It may be a good time to hook on to PFC, REC

Power sector reforms will benefit the two entities, which are trading at reasonable valuations

Leading power financiers Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) have outperformed the broader markets in the past week. The government's focus on improving the health of sick state electricity boards (SEBs) is a key reason behind the improving sentiments. Reforms in SEBs will make them financially stronger allowing them to purchase more power from generation companies, many of whom are faced with under-utilised capacities. In turn, the move will increase revenues for power generation companies helping them better service their high debts. Consequently, asset quality as well as credit growth of power financiers will improve.

Notably, power generation companies account for a large part of loan books of both PFC (73 per cent) and REC (42 per cent). Thus, while Coal India is trying to address the issue of fuel availability, improvement in offtake by power generation companies will be a key trigger for the power lenders.

Although these companies stand to gain from power sector reforms, these are likely to be gradual in nature. Further, the numbers will be reflected in the power financiers’ balance sheet with a lag effect. Positively, both these stocks are trading at reasonable valuations and can be considered by long-term investors. At Thursday’s closing prices, both PFC and REC stocks are trading at one time their estimated FY16 book values. Healthy return on equity ratio of 20 per cent for PFC and 23 per cent for REC in FY15 are the other positives.

High yield from SEB loans, which are also sub-sovereign in nature, is one factor boosting the profitability of power financiers. Despite their poor health, SEB loans have not led to actual losses for the lenders. Going forward, though, margins of power financing companies could see some pressure if SEBs were to re-negotiate interest rates with them.

Despite continued pressure in the power sector, asset quality ratios remain healthy for both PFC and REC with gross non-performing assets ratio at relatively lower levels of 1.3 per cent and 0.9 per cent, respectively. However, a key downside risk arises from the difference in classification of restructured loans.

While REC follows RBI definition and covers both public and private sector borrowers, PFC's restructured loans only cover its private sector loans. Thus, PFC's restructured book does not reflect the actual asset quality stress in the SEB segment and, hence, is more vulnerable to negative surprises.

Going forward, implementation of power sector reforms is a pre-requisite for a meaningful improvement in the asset quality as well as prospects of these companies, say analysts.

In this backdrop and given the long-term growth potential, most analysts remain positive on the two companies. For FY16, analysts expect PFC and REC's loan growth to be at 12-13 per cent. They expect Power Grid to start the ordering for transmission and distribution projects for the 13th five-year Plan, which along with some activity in the generation space augurs well for the financiers.