We plan to use the ongoing quarterly results season in India to take a preliminary look at some Indian companies and sectors. Last week we wrote a note on the large IT companies which can be found here.
This week we look at banks as this is another important sector in India.
HDFC Bank
The shares of HDFC Bank, India’s second largest bank have fallen 12% since they reported results on the 16th of January. What does this mean for a stock which has given a near 20% (CAGR) return for nearly three decades? Is it time to buy it on this correction?
Introduction
We will start by looking at the history of the banking sector before looking in some details at some banks. In this note, the focus is on HDFC Bank, and will be followed by ICICI Bank. International investors can track these companies as they both have ADRs. They trade in the USA under the tickers HDB and IBN respectively.
A short history of Indian banks
We will begin with a short overview of the history of banks and banking in India. This will be useful background for those not familiar with India.
The history of formal, organised Indian banking probably goes back to the 18th/ 19th Centuries, when the sub-continent was ruled by the East India Company and later, was the “Jewel in the Crown” of the British Empire.
The State Bank of India (SBI), the largest bank in India (by assets), was formerly known as the Imperial Bank of India. Its constituent predecessor banks trace their history to the 1800s. British overseas banks such as Chartered Bank and Grindlays also trace their origins in India to the 1800s. Both have been absorbed into Standard Chartered which remains a major foreign bank in India.
In the early 20th century, groups of Indian merchants and royals came together to form banks which still exist today. Bank of Baroda (1908), Punjab National Bank (1894) and Canara Bank (1906) date from this time.
At Independence, the major banks were all private and mainly active in the major cities. This was a political problem as people in rural areas were dependent on money lenders who charged high interest rates. Banks were nationalised in starting with the Reserve Bank of India (RBI) in 1949 and State Bank of India in 1955. 14 banks were nationalised banks in 1969 and another 6 were taken into public ownership as recently in 1980.
By 1980, most of the banking sector was under government ownership. A few small banks, mainly in the south, escaped nationalisation. This state dominance has to be seen in the context of the autarkic, socialist, planned economy of the time.
The government had a high degree of influence on the nationalised banks. The latter were pushed to achieve political aims. They were pressured to direct lending to sectors favoured by the government or open branches in rural areas. Senior managers were appointed by the government and the business culture was bureaucratic and slow moving.
The nationalised banks are now known as Public Sector Unit or PSU banks. These days, they are listed but the Government of India owns between 52% to 70% of the equity. In recent years the number of PSU banks have fallen as small weak PSU bank have been taken over by larger ones. The sector is dominated by the State Bank of India (SBI) which is the largest bank in India.
Foreign banks such as Citibank, HSBC and Standard Chartered were active in India but were restricted in the number of branches they could open and the range of activities they could undertake.
The planned socialist economy delivered poor rates of growth between 1945 and 1990 and there was a balance of payments crisis in 1991. India had little choice but to embark on a period of reform and liberalisation.
In the banking system, reforms meant 10 new private sector bank licences were given in the 1990s. These included HDFC Bank, ICICI Bank, IndusInd Bank and Axis Bank (formerly UTI Bank). A few more licenses were given later and these included Kotak Mahindra Bank and Yes Bank.
In addition,
Foreign banks were allowed to expand their branch networks.
Payments banks were introduced with the development in the field of banking and technology. The leading telecom company, Bharti Airtel, operates a payments bank.
Small Finance Banks were allowed to set their branches across India. The most notable of these is AU Small Finance Bank.
While some of the new private banks faltered, most have done very well.
Unlike the PSU banks, the private banks were not burdened by bureaucratic government controls or large unionised labour forces and other restrictions.
PSU banks had to operate large branch networks and expand into less profitable rural areas in line with financial inclusion policies. They often had to change their lending policies to suit government priorities and forgive groups of defaulting borrowers due to political or other pressures.
The new banks had few such pressures and focused on wealthy urban customers. They offered a more responsive flexible services and were able to offer higher salaries to attract the best employees etc.
For three decades, the PSU banks have lost market share to the Private banks.
Some of the private sector banks, particularly HDFC bank, have done very well. For many years, HDFC Bank consistently and reliably reported assets and profit growth of 20% per annum Investors have been rewarded with stock returns of about 20% over three decades and a total return of 24,576%. A remarkably long period of outperformance.
As noted above, there has been some much-needed consolidation among PSU banks, In the last three to four years, the performance of PSU banks has improved as a response to the superior performance of the Private banks.
PSU Bank shares tended to trade at Price to Book Value Ratios (P/BV) of 0.5X to 1X while Private Sector banks trade at a much higher range of between 2X and 6X.
In the last two or three years, the shares of PSU Bank have outperformed Private Sector banks and the valuation gap between them has been closed but not eliminated.
