12/24/24, 11:02 AM Case Study on IRFC – Fundoo Professor

Fundoo Professor

I practice what I teach and I teach what I practice.

Case Study on IRFC

Posted on December 8, 2023December 9, 2023 by fundooprofessor

Twice a year, I go to Flame Investment Lab at Flame University to teach a program called “Case
Studies in Business and Investment Analysis.” These case studies are based on real businesses and
sometimes the coverage is also in real time. In June 2022, I presented several cases, including one on
IRFC. In this post, I am reproducing (with only minor grammatical changes) what I said in the class
on IRFC.

As of this writing, I do not have any investment in this stock, nor do any clients of my firm. This is
not a current recommendation to own this stock, nor was it during the case presentation. The
business model of this company is unique. I presented it to the participants so they could learn about
it.

As a learning exercise, compare what I said on this business in June 2022 with what happened
subsequently.

IRFC

IRFC is a “systemically important” and regulated non-banking financial company (NBFC). The
government of India owns 86% of its equity. The balance 14% is owned by public shareholders. The
company went public in January 2021 through a combination of a primary issue of new shares and an
offer for sale by the government of India.

IRFC is the dedicated market borrowing arm for the Indian Railways (IR). The primary business of
IRFC is the financing of the acquisition of rolling stock (locomotives, carriages, or wagons etc.) for
Indian Railways as well as providing funding for its other infrastructure assets. The company does
this by borrowing money from debt markets for investing in rolling stocks and infrastructure projects
sanctioned by the Indian Railways and then leasing these assets to IR at an effective yield at just a
little above its cost of borrowing.

In effect, IRFC is like an investment banker having just one customer: The Indian Railways and
companies owned by it. IRFC borrows money on its own balance sheet and lends (leasing is a form of
lending) it to its only customer and majority shareholder at a markup over its cost.

Robust Business Model

IRFC’s business model is strong and is capable of withstanding all sorts of adverse developments.
Here are its key features:

First, IRFC has no non-performing assets (NPAs) and has had none in the thirty-three years of its
existence. Indeed, IRFC is designed to never have any NPAs because it is effectively lending money to
the safest credit in India: the government of India.
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Second, because it lends money to just one client, which is the government of India and companies
controlled by the government of India, IRFC does not have to worry about customer concentration
risk. It has just one customer, yet its lending business has no risk of customer concentration because
that customer is sovereign.

Third, the business is immune from any time and cost overruns for the projects it finances. All cost
escalations are contractually passed on to IR. If there is an increase in the cost of borrowing in foreign
currency, then this increase, too is passed on to IR. The model is designed as a principal-agent
relationship. In accordance with the well-established rules of such a relationship, IR has a duty to
reimburse the agent (IRFC) for all costs and expenses incurred by it on behalf of the principal. IR also
has the duty to indemnify (hold harmless) its agent (IRFC) for any losses during the time of the
relationship.

Fourth, there is no asset-liability mismatch in this business, which is a frequent cause of the blowing
up of leveraged businesses (recall IL&FS, Lehman Brothers, Bear Stearns and LTCM). IRFC borrows
money on a long-term basis to fund IR’s long-term capital investment, projects. But despite being
careful in matching the duration of assets with that of its liabilities, IRFC’s leasing contracts with IR
have an additional buffer in the form of a clause, which was recently explained by the company’s
CEO in a conference concept, call with investors. And he said:

That is a standard clause that we are building in all our standard lease agreement just in case IRFC fall short at
the time of redemption of its bonds or its liabilities by way of term loans from banks and we are falling short of
the liquidity then Indian Railways will chip in with the necessary amount well in advance so that at no point of
time IRFC faces the risk of defaulting and experience. Although, in all its years of its existence we have never
had the occasion to invoke this clause, but this standard clause will always be there for giving that added
comfort to the investors and the other stakeholders.

The presence of this additional buffer reminds me of the engineering concept of redundancy.

