February 15, 2010

Gold Financing
THEMATIC

Potholes on the road to El Dorado

Whilst the recent RBI clarification removing gold loans from the priority sector will decrease funding for the sector, we are positive on the long term prospects of gold loan NBFCs because of: (i) the unavailability of formal debt finance for a large part of the Indian population and the abundant availability of gold as collateral; (ii) the quick and hassle free loan delivery provided by NBFCs vs banks; and (iii) the increasing reach and acceptability of this form of finance. Manappuram is the best play on this theme given its branch strength, strong brand name, well developed gold appraisal skills and strong risk management. We initiate with a BUY. Despite short term funding concerns, our positive stance on the sector and the main NBFC in this segment Manappuram is driven by: Demand of credit and availability of collateral: Indias credit:GDP ratio is one of the lowest globally at ~4% due to the unavailability of formal banking services for a large part of the population. Banks and NBFCs have tried to tap into this potential in the past by offering unsecured personal loans but those initiatives did not succeed due to heavy defaults on these portfolios (even in benign economic conditions). Loans against gold jewelry have therefore emerged as a major alternative to tap this latent credit demand as Indians have about 18K tones of gold (~10% of total world gold stock) mostly in the form of jewelry worth ~$800 bn. Increasing market share of NBFCs: Whilst the total estimated gold loan market is ~$50-60 bn, the entire organized lending sector put together has only ~25% market share in this business and specialized NBFCs have ~8% market share in this business. We expect the market share of NBFCs to grow further at the expense of banks and moneylenders as: (i) NBFCs have quick and hassle free loan delivery vs banks because of their specialized gold appraisal skills; (b) NBFCs charge lower interest rates and have a better image than moneylenders; and (c) NBFCs are acquiring a new set of borrowers via the rapid expansion of branches and heavy advertising fronted by well known movie stars. Initiate with a BUY on Manappuram (MGFL.IN, $1.0 bn mkt cap, 36% upside): Whilst the recent RBI clarification removing gold loans from the priority sector is likely to impact the growth and NIMs of Manappuram, the company has adequate sources of funding to grow its loan book at a healthy pace of ~38% CGAR between FY11-13 and maintain its ROAs (as an improvement in operational efficiency would largely mitigate the adverse impact of NIM compression). Over the last 2 months the stock price has corrected by ~45% from its peak and at 1.9x FY12 P/BV we believe that all the negatives are priced in. We initiate with a BUY. External factors are the major risks: A sharp decline in gold prices by 40% or more (similar to what happened in the early 1980s) and further regulatory and political intervention are the major risks for the sector and for Mannapuram.

Analyst contacts
Pankaj Agarwal, CFA
Tel: +91 22 3043 3206 [email protected]

Krishnan ASV
Tel .: + +91 22 3043 3205 [email protected]

Poonam Saney
Tel: +91 22 3043 3216 [email protected]

Recommendation
CMP: Target Price (Period): Upside (%) EPS (FY11E):
Change from previous (%) Variance from consensus (%)

Rs106 Rs143 36 Rs7.6

NA 6

Stock Information
Mkt cap: 52-wk H/L: 3M ADV: Beta: BSE Sensex: Nifty: Rs44bn/US$963mn Rs190/62 Rs215mn/US$4.7mn 0.7x 18,105 5,426

Stock Performance (%)

1M Absolute Rel. to Sensex 3M 12M YTD -21.2 -41.3 -17.2 -31.1 50.9 -29.6 38.8 -18.3

Performance (%)
25,000 20,000 1 5,000 1 0,000 1 5-Feb-1 0 8-Jul-1 0 Sensex 26-No v-1 0 M anappuram Gen. Fin. 200 1 50 1 00 50

Source: Bloomberg, Ambit Capital research

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.

Indian Gold Financing- The Road to El Dorado with some potholes

Gold financing has come of age

Gold financing has been a popular form of financing in India for many decades due to the unavailability of formal financing options for a large chunk of the Indian population. Industry sources peg the size of the total gold loan market to Rs. 2.53.0 trn (implying ~10% of the value of the total gold in the hands of the Indians). However, historically this has been a fragmented market largely catered to by small moneylenders and pawn-shops (~75% market share). Over the last five years, the gold financing market has caught the fancy of organised lenders, especially NBFCs, who are not only increasing their market share at the expense of unorganized sector, but are also expanding the market by expanding into new geographies, introducing innovative products and spending heavily on marketing. The gold loan portfolio of organised players has increased at a CAGR of ~48% between FY07-10. Within this segment, specialized NBFCs (e.g. Manappuram, Muthoot) have grown their loan books at a much faster pace (~70%) during FY07-10.
Exhibit 1: Growing size of the organized gold loan market ( Rs bn) Exhibit 2: Increasing market share of NBFCs in the organized sector FY07 Public Sector banks Pvt Sector banks NBFCs Co-operatives 52% 15% 18% 15% 100% FY09 51% 14% 24% 12% 100% FY10 47% 12% 32% 10% 100%

600 500 400 300 200 100 0 FY02 FY07 FY09 FY10 25 120 250
CAGR 40%

515 375

FY11

Total

Source: Manappuram using ICRA data, Ambit Capital

Source: Manappuram using ICRA data, Ambit Capital

and has the legs to grow further

Despite growing their portfolio at a CAGR of ~48% over FY07-10, we believe that organised players are well placed to continue growing at a similar pace over the next 3-4 years. Our optimism is based on three factors:

An increase in the total potential market size due to increased gold holdings: As per the World Gold Council, Indians hold about 18k tones of gold (~10% of total world gold stock) worth $800 bn. Just as importantly, Indians add ~700 tonnes to their gold portfolio every year and ~75% of these gold holdings are in the form of jewelry. Historical data suggests that the demand for gold in India has been relatively inelastic to gold prices and inspite of gold prices growing at a CAGR of 13% over the last decade, the demand for gold has been robust. Hence looking at historical trends and Indias healthy GDP growth rate and savings rate, we believe that the total gold stock available (in volume terms) can continue to rise at a CAGR of ~5% for the next decade. Moreover, although we do not have a view on the evolution of the price of gold, it is reasonable to assume that gold prices can continue increasing at a 5% CAGR based on the last 90 year history of gold prices (2000-10 CAGR of gold prices is 13%). Hence we estimate that the total value of gold holdings in India can increase at a 10% CAGR over the next 5 years. Increased penetration from organized players: Organized players would not only benefit from this increased market potential as explained above but also from the increased penetration of the industry driven by:
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Indian Gold Financing- The Road to El Dorado with some potholes

1. Increased reach: Organized sector players (especially NBFCs) are rapidly expanding their reach by opening new branches in their existing and new geographies (e.g. Manappuram expanded its branch network ~7x over the last four years). Moreover, banks like HDFC are increasingly offering these products through an increasing number of branches. 2. Increased acceptability of the product: Furthermore, thanks to heavy advertising through the print and electronic media using movie stars and sports personalities, the organized sector is not only eating into market share of unorganized players but also trying to shed the stigma attached to pledging jewelry. This we believe can bring a new set of borrowers to the industry. 3. Better rates and services: Whilst we believe that the demand for the gold financing product is not interest rate sensitive, banks and NBFCs are offering gold loans at much lower rates than the unorganized players (12%-24% vs ~36%-60% by local moneylenders and pawnshops). Moreover the organized players score over local moneylenders in terms of quick disbursals and higher confidence in the lenders ability to keep the borrowers gold safely. 4. Unsecured financing drying up: Between FY09-11 banks and NBFCs suffered substantial losses on their unsecured loan portfolios (e.g. ICICI Bank, Reliance Capital, India Infoline, Cholamandalam Finance etc.). Since then the organised sector has become wary of unsecured financing. This should help the gold financing segment. Anecdotal evidence to support this point can be found from global trends as well where banks reluctance to advance unsecured loans post the Lehman crisis led to the growth in pawnbroking in both the US and the UK.
Exhibit 3: Potential Size of the Indian gold loan market
FY02 Gold holdings (in Tonnes) Gold Holdings in (Rs. Bn) Organised loan industry as a % of total value of gold holdings Organised gold loan industry (Rs. Bn) Share of NBFCs (%) Total Gold AUM of NBFCs (Rs. Bn) na 6,462 0.4% 25 NA NA FY07 na 11,669 1.0% 120 18% 24 FY09 FY10 FY11E FY12E FY13E FY14E FY15E 21,100 53,586 2.2% 1,179 70% 825 47% 26% FY10-15E CAGR 4% 10%

