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HDFC
Solid fundamentals but valuations expensive; initiate with UNDERPEROFRM
We initiate on HDFC, India’s leading mortgage financier,
with UNDERPERFORM and price target of Rs640.
It has strong fundamentals with current spreads higher
than historical averages, strong NIMs and superior asset
quality.
We believe HDFC’s rich valuations are fully pricing in
these strengths.
The stock trades at 5.8x P/ABV for FY12E, at a steep
premium to the market and to other bank stocks.
We value the core business at Rs390/sh and
subsidiaries at Rs250/sh.
Underperform rating on account of rich valuation – We
believe HDFC remains one of the best managed Indian
companies with a strong brand name and consistent track
record of strong earnings growth, improving margins and
robust asset quality. While these fundamentals are priced
into its rich valuations of 5.8x FY12E P/BV, we believe
current valuations are not fully factoring in the impact of
increased competition and rising cost of funds. We expect
earnings growth to slow to 15% for FY12E from 20% over
FY09-11E as we expect cost of funds to rise. 76% of
HDFC’s total borrowings are wholesale and more vulnerable
to rising rates than retail (household) borrowings.
Target P/BV of 4.8x – Our price target of Rs640 comprises
Rs390 for the core business and Rs250 for subsidiaries. We
have used sustainable RoE of 30%, RoA of 2.5% and cost
of equity of 12.5% to arrive at our target P/BV of 4.8x for the
core business.
Earnings not adjusted for interest on zero coupons –
HDFC charges interest expenses on its zero coupon NCDs
directly to shareholders’ funds. If we adjust for the cost of
zero coupon NCDs through the P/L, our earnings for FY11E
will be 7% lower.
Risks – Faster-than-expected rise in rates can impact loan
growth and spreads for HDFC and is the key downside risk.
Positive news flow on HDFC’s subsidiaries and higher than
expected capital gains are the key upside risks to our rating
and price target.
Investment argument and valuation
Consistent track record of earnings and superior asset quality
We believe HDFC remains one of the best managed Indian companies with a sound
management team, strong brand name and consistent track record of strong earnings growth.
Strong growth over the past ten years: Over the past ten years, HDFC’s reported earnings
have grown consistently at 19% p.a. Calculated spread on housing loans has improved from 2%
to ~3%. RoE of the core housing business (after excluding dividends from subsidiaries from net
profit, and, investments in subsidiaries from book value) has improved substantially from 21% to
30%. Gross NPLs have declined from 1.7% to 0.8%. HDFC has achieved the improvement in all
key performance parameters in a period when competition for housing loans has intensified.
HDFC performed better than peers on account of its strong risk management practices, economic
rather than competitive loan pricing policies, good customer service with quick application
turnaround times, and the use of innovative liability instruments (convertibles, zero coupon NCDs)
to keep a check on cost of funds.
Slowdown ahead with rising cost of funds and aggressive competition: After strong growth
of 19% p.a. over the past ten years and an even stronger growth of 26% yoy for 9M FY11, we
expect earnings growth to slow to 15% yoy in FY12E on the back of higher cost of funds.
Our earnings estimates do not factor in cost of zero coupon bonds
HDFC raised Rs40bn of non-convertible debentures (NCDs). HDFC has decided to charge the
interest on NCDs directly to the share premium account without taking it through the profit and
loss account. HDFC’s rationale is that the proceeds of the NCDs were used to infuse capital into
its subsidiaries. While these subsidiaries are market leaders in their business segments, HDFC
has not been able to fully capture the performance of these subsidiaries into its earnings. HDFC
Bank is amongst the most profitable banks in India. HDFC has paid an average rate of 7.9% on
its zero coupon bonds to increase its stake in HDFC Bank in FY10. However, the dividend yield
on HDFC Bank is low at 0.5%. Under the IFRS, HDFC is in a position to capture more upside
from profitable subsidiaries than under the current accounting standards of Indian GAAP.
Therefore under the Indian GAAP, HDFC has adopted the policy of deducting the interest
expenses directly through the profit and loss account rather than charge it through earnings, to
ensure that earnings are not unduly impacted.
Competition gaining strength now
Over FY03-06, when banks grew their mortgage portfolios aggressively, investors were
concerned that HDFC would lose market share and its margins would come under severe
pressure due to competitive pricing from banks. Over FY03-08, HDFC’s calculated spread on
housing loans improved from 2.2% to 3% and gross NPLs that were already lower than the sector
declined from 1.8% to 0.8%. On the other hand, NPLs on housing loans for banks remained high
at 3-4% in FY08. Also due to competitive pricing, some banks faced huge pressure on profitability
of home loans.
