Gold Finance NBFCs All that glitters is gold; gold NBFCs a direct play on upcycle

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1 INSTITUTIONAL EQUITY RESEARCH Gold Finance NBFCs All that glitters is gold; gold NBFCs a direct play on upcycle INDIA NBFC Sector & Initiating Coverage Large gold holdings with households make India the biggest gold loan market India has the largest gold stock in the world Indian households hold more than 22, metric tonnes of gold, which is more than 1% of the world s total gold stock. Over the past ten years, the value of gold in India has seen a 13% CAGR, outpacing the country s real GDP, inflation, and population growth by 6 12%. Its large household holdings make India one of the largest gold markets, offering huge potential for gold financiers such as Muthoot Finance and Manappuram Finance. Huge untapped potential as the organised segment penetration remains sub 4% Industry estimates suggest that around 1 12% of the country s household gold holdings are pledged. Of this, around 7 75% is with the unorganised segment and the rest is with organised players such as specialised gold loan NBFCs and banks; the latter s share has been increasing rapidly due to their increased focus on gold loans. The gold loan market in India is grossly under penetrated (<4%) considering the size of gold holdings with households. This presents significant scope for organised gold loan financiers. Companies 17 October 216 MANAPPURAM FINANCE Reco BUY CMP, Rs 94 Target Price, Rs 13 Upside (%) 37 MUTHOOT FINANCE Reco BUY CMP, Rs 35 Target Price, Rs 45 Upside (%) 29 Gold finance NBFCs are better positioned than banks While banks hold a larger market share of gold financing vs. NBFCs, the latter are better placed on the competition front and are rapidly gaining market share from other organised and unorganised players. The competitive intensity with banks and other non specialised NBFCs has subsided over the last couple of years, as many non serious players either exited or slowed down considerably due to adverse market conditions. Gold finance NBFCs used this period to improve their product structure and business model, which, along with favourable market conditions, augurs well for these companies. Manappuram and Muthoot are direct plays on the gold upcycle Historically, Muthoot and Manappuram s balance sheets have shown a high correlation to gold price movements (coefficient of.97x over FY7 12). While gold prices CAGR was 21% over FY7 12, these players aggregate AUM CAGR was 8%. FY12 14 saw balance sheet erosion for both companies led by regulatory tightening by the RBI and a sharp fall in gold prices. However, with gold prices in a strong uptrend for the last nine months, we expect Gold loan AUMs of both companies to rebound at a CAGR of 25% over FY Valuations to track balance sheet growth Historical evidence shows that the valuation of niche NBFCs (CIFC, SHTF, SCUF, MMFS) has tracked their balance sheet growth. We expect both Manappuram and Muthoot to see more than 25 35% CAGR in FY16 19, aided by firm gold prices, changed product structure, and diversification. Hence, we believe that despite 2 3x growth in MAGFIL s/ Muthoot s market capitalization over the last one year, they are still very attractive opportunities for long term investment. When seen in isolation too, MAGFIL s/ Muthoot s valuations at 2.1x/ 1.9x FY18E BV are extremely attractive considering robust RoEs of 2 22%. Pradeep Agrawal ( ) pagrawal@phillipcapital.in Manish Agarwalla ( ) magarwalla@phillipcapital.in Peer Valuation CMP Reco Target MCAP RoA (%) RoE (%) ABV (Rs) P/ABV (x) (Rs) Price (Rs) Rs bn FY16 FY17E FY18E FY16 FY17E FY18E FY16 FY17E FY18E FY16 FY17E FY18E Manappuram Finance 94.5 BUY Muthoot Finance 35 BUY Page 1 PHILLIPCAPITAL INDIA RESEARCH

2 NBFC SECTOR Table of Contents Industry 3 Large household holdings make India a big market for gold loan financiers 3 Huge untapped potential as organised segment penetration remains below 4% 3 Gold finance NBFCs are better positioned than banks 4 Stable gold prices bode well for gold NBFCs a direct play on the gold upcycle 4 Regulatory overhang behind; gold loan NBFC have started gaining lost ground 4 Valuations to track balance sheet growth 5 Companies Section Manapuram Finance 9 Muthoot Finance 17 Page 2 PHILLIPCAPITAL INDIA RESEARCH

3 NBFC SECTOR Industry Large household holdings make India a big market for gold loan financiers India has the largest gold stock in the world, with more than 22, metric tonnes of gold held by Indian households more than 1% of the world s total gold stock. Over the past ten years, the value of gold in India has seen a CAGR of 13%, outpacing the country s real gross domestic product (GDP), inflation, and population growth by 6 12%. India has one of the highest savings rates in the world (32.3% of GDP), of which around one fourth is invested in gold. A large part of rural India s savings (which holds around 65% of India s total gold stock), is in the form of gold as it is a good hedge against inflation and is fairly liquid. India s large household gold holdings make the country one of the world s largest gold markets, offering huge potential for gold financiers like Muthoot Finance and Manappuram Finance. Demand for gold has remained buoyant due to the sentimental value attached to the metal. During , annual gold demand remained relatively stable at around 7 9 tonnes, despite the rise in prices. In India, rising prices have not adversely affected gold demand. India has one of the highest savings rates in the world (32.3% of GDP), of which around one fourth is invested in gold. During , annual gold demand remained relatively stable at around 7 9 tonnes, despite the rise in prices Globally, India is at 11 th position in terms of official gold reserves 9, 8, 7, 6, 5, 4, 3, 2, 1, United States Germany IMF Italy France China Russia Switzerland Japan Netherlands India ECB Turkey6) Taiwan Portugal Jewellery demand in India remain buoyant (Tonnes) Source: World Gold Council, Company, PhillipCapital India Research Huge untapped potential as organised segment penetration remains below 4% It is estimated that around 1 12% of India s household gold holdings are pledged, of which around 7 75% are with the unorganised segment while only 25 3% are with organised players like banks and NBFCs. However, 6 7 years ago, the organised market s share used to be just 1 2% this share has increased rapidly due to better focus on gold loans by specialised gold loan NBFCs and banks. Gold loan demand has picked up well in the last 8 1 years due to lower rate of interest charged by organised players as compared to moneylenders and pawn brokers, higher LTVs (loan to value ratios), quick disbursement, flexible terms, and perceived safety of the ornaments. Moreover, high rural indebtedness, ineligibility to get loans from banks, and changing attitude of customers to gold loans, have contributed to the sharp growth in the gold loans. With just less than 4% penetration, the gold loan market in India is grossly underpenetrated, considering the large gold holdings with households. This presents a significant scope for growth for organised gold loan financiers. Just 1% additional penetration could drive about ~25% growth for the entire organised segment. With just less than 4% penetration, the gold loan market in India is grossly underpenetrated, considering the large gold holdings with households. This presents a significant scope for growth Page 3 PHILLIPCAPITAL INDIA RESEARCH

