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IDFC: Relying on ‘fee’ - Views on News from Equitymaster
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IDFC: Relying on ‘fee’
Jan 23, 2006

Performance summary
IDFC announced results for the third quarter and nine month ended December 2005 late last week. The institution has reported a relatively muted bottomline performance as compared to the previous quarters. While on one hand pre-payment and repricing of loans have weighed heavy on the institution’s margins, fee income and buoyancy in the proprietary treasury book have cushioned the same. Low leverage and operating efficiency continue to remain IDFC’s competitive edge. The result analysis also includes excerpts of the conference call with the company.

Rs (m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Income from operations 1,725 2,445 41.7% 4,692 7,585 61.7%
Other Income 50 3 -94.0% 75 5 -93.3%
Interest Expense 792 1,314 65.8% 2,179 3,593 64.9%
Net Interest Income 933 1,132 21.3% 2,513 3,992 58.9%
Other Expense 68 86 27.4% 180 246 36.5%
Net interest margin (%)       3.9% 3.1%  
Provisions and contingencies 29 19 -33.0% 114 409 257.7%
Profit before tax 886 1,029 16.1% 2,294 3,343 45.7%
Tax 84 135 60.7% 235 323 37.2%
Profit after tax/ (loss) 802 894 11.4% 2,059 3,021 46.7%
Net profit margin (%) 46.5% 36.6%   43.9% 39.8%  
No. of shares (m)       1,000 1,122  
Diluted earnings per share (Rs)*         3.6  
P/E (x)         19.2  
* (12 months trailing)            

A headstart in infrastructure funding
Established in 1997 as a private sector enterprise by a consortium of public and private investors, IDFC operates as a professionally managed infrastructure financing entity whose focus areas are energy, telecom, transportation and industrial and commercial projects. IDFC financed 25% of the total infrastructure outlay in the country in FY05. Its expertise in the infrastructure sector and strong relationship with government and infrastructure sponsors provides it with a platform for facilitating private investment and public-private partnerships in infrastructure projects in sectors where market structures, government policy and regulations are evolving. IDFC has capitalised on its domain knowledge and structuring expertise in financing activities to garner fee-based revenues.

What has driven performance in 3QFY06?
Pre-payment pares margins: IDFC witnessed a growth of 37% YoY in its net outstanding loans (net of pre-payments/repayments) during the nine month period. This was on the back of 46% YoY growth in approvals and 60% YoY growth in disbursements during the same period. The institution has a disbursal to sanction ratio of 55%, which though lower than the sector average (70% to 80%), is an improvement over the previous quarters (51% in FY05). However, what is depressing the net asset growth is the problem of pre-payment/repayment of loans (pre/re-payment ratio 30% in 9mFY06), which is peculiar to IDFC’s business. Since the institution offers loans to start-up ventures at higher yields, the assets get pre-paid or repaid at a later date, wherein the borrower prefers to pay off its liability to IDFC and borrow from banks at cheaper rates. Alternately, once the risk propensity of the borrower falls (with operational maturity), the borrowers bargain for lower rates from IDFC, resulting in the asset getting re-priced. This has resulted in the institution’s net interest margins (NIMs, 3.1% in 3QFY06) witness a consistent fall over the past few quarters, despite the average cost of funding remaining flat.

(Rs m) 3QFY05 % of total 3QFY06 % of total Change
Revenue 1,775   2,448   38%
(i)Infrastructure 1,657 93.4% 2,219 90.6% 34%
(ii)Treasury 118 6.6% 229 9.4% 94%
Profits 884   1,119   27%
(i)Infrastructure 899 101.7% 1,136 101.5% 26%
(ii)Treasury (15) -1.7% (17) -1.5% -13%

IDFC, however, believes that the downside hereon to its NIMs is limited due to the following reasons:

  1. The institution has already made borrowings at attractive rates in December 2005, which is expected to suffice its funding needs for near term. Also, it has made an application to the RBI for borrowing in US dollars. This is because such long-term (5-year) overseas borrowings, even on a fully hedged basis, are 30 to 40 basis points cheaper than the domestic rates.

  2. The institution has its entire funding (debentures and bank loans in 50:50 ratio) on a fixed cost basis while it is seeing an upward trend in asset yields due to the rising interest rates.

  3. Going forward, as the risk weightage on its asset profile (infrastructure advances) reduces, with projects nearing completion and revenue streams getting unlocked, IDFC plans to securitise them to asset hungry financial entities at a premium, before the same get prepaid.

Nevertheless, we would herein like to clarify that the said fall in NIMs is exactly in line with our estimations (3.1% for FY06) and given the upside in interest rates, we have assumed further depression in margins for our forward projections.

Non-fund cushion: While IDFC’s non-interest income grew by 128% YoY in 9mFY06, the fee revenue from advisory services (included in income from operations) increased by 71% YoY. Profits booked on sale of equity investments gave the maximum leverage to the institution‘s other income by growing at 233% YoY. The share of fee income in operating income increased to 11.2% in 9mFY06, from 9.8% in 9mFY05. The institution expects this to go upto 20% in the next 2 to 3 years. Also, the unrealised gains on equity book stood at Rs 2.8 bn at the end of December 2005.

Provision write back: IDFC, as per the RBI guidelines, has made cumulative provisions to the tune of Rs 1.3 bn on its ‘re-priced’ assets. The said regulation now having got reversed (as provisions are now only for restructured assets) authorises the institution to write back the provisions over the life of the asset. The same has led to IDFC showing lower provisioning in its books for the past few quarters, which is expected to continue over the next couple of quarters.

Returns to amplify: IDFC’s return on assets (RoA) has remained stable at 4.2% in 9mFY06, as was the case in the corresponding period of FY05. The entity continues to enjoy the highest return ratios in the sector. Also, with increasing leverage, IDFC’s return on equity has considerably increased (17.8% in 9mFY06) and the same is expected to improve going forward. It must be noted that despite higher leverage, the institution expects its RoA to stabilise at 2.8% to 3% in the next 2 to 3 years (which will be much higher than the sector average).

What to expect?
Besides having sufficient equity capital to support growth, IDFC also enjoys the highest operating efficiency in the financial sector. While its lower cost to income ratio (3.2% in 9mFY06) as compared to banks is understandable (because of leaner size of branches and employees), it is also lower as compared to HDFC. The institution plans to sustain a lean franchise going forward, even with the expansion in balance sheet size. Its impressive growth history and good asset quality also adds to our comfort factor.

At the current price of Rs 69, IDFC’s stock is trading at 2.6 times our estimated FY08 adjusted book value. Though the stock seems to be fairly valued in terms of its future growth prospects and possible depression in margins, we believe that given the prospects of private sector financing in the country’s infrastructure lending needs, IDFC is ideally positioned to capitalise on the same.

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