HDFC Bank: Shooting For The Moon

HDFC Bank is India’s largest private-sector bank. I made the case for it in early 2020, emphasising that the bank’s impeccable risk management allowed me to sleep well at night. This is crucial because, in my opinion, poor lending standards are the only thing which could derail a multi-decade compounding opportunity as credit expands and the bank takes market share in one of the world’s fastest-growing and least indebted large economies.

The bank performed superbly through COVID and the challenging economic conditions which followed, compounding book value per share plus dividends by 17% p.a. from the quarter ending 31st December 2019 to the quarter ending 31st December 2022.

But since my last post, the bank’s stock has languished. In US dollars, its ADR has underperformed the MSCI AC World Index, rising 3% p.a. versus 5% p.a. In Indian rupees, the bank’s local line has risen 9% p.a. compared to India’s Sensex index’s 13% p.a. And it has underperformed its peers, with private-sector ICICI Bank returning 17% p.a. and public-sector State Bank of India returning 18% p.a.

Besides the headwind of a strong US dollar, what happened? In short, the banking and corporate balance sheet crisis which hamstrung India for more than a decade appears over. According to data from the Reserve Bank of India, the ratio of gross non-performing assets in India’s banking system has fallen from a high of 11.2% in the fiscal year 2018 to 5.8% in the fiscal year 2022. HDFC Bank’s less prudent peers have risen from the ashes, and their improving balance sheets and reduced provisioning fuelled supernormal earnings growth and higher market valuations. And HDFC Bank lost the valuation premium it enjoyed for side-stepping the mess.

I’m still excited about HDFC Bank and will share my thoughts below on some key issues: the leadership transition; net interest margins; IT and Fintech; the merger with HDFC Limited; the need to raise deposit funding; and the unfolding Adani crisis.

AFTER A SMOOTH TRANSITION, NEW CEO IS MAKING HIS MARK

HDFC Bank’s founding CEO Aditya Puri retired in October 2020 after 26 years in the role. He was the architect of the bank’s strategy and deserves credit for building a culture and the systems to manage the risks of meteoric growth.

His successor, Sashidhar Jagdishan, has been with HDFC Bank since 1996. He served as CFO from 2008 before becoming the ‘Strategic Change Agent of the Bank’ in 2019, essentially CEO-in-waiting. Sashi is cogent and insightful when he speaks. The transition has been smooth, and Sashi appears to have full authority. He restructured the bank in April 2021 and re-engineered its tech stack from the ground up. Then in April 2022, he announced a transformational reverse merger with the bank’s parent company, HDFC Limited.

Puri’s departure was my most significant concern about this investment. It’s too early in the credit cycle to judge his successor conclusively. But there’s no doubt that Sashi is already making his mark.

Leaning into Corporate was the right choice

HDFC Bank continued to take market share over the last three years but leaned into Wholesale (Corporate) lending, changing the balance of its loan book away from Retail.

Corporate lending is just as profitable despite lower net interest margins because ancillary fees are higher, and overheads and credit costs are lower. This is remarkable given the bank estimates its Corporate book would have an aggregate external credit rating of AA/AA+ (i.e. it is extremely safe).

During the depths of COVID and the subsequent economic recovery, the range of possible outcomes was wide and skewed to the downside. Leaning into a safer asset was the prudent course of action – and exactly why this management team lets me sleep well at night. Sell-side analysts and others are concerned about the bank’s declining net interest margins, but I am not.

REMAKING THE TECH STACK

Thanks to the government’s Unified Payments Interface, mobile-first computing and ample venture capital, India is home to one of the world’s most vibrant fintech ecosystems. This is a threat to any traditional bank heavily invested in physical branches offering inferior service.

This risk was brought home to HDFC Bank after repeated outages of its online and mobile services led to public outcry. The RBI sanctioned the bank in December 2020, prohibiting it from issuing new credit cards and digital products until it rectified the situation. This prohibition remained on credit cards until August 2021 and digital products until March 2022. During that time, the bank ceded an estimated ~200 basis points of credit card market share, primarily to ICICI Bank.

The problem was that the monolithic system undergirding the bank’s IT could not keep up with the bank’s scale and the demands of processing some 95% of its transactions through digital channels.

Former CEO Aditya’s “HDFC 2.0” initiative emphasised building a strong tech capability within the bank. This begs the question, were these outages in spite of or because of HDFC Bank’s commitment to building its own tech stack? I suspect the latter.

