HDFC Bank reported earnings of Rs 8.4 billion in quarter ending March 2010, up 33% year-on-year (YoY) and 2% quarter-on-quarter (QoQ). PBT was up 37% YoY and 7% QoQ. Owing to the impact of dilution, EPS growth was 24% YoY. The bank reported good earnings progression despite a significant swing in capital gains (from a Rs 2.4 billion gain in Q4FY09 to a loss of Rs 0.5 billion in Q4FY10); if we look at PBT ex- capital gains, core earnings almost doubled YoY. There was some benefit from recovery on some NPLs–but even if we account for that, the underlying earnings progression was extremely strong.

Valuations for this stock are not cheap (22.6x FY2011e earnings, 11.6x core PPoP and 3.6x book). However, with earnings growth much more assured than other Indian banks, we think the stock can continue to re-rate upwards. We maintain our OW rating on the stock and are raising our target price to Rs 2,400 ? implying 23% upside from current levels. At our target price, the stock would be trading at 20.8x one-year forward earnings.

In our view, HDFC Bank has made all provisions needed (and restructured loans are negligible) hence, it is the only large Indian bank with no legacy bad loan issues. Moreover, given that we are entering a new credit cycle, revenue progression should be extremely strong (strong loan growth and stable NIMs). This would cause core earnings growth to remain extremely strong. The other way to see the significant pickup in earnings is to look at segmental earnings. Last year retail banking was under pressure (due to higher credit costs) but the pick-up in treasury gains had helped support earnings progression. However, now retail earnings have moved up sharply?implying significantly higher earnings quality.

NII grew by 27% YoY and 6% QoQ: The sequential growth was driven by both volume growth (deposit growth 8% QoQ, loan growth 5%) and margin expansion.

Loan book grew at 27% YoY and 5% QoQ: This was well ahead of system loan growth of 17% in FY2010. On a sequential basis, the key drivers of loan growth were business banking, auto & CV loans and mortgages. Aggregate deposits were up 8% QoQ and 17% YoY with CASA ratio improving to 50% from 49% last quarter and 45% a year back.

Margins ticked up by about 10 bps QoQ: The bank saw a margin expansion of about 10 bps QoQ to 4.4%. HDFC benefited from a higher CASA ratio, downward repricing of high cost deposits, and the free funds effect of equity infusion. In Q1FY11, NIMs will likely decline by around 18-20 bps due to the change in savings deposit interest computation. Plus, there will also be some impact from higher CRR. However, for the full year we expect NIMs to be broadly stable (at FY2010 average levels) as loan pricing has improved and competition in some of the retail loan segments is likely to remain below levels seen in FY2006-2007.

Fee income hitting base effect: Fee income growth slowed to 7% YoY but was up 6% on a QoQ basis. The bank generated very high fees income in Q3FY09 and Q4FY09 ; this base effect affected the YoY growth. The quarterly trend indicates a meaningful pickup in fees income. We are building in fee income growth in line with loan growth for the bank.

Capital gains turn negative: HDFC recorded a capital loss of Rs. 0.5 bn vs. a gain of Rs 2.4 bn in the same quarter last year.

Costs under control: Costs increased by 7% QoQ, marginally ahead of core revenues, which were up 6% during the period. Core cost to income ratio was 47.3% compared to 51% last year and 46.8% a quarter back.

Asset quality continued to improve: If we look at the NPL creation, this decreased to about 0.5% of loans (annualised) from a peak of about 2.5% in June 2009. This enabled the loan loss provisions to continue declining. The bank reported loan loss provisions of less than 1% for the quarter (there was some benefit from recoveries). Given the sharp drop in NPL creation and no backlog from old NPLs, we expect that credit costs should continue to taper off for HDFC Bank in FY2011. We are now assuming LLP at 125 bps for both FY2011 and FY2012.

Target price: We arrive at our price target of Rs 2,400, using the base-case scenario in our residual income valuation model. This model has three phases —- a 5-year high growth period, a 10-year maturity period, followed by a declining period.