IDFC: Buy

Investors with high risk-appetite and a two-three year investment horizon can consider investing in Infrastructure Development Financing Company (IDFC). However, given the range-bound market conditions, we recommend buying the stock in a phased manner to take advantage of declines. Rs 48-50 levels are good entry points to the stock.

IDFC, a leading non-banking financial company (NBFC) in the infrastructure financing space, provides a wide array of financial services, which include core lending, private equity, project equity, investment banking and advisory, equity broking and asset management.

Superior return on assets (2.6 per cent for trailing one year ended December 2008), robust other income, lower operating costs, high capitalisation (capital-adequacy ratio of 22.1 per cent) and a good quality advances book are the key takeaways. IDFC may be among the beneficiaries from the stimulus package proposal to set up a special purpose vehicle for NBFC financing and to allow easier access to ECBs.

At current market price of 59, the stock is trading at 9-10 times its trailing one year consolidated earnings and 1.2 times its expected book value at the end of FY09. The stock is trading at a premium to most of the banks and other NBFCs, thanks to IDFC’s focussed role in the infrastructure sector, strong subsidiaries which may survive the downturn and creditworthy clients which may protect the loan book from major slippages.

In a falling interest rate scenario, the slightly longer duration of IDFC’s advances book, compared to its borrowings, may help give it a better spread. In addition, advances are locked in at higher rates, partially shielding the company’s spreads from declining rates.
Business prospects

While around $500 billion is expected to be the infrastructure spending for the Eleventh Plan, there is a huge funding gap which the Government intends to fill by allowing private investments. This is where IDFC comes in. The lender has an advantage by virtue of its high exposure to roads and power (62 per cent of total exposure) which may continue to attract higher levels of investment.

The advances book (Rs 21,022 crore outstanding at end-December 2008) of IDFC is mainly accounted for by energy (37 per cent), transport (25 per cent), telecom (11.8 per cent), industrial and commercial real-estate (14 per cent), tourism (5 per cent) and cement and steel (1.8 per cent).

The top sectors in the loan book appear relatively immune to the slowdown. Bonds and debentures form 50 per cent of the total borrowings followed by rupee loans (25 per cent), short-term loans (12 per cent) and forex loans (10 per cent). Given IDFC’s triple-A ratings it may be able to raise bonds at reasonably good rates in a falling interest rate regime. The forex exposure is completely hedged from currency fluctuation.
Financials

Based on consolidated numbers, the advances disbursed by IDFC grew at 45 per cent compounded annually for the last five years. But this slowed to 7 per cent for the nine months ended December 2008. Moderate growth in the loan book can be attributed to IDFC’s attempt to go slow on advances to avoid slippages; high interest rates prevailed during the quarter which forced some borrowers to wait on the sidelines for better rates.

Though the loan book grew at 7 per cent, net interest income from lending activity grew by 41 per cent for this period on the back of improved spreads due to re-pricing of some advances. Net interest income (NII) from treasury was flat and dragged the total NII growth to 32 per cent. IDFC’s net profits grew by 7 per cent for the nine months ended December 2008, muted due to a fall in the non-interest income and increase in operating expenses.

Non-interest income fell by 6 per cent due to fall in income from investment banking activity (IDFC SSKI) and the income from equity (Principal) investments, both of which are equity market linked. Operating expenses grew by 40 per cent due to integration of the Stanchart AMC, which was acquired in March, 2008; but the company has taken variable pay cuts in recent times to moderate these costs.

The interest spread of the company, which is at 2.3 per cent, has improved sequentially as well as year-on-year. Slower fund-based activity, that is, slowing disbursement may pressure lending rates in coming quarters, but may be partially offset by lower borrowing costs. Consolidated numbers show income from asset management increasing threefold year on year, helped partly by inorganic factors. The net NPA is zero and Gross NPA to advances is 0.2 per cent.

However, IDFC does perceive some stress to its real-estate exposure (Rs 3000 crore, around 14.2 per cent of loan book), which may require some restructuring.
Outlook

Though asset quality is not a major concern for IDFC given the composition of its loan book, loan growth may be slower in the coming quarters given the company’s cautious stance on lending. Key subsidiaries of IDFC do depend on equity market conditions; and weak equity markets may continue to weigh on fee income until market conditions improve. In this context, the continuing expansion in assets under management in the projects, mutual fund and private equity businesses inspires confidence.

The possibility of raising further capital to protect its credit ratings have been a key concern weighing on the stock over the past year. Though the company is allowed to raise $750 million to maintain its CAR, the company is biding its time on account of market conditions and is now looking mainly at internal accruals.

A credit downgrade may carry the risk of pegging up the cost of funds. The management has already made it clear that it would not raise funds in the near future and that its loan growth target will be moderated to maintain asset quality, spreads and capital adequacy.

Investors in IDFC can also watch for a stake sale on the NSE, which may unlock considerable value. However, this is unlikely to materialise anytime soon given the market conditions. An equity market upturn would also significantly buoy the profitability and valuation for IDFC’s large subsidiaries.