Description

Shriram City Union Finance (SCUF) – Financing the unbanked/underbanked Indian customers

Disclaimer: I/ We have investments in this name and hence my views are biased. Please verify and do your own research on the name. I have used some images from other sell-side firms like Ambit Capital and Spark Capital in this note.

This is a relatively simple investment thesis of buying into a well run financial compounder that is available at attractive valuations because of recent temporary headwinds. The quality of the management team, size of the opportunity, returns profile of the underlying business and an attractive entry point makes this is a fat pitch for long-term investors.

There are 36 million Micro, Small and Medium enterprise owners who contribute around 30% of India’s GDP (6%-small manufacturing and 24%-small services) and are starved of debt capital at reasonable cost. This is a USD 120 billion opportunity that is vastly untapped and is up for grabs for players who are nimble, localized in their approach and has a sound understanding of this community.

Image Source: Ambit Capital

Shriram City Union Finance (SCUF) is a Non-Banking Finance Company and is the largest MSME lender in India. SCUF is part of the south-based Shriram group, which is known for its capital allocation skills, prudent underwriting process, transparent management practices, and a sound understanding of India’s under banked/unbanked.

SCUF is a 3% ROA, 18% ROE business with an AUM of INR 29,748 Crore (~USD 4.25 billion). MSME business loans form 57.5% of the loan book followed by Two-Wheeler loans (18.25%), Gold Loans (11%), Personal loans (8.4%), and Auto loans (4.7%). Other than being the largest MSME lender in India, SCUF is also the among Top-3 Two wheeler financiers in the country (Top two being HDFC Bank and Bajaj Finance). The business segments of MSME finance and Two-Wheeler finance are highly under penetrated and SCUF with its highly entrenched market position is extremely well placed to grow its earnings significantly for a long time to come.

Image Source: Spark Capital

At INR 1550/ share, SCUF is trading at around 1.7X current Book Value, 9X Trailing PBT and at around 10X forward PAT for a highly seasoned granular retail book. I believe that the market under appreciates/ misunderstands the long-term potential of MSME financing and the high quality franchise that SCUF is. I expect an earnings growth of 18-20%+ for the next 5 years and there could be an added bonus of valuation re-rating from the current levels, leading to healthy risk-adjusted returns for a long-term investor.

Company & Group Background –

Shriram Group over the last 4 decades has emerged as India’s leading financier for the underbanked/ unbanked segments of customers. SCUF was established in 1986 and is a part of the Shriram Group. Shriram Group continues to run one of the largest chit funds in the country with around 1.5 million active customers and is also the promoter of market leader in pre-owned CV lending segment - Shriram Transport finance. In October 29, 1988, SCUF became a public limited company and renamed as Shriram Hire Purchase Finance Ltd. In March 1990, City Union Bank Ltd. acquired shareholding 200,000 shares at par. Consequently; the name of the company was changed to Shriram City Union Finance Ltd. The company registered as a deposit-taking asset financing NBFC with RBI and went public in 1994.

Prior to 2002, the company was exclusively engaged in transport finance with special emphasis on financing pre-owned commercial vehicles to small road transport operators. In 2002, the company discontinued the truck financing business (except for trucks > 10 year old) as that business was consolidated in its sister concern (Shriram Transport Finance Ltd) and started as a separate business unit in year 2002 as Shriram City Union Finance Ltd. Listed on BSE in 2003. Even until 2006, SCUF was predominantly an auto financier with two-wheeler and pre-owned CV segment making up 70% of the loan book.

Currently, Shriram Transport Finance is India’s largest owned CV financier with a market capitalization of over 4 Billion $’s and a book size of over 14 Billion $’s. The group has created significant shareholder value over the years by focusing on lending to the unbanked/ underbanked segment across categories.

Since 2006 onwards, SCUF has focused on the MSME segment and has transformed itself to a leader in MSME lending in India. The quick turnaround and the successful transformation was possible by leveraging 1) Franchise of its associate company Shriram Chits (7000 employees transferred to SCUF from Chit entity) 2) 350 branches of Shriram Chits 3) 4 million customer base of Shriram Chits.

