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Earnings reflect normalization of credit costs going ahead

* L&T Finance Holdings (LTFH) reported Q2FY23 PAT of Rs4.1bn. Excluding income from the discontinued business, PAT was 2% above our estimates. Disbursements increased 5.6% QoQ/50.6% YoY, driven by micro finance and consumer loans. AUM grew 2.3% QoQ/3.6% YoY. With focus on retailisation increasing, the share of retail stood at 58% of AUM (Q2FY22: 47%). NIMs increased 44bps QoQ to 7.4%, reflecting the impact of the higher-yielding retail loans, while CoFs saw a modest rise. Opex remained elevated during the quarter, on account of higher employee-benefit expenses and continued investment in technology and branches. Cost-to-income ratio stood at 37.8% (Q1: 35.8%). As a result, pre-provision operating profit came in at Rs11.3bn, in line with our estimates.

* Of the estimated retail unsecured OTR pool of ~Rs11.2bn, Rs4.2bn moved into GS3 during Q2. Against this, the management utilized Rs3.5bn of macro-prudential provisions to fully provide for the loans. The remaining OTR book is largely for home loans, of ~Rs9bn, of which ~Rs6.5bn will come out of restructuring in the next fiscal. Taking into account the write-off on unsecured retail restructured assets and other standard assets, GS3 and NS3 marginally improved to 4.02% and 1.85%, respectively. P&L credit costs have normalized to a run-rate of ~Rs5.8bn per quarter. With the approval for sale of LTIM now received from SEBI, the transaction is expected to be completed in Q3FY23; we expect the resultant gain of ~Rs23bn to be added to the provision overlay for RE assets.

* We retain our BUY rating with unchanged Sep-23E TP of Rs100, valuing the lending business based on the ‘excess return on equity’ method. Our TP implies Sep-24E price/BVPS of 1.0x. Key downside risks: Additional provision cover on its real-estate finance portfolio; weakness in the rural household balance sheets resulting in higher NPAs in the rural portfolio.

* What we liked: 1) Strong disbursement growth in higher-yielding retail loans augurs well for margins. 2) Credit costs from the retail unsecured OTR pool are now largely behind. What we didn’t like: Delay in resolution of the real-estate and infra-financing portfolios via stake sales or introduction of new partners.

* Earning call KTAs: 1) LTFH retained its guidance for retail-portfolio CAGR of 25% and for the share of retail in overall AUM reaching 80% by FY26. 2) While interest costs will rise, the pace would be slower than the broader market’s due to its prudent ALM. This, coupled with asset mix changes, will aid in maintaining stable NIM+Fees. 3) Higher RE collection during the quarter, due to project resolution. LTFH received Rs8.5bn in Q2 in the form of principal pre-payment and repayment. The overall RE book stands at Rs91.4bn. 4) Gain from sale of LTIM will be mainly used for strengthening the balance sheet. In our view, the management overlay for the RE book could increase to Rs23bn post Q3FY23.

* Change in estimates: We revise upwards our credit cost estimates for FY23 by 34bps to 5.7% to reflect the higher write-off of the stressed loans from the unsecured retail pool undertaken in Q2FY23. We broadly retain our estimates for FY24/25.

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