Weak prospects for PFC, REC

Continued demand slowdown in power sector,asset quality woes to keep the stocks under check

The results of Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) partly reflect the state of India’s power sector, been reeling due to lack of demand and the weak financials of many companies, especially state electricity boards (SEBs).

A spike in the impaired loans of the two companies hit their earnings for the quarter ended March. Growth rates have also been muted. As a result, both stocks under-performed the BSE Sensex after their results were announced on May 28. Post the dismal show, analysts have trimmed their target prices for PFC by three-five per cent and for REC by seven-nine per cent. And, most believe the stocks will continue to lag in the near term.

While PFC’s restructured loans grew 17 per cent sequentially to Rs 20,500 crore, REC recorded a 72 per cent sequential jump in restructured loans at Rs 16,400 crore. Despite the fact that both companies saw more asset quality woes, their earnings performance was divergent. While PFC’s net profit rose 10.7 per cent year-on-year, it was only 1.4 per cent lower than the Bloomberg consensus estimate of Rs 1,582 crore. On the other hand, REC saw its profit decline eight per cent, missing the Street estimate of Rs 1,413 crore by a whopping 22.4 per cent.

A 72 per cent year-on-year fall in operating expenses at Rs 24 crore is one reason for PFC’s good show. Another is the difference in classification of restructured loans. While REC follows the Reserve Bank of India’s definition, covering both public and private sector borrowers, PFC’s restructured loans cover only its private sector loans. Therefore, PFC’s restructured book does not reflect the actual asset quality stress in the SEB segment.

“PFC’s current return on equity (of 20 per cent) does not correctly and adequately reflect the company’s profitability, as credit costs and NPAs (non-performing assets) are substantially low due to regulatory forbearance. We believe even if SEBs were able to improve their financials, headwinds would still persist to PFC’s loan growth and margins,” say analysts at Religare Capital Markets. They have downgraded the stock from ‘buy’ to ‘hold’ to factor in the weak results.

The stress is also visible from the fact that despite a 45 per cent year-on-year surge in provisions, PFC’s gross and net NPA ratios inched up, both sequentially and annually. REC, however, saw a surge in provisions, which were up 221 per cent year-on-year. As a result, there was a sequential improvement in the gross and net NPA ratios during the quarter. The gross NPA ratio was only 0.7.

During the quarter, the two companies posted steady loan growth, but that was driven primarily by SEBs (up 17 per cent each). Given the weak financials of many SEBs, that might not necessarily be a good sign. Private sector loans also grew at a healthy pace during the quarter, though that was partly a function of a low base. Further, the uptick in private sector loans/disbursals does not necessarily indicate a revival in private sector demand, given some of the loan approvals to the private sector could be conditional.

Going forward, most brokerages remain cautious on demand revival and expect annual loan growth to be 10 per cent for PFC and 11-13 per cent for REC through the next two years.

“We are revising down REC’s earnings by four-five per cent to factor in the near-doubling of the credit cost estimate (0.4 per cent of loans, compared with 0.2 per cent earlier), even as we increase our loan growth forecasts. We expect restructured loans to rise 35-40 per cent. Consequently, our adjusted book value is 19 per cent lower than the reported book value,” says Nischint Chawathe of Kotak Institutional Equities.

While both stocks are trading at reasonable valuations and have come off about 20 per cent each from their annual highs, absence of near-term triggers on demand/asset quality are key overhangs.