Indostar Capital Finance

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1 September 17, 2018 Buy Indostar Capital Finance Industry: BFSI High growth + low valuations l!! Indostar Capital Finance, is promoted by Mauritius based PE Everstone Group, one of the well-known India & Southeast Asia focused PE firm. It operates into the niche space of early stage financing to real estate developers largely in Mumbai region. Recently, the company has embarked upon strategy to diversify its business mix more towards the retail including housing, vehicle finance from earlier concentrated corporate & SME loan book. To grow these new segments, it has front-ended opex cost resulting in drop in ROAs 2.2% levels in Q1FY19 from ~4% during FY14-18 period. However, going forward, operating leverage benefits would be realized coupled with increase in the leverage of assets + improvement in the business mix all these factors put together would give big boost to profitability. We expect earnings to grow at of 46% CAGR over FY19-22E period. Also, ROE to show marked progress from 11.1% and 7.7% in FY17 & FY18 resp. to 14.8% by FY22E. Initiating Coverage Stock Data Rating BUY Current Market Price ( ) M Price Target ( ) 593 Potential upside (%) 36 FV ( ) 10 Market Cap Full ( bn) Week Range ( ) 607 / 423 BSE / NSE Code / INDOSTAR Reuters / Bloomberg INAC.NS / INDOSTAR IN Diversification would reduce the cyclicality of the earnings and also give upper edge against the NBFCs who have monoline single product business. The company has appointed R.Sridhar as CEO of the company, who was instrumental to the Shriram Transport Finance growth story. Strong management in place gives high hopes of better future performance of the company. AUM to grow at rapid pace - The company has strategized to bring diversity in business mix and increase the size of non-corporate loans sizeably going forward. In the next 5 years, it aims AUM mix of VF 35%, corporate loans 35%, SME 15% and housing loans 15%. Over the FY18-22E period, we anticipate AUMs to grow at 50% CAGR which would be mainly driven by vehicle finance loans. Shareholding Pattern MF 9% FPI 13% Others 20% Promoter 58% Operating leverage set to play out in the longer run, boosting return profile of the company - To develop new lines of businesses, initial cost to expand number of branches & employees is required to build AUMs. Average cost/income ratio which was 18% in FY17 is estimated to surge to 39% in FY19E. However, in our view, once the branches become fully operational, achieve desired break-even and AUMs per branch increases, profitability would get preferred boost. Opex to avg. assets is estimated to fall to 2.2% levels in FY22E vs. 2.6% in FY19E. Margins would be sustained - The average margins of the company was ~6.3% during FY14-18 period. Higher margins were resultant of high IRR drawn in the corporate loans. Going forward as well, we expect margins to sustain above 6% given i) change in the AUM mix will not be deterrent to margins since the VF loans also equally draw higher margins of bps. ii) it enjoys strong pricing power in corporate & VF loans Compelling valuations one of the cheapest NBFC available In our view, experienced management team, strong profitability trends, improving return profile coupled with change in business mix more towards retail all these factors put together would drive re-rating in the stock. At current pricing, it is trading at compelling valuations of 1.4x FY19E and 1.2x FY20E ABV. It is one the cheapest NBFC available currently. We initiate coverage on the stock with TP of 593 giving upside potential of 36% - according 1.7x multiple to its FY20E ABV. Anusha Raheja anusha_raheja@lkpsec.com YE Mar FY18 IGAAP FY19E IndAS FY20E IndAS FY21E IndAS PAT (.mn) yoy (%) BV ( ) ABV ( ) P/ABV (x) ROE (%) ROA (%) Gross NPAs (%) PCR (%) Relative Price Performance May-18 Jun-18 Jul-18 Aug-18 Sep-18 Indostar Capital BSE Sensex LKP Research

