Retail finance thematic - media. · PDF fileSKS Microfinance (SKSM IN) Buy ... As part of the loan application, ... all the documentation on his/her income,

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FUNDAMENTAL INSIGHT

India | Financial Services | 25-February-2013

Retail finance thematic

Long tail of finance

Asset finance NBFCs had a great run last year with most stocks up >50%, prompting investors’ concern about whether they are now overpriced. Our review of asset financiers suggests otherwise. Rural financiers are now in a secular growth phase with structural drivers for improving credit quality and, while the vehicle consumer finance and LAP segments may face some pressure in the near term, long-term growth drivers are intact. We add Mahindra Finance, Sundaram Finance and Bajaj Finance to our coverage, all with BUY ratings, and highlight Mahindra Finance as a core portfolio holding. We downgrade Shriram Transport Finance to NEUTRAL.

Some very high quality plays

After the 2009 slump, NBFCs fine-tuned their business models and fortified their balance sheets and subsequently their share prices had a strong run on the stock market. Our analysis of the various segments of financing suggests:

Rural segment most dynamic: Through our primary research while travelling

across India and based on the analyses by various leading academics, we conclude that the rural economy’s dependence on agriculture is declining, rural wealth is increasing and so is rural consumption. This is also leading to structurally better credit quality. Some of the NBFCs, like Mahindra Finance, have understood the nuances of the rural economy better than others and have created a sustainable competitive advantage through innovation.

Vehicle finance may see some slump: Although longer term drivers for

vehicle growth remain intact, in the near term we may see some stress both on growth as well as credit quality. We expect a divergence in performance as

different firms navigate these challenges, and see Sundaram Finance and Shriram Transport coping well, given their strong franchise.

Better credit infrastructure: Over the past four years, credit infrastructure in

the country has improved significantly, with the CIBIL database more than doubling. Also, companies have worked hard on their credit assessment processes, adopting innovative credit processes and investing heavily in collections: Bajaj Finance is a clear example of this.

Risk to the investment case

The main risk to our investment case comes from the economy — a major slump could see credit quality deteriorate and growth disappoint. Also, if the government were to significantly tighten expenditure around the rural economy, we would naturally expect some pain.

Key ideas

Given robustness in the rural economy and its sustainable competitive advantage we initiate on Mahindra Finance (MMFS IN, BUY, FV: Rs246, 20% upside) with a BUY and highlight it as a core holding. Sundaram Finance (SUF

IN, BUY, FV: Rs660, 28% upside) offers the highest upside and could attract

investors who like proven performers. We also initiate with a BUY on Bajaj

Finance (BAF IN, BUY, FV: Rs1406, 12% upside), given the attractive valuation

and expectation of sustainable 20% ROE. We highlight LIC Housing Finance

(LICHF, BUY) as our top pick in housing and like SKS Microfinance (SKSM IN, BUY) given our optimistic stance on the microfinance industry.

Priced as on 21 Feb, 2013

Company (Ticker) Rating Price Mkt Cap Fair Value

Bajaj Finance (BAF IN) Buy Rs1,258.00 Rs62,131.00m Rs1,405.55

Dewan Housing Finance (DEWH IN) Buy

Rs189.35 Rs22,168.61m Rs287.03

Housing Dev Fin (HDFC IN) Neutral Rs815.05 Rs1,256,876.83m Rs838.00

L&T Finance (LTFH IN) Sell Rs77.80 Rs133,519.45m Rs58.28

LIC Housing Finance (LICHF IN) Buy Rs245.40 Rs123,844.30m Rs308.30

Mahindra & Mahindra (MMFS IN) Buy Rs205.00 Rs115,107.76m Rs246.38

Shriram Transport Finance (SHTF IN)

Neutral

Rs710.00 Rs170,107.17m Rs772.78

SKS Microfinance (SKSM IN) Buy Rs140.00 Rs15,253.00m Rs186.03

Sundaram Finance (SUF IN) Buy Rs514.00 Rs57,107.45m Rs659.85

Source: Espirito Santo Investment Bank Research, Company

Data, Bloomberg

AAnalysts Santosh Singh, CFA +91 22 43156822 [email protected] Espirito Santo Securities India Private Limited Nidhesh Jain +91 22 4315 6823 [email protected] Espirito Santo Securities India Private Limited

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Retail financiers have outperformed

Most of the shares of the NBFCs involved in retail finance have significantly outperformed the broader indices in the last year, and performed better than investors’ expectations.

Figure 1 Share price performance of select NBFCs

Source: Espirito Santo Investment Bank Research, Company Data

The outperformance can be primarily attributed to:

1. Growth rates remain high: When the financial market was searching for

avenues of growth last year, most of the retail finance NBFCs were growing at more than 20% (refer to Figure 2).

2. NPLs have been under control: At the end of 2012 it was expected NBFCs

would suffer given the heightened stress on the economy. However, we have not seen any significant increase in the NPL levels for most NBFCs (refer to Figure 3).

3. Impact of regulations overdone: In CY11, NBFCs were one of the worst

performers as the sector was weighed down by various draft regulations

and investors went from being negative on the prospects of the sector to completely writing them off. However, CY12 proved to be much better, with the Reserve Bank of India (RBI) acknowledging the failure of traditional banks to reach out to the rural masses and the importance of NBFCs to bridge this gap and so it provided some relief on already-announced regulations. Also, investors understood that the announced regulations were not as detrimental to NBFCs’ prospects as initially

feared.

4. Banking license hopes: By the end of 2012, with the government moving

into reform mode, there was hope that the new banking licences were a realty in the not so distant future. These hopes were further fuelled by passing of the Banking Amendment Bill in parliament.

However, with the rally over the past year, future share price performance is

now dependent on the sustainability of growth and profitability of NBFCs at a time when the economy is still navigating one of the toughest phases in recent history. Nevertheless, after our comprehensive review, we are positive NBFCs will continue to thrive.

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Figure 2 Loan book growth rates Figure 3 Gross NPA

Source: Espirito Santo Investment Bank Research, Company Data Source: Espirito Santo Investment Bank Research, Company Data

Figure 4 Credit Cost Figure 5 RoEs


In the middle of difficulty lies opportunity?

The segments that the current crop of successful NBFCs forayed into and succeeded were seen as an obligation or unwanted distraction by the traditional banking system, given the higher cost of delivery, higher credit costs and lower ticket size. However, these NBFCs have overcome all these obstacles and forged a highly profitable business model. Now with these companies achieving scale, competition picking up and their respective stocks outperforming the market, future stock outperformance will depend on the sustainability of the business model.

We have looked at the opportunities offered by the various market segments where retail NBFCs are operating and identify three areas where NBFCs have excelled:

a) rural financing

b) CV/auto financing

c) consumer financing.

Rural financing

This is still viewed as an obligation by the traditional banking system given the higher credit cost. However, some NBFCs have made real inroads in the following segments:

Tractor finance: This is one of the key market segments in rural areas and has

seen very fast growth given mechanization and the shift in tractor usage from agricultural purposes to the non-agricultural segments like construction. NBFCs over the years have been able to increase their penetration in this area. Our primary data checks suggest that the main reasons why this has been a good market segment for NBFCs are their collection mechanism and relationship with the tractor dealers.

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Figure 6 Agri-credit & Kisan credit cards Figure 7 Domestic tractor sales

Source: Espirito Santo Investment Bank Research, RBI Source: M&M, Espirito Santo Investment Bank Research

Vehicle finance is another segment in which NBFCs have set up a profitable

business model in rural areas and enjoy a head start over traditional banks.

Rural housing finance: This is a relatively new segment with huge potential

and mainly involves small ticket sizes (less than Rs2 lakhs, or Rs200,000) for

construction/improvement of homes.

Microfinance: This segment of the business is dominated by NBFCs that are

mainly involved in the activity of unsecured lending to women. We have discussed this segment in detail in our microfinance thematic dated 24 November, 2010 (link here).

The main reason why NBFCs have succeeded in segments traditional banks ignored are:

A business model aligned with customer needs

Some of the challenges confronting any player wishing to enter the rural

finance space are: a) rural India is predominantly a cash economy, b) the rural economy is dominated by daily wage earners and so timings of cash flows are uncertain and c) availability of documents. These three peculiarities have meant that private banks, with their brick and mortar branch based model, have mostly ignored the rural population, or at best opened branches just to fulfil regulatory requirements, and PSU banks, which had the ability to tap the rural market, have suffered significantly on bad loans. Looking into these peculiarities some NBFCs stepped in and smartly created a sustainable

competitive advantage by aligning their business model with the rural economy, rather than asking their customers to adapt to their business model. NBFCs have been able to achieve this via:

Understanding the economy: A key ingredient of NBFCs’ success has been

their innate understanding of the rural economy, aided by their on the ground

presence. In order to shed more light on this we present a case study of a tractor dealer in the district of Sewan in rural Bihar. Below are the key take-aways from that interaction:

As part of the loan application, a bank would insist on the customer providing all the documentation on his/her income, ownership of land etc. and full margin money. However, many of the customers approaching these banks do not have land documents/income proof given the non-availability of clear land deeds (a key problem in rural India) or IT returns. But NBFCs chose to chart a

different path: if it’s an NBFC (say, Mahindra Finance) the loan is disbursed based on the credibility of the customer (based on on-the ground verification; most of the farmers, although they don’t have any income document, are the real owners of the land they work on).

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Also on the repayment rate, NBFC and private banks have a higher repayment

rate than PSU banks, and also insist on the dealer vouching for the ability of

the borrower to pay. Also, NBFCs are very proactive in loan recovery.

Innovation to surmount difficulties

In order to overcome the main challenges around doing business in semi-urban and rural areas, many of these NBFCs have introduced a lot of innovations, such as opting for a joint liability group model in order to overcome the problems around absence of security. One of the bigger innovations we came across was the introduction of portable handheld devices by Mahindra Finance (see Figure 8). Instead of increasing the number of branches, MMFS decided to transform its on-field executives into mini-

branches to bridge the last mile gap. With handhelds at their disposal, a collection executive gets details of the consumers beforehand, enabling him to plan his time and route appropriately. Once on-site, he can either issue receipts to the consumer from the attached thermal ink printer after collecting an EMI payment or create information trails, address business queries, record customer commitments and note relevant information for further follow-ups, undertaken with the customer at his doorstep.

We were able to see the impact of this when we visited one of the car dealers

at a location in UP that was 52kms away from its branch in Meerut. Aided by the handheld device, the Mahindra Finance executive was able to visit the dealer thrice a week and from the company’s hub at Meerut, executives were catering to clientele in a radius of 50kms; we have visually tried to demonstrate this in Figure 9.

Challenges around collection: One of the major challenges in rural India is

collection, given the cash economy and uncertainty of cash flow. Although

many would have bank accounts, cash is rarely deposited given that this

would require on-and-off visits to the bank branch to access the cash. Hence,

NBFCs have to rely on collection agents to recover cash loaned out. Collection

is a costly exercise with the attendant risks of a) misappropriation if one starts

collecting in cash and b) nonpayment if one does not collect money on a

regular basis (as the customer may spend it for other purposes). NBFCs have

worked extensively on this and created a network where they are able to

collect from the door of the customer.

Encouragingly, we are seeing structural changes in the rural economy and this

should make lending and recovery of loans easier. This is good news for

NBFCs.

Figure 8 Hand held device of Mahindra Finance

Figure 9 Our visit to areas around Meerut serviced by Meerut branch of MMFSL

Source: Espirito Santo Investment Bank Research, Company data Source: Google Maps, Espirito Santo Investment Bank Research Page 5

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Structural changes in Indian rural economy

We have tried to analyse the structural changes in the Indian rural economy, and we have used primary data findings, work of academics like Hans P. Binswanger, Ravallion and Datt, and RBI and NSSO data. We have also tried to draw a parallel with the Chinese economy. Some of the noteworthy structural changes are:

1. The gap between non-agri productivity and agri productivity is widening due to a) a decline in contribution of agriculture to rural NDP

(net domestic product) and b) limited migration of workers from agri to

non-agri activities. In any developing economy this gap widens first as the share of agriculture in GDP falls faster than the share of agricultural labour. However, as industrialisation kicks in, people move from agriculture to the industrial sector and then we see the two starting to converge with mechanisation of the farm sector. A similar structural transformation was seen in Korea, where it has almost converged (see Figure 13), and China (see Figure 10) which is now near its turning point towards a structural transformation.

However, the growth dynamics in India are different from China and Korea due to the relatively low share of industry in the GDP and hence India has not witnessed a substantial rural to urban migration. It seems that India is still a long way from a turning point and agriculture has yet to see the onset of full mechanisation, with tractors the only source of mechanisation and other activities still done manually (see Figure 11).

Figure 10 Structural transformation in China Figure 11 India is still away from structural transformation

Source: Binswanger-Mkhinze and D’Souza, Espirito Santo Investment Bank Research Source: Bingswanger-Mkhinze and D’Souza, Espirito Santo Investment Bank Research

Figure 12 Farm and non-farm contribution to rural NDP Figure 13 Structural transformation in Korea

Source: NSSO, Espirito Santo Investment Bank Research Source: Timmer and Akkus, Espirito Santo Investment Bank Research

2. Wealth in the rural economy has increased significantly: Over the past

decade, although liquidity in the rural economy has not increased significantly, immovable wealth (as a proportion of the rural economy) has increased significantly given the multifold increase in land prices,

which has also led to a vast divide in wealth amongst people in rural areas. All this has happened due to the better connectivity created by road/rail networks over the last decade (see Figure 14), leading to a drastic cut in distance, travel times and ease in travelling between urban

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and rural centres. Examples abound of farmers in Gurgaon and Noida owning premium luxury vehicles or the multifold increase in rates of arid land in Rajasthan.

Figure 14 Correlation between road connectivity and Rural poverty Figure 15 Growth in income post construction of roads

Source: Espirito Santo Investment Bank Research, Planning commission Source: Espirito Santo Investment Bank Research, Planning commission

Case Study: Better infrastructure connection between rural and urban India increasing wealth.

This is a case study from rural Bihar where the start of construction of a rail road bridge over Ganga River has connected Patna, capital of Bihar, with many other villages. This has exponentially (in some areas more than 20x in the last decade) increased the price of land in the adjoining areas; also, it has increased CV and tractor ownership numbers in areas in close proximity to the bridge.

Figure 16 Case Study 1 : Rail Road bridge on Ganga river Figure 17 Case Study 2: Most farming is still manual

Source: Espirito Santo Investment Bank Research, Source: Espirito Santo Investment Bank Research

3. Growth in rural non-farm sector: Given the limited rural to urban

migration in India, a large section of population is stuck in rural areas and the employment trends show that in the last decade there has been a

sharp increase in trade, infrastructure construction, construction of hotels and restaurants, all driving rapid growth in the rural non-farm sector. Other large increases include retail trade, large increases in STD/PCO booths, maintenance and repair of motor vehicles.

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Figure 18 Distribution of work force Figure 19 Share of workers between agriculture and construction

Source: Espirito Santo Investment Bank Research, NSSO Source: NSSO. Espirito Santo Investment Bank Research

Figure 20 Income pie chart of rural India in 1999 Figure 21 Income pie chart of rural India in 2007

Source: NSSO, Espirito Santo Investment Bank Research Source: NSSO, Espirito Santo Investment Bank Research

4. Entry of female workforce into agriculture: Due to the rapid growth in

the non-farm sector, young men with some education are more likely to move out of agriculture and to replace them there is a visible trend of more women joining the agriculture work force. This has also led to the emergence of double-income families in the rural economy, increasing spending power.

5. Diversification out of agriculture: Moreover, within agriculture of late a

trend of people moving towards remunerative self-employment in the non-farm sector is also evident, highlighting a shift to a productive and modern model of part time farming.

Figure 22 Rural labour force employed in agriculture Figure 23 Wealthy rural population has diversified from agriculture

Source: NSSO, Espirito Santo Investment Bank Research Source: NSSO, Espirito Santo Investment Bank Research

Impact of MNREGA on rural wages

MNREGA, introduced in 2006-7, has led to the creation of 9870m person-days of work from 2007-2011. In FY2011, it provided employment to 54.5m households, generating 2536.8m person days (see Table 1). It has also raised

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the negotiating power of agricultural labour. Studies indicate that by influencing wage rates in the rural unskilled labour market, NREGA has provided an additional opportunity for the government to enforce statutory

minimum wages. Also, based on NSSO 64th round during FY09, both male and female workers reported an average of Rs79 per day for work under the act. These earnings are 12% higher than the average daily earnings for casual workers. However, we believe it only accounts for a relatively small share of rural employment (see Table 1).

Table 1 Outlay in MNREGA scheme

Source: Ministry of Rural Development, Espirito Santo Investment Bank Research, ** Based on Census of 2011 data

Drivers of rural wage growth

Rural wages rose during 2005-10 (see Figure 25), driven by the following factors:

1. Sharp increase in agricultural prices due to the frequent increase in minimum support prices by the government (see Figure 24)

2. During 2005-10, rural wages grew at faster pace (see Figure 25) given the factors discussed above and the implementation of government flagship program MNREGA (discussed above).

Figure 24 MSP growth over last 9 years Figure 25 Growth in Average daily wage

Source: Ministry of Agriculture Source: Labour Bureau

3. Significant rural non-farm sector growth as is explained on page 8

4. Growth in public expenditure in rural areas has increased rural purchasing power. The public expenditure for the 13 flagship programs for agriculture, rural development and social development have been increasing rapidly since the 11th Five Year Plan. Around 85% of this expenditure is directed towards programs operating only in rural areas and currently account for c.18% of agriculture GDP. Therefore, these programs, in spite of large leakages, are increasingly transferring purchasing power to the rural

economy.

FY2009 FY2010 FY2011 9MFY2012

A. Employement provided to households (mn) 45 53 55 38

B. Persondays (mn) 2,163 2,836 2,572 1,209

C. Persondays per HH (= B/A) 48 54 47 32

D. Proportion of rural HH coverd** 27% 31% 33% 22%

E. Proportion of total available rural labour (Assuming one labour per HH, 250 days of work per year)** 5.1% 6.7% 6.1% 2.9%

F. Total expenditure (mn) 272,501 379,052 393,773 208,666

G. Expenditure on wages (mn) 182,000 255,793 256,865 144,048

H. Wage per HH per annum 1,084 1,524 1,531 858

F. Expenditure on wages by MNREGA as % of Agri GDP 1% 2% 2% 1%

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Figure 26 Distribution of employment of rural males by sector Figure 27 Distribution of employment of rural females by sector

Source: Espirito Santo Investment Bank Research,NSSO Source: Espirito Santo Investment Bank Research, NSSO

Implication of structural changes on credit quality and growth

We expect the rural economy will continue to thrive leading to better credit quality, which should lead to higher credit growth as the perception of the credit worthiness of the rural population improves, with these consequences:

a) Strong growth in the non-farm sector (which to some extent is a result of

urban spill over) and diversification away from purely agriculture.

b) Moreover, as the gap between non-farm productivity and farm productivity is expected to widen over the next 3-5 years, we expect the rural demand to be driven by the non-farm sector in the medium term, driven by construction, trade, transportation, hotel and manufacturing sectors. At the same time, the farm sector will focus more on horticulture, milk, poultry and eggs. This bodes well for auto demand (especially LCVs, UVs and cars) from the rural sector. Also, as the vehicles purchased are

more likely to be used for non-farm activities, or both, the underlying cash flows are more certain and less dependent on climate (as is the case with agricultural income). It is to be noted that growth in the non-farm sector and the shift towards more profitable produce is to some extent driven by urban spill over and hence urban economic growth will remain critical for rural income growth.

c) However, as we arrive at the turning point as we have seen with Chinese and South Korean economies farm sector productivity will rise rapidly

(explained on page 6), with mechanization of farming and irrigation, creating demand for financing.

d) It is visible from the charts above that the composition of workers in the rural economy has gone through a shift post 2008, with construction’s share almost doubling to 9% in 2010 from 5% in 2008. This has been an important reason why sales of CVs and tractors have increased over this period, given more and more equipment is required to fulfil this demand.

We think this is going to be an on-going theme with less lucrative agricultural work losing out to the more lucrative construction and manufacturing sector. Agriculture’s share in the rural economy has seen a sharp decline, dipping from 75% to 68% in the period between 2008 and 2010. We anticipate that this trend continued over 2010 to 2012.

Further, government initiatives, like the cash-based subsidy, which has the potential to make the rural economy more vibrant, are likely to keep the rural economy performing well and companies with a strong rural footprint are

most likely to do well.

As a results of all this we think that the credit quality in the rural areas are improving significantly as the dependence on agriculture of the rural population is reducing, which is the key for growth in rural areas, given a vast proportion of the rural population has been devoid of credit on the perception of bad credit quality.

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Direct Benefit Transfer could accelerate structural change

We have seen that various social welfare schemes, in spite of leakages, (on account of tardy implementation) have aided economic growth in rural areas. All the analysis suggests that Direct Benefit Transfer (DBT), if implemented correctly, could accelerate the structural change as it will ensure direct delivery of benefits to the needy with lower leakage. The DBT scheme should boost consumption in rural areas and thereby foster growth, particularly in trade, transportation and storage sectors, further strengthening our

hypothesis on the non-farm sector.

What is driving economic growth in Tier-II and Tier-III cities?

