India Financials look attractive with HDFC-HDFC Bank mega-merger back in focus

Updated: Aug 11 2014, 15:39pm hrs
HDFC BankA potential merger of HDFC and HDFC Bank has been back in focus. (Reuters)
India Financials

Rating: attractive

A potential merger of HDFC and HDFC Bank has been back in focus. If it happened, it would create one of the biggest consumer lenders in EM Asia. We are Overweight on both the stocks. In this report, we present our analysis on the profitability of a combined entity, assuming a hypothetical merger were to take place.

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Recent RBI moves on the reserve requirements for affordable housing have raised prospects of a merger

These initiatives should reduce regulatory drag if a merger were to happen. Both company managements have said that reserve requirements have been a hurdle to a merger and they would have to study whether RBI moves have addressed this. As of now, no discussions between boards have taken place.

If a merger were to occur, we believe both entities stand to benefitA key concern with HDFC has been how long can it keep growing at its current pace funded by wholesale lenders a merger would remove that problem. On the other hand, HDFC Bank would gain access to mortgages, insurance, and asset management. Synergies are not obvious on the cost side but capital usage could improve materially (given lower risk weights, the Bank could lever much more than HDFC).

A self-sustaining ~25% ROE (return on equity) business is possible (FY15 ROE for HDFC Bank is 23% and for HDFC is 21%)We have presented scenarios for different prices at which HDFC merges with HDFC Bank assuming current prices, long-term ROE would be 25-26%. Even in the first full year of a merger, FY16, ROE could be in excess of 20%. High ROE would imply that the growth can be funded through internal capital generation.

We are Overweight on both stocksBoth entities are entering a pickup in the economic cycle with pristine balance sheets (few bad loans and well capitalised) implying EPS growth could be well in excess of 20% for the next 2-3 years. This, coupled with attractive multiples, should help the stocks do well. We raise the target price of HDFC by 5% to reflect the 6M (six months) roll forward.

Who gains more Given that the profitability of the combined entity is more than either of the two entities, driven by better capital utilisation, our view is that the shareholders of both businesses will benefit from a combination. Among the two, HDFC is a bigger beneficiary. Currently, investors are unsure of how long will the 20% per annum growth rates continue at HDFC, given the wholesale nature of its funding. Hence, any move that removes/reduces that problem will help the stock.

HDFC has lagged the bank materially over the last five years given the lower long-term growth profile. Some of this underper formance could reduce. We have seen signs of this in the last two weeks since the RBI announced the forbearance on affordable housing HDFC has outperformed the bank by 6-7% since then.

Rationale for a merger

HDFC Bank was created by HDFC when RBI issued new bank licences in the mid-1990s. Given the success of HDFC Bank in terms of becoming a well-run bank, investors have constantly asked whether the two should merge to create one entity. This is especially true given that the other big private bank, ICICI Bank, had merged with its parent ICICI in 2002. However, both HDFC and HDFC Bank have always said that reserve requirements were a big hurdle to any merger. A combined entity could potentially offer a number of positives for both businesses, in our view. The primary areas of benefit include the longer-term growth outlook at HDFC, the product suite at HDFC Bank and effectiveness of capital utilisation at the two entities. We discuss these in more detail below:

(i) Sustainability of growth and profitability for HDFCs mortgage lending business could improve owing to access to stable source of fundsHDFC is clearly the strongest mortgage underwriter in India, measured in terms of profitability across cycles and its asset quality. This, coupled with the fact that the mortgages to GDP ratio in India is only 8%, implies that longer-term growth potential on asset side is immense for HDFC. However, the question we have often been asked by investors on HDFC is the sustainability of funding. Its essentially a wholesale-funded business. While the rating of HDFC is AAA, the concern has been whats the size of assets that wholesale funding can sustain in the very long run. To an extent, the de-rating of the stock over the past two years has been driven by this concern. If it becomes a bank, the balance sheet could start being funded by more retail deposits. This, in our view, could help regain the premium multiples as investors pay up for a better longer-term growth profile.

(ii) Lower cost of funding for HDFC Bank borrowings constituted ~16% of borrowings for HDFC as of June 2014. The annualised cost of bank borrowings is currently running at 10.5-10.75%, while bank retail term deposits are currently priced at 9%. Also, deposits constituted 32% of borrowings. These are typically priced 25-50 bps higher than rates offered by banks and also there is a sourcing fee that is paid to agents. There would be an opportunity to save on these costs upon becoming a bank. The other benefit would be any additional CASA that the merged entity could get as HDFC Bank gets more mortgage customers (which is the stickiest product from a retail customers perspective).

(iii) Potential to lever up the mortgage lending business could increase Even though the theoretical leverage for a retail mortgage lending business can be high given the low-risk weights on retail mortgages (50% up to R7.5 million), large housing finance companies are constrained on leverage (assets/equity) being predominantly wholesale-funded entities, and given the need to maintain an AAA rating to be able to raise cheap funds. Holding finance companies (HFCs) also have limited access to retail deposits (up to 5 times of net owned funds). Banks, given unlimited access to retail deposits and to the RBI liquidity facility, can lever up their balance sheets more. As a bank, the combined entity would be able to lever up almost 18-20 times on mortgage business. The benefit could increase multi-fold if risk weights on retail mortgages were lowered further in India over the longer term.

(iv) For HDFC Bank, a merger with HDFC would potentially offer access to some of the large businesses such as mortgages, insurance and asset management. While HDFC Bank does have an agreement to buy mortgages from HDFC, the size of its mortgage book is still small6% of total loans as of June 2014. This was driven by the fact that HDFC retained some spreads on the loans sold down to HDFC Bank. As a combined entity, they would get HDFC Banks distribution and HDFCs operational expertise (<10% cost income ratio; 4-5 bps credit cost) which would help them gain further market share in mortgages.

(v) The merged entity could be a self-sustaining model Based on our calculations, the combined entity would be able to fund growth from internal capital generation. We look at the amount of capital which the combined entity would consume every year to grow risk-weighted assets at about 20% a year. We then look at the retained profits assuming an average of 25% dividend payout ratiothis implies that by F18, most of the capital consumption can be funded by retained profits implying no further need for capital issuance.

(vi) It could reduce volatility on credit costs for HDFC Bank Given that bulk of HDFC Banks loan book is non-mortgage consumer loans, the volatility in credit costs is fairly high. On the other hand, the actual credit losses for HDFC over the past four decades have been close to zero. A merger would reduce the volatility in loan losses. An example would be if we look at the proposed dynamic provisioning (DP) framework in India. In its draft document on DP, the RBI had said that non-retail housing would attract provisioning at 267 bps a year and housing loans at 27 bps. This was the system average and specific banks will probably be allowed to use their own models. But an HDFC-HDFC Bank merger could reduce the risk of a sharp spike in provisioning due to DP.

Applying the RBI formula on HDFC Banks loan book would imply DP of ~145 bps for HDFC Bank, but ~105 bps for the merged entity. If it were allowed to use its own models, then the credit costs could be much lower.

Morgan Stanley