Rural Electrification Corporation

Financial stocks have been pummelled in recent sessions on fear of rising interest rates cutting into margins. This provides a good entry point for long-term investors in the stock of REC (Rural Electrification Corporation) as its prospects are quite promising. REC may manage to retain industry spreads in excess of 3 per cent even in a rising interest rate scenario, owing to its access to low-cost funding and its recent ‘infrastructure financing company' status.



Given the constraints on bank lending to the infrastructure sector and the sustained demand for such financing, rural infrastructure funding holds growth potential. REC, a navaratna PSU incorporated in 1969 to finance the State electricity board for the development of rural infrastructure in transmission and distribution (T&D) has, however, in recent times shifted focus to fund power projects, including generation. Fresh investments with a three-year investment horizon can be considered in the stock.

REC has a strong return on equity (annualised 20.65 per cent for first half of FY11) despite expansion in equity during the last fiscal, thanks to a high spread and low-cost structure. Relatively low cost of funds have allowed REC to protect the spreads to some extent even during the rising interest rate periods.

At the current price of Rs 270, the stock discounts its estimated FY-12 book value by 1.73 times, while the price-to-FY-12 earnings multiple works out to 8.8 times. It trades at a similar valuation to its larger peer, Power Finance Corporation. Superior spreads and a strong rate of business growth make a compelling case for a premium valuation for REC.

Negligible non-performing assets (NPAs), despite shaky borrower's financials, the ability to float low-cost capital gain bonds (cost of funds only 6 per cent on such bonds) are other key positives for REC. For the first half of this fiscal, the cost-income ratio of REC was 4.2 per cent while the net NPA ratio was at just 0.003 per cent.

Loan book growth

The loan book grew at an annual rate of 27 per cent during the period 2007-10, a spectacular rate even as the base was expanding. While the growth has slightly moderated during the first half of the year to 25 per cent, the growth rates may continue to be quite healthy.

With more than Rs 1.3 lakh crore of net loan sanctions yet to be disbursed (works out to around twice the September-end loan book), growing its credit book may not a pose a problem for REC over the next three-four years. The funds requirement of Rs.11 lakh crore for power projects in the Twelfth Plan (2012-17), around 70 per cent of which is expected to be debt, also provides visibility.

Over the years, REC has increased financing to generation projects whose credit-worthiness is better than that of transmission and the distribution sector. Additionally, for state electricity board financing, it gets government guarantees which protect its loan book.

The power generators' share in the outstanding loan book of REC increased from 26 per cent at the end of 2007-08 fiscal to 42 per cent as of September 2010. Within this, high yielding private sector loans are on the rise with their share going up from 4 per cent to 7 per cent in the above-mentioned period.

Threat from competition has intensified lately as evidenced by low-growth in disbursements of REC, as banks managed to offer attractive rates to infrastructure players. However, with many banks coming up against exposure limits to infrastructure funding and dealing with short term liabilities, competition from this source may abate.

Spread compression not a threat

Even as the liquidity situation worsened during the quarter-ended December, the cost of borrowings for REC went up by 30 bps to 7.82 per cent. The rise in the cost of funds sequentially and year-on-year led to moderation in interest spreads. REC's spread (annualised) — the difference between yield on advances and cost of borrowing — stood at 3.32 per cent for the first half of 2011 from 3.47 per cent during the same period the preceding year.

While the spreads may moderate to some extent over the course of the year, the damage may be limited for REC for the following reasons. One, REC has increased its lending rates by 25-50 bps recently. It is also concentrating on high-yielding private sector advances and short-term loans (which reduce interest rate risk) to maintain its yields. On the borrowings side, REC's infrastructure status will allows it to raise money through low-cost external commercial borrowings (ECB) and tax-exempt infrastructure bonds at gilt yields.

Reports suggest that REC may raise ECBs worth $500 million this month, which may increase the foreign liabilities from the current proportion of 7 per cent and moderate cost of funds. During the September quarter, for instance, REC raised $ 400 million at 6.95 per cent, against an excess of 8 per cent average rate for its debentures and bank borrowings.