Currently, SCUF has positioned itself as a MSME and Retail lender and its long term focus will be on MSME segment. Over the last few years SCUF has invested significantly by getting into new geographies, growing its branch network in North India, boosting employee strength and raising capital. Even though SCUF has built the largest book in the MSME segment it strongly believes that it had not even penetrated the core of the MSME lending segment. Over the next 5 year time period, I expect the MSME segment to contribute more than 65% of the book with Two-wheeler financing segment at around 20%.

SCUF has built a credible strategy of penetrating non-chit geographies through two-wheeler financing segment. Highly granular, short-term, high yield Two-wheeler loans are first rolled out in a new geography and over time gold loans are introduced. These two segments allow SCUF to better understand the geography and the locale before introducing MSME loans. Case in point – SCUF is the 3rd largest two- wheeler financier in India and derives more than 50% of its 2-wheeler book from non-south, non-chit geographies. This clearly indicates the capability of SCUF and its management to grow its business in newer geographies. More than 50% of Shriram transport finance’s (STF) branches are located in Non-south regions and STF has been successful in generating business on a pan-India scale. This can serve as an empirical evidence for Shriram group’s management capability. As mentioned above, SCUF already has 50% of its two-wheeler book in non-south regions with asset quality better than southern states and there is no better person to understand the unbanked/underbanked segment in India than the Shriram group.

SCUF benefits from the group’s brand image in its target segment. In the Chits business and the transport finance business, the group has over 3.5 Million customers that can be tapped for different credit products that SCUF underwrites.

Huge Opportunity Size in MSME lending –

Various estimates suggest that there are between 30 million and 40 million MSMEs in India. MSMEs around the urban areas tend to be concentrated on both services and manufacturing, while the MSMEs in semi-urban and rural areas are concentrated in the segments of services and trade. However, only 5% of unregistered and 10% of registered MSMEs have access to organized finance.

More than half of MSMEs’ funding requirements are sourced from a mix of equity, family & friends and trade credit, which are expensive and not guaranteed. The total gap in MSME funding is estimated to be around USD 126 Billion. Out of this, the debt gap is approximately USD 84 Billion and equity GAP is about USD 42 Billion.

SCUF’s MSME Advantage – In-house Origination + Appraisal + Collections

Without a doubt, Shriram group has been the most successful entity in tapping the opportunity at the bottom of the pyramid in India. It has time and again accomplished what banks and other NBFCs have found challenging. At the heart of the group’s success in establishing scalable business models are its underwriting, appraisal, collection and HR policies that are unique.

Reliable, low-cost, referral-based origination – 70% of SCUF’s MSME loan book today has been originated either directly or indirectly (referral based) from the strong customer base of its group companies. SCUF also seeks references and cross-references from customers and cross-sells them various products like personal loans and consumer durable loans. Such competitive advantages drive SCUF’s low cost and higher-quality origination as compared to other lenders.

Local intelligence based appraisal process - Small-ticket SME loan segment is faced with complexities of higher origination costs, data obscurity for appraisal and high collection costs. Locally sourced  manpower network drives SCUF’s superiority versus organized players in appraisal and collection of such customer segment. An ideal customer for a MSME lender is expected to be lacking the documentation proof and in such a scenario, local intelligence become absolutely critical. Local intelligence cannot be easily acquired unless your field force belongs to the same community that you lend.

On an average, around 75% of the employees of SCUF reside within 15 Kms from the branch that they are part of. This is in stark contrast to bank employees who usually get transferred every three years making it difficult to develop local knowledge and rely on the paper trail.

