Let's talk about one of the most talked about stock during the time when Covid-19 posed such systematic risks for NBFCs and banks alike that Bajaj Finance fell from Rs. 4800 in Jan to Rs. 2000 in March. Bajaj Finance was the dearest stock for the investors until 2019, rising from Rs. 55 in 2011 to Rs. 4800 in 2019 giving a staggering 85x return in just 8 years.
Bajaj Finance Ltd. (BFL.) is a deposit-taking Non-Banking Financial Company (NBFC-D) registered with the Reserve Bank of India (RBI). It is a subsidiary of Bajaj Finserv Ltd. and is engaged in the business of lending.
It accepts public and corporate deposits and offers a variety of financial services products to its customers. It has two 100% subsidiaries: (i) Bajaj Housing Finance Ltd., which is registered with National Housing Bank as a Housing Finance Company (HFC); and (ii) Bajaj Financial Securities Ltd., which is registered with SEBI. BHFL started its business in the financial year 2017-18 (FY2018). Bfinsec is yet to start its operations.
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In simple terms, Bajaj Finance is an entity which offers financing to various segment groups who are in need of money / good or services but can't afford it right then. It offers to finance such requirements immediately in exchange for a fees on their services.
BFL focuses on six broad categories: (i) Consumer lending, (ii) SME lending, (iii) rural lending, (iv) commercial lending, (v) loans against securities and (vi) mortgages. The company reported Gross NPA of 1.54% and Net NPA of 0.63% for the FY2019. Below is the AUM for Bajaj Finance (FY2018 and FY 2019):
Bajaj Finance's loan book majorly consists of (i) Mortgages (29%) and (ii) Consumer Lending (Both B2B and B2C - 39%). AUM have seen an incredible growth of 40.6% from 2018 to 2019. Rural Lending arm of the business is the fastest to grow among all others @ 69.35% YoY (which contributes just 4.59% to the loan book growth due to small weightage in portfolio). The company's loan book has actually been growing at a staggering growth rate of 60%~ (CAGR) over the past 5 years.
The loan book is made up of 59%~ Secured loans (against hypothecation of automobiles, equipments, durables, plant and machinery, equitable mortgage of immovable property and pledge of securities etc) and 41%~ Unsecured loans.
DECODING THE HIGH GROWTH RATE
Before we understand how Bajaj Finance has been defying the gravity and achieving mind-boggling growth rate of around 45%~ (CAGR) in net profit over the years, it is important to understand their business model ->
The key to their business success is cross-selling to existing customers and automatic acquisition of new customers at minimal costs. Let's discuss this below:
The secret is that BFL doesn't really has to do much to acquire customers. They have a scheme of 'providing loans at 0% interest rate' or 'no cost EMI' to potential customers with fairly good CIBIL scores (Segment: Consumer Finance). For example, in consumer lending model, Mr. A wants to buy a mobile phone for Rs. 12,000. What BFL offers is to finance this purchase with 1 year loan at no cost therefore effectively making the EMI as Rs 1,000 (at least thats what Mr. A thinks he will be paying). Having such an attractive sounding scheme available, people eventually come automatically (and through some of their sales team efforts) and start financing their needs through BFL. They prefer BFL upon credit cards as there is some interest cost availed on credit cards as well.
-> How does Bajaj Finance earns through no cost EMI?
The company has tied up with multiple brands and stores all across India (Croma, Vijay Sales, Amazon, MakeMyTrip, Yatra and many more) and what happens is that the retailers take a cut in their margin and share it with Bajaj Finance. The benefit the retailer gets out of this is increased business due to easy financing. The volume of BFL business is massive so Bajaj Finance earns a lot of profit in this way. In our earlier example, suppose the retailer agrees to share 10% revenue with BFL. In this way the company has already earned 10% (ie Rs. 1,200) on the transaction.
Additionally, they also charge 'Processing Fee' (around 2.25% - 3%) on their loans which further adds to their profitability. So therefore, in our example, Bajaj Finance has already earned 12.5% on Rs.12,000.
