Earnings rebound seen for PFC, REC by 2020-21 on 50-60% NPA provision

Though analysts have turned positive, stocks remain prone to asset quality shocks

After underperforming the broader markets, stocks of power financiers Power Finance Corporation (PFC) and REC (formerly Rural Electrification Corporation) are figuring in the return charts. The two stocks have gained 24-30 per cent each over the past year, though the Street was not too positive after their merger was announced in November last year.
 
While there hasn’t been a material change in financials, asset quality issues and state utilities, including state electricity boards (SEBs) making fresh investments, are leading to the Street’s optimism.
 
CLSA, which recently turned optimistic on PFC changing its recommendation from ‘sell’ to ‘buy’, says that with the risk-reward turning positive, earnings rebound will begin in 2020-21 once PFC and REC provide for 50–60 per cent of the non-performing assets. The brokerage also feels that both firms should benefit from the resolution process underway for some of the stressed names such as GMR Chhattisgarh Energy and Lanco Infratech.
 
However, while sentiments are turning for the good, investors should still be aware of the risks the stock could be vulnerable to. To start with, one of the key advantages that PFC and REC enjoyed was that of net interest margin (NIM) upwards of 4 per cent. Over the years, both have slipped on this parameter.

 
In the April-June quarter (first quarter, or Q1), PFC recorded NIM of 3.1 per cent, which is the weakest in five years. While costlier funding has hurt PFC, with marginal cost of borrowing at an all-time high of 9.57 per cent in Q1, analysts at CLSA say they do not see upside to margins, as the fall in funding costs will be offset by lower yields and spreads on loans to state electricity boards (SEBs).
 
Secondly, while a large part of the stress (30 projects totalling to Rs 34,000 crore) has been provided for (35-60 per cent) and resolution is anticipated in some of the projects, vulnerability to further asset quality shocks does exist and provisioning costs may remain elevated over the next three-six quarters. Therefore, much of the earnings uptick hinges on recovery and PFC’s ability to cash in on selective capital expenditure visible in SEB and state utilities. Analysts expect loan growth to marginally revive in 2019-20 (FY20) and peg it about 13–15 per cent led by state orders.
 
Amidst these concerns, benign valuations at 0.6x FY20 book and PFC’s positioning as dividend yielding stock could appeal to investors. However, with concerns not entirely fading away, investors need to be cautious on the stock.