In many safety-critical systems, such as fly-by-wire aircraft, some parts of the control system may be
triplicated. An error in one component may then be overriden by the other two. In a triply redundant system,
the system has three sub components. All three must fail before the system fails. Since each one rarely fails, and
the sub components are expected to fail independently, the probability of all three failing is calculated to be
extremely small.

IRFC’s business model has several redundancies built into it. And that is the key reason credit rating
companies give the highest rating — AAA to its debt.

Here’s what CRISIL — India’s most respected credit rating company — has to say on the safety of
IRFC’s debt while consistently giving it a AAA rating:

IRFC was set up as a dedicated funding arm of MoR, specifically to raise resources from the capital market to
finance rolling stock (wagons and coaches). IRFC leases rolling stock to IR and collects lease rentals from IR in
advance, at half-yearly intervals. An annual lease agreement, structured to ensure that IRFC’s expenses are
covered, backs this arrangement and allows IRFC to earn adequate margin.

IRFC functions under the Ministry of Railways (MoR) and constitutes a crucial part of India’s infrastructure.
Hence, IRFC derives substantial business and financial support from GoI. The support is reflected in IRFC’s
majority ownership (86.36%) by GoI. Moreover, IRFC has a close working relationship with IR and has MoR’s
officials as directors on its board. Favourable lease agreements between IRFC and IR protect the former’s net
interest margin, as interest and foreign exchange risks on its borrowings are transferred to IR.

It’s clear that as far as credit rating companies are concerned, lending to IRFC is as safe as lending to
the government of India.
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Fifth, a few years ago, the government changed the income tax law, which helped many businesses,
including IRFC. A subsequent privilege was granted by the government just before the company’s
IPO. These two changes exempted IRFC from the need to provide for or pay, any tax on its profits to
the government. This resulted in an increase in the company’s profit margins, book net worth and
debt capacity. It also improved its ROE. A government press release just before the company’s IPO
had this to say:

[This change will lead to a] substantial improvement in Profit After Tax, Earnings per Share and Book Value
per share. This is going to improve the valuation of the Company for its maiden IPO.

Separately, the company was also exempted from goods-and-service (GST) tax.

All these significant changes tell us about the strategic importance of IRFC and the government’s
desire to get a good valuation for its shares in the stock market.

Finally, IRFC is hugely over-capitalized. That is, the amount of equity it carries to support its business is
far more than what regulations require. To appreciate this, take a look at the capital adequacy ratios
as of March 31, 2021 for some of India’s most respected lending businesses:

(https://fundooprofessor.com/wp-
content/uploads/2023/12/screenshot-2023-12-08-at-13.32.24.png)

In contrast, IRFC’s capital adequacy ratio as of March 31, 2021 was a mind-blowing 416%! This is not
a typo.

This astonishingly high capital-adequacy ratio exists because IRFC lends to the sovereign, and the
risk-weightage of its loans (via lease agreements) given to IR is zero. After all, lending to businesses
that could default is riskier than lending to the government. The amount of risk capital required to
absorb losses should be substantial for business lending. But for a lender which only lends to the
government, theoretically the amount of risk capital required to absorb credit losses is zero. And this
point will become important when I talk about valuation later.

Profitability

Because of all these wonderful privileges granted to IRFC, the government of India controls the
company’s profitability. The government does this by fixing a spread over IRFC borrowing and other
costs while determining the income yield built into IR’s lease agreements with the company. For
financing rolling stock, this spread is just 40 basis points over cost, and for financing project assets,
this spread is even lower at just 35 basis points. These spreads have remained stable for many years
before the IPO, and in a recent conference call, the CEO said that for FY22, they will be the same.
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Despite these seemingly low spreads over cost, IRFC is very profitable. See the table below.

