60832973 Manappuram PDF

February 15, 2010

Gold Financing THEMATIC

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.

Potholes on the road to El Dorado Whilst the recent RBI clarification removing gold loans from the priority sector will decrease funding for the sector, we are positive on the long term prospects of gold loan NBFCs because of: (i) the unavailability of formal debt finance for a large part of the Indian population and the abundant availability of gold as collateral; (ii) the quick and hassle free loan delivery provided by NBFCs vs banks; and (iii) the increasing reach and acceptability of this form of finance. Manappuram is the best play on this theme given its branch strength, strong brand name, well developed gold appraisal skills and strong risk management. We initiate with a BUY.

Despite short term funding concerns, our positive stance on the sector and the main NBFC in this segment Manappuram is driven by:

Demand of credit and availability of collateral: India’s credit:GDP ratio is one of the lowest globally at ~4% due to the unavailability of formal banking services for a large part of the population. Banks and NBFCs have tried to tap into this potential in the past by offering unsecured personal loans but those initiatives did not succeed due to heavy defaults on these portfolios (even in benign economic conditions). Loans against gold jewelry have therefore emerged as a major alternative to tap this latent credit demand as Indians have about 18K tones of gold (~10% of total world gold stock) mostly in the form of jewelry worth ~$800 bn.

Increasing market share of NBFCs: Whilst the total estimated gold loan market is ~$50-60 bn, the entire organized lending sector put together has only ~25% market share in this business and specialized NBFCs have ~8% market share in this business. We expect the market share of NBFCs to grow further at the expense of banks and moneylenders as: (i) NBFCs have quick and hassle free loan delivery vs banks because of their specialized gold appraisal skills; (b) NBFCs charge lower interest rates and have a better image than moneylenders; and (c) NBFCs are acquiring a new set of borrowers via the rapid expansion of branches and heavy advertising fronted by well known movie stars.

Initiate with a BUY on Manappuram (MGFL.IN, $1.0 bn mkt cap, 36% upside): Whilst the recent RBI clarification removing gold loans from the priority sector is likely to impact the growth and NIMs of Manappuram, the company has adequate sources of funding to grow its loan book at a healthy pace of ~38% CGAR between FY11-13 and maintain its ROAs (as an improvement in operational efficiency would largely mitigate the adverse impact of NIM compression). Over the last 2 months the stock price has corrected by ~45% from its peak and at 1.9x FY12 P/BV we believe that all the negatives are priced in. We initiate with a BUY.

External factors are the major risks: A sharp decline in gold prices by 40% or more (similar to what happened in the early 1980s) and further regulatory and political intervention are the major risks for the sector and for Mannapuram.

Analyst contacts

Pankaj Agarwal, CFA Tel: +91 22 3043 3206 [email protected]

Krishnan ASV Tel .: + +91 22 3043 3205 [email protected]

Poonam Saney Tel: +91 22 3043 3216 [email protected]

Recommendation

CMP: Rs106

Target Price (Period): Rs143

Upside (%) 36

EPS (FY11E): Rs7.6 Change from previous (%) NA

Variance from consensus (%) 6

Stock Information

Mkt cap: Rs44bn/US$963mn

52-wk H/L: Rs190/62

3M ADV: Rs215mn/US$4.7mn

Beta: 0.7x

BSE Sensex: 18,105

Nifty: 5,426

Stock Performance (%)

1M 3M 12M YTD

Absolute -21.2 -41.3 50.9 -29.6

Rel. to Sensex -17.2 -31.1 38.8 -18.3

Performance (%)

10,000

15,000

20,000

25,000

15-Feb-10 8-Jul-10 26-Nov-10

50

100

150

200

Sensex M anappuram Gen. Fin.

Source: Bloomberg, Ambit Capital research

Indian Gold Financing- The Road to El Dorado with some potholes

Ambit Capital Pvt Ltd 2

Gold financing has come of age… Gold financing has been a popular form of financing in India for many decades due to the unavailability of formal financing options for a large chunk of the Indian population. Industry sources peg the size of the total gold loan market to Rs. 2.5-3.0 trn (implying ~10% of the value of the total gold in the hands of the Indians). However, historically this has been a fragmented market largely catered to by small moneylenders and pawn-shops (~75% market share).

Over the last five years, the gold financing market has caught the fancy of organised lenders, especially NBFCs, who are not only increasing their market share at the expense of unorganized sector, but are also expanding the market by expanding into new geographies, introducing innovative products and spending heavily on marketing. The gold loan portfolio of organised players has increased at a CAGR of ~48% between FY07-10. Within this segment, specialized NBFCs (e.g. Manappuram, Muthoot) have grown their loan books at a much faster pace (~70%) during FY07-10.

Exhibit 1: Growing size of the organized gold loan market ( Rs bn)

25

120

250

375

515

0

100

200

300

400

500

600

FY02 FY07 FY09 FY10 FY11

CAGR 40%

Source: Manappuram using ICRA data, Ambit Capital

Exhibit 2: Increasing market share of NBFCs in the organized sector

FY07 FY09 FY10

Public Sector banks 52% 51% 47%

Pvt Sector banks 15% 14% 12%

NBFCs 18% 24% 32%

Co-operatives 15% 12% 10%

Total 100% 100% 100%

Source: Manappuram using ICRA data, Ambit Capital

… and has the legs to grow further Despite growing their portfolio at a CAGR of ~48% over FY07-10, we believe that organised players are well placed to continue growing at a similar pace over the next 3-4 years. Our optimism is based on three factors:

An increase in the total potential market size due to increased gold holdings: As per the World Gold Council, Indians hold about 18k tones of gold (~10% of total world gold stock) worth $800 bn. Just as importantly, Indians add ~700 tonnes to their gold portfolio every year and ~75% of these gold holdings are in the form of jewelry. Historical data suggests that the demand for gold in India has been relatively inelastic to gold prices and inspite of gold prices growing at a CAGR of 13% over the last decade, the demand for gold has been robust. Hence looking at historical trends and India’s healthy GDP growth rate and savings rate, we believe that the total gold stock available (in volume terms) can continue to rise at a CAGR of ~5% for the next decade. Moreover, although we do not have a view on the evolution of the price of gold, it is reasonable to assume that gold prices can continue increasing at a 5% CAGR based on the last 90 year history of gold prices (2000-10 CAGR of gold prices is 13%). Hence we estimate that the total value of gold holdings in India can increase at a 10% CAGR over the next 5 years.

Increased penetration from organized players: Organized players would not only benefit from this increased market potential as explained above but also from the increased penetration of the industry driven by:



1. Increased reach: Organized sector players (especially NBFCs) are rapidly

expanding their reach by opening new branches in their existing and new geographies (e.g. Manappuram expanded its branch network ~7x over the last four years). Moreover, banks like HDFC are increasingly offering these products through an increasing number of branches.

2. Increased acceptability of the product: Furthermore, thanks to heavy advertising through the print and electronic media using movie stars and sports personalities, the organized sector is not only eating into market share of unorganized players but also trying to shed the stigma attached to pledging jewelry. This we believe can bring a new set of borrowers to the industry.

3. Better rates and services: Whilst we believe that the demand for the gold financing product is not interest rate sensitive, banks and NBFCs are offering gold loans at much lower rates than the unorganized players (12%-24% vs ~36%-60% by local moneylenders and pawnshops). Moreover the organized players score over local moneylenders in terms of quick disbursals and higher confidence in the lender’s ability to keep the borrower’s gold safely.

4. Unsecured financing drying up: Between FY09-11 banks and NBFCs suffered substantial losses on their unsecured loan portfolios (e.g. ICICI Bank, Reliance Capital, India Infoline, Cholamandalam Finance etc.). Since then the organised sector has become wary of unsecured financing. This should help the gold financing segment. Anecdotal evidence to support this point can be found from global trends as well where banks’ reluctance to advance unsecured loans post the Lehman crisis led to the growth in pawnbroking in both the US and the UK.

