Tuesday, January 12, 2010

Analysis of Mahindra Finance’s Fixed Deposit Scheme

I had mentioned in my previous blog that bank FDs should only be used as a means to park ‘transitory’ funds before deploying them in higher yielding securities. Since stock markets have continued their upward movement (Sensex is currently at 17,500) equities have become more and more expensive and risky. Interest rates on government securities have also gone up since my last blog. The 10 year bond is currently trading at 7.66%. I currently invest in a monthly SIP on Fidelity Flexi Gilt Fund, which invests in government securities (as recommended in my previous blog). I think the next 6 months will be a good time to buy government securities at such high interest rates.

Between all this, Mahindra Finance has launched an FD scheme that seems interesting. Since it also has a 1 year investment option, I thought I’ll take some time to analyze the issue. The key terms of the issue are mentioned below: (For the full terms and conditions click here)

Key Questions:

I think the key questions to ask as an investor in the FD are the following:

1. What does the company do?
2. Are the returns adequate?
3. Is my capital safe?

Let’s try and answer each of these questions

Question 1 – What does the company do?

Mahindra Finance is a non-banking finance company that provides loans to customers in rural and semi-urban areas to finance the purchase of utility and commercial vehicles like tractors, cars etc. They are placed between the organized banking sector and local money lenders in rural India. The company was originally started to provide finance for Mahindra utility vehicles but has today diversified into personal loans, construction equipment finance, rural housing finance etc. Its primary business remains financing utility and commercial vehicles in rural and semi urban India.

Question 2 - Are the returns adequate?

The asset class we are dealing with here is a fixed deposit. The natural comparable is the FD rates at banks. Below is the comparison between the Mahindra FD rates and the ones being offered at various banks. I have also included the rates offered by Post Office term deposit schemes.

Mahindra offers rates 125-150 bps higher than what banks are currently offering for a similar tenure product. I think 150 bps over bank rates is not too bad. However this return has to be seen in conjunction with the risk of investing in the FD, which leads us to question 3.

Note: I am not sure if one can buy 1 share of the company and ask for 0.25% more interest by qualifying as a ‘shareholder’ though the offer document seems to imply so. In that case the returns would be 150 bps to 175 bps higher.

Question 3 – Is my capital safe?

To answer this question, we need to look at where we stand in the company’s capital stack and whether the company is earning enough to be able to repay our principal and interest obligations.

As of Mar 09, there was Rs. 4,467 crores of senior secured debt ahead of us in the capital structure (the blue box is our position in the stack). This means that the company’s profits will first go to service these debt holders. A quick read through the notes to accounts reveals that this includes non-convertible debentures and bank loans which have a charge over the company’s fixed and current assets. However, we do have Rs. 3,260 crores of equity buffer below us. The current equity value implies that assets would have to fall by 38% (or in other words 38% of the loans would have to go ‘bad’) before our capital is affected. Even at its lowest point in Mar 2009 the equity value was Rs. 1,700 crores implying a 25% buffer. From a balance sheet point of view, our capital seems to be relatively safe.

Now let’s look at the company’s ability to pay interest and repay our capital.


Last 10 years Analysis

Last 2 years Analysis Using Cumulative Deductions

Ideally, we would have liked to look at a longer term average in order to counter the effect of prosperous and average years in earnings, but we will have to be content with 2 years in this case. The company earned about ~2.2x of its interest obligations in the last 2 years (data for prior periods is not available) which means that even if earnings halve, the company will have enough to pay interest on its debt. For an NBFC, this number seems conservative since the variation in earnings will probably not be as high as say a commodity company. Also, the history of earnings shows a growing trend with no wild fluctuations.

The other way to look at this is that the company had Rs. 1,126 cr and Rs 983 cr left in FY 09 and FY 08 respectively to pay interest on debt after paying its operating expenses. This translates to a 22% and 20% yield respectively, meaning it could theoretically pay ~21% interest on debt.

Other Reasons to Feel Safe

Dividend History

It looks like the company has had a good history of paying dividends to it shareholders. Also, the dividends have been progressively higher over the years. Even in a bad year (FY09) the company managed to pay 55% to the equity holders (higher than the 45% in FY08 – a good year). Though not conclusive, this is a good sign for us because it means that the company has had enough cash flows in the past to service the lowest stack in the capital structure. It also means that we can monitor the health of the company in the future by looking at the company’s dividend policy. If it is lower or stops altogether we will hopefully receive a timely warning of impending trouble.

The Mahindra Name

The company is a subsidiary of Mahindra & Mahindra Ltd, a six decade old conglomerate with revenues in excess of $6.3 billion. The issue has the strong backing of a big business house which provides good confidence to any debt investor. In fact, for some, the backing of M&M itself would be enough to trust the company’s credentials. However, the past year has seen some of the biggest business houses like the Tatas dither in the wake of one of the worst economic downturns we have seen. Therefore, though it is comforting to know that the company has the backing of M&M, it should not be the only reason for investing in the issue.

Final Word

I think this is the best debt option available right now. I would recommend this issue to anyone looking to invest in debt.