This case study will be done in three Phases:

1) Part 1 – 31^st July, 2012

2) Part 2 – 2013-2017

3) Part 3 – 2017 and Beyond

Part 1

For this part let us assume that today is 31^st July, 2012.

Screening: While going through companies on screener, we observe a company named DHFL which is growing rapidly. The company is a non-banking finance intermediary.

Business Internal

In this section we will try to understand the business of the company through an internal perspective using DHFL’s:

1) Income Statement

2) Balance Sheet

DHFL is in the business of giving housing loans to people. They are particularly targeting those people where the dwelling (House) is in the range of Rs 3 Lakhs to 50 Lakhs.

Traditional Business: Loan industry is not new, it’s very old. Even the company is very old. It is listed in markets since late 90’s, however they have chosen a new segment, which is generally not considered loan worthy.

Naturally a question arises in the mind,This is similar to what Banks do, then what is the difference between banks and NBFC’s?

As per RBI’s website:NBFCs lend and make investments and hence their activities are akin to that
of banks; however there are a few differences as given below:

i. NBFC cannot accept demand deposits;
ii. NBFCs do not form part of the payment and settlement system and cannot
issue cheques drawn on itself;
iii. deposit insurance facility of Deposit Insurance and Credit Guarantee
Corporation is not available to depositors of NBFCs, unlike in case of banks.

Source: RBI

Product Portfolio: Once a company is in the business of lending, it has two sides to look into:

1) The sources of funding

2) Where those funds are being used

DHFL is focused on the housing loan segment of the market. Around 89% of the loans disbursed are focused on housing while the rest are on non-housing market.

Sales: DHFL is mostly focused on selling through own branches. It is focused on selling mainly in Tier 2 and Tier 3 cities.

Before going further lets have a look at the income statement of the business. How does it look like? What is the main cost (Important parts of business)? What is the nature of cost? How it has changed over time?

Main Components – Income Statement

If we look closely at financing business the major cost (Raw material cost) is the interest charged. As money is just a raw material for a finance company.

Other expenses includes the employee and distribution cost of giving loans (Selling expenses, office expenses, etc).

Nature Of Cost Over Time

Generally, the interest cost is very volatile and NBFC’s are unable to pass on the cost to borrowers. However, flexible rate loans avoid such problems. In the long run, it all depends on quality of borrowers to whom loans have been given (as NPA’s may come later during the life of a loan which is 20 years long)

This is further corroborated by the evidence of Fluctuating Gross margins. Long evidence is needed to see what are the real average margins of DHFL.

Since, Lending is a long term contract (15-20 years) with the customer, generally, balance sheet takes more importance as few wrong loans may take many years to show in the actual numbers. Generally, the industry is categorised by profits for very long periods ( 5-7 years) and losses in few years. In this industry higher margins does not necessarily mean its better (This has been the historical evidence). So lets have a look at the Balance Sheethow does it look like? (What are the main components)? What are the terms of trade? How has it changed over time?

Components: The Balance Sheet

of the company is divided mainly into two parts:

1) The Money Raised

A)Borrowings (Which act as creditors for a finance Business) – Banks 73%, NHB (RBI) – 7%, Pubic Deposits- 5%, NCD (Borrowings from markets ) – 10%

B) Equity Holders (Which receive dividends)

Money may be raised opportunistically from different markets depending on different conditions. Currently the company wants to reduce its dependence over funds from banks during the next 3 years and get more borrowings from Money Markets and NHB.

2) The Money Invested

A) Loans – Nearly 85% of the Balance sheet is utilised to give loans

B) Investments – This may be mandated by the regulator from time to time

Over Time: If we look in detail about borrowing and lending side of the business, two points are noteworthy:

Observations:

1) Increase in Borrowing from Banks

There is increase in Borrowings from Banks to DHFL. This increase is mainly being used to finance the remarkable growth in Loan Book from past 4-5 years. Another point to wander is that despite showing such remarkable growth in loan Book the Financing Margins have been consistently maintained at 4-5%.

This could mean two things:

-Either there is a permanent change in the strategy of DHFL so we could only consider data regarding past 4-5 years as relevant

– Or this is a temporary phenomena

We need to evaluate later which is the more probable case

(This will effect our analysis later as we need to determine what is normal in case of DHFL? 10 year average or past 4 years trend)

2) The Debt/Equity ratio of the business has risen over past 10 years – Seen in the whole picture of above mentioned points this may be normal.

These two observations can be evaluated later, once we make the competitive position of the business very clear.

Business External

In this section we will try to evaluate:

1) the competitive position of DHFL

2) the relevance of the industry in which DHFL operates

On the basis of Loan Book, competitors can be numbered as (in decreasing order):

1) HDFC

2) LIC

3) DHFL

4) GRUH

Currently, the housing loan (NBFC) industry in India has characteristics of multiple competitors with a very large player among others (On the Basis of Loan Book).

