Power Finance Corporation Limited : Rare profit making PSU?

1

Quick Snapshot

CMP: 85 as of 19th June

Market Cap: 22,439cr

P/E: 2.38

Div Yield: 11.15%

ROE: 22.82%

52 W H-L: 75.15/138.8

History
-1986: Started Business
-1993: MoU with Government of India with the aim of developing the country power sector
-1999: Started consultancy services to both State and Private owned companies
-2005: Entered into MOU with LIC and other 10 private banks for financing of Power Projects
-2015: Incorporated Jharkahnad Infra project and Bihar Mega power as a wholly-owned subsidiary

-2019: PFC acquired majority of the REC which is the second-largest PFC controller by GOI.

Segment
Company has only one segment which is lending loans to power sector companies which are engaged in:

  • Construction of Power Plant &
  • Generation supply and distribution of electricity.

Note that the company doesn’t have any other geographical segment other than India.

Promoter Holding

  • GOI holds 55.99% ownership in this company. GOI has divested its stake in this company from 66.6% at one time in 2018 to 56% currently. It is one of few consistent profit-making PSU which was divested by Government

My personal views on the disinvestment are positive. I believe in disinvestment of PSU because from a company viewpoint :

(i) it helps in improving the efficiencies of such companies when it comes to management policies and productivity as it’s now more governed by professionals instead of bureaucrats :slight_smile: although it can be argued that public sector companies can also appoint professionals so this argument is not valid. However, we all know the efficiencies b/w Public and Private sector in reality esp in the context of India hence my views are biased towards the positive side.

(ii) It helps to attract private foreign investors for JV which is much better than foreign borrowing which PFC is currently doing to fund its loan book.

  • FII holds18.92% as of March-20 which is up from 14-15% in 2018. Its mainly owned by :
    Windacre partnership master fund 4.87% and UBS principal capital 3.28%

  • DII holds 20.4% mainly by LIC 5.59% and HDFC Trustee company 9.25%

Loan Book

  • Company has continued to increase its loan exposure to 3,14,667 cr as of March19 as compared to 2,79,329cr as of March-18 i.e. up by 13%

It has been able to consistently grow its loan book by 10% during the last 5yrs.

  • The cost of the fund has gone down to 7.95% from earlier 8.21% in FY19. This year company has further benefited from it going down due to a low rate.

  • Looking at the annual statement of the company, one can make out that it has a high % of the loan to financial weak state sector companies which do give the risk of NPA however company argument is opposite that its state-backed so won’t default. To me, this is a risk factor in the book given a high concentrated profile of the borrower.

  • Company loan book growth has been from the borrowing against the internal accrual as we can see from the cash flow of the company.

As we can see below the majority of the investment of the company is funded by external borrowings under CFF as compared to a small percentage being funded by Internal profit actual. This exposes the risk further when GOI holdings say goes below 51%. The cost of borrowing might further increase in that case of the company while its highly concentrated state loan portfolio if gets distress can become a debt trap for the company.- Company loan book growth has been from the borrowing against the internal accrual as we can see from the cash flow of the company.

As we can see below the majority of the investment of the company is funded by external borrowings under CFF as compared to a small percentage being funded by Internal profit actual. This exposes the risk further when GOI holdings say goes below 51%. The cost of borrowing might further increase in that case of the company while its highly concentrated state loan portfolio if gets distress can become a debt trap for the company.

Financials

  • Financial performance has been quite good. It has increased its sales every yeat at a decent rate and its expected to overall report 12% higher sales as compared to 2019

  • Net profit is expected to be down however given the current market price and strong growth in strong growth in Sales and Profit in 2018 and 2019, this year’s profit and Sales don’t look bad. It’s one of the few Profit-making PSU.

Also, note that we can see that Price is at the 2018 Year-end levels currently at 85.7 while EPS, Sales, and Profit has already increased by 50% almost to those levels of FY 2018.

  • The company has been a consistent dividend payer and has paid a dividend of Rs 49.55 in the last 10yrs. Given the Price of stock at 85.7, it’s trading at an attractive dividend yield of nearly 11% to its FY20 dividend.

