Long-Term Power Surge

We had recommended Power Finance Corporation (PFC)—a non-banking financial company focused solely on the funding needs of the power and related sectors—almost a year back, when it was at a level of Rs 200. Considering that PFC’s business has run in a stable manner in a difficult economic environment and it has future earnings visibility, at a price of Rs 276 today, the stock has gained 38 per cent in a year. We are re-recommending it as a long-term buy.

Business performance. PFC is a Navratna public sector unit that finances power generation, transmission and distribution projects. It is also the nodal agency, selected by the government of India, to facilitate development of power projects with capacity of over 4,000 megawatts, also called ultra mega power projects or UMPP. Although PFC’s consulting business contributes little to its total income, it does give a diverse mix to the company’s product portfolio.

PFC’s business has grown at a healthy pace over time. The compounded annual growth rate (CAGR) of loan assets in last five years is 22 per cent. In FY10, PFC’s loan book expanded by 24 per cent, which is higher than overall growth in bank credit. The commendable part is that despite high loan growth, the asset quality is impeccable. The net non-performing asset is just Rs 6 crore, or 0.01 per cent of loan assets.

PFC faces competition in the lending business from banks, but the nature of its capital gives it advantage over them. First, banks face asset-liability management challenge in financing long-term power projects, as it uses short-term deposits to give long-term loans. On the other hand, PFC has the advantage of raising funds by issuing long-term bonds to fund long-term assets. Second, there is a cap on lending by banks to any sector, whereas there is no such restriction for PFC, giving it a free hand to meet large funding demand from the power sector.

Financial performance. Its five-year (FY05-FY10) CAGR of total income is 19 per cent. In FY10, company’s total income grew by over 22 per cent, while profit grew by 19.5 per cent. The net interest margin has moved to 4 per cent. Several factors help PFC maintain its margin. It raises a major portion of its debt at a fixed cost and has the flexibility to price its loans. Therefore, it is not impacted much by interest rate fluctuations. PFC’s credit rating, equivalent to sovereign debt rating, also helps it raise fund at low costs. Unlike many other PSUs, the company maintains a lean cost structure, which boosts its margin.

Investment rationale. India, being a power-deficient nation, will need huge investment in this sector. The government too realises this, and work on several ultra mega power projects (UMPPs) has already started. Even if capital becomes easily available, not all the investment in the power sector will be funded through equity. This is evidenced in the current debt-equity ratio of around 3:1 for an average power project. So, clearly, the demand for debt will exist and PFC is well positioned to take advantage of this opportunity. It also has an edge over banks.

Besides financing power projects directly, it has also started financing power companies’ purchase of raw materials. Another initiative is to finance power sector equipment manufacturers. Combined, these give visibility to PFC’s future earnings. Its track record in maintaining quality assets is another plus.

Considering these, PFC’s stock at Rs 276, or 13.45 times FY10 earnings per share, is attractively priced and will be a long-term bet for you in the sector.