The Hindu Business Line : Retail financing: NBFCs getting into fast lane

The boom in retail financing over the last few years — largely a result of consumer credit remaining an under-served area — has fuelled the rapid growth of financial services companies. While banks are the biggest beneficiaries, non-banking finance companies (NBFCs) and housing finance companies have also benefited greatly. In particular, NBFCs, which compete closely with banks, have withstood competitive pressure from banks in their chosen niche areas, despite operating on a higher cost structure.

However, with intensifying competition eating into their market share, can NBFCs sustain the momentum? Does retail finance hold enough potential? What will be the key growth drivers over the medium term? And what do the recent changes in the regulatory framework mean for NBFCs? This article discusses these aspects and looks at select stocks that hold promise from an investment perspective.

Strong focus on niches

While banks (mostly private sector and foreign) have adopted a metro-focused model in building their retail portfolios, NBFCs follow a multi-pronged strategy aimed at widening reach in non-metro locations. Their focus on financing commercial vehicles and two-wheelers in such regions and their strong relationships with customers and manufacturers have helped them garner strong business volumes.

Companies such as Sundaram Finance and Shriram Transport Finance boast of longstanding bonds with non-metro customers. Moreover, Sundaram Finance, Bajaj Auto Finance, Mahindra & Mahindra Financial Services and Cholamandalam DBS Finance have also forged strong ties with equipment/asset manufacturers. These are vital linkages given the intensity of competition.

A sharp focus on financing commercial vehicles and two-wheelers, segments that private and foreign banks are not too active in, has worked to the advantage of these companies. There has been 30 per cent growth in these segments over the last couple of years.

Small-ticket loans such as for consumer durables and two-wheelers have traditionally been the preserve of NBFCs, but private and foreign banks, flush with low-cost funds, are slowly eating into their market share. Citi Financial, GE Countrywide and Bajaj Auto Finance together control about 85 per cent of the consumer durables financing market.

In two-wheeler financing, ICICI Bank and HDFC Bank lead the pack.

Pre-owned (second-hand) vehicle financing, where banks have been largely inactive, also offers huge potential. Earlier dominated by money-lenders, this segment has drawn considerable interest from new private sector banks. Shriram Transport Finance is one of the largest truck financing companies in the organised sector. M&M Financial Services, with a wider reach in semi-urban and rural areas, has recorded strong growth in tractor financing — an area where the PSBs still dominate owing to priority sector commitments.

Subdued performance

For NBFCs, the cost of funds works out higher compared to public sector banks and, to some extent, with new private sector banks owing to restrictions on their raising public deposits. This perhaps explains the reason for their higher dependence on banks and financial institutions for sourcing funds. The rising interest rates have impacted their cost structure. Further, the spread between the maximum interest rate on public sector bank deposits of `one-to-three-year' maturity and the interest rate offered by NBFCs on deposits with the same maturity widened to 4.75 per cent at end-March 2006 from 4 per cent at end-March 2005. Borrowings by NBFCs from banks and financial institutions, and by way of debentures, increased sharply by 26.5 per cent and 17.1 per cent, respectively, during 2005-06. Consequently, higher costs dented profits after tax, which declined sharply across the industry, though the larger players fared better.

Growth drivers

Retail finance, which has seen a significant spurt over the last three-four years, is expected to grow, albeit at a moderate pace. While cyclical factors may play out, the structural drivers of the retail boom are expected to remain intact, lending a favourable outlook to the mortgage market.

High-yielding segments such as consumer durables, two-wheelers and pre-owned CVs, where NBFCs have registered strong growth, still offer potential to grow. Rural and semi-urban areas, which are largely under-banked, also offer substantial scope for NBFCs to improve their business volumes. Overall, higher disbursements may make up for the decline in spreads.

The RBI's recent decision to allow NBFCs to distribute mutual funds and issue co-branded credit cards presents them with a growth opportunity. With forays into insurance and other financial services, these sectors are poised for more action. Companies such as Reliance Capital, with a strong distribution network and investment management skills, are expected to gain from this.

With financial services becoming increasingly commoditised, the cost of distribution will be the key metric to service the customer effectively. NBFCs, with a wider reach in locations where banks with a more `heavy cost' structure have left a gap, are well placed to service this largely under-penetrated market. Their operating costs (barring funding costs) and staff costs are more competitive than other organised intermediaries.

Disbursements are expected to grow at a CAGR of 18-20 per cent over the next three years or so. For NBFCs, areas such as personal loans and credit cards hold a lot of promise owing to their limited exposure so far. With the consumption story fast gathering pace, volumes in these sectors can only be expected to rise.

Regulatory changes

Uneven regulations and lax prudential norms for NBFCs resulted in mainline banking players taking recourse to the NBFC route to spread their network in an attempt at regulatory arbitrage. Bringing non-deposit-taking NBFCs with an asset size of over Rs 100 crore and those promoted by foreign banks within the regulatory net is likely to affect the flow of credit from NBFCs and their cost of funds.

The requirement that non-deposit taking NBFCs maintain a capital adequacy ratio of 10 per cent is likely to exert some pressure on their lending. And the impact is likely to be higher for the smaller players. Restrictions on borrowings from banks capped at 10 per cent of the banks' capital funds is likely to increase the cost of borrowings for NBFCs as their dependence on bank finance is quite high.

However, on the brighter side, NBFCs that are subsidiaries of banks are permitted to offer discretionary portfolio management services on a case-by-case basis. This is likely to benefit Kotak Mahindra Prime and Indbank Merchant Banking, among others, in the form of higher fee income.

Preferred picks

Shriram Transport Finance is our preferred pick in the sector. Although financing pre-owned commercial vehicles may not appear an exciting business, the company has shown it can be very profitable.

The opportunity for pre-owned truck financing is estimated at Rs 40,000 crore over the next 10 years; the company, being a market leader, is well-placed to cash in on this. Investors holding stocks of M&M Financial Services and Bajaj Auto Finance may retain them, though M&M's valuations appear a little high, despite its USP of `superior operational processes and wider reach'. However, if the company does grow its business volumes at 25-30 per cent, the returns are likely to be good.

While Bajaj Auto Finance appears reasonably valued, the higher operating costs and relatively higher level of NPAs are areas of concern.

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