Screening: Lets assume that today is 30th July, 2014 and we come to know about a company named can fin homes. The fast increase in share price surprises us.
Let us try to understand the business of the company.
The company is in the business of giving housing loans. It is in a similar industry as DHFL ( More details here). Specifically, it is a deposit taking NBFC.
Loan industry is not new, it’s very old. 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.
In a lending business, there are two sides which are majorly important:
We will try to understand both the lending and borrowing side of the business using income statement and balance sheet of the company.
If we look in the income statement of the company, it seems clear that interest cost is the main component of cost which are more or less uncontrollable while Other and employee cost are a small component which are somewhat controllable and have some form of operating leverage built into them.
Generally, in a lending business money is like a commodity, it borrows and lends further in quest of a small profit. Hence, Leverage is an inherent feature of the business. Let’s dig into the balance sheet to see further.
In the Balance Sheet, there are two sides:
1) Borrowings – Over time the company has become more dependents on bank as a source of lending. Though from last 2-3 years there seems to be some changes in the same.
2) Loans given (Other assets)
There are multiple ways to see the financials of a finance company, however we think this is a simpler way:
1) Average lending rate – the cost at which loans have been lent (Revenue/Loan Book)
2) Average Borrowing rate – the cost at which money has been borrowed (Interest/Loan Book)
3) Subtract both we get the financing margin
4) If we subtract the operating expenses (employee cost, Tax,etc) from financing margin and divide it by Loan book – we get the net return on loan or famously called Return on assets
5) Return on Assets from above can be multiplied by leverage to get Return on equity
Over time it is the interest rates which determine the environment of NBFC’s. Generally it is in lower interest rate environments that NBFC’s prosper.
If we focus more on the 2000-2006 period, the company prospered with good growth and with high Return on Assets, however from 2006-2012 the company suffered with slightly low growth and falling ROA.
Additionally, the fall in financing margin from 2009 to 2014, seems to point out at operating leverage, as the Loan Book has grown from around 1800 crores to 5700 crores. There are some changes going on in the company since 2012. There has been a change in the management of the company. It is further corroborated by the visible change in numbers.
Lets now, focus on the external aspects of the business, its competitiveness, regulatory environment, industry
The housing finance industry in India contains of lot of players. We can categorise them on the basis of size as follows:
DHFL, LIC, India Bulls can be said to be very large players. Clearly, true competitors of CAN FIN in terms of size seems to be REPCO, GRUH.
Let us try to gain further knowledge of the industry using Michael Porter Framework:
1) Threat From New Entrants – We think this is very high especially from Banks.
2) Bargaining Power From Suppliers – It depends on how much of the deposit base is from sticky depositors. Overtime, NBFC’s have become more dependence on Banks from 2003 to 2012 thereby reducing their bargaining power, however this seems to be changing from 2012. This can be only confirmed after more evidence.
3) Bargaining Power From Customers – The price is decided by the banks not the customers. If we think in terms of size the small size of each customer does not give much bargaining power to customers.
4) Existing Rivalry Among Players – It is not as high as tech companies and not as low as paint suppliers.
5) Threat of Regulation – Regulation plays a big role in growth or slowdown of the industry as a whole, as the NHB (regulator) is among the main financiers of NBFC’s.
There seems to be no Moat with Can Fin Homes as in a business of NBFC, the company which can raise capital at the cheapest cost and further supply to the customers at cheapest cost is generally the leader.
Can Fin homes, does not seem to have a strong deposit franchisee.
There seem to be no signs of fraud by the management. We are in no way to damage the hardwork put in by entrepreneurs, this is just a basic check in the analysis.
Industry Growth: Overall on the demand side there is shortage of housing units in India. The supply side has slowly started increasing over time, as more and more of low income group enters into the formal sector. Urbanisation over long term has played huge role in the same.
Key Driver: One of the key drivers which needs to be tracked is the long term direction of interest rates. Low interest rates will be favourable for NBFC’s going forward.
Over the past 2years, the NBFC industry (almost all companies) have reported tremendous growth.
The growth prospects of the industry seem positive considering the companies are expected to reduce their dependency on banks thereby reducing the riskiness of their business model.
Company Growth Plan
Since the new management has taken over in 2012, the company seems to have shifted its focus on growth. (Loan growth of 2x in 2 years and increase in leverage). Further the management of the company plans to open 26 more branches by the next year taking the total number to 100. Currently, the company seems to be going through a growth phase or capex phase.
Once the company reaches a critical size, effects of operating leverage can kick in.
The effect of operating leverage can be seen in Low ROA of Can Fin mainly due to high expenses per branch (Till 2012 Below 45 Lakhs) as the company is in an expansion phase since 2012.
Nothing much can be commented regarding the management, as there is a new management since 2012. However, the new management is more growth aggressive vs the old one as evidenced by the increase in leverage and growth after the change in management.
Any valuation is dependent on assumptions and similar is the case here:
Price To Book Model
1) Loan Book Growth – The company is positioned for higher growth as can be seen in high number of new branches (estimated from high operating expense per branch since 2012)
A) Number of Branches – Since the branches of the company are low in comparison to others and it has already doubled the number of branches since last five years. It is reasonable to assume the number of branches will double in the next 5 years.
Considering the size of opportunity too, further enhances the same.
B) Average Business per Branch – The business per branch currently has grown from 54 crore to 62 crore. Since Loan Book growth is not a problem in an NBFC and with the new management (growth focus) taking over, we think this to reach around 100 crore per branch on an average.
This is a critical variable and it is heavily dependent on low interest rates in future.
2) Debt/Equity – We think this will remain similar, as a result there may be some dilution in equity going forward. It will help us to check the capital allocation skills of the management.
3) Future Price to Book Multiple – After five years the Growth may still be there considering Price to Book multiple of 1.
This process results in future valuation to be around 1400 crores, while the current value is around 1000 crores, resulting in 7% CAGR.
However, if we give Future Price to Book Multiple of 1.5 the valuation jumps to 2000 crores five years from now, resulting in 16% CAGR. It all depends on whether there will be future growth five years from now?
We think the company is neither cheap nor much expensive. However, you may have a different viewpoint we will love to know why you think so. Lets use another tool for the same.
Clearly, Mr. Market is paying more for GRUH AND REPCO. However, if you believe that the changed growth prospects of Can Fin Homes are not properly discounted by the market then buying Can Fin Homes may be fine.
Value is in the eyes of the beholder. We can give any value we want to the company
In order to keep a further check on our valuation we did not assign a higher future multiple than the current one.
1) Interest Rates – If interest rates turned out to be way higher than now over the next 5 years, then there may be threat to the company. However, the probability of same happening is low as the conditions are ripe for the industry to mature.
2) Competitive intensity increasing
The company has almost no competitive intensity as of now, hence any valuation done is not that confident. The business model of the company is not competitively superior.
As on 30th July 2014, We may invest a very small portion of our portfolio though not a very large %age considering it is still not robust model. We may prefer to invest more as more results are declared by the company or less with time.
1) Interest Rates
2) Average Business Per Branch
3) Marginal ROE
4) Leverage needs to be reduced over time
Review: We will review it almost every year, keeping in mind the 5 year view.
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.
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.
Pick Parts of the case study and use it as it may be helpful to you.
May we all learn and progress together.
If you would like to see the next phase (2015-2017) please proceed to part 2 by clicking on “2” on the bottom of the page