initiating coverage baf in equity october 13, 2014...

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Beyond the ‘halo effect’ Competitive advantages around customer acquisition, cross-selling, superior product and service delivery coupled with a vigorous execution have driven BAF’s 56% EPS CAGR over FY10-14. Nonetheless, we believe that the company is likely to find it difficult to sustain its growth and RoEs across cycles due to: (i) higher credit costs; (ii) increased competitive pressures; (iii) closing of regulatory arbitrage between banks and NBFCs; and (iv) change in customer preferences. Current valuations of 2.4x FY16 P/B (60% premium to its cross-cycle average) make the risk-reward unfavourable. We initiate with a SELL stance.

Competitive position: STRONG Changes to this position: NEGATIVE

Competitive advantages and execution - Drivers of robust profitability Bajaj Finance (BAF) has delivered robust EPS CAGR of 56% in FY10-14 driven by a combination of higher loan growth (56% CAGR) and improvement in RoEs (~15 percentage point improvement over FY09-14 to 19.5%). This improvement was driven by: (i) competitive advantages around high-quality customer acquisition; (ii) superior cross-selling architecture; and (iii) a strong customer proposition based around superior products and services.

Exposed to challenges on cross-cycle basis Whilst BAF has differentiated itself in a crowded market through superior innovation and execution, BAF’s unseasoned loan book could face the following challenges: (i) Credit costs would be higher across cycles, as BAF lacks control over cash flows of the borrower and protection of SARFESI; (ii) Increased competition from banks could affect BAF’s growth and margins, as it predominantly operates in mainstream banking territory; (iii) The closing of regulatory arbitrage between banks and NBFCs could weaken BAF’s competitive positioning vs banks; and (iv) Change in customer preferences in buying consumer durables from offline to online and greater use of credit cards could slow down BAF’s customer acquisition.

Profitability growth likely to moderate and valuations expensive We expect 16% EPS CAGR over FY14-17 (vs 29% CAGR over FY11-14) due to: (i) moderation in AUM growth (CAGR of 21% in FY14-17E vs 58% over FY10-14); and (ii) 110bps decline in RoEs primarily due to lower NIMs (from 10.7% in FY14 to 9.3% in FY17E). We see BAF’s sustainable RoE at 17-18% over FY17-34 vs the last three-year average of ~22%. At 2.6x one-year forward P/B, a 60% premium to its cross-cycle average, we find the risk-reward to be unfavourable. We assign a one-year forward TP of `2300 based on EVA-based valuation, implying 2x FY16 P/B, 11x FY16 P/E and 16% downside. Key risks: A profitable entry by BAF into a niche segment.

Bajaj Finance SELL

INITIATING COVERAGE BAF IN EQUITY October 13, 2014

BFSI

Recommendation Mcap (bn): `137/US$2.2 6M ADV (mn): `83/US$1.4 CMP: ` 2,730 TP (12 mths): ` 2,300 Downside (%): 16

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: GREEN

Catalysts Banks becoming more competitive in

retail and LAP loans over FY15-16

Regulatory changes

Performance

Source: Bloomberg, Ambit Capital research

Analyst Details

Aadesh Mehta, CFA +91 22 3043 3239 [email protected]

Pankaj Agarwal, CFA +91 22 3043 3206 [email protected]

Ravi Singh +91 22 3043 3181 [email protected]

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Sensex BAF IN Equity

Key financials (` mn, unless specified)

` mn FY13 FY14 FY15E FY16E FY17E

Total Income 19,040 25,001 29,895 36,139 42,566

PAT 5,913 7,190 8,485 10,117 11,257

Dil. EPS (`) 135 144 170 202 225

BVPS (`.) 676 802 949 1,124 1,320

ROE (%) 21.9 19.5 19.3 19.5 18.4

P/E (x) 20.3 19.0 16.1 13.5 12.1

P/BV (x) 4.0 3.4 2.9 2.4 2.1

Source: Company, Ambit Capital research

Bajaj Finance

October 13, 2014 Ambit Capital Pvt. Ltd.

CONTENTS

Snapshot of company financials……….……….……….……….……….……….………….3

A diversified NBFC with high profitability……….……….……….……….……….………..4

Understanding BAF’s retail finance book……….……….……….……….……….……….. 6

Differentiated SME lender in a competitive market……….……….……….……….……10

Strength# 1: A robust customer acquisition engine - ……….……….……….…………13 consumer durable financing

Strength#2: Superior cross-selling architecture……….……….……….……….………. 16

Strength#3: Superior products and service……….……….……….……….……………. 18

Unique strengths vs long-term challenges – Beyond the ‘halo effect’……….………...19

Challenge#1: Low credit costs unlikely to sustain across cycles……….……….………20

Challenge#2: Vulnerable to competitive pressures……….……….……….……….….. 22

Challenge#3: Closing regulatory arbitrage between banks and NBFCs……………...24

Challenge#4: Change in customer preferences……….……….……….……….……… 25

Near-term earnings to moderate but still remain robust……….……….……….……...27

Key assumptions and estimates……….……….……….……….……….……….…………31

Expensive valuations not factoring in the cross-cycle……….……….……….…………. 32 profitability of the franchise

Key catalysts for our SELL stance……….……….……….……….……….……….………. 34

Risks to our SELL stance……….……….……….……….……….……….……….………....34

Bajaj Finance


Snapshot of company financials Profit and Loss statement

Year to March (` mn) FY15E FY16E FY17E

Net interest income 26,098 31,120 36,393

Interest Income 47,110 55,908 65,113

Interest Expense 21,013 24,788 28,720

Fee based and other income 3,798 5,019 6,173

Total Income 29,895 36,139 42,566

Total expenses 13,989 16,727 20,205

Operating and other expenses 9,729 11,402 13,548

Employee Cost 4,260 5,325 6,656

Pre provision profit 15,906 19,412 22,361

Provisions 3,241 4,313 5,560

Profit before tax 12,665 15,099 16,801

Tax 4,179 4,983 5,544

PAT 8,485 10,117 11,257

BVPS (`.) 949 1,124 1,320

Dil. EPS (`) 170 202 225

ROA (%) 3.1 3.0 2.8

ROE (%) 19.3 19.5 18.4

Company background

Bajaj Finance Ltd (BAF) is a subsidiary of Bajaj Finserv Ltd, the financial services arm of the Bajaj Group. BAF is the largest financier of two-wheelers and consumer durables in India, with a presence also in other retail-lending segments such as consumer durable loans, personal loans, LAP, small business loans and LAS. Timeline of events

Year Event

1987 Incorporated as Bajaj Auto Finance Pvt Ltd, a captive financier for Bajaj Auto

1994 Initial public offering

1998 Registered with RBI as an NBFC; ventured into consumer durable financing

2006 Raised ~`2bn of incremental capital through preferential issue to promoters and FIIs

2007 Raised ~`5bn of incremental capital through rights issue and preferential issue. Mr. Rajeev Jain joins Bajaj Finance as the CEO.

2007-10 Diversified its product offerings and transformed itself from a captive financier to a multi-product retail financing NBFC

2010 Rebranded as Bajaj Finserv Lending and renamed as ‘Bajaj Finance Limited’

2012 `3.3bn of capital infused by Bajaj Finserv

2013 Raised `8bn of incremental capital through rights issue and conversion of warrants; also applied for a banking licence through the parent, Bajaj Finserv, but failed to receive it

Balance sheet

Year to March (` mn) FY15E FY16E FY17E

Networth 47,580 56,376 66,164

Borrowings 255,714 312,010 375,056

Total liabilities 303,294 368,386 441,219

Fixed assets 2,748 3,435 4,294

Investments 282 282 282

Loans and Advances 293,627 357,597 429,028

Cash and Bank Balance 8,545 8,545 8,545

Deferred tax assets 1,740 2,174 2,718

Net working capital (3,648) (3,648) (3,648)

Total assets 303,294 368,386 441,219

Key Ratios

Year to March FY15E FY16E FY17E

AUM growth (%) 22.0 21.8 20.0

Dil Consol EPS growth (%) 18.0 19.2 11.3

Net interest margin (NIM) (%) 9.8 9.6 9.3

Cost to income (%) 46.8 46.3 47.5

Opex (% of AAUM) 5.24 5.14 5.14

Gross NPAs (%) 1.2 1.2 1.2

Credit costs (% of AAUM) 1.21 1.32 1.41

Provision Coverage (%) 76.4 76.4 76.4

Capital adequacy (%) 19.0 18.6 18.3

Tier-1 (%) 16.0 15.6 15.3

Leverage (x) 6.3 6.5 6.6

AUM growth over FY09-14

Diluted EPS growth over FY09-14

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FY09 FY10 FY11 FY12 FY13 FY14

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FY09 FY10 FY11 FY12 FY13 FY14Diluted EPS (Rs)

73% CAGR57% CAGR

Bajaj Finance


A diversified NBFC with high profitability Bajaj Finance (BAF) has historically been a captive financing arm of its erstwhile holding company, Bajaj Auto, since 1987, financing its 2/3 wheeler sales. In late 1999, it forayed into financing of consumer durables. The company faced some turbulent times in 2006-2010 when its retail loan segment was under stress. However, since 2008, when BAF was demerged from Bajaj Auto, the thrust has been more on diversifying its loan book. Currently, ~56% of the loan book is SME loans and ~37% of the loan book is consumer loans, with the residual ~7% of the loans being wholesale loans.

A diversified lender across highly competitive segments Unlike other NBFCs (like M&M Finance and Shriram Transport Finance), BAF is not a niche lender and operates in various lending segments. In fact for most of its loan products, BAF is a new entrant in highly competitive segments that are traditionally dominated by banks. The exhibit below shows a brief synopsis of BAF’s loan book and the competition it faces from various market participants.

Exhibit 1: Business segments - Consumer finance and mortgages have been BAF’s growth drivers

Loan Product As a % of portfolio*

IRR (%) Year of

introduction AUM CAGR

(FY09-14) Ticket size range

Estimated RoA

Major competitors

Consumer Finance: 37%

38%

Two and Three Wheelers 13% 22-28% 1987 25% `30k-120k ~3%-3.5% HDFC Bank, Shriram City Union Finance, IndusInd Bank

Consumer Durables / Sales Finance

14% 24-26% 1999 53% `20k-100k ~1-2% Credit Cards issued by commercial banks, Capital First, Tata Capital, Shriram City Union Finance

Personal Loan Cross Sell 7% 22-35% 2007 40% `50k-5mn ~3%-4% HDFC Bank, ICICI Bank, Axis Bank, Standard Chartered, Citibank Salaried Loans 4% 14-20% 2012 102% `0.2mn-5mn ~2%-3%

SME & Business loans 56%

92%

Small Business Loans 9% 18-20% 2008 54% Upto `5mn ~3% HDFC Bank, ICICI Bank, Axis Bank, Kotak Mahindra Bank, IndusInd Bank, Standard Chartered, Citibank, Religare Finserv, Reliance Capital

Mortgages 43% 10.3-13% 2009 128% `10-150mn ~2%

Loan Against Shares (LAS)

4% 12-14% 2009 54% NA ~2%

Commercial Business 7%

76%

Vendor funding/PO financing

3% 10.5-12.5% 2011 58% `10mn onwards ~1%-2%

All banks and NBFCs Construction Equipment^ 1% 10-15% 2011 -9% `10mn+ ~1%-2%

Short term & Infrastructure Loan^^

2% 12-14% 2011 -16% `10mn+ ~1%-2%

Source: Company, Ambit Capital research. Note: * Portfolio as of 30 June 2014; ^ In process of winding down; ^^ Currently in pause mode.

