HDFC Bank: Favor Quality On The Recovery Path

Following a review of HDFC Bank's (NYSE:HDB) strong FQ2 '21 performance, I think shares warrants a closer look. Through COVID-19, the strength of the HDFC Bank franchise has allowed the company to navigate choppy waters unscathed, and with the worst of the asset quality issues now behind us, I think the long-term growth story should come back into focus. The valuation is not cheap at over 3x book, but quality rarely is, and backed by a strong capital position, HDFC Bank looks poised to outperform.

Loan Growth Points Toward a Demand Recovery

For its latest quarter, HDFC Bank posted a 16% Y/Y growth in total advances, with corporate loans the key driver at +27% Y/Y. Surprisingly, retail loan growth was also a bright spot, showing signs of improvement at +5% Y/Y.

Source: Company Data, INR millions

At the same time, deposit growth was also strong at +20% Y/Y, helped by higher Current Account/Savings Account (CASA) growth. With loans trending in the right direction, I think demand may be normalizing, and as businesses get back on track, I see HDFC Bank promptly returning to 15+% loan growth in the upcoming years.

Margin Headwinds Outweighed by Lower Provisions

Encouragingly, fee income has shown signs of normalizing, returning to flat Y/Y growth in FQ2 '21. However, like most other banks in the current rate environment, margins remain an issue. HDFC Bank's 4.1% net interest margin in the quarter was down c. 10bps Y/Y, dragged down by the excess liquidity on the balance sheet (the liquidity coverage ratio rose to 153% in the quarter). Adjusted for the excess capital impact, the NIM would have been higher by c. 15bps.

Source: Company Data

Headline pre-provision operating profit (PPoP) also rose c. 18% Y/Y due to higher treasury contribution and steady opex, while core PPoP growth was closer to c. 14% Y/Y. Considering the strength in corporate lending, I see the NIM sustaining within the historical 4.0-4.5% band, with fee income also set to improve in line with the broader growth trends.

Source: Company Data, INR 'millions

Clearing the Asset Quality Overhang

Encouragingly, HDFC Bank also noted improved asset quality trends across segments compared to recent quarters. Within retail, for instance, the bank's collection efficiency improved to 95% in September, with management pointing toward a further rise to 97% in October, moving closer toward the steady-state run-rate of 99%. Corporate banking has also outperformed, backed by an especially strong customer base - c. 93% of the portfolio is A-rated (considerably above the banking system).

Even in the troubled SME segment, the bank has reduced its estimate of highly stressed loans to "the 3-point-percentage range" (significantly down from the prior mid-single-digit guidance in FQ1 '21). Similarly, moratorium loans are performing well, with overall collections at 85%, implying limited restructuring ahead. In sum, the worst of HDFC Bank's asset quality issues may now be behind it.

Digitization as the Next Growth Driver

Looking ahead, HDFC Bank's digital initiatives are set to emerge as a key driver, with the bank actively looking towards digitizing lending. Leveraging upon its digital capabilities, HDFC Bank will offer banking services across target ecosystems with use cases in Healthcare (with Apollo) and Automobile. Additionally, management is also looking to digitize the unsecured personal loan vertical in an effort to deepen the "10-second personal loan" initiative.

The growth impact could be significant - through digitization, HDFC Bank looks set to effectively gain market share across geographies while simultaneously expanding profit pools such as personal loans and credit cards. In effect, the HDFC Bank of the future could well be comparable to large digital financiers in other regions, offering a full suite of services and benefiting from a lower-cost growth model.

Challenges at HDB Financial Offset Strength at HDFC Securities

In contrast with the broking subsidiary (97% stake), which reported a c. 84% Y/Y rise in profit (mainly due to higher retail trading activity), the HDB Financial subsidiary (95% stake) underwhelmed for the quarter. Loan growth was 2% Y/Y, as the lender shifted its staff to collection efforts, while profits fell 94% Y/Y due to elevated credit costs. Considering HDB Financial typically services customers a few notches below the bank, the asset quality issues make sense in the current macro backdrop.

However, management countered that the steep decline in earnings was attributable to accelerated provisioning in line with banking industry norms (as opposed to non-banking financial companies' (NBFC) norms). Nonetheless, I think HDB Financial's ongoing challenges reflect the fact that stress levels may be diverging across borrower segments. In other words, lenders focusing on less creditworthy clients may lag on the recovery path. Nonetheless, as HDB Financial is a small contributor to overall earnings/valuation, performance at the core bank remains the needle-mover.

Favor Quality on the Recovery Path

In sum, HDFC Bank offers investors a quality way to play the Indian banking sector recovery. Backed by a resilient margin profile, strong asset quality, and a solid management team, along with digitization initiatives in the pipeline, the bank appears poised to deliver long-term growth through the cycles.

While HDFC Bank is not cheap at c. 3x fiscal 2022 book (my estimates), I see plenty of room for it to grow into its valuation. Overseas/US-based investors should note that the ADRs (each ADR equates to three underlying shares) currently trade at a slight premium.

Source: Company Data, Own Estimates

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.