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HDFC Bank: Indomitable spirit!

Oct 17, 2006

Performance summary
HDFC Bank has announced its results for 2QFY07, retaining the growth rates across parameters. The result for the half-year period as well shows little fluctuation. The bank’s stability in terms of sustenance of profit growth, net interest margins, asset book expansion and asset quality by itself accentuates its operating efficiency and growth prospects. The additional provisioning despite a good asset quality and well-hedged treasury book gives indications of resilience to sectoral cyclicalities.

Rs (m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Income from operations 10,229 16,357 59.9% 19,170 31,400 63.8%
Other Income 2,602 3,977 52.9% 5,237 7,485 42.9%
Interest Expense 4,108 7,901 92.3% 7,812 14,767 89.0%
Net Interest Income 6,121 8,456 38.1% 11,358 16,632 46.4%
Net interest margin (%)       4.0% 4.0%  
Other Expense 4,016 5,791 44.2% 7,597 11,319 49.0%
Provisions and contingencies 1,806 3,057 69.3% 3,465 5,696 64.4%
Profit before tax 2,900 3,585 23.6% 5,534 7,103 28.4%
Tax 903 955 5.8% 1,702 2,081 22.2%
Profit after tax/ (loss) 1,997 2,630 31.7% 3,831 5,022 31.1%
Net profit margin (%) 19.5% 16.1%   20.0% 16.0%  
No. of shares (m) 312.0 314.3   312.0 314.3  
Diluted earnings per share (Rs)       24.6 32.0  
P/E (x)*         32.6  
* 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 FY06, the bank had a franchise of 535 branches and 1,323 ATMs. Strong understanding of the retail sphere (56% of total advances) and inorganic growth initiatives has made the bank the second largest private sector bank in the country. The bank’s capital adequacy ratio stood at 12.1% at the end of 1HFY07.

What has driven performance in 2QFY07?
Stability in margins: Not deterred by the unusual rise in funding costs (interest expenses nearly doubled in 1HFY07 over that of 1HFY06), HDFC Bank managed to grow its advance book at rates that surpassed the sector average in 2QFY07. While the retail book continues to assume dominance in its portfolio allocation (59% of advance book in 1HFY07), the growth in the corporate book is also appreciable. What has enabled the bank to retain its net interest margins (at 4%) is the fact that it continues to enjoy the distinction of having the highest proportion of low cost deposits in its books (52% in 1HFY07). Given the fact that the bank has recently raised subordinated debt of Rs 4.5 bn for its Tier II funding, the pressure on cost of funds will continue to linger.

Asset book: Retail dominance
(Rs m) 1HFY06 % of total 1HFY07 % of total Change
Advances 317,056   427,793   34.9%
Retail 174,591 55.1% 252,110 58.9% 44.4%
Corporate 142,465 44.9% 175,683 41.1% 23.3%
Deposits 454,461   634,468   39.6%
CASA 232,450 51.1% 329,923 52.0% 41.9%
Term deposits 222,011 48.9% 304,545 48.0% 37.2%
Credit deposit ratio 69.8%   67.4%    

Other income–In line with fees: The growth in HDFC Bank’s other income treads close to the growth witnessed in its fee income base. This is because there has been no perceptible change in its treasury portfolio with 85% of its investments in the HTM basket and duration of less than 2 years in the AFS portfolio. The bank’s fee income, which grew by 42% YoY continued to comprise 13% of total income as was the case in the corresponding quarter of FY06. The proportion of fee income to other income also remained at 42%, indicating that the bank continued to rely on its forex transactions and profit on sale / revaluation of investments to augment its non-fund income base. The bank has been facing some competition in its market share in cash management services, vending third party products and POS (point of sales) terminals. It is also pertinent to point out that the high reliance of non-fund based income on mutual fund distribution (25% of fee income in FY06) may suffer some set backs going forward.

Provisioning excessively: 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 1HFY07 against 0.2% in 1HFY06), although very trivial when compared to its peers in the sector. Although we also draw comfort from the fact that the bank has made more-than-adequate provisioning for the delinquencies, the same may no longer prove benign for the future. In a very important development, the RBI has disallowed banks from writing back the excess provisions made earlier. The excess provision may thus prove to be costly for the bank going forward.

Embargo on branch expansion: The IPO scam early this fiscal proved to be very detrimental to the growth of banks like HDFC Bank, with the RBI placing an embargo on the additional branch licences to be issued to it for a year. HDFC Bank that traditionally grows its branch franchise by nearly 25% each fiscal has not added a single branch in 1HFY07. While it is appreciable that the bank has not let this handicap come in its way to augmenting its advance base so far, the same may not hold true for long.

What to expect?
At the current price of Rs 1,011, the stock is trading at 4.6 times our estimated FY08 adjusted book value. Although the bank continues to outperform our estimates in term of asset growth, its margin performance is in line with our estimates. Also, despite the rising interest rates, negative surprises on the treasury side are not foreseen. Nonetheless, the embargo on branch licences and dependence on treasury portfolio are lingering concerns. Having said that, at the current valuations, the stock appears steeply priced despite its growth prospects going forward, and therefore, the upside hereon stands limited.

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