In 2022, markets were buffeted by the war in Europe, rising inflation and supply chain shocks. Despite these uncertainties, finance stocks have seen some recovery over the past month. According to recent reports, financial services saw an FPI inflow of Rs 2,368 crore in the first half of February. This is despite the Reserve Bank of India (RBI) raising repo rates by 25 bps to 6.5%.

One such non-banking finance company (NBFC) that scraped through the troubled times that began with Covid-19 was Bajaj Finance. While the industry struggled, it was an outperforming stock, even when the Reserve Bank of India (RBI) imposed new NPA (non-performing assets) classification norms on NBFCs at the end of 2021.

Results above expectations; AUM growth encouraging

Bajaj Finance’s Q3FY23 results have been encouraging with 40% YoY growth in net profit (Rs 2,973 crore). It beat Trendlyne’s Forecaster estimates by 0.02%. Although the difference was marginal, analysts from Geojit, ICICI Direct and Motilal Oswal paint a positive outlook on the company and the stock. An increase in net interest income (NII) led to net profit growth for the company, compared to Q3FY22.

The NBFC witnessed the highest number of customer additions in Q3FY23. Rajeev Jain, Managing Director of Bajaj Finance adds, ‘Q3 saw highest-ever loans booked and new customer addition. For the first time, we've crossed 3 million customers. It looks like we'll cross 11 million new customers in the current year.’

NII saw healthy growth largely because of assets under management (AUM) rising 27% to Rs 2.3 lakh crore. The highest growth came from securities and commercial lending segments, both improving more than 40% YoY. Two and three-wheeler finance also grew by 11%, thanks to the revival in the auto sector.

In the lending segment, major categories under retail are auto, commercial vehicle and agriculture. These three constitute 28% of the total lending mix in the financial space. However, Bajaj Finance’s presence in this segment is limited. In Q3FY23, its two- and three-wheeler financing went down to 5.1% from 5.9%. Interestingly, its exposure to riskier businesses like SMEs, securities and commercial lending has gone up.

Bajaj Finance’s commercial lending has increased, particularly in the developer finance segment where real estate developers seek funding for their projects. Developer loans are considered risky and even PSU banks tend to stay away from lending to these segments. Also, the management indicated a slight compression in demand in the secondary housing market. Securities lending is also risky as market movements keep the value of collateral volatile. Bajaj Finance’s foray into the high-risk and high-return segment is something to look out for.

However, analysts expect to see a better loan mix with reduced risks as Bajaj Finance is increasing its exposure to auto and tractor finance. In its earnings call, the management has hinted that it would limit its exposure to B2B businesses, thereby reducing the effect of seasonality. The management expects 25-27% CAGR growth in AUM over the medium term.

Management chooses margin over growth eyeing long-term sustainability

Rajeev Jain, in Bajaj Finance’s Q3FY23 earnings call, said, “Between growth and margin, choose margin. The choice is clear because margin creates better sustainability of the business from a long-term standpoint.” In Q3, Bajaj Finance’s net interest margin (NIM) fell 19 bps YoY to 10.7% but increased 13 bps on a QoQ basis. The NBFC has maintained margin expansion despite the cost of funds rising 42 bps YoY to 7.14%. However, this expansion might not sustain as it has no pricing power over lending rates.

Elevated cost of funds for a financial institution indicates that it is borrowing from the market at a higher interest. This is an internal cost and the company needs to be careful to not let it shoot up too high. If the cost of funds is high, NBFCs will charge higher interest rates on the loans to maintain their margins and profitability. Given that there are a lot of players in this field, like banks who offer lower interest rates, elevated cost of funds will hamper NBFCs’ margin and growth. As the interest rate rises, NBFCs' competitive advantage of faster loan disbursals would be offset by cheaper loans from banks.

Bajaj Finance’s strategy to contain its cost of funds was to swerve away from the traditional approach. Instead of long-term borrowings, it increased short-term borrowings to raise funds. In Q3FY23, its liability mix shifted towards short-term borrowings, increased to 10% from 7% in Q2FY23, and deposits reduced to 21% from 22%.

Increase in short-term borrowings to fund long-term assets (advances) can lead to an asset-liability mismatch (ALM). However, Bajaj Finance is well placed in this area as its total inflows (assets) are higher than total outflows (liabilities) in Q3. According to its management, the impact of recent interest rate hikes on the cost of funds will remain moderate with strong ALM management.

Valuations have been hit but long-term growth remains intact

The NBFC’s loan losses & provisions have increased by 14.5% on a QoQ basis. Its investor presentation reveals that stage 3 gross asset receivables increased to Rs 2,610 crore in Q3FY23 from Rs 2,530 crore in Q2FY23. (Stage 3 is classified as loans overdue for more than 90 days). The majority of stage 3 loans lie in SME and mortgage segments. These segments fall under the expected credit loss category, indicating a shift towards riskier business.

However, reported asset quality has been on a steady improvement as gross NPA fell 59 bps YoY to 1.14% and net NPA dipped by 37 bps. This was aided by high AUM growth.

In April 2022, Bajaj Finance’s Price to Book value hit 12.2 after the markets recovered from the impacts of Covid-19. But it has now dropped to the 8.5-8.8 range. Despite showing consistent growth in basic metrics like interest income, profitability and margins, investors aren’t very enthusiastic about the stock.

The primary reason for this is the high-interest rate cycle. Compared to banks, NBFCs work better in a low-interest rate cycle because of their lack of pricing power. When the interest rates start to fall, they would still take 2-3 quarters (lag effect) to see the full impact of the low cost of funds on NIMs expansion.

According to the management, the NBFC has been gradually passing on the impact of higher interest rates to its customers. The management says that the price hikes were mainly across the fixed loan product segment. They expect to deliver a return on equity (RoE) of 23-24% over FY23-25E. Bajaj Finance looks to be on a path of long-term growth as it transfers the impact of interest rate hikes to customers, sees margin expansion and continues to grow AUM.

This analysis by Trendlyne is meant for investor education - to help understand companies and make informed investment decisions on their own. It should not be considered an investment recommendation.