Stock Recommendation | HDFC - ADD - Target price : 1,980

▶ We find risk of compression on NIM due to rise in funding costs in bond markets and HDFC/HFCs’ shift to bank loans and deposits; this may partially be offset by higher asset yields post its recent rate hikes. HDFC has raised lending rates by 15 bps in retail loans last month (65 bps in CY2018 YTD) and 65 bps in non-individual loans (120 bps in CY2018 YTD).
▶ HDFC/other HFCs are taking a cautious stand in real estate lending due to liquidity challenges of developers. This may lower business momentum in the industry, which can eventually affect retail business as well; HDFC’s focus on the affordable segment somewhat helps.
▶ We find risk to developer book NPLs in the current environment. HDFC’s stage 3 loans were down marginally to ₹50.2 bn as compared to ₹51.5 bn in 1QFY18. While a large account of ₹9 bn was sold to ARCs last quarter, the balance (₹8 bn) was on account of slippages, mostly in the non-individual segment.

AUM growth stable qoq, up 17% yoy
▶ AUM growth on track. HDFC reported 17% yoy AUM growth in 2QFY19 driven by 18% yoy growth in the individual home loan segment while the non-individual segment saw slightly lower growth at14% yoy (down 1% qoq). Individual segment witnessed robust growth for the fourth quarter in a row (>16% yoy growth). ■ Growth has mostly been driven by strong volume as average ticket size is broadly constant at ₹2.7 mn (similar to average ticket size for individual loans for the past 7-8 quarters).
■ A large portion of the incremental growth is coming from tier-II and lower cities as the company has increased focus on affordable housing.
■ Increasing contribution of the affordable housing segment continued to ramp up pace of growth in this segment. HDFC has increased focus towards the economically weaker section (EWS) and low income group (LIG) segments. These segments contributed 37% of home loans approved in volume terms and 18% in value terms during 2QFY19. The company is approving and average of 8,300 loans on a monthly basis to the EWS and LIG segments, with monthly such average approvals at approximately ₹13.5 bn. The average home loan to the EWS and LIG segment stood at ₹1.01 mn and ₹1.76 mn, respectively, stable qoq.
■ Non-individual AUM also recorded growth at 14% yoy in 1QFY19, lower than 18-23% over the previous five quarters. Growth has slowed down likely towards the end of the quarter.
▶ Loan sell-down remain high, similar to 1QFY19. HDFC sold ₹61 bn of loans to HDFC Bank (₹35 bn in 2QFY18 and ₹97 bn in 1QFY19). The increase in the amount of loans assigned to HDFC Bank in 1QFY19 and 2QFY19 was due to the fact that no loan assignments were done during August 2017-March 2018. Thus, the entire loan assignments during 1QFY19 and 2QFY19 pertained to the backlog under the arrangement.
▶ We forecast 17% AUM CAGR over FY2018-21E. We forecast 17% AUM CAGR over FY2018-2021E as we retain our constructive medium-term view on the sector. We have slightly moderated our estimates post recent turmoil in the sector and cautious stance of the company on the developer loan space. As discussed earlier, slowdown in real estate lending and slowdown in new launches might have a spillover impact on individual home loans. This will be partially offset by rising demand in the affordable housing segment.

