Indostar Capital Finance IPO: High growth potential at reasonable price; Subscribe

Indostar Capital Finance’s Rs 1,844 crore initial public offering (IPO) opens for subscription today. The company plans to raise Rs 700 crore of fresh capital in addition to an offer-for-sale from promoters and existing shareholders amounting to Rs 1,144 crore. The primary market offering of the non- banking finance company (NBFC) comes at a time when the space is fast gaining share in the overall credit pie and its fortunes are on an uptrend.

Incorporated in 2009, Indostar is primarily engaged in providing structured term financing solutions to corporates and loans to small and medium enterprise (SME) borrowers. It recently expanded its portfolio to offer vehicle and housing finance products. It is a professionally managed company and has been sponsored by institutions of repute such as Everstone Capital, Goldman Sachs Group, Baer Capital Partners, ACPI Investments and CDIB Capital International Corporation.

Indostar’s outstanding loan book stood at Rs 5,172 crore as at the end of December 2017. Corporate lending constitutes 77 percent of the total book while loans to SME stood at 23 percent in the period under review. Going forward, the loan mix will slightly change as the NBFC has just forayed into vehicle and housing finance. The management said 75-80 percent of its business going forward will accrue from the corporate and vehicle business.

Indostar enjoys a healthy earnings profile with above industry average return on assets (RoA), supported by high margins and low credit and operating cost. RoA stood around 3.8 percent for nine-months ended December 2017 (vs 4.1 percent for FY17).

The company earns an average interest spread of more than three percent on its loan portfolio, with highest yields on its real estate loans. Its ability to diversify its resource profile and reduce cost of borrowing over time has aided margins.

With gross non-performing asset (GNPA) at 1.7 percent, its credit cost is low. The lender adheres to strong credit appraisal and risk management processes, especially in the real estate segment, that helps in keeping a check on asset quality. In addition to targeting reputed borrowers with a long track record of timely repayment, the NBFC maintains security cover in the 1.5 to 2.5 times range. It lends against business cash flows with property as security cover (not a pure loan against property product). For real estate, project cash flows are escrowed and sometimes it resorts to selling down some part of the real estate loans originated to avoid concentration and free up capital.

With focus on new segments - vehicle and housing finance, we expect cost-to-income ratio to inch up in the near future as it builds retail infrastructure for the same. Despite this putting slight pressure on return ratios, we view the move as desirable as it will de-risk its loan portfolio. Also, we don’t expect any significant fall in return ratios as scaling up in these segments will be gradual and measured.

Though performance of the company has been resilient so far, investors should be cognizant of the inherent risks as well. Indostar’s lending book is relatively unseasoned and needs to be tested through a business cycle. However, we see it gaining market share due to its better focus and not by taking higher risks.

Indostar, with a presence in some of the fast growing lending segments, will be the key beneficiary of sectoral tailwinds as banks (public sector) are fast vacating the market.

According to Crisil, the wholesale credit book of non-banks is seen growing at 21 percent annually till 2020. Growth in real estate financing, which constitutes more than half of wholesale credit book, will remain strong. According to Ajit Velonie, Director, Crisil Ratings, “Given the high net interest margins and low credit costs in real estate and structured loans, this segment has among the highest profitability metrics for non-banks. Lenders earn RoAs of 3-3.5 percent on an average”.

Prospects of the commercial vehicle (CV) financing business is equally good and Indostar intends to take advantage of the opportunity by entering the segment.

Crisil expects the vehicle finance portfolio of NBFCs to grow 300 basis points (bps) faster over the next three fiscals to 2020, clocking a compound annual growth rate (CAGR) of 15 percent as against 12 percent seen in the past three fiscals. While all segments of vehicle finance are expected to grow faster than before, CV financing, in particular, is expected to rebound from the lows seen over the past several years and clock 14 percent CAGR till 2020. Expected finalisation of the scrappage policy or the Voluntary Vehicle Modernisation Programme will boost growth.

At the upper end of the price band - at Rs 572 per share, the company will have a market capitalisation of around Rs 5,200 crore. Indostar is valued at 1.9 times trailing book (Q3 FY18 book) on a post money basis at the IPO offer price of Rs 572 per share. For a NBFC with a strong earnings growth potential and ability to generate RoA between 3.5 percent and 4 percent, valuation seems pretty reasonable. On a relative basis also, valuations looks undemanding when compared to well established NBFCs operating in retail lending space and can expand further if Indostar can scale up its retail lending franchise.

Given the sectoral tailwinds, experienced management along with a well-capitalised balance sheet, Indostar is well poised for the next leg of growth. It is a good long-term bet available at a reasonable price. We recommend investor to subscribe to the issue.