Morningstar’s senior equity analyst Michael Wu shares his view of the stock.
Fair Value Estimate, or FVE
Our FVE HDFC Bank is Rs 1,240. This represents 3.6 times 2017 book value per share and 21 times our 2017 earnings per share estimate of Rs 59. We forecast earnings to increase 20% annually over the next five years.
We project average loan growth of 22% and deposit growth of 17% over our 5-year explicit forecast. With the bank taking more and more initiatives to help customers transact via cashless modes of payment through the use of technology, while simultaneously opening more branches to ensure access to rural deposits, we anticipate that the cost/income ratio for the bank will move modestly in five years, from 44% in 2016 to 43% in 2020. With the number of banked individuals in India still relatively low, we anticipate that HDFC Bank will continue to take market share away from the less stable state-owned banks.
Overall, HDFC Bank will comfortably exceed its estimated 12% COE while maintaining adequate equity coverage in our opinion.
Scenario Analysis
In our view, HDFC Bank's fair value estimate lies between a bear case of Rs 690 and a bull case of Rs 2021 per share, leading to a high uncertainty rating.
In our optimistic case, we model NIMs of around 4.8%, which are about 10 basis points above our base case. With the bank benefiting from economy of scale, we project an even more favorable average efficiency ratio of around 40% over our explicit forecast period.
Also, we factor in lower loan losses, with provisions at a long-run average of 0.6% of loans. The lower loan losses and operating costs boost our FVE to Rs 2,021 per share.
In contrast, if strong loan growth sees underwriting standards at HDFC Bank decline or a pull-back in India's economy reduces credit quality, we think higher impaired-loan balances would restrict interest collection and raise the firm's costs. Under this bleaker scenario, we forecast NIMs of 4.6% and model average provisions at 0.7% of loans.
In addition, we think lower revenue would push-up the company's efficiency ratio marginally to 50%.
Consequently, the lower net interest margins, loftier loan losses, and higher efficiency ratio yield a FVE of Rs 690 per share intrinsic valuation in our bear-case scenario.
Economic Moat
HDFC's narrow moat is based on low funding costs from sizeable deposit market share, low loan losses, and improving operational efficiency.
First, the bank possesses a sizeable deposit base, and we estimate that it has 6.4% market share in deposits in India. This is the largest among private banks in the country, and it matches some public banks with incumbent positions. The low-cost deposit base allows the bank to earn healthy margins on the spread between money lent and deposited. The bank’s average NIMs of 4.7% (between 2011 and 2016) rank highly against peers.
Second, the bank's prudent lending policy has resulted in superior asset quality relative to peers. Nonperforming assets averaged 1% of total loans over the past five years, having improved from 2% in fiscal 2009. A healthy loan book sees the bank's provisioning level averaging 0.6% of total loans during the past five years, resulting in higher profitability.
Third, the bank maintains an efficiency ratio (noninterest expense/revenue) of below 50%. Given its vast network of 4,500 branches across India and its digital strategy, we believe that increasing economies of scale will see the efficiency ratio continue to improve.
Overall, HDFC Bank boasts cost-efficiency and a diverse revenue stream derived from switching cost advantages. The bank has earned average returns on equity, or ROEs, of 18% during the past three years, above its 12% estimated cost of equity, or COE. We believe the bank will continue to earn ROEs higher than its COE, as loan losses and operating costs have improved significantly since the financial crisis of 2009.
Moat Trend
In our view, HDFC's narrow moat is stable. The bank is a well-established financial institution with an increasing presence in India's most important (urban) markets. The business is focused on the more profitable retail segment of the Indian market and has been able to garner superior net interest margins and returns on equity.
Despite the bank's strong growth in recent years, management maintains a tight control on noninterest expenses and underwriting standards, leading to a 35% compound annual growth in net earnings between 2011 and 2016. Even at the peak of the financial crisis, HDFC bank's provisions expanded to just above 2% as a percentage of the total loan book.
With new deposit-taking banking licenses being issued to a few lending firms, we believe deposit gathering is more than just about offering the best interest rates (due to the sticky nature of customer deposits). It would take a decade or more for these new firms to catch up with HDFC Bank in size and offer such healthy returns.