Liquidity

  • As shown above, that company heavily relies on the interest income and refinancing to pay its debt. The current COVID time with 3 months of moratorium doesn’t give that much of comfort at this time.

  • One thing which does separate this entity from all other NBFC is its sovereign ownership which is the main reason to recommend this NBFC. Its a good consistent profit-making PSU and given its backing of GOI, it has the ability to raise funds at short notice when required as it has shown in the past when the situation demands.

Valuation as per different methods:

Looking at the valuation right now, we do have a chance of 50% to 100% upside. These evaluations are made under certain assumptions which are given below.

  1. EPS based valuation:

PFC has been historically been trading at a P/E of 4-5 as an average over the last 2-3 yrs. Lowest P/E has been 2 which its currently trading at and highest has been around 18.

We have a fairly good upside of ~30-40% on this stock-based upon EPS remaining the same over the next few yrs ( which is quite a conservative assumption) and P/E reverting back to somewhat normal of 3 times instead of 4-5 times currently more inline with the past historical average.

Also, its worth noting that its the largest power finance company in India even larger than REC while REC is trading at P/E of 4.3 vs PFC at 2.8

Note: 30-40% also takes into account the Dividend income of ~17rs on Rs87 stock price.

  1. Peer-Based Valuation

image

Again we have got a 60% upside against Peer-Based valuation (including dividend Yield) under a conservative 25% discounting to average P/E of the Peers. This I have done as I have highlighted risk earlier of Loan book being highly concentrated to state-owned power companies and risk of raising money to fund the loan book.

Also if you look at the above Peer, reason, why this company is so attractive, it has the lowest P/E in spite of being the largest Power financing NBFC in India and beating other NBFC’s in terms of ROE, ROCE yet lowest P/E.

  1. Graham

Looking at the Graham, we will come up with a much higher valuation of INR 374. However, the Graham formula has certain flaws like P.E of 15 and P.B of 1.5 is assumed

this is obviously going to show the stock as massively undervalued. However, the core concept of Graham is still relevant, blind usage of the formula without understanding will not yield a correct result like below its yielding 374

In the below, I have modified the Graham formula to take a P/E of 4 which given the historical range of 2-18 and average of 4-5 P/E looks to be a much more reasonable and conservative P/E and P/B is assumed to be 1 given a growing company should always trade at least equal to its book value. Also looking at the closest Proxy of REC at ~4 clearly suggests this stock is mispriced.

Given the modified Graham formula, I get a price of 157 which shows an upside of >100% in relation to the current stock price.

  1. Book value approach

Looking at the book value, this stock is trading much lower than its book value as compared to its peers.

You might argue that why not IFC. We can clearly see that its not only has other poor parameters like ROE%, ROCE%, etc but also dividend yield is nil which doesn’t have GOI India backing yet trading at a P/E ~5.

This has the lowest P/E in the sector and trading at 0.45 P/B times just.

Risk:

  1. The loan book is highly concentrated towards the State-owned power companies are highlighted earlier. Due to COVID, we do have a risk of delay in servicing of loans by these state government power companies however given power segment is a profitable segment and given company is a profit-generating entity so it should be able to sail through

  2. There have been talks in the street that the GOI might reduce its stake < 51% on this company. While disinvestment I believe is good overall but <51% might turn to be bad in short term and the company will not be Govt controlled entity below 51% thus losing the ability to raise money at a cheap rate in the market. In the long term, I still think it will be good as a company can enter into JV with Foreign counterparties which are always better than raising money from abroad which the company is currently doing.

  3. The ability of the company to grow its Loan book without incurring heavy Credit costs will be important esp during COVID times when the chances of getting caught in a bad debt trap could be huge.

4) Most important risk is the REC merger with PFC. Although the merger of the two largest power financing companies will create a monopolistic market however it is expected to limit the ability of the company to borrow from banks due to large combined debts. As per the latest update, due to this reason, the merger is still on hold. Due to this reason, PFC doesn’t have management control of REC although it has majority share in it. This issue needs to be examined closely however both are good profit-making PSU’s

Overall its a company with good historical growth, the strong Loan book growth, Lowest P/E in the Industry in spite of being the largest power financing NBFC, GOI backed and profit-making PSU, trading at all-time low P/E with best ROE and ROCE in the industry in its sector and good dividend payment history.

