Investors over-bullish on PFC, REC; risk-reward not impressive: Green Edge’s Digant Haria

Technically, these are NBFCs, but they are government departments. And because they are government-backed, they have triple-A credit ratings. They borrow money at 7.0-7.5 percent and then lend that money at 10-11 percent to the electricity sector of India.

For example, PFC's largest customer is a company called Tamil Nadu Electricity Board. TNEB is not a well-run company and is running huge losses. It is because of the state guarantee that PFC and REC can lend money to them and also recover it. In a way, PFC and REC are nothing but the central government lending money to the state government in some form. And, well run electricity boards like the Gujarat Electricity Board can borrow money at lower rates from the market, which a TNEB cannot. So, PFC and REC, in effect, are central government vehicles to help out-state government arms.

But PFC, REC and even the Indian Railway Finance Corporation (IRFC) have had a one-sided rally in 2023 so far. What is fuelling the mad rush for these stocks?

There's a lot of excitement around PFC and REC now because the power sector is going to boom. India has not seen much investment in the power sector for the last eight years. Right now, we are seeing growth in renewable energy, and thermal energy, and the need to upgrade our grids to connect new power plants to it and ensure stability. A Kotak Bank or an ICICI Bank naturally won't lend to these power projects. So, who is left? Only SBI and the PFC-REC duo.

However, I still think that investors in these stocks should be cautious. Because, at the end of the day, they are single-product companies and, to some extent, single-customer as well. The central government lending is to the state government. It will do well as long as the power cycle is strong, which I think is up to 2026-27. After that, we do not know how well these companies will perform.

But 2026-27 is still a good three years away. So, investors still have some runway left, don’t they?

But much of the expected growth in earnings has already been captured in the stock price. These stocks have shot up from around 0.4 times price to book (value) and are now quoting around 1.3 times price to book, which is high, given that their loan books are set to grow at only 10-12 percent compounded over the next three years. Assuming a price to book of one time on estimated FY27 earnings, these stocks may have at best around 35-40 percent upside, and that is if all goes well.

For a new investor, I would think the risk-reward ratio is not great. Also remember, the increasing shift to renewables will put the margins of PFC and REC under pressure because the margins in that business are not great.

Some investors point out that on a price to book, the stocks are much cheaper than what they were during the boom of 2010-11. Does that argument hold merit?

PFC/REC traded at 2.5 times book in 2010-11, but that was because their loan books were growing at over 20 percent and profits at 25 percent plus. In the current scenario, their size has become so big that they cannot grow more than 10-12 percent. So, it does not make sense to assign them multiples over 1 time book.

What is IRFC’s business model?

IRFC finances the railway sector. So, it's again a government company and they finance the Indian Railways and the vendors of Indian Railways. The business model is like that of PFC and REC, except that it lends to railways.

The government has come up with various schemes to improve the financial health of state electricity boards. Investors bullish on these stocks say a scheme like the Late Payment Surcharge Scheme (LPSS) which incentivised power distribution companies to repay their loans faster has made a difference to the financial health of companies like REC and PFC. What are your thoughts?

Firstly, let’s understand why these electricity boards of various states are in losses. Because in India, politics always involves providing free power to the farmers. They charge a higher rate to industrial customers to compensate. Now, the government is allowing industrial customers to set up their solar plants. So, why would an industrial customer buy high-priced power from a state electricity board? I think it's a complex issue; we had a UDAY scheme that came in 2014, but reasonable to say that it was a failure. It didn't gain much traction because these are very tough decisions. Revoking free power to farmers could lead to losing an election, and nobody wants to risk that.

So, I think reforming state electricity boards is not easy. What can happen is that they may stop giving additional free power, which is happening now. Whatever has happened in the past, they let it be and focus on newer, more sustainable ways. They can encourage farmers to put up their solar pumps and draw electricity from there, rather than depending on the state board. So, you can minimise this, but you can never really turn around electricity boards.

And, there is a problem for PFC and REC if electricity boards become profitable. Because then they will not need to borrow funds at high rates from PFC and REC. And that will cause the margins of these companies to decline.

But the loans that loss-making electricity boards take from PFC and REC are guaranteed, so in a way investors of these companies are protected, right?

The money is more or less guaranteed, but as an investor, my perception is that if a state like Tamil Nadu is in such financial trouble, it can default on loans to PFC and REC. It has never happened in the past, but such concerns linger. All said, PFC and REC got stuck in private sector power projects as well in the last eight years, and the NPAs are all in private sector power projects.

For example, a project like Lanco Amarkantak that was coal-based didn't get a coal supply. Another is a gas-based project like KSK Mahanadi…..everything was fine, but the plant never had gas, so it never started production and couldn't repay the loan. So, whatever bad things happened, it happened in the private sector.

Have PFC and REC cut down exposure to private-sector projects?

I don't think they've cut it down significantly. But now they are being much more cautious. They have started giving loans to solar projects with shorter gestation periods and lower risk. They've also started financing logistics infrastructure and metro projects. So, they are trying to diversify, but their private sector exposure is still around 15 percent, mainly because the power sector still dominates their portfolio.

Is competition building up because of various incentive schemes for electricity boards? Are banks other than SBI looking to step up their presence in this segment?

I don't think banks can enter this segment effectively because they would have a significant Asset Liability Mismatch (ALM). All these infrastructure financing projects are 15-year projects. A bank's average liability profile has an average maturity of around seven years. If a bank lends to a power company or an infrastructure project, it creates a significant ALM mismatch. So, what PFC and REC do is they enter into 15-year bonds; they borrow for 15 years and lend for 15 years, reducing ALM mismatches. Banks would likely provide short-term funding or three-year bridge financing products, but they would not be interested in long-term financing.

The REC management recently said in an interview with our channel that they were mindful of competition in the power sector. What is the competition they are worried about?

In the last two years, during 2021 and 2022, due to COVID-19, there was no growth in the system. So, many PSU banks offered lower interest rates to customers of PFC and REC, in effect poaching their top-performing assets. PFC and REC took on the risk when projects were under construction, and once the projects started performing well, banks showed up on the scene and said: “Hey I can give you 150 bps lower” and a lot of customers went to the banks.

Banks could afford to do that because they have the advantage of lower borrowing costs. Banks can still do that but are no longer interested because retail loans and corporate loans have started growing, so there is more work to do. In 2021, they had no work and plenty of funds, so they were going at each other’s throats. A small bank like the Central Bank of India got aggressive and managed to poach a client of SBI’s. This is unheard of. But such things are no longer happening.