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HDFC: Interest rate pinch - Views on News from Equitymaster
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HDFC: Interest rate pinch
May 3, 2007

Performance Summary
HDFC, India’s largest mortgage lending institution’s performance in FY07, manifests the fact that the contribution of mortgage finance to the country’s GDP has doubled from 3% to 6% in the last 2 fiscals. The institution has announced yet another fiscal of strong performance. For FY07, while income from operations have grown by 40% YoY, net profits are up 25% YoY. The financial institution has, however, faced margin pressures despite the sustenance in asset growth. HDFC’s net profit margins have infact contracted by 360 basis points (3.6%) due to higher cost of funds and higher effective tax rates.

(Rs m) 4QFY06 4QFY07 Change FY06 FY07 Change
Income from operations 10,810 15,267 41.2% 37,863 53,140 40.3%
Other Income 1,588 2,062 29.8% 4,920 5,822 18.3%
Interest Expense 6,773 10,042 48.3% 24,911 36,668 47.2%
Net Interest Income 4,037 5,225 29.4% 12,952 16,472 27.2%
Net interest margin       3.5% 3.0%  
Other Expense 439 475 8.2% 2,112 2,442 15.6%
Provisions and contingencies 46 52 13.0% 187 175 -6.4%
Profit before tax 5,140 6,760 31.5% 15,573 19,677 26.4%
Tax 874 1,260 44.2% 3,000 3,974 32.5%
Effective tax rate 17.0% 18.6%   19.3% 20.2%  
Profit after tax/ (loss) 4,266 5,500 28.9% 12,573 15,703 24.9%
Net profit margin (%) 39.5% 36.0%   33.2% 29.6%  
No. of shares (m)       249.6 253.0  
Diluted earnings per share (Rs)*       50.4 62.1  
P/E (x)         27.1  
* (12 months trailing)

India’s largest HFC
HDFC, India’s largest housing finance company (HFC), with strong brand equity and market share of 21%, has an extensive reach with 237 branches (FY07) spread across the country and abroad. HDFC’s strength over the years has been its core business of housing loans. Meanwhile, it also has tried to benefit from the retail reach of its banking subsidiary (HDFC Bank) and has entered into an agreement to source ‘home loan accounts’ from the latter. However, 70% of the accounts are sold back to HDFC Bank in the form of Pass Through Certificates (PTCs). Over the years, HDFC has emerged as a financial conglomerate by not restricting its ambitions to just housing finance but also venturing into new businesses like insurance, banking and asset management (mutual funds). It has recently set up a ‘real estate fund’. The HFC has grown at a scorching pace over the years despite competition from banking entities in the mortgage financing space.

What has driven performance in 4QFY07?e
Margin blip: The statistics of mortgage finance contributing 6% of India’s GDP in FY07 from 3% in FY05 may appear enthusing. However, this does not demean the shortage of 45 m dwelling units as per the 11th 5-year plan (5 m backlog, 22 m in rural and 16 m in urban areas; Source HDFC). HDFC continues to cash in on the potential demand in the Indian hosing finance industry. The same has been further aided due to the effective cost of home loans being brought down from 11.3% in FY00 to 6.1% in FY07, due to the fiscal incentives.

The rise in interest rates in this fiscal, which has not been commensurate to the rise in income levels has, however, had a lagged impact on the institution’s incremental disbursals.

Approvals Vs Disbursements
(Rs m) FY06 FY07 Growth
Current year      
Approvals 256,340 333,320 30.0%
Disbursements 206,790 261,780 26.6%
D/A 80.7% 78.5%  
Approvals 1,124,320 1,547,640 37.7%
Disbursements 931,030 1,192,810 28.1%
D/A 82.8% 77.1%  

During FY07, HDFC’s disbursements grew by 27% YoY on the back of increase in loan approvals by 30% YoY. The disbursements to approval ratio at over 77%, although healthy, suggest a slowdown in incremental disbursals over the corresponding period of FY06. Also, despite the higher yield on assets, HDFC’s net interest margin has witnessed a blip of nearly 50 basis points in this fiscal. HDFC raised foreign currency bonds in FY07 and has indicated that it will incrementally resort to long term funding in the near future as against short term bank borrowings, the latter being available at steep costs.

Loan book break up…
  FY06 FY07 Change
Individuals 302,617 373,624 23.5%
% of total 67.3% 66.1%  
Corporate Bodies 139,757 178,585 27.8%
% of total 31.1% 31.6%  
Others 7,526 12,914 71.6%
% of total 1.7% 2.3%  
Total loans 449,900 565,123 25.6%

The fact that HDFC saw a faster accretion of corporate customers to its loan book (against retail) must have also led to the institution falling short of bargaining power (in interest rates) against the former. The growth of 26% in loan book is in line with the sector average and the institution’s targets. This is also higher than our estimate of 20% YoY growth in loan book in FY07.

Other income - buoyed by surpluses: HDFC’s fee income remained flat in FY07 over that in FY06, suggesting continued pressure on processing income, in spite of higher pricing power. While the FI has been taking a cut in its fee income to compete in the increasingly competitive mortgage financing market, which is getting increasingly crowded by banking companies, its fee income (linked to incremental disbursements) has not grown at commensurate rates. This is also due to the fact that the institution has been increasingly relying on its subsidiary HDFC Bank (25% of the loans sourced in FY07) for sourcing the home loans from locations where it does not have a presence. Despite the fall in fee income, the HFC’s other income grew by 34% YoY during FY07, thanks to a 43% YoY growth in profit on sale of investments and higher surpluses from cash deployed in cash management schemes of mutual funds. The same may, however, not be sustainable going forward. The unrealized gains on investments at the end of March 2007 rose by 16% YoY.

Breakup of other income
(Rs m) FY06 % of total FY07 % of total Change
Fee income 675 16.4% 686 12.5% 1.6%
Surplus from deploment in MFs 89 2.2% 387 7.0% 334.8%
Profit on sale of investments 2,272 55.2% 3,253 59.1% 43.2%
Dividend & other incomes 1,079 26.2% 1,179 21.4% 9.3%
Total other income 4,115   5,505   33.8%

Addressing resource constraints: As per the monetary policy for FY07, the provisioning requirement for commercial real estate loans has risen from 0.4% to 1.0% signaling the fact that the RBI is worried about the increase in real estate prices in India (risk weight on exposures to commercial real estate raised from 125% to 150%). In line with the RBI’s diktat, its counterpart NHB (regulatory body for mortgage loans) also hiked the provisioning requirements, which proved costly for HDFC. However, HDFC’s comfortable CAR of 12.9% at the end of March 2007 relieves it of capital raising requirement in the short term. Further, gross of 0.9% and net NPAs of 0.2% keep the asset quality provisioning requirements low for the institution.

What to expect?
At the current price of Rs 1,675, the stock is trading at 3.1 times our estimated FY09 adjusted book value. The investment value per share is Rs 145 (at book value). HDFC’s unique business model (sales through DSAs and arrangement with HDFC Bank) enables it to sustain the lowest cost to income ratio (11% in FY07) and enjoy operating leverage. The management has indicated that the timely lending rate hikes will ensure that its spreads are protected. However, this may have an impact on its asset growth.

In search for new avenues of growth, the institution is now targeting smaller cities, where real estate prices have risen, but not as much as the rise witnessed in metros and other large cities. On the international front, HDFC launched its operations in London in November 2006, in order to facilitate the Indians in England, through providing them with advisory services on housing finance and property acquisition in India. While the valuations, factoring in the market value of investments appear reasonable from a long term perspective, the same is subject to substantial downsides, in the event of inability to book the unrealized gains at opportune times.

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