2 Profit & Loss Statement (Consolidated) (.mn) FY18 FY19E FY20E FY21E FY22E Interest Income 7,031 11,725 19,715 28,636 38,684 Interest Expense 3,244 5,675 10,099 15,562 21,792 Net Interest Income (NII) 3,787 6,049 9,615 13,074 16,893 Other Income 1, Total Income 5,095 6,209 9,825 13,334 17,203 Total Expenses 1,509 2,444 3,508 4,884 6,227 Employee Benefit Expense 816 1,505 1,968 2,568 3,152 Other Expenses ,430 2,174 2,901 Depreciation & Amortization Total Operating Income 3,586 3,765 6,317 8,449 10,976 Provisions ,112 1,465 1,720 PBT 3,497 2,988 5,206 6,984 9,256 Tax Expense 1,253 1,016 1,770 2,375 3,147 PAT 2,244 1,972 3,436 4,610 6,109 Growth (%) EPS Balance Sheet (Consolidated) (.mn) FY18 FY19E FY20E FY21E FY22E Share Capital Reserves and Surplus 20,584 28,806 32,482 37,292 43,551 Shareholders' Funds 21,371 29,716 33,392 38,201 44,460 Borrowings 48,228 85, , , ,890 Non-Current Liabilities ,903 3,155 4,359 Current Liabilities 3,002 3,002 3,002 3,002 3,002 Total Liabilities 72, , , , ,711 Cash and Bank Balances 1,278 1,200 1,200 1,200 1,200 Loans & Advances 60, , , , ,517 Other Assets 1,391 1,434 1,676 1,826 1,994 Total Assets 72, , , , ,711 LKP Research 2

3 Key Ratios (Consolidated) Growth (%) FY18 FY19E FY20E FY21E FY22E Total Assets AUM (%) Disbursements (%) Borrowings (%) Interest Income (%) NII (%) Total Expenses (%) Operating Income (%) Provisions (%) PAT (%) Yields (%) FY18 FY19E FY20E FY21E FY22E Yield on loans (%) Cost of Borrowings (%) Gross Spread (%) Margins (%) Cost Ratios FY18 FY19E FY20E FY21E FY22E Cost/Income ratio (%) Opex / AUM (%) Opex / Avg. Assets Asset Quality Gross NPAs (%) Net NPAs (%) PCR (%) Credit Cost (%) Delinquency Rate (%) Return Ratios (%) FY18 FY19E FY20E FY21E FY22E ROE (%) ROA (%) Leverage (%) D/E Per Share Data FY18 FY19E FY20E FY21E FY22E Share Capital ( ) FV ( ) No. of shares (no. in mn) EPS ( ) BV ( ) ABV ( ) P/E (x) P/BV (x) P/ABV (x) Branches Data FY18 FY19E FY20E FY21E FY22E No. of branches (No.) AUM / Branch (Rs) No. of employees (No.) Employee Per Branch ( ) Salary / Employee( ) LKP Research 3

4 Investment thesis We expect change in the business mix going forward with non-corporate loans occupying dominant share of 67% by FY22 vs. 26% in FY18. Corporate loans currently have major pie of 74% in total loans currently (FY18). Change in the portfolios will not be deterrent to margins or the profitability. Margins are estimated to sustain above 6% levels led by high yielding vehicle finance & corporate loans AUM to grow at strong pace of 57% CAGR over next 3 yrs FY18-21E Operating leverage set to kick in boosting profitability & return ratios. PAT to grow at 57% CAGR during FY19-21E period. However, profits to remain subdued in FY19 given higher opex incurred on branch expansion. ROE to surge exponentially from 11.1% and 7.7% in FY17 & FY18 respectively to 14.8% by FY22E. While ROA would be sustained at 2.2% levels. In our view, strong profitability trends, improving return profile coupled with change in business mix more towards retail all these factors put together would drive re-rating in the stock AUM to grow at strong pace at a CAGR of 57% over FY18-21E..this would be driven by retail loans (vehicle, home & SME loans) AUM (Rs.bn) 81.6 growth (%) FY15 FY16 FY17 FY18 FY19E FY20E FY21E FY22E SME Loans Housing Finance Vehicle Finance Corporate Loans 100% 90% 23.4% 21.6% 20.3% 19.1% 18.3% 80% 0.8% 7.3% 12.6% 15.0% 16.2% 70% 2.1% 13.7% 60% 23.3% 50% 28.8% 32.4% 40% 73.7% 30% 57.3% 20% 43.8% 37.1% 33.0% 10% 0% FY18 FY19E FY20E FY21E FY22E Alongwith this high margins of 6% would be sustained Operating leverage set to play in the long run Margins (%) Cost/Income ratio (%) Opex / Avg. Assets (%) FY17 FY18 FY19E FY20E FY21E FY22E FY18 FY19E FY20E FY21E FY22E LKP Research 4