Stage of industry: The industry is very old. Though considered from the perspective of housing requirement in India it is still relatively new. The need for housing is large due to prospective increase in urbanisation. (Source: LIC Housing Finance Annual report 2011-12)

Let us use Michael Porter’s Framework to deepen our understanding about the working of Housing Finance Industry:

1) Threat of New Entrants: Except some regulatory barriers due to capital, there are not many barriers for a new player to enter the industry.

There is lot of competition in the industry and no barriers as banks, nbfc’s, unorganised sector, all are involved in this similar business.

2) Bargaining Power Of Suppliers: Though there is no particular supplier to an NBFC. It is dependent on the markets and Banks. The bargaining power generally of suppliers is lower when there is excess capital and vice-versa. However, overall as there are large number of suppliers, their bargaining power is not that high compared to an industry where there is one or two suppliers of raw material (As in the case of Coal India)

3) Bargaining Power of Customers: The bargaining power of customers is not that high, considering there are large number of customers.

4) Competition among Existing Players: There is too much competition among the existing players, however it is not like the technology industry. The competition is profitable as the size of the market is very huge.

5) Regulation: Threat of regulation is not that high when compared to agriculture or power industry. Though regulatory behaviour is lax sometimes which introduces capital in the industry sometimes while most of the times its very strict.

All the above mentioned characteristics, change with time this thinking model is not that static.

Let’s further investigate, to see whether DHFL has some competitive advantage in the industry or not?

Moat

Since Loan is a long term contract it is better in the loan business to have look at long term data over 1 cycle, to see evidence of some competitive advantage.

It is better to compare DHFL with LIC housing finance, as their loan book sizes are nearby.

Despite having similar Leverage the Long term ROA of LIC Housing Finance is higher than that of DHFL, though DHFL has grown at a faster rate over the past 10 years. As per previous analysis, it is clear that the NBFC industry has characteristics of a commodity industry. Generally, in a commodity industry it is the player which has the strongest power to raise capital at the cheapest cost, shows characteristics of strong competitive advantage. Let’s dig deeper in DHFL, as from ROA we can’t find any such signs?

Cost of Borrowing for DHFL is clearly high. The above table shows either DHFL is operating in a different market where it has found some niche or it is lending to less loan worthy borrowers. This only time will tell.

Currently, it seems DHFL is having most probably no signs of sustained Competitive Advantage.

Fraud

Lets evaluate DHFL to look for signs of fraud. This is just a part of basic analysis. In no way we claim to undermine the hardwork put by promoters on ground. Its easy to do analysis but tough to do the work on ground.

If we think from the perspective of Low and Middle Income housing, DHFL, GRUH and LIC Housing Finance all three are targeting same. Their numbers seem to confirm the same. However, GRUH seems very conservative vs DHFL? It could mean two things, either DHFL has found some really good opportunities or the loan book of DHFL is impaired.

Currently, no signs can be found regarding any wrongdoing or conservatism, so we won’t take any sides regarding the above mentioned thesis. Its better to remain neutral.

While it is really tough to find some errors in accounting numbers of a Loan company, The history of promoters is not that clean. There are three evidences:

1) Another firm, HDIL, in which the promoters were directors was found to have concealed income of around Rs 350 crores.

2) An IB report mentions DHFL, as involved in K-10 stocks scam done by Mr. Ketan Parekh.

3) One minor SEBI Case of non-disclosure – which can be ignored (Regarding pledge of shares of DHFL)

There is another information which we need to consider. The promoters have had a family split and separated from the business of HDIL in 2009. Now if the management doing something exceptionally different, the numbers of DHFL from past 4 years will be different than before, However this does not seem to be the case.

Hence, right now no opinion can be formed regarding integrity of promoters, however we need to be ultra-cautious as it is a financing business (where years of misdeeds can be hidden) + History of promoters we are not so sure.

Growth

Industry Growth: Currently, the housing mortgage penetration in India is very low. There in lies opportunity. As the incomes (GDP per capita) of people will grow, there are high chances of massive growth in Mortgage Industry.

“In spite of more than dozen rate hikes by RBI in last 24 months, housing credit grew by 18% y/y in FY12 “ – DHFL Presentation 2012

There are high chances of Housing Finance Segment rising in India, once GDP per capita rises. The next important step remains to figure out whether DHFL is well prepared and ready for such a gain?

