SREI’s stock has underperformed BANKEX for the most of the past eight years, although over the past year the stock has narrowed the gap with the index . SREI has also been significantly outperformed by its NBFC peers over the past few years.
The relatively poor performance of SREI’s shares is attributable to concerns about the company’s capital allocation, which investors believe has stressed the balance sheet. The stock’s underperformance versus BANKEX started in FY3/11. During 2010–13, SREI made a series of equity investments in infrastructure assets including roads, telecom towers and SEZs. The largest of these investments was the merger with Quippo Infrastructure Equipment. This amalgamation caused Quippo’s subsidiaries to become SREI investments, and as a result SREI ended up with an 18.5% stake in Viom, the second-largest tower company in India (including Rs16bn in direct equity investment and Rs11bn in quasi equity). This pushed SREI’s total equity investment in infrastructure businesses outside of its core finance operation to 98% of its standalone net worth. In addition, as all of these projects were still in their investment phases, they were not generating any returns.
The situation worsened for SREI when the operating and investment climate in the infrastructure space started to deteriorate after 2012. This hampered SREI’s ability to liquidate these assets, so the firm had to hold them longer than it had initially anticipated.
As a result of the high leverage on its balance sheet, SREI’s credit profile deteriorated (see Figure 7). This caused its cost of borrowing to surge 290bps from 9.8% in FY3/11 to 12.7% in FY3/14. The interest yield rose by just 80bps during FY3/11–14 as this borrowing was used to make non-core investments that were not generating any interest income (in contrast, the HDFC Bank (HDFCB IN) base rate increased by 130bps over this period).
Specifically the credit rating from CARE Ratings for SREI’s non-convertible debentures (NCDs) fell from ‘AA’ in FY3/11 to ‘AA-‘ in FY3/14. Its NCD rating then dropped further to ‘A+’ in FY3/16. As a result, the spread deteriorated from 4.7% in FY3/11 to 2.7% in FY3/14. Consequently, NIM fell from 3.3% in FY3/11 to 0.9% in FY3/14.
The balance sheet became inefficient as borrowing was used to fund the equity investments. This borrowing exceeded the balance sheet loans, which pushed NIM below the core business spread.
The situation was further exacerbated by the difficulties in the infrastructure sector. The downturn in the infrastructure operating environment was characterized by a variety of defaults including in the power sector and for road projects. This in turn resulted in a sharp increase in nonperforming assets for SREI. The firm has responded by writing-off loans over the past couple of years, particularly in its construction equipment operation.
Viom Stake Sale Has Freed Up Equity
The proceeds from the sale of its Viom stake totaled Rs29bn for SREI, including equity and quasi equity. As a result of the sale, SREI has reduced its borrowing and capital has been freed up for the core business.
Reduction in Borrowing to Improve Credit Rating and Lower Funding Costs
Currently the major source of funding for SREI is wholesale funding through banks. The consortium for the construction equipment business includes 37 banks while that for the standalone book (mainly project finance) includes 30 banks. The company is looking to reduce its funding costs by diversifying its loans through a wide spectrum of lenders. SREI also recently issued NCDs with a maximum annual coupon of 10% aggregating to Rs2.5bn. This should help improve its borrowing costs.
Operational Changes
Not only is the operating environment improving significantly in SREI’s core equipment financing business, but the company has also adopted a strategy of not exposing the balance sheet excessively to infrastructure assets, as was the case in the last cycle.
SREI enjoys competitive advantages in its construction equipment finance business stemming from its presence in all segments of the construction equipment life cycle (from the initial asset purchase to the exit from the investment or its resale). The company has tie-ups with all the leading construction equipment makers, which gives it an edge in purchasing the assets, and it understands the segment well due to its 25 years of experience in the business. These assets are used primarily by construction and mining companies and given its project financing exposure and its equity interest in road projects, SREI is able to deploy its construction equipment assets efficiently and quickly. SREI has 32 stock yards for maintaining and refurbishing its assets, which improves their residual value. At the end of the equipment lifecycle, SREI offers valuation and inspection services and related financing.
On-balance-sheet loans as percentage of capital available for lending reached 113% in FY3/16, which in our view indicates that balance sheet utilization in the construction equipment business is excellent. This ratio exceeded 100% each year during FY3/10–16, which signifies better efficiency for SREI than that at peer NBFCs (in FY3/16, the ratio at Sundaram Finance (SUF IN) was 96% and that at Mahindra & Mahindra Financial Services (MMFS IN) was 104%). Due to demand for securitization, off-balance-sheet loans as a percentage of SREI’s total construction equipment AUM has been high (16% in FY3/16). Thanks to the lofty on-balance-sheet utilization and its securitization of assets, NIM on total assets for the construction equipment business (i.e., its capital available for lending) is significantly above its spread (for FY3/16, the construction equipment business spread was 4.5% and the NIM on its balance sheet was 8.0%).
