Fitch Ratings: Shriram Transport Risk Appetite May Rise with Envisaged Merger

Mumbai/Singapore: The recent announcement by India's Shriram group to merge Shriram City Union Finance Limited (SCUF) with Shriram Transport Finance Company Limited (STFC; BB/Stable) would result in a rise in STFC's exposure to riskier asset segments, says Fitch Ratings. This, along with management's plans for higher growth by the combined entity, could heighten STFC's risk appetite and raise asset-quality risks.

We believe execution risks will be elevated, notwithstanding the two businesses being sister companies. The core rationale for the combination is to boost growth, supported by cross-selling opportunities. Each business targets different market niches with differentiated lending products which require tailored underwriting skills. STFC's used commercial vehicle (CV) underwriting requires vehicle-valuation expertise and a feel for freight market dynamics, whereas SCUF's varied products - small business, two-wheeler, rural housing, and gold loans - need altogether separate risk assessments. Furthermore, management's plan to introduce more technology into its processes is untested, having depended until now on manual procedures.

That said, senior management continuity in the combined entity should help the company navigate its transition to a much larger and more diversified operation. STFC's CEO would become the vice-chairman of the combined entity, while SCUF's CEO will be the CEO of the combined entity. Both have been part of the Shriram group for more than two decades.

STFC's ratings currently benefit from its dominant 30% share in used-CV financing in India. Meanwhile, although SCUF's size is material relative to STFC (equivalent to 29% of STFC's assets), its market positioning is less of strength, with no prominent competitive advantage in its main lending segments. Management is targeting market-share gains in small business loans and two-wheelers, based on cross-sell opportunities to STFC's customer base. However, an excessive focus on growth may lead to a higher risk appetite via less stringent risk underwriting.

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We view the merged entity's blended asset-quality profile as somewhat weakened from the addition of SCUF's portfolios. Its unsecured personal, small business and two-wheeler loans typically carry a greater risk of credit fluctuations. This is although Pro-forma combined asset-quality metrics appear similar to that of STFC. The merged Pro-forma gross non-performing loan (NPL) ratio of 6.9% at end-March 2021 is marginally lower than STFC's 7.1%, while the combined average credit cost of 2.4% over FY18-FY21 was similar to that of STFC.

Any scale benefits from the merger are only likely to be visible in the medium term if executed well. Aggregated pre-provision profitability of 6.4% on average over FY18-FY21 was only slightly higher than STFC's 6.1% and is due mainly to SCUF's higher-yielding loan products. This could improve further if targeted merger synergies of around 10% of the net profit are achieved. Any rise in risk appetite following the merger could subsequently pressure asset quality and credit costs.

We expect capital and funding access for the combined entity to be comparable with that of STFC in the medium term. Both STFC and SCUF have had adequate access to equity and debt capital markets in the past. Both benefit from a diversified funding mix along with broad banking relationships. The merged entity's leverage is unlikely to be significantly different from that of STFC, as SCUF carries lower leverage. The Pro-forma combined debt/tangible equity ratio of 4.2x at the end-September 2021 compares with 4.6x for STFC.

STFC will also absorb Shriram Capital Limited, its non-operating holding company, and the merged entity will be renamed Shriram Finance Limited. The merger is subject to shareholder and regulatory approval, and Fitch will review its implications for STFC's credit profile following further clarity on the medium-term operational strategy and financial plans.