Not much information can be found regarding the same, however, there are some important things past

1) 4 year Loan growth of the company is 41% (New management) – Which is the fastest in the Industry

2) The company plans to diversify its borrowers profile over next 3 years reducing dependency on Banks

Overall, it is too early to say anything as currently the industry is in a rising trend, it is like all boats are sailing when the tide is strong. As in Finance industry, it is important to have bad years to really judge how the company behaves.

Management

It is tough to evaluate management, keeping in mind it has been just 4 years since the family split, however we can find some clues on various basis.

Integrity

Despite the evidence already mentioned in Fraud section, In terms of integrity no significant evidence for or against the promoters could be found.

As of now no opinion regarding the integrity of promoters can be formed.

Efficiency

(*Expenses (Excluding Interest) as a % of Revenue)*

The above table indicates that the management is not that efficient vs its peers.

Though the management may be spending more to get scale and then reduce Cost of operations (As operating leverage plays a role in this industry), however this seems unlikely as LIC seems to be operating in the similar industry/market with similar scale, and There are almost no barriers to entry within the housing finance industry as the customers are not that sticky.

More evidence with time is needed to form a positive evidence regarding management efficiency.

Capital Allocation Skills

The capital allocation skills seem to be

A) The promoters have allocated capital in the company in past 3 years, by buying shares at prices significantly higher than the market. (Indicating confidence)

B) There was M&A deal in 2010 which the promoters bought a new housing finance company (FBHF) at two times book value, while issuing shares finally of DHFL in 2012, which were trading at less than half the book value.

Whether this was an expensive acquisition or a cheaper one, with time, the quality of loan book of FBHF will tell.

The capital allocation skills of the management seem fine, however of now they can’t be said to be superior than others (which may help us in valuation)

Opinion: Overall no opinion can be formed regarding the superiority of management vs others.

Risk

1. Fragility in Loan Book – Finance business by their nature are very fragile as they involve huge amounts of debt and hardly any competitive advantage.

2. Dependency – Finance businesses constantly require capital to grow. There is constant dependence on financial markets or Banks. Generally, a good track record is like a feedback loop in the business of finance. DHFL as of now lacks the same.

3. Management Quality – Since there is past evidence of poor promoter quality and no significant evidence of excellent capital allocation skills (required in the finance business), this may be a risk in future.

Valuation

Valuation is case-subjective and is dependent on the personal analysis. One may differ accordingly.

For valuation to be sensible some assumptions need to be made:

Assumption- 1: Current year loan book as the base year- As there is less chances of cyclicality in the industry. India seems still under-penetrated.

Assumption- 2: 25% loan book growth in future 5 years – Past 10 years were taken as an average growth estimate for future instead of last 4 years, as there is no significant evidence regarding the superiority of management in terms of capital allocation or efficiency.

Past 10 years growth average was 37%, however, we took 25%, as we think it is very unlikely for DHFL to continue with similar growth rates considering no competitive advantage.

Assumption- 3: Net operating margin was taken based on past 10 years average. Debt equity ratio was assumed to be at same levels for future. Discount rate (10%) was taken slightly above the 10 year yield (8.5%) as there is not much confidence in the certainity of cash flows.

Terminal growth rate was taken as 3%.

This all resulted in Value of the company coming to be around 4400 crores. The current market capitalisation of the company is around 2800 crores.

Fiction can be very easily written in excel, in order to conservative, it was ensured that future price to book multiple is not higher than current (around 1.4).

Another Approach: Relative Valuation

Clearly, Mr. Market is not giving same valuation as LIC, as the market seems to be not sure of the Loan book Quality (Lower ROA) of DHFL or the management quality.

Opinion: Since there are no barriers to entry in this business (Moat), as of now it does not make sense in valuation estimates unless we have reasonable evidence to believe the growth will mature into some advantage or there will be super normal growth.

Seen from other perspective if there is some belief regarding superior quality of management or further super normal growth in the industry, DHFL is highly cheap considering the loan book size.

Conclusion

As per this stage, we may invest a very small portion of the portfolio or nothing at all. As we are not that sure regarding quality of management and have no confidence in the competitive ability of the company.

If you think differently we would love to know why? This view is not static it will change with time.

Key variables to Track

1) Marginal ROA

2) Loan Book Growth

Purpose

The purpose of these case studies is to practice such cases and help all of us develop patterns to take similar decisions in future and avoid mistakes of both omission/comission. Its like practice before the main match. We may have made some mistakes or you may not agree with us. However, we would love to know why you think so or what you may have done differently? So that we may all learn together.

You may visit screener.in, main annual reports, valuepickr.com to see how people were thinking at that time and in.tradingview.com for prices. These resources are really helpful..

Before Going further it would be better if you Analyse the case or do the valuation or allocation according to your own Method. That way it may help you to do better with the case further and sharpen your mind for future.

DHFL-Case Study

Part 1