Sundaram Finance: Hold

Recommendation: Hold

Sanjiv Shankaran

SUNDARAM Finance's (SF) financial performance is likely to be under pressure for the next few years.

The changing financial sector milieu has led to a gradual erosion in the company's profitability, and this trend is likely to continue. But SF continues to have one of the soundest operations in the financial sector and should be really affected in the churning taking place in the industry.

Gradual decline in profitability

A look at SF's financial statements reveals the developments that affected most entities in the sector over the last five years. Aided by a 25 per cent compound annual growth in the commercial vehicle segment in 1994-97, the company grew fast in the mid-1990s. On the heels of the fast-paced growth came a sudden and sharp contraction in demand for commercial vehicles.

At the same time, the industrial slowdown that had set in began to affect the quality of SF's loans. In line with the rest of the financial sector, the provisioning for non-performing assets (NPAs) increased. This and the write-offs rose from Rs. 2.16 crores in 1997 to Rs. 41 crores in 2000.

A third development in this period, and which has had and will have a far-reaching impact on SF, is the growing competition from banks and financial institutions in the market for retail loans. Earlier, the retail loan market was largely dominated by non-banking finance companies (NBFCs).

The advent of banks and financial institutions set off a rate war in the market for retail loans. The market is characterised by a steady decline in the interest rate charged for a loan. This has allowed banks and others to quickly capture market share because they have access to the cheapest funds.

The effect of these diverse developments may be seen on SF's financial statement. The return to equity shareholders, as measured by the return on networth (RONW) shows a steady decline over the last four years. The RONW, at 26.84 per cent in 1997, dipped to 12.65 per cent in 2000.

Positive development

The declining profitability may paint a bleak picture. But it also conceals the resilience displayed by SF in the recessionary phase. The ability to contain risk is most important in the financial sector. A look at the stock price performance of most banks and financial institutions shows that the price began to decline once the market began to speculate on the extent of bad loans on their books.

In this context, SF has done well. It managed to contain its bad loans to a fraction of its total assets. The company's net NPAs (after including security against a loan) were at 2.57-3.26 per cent over the last three years _ probably the worst period for NBFCs.

The ability to contain risks is a factor that may make some NBFCs competitors in an environment where only the toughest will survive. The performance on this front is all the more creditable when one considers that NBFCs probably operate in the least hospitable environment. They are not entitled to some of the tax breaks available to others, nor do they get any benefits from the debt recovery regulations.

Emerging scenario

The manner in which the financial sector has evolved over the last few years suggests that the phase of low profit margins for all the players has come to stay. Most financial intermediaries saw their profit margins shrink over the last few years.

This makes banks and financial institutions the best-equipped players because they have access to the lowest cost funds. A powerful tool when interest rate cuts to capture market share are not uncommon. But other players may have an edge in two key areas outside of cost.

Other than the cost of a loan, two other factors that are emerging as important determinants of competitiveness are the ability to provide satisfactory service and the degree of comfort potential customers have with a financial intermediary. On these two factors will rest the success of NBFCs such as SF.

Tapping new markets

SF's strengths are a strong brand loyalty and tremendous depth of knowledge about the customer. On these factors, in addition to effective service, will rest the company's success. In its existing businesses, the company's fortunes hinge on the performance of the commercial vehicle industry. In this market, hire-purchase and leasing firms such as SF are among the earliest entrants. The large segment of commercial vehicle market functions outside the ambit of the organised sector.

Given that many potential customers in this market fall outside the ambit of banking transactions, SF is unlikely to face that much competition in this sector. The market for commercial vehicle loans is likely to be largely dominated by a handful of NBFCs.

Car finance is an area SF has seen fast-paced growth in disbursements. Last fiscal, the company's car finance operations recorded a 52 per cent increase in value. However, this may soon slow down as the market for cars seems headed for slower growth over the medium term. In this segment, NBFCs face intense competition in bigger urban areas from a handful of banks and ICICI. In this backdrop, commercial vehicle financing is an area where SF is likely to be dominant.

Key strengths

The company's ability to contain risk in its commercial vehicle financing operations is also likely to be fairly strong as SF's familiarity with the market may help it keep bad debts at a low.

In this context, a sharp increase in SF's provisioning over the last year has come on the heels of the company bringing erstwhile subsidiary, India Equipment Leasing (IEL), into its fold. The high level of bad debts in IEL's portfolio has had an impact on SF's provisioning.

The soundness of SF's financial position may be gauged by the fact that the company's gross non-performing assets still comprise only a relatively small proportion of its networth. The comfortable cushion provided by the company's own funds indicates the strength of its balance-sheet.

New sectors

A look at SF's gross disbursements over the last few years indicates that the company has remained stagnant in terms of business volumes. The disbursement was Rs. 984 crores in 1996 and Rs. 969 crores in 2000. At the heart of the matter is the company's conservative approach in the backdrop of a deteriorating industrial situation.

In future, it may not just be the disbursements that count but also the funds SF places in other ventures. For instance, SF started a housing finance company last year. Housing finance entails low risk, and the returns are also low. The company has set about making the best of its familiarity with a section of potential customers to commence operations. Given SF's low cost of operation - the housing company uses the parent as a platform _ it may be able to provide returns soon enough.

The housing foray comes in the backdrop of top-rung NBFCs using their market understanding and reach to tap newly opened areas of finance. The NBFCs are driven by a mix of new opportunities and increasing competition to explore areas where their traditional skills, such as a good understanding of the customer and quick service, may be put to good use.

One area where SF will have to allocate significant resources is the general insurance venture with Royal Sun and a few TVS group companies. With the insurance sector recently opened up for private participation, there has been a scramble to enter the business. But it threatens to be a business with a long gestation period. It may take four-five years for the SF's general insurance joint venture to break even. Also on the agenda are a foray into the depository participants business, and information technology-enabled services.

Investment time? Not yet

SF faces a future of fresh challenges in its traditional markets, and some of its big-ticket new ventures are taking a while to pay off. While the company lowered the cost of its funds last year, the trend of shrinking or tight profit margins is unlikely to change. SF remains one of the soundest entities in the financial sector. The company's current share price of Rs. 112 is at a price earnings ratio (PER) of about 5 times its 2000 earnings per share.

Shareholders may consider waiting for a rally to book profits. However, new exposure may be avoided because financial entities such as SF are unlikely to attract much investor interest for some time to come. The intense competition and the risks associated with the sector do not make for the best possible investment at this moment, the company's pedigree notwithstanding.