Rural Electrificiation Corporation

Investors with a low-risk appetite can consider taking exposures in the State-owned Rural Electrification Corporation (REC) stock as it is trading at attractive valuations. High demand for funds on the back of huge capacity-addition targets, a relatively low cost of funds as it can float tax-free bonds, advances secured by government guarantees and zero mandatory reserve requirements are key investment positives.

At the current market price of Rs 76, REC trades close to its book value and six times its expected FY-09 earnings. It trades at a substantial discount to peers PFC (12 times) and IDFC (11 times).
Strong Business

REC was recently awarded Navaratna status, endowing it with greater managerial autonomy and access to more funds, without the government’s prior approval. REC was primarily set up to fund State electricity boards for electrification of villages, especially in energising agriculture pumpsets, but has since expanded far beyond its original mandate and is now a broad-based power financier similar to PFC.

Power generation companies (to which it started lending only from 2003) accounted for 33 per cent of outstanding advances as on June 30, 2008 and their share is expected to go up to 50 per cent in future quarters. REC is also diversifying its disbursement by lending to private sector projects (now 6 per cent of total advances).

The power-for-all programme (which envisages major investment in rural electrification and generation) is expected to add additional 92,000 MW in the Eleventh Plan (2007-2012) and lending to state utilities for upgradation, renovation and maintenance of existing projects, to new projects in generation and for 100 per cent metering, all offer scope for advances growth. REC expects to lend Rs 1,00,000 crore in the Eleventh Plan. Additionally, REC is acting as a nodal agency for the Rajiv Gandhi Grameen Gruha Vidyutikaran Yojana (RGGVY), which has an investment outlay of Rs 33,000 crore, of which 90 per cent is given in the form of grants by the government and 10 per cent is funded by REC.

REC will disburse around Rs 3,300 crore under this programme. It will also get commission of 1 per cent — Rs 330 crore over a five-year period.
Financials

REC’s advances have grown at 19 per cent CAGR for last five years, while operating profit grew at 13 per cent in the same period.

Net profit for the first half of 2008-09 has, however, jumped 41 per cent on the back of higher advances growth. Even as advances may continue to grow at healthy rates, profitability may grow at higher rates than the historic rate; as cost of funds fall even as loans have been locked in at higher rates.

As of March 2008, secured bonds constituted 67 per cent of the total borrowings for REC. The gap between cumulative disbursements (Rs 75,000 crore as on March 31, 2008) and amounts sanctioned (Rs 1,79,526 crore), suggest room for growth in advances even without any fresh sanctions.

The company’s asset quality appears good given that by March 2008, 98.4 per cent of the disbursed amount was recovered as per schedule. Non-performing assets stood at 0.8 per cent in March 2008. Most of the disbursements are long dated with three-year and 10-year reset clauses. REC’s ‘other income’ is currently low, but new subsidiaries such as REC Transmission and Distribution may have potential to increase this component.
Outlook

Fresh sanctions apart, the Rs 1,00,000-crore gap between sanctions and disbursements point to healthy growth in the loan book. REC’s lending rates have not yet been revised in proportion to the falling rates in the market (the rates last hiked on October 1, 2008 and lending rate ranges between 12.75 per cent and 14.0 per cent). Though existing loans have been locked in, fresh lending may require REC to reduce rates to some extent, failing which borrowers may choose to wait.

REC plans to buy equity stake in coal-rich power projects which will help in diversifying from core-lending business. It also plans a joint venture with companies and expression of interest (EOI) was issued. It has already ventured into consultancy and transmission businesses.

REC may gain access to overseas funds with the recent RBI measure of removing cap on the external commercial borrowing (ECB) rate. ECBs can be raised at lower rates compared to domsetic bond issues, with the libor falling to 0.1 per cent. The sovereign rating for REC’s foreign currency bonds are also a help though rupee volatility may be a risk.
Risks and concerns

SEBs, which account to more than 90 per cent of their loan book, are not showing any signs of turnaround and still have a long way to go in up-gradation of transmission and distribution equipment.

For now, REC is protected by government guarantees, Escrow accounts are maintained to shield against the losses incurred by SEBs. In future, unbundling of SEBs and their privatisation could lead to the government stepping away from the present system of guarantees to back up SEBs. Any slowdown in commencement/execution of the projects may also delay the payments. The possibility of REC coming under RBI purview may also lead to more stringent capital adequacy and provisioning requirements.