SKS Microfinance

Type	Public issue, 100% Book building	Shares on offer	16.8 m shares (Fresh Issue of 7.4 m shares and Offer for sale of 9.3 m shares)
Size	Rs 16.3 bn to Rs 14.0 bn	Face Value	Rs 10 per share
Price Offer	Rs 800 to Rs 935 per share (including Rs 50 discount for retail investors)	Promoters post issue holding	55.8% / 37.1%
Minimum subscription	7 shares	Promoters	Dr. Vikram Akula, SKS Mutual Benefit Trusts, Mauritius Unitus Corporation (MUC), Kismet Microfinance (formerly SKS Capital), Sequoia Capital India II LLC (SCI II) and Sequoia Capital India Growth Investments -I
Listing	BSE & NSE	Lead Managers	Kotak, Citi, Credit Suisse
Bid/Issue opens	July 28, 2010	Bid/Issue closes	August 2, 2010

	QIBs	Non-Institutional Investor	Retail Portion
No. of shares	10.1 milliion	1.7 million	5.0 million
% offered from Net public offer	60%	Minimum 15%	Minimum 25%
Minimum Bid/Application size	Rs 100,000 in multiples of 7 shares	Rs 100,000 in multiples of 7 shares	7 shares
Maximum Bid/Application size	Not exceeding the issue size	Not exceeding the issue size	Rs 100,000 in multiples of 7 shares

* The Company may allocate 30% of the QIB portion to Anchor Investors on a discretionary basis (1/3rd of which will be reserved for domestic mutual funds)

Augment the company's capital base to meet future capital requirements arising due to growth of the business

In 1997, Swayam Krishi Sangam, or SKS Society, was initially founded as an NGO in order to provide microfinance in poorer section of Andhra Pradesh. SKS was later incorporated as a private limited company in 2003 and was registered as a NBFC with the RBI in 2005. After this it was converted into a public limited company in May 2009.

SKS Microfinance is currently the largest microfinance institution (MFI) in India, providing microfinance services to rural poor. Its core business involves providing small loans exclusively to poor women mainly in rural areas. These loans are provided for use in small businesses or other income generating activities, and not for personal consumption. SKS uses a village centric, group lending model in order to provide loans to its members. Since these loans are unsecured, this group model ensures credit discipline through mutual support and peer pressure within the group. As of FY10, almost 85% of SKS' loans were for income generating purposes, with the rest comprising of life insurance loans, emergency loans, productivity generating, and housing loans. Its repayment rate for these unsecured loans is well over 99%. At the end of March 2010, SKS has 2,029 branches, serviced by a workforce of around 21,154 employees, which rivals a number of banks and NBFCs. The MFI has grown its income and advances at average annual rates of 214% and 148% over the past five years, with negligible non-performing assets (NPAs).

Dr. Vikram Akula is the Founder and Chairman of SKS Microfinance. He holds a degree of Bachelor of Arts from Tufts University, and Master of Arts from Yale University and Doctor of Philosophy from the University of Chicago. He has over 10 years of experience in the field of microfinance, and has worked as a community organizer with the Deccan Development Society in India. Prior to joining the Company he was with Mckinsey & Company. Dr. Akula is currently also on the board of STAPL, the trustee for the SKS MBTs and is founder of SKS NGO. In 2006, he was named by TIME Magazine as one of the world's 100 most influential people.

Mr. Suresh Gurumani is the Managing Director and CEO of the Company. He is a qualified Chartered Accountant with 22 years of experience in the banking sector. Before the joining the Company, he was with Barclays Bank Plc as Retail Banking head.

Microfinance offers financial services to low-income clients who lack access to the traditional banking system. Basic financial services such as loans, savings, money transfer services and insurance are provided to these customers. The ultimate goal of this sector is to enable the poorer section of society to build assets, increase income, and improve their quality of life by allowing them access to education and healthcare. It started to gain prominence as a sector in 1980s and currently almost 50% of all MFIs are present in the Asia Pacific region.