In fact SCUF’s management has shown that the competitive advantage that they have in local knowledge based lending in terms of scale and quality of underwriting allows them to sustainably target a 3+% ROA despite any headwinds. I personally believe that the OPEX advantage of 2% in itself limits competition. SCUF has also shown that it can also do document trail based lending in a sustainable manner at 2.5% ROA, but it would not want to build that book hugely and instead wants to focus its energies on building the tougher but more valuable franchise of local knowledge based lending in which it completely competes with unorganized money lenders and can have a really big opportunity size.

Responsible and incentive-based collection mechanism – While in most other NBFCs and banks each of the origination, appraisal and collection steps are executed by various teams, SCUF ensures that the employee who originated the loan is responsible for collection as well. This added responsibility not only results in better and prudent origination but high collection efficiency too. While most other lenders incentivise the team for incremental business generation, 50% of salary of SCUF’s field force is based on collection efficiency and portfolio performance.

HR policies – At the heart of the seamlessly though out strategy of adding local intelligence to Origination, appraisal and collection process is SCUF’s HR policy. As mentioned earlier, employees who belong to the same locale and surrounding usually man the branches. These employees do not undergo frequent transfers and in fact only after they become branch manager can a transfer be possible. Becoming a branch manager usually takes 12 years. Since SCUF recruits from the locale and since moving away from home is not required, SCUF manager to attract talent at lower costs. The pay scale of the field force is heavily determined by the collection efficiency (50% of salary). Employees starting from the branch manager level are given ESOPs on performance parameters.

Field force larger than that of national banks

SCUF does not use expensive and unreliable DSAs that other bank and NBFCs make use of. SCUF today has around 26,000 employees located across 1000 branches in India. SCUF’s large network is comparable to even large banks in its home turf of the states of Andhra and Tamil Nadu, both in terms of branch and employee network. Such a large network ensures that SCUF gets large volumes to carry out in-house origination processes of small-ticket loans and not rely on any third party outsourcing agent.

While by now, it would be evident as to why banks can never penetrate this segment, let us examine this possibility further.

Banks have traditionally favoured big-ticket loans since in a way the public sector banks were in fact created to fund corporate India. Moreover, with the book size that the banks run, small ticket loans are extremely granular and carry very high frictional and transaction costs. Banks will never be able to penetrate the small ticket loan MSME segment since

Higher operating costs: Lower ticket sizes of SME loans (<`2mn) make outsourcing of origination and collection process more expensive for lenders as compared to large-ticket-sized loans.

Challenges around credit appraisal: High cash transactions resorted by SMEs make document - based appraisals of SMEs redundant.

Better opportunities elsewhere: Due to high costs in the outsourcing model along with challenges on appraisal, the only way a lender can build its competitive advantages in this segment on a sustainable basis is by incubating its employee base in this segment over time. However, given the ample opportunities available to banks in large corporate credit and large-ticket-sized personal loans, only a few banks have pursued the concept of small-ticket lending in a meaningful way.

It has always been a question of both intent and capability. The top 3 public banks in India together have more than 32,000 branches and more than 300,000 employed across India. They have branches and field force across every nook and corner of the country, but they have never made any effort to make a substantial contribution to MSME lending segment. There is an inherent apprehension in the minds of banks that lending to MSME is risky and that they do not really understand the segment well enough to underwrite loans.

Two-Wheeler Financing:

Two-Wheeler financing segment in India is estimated to be around INR 18,000 Cr (USD 3 billion) and is on a healthy growth pace. The growth is likely to be driven by volume growth, ticket size growth and higher penetration of financing (which is currently at around 35% to 40%). While the segment may be small, it offers a highly profitable growth opportunity for the concentrated players. Even after assuming a 4% GNPA, the entrenched players can expect a 3.3% ROA and 20%+ ROE. SCUF is the market leader in non-bureau listed segment.

Currently Bureau listed segment is concentrated in urban and semi-urban areas and comprise employed customers with a valid document trail. NBL segment is spread across urban, semi-urban and rural areas and primarily comprises self-employed and other informal sources of employment. HDFC Bank and IndusInd bank dominate the Bureau segment while NBFCs like SCUF and Bajaj Finance dominate the NBL segment. Bajaj Finance primarily focused on financing Bajaj’s two wheelers.