17,000 17,700 18,300 19,000 25,000 32,000 36,600 40,260 1.0% 250 24% 57 1.2% 375 32% 121 1.4% 515 50% 264 1.60% 644 55% 354

19,700 20,400 44,286 48,715 1.8% 797 60% 478 2.0% 974 65% 633

Source: Historical estimates from Manappuram using ICRA estimates, Ambit Capital research

NBFCs are better placed than banks

Whilst banks provide lower interest rates than NBFCs (~13%-15% vs 18%-24% by NBFCs), given the small ticket size (~Rs. 30K) and low duration of the product (~100 days), this difference in interest cost is not particularly apparent to the borrower. Hence we believe that within the organized segment, specialized NBFCs like Manappuram and Muthoot are better placed than banks and their loan portfolio will grow faster than banks in this segment because of:

Better reach to customers: NBFCs are quickly growing their branch network in the key catchment areas. Banks find this difficult to replicate as: (i) banks get limited branch licenses from the RBI which they would prefer to use keeping in mind their overall growth strategy rather than just the needs of the gold finance segment; and (ii) it takes time for banks to fully operationalise a branch given the infrastructure needed to open a bank branch.
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Indian Gold Financing- The Road to El Dorado with some potholes

Better products and service: Due to the very nature of this loan product (a short term liquidity product for borrowers with ~100 days average duration), quick and hassle free delivery of gold loans is a key competitive advantage. Moreover, since the borrower normally pledges his family jewelry, he wants to pledge the minimum amount of jewelry to get the desired amount. NBFCs have advantage on these parameters as they have experienced gold valuers in all their branches (in-fact all the new hires at these NBFCs go through extensive gold appraisal training before they join a branch). This helps them to quickly and accurately value the pledged jewelry and hence helps them quickly disburse the loan (in 10 minutes as per the personal experience of the author of this note) and provide higher LTV (up to 85%) to the customers.

Sources of Competitive Advantage

Whilst on the face of it gold financing business looks like any other financing business with no visible competitive advantages, deeper scrutiny points to the following key competitive advantages in this sector:

Reach/distribution channel: Given that gold loans are generally liquid loans where the borrower is in urgent need of funds and given the borrowers unwillingness to travel beyond a certain distance from his home (due to the risk and cost associated with travelling long distances), local branch based distribution is a key competitive advantage. However, given the need for experienced staff who can appraise the gold jewelry and provide robust operational risk management, it is not easy for a new entrant to roll out branches rapidly. NBFCs have an advantage over banks on this front as due to their low operational cost in running a branch, they are able to add branches faster than banks. Trust and brand name: Once the lender is near the customer, the lender then needs the customers trust in his ability to safely store the pledged gold. Banks have a natural advantage over NBFCs on this parameter given their long operating history and a general reputation for safety. Moreover, banks longer track record in providing locker facilities also helps. However, NBFCs seem to have acknowledged this and are spending heavily on brand building by hiring popular movie stars and sports personalities (advertising expenses for Manappuram were 14% of its net revenues in FY10 vs 9% in FY08). NBFCs are also spending on risk and safety measures by regularly auditing the gold stock at all branches, installing safety vaults and CCTV cameras. Quality of products and services: Given that gold loans are meant to provide short term financing, the ability to provide higher LTV loans and quick disbursal of the same is a key competitive advantage. The key to provide higher LTV and quick disbursal lies in accurately and quickly appraising the quality of the gold. NBFCs like Manappuram and Muthoot score over banks on this parameter as due to their decades of experience in this business, they have been able to develop multiple check and balances to accurately appraise the quality of gold quickly. This has helped them in building a product portfolio with interest rates ranging from 12%-24% depending on LTV and the type and quality of gold. Banks on the other hand are at a disadvantage here due to their weaker domain knowledge and hence are not able to offer higher LTV loans. Instead banks for the most part sell a single standardized gold loan product with an LTV of less than 65%.. Managing Operational risk: As lenders handle a large amount of cash and gold on a daily basis in branches scattered across the country, they are at risk of employee theft, burglary and fraud (i.e. taking spurious gold as collateral). Decades of experience in these businesses have helped specialised NBFCs like Manappuram and Muthoot develop systems and procedure to counter these risks. However, for newer NBFCs in this segment (like India Infoline, Karvy, etc.) the lack of such experience and knowledge will be an obstacle to scale up their operations and compete with established players.
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Ambit Capital Pvt Ltd

Indian Gold Financing- The Road to El Dorado with some potholes Exhibit 4: Competitive assessment of the various players in the gold financing industry
Parameter Specialised NBFCs like Manappuram and Muthoot Banks New NBFCs who are entering the Local money segment (e.g. lenders Karvy, IIFL) Comments Due to aggressive branch expansion, established NBFCs have better reach than banks as banks dont offer this product through all their branches. New NBFCs only have presence in limited geographies and moneylenders are confined to their respective localities. Banks score well on this parameter because of their long operational history. However, established NBFCs have a strong brand name in southern India and are trying to build pan-India brands through heavy advertising. NBFCs because of their ability to quickly appraise the value of the gold and swiftly disburse the loan have an advantage over banks. Banks because of their internal checks and procedures are able to adequately manage operational risk. Established NBFCs because of their decades of experience have been able to develop the systems to deal with operational risk effectively. For new NBFCs, dealing with operational risks whilst scaling up their operations would be a challenge.

Reach and distribution channel Brand name and trust Products and services Ability to manage operational risk

Overall
Source: Ambit Capital research

Note :

- Strong; - Relatively Strong;

Average; -

Relatively weak.

Ambit Capital Pvt Ltd

Indian Gold Financing- The Road to El Dorado with some potholes

How do gold prices affect this sector?

Given that: (i) ~30% of the growth in the loan portfolio of the major NBFCs over the last four years has been driven by the increase in gold prices, and (ii) NBFCs provide up to ~85% LTV on gold jewelry, a drop in gold prices can impact both the credit quality and growth of the sector. Whilst gold has been steadily rising over the last decade, there have been multiple instances in the past where gold prices have declined sharply and languished for a long period of time
Exhibit 5: Periods of declining gold prices
Period Fall in gold Maximum 3 prices No. of days month during the decline period 120 days 21% 21% Maximum 6month decline na Maximum 1 year decline Comments After correcting by 21% in 4 months, prices went back to the earlier levels within a month. After declining 18% in 3months the prices went back to earlier levels within 3 months. Gold had a losing streak of 18 months where it lost 43% and it took another 18 months to reach at previous levels. A sharp decline of 19% within 16 days. It took around 80 days for the gold to reach its previous levels A sharp decline of 43% in less than 2 months. Whilst the gold bounced back 20% in the next 9 months, it took 28 years for the gold to reach the peak that it hit in Jan80. Lost ~57% in 21 months. It took gold 25 years to return to its pre- decline prices! 44% decline over 2 year period took close to 35 months to reach the peak prices

From Aug73Dec73 From May74 Aug74 From Feb75Aug76 From Oct78Nov78

na

90 days

18%

18%

na

na

560 days

43%

21%

25%

36%

16 days

19%

na

na

na

From Jan80Mar80

57 days

43%

40%

na

na

From Sep80Jun82 Feb83-Feb85 Feb90-Jun90 Feb97-Jan98

640 days

57%

27%

32%

41%

740 days 130 days 315 days

44% 18% 23%

16% 14% 16%

19% na 17%

28% Na Na

Source: Ambit Capital research, Bloomberg,

The last 90 years of data on historical gold prices show that there have been nine instances when gold prices have fallen more than 15% within a 3 month period and two instances when they have fallen more than 25% within a 3 month period.

