2012-11-28 511218 in (ICICI Securit) Shriram Transport Finance

Equity Research
November 27, 2012 BSE Sensex: 18537
INDIA
Shriram Transport Finance

Old remains gold Financials
Target price Rs850 Shareholding pattern
Promoters Institutional investors MFs and UTI Insurance FIIs Others Source: NSE Mar 12 45.6 41.7 2.5 0 39.2 12.7 Jun 12 46.2 42.1 2.0 0 40.1 11.7 Sep 12 46.2 42.7 1.4 0 41.0 11.1
BUY
Rs631
Reason for report: Initiating coverage

Shriram Transport Finance (STFC), a near-monopoly in used commercial vehicle (CV) financing, has derated significantly on the back of credit quality concerns and regulatory intervention. A potential beneficiary of interest rate softening with an expected 4% QoQ growth runrate in AUM, RoE levels remain at >20% despite assuming no asset quality improvement. The new securitisation guidelines have marginal impact on profitability and snew NPA norms do not have much of a longterm impact. With stock valuations attractive, we initiate coverage with a BUY. f Historical response to stress shows remarkable strategic clarity. Our two case studies of the companys strategies in periods of macro-economics driven asset stress shows remarkable coherence in strategic action slowdown of disbursements (especially in new vehicle loans), lowering maximal LTV, cash equivalents build-up and tighter repossession strategy. While current NPA levels of 3% reflect the stress in the economy, we feel concerns on account of application of 90-day recognition norms (vs 180 days now) are overdone. Our base case numbers assume a complete shift by Q2FY15 and even our NPA stress test of one-shot adoption in Q1FY14 impacts FY14E EPS by 17% and FY15E EPS by only 5% at coverage of 77.6%. f Unique competitive advantage protects pricing power, growth opportunities remain healthy. The companys unique close-to-the-customer business model driven near-monopoly position has kept yields in old CV financing firm through business cycles. We estimate the old CV financing opportunity to grow at 15.6% CAGR over the next five years and accordingly build in 4% sequential growth in AUM till FY15 (17% annualised) as internal capacity ramp-up is in progress. Construction equipment finance is expected to grow at 8-10% sequentially while Automalls (buyer-seller exchanges) provide a fast-growing fee opportunity. f Liability strategy crucial to margins and business stability. Primarily wholesale funded (25% from retail NCD), securitisation remains a low-cost viable option post new guidelines. While restriction on credit enhancements on bilateral assignments is likely to raise the cost of that route, even with no shift in incremental PTCassignment mix, impact should be limited at 80bps on securitisation costs. f Healthy financials and attractive valuations. STFC is a likely beneficiary of interest rate cuts. The company is carrying 24% of its balance sheet in liquid assets and at 17.3% tier-1 CAR, leverage headroom remains high. Valuations at 1.6xFY14E P/B are at a 27% discount to 5-year average and look attractive in a peer comparison on a RoE adjusted basis. Our 12-month target price of Rs850 (2.2xFY14E P/B) shows 35% upside. Worsening macro remains the key risk.
Market Cap Reuters/Bloomberg Shares Outstanding (mn) 52-week Range (Rs) Free Float (%) Rs140bn/US$2.6bn SRTR.BO/SHTF IN 223 659/418 53.8 41.0 5,632 3.8 24.2 4.8 14.7 Year to March NII (Rs mn) Net Profit (Rs mn) EPS (Rs) % Chg YoY P/E (x) P/BV (x) Net NPA (%) Dividend Yield (%) RoA (%) RoE (%) 2012 34,429 13,088 57.8 7.5 10.8 2.3 0.4 1.0 3.8 24.0 2013E 37,912 14,806 65.4 13.0 9.6 1.9 0.4 1.4 3.8 22.2 2014E 45,419 16,690 73.7 12.7 8.5 1.6 1.1 1.5 3.7 20.9 2015E 54,497 19,261 85.0 15.4 7.4 1.4 1.3 1.8 3.6 20.2
Price chart
690 640 590 540 490 440 390 340 May-12 Jan-12 Mar-12 Jul-12 Sep-12 Nov-11 Nov-12
(Rs)
Santanu Chakrabarti
santanu.chakrabarti@icicisecurities.com
FII (%) Daily Volume (US$/'000) Absolute Return 3m (%) Absolute Return 12m (%) Sensex Return 3m (%) Sensex Return 12m (%)
+91 22 6637 7351
Digant Haria
digant.haria@icicisecurities.com
+91 22 6637 7314
Please refer to important disclosures at the end of this report
Shriram Transport Finance, November 27, 2012
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TABLE OF CONTENT
Historical response to stress shows remarkable strategic clarity .............................3 Case study 1: Navigating the credit crisis of end 2008 to mid 2009...............................4 Case study 2: Navigating the current macro slowdown..................................................5 Current NPA classification & provisioning policy ............................................................6 Impact of moving NPA reporting standards in line with banks is being overestimated ..7 NPA stress test results provide comfort........................................................................11 Credit loss sensitivity to macro-economic environment................................................12 Unique competitive advantage protects pricing power, growth opportunities remain healthy................................................................................................................14 Market dominance in used CV is absolute and protects yields ....................................18 Used CV financing opportunity is Rs801bn growing at an estimated 15.6% over next 5 years..............................................................................................................................18 Internal capacity for growth remains robust..................................................................22 Construction equipment finance is an exciting new growth opportunity .......................24 Automalls testimony to STFCs dominance of the asset class ..................................26 Multiple growth avenues remain open given captive customer base ...........................26 Liability strategy crucial to margins and business stability .....................................27 Diversifying the liability mix ...........................................................................................27 STFC will be a beneficiary of softer interest rates ........................................................28 Credit ratings are healthy..............................................................................................29 Securitisation remains a key enabler of liability strategy and a profit enhancer ...........29 Multiple regulatory developments may reduce profitability of this route to some extent33 Healthy financials and attractive valuations ...............................................................35 Margin outlook is robust ................................................................................................35 Significant leverage headroom .....................................................................................36 Cash levels remain high, a case for higher payouts remain .........................................37 Valuations appear quite attractive.................................................................................39 Comparative valuations make the picture clearer.........................................................40 Risks to our investment theses .....................................................................................41 Financials........................................................................................................................43 Index of Tables and Charts ...........................................................................................45
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Historical response to stress shows remarkable strategic clarity

Freight volume slowdown causes asset stress Management of asset quality in its niche segment of financing used truck buyers is what differentiates Shriram Transport Finance (STFC) from its competitors in the segment. STFCs long journey in establishing itself as a credible player with a valid business model has been one of continuous demonstration of an ability to manage its asset quality through business cycles. To this end, liquidity squeezes and freight movement slowdowns that impact the profitability of the loan end user has always been the times needing maximal management oversight in STFC. There have been three periods of stress of differing magnitude in terms of threat to the companys business model i) the overall crisis in the Non Banking Financial Companies (NBFC) sector in 1999-2000, ii) the post-Lehman-collapse liquidity squeeze in India in 2009 and iii) the current spike in NPAs (in relative terms) driven by an industrial and freight movement slowdown during the fag end of 2011 and continuing into 2012. Among these, the company data in 1998-2000 is scarce, and in any case the merger of the four constituent companies was yet to take place. At that stage, the Reserve Bank of India (RBI) had put a restriction on leverage in NBFCs at 1.5x, while in line with most NBFCs of that time STFCs leverage was greater than 8x. At that stage, institutional funding was a tiny fraction of STFCs liabilities and the business was run on retail deposits (only Rs12bn in end FY12). We analyse in detail the other two cases (2008 end and 2011 middle) in the mature phase of the business to gauge the management style. Although the nature of the crisis has been different in each case there are remarkable consistencies in STFCs reaction to such troubled times. Strategic coherence in handling multiple periods of stress The company has been invariably willing to slow its business growth down by slowing down disbursements Cherry picking assets by raising the maximum allowed Loan to Value (LTV) for loans Building up cash on its books in order to stave off any liquidity issue Shifting the business mix further away from new vehicle loans where ticket sizes are larger and demand is generally more cyclical Finally, an obsessive focus on repossession in case of full default and quickly moving the asset into another customers hands through its buyer-seller intermediation facilities
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Case study 1: Navigating the credit crisis of end 2008 to mid 2009
In the aftermath of the credit crisis in the US and the consequent global liquidity crunch, being wholesale funded and being a credit provider in an end-user segment that was severely affected by the industrial slowdown was a tricky situation for STFC to negotiate. To understand this better, we need to analyse the impact of such a slowdown on a typical STFC loan end user, a first time truck owner who has just graduated from being a driver. Table 1: Trucker economics A typical single vehicle owner
Truck value (Rs) Loan (Rs) Annual interest rate (%) Tenure (months) EMI (Rs) Utilisation (days) Earnings Disposable income (Rs) Source: I-Sec research 500,000 300,000 20 36 11,149 Normal scenario 25 24,000 12,851
Credit crisis 2009 <20 days 17,000 5,851
Truckers IRR from sanction to repayment is 100%+
His loan outstanding is about Rs300,000 for a tenure of about three years (initial term) for a five-six year old nine tonne truck whose valuation is about Rs500,000. His Equated Monthly Installment (EMI) works to about Rs11,149 assuming a loan interest rate of 20% payable monthly. In a steady state scenario, his earnings from the truck on a net of fuel basis assuming a monthly utilisation of about 24-25 days is around Rs24,000. This implies the coverage of EMI by net earnings is about 2.1x, which is quite healthy as the owner has a monthly disposable income of Rs12,000 net of EMI. As monthly utilisation dropped in mid to late 2008 to less than 20 days for certain route / cargo operators, this EMI coverage dropped to about 1.5x, which barely left Rs6,000 in his hand. In this situation, the reported Non Performing Assets (NPAs) of the company did not spike up immediately in Q2FY09, as NPA recognition for NBFCs is on a 180 day basis (vis--vis 90 days for banks), however, the companys commentary did indicate underlying asset quality strains. The extent of underlying problem was clearly more than the 2.8% gross NPA (GNPA) reported about six months down the line after the beginning of the crisis in the March quarter of 2010. Because of the subsequent strong recovery driven by economic stimulus and liquidity infusions it is easy to miss the actual extent of the problem. The response of the company illustrates its maturity in assessing the situation and its internal understanding of the cyclical nature of NPAs. The measures affected by the company in troubled times included: New vehicle loan book was shrunk for two consecutive quarters Cash reserves were kept at levels of US$1bn+, which was doubled from a quarter earlier and maintained at those levels Old vehicle loan book incremental disbursements were brought down so that old loan AUM growth moderated, but the company did not panic and bring it down to a level so that the overall book shrunk. The company actually grew combined AUM even in those quarters.
Shriram Transport Finance, November 27, 2012 Chart 1: New vehicle loan book was consciously reduced since Sep-08
New CV - AUMs 70 65 (Rs bn) 60 55 6 50 45 40 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 4
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Chart 2: Cash levels more than doubled in Mar-09, to stave any possible liquidity crunch off
70 60 50 53.6 44.8 37.6
New CV - disbursements (RHS) 14 12

(Rs bn)
10 (Rs bn) 8
40 30 20 16.8 19.9
2 0
0 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09
Source: Company data, I-Sec research
Case study 2: Navigating the current macro slowdown

