HDFC BANK: Buy, Hold or Sell?

A close to 15% correction in the stock of HDFC Bank post the company’s results triggered very divided questions from some of you – whether the correction is a good opportunity to buy or whether one should book losses and exit. This report will analyse the reason for the fall and what are the prospects for the stock, with our recommendation on it. 

We had moved the stock of HDFC Bank to Hold from Buy after the merger announcement (read our detailed report on it here) of HDFC with HDFC Bank – comprising financial integration, regulatory approvals, balance sheet challenges, etc.

We encourage you to read it first to get a more detailed picture of our views on the merger. As some of the things we wrote are playing out at this point of time, we are now moving the stock to a Buy.

Q3 results, what’s the disappointment?

HDFC Bank stock plunged 15% in a week after the company announced its Q3 results, reporting 35% growth in net profit over the same quarter last year.  So, what was there to complain after a 35% growth?

If you look one line below the PAT you will know the reason for the market’s negative reaction. The Earnings per share (EPS) remained flat (EPS of Rs.21.98 VS EPS of Rs.21.56) as opposed to the same quarter last year. Adjusting for lower taxes and exceptional items the EPS decline would have been more pronounced. For HDFC Bank, EPS gives a better sense of its growth post-merger, as the share capital has expanded. So the per share earnings you derive on an expanded capital base would tell you the real growth. 

Let’s go a bit in detail in to Q3 results. The first line on a banking earnings is the Net Interest Income (NII) and the ratio Net Interest Margin (NIM) reflects how good a bank is in generating Income from its assets (advances). 

This ratio has come as a disappointment in Q3 at 3.6% Vs the expectation of 3.8% (a natural contraction was already expected on account of merger from 4.3% to 3.8%). The key driver of NIM, deposits (cost of funds), has come as a challenge as the bank fell short of deposit mobilisation. Overall CASA grew at 9.5% in this quarter (growth in retail, de-growth in wholesale) as compared to 24% growth in NII and 35% growth in net profit on a year-on-year basis. 

If we break down Q3FY24 further as compared to the preceding quarter (Q2FY24), credit grew at ~5% during the quarter, but deposits grew at ~2%. The bank also monetised some of its liquid investments during the quarter to compensate for lower deposit growth to fund its credit growth. 

This is what unnerved the street – raising concerns on how the bank would fund its incremental credit growth going forward without growing its deposits. This is even more critical for HDFC bank, given that it needs to mobilise additional deposits pursuant to the merger.

Deposit forms the base for credit growth and is technically reflected in the ratio called credit deposit ratio. This ratio was at 110% for the bank in Q3FY24 Vs 87% prior to merger and 85-90% in general for the peers. While the elevated ratio was not unexpected pursuant to merger, the bank was expected to make up with higher deposit growth. That did not transpire this quarter. 

From a narrative that HDFC bank would create another HDFC bank every four years at the time of merger, there is now a big question over its very growth at this point of time, primarily emanating from the deposit mobilisation challenge. The inability of the bank to open branches at the pace it initially guided for (a key channel for deposit mobilisation) also added to the woes.

So, from a linear growth story, it now turns to a re-adjustment phase where the bank will have to tweak its growth rate to get its credit – deposit mix right before pressing the pedals to create another HDFC bank. 

Let’s understand this a bit in detail with the help of numbers and what are the options available for the bank at this point.

A readjustment phase for HDFC Bank

First, the merger has brought in a structural change to the bank’s advances and margin profile. Now mortgage loan has become a significant share of book (25%) from low single digits earlier while this mammoth addition has reduced the other retail book also to 25%, taking the overall retail book at 50-51%. Since home loan book comes with a lower yield, it was expected to have an impact on the NIM of the bank, naturally, while the RoA was expected to be in-tact (compensated by lower cost).

The merger also came with lot of borrowings inherited from HDFC as it was an NBFC that was predominantly relying on borrowings. This is reflected in spike in borrowings, which the bank must eventually replace with deposits.

Here’s a quick glimpse into what HDFC Bank balance sheet was Vs what it is. 

Now let’s again look into the issue of deposit mobilisation and how it is related to growth and the sell-off that happened in the stock.

From the numbers, you can see that, prior to merger, the credit to deposit ratio was 87% and post the merger, credit to deposit is 110% as we can see from above numbers. This was not unexpected as pointed out earlier, but there is so much attention on this as deposit mobilisation has become a challenge for the industry as a whole and after regulator’s emphasis on this recently. 

Moving back to 87% credit to deposit means the bank will have to mop up additional deposits of ~Rs. 7 lakh crore in next one year, after building 15% growth on either side (not considering that it has to park 18% in SLR as well). 

Organically, when deposits are growing at 10-13% in the industry, HDFC Bank can mop up to Rs. 3 lakh crore in the normal course without getting aggressive, but its requirement is more than twice that. This leaves it with two difficult options that would eventually hit its profitability: 

1. Either slow down credit growth to gain control of credit deposit ratio, which will hurt credit growth and in turn PAT growth OR
2. Continue credit growth with aggressive deposit mobilisation (paying higher rates) which will hurt NIMs and in turn PAT growth (but will protect its market share).

Either way, PAT growth may take a hit in the short to medium term. This is something that we acknowledge and factor in. However, we see them as events that the bank has to go through to get better, eventually.

Hypothetically, if HDFC bank grows credit at 10% (5% lower than industry) and deposits at 18% (5% higher than industry), it can achieve 89% credit to deposit ratio in next 3 years. This could be a re-adjustment phase where credit growth may be lower than deposit growth and PAT growth may take a hit based on what path it takes. 