Impact of a price correction on credit quality

Due to limited listing history of gold loan companies, we do not have data on impact of a sharp gold price correction on gold financers credit quality. However, we believe that the impact would be lower than what one might instinctively expect it to be. Given that specialized NBFCs have an average LTV of around ~75% on their gold loan portfolio and have around 25% of their portfolio at ~85% LTV, a straight forward conclusion would be that a 25%+ correction in the gold price can be catastrophic for the sector. However, a closer look suggests that things are not as simple as that.

LTV is calculated on the scrap value of the gold: NBFCs normally provide loans against household used jewelry and not against gold bars. They calculate the LTV on the scrap value of the gold. This improves the margin of
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Indian Gold Financing- The Road to El Dorado with some potholes

safety for them in the event of a fall in gold prices as the value of the jewelry is normally ~15-20% higher than the scrap value of the gold as it includes the making charges of the jewelry and the valuable stones embedded in the jewelry. Hence the replacement cost of the jewelry for the borrower is much higher than the scrap value and this makes willful default less likely even if the gold price corrects.

Emotional quotient: Normally the borrowers pledge their family jewelry and hence have some emotional attachment to the jewelry. Hence the borrowers have an emotional incentive to repay even if they are slightly out of money. We believe that this adds an additional ~5% margin of safety for the lender. Shorter duration of the loans: The average duration of the jewelry loans is around ~100 days and around ~65% of the loans are repaid within 90 days and 85% within 180 days. Only 15% of the loans go beyond 180 days. Hence the sector is insulated to a significant extent from a gradual decrease in gold prices. Lenders have option to make margin call and enter into options contracts: Some lesser know features of gold financing contracts mitigate to a great extent the NPA risk in the event of sharp decline in gold prices: a) the lender has right to make a margin call if the LTV falls below their comfort level; b) the lender has the right to sell the pledged gold even before the completion of loan tenure in case the LTV crosses 90%; and c) the lender has right to enter in to gold options on behalf of the client to hedge the gold price risk. That being said, lenders are unlikely to sell the pledged gold to mitigate default risk as they are likely to loose that customer forever and suffer reputational damage.

Hence we believe that whilst from the lenders perspective the average LTV is 75%, including making charges of the jewelry and some margin of safety due to the borrowers emotional attachment to the jewelry, prices have to fall by at least 35%-40% for borrowers to willfully default on their loans. Hence even in the worst case scenario based on historical trends (when gold prices fell 40% within 2 months in 1980), write-offs for the Manappuram would be ~4% of the loan book. This could be absorbed by the company within a single year since the company has an ROA of ~5%.

Impact of a price correction on loan book growth

The data suggests that ~30% of the loan growth of major NBFCs over the last 5 years has been driven by the increase in the gold prices (which increased at a CAGR of ~19% between FY06-11). Whilst the monthly volatility in gold prices could have a limited impact on growth, a structural decline in gold prices similar to the 1980s could seriously impact the growth of the sector as the average tenure of the loan is only ~100 days. Hence a decline in gold prices can bring down the loan growth as the: (i) loans get repriced at lower rates and the potential market size decreases with the value of the gold, and (ii) a steep fall in gold prices can shut out marginal customers who do not have sufficient amount of gold to meet their loan requirement.

Ambit Capital Pvt Ltd

Indian Gold Financing- The Road to El Dorado with some potholes

Removal of priority sector profitability and growth

Exhibit 6: Financials of typical gold loan NBFCs
Parameter NIMs Operating Margins PAT margin RoA RoE (%) ~15% ~55% ~30% ~4%-5% ~25%-30%

status

impacts

Until recently a major portion of loans originated by gold financing NBFCs were classified as priority sector advances. Hence Indian banks, who need to advance 40% of their advances to priority sectors, met some portion of this requirement by buying loan portfolios from gold NBFCs and advancing loans to them. This was not only a cheaper (~150-200 bps lower cost of funds on these advances) but also a easily available source of funding for gold NBFCs (~55% of Manappurams funding was through this route) as banks were happy to lend to gold loan NBFCs under the priority sector category without breaching their sectoral cap on NBFCs. However, on 3rd February, 2011 the RBI said that gold loans no longer be classified as priority sector loans. This new guideline will impact the growth and profitability of the sector as:

Source: Company, Ambit Capital research

Increase in cost of funds: Since the cost of funds which came through the priority sector were ~150-200 bps cheaper than normal bank borrowings, removal of priority sector status would increase the cost of funds for gold NBFCs. For Manappuram, we expect the cost of funds to go up by ~110 bps as 55% of its funding came from banks through priority sector loans. Availability of funds: Since loans to gold NBFCs were classified as priority sector, the banks were happy to advance loans to these NBFCs without breaching their sectoral advance caps to NBFCs. However, under the new regime, gold NBFCs would have to compete with other NBFCs as well as other sectors to secure funding from banks. We believe this could be a short term challenge for Manappuram given the current tight liquidity environment. Constrained credit availability in turn could affect its growth for some time. However, we believe that in the medium-to-long term the company would tide over this obstacle as healthy profitability, stable credit quality (NPAs less than <1.0%) and comfortable capital adequacy (~25% at FY11E) should give enough confidence to credit providers to continue lending to the company. Increased capital adequacy: Gold financing companies were selling ~25% of their loan portfolio to banks for which they were not required to set aside equity capital. Now NBFCs will not be able to sell their portfolio to banks and will have to keep this portfolio on their books. Hence the NBFCs will have to set aside the mandatory regulatory capital of 15% for these loans. This means that the NBFCs ability to leverage would go down. Prior to these guidelines, NBFCs could have effectively leveraged up 8.5x (assuming ~20% loans off the books). This could now come down to ~6.6x. This means that keeping everything else constant, this would decrease ROE of the NBFCs by 8%-12% depending on their respective ROAs (see table below for explanation).

Ambit Capital Pvt Ltd

Indian Gold Financing- The Road to El Dorado with some potholes

Exhibit 7: Impact analysis of RBI removing gold loans from priority sector (taking Manappuram 3QFY11 financials)
As a % of average assets Yield on advances Pre RBI guidelines 23.17% Post RBI guidelines 23.17% Comments The RBI guidelines does not impact lending rates ~55% of borrowed funds of Manappuram were through priority sector route where Manappuram was getting these funds at ~200 bps cheaper than normal borrowings. These 55% funds will get repriced at 200 bps higher rates resulting in ~110 bps increase in cost of funds.

Cost of funds Spreads Opex Loan loss provisions Pre Tax ROA Post Tax ROA Assuming optimal leverage

9.15% 14.02% 6.77% 0.46% 6.79% 4.48% 8.33

10.25% 12.92% 6.77% 0.46% 5.69% 3.75% 6.66

Operational expenses and credit quality do not get impacted by the new rule Impact of 70 bps on ROA ROE is a function of leverage and prior to new guidelines Manappuram could have leveraged up to 8.33 times in the optimal conditions as they were required to set aside 15% capital adequacy only for the 80% of loans which were on the books reducing effective capital requirement to only Rs. 12.5 for Rs. 100 of AUM (i.e. 15% of Rs. 80 on book loans). In the new regime the company will have to set aside capital adequacy of 15% for entire portfolio of Rs, 100 implying capital adequacy requirement of Rs. 15.

ROE

37.32%

25.00%

Source: Manappuram, Ambit Capital research* Please not that above analysis is only for illustration purpose and not our estimates for the company.

Regulatory/political risk is there more to come?

The Indian specialty finance sector has been at the wrong end of regulatory and political intervention in the recent past:

Andhra Pradeshs state ordinance on microfinance institutions (MFIs) in Oct10 has led to mass default by borrowers in that state. In Jan11, a committee set up by the RBI on microfinance institutions (the Malegam Committee) proposed capping the interest rates charged by MFIs and imposing many other restrictions on their business operations. As explained in the previous section, on 1st February, the RBI removed priority sector status on gold loans originated by NBFCs.