Early signs of macro-economic stress started emerging in H1FY12 with i) inflation continuing above the RBIs comfort zone of 6% of GDP, ii) elevated oil prices threatening an already weak fiscal balance, iii) exports to Europe and USA slowing down and iv) policy log-jams crippling under-construction projects in power, road and mining segments. Though the government responded in H2FY12 with an elevated borrowing plan while the RBI continued to hike repo rates in a bid to contain inflation (at the same time providing liquidity assistance through open market operations since then), the Index of Industrial Production (IIP) and the GDP growth registered decline over H2FY12 and H1FY13. The twin effect of low demand and high interest rates pressurised the profitability of corporate and Small and Medium Enterprises (SME) sectors. Banks too witnessed severe stress, with their mid-corporate and SME portfolios registering elevated restructurings and slippages over December 2011September 2012. Illegal mining ban impacted some borrowers Apart from the usual pressures of a slowdown in industrial activity impacting the freight market and hence utilisation of trucking fleet, STFC was hit by another event. The company suffered a slippage of about Rs1bn in a single geography, Bellary, where a ban on illegal mining hit small truckers involved in transferring mined ore in the region. Based on this and lowered utilisation adversely affecting the profitability of truckers in a manner similar to that in FY09 in the aftermath of credit crises (although freight utilisation was higher this time around), the companys GNPAs touched around 3% for the first time since comparable financials have been available after the threeway merger in 2006. The company affected the following measures to deal with the situation.
Shriram Transport Finance, November 27, 2012 Chart 3: New CV disbursements consciously slowed down since June 2011
Jun-11 60 50 (Rs bn) 40
(%)
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Chart 4: With major focus on old CVs, their proportion increased steadily
Old CV 100 New CV
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
Steady grow th
90 24 24 23 23 22 21
30 20 10 0 Old CV New CV No grow th
80
70
76
76
77
77
78
79
60 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12
It sharply slowed down disbursement of loans against new commercial vehicles but let old vehicle loans grow at a healthy rate. The loan book mix consequently shifted. Decreased maximum allowed LTV to 65-70% from 80%. Cash this time been lower than usual but stood at ~Rs30bn. With the current Non Convertible Debenture (NCD) issue being subscribed, the cash levels should be much higher in the next quarter. Almost completely exited mining as an end-user segment by Q2FY13. Increased the proportion of retail liabilities as a pre-cautionary insurance against any liquidity squeeze.
Current NPA classification & provisioning policy

STFCs current provisioning policy is industry-leading in its conservatism. The company has provided almost twice the minimum requirement stipulated by the RBI. It has maintained coverage ratio at 80%+. Table 2: Asset classification and minimum provisioning norms NBFCs
Standard assets Asset classification No default in payment of principal and interest amount Currently, non-performance of 180 days results in classification as NPA Asset is in the NPA state for more than 18 months If loan has been restructured, the asset remains sub standard for the 12 months of satisfactory performance Asset remains sub standard for a period of more than 18 months Asset provisioning 0.25% Standard asset provisioning along with loan loss provisions can be included in tier 2 capital to the extent of 1.25% of RWA 10% 10%
Sub standard assets
Doubtful assets Loss assets Source: RBI
Identified as loss
100% to the extent which asset is not covered by security 20% if doubtful for 12 month 30% if doubtful for 1 year to 3 years 50% if doubtful for more than 3 years 100%
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Impact of moving NPA reporting standards in line with banks is being overestimated
In keeping to the RBIs circular and guidelines on accounting for NBFCs in 2007, STFC recognises NPAs on a 180 days basis than on a 90 days basis. The Usha Thorat Committee report in August 2011 has recommended moving NPA accounting standards for NBFCs in line with those for banks (90 day recognition). However, the company expects NBFCs will be given a window of two-three years to comply with the guidelines and the raising of standards would be a gradual process. We feel that the impact of moving NPA standards for NBFCs in line those for the banks has been exaggerated. The company is already reporting its off-book assets, which constitutes 35% of its books in line, with the 90-day norm. Hence, the regulation will impact only 65% of its AUM. The companys incremental bad assets in the 90-180 day bucket lie principally in the 90-120 day bucket with very little in the 150-180 day bucket. The current bucketing of doubtful loans is shown in the following chart. Chart 5: NPA bucketing for STFCs CV business
3.5 3.0 2.5 2.0 (%) 1.5 1.0 1.0 0.5 0.5 0.0 180+
2.9
Large proportion of incremental NPAs lie in 90-120 day bucket
1.4
150-180 (days)
120-150
90-120
Hence, if the move to 90 day standards is a gradual one, there may not be much near-term impact on STFC until reporting norms touch 120 days level. We feel moving to 90 day standards will raise NPA levels by about 250-300bps on a secular basis (unless underlying credit quality also improves by means of an economic upturn) but will not have much long-run impact on the earnings. The initial spurt in provisions (if the current provisioning coverage policy is followed) is most likely to be written back in the subsequent quarters, as the underlying asset behavior of credit loss will not change (thereby increasing quantum of write-backs as well). If the company does not keep the coverage ratio at such high levels in the transition phase, even the initial impact on earnings will be more muted. The companys management has always been upfront about the fact that if NPA recognition for NBFCs is moved in line with those for banks, its NPA levels will roughly double. Changing the disclosure norm may have an immediate impact through an
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earnings shock, but unless there is a significant departure from the levels guided for, we do not foresee a long-term impact on price. Collection model unlikely to be tweaked by much A strategic concern now being voiced is that with tighter norms, the effectiveness of targeting STFCs niche customer base will be under pressure, as the customer segment needs some leeway in payment schedules given their economic standing and earning patterns. We think that such concerns are unfounded, as STFC as a company is concerned about the underlying credit loss and will not do anything to compromise operational fidelity by targeting what in essence is nothing more than a normative classification (GNPA). We do not mean that the company will not be sensitive to the same, but changes (if any) in collection method timelines will keep operational viability as the first priority. We are assuming that on a conservative basis the regulation will move to 150 days in Q2FY14, to 120 days in Q4FY14 and to 90 days in Q2FY15. The NPA levels we have assumed are presented in the following chart. We have built in no improvement in underlying credit quality. Chart 6: GNPA trajectory, assuming phased migration to 90 day recognition
6.0 5.5 5.0 4.5 (%) 4.0 3.5 3.0 2.5 2.0 Jun-11 Jun-12 Jun-13 Mar-13 Mar-14 Jun-14 Sep-12 Sep-13 Sep-14 Dec-12 Dec-13 Dec-14 Mar-15 2.7 3.0 3.3 2.9 3.0 2.9 2.8 3.3 4.3 4.3 4.3 180 day recognition 150 day recognition 120 day recognition 90 day 5.8 5.8
A study of the long term P&L provisions and write-offs show that the number has fluctuated around 0.4% of AUM per quarter (peaking at 0.5%), tying in with the companys commentary of a sub-2% long-term annual credit loss.
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Chart 7: Provisioning as proportion of assets to rise commensurately

0.80 0.75 0.70 0.65 0.60 (%) 0.55 0.50 0.45 0.40 0.35 0.30 Mar-13 Mar-14 Dec-13 Dec-12 Sep-12 Sep-13 Dec-14 Sep-14 Mar-15 Jun-11 Jun-12 Jun-13 Jun-14 0.4 0.5 0.5 0.5 0.5 0.7 0.6 0.6 0.6 0.6 0.6 0.7 0.7 180 day recognition 150 day recognition 120 day recognition 90 day
We have built in incremental provisioning going up to 0.7% of AUM per quarter in order to build in the impact of the new NPA norms. We do see significant upside to the numbers if the implementation is delayed and if the coverage ratio is lowered. (Our lowest level of assumed coverage is 74.4%, which is probably higher than what the actual number will be, as the company has already provided for almost double the requirement of the current RBI norm). The securitised portfolio is provided for to the extent of 4.5% in the end of FY12. We have been very conservative and have provided for the entire first loss of 5%.
Shriram Transport Finance, November 27, 2012 Table 3: Key NPA details for on-book assets
(Rs mn) Gross NPA (Rs.mn) Net NPA (Rs.mn) Gross NPA (%) Net NPA (%) Provision coverage ratio (%) Source: Company data, I-Sec research FY09 3,843 1,475 2.1 0.8 61.2 FY10 5,113 1,285 2.8 0.7 74.9 FY11 5,286 745 2.6 0.4 85.5 FY12 6,989 992 2.9 0.4 85.8
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FY13E 9,491 1,309 2.9 0.4 86.2
FY14E 16,521 4,226 4.3 1.1 74.4
FY15E 26,518 5,944 5.8 1.3 77.6
Table 4: Provisions on consolidated P&L

(Rs mn) For NPA For standard assets For credit loss on securitisation For erosion of value in investments Bad debts written off Bad debt recovery Total provisions and write offs (P&L) Source: Company data, I-Sec research FY09 1,335 0 446 8 1,344 (77) 3,057 FY10 1,458 0 797 2 1,867 (55) 4,069 FY11 715 504 1,780 (8) 2,260 (63) 5,187 FY12 1,455 93 1,881 18 4,311 (61) 7,696 FY13E 2,186 221 2,493 20 5,237 (1,191) 8,966 FY14E 4,112 142 2,658 20 6,147 (109) 12,971 FY15E 8,280 183 2,742 20 7,315 (1,417) 17,123
Table 5: Provisions on consolidated balance sheet

(Rs mn) For non-performing assets % of on-book loans For standard assets For credit loss on securitisation % of off-book loans Others Total provisions Source: Company data, I-Sec research FY09 2,368 1.3 0 894 1.7 1,065 4,327 FY10 3,826 2.1 0 2,499 2.2 2,133 8,458 FY11 4,541 2.3 504 5,201 3.2 1,710 11,956 FY12 5,996 2.5 597 7,275 4.0 1,779 15,646 FY13E 8,182 2.5 818 9,147 5.0 2,290 20,437 FY14E 12,294 3.2 960 10,982 5.0 2,533 26,770 FY15E 20,574 4.5 1,143 12,847 5.0 2,878 37,443
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NPA stress test results provide comfort

We have also tried to examine the case where the new norms are implemented overnight in Q1FY14. In this case, we assume NPA levels immediately double to 5.8% and provisioning coverage of 77.6% is still maintained (provisioning being 0.7% of assets), which will lead to a large profitability knock in Q1FY14. This will shave off 17.3% from FY14 EPS and reduce RoE from 20.9% to 17.6%. However, the impact on FY15 EPS is only 5.1%. We underscore here that this stress test is a combination of two unlikely outcomes immediate implementation of 90 day norm and coverage ratio being maintained at 77.6%. Also, FY15 numbers may look much better as credit costs may fall on account of higher write-backs if the underlying asset quality does not change. Chart 8: NPA progression base and stress case
GNPAs - base case 7.0 6.0 5.0 (%) 4.0 3.0 3.0 3.0 2.0 1.0 Mar-13 Mar-14 Dec-13 Dec-12 Sep-13 Dec-14 Sep-14 Mar-15 Jun-13 Jun-14 2.9 2.8 2.9 3.3 3.3 4.3 4.3 4.3 5.8 5.8 5.8 5.8 5.8 5.8 5.8 5.8 5.8 5.8 GNPAs - stress case
Source: I-Sec research
Table 6: Stress test result summary

FY14E Base case phased implementation GNPA (Rs.mn) NNPA (Rs.mn) GNPA (%) NNPA (%) Provision coverage EPS (Rs) ABV (Rs) RoE (%) Stress case one shot implementation GNPA (Rs mn) NNPA (Rs mn) GNPA (%) NNPA (%) Provision coverage EPS (Rs) ABV (Rs) RoE (%) Impact on key parameters GNPA (bps) EPS (%) ABV (%) RoE (bps) Source: I-Sec research 16,521 4,226 4.3 1.1 74.4 74 384 20.9 22,284 4,995 5.8 1.3 77.6 61.0 372 17.6 (150) (17.3) (3.3) (328) FY15E 26,518 5,944 5.8 1.3 77.6 85 457 20.2 26,518 5,944 5.8 1.3 77.6 80.7 439 19.9 (5.1) (3.7) (33)
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Credit loss sensitivity to macro-economic environment

