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An Assignment on “The Impact of Merger Between CBOP and HDFC BANK”

Submitted to: Shreeniwas V. Bidwai Adjunct Professor IBS Mumbai

Submitted By: Ashish Sikarwar 06bs0684

HDFC BANK
KEY HIGHLIGHTS HDFC Bank Ltd.’s results were in line with expectations as net profit for Q4FY08 rose 37% YoY to Rs4.7bn. This was on the back of robust asset growth, margin improvement due to high CASA and a strong surge in interest income. Interest on advances surged 55% to Rs20bn, tracking a 35% growth in advances to Rs634bn. Deposits outpaced advances by 47% to Rs1trn and the bank continues to command highest CASA ratio of 54.5% within the industry. NIM

expansion

Sequentially margins continued to show improvement of 6-10bps, which has been a positive development. We expect margins to remain more or less stable at around 4.6%.

Net Interest Income growth
The bank reported a strong 47% YoY growth in its NII at Rs16.4bn on the back of 46% YoY growth in assets and a stable NIM of 4.4%.

Surge in net profits

Despite rising interest expenditure, net profits exhibited a sharp 45% jump to Rs4.7bn due to buoyancy in asset growth, in both retail and wholesale corporate credit. Fee income has also been significant and its contribution to total income accelerated 250bps to 13.5%.

VALUATION AND RECOMMENDATION
At the CMP of Rs1,540, the stock is trading at P/E and P/ABV of 28.3x and 3.75x its FY09E earnings. Considering the significant visibility in earnings growth, highest CASA and NIM in the industry, the bank would continue to trade between 4x - 4.5x, PBV, a marked premium to its peers. Assigning a fair P/ABV of 4.39 (5% premium over frontline private sector banks), we arrive at FY09 target price of

Rs1,788, translating into a 16% upside from the CMP. In view of the above, we maintain our ‘BUY’’ recommendation with a price target of Rs 1,788 on an investment perspective of 12 months.

PERFORMANCE OVERVIEW
HDFC Bank‘s Q4FY08 performance was above our expectations, and was driven by strong growth in core income and non-interest income. Net Interest Income rose 47% to Rs16.4bn, led by interest on advances, which grew 55% to Rs20bn due to yield improvement. Core NIM (excluding treasury income and adjusted for HTM premia amortization) expanded by 10bps sequentially to 4.4%.

Non - Fund income
Other income growth in Q4FY08 was relatively slower at 39% YoY, largely due to decline in the forex/ derivative revenue as expected considering the turmoil in the industry. The fees and commission expenses have shown a healthy growth of 39% primarily driven by third party product distribution and corporate commissions, with the former constituting ~20% of the total fee income. In addition, the bank has reported trading profits of Rs11.4m

as against a loss of Rs650mn in Q4FY07. Operating expenses scaled up 61% to Rs11bn led by 60% growth in employee costs to Rs3.4bn. Cost-income ratio of the bank has remained stable at ~50% over the last 4 quarters. Operating profit witnessed a strong growth of 31% to Rs10.8bn. OPM was lower by 368bps to 31.1% due to the high operating overhead. After provisioning of Rs4.6bn, net profit grew by 37% to Rs4.7bn. While provisioning trend improved during the quarter, the Bank has been cautious of its exposure to FX derivative related potential losses and has made a provision of Rs1.72bn including tax and other legal contingency related items. If these contingency amount was excluded, profit growth would have been higher at 60% (instead of the reported 37% YoY).

Business Growth:
HDFC bank has reported a a 35% YoY growth in advances to Rs634.3 bn. Sequentially the advances has seen a fall of ~Rs80bn. During the quarter, the bank has sold IBPC (Inter-Bank Participation Scheme) worth Rs35 bn. IBPC is temporary transfer of standard assets to another bank for a maximum period of 1 year . The same asset is repurchased at the end of the year. Further, rediscounting of bill worth Rs30bn also resulted in sequential decline of credit. As a result of transfer of standard assets, which were corporate advances, the share of retail has surged to 62% from 52% in Q4FY08. Retail advances have grown by ~39% YoY, albeit with some moderation the from previous high levels in line with the industry. The growth in retail portfolio continues to be on account of the personal loan, credit card segments and business banking. While no substantial change in the composition of the retail portfolio is visble, while a de-growth trend in two wheelers is observed in line with industry and the conscious management decision to exit certain current segments.

The bank has allowed some of its high cost deposits to run-off leading to CASA settling at 54.5% an improvement of 360 bps sequentially. Saving deposits have grown at an accelerated pace of 34% as against an average of ~25% in 9MFY08, though proportion of savings deposits has remained at 26% of total as in the previous quarter. CASA continues to remain the best in the industry. Further, the bank is planning to open 150 branches in the current quarter, which would impact CASA positively. Asset quality of the bank has been improving as Gross NPA and Net NPA improved to 1.2% and 0.4% respectively.

