HDFC Bank: Will the elephant ever dance again?

We believe it will. Here’s why.

The principles of investing say that the stock price should track the company’s earnings. HDFC Bank's stock has been flat, before and after the merger. So either the starting valuations were too high, or earnings growth has slowed. Or both.

The 'scarcity premium' (rich valuation) HDFC Bank enjoyed before 2020 is hard to justify in today’s context. With non-performing asset (NPA) ratios in the banking sector at a 15-year low, HDFC Bank's top-notch asset quality does not stand out as much as it used to – for now.

As a result the standalone price to book, which topped out at 6x in June 2019, is now at 2.7x. The only other time in the past 20 years when the price to book was lower than it is today was in March 2009, at 2.5X.

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Then, there’s the question of future growth. At the end of the June 2024 quarter, HDFC Bank had a loan book of ₹24.8 trillion and a 15.6% share of total loans. So, it's fair to wonder how the bank can sustain 18-20% growth rates. The question is more relevant now, given that earnings-per-share (EPS) growth has been stagnant for four quarters.

We can't say for sure if EPS growth will be 14% or 18%. But we can highlight the factors that could lead to EPS growth. To that effect, the levers that supported HDFC Bank’s growth before the merger remain intact.

First, public sector banks continue to lose market share to private banks. According to a BCG report, between FY20-24, public sector banks’ market share of total credit fell from 63% to 58%, while their market share of deposits declined from 69% to 63%. The pace of 'value migration' may vary with the health of the public banks. But the trend is structural.

Second, home loans now make up around 31% of the total book compared to around 11% pre-merger. Home loans have consistently grown at around 15% over the past 10 years and have the lowest default risk (lowest NPAs). The bank should grow at least as fast as the market, if not faster, given its dominance in the mortgage market.

Third, the overall banking sector’s credit growth is itself robust. It's in the best shape it’s been since 2014. Credit growth is so strong it has outpaced deposit growth in the past two fiscals. On a long-term basis, HDFC Bank is likely to grow at least marginally faster than the overall industry.

Yet, short-term headwinds overshadow the bank’s long-term advantages. A high credit-deposit (CD) ratio and challenges in raising deposits have forced the bank to lower credit growth. We believe these headwinds are temporary. Here’s why:

At 80%, the banking sector's CD Ratio is at a multi-year high. In comparison, HDFC Bank’s CD Ratio is significantly higher at 104.4%. This is alarming but not surprising.

At the time of the merger, HDFC Ltd’s loan book was 26.5% of the combined entity’s. Yet, it contributed only 7.3% of total deposits. HDFC Ltd's loan book was funded almost entirely by borrowings. Housing finance companies primarily use long-term borrowings, not deposits, to fund loans. That's why the combined entity's credit-to-deposit ratio was expected to be higher right from the get-go.

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Why is a high CD ratio a problem? Because It implies incremental loans are funded by borrowings, not deposits. This is because deposit growth in the system is unable to meet the demand for loans. To attract deposits, banks must raise interest rates or borrow from costlier sources. This raises the cost of borrowings and hurts net interest margins (the gross margin of banks). Lower NIMs mean lower profitability and lower return on equity.

Even if this scenario plays out, fears of a high CD ratio and a liquidity crunch are transitory.

Firstly, a CD ratio of over 100% is neither a new phenomenon nor a structural one. According to an SBI white paper, the incremental CD ratio has crossed 100% more than eight times since 1951-52. Such periods have lasted two to four years. It's safe to say, this too shall pass.

To bring the CD ratio to pre-merger levels of around 85%, the bank aims to grow its advances a little more slowly than deposit growth.

Also, the belief that deposits are scarce must be viewed in the context of loan growth. On a systemic level, deposit growth came in at 13% in FY24. This is the highest year-on-year growth in the past 10 years. It's not that there aren't enough deposits. It's that credit growth is very strong and has outpaced deposit growth. This is a natural outcome of a healthy credit cycle.

According to an SBI research report, the concern is not so much about the quantum of deposits but rather the price at which they are available. Unlike some new private banks, HDFC Bank won't rely heavily on deposit pricing to attract deposits. Thus, the impact of the CD ratio on HDFC Bank NIMs may not be as bad as feared.

Despite that, it's true HDFC Bank’s NIMs have fallen by around 60 basis points year-on-year since the merger.

But this is primarily because of the around ₹4 trillion worth of higher cost borrowings it inherited from HDFC Ltd. On the plus side, 15% of these high-cost borrowings are due each year for the next three years. Plus, it will likely increase its share of higher-yielding retail loans to get back around 4% NIMs in two to three years.

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To meet its goal of lowering the CD ratio to pre-merger levels, the bank has paid down ₹60,000 crore in borrowings in FY24. As planned, it has slowed loan growth relative to deposit growth. A combination of these is showing positive results.

Its CD ratio has been declining over the past three quarters. NIM has improved marginally quarter-on-quarter and should continue improving. As these issues are resolved, the bank should return to its goal of profitable growth.

All the pieces for an HDFC Bank re-rating are in place. What shareholders need now is patience.

Note: The purpose of this article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your advisor. This article is strictly for educational purposes only.

Rahul Rao has been Investing since 2014. He has helped conduct financial literacy programs for over 1,50,000 investors. He helped start a family office for a 50-year-old conglomerate and worked at an AIF, focusing on small and mid-cap opportunities. He evaluates stocks using an evidence-based, first-principles approach as opposed to comforting narratives.

Disclosure: The writer or his dependants may or may not hold the stocks/commodities cryptos/any other asset discussed here as per Sebi guidelines.