In light of this, there are fears of further regulatory intervention. Two major risks which investors are anticipating are:

The RBI capping rates charged by gold financing companies; and State government intervention in the gold financing sector along the lines of what the Andhra Pradesh state ordinance did to MFIs.

Will RBI cap the interest rates?: Whilst it is difficult to anticipate the RBIs
policy making regarding gold financing companies, we believe that the probability of the RBI capping interest rates charged by gold financing companies is low:

The RBI removing gold loans originated by NBFCs from priority sector effectively means that the RBI does not think that these loans are going to the poorer/credit starved section of the society. Hence the need to cap interest rates presumably does not arise. Different customer Profile small businessmen and the middle class: Unlike the microfinance sector, which deals with customers who are very poor and do not have access to formal bank credit, gold financing companies cater to more middle class people and small businessmen (who use gold financing
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Indian Gold Financing- The Road to El Dorado with some potholes

to meet their short term liquidity requirements). Hence the political or social need to intervene is more muted.

Further state government intervention?: Whilst gold financing NBFCs are

regulated by the RBI, some state governments including Kerala (the state accounts for the biggest proportion of the loan portfolios of Manappuram and Muthoot) want to regulate these NBFCs under the State Money Lenders Act. The Kerala State Money Lenders Act, amongst other things, caps interest rates charged by moneylenders at 2% above the rates charged by banks. The act, however does not explain which bank rate to be taken for this calculation as banks charge anywhere between 8%-20% on different loan products. Hence it is difficult to calculate the financial impact of applicability of Kerala Moneylenders act applying on gold loan NBFCs. Whilst the final decision on this matter is still pending with apex court of India, its comforting that one of the technical committees set up by the RBI on this issue recommended that NBFCs should not come under State Money Lenders Act and the recent Malegam Committee report on microfinance also endorsed this view.
Exhibit 8: Conclusion - Porter analysis of Indian gold financing industry
Bargaining power of suppliers High Given that the industry is still at a nascent stage and requires continuous debt and equity capital, the bargaining power of capital suppliers (both equity and debt) is high. Competitive intensity Medium The competitive pressure facing specialised gold NBFCs is not high given their unique offering of better service than banks and lower interest rates and better safety than moneylenders. However, competition within NBFCs will intensify with the entry of more NBFCs in to the sector. Bargaining power of buyers Medium Given that alternative sources of borrowing is limited for such borrowers and there are very few alternate avenues to get financing at such a short notice, the bargaining power of customers is low.

Barriers to entry MEDIUM Whilst barriers to entry is not very high to start small scale operations, scaling up operations needs substantial capital, operational knowledge, time and advertising expense. However, as the existing players gain substantial scale and build a trustworthy brand name in major catchment areas, it would be tough for a new player to break in.

Threat of substitution LOW Microfinance loans and unsecured personal loans from banks and NBFCs are the two other major substitutes for the borrowers. However, post recent developments in the microfinance sector in India we believe that the availability of finance from this route would be limited. Moreover, as banks and NBFCs burnt their hands in unsecured personal loans, they have scale down their unsecured loan books and have altogether exited from this segment (e.g. IIFL, Reliance Capital, Cholamandalam etc.)

Improving Unchanged Deteriorating

Source: Ambit Capital research, Industry

Whilst a sharp decline in gold prices and regulatory changes could impact the growth and profitability of the sector, given the under-penetration of credit in India and given the abundant availability of gold as collateral, we cannot but feel that the gold financing sector is well placed to grow rapidly.

Ambit Capital Pvt Ltd

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Indian Gold Financing- The Road to El Dorado with some potholes

Manappuram General Finance

(MGFL IN, mcap US$1.0bn, BUY, TP Rs 143, 36% upside):
Manappuram is the second biggest gold loan NBFC in India after Muthoot Finance and it is the only listed pure play gold loan NBFC. The companys loan book and profitability has grown at a CAGR of more than 100% over the last 4 years which has resulted in a ~30x increase in its share price over the same period. Whilst the recent RBI clarification removing gold loans from priority sector would impact the growth and NIMs of Manappuram, the company has adequate sources of funding to grow its loan book at a healthy pace of ~38% CGAR between FY1113 and maintain its ROAs as improvement in operational efficiency would largely mitigate the impact of margin compression. The stock has corrected ~50% from its peak over the last 2 months and at 1.9x FY12 P/BV we believe that all the negatives are already priced in. We initiate with a BUY. .

Ambit Capital Pvt Ltd

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BFSI-Specialty Finance

February 15, 2010

Manappuram
Bloomberg: MGFL Equity

BUY

INITIATING COVERAGE Analyst contacts

Pankaj Agarwal, CFA
Tel: +91 22 3043 3206 [email protected]

The genuine article

Whilst the recent RBI clarification (which removed gold loans from the priority sector) could impact loan book growth and NIMs, Manappuram has adequate sources of funding to grow its loan book at a CAGR of 38% between FY11-13 and maintain its ROAs as improvement in operational efficiency would mitigate the impact of NIM compression. Over the last 2 months, the stock has corrected ~45% from its peak and at 1.9x FY12 P/BV, all the negatives appear to be priced in. We initiate with a BUY. Even after a 45% correction over the past 3 months, Manappurams share price is up ~30x over the last four years driven by a CAGR of 135% in net profits between FY06-11. However, following the recent correction (which was in part driven by a regulatory change from the RBI), at 1.9x FY12 P/BV all the negatives seem priced into Mannapurams share price as: Funding concerns are overdone: Whilst the RBI guidelines will impact the availability of funding to some extent, we do not see funding drying up for Manappuram as at 3QFY11 ~45% of its debt funding is from the non-priority sector route (bank credit lines, CPs, NCDs). Even within priority sector borrowings, only 35% was from selling loan portfolios to banks (a source of credit which seems likely to dry up); the remaining 65% were credit lines from banks at slightly lower rates due to the priority sector tag. Increased operating efficiency to mitigate margin compression: Whilst we expect NIMs to compress by ~260 bps between FY11 and FY12 driven by (a) system wide rates rising (b) priority sector liabilities being repriced upwards by ~110bps; (c) slight decrease in lending rates, the increased operational efficiency (opex as of % average assets declining by ~120 bps by FY13) should mitigate the impact on ROAs. Loan book grow should be healthy: Whilst loan book growth seems likely to slow down from its historical rate (120% CAGR between FY07-11), we still expect it to be healthy at 38% CAGR over the next 2 years driven by increased business from the branches were opened in the last one year (52% of the branches) and the further roll out of ~1000 branches over the next two years. Valuation In a country where personal lending from the banks has almost stopped and where gold is a commonly available form of collateral, gold financing looks well placed to continue growing rapidly. Mannpuram is the lender with the most well developed competitive advantages in the gold financing market. Our excess return model (using a cost of equity of 15% and perpetuity growth of 5%) values the firm at Rs.143 implying 36% upside (implied FY12 P/B of 2.5x and FY12 P/E of 13.1x)
Exhibit 9: Key financials
Year to March Net Revenues Operating Income Net Profits Diluted EPS (Rs) RoA (%) RoE (%) P/B (x)
Source: Company, Ambit Capital research

Krishnan ASV
Tel .: + +91 22 3043 3205 [email protected]

Poonam Saney
Tel: +91 22 3043 3216 [email protected]

Recommendation
CMP: Target Price : Upside (%) EPS (FY11E):
Change from previous (%) Variance from consensus (%)

Rs106 Rs143 36 Rs7.6

NA 6

Stock Information
Mkt cap: 52-wk H/L: 3M ADV: Beta: BSE Sensex: Nifty: Rs44bn/US$963mn Rs190/62 Rs215mn/US$4.7mn 0.7x 18,105 5,426

Stock Performance (%)

1M Absolute Rel. to Sensex 3M 12M YTD -21.2 -41.3 -17.2 -31.1 50.9 -29.6 38.8 -18.3

Performance (%)
25,000 20,000 1 5,000 1 0,000 200 1 50 1 00 50 8-Jul-1 0 Sensex 26-No v-1 0 M anappuram Gen. Fin.

