M&M Financials Services' Q1FY20 results (Downgrade to Neutral) - Big miss; back to sharp cyclicality in credit cost

Q1FY20 result highlights

• MMFS reported PAT of Rs684M which is a big miss versus our expectation of Rs3bn. The miss was on account of a sharp increase in credit cost. Credit cost rose sharply to Rs6.2bn in 1Q20 versus 2.9bn in 1Q19 and a write back in 4Q19. Credit cost was higher due to 1) a sharp, sequential rise of 30% in NPLs and 2) change in ECL assumptions.  The LGD rose by 200 bps to 29%. While PD declined, the decline was not enough to offset the negative impact of higher LGD resulting in higher provisions on the back book. GNPAs rose sharply by 30% from Rs40bn to Rs53bn qoq. (from 5.9% to 7.4%)
• Disbursal growth remained weak at 2.5% yoy. AUMs grew 22% yoy. NIM declined 50 bps qoq to 7.6% due to pressure on yields from higher NPLs while cost of funds remained unchanged. NII grew 18% yoy but declined 3% yoy. 
• Opex continued to increase sharply by 45% yoy. Ex one-offs growth in opex remained high at 28%. As opex grew faster than NII, growth in operating profit wsa weak at 3% yoy.
• 1Q is seasonally the weakest quarter. While management attributed the rise in credit cost in 1Q20 to normal seasonality we believe the disappointment is beyond the normal seasonality. We are disappointed because 1) the cyclicality in the business model remains high despite investment in a sound recovery infrastructure. MMFS has seen a sharp rise in opex over the last 2 years as it is building a strong recovery infrastructure to ensure that the seasonality in NPLs is less severe. However, even after such heavy investment, the seasonal increase in NPLs in 1Q20 has been sharp 2) There was a fear that LGD of 27% in FY19 looks unsustainable across cycles. That fear has come true because the company had to increase LGD as they rolled over base. There is also a high likelihood of LGDs rising in the next review in December 2019 which means higher credit cost in 3Q.

Valuation and view

We are cutting earnings sharply by 29% and 17% for FY20/21 on higher credit cost. 1Q earnings have exposed the high cyclicality of MMFS’s business model which was less severe in FY19 but has become more severe in FY20. MMFS will review the PD and LGD every June and December. Currently the starting point for the 3.5-year data series for LGD is September 2015. In December it will roll forward by 6 months to March 2016. There was a sharp rise in NPLs in FY17 over FY16 which indicates that there is a high likelihood of LGDs rising in the next few reviews as the number of quarters with higher NPLs rises.  We believe with slowing growth of OEMs, no rural thrust in the Union Budget which could lead to deterioration in cash flows of MMFS’s rural borrowers and likely volatility in LGD rates, rating drivers for MMFS have turned negative. We slash our fair value multiple to 1.3x from 1.9x and reduce TP to Rs280. We downgrade the stock to Neutral. The RoE recovery that started in FY19 has been stalled in our view. We expect RoE of 11% in FY20 and 14% in FY21E versus 15% in FY19.