Description

I’m guessing many of you are already familiar with HDFC Bank – it was the subject of an excellent writeup about two years ago by Ideafactory.

HDFC Bank is a terrific bank. It’s the largest private sector bank in India with 11% market share of deposits. It has a long track record of consistently compounding book value per share and EPS, and I believe it continues to have a bright future.

But HDFC Bank’s stock price has underperformed lately. HDB (the ADR for HDFC Bank) returned -1% in 2023 and due to a 15%+ drop after the December quarter’s earnings were announced in January, HDB has returned -11% so far in 2024.

The stock price underperformance is mainly related to HDFC Bank’s merger with Housing Development Finance Company. The merger was first announced in April of 2022, and the market cheered it at the time. Housing Development Finance Company was a related non-bank finance company that was one of India’s largest mortgage lenders (and boasted its own track record of strong profitability and growth).

The deal seems to make strategic sense. Combining the two entities allows for cross-selling opportunities as the combined entity offers banking services to Housing Development Finance Company customers (70% of which don’t bank with HDFC Bank) and mortgages to existing HDFC Bank customer (92% of which don’t have a mortgage). The combination also allows Housing Development Finance Company to replace its relatively expensive wholesale funding with HDFC Bank’s cheap deposit funding. Moreover, HDFC Bank management guided for the deal to be accretive to both book value per share and EPS on day 1.

The merger finally closed in July of 2023, and there have been negative surprises since then. In September of 2023, HDFC Bank held a meeting with sell-side analysts where they disclosed that the merger, instead of being accretive on day 1, would actually be dilutive.

This was due to accounting adjustments (the acquired entity used a different accounting standard) and credit adjustments (HDFC Bank decided to book a higher loan loss allowance for the acquired entity on day 1). Additionally, management guided to temporarily lower profitability as a result of the merger. Historically, HDFC Bank has generated a return-on-assets of 1.9-2.0%, which translated to an ROE of ~17%. But management instead implied that ROA in FY 2024 would be closer to 1.8% (implying an ROE of ~15%). Management explained that these issues would be temporary as they integrated the merger.

Then in January, HDFC Bank announced disappointing earnings for the December quarter. The culprit was sluggish deposit growth and a therefore a rising loan-to-deposit ratio. For the merger with Housing Development Finance company to make sense, HDFC Bank needs to replace the acquired entity’s high cost wholesale funding with low cost deposits. But due to weak deposit growth in the December quarter, that wasn’t happening. As a result, the market fears that HDFC Bank’s merger-related problems will be more persistent.

As I’ll explain further below, despite the merger-related issues, HDFC Bank is still a terrific bank, and I think the problems it faces right now will ultimately prove temporary. In the meantime, the stock trades near trough multiples. With recent disclosure that deposit growth reaccelerated in the March quarter, things may already be getting better.

HDFC Bank is a terrific bank...

They are a consistent share gainer:

And they do this while generating consistently strong ROEs:

As a result, they have a terrific track record of compounding EPS at a double-digit clip on a real basis:

What is the secret sauce that allows HDFC Bank to generate such consistent growth and profitability?

Some of it is that India is an attractive market in which to be a private sector bank. India is underbanked relative to most other countries – a smaller proportion of Indians have banking accounts than in most other countries, and the amount of domestic credit extended by banks as a % of GDP is around 50% in India (vs 70% in Brazil, 90% in the Euro Area, 177% in China, and 216% in the US). In places like the US, when banks are trying to grow their deposit base and their loan book, it’s essentially a zero-sum game. In India, that is not the case. Moreover, state-controlled banks in India continue to represent >50% market share for both loans and deposits (prior to 1994, all banks in India were state-controlled). India’s state-owned banks tend to be less well-run that their private sector peers. HDFC Bank does face some well-run competitors, but much of its competition is sleepy and bureaucratic.

Besides operating in an attractive banking competitive environment, HDFC Bank also just seems to have a superior corporate culture. Where this culture most manifests itself is with credit risk. From time to time, other Indian banks have had loan loss issues. HDFC Bank hasn’t:

The problem they are facing will ultimately prove to be temporary...

When HDFC Bank merged with Housing Development Finance Company in July of 2022, they added a bunch of mortgage loans to the asset side of their balance sheet – as the acquired company was not a bank, those loans were funded by wholesale funding, not deposits. As a result, post-merger, HDFC Bank’s loan-to-deposit ratio spiked:

This high of a loan-to-deposit ratio is not ideal  - it’s near regulatory caps, and it’s causing net interest margin to be lower than it should be (since deposits are cheaper than wholesale, it’s more lucrative to fund loans with deposits rather than wholesale funding). They don’t need to get back to 85% pre-merger levels, but they do need to start showing progress at moving this metric down.

To improve its loan-to-deposit ratio (and relatively improve its net interest margins), one of two things will have to happen:

• Deposit growth needs to reaccelerate (it has averaged 15-20% over the last several years as the bank continues to expand its branch network, but the growth has been lumpy from quarter to quarter and ran at a disappointing 8% annualized rate in 4Q23).
• HDFC Bank needs to tap the brakes on loan growth.

The better outcome from here would be if deposit growth reaccelerates (allowing them to optimize NIMs and improve liquidity without postponing growth and market share gains) – but even if that doesn’t happen, it’s still ultimately a temporary issue if they have to slow loan growth to allow deposits to catch up.

Due to these (temporary) problems, HDFC Bank’s valuation is near historic lows...

HDFC Bank is trading near the same P/B level the stock reached in the Great Financial Crisis and during peak COVID fears (and it no longer trades at a premium to some of its Indian banking peers – ICICI Bank and Kotak Mahindra both trade at higher P/B multiples:

At 7% currently, the premium of the ADR to the underlying shares is below its historical average:

Recent disclosure on 3/31/24 deposit and loan balances suggests things are already getting better

Full earnings for HDFC Bank’s March quarter haven’t been reported yet, but they did recently disclose quarter-end loan and deposit figures. Deposit growth was strong, and the mix of added deposits was good (growth weighted more towards low cost checking and savings accounts and less towards high cost time deposits):

As a result, HDFC Bank’s loan-to-deposit ratio has started to tick down:

Risks:

• Merger integration challenges persist for much longer
• HDFC Bank screws up on credit
• Any of the other myriad risks facing an emerging markets bank :)

Catalyst

• Strong deposit growth => Improving loan-to-deposit ratio => improving net interest margins => improving ROA/ROE => multiple expansion
• Compounding of EPS and BV/share over time