4 Gold finance NBFCs are better positioned than banks While banks hold larger market share in gold financing as compared to NBFCs, the latter are better placed on the competition front. Competitive intensity with banks and other non specialised NBFCs has subsided over last couple of years, as lot of nonserious players have either exited or slowed down considerably due to adverse market conditions. Gold finance NBFCs have used this respite to improve their product structure and business models. NBFC SECTOR The operating dynamics of banks and NBFCs are also very different specialised NBFCs focus on customer convenience, quick disbursement, and flexibility, while banks focus largely on lower interest rates. While NBFCs charge higher interest rates of 18 24%, banks charge 12 15%. However, even though banks offer lesser interest rate, target customers prefer NBFCs, as gold loans have largely become a convenience product. However, even though banks offer lesser interest rate, target customers prefer NBFCs, as gold loans have largely become a convenience product. Comparison among various market players Parameter Gold loan NBFC's Banks Moneylenders LTV Up to 75% Lower LTV than NBFC's Higher than 75% Processing Fees No / minimal processing fees Processing charges are much higher No processing fees compared to NBFCs Interest Charges ~18% to 24% p.a ~12% to 15% p.a Usually in the range of 36% to 6% p.a. Penetration Highly penetrated Not highly penetrated. Selective Highly penetrated branches Mode of Disbursal Cash/cheque (disbursals more than Rs Cheque Cash.1mn in cheque) Working Hours Open beyond banking hours Typical banking hours Open beyond banking hours Regulated Regulated by RBI Regulated by RBI Not regulated Fixed Office place for conducting transactions Proper branch with dedicated staff for gold loans Proper branch No fixed place for conducting business Customer Service High gold loan is a core focus Non core Core focus Documentation Requirement Minimal documentation, ID proof Entire KYC compliance Minimal documentation Repayment Structure / Flexibility Flexible re payment options. Borrowers EMI compulsorily consists of interest can pay both the interest and principal and principal. Pre payment penalty is at the closure. No pre payment charged. charges. Turnaround Time 1 minutes 1 2 hours 1 minutes Source: Manappuram, PhillipCapital India Research Stable gold prices bode well for gold NBFCs a direct play on the gold upcycle Historically, balance sheet growth for gold loan financiers has traced gold price movement. Muthoot and Manappuram s balance sheet growth has historically shown high correlation to gold price movements with a high coefficient of up to.97x over FY7 12. While gold prices saw a CAGR of 21% over FY17 12, aggregate AUM of Muthoot/Manappuram saw a CAGR of 8%. FY12 14 saw balance sheet erosion for both companies due to regulatory tightening by the RBI and a sharp fall in gold prices. With gold prices showing a strong uptrend in the last nine months, we expect strong rebound in gold loan AUMs of both Muthoot and Manappuram 25% CAGR over FY We expect strong rebound in AUMs of both Muthoot and Manappuram 25% CAGR over FY Regulatory overhang behind; gold loan NBFC have started gaining lost ground Gold financing companies had a phenomenal time until FY12; their balance sheets grew exponentially with minimal regulation from the RBI. However, a sharp correction in gold prices in 212 and the RBI introducing some tough regulations had a significant impact on their borrowing costs and balance sheet growth. In 211, the RBI denied priority sector status to banks for any loan given to gold loan NBFCs, which, in turn, led to higher (by around 2%) borrowing costs for gold finance NBFCs. Page 4 PHILLIPCAPITAL INDIA RESEARCH

5 NBFC SECTOR Also in 212, the RBI reduced the limit for banks to lend to a single NBFC in the goldloan business to 7.5% from 1%. Another major blow came in March 212, when the RBI capped maximum LTV at 6%. Lower LTVs, along with softening gold prices, led to significant portfolio erosion for Muthoot and Manappuram, as customers turned to banks and unorganised sectors, where there were no LTV limits. The market share of specialised gold loan NBFCs fell to 31% in FY13 from a high of 36.5% in FY12 it declined further to 27.6% in FY14. The market share of specialised goldloan NBFCs fell to 31% in FY13 from a high of 36.5% in FY12 it declined further to 27.6% in FY14. Sharp deterioration in business compelled Gold loan NBFCs to reconsider their strategies and rework their business plans. They regained some of the lost ground by FY15, they had clawed back a market share of 29.4%. Today, with a stable regulatory regime and gold prices holding firm, these NBFCs seem poised for healthy growth. Manappuram expects gold prices to be relatively stable in FY17, at US$ 1,2 1,4 per troy ounce. Valuations to track balance sheet growth Historical evidence suggests that valuations of niche NBFCs such as Cholamandalam, Shriram Transport, Shriram City Union, and Mahindra Finance have tracked their balance sheet growth. We expect both Manappuram and Muthoot to see more than 25 35% CAGR in FY16 19, aided by firm gold prices, changed product structure, and diversification. Hence, we believe that despite 2 3x growth in MAGFIL s/ Muthoot market capitalization over the last one year, it is still a very attractive opportunity for long term investment. When seen in isolation too, MAGFIL s/ Muthoot valuations at 2.1x/ 1.9x FY18E BV are extremely attractive looking at robust RoEs of 2 22%. Manappuram and Muthoot are likely to see more than 25 3% CAGR in FY16 19, aided by firm gold prices, changed product structure, and diversification. Page 5 PHILLIPCAPITAL INDIA RESEARCH

