Assurance of increased coal allotment to power projects and the proposed distribution sector reforms are key positives.

Fresh investments with a three-year horizon can be considered in the stock of Power Finance Corporation (PFC), India's largest infrastructure financing company. The Government's recent assurance that coal allotment to power projects would be increased, which reduces PFC's credit risk and the implementation of Shunglu Committee recommendations (distribution sector reforms), which reduce the counter-party risk for its power generation clients, are key positives.

Besides, investment demand in the power sector may continue to remain robust, driven by the Rs 11 lakh crore of investments expected during the 12{+t}{+h} Plan (2012-2017). Near-term visibility for PFC comes from undisbursed loans. Loans sanctioned but yet to be disbursed amount to 1.65 times of PFC's current loan book.

Secured nature of the loan book with low non-performing assets (NPA), access to low-cost borrowings such as tax-free bonds and negligible operating costs are other positives.

At the current price of Rs 192, the stock trades at 1.2 times its estimated FY13 book (adjusted for NPAs). The price-to-earnings multiple works out to 7.1 times its expected FY13 earnings. On the price-to-book value basis, the valuation is at a discount to Rural Electrification Corporation and IDFC. High visibility in terms of loan book growth with improved operational prospects of its clients and expectation of expansion in interest spreads make a good case for investing.

Strong demand for loans

PFC has been losing market share to banks due to aggressive lending by banks.

During the period FY 2007 to FY2011, the banks' loans to power sector grew at an 38 per cent as against 22 per cent growth clocked by PFC. However, the market share has marginally improved during the fiscal as the banks are going slow on this segment due to stretched exposure limits and asset quality concerns

PFC has put in place stricter under-writing standards for loan disbursement to private players and State electricity boards (SEBs). For instance, PFC sanctions loans to private projects only after the project secures power purchase agreement and coal linkages.

The projects commissioned prior to April 2009 have already secured fuel supply agreements. Therefore, only exposure to projects during FY10 and FY11 were at risk. The Prime Minister's directive that Coal India sign fuel supply agreements for 80 per cent of the normative quantity required would, therefore, be a game changer for PFC. Coal India has been asked to sign fuel agreements for projects up to 2015 which immensely improves the prospects of generation sector. This coupled with on-time payments by electricity boards (post-reforms) will ensure that the asset quality remains at current levels. Generation projects account for 84 per cent of the loan book. Exposure to the troubled distribution sector is at 4 per cent as against 25 per cent in case of banks and higher proportion in the case of REC.

Interestingly, the proportion of restructured assets is rising in case of banks, while PFC didn't restructure any power sector loans.

Interest spreads to expand

Even if the loan growth moderates in near term due to stricter underwriting and lower offtake , the company's financials would be driven by expansion in spreads.

The company's access to low-cost funding sources such as tax-free bonds, tax-savings bond and external commercial borrowings will keep tab on its overall cost of borrowing, thereby aiding its spreads. It is noteworthy that the yield on advances for PFC is stickier than the cost of funds, as interest on most of the loans is reset every three years. Cost of funds (for instruments other than bonds) on the other hand moves in line with prevailing interest costs. Therefore, any decline in interest rates can be margin accretive for PFC. The current yields on assets are at 11.2 per cent as against minimum lending rate for project loan of 12.5 per cent.

With high proportion of assets — about Rs 33,000 crore — being re-priced during the next fiscal, the margins will further improve. The management has guided 2.5 per cent interest spread as against the spread of 2.22 per cent for the nine-months ended December 2011. Higher disbursements to private sector projects to which PFC lends at higher rate will also drive the spreads for PFC.

Risks

Foreign exchange risk from unhedged position is a key concern for PFC. Post change in AS11 Accounting Standard, PFC has taken Rs 1,033 crore loss to its balance-sheet. It will be amortised over the life of the loan. Due to reversal in earlier provided notional forex loss, the profit growth for the quarter was 68 per cent. Adjusting for the amortised forex, the net profit growth would have been 17 per cent. The volatility in foreign exchange is a key risk for PFC as the ECB borrowing is set to rise.

Another risk for PFC would be recognition of NPAs in 90 days against 180 days past due, if NBFC regulations come through. This would increase the provisioning, put pressure on margins and increase the NPAs proportion. Standard asset provisioning however would not be a problem as PFC has been setting aside 5 per cent of its profits every year to create a buffer for bad loans.

(This article was published on March 3, 2012)
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