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Pivoting to enhance performance stability

RoA/RoE to structurally improve to 2%/13% respectively by FY25

* Mahindra Finance (MMFS) has over the last 18 months embarked on multiple strategic initiatives, which we believe will lead to 1) lower operating cost ratios through improved productivity aided by higher efficiencies, 2) sustainable improvement in asset quality resulting in lower credit costs, 3) much better risk management by leveraging analytics/business intelligence, and 4) improvement in business volumes by targeting the affluent rural and semi-urban (RUSU) customer segment with relevant lifecycle products.

* Rural demand, which is already showing green-shoots of revival, should improve further, driven by higher rural spending (in the year leading up to the general elections), improvement in mining activity and the opening up of the contracting segment. A better minimum support price (MSP) and better agri yields for customers in the agri ecosystem should result in healthy rural cash-flows and would help to sustain demand even beyond the narrative of general elections.

* MMFS has significantly beefed up the processes around repossessions and additional safeguards have been built. The regulator has seen through all the measures undertaken by the company and has revoked the ban on deploying third-party collection agencies. This will now aid improvement in repossessions activity and prevent any volatility in asset quality (which could have otherwise been there).

* Mahindra & Mahindra Financial (MMFS) appointed Mr. Raul Rebello (current COO) as the MD & CEO designate and he will assume charge after Mr. Ramesh Iyer (the current MD & CEO) superannuates in Apr’24. We expect this to be a smooth and seamless transition given that Mr. Rebello (ex-Axis Bank) has been with MMFS for the last ~18 months and he has been at the forefront in strengthening the operational framework.

* We model an AUM/PAT CAGR of 18%/17% over FY23-FY25E with an RoA/RoE of 2.0%/13% in FY25E. MMFS is also part of our model portfolio. We retain our BUY rating on the stock with a TP of INR285 (premised on 1.8x FY25E P/BV). Key risk to our call: external disruptions like COVID waves leading to volatility in asset quality and credit costs.

Demand momentum to sustain; M&M auto volumes are further enablers

* In addition to expected buoyancy in rural demand from election-related spending, MMFS is actively participating in M&M’s urban vehicle segment. Catering to the RUSU affluent customer segment could hurt margins, which can be offset by lower opex and credit costs.

* The contribution of M&M’s assets to MMFS’ AUM stood at 43% in Dec’22 and has been in the range of 40-45% over the last four years. We expect MMFS to continue to benefit from higher volumes of M&M, particularly in the UV segment, which has always been the former’s strength.

* Non-vehicle products like consumer loans, SME loans and leasing will also start contributing to the loan mix from FY25 onward. Management targets to grow this segment to 15% of the mix in the next three to five years.

Strategic initiatives to drive potential transformation

* To achieve its Vision 2025, MMFS has introduced multiple initiatives and formulated goals to firmly secure some of the articulated targets. These initiatives include: 1) scaling up new growth engines, 2) changing customer segment mix, 3) diversifying product mix, 4) having collection war-rooms and legal efforts, 5) leveraging AI/ML models by hiring quality tech and data science teams, and 6) empowering employees with the latest technology to improve productivity and drive process optimization.

* The company has also effected process-level changes in origination and collections. On the origination side, it aims to cut down the bottom 2% of tail customers, who exhibit the highest vulnerability. On the collection side, it is keeping a hawk-eye view on the performance of new originations and the field staff is better equipped with insights from data analytics.

Reduction in opex ratio to mitigate the impact of margin compression

* MMFS (as well as the other vehicle financiers) is expected to remain vulnerable to margin compression in FY24. Given that MMFS is targeting M&M’s urban vehicle segment and the RUSU affluent segment, organic yields could be under pressure. Moreover, given that banks remain aggressive in retail loans, vehicle financiers have (until now) not been able to take significant IRR increases on new disbursements.

* The company has invested in scaling up teams in its new businesses like Digital Finance and Leasing. It has also invested in technology and data analytics to drive improvements across origination, underwriting and collections. We expect that productivity improvements and operating efficiencies should lead to a moderation in the cost ratio. We estimate the opex-to-average asset ratio to fall to 2.8% by FY25 from 3.1% in FY23E.

Volatility in asset quality to subside; credit costs at ~2% in FY24-FY25E

* After the implementation of the RBI NPA circular, we expect GNPAs (under IRACP) to be higher than Ind-AS Stage 3 (GS3) by ~INR12-15b on a steady state basis. Both the GS3 and GNPAs can be contained below 4% and 6%, respectively, and there will be no additional provisioning requirement.

* Given better customer selection (by culling out the most vulnerable segment) and the implementation of initiatives to monitor early warning signals and equip the field collection team with data insights, we expect that volatility in asset quality will significantly subside. We model credit costs of ~2% over FY24-25E.

Higher performance stability on the cards – Maintain BUY

* While MMFS has exhibited volatile operating performance and weak asset quality in the past, we believe that the various strategic initiatives undertaken by the management, if executed correctly, have the potential to script a credible transformation.

* Deep moats in rural/semi-urban customer segment position MMFS well to reap rewards of the hard work that is going into evolving this franchise.

* We model an AUM/ PAT CAGR of 18%/17% over FY23-FY25E for an RoA/RoE of 2.0%/13% in FY25E, respectively. Maintain our BUY rating on the stock with a TP of INR285 (premised on 1.8x FY25E P/BV).

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