STFCs actual credit losses and underlying credit quality are closely tied to the fortunes of the end-user of the loan the trucker. Our research shows us that freight volumes rather than freight rates are of critical import to a truckers economics. Freight rates have proven to be fairly sticky over the long term while freight volumes, which determine fleet utilisation, change sharply based on the quantum of economic and industrial activity. This puts pressure on truckers income and generally impact the asset quality. Chart 9: Freight index relatively sticky on downside & maintained upward trend
200 180 (Freight index - TCI) 160 140 120 100 80 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 Q2 56 54 52 50 48 1.5 46 1.0 0.5 0.0 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 YTD13E 44 42 40 (%) 2.0
FY11
FY12
FY13
Chart 10: Drop in freight utilisation leads to increase in NPA

3.5 3.0 2.5 (%) GNPAs Freight utilisation (RHS)
STFCs loan end user truckers can be divided into five broad categories industrial goods, container traffic (export and import), mining and infrastructure, agriculture and daily consumable essentials. Out of these five categories, given the vintage of STFCs portfolio, the first three types of activities requiring large tonnage newer vehicles that ply on national highways form a small part of the companys portfolio, which slightly insulates it from a slowdown in heavy industries. However, such a slowdown will
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surely have a lagged impact on the broader economy, thereby affecting other two categories as well. Chart 11: Lagged impact of industrial activity (IIP) on NPA levels
4.0 3.0 2.0 (%) 1.0 0.0 -1.0 -2.0 FY07 FY08 FY09 FY10 FY11 FY12 YTD13E GNPAs IIP (RHS) 20 15 10 5 0 (5) (10) (%)
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Unique competitive advantage protects pricing power, growth opportunities remain healthy
The unique customer niche on which STFC focuses on is single truck owners (STO). The STO is basically a micro-entrepreneur investing in an asset for the first time after working as a driver for a few years. The usual source of organised financing, the bank, is closed to such a person, as he does not have any collateral to offer, has no bank account of his own ruling out any post dated cheque (PDC) based collection methodology and has no income antecedent like income tax filing. Typically, such a person would have saved up about Rs300,000 over a period of five years. His aspired-for vehicle will be a five-year old nine tonne truck, which would command a value of around Rs700,000. With no organised financing available to bridge this gap of Rs400,000, the only option available to him is the local moneylender. The money lender will extend finance to a trucker at an absurdly high interest rate of 36-40% annually. In such a situation, it is not difficult to realise why STFCs loan products targeted at financing resale of used vehicles has proven so popular (as illustrated by the IRR analysis of a typical STFCS borrower). The following example brings out the lucrativeness of the deal for a STFC borrower. Table 4: Loan details of a typical STFC customer
Truck value - 5 yr old (Rs) Loan (Rs) Tenure (months) 500,000 300,000 36 Truck value - 8 yr old (Rs)* Own equity (Rs) Interest rate (% p.a.) EMI (Rs) 360,028 200,000 20 11,149 Note: truck driver becomes the owner of a 8 year old truck at the end
Source: I-Sec research *as per depreciation schedule in chart 16
Table 5: IRR of a trucker taking the aforementioned loan

Month 0 1 2 . . . 36 Salvage value IRR (annualised) Source: I-Sec research Inflow (Rs) 24,000 24,000 . . . 24,000 360,028 Outflow (Rs) 200,000 11,149 11,149 . . . 11,149 Net cashflow (Rs) (200,000) 12,851 12,851 . . . 12,851 360,028 123%
STFCs focus as a group has always been on such credit-starved niches that let its unique competitive advantages come into full force. The company felt that the actual credit quality driven by the economics of the trucker segment once the unique collection and asset valuation challenges in the segment was addressed was actually far better than the perception within the large financial institutions. STFCs exemplary success since its inception in 1979 is a vindication of this basic conviction, perhaps best illustrated through its long-term NPA track record. The key to such a delinquency track record has been its close-to-the-customer business model that introduced unique changes to both the organisational set-up and daily business processes. The business model is so execution intensive and presents such a steep learning curve that the difficulty of replicating the only proven model in this niche becomes a very high entry barrier.
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The company divides its country operations into six regions. The next level of reporting is strategic business units (SBUs), each of which has specific number of the total 513 branches allocated to them. The branches are the basic operating units of the business. The number of field officers per branch is about 12-15. Apart from them, it also has a branch manager and a support staff. Chart 12: Process flow Loan life cycle
Top Management
NPA
SBU Manager
LTV
Pricing
Branch Manager
Appraisal
Fixing loan tenure
Disbursal
Lead generation through referrals
Asset Inspection & valuation
Field officers are key to the business model
The field officers are the foot soldiers who have conquered this profitable niche for STFC. They are the one who are in regular direct contact with the customers and the bulwark of this close-to-the-customer business model. Their skill is the key competitive strength of the company and includes asset (vehicle) valuation, which is key to determination of true marketable value of collateral, generation of sales leads for future origination by utilising their elaborate social networking in the customer group, collection management (mostly in cash) and if needed repossession as well. The assessment of credit worthiness of any application rests with the branch manager as do the responsibility of having proper documentation in place and also of doing due diligence at the Regional Transport Office. The final power of approval for both fresh loans and top-ups lies with SBU heads. A quick glance at the business model of the company reveals that it has quite a few unique features the disbursement, lead generation and collection responsibilities lie with the same person, which rules out any conflict of interest or moral hazard; new customer recruitment relies heavily on referrals, which brings with it an attendant benefit of social peer pressure in case of adverse borrower behavior; focus on an underfinanced asset class (5-12 year old vehicles) and an under banked or unbanked customer group; and finally, field officers relationship with borrowers including collections at customers doorstep or at important nodal points of freight trade.
Hard to replicate model is key competitive advantage
It becomes very obvious on close study that the key competitive advantage of this company is its operating model, and maintaining the fidelity of the same is critical to its competitive position.
Field office
Due diligence with RTO
Collection (including cash)
Repossess in case of default
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The operational group is like an army within itself. There is almost no lateral hiring in operational roles with field officers being the only recruitment level. Both the current and earlier managing directors of the company had started off as field officers and rose to the top. The company routinely moves out the non-performers in this group by either dismissing them or moving them to non-operational activities. Management has ears close to the ground Being from an operational background, the umbilical cord is never really severed for the top management, as every case of a defaulted loan is continuously escalated, coming finally to the managing directors purview at a certain point in time. The company understands the criticality of retaining this field force that is both its operating arm as well as its store of domain knowledge, and human resource (HR) policies are designed to minimise undesirable attrition. Attrition numbers in this group is low as 1% overall. Apart from the obvious aspiration factor of moving onto a senior management role someday with educational background that renders such aspiration unlikely elsewhere, the company has an aggressively designed compensation policy that rewards performance. As much as 50% of the total take home pay of field officers is variable. The company also runs an Employee Stock Option Plan (ESOP) scheme that has already created substantial wealth for a large group of employees. It is this operational base with an experience and learning of about 33 years in the domain (since 1979) and its unique policies and systems that are the companys greatest competitive advantage. This allows it to manage a supposedly ruinous financing activity at long term credit losses of less than 2% in spite of having grown its portfolio size from virtually nothing to Rs440bn. Entry barriers remain high The company runs a business which has two thirds of its collections in cash going on in a continuous basis to diverse geographies with a minimal leakage. This model has proved extremely difficult to replicate and has emerged as an example of a naturally high entry barrier in the asset financing business. All manners of financial institutions and banks, inspired by STFCs success, have tried to get into the business, but have failed to make any serious dent in the space. The examination of STFCs competitive franchise in a Porters five forces framework brings out its strengths.
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Shriram Transport Finance, November 27, 2012 Chart 13: Porters five forces analysis
Threat of entrants is low (Operating model difficult to replicate)
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Suppliers Power is medium (Dependence on wholesale funding)
Low competition (lack of organised player of consequence)
Customer power is low (Best possible opinion despite high rates)
Threat of substitutes is low (100% equity opinion or gold loan not affordable to trucker)
Mitigation factors PSL classification driving securitization demand AA rating and credit check record NCD NW 25% of book
Suppliers bargaining power is medium: The only force in the framework that is not much of an area of strength for STFC is the sources of fund side of the business. We have dealt in detail with this issue in the third section of the report but suffice to say that being primarily wholesale-funded, availability of funds for STFC will always be vulnerable to liquidity squeeze. However, there are multiple mitigating factors which put STFC on a stable footing in this scenario. As a dedicated commercial vehicle financier, all its assets have priority sector classification. This coupled with the excellent credit quality behavior that its originated pools have exhibited over the long term has fuelled heavy demand for securitised assets at pretty attractive spreads for the company. As we demonstrate later that although new regulations may increase securitisation costs over the next four years, the route will remain an attractive financing option. The company is rated AA by Fitch and has now a long credit history, making it a preferred borrower to most banks. Retail NCDs are now almost 25% of the companys on-book liabilities, reducing its institutional dependence.
Customers bargaining power is low: For its unbanked customer niche, even STFCs high rate of interest of 18-22% presents itself as an extremely attractive proposition (generating IRR of 123% annualised over the three year loan tenor). The companys only alternative remains the unorganised money lender who charges an interest rate of 36-40%. The biggest proof of the low bargaining power of customers is the stickiness of yields at such high levels for a long period of time. Threat of new entrants is low: The lure of a 20% yield has over the years attracted financial companies across the spectrum to this segment, but none of them has made any serious dent into STFCs market share. The key to this we feel is the difficulty in replicating STFCs operating model (the only proven one in the segment).
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Threat of substitutes: The only product substitute for STFCs loan in its customer segment is 100% equity or a gold loan, which will rule out first-time buyers on account of inadequate resources. In summary, the companys competitive position is exceptionally strong and the only chink in the armor is dependence on institutional financing.
Market dominance in used CV is absolute and protects yields

