Concentrated State Risks Will Hinder Performance Yet Renewables Promise Recovery

Key Takeaways

• Heavy concentration in the state power sector and slow fossil fuel exposure reduction make REC vulnerable to regulatory risk and higher credit and borrowing costs.
  
• Delays in renewables project execution and growing competition in green financing threaten revenue growth, asset quality, and profitable lending spreads.
  
• High credit concentration, shrinking core markets, riskier private sector exposure, and funding cost pressures threaten REC's asset quality, profitability, and long-term growth.

Catalysts

Engages in the provision of financing services for power generation, transmission, and distribution projects in India.

• Although REC has benefited from long-term government infrastructure and electrification initiatives, the company's loan book remains heavily concentrated in the state power sector, making it vulnerable to sector-specific risks such as regulatory changes and potential reduction of state guarantees. This could translate to higher credit costs and provisioning, impacting net margins and future earnings growth.
  
• While digitization and increased efficiency in risk management are improving REC's operational performance, tightening global climate finance norms and an accelerated push towards green funding could raise REC's borrowing costs if its exposure to fossil fuel-related projects does not decline rapidly enough. This may reduce net interest margin and profit growth expectations over the medium-to-long term.
  
• Despite the ambitious targets for expanding renewables financing and capitalizing on India's green energy push, the company's growth in renewable energy disbursement is largely dependent on timely execution of power purchase agreements and distribution company (DISCOM) reforms, both of which remain prone to delays. Prolonged bottlenecks could curb both revenue growth and asset quality improvements.
  
• REC's cost of funds has been declining and its credit profile remains robust, but with a significant portion of growth coming from repayments and refinancing cycles-exacerbated by competitive pressures from banks in a falling interest rate environment-overall growth in assets under management and the sustainability of spreads could be challenged in the future, limiting top-line growth and pressuring return on equity.
  
• While the company is leveraging its scale and strong public sector linkages for competitive funding, increased competition from private NBFCs and evolving technology in renewable project financing might compress lending spreads over time, potentially eroding REC's profitability as the addressable market for large, centralized power projects shrinks in favor of more distributed renewables.

REC Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on REC compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming REC's revenue will grow by 10.6% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 74.3% today to 69.1% in 3 years time.
• The bearish analysts expect earnings to reach ₹199.9 billion (and earnings per share of ₹76.33) by about July 2028, up from ₹158.5 billion today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 8.8x on those 2028 earnings, up from 6.6x today. This future PE is lower than the current PE for the IN Diversified Financial industry at 28.4x.
• Analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 14.21%, as per the Simply Wall St company report.

REC Future Earnings Per Share Growth

Risks

• High concentration of loans to state government-backed entities, with only about half of state sector loans backed by explicit government guarantees and the remainder exposed to the operational and payment risks of state utilities; in the longer term, any weakening in political will or fiscal health at the state level could result in increased defaults, higher provisioning requirements, and pressure on asset quality and net margins.
  
• The continued reliance on rapid growth in thermal and large state-led power projects faces secular headwinds as distributed renewables and decentralized energy systems gain wider adoption, potentially shrinking REC's core lending market, limiting loan book growth, and reducing long-term revenue expansion opportunities.
  
• Rising prepayments driven by competitive refinancing environments and declining interest rates pose a risk that loan growth targets may not be achieved, forcing REC to chase new lending aggressively and potentially compressing net interest margins and lowering profitability.
  
• Increasing exposure to private renewable projects, while supportive of growth, comes with higher credit risks, as evidenced by a significant increase in Stage 1 and 2 provisioning in the private renewable book and elevated concerns around asset quality; this could result in higher credit costs and reduced net earnings if private sector stress materializes further.
  
• The company's funding strategy of dynamically switching between ECBs and domestic markets is dependent on continued access to low-cost global capital and stable hedging costs; any global tightening of interest rates, changes in climate finance norms, or disruption in capital markets could raise funding costs and reduce net interest margins, ultimately impacting earnings and returns on equity.

Valuation

• The assumed bearish price target for REC is ₹450.0, which represents the lowest price target estimate amongst analysts. This valuation is based on what can be assumed as the expectations of REC's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of ₹620.0, and the most bearish reporting a price target of just ₹450.0.
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be ₹289.1 billion, earnings will come to ₹199.9 billion, and it would be trading on a PE ratio of 8.8x, assuming you use a discount rate of 14.2%.
• Given the current share price of ₹400.0, the bearish analyst price target of ₹450.0 is 11.1% higher.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.