Exhibit 3: Potential Size of the Indian gold loan market

FY02 FY07 FY09 FY10 FY11E FY12E FY13E FY14E FY15E FY10-15E CAGR

Gold holdings (in Tonnes) na na 17,000 17,700 18,300 19,000 19,700 20,400 21,100 4%

Gold Holdings in (Rs. Bn) 6,462 11,669 25,000 32,000 36,600 40,260 44,286 48,715 53,586 10%

Organised loan industry as a % of total value of gold holdings

0.4% 1.0% 1.0% 1.2% 1.4% 1.60% 1.8% 2.0% 2.2%

Organised gold loan industry (Rs. Bn)

25 120 250 375 515 644 797 974 1,179 26%

Share of NBFCs (%) NA 18% 24% 32% 50% 55% 60% 65% 70%

Total Gold AUM of NBFCs (Rs. Bn)

NA 24 57 121 264 354 478 633 825 47%

Source: Historical estimates from Manappuram using ICRA estimates, Ambit Capital research

NBFCs are better placed than banks Whilst banks provide lower interest rates than NBFCs (~13%-15% vs 18%-24% by NBFCs), given the small ticket size (~Rs. 30K) and low duration of the product (~100 days), this difference in interest cost is not particularly apparent to the borrower. Hence we believe that within the organized segment, specialized NBFCs like Manappuram and Muthoot are better placed than banks and their loan portfolio will grow faster than banks in this segment because of:

Better reach to customers: NBFCs are quickly growing their branch network in the key catchment areas. Banks find this difficult to replicate as: (i) banks get limited branch licenses from the RBI which they would prefer to use keeping in mind their overall growth strategy rather than just the needs of the gold finance segment; and (ii) it takes time for banks to fully operationalise a branch given the infrastructure needed to open a bank branch.



Better products and service: Due to the very nature of this loan product (a

short term liquidity product for borrowers with ~100 days average duration), quick and hassle free delivery of gold loans is a key competitive advantage. Moreover, since the borrower normally pledges his family jewelry, he wants to pledge the minimum amount of jewelry to get the desired amount. NBFCs have advantage on these parameters as they have experienced gold valuers in all their branches (in-fact all the new hires at these NBFCs go through extensive gold appraisal training before they join a branch). This helps them to quickly and accurately value the pledged jewelry and hence helps them quickly disburse the loan (in 10 minutes as per the personal experience of the author of this note) and provide higher LTV (up to 85%) to the customers.

Sources of Competitive Advantage Whilst on the face of it gold financing business looks like any other financing business with no visible competitive advantages, deeper scrutiny points to the following key competitive advantages in this sector:

Reach/distribution channel: Given that gold loans are generally liquid loans where the borrower is in urgent need of funds and given the borrower’s unwillingness to travel beyond a certain distance from his home (due to the risk and cost associated with travelling long distances), local branch based distribution is a key competitive advantage. However, given the need for experienced staff who can appraise the gold jewelry and provide robust operational risk management, it is not easy for a new entrant to roll out branches rapidly. NBFCs have an advantage over banks on this front as due to their low operational cost in running a branch, they are able to add branches faster than banks.

Trust and brand name: Once the lender is near the customer, the lender then needs the customer’s trust in his ability to safely store the pledged gold. Banks have a natural advantage over NBFCs on this parameter given their long operating history and a general reputation for safety. Moreover, banks’ longer track record in providing locker facilities also helps. However, NBFCs seem to have acknowledged this and are spending heavily on brand building by hiring popular movie stars and sports personalities (advertising expenses for Manappuram were 14% of its net revenues in FY10 vs 9% in FY08). NBFCs are also spending on risk and safety measures by regularly auditing the gold stock at all branches, installing safety vaults and CCTV cameras.

Quality of products and services: Given that gold loans are meant to provide short term financing, the ability to provide higher LTV loans and quick disbursal of the same is a key competitive advantage. The key to provide higher LTV and quick disbursal lies in accurately and quickly appraising the quality of the gold. NBFCs like Manappuram and Muthoot score over banks on this parameter as due to their decades of experience in this business, they have been able to develop multiple check and balances to accurately appraise the quality of gold quickly. This has helped them in building a product portfolio with interest rates ranging from 12%-24% depending on LTV and the type and quality of gold. Banks on the other hand are at a disadvantage here due to their weaker domain knowledge and hence are not able to offer higher LTV loans. Instead banks for the most part sell a single standardized gold loan product with an LTV of less than 65%..

Managing Operational risk: As lenders handle a large amount of cash and gold on a daily basis in branches scattered across the country, they are at risk of employee theft, burglary and fraud (i.e. taking spurious gold as collateral). Decades of experience in these businesses have helped specialised NBFCs like Manappuram and Muthoot develop systems and procedure to counter these risks. However, for newer NBFCs in this segment (like India Infoline, Karvy, etc.) the lack of such experience and knowledge will be an obstacle to scale up their operations and compete with established players.



Exhibit 4: Competitive assessment of the various players in the gold financing industry

Parameter

Specialised NBFCs like

Manappuram and Muthoot

Banks

New NBFCs who are entering the

segment (e.g. Karvy, IIFL)

Local money lenders Comments

Reach and distribution channel

Due to aggressive branch expansion, established NBFCs have better reach than banks as banks don’t offer this product through all their branches. New NBFCs only have presence in limited geographies and moneylenders are confined to their respective localities.

Brand name and trust

Banks score well on this parameter because of their long operational history. However, established NBFCs have a strong brand name in southern India and are trying to build pan-India brands through heavy advertising.

Products and services

NBFCs because of their ability to quickly appraise the value of the gold and swiftly disburse the loan have an advantage over banks.

Ability to manage operational risk

Banks because of their internal checks and procedures are able to adequately manage operational risk. Established NBFCs because of their decades of experience have been able to develop the systems to deal with operational risk effectively. For new NBFCs, dealing with operational risks whilst scaling up their operations would be a challenge.

Overall

Source: Ambit Capital research

Note : - Strong; - Relatively Strong; Average; - Relatively weak.



How do gold prices affect this sector? Given that: (i) ~30% of the growth in the loan portfolio of the major NBFCs over the last four years has been driven by the increase in gold prices, and (ii) NBFCs provide up to ~85% LTV on gold jewelry, a drop in gold prices can impact both the credit quality and growth of the sector. Whilst gold has been steadily rising over the last decade, there have been multiple instances in the past where gold prices have declined sharply and languished for a long period of time

Exhibit 5: Periods of declining gold prices

Period No. of days

Fall in gold prices

during the period

Maximum 3 month decline

Maximum 6month decline

Maximum 1 year decline Comments

From Aug’73-Dec’73

120 days 21% 21% na na After correcting by 21% in 4 months, prices went back to the earlier levels within a month.

From May’74 Aug’74

90 days 18% 18% na na After declining 18% in 3months the prices went back to earlier levels within 3 months.

From Feb’75-Aug’76

560 days 43% 21% 25% 36%

Gold had a losing streak of 18 months where it lost 43% and it took another 18 months to reach at previous levels.

From Oct’78-Nov’78

16 days 19% na na na A sharp decline of 19% within 16 days. It took around 80 days for the gold to reach its previous levels

From Jan’80-Mar’80 57 days 43% 40% na na

A sharp decline of 43% in less than 2 months. Whilst the gold bounced back 20% in the next 9 months, it took 28 years for the gold to reach the peak that it hit in Jan’80.

From Sep’80-Jun’82 640 days 57% 27% 32% 41%

Lost ~57% in 21 months. It took gold 25 years to return to its pre- decline prices!

Feb’83-Feb’85 740 days 44% 16% 19% 28% 44% decline over 2 year period took close to 35 months to reach the peak prices

Feb’90-Jun’90 130 days 18% 14% na Na

Feb’97-Jan’98 315 days 23% 16% 17% Na

Source: Ambit Capital research, Bloomberg,

The last 90 years of data on historical gold prices show that there have been nine instances when gold prices have fallen more than 15% within a 3 month period and two instances when they have fallen more than 25% within a 3 month period.