FY09 1,274 674 302 2.2 3.3% 23.2% 10.9

FY10 3,413 2,018 1,197 4.1 5.6% 30.8% 5.9

FY11E 8,410 4,836 2,865 7.6 5.0% 22.4% 2.3

FY12E 12,561 7,296 4,608 11.0 4.6% 21.5% 1.9

FY13E 16,884 9,963 6,300 15.0 4.6% 24.1% 1.5

1 5-Feb-1 0

Source: Bloomberg, Ambit Capital research

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to disclaimer section on the last page for further important disclaimer.

Manappuram General Finance & Leasing

Company Financial Snapshot

Company timeline
Year 1992 1996 1999 2007 2008 2009 2010 2010 2010 Event Company established Company goes public via an IPO Commencement of gold financing business PE funding of Rs. 700 mn from Sequoia and others PE funding of Rs. 700 mn from Ashmore and others Acquired sister company MAFIT from promoters Raised Rs. 2.5 bn through a QIP Preferential issue of Rs. 1bn to promoters Raised Rs. 10 bn through another QIP

Company Background

Manappuram is Indias second largest gold loan provider with a loan book of Rs.~70 bn. The company provides loans against household jewelry and has grown its loan book at a CAGR of 120% over the last 4 years driven by its expanding branch network, a strong brand name and the ability to swiftly appraise gold, make a lending decision and then structure a loan for the retail or SME borrower.
Balance Sheet
Rs. Mn Sources of Funds Shareholders' Funds Loan Funds Total Sources of Funds FY10 6,106 25,434 31,539 FY11E 19,488 64,158 83,646 FY12E 23,450 93,437 116,888

Profit and loss account

Rs. mn Net Income Net Interest Income Interest Income Interest Expense Fee Income Expenditure Employee Cost Other expenses Operating Profit Profit Before Tax Net Profit Diluted EPS (Rs) FY10 3,413 3,306 5,351 2,045 107 1,395 536 859 2,018 1,818 1,197
4.1

FY11E 8,410 8,249 11,765 3,516 161 3,574 1,544 2,030 4,836 4,300 2,865
7.6

FY12E 12,561 12,392 20,666 8,274 169 5,265 2,805 2,460 7,296 6,914 4,608

Application of Funds Fixed Assets Investments Cash and Bank balances Net Loan book Net Current Assets Total Applications of 11.0 Funds BVPS (Rs)

569 1,407 2,682 25,871 1,010 31,539 17.9

1,301 403 3,948 74,835 3,159 83,646 46.7

1,541 403 5,545 104,962 4,437 116,888 56.2

Loan, revenue and net profit growth

320% 280% 240% 200% 160% 120% 80% 40% 0% 298% 173% 98% 88% 55% FY08 95% 91% 43% FY09 FY10 FY11E 168% 188% 178% 162%

ROE decomposition (as a % average assets)

Net Income NII Fee Income Operating Expenses Employee Expenses Other opex Operating Income Depreciation Loan loss provisions Pre Tax ROA Tax ROAA Average Leverage(x) ROAE FY10 15.8% 15.3% 0.5% 6.5% 2.5% 4.0% 9.4% 0.7% 0.3% 8.44% 2.9% 5.6% 5.5 30.8% FY11E 14.6% 14.3% 0.3% 6.2% 2.7% 3.5% 8.4% 0.7% 0.3% 7.47% 2.5% 5.0% 4.5 22.4% FY12E 12.5% 12.4% 0.2% 5.3% 2.8% 2.5% 7.3% 0.1% 0.3% 6.90% 2.3% 4.6% 4.7 21.5%

Loan book

Revenues

Net Profits

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Manappuram General Finance & Leasing Exhibit 10: SWOT analysis

Strengths Weaknesses

Strong branch network of ~1,800 branches spread across India. Strong brand name in the gold financing in south India Ability to quickly disburse gold loans based on the gold appraisal skills developed over decades. Strong risk management architecture to shield the company from employee thefts, burglaries and the use of spurious gold as collateral.
Opportunities

The brand is relatively unknown outside south India. However, the company is trying to build its brand through heavy advertising. Lack of a broad based funding base and heavy dependence on banks for funding.

Threats

Opportunity to grow its underpenetrated north India.

operations

in

Opportunity to diversify in the related businesses like selling gold coins and bars and financing these purchases.

There is a potential regulatory threat that the interest rates charged by gold lenders like Mannapuram could be capped. However, the removal by the RBI of gold loans from the priority sector somewhat reduces this risk. State governments intervening in the operations of gold lenders like Mannapuram. A sharp correction in gold prices could lead to NPAs rising and/or reduce the potential size of the gold loans market.

Source: Ambit Capital research

Exhibit 11: Competitive assessment of the various players in the gold financing industry
Parameter Manappuram Muthoot Finance Muthoot FinCorp Shriram Karvy, City Union Indiainfoline Finance Comments Manappuram and Muthoot have a wider distribution reach from ~2000 branches compared to City Union Finance (~600 branches) and new players like Karvy and IndiaInfoline (who have a negligible branch presence). Both Manappuram and Muthoot have been in the industry for decades and are the better known brands in the segment. Manappuram scores over Muhtoot on brand recognition as the Muthoot brand name is more generic in nature (there are already three big gold financing firms by the name of Muthoot which could lead to cannibalization and confusion). Because of their decades of experience in the industry, Manappuram and Muthoot have developed systems to deal with operational risks effectively. For new NBFCs, dealing with operational risk whilst scaling up their operations would be a key challenge.

Reach and distribution channel

Brand Name and trust

Ability to manage operational risk Overall

Source: Company, Ambit Capital research, Industry, Bloomberg,

Note :

- Strong; - Relatively Strong;

Average; -

Relatively weak.

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Manappuram General Finance & Leasing

Mannapuram has come of age

Manappuram is India second largest gold loan NBFC with ~Rs. 70 bn in loan assets. From being one of the thousands of small cap companies listed on the exchanges, Manappuram has emerged as one of the top wealth creators in the country over the last 4 years with its stock price increasing by ~30x over the last 4 years despite the recent 50% correction. Rapid branch expansion (from 291 branches in FY07 to 1,795 now), the increase in gold prices (21% CAGR between FY07-11), the drying up of personal loans from banks since the Lehman crisis and continuous funding from both debt and equity providers has helped Manappuram to grow its loan book and revenues at a ~120% CAGR over FY07-11.
Exhibit 12: Robust loan growth
70 60 50 40 30 20 10 FY07 FY08 FY09 FY10 9MFY11
YoY Growth (%) Outstanding loan book (Rs. bn)
Source: Company, Ambit Capital research

Exhibit 13: with a proportional increase in revenues

188%

173% 91% 55%

200% 150% 100% 50% 0%

6,000 5,000 4,000 3,000 2,000 1,000 FY07 FY08 FY09

88% 95% 174%

168% 178%

200% 150% 100% 50% 0%

FY10 9MFY11 YoY Growth (%)

Net Revenues (Rs. mn)

Source: Company, Ambit Capital research

Exhibit 14: Healthy net profit growth

6,000 5,000 4,000 3,000 2,000 1,000 FY07 FY08 FY09 FY10 9MFY11 YoY Growth (%) Net Profits (Rs. mn)
Source: Company, Ambit Capital research

Exhibit 15: ...but EPS growth has been lower due to dilution
350% 300% 250% 5.0 4.0 3.0 2.0 1.0 0.0 FY07 EPS
Source: Company, Ambit Capital research

298%

200%
173% 86% 84% 27% 62%

150% 100% 50% 0%

168% 98% 43%

162%

200% 150% 100% 50% 0%

FY08

FY09

FY10

9MFY11

YoY Growth (%)

and now has a bright future

We expect Manappuram to show continued growth in its top and bottom line (although at a slightly lower pace than it has done over the past five years) due to the increased productivity of its recently opened branches (52% of the branches currently under operation were opened in the last one year), further branch expansion and improved efficiency in the branches. These positive forces should largely mitigate the negative impact of NIM compression (arising from the increased cost of funds and the decrease in lending yields due to increased competition). In this section we expand on these conflicting forces.