HDFC performed better than banks as management focussed on steady volume growth of 20-
25% against some banks who were chasing higher growth by lending for speculative purposes.
Banks relied more on distribution agents/mortgage brokers while for HDFC only 3% of loans were
originated by agents, which is why HDFC’s asset quality turned out to be better than banks’.
HDFC’s solid performance amidst intense competition addressed investor concerns about its
competitive position causing the stock to re-rate over the past five years.
While HDFC has withstood competitive pressures due to its robust risk management practices,
competition, too, has learnt from its mistakes. Banks are now working hard to control the quality
of their mortgages. Most banks are focussing on the salaried class. Banks like SBI that have a
funding advantage over other players are offering competitive rates on home loans to take market
share. ICICI Bank that saw a yoy decline in home loans over FY08-9M FY11 has again started
growing its retail mortgage portfolio. State-owned banks other than SBI, too, are focussing on this
segment as the incidence of NPLs for housing loans is lower than that for other retail loans.
HDFC Life likely to list in FY12E
All key subsidiaries of HDFC are performing well in their respective fields. HDFC Bank is the
second-largest private bank in India, HDFC Asset Management ranks among the top three AMCs
in the country and HDFC Life ranks third among private life insurers on new business premium.
Positive news flow on subsidiaries is likely to have a positive impact on HDFC’s stock price.
Management has announced plans of listing the life insurance subsidiary in FY12E. We believe
HDFC Life will be the first insurance company to list on the stock exchanges.
Valuation
Stock currently trades at peak multiples, expect it to trade lower as earnings have peaked
Our price target of Rs640 comprises Rs390 as the value of the core housing business and Rs250
as value of subsidiaries. We have used target P/BV of 4.8x to value the core housing business.
We have used sustainable RoA of 2.5% (current RoA is also 2.5% for 9M FY11), RoE of 29.8%
and cost of equity of 12.5%. We value life insurance based on the appraisal method. We have
valued the new business at 12x new business profit for FY12E. Our target multiple of 4.8x P/BV
is lower than what HDFC currently trades at.
At the current price, HDFC trades at 5.8x P/adjusted BV FY12E, higher than its previous peak of
5.7x in Jan ’08. Going ahead, we expect the stock to trade lower than the current multiple as we
believe earnings growth has peaked. Our target multiple is at a significant premium to the five
year average multiple of 3.7x. The stock deserves to trade higher than its five-year average as it
has delivered consistent and high-quality earnings in periods of volatile interest rates. The tables
below explain the derivation of our price targets for the core business and the subsidiaries.
Company profile
HDFC, India’s leading mortgage financier, ranks second by market share of individual home
loans after SBI, which has the largest portfolio of individual home loans. In addition to individual
home loans that account for ~65% of total loans, HDFC also provides loans to developers. HDFC
has also entered the non-mortgage businesses of insurance, asset management, and
commercial banking.
HDFC's distribution network spans 283 outlets that include 66 offices of HDFC's distribution
company and HDFC Sales Private Limited. In addition, HDFC covers over 90 locations through
its outreach programmes. HDFC's marketing efforts continue to be concentrated on developing a
stronger distribution network. Home loans are also sourced through HDFC Sales, HDFC Bank
Limited and other third-party Direct Selling Agents (DSA).To cater to non-resident Indians, HDFC
has offices in London, Singapore and Dubai and service associates in GCC countries.
Management team
Deepak S. Parekh, Chairman of HDFC is a Fellow of the Institute of Chartered Accountants
(England & Wales). He joined HDFC in a senior management position in 1978.
Keki M. Mistry, Vice Chairman & Chief Executive Officer of HDFC is a Fellow of the Institute of
Chartered Accountants of India. He has been employed with HDFC since 1981 and was
appointed as the executive director in 1993.
Renu Sud Karnad, Managing Director of HDFC, is a graduate in law from the University of
Mumbai and holds a Master's degree in economics from the University of Delhi. She is a Parvin
Fellow - Woodrow Wilson School of International Affairs, Princeton University, U.S.A. She has
been employed with HDFC since 1978 and was appointed as the Executive Director in 2000.
V. Srinivasa Rangan, Executive Director, holds a Bachelor's degree in Commerce and is an
associate member of the Institute of Chartered Accountants of India and Institute of Cost and
Works Accountants of India. He joined HDFC in 1986 and has served in Delhi and was the Senior
General Manager - Corporate Planning & Finance at Head Office since 2000.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
HDFC
Solid fundamentals but valuations expensive; initiate with UNDERPEROFRM
We initiate on HDFC, India’s leading mortgage financier,
with UNDERPERFORM and price target of Rs640.
