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* Fusion Microfinance (Fusion) is the second largest NBFC-MFI in India having an AUM of ~INR93b as of Mar’23. It’s AUM has reported a 43% CAGR over FY18-FY23 (v/s micro-credit industry CAGR of 21%). Fusion has a diversified presence across 20 states (including two UTs) with a distribution network of over 1,086 branches. The company is likely to benefit from the cyclical recovery in the MFI sector and also from the harmonized MFI guidelines, which were published esarlier in Mar’22.

* Fusion has grown its borrower base at a 28% CAGR over FY18-FY23 and enjoyed a strong rural presence with its portfolio comprising ~93% of rural AUM. The company’s average ticket size (ATS) of ~INR38K (one of the lowest in the industry) has clocked 10% CAGR during this period. This implies its ability to showcase loan growth through borrower additions.

* Fusion has managed its risks well with less AUM concentration (no state/ district contributed more than 20%/3% of its AUM). It has a strong presence in Bihar, UP, Odisha, MP and Rajasthan that have relatively lower MFI penetration. Fusion has also managed to curb its presence in a few relatively vulnerable states like Assam/West Bengal/Maharashtra to ~4% of its total branches.

* Fusion has managed the Covid-induced stress relatively well with GNPA and the restructured book declining to 3.5% and 0.2%, respectively, in Mar’23. Credit cost, which was at 6.9% in FY22, has moderated to 2.8% in FY23. We expect it to decline sustainably to ~1.9% by FY25.

* Fusion has a strong and diversified liability franchise with relationships across private/PSU banks and foreign institutions. The company should see the benefit of the recent credit rating upgrade (to A Stable) in its borrowing costs. After the equity raise during the IPO, its CRAR stood at ~28% as of Mar’23 and is now strongly capitalized for growth.

* We model an AUM and PAT CAGR of 28% and 37% over FY23-FY25E, respectively, driven by strong borrower additions, NIM improvement, operating leverage and moderation in credit costs. These will also lead to an improvement in the return ratios and we estimate RoA/RoE of ~5.5%/22.5% in FY25. Fusion currently trades at 1.7x FY25E P/BV and we believe its valuations would re-rate as it demonstrates healthy execution on loan growth and asset quality. Initiate coverage with a BUY rating and a TP of INR720 (based on 2.0x FY25E P/BV).

* Key risks include: a) Political interference, announcement of loan waivers or natural calamity resulting in asset quality deterioration, b) regulatory changes towards asset recognition and provisioning and c) increase in competitive intensity leading to NIM compression.

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