Muthoot Finance gleams with promise

What gives confidence in the stock is that domestic gold prices continue to remain high even as global gold prices have corrected in recent times.

High margins, rapid growth in gold lending and the likelihood of gold prices remaining firm make the Muthoot Finance stock an attractive buy. Investors with a high risk appetite and a two-year horizon can consider fresh exposure to the stock.

The stock, despite outperforming the market from the time of listing, continues to look attractive especially after the recently announced quarterly results. Muthoot Finance, the largest financier of loans against gold, saw its loan assets grow by 81.5 per cent during the year-ended September 2011. Profits grew by 104 per cent for the half-year ended September 2011.

Muthoot Finance's prospects are highly correlated to gold price movements. What gives confidence in the stock is that domestic gold prices continue to remain high even as global gold prices have corrected in recent times. Thanks to rupee depreciation, from September 2011 peak, gold returned 3 per cent to domestic investors as against a loss of 9 per cent in dollar terms. The secure nature of the business coupled with high risk-adjusted margins and high potential for lending are key positives for gold financing companies. The net NPA ratio as of September 2011 was 0.51 per cent.

At the current price of Rs 172, the stock is discounting its estimated FY13 book value by 1.65 times and is trading at price-to-FY13 earnings multiple of 6.5 times. In terms of trailing price-to-book ratio, Muthoot Finance currently trades at a slight premium to Manappuram Finance.

With a larger capital overhang, Manappuram Finance has a lower return on equity compared to Muthoot Finance. Additionally, a larger loan book (almost double the size of Manappuram), bigger branch network, lower loan-to-value (LTV), better Pan-India presence and diversified borrowing, make a good case to invest in Muthoot Finance' stock.

Attractive business

As of September 2011, Muthoot Finance mainly focuses on loan against gold and manages assets worth Rs 20,766 crore and holds 130 tonnes of gold as security. The company has been steadily moving out of South India into other parts of the country.

As of September 2011, 29 per cent of its loans and 35 per cent of its branches are outside South India. In 2007, 16 per cent of the business and 14 per cent of the branches were from outside the Southern states.

Many of the non-south branches are under-leveraged as the share of business has not kept pace with rise in branch network.

Muthoot Finance has a branch network comparable with the largest private banks. It continues to aggressively expand which may put pressure on its operating costs but takes care of business growth, especially in under-penetrated areas.

However, it may face stiff competition from private banks as branch expansion (other than Tier-1 cities) is liberalised recently. While this gold financing segment is highly under-penetrated, the threat to business growth may be limited but margins may be pressurised.

During the half-year ended September 2011, Muthoot Finance has managed to maintain its interest spreads at 10.9 per cent. This despite witnessing a sharp rise in cost of borrowing due to the removal of priority sector tag on gold loans sold by NBFCs to banks.

This shows the bargaining power of Muthoot to pass on the costs is high. However, such high spreads for a secured loan with lower slippages has attracted all and sundry into the gold financing business. Therefore, spreads at this level may be unsustainable.

While it witnessed almost 2 percentage point rise in the cost of funds, the rise was still lower than Manappuram Finance, thanks to Muthoot's diversified borrowing profile. Bank borrowings only account for 38 per cent of the total liabilities.

Gold bonds sold through private placement to retail investors accounted for 25 per cent of the borrowing. The average maturity of the borrowing is higher than maturity of the book (as of March 2011), which shields the company from liquidity risk.

Rising gold prices

While volatility in gold prices is seen as the biggest risk to the loan book, Muthoot's low loan-to-value offers comfort. At average prices during the September quarter, the LTV stood at a modest 63 per cent. At current prices LTV may be even lower at 55 per cent which shields the company from high gold price volatility. In addition to low LTV, the making charges and stones on gold are not considered, which gives further margin of comfort.

Growth in gold loans was more to do with the sharp rise in gold prices. During the period March 2007- September 2011, while the gold holdings grew at a compounded annual rate of 47 per cent, the loan book grew by 81 per cent during the same period, thanks to the rise in gold prices. Therefore, gold price volatility may not affect the asset quality but may take a toll on growth of this sector.

Other factors

If proposed NBFC norms come through, capital may be freed up for gold-financing companies, despite having to adhere to tier-1 capital requirements of 12 per cent. The risk weights for small ticket loans are expected come down to 50 per cent as against 100 per cent which Muthoot Finance is adhering to currently. The NPA recognition of 90 days from 180 days is, however, expected to put pressure on profitability

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