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Power Finance Corporation IPO: Our view
Jan 31, 2007

Power Finance Corporation Ltd. (PFC) is issuing 117.3 m shares (including 2.5 m reserved for employees) as part of its initial public offering (IPO), which opens today for subscription. The company has priced the issue in a range of Rs 73 to Rs 85 per share, thus expecting to raise Rs 8.4 bn to Rs 9.8 bn. For retail investors, minimum subscription for this issue is 80 shares. The issue will close on February 6, 2007.

Company background
Power Finance Corporation (PFC) is a leading power sector public financial institution and a non-banking financial company (NBFC) providing fund and non-fund based support for the development of the Indian power sector. The company occupies a key position in the government’s plans for the growth of this sector, and performs a major role in channeling investment into the sector.

PFC commenced its operations in fiscal 1988 as part of the Government of India’s initiative to enhance funding of power projects in India. It initially provided funding to power projects for state electricity boards (SEBs) and power departments. In line with the government’s decision to encourage private sector participation, the company began financing power projects in the private sector from fiscal 1997. PFC’s clients include state power utilities, central power sector utilities, power departments, private power sector utilities (including independent power producers), joint sector power utilities, power equipment manufacturers and power utilities run by local municipalities. These clients are involved in all aspects of the generation, transmission and distribution and related activities in the power sector.

Loan outstanding by project type
(Rs bn) FY02 FY03 FY04 FY05 FY06 1HFY07 CAGR*
Generation
Thermal 52 62 75 108 136 161 28.4%
Hydroelectric 29 44 59 68 94 100 31.3%
Renovation & Modernisation              
Thermal 16 16 17 18 19 19 4.2%
Hydroelectric 3 3 3 4 4 3 6.7%
Transmission 31 34 35 37 40 43 7.1%
Distribution 18 20 21 20 22 22 4.9%
Shunt capacitor projects 1 1 1 1 0 0 -18.9%
Others # 14 28 38 40 40 37 23.6%
Total 165 208 248 295 356 386 20.8%
* Compounded Annual Growth Rate during the period FY02 to 1HFY07;
# Includes bill discounting, buyers line of credit, loans to equipment manufacturers, loans for asset acquisition, loans for redemption of bonds, medium term loans, short-term loans, pre-investment fund, project settlement and wind power, translation loss recoverable, provisions for contingencies and interest accrued and due

PFC’s financial products and services include financing in the form of rupee term loans, foreign currency loans, bridge loans, short-term loans, transitional loans, bill discounting, equipment leasing, buyers’ line of credit, loans to equipment manufacturers, line of credit for the import of coal, debt refinancing, asset acquisition schemes, study assistance and non-fund based products such as guarantees. The company is also allied with the government in the implementation of its Accelerated Generation and Supply Program (AG&SP) and Accelerated Power Development and Reform Program (APDRP).

As of September 30, 2006, PFC had made cumulative sanctions of Rs. 1,139 bn (US$ 25 bn) and cumulative disbursements of Rs 677 bn (US$ 15 bn) respectively to power sector projects. During the period between FY02 to FY06, the company grew its income and net profits at compounded rates of 10% and 5% respectively. During this period, it’s average return on net worth stood at 15.5%.

Resource mobilisation
PFC funds its assets, comprising loans to the power sector, with borrowings of various maturities in the international and domestic markets. Its market borrowings include bonds, short-term loans, medium-term loans, long-term loans, and commercial papers. Since 1999, the company has raised all funds, both domestic and international, on an unsecured basis and it has no outstanding secured loans as on September 30, 2006.

Reasons to apply
Vehicle for financing India’s growth: PFC has been designated as the nodal agency by the Government of India for the development of seven ultra mega power projects (UMPPs) located in Sasan in Madhya Pradesh, Mundra in Gujarat, Krishnapatnam in Andhra Pradesh, Tadri in Karnataka, Girye in Maharashtra, Ib Valley in Orissa and Akaltara in Chattisgarh. As of November 30, 2006, the company had incorporated seven wholly owned subsidiary companies to act as special purpose vehicles (SPVs) for these projects. The company, through these subsidiaries and in conjunction with the Ministry of Power and Central Electricity Authority, will undertake all activities necessary to obtain the appropriate clearances required to establish these generation projects. It is intended that these SPVs will be transferred to successful bidder(s) selected through a tariff based international competitive bidding process managed by PFC and the developers will then implement these projects. The company is also incorporating subsidiaries as SPVs for two transmission and one hydroelectric project on lines similar to that of UMPPs. The company also intends to venture into power trading through SPVs.

