Abraham Maslow was an American psychologist who was well known for creating Maslow’s hierarchy of needs pyramid. He studied the behaviors of exemplars like Albert Einstein. And wanted to understand why some people could attain such unbelievable heights, while so many others continue to struggle. He explained this difference with hierarchy of humans needs pyramid. According to Maslow, the needs at each levels have to be satisfied before a person can progress to the next level. Exemplars like Albert Einstein is at the top of the pyramid and the rest struggle at the first and second levels.
In India urbanization is on the rise. Around 34% of Indians live in urban areas compared to 18% in 1971. This created a shortage of 18.78 million homes. In order to buy a home people need credit. Majority of people in India are self employed and banks will not lend money to them. Why is that? Unlike salaried people, the cash flows of self employed are volatile. And banks don’t like volatility. So the self employed are perpetually stuck in the second level of Maslow’s pyramid. Is there a solution? Housing Finance Companies (HFC) give credit to these people and help them to fulfill their aspirations and progress to the next level of Maslow’s pyramid. And Repco Home Finance Limited (RHFL) is one such company.
RHFL was promoted by Repco Bank in April 2000 to tap the growth potential in the housing finance industry. RHFL is headquartered in Chennai, Tamil Nadu and it went public in March 2013. It lends money to people to buy homes in tier 2, tier 3, and at the peripheries of tier 1 cities. Around 93% of its loans are given to people in South India with Tamil Nadu representing 63%. RHFL gives individual home loans and loans against properties to both salaried and self employed people.
RHFL lends conservatively with an average loan-to-value ratio of 62% and income-to-installment ratio of 50%. For a property worth Rs 10 lakhs it lends Rs 6.2 lakhs and the rest is paid by the customer as a down payment. If the monthly mortgage payment comes to Rs 6,000 then the customer should earn at least Rs 12,000 to qualify for the loan. A low loan-to-value and high down payment is an excellent combination as it provides sufficient margin-of-safety for RHFL and also keeps the customers committed to pay back the loan.
As of March 2015, RHFL had 57,415 customer accounts with an average loan size of Rs 12 lakhs (0.002% of loan assets). Loaning money to several customers reduces single points of failure. What happens when a customer defaults on his loan. Should RHFL go to the court to repossess the property? With the introduction of SARFAESI act RHFL can foreclose the property after 60 days of notice to the customer who defaulted on his interest or principal payments. From the chart given below you can see that in six years RHFL grew its loan book at 38.69% and it hardly spent any money on advertising. If it didn’t spend much on advertising then how did customers looking for loans know about RHFL?
RHFL’s primary sources of customer acquisition are loan camps, customer walk-ins and referrals. Of these, loan camps contribute to about 70% of incremental originations. Manager of each branch conducts a loan camp once in every 2 months where, a primary assessment of customer documents is done and an in-principle sanction is given. The customer then approaches the branch for further processing of his/her loan. The branch personnel act as single point of contact to customers and are responsible for sourcing loans, carrying out preliminary checks on the credit worthiness of potential customers, providing assistance in documentation, disbursing loans and monitoring repayments and collections. – 2014 Annual Report
In the Maslow’s pyramid, property comes in the second level. Humans crave for anything in the first and second levels of the pyramid and decisions are made subconsciously in emotional parts of their brain. This is the reason why low cost marketing strategies like loan camps work very effectively and customers walk-in without persuasion. Also RHFL provides quality service in quick time at a reasonable cost. This makes its existing customers to recommend (a pattern also seen in Ashiana Housing) RHFL to their friends & family.
Until 2014, RHFL didn’t employ any direct sales agents (DSA) to avoid incentive caused bias. But in 2015 it employed DSAs in Maharashtra for experimentation purposes. If this works then it would use DSAs to expand into new geographies. Each branch is responsible for originating loans and collecting monthly payments. But loan approvals happen only at the head office. By separating loan origination and approval RHFL is reducing the probability of issuing bad loans. I like this separation even though it introduces some delays in the process. Take a look at the loan origination and approval process which I got from here. From the diagram you can see that each customer is lent money at different rates of interest depending on their credit score.
