Magma Fincorp. BUY Quick Insight. A turnaround story at the inflection point AMBIT INSIGHTS

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1 Magma Fincorp A turnaround story at the inflection point Magma has run a pilot project in the state of Maharashtra to improve its operational efficiency and has met with reasonable success. Management is planning to replicate this restructuring project on a pan-india basis which should result in ~20bps improvement in RoAs due to lower headcount and lower DSA payouts (~71% of its opex). Moreover, changing asset and liability mix should continue to drive NIM improvement. Hence, we expect RoEs to improve from ~11% in FY15 to 13% in FY17E leading to a robust 25% EPS CAGR over FY15-FY17E despite operational restructuring restricting its AUM growth to a modest 8% CAGR. This should lead to a significant rerating from its current valuations of 0.9x FY17E P/B and 7.2x FY17E P/E, which are at a ~50% discount to the peer average. Yesterday we attended Magma s analyst meet, wherein management gave a headsup on the business restructuring process they have been undertaking over FY16. The key takeaways: Pilot run to restructure operations: In a pilot run, Magma has restructured its business operations in the state of Maharashtra (contributes ~9% to Magma s business) as a part of its overall business restructuring strategy, In Maharashtra, Magma has: (i) Modified its operational architecture by merging the sales and collections verticals, this has led to a reduction in headcount; (ii) Rationalized its employee incentives to reflect a change in the organizational architecture; lowered incentive caps and performance evaluation based on branch profitability rather than business volumes; and iii) Made process improvements through technology by migration of the entire loan appraisal cycle to the online platform. Pilot run has met with reasonable success: Magma has met with reasonable success in this pilot project, with its operating costs in Maharashtra coming down by ~10%. Key reasons for success are: i) Improvement in employee efficiency Magma s employee count has reduced by 27% even as its customer count runrate per month has gone up by ~14%, without any adverse impact on collection efficiency; ii) More direct business and fee income Magma s direct business/cross-selling as a % of overall sales has risen from 16%/18% in FY15 to 49%/36% in 2QFY16; and iii) Improved sourcing from channels due to improvement in turnaround time and improvement in service quality. Pan-India implementation likely to meet success: Magma management indicates that it will replicate this restructuring exercise on a pan-india basis December 2015 onwards. Whilst simultaneous implementation of such restructuring on a pan-india basis poses operational risks, we believe Magma will eventually succeed in lowering its industry-highest cost of operations through such restructuring, as it addresses Magma s key pain-points highest employee base amongst peers and high payouts to DSAs (~71% of its operating costs). Management indicates its employee count going down over the next 2 quarters and opex costs dropping by ~10% over FY17. Where do we go from here? Despite improving NIMs (6.4% in 1HFY16 vs 5.2% in 1HFY15), Magma s RoEs continue to lag its peers (~10% vs ~15% for peers) due to high operating costs (3.4% of AUM vs ~3% for pears) and increase in credit costs (1.84% in 1HFY16 vs 1.17% in 1HFY15) due to a stressed external environment. However, successful implementation of the operations, restructuring at a pan-india level could lead to ~20bps improvement in RoAs. Moreover, Magma s NIMs should expand by ~70bps over FY15-17E due to a change in the portfolio mix towards highyield assets and a change in the liability mix towards low-cost liabilities. Moreover, the cycle improvement in economy should lead an increase in loan growth and better asset quality trends. Overall, we expect Magma s RoEs to improve from ~11% in FY15 to 13% in FY17E leading to a robust 25% EPS CAGR over FY15-FY17E even as the operational restructuring restricts its AUM growth to a modest 8% CAGR. This should lead to a significant rerating from the current valuations of 0.9x FY17E P/B and 7.2x FY17E P/E, which are at a 50% discount to the peer average. Our EVA-based target price of Rs133 implies 1.2x FY17E P/B. Risk-reward is highly skewed at current valuations. BUY Quick Insight Analysis Meeting Note News Impact Stock Information Bloomberg Code: MGMA IN CMP (Rs): 101 TP (Rs): 133 Mcap (Rs bn/us$ mn): 24/359 3M ADV (Rs mn/us$ mn): 12/0.2 Stock Performance (%) 1M 3M 12M YTD Absolute (3) Rel. to Sensex Source: Bloomberg, Ambit Capital research Ambit Estimates (Rs bn) FY15 FY16E FY17E Total income Adj. PAT EPS (Rs) Source: Ambit Capital research Analysts Aadesh Mehta, CFA Tel: aadeshmehta@ambitcapital.com Pankaj Agarwal, CFA Tel: pankajagarwal@ambitcapital.com

