Gold financing companies: All that glitters may not be gold

Madhuchanda Dey Moneycontrol Research

Gold financing companies had a difficult FY18 and the performance of stocks - Muthoot Finance and Manappuram Finance - captures this adequately. In the past 1 year, Muthoot and Manappuram have generated returns of a negative 16 percent and 2.4 percent, respectively, as against over 12 percent gains for the Nifty. While the weakness prima facie looks like an opportunity, it is pertinent to examine if the same is cyclical or structural?

A weak FY18
Muthoot reported muted growth in core gold loan assets. However, investment gains and tax credit boosted other income.

For Manappuram, core loan growth remained muted. However, growth in the non-gold businesses was impressive. Deteriorating asset quality in new businesses, especially in the micro finance lending, contributed to a huge surge in provision, leading to a decline in FY18 profit.

A spike in bad assets?
Gold loan is inherently a secure lending business, with adequate collateral in the form of gold jewellery. Muthoot saw a sharp spike in its non-performing assets to 7 percent of loans (90 day past due) from 5.6 percent (120 dpd) in Q3 FY18 and 2.1 percent (120 dpd) in Q4 FY17 due to increase in share of shorter tenure loans and change in recognition norms to a borrower-based recognition.

Muthoot’s management is confident of recovering the entire amount in the next couple of quarters. However, it was quick to add that they do not want to auction the gold quickly as it kills customer loyalty. Manappuram kept a check on delinquency in its core business, with a strategy of prompt auctioning.

Diversification the mantra
Both gold financing companies are diversification their loan book. Manappuram, for instance, now derives 25 percent of its assets under management (AUM) from non-gold lending. In FY18, its non-gold portfolio grew much faster.

Muthoot too is walking the path of diversification and plans to boost its share of non-gold loans to 20 percent by 2020 from 10 percent at present. It has two wholly-owned subsidiaries in the areas of home finance and insurance broking. It owns 66.6 percent in microfinance entity: Belstar Investment & Finance. The company also owns 60 percent stake in an asset financing company in Sri Lanka.

The management of Muthoot is eyeing significant growth in home as well as the micro finance book in FY19 and is contemplating entry into businesses like vehicle finance and personal loans.

Is diversification a sure shot path to success?
While a diversification strategy de-risks the book, the same is fraught with risks. For instance, diversification has come at a price for Manappuram. Growth in its non-core businesses accompanies a steady asset quality deterioration in its new businesses.

Manappuram’s microfinance subsidiary - Asirvad Microfinance (95 percent stake) - reported a loss in FY18, weighed down by provisions on account of high non-performing assets (NPA). Delinquency levels in the housing and vehicle finance businesses are also quite high. While the management is guiding for a turnaround in the micro-lending as well as housing finance businesses (focus on affordable housing), its success remains to be seen.

Structural shift: What it means for return ratios?
The opportunity in the gold financing business is itself significant with the unorganised sector 2-3 times larger than organised peers. Tardy growth in the gold loan business and emphasis on diversification raises questions about the opportunity in gold lending.

The market in recent times is witnessing heightened competition in the retail space with a large number of non-banking financial companies (NBFCs) and banks eyeing these businesses. Hence, a profitable scaling up in these areas is not guaranteed and needs to be monitored.

Barring microfinance, most other lending have intrinsically lower return on assets. As the loan book diversifies from gold loans, growth will occur on lower return ratios. We do not see a multiple re-rating for these companies, although we expect a cyclical upturn in the medium term.

Manappuram and Muthoot have been alluding to a difficult operating environment in FY18. They are now seeing traction returning and expect core gold loan growth to touch double-digits in FY19. Health of the rural economy is also on the mend, with the waning impact of demonetisation and expectations of a normal monsoon.  Both companies are well capitalised for growth.

Owing to a long period of underperformance, the valuation of both players appear reasonable. We expect a reversal of underperformance in the medium term. Both companies, especially Manappuram, remain a suitable acquisition candidate by any large player and may therefore enjoy certain inorganic premium.

Investors need to keep in mind that in the absence of a re-rating in the valuation multiple, long-term performance will largely track earnings growth.