I have invested in this at the current market price of 85 for long term purposes given the above.

Disclosure:

  1. I have an investment in this stock so my views might be biased. I request you to take your own judgment call before you make any investment in this name.

  2. I am not a SEBI registered analyst so don’t have any recommendation service/Paid service. It’s an educational website that is just meant to share the analysis I do before I invest.

8 Likes
2

This is a bit annoying but it doesnt allow new user to have more than 1 image in 1 post. this is a silly rule. Can i request admin to remove such rules which defeats the spirit of analysis please

1 Like
3

Loan book growth pic which in wasnt able to enter due to 1 picture per post for few user rule

image
image808Ă—548 77.9 KB

4

High exposure to State Power companies

image
image851Ă—233 75.1 KB

1 Like
5

Cash flow statement showing how new loans are mainly supported by borrowing

image
image843Ă—1072 348 KB

6

Financial snapshot of company

image

7

Dividend paying history

image

8

Valuation as per different principles using the models i have given in original post

image

9

Modified Graham using P/E of 4 and P/B of 1

image

10

last pic which i wanted to give in my original post was on comparision of book value approach across Peers and other Parameter of PFC with other NBFC in same segment…clearly standing out vs others

image

11

Problem with all these dividend yield utility players in the PSU sector is that they seem like value stocks but are actually value traps. These companies look like buys even at higher prices. Example: PFC at 150 will have a P/E close to 4 and will look like a buy with an earnings yield of 25%. There is no limit to how low they can go and can even trade at P/E of 1!

Look at Coal India. Seems like a value stock but is actually a value trap.

The dividend yield of these stocks make us feel like they are bonds. Example: the 49.55 dividend earned over last 10 years. Problem is that they are not like bonds because there is no guarantee that the principal amount will be returned!

Best avoid these type of PSU utility stocks - buy only when the results are near to see if you get a dividend and exit soon after

3 Likes
12

I couldn’t agree more!
Also, read this interesting article published by Marcellus on PSU stocks:
What’s to lose in a 6x PE stock?

2 Likes
13

Couldn’t agree more with them being value traps. The only psu I’d even consider investing in is RITES. And that’s only cause it feels like less of a PSU than the rest. Maybe buying IOC in the year 2000 and taking in all the bonuses and dividends made sense if you wanted a salary per year and dint care about capital. I had an uncle who did that. Invested in ioc years ago since he said it was like a job he was applying to at ioc which they would pay him when he retired lol. However I’m pretty sure an investment in the likes of hdfc or hul would’ve led to a LOT more. I’ve not checked

14

Thanks for all your views. Over last 10 yrs I have made investment in very few PSU myself but at same time I also believe all PSU has a fair price . Just because a stock is PSU , it would be wrong to ignore it. Although yes I have just invested 3 times in PSU myself in my entire life and I think if it’s entered at correct price , it not only gives good dividend [ as govt needs money so companies are forced to give good dividend ] but also can give decent upside . I do agree private player will most likely offer better returns as you rightly pointed in banking etc but depending upon sectors like power etc private players are too less.

I always uses my own valuation models to buy things and as per me the price is just a right although I completely agree that P/E is not a reliable measure . My focus is always on a growing profitable sector and this is the primary reason . Just that it’s peers and other factors like p/e makes it further attractive is a bonus on top of this

2 Likes
15

Appreciate your new find.
If one can catch hold of good dividend yield stock at right price it is incremental cash flow generator for long time. Historically Microsoft and Reliance have this strategy of creating cash cows and then deploying to growth oriented businesses.

16

Would like add some of my thoughts here:

• To my mind, this is like an arbitrage business wherein the interest rates are charged based on the ratings of the DISCOMs (most of whom are not rated well) while as these companies are owned by the State itself and therefore there is an inherent sovereign element to it. So, ideally speaking there should be any default.

• Unlike other NBFCs, PFC has an advantage in terms of cost of borrowing and also is able to raise low cost funds through 54EC (which others cannot).

• Merger: On merger, the decision from GOI is pending – Deloitte is the consultant and has presented the proposal to PFC/GOI. I don’t think anything changes materially if this is deayed.

