A granular retail credit platform run by a brilliant owner-operator with best in class operating and growth metrics available at 0.85X Book and <5X normalized profits with clear catalysts !
Brief Investment Thesis:
IIFL Finance is a well-run AA rated Indian NBFC that can consistently grow at 20%+ CAGR by re-investing its profits and compounding shareholder value. If the firm is able to achieve its aspirational technology pivot towards an asset-light business model through Co-Origination & Loan Assignment and also bring down its wholesale exposure substantially down from the current 11% of AUM, I believe that the firm will easily deliver multi-bagger returns in less than 3 years through sheer valuation re-rating. In the long run, investing in IIFL Finance is an opportunity to partner with a smart and ethical owner-operator who can identify and execute well on opportunities in the fast-growing Indian financial services space. The firm is uniquely positioned to ride on its large branch footprint created to support its gold loans and microfinance business to roll-out other granular retail loans like Home and Business credit in a cost-effective manner and also cross-sell fee-based products through the group’s expertise.
The platform’s ability to originate, underwrite, cross-sell, and collect retail loans cost-effectively at scale in sub-segments underserved by banks through better execution would be valuable in an environment in which liquidity constraints are lower. While headwinds from increased credit costs post COVID exist, I believe that there are enough tailwinds for the firm in terms of better liquidity, lower funding costs, higher assignment income, improved cross-sell fees, cyclical economic recovery, rating upgrades, etc. The competitive peer set is benign at this point as the 2-year liquidity freeze in the Indian credit markets has led to consolidation with the exit of several weak firms. While Indian NBFC’s across the board (except the top 3) have been beaten down badly ever since the IL&FS crisis, I believe that nimble firms with the right portfolio exposures like IIFL Finance can compete effectively in the market place and position themselves well for the upcoming growth cycle.
5 Reasons why this asymmetric investment opportunity exists!
1.) India’s Lehman moment:
Indian NBFC’s (Non-Bank Financial Companies) were on a tear until 2018 when the collapse of a large financial institution (IL&FS) froze the credit markets completely. The Indian bond markets have been dislocated for over two years now as there has been a spate of large financial bankruptcies that followed: DHFL, Yes Bank, Reliance Capital, Religare, Franklin credit funds, etc. All NBFC’s had to vacate the short term CP (Commercial Paper) market as firms weren’t able to roll over these liabilities and shift to longer tenure funding with an increasing dependence on banks. The credit risk and term spreads have been extremely elevated since then.
India’s central bank and the finance ministry has put in place multiple initiatives to heal the credit markets and revive NBFC lending. As the central bank pumped in a huge liquidity surplus to tackle the market stress, there have been signs of bond markets reviving. As interest rates have fallen significantly (over 200 bps), the spread between AA bonds and AAA/ G Sec bonds has started to compress and I believe that the search for yields would flush in liquidity towards well-run AA firms like IIFL Finance.
I believe that only a few NBFC’s like IIFL have come out of this crisis without any meaningful hit to their governance reputation. IIFL Finance had to reduce its commercial paper exposure from 35% of its liabilities in 2018 to almost zero now. They were able to make this transition successfully while still growing their asset base (10% growth even in a crisis year) because of their ability to securitize/ assign granular liquid retail loans. IIFL’s exposure towards short tenure loans like Gold loans, Micro Finance loans also helped in better asset-liability management with positive liquidity across time buckets.
2.) Bad credit cycle in a slowing economy:
Indian economy had been slowing down even before COVID with 8 quarters of continuous reduction in GDP growth rates on the back of a tight monetary and fiscal policy. The country had also gone through several resets in terms of Demonetisation, GST, RERA, IBC, etc which exposed firms who were swimming naked. The credit costs across financial institutions were creeping up and the Indian financial sector as a whole has one of the largest pile-ups of non-performing loans globally. The massive COVID disruption has only added to the credit woes of financial institutions.
