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HDFC Bank: Superlative growth - Views on News from Equitymaster
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HDFC Bank: Superlative growth
Jan 10, 2006

Performance Summary
HDFC Bank announced the results for the third quarter ended December 2005. The numbers stack up very impressively in terms of absolute as well as relative growth. Not only has the bank kept its reputation of consistency in margins untarnished, but has also shown appreciable prudence in provisioning. Infact, considering the bank’s good asset quality, the high provisioning seems to be an act of ‘saving for the future’.

Rs (m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Income from operations 7,790 11,798 51.4% 22,263 30,968 39.1%
Other Income 2,005 2,961 47.7% 4,313 8,198 90.1%
Interest Expense 3,390 5,092 50.2% 9,619 12,904 34.1%
Net Interest Income 4,400 6,706 52.4% 12,644 18,064 42.9%
Net interest margin (%)       3.7% 3.9%  
Other Expense 2,786 4,491 61.2% 7,567 12,088 59.7%
Provisions and contingencies 1,131 1,972 74.3% 2,579 5,436 110.8%
Profit before tax 2,488 3,205 28.8% 6,811 8,739 28.3%
Tax 779 961 23.4% 2,179 2,663 22.2%
Profit after tax/ (loss) 1,709 2,244 31.3% 4,632 6,076 31.2%
Net profit margin (%) 21.9% 19.0%   20.8% 19.6%  
No. of shares (m) 286.4 312.3   286.4 312.3  
Diluted earnings per share (Rs)* 23.9 28.7   21.6 25.9  
P/E (x)**         29.1  
* annualised
** trailing 12 months

Pioneer of retail banking HDFC Bank, the pioneer of the retail-banking movement in India, is one of the fastest growing and most profitable banks in India with a strong urban presence. At the end of 9mFY06, the bank had a franchise of 535 branches and 1,326 ATMs. Strong understanding of the retail sphere (40% of total advances) and inorganic growth initiatives has made the bank the second largest private sector bank in the country. Despite having raised capital in the form of ADS issue during 4QFY05 the capital adequacy ratio stands at 10.3% at the end of 3QFY06.

What has driven performance in 3QFY06?
Retail – pressurising margins? HDFC Bank’s retail portfolio continued to grow at a faster clip (76% YoY) as compared to its corporate portfolio (43% YoY) during 3QFY06. With this, the retail portfolio comprised 54% of the bank’s advance book at the end of this quarter. Although the bank has not divulged details about the average yields and cost of funds, the higher exposure to retail assets seems to be weighing heavy on margins (NIMs 3.9% in 3QFY06), which have shown marginal decline over the previous quarter (4% in 2QFY06). It must however be noted that a higher concentration of low cost deposits (53% in 3QFY06) has helped the bank sustain margins despite the rise in interest costs.

Credit deposit ratio up
(Rs m) 3QFY05 % of total 3QFY06 % of total Change
Advances 239,609   380,460   58.8%
Retail 117,648 49.1% 206,590 54.3% 75.6%
Corporate 121,961 50.9% 173,870 45.7% 42.6%
           
Deposits 374,290   511,950   36.8%
CASA 174,478 46.6% 272,060 53.1% 55.9%
Term deposits 199,812 53.4% 239,890 46.9% 20.1%
Credit deposit ratio 64.0%   74.3%    

Although it is worth a mention that the bank has sustained one of the highest net interest margins in the sector over the past several quarters, given the high cost borrowings it is resorting to at present, the retention of the same is doubtful. The bank had filed a shelf prospectus for raising Rs 10 bn of Tier II borrowing in 1HFY06. The same will mean 23% increase in borrowing costs and 50 basis points contraction in interest margins at the current cost of funds. Of this, it has raised Rs 4.1 bn as Tier II capital in the form of subordinated bonds (having maturity of 9.5 years) in 3QFY06, at an interest rate of 7.5% p.a. The same is approximately 300 basis points higher than the bank’s average cost of funds. Nevertheless, here we would also like to state that in the wake of the current liquidity crunch and lower deposit mobilisation, our outlook for the entire sector’s margins are not very attractive in the medium term.

Treasury concerns – to be evaded: The bank’s other income grew by 48% YoY during 3QFY06. Fee income constituted 93% of the bank’s other income during this period, having grown at 81% YoY. The bank has attributed the same to higher market share in cash management services, vending third party products and POS (point of sales) terminals. Also, the higher reliance on non-fund based revenues is a matter of comfort, due to the risk exposure on the treasury side in a rising interest rate scenario. The bank had 45% of its investments in the HTM category at the end of 1HFY06 and has transferred more investments to the HTM category in this quarter. The same is however, lower as compared to its peers in the private banking sector and with interest rates keeping an upward bias, negative repercussions of the same on HDFC Bank’s treasury portfolio cannot be ruled out.

Provisioning for the future? HDFC Bank has stated that the delinquencies and NPAs in its asset book are in line with the changing mix of the loan book towards retail loans. Although the bank sees the riskiness of high-risk assets being compensated by higher yields, the same may not augur well for its asset quality going forward. The net NPA to advance ratio continues to inch upwards (0.4% at the end of 3QFY06 against 0.2% in 3QFY05), although very trivial when compared to its peers in the sector. We also draw comfort from the fact that the bank has made more-than-adequate provisioning for the delinquencies, thus suggesting that it has provided for the future.

Higher costs envisaged: The National Housing Bank (NHB) has increased the risk weightage for loans to the commercial real estate sector from 100% to 125%, to which HDFC Bank has an exposure due to alliance with parent HDFC. Also, the investment in mortgage-backed-securities (MBS) will attract risk weightage of 125%. This is expected to weigh heavy on the bank’s already stretched capital adequacy ratio of 10.3%, thereby necessitating access to additional high cost funds. Also, the bank’s cost to income ratio continues to inflate (46% in 3QFY06) due to a larger franchise and higher operational costs.

What to expect?
HDFC Bank gives a very clear visibility in terms of asset growth and acceleration in fee based revenues in the longer term. However, we believe that competition in the retail space may make it increasingly difficult for the bank to retain margins. Also, due to the rising interest rates, negative surprises on the treasury side are not unforeseen. Having said that, proactive provisioning will stand the bank in good stead in the longer term.

At the current price of Rs 754, HDFC Bank’s stock is trading at 3.8 times our estimated FY08 adjusted book value. Although the bank remains amongst our top picks in the sector, we believe that the current valuations warrant caution.

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