L&T Finance Holdings: Well positioned in high growth segments

L&T Finance Holdings (LTFH), the diversified financial services business of L&T group, has done well and turned around after new management took over the business in July 2016. The result of the focused strategy is very encouraging and is reflected in improved profitability of the company.

We delve deep into the NBFC’s (non-banking financial services) strategy and business segments to understand the sustainability of the profitable growth.

Strategic clarity with focus on RoE

After the appointment of Mr. Dubhashi as MD & CEO in July 2016, LTFH redefined its business strategy to achieve top quartile return on equity (RoE) by FY20 or earlier. Accordingly, it has restructured its lending business and exited from number of segments that were a drag on overall profitability. It now focusses on three lending segments: rural housing and wholesale finance and is running-down the de-focused businesses. Also, the NBFC is now increasingly focused on expanding two non-lending fee based segments mainly, investment management and wealth management. In addition to identifying key revenue drivers, the management has reduced the costs and is investing in technology.

Wholesale finance – niche segment with differentiated approach

LTFH’s consolidated loan book stood at Rs. 83,654 crore as at end March 2018.  It remains wholesale heavy with 56% exposure to infrastructure, corporate and supply chain lending. Renewable power and road projects are the key loan segments.  Despite having experience and expertise in infrastructure space stemming from parent L&T Group, the slowdown in the segment adversely impacted asset quality and profitability in the past. RoE is relatively low in wholesale finance mainly due to higher provisions. Management envisages reducing exposure to 50% of the loan book by 2020.

We see LTFH as niche player with a competitive advantage in this segment. First, it has the ability to source funds at a cheaper rate compared to peers due to PFI (Public Financial Institutions) and IFC (Infrastructure Finance Companies) status. Secondly, it follows a differentiated strategy with focus on sell down. It intends to keep ~30% of loan originations on its book and aims to sell down the remaining 70% to other NBFCs and banks. This move is likely to improve RoE in wholesale segment as it will generate revenue through fees without consuming much capital. Overall, we see LTFH capitalize on the vacuum created by the current troubled state of state-run banks and continue to achieve profitable growth in this segment.

Housing finance – leading in developer funding

The housing book of Rs 18,898 crore as at end March 2018 consists of home loans, loan against property and real estate lending. The real estate funding at 53% of housing book is the most profitable segment that helped the housing segment generate RoE of 29% in FY18.

The real estate/developer financing has one of the highest profitability metrics for the non-banks as per Crisil estimates. With high net interest margins and low credit costs in real estate and structured loans, lenders earn RoAs of 3-3.5 percent on an average. LTFH being second largest player in real estate funding, after Piramal Enterprise, is well positioned in this segment.

Though performance of the segment has been resilient so far, investors should be cognizant that the LTFH’s developer lending book is relatively unseasoned and needs to be tested through a business cycle.

Rural finance – continues to be a focus area

LTFH’s rural business book of Rs. 16,457 crore comprises three product segments: microfinance, two-wheeler (2W) finance and farm equipment finance. It entered the 2W financing business with the acquisition of Family Credit from Societe Generale in FY13. Over the past four years, LTFH has grown to become a significant player in the 2W lending market and is among the top three players in the tractor finance market. Overall, rural financing is the second most profitable segment for LTFH, with RoE of ~25% and will be future growth driver.

Profitability improvement to continue

The substantial progress of the restructuring process is reflected in the improved return ratios with RoE increasing from 9.78% in Q1FY17 to 15.06% in Q4FY18.  Improvement in earnings is achieved despite accelerated provisions in FY18, especially on impaired wholesale loans. While the return ratios improved, it is comforting to see balance sheet also strengthening with provision coverage ratio improving to 52.5% in Q4FY18 from 15.1% in Q1FY17.

Profitability improvement to continue

The substantial progress of the restructuring process is reflected in the improved return ratios with RoE increasing from 9.78% in Q1FY17 to 15.06% in Q4FY18.  Improvement in earnings is achieved despite accelerated provisions in FY18, especially on impaired wholesale loans. While the return ratios improved, it is comforting to see balance sheet also strengthening with provision coverage ratio improving to 52.5% in Q4FY18 from 15.1% in Q1FY17.

LTFH is emerging player in asset management with average assets under management (AUM) of Rs. 65,932 crore for the quarter ended Mar’18. We particularly like the asset mix as 53% of AUM consists of high fee earning equity assets. Though the current size of LTFH’s wealth is modest with assets at around Rs 13,623 crore, we see enough potential this segment. The operating metrics of both these fee-based businesses is also improving and is expected to make meaningful contributions to future profits.

Overall, we see LTFH well on track to deliver on its stated objective and see further RoE improvement driven by loan book growth and decline in the cost-income ratio. Also, while credit costs were elevated over the past few years due to legacy asset quality issues, they are expected to moderate going forward due to better underwriting post 2012 aiding profitability.

 Valuation will be driven by earnings growth as turnaround priced in

LTFH Finance, with diversified business segments, will be the key beneficiary of the multiple growth drivers across various financial services business.

We have valued the stock on SoTP (sum of the parts) basis and see reasonable upside to current market price. Since the stock has rerated well over the past two years on account of strong execution by management, we expect future stock upside to be driven by strong earnings growth.  The recent capital raise of Rs 3,000 crore will adequately equip the NBFC to take higher market share, especially in infra space, in an environment where a large part of the banking system has been rendered weak due to asset quality woes. Investors, with a long-term horizon and wanting to participate in high growth diversified financial services company, should buy into the stock.