoy, mortgages (including LAP) was up 34% yoy, SME lending saw strong increase at 34% yoy while rural and commercial lending maintained momentum at 72% and 38% yoy growth respectively in 2QFY19. Within the consumer B2B business, auto segment saw swift pace of growth at 42% yoy (38.2% of consumer B2B business) while consumer B2C segment continued to deliver robust growth at 44% yoy (48.2% of overall consumer loans). The mortgage business (consolidated) saw modest growth at 32% yoy in 2QFY19. Adjusting for loan against securities, the commercial lending business saw sharp growth at 81% yoy in 2QFY19.
We are moderating our loan growth forecasts to 34% in FY2019E from 42% earlier to reflect the current debt markets conditions. The company is well placed in the liquidity front (discussed later) but a rise in the cost of funds may prompt the company to moderate its trajectory and cherry pick relatively higher yield loans.

2QFY19: segmental trends
▶ Strong cross-sell franchise of 30 mn customers. Large part of Bajaj's loan growth has been driven by its ability to acquire customers. It has a total franchise of 30.1 mn customers (addition of 7 mn new to Bajaj Finance customers in the past four quarters). Cross-sell of high-margin personal loans has driven loan growth in this segment over the past few quarters.
▶ Card franchise continues to scale up. Bajaj Finance has an EMI card base of 15.4 mn (14.2 mn as of 1QFY19), compared to 11.6 mn credit cards for HDFC Bank as of August 2018, with growth in transaction volumes across segments such as consumer durables, digital, lifestyle, etc. Bajaj Finance has also tied up with RBL Bank for its co-branded credit card distribution business (card base of 0.67 mn; up from 0.5 mn qoq). Additionally, the company has access to 0.33 mn active users via the Mobikwik app.
▶ Consumer business loans up 39% yoy. Consumer finance loans grew 39% yoy to ?388 bn. Loan growth in consumer B2B businesses (consumer durables, digital products, etc.) was 34% while consumer B2C (EMI card, personal loans cross sell, etc.) was 44% yoy. Within the consumer B2B business, the auto finance segment (2-W/3-W) saw steep growth at 42% yoy in 2QFY19.
▶ Business loans pick pace. Bajaj Finance had slowed growth in the business loan segment post demonetization but has picked pace off-late driven by improvement in collections and greater availability of data owing to GST implementation. Unlike other private players, the company does not find any signs of stress in this segment. Business loans are now classified in three key buckets, viz. commercial loans, SME loans and mortgages.
▫ Commercial loans (13% of total AUMs) include relatively low-yield and higher-ticket loans such as rental discounting, vendor finance, corporate and warehouse finance, etc. These loans had zero NPLs as of September 2018. The average ticket size in this segment is around ₹100 mn with an upper limit of ₹500 mn. Loan against securities comprises 55% of overall commercial lending book (up 15% yoy). Out of the remaining 45% (up 81% yoy), lending to auto component manufacturers and FIG's comprised major share at 27% and 9.3% of overall commercial lending respectively.
▫ Mortgages (up 32% yoy, 29% of AUMs on consolidated basis) are now booked under its new subsidiary. These loans include home loans, LAP, developer loans, etc. Being a secured business, the business reported GNPLs of 0.56% in June 2018 but saw a rise in GNPL to 0.8% in 2QFY19. A transition of the business to a separate subsidiary has improved management concentration, results of which are reflected in superior expense control.
▫ SME loans were up 33% yoy but just at about 13% of its AUMs. SME loans include unsecured business loans and loans to professionals. GNPL in this segment continues to be high at 1.9%. The company maintains a high coverage around 77% on this portfolio.

Higher yields to offset rise in borrowings cost over medium-term
▶ NIM to remain flat. We forecast NIM (calculated) to remain flat at 11.8% over FY2019- 20E (up from 11.3% in FY2018) driven by a rise in yields which will offset the current rise in the cost of funds.
▶ Rise in loan yields last month. Diversification in product mix towards higher share of high yielding unsecured loans (as growth moderates a bit in 2H) supported by 20-50 bps rise in yields across most products last month will likely improve yields from here on.
▶ Borrowing cost rising, liquidity may not be a concern. We forecast borrowings cost to increase 40 bps yoy to 8.4% in FY2019E and continue to inch up to 8.6% by FY2021E. Cost of funds has seen a modest rise over the last few months. Its comfortable capital position (tier I at 17.2%), positive ALM, strong parentage coupled with a AAA rating are likely to provide comfort to debt markets and banks. We don't envisage any liquidity issues for the company over the near-term though cost of funding poses risk of upside in the current environment especially given its high growth trajectory.
▶ Raising public deposits to improving financial flexibility. In order to reduce its dependence on bond markets and banks, the company has increased its share of public deposits (up to 15% of overall borrowings from 8% in FY2017 and 12% in FY2018)- however, a large part of the deposits are corporate. The company guided at increasing this mix to ~22-25% of overall borrowings by FY2020E.

Flat qoq collection trends; rise in slippages qoq
Bajaj Finance continued to demonstrate robust asset quality driven by strong collections across most buckets except the 2-W/3-W portfolio (though collections have been gradually improving in this segment on a sequential basis). Collection efficiency in this segment has increased to 88.3% as of 2QFY19 from 87.6% in 1QFY19 and 85.8% in 2QFY18. This segment was impacted by demonetization as the end customer is below mass segment.
However, it bounced back significantly in the past few quarters prior to trend reversal in 1QFY19. Most segments now have collection efficiency of >98.5%.
Reported stage-3 loans however increased 10 bps qoq to 1.5% owing to a rise in slippages. Total slippages were high at ₹4.8bn in 2QFY19 compared to ₹3.8 bn in 1QFY19.

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.
NM	=	Not Meaningful. The information is not meaningful and is therefore excluded.

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