Five-Star Business Finance

Lender of secured small business loans

Healthy growth, margins and asset quality, face challenge of regional concentration and NBFC regulations

Five-Star Business Finance is an NBFC-ND-SI providing secured business loans to micro-entrepreneurs and self-employed individuals largely excluded by traditional financing institutions.

The company was incorporated on 07 May 1984 in Chennai, Tamil Nadu, and has strong presence in south India. All of loans are secured by borrowers’ property. It has recorded strong a compound annual growth rate (CAGR) of 65.0% from FY2017 to FY2021. Gross term loans (GTL) grew to Rs 5296.53 crore end June 2022.

The company generated strong average return on GTL of 7.5% from FY2020 to FY22 with best asset quality indicated by gross NPA at 1.05% end March 2022. Over 95% of loan portfolio comprises loans between Rs 1-10 lakh in principal amount, with an average ticket size (ATS) of Rs 2.9 lakh end June 2022.

The company primarily offers customers small loans for business purposes which accounted for 62.12% of GTL end June 2022 as well as loans for asset creation such as home renovation or improvement, or for meeting expenses for significant economic events such as marriage, healthcare, and education, which accounted 37.88% of GTL. Growth is primarily volume-led through increasing customer base while keeping the ATS stable.

Interest rates on loans depend on the underlying tenor (which ranges from two to seven years), with approximately 95% of the loans sanctioned being between the interest rate range of 24% to 26% and between the tenure range of five to seven years. The entire customer sourcing is in-house without any use of direct selling agents to source leads. All of loans are also fully secured with more than 95% of the collateral being self occupied residential property at the time the loan application is approved.

The target customers are in urban and semi-urban locations, as well as in the rural markets of India deriving income from everyday cash and carry businesses with a focus on services who can provide collateral and whose family will act as co-applicants on the loan.

The company has an extensive network of 311 branches end June 2022, spread across approximately 150 districts, eight states and one union territory, with Tamil Nadu, Andhra Pradesh, Telangana, and Karnataka being key states. The company started operations in Chennai and has increased the scale of operations through growth in number of branches by adopting a calibrated strategy of contiguous expansion across geographies with focus on hiring local staff with an understanding of the catchment area, strong local personal and professional networks, and the market. Approximately 95% of branches were in cities and towns with populations up to one million.

The company has implemented a comprehensive and robust credit assessment, risk management and collections framework to identify, monitor and manage risks inherent in line of business. It conducts an in-depth analysis of the potential customer by considering ‘3 Cs’, being their character, their existing cash-flow to assess their repayment abilities, and their collateral to ensure that there is adequate ability and a high motivation on the part of the customer to repay.

The company has leveraged established processes and technology in many of business processes and reduced the turnaround time from login to loan sanction.

The company secures financing from diversified sources of capital, including term loans, proceeds from loans securitized, proceeds from the issuance of NCDs, issuances of principal protected market linked debentures, and proceeds from loans assigned from banks, financial institutions, mutual funds, and other domestic and international development financial institutions.

Total borrowings were Rs 2520.32 crore end June 2022. The average cost of borrowings was 10.53% as of June 2022. The weighted average residual tenure of outstanding borrowings was 29.78 months. Further, long-term ratings from ICRA and CARE is A+ (a significant improvement from rating of BBB-, from CARE in FY2015), short-term borrowings are rated A1+ by CARE.

The company had a total of 6077 employees end June 2022. It is backed by marquee institutional investors such as TPG Capital, Sequoia Capital, Matrix Partners, Norwest Venture Partners, KKR and TVS Capital Funds Limited.

Lakshmipathy Deenadayalan is the founder, promoter, and chairman and managing director of the company and has been associated with Five- Star for the past 20 years. He has a deep understanding of customer behavior and business and operations and has been critical to developing and enhancing business model and driving total income and profitability.