Near monopoly in used CV financing The company with an old CV AUM of about Rs346bn in Q2FY13 has penetrated about 43% of the total current opportunity size of Rs801bn. The only other players of some consequence is IndusInd Bank with an old CV book of Rs0.9bn (the bank has acquired Ashok Leyland Finance), M&M Financial Services (total old vehicle financing book of Rs1.5bn, no separate data available for CVs) and Sundaram Finance (more focused on new vehicle financing for large fleet operators). The company has continued financing old vehicles at between 18-24%, through cycles, for as long as we could go back in history. This is principally because there is no need to fight for market share. We expect the basic yield levels to remain firm and under control of the company barring regulatory intervention.
Used CV financing opportunity is Rs801bn growing at an estimated 15.6% over next 5 years
Change in tonnage profile of Medium and Heavy Commercial Vehicles (M&HCVs) over FY04-12 coupled with robust growth in Light Commercial Vehicles (LCVs) over FY09-12 will result in a large financing opportunity for used vehicles over FY14-18. We feel that inflation of resale values will also have a crucial role to play. Chart 14: Strong growth in MHCVs and LCVs over FY09-12
500 450 400 (% of total) 26% CAGR 299 316 275 202 149 253 174
20 0 11.6 FY04 18.0 FY06 17.6 FY08 21.6 FY10 22.4 FY12 (% of total) 100
Chart 15:coupled with steady shift towards higher tonnage vehicles within MHCV
120 >7.5T & <12T 0.2 2.3 <16.2T 6.3 >16.2T & <35T 4.8 >35T 5.9
FY09
FY10
FY11
FY12
350 300 250 200 150 100 50 0
33% CAGR
410
80 60 40
43.2
45.8
50.1
49.5
51.4
45.1
34.0
26.0
24.1
20.4
MHCVs
Source: SIAM, I-Sec research
LCVs
In order to determine the size of opportunity in used vehicle financing, we first figure out the number of 5-12 year old vehicles in India and how the number will change over the next five years, which is accurately determinable given the historical data on
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new Commercial Vehicle (CV) sales that is available. The following table provides the size and composition of the 5-12 year pool over the next five years. Table 7: 5-12 year pool for next 5 years total vehicles
Number of vehicles FY14E MHCVs >7.5T & <12T <16.2T >16.2T & <25T >25T >16.2T - Haulage Tractor (Tractor-Semi Trailer/Trailer) >16T <26.4T >26T & <35T >35.2T LCVs <3.5T >3.5T & <5T >5T & <7.5T MHCV total LCV total Total CV Source: SIAM, I-Sec research 170,191 397,602 295,126 184,931 1,471 51,538 36,034 502,750 8,618 247,171 1,136,893 758,539 1,895,432 FY15E 189,926 404,580 349,091 174,555 267 52,632 41,283 635,636 10,667 242,817 1,212,334 889,120 2,101,454 FY16E 222,463 407,901 413,283 165,816 10 58,274 50,977 825,570 16,960 242,219 1,318,724 1,084,749 2,403,473 FY17E 261,968 407,731 479,201 177,929 4 63,378 66,944 1,057,413 26,658 236,956 1,457,155 1,321,027 2,778,182 FY18E 303,016 399,350 535,494 198,943 0 62,787 83,987 1,362,233 63,740 205,120 1,583,577 1,631,093 3,214,670
As of date, prices of new CVs in each category are as follows and the resale values time schedule of LCVs and MHCVs are given in the charts. Table 8: New CV prices
MHCVs (per unit) >7.5T & <12T <16.2T >16.2T & <25T >25T >16.2T - Haulage Tractor (Tractor-Semi Trailer/Trailer) >16T <26.4T >26T & <35T >35.2T LCVs (per unit) <3.5T >3.5T & <5T >5T & <7.5T Source: SIAM, I-Sec research (Rs mn) 0.80 1.30 2.00 2.50 3.00 3.50 4.00 0.30 0.40 0.55
Chart 16: Residual value schedule MHCVs

120 100 (% of original value) 80 60 40 20 0 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 100
Chart 17: Residual value schedule LCVs

120 100 (% of original value) 100 85 80 60 40 20 0 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 75 67 58 50 44
85 75 67 58 50 45 40 36 32
38
28
24
32
20
26
20 15
10
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Assuming the representative vehicle of the 5-12 year old pool is an eight-year old vehicle and that the above depreciation schedule holds true, we arrive at the following average prices for the current members of the pool in each category. Table 9: Current 8 year old vehicle price
FY13 MHCVs: Goods Carriers (Rs mn /unit) >7.5T & <12T <16.2T >16.2T & <25T >25T >16.2T - Haulage Tractor (Tractor-Semi Trailer/Trailer) >16T <26.4T >26T & <35T >35.2T LCVs: Goods Carriers (Rs mn /unit) <3.5T >3.5T & <5T >5T & <7.5T Source: SIAM, I-Sec research 0.29 0.47 0.72 0.90 1.08 1.26 1.44 0.11 0.14 0.20
For FY01, new CV sales data is not available at this granularity and new CV sales are just broadly broken up into LCVs and M&HCVs. This means that for the current FY13 pool of 5-12 year old vehicle, the pool can only be divided into MHCVs and LCVs. We assume as usual that the representative age of the pool is eight years. This lets us arrive at the current market size by assuming average new M&HCV prices to be Rs2mn and that for LCV counterparts at Rs0.45mn and applying their respective economic schedules to find prices of eight-year old vehicles. Table 10: Market sizing for FY13E
No of MHCV (5-12 year old) No of LCV (5-12 year old) Average price assumption (8 yr old MHCV) - Rs mn Average price assumption (8 yr old LCV) - Rs mn 5-12 yr old MHCV market size (Rs mn) 5-12 yr old LCV market size (Rs mn) Total market size (Rs mn) Source: I-Sec research 986,534 625,053 0.72 0.14 710,502 90,036 800,538
We are however in a position to estimate the market size over the next five years specifically for each category by assuming an annual inflation of 6% in prices of eightyear old vehicles. Table 11: 5-12 year old CV financing opportunity category-wise
(Rs mn) MHCVs >7.5T & <12T <16.2T >16.2T & <25T >25T >16.2T - Haulage Tractor (TractorSemi Trailer/Trailer) >16T <26.4T >26T & <35T >35.2T LCVs <3.5T >3.5T & <5T >5T & <7.5T MHCV total LCV total Total CV Source: I-Sec research FY14E 51,970 197,297 225,303 176,473 FY15E 61,477 212,805 282,490 176,566 FY16E 76,329 227,425 354,502 177,790 FY17E 95,276 240,970 435,707 202,224 FY18E 116,818 250,178 516,104 239,674
1,684 68,853 55,018 57,571 1,316 51,891 776,599 110,777 887,376
324 74,534 66,814 77,155 1,726 54,035 875,010 132,917 1,007,926
13 87,475 87,453 106,222 2,910 57,136 1,010,987 166,268 1,177,255
5 100,845 121,736 144,216 4,848 59,248 1,196,764 208,312 1,405,075
0 105,899 161,892 196,936 12,286 54,365 1,390,564 263,588 1,654,152
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Table 12: 5-12 year old CV financing opportunity shows 15.6% CAGR in FY13-18
(Rs bn) Market size MHCV total LCV total Total CV Source: I-Sec research FY13E 710.5 90.0 800.5 FY14E 776.6 110.8 887.4 FY15E 875.0 132.9 1,007.9 FY16E 1,011.0 166.3 1,177.3 FY17E 1,196.8 208.3 1,405.1 FY18E 1,390.6 263.6 1,654.2 5 yr CAGR (%) 14.4 24.0 15.6
Chart 18:Addressable market opportunity growing at 15.6% CAGR over next 5 years
1,900 1,700
Chart 19: LCV opportunity growing fastest given strong new vehicle sales in recent years
40 35 (% CAGR FY14E-18E) 36.0
1,500
(Rs bn)
Overall value CAGR - 15.6% 208 166 133 90 711 111 777 875 1,011
264
30 25 20 15 10 5 0 MHCV (overall) 16.2-25T LCV (overall) <16.2T <3.5T 7.5-12T 5-7.5T

>12yrs
1,300 1,100 900 700 500 300
22.4
23.0 15.7 8.0 1.2 >25T
24.2
1,391 1,197
6.1
FY13E FY14E FY15E FY16E FY17E FY18E

We see that the overall market opportunity is growing at an annual pace of 15.6% to reach a size of Rs1.65tn from Rs801bn currently. However, around 10% of CV purchases in India is made by government agencies and do not enter the financing pool. It is prudent to take a haircut of 10% to the market opportunity estimate to reflect this phenomenon. Obviously, this does not impact the growth rate of the market.
Life cycle of a CV offers multiple financing opportunities

A typical nine tonne CV generally changes ownership four times in its life cycle. It starts of on the long haul national highways, moves down to interstate by the fifth year, further on to less than 300km intercity routes and finally goes on to local uses like garbage trucks after 13-14 years. These changes of ownership creates multiple financing options for financiers. Chart 20: Financing opportunities over life cycle of a typical 9 tonne truck
0-5yrs Long haul national highway 5-9yrs 9-12yrs Less than 300km intercity transport
Interstate transport
Local transportation
Shriram Transports expertise
Moderate competition
Low competition
No competition
Finance not available
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Internal capacity for growth remains robust

The field officers are crucial for the companys growth, as they remain the only conduit for both disbursement and subsequent collection. Two points are worth noting in the following charts one, after a fall in the later quarters of FY12 (mostly on account of reassignments), the strength of field officers picked up significantly in the last quarter., although the AUM and disbursement per field officer is much higher and have grown at a quarterly CAGR of 3-4% from FY10, at least half of the growth has come from asset inflation. The company has added almost 35,000 new customers in the past eight months by opening rural offices, which in some cases are one man offices. Rural ticket sizes are generally about 65-70% of urban ticket size. We feel that the company is building capacity to ramp up growth (as evidenced in the field officer recruitment spurt in this quarter) once it has gained confidence in the macroeconomic situation. Chart 21: Spike in field officers point to strong impending growth
10,500 10,000 9,500 9,000 (Nos) 8,500 8,000 7,500 7,000 6,500 6,000 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12
9,830 9,439 9,001 8,412 7,715 9,339 8,716 8,155 8,212
7,546
Chart 22: Steady increase in business handled by field officers

AUM per field officer 60 Disbursement per field officer (RHS) 9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 Jun-12 Sep-12
50 CAGR - 3.6% (Rs mn) 40
30
CAGR - 4.3%
20 Mar-11 Dec-10 Sep-10 Dec-11 Sep-11 Mar-12 Jun-10 Jun-11
22
(Rs mn)
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We assume a quarterly sequential growth run rate of 4% in CV AUM

We feel CV AUM could grow by about 5% QoQ in Q3FY13, followed by a sequential growth run-rate of 4% till end FY15. A 4% QoQ growth generally means an annual growth of around 17% in CV AUM. This is very close to our estimate for market opportunity growth and will not require much market share gain. We feel there could be some upside to these numbers if the macroeconomic condition improves. Chart 23: CV AUM ramp-up
700 600 500 400 CAGR-20% 300 70 200 100 0 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15
New CVs Old CVs
CAGR-18% 145 124 106 91 88 514 273 310 375 439 59 57 138 174 222
Chart 24: 16% CV disbursement CAGR implied given loan repayment patterns
90 80 70 60 (Rs bn) 50 40 30 20 10 0 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 26 24 12 4 31 8 45 40 45 52 61 17 10 13 15 Old CVs New CVs
CAGR-1 6%
(Rs.bn)
17
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Chart 25: Old / new CV mix expected to remain stable over FY13-15E
Old CVs 100 90 29 80 (%) 70 60 71 50 40 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 75 76 76 77 78 78 78 24 24 23 22 22 22 New CVs
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Construction equipment finance is an exciting new growth opportunity