6 NBFC SECTOR Cholamandalam Finance: Total Assets (Rs bn) 3 Market cap / Asset Ratio Mcap 12, Mcap/ Assets , , , , 15 5 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 2, FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY Manappuram Finance: Total Assets (Rs bn) 14 Market cap / Asset Ratio Mcap 6, Mcap/ Assets , , 3, , 4 2 1, 2 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 Shriram City Union finance: Total Assets (Rs bn) 25 Market cap / Asset Ratio 14, Mcap Mcap/ Assets , 1, 8, 6, 4, 2, FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 Page 6 PHILLIPCAPITAL INDIA RESEARCH

7 NBFC SECTOR Mahindra Finance: Total Assets (Rs bn) FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 Market cap / Asset Ratio 16, Mcap Mcap/ Assets 14, 12, 1, 8, 6, 4, 2, FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY Muthoot Finance: Total Assets (Rs bn) 35 Market cap / Asset Ratio 9, Mcap Mcap/ Assets , 7, 6, 5, , FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 3, 2, 1, FY12 FY13 FY14 FY15 FY Shriram Transport Finance: Total Assets (Rs bn) 8 Market cap / Asset Ratio Mcap 3, Mcap/ Assets , 2, , , 2 1 5, 1 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16 Page 7 PHILLIPCAPITAL INDIA RESEARCH

8 NBFC SECTOR Companies Section Page 8 PHILLIPCAPITAL INDIA RESEARCH

9 INSTITUTIONAL EQUITY RESEARCH Manappuram Finance (MGFL IN) What doesn t kill you makes you stronger INDIA NBFCs Initiating coverage Emerged stronger from the last battle; business model de risked: German philosopher Friedrich Nietzsche famously said, That which does not kill us, makes us stronger very true for Manapurram, which emerged much stronger after the regulatory and market challenges it faced in FY Learning from them, it made the following changes to its business model and product structure: (1) it introduced short term products to delink its business from volatility in gold prices, (2) added new product segments organically and inorganically to reduce its dependence on the gold loan segment, and (3) increased its focus on non south regions to dilute geographical risk. Manapurram seems to be on the right track for achieving long term sustainable growth. We believe it is future ready to take on any challenge and that with a stronger foundation, favourable market dynamics put it in a very sweet spot. Rising gold prices, lower auction, and high growth in non gold portfolio to drive 35% AUM growth: Gold finance companies are a direct play on the gold upcycle. When prices are rising, balance sheet growth accelerates as existing and new customers receive a larger loan amount on the same quantum of gold. Manapurram s AUM CAGR in FY7 12 was 83%, aided by 21% CAGR in gold prices and 8x increase in its customer base. However, when gold prices started falling in 212, its AUM took a hit (3% overall decline over FY12 14). With gold prices in a strong uptrend since the last nine months, we expect a strong rebound gold loan AUM CAGR of 25% over FY Moreover, other newly added segments (microfinance, housing, vehicle finance) are doing well and growing robustly on a low base. Its non gold loan book should see a 9% CAGR over FY16 19; as a result, its consolidated book would see 35% CAGR over FY Fall in borrowing cost and lower accrued interest to keep NIMs healthy: Earlier, accrued interest used to be around 8 1% of AUM, as the lending period was 12 months with bullet repayment at its end. As a result, the sharp correction in gold prices in FY12 14 led to effective LTVs rising more than 1%, which led to more defaults by customers; this in turn led to sharp erosion in NIMs. However, in FY15, the company introduced lower tenure products, keeping effective LTVs in the range of 65 85% at any point during the loan period this led to accrued interest proportion falling to less than 5%. As on June 216, accrued interest was 3.4% of gold AUMs. Net yields have shown healthy improvement over the last three quarters, as accrued interest has come down significantly. NIMs also benefited from a decline in the costs of funds, which have been falling for many quarters due to continued easing of the monetary policy and healthy liquidity. Cost of funds is likely to decline by another ~5bps over FY17/18, in line with expected fall in market rates. Valuation and recommendation: We believe high balance sheet growth for Manappuram in FY17/18 along with a sharp improvement in profitability ratios will drive stock rerating. Earnings will see a CAGR of 5% led by 35%+ CAGR in AUMs and improvement in NIMs and opex ratios. Manappuram s current valuation, at 2.1x FY18 BV, looks attractive given sharp improvement in RoA/RoE to 4.9%/22.3% in FY18 from 2.9%/12.6% in FY16. We value the standalone business at 2.5x FY18 BV, the microfinance business at 3.x FY18 ABV, and the housing finance business at 2.5x FY18 ABV. Consequently, our SOTP value (target price) for the company comes to Rs 13. We initiate coverage with a BUY rating. 17 October 216 BUY CMP RS 94 TARGET RS 13 (+37%) COMPANY DATA O/S SHARES (MN) : 841 MARKET CAP (RSBN) : 79.5 MARKET CAP (USDBN) : WK HI/LO (RS) : 11 / 16 LIQUIDITY 3M (USDMN) : 9.6 PAR VALUE (RS) : 2 SHARE HOLDING PATTERN, % Jun 16 Mar 16 Dec 15 PROMOTERS : FII / NRI : FI / MF : NON PRO : PUBLIC & OTHERS : PRICE PERFORMANCE, % 1MTH 3MTH 1YR ABS REL TO BSE PRICE VS. SENSEX Jan 15 Jul 15 Jan 16 Jul 16 Manappuram BSE Sensex Source: Phillip Capital India Research KEY FINANCIALS Rs mn FY16 FY17E FY18E Net Income 13,336 17,952 22,649 % growth Net Profit 3,372 5,955 7,83 % growth EPS (Rs) PER (x) Book value (Rs) P/BV (Rs) Adj. book value (Rs) P/ABV (Rs) Source: PhillipCapital India Research Est. Pradeep Agrawal ( ) Manish Agarwalla ( ) Page 9 PHILLIPCAPITAL INDIA RESEARCH