It has strong fundamentals with current spreads higher
than historical averages, strong NIMs and superior asset
quality.
We believe HDFC’s rich valuations are fully pricing in
these strengths.
The stock trades at 5.8x P/ABV for FY12E, at a steep
premium to the market and to other bank stocks.
We value the core business at Rs390/sh and
subsidiaries at Rs250/sh.
Underperform rating on account of rich valuation – We
believe HDFC remains one of the best managed Indian
companies with a strong brand name and consistent track
record of strong earnings growth, improving margins and
robust asset quality. While these fundamentals are priced
into its rich valuations of 5.8x FY12E P/BV, we believe
current valuations are not fully factoring in the impact of
increased competition and rising cost of funds. We expect
earnings growth to slow to 15% for FY12E from 20% over
FY09-11E as we expect cost of funds to rise. 76% of
HDFC’s total borrowings are wholesale and more vulnerable
to rising rates than retail (household) borrowings.
Target P/BV of 4.8x – Our price target of Rs640 comprises
Rs390 for the core business and Rs250 for subsidiaries. We
have used sustainable RoE of 30%, RoA of 2.5% and cost
of equity of 12.5% to arrive at our target P/BV of 4.8x for the
core business.
Earnings not adjusted for interest on zero coupons –
HDFC charges interest expenses on its zero coupon NCDs
directly to shareholders’ funds. If we adjust for the cost of
zero coupon NCDs through the P/L, our earnings for FY11E
will be 7% lower.
Risks – Faster-than-expected rise in rates can impact loan
growth and spreads for HDFC and is the key downside risk.
Positive news flow on HDFC’s subsidiaries and higher than
expected capital gains are the key upside risks to our rating
and price target.
Investment argument and valuation
Consistent track record of earnings and superior asset quality
We believe HDFC remains one of the best managed Indian companies with a sound
management team, strong brand name and consistent track record of strong earnings growth.
Strong growth over the past ten years: Over the past ten years, HDFC’s reported earnings
have grown consistently at 19% p.a. Calculated spread on housing loans has improved from 2%
to ~3%. RoE of the core housing business (after excluding dividends from subsidiaries from net
profit, and, investments in subsidiaries from book value) has improved substantially from 21% to
30%. Gross NPLs have declined from 1.7% to 0.8%. HDFC has achieved the improvement in all
key performance parameters in a period when competition for housing loans has intensified.
HDFC performed better than peers on account of its strong risk management practices, economic
rather than competitive loan pricing policies, good customer service with quick application
turnaround times, and the use of innovative liability instruments (convertibles, zero coupon NCDs)
to keep a check on cost of funds.
Slowdown ahead with rising cost of funds and aggressive competition: After strong growth
of 19% p.a. over the past ten years and an even stronger growth of 26% yoy for 9M FY11, we
expect earnings growth to slow to 15% yoy in FY12E on the back of higher cost of funds.
Our earnings estimates do not factor in cost of zero coupon bonds
HDFC raised Rs40bn of non-convertible debentures (NCDs). HDFC has decided to charge the
interest on NCDs directly to the share premium account without taking it through the profit and
loss account. HDFC’s rationale is that the proceeds of the NCDs were used to infuse capital into
its subsidiaries. While these subsidiaries are market leaders in their business segments, HDFC
has not been able to fully capture the performance of these subsidiaries into its earnings. HDFC
Bank is amongst the most profitable banks in India. HDFC has paid an average rate of 7.9% on
its zero coupon bonds to increase its stake in HDFC Bank in FY10. However, the dividend yield
on HDFC Bank is low at 0.5%. Under the IFRS, HDFC is in a position to capture more upside
from profitable subsidiaries than under the current accounting standards of Indian GAAP.
Therefore under the Indian GAAP, HDFC has adopted the policy of deducting the interest
expenses directly through the profit and loss account rather than charge it through earnings, to
ensure that earnings are not unduly impacted.
Competition gaining strength now
Over FY03-06, when banks grew their mortgage portfolios aggressively, investors were
concerned that HDFC would lose market share and its margins would come under severe
pressure due to competitive pricing from banks. Over FY03-08, HDFC’s calculated spread on
housing loans improved from 2.2% to 3% and gross NPLs that were already lower than the sector
declined from 1.8% to 0.8%. On the other hand, NPLs on housing loans for banks remained high
at 3-4% in FY08. Also due to competitive pricing, some banks faced huge pressure on profitability
of home loans.
