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  • Stock Recommendation | HDFC Bank - ADD - Target price : 2,100

    Publish date: OCTOBER 22, 2018

    Unchanged trends. HDFC Bank reported stable 2QFY19 results with earnings growth of 21% yoy on the back of 18% yoy growth in revenues led by solid loan growth of 24% yoy. NIM expanded, as expected, by 10 bps qoq, on the back of recent capital infusion. While valuations are a lot more comfortable for a positive view on the bank, rising share of unsecured loans remains a key area of concern given its higher contribution to the bank’s earnings. Maintain ADD with TP at ₹2,100 (unchanged).

    HDFC Bank reported 21% yoy earnings growth on the back of 18% yoy revenue growth, slower cost growth of 14% yoy while provisions grew 23% yoy. NIM expanded 10 bps qoq led by the recent capital infusion but spreads have been maintained qoq despite further change in asset mix towards unsecured loans. Non-interest income growth was slower at 11% yoy on the back of treasury losses. Fee income (up 22% yoy) saw traction led by credit cards, retail loans and sale of third-party products. CASA ratio was flat qoq at 41% on the back of ~18% yoy growth in CASA deposits.

    As we have highlighted in the past, we see that earnings growth is getting support from cost control while revenue growth is seeing higher support from NII led by a change in asset mix. We are not reading too much into NIM expansion given the recent capital infusion and we do believe that the flat spreads are still a reflection of the underlying pricing pressure as the loan mix is not seeing the required tailwind on NIMs. This quarter saw growth in loan-loss provisions at a slower pace, which is positive but directionally gross NPLs are growing at a marginally faster pace than loan growth indicating that the retail cycle is probably past its best phase. This has implications for the bank as the contribution of profits from unsecured loan products is quite high and a retail slowdown can force the bank to move towards low-profit businesses.

    We maintain our ADD rating post changes to earnings. At our TP, we value the bank at 3.3X book (lower than historical multiple to factor the equity dilution) and 20X September 2020E EPS for 20% earnings CAGR for FY2019-21E and RoEs in the range of 16-17% over the same period. Gradual increase in competition in the retail space and change in product mix raise concerns over risk-adjusted NIM and its impact on asset quality in the medium term. While growth remains strong, earnings drag on the back of margin compression remains our key concern. Valuations have turned favorable post the recent correction leading to our positive view on the stock today.

    Loan growth accelerates; share of unsecured loans stable qoq
    HDFC Bank reported 24% yoy loan growth, driven by similar growth of 24% yoy in retail and non-retail loans segments, which grew 18% yoy as per RBI classification and 23% yoy growth in retail and 26% growth yoy in corporate loans as per internal classification. Loan growth had marginally slipped 20% levels. The bank has been rapidly expanding its retails asset base, which now stands at ~55% compared to 51% in FY2017 and 48% in FY2016 (as per RBI classification). Unsecured loans continue to gain dominance amid a low base with its share in total loans at 16.5% (as per RBI classification). There has not been too much change qoq but it is an increase of 140 bps yoy.
    Within retail loans (as per RBI classification), unsecured loans (personal loans and credit cards) and 2-wheeler loans saw maximum traction followed by business banking and commercial vehicles. Personal loans witnessed 38% yoy loan growth and credit cards witnessed 32% yoy loan growth. Business banking and 2-W loans on the other hand recorded 19% yoy and 40% yoy growth respectively. Car and CV loans also increased 16% yoy and 26% yoy respectively. Housing loans however grew 20% yoy as the bank has again started to buy back loans from HDFC Ltd as they have the requisite clarification on GST.
    Unsecured loan growth remains high, contributing ~30% of retail loans
    The trend in growth in unsecured loans was broadly similar to that in previous quarters with personal loans and credit cards contributing major portion of incremental retail loan growth.
    Contribution of unsecured retail loans to total retail loans has grown to ~31% from ~22% in FY2014.
    With strong support from low cost funding and emerging yield pressure arising from rising competition in various retail segments, the bank has been aggressive in growing the unsecured book, thus providing support to the overall margins. Given the strength of the retail balance sheets, the current level of strong growth does not raise any red-flags at the moment.
    HDFC Bank has grown at ~20% CAGR over past 4 years, well above the industry loan growth. The bank has indicated that it plan to grow above the industry growth rate going ahead though the difference may taper down with rising competition. The bank does not explicitly target any share for retail, but the relative slowdown in corporate have led to increase in share of retail loans.
    We are not too sure if the bank would be able to improve loan growth >25% in the medium term considering that the underlying business environment is yet to improve firmly across corporate and SMEs, even as retail engine continues to deliver strong growth. We forecast 18% loan CAGR over FY2018-2021E.