Demand for construction equipment is highly correlated to investment in the infrastructure sector. As investment gains momentum, we expect growth in SREI’s construction equipment business to improve substantially. In the difficult markets of the past three years, several banks and NBFCs exited the construction equipment financing business. However, SREI stayed the course standing by its dealers, its customers and the manufacturers, and as a result it has strengthened its overall market position.
Earthmoving equipment dominates construction equipment volumes. In Q1 FY3/17, it accounted for about 81% of the total. Backhoe loaders, a subset of earthmoving equipment, constituted 60% of earthmoving equipment, and crawler excavators constituted 32% in Q1. Construction equipment volume rose 58% YoY industrywide in Q1, with earthmoving equipment volumes up by 59% YoY during this period.
Purchase of Construction Equipment Stake from BPLG
BPLG sold its 50% stake in SREI Equipment Finance to SREI in lieu of 5% equity in the parent company and SREI Equipment Finance became a 100% subsidiary of SREI from 17 June 2016. This allowed SREI to regain direct control of the fund-based segment of its infrastructure operation. We expect SREI’s 100% consolidation of the equipment finance business and profits to enhance shareholder value
Strategic Opportunities
Call Option 1: Sahaj Sahaj e-Village (unlisted), a venture initiative of SREI, aims to bridge the digital divide between urban and rural India. Sahaj has established 40,768 touch points in the Indian states of Assam, Bihar, Odisha, Tamil Nadu, Uttar Pradesh, Maharashtra, Rajasthan, Himachal, Jharkhand, Delhi, Tripura and West Bengal that support the information technology requirements of rural villages with a range of services for (1) e-governance (including government-to-consumer (G2C), unique identification number (UID)-related and, bill collection services), (2) e-commerce (including insurance, mutual funds, financial inclusion (business correspondent (BC) model), mobile and direct-to-home (DTH) recharges, product sales and distribution) and (3) e-learning.
All the Sahaj retail outlets operate as franchises (i.e., retail outlets at the gram panchayat (local government) and village levels in each state, known locally as Sahaj Mitr) or star franchises (i.e., retail outlets at the metro, district headquarters and tehsil (county government) levels and hubs that serve as logistics and distribution centers, known locally as Param Mitr). Franchisees manage the day-to-day operations of the stores. All capex and operating expenses are borne by the franchisees. In turn, Sahaj is responsible for project management, quality assurance, infrastructure setup, franchisee training, and access to new services and content at the retail outlets.
In working with the franchisee, Sahaj serves as a BC and in that capacity receives fixed monthly remuneration from the banks. It also receives a variable income stream in the form of transaction fees from banks, e-governance and e–commerce partners. One time transaction fees are derived from account opening and UID generation while steady fees are generated from BC transactions (such as when deposits, withdrawals, and remittances are made), G2C transactions (e.g., when utility bills are paid), and B2C transactions (e.g., mobile and DTH recharges and product sales).
In absolute terms, revenue for Sahaj did not increase significantly during FY3/11–16. However, the company did reduce the level of government support to its top line from Rs495mn in FY3/11 to zero in FY3/16.
Call Option 2: Road Asset Portfolio
SREI has a well-diversified portfolio of build operate and transfer (BOT) road assets in Madhya Pradesh, Maharashtra, Uttar Pradesh, Kerala, Arunachal Pradesh, Odisha and Haryana. Of the eight total projects in which SREI has a significant economic interest, five are already operational covering 1,690km, and an additional 760km is under construction. Total revenue from road assets exceeded Rs4bn in FY3/16
Shareholder Returns
We see consolidated ROE rising from 2% in FY3/16 to 11% in FY3/19, led by an improvement in ROE in the construction equipment business from 5% to 15% during this period accompanying a decline in credit costs. With NIM increasing on reduced borrowing following the sale of the Viom stake, we also see ROE increasing the project finance operation from 4% in FY3/16 to 7% in FY3/19
Investment Thesis – Target Price – Share Price Catalysts
We think SREI is a classic turnaround story. It seems as if everything went wrong for SREI over the last decade, including mistakes by management on capital allocation (i.e., the buyout of Viom) and the firm’s heavy funding exposure to the infrastructure sector which suffered as a result of deterioration in the operating environment.
However we believe these problems are unwinding with
(1) the sale of the stake in Viom in FY3/16 enhancing the bank’s capital position,
(2) an improvement in the operating environment for the core construction equipment business,
(3) reduced financing costs, which has strengthened the balance sheet, and
(4) the purchase of 50% stake in the construction equipment business from BPLG in lieu of 5% stake in the holding company. In addition, we see the potential stake sale in Sahaj and/or in the road asset portfolio as call options.
We have a BUY rating on SREI with a target price of Rs126.90, based on our SOTP analysis, through which we have derived a FY3/18 PBR value for the project finance business of 0.7x and for the construction equipment segment of 1.5x. We expect ROE to rise through FY3/19 on an improvement in NIM accompanying reduced borrowing levels. We see this as a key positive catalyst for the share price.