In 2008, the World Bank estimated that there are 1.4 bn people living in extreme poverty (earning less than US$ 1.3 per day using purchasing power parity-PPP) and 2.6 bn people are living in moderate poverty (living on less than US$ 2 per day-PPP). It estimates that there are around 150 m poor households in India or approx. 828 m poor people in the country, thus being the largest microfinance market in the world. Most MF loans in India are in the range of Rs 5,000 - Rs 20,000 and charge interest rates of 32-38%.

Microfinance has attempted to fill the gap between commercial banks and private money lenders. It has quickly emerged as an enabler to provide poor the access to financial services.

Source: Inverting the Pyramid Report, Intellecap, 2008,
Prospectus; Note: Total microfinance loan disbursements do not include loans
made by commercial rural banks and other informal money lenders

Currently, there are two microfinance models in India. They include:

Self Help Group (SHG): An SHG is a group of 10-20 poor village women who pool their regular savings into a common fund. They deposit the same with a bank as collateral for future loans. The group has collective decision making power and obtains loans from partner banks and other sources. It then loans funds to members on commonly decided terms. Group members meet on a monthly basis and leaders are responsible for maintaining records. It is currently the dominant model in India in terms of number of borrowers and loans disbursed. The MFI model, however, is gaining market share from the SHG model.

Microfinance Institution (MFI): The MFI model has gained significant momentum in India in recent years as an alternative to SHGs. In contrast to an SHG, an MFI is a separate legal organization providing financial services directly to borrowers. MFIs have their own employees, record keeping and accounting systems and are usually subject to regulatory compliance. MFIs require borrowers from a village to organize themselves in small groups, having joint decision making responsibility for the approval of loans. The groups meet weekly to conduct transactions. MFI staff travel to villages to attend group meetings where they give out loans and collect repayments. Unlike SHGs, loans are issued by MFIs without collateral or prior savings. MFIs now exist in various legal forms both for profit and not for profit, including trusts, societies, cooperatives, non-profit NBFCs, and for profit MFIs registered with the RBI as NBFCs.

• Strong market leadership position: According to a report by CRISIL at the end of October 2009, SKS was the largest MFI in India in terms of total value of loans outstanding, number of borrowers, and number of branches. As of FY10, the company maintained its leader status with approximately 6.8 m members (women borrowers - 85% are active), 2,029 branches, a presence in 19 states, and had loans outstanding of Rs 43 bn. SKS did all of this in around ten years, in contrast 'Grameen Bank' the venture started by Muhammad Yunus, the father of Microfinance, took 30 years to reach 6 m borrowers.
  
  A market leadership position in the sector helps enhance SKS' reputation and credibility with borrowers and lenders. These in turn help the company secure capital at lower costs and rapidly expand into new regions and product areas. SKS has grown its operating income at an average annual growth rate of 214% over the past 5 years; advances have grown at 148% over the period. It is also highly profitable with profits increasing at an average annual rate of 221% over the period.
• Specialised knowledge: Since its inception, SKS has been focused on lending to poor women in India. Through its experience of more than a decade it has a special understanding of the needs of its clients. It provides customized financial products to its members. It used its knowledge about their cultures, habits and education in order to design loan products. For example, its core loan product has a weekly repayment plan in small installments. This corresponds with the cash flow of the member's businesses. SKS also provides basic product awareness training to its members. Most of the poor in India are illiterate or semi-literate and unaware about loan terms or interest rates. Its training program incorporates visual aids such as seeds, coins, and stones to explain its products and procedures. This helps increase trust among the group and increases transparency in operations.
  
  Diversified sources of capital and benefits of priority sector lending: The company has been able to diversify its sources of capital. At the end of FY10, the company had loans of around Rs 27 bn from more than 48 different banks and other financial institutions. Historically, the sector has relied mainly on priority sector funding from commercial banks (public, private and foreign banks). As of March, 2010, no single creditor represented more than 22.5% of SKS' total loans taken. Besides such funding, SKS has been able to fund its rapid growth through equity issuances to private equity investors etc. It has also been able to leverage on private and publicly traded debt securities, and securitization of parts of its loan portfolio.
  
