IDFC's fall offers good entry point

The infrastructure financier could gain from expedition of key projects in the sector and is a front-runner for the new banking license. Valuations are lowest since listing in 2005

IDFC stock was one of the biggest losers last week, falling 22 per cent as against 0.54 per cent fall in Sensex. In order to comply with the new banking license requirements, the infrastructure financier had trimmed Foreign Institutional Investors (FIIs) shareholding from 74 per cent to 54 per cent. Consequently, the stock was removed from the MSCI index resulting in selling pressure in the counter.

Operationally, although the environment is challenging and the pressure on asset quality could increase, over the medium- to long-term the company’s fortunes could improve. While the company has lowered its loan growth guidance to 10 per cent for this financial year (versus 15 per cent in FY13), government’s steps to revive stalled projects could increase credit demand by infrastructure building companies and act as a growth catalyst. Also, IDFC is the front-runner to bag the new banking license and will gain on multiple fronts if it bags the same. One, IDFC will get access to relatively low-cost funds namely Casa deposits which will improve its spreads. Secondly, according to RBI norms, banks have to maintain the capital adequacy ratio of nine per cent as against 15 per cent requirement for Infrastructure NBFCs such as IDFC. IDFC’s CAR stands at 23 per cent currently and it could benefit from lower CAR requirements if it bags the license.

While asset quality pressures are likely to increase and growth may be muted in the near term, analysts believe current valuations seem to adequately factor in these negatives, whilst ignoring upsides from banking license and/or steps to clear infrastructure projects by the government. In this backdrop, most analysts remain positive on the stock and believe the risk-reward appears to be attractive. In fact, valuations are the lowest since its listing in 2005.

“IDFC carries significant risk to likely sharp deterioration in corporate asset quality and will be affected by the spike in wholesale funding costs, too, but a lot is priced in. IDFC’s high pre-provisioning operating profit margins (five per cent) reduces probability of book value or capital stress. We upgrade IDFC to equal weight from underweight on lower valuations”, writes Anil Agarwal, financials analyst at Morgan Stanley in a report dated August 30.

According to a Bloomberg poll of six analysts since August 26 (when RBI restricted further purchase of IDFC stock by FIIs), four have a Buy rating on the stock with one Sell and Hold recommendation each. The average target price stood at Rs 110.7 a share, translating into 37 per cent upsides from Friday’s closing price of Rs 80.9.

“IDFC’s high quality loan book and significant buffer built up on provisioning should help it navigate through a very difficult backdrop. IDFC is a front runner for a banking license, and with capable and cautious management, the current valuation looks a sensible entry point for long-term investors”, says Santosh Singh, financials analyst at Espirito Santo Securities.

Going forward, analysts expect IDFC to post loan growth of nine per cent this financial year. This growth will be driven by re-financing and stepping up lending to sectors such as education, hospitality, amongst others (which now form 15 per cent of overall portfolio versus 10 per cent in FY12). Notably, these sectors have formed 30 per cent of incremental disbursements in the past year. However, with margins expected to see some pressure, IDFC’s net profit may remain flat or see some decline in FY14, after which analysts see a healthy rebound (FY15).

While IDFC has a strong track record of maintaining asset quality even in weaker times, the prolonging macro slowdown is likely to lead to higher asset quality pressure. Analysts at Morgan Stanley estimates IDFC's net NPA ratio to inch up to 0.6 per cent this fiscal and 0.7 per cent in FY15. The ratio stood at 0.4 per cent in FY13 and 0.2 per cent in the June 2013 quarter.

However, Alpesh Mehta, banking analyst at Motilal Oswal Securities says, “IDFC has loan loss provisions of 1.9 per cent. Further, cumulative provisions on balance sheet (over Rs 1,400 crore) can take care of unanticipated asset quality issues”.

Unless NPAs surge to levels significantly higher than Street estimates, at Rs 83.50 the stock’s current valuation of 0.8 times FY14 estimated book value provides comfort.