Driven by the opportunities created by massive infrastructure investments over FY0512, a host of STFC's existing customers, mainly small fleet operators, diversified into the construction equipment (CE) space. Sensing long-term growth potential coupled with huge operational synergy in this segment, STFC had been financing construction equipment of small ticket size (like tippers and dumpers) for quite a few years but it created a separate subsidiary to look at this business in FY10. Shriram Construction Equipment Finance currently has an AUM of Rs23.8bn and is clocking a quarterly sequential growth rate in excess of 11%. New business in line with core competencies The analysis of STFCs core competencies related to lending business brings out the following: There is a clear focus on financing cashflow generating assets. This is one of the reasons for the companys reticence to finance tractors. Construction equipment generates lease rentals and operating fees and fit into this framework. The company focuses on end user financing rather than dealer financing, which is another reason why it does not venture seriously into tractors. CE finance is end user based and hence fits the bill perfectly. The company always lends to livelihood linked assets, where the assets cash flow is the source of sustenance for the borrower. Even in CE finance, especially the segment within construction equipment that the company intends to focus on characterised by small ticket sizes and financing of used equipment, the asset is the mainstay income source of the borrower. The company generally generates new sales leads through referrals from existing customers. In a closely knit community, this is tantamount to an implicit guarantee. The entrenched relationships that the field officers have within the community ensure that moral hazard remains a high social cost option for the borrower.
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The company always tries to operate in credit starved under-banked niches, which allow it earn a handsome yield and build specialised capabilities rather than be a me-too player in a competitive space where its cost of funds puts it at a natural disadvantage against banks. Construction equipment finance qualifies on this front.
Business has some key differences from CV financing
Unlike the used CV demand, business cycles have more pronounced effect on the CE demand. Despite the current slowdown, long-term demand for new and used CEs is expected to remain robust given the proposed infrastructure investment over 2012-17. While some large construction and infrastructure companies remain under a cloud of stress, the level of on-the-ground activity still remains healthy at semi-urban and rural locations. STFC chooses to focus on single unit owners who provide the subcontractors with their equipment against cash advances, and thus remain largely insulated from any ballooning of receivables. The capital intensive nature of CE business makes financing an essential part with about 85% of industry purchases being financed. The used CE financing market is completely unorganised. Also, generally, the ticket sizes are larger in the CE finance business. With domain specific management bandwidth created within the organisation, we feel STFC is in a great position to penetrate yet another credit starved niche. We feel the business will clock a QoQ growth rate of 10% for another four quarters and then 8% QoQ till the end of FY15. Given this growth rate, we have assumed equity infusion from the parent in two tranches of Rs1bn each over the next three years. We also feel that the mix of AUM will increasingly shift towards used equipment, thereby pushing up yields, though we have not built in the same. Chart 26: CE AUM to post a robust growth over FY13-15E
70 60 50 41 CAGR - 37% 55
(Rs bn)
40 30 20 10 0 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 6 19 29
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Automalls testimony to STFCs dominance of the asset class

Automalls are a fee income opportunity The automall concept is a descendant of the Truck Bazaar event that the company has been organising for long. The idea in this event was initially to organise a meeting point for buyers and sellers of used CVs including those repossessed by the company. This is a source of fee income for the company and an opportunity for both fresh financing as well as a means to gain control of a large multitude of transactions in its preferred asset class. Automalls have taken this concept forward by providing a periodic opportunity for such transactions and by acting as a de-facto monopoly exchange for vehicle transactions in the malls catchment area. Vehicles are auctioned on a regular basis in the central hall and the inaugural auction at its first Chennai Automall sold 120 vehicles. The concept has proved so successful that even other financing companies are trading their repossessed commercial vehicles through these malls in lieu of payment of a fee. STFC has already set up 10 automalls (including five mini automalls) and plans to increase them to 20 by the end of FY13. The company is currently clocking about 12,000 transactions per month through its automalls. An extension of this idea is Shriram One Stop, which is an electronic kiosk system that provides a touch screen platform at select branches where a potential buyer could inspect the available inventory by getting all details on the individual vehicles including their pictures from eight angles. By the end of Q2FY13 this has already been launched at around 460 branches. The company expects this business to generate Rs800mn in revenues in FY13 with Rs80-100mn contribution to PAT.
Multiple growth avenues remain open given captive customer base

STFC has a customer base of more than 800,000 as of date. Most of these customers have a monthly disposable income of Rs12,000 (net of EMIs). Building in the fact that this segment is virtually unbanked, STFCs franchise basically holds the solitary key to access Rs9.6bn of monthly purchasing power. This provides an opportunity for multiple business models to be layered on the basic operating architecture in future years. The key businesses where the company can make serious forays are freight bill discounting (STFC has a 40:60 joint venture with Ashok Leyland called Ashley Transport for this activity, addressable market size estimated at Rs60-70bn annually), credit card distribution and insurance distribution.
Unique access to Rs9.6bn of monthly purchasing power
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Liability strategy crucial to margins and business stability

When STFC started operating it had no access to institutional funding and relied heavily on retail deposits (strengths developed in chit fund business). Even in 1999 bank funds constituted a tiny fraction of its total liability book. The advent of Citicorp in 2000 and Axis Bank (UTI Bank then), to whom STFC offered portfolio management services, went a long way to change STFCs credit perception in institutional finance circles. Subsequently, its long-term credit track record and behavior of securitised pools made it fairly attractive borrowers for banks and financial institutions.
Diversifying the liability mix

History has however come full circle for STFC, as with increasing institutional profile the company has started to reduce dependence on wholesale funding with approximately a quarter of its liabilities now coming from NCDs which it has issued. Although this route is costlier for the company by about 100bps than the bank borrowings, the company is willing to bear the cost in order to build strategic strengths in the retail NCD market. Table 13: Details of retail NCDs
(Rs bn) Jun-09 10 May-10 5 Jun-11 10 Jul-12 6 Source: Company data, I-Sec research Coupon range 10.75%-11.25% 9%-10.5% 11.0%-11.6% 10.25%-11.4% Maturity range 3yrs-5yrs 3yrs-7yrs 3yrs-5yrs 3yrs-5yrs
Chart 27: Evolving liability profile reducing reliance on banks

Banks 100% 5.6 90% 6.7 80% 70% 60% 50% 59.8 40% 30% FY08 FY09 FY10 FY11 FY12 59.8 59.2 52.9 43.8 21.4 24.1 26.3 23.6 35.7 7.7 11.2 16.3 14.1 NCDs Sub-ordinate debt Fixed deposits Others 5.0
27
Shriram Transport Finance, November 27, 2012 Chart 28: Borrowing profile large proportion of unsecured borrowing
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Chart 29: Diversified liability mix March 2012
Un-secured, 22.4
Sub debt, 14.1 Fixed deposits, 5.0
Redeemable NCD, 35.7
Cash credit, 13.3 Loans from corporates, 1.4
Secured, 77.6
Bank borrow ings, 30.5
The companys debt schedule details reveal that about 37.2% of debt will expire in a year. The average duration of its liabilities is about three years which is closely matched with its asset duration. This low to almost no ALM mismatch gives us confidence that the company is unlikely to face any payments issue. Chart 30: Staggered maturity across instruments March 2012
< 12 Months 12-36 Months 36-60 Months Over 60 months
Chart 31: About a third of liabilities mature in a year March 2012
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
7.4 29.5
15.6 48.0
Maturity < 1 year, 37.2
26.5
61.3 18.1
Matrutiy > 1 year, 62.8

36.6 22.0 33.9 Sub-debt NCDs Banks
STFC will be a beneficiary of softer interest rates

Most of STFCs bank borrowings are floating rate in nature. The principal fixed rate component of liabilities is NCDs. In summation, about 70% of the companys liabilities are floating rate in nature while all loan assets are fixed rate in nature, making the company a beneficiary of any cut in headline rates. It should also be noted that because of the companys dominance in the used CV market, its yields on assets will remain firm even for incremental lending but yields will soften in the new CV financing business (23% of AUM). However, banks are not immediate in passing on the benefit to borrowers and any improvement in borrowing costs of STFC will be gradual. We
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expect that a 100bps rate cut will probably translate into a 50bps borrowing cost advantage for the company. We have not built in much improvement in the companys borrowing costs. Chart 32: Declining interest rates to aid borrowing costs
13 13 12 12 11.3 11.0 11.7 11.9 11.4 11.4 11.5 10.9
(%)
11 11 10 10 9 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14
Mar-15
Source: Company data, I-Sec Research
Credit ratings are healthy

Credit ratings are quite good for STFC and the company remains optimistic of an upgrade if the macroeconomic conditions improve. Table 33: Credit ratings table
NCDs Fixed Deposit Subordinated debt Long term bank loan Short term bank loan Source: Company data Fitch AA AA AA CARE AA+ AA+ CRISIL AA fAA+ AA AA A1+ ICRA MAA+ -
Securitisation remains a key enabler of liability strategy and a profit enhancer

STFC heavily uses securitisation (both pass through certificates (PTC) and bilateral assignments) to move assets off balance sheet. At present, little more than a third of its balance sheet is off books. The economics of these transactions has been very lucrative till now with securitisation NIM touching 12% (without considering cash deposits as credit enhancement / margin money). To understand why banks have been queuing up for these assets at effective yields of 7-9%, it is important to look at the regulatory framework governing banks in India. Banks in India have to allocate 40% of their Adjusted Net Bank Credit (ANBC) to specific sectors which are of high social relevance in India. Banks often have had challenging credit experiences in these sectors due to various constraints. The only assets that are safe are bonds issued by a few developmental authorities, but they offer poor yields.
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Overall priority lending 40.0 37.2 851 39.4 44
Table 14: Shortfall in priority lending by banks securitisation opportunity

% of ANBC Target Public sector banks Shortfall (Rs.bn) Private sector banks Shortfall (Rs.bn) Source: RBI
All loan assets of STFC qualify under priority sector norms. Given the long-term credit track record of its off balance sheet pools (1.6% loss), even a yield of 7% is a good deal for banks in relative terms, as just the credit enhancement provided by STFC on those pools is 5-10% and easily cover first loss. Banks struggle to fulfill their asset quotas and desperation generally reaches its highest levels near the closure of the financial year, the time when STFC does most of its securitisation deals. The two major structures that are used for these securitisation deals are PTCs and bilateral assignments. Here, we are loosely using the term securitisation, as a bilateral assignment is a loan sell down and technically not a securitisation transaction. The basic structures of these two transactions are depicted in the following exhibits. Chart 34: A typical securitisation structure (PTC route)
STFC borrower Interest of principal Sale of loans STFC Consideration for loans
STFC & other banks Credit enhancement, Liquidity support, 3rd party guarantee Serving of security Special purpose Issue of security vehicle (SPV) Banks
Original loan
Rating agency
30
Shriram Transport Finance, November 27, 2012 Chart 35: Illustration of direct assignment route
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STFC borrower Interest of principal Sale of loans STFC Consideration for loans
STFC & other banks Credit enhancement, Liquidity support, 3rd party guarantee
Original loan
Bank
The key differences between the structure of PTC and bilateral assignment are as follows: There is no SPV with a true sale based ownership of all assets for pooling of all collections that issues the securities to the investors (banks in this case) and routes the cash flow to them (banks). In bilateral assignment, the whole pool goes to one buyer while in a PTC, since securities are issued, there could be multiple investors with pari passu claims.
Chart 36: Break-up of annual amount securitised by STFC

100 90 80 70 60 50 40 30 20 10 0
Securitization (PTCs) Direct assignments
(Rs bn)
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
The companys accounting policies on securitisation are conservative and create an assured future revenue stream from deferring revenues even where cash flow has actualised upfront. Gains arising on securitisation / direct assignment of assets are recognised over the tenure of securities issued by SPV / agreements as per guideline on securitisation of standard assets issued by the RBI, loss, if any is recognised upfront. (Note that securitisation deferred consideration receivable comprises of
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STFCs share of future interest strip receivables in case of a par structure securitised / assigned deals.) Expenditure in respect of securitisation / direct assignment (except bank guarantee fees for credit enhancement) is recognised upfront. Bank guarantee fees for credit enhancement are amortised over the tenure of the agreements.
Chart 37: Securitisation NIM is assumed to fall

15.0 14.0 13.0 12.0 12.3 11.8 11.5 11.5 11.0 10.5 10.0 9.5 9.5 9.0 Credit enhancement on direct assignment not allow ed
(%)
11.0 10.0 9.0 8.0 7.0 6.0
9.0 8.5
Mar-13
Mar-14
Dec-12
Dec-13
Chart 38: On book/ off book mix annual with projections