5 All factors put together would lead to strong growth in PAT which would grow at CAGR of 46% during FY19-22E.leading to jump in the ROE 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 PAT (Rs.mn) 74.2% 34.2% 32.5% 1% 6.4% -12.1% 2,108 2,244 1,972 3,436 4,610 6,109 FY17 FY18 FY19E FY20E FY21E FY22E 8% 7% 6% 5% 4% 3% 2% 1% % -1% -2% ROE (%) ROA (%) FY17 FY18 FY19E FY20E FY21E FY22E ` About the company Promoted by Everstone Capital in 2009, Indostar Capital Finance is systematically important non-deposit taking NBFC which is largely into early stage financing to real estate developers. The company recently expanded its portfolio to offer vehicle finance & home finance products alongwith SME lending. As at Q1FY19, it had AUM of 76.4 bn, branch network of 129, employee base of 1431 and total customer size of Recently in May 2018, the company had raised capital via IPO amounting to 18.4 bn. Last year, the company had appointed Mr. R.Sridhar as CEO of the company who has 3 decades of experience in financial industry and was instrumental in building vehicle finance book for Shriram Transport Finance Ltd. Indostar Capital, is the holding company of Indostar Capital Finance, which again is owned by Everstone (51.2%), Beacon India PE Fund (10.8%), CDIB Capital Investments (4.7%). Also the NBFC has two fully owned 100% subsidiaries namely Indostar Home Finance (housing loans business is done via this subsidiary) and Indostar Asset Advisory LKP Research 5

6 Shareholding pattern 51.2% 19.3% 14.1% 10.8% 4.7% Indostar Everstone: 42.5% Everstar Holdings Pte. Ltd.: 8.7% ACP LIBRA Limited: 16.4% Beacon Light Group Limited: 2.9% Global Long Short Partners Mauritius I Ltd: 8.4% Private Opportunities (Mauritius) I Ltd: Beacon India Private Equity Fund: 10.8% CDIB Capital Investment II Limited: 4.7% 57.7% 1.3% 1.1% Indostar Capital, Mauritius (ICM): 57.7% (Promoter) Everstone Capital Partners II LLC: 1.3% (Promoter Group) Public Shareholders IndoStar Capital Finance Limited IndoStar Home Finance Private Limited (100% Subsidiary) IndoStar Asset Advisory Private Limited (100% Subsidiary) Key milestones of the company INCEPTION EARLY GROWTH PRODUCT EXPANSION EXPANSION CONTINUED RETAILISATION FY FY FY FY FY Started lending business. First external credit rating of AA - from CARE. Corporate Lending Business achieves a 74% CAGR over FY12-14 Forayed into SME business Geographical expansion to 7 SME branches NHB issued HFC license R Sridhar joined as Executive VC & CEO Commenced CV/ Housing finance business Expanded branch network to 91 branches Listed on stock exchange on 21st May 2018 LKP Research 6

7 Details of the management team Management Designation Previous organisation work experience R Sridhar Executive Vice Chairman & CEO 30 yrs experience, served as MD of Shriram Transport Finance Shailesh Shirali MD, Head of Corporate Lending & Markets 30+ yrs experience, worked with Future Capital Holdings A.Gowthaman Hansraj Thakur Business Head - Vehicle Finance Business Head - SME Finance 20+ yrs of exp, previously worked with CIFC, Shriram Transport Finance, Shriram Investments & others Experience in SME commercial banking, worked with IDFC Bank and Standard Chartered Bank Shreejit Menon Business Head - Affordable HF Worked with Religare Housing, HSBC, Muthoot Finance Prabhat Kumar Tripathy Business Head - Retail HF Worked with Equitas SFB, ICICI Bank, Dewan Housing Finance Pankaj Thapar CFO 30+ yrs of experience, worked with Everstone Capital Advisors, Dentsu Marcom, ICICI, Coca-Cola India, ANZ Grindlays Bank, Citibank India More about the loan profile of the company Indostar Capital Finance, is promoted by Mauritius based PE Everstone Group, one of the wellknown India & Southeast Asia focused PE firm having USD$4bn of assets under management. Below is the details of broad businesses of the company Corporate loans Corporate loans currently form 74% of the total loans as on FY18 vs. 100% in FY13. The corporate lending business primarily consists of advancing (i) loans to leading real estate developers for financing project level construction of residential & commercial properties which have received key regulatory approvals. (ii) secured loans to companies in the manufacturing, services and infrastructure industries by way of structured financing, promoter financing and special situation funding (such as family settlements, buy-outs and bridge financing) In the total corporate lending portfolio, loans backed by real estate (RE) collaterals is 50% while the balance 50% are the loans where the collaterals are non-real estate backed ones. In RE corporate loans, nearly 90% of the loans is in MMR (Mumbai Metropolitan Region). In RE corporate loans, the average ticket size of individual flats in these residential project is approx. Rs15-20 mn. The product offering for real estate financing includes structured debt for take-out of early stage equity investors, mezzanine financing and construction finance. Usually in these construction projects, original structured debt investment is often refinanced by bank once the project achieves certain milestones. In order to safeguard servicing of interest and principal payments, the company mandates to open project escrow account of borrowers to regulate its cash flows. These loans are usually floating based loans and have duration of 3-5 yrs. The security in these loans is largely in the form of mortgage of fixed assets, pledge of shares or escrow of existing and future revenues. It provides extend loans to the certain repeat borrowers based on its past experiences and familiarity with them, which has helped the company to sustain highquality asset portfolio. Also, it does not provide funding for greenfield projects. In non-re corporate loans, it focuses on mid & small corporates catering to nearly companies. These lending typically happens in the form of a) Structured financing, where the company forms specialized structured financing solutions for acquisition funding, family settlements and other asset financings b) Promoter financing, where it provides promoter funding for acquisitions, take out of other shareholders c) Special situation funding and mezzanine financing, where financing against listed securities, select unlisted securities, operating cash flows or any other tangible collateral is provided. The customers of corporate finance business line belong to diverse industries including financial services, infrastructure, iron and steel, and poultry. LKP Research 7

