2A-KARIM CHAMBER AMBALAL DOSHI MARG FORT MUMBAI – 400 001

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Shriram Transport Fin.Co.Ltd. Buy at Rs 552 (Target Price: Rs 970) Background

STFC is the country's largest asset financing NBFC (non-banking finance company) with a 25% market share in pre-owned truck financing and around 8% market share in new truck financing. The company has niche presence in the high-yielding pre-owned CV financing business with expertise in loan origination and valuation. It had a total employee base of over 15,947 at the end of 3QFY12 and has 498 branches across India with around 1 m customers (a huge chunk of the country's truck owners).

Investment Rationale

Conservatism is expected to pay off in the long run: The Reserve Bank of India's (RBI) thirteen rate hikes in quick succession put a dampener on growth in the country. Index of industrial production (IIP) data was also dismal, growing only 1.8% in December 2011. With sales of commercial vehicles closely mirroring GDP and IIP growth, it is not surprising that players like Shriram Transport (STFC) have seen slower growth this year. But, what enthuses us about this company is that it has not been blindly chasing growth but has rather been extra cautious in this difficult market.

The financier has been lending mainly to its existing customer base and has not added many new customers or fresh loans. While it provides loans to existing customers at a 2% lower yield versus new borrowers, it has the benefit of a long standing relationship with the customer. This should prevent a willful default even if the economy continues to remain in a flux. While other players have been chasing after new CV buyers offering dealer commissions and sourcing through the direct sales agent (DSA) channels,

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Shiriram prefers to sacrifice short term growth than to indulge in such practices.

The company has also conservatively reduced its loan to value (LTV) ratio for vehicle loans. This has now come down to around 65%, the same being 5-8% higher a few quarters back. A lower LTV ratio ensures that the borrower has more equity in the asset, reducing his chance of default. In the rare case that a low LTV loan defaults, lenders have a high probability of recovering their capital even if the asset is sold at a discount. While growth may be sacrificed on account of lower interest income, as well as a smaller quantum of loan given, we believe this conservative practice will be beneficial in the long run, especially on the asset quality front. STFC has also not hired new employees over the last quarter, preferring to hire only when the economic cycle improves. It thus does not have to pay out of its pocket for unproductive employee expenWe believe that all these moves are all part of a conservative long term growth strategy. Shriram already has around Rs 400 bn in assets under management, and prefers to focus more on quality versus quantity. Once the economic sentiment improves, it should be able to easily capitalize on the same. At this point we believe investors have a sufficient margin of safety to invest in the stock. Thus at current levels, we recommend investors to 'BUY' the stock with a target price of Rs 970 from a 2 year perspective.

Despite temporary blip, asset quality continues to be superior: STFC stumps even the best banks in the country when it comes to margins and asset quality. In terms of net interest margins (NIM), the superior yields it derives on pre-owned CVs gives the financier a lead of nearly 3% to 4% over the auto loan assets of banks. Having said that, the change in the composition of assets (with higher composition of new CVs going forward) will bring down its yields and the lack of access to low cost deposits will reduce the difference in spreads to that of banks. Plus, given the company's conservative policy on lending, in the current economic environment it focused on lending mainly to repeat customers, which usually gives it a 2% lower yield versus newer borrowers. It has also reduced its loan to value (LTV) ratio. Nevertheless, the return on equity derived by it is far superior to its banking peers.

Shriram has maintained an impressive asset quality (average net NPAs to advances 0.9% over past 5 years). In the current financial year of FY12, however, the company had to face some write-offs on account of the mining ban in the states of Karnataka and Goa. So far around Rs 800 bn has been written off. The company continues to be very prudent on the provisioning front and its provisioning coverage ratio is in excess of 86% (9mFY12).

Subsidiaries to help fuel growth: STFC is no longer only in the business of financing used and new trucks. Instead it is also using its customer base to venture into areas like freight bill discounting, tractor

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financing, passenger vehicle financing and construction equipment financing. This effort will help it grow its credit book independent of the cyclicality in the automobile sector.

