Ugro Capital - Opportunity To Invest in a Fintech-like Company Below Book Value

Stock Opportunities Untested - but worth a good look
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It’s unusual that the company chose to skip addressing the challenging questions this quarter. Even in interviews, Sachindra Nath hasn’t mentioned anything about the rundown of SC loans. The presentation shows that NPAs on SC loans have exceeded 7%. Meanwhile, SG Finserv, another player in supply chain financing, has reported disappointing numbers, with two directors resigning. Management integrity is truly tested during tough times—it’s easy to craft a compelling narrative when things are going well.

Disclosure: This is one of my largest holdings, so I’m biased and hopeful that management takes a balanced approach in their communications.

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Absolutely. Though management highlights every quarter that when Ugro started things were bad, then Covid came, after that now we are going great in our strength due to our business model, in all those times the management was in sideline watching. Now they have their foot in water, we will see how things work out. This now is going to be true test of management and business model.
But for us investors, I think this will help us to assess the company with AUM well under 10000 crores. Would have been much worse, had the tough times came later, like at AUM around 25000 crores.

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The Company had guided 20k cr AUM by FY 25 . The growth in MSME and bridging their credit gap through digital lending was the whole premise of investing in Ugro Capital. Based on Q1 update, AUM does’nt look like even touching 15k crore.

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Disc: Exited after Q1 updates with Opportunity cost losses.

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During the Q4 FY24 earnings call, UGRO Capital discussed its experience and strategy regarding supply chain financing:

  1. Focus on Last-Mile Financing: UGRO emphasized its strength in financing the last leg of the supply chain, particularly from distributors to retailers. This segment is well-suited to UGRO’s data-driven and digital underwriting capabilities.
  2. Challenges with Anchor Financing: The company found challenges in providing financing for larger, anchor-led supply chains, which are dominated by larger NBFCs and banks. UGRO’s higher cost of funds and the competitive nature of these segments led to some negative selection and higher NPAs.
  3. Strategic Shift: Due to the complexities and risks associated with financing larger entities, UGRO decided to focus on the more granular last-mile retailer financing. This segment offers better yields and aligns with UGRO’s digital and physical infrastructure strengths. The company plans to gradually reduce exposure to the higher-risk segments of the supply chain while building out its retailer finance portfolio.
  4. Risk Management: UGRO acknowledged that the higher NPAs in its supply chain financing were due to the inclusion of lower-rated customers. They plan to manage this by focusing on segments that align better with their core competencies and by increasing the granularity of their portfolio.

Anchor-Led Supply Chain Financing:

What It Means:

  • Anchor: In supply chain financing, an anchor refers to a large, reputable company (usually a big manufacturer or retailer) that serves as the central point in the supply chain. Smaller suppliers or distributors work with or supply goods to this anchor company.
  • Anchor-Led Financing: This type of financing involves financial institutions extending credit to the suppliers or distributors based on their relationship with the anchor company. The credit is often secured against the invoices or purchase orders issued by the anchor.

Why It’s Competitive:

  1. Lower Risk Profile: Anchors are typically large, creditworthy entities. Financial institutions perceive lending against their receivables as lower risk, making it highly attractive.
  2. Lower Margins: Due to the lower perceived risk, the interest rates (or yields) on these loans are generally lower. Large banks and established NBFCs (Non-Banking Financial Companies) dominate this space as they can afford the lower margins due to their lower cost of funds.
  3. Volume and Scale: Large institutions are often better equipped to handle the high volumes and operational requirements of anchor-led supply chain financing, giving them a competitive edge.

UGRO’s Approach: UGRO found that competing in this space was challenging due to its relatively higher cost of funds and the pressure to compete on price (interest rates). Consequently, they faced negative selection, where they ended up financing lower-rated companies willing to accept higher rates, leading to higher NPAs.

In response, UGRO shifted its focus towards last-mile financing, where it could leverage its data-driven approach and physical distribution capabilities, thus avoiding direct competition with larger, more established financial institutions in the anchor-led space.