120 100 23 80 23 38 45 45 38 39 39 On-book AUM Off-book AUM
(%)
60 40 20 0 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 77 77 62 55 55 62 61 61
32
Sep-12
Sep-13
Dec-14
Sep-14
Mar-15
Jun-12
Jun-13
Jun-14
Shriram Transport Finance, November 27, 2012 Chart 39: Annual securitisation to remain robust
160 140 120 102 88 83 79 131
ICICI Securities
149
(Rs bn)
100 80 60 40 20 0
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
Mar-15
Multiple regulatory developments may reduce profitability of this route to some extent
In a bid to curb the regulatory arbitrage enjoyed by the NBFCs in the form of unlimited access to low-cost funding from banks in return for originating and selling priority sector loans, the regulator came out with a slew of regulations over the past eighteen months. Multiple committees were set up to deal with securitisation and the regulator issued specific guidelines for securitisation on minimum holding period, minimum retention ratio and spread cap. Some other regulations that have been proposed but not accepted include cap on off-book loans (MN Nair Committee). Table 15: Regulatory developments and their impact
Minimum holding period Old norm No such holding period prescribed New norm 6 months of holding period (STFC's loans are have monthly repayment and duration of 3 years) 10% of loan pool securitised No credit enhancements allowed on direct assignment. No such rule for PTC route. End-user interest rate cap on individual assets in the pool: base rate + 800bps Impact Minimum impact - large loan book to ensure adequate availability of loans that fulfill MHP criterion. ~65% of STFCs loans will generally qualify given asset duration profile. Minimal impact Direct assignments: margins will decline sharply given the absence of credit enhancements Securitisation (PTC): volumes will increase as this becomes the preferred route over direct assignments Large proportion of new CV loans would be securitised.
Minimum retention rate Credit enhancements
No such retention requirement Used to provide enhancements with no capital charge
Interest rate cap on No end user securitisation and interest rate cap direct assignment (eligibility as priority sector) Source: RBI, I-Sec research
The upshot is that the only regulatory change that impacts STFC is that its assets cannot get classified as priority sector (the driving force of securitisation demand) if their yields are more than 8% higher than the bank base rate. This, we feel, will have the following impact and we have built the same into our model.
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ICICI Securities
The NIM on securitisation will gradually move down over the next three years, as banks will charge extra for taking the credit risk on first loss in the bilateral assignment route. We have assumed securitisation NIM going down to 8.5% by March 2015 through the dual impact of higher cost of bilateral assignments and the fact that lower yield pools will be securitised. On book yields set to rise As more new vehicle loans will now get securitised, the on book portfolio will naturally have a high proportion of high yield old CV loans. This will improve on book yields. The company will change its current mix of PTCs and direct assignments from 20:80 to about 50:50 in the long term, as the fact that one cannot now provide credit enhancements on bilateral assignments has dampened activity in the segment. In bilateral assignments, our view is that the banks may look at pricing in that risk into their yield on the securitised paper, however, as no extra spread is a guarantee against actual default, risk appetite is likely to remain low in the current environment. It is crucial to understand that if we consider securitisation as a source of funds then its cost to STFC currently stands at 8-9%. Even if we assume that the bilateral assignment route will become expensive by another 100bps and also the current 80:20 mix of bilateral assignments and PTCs is maintained (highly unlikely), the net impact on securitisation costs is 80bps. Since securitisation is about a third of total AUM, the impact on blended NIMs is unlikely to be more than 30bps, all other things remaining equal.
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ICICI Securities
Healthy financials and attractive valuations

Our financial assumptions and the rationale behind them are articulated in the following table. Table 16: Assumptions and rationale
Item CV AUM growth Assumptions Sequentially 5% in the coming quarter and 4% thereafter till March 2015 Fluctuates between 35% and 38% depending on the particular quarter Maintained at 78% Starts to go up by 10bps every quarter Going down from 11.8% currently to 8.5% by March 2015 Growth of 10% QoQ for the first 4 projected quarters and 8% from there on till March 2015 17% Rationale Old CV financing opportunity expected to grow at 16% every year. Our implied 17% YoY growth looks likely without much of a shift in market penetration. Also, ramp up in number of field officers is a clear indication of acceleration. Even Nair Committees recommendations allow for 35% of loans to be off book. Also remember that the percentage assumed is just on CV loan book and does not include CE loans. Historically has not fluctuated by much from this number. In fact, we feel the number can be higher providing upside to yield estimates. As more new vehicle loans are securitised on account of the 8% spread cap on pool asset yields from base rate, in order for PSL classification The spreads go down as lower yield assets are incrementally securitised on account of the spread cap, and the increased costs of the bilateral assignment route on account of no scope for credit enhancement. Portfolio currently growing at 11.8% QoQ and with a big ramp-up in operations taking place our growth assumptions look fair barring a massive deterioration in macroeconomic outlook. Marginally below current levels. Could see upside as proportion of old CE loans increase with the company gaining more confidence in the business. Interest rate cuts expected at some stage. Numbers again could provide further upside. No efficiency gains factored in
Percentage of CV loans off book
Percentage of old CV loans in total CV loans Yield on on-book CV loans NIM on securitisation
Growth in CE AUMs
Yield on CE book
Cost of debt Non staff non-interest expenses
Employee costs
P&L provisions and write-offs
50bps improvement from FY12 to FY15 Expected to continue at the same levels as percentage of operating assets (AUM) 1.5% QoQ salary inflation and 2% QoQ manpower addition assumed Assumed to rise from 0.45% of AUM per quarter currently to 0.7% by end FY15
Employee ramp-up will continue in order to deliver the growth the company has guided for Higher provisioning on account of our assumption of maintaining 74% minimum coverage even when 90% norms come into place. The actual number could be smaller given higher proportion of expected write-backs underlying credit quality does not change.
Margin outlook is robust

We believe STFCs margins are not going to erode much, but in fact could see some upside from our projected numbers as In the CV financing business, we believe that yields will remain firm in old CV financing while there may be some drop in new CV financing rates. On a blended basis, impact on yields will be minimal. Argued earlier, STFC is a beneficiary of any cut in headline interest rates on the borrowing cost side. The impact on bilateral assignment costs on account of credit enhancement restrictions will not be more than 100 bps on the total incremental securitisation, with impact on total securitisation portfolio being even lower.
Although we have built in very slight deterioration of NIM, we believe there could be some upside to our NIM assumptions.
35
Shriram Transport Finance, November 27, 2012 Chart 40: Minimal impact on blended NIMs
On-book NIM 14 12.4 12 10 9.5 8.4 8 6 4 2 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 6.9 6.5 7.0 6.1 8.2 7.8 7.4 Off-book NIM 12.8 10.7 9.8
ICICI Securities
Blended NIM
8.6 7.5 7.6 7.1 5.8 4.7 5.6 6.3
(%)
Mar-15
Significant leverage headroom

A quick look at STFCs capital adequacy levels is enough to reveal that the company is following an extremely conservative strategy on financial leverage and there is significant scope for increasing leverage. The companys tier 1 capital adequacy is 17.3% in FY12, which is the highest in past 10 years. The RBI stipulation for tier 1 capital is 12% for a deposit-taking NBFC like STFC. Table 17: Capital adequacy
(Rs mn) CAR (%) Tier 1 CAR (%) Tier 2 CAR (%) Tier 1 capital (Rs m) Tier 2 capital (Rs m) Shareholders funds Credit enhancement and other deductions from tier 1 CE and other deductions from tier 1 as a % of off book AUM Source: Company data, I-Sec research FY07 13.6 10.3 3.4 8,410 2,773 10,864 2,454 6.7 FY08 12.7 9.8 2.9 14,832 4,326 18,164 3,331 7.6 FY09 16.4 11.1 5.2 19,947 9,355 23,166 3,220 6.0 FY10 21.4 16.0 5.3 28,750 9,565 38,441 9,692 8.7 FY11 24.9 16.6 8.2 32,856 16,270 48,934 16,078 9.9 FY12 22.3 17.3 5.0 41,271 11,956 60,326 19,056 10.5
A look at the (following) chart on gross and net debt equity makes it clear that company in its current balance sheet management strategy is continuing to deleverage.
36
Shriram Transport Finance, November 27, 2012 Chart 41: Gross and net debt to equity indicate significant leveraging headroom
Gross Debt-Equity ratio 10 9 8 7 (%) 6 5 4 3 2 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 4.8 3.6 4.1 4.0 3.8 3.8 3.8 3.4 3.2 3.2 3.2 3.1 8.7 8.1 7.4 Net Debt-Equity ratio
ICICI Securities
Chart 42: Leverage (loan assets to equity set to improve over FY13-15E)
9 8.3 8 7 (%) 7.7
6.2
6 5 4 3 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15

FY12 21,062 14,500 17,656 53,218 36,045 89,263 368,195
4.7 4.0 4.0
4.5
4.4
4.4
Cash levels remain high, a case for higher payouts remain

A look at FY12 balance sheet brings out that cash and liquid investments remain at 24.2% of the total balance sheet assets, its highest levels ever. Of this cash, if it is assumed that the quantum maintained in current account is working capital on a rolling basis and if margin money deposits that are used as credit enhancements are excluded, there are still cash equivalents worth 14.5% of the balance sheet. If we look at the past dividend payouts of the company, it used to be 30% of net profit till FY08 in a phase of blistering asset growth. Currently, payout ratio has come down to 12%. In our assumptions, in line with the management commentary, we have maintained payouts at similar levels. However, when we look at the surplus cash on the balance sheet and realise that the company has a lot of headroom for leverage, the case for raising payouts and increasing leverage becomes very strong as a means to adding shareholder value. Table 18: Liquid assets remain plentiful
(Rs mn) Cash in current account (X) Margin money deposit (enhancements) (Y) Other cash (Z) Total cash (A) = (X+Y+Z) Liquid investments (B) Cash and cash equivalents - C= (A+B) Total balance sheet assets Source: Company data, I-Sec research FY07 2,641 3,664 11,801 18,106 2,121 20,227 108,355 FY08 4,526 6,479 903 11,908 13,736 25,644 182,684 FY09 9,560 11,537 35,303 56,400 6,270 62,670 249,633 FY10 16,602 20,596 6,935 44,133 18,064 62,198 268,997 FY11 9,384 18,225 9,505 37,114 33,415 70,530 319,675
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ICICI Securities
Chart 43: High proportion of discretionary liquid assets on balance sheet

Other liquid assets Cash in current account and margin money Payout ratio (RHS)
30 25
40 35 30
(% of BS assets)
20 15 12.8 10 5 5.8 0 Mar-07 Mar-08 Mar-09 6.0 8.0 16.7
13.4
14.6 20 15
13.8 8.5 8.6 9.7
10 5 0
Mar-10
Mar-11
Mar-12
Source: Company data, I-Sec research Note: We assume current account cash and margin money deposits are operating in nature; other liquid assets are discretionary.
Return ratios remain healthy despite heavier balance sheet

Even with the extreme conservative stance that the company has taken on cash preservation and leverage, RoE continues to stay above 20%. Decreasing tier 1 CAR by 200bps, our estimation could provide at least 300bps boost to RoE. Another fact that could boost RoE is that credit enhancements will no longer be required for bilateral assignments and thereby free up tier 1 capital. Table 19: RoAE tree
(%) NII/ average assets (A) Net other income/ average assets (B) Cost to income ratio (C) Provisions and writeoffs/ average assets (D) Tax rate (E) RoAA (F) = ((A+B)x(1-C) - D)*(1-E) Avg total assets/ avg net worth (G) RoAE = FxG Source: I-Sec research, Company FY07 7.7 0.2 32.7 2.0 34.2 2.2 9.0 20.0 FY08 8.2 0.1 29.7 1.7 35.7 2.7 10.0 26.9 FY09 7.9 0.2 30.1 1.4 33.5 2.8 10.5 29.6 FY10 8.4 0.2 22.8 1.6 34.1 3.4 8.4 28.3 FY11 10.3 0.5 26.0 1.8 33.8 4.1 6.7 27.9 FY12 10.0 0.6 25.3 2.2 33.1 3.8 6.3 24.0 FY13E 9.6 0.7 23.4 2.3 33.0 3.8 5.9 22.2 FY14E 9.9 0.7 22.4 2.8 33.0 3.7 5.7 20.9 FY15E 10.1 0.7 21.6 3.2 33.0 3.6 5.7 20.2
Chart 44: Returns ratios remain healthy over FY13-15E