SCUF is the 3rd largest player overall in the highly concentrated market today and is the largest player in the NBL segment, yet again a testimony of its practices and processes in financing the unbanked/under banked.

SCUF today derives almost 50% of its two-wheeler book from the non-south region and has shown strong focus on growing this segment. Its two-wheeler lending book has grown at a CAGR of 22% over the last 4 years and the management believes that the long-term potential to grow in this segment is immense.

SCUF has developed deeply entrenched position and a strong understanding in the two-wheeler segment and has been able to grow better than focused players like IndusInd bank that has pan- India presence. Case in point, even a player like Bajaj finance that has inherent competitive advantage by way of its parentage has managed to grow the book only of similar size to SCUF’s.

SCUF’s MOAT – Dealer relation + Appraisal + NBL segment leadership:

There are two things which are absolutely necessary to build a sustainable two-wheeler lending business – tie-ups with OEMs and relationships with dealers. SCUF is empanelled with OEMs that make 75% of the two-wheeler market share in the country. And given that financing decisions are made at the point of sale (POS), SCUF has been able to maintain a robust presence and relationship across the dealer network. The dealer is usually paid a commission of .5% to 2% on the financing amount for offering his premise as a source of customer origination. While this is absolutely important to a dealer, his decisions are influenced by two other critical factors – ability to provide other services and the ability to finance the NBL segment.

While SCUF lags behind the banks in providing working capital loans and other banking & credit facilities at a cost effective rate, it scores over them completely through its ability to appraise the NBL segment. Case in point, SCUF is the financier which pays the least of the commissions to the dealer but which is most preferred. Whilst the advent of credit bureaus has made the appraisal process more standard, it could still be the biggest competitive advantage in the non- bureau listed customer segment, as credit bureaus cover only ~25% of the total adult population.

In the non-bureau listed segment, a lack of bankable habits by these customers (very low account balances) and uncertain cash flows imply that these customers prefer paying in cash rather than through PDCs and ECS. Consequently, collections in this segment through convenient branch network and an on-ground collection team would be the key competitive advantages a lender has over others in this segment. SCUF scores better than its peers in this segment, as it not only has a huge collection team but more importantly it has an in-house team which helps it save a lot on collection expenses, which tend to be much higher when outsourced especially during periods of high delinquencies.

Gold Financing:

Gold loan portfolio of SCUF has witnessed tremendous volatility in recent times and has shrunk in % terms of overall portfolio mix. A large part of the shrinkage was due to the RBI’s actions to regulate the gold loan segment and the increase in competitive pressure. The huge size of the opportunity and the strong growth rates of Gold loan financiers such as Muthoot and Manappuram had allured banks and other NBFCs to quickly rollout branches and to capture a part of the pie. RBI reigned in the gold loan industry by implementing a cap on the LTV (at 60% from the then industry practice of 90%+) and also introducing norms defining which loans can become part of the PSL buckets and which ones cannot. The volatility in gold prices also added to the scenario. Gold loans continue to be an attractive add-on in the existing branches and helps SCUF to sweat its assets better. Since almost all costs are fixed in nature, the operating leverage with accelerated growth can boost margins significantly in an upcycle.

In the long run, SCUF wants to focus on gold loans not through on-book balance sheet but through tie-ups with banks that in a way will work similar to securitization. SCUF will position itself as the originator and the portfolio manager of the gold loan product on behalf of banks and will collect the spreads as commissions, with banks meanwhile making use of these loans for PSL norms.

SCUF has had healthy disbursement and AUM growth at over 17% over the last several years. The MSME segment has been growing at over 20% consistently. The gold loan segment has been struggling for growth over the last 3 years and that has pulled down the aggregate growth numbers. Since, MSME financing and 2W financing are now over 75% of the portfolio and have a longer tenure, the AUM growth will continue to be healthy going forward.