From a rough ride to a dream run Over FY05-09, the company ran into a rough patch due to an increase in bad assets in the personal loans segment. During this period, its RoE declined from 22.6% in FY05 to 3.2% in FY09 and EPS declined by 28% CAGR over the same period.

However, the company has significantly turned around its business over the last five years, wherein BAF has demonstrated robust loan growth without any stress on asset quality. Higher loan growth supported by improvement in asset quality and operating efficiencies has resulted in robust EPS growth (73% CAGR) over FY09-14. This in turn has led to a stock rerating from 0.9x in FY10 to 2.6x one-year forward P/B at present.

BAF is a new entrant in highly competitive segments that are traditionally dominated by banks

BAF went through a rough phase over FY05-09 due to high delinquencies in personal loans but it has been witnessing a purple patch over the last five years

Bajaj Finance


Exhibit 2: BAF has hit a purple patch over the last five years after a rough period

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

NII 10.9% 10.2% 8.3% 10.0% 8.3% 11.5% 16.3% 13.8% 11.3% 10.8% 10.2%

Interest Income 14.3% 13.8% 12.5% 15.1% 14.2% 16.9% 21.8% 19.5% 18.1% 18.4% 17.4%

Interest Expense 3.5% 3.5% 4.1% 5.1% 5.9% 5.5% 5.4% 5.8% 6.8% 7.6% 7.2%

Other Income 3.8% 3.3% 2.9% 2.3% 3.3% 3.0% 2.9% 1.9% 1.6% 1.2% 1.3%

Net Income 14.7% 13.6% 11.3% 12.2% 11.6% 14.5% 19.2% 15.6% 12.9% 12.0% 11.5%

Operating expenses 5.9% 5.2% 5.4% 5.7% 6.7% 7.3% 8.6% 6.9% 6.1% 5.4% 5.3%

Operating Income 8.7% 8.3% 5.9% 6.6% 4.8% 7.1% 10.6% 8.7% 6.8% 6.6% 6.2%

Loan loss provisions 0.9% 1.7% 2.4% 3.5% 3.8% 5.4% 7.0% 3.1% 1.4% 1.1% 1.2%

PBT 7.8% 6.6% 3.5% 3.1% 1.0% 1.7% 3.6% 5.6% 5.4% 5.5% 5.0%

Tax 2.1% 1.0% 1.1% 1.0% 0.3% 0.6% 1.2% 1.9% 1.8% 1.8% 1.7%

PAT 5.7% 5.6% 2.4% 2.0% 0.7% 1.1% 2.4% 3.8% 3.7% 3.7% 3.3%

Leverage 3.4 4.0 4.2 3.1 2.8 2.8 3.3 5.2 6.5 5.9 5.9

RoE (%) 19.2% 22.6% 10.0% 6.3% 1.9% 3.2% 8.0% 19.6% 23.9% 21.9% 19.5%

PAT growth (YoY, %) 41% 32% -32% 25% -57% 69% 163% 176% 65% 46% 22%

Diluted EPS growth (YoY, %) 41% 32% -47% 5% -70% 63% 164% 176% 59% 26% 6%

AUM Growth (YoY, %) 15% 54% 65% 11% 20% 2% 59% 88% 73% 34% 37%

Source: Company, Ambit Capital Research

Exhibit 3: BAF’s high diluted EPS CAGR …


Exhibit 4: … has led to a rerating of the stock


Can the outperformance sustain?

With the stock getting significantly re-rated, the key question is whether BAF can sustain its growth and profitability not only in the near term but also in the long term. In the following sections, we have delved deep into BAF’s business model and its competitive advantages to see if the company’s current growth and profitability is sustainable in the near term and long term and whether the risk-reward is favourable for investors at current valuations.

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Bajaj Finance


Understanding BAF’s retail finance book BAF’s retail loan book (37% of the loan book) has been the key driver of not only its loan book growth (38% CAGR over FY09-14) but also its profitability. Strong competitive advantages in consumer durable financing business coupled with its relentless focus on cross-selling has enabled BAF to inexpensively originate customers for other highly profitable retail products.

Exhibit 5: A synopsis of BAF’s retail financing business (~37% of BAF’s AUM)

Loan Product As a % of

BAF’s portfolio*

Yields Year of

introduction AUM CAGR (FY09-14)

Estimated RoA

Competitive advantages

Two and Three Wheelers 13% 22%-28% 1987 25% ~3%-3.5% High penetration in Bajaj Auto’s 2-wheeler sales

Consumer Durables / Sales Finance

14% 24%-26% 1999 53% ~1-2% Innovative customer/dealer proposition, strong penetration

Personal Loan Cross Sell 7% 22%-35% 2007 40% ~3%-4% Cheaper origination costs due to cross-selling

Salaried Loans 4% 14%-20% 2012 102% ~3% Innovative customer proposition; cheaper origination costs due to digital platform

Overall 37% 24% 38% ~3.5-4%

Source: Company, Ambit Capital research. * Portfolio as of 30th June, 2014.

Economics of consumer durable financing Consumer durables/sales financing accounts for ~14% of BAF’s AUM and has exhibited a CAGR of 53% over FY09-14. The company has had a presence in this segment since 1999 (starting with the financing of computers), and its product range today consists of white consumer goods like LED TVs, washing machines, refrigerators, air conditioners and more recently cell phones. The following flowchart explains the working of its consumer financing business:

Exhibit 6: Process flowchart of BAF’s consumer durable financing

Source: Company, Ambit Capital research; Note: CC = Credit cards.

Bajaj Finance (BAF)

Customer

Manufacturer

Dealer

3. Customer approaches the dealer to buy a consumer durable.

2. BAF enters into tie-ups with various dealers of the manufacturer to finance its sales by enabling uptrading.

4. Dealer prefers its customers getting financed from BAF over CC, as it would save up to 2% interchage fees on the amount swiped by CC.

6. Post the loan approval, the amount is disbursed to the dealer within 2-3 days.

5. BAF does due-diligence based on various parameters like de-dupe tests, CIBIL scores, etc.

1. BAF enters into tie-ups with the manufacturer to finance its sales by offering the value proposition of enabling uptrading beyond the customer's CC limit.

7. BAF receives subvention fees from the manufacturer on the invoice amount depending on the downpayment and the model.

Bajaj Finance


To summarise the process in the exhibit, BAF’s consumer financing business works in the following way:

BAF has a tie-up with major white good manufacturers and major electronics retail chains wherein it has a physical presence at the dealer location.

Dealers prefer their customers to be financed through BAF, as they can then avoid credit card interchange fees that could go up to 2% in certain cases and also drive higher ticket-size purchases. Since financiers like BAF help increase the sales of dealers, BAF does not pay anything to the dealers.

Based on the customer’s credit appraisal, BAF finances the purchase of the customer and the customer pays BAF back in 6-12 monthly instalments. Customers generally do not pay any interest to BAF if there is a tie-up between BAF and the manufacturer. The manufacturer pays a subvention fee (which is 6-8% of the sale amount) to Bajaj Finance on the invoice value.

Credit appraisal driven by multiple filters BAF’s credit appraisal process relies primarily on the borrowers having credit cards and credit scores. In addition, BAF also has internal checks like de-dupe (identifies bad cases early) and application scoring (BAF’s internal credit scoring matrix). In case of absence of the credit history of the borrowers in CIBIL, BAF also uses credit surrogates such as residential proof, income documents etc for certain customers depending on the risk ranking of the dealers. We explain how BAF uses each filter for their credit appraisal:

CIBIL scores and credit cards swipe are primary defence: BAF instantaneously accesses the CIBIL score of the borrower before lending to the customer. Over and above that, BAF also tests the credit worthiness of the borrower and the validity of the credit card by insisting the customer to swipe the credit card for the down-payment. This check is useful, as the possession of a credit card is a sound indication of the credit worthiness of the borrower in the recent times as the underwriting standards of banks in credit cards have become stricter post the shakeout in retail lending in 2008.

Application scorecard and de-dupe tests: Application scorecard predicts the probability of the customer defaulting using various inputs on the prospective customer like his age, salary, nature of employment etc. De-dupe tests refer to a customer screening process which ascertains if the prospective customer has had any history with BAF and flags off black listed customers/fraud cases.

Surrogates and dealer ranking used for non-credit card customers: BAF uses surrogates like residential proof and income proof to ascertain the credit worthiness of the prospective borrowers, along with the dealer ranking to lend to customers without a credit card or a CIBIL score. The management highlights that such non-credit card customers would be accounting for ~23% of the incremental customer acquisition in consumer durable segment.

Meaningful market share in a growing opportunity Banks have stayed away from the consumer durable financing segment directly due to the fragmented dealer network, lack of scalability and high operating costs involved in this business apart from high credit costs in an unfavourable cycle. However, through credit cards, banks enjoy a high market share in this segment. Based on various estimates, the size of the consumer durable financing market is roughly around ~`137bn (~30% of total consumer durable sales of `455bn in India). BAF estimates its market share in consumer electronics sales to be ~15%.

BAF uses CIBIL score and its internal technological platform to access the creditworthiness of the borrowers

Bajaj Finance


Exhibit 7: Delinquency levels in consumer durable financing

Source: Company, Ambit Capital research; Note: Delinquency is defined as receivables overdue for more than 1 day.

Exhibit 8: BAF dominates the financing segment

Source: Company estimates

With the penetration of consumer durables mostly confined to the cities (urban areas account for 65% of consumer durable sales in India), non-urban India is likely to contribute meaningfully to incremental growth in the future.

But a tough business to generate profitability from High yields notwithstanding, consumer durable lending is a tough business to generate profitability from on a standalone basis. To illustrate, whilst BAF generates IRR of ~26% in consumer durable lending, its final profitability is very low due to the high operating costs (~12-13%) in this segment. Higher origination costs and higher technology costs lead to higher operating expenses and hence low RoAs in this business with RoEs at ~10-12%. However, BAF compensates for low returns in the consumer finance business by cross-selling other high-return products like personal loans, business loans, etc to the same set of customers, saving on originating costs of up to ~3% of disbursal amount, thus making the business attractive on a consolidated basis.

Cross-selling drives profitability After testing credit track records, BAF cross-sells non-salaried and salaried personal loans to its consumer durable finance borrowers. The pricing of loans is done based on data analytics to factor in the risk characteristics of the borrower.

Cross-sold personal loans currently account for 7% of BAF’s loan book and yield ~26-28%. Salaried personal loans account for 4% of BAF’s loan book, bearing yields of ~14-15%. This cross-selling not only saves origination cost (of up to 3.0% of the loan amount) but also leads to lower credit costs (as these loans are given to existing customers with a track record), thus making the business attractive on a consolidated basis. Hence, though consumer durable finance forms only ~14% of BAF’s total loan book and generates RoAs of only ~1-2% on a standalone basis, it’s the backbone of BAF’s retail finance business.

Two/three-wheeler financing driven entirely by parent BAF is one of the largest financers of two wheelers in India. It finances two/three wheeler sales of only its parent, Bajaj Auto. Consequently, its disbursement growth has more or less tracked the domestic sales of Bajaj Auto. BAF currently contributes to 30% of Bajaj Auto’s domestic two-wheeler sales and 27% of its three-wheeler sales. The segment’s higher yields compensate its higher delinquencies, thus helping it generate RoAs of 3-3.5%. We expect BAF’s two/three-wheeler book to track the growth of its parent, Bajaj Auto.

