Prime Analysis: Impact of HDFC Merger & our recommendation

When good quality businesses get beaten down in the markets, unexpected corporate actions and events sometimes act as a trigger to their re-rating. The HDFC merger announcement of HDFC with HDFC Bank, which has sent HDFC’s stock soaring by 9% on April 4 (up over 20% from our recent accumulate call on March 10, 2022) is such a case.

The HDFC group has announced the merger of its housing finance company HDFC with HDFC Bank, at a share swap ratio of 25:42. Holders of HDFC shares on the record date will receive 1.68 shares in HDFC Bank, for every share. (Fractional holdings may be compensated in cash but such details need to be thrashed out later). Given that the deal requires regulatory approvals from RBI, stock exchanges, IRDAI, SEBI and CCI, apart from shareholders of the two companies, it is expected to be concluded in about 18 months’ time, by Q2/Q3 of FY24.

Until then, the two stocks will trade as separate entities on the stock exchanges. The declared swap ratio will ensure that the movements in one are mirrored by the other. Therefore, HDFC shareholders will need to closely track the financial performance of HDFC Bank and vice versa. After Monday’s moves, the HDFC share trades at Rs 2676 and the HDFC Bank share at Rs 1654, a ratio of 1.61, allowing marginal short-term upside for HDFC.

Based on current business prospects for the two entities, the HDFC merger with HDFC Bank appears quite advantageous to HDFC.

Positives of the HDFC merger with HDFC Bank

#1 Lower cost of funds

While HDFC has been reporting strong loan book growth in recent times on the back of home loan disbursals (individual loans up 48% yoy in April-December FY21), its margins have come under pressure from rising competition. With banks and NBFCs, apart from smaller HFCs competing aggressively for the secured loan pie, HDFC’s loan yields have fallen from 10.3% in FY19 to 8.1% in April-December 2021.

Cost of funds have not fallen at the same pace, leading to HDFC’s loan spreads shrinking from 2.30% to 2.26%. While HDFC’s market borrowings come at costs comparable with banks, its public deposits and are much more expensive. With the merger, HDFC’s public deposits and market borrowings could be replaced by lower-cost CASA, reducing its cost of funds below the current 5.83% and expand margins.

#2 Better yields

With a 5-year CAGR of 16%, gross NPAs of sub-2.5%, HDFC’s secured loan book with a 79% focus on individual home loans is one of the safest lending franchises. But the secured nature of this business makes for low yields. HDFC’s merger into HDFC Bank would help the housing finance lenders’ investors participate in HDFC Bank’s more diversified loan book consisting of higher yielding personal loans, corporate loans and micro loans, leading to better spreads and NIMs.

HDFC Bank’s NIMs have traditionally hovered at 4% plus compared to 3.5-2.6% for HDFC.  The merger won’t entail asset quality compromises either. Despite its diversified and higher yield loan book, HDFC has maintained its gross NPAs at sub- 1.5% in the past two years.

#3 Removes regulatory overhang

For the last couple of years, RBI’s tightening regulatory framework for NBFCs and HFCs has made for a negative overhang on these stocks. Since the IL&FS and DHFL failures, RBI has made no secret of the fact that it plans to more tightly regulate NBFCs, so that they enjoy no regulatory arbitrage relative to commercial banks. It has been true to its word, setting a higher bar on capital adequacy for NBFCs compared to banks, tightening NPA recognition norms and putting an LCR framework in place.

These changes have largely taken away the operational flexibility that non-banks like HDFC enjoyed, even as they have not had the CASA advantage available to banks. Recently bringing in scale-based regulation of NBFCs, RBI has clearly said that it expects large NBFCs/HFCs to eventually convert to banks. With the merger with HDFC Bank, investors in HDFC need not fear regulatory uncertainty.

# 4 Easier capital access

The post-merger HDFC Bank will be over three times the size of standalone HDFC and the combination will be the second largest financial institution in India after SBI. Sheer size and pedigree will enable the entity to enjoy easy access to bond markets at lower costs than now.

#5 Cross-selling opportunities

About 70% of HDFC’s customers do not bank with HDFC Bank and the same proportion of HDFC Bank’s clients do not have a mortgage loan with HDFC. This could present opportunities for the merged entity to significantly expand its customer base by cross-selling a wider range of products to the combined client case. HDFC shareholders will gain access to the bank’s pan-India, much larger branch network.               

The merger envisages the cancellation of the 21% equity shares held by HDFC in HDFC Bank, suggesting  the merger could be marginally EPS accretive immediately after the deal. On a proforma basis, HDFC estimates that the combined entity would report a book value of Rs 446 per share and EPS of Rs 67 per share based on current trailing financials.  

Negatives

#1 Slower growth

In becoming part of the bank from a pure-play housing finance company, shareholders of HDFC would be losing out on the opportunity to participate in the upturn and high growth potential of the residential real estate sector in India, which seems to be on the cusp of a turnaround. The sheer size of the merged entity also suggests that the 15-20% loan growth that the HDFC twins have regularly delivered may be a challenge post merger.  

# 2 Statutory obligations

In absorbing HDFC’s loan book into the bank, the combined entity will need to provide for SLR and CRR requirements at 22% of the acquired loans and also budget to set aside 40% of the loan book towards priority sector lending obligations, neither of which was required of the HFC. The SLR/CRR requirements, estimated at about Rs 80,000 crore presently offer positive carry given the difference between the cost of funds and g-sec rates, but will call for additional capital requirements.

The priority sector obligations which will require the merged entity to deploy about Rs 2 lakh crore in loans to specific sectors such as agriculture, MSMEs et al can prove a significant drag on yields too. HDFC’s affordable loan portfolio and the bank’s micro loan portfolio expansion may help, but it is quite likely that the bank will need to sacrifice on yields to fulfil the other priority sector obligations.

#3 Status of subsidiaries

The HDFC stock currently derives a significant portion of its value from its equity stakes in its bank(21%), AMC (69%), life insurance (48%) and general insurance (50%) subsidiaries. The merger will transfer these subsidiaries and associates to the bank, while cancelling HDFC’s holdings in the bank. The transfer of stakes will require regulatory approvals from RBI and IRDAI. In the past RBI has objected to direct holdings by banks in life insurance and general insurance subsidiaries. Forced divestiture of stakes could hurt stock valuation, moving them into a holding company structure will contribute to a holding company discount.

#4 Execution risks

While replacing HDFC’s public deposits with low-cost CASA, tapping into cross-selling opportunities etc look good in theory, they come with execution risks. The proliferation of deposit products may make it difficult for HDFC Bank to woo fresh CASA in short order to compensate for its sharp increase in size. Managing cross-selling of insurance or loan products in an over crowded market for retail loans may prove equally difficult. The merger also does little to mitigate recent concerns around HDFC Bank failing to keep up with competition on digital transformation to woo new age customers.

Overall, though the benefits of the deal in terms of scale and costs tilt in favour of HDFC, investors will need to watch out for actual execution and changes in business prospects over the next 18 months to gauge the true impact of this merger.

We continue to feature the HDFC stock on our buy list in Prime Stocks because we consider the HDFC merger deal an incremental positive for HDFC shareholders while the bank stock also offers upside from its current depressed valuations. Recent negativity about HDFC Bank missing the bus on digital initiatives has led to the stock being out-of-favour in the markets, with current valuations at about 3 times forward book value.