Stock Recommendation | Shriram Transport - BUY - Target price : 1,450

STFC’s marginal borrowings cost has increased by about 100 bps in the last one month. Market sources suggest that funding cost of AA+ rated NBFCs has increased by 75-100 bps during the last one month. The company aggressively worked on diversifying its funding sources viz. ECB issuance (Rs24 bn in last quarter), retail NCD issuance and will pursue loan securitization- its loan pools have wide acceptability with PSU and private banks.
STFC’s margin expansion in 2QFY19 shows its pricing power in the used CV segment despite increasing competition from select banks and other NBFCs. The company has raised lending rates by 50-150 bps from the first week of October in order to pass the hike. With challenges on the liquidity front, STFC will likely cherry pick higher-yield loans. As such, we don’t expect the impact of a sharp rise in funding costs to be severe for STFC even as the company may moderate its growth in the near-term.

We are reducing our forecasts by 2-6% to factor in lower loan growth and NIM reflecting tighter liquidity in debt markets. Strong collection trends imply that NPLs will likely be lower than expected.
Post the revision in estimates, we expect STFC to deliver 17-18% medium-term RoE and 16% EPS CGR during FY2020-21E. At our RGM-based TP of Rs1,450, the stock will trade at 1.8X FY2020E book. Sharp stock correction over the last few weeks underpins our recommendation.
While all NBFCs face challenges on the liability side, STFC will benefit from diversified funding avenues comprising of ECBs and retail investors, in addition to banks and other financial institutions. However, a large balance sheet size constrains to some extent.

Strong AUM growth at 21% yoy in 2QFY19; disbursements up 12% yoy
▶ Disbursements up 12% yoy. STFC reported 12% yoy increase in disbursements to ₹138 bn in 2QFY19. Overall AUM growth remained strong at 21% yoy to Rs1.04 tn. Its segmental AUM mix has broadly remained stable with M&LCVs and HCVs comprising 67%, passenger vehicles at 23%, tractors at 4%; share of business loans (the few focus area) increased to 3% (up from 1.8% in 2QFY18).
▶ We expect some moderation hereon. We expect STFC to moderate its loan growth to 15% in FY2019E from 21% in 2HFY19. Challenges on the liquidity front and likely slowdown in CV sales in 2H versus 1H will likely bring down growth momentum. We continue to build in 15-16% loan book CAGR in FY2020-21E.
▶ Two segments of expansion. STFC has two key segments of expansion over the medium term.
■ Business loans comprise LAP cross-sell for its customers that have diversified into segments like warehouses, petrol pumps etc. This business started as a pilot about three years back and scaled up over the last year. Ticket size is ~₹2 mn though there are some high ticket loans in the range of ₹40-50 mn. This book has shown a 105% yoy growth (on a low base) and stands at ~Rs33bn in 2QFY19 (3% of loans).
■ STFC continues to grow its rural presence with share of branches increasing to 50% in 2QFY19 from 45% in 2QFY18. The proportionate share of AUM for rural has increased sharply in 2QFY19 to 35% from 29% in 2QFY18. Though the average AUM per branch remains lower in these areas (almost half that of urban areas), greater pricing power, latent demand, lower competition, pick-up in rural demand on the back of adequate monsoon coupled with increased MSPs by government are major stimulus for increasing rural penetration. STFC has guided for focusing on expansion in north and eastern parts of India.

NIM compression on the horizon
▶ Improvement in margins comes as a surprise. STFC’s calculated NIM improved 23 bps yoy and 60 bps qoq to 8.1% in 2QFY19 driven by stable costs on liability side while yields on advances have inched up despite strong competition in HCVs. The company has passed on lending rate hike early this year; this, coupled with a favorable business mix has increased its NIM.
▶ Margin compression in medium term. We expect NIM (calculated as NII/AUM) to decline 23 bps yoy to 7.1% in FY2020E. Notably, it would be inaccurate to compare NIM for FY2018 with FY2019E and beyond due to Ind-AS migration. The recent liquidity crunch has raised STFC’s borrowings cost by 100 bps. The company has raised lending rates by 50-150 bps from the current month. This will reduce the liability side pressures to some extent.
Cost pressure looms in medium-term due to continuous rapid expansion
Operating expenses increased 29% yoy in 2QFY19, driven by higher staff costs at 42% yoy as net employee additions remained high. The company added 266 branches and posted 18% yoy growth in staff. Cost to average AUM increased ~10 bps yoy to 1.8%.
We estimate cost-to-income ratio to remain high at ~24%. We forecast operating expenses to grow at 15% CAGR over FY2019-21E on the back of 18% CAGR in employee expenses during the same period. Continuous investment in rapid expansion in branches (focusing towards greater penetration in rural areas), employees and field staff clearly reflects that operating expenses will remain high in the medium-term. Once these branches improve productivity going ahead, cost ratios are expected to soften.

Positive trends in asset quality
STFC’s stage 3 loans declined to 8.6% from 10.6% in 2QFY18 and 9.1% in 1QFY19. The coverage on these loans moderated a bit to 34.2% from 35.9% yoy. Similarly, coverage on stage 1-2 loans moderated to 2.7% from 2.9% yoy; on a qoq basis, the coverage increased 20 bps due to transition between stage 1 and 2 loans. The company made extra provisions of Rs600 mn for any likely losses from the recent floods in Kerala.
Limited trends in loans between stage 1, 2 and 3 makes it challenging for us to forecast the asset quality bucket movement and likely impact on credit costs. We are building in credit cost at 1.8-2% of AUM in FY2020-21E from 2.1% in FY2019E. We expect the overall ECL coverage to moderate to 4.8% of loans in FY2021E from 5.4% in FY2019E- this will be driven by 30 bps reduction on ECL for stage 1-2 to 2.3% and 33-34% coverage on stage 3.

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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