2.2% 2.2%

1.8%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

FY12 FY13 FY14

15%

3%

9%

35%

38%

Consumer durable sales - Estimated market share

BAF

Other NBFCs

Credit cards -EMI loans

Credit cards

Cash

Despite not being very profitable on a standalone basis, consumer durable finance is the backbone of BAF’s retail finance business as it helps the company to originate other loans at much lower costs

Cross-selling of personal loans to the existing overall retail business is attractive for Bajaj Finance

Bajaj Finance


Exhibit 9: BAF tracks Bajaj Auto’s sales volumes

Source: SIAM, Company, Ambit Capital research

Moreover, higher profitability in 2Ws/3Ws also leads to robust profitability in the retail segment, with blended RoAs in the consumer finance business at ~3.5%. The exhibit below estimates the blended profitability of the retail finance business.

Exhibit 10: Estimated blended profitability of retail finance business (%)

Loan Product Consumer durables

Personal Loans -

Salaried

Personal loans -

cross-sell

2W/3W financing

Combined

NII 18.0 7.0 16.0 18.0 16.4

Interest Income 26.0 15.0 24.0 26.0 24.4

Interest Expense 8.0 8.0 8.0 8.0 8.0

Operating expenses 14.6 3.0 3.0 4.0 6.8

Operating Income 3.4 4.0 13.0 14.0 9.6

Loan loss provisions 2.0 0.5 4.0 8.0 4.6

PBT 1.4 3.5 9.0 6.0 4.9

Tax 0.4 1.1 2.7 1.8 1.5

ROA 1.0 2.5 6.3 4.2 3.5

Leverage 7 7 7 7 7

RoE (%) 7.0 17.2 44.1 29.4 24.2


38% 34%

6%

-3%-15%

74%

49%

31%24%

-5%-20%

0%

20%

40%

60%

80%

FY10 FY11 FY12 FY13 FY14

YoY growth (%)

Bajaj Auto 2/3 wheeler volumes Bajaj Finance 2/3 wheeler disbursements

Bajaj Finance


Differentiated SME lender in a competitive market BAF has been able to deliver a robust performance in a crowded SME segment due to its strong customer proposition through faster turnaround time and cross-selling through digital channels. The robust cross-selling platform has not only helped BAF to penetrate this market without compromising on credit underwriting but has also helped BAF to: (i) maintain customer stickiness in a market characterised by high churn due to DSA commissions and regulatory changes and (ii) maintain lower origination costs by incrementally avoiding the costly DSA route.

BAF’s SME loans comprise LAP, small business loans and loans against securities. Whilst LAP is a secured product with ticket sizes of at least `10mn, small business loans are unsecured loans to the self-employed segment (both professional and non-professional) with a maximum ticket size of `5mn. LAP accounts for a lion’s share of SME loans with 77% share.

Exhibit 11: A synopsis of BAF’s SME financing business

Loan Product As a % of

BAF’s portfolio IRR

Year of introduction

AUM CAGR (FY09-14)

Estimated RoA

Competitive advantages

Small Business Loans 9% 18-20% 2008 54% ~3% Innovative customer proposition, strong penetration, cheaper origination costs due to digital channel

Mortgages 43% 10.3-13% 2009 128% ~2% Innovative customer proposition, cheaper origination costs due to cross-selling

LAS 4% 12-14% 2009 54% ~2%

Overall 56% 13% 92% 2-2.5%

Source: Company, Ambit Capital research; * Portfolio as of 30th June, 2014.

BAF competes with banks in LAP The mortgage business consisted of 43% of BAF’s AUM as at FY14 and has exhibited a CAGR of ~128% over FY09-14 since BAF entered into this segment in 2009. Out of total mortgage loans in FY14, 30% were home loans and 70% were loans against property (LAP). Whilst yields are lower in this product (~12-13% vs 26% on consumer loans), lower credit costs and lower operating expenses due to economies of scale means that profitability is still reasonable in this product (RoE of ~12-14%). The exhibit below articulates the estimated profitability of BAF’s LAP lending business.

Exhibit 12: Estimated profitability of BAF’s LAP lending business

Particulars (%)

NII 5.0

Operating expenses 1.5

Operating Income 3.5

Loan loss provisions 0.5

PBT 3.0

Tax 0.9

PAT 2.0

Leverage 7

RoE (%) 14.0

Source: Ambit Capital research

Our discussion with the BAF management indicates that BAF operates in a highly competitive low-risk segment which is dominated by banks. This is further validated by our channel checks which reveal that BAF faces more competition from banks rather than NBFCs in the LAP segment it operates in. The exhibit on the next page buckets the key metrics in LAP financing as per their risks and BAF’s positioning as per our channel checks.

Bajaj Finance


Exhibit 13: Bucketing of key risk metrics in LAP financing and BAF’s positioning (in dotted area)

Source: Ambit Capital research; Note: FOIR – Fixed obligation income ratio; Higher FOIR implies a more leveraged borrower.

Recent incident of ever-greening by employees is unexpected but portfolio continues to be robust …

Media reports (http://goo.gl/4fFCsB) highlighted that BAF, based on a whistle-blower complaint, had identified fraudulent connivance between a few senior employees and some delinquent customers in its LAP business which was going on for around 10 months. Whilst all loans were backed by security and hence the economic loss may be negligible, the company has already provided ~`50mn as per its own policies (BAF maintains a more stringent provisioning policy over RBI norms) which is ~1-2% of its PAT.

We believe that such frauds with employee involvement are not uncommon in NBFCs, as collections for most NBFCs are done by the same employee who originates the loan. But, what has surprised us in the BAF case is the quantum of fraud and the involvement of employees at such a senior level in an organisation which uses cutting-edge technology for fraud detection on its consumer loans portfolio. That being said, we believe that such a fraud in BAF is an operational issue (process risks) rather than reflecting anything adverse on its credit appraisal or quality:

Even post the fraud, BAF’s collections on the LAP book remain fairly robust at 99.52%. Further, BAF is the only NBFC that transparently discloses bucket wise delinquencies in all of its loan portfolios and provides for NPAs on 90 day recognition norm.

Our channel checks indicate that BAF continues to be one of the most conservative lenders in the LAP market in terms of its collateral preference, LTVs and target customers. Such a fraud does not indicate any widespread problem across its portfolio or a bad credit appraisal.

BAF’s differentiation in small business loans

BAF’s small business loans consist of unsecured loans to the self-employed segment (both professional and non-professional) with a maximum ticket size of `5mn. Currently, this segment accounts for 9% of its AUM, and has recently started offering end-to-end online approval of unsecured small ticket business loans and is the only NBFC to do so. As BAF’s online origination scales up, BAF would save DSA commissions of ~2-3% of the disbursal amount.

Occupancy LTVs Ticket Sizes (Rs mn) FOIR Yields

ResidentialResidential: 50-60%

Commercial: 45-50%Industrial: 40-45%

20-50 70-100% 12-13%

CommercialResidential: 60-70%

Commercial: 50-55%Industrial: 45-50%

0.5-20 100-200% 13-15%

Industrial/ Rural/ Farmhouses

Residential: 70-80%Commercial: 55-60%

Industrial: 50-55%Less than 0.5 200%+ 15%+

Legend:Lower risk: Medium risk:

Higher risk: BAF domain:

Such fraud in BAF is an operational issue rather than reflecting anything adverse on its credit appraisal or quality.

Bajaj Finance


Small business loan customers are then cross-sold LAP. Such cross-selling helps BAF avoid the costly DSA route of acquisition of LAP customers, wherein the intermediate costs range between 0.8% and 1.2% of the loan amount disbursed. Currently, small business loans have cross-sold ~15-18% of BAF’s LAP which the management is targeting to increase to 50% by FY16. Given the removal of pre-payment penalty on such loans in May 2014, we believe that self-origination would be a key competitive strength for BAF going forward.

BAF’s competitive advantages have driven its robust profitability … When Rajeev Jain took charge as CEO in September 2007 (FY08), BAF was predominantly a captive financer with company struggling with declining earnings and low single digit ROEs. However, the change in management triggered some key changes which led to the incubation of BAF’s competitive advantages, as articulated in the exhibit below.

Exhibit 14: Impact of the new management - Before and After

Driver Before FY08 Post FY08

Cross- selling

Used to predominantly offer three products - two-wheeler loans, consumer durable loans and personal loans.

Product suite has expended to ~7 lending based and ~8 fee based products. On an average, BAF cross-sells 2.2 products per retail customer and 3.14 products per SME customer.

Turn-around time (TAT)

3 day TAT in consumer durable financing

TAT in consumer durable financing has come down to 3 minutes for first time customers due to 100% POS link up through cloud computing. TAT is nil for repeat customers due to EMI card.

Innovation

Products were mostly off-line presumably due to lack of ecosystem for online lending. However, lack of innovation led to BAF being subject to severe competition from other banks and NBFCs in FY04-08.

BAF is one of the few lenders offering online end to end appraisal and disbursement process for personal loans and unsecured loans. Apart from that BAF is a case study in terms of innovative products or channel for distribution.

Customer acquisition (non-2wheeler business)

Whilst incremental unique customer acquisition (ex-2wheelers) had multiplied over a small base in FY04-08, it declined at 5% CAGR over FY06-08, due to adverse retail cycle and absence of credit bureaus.

BAF’s incremental unique customer acquisition (ex-2wheelers) has grown at a healthy rate of 21% CAGR over FY08-14 driven by: introduction of new products and new channels (eg. digital) and instant verification of the credit score at POS that has reduced the TAT.


Over the years, BAF has built strong competitive advantages on customer acquisition, cross-selling and loan origination, which have ensured robust growth and profitability for the company. These advantages have helped the company deliver a robust 58% AUM CAGR in FY10-14, with RoEs improving from 8% in FY10 to ~19% in FY14.

The underlying strengths which drove such robust profitability growth are:

Strength#1: A robust customer acquisition engine - consumer durable financing

Strength#2: Superior cross-selling architecture

Strength#3: Superior products and service

In the following sections, we discuss BAF’s strengths in greater detail.

Given the removal of pre-payment penalty on LAP, we believe that self-origination would be a key competitive strength for BAF going forward

Bajaj Finance


Strength# 1: A robust customer acquisition engine - consumer durable financing BAF’s consumer durable financing scores over credit cards by: (i) enabling savings to the dealer; (ii) providing higher limits to the customer along with ease of repayment over time; and (iii) affording a cheaper and convenient loan structure. This amplifies BAF’s competitive advantages of: (i) strong distribution channel in a fragmented OEM-dealer ecosystem and (ii) strong brand amongst the dealer community; thus enabling BAF to inexpensively acquire a large and high-quality customer base.

How BAF scores over credit cards Given that BAF mostly give loans to customers who have a credit card, there is a big threat that the customer could use its credit card for purchase rather than taking a loan from BAF. However, BAF has the following competitive advantages over credit cards:

Savings for the dealer: The dealers would prefer their customers getting financed through non–credit card sources as they have to pay interchange fees on credit card transactions that could go up to 2% in certain cases. Thus, getting their customers financed from BAF instead of credit cards would imply savings of up to 2% for the dealers on the swiped amount.

Higher limits for the customer: Given that the average credit card outstanding in India is ~`25K vs the price of consumer durable goods (like LCD/Plasma TV) which ranges around ~`40K-`100K, using a credit card would imply using a meaningful limit of the credit card, which otherwise could be preserved for emergencies. Hence, there is an incentive for customers to take finance from lenders like BAF vs using their credit cards.