2 Pilot run to restructure operations As a part of its restructuring strategy, Magma has restructured its business operations in Maharashtra as a pilot run before it implements this on a pan-india basis. In Maharashtra, Magma has modified its operational architecture, rationalised employee incentives and initiated process improvements through technology as follows: 1) Modifying operational architecture: Magma has merged the sales and collections verticals versus its earlier approach of segregating the respective verticals. Magma has also made 1-2 layers of mid-senior level employees redundant. Magma s employees are now closer to the customer than before. Earlier its employees had an expansive coverage of ~100kms radius, which has now come down to a ~30kms. 2) Rationalizing employee incentives: Employee packages have been realigned to reflect the change in the organizational architecture. Incentive caps have been reduced with a simultaneous increase in threshold targets for the incentives. Branch managers are now measured on profitability rather than business volumes. Hiring from talukas is now preferred due to lower employee and travelling costs. 3) Process improvements through technology: Magma s entire loan appraisal cycle has migrated to the online platform, which will enable the feet on street (FOS) to keep the dealer updated with the loan approval status. Credit parameters are now better defined in the loan system in contrast to the earlier approach of a more subjective approach by the Magma salespersons. Technology-based tracking of Magma s feet on street will ensure that all its empanelled channels get a uniform service. Hind-sighting analysis has been introduced to reduce employee misreporting of customer quality. Pilot run is a reasonable success Magma has met with reasonable success in this pilot project, with its operating costs in Maharashtra coming down by ~10%, even as its customer accounts handled per month have gone up by 14%. We articulate below how the measures mentioned above have resulted in an improvement for Magma s operating costs: 1) Improvement in employee efficiency: The above mentioned restructuring of its operations and process improvements through technology has led Magma to improve its employee efficiency, thus enabling it to increase its disbursements even as it has reduced its headcount in the state Magma s employee count has reduced by 27% even as its customer count run-rate per month has gone up by ~14%, without any adverse impact on collection efficiency. 2) Improved channel experience: Sourcing for Magma through channels has improved due to improvement in turnaround time and improvement in service quality to channels (dealers, DSAs). Magma s industry highest TAT (turnaround time) has reduced by 2-3 days and is converging with its peers. Moreover, through employee tracking of dealer servicing, it will ensure that all its empanelled dealers get a uniform and better serving. This has led to increased sourcing for Magma even as a sizeable portion of its sales teams have been made redundant. 3) More direct business and fee income: Magma s closer connect with the customers (from earlier spread of ~100km radius per employee, to a more focused ~30km per employee), has driven its increased direct origination and cross-selling. Magma s direct business as a % of overall sales has gone up from 16% in FY15 to ~49% in 2QFY16. Its insurance cross-selling has improved from 18% in FY15 to 36% in 2QFY16 leading to doubling of fee income as a % of disbursements (from 0.46% in FY15 to 1.02% in 2QFY16).

