HDFC Bank: The Jury Is Still Out, Although The Risk-Reward Is In A Better Place (NYSE:HDB)

Introduction

HDFC Bank Limited (NYSE:HDB), which was widely considered to be one of the pre-eminent financial institutions in India over the last few decades, has been going through a relatively rough patch for a while now. Last year, the talk of the town was the bank’s merger with HDFC Limited, a giant in the non-banking finance space.

As things stand, it looks like the market is not too enthused with this merger, as the HDB ADR has witnessed a contraction within the high-teens threshold (since the merger date), and consequently also underperformed its peers from the Indian financial space, Nifty India Financials ETF (INDF), and a diversified basket of Indian equities, iShares MSCI India ETF (INDA), both of whom have delivered positive returns during this period.

In case you’re wondering how to position yourself around this once-haloed name, here’s a discussion of some important metrics, which may help you make a call on this stock.

Key Metrics

One of the most important developments of late has been the shift in the bank’s net interest margin (NIM) profile. This was a bank that previously had a competitive NIM position which was more or less in line with some of the other major Indian private sector stalwarts, but these days, the NIM has been floundering at the sub 3.5% threshold.

To better understand this deterioration, investors need to note that HDB, which was previously largely exposed to retail loans (which includes a useful chunk of credit cards, personal loans, etc.), has now started chasing wholesale loans with greater fervor. Also, note that the merger with HDFC also brings a much larger component of low-yielding mortgage loans.

Principally, wholesale loans aren’t as lucrative as retail loans, but what it does is open up opportunities for HDB to engage in greater cross-selling opportunities with India’s corporate base, thus also bringing a degree of stickiness over time. Also, what it loses out on by way of NIMs, it could potentially recoup by way of a higher other income or fee contribution.

NIMs have also been hamstrung by the falling share of low-cost CASA deposits. This was around 42% of the total deposit mix before the merger, now it has dropped to 38%, but we wouldn’t worry too much about this, as we expect it to bounce back.

Why? Well, do consider that only 35% of HDFC’s customers previously had an HDFC Bank account, but an overwhelming majority (80%) of new business for the HDFC side of the business now involves opening new HDFC bank accounts. These customers typically maintain 6-12 months’ worth of fund balances to pay down their EMIs, and this could serve as a very useful source of low-cost funding. Management also plans to introduce nine new products which could help maintain some customer stickiness and some stability on the CASA front.

The investment community is also concerned by how the bank’s ROE (Return on Equity) trajectory has deteriorated recently. A decade ago, this was a bank that was churning out ROEs to the tune of 20%; in the December quarter this dropped to 15.8%, and there are now reports that it may take another 4-5 years for the bank to get back to its old ROE regime of 17%+ levels.

Ostensibly, a 4-5-year time frame may put off a fair number of investors, but we would urge these investors not to get too hung up about this particular metric, as ROEs don’t necessarily do a great job of capturing the leverage risks of a business. With a low equity base, banks can lever up their balance sheet and seek to generate high returns on that small base. We would be more inclined to look at the Return on Assets (ROA) metric, where the leverage impact is played down, and you get a sense of the quality of assets on the books. In that regard, note that HDB’s ROA hasn’t really fallen off a cliff; rather, they’ve been able to keep it at the 2% range even post-merger.

Crucially, the quality of assets on the books appears to be in solid shape. The net NPA ratio has consistently been maintained at 0.3% since the December ’22 quarter, and this stability should be commended particularly as they’ve just absorbed an entirely new pool of assets from HDFC.

One metric that could well slow down going forward is HDFC Bank’s loan growth; in the December quarter advances grew at nearly 20% but it’s difficult to envisage an improvement from here, as the bank’s loan-to-deposit ratio already looks quite elevated at 110% (previously it used to maintain a rate of 85-87%). For further context, note that for the banking industry as a whole, the loan-to-deposit ratio currently averages around 80%, so clearly HDB has its task cut out, and will have to take steps to curtail loan growth. Some loan growth moderation is all but inevitable given that the RBI has increased risk weights on certain loan categories including unsecured personal loans, credit cards, and NBFC lending (the deadline to implement this was February 29).

Closing Thoughts – Technical Considerations

Leaving the mixed fundamentals aside, and only looking at the charts, we think the risk-reward is now in a much better place.

For instance, if we look at HDB’s monthly price imprints over the last 40 months or so, it looks like we are experiencing a bout of range contraction, in the form of a quasi-descending channel/quasi falling wedge. The range contraction thesis is further validated by a drop-off in the ATR (Average True Range) readings. If you’re looking to go long in an asset class, it’s more prudent to buy when the range or volatility is in a subsidized state.

In addition to that, also consider that even if we don’t necessarily see a breakout from the wedge boundary, the reward-to-risk equation within the wedge structure looks quite attractive now. Considering where the price is currently perched, and using the upper and lower boundaries of the wedge as potential pivot points, we have a favorable reward-to-risk equation of over 1.77x (essentially the price is a lot closer to its downward-sloping support than its downward-sloping resistance).

The other key point to note is that investors who are looking for suitable mean-reversion opportunities within the broad Indian financial landscape will likely have HDB on their watchlists. Currently, HDB’s valuation relative to the Nifty India Financials ETF (INDF) is around 20% below its long-term average, increasing the probability of some normalization.