Cheaper and convenient loan structure: Our channel checks indicate that consumer durable loans from banks are more expensive than BAF, as BAF gets subvention from the manufacturer whereas banks do not. If a customer pays through a credit card, then the customer would have to pay back the money in the next 30 days. However, a loan from BAF could be repaid over 6-12 months in equated monthly instalments.

Distribution channel and brand are BAF’s competitive advantages Our competitive assessment through channel checks suggests that BAF is placed favourably in consumer durables financing as compared to banks and other NBFCs due to the following competitive advantages:

Strong distribution channel in a fragmented ecosystem: Given that the manufacturer pays a subvention fee to the financier to enable a sale and the customer decide to buy a product at the time of visiting a store, we believe that tie-ups within the vast ecosystem of manufacturers and fragmented dealers along with the presence at the point of sale is a major competitive advantage in the consumer durable financing segment. BAF has the highest dealer touch-points (more than 4,000) amongst banks and NBFCs. Such scale and network with fragmented touch-points help BAF to negotiate better terms with the manufacturer. Whilst many banks offer personal loans to buy consumer durables, given that they charge an interest rate to the borrower and are not present at the point of sales, they are relatively disadvantaged vs BAF.

Strong brand amongst the dealer community: Brand is important for a financer to partner with a much fragmented dealer community. BAF has indisputably enjoyed a strong brand name by virtue of it being focused in the consumer durable financing business for almost 15 years even across the toughest of times. On the contrary, banks have frequently been in and out of the consumer

Dealers prefer customers take a loan from BAF rather than swiping credit card as it saves them 2% interchange fees

Interest free loan for 6-12 month duration gives an incentive to customer to take a loan from BAF vs using its credit card

Huge scale and a strong network with fragmented dealers help BAF to negotiate better terms with the manufacturers

Banks have frequently been in and out of the consumer durable financing business, as this segment was too small for banks to focus on

Bajaj Finance


durable financing business, as this segment was too small for banks to focus on. To offer a perspective, with a market size of ~`137bn, even at a 100% market share, consumer finance would amount to only 4-5% of the existing loan book of ICICI Bank and HDFC Bank. A strong brand gives dealers a higher comfort to partner with BAF rather than a new entrant or a smaller NBFC.

Exhibit 15: Competitive assessment of the various players in the consumer durable financing industry

Particulars BAF Other NBFCs

Banks Comments

Distribution reach

BAF has the highest dealer touch-points (more than 4,000) followed by Capital First (more than 1,000) and SCUF (more than 30) in the top-20 cities we have analysed. Such scale and network with fragmented touch points help BAF to negotiate better terms from the manufacturer.

Pricing structure

Our channel checks indicate that since banks do not usually get subvention from the manufacturers, they generally would be more expensive than NBFCs which get subvention.

Brand recall across the fragmented dealer segments

Brand is important for a financer to partner with in a much fragmented dealer community. BAF has indisputably enjoyed a strong brand by virtue of its focus in the consumer durable financing business for almost 15 years now and even during the toughest of times. On the contrary, banks have frequently been in and out of the consumer durable financing business.

Source: Ambit Capital research; Note: - Strong, - Relatively strong, - Average, - Weak

Such competitive advantages of BAF’s consumer-durable financing franchise have enabled it to originate a very high-quality large customer base, as evidenced by the EMI card customer base below, wherein BAF has a higher number of EMI cards than credit cards of even few large banks.

Exhibit 16: Credit/EMI card customer base of retail financers


5.3

3.3 2.9

2.1

1.5

0.4 0.3

-

1.0

2.0

3.0

4.0

5.0

6.0

HDFCB ICICIB SBIN BAF AXSB KMB IIB

mn

The EMI card acts as a customer retention tool of BAF’s consumer durable financing business to prevent its customers from migrating to other lenders/credit cards; as 55% of BAF’s retail customers are repeat customers, EMI Card acts as a customer retention strategy

Bajaj Finance


Exhibit 17: Porter analysis of BAF’s positioning in consumer durable financing


Competitive intensity

LOW

With Capital First being the only meaningful competitor, its dealership presence is one-fourth and loan book is one-seventh of BAF. Nonetheless, competitive intensity should only increase going forward, as there are only 2 players this cycle vs 7 players in the past cycle.

Banks would prefer staying out of this segment as it is too small a market for a large bank to poach. It will take 3-4 years just to build a `10bn book.

Threat of substitution

HIGH

Credit cards remain a meaningful threat owing to the overlapping of the customer base, greater transactional convenience and no down-payments.

However, BAF is trying to protect its customer base by introducing the EMI card, which acts almost as a credit card for his next consumer durable purchase. Note that ~55% of its customers are repeat customers.

Barriers to entry

HIGH

Building a large dealer network is a time-consuming affair due to its fragmented nature.

Quick on-the-spot delivery of the service requires involvement of highly technological and automated processes which implies heavy opex.

Deteriorating Unchanged Improving

Bargaining power of manufacturers

LOW

Industry estimates suggest that ~20-30% of consumer durable sales are financed. Consequently, given the absence of banks in this segment and Bajaj Finance’s proposition to finance over the credit card limit of the borrower, bargaining power of manufacturers is low.

BAF (with >4,000 dealers) has the best network in fragmented consumer durable dealers vs its peer Capital First (>1,000 dealers). Also, BAF is practically the sole financer in most of the tier-1 dealerships (Croma, E-zone, Vijay Sales). However, with competitors like Capital First catching up with BAF by tying up with more manufacturers and dealers, we believe that the bargaining power of manufacturers and large dealers would only increase going forward.

Bargaining power of borrowers

LOW

Given the hitherto solitary presence of BAF across the widely fragmented dealer network, consumers seeking financing over their credit card limit have very low bargaining power.

However, with competitors like Capital First catching up with BAF by tying up with more dealers and penetrating deeper into the Tier-1 dealership space, we believe that the bargaining power of borrowers would only increase going forward.

Bajaj Finance


Strength#2: Superior cross-selling architecture BAF enjoys a superior cross-selling architecture driven by a diversified and synergistic product base, robust analytics and employee orientation. Such architecture has enabled BAF to retain more customers, lower its originating costs and improve its fee income.

Why is BAF’s cross-selling architecture superior? We believe BAF enjoys a superior cross-selling architecture driven by a diversified and synergistic product base, robust analytics, and cultural and employee orientation, which would be difficult for other NBFCs to replicate.

Exhibit 18: BAF has a superior cross-selling engine as compared to other NBFCs

Requirements Other NBFCs Bajaj Finance

A diversified and synergistic product base

Most of the other NBFCs lack a broad synergistic product base as they are niche mono-line financers (auto or home loans). Most of them do not have fee-income products.

BAF has one of the most diverse product bases synergistic to its target customers. Cross-selling extended warranty and personal loan to a consumer durable borrower is easier than cross-selling an auto loan or an SME loan to a CV loan customer.

Robust analytics

A robust cost-effective cross-selling platform requires robust analytics of customers in terms of their credit history and preferences and past customer behaviour. Our discussions with NBFCs suggest that: (i) Most NBFCs have not reached that stage of evolution to standardise and templatise the customer need as most of their customers are first-time customers; (ii) Mono-line NBFCs are not keen to invest heavily on analytics as these customers eventually migrate to banks.

Whilst other NBFCs mainly deal with first-time customers, BAF’s customer base mostly deals with customers who have had a banking relationship before. Consequently, BAF through its analytical platform partnership with Equifax has a fair sense of customer preferences.

Cultural and employee orientation

Employees of NBFCs are more specialised as compared to employee of banks wherein one bank employee deals with many products. Thus, traditionally NBFCs have not been that focussed on cross-selling as their profitability targets are anyway met by their focus on niche lending products wherein they enjoy high pricing and there is still further growth left due to increased penetration.

BAF’s focus on cross–selling is reflected not only in its business model but also in the incentive structure of its employees.

Source: Company, Ambit Capital Research

Cross-selling benefits BAF on multiple fronts Such unique cross-selling helps BAF on the following multiple fronts:

Higher customer retention: The higher the customer penetration by a financer, the higher the switching cost for the customer. Hence, a lender that cross-sells more is less likely to be displaced by the competitor. This ensures a higher tenure for a loan book due to customer stickiness despite the lower duration and ticket sizes of the product. Hence, BAF has a higher rate of customer retention in a hyper-competitive segment like LAP/personal loans that are characterised by churning by DSAs.

Lower originating costs: Cross-selling its diverse products to its vast customer base leads to lower originating costs in a business traditionally characterised by high origination costs. BAF saves ~0.8-3% of the loan amount on every loan it cross-sells.

Higher fee income contribution: BAF could generate higher fee income from its vast customer touch-points of 6.4mn customers. Fee income currently accounts for 30bps of BAF’s total assets and we estimate such fee income would go up to 60bps of total assets by FY16, as BAF’s cross-selling capabilities improves, in line with the management’s guidance.

BAF would save ~0.8-3% of the loan disbursement on every loan it cross-sells

Higher product penetration by the financer implies higher switching cost for the customer

Bajaj Finance


Adding value to its large retail customer base BAF’s cross-selling architecture discussed above adds a lot of value to its huge retail customer base that it has built over its 15-year presence in consumer financing. Such a huge customer base is then used to cross-sell its wide array of various other fee-based and lending-based products, after testing for their credit track records. Whilst the concept of cross-selling may seem very straightforward to understand, it is very difficult to implement and scale up in a cost-effective way. The key proposition of cross-selling lies in origination of the right customers at the right time at the right price.

BAF uses its huge customer base of ~6.4mn (excluding two-wheeler financing) to cross-sell its various other fee-based and lending-based products. Thus, consumer durable financing is a key strategic tool for customer acquisition for BAF’s other products.

Exhibit 19: BAF’s cross-selling product matrix

Source: Company, Ambit Capital research. Note: Products in red font denote fee-based products and those in black denote lending-based products (except deposits). Products shaded in grey denote the cluster of products offered to customers originated through consumer durables financing. Products within the dashed border denote the cluster of products offered to customers originated through LAP/small business loan financing.

Consumer Lending Small Business Lending Wealth management Distribution Services↓ ↓ ↓ ↓

Consumer durables Business Loans Term Deposits CRISIL RatingEMI Card Loan Against Property Life Insurance Distribution Co-Branded Credit CardsPersonal Loans Home Loans General Insurance Distribution Property Search ServicesHome Loans Loan Against Securities Mutual Fund Distribution Financial Fitness Report

Lease Rental Discounting

Key proposition of cross-selling lies in origination of the right customers at the right time at the right price

Bajaj Finance


Strength#3: Superior products and service Our channel checks suggest that BAF has a superior product and customer service proposition rooted in innovation and faster turnaround time. This has driven its penetration in a high-quality but commoditised customer segment.

BAF has built a strong customer proposition based on innovation (both in products and distribution channel) and faster turnaround time (amongst the best in the industry) that has driven its penetration in an over-crowded retail segment dominated by private and foreign banks alike. In the exhibit below we highlight how such advantages help BAF penetrate in each and every segment of its loan book.

Exhibit 20: Channel checks indicate that innovation and faster turnaround time drive BAF’s strong customer proposition

Loan Innovative products and channels Turnaround time

LAP

BAF’s FlexiSaver product competes with current account/cash credit/overdrafts offered by banks as the borrower gets the flexibility to not only pay back the loan anytime but also borrow it back whenever he wants to.

Before the scrapping of prepayment penalties on floating rate products by the RBI, BAF was the only lender not charging any prepayment or foreclosure charges on LAP.