Capital Adequacy
CAR is comfortable and has increased by 30bps to 13.6% with Tier-I ratio at 10.3%. The bank raised capital via an ADS issue in Q2FY08, which netted Rs23.9bn and was preceded by a Rs13.9bn preferential allotment in Q1FY08. Also, after the merger announcement with CBoP, the bank issued 26.2mn shares as warrants to the promoters at a price of Rs1,530. Post the effective date of merger, the above warrants would be converted and dilution, and the liquidity infusion is expected to bouy its margins, which otherwise could have been depresed due to comparatively lower NIM of CBoP. Thus, the bank is well capitalized to tap lending opportunities across different segments.

Merger with CBoP
The merger with CBoP, which the management expects to complete in the next 3 months, should be considerably value-accretive as it provides the bank with a materially expanded branch/customer franchise. The merger adds 400 branches to HDFC Bank and would potentially enable the bank to double its balance sheet size in the next 24 months. Over a period of 30 months, HDFC Bank expects CBoP’s branches to scale up to the efficiency and productivity levels of HDFC Bank. The merger adds value as new branch licences may not always come in the desired mix and the presence of existing customers provides an additional advantage. Synergy in geographical presence The CBoP aquisition would give HDFC Bank access to 393 branches of CBoP. CBoP has a larger presence in the north and south regions, and post the merger, HDFC Bank’s presence would expand its presence. Thus, HDFC Bank can now effectively leverage this network of CBoP to generate higher CASA per branch. This makes HDFC Bank the largest private bank in terms of branches and makes up for two years of branch licensing, even under benign regulatory dispositions on branches. Upfront provisions/write-offs to be done wherever required HDFC Bank is aware of asset quality issues of CBoP in personal loans and 2 Wheelers portfolio. It would take upfront write-offs and/or provide aggressively to ensure that provisioning norms are in line with its aggressive provisioning policy. But CBoP had slowed down these businesses two quarters back after sensing problems, and hence HDFC Bank does not have to take extraordinary corrective measures.

INVESTMENT ARGUMENT
HDFC Bank enjoys the highest CASA ratio and NIM among the top 15 Indian banks and has consistently delivered in excess of 30% YoY growth in net profit every quarter over the past 6 years. We anticipate that CASA of HDFC Bank would decline in FY09 due to the impact of merger with CBoP. However, the same would show rising trend from FY10 onwards and we estimate it to be ~47% by FY10 on the back of rapid business growth per branch. The quality of its loan book has not been compromised even after achieving a sharp increase in loan base and this makes it the safest play amongst private sector banks. Keeping in view the aggressive nature of HDFC Bank in terms of provisioning, we believe the Bank would provide fully or write-off the reasonably high level of bad debt of CBoP as compared to the HDFC Bank. We view the stock as the most favourably valued and fundamentally stable among the frontline private sector banks. The stock commands a premium over its competitors on account of consistent profit growth of ~30% over the last few years, clean asset book, ability of the bank to maintain high margins on account of high CASA and consistent growth in credit and fee income.

OUTLOOK
The total dilution because of the merger with CBoP along with the issue of warrants to HDFC in order to maintain its holding at ~23% would be around 22% thereby pulling down the ROE in the near term. We do not expect the merger to be EPS-dilutive for HDFC Bank beyond FY10, though further clarity would emerge only after the extent of write-off by the management at the time of consummating the merger. We expect the bank to deliver net profit CAGR of 30% during FY08-10 on the back of a 31% CAGR in loans. While we expect NIM to be under pressure and exhibit a declining trend, we expect it to be ~4.6% during FY08 & FY09. Delinquencies are expected to rise ~2.46% in FY09 before declining to ~2.4% in FY10. RoA is expected to decline post merger to 1.24 in FY09 and would be accretive from FY10 onwards. Equity dilution in Q2FY08 and recent warrant issue post conversion would spruce up Tier-I capital. This would capitalize the bank to grow along with its retained earnings till FY13 when the RoE is likely to be ~20.02% with Tier-I CAR of 7.1%.

VALUATIONS Using Gordon model at a fair price-to-adjusted book value of 4.24x based on sustainable RoE at 20.3%, cost of equity at 12.5% suggests a fair price of Rs1,561 for the stock for a 12-month investment horizon. However, considering the cleanliness of its balance sheet, the strong sustainable traction in balance sheet growth, its positioning amongst peerset,as well the merger benefits that would accrue after 18-24 months, we are of the opinion that the above does not capture the synergy benefits and hightened growth of the bank. The stock is trading at P/E and P/ABV of 28.5x and 3.78x its FY09 estimates. Considering the significant visibility in earnings growth, highest CASA and NIM in the industry, the stock would continue to trade between 4x - 4.5x PBV which is at a premium to its peers. Assigning P/ABV of 4.39 (5% premium over frontline private sector banks), we arrive at FY09 target price of Rs1,788, which represents 16% upside from CMP. Considering the above, we maintain our ‘BUY’ recommendation .