The government has announced a revival package for state electricity distribution companies (SEBs/ DISCOMS). SEBs have accumulated losses of ~Rs 3.8tn and debt of ~Rs 4.3tn as of FY15, held largely by banks and specialised financial institutions like Rural Electrification Corporation (REC) and Power Finance Corporation (PFC). We see this as a positive for the banking sector to lower stress levels in the power sector but it will hurt margins and loan growth for REC/PFC. State governments will take 50% of DISCOM debt in FY16 and 25% in FY17 by issuing state development bonds (no SLR) carrying interest rate of 50bps over the state government yield. State guaranteed DISCOM bonds will be issued for rest at Base Rate + 0.1%. While it’s voluntary for state governments, they will be incentivised by subsidised funding from the Centre for power and coal.
Downgrading REC and PFC to Neutral; Cut EPS and PO
PFC and REC are most negatively impacted having an estimated 23% and 33% loans to DISCOMs. We estimate earnings hit of 18/23% in FY17 owing to margin compression and lower loan growth. This assumes only the state governments having the big lossmaking SEBs accepting the proposal. Earnings hit can be +30% in a scenario in which all states implement. We downgrade REC (XULEF) and PFC (PWFEF) to a Neutral (from Buy) after cutting net profit estimates by ~18/23% for FY17 and PO to Rs 260 (from Rs 375) for REC and to Rs 255 (from Rs 350) for PFC. On nominal book, both REC and PFC trade at ~0.8-0.9x one year forward book. But adjusting for estimated NPLs, REC trades at 1.5x FY17 and PFC trades at 1.2x FY17. We think stocks are unlikely to re-rate given the earnings risk overhang arising from the DISCOM package. Hence, we peg our target multiples at 1.5x FY17 adjusted book for REC and at 1.2x FY17 adjusted book for PFC, based on Gordon model with 16.8% average RoEs for REC and 15.5% for PFC for FY17-18e. Given that we believe the overall risk reward still appears reasonable, we don’t cut our ratings to Underperform.
Banks’ impact is likely to be much lower: The overall earnings impact is likely to be much lower for banks given their smaller share of SEB loans as percentage of their total loans. On the positive side, it would lower the share of impaired loans as most of these exposures are classified as restructured and release provisions (5% of loans).
Scheme, if successful, very positive longer term: We think the scheme, if implemented successfully, could be very beneficial over the longer term. In particular, the scheme focusses on bringing cost-side efficiency through reduction of interest service burden, fuel costs through coal swapping, etc. On the revenue side, it seeks to have quarterly fuel cost adjustments, annual tariff increases, taking regulators on board and including discoms losses in the FRBM limits for states.
Key challenges
The key challenges for this scheme are: (i) The states’ ability to finance these by finding takers for state issued bonds; (ii) Ability of state governments to ensure SEBs package is successfully implemented in terms of tariff hikes, cost side efficiency etc.
SEB package hurts power financiers; Downgrade REC and PFC to Neutral
The scheme announced by the government to help the finances of the SEBs while very beneficial for potentially easing the pain of the SEBs/Discoms, is likely to cause severe margin compression and volume growth to be lower for the specialised lenders like REC and, to a lesser extent, PFC. Hence, we are downgrading both REC and PFC to Neutral from Buy.
Ujwal Discom Assurance Yojana (UDAY) to help SEBs
The government has announced—Ujwal Discom Assurance Yojana (UDAY)—to help the finances of state electricity distribution companies (DISCOM). The DISCOMs have accumulated losses of approximately Rs 3.8tn and outstanding debt of ~Rs 4.3tn as of March 2015. These are largely held by banks and financial institutions As per the scheme, the state governments will take over 50% of DISCOM debt in FY16 and 25% in FY17. This would not be counted as part of that states’ fiscal deficit. These bonds, issued by the state government would, however, not qualify for SLR status. These bonds would be issued to the banks/FIs in lieu of existing loans to DISCOMs at an interest rate of 50bps above the state government yields. Any shortfall would be auctioned. The balance would be converted into state guaranteed DISCOM bonds at Base Rate+ 0.1%. The portion of the discoms’ debt which is under restructuring would also be converted to bonds.
States will be incentivised by providing them subsidised funding from the central government’s power schemes and easier supply of coal.
Downgrade REC, PFC to Neutral (from Buy); Cut EPS, price objectives: We are downgrading both REC and PFC to a Neutral (from Buy) after cutting net profit estimates by ~18% and 23% for FY17 and PO to Rs 260 (from Rs 375) for REC and to Rs 255 (from Rs 350) for PFC. REC and PFC are most impacted as we estimate 33% and 23% of their loans are to DISCOMs. These will earn a lower yield and their loan book will also shrink as they convert into bonds.
Re-rating unlikely as earnings risk overhang persists till full clarity: The market is unlikely to re-rate these stocks to what our original target multiples were on REC (1.9x FY17 adj. BV) and PFC (1.9x FY17 adj. BV) owing to the high earnings risk arising from the DISCOM package. While the package is voluntary (for state governments), many of the key states having the high loss making SEBs will be keen to take the package. This amounts to over 50-60% of the total SEB debt.
Hence, even assuming some states do not implement the package, we see REC and PFC earnings being impacted by 17/23% arising from the margin compression and the slower loan growth. Further, we see more downside risk to earnings if the entire package is implemented extending the earnings hit to +30% for PFC/REC.
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