Prepayment syndrome

Any increase in the level of repayments of earlier loans taken by customers holds the potential to derail HDFC's profit growth. In 2002-03, growth in repayments outstripped disbursements. Disbursements rose by 30.6 per cent. Additions to loan assets were however lower at 25.1 per cent.

The difference between disbursements and addition to loan assets is the reduction in loan assets during the year. The rate of reduction to loan assets in 2002-03 is higher than in the previous year.

This is after adjusting for sale of loans through securitisation in 2002-03.

Unique to India, customers prefer to prepay loans. For example, a 15-year loan is usually repaid over 7-8 years. This is a positive factor in that it reduces delinquency.

However, at a time when interest rates have fallen dramatically over the last three years, increased prepayments can lead to reduction in profit margins. This is because the margins on the fresh loans will be lower than that of repaid loan.

For investors prone to repaying earlier than scheduled, the rationale for repayment is now exceptionally strong. Loans disbursed by HDFC from 1996 to 2000 were contracted at rates much higher than what prevails now. Gains from prepayment of housing loans for such customers will be higher than gains from investing any surpluses.

In this context, there is the probability of a higher level of repayment the next couple of years exists. If that happens, then HDFC would have to substantially increase fresh disbursements to maintain profit growth.

However, with stiff competition at work, gaining market share may prove quite a challenge. HDFC may then have to contend with lower profit growth. But having said that, it needs to be emphasised that higher repayments have not affected HDFC's margins in 2002-03.

Bank needs HDFC

The arrangement that HDFC has struck with HDFC Bank also raises a few questions. HDFC Bank would now source customers for HDFC and pocket a fee. HDFC Bank would also buy housing loans from HDFC and the latter would charge a fee for administration and serving of the loans.

HDFC Bank needs HDFC more than the latter. HDFC Bank's competitors are piling substantial portion of lucrative retail housing loans on to their portfolio and improving their profitability. HDFC Bank has until now stayed away from housing finance so as not to cannibalise on HDFC's market. The arrangement seems to suggest that an end to the bank's resolve has been reached.

However, what the arrangement does not indicate is the impact on profitability. Will the 2 per cent that HDFC Bank would be paid affect margins of HDFC? HDFC has grown its disbursements without the help of HDFC Bank all these years.

What can HDFC Bank with its urban-centric network offer HDFC? As such, the sourcing fee to be paid might eat into HDFC's margins. Again, the volume of transactions with HDFC Bank will hold the key.

Double-digit growth

HDFC stock's market price is about 2.7 times its book value compared with much lower numbers for stocks of public sector banks.

The stock offers a dividend yield of 3.3 per cent, which is comparable or even higher. However, its dividend payout is higher at about 40 per cent compared to the less than 20 per cent level in most public sector banks. In this backdrop, HDFC needs to clock double-digit earnings growth to justify its premium valuation.

A higher level of repayment in 2003-04 might affect earnings growth though. As such, fresh investments need not be made now.

Shareholders can, however, hold on to the stock since the company has consistently shown its ability to overcome the odds. Only a marked deceleration in growth over the next few quarters will warrant reducing exposures to the stock.

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