Relationship with the government: PFC’s strong relationship with its chief promoter, the government, gives it access to decision makers in government entities and multilateral development agencies. As a consequence, the company is able to play a significant role in the direction of power policy in the country. Its policy-related initiatives have helped rationalize India’s regulatory frameworks within the sector, which has encouraged an increased flow of private capital including foreign capital, into power sector investment.

Low leverage and access to long-term funds: PFC’s conservative capital structure and low leverage allows it significant room to grow its balance sheet and return on equity. Its leverage (long-term borrowings divided by net worth) was 3.8 times at the end of 1HFY07, which is lower than most of its competitors, including banks (industry average of 15 times).

Excellent asset quality: PFC has one of the strongest asset quality positions amongst the financial entities in India (rivaled only by IDFC, HDFC and HDFC Bank). According to the institution, this has been achieved due to its strong credit and project appraisal skills and disciplined risk management practices. The company employs extensive screening and financial analysis to assess potential risks of the projects under scrutiny and devises appropriate risk mitigation mechanisms. Due to this, it had 0.23% gross NPAs and 0.16% net NPAs at the end of 1HFY07. Also, the company’s capital to risk-weighted asset ratio (CAR) as of September 30, 2006 was 17.77% (annualised), indicating that the company is adequately capitalised.

Reasons not to apply
Dependence on government policy and regulation: The growth of the power sector industry in India and PFC’s business is largely dependent on stable government policies and prudent regulations. The Indian power sector has historically been constrained by various factors such as shortages of public funding, political considerations and issues of transparency and accountability. Given the long gestation periods for the commencement, construction and deployment of project assets and the long-term nature of project objectives, power sector projects are susceptible to changes in various factors, such as interest rates, regulations and policies, the cost and availability of raw materials and other key inputs and general economic conditions. These factors could affect project viability and the ability of projects and their sponsors to repay the financing that PFC extends to them.

Margin pressures on the rise: PFC is expected to face pressures on the net interest margin front due to rising interest rates. Since its borrowings are linked to G-Sec yields, the rise in interest rates will push the cost of funds upwards, while slower rise in lending rates (due to competition) may put pressure on margins and thus, impact profitability. Since the institution has no retail exposure, lack of low-cost deposit mobilisation puts it at a disadvantage.

Stiff competition: PFC will have to withstand stiff competition in power sector lending from some of the public sector banks, private sector banks, foreign banks and other financial institutions. The large public sector banks (comprising approximately 60% of the total market share) have traditionally been market leaders in this segment. Other new private banks have also been able to compete in this space on the basis of efficiency, service delivery and technology. In advisory services, PFC will need to counter some of the leading investment banking companies in the country.

Comparative Valuations & Comments
The banking and financial lending sector is dependent on credit growth. This is in turn a function of how well the economy is performing. Unlike other sectors, a financial institution's asset is cash and the ability to grow the topline and is therefore, largely dependent on the capital base (net worth in a broader sense). Therefore, more than the price to earnings ratio, the price to adjusted book value (P/ABV) is relevant while valuing a banking or non-banking financial company (NBFC) stock. By P/ABV, we mean reducing net non-performing asset from the net worth and then, dividing it by the number of shares. While the historical buy-sell limit is 0.6 times to 1.4 times adjusted book value, considering the de-regulation, we believe that the P/ABV of the sector should be in the range of 1.0 time to 2.3 times.

PFC, over the years, has emerged as one of the most prominent players in power sector financing in the country with a popular brand name and sound asset quality. However, increasing competition from the banking sector poses a threat to the company's market share. Considering that the company has still managed to hold ground in the face of competition, we shall accord PFC valuations that are at a marginal discount to those given to more diversified infrastructure lending agencies like IDFC (2.25 times to 3.25 times adjusted book value); discount considering the risk due to PFC’s dependence on only one sector, i.e., power. Despite this, considering that the company’s IPO is attractively priced at 1.4 times its adjusted book value for 1HFY07, we shall advice our subscribers to ‘Apply’ to the issue.

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