HDFC Bank
History
After the liberalisation process started in 1991, a number of new banking licences were awarded by the government and the Reserve Bank of India (RBI). One of the recipients was Housing Development Finance Corporation Limited (HDFC Ltd). HDFC Ltd was founded in 1977 as a private sector mortgage lender and was the biggest housing finance company (HFC) in India.
The company borrowed money in the wholesale bond markets and provided housing finance to individuals and corporates for purchase/construction of residential houses.
HDFC Ltd was a well-run company and gave excellent returns to tock investors.
HDFC bank grew strongly from the beginning and HDFC Ltd’s shareholding in the bank declined to about 26.4% after listing of HDFC Bank. HDFC Bank gave shareholder returns of 20% CAGR over for three decades. As of April 2023, its market capitalisation was US$120 billion, making it India's third largest publicly traded company. It is the largest private sector bank and serves over 68mn customers.
HDFC Bank became much larger than its older parent. The latter had 445 offices or service centres across India. On the other hand, the bank has grown to over 8,000 branches.
On July 1, 2023, HDFC was merged with HDFC Bank. Various subsidiaries of HDFC involved in Asset Management, Insurance and Securities Trading were transferred to HDFC Bank.
There were a number of reasons for the merger to be done at this time.
The RBIs regulatory regime for Banks, Non-Bank Finance Companies (NBFCs) and Housing Finance Companies (HFCs) had converged very significantly. It made little sense to keep the Bank (HDFC Bank) and the HFC (HDFC Ltd.) separate.
The HFC assets were secured against property and were less risky and had a lower regulatory capital cost than the Bank’s business. Therefore, the merger reduced the overall riskiness of the portfolio, reducing the proportion of unsecured lending significantly.
HDFC Ltd had funded itself by long-dated bonds in the wholesale debt markets. After the merger, this high-cost debt can gradually be replaced by lower cost deposits, sourced from the HDFC Bank branch network and wholesale commercial banking business. Post-merger synergies would slowly accrue as HDFC Ltd bonds would mature and be replaced by lower cost deposits.
If you Google the world’s largest bank by market capitalisation, HDFC bank appears at about no. 10 after the big US and Chinese Banks and HSBC.
On the other hand, if you look at the biggest 100 banks ranked by total assets, there is only one Indian bank in the top 100 (SBI at no 48). HDFC Bank is nowhere to be seen in this second table.
This suggests that HDFC Bank is relatively highly valued and has a high proportion of non -interest income relative to interest income. As we see below, we find evidence to support both these ideas.
From 1994 to 2020, the CEO of HDFC Bank was Aditya Puri. He had worked for Citibank in India and Malaysia. Puri was the longest-serving head of any private bank in the country and oversaw shareholder returns of 20% (CAGR) over his tenure.
There were a number of reasons for this strong performance by HDFC Bank:
The bank was well run with a strong emphasis on risk management especially credit risk management.
Compared to ICICI Bank it was cautious on aggressive growth and overseas expansion. These two factors which led to significant problems for ICICI Bank.
HDFC Bank was cautious on long term lending to the industrial sectors especially infrastructure and was thus able to avoid the bad debts its rival suffered.
The Bank always had a strong focus on growing fee income.
It earned fee income for sourcing mortgage business for HDFC Ltd which ended up on the latter’s balance sheet.
In the last three years, the share price has fallen by about 26% and over this period HDFC Bank has clearly underperformed both the market and other Banks including PSU Banks. This, perhaps coincidentally, makes Aditya Puri’s exit well-timed.
The Results
HDFC Bank reported Q3 FY24 results on January 16, 2024.
The summary numbers were as follows:
Gross advances rose 4.9% (Q-o-Q) to INR 24693bn (US$ 313bn).
These are strong long numbers consistent with annual growth of about 20%
Deposits rose by 1.9% to INR 22,140bn (US$ 281bn).
The growth which implies annualised growth of about 8% was disappointing as it was less than expected and too low given the strong demand for credit and the current high growth in advances.
Net Interest Margin (NIM) came at 3.4%
NIM came in less than expected.
Cost to Income ratio was 40.3%
Gross NPA as 1.26%- Gross NPA is very low and shows the lack of distress in the book.
Return on Assets was 2.0%
The BIS Capital adequacy Ratio is 18.4% of which the Common Equity Tier 1 (CET1 Ratio is 16.3%. HDFC Bank is well capitalised and well above RBI’s regulatory norms under the Basle Frameworks.
More details on these numbers can be found here.
The stock has fallen about 12% since the results were announced.
The market was disappointed by two things.
The slow growth in deposits.
