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Growth revival with improving asset quality; Attractive valuations

We are initiating coverage on Power Finance Corp. (PFC) with a Buy rating and a TP of Rs210 (+73% upside). Our TP implies 1.0x FY23E adjusted standalone P/B multiple and 6x P/E. We believe that with the rising share of PSU exposure and stringent underwriting practices, PFC’s asset quality trend is likely to improve. Our account-byaccount analysis of stressed assets indicates that the current provision coverage is adequate for previous years’ NPAs. In our view, the government’s Aatmanirbhar Bharat package for discoms should boost loan growth in the near term.

* Legacy NPAs from private sector; zero credit loss in government-backed entities: Despite stringent underwriting standards, PFC witnessed volatile asset quality trends due to private sector exposure; NPA formation here was a result of regulatory changes, which affected all power sector lenders. As of Sep’20, the private sector accounted for 16% (Rs611bn) of PFC’s loan book, of which 43% was already recognized as NPAs. We remain comfortable with the rising share of Government/PSU sector (including state utilities) in PFC’s loan book, since it potentially entails lower credit losses.

* Provisions towards legacy NPAs are adequate: Our account-by-account analysis of the existing stressed asset pool suggests limited risk of additional credit costs. We expect the overall haircut on the existing stressed portfolio to be 48-50%; therefore, the current provision coverage of 56% is adequate. With gradual resolution of NPAs, we expect some reversal in provisions over a period of time; however, we are not building in the same in our estimates.

* Aatmanirbhar package to boost loan growth; may need to look beyond power sector to sustain growth: In a major push to revive financial health of ailing discoms, the government under the Aatmanirbhar scheme has decided to infuse liquidity of Rs1.2tn through PFC and REC. As state discoms seek loans and receive sanctions (Rs311bn sanctioned so far), we expect a steady revival in disbursements. In our view, PFC’s Genco book has largely peaked, given the current low-PLF operating environment, and as future generation capacity will largely come in the renewables segment (PFC’s market share is low here). Accordingly, the government may allow PFC to expand beyond the power sector, which could help it avoid stagnation/decline beyond the next 2-3 years, in our view.

* TP of Rs210 based on excess-return methodology: We value PFC on the basis of a sum-of-the-parts (SOTP); standalone PFC is valued by discounting profits in excess of CoE, and we add the value of 52.6% stake in REC at the current market cap after a 30% holdco discount. We model a 25% dividend payout ratio (DPR) through FY23E and 50% thereafter. Our bull case scenario yields Mar’22 fair value of Rs265, based on: (1) a 50% DPR in FY22E/FY23E; (2) REC valuation done at a multiple similar to that of PFC.

* Key risks: PFC has 58% of its FX exposure unhedged. We model FX losses based on 1.5% annual INR depreciation; however, a more adverse FX movement could impact our earnings forecasts. Further, we build in a 50% DPR beyond FY23, but if the RBI maintains dividend restrictions, our TP would be adversely affected by lower RoEs.

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