PFC, REC have more upside room

But a change in accounting policy for restructured loans could hurt in the near term

The shares of Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) have outperformed the benchmark Sensex over the past year on the BSE exchange. Both companies would gain significantly from power sector reforms (among the priorities of the new government) through better credit offtake, improved asset quality and profitability.

Not surprisingly, analysts are bullish on the stocks. Of the 24 polled by Bloomberg since May, 19 have a Buy, four have a Hold and only one has a Sell rating on the PFC scrip. Their average target price is Rs 342, an upside of 15 per cent from current levels. For REC, of 21 analysts polled, one each has a Hold and Sell rating, with the rest having a Buy. Their average target price is Rs 374, indicating potential upside of nine per cent.

Manish Shukla, research analyst at Deutsche Bank Markets Research, says he has raised REC's FY15 estimated earnings by four per cent, factoring in a better net interest margin (NIM). “We have also raised our medium-term earnings growth estimate to 10 per cent, from seven 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 for the two companies. Both follow their own accounting norms for restructuring of loans. However, the Reserve Bank of India (RBI) had asked them to follow the same norms as banks in this regard. Though both have written to RBI for clarity on complying with this, the stress on their asset quality could increase significantly, believe analysts.

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

“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 for reported earnings,” says Darpin Shah of HDFC Securities.

For now, the situation is comforting, given that the gross non-performing assets as a proportion of the loan book was 0.4 per cent for REC and 0.7 per cent for PFC in FY14, much lower than those of leading public sector banks (five per cent and above).

The positives of recovery might partly offset the negative impact. Notably, both scrips trade at a reasonable 1.3 times the FY15 estimated adjusted book value.