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Reasons for Muted Q1 Results for UGRO Capital (Q1 FY25)

  1. Income on Co-Lending/Direct Assignment Decline:
  • There was a significant decrease in income from co-lending and direct assignments, falling by 59% quarter-on-quarter, which impacted total income and profitability.
  1. Credit Costs Increase:
  • Credit costs rose by 58% year-over-year, driven by increased provisioning, which affected the bottom line.
  1. Higher Interest Expenses:
  • Interest expenses grew by 47% YoY, narrowing the net interest margin, contributing to a more muted net total income.
  1. Operational Expenses:
  • Despite a moderate increase in employee costs (48% YoY), other operational expenses showed only an 8% YoY rise, which helped maintain control but did not offset the drop in income from co-lending.
  1. Lower Loan Origination:
  • The overall net loan origination was modest, with adjustments due to reduced disbursements in supply chain financing, which typically contributes to the company’s higher-yield segments.
  1. Tax Impact:
  • A significant reduction in tax expenditure (-60% QoQ) was recorded, primarily due to deferred tax write-offs, which provided some relief but did not significantly boost the PAT.
  1. Overall Net Income Decline:
  • The net total income saw an 18% decline quarter-on-quarter due to the factors mentioned above, leading to a more muted performance compared to previous quarters.

These elements combined led to more subdued results for UGRO Capital in Q1 FY25, despite ongoing efforts in branch expansion and operational scaling.

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Did anyone here attend the AGM on the 8th? If there are any notes you could share that would be much appreciated.
Also just speculating here but, is that why they chose to not have a quarterly earnings call this time around? Either ways, not too thrilled that management is shying away from questions on a not so perfect quarter.

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Wanted to share one hypothesis:
Best value creators have either being consumer facing companies, or lending businesses. Good example from the past is Bajaj finance, a consumer facing lender. It was appreciated by 30x in 6years.

That is the primary reason why I have invested 36% of my portfolio in Ugro Capital and Muthoot finance, Unfortunately, both of them are not performing for long time now. I still believe in my hypothesis, just waiting for the rate cycle to take downturn, hopefully 2-3 rate cuts this years may re-rate the these companies.

Question: Do you think rate cuts this years will re-rate the financial sector?

Refer: Muthoot Microfin Limited is it next JP Morgan? - #21 by dpk1994

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If you listen to Das (RBI Governor), i don’t think we are in any hurry to do a rate cut. As long as inflation is higher than 4%, there is no reason to cut rates. Even if we hit that target, they would see if it sustains for a quarter or two or more and then think about cutting rates. So if all your eggs are in one basket, you cannot rely on just one trigger (rate cut in your case) to determine future prospects of a company. Bajaj finance was a resounding success because of their timing and understanding of the consumer market.

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For a company management which likes doing PR on overdrive, it is very strange that they didn’t feel the need to tell the investor base the reason why they skipped the quarterly call. Their IR team had the time to prepare and send a doc yesterday what the Budget had for MSME’s, but hasn’t yet replied to my query on why no quarterly call. If there was ever a need for a call, it was now when suddenly there was negligible growth in AUM.
It is Mr. Nath who loves bringing Bajaj Finance into the picture while showing us the path to the pot of gold at the end of the rainbow, lets not get too excited. BF executed very well over many years, they were not capital constrained, and RBI had not put any speed breakers on Consumer lending during their initial growth phase.
Right now, interest rates are not our main problem, as its not very high by Indian standards.
IMHO Issue is
UC is slightly capital constrained. Not saying that they have no money, but they dont have ample amount to achieve 20K AUM at the original planned timeline, I feel. UC doesn’t have the backing of a big biz house, RBI has also asked Banks to go slow on lending to NBFCs and UC has yet to prove itself over a credit cycle that PE/Family offices will right big cheques to them when asked for.
Also, MSME lending has unique characteristics. It needs special categorization/handling like we have for HFC’s. RBI/Finance Ministry needs to do something about it, if we are to fill the huge credit gap.
What best UC can do is operate within the constraints till it catches some tailwind and be upfront about any issues rather than going MIA at the first indication of (possible) issue.
Disc: Invested - 2nd biggest holding. It has been a drag on PF.
PS: Had the share price been 30-40% higher, we wouldn’t be pontificating here. The Mgmt may have been considered as faultless. Share price dictates the sentiments for most investors.