Impact of a price correction on credit quality Due to limited listing history of gold loan companies, we do not have data on impact of a sharp gold price correction on gold financers’ credit quality. However, we believe that the impact would be lower than what one might instinctively expect it to be. Given that specialized NBFCs have an average LTV of around ~75% on their gold loan portfolio and have around 25% of their portfolio at ~85% LTV, a straight forward conclusion would be that a 25%+ correction in the gold price can be catastrophic for the sector. However, a closer look suggests that things are not as simple as that.

LTV is calculated on the scrap value of the gold: NBFCs normally provide loans against household used jewelry and not against gold bars. They calculate the LTV on the scrap value of the gold. This improves the margin of



safety for them in the event of a fall in gold prices as the value of the jewelry is normally ~15-20% higher than the scrap value of the gold as it includes the making charges of the jewelry and the valuable stones embedded in the jewelry. Hence the replacement cost of the jewelry for the borrower is much higher than the scrap value and this makes willful default less likely even if the gold price corrects.

Emotional quotient: Normally the borrowers pledge their family jewelry and hence have some emotional attachment to the jewelry. Hence the borrowers have an emotional incentive to repay even if they are slightly out of money. We believe that this adds an additional ~5% margin of safety for the lender.

Shorter duration of the loans: The average duration of the jewelry loans is around ~100 days and around ~65% of the loans are repaid within 90 days and 85% within 180 days. Only 15% of the loans go beyond 180 days. Hence the sector is insulated to a significant extent from a gradual decrease in gold prices.

Lenders have option to make margin call and enter into options contracts: Some lesser know features of gold financing contracts mitigate to a great extent the NPA risk in the event of sharp decline in gold prices: a) the lender has right to make a margin call if the LTV falls below their comfort level; b) the lender has the right to sell the pledged gold even before the completion of loan tenure in case the LTV crosses 90%; and c) the lender has right to enter in to gold options on behalf of the client to hedge the gold price risk.

That being said, lenders are unlikely to sell the pledged gold to mitigate default risk as they are likely to loose that customer forever and suffer reputational damage.

Hence we believe that whilst from the lender’s perspective the average LTV is 75%, including making charges of the jewelry and some margin of safety due to the borrower’s emotional attachment to the jewelry, prices have to fall by at least 35%-40% for borrowers to willfully default on their loans. Hence even in the worst case scenario based on historical trends (when gold prices fell 40% within 2 months in 1980), write-offs for the Manappuram would be ~4% of the loan book. This could be absorbed by the company within a single year since the company has an ROA of ~5%.

Impact of a price correction on loan book growth The data suggests that ~30% of the loan growth of major NBFCs over the last 5 years has been driven by the increase in the gold prices (which increased at a CAGR of ~19% between FY06-11). Whilst the monthly volatility in gold prices could have a limited impact on growth, a structural decline in gold prices similar to the 1980s could seriously impact the growth of the sector as the average tenure of the loan is only ~100 days. Hence a decline in gold prices can bring down the loan growth as the: (i) loans get repriced at lower rates and the potential market size decreases with the value of the gold, and (ii) a steep fall in gold prices can shut out marginal customers who do not have sufficient amount of gold to meet their loan requirement.



Removal of priority sector status impacts profitability and growth Until recently a major portion of loans originated by gold financing NBFCs were classified as ‘priority sector’ advances. Hence Indian banks, who need to advance 40% of their advances to priority sectors, met some portion of this requirement by buying loan portfolios from gold NBFCs and advancing loans to them. This was not only a cheaper (~150-200 bps lower cost of funds on these advances) but also a easily available source of funding for gold NBFCs (~55% of Manappuram’s funding was through this route) as banks were happy to lend to gold loan NBFCs under the priority sector category without breaching their sectoral cap on NBFCs.

However, on 3rd February, 2011 the RBI said that gold loans no longer be classified as priority sector loans. This new guideline will impact the growth and profitability of the sector as:

Increase in cost of funds: Since the cost of funds which came through the priority sector were ~150-200 bps cheaper than normal bank borrowings, removal of priority sector status would increase the cost of funds for gold NBFCs. For Manappuram, we expect the cost of funds to go up by ~110 bps as 55% of its funding came from banks through priority sector loans.

Availability of funds: Since loans to gold NBFCs were classified as priority sector, the banks were happy to advance loans to these NBFCs without breaching their sectoral advance caps to NBFCs. However, under the new regime, gold NBFCs would have to compete with other NBFCs as well as other sectors to secure funding from banks. We believe this could be a short term challenge for Manappuram given the current tight liquidity environment. Constrained credit availability in turn could affect its growth for some time. However, we believe that in the medium-to-long term the company would tide over this obstacle as healthy profitability, stable credit quality (NPAs less than <1.0%) and comfortable capital adequacy (~25% at FY11E) should give enough confidence to credit providers to continue lending to the company.

Increased capital adequacy: Gold financing companies were selling ~25% of their loan portfolio to banks for which they were not required to set aside equity capital. Now NBFCs will not be able to sell their portfolio to banks and will have to keep this portfolio on their books. Hence the NBFCs will have to set aside the mandatory regulatory capital of 15% for these loans. This means that the NBFCs’ ability to leverage would go down.

Prior to these guidelines, NBFCs could have effectively leveraged up 8.5x (assuming ~20% loans off the books). This could now come down to ~6.6x. This means that keeping everything else constant, this would decrease ROE of the NBFCs by 8%-12% depending on their respective ROAs (see table below for explanation).

Exhibit 6: Financials of typical gold loan NBFCs

Parameter (%)

NIMs ~15%

Operating Margins ~55%

PAT margin ~30%

RoA ~4%-5%

RoE ~25%-30%

Source: Company, Ambit Capital research



Exhibit 7: Impact analysis of RBI removing gold loans from priority sector (taking Manappuram 3QFY11 financials)

As a % of average assets Pre RBI guidelines

Post RBI guidelines Comments

Yield on advances 23.17% 23.17% The RBI guidelines does not impact lending rates

Cost of funds 9.15% 10.25%

~55% of borrowed funds of Manappuram were through priority sector route where Manappuram was getting these funds at ~200 bps cheaper than normal borrowings. These 55% funds will get repriced at 200 bps higher rates resulting in ~110 bps increase in cost of funds.

Spreads 14.02% 12.92%

Opex 6.77% 6.77%

Loan loss provisions 0.46% 0.46% Operational expenses and credit quality do not get impacted by the new rule

Pre Tax ROA 6.79% 5.69%

Post Tax ROA 4.48% 3.75% Impact of 70 bps on ROA

Assuming optimal leverage 8.33 6.66 ROE is a function of leverage and prior to new guidelines

Manappuram could have leveraged up to 8.33 times in the optimal conditions as they were required to set aside 15% capital adequacy only for the 80% of loans which were on the books reducing effective capital requirement to only Rs. 12.5 for Rs. 100 of AUM (i.e. 15% of Rs. 80 on book loans). In the new regime the company will have to set aside capital adequacy of 15% for entire portfolio of Rs, 100 implying capital adequacy requirement of Rs. 15.

ROE 37.32% 25.00% Source: Manappuram, Ambit Capital research* Please not that above analysis is only for illustration purpose and not our estimates for the company.

Regulatory/political risk – is there more to come? The Indian specialty finance sector has been at the wrong end of regulatory and political intervention in the recent past:

Andhra Pradesh’s state ordinance on microfinance institutions (MFIs) in Oct’10 has led to mass default by borrowers in that state.

In Jan’11, a committee set up by the RBI on microfinance institutions (the Malegam Committee) proposed capping the interest rates charged by MFIs and imposing many other restrictions on their business operations.

As explained in the previous section, on 1st February, the RBI removed priority sector status on gold loans originated by NBFCs.