8 High IRRs - Key plus of the corporate lending portfolio is that it enjoys very high yields to the tune of 14% in this segment and net IRR of above >16%. High IRR is largely due to advisory services provided by the company apart from lending done. Principally, corporate book is not just plain vanilla lending but also advisory services & early stage financing where it has less competition from banks & other NBFCs. Self-originated book - Another key positive is the fact that the entire book is self-originated rather than syndicated loans originated by other lenders. The company has experience and expertise in identifying and directly sourcing potential borrowers through knowledge of local markets. Details of the corporate loan products Share of corporate loans in total loan book pie (FY18) Lending process corporate lending credit assessment and risk management framework comprises of four stage framework, spanning across the i) screening stage, where the credit and sourcing teams conduct an initial screening of prospective borrowers; ii) the evaluation stage, where the credit team evaluates the prospective borrower s business and financing needs and investigates its track record, market reputation, repayment capability before presenting it to corporate lending committee iii) the approval stage; where the loan proposal is presented to credit committee for final approval and loan disbursement and iv) the sanction and monitoring stage, where the credit team regularly monitors the loan portfolio for early identification of problematic loans. Products Target Customers Features 74% Real Estate Loans Structured Corporate Loans Mid-sized Real Estate Developers Mid-to-large sized Corporates Loans for construction of commercial and residential properties. Structured lending to align cash flow, achieve strategic objectives and growth plans. Acquisition funding, promoter funding for equity buy back/take outs, family settlements and asset financing. Vehicle finance portfolio In order to diversify the businesses, the company commenced vehicle financing operations in November It finances used or new commercial vehicles, twowheelers and passenger vehicles. Currently, 30% and 70% of the portfolio consist of new and used vehicle finance book respectively. In the used segment, it lends for 5-12 years old vehicles to the small fleet operators. Blended yields in this segment are relatively high at 15.5% (yields in used & new vehicles is 13-14% and 17-18% respectively). This portfolio involves large sourcing team as compared to other business lines and hence, the company has build strong relationship with the dealer network to drive AUMs. The customers are predominantly transport operators, small businesses and self-employed and salaried individuals, who generally contribute between 10% to 30% of the purchase price of the asset financed while balance is financed by the company. Management strong expertise and prior experience (under the aegis of Mr. R.Sridhar) comes as added advantage for building this vehicle finance book. Vehicle finance business is currently headquartered in Chennai as it expects Tamil Nadu to be the key market for initial rollout of the business. As it requires local on ground presence, it has build presence via 114 branches across geographically spread 15 states. It has total AUMs of 4 bn, employees strength of 883 and customer base of 5979 as on Q1FY19 in this segment LKP Research 8