This is just a hypothetical scenario which the bank may tweak either side. There are talks of bank doing asset sales through securitisation.

What could happen in real world scenario is that Year 1 will have more pain (current year), Year 2 can look better on the equation and things could even normalise in Year 3 as the management can tweak the growth rates on either side accordingly. It is quite OK to have a credit deposit ratio of 90% in Year 3 and still grow advances at industry growth rate and keep this ratio elevated for 2 or 3 more years. Management may not even plan to take it back to 87% that they had pre-merger. 

Market participants are also making their own assumptions at this point of time, leading to divergent opinions. A guidance from management on this front will be appreciated (may be possible along with Q4 results) by the market and could bring consensus back in the street, while removing uncertainty. In other words, a clear path to reducing Credit Deposit ratio and which metrics they will cut down on to achieve the same – will be appreciated.

After the adjustment phase, which could happen in not more than 12-18 months, growth could head back to normal rates and PAT growth will also start mirroring credit growth, whether it is 15% or 18% or 20%. This is our hypothesis, based on whichever metric is compromised for a while. We think this near-term pain is captured in the valuation, leaving room for upside. That is the primary reason for our shifting the stock to a Buy.

What’s in store at this price?

At this price, the bank is available at 2.5 times price to book value on a standalone basis.

The total valuation of its subsidiaries (HDFC Life, HDFC Ergo, HDFC Asset Management & HDB Financial) is anywhere between Rs.140 to Rs.180 per share as per various estimates (at an appropriate discount), which equals to 10-12% of the current valuation of the bank.

(We are not getting into detail on this as all the subsidiaries have proper valuation discovery either because they are listed or their peers are listed. So, their valuation estimates are unlikely to vary beyond this band)

Adjusted for this, the bank is available at 2.3 times price to book at the end of Q3FY23 (Book value of Rs.556 per share, standalone). The sudden sell-off and valuation contraction has already factored in earnings growth moderation in the short to medium term. 

Before this, it is only in March 2009 that the bank has traded at lower price to book while it has largely traded at 4-5 times book in the last 15 years. However, we do not wish to go by the past valuation as it may no longer be fully relevant. 

The structural changes in the business mix, size of balance sheet and lower growth rates than in the past may result in permanent moderation in valuation towards 3 – 3.5 times book. But we think for a buyer at this point of time, it leaves 20-25% upside on book value alone once things normalises for the bank. ICICI bank trades at 3 times book.

If we go back to any period in history in the last two decades, this is a bank that has commanded superior RoA throughout, derived from best-in-class metrics on each core driver of RoA (NIM, cost of funds, cost-to-income-ratio and asset quality). 

This makes it a compelling investment opportunity for both quality and value seeking investors with a long-term view.

Are there alternate options?

If you are a short to medium term investor, there may be options available in this space where growth is higher than the industry growth rate, but unlikely to see a re-rating in book value (Say, ICICI or IndusInd or Federal) as it has already happened.

That means we do not think there is phenomenal returns there, at the current valuation at which the other stocks are trading. So, the returns in such cases can be equivalent to their credit growth rate, which could be the PAT growth rate as well. And it may also come with little compromise on quality.

If you are a long-term investor with enough patience, HDFC may offer book value re-rating as well as earnings growth once this situation stabilizes. 

Suitability

If you are already holding HDFC Bank at much higher price and your exposure is low, you can accumulate, provided you have a long-term view. Expect pain in the short term. If you are a new investor, this opportunity will fit you only if you have patience. This is not a multi-bagger call. Rather it can be (as it was earlier) a steady earnings compounder, but only after the current pain is over. 

Disclosures and Disclaimers

The following Disclosures are being made in compliance with the SEBI Research Analyst Regulations 2014 (hereinafter referred to as the Regulations).

1. PrimeInvestor Financial Research Pvt Ltd is a SEBI-Registered Research Analyst having SEBI registration number INH200008653. PrimeInvestor Financial Research Pvt Ltd, the research entity, is engaged in providing research services and information on personal financial products. This Research Report (called Report) is prepared and distributed by PrimeInvestor Financial Research Pvt Ltd with brand name PrimeInvestor.

2. PrimeInvestor Financial Research Pvt Ltd, its partners, employees, directors or agents, do not have any material adverse disciplinary history as on the date of publication of this report. 

3.  I, N V Chandrachoodamani, author/s and the name/s in this report, hereby certify that all of the views expressed in this research report accurately reflect my/our views about the subject issuer(s) or securities. I/We also certify that no part of my/our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report. I/we or my/our relative or PrimeInvestor Financial Research Pvt Ltd do not have any financial interest in the subject company. 

I/we or my/our relative or PrimeInvestor Financial Research Pvt Ltd do not have beneficial ownership of 1% or more in the subject company at the end of the month immediately preceding the date of publication of the Research Report. I/we or my/our relative or PrimeInvestor Financial Research Pvt Ltd do not have any material conflict of interest. I/we have not served as director / officer, etc. in the subject company in the last 12-month period.

4.  I, N V Chandrachoodamani, do not hold this stock as part of my investment portfolio. I/analysts in the Company have not traded in the subject stock thirty days preceding this research report and will not trade within five days of publication of the research report as required by regulations.

5.  PrimeInvestor Financial Research Pvt Ltd has not received any compensation from the subject company in the past twelve months. PrimeInvestor Financial Research Pvt Ltd has not been engaged in market making activity for the subject company.

6.  In the last 12-month period ending on the last day of the month immediately preceding the date of publication of this research report, PrimeInvestor Financial Research Pvt Ltd has not received compensation or other benefits from the subject company of this research report or any other third-party in connection with this report.

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