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Luxurious valuations for affordable business model

We initiate coverage on Aavas Financiers (Aavas), a solid franchise in the affordable housing space with a REDUCE and TP of Rs2,360. Aavas has built a superior lending model in an otherwise riskier segment, led by greater focus around clientele, sourcing, underwriting and collections. These aspects have enabled Aavas to deliver robust asset growth without diluting its quality and see ROE inching to the mid-teens. While we like the model and the ROE progression, we believe that the valuations do not capture the risk in asset growth slow down as the balance sheet reaches a critical mass (as seen in the case of NBFCs). Risk-reward at current valuations remains unfavorable.

* Well-poised for solid growth: Aavas has a strong presence in affordable housing states of Rajasthan, Gujarat, and Maharashtra, which are the key states having housing shortages in the less than Rs.1mn ticket size. Expansion into newer geographies and deeper penetration in existing but relatively newer states should drive AUM growth. We factor in AUM growth CAGR of 22% over FY21-24E.

* Stable asset quality: Despite having a presence in the high-risk selfemployed segment in the low-ticket size category, Aavas has been able to contain its credit costs and maintain stable GNPAs due to its in-house sourcing, underwriting and collections model. NPAs have remained better (and to its peers) due to the strong domain expertise and loan book mix with no developer loan exposure. We expect Aavas to maintain stable asset quality with credit costs at 40bps in FY24E.

* Drivers in place to achieve mid-teens ROE: Diversified borrowing mix has enabled Aavas to bring down its cost of funds and maintain spreads in the range of 5-6%. As it continues to grow at 20%+, attaining a meaningful AUM size can help in improving its credit rating, which could further bring down its borrowing costs. As it penetrates further in existing states, economies of scale will drive operating leverage and aid in improving its opex/AUM ratios even as it expands to newer geographies.

* Valuation & Risks: We have valued Aavas on a P/E basis and arrived at a target price of Rs2,360. Our blue-sky scenario suggests potential TP at Rs3,200. The bear-case TP is at Rs1,690. We recommend a REDUCE on Aavas as we believe that despite the strong management team and resilient business model, current valuations do not factor in the possibility of asset slowdown as the balance sheet attains scale. The period between FY15-19 saw Gruh report 18% CAGR in loans (vs 22% CAGR over the longer run) and saw its PE multiples contract. Key risks: higher than expected growth, lower credit costs.

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