SCUF has also invested meaningfully in scaling up its mortgage loan subsidiary that focuses on the housing needs of its customer set. The subsidiary is still in scale up mode and it would take another 5 years for it to be a meaningful contributor to the overall value. It currently pulls down the aggregate ROA numbers. Currently around 20% of incremental disbursals in 2-W loans, personal loans and auto loans are to existing customers. I believe that this cross-sell with continue to increase as SCUF truly becomes a multi-line financier for the underbanked population.

Variant Perception:

It is important to understand that SCUF’s borrowers are not exactly subprime in the developed market sense (people with low credit scores). Most of these customers/ enterprises don’t have any credit score at all as there is no banking history or formalized income sources for them. Hence, unlike the subprime borrowers, this customer set has no issues with respect to credit behaviour or intention to repay the loan. With the high penetration of micro-finance, it can be seen that even on unsecured loans, the customer repayment is very high if the lender underwrites well.

For an enterprising customer who borrows 10K-15K $’s loan, the monthly EMI on a 3-5 year loan is arougly around 300-325 $’s. On such low ticket lending, the yields are sticky as the monthly payment differential between borrowing at 16% or 18% doesn’t vary much. The more important criteria for the borrower becomes turnaround time, servicing, relationships etc. Building and managing a large feet on the street organization is difficult and requires a DNA that is committed to serving the under penetrated segment.

SCUF currently has around 1000 branches with 28K+ employees with an average employee AUM of less than 10 Million INR (140K USD). Branch throughput has been increasing at 13% CAGR over the last 4 years. It is extremely difficult for a new player to build a similar branch network or employee base. I believe that disrupting this segment is extremely tough and hence will provide better risk-adjusted returns for SCUF.

The average ROE of SCUF was upwards of 21% before FY15 and only 12.5% over the last 3 financial years. While it is easy to look at these figures and believe that there is some structural issues with the business, I don’t believe so.

First the ROA volatility (3.4% pre-FY15 and 2.6% over the last 3 years)  is lower than ROE volatility as the firm is now running with lower leverage post the FY15 equity raise and has adequate regulatory room to increase leverage going forward. The company can increase leverage by another 1.5X to 2.5X as per prudent regulatory norms.

Second and most importantly, the firm had to undergo a big change in its NPA recognition and provisioning policies during this period. The company was on a 180 dpd recognition pre-FY15 and the regulator asked all financial institutions to come on a common 90 dpd recognition norms by phasing recognition rules from 180 to 150 dpd in FY 16, 150 to 120 dpd in FY 17 and 120 to 90 dpd in FY 18. The company had to provide for the delayed payments on its whole back book during the transition phase.

Third, SCUF’s customer segment has been through a major shake-up over the last 2 years that has disrupted their cash flow and subdued growth temporarily. The government’s 2016 decision to withdraw cash (demonetization) and the 2017 roll out of a unified indirect GST tax regime had affected the semi-urban and the informal economy in a big way. This increased the delinquencies of the portfolio. As the effects of these changes wears out and growth returns back to this segment, there will be an improvement in the non-performing asset numbers going forward.

It is extremely important to understand that delinquencies and real credit costs or write-off differ meaningfully in this segment. Since the customers operate businesses in which there are huge seasonalities, the monthly repayment sometimes gets delayed because of a bad monsoon or some other temporary issue. In most cases, the customer starts repaying once the business comes back on stream as the repayment intent is always there. This along with the underlying collateral value (150%+ of outstanding loan value at origination) enables a big divergence in delinquencies/ late payments and real write-offs in this business. Even during the 2008 GFC crisis, SCUF’s net credit costs didn’t move up substantially while there have been huge fluctuations in delinquency data over the years. Hence, the change from 180 to 90 dpd is only from an accounting point of view and the real credit costs in this business hasn’t changed substantially. Ultimate credit loss experience continues to be in-line with historical levels of ~2.75-3%

Currently, the firm is running with very healthy provisioning cover (over 1.5X the regulatory provisioning norms) and I believe that the credit costs would normalize to a 3% range soon as can be seen from the recent quarterly results. Higher recoveries can lead to healthy writebacks and lower P&L charges going forward. With the recent transition to Ind-As, the firm is well placed to increase its ROE upwards of 18% (without housing subsidiary) over the next few quarters.