9 Details of the vehicle loan products Share of vehicle loans in total loan book pie (FY18) Products Target Customers Features 2% Commercial Vehicles Passenger Vehicles Two Wheelers Small and medium fleet operators, Salaried employees and self-employed professionals Focus on financing used LCVs and HCVs for medium and small fleet operators, and small businesses. Two wheeler loans for salaried professionals and self-employed individuals. Details of the SME loan products SME portfolio SME business line commenced operations in March As on Q1FY19, this segment has AUMs of Rs16.5 bn, branch network of 10, total customers 1293 and employee base of 77. These SME loans are given to small and medium term enterprise having turnover of mn including traders, wholesalers, distributors, retailers, self-employed professionals and small manufacturing companies. Dedicated SME branches are placed in ten key locations across India namely Mumbai, Delhi, Chennai, Bengaluru, Hyderabad, Jaipur, Surat, Ahmedabad, Pune and Indore. Typical loan size ranges from 5 mn to 30 mn with average ticket size being 11mn. Collateral in these loans is largely property 65% of collateral is in the form of residential properties and balance 35% are commercial properties. These collaterals are usually selfoccupied properties while it doesn t lends for vacant properties. The average LTVs in this segment are 65% and yields are %. These loans are typically floating rate based ones and tenors of the loans is upto 15 yrs. 50% of its SME loans qualifies for the PSL status. The various type of the loans given in this segment are plain vanilla loans, gross turnover loans, debt consolidator loans, mortgage & top-up loans, loans for purchase of commercial properties and banking profile based loans. Share of SME loans in total loan book pie (FY18) Products Target Customers Features Vanilla Loans 23% Gross Turnover Loans Debt Consolidation Loans Mortgage & Top-up Loans Loans for Purchasing Commercial Property Traders, Distributors, Retailers, selfemployed professionals and small manufacturing companies Business loan to SMEs with a turnover of approx. Rs mn professionals. Banking Profile Based Loans Housing Finance Housing Finance business was launched in September As this business line is newly set-up, AUMs are relatively small at 1.8 bn. This segment has customer base of 1442, employee strength of 391 and branch network of 40 (Q1FY19). Operations of housing finance business is done through wholly-owned subsidiary IndoStar Home Finance Private Ltd. Focus area in this segment is affordable housing segment, self-employed or salaried individuals in the outskirts of urban markets and Tier II cities. Affordable housing segment involves projects where the property cost is typically 5 mn and loan amount is not more than 3 mn. Loans are provided to salaried as well as self-employed customers. The company leverages relationships with the real estate developers customers to build this portfolio. Branches of vehicle finance network are utilized for operations of housing finance loans. Also, it has hired experienced personnel from ICICI Bank & HDFC to head this housing business in order to expand this portfolio. Currently, 40% of the home loans are given in the state of Tamil Nadu and yields in this segment are ~12%. LKP Research 9

10 Details of the housing loan products Share of housing loans in total loan book pie (FY18) Products Target Customers Features 1% Housing Salaried employees and self-employed professionals New and Resale Home purchase loan, home construction loan to self-employed/salaried individuals. Affordable Housing Non-documented self- employed segment New and resale home purchase loan, home construction loan to self-employed and salaried individuals in outskirts of urban markets, Tier II cities. Diversification of the business mix with increasing share of the retail portfolios Currently, 74% of the AUMs consist of corporate loans. Under the leadership of current CEO Mr.R.Sridhar, the company has embarked on the right strategy to diversify its loan mix more towards retail loans including vehicle finance, home loans & small sized SME loans than highly concentrated corporate loan book currently. This strategy would not only bring stability to its earnings but also give desired leverage benefits boosting its overall profitability parameters. Since inception, the company has enjoyed one of the highest return ROAs in the industry at 4.1% during FY14 to FY18 period. Factors contributing to higher profitability were 1) high IRR in corporate portfolio as it has relatively less competition in this space and more of advisory related services are provided 2) operating cost was also less due to corporate heavy balance sheet 3) asset quality was impeccable due to strong risk management practices implemented. Although, ROA was high at 4% odd, average ROE was less at 11% (during FY14-18) due to less leverage (3x). Since the repayments & prepayments are higher in these corporate loans & opportunistic led demand, leverage was relatively less in this segment. Recent IPO suppressed ROEs (current CAR is >32%). However, there has been a paradigm shift in the strategy of the company to diversify its business mix more towards retail driven loans than concentrated corporate loans. Since last one year, the bank has launched vehicle finance, home finance businesses. For the same, it has incurred meaningful cost there has been more than 12x jump in branches from 10 in Q1FY18 to 129 in Q1FY19, similarily, employees have increased from 75 to 1374 for the same period. This has distorted cost/income ratio in the near term and resultant return ratios too. ROE and ROA has fallen from 11.1% and 3.9% in Q1FY18 to 7.2% and 2.2% in Q1FY19 respectively. However, in our view, once the branches become fully operational and achieve desired break-even, profitability would get preferred boost. In our opinion, the company has selected the right segments for growth viz. home, vehicle & SME loans which have strong long term demand and good profitability as well. Since the current management has strong expertise in this vehicle finance business, which would be core focus area going forward, growth is not likely to come at the cost of asset quality. Additionally, high yields in this segment similar to corporate loans would give boost to its return ratios. Hence, increase in the leverage of the assets (higher growth) coupled with realization of operating leverage + improvement in the business mix would not only boost return ratios but also its quality too. We expect ROE to show marked progress from 11.1% and 7.7% in FY17 & FY18 resp. to 14.8% by FY22E. However, FY19 year profitability would be impacted given front-ending of cost incurred for employees and branches to change AUM mix. We expect ROE to drop to 7.7% in FY19E before surging to 14.8%. Profits to drop by 12% from 2.2 bn in FY18 to 2 bn in FY19E. LKP Research 10

