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HDFC: Be forewarned!

Jul 18, 2006

Performance Summary
Well in line with the numbers posted over the past several quarters, HDFC has registered strong asset growth and bottomline figures for the first quarter ended June 2006. However, the fall in other income, margin pressures and excess provisioning suggest early signs of a possible slowdown in the housing finance company’s (HFC) growth. The HFC has also acknowledged pricing pressures and will review its lending rates later this month.

Rs (m) 1QFY06 1QFY07 Change
Income from operations 9,187 12,387 34.8%
Other Income 161 99 -38.6%
Interest Expense 5,669 8,014 41.4%
Net Interest Income 3,518 4,373 24.3%
Net interest margin (%) 3.5% 3.4%  
Other Expense 557 614 10.2%
Provisions and contingencies 40 90 125.0%
Profit before tax 3,082 3,767 22.2%
Tax 609 799 31.2%
Profit after tax/ (loss) 2,473 2,968 20.0%
Net profit margin (%) 26.9% 24.0%  
No. of shares (m) 249.1 249.5  
Diluted earnings per share (Rs)*   52.4  
P/E (x)   20.4  
* (12 months trailing)

‘Shelter’ing growth
HDFC, India’s largest housing finance company, with strong brand equity and market share of 21%, has an extensive reach with 203 branches 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 1QFY07?
NII - Buoyancy sustained: The continuation of fiscal incentives offered by the government on home loans, which effectively reduce the cost by 300 to 400 basis points, seems to have kept the demand for mortgage loans steady in 1QFY07, despite the higher lending rates. While on one hand a 30% YoY growth in incremental approvals backed by 28% YoY growth in disbursements suggests consistency in the HFC’s performance over the corresponding quarter of FY06, on the other hand, a steep decline in the disbursal to sanction ratio (from 83% in 1QFY06 to 74% in 1QFY07) reflects otherwise. The net interest income of the HFC continues to be buoyant due to higher yields on assets. However, given the higher cost of funding and pressure on net interest margins, we see the same getting impacted in the coming quarters. HDFC raised FCCBs in FY06 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.

Fees nosedive: HDFC’s fee income once again truncated by nearly 49% in 1QFY07 with the HFC continuing to take a cut in its fee income to compete in the increasingly competitive mortgage financing market. However, the profits garnered through the sale of investments, which earlier were hedging the HFC’s other income, have failed to do so in this quarter resulting in a 39% YoY fall in other income. Also, the compromise in fees, although reducing the contribution of other income to its profitability, may prove to be beneficial if it helps the HFC regain its lost market share. It is also worth noting that HDFC’s unrealised gains on investments have grown by 30% YoY at the end of 1QFY07.

Breakup of other income
(Rs m) 1Q06 % of total 1Q07 % of total Change
Fee income 139 86.3% 71 71.6% -49.1%
Dividend & other incomes 22 13.7% 28 28.4% 27.3%
Total other income 161   99   -38.6%

High capital costs: 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 dictate, its counterpart NHB (regulatory body for mortgage loans) also hiked the provisioning requirements, which proved costly for HDFC. However, HDFC’s comfortable CAR of 13.3% in 1QFY07 relieves it of capital raising requirement in the short term. But, net NPAs of 1.4% keep the asset quality provisioning requirements low for the institution.

What to expect?
At the current price of Rs 1,069, the stock is trading at 5.6 times 1QFY07 adjusted book value (4.5 times estimated FY08 adjusted book value). If the book value of the investment in subsidiaries and associates is taken into account, the valuation comes to 4.6 times 1QFY07 adjusted book value. The investment value per share is Rs 152. While the valuations are reasonably stretched on a standalone basis, willingness to hold on for the longer term may accrue benefits to investors, as the consolidated value gets unlocked.

In his letter to the shareholders in HDFC’s annual report for FY06, the chairman Mr. Deepak Parekh has quipped, ‘To be forewarned is to be forearmed – the dynamics of the industry needs to be understood and respected.’ He has further explained that while a portion of the current demand is real, at least a quarter of this is being driven by speculation. These buyers are unlikely to be the end users and hence real estate is fast becoming a speculative commodity. This being an unhealthy trend leading to a bubble in the mortgage market, it is pertinent for investors to exercise caution.

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