NBFCS: Investors should brace for liquidity crunch impact

With funding structures changing, growth pangs may be most visible in Q2

With the funding structure changing significantly and banks playing a pronounced role, growth pangs may be most visible in the September quarter.

LIC Housing Finance and L&T Finance Holdings published their September quarter (Q2) results over the past weekend. Net profit growth wasn’t a worry. What investors of nonbanking finance companies (NBFCS) have to be cognizant of, however, is that growth is well off the past levels. LIC Housing’s 14 per cent loan growth was quite off the 18 per cent levels registered until two quarters ago, and same is the case with L&T Finance, indicating, for the first time in a year, that growth may be a tough chase for NBFCS. Analysts at Emkay Global expect NBFCS in their coverage to post 10 per cent rise in the net profit in Q2, half the run rate compared to a year ago.

The reason why growth assumes higher importance now than before is that Q2 is most likely to be the first quarter reflecting the full impact of the balance sheet correction, which was extensively underway in most NBFCS over the past nine months. The biggest lesson learnt in this period is that the idea of borrowing short and lending long, which has forced the industry to mandatorily rethink their asset-liability management (ALM) practices, may well be history. The Reserve Bank of India's move making it mandatory for NBFCS to maintain a certain level of high-quality assets and risk weights will also compound the issue.

While regulatory action and moves by NBFCS to correct ALM mismatch are long-term positives, the near-term ride may remain bumpy, as cost of money on a sustainable basis isn’t close to the comfort zone yet. Based on the June quarter numbers of NBFCS, marginal or incremental cost of funds remains expensive and analysts at Credit Suisse say that even as aggregate liquidity has turned surplus, bond markets have continued to differentiate in their willingness to fund them. One of the cheapest source of funds for NBFCS come in the form of nonconvertible debentures (NCDS) and commercial papers (CPS), both of which witness high participation from mutual funds (MF). Analysts at Nomura point out that from 35 per cent participation of MFS, the share of MF debt funds has now fallen to 27 per cent, and their preference towards housing finance companies and wholesale funding NBFCS has deteriorated significantly. MF participation in the two segments, according to Nomura, has declined by 80 per cent and 50 per cent respectively. The Q2 numbers of LIC Housing and L&T Finance also indicate that asset quality and cost of funds may remain pain points for the sector.

Simultaneously, NBFCS’ leaning towards securitisation as a means of augmenting capital has also increased. NBFCS’ dependence on securitisation of assets to fund their books rose to 7 – 14 per cent (22 per cent for Indiabulls Housing, the highest in the industry) of total borrowing profile in the June quarter, a jump of 50 – 100 percentage points in a year. Securitisation involves pooling of loans receivable into debt instruments for sale to investors or banks, and enables the seller to generate liquidity to fund growth. If growth slows down, the pool of assets available for securitisation will come under trouble, putting more pressure on cost of funds.

To sum up, an analyst from a foreign brokerage says that those holding NBFC stocks could brace for the worst quarterly results this time around.

“The full effect of liquidity squeeze will be felt in Q2 because both the assets and liabilities will look very different from a yearago. Given that quality names such as Bajaj Finance and HDFC Limited have gone slow during the quarter, Q2 results for across the NBFC sector may be a let-down,” he states. While the recent valuation de-rating of 5 – 12 per cent in the last three months partly captures the pain, analysts say there could be more, and buying into NBFC stocks may become more selective. HDFC and Bajaj Finance remain the most preferred stocks in the segment, but valuations at 4.7x and 7x FY20 estimated books respectively are quite steep.