BAF is the most prepared NBFC in terms of retaining its customers through strategies like deepening relationships through cross-selling of SME loans and other fee-income products besides matching the rates. One manager in a mid-sized bank conceded that they do not take refinance cases from Bajaj Finance, as there is a little chance of it not being retained by BAF.

Our channel checks indicate that at 7-10 days, BAF has one of the fastest turnaround times amongst its banking and NBFC peers. This becomes strategically important, as normally the DSAs would approach 2-3 lenders to get their loans sanctioned and the lender which approves the fastest would be preferred by the DSA even if the DSA commissions are slightly lower.

Small Business Loans

BAF has recently started offering end-to-end online approval of unsecured small ticket business loans. It is currently the only NBFC to do so. Online origination would save BAF DSA commissions of ~2-3% of the disbursal amount.

Small Business loan customers are then cross-sold LAP. Such cross-selling would help BAF avoid the costly DSA route of acquisition of LAP customers, wherein the intermediate costs range between 0.8% and 1.2% of the loan amount disbursed.

Currently this small business loans account for around 15-18% of BAF’s LAP. However, the management is targeting to increase the share of this channel to 50% by FY16. Given the removal of pre-payment penalty on such loans in May 2014, we believe that self-origination would be a key competitive strength for BAF going forward.

At 5-minute approval turnaround time and 48-72 hours of disbursement turnaround time, BAF’s turnaround time is one of the fastest in the unsecured business loan segment.

Personal loans – Salaried

BAF is the only NBFC offering end-to-end online approval of salaried personal loans. BAF is the only lender not charging any prepayment or foreclosure charges on

personal loans.

At a 5-minute approval turnaround time and 48-72 hours disbursement turnaround time, BAF’s turnaround time is one of the fastest in the salaried personal loan segment.

Home Loans

Provides a flexible option of having the three months EMI holiday to poach refinance customers from banks/HFCs.

Offers bundled products like property search and interior design consultancy services that differentiate itself from the rest of its peers.


We believe such a strong customer proposition drove BAF’s robust growth in commoditised segments without the need to dilute the underwriting standards as it poached market share from banks (refer to the exhibits below).

Exhibit 21: BAF’s growing market share across segments…


Exhibit 22: … including personal loans


11%

7%

10%

14%

7%

11%

15%

8%

15%

0%

2%

4%

6%

8%

10%

12%

14%

16%

CD Finance Small BusinessLoans

LAP

FY12 FY13 FY14

93%

63%58%

36% 35%

21%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

ICICIBC BAF AXSB KMB IIB HDFCB

FY12-14 CAGR

Bajaj Finance


Unique strengths vs long-term challenges – Beyond the ‘halo effect’ The competitive advantages mentioned in the previous sections coupled with execution capabilities have helped BAF penetrate in highly competitive businesses. However, the following challenges pose a risk to BAF’s sustainability of earnings on a cross-cycle basis:

Challenge#1: Low credit costs unlikely to sustain across cycles

Challenge#2: Vulnerability to competitive pressures

Challenge#3: Closing regulatory arbitrage between banks and NBFCs

Challenge#4: Change in customer preferences

Bajaj Finance


Challenge#1: Low credit costs unlikely to sustain across cycles BAF’s credit costs have trended downward over FY09-14 driven by multiple tailwinds. However such low credit costs would be difficult for BAF to sustain on cross-cycle basis, as: (i) it lacks control over the cash flows of a personal loan customer; (ii) it lacks protection of SARFESI in LAP; and (iii) credit costs have bottomed out in a fast-growing unseasoned book.

BAF reported a remarkable decline in credit costs over FY10-14, with credit costs declining from the peak of 7.9% in FY10 to 1.2% in FY14. Such a decline was primarily driven by: (i) increase in the share of low-risk LAP in its book (from 7% in FY09 to 41% in FY14); (ii) advent of credit bureaus like CIBIL that has resulted in improvement in the credit quality in consumer loans from historical levels; (iii) BAF’s internal initiatives on improving its analytics platform that have resulted in higher quality origination, underwriting and appraisal process; and (iv) a favourable asset quality environment for all consumer lenders in India despite the significant slowdown in the Indian economy.

Exhibit 23: BAF’s gross and net NPAs have declined over FY09-14...


Exhibit 24: …lower credit costs despite higher provisioning coverage


However, we expect overall credit costs to increase from the current levels, as credit costs in both consumer loans and LAP are at historically low levels and are unlikely to sustain at the current levels on a cross-cycle basis.

Lack of control over cash flows of the personal loan borrower: In terms of personal loans, BAF does not have access to a liability-based relationship (eg. salary account) with a customer, unlike banks. Hence, lack of control over the cash flows of the borrower would imply higher credit costs for BAF compared to banks in this segment. The exhibit below demonstrates how BAF’s NPAs in retail consumer loans (personal loans, consumer durable loans and credit cards) is higher than that of banks.

15.6%

7.6%

3.0%1.2% 1.1% 1.2%

11.8%

3.7%0.8% 0.1%

0.2% 0.3%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%


Gross NPA (%) Net NPA (%)

29% 32% 55% 73% 89% 83% 76%

4.8%

6.5%

7.9%

3.5%

1.5% 1.2% 1.2%

0%10%20%30%40%50%60%70%80%90%100%

0.0%

1.0%2.0%

3.0%

4.0%5.0%

6.0%7.0%

8.0%

9.0%

FY08 FY09 FY10 FY11 FY12 FY13 FY14

Provisioning Coverage ratio (%) (RHS)Credit costs as a % of AUM (LHS)

Bajaj Finance


Exhibit 25: BAF’s NPAs in retail consumer loans is higher than that of banks

Source: Company, Ambit Capital research; Note: Retail consumer loans include credit cards, consumer durable loans and personal loans for banks and BAF.

Credit costs could increase in LAP segment on cross-cycle basis: Our channel checks suggest that BAF lends at a higher FOIR (fixed obligation income ratio) than banks. Thus, its asset quality is more dependent on the recoverable price of the collateral rather than the cash flows of the borrower. Whilst BAF mitigates such risk by keeping a lower LTV as compared to its peers, BAF lacks protection of SARFESI in recovering the loan dues in case of default. Hence, unexpected volatility in the cash flows of the borrower could severely impair the gestation period and recoverable amount. Hence, we believe it would be imprudent to extrapolate the current trends in LAP as sustainable trends on cross-cycle basis.

Unseasoned book that has grown fast: BAF has seen phenomenal growth in its loan book over the last 3-4 years which has been much higher than the industry average. History has shown us that more often than not, periods of high growth have been followed by periods of sudden and significant jump in NPAs for lenders. Hence credit costs increasing going forward cannot be ruled out.

Exhibit 26: BAF’s growth in the LAP segment has been higher than its competitors


Exhibit 27: BAF’s unsecured retail loan growth has been higher than its banking peers


Hence, we believe that BAF’s asset quality would remain highly leveraged to the retail and real estate cycle and we anticipate a meaningful increase in credit costs for BAF should either the retail or real-estate cycle turn hostile.

However, we are yet to see any stress in the retail asset quality for Indian banks/NBFCs and hence for BAF. Hence, we factoring in only a ~20bps increase in credit costs for BAF in FY14-17, resulting in an increase in credit cost to 1.4% by FY17E from 1.2% in FY14.

1.3%

0.5%

1.1%1.1%

0.6%

0.9%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

BAF HDFC Bank IIB

Retail consumer loans* - NPAs

FY13

FY14

114%

39%29% 27%

0%

20%

40%

60%

80%

100%

120%

BAF Chola Indiabulls Religare

FY11-14 CAGR54% 53%

43%

36% 36%

25%

0%

10%

20%

30%

40%

50%

60%

BAF AXSB ICICIBC KMB IIB HDFCB

FY12-14 CAGR

BAF does not have access to a liability-based relationship (eg. salary account) with a customer, unlike banks; hence, lack of control over the cash flows of the borrower would imply higher credit costs for BAF as compared to banks in this segment

Lower LTVs notwithstanding in LAP, lack of SARFESI protection could severely impair BAF’s recoverable time and amount, in case of default; this could lead to much lower than anticipated IR` in LAP

Bajaj Finance


Challenge#2: Vulnerable to competitive pressures BAF’s growth and earnings sustainability is vulnerable to competitive pressures as it competes head to head with banks. Whilst competition is already intense in the personal loans and LAP segment, a further pressure on pricing cannot be ruled out in these segments in the near term.

Given that BAF mostly operates in the segments which are crowded by banks and other NBFCs, we believe that BAF is comparatively more exposed to competitive pressures as compared to specialised NBFCs.

Competition already intense over the past two years

In fact, in LAP and personal loan segment, the competitive intensity has already been increasing over the last two years. With growth in large corporate loans slowing down, banks have been focussing on personal loans and mortgages to grow their loan books. Consequently, yields in LAP and personal loans have declined by ~150-200bps over the past 2 years.

Exhibit 28: Competitive intensity has driven down loan against property yields

Source: Ambit Capital research; Media reports, surveys

Exhibit 29: Competitive intensity has driven down salaried personal loan yields

Source: Ambit Capital research; Media reports, surveys

PSU banks pose risk to further competition in the LAP segment

Despite the yields coming down over the last two years, there is further headroom for rates to further come down in this LAP segment. The exhibits below show that the pricing band in the LAP segment is ~150bps vs ~20bps in home loans.

Exhibit 30: Pricing band in LAP is broad at ~150bps

Source: Ambit Capital research, surveys, Apnapaisa

Exhibit 31: Pricing band in home loans is narrow at ~20bps

Source: Ambit Capital research, survey, Apnapaisa

13.0%

11.5%

10%

11%

11%

12%

12%

13%

13%

14%

FY12 FY14

Minimum rates - LAP (prime)

15.0%

13.0%

10%

11%

12%

13%

14%

15%

16%

FY12 FY14

Minimum rates - Salaried loans (prime)

11.5%

12.2%

12.5%12.7%

13.0% 13.0%

10.5%

11.0%

11.5%

12.0%

12.5%

13.0%

13.5%

Foreignbanks

HDFC BAF New Pvtbanks

SBI PSUBanks

10.05% 10.15% 10.25% 10.20% 10.15% 10.22%

8.0%

8.5%

9.0%

9.5%

10.0%

10.5%

Foreignbanks

HDFC BAF New Pvtbanks

SBI PSUBanks

Bajaj Finance


To put things in perspective, the LAP segment has been one of the fastest-growing lending segments for banks/NBFCs over the last 4-5 years. Ever-increasing real estate prices (~10% CAGR over the last five years) have been one of the major drivers of growth in this segment. Currently, the LAP market is predominantly dominated by private sector banks (Kotak Mahindra and HDFC Bank), foreign banks (Standard Chartered and Citi) and NBFCs (Bajaj Finance, Indiabulls, etc).

Exhibit 32: Five-year CAGR of real estate prices in the top cities of India

Source: NHB, Ambit Capital research

Further, competition risk in this segment comes from PSU banks similar to what we have seen in home loans over the last three years. With weak credit demand from the corporate segment, with weak capital and intense scrutiny by the RBI/Government on large corporate loans and with better asset quality in retail loans, there is a high probability of PSU banks becoming aggressive in retail loans. We have already started seeing some PSU banks offering attractive rates on the LAP segment.

As highlighted in the exhibit below, we envisage the probability of threats to mortgages and salaried personal loans to be high in the near term and threats to consumer durable loans to be medium over the near term.