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Manappuram General Finance & Leasing

Loan book to grow at a CAGR of 38% Mannapurams loan book has grown at a CAGR of ~120% between FY07-11 and management is guiding the market towards loan growth at ~80% CAGR between FY11-13. However, we are skeptical about managements ability to meet this guidance because of our concerns regarding the abundant availability of the funds following the recent policy change by the RBI which removed gold loans from the priority sector (~55% of the borrowings of Manappuram were priority sector), uncertainty regarding the evolution of gold prices (which has driven ~40% of the loan growth between FY07-11) and lower business from the new branches due to lower availability and willingness to pledge gold in the rest of the India vis a vis south India. However, we believe that even with constant gold prices and with a slight improvement in branch productivity, the company can achieve loan growth of 38% CAGR between FY11-13 (implying average loan book CAGR of ~58% between FY11-13 as the growth was back-ended in FY11): (i) Funding to become more expensive but not dry up: Whilst funding is likely to become expensive post the recent RBI guidelines removing gold loans from priority sector, we cannot see funding drying up for Manappuram completely. ~55% of the funding for Manappuram was coming through priority sector and only ~20% of the funding was through assignment of the portfolios (see table below). Our discussions with bankers suggest that whilst funding through the securtisation route (which accounts for ~20% of Mannapurams funding) might dry up, the direct bank funding under priority sector (which accounts for 35% of Mannapurams funding) would still continue but at slightly higher rates (100-200 bps). Moreover, the company has two more sources of funding which it has not fully explored as yet: The Company has the highest credit rating available for Commercial Paper (CP)/NCDs. It can raise ~Rs.20 bn in CPs but has so far utilised only 5% of this limit. Only ~5% of the funding for Manappuram comes from retail NonConvertible Debentures (NCDs). Manappurams competitor Muthoot Finance gets ~50% of its funding through this route suggesting that Mannapuram, a larger and more established firm, should also be able to avail of NCD funding.

Exhibit 16: Funding mix for Manappuram at the end of 3QFY11

Funding Source Bank Funding (a+b) a. Through Priority Sector Assignments Working capital loans from banks b. Non Priority Bank funding Non bank Funding NCDs Subordinated bonds Subordinated debt CPs Others Total Amount % contribution Comments (Rs. Mn) 47,694 88% 29,807 14,242 15,565 17,887 6,501 2,934 1,628 1,000 913 25 54,195 55% This is the part most impacted by the RBI 26% policy change as it is no longer attractive for banks to buy these portfolios Interest cost likely to increase on these 29% liabilities by ~150-200 bps This is unlikely to be affected as these are 33% normal working capital loans. 12% Can access this route. Rival Muthoot 5% Group gets 50% of its funding through this route. 3% 2% 2% 0% 100% Company has the highest rating for raising CPs. Can raise upto Rs. 20 bn

Source:Company, Ambit Capital research

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Manappuram General Finance & Leasing

Exhibit 17: Increasing branch productivity

Year FY07 FY08 FY09 FY10 3QFY11 Portfolio per branch (Rs. Mn) 13.4 18.2 19.5 25.9 35.8

(ii) Branch expansion and improved branch productivity: ~52% of the branches in Manappuram have been opened over the last one year. In these branches the average portfolio is still below Rs. 10 mn whereas in the older branches, the average loan portfolio is in the range of Rs. 40-150 mn. Going forward we expect the business from the new branches to increase as they become mature as they benefit from heavy advertising and marketing by Manappuram. Over and above that, the addition of ~1000 more branches over the next 2 years should further add to loan book growth.

Source: Company, Ambit Capital research

Exhibit 18: Loan growth analysis for Manappuram

FY07 Total Gold loans (Rs. Mn)* Loan Growth (YoY) LTV Value of the gold stock (Rs. Mn) Average Gold prices per gram (Rs.) Gold Stock (MT) Gold pledged per customer (grams) No. of customers Customer per branch Number of branches Portfolio per branch (Rs. Mn) Average Ticket Size per customer ('000) 48% 6,592 930 7.09 48.8 145,371 500 291 18.2 21.9 3,176 FY08 4,914 55% 45% 10,942 1,189 9.2 41.2 223,039 512 436 19.5 22.0 FY09 9,381 91% 48% 19,372 1,452 13.3 39.8 335,156 520 645 25.9 28.0 FY10 25,589 173% 69% 37,267 1,660 22.5 40.9 549,172 546 1,005 35.4 46.6 FY11E 74,740 192% 70% 106,771 2,017 52.9 46.2 1,145,279 573 2,000 37.4 65.3 FY12E 104,962 40% 70% 149,946 2017 74.3 48.5 613 2,500 42.0 68.5 FY13E 141,510 35% 70% 202,158 2017 100.2 51.0 656 3,000 47.2 71.9

1,531,811 1,966,845

Source: Company, Ambit Capital. *Including securtised/assigned loans

Profitability is likely to fall Between FY07-11, net profit for Manappuram grew at a 128% CAGR which is higher than the loan book CAGR of 120% during the same period as: (i) cost of funds decreased for Manappuram (from ~11.8% in FY08 to ~9.2% in 3QFY11) due to improved credit ratings, and (ii) operational efficiency improved between this period as opex as a % of average assets fell from 7.0% in FY08 to 6.8% in 3QFY11. However, going forward we expect net profits to grow at slightly lower rate (~48% CAGR between FY11-13) than the growth in average loan book (~58% CAGR between FY11-13) as it seems likely that there will be some compression in net interest margins due to: (i) the cost of funds increasing by ~100-150 bps due to the RBI removing gold loans from priority sector; (ii) the decline in the lending yields as competition increases in the gold loan sector in the wake of new players entering the market. However, enhanced operational efficiency will offset to a significant extent the adverse impact of fallings NIMs. We describe these dynamics in more detail in this section. NIMs to decline but still stay healthy: Between FY08-11, Manappuram has maintained net interest margins in the range of 15%-18%. Going forward we expect net interest margins to decline to ~13.5% by FY13 as: (i) Cost of funds for Manappuram are likely to increase by 100-150 bps as the double whammy of system wide interest rates rising kicks in and the removal by the RBI of gold loans from priority sector bites (leading to ~55% of Mannapurams liabilities being repriced at ~200 bps higher); and

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Manappuram General Finance & Leasing

(ii) Increased competition from other NBFCs (like Shriram City Union, Karvy, India Infoline, etc.) which have recently entered the gold loans market leads to a 100-150 bps decline in lending yields.
Exhibit xx: NIMs to decline but still at healthy level
30% 20% 10% 0% FY11E FY12E FY13E NIMs (%) 5.9% 5.6% FY12E FY13E FY08 FY09 FY10 24.9% 15.6% 14.5% 29.0% 17.9% 25.0% 16.4% 23.0% 23.0%

27.5% 16.8%

13.8% 10.5%

13.6% 10.5%

11.8%

10.7%

8.9%

Yield on advances (%)

Source: Company, Ambit Capital

Cost of funds (%)

Improved operational efficiency to compensate for NIM erosion: Whilst Manappurams operational efficiency have improved marginally between FY08-11 with operating expenses as a % of average assets decreasing from 7% in FY08 to 6.8% in Q3FY1, going forward we expect operational expenses to decrease further to 5.6% of average assets by FY13 as: ~64% of the firms branches have been opened in the last two years and are yet to reach their optimal capacity. Whilst some of the expenses related to branches (eg. rent and electricity) will increase with inflation and employee expenses are likely to rise up with competition heating up in the sector, the increase in such expenses will be outpaced by the loan book growth that these branches will show as they move towards optimal capacity (see Exhibit 17 on page 17). Advertising expenses for Manappuram have been ~33% of total expenses (~1.2% of average AUM) in FY10 and FY11. These expenses have increased at a CAGR of 162% between FY06-11 as company has heavily spent on brand building by hiring well known movie stars. Clearly, these expenses are totally discretionary in nature. Even if assume Manappuram maintains its advertising expenses, they are likely to come down as a % of average assets.