India has witnessed high migration to urban areas, primarily skilled worker migration. Moreover, the share of inter-district and inter-state migration is higher in urban areas, which highlights the higher mobility of urban migrants.

We believe skilled migrants form a high proportion of urban migrants, who are generally employed in the services sector and account for a substantial share of intra-country remittances, which is driving the economy to some extent in Tier-II and Tier-III cities.

The other driver is the increase in construction activity over the last decade which is evident from the 2.7 times increase in the contribution of the sector to total working population in the last three decades. The trade, hotel and

restaurant sector has also seen significant growth, with its contribution increasing to 27% of the total working population from 22% four decades ago.

Though there is a slowdown in both the real estate and infrastructure sectors, we expect the slowdown to be cyclical given a) the huge shortage of housing units in India and b) the current state of infrastructure.

Figure 28 Migration rates are higher in urban areas Figure 29 Distribution of migrants

Source: Espirito Santo Investment Bank Research,NSSO Source: Espirito Santo Investment Bank Research, NSSO

Figure 30 Distribution of employment of urban males by sector Figure 31 Distribution of employment of urban females by sector

Source: Espirito Santo Investment Bank Research, NSSO Source: Espirito Santo Investment Bank Research, NSSO

Vehicle finance – short-term pain

Vehicle finance is another segment of the market where NBFCs have done

well. Even some of the top five banks have been able to achieve this, given

0

5

10

15

20

25

30

1983 1988 1993 2000 2008

Mig

rati

on

Rate

s

Rural Urban

28%

39%

18%32%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Rural Urban

% d

istr

ibu

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n o

f m

igra

nts

Intra-district Inter-district Inter-state International

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1978 1988 2000 2010

Other services



Construction


Manufacturing

Mining

Agri 0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1978 1988 2000 2010

Other services



Construction


Manufacturing

Mining

Agri

Page 11

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they were NBFCs in the past and hence have a focussed approach to this segment.

Table 2 Market share in commercial vehicle finance


The increased investment in infrastructure development and expansion is expected to have both short- and long-term impact on the commercial vehicles market in the country. In the short term, there would be immediate demand for heavy commercial vehicles, like construction and infrastructure trucks and mining trucks due to the growing need for raw materials. The demand for tippers, trailers and transit vehicles for road and airport construction has started to grow significantly. In the long term, we can expect

a positive effect on the economy and consequently the heavy commercial vehicles sector is expected to grow on the basis of infrastructure already in place. SIAM is forecasting 13% CAGR over the next 20years.

Figure 32 Commercial vehicle sales forecast

Source: SIAM, Espirito Santo Investment Bank Research

However, in the near term we see a down cycle in the various segments of vehicle sales.

Commercial vehicles’ sales growth likely to decline: As is clear from the

tables and charts below, commercial vehicle sales have been on a declining trend for last seven quarters. While the LCV segment has held up pretty well, there is a clear dip in sales of other segments. Our discussion with one of the largest transporters suggest that there is no plan on their side to increase the

number of vehicles in the near term; however, there is a clear preference for

2007 2008 2009 2010 2011 2012

HDFC Bk 7.7% 15.1% 17.8% 19.6% 16.8% 17.8%

Shriram Transport

13.2% 17.2% 16.3% 18.6% 18.8% 17.0%

ICICI Bk 23.6% 18.1% 21.8% 13.4% 11.7% 11.2%

Mahindra Finance

6.4% 5.9% 5.1% 5.7% 6.6% 8.5%

Kotak 11.5% 8.2% 6.9% 7.0% 7.7% 7.7%

SBI 6.3% 6.3% 6.8% 9.0% 10.9% 7.7%

Indusind 7.3% 6.3% 4.9% 5.2% 5.9% 7.0%

Magma 5.4% 5.4% 5.0% 5.2% 5.0% 5.1%

Sundaram Finance

6.1% 6.0% 4.8% 5.3% 5.0% 4.8%

Cholamandalam

1.9% 1.8% 1.4% 2.0% 3.0% 4.2%

Axis bank 2.4% 1.9% 1.6% 1.8% 1.6% 2.1%

Reliance Capital

1.4% 2.3% 2.2% 1.3% 1.3% 1.2%

BOI 0.5% 0.5% 0.6% 0.8% 0.7% 0.8%

0

500

1,000

1,500

2,000

2,500

2006 2007 2008 2009 2010 2011 2012 2016E 2021E

'00

0 U

nit

s 13% CAGR

Page 12

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multi-axle vehicles on the longer routes and according to him although the situation is bad, it not as bad as it was in 2009. The main stress is from the working capital cycle, which is getting stretched given that the transporters

have long-term contracts with the manufacturers whose working capital cycle is under stress and the transporters are the first one whose payment is delayed.

Also, the charts (refer Figures 33-37) are clearly showing that there has been structural change in the way commercial vehicles are being sold, with;

1. Sales of LCVs increasing at a faster pace, given that these vehicles are preferred for intra-city and shorter haul carriage and mostly owned by smaller and single truck owners.

2. Sales of bigger trucks (>25T) is increasing, and our discussion with transporters suggest that they prefer this to other trucks on longer haulage, given that these trucks are economical.

Our primary data checks (transporters, dealers, financiers etc.) suggest that banks hold an upper hand in larger trucks given these are bought by big transporters who are able to arrange credit at better rates, whereas in the LCV segment NBFCs and mostly captive financiers have the upper hand.

Figure 33 LCV less than 3.5T sales data Figure 34 LCV (3.5T-7.5T) sales data Figure 35 MHCV (7.5T-12T) sales data

Source: Espirito Santo Investment Bank Research, SIAM Source: Espirito Santo Investment Bank Research, SIAM Source: SIAM, Espirito Santo Investment Bank Research

Figure 36 MHCV (12T-16.2T) sales data Figure 37 MHCV (16.2T-25T) sales data Figure 38 MHCV (>25T) sales data

Source: SIAM, Espirito Santo Investment Bank Research Source: SIAM, Espirito Santo Investment Bank Research Source: SIAM, Espirito Santo Investment Bank Research

Figure 39 Passenger vehicle sales forecast Figure 40 Small car sales for Maruti and Hyundai

Source: SIAM, Espirito Santo Investment Bank Research Source: SIAM, Espirito Santo Investment Bank Research

Used vehicle financing

Given the slowdown and uncertainty in the broader economy, large truck operators prefer used trucks due to the low investment required. Moreover, the credit quality in the used CV space has broadly held up in spite of the stretched working capital cycle in the system due to the cash & carry model,

-10%0%10%20%30%40%50%60%70%80%

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Sales YoY Growth

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Sales YoY growth

-30%-20%-10%0%10%20%30%40%50%60%

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Ju

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12 - 16.2 tonnes

Sales YoY Growth

-40%-30%-20%-10%0%10%20%30%40%50%60%70%

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Sales YoY Growth

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Sales YoY Growth

1,309 1,545 1,778 1,839 2,357

2,987 3,124

5,100

9,700

-

2,000

4,000

6,000

8,000

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FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY16EFY21E

Passenger Vehicles Production (In '000 units)

CAGR of 16%

CAGR of 13%

-

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Maruti Hyundai

Page 13

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involvement of brokers for SRTOs (small road transport operators) and lower LTVs (65% as compared to 85% for new trucks). We expect the preference to shift towards new CVs as economic growth revives migration towards a hub

and spoke model, diesel prices increase and new technologies improve fuel efficiencies.

However, for cars the same may not be true, given that the used car market is larger than the new car market in many global economies. In India until recently the used car market was dominated by the unorganised sector and hence financiers were sceptical of financing sales in this segment; however, with most car makers now entering the used car market, we expect this market to grow at a faster pace than historically. We expect companies like

Mahindra Finance to gain from this given it is a pioneer in this segment.

Figure 41 Used cars/new cars sales Figure 42 Age of cars

Source: Espirito Santo Investment Bank Research, Capgemini Source: Espirito Santo Investment Bank Research, Capgemini

What makes vehicle financiers successful?

Our research across geographies and our interactions with dealers and financiers suggest that the following metrics determine the success of a financier:

Relationship with dealers: Dealers have a big say in determining the lender

given that they are the ones (other than in case of large operators) who

recommend the financier. Hence, in order to maintain good relationships, we have seen financiers providing lines of credit to dealers, which is more of a working capital facility. NBFCs have been able to create and maintain excellent relationship with dealers.

Interest rates: In the case of bulk buyers this plays a very important role, given

that they have access to multiple lenders and also have negotiating power; however, this is not the most critical element when it comes to single vehicle owners. Banks have an upper hand with single vehicle owners.

Servicing: Bulk buyers are able to secure servicing from any financier and

hence interest rates play the most important role; however, service quality

plays the most important role in gaining market share in the single vehicle/small transporters segment. Barring a few private sector banks, NBFCs have an upper hand here.

Captive financiers hold an edge: Given that dealers play a critical role in the

determination of the financiers, and dealers have some affiliation with the manufacturers, captive financiers have an edge. Also, captive financiers are

created with an aim of increasing the sales of manufacturers and hence they offer more attractive schemes, for e.g., Tata Motors’ scheme on the Ace range of vehicles and MMFSL’s scheme on Maximo. This has meant that the captive financiers hold the majority of market share with the respective manufacturers, i.e. Tata Motors Finance is the largest financier of Tata Motors vehicles and Mahindra Finance is the largest financier of Mahindra vehicles.

-

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<1 Year 1-5 Year 5+ Year

Page 14

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Credit infrastructure has improved significantly due to credit

bureaus

The credit infrastructure has improved significantly over the last decade,

enabling higher retail credit penetration. The biggest factor that has led to the

improvement of retail credit infrastructure in India is the setting up of

consumer credit bureaus. The establishment of Credit Information Bureau

India Limited (CIBIL) has already led to significant changes in the way banks

approach retail credit in India.

Credit bureaus around the world can be classified depending on the type and

source of information. CIBIL is both a ‘positive and negative information’

bureau based on full information shared by banks, retailers and NBFCs. This

puts India on a par with other developed markets such as the US and the UK.

Based on the experience of these countries, one can conclude that banks in

India are now relatively better placed to predict with high probability the

credit behavior of borrowers.

Negative information credit history only contains information on

defaults. The information may include amounts outstanding at default

and the date of last payment. When the debt is repaid, information on

delinquencies is deleted from the database. These credit bureaus

discourage borrowers only to the extent that as borrowers they do

not benefit from maintaining a high credit score.

Positive (and negative) or full-file information credit history contains

information on all open and closed credit accounts, including the

amount approved, as well as the information on repayment. If a

borrower has defaulted on payments, but eventually paid it off, the

default information remains on file and is not deleted for a defined

period of time. Borrowers benefit from maintaining a better credit

profile.

Figure 43: Types of credit bureaus

Figure 44: Positive credit information reduces default rates

Source: IFC, Espirito Santo Investment Bank Research Source: IFC, Espirito Santo Investment Bank Research

Regulatory changes in the NBFC space

There have many regulatory changes over the last 12 months, starting with the securitization guidelines from the Nair Committee to the Usha Thorat Committee’s guidelines on the gold loan industry. We think that whilst this has somewhat changed the shape of the industry, the changes will not be as detrimental as many originally had anticipated.

Usha Thorat Committee recommendations: This was one of the biggest reasons for the de-rating of NBFCs in 2011; however, the draft guideline announced by the committee is less onerous as can be seen from table 3. The main concern pending now is concerns provisioning, with the committee Page 15

Page 16 of 25

recommending bank-like provisioning norms. Although we expect the gross NPLs will increase significantly for most of the NBFCs, the P&L the impact would be more visible as we demonstrate in Table 4.

Table 3 Usha Thorat final draft was less onerous than the previous recommendations

Source: RBI, Espirito Santo Investment Bank Research

Table 4 Our analysis shows that the movement to 90 days NPL recognition will not have material impact on credit costs for NBFCs

Source: Espirito Santo Investment Bank Research

Nair Committee recommendations: Final guidelines from the Nair Committee

were announced on 20 July 2012 and permitted lending from MFIs and HFCs

only eligible for PSL. We show our detailed analysis in Table 5, which suggests that the recommendations would have a small impact on spreads; however, given that most PSL loans have already been assigned/securitized, there is no significant impact on availability of funding or cost of funding.

Existing guidelines UT committee Draft guidelines CommentsTier -1 of 10% for IFCs, Tier-1 of 10% for IFCs,

12% for Gold loan companiesTier-1 of 12% for captive NBFCs and NBFCs lending to sensitive sectors.

7.5% for others Tier-1 of 10% for others.

Maintain 15% of the aggregate deposits at SLR for deposit taking NBFCs

15% of the aggregate deposits at SLR for deposit taking NBFCs

Maintain 15% of the aggregate deposits at SLR for deposit taking NBFCs

Negative gap in 1-30 day bucket should not exceed 15% of the cash outflows

NBFCs should maintain high quality liquid assets to eliminate any gap

No negative gap is permitted and NBFCs should maintain high quality liquid assets to eliminate any gap

Risk Weights Uniform risk weights of 100%Risk weights to capital markets and real estate for NBFCs will be 150% and 125% respectively.

Risk weights to capital markets and real estate for NBFCs will be 150% and 125% respectively.

No impact on NBFCs under our coverage except Edelweiss, ABNL-NBFC who have meaningful exposure to capital markets.

Recognition of NPA based on 180 day overdue

Migration of Provisioning norms similar to banks in a phased manner.

The impact of the provisioning norm will be optical rather than fundamental in our view.

Standard asset provisioning of 25 bps

Migrate to 120 days overdue from April,2014 to March, 2015 and 90 days norm thereafter.

The impact of the provisioning norms will be limited to decreased profitability in the quarter when the NBFC migrate to the new guidelines.

Standard asset provisioning of 40 bps to be maintained from March 31, 2014.

Credit rating is not mandatory for accepting deposits

All deposit taking NBFCs should be credit rated

NBFC-AFCs can accept deposits with a limit of 4 times of net owned funds (NOF)

NBFC-AFCs can accept deposits with a limit of 2.5 times of net owned funds (NOF)

Government NBFCsAll government NBFCs will be required to comply with regulatory framework applicable to NBFCs.

All government NBFCs will be required to comply with regulatory framework applicable to NBFCs.

Government NBFCs (PFC & REC) will have impact on account of provisioning requirements applicable to them.

Deposit takingNo impact of the limits on fixed deposits as deposits are less than 20% of NOF for SHTF and less than 60% of NOF for MMFS.

Capital Requirements

Tier-1 of 12% for all NBFCs

The draft guidelines are less onerous than the proposed guidelines. We do not see material impact of the proposed guidelines on the RoEs as all NBFCs maintain Tier-1 more than 12%.

Liquidity Management

Liquidity requirement has increased which will impact the RoEs as NBFCs will be required to keep funds for liquidity management which will earn low interest rates.

Provisioning normsAsset classification and provisioning norms similar to banks

in Rs. millions Q-1 Q0 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10

Growth Rate 3% 3% 3% 3% 3% 3% 3% 3% 3% 3% 3%

Existing Loan Book 400,000 Disbursements 47,130 48,544 50,000 51,500 53,045 54,636 56,275 57,964 59,703 61,494 63,339 65,239 180-days overdueGNPA on Disbursements 1,178 1,214 1,250 1,288 1,326 1,366 1,407 1,449 1,493 1,537 Gross NPA on existing book 10,000 Total GNPA 11,178 12,392 13,642 14,929 16,255 17,621 19,028 20,477 21,970 23,507 Provisions 1,500 1,677 1,859 2,046 2,239 2,438 2,643 2,854 3,072 3,295 3,526 Incremental Provisioning 177 182 188 193 199 205 211 217 224 231 90-days overdueGNPA on disbursements 5,740 3,000 3,090 3,183 3,278 3,377 3,478 3,582 3,690 3,800 Gross NPA on existing book 24,000 Recoveries on existing bookRecoveries on disbursements 1,699 1,750 1,803 1,857 1,912 1,970 2,029 2,090 2,152 Gross NPA 29,740 31,041 32,381 33,762 35,183 36,647 38,156 39,709 41,309 42,957 Provisioning 1,500 4,461 4,656 4,857 5,064 5,277 5,497 5,723 5,956 6,196 6,444 Incremental Provisioning 2,961 195 201 207 213 220 226 233 240 247 Increase in Provision (B/S) - 2,784 2,797 2,811 2,825 2,839 2,854 2,869 2,885 2,901 2,917

Increase in Provisioning (P&L) 2,784 13 14 14 14 15 15 16 16 17 CommentsIncremental Credit cost 0.7% 0.03% 0.03% 0.03% 0.03% 0.03% 0.03% 0.03% 0.03% 0.03%

This increase in provisions will be written back over the period of loan tenure

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Table 5 Details of Nair Committee recommendations

Source: Espirito Santo Investment Bank Research

Securitization guidelines The RBI came out with final guidelines on securitisation transactions done by Banks and NBFCs. On 7 May 2012 the regulator made provisions on the minimum holding period (MHP) and minimum retention requirement (MRR) to be maintained by the originator before securitising the assets (see Table 6).

Table 6 ‘MHP’ and ‘MRR’ requirements as specified in the draft securitization guidelines for NBFCs by the RBI

Minimum holding period (‘MHP’) Minimum retention requirement (‘MRR’) Weekly Fortnightly Monthly Quarterly Maturity < 2 years 12 6 3 2 5% Maturity between 2-5 years 18 9 6 3 10% Maturity > 5 years 12 4 10% Bullet Payment (when allowed)

10%


We expect a) assignment volumes to decline and b) an increase in the cost of assignments as credit enhancement cannot be offered, which will increase the risk in the pool of assets.

From the originator’s perspective, PTCs (Pass through certificates) will increase the capital requirements as compared with assignments. For the originating NBFCs, first loss and credit enhancement are included in risk weighted assets vs. deduction of these from tier-1 capital for PTCs. From the buyer’s perspective, the only incentive for PTC transactions will be the attached priority sector status.

Hence, we believe that a) the capital requirements for originating NBFCs will increase, b) securitisation/assignment volumes may decline and c) costs may marginally increase for the originator.

Table 7 ‘MHP’ and ‘MRR’ requirements as specified in the draft securitization guidelines for NBFCs by the RBI

Assignment Pass through certificate Comments Capital requirement Low High Only credit enhancements are included in risk weights

versus stricter norms of deducting these from tier 1 capital under PTCs.

Demand from Banks High Low The demand for assignment is high as the loans are directly added to loan book, no marking to market and increase retail loans in loan book without significant risks.

Discount rate/Cost Low High As there will be less demand for PTC as compared to assignments we expect cost to increase marginally.

Source: RBI, Espirito Santo Investment Bank

Table 8 Impact of securitization guidelines (Bigger the pie – higher the impact)

NBFC-AFC Gold Loan NBFC MFI NBFC-HFC MHP 6 months Not allowed 3 months 12 months MRR 10% Not allowed 5% 10% Capital requirements Increase Not allowed Increase Increase Margins Decline Not allowed No Impact Decline Priority sector status Yes Not allowed Yes Yes Overall


Key themes for the current year

In our opinion two key themes are going to impact NBFC share prices in the current year: a) a reduction in interest rates and b) banking licenses (discussed in detail in Banking license thematic published on 25 Feb 2013). We expect RBI to reduce the repo rates by 75-100bps over the next 12 months,

Nair Committee Recommendations Final guidelines Comments

On-lendingPriority sector status allowed subjected to spread cap

PSL allowed for MFIs and HFCs only. RBI has already revoked the PSL status for on-lending to NBFCs in Annual monetary policy.

Securitization PSL allowed for securitized/assigned loans subjected to spread caps

PSL allowed for secutized/assigned loans subjected to spread caps.

PSL on securitization/assigned retained

Spread cap 3.5% for HFCs; 6% for AFCs; 12% MFIs. All inclusive interest rate charged to borrower should be bank base rate + 8%, 10% MFIs

Final spread was higher than the spread cap proposed earlier

Other conditions65% of total assets should be on balance sheet

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which would mean that the cost of funds in the system will decline significantly. This should help wholesale borrowers given that the cost of funds for them will decline faster than retail borrowers. The impact will be

much sharper in the case of companies where the assets are on fixed rate and liabilities are on floating rate, as explained in section below and Figures 53 to 56.

Housing finance companies

In our opinion this is one of the most defensive sectors that can grow in excess of 15% over the next 3-5 years, given the low penetration of mortgages

and increasing affordability. However, the stocks have underperformed over the last six months on the back of concerns around increased competition leading to lower growth and lower NIMs. We do not see this happening in the near term; on the contrary, with interest rates reducing we can see NIMs increasing for some of the housing finance companies.

Concerns over competition are overdone: It has been more than six quarters

since banks turned aggressive towards housing finance and regulators waived off prepayment penalties, but we have not seen a) market share shift towards banks, b) increase in prepayment rates and c) decline in yields/NIMs. Leading HFCs (HDFC, LICHF and DEWH) continue to garner market share with similar spreads/NIMs on the retail housing portfolio.

