Macquarie Research:: HDFC- The last bastion falls Structural de-rating in the making; Downgrade to UP

HDFC
The last bastion falls
Structural de-rating in the making; Downgrade to UP
We downgrade HDFC Ltd to an anti-consensus Underperform rating from
Outperform with a TP of Rs550, which offers 17% downside. We believe a
structural de-rating is likely because the quality of earnings and ROE reported is
being driven more by its corporate book and aggressive accounting practices.
Mortgage profitability is declining structurally and regulations have become
adverse. All this would make it tougher for HDFC Ltd to sustain its super-normal
multiples/valuations. Though near-term catalysts are absent, the de-rating call is
more a longer-term view as the stock appears fundamentally overvalued.
ROE driven by corporate book; getting riskier structurally
Over the past eight years, HDFC has increased the share of the corporate book
(loans to real estate developers, lease rentals etc) in the overall loan portfolio
from 29% to 37%. The issue is that housing loan profitability has been falling
structurally and the company has been resorting to higher-risk non-retail
categories to drive up ROE. We estimate the non-retail book now generates
more than 30% of ROE and contributes more than 65% to HDFC’s profits.
Retail housing loan profitability falling structurally
Over the past several years, competition in retail housing has picked up, and
some of HDFC’s peers have grown at exceptional rates. The premium product
pricing that HDFC Ltd used to enjoy no longer exists. Competition is intense and
likely to increase since banks have limited opportunities in the corporate
segment this year. Retail business ROE has also been affected by regulatory
changes and we estimate the retail business now generates a poor ROE of
around 13-14% compared with 20%-plus five years ago.
Accounting practices used to inflate earnings and ROE
Over the past two years, HDFC Ltd has been adopting aggressive accounting
practices by passing provisioning through reserves and also making the
adjustments for zero-coupon bonds (ZCBs) through reserves. We believe FY11
and FY12 earnings are overstated by 38% and 24% respectively and reported
ROE would have been 600 and 400 bps lower at 16% and 18% respectively if
the adjustments had been made through the P&L. In other words, earnings
growth has been managed, in our view.
Regulations – another overhang
We also think investors are underestimating the longer-term implications of
regulatory changes and consequently this also presents a strong case for derating
in our view. The regulator has increased the provisioning requirements,
has banned pre-payment charges, and asked for re-alignment of rates for old
and new customers, all of which could have an impact, especially in a predatory
pricing environment. We also expect capital requirements to be increased,
similar to the banking and NBFC sector, and this is one big event risk (with a
high probability of happening) that the market is not factoring in, in our view.
TP cut by 30%, driven by sharp cut in multiples
We cut our TP by 30% to Rs550 on account of a sharp reduction in our target
multiple. We are now valuing the core business at 2.0x P/BV compared to 4.0x
previously. The reduction in multiple is on account of: i) lower retail business
ROE driven by lower spreads in the retail business and higher capital
requirements; and ii) a sharp reduction in corporate business ROE driven by
factoring in credit losses and higher capital requirements.

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