IIFL Finance was able to navigate this tough credit environment with little impact as its overall Gross NPA’s rose by less than 60 bps and Net NPA’s by less than 30 bps during this period, outperforming its peer set significantly. IIFL has also reported a healthy rebound in collections as the COVID-related moratorium ended. Similarly, the collateral values of its underlying loans like Gold, Home, Real estate, etc have held up well and hence even in the case of a default, the recovery would be healthy as LTV’s continue to be below 65% across segments. The firm had provisioned healthily upfront for the COVID stress (114% GNPA coverage) and carries overall provisions of 4.2% of on-book AUM despite historical gross NPA’s being lower than 2%. The firm has healthy pre-provision profits to continue generating strong profitability (15-20% ROE) even while providing for COVID stress. I expect the credit costs to normalize in a couple of quarters as the economy seems to be bouncing back quickly.
3.) Spin-Off dynamics:
The firm used to trade as IIFL Holdings until May 2019 post which its wealth and securities business was spun off as separate listings. The combined stock had a market cap of almost 4X of IIFL Finance’s and the wealth business has almost 2X. I believe that the stock had to undergo technical selling dynamics as with all post-spin-off shares. I believe that this corporate restructuring happened during one of the toughest periods for NBFC’s and hence it hasn’t been priced well by the markets. There has been very little analyst coverage on the stock and it gets clubbed with other wholesale lending or brokerage based firms that have a completely different business profile.
Similarly, IIFL Finance has undergone meaningful transition as the wealth business built its own NBFC book overtime and the firm acquired a Micro Finance institution and sold its CV lending book which makes it difficult to compare historical financials. The firm has only one standalone annual report but the investor presentation (attached here) is pretty detailed and the management call transcripts are insightful as well. I expect the market to understand the business better over time and give it the valuation it deserves.
4.) Exaggerated concerns around real estate lending:
Indian real estate lending firms went through a trial by fire over the last 2 years as it has been the worst hit segment in this whole liquidity crisis episode. IIFL Finance often gets clubbed with other wholesale lending peers like Edelweiss, Piramal, JM Financial, etc because of its history in funding real estate developers. While the firm initially started with construction finance at the start of the decade, it has been defocusing that segment since early 2016 as the management believed that the better lending opportunity was in the retail segments. The firm’s wholesale lending AUM is less than 12% of its overall portfolio but in absolute terms equals 88% of its book value.
I believe that the fears around the firm’s wholesale construction financing book are exaggerated as it carries around 13%+ provisions for this book (580 Cr provisions on a 4000 Cr book). Also, the firm has started providing detailed disclosures on this book with a large part of their exposure being towards late-stage construction projects in the affordable housing segment. The management also discloses the stress test results of this portfolio with assumptions that have clearly not turned true. It is very clear from primary data over the last few months that the Mumbai real estate market has picked up significantly post unlock especially in the affordable segment from reputed developers and hence I believe there is enough reason to believe that the firm is more than adequately provided on this portfolio.
IIFL has been prudent in ensuring that they are the sole lenders in all their projects with proper ring-fenced structures and personal guarantees from promoters. The biggest risk with the real estate lending portfolio is projects getting stuck midway because of liquidity constraints. In IIFL’s case, the firm needs only around 350 Cr of incremental disbursements to complete it’s under construction portfolio. The management has also been pro-active in roping in new developers, fund infusion, etc for the resolution of slow-moving projects.
Most importantly, I believe that the wholesale lending portfolio can decrease by over 50% naturally as they get refinanced by banks once they are near completion. So even without any management action, it should become less than 5% of overall AUM in the next 6-8 quarters as the retail portfolio will continue to grow strongly. Meanwhile, the management has clearly stated their intention of selling this wholesale portfolio within the next 3 months and I believe that would be the single biggest catalyst for valuation re-rating. The management has already started negotiations with external investors for this portfolio and they don’t expect any higher provisions/ write-down from this sale.
5.) Undifferentiated space/ Company-specific concerns:
The freezing of Indian credit markets had broken the business models of several NBFC’s as they didn’t have access to a low-cost deposit base and became dependent on the banks to roll over their existing liabilities. This made them totally uncompetitive in any lending segment in which their primary competitor were banks or in segments where there were no natural buyers for their loans. This completely changed the investment thesis of NBFC’s from nimble market share gainers to losers and thus the tremendous de-rating. The wholesale NBFC’s had to move their portfolios to AIF structures or de-grow their balance sheets in absolute terms to survive the crisis.
