Monday, September 16, 2013

NBFCs - the case of the Unknown Unknowables

For a long time, NBFCs in India have been talked about, from both the positive and negative points of view. Positive, because India is such a huge country where a large chunk of population is not served by the banking system. NBFCs therefore have a huge opportunity to serve this un-addressed market. Negative, because of the huge frauds happening, opaque lending practices, allegations of NPA 'management' etc etc. 
In this post, I am talking about 2 NBFCs; First Leasing Company of India Ltd and Tourism Finance Corporation of India Ltd. My objective is not to pass judgement about these companies, but to showcase why investing in NBFCs is full of unknown risks.

Some fantastically managed NBFCs like Sundaram Finance, Bajaj Finance have been huge wealth creators for investors. The case of First Leasing is, well, a bit different.
  • First Leasing Company of India Ltd was, well, the first leasing company of India! Started way back in 1973 by Mr.Farouk Irani, the company was the pioneer in corporate leasing industry. 
  • Over the period of 4 decades of its existence, the company reported good numbers, gave good dividends, had negligible NPAs and was considered as the benchmark in the field.
  • Last week, the CMP of the stock was Rs.32, with a book value of Rs.150 plus and a dividend declared of Rs.1.80, making it a dirt-cheap, attractive opportunity. 
  • There were also talks of a sell-out happening, making it even more attractive.
  • I had looked into this company earlier and the only thing I found amiss was that long term lending was being done with short term funds. This typically happens when an NBFC falls short of capital and needs funding. However, to be honest, I did not find any 'fraud' in the books, on the face of it.
On this background, it was quite shocking to read RBI's press release.

In the light of the findings of the inspection of the books of accounts and other records as on March 31, 2013 of First Leasing Company of India Ltd., 749, Anna Salai, Chennai 600002, the Reserve Bank of India has, in public interest and in exercise of the powers conferred on it by Sections 45JA and 45L of the Reserve Bank of India Act, 1934, directed that until further orders, First Leasing Company of India Ltd. shall not,
  1.  sell, transfer, create charge or mortgage or deal in any manner with its property and assets without prior written permission of the Reserve Bank of India;
  2.  declare or distribute any dividend;
  3.  transact any business; or
  4. incur any further liabilities.
Essentially, RBI has frozen the company's business altogether. This happens only when there is a system level fraudulent issue or there is severe non-adherence to laws and guidelines. Something of this sort happening to a company with a 40 year history, consistently negligible NPAs, great looking financials, great dividends is very shocking indeed. There are such a lot of things about the lending business we dont know and cant know. IMHO, this event will surely have an impact on overall NBFC valuations and the way the market perceives the sector and its companies.

Let me give you another example, that of Tourism Finance Corporation of India Ltd. This is again a listed company with a market cap of Rs.160 cr. Book value is Rs.50, CMP is Rs.20. They have also applied for a banking license recently! :-)

Have a look at this bid document. This is about a company they had lent to which went under and now they are auctioning off that company's assets to recover their dues. On page 11 of the document, details of their exposure are given, which i am reproducing here..

On a loan given of Rs.3.35 cr, there was interest accrued of Rs.109 cr!!! How much of this has been accounted for as income in their books is not known, but the sheer size of one of their loans with respect to the company's overall size is mind boggling. If a large write-off like this one happens, the book-value itself would be massively hit and the stock would no longer look cheap.

Learnings from all of the above:
  • The NBFC business is structurally a risky business, where a fine balance has to be maintained between growth and quality of assets. Few companies which sacrifice quality to show growth and adopt aggressive accounting do great for some time, until the bad quality loans catch up with them and then comes a huge huge write-off.
  • It is extremely critical to understand what the business is. Merely going by its financials and book-value (which a lot of investors do) will not help. Book value is an accounting concept and can be bloated very easily. If one does not understand how the business is operated, better to not get into it at all. 
  • It is also extremely critical to understand the laws governing the NBFCs. The capital and provisioning requirements of the RBI can change the overall picture of a company very fast and one needs to have a good grasp on the same.
  • All in all, one needs to acknowledge that there are a lot of 'unknown, unknowable' aspects in the NBFC business. One should therefore not rely 100% on the numbers for taking investment decisions. It is much better to go with a proven management, which is fully transparent on all the aspects of the business and is in a business which one can understand and identify with properly. Good knowledge of accounting and ability to dissect the financial statements is also essential. If investing is risky, investing in NBFCs is, ummm, more risky!
Please do greater due diligence while investing in NBFCs. There are many aspects of the business which we cannot understand by studying the financials alone.

Cheers and happy investing!!!

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