Rally in PFC, REC may be short-lived

Caution amid expectations of muted credit demand, earnings growth, shrinking return ratios

Stocks of power financiers, Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) are up seven to 14 per cent in the past month, after a rally in broader markets. But, this trend is unlikely to sustain and the stocks are expected to again lag behind markets as in the past six months.

A reason for the under-performance is that after the implementation of power reforms, particularly the Ujwal Discom Assurance Yojana (Uday), loan demand from state electricity boards (SEBs) is expected to trend southwards. Also, under Uday, SEB loans are expected to be converted into low-yielding state government bonds, hitting PFC and REC. Even if SEB loans are taken over by the states with REC and PFC getting paid upfront, it will lead to their loan books shrinking.

Second, a large chunk of these companies’ private sector loans are in the impaired/bad loans category — about 70 per cent for PFC and 40 per cent for REC, estimate analysts. Thus, the consensus is PFC and REC’s net profit might fall 1.3 and 5.4 per cent, respectively, in FY17. Their return on equity (RoE) ratio, too, is expected to dip 100-200 basis points in FY17.

Suresh Ganapathy, analyst at Macquarie Capital, says, “Private sector balance sheets are stretched and their ability to borrow is limited. PFC and REC will now have excess capital, without having meaningful avenues to deploy, leading to questions around their existence.” He has trimmed earnings estimates for PFC and REC by 30-40 per cent for FY17-18 and believes these companies should increase dividend payouts.

E-mails to both companies did not get response. These companies have grown their loan books apparently by taking higher risks. An analyst with a domestic brokerage said the companies had been ever-greening loans given to private sector players. Ever-greening refers to the extension of short-term line of credit that is routinely renewed to service existing loans (principal remains outstanding) to prevent such loans from being classified as bad ones.

Any spill-over from such loans could hurt asset quality.

Unless capital expenditure from private power players or order inflow from SEBs (undertaking Uday to boost their distribution and lower transmission and distribution losses) picks up meaningfully or if the companies focus on renewable energy to drive loan growth, their financials will remain under pressure.