Five-Star Business Finance Ltd

About the company: 

It is an NBFC providing secured loans to small business customers and self-employed individuals who are largely cut off from the formal lending ecosystem, with a loan book of 10,927 crores as of Q2FY25. It operates in the 2-5 lacs segment, offering loans at 22-24% interest rates to self-employed business owners in rural and semi-urban areas having a monthly household income of Rs. 30,000-50,000.

These loans are primarily secured against self-occupied residential properties with an average ticket size of Rs. 3.5 lacs at 50% LTV. It has a 100% in-house sourcing team and a collection efficiency of 98.4%. 

Currently, it is present in 10 states, with Tamil Nadu and Andhra Pradesh having 30% and 38% shares, respectively. It has 660 branches and 10,366 employees as of Q2FY25. It is currently rated AA- (stable). 

The promoter holding is at 21.59%, out of which PE promoter Peak Xv Partners Investments V holds 2.92% as of Sep-2024. 

Some basic stats regarding the AUM, customer profile, product, underwriting, and collections:

About the industry: 

MSME lending is a large segment with 25 trillion outstanding loans (15% of total bank + NBFC credit) as of Mar-23, growing at 8.4% CAGR from FY18-FY23.

Over the last 5 years, the growth in the segment is primarily led by micro segment which is below 1 cr at 9.4%. Within MSME, small business loans defined as loans with ticket sizes of less than 10 lacs have  grown at 24% over the last 6 years and it is expected to grow at 15% CAGR. 

 

Generally, the customers are traders, retail shop owners, small industries, manufacturers, steel fabricators, and many other self-employed non-professionals. 

MSME make significant contribution to India’s GDP, manufacturing output, exports, and employment generation. Despite that, there is a large MSME funding gap of 92 trillion rupees.

 

This is due to the customers often earning part or all their income in cash, making it difficult to provide formal income proof, and serving this customer requires alternative income assessment method with high service costs, significant time to develop expertise, strong local knowledge, and robust infrastructure for credit underwriting and collections. Hence, they are majorly underserved and unbanked by large banks present in India. 

Alternative income assessment: method includes visiting the borrower's workplace (for self-employed individuals) to estimate monthly income and expenses, meeting suppliers and customers for verification, and even conducting home and neighbor visits to check their income, expenses, and savings. 

As evident, the loan approval process for informal segment is extremely high touch, tedious, and time consuming.

There are multiple visits required to the work-place and home of the borrowers. Moreover, bounce rates are relatively high compared to formal segment. Hence, banks are simply not equipped nor interested in lending to this informal segment. 

Additionally, since the properties are often in small towns or outside municipal limits, lenders need local knowledge of property laws to carry out proper technical and legal evaluations. 

Another reason for this lack of formal credit is that out of 70 million estimated MSMEs present in India 2/3rd is not registered on Udyam portal which grants formal recognition for an MSME part.

So, the question arises is why is this a good industry?

Within the broader MSME lending segment, the estimated potential market for residential property-backed secured MSME lending is estimated to be ~INR 22 Lakh Cr. Such residential property used as collateral for secured lending is called SORP (Self Owned Residential Property).

State wise TAM bifurcation:

Due to most banks are simply not equipped nor interested, MSME financing companies are able to earn relatively high spreads, and able to enjoy significantly higher ROAs and ROEs than most prime loan companies, thus immense opportunity, and no competition from banks makes them an attractive niche segment to invest in.

Story in charts:

AUM has grown at a CAGR of 29.4% over the last 3 years, and 35.5% over the last 5 years with a disbursement CAGR of 57.5%, and 26.9% as of FY24 respectively. 

Aided by branch expansion and addition of employees…

while cost to income ratio has been stable maintaining economies of scale... 

Credit cost and GNPA well under control; peak during covid only at 1.64%

As a result, PAT has grown at an impressive CAGR of 29.8% over the last 5 years.

ROE has inched up slightly while ROA has remained stable.

Loan Underwriting process:

• The relationship Manager (RM) is responsible for sourcing potential borrowers and conducting a preliminary assessment before logging into the application. This includes basic checks such as reviewing income documents, understanding the purpose of the loan, and gaining insights into the borrower’s perspective.

• If the initial assessment is satisfactory, the RM/sales team/field officer discusses the case with the branch manager. Subsequently, the branch manager and field officer visit the borrower’s property to conduct a thorough evaluation. This involves assessing the borrower’s cash flow, documenting daily expenses, performing a neighborhood check by speaking to 4–5 neighbors, and capturing photos of the property. 

• By this stage, two visits to the borrower’s house have typically been completed.

• Once the branch manager is satisfied with the evaluation, the operating team logs the file into the system. At this point, the application is assigned a file number and sent to the field credit team. 

• The credit assessment process is divided into three layers:

• Field Credit Assessment: Conducted by a team based at the branch, but they report to the regional credit head rather than the branch manager. They independently verify details such as the borrower’s daily expenses, property condition, marketable value, and any recent property purchases. Once this verification is complete, the findings are entered into the system.

• Process Credit Assessment: This team oversees multiple branches (typically 3–4) and ensures impartiality by not assessing files from their assigned branch. They review the information submitted by field credit and contact the borrower for additional checks.

