PFC-REC merger likely to weigh on near-term financial performance

Additional market borrowing to raise funding cost

Apart from the Union power ministry, the Street is also trying to gauge the impact on operational and financial health of Power Finance Corporation and REC (earlier known as Rural Electrification Corporation) if the two were to operate as a single entity.

The proposed deal (merger or acquisition) is part of the central government’s plan to meet its 2018-19 divestment target of Rs 800 billion. The government owns majority stakes in both power financiers. Though not clear if it would be a merger or acquisition, experts believe the former option is unlikely, as this will not fulfil the government’s divestment objective.

The proposal could also weigh on near-term performance of the acquiring entity, in this case likely to be REC. At the current market capitalisation of PFC, the government could garner at least Rs 170 bn. REC would need to borrow this to fund the transaction, given the subdued cash position. “This could add to the funding cost in the near term,” says G Chokkalingam, managing director at Equinomics Research.

Some analysts believe the entities would get more pricing power after the deal, which could help protect profitability. However, near-term profitability pressure cannot be ruled out, as the interest on expected additional borrowings would have to be paid from operational profits. Positively, the impact of higher funding cost can be absorbed, unless this crosses the return on net worth. REC’s return on net worth, as of June, was a little over 18 per cent. Versus a 7.3 per cent cost of funding (PFC’s return on net worth was 14.3 per cent and funding cost was around eight per cent as of September).

From the latest available reports of these entities, their capital position is satisfactory and above the Reserve Bank of India’s minimum requirement of 15 per cent. Even their tier-1 capital ratio is above RBI’s requirement of 10 per cent. But, if the deal goes through, this could change. “The acquiring company mighty have to knock off its investment in the company getting acquired while calculating its regulatory capital ratios. This might lead to a significant weakening in its capital ratios. Any deal needs to consider this,” says Anil Gupta, head-financial sector ratings at ICRA. The inadequate capital base could in turn hamper balance sheet growth. Advances of these two companies grew at an annual 9-10 per cent over the three years ended March 2018.

Even if PFC acquires REC, the worries remain the same, say analysts. Still, they are positive on the attractively valued stocks, given that their bad loan cycle has peaked out and a strong provision coverage ratio (45-50 per cent), which limits future provisioning requirement. PFC and REC currently trade below their respective estimated FY20 book values.