• On the GOI holdings issue, my sense is that the government will not bring it below 51% and will likely look at other methods to keep it above 51% as these companies are important vehicles for the reforms in the power sector. As per the news articles, Centre is reaching out to other public sector companies such as Life Insurance Corporation (LIC) and state-owned power companies like NTPC to pick up a stake in the merged company.
Web-link to these articles:
a) https://www.business-standard.com/article/finance/pfc-rec-merger-stuck-centre-reaching-out-to-psus-to-pick-up-stake-120021900029_1.html
b) https://newspublic.in/pfc-rec-merger-stuck-centre-reaching-out-to-psus-to-pick-up-stake/

• The biggest risk in Investing in Financial Companies is that it is very difficult to understand the books – all of these are black box to the minority investor. As PFC is a government-run entity, there is no incentive to cook the books by playing with recognition of NPAs. Furthermore, they have been very transparent with the problematic part of their books – Private companies. This also gives comfort.

• NPAs – The Net NPAs have reduced to 3.8% in FY20 from 7.4% in FY18; the total provision for the NPAs (for private sector) is 53%.

• Upside on Resolution: The total amount stuck in Stage 3 is Rs 28,000 Cr while they have made a provisioning of Rs 15,000 Cr. Therefore, on 13,000 Cr they are not earning anything – assuming further haircut of 3,000 Cr before final resolution will release Rs 10,000 Cr; assuming 10% interest rate it will directly add Rs 1,000 Cr to the bottom line [Note: PFC does not accrue any interest on NPAs].

Investment Thesis

• There is a considerable comfort on the valuation front – assuming 10% dividend and a meagre 5% growth in price over long term would mean 15% CAGR. So, I believe there is room for upside while the downside is limited.

Risks to the thesis

• The company is a Government-owned and therefore any diktat from the MOP that impacts the profitability to be closely monitored.

• Defaults by State-owned DISCOMs.

• Holding of Government reduces below 51% to impact costs.

Disclosure: Invested

7 Likes
17

Hi Anupam

Glad to receive your valuable thoughts. I completely second your views and risk you have raised are the ones i also felt and highlighted in my original article

I think if anyday this company shareholding of GOI goes below 51% then its a big red flag although history has shown that once company looses sovereign guarantee , the borrowing cost rises and credit rating falls however if they can enter in JV then on long term basis this is best way to finance your needs.

Lets imagine a worst case scenario that Govt holding goes below 51%. Do you think they are in a position to go into JV?

Thanks

18

I am not sure if I understand the question - JV with?

Having worked in the sector for a long time, I am more worried about the first risk that I have highlighted in practical sense:
The company is a Government-owned and therefore any diktat from the MOP that impacts the profitability to be closely monitored.

On the public sector character, I think the Government would be able to handle it. Today, LIC holds 5.5% in PFC and 2.8% in REC; increase in holding from LIC would get them out of this issue. And I am sure that Central government would not let these companies go out of their stable as they use the carrot and stick approach to get reforms done using Financing from these companies as a tool. I am sure Deloitte would have given them a way out of the problem - its only a matter of priorities I guess [they have got their 14,000 cr for now and it cannot be milked further].

19

i do agree with your point. Government wouldn’t let this rare profitable PSU go out of their hand esp with so much of state owned power company it finance.

My question is suppose in worst case government holding reduces below 51% . Company would then loose the benefit of lower funding and better credit rating it has

so in that worst case scenario ( although it may never happen), do you believe company would be able to survive?

When i say JV, i mean a way of raising fund from foreign investor like a partnership. Is this sector and company attractive enough in your view to attract JV from foreign investor ? ( given you have spend lot of time in this sector, i am just trying to forecast worst of the worst scenario )

20

I would think so - if we don’t look at the company from the prism of stock market, I think its a solid franchise. PFC and REC have 6 lakh crore of Balance sheet - not sure how many banks can boast of that kind of book…

Further, I understand from my colleagues in Finance is that when PFC/REC lend, they do it on their own terms (loan covenants such as pre-payment penalty, reset date etc heavily tilted in favor of lender).

1 Like