10 MANAPPURAM FINANCE LTD INITIATING COVERAGE Emerged stronger; business model de risked Manapurram fought tough battles on many fronts (including regulatory) for almost two years (FY12 14). This weakened the company greatly, as not only did its balance sheet erode quite a lot, but it also put a question mark on the sustainability of its business model. Learning from challenges, Manapurram changed its business model and product structure. It: (1) introduced short term products to delink its business from volatility in gold prices, (2) added new product segments organically and inorganically to reduce its dependence on the gold loan segment, and (3) increased its focus on non south regions to dilute geographical risk. It has made these changes over FY15 16 and the results have been inspiring. It seems to be on track to achieve its objective of long term sustainable growth. We believe it is future ready to take on any challenge. Moreover, with a stronger foundation, favourable market dynamics put it in a very sweet spot. New product structure makes business less vulnerable to gold price movements Over FY15 16, Manapurram introduced short duration products of 3 6 months and also adjusted the LTVs based on loan tenure, with the highest LTV of 75% on a threemonth loan and lowest LTV of 6% on a 12 month loan. Its objective was to protect its business from volatility in gold prices and drive volume growth. Before FY12, it was offering 12 month loans with LTVs of up to 85%. This combination of high LTVs and long tenure products worked well for the company until FY12, as gold prices were on an uptrend from 28 until 212. However, with a fall in gold prices and the RBI suddenly tightening norms in 212, the company was caught off guard. The turn of events had a significant impact on its asset quality and growth. While its GNPA increased to 2% in September 214 from just.6% in FY12, AUMs declined 3% over FY12 14 vs. +96% CAGR over FY8 12. Its new products are well accepted by customers, evident from the increased share of these products in its total portfolio. Currently almost 9% of the company s entire portfolio is into short term buckets of 3 6 months, which makes them relatively immune to any corrections in gold prices. In the current product structure, even if gold prices were to fall by ~2% within three months to a year, Manapurram would have enough collateral to recover its principal as well as interest dues by auctioning the underlying collateral. Learning from challenges, Manapurram changed its business model and product structure With a stronger foundation, favourable market dynamics put it in a very sweet spot Manapurram introduced short duration products of 3 6 months to protect its business from volatility in gold prices and drive volume growth Focus shifted to lower tenure products after the last down cycle (FY12 14) Product Features Earlier Now Duration 12 Months 3 Months 6 Month 9 Months 12 Months LTV 75% 75% 7% 65% 6% Loss given default Medium Negligible Negligible Negligible Negligible Page 1 PHILLIPCAPITAL INDIA RESEARCH

11 MANAPPURAM FINANCE LTD INITIATING COVERAGE Diversification into other product segments to smooth out cyclical swings Historically, Manapurram s balance sheet growth has shown high correlation to gold price movements (correlation coefficient as high as.97x over FY7 12). With almost all its business coming from gold loans until FY12, such a high correlation made the business model very vulnerable to down cycles. In the last down cycle of FY12 14, while gold prices saw 1% CAGR, Manapurram s AUM saw 16%. Learning from this, over FY15 16, the company diversified into other product segments including housing, microfinance, SME, and commercial vehicle finance. Its non gold finance book has seen a robust 4x increase in AUM constituting 12% of the total AUM in FY16 vs. 4% in FY15. The management intends to take the non gold book to almost 25% by FY18. We believe that the higher share of non gold loan book will smooth out the negative impact of sharp cyclical swings in gold prices. The management intends to take the non gold book to almost 25% by FY18.97x correlation between gold price and MGFL AUM Non gold loans to form 25% of the AUM by FY18 14, Manappuram AUM Average Gold price/ 1 gm (MCX) Gold Loan 35 1% Micro Finance Commercial Vehicle Home Loan 12, 3 9% 1, 25 8% 7% 8, 2 6% 6, 15 5% 116,38 1,86 4% 4, % 2, 5 2% 1% % FY12 FY16 FY18E Increased focus on non southern regions to dilute geographical concentration risks Over the last few years, Manappuram has increased its focus on the northern region as it offers significant potential for growth and dilutes its geographical concentration (share of south India in AUMs was almost 83% in FY12, which has now come down to 65%). Though its branch network has remained stable over the last four years, AUM per branch in the northern region has seen a CAGR of 32% over FY14 16 to Rs 31mn vs. 7 9% CAGR for all other regions. Gold loan branch distribution region wise (%) Gold loan AUM distribution region wise (%) 1 East West North South 1 East West North South FY12 FY13 FY14 FY15 FY16 FY12 FY13 FY14 FY15 FY16 Page 11 PHILLIPCAPITAL INDIA RESEARCH

12 MANAPPURAM FINANCE LTD INITIATING COVERAGE AUM per branch (Rs mn) Rural urban Branch mix (%) East West North South Metro Rural 16% 22% Urban 3% Semi Urban 32% FY12 FY13 FY14 FY15 FY16 Rising gold prices, lower auction, and high growth in non gold portfolio to drive 35% growth in AUMs Gold finance companies are a direct play on the gold upcycle. When prices are rising, their balance sheet growth accelerates as existing and new customers receive higher loan amounts on the same quantum of gold. Manapurram s AUM saw 83% CAGR over FY7 12, aided by a 21% CAGR in gold prices, and an 8x increase in customer base. However, between FY12 and FY14, when gold prices started falling, Manappuram s AUM took a hit ( 16% CAGR). With gold prices showing a strong uptrend for the last nine months, we expect a clear rebound in Manapurram s AUM growth. We see gold loan AUM CAGR at 25% over FY Other newly added segments microfinance, housing, and vehicle finance have picked up well, and are growing at a robust pace on a low base. Its non gold loan book is likely to see 9% CAGR over FY As a result, its consolidated book see 35% CAGR over FY Manapurram s AUM saw 83% CAGR over FY7 12, aided by a 21% CAGR in gold prices, and an 8x increase in customer base. We see gold loan AUM CAGR at 25% over FY16 19 Segmentwise AUM growth projections FY15 FY16 FY17E FY18E FY19E CAGR (FY16 19) Gold 92,693 1,86 126,8 157,59 196,887 25% yoy change(%) Asirvad Microfinance 3,22 9,998 19,996 38,992 62,388 84% yoy change(%) Commercial Vehicle 154 1,298 2,596 5,192 9,346 93% yoy change(%) Home Loan 272 1,286 4,51 9,2 15,33 128% yoy change(%) Consolidated AUM 95, ,33 153,11 21, ,923 35% yoy change(%) Page 12 PHILLIPCAPITAL INDIA RESEARCH