Unique Management Culture & Skin-in-the game of Employees:

Shriram group is certainly only of the best lenders in the country. Their understanding of the un- banked segment is un-paralleled. The company has been aggressive on growth, yet conservative on lending practices. The Shriram tag commands immense brand equity on a pan-India basis. But the fact that this brand equity was accomplished with a near-zero advertisement spending stands to speak something about the management.

It is no surprise that any smart long-term investor would want to partner with a prudent management. SCUF and the Shriram group continue to attract some of the best long-term investors. Promoters (Shriram Capital) of the Shriram group own 33.79% of SCUF. While the free float looks large, a significant part of it is held by strategic/financial long term investors. Apax holds 20.3% (which it bought from TPG) while Mr. Piramal holds 9.98% in SCUF. In total 63.8% of SCUF is held by promoters and strategic partners. South African financial services group SANLAM holds 7.85% in SCUF indirectly. Chrys Capital, Bessemer Ventures, Norwest Venture Partners, ICICI Ventures have all invested in SCUF and other Shriram group entities at various points.

Ajay Piramal is a value investor, disciple of Buffett and a very shrewd deal maker. It was all evident in the way in which he built and sold Piramal’s domestic formulation business. When international pharma companies were exiting the Indian markets, Piramal bought them out. His contrarian approach of investing in the domestic formulations business when everyone else was chasing the international generics market delivered rich dividends. In 2010, his domestic formulations business was valued by Abbott at 18,000Cr, an unprecedented 9X Sales and 30X EBITDA. And do remember, he did not use investment bankers (“Don’t ask the barber if you need a haircut”-Charlie) for the $3.8 billion sale. The markets are aware of not just his deal-making prowess but also the high level of integrity and respect that he commands. When the Essar group wanted to exit Indian operations of Vodafone and since the Indian regulations then wanted an Indian ownership, Piramal was then their go-to person. He has built a strong real estate developer and wholesale financing business in a short time frame by attracting some of the smartest minds in the business.

But when RT (R. Thyagarajan, Founder Shriram Group) invited Piramal to make investment in Shriram Capital (the holding company of Shriram’s financial divisions) and made him the Chairman of the board, the opinion was the other way – “What an opportunity it was for Piramal?”. Such is the culture and trust that Shriram group has built over the last 40 years with all of its stakeholders. Rajesh Laddha, a Chicago MBA alum and Piramal’s go-to finance man since 2001 is Shriram Capital’s MD & CEO. While there is a lot of uncertainty around possible merger of SCUF with other group entities or a bank, I believe that there are ethical people and smart investors who could create overall value for shareholders and not do anything that is bad for the minority investors. It needs to be noted that last year’s proposal for merger with IDFC was dropped when it became clear that it wouldn’t create value for shareholders. Similarly, when a contingent liability arose for SCUF and STF because of issues in a non-financial Shriram group company, the group was quick to move the liability from the listed entities to the Trust.

To understand the governance at SCUF, it is very important to understand the Shriram culture and its emphasize on trusting people. Time and again over the last 40 years, Shriram group has built scalable business models targeted at a consumer segment which was tagged untrustworthy. This was possible only by trusting people, understanding their risks and working along with them.

Employees are embedded with this culture the moment that they join the group. The only way that they could be successful is by being closer to the people who invest and borrow money from Shriram. In order to serve this consumer segment, it is very imperative to live their life and live like them. This is what RT’s ideology is and the entire group is influenced by this principle. Every other NBFC knows that there is a huge opportunity lending to this target segment. It is just that they could not develop the trust factor and the culture of Shriram is difficult to replicate.

