HDFC Bank, for the longest time, was the largest private bank. With the merger of HDFC Limited and its asset size bulging to over ₹22.21 lakh crore based on FY23 financials, it is now the largest private bank with very little competition. That’s the biggest advantage that the merger brings and why investors should look at HDFC Bank with a new lens.

The most compelling aspect, though, is the valuation. Trading at about 2.5x FY24 price to book, it is at a level where investors can consider accumulating their position in the stock. The stock is at 35 per cent discount to its 10-year average asking price and, combined with the advantage of size, it presents a good opportunity.

That said, there are a few things that one must be mindful of.

There was a point in time, around 2016-2019, when HDFC Bank would consistently outperform the market returns by a huge margin. Likewise, its growth rate could also easily outdo that of peers. Back then, when the other banks were caught with asset quality issues, HDFC Bank was among the few that consistently earned net interest margin or NIM of over 4 per cent.

Also read: Can HDFC be the same under HDFC Bank?

These are some of the factors that supported HDFC Bank’s valuation, which was trading over 4x, making it one of the most expensive banking stocks. However, post FY19, there has been a slowdown in pace of growth and the merger presents headwinds to ensuring that the past advantages remain intact. Therefore, if investors want to take a fresh position in the stock, they should factor these challenges and be willing to hold the stock for a long term, say, 3-5 years.

Advantages of the merger

The direct implication is the loan book growing from ₹16 lakh crore to ₹22 lakh crore in just about 15 months. Organically it may have taken over four years to get to this scale for HDFC Bank. Therefore, the merger is a clear head-start to its positioning in the industry. It also addresses a key shortcoming in the bank’s portfolio — that of not enjoying a direct play in the housing business; an aspect its peers have built neatly since FY18.

The merger also brings in a reasonable amount of granularity to HDFC Bank’s retail portfolios which, for a long time, have been skewed to short-tenure (maximum of seven years, thanks to the auto loans book) and unsecured loans. Credit cards and personal loans accounted for over 17 per cent of its total book pre-merger and that wasn’t comforting. The bank was merely sourcing home loans from HDFC Limited, when its peers were organically building and/or strengthening this book. The merger will effectively address this concern, as home loans will account for about 38 per cent of the total book starting July 1, 2023.

Also read: Synergies between HDFC Bank and group companies to deepen following merger: Parekh

These are the two direct advantages of the merger. But along with this would come a fair share of near- to medium-term concerns for the bank to address.

Disadvantages of the merger

The mammoth home loan book has historically enjoyed yield of 1.9–2 per cent (for the retail book), while the bank’s NIM is 4 per cent. The apparent flipside of adding the large pool of mortgages is, unavoidably, a likely hit on profitability. This is also when most of its peers are comfortably expanding their margins, while HDFC Bank is just about maintaining it at 4 per cent.

Secondly, for the bank, which has constantly outperformed the market in terms of growth, are the signs of cooling off becoming more evident now? While the standalone growth of HDFC Bank was maintained at 20 per cent as per the provisional data for June FY24, the merged entity’s growth was 15 per cent. Is this attributable to a run-down in HDFC Limited’s wholesale book or did the retail segment also slow down or is it because of some merger-related adjustments? Investors should get clarity in the Q1 results.  

There are also regulatory requirements, such as maintaining the threshold cash reserve ratio, statutory reserve ratio and priority sector loans (PSL). While PSL is the lighter concern, mandatory ratios could increase the carrying cost of capital for the bank and can be margin-depletive. The bank did not receive significant leeway from the regulator on these aspects.

Hence, from Q2 FY24, investors will get an idea of how these costs may affect profitability. For now, a net impact of 50-100 basis points hit on net yield is being factored.

Investment rationale

With the disadvantages seeming to outdo the advantages, one may wonder why accumulate HDFC Bank.

Post the merger, HDFC Bank’s direct competition could be State Bank of India, which is over two times its balance sheet size. Being the behemoth that SBI is, the Street doesn’t expect the lender to outperform the industry average growth. While margins have improved for SBI over the last two years even if it is maintained at current levels, it might be viewed reasonably. Likewise, there is a healthy net profit growth that accrues due to its core operations.

Also read: HDFC Bank chief targets accelerated growth, aims to create a new bank every four years

Once the weaknesses owing to the merger recede and there is a reset in the business approach, expectations from HDFC Bank could be very similar to SBI. Given that the stock has de-rated reasonably from its peak and there could be a little more correction in the next 12 months as the merger takes shape, purely on valuation the bank is at an attractive spot.

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