Constrained coal availability and ailing financial health of State electricity boards (SEBs) dragged not only the power sector, but also the stock performance of lenders such as Power Finance Corporation (PFC).

However, recent initiatives have improved hopes of accelerated reforms in the sector. These include the financial restructuring package to SEBs, increased momentum in the signing of fuel supply agreements by Coal India, and expectation of further tariff hikes by state power distribution companies (many state boards have hiked tariffs in the last 12-18 months). This should drive the investment cycle and aid loan growth for lenders such as PFC over the next year.

At the current valuation of 0.97 times one year forward price-to-adjusted book value (historical average of 1.3 times), the stock looks attractive, given its stable returns, comfortable capital adequacy and consistent asset quality. Also, it trades at a discount to its peers such as REC (trading at 1.04 times) and IDFC (1.4 times). PFC is well placed to meet the Reserve Bank of India’s proposed guidelines to increase Tier-I capital requirement from 10 per cent to 12 per cent.

As of December end, the company had an overall capital adequacy of 18.1 per cent and Tier I ratio of 16.9 per cent. The return on assets for the nine months ended December 2012 stood at a healthy 2.9 per cent, and asset quality remained stable with gross non-performing asset (GNPA) at 0.92 per cent of loans.

Good loan prospects

PFC is an infrastructure finance company set up by the government (73 per cent holding), dedicated to power sector financing.

The company’s exposure to the riskier state government owned distribution utilities is limited. Majority of its lending (82 per cent) is to the generation segment.

Notwithstanding the current challenges in the power sector, the potential for growth in generation capacity remains large. During the 11th plan (2007-2012), the increase in generation capacity was twice that achieved in the 10th Plan. This meant that 70 per cent of the targeted capacity was added – an all-time high- thanks to 20,501 MW added in the last leg of the plan (2011-12).

Out of the target 17,956 MW to be added in 2012-13, 75 per cent has been achieved as of February. If the momentum continues, a good chunk of the 88,000 MW envisaged for the 12{+t}{+h} plan (2012-2017) entailing an investment of around Rs 11 lakh crore should be achieved.

PFC is well placed to gain from this investment with a market share of more than 20 per cent in the country’s power sector lending.

The company’s loan growth over the last four years has been an impressive 26 per cent annually; as of December 2012, it was Rs 1.5 lakh crore, a growth of 26 per cent from last year. This was driven by a sharp 124 per cent growth in the ‘others’ segment which includes transitional loans to SEBs.

As part of transitional funding to state power distribution companies of six states, PFC has sanctioned Rs 16,630 crore and disbursed Rs 8,211 crore as of December.

This is part of the restructuring package cleared by the Government, which provides 50 per cent of short-term loans to be taken over by the State government and the rest to be restructured by lenders with moratorium on principal repayment. In the March quarter, the company has disbursed an additional Rs 4,000 crore towards this.

PFC’s loan pipeline remains strong with cumulative outstanding sanctions of Rs 1.7 lakh crore, which can get converted into disbursements over the next two years. We expect the loan growth of 20 per cent in FY2014-15.

Margins improve

PFC improved its net interest margin (NIM) by 76 basis points (to 4.6 per cent) on a yearly basis in the December quarter, thanks to increase in yields by 86 basis points and decline in cost of funds by 8 basis points.

The company has reduced its cost of funds by increasing proportion of low-cost tax free bonds and foreign currency borrowings. In the December quarter, the company raised tax-free bonds of Rs 1,110 crores, and external commercial borrowing (ECB) of $250 million. The cost of funds is expected to decline further in the coming quarters. Tax-free bonds were issued only in the last month of the December quarter.

The full benefit of lower cost of borrowing will be visible in the March quarter and beyond. Second, the company has been able to raise an additional $250 million of ECB in the March quarter.

With continued access to lower cost of funds (tax-free bonds and ECBs) and a likely fall in domestic interest rates, PFC’s net interest margin should remain in the 4.1 - 4.3 per cent range for FY-14.

Asset quality holds up

The company’s asset quality remains stable with GNPAs at 0.92 per cent of loans.

While significant exposure to state power utilities makes PFC vulnerable to slippages, a strong track record of recoveries (over 99 per cent) in the past, lends comfort.

Also one of the non-performing assets of the company has converted into a performing asset in the March quarter, and Rs 22 crore of provision will be reversed.

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