Exhibit 19: Operating efficiency to improve further with scale

10% 9% 8% 7% 6% 5% 4% 3% FY08 FY09 FY10 Q3FY11 Q4FY11E Opex as a % of avg assets (%)
Source: Company, Ambit Capital research

8.4% 7.0%

8.0% 6.8% 6.2%

Credit quality to remain stable with a sharp decline in gold prices being the main concern: Credit quality trends have been stable for the company in the past with NPAs in the gold loan business being less than ~1% over the last two years. Manappurams superior credit quality is driven by the following factors:

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Manappuram General Finance & Leasing

The average loan to value (LTV) of the Manappuram loan portfolio is ~70%. Hence the chances of willful default are relatively low as the borrower is incentivised to pay up and reclaim his jewelry. Mannapuram calculates LTV without including the value of the precious stones embedded in the jewelry. Including the value of stones and taking account of making charges makes it even less likely that borrowers will willfully default on a loan. Gold prices have been continuously rising over the last decade. Hence even in the cases of default, Manappuram has been able to recover its loans and interest by selling the pledged jewelry. Manappuram offers loan against jewelry which households have used for some time and to which the borrower usually has an emotional attachment. This further reduces the chances of willful default.

Therefore, we expect credit quality trends for Manappuram to remain stable unless there is a sharp correction in the gold prices. The key question then becomes What if gold prices correct sharply?. Our sensitivity analysis based on the LTV breakup of Manappuram portfolio shows that if we assume a worst case scenario of a 40% fall in the gold prices within three months (this sort of correction has not happened in the last 30 years), the total write-offs after recoveries could be ~4.0% of the portfolio which could be absorbed by a years earning as companys ROA is ~5% (see table below explaining the maths).
Exhibit 20: LTV breakup of the portfolio
% of loans 4% 10% 1%

Exhibit 21: Sensitivity of Mannapurams NPAs to a gold price fall

3 month fall in gold prices 40% fall Portfolio write offs* in the case of willful defaults 4.0% 1.0% NA NA

2%

6%

26% 17%

30% fall 20% fall 10% fall

34%
<50% 81%-85% 51%-60% 86%-90% 61%-70% 91%-95% 71%-80% >95%

Source: Company, Ambit Capital research

Source: Company, Ambit Capital. To factor in making charges and the emotional quotient, we have reduced ~15% from disclosed LTV to arrive at effective LTV and have assumed that ~35% of the borrowers who are due after 3 months will default below their effective LTV. The write-off numbers are calculated after factoring in sell of pledged gold at scrap value.

Comfortable capital adequacy: Manappuram is a registered NBFC with the RBI and hence needs to meet the RBI guidelines of 15% capital adequacy ratio (CAR) by Mar12. Manappuram did a QIP in Nov10 (~$250m) which boosted its CAR to ~32.4%. However, the recent RBI notification that gold loans should not be classified as priority sector loans means that ~20% of Manappurams loan book (which the company had assigned to banks in bilateral transactions) would now stay on its books. This would reduce Manappurams CAR to ~25.5%. Even then, based on our loan growth projections (FY11-13 CAGR of 38%), this lenders CAR would be above the mandatory 15% until FY13.

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Manappuram General Finance & Leasing Exhibit 22: Capital adequacy to remain above regulatory levels
44% 40% 36% 32% 28% 24% 20% 16% FY08 FY09 FY10 FY11E FY12E FY13E 31.7% 29.3% 22.6% 19.3% 17.7% 40.8%

Capital Adequacy Ratio

Source: Company, Ambit Capital research

However, if the loan book growth is higher than our expectations (and is nearer to the management guidance of ~80% between FY11-13), Mannapuranm would have to raise more equity by late FY12 or early FY13. Clearly, this dilution would not necessarily be bad for the shareholders because if management is able to meet its guidance, the P/B multiple would be much higher than what we are assigning to the company in the valuation section of this note.

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Manappuram General Finance & Leasing

Key assumptions & estimates

Exhibit 23: Key assumptions and estimates for Mannapuram (all figures in Rsmn unless otherwise mentioned)
FY09 Assumptions Number of branches Customers per branch 645 520 1,005 546 2,000 573 2,500 613 3,000 656 Branch expansion numbers based on historical trends and management guidance Customers per branch will increase with increased branch productivity as the newly opened branches mature Increase in the amount of gold pledged per customer based on historical trends and increased per capita gold holdings We do not have a view on gold prices and hence have assumed constant gold prices in the near future Assuming constant LTV on the gold pledged Decrease in yield due to increased competition in the segment Increase in cost of funds due to rising systematic rates and gold loans being removed from priority sector FY10 FY11E FY12E FY13E Comments

Gold pledged per customers (gms) Gold prices per gram (Rs) LTV ratio Yield on advances Cost of funds No. of employees per branch Expense per employee (Rs000) Rent per branch (Rs000) Advertising expenses (Rsmn) Other expenses (Rsmn) Key Outputs (YoY growth) Loan Book Net Revenues Operating Income Profit After tax EPS
Source: Ambit Capital research

39.8 1,452 48% 27.5% 11.78% 6.3 81.3 101 82 181

40.9 1,660 69% 29.0% 10.66% 6.9 97.6 162 482 243

46.2 2,017 70% 25.0% 8.94% 8.2 132.6 217 1,081 623

48.5 2017 70% 23.0% 10.5% 8.2 152.5 239 1,024 899

51.0 2017 70% 23.0% 10.5% 8.2 175.4 263 1,024 1,232

In line with general salary rise in India In line with inflation

9,381 1,274 674 302 2.2

25,589 3,413 2,018 1,197 4.1

74,740 104,962 141,510 8,410 4,836 2,865 7.7 12,561 7,296 4,608 11.1 16,884 9,963 6,300 15.1

FY11-13 CAGR of 38% vs FY09-11 CAGR of 182%. FY11-13 CAGR of 42% vs FY09-11 CAGR of 157%. FY11-13 CAGR of 44% vs FY09-11 CAGR of 168%. FY11-13 CAGR of 48% vs FY09-11 CAGR of 208%. FY11-13 CAGR of 40% vs FY09-11 CAGR of 87%.

Ambit versus consensus

Exhibit 24: Ambit v/s consensus
(Rs mn) Net Revenues FY11E FY12E Net profits (Rs) FY11E FY12E
Source: Bloomberg, Ambit Capital research

Consensus 7,940 13,152 2,668 4,547

Ambit 8,410 12,561 2,865 4,608

% change 6% -4% 7% 1%

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Manappuram General Finance & Leasing

Our FY11 numbers are ~6% above consensus estimates as we are expecting the impact of new RBI guidelines to crystallize in FY12 and not in Q4FY11.

Absolute valuation
We have valued Manappuram using an excess return to equity model which is based on Net Profits (cost of equity x beginning of the year book value) for all the future years discounted back to the present using a cost of equity of 15%. We have explicitly forecast net profits for FY11, FY12 and FY13 based on the assumptions in the table above. Between FY13-FY20, in order to mimic the impact of rising competition, we have faded the loan book growth from 35% to 10% and ROA from 4.6% to 4.0%. From FY20 we have assumed terminal growth of 5%

Based on these assumptions our excess return model values Manappuram at Rs143 per share (implied FY12 P/B of 2.5x and FY12 P/E of 13.1x), implying 36% upside from current levels.