Further through this arrangement, BFL gets a massive database of potential customers for their other services, without spending on marketing. Bajaj has a very low customer acquisition cost because of this very reason. They do lot of data analytics with this data and use it to cross-sell other products like home loan, personal loan, insurance etc. They have algorithms based on repayment data which generate automatic offers which get sent to email. They are bringing automation in lot of processes to reduce cost of originating a loan. (Machine learning and algorithms are a huge part of BFL culture)
They also charge various other fees (both ethically and unethically) on the given loans. In our example, if Mr. A misses on the timely payment of EMI, BFL would charge an interest of 24-36% p.a. and put a heavy penalty in the form of late payment fees as well. Many customers have also complained that they are sent Bajaj EMI cards without even asking them and deducted a charge for the same. (More on this later - Key Risks)
More or less, in this way BFL is able to earn around 12% - 22% on their loans which varies according to the type of loan, financing amount and risk profile of the potential customer.
The next step, BFL cross-sells their products like home loans, business loans, insurance etc to their existing customers. This is where the real work of their sales team begins. It is not clear whether Bajaj Finance outsources this activity to other companies or they do it internally. As of Sept 2019, BFL has an active base of around 38.7 million customers. This creates a huge opportunity (and they do exploit it) for the company to cross-sell every type of product available to the company aggressively.
The company recently reported that existing customers accounted for roughly 69% of the new loans booked during Q2 2020. Imagine the level of cross-selling happening here! The problem arises when they go to the next step and start irritating and exploiting the customer which slowly turns into customer dissatisfaction. (Explained later - Key Risks)
Now, you might be thinking that this type of model largely explains consumer lending business of BFL and not others. But all the other businesses like mortgages, commercial lending etc are all very much dependent on each other more than we think. For example, in our earlier example, Mr. A took a consumer loan from Bajaj Finance. What the company would do is try to cross-sell other products like mortgage services to Mr. A who has been already identified as a good customer by the company. This would help them save on marketing and customer acquisition as well as control the risk in their loan book as they would be already aware of Mr. A's traits. This is the real trick how they are able to maintain high growth rate alongside with low NPAs.
Lets start off with the basic numbers:
The company has been able to grow its profits by an astonishing multiple of 40x in the past 10 years, reporting net profits totalling Rs. 3995 cr in FY2019. On average, BFL has been able to maintain an impressive 19% net profit margin over the years. BFL has been giving out around 95%~ of its total assets as loans and advances.
In order to maintain the lending capacity, the company borrows money by mainly issuing secured loans through Non Convertible debentures and Term loans from banks. The rest of the money comes from unsecured loans (including deposits) and their own money. On average, BFL has been maintaining a leverage of 4.5 over the past 10 years.
Key Financial Metrics
Over the past 10 years, Bajaj Finance has been able to earn roughly 17%~ on their loan book and paying only 7-8%~ on their borrowings and deposits. This leaves them with a net interest margin of roughly 10%~ as per the past few years data. Having both high net interest margin as well as very low NPAs usually never goes together but this company seems to be achieving this incredibly well.
Bajaj Finance being the industry leader, having diversified and low risk loan book as well as adequate liquidity buffer makes it possible for the company to avail borrowings for themselves at low cost. Checkout how the market is providing CP borrowings at differentiated rates to different entities:
Their recently issued NCDs in 2019 (with tenors of 1092 days and 1852 days) have a coupon rate of 7.35% and 7.66% respectively. The instruments have been rated ‘CRISIL AAA/ Stable’ by the ratings agency CRISIL.
POSSIBLE ECONOMIC MOATS
According to our analysis, Bajaj Finance has grown to a size and level of complexity that it is very difficult for any new / existing player to beat BFL.
1. NETWORK EFFECT: The biggest economic moat, for the company is the number of partnerships it has secured. Name any brand / store, most of them will be associated with BFL. Their no cost EMI scheme works very well in attracting huge number of customers every year and this has been made possible because of the growing number of partnerships they have.
How is this an economic moat for the company? What these partner stores would do is directly increase the potential customers for BFL. Think of why would you go to BFL. To finance your needs and wants! If you have more and more kinds of stores where BFL provides financing, you would be more and more tempted to finance all such purchases. Having more options where BFL provides financing directly increases customer attraction. Not only that, even these stores would be tempted to partner with such NBFCs which have huge customer base as more customers again mean, increased business for these stores as well. This also gives pricing power to BFL.
2. COST ADVANTAGE: Let's think about how NBFCs really make money. They borrow money from outside at low rates and lend it out at higher rates, earning a spread on the money. Without borrowing, no NBFC can sustain high growth.