(https://fundooprofessor.com/wp-content/uploads/2023/12/screen-shot-2023-01-16-at-12.30.52.jpg)

IRFC’s operations are rapidly growing in a risk-less manner, thanks to the massive expansion and
modernisation plans for Indian Railways over the last few years. Assets under management (AUM)
have grown at 28% a year over the last five years, 32% a year over the last three years, and 34% a year
over the last two years. This is a very large company. Assets under management as of the end of
March 2021 were a staggering USD 49 billion (USD = INR75).

Because the business is riskless (no NPAs) and has stable profit margins, IRFC’s earnings have been
growing rapidly as well. They grew at 39% a year over the last five years, at 30% a year over the last
three years, and at 40% a year over the last two years.

There are a number of lending businesses which have grown a lot over the years, but that kind of
growth comes by taking credit risks, and sometimes those risks are too high. This is not the case with
IRFC. Here we have a lending operation with extremely high growth in assets, and earnings, but with
no credit risk!

When measured on return on equity, IRFC is quite profitable, too. In FY21, it earned a respectable
return on equity (ROE) of 13.3%. For FY22, its ROE should be an outstanding 16.4%.

HDFC Bank has a ROE of 16.5%, Kotak Mahindra Bank 13.8% and ICICI Bank 14.8%.

Growth in Earnings Per Share

Look at the table below, which depicts the change in earnings per share of the company over time.

(https://fundooprofessor.com/wp-content/uploads/2023/12/screen-shot-2023-01-16-at-12.28.54.jpg)

Three things stand out.

One, aggregate earnings have grown rapidly, and the company earned in FY21 a sum that was ten
times what it earned in 2010.

Two, earnings on a per-share basis have not grown rapidly, and the reason is the third point which is
that the number of shares outstanding has grown a lot over the years.

It is here when things become extremely interesting for us when we seek answers to a key question
and contemplate the possibilities of the future in a world where the company’s stock is listed on
exchanges. The key question is this:

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Why did the share count grow from about 1 billion shares on March 31, 2010, to a staggering 13 billion by the
end of March 2021?

There are three reasons: (1) the huge growth in AUM over the years, (2) a desire to keep debt: the
equity ratio at less than 10:1, and (3) issuing shares for cash at par value except during the IPO.

Given these reasons, as the company grew over the years and expanded its loan book hugely, it kept
issuing more and more shares to the government to maintain a target debt-equity ratio of around
10:1. Incredibly, all of those issuances were done at a low par value of INR10 per share. As a result of
this low pricing (well below book value) and huge amount of equity capital raise, a very large number
of new shares were created over the years dragging down per-share earnings.

Indeed, EPS in FY21 was lower than in FY10, even though the aggregate earnings multiplied by a
factor of ten! While the earnings multiplied by ten times, the share count multiplied by twelve times.
Naturally, EPS declined.

Now, a key part of this case emerges.

Recall from earlier discussion that the company is hugely over-capitalised as its capital adequacy
ratio is staggeringly high at 416%. This is because the zero risk weightage to loans given to the
sovereign and IRFC does just that.

Why, then the need to maintain a target debt-equity ratio at 10:1? It turns out that no law or
regulation requires the company to maintain this ratio and keep issuing new shares to raise equity
capital even though the existing capital adequacy ratio is so high. That it did so in the past is a
historical reality. But now, the company is no longer privately held. Now, it’s a publicly listed
company.

What’s important for us to contemplate is this: As a publicly listed company, will IRFC breach this
internal target of debt: an equity ratio of 10:1? And if so, what will the consequences and likelihood
be?

Will the debt markets and credit rating companies baulk if IRFC kept expanding but did it without
asking for its shareholders to give it more money just to maintain the target capital structure of the
past? In my view, no. IRFC is an arm of the government. Lending money to the company is as good
and safe as lending it to the government. Given the extremely safe existing capital adequacy ratio of
416%, in my view, there is ample room for the business to grow without increasing the share count
and there is room for the degree of leverage on IRFC’s balance sheet to grow without any impairment
of its credit rating.

