Street cautiously optimistic on PFC and REC

But companies will be hit if regulators act tough on coal block allocations termed illegal by SC

Stocks of Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) have underperformed the S&P BSE Sensex recently by a huge margin. Since July 14, PFC and REC have fallen 12 per cent and 18.6 per cent, respectively, against a 6.4 per cent rise in the Sensex.

Part of the reason is the strong rally in PFC (up 135 per cent) and REC (54 per cent) over the past year. These stocks had run-up in anticipation of power sector reforms (after formation of a stable government at the Centre), key to PFC and REC's prospects.

While the recent fall could be partly taken as a correction, Digant Haria, AVP Research, Antique Stock Broking, says increasing competition from banks in the infrastructure space, along with no improvement in the on-ground situation of power companies, has pulled PFC and REC stocks down.

The Supreme Court's verdict declaring coal mine allocations since 1993 illegal or arbitrary has added to weak sentiment. Analysts say a blanket de-allocation will put pressure not only on the asset quality but also credit offtake for both PFC and REC. Though the final decision on further action is awaited, the Street feels such stringent measures are unlikely. As a result, most remain positive on these two stocks. While BNP Paribas came out with a 'Buy' call on REC, with a target price of Rs 381 on Tuesday, Haria remains positive on the scrips over the next two years, as he believes power sector reforms are likely.

Notably, most analysts were already factoring weakening growth and asset quality for these companies in FY15. While they estimate net interest income (NII) growth to fall from 35.2 per cent and 28 per cent to 13.9 per cent and 14.4 per cent for PFC and REC, respectively, in FY15, net profit growth, too, is likely to taper from 22.7 per cent each to about 11.8 per cent for PFC and 20.7 per cent for REC. The gross non-performing asset (NPA) ratio is also expected to inch up marginally, and so is loan growth expected to get slower, again marginally to 16-18 per cent in FY15. In FY16, most of the metrics, however, are expected to remain at FY15 levels.

This is also reflecting in the reasonable valuations (about 0.9 times FY16 estimated earnings), which along with attractive return ratios (return on equity of 21-25 per cent and return on assets of 3.1-3.4 per cent), makes a strong case for long-term investment in these companies. The recent average target price of analysts indicates upside potential of 30 per cent for PFC and about 36 per cent for REC.

Larger gains could come if power sector reforms accelerate and there is no adverse ruling on coal mines allocation, which otherwise can add pressure on their financials and share price.