HDFC Bank: Not a recommendation at current price

Despite a pristine balance sheet and solid quarterly returns, its bright prospects are priced into the current share price. We require a larger margin of safety before recommending the bank.
By Morningstar Analysts |  28-10-16 | 
 

This analysis has been done by senior equity analyst Michael Wu from Morningstar Investment Management. 

Narrow moat-rated HDFC Bank posted strong quarterly results. Second-quarter net profit increased 4% against last quarter to Rs 34.5 billion, or 20% against the same period last year.

The result was propelled by accelerating loan growth on the first quarter, a largely steady net interest margin, or NIM, and sustained high asset quality.

The solid result does not change our long-term view and underpins the bank's premium valuation. The bank is trading in line with our unchanged Rs 1,240 fair value estimate, representing fiscal 2017 price/book value per share of 3.6 times. The price/book multiple is one of the highest among banks globally, reflecting the high growth India market, the bank's pristine balance sheet and in turn, its annualized second-quarter return on equity of 18.3%.

However, its bright prospects are priced into the current share price and any deterioration of the above will see its valuation multiple compress. As such, we require a larger margin of safety before recommending the bank despite our preference for privately owned banks in India such as HDFC Bank.

Our long-term thesis is unchanged and we continue to believe the bank is favorably positioned to leverage India's strong long-term economic growth prospects, generating higher than peer return on equity.

Net interest income increased 2.8% against last quarter and we attribute the slower growth to a decline in NIM. We estimate a second-quarter annualized NIM was 4.35%, compared with 4.41% in the first quarter. We continue to expect NIMs to be pressured in the near term as the Reserve Bank of India maintains its easing stance, with one more interest rate cut expected before year-end. Management also noted competition for better quality corporates and in the retail segment in general it is further pressuring margins. However, we believe lower margins should be offset by higher loan growth, which remains robust.

Loan balance increase of 5.1% on the last quarter to Rs 4.9 trillion was ahead of the seasonally weak first quarter. Deposits grew at a slower pace at 3.1% on the last quarter to Rs 5.9 trillion. While deposit growth lagged system growth and the increase in loans, the bank's liquidity remains high with a loan/deposit ratio of 83%.

Slippage in its asset quality was a slight negative in the first quarter but the bank reversed the trend this quarter. Asset quality improved with nonperforming loans as a percentage of total loans declining by 2 basis points to 1.02%. Provisioning coverage on nonperforming loans is healthy and steady at 70% while its capital adequacy ratio declined by 10 basis points to 15.4% on the last quarter.

The bank's asset quality remains ahead of peers, particularly against publicly owned banks. With lower non-performing assets and a strong liquid and capital position, we maintain our view that HDFC can focus purely on growth and is in a good position to capture market share from publicly owned banks.

Investment thesis

We think HDFC Bank will continue to generate high returns on equity, or ROE, and is favourably positioned to leverage India's strong long-term economic growth prospects. The bank is able to maintain strong loan growth, averaging about 31% annually for the past 10 years, underpinned by an expansion of its deposit base at nearly the same pace (29%). The latter allows the bank to maintain low-cost funding and uphold its profitability. As such, net interest margin averaged 4.7% over the past decade, much higher than any of its peers. Liquidity remains strong, with the bank's loan/deposit ratio at 85% as of fiscal 2016.

HDFC Bank's maintain strong cost-control practices, with the bank's cost/income ratio declining steadily over the past five years. The bank's scale advantage is kicking in as the bank reaps benefits from investing in branches in both urban and rural areas. A digital strategy will complement the firm's targeted expansion of 200 to 300 branches annually. Management noted that 30% of personal loans in fiscal 2016 are originated through the online channel, with other products tracking around 20%. We anticipate that the bank's cost/income ratio will further decline as additional products are directed towards the digital channel and its branches become more efficient, with a focus on cross-selling additional financial products.

We believe there is still considerable scope for long-term expansion and shareholder value creation, as the bank benefits from rising incomes across India's middle and upper classes, which have been its target customer segments for a long time. The bank’s focus on salaried individuals with steadily rising incomes, and on giving loans mainly to existing clients within this segment, has allowed HDFC Bank to control nonperforming loans at about 0.6% of loans for the past five years; we see this as commendable.

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