Q2FY19 preview: NBFCs' medium-term challenges to stay; not yet time for buy

Asset quality for NBFCs has so far been under control, but a sharp rise in interest can start having some issues with interest servicing capability of borrowers

Non-banking financial companies (NBFCs) in India or across the globe have a simple business model —  borrow from banks or capital markets in the form of non-convertible debentures (NCD) or (commercial papers) CPs or any other financial instruments and lend to end users. While the regulator/nodal agencies like RBI/ NHB (National Housing Bank) also lend to the set of finance companies, a large part of the borrowing has to be done from the markets to meet their business growth.

While the business model looks easy on the face of it, it is a complex process as the NBFCs/HFCs (housing finance companies) have to balance the maturity profile of the assets they finance and the borrowings they take. Any mismatch in the same can really hit the margins hard and that is what the fear has been currently in the Indian markets for NBFCs. The rate at which the NBFCs borrow in India is linked to the 10-year G-Sec yield.  The rate has been on a continuous rise. In the last three months, it has gone up by 25 bps and in six months by 102 bps and in last one year it has gone up by a whopping 139 bps. Thus, looking at the current liquidity scenario, it is very unlikely that the trend will reverse.

As mentioned earlier, HFCs had been operating on thin margins and the rise in the cost of funding will certainly impact their spread and net interest margin (NIM) in the medium term. Further, the difficult part is that HFCs can’t pass on the entire rise in the cost of funds to the borrowers, as banks still have enough liquidity and can finance those set of borrowers and there is a risk of customer migrating from HFCs to banks. So, it is fair to assume that HFCs will take a margin hit in the near term.

Asset quality for NBFCs has so far been under control, however, a sharp rise in the interest can start having some issues with interest servicing capability of borrowers. But the risk with regards to loan against property (LAP) is more, compared to the individual investors. If we look at the last three years, loan growth of HFCs has been really strong over FY15-18, DHFL has reported 22 per cent CAGR (compound annual growth rate), PNB Housing 50 per cent CAGR, and Small HFCs like Can Fin Homes have grown by 24 per cent CAGR.

Looking at the current scenario, we believe the NBFCs, both asset financing as well as HFCs, will have to tone down their growth rates, which is logical as well. The market has taken cognizance of the slowdown in the business and hit in margins and accordingly, the stocks have corrected sharply. However, we feel the damage in terms of price has been quite significant in the last few weeks.

In the medium-term, challenges will persist but NBFCs have not only survived but also grown with healthy profitability over the last many years, despite competition from banks. While we don’t suggest venturing and buying NBFC stocks immediately, investors should wait for the dust to settle before taking positions in the space. Again within the NBFC space, we believe the asset financing companies/ vehicle financing companies should see faster rebound vis-a-vis the HFCs when things turn around.

Siddharth Purohit is research analyst at SMC Institutional Equities