Weakening asset quality, rural slowdown key challenges for M&M Financial

The Mahindra & Mahindra Financial Services (MMFS) scrip has underperformed the benchmark S&P BSE Sensex in the past month and corrected 17 per cent.

A slowing rural economy, worsening asset quality and weak earnings growth are the key reasons for this underperformance. Most leading brokerages have trimmed their earnings estimates for FY15 and FY16 to factor in these negatives.

Leading brokerages such as JP Morgan and HSBC have even downgraded the stock recommendation to under-weight after a dismal show in the December 2014 quarter.

“MMFS’ asset quality pressures are expected to stay elevated and FY16 will again depend on how monsoons shape up. With the focus shifting to collections, loan growth has been moderating and the trend is likely to continue. We cut our FY15 and FY16 EPS estimates by 16 per cent and downgrade the stock to underweight,” a JP Morgan report on the company dated January 19 said.

MMFS’ rural focus and strong parentage will enable it to benefit significantly from a pick- up in the rural economy on a longer term basis. However, the stock appears expensive given the weak visibility in the near term. The MMFS scrip currently trades at 2.1 times the FY16 estimated book value, or an 18 per cent premium to its historical average one-year forward price/book ratio of 1.8.

“Intensifying headwinds and potential downside risks to earnings outlook makes risk-reward less attractive. A challenging near-term outlook is likely to moderate MMFS’ valuation,” says Sampath Kumar of IIFL. He has trimmed his earnings forecast 11-14 per cent over FY15-17.

In the December 2014 quarter, MMFS put up a dismal show, with the gross non-performing assets (NPA) ratio at a five-year high of 7.1 per cent. A slowing rural economy hit demand for tractor financing loans leading to meagre 11.1 per cent year-on-year growth in assets under management (AUMs).

Provisions grew 49.8 per cent to Rs 269 crore, leading to a huge 16.9 per cent fall in net profit to Rs 136.4 crore. As a result, the pre-tax return on assets ratio compressed 250 basis points to two per cent for the nine months ended December 2014.

This is because of continued moderation in AUM growth – a sharp decline in FY15 disbursement volume is likely to affect AUM growth in FY16, too, and lead to high credit costs as well. Downside risks accrue from yet another year of poor rainfall in FY16 and further deterioration in asset quality.

MMFS’ prospects hinge largely on recovery in rural economy, a strong monsoon and policy measures to push rural growth. Any pick-up in rural economy will boost MMFS’ profitability and asset quality. The lender’s margins though should benefit from falling cost of funds.

The management says it will continue to focus on improving recoveries and collections to enhance profitability.

The company is likely to remain cautious on lending and will focus on slower branch additions and cost rationalisation efforts.