  The RBI has set targets for domestic and foreign banks operating in India to lend to certain priority sectors including agriculture, small enterprises, retail trade, micro-credit, education and housing. The target for total priority sector loans for domestic banks is 40% of net banking credit and 32% for foreign banks. Micro credit loans provided by banks either directly or through an NBFC, such as SKS, meet the priority sector requirements as per RBI. These loans however have a Rs 50,000 per borrower cap. Banks can also purchase securitized assets comprising of MF loans from SKS, as part of priority sector lending.
• Pan India network: SKS is present in around 19 states, 354 districts with 2,029 branches. Through this network it currently has access to 6.8 m members. Its highest concentration of loans is in Andhra Pradesh (29%), West Bengal (16%), Karnataka (11%), and Orissa (9%). Its exposure to states in North and East India is relatively low, showing vast room to grow nationally.
  
  Its presence across India works as a good distribution network. It has constant contact with its members for sales, collections, training, and group decision making. This gives SKS the means to offer other products in areas that most other companies cannot reach. It can also negotiate terms with players wanting to tap rural India, at lower costs. Thus the company can work as a distribution network for the bottom of the pyramid. It has already tied up with Nokia to provide loans for cell-phones, retail chains such as Future Agrovet to provide working capital financing to members operating local retail shops or 'kirana stores' purchasing supplies from them. It also provides housing loans in a tie up with HDFC and life insurance through Bajaj Allianz Life Insurance.
• Scalable operating model: SKS recognised the need to have a scalable model to be successful in the business of microfinance. The management took inspiration from the model of Coke which has a standardised product distributed worldwide. They also drew from MacDonald's model which trains its staff uniformly across the globe. It has effectively used 3Cs in order to achieve scale. These include:

  Capital - The main reason MFIs have not scaled is lack of capital. SKS plans to use the equity markets in order to access commercial capital. It has already successfully raised capital in the past with private equity funding and bond issuances.

  Capacity - Traditional MFIs have lacked capacity to scale. SKS has standardized its recruitment and training programs. Business processes such as member acquisition and cash collections have also been standardised and are well documented.

  Cost reduction - Traditional MFIs suffered from having high operating costs. In order to service low value, high volume loan disbursement, access to technology is key. SKS has implemented technology and process based systems in order to reduce the cost of conducting numerous complex transactions. It has deployed a sophisticated technology platform. This helps improve productivity by simplifying data entry, improving accuracy, loan tracking and efficiency of collections and improving fraud detection.

• Positive asset liability mismatch and good asset quality: Compared to other NBFCs such as PFC or IDFC or even some banks, SKS has a positive liability mismatch. The others have to borrow relatively short term, while lending long term, thus leading to a negative mismatch. SKS on the other hand borrows relatively long term while lends for the short term. Cash collections are done on a weekly basis in correspondence to cash flows of its borrowers. It manages liquidity through stringent financial metrics. It monitors its growth funding needs in a disciplined and well defined manner.
  
  Despite rapid growth in its loan book, the company has maintained negligible NPAs. As FY10, its net NPAs were 0.16% of its loan portfolio outstanding. This is lower than most of its peers. The company has a unique model of ensuring repayment, which does not involve any physical collateral. It structures its loans through a village centric, group lending model. This ensures credit discipline through mutual support and peer pressure within the group. Failure by an individual member to make timely loan payments will cause other group members to also be blacklisted. Its loans are mainly given for income generating activities or funding productivity increases and not consumption purposes. This also helps ensure repayments through the cash flows of the business.