11 AUM to grow at rapid pace From last one year, share of non-corporate loans have been surging with vehicle financing forming 2% share, home finance 1%, and SME loans 23% (FY18). Going forward, the company has strategized to bring diversity in business mix and increase the size of non-corporate loans sizeably. In the next 5 years, it aims AUM mix of VF 35%, corporate loans 35%, SME 15% and housing loans 15%. Over the FY18-22E period, we anticipate AUMs to grow at 50% which would be mainly driven by vehicle finance loans. While the share of VF loans to rise to 33% in FY22E from 2.1% in FY18 while share of corporate loans to fall to 33% from 74% for the same period. In our view, higher growth is quite achievable and not tough target to be met given i) current management strong expertise in building vehicle finance business ii) the company has less competition in corporate loans since it is into early stage financing of developer s project where banks funding come at later stage iii) PSU banks lingering asset quality woes would give apt opportunity to NBFCs to grow in competitive space of housing & SME finance businesses. Margins would be sustained The average margins of the company was ~6.3% during FY14-18 period. Higher margins were resultant of high IRR drawn in the corporate loans. Going forward as well, we expect margins to sustain above 6% given i) change in the AUM mix will not be deterrent to margins since the VF loans also equally draw higher margins of bps ii) in the rising interest rate scenario, it is perceived that NBFCs take a hit on the margins, however, this will not be the case with Indostar. It has pricing power in the corporate loans and vehicle finance loans any incremental rise in the costs shall be transferred to the borrowers without hurting the AUM growth iii) higher yields in corporate and VF loans shall compensate for lower yields in home and SME loans without much impacting the profitability as former would still continue to dominate the loan book pie (share of 65% by FY22E) iv) company enjoys good rating for its borrowings programme term loans and redeemable NCDs have rating of AA- (CARE) while CP have rating of A1+ (ICRA). We expect good rating to continue given higher CAR levels post IPO, strong management in place and sound profitability. This should enable the company to draw borrowings at lower cost going forward as well. While, net margins are relatively less in home loans & SME loans these segments would give desired leverage to the balance-sheet and are less riskier from asset quality standpoint. Strong credit ratings Borrowings Type Rating Firm FY18 - Ratings Term Loans India Ratings / CARE AA- Redeemable NCDs India Ratings / CARE AA- CPs CRISIL / CARE / ICRA A1 (+) Borrowings Chart Borrowing Mix - March 2016 Borrowings Mix - Jun 2018 Others 4% NCD 35% Banks 52% NCD 36% Banks 38% CPs 13% CPs 22% LKP Research 11

12 Margins to sustain above 6% mark Margins (%) FY17 FY18 FY19E FY20E FY21E FY22E Operating leverage set to play in the longer run, boosting return profile of the company To develop new lines of businesses, initial cost to expand number of branches & employees is required to build AUMs. It has incurred meaningful cost there has been more than 12x jump in branches from 10 in Q1FY18 to 129 in Q1FY19, similarily, employees have increased from 75 to 1374 for the same period. This has distorted cost/income ratio in the near term and resultant return ratios too. Average cost/income ratio which was 18% in FY17 is estimated to surge to 39% in FY19E. ROE and ROA has fallen from 11.1% and 3.9% in Q1FY18 to 7.2% and 2.2% in Q1FY19 respectively. However, in our view, once the branches become fully operational, achieve desired break-even and AUMs per branch increases, profitability would get preferred boost. Opex to avg. assets is estimated to fall to 2.2% levels in FY22E vs. 2.6% in FY19E. Opex/avg. assets to fall by FY22E before peaking out in FY19E Cost/Income ratio to fall to 36% in FY22E from 39% in FY19E Cost/Income ratio (%) Opex / Avg. Assets (%) FY18 FY19E FY20E FY21E FY22E AUMs per branch to increase Branches Data FY18 FY19E FY20E FY21E FY22E No. of branches (No.) AUM / Branch No. of employees Employee Per Branch Salary / Employee LKP Research 12