CEO Sashi used the crisis to re-engineer the bank’s tech stack around APIs and best-in-class services from public cloud providers like AWS, Microsoft and Google. This may sound technical, but the changes will be profound. Not only will the bank be better able to manage its growth, but it will also be better able to analyse and act on its data, and to more nimbly launch and iterate digital products.

APIs also make it easier for the bank to partner with third parties to bring more services to its customers. The best example is the deal it struck with PayTM, its most visible fintech rival, to offer enhanced point-of-sale services and a buy-now-pay-later product to small merchants. I expect to see more partnerships like this, where the bank leverages its 70 million plus client base and nationwide branch network to co-opt would-be rivals.

Merger: A Long Time Coming

HDFC Bank was founded in 1994 by HDFC Limited, a non-bank financial corporation (“NBFC”) which specialises in home mortgages. Besides using the HDFC name and an exclusive agreement to originate mortgages for its parent, HDFC Bank has always operated independently.

But the bank’s success has seen it eclipse its parent: its market cap is now roughly double the size; it has fourteen times as many exclusive branches; and twice the amount of loans outstanding.

CEO Sashi eloquently made a case for a merger at the bank’s 2022 Analyst Day:

India’s residential housing market is coming out of a prolonged slump and will drive economic growth over the next decade. Mortgages are the best way for the bank to participate, especially if it can bundle loans to purchase household durables. Mortgages are good for the bank’s deposit franchise too: existing customers with home loans are sticky and have deposits between 5-7x more than the average.
As one entity, approval times for mortgages can be cut from the current average of 8-10 days to something commensurate with the bank’s almost instant personal loan approvals. Only 2% of the bank’s customers have a home loan originating with the bank, but 5% have a home loan originating elsewhere. It doesn’t jibe, and management thinks the long wait and poor targeting are to blame.
HDFC Limited’s mortgage book will diversify HDFC Bank’s loan book, reducing the share of unsecured loans from the mid-30s to the low-20s. And it will increase the HDFC Bank’s book’s duration without necessarily increasing credit risk (at least, viz-a-viz long tenor Corporate loans).
As an NBFC, HDFC Limited cannot take deposits for less than twelve months. There is, therefore, an opportunity for the merged bank to lower its average cost of funds by some 320 basis points by replacing expensive long-term deposits and wholesale funding with cheaper short-term deposits.
In addition to the bank, HDFC Limited has launched a life insurer, a general insurer, and an asset manager. These sister companies currently partner with HDFC Bank on an arms-length basis. The bank’s management argues that accelerating sales growth would be easier if it became their parent.
HDFC Limited’s valuation has compressed to the point where its assets – including its stake in HDFC Bank – trade at a material discount to its public market valuation. The merger will be immediately accretive to earnings and book value per share because HDFC Bank will effectively buy back and cancel a large block of its own stock at a discount.
Finally, the regulations governing NBFCs have tightened to become more like banks. It would not have been practical for HDFC Limited to continue in its current form, and it almost certainly would have had to merge with a bank anyway. By proposing the merger proactively, HDFC Bank eliminates the risks of an unfriendly party taking over its major shareholder. In the worst case, it could have even lost the right to its name.

Sashi’s arguments make a lot of sense. The bank hopes the merger will be close by the end of this calendar year, subject to regulatory and shareholder approval. If successful, it will create a juggernaut. If it was hard for other banks to compete with HDFC Bank before, wait until it gets even bigger and better integrated.

The catch is the capital required to pull it off

Using rough numbers, the merged bank’s loan book will be 40% larger than HDFC Bank’s existing loan book. But because HDFC Limited does not rely on deposit funding to the same extent as HDFC Bank, the merged bank’s deposits will only be roughly 10% larger. To maintain a constant ratio of loans to deposits, the merged bank must therefore grow its deposits by an additional 26%, some INR5 trillion.

Actually, it’s even more. Financial institutions in India are required to hold a certain percentage of their deposit liabilities with the central bank as cash (the Cash Reserve Ratio requirement) and another percentage in lower-yielding liquid securities instead of higher-yielding loans (the Statutory Liquidity Ratio requirement). For banks, the combined CRR and SLR are currently 22.5%. For NBFCs like HDFC Limited, it is 13.0%. So, the merged bank will have to raise even more deposits to make up this eight-and-a-half percentage shortfall.

And this assumes zero loan growth. If the bank keeps growing, which it will, it will need more deposits still.

There are, of course, important details around timing and quantum. But it’s going to be a tall order. HDFC Bank grew its deposits by 19% year-on-year in 3Q FY23 and 17% y-o-y in FY22. The merged bank will have to do even better, accelerating deposit growth off a much larger base.

