PFC’s stake sale plan scrapped? What’s cooking?

Reports stated that REC had asked the government to consider selling PFC’s stake in the company to Power Grid.

According to Jefferies, the rationale is that PFC could finance power projects by selling its stake in REC.

There is also a perception among market participants that the government declined the proposal because Power Grid is not in the power financing business, which might not be viable for a non-banking finance company to allocate capital towards REC's acquisition.

“Now if this deal had received a heads up, it would have adversely impacted Power Grid business metrics. Power Grid was just a name which has enough cash on books to absorb with no loss deal to the government at which REC bought in 2019,” said Prashanth Tapse, Research Analyst and Senior Vice President, Research, Mehta Equities.

This stake sale proposal came after PFC, in March 2019, bought the government's 52.6 per cent stake in REC for Rs 14,500 crore to consolidate the two power financiers.

History and rationale behind PFC buying the stake in REC

PFC is India's largest government-owned non-banking finance company and provides funding to the Indian power sector. Its clients include central power utilities, state power utilities, private power sector utilities (including independent power producers), joint sector power utilities and power equipment manufacturers. REC, another non-banking financier with infrastructure loan status,  finances and promotes power sector projects across India.

“Both PFC and REC are Navratna Central Public Sector Enterprises with combined annual revenues of about Rs 50,000 crore and this acquisition is a step towards consolidation of companies operating in the same space,” a press release had said.

The rationale was to create a larger financing company for the power sector rather than having two public sector units competing in the same space.

"In 2019 when PFC bought a stake in REC, the intention was for the two entities to eventually enter a merger. Since the merger has not happened, it'll be beneficial for both the power financing companies to be present in the industry independently. With PFC's 52.6 per cent stake in REC, the two companies are cannibalizing business,” said Shravan Shetty, Managing Director, Primus Partners.

Before the stake acquisition, PFC and REC could each borrow up to 20 percent of a bank’s net worth. But after PFC acquired the majority stake in REC, their combined credit exposure limit stood revised to 25 percent of a bank’s net worth. Further, once they merge, the combined entity will be able to borrow only up to 20 percent of its net worth from a bank, restricting its ability to lend, reports said.

Arun Malhotra, Founding Partner and Portfolio Manager, CapGrow Capital Advisors, said REC was being considered for sale to another non-banking PSU entity because the combined entity has limited the capability to fund power projects.

Malhotra explained, “An entity cannot have more than 25 percent exposure to a project while the combined entity exceeds this limit in a number of cases, as both have extended loans to same projects. This violates the RBI (Reserve Bank of India) prudential lending norms. The idea is to sell the stake to a non-banking PSU entity to overcome these hurdles and provide credit to the capital-starved power sector”.

Financials

The financier logged its highest-ever annual profit after tax of Rs 10,022 crore in FY22 against Rs 8,444 crore in the previous year. PFC has improved its capital adequacy ratio to 23.48 percent as compared with 18.83 percent in the previous year, due to its active resolution efforts of Tier III assets.

Meanwhile, net non-performing assets declined to 1.76 percent in FY22, the lowest level in 6 years, from 2.09 percent last year. Further, PFC has declared a total dividend of 120 percent i.e. Rs 12 per share during FY 2021-22, the highest payout in the history of the company, its latest annual report said.

REC’s capital adequacy ratio, a measure of financial strength expressed as the ratio of capital to risk-weighted assets, as of March 31, 2022 was 23.61 percent. The total dividend for the financial year 2021-22, including the proposed final dividend, amounts to Rs 15.30 per share of face value of Rs 10/- each, which is 153 percent of the paid-up share capital of REC.

REC is one of the highest dividend paying companies among peers. Its consolidated net profit in FY22 stood at Rs 10,035.70 crore against last year’s Rs 8,378.24 crore.

Read here | Power ministry meets gencos, discoms, lenders to resolve payment issues: Sources

Investment bet

A Mumbai-based fund manager said PFC and REC have always been cheaper than peers in terms of valuation. And that is because their borrowers are predominantly power distribution companies, which are in a risky business.

According to moneycontrol.com, the price-earnings (P/E) ratio of PFC and REC in the trailing 12 months were below the industry median.

REC’s trailing 12 month P/E ratio is 2.49 and PFC’s is 2.00. A low P/E ratio likely indicates that a stock is cheap.

PFC and REC can be re-rated only when the credit profile of their clients--power distributors--improves.

Power distributors have been beset by low collections, rise in power purchase cost, inadequate tariff hikes and subsidy disbursement, and unpaid dues from government departments.

“PFC and REC have gross non-performing asset ratio at 5.02 percent on consolidated basis, while net non-performing asset ratio is at 1.57 percent which looks decent. However, repayment from the power distribution companies and resolution of old stressed assets has been on a slower track which remains a concern,” explained the head of portfolio management services at an asset management company (AMC) that manages over $200 million worth of assets.

For PFC, the exposure to power distribution companies would be nearly 50 percent on a consolidated basis, which means any delay in repayment remains a serious concern, he pointed out.

State power distribution companies have Rs 1.18 lakh crore of electricity dues to power producers, a report in The Economic Times stated in June.

Power distribution companies have accumulated losses of over Rs 5 lakh crore and regulatory assets, which represent costs that are deferred for recovery through future tariff revisions, worth Rs 1.25 lakh crore. Yet, they continue supplying electricity to consumers with occasional power cuts.

“Once the electricity amendment bill, which is tabled for this winter session, is cleared, the outlook for power distribution companies is expected to improve gradually which in turn would better the business outlook for power project financiers like PFC and REC,” the Mumbai-based fund manager said.

Post the Centre’s rejection, Tapse is positive on Power Grid, but has a neutral outlook on REC and PFC.

Read here | Explained: What is the new discom revamp scheme and how can it reduce the woes of the power sector?

Technical levels

Post a strong rally from the lower levels, shares of both--PFC and REC--are in a correction phase, said Arpan Shah, Senior Research Analyst, Monarch Networth Capital.

PFC shares are seen drawing support at Rs 97 while the stock can face resistance at Rs 122, according to Shah. The stock’s 52-week high is Rs 153.75 but is trading closer to its 52-week low of Rs 97.10.

Similarly, REC shares are also trading closer to the 52-week low of Rs 82.24 whereas its 52-week high was at Rs 126.64. Shah said that the support level for REC is Rs 82 and the resistance level is Rs 115. He has a neutral view on both stocks.

Year-to-date, shares of PFC have fallen 13 percent while those of REC have shed 7 percent.

The stock performance in past three years has also been poor; PFC rose 14 percent while REC was up nearly 1 percent.

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