Exhibit 33: BAF’s vulnerability to competition – A synopsis

Segment Competitive threats Impact on Bajaj Finance Probability of threat playing out in the near/medium term

Mortgages (43% of AUM)

Pricing has already been under pressure in the LAP segment due to aggression from banks. However, pricing could lead to more competition, as lenders re-price their loans to retain customers after the removal of pre-payment penalties to individuals.

Given that Bajaj Finance works in a comparatively less risky segment as compared to NBFCs, further competition from banks could impact both growth and yields in this segment.

HIGH Banks have been focussing on personal loans and mortgages to grow their loan books due to the slowdown in corporate loans. Yields in LAP and personal loans have declined by ~150-200bps over the past 2 years (refer to the exhibits on the next page). Further decline in yields for personal loans could see bad lending in the segment.

Salaried personal loans* (8% of AUM)

Banks not only have a much larger customer base, but they also have competitive advantages on pricing salaried loans efficiently due to access to: (i) the behavioural pattern of their customers and (ii) the salary accounts of the borrowers for recoveries in case of default.

Given that its customer segment (urban affluent) overlaps with banks, BAF is most probably a price taker in this segment.

However, unlike banks, BAF does not have access to a liability-based relationship (eg. salary account) with a customer. Hence, lack of control over the cash flows of the borrower would imply higher credit costs in an event of default.

Consequently, in an event of cut-throat competition, BAF would either grow only by lower risk adjusted margins or would chose not to grow its book.

Consumer durable loans (11% of AUM)

Vulnerable to the competition from banks given that bulk of the catchment area is concentrated in urban areas (65% of consumer durable sales happen in urban areas).

A determined competitor can increase its market share by offering: (i) dealer subvention; (ii) blanket increase of the credit card limits; (iii) waive-offs on credit card interchange fees.

A low duration (12 months) of the consumer durable financing book implies non-scalability of this business. Any adverse macro events or competitive behaviour might spell a fast decline in the loan book.

Also, given that consumer durable financing is the driver of customer acquisition, decline in growth in this segment would also result in a decline in growth in other retail products that are cross-sold (personal loans).

MEDIUM Too small a segment to chase and manage for a bank (combined market size would amount to only 4-5% of existing loan book of ICICI Bank/HDFC Bank). Nonetheless, competitive intensity should only increase going forward, as there are only 2 major players in this segment vs 7-8 players around 7-8 years ago.

Source: Ambit Capital research; Note - * Whilst salaried personal loans account for 4% of BAF’s AUM, we have also included ~60% of BAF’s personal loans cross sell (7% of BAF’s AUM) that have salaried customers.

24%18%

13% 13% 13% 10% 10% 10% 8% 8% 8% 7% 7% 5%

-1%-5%0%5%

10%15%20%25%30%

Che

nnai

Pune

Luck

now

Mum

bai

Ben

galu

ru

Ahm

edab

ad

Del

hi

Bhop

al

Fari

daba

d

Sura

t

Hyd

erab

ad

Jaip

ur

Patn

a

Kol

kata

Koc

hi

With weak credit demand from the corporate segment, weak capital and intense scrutiny on large corporate loans and better asset quality, there is a high probability of PSU banks becoming aggressive in retail loans

We have already started seeing some PSU banks offering attractive rates on the LAP segment

Bajaj Finance


Challenge#3: Closing regulatory arbitrage between banks and NBFCs Closing of regulatory arbitrage between banks and NBFCs on CRR/SLR requirement would structurally decline BAF’s pricing power in the segments it competes with banks.

As highlighted in our note dated August 8, 2014, ‘Closing the regulatory arbitrage’ (click here), we believe that BAF could be negatively impacted if the forthcoming regulatory framework for NBFCs (likely to come out by October 2014) is on the lines of the Mor Committee’s recommendations, which recommends elimination of regulatory arbitrage between banks and NBFCs.

Whilst tougher NPA norms and capital norms would not impact BAF’s profitability meaningfully, BAF could be impacted if the regulatory arbitrage is eliminated between banks and NBFCs on CRR/SLR requirement.

The regulatory arbitrage on CRR/SLR could be removed by either imposing CRR/SLR on certain liabilities of NBFCs or removing such requirements for certain liabilities of banks. So either the cost of running operations could come down for banks or it could increase for NBFCs like BAF. Given that BAF competes head to head with banks on most asset classes, the competitive positioning of BAF could be under threat in many asset classes.

Exhibit 34: Impact on BAF on various metrics due to the Mor Committee’s recommendations

Key metrics Current regulations Mor Committee recommendations Impact on Bajaj Finance

Capital requirements

Minimum capital adequacy ratio (CAR) of 15%; minimum tier-1 of 7.5%

Minimum capital adequacy ratio (CAR) of 15%; Tier-1 ratio of 12%

BAF is comfortable capitalised at CAR of 18.0% and tier-1 ratio of 15.2%. Historically, BAF has never operated below tier-1 ratio of 14%. We expect impact on BAF to be minimal in this regard.

NPA recognition

NPA classification at 180 days

Risk-based approaches to be followed for NPAs. But 90 days NPA recognition for categories overlapping with banks cannot be ruled out.

Whilst BAF provides for loans 90+ day delinquent, it still books income for loans up to 180+ day delinquent. So whilst moving to 90+ day NPA recognition would not impact BAF’s provisioning cost, it would impact BAF’s interest income, leading to a ~21bps impact on its NIMs.

SLR and CRR

22.5% SLR for banks on NDTL and 15% SLR for NBFCs on the deposits; 4% CRR for banks on NDTL

For banks: Eventual removal of SLR with the mid-term target of ~15%. Removal of CRR on time liabilities. For NBFCs: SLR requirement for deposit taking NBFCs.

Cost of funding arbitrage between BAF and banks should reduce to a certain extent (by ~30bps) and the benefits could be passed by the banks to the customers in the form of lower rates of interest. Hence we expect: (i) either SLR to be imposed on NBFCs on their non-deposits liabilities also; or (ii) banks to be required to keep aside lower SLR for their borrowings. Given that BAF competes head to head with banks on most of the asset classes like mortgages and personal loans, BAF could see yield compression in the respective segments.


Exhibit 35: BAF prudently provides for NPAs

NPA provision Standard

Provisioning

Bajaj Finance* 90days 0.40%

SUF 120days 0.40%

MGMA 120days 0.30%

MMFS 150days 0.25%

CIFC 180days 0.25%

SHTF 180days 0.25%

SCUF 180days 0.25%

Source: Company, Ambit Capital research; Note: * Bajaj Finance provides on 90 day basis for ~95% of its AUM.

Exhibit 36: Quantifying the regulatory arbitrage

Banks BAF- deposits BAF-NCDs

Cost of term deposits 8.75% 9.50% 9.50%

Add: Regulatory costs

Cost of carry on CRR 0.38%

Cost of carry on SLR 0.22% 0.15%

Cost of carry on PSL 1.04% - -

Overall cost of deposits 10.39% 9.65% 9.50%

Impact of Mor Committee:

- SLR carry 0.07% 0.22%

- Reduction of NDTL for CRR 0.19%

Adjusted cost of deposits 10.20% 9.72% 9.72%

Cost differential – existing 74bps 89bps

Cost differential – expected 48bps 48bps

Decline in regulatory arbitrage 26bps 41bps


Bajaj Finance


Challenge#4: Change in customer preferences Stores purchases of consumer durables and financing it from BAF (rather than using credit cards) are a basic requirement for BAF’s consumer durable financing business to succeed. However, BAF’s consumer durable financing business model could come under threat due to changes in customer preferences such as: i) purchase of consumer durables from offline to online channels; and ii) greater use of credit cards. This could slow down BAF’s customer acquisition.

Online channel gaining prominence in consumer durables Since BAF’s competitive advantage is a physical presence at fragmented points of sale, customer preference shifting to online purchases is a big threat to BAF.

There is a high probability that online platforms could gain market share in consumer durables sales due to: (i) growing penetration of internet in India – At 19%, India is currently underpenetrated vs BRICS average of ~50%; and (ii) strong preference of the online shoppers to buy consumer electronics online – Surveys highlight 45% of online Indian shoppers would prefer buying a consumer durable online than in a store.

Exhibit 37: Internet market is hugely under-penetrated

Source: PWC Global Total Retail Survey, Internet Live Stats, Ambit Capital research

Exhibit 38: BAF’s market share could be capped arbitrage

Current

Expected - BRICs avg

Expected – developed

avg

Internet penetration 19% 50% 70%

Internet users shopping on net 70% 70% 70%

Shoppers preferring consumer durables online

45% 50% 50%

Online sales market share 6% 19% 25%

Offline sales market share 94% 81% 75%

BAF market share – total 15% 13% 12%


However, we highlight that BAF would not be in a position to compete with banks on online sales platform, as:

BAF would struggle to verify documentation and execute transaction for a new/existing customer unlike credit cards which offer no need for documentation and ease of transaction.

BAF would struggle to get subvention from the manufacturer on online sales due to products already being sold at lower margins.

India

BrasilChina

RussiaSouth Africa

France Germany

Turkey

UKUSA

0%

20%

40%

60%

80%

100%

40% 50% 60% 70%

Inte

rnet p

en

etr

ati

on

% of online buyers preferring to buy consumer electronics online

Bajaj Finance


Customers preferring online purchases could make BAF redundant in this business, as BAF does not offer a credit card which is mostly a mode of payment during online purchases. Consequently, purchase trends shifting to such online platforms could be negative for BAF over the long term. Also, given that consumer durable financing is the driver of customer acquisition, a decline in growth in this segment would also result in a decline in customer acquisition and hence growth in other retail products for BAF.

However such a threat will be mitigated away if the online sales happen through the portals of manufacturers, which will take care of the subventions as well as physical verification of the customers address.

Replacement threat from credit cards Banks do not pose a significant threat to BAF in terms of direct competition at the point of sale, as it is not a big and lucrative opportunity for banks, given that the total estimated financing opportunity of ~`137bn in consumer finance is hardly 4-5% of the total loan book for most large private sector banks. However, banks pose a big threat to BAF through their presence in credit cards.

We have seen many manufacturers/retailers tying up with credit cards wherein credit card companies are providing interest-free payment options to consumers if they use their credit cards to buy goods manufactured by certain manufacturers. For example, our channel checks indicate that, this festival season, SONY has tied up with HDFC Bank and Standard Chartered credit cards for 0% interest up to 6 months EMI. Banks tying up with various manufacturers to offer this product to their broader set of customers could see credit cards posing a meaningful replacement threat to BAF.

However, BAF is trying to protect itself from replacement risk by issuing EMI cards. BAF issues EMI Cards (Existing Member Identification cards) to its existing customers who can use it for consumer durables and lifestyle purchases, by availing a loan from BAF without any documentation. Given that 54% of BAF’s retail disbursements are repeat customers, the EMI card acts as a customer retention tool to prevent its customers from migrating to other lenders. In fact, BAF has a higher number of EMI cards than the credit cards of various banks.

Exhibit 39: Credit/EMI card customer base of retail financers


Hence, in higher ticket-size purchases, BAF has a distinct advantage over credit cards and BAF is also devising strategies to thwart substitution risk from credit cards. That said, substitution risk from credit cards remains the biggest threat to BAF’s business model in consumer durable financing.

