Aditya Birla Capital : Creating market in under penetrated sector in India

Before discussing about the business, I want to express my opinions about what makes a financial institution worthy of investment. In my honest opinion, financial institutions are leveraged bets. That means, leveraged companies involve the risk of bankruptcy if strict underwriting discipline is not followed. This is because, such companies raise money from financial markets and lend it to retail and corporates. If end users don’t repay the borrowing, company would default. So, what does make financial institutions like HDFC, HDFC Bank and Kotak Mahindra Bank successful? Few essential points :

• First of all, cost of capital needs to be contained so that higher net interest margin can be earned. Now, question is how can a company contain the cost of capital? Rating agencies (ICRA, CRISIL etc) will tell that if you eliminate provision pressure by using strict underwriting discipline, cost of capital will be contained. So, the reason behind success of any financial institution is underwriting discipline.
• Underwriting discipline can be maintained by great quality people who set up the impeccable processes. Such processes will ensure that default rates will always be down. So, financial institution must invest in great quality people and flawless processes.
• Growth in lending book has to be maintained. This will ensure net interest income will keep flowing. However, growth should be matched with equally strong underwriting discipline. So, growth with stringent underwriting is the key.
• Understanding of the sector in which company is lending. Management needs to have deep understanding of the sector so that they can maintain margin of safety in lending.
• How to keep competition at bay ? This can be done by quick turnaround time, use of technology to keep default less and to maintain customer-centric institution. At the same time, I would say, if financial institution can become partner in solving problems of industry, that would be great. Money is commodity — anyone can lend. But, if you act as solution provider to the sector, people will come to you to solve their problems.

And you can sense what makes many of public sector banks fail to deliver.

With that said, lets look at ABCapital business model. Primarily, ABCapital works to meet customer requirements in -

1. Finance
2. Insurance
3. Asset Management

Financing solutions

In last 10 years, this division is catering to corporates, mid-corporates and SME. They entered into housing finance and became profitable last year. A very good asset quality is maintained with NPA less than 1%, NIM around 4%. This division continues to grow at healthy rate in the long run. I am saying this because, Indian economy is growing at 6–7%. With this much rate, people will need access to finance. Hence, NBFCs like ABCapital will gain heavily. With very good processes in place, this should not have asset quality problems in the long run.

Insurance

Before I dive into specifics, I want to talk about specifics of insurance business. Many Indians don’t have access to insurance and slowly private players are eating market share from PSUs. Insurance is very tough to enter business because of requirements of capital and IRDAI regulations. Insurance business collects money from customers in the form of premiums with the guarantee that if something goes wrong, then company will pay the insured amount. This premium money is invested in the capital markets. Such money is called “float”. In insurance activities, cost of capital for that float matters. Cost of capital can be minimized by having good underwriting discipline.

ABCapital is taking many steps to increase the market share in insurance market. They are aligning with bank partners like HDFC Bank, AU Small Finance bank etc. These partnerships are generating growth in the business. Their persistency ratio (retention of customers) is at 60%+ in 2016.

Asset Management

Asset management business doesn’t require lot of capital to run. Company needs investment in fund managers. Indian customers are slowly turning towards stock markets via mutual funds and PMS. ABCapital’s market share stands at number three in terms of asset under management. I think it is attributed to their mutual funds. They have performed very well over the years.

ABCapital also works in other financial services as well like brokerages, MyUniverse etc. Recently, they formed joint venture with Vaarde Partners for asset reconstruction company. This JV will help in acquiring distressed assets through NCLT proceedings under IBC.

Overall perspectives

Financial services like lending, insurance and asset management are not penetrated in India. So, players like ABCapital will have great growth opportunities going ahead. It is also visible from results that the company has posted in these many years. So, this company has lot of headroom for growth.

ABCapital is currently investing a lot in these three business divisions. That’s the reason, management has raised capital. This step will yield good returns over the long run.

ABCapital has a great underwriting discipline in their NBFC and insurance business. Their book is a rare combination of good asset quality and growth in loans. Asset management business is in sweet spot.

Risks in overall business

Risks in NBFC

1. Increase in cost of capital due to weak economic conditions, inflation etc.
2. Shift to weak underwriting discipline in order to favor growth.
3. Increased corporate loan book. If assets turn into NPAs then it will be a problem.
4. If MSME problem happens like demonetization, GST etc. then EMIs will be due.
5. Bajaj Finance is playing as a major competitor in retail space.
6. HFC should continue to face lot of competition from peers. But, it is going to generate lot of demand in future.
7. P2P lending can act as disruption force for entire banking and finance industry if they start lending at discounted interest rates.

Risks in AMC

1. If people find other asset class other than equity like gold, real estate etc, AMC’s assets under management will decrease.
2. Failure to generate satisfactory returns over short term or long term. In short, if fund managers don’t perform well.

Risks in Insurance

1. If underwriting discipline is not maintained, then profitability hits.
2. Currently, only few players are present. If competition rises, then it will hit top line growth. Also, it will hit ability to raise premiums.
3. If persistency drops, then profitability hits.

References

Annual reports of ABCapital

https://www.adityabirlacapital.com

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Disclaimer

Investment in equity market is subject to market risk. Please analyze annual reports carefully. Views expressed in this article are personal. Views should not be treated as recommendations to buy or to sell stock.

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