3 Pan-India implementation likely to meet with success Magma operates at the highest operating cost structure amongst peers its opex/aum in vehicle financing at 3.8% compares with the peer average of ~3%. Notably, such a high cost structure is driven by high employee cost and high DSA payouts, which together account for ~71% of its operating costs. Experience from the pilot run indicates that Magma can successfully address these twin drivers of high operating costs as: 1) Improved employee efficiency will eventually lower Magma s industry highest employee costs; and 2) Higher direct origination will eventually lower Magma s industry highest DSA payouts; with improving channel experience giving an opportunity to eventually lower the remaining payouts. Magma management indicates that it will replicate this restructuring exercise on a pan-india basis this month (December 15) onwards. This should see its employee count going down over the next two quarters and opex dropping by ~10% over FY17. Whilst simultaneous implementation of such restructuring on a pan-india basis poses operational risks, we believe Magma will eventually succeed in lowering its high cost of operations through such restructuring. Exhibit 1: Magma has higher opex vs peers Exhibit 2: due to high employee base relative to AUM 4.0% Opex/AUM % 3.0% 2.5% 2.0% 1.5% 1.0% 3.8% 3.6% 3.0% 2.5% 1.9% MGMA -VF CIFC-VF MMFS SUF SHTF AUM/Employee (Rs mn) Disb/employee (Rs mn) SUF SHTF MMFS CIFC - VF MGMA - VF. Exhibit 3: and one of the highest origination costs 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% Origination cost (% of disbursements) 1.50% 1.27% 0.90% 0.46% NA CIFC MGMA MMFS SUF SHTF ; Note: CIFC s origination costs also include incentives to employees on meeting origination targets; MMFS s origination costs also include brokerage on deposits raised. Data is not available for SHTF. Exhibit 4: but pilot run indicates that restructuring would improve trends Magma Maharashtra Avg. FY15 Avg. 2Q16 Employee efficiency parameter Customer cases per month per employee Direct business parameter Oct'15 Nov' Direct business 16.3% 48.6% 45.8% 51.3% Cross-selling parameter Life insurance conversion 37.6% 90.3% 88.4% 90.6% Rent insurance conversion 18.2% 36.0% 43.0% 43.2% Collections parameter 0 bucket collection efficiency 95.0% 95.7% 95.4% 95.1%

4 Cheapest amongst its peers AMBIT INSIGHTS Exhibit 5: Relative valuation snapshot Mcap Reco. TP Upside/ P/B P/E EPS CAGR ROA ROE Asset Financers US$bn Rs downside FY16E FY17E FY16E FY17E FY15-17E FY16E FY17E FY16E FY17E Shriram Transport 2.9 SELL % % 2.0% 2.1% 14.5% 15.3% M&M Finance 2.1 SELL 225-6% % 2.2% 2.5% 13.1% 15.1% Sundaram Finance 2.2 NA NA NA % 2.7% 2.7% 15.8% 16.1% Cholamandalam 1.5 BUY % % 1.8% 2.1% 15.7% 17.4% Average % 2.2% 2.3% 14.8% 16.0% Magma Fincorp 0.4 BUY % % 0.9% 1.5% 9.4% 13.3% Premium/(Discount) to its peers (%) -63% -63% -37% -55% 56% -57% -35% -36% -17% Source: Bloomberg, Ambit Capital research

5 Income statement (`mn) Net Interest Income 7,177 8,743 10,486 11,934 13,419 Non- Interest Income ,040 1,196 1,376 Total Income 7,752 9,404 11,526 13,130 14,795 Operating expenditure 4,662 5,586 6,847 6,773 7,249 Pre Provisioning Profit 3,091 3,818 4,679 6,357 7,546 Provisions 966 1,841 2,444 4,030 3,205 Profit before tax 2,125 1,977 2,235 2,327 4,341 Tax Profit after tax 1,449 1,596 1,873 2,012 3,473 Adjusted Profit after tax 1,246 1,391 1,687 1,866 3,280 Balance Sheet (`mn) Networth 13,974 15,038 16,549 23,198 26,097 Preference Capital 1,970 1,498 1, Borrowings 167, , , , ,422 Total liabilities 183, , , , ,369 Loan Book 162, , , , ,459 Other Assets 21,378 18,262 2,674 2,847 3,910 Total assets 183, , , , ,369 Key Metrics AUM growth (%) DilConsol EPS growth (%) (10.7) 75.8 Net interest margin (NIM) (%) Cost to income (%) Opex (% of AAUM) Credit costs (% of AAUM) Capital adequacy (%) Tier-1 (%) Leverage (x) Valuation parameters BVPS (`) Diluted EPS (`) ROA (%) ROE (%) P/E P/BV Dividend yield (%)

6 Magma Fincorp Ltd (MGMA IN, BUY) Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 MAGMA FINCORP LTD Source: Bloomberg, Ambit Capital research

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