Figure 45 Repayment rates for LICHF and DEWH Figure 46 Housing loan book growth for Banks/SBI


Figure 47 Standard deviation in RoAs Figure 48 RoAs for HDFC/LICHF/DEWH


LIC Housing Finance (LICHF IN, BUY, FV: Rs308, CMP: Rs245, 26% upside): Ignore noise and follow the trend

LIC Housing Finance is our top pick in this space given its slow but steady improvement in NIM, a more than 20% growth rate in the loan book and, with more than Rs 150bn of borrowings from banks other than SBI, it should see a larger reduction in interest cost in an environment of falling interest rates. Hence, we expect the company to generate more than 18% ROE; the stock is trading at 1.6x its FY14E book.

0.0%

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LICHF DEWH

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LICHF HDFC DEWH

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The stock has dropped after its Q3 results as the company showed a reduction in NIM and an increase in gross NPLs, which was mainly on account of an increase in NPLs in project loans. In our view, on qualitative aspects the

company has shown significant improvement given:

a) For the first time after many quarters we have seen an increase in the project loan portfolio, which was the main reason behind the decline in NIM for the company as high yielding project loans were declining.

b) Over the last couple of years we have seen the highest increase in spreads in the individual loan portfolio, where the spreads have been continuously declining. Also incremental spreads are one of the highest for the company in many quarters.

c) The increase in the cost of funds has now stabilised, with most of the low cost liabilities being re-priced and incremental money coming at c.9% compared with company’s average cost of funds of 9.67%.

Risk to Fair Value

Other than the macro factors concerning the entire housing finance sector our

investment case on LICHF mainly depends on an increase in NIMs from hereon given conversion of teaser rate loans into floating rate loans. However, we see a risk if there is no NIM expansion due to increase in cost of funds or the teaser rate loans start getting prepaid.

Valuation Methodology

We have used excess return on equity method to calculate the fair value of

LICHF, using a cost of equity of 14.5%. Our model is a two stage model with time horizon of twenty years, first ten years of explicit forecast and next ten years of declining RoEs to CoEs on a straight line basis

Figure 49 Yields and cost of funds movement for LICHF Figure 50 Incremental spreads for LICHF


Dewan Housing Finance (DEWH IN, BUY, FV: Rs287, CMP: Rs189, 52%

upside)

We have the highest upside (among HFCs) on Dewan Housing Finance, which in our opinion is the most undervalued company in the financial sector space with extremely strong fundamentals.

a) In our opinion the company is one of the best financiers in its market segment in Tier 2 and Tier 3, and has grown at more than 40% CAGR over the last three years.

b) It has consistently maintained its credit quality and we have not seen any concern on the credit quality in the near term

c) It is one of the better placed HFCs in a declining interest rate environment, given 69% of its funds come from the banking system.

Please see our note on Housing Finance dated 27-Nov-2012 for valuation

methodology and risk factors.

0.0%

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Yeilds on Project Loans Cost of funds0.0%

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Page 19

Page 20 of 25

HDFC (HDFC IN, NEUTRAL, FV:Rs838, CMP:Rs815, 3%upside)

A top quality company in the housing finance space with a consistent track record of performance. We think that the company can keep on growing at c.20% and can deliver around 20% YoY growth in earnings. Hence, we think it deserves to be the most expensive stock in the sector trading at 4.5x core book. However, given its premium valuation we do not see currently see any significant upside.

Please see our note on Housing Finance dated 27-Nov-2012 for valuation

methodology and risk factors.

Asset finance companies

Listed below are the companies that will benefit from a decline in interest rates; however, many of these companies have seen significant share price rises over the past year. Our top pick in this space is Mahindra Finance, which

we initiate in this note, and L&T Finance remains our high conviction SELL.

Mahindra Finance (MMFS IN, BUY, FV: Rs246, CMP: Rs 205, 20% upside)

Mahindra Finance Limited (MMFSL) has been one of the top performers vs. the Bankex over the last years, with the stock moving up more than 50%. This surge has been on the back of a robust loan book and profitability growth.

MMFS has a business model that provides it with a sustainable competitive advantage in rural India which we expect to result in long-term outperformance. We see this as a long-term core portfolio holding and initiate with a BUY, though after the run we only see 20% upside.

Bajaj Finance (BAF IN, BUY, FV: Rs1406, CMP: Rs1258, 12% upside)

With its innovative business model and strong franchise, we initiate coverage

on Bajaj Finance with a BUY and a valuation pointing to 12% upside. The stock has done well and has risen >80% since 1 January 2012, mainly due to a more than 100% increase in profitability on a YoY basis. We expect the loan book to grow in excess of 20% for the next 3-4 years. Although we expect the credit costs to increase by 50bps and the NIM to decline by 30bps for the foreseeable future, we still expect sustainable ROEs of 20%.

Sundaram Finance (SUF IN, BUY, FV:Rs660, CMP:Rs514, 28% upside)

A company with no equity dilution in the past eight years, consistent ROE of >15% and a share price CAGR of 30% is hard to ignore, and testament to strong management, a diversified liability base and superior asset quality. We initiate coverage on Sundaram Finance with a BUY and fair value of Rs660, 28% upside from current levels, as in our view this is one of the best managed companies in the sector. Its general insurance and housing finance segments

are key drivers that could provide substantial upside from hereon.

Shriram Transport Finance (SHTF IN, NEUTRAL, FV:Rs773, CMP:Rs710, 9% upside)

Shriram Transport is a top quality NBFC in the used CV financing business and we’ve been long-term buyers of the stock given our perception of a wide moat around the business, sustaining its position despite sporadic attempts of others to take market share. But the stock has run up 77% since its low in January 2012 and we think there now is limited upside. Whilst our FV increases to Rs773 from Rs681 as we rollover our base to FY14E, given the slowdown in the CV segment and the recent run, we now see limited upside and so change our stance from Buy to NEUTRAL.

L&T Finance Holdings (LTFH IN, SELL, FV:Rs58, CMP:Rs78, 25% downside)

LTFH’s stock has risen >50% in the past four months on news flow, ranging from the company acquiring a general insurance company, which it denied, to it receiving a banking licence (in our opinion possible), to it acquiring a bank. The Reserve Bank of India (RBI) has not in living memory given permission to

a NBFC to acquire a bank, whilst new bank licences are dependent on the banking regulation act being amended in the Winter session and it will then take at least six months before a licence is issued. Even if it were imminent, we Page 20

Page 21 of 25

would still struggle to justify the current multiple at sub 15% RoEs. We reiterate our SELL rating on the company with a FV of Rs58.

Risk to Fair Value

If the company were to acquire a bank and ramp up the CASA franchise, with a subsequent impact of increasing the RoEs, then this could present upside risk to our fair value.


We value L&T Finance Holdings on a SOTP basis, with the key constituents being the lending businesses which we value on an excess return on equity basis using a cost of equity of 14.5%. We have taken into account the Fidelity acquisition by the company in its asset management business.

Microfinance Institutions

SKS Microfinance (SKSM IN, BUY, FV: Rs186 , CMP: Rs140, 33% upside)

SKS Microfinance stock had moved up more than 100% from the QIP price over the last seven months on the back of increased clarity around funding and better regulatory environment. The company has been able to generate

marginal profit in Q3, given higher than expected cost cuts. Given better than expected numbers and more visibility on loan growth we retain our BUY stance with a fair value of Rs186. Further upside can be expected if the microfinance bill were to be passed and the company is able to recover some money from Andhra.

Risk to Fair Value

With regulatory risk easing, the main risk to our investment case is political risk, given that the target market of poor women is politically sensitive. Also, availability of funding remains the key for future growth.


We have valued the company using the excess return on equity methodology with a cost of equity of 15%. Our model is a two stage twenty year horizon

with ten years of explicit forecast and the subsequent ten years of a declining RoE to the cost of equity (15%) over ten years.

Figure 51 Funding profile Bajaj Finance Figure 52 Funding profile Mahindra Finance


33%

58%

9%

Bajaj Finance

NCDs Bank Loans CPs & others

25%

64%

10%

1%

Mahindra Finance

NCDs Bank Loans Fixed deposits Others

Page 21

Page 22 of 25

Figure 53 Funding profile Sundaram Finance Figure 54 Funding profile Shriram Transport


Table 9 Relative valuations table


44%

39%

12%

5%

Sundaram Finance

NCDs Bank Loans Fixed deposits CP

37%

44%

5%14%

Shriram Transport

NCDs Banks Fixed deposits Sub-debt

FY13E FY14E FY13E FY14E FY13E FY14E FY13E FY14EHDFC NEUTRAL 838 815 1,163 23,267 2.5% 2.5% 23% 23% 26 22 5.4 4.7LICHF BUY 308 245 112 2,249 1.3% 1.4% 17% 19% 12 9 1.9 1.6DHFL BUY 287 189 20 401 1.2% 1.3% 19% 20% 5 4 1.0 0.8

1.7% 1.7% 19% 21% 14 12 2.7 2.4

FY13E FY14E FY13E FY14E FY13E FY14E FY13E FY14EMMFS BUY 246 205 108 2,153 3.5% 3.3% 22% 21% 14 11 2.6 2.2SUF BUY 660 514 53 1,061 2.8% 2.8% 21% 22% 12 9 2.2 1.9MGFL BUY 44 36 28 562 3.3% 3.4% 18% 18% 7 6 1.1 1.0Muthoot NOT RATED 215 74 1,478 3.6% 3.5% 31% 28% 8 6 2.1 1.6SHTF NEUTRAL 773 710 147 2,938 4.3% 4.0% 22% 22% 11 10 2.2 1.9LTFH SELL 58 78 124 2,473 2.1% 1.9% 14% 13% 19 17 2.5 2.2Bajaj Finance BUY 1406 1,258 51 1,027 3.9% 3.7% 21% 19% 11 9 1.9 1.6SKS Microfinance BUY 186 140 14 281 -13.7% 4.9% -60% 20% -- 11 2.2 2.0

3.4% 3.2% 21.3% 20.6% 12 10 2.1 1.8

P/E P/BHFCs Rating Fair Value (Rs)

CMP (Rs)

Mar. Cap (Rs bn)

Mar. Cap ($mn)

NBFCs Rating Fair Value (Rs)CMP (Rs)

Mar. Cap (Rs bn)

Mar. Cap ($mn)

RoE P/E P/BRoA

RoA RoE

Page 22


COVERAGE INITIATION


Mahindra Finance

High quality play on rural India

Mahindra Finance Limited (MMFSL) has been one of the top performers vs. the Bankex over the last one year, with the stock moving up more than 50%. This surge has been on the back of a robust loan book and profitability growth. MMFS has a business model that provides it with a sustainable competitive advantage in rural India which we expect to result in long-term outperformance. We see this as a long-term core portfolio holding and initiate with a BUY, 20% upside from current levels.

A business with a sustainable competitive advantage Mahindra Finance has an excellent franchise in rural India, delivering loan book growth at a 24% CAGR over the past five years and putting the difficulties of 2009 behind it, when NPLs moved above 9%. We expect sustained outperformance for these reasons: Top franchise in rural areas: MMFSL is a top franchise in rural India given a) it

has first mover advantage and is well versed in the nuances of rural financing; b) the excellent rapport it shares with dealers, be it in a faster turnaround time or stepping in when banks back out; c) it is a Mahindra company, a big plus as its parent company is the largest tractor and UV manufacturer in India and enjoys strong brand recall in rural areas and d) its strong collection model, which is a key requirement if one wants to grow profitably in rural and semi urban areas, and underwriting abilities, which are based on on-ground realities and not just submission of documents.

NPLs at trough but do not expect repeat of 2009: MMFSL’s NPLs have been

declining for the past four years, given the rural market has been robust. However, there have been concerns in the market about whether we could see a repeat of 2009, when against a backdrop of drought across the country MMFSL’s gross NPLs rose to over 9% from 6% in 2007. In our opinion, if the

operating environment deteriorates in rural India, then NPLs could increase (say 50-100 bps). However, we do not expect a repeat of 2009 given a) MMFSL’s dependence on direct agricultural activities is now lower (c.15% currently from c.40% in 2009); b) rural India’s dependence of agricultural activity is getting lower (see page 6 & 8) and c) MMFSL’s collection and credit appraisal process have improved significantly. Other initiatives can yield results: MMFSL has entered the used car financing

segment, which we believe offers an interesting opportunity as it becomes institutionalised. Also, we are very hopeful on MMFSL’s foray into housing finance in rural India, given limited competition and the untapped potential, and we believe MMFSL is one of the few firms which could execute on this. Banking licence can be a positive: As discussed in our banking license

thematic section, of all the names being bandied about for a new banking licence, MMFSL stands out with its ability to leverage the new banking licence given its rural footprint and franchise strength.

Valuation MMFS is trading at 2.2x FY14E book value, a 15% premium to its peers (SHTF, SUF and CIFC). We think the premium is justified given its niche target segment, diversified loan book and better growth visibility. We have valued it on a SOTP basis with a fair value of Rs.246, 20% upside from current levels, implying 2.6x FY14E BV. Also, we think it is the best placed NFBC to benefit should new banking licenses be issued to NBFCs (see our note on Banking

licenses published on 25th Feb, 2013).

Accounting & corporate governance GREEN

Franchise Strength GREEN

Earnings Momentum GREEN

BUY 20% upside

Fair Value Rs246.38

Bloomberg ticker MMFS IN Share Price Rs205.00 Market Capitalisation Rs115,107.76m Free Float 48%

IINR m Y/E 31--MMar 22011A 22012A 22013E 22014E

Total revenue 20,386 29,104 39,458 50,941

Total Expenses 12,909 19,491 26,949 35,536

Profit before tax 7,477 9,613 12,509 15,406

PAT after MI 4,928 6,435 8,356 10,291

EPS 9 12 15 18

DPS 2 3 3 4

YY/E 31--MMar 22011A 22012A 22013E 22014E

P/E 21.6 16.6 14.0 11.3

P/BV 4.2 3.5 2.6 2.2

ROA 4.0% 3.9% 3.5% 3.3%

ROE 19.4% 23.1% 22.1% 21.0%

Dividend Yield 1.0% 1.4% 1.6% 1.9%


Data, Bloomberg

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Apr 2012 Jul 2012 Oct 2012 Jan 2013

MMFS IN vs BSE500 Index

Share Price Performance

Analysts Santosh Singh, CFA +91 22 43156822 [email protected] Espirito Santo Securities India Private Limited Nidhesh Jain +91 22 4315 6823 [email protected] Espirito Santo Securities India Private Limited

Page 23

Page 2 of 14

Company snapshot Mahindra Finance is a leading asset finance company with a focus on rural centres (more than 80% in rural and semi urban). The company started as a captive NBFC of Mahindra Auto in 1993 with the aim to provide financing to

buyers of Mahindra utility vehicles. Since then, the company has significantly transformed itself from a 100% captive NBFC to an independent NBFC with less than 50% of disbursements accounting for Mahindra vehicle financing. The company now has more than 625 branches in India and AUM of more than Rs240bn with a focus on rural and semi-urban locations. The company is now the largest financier of Maruti passenger cars in rural India with c.10% market share.

Mahindra Finance has an 87.5% economic interest in Mahindra Rural Housing Finance, a venture with NHB. The company also has other two subsidiaries, Mahindra Insurance Brokers (Insurance broking in rural areas) and Mahindra Business & Consulting Services Private Limited (provides staffing services mainly to Mahindra finance and its other subsidiaries).

Figure 1 AUM growth (MMFSL) Figure 2 Product-wise AUM breakup Figure 3 Total income by subsidiary

Source: Espirito Santo Investment Bank Research, Company Data Source: Espirito Santo Investment Bank Research, Company Data Source: Espirito Santo Investment Bank Research, Company Data

Figure 4 MMFSL group structure


SWOT analysis Strengths Weaknesses

� Strong brand name and trust among the customers due to its parent, Mahindra & Mahindra Ltd. The parent is a well-known brand in India, particularly strong in rural and semi-urban areas of India.

� Strong management team with vast experience in the financial services domain.

� Strong underwriting processes which have been developed through experience and specific to their segment.

� Multi-product approach has reduced its dependence on parent company or any specific line of product.

� The company is exposed to rural economy where NPLs could be cyclical.

� Dependence on Mahindra dealers can impact the company’s growth when M&M is not doing well.

Opportunities Threats

� Favourable demography presents huge opportunity for growth.

� Rural economy is buoyant and expected to continue on its growth path owing to the structural changes highlighted in the thematic section.

� The company is one of the front runners for the new banking license.

� Adverse regulatory changes may put NBFCs at a disadvantage versus banks.

� The rural market given its attractiveness can increase competition and impact margins and profitability.


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Cars & others non M&M CV and CE

Pre-owned

94%

3%3%

MMFSL MRHFL MIB

Mahindra Finance

Mahindra Rural Housing Finance (87.5%)

Mahindra Insurance Brokers(100%)

Mahindra Business & Consulting Services Private Limited

(100%)

Mahindra Finance USA LLC (51%)

Page 24

Page 3 of 14

An excellent recovery

Mahindra Finance has registered one of the highest growth rates in the industry (40% CAGR) and its NPLs have fallen from a peak of 9.6% to 3.2% over the last 36 months. Despite regulations on priority sector lending and securitization, NIM was in excess of 8% with ROE growing consistently (from

around 16% in 2009 to 22% in 2012). The stock performance was further helped by two book value accreting capital raisings. We expect the company to do exceptionally well in coming years due to:

Quality rural franchise

There are many peculiarities related with rural financing, key amongst them:

a) Cash dealing: With poor banking penetration across rural India, most of

the transactions are carried out on a cash basis and hence the ability to handle cash on the recovery side is a critical requirement for rural NBFCs. About 65% of the collection is done in cash and at the doorstep of the customer for MMFSL.

b) Absence of collaterals: Given that most of the assets offered as collateral

in rural India are either land or gold, and as land seldom has clear titles, it is difficult to identify good collateral in rural India other than the equipment against which the loan is granted.

c) Lack of credit rating: Given the lack of banking facilities in rural India

there is a lack of data on the history of borrowers. This is a big barrier to entry into rural India and penetration into this market requires a brick and mortar presence, which as of now none other than PSU banks have had. For a long time, PSU banks have been the major providers of finance in rural India; however, increased losses from this segment have forced PSU banks to go slow. Also, the inability of PSU banks to think innovatively

meant that they relied more on branch-based banking, as opposed to Mahindra Finance’s business model of reaching out to borrowers. Mahindra Finance has done exceedingly well by creating rural infrastructure with the know-how gleaned from Mahindra & Mahindra’s rural tractor dealerships.

d) Requirement of on-ground presence: With population in rural areas

spread out, it is imperative that financial firms reach out to borrowers. The traditional branch-based model followed by PSU banks is not very successful as it entails a high fixed cost and a single location can only serve a limited number of customers. NBFCs follow a field-based approach which enables them to serve customers miles away from the braches. Mahindra Finance’s branches serve customers within about a 100km radius from a single branch.

All this has meant that Mahindra Finance has become the financier of choice in

rural India.

Case studies from our rural visits

While conducting our primary data research on Mahindra Finance we came across many cases where knowledge of the local markets has helped the company, one such case is outlined below.

Vehicle financed: XUV 500

Borrower: A well-known person in the vicinity, but retired and hence had not filed an IT return for a couple of years. Also the person has businesses related to agriculture and so income from this activities falls under agricultural income and hence this person is not required to pay tax.

As the person was unable to furnish an income document or tax returns, banks did not provide finance. However Mahindra Finance was able to finance it very quickly as the borrower’s credibility and the cash flow sustainability were established and verified by doing on the ground checks.

Page 25

Page 4 of 14

Maruti Car dealer, Baraut, Uttar Pradesh

Baraut is a small city in Bagpat district, Uttar Pradesh, with a population of around 100,000. The economy of Baraut and surrounding villages is reliant on agriculture. It is about 56km from Delhi, and has not much to show for in terms of development as compared with the adjoining National Capital Region. We met a Maruti car dealer in Baraut and the key takeaways are as follows:

More than 60% of the cars sold are bought on loans and 80% of the financing is done by Mahindra Finance.

The dealer has developed a strong relationship with Mahindra Finance over the last three years.

The nearest Mahindra Finance branch is located in Meerut, about 60km away from the dealership. Despite this, a Mahindra Finance employee visits the dealership three times a week.

The dealer said the turnaround time is very important as there is no significant difference in interest rates. He said that, “some customers wanted to buy car on Dhanteras and only Mahindra Finance was able to approve loans on the same day.” Mahindra Finance has a process where loan approval can be sought online by sending the scanned documents to Mahindra Finance.

Our interaction suggests that both dealer and financier are dependent on each other and many a time the financier’s decision is based on the dealer’s recommendation, as the dealer has local knowledge. If the loan goes bad, then the relationship with the dealer is strained and this has an impact on sales for the dealer. The relationship between the dealer and financier takes time to develop.

Mahindra backing a major help: MMFSL was started as a captive financier

for M&M vehicles; however, over the years it has transformed itself as the

financier of choice in rural India. But it remains one of the biggest financiers of

Mahindra vehicles in rural India where MMFSL’s market share is still around

30%. Our discussion with various financiers and distributors suggests that

vehicles like the Mahindra Maximo, Bolero and tractors enjoy a

disproportionate market share, thanks to the deep reach of Mahindra Finance.

With the Mahindra vehicles doing exceedingly well, we expect Mahindra

Finance to ride the growth. In addition to this, Mahindra is a well-known and

respected brand and enjoys a strong brand recall in rural India.

