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The stars are aligned!

Five-Star Business Finance (Five-Star) is a direct play on the increasing formalisation of credit, especially in the small-ticket business loan segment (total lending opportunity: Rs22trn). Peers include SCUF, Aavas, Aptus, HomeFirst, Equitas, AU, Repco, Can Fin, Veritas, Vistaar, etc. Barring SCUF and Repco, key players in similar ticket-size SME loans reported >30% AUM CAGR during FY18-FY23 while Five-Star delivered an industry-leading 47% during the same period. Notably, gross stage-3 assets and credit cost remaining at <2% during its high growth phase (FY17-FY23) is testimony to the company’s proven credit underwriting model built on >2 decades of experience in the segment in urban and semi-urban locations.

While its low leverage (‘debt to equity’ ratio at an average of 1.2x during FY15-FY23) has aided NIM at >17% since FY15, stable asset yield at ~24% (given ~30% new-to- credit customers imparting high pricing power) and ~135bps reduction in average cost of borrowing, even during rising rate cycle, improves visibility on it sustaining spread at 12-13% going ahead. We expect >25% AUM CAGR for Five-Star over FY23- FY25E on the back of: 1) one of the most extensive branch network of ~370 vs <300 for most peers as of Mar’23, 2) deep understanding of the customer segment it serves, and 3) focus on deepening presence in existing geographies. Overall, we believe Five-Star is poised to sustain industry-leading RoA of >7% and deliver RoE of >15% over FY23-FY25E. Initiate with BUY and a target price of Rs765, valuing the stock at 4x on Sep’24E BVPS.

* Scalability in small-ticket / self-employed financing is cognisant to distribution capabilities – Five-star has one of the most extensive branch networks. Since FY15, the company has added an average of 40 branches each year, taking its total branch count to 373 as of Mar’23 – highest among select peers (chart 7). We believe distribution infrastructure is a prerequisite to scale a business model involving high human touch. Five-Star’s focused target market is semi-urban and rural areas and self- employed customers with household-level net cashflows between Rs25,000 to Rs40,000 per month.

* Proprietary credit model built over >2 decades of experience in small-ticket SME financing is key enabler of pristine asset quality across cycles. While Five-Star’s target customers appear to be vulnerable to even the smallest external event, its careful customer selection, deep understanding of customer behaviour (gained through >2 decades of experience in catering to this customer segment) and preference for high customer equity (in collateral) have enabled it to maintain pristine asset quality across credit cycles. (refer table 1)

* 100% in-house sourcing, ~95% self-occupied residential property as collateral and conservative LTVs at ~38% provide resiliency to business model. Five- Star’s preference for customer-led growth journey rather than increasing average ticket-size requires detailed screening of borrowers before onboarding. With ‘spend time with borrowers before disbursements rather than on collections post onboarding’ philosophy, it has built 100% in-house operational capabilities – right from sales to credit to collections. In-house sourcing allows complete control over quality of customers approached for loan and the process involved in disbursements. Further, to contain probability of default (PD), the company strategically prefers self- occupied residential property as collateral and high customer equity. Also, maintaining LTVs at <40%, it has ring-fenced its loss given default (LGDs). Combination of these strategies reflects in its average GNPL at <2.5% and credit cost at <1% between FY17-FY23.

* Strong pricing power (serving underserved) and scale with stable asset quality are key enablers of steady >12% spread since 2018. Five-Star’s key strength is in its ability to acquire new customers that are not yet serviced by any formal lenders – as reflects in 63% CAGR in live accounts vs 55% CAGR in AUM between FY17-FY23. The same gives it strong pricing power – ~95% of loans sanctioned are priced between 24%-26%. Since FY18, reported yield has fluctuated in a narrow range of 10-20bps and remained at ~24%. Secondly, Five-Star has demonstrated robust financial performance as reflected in >50x growth in AUM, 10x growth in branch network and >60x growth in PAT during FY15-FY23. Notably, asset quality even during high growth phase remained pristine (average GNPL at <2.5% and credit cost at <1% between FY17-FY23). The same has enabled it to broad-base its lending relationships (30 lenders in FY19 to 50 in FY23). As a result, cost of borrowing steadily fell to 10.1% by Mar’23 from 11.1% in FY19 despite the rising rate cycle. Combination of strong pricing power and declining cost of borrowing led to spread improving to 14% by Mar’23 from 12.1% in FY20.

* Valuation. Five Star, with a two decade-long experience in self-employed business loans, well-diversified borrowing profile, strong pricing power and stable management team, is likely to emerge as a preferred player to gain exposure to India’s financial inclusion story. We initiate coverage on Five Star with a BUY rating and target price of Rs765, valuing the stock at 4x Sep-24E BVPS. Stock is currently trading at 3.1x FY25 BVPS, at par with Aptus and Home First, FY25E PBV multiple at 3.1x. Considering better return & growth outlook, we believe Five Star would command premium over peers.

* Key risks. Deceleration in AUM growth, and stress unfolding higher than anticipated.

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