IIFL Finance has been able to grow during this period because of its focus on granular retail loans that are liquid and are difficult to access for the banks. Even in segments like home loans where banks have a strong presence, IIFL Home Finance has focused on Tier-3 cities or on customers in niches like the self-employed segment where there is underwriting/ collections complexity. In most of its lending segments, the biggest competitor for the firm were from other NBFC’s/ HFC’s (Housing Finance Companies) and hence they have benefited from the reduced competitive intensity. Their pricing power can be seen from sticky NIM’s that they were able to generate through this crisis. The firm’s securitization/ assignment history has ensured that banks were ready buyers for these priority sector loans to fulfill their regulatory obligations.
Since IIFL’s onboarding yields on all their credit segments except home loans are upwards of 15%, I don’t believe that a few bps of higher borrowing costs breaks their business model. I believe that lending successfully to these segments is primarily a function of efficiency and the winner is usually a firm with the right people, processes, and branches to source, disburse and collect loans in a cost effective manner. For example, the total employee cost is almost 25% of the net interest income and 65% of the total fixed expenses. IIFL employs almost 17, 300 people, and the higher operational cost (50% cost/ income ratio) for banks to replicate IIFL’s employee or branch count would more than negate their borrowing cost advantage.
One of the other concerns for markets has been the relatively higher gearing of IIFL Finance (6X - Debt/ Equity) with limited room for growth. I believe that the total capital adequacy at the firm’s Holdco level is 18.7% with 15% of Tier-1 equity, but the majority of the growth (60%+) is happening at the subsidiary levels (Housing Finance subsidiary and Micro Finance subsidiary) which have 24.3% (Tier 1 - 19.4%) and 23.9% (Tier 1 - 19.5%) capital adequacy respectively. Also, they have gold loans at the Holdco level which can be sold even in a distressed market for upfront profits to boost equity capital if required. The business generates 15%+ ROE even during a stress period and hence they would be able to grow at a healthy pace without diluting their equity capital.
5 Reasons why IIFL Finance can be a long term compounder!
1.) Nimble management with a history of strong execution:
While IIFL Finance has been run by two professional CEOs over the last 5 years, the group’s founder Chairman Mr. Nirmal Jain (age-53) who took over as CEO of the firm earlier this year has always been a hands-on manager of the credit business. He is a first-generation professional entrepreneur who foresaw the growth opportunities in the Indian financial services space and executed well to build four well-governed publicly traded businesses with a combined market cap of over 16,000 Cr - IIFL Wealth (India’s largest wealth and alternative asset manager), IIFL Securities (Equity capital market focused broking and investment banking business), 5 Paisa (India’s 3rd largest discount brokerage) and IIFL Finance. He has achieved this by being able to attract the right talent and incentivizing them through equity ownership. All the group entities are run by CEOs with substantial skin in the game and hence Nirmal is able to spend over 80%+ of his time on building IIFL Finance as the leading retail lender. He hasn’t sold a single share of his since the group’s listing and just clips dividends from his holdings.
IIFL Finance has executed well on scaling the retail credit business aggressively from an AUM of <1,000 Cr in 2010 to 12,000 Cr in 2015 to 35,000 Cr in 2020. They have managed risks well through adequate diversification by continuously adding new segments and moving into lower ticket categories (Net NPA’s have consistently been below 1%). The management was prudent and ahead of its peers in shifting the business model away from wholesale lending when the easier route for AUM scale-up was to press the pedal on construction and structured finance in which IIFL had an established business. IIFL’s management has not just been nimble in spotting new opportunities but also in adapting to reality quicker as they did with the disposal of their CV lending immediately post the IL&FS crisis or tapping the foreign bond markets at the right time.
While several NBFC’s have quickly grown their wholesale book, I believe it is very unique for a professional entrepreneur to build a 35,000+ Cr retail lending book within a decade from scratch. Even larger NBFC’s like Aditya Birla capital or L&T Finance have a smaller retail book than IIFL Finance.
2.) Right exposure to attractive Credit segments:
IIFL Finance’s retail credit AUM break-up is as follows: Home Loans (36%), Gold Loans (32%), Business Loans (22%), and Micro Loans (10%). While Home loan is a long tenure asset, business loans are medium tenure and Gold & Micro loans are shorter tenure and this diversification enables better asset-liability matching. I believe that the firm has found the right team, cost structure, and processes in each of these segments to scale up their book going forward. Indian retail credit is a huge opportunity with low household debt/ GDP and a young aspirational population. The firm doesn’t need to take higher credit risks as there are enough underserved segments because of the Indian lending landscape being tilted towards PSU Banks (over 50%+ share) who are extremely inefficient as shown from their credit costs in like-to-like segments at 3X of well run NBFC’s like IIFL FInance.