The company recently set up two subsidiaries, Shriram Equipment Finance Company Ltd. and Shriram Automall India Ltd. What excites us is that these newly formed subsidiaries are not random diversifications, but actually help complement the company's already established skills and expertise.

In FY11, STFC inaugurated its first Automall in Chennai. Now it has outlets in Baroda, Delhi and Mumbai as well. These automalls offer a platform for potential buyers and sellers to meet and decide the value of vehicles based on a public auction system. This subsidiary will help STFC earn a fee income from each vehicle it auctions, plus give it access to a new set of customers to offer vehicle finance to. Within one year, STFC plans to open 50-60 Automalls across India, each with a parking capacity of around 250 vehicles.

The construction equipment industry is also growing rapidly. It is expected that spending on construction equipment in India will reach Rs 1.8 trillion by 2015. This is in line with the government's strong commitment towards improving India's roads, ports, power plants etc. This growth will help increase the demand for construction equipment including crawlers, excavators, wheeled loaders, crawler dozers and compaction equipment. In its first year of operation, Shriram Equipment Finance made a total disbursement of Rs 6.6 bn. Assets under finance have more than doubled to Rs 15 bn at the end of 9mFY12. Plus this subsidiary has already started contributing positively to the bottom line. The company envisages the new ventures to contribute 15% of its revenues in the next 3 years. We have been reasonably conservative in our estimates and have factored in not more than 5-6% contribution of the new segments to the company's topline over the next three years.

Industry Prospects

Despite commercial banks' presence in various consumer-financing categories, a large segment remains un-tapped and is being catered to by local moneylenders at usuriously high rates. NBFCs (non-banking finance companies) are well exploiting the gap between banks and local moneylenders. Attractive yields and immense opportunity of growth puts the sector in a sweet spot. This has been made possible due to the following reasons:

Greater reach and network enables wider accessibility Better understanding of the needs of the target segment

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Focus on recovery and expertise in handling cash Improved risk assessment and management capabilities. Compared to the banking industry, NBFCs that are into CV financing typically have delivered higher

net interest margins, return on assets and return on equity while maintaining low NPA ratios.

The CV industry will also stand to benefit from certain structural changes that will be witnessed in the future. Besides

consolidation of the bigger freight operators, replacement demand is expected to be a major catalyst of the incremental demand.

The Large CV Financing market in India is estimated to be around Rs 900 bn. Out of this, the more than 5-year old CV segment accounts for 61%. The potential financing market for Large CVs aged 5-12 years in India is pegged at Rs 400 bn, which also accounts for 35% of the total existing CV population in India. The pre-owned CV segment accounts for almost 70% of the total CV sales. Several policy and legislative factors (Bharat-III emission norms and legislation on banning trucks of age greater than 15 years) that are expected to propel the demand for 'younger' vehicles in the industry - leading to the phasing out of vehicles in the 5 to 12 years age profile and thus reducing the dominance of unorganised financers in the market.

Valuations

The NBFC space went through a tough time over the past few months, on increased regulatory scrutiny by the RBI. While securitization is still allowed for players like STFC and Mahindra Finance, full guidance on the same is still awaited. Growth has not come easily on account of the RBI's rampant interest rate hikes and a slowdown in GDP growth. IIP growth was also dismal and infrastructure activity in the country almost came to a standstill so far in FY12. All this affected the balance sheet growth of various financiers. But, rather than trying to aggressively vie for scarce growth, STFC chose to focus on quality rather than quantity. It preferred to sacrifice short term growth and yields than to indulge in unsustainable growth practices.

When the economic cycle turns for the better, we believe that the management's conservative practices will hold it in good stead. Being one of the largest asset financiers it will be better equipped to handle credit demand once the economic bounces back. It has a well capitalized book and plans to tap under-penetrated segments of freight bill discounting and construction equipment financing. We believe that STFC has well-aligned growth path ahead, despite a slowdown in the sector.

In keeping with the fundamental strengths of the company and its conservative management, we reiterate our positive stance, and recommend you to 'BUY' the stock of STFC with a target price of Rs 970 from 2 year perspective. This will offer average annual returns of 31% to investors (75% point-to-point) over this time period

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