Macro environment is conducive

Although Mahindra Finance started as a captive financier for Mahindra vehicles, over a period of time it has turned itself into financier of choice for many of the manufacturers. Maruti and Hyundai are two car manufacturers who have started forming a substantial portion of sales for Mahindra. Also, the segment that MMFSL is financing the most for these two players is becoming

the bestselling segment for both (Maruti Alto 800 and Hyundai Eon). This is one of the reasons why although overall auto sales numbers are dipping, Mahindra Finance has shown more than a 30% increase in disbursements.

Page 26

Page 5 of 14

Figure 5 Maruti small passenger vehicle sales Figure 6 Hyundai small passenger vehicle sales


Figure 7 DuPont analysis for Mahindra Finance


Figure 8 AUM break-up for Mahindra Finance Figure 9 Used cars/New cars ratio global data


New initiatives to further enhance the value proposition

A couple of initiatives of Mahindra Finance can be value accretive in the medium term given that we think there is huge scope in these areas and MMFSL with its early mover advantage and reach can become one of the best

players in this field.

Used vehicle financing: MMFSL also finances the purchase of used vehicles,

though it is small proportion of its total AUM (c.7%). This is a bigger market than new car sales globally (see Figure 9). For institutional players, the used-car segment in India is an untapped one given the ‘Lemons problem’, a situation where information asymmetry exists between the buyer and the

seller, with the scales tilted in favour of the seller. Further complicating the situation is that the used-car market is dominated by small garage owners and

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Mahindra Finance 2010 2011 2012 2013E 2014E 2015E Sustainable

NII 14.0% 10.9% 9.9% 9.2% 9.1% 9.0% 8.9%

Other operating income 0.3% 2.0% 1.7% 1.4% 1.3% 1.3% 1.2%

Total income 14.4% 12.9% 11.5% 10.6% 10.4% 10.3% 10.1%

Employee Expense 1.7% 1.5% 1.4% 1.2% 1.0% 0.9% 0.8%

Admin and other expenses 2.5% 3.1% 2.6% 2.2% 2.0% 1.9% 1.8%

Credit Cost 3.0% 1.3% 1.1% 1.3% 1.8% 1.8% 1.8%

Depreciation 0.1% 0.2% 0.1% 0.1% 0.1% 0.1% 0.0%

PBT 7.0% 6.9% 6.4% 5.8% 5.4% 5.6% 5.7%

PAT 4.6% 4.6% 4.3% 3.9% 3.7% 3.7% 3.8%

RoE 21.5% 21.9% 22.8% 21.5% 20.6% 22.6% 23.9%

Leverage (X) 4.6 4.8 5.3 5.5 5.6 6.1 6

0%10%20%30%40%50%60%70%80%90%

100%

2009 2010 2011 2012 9M'2013

Auto/UV (M&M) Tractors (M&M)

Cars and Non-M&M UVs CVs & CEs

Old vehicles & others

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Page 6 of 14

non-corporate entities, which makes loan disbursal difficult. However, with organized players entering the market and car manufacturers themselves starting to sell used and old vehicles, we can expect this market to grow at a very fast pace from hereon, helping Mahindra Finance; this market segment also offers higher yields.

Mahindra rural finance: This is another venture of Mahindra Finance which we

think has an incredible franchise and can generate a great amount of value in the long term. Across India we cannot find any franchise (other than smaller players) with a focus on this area. Barriers to entry are significant given the business model makes very little sense for the banks given the small ticket size. We think there is significant amount of potential in this market, thanks to the sustainable improvement in the cash flows for rural population.

Direct marketing initiative: Mahindra has started direct marketing initiative

with 1.3mn customers; the company has been able to generate c.10% incremental business through referrals from these customers.

Figure 10 AUM growth Figure 11 PAT growth Figure 12 RoAs/RoEs of MRHFC


Figure 13 DuPont for Mahindra Rural Housing Finance Company


Collection is the differentiator

In an effort to understand what differentiates Mahindra Finance from other players in the market, we went across regions to gain a better understanding of its business model and on-ground reality. What was clearly visible was that the biggest strength of the company’s business model is collection, given that most of the customers it lends money to do not have a CIBIL (India’s credit

information bureau) record. This is evident from the company employee base where more than 50% of the field employees are collection officers (Out of c.8,000 field officers, c.5,000 are collection officers). Also, the focus on importance of collection is further exemplified from the fact that the entire loan approval process is based on the financial investigation report of the collection officers.

NPLs in a challenging environment

The commentary from the management of NBFCs conveys a picture of a tough environment, with most acknowledging stress in the CV and car portfolios. We expect credit quality for MMFSL to deteriorate in the near term

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PA

T (

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2.5%4.1% 2.9%

16%

34%

24%

0%

5%

10%

15%

20%

25%

30%

35%

40%

2010 2011 2012

RoA RoEs

Mahindra Rural HFC 2010 2011 2012 2013E 2014E 2015E Sustainable

NII 12.7% 13.3% 11.1% 10.3% 9.9% 9.4% 9.8%

Fee Income 0.1% 3.3% 1.8% 1.1% 1.0% 0.9% 0.9%

Total Income 12.8% 16.5% 12.9% 11.3% 10.8% 10.3% 10.7%

Employee benefits expenses 6.1% 5.8% 4.3% 3.9% 3.8% 3.6% 3.7%

Other admin costs 3.4% 4.3% 3.9% 3.7% 3.6% 3.5% 3.5%

Credit Costs 0.3% 0.6% 0.7% 0.8% 0.8% 0.8% 0.8%

Depreciation 0.1% 0.1% 0.1% 0.1% 0.1% 0.0% 0.0%

Profit before tax 2.9% 5.7% 3.9% 2.9% 2.6% 2.3% 2.7%

Profit after tax 2.5% 4.1% 2.9% 2.1% 1.9% 1.7% 2.0%

RoE 15.6% 34.2% 24.0% 20.1% 21.3% 21.2% 23.7%

Leverage (x) 6.2 8.3 8.3 9.5 11.2 12.5 12

Page 28

Page 7 of 14

with credit costs increasing by 50bps from 1% currently to 1.5%; however, given the structural change in the rural environment as we have highlighted in the thematic section (page 6), we do not expect a repeat of 2008-09 for NPLs given that the company has reduced its dependence on agriculture. Also, the company’s processes are much stronger now compared with 2008-09.

As is visible from Figure 8, the company’s dependence on tractors and UVs has decreased by more than 10% points and UV’s dependence on direct agriculture has reduced from more than 35% to less than 10% over the past

four years. This has led to significant reduction in credit cost as is visible from Figure 15.

Figure 14 Gross NPA movement for MMFS Figure 15 Credit cost for MMFS


Figure 16 Assumption table


0%

2%

4%

6%

8%

10%

12%

2007 2008 2009 2010 2011 2012

Gro

ss N

PA

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

2009 2010 2011 2012

Cre

dit

Co

st

Mahindra Finance FY13E FY14E FY15E Comments

AUM 270,383 346,237 436,596 Expect robust AUM growth which tapers down due to base effect

YoY Growth 31% 28% 26%

Disbursement 177,489 221,861 277,327

YoY Growth 30% 25% 25%

NIMs 7.8% 7.9% 7.8% NIMs increases in FY14 in declining interest rate environment

NII 18,669 24,373 30,451

Total Income 21,542 27,911 34,821

Opex 6,986 8,231 9,564

Credit costs 2,550 4,883 6,175 Expect credit cost at 1.25% & 1.5% in FY14 & FY15. Standard asset provisioning at 0.4%

PAT 7,913 9,783 12,655

Mahindra rural HFC FY13E FY14E FY15E Comments

AUM 7,964 11,198 15,266 Expect AUM growth to decline as size increases

YoY growth 49% 41% 36%

Disbursement 3,468 4,508 5,860 Expect robust disbursement growth of 30%

YoY growth 30% 30% 30%

NII 669 932 1,237

NIMs 10.1% 9.7% 9.3% NIMs decline as leverage increases and loan book grows

Total Income 739 1,022 1,354

Opex 493 695 939

Credit costs 53 77 106 Assumed stable credit cost

PAT 138 180 222

MIB FY13E FY14E FY15E Comments

Net premium 5,379 6,724 8,405

YoY Growth 30% 25% 25% Expect strong growth in line with AUM growth

Revenue 559 694 862

PAT 169 209 260

Page 29

Page 8 of 14

ESIB versus consensus

We are broadly in line with consensus on FY13E and FY14E numbers. Our EPS for FY13E is lower than consensus as some of the constituents of consensus may yet have to factor-in a capital raising (10% increase in number of shares) and the subsequent increase in the number of shares. Our estimates for FY15

are higher than the consensus due to our expectations of stable growth and sustainable margins. It should be noted that we have used standard asset provisioning at 40bps and a credit cost of 1.5% from FY14E onwards.

Figure 17 ESIB versus consensus


SOTP

We have valued MMFSL on SOTP basis with more than 90% of valuation coming from Mahindra Finance which we have valued on excess cost of equity model using a cost of equity of 14.5%

Figure 18 Sum of the parts (Mahindra Finance)


Table 1 Traffic Lights: criteria for judgement

Parameter Traffic signal Reasons

Accounting &

governance

GREEN

The company has one of the best disclosure levels both on the standalone and

consolidated basis. Moreover, the disclosures at the subsidiary levels are also strong. We

have a GREEN rating on the corporate governance.

Franchise

strength GREEN

We have a GREEN rating on Franchise strength due to its strong brand name (primarily

due to parent), relationships with dealers (both Mahindra and Non-Mahindra) and

branch network.

Earnings

momentum GREEN

See charts below

Source: Espirito Santo Securities, Bloomberg, Company data.

FY13E FY14E FY15E FY13E FY14E FY15E FY13E FY14E FY15E

Sales 23,190 29,429 36,209 22,840 29,627 37,037 -1.5% 0.7% 2.3%

PAT 8,359 10,149 12,705 8,381 10,322 13,281 0.3% 1.7% 4.5%

EPS 15 18 22 15 18 23 -3.2% -0.2% 3.8%

BVPS 78 92 110 79 93 111 1.5% 1.1% 1.0%

DPS 3.2 3.8 4.4 3.2 3.9 4.8 1.1% 3.7% 8.0%

Consensus ESIB Estimates % difference

Valuation StakeValuation of

StakeValue per

shareComments

Mahindra Finance 128,353 100% 128,353 229 2.4x FY14E book value

Mahindra Rural HFC 5,113 87.5% 4,474 8 5.5x FY14E book value

Mahindra Insurace Brokers 5,521 100% 5,521 10 26x FY14E earnings

Total Valuation 138,347 246

Page 30

Page 9 of 14

Figure 19 Earnings momentum Figure 20 Earnings momentum chart


0

20

40

60

80

100

120

140

160

180

200

-150%

-100%

-50%

0%

50%

100%

150%

Net upgrades/downgrades Price (RHS)

0

50

100

150

200

250

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

% Change in NTM EPS growth forecasts Price (RHS)

Page 31

Page 10 of 14

Source: Company Data, Espirito Santo Investment Bank Research

Valuation Metrics 2011 2012 2013E 2014E 2015E

Recommendation: BUY P/E 22 17 14 11 9Fair Value: INR 246 P/BV 4.2 3.5 2.6 2.2 1.9

ROA 4.0% 3.9% 3.5% 3.3% 3.4%Share Price: INR 205 ROE 19% 23% 22% 21% 23%Upside / Downside 20% Dividend Yield 1.0% 1.4% 1.6% 1.9% 2.3%

3 Month ADV ($m) 5.6Free Float 48% Implied Valuation Ratios 2011 2012 2013E 2014E 2015E52 Week High / Low 120-245 P/E 26 20 17 14 11

P/BV 5.0 4.2 3.1 2.6 2.2Bloomberg: MMFS INModel Published On: 25 February 2013

P&L Summary 2011 2012 2013E 2014E 2015E

Shares In Issue (mm) 562 Revenue from operations 20,256 28,849 39,226 50,710 63,659 Market Cap ($mn / Rs bn) $2561 mn/Rs.115bn Other income 130 255 232 232 232 FII holding 36% Total revenue 20,386 29,104 39,458 50,941 63,890

Employee expenses 2,240 3,128 3,604 4,047 4,545 Finance Costs 6,662 11,399 16,618 21,314 26,853 Other expenses 2,467 3,161 3,921 5,012 6,186 Provisions and write-offs 1,379 1,600 2,603 4,960 6,281 Depreciation 161 203 203 203 203 Total Expenses 12,909 19,491 26,949 35,536 44,068 Profit before tax 7,477 9,613 12,509 15,406 19,822 Tax 2,541 3,168 4,128 5,084 6,541

Espirito Santo Securities Analyst Profit after tax 4,937 6,445 8,381 10,322 13,281 Santosh Singh, CFA PAT after MI 4,928 6,435 8,356 10,291 13,235 (91) 22 43156822 EPS 9 12 15 18 23 [email protected] DPS 2 3 3 4 5 Nidhesh Jain(91) 22 [email protected] Balance Sheet Summary 2011 2012 2013E 2014E 2015E

Net Worth 25,450 30,311 45,202 52,926 63,013 Shareholding Pattern Minority Interest 47 77 102 133 180

Borrowings 97,846 176,146 230,633 291,266 361,759Total Sources of funds 123,343 206,534 275,936 344,325 424,952

Fixed assets 811 1,028 1,028 1,028 1,028 Non current investments 936 1,473 1,473 1,473 1,473 Deferred Tax Assets 2,176 2,033 2,033 2,033 2,033 Loans & Advances 126,070 183,878 252,872 320,723 400,640 Net working Capital (6,650) 18,122 18,531 19,069 19,778 Total Application of funds 123,343 206,534 275,936 344,325 424,952

BVPS 49 58 79 93 111

DuPont (Mahindra Finance) 2011 2012 2013E 2014E 2015E

NII 10.9% 9.9% 9.2% 9.1% 9.0%Loan Book Growth Fee income and others 2.0% 1.7% 1.4% 1.3% 1.3%

Total Income 12.9% 11.5% 10.6% 10.4% 10.3%Employee cost 1.5% 1.4% 1.2% 1.0% 0.9%Admin Cost 3.1% 2.6% 2.2% 2.0% 1.9%Credit Cost 1.3% 1.1% 1.3% 1.8% 1.8%PBT 7.0% 6.9% 6.4% 5.8% 5.4%PAT 4.6% 4.6% 4.3% 3.9% 3.7%RoE 22% 22% 23% 22% 21%Leverage (x) 4.6 4.8 5.3 5.5 5.6

DuPont (MRHFC) 2011 2012 2013E 2014E 2015E

NII 13.3% 11.1% 10.3% 9.9% 9.4%Fee & other income 3.3% 1.8% 1.1% 1.0% 0.9%Total Income 16.5% 12.9% 11.3% 10.8% 10.3%Employee benefits expenses 5.8% 4.3% 3.9% 3.8% 3.6%

Margin Trends Other admin costs 4.3% 3.9% 3.7% 3.6% 3.5%Credit Costs 0.6% 0.7% 0.8% 0.8% 0.8%Profit before tax 5.7% 3.9% 2.9% 2.6% 2.3%Profit after tax 4.1% 2.9% 2.1% 1.9% 1.7%RoE 34.2% 24.0% 20.1% 21.3% 21.2%Leverage (x) 8.3 8.3 9.5 11.2 12.5

Key Data (MIB) 2011 2012 2013E 2014E 2015E

Net Premium 2,892 4,138 5,379 6,724 8,405 Total Revenue 493 425 538 672 841 PAT 219 136 169 209 260

Mahindra Finance

Promoter52%FII

36%

DII7%

Others5%

-

50

100

150

200

250

300

350

400

450

FY12A FY13E FY14E FY15E

Rs.

bn

0%

5%

10%

15%

20%

25%


RoA RoE

Page 32

Page 11 of 14


We have valued Mahindra Finance and Mahindra Rural Housing Finance on excess return on equity methodology with CoE of 14.5%. We have used the two stage model with a twenty year time horizon and first ten years of explicit forecast and subsequent ten years of declining RoE to CoE. Mahindra Insurance Brokers is valued using the discounted free cash flow methodology with ten years of explicit forecast and subsequent ten years of declining growth rate to terminal growth rate. We have assumed a CoE of 14.5% and a

terminal growth rate of 4%.

Figure 21 DCF disclosures for Mahindra Finance


Figure 22 Mahindra rural housing finance DCF disclosure


Figure 23 Mahindra Insurance broking DCF disclosure


Risks to Fair Value

The company is exposed to the rural economy and any deterioration in the rural economy will have a negative impact on our estimates and fair value. Although the company has reduced its direct dependence on agriculture, it still has a substantial proportion of its loan book exposed to that sector. Hence, drought/excess rains will have impact on the financials of the company.

Cost of Equity 15%

Shares in Issue 562

Rs. Mn Rs./share

Free cash flow to equity NPV 128,319 229

Rs. Mn Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 Mar-20 Mar-21 Mar-22 Mar-23 Mar-24 Mar-25 Mar-26 Mar-27 Mar-28 Mar-29 Mar-30 Mar-31 Mar-32

Beginning book Value 28,851 43,300 50,517 60,024 71,664 85,995 103,502 124,807 150,697 182,116 220,436 262,580 310,207 363,431 422,224 486,390 555,537 629,069 706,166 785,790

Net Profit 7,913 9,783 12,655 15,873 19,553 23,894 29,097 35,373 42,956 51,554 59,358 67,080 74,964 82,808 90,373 97,391 103,566 108,588 112,145 113,939

Cost of Equity 4,183 6,279 7,325 8,704 10,391 12,469 15,008 18,097 21,851 26,407 31,963 38,074 44,980 52,697 61,223 70,526 80,553 91,215 102,394 113,939

ROAE 27% 23% 25% 26% 27% 28% 28% 28% 29% 28% 27% 26% 24% 23% 21% 20% 19% 17% 16% 15%

Excess Return 3,730 3,505 5,330 7,170 9,162 11,424 14,089 17,276 21,105 25,147 27,395 29,006 29,984 30,110 29,151 26,865 23,013 17,373 9,751 -

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1

Present Value 3,676 3,017 4,007 4,708 5,254 5,722 6,163 6,600 7,041 7,327 6,971 6,447 5,820 5,105 4,316 3,474 2,599 1,714 840 -

Mahindra Finance excess return on equity calculation

Cost of Equity 15%

Shares in Issue 562

Rs. Mn

Free cash flow to equity NPV 5,113


Beginning book Value 617 754 934 1,156 1,461 1,883 2,467 3,275 4,393 5,936 8,063 10,779 14,181 18,355 23,365 29,245 35,980 43,500 51,663 60,256

Net Profit 138 180 222 305 422 584 808 1,118 1,543 2,127 2,717 3,402 4,174 5,010 5,880 6,735 7,519 8,163 8,593 8,737

Cost of Equity 89 109 135 168 212 273 358 475 637 861 1,169 1,563 2,056 2,661 3,388 4,241 5,217 6,307 7,491 8,737

ROAE 22% 24% 24% 26% 29% 31% 33% 34% 35% 36% 34% 32% 29% 27% 25% 23% 21% 19% 17% 15%

Excess Return 48 70 86 138 210 311 451 643 906 1,266 1,548 1,839 2,117 2,349 2,492 2,495 2,302 1,856 1,102 -

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1

Present Value 47 61 65 90 120 156 197 246 302 369 394 409 411 398 369 323 260 183 95 -

Mahindra Rural Housing Finance return on equity calculation

Cost of Equity 15%

Shares in Issue 562

Rs. Mn



FCFE 169 209 260 323 402 482 577 662 760 874 994 1,120 1,250 1,382 1,512 1,639 1,758 1,866 1,961 2,040

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1

Present Value 166 179 194 209 227 236 246 245 245 245 242 237 230 221 211 198 185 171 156 141

Terminal Value 1,335

Mahindra Insurance Broking FCFE Model

Page 33

Page 12 of 14

Please visit our website at www.EspiritoSantoIB.co.uk for up to date recommendation charts.

Mahindra & Mahindra MMFS IN

Report date Recommendation Fair value Share price (INR)Recommendation history is not available

Source: Bloomberg, Espirito Santo Investment Bank Research

0

200

400

600

800

1000

1200

1400

Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13

Buy Trading Buy Neutral Trading Sell Sell Restricted Dropped Coverage

Page 34


COVERAGE INITIATION


Sundaram Finance

Consistent, Clear and Credible

A company with no equity dilution in the past eight years, consistent ROE of >15% and a share price CAGR of 30% is hard to ignore, and testament to strong management, a diversified liability base and superior asset quality. We initiate coverage on Sundaram Finance with a BUY and fair value of Rs660, 28% upside from current levels, as in our view this is one of the best managed companies in the sector. Its general insurance and housing finance segments are key drivers that could provide substantial upside from hereon.

Building business the Sundaram way

The last decade (2000-2010) has been a volatile one for financial sector firms, with most of them forced to raise capital from the market to bolster their balance sheets and fund growth. However, Sundaram has been the odd one out, growing at a steady pace without equity dilution. The stock has given shareholders a return of more than 30% (CAGR) over the past eight years and we think the stock has significant potential to continue on that path.