Gold Loans - I believe that IIFL’s biggest execution success has been in gold loans which is a pull product with very high OPEX. While every analyst understands that Gold loan lending has tremendous tailwinds for the next few years, I don’t think many realize that IIFL’s gold loan book (AUM of 11,400 Cr) is the fastest-growing among scaled-up NBFC’s and is already the 3rd largest at around 60% the size of Manappuram’s and 25% of Muthoot’s. The firm has recently roped in Indian cricketer ‘Rohit Sharma’ as its brand ambassador for its marketing campaigns. I believe there is still headroom for higher disbursements from its existing Gold loan infrastructure and the business can continue growing faster than peers for the next few years. Gold lending leaders like Muthoot and Manappuram have had a long and successful operating history in the Gold lending segment but have found it difficult to diversify into newer segments.
Home Loans - In home loans, IIFL Finance’s average onboarding ticket size is 15 Lakh Rs and they are one of the largest processors of affordable housing subsidy targeted towards first-time buyers. While this is a yield sensitive segment unlike others, IIFL’s strategy here is to assign/ securitize lower-yielding loans while generating fee income through cross-selling of other financial products to maintain 20% ROE’s. Similarly, since they focus on difficult-to-access segments in terms of geography or client profile, they are able to get almost 20% of their home book to be funded by NHB refinance at subsidized rates, and that allows them to compete effectively against larger HFC’s or banks. The churn on their home loans to refinance/ balance transfer is only 12-15% of their opening book. With 3 of the top-5 HFC’s in major trouble, the management sees them going up the market share ladder from Top-10 in the mortgage industry to Top-5 over the next few years.
Business Loans - The split between secured and unsecured business loans is 67% and 33% respectively. As with the other segments, IIFL Finance has continuously increased the granularity of their loans by reducing the average ticket size from 90 Lakhs in 2016 to around 18 Lakhs now. This has allowed the firm to increase the onboarding yield from 13% to 18% during this period. Around 75% of their business loan customers are small retailers and traders and only 25% are in the manufacturing sector. I believe that the small service business owner is extremely underserved and often depends on informal financial lenders for his credit needs. They are able to assign roughly 10% of this portfolio to banks. COVID-related stress is highest in this portfolio and hopefully, the key learnings from this cycle will enable the firm to tweak its processes and scale-up this business going forward amidst weakened competition especially on the unsecured business loans.
Micro Loans - The firm’s micro loans business is a result of its acquisition of Samasta Microfinance whose founder continues to run this segment.
This business has allowed the group to expand its branches into small villages while delivering profitable growth. Currently, health insurance is the only cross-sold product from these MFI branches (560 in total) but the management has tested a few pilot projects of rolling out home and business loans out of these MFI branches which have been successful and would be scaled up going forward. The firm’s MFI portfolio is well-diversified geographically and has an average loan size of 33,000 Rs.
3.) Robust branch infrastructure & Technology investments:
IIFL Finance has one of the most expansive branch network spread out across India with a total count of 2400 which is higher than several large NBFC’s that are multiple times bigger. The management has grown its branch count at an impressive rate with it being doubled over the last 5 years alone. The firm hasn’t rolled out all its lending products from all branches and I believe that there are still meaningful operational synergies and leverage to be extracted going forward which should help it to decrease the cost to income ratio. With 85% of its branches in Tier-2 and 3 locations, IIFL has the ability to put together a geographically diversified pool of securities that can be sold to banks and other investors.
IIFL’s gold loan business would always require a physical branch in a convenient location with adequate security and vaults for their walk-in customers. This branch network enables the firm to roll out other lending products at minimal costs. For example, the operating cost of running a gold loan business is almost 7-8% of AUM and this can be spread over other credit products. Gold loans as a standalone business covers the entire fixed costs of the platform, providing tremendous advantages to its other segments. Gold loans are currently disbursed out of 1740 branches but the home & secured MSME loans are sourced only in 450 branches as they didn’t want to spread themselves too thin. The management is mapping their gold branches with nearby HFC branches and this will enable them to grow distribution as the firm has completely digitized its home loan processing end-to-end.
