The reasons for REC's low valuations

At 6.2 times its trailing 12 months price-to-earnings (P-E) multiple, Rural Electrification Corp. Ltd (REC) is one of the cheapest stocks in the infrastructure financing industry. Growth has been decent. The company’s loan book grew by 16-18% in the first three quarters of 2014-15. Net interest income increased in the range of 17-23%. But the stock has underperformed the broader markets since the beginning of this calendar year.

True, the underperformance is coming on the back of a 51% rise in 2014. Also while the impending offer for sale of shares—priced at a 6% discount to Monday’s closing stock price has been an overhang, two other factors are bothering investors.

One is the weak business outlook. Loan sanctions, which indicate future revenue potential, fell 15% in the first nine months of the last fiscal year. The slow progress of reforms and the poor financial condition of the state electricity boards mean that demand for loans can remain tepid for some time.

The second issue is asset quality. Compared with a year ago, the percentage of net non-performing assets to loan outstanding doubled to 0.65% in December 2014. As a result the company has to set aside a greater amount of its earnings for provisions, impacting profit growth. Total provisions increased 52% to ₹ 2,360 crore in the first nine months of 2014-15.

Interestingly, most non-performing loans are from the private sector, Ventura Securities Ltd said in a January note. With loans to the private sector steadily rising, analysts fear that bad debts will follow suit. “CRISIL, however, believes that REC’s asset quality will remain vulnerable over the medium term primarily because of the weak financial risk profiles of SPUs (state power utilities) and the increased challenges faced by the private sector borrowers,” Crisil ratings said in March. Ventura Securities and ULJK Financial Service Pvt. Ltd forecast that REC’s gross and net non-performing loans will rise.

That said, REC will continue to benefit from being a nodal agency to central government schemes in the power sector. Thanks to better yields on loan assets and increasing share of high margin private sector business, the company’s net interest margin is expected to improve. While this may provide comfort to investors, an improvement in loan demand can help the stock overcome asset quality fears.

The writer doesn’t own shares in the above-mentioned companies.