Rural Electrification Corporation - BUY

Fresh investments with a three-year horizon can be considered in the stock of Rural Electrification Corporation (REC). The company has managed to keep non-performing assets under check amidst a challenging environment for the power sector. It trades at an attractive valuation level from a long-term investment perspective.

At the current price of Rs 196, the stock trades at one time its FY14 book value (adjusted). At this level, the stock price is implying a no growth scenario and steep decline in return ratios for REC. However, the company has been posting return on equity of around 20 per cent over the last few years and may sustain high return ratios (17-18 per cent), going forward. Earnings growth is also expected to be driven by strong growth in loan book.

This makes a good case for investing in the stock. The price-to-earnings multiple on FY14 earnings works out to six times, lower than levels traded in the past.

Long-term prospects intact

Transmission and distribution loans account for 48 per cent of the company’s loan book. This is followed by generation loans at 44 per cent. State and Central public sector undertakings account for close to 90 per cent of the loan book.

The loan book growth is expected to be strong in the long-term, given the huge investment opportunity in the transmission and distribution space where REC is the top financier. Given its ‘infrastructure financing status’ and the reducing exposure of banks to power sector loans, REC may gain market share in power sector advances from banks.

REC’s unutilised sanctions (funds sanctioned but not disbursed), as of June 2012, were about Rs 1.55 lakh crore. This is around 1.5 times the current loan book, providing visibility for loan book growth. Additionally, according to the Planning Commission’s estimates, REC is expected to fund around Rs 1.75 lakh crore worth of power projects in 12th plan (2012-17). This translates into a 22 per cent growth annually over this period.

Apart from high demand for credit, the company’s access to Section 54EC bonds and tax-free bonds for low-cost funding may help it maintain its margins. The net interest margin for the June 2012 quarter was 4.53 per cent. This was primarily driven by improved yields. REC managed to raise overseas loans at competitive rates, which also helped it limit the cost of funds. It plans to raise more low-cost overseas loans and has received approval from the RBI to raise $750 million (around Rs 4,100 crore) in FY13. The cost of external commercial borrowing was 4.8 per cent in FY12 and 2.5 per cent in the June quarter as compared to 9.35 per cent cost of funds in the domestic bond market.

Near-term challenges

But investors have to take note of the near-term headwinds for the power sector. .Growth could be slow or delayed till more clarity emerges on fuel supply agreements, distribution sector reforms, environmental clearances and revision of power purchase agreements.

While REC is sanctioning loans to power sector, the pace of growth in disbursals has declined. Much of the disbursements during the last couple of quarters are short-term in nature .

The company’s asset quality is stable with current gross NPA ratio at 0.46 per cent. This may be a small amount, but the high exposure to state utilities increases the risk of the portfolio. The rising proportion of short-term loans (8 per cent of the portfolio) is also a worry.

However, the risks may be overstated, given that REC has State government guarantees for the short-term loans. For project financing for state distribution companies, it operates through escrow mechanism where the revenue of SEBs flows into the escrow account. In case of default, REC can access this money. This reduces the credit risk from projects which are commissioned without delays. In cases where projects get delayed, REC reschedules the loans; however, it takes minimal losses (net present value losses on such projects). As of March 2012, around 20 per cent of the company’s loan book is rescheduled.

Higher risk may emanate for REC from the private sector loans, which account for 11 per cent of the portfolio. These loans do not have government backing and are subject to higher risks from extraneous factors such as fuel supply uncertainties.

But, even here, the Government’s push to improve fuel availability to power projects may reduce the risk of default as most of the projects are being setup beyond 2014. Regular tariff revision by State electricity boards (SEBs) and swift environmental clearances for coal and thermal projects will reduce the asset quality threat over a long-term.

Besides, push by the Centre in implementing SEB reforms, which include reducing the transmission and distribution losses and making SEBs more accountable, will also help improve asset quality.

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