All the financial services business entities of the Shriram group are housed under “Shriram Capital”. Shriram Capital owns the majority in the listed Shriram Transport Finance and Shriram City Union Finance. Around 47% of Shriram Capital is owned by Shriram Ownership Trust (SOT), with the rest being owned by Ajay Piramal and Sanlam.

Now, who owns Shriram Ownership Trust? It turns out that the top 36 executives of the Shriram group own SOT along with RT who owns a miniscule 2.5%. Executives at the decision-making level, such as Shriram Transport Finance Co. managing director R. Sridhar, who spent 15 years with the group, will own a 2.5% stake while operating-level executives will own 1.5%.

SOT also has a committee made entirely of outsiders and this committee is responsible to select employees from the eligible base of around 45,000 to become a member of the trust. These employees who own shares in the trust can either take their wealth at the time of their retirement with full benefits or will have to take a cut if they resign before they retire.

R. Thyagarajan, 79, is the Founder of Shriram group and is one of the most respected business leaders in India. Until about 7 year ago, RT who has built a $15 billion financial conglomerate lived in a 1,500 sq.ft rented apartment. He never travels business class, does not own a mobile phone and travels in Maruti WagonR, one of the cheapest cars available.

Unlike many other Indian promoters who gleefully pass on the baton to their children, RT has made sure that every business in Shriram Capital is professionally run. The family members of the founders are nowhere to be seen in any management positions inside Shriram Capital. The elder son who is an engineer by profession runs construction and energy oriented businesses outside Shriram Capital, while the younger son is not visible in any of the board inside Shriram Capital. The Shriram group entities continue to be managed by either executives who have been with the group for several decades or outsiders who have high level of achievement.

Risks to the thesis:

There are geographic concentration risks in this business as SCUF’s major markets include Tamilnadu and Andhra Pradesh (with Telangana). Any slowdown in these markets due to political uncertainty or natural calamities could affect growth.

Increased irrational competitive intensity from the small finance banks or NBFC’s in adjacent lending categories such as gold financiers or micro financiers could lead to decreased return ratios and a valuation de-rating.

Conclusion

The stock has corrected recently due to the ongoing liquidity crunch for the NBFC’s (Non Banking Finance Companies) in India post the shock IL&FS bankruptcy that freezed credit markets. It is important to note that the Shriram group has seen far bigger crisis than this one and has come out stronger every time. Counter intuitively, this credit freeze improves the competitive positioning of SCUF as peers get less aggressive as theys don’t have the deposit taking ability of SCUF or the shorter tenure products that provide much better ALM match to SCUF’s books.

The stock has been trading at around 1.7X existing book value and 13X trailing earnings and we believe that is attractive for a business that generates around 18% across-the-cycle ROE and can deliver 15%+ growth for the next several years. I believe that this financing business can sustainably generate 3-3.5% of ROA and 18-20% of ROE. SCUF has always traded in its history at around 2.5X+ on trailing P/B valuations compared with the current 1.7X P/B Valuations. As ROE picks up there is a high probability of valuation re-rating.

There are multiple levers for earnings growth. Increased writebacks, lower provisioning charges, better liability management and higher operating leverage can help earnings grow faster than loan growth. The effective tax rate of SCUF is currently above 34% and we expect a glide down to under 30% over the next 5 years with tax rationalization.

Lending to the Micro segment of the Micro, Small & Medium enterprise is at a very nascent stage. Neither the banks nor the majority of NBFCs really understand how to appraise this segment and have stayed away. SCUF and its parent Shriram Group have a 4-decade experience building scalable businesses focused on the unbanked and underbanked. I believe that SCUF has not even penetrated the tip of the iceberg in the MSME lending opportunity and that there is an extremely long runway for growth. SCUF with its strong leadership position in both MSME lending and Two-Wheeler loans is extremely well positioned to take advantage of the India growth story and I believe that it would deliver healthy risk adjusted returns for its long-term investors.

Catalyst

There is no specific catalyst in this trade. Any corporate action with the Shriram/ Piramal Group can be a trigger.