5.3

3.3 2.9

2.1

1.5

0.4 0.3

-

1.0

2.0

3.0

4.0

5.0

6.0

HDFCB ICICIB SBIN BAF AXSB KMB IIB

mn

Banks tying up with various manufacturers to offer 0% interest product to the broader set of their customers could see credit cards posing a meaningful replacement threat to BAF

The EMI card acts as a customer retention tool to prevent BAF’s customers from migrating to other lenders/credit cards

Bajaj Finance


Near-term earnings to moderate but still remain robust BAF delivered a robust AUM CAGR of 58% in FY10-14, with RoEs improving from 8% in FY10 to ~19% in FY14. The combination of higher loan growth coupled with improvement in RoEs helped the company deliver 56% EPS CAGR in FY10-14. The improvement in RoE was primarily driven by improvement in operating efficiencies (opex/AUM down from 8.6% in FY08 to 5.3% in FY14) and decline in credit costs (credit costs down from 7.0% in FY08 to 1.2% in FY14).

However, we expect BAF’s EPS growth to moderate to 16% CAGR in FY14-17. Our expectations of a moderation in BAF’s earnings growth is driven by two factors:

Moderation in loan growth on a higher base – We are expecting loan growth to clock in at 21% CAGR in FY14-17 vs the 58% CAGR in FY10-14.

Some moderation in RoEs primarily due to decline in margins – We are expecting RoEs to decline by 100bps primarily due to a ~150bps decline in margins and some increase in credit costs.

Loan growth to moderate but remain robust Over FY10-14, BAF has recorded an AUM CAGR of 58% driven primarily by consumer finance (39% CAGR) and SME and business loans (90% CAGR). Such growth has been driven by BAF penetrating into the market share of banks, both in the personal loan and the LAP segment, due to the competitive advantages discussed in the earlier sections.

Exhibit 40: Robust AUM growth …


Exhibit 41: … driven by consumer and SME loans …


Going forward, we expect a moderation in loan book growth, as BAF seeks to consolidate its loan book that has expanded at a CAGR of 55% over FY10-14. We estimate loan growth to be at 21% over FY14-17E.

Mortgage growth to moderate…: We expect growth in the mortgage segment to moderate due to: (i) increasing competitive intensity in the segment due to entry of various players; (ii) BAF losing its key competitive advantage of not charging pre-payment penalties on the loans, given that now regulators have banned pre-payment charges on all floating rate loans. Overall, we expect loan growth in the mortgage segment to clock at 22% CAGR in FY14-17 vs 78% CAGR in FY11-14.

...but consumer finance and SME segment growth to remain robust: However, we expect growth in the SME and consumer segments to be robust at ~27% CAGR over FY15-17E vs 56% CAGR in FY11-14. Our expectations of healthy growth in these two segments are driven by:

25 25 40 76 131 175 241

20%

2%

59%

88%

73%

34% 37%

0%10%20%30%40%50%60%70%80%90%100%

-

50

100

150

200

250

300


` b

n

AUM (Rs bn) AUM Growth (YoY, %, RHS)

23%52% 49% 42% 33%

220%

103%

72%49% 51%

-16%

165%

-18%-3%-20%

30%

80%

130%

180%

230%

FY10 FY11 FY12 FY13 FY14

YoY growth (%)

Consumer Finance: SME & Business loans Commercial Business

Robust loan growth should moderate over the near term which should correspond with declining margins; however, improvements in operating efficiencies and fee income should help BAF to deliver RoEs of 18-20% over FY14-17E

*370%

Bajaj Finance


Increase market share in personal and SME loans: BAF’s market share in the SME and personal loan segment is still below 10% (~7% as per BAF’s estimates for SME and ~5% as per our estimates for personal loans). We believe BAF would have enough headroom to expand in these segments (up to 10% of market share in each segment over FY14-17E).

Increasing product penetration in consumer durable finance: Whilst BAF’s market share in consumer durables financing is already high at ~15%, BAF’s entry into lifestyle financing (cell phones and furniture) should keep loan growth at 27% CAGR over FY14-17E for BAF in this segment.

RoEs should moderate from hereon BAF has clocked in average RoEs of 21% over FY11-14. However, we expect BAF’s RoEs to moderate at average ~19% in FY15-17E. Our expectations of RoE moderation are driven by the following factors:

NIMs to moderate further: Over FY10-14, BAF’s NIMs have been trending downward due to the decline in yields and increase in cost of funds. Decline in yields was due to the increasing proportion (from 7% in FY09 to 41% in FY14) of the lower-yielding LAP book, which yields ~11-13% vs 18-24% on retail loans. Increase in cost of funds over FY10-14 was caused by the increase in the wholesale market rates across that period.

Exhibit 42: NIMs have declined over FY10-14 …


Exhibit 43: … due to decline in yields and increase in cost


We expect a 75bps reduction in systemic interest rates over FY15-17E to result in a ~20bps decline in cost of funds. Nonetheless, we expect BAF’s NIMs to further decline by 100bps over FY15-17E to 9.7% due to a ~170bps decline in yields primarily due to the higher share of home loans in the mortgages portfolio and decline in yields in personal loans category (as the competition becomes more aggressive).

We expect BAF’s NIMs to further decline by 100bps over FY15-17E to 9.7% driven by:

~170bps decline in yields primarily due to higher share of home loans in the mortgages portfolio and decline in yields in personal loans category as the competition becomes more aggressive over FY15-17E.

We expect 75bps reduction in systemic interest rates over FY15-17E to result only in a ~20bps decline in cost of funds. This is because the elimination of tax arbitrage between debt mutual funds and bank deposits should result in incrementally lower flows to debt funds which provide BAF with cheaper funds. We expect ~10-15% of BAF’s liabilities from such funds to move to bank borrowings whose rates are less elastic to systemic interest rates.

10.5%13.7%

18.5%

15.6%

12.1%11.2% 10.7%

8.7%

11.8%16.9%

14.8%

10.8%

9.4% 9.1%7%

9%

11%

13%

15%

17%

19%

21%


NIM (% on AUM) Spreads (%)

18.0%

20.3%

24.7%

22.1%

19.3%19.1%18.2%

9.3%

8.5%

7.8%7.3%

8.5%

9.8%

9.2%

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

10.0%

17%

18%

19%

20%

21%

22%

23%

24%

25%


Yield on AUM (%) Cost of funds (%)

We expect BAF’s RoEs to moderate at ~19% in FY15-17E

We expect BAF’s NIMs to further decline by 100bps over FY15-17E

Bajaj Finance


Exhibit 44: High proportion of borrowings from banks offers headroom for decline in cost of funds


Exhibit 45: Cost of funds increased as wholesale rates increased


Credit costs to increase marginally: BAF reported a remarkable decline in credit costs over FY10-14, with credit costs declining from the peak of 7.9% in FY10 to 1.2% in FY14. However, as explained in one of the previous sections, we expect overall credit costs to increase from the current levels, as credit costs in both consumer loans and LAP are at historically low levels and are unlikely to sustain at the current levels. We factor in a ~20bps increase in credit costs for BAF in FY14-17, resulting in a credit cost increase to 1.4% by FY17E from 1.2% in FY14.

Operating efficiency to offset decline in NIMs: BAF has one of the highest operating costs/asset ratios amongst NBFCs due to its people-intensive retail franchise and higher technology costs. However, as growth picked up over FY10-14, the cost/asset ratio declined, as the proportion of lower-opex products like LAP increased in the loan book.

Exhibit 46: Opex/AUM – BAF vs other NBFCs


Exhibit 47: Cost/income – BAF vs other NBFCs


We believe that going forward the opex/asset ratio should further decline as origination costs come down as more loan originations take place through cross-selling and direct channels. Hence, we expect further improvement in the opex/asset ratio to 5.1-5.2% over FY14-17E from 5.5% in FY14.

1%

41%

58%

Deposits

Debt Markets

Banks

9.3%

8.5%

7.8%7.3%

8.5%

9.8%

9.2%

6%

7%

8%

9%

10%


Cost of funds (%) Avg. AAA yields (%)

1.8%

3.1% 3.3%

5.5%

6.7%

0%

1%

2%

3%

4%

5%

6%

7%

8%

SHTF MMFS MGMA BAF MGFL

Opex/AUM (%)

25.1%

33.0%

46.0%

54.8%59.4%

0%

10%

20%

30%

40%

50%

60%

70%

SHTF MMFS BAF MGFL MGMA

Cost/income (%)

Bajaj Finance


Cross-selling likely to result in higher fee income: Fee income currently accounts for 30bps of BAF’s total assets. We estimate fee income would go up to 60bps of total assets by FY16, as BAF’s cross-selling capabilities improves, due to: (i) increase in BAF’s customer penetration driven by increasing customer vintage; (ii) improved cross-selling efficiency, as BAF’s analytical platform continues to mature; and (iii) addition of new products like wealth management to the already existing suite of products like general insurance, life insurance, extended warranty schemes, CRISIL ratings, co-branded credit cards, property search services and financial fitness report.

The exhibit below illustrates BAF’s increasing penetration of fee-based products to its retail and SME customers.

Exhibit 48: Increasing penetration of fee product per customer


0.69 0.73 0.74 0.78 0.78 0.91

1.52 1.60

1.80 1.80

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

1QFY14 2QFY14 3QFY14 4QFY14 1QFY15

Retail customer SME customer

Bajaj Finance


Key assumptions and estimates Exhibit 49: Our estimates are not materially different than consensus

Key assumptions and estimates FY13 FY14 FY15E FY16E FY17E Comments

Assumptions

YoY AUM growth (%) 34% 37% 22% 22% 20% We expect loan growth to moderate as the management seeks to consolidate its loan book that has recorded 55% CAGR over FY10-14.

Net interest margins (%) 11.2% 10.7% 9.8% 9.6% 9.3% Higher proportion of secured portfolio and pressure on pricing in the LAP segment should result in decline in NIMs.

Fee income (% of assets) 0.3% 0.2% 0.3% 0.4% 0.4% Cross-selling to result in higher fee income.

Opex/avg loan book ratio (%) 5.6% 5.5% 5.2% 5.1% 5.1% Opex to come down, as BAF moves to products with lower operating costs and as more originations take place through the DSA channel.

Credit costs (%) 1.2% 1.2% 1.2% 1.3% 1.4% We expect credit costs to increase from the current levels due to increase in retail delinquencies.

Key output (` mn)

Net revenues 19,040 25,001 29,895 36,139 42,566 FY14-17 CAGR of 19% vs FY12-14 CAGR of 32%.

Operating profits 10,534 13,490 15,906 19,412 22,361 FY14-17 CAGR of 18% vs FY12-14 CAGR of 34%.

Net Profit 5,913 7,190 8,485 10,117 11,257 FY14-17 CAGR of 16% vs FY12-14 CAGR of 33%.

Diluted EPS (`) 136 145 170 202 225 FY14-17 CAGR of 16% vs FY12-14 CAGR of 16%.

BVPS 676 802 949 1,124 1,320 FY14-17 CAGR of 18% vs FY12-14 CAGR of 28%.

ROE (%) 21.9% 19.5% 19.3% 19.5% 18.4%

Source: Company, Ambit capital research

Ambit vs consensus Our FY15-16 earnings estimates are marginally lower than consensus estimates. However, our FY17 estimates are materially lower than consensus estimates due to our lower NIM and higher credit cost estimates.