2. The 3.4% NIM margin was lower than expected
Deposits
One of the promised synergies of the merger was the combined entity will be able to replace the high cost HDFC Limited bonds as they mature, with lower-cost deposits raised by the HDFC bank 8,000 branch network.
The 1.9% (q-o-q) deposit growth is low for a bank used to 20% growth (y-o-y) on both sides of the balance sheet. The slow deposit growth led to fears the high growth period is over and the scope for reducing deposit costs may be weaker than previously thought.
Margins
The bank had enjoyed NIMs of around 4.1% to 4.4% for decades. The historic numbers are not comparable as HDFC bank and HDFC merger was effective on 1st July 2023.
The HDFC mortgage business was lower margin than HDFC Bank’s business, so the blended margin of the combined entity was bound to be lower.
The 4.3% historic NIM is unlikely to be seen again. The real question is whether HDFC Bank can increase the NIM for the merged entity closer to 4.0% or whether 3.4% is the new level of steady state profile margin for the merged entity.
The worry about deposits raises an important question which is whether HDFC Bank is losing market share.
Deposit trends in Detail.
In 2014, HDFC Bank’s market share in Advances was 5.0% and it was 4.7% in deposits. By 2023 these numbers had risen to 11.6% and 10.1 % respectively. This change was achieved in fast growing and competitive market. HDFC Bank has been gaining market share on both sides of the balance sheet for the last ten years.
No other large bank has been able to gain market shares of such magnitude in history. One should not be surprised if the law of large numbers catches up with HDFC Bank. In this case, market share gains become harder to come by and absolute growth rates slow.
However, if one looks at the data for 9 months to December 2023, HDFC Bank’s market share in incremental deposit growth has been about 15% above than the point market share of 10.1%. This suggests the growth in market share continues to be strong.
HDFC Bank’s progress is part of a broader trend of PSU banks losing market share to the private banks. The latter have seen market share rising from 18% to 32% in the last decade. There has been a long-term transfer of market share from PSU banks to Private banks.
The Credit-Deposit ratio for the banking sector as a whole, is at an all-time high and therefore the whole sector faces the challenge to attract deposits. Unless they can increase the rate of deposit mobilisation, banks will not be able to meet credit demand and will be unable to grow.
Deposit mobilisation is a function of many things such as the growth rate of the economy, the extent of financialization of the economy, the preference for physical assets relative to financial assets, the rate of interest etc, etc.
However, for an individual bank, the most important determinant of deposit growth is the growth of the branch network, the vintage of the branch network and the size of deposits per branch.
We have examined these matters in great detail and believe that HDFC Bank is well placed on these metrics, both on an absolute basis and compared with its peers. We cannot state all our finding here as the note will become too long.
The summary argument is as follows:
According to a report from IIFL Securities Research, HDFC Bank is opening between 2 and 5 times more branches in districts witnessing strong deposit growth, compared with their Peers.
They are also opening between 3 to 10 times more branches than their peers in high potential districts.
These data reflect the fact HDFC Bank embarked on aggressive branch expansion about 18 months ago with a view to doubling its branch footprint over the next 3-4 years. In the last 24 months, it has added over 2,300 branches. The bank’s physical footprint has expanded 50% over the last 2 years.
Almost 60% of HDFC bank branches are less than 10 years old. This is one of the highest among all banks. The highest level of deposits is usually in branches which are more than fifteen years old. As the branch network ages, HDFC Bank should see a disproportionate growth in deposits. Only 688 of the banks current 6352 branches are more than 15 years old.
In addition, it has an important first mover advantage. According to the report from IIFL Securities, out of 1,900+ pin codes where HDFC has opened branches in the last two years, ICICI, Axis and Kotak do not have a presence in 45%-75% of the pin codes. This means their competition is mostly from the PSU Banks where it should be easy to win market share due to better service etc.
In terms of regions, PSU banks have 55-65% of their branches in semi-urban and rural region vs 30-50% for Private banks. Therefore, Private banks have a good opportunity for expanding in rural areas.
Total deposits per branch for HDFC bank are the highest at INR 3.34 bn (US$ 42mn). The equivalent for Kotak, ICICI, SBI and Axis bank are at US$ 30mn, US$ 29mn, US$ 25mn and US$ 24mn respectively. This is a significant difference.
Non-interest income.
Private banks have always outperformed in capturing customers’ transaction flows relative to their deposit market share.
HDFC Bank is the leader in both customer transaction flows and agency business. HDFC Bank has the highest share in National Electronic Funds Transfer (NEFT) and Real Time Gross Settlement (RTGS) market share among the individual banks, and also relative to banks’ own deposit market share. HDFC Bank’s Non-fee income is a 30% of net interest income which is higher than peers.