The firm’s robust branch network combined with its investment in technology would enable them to provide a far better phygital/ omnichannel experience when compared with fintech peers. The management has used the COVID crisis to dramatically overhaul its cost base by automating several processes and reducing turnaround time through process innovations. They expect all their sales leads to be generated digitally or through walk-in customers and thereby reduce the requirement of sales employees. IIFL has made the processes for all its loans digital, paperless, and to a large extent faceless. All these technology investments have enabled it to provide complete transparency on the loans to their bank buyers.
Indian policymaking is moving towards OCEN (open credit enablement networks) which would help the firm to access alternate user data digitally with consent from customers and this should enable digital underwriters with experience like IIFL to grow quickly over the next decade. The firm has already tied-up with several technology companies with first loss guarantees to disburse digital loans for their customers with a current book size of 400 Cr. The group has always been comfortable with large technology investments since inception as they started their journey as an internet-based brokerage business with a strong trader terminal to cater to the DIY customer base but lost their focus with diversification into other financial services. Nirmal Jain has learned from his mistakes in the brokerage segment in which they were late to the mobile app-based discount brokerage game and had to cede market share to upstarts like Zerodha. He doesn’t want a repeat of that in the retail credit business and hence wants to keep investing heavily in technology going forward as well.
4.) Business model pivot is highly ROE accretive:
IIFL’s management has made a pivot towards a capital-light business model that can be captured under the tagline “Own the customer, Sell the loan”, post the IL&FS liquidity crisis and the recent corona virus disruption. They are moving more of their loans towards either a co-origination model with public sector banks (PSB’s) or securitize/ assign their loan pools to transfer the balance sheet risks while clipping fee income. In the co-origination model, the customer also benefits as the borrower gets a lower blended interest rate of the two lending partners which enables a Win-Win relationship for all stakeholders.
In any liquidity crisis, money moves towards PSB’s as they have the strongest liability franchise. The biggest weakness of PSB’s is their bloated OPEX cost structure and lack of a good underwriting culture that makes them totally uncompetitive in the small-ticket retail lending segments. Thus IIFL Finance is an ideal partner for PSBs to grow their retail finance books by buying their asset pools. Since IIFL Finance will continue to own the customer relationship, they will have the ability to generate fee income by cross-selling investment/ insurance products (almost 10% of PAT) throughout the loan tenure using the group’s financial product distribution expertise.
As of today, IIFL Finance’s on-balance sheet assets are 73% of AUM, and assigned loans are 27%. The management believes that they will be able to shift more of the AUM towards assigned and co-originated loans which would enable them to grow faster without any equity/ debt capital constraints. The firm currently works with multiple banking/ financial institution partners but around 80% of the assignment sales is to PSB’s. Almost 35% of its gold loan and home loan books are assigned to partners and the firm has been able to generate almost 6% of AUM on its assigned assets which is an indication of healthy pricing power.
One of the major concerns of the assignment model is the buyers’ ability to cherry-pick the best assets which would leave the higher risk non-performing assets on IIFL’s balance sheet. The firm’s gross NPA’s in on-balance sheet assets is definitely much higher than that of its overall AUM, but the difference isn’t meaningfully large to be concerned. While it has been a buyers market over the last 2 years as several weaker players were desperate sellers of their loan books, I believe that the pricing on assignment transactions would tighten going forward as there is surplus liquidity in the system (seller’s market) and the weaker players have been weeded out. NBFC’s losing seasoned books/ customers to cheaper bank refinancing has always been there even in the older lending model and is nothing new to be worried about.
I also believe that some analysts wrongly believe that the co-origination and assignment models have no entry barriers. IIFL has ready buyers for its retail pools primarily because of the firm’s track record. Their securitized/ assigned assets in general have performed much better than the credit expectations of buyers. All assignment transactions with NBFC’s start off on small pools and, partner banks scale up their purchases only after witnessing the performance of the originator’s assets across a few loan cycles. This evolution is pretty similar to how a finance firm generally moves up the rating curve with lower borrowing costs as it executes well by managing risks across cycles. The spread for a similarly rated pool that is originated by firms with different governance perception can be as high as 100-300 bps.