The Offer and the Objects

The initial public offer (IPO) consists entirely of an offer for sale (OFS) to raise Rs 1960 crore by issuing 4.36 crore equity shares of face value of Re 1 each at lower price band Rs 450 and 4.14 crore equity shares at upper price band of Rs 474.

Among the promoters, Matrix Partners India Investment Holdings II, LLC is proposing to raise Rs 719 crore and SCI Investments V Rs 167crore. Among the selling shareholders, Matrix Partners India Investments II Extension, LLC is proposing to raise Rs 12 crore, Norwest Venture Partners X -Mauritius Rs 361 crore and TPG Asia VII SF Pte. Ltd Rs 700 crore.

The promoter and promoter group shareholding will decline to 33.7% post IPO from 40.1% pre-IPO.

The issue is to be made through the book-building process and will open on 09 November 2022 and will close on 11 November 2022.

The company expects to receive the benefits of listing of the equity shares on the stock exchanges and enhancement of the company’s brand name amongst existing and potential customers and creation of a public market for equity shares in India.

Strengths

The company has recorded significant loans growth with strong return and growth metrics and a significant potential addressable market.

The company had the highest average return on GTL of 7.5% in FY2022, driven by ability to lend to customers at consistently superior yields and then control costs. The net interest margins (NIM) were strong at 19.17% Q1FY2023.

The company has been able to achieve strong growth, without adversely affecting asset quality. The gross NPA (GNPA) stood at 1.12% and the net NPA (NNPA) at 0.68% end June 2022.

The company has developed an underwriting model that evaluates the cash-flows of small business owners and self-employed individuals in the absence of traditional documentary proofs of income helping to onboard suitable customers.

The company has also created a strong “on-ground” collections infrastructure to ensure a high asset quality. The branches adequately staffed with business officers, with the number of loans per relationship officer on average not exceeding 120, which is expected to provide each officer with the capacity to undertake both business and collections activities effectively.

The customers in underserved or unserved MSMEs and self-employed individuals segment offer huge growth potential.

The company has ability to expand to new underpenetrated geographies through a calibrated expansion strategy. Recently, it expanded into Madhya Pradesh, Chhattisgarh, Maharashtra, and Uttar Pradesh.

100% in-house sourcing, comprehensive credit assessment and robust risk management and collections framework, leads to good asset quality. The organizational structure is such that almost all of business and collections team members are also responsible for collections.

The company has access to diversified and cost-effective long-term financing with a conservative approach to asset liability and liquidity Management. It has reduced average cost of borrowings to 10.53% end June 2022 from 12.07% end March 2020. The cost of incremental borrowings decreased from 11.37% in FY2020 to 8.42% in Q1FY2023.

CRAR was robust at 69.93%, which is entirely Tier I capital comprising 69.93% end June 2022.

Weaknesses

The company primarily serves customers in the low and middle-income groups (70.15% of GTL end June 2022), with majority of borrowers being small business owners and self-employed individuals, who are prone various risks such as business failure, insolvency, lack of liquidity, loss of employment or personal emergencies such as the death of an income-generating family member.

The customers often may not have credit histories or formal income proofs to assess their creditworthiness.

Self-employed customers are often considered to be higher credit risk customers due to their increased exposure to fluctuations in cash flows due to adverse economic conditions.

NBFCs are subject to periodic inspections by the RBI. The RBI inspects books of accounts and other records for the purpose of verifying the correctness or completeness of any statement, information or particulars furnished to the RBI.

As per RBI observation, there were higher delinquencies in 1-90 DPD categories, which represents inherent stress in the credit portfolio, the RBI noted that the aggregate stressed accounts in the time categories up to 90 DPD category aggregated to 19.56% end March 2019 which was significantly on the higher side

A substantial portion of customers at 30.42% end June 2022 are first time borrowers which increases risks of non-payment or default. The borrower profile of company comprised mainly customers with marginal credit profile, mostly first-time borrowers is fraught with various facets of credit risks

During covid, moratorium was granted to 141,251 loans with a principal outstanding of Rs 3838.75 crore or 98.63% of the total principal outstanding as of March 2020.

