Earnings momentum is clearly back on track

Q1FY11 earnings: HDFC?s Q1FY11 earnings, at Rs 6.9billion, up 23%, were exactly in line with our estimates, but quality of earnings was much better led by topline growth (NII) of 34% YoY (year-on-year), driven by lower funding costs resulting in YoY spread increase by 15 bps to 2.34%. Volume growth also surprised, coming in at 23% YoY (adjusted for sell-down to HDFC Bank), although on reported basis, was only at 17% YoY. The most encouraging part was a strong retail disbursement growth, which was up 62% YoY (total disbursement growth at 25%). Fees disappointed (down +45% YoY) on the base effect of last year. Asset quality remains comfortable [gross NPLs (nonperforming loans) at 89 bps].

We have raised our earnings growth estimate by <2% for FY11/12. We expect earnings growth at +20-19% for FY11/12, factoring in warrants conversion, driven by volume growth of +22-23%. Asset quality is comfortable, with gross at <1.0%.

We believe HDFC is likely to deliver ROE (return on equity) of ~20% (post-warrant conversion; core RoEs of ~30%) on profit growth of 20%. Being a quality ?defensive growth? stock, the valuations for the stock to be more PE (price-to-earnings)-led than BV (book value)-led. We believe this is likely to become even more relevant as we begin to move into the ?growth phase? as buoyancy returns (demand). We also maintain our SOTP (sum-of-the-parts) Rs 819/share, despite headwinds in the insurance business, as any reductions in insurance value is likely to be offset by Ergo and Gruh Finance stakes of HDFC, wherein we have not assigned any value as yet. Hence, maintain PO (price objective) at Rs 3,350.

Key result highlights: HDFC reported loan growth at 17% (23% adjusted for sell-down to HDFC Bk). Also, the encouraging feature was individual segment that grew at 27% YoY against 12% in Q4FY10, indicating a positive momentum. Individual business for Q1FY11 was robust, with individual approvals growing by 56% and disbursements growing by 62% compared to the same quarter last year. The high growth rates are also partly reflective of a lower base in the previous year.

Spreads were up 15 bps YoY and 3 bps QoQ to 2.34% in Q1FY11. The increase in spreads is due to benefit from lower funding costs, especially from the bond source, as we estimate that cost from this source is down +170bps QoQ against the overall costs down by only +30bps QoQ. Non-interest income disappointed and was down 15% YoY to Rs 1.8 billion, partly due to the absence of any gains from the sale of investments, but overall the core fees were also down sharply (+45% YoY) on base effect as all players, including HDFC, were charging upfront fees to corporate borrowers, which is absent this year and also lower surplus from deployment in mutual funds (down +30% YoY).

Opex continues to be under check with cost-income ratio at 9.3% against 10.6% last year. In absolute terms, opex has increased by only 6.8% YoY. Incremental borrowings increased by Rs 32 billion, of which 54% came from bonds, 26% from deposits and the balance from bank term loans. Asset quality remains comfortable, with gross NPLs coming down by 9 bps YoY to 89 bps (but is up 10 bps YoY, which is seasonal). HDFC continues to carry more than double of required provisioning on its books. HDFC?s tier-I capital continues to be healthy at 13.6%.

Net profit to grow at +20% in FY11-12: Momentum is clearly back on track on the volume front and we expect this to continue through FY11. We estimate HDFC?s net profit likely to grow at +20% over FY11-12, supported by strong disbursal growth at +24-25% leading to volume growth of +22-23% in FY11 and spreads maintained YoY.

More importantly, we believe the ROE is also likely to sustain at +19-20% through FY11-12 after factoring in warrant conversion. Core ROEs are still at +30% in FY11. We are not giving HDFC the benefit of ?assigned interest? on the conversion money as the 7.5% cost of its Rs 40 bn NCDs (non-convertible debentures) are also being debited directly through the reserves.

Maintain PO at Rs 3,350; subs at Rs 819. We believe HDFC, trading at 3.4-3.5x FY11 adjusted BV, could continue to trade at similar multiples one-year forward adjusted book, given profit growth of +20% that is likely to sustain, excellent asset quality and RoEs of +19-20% by FY11 (core RoEs at ~30%). Maintain subs at Rs 819. We maintain our subs value at Rs 819, which includes life insurance value at Rs 230/share; HDFC Bank at Rs 870 and the balance is AMC (asset management company) business, at Rs 121, pre hold co discount.