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very good points raised @njain1983

As the management says, UC is the listed startup and unlike other NBFCs it’s valuation wasn’t pumped up by the PE players as generally happens during IPOs. Since last year, management is going live on all the possible media outlets to promote his companies, as until last year nobody in the industry knew about it. Sometime, it looks bit over to me, but i guess it’s a new trend. Most of the small size companies are continuously going for interviews for building up the investor sentiment.

Interest rate (IR) is insanely high right now, even considering Indian standard. Pr-pandemic IR was 5.15% and it was slowly coming down. Between 2014 to 2017, IR declined by 2% (from 8 to 6%).
IR was declining some 75bps per year (approx). Had there been no Pandemic, IR would have been significantly reduced by now. Unlike China or other big western economies which are export based, India is a consumption based economy. Broad scale consumption can only thrive in moderate IR environment. Current lackluster consumption can be attributable to high IRs.

High IRs could be one reason of higher delinquencies in the finance sector, irrespective of vintage of the organization everyone reported higher credit cost, elevated NPAs and reduced lending in the Q1 FY2025. UC is no exception. I was bit unhappy about the result of UC but after reading into the results of its peers (or adjancies), i am fine with the performance. On the portfolio level UC has reported satisfactory asset quality.

Like any-other NBFC, UC is also affected by bank to NBFC lending norms. There co-lending model comes into highlight here, as they do not need to lend on their balance sheet and still get good fee income. So funding per-se shouldn’t be a major problem for Ugro, with easing rate cycle, situation should improve. AUM around 13.5k by fy2025 and 19k by fy26 is doable. I am much more interested in seeing ROA>4%, ROE>16%, AUM alone is not of much value. FIIs, DI looks for asset quality over just AUM.

I also hope someday RBI realizes the need of dedicated MSME categorization in NBFCs. Like MFI there should also be a separate category. This is inevitable if MSME sector really has to grow. It’s better to be with the best class NBFC rather than waiting for the clarity, won’t get value later. UC may not be the best class NBFC, but certainly a very good one.

UC raised 1280cr from large family offices, PE and individual investors, on the top got rating upgrade. Financial market is certainly understanding the opportunity here. Price movement is very well based on the sentiment in the current market rather than on fundamental. UC intends to grow its AUM and PAT at >30% (>40% for the next 2 years) siting on a huge operating leverage and available at just 1.3x 1 year fwd P/BV. This investment offers huge risk to reward ratio to me.

Disc: Among top 2 biggest holdings
PS: I have similar opinion for Muthoot micro finance

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There is a significant risk in co-lending model sustainability after recent budget announcementa:

Here are some points:
In the 2024 Union Budget of India, there was a significant focus on the digitization of Public Sector Undertakings (PSUs) to enhance SME (Small and Medium Enterprises) lending. The key announcements included:

  1. Digital Platforms for SME Lending: The government proposed the development and enhancement of digital platforms by PSUs to streamline SME lending. These platforms are designed to simplify the loan application process, reduce processing times, and ensure transparency. The initiative aims to make it easier for SMEs to access credit and financial services, thereby supporting their growth and development.

  2. Integration with National Financial Information Registry: The budget also emphasized the integration of PSUs’ digital lending platforms with the National Financial Information Registry (NFIR). This integration is intended to improve credit assessments and risk management by providing a comprehensive financial history of SMEs.

Does it mean PSUs will end lending through co-lending as they are developing their own platform?

If yes, could this be the reason management is avoiding concol to answer such questions?

Disc: Invested

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I got a response from the UGRO senior management and they have flagged their IR team. They said the analyst meet was there, but it was a physical meeting this time.

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Budget announcement can be interpreted in a slightly different way as well:

  1. Improved credit assessment model to be developed and used by bank: What UC has been already making/maturing and using since last 5yrs, PSUs are going to make now. It’s like asking PSU to make a data analytics driven consumer lending model similar to Bajaj finance. Possible but very challenging as vintage of such models plays a crucial role for accuracy.
    Solution could be PSUs are tying up with UC as a co-lending partner, which they are already doing and ramping up in a phased manner.
    Even if PSUs are able to make the assessment model, the market is enormous and under penetrated. Despite so many commercial banks, MFIs, NBFCs, SFBs, the credit penetration is so little in India. Market is huge and there is a level playing field for 20 more UCs and banks to come.

