Earnings outlook for the core mortgage lending of HDFC is set to improve following sluggish growth over FY14-16. The intrinsic value of the stock would also get a fillip from the recent acquisition announced by the life insurance arm, driven by strengthening market position of the business and potential for unlocking synergies. Under-valuation of the core mortgage lending franchise, improving outlook for the same, and upside to the value of life insurance business from the merger are key catalysts for HDFC’s stock price, in our view.
Boost to the life insurance franchise from acquisition
HDFC Life (HDFCL) and Max Life Insurance (MLI) announced their intention to merge their life insurance franchises to create the largest company among the private sector insurers. The merger would complement the strengths of both players and offer significant potential to unlock synergies. Valuation of the life insurance business is set to get a boost from the combination for the above-mentioned reasons.
Improving outlook for the core mortgage lending franchise
Earnings outlook is set to improve over FY16-19ii, led by improvement in the operating environment. We cut our headline EPS forecast by 2-5% for FY17-18ii mainly to reflect the additional contingency reserves that the management chose to undertake. The franchise enjoys significant positive operating leverage and has the potential to drive stronger earnings growth over FY16-19ii.
At an inflection
Implied valuation for the core lending franchise suggests significant moderation over the past 12 months, mainly due to sharp deceleration in its earnings growth. A turnaround in outlook, fillip to the value accruing from the life insurance franchise due to the acquisition, and under-valuation of the lending franchise point to significant upside potential over the next 12 months. We raise our 12-m target price to R1,450, which presents 16% upside to CMP.
A bigger and stronger franchise
The merger combination announced by HDFCL and MLI is set to make the merged entity a market leader among private sector insurers with a well-balanced product mix of non-unit linked and linked products in its stable. The merger will bestow the company stronger distribution architecture across agency and bancassurance tie-ups too.
HDFCL brings to the merger combination a balanced product portfolio mix, niche position in few product markets, leadership position in direct sales initiatives, and higher operating efficiency. MLI brings a strong market position in participating product segment and established tied agency network to the merger. Both enjoy strong bancassurance partnership and robust financials. The combined entity would aim to build on the strengths of the two entities’ unique distribution capabilities, improve operating efficiency and consolidate market position further.
The acquisition would be consummated by merging HDFCL into MLI. Prior to this, MLI would merge into Max Financial Services (MFS), which serves as a holding company of MLI presently. The combination would be achieved through share swap. Through this process, HDFCL would achieve its listing objective. The process would require approval from multiple regulators such as IRDA, SEBI, and CCI, and from the courts. Given the multiplicity of approvals involved, the transaction is likely to be consummated by Q4FY17 at the earliest. Boost to the valuation of merged entity is likely. The swap ratio for the merger between HDFCL and MLI would be announced once both the parties complete due diligence and propose a definitive agreement. In the interregnum, it cannot be inferred from stock prices too as HDFCL is an unlisted entity. Without a definitive swap ratio for the merger, at this juncture, a range of values could be envisaged. This includes higher swap ratio in favour of MLI or a swap ratio in proportion to the EV of the respective companies. The former case could be justified through an acquisition premium paid by the acquirer while the latter case could be justified based on the underlying fundamentals of the businesses.
We derive the valuation range using benchmarks established through divestment in favour of financial investors as well as implied P/EV multiple of MLI before and at the time of announcement of exploratory arrangement for merger combination. The best-case scenario represents the value based on current P/EV of MLI. The lower threshold would suggest premium for MLI as a target. The median and the best case do not consider any such premium, given superior financial metrics of both HDFCL and MLI and larger economies of scale of HDFCL.
Whole is greater than SOTP
The merger combination would bring together two players who have created a superior franchise and would complement the strengths of the respective franchise in terms of market positioning, distribution, and efficiency.
Earnings growth set to recover
Earnings growth from core mortgage lending has been subdued over FY14-16 at 7% CAGR. HDFC bore the brunt of this slowdown in FY15. Earnings of core mortgage lending represent only the revenues and costs associated with the same and exclude exceptional income, dividend received from the subsidiaries and contingency reserves created from exceptional income. Core ROE declined 400bp as a consequence from 28% in FY14 to 24% in FY16.
Many factors have contributed to the sluggishness in earnings growth including the following:
* Sharp decline in the share of non-retail AUM – 400bp decline over FY13-16 and 700bp decline from the peak level in Q1FY12.
* Higher securitisation volume—24% CAGR in the outstanding volume of securitised assets versus 16% CAGR in AUM growth over FY13-16.
* Decline in investment yields—100bp decline in yields in FY16 .
* Increase in provision charge for standard assets — standard asset provision charged entirely through P&L from FY16.
* Increase in effective tax rate since FY15 due to changes in accounting standards and lower capital gains.