We initiate coverage on Bajaj Finance Ltd (BFL) with a Hold rating. We value BFL using a two-stage residual income model. Assumptions for the model: income CAGR (compound annual growth rate) of 20%, dividend payout of 15%, cost of equity at 13.9%, terminal growth rate at 5% (nominal growth rate for developed countries). This gives us a target price of R5,500 which results in a target P/BV (price-to-book value) of 3.3x FY17e P/B.
Earnings are highly sensitive to credit costs: There is not much of an impact on earnings even when interest rates decline by 50 basis points, as BFL will benefit from lower funding costs. However, for a 25 bps increase in credit costs, earnings decline by about 5%. We believe the current valuations for BFL at 3.1x FY17e P/B and 18x FY17e P/E (price-to-earnings) are fairly priced, given the likely RoE (return on equity) of 19% and earnings growth of 28%.
Hence, near-term upsides could be capped.
We forecast an AUM (asset under management) CAGR of 28% over FY15-18e, driving an earnings CAGR of 29%. Asset yields are likely to trend lower as the asset mix shifts in favour of lower-yielding secured assets; some of this could be offset by lower funding costs – but overall NIM (net interest margin) is likely to trend lower. We expect cost ratios to decline at a gradual pace as BFL originates more of its business via internal sourcing and reduces its reliance on third-party origination. Overall, we expect average RoA (return on assets) of 3.1% and average RoE of 19% over FY15-18e.
Diversified product mix to drive growth: BFL has been steadily diversifying its product offerings across customer segments. It has leadership positioning among segments like consumer durables, lifestyle products, and two/three-wheeler financing. This has helped it deliver a robust AUM CAGR of 44% over FY11-15. It currently offers 33 products across five verticals—Consumer Lending; SME Lending; Commercial Lending; Rural Lending; and Fee Based Products and Fixed Deposits.
As at 30 June 2015, Consumer Lending AUM was R149.4 billion (up39.2% y-o-y), which represented 42% of total AUM. BFL’s consumer AUM is just 1.2% of banking system retail loans. However, within this, BFL is fairly large in consumer durables. It is relatively small in home loans and this could be a big growth driver. As of now, BFL does not offer car loans.
BFL is the largest two-wheeler lender in India. It finances only Bajaj Auto two-wheelers. It operates from more than 3,000 Bajaj Auto outlets. It is the second largest three-wheeler financier.
BFL claims it is the largest consumer electronics lender. In FY13, BFL started financing lifestyle products (furniture, furnishings, fitness equipment, watches, etc.). These are among the fastest-growing segments. In FY15, BFL started financing digital products (mobile phones, laptops, etc) and has tied up with Samsung, Apple, Sony, etc. It is already a large player in consumer durable loans. As of Q1 FY16, BFL had consumer durable AUM of Rs 51 billion which was 51% of total consumer durable loans in the banking system of Rs 159 billion.
Personal loans could grow at a rapid pace. BFL offers personal loans to existing customers with timely repayment track records and to affluent salaried class.
NIM likely to trend lower, credit costs to be stable: By our estimates, yield on loans fell to 18.3% in FY15 from 20.6% in FY11 as the asset mix has changed in favour of secured assets. We believe this trend will continue due to the change in asset mix; but some of this could get offset by lower funding costs. Overall, we expect NIM to decline 20 basis points over FY15-18e.
BFL has a diversified borrowing mix across banks, bonds, short-term commercial paper and fixed deposits(FDs). This helps it to keep borrowing costs under check. It is looking to move away from bank loans as these are more expensive than bond borrowing. Bank loans are at 48% of total borrowing as of June 2015, from 58% in March 2014.
Share of FDs is gradually rising—at 4% of liabilities as of June 2015, from almost nil in March 2013. BFL plans to increase the share of FDs to 15% of liabilities over three-five years.
Access to credit scores from credit bureaus, internal scorecards, and strong underwriting has resulted in stable asset quality. BFL follows conservative lending practices, e.g., it stopped lending to construction equipment when the sector came under stress.
Earnings growth and RoE outlook positive: Due to the retail nature of its business, cost ratios are on the higher side.
BFL plans to use technology to reduce operating costs. BFL is looking to reduce its reliance on third-party direct selling agents (DSAs) for business sourcing, as origination costs are higher for DSAs compared to internal sourcing.
It stopped doing salaried home loans via DSA from April 2015. Most self-employed home loans are also direct. The current cost/income ratio for home loans is 40%. BFL aims to cut it to the mid-to-high teens (in line with larger housing financiers.) We expect NIM compression to be offset by lower cost ratios. This, combined with stable credit costs, should lead to average RoA of 3.1% and RoE of 19% over FY16e-18e. RoE declines in FY17 as we have assumed that the warrants issued to the promoters will get converted during FY17e.
