Mahindra & Mahindra Financial Services: Sell

The stock of Mahindra and Mahindra Financial Services has underperformed the market in the last one year, due to slowing loan growth and deterioration in asset quality.

In the latest June quarter, the company’s net profit declined 19 per cent over the same period last year and loan disbursements fell for the second quarter in a row by 13 per cent. Bad loans are now 6.2 per cent of total loans, the highest in the last four years.

At the current price of ₹282, the stock trades at 2.4 times its one-year forward book value; down from 2.9 times last year.

The stock has always traded at a premium to its peers such as Shriram Transport Finance (2.2 times) and Bajaj Finance (now trading at similar valuations), given its diversified loan portfolio and strong return ratios.

But the company is likely to continue to witness asset quality pressure over the next three to four quarters.

This, along with slowing loan growth, should result in earnings growth slipping to 15-16 per cent over the next two years, down from the robust 27 per cent annual growth in the last four years.

Investors can book profits at this juncture. The stock has gained 6 per cent from our previous recommended Buy call at ₹264 in July 2013. A strong presence in rural and semi-urban areas, as well as a diversified loan portfolio supported the growth momentum for M&M Finance in the past.

The company’s loan book grew by a robust 36 per cent annually between 2010 and 2014. By catering to other manufacturers (aside from its parent M&M), the company was able to de-risk its loan portfolio.

However, the loan growth has slowed down in the last one year. In 2013-14, the company’s loan book grew by 23 per cent; the pace slowed further to 16 per cent in the latest June quarter.

After declining 11 per cent in the March quarter, loan disbursements dipped 13 per cent in the June quarter.

Sluggish UV and tractor sales and some loss in market share in the car segment impacted the company’s loan growth. While weak monsoons impacted sales of UVs and tractors, increase in diesel prices has been an added dampener for the former.

Currently, of the total assets financed by M&M Finance, the UV segment accounts for 30 per cent, tractors 19 per cent, cars 23 per cent and CV/CE 14 per cent. In 2012-13, the company increased its share of lending significantly to the UV segment, and reduced its exposure to the ailing commercial vehicles segment.

While lower exposure helped when the CV cycle was down, if the economy revives and CV sales pick up, M&M Finance may not be able to ride the recovery quickly.

The company’s overall loan growth is expected to hover in the 15-16 per cent range over the next two years as it plans to focus on recovery of bad loans rather than pursue an aggressive growth strategy.

Consequently, the return on equity which was a healthy 22 per cent two years back, slipped to 12 per cent in the June quarter. Slow loan growth and pressure on asset quality are likely to continue weighing on margins over the next two years.

Having succeeded in bringing down the gross non-performing assets (GNPA) significantly from 6.4 per cent of loans in 2009-10 to 3 per cent in 2012-13, the company’s asset quality has deteriorated over the past four quarters.

In 2013-14, the GNPA stood at 4.4 per cent of loans, which rose sharply to 6.2 per cent in the June quarter.

The provision cover, which was a healthy 80-85 per cent two years back, has fallen to 54 per cent in the June quarter.

Pressure on asset quality is expected to persist over the next four to five quarters, impacting the company’s earnings.

Recovery of bad loans is expected to be long drawn, and the management has indicated GNPA of about 5 per cent by the end of FY2014-15.

Given that the management plans to focus on containing bad loans rather than pursuing growth, the company's earnings are expected to remain under pressure over the next couple of quarters. This may weigh on the stock’s valuation.

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