HDFC Life Rating ‘Neutral’; Valuation is dear for buy of sub-par biz

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September 07, 2021 3:45 AM

Exide Life saw EV CAGR of just 8% over FY18-21; but deal size is not large and operating metrics could improve; ‘Neutral’ retained

With an improvement in persistency and operating leverages, VNB margins will materially improve over the medium term, in our view.

HDFC Life announced the acquisition of Exide Life on 03 September 2021 (subject to regulatory approval) for a consideration of Rs 66.9 bn (Rs 7.3 bn in cash and will issue ~87mn new shares to Exide Industries [EXID IN, Buy]). The acquisition is not large and will lead to a dilution of only 4.3%. The Exide Life acquisition will add: (1) ~10% to the EV; (2) 1.3% market share for HDFC Life; (3) 8-9% in APE; and (4) 34% to the agency strength.

But, we believe Exide Life’s business has been subpar, with: (1) 2% APE decline CAGR in the past three years; (2) opex ratio at 20% vs 12% for HDFC Life (FY21); (3) persistency ratios at 14-20% lower across buckets vs HDFC Life; and (4) EV growth of just 8% CAGR vs +20% CAGR for HDFC Life over FY18-21. Hence, we think paying 2.5x trailing EV looks expensive vs 3.2x-3.4x trailing EV for IPRU/SBI Life, which are far superior franchises.

Rationale for the deal
The key reasons highlighted by management for this acquisition are (1) Exide Life’s agency force (~36.7k agents); (2) strengths in tier-2/3 markets (especially in south); and (3) broadening of product suite. Management highlighted that the acquisition will not only provide a large agency network (34% of HDFC Life) but also help to improve its presence in southern geographies and tier-2/3 markets (contribute +60% of the business).

Further, despite VNB margins (post over-run) being in single digit for Exide life, HDFC Life will be able to improve the margins meaningfully with cost synergies, optimised product mix and improvement in persistency, in our view. That said, the improvement in margins should be more of a FY23/24F story –approval will take 6 months and further 12-15 month timeline for improvement in margins.

Strong currency permits to pay such a premium
While we see a possibility of operating parameters improving materially, we think valuation of 2.5x trailing EV is not justified for such a sub-par business, especially given that weaker players (beyond top 8) have been struggling. Peers like SBI Life / IPRU Life trade at 3.2x/3.4x trailing EV, but have strong brand positioning, largest banca distribution and significant scale advantage. That said, HDFC Life’s strong currency (trading at 5.1x trailing EV) does permit the company to pay a premium for such an acquisition especially given the small size of the acquisition (only 4.6% of its market cap), in our view.

Exide Life highlights
The merger should lead to EV accretion of ~10% for HDFC Life while EV growth of Exide Life has just been 8% over FY18-21F. Management highlighted that it does not expect a large adjustment on EV (<5%) and even remains well provided for COVID-19-related mortality costs.

Agency channel: The merger will add ~34% more agents to HDFC Life and the agency productivity will likely improve further with a broader product suite. HDFC Life has even in the past tried to strengthen its agency through the inorganic route. That said, number of agents has been declining by a 7% CAGR for Exide Life vs a 13% CAGR for HDFC Life over FY18-21.

Persistency remains significantly sub-par with 75%/41% (13th/61st month) for Exide Life vs 92%/54% for HDFC Life. Cost ratios remain elevated given a subscaled business with opex/premium at 20% for Exide Life vs 12% for HDFC Life. Product mix also remains largely skewed towards PAR (70%), while protection mix is reasonable at 11% (largely ROP). VNB margin, according to management, is in low single digit while pre-over-run VNB margins are comparable and product wise margins are also comparable. With an improvement in persistency and operating leverages, VNB margins will materially improve over the medium term, in our view.

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