In light of this, there are fears of further regulatory intervention. Two major risks which investors are anticipating are:

The RBI capping rates charged by gold financing companies; and

State government intervention in the gold financing sector along the lines of what the Andhra Pradesh state ordinance did to MFIs.

Will RBI cap the interest rates?: Whilst it is difficult to anticipate the RBI’s policy making regarding gold financing companies, we believe that the probability of the RBI capping interest rates charged by gold financing companies is low:

The RBI removing gold loans originated by NBFCs from priority sector effectively means that the RBI does not think that these loans are going to the poorer/credit starved section of the society. Hence the need to cap interest rates presumably does not arise.

Different customer Profile – small businessmen and the middle class: Unlike the microfinance sector, which deals with customers who are very poor and do not have access to formal bank credit, gold financing companies cater to more middle class people and small businessmen (who use gold financing



to meet their short term liquidity requirements). Hence the political or social need to intervene is more muted.

Further state government intervention?: Whilst gold financing NBFCs are regulated by the RBI, some state governments including Kerala (the state accounts for the biggest proportion of the loan portfolios of Manappuram and Muthoot) want to regulate these NBFCs under the State Money Lenders Act. The Kerala State Money Lenders Act, amongst other things, caps interest rates charged by moneylenders at 2% above the rates charged by banks. The act, however does not explain which bank rate to be taken for this calculation as banks charge anywhere between 8%-20% on different loan products. Hence it is difficult to calculate the financial impact of applicability of Kerala Moneylender’s act applying on gold loan NBFCs.

Whilst the final decision on this matter is still pending with apex court of India, its comforting that one of the technical committees set up by the RBI on this issue recommended that NBFCs should not come under State Money Lender’s Act and the recent Malegam Committee report on microfinance also endorsed this view.

Exhibit 8: Conclusion - Porter analysis of Indian gold financing industry

Source: Ambit Capital research, Industry

Whilst a sharp decline in gold prices and regulatory changes could impact the growth and profitability of the sector, given the under-penetration of credit in India and given the abundant availability of gold as collateral, we cannot but feel that the gold financing sector is well placed to grow rapidly.

Bargaining power of suppliers High

Given that the industry is still at a nascent stage and requires continuous debt and equity capital, the bargaining power of capital suppliers (both equity and debt) is high.

Competitive intensity Medium

The competitive pressure facing specialised gold NBFCs is not high given their unique offering of better service than banks and lower interest rates and better safety than moneylenders. However, competition within NBFCs will intensify with the entry of more NBFCs in to the sector.

Barriers to entry MEDIUM

Whilst barriers to entry is not very high to start small scale operations, scaling up operations needs substantial capital, operational knowledge, time and advertising expense. However, as the existing players gain substantial scale and build a trustworthy brand name in major catchment areas, it would be tough for a new player to break in.

Bargaining power of buyers Medium

Given that alternative sources of borrowing is limited for such borrowers and there are very few alternate avenues to get financing at such a short notice, the bargaining power of customers is low.

Threat of substitution LOW

Microfinance loans and unsecured personal loans from banks and NBFCs are the two other major substitutes for the borrowers. However, post recent developments in the microfinance sector in India we believe that the availability of finance from this route would be limited. Moreover, as banks and NBFCs burnt their hands in unsecured personal loans, they have scale down their unsecured loan books and have altogether exited from this segment (e.g. IIFL, Reliance Capital, Cholamandalam etc.)

Improving

Unchanged

Deteriorating



Manappuram General Finance (MGFL IN, mcap US$1.0bn, BUY, TP Rs 143, 36% upside):

Manappuram is the second biggest gold loan NBFC in India after Muthoot Finance and it is the only listed pure play gold loan NBFC. The company’s loan book and profitability has grown at a CAGR of more than 100% over the last 4 years which has resulted in a ~30x increase in its share price over the same period.

Whilst the recent RBI clarification removing gold loans from priority sector would impact the growth and NIMs of Manappuram, the company has adequate sources of funding to grow its loan book at a healthy pace of ~38% CGAR between FY11-13 and maintain its ROAs as improvement in operational efficiency would largely mitigate the impact of margin compression. The stock has corrected ~50% from its peak over the last 2 months and at 1.9x FY12 P/BV we believe that all the negatives are already priced in. We initiate with a BUY.

.

BFSI-Specialty Finance February 15, 2010

Manappuram Bloomberg: MGFL Equity INITIATING COVERAGE

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.

BUY

Exhibit 9: Key financials

Year to March FY09 FY10 FY11E FY12E FY13E Net Revenues 1,274 3,413 8,410 12,561 16,884 Operating Income 674 2,018 4,836 7,296 9,963 Net Profits 302 1,197 2,865 4,608 6,300 Diluted EPS (Rs) 2.2 4.1 7.6 11.0 15.0 RoA (%) 3.3% 5.6% 5.0% 4.6% 4.6% RoE (%) 23.2% 30.8% 22.4% 21.5% 24.1% P/B (x) 10.9 5.9 2.3 1.9 1.5 Source: Company, Ambit Capital research

Analyst contacts

Pankaj Agarwal, CFA Tel: +91 22 3043 3206 [email protected]

Krishnan ASV Tel .: + +91 22 3043 3205 [email protected]

Poonam Saney Tel: +91 22 3043 3216 [email protected]

Recommendation

CMP: Rs106

Target Price : Rs143

Upside (%) 36

EPS (FY11E): Rs7.6 Change from previous (%) NA

Variance from consensus (%) 6

Stock Information

Mkt cap: Rs44bn/US$963mn

52-wk H/L: Rs190/62

3M ADV: Rs215mn/US$4.7mn

Beta: 0.7x

BSE Sensex: 18,105

Nifty: 5,426

Stock Performance (%)

1M 3M 12M YTD

Absolute -21.2 -41.3 50.9 -29.6

Rel. to Sensex -17.2 -31.1 38.8 -18.3

Performance (%)

10,000

15,000

20,000

25,000

15-Feb-10 8-Jul-10 26-Nov-10

50

100

150

200

Sensex M anappuram Gen. Fin.


The genuine article Whilst the recent RBI clarification (which removed gold loans from the priority sector) could impact loan book growth and NIMs, Manappuram has adequate sources of funding to grow its loan book at a CAGR of 38% between FY11-13 and maintain its ROAs as improvement in operational efficiency would mitigate the impact of NIM compression. Over the last 2 months, the stock has corrected ~45% from its peak and at 1.9x FY12 P/BV, all the negatives appear to be priced in. We initiate with a BUY.

Even after a 45% correction over the past 3 months, Manappuram’s share price is up ~30x over the last four years driven by a CAGR of 135% in net profits between FY06-11. However, following the recent correction (which was in part driven by a regulatory change from the RBI), at 1.9x FY12 P/BV all the negatives seem priced into Mannapuram’s share price as:

Funding concerns are overdone: Whilst the RBI guidelines will impact the availability of funding to some extent, we do not see funding drying up for Manappuram as at 3QFY11 ~45% of its debt funding is from the non-priority sector route (bank credit lines, CPs, NCDs). Even within priority sector borrowings, only 35% was from selling loan portfolios to banks (a source of credit which seems likely to dry up); the remaining 65% were credit lines from banks at slightly lower rates due to the priority sector tag.

Increased operating efficiency to mitigate margin compression: Whilst we expect NIMs to compress by ~260 bps between FY11 and FY12 driven by (a) system wide rates rising (b) priority sector liabilities being repriced upwards by ~110bps; (c) slight decrease in lending rates, the increased operational efficiency (opex as of % average assets declining by ~120 bps by FY13) should mitigate the impact on ROAs.

Loan book grow should be healthy: Whilst loan book growth seems likely to slow down from its historical rate (120% CAGR between FY07-11), we still expect it to be healthy at 38% CAGR over the next 2 years driven by increased business from the branches were opened in the last one year (52% of the branches) and the further roll out of ~1000 branches over the next two years.