Due to the risk management policies practised at Baja Finance and the way they are growing by mostly cross-selling its products to existing customers, BFL is able to control the risk in their loan book. Because of this very reason coupled with their liquidity buffer and brand name, BFL is able to borrow money at cheap rates from the market. This directly leaves them with much higher spread on the money as compared to other NBFCs which in turn increases business profitability as well as provides buffer for unforeseen circumstances in the future. Alongside the mentioned advantages, it also provides Bajaj Finance with the ability to reduce the interest rates charged from its customers to weed out any unwanted competition.
3. RISK MANAGEMENT CAPABILITIES: One of the biggest reasons contributing to the success in keeping the risk low in the loan book is the way they calculate risk for individual loans. BFL has deeply invested in analytics to build models to support decisions, implemented Machine Learning (ML) models in addition to classical logistic regressive models and is deeply investing in Artificial Intelligence (AI). These models and decision trees are deployed on state- of-the-art technologies like decision engines with real time processing capabilities. Although not a wide moat, it still provides a competitive advantage to BFL in improving its partner stores experience.
In simple words, what Bajaj Finance does it, studies the credit history, age, income levels, payment behaviour of the potential customer, combines it with the huge data it gathered from previous customers + other sources and gives out a risk controlled decision of whether to finance the purchase or not within 1 minute to the partner store. Nobody till date has been able to do that in India as of April 2020. What parter stores tell about other NBFCs is that they take atleast 4-5 days time to decide whether to finance the purchase or not. If not, the liability of collection falls upon the store! Thats what gives BFL an edge (till now).
KEY RISKS & AREAS OF CONCERN
Lets address some of the negatives now. Further discussing the areas of concern which needs to be addressed by Bajaj Finance, even if it leads to low growth for the company.
Ongoing Unethical Practises (if true)
These relate mostly to 'consumer finance' segment -> Call it unethical or not, what Bajaj Finance has been doing is attracting customers through zero cost EMI and then charging on average 16%~ on such financing. We have reviewed on many websites how its customers feel about the company and found out that many of them are unhappy by the way the company has been dealing with them. Here are a few link where we found out of the issue:
Some of the common complaints shared by its existing customers are, (i) BFL has been intentionally bouncing their EMIs so that they can charge late payment fees on the loans (ii) they are being troubled by BFL's collection agency for not making timely payments (iii) many people were not told about various fees and charges involved with no cost EMIs.
We do not know what % of its existing customers are facing this issue because mostly only those customers are coming forward who are having a bad experience with BFL. It is not possible to ascertain whether such the claims against BFL are true and happening at a broader level. Nonetheless, if true, what Bajaj Finance is doing is wrong and it can hamper its business and growth prospects. In the end, it is the customer only who provides value to the business, if the customer is not happy, you cannot expect the business to sustain for long.
Impact of Coronavirus + Asset Liability Mismatch
Coronavirus has caused a havoc in the world where the global economy came to a standstill. RBI's recent decision of delaying EMI payments by 3 months will indeed have a huge effect on BFL. The company will face severe stress in the coming months as people are currently losing out on their ability to pay back the loans and EMIs. NPAs are expected to shoot up in Q1 and Q2 FY2020 with the possibility of BFL facing losses let alone growth.
Lawsuits and complaints against the company are also expected to shoot up considerably as BFL would most likely try to recover their dues along with increased interest. The cash collection would delay for the upcoming few months creating liquidity pressure in the company as they would face asset liability mismatch.
Bajaj Finance will likely face severe stress while collecting dues in Q1 and Q2 FY2020 (highlighted above) and it would be interesting to see how Bajaj Finance handles the situation. It's uncertain how will be situation unfold and we refrain from making any predictions in this case. However, we expect that RBI's recent decision to provide liquidity to bigger NBFC players would largely keep the situation under control.
Finally, lets look at the market value vs fair value for Bajaj Finance. The below chart reflects the data from the period 2010 - 2020 (April):
As of 30th April 2020, our valuation model suggests a fair value of around Rs. 1800~ as against CMP of Rs. 2300~. This is one such company where we faced difficulty while valuing the company because of the below mentioned reasons:
How to incorporate such practises if true going on at BFL in our valuation?
Can this risk materialise in the future and hamper company's growth story?
Is such a high growth rate sustainable? What about the future?
Can big FIs like HDFC bank copy the model and eat away market share?
We do not worry much about losses, as they are bound to happen to levered businesses during crisis times. After carefully thinking about all such factors, we decided to actively monitor the stock and invest in the business only if the stock comes under our buy zone. We shall limit the allocation for this stock to a small % in our portfolio.
Let us know what you think about the company and share your views in the comments section. We would love to hear your thoughts.