PFC, REC: More room for upside

The power financiers will be key beneficiaries of likely power sector reforms, but a change in accounting policy regarding restructured loans to hurt in the near-term

Stocks of power financiers - Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) have outperformed the benchmark Sensex over the past one year. Both these companies stand to gain significantly from power sector reforms (which are amongst immediate priorities of the new government) in the form of better credit off-take, improved asset quality and profitability.

Not surprisingly, analysts are bullish on the stocks. Of the 24 analysts polled by Bloomberg since May 2014, 19 have a Buy and just four have a Hold, while only one has a Sell rating on the PFC scrip. Their average target price stands at Rs 342, an upside of 17 per cent from current levels. For REC, of 21 analysts polled since May, one each has a Hold and Sell rating with the rest having a Buy call. Their average target price stands at Rs 374, indicating potential upside of 11 per cent.

Manish Shukla, research analyst at Deutsche Bank Markets Research says that he has raised REC's FY15 estimated earnings by four per cent, factoring in better net interest margin (NIM). “We have also raised our medium-term earnings growth estimate to 10 per cent, from 7 per cent earlier, on the back of improving economic outlook and lower asset-quality risks. Consequently, we have raised our target price to Rs 380, from Rs 320", he adds.

While this optimism seems justified, there is a key risk surrounding the two companies. Both PFC and REC follow their own accounting norms for restructuring loans. However, RBI had asked them to start following same norms as banks in this regard. Though the two companies have written to RBI to get clarity and direction on complying with this norm, the stress on their asset quality could increase significantly, believe analysts.

"If RBI prescribes the restructuring norms similar to banks, PFC’s asset quality may deteriorate significantly, which may act as a hangover for the stock", says Amit Jain of Sunidhi Capital.

Gross non-performing assets (NPA, as a proportion of loan book) stood at 0.4 per cent for REC and 0.7 per cent for PFC in FY14 - much lower than that of leading PSU banks (five per cent and above).

"REC has seen a sharp run-up recently with hopes of reforms in the power sector. If reforms do play out, they will improve business visibility, help keep NIMs high and assure higher return ratios. REC enjoys regulatory arbitrage since it is not required to provide for rescheduled loans. To our mind, this is a key risk to reported earnings", says Darpin Shah of HDFC Securities.

However, positives of recovery may partly offset the negative impact. Both the scrips trade at a reasonable 1.3 times FY15 estimated adjusted book value currently.