To compound capital over long periods of time, one does not necessarily have to purchase cheap assets that we usually showcase on this site. Sometimes it is best to own a seemingly expensive company which can benefit from multiple positive tailwinds. This brings us to Capital First. Capital First (CAPF) is a specialized lender to SMEs (Small and medium enterprises) and consumers in India and has the potential long term benefits of high India GDP growth, a middle class which could approach 500mm consumers in 15 years, rising per-capita income, low credit penetration in India, improving NPLs and interest margins, and high operating leverage.

Indian banks and non-bank financials have a very long runway ahead of them given the low penetration of credit in India. Mortgages and consumer credit remain very underpenetrated and these sectors offer opportunities for proficient management teams to build highly scalable, high ROE businesses.

An example of a well recognized success in mortgage financing is Gruh Finance and in consumer and small business (SME) lending is Bajaj Finance. Both have built exceptional franchises in the niches they serve and have created meaningful competitive advantages over traditional banks’ offerings. We believe Capital First is building a franchise with similar attributes.

Capital First is a specialized lender to SMEs (Small and medium enterprises) and consumers in India. The company was formerly known as Future Capital when it was run by a different promoter group (Future Group) and was largely a real estate and corporate financing business with liabilities highly concentrated among 4-5 lenders.

The company changed strategies when Mr. V.Vaidyanathan from ICICI Bank (then considered one of the front runners for the top spot at ICICI Bank) picked up a stake in Future Capital and took over the reins to convert the business into a retail focussed entity. As the Future Group was looking to exit the business completely, Warburg Pincus purchased their stake and became the promoters of the business along with Mr. Vaidyanathan.

Excluding financiers run by large business houses, this is one of the rare Indian NBFCs where a senior member of management owns ~13% of diluted equity which creates a very strong alignment of incentives for long term shareholders of the business.

Capital First has financed 2.8MM customers (up from 13,000 in 2010) from ticket sizes ranging from INR 15,000 - INR 20M ($200-$300,000) across three product segments - consumer durable loans for requirements like personal computers, mobile phones, tablets, office furniture, air-conditioners; two wheeler/ motorcycle loans; and SME loans - largely backed by residential or commercial property as collateral although the company also provides shorter term unsecured working capital loans to creditworthy borrowers.

This is particularly interesting because these are all segments that remain deeply underserved across the Indian financing landscape - either because they are difficult due to evaluation of cash flows of smaller businesses and credit-worthiness of such customers or because of the low ticket sizes creating very high collection costs and thereby making it uneconomical for banks or larger financials to build meaningful AUMs. Additionally the lower ticket-size consumer durable loans have very short tenures (~8-10 months). This adds to the complexity of underwriting faster than the book runs-off while retaining underwriting standards in order to build larger and sustainable AUMs. Hence, the best businesses in these segments will be those which can acquire high quality customers inexpensively and retain & cross-sell to them. Typically these are segments that are easy to understand in principle but difficult to execute in practice. However, if executed well these businesses can be extremely profitable, especially with tail winds such as rising per-capita incomes, lower consumer durable replacement cycles, a growing market for white label and brand name goods, and a rise in organized retail.

Over the past ~6 years Capital First has been able to grow from 9 branches to 222; grow AUM 18x from $130MM to $2.5BN (the bulk of which is retail business). As business has scaled gross NPAs have fallen from 5.3% to 1.18% and net NPAs have gone from 3.78% to 60 bps. These numbers are available in the company’s latest investor presentation. In our view, the best years lie ahead because these are iterative businesses where underwriting continually gets better over time; operating expenses do not grow as fast as revenues and the segments they operate in remain underpenetrated and outside the preferred domain of several larger rivals.

Operating expenses as a percentage of revenue (net of interest expense) has fallen from as high as 75% two years ago (as the business was being built out rapidly) to ~50% now. Over the next 3 years we think this could settle between 37 - 40% given that the bulk of the physical and technology infrastructure has been built out. For example, the rate at which branches will grow over the next few years will be substantially lower than over the previous 5 years leading to lower increase in expenses, while business from existing branches will continue to grow meaningfully.

Interest margins will also continue to trend upward as the retail portion of the book continues to gain share and credit costs should remain in check as iterative processes improve underwriting capabilities. Given these tailwinds we find it possible that over the next three years revenues grow at ~22 - 25% while profits grow meaningfully faster at ~30 - 35%. This will propel ROEs from ~10% to closer to 14-16% over the next three years.

CAPF looks expensive currently trading at almost 38x LTM earnings of 166 crores (~25mm dollars, 1 crore = 10MM INR), but has a much better growth profile than some of the larger Indian Financials such as HDFC bank (which trades at almost 5.5x book). Although the stock has run up meaningfully in anticipation of positive factors (currently trading around 700 INR, up from 550 in July) getting increasingly appreciated, we believe it could compound capital from here for patient investors. The stock could continue to trade at a premium valuation given the growth runway and higher ROE combination creating confidence among investors in the business’ ability to truly compound capital by continuing to grow AUM and keep NPAs low. If so, it is quite possible for CAPF to earn ~550 crores ($83MM) 4 years out and hence be valued twice as much by the market three years out leading to a ~26% IRR.