Will the company’s behaviour post-IPO be different from its stance before the IPO? It seems that to be
the case. In multiple statements, the company has stated that no law prevents it from breaching the
internal leverage benchmark and may breach this self-imposed limit in the near future because it
makes economic sense to breach it.

Here is what the CEO said recently:

I would rather go for easing the limit than go to approach the market for fresh capital infusion because as of now
I am already quite adequately capitalised. So, I would rather go for [additional borrowing and no issue of new
shares] especially with a capital adequacy ratio 415% I do not see any reason why I should not go below 10%
[for equity:debt ratio]. It does not make sense to stick to 10% and then having a huge capital adequacy ratio
because almost all my loans are secured.

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There are no regulatory guidelines on this [10:1 debt:equity ratio maintenance]. It is an internal decision of the
management, and we are absolutely open to going below 10% also if the requirement arises.

In my view, given that (1) the company is no longer privately owed but is a listed company, (2) its
extraordinarily high capital-adequacy ratio; and; (3) the statements made by the management, the
probabilities favour breaching of the self-imposed but unnecessary leverage limits.

What will be the consequences if the limit is breached? There will be significant value creation for
shareholders. That’s because of two key reasons. One, despite additional interest expense on
incremental borrowings done to prevent the issue of new shares for cash, the aggregate earnings will
keep growing at a rapid clip thanks to stable profit spreads allowed by the government and the
anticipated growth in AUM based on plans announced by the government for expanding and
modernising Indian Railways. And two, the share count will stop growing because the company will
not issue new shares just to maintain a target debt:equity ratio.

If this hypothesis is correct, then the EPS growth of this company, which was stagnant in the past,
will become a thing of the past. It will soar. And if that happens, so will the stock price.

But even if this hypothesis is wrong, there is very little downside here. The reason for that is the
extremely low valuation of the stock.

Valuation and a Thought Experiment

At its current stock price of INR 21 per share, the company’s market cap comes to about INR 274
billion. FY22 earnings (based on annualising Q4 FY21 earnings) are likely to be INR 59 billion. The
P/E comes to just 4.6 times FY22 earnings – without counting any growth over FY21!

The per-share book value as of 31 March 2021 was INR 27.5, and the estimated per-share book value
at the end of June 2022 was INR 28.6. The Price/Book value comes to just 0.7 times.

IRFC lending business is safe because it only lends to the government. It’s a business whose
aggregate earnings have grown at 39% a year over the last five years, at 30% a year over the last three
years, and at 40% a year over the last two years.

And the entire equity of this company is valued at 4.6 times earnings and 0.7 times book value.

Here is a thought experiment to demonstrate just how cheap the stock is. We do this by simulating a
leveraged recapitalisation plan, which involves borrowing money to fund a dividend paid by IRFC.

The current stock price is INR 21 per share. The current market cap is INR 274 billion. Imagine that
the company borrows INR 274 billion and uses the money to pay a special dividend of INR 21 per
share – an amount identical to the stock price!

Can it do this? Is this even legal? Park those thoughts for now. Just imagine that it happened. What
will be the consequences?

If the market is efficient, then on the announcement, nothing should happen, and on the ex-dividend
date, the stock should go to zero! Recall the Modigliani and Miller proposition on dividends
according which the value of a firm is independent of its dividend policy – when dividends are paid,
the value of the firm simply falls by the amount of the dividend.

Will debt investors baulk at lending INR 274 billion to the company to fund this seemingly crazy
dividend payout? Not at all. Why? Lending to IRFC is like lending to the government of India and
because the capital adequacy ratio is so high and also because INR 274 billion of additional

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borrowings would be small — less than 9% of the total debt of INR 3.2 trillion as on 31 March 2021 of
the company.

An additional interest expense on incremental debt taken for the dividend will be recorded in the
P&L. Specifically, interest expense will rise, and FY22 expected earnings estimated to be INR 59
billion before this hypothetical transaction will fall by INR 16 billion to become INR 43 billion. With
13 billion shares outstanding, EPS will come to 43/13 = 3.3, and the ROE will be infinite!