• Employee risks: Since its customers do not have bank accounts, all disbursements and collections from members are done in cash. This increases risks of theft, fraud and mismanagement of funds and in some cases even murder of employees. In FY10, the company had 82 cases of cash embezzlements by its employees, 61 cases of loans given to non-existent borrowers and 31 cases of loans taken in collusion with other borrowers. These frauds totaled Rs 35 m, of which 64% has been written off. The company recently implemented an integrated cash management system, operational in 1,338 of its branches at the end of FY10. With increasing scale, cash management will become all the more important.
  
  Employee attrition is also high at SKS; its past 3 year's average attrition is 26.7%. Considering, the company is growing fast, it also means that most employees are new hires. The company plans to double its employee base this year to over 40,000. This attrition issue will only compound further unless it works hard on employee retention.
• Dependant on government regulations: SKS is subject to a number of regulations which will hamper its growth if they are unfavourable. Recent legislation requires NBFCs to maintain a capital adequacy ratio (CAR) of at least 12.0% by FY10 and 15.0% by FY11. As of now, this is not an issue as SKS has a healthy CAR of over 28% (as of March, 2010). The company currently charges interest rates between 26.7% and 31.4%. The RBI has not yet established a ceiling on the interest rates that can be charged by an NBFC in the microfinance sector. Currently, the RBI requires that the board of all NBFCs adopt an interest rate model taking into account relevant factors such as the cost of funds, margin and risk premium. SKS will be adversely affected in case legislation is passed that it has to cap interest rates, which has been done for money lenders in certain states and some banks.
• High costs: SKS suffers from high costs of operations. Its cost/income ratio is currently 52.3% (FY10), which is higher than most banks and other NBFCs. However, this ratio has come down for SKS from almost 80% in FY07. The company has been leveraging its technology in order to reduce costs. However, the ratio might rise as it increases scale. It will have to spend more on employees, opening branches as well as starting operations in new, and unfamiliar geographies. Currently its main cost heads include travel and conveyance, printing and stationary and rent. It needs high volumes in order to remain profitable from its low value loans. As of now It has the flexibility to increase interest costs to cover for operating expenses; however, it cannot increase them indiscriminately.

FY10	Profit margin (%)	ROA (%)	RONW (%)	CAR (%)	Net NPA (%)	P*/ABV (x)
Shriram Transport	23.1	3.4	28.3	21.4	0.8	3.9
Mahindra Finance	22.2	3.9	21.2	18.5	0.9	3.1
SBI	11.5	0.9	14.0	13.4	1.7	2.7
SKS Microfinance*	18.2	4.9	21.7	28.3	0.2	4.1

* P/ABV for SKS has been calculated by considering the post issue adjusted book value at the upper end of the price band.

The microfinance sector is dependent on outreach to rural poor to provide them financial services. The sector’s main aim is financial inclusion and alleviation of poverty. Unlike other sectors, a financial institution's asset is cash and the ability to grow interest income (topline) and is therefore, largely dependent on its capital base (or net worth). Therefore, as compared to the price to earnings (P/E) ratio, the price to adjusted book value (P/ABV) is more relevant while valuing a banking or non-banking financial company (NBFC) stock. By P/ABV, we mean reducing net non-performing asset from the net worth and then, dividing it by the number of shares. We have chosen to value the company on the price to adjusted book value multiple due to its NBFC structure and considering the fact that the incremental capital being raised is primarily to be invested in the lending business.

The stock is valued between 3.5 times and 4.1 times its post issue book value at the lower and upper end of the price band respectively. It is trading at a premium when compared to some of its NBFC competitors Shriram Transport and Mahindra Finance, even though its fundamentals are competitive to that of its peers. Investors also need to recognize the fact that the risk of micro lending is far more pronounced due to the small ticket size and uncollateralized nature. We believe that that the issue of SKS Microfinance looks overvalued at this juncture as it does not offer any margin of safety in terms of valuations. As such, we recommend you to 'AVOID' the issue.

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We would like to inform our readers that this IPO note is just a one-time view on the company and in no way implies that there will be regular coverage on the company's performance or any other development. Should we decide to bring the company under research coverage in the future, it will be available exclusively to subscribers of the respective subscription.