Exhibit 50: Our estimates are not materially different than consensus on FY15-16

Particulars Ambit Consensus Divergence

Total Income (` mn)

FY15E 29,895 30,388 -2%

FY16E 36,139 37,180 -3%

FY17E 42,566 46,321 -8%

PAT (` mn)

FY15E 8,485 8,638 -2%

FY16E 10,117 10,466 -3%

FY17E 11,257 12,989 -13%

EPS (` mn)

FY15E 169.5 173.0 -2%

FY16E 202.1 210.0 -4%

FY17E 224.9 251.0 -10%


Bajaj Finance


Expensive valuations not factoring in the cross-cycle profitability of the franchise We have valued BAF using the excess return to equity model which is ‘net profit – (cost of equity x average net worth)’ for all the future years discounted back to the present using cost of equity.

We have explicitly forecast net profit for FY15-17E based on the assumptions in Exhibit 49.

We have assumed 21% CAGR in loan growth for FY17-20, and have faded it to average 16% over FY20-34.

We have assumed sustainable RoA on of 2.2% and sustainable RoE of 17.0% from FY17 onwards, as margins would decline and credit costs would get higher from the current levels on a cross-cycle basis.

We have assumed cost of equity of 14.5% and terminal growth of 5%.

Based on these assumptions our excess return model values BAF at `2,300/share (implied FY16 P/B of 2.0x and implied FY16 P/E of 11x), implying 16% downside from current levels.

Further decline in LAP/personal loan yields could imply a ~7% cut to our valuation.

As discussed in the earlier sections, BAF’s business not being present in a niche field makes it very vulnerable to competition. Consequently, its valuations would be mainly driven by how the competitive landscape emerges in the medium term in the retail/LAP finance space. We articulate its valuation if competitive intensity in the retail and LAP space deteriorates further. In a bear-case scenario, we factor in yields to fall further by ~100bps in LAP and salaried personal loans and FY14-17E AUM CAGR to come down to 18% (vs 21% CAGR in base case scenario).

Exhibit 51: Scenario analysis of BAF’s valuations % of Average assets (incl off-balance sheet) over FY14-17E

Base case scenario Bear case scenario of

higher competitive intensity

NII 9.2% 9.1%

Other income 1.5% 1.5%

Total income 10.7% 10.6%

Operating expenses 5.0% 5.0%

Operating profits 5.7% 5.6%

Credit costs 1.3% 1.4%

PBT 4.4% 4.2%

Tax 1.5% 1.4%

PAT 3.0% 2.9%

Leverage 6.5 6.3

RoEs 19.1% 18.1%

AUM CAGR 21% 18%

EPS growth 16% 14%

Fair value multiple 2.0x 1.9x

TP `2,300 `2,130

Upside/(Downside) -16% -23%


Bajaj Finance


Cross-cycle valuations at a premium BAF’s current 12-month forward P/B of 2.6x and 12-month forward P/E of 14x are both at a 60% premium to their cross-cycle averages P/B driven primarily by improvement in growth and RoE over the last five years. However, we expect current valuation multiples to not sustain going forward, as BAF delivers 16% EPS CAGR over FY14-17E.

Exhibit 52: BAF is trading at a premium to its one-year forward P/B


Exhibit 53: BAF is trading at a premium to its one-year forward P/E


BAF deserves a discount to niche and regional players Despite having higher RoAs and RoEs compared to niche-lenders, BAF trades at a ~8% discount on P/E to other NBFCs. This discount is justified given the highly commoditised segment BAF operates in and should widen further as the RoEs of BAF moderate over the long term on a cross-cycle basis.

Exhibit 54: Relative valuation snapshot – BAF vs niche NBFCs

Name Mkt Cap

(` bn) P/BV P/E RoA (%) RoE (%)

15Y 16Y 15Y 16Y 15Y 16Y 15Y 16Y

M&M Finance 2.6 2.8 2.5 16.9 13.6 2.8 2.9 17.8 19.1

Shriram Transport 3.2 2.1 1.8 14.0 11.4 2.7 2.9 16.2 17.2

Cholamandalam Investment And 1.1 2.5 2.0 14.8 12.0 2.0 2.1 18.0 18.8

Magma Fincorp 0.4 1.4 1.3 12.3 9.7 1.3 1.5 12.0 13.3

Sundaram Finance 2.2 4.9 4.2 27.3 23.4 3.1 3.1 19.0 19.0

Shriram City Union Finance 1.8 2.6 2.3 17.9 14.5 3.6 3.7 17.3 16.8

Average

2.7 2.3 17.2 14.1 2.6 2.7 16.7 17.4

Bajaj Finance 2.2 2.9 2.4 15.8 13.0 3.1 3.1 19.7 20.1

Premium (discount) to above

5% 2% -8% -8% 23% 14% 18% 16%

Source: Bloomberg estimates

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Apr

-10

Oct

-10

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

BAF - 1 year forward P/B

2.6x

1.6x

3

5

7

9

11

13

15

Apr

-10

Oct

-10

Apr

-11

Oct

-11

Apr

-12

Oct

-12

Apr

-13

Oct

-13

Apr

-14

Oct

-14

BAF - 1 year forward P/E

9x

14x

Bajaj Finance


Key catalysts for our SELL stance Retail cycle turning hostile: BAF lacks competitive advantages on recoveries, as it does not enjoy a liability-based relationship with the end customer wherein it would be in control of the cash flows of the customer. Thus, despite having the same segments that banks service, BAF would experience a greater loss given defaults in case of a default. Hence, an unfavourable retail cycle would be a meaningful negative for BAF.

Further increase in competition in retail segment: Further increase in competition in the retail/SME segment would lead to either lower growth and NIMs for BAF or higher credit costs. Competition remains a key monitorable over FY15.

Decline in real estate prices: Ever-increasing property prices (10% CAGR over the last 5 years) have not only helped growth of this segment but has also led to better asset quality, as distress borrowers were able to refinance their loans. Whilst our channel checks suggest that BAF has been more prudent as compared to its peers, the pressure on asset quality and growth cannot be ruled out if the real estate prices start decreasing. Not having the benefit of SARFESI protection in terms of recovery could significantly delay recovery of the asset should the recovery case go into litigation. With 41% of BAF’s book concentrated in LAP, any meaningful decline in real estate prices (30% plus) could have a negative impact on BAF’s asset quality and growth.

Risks to our SELL stance Successful foray into rural financing: A successful foray into rural financing would enable BAF to sustain its medium/long-term profitability. This is especially relevant as the current existing businesses of BAF are largely vulnerable to competition due to its urban-centric nature. The management plans to increase the proportion of rural financing from 0% of AUM currently to ~5% of AUM by FY17.

Receiving a banking license: Receiving a banking license would stress the near term profitability of BAF through higher operating costs, cost of meeting regulatory requirements like PSL/SLR/CRR. However, BAF would also benefit from a lower cost of funding that would increase its competitiveness with the banks and thus improve the prospects of long term growth and sustainability of BAF’s franchise.

That said, we envisage the probability of RBI handing out a banking license very less in the near future as the RBI has highlighted that it will issue new licenses for universal banks only post observing the performance of the recent license awardees (IDFC and Bandhan) on their banking operations. We expect the time frame for observing their performance to not be less than 2/3 years from the start of their operations.

The exhibit below articulates our rough cut numbers on how BAF’s RoAs and RoEs would look if it becomes a bank.

Exhibit 55: Impact of banking license on BAF

Particulars (%)

Current RoAs – FY14 3.4%

Immediate impact:

SLR 1.5%

CRR 0.2%

PSL 1.5%

Immediate RoAs post becoming a bank 0.2%

Long term impact:

Improvement in operating costs 0.7%

Improvement in funding costs 1.0%

Long term RoAs post becoming bank 1.9%

Leverage under bank 10

Long term RoEs post becoming bank 18.7%


Bajaj Finance


Forensic accounting Exhibit 56: BAF comes clean on all parameters

Segment Score Comments

Accounting GREEN With 90dpd provisioning and standard assets provisioning of 0.4%, BAF has been one of the most prudent providers of NPAs amongst NBFCs. We believe that its accounts are the true representation of the accounts of the company.

Predictability GREEN BAF has always guided the markets well in advance and in most cases has not surprised negatively. The company provides adequate information on a quarterly basis and its investor presentations, unlike many larger and smaller peers, provide a very detailed view about the management’s approach to its business.

Earnings Momentum GREEN We have not seen meaningful downgrades in consensus FY15 and FY16 EPS estimates over the past six months.


Bajaj Finance


Income statement

FY13 FY14 FY15E FY16E FY17E

Net interest income 17,174 22,153 26,098 31,120 36,393

Interest Income 29,231 37,886 47,110 55,908 65,113

Interest Expense 12,057 15,732 21,013 24,788 28,720

Fee based and other income 1,866 2,848 3,798 5,019 6,173

Total Income 19,040 25,001 29,895 36,139 42,566

Total expenses 8,506 11,511 13,989 16,727 20,205

Operating and other expenses 6,055 8,103 9,729 11,402 13,548

Employee Cost 2,452 3,408 4,260 5,325 6,656

Pre provision profit 10,534 13,490 15,906 19,412 22,361

Provisions 1,818 2,578 3,241 4,313 5,560

Profit before tax 8,716 10,912 12,665 15,099 16,801

Tax 2,803 3,722 4,179 4,983 5,544

PAT 5,913 7,190 8,485 10,117 11,257


Balance Sheet


Networth 33,670 40,203 47,580 56,376 66,164

Borrowings 140,734 208,400 255,714 312,010 375,056

Total liabilities 174,404 248,603 303,294 368,386 441,219

Fixed assets 1,762 2,199 2,748 3,435 4,294

Investments 53 282 282 282 282

Loans and Advances 175,170 240,610 293,627 357,597 429,028

Cash and Bank Balance 4,164 7,768 8,545 8,545 8,545

Deferred tax assets 904 1,392 1,740 2,174 2,718

Net working capital (7,648) (3,648) (3,648) (3,648) (3,648)

Total assets 174,404 248,603 303,294 368,386 441,219


Key Metrics


AUM growth (%) 33.6 37.4 22.0 21.8 20.0

Dil Consol EPS growth (%) 25.7 6.6 18.0 19.2 11.3

Net interest margin (NIM) (%) 11.2 10.7 9.8 9.6 9.3

Cost to income (%) 44.7 46.0 46.8 46.3 47.5

Opex (% of AAUM) 5.6 5.54 5.24 5.14 5.14

Gross NPAs (%) 1.1 1.2 1.2 1.2 1.2

Credit costs (% of AAUM) 1.19 1.24 1.21 1.32 1.41

Provision Coverage (%) 83.0 76.4 76.4 76.4 76.4

Capital adequacy (%) 22.0 19.5 19.0 18.6 18.3

Tier-1 (%) 18.7 16.5 16.0 15.6 15.3

Leverage (x) 5.7 5.7 6.3 6.5 6.6


Valuation parameters


BVPS (`.) 676 802 949 1,124 1,320

Dil. EPS (`) 134.7 143.7 169.5 202.1 224.9

ROA (%) 3.9 3.4 3.1 3.0 2.8

ROE (%) 21.9 19.5 19.3 19.5 18.4

P/E 20.3 19.0 16.1 13.5 12.1

P/BV 4.0 3.4 2.9 2.4 2.1

Dividend yield (%) 0.5 0.6 0.7 0.8 0.9


Bajaj Finance


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Bagul Consumer (022) 30433264 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Real Estate (022) 30433205 [email protected]

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave Healthcare (022) 30433212 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Midcaps – Chemical / Retail (022) 30433242 [email protected]

Ritesh Vaidya Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Tanuj Mukhija, CFA E&C / Infra / Industrials (022) 30433203 [email protected]

Utsav Mehta Technology (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

Bajaj Finance


Explanation of Investment Rating Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell <5%

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initiating coverage baf in equity october 13, 2014...

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