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Diversification and strong execution boost growth outlook

* Shriram Finance (SHFL), the merged entity of Shriram Transport Finance (SHTF) and Shriram City Union Finance (SCUF), has emerged as a stronger player in all its product segments. With a more diversified AUM mix and better access to liabilities, SHFL is effectively driving cross-selling of non-vehicle products to its customers.

* With a legacy spanning over four decades, SHFL has demonstrated its execution capability in the commercial vehicle (CV) segment across multiple credit and economic cycles. Gold loans and personal loans have now been rolled out across most of the branches. The company is also extending its 2W franchise to more locations and dealerships. In the MSME segment, the company wants to first gain insights into the respective micro-markets before scaling up.

* SHFL is rated AA+ by both CRISIL and India Ratings. Although our investment thesis is not predicated on a credit rating upgrade, we believe SHFL now has a strong case to work with credit rating agencies for an upgrade. A credit rating upgrade is an option value, which can help SHFL reduce its borrowing costs by 40-50bp.

* While there are already various views emerging about the CV uptrend, we believe that SHFL will be better placed compared to its vehicle finance peers because of its predominant presence in the used vehicle segment. We believe that CV demand will recover after the 2024 general elections and the Union Budget as investments resume in the infrastructure and construction/real estate sectors. Moreover, SHFL is yet to fully tap its expanded distribution network (from the merger) for non-CV products.

* Higher cross-selling of non-vehicle products by leveraging its enhanced distribution network would translate into a CAGR of 17% in AUM and 19% in PAT over FY24-26E. This implies RoA/RoE of 3.3%/17% in FY26E.

* SHFL’s valuation multiple has already re-rated from 1.0x to 1.6x 1-year forward P/BV over the last 12 months. This re-rating was driven by the fading of the supply overhang after the exits of a few large shareholders and steady execution on AUM growth, asset quality and profitability after the merger.

* We see scope for further re-rating if the company is able to sustain the execution on AUM growth, margins and credit costs. SHFL is our preferred pick among diversified lenders with a TP of INR2,900/- (based on 1.7x FY26E P/BV). The monetization of a part or complete stake in Shriram Housing can further unlock the optionality value.

* Key downside risks include: a) a deterioration in macroeconomic indicators could impact CV demand; and b) asset quality deterioration and higher delinquencies in the personal loans segment.

Diversified loan mix; strong loan growth in the non-vehicle products

* Vehicle finance (excluding 2W) forms ~76% of the company’s AUM mix, with the balance contributed by products of erstwhile SCUF (MSME, 2W, gold loans and personal loans). In the near term, we expect a CAGR of ~16% in the CV portfolio (erstwhile SHTF business) and a CAGR of ~21% in the non-vehicle portfolio (including 2W). Combined, we expect SHFL to register a CAGR of ~17% in AUM over FY24-26.

* The shift in the product mix to high-yielding non-vehicle products will also be marginally accretive to the blended yields. A large proportion of this improvement in yields is expected to be driven by a higher proportion of personal loans and MSME loans in the AUM mix.

Strong ability to sustain margins with benefits on both asset and liability sides

* The company’s target customer segment gives it pricing power and allows it to steer clear of any irrational pricing in the marketplace. Occasionally in the past, SHFL struggled to access liabilities, but it has always been able to pass on its higher borrowing costs to customers, with little impact on its margins.

* After the merger, it is reaping the re-pricing benefit on the SCUF portion of the liabilities (as and when they come up for maturity/renewal). If the company is able to work with credit rating agencies for an upgrade, it can reduce the borrowing cost by ~40-50bp. Moreover, with an improving proportion of 2W and gold loan products (short-tenured) in the AUM mix, the company can also increase (if need be) the proportion of CPs in its liability mix.

* We estimate NIM on AUM of 9.0%/9.2% in FY25/FY26 (vs. 9.1% in FY24) without considering any positive impact on the credit rating of SHFL.

Productivity improvements and scale to drive gradual improvement in cost ratios

* There has been no significant rationalization of branches or staff after the merger. Instead, SHFL has added ~12-13k employees over the last one year to augment the sales team for cross-selling SCUF products.

* We do not expect any significant operating synergies from the merger to accrue in the years ahead. We estimate a gradual decline in the opex-to-assets ratio to 2.4% by FY26 from 2.7% in FY24E, primarily driven by scale benefits and improvements in productivity.

Asset quality improving; credit costs to hover around 2.5%

* Higher prices of new CVs have driven up the prices of used CVs. Also, the repossessions have not been significant since the earnings of CV customers have been good. Higher utilization of vehicles has led to an improvement in asset quality. PL is disbursed as a cross-sell product to 2W customers or repeat customers who have earlier completed their PL/2W loans.

* Before Covid, the merged entity (pro-forma) operated at a credit cost of ~2.6% over FY18/FY19. Along with a steady improvement in Gross Stage 3, we estimate a credit cost of ~2.5% (as % of average loans) in FY25 and FY26.

Valuation and view:

The sum is greater than the parts – execution better as merged entity; maintain BUY

* While the merger has served its intended purpose of giving exits to some large investors of the erstwhile Shriram Capital, it has also allowed SHFL to offer the complete product suite across the customer lifecycle. Moreover, it is now also able to offer all the lending/investing/insurance products based on customer needs.

* The merged entity, in our view, has emerged stronger than the respective standalone businesses of SHTF and SCUF. It continues to leverage the expanded distribution network to offer a much wider product bouquet to its customers. SHFL will continue to execute well to deliver a CAGR of 17% in AUM and a CAGR of 19% in PAT over FY24-26E. This translates into RoA/RoE of 3.3%/17% in FY26E. We maintain our BUY rating on the stock with a TP of INR2,900 (premised on 1.7x FY26E standalone BV)

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