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Untapped opportunity with benign competition to aid >30% AUM CAGR

Five-Star Business Finance (FIVESTAR) is a Non-Banking Financial Company (NBFC) that provides small business loans (SBL) predominantly to micro-entrepreneurs, self-employed individuals, or informal salaried individuals for working capital, asset creation, or personal expense purposes. These loans are secured against collateral, typically a self-occupied residential property (SORP). FIVESTAR has delivered an AUM CAGR of ~25% over FY20- FY24, with an AUM of ~INR96.4b as of Mar’24. FIVESTAR’s key states are Andhra Pradesh, Telangana, Tamil Nadu, and Karnataka, which together contribute ~94% of the AUM. The company has 520 branches spread across 10 states and UT.

* Huge untapped potential in the small-ticket secured business loans: Industry reports estimate the total addressable market (TAM) at ~INR104t in MSME lending. Within this, the potential market for Secured MSME Loans (against SORP) with ticket sizes of

* Pricing power aiding healthy NIM and spreads: The company’s focus on unbanked customers and benign competition in the 

* Underwriting strength with deep distribution: FIVESTAR has a proprietary credit model that it has refined over the last few decades. Its meticulous customer selection and deep understanding of customer behavior, coupled with an emphasis on high customer equity (via a lower LTV of ~40%) have helped it maintain robust asset quality through cycles, with average credit costs of ~90bp over FY20-FY24. Scalability in this segment relies heavily on distribution capabilities, and FIVESTAR has doubled its distribution by adding ~260 branches over the last three years

* High growth and profitability to help sustain valuation premium: The company has developed strengths and capabilities in its business model, which are difficult for peers to replicate. We anticipate that the company will maintain its best-in-class growth and profitability, with an estimated AUM/PAT CAGR of ~31%/~23% over FY24-26. FIVESTAR is expected to command premium valuations relative to its NBFC/HFC peers due to its ability to deliver strong RoA/RoE of 7.2%/18.5% by FY26E.

* We initiate coverage on the stock with a BUY rating and a TP of INR950 (based on 3.7x FY26E P/BV). Key downside risks include concentration in southern India, rising competitive intensity resulting in loss of pricing power, and further seasoning of the portfolio leading to asset quality deterioration and higher credit costs.

Strong distribution and productivity benefits to aid robust AUM growth

* FIVESTAR has doubled its branch distribution over the last three years to ~520 branches and now has ~86% of its branches located in Tier 4-6 cities. Its growth levers will include expanded distribution, inflationary growth in average ticket size, which we project to increase to INR400k by FY26 from INR350k, and proximity to the customer through an increasing number of relationship officers (alias, the Feet on Street).

* Productivity benefits will emerge as the newer branches mature and gain vintage. We model a robust AUM CAGR of ~31% over FY24-26.

Target customer and benign competition generate pricing power

* The company provides loans to target customers who do not possess formal income documents. FIVESTAR has an on-ground presence for conducting physical verifications and credit appraisals based on informal income.

* Ticket sizes of do not interest large banks, leaving the underserved customers for select specialized NBFCs like FIVESTAR. Benign competition gives the company a pricing power to sustain yields at ~24%. The liability franchise continues to improve with a focus on long-term liabilities. We expect NIM to moderate (with financial leverage) but remain healthy at 18-19% over FY25/26 

Process intensive, but operating leverage will come into play

* The company has a fully in-house business model for sourcing, underwriting, and collections, incorporating a maker-checker system to prevent oversight and collusion. Processes are operationally intensive with a high level of interaction and a significant portion of cash collections at ~53% in FY24 (vs. ~70% in FY20). It continues to make efforts to improve the proportion of non-cash collections.

* TAT has declined to ~10 days in FY24 from ~17 days in FY22, thanks to investments in technology and improvement in productivity. TAT is expected to further decline to 8-9 days in a steady state. We expect scale benefits and improvements in employee productivity to result in opex-to-average AUM declining to 6.3% by FY26E from 6.7% in FY24.

Focus on collections keeps NPAs under control; credit costs to remain <1%

* Despite the unavailability of SARFAESI, FIVESTAR’s focus on identifying ‘suitable’ collateral, enhanced by conservative LTV ratios, family members as coapplicants, and a strong on-ground collections infrastructure, has kept its 90+ dpd consistently low despite relatively higher soft delinquencies.

* Through a combination of legal notices and arbitration, the company has historically managed to settle its NPAs with <2% IRR loss. We expect the portfolio to season, and Stage 3 to increase but stabilize at <2% in a steady state with credit costs of <1%.

Sustained profitable growth to attract premium valuations; Initiate with BUY

* The company operates in the micro-LAP (backed by SORP) segment, where its business model has been enhanced for over two decades to deliver a combination of healthy loan growth and strong profitability. Deep understanding of customer behavior, along with regional dynamics in semi-urban and fast-growing rural areas, position FIVESTAR well to remain dominant in this product segment.

* The stock currently trades at 2.9x FY26E P/BV. We believe that FIVESTAR’s premium valuations will sustain in the medium term based on its niche market position, strong growth potential, superior underwriting practices, resilient asset quality, and high return metrics. We estimate a PAT CAGR of ~23% over FY24- FY26 for an RoA/RoE of 7.2%/18.5% in FY26. We initiate coverage on the stock with a BUY rating and a TP of INR950 (based on 3.7x FY26E P/BV).

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SEBI Registration number is INH000000412