There is, therefore, reason to doubt whether HDFC Bank can continue to grow at its historical rate. And if it can, whether the cost of that growth will be prohibitively expensive in terms of operating expenses and the higher rates needed to attract depositors.

Management is confident they can pull it off, and I give them the benefit of the doubt. They plan to double the bank’s branch network within the next three years to almost thirteen thousand outlets. That may sound like a lot, but it will still be less than half of the State Bank of India’s branches. And it will still equate to less than one branch for every hundred thousand people in India.

Management also expects to gain more deposits from existing branches as they mature. Their data suggest that branch deposits compound with time, and that the vintage of their existing network is on the cusp of a significant inflection.

The bank has also been raising more time deposits, unusual given its preference for cheap CASA funding. But management argues that this is an underpenetrated resource, with just 14% of their 70 million plus customers taking out a time deposit. I find their strategy for raising more time deposits without competing on interest rates compelling:

Introduce the product to frontline staff’s evaluation metrics. Simply raising the penetration of time deposits by one percentage point will raise an estimated INR6-7 billion of incremental deposits, so getting to 20% penetration could raise an additional INR42 billion at the upper end.
Mobilise high volumes of what the bank calls “granular deposits”. These are in the range of INR25,000 (roughly USD300) and are small enough that the depositor doesn’t worry about getting the best rate.

Pinpointing prospective customers for granular deposits is an excellent showcase of the bank’s machine learning capabilities, a key area of investment over the last few years. If you have access, I highly recommend reading the interview Third Bridge’s Patrick Stokvis hosted on this topic in September 2022.

The Adani Group: What goes up must come down

As I write, the market capitalisation of the politically connected Adani group of companies has fallen by some USD100 billion since a short-seller published a report alleging financial fraud. The magnitude of this decline is enormous. India was one of the world’s better-performing stock markets in 2022. But for context, at one point, some 80% of the market’s appreciation came from Adani’s companies alone.

I have nothing to add to this saga except to say I am watching with interest. Brokerage CLSA’s financial analyst Adarsh Parasrampuria estimates that the combined debt of the five largest Adani companies totalled INR1.9 trillion - about USD23 billion at current exchange rates – of which banks lent 38%. This is equivalent to 0.5% of system loans and 3.6% of system equity. Not surprisingly, public-sector banks are more heavily exposed.

Public-sector banks’ aggressive lending to politically connected promoters’ infrastructure projects caused India’s last banking crisis. So, is this deja vu all over again? I hope not. It is in no one’s interest for India’s economy to be stymied again, especially when it so desperately needs credit to fund investment.

HDFC Bank earned its stripes by avoiding promoters like Adani in the past, and I would like to believe they’ve done so again. I hope management makes transparent disclosure on their next earnings call.

Valuation:

HDFC Bank currently trades at 16x the mean of broker forecasts for FY24 earnings per share. If we leave aside March 2020, that is in the bottom quartile of its ten-year trading range. It trades at 3.4x trailing price to book, which is in the second quartile over the same time.

CLSA’s Adarsh Parasrampuria has prepared a helpful table of his forecasts for the standalone bank and merged bank. He forecasts the bank’s standalone EPS to grow at 20% p.a. from FY23 to FY25, and for the merged bank’s EPS to grow at 19% p.a. He forecasts the standalone bank to have an ROE of 16% in FY25 and the merged bank to have an ROE of 15%. The merged bank trades at a 5% discount, at about 15.5x PE, ignoring any discount the market places on its subsidiaries.

I’ve consciously ignored currency depreciation in the past, but I acknowledge now that it creates a material headwind. When I visited India for the first time in December 2011, the rupee traded at 52 to the US dollar. Today, it is at 82, a steady 4% p.a. depreciation. This is in contrast to China - the other emerging market in which I invest - where economic growth has led to currency appreciation. (I need to better understand why - is it because of higher inflation in India?)

Wrapping it up:

I began by saying that I see a multi-decade compounding opportunity for HDFC Bank as credit expands and it takes market share in one of the world’s fastest-growing and least indebted large economies.

A lot has changed at HDFC Bank in the last three years, much of which has been beneath the surface. With the merger with HDFC Limited, management is shooting for the moon. Execution is paramount, and I would not trust another team to attempt something on this scale. But the bank’s management has earned the right to try. And if they get it right, there will be handsome rewards. The key metric to monitor will be deposit growth.

Disclosure: Longriver Investment Partners Limited manages the Longriver Partners Fund and separately managed accounts. These portfolios may hold or trade securities discussed in this article, and their holdings may change without notice.