Relative valuation
Exhibit 25: Relative Valuation NBFCs Power Finance Corporation Dewan Housing Finance LIC Housing Finance IDFC Shriram Transport Finance M&M Finance SREI Infrastructure Finance Ltd REC SKS Finance Average of above Manappuram Gen. Fin. & Leasing Premium or Discount to above
Source: Bloomberg, Ambit Capital research

Price 264 264 178 139 698 696 46 247 643

Mcap 6.7 0.6 1.9 4.5 3.5 1.7 0.2 5.4 1.0

RoA (%) 2.9 1.9 2.0 3.3 4.3 4.2 2.2 3.3 3.5 3.0 2.8 1.9 1.8 3.3 4.3 4.2 2.4 3.2 3.4 3.0

RoE (%) 18.7 19.6 23.5 14.5 28.3 23.5 15.2 21.0 14.3 19.7 18.6 19.5 22.8 13.8 28.2 24.1 19.0 21.4 12.7 19.9

P/BV (x) 2011E 2.0 1.9 2.1 1.9 3.3 3.1 0.6 1.9 2.4 2.1 2012E 1.6 1.6 1.7 1.7 2.6 2.5 0.5 1.6 2.1 1.8

P/E (x) 2011E 11.3 11.4 9.9 14.9 12.8 14.6 6.4 9.7 19.9 12.2 2012E 9.8 8.7 8.5 11.7 10.4 11.3 4.6 8.2 14.2 9.7

(Rs) (USD bn) 2011E

2012E 2011E 2012E

91

1.0

5.4 77%

5.1 70%

22.8 16%

23.9 20%

2.3 8%

1.9 9%

16.4 34%

9.5 -2%

Mannapuram currently trades at 1.9x FY12 book value and 9.5x FY12 earnings which is at 8% and 33% discount respectively to its closet peer SKS which we believe is unjustified given that gold financing is a much better business model than unsecured microfinance model.

Key risks to our stance

All three key risks to our positive stance on Manappuram are external in nature: A sharp decline in gold prices: a decline of more than 40% in gold prices within a quarter with gold prices then staying at those depressed levels for more than a year could seriously impact credit quality for Manappuram as the likelihood of willful defaults would increase in such a scenario. We take comfort from the fact that such a sharp correction in gold prices has not been witnessed for 30 years. Our sensitivity analysis shows that such scenario could erode Manappurams entire year profitability.

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Gold losing its status as a precious commodity: Gold does not have as much utilitarian real value like other commodities (e.g crude, steel, etc.) and its value is primarily driven by the perceived notion that it is a valuable commodity. Hence any changes at the global level which could erode confidence in the commodity would be damaging for gold prices and hence for Mannapuram. Regulatory and political intervention: Whilst we do not foresee the RBI capping interest rates for gold loans following its decision to remove gold loans from priority sector, we cannot rule out such an irrational decision being taken under political pressure. Moreover, whilst the Supreme Court of India has still to give its verdict on validity of Kerala Moneylenders Act on NBFCs like Manappuram, If the verdict goes in favour of Kerala government state, it could affect Mannapurams operational flexibility and lending yield in the state of Kerala (~19% of Manappurams loan book comes from this state).

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Exhibit 26: Balance sheet

Year to March (Rs mn) Sources of Funds Shareholders' Funds Loan Funds Secured loans Unsecured loans Total Sources of Funds Application of Funds Fixed Assets Investments Cash and Bank balances Net Loan book Net Current Assets Total Applications of Funds Total assets including assignments
Source: Company, Ambit Capital research

FYO9 1,679 4,506 3,712 793 6,185 280 11 1,134 4,412 348 6,185 11,566

FY10 6,106 18,357 16,501 1,856 24,462 569 1,407 2,682 18,794 1,010 24,462 31,539

FY11E 19,488 64,158

FY12E 23,450 93,437

FY13E 28,869 128,234

83,646 1,301 403 3,948 74,835 3,159 83,646 83,646

116,888 1,541 403 5,545 104,962 4,437 116,888 116,888

157,103 1,733 403 7,475 141,510 5,982 157,103 157,103

Exhibit 27: Income statement

Year to March (Rs mn) Net Income Net Interest Income Interest Income Interest Expense Non-Interest Income Fee based services Other income Expenditure Employee Cost Other operating expenses Advertisements Rent Others Operating Profit Bad debts and provisiosn Depreciation Profit Before Tax Taxes Tax rate Net Profit Basic EPS Diluted EPS
Source: Company, Ambit Capital research

FYO9 1,274 1,198 2,114 916 76 20 56 601 284 317 82 54 181 674 178 34 462 160 35% 302 2.2 2.2

FY10 3,413 3,306 5,351 2,045 107 25 82 1,395 536 859 482 133 243 2,018 142 57 1,818 621 34% 1,197 4.1 4.1

FY11E 8,410 8,249 11,765 3,516 161 21 140 3,574 1,544 2,030 1,081 326 623 4,836 379 158 4,300 1,434 33% 2,865 7.7 7.6

FY12E 12,561 12,392 20,666 8,274 169 22 147 5,265 2,805 2,460 1,024 538 899 7,296 122 260 6,914 2,307 33% 4,608 11.1 11.0

FY13E 16,884 16,707 28,344 11,638 177 23 154 6,921 3,942 2,979 1,024 723 1232 9,963 200 308 9,454 3,154 33% 6,300 15.1 15.0

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Exhibit 28: Ratio analysis

Year to March (%) Loan Growth (YoY) Yield on advances- Calculated Cost of funds- Calculated Spreads NIM-Calculated Cost to income ratio Opex as a % avg assets Gross NPAs (gold loans) Net NPAs (gold loans) CAR
Source: Company, Ambit Capital research

FYO9 92% 27.5% 11.78% 15.7% 16.81% 47.1% 8.4% 1.66% 0.18% 40.8%

FY10 173% 29.0% 10.66% 18.3% 17.91% 40.9% 8.0% 0.94% 0.13% 31.7%

FY11E 192% 25.0% 8.94% 16.1% 16.44% 42.5% 7.1% 0.55% 0.18% 29.3%

FY12E 40% 23.0% 10.5% 12.5% 13.79% 41.9% 5.9% 0.31% 0.14% 22.6%

FY13E 35% 23.0% 10.5% 12.5% 13.56% 41.0% 5.6% 0.31% 0.14% 19.3%

Exhibit 29: Valuations

Year to March (%) P/E P/BV ROA ROE Dividend Yield
Source: Company, Ambit Capital research

FYO9 61.1 17.0 3.9% 34.7% 0.2%

FY10 48.2 10.9 3.3% 23.2% 0.3%

FY11E 26.0 5.9 5.6% 30.8% 0.5%

FY12E 13.9 2.3 5.0% 22.4% 1.0%

FY13E 9.6 1.9 4.6% 21.5% 1.5%

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Institutional Equities Team

Saurabh Mukherjea, CFA Research Analysts Amit K. Ahire Ankur Rudra, CFA Ashish Shroff Ashvin Shetty Bhargav Buddhadev Chandrani De, CFA Chhavi Agarwal Gaurav Mehta Krishnan ASV Nitin Bhasin Pankaj Agarwal, CFA Parikshit Kandpal Poonam Saney Puneet Bambha Rajesh Kumar Ravi Ritika Mankar Ritu Modi Subhashini Gurumurthy Vijay Chugh Sales Name Deepak Sawhney Dharmen Shah Dipti Mehta Pramod Gubbi, CFA Sarojini Ramachandran Designation VP - Ins Equity VP - Ins Equity Senior Manager Equities VP - Ins Equity Director, Sales Desk-Phone (022) 30433295 (022) 30433289 (022) 30433053 (022) 30433228 +44 (0) 20 7614 8374 E-mail [email protected] [email protected] [email protected] [email protected] [email protected] Industry Sectors Telecom / Media & Entertainment IT/Education Services Technical Analysis Consumer Power/Capital Goods Metals & Mining Infrastructure Derivatives Research Banking Infrastructure NBFCs Construction / Real estate BFSI Power/Capital Goods Cement Economy Metals & Mining IT/Education Services Consumer (incl FMCG, Retail, Automobiles) Desk-Phone (022) 30433202 (022) 30433211 (022) 30433209/3221 (022) 30433285 (022) 30433252 (022) 30433210 (022) 30433203 (022) 30433255 (022) 30433205 (022) 30433241 (022) 30433206 (022) 30433201 (022) 30433216 (022) 30433259 (022) 30433274 (022) 30433175 (022) 30433292 (022) 30433264 (022) 30433054 E-mail [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected] Managing Director - Institutional Equities (022) 30433174 [email protected]

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Explanation of Investment Rating

Investment Rating Expected return (over 12-month period from date of initial rating) >15% 5% to 15% <5%

Buy Hold Sell

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