13 MANAPPURAM FINANCE LTD INITIATING COVERAGE Fall in borrowing cost and lower accrued interest to keep NIMs healthy Before FY12, NIMs used to be 15%+, which declined substantially to less than 1% over FY13 15 led by higher interest reversal on a rise in default after a fall in gold prices. Earlier, accrued interest used to be around 8 1% of the AUM, as lending was for 12 months with bullet repayment at the end of the period. As a result, the sharp correction in gold prices in FY12 14 led to effective LTVs rising more than 1%, which led to many defaults by customers. However, in FY15, the company introduced lower tenure products, keeping effective LTVs at 75 85% at any point during the loan period. This resulted in accrued interest proportion falling to less than 5%. As on June 216, accrued interest stood at 3.4% of gold AUM. Net yields have shown healthy improvement over the last three quarters, as accrued interest has come down significantly. Net yield in Q1FY17 was 24.6% vs. 21.8% in Q2FY16, as accrued interest has come down significantly over the last few quarters. Even NIMs benefited from a decline in the cost of funds, which has been falling since last many quarters due to continued monetary policy easing and healthy liquidity. It is likely to come down further by another 25 5bps over FY17 18, in line with an expected decline in market rates. Accrued interest proportion as % of AUM Net yield increased due to lower auctions Net Yield on advances NIM FY14 FY15 FY16 Jun 15 Sep 15 Dec 15 Mar 16 Jun 16 Manapurram s borrowing profile remains largely skewed towards bank loans at almost 77%. Another 2% is equally divided between commercial papers and bonds. The company recently increased its commercial paper mix to 1% from almost negligible in March 215, to take advantage of a fall in short term rates. Cost of funds continue to decline Borrowing mix 12 1 Bank loans Commercial Paper Debentures Subordinated Debt Others Jun 15 Sep 15 Dec 15 Mar 16 Jun 16 FY14 FY15 FY16 Page 13 PHILLIPCAPITAL INDIA RESEARCH

14 MANAPPURAM FINANCE LTD INITIATING COVERAGE Asset quality in gold loans best compared to other non gold NBFCs Unlike other NBFCs, gold loan NBFCs have historically seen low GNPAs and loss given default (LGD) due to the highly liquid nature of the collateral, adequate margin, and fast auction process. Historically, Manapurram s GNPA has remained sub 2% and currently stands at.8% despite transition to 9dpd from 12dpd. The company also made accelerated transition to 4bps of standard assets vs. the RBI s requirement of 4bps by FY18. After its change in product structure towards tower tenure loans, auctions have seen considerable decline; in Q1, these were the lowest ever at just 1% of disbursement. The management expects the auction rate to remain low going forward. Manappuram s GNPA remains the lowest across all asset financing NBFCs 1 Mahindra Finance Shriram City Union Finance Shriram Transport Finance Cholamandalam Muthoot Manappuram FY11 FY12 FY13 FY14 FY15 FY16 Valuations attractive; sharp improvement in profitability to drive rerating We believe high balance sheet growth for Manappuram in FY17/18 along with sharp improvement in profitability ratios will drive its stock rerating. Earnings are likely to see 5% CAGR led by 35%+ CAGR in AUMs and improvement in both NIMs and opex ratios. Manappuram s current valuation at 2.1x FY18 BV looks attractive given sharp improvement in RoA/ RoE to 4.9%/ 22.3% in FY18 from 2.9%/ 12.6% respectively in FY18. We value its standalone business at 2.5x FY18 ABV, its microfinance business at 3x FY18 ABV, and housing finance at 2.5x FY18 ABV. Consequently, our SOTP value for the company (also target price) is Rs13. We initiate coverage with a BUY rating. One year forward P/ABV band x 1.9x 1.2x.3x Sep 16 May 16 Jan 16 Sep 15 May 15 Jan 15 Sep 14 May 14 Jan 14 Sep 13 May 13 Jan 13 Sep 12 May 12 Jan 12 Sep 11 May 11 Jan 11 Page 14 PHILLIPCAPITAL INDIA RESEARCH

15 MANAPPURAM FINANCE LTD INITIATING COVERAGE Background Manappuram Finance, incorporated in 1992, is the second largest gold loan NBFC in India. It has 3,293 branches across 28 states and UTs with assets under management (AUM) of nearly Rs 115bn and a workforce of 17,752. Over the last two years, the company has diversified into new business areas like microfinance, vehicle and housing finance, and SME lending. In February 215, it acquired Asirvad Microfinance Pvt. Ltd that had an AUM of ~Rs 3bn. Management Mr VP Nandakumar, MD & CEO (age 62): He promoted Manappuram Finance in He is a managing committee member of leading trade and industry associations such as ASSOCHAM and FICCI. He is the chairman of the Kerala state council of the Confederation of Indian Industry (CII). He was a member of the FICCI delegation to the fourth session of India Poland Joint Commission for Economic Cooperation held at Warsaw, Poland, in June 215. Mr Nandakumar has a postgraduate degree in science and qualifications in banking and foreign trade. He has attended Management Development Programmes for CEOs at IIMs Ahmedabad and IIM Bangalore. In December 213, he took part in a Global Strategic Leadership Program at the Wharton Business School, Philadelphia (USA). Mr BN Raveendrababu, Executive Director. He is a postgraduate in commerce with additional qualifications in management accounting from the UK. Before joining Manappuram Group, he occupied senior positions in finance and accounts in various organisations. Key Shareholders % of total Promoters Nandkumar V P Sushma Nandkumar 5.71 Other Individuals.53 Other key shareholders Baring India Private Equity Fund 12.6 Goldman Sachs (Singapore) 1. WF Asian Reconnaissance Fund Ltd 4.5 AshishDhawan 2.9 DSP Blackrock Microcap Fund 3.1 Morgan Stanley Asia(Singapore) 2. MeryllLynch Capital Markets 1.2 BRIC II Mauritius Trading 1.5 MousseganeshLtd 1.3 Total 3.1 Page 15 PHILLIPCAPITAL INDIA RESEARCH

