Housing Finance Companies Rating: Buy – LICHF, Indiabulls Housing Finance, Dewan Housing; Neutral: HDFC
Structural drivers remain in place for mortgage growth in India with penetration still more than 50% lower than peers and cyclically we expect the funding environment to remain favourable. We upgrade LIC Housing to Buy (target price:R500) as we believe it is the sector’s biggest beneficiary of lower wholesale cost of funds. We initiate on Indiabulls Housing Finance (IHFL) and Dewan Housing Finance with Buy ratings as their consistent performance have led to continuous credit rating upgrades and the funding profile improvement should drive up their competitiveness in prime mortgages. Among larger housing finance companies, our top pick is LICHF and among mid-sized HFCs, we are more convinced on IHFL.
Structural story continues: With just about 8% mortgage to GDP penetration, and rising income levels, we expect 18% CAGR mortgage growth in India over the next five years. While competition has remained intense, large HFCs have gained share due to their competitive cost of funds and lower opex structure vs banks and smaller HFCs have built niches in funding low-cost housing (ticket size of less than R1.5m). HDFC/LICHF should continue to remain as the dominant players and we see smaller HFCs like IHFL graduate to become prominent in prime mortgages as their cost of funds become more competitive.
Cyclically funding environment favourable: We expect wholesale funding environment to remain favourable. While banks, especially PSUs, are re-orienting their focus to retail/mortgages, their ability to cut mortgage/base rates is lower than FY08-10 given their weak profitability (ROAs—return on asset—0.6-0.7% lower than FY09).For smaller HFCs like IHFL/Dewan, credit ratings upgrades should result in significant improvement in their funding profile and acceptance of their bonds. This should help offset any yield pressure on LAP (loan against property)
and drive up their competitiveness in prime mortgages.
Valuations and preferences: (i) Among large HFCs, LICHF’s valuations seem reasonable at 1.9x FY17F (forecast) book (BVPS—book value per share—R212) as improving margins should drive up ROEs (returns on equity) to 18-19% in FY17F. (ii) HDFC’s valuation at 3.6x FY17F book (BVPS: Rs 195) is above mean and hence we maintain Neutral. (iii) IHFL’s re-rating is likely to continue as ROEs at 27-28% are best in class, improving rating profile should offset any yield pressure and recent management steps to address weak perception of corporate governance is all positive. (iv) Dewan’s focus on low-cost housing is to its advantage and lower profitability vs peers is reflected in its valuation (1x book). Dewan’s use of cashflows have been inefficient in the past and improvement there should drive a re-rating.
Investment thesis—HFCs well placed: HFCs have been strong value creators in the past decade with 20-24% CAGR return driven by secular growth opportunities in the mortgage space. Given India’s low mortgage penetration levels (9% vs 15-20% for other markets); we believe the secular trend will continue. Mortgage funding is largely pricing sensitive, thus, only HFCs with the lowest cost of funds (eg, HDFC and LICHF) have consistently gained market share, despite competition from banks, as their low operating cost structure mitigates their cost of funds disadvantage.
Mid-sized HFCs moving to the next level on improved funding mix: Apart from HDFC and LICHF, a few HFCs have been operating in niche segments and have built successful business models around those niches. We believe the biggest opportunity for these mid-sized HFCs is to move into prime mortgages as this is still the largest part of India’s mortgage market. They have been able to move into this segment because their consistent financial performance has led to rating upgrades over the past two years. IHLF and DHFL fall into this category with IHFL’s credit rating (AA+ from Crisil) now being just one notch below HDFC’s and LICHF’s.
Rate cycle remains favourable; ability of banks to cut rates low: Cyclically we believe the funding environment will remain favourable for HFCs as system credit growth remains weak. Although banks are shifting their focus to mortgages and hence competition should intensify, we do not expect this to lead to irrational pricing given PSU banks’ current weak profitability. LAP, which contributes more than 20% of loan book for IHFL and DHFL, is seeing yield compression which could significantly impact their profitability. However, as explained above, their rating upgrades should bring down their cost of funds and help offset yield pressure in the LAP book.
Valuations reasonable: Given reasonable valuations, we upgrade LICHF to Buy from Neutral and maintain HDFC as Neutral. Among mid-sized HFCs, IHFL has best-in-class ROEs (27-28%) and has tried to address investors’ concerns over its corporate governance and this should drive further re-rating. DHFL operates in a good niche (low-cost housing) but may need to demonstrate better use of cash flows to see a meaningful re-rating.