One of the best franchises: In our opinion this is one of the best franchises in

the lending space and during our primary data checks we were surprised by the respect Sundaram commanded from its peers. Three points that drive profits in new CV and cars finance are: a) relationship with dealers — Sundaram is amongst the most respected names with dealers in the Southern states; b) lower cost of funds — we estimate that the company has the lowest cost of funds amongst NBFCs and c) credit quality — Sundaram has one of the

lowest credit costs amongst NBFCs and even during the turbulent 2008-09 phase its credit costs were less than 0.75%.

Self-sustained business model: We think that Sundaram could be the only

franchise in the Indian BFSI space that has grown at a CAGR of c.20% over the past eight years and not raised capital. This has been possible mainly due to

the company’s ability to use capital very effectively and utilise securitisation transactions in an efficient way. The company’s strategy of controlled growth has also enabled it to maintain its cost of funds.

Other businesses offer significant upside: The company has one of the better

general insurance entities, which has of late been under stress given the macro

factors in the sector. However as we have discussed on page 11, we think that the sector is coming out of the trough and Sundaram should be a 15%+ ROE company in the next couple of years. Also the home finance venture has picked up significantly, generating more than 30% ROE and 30% growth rate. We expect this business to generate > 20% ROE in the longer term.

Valuation The company is trading at 1.9x and 9x our FY14E book value and earnings respectively, which is a 15%-30% discount to its peers (SHTF & MMFS). On consensus estimates, it trades at 2.1xand 11x FY14E book value and earnings. We think consensus has ignored the increased profitability of housing finance and general insurance and therefore we expect upgrades. We have valued the company on a SOTP basis with a fair value of Rs660, offering 28% upside from

current levels. At our fair value the company is valued at 2.4x FY14E book value and 12x FY14E earnings.

Accounting & corporate governance AMBER



BUY 28% upside

Fair Value Rs659.85

Bloomberg ticker SUF IN Share Price Rs514.00 Market Capitalisation Rs57,107.45m Free Float 35%


Total Revenue 24,382 30,406 36,954 45,253

Total expenses 18,830 24,097 29,397 35,880

PBT 5,552 6,309 7,557 9,373

PAT after MI 3,889 4,579 4,980 6,176

EPS 35 41 45 56

DPS 7 8 8 10

YY/E 31--MMar 22011A 22012A 22013E 22014E

P/E 14.7 12.5 11.5 9.2

P/BV 3.2 2.6 2.2 1.9

ROA 3% 3% 3% 3%

ROE 24% 23% 21% 22%

Dividend Yield 1% 2% 2% 2%


Data, Bloomberg

80

100

120

140

160

180

Apr 2012 Jul 2012 Oct 2012 Jan 2013

SUF IN vs BSE500 Index



Page 35

Page 2 of 15

Company snapshot Sundaram Finance is a leading asset finance company with more than five decades of experience in commercial vehicle and passenger car financing. The company also has interests in housing finance, asset management, general

insurance, IT-ITeS and financial product distribution. It was established in 1954 and has a very strong track record with more than 200,000 depositors and Rs200bn consolidated AUM.

Figure 1 Steady AUM growth of 19% CAGR Figure 2 Consolidated revenue breakup Figure 3 PAT has grown at a CAGR of 26%


Figure 4 Sundaram Finance subsidiaries


Key risks

Other than a slowdown in demand for commercial vehicles, Sundaram is exposed to these risks:

(i) Competition: The asset financing space is getting increasingly competitive with renewed focus from banks.

(ii) Slowdown in the macroeconomic environment: Commercial vehicle demand is directly related to economic activity and hence any prolonged slowdown in the macro-economic environment may pose risks on growth and credit quality.

SWOT analysis Strengths Weaknesses

� A strong brand name and trust among customers developed over decades of consistent service.

� A strong management team with vast experience in the financial services domain.

� Strong underwriting skills which have evolved over a period of 34 years of experience.

� Sustainable business model with sustainable RoEs exceeding growth rates.

� A diversified borrowing profile with a high proportion of low cost NCDs has resulted in lower cost of funds.

� Concentrated portfolio with high reliance on commercial vehicles in assets under management

� Geographic concentration with more focus on the four southern states.


� Favourable demography presents a huge opportunity for growth

� The commercial vehicles industry is going through a transition with high reliance on efficiency of vehicles. This should augur well for new commercial vehicle sales.

� There is a huge shortage of housing units in India, which means demand for housing will continue.

� Adverse regulatory changes may put NBFCs at a disadvantage to banks.

� Further deterioration/continued slowdown in the economic activity may have an adverse impact on the commercial vehicle industry.


-

20

40

60

80

100

120

140

160

180

2004 2005 2006 2007 2008 2009 2010 2011 2012

Su

nd

ara

m F

inan

ce

AU

M (

Rs.

bn

)

39%

49%

8%

4%

Sundaram Finance Royal Sundaram

Sundaram Housing Finance Sundaram AMC -

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2004 2005 2006 2007 2008 2009 2010 2011 2012

Su

nd

ara

m F

inan

ce

PA

T (

Rs.

mn

)

Sundaram Finance

Sundaram BNP Home Finance

(50.1%)

Royal Sundaram General Insurance

(49.9%)

Sundaram BNP AMC (100%)

Sundaram Business Services

Sundaram Finance Distribution

Limited

Sundaram Insurance broking Services Limited

LGF Services Sundaram Infotech Solutions Limited

Sundaram BNP Paribas Fund services Ltd.

Page 36

Page 3 of 15

The Sundaram way

Sundaram Finance has been one of the consistent performers over the past decade, growing its assets under management (AUM) at a CAGR of 19% without any dilution. We like the way the firm does business, with its risk-

averse and steady approach to building market share. Our view is that a medium term growth rate of 20% with a sustainable ROE of 20% is achievable.

Strong brand name in commercial vehicles As we have discussed in the thematic section of the note that the main drivers for growth in the new CV/car segment are the brand name and relationships

with dealers. Our primary data checks highlight Sundaram as the top brand name in the Southern states from where it derives most of its business.

Low cost of funds Given lower yields in the new vehicle segment, we believe lower costs hold the key to competing profitably with banks, the main competitors to Sundaram in

the segment. With a strong franchise Sundaram has been able to secure funding at the lowest rates compared to other NBFCs (see Figure 5). This is primarily on account of its ability to generate funds outside the banking system at a very low rate, a sign of investor confidence in the franchise. Moreover, the company has a diversified borrowing profile with a higher component of NCDs, which are raised at competitive rates. Also, its cost of borrowing has been lower due to two reasons: a) given the growth rate of AUM has been around 20%, the company’s requirement for additional funds

has not been extraordinarily high and hence it has been able to negotiate best rates and b) regular use of securitisation, which has lowered costs for the company. We expect the company’s strategy of growing both sides of its balance sheet at a reasonable pace will enable it to maintain cost of funds at competitive levels.

Figure 5 Cost of funds for leading NBFCs Figure 6 Diversified borrowing profile for Sundaram Finance


Credit costs under control This is another metric that highlights the quality of the franchise; the company has been able to keep its credit costs below 0.6% over the past six years, including the crisis years of 2008-09, demonstrating its underwriting

capabilities. The credit cost metric becomes all the more important when one considers that the company is in the business of financing new vehicles where the yields are less than 14%, leaving little margin for error. We do not see a material rise in credit costs for Sundaram in the near term given its underwriting quality; however, we have increased credit costs to 0.6% for FY13E, FY14E and FY15E on account of a change in provisioning guidelines.

7.7%8.2%

7.5%

11.9%

8.6%9.5%

8.8%

11.4%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

SUF MMFS BAF SHTF

Co

st o

f fu

nd

s

FY11 FY12

44%

39%

12%

5%

NCDs Bank Loans Fixed deposits CP

Page 37

Page 4 of 15

Figure 7 Gross NPA & credit cost Figure 8 AUM break-up: on balance sheet vs off-balance sheet


Figure 9 Sundaram Finance Standalone DuPont


General insurance can be a big delta This has been one of the worst performing sectors post de-tariffing in 2008, given

a) rates in the fire and engineering verticals were down as much as 90% in certain

cases; b) group mediclaims continued to bleed and c) third party motor losses

mounted every year, after the formation of the third party motor pool. As a result

of all this, losses in the sector increased substantially.

However the operating environment is improving Over the past six months, the operating environment in the general insurance

industry has significantly improved.

Public sector insurance companies under pressure to rein in the price war: PSU

insurance companies had considerable power given their huge investment

portfolio (see Table 1), which was offsetting underwriting losses that were

continuously deteriorating given the pricing war that started post de-regulation in

2008. However, now the central government has stepped in and asked insurance

companies to stop the pricing war. Our discussion with primary data contacts

suggest that the competition is coming off due to this and hence we can expect

more rational pricing going forward.

Dissolution of the third party motor pool: The third party motor pool was

dissolved by the Insurance Regulatory and Development Authority (IRDA) in 2012.

This was a pool formed by IRDA in 2008 wherein all the third party motor

premiums were contributed into the pool and claims were paid from the pool. The

losses were divided among insurance companies based on their market share; a

major flaw in this scheme was that the underwriting quality or claim settlement

efficiencies of individual firms were not taken into account. Initially, insurance

firms were reserving at 126% (still loss making); however, in 2011 IRDA

acknowledged, based on a review by actuaries, the gross under-reserving in this

portfolio and asked the insurance companies to provide for the rest of the losses

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

2.0%

2005 2006 2007 2008 2009 2010 2011 2012

Gross NPA Credit Cost

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120

2006 2007 2008 2009 2010 2011 2012

AU

M R

s. b

n

On-balance sheet Off-balance sheet

Sundaram Finance 2009 2010 2011 2012 2013E 2014E 2015E SustainableNII 5.3% 5.6% 5.7% 6.3% 6.7% 6.4% 6.3% 6.2%Other operating income 1.4% 1.8% 1.6% 1.5% 1.1% 1.0% 0.9% 0.9%Total income 6.7% 7.4% 7.3% 7.8% 7.8% 7.4% 7.3% 7.1%Origination cost 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3%Employee cost 1.3% 1.2% 1.1% 1.2% 1.3% 1.3% 1.3% 1.3%Operating expenses 1.0% 0.7% 1.0% 1.0% 0.9% 0.8% 0.8% 0.7%Credit cost 0.6% 1.0% 0.4% 0.3% 0.6% 0.5% 0.6% 0.6%Depreciation 0.5% 0.5% 0.5% 0.6% 0.5% 0.4% 0.3% 0.3%Pre-Tax RoA 3.0% 3.8% 4.0% 4.3% 4.2% 4.0% 4.0% 3.9%Post-Tax RoA 2.1% 2.6% 2.8% 3.0% 2.9% 2.8% 2.8% 2.6%RoE 13.7% 18.4% 20.7% 21.4% 20.7% 21.4% 21.5% 19.8%Leverage (x) 6.6 7.0 7.5 7.1 7.2 7.7 7.7 7.5

Page 38

Page 5 of 15

(at least at 153%). This portfolio was a continuous drain on the profitability of

insurance firms. At the dissolution of the pool, IRDA allowed an increase on third

party insurance premiums by 10% - 69% to take care of the losses and therefore

once these one-time losses are written off by the insurance companies over

current and next year, we would expect the loss ratio to reduce by up to 20% for

many general insurance companies over FY11-12.

Royal Sundaram is a quality company Royal Sundaram is amongst the top seven general insurance companies in terms

of gross written premium (GWP) and has registered a growth rate of 24% over

the past seven years. We see it as one of the top quality plays in the general

insurance space, given the underwriting standards. This is evident from the fact

that over the past eight years Sundaram is among a handful of firms that has been

continuously profitable. We expect the company to generate 20% a ROE (see

figure 10) on a sustainable basis as we expect the company’s combined ratio to

go down by at least 8-10 percentage points due to the dissolution of the third

party motor pool and a better rate environment (see du pont in Figure 10).

Figure 10 Du-pont of Royal Sundaram


Figure 11 Combined ratio Figure 12 Investment/NEP Figure 13 PAT for Royal Sundaram


Royal Sundaram GI 2009 2010 2011 2012 2013E 2014E 2015E SustainableClaims ratio 69% 71% 75% 78% 69% 68% 67% 70%Combined ratio 111% 108% 113% 112% 106% 105% 104% 105%Investment return 10% 10% 6.8% 7.3% 7.2% 7.2% 7.2% 7.5%Investment/NEP 1.3 1.3 1.6 1.7 1.8 1.8 1.9 2.0Investment return/NEP 13% 13% 11% 12% 13% 13% 14% 15%PBT/NEP 1.6% 4.7% -1.7% -0.1% 6.2% 8.2% 9.9% 10.0%PAT/NEP 0.9% 4.3% -2.3% 0.0% 4.1% 5.5% 6.6% 6.9%NEP/Assets 2.7 2.8 2.9 3.1 3.3 3.3 3.1 3.8 RoA/RoE 2.6% 12.2% -6.8% 0.1% 13.5% 17.9% 20.6% 26.3%

98

100

102

104

106

108

110

112

114

2005 2006 2007 2008 2009 2010 2011 2012

Co

mb

ine

d R

ati

o (

incl

TM

P)

-

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2005 2006 2007 2008 2009 2010 2011 2012

Inv

est

me

nts

/NE

P

-300

-200

-100

0

100

200

300

400

2005 2006 2007 2008 2009 2010 2011 2012PA

T (

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mn

)

Page 39

Page 6 of 15

Table 1 Past performance of general insurance companies

Source: Espirito Santo Investment Bank, IRDA

Claims Ratio 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) 84% 82% 85% 93% 86% 91% 92% 89% 97% 90%Reliance General 151% 93% 84% 65% 86% 84% 77% 85% 103% 109%IFFCO-Tokio 84% 79% 76% 79% 74% 82% 84% 81% 88% 93%ICICI Lombard 79% 93% 81% 81% 83% 81% 86% 89% 96% 101%Bajaj Allianz 74% 72% 70% 75% 73% 73% 74% 75% 81% 79%HDFC Ergo 107% 90% 70% 59% 55% 79% 82% 99% 90% 87%Cholamandalam 89% 94% 82% 80% 65% 71% 75% 77% 81% 79%Royal Sundaram 83% 73% 70% 70% 67% 72% 72% 73% 78% 81%TOTAL (Private) 82% 78% 73% 74% 75% 77% 79% 83% 88% 90%Expense Ratio 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) 31% 39% 38% 40% 33% 33% 35% 36% 37% 31%Reliance General -10% 23% 24% 24% 20% 36% 36% 31% 37% 36%IFFCO-Tokio 20% 21% 22% 24% 28% 27% 27% 28% 27% 24%ICICI Lombard 56% -7% 18% 24% 21% 24% 28% 25% 21% 20%Bajaj Allianz 28% 28% 22% 22% 26% 29% 31% 29% 30% 28%HDFC Ergo 140% 48% 42% 46% 52% 42% 45% 25% 25% 21%Cholamandalam 249% 51% 34% 36% 37% 34% 31% 34% 32% 30%Royal Sundaram 38% 34% 34% 33% 35% 36% 38% 35% 34% 30%TOTAL (Private) 35% 28% 27% 27% 27% 31% 34% 32% 31% 28%Underwriting Loss 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) -15% -21% -23% -33% -19% -24% -27% -25% -34% -21%Reliance General -41% -16% -8% 11% -6% -20% -14% -16% -40% -45%IFFCO-Tokio -5% -1% 2% -2% -2% -8% -11% -9% -15% -17%ICICI Lombard -34% 14% 1% -5% -4% -5% -15% -14% -16% -21%Bajaj Allianz -2% 0% 8% 3% 2% -2% -5% -4% -10% -7%HDFC Ergo -147% -38% -12% -5% -6% -20% -27% -24% -15% -8%Cholamandalam -238% -45% -16% -16% -1% -5% -6% -11% -12% -8%Royal Sundaram -22% -6% -4% -4% -1% -8% -10% -8% -11% -11%TOTAL (Private) -18% -6% 0% -2% -2% -8% -13% -14% -19% -18%Combined Ratio 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) 115% 121% 123% 133% 119% 124% 127% 125% 134% 121%Reliance General 141% 116% 108% 89% 106% 120% 114% 116% 140% 145%IFFCO-Tokio 105% 101% 98% 102% 102% 108% 111% 109% 115% 117%ICICI Lombard 134% 86% 99% 105% 104% 105% 115% 114% 116% 121%Bajaj Allianz 102% 100% 92% 97% 98% 102% 105% 104% 110% 107%HDFC Ergo 247% 138% 112% 105% 106% 120% 127% 124% 115% 108%Cholamandalam 338% 145% 116% 116% 101% 105% 106% 111% 112% 108%Royal Sundaram 122% 106% 104% 104% 101% 108% 110% 108% 111% 111%TOTAL (Private) 118% 106% 100% 102% 102% 108% 113% 114% 119% 118%Investment Income 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) 26% 37% 39% 48% 44% 45% 30% 35% 35% 27%Reliance General 122% 47% 23% 27% 6% 8% 10% 11% 15% 17%IFFCO-Tokio 18% 11% 8% 7% 10% 10% 12% 12% 11% 14%ICICI Lombard 33% 20% 16% 12% 9% 13% 17% 20% 13% 13%Bajaj Allianz 11% 11% 8% 7% 9% 11% 11% 12% 12% 13%HDFC Ergo 43% 14% 8% 9% 11% 9% 14% 8% 11% 12%Cholamandalam 169% 32% 12% 13% 10% 8% 9% 10% 9% 10%Royal Sundaram 17% 11% 7% 7% 8% 9% 11% 12% 10% 11%TOTAL (Private) 21% 14% 10% 9% 9% 10% 13% 13% 12% 12%Profit before tax 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) 9% 15% 16% 13% 25% 20% 4% 8% 0% 5%Reliance General 80% 30% 12% 38% 0% -12% -4% -6% -27% -29%IFFCO-Tokio 13% 11% 10% 5% 7% 2% 1% 4% -4% -3%ICICI Lombard 10% 33% 17% 7% 6% 7% 0% 7% -3% -10%Bajaj Allianz 9% 11% 16% 12% 11% 10% 7% 9% 3% 7%HDFC Ergo -97% -25% -6% 3% 2% -10% -13% -16% -5% -3%Cholamandalam -69% -13% -4% -3% 9% 3% 3% 0% -3% 2%Royal Sundaram -4% 5% 3% 3% 7% 1% 1% 5% -2% 0%TOTAL (Private) 3% 8% 10% 8% 7% 2% -1% 0% -7% -6%Investments/Capital 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) 346% 426% 422% 541% 434% 456% 322% 448% 502% 470%Reliance General 147% 137% 125% 144% 244% 216% 171% 165% 186% 170%IFFCO-Tokio 104% 128% 163% 130% 160% 179% 154% 172% 280% 276%ICICI Lombard 192% 147% 186% 243% 216% 221% 189% 225% 305% 325%Bajaj Allianz 204% 265% 325% 284% 322% 323% 326% 319% 396% 403%HDFC Ergo 94% 129% 148% 150% 143% 148% 136% 150% 207% 244%Cholamandalam 104% 120% 140% 152% 179% 226% 238% 205% 362% 385%Royal Sundaram 112% 159% 199% 262% 320% 316% 349% 357% 463% 507%TOTAL (Private) 136% 158% 196% 206% 230% 220% 193% 204% 241% 251%Investments/NEP 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012TOTAL (PSU) 242% 329% 341% 457% 409% 454% 290% 373% 337% 280%Reliance General 942% 527% 279% 395% 126% 98% 97% 116% 185% 228%IFFCO-Tokio 159% 106% 82% 76% 82% 74% 79% 82% 99% 104%ICICI Lombard 472% 256% 145% 124% 118% 133% 143% 163% 154% 147%Bajaj Allianz 124% 122% 122% 108% 125% 106% 109% 128% 143% 143%HDFC Ergo 1437% 174% 132% 130% 134% 132% 140% 106% 158% 162%Cholamandalam 2420% 353% 222% 219% 160% 103% 84% 111% 133% 127%Royal Sundaram 133% 132% 128% 123% 117% 105% 116% 120% 144% 147%TOTAL (Private) 221% 165% 132% 121% 119% 113% 117% 130% 152% 151%

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Page 7 of 15

Housing finance another valuation driver The company forayed into the housing finance segment in 1999 with focus on

lower and medium income groups in southern states, particularly Tier-II and Tier-

III centres. It offers housing loans to the lower and middle income (LMI) segment

with average ticket size of Rs1.3m and loans against property. It has grown its loan

book steadily to more than Rs40bn by the end of FY12 at a CAGR of 27% over

eight years. The growth rates have accelerated significantly in recent years, which

has increased its leverage and improved its RoE (see Figure 16). Moreover, the

company is able to maintain its credit costs and cost of funds which have led to a

significant increase in RoAs.

We expect Sundaram to maintain healthy loan book growth rates in excess of

20% over the next five years, as it is starting to increase its geographic presence

outside of the four southern states. It has 91 branches, of which 16 were opened

during H1FY13, including some in Maharashtra and MP. Also, we believe that this

will be a sustainable c.25% RoE company and hence believe it should command a

premium valuation. We have given detailed dupont analysis in Figure 20, where

we have reduced the NIM as well as other income of the company by c.50bps, as

we expect this to decline once the loan book starts increasing.