HDFC performed better than banks as management focussed on steady volume growth of 20-
25% against some banks who were chasing higher growth by lending for speculative purposes.
Banks relied more on distribution agents/mortgage brokers while for HDFC only 3% of loans were
originated by agents, which is why HDFC’s asset quality turned out to be better than banks’.
HDFC’s solid performance amidst intense competition addressed investor concerns about its
competitive position causing the stock to re-rate over the past five years.
While HDFC has withstood competitive pressures due to its robust risk management practices,
competition, too, has learnt from its mistakes. Banks are now working hard to control the quality
of their mortgages. Most banks are focussing on the salaried class. Banks like SBI that have a
funding advantage over other players are offering competitive rates on home loans to take market
share. ICICI Bank that saw a yoy decline in home loans over FY08-9M FY11 has again started
growing its retail mortgage portfolio. State-owned banks other than SBI, too, are focussing on this
segment as the incidence of NPLs for housing loans is lower than that for other retail loans.
HDFC Life likely to list in FY12E
All key subsidiaries of HDFC are performing well in their respective fields. HDFC Bank is the
second-largest private bank in India, HDFC Asset Management ranks among the top three AMCs
in the country and HDFC Life ranks third among private life insurers on new business premium.
Positive news flow on subsidiaries is likely to have a positive impact on HDFC’s stock price.
Management has announced plans of listing the life insurance subsidiary in FY12E. We believe
HDFC Life will be the first insurance company to list on the stock exchanges.
Valuation
Stock currently trades at peak multiples, expect it to trade lower as earnings have peaked
Our price target of Rs640 comprises Rs390 as the value of the core housing business and Rs250
as value of subsidiaries. We have used target P/BV of 4.8x to value the core housing business.
We have used sustainable RoA of 2.5% (current RoA is also 2.5% for 9M FY11), RoE of 29.8%
and cost of equity of 12.5%. We value life insurance based on the appraisal method. We have
valued the new business at 12x new business profit for FY12E. Our target multiple of 4.8x P/BV
is lower than what HDFC currently trades at.
At the current price, HDFC trades at 5.8x P/adjusted BV FY12E, higher than its previous peak of
5.7x in Jan ’08. Going ahead, we expect the stock to trade lower than the current multiple as we
believe earnings growth has peaked. Our target multiple is at a significant premium to the five
year average multiple of 3.7x. The stock deserves to trade higher than its five-year average as it
has delivered consistent and high-quality earnings in periods of volatile interest rates. The tables
below explain the derivation of our price targets for the core business and the subsidiaries.
Company profile
HDFC, India’s leading mortgage financier, ranks second by market share of individual home
loans after SBI, which has the largest portfolio of individual home loans. In addition to individual
home loans that account for ~65% of total loans, HDFC also provides loans to developers. HDFC
has also entered the non-mortgage businesses of insurance, asset management, and
commercial banking.
HDFC's distribution network spans 283 outlets that include 66 offices of HDFC's distribution
company and HDFC Sales Private Limited. In addition, HDFC covers over 90 locations through
its outreach programmes. HDFC's marketing efforts continue to be concentrated on developing a
stronger distribution network. Home loans are also sourced through HDFC Sales, HDFC Bank
Limited and other third-party Direct Selling Agents (DSA).To cater to non-resident Indians, HDFC
has offices in London, Singapore and Dubai and service associates in GCC countries.
Management team
Deepak S. Parekh, Chairman of HDFC is a Fellow of the Institute of Chartered Accountants
(England & Wales). He joined HDFC in a senior management position in 1978.
Keki M. Mistry, Vice Chairman & Chief Executive Officer of HDFC is a Fellow of the Institute of
Chartered Accountants of India. He has been employed with HDFC since 1981 and was
appointed as the executive director in 1993.
Renu Sud Karnad, Managing Director of HDFC, is a graduate in law from the University of
Mumbai and holds a Master's degree in economics from the University of Delhi. She is a Parvin
Fellow - Woodrow Wilson School of International Affairs, Princeton University, U.S.A. She has
been employed with HDFC since 1978 and was appointed as the Executive Director in 2000.
V. Srinivasa Rangan, Executive Director, holds a Bachelor's degree in Commerce and is an
associate member of the Institute of Chartered Accountants of India and Institute of Cost and
Works Accountants of India. He joined HDFC in 1986 and has served in Delhi and was the Senior
General Manager - Corporate Planning & Finance at Head Office since 2000.
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