16 MANAPPURAM FINANCE INITIATING COVERAGE Financials Profit and loss (Rs mn) Balance sheet (Rs mn) (Year Ending Mar 31) FY15 FY16 FY17E FY18E (Year Ending Mar 31) FY15 FY16 FY17E FY18E Net interest income 1,633 12,963 17,56 22,165 Equity 1,682 1,682 1,682 1,682 Other income Reserves 24,591 25,686 3,22 36,554 Net Income 11,83 13,336 17,952 22,649 Net worth 26,274 27,368 31,93 38,236 Operating expenses 6,684 7,822 8,517 1,224 Borrowings 83,918 88,3 17, ,771 Preprovision profit 4,399 5,514 9,435 12,425 Current liabilities & others 3,13 3,737 4,886 4,886 Provisions Total liabilities 113, ,19 144,15 176,893 Profit before tax 4,124 5,189 9,22 11,863 Net block 1,723 1,898 2,12 2,473 Tax 1,417 1,817 3,68 4,34 Investments 3,795 3, Tax rate Loans 93,55 13, , ,992 Adjusted Profit after tax 2,77 3,372 5,955 7,83 Current assets & others 14,254 1,77 9,378 9,378 Total assets 113, ,19 144,15 176,893 Dupont (as % of Assets) Key ratios (Year Ending Mar 31) FY15 FY16 FY17E FY18E (Year Ending Mar 31) FY15 FY16 FY17E FY18E Interest Income NIM (%) Interest Expense NIM (%) On AUM Net Interest Income Cost/ Income (%) Other income total Credit cost (%) Net Income total RoA(%) Operating expenses total RoE (%) Preprovision profit Leverage (x) Provisions Tier I (%).... Profit before tax and exc. items CAR (%).... Profit before tax No of shares (mn) Tax total Gross NPA (%) Profit after tax Net NPA (%) Provision coverage (%) Growth (%) Valuation ratios (Year Ending Mar 31) FY15 FY16 FY17E FY18E (Year Ending Mar 31) FY15 FY16 FY17E FY18E Net interest income EPS (Rs) Net Income total PER (x) Preprovision profit Book value (Rs) Profit before tax P/BV (Rs) Profit after tax Adjusted book value (Rs) Loan P/ABV (Rs) Disbursement P/ PPP AUM Dividend yield (%) Page 16 PHILLIPCAPITAL INDIA RESEARCH

17 INSTITUTIONAL EQUITY RESEARCH Muthoot Finance (MUTH IN) Biggest beneficiary of gold cycle turnaround 17 October 216 INDIA NBFCs Initiating coverage Leading player in gold loan financing; biggest beneficiary of gold cycle turnaround: Being the trusted brand and market leader in gold loan financing, Muthoot will be the biggest beneficiary of a turnaround in the gold cycle. As per an IMaCS industry report, Muthoot s market share in the organised gold loan industry was ~2%. With a highest pan India branch network (4,294) and lowest interest rate among peers (~19%), it is best placed to gain market share in a rapidly expanding market. In the last nine months, gold prices have increased by ~25%, which has helped to kick start balance sheet growth. With regulatory hurdles behind, and strengthening of gold prices, Muthoot is now well placed to increase its balance sheet faster we see +22% CAGR for the next 2 3 years. Diversification to boost growth while reducing concentration risk: For long, NBFCs have been niche players with a focus on just one product category this helped them gain scale, reduce costs, and beat competition, but it also made them susceptible to higher risk due to dependence on just one product category. Gold loan NBFCs, Muthoot and Manappuram, decided to diversify into other synergic product segments after facing challenges in FY13 15 (regulatory and cyclical downturn). Manappuram entered a little earlier into other businesses such as microfinance and housing finance (in FY15) while Muthoot entered in FY16. A diversified product portfolio not only helps reduce product concentration risk, but aids leverage and bolsters return ratios. We expect Muthoot s non gold portfolio to constitute ~5% by FY19. Long term, it aims to have 25% of its overall loan book from these businesses. Higher productivity and efficiency led to superior ratios; business can grow another 4% without incurring capex: While Muthoot offers the lowest interest rate on gold loans among peers, its cost efficiency enables it to generate superior profitability ratios than Manappuram. Muthoot s average net yield at 19% is lower than Manappuram s 22%, but this is more than compensated by its lower operating cost ratios (4.2% of assets vs 6.7%). As a result, Muthoot has been generating higher RoAs of 2.8% in FY14 16 vs. Manappuram s 2.4%. Robust risk management system ensures low loss given default (LGD): Given the secured nature of loans (with underlying collateral being very liquid), its LGD across cycles has moved in the range of 2 1bps of loan book. Even during FY12 14, when gold prices corrected by 25%, LGD did not rise above 1bps. Unlike Manappuram, which has shifted to short tenure loan model, Muthoot Finance offers 12 month loans, but gives a lot of emphasis to changing customer behaviour for monthly repayments of interest as against bullet repayments. The company is also incentivizing its employees for customer acquisitions and regular collection of interest, unlike earlier, when its focus was limited to disbursing loans. Its initiative has borne fruit; many of its customers now make regular payments, hence, making its business model less susceptible to any default risk from a sharp correction in gold prices. Valuation and recommendation: Though the stock has run up significantly over the last few months, we believe there is further scope for rerating given strong balance sheet growth (we see 25% CAGR over FY16 18) and earnings growth visibility (3%). At CMP, the stock is trading at 1.9x our FY18 BV with an RoA of 3.8% and RoE of 19.8%. We initiate coverage with a BUY rating and target price of Rs 45. BUY CMP Rs35 TARGET Rs45 (29%) COMPANY DATA O/S SHARES (MN) 399 MARKET CAP (Rs BN) MARKET CAP (US$ BN) WK HI/LO (Rs) 45 / 16 LIQUIDITY 3M (USDMN) 7.2 PAR VALUE (Rs) 1 SHARE HOLDING PATTERN, % Jun 16 Mar 16 Dec 15 PROMOTERS : FII / NRI : FI / MF : NON PRO : PUBLIC & OTHERS : PRICE PERFORMANCE, % 1MTH 3MTH 1YR ABS REL TO BSE PRICE VERSUS SENSEX Jan 15 Jul 15 Jan 16 Jul 16 Muthoot Fin BSE Sensex Source: Phillip Capital India Research KEY FINANCIALS Rs mn FY16 FY17E FY18E Net Income 26,173 29,67 36,87 % growth Net Profit 8,96 1,723 13,739 % growth EPS (Rs) PER (x) Book value (Rs) P/BV (Rs) Adj. book value (Rs) P/ABV (Rs) Source: PhillipCapital India Research estimates Pradeep Agrawal ( ) Manish Agarwalla ( ) Page 17 PHILLIPCAPITAL INDIA RESEARCH

