HDFC: On solid ground - Buy

The pace of growth in the housing finance space has moderated in the last couple of quarters. For market leader Housing Development Finance Corporation (HDFC) too, the growth in loans has slowed from 19-20 per cent two years back to 14-16 per cent in recent quarters.

The main reason for this has been the subdued growth in the non-retail (developer) segment. But the pace of growth in retail loans continues to be on a strong footing and above the industry average as in the past.

In the last five years, HDFC’s retail loan book has grown at a rate which is at least 5 percentage points above banks’ growth in this segment. In the latest September quarter, while bank credit growth in the housing segment was about 17 per cent, HDFC’s retail loans (before sale of loans to HDFC Bank) grew 23 per cent. Under the arrangement with HDFC, HDFC Bank has the option of buying back the loans it originated.

A slow revival in the economy will mean that activity in the developer market will also pick up only gradually. While a strong growth in this segment is needed to propel higher loan growth, it is unlikely to happen in a hurry. Even so, HDFC’s steady loan growth in the retail segment, margin expansion and very low loan delinquencies should continue to drive earnings growth of 18-20 per cent over the next two years.

Given that earnings visibililty is commanding a premium in the market for now, there still seems scope for upside in the stock.

At the current price of ₹1230, the stock trades at four times its one-year forward book value, twice that of its peer — LIC Housing Finance — but in line with its five-year historical average.

The stock has always traded at a huge premium to peers in the space, thanks to its steady earnings, good asset quality and leadership position.

The many deals in the insurance space recently also open up the possibility of value unlocking in HDFC’s insurance subsidiaries; this can add value to the company’s core business value. In August this year, HDFC agreed to sell its 9 per cent stake in HDFC Life to its foreign partner Standard Life. At ₹95 a share of HDFC Life, the total deal consideration works out to about ₹1,700 crore, and pegs the value of the life insurance business at about ₹19,000 crore.

This is two times the embedded value of the life insurance business (as on March 2015). Embedded value is a measure used to value a life insurance business which, among other parameters, takes into account the future earnings of the company.

With deals in the life insurance space happening at one to three times the embedded value of the business, HDFC’s stake sale seems rightly priced. After this sale, HDFC’s remaining holding (61.6 per cent) in the life insurance business can be valued at ₹74 a share based on the deal value. This is about 6 per cent of the stock’s current market price.

Further stake sale in HDFC’s life and other subsidiaries that include general insurance and asset management can act as a trigger for the stock.

For HDFC, the residential space has always been a steady growth segment, thanks to the strong demand from the mid-income group. However, growth in the high-margin non-retail segment remained subdued at 8 per cent year-on-year in the September quarter.

This segment accounts for 30 per cent of the loan portfolio. Despite this, the company was able to marginally increase its spread on loans (return on loans less cost of borrowings) to 2.32 per cent in the September quarter from 2.29 per cent last year.

With interest rates cooling off, HDFC is likely to see some relief on its funding costs which will aid margins. Besides the flexibility to switch between different funding sources — bank borrowings, deposits and bonds — that helped the company to maintain its margins in the past, new funding sources, such as external commercial borrowings (ECB) and Masala bonds (rupee denominated bonds) will help lower HDFC’s funding costs.

HDFC recently raised ECB of $500 million for low-cost affordable housing and has approved issue of rupee-denominated bonds up to $750 million.

HDFC’s ability to maintain very low level of delinquencies over the years is a key positive. The gross non-performing assets in the September quarter stood at 0.71 per cent of loans.

HDFC has a 21.6 per cent stake in HDFC Bank, 61.6 per cent (after the stake sale) in HDFC Life, 73.6 per cent in HDFC Ergo General Insurance and 59.8 per cent in HDFC AMC.