• Approval Credit Assessment: Located at the regional or head office, this team is involved in evaluating larger or exceptional files that require additional scrutiny.

• If the file is straightforward and free of exceptions, the process credit team may directly approve it. However, in complex cases, the approval credit team makes the final decision.

• Once the approval team gives the go-ahead, then the legal team prepares the memorandum of document and registers the pledging property with authority in favor of Five Star Business Finance. This legal evaluation is done by the internal as well as external legal team, and both must make unanimous decisions.

• Once this is done, the file is submitted to the HO, and the operation team verifies everything, and disbursement is done.

Collection mechanism:

• Loans with a vintage of up to 30 months are managed by the business team (sales team and branch manager), while loans exceeding 30 months of vintage are handled by the collections team. 

• Its collection efficiency is 98.4% where 40% of the payment is made by cash. To decrease the cash repayment, they introduced all digital modes of payment. To decrease it even further, they are planning to introduce payment through UPI, and QR code imprinted on a passbook so that customers can directly pay by scanning it. They are also going to make UPI autopay mandatory for customers taking loans from the month of May 2025 onwards.

Result in Asset Quality:

Details of Management:

Why do I like Five-Star Business Finance Ltd?

The focus is primarily on giving small business secured loans to "self-employed non-professionals" living in Tier 3 to Tier 6 towns, which results in reduced direct competition with banks.

100% of loans sourced by in-house team and no dependence on DSAs vs other players.

The company’s segment has lower NPAs compared to peers due to its in-house sourcing strategy, pristine underwriting and collection mechanisms, all of which contribute positively to its asset quality.

It gives secured loans by keeping 96% Self Occupied standalone Residential well-built cemented property located in average but strategic areas, often within catchment zones near industries and 4% other assets.

Conservative nature of promoters: The company gradually expanded its portfolio by thoroughly understanding all aspects of its high-risk borrower segment by not compromising asset quality of the loans. It successfully navigated the challenges of the COVID-19 crisis and the ongoing stress in the microfinance industry, as reflected in its impressive GNPA numbers which are at PAR with HFCs. 

Management practices what they preach.

Core investment thesis:

They are only offering MSME loans at a higher interest rate to low-income borrowers, therefore upselling and crossing selling opportunities are non-existent. Hence the addition of new customers via increasing branches into different geographies and improvement in productivity of newly opened branches will drive the business.

• Branch expansion: They are planning to increase penetration in southern states and expansion into newer geographies by adding 70-80 new branches every year and splitting all the super branches into normal branches to increase the reach to drive the growth. 

• They are implementing a strategic cluster-based expansion into an attractive market. Under this approach, branches performing consistent growth and meeting specific quantitative and qualitative factors over 18-24 months will be divided into 2-4 new branches. This process involves transferring some accounts to the new branches, thereby broadening the operational footprint, enhancing customer accessibility, and allowing the older branches to concentrate on further growth while the new branches develop expertise in collections early on.  

• Small Business Loan is still a quite nascent lending segment with ~11% penetration on pan-India basis. Of the Rs2.5tn o/s SBL loans currently, Five Star has 3.6% market share on overall basis and ~10% in the four southern states of TN, AP, KA, and TG given its long operating history in these geographies. Hence there is a room for Five-Star to continue growing in its core southern geographies.

• Maturity of newly opened branches and productivity improvement: Around 50% of their branches have been open in the last 3 years therefore it can grow 4x as branches mature to 5+years.

Forecasted Numbers:

AUM Growth: The company is expected to increase AUM by 25.5% during FY24-27E, with yields are anticipated to decrease as the company passes on a 200-basis point rate cut to customers for incremental disbursements starting November, reducing yields from 24.99% in FY24 to 23.8% in FY27E, resulting in a 25.4% growth in interest income over FY24-FY27E.

Profitability: Due to the rate cut and decrease in borrowing from banks in overall borrowing mix, CoF will lead to 9.1%/9.3%/9.5% FY25E/FY26E/FY27E, resulting in a NIM compression from 19.9% in FY24 to 17.2% in FY27E.

OPEX: Except for the cost associated with adding branches expansion and additional staff, the majority of OPEX is done on the employee side, and Tech side. As the company grows, it expects to benefit from economies of scale, leading to a 20.4% increase in PPOP between FY24 and FY27E. However, profit after tax (PAT) is expected to grow at a slightly lower rate of 17.8% during this period, as credit costs are projected to rise from 0.67% in FY24 to 1.3% by FY27E, reflecting a conservative approach.

Return Ratios: With slightly low spreads and asset quality well under control, we expect ROA to be 6.78% on FY27E basis, with 17.07% ROE coming through FY27E.

Valuations:

Risk:

• Lower growth than expectations due to scale up challenges in new states.

• High geographical concentration in TN, AP could cause AQ challenges in the event of political interference, natural disasters, or climate issues in these states.

• Lack of adequate availability of human resources at competitive cost as the segment is highly human intensive business

• Increase in competition from other NBFCs

• Inability to arrest early delinquencies to forward buckets could result in an increase in NPAs and credit costs.