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.
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 benefit—A 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 stocks—Both 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