Valuation In a country where personal lending from the banks has almost stopped and where gold is a commonly available form of collateral, gold financing looks well placed to continue growing rapidly. Mannpuram is the lender with the most well developed competitive advantages in the gold financing market. Our “excess return model” (using a cost of equity of 15% and perpetuity growth of 5%) values the firm at Rs.143 implying 36% upside (implied FY12 P/B of 2.5x and FY12 P/E of 13.1x)

Manappuram General Finance & Leasing


Company Financial Snapshot

Company timeline Year Event 1992 Company established 1996 Company goes public via an IPO 1999 Commencement of gold financing business 2007 PE funding of Rs. 700 mn from Sequoia and others 2008 PE funding of Rs. 700 mn from Ashmore and others 2009 Acquired sister company MAFIT from promoters 2010 Raised Rs. 2.5 bn through a QIP 2010 Preferential issue of Rs. 1bn to promoters 2010 Raised Rs. 10 bn through another QIP

Company Background

Manappuram is India’s second largest gold loanprovider with a loan book of Rs.~70 bn. The company provides loans against household jewelry and has grown its loan book at a CAGR of 120% over the last 4years driven by its expanding branch network, a strongbrand name and the ability to swiftly appraise gold,make a lending decision and then structure a loan forthe retail or SME borrower.

Profit and loss account Rs. mn FY10 FY11E FY12E Net Income 3,413 8,410 12,561

Net Interest Income 3,306 8,249 12,392 Interest Income 5,351 11,765 20,666 Interest Expense 2,045 3,516 8,274

Fee Income 107 161 169 Expenditure 1,395 3,574 5,265

Employee Cost 536 1,544 2,805 Other expenses 859 2,030 2,460

Operating Profit 2,018 4,836 7,296 Profit Before Tax 1,818 4,300 6,914 Net Profit 1,197 2,865 4,608

Diluted EPS (Rs) 4.1 7.6 11.0

Balance Sheet Rs. Mn FY10 FY11E FY12E Sources of Funds Shareholders' Funds 6,106 19,488 23,450 Loan Funds 25,434 64,158 93,437 Total Sources of Funds 31,539 83,646 116,888 Application of Funds Fixed Assets 569 1,301 1,541 Investments 1,407 403 403 Cash and Bank balances 2,682 3,948 5,545 Net Loan book 25,871 74,835 104,962 Net Current Assets 1,010 3,159 4,437 Total Applications of Funds 31,539 83,646 116,888 BVPS (Rs) 17.9 46.7 56.2

Loan, revenue and net profit growth ROE decomposition (as a % average assets)

188%173%

55%

91%

95% 168%

178%

88%

162%

298%

43%

98%

0%40%80%

120%160%200%240%280%320%

FY08

FY09

FY10

FY11E

Loan book Revenues Net Profits

FY10 FY11E FY12E Net Income 15.8% 14.6% 12.5%

NII 15.3% 14.3% 12.4% Fee Income 0.5% 0.3% 0.2%

Operating Expenses 6.5% 6.2% 5.3% Employee Expenses 2.5% 2.7% 2.8% Other opex 4.0% 3.5% 2.5%

Operating Income 9.4% 8.4% 7.3% Depreciation 0.7% 0.7% 0.1% Loan loss provisions 0.3% 0.3% 0.3%

Pre Tax ROA 8.44% 7.47% 6.90% Tax 2.9% 2.5% 2.3% ROAA 5.6% 5.0% 4.6% Average Leverage(x) 5.5 4.5 4.7 ROAE 30.8% 22.4% 21.5%



Exhibit 10: SWOT analysis

Strengths Weaknesses

Strong branch network of ~1,800 branches spread across India.

Strong brand name in the gold financing in south India

Ability to quickly disburse gold loans based on the gold appraisal skills developed over decades.

Strong risk management architecture to shield the company from employee thefts, burglaries and the use of spurious gold as collateral.

The brand is relatively unknown outside south India. However, the company is trying to build its brand through heavy advertising.

Lack of a broad based funding base and heavy dependence on banks for funding.

Opportunities Threats

Opportunity to grow its operations in underpenetrated north India.

Opportunity to diversify in the related businesses like selling gold coins and bars and financing these purchases.

There is a potential regulatory threat that the interest rates charged by gold lenders like Mannapuram could be capped. However, the removal by the RBI of gold loans from the priority sector somewhat reduces this risk.

State governments intervening in the operations of gold lenders like Mannapuram.

A sharp correction in gold prices could lead to NPAs rising and/or reduce the potential size of the gold loans market.


Exhibit 11: Competitive assessment of the various players in the gold financing industry

Parameter Manappuram Muthoot Finance

Muthoot FinCorp

Shriram City Union

Finance

Karvy, Indiainfoline Comments

Reach and distribution channel

Manappuram and Muthoot have a wider distribution reach from ~2000 branches compared to City Union Finance (~600 branches) and new players like Karvy and IndiaInfoline (who have a negligible branch presence).

Brand Name and trust

Both Manappuram and Muthoot have been in the industry for decades and are the better known brands in the segment. Manappuram scores over Muhtoot on brand recognition as the Muthoot brand name is more generic in nature (there are already three big gold financing firms by the name of Muthoot which could lead to cannibalization and confusion).

Ability to manage operational risk

Because of their decades of experience in the industry, Manappuram and Muthoot have developed systems to deal with operational risks effectively. For new NBFCs, dealing with operational risk whilst scaling up their operations would be a key challenge.

Overall

Source: Company, Ambit Capital research, Industry, Bloomberg,

Note : - Strong; - Relatively Strong; Average; - Relatively weak.



Mannapuram has come of age… Manappuram is India’ second largest gold loan NBFC with ~Rs. 70 bn in loan assets. From being one of the thousands of small cap companies listed on the exchanges, Manappuram has emerged as one of the top wealth creators in the country over the last 4 years with its stock price increasing by ~30x over the last 4 years despite the recent 50% correction.

Rapid branch expansion (from 291 branches in FY07 to 1,795 now), the increase in gold prices (21% CAGR between FY07-11), the drying up of personal loans from banks since the Lehman crisis and continuous funding from both debt and equity providers has helped Manappuram to grow its loan book and revenues at a ~120% CAGR over FY07-11.

Exhibit 12: Robust loan growth…

55%

91%

188%173%

-10203040506070

FY07 FY08 FY09 FY10 9MFY11

0%

50%

100%

150%

200%

Outstanding loan book (Rs. bn) YoY Growth (%)


Exhibit 13: …with a proportional increase in revenues

174%

88% 95%

168%178%

-

1,000

2,000

3,000

4,000

5,000

6,000


0%

50%

100%

150%

200%

Net Revenues (Rs. mn) YoY Growth (%)


Exhibit 14: Healthy net profit growth…

168%

298%

43%98%

162%

-

1,000

2,000

3,000

4,000

5,000

6,000


0%50%100%

150%

200%

250%300%

350%

Net Profits (Rs. mn) YoY Growth (%)


Exhibit 15: ...but EPS growth has been lower due to dilution

173%

62%

86%

27%

84%

0.0

1.0

2.0

3.0

4.0

5.0


0%

50%

100%

150%

200%

EPS YoY Growth (%)


…and now has a bright future We expect Manappuram to show continued growth in its top and bottom line (although at a slightly lower pace than it has done over the past five years) due to the increased productivity of its recently opened branches (52% of the branches currently under operation were opened in the last one year), further branch expansion and improved efficiency in the branches. These positive forces should largely mitigate the negative impact of NIM compression (arising from the increased cost of funds and the decrease in lending yields due to increased competition). In this section we expand on these conflicting forces.



Loan book to grow at a CAGR of 38%

Mannapuram’s loan book has grown at a CAGR of ~120% between FY07-11 and management is guiding the market towards loan growth at ~80% CAGR between FY11-13. However, we are skeptical about management’s ability to meet this guidance because of our concerns regarding the abundant availability of the funds following the recent policy change by the RBI which removed gold loans from the priority sector (~55% of the borrowings of Manappuram were priority sector), uncertainty regarding the evolution of gold prices (which has driven ~40% of the loan growth between FY07-11) and lower business from the new branches due to lower availability and willingness to pledge gold in the rest of the India vis a vis south India.

