Why the worst is yet to come for IRFC investors

Indian Railway Finance Corporation (IRFC) investors have seen better days. After years of stonking gains that earned them multifold returns, the stock is in peril, down nearly 40 per cent from its July 2024 peak. And yet, there's a good chance that the worst might not be over yet. That's because the growth challenge that it's been facing for over a year now has no end in sight. The company, however, is not sitting idle. It's making moves to pull itself out of the slump. We assess whether these efforts will make a difference.

But first, what is the growth challenge?

The last few years have been extraordinary for IRFC. It saw its assets under management (AUM) grow at a healthy pace (five-year growth of 18 per cent) as it funded Indian Railways' rapid capex spending and also received a steady stream of income from lease rentals. Further, not having to pay any taxes (exempted as per a government mandate) and having zero bad loans on the balance sheet, owing to sovereign-backed lending (since it lends to the railways), made it a low-risk business and one which has been a favourite for dividend investors.

However, the rapid growth is set to slow down along with the fat dividend payouts. The reason? The lender has not disbursed any fresh loans to Indian Railways for five straight quarters. Historically, IRFC's growth mirrored the capex cycle of Indian Railways, and that engine now appears to be stalling.

It's still keeping its AUM steady by adding to it interest on loans that are under moratorium. Meaning these loans (which form 46 per cent of its AUM) are not seeing any repayment yet, and IRFC will begin to receive the actual interest payments only after five years (post FY28).

Booking these interests to the loan book in advance creates a temporary illusion of stability. However, once repayments begin post-FY28, IRFC's AUM will begin to contract, dragging down both revenue and net profit.

So, what is it doing?

To combat this future stagnation, IRFC is diversifying into non-railway projects. Some of the new segments it has entered include:

• Green energy financing (it has disbursed loans to NTPC Green Energy).
  
• Coal logistics and railway-linked mining infrastructure (disbursed loaned to NTPC).

Management is confident that this pivot will unlock significant upside. It expects higher interest spreads—three to five times the 40-45 basis points IRFC currently earns on traditional railway loans. This, they roughly estimate, would mean that Rs 10,000 crore of new loans (non-railway) could deliver the same profits that Rs 30,000-40,000 crore of existing railway loans generate. Meaning no change in profitability despite lower AUM.

However, it will not be as rosy as the diversification strategy is not easy to execute.

Risks to IRFC's diversification strategy

1) Lengthy execution timeline. Currently, non-railway AUM is less than 1 per cent of the total. Scaling this meaningfully—while railway AUM potentially declines—will be an uphill battle.

2) Intense competition. In targeting energy and infrastructure lending, IRFC steps into a crowded segment. REC and PFC are already well-established players, offering similar lending rates of 6.25 to 8.5 per cent. To compete, IRFC may be forced to lower spreads, reducing the profitability of its new book.

3) Regulatory constraints. Even as the company is finding a way around it, it is still bound by its original regulatory mandate: it can only finance railway-linked infrastructure. This significantly limits the scope of its diversification compared to peers like PFC and REC that have broader lending freedom.

4) Tax and provisions. Until now, IRFC enjoyed a tax-free status. However, as it expands beyond sovereign-backed railway lending, it will begin to resemble a typical NBFC and will likely be taxed like one.

Additionally, lending to PSUs and private players, even in railway-linked sectors, introduces credit risk. This means IRFC may eventually need to create provisions for potential defaults, impacting its profitability—something it never had to deal with under its earlier, risk-free model.

Premium valuation without a moat

Despite the headwinds and its recent correction, IRFC trades at a P/B ratio of 3 times, while both REC and PFC trade below 1.5 times. This premium once reflected its near-zero risk profile, tax-free status and sovereign-backed lending model. But with no fresh disbursements to the Railways, rising dependence on moratorium loans and a pivot into competitive, higher-risk sectors, IRFC is losing that unique edge.

Its diversification efforts are still nascent, borrowing costs are in line with peers, and regulatory constraints limit flexibility. Add an inevitable slowdown in the loan book and profitability and the risk-reward seems unjustified at current levels. Unless IRFC can scale its new loan book profitably while maintaining asset quality, its premium valuation may not hold.

Also read: Why is the Aditya Birla Group entering new markets?