RHFL borrows money from three sources. They are (1) term loans from banks; around 65% (2) term loans from NHB; around 25% (3) working capital loans from its promoter Repco Bank; around 10%. From the chart given below it’s evident that term loans from NHB has come down over the years. At this point I have couple of questions. Who is NHB? And why did the borrowing from NHB come down?
In India RBI governs all the banks. Similarly National Housing Bank (NHB) governs all the HFCs. NHB operates as a principal agent for promoting, regulating, and providing financial support to HFCs like RHFL. In order to facilitate priority sector and rural lending, NHB refinances funds to HFCs at lower than market rates. But with low rates comes tight regulations like capping the interest rate spread to 2%. And this spread is insufficient to compensate for the risks taken by RHFL. So it reduced its borrowing from NHB.
The share of NHB funding has declined over the years. It has gone down from 56.43% in FY10 to 24.99% in FY14. Effective Sep 2013, refinance from NHB under the Rural Housing Fund (RHF) entailed an on-lending spread cap of 2%, which was insufficient given the risks and operational costs involved in servicing loans in rural areas As a result, the company did not avail refinance under this window. – 2014 Annual Report
Interest on a housing loan can be fixed or floating in nature. Average age of a housing loan is around 15.75 years. And the average age of RHFL borrowing is around 9 years. Due to the long term nature of housing loans and medium term nature of RHFL borrowing, it prefers to lend at floating rates. This allows RHFL to reprice the loans when its cost of borrowing increases. This reduces interest rate risk to some extent. As of 31-Mar-2014, 19.76% of borrowings were on fixed rate basis and 80.24% were on floating rate basis. And all its outstanding loans were on floating rate basis.
How good are the quality of RHFL loans? In order to answer this question we need to look at its NPAs and write-offs. To learn more about NPAs go here. From the chart we can see that the RHFL has high quality loan assets. The only concern is that its provision coverage ratio in 2015 is 62.4% which is low. Ideally I would like to see this at 80-90%. The management is working on this to increase the coverage to 100% in the near future.
Provisioning is an accounting liability created by the company according to the rules set by NHB. What is more important is to see how much of that liability actually turned bad. This is measured by write-offs. Since inception RHFL has written off loans aggregating Rs 4.33 crores, which is only 0.07% of total cumulative disbursements.
As on March 31, 2014, RHFL had 55% loan book exposure to non-salaried segment (consisting of professionals and non-professionals). Generally, income profile of the non-salaried segment tends to be lumpy which leads to significant quarter-on- quarter volatility in NPAs. However, such volatility in NPA profile is not representative of the true asset quality given conservative underwriting policies of the Company. RHFL has, since inception, written off loans aggregating Rs 4.33 crore, which is a mere 0.07% of total cumulative disbursements. – 2014 Annual Report
It’s time to look at the report card of RHFL. From the table and chart given below we can see that it did a fantastic job by compounding its net-interest-income and profit-before-tax at 39.37% and 37.73%. At the same time it kept its operating expenses (also known as cost-to-income ratio) very low between 18-20%. These are fantastic achievements and the management deserves some credit.
Lending is a commodity business and customers don’t care from whom they borrow the money from. They will go to someone with low lending rates. So RHFL doesn’t have power over its customers. Also the company doesn’t have any power over its suppliers; banks and NHB. Its interest rate spread and NIMs fluctuate according to market conditions. This is clearly evident from the chart.
Low refinance rates from NHBs are available to other HFCs. So this can’t be an advantage. Around 65% of RHFL borrowed funds comes from banks. And banks are dinosaurs as they have access to low cost funds in the form of deposit accounts. So what is the source of RHFL moat? To answer this question let’s travel back 70 million years. You’ll see dinosaurs (banks) roaming all over earth. It would be hard to spot mammals (RHFL). But if you look inside the burrows you will find them. Why does it live inside the burrows? It is the only way for mammals to survive the onslaught of dinosaurs.
