Power Finance Corporation’s (PFC’s) Q1FY08 numbers were ahead of our expectations. Profit after tax (PAT) grew 100% plus to Rs 3.09 billion, primarily driven by foreign exchange gains of Rs 409 million booked in Q1FY08 as against forex loss of Rs 305 million in Q1 FY07. This gain was on account of Rupee appreciation impact on the company’s foreign currency borrowings of Rs 19 billion. Excluding the foreign exchange gains, PAT grew 60% Y-o-Y to Rs 2.78 billion, supported by improvement in margins and higher fee income.

Key quarterly highlights

* Loan book grew 23% and disbursements improved 12.7%.
* Spreads improved 22bps Y-o-Y to 1.93%.
* Net-interest income grew 38%.
* Management and upfront fee of Rs 137 million booked.
* Net NPA declined to near zero levels and provision coverage increased to 70%.

We are revising our EPS estimate upwards by 4% for FY08E to Rs 11.9 and by 2.5% for FY09E to Rs 13.9 (adjusted for tax benefits) to factor in relatively higher margins and better fee income. The stock currently trades at 2.1x FY09 book (adjusted for tax benefits and reserve for doubtful debts) and 14.1x FY09E earnings. We expect RoE to improve to 15% by FY09E from 12% in FY07. The stock price has moved up by 35% in the past one month and valuations appear fair at these levels. We recommend investors to book profit and re-enter the stock at lower levels. However, we continue with our ‘ACCUMULATE’ recommendation from a long term perspective, considering strong industry outlook on the infrastructure space, unique power financing play, and the stock’s inadequate liquidity with only 10% free float.

Disbursement growth to pick up in future

Net interest income rose 38% to Rs 4.15 billion on the back of 23% Y-o-Y growth in loan book and 36bps Y-o-Y expansion in interest margins to 3.67%. The company has disbursed loans of Rs 32 billion, a 12.7% Y-o-Y growth, led by demand for generation (68.6% of the total disbursements) and transmission projects (14% of the total disbursements). We believe disbursement growth will pick up in the coming quarters, posting 30% plus growth for FY08E. This will lead to 25% growth in loan book in FY08E and 22% growth in FY09E.

Margins improved due to re-pricing benefits

Yield on assets improved 87bps Y-o-Y to 9.88% due to hike in lending rates and re-pricing benefits on 3–year reset clause loans. By the end of this quarter, 61% of its loan book is on 3- year reset basis and 34% on fixed basis. We expect yield on advances to improve further as Rs 70-80 billion of loans with 3-year reset clause will be due for re-pricing upwards by 200- 250bps during FY08E.

Higher fee income to kick in

PFC has booked management and upfront fee of Rs 137 million during Q1FY08. We expect the company’s proposed UMPP advisory services and loan syndication contracts, to boost its fee income. Fee income is likely to increase further with the expected launch of Rs 10 billion India Power Fund, as PFC will manage the equity portion of this fund.

Opex/assets remain at low levels

Operating and administrative cost remained low at 3% of the income and 0.1% of the average assets. However, salary scale is due for revision in FY08E (revised every 10 years - last revision was in FY97-98) and we expect employee cost (that forms 40% of the total expenses) to pick up in the coming quarters.

Asset quality remains strong

Asset quality remained under check with net NPAs declining close to zero levels and gross NPA also coming down to 0.06%. Provision coverage has increased from 70% in Q1FY08 from 39% in FY07, as the company raised its provisioning on doubtful assets from 50% to 100%.

Investment Theme

The outlook for PFC remains strong, given USD 155 billion investments lined up in the power sector over FY07-12E, the company’s leadership position in power financing, superior domain knowledge, and lean cost structure. Growth triggers for the stock could be factors such as: 1) ruling for tax benefits on long term infrastructure financing income, which is likely to be in PFC’s favor, 2) the company’s heightened focus on augmenting fee-based income, and 3) option value attached to its private equity investments in terms of performance fees. We expect PFC’s RoEs to increase to 15% by FY09E, driven by increase in leverage to 7x by FY09E and eligible tax exemption (for engagement in infrastructure financing), supported by the company’s lean cost structure and lower provisioning (better asset quality).