35 29.6 30 25 (%) 20 15 10 5 0 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 2.7 2.8 3.4 4.1 26.9 28.3 27.9 24.0 22.2 20.9 20.2 3.5 3.0 2.5 2.0 (%) 4.0 3.8 3.8 3.7 3.6 RoE RoA (RHS) 5.5 5.0 4.5
38
(%)
9.3
25
ICICI Securities
Valuations appear quite attractive

A quick look at STFCs historical trading bands shows it is trading at valuation levels which have been worse only in the period of global credit squeeze. We feel that the derating brought about by regulatory uncertainties and souring of asset quality makes the valuations really attractive. Chart 45: Rolling 1-year forward P/E ratio
1,200 1,000 800
(Rs)
Chart 46: Rolling 1-year forward P/ABV ratio

1,200 14x 11x
(Rs)
3.0x 1,000 800 600 1.75x 400 1.0x 2.25x
600 8x 400 200 0

Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 May-12 Nov-12 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11
5x
200 0
Oct-06 Oct-07 Oct-08 Oct-09
Oct-10
Oct-11
May-12 Jun-12
Source: Bloomberg, I-Sec research
We also see that STFC is trading at a 12% and 27% discount to its 5 year average P/E and P/B multiples. Chart 47: Historical P/E
18 16 14 12 (Rs) Avg P/E - 9.7x
Chart 48: Historical P/ABV

4.5 4.0 3.5 3.0
(Rs)
10 8 6 4 2 0 Nov-07
2.5 2.0 1.5 1.0 0.5 0.0
Avg P/B - 2.2x
Feb-09
May-10
Dec-09
Oct-10
Jul-09
Mar-11
Jan-12
Jun-12
Nov-12
May-10
Feb-09
Oct-10
Nov-07
Dec-09
Mar-11
Jul-09
Jan-12
Aug-11
Aug-11
Nov-12
Sep-08
Sep-08
Apr-08
Apr-08
Nov-12
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
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ICICI Securities
Comparative valuations make the picture clearer

A lot of STFCs peer companies have had strong stock price performance on the back of reasons as diverse as expectation of banking licenses being granted, high growth plans being disclosed, improvement in asset quality and emergence of new asset class capabilities. A quick comparison of STFC with its peers in the context of hard numbers shows why STFCs risk-return appears attractive to us. Chart 49: Attractively priced vis--vis NBFC peers
2.4 2.2 2.0 P/BV (x) 1.8 1.6 1.4 1.2 1.0 5 7 9 11 13 15 17 RoE (%) 19 21 23 25 Sundaram Finance MMFSL
12.0 11.0 Sundaram Finance Shriram Transport
MMFSL
Bajaj Finance Shriram City
10.0 P/E (x) 9.0 8.0 7.0 6.0 5.0 4.0 9.0
Bajaj Finance Shriram City Chola Invst
Shriram Transport
Chola Invst
14.0
19.0
24.0
29.0
EPS CAGR (%)
Note: Prices as of Nov 26,12 Source: Bloomberg, I-Sec research
Table 20: Comparative valuation summary

P/E (x) (FY14E EPS) MMFSL 11.3 Shriram Transport 8.5 Bajaj Finance 8.7 Chola Invst 8.2 Sundaram Finance 11.6 Shriram City 8.6 Source: Bloomberg, I-Sec research EPS CAGR (%) (FY13-15E) 18.8 14.1 21.6 26.4 7.6 21.4 P/BV (x) (FY14E BV) 2.3 1.6 1.8 1.5 2.1 1.8 RoE (%) (FY14E) 22.8 20.9 22.1 20.5 20.1 22.9 Dividend yield (%) (current) 1.4 1.0 0.9 1.1 1.6 0.7
Target price set at Rs 850, 35% upside in next 12 months

We think that given the RoE profile of the company and its long term valuation history, a valid 12 month target P/B multiple for this company will be 2.2xFY14E BVPS. This provides us with our target of Rs850 indicating a 12 month upside of 35%. We initiate coverage on the stock with a BUY recommendation.
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ICICI Securities
Risks to our investment theses

Further deterioration of economic scenario
Worsening macro remains biggest risk As we have argued earlier, freight volumes (key to trucker profitability) is the key macroeconomic variable impacting STFCs business outlook. Indias economic deceleration and industrial slowdown have had an impact on trucker economics (though not as pronounced as it was in March 2009). However, if the economic situation worsens further we see the following risks to our investment thesis. Souring of underlying asset quality: The most direct impact that we see of such a slowdown is utilisation of trucker fleets going down further, as freight volume levels drop. When this happens, the spread between truckers monthly gross income (net of fuel cost) and the EMI payable on the loan starts to dip. This lowering of EMI affordability and attendant cash flow strains will immediately start to show up in STFCs underlying asset quality (though the 180 day NPA norms ensure a lagged impact on reported numbers). Slower-than-expected growth: Loan asset growth for STFC is driven more by internal preparedness and willingness than by competitive environment given the companys niche dominance and still low levels of penetration. However, the souring of asset quality generally rings the alarm bells in the psyche of managers and inevitably slows down loan growth. This will put our earnings projections at risk. Deterioration of return ratios on account of excess balance sheet conservatism: As we argued earlier, STFC currently is carrying a large chunk of cash and cash equivalents on its balance sheet (24% of balance sheet assets). The tier 1 CAR of the company at the end of FY12 stood at 17.3% versus the 12% it needs to conform to and the gross and net leverage is also at its lowest ever levels. This balance sheet conservatism is likely to increase further in a stressed scenario, as the company will rightly choose prudence over bravado. In such a scenario, the return ratios will look less attractive than it has in past and may lead to a derating.
Execution risks in construction equipment finance business

STFC is not new to the construction equipment finance business but the scale of operation has always been small relative to its size in CV financing. Dedicating resources to the business (creation of an independent wholly-owned subsidiary with its own management team) shows its ambition for a faster growth. (11.8% QoQ loan growth being clocked currently). There is execution risk involved in this rapid ramp-up that one needs to be cognizant of as the companys knowledge depth in this business has to be lower than its core business. However, we drive comfort from the fact that the business does fit into the companys core competence of financing cash flow generating assets, end-user financing, livelihood linked lending, use of its field officer model for customer interaction depth and choice of small ticket size unbanked customers who are trying to upgrade from being operator to owner.
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ICICI Securities
Adverse regulatory action in NPA disclosure norms

The Usha Thorat Committee report in August 2011 has recommended moving NBFC NPA accounting standards in line with those for banks. Although this conformance is expected to happen in a phased manner, on the off chance it does happen at one go, the company will receive an earnings shock in that quarter and the market may react adversely. But as brought out by our stress sensitivity analysis, the impact will not be a debilitating one with earnings recovering by FY15.
Adverse regulatory action in securitisation guidelines

Securitisation guidelines in its present form and even including Nair Committees recommendations of a 35% cap on off-book loans will not have any impact on STFC. The only regulation which may raise its cost of incremental securitisation is that no credit enhancement can now be provided on bilateral transactions and the insurance cost of first loss may get built into the spread. Even in this case, there is some benefit from tier 1 capital getting freed up, which would have been blocked otherwise.
42
ICICI Securities
Financials
Table 21: Income statement summary
(Rs mn, year ending March 31) Fund based income Income from securitisation Fee & trading income Income from operations Interest Expenses Net interest income Net Op Income Non operating income Gross Operating Profit Staff Expenses Depreciation Operating expenses Total Non-Interest Expenses Pre provision operating profits Provisions & write-offs Pre-Tax Profit Tax Rate (%) Net Profit Share of profit/ (loss) of associate Minority interest PAT after minority interest and share of profit/ (loss) of associate Extraordinary Items Adjusted PAT Source: Company data, I-Sec research FY10 36,539 7,838 305 44,682 22,519 21,858 22,163 277 22,441 2,251 150 2,726 5,126 17,314 4,069 13,246 34% 8,731 (1) 0 8,730 0 8,730 FY11 36,200 17,003 892 54,095 22,928 30,275 31,167 675 31,842 3,711 113 4,456 8,280 23,563 5,187 18,375 34% 12,171 (0) 0 12,171 0 12,171 FY12 37,594 22,153 1,155 60,901 25,317 34,429 35,584 914 36,498 4,076 174 4,977 9,226 27,271 7,696 19,575 33% 13,088 1 0 13,088 0 13,088 FY13E 47,903 19,449 1,650 69,001 29,439 37,912 39,562 1,009 40,571 4,429 200 4,877 9,506 31,064 8,966 22,099 33% 14,806 FY14E 60,537 19,788 2,269 82,593 34,905 45,419 47,688 1,110 48,798 4,800 230 5,887 10,917 37,881 12,971 24,910 33% 16,690 FY15E 73,843 20,413 2,784 97,040 39,759 54,497 57,281 1,212 58,494 4,975 260 7,388 12,623 45,871 17,123 28,747 33% 19,261
14,806 0 14,806
16,690 0 16,690
19,261 0 19,261
Table 22: Balance sheet summary