Figure 14 Robust loan book growth Figure 15 Credit costs under control Figure 16 RoAs and RoEs have improved


Figure 17 Yields and cost of funds Figure 18 Borrowing profile Figure 19 Opex/Avg. AUM


Figure 20 Dupont of Sundaram BNP HFC


-

5

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2004 2005 2006 2007 2008 2009 2010 2011 2012

AU

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)

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2005 2006 2007 2008 2009 2010 2011 2012

Cre

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et

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)

0.5% 0.6% 1.3% 1.6% 1.5% 1.3% 1.9% 2.7%

0%

5%

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2005 2006 2007 2008 2009 2010 2011 2012

Ro

As/

Ro

Es

RoA RoE

0%

2%

4%

6%

8%

10%

12%

14%

2005 2006 2007 2008 2009 2010 2011 2012

Yields on Loans Cost of funds

45.7%

17.0%

17%

14.3%

6.0%

NCDs Bank Loans NHB Fixed Deposits CPs0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2005 2006 2007 2008 2009 2010 2011 2012

Op

ex/A

vg

. A

UM

Sundaram BNP HFC 2009 2010 2011 2012 2013E 2014E 2015E SustainableNII 2.6% 2.0% 3.1% 3.9% 3.8% 3.7% 3.7% 3.7%Other operating income 1.0% 1.5% 1.4% 1.8% 1.4% 1.2% 1.1% 1.0%Total income 3.6% 3.5% 4.5% 5.6% 5.2% 4.9% 4.7% 4.7%Employee cost 0.5% 0.4% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%Operating expenses 0.7% 0.8% 0.8% 0.9% 0.8% 0.8% 0.7% 0.7%Credit cost 0.2% 0.2% 0.5% 0.4% 0.3% 0.3% 0.3% 0.3%Depreciation 0.0% 0.0% 0.1% 0.1% 0.1% 0.0% 0.0% 0.0%Pre-Tax RoA 2.3% 2.0% 2.7% 3.8% 3.4% 3.3% 3.1% 3.1%Post-Tax RoA 2% 1% 2% 3% 2% 2% 2% 2%RoE 14% 13% 20% 32% 32% 31% 29% 27%Leverage (x) 9.0 9.7 10.5 11.8 12.9 13.2 13.0 12.0

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Page 8 of 15

Sundaram Asset Management Company The company manages more than Rs142bn ($2.7bn) in assets, of which more than 40% is equity. Sundaram AMC is a 100% subsidiary of Sundaram Finance. The company has been able to control its AUM despite the tough environment given its brand in the Southern states. The company is profitable and generates yields of 8-10bps on AUM. We expect the yields to improve given a)

the regulator has introduced fungibility and passed on a service tax to unit holders; b) the regulator has increased the cap on fund management charges by 30bps if a minimum 30% of the inflows come from beyond the top 15 centres. The company should be able to get 30% of inflows from beyond the top 15 centres due to its focus on Tier-II and Tier-III cities.

We have valued the entity on DCF basis which turns out to be 4% of AUM which in our view is conservative, given the recent deals in the sector for

companies with more than 40% equity AUM have been at much higher valuations (see Figure 23).

Figure 21 AUM data for Sundaram and industry Figure 22 Equity AUM data for Sundaram and industry

Source: Ace MF, Espirito Santo Investment Bank Research Source: Ace MF, Espirito Santo Investment Bank Research

Figure 23 Deals in Mutual Funds space


115

120

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Jun-12 Sept-12 Dec-12 Jan-13

Su

nd

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s. b

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Industry Sundaram AMC

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1,750

1,800

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Jun-12 Sept-12 Dec-12 Jan-13

Su

nd

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M (

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Ind

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qu

ity A

UM

Rs.

Bn

Industry Sundaram AMC

Transaction DateAUM (Rs.

Bn)Debt: Equity

proportion in AUM Valuation as % of

AUMEton park bought 5% stake in Reliance AMC 7-Dec 773 56:44 12.90%

Valiant, Blue Ridge and Eaton Park bought stake in JM MF 8-Jul 111 62:38 7.30%

IDFC bought Standard Chart AMC 8-Mar 140 71:29 5.70%

T Rowe Price bought 26% stake in UTI AMC 9-Nov 768 72:28 3.30%

Nomura bought 35% stake in LIC AMC 8-Jul 324 96:04 2.50%

Religare bought Lotus AMC (distress sale) 8-Nov 55 90:10 1.80%

L&T bought DBS Cholamandlam AMC 9-Sep 29 92:08 1.60%

Nippon bought 26% in Reliance AMC 12-Jan 843 60:40 6.64%

L&T Finance bought Fidelity 12-Mar 88 32:68 6.20%

Page 42

Page 9 of 15

Key assumptions

Figure 24 Key assumption table


SOTP valuation Figure 25 Sum of the parts (Sundaram Finance)




Accounting &

governance

AMBER

The corporate governance and accounting policies of the company are one of the best

in the industry. Despite that, we have used an AMBER rating given disclosure low levels

in quarterly earnings and communication with markets. Company does not conduct any

earnings call post its results.

Franchise

strength GREEN

We have a GREEN rating on franchise strength due to its strong brand name,

relationships with dealers and branch network. The company is operating in the same

segment for last five decades and continued its focus even in the crisis periods.

Earnings

momentum GREEN

See charts below.


Sundaram Finance FY13E FY14E FY15E CommentsAUM 189,384 227,596 270,625 Expect to maintain growth rate around 20%YoY Growth 22% 20% 19%Disbursement 111,684 132,904 156,827 YoY Growth 20% 19% 18% Disbursement growth rate decline as size increaseNIMs 5.4% 5.3% 5.2% Expect the company to maintain NIMsNII 9,332 11,009 12,919 Total Income 10,891 12,780 14,856 Opex 3,599 4,174 4,817 Credit costs 690 834 996 Expect the company to maintain credit costsPAT 4,007 4,821 5,688

Sundaram BNP HFC FY13E FY14E FY15E CommentsAUM 59,261 77,781 98,538 Expect AUM growth to decline as size increasesYoY growth 40% 31% 27%Disbursement 26,298 31,558 37,869 Expect disbursement growth of 20% in FY14E & FY15EYoY growth 35% 20% 20%NII 1,829 2,372 2,983 NIMs 3.6% 3.5% 3.4%Total Income 2,481 3,140 3,870 Opex 641 824 1,023 Credit costs 152 206 264 PAT 1,194 1,498 1,837

Royal Sundaram GI FY13E FY14E FY15E CommentsNEP 13,692 16,666 19,963 Investments 24,213 30,179 37,818 Combined ratio 106 105 104 Combined ratio is expected to improve post removal of TP motor poolPAT 566 912 1,320

Sundaram AMC FY13E FY14E FY15E CommentsAvg. AUM 149,376 160,580 172,623 Expect a 5% growth rate in FY13, FY14 and FY15PAT 143 237 254 Assumed fund management charges and remained at 75 bps

ValuationSundaram

Finance StakeValue of

StakeValue per

share CommentsSundaram Finance 46,248 100% 46,248 416 2.5x FY14E book valueSundaram BNP Housing Finance 16,497 50% 8,265 74 3.0x FY14E book valueRoyal Sundaram General Insurance 25,662 50% 12,805 115 FCFESundaram BNP AMC 5,975 100% 5,975 54 4% of FY14E AUMTotal Valuation 73,293 660

Page 43

Page 10 of 15

Figure 26 Earnings Momentum Figure 27 Earnings Momentum


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Page 11 of 15

Source: Company data, Espirito Santo Investment Bank Research estimates



ROA 2.9% 3.0% 2.6% 2.6% 2.5%Share Price: INR 514 ROE 23.7% 23.1% 21.1% 22.1% 22.2%Upside / Downside 28% Dividend Yield 1.4% 1.5% 1.6% 1.9% 2.3%


P/BV 4.1 3.4 2.9 2.4 2.0Bloomberg: SUF INModel Published On: 25 February 2013

P&L Summary 2011 2012 2013E 2014E 2015E

Shares In Issue (mm) 111 Total Revenue 24,382 30,406 36,954 45,253 53,449 Market Cap ($mn / Rs bn) $1271 mn/Rs.57bn Finance costs 9,003 11,765 14,982 19,078 22,728 FII holding 4% Insurance claim incurred 3,294 4,319 4,719 5,621 6,633

Employee benefits 2,316 2,925 3,517 4,118 4,781 Adminstrative and other expenses 3,268 3,705 4,362 5,057 5,821 Provisions & Write-off 238 542 966 1,154 1,390 Depreciation 710 841 852 852 852 Total expenses 18,830 24,097 29,397 35,880 42,205 Profit before tax 5,552 6,309 7,557 9,373 11,244 Tax 1,859 2,023 2,424 3,006 3,606 Profit after tax 3,693 4,286 5,134 6,367 7,638

Espirito Santo Securities Analyst MI & profit from associates 196 293 (154) (191) (229) Santosh Singh, CFA PAT after MI 3,889 4,579 4,980 6,176 7,409 (91) 22 43156822 EPS 35 41 45 56 67 [email protected] DPS 7 8 8 10 12 Nidhesh Jain(91) 22 [email protected] Balance Sheet Summary 2011 2012 2013E 2014E 2015E

Net Worth 18,066 21,646 25,544 30,418 36,292 Shareholding Pattern Minority Interest 1,426 1,805 2,575 3,530 4,676

Borrowings 125,203 140,432 188,626 230,197 276,395Total Sources of funds 144,696 163,883 216,745 264,146 317,363

Fixed assets 4,572 5,110 5,110 5,110 5,110 Non current investments 9,098 9,946 9,946 9,946 9,946 Deferred Tax Assets 468 638 638 638 638 Other non current assets 92 90 90 90 90 Loans & Advances 124,811 151,505 196,997 241,953 292,491 Net working Capital 5,656 (3,406) 3,965 6,409 9,088 Total Application of funds 144,696 163,883 216,745 264,146 317,363

BVPS 163 195 230 274 327

DuPont (Sundaram Finance) 2011 2012 2013E 2014E 2015E

Loan Book Growth NII 5.7% 6.3% 6.7% 6.4% 6.3%Other income 1.6% 1.5% 1.1% 1.0% 0.9%Total Income 7.3% 7.8% 7.8% 7.4% 7.3%Origination cost 0.3% 0.3% 0.3% 0.3% 0.3%Employee cost 1.1% 1.2% 1.3% 1.3% 1.3%Admin Cost 1.5% 1.6% 1.4% 1.2% 1.1%Credit Cost 0.4% 0.3% 0.6% 0.5% 0.6%PBT 4.0% 4.3% 4.2% 4.0% 4.0%PAT 2.8% 3.0% 2.9% 2.8% 2.8%RoE 20.7% 21.4% 20.7% 21.4% 21.5%Leverage (x) 7.5 7.1 7.2 7.7 7.7

DuPont (Sundaram Finance) 2011 2012 2013E 2014E 2015E

NII 3.1% 3.9% 3.8% 3.7% 3.7%Fee & other income 1.4% 1.8% 1.4% 1.2% 1.1%

Margin Trends Operating cost 1.3% 1.4% 1.4% 1.3% 1.3%Credit cost 0.5% 0.4% 0.3% 0.3% 0.3%PBT 2.7% 3.8% 3.4% 3.3% 3.1%PAT 1.9% 2.7% 2.5% 2.3% 2.3%RoEs 20% 32% 32% 31% 29%Leverage(x) 10.5 11.8 12.9 13.2 13.0

Key Ratios (Royal Sundaram) 2011 2012 2013E 2014E 2015E

Combined Ratio 113% 112% 106% 105% 104%Investments/NEP 1.6 1.7 1.8 1.8 1.9RoE -7% 0% 15% 20% 23%

Sundaram Finance

Promoter38%

FII4%

DII10%

Others48%

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Page 12 of 15


We have valued Sundaram Finance and Sundaram BNP HFC on excess return on equity methodology with CoE of 14.5%. We have used the two stage model with a twenty-year time horizon, with the first ten years of explicit forecast and subsequent ten years of declining RoE to CoE. Sundaram BNP HFC is valued on DCF methodology with a two stage model of twenty year time horizon. We have used a CoE of 14.5% and long-term growth rate of 4%. The asset management entity is also valued on a two stage twenty years DCF

methodology. We have used CoE of 14.5% and long-term growth rate of 5%.

Figure 28 Sundaram Finance DCF disclosure


Figure 29 Sundaram BNP Housing Finance DCF disclosure


Figure 30 Royal Sundaram DCF disclosure


Cost of Equity 15%

Shares in Issue 111

Rs. Mn Rs./share




Net Profit 4,007 4,821 5,688 6,927 8,339 9,826 11,359 13,210 15,318 17,913 20,303 22,817 25,417 28,060 30,690 33,245 35,653 37,836 39,714 41,204

Cost of Equity 1,918 2,342 2,852 3,454 4,188 5,070 6,110 7,313 8,711 10,332 12,229 14,378 16,793 19,483 22,453 25,702 29,221 32,995 37,000 41,204

ROAE 30% 30% 29% 29% 29% 28% 27% 26% 25% 25% 24% 23% 22% 21% 20% 19% 18% 17% 16% 15%

Excess Return 2,089 2,479 2,835 3,473 4,152 4,756 5,249 5,897 6,607 7,581 8,075 8,439 8,624 8,577 8,237 7,543 6,432 4,842 2,715 -

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1

Present Value 2,059 2,134 2,132 2,280 2,381 2,382 2,296 2,253 2,204 2,209 2,055 1,876 1,674 1,454 1,220 975 726 478 234 -

Sundaram Finance excess return on equity calculation

Cost of Equity 15%

Shares in Issue 111

Rs. Mn




Net Profit 1,194 1,498 1,837 2,294 2,865 3,549 4,284 5,034 6,060 7,236 8,433 9,534 10,677 11,841 13,002 14,128 15,186 16,139 16,947 17,572

Cost of Equity 473 611 796 1,030 1,323 1,689 2,141 2,688 3,330 4,077 4,969 5,886 6,923 8,084 9,372 10,786 12,322 13,974 15,729 17,572

ROAE 37% 36% 33% 32% 31% 30% 29% 27% 26% 26% 25% 23% 22% 21% 20% 19% 18% 17% 16% 15%

Excess Return 721 887 1,042 1,264 1,542 1,861 2,143 2,346 2,730 3,158 3,464 3,648 3,754 3,757 3,630 3,342 2,864 2,165 1,218 -

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1

Present Value 711 764 783 830 884 932 937 896 911 920 882 811 729 637 537 432 323 214 105 -

Sundaram BNP Housing Finance return on equity calculation

Cost of Equity 15%

Terminal growth rate 4%

Shares in Issue 111

Rs. Mn


Rs. Mn Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 Mar-20 Mar-21 Mar-22

FCFE 566 912 1,320 1,654 2,027 2,486 2,859 3,015 4,139 5,051

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3

Present Value 558 785 993 1,086 1,162 1,245 1,251 1,152 1,381 1,472

Terminal Value 14,578

Royal Sundaram FCFE Model

Page 46

Page 13 of 15

Risks to Fair Value

Other than a slowdown in demand for commercial vehicles, Sundaram is exposed to these risks:

(i) Competition: Asset financing space is getting increasingly competitive with renewed focus from banks.

(ii) Slowdown in macro-economic environment: Commercial vehicle demand is directly related to the economic activity and hence any prolonged slowdown in the macro-economic environment may pose risks on growth and credit quality.


Sundaram Finance SUF IN



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Page 47


COVERAGE INITIATION


Bajaj Finance

Innovations driving growth

With its innovative business model and strong franchise, we initiate coverage on Bajaj Finance with a BUY and a valuation pointing to 12% upside. The stock has done well and has risen >80% since 1 January 2012, mainly due to a more than 100% increase in profitability on a YoY basis. We expect the loan book to grow in excess of 20% for the next 3-4 years. Although we expect the credit costs to increase by 50bps and the NIM to decline by 30bps for the foreseeable future, we still expect sustainable RoEs of 20%.

Growth momentum to continue Bajaj Finance has grown its loan book at a 73% CAGR and profit at a 129% CAGR over the past four years. We expect this momentum to continue in the near term given:

Niche existing businesses: The company has created a niche for itself in

consumer finance and two wheeler financing. In consumer finance, we think it has built a competitive advantage through its network of relationships with manufacturers and stores. In two wheeler finance, by virtue of being a captive finance unit of Bajaj Auto, it again enjoys a competitive advantage over rivals. We expect the loan against property (LAP) portfolio to grow in excess of 20%

on a YoY basis.

New business segments to aid growth: The company has entered the lifestyle

financing and salaried home loans segment which should further help growth plans as it expects to disburse around Rs6bn in FY14 in salaried home loans. The company is planning for lifestyle financing loans to account for around

50% of its consumer durables loans in the next 3-4 years.

Credit cost to remain under control: The biggest concern for investors has

been the future sustainability of the current low credit costs. We don’t think the current credit costs are sustainable and expect around a 50bps increase in on a sustainable basis. However, we do not see a repeat of 2008-10 given a) diversification of loan book, with earlier risky two wheeler loans declining from

60% in 2007 to c. 20% in 2012-13 and b) strengthened credit process; over the past four years there has been significant improvement structurally given the expansion of CIBIL and the significant improvement in the company’s credit appraisal process.

Banking licence: In our opinion BAF IN is a strong contender for a banking

licence, given its size, good corporate governance and deep pockets. However, we are cautious on the company’s ability to leverage the banking licence, given first Bajaj Finance is an urban brand with the majority of its branches in Tier 1 and Tier 2 cities and second, in issuing a banking licence, the RBI principally wants the new banks to open 25% of branches in tier 5 to 6 centres, in accordance with the draft guidelines.

Valuation The company is trading at 1.6x FY14E book value, a 20-35% discount to other listed NBFCs (though there is no direct listed comparable). We have valued the company at Rs.1406, 12% upside from current levels. At our value, the implied valuation will be 1.8x FY14E book value, which we believe is justified

given c.20% sustainable RoEs and comfort on reduced volatility in earnings from its historical levels (though we expect the earnings to be more volatile than other retail-focused NBFCs).




BUY 12% upside

Fair Value Rs1,405.55

Bloomberg ticker BAF IN Share Price Rs1,258.00 Market Capitalisation Rs62,131.00m Free Float 35%


Net Interest Income 9,128 12,501 18,482 23,445

Total Income 10,351 14,257 20,609 26,193

Operating expenses 4,510 6,574 9,463 11,584

Profit before tax 3,699 6,022 8,493 10,369

Profit after tax 2,470 4,064 5,690 6,948

EPS 67 98 115 141

YY/E 31--MMar 22011A 22012A 22013E 22014E

P/E 18.6 12.8 10.9 8.9

P/BV 3.4 2.6 1.9 1.6

ROA 4.0% 4.0% 3.9% 3.7%

ROE 19.7% 24.0% 21.2% 19.1%

Dividend Yield 0.8% 1.0% 1.1% 1.3%


Data, Bloomberg

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Apr 2012 Jul 2012 Oct 2012 Jan 2013

BAF IN vs BSE500 Index



Page 48

Page 2 of 12

Company snapshot

Bajaj Finance started as a captive NBFC for financing two and three wheelers for Bajaj Auto. It was among the first to enter the consumer durables segment in 1999 when the segment was non-existent. It now has a fairly diversified loan

book with exposure to two/three wheelers, consumer durables, mortgages, Infrastructure, construction equipment, business loans and personal loans. The company recently forayed into lifestyle financing (i.e. furniture, kitchen equipment’s etc), which is again a new segment for the Indian financial industry.

The company has witnessed strong growth during the past four years, post the debacle of 2008, and it has made sweeping changes in the business with the result that AUM have grown at a CAGR of 73% and PAT at a CAGR of

129%. In the past four years, the company has re-invented itself by improving processes, implementing new technologies and diversifying away from risky segments such as two and three wheeler financing. The company is now a significant player in consumer durables (market share of 14% in consumer electronic sales) and two wheelers (market share of more than 80% in Bajaj Auto).

Figure 1 AUM growth Figure 2 PAT growth Figure 3 Portfolio breakup FY12


SWOT analysis

Strengths Weaknesses

� Strong brand name and trust among the customers due to its parent. The parent is a well-known brand in India.

� Strong management team with vast experience in the financial services domain.

� Over two decades of experience in this segment and has developed strong processes that enable low turnaround time.

� Diversified loan book reduces dependence on single product line for growth.

� Substantial proportion of its loan book is in the high risk segment where adequate collateral is not available. This led to substantial increase in non-performing assets during the financial crisis of 2008.

� The company depends on dealers for origination of consumer durable loans and two/three wheeler loans.


� Favourable demography presents huge opportunity for growth.

� Consumption remains fairly buoyant despite slowdown in the broad economy. We expect fundamentals to remain robust for consumption in India.

� One of the front runners for the new banking license.

� The company can replicate its success with other auto manufacturers.

� Consumer durable financing is getting competitive with private sector banks eyeing this space and rolling out attractive offerings.

� The company is entering the Housing Finance segment, which is highly competitive and may put pressure on margins.

� The company is also exposed to the Infrastructure segment, where near-term challenges are likely.


