Should you subscribe to IPO of IRFC?

The IPO of Indian Railway Finance Corporation (IRFC), a public sector enterprise and the dedicated market borrowing arm for the Indian Railways, appears reasonably priced for medium- to long-term investors.

The ₹4,600-crore IPO is open for subscription during January 18 - 20 at a price band of ₹25- 26 per equity share. It is a combination of fresh issue of shares (118.8 crore shares) and offer for sale ( 59.4 crore shares). Post-IPO, the promoter holding (Government of India) will drop to about 85 per cent.

This 34-year-old company raises financial resources through taxable bonds, term loans and external commercial borrowing to fund the capex requirements of the Indian Railways. The growth in IRFC’s loan book is directly correlated to the Railways’ capex plans, while margins are protected by fixed spreads. A significant portion of its revenues arise from financial leasing arrangements with the Railways for rolling stock assets, with the lease rentals paid by the Ministry of Railways (MoR). All this contributes to high visibility of both business growth and margins with zero non-performing assets.

At the upper end of the price band of ₹26 per share, IRFC is valued at 0.97 times book value (September 2020). This is slightly higher than other PSU financiers like REC and Power Finance which trade at about 0.7 times of book value. However, IRFC is a safer bet by virtue of its direct dealings with the Central government, with very low risk of defaults and payment delays.

Investors with a long-term horizon can consider investing in this offer. Being a CPSE, the company has to pay a minimum annual dividend.

Visible growth

The primary business of IRFC is to finance the acquisition of rolling-stock assets such as locomotives, coaches and wagons on a lease model, leasing of railway infrastructure assets (called project assets) and lending to other entities under the MoR.

As on September 2020, the assets under management consist of 55.34 per cent of rolling stock assets financing, 42.41 per cent of project assets and others.

In rolling stock financing, the transaction is recorded based on financial lease model. Every year, IRFC receives lease rentals on rolling stocks. During the lease period, the full value of assets, including interest, will be recovered from the Railways. After 30 years, assets will be transferred to the Railways at nominal price. The leasing of project assets, which started in FY16, have been under moratorium till FY21.

The on-lending activities of IRFC operate on a cost plus margin model. Loans are given out to the Railways at the weighted average cost of incremental borrowing plus a certain pre-decided margin.

This margin is determined by the MoR in consultation with IRFC at the end of each fiscal. For FY20, the margin on rolling stocks was 0.4 percentage points (0.4 per cent in FY19, 0.3 per cent in FY18 and 0.5 per cent in FY17), while the margin on project assets has been fixed at 35 basis points.

While there is no hard assurance that the margins will not fall, the management claims that it is unlikely given IRFC’s crucial role in sourcing low-cost funds for the Railways.

Despite the modest margins on lending, it is the likely growth in capital expenditure by Indian Railways will result in higher business for IRFC in future. From FY15 to FY20, the capital expenditure of Indian Railways grew at 20 per cent CAGR, leading to its funding requirement through IRFC jumping over 40 per cent CAGR . The share of IRFC funding in the overall capex requirements of Indian Railways have also grown from 19 per cent in FY15 to 45 per cent in FY20.

With government’s thrust on infrastructure and railways’ dependence on the market borrowings, IRFC is expected to benefit going ahead. In the long-term, the National Infrastructure Pipeline’s ambitious allocation for Railways capex at ₹13 lakh crore (FY20-25) offers opportunities.

Decent fundamentals

Between FY18 and FY20, the disbursements of IRFC grew by40 per cent CAGR and stood at ₹71,392 crore for FY20. Possibly due to the impact of Covid-19, for the six months ended September 2020, the disbursements stood at ₹19,016 crore as against ₹24,534 crore in the year-ago period.

The net interest margins (NIMs) of IRFC fell from 1.65 per cent in FY19 to 1.59 per cent in FY20. For the six months ended September 2020, the NIM stood at 0.71 per cent . However, with increase in overall revenues, the net profit grew by about 22 per cent CAGR in the last two years to ₹3,192 crore in FY20. The MoR relationship enables IRFC to have a high-quality asset book (nil bad loans), with a high capital adequacy ratio of 395 per cent.

Key risks

If the margins determined by MoR are lowered, it may adversely impact the company’s finances. Since funding by IRFC comes as a part of IEBR (internal and external budgetary resources) of Indian Railways, any policy stance by the Centre to cut IEBR funding by ministries will have a significant impact. Privatisation of the railway network, leading to a lower capex need, could also dampen prospects.