Any failure or significant weakness of internal processes or systems could cause operational errors or incidents of fraud, which would adversely affect business.

The fixed interest rate financial liabilities were 60.66% and floating interest rate financial liabilities were 39.34% of total borrowings. All of loan portfolio is at fixed rates of interest and the company may be unable to pass on any increase in cost of borrowings to customers.

The states of Tamil Nadu, Andhra Pradesh, Telangana, and Karnataka account for 85% of branch network. Tamil Nadu account of 38.09% of Gross Term Loans, Andhra Pradesh 29.77%, Telangana 19.50%, and Karnataka 7.16% end June 2022. Any significant social, political, or economic disruption, or natural calamities or civil disruptions in these regions, or changes in the policies of the state or local governments of these regions could disrupt business operations

About 61.90% of total collections were in cash in Q1FY2023, of which 100% were cash collections at branches.

The employee base of the company stood at 6,077 end June 2022 and the employee attrition rate was 11.16% for Q1FY2023 and 40.25% FY2022, 28.06% in FY2021 and 28.80% in FY2020 with minimal attrition within senior management.

As this offer is a complete OFS for sale of equity shares by the selling shareholders, the company will not receive any proceeds from IPO.

Valuation

Five-Star Business Finance is one of the fastest growing small business loans focused NBFCs with strong earnings performance. The company has recorded healthy return ratios, while marinating strong asset quality. The revenues of the company jumped 19% to Rs 1203.77 crore and net profit galloped 26% to Rs 453.55 crore in FY2022. The revenues have increased 16% to Rs 335.22 crore and net profit surged 37% to Rs 139.43 crore in Q2FY2023.

The annualized EPS on post-issue equity (which is same as pre-issue equity as offer is entirely OFS) works out to Rs 16.9 for TTM ended June 2022. At the price band of Rs 450 to Rs 474, P/E works out to 26.7-28.1 times of annualized EPS for TTM ended June 2022.

Post-issue, the book value (BV) will be Rs 132.4 at upper price band and adjusted BV (ABV) is Rs 131.1 (net of NNPA). The scrip is being offered at price to Adj BV multiple of 3.6x at the upper price band.

Among peer NBFCs, MAS Financial Services is trading P/Adj BV (end June 2022) multiple of 4.0x and Shriram City Union Finance at 1.5x. The small business loans account for 50% of the loan book of MAS Financial Services and 42% for Shriram City Union Finance end September 2022.

In terms of P/E, Five Star Business Finance is offered at 28.1x of annualized EPS for TTM ended June 2022 at upper price band. Among peers, MAS Financial Services is trading at PE of 30.3x of annualized EPS for TTM ended June 2022 and Shriram City Union Finance at 10.7x.

The company has generated robust return on assets (RoA) of 7.2% in FY2022 up from 6.0% in FY2020. The RoA has further jumped to 8.6% in Q1FY2023. The return on equity (RoE) has been also healthy at 14% in Q1FY2023, while RoE has been impacted due to lower debt to equity ratio of mere 0.69x.

Five-Star Business Finance recorded strong AUM growth of 50% CAGR over FY2018-22, with disbursement growth of 26% CAGR over FY2018-22. The company also has a strong branch network of over 300 branches and an employee base of over 6000 employees focused on entire loan sourcing, monitoring and collections.

The NIM was healthy at 17.68% in FY2022 and 19.17% in Q1FY2023, driven by strong yields. It has been able to charge higher yields because of specific focus on the target segment and decline in cost of funds from 13.1% end FY2020 to 10.0% end FY2022.

The GNPA ratio of Five-Star Business Finance is among the lowest at 1.12% and the NNPA ratio at 0.68% end June 2022 compared with all the other MSME focused players reporting GNPA of more than 2%.

Five-Star Business Finance has the robust CAR of 69.93% and has the lowest leverage of 0.69x indicating at better ability to leverage further leading to better RoEs.