However, we believe that even with constant gold prices and with a slight improvement in branch productivity, the company can achieve loan growth of 38% CAGR between FY11-13 (implying average loan book CAGR of ~58% between FY11-13 as the growth was back-ended in FY11):

(i) Funding to become more expensive but not dry up: Whilst funding is likely to become expensive post the recent RBI guidelines removing gold loans from priority sector, we cannot see funding drying up for Manappuram completely. ~55% of the funding for Manappuram was coming through priority sector and only ~20% of the funding was through assignment of the portfolios (see table below). Our discussions with bankers suggest that whilst funding through the securtisation route (which accounts for ~20% of Mannapuram’s funding) might dry up, the direct bank funding under priority sector (which accounts for 35% of Mannapuram’s funding) would still continue but at slightly higher rates (100-200 bps). Moreover, the company has two more sources of funding which it has not fully explored as yet:

The Company has the highest credit rating available for Commercial Paper (CP)/NCDs. It can raise ~Rs.20 bn in CPs but has so far utilised only 5% of this limit.

Only ~5% of the funding for Manappuram comes from retail Non-Convertible Debentures (NCDs). Manappuram’s competitor Muthoot Finance gets ~50% of its funding through this route suggesting that Mannapuram, a larger and more established firm, should also be able to avail of NCD funding.

Exhibit 16: Funding mix for Manappuram at the end of 3QFY11

Funding Source Amount (Rs. Mn) % contribution Comments

Bank Funding (a+b) 47,694 88% a. Through Priority Sector

29,807 55%

Assignments 14,242 26% This is the part most impacted by the RBI policy change as it is no longer attractive for banks to buy these portfolios

Working capital loans from banks

15,565 29% Interest cost likely to increase on these liabilities by ~150-200 bps

b. Non Priority Bank funding 17,887 33%

This is unlikely to be affected as these are normal working capital loans.

Non bank Funding 6,501 12%

NCDs 2,934 5% Can access this route. Rival Muthoot Group gets 50% of its funding through this route.

Subordinated bonds 1,628 3%

Subordinated debt 1,000 2%

CPs 913 2% Company has the highest rating for raising CPs. Can raise upto Rs. 20 bn

Others 25 0%

Total 54,195 100%

Source:Company, Ambit Capital research



(ii) Branch expansion and improved branch productivity: ~52% of the

branches in Manappuram have been opened over the last one year. In these branches the average portfolio is still below Rs. 10 mn whereas in the older branches, the average loan portfolio is in the range of Rs. 40-150 mn. Going forward we expect the business from the new branches to increase as they become mature as they benefit from heavy advertising and marketing by Manappuram. Over and above that, the addition of ~1000 more branches over the next 2 years should further add to loan book growth.

Exhibit 18: Loan growth analysis for Manappuram

FY07 FY08 FY09 FY10 FY11E FY12E FY13E

Total Gold loans (Rs. Mn)* 3,176 4,914 9,381 25,589 74,740 104,962 141,510

Loan Growth (YoY) 55% 91% 173% 192% 40% 35%

LTV 48% 45% 48% 69% 70% 70% 70%

Value of the gold stock (Rs. Mn) 6,592 10,942 19,372 37,267 106,771 149,946 202,158

Average Gold prices per gram (Rs.) 930 1,189 1,452 1,660 2,017 2017 2017

Gold Stock (MT) 7.09 9.2 13.3 22.5 52.9 74.3 100.2

Gold pledged per customer (grams) 48.8 41.2 39.8 40.9 46.2 48.5 51.0

No. of customers 145,371 223,039 335,156 549,172 1,145,279 1,531,811 1,966,845

Customer per branch 500 512 520 546 573 613 656

Number of branches 291 436 645 1,005 2,000 2,500 3,000

Portfolio per branch (Rs. Mn) 18.2 19.5 25.9 35.4 37.4 42.0 47.2

Average Ticket Size per customer ('000) 21.9 22.0 28.0 46.6 65.3 68.5 71.9 Source: Company, Ambit Capital. *Including securtised/assigned loans

Profitability is likely to fall

Between FY07-11, net profit for Manappuram grew at a 128% CAGR which is higher than the loan book CAGR of 120% during the same period as: (i) cost of funds decreased for Manappuram (from ~11.8% in FY08 to ~9.2% in 3QFY11) due to improved credit ratings, and (ii) operational efficiency improved between this period as opex as a % of average assets fell from 7.0% in FY08 to 6.8% in 3QFY11.

However, going forward we expect net profits to grow at slightly lower rate (~48% CAGR between FY11-13) than the growth in average loan book (~58% CAGR between FY11-13) as it seems likely that there will be some compression in net interest margins due to: (i) the cost of funds increasing by ~100-150 bps due to the RBI removing gold loans from priority sector; (ii) the decline in the lending yields as competition increases in the gold loan sector in the wake of new players entering the market. However, enhanced operational efficiency will offset to a significant extent the adverse impact of fallings NIMs. We describe these dynamics in more detail in this section.

NIMs to decline but still stay healthy: Between FY08-11, Manappuram has maintained net interest margins in the range of 15%-18%. Going forward we expect net interest margins to decline to ~13.5% by FY13 as:

(i) Cost of funds for Manappuram are likely to increase by 100-150 bps as the double whammy of system wide interest rates rising kicks in and the removal by the RBI of gold loans from priority sector bites (leading to ~55% of Mannapuram’s liabilities being repriced at ~200 bps higher); and

Exhibit 17: Increasing branch productivity

Year Portfolio per branch (Rs. Mn)

FY07 13.4

FY08 18.2

FY09 19.5

FY10 25.9

3QFY11 35.8




(ii) Increased competition from other NBFCs (like Shriram City Union, Karvy, India

Infoline, etc.) which have recently entered the gold loans market leads to a 100-150 bps decline in lending yields.

Exhibit xx: NIMs to decline but still at healthy level

23.0%23.0%25.0%29.0%24.9%

27.5%

11.8% 10.7% 8.9% 10.5% 10.5%14.5%

13.6%13.8%16.4%

17.9%16.8%15.6%

0%

10%

20%

30%

FY08

FY09

FY10

FY11

E

FY12

E

FY13

E

Yield on advances (%) Cost of funds (%) NIMs (%)

Source: Company, Ambit Capital

Improved operational efficiency to compensate for NIM erosion: Whilst Manappuram’s operational efficiency have improved marginally between FY08-11 with operating expenses as a % of average assets decreasing from 7% in FY08 to 6.8% in Q3FY1, going forward we expect operational expenses to decrease further to 5.6% of average assets by FY13 as:

~64% of the firm’s branches have been opened in the last two years and are yet to reach their optimal capacity. Whilst some of the expenses related to branches (eg. rent and electricity) will increase with inflation and employee expenses are likely to rise up with competition heating up in the sector, the increase in such expenses will be outpaced by the loan book growth that these branches will show as they move towards optimal capacity (see Exhibit 17 on page 17).

Advertising expenses for Manappuram have been ~33% of total expenses (~1.2% of average AUM) in FY10 and FY11. These expenses have increased at a CAGR of 162% between FY06-11 as company has heavily spent on brand building by hiring well known movie stars. Clearly, these expenses are totally discretionary in nature. Even if assume Manappuram maintains its advertising expenses, they are likely to come down as a % of average assets.

Exhibit 19: Operating efficiency to improve further with scale

7.0%

8.4%8.0%

6.8%6.2% 5.9% 5.6%

3%

4%

5%

6%

7%

8%

9%

10%

FY08 FY09 FY10 Q3FY11 Q4FY11E FY12E FY13E

Opex as a % of avg assets (%)


Credit quality to remain stable with a sharp decline in gold prices being the main concern: Credit quality trends have been stable for the company in the past with NPAs in the gold loan business being less than ~1% over the last two years. Manappuram’s superior credit quality is driven by the following factors:



The average loan to value (LTV) of the Manappuram loan portfolio is ~70%.

