rates and pass on the increase in cost of funds and thereby improve NIMs (net interest margins). We expect a slight moderation in NIMs as (a) the company resets lending rates on an annual basis and (b) other financial institutions are still shying away from the sector.
Credit quality to remain strong: Our analysis of past global PPP projects suggests the absolute credit losses in the sector will be limited. In addition to this, PFC and REC has more than 85% of loan book exposed to central or state utilities which provides comfort on credit quality.
Structural headwinds pose risks: PFC and REC have gone through a big re-rating in the past six months, with stock prices moving up 88% and 68%, respectively. While we expect robust results in the near term, the long-term prospects of these stocks may not be in line with the market expectations which seems to have gone from very bearish to very bullish in nine months.
Near-term numbers look good: Given the pipeline created over the last five years PFC/REC still have sanctioned, but not disbursed, loans accounting for c.80% of their current AUM (asset under management). Thus both companies will be able to show AUM growth of more than 15% for the next couple of years. Also, the spreads i n the near term will remain high as R15 bn in new loans were disbursed at 12.5% yield in FY14. We do not expect any default from the state governments and with most SEB loans going through the restructuring process big credit losses in the near term are unlikely. We expect c.15%-20% EPS (earnings per share) growth for the next couple of years.
However,current profitability may moderate: Profitability of power finance companies increase in bad markets as those willing to lend to SEBs then are few, allowing PFC and REC to charge higher rates despite state government guarantees. However, if the much-talked about power sector reforms are implemented and financial health of SEBs were to improve then we may see cost of funding for SEBs come down as more financiers (like banks) will be willing to finance them; the downside to this would be lower loan growth and decline in margins for PFC and REC. Also, their back book, i.e. sanctioned but not disbursed loans, has come down from c120% to 80% of AUM in past couple of years as a majority of the loans disbursed in the