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First quarter results validate the cyclical recovery, setting the stage for a broadbased earnings upgrade and re-rating cycle

* Onset of the earnings upgrade cycle: The 1QFY27 earnings season has strongly validated our thesis that NBFCs are entering a new cyclical recovery. Operating performance has improved meaningfully across the sector, with healthy loan growth, broad-based asset-quality normalization, resilient margins, and improving operating leverage driving earnings beyond expectations. More importantly, the strength and breadth of the recovery have already translated into meaningful upward revisions to FY27/FY28 earnings estimates across our NBFC coverage universe – earlier than would typically be expected at this stage of the financial year.

* Unlike previous cycles, upgrades not merely provision-led: The current earnings recovery is fundamentally different from periods when earnings upgrades were driven primarily by lower-than-expected credit costs. This time, multiple earnings levers are moving favorably at the same time:

1) loan growth has remained healthy across secured and unsecured segments

2) credit costs have normalized faster than anticipated

3) funding costs are likely to exhibit relative moderation (vs. levels seen in 1Q)

4) margins remained resilient despite minor moderation in lending yields

5) operating leverage is beginning to support profitability. We therefore believe the current earnings trajectory is more sustainable than a recovery driven by provisioning normalization alone.

* Estimate upgrades broad-based and gaining momentum: Our NBFC lending coverage universe, excluding Muthoot Finance, PFC and REC, has witnessed ~4%/1% upgrades to FY27/FY28 earnings estimates over the past three months and ~6%/3% over the past six months. The vehicle finance segment has been the largest contributor, supported by robust loan growth and meaningful moderation in credit costs. However, the upgrade cycle is increasingly broadening to diversified NBFCs, microfinance lenders, and HFCs, reflecting improving operating trends across the lending ecosystem.

* Asset quality emerges as the most notable surprise: Following nearly two years of stress across microfinance, unsecured personal/business loans, and select secured retail segments, collection efficiencies have improved, and fresh slippage has moderated. Tighter underwriting, stronger collection infrastructure, lower borrower leverage, and a greater emphasis on secured lending have structurally improved portfolio quality. Consequently, credit costs have surprised positively across several lenders, providing greater confidence that the sector has moved beyond the peak of the asset quality cycle.

* Growth recovers without a deterioration in risk discipline: Credit growth remains healthy across most retail lending segments, supported by strong underlying demand and continued formalization of credit. Vehicle financiers have benefited from strong growth post-GST cuts, steady CV replacement demand, and improving used vehicle financing. HFCs continue to see healthy disbursements across affordable and mid-income housing. Gold financiers continue to benefit from strong demand for secured credit, while growth is also recovering across MSME, personal loans, and digital lending. Importantly, management commentary points to a clear shift toward profitable, returnaccretive growth rather than market-share maximization.

* Margins have held up; operating leverage emerging as the next earnings lever: While lending yields are gradually moderating following the monetary easing cycle, the impact has largely been offset by lower funding costs. Bond yields have also moderated from the highs seen during the West Asia War, improving visibility on incremental borrowing costs. At the same time, investments made over the past few years in technology, digital sourcing, centralized operations, and analytics are beginning to translate into operating leverage. We expect these factors to support stable margins and improve return ratios over the medium term.

* Debate shifting from recovery to re-rating: We believe 1QFY27 marks an important inflection point for the sector. The question is no longer whether the cyclical recovery will materialize but how far the earnings and return-ratio cycle can extend. As earnings estimates move higher and balance-sheet risks recede, we see scope for further valuation re-rating. While vehicle financiers and diversified lenders are likely to lead the initial phase of the re-rating cycle, we believe investors could increasingly look toward relatively under-owned HFCs and other monoline lenders as the cycle broadens.

* Further potential upside likely from both earnings and multiples: Despite the healthy stock price performance across several NBFCs, most companies under our coverage continue to trade below the peak valuation multiples achieved during the previous NBFC upcycle. We therefore see scope for the sector to challenge - and in select cases surpass - previous valuation peaks as earnings upgrades translate into stronger RoA/RoE and greater investor confidence. Our top picks are Bajaj Finance, L&T Finance, PNB Housing, and Five-Star Finance.

* Key Risks:

1) West Asia crisis and inflation: The ongoing West Asia crisis and any further escalation remain key macro risks, particularly through their potential impact on crude oil prices and, consequently, domestic inflation. A sustained increase in energy prices could delay monetary easing, tighten financial conditions, and adversely affect borrowing costs and credit demand across NBFCs.

2) El Niño and monsoon progression: The evolution of El Niño conditions and the progress and distribution of the Indian monsoon will remain important monitorables. Any meaningful deviation from a normal monsoon could affect rural incomes, consumption, and credit demand while potentially leading to higher delinquencies in rural-focused lending segments such as microfinance and certain vehicle-financing portfolios.

3) Interest rate trajectory: We anticipate the possibility of a 25–50 bp increase in interest rates over the next 6-9 months, depending on the evolution of inflation and macroeconomic conditions. A rising rate environment could increase funding costs and exert pressure on margins across several NBFC segments, particularly those with limited pricing power. However, HFCs could be relative beneficiaries of a risingrate cycle, given their ability to reprice assets and the potential for spreads to improve as the cycle progresses

4) Regulatory changes: Evolving RBI regulations continue to be a critical area to monitor, particularly the proposed restrictions on revolving and Flexi credit facilities, as well as potential modifications to credit-life insurance commissions. These changes could affect product structures, loan growth, and fee income for certain diversified NBFCs

Our view

* NBFCs continue to offer an attractive combination of healthy growth, improving asset quality, and resilient profitability. Within the sector, we continue to prefer lenders that combine strong liability franchises, diversified portfolios, disciplined underwriting, and superior execution. Such franchises are likely to continue delivering industry-leading growth while sustaining healthy return ratios, thereby supporting further earnings upgrades and valuation rerating over the course of this fiscal year.

* The sector has witnessed a meaningful rerating over the past three months as earnings upgrades have reinforced investor confidence in the sustainability of growth and profitability. Our top picks are Bajaj Finance, L&T Finance, PNB Housing, and Five-Star Finance.

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