HDFC Bank

Investors with a one-year horizon can hold on to the HDFC Bank stock. Though the bank has sound financials, concerns about rising interest rates, higher cost of funds and compressing spreads have cut down valuations for banking stocks.

The stock has generated a 35 per cent CAGR over the past five years. One can only reap the benefit of this investment once inflation subsides and interest rates cool off.

HDFC Bank trades at a P/BV ratio of 3.6 and a price-earning multiple of 25 times its FY-08 earnings; and at a P-E multiple of 17 times and P/BV ratio of 2.5 times its FY-10 forward earnings.

Though the valuations look pricey compared to peers, they appear justified in the light of the consistent performance and superior margins. HDFC Bank, which was among the first new-age private banks, is now the seventh largest in terms of assets and third largest by market capitalisation.

The bank’s access to low-cost deposits, successful ventures into high-yielding businesses and sound risk management systems have helped it grow its net interest margins strongly in recent years.

Financials
The bank’s profit-after-tax has grown at a CAGR of 33 per cent from 2003-04 to 2007-08, driven by net interest income growth at 43 per cent and ‘other income’ growth of 47 per cent.

The net interest margin improved from 3.7 per cent in FY-06 to 4.3 per cent in FY-08, rating it the best even among private peers, while the gross NPA/advances was maintained at 1.2-1.3 per cent. The contribution of retail loans to the mix rose to 58 per cent in FY-08 from 46 per cent in FY-05.

For FY-08, the net revenue improved by 50 per cent mainly due to the profits on investments and ‘other income’. Operating expenses have increased by 50 per cent year-on-year with increase in employee costs and branch expansion; marketing costs and other operating expenses have also risen because of the growth in credit-card and retail businesses. Low-cost deposits (CASA)/total deposits stood at 54.5 per cent in FY-08. As HDFC Bank’s bond portfolio has a larger proportion in the held-to-maturity category (81 per cent in March 2008), the bank appears to have booked lower losses in the bond portfolio. Strong management systems to monitor credit, market and operational risks are also a plus.
Merger implications

HDFC Bank’s financial results for the June quarter were closely watched by the market, on account of the merger of Centurion Bank of Punjab (CBoP), which weren’t fully known.

The numbers showed growth in revenues offset by higher costs, with clear signs of earnings dilution. HDFC Bank’s net profit grew 44 per cent over last year, aided by total income growing at 60 per cent and net interest income at 75 per cent; this was mainly because of the increase in the size of the balance-sheet, post-merger. Higher provision for CBoP’s NPAs, higher employee costs and other integration costs of branches and technology appear to have driven up HDFC Bank’s cost-structure, with the cost-income ratio rising from 50 per cent to 56 per cent sequentially.

While CBoP’s provision coverage was at 55 per cent of NPAs (in the latest available financials for December 2007), HDFC Bank has maintained it at 67 per cent. The higher provision coverage of 67 per cent in the combined balance-sheet suggests that HDFC Bank has increased provisioning on the merged bank’s assets. HDFC Bank had to set aside Rs 77 crore for the mark-to-market loss of the bond portfolio.

Gross NPAs rose by 20 bps as a percentage of gross advances. Capital adequacy ratio has reduced to 12.2 per cent from 13.6 per cent, indicating the higher risks, post-merger. Though the merger has diluted HDFC bank’s balance-sheet in terms of low-cost deposits and NIMs, it is still better-placed vis-À-vis its peers.

Going forward, the key benefits for HDFC Bank from the merger will arise from CBoP’s presence in Kerala, several western states and Punjab, Haryana and Delhi.

Post-merger, HDFC Bank has access to 412 additional branches, a 50 per cent increase over the existing network, helping it to catch up with ICICI Bank in branch network. The merged bank has a strong presence in metros as well as in Tier-1, Tier-2, and semi-urban areas. The SME segment which contributes 19 per cent of the total advances is also a window of opportunity for HDFC Bank.

But CBoP’s larger exposure to retail advances (60 per cent), two-wheeler loans, commercial vehicle loans, personal loans and mortgage loans, may peg up credit risk for HDFC Bank, in a scenario of rising interest rates, where concerns about retail delinquencies are on the rise. Though HDFC Bank has started to go slow on retail lending, the exposure is already significant and any slowdown may impact overall growth. The bank hopes to complete the integration process by FY-09, with the full benefits of the merger expected to be reaped after FY-10.
Outlook and Risk

The conversion of warrants issued to HDFC (to maintain the latter’s stake in the bank), may be earnings-dilutive. The CBoP merger has offered HDFC Bank a substantial opportunity for inorganic growth, which may not be available to competitors. The bank already has a track record of successfully integrating Times Bank with itself in 2000. The bank’s ability to transfer its current efficiency to the acquired business will be a critical factor.

HDFC Bank also appears better-placed among its peers to manage higher reserve requirements and rate hikes, cost of funds and retain healthy NIMs.

The only real concern is capital adequacy, which has come down sharply. From a sector perspective, the key risks to earnings arise from further hikes in interest rates and unexpected increases in credit risk (NPAs), which could keep valuations depressed.