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  • Stock Recommendation | Mahindra & Mahindra Financial - ADD - Target price : 450

    Publish date: OCTOBER 25, 2018

    A strong quarter, near-term trends crucial. MMFS reported strong performance in 2QFY19 on the back of high (26% AUM) growth across segments indicating buoyant pent-up demand and high recoveries leading to 40 bps qoq decline in stage-3 ratio to 9%. Muted festive demand to date, concerns of droughts and government spending in rural India will drive medium-term performance. Its current strong momentum and comfortable valuations drive our positive stance even as we are a bit watchful of the rural trends. Retain ADD with TP of ₹450 (no change).

    Mahindra Finance reported PAT (Ind-AS) of ₹3.81 bn, up 133% yoy. PBT before provisions was up 66% yoy (5% above estimates) on the back 49% NII growth. NII was driven by 26% yoy loan growth and NIM expansion (140 bps to 8.4%) due to shift to high-yield loans, rise in lending rates across products and reduction in stage-3 ECL (explained later in the note). Strong recoveries also led to lower provisions, up just 3% yoy leading to acceleration in PAT.
    MMFS' 2QFY19 earnings were significantly ahead of estimates due to high growth across products, NIM expansion and strong recoveries. The sheer momentum of business suggests that FY2019E will be a good year for the company. Typically, business trends (growth and recovery) are weak in 1H (in that sense MMFS' performance in 2QFY19 is commendable) and pick up in 2H. However, signs of weak festive demand, concerns on lagged impact of droughts coupled with migration to Ind-AS, which reduces seasonality of business, will imply that MMFS' performance in 2HFY19E may not be significantly better than 1HFY19. According to the management, festive demand to date has been muted but will likely pick up in Diwali when sales in North India pick up. Against this backdrop, trends in government spending in rural India ahead of elections will be crucial to sustain demand. Weak monsoon in contagious years poses higher risk of slowdown in rural India.
    We are revising our estimates by -3% to +3% to reflect lower growth, margins and credit costs over the medium term. Post our revisions, we expect the company to deliver 15-16% mediumterm RoE and 23% earnings CAGR during FY2018-21E and value the stock at ₹450, i.e. 1.9X book FY2020E and add ₹65/share for its stake in housing and insurance distribution business.

    AUM growth at 26% yoy in 2QFY19
    MMFS maintains growth momentum at 26% yoy in 2QFY19. MMFS reported strong growth in AUM at 26% yoy. Disbursement growth (up 43% yoy) was strong across the board. Most segments were strong - tractors (up 44% yoy), CVs (up 147% yoy), car (up 30% yoy) and refinance (up 31% yoy). Growth in auto/utility vehicles (M&M business) was marginally lower at 22% yoy. The company seems to be a bit opportunistic in CVs.
    We forecast 23% CAGR in AUM over FY2019-21E. We expect MMFS to deliver 23% AUM growth in FY2019E. According to the management, festive demand to date has been weak even as 1H was robust. While the rest of the season is still monitorable, this may be a sign of weakness likely on the back of a weak monsoon. This, coupled with tightness in debt markets, will likely curtail its business growth in 2HFY19E. Incrementally, government spending and monsoon CY2019 will be crucial.

    NIM expands sharply in 2QFY19
    Margins improve sharply. Calculated NIM improved 30 bps qoq and 140 bps yoy to 8.4%. We find three drivers for higher NIMs. (1) Sharp increase in high yielding products viz. tractors and refinance. Disbursements for tractors grew by ~45% yoy while used vehicles witnessed a growth of ~30%. This was partially offset by high growth in CV loans. (2) The company has been able to pass on the higher cost of funds to its customers and raised lending rates by about 25 bps. (3) MMFS does not recognize income on stage 3 ECL; as such, reduction in stage 3 ECL will boost interest recognition and hence NIM. Notably, some industry players recognize interest income on all (gross) stage-3 loans while some NBFCs (like MMFS) recognize income only on net stage-3 loans.
    Borrowing costs on a rise. MMFS' calculated borrowing cost increased 20 bps both yoy and qoq due to rising interest rate environment. Share of bank borrowing has increased by 700 bps yoy to 31%. Borrowing cost would remain elevated due to the tightening liquidity environment faced by the sector.
    We are building 30 bps compression in spreads in FY2020E. Tightness in debt markets has increased funding cost of MMFS by about 40-50 bps. Liquidity is not an issue due to strong M&M parentage, long track with lenders and comfortable ALM position. However, NIM may contract due to rise in funding costs, which may have to be partially absorbed by the company and balance by the OEM and the borrowers.

    Asset quality improves
    MMFS's GNPLs/stage-3 loans reduced 21% or 400 bps yoy to 9% of loans in 2QFY19 as strong collections sustained in 1HFY19. On qoq basis, stage-3 loans declined to 40 bps. Coverage on stage-3 loans was stable yoy and qoq at 35% and stage 1-2 at 2.1%.

    ECL at 4.7-5%
    Exhibit 11 shows our forecasts for ECL provisions of MMFS. We continue with our forecast of 7-7.3% GNPL over FY2019-21E. We assume stage-3 provisions at about 1.1X GNPLs. Stage-1 provisions were about 2.4% of stage 1 and 2 provisions as of 1HFY19. We assume a rate of 2.4% in FY2019E, which reduces to 2.2% over the next two years. We expect coverage on stage-3 provisions at 34% in FY2019E, which will moderate to 31% over the next two years. Thus, the overall ECL ratio will moderate to 4.7% in FY2021E from 5% in FY2019E.

    Expense ratio stable
    Calculated cost-average AUM remained stable at 2.9% in 2QFY19. Sharp increase in operating expense at 28% yoy was offset by robust growth in AUM at 26% yoy. We expect cost to average AUM to remain stable at 2.9% in FY2019E.

    Highlights of key subsidiaries
    MRHF - Asset quality worsens, MRIL maintains smooth run
    GNPL up 110 bps yoy and ~360 bps qoq to 17.4% in 2QFY19. Asset quality of the rural housing business continues to worsen on a sequential basis even when the company maintained a high growth rate. GNPL increased 110 bps yoy and ~360 bps qoq in 2QFY19 (as per Ind-AS) to 17.4%. The company however continues to expand its asset base on a low base. Reported loan book under Ind-AS increased 33% yoy in 2QFY19 (up 2% qoq). The company has been rapidly expanding presence in rural geographies thereby recording a strong 54% yoy increase in number of customer contracts. The average loan per customer, however, dropped 8% yoy. Thus expansion in asset book is driven by acquisition of new customers.
    Insurance distribution PAT up 40% yoy. Mahindra Insurance Brokers (MIBL) reported PAT of ?118 mn in 2QFY19 (up 40% yoy) as per Ind-AS. Net premium growth was muted at 4% yoy in 1QFY19 (up 13% qoq). Number of policies, however, continues to see robust growth at 17% yoy in 2QFY19.

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

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