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Will continue to stand tall despite the many challengers

Muthoot Finance (‘MUTH’) is our top pick for CY22 in the NBFC Lending space. Our investment idea is premised on our thesis of a structural opportunity in Gold lending as the market pie expands with customers evolving, taboo around Gold loans fading away, and apprehensions regarding Gold loans addressed through customer education. In this report, we list MUTH’s competitive strengths vis-à-vis its peers and some of the challengers like Fintech Gold loan NBFCs. MUTH is well placed to build on its competitive heft and continues to create strong value for its stakeholders.

* Key investment thesis for Gold Finance is the 13%-15% CAGR in Gold loans over the next five years, with MUTH best positioned to deliver across economic cycles.  Around 55% of its Gold loan portfolio has a ticket size of over INR100k, which leads to higher stickiness and lesser churn feeding into Gold loan growth.

* The management has built in adequate safeguards through appropriate combinations of tenure and LTV (average Gold loan tenure is in the six-to-nine months range), which protects it against any significant volatility in gold prices.

* Over the last decade, MUTH has delivered average credit costs of 40bp. We expect credit costs of 25-30bp over the next two years.

* Given the kind of RoE that MUTH is able to churn out (relative to loan growth), it is able to generate surplus cash, which can be deployed for diversification into non-Gold product segments. We expect the proportion of non-Gold businesses to improve to 14-15% (v/s 10% at present) over the next three years.

* Over the past five years, MUTH has exhibited an improvement in efficiency, with AUM per branch rising to ~INR110m in FY21 from ~INR60m in FY16. This traction in operating efficiency has led to higher growth in revenue (relative to AUM growth). We model in 15% PAT CAGR over FY22-24E and a RoA/RoE of 6%/22% in FY24E.

Strong brand with enviable execution; expect 15% AUM CAGR over FY22-24E

Standalone AUM clocked 17% CAGR over FY16-21. Even before the COVID-19 outbreak and the sharp run-up in gold prices in FY21, MUTH had delivered a two/three/four year CAGR of 19%/15%/14% as of Mar’20. Though higher gold price aid demand for Gold loans, franchises like MUTH have a strong brand and well-entrenched distribution that it will help it gain incremental share in the expanded market pie for Gold loans.

Riding on improved operational efficiency to mitigate any NIM pressure

MUTH has achieved a remarkable improvement in operating efficiency. While it has not been adding branches/employees aggressively, AUM/employee has almost doubled to INR20.3m over FY16-21. The same is equally true for AUM/branch as well. We believe current cost ratios of ~3.3% (as a percentage of average loans) are sustainable over FY23-24E. Though NIM has already

witnessed a sharp contraction due to the burgeoning challengers (particularly aggressive Banks and Fintechs) in Gold Financing, we believe the same has bottomed out at current levels of ~13% and should remain stable in the near-tomedium term.

Builds cushions to guard against volatility in gold prices

Longer-tenured Gold loans act as a hedge against volatile gold prices. With shortertenured Gold loans (especially those to be repaid within three-months), volatility in gold prices has the potential to trigger high auctioning, which can adversely impact both AUM growth as well as result in losses on the accrued interest portion on the non-performing Gold loans. With a six-to-twelve month Gold loan product and an appropriate combination of LTV, MUTH has built adequate safeguards to guard against volatility in gold prices.

Expect pristine asset quality; credit costs in the 25-30bp range

Gold Finance emerged as the safest product segment during the COVID-19 outbreak given the liquid nature of the collateral. MUTH is always perceived as the most liberal and empathetic lender, offering additional time to borrowers to repay their loans. This also enhances customer confidence, who feel reassured to pledge their gold jewelry with MUTH. While Stage 2 and 3 could periodically appear elevated, leading to higher auctions, actual economic losses (write-offs) have historically been in the 7-10bp range and average credit costs (including provisions) over the last decade were ~40bp. We expect credit costs of ~25-30bp over FY23-24E.

Operationally intensive nature of the business and a strong brand provide business moats

During FY21, Gold loan NBFCs saw higher aggression from Banks, led by rising gold prices as also the regulatory arbitrage of ~90% LTV on Personal Gold loans until 31st Mar’21. Over the last 18 months, this segment has witnessed quite a few Gold Lending Fintechs work closely with Banks and try to disrupt the competitive landscape for Gold loan NBFCs. However, MUTH, with its strong brand presence, a loyal client base, and deep and wide distribution network in semi-urban and rural centers, has built business moats that are difficult to replicate. Both MUTH/MGFL also offer online Gold loans (OGL). Despite all the hype surrounding digital lending in Gold loans, there will always be an important element of physical evaluation/deposit/withdrawal of the gold jewelry, which will keep it relatively insulated from challengers in this space.

Cognizant of the importance of product diversification, but treading cautiously in non-Gold loans

Non-Gold subsidiaries contribute ~10% to the consolidated AUM of MUTH, with their contribution to consolidated profit ~1% in 9MFY22. Gold loan growth has historically tended to be volatile due to: a) regulatory disruptions, and b) fluctuation in gold prices. The management realizes the importance of diversification into the non-Gold product segments. MUTH has been relatively insulated, despite the vulnerability seen in Vehicle/ Housing Financers after the COVID-19 outbreak. It will continue to tread cautiously in the non-Gold product segments. We expect it to grow its non-Gold segments to 14-15% (of consolidated AUM) over the next three years. The Gold loan business of MUTH is a high RoE (22-23%) generating business, which creates surplus retained earnings and, if required, can be used to meet the growth capital requirements of its non-Gold subsidiaries.

Leading the way for Gold Financing in India, with a healthy return profile; Top Pick among lending NBFC

MUTH ticks all the right boxes for us: a) Strong execution track record of the management and the next generation of the family being groomed to take up leadership positions in the future; b) Strong brand presence and deep penetration, which enhances customer confidence in the franchise; c) Robust risk management control and processes to further scale up the operationally intensive Gold Lending business; d) The credit rating of AA+ and consequently lower cost of borrowings will enable it to offer competitive interest rates to customers; and e) Ability to keep driving operating efficiencies can lead to 15% AUM and PAT CAGR over FY22-24E. The company appears strongly positioned to deliver standalone RoA/RoE of ~6%/22% over the medium term. MUTH is our top pick among NBFCs, with a TP of INR1,750 (2.7x FY24E standalone BVPS) and a potential upside of ~26%.

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