  2. Co-lending is the new way of lending, regulated by RBI and supported by Gov. As per the report shared by UC, it will grow exponentially from here atleast by 30-40% in the years to come. Co-lending is a win win situation for banks and NBFS. NBFS get fee income and lend off-balance sheet and banks have better control on the asset quality. It may replace significantly bank direct lending to NBFCs.
    Only caveat is, if all of sudden RBI deprecate co-lending. Highly unlikely in my opinion as this was established to demotivate banks direct lending to small NBFCs, which sometimes get busted. At the same providing credit to deserving NBFCs.

  3. Agree, these are the question, i also want management to answer in detail.

Disc: Invested

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They will be uploading the recording today.

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Disc: invested

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The company that raised 1200 odd cr and trading at 2400cr Mcap is really not fair. As the interest rate cycle takes a U-turn the company should perform way better. This is classic example of a value investing for me. Best in class company with pristine governance and trading at peanut valuation.

Market has a few reservations from my understanding, namely:

  1. Company did an elevated dilution, what if the company is not able to grow the AUM and PAT at a rate that will compensate the dilution of EPS!
  2. What if the company is not able to maintain the asset quality!
  3. Future of co-lending!

One thing is really no-brainer for me, the TAM of MSME lending is incredibly huge and unlike affordable housing market, the competition is not proportional. Companies like SBFC finance and UGRO that have built the physical and digital infrastructure will take the lead, it’s just the matter of time.

One caveat is; the opportunity cost of remain investing in Ugro has been huge, when the whole market is exploding. IMHO it’s a choice, Ugro has all the ingredients to be a 10 bagger from here with low or no risk, even then the Mcap would be just 30k cr.

PS: Mcap would be around 3400cr if you include all the CCDs and warrants that will get converted into shares in the next 18months.

Disc: invested

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Just like you, I’ve been holding this one for quite sometime now while others around us have done really well.
I have following concerns on the company though:

  1. Now, I see them focusing on the RoA metric which will definitely improve once a company raises lot of capital (as interest cost goes down) - they have started chasing 4% RoA instead of RoE metric which is a hard pill to swallow for a company that has so much of headroom to grow.
  2. Their disbursement growth has also been tepid since last 2 qtrs. Generally, NBFC slow down when they see issues in Asset Quality. NPA’s related concern can crop up in coming time (i hope not).
  3. I’m also unable to find their Q1 FY’25 concall link or transcript - if they didn’t do it just because of the poor nos (or Q4 concall was all over the place when they were bombarded with heavy dilution related questions) then it’s not a sign of good governance.
  4. For them to be re-rated, it’s important to have an improving RoE on a YoY basis. If RoE falls or is not upto the mark then re-rating is very difficult or process is prolonged.
  5. In their case, RoE is gone for toss for atleast 2 years due to heavy dilution, as a result, management is talking more about RoA than RoE.

On the positive front,

  1. Based on my scuttlebutt checks, I’ve been hearing a lot from MSMEs about Ugro. They have managed to penetrate to a good level.
  2. Headroom for growth is unlimited and they have the professional management.
  3. But they will be tested truly now as scaling from 10k to 20k maintaining asset quality and a RoE of atleast 15% will make them a true candidate for the re-rating.

Disc: Invested since lower levels.

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Good business, however in hibernation mode. Let’s see how things will play out in the coming quarters.

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Opportunity cost has been something which is quite evident in the stock price, which has mostly been sideways or on a one way downside that being said on valuation front Ugro is available at a solid cmp/bv of 1.5 which is reasonable given the headwinds in NBFC sector facing heat from the increased interest rate scenario.

Now, as of yesterday the fedresv has decided to cut rates by 50 bps, possibly RBI will also weigh in on a rate cut by nov mpc meet, since the inflation in india is now also in tolerance band. Ugro also recently floated a 15cr NCD issue through ppo (operational issues?)

That being said, interest rates as such can only give a tailwind and the internal efficiency ratios lies under management’s control. A respectable cmp/bv for a company like ugro would be 2.2 to 2.5 but only if the roce picks up in the upcoming Q.

Looking at overall trend of decrease in the net loan origination if let’s assume the election season had nothing to do with the overall performance of the industry we might see a slight uptick in the NPA for upcoming quarters since if mgmt has decided to halt loan disbursement they have sensed that the ongoing loan disbursement might be riskier given the high interest rate scenario.

Disc: holding, biased.

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