13 Strong management team at the helm The company has appointed Mr.R.Sridhar as Executive Chairman & CEO of the company who was instrumental in building Shriram Transport Finance vehicle finance business. With the right knowledge and expertise in place, we expect management to deliver quality growth in vehicle business at Indostar. Mr.Shailesh Shirali, who is the MD, is looking after corporate lending & market segments currently. He has 20+ yrs of experience and previously worked with Future Capital Holdings. Similarly, to grow housing finance business, people appointed to the lead the teams have sound experience of 20+ yrs and have previously worked with good reputed names like ICICI Bank, HSBC etc. In our view, with the right team in place headed by R.Sridhar, the company is likely to embark on strong & profitable growth trajectory going forward. Management team details Management Designation Previous organisation work experience R Sridhar Executive Vice Chairman & CEO 30 yrs experience, served as MD of Shriram Transport Finance Shailesh Shirali MD, Head of Corporate Lending & Markets 30+ yrs experience, worked with Future Capital Holdings A.Gowthaman Hansraj Thakur Business Head - Vehicle Finance Business Head - SME Finance 20+ yrs of experience, previously worked with CIFC, Shriram Transport Finance, Shriram Investments & others Experience in SME commercial banking, worked with IDFC Bank and Standard Chartered Bank Shreejit Menon Business Head - Affordable HF Worked with Religare Housing, HSBC, Muthoot Finance Prabhat Kumar Tripathy Business Head - Retail HF Worked with Equitas SFB, ICICI Bank, Dewan Housing Finance Pankaj Thapar CFO Asset quality well in place 30+ yrs of experience, worked with Everstone Capital Advisors, Dentsu Marcom, ICICI, Coca-Cola India, ANZ Grindlays Bank, Citibank India Self-originated credit book, strong underwriting skills, robust credit & risk management framework, repeated customer base all these factors put together have worked wonderfully for Indostar keeping its NPA levels in check. Despite being into riskier segment, asset quality performance of the company is relatively good gross NPAs and net NPAs were at 1.2% and 1% for the year FY18. Lending process corporate lending credit assessment and risk management framework comprises of four stage framework, spanning across the i) screening stage, where the credit and sourcing teams conduct an initial screening of prospective borrowers; ii) the evaluation stage, where the credit team evaluates the prospective borrower s business and financing needs and investigates its track record, market reputation, repayment capability before presenting it to corporate lending committee iii) the approval stage; where the loan proposal is presented to credit committee for final approval and loan disbursement and iv) the sanction and monitoring stage, where the credit team regularly monitors the loan portfolio for early identification of problematic loans. Going forward, with sizeable increase in the AUMs, we estimate nominal surge in NPAs strong asset growth alongwith maintaining the asset quality performance would be the key. We expect gross NPAs to speed upto 1.7% by FY22E from 1.2% in FY18 while PCR would gradually increase to 50% mark for the same period. LKP Research 13

