Investors can consider subscribing to the follow-on public offer of Power Finance Corporation (PFC), one of the largest infrastructure financing companies. This equity offer would give PFC the much-needed capital boost to support loan growth. Additionally, the Rs 3,700 crore fresh equity (at current prices) would, to some extent, help PFC reduce the impact of rising interest costs to some extent. The recent correction in the stock has brought prices down to an attractive valuation.

At Rs 193 (reflecting a 5 per cent discount over the upper end of the price band Rs 193-203), the stock would be offered at 1.03 times its estimated FY12 book value. The price-earnings ratio of PFC works out to 8.3 times the estimated FY12 earnings which appears attractive. The valuation is at a discount to that of Rural Electrification Corporation. The company's return-on-equity may continue to be strong even after expansion in the equity base. This, coupled with strong business growth, makes a good case for investing in the company. The secured nature of the company's loan book with negligible non-performing assets and the low cost-income ratio (2.5 per cent as for FY11) are key positives. There is visibility on loan book growth, given the large size of sanctions approved, but not disbursed. The sanctions, as of December 2010, amounted to 1.6 times the March 2011 loan book.

Business

PFC's loan book exposure to the States has come down from 77 per cent in March 2006 to 65 per cent in December 2010, while the Central and joint sector loans rose to 27.6 per cent. Private sector accounted for 7.1 per cent of the total loan book as of December 2010.

While the demand for loans to fund power projects is high and sustainable, it is the rising interest rates and worries about asset quality pressures that led to the stock correcting sharply over the last six months. PFC lost 35 per cent year-to-date and 46 per cent from its peak in October 2010. A concern that non-banking finance companies such as PFC are facing is interest rate risk. The sharp rise in interest costs has led to margins of PFC falling. Sequentially the March quarter margins for PFC fell almost 65 bps to 3.45 per cent.

However, this risk can be mitigated once the full benefits of the company's “infrastructure financier” status start flowing in and inflation cools off. PFC is allowed to raise tax-free retail bonds, ECBs and can raise funds from banks at cheaper rates. In the previous fiscal, it raised Rs 265 crore infra bonds and $260 million in ECBs, which are far below the permissible limits. Though PFC has so far enjoyed good asset quality, its loan book faces the risk of slippages. Apart from rising interest rate putting pressure on the heavily indebted power generators, burgeoning losses of the State electricity boards (SEBs), the largest borrowers from PFC, add to the concerns. The book losses of SEBs, as of March 2009, were Rs 22,900 crore.

This is expected to be mitigated, however, as the process of SEB reforms takes off. PFC's exposure to the generation, rather than the distribution segment, makes it less exposed to the credit risks in this segment.Its exposure to loss-making distribution segment is only 4.4 per cent.

On the asset side, PFC has a significant proportion of loans in portfolio with 3 and 10 year re-sets of interest rates, which lends stability to yields. While the company has been actively raising lending rates for fresh loans (last change in March 2011), the existing loan portfolio will reflect higher rates only when resets happen.

While the company's focus on one sector — power — poses concentration risks, it plans to extend loans to related segments such as coal mining equipment to add diversity.

Financials

PFC's loan book grew at an annualised rate of 22.8 per cent over the period FY06 – FY11. For the year ended March 2011, the profit growth was at a modest 13 per cent despite the loan book growing by 24 per cent. Rising interest costs put pressure on margins and falling ‘other income, given the lumpy nature of the fee income took a toll on the company.

The current capital raising plan would boost the capital adequacy significantly. The ratio stood at 17.3 per cent in December 2010 against mandatory 15 per cent requirement for infrastructure financing companies. Foreign exchange fluctuation is one risk, as the company does not hedge its forex borrowings.

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