(Rs mn, year ending March 31) Total equity capital Reserves & surplus Shareholders funds Secured loans Unsecured loans Total debt Net Deferred Tax liability Total sources of funds Total fixed assets Loans & advances Investments Inventories Sundry Debtors Cash & bank balance Loans Other current assets Total current assets Current liabilities Provisions Total current liabilities & provisions Net current assets Misc exp not written off Total uses of funds Source: Company data, I-Sec research FY10 2,255 36,186 38,441 151,725 32,874 184,599 (747) 222,293 465 179,792 18,556 0 0 45,395 23,915 502 69,813 38,246 8,458 46,704 23,109 371 222,293 FY11 2,262 46,672 48,934 151,694 50,123 201,817 (1,542) 249,209 435 146,965 34,774 129 0 37,114 98,782 1,475 137,501 58,510 11,956 70,466 67,035 0 249,209 FY12 2,263 58,063 60,326 187,182 54,185 241,367 (2,183) 299,510 537 165,287 36,663 9 3 53,218 110,641 1,838 165,709 53,039 15,646 68,685 97,024 (0) 299,510 FY13E 2,265 70,617 72,882 214,131 62,313 276,443 (3,018) 346,307 772 227,282 42,529 20 0 45,110 100,000 2,298 147,428 63,647 20,437 71,703 75,725 0 346,307 FY14E 2,265 84,789 87,054 260,903 71,660 332,562 (4,102) 415,514 942 264,199 49,333 30 0 58,150 120,000 2,872 181,052 76,376 26,770 80,011 101,040 0 415,514 FY15E 2,265 101,135 103,400 312,457 82,408 394,866 (5,512) 492,753 1,182 307,209 57,226 40 0 66,190 150,000 3,590 219,820 91,651 37,443 92,684 127,136 0 492,753
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Shriram Transport Finance, November 27, 2012 Table 23: Ratio summary
(%, year ending March 31) FY10 Growth (%) New CV disbursement Old CV disbursement CV Disbursement CE disbursement Net Op Income Net Interest Income Pre provisioning operating profits APAT EPS On book loan assets Securitised book Securitisation in the year Profitability (%): NIM - on book NIM - securitised piece NIM - AUM Average cost of funds Non-interest income as % of total Cost to income ratio Op.costs/avg. earning assets (%) Increase in unit staff costs (%) Salaries as % of non-int.costs (%) Revenue/employee (Rs mn) Assets/employee (Rs mn) APAT margin Tax Rate Leverage & Capital (%): Gross Debt-Equity ratio Net Debt-Equity ratio Loan assets/ shareholders funds CAR (%) Tier 1 CAR (%) Tier 2 CAR (%) Per share data EPS (Rs) BVPS (Rs) DPS (Rs) Asset quality data (%) GNPA NNPA Provision coverage Return ratios (%) Return on average net worth Return on average assets Payout Ratio Source: Company data, I-Sec research 59 22 28 29 28 41 43 29 0 109 0 FY11 74 26 35 41 39 36 39 39 10 46 17 FY12 -23 5 -2 14 14 16 8 7 21 12 (18) FY13E 21 18 19 11 10 14 13 13 37 0 (5)
ICICI Securities
FY14E 20 6 9 35 21 20 22 13 13 17 20 66
FY15E 17 17 17 30 20 20 21 15 15 19 17 13
6.1 9.5 7.0 11.7 0.6 22.8 1.5 7.8 43.9 3.5 17.5 19.4 34.1
5.8 12.4 8.2 11.9 1.2 26.0 2.4 23.7 44.8 3.2 14.7 22.2 33.8
4.7 12.8 7.8 11.4 1.5 25.3 2.3 23.4 44.2 4.1 19.9 21.2 33.1
5.6 10.7 7.4 11.4 1.4 23.4 1.7 11.1 46.6 4.8 23.5 21.1 33.0
6.3 9.8 7.5 11.5 1.3 22.4 1.7 0.1 44.0 5.2 26.1 19.9 33.0
7.1 8.6 7.6 10.9 1.2 21.6 1.8 -4.2 39.4 5.7 28.5 19.6 33.0
4.8 3.6 4.7 21.4 16.0 5.3
4.1 3.4 4.0 24.9 16.6 8.2
4.0 3.1 4.0 22.3 17.3 5.0
3.8 3.2 4.5 21.1 16.1 5.0
3.8 3.2 4.4 21.9 16.9 5.0
3.8 3.2 4.4 22.0 17.0 5.0
38.7 170.5 6.0
53.8 216.4 6.5
57.8 266.6 6.5
65.4 321.8 8.5
73.7 384.4 9.5
85.0 456.5 11.0
2.8 0.7 74.9
2.6 0.4 85.5
2.9 0.4 85.8
2.9 0.4 86.2
4.3 1.1 74.4
5.8 1.3 77.6
28.3 3.4 17
27.9 4.1 15
24.0 3.8 12
22.2 3.8 11
20.9 3.7 13
20.2 3.6 13
44
ICICI Securities
Index of Tables and Charts

Tables
Table 1: Trucker economics A typical single vehicle owner ..............................................4 Table 2: Asset classification and minimum provisioning norms NBFCs............................6 Table 3: Key NPA details for on-book assets .....................................................................10 Table 4: Provisions on consolidated P&L ...........................................................................10 Table 5: Provisions on consolidated balance sheet ...........................................................10 Table 6: Stress test result summary ...................................................................................11 Table 7: 5-12 year pool for next 5 years total vehicles ....................................................19 Table 8: New CV prices ......................................................................................................19 Table 9: Current 8 year old vehicle price ............................................................................20 Table 10: Market sizing for FY13E .....................................................................................20 Table 11: 5-12 year old CV financing opportunity category-wise .......................................20 Table 12: 5-12 year old CV financing opportunity shows 15.6% CAGR in FY13-18..........21 Table 13: Details of retail NCDs .........................................................................................27 Table 14: Shortfall in priority lending by banks securitisation opportunity.......................30 Table 15: Regulatory developments and their impact ........................................................33 Table 16: Assumptions and rationale .................................................................................35 Table 17: Capital adequacy ................................................................................................36 Table 18: Liquid assets remain plentiful ............................................................................37 Table 19: RoAE tree ...........................................................................................................38 Table 20: Comparative valuation summary ........................................................................40 Table 21: Income statement summary ...............................................................................43 Table 22: Balance sheet summary .....................................................................................43 Table 23: Ratio summary....................................................................................................44
Charts
Chart 1: New vehicle loan book was consciously reduced since Sep-08.............................5 Chart 2: Cash levels more than doubled in Mar-09, to stave any possible liquidity crunch off ....................................................................................................................................5 Chart 3: New CV disbursements consciously slowed down since June 2011 .....................6 Chart 4: With major focus on old CVs, their proportion increased steadily ..........................6 Chart 5: NPA bucketing for STFCs CV business.................................................................7 Chart 6: GNPA trajectory, assuming phased migration to 90 day recognition .....................8 Chart 7: Provisioning as proportion of assets to rise commensurately.................................9 Chart 8: NPA progression base and stress case.............................................................11 Chart 9: Freight index relatively sticky on downside & maintained upward trend ..............12 Chart 10: Drop in freight utilisation leads to increase in NPA.............................................12 Chart 11: Lagged impact of industrial activity (IIP) on NPA levels .....................................13 Chart 12: Process flow Loan life cycle.............................................................................15 Chart 13: Porters five forces analysis ................................................................................17 Chart 14: Strong growth in MHCVs and LCVs over FY09-12 .........................................18 Chart 15:coupled with steady shift towards higher tonnage vehicles within MHCV .......18 Chart 16: Residual value schedule MHCVs.....................................................................19 Chart 17: Residual value schedule LCVs ........................................................................19 Chart 18:Addressable market opportunity growing at 15.6% CAGR over next 5 years .....21 Chart 19: LCV opportunity growing fastest given strong new vehicle sales in recent years ......................................................................................................................................21 Chart 20: Financing opportunities over life cycle of a typical 9 tonne truck........................21 Chart 21: Spike in field officers point to strong impending growth......................................22 Chart 22: Steady increase in business handled by field officers ........................................22 Chart 23: CV AUM ramp-up................................................................................................23 Chart 24: 16% CV disbursement CAGR implied given loan repayment patterns...............23
45
ICICI Securities
Chart 25: Old / new CV mix expected to remain stable over FY13-15E ............................24 Chart 26: CE AUM to post a robust growth over FY13-15E ...............................................25 Chart 27: Evolving liability profile reducing reliance on banks.........................................27 Chart 28: Borrowing profile large proportion of unsecured borrowing.............................28 Chart 29: Diversified liability mix March 2012..................................................................28 Chart 30: Staggered maturity across instruments March 2012 .......................................28 Chart 31: About a third of liabilities mature in a year March 2012...................................28 Chart 32: Declining interest rates to aid borrowing costs ...................................................29 Table 33: Credit ratings table..............................................................................................29 Chart 34: A typical securitisation structure (PTC route) .....................................................30 Chart 35: Illustration of direct assignment route .................................................................31 Chart 36: Break-up of annual amount securitised by STFC ...............................................31 Chart 37: Securitisation NIM is assumed to fall ..................................................................32 Chart 38: On book/ off book mix annual with projections ...................................................32 Chart 39: Annual securitisation to remain robust................................................................33 Chart 40: Minimal impact on blended NIMs........................................................................36 Chart 41: Gross and net debt to equity indicate significant leveraging headroom .............37 Chart 42: Leverage (loan assets to equity set to improve over FY13-15E)........................37 Chart 43: High proportion of discretionary liquid assets on balance sheet ........................38 Chart 44: Returns ratios remain healthy over FY13-15E....................................................38 Chart 45: Rolling 1-year forward P/E ratio ..........................................................................39 Chart 46: Rolling 1-year forward P/ABV ratio .....................................................................39 Chart 47: Historical P/E.......................................................................................................39 Chart 48: Historical P/ABV..................................................................................................39 Chart 49: Attractively priced vis--vis NBFC peers.............................................................40
46
ICICI Securities
This report may be distributed in Singapore by ICICI Securities, Inc. (Singapore branch). Any recipients of this report in Singapore should contact ICICI Securities, Inc. (Singapore branch) in respect of any matters arising from, or in connection with, this report. The contact details of ICICI Securities, Inc. (Singapore branch) are as follows: Address: 30 Cecil Street #15-29 Prudential Tower, Singapore 049712, Tel: +65 6232 2451 and email: ashvin_patil@icicisecuritiesinc.com, Rishi_agrawal@icicisecuritiesinc.com.
New I-Sec investment ratings (all ratings based on absolute return) BUY: >15% return; ADD: 5% to 15% return; REDUCE: Negative 5% to positive 5% return; SELL: < negative 5% return
ANALYST CERTIFICATION
We /I, Santanu Chakrabarti, PGDM, MBA (Finance); Digant Haria, MBA research analysts and the authors of this report, hereby certify that all of the views expressed in this research report accurately reflect our personal views about any and all of the subject issuer(s) or securities. We also certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report. Analysts aren't registered as research analysts by FINRA and might not be an associated person of the ICICI Securities Inc
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2012-11-28 511218 in (ICICI Securit) Shriram Transport Finance

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2012-11-28 511218 in (ICICI Securit) Shriram Transport Finance

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Equity Research

November 27, 2012 BSE Sensex: 18537

Shriram Transport Finance

Reason for report: Initiating coverage

+91 22 6637 7351

+91 22 6637 7314

Please refer to important disclosures at the end of this report

Shriram Transport Finance, November 27, 2012

Shriram Transport Finance, November 27, 2012

Historical response to stress shows remarkable strategic clarity

Shriram Transport Finance, November 27, 2012

Credit crisis 2009 <20 days 17,000 5,851

Truckers IRR from sanction to repayment is 100%+

New CV - disbursements (RHS) 14 12

Source: Company data, I-Sec research

Case study 2: Navigating the current macro slowdown

30 20 10 0 Old CV New CV No grow th

60 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12

Source: Company data, I-Sec research

Current NPA classification & provisioning policy

Sub standard assets

Doubtful assets Loss assets Source: RBI

Shriram Transport Finance, November 27, 2012

Large proportion of incremental NPAs lie in 90-120 day bucket

Shriram Transport Finance, November 27, 2012

Source: Company data, I-Sec research

Shriram Transport Finance, November 27, 2012

Chart 7: Provisioning as proportion of assets to rise commensurately

Source: Company data, I-Sec research

FY13E 9,491 1,309 2.9 0.4 86.2

FY14E 16,521 4,226 4.3 1.1 74.4

FY15E 26,518 5,944 5.8 1.3 77.6

Table 4: Provisions on consolidated P&L

Table 5: Provisions on consolidated balance sheet

Shriram Transport Finance, November 27, 2012

NPA stress test results provide comfort

Source: I-Sec research

Table 6: Stress test result summary

Shriram Transport Finance, November 27, 2012

Credit loss sensitivity to macro-economic environment

Chart 10: Drop in freight utilisation leads to increase in NPA

Source: Company data, I-Sec research

Shriram Transport Finance, November 27, 2012

Source: Company data, I-Sec research

Shriram Transport Finance, November 27, 2012

Source: I-Sec research *as per depreciation schedule in chart 16

Table 5: IRR of a trucker taking the aforementioned loan

Shriram Transport Finance, November 27, 2012

Fixing loan tenure

Lead generation through referrals

Asset Inspection & valuation

Source: I-Sec research

Field officers are key to the business model

Hard to replicate model is key competitive advantage

Due diligence with RTO

Collection (including cash)

Repossess in case of default

Shriram Transport Finance, November 27, 2012

Suppliers Power is medium (Dependence on wholesale funding)

Low competition (lack of organised player of consequence)

Customer power is low (Best possible opinion despite high rates)

Source: I-Sec research

Shriram Transport Finance, November 27, 2012