Hence the chances of willful default are relatively low as the borrower is incentivised to pay up and reclaim his jewelry.

Mannapuram calculates LTV without including the value of the precious stones embedded in the jewelry. Including the value of stones and taking account of making charges makes it even less likely that borrowers will willfully default on a loan.

Gold prices have been continuously rising over the last decade. Hence even in the cases of default, Manappuram has been able to recover its loans and interest by selling the pledged jewelry.

Manappuram offers loan against jewelry which households have used for some time and to which the borrower usually has an emotional attachment. This further reduces the chances of willful default.

Therefore, we expect credit quality trends for Manappuram to remain stable unless there is a sharp correction in the gold prices. The key question then becomes “What if gold prices correct sharply?”. Our sensitivity analysis based on the LTV breakup of Manappuram portfolio shows that if we assume a worst case scenario of a 40% fall in the gold prices within three months (this sort of correction has not happened in the last 30 years), the total write-offs after recoveries could be ~4.0% of the portfolio which could be absorbed by a year’s earning as company’s ROA is ~5% (see table below explaining the maths).

Exhibit 20: LTV breakup of the portfolio

% of loans

26%17%

6%10%

4% 2%

34%

1%

<50% 51%-60% 61%-70% 71%-80%81%-85% 86%-90% 91%-95% >95%


Exhibit 21: Sensitivity of Mannapuram’s NPAs to a gold price fall

3 month fall in gold prices Portfolio write offs* in the case of willful defaults

40% fall 4.0%

30% fall 1.0%

20% fall NA

10% fall NA

Source: Company, Ambit Capital. To factor in making charges and the emotional quotient, we have reduced ~15% from disclosed LTV to arrive at effective LTV and have assumed that ~35% of the borrowers who are due after 3 months will default below their effective LTV. The write-off numbers are calculated after factoring in sell of pledged gold at scrap value.

Comfortable capital adequacy: Manappuram is a registered NBFC with the RBI and hence needs to meet the RBI guidelines of 15% capital adequacy ratio (CAR) by Mar’12. Manappuram did a QIP in Nov’10 (~$250m) which boosted its CAR to ~32.4%. However, the recent RBI notification that gold loans should not be classified as priority sector loans means that ~20% of Manappuram’s loan book (which the company had assigned to banks in bilateral transactions) would now stay on its books. This would reduce Manappuram’s CAR to ~25.5%. Even then, based on our loan growth projections (FY11-13 CAGR of 38%), this lender’s CAR would be above the mandatory 15% until FY13.



Exhibit 22: Capital adequacy to remain above regulatory levels

40.8%

31.7%29.3%

22.6%19.3%

17.7%

16%

20%

24%

28%

32%

36%

40%

44%

FY08 FY09 FY10 FY11E FY12E FY13E

Capital Adequacy Ratio


However, if the loan book growth is higher than our expectations (and is nearer to the management guidance of ~80% between FY11-13), Mannapuranm would have to raise more equity by late FY12 or early FY13. Clearly, this dilution would not necessarily be bad for the shareholders because if management is able to meet its guidance, the P/B multiple would be much higher than what we are assigning to the company in the valuation section of this note.



Key assumptions & estimates Exhibit 23: Key assumptions and estimates for Mannapuram (all figures in Rsmn unless otherwise mentioned)

FY09 FY10 FY11E FY12E FY13E Comments

Assumptions

Number of branches 645 1,005 2,000 2,500 3,000 Branch expansion numbers based on historical trends and management guidance

Customers per branch 520 546 573 613 656

Customers per branch will increase with increased branch productivity as the newly opened branches mature

Gold pledged per customers (gms) 39.8 40.9 46.2 48.5 51.0

Increase in the amount of gold pledged per customer based on historical trends and increased per capita gold holdings

Gold prices per gram (Rs) 1,452 1,660 2,017 2017 2017

We do not have a view on gold prices and hence have assumed constant gold prices in the near future

LTV ratio 48% 69% 70% 70% 70% Assuming constant LTV on the gold pledged

Yield on advances 27.5% 29.0% 25.0% 23.0% 23.0% Decrease in yield due to increased competition in the segment

Cost of funds 11.78% 10.66% 8.94% 10.5% 10.5% Increase in cost of funds due to rising systematic rates and gold loans being removed from priority sector

No. of employees per branch 6.3 6.9 8.2 8.2 8.2

Expense per employee (Rs’000) 81.3 97.6 132.6 152.5 175.4 In line with general salary rise in India

Rent per branch (Rs’000) 101 162 217 239 263 In line with inflation

Advertising expenses (Rsmn) 82 482 1,081 1,024 1,024

Other expenses (Rsmn) 181 243 623 899 1,232

Key Outputs (YoY growth)

Loan Book 9,381 25,589 74,740 104,962 141,510 FY11-13 CAGR of 38% vs FY09-11 CAGR of 182%.

Net Revenues 1,274 3,413 8,410 12,561 16,884 FY11-13 CAGR of 42% vs FY09-11 CAGR of 157%.

Operating Income 674 2,018 4,836 7,296 9,963 FY11-13 CAGR of 44% vs FY09-11 CAGR of 168%.

Profit After tax 302 1,197 2,865 4,608 6,300 FY11-13 CAGR of 48% vs FY09-11 CAGR of 208%.

EPS 2.2 4.1 7.7 11.1 15.1 FY11-13 CAGR of 40% vs FY09-11 CAGR of 87%.


Ambit versus consensus

Exhibit 24: Ambit v/s consensus

(Rs mn) Consensus Ambit % change

Net Revenues

FY11E 7,940 8,410 6% FY12E 13,152 12,561 -4% Net profits (Rs)

FY11E 2,668 2,865 7% FY12E 4,547 4,608 1% Source: Bloomberg, Ambit Capital research



Our FY11 numbers are ~6% above consensus estimates as we are expecting the impact of new RBI guidelines to crystallize in FY12 and not in Q4FY11.

Absolute valuation

We have valued Manappuram using an “excess return to equity” model which is based on ‘Net Profits – (cost of equity x beginning of the year book value)’ for all the future years discounted back to the present using a cost of equity of 15%.

We have explicitly forecast net profits for FY11, FY12 and FY13 based on the assumptions in the table above.

Between FY13-FY20, in order to mimic the impact of rising competition, we have faded the loan book growth from 35% to 10% and ROA from 4.6% to 4.0%.

From FY20 we have assumed terminal growth of 5%

Based on these assumptions our excess return model values Manappuram at Rs143 per share (implied FY12 P/B of 2.5x and FY12 P/E of 13.1x), implying 36% upside from current levels.

Relative valuation

Exhibit 25: Relative Valuation

NBFCs Price Mcap RoA (%) RoE (%) P/BV (x) P/E (x)

(Rs) (USD bn) 2011E 2012E 2011E 2012E 2011E 2012E 2011E 2012E

Power Finance Corporation 264 6.7 2.9 2.8 18.7 18.6 2.0 1.6 11.3 9.8

Dewan Housing Finance 264 0.6 1.9 1.9 19.6 19.5 1.9 1.6 11.4 8.7

LIC Housing Finance 178 1.9 2.0 1.8 23.5 22.8 2.1 1.7 9.9 8.5

IDFC 139 4.5 3.3 3.3 14.5 13.8 1.9 1.7 14.9 11.7

Shriram Transport Finance 698 3.5 4.3 4.3 28.3 28.2 3.3 2.6 12.8 10.4

M&M Finance 696 1.7 4.2 4.2 23.5 24.1 3.1 2.5 14.6 11.3

SREI Infrastructure Finance Ltd 46 0.2 2.2 2.4 15.2 19.0 0.6 0.5 6.4 4.6

REC 247 5.4 3.3 3.2 21.0 21.4 1.9 1.6 9.7 8.2

SKS Finance 643 1.0 3.5 3.4 14.3 12.7 2.4 2.1 19.9 14.2 Average of above 3.0 3.0 19.7 19.9 2.1 1.8 12.2 9.7 Manappuram Gen. Fin. & Leasing 91 1.0 5.4 5.1 22.8 23.9 2.3 1.9 16.4 9.5 Premium or Discount to above 77% 70% 16% 20% 8% 9% 34% -2%


Mannapuram currently trades at 1.9x FY12 book value and 9.5x FY12 earnings which is at 8% and 33% discount respectively to its closet peer SKS which we believe is unjustified given that gold financing is a much better business model than unsecured microfinance model.