    An outsider’s view on the profitability of the unsecured business of HDFC Bank
    As discussed in our previous report, we have tried to look at the profitability and contribution of the unsecured business. HDFC Bank has grown its credit and unsecured loan portfolio quite meaningfully in the previous few years. The share of these loans is at an alltime high at ~15% of loans. The management articulated that the performance on these portfolios remains quite solid. The credit card business has seen a reasonably strong growth in volumes and spends but is marginally offset by lower revolve rates. Card acceptance is gaining ground across all segments of population (salaried and non-salaried), age as well as in semi-urban, urban and metropolitan areas. The bank is building a reasonably welldiversified portfolio to reduce the underlying risk. The contribution between new-to-credit customers appears to be quite healthy. At this point, there are no signs of worry.
    We looked at the contribution of these two portfolios. Note that these are our internal estimates and not been shared by the management. We have based our assumption looking at the financials of SBI Cards and Payment Services, which is the credit card subsidiary of SBI. We have made further adjustments to various metrics to account for relative strengths of each company. Our study suggests that though the contribution of these two loans was ~15% of the overall loans, the contribution towards PBT could be 25-30% of the overall bank. The credit card business which is 5% of loans is probably contributing to ~15% of PBT while the personal loans, 10% of loans, could be ~10-12% of PBT. The share of profits from the credit card business is probably moved to ~15% of PBT in FY2018 from 10% a few years back. The card business probably generates ~50% of its income from net interest income (revolving customers) and the balance through interchange fees, foreign exchange and other cross sell/late fees etc (see Exhibits 1 and 2).
    The main challenge that we see currently is that these business can turn towards low profitability or losses in extreme scenarios quite quickly. This would result in the bank immediately lowering its exposure to these segments resulting in slower loan growth which would put higher pressure on revenue growth as NIM are quite high along with fee income opportunities. Further, the bank would need to strengthen its collection team resulting in higher operating expenses while it would also have to make for higher provisions for bad loans. In many ways, the cyclicality of this business appears to be less comforting, in our view.

    Asset quality stable qoq; absolute growth in NPLs surpass loan growth
    Gross NPL and net NPL ratios were flat qoq at 1.3% and 0.4% respectively; a trend observed over the past four quarters. On an absolute basis, GNPL increased by 6% qoq whereas NNPL increased 4% qoq. The bank’s provision coverage ratio was stable at ~70%. Slippages for the quarter stood at 1.8% of loans. We note that the growth in GNPLs at 32% yoy is higher than loan growth at 24% yoy indicating gradual rise in stress of the book. This could also be a reflection of the vintage cycle of the loan book reflecting maturity of various cycles and that the retail cycle is probably past its best phase. We forecast 1.3%-1.5% gross NPL ratio over next two years with credit costs of ~90 bps.

    Margin expansion led by recent capital infusion; spreads stable despite higher share of unsecured loans
    NIM expanded ~10 bps qoq to 4.3% on the back of recent capital infusion. The management indicated that the spreads were stable for the quarter. Calculated yields increased 10 bps qoq to 10.3% while calculated cost of funds increased 10 bps qoq to 5.2% in 2QFY19. It is quite likely that the bulk of pressure on lending yields is coming from the retail asset book as the bank has been increasing its lending yields for the past few quarters. The retail loan book has a higher share of loans that are fixed in nature which is probably driving a much slower expansion in lending yields as competition has been quite high in the past two years in select secured retail loan products. A sharp decline in cost of funds post demonetization and a relatively fixed rate interest rate book allowed the bank to reported slightly better NIM in FY2018 which is probably now starting to reverse.
    We forecast NIM to drop in medium term though the pressure of sharper compression looks unlikely given the change in competitive environment where NBFCs are currently struggling on managing their liability side issues. We expect NII CAGR of ~18% in FY2018-21E and expect it to lag ~18% loan CAGR during the same period. We forecast NIM (calculated) to decline by ~20 bps over FY2018-21E.
    Treasury losses drag other income growth; fee income growth solid
    HDFC Bank reported robust 26% yoy growth in fee income; a trend similar to previous quarters. The strong traction in fee income has been on the back of credit cards, sale of third party products and retail loan disbursements. Bank has tied up with two more life insurance companies (apart from HDFC Life) and one general insurance company in FY2018. There could be a slowdown in retail third party fees given the changes in guidelines (trail fees) and sharp volatility in equity markets. The bank reported treasury losses of `.3 bn (high M2M losses) in 2QFY19 which led to sharp drop in other income.
    Cost-income ratio showing marginal improvement yoy
    Cost-income ratio dropped 100 bps yoy as growth in operating cost at 14% yoy in 2QFY19 was lower than revenue growth at 18% yoy. The management indicated that the digital initiatives are helping the bank in costs. Ongoing staff efficiency program led to savings as employee expenses growth was low at 11% yoy even though employee count increased yoy. Non-staff cost growth was modest at 15% yoy.
    We forecast cost-to income ratio to moderate to ~38% by FY2021E on the back of strict cost controls and robust revenue growth. However, a key concern would be on the pace of delinquencies as the bank would have to step up collection teams.
    CASA ratio stable qoq at 42%
    Overall deposit growth was strong at 21% yoy led by strong growth in term deposit at 23% yoy and SA at 19% yoy. CA growth was solid at 18% yoy; reversing a trend in recent quarters. CASA growth has recovered quite well post a slowdown in recent quarters. The management indicated that the focus to build deposits was higher this quarter and this has helped in keeping a comfortable liquidity coverage ratio.
    We project 18% CAGR in CASA balances from FY2018-21E driven by ~18% CAGR in savings account during the same period. We project CASA ratio to moderate down to ~43% by FY2021E.
    Others key highlights
    ▶ Tier-1 ratio stands comfortable at 15.6% with overall CAR at 17.1% as per Basel-3 guidelines.
    ▶ The bank has slowed down on expansion adding only 21 branches (net) in 2QFY19 taking the total branches to 4,825. Growth in ATM stood low at 6% yoy to 13,018. The bank has been rapidly expanding footprint in semi-urban areas and rural areas. Of the total banking outlets, 53% are in semi-urban and rural areas.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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