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MFI sector primed to ride the new growth wave 3.0, with focus on portfolio resiliency: The MFI sector has faced major political/asset-quality headwinds in the past couple of years, leading to slower CAGR, at 15% over FY20-23 vs 29% over FY14-20. However, with assetquality woes largely behind and new regulations offering a level playing field for NBFC-MFIs, coupled with higher HH limits, the sector is already riding the new growth wave (22% in FY23), albeit with an eye on building portfolio resiliency. We expect overall MFI GLP CAGR of 21% over FY23-26E (including 22% in FY24E), and reach Rs6.2trn (USD75bn) led by 9% borrower growth (due to increased penetration in current/new geographies) and 11% o/s per borrower growth as ticket size/loan tenure inches-up. However, despite such strong growth, household penetration will only increase, from 32% to 36%, while GLP/opportunity share would improve from 31% to 35% by 2025-26, offering a long growth run-way and allaying concerns around saturation. In this new growth phase, we expect southern India (mainly aided by opening up of AP/Telangana), western India (led by Gujarat/Maharashtra), and northern India (mainly led by UP) to seize some share from eastern India (prone to frequent disruptions). Separately, we expect the sector to undergo a structural transformation, led by increased digitization for expanding business/collection at lower CAC, gradually shifting towards an individual vs traditional JLG MFI lending model, amid changing customer preferences and an expanding nonMFI portfolio (micro mortgage, TW/used CV, Gold, Consumer and SBL) to deliver sustainably healthy growth/RoAs.

NBFC-MFIs to claw-back some market share in the near term, but banks set to dominate in the long run: After a long time, banks (including SFBs) have lost market share (51% vs 60% in FY21) to NBFCs; this is likely to persist in the near term, as such players (including CREDAG, Fusion, Spandana, Satin, etc) look for accelerated growth (>25%) vs calibrated (~18-20%) growth for a few large universal banks (incl. Bandhan Bank/IIB/RBL), given their strategy to limit share of unsecured loans/diversify portfolio. That said, the MFI sector, given its high growth (of >20%)/RoA potential of >2%, will continue to attract new banks (KVB, Yes Bank, Federal Bank) and thus even look for inorganic acquisitions. On the other hand, NBFC-MFIs (e.g. Spandana) would ultimately converge with banks given their scale/cost advantage/regulatory cover, thereby consolidating the bank’s dominance in the long run. We believe the ensuing strong growth phase could also possibly open up the listing gates for long-time aspirants like ESAF SFB, Utkarsh SFB, Fincare SFB and Arohan (NBFC), thereby infusing fresh growth capital into the sector. Among such unlisted players, Fincare looks to be relatively better, given its lower geographic concentration and better liability/returns profile.

LLP to moderate over FY24-26E, but stay slightly elevated vs pre-Covid, factoring-in contingent buffers to absorb future shocks: The MFI sector has recovered from back-toback asset quality shocks (NIA/CAA, elections in East India, Covid, Floods, etc) with the 30- 180 DPD book declining to 3.8% (Dec-2022) from the 15% peak due to improving collection efficiency and heavy w-offs. Among individual lenders, CREDAG, Ujjivan and IIB (BFIL) now have the lowest stress pool (GNPA+RSA), while Bandhan’s elevated stress pool too is expected to gradually improve on CGFMU + the Assam state government’s recovery scheme. Lenders expect the PAR (30-90DPD) book to steadily normalize in FY24 back to pre-Covid levels, while the stock of NPAs (>90 DPD) is largely provided for, thereby leaving elbow room to continue the w-offs/NPA sale. However, we believe that a clear lesson from events in the past 5-7 years is that growth/asset-quality cycles for the MFI sector have been short and volatile, amid rising micro-economic/political/climatic disruption. Thus, apart from strengthening credit underwriting/monitoring/collection mechanism, building provision buffers too is necessary when the going is good. Thus, we expect overall credit cost to moderate over FY24-26E, albeit still remain slightly elevated at 1.5-2.1% vs 0.5-1.6% during pre-Covid, thereby protecting long-term profitability/RoAs.

Initiate coverage on CREDAG (BUY), Fusion (BUY); prefer Ujjivan among SFBs: Amid the broader macro/credit slow down, we believe the MFI sector offers a strong play on growth (>20%), coupled with higher return ratios (RoA of 1.5-4%/RoE at >18-20%) and aided by healthy margin/contained opex/LLP. Most MFI players are positively focused on building portfolio resilience/provision buffers, which should help them withstand frequent disruptions and address the growth/earnings volatility concerns among investors. Thus, we initiate coverage on Fusion (TP: Rs725/share based on 2.2x FY25E ABV) and CREDAG (TP: Rs1,650 based on 3.5x FY25E ABV) with a BUY, given superior growth, RoA trajectory (>4%) and Management credibility. Among SFBs, we have recently turned positive on Ujjivan SFB (BUY, with TP of Rs50 based on 1.7x FY25E ABV), given that asset quality/Management woes are now behind; also it is set to be the key beneficiary of the MFI growth wave and deliver higher return ratios. We continue to favor Equitas (BUY; revised TP of Rs102 based on 1.7x FY25E ABV) given its diversified asset portfolio, better liability/return profile and ensuing transition into a ‘universal bank’. We retain BUY on Bandhan Bank, with a TP of Rs300 based on 1.8x FY25E ABV, given its strong liability profile and expected NPA recovery, but believe that product/geographic diversification and building provision buffers will be key for long-term profitability/re-rating.

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