Description

HDFC BANK (HDB US, Market cap: $96bn, P/B: 2.6x, P/E 17x) 

If you prefer investing in a compounder undergoing technical selling and short-term transient challenges, this company might excite you. And if I add to it that it also gives you an option to diversify into the the best of India's secular underbanked demographics growth story sitting within the comfort of our home country. In that case, I'm hopeful that HDFC Bank ADR would resonate with many of us.

HDFC Bank (HDB US) has had a dream journey with 26% EPS CAGR (since 2006) and 20% since 2012, resulting in an almost proportionate rise in its share price (25%/18% CAGR). It survived the 1998 Asian currency crisis, the 2008 GFC, the Indian banking NPA crisis (2012-2015), and demonetization (2017) unscathed. Because, unlike other Asian banks, the underwriting is strictly risk-oriented with no interference from the Government (like in China or state-owned banks in India). Moreover, the bank is primarily into plain-vanilla/traditional lending segments like personal, auto, business and high-quality corporate loans. It has never ventured into exotic banking products (like JPM, UBS etc.) or instruments. Notably, the managers have the highest integrity and the best corporate governance for an Emerging economy. 

Why do we have an opportunity? 

The market price has gone on a holiday for the last two years (underperforming India's benchmark Nifty by 20%), with the stock trading at its all-time low Price to Book of 2.5x. Despite the bank improving its market share and becoming much stronger post-COVID . And these are backed by solid growth of 18-20% in Loan book,  Book value and EPS. 

There have been numerous occasions when the market value has gone on vacation, but this time the reasons are:

1. CEO Aditya Puri resigned in 2020 due to the Reserve Bank of India's (RBI) rule on the retirement age of 70 years. Aditya Puri has been with the bank since its inception in 1994. He was brought from Citibank in Malaysia to set up the bank. He has been succeeded by the new CEO, Shashi (57 age), who has been a critical pillar in building the bank. 

2. RBI stopped HDB from issuing new credit cards and digital initiatives in December 2020 because it slipped behind in upgrading its tech stack. HDB receives ~250m views on its website in a single quarter with 29m unique views, 30-70% more than its private and public competitors. This ban was lifted around a month back, with HDB gaining the lost market share in credit cards. 

3. HDB being most highly owned by foreign investors has suffered the brunt of technical selling in emerging markets. While the Indian markets have been the best performer, there's been a profit booking in HDB ahead of the Fed rate hike, likely impacting HDB within the Indian markets.

Merging with its Parent - HDFC 

HDFC Groups (Parent) owns a ~21% stake in HDFC Bank. HDFC Group is a much older entity than HDB and is run by India's most respected bankers, Deepak Parekh (77 age) and Keiky Mistry ( 67 age). Deepak Parekh brought Aditya Puri from Citigroup to set up HDFC Bank and gave him a free hand. On the other hand, the Parent focused only on the mortgage loans as a non-banking entity (which absolves it from maintaining a ~30% reserving ratio into low-yielding Govt papers). With the exit of Aditya Puri, both the Parent and HDB decided to merge as the reserving ratio had come down to 22% (eradicating the benefit of Parent operating as a non-banking entity). 

The merging ratio was neutral for both and will be EPS accretive from day 1. The Parent has a market cap of $50bn against $96bn for HDB, with advances at 43% of HDB. Overall, I believe that the combined bank will be the fastest-growing (15-18%) "Non-Tech." business with +100bn in the market cap category in the world.

Moreover, the merger will strengthen the home mortgage portfolio for HDB, which was the only missing part. Additionally, 70% of HDFC's customers do not bank with HDFC Bank, giving an immense potential for cross-selling. Most importantly, the Parent has majority stakes in HDFC Life Insurance, HDFC AMC and HDFC Ergo (General insurance). These are the Best-in-class market leaders, run by the most efficient managements, giving immense optionality.

What makes HDFC Bank so unique?

1. Conservative underwriting: A fascinating aspect of HDFC's asset quality has been that the non-performing assets (NPA) have never crossed 2%. Contrast this to the Indian Banking sector averaging 6/10% (5/10 years) and even the private banking sector at 4/5%. How has HDFC Bank been able to pull through this? The risk culture plays a big part. It permeates all levels of the organization. The process-led lending with strict checks also plays a big role, disallowing any manual intervention. 

2. Granular loan book: HDFC Bank and Kotak Bank stayed away from infrastructure financing during 2004-13, while many other large banks (including ICICI) aggressively grew their loan book in the segment. As a result, most of these loans turned NPAs for them. Moreover, any new retail segment experiment is done through small pilot projects without substantial balance sheet risk.

3. Asset Light growth: HDFC Bank is India's largest credit card issuer and merchant acquirer. It has a ~ 23% market share, followed by SBI Cards at 19% and ICICI Bank at 18% (the top 3 are 60%!). Further, led by its high quality and more affluent client base, HDFC has a 29% spend share. Notably, the country's credit card penetration remains low, indicating a massive runway! Moreover, this source of fee income brings an asset-light growth providing a competitive advantage.   