Like mammals living inside the burrows, RHFL operates in tier 2, tier 3, and at the peripheries of tier 1 cities. And it lends money to non-salaried people the segment which banks don’t bother to touch. This unique strategy is the first source of RHFLs moat. Is there any other moat for RHFL? Insurance like lending is a commodity business. May be we can look at what Buffett wrote about moats in an insurance business.
RHFL operates with a cost-to-income ratio of 18-20%. How does it run on such low costs? It runs its branches efficiently by having only 3-4 employees. On average each employee handles 105 customer accounts. This makes RHFL a low-cost operator and it’s one of the key moats for the company. From all this I am convinced that banks can’t compete with a low cost operator like RHFL for sometime. But what about other HFCs. Can they not compete? Yes they can and there is one player that I can think of. GRUH Finance an NFC promoted by HDFC Ltd is one of the competitors of RHFL. Both RHFL and GRUH are low-cost operators and they compounded their loan book at 31%.
Some of the differences that I see between them are (1) GRUHs strategy is based on women empowerment + non-salaried segment and RHFL is based on non-salaried segment (2) GRUH sources loans through third party channels by appointing associates and RHFL doesn’t have a sales agent and it mainly depends on loan camps (3) GRUH has more diverse source of funding like NCDs and public deposits. RHFL went public recently so it will diversify its funding sources in future (4) GRUH has a coverage ratio of 100% and RHFL needs some work on this (5) GRUHs loan approval process is decentralized whereas RHFLs is centralized.
As the opportunity size is huge, I believe that RHFL and GRUH will thrive and grow for a very long time. The key is set up pan-india branch network and make life harder for others.
The first test for a good management is conservatism. From the chart given below you can see that RHFL management produced decent returns on assets and equity. At the same time they didn’t over leverage their balance sheet and stayed within the boundaries of permissible limits set by NHB.
The second test for a good management is to look at how they compensate themselves. R.Varadarajan is the managing director of the company. His salary and allowances are paid by the promoter; Repco Bank. RHFL reimburses the additional pay to Repco Bank for the services provided by him. For the year 2013-14 his additional pay was Rs 3.22 lakhs and performance incentives including cash award came to Rs 20.5 lakhs. On a pretax profit of Rs 149 crores his total compensation is a rounding error. T.S. Krishnamurthy is the chairman of the company and he receives a sitting fees of Rs 80,000 per annum which is miniscule. Overall I am sold on RHFLs management.
Before valuing the business let’s first understand the thesis on which our valuation is going to hinge on. There is a shortage of 18.78 million homes. In 2015 RHFL had 57,415 accounts. If we assume that each account represents one home then RHFL current market share of homes is 0.31%. From the chart given below we can see that mortgage penetration in India is very low. From these two facts we can safely assume that there is a lot of room for future growth.
Here are the assumptions I am going to use for valuing RHFL.
Loan book growth : 25% for five years and 20% next five years Net Interest Margin : 4% Cost-to-income ratio : 20% Provisioning : 5% Taxes : 33% Dividend payout : 8% for five years and 10% next five years Exit multiple : 2 times book Share dilution : None and I understand this is unrealistic Home price : 8% growth
With a reasonable exit multiple of two times book the market capitalization + dividends of RHFL in year 2025 will be around Rs 10,500 crores. Its current market capitalization is Rs 3,750 crores. If someone buys RHFL today and holds it for the next ten years then he would get a compounded return of around 11%. Given that lending business is prone to negative black swans, I need additional returns to commensurate for the risk incurred.
As of this writing I don’t own any shares of RHFL. Click here to download the financial data I used to write this post. Also I would recommend you to read its IPO filing document which contains tons of information about HFC industry. Disclaimer: This is not a recommendation to Buy-Sell-Hold. And I am not a SEBI registered analyst.