Outlook for the banking sector
Banking analysts believe the banking sector is set for loan growth of 16% for the next few years. This is due to positive trends in both the supply and the demand side,
On the supply side, there is better data on SME finances, thanks to the UPI digital payments revolution (70% of all payments are digital), strong state of balance sheets, high bank capitalisation, and a decline in capital market disintermediation. On the demand side, there is rising consumption-led loan demand, a shift from unorganised to formal financing and a gradual growth in corporate loan demand.
The management has said the post-merger consolidation will take 4-5 years and it will take some time for growth and profitability metrics seen during the high growth era for the standalone bank.
For example, before the merger, the bank's return on equity was above 17%, but has since declined to 15.8% as of December-end. The question is whether this will rise to former levels and how long will it take.
Margins
Our best guess is that NIMs will rise to about 3.6% to 3.8%
Our optimism is based on a number of factors,
There will be an increase in the growth of retail/ personal loans on the asset side.
On the liabilities side, there will be a rise in share of deposits over high-cost bonds (as old, expensive HDFC Ltd bonds mature) and are replaced by lower cost deposits.
The increase in deposits from new branches will help margins over time. The growth will be achieved without any increase in interest rates though this may not be apparent in the next two quarters.
Summary
There is little doubt that HDFC Bank is a strong institution which has performed well in the past. However, it seems to have lost momentum in recent years.
Size is one factor as well as too high a valuation in 2019/ 2020.
The competition whether it is other Private Banks such as ICICI Bank, IndusInd Bank and Axis Bank or the large PSU Banks, has improved their performance.
The merger with HDFC has reduced the overall risk profile of the business but has also reduced NIMs and Profitability. These will rise going forward but may take some time and this will test the patience of investors.
Banks are involved in a “race for deposits” and HDFC Bank is the most aggressive in its new branch roll out and seems the favourite to win the race of deposits. However, in an increasingly digital world and online financial world, physical branches may not either be the only weapon, or the best one, in the war for deposits.
Social media is full of stories about how HDFC’s app and online banking experience is poor, and the overall level of service is deteriorating. These are things the management will have to address urgently.
Valuation
The HDFC Bank stock currently trades at INR 1437 per share. Analysts estimate the various subsidiaries involved in Asset Management, Life Insurance, General Insurance are worth about INR 225 per share. This means the “core bank” is at INR 1212 per share.
The estimated book value per share (bvps) is INR 576. This means the bank is trading at 2.1 x FY 2025 bvps and 1.8 x FY 2026 bvps.
We can compare this with international banks.
JP Morgan, Bank of America and Wells Fargo share prices are at 1.69, 1.0 and 1.07 x next year’s bvps respectively. These figures may reflect the fact the prospective growth rates for the American banks are much lower less than those available to Indian banks.
In Europe, BNP Paribas, Deutsche Bank and Barclays trade on 0.64, 0.34 and O.33 x next year’s bvps respectively. These low figures may reflect fears that European banks’ bvps value may fall due to bad debts and write-offs. Another factor may be significant pessimism about growth prospects in Europe and the UK.
For HDFC Bank, a level of 2.1x bvps is the lowest in the last 10-20 years. It compares with a long-term average of 3.1x.
In 2010, HDFC Bank was trading at P/BV of 6x times while ICICI was at 2x
In 2021, HDFC Bank P/BV fell below 4x for the first time. Today the HDFC Bank P/BV of 2.1 x is lower than ICICI P/BV of 2.9 x for the first time.
The historical rates may not be relevant any more as times have changed, the competition has improved and HDFC bank has changed as a result of the merger.
Nevertheless, on balance, we believe the stock valuation is starting to look attractive.
The growth prospects for India looks good, the banking sector is well capitalised, and the quality of assets looks very good compared with the past. Therefore, the banking sector looks set to grow strongly and HDFC bank as the leading player will benefit from this rising tide.
Investors are worried about HDFC Bank’s ability to deliver healthy ROEs post-merger. The fact that the bank has delivered 1.8-1.9% Return on Assets (ROA) and 15%+ Return on Equity (RoE) (for the merged entity) in the last 2 quarters suggest stabilisation and scope for some additional improvement to follow.
Conclusion
The historically low valuations make the risk-reward potentially compelling.
We have long held a position in HDFC Bank through the ADR. The current downward momentum is strong, but we will add to our holdings if the price falls another 10% to 12.5%.
There is nothing scientific about this 10% to 15%. It reflects caution given the strength of the current downward trend and a recognition of the likely time required to raise margins and improve profitability for the merged entity.
This would imply a purchase point of INR 1270 per share or about US$ 50 per ADR (Each ADR is equal to 3 of the India listed share and trades at a slight premium to the local stock).
The Bank has some significant strengths and is well placed to perform strongly over the next two decades. The challenge for investors is to acquire additional stock at an attractive price.