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Operating profit growth fueled by NIM expansion

Result highlights: Poonawalla Fincorp Limited (PFL) reported Q3FY23 standalone PAT of ~Rs1.5bn (+15.6% QoQ/+87.5% YoY), driven by margin expansion as PFL continues to pass on rate hikes to its customers and introduce high-yield products to expand its digital offerings. During the quarter, PFL launched new products covering consumption finance, transaction credit, and consumer finance. In a seasonally strong quarter, PFL posted the highest-ever customer acquisition and disbursements of Rs33.7bn (+8.3% QoQ/+157.2% YoY), entirely via the organic route. Direct digital partnership (DDP) contribution to disbursements increased to 66% (Q2: 54%). As a result, AUM grew by 5.8% QoQ/27.6% YoY to Rs139.3bn. Operating expenses declined 3% QoQ, as the firm continued to rationalize its branch network and personnel resource pool. Asset-quality pressures eased with GS3 at 1.69% (Q2: 1.77%) and NS3 at 0.89% (0.94%), with continued provision reversal resulting in quarterly RoA of 4% and RoE of ~9.8%.

PFL, in its board meeting held on December 14, 2022, approved the sale of its housing finance subsidiary – Poonawalla Housing Finance Limited (PHFL) – to TPG for a consideration of Rs39bn. As per our analysis, we expect a post-tax gain of ~Rs23.3bn, resulting in a net worth accretion of ~Rs31.5bn in Q1FY24 (Exhibit 4). To account for the sale of PHFL, we change our valuation to be based on the standalone entity and roll over our estimates to Mar-24E. We retain our HOLD rating, valuing the company at a Mar’24E TP of Rs300 (earlier Rs270), using the excess return on equity (ERE) method. Our TP implies Mar-25E P/BVPS of 2.1x for FY25E RoA of ~4.1% and RoE of ~10.4%.

Margin expansion and reversal of provisions fuel earnings growth:

A 39bps QoQ NIM expansion drove NII growth of 10% QoQ/23.6% YoY. Calculated yields rose 63bps QoQ, with PFL passing on the rate hikes of 150-200bps to its customers across all product lines since the beginning of the rate hike cycle. Calculated CoF rose 38bps sequentially. Operating expenses declined 3% QoQ, as PFL has initiated employee rationalization to address the excess bandwidth. Cost-to-income ratio stood at 56.7% (Q2: 60.4%). As a result, PPOP came in at ~Rs1.56bn (+23.9% QoQ/+35.6% YoY). Asset quality witnessed sequential improvement, with GS3 at 1.69% (Q2: 1.77%) and NS3 at 0.89% (Q2: 0.94%). PCR on stage-3 assets stood at 47.8% (Q2: 47.3%). Credit costs came in at -1.34%, as PFL continues to write-back provisions on the legacy book. Management expects this to continue for the next two quarters. The restructured book stood at ~Rs1.72bn (1.2% of AUM) vs. Rs2.46bn (1.9% of AUM) as of Q2FY23. The restructured book in the zero bucket stood at Rs0.78bn (~45% of the book).

Management guidance:

Management has laid out the following targets going ahead – 1) AUM growth of 35-40% over the next three years, 2) Constant RoAs of 4-4.5%, 3) Gross NPAs of 1.3-1.8% and net NPAs of 0.5-0.9%, and 4) Profit growth of 30-35%. Management also expects the AUM mix to be 70%::30% between unsecured and secured products.

Our forecasts

On a standalone basis, we have built in a disbursement CAGR of ~43% over FY23-25E, translating into AUM growth of ~40% over the forecast period to ~Rs289bn. While the continued run-down of the legacy, Magma Fincorp book (~Rs11bn in Q2FY23, expected to run-down by Q1FY24), and the DA acquired book (~Rs22bn in Q3FY23, expected to run-down by Q1FY25), are expected to weigh-down on growth, the introduction of new products such as the credit card and EMI card should augur well for AUM growth.

We estimate a sharp reduction in operating expenses, with opex-to-AUM declining by 150bps in FY24E and ~103bps in FY25E from ~6.27% in FY23E on account of two factors: 1) Employee and branch rationalization, as PFL aims to maintain a branch-light model, with a presence in 100 branches across 22 states and UTs. The branches are expected primarily to aid in collection efforts, with sourcing and origination to be conducted digitally. 2) Reduction in ESOP expenses by ~Rs1bn in FY24E and ~Rs0.3bn in FY25E from ~Rs1.6bn in FY23E.

We expect recoveries of 45%/~Rs6bn from the legacy written-off pool over FY23-25E. As the effect of the write-back diminishes, we expect credit costs of 64bps in FY24E and 138bps in FY25E. As a result, we expect FY25E RoA of ~4.1%, translating into RoE of ~10.4% due to lower leverage on account of excess capital of ~Rs31.5bn accreted to the net-worth after the expected sale of PHFL in Q1FY24.

Valuation and risks: To account for the sale of PHFL, we change our valuation to be based on the standalone entity (earlier based on the consolidated lending entity) and rollover our estimates to Mar-24E. We retain our HOLD rating, valuing the company at a Mar’24E TP of Rs300 (earlier Rs270), using the ERE method. Our TP implies a Mar-25E P/BVPS of 2.1x for FY25E RoA of ~4.1% and RoE of ~10.4%. We believe the underlying opportunity in consumer/MSME lending in India provides ample opportunity for the firm to leverage much more and result in superior RoEs. Upside risk: Utilization of the proceeds from the sale of PHFL for inorganic expansion will result in leverage ratios improving earlier, aiding in RoE expansion. Downside risk: Considering the dominant composition of unsecured loans with the portfolio, credit costs could be impacted in the event of any extraneous shocks or operational lapses.

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