REC FPO Review

Investors can subscribe to the follow-on offer from Rural Electrification Corporation (REC), as the valuation at which the offer is made is reasonable in the light of the strong earnings visibility and growth expectations. REC, which specialises in financing power projects, is witnessing a huge and sustainable demand for funds, which would drive loan book growth for the next few years.

Superior net interest margins (NIM) of 4.54 per cent, despite secured lending, continue to aid profit growth. High return on net worth (21 per cent estimated for the fiscal ended March, 2010 despite equity expansion), low operating costs, high levels of capital to support the loan growth and near-zero non-performing assets are the key positives. At the offer price of Rs 203, the stock trades at nine times its estimated FY-11 EPS and 1.8 times its expected FY-11 adjusted book value. In book value terms, it is at a slight premium to its peer, Power Finance Corporation. A valuation of nine times earnings is cheap as the company may post an earnings growth of more than 30 per cent annually for the next three years.

Capital augmentation

REC, a navaratna PSU, is tapping the primary markets to augment its capital base to support future loan growth; this in addition to disinvestment of the government's stake. REC is expected to realise more than Rs 2,600 crore from the issue and, as a result, the company's net worth would increase by at least 38 per cent.

However, the dilution in equity base is only 17.39 per cent. We expect no earnings dilution for the current shareholders despite equity expansion, as the company may grow at a higher rate. Assuming a 70:30 debt-equity mix in funding for the upcoming power projects, around Rs 14 lakh crore of debt investment is required for the power sector over the 11th (2007-12) and 12th Plans (20012-17).

This offers immense scope for REC to grow. According to working group report of power projects, REC was to fund 16 per cent of the debt component in the 11th plan.

The company's loan book grew at an annual rate of 24 per cent during the period 2004-09. Even as the loan book expands, we expect the company to grow at a healthy rate (greater than 25 per cent) as the sanctions get converted into disbursements. As new projects get awarded, the sanctions may only increase. REC also plans to diversify into other power-allied activities such as coal mining and equipment financing, which would open up new funding opportunities for the company.

Business

Loans to the power generation segment, as a proportion of total loans, increased to 38 per cent, as of September 30, 2009, from 23 per cent in 2007. Majority of incremental sanctions are arising out of this segment.

Private sector now constitutes only 6 per cent of total loan book. However, this proportion would increase as bulk of capacity additions in 12th plan are being added by private players. This may have a beneficial impact on margins as private sector loans have higher yields compared to loans extended to state owned companies. The company's borrowing profile is pretty much diversified, with 19 per cent raised through 54EC bonds, 20 per cent from bank borrowings and 51 per cent from taxable bonds.

Net profit grew by 29 per cent compounded annually over 2005-09, driven by strong disbursements and improved NIM. For the nine months ended December 31, 2009, net profits grew by 62 per cent.

NIMs may moderate as rates harden, as majority of loans disbursed are fixed in nature. However, REC would continue to maintain superior margins within the financial services space thanks to its access to low cost funds..

Few risks

Delays in power projects could lead to rescheduling of loans; REC has 3.31 per cent of its total loan book as rescheduled loans which would delay the cash flows.

The cost of fund advantageis falling by the quarter as the 54EC proportion bonds, as a share of funding, is declining. The key upside risk is the allowance of government to raise tax-free bonds to bridge the funding gap in the power sector.