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Sharp deterioration in asset quality; stress pool getting bigger

Weak operating performance and elevated credit costs led to a net loss

* MMFS reported a net loss of INR15.3b v/s our PAT estimate of +INR2.9b. While operating profit declined by 28% YoY to INR7.5b (31% miss), higher credit costs of INR28.2b (est. INR7b) drove the PAT miss. Elevated credit costs are a function of forward flows into S2/S3, higher provisions on restructured loans, and additional COVID-19 provisions to strengthen the ECL overlay.

* NII was down by 16% YoY/25% QoQ, driven by: a) interest income reversals on NPAs, b) 6% YoY decline in business assets, and c) some moderation in loan yields. NIM (calculated) stood at 8.04%, down 60bp YoY. Total credit costs stood at 4.84% (non-annualized).

* MMFS has always exhibited the highest volatility in asset quality and associated credit costs within its peer set. In an unfavorable external environment, its asset quality has exhibited vulnerability and has taken 12- 18 months for some normalcy to return. On a low base, we cut estimates sharply for FY22E to factor in up-fronting of provisioning expenses. We maintain our Buy rating with a TP of INR175 per share (1.3x FY23E BVPS)

Forward flows into S2/S3; restructuring at 3.5%; ECLGS muted

* The GS 2/3 loan ratio increased by 680bp/650bp QoQ to 19.4%/15.5%. Despite elevated provisions, PCR on S3 declined to ~54% (from ~58% QoQ). ECL/EAD stood at 11.3% and improved ~400bp QoQ.

* Write-offs stood ~INR3b (v/s INR630m QoQ). The company made additional COVID-19 provisions of INR3.93b (standalone) in 1QFY22, with total COVID-19 provisions of INR28.1b (~4.3% of business assets).

* MMFS restructured loans worth INR21.72b (standalone) in 1QFY22, with the total restructured pool at INR22.35b (3.5% of business assets). A large part of this was classified under Stage 2, and MMFS made additional provisions of INR1.57b on the restructured pool (PCR: ~17%).

* ECLGS disbursements in 1QFY22 remained muted (at INR270m), with total disbursements under the scheme at INR5.55b (~0.9% of loans).

Moderation in yields leads to a decline in NIM; disbursements decent

* Interest income fell ~17% QoQ, with: a) interest income reversals of INR2b on NPAs, b) moderation of 15-20bp in incremental yields, and c) about 2% QoQ decline in business assets being the contributing factors. Despite the slight mitigation from lower CoF, NIM fell 210bp QoQ/60bp YoY.

* Disbursements were down 35% QoQ to INR38.7b. MMFS maintained its market share across product segments (ex-tractors) and remained conservative in the CV/CE segment. While agri-tractor demand has been robust, commercial-use/haulage tractor demand were impacted in the last 12-18 months. Pure agri-tractors form ~30% of its tractor portfolio.

* Collection efficiency was impacted in May’21. It recovered to 90% in Jun’21, leading to a collection efficiency of 80% in 1QFY22.

Management commentary and other highlights

* Collections efficiency (%) in Apr’21/May’21/Jun’21 stood at 70%/60%/90%. A similar trend as Jun’21 is being witnessed in Jul’21. The management is optimistic about rollbacks from Stage 2/Stage 3 in coming quarters.

* Expect positive AUM growth trajectory from Mar’22 onwards.

* Mahindra Rural Housing Finance (MRHFL) has restructured loans worth INR19.8b (~29% of its loan book). This restructuring is seen across ~193k loan contracts (ATS: ~INR100K).

* The management expects a provision write-back in 3Q/4QFY22, led by economic recovery and improving cash flow in the hands of the customer.

Valuation and view

* Asset quality deterioration was more pronounced (GNPA: 15.5%) and higher than expected, even after adjusting for seasonality. The restructuring was largely in line with our expectations ~3.5% of business assets. MMFS has tried to frontload its provisions and can realistically expect some write-backs, provided there are no more COVID resurgences in FY22.

* On the flip side, any fresh COVID wave has the potential to further prolong the expected gradual recovery in asset quality. Acceleration in disbursements may get pushed out by a further 1-2 quarters, and collection costs could increase further during FY22. Given its long lineage, strong parentage, and great liability franchise, MMFS is well-equipped to deal with the higher stress it is witnessing at present.

* Macro-economic situation remains highly volatile led by challenges posed by COVID. Management focused on recognizing pain upfront rather than restructuring, which led to high credit cost in the quarter. Rural economy still remains resilient and we expect significant recovery from NPA recognized in 1QFY22. Nevertheless, on a low ROA profile, even a marginal tweaking in NIMs or credit cost is leading to significant volatility in estimated profits.

* We remain conservative and cut our estimates sharply for FY22E to factor in up-fronting of provisioning expenses. If there is no incremental pain due to COVID then we might as well see upgrades going forward. While RoE is likely to remain subdued at ~5% in FY22E, it should touch ~15% in FY23E. We maintain our Buy rating with a TP of INR175 per share (1.3x FY23E BVPS).

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