The successful execution of shifting more AUM under co-origination and assignment models would result in IIFL Finance becoming a capital-light business with sustainably high ROE’s. While banks are the primary buyers of loan pools at this point, I believe that quality originators like IIFL Finance will have access to a diversified investor base in the future with the evolution of insurance firms, pension funds, alternate funds, etc. The recent reforms on creation of CDS markets, IBC, etc along with sustainably lower interest rate regime and digital distribution costs will help to create a proper high yield credit market and broaden the investor participation for loan pools.
5.) Juicy valuations backed by healthy earnings growth:
I believe that the accounting around assignment transactions makes it slightly complicated to understand the normalized earnings power of IIFL Finance. In assignment transactions, the net interest margin strip between the pool’s loan yield and the buyers’ cap rate (the rate at which the bank wants to lend to IIFL + its credit loss expectations on the pool with a buffer) is discounted back and booked immediately in the P&L statement. Since the credit risk is entirely transferred to the buyer, the upfronting of income is fair and mandated under IFRS. Unwind of the discount rate from the NIM strip and amortization of fee income are spread over the tenure of the loan through the firm’s P&L statement. IIFL Finance usually charges around 25 bps maintenance fees on assigned assets.
Currently, 65% of IIFL’s fee income is from credit processing related fees and 35% is from cross-selling income. Fee Income is incrementally around 25-30% of the firm’s overall profits and the management expects it to improve it to 30-35% over the medium term. Roughly 50% of the assignment income is up-fronting of NIM from the sale of assets in that quarter and the remaining 50% is from the discount unwind of the assignment back book along with maintenance fees. Hence there is healthy predictability in the firm’s income statement and we don’t need to do any major adjustments to calculate the normalized earnings power as the trend of assignments is only expected to accelerate going forward.
Even during the last quarter when there were additional provisions for COVID, the firm was able to generate over 17% ROE. IIFL Finance in H1FY21 has generated a profit before tax of almost 800 cr if you exclude the special provisions for COVID related stress. The firm’s high pre-provision profits would enable it to survive even if economic stress continues for many more quarters. If the economy normalizes quickly, I believe that the firm will generate almost 1400 Cr of profit after tax next year (3X PAT of FY 22E). It’s not very difficult to understand that the current trading valuations of 0.85X Price/ Book and <5X normalized earnings is extremely juicy for a well-run business with healthy growth prospects.
Conclusion - Near term catalysts and Long term optionalities:
IIFL Finance is a play on the megatrend of ‘Formalization and Financialization of Indian economy’ over the next decade. Unlike developed markets, the Indian retail credit opportunity is extremely attractive as well run financiers like IIFL Finance are able to originate secure Gold or Home loans at 70% LTV ratio with a spread of over 800 bps on Gsec’s. IIFL’s team has navigated through several challenges over the last decade and built a strong retail credit platform to ride the next wave of growth.
Over the next 4-8 quarters, I believe that stabilization and possible up-gradation of its credit rating would be possible. The broader economic recovery and the declared profits of IIFL Finance over the next few quarters should in itself catch the attention of market participants. IIFL’s Promoters currently own 25% of the firm while long-term investors like Fairfax and CDC own 30% and 15.5% of the firm respectively. Since almost 75% of the firm is held by strong hands, the real free float of the stock is limited and hence any large incremental buying could re-rate the stock quickly.
In the long-term, I believe that the end game for IIFL Finance would be to convert itself from an NBFC to a universal bank. Since the group is focused only on financial services and has a history of transparent operations under various financial regulators, I believe that it would face little resistance from the banking regulator to convert to a bank over the next decade. Even otherwise, I believe there could be a possibility of Fairfax backed CSB Bank merging with IIFL Finance as the former needs to reduce the promoter shareholding and there are synergies between CSB’s liability franchise and IIFL’s asset franchise. I think Nirmal Jain wants to emulate Uday Kotak in building a large financial services group with a retail bank as the nucleus. Anyways an investor in IIFL Finance at the current valuations only needs a normalization in the credit environment to generate healthy returns and these long-run ambitions are just free optionalities.