>NON BANKING FINANCE COMPANIES: TOP PICKS - M&M Financial Services (MMFS) and Shriram City Union Finance (SCUF)

Mission possible: The rural protocol

The operating environment of retail NBFCs is likely to improve over the next 12 months, led by an expected dip in inflation, easing monetary policy stance and falling wholesale borrowing rates. Regulatory issues, barring priority-sector status, are near finalization and are unlikely to have a material impact on earnings. In addition, our NBFC coverage universe is strategically poised to cash in on rising rural demand. At current valuations, the risk-reward appears favourable for these stocks. We initiate coverage on the sector with a positive stance. Top picks: M&M Financial Services (MMFS) and Shriram City Union Finance (SCUF).

■ Macro headwinds to ease. We expect the economic environment to improve, led by falling inflation (estimated to soften to 7% by Mar ’12), easing monetary policy stance (estimated ~100bps CRR cut by Mar ’12) and falling wholesale borrowing rates. This is likely to drive growth in NBFCs.

■ Regulatory issues unlikely to impact earnings. Regulatory changes regarding capital adequacy, NPA recognition norms and securitization are unlikely to materially impact the earnings of our NBFC universe. We see little possibility of a complete curb on priority sector status on securitization, given: 1) the importance of lending to under-banked regions/credit-starved sections of society and 2) the necessity of meeting priority-sector lending criteria for foreign/small private-sector banks.

■ Strategically poised to cater to rising rural demand. Our coverage universe of retail NBFCs has strong parentage and several decades of expertise. The NBFCs have built large-scale franchises and have improved loan origination and risk management processes. They are now strategically placed to reap the benefit of greater rural demand due to rising food prices, high minimum support prices and rising government expenditure on rural projects and employment-generating schemes.

■ Top picks: MMFS (Buy; TP: `845) & SCUF (Buy; TP: `680). Our preference is for wholesale funded retail NBFCs (backed by secured assets) over banks and infrastructure NBFCs. At current valuations, the risk-reward favours NBFCs. We initiate coverage on Magma (Buy; TP: `80), SCUF (Buy; TP: `680), Chola Finance (Buy; TP: `181) and Bajaj Finance (Sell; TP: `712).

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RISH TRADER