How will the market value such a business which has already delivered 100% of its market value to
its stockholders and they still own all of the business (after considering debt)? Will that stock be
worthless as per Modigliani and Miller? I think you will agree that it won’t be worthless at all.

By the way, this is exactly how Benjamin Graham demonstrated the cheapness of a situation. He
would take up a live example and then, he would do these thought experiments involving a
leveraged recapitalisation to demonstrate how cheap the stock was. See, for example, his case study
on American Laundry Machinery on pages 504-507 of the 1st edition of his book, “Security Analysis,”
published in 1934.

I am trying to do the same here.

Posted in Abstract Ideas in Finance, Case Study, Security & Business Analysis

Published by fundooprofessor

I am Distinguished Adjunct Professor at Flame University, Pune. Previosuly, I was Adjunct Professor
at MDI, Gurgaon, where I taught MBA students two popular courses titled “Behavioral Finance &
Business Valuation"(BFBV) and Forensic Accounting and Corporate Governance (FACG) for many
years. I am also Managing Partner at ValueQuest Capital LLP— an investment advisory boutique
which helps its clients invest their capital in good quality businesses. View all posts by fundooprofessor

11 thoughts on “Case Study on IRFC”

1. AMIT SAXENA December 8, 2023

Thanks for sharing this case study Sir. It has come after a long gap.

Can you continue sharing more often, for the benefit of your online students 🙂

2. rk4g10 December 8, 2023

Wow ! The way this investment thesis built up and explained was nothing short of Art or a Music
or a Movie. Thanks for the taking the time to write, wish you would do it more often.

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3. Vinayak Gavankar December 9, 2023

Sir for us you are the Ben Graham, Charlie Munger & Warren Buffet combined together of India !
Excellent write up ! Please share more such nuggets of wisdom ! Thank You very much !

4. Rajat Gupta December 9, 2023

Sir, thanks for the blog post.

A lending business whose Spread is capped & hence RoE is also capped as the RoA was stuck at
0.75%-0.8% till 2017 & as the tax rate came down it moved up to 1.1%-1.3% & hence RoE
expanded from 8% to 15-16% range, how much expansion in BV can the market assign is the
question.
Since IPO no fresh Equity has been diluted but RoE is stuck at 15%-16% & stock is at 2X BV
already. May be market is already pricing in expanding of leverage way beyond the traditional
10:1. Surely it was available at basement bargain at 0.7X BV in 2021 but not much MoS left now.

5. Gaurav December 9, 2023

Excellent investment analysis Professor. Can you tell us the reason why this stock is not in your
portfolio? If you can’t tell us that, can you at least tell whether this was in the past when you
evaluated? I want to understand the downside. Are you not holding it because unlocking its value
is dependent on the government decisions and such decisions are necessarily not in the interest of
non-controlling shareholders (who just hold 14% anyways)?

6. s w December 10, 2023

Wondering… What would be the reason for Government to bring in private investors into a
business which is 100% risk free plus providing 15% return on face value :). More so excluding
capital gains.
Is there a catch?

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10. AMIT SAXENA December 13, 2023

Prof Bakshi, I am playing Devils Advocate here. Below are the points that discourage investment
in IRFC. Do you agree with the comments below?

1) With such a small spread (0.4%), the company will have to lend incremental 1 Lakh Core, to
generate additional revenue of Rs 400 Cr. Irrespective of huge demand for Capex in Railways,
Realizing incremental profitability looks very difficult for IFRC.

2) Assuming 8% average cost of debt and 10 times leverage with 0.4% spread, one cannot make
more than 12% RoE (8+(0.4*10)) in best case scenario. How RoE of 15.5% is achieved by the
company is difficult to understand.

3) If Interest rate drops in market, RoE will further reduce, as IFRC cannot change the spread
(0.4%)
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