Calculated NIM expands stable yoy
▶ NIM stable yoy. Calculated NIM was broadly stable in 2QFY19 (up 4 bps yoy) at 2.6%. On a qoq basis, calculated NIM dropped 17 bps as NIM expanded in base quarter as surplus funds post capital issuance was parked as short-term investments leading to higher income on liquid funds. Calculated yields on AUM saw 17 bps yoy expansion to 9.8%, offset by rise in funding cost. The cost of bank borrowings saw a steep increase in 2QFY19 (up 240 bps qoq) owing to fluctuations in foreign currency loans payouts; this may be one-off due to INR depreciation and bank borrowing costs may come down next quarter.
▶ Rise in home loan rates to provide some comfort to yields. Despite a highly competitive environment, most HFCs and banks have increased their home loan rate in the past two months (HDFC raised its home loan rates by ~45-50 bps on the retail side from March 2018-September 2018). The company has raised home loan rates by another 15 bps in October 2018. Going ahead, rise in home loan rates will provide comfort to yields. As such impact of rise in home loan rates have not yet fully translated to yield expansion. The company has guided for stable NIMs.
▶ Bank term loans increase. Given the rising bond borrowing rates since 3QFY18, there is increase (up 510 bps yoy and 210 bps qoq) in share of term loans in borrowing mix. Bank borrowings have increased 58% yoy compared to 8% for NCDs and 5% for public deposits. The company has raised additional ₹50 bn of bank loans last month. The share of public deposits has dropped 210 bps qoq to 28% due to some lumpy corporate exits but this is now a focus area for the company.
▶ Raising bond, though at higher yields. Despite the challenges in bond markets, HDFC has been able to raise ₹60 bn bonds since September 20 through two tranches. Its bond borrowing cost increased by ~160 bps and 190 bps to 9.1% in October 2018 from October 2017 and June 2018, respectively.
▶ Strong market position augurs well for maintaining liquidity. HDFC has maintained a positive ALM. Its last available ALM (March 2018) shows positive ALM gap in the first bucket (1 year) of 15%. HDFC’s market instruments are rated ‘AAA’ and enjoy finest pricing in the private sector NBFC space. Comfort of banks, debt markets and retail depositors will likely ensure liquidity support even as its large size poses some challenges. The company had CPs of ₹590 bn, which it will bring down to ₹540 bn this month. About 40% of its CPs are with banks and 40% with mutual funds. It has recently received approval for ECB of US$1.5 bn and Masala bond of ₹50 bn. The company maintained cash of ₹100-120 bn on its balance sheet.
▶ NIM compression in our forecasts. We expect pressure on NIM for HDFC, driven by rise in cost of funds. We are building 15-20 bps lower NIM in 2HFY19 over 1HFY19. Rise in lending rates will provide some comfort going ahead. HDFC has raised non-individual rates by 65 bps (blended) in October 2018; 100 bps in wholesale, 75 bps in developer loan portfolio and 65 bps in LRD segment. However, we expect the company to moderate a bit in high-risk wholesale segments in case the liquidity stress continues.

Asset quality stable qoq
▶ Gross stage-3 loans at 1.3%. Gross stage 3 loans were down marginally to ₹50.2 bn as compared to ₹51.5 bn in 1QFY19. Gross stage-3 loans were 1.31% compared to 1.37% in 1QFY19 and 1.30% in 4QFY18. A large account of ₹9 bn was sold to ARCs in the last quarter, the balance (₹8 bn) was rise on account of slippages; mostly from the developer loan portfolio. GNPL ratio (as per IGAAP) dropped 5 bps qoq (flay yoy) to 1.13% in 2QFY19. The company has revised its ECL classification and done away with stage 3A.
▶ ECL coverage dropped 6 bps qoq to 1.3% of overall portfolio. The company reported stage-1 and 2 loans of 98.69% of portfolio in 2QFY19. HDFC has ECL coverage of 0.81% on these loans. The overall ECL coverage on the portfolio is 1.31% (down 6 bps qoq), higher than most peers.
▶ Asset quality to remain stable going ahead. We forecast gross stage-3 loans to remain stable around 1.3% over FY2019-21E. The company has started to maintain a cautious stance on the developer loan portfolio given speculations over rising stress in this space. ECL coverage on stage-3 loans is expected to drop marginally to ~39% in the medium term from 42% in FY2018.

Sharp drop in ESOP expenses
Drop in ESOP expenses lead to reduction in cost ratios. Cost-income ratio dropped to 7.6% in 2QFY19 from 16.1% in 2QFY18 and 14.2% in 1QFY19 driven by sharp drop in employee expense. Employee expenses decreased 67% yoy on the back of steep decline in ESOP expenses by 97% yoy to ₹86 mn in 2QFY19. Adjusting for ESOP employee expenses were up 11% yoy. Cost-income ratio (adjusted) dropped 140 bps qoq to 7.4% (up 20 bps yoy). Cost ratios for the company continued to be better than peers.

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