UDAY an unlikely hero in PFC, REC rally

Financial aid to SEBs under the scheme helps in substantial loan prepayment; lower cost of funds to aid profit margins

The stocks of Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) have recovered around 30 per cent and 46 per cent, respectively, from their 52-week low in February. This is despite reports from brokerages questioning the road ahead for them, given the strained financials of state electricity boards (SEBs).

However, what was earlier perceived as a potential disadvantage for these institutions is now working to their advantage. For instance, PFC garnered Rs 4,500 crore as loan prepayment from SEBs in FY16 and similar gains are expected in FY17. These prepayments are due to SEBs opting for financial aid under the UDAY or Ujwal Discom Assurance Yojana. REC benefited by Rs 10,000 crore in FY16 for the same reason.

Reports suggest PFC is likely to see loan prepayment of Rs 21,500 crore from SEBs participating in UDAY; for REC, the expected amount is Rs 35,000–40,000 crore. These will flow in over the next few years. Hence, in the near term, they provide higher earnings visibility, as the companies will be able to book interest income in their profit & loss statement. This is in contrast to the case if they'd opted for receiving bonds in lieu of the loans to SEBs, as the interest receivable would have not immediately reflected in the earnings.

Analysts also say while SEBs participating in UDAY could limit the fund utilisation for PFC and REC (given the loan prepayment), it at least helps arrest likely defaults on loan repayments. In fact, factoring for the benefit of delayed UDAY implementation, analysts at Edelweiss have revised their FY17 earnings per share estimate of PFC and REC upwards by six per cent and 23 per cent, respectively.

However, how these additional funds are used will guide the further course of re-rating. For now, the Street is not pleased with PFC and REC bailing out a few state-owned banks in FY16 by using the prepayment inflows and will be keeping an eye out for such transactions. A note by Jefferies says the investment by REC in (bonds of) Syndicate Bank, Vijaya Bank and Indian Bank are unhealthy. Analysts in Edelweiss are also cautious about the prepayment amount received by PFC being deployed towards buying bonds of Dena Bank and Andhra Bank. “Any similar usage of incremental prepaid amount will reflect negatively on the company”, the note warns.

PFC and REC have said there'd be increased loan disbursal towards renewable power projects but the Street will keenly gauge the progress on this front.

Declining bond yields is also keeping the two stocks buoyant for now. “PFC and REC might utilise this trend of falling yields to repurchase the old bonds (at pre-determined value, by exercising call option) and reissue these at lower rates,” says an analyst from a domestic brokerage. “Though we don’t have an update on whether the power finance companies have opted for this, a move in this direction can lift up their net interest margins (NIMs). “Lately, the NIMs of both financiers have come under pressure (4.43-4.5 per cent) and are well off their peak of over five per cent. As a little over 80 per cent of the funding requirement of PFC is met through issuance of bonds, 65 per cent in the case of REC, any breather in the cost of funds will be incremental for NIMs.

While these are the near-term tailwinds for PFC and REC that could give significant fillip to FY17 earnings, larger concerns on weak electricity demand and its underlying impact on declining disbursals towards power generation projects persist. These concerns could remain a medium-term overhang for the stocks, unless the companies can sustain loan growth by disbursing to related sectors like renewables.