-

20

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2006 2007 2008 2009 2010 2011 2012

AU

M (

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2006 2007 2008 2009 2010 2011 2012

PA

T (

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Mn

)

22%

10%

6%

2%8%

29%

4%

8%

6%5%

Two & Three Wheelers

Consumer Durables

Personal Loan Cross Sell

Salaried Loans

Business Loans

Mortgage

Loans against Securities

Contruction EquipmentFinanceInfrastructure Finance

Vendor Financing

Page 49

Page 3 of 12

Bajaj Finance has been a top performer in the last two years

The stock has been one of the top performers in the BSE 200 in the past two years, registered earnings growth over the period on the back of declining NPLs (see Figures 4 & 6) and increasing loan book (see Figure 1). This was helped by diversification in the portfolio (see Figure 7) and improvement in

credit quality.

Figure 4 Gross NPA Figure 5 Credit Cost Figure 6 EPS


However the key questions are: 1) is this growth sustainable, and 2) will it sustain credit quality?

Will credit quality hold?

The stock’s excellent performance in the past two years was in large part due to the significant improvement in credit quality. However, given most of the business done by Bajaj Finance is unsecured in nature, many investors are still concerned if the credit quality will hold if the economy encounters more

stress. Although we don’t think that the current level of credit cost is sustainable and we expect it to rise by around 50bps, we do not see a repeat of 2008-10 for these reasons.

Significant diversification in portfolio: Before 2010, Bajaj Finance’s loan book

primarily was loaded with two and three wheeler financing (more than 50% of

loan book), which by nature is risky, given the credit quality of the customer base is not that good and the value of the asset post repossession is significantly lower. However, over the past three years the company has diversified its loan book and now the two and three wheeler vertical accounts for c.20% of the total value, clearly visible from Figure 7. For most of the segments there has been no deterioration in credit quality post the diversification in 2010.

Figure 7 Portfolio composition of Bajaj FInance


0%

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Mortgage & othersecured

SME loans &personal loans

Consumer Durables

Two & ThreeWheelers

Page 50

Page 4 of 12

Strengthened credit appraisals: Given the nature of its business, credit

appraisal is very important for Bajaj Finance, as collaterals in most of the lines lose their market value very fast. The company has over the years extensively reviewed its business model and taken a number of steps, such as cutting down the total number of branches to 51 including attached locations; in 2008-09 it had around 120 branches and 60 attached locations. Also,

availability of data has improved significantly over the past four years with CIBIL data increasing multifold.

Figure 8 Number of trades on CIBIL Figure 9 Distribution of CIBIL accounts as per cities


In order to understand the credit process we have done extensive analysis and have visited various stores across regions.

Figure 10 Findings from our consumer durables visit


Figure 11 Credit quality of Consumer durables loans

Figure 12 Credit quality of personal loans cross sell

Figure 13 Credit quality of salaried personal loans


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CAT A cities CAT B cities CAT C cities

StoreFinancing options

availableCompetition Products available Underwriting process

Single brand format

Bajaj Finance

Only Bajaj Finserv Lending finance option was available. However, the dealer was offering me discount of about 5%-6% if I pay lumpsum. Also, he discouraged me to go for loan by saying that processing fee is Rs. 1,000. There was no Bajaj's employee in the store.

Product with 30% downpayment was avaialble

Same as above except the processing time is higher.

Large store format -1

Large store format -2

Same as above Same as above

Similar products as above, 0% downpayment option

also available for SAMSUNG LED TV

Documents required are credit card, Pan Card, cancelled cheque and adress proof. In case the customer has platinum credit card, the approval is instant with out any income proof. No questions asked on current loans/sources of income/customer profile etc. Approval in 10 mins.

Bajaj Finance, Citibank,

ICICI Bank, HDFC Bank

Bajaj Finance, Citibank,

ICICI Bank, HDFC Bank

On enquiry, sales person instantly referred to Bajaj Finserve Lending. There is a Bajaj's employee in the store. The schemes for Citibank, ICICI and HDFC are all credit card related with high process ing fees in upwards of Rs. 500. Bajaj's processing fee was Rs. 200. There was no discount on SAMSUNG and SONY even if lump sum payment is done.

30% downpayment + 8 EMIs; 5% downpayment + 9 EMIs

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Page 51

Page 5 of 12

As a result of all these efforts post actions taken in 2010, we have not seen any deterioration in most of the segments as is visible above, with the consumer segment showing almost negligible delinquencies in the 3rd to 5th bucket.

Growth is a function of innovation

Bajaj Finance’s AUM has been growing at more than 73% CAGR over the past

four years, with a majority of growth coming from LAP, personal and SME loans. Also, the company has been able to maintain its predominant position in the consumer durable segment. We think the company will be able to deliver c.20% AUM growth from here on with more than 25% growth in FY14E and FY15E given:

Strong fundamentals for consumer durable financing: We expect the

consumer durable financing growth to remain strong given the a) increase in share of sales through organised retail; b) the shortening life cycle of consumer electronics; c) favourable demographics; d) increasing disposable income and e) increasing availability of consumers’ credit behaviour data. Also, the company is the financier of choice for storeowners, which was evident during our visit to various stores (please see Figure 10). Despite various finance options available the large format store was pushing for Bajaj Finance, given that an employee of Bajaj Finance was always present to

explain the details and help customers (plus Bajaj Finance charges one of the lowest upfront fees). Also, in the consumer durables space manufacturers play an important role and Bajaj Finance has a very strong relationship with manufacturers, thanks to Bajaj Finance not pulling out from the market even during the financial crisis. The manufacturer pays c.80% of the subvention to Bajaj Finance and so in consumer durables financing the relationship with the manufacturer is more important than that with dealers.

Figure 14 Distribution of consumer durable financed for Industry Figure 15 Bajaj Finance entering lifestyle financing

Source: Crisil, Espirito Santo Research Source: Espirito Santo Investment Bank Research, Company Data

Moving into new business segments: The company has started to move into

new business segments of lifestyle financing, including furniture and high-end watches. This is innovative given we have not seen this from the organised players in India. This is an untapped market and we understand as of now

Bajaj Finance is only trying to tap the upper segment of this market and is only tying up with top-end brands in large retail formats. This could become an important medium term driver. The company expects this segment to have around 50% of the consumer durable segment. We are not expecting any significant deterioration in credit quality given the company is going to use a similar credit appraisal process as it has used for consumer durables.

Increase in secured businesses

Over the years the company has increased its secured loan business and entered the mortgage segment. Currently, its mortgage loan book is mainly loan against property (LAP). We expect this book to do well given the company’s foray into salaried home finance and its self-employed loan book is

46%

17%5%

20%

12%

Panel TV Refrigerator Washing Machine

Air-conditioner Others

Page 52

Page 6 of 12

gaining traction. The company has created a niche in these market segments with focus on just the top end as is visible from Figure 16. We expect this line of business to grow in excess of 20% over the next 3-4 years. Although we think that his would mean that the NIM for the company may decline by c.25-50bps on a blended basis, we also think that the defensiveness of the loan book will increase.

Figure 16 Portfolio details for Bajaj Finance


Sustainable RoEs should trend above 20%

We expect the company to generate sustainable RoA of 3.5% (FY12: 4%) and

RoE of c.21% (FY12: 24%) by 2014E. We expect the NIM to decline to 12% on account of change in loan portfolio mix (increasing proportion of LAP and housing) and the credit cost to increase to 2.2% (1.5% in FY12), as we believe that the current credit quality in consumer durable and personal loans is not sustainable, although the portfolio is getting more secured.

Figure 17 DuPont for Bajaj Finance


Product Ticket Size IRR Approval Rate LTV Comments

Personal Loans 70K-80K 25% to 26% 60% NA Predominantly to existing clients

Salaried Loans 800K 15%-16% 60%-65% NAHigh salary employees with salary upwards of 9-10lakh, both to existing as well as new customers

Small Business Loans 1500K-2000K 18%-20% NATotal underwriting, origination through DSAs, Referrals (CAs/Advocates), Own sales force. DSAs are the largest contributor

LAP 25mn 12.75%-13.00% 50%-55% SME lending and Corporate LRD

Housing 17.5mn 11.25%-11.50% 65%-80%Housing loan to self employed people (1.75 crore) and salaried (1.25 crore).

Loan against securities 12% 40%-45%Only promoter/retail funding. No broker funding, 430 crore book size. Portfolio is divided into three categories, A (60% LTV), B (50% LTV) and C (40% LTV)

Consumer Durable 23K-25K 23%-24% 67%60% salaries, 40% self employed. LCD/LED form 50%-55% of overall sales, 30% od LEDs sold are financed, 85% of interest comes from manufacturers

Two wheelers 35K 24% 75%50% CIBIL hit rate, 40% of collections through DCC mode, 80%-85% market share in Bajaj Auto which is stagnant for last four years, 35%-37% of Bajaj Auto domestic sales are financed

2010 2011 2012 2013E 2014E 2015E SustainableNet Interest Income 17.2% 14.7% 12.3% 12.7% 12.4% 12.5% 12.0%Fee income and others 3.0% 2.0% 1.7% 1.5% 1.5% 1.3% 1.30%Total Income 20.2% 16.6% 14.0% 14.2% 13.9% 13.8% 13.3%Employee expenses 2.8% 2.3% 1.9% 1.8% 1.7% 1.7% 1.7%Operating expenses 6.0% 4.9% 4.6% 4.7% 4.4% 4.2% 4.2%Credit cost 7.4% 3.3% 1.5% 1.7% 2.2% 2.2% 2.2%Pre-Tax RoA 4.0% 6.1% 6.0% 5.9% 5.6% 5.7% 5.2%Post-Tax RoA 2.5% 4.0% 4.0% 3.9% 3.7% 3.8% 3.5%RoE 8.0% 19.7% 24.0% 21.2% 19.1% 20.8% 20.8%Leverage (x) 3.2 5.0 6.0 5.4 5.2 5.5 6

Page 53

Page 7 of 12

Figure 18 Assumption table


ESIB versus consensus

Our revenue and PAT estimates are higher than consensus for FY13 and FY14 by c.7% and c.1%; however, the EPS estimates for FY13 are lower than consensus given the capital raising, which is not factored in by consensus. We are also ahead of consensus on BVPS by 7% in FY13E and c.2% in FY14E and FY15E.

Figure 19 ESIB versus consensus


Valuation

The company is trading at 1.6x FY14E book value, a 20%-35% discount to other listed NBFCs (though no direct listed comparable). We have valued the company at Rs1406, 12% upside from current levels. At our value, the implied valuation will be 1.8x FY14E book value, which we believe is justified given

c.20% sustainable RoE and our comfort on reduced volatility in earnings from its historical levels (though we expect the earnings to be more volatile than other retail-focused NBFCs).



Accounting &

governance

GREEN The corporate governance and accounting policies of the company are one of the best

in the industry. We have a GREEN rating on Accounting and governance of the

company.

Franchise

strength GREEN

We have a GREEN rating on franchise strength due to its strong brand name,

relationships with dealers, branch network, strong parent brand name and processes.

Earnings

momentum GREEN

See charts below.


Bajaj Finance FY13E FY14E FY15E CommentsLoan book 168,343 211,469 262,833 Expect the company to grow at c.30%YoY Growth 37% 26% 24%

Net Interest Income 18,482 23,445 29,449 We expect the NIMs to compress as secured portfolio and housing loans increases

NIMs 12.7% 12.3% 12.4%Total income 20,609 26,193 32,621 Operating expenses 9,463 11,584 13,992

Credit cost 2,535 4,122 5,128

We expect the credit costs to increase from current levels.

PAT 5,690 6,948 8,967 EPS 115.2 140.7 181.5 Gross NPA 2,525 3,172 3,943 Gross NPA (%) 1.5% 1.5% 1.5% Gross NPA to increase to 1.5%

FY13E FY14E FY15E FY13E FY14E FY15E FY13E FY14E FY15E

Sales 19,322 24,996 31,054 20,609 26,193 32,621 6.7% 4.8% 5.0%

PAT 5,645 7,111 8,959 5,690 6,948 8,967 0.8% -2.3% 0.1%

EPS 123 146 177 115 141 182 -6.6% -4.0% 2.4%

BVPS 630 776 930 674 795 952 7.1% 2.5% 2.3%

DPS 14.7 17.1 20.5 13.8 16.9 21.8 -5.9% -1.4% 6.5%

Consensus ESIB Estimates % difference

Page 54

Page 8 of 12

Figure 20 Earnings Momentum Figure 21 Earnings Momentum


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Page 9 of 12

Source: Company Data, Espirito Santo Investment Bank Research estimates



ROA 4.0% 4.0% 3.9% 3.7% 3.8%Share Price: INR 1258 ROE 19.7% 24.0% 21.2% 19.1% 20.8%Upside / Downside 12% Dividend Yield 0.8% 1.0% 1.1% 1.3% 1.7%


P/BV 3.8 2.9 2.1 1.8 1.5Bloomberg: BAF INModel Published On: 25 February 2013

P&L Summary 2011 2012 2013E 2014E 2015E

Shares In Issue (mm) 49 Income from Financing 12,838 19,963 29,117 37,032 46,245 Market Cap ($mn / Rs bn) $1383 mn/Rs.62bn Interest expense 3,710 7,462 10,636 13,586 16,796 FII holding 35% Net Interest Income 9,128 12,501 18,482 23,445 29,449

Fee Income and others 1,223 1,757 2,127 2,748 3,172 Total Income 10,351 14,257 20,609 26,193 32,621 Employee expenses 1,447 1,904 2,621 3,228 4,032 Other expenses 3,063 4,670 6,843 8,356 9,960 Credit Cost 2,046 1,544 2,535 4,122 5,128 Depreciation 96 118 118 118 118 Profit before tax 3,699 6,022 8,493 10,369 13,383 Taxation 1,229 1,958 2,803 3,422 4,416

Espirito Santo Securities Analyst Profit after tax 2,470 4,064 5,690 6,948 8,967 Santosh Singh, CFA EPS 67 98 115 141 182 (91) 22 43156822 DPS 10 12 14 17 22 [email protected] Jain(91) 22 43156823 Balance Sheet Summary 2011 2012 2013E 2014E [email protected]

Net Worth 13,581 20,336 33,308 39,287 47,003 Borrowings 67,086 102,264 134,081 171,229 214,877

Shareholding Pattern Total Sources of funds 80,667 122,600 167,389 210,515 261,879

Fixed assets 1,026 1,389 1,389 1,389 1,389 Non current investments 4,453 55 55 55 55 Deferred Tax Assets 649 692 692 692 692 Loans & Advances 72,700 123,554 168,343 211,469 262,833 Net working Capital 1,838 (3,090) (3,090) (3,090) (3,090) Total Application of funds 80,666 122,600 167,389 210,515 261,879

BVPS 371 477 674 795 952

DuPont (Bajaj Finance) 2011 2012 2013E 2014E 2015E

NII 14.7% 12.3% 12.7% 12.4% 12.5%Other income 2.0% 1.7% 1.5% 1.5% 1.3%Total Income 16.6% 14.0% 14.2% 13.9% 13.8%

Loan Book Growth Employee cost 2.3% 1.9% 1.8% 1.7% 1.7%Admin Cost 4.9% 4.6% 4.7% 4.4% 4.2%Credit Cost 3.3% 1.5% 1.7% 2.2% 2.2%PBT 5.9% 5.9% 5.9% 5.5% 5.7%PAT 4.0% 4.0% 3.9% 3.7% 3.8%RoE 19.7% 24.0% 21.2% 19.1% 20.8%Leverage (x) 5.0 6.0 5.4 5.2 5.5

Key Ratios 2011 2012 2013E 2014E 2015E

Yields 22.7% 20.4% 20.0% 19.5% 19.5%Cost of funds 7.5% 8.8% 9.0% 8.9% 8.7%NIMs 16% 13% 13% 12% 12%Cost to income 43.6% 46.1% 45.9% 44.2% 42.9%Credit cost 3.6% 1.6% 1.7% 2.2% 2.2%Opex/AUM 8.0% 6.7% 6.5% 6.1% 5.9%

Margin Trends Gross NPA 3.0% 1.2% 1.5% 1.5% 1.5%

Capital Adequacy Ratios 2011 2012 2013E 2014E 2015E

CAR 20% 18% 20% 19% 19%Tier-I 17% 15% 18% 17% 16%Tier-II 3% 2% 2% 2% 2%

Bajaj Finance

Promoter62%

FII6%

DII13%

Others19%

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We have valued the company using excess return to equity methodology with a CoE of 14.5%. We have used a two stage model with twenty year time horizon with first ten years of explicit forecast and subsequent ten years of declining RoEs to CoE.

Figure 22 DCF disclosure


Risks to Fair Value

Any increase in competitive intensity in the consumer durables financing space with captive NBFCs like Tata Capital becoming aggressive will be a negative for the company. Moreover, the company is entering the highly competitive segment of salaried housing loans, where the spectre of low margins looms ahead.

Any further deterioration in Infrastructure or construction equipment segment will have a negative impact on the company; however, the company is going

slow on these segments.

A substantial proportion of the company’s loan book is unsecured and has an urban focus, where we are seeing a slowdown in consumption. The consumption slowdown is a negative for the company.


Cost of Equity 15%

Shares in Issue 49

Rs. Mn Rs./share

Free cash flow to equity NPV 69,419 1,406



Net Profit 5,690 6,948 8,967 11,841 14,608 17,413 20,526 21,136 24,344 27,970 31,855 36,113 40,750 45,764 51,149 56,889 62,960 69,329 75,952 82,773

Cost of Equity 2,949 4,830 5,697 6,815 8,293 10,116 12,288 14,849 17,487 20,524 24,014 27,990 32,498 37,584 43,296 49,680 56,781 64,639 73,293 82,773

ROAE 28% 21% 23% 25% 26% 25% 24% 21% 20% 20% 19% 19% 18% 18% 17% 17% 16% 16% 15% 15%

Excess Return 2,741 2,118 3,270 5,026 6,315 7,297 8,237 6,286 6,857 7,445 7,840 8,123 8,252 8,180 7,853 7,209 6,179 4,690 2,659 -

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1

Present Value 2,741 1,850 2,494 3,348 3,674 3,708 3,656 2,436 2,321 2,201 2,024 1,832 1,625 1,407 1,180 946 708 469 232 -

Bajaj Finance Limited

Bajaj Finance BAF IN



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MARKET UPDATE


Shriram Transport Finance

Steady as a rock but upside priced in

Shriram Transport is a top quality NBFC in the used CV financing business and we’ve been long-term buyers of the stock given our perception of a wide moat around the business, sustaining its position despite sporadic attempts of others to take market share. But the stock has run up 77% since its low in January 2012 and we think there now is limited upside. Whilst our FV increases to Rs773 from Rs681 as we rollover our base to FY14E, given the slowdown in the CV segment and the recent run, we now see limited upside and so change our stance from Buy to NEUTRAL.

Strong performance in tough environment We like Shriram’s franchise, with its unparalleled understanding of the used-trucks financing business. Shriram’s robust loan growth and stable credit quality in a tough macroeconomic environment exemplifies the strength of its business model. Management again demonstrated its ability to manage risk, turning cautious in Q2FY12 and reducing LTVs, when competitors were

rubbishing all theories of a slowdown. The company’s Q3 numbers were ahead of consensus. During this quarter, all CV financiers have turned cautious and have seen an uptick in their gross NPAs, whilst Shriram Transport is looking to achieve or beat its loan book growth target of around 15% YoY without any increase in NPLs.

The stock price has run up in a difficult environment We do not expect the company to achieve more than 15% growth rate for

FY14 given the difficult operating environment; we expect month on month

declines in CV sales. Also, our on the ground research suggests that although

the operating environment for single truck owners is not that bad, some

amount of stress is visible, given the elongated working capital cycle in the

manufacturing and infrastructure sector, who in turn pay single truck

operators to use their services. Hence, the current 15% uptick in the stock price

over last three months in our view captures any likely near-term upside.

Moreover, we feel that the company will face a margin versus growth

conundrum even if the macroeconomic environment turned favourable, given

GDP growth will drive new CV sales more than old CVs, yet this is where

competition is stiffer and yields are lower. The company has already started

increasing the number of 3-5 years old CVs in its portfolio to support growth.

Risk to our investment case If mining activities were to resume in the near term, then we may see Shriram

Transport’s AUM increase to more than 20% and hence we could see a good

uptick in the stock price. On the downside it remains exposed to a prolonged

downturn in the economic environment.

Valuation SHTF is trading at 1.9x FY14E book value, a 10-15% premium over its closest

competitors (SUF and CIFC). We believe that the current valuation looks

reasonable given SHTF’s franchise strength; however we do not expect further

upside given subdued growth expectations amidst CV sector challenges. We

have revised our fair value to Rs773 from Rs681 (published on 11 Jan 2012) as

we roll over our estimates to FY14 and thus we downgrade to NEUTRAL.