18 MUTHOOT FINANCE INITIATING COVERAGE Leading player in gold loan financing; biggest beneficiary of gold cycle turnaround Being a trusted brand and market leader in gold loan financing, Muthoot will be the biggest beneficiary of a turnaround in the gold cycle. As per IMaCS Industry Report, Muthoot s market share in the organised gold loan industry was ~2%. With highest pan India branch network of 4,294 branches and lowest interest rate of ~19% among peers, it is best placed to gain further share in a rapidly expanding market. As per IMaCS Industry Report, Muthoot s market share in the organised gold loan industry was ~2%. During the last upcycle (FY7 12), 21% CAGR in gold prices drove ~8% CAGR in Muthoot s assets under management. The following three years (FY13 15) were challenging for the company, as softening gold prices and tightening regulations had a negative impact on asset quality and growth. AUMs saw 2% CAGR over FY12 15, with GNPA ratio showing a significant rise to 2.2% in FY15 from.6% in FY12. However, in the last nine months, gold prices have increased by ~25%, which has helped kickstart balance sheet growth. With regulatory hurdles behind, and strengthening of gold prices, Muthoot is well placed to increase its balance sheet at a faster pace. We expect growth to accelerate to a CAGR of +22% for the next 2 3 years. Higher balance sheet growth will also drive huge benefits on the operating side. As 75 85% of the company s operating costs are fixed, any rebound in business would lead to optimum utilisation of existing infrastructure, driving operational efficiency and improvement in profitability ratios. Muthoot leading gold loan NBFC Source: Company, Bloomberg, PhillipCapital India Research, RBI Muthoot AUM growth vs. gold price movement 14 AUM (yoy change) Gold price (yoy change) FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY Diversification to boost growth and reduce concentration risk Since long, NBFCs have been niche players focused on just one product category. Being niche players helped them gain scale, reduce costs, and beat competition, but it also made them susceptible to higher risks due to dependence on just one product category. Gold loan NBFCs Muthoot and Manappuram decided to diversify into other synergic product segments after facing challenges in FY13 15, both regulatory and due to the cyclical downturn. Manappuram has been an early entrant (in FY15) into other businesses such as microfinance and housing finance; Muthoot entered in FY16. A diversified product portfolio will not only reduce product concentration risk, but help the company to improve leverage and bolster return ratios. We expect nongold portfolio to contribute ~5% by FY19. Over the long term, Muthoot aims to have 25% of its overall loan book from these businesses. Muthoot aims to have 25% of its overall loan book from these businesses over long term Page 18 PHILLIPCAPITAL INDIA RESEARCH

19 MUTHOOT FINANCE INITIATING COVERAGE Segmentwise AUM estimates Rsmn FY16 FY17E FY18E FY19E Gold Loan 243,355 34, , ,569 % yoy change Housing % yoy change Microfinance % yoy change Total AUM 246,295 31, , ,859 % yoy change Muthoot Homefin (India) Ltd: Muthoot invested Rs 449mn in Muthoot Homefin in FY16, acquiring 79% of its share capital, making it a subsidiary. This company focuses on extending affordable housing finance and targets customers in Economically Weaker Sections (EWS) and Lower Income Groups (LIG) in tier 2 and tier 3 locations. It has a loan portfolio of Rs 44mn as on 31st March 216. Belstar Investment and Finance Private Limited: Muthoot acquired a stake in this company to make inroads in microfinance. As of July 216, Muthoot holds 46.83% in Belstar and is looking at enhancing its holding to 57%, making it a subsidiary. Belstar was incorporated on January 1988 at Bangalore and was registered with the RBI in March 21 as an NBFC. It was reclassified as NBFC MFI by RBI from 11th December 213. Belstar has 94 branches spread over five states Tamil Nadu, Karnataka, Madhya Pradesh, Maharashtra, and Puducherry with a microfinance loan portfolio of Rs 2.9bn. About 81% of Belstar s clients are in Tamil Nadu. It has plans to expand to northern states in the next three years. Muthoot Insurance Brokers Pvt Limited (MIBPL): Muthoot acquired MIBPL, an IRDA registered insurance direct broker, making it its wholly owned subsidiary in June 216. It distributes both life and non life insurance products of various insurance companies; this has enabled it to diversify its bouquet of investment products for customers. MIBPL intends to continue leveraging Muthoot s large customer base to grow this business consistently. In FY15, it insured more than 292, lives with a premium collection of Rs 35mn under traditional, term and health products this increased to 459, lives with a premium collection of Rs 49mn in FY16. In Q1FY17, its premium collections were Rs 1mn. Asia Asset Finance PLC: In , Muthoot enhanced its shareholding in this company (its Sri Lankan subsidiary) to 59.7% from 51%. Synergies have already started to show results interest income increased by 49% to LKR 1.2bn and profitability by 73% to LKR 175mn. Asset base grew 52%, reaching LKR 8.1bn. Introduction of gold loans and expansion of microfinance portfolio have been key contributors of growth in Higher presence in rural and semi urban markets ensures larger potential pie More than 7% of Muthoot s branches are in rural and semi urban regions vs. 54% for Manappuram. With almost 65% of the domestic gold holdings lying in rural areas, Muthoot is likely to gain larger market share from these regions. As per few estimates, there is about 2,7 tonnes of gold with unorganised players. We believe Muthoot is at an advantageous position to cannibalise larger market share from unorganised players due to its higher penetration in rural geographies and lower interest rate than peers. Page 19 PHILLIPCAPITAL INDIA RESEARCH

