REC, PFC: Valuation cheap but risks aplenty

Another alarm bell for the power sector! Specialised power sector lenders Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) could be in real trouble. Given their huge exposure to risky state distribution utilities, even a five percent haircut to their exposure would erode 17 percent of net worth for PFC and 27 percent for REC.

According to Ambit Capital, 62 percent of PFC’s loan book and 84 percent of REC’s are exposed to the nine most stressed distribution companies and independent power producers. Some utilities have begun to raise their tariffs but that is negligible compared to Rs 1,70,000 crore losses already in their kitty. Each one needs a tariff hike of 25-125 percent to break even, according to Ambit estimates. Since that is a bullet the political parties may not be ready to bite so soon, and restructuring some existing loans will become inevitable.

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When loans are restructured, the term of repayment goes beyond estimates, which could lead to serious concerns over cash flows of the banks. This means that banks may get more cautious about lending to the power sector in the future. Even if this may improve the asset quality of lenders, credit growth would fall substantially from 23-27 percent to 12-15 percent.

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The Usha Thorat Committee has recommended that the non-performing assets (NPAs) and asset quality regulations of power finance companies must be brought at par with NBFCs (non-banking finance companies). If PFC and REC start adhering to these recommendations then they will have to make extra provisioning of 6 percent and 4.5 percent of their networths, respectively.

Depreciating rupee has already had an impact on the companies. At the current exchange rate both the companies will have to provide for their unhedged foreign exchange liabilities which is 5 percent and 2 percent for PFC and REC. This would lead to a net worth writedown of 2.3 percent and 0.8 percent, respectively.

Both the power finance companies are trading at a discount to book value as compared to a premium valuation of banks. However, the diversified nature of portfolio of banks and a healthier asset quality is a reason for the difference in valuation.Even if the valuation of PFC and REC looks cheap, a five percent haircut could erode 20 percent of their networth, which would bring down the differential between the banks and power finance companies.