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Newer businesses to become RoA accretive from FY25 and aid RoA expansion

* Cholamandalam Finance (CIFC) has made a big push towards reducing the cyclicality, which is so inherent in its core vehicle financing business. As a result of its focused efforts to diversify the mix, CIFC's disbursements in FY23 were buoyed by robust performances in Home Loans, LAP, CSEL, SBPL and SME segments.

* In addition to product diversification, the overall loan portfolio is also geographically well spread out with presence across 29 states. The largest state accounts for just 11% of its Vehicle Finance loan book as on Mar’23. Such diversification provides flexibility in re-orienting the portfolio based on market opportunities. In addition, over 80% of its branches are located in tier III-IV towns.

* CIFC has managed its liabilities very well by maintaining a healthy mix of its EBLRlinked and MCLR-linked bank term loans. With expectations that the interest rates have largely peaked and will subsequently start abating, we forecast vehicle finance margins to first plateau and eventually expand from 2QFY24 onwards.

* Our deeper understanding of the approach undertaken by CIFC to build the new businesses has made our conviction stronger that the company may not repeat the follies from a decade back when it forayed into consumer finance through a JV with DBS Bank. While the investments in creating newer business lines will keep the opex ratio elevated in FY24E, we expect these businesses (CSEL and SBPL) to become RoA accretive from FY25 onwards and contribute to the company-level RoA expansion to ~3%.

* We model an AUM/PAT CAGR of 23%/32% over FY23-25, with an RoA/RoE of 3.0%/23.3% in FY25. While its current valuation of 4.4x FY25E P/BV appears expensive, we believe that the scarcity of high-quality NBFC franchises, which have high predictability of strong earnings will keep its valuations elevated. Reiterate BUY with a TP of INR1,350 (premised on 5.0x FY25E P/BV).

Risk-calibrated expansion strategy to scale the three newer businesses

* For a company with the lineage, track record, and balance sheet strength like CIFC, we would believe that it would be able to tap the huge opportunities present in Consumer, MSME, and SME loans with a diversified suite of products for its targeted segment of middle-of-the-pyramid customers.

* CIFC is planning to take a cautious approach in scaling up the newer product segments and it will remain steadfast in pursuing a risk-calibrated expansion strategy. Management diligently tracks the monthly disbursement run-rates in each of the newer productsegments, taking into account factors such as bounce rates, delinquencies, and the underlying asset quality.

* CIFC also has plans to roll-out its own consumer app that will be equipped to handle the Consumer and Small Enterprise (CSEL) products end-to-end and the app can also serve as the origination platform for all other product segments. This consumer app, in our view, will reduce the dependence on digital partnerships over time

* We estimate an AUM CAGR of 19%, 23%, 34%, and 44% for CIFC over FY23-25 in its Vehicle Finance, LAP, Home Loans, and Newer Business segments, respectively, translating into an overall AUM CAGR of 23% over the same period.

Margins should bottom out and gradually improve as rates stabilize

* CIFC has strategically managed the composition of its loan portfolio (both within vehicle finance and non-auto segments) to achieve healthy blended yields. Further, effective management of the liability mix and prioritizing borrowings under the PSL guidelines have helped CIFC manage its CoF efficiently, despite the rising repo rates (by 250bp) in FY23.

* As interest rates peak, margins will stabilize over the next 1-2 quarters. Subsequently, we expect margins in the vehicle finance industry to expand gradually as the existing book is replaced with higher-yielding new loans.

* CIFC has already rationalized the excess liquidity on its balance sheet and has optimized its product mix to prioritize higher-yielding segments. We expect NIMs to expand ~5bp to 7.1% in FY24 and to further improve to 7.3% in FY25. The company can flex the levers of opex ratios and margins to drive improvement in its return profile

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