14 We estimate nominal increase in the NPAs going forward Gross NPAs to surge to 1.7% in FY22E from 1.2% in FY Gross NPAs (%) PCR (%) FY15 FY16 FY17 FY18 FY19E FY20E FY21E FY22E Impact of IndAS The company has to implement Ind AS accounting standards beginning from the financial year FY19. Its impact on the financials would be i) loan processing fee income would be charged over the life of the assets vs. current norm of charging fee upfront. And this origination fee income would be part of interest income line unlike previously included in other income in IGAAP reporting ii) since the company has limited history in the new lending businesses, provisioning for NPAs would be over and above under IGAAP based on expected credit loss model (which would also take into consideration time value of money, forecast of future economic conditions etc.) iii) ESoPs costing the company has allocated nearly 10-11% of equity outstanding as ESoP to its management & employees. And under Ind AS, fair valuations of unvested options also need to be adjusted against the retained earnings. This implies ESoPs expenses have to be charged to P&L over the life of ESoPs. And the total ESoP expenses stands at 1.48 bn which needs to be amortised over FY18-23E ( 280 mn in FY19E, 240 mn in FY20E, 200 mn in FY21E and 150 mn in FY22E these are based on management estimates). We have factored all the above mentioned parameters in our calculations. Hence, our future financial statement estimates are under Ind AS format. Compelling valuations one of the cheapest NBFC available currently Indostar Capital Finance is new age NBFC promoted by Mauritius based PE Everstone Group. It operates in niche space of early stage financing to real estate developers where relative competition from the banks & other NBFCs is very less. The company has embarked upon strategy to diversify its business mix more towards the retail including housing, vehicle finance. What we like is not only right choice of segments to grow but also these segments would give appropriate mix of leverage & profitability drivers to the company. Diversification would reduce the cyclicality of the earnings and also give upper edge against the NBFCs who have mono-line single product business. Another plus for the NBFC is strong management team headed by R.Sridhar, who was instrumental in building vehicle finance portfolio of Shriram Transport Finance. In the near term, it has front-ended its opex cost to increase the size of its branches & employees to drive new businesses. However, in the longer run, we expect ROEs to jump once the benefits of operating leverage, higher growth in AUMs is realized. We expect ROE to jump to 14.8% in FY22E from 11.1% in FY17 and 7.7% in FY18. While the ROA would be maintained at 2.2% in future periods as well. We expect earnings to grow at 46% CAGR over FY19-22E period. LKP Research 14

15 At current pricing, it is trading at compelling of 1.4x FY19E and 1.2x FY20E ABV. It is one the cheapest NBFC available currently. We expect re-rating in the stock given cheap valuations, strong management, better profitability anticipated & change in business mix towards retail assets. We initiate a coverage on the stock with TP of 593 giving upside potential of 36% - according 1.7x multiple to its FY20E ABV. Return ratios to show meaningful improvement ROE (%) ROA (%) FY17 FY18 FY19E FY20E FY21E FY22E LKP Research 15

16 Financials Profit & Loss Statement (Consolidated) Historical Data (.mn) FY15 FY16 FY17 FY18 Interest Income 4,667 5,644 6,436 7,031 Interest Expense 2,581 2,893 3,118 3,244 Net Interest Income (NII) 2,086 2,751 3,317 3,787 Other Income ,309 Total Income 2,700 3,548 4,081 5,095 Total Expenses ,509 Employee Benefit Expense Other Expenses Depreciation & Amortization Total Operating Income 2,291 2,966 3,354 3,586 Provisions PBT 2,260 2,932 3,230 3,497 Tax Expense 770 1,016 1,122 1,253 PAT 1,490 1,916 2,108 2,244 Growth (%) EPS Balance Sheet (Consolidated) Historical Data (.mn) FY15 FY16 FY17 FY18 Share Capital Reserves and Surplus 12,169 14,684 18,244 20,584 Shareholders' Funds 12,852 15,418 19,027 21,371 Borrowings 25,738 30,009 33,733 48,228 Non-Current Liabilities Current Liabilities 1,068 1,258 1,785 3,002 Total Liabilities 39,916 46,933 54,888 72,964 Cash and Bank Balances 4,856 3, ,278 Loans & Advances 33,921 42,839 51,606 60,403 Investments ,870 9,891 Other Assets Total Assets 39,916 46,933 54,888 72,964 Key ratios (Consolidated) Historical Data Growth (%) FY15 FY16 FY17 FY18 Total Assets AUM (%) Disbursements (%) Borrowings (%) Interest Income (%) NII (%) Total Expenses (%) Operating Income (%) Provisions (%) PAT (%) Yields (%) Yield on loans (%) Cost of Borrowings (%) Gross Spread (%) Margins (%) Cost Ratios Cost/Income ratio (%) Opex / AUM (%) Opex / Avg. Assets Asset Quality Gross NPAs (%) Net NPAs (%) PCR (%) Return Ratios (%) ROE (%) ROA (%) Leverage (%) D/E Per Share Data Share Capital ( ) FV ( ) No. of shares (no. in mn) EPS ( ) BV ( ) ABV ( ) P/E (x) P/BV (x) P/ABV (x) Branches Data No. of branches (No.) AUM / Branch No. of employees Employee Per Branch Salary / Employee LKP Research 16

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