SKS has announced the final pricing range for its IPO at Rs850 to Rs 985 per share. We think these are punchy valuations even at the lower end implying a 5.8x FY10 P/B (pre money) and 3.8x FY10 P/B (post money). Whilst global microfinance peers tend to trade at a higher multiple, those have significantly higher return ratios (30-40%) compared to SKS’ FY10 RoE of 21%.
Clearly, the valuation factors in expectations of significant RoE expansion in the future to which we see challenges from : a) Competitive, political and regulatory risks to yields b) Credit costs already at a low of 0.5% to 1.5% in the past three years could rise c) Limited operational and financial leverage. Whilst we acknowledge SKS as a strong business exposed to a huge market opportunity, valuations do not factor in these risks.
SKS Microfinance is the biggest micro-finance institutions in India with 20% market share amongst organised players. Given that micro-finance institutions are currently catering to a mere ~8% of the potential market, there is a huge market waiting to be tapped.
However, increased competition, the possibility of regulatory and political interventions and lack of operating and financial leverage in the business model leaves little scope for return ratios to expand from here:
• Pressure on yields going forward: The yield on advances for SKS has been in the range of 25-28% over the last three years. However, the yields can come under pressure going forward as competition is rising with more players are entering the market (two prominent MFIs recently decreased their interest rates). Moreover, the authorities are not happy with high interest rates
charged by MFIs (25%-35%) and the possibility of the RBI or state governments capping the interest rates charged by MFIs cannot be ruled out.
• Credit quality can worsen: Whilst credit costs for SKS has been in the range of 0.5%-1.5% over last three years, it can deteriorate going forward to more than 2% due to: a) increased competition in the sector (multiple borrowings by clients beyond their repayment capacity); and b) expansion into new geographies. Globally, the average credit costs for the sector have been in 2%- 5% range. Moreover, the bigger risk for credit quality comes from instances of mass defaults (e.g. Kolar incident in India) which have plagued the microfinance industry the world over.
• Limited operational leverage in the model: Whilst cost to income ratio of SKs has come down from 79% in FY07 to 52% it is primarily driven by increased loan ticket size rather than operating leverage in the business model. Unless SKS increase its average ticket size per customer (which might have an adverse impact on credit quality), we do not see leverage economics working in SKS model because of large administrative and employee costs associated in reaching out to the customer base. A look at global microfinance companies show that cost to income ratio of these companies has been in the range of 45% to 55% (SKS is currently at 52%).
• Financial Leverage to remain low: Whilst the company management claims that it can leverage up to ~7.0x (currently at 3.8x) and hence enhance ROE to 40% going forward (currently at 21.5%). We are sceptical that company would be able to leverage more than 5x as regulators and bankers might not be comfortable with high leverage given the inherent risk in the business model.
Even globally micro finance companies have been leveraged less than 3x because of the higher capital adequacy required by regulators and bankers. Hence on a best case basis we do not see ROA for SKS going beyond 6% (from 5.4% in FY10) and ROE beyond 30%.