Key risks to our stance

All three key risks to our positive stance on Manappuram are “external” in nature:

A sharp decline in gold prices: a decline of more than 40% in gold prices within a quarter with gold prices then staying at those depressed levels for more than a year could seriously impact credit quality for Manappuram as the likelihood of willful defaults would increase in such a scenario. We take comfort from the fact that such a sharp correction in gold prices has not been witnessed for 30 years. Our sensitivity analysis shows that such scenario could erode Manappuram’s entire year profitability.



Gold losing its status as a precious commodity: Gold does not have as

much utilitarian real value like other commodities (e.g crude, steel, etc.) and its value is primarily driven by the perceived notion that it is a valuable commodity. Hence any changes at the global level which could erode confidence in the commodity would be damaging for gold prices and hence for Mannapuram.

Regulatory and political intervention: Whilst we do not foresee the RBI capping interest rates for gold loans following its decision to remove gold loans from priority sector, we cannot rule out such an irrational decision being taken under political pressure. Moreover, whilst the Supreme Court of India has still to give its verdict on validity of Kerala Moneylender’s Act on NBFCs like Manappuram, If the verdict goes in favour of Kerala government state, it could affect Mannapuram’s operational flexibility and lending yield in the state of Kerala (~19% of Manappuram’s loan book comes from this state).



Exhibit 26: Balance sheet

Year to March (Rs mn) FYO9 FY10 FY11E FY12E FY13E

Sources of Funds

Shareholders' Funds 1,679 6,106 19,488 23,450 28,869

Loan Funds 4,506 18,357 64,158 93,437 128,234

Secured loans 3,712 16,501

Unsecured loans 793 1,856

Total Sources of Funds 6,185 24,462 83,646 116,888 157,103

Application of Funds

Fixed Assets 280 569 1,301 1,541 1,733

Investments 11 1,407 403 403 403

Cash and Bank balances 1,134 2,682 3,948 5,545 7,475

Net Loan book 4,412 18,794 74,835 104,962 141,510

Net Current Assets 348 1,010 3,159 4,437 5,982

Total Applications of Funds 6,185 24,462 83,646 116,888 157,103

Total assets including assignments 11,566 31,539 83,646 116,888 157,103 Source: Company, Ambit Capital research

Exhibit 27: Income statement

Year to March (Rs mn) FYO9 FY10 FY11E FY12E FY13E

Net Income 1,274 3,413 8,410 12,561 16,884

Net Interest Income 1,198 3,306 8,249 12,392 16,707

Interest Income 2,114 5,351 11,765 20,666 28,344

Interest Expense 916 2,045 3,516 8,274 11,638

Non-Interest Income 76 107 161 169 177

Fee based services 20 25 21 22 23

Other income 56 82 140 147 154

Expenditure 601 1,395 3,574 5,265 6,921

Employee Cost 284 536 1,544 2,805 3,942

Other operating expenses 317 859 2,030 2,460 2,979

Advertisements 82 482 1,081 1,024 1,024

Rent 54 133 326 538 723

Others 181 243 623 899 1232

Operating Profit 674 2,018 4,836 7,296 9,963

Bad debts and provisiosn 178 142 379 122 200

Depreciation 34 57 158 260 308

Profit Before Tax 462 1,818 4,300 6,914 9,454

Taxes 160 621 1,434 2,307 3,154

Tax rate 35% 34% 33% 33% 33%

Net Profit 302 1,197 2,865 4,608 6,300

Basic EPS 2.2 4.1 7.7 11.1 15.1

Diluted EPS 2.2 4.1 7.6 11.0 15.0 Source: Company, Ambit Capital research



Exhibit 28: Ratio analysis

Year to March (%) FYO9 FY10 FY11E FY12E FY13E

Loan Growth (YoY) 92% 173% 192% 40% 35%

Yield on advances- Calculated 27.5% 29.0% 25.0% 23.0% 23.0%

Cost of funds- Calculated 11.78% 10.66% 8.94% 10.5% 10.5%

Spreads 15.7% 18.3% 16.1% 12.5% 12.5%

NIM-Calculated 16.81% 17.91% 16.44% 13.79% 13.56%

Cost to income ratio 47.1% 40.9% 42.5% 41.9% 41.0%

Opex as a % avg assets 8.4% 8.0% 7.1% 5.9% 5.6%

Gross NPAs (gold loans) 1.66% 0.94% 0.55% 0.31% 0.31%

Net NPAs (gold loans) 0.18% 0.13% 0.18% 0.14% 0.14%

CAR 40.8% 31.7% 29.3% 22.6% 19.3%Source: Company, Ambit Capital research

Exhibit 29: Valuations

Year to March (%) FYO9 FY10 FY11E FY12E FY13E

P/E 61.1 48.2 26.0 13.9 9.6

P/BV 17.0 10.9 5.9 2.3 1.9

ROA 3.9% 3.3% 5.6% 5.0% 4.6%

ROE 34.7% 23.2% 30.8% 22.4% 21.5%

Dividend Yield 0.2% 0.3% 0.5% 1.0% 1.5%Source: Company, Ambit Capital research



Institutional Equities Team

Saurabh Mukherjea, CFA

Managing Director - Institutional Equities – (022) 30433174

[email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Amit K. Ahire Telecom / Media & Entertainment (022) 30433202 [email protected]

Ankur Rudra, CFA IT/Education Services (022) 30433211 [email protected]

Ashish Shroff Technical Analysis (022) 30433209/3221 [email protected]

Ashvin Shetty Consumer (022) 30433285 [email protected]

Bhargav Buddhadev Power/Capital Goods (022) 30433252 [email protected]

Chandrani De, CFA Metals & Mining (022) 30433210 [email protected]

Chhavi Agarwal Infrastructure (022) 30433203 [email protected]

Gaurav Mehta Derivatives Research (022) 30433255 [email protected]

Krishnan ASV Banking (022) 30433205 [email protected]

Nitin Bhasin Infrastructure (022) 30433241 [email protected]

Pankaj Agarwal, CFA NBFCs (022) 30433206 [email protected]

Parikshit Kandpal Construction / Real estate (022) 30433201 [email protected]

Poonam Saney BFSI (022) 30433216 [email protected]

Puneet Bambha Power/Capital Goods (022) 30433259 [email protected]

Rajesh Kumar Ravi Cement (022) 30433274 [email protected]

Ritika Mankar Economy (022) 30433175 [email protected]

Ritu Modi Metals & Mining (022) 30433292 [email protected]

Subhashini Gurumurthy IT/Education Services (022) 30433264 [email protected]

Vijay Chugh Consumer (incl FMCG, Retail, Automobiles)

(022) 30433054 [email protected]

Sales

Name Designation Desk-Phone E-mail

Deepak Sawhney VP - Ins Equity (022) 30433295 [email protected]

Dharmen Shah VP - Ins Equity (022) 30433289 [email protected]

Dipti Mehta Senior Manager Equities (022) 30433053 [email protected]

Pramod Gubbi, CFA VP - Ins Equity (022) 30433228 [email protected]

Sarojini Ramachandran Director, Sales +44 (0) 20 7614 8374 [email protected]



Explanation of Investment Rating Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >15%

Hold 5% to 15%

Sell <5%

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