HDFC Bank also benefits from its vast branch network to sell life insurance and asset management products. India has low penetration of these products and a very young population. There is a long runway here! A minimal fee comes from stock trading and investment banking (unlike US/European banks).

4. Low cost of funds advantage: The Bank has developed a significant competitive advantage of garnering low-cost savings, chequing and term deposits account. The non-interest-bearing current and low interest-bearing savings account are 46% of its total deposits. As a result, the net interest margin has never gone below 4%, irrespective of interest rate movements.

5. Growth machine: Even after growing at 25%, its market share is still 8.5% in deposits and 10% in loans. SBI has a 22.5% share of loans, and the public banking system has a 60-65% share. Of course, growth has slowed due to HDFC's large size and increased competition. But It is important to note that HDFC's foray into rural and semi-urban markets is recent. By some estimates, these markets are as big as urban markets (and growing much faster). So HDFC Bank will likely gain share in this market for a long time.  

6. Technological advantage: A typical US bank operates at a 50-60% Cost to Income ratio. HDFC Bank operates at 37%! And this has declined from a high of 50% in 2012 despite the number of branches doubling from 2,544 in 2012 to 5,416. Even the no. of employees has almost doubled from 66,000 in 2012 to 117,000 in 2020. 

So how does HDFC achieve it?

HDFC Bank has a first-mover advantage. It was one of the first private banks to build branches in more affluent urban areas and lock in the best customers. It has replicated this strategy in semi-urban and rural areas in the last five years. Other private banks find it too cost-prohibitive to enter these regions, but HDFC Bank has the scale and scope to enter this business. As it is the first mover in semi-urban and rural areas, like it was in urban areas, it is likely to gain the best business available in these regions. The second player cannot have the same efficiencies. Secondly, HDFC Bank has had the advantage of starting its technology stack from scratch. 

HDFC Bank's RoA has been pretty consistent. It improved from 1.45% in 2010 to 1.89% in 2020 owing to lower cost and higher Net interest margins. In addition, the management's foray into digital investments has helped the bank improve its performance.    

Base case valuation 

HDFC Bank post-merger will be valued on = HDFC Bank + HDFC - 21% stake extinguishment of HDFC in HDFC Bank + synergies (cross selling) – reserve requirement for HDFC loan book.

I have valued HDFC Bank standalone (before the merger) to keep it simple. The base case is close to 50% upside. In my opinion, the Parent is also deeply undervalued. For context, the Parent owns a 47.8% stake in HDFC Life Insurance (listed) and a 52.6% stake in HDFC AMC, HDFC General Insurance and a 51% stake in HDFC ERGO (General Insurance) which gives them immense optionality in Best-in-class firms. 

Assumptions for Growth 

India remains a severely underbanked country by many parameters, and hence the growth in banking has been ~1-2x the GDP growth. Private Banks like HDFC are in a sweet spot as they benefit from the mega-trend of gaining market share. 

Mega Trend = Real GDP Growth + Inflation + Share gain from public banks + unorganized to organized.

The Indian banking system opened to the Private sector only in the mid-1990s. HDFC (the largest private Bank with an 11% market share) was one of the few private sector banks to get the banking license, giving it a first-mover advantage. ICICI (7% market share) earned it a few years later, and Kotak Mahindra Bank (2% market share) in 2003. Unable to compete, other banks have found their niche and operate within that.

State Bank of India (SBI) is the largest public sector bank that has been consistently losing incremental market share but remains ~3x of HDFC Bank. Moreover, other public sector banks continue to deteriorate, and a few got acquired by the SBI. 

The below table shows that despite growing 20-25% over the last two decades, HDFC Bank still has a market share of just 11%.

Source: Reserve Bank of India

a. During 2000-2010, the banking industry credit grew at a 22% CAGR, but HDFC Bank grew at 44%. 

b. During 2011-2020, the banking system credit slowed down to 9% CAGR, but HDFC grew 22%.

Source: Reserve Bank of India

Catalyst

Catalysts 

1. Inclusion in MSCI and FTSE indices. For a stock to be eligible for inclusion in an MSCI Index, the proportion of shares available to foreign investors compared to the maximum limit must be at least 15%. Currently, it is 13.7%. As more foreign investors sell and HDFC merger, the free float available to foreign investors will improve to 15%. For context,  RBI mandates a maximum stake of 74% held by foreign investors in Indian banks. 

2. A merger will increase the combined weight to ~14%. Indian mutual funds cannot own more than 10% in a single company as per regulations. As a result, every domestic fund will have to buy the stock and still remain underweight to the benchmark. Indirectly, every incremental flow coming into the domestic markets will be investing 10% in HDFC-HDFC B combined entity.

3. Credit cycles: The history of Indian banking has always led to mismanagement in public sector banks and private banks, including ICICI. Time and again, the competitor banks recapitalize, underwrite aggressively, and then go back to raise money. This is where HDFC has stood above others, and I believe it should happen in the future (unless we are unlucky this time).