Royal Bank of Scotland: HDFC - Good show, but priced in

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HDFC Ltd 
Good show, but priced in 
HDFC Limited delivered in-line core earnings for 3QFY11. The pre-emptive buildup of liquidity and possible deployment of such in the near term should help
alleviate margin pressure. The momentum in individual loan growth was a
pleasant surprise. However, core business valuations still appear rich. Sell.
3QFY11: Core earnings in line with loan growth; strong growth in individual loans
HDFC Limited posted 20% yoy net interest income (NII) growth for 3QFY11, on the back of
20% yoy loan growth. NII remained flat qoq while loans grew about 3% qoq, implying some
pressure on spreads. Reported spreads were 2.33% in 9MFY11 (2.34% in 1HFY11). Net
profit of Rs8.9bn was higher than our estimate on account of the Rs1.7bn profit on the sale of
investments. Individual loans continued to grow sharply (see Chart 2) and loan mix remained
largely stable

Pre-empting the interest rate cycle aids near-term margins
As of September 2010, HDFC Limited had excess liquidity of Rs64bn on its balance sheet
(about 6.0% of interest-bearing liabilities) parked in liquid funds and commercial paper, which
has come down to about Rs32bn as of December 2010 (3.0% of interest-bearing liabilities).

Absolute net loan book growth during 3QFY11 was Rs27.6bn. In the near term, further
deployment of this float would aid margins. The three-month certificate of deposit rate (CD)
has gone up 150bp qoq and 465bp yoy to 9.1%, while the one-year CD has gone up to 9.8%
(up 145bp qoq and 380bp yoy). In general, limited pricing ability due to competition and a
sustained flattening of the yield curve will put pressure on margins.

We charge off interest on ZCBs to the income statement
NII increased 29% yoy in 9MFY11, on the back of 20% yoy growth in loans. However, this
excludes interest of Rs3.9bn for 9MFY11 on account of premiums payable on zero-coupon
bonds (ZCB) charged off against the securities premium account. Our annual NII estimate is
after adjusting for actual interest on ZCB (FY10) and the estimated annualised impact of
interest on ZCB (FY11-13) of about Rs5bn annually (pre tax).

All looks good, but valuations of the core business still appear stretched; Sell
At the current market price, the core mortgage business of HDFC Limited trades at 4.5x
FY12F book value, after factoring in its conversion of warrants (see Table 2). We maintain
our Sell rating on HDFC Limited, due to rich valuations. We increase CoE to 14% and
terminal RoE to 17%, leading to a slight increase in our core business valuation, offset by a
decline in market value for listed associates/subsidiaries. Thus no material change to our TP.