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Magma Fincorp’s (Magma) Q3FY21 earnings were a mixed bag as rise in vulnerable pool (stage-2 plus stage-3) and higher credit cost (>500bps) were offset by stringent cost controls and better NIMs (due to focus on high-yielding products). MoM improvement in collection efficiency (97% in Jan’21) and overall provisioning buffer of 5.3% suggest that stress should peak out soon. Strategically, Magma has stopped sourcing low-RoA products (namely new cars, CV, CE, etc.) and will deploy the capital release towards focused products (used assets, tractors, housing). While this will structurally enhance margins and return profile, it will also lead to balance sheet consolidation and modest AUM growth in the interim. Business reorganisation and consolidation phase has depressed the valuation multiple sub-0.5x, but is now looking up (from medium-term perspective). Also, value discovery in housing finance and general insurance, being in an advanced stage, can be a key rerating trigger. Upgrade to BUY with a revised target price of Rs95 (previously: Rs40) assigning a multiple of 0.8x consolidated FY23E book value.

* Focus on collections; efficiency improving MoM: Collection efficiency has been improving MoM and reached 97% in Jan’21 from 94%/90%/90%/85% in Dec / Nov / Oct / Sep’20. For the asset finance business, collection efficiency of 98.8% is almost at preCovid levels. With recovery and resolution efforts, customers in moratorium portfolio, who have not paid even one EMI till Dec’20, are consistently declining and now stand at Rs2.8bn (1.9%, down from 3.8%/9.6% in Oct/Sep’20).

* Stage-2 plus stage-3 pool (including restructuring) widens to 18.8%: Proforma gross stage-3 assets have risen to 6.9% (from 5.1%/5.8% in Q2FY21/Q1FY21) and consequently net stage-3 expanded to 4.5% (from 3.2% in Q2FY21). Stage-2 assets too spiked to 11.8% in Q3FY21 (from 5.4% in Q2FY21). The vulnerable pool (stage-2 plus stage-3), compared to 16% at the end of Mar’20 has now widened to 18.8%. Nonetheless, this includes the restructured portfolio worth Rs2.8bn (1.9% of AUM) till date, on which the company is carrying provisioning of 15%. It expects overall restructured portfolio at 4.5-5.0% by Mar’21 (compared to earlier guidance of 3%). Further flow-through into stage-2 and stage-3 will be the key risk to earnings.

* Bucket-wise movement leads to higher credit cost; should peak out now: Movement of Covid-stressed portfolio to higher bucket led to higher credit cost of >500bps (provision of Rs1.82bn was made in Q3FY21). After utilising some portion of the contingency buffer, contingency provisioning is now down to Rs1.5bn (1.1%) from Rs2.4bn (1.5%) in Q2FY21. Repossession, release and settlement cases are returning to pre-Covid levels, which is also reflected in loss on settlement/repo. Coverage on stages-1&2 assets stays flat at 3.0% and provisioning on on-balance sheet assets is up 50bps QoQ to 5.3%. With strategic shift in business mix, we are building-in credit cost of 3.0-3.5% over FY21E/FY22E/FY23E.

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