A large one. - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
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6 MARCH 2008

Many years ago - in the days when Doordarshan was a monopoly and we all sat around the family black and white TV set to watch serials like Rajni, Chhaya Geeth, and I Love Lucy - I recall hearing a joke on what may have been a Benny Hill (a UK comedian) show.

The joke: A man enters into a bar, wishes to order a drink, and shouts loudly, “Mine’s a large one”.

The financial services industry, worldwide, seems to be obsessed by size. Financial analysts and commentators, too, seem to believe that the sole objective of any business is to be large. The power and the influence of being recognised by a media obsessed by rankings based on size, makes most CEOs dream of walking up to the bar and saying, “Mine is the largest”.

In an interesting article by a CFA (someone who knows more about financial matters than I ever will), the author was suggesting that Infosys had to use its extra cash (and borrowed funds) to grow and that cash in the bank was a waste. Similar arguments have been used against Bajaj Auto, too, in the late 1990’s: cash in the bank is a waste grumbled every analyst, please give it back to us. Japanese companies, too, are often criticised for having excess cash which should be returned to shareholders.

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The discovery of the power of Excel sheets has made us financial types pretty powerful people. From never having run any real business - or facing the challenges of even starting one – the financial analysts and investment bankers have emerged as the new leaders who can guide the world – and all the companies in it – to some sort of economic nirvana.

So, cash is bad because it does nothing? Maybe cash is good to keep till there can be some useful use for it, eventually. Having cash in the bank is good for a rainy day – for those who think long-term enough to know that we can have storms. Like writing off bank loans to poor farmers is good because it will reduce the suicide rate (two farmers every hour) and prevent the growing influence of rural rebel armies. Maybe Rs 60,000 crore on farm loans is cheaper than spending tens of thousands of crore in a war with Naxalites. I don’t know the right answers, but others are confident that they have the solutions.

There are a few companies that, thankfully, seem happy to let this obsession with “large” remain in newspaper articles and the spreadsheets of young analysts. Over the past five years, HDFC has “surrendered” its market share leadership position in the home loan business to ICICI Bank. But HDFC remains focused on profits. On being the flag bearer for corporate governance and “goodness”. It has little interest in standing by the bar and saying, “Mine is a large one.”

So, it came as a surprise – since HDFC is the largest shareholder – when, on February 23rd, HDFC Bank issued a press release announcing a proposed merger with Centurion Bank of Punjab (CBoP). On February 25th the boards of both banks met again to consider the swap ratio (1 share in HDFC Bank : 29 shares in CBoP) and on February 28 decided to move ahead with the merger. The rationale: the larger we are, the bigger we will be.


Source: Bloomberg

All this, just as the global financial giants are witnessing the pain of having grown too large. UBS went from being a small Swiss bank, to the world’s largest wealth manager and then began worrying about its rankings in the league tables for other financial businesses and did silly things – at bad prices. They bought Paine Webber, Dillon Reed, hired a bunch of investment bankers and planted flags in every business in any part of the world. J. P. Morgan, Merrill Lynch – you read about them every day now. They all chased size and “opportunity”. The market shares matter more than a control on risks. Cultural differences and differing styles of management were brushed aside. The numbers mattered, not the people that built the numbers.

So as of December 31, 2007, HDFC Bank had a network of 754 branches and 1,906 ATMs in 327 cities. CBoP had 394 branches and 452 ATMs in 180 cities. Add up the two banks and, bingo, bigger is better. Maybe. Maybe not.

ICICI Bank is the private sector bank standing tall at the bar with the largest tag around its neck. That tag excites some people, and does not excite others. The recent announcements by ICICI Bank that it has been hit by some fallout of the global sub-prime crises are reason to pause. The joke in the retail borrower space reportedly is: if you cannot get a home loan from HDFC, go to ICICI Bank.

Not that mergers are bad or growth is bad.
It is good to aspire for growth – and to achieve it.
Infosys has grown – with “extra” cash in its balance sheet.

But in an acquisition there has to be a cultural fit. Because any merger is like a marriage, there has to be a “suitable match”. And even on that count, the HDFC Bank and CBoP merger sort of fails the test. HDFC has one set of cultural values, the stand-alone HDFC Bank another still-evolving set of values: the press often talks about a merger between the two HFDC entities. Such an event would throw up its own challenges and a need to iron out a “value” fit. Not impossible, but something that needs to be worked on. But this proposed merger between HDFC Bank and CBoP could probably take the new, merged banking entity even further away from the core HDFC culture.

On a personal level, I am saddened by the merger. The financial ratios and rationale for the merger don’t sound that compelling. It seems to be an obsession with size. HDFC has taken 30 years to build itself into one of India’s most respected institutions. It has never had a desire to be on the top of any ranking list. Yet, as a shareholder in HDFC Bank, HDFC’s support for the merger with CBoP suggests that size seems to matter. While that may be true, there is another fact: India needs more institutions, we have enough companies. HDFC is an institution, and I hope it remains one.

Disclosures: Clients and portfolios we manage or advise on, own shares in Bajaj Auto, Infosys, HDFC, and HDFC Bank.


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