20 MUTHOOT FINANCE INITIATING COVERAGE 27 tonnes of gold holding with unorganised segment Muthoot has high share of branches in the rural region Organised Unorganised Organised, 9 8% 7% 6% 5% 54% Manappuram 7% Muthoot 46% 4% 3% 3% 2% 1% Unorganised, 27 % Rural/ Semi urban Metro/ Urban, RBI Higher productivity and efficiency led to superior ratios; business can grow 4% without incurring any further capex While Muthoot offers lowest interest rates on gold loans among all its NBFC peers, cost efficiency enables it to generate better profitability ratios. Its average net yield stands lower at 19% vs. 22% for Manappuram, which gets more than compensated by its lower operating cost ratios, which stand at 4.2% of assets vs. 6.7% for Manappuram. As a result, Muthoot generated higher RoA at 2.8% (FY14 16) vs. Manappuram s 2.4%. Lower cost for Muthoot is largely because of higher utilisation of branches. While Muthoot s AUM per branch is almost double at Rs 57mn (vs. just Rs 31mn for Manappuram), its cost per branch is just slightly higher at Rs 2.7mn (vs Rs 2.4mn for Manappuram). What this means is to generate Rs 1 of business, Muthoot incurs a cost of Rs 4.7 vs. Rs 7.75 for Manappuram. Muthoot generated higher RoA at 2.8% (FY14 16) vs. Manappuram s 2.4%. To generate Rs 1 of business, Muthoot incurs a cost of Rs 4.7 vs. Rs 7.75 for Manappuram AUM per branch(rsmn) 7 Muthoot Finance 66.4 Manappuram FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY15 FY16, RBI Opex per branch (Rsmn) Muthoot Finance Manappuram FY11 FY12 FY13 FY14 FY15 FY16 Page 2 PHILLIPCAPITAL INDIA RESEARCH

21 MUTHOOT FINANCE INITIATING COVERAGE Cost incurred to generate Rs1 of AUM Significant capacity buffer Muthoot Finance Manappuram , , , 25, 6 2, 4 15, , , FY11 FY12 FY13 FY14 FY15 FY16 243,789 11,381 11,381 Current Matrix Opex AUM 4% higher growth possible on same cost Capacity buffer, RBI In our view, a pick up in growth could lead to significant operating leverage as most of the costs are fixed in nature and the existing infrastructure is capable of handling 4% more business. Highest rating among peers keeps the cost of funds low Muthoot enjoys a credit rating of AA Stable, which is the highest among all gold loan NBFCs this has enabled mobilisation of adequate low cost funds. Both CRISIL and ICRA recently upgraded its long term rating to AA/Stable from AA /Stable. The rating upgrade is a reflection of improvement in financial performance in FY16. The upgrade will help the company to get better rates from financial institutions and banks, enabling it to reduce its cost of borrowings further. Muthoot has a lower cost of borrowing than Manappuram, as its cost of funds is almost 3 5bps lower. Muthoot has a lower cost of borrowing than Manappuram, as its cost of funds is almost 3 5bps lower. Credit Rating Muthoot Manappuram Short term rating A1+ A1+ Long term rating AA A+ Diversified funding profile Muthoot s borrowing profile remains well diversified with almost 4% each contributed by banks and NCDs, 13% from subordinated debt, and 4% from commercial papers. Borrowing profile 1% 8% Debentures Banks Subordinated Debt Commercial Paper Other Loans % % 2% % Sep 15 Dec 15 Mar 16 Jun 16, RBI Page 21 PHILLIPCAPITAL INDIA RESEARCH

22 MUTHOOT FINANCE INITIATING COVERAGE Robust risk management system ensures low LGD Given the secured nature of loans, with underlying collateral being very liquid, loss given default (LGD) for the company across cycles has moved in 2 1bps of loan book. Even in FY12 14, when gold prices corrected by 25%, LGD did not go above 1bps. Unlike Manappuram, which has shifted to the short tenure loan model, Muthoot Finance offers 12 month loans, but gives a lot of emphasis on changing customer behavior for monthly repayments of interests, as against bullet repayments. It is also incentivising its employees for customer acquisitions and regular collection of interest, unlike earlier, when its focus was limited to disbursing loans. Its initiatives have borne fruit, most customers now make regular payments, making its business model less susceptible to default risk from sharp correction in gold prices. LGD (loss given default) remain low Bad debt written off As % of Loans FY11 FY12 FY13 FY14 FY15 FY16., RBI Valuation and view Though the stock has run up significantly over the last few months, we believe there is further scope for rerating, given strong balance sheet growth and earnings growth visibility. We expect balance sheet CAGR of 25% with earnings growth CAGR of 3% over FY At CMP, the stock is trading at 1.9x FY18 BV with an RoA of 3.8% and RoE of 19.8%. We initiate coverage on the company with a BUY rating and target price of Rs 45. One year forward P/ABV band x 1.9x 1.2x.6x Sep 16 May 16 Jan 16 Sep 15 May 15 Jan 15 Sep 14 May 14 Jan 14 Sep 13 May 13 Jan 13 Sep 12 May 12 Jan 12 Sep 11 May 11 Jan 11 estimates Page 22 PHILLIPCAPITAL INDIA RESEARCH