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Structural opportunity in power finance intact

Minor weakness in loan growth in the near term

* Power financiers, PFC and REC, have a structural opportunity to finance India’s ambitious energy transition goals, which necessitate a projected capex of ~INR42t over the next decade to expand generation infrastructure.

* Renewable energy (RE) will dominate the growth trajectory, with installed capacity expected to reach 596GW by FY32, comprising ~66% of total capacity. Transmission infrastructure, essential to support RE integration, will require investments of INR9.2t by FY32.

* PFC and REC collectively command ~44% market share in infrastructure (including power) financing and have filled the gap left by traditional banks, which have reduced their exposure to the power sector due to concerns over asset quality. Having said that, RE financing still remains highly competitive, with PFC/REC having to compete aggressively on pricing with banks.

* Government policies, such as the revamped distribution sector scheme (RDSS) and UDAY, are aimed at strengthening DISCOMs by improving operational efficiency and financial sustainability. The power sector will benefit from macroeconomic tailwinds, including rising energy demand (India’s power demand to grow 8-9% over FY24-27E) and almost doubling of installed capacity to ~900GW over the next decade. The inclusion of infrastructure and logistics financing in PFC and REC's mandates has opened up avenues for diversification, reducing dependence solely on the power sector.

* Asset quality metrics of power financiers are improving, with GNPA ratios of PFC/REC declining to 2.7%/2.5% as of Sep’24, which reflects a lower risk profile. In the current power demand uptrend, many distressed power plants have been acquired by larger players, resulting in the resolution of multiple stressed projects. This trend is expected to continue, leading to further recoveries for lenders like PFC and REC. We do not see risks of incremental additions to the stress pool over the next 12-18 months, and this should keep credit costs benign at <5bp in FY26E as well.

Our view on loan growth and asset quality in the near term

Loan growth

* REC delivered loan growth of ~15% YoY as of Sep’24. With this, generation grew ~19% YoY, transmission remained flat YoY, and distribution rose ~5% YoY. Over the last two years, distribution in the loan mix has remained largely flat at ~40%, RE loans have clocked a ~37% CAGR, and RE in the loan mix now forms ~9%.

* PFC delivered loan growth of ~10% YoY as of Sep’24. With this, generation grew ~2% YoY, transmission grew 14% YoY, and distribution rose ~12% YoY. Over the last two years, distribution in the loan mix has improved from 35% to 41%, RE loans have seen a CAGR of ~30%, and RE in the loan mix now forms ~13%.

* In the near term, we expect some weakness in sanctions because of a slowdown in the overall economic activity, resulting in slower investments in power and infrastructure projects. Moreover, in distribution, a large part of loan growth seen over the last two years came from schemes like the late payment surge (LPS) and the liquidity infusion scheme (LIS). Currently, PFC and REC are disbursing to distribution companies, predominantly under the two schemes, RBPF and RDSS. RBPF is a revolving facility and acts more like working capital loans for the distribution companies. RDSS is linked to improvements exhibited by state-owned distribution companies in their AT&C losses and the ACS-ARR gap.

* In FY25, we expect PFC and REC to report loan book growth of ~13% and ~17%, respectively. We estimate Loan CAGR of ~15% and ~18% for PFC and REC over FY25E-27E.

Asset Quality

* On 9th Jan’25, the Indian Renewable Energy Development Agency (IREDA) in 3QFY25 results reported a ~30bp QoQ deterioration in its gross NPA, which suggested that one RE exposure of ~INR4b slipped during the quarter. This naturally brought up the question of whether this had any implications for PFC/REC’s RE loan book and whether we are already beginning to see new NPA formation in RE projects.

* Our discussions with few experts in the power ecosystem suggested that the RE space still continues to do well and there is nothing that suggests any structural deterioration brewing in the RE segment. They did, however, highlight that there could always be project-specific nuances in the RE power projects, which could lead to one-off slippages in the segment.

* Asset quality will continue to see improvement, aided by resolutions of stressed exposures. Both PFC and REC have shared a list of stressed projects with total exposures of ~INR50b and ~INR53.5b, respectively, which are in advanced stages in resolution. Lanco Amarkantak Power received NCLT approval for acquisition by Adani Power in Aug’24 and was resolved in Sep’24.

* Recently, JSW Energy announced that its resolution plan submitted for KSK Mahanadi has received a letter of intent (LoI) from the resolution professional. This will be followed by the approval of the CoC, NCLT and CCI. While NCLT approval will take its own course, we believe that KSK Mahanadi could be resolved in the next 3-4 months. Both PFC and REC will benefit from this as they have ~INR34b and ~INR27b outstanding to KSK Mahanadi. PFC and REC have made provisions of ~55% and ~50%, respectively, on this account. Our estimates suggest that the resolution of KSK Mahanadi could translate into write-backs of ~INR8.2b for PFC and ~INR5.2b for REC. Refer Exhibits 16, 17 and 18 for the detailed workings.

Structural opportunity intact; still in the early part of the RE uptrend

* PFC and REC are pivotal players in India's energy transition journey, together commanding ~44% market share in infrastructure (including power) financing. With a combined loan disbursement of ~INR9t over FY20-24, both these government-backed NBFCs are driving growth in RE and infrastructure projects. PFC, with the largest RE loan book of INR643b (~30% CAGR in the last two years), and REC, with a robust portfolio of INR5.4t, are key enablers of India’s ambitious INR42t power capex requirements

* Both PFC and REC have strong financial health, with GNPA ratios below 3%, high provisioning coverage, and impressive RoE of ~18% and ~21%, respectively. Backed by government initiatives like RDSS and expansion into logistics and infrastructure, PFC and REC are strategically positioned to capitalize on India’s growing energy demand while maintaining sustainable growth and profitability.

* PFC and REC will be beneficiaries of the revival in power sector capex. We do not see risks of incremental additions to the stress pool over the next 12-18 months, and this should keep credit costs benign at <5bp over FY26E as well. For RoA 2.9%/2.6%, RoE of ~18%/21%, and dividend yields of ~4.3%/4.9% in FY27E, we believe current valuations of 0.9x and 1.2x FY27E P/ABV for PFC (standalone) and REC, respectively, are attractive.

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