NEUTRAL 9% upside

Fair Value Rs772.78

Bloomberg ticker SHTF IN Share Price Rs710.00 Market Capitalisation Rs170,107.17m Free Float 55%


Net Interest income 30,275 34,429 38,648 44,039

Total income 31,906 36,559 40,936 46,524

Operating expenses 8,167 9,053 10,693 11,813

Provisions & write-offs 5,251 7,757 8,343 9,172

PAT 12,171 13,088 14,526 16,959

EPS 55 58 64 75

DPS 7 8 9 14

YY/E 31--MMar 22011A 22012A 22013E 22014E

P/E 12.8 12.3 11.0 9.5

P/BV 3.2 2.7 2.2 1.9

ROA 5.1% 4.8% 4.3% 4.0%

ROE 28% 24% 22% 22%

Dividend Yield 0.9% 1.1% 1.2% 2.0%


Data, Bloomberg

80

100

120

140

Apr 2012 Jul 2012 Oct 2012 Jan 2013

SHTF IN vs BSE500 Index



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Change in estimates

Table 1 Change in estimates (standalone numbers)


Rs millions FY13 FY14 FY13 FY14 FY13 FY14

AUM 461,282 550,042 469,409 551,926 2% 0%

Net Interest Income 34,170 40,639 36,070 40,986 6% 1%Higher proportion of Old vehicles than estimates

Total Income 36,221 43,077 37,513 42,626 4% -1%Operating expenses 8,661 9,971 8,658 9,676 0% -3%Pre Provisioning Profit 27,560 33,106 28,855 32,950 5% 0%

Provisions 6,160 8,133 8,343 9,172 35% 13%

Credit cost has increased due to mining ban and slowdown

in industrial activity.PBT 21,399 24,974 20,513 23,778 -4% -5%PAT 14,273 16,657 13,682 15,860 -4% -5%EPS (Rs)-Diluted 63 74 61 70 -4% -5%

Old New % Change

Comments

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Source: Company Data, Espirito Santo Investment Bank Research


Recommendation: NEUTRAL P/E 12.8 12.3 11.0 9.5 8.1Fair Value: INR 773 P/BV 3.2 2.7 2.2 1.9 1.6

ROA 5.1% 4.8% 4.3% 4.0% 3.8%Share Price: INR 710 ROE 28% 24% 22% 22% 22%Upside / Downside 9% Dividend Yield 0.9% 1.1% 1.2% 2.0% 2.3%

Book value per share (BVPS) 223 267 321 380 449 3 Month ADV ($m) 5Free Float 55%52 Week High / Low INR 800 - 475 Implied Valuation Ratios 2011 2012 2013E 2014E 2015E

P/E 13.9 13.3 12.0 10.3 8.8 Bloomberg: SHTF IN P/BV 3.5 2.9 2.4 2.0 1.7 Model Published On: 25 February 2013

Consolidated P&L 2011 2012 2013E 2014E 2015EShares In Issue (mm) 226 Net Interest income 30,275 34,429 38,648 44,039 50,586 Market Cap (Rs bn) 160 Other operating income 1,631 2,130 2,289 2,485 2,725 Market Cap ($ mn) 2,971 Total income 31,906 36,559 40,936 46,524 53,311

Operating expenses 8,167 9,053 10,693 11,813 13,039Operating profit 23,739 27,506 30,243 34,711 40,272Provisions & write-offs 5,251 7,757 8,343 9,172 10,356Depreciation 113 174 174 174 174Profit before tax 18,375 19,575 21,727 25,365 29,742

Espirito Santo Securities Analyst Taxes 6,204 6,488 7,201 8,407 9,857Santosh Singh PAT 12,171 13,088 14,526 16,959 19,885 (91) 22 43156822 EPS 55 58 64 75 88 [email protected] DPS 6.5 7.7 8.6 14.0 16.3Nidhesh Jain(91) 22 [email protected] Consolidated Balance Sheet 2011 2012 2013E 2014E 2015E

Networth 48,934 60,326 72,579 85,827 101,387Borrowings 201,817 241,367 314,648 387,124 462,218Total Sources of funds 250,751 301,693 387,228 472,951 563,606

Fixed assets 435 537 537 537 537 Shareholding Pattern Non-current investments 2,232 2,721 2,721 2,721 2,721

Deferred tax assets 1,542 2,183 2,183 2,183 2,183 Loans and advances 245,747 275,928 360,446 445,103 534,637 Net current assets 795 20,324 21,341 22,408 23,528 Total assets 250,751 301,693 387,228 472,951 563,606 BVPS 223 267 321 380 449

Standalone P&L 2011 2012 2013E 2014E 2015ENet Interest income 29,582 32,261 36,070 40,986 46,982Other operating income 1,995 1,284 1,443 1,639 1,879Total income 31,577 33,545 37,513 42,626 48,862Operating expenses 7,540 7,114 8,658 9,676 10,795Operating profit 24,037 26,431 28,855 32,950 38,066 Provisions & write-offs 5,548 7,622 8,343 9,172 10,356 Profit before tax 18,489 18,809 20,513 23,778 27,711 PAT 12,299 12,575 13,682 15,860 18,483

Loan book Breakdown

Standalone Balance Sheet 2011 2012 2013E 2014E 2015ENetworth 49,044 59,923 71,332 83,481 99,958 Borrowings 198,743 231,219 297,179 387,293 440,353 Total Sources of funds 247,787 291,142 368,511 470,773 540,312

Fixed assets 384 397 397 397 397 Non-current investments 36,453 39,646 39,646 39,646 39,646 Deferred tax assets 1,537 2,167 - - - Truck Loans 197,690 219,019 292,156 363,154 436,298 Net current assets 11,723 29,912 36,312 67,576 63,970 Total assets 247,787 291,142 368,511 470,773 540,312

Key Ratios 2011 2012 2013E 2014E 2015E

Margin Trends Gross NPA 2.8% 3.1% 3.5% 4.1% 4.6%Credit cost 1.7% 2.0% 1.9% 1.8% 1.7%CAR 24% 25% 25% 24% 25%Tier-II 18% 19% 18% 18% 19%Tier-II 6% 6% 6% 6% 6%

Loan book ratios 2011 2012 2013E 2014E 2015E

On Balance sheet 197,690 219,019 292,156 363,154 436,298 Off Balance sheet 163,170 182,261 177,254 188,772 208,081 Old CV 76% 77% 79% 80% 82%New CV 24% 23% 21% 20% 18%AUM growth 24% 11% 17% 18% 17%

Shriram Transport Finance

Promoter26%

FII42%

DII1%

Others31%

Pre-owned78%

New CV Finance

22%

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25%

30%

FY11A FY12E FY13E FY14E FY15E

RoA RoE

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We have used excess return on equity methodology to value the company using a cost of equity of 14.5%. Our model has two stages with twenty years horizon, with ten years of explicit forecast and subsequent ten years of declining RoE to converge on CoE.

Figure 1 DCF disclosures SHTF


Risks to Fair Value

The company operates in the commercial vehicle financing space, which is

highly correlated to the GDP and manufacturing sector. In the event of any

prolonged slowdown in the economy, there could be an impact on the credit

quality and growth for the company.

On the other hand, we have not factored in any growth from the opening of

the mining sector or accelerated improvement in GDP growth. Also, its

subsidiary Shriram Construction Equipment Finance is doing well for which we

have not assigned any value. It could pose upward risks to our fair value if it

continues to deliver.


Cost of Equity 14.5%

Shares in Issue 226

Rs. Mn Rs./share




Net Profit 13,682 15,860 18,483 21,996 27,009 32,413 38,502 45,308 52,625 60,968 72,829 80,374 88,024 95,645 103,083 110,166 116,710 122,517 127,386 131,114

Cost of Equity 8,689 10,343 12,105 14,494 16,900 19,778 23,165 26,788 31,052 36,004 44,845 51,698 59,262 67,545 76,546 86,246 96,614 107,597 119,126 131,114

ROAE 23% 22% 22% 22% 23% 24% 24% 25% 25% 25% 24% 23% 22% 21% 20% 19% 18% 17% 16% 15%

Excess Return 4,993 5,517 6,378 7,502 10,108 12,634 15,337 18,520 21,573 24,964 27,984 28,676 28,763 28,100 26,537 23,920 20,096 14,921 8,260 -

Discount Factor 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.4 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1

Present Value 5,639 5,441 5,495 5,644 6,642 7,251 7,687 8,107 8,247 8,335 8,160 7,303 6,397 5,459 4,502 3,544 2,601 1,686 815 -

Shriram Tansport Finance Company excess return on equity calculation

Shriram Transport Finance SHTF IN

Report date Recommendation Fair value Share price2012 January 11 Buy Rs681.00 Rs498.00

2011 June 6 Buy Rs763.00 Rs684.25

February 14 Buy Rs839.00 Rs698.40

February 10 Buy Rs718.00 Rs684.90

2010 July 22 Buy Rs719.00 Rs597.10

June 28 Buy Rs718.00 Rs575.75


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IIMPORTANT DISCLOSURES

110213

This report was prepared by Espírito Santo Investment Bank Research, a global brand name for the equity research teams of Banco Espírito Santo de Investimento, S.A., with headquarter in Lisbon, Portugal, of its Branches in Spain and Poland and of its affiliates BES Securities do Brasil, S.A – Corretora de Câmbio e Valores Mobiliários, in Brazil, and Execution Noble Limited, in the United Kingdom, all authorized to engage in securities activities according to each domestic legislation. All of these entities are included within the perimeter of the Financial Group controlled by Espírito Santo Financial Group S.A. (“Banco Espírito Santo Group”).

Analyst Certification

Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; the issuers were not previously informed about the content of the recommendation included in this research report and the assumptions were not validated by the issuers; (2) no part of his or her compensation is directly or indirectly related to: (a) the specific recommendations or views expressed by that research analyst in the research report; and/or (b) any services provided or to be provided by Banco Espírito Santo de Investimento, S.A. and/or by any of its affiliates to the issuer of the securities under recommendation. Moreover, each of the analysts hereby certifies that he or she has no economic or financial interest whatsoever in the companies subject to his or her opinion and does not own or trade any securities issued by the latter.

Ratings Distribution

Espirito Santo Investment Bank Research hereby provides the distribution of the equity research ratings in relation to the total Issuers covered and to the investment banking clients as of end of December 2012.

Explanation of Rating System RRatings Distribution

12-MONTH RATING DEFINITION

BUY Analyst expects at least 10% upside potential to fair value, which should be realized in the next 12 months

NEUTRAL Analyst expects upside/downside potential of between +10% and -10% to fair value, which should be realized in the next 12 months

SELL Analyst expects at least 10% downside potential to fair value, which should be realized in the next 12 months

As at end December 2012 Total ESIB Research Total Investment Banking Clients (IBC)

Recommendation Count % of Total Count % of IBC % of Total

12 Month Rating:

Buy 222 45.3% 29 53.% 5.9%

Neutral 171 34.9% 17 31.5% 3.5%

Sell 91 18.6% 5 9.3% 1.0%

Restricted 5 1.0% 3 5.6% 0.6%

Under Review 0 0.0% 0 0.0% 0.0%

TRADING RATING DEFINITION

TRADING BUY Analyst expects a positive short-term movement in the share price (max duration 2 months from the time Trading Buy is announced) and may move out of line with the fair value estimate during that period

TRADING SELL Analyst expects a negative short-term movement in the share price (max duration 2 months from time Trading Sell is announced) and may move out of line with the fair value estimate during that period

Trading Rating:

Trading Buy 1 0.2% 0 0.0% 0.0%

Trading Sell 0 0.0% 0 0.0% 0.0%

Total recommendations 490 100% 54 100% 11.0%

For further information on Rating System please see “Definitions and distribution of ratings” on: http://www.espiritosantoib-research.com.

Share Prices

Share prices are as at the close of business on the day preceding publication, unless otherwise specified.

Coverage Policy

Espírito Santo Investment Bank Research reserves the right to choose the securities it expresses opinions on. The main criteria to choose such securities are: 1) markets in which they trade 2) market capitalisation 3) liquidity, 4) sector suitability. Espírito Santo Investment Bank Research has no specific policy regarding the frequency in which opinions and investment recommendations are released.

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Espírito Santo Investment Bank Research has issued this report for information purposes only. This material constitutes "investment research" for the purposes of the Markets in Financial Instruments Directive and as such contains an objective or independent explanation of the matters contained in the material.

Any recommendations contained in this document must not be relied upon as investment advice based on the recipient's personal circumstances. This report is not, and should not be construed as an offer or a solicitation to buy or sell any securities or related financial instruments. The investment discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. The material in this research report is general information intended for recipients who understand the risks associated with investment. It does not take account of whether an investment, course of action, or associated risks are suitable for the recipient. This research report does not purport to be comprehensive or to contain all the information on which a prospective investor may need in order to make an investment decision and the recipient of this report must make its own independent assessment and decisions regarding any securities or financial instruments mentioned herein. In the event that further clarification is required on the words or phrases used in this material, the recipient is strongly recommended to seek independent legal or financial advice. Where an investment is denominated in a currency other than the investor’s currency, changes in rates of exchange may have an adverse effect on the value, price of, or income derived from the investment. Past performance is not necessarily a guide to future performance. Income from investments may fluctuate. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. Any recommendation and opinion contained in this report may become outdated as a consequence of changes in the environment in which the issuer of the securities under analysis operates, in addition to changes in the estimates and forecasts, assumptions and valuation methodology used herein. The securities mentioned in this publication may not be eligible for sale in some states or countries.

All the information contained herein is based upon information available to the public and has been obtained from sources believed to be reliable. However, Espírito Santo Investment Bank Research does not guarantee the accuracy or completeness of the information contained in this report. The opinions expressed herein are Espírito Santo Investment Bank Research present opinions only, and are subject to change without prior notice. Espírito Santo Investment Bank Research is not under any obligation to update or keep current the information and the opinions expressed herein nor to provide the recipient with access to any additional information.

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Banco Espírito Santo de Investimento, S.A. and/or its Affiliates (including all entities within Espírito Santo Investment Bank Research) and/or their directors, officers and employees, may have, or have had, interests or qualified holdings on issuers mentioned in this report. Banco Espírito Santo de Investimento, S.A. and/or its Affiliates may have, or have had, business relationships with the companies mentioned in this report. However, the research analysts may not purchase or sell securities or have any interest whatsoever in companies subject to their opinion.

Banco Espírito Santo Group has a qualified shareholding (1% or more) in EDP, ImmuPharma, Portugal Telecom and ZON Multimédia. Portugal Telecom has either a direct or indirect qualified shareholding (2% or more) in Banco Espírito Santo, S.A. and Lloyds Banking Group has a shareholding of 3.3% in Espírito Santo Investment Holdings Limited. Bradesco has an indirect qualified shareholding (4.8%) in Banco Espírito Santo, S.A. and has a direct qualified shareholding (20%) in BES Investimento do Brasil, S.A., the parent company of BES Securities do Brasil S.A. CCVM.

BES Securities do Brasil S.A. CCVM does not hold a direct or indirect stake in the capital of the company (companies) that are subject of analysis(es)/recommendation(s) in this report, but the Banco Espírito Santo Group within which it is inserted, holds, directly and in some cases indirectly, 1% or more of the equity securities of Bradesco. With the exception of the company mentioned before, BES Securities do Brasil S.A. CCVM does not hold direct or indirect stakes in the capital of the other companies that are subject of analysis(es)/recommendations in this report, and it was not involved in the acquisition, alienation and intermediation of securities issued by these companies in the market. Pursuant to Polish Ministry of Finance regulations, we inform that Banco Espírito Santo Group companies and/or Banco Espírito Santo de Investimento, S.A. Branch in Poland do not have a qualified shareholding in the Polish Securities Issuers mentioned in this report higher than 5% of its total share capital.

Mr. Ricardo Espírito Santo Silva Salgado, the CEO of Banco Espírito Santo, S.A. and Chairman of Banco Espírito Santo de Investimento, S.A., is a board member of Bradesco since June 2003. The Chief Executive Officer of Banco Espírito Santo de Investimento, S.A., Mr. José Maria Ricciardi, is a member of EDP’s General and Supervisory Board. Mr. Rafael Valverde, a member of the board of Banco Espírito Santo de Investimento, S.A., is a non-executive board member of EDP Renováveis. Mr. Ricardo Abecassis Espírito Santo Silva, a member of the board of Banco Espírito Santo de Investimento, S.A., is a board member of Brazil Hospitality Group.

Banco Espírito Santo de Investimento, S.A and/or its subsidiaries are liquidity providers for Altri.

Banco Espírito Santo de Investimento, S.A. and/or its subsidiaries participate or have participated as a syndicate member in share offerings of ACM Shipping Plc, Burford Capital, Equatorial, Fibria Celulose, IQE plc, Marfrig, Minerva, Santander, Sonae and Suzano Papel e Celulose in the last 12 months.

Page 62

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Banco Espírito Santo de Investimento, S.A. and/or its subsidiaries participate or have participated as a syndicate member in the bond issues of the following companies: Bradesco, Cemig, EDP, Jerónimo Martins, Mota-Engil, Oi, Portugal Telecom, REN, Semapa and ZON Multimédia in the last 12 months.

Banco Espírito Santo de Investimento, S.A. and/or its subsidiaries provided investment banking services to the following companies: Acciona, ACM Shipping, AGA Rangemaster Group, Altri, Assura, Bradesco, Burford Capital, Casino Guichard, Cemig, Copel, EDP, Ence, Equatorial, Fibria Celulose, Flybe Group Plc, Galp Energia, Grupa Lotos, Ibersol, ImmuPharma, Impax Asset Management Group, Inditex, IQE, Jerónimo Martins, Kredyt Inkaso, Laird, Marfrig, Minerva, Mota-Engil, Novae Group Plc, Oi, Portugal Telecom, REN, Rovi, Sacyr Vallehermoso, Santander, Semapa, Shaftesbury Plc, Sonae, Suzano Papel e Celulose, SVG Capital, Ted Baker, The Local Shopping REIT Plc, Tim, Vertu Motors, Workspace Group Plc, Xchanging and ZON Multimédia in the last 12 months.

Banco Espírito Santo Group has been a partner to Mota-Engil in the infrastructure business in Portugal and other countries. Mota-Engil and Banco Espírito Santo Group, through ES Concessões, S.G.P.S., S.A., have created a joint holding company – Ascendi – for all stakes in transportation infrastructure concessions, in Portugal and abroad. Banco Espírito Santo de Investimento, S.A. provided, or continues to provide, investment banking services to Ascendi.

Banco Espírito Santo de Investimento, S.A. and/or its subsidiaries do and seek to provide investment banking or other services to the companies referred to in this research report. As a result, investors should be aware that a conflict of interest may exist.

MMarket Making UK

Execution Noble Limited is a Market Maker in companies covered and may sell to or buy from customers as principal in certain financial instruments listed or admitted to listing on the London Stock Exchange. For information on Companies to which Execution Noble Limited is a Market Maker please see “UK Market Making” on http://www.espiritosantoib-research.com.

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This report cannot be reproduced, in whole or in part, in any form or by any means, without Espírito Santo Investment Bank Research’s specific written authorization. This report is confidential and is intended solely for the designated addressee. Therefore any disclosure, replication, distribution or any action taken in reliance on it, is prohibited and unlawful. Receipt and/or review of this research report constitutes your agreement not to redistribute, retransmit, or disclose to others the contents, opinions, conclusion, or information contained in this report (including any investment recommendations, estimates or price targets without first obtaining express permission from an authorized officer of Banco Espírito Santo de Investimento, S.A.

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http://www.espiritosantoib-research.com.

IMPORTANT DISCLOSURES FOR U.S. PERSONS

This report was prepared by Espírito Santo Investment Bank Research, a global brand name for the equity research teams of Banco Espírito Santo de Investimento, S.A., with headquarter in Lisbon, Portugal, of its Branches in Spain and Poland and of its affiliates BES Securities do Brasil, S.A – Corretora de Câmbio e Valores Mobiliários, in Brazil, and Execution Noble Limited, in the United Kingdom, all authorized to engage in securities activities according to each domestic legislation. Neither Banco Espírito Santo de Investimento, S.A. nor these affiliates are registered as a broker-dealer in the United States and therefore, is not subject to U.S. rules regarding the preparation of research reports and the independence of research analysts. This report is provided for distribution to U.S. institutional investors in reliance upon the exemption from registration provided by Rule 15a-6 of the U.S. Securities Exchange Act of 1934, as amended.

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Espírito Santo Investment Bank Research has issued this report for information purposes only. All the information contained therein is based upon information available to the public and has been obtained from sources believed to be reliable. However, Espírito Santo Investment Bank Research does not guarantee the accuracy or completeness of the information contained in this report. The opinions expressed herein are our present opinions only, and are subject to change without prior notice. Espírito Santo Investment Bank Research is not under any obligation to update or keep current the information and the opinions expressed herein. This report is not, and should not be construed as an offer or a solicitation to buy or sell any securities or related financial instruments. The investment discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Where an investment is denominated in a currency other than the investor’s currency, changes in rates of exchange may have an adverse effect on the value, price of, or income derived from the investment. Past performance is not necessarily a guide to future performance. Income from investments may fluctuate. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. Any recommendation and opinion contained in this report may become outdated as a consequence of changes in the environment in which the issuer of the securities under analysis operates, in addition to changes in the estimates and forecasts, assumptions and valuation methodology used herein. The securities mentioned in this publication may not be eligible for sale in some states or countries. Espírito Santo Investment Bank Research does not accept any form of liability for losses or damages which may arise from the use of this report. Please note that investing in any non-U.S. securities or related financial instruments discussed in this research report may present certain risks. The securities of non-U.S. issuers may not be registered with the U.S. Securities and Exchange Commission or subject to regulation in the United States. Information on such non-U.S. securities or related financial instruments may be limited. Foreign companies may not be subject to audit and reporting standards and regulatory requirements comparable to those in the United States.

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