>HOUSING DEVELOPMENT FINANCE CORPORATION (EDELWEISS)

NCDs+warrants: the right mix

HDFC is planning to raise up to INR 40 bn through non-convertible debentures (NCDs), issued along with warrants (convertible at a premium). The proceeds will be utilized for subscription to HDFC Bank’s warrants (INR 36 bn) and capital infusion in the life insurance subsidiary (~INR 3-4 bn). We are positive on the structure of the deal as it will provide funding for warrant subscription with minimal impact on profitability and RoEs. The bank’s warrants are due for conversion in December 2009 and HDFC Bank’s stock price is nearing exercise price of INR 1,530/share. Moreover, the stake sale in life insurance/AMC subsidiary is likely to take more than six months. HDFC Bank would gain ~INR 80 per share in book value due to warrant subscription by HDFC.

■ Optional value of warrants to lower effective interest cost
Optional value attached to warrants will result in lower effective interest cost. We believe the tenure of debentures could range from 3-5 years and warrants will be converted into equity shares at a premium (30-50%) in 3-5 years. HDFC is incrementally borrowing 3-year money through debentures at ~7.7% and 5-year money at ~8.25%. Considering few structures around which the product can be built, we expect effective interest cost (considering similar tenure for debentures and warrant conversion) to be ~3.25% (assuming 30% premium to CMP for warrant conversion) and ~5% (for 50% premium). Potentially, the deal can also be structured in a way with varying maturities such that the effective cost is minimal at 0-2% (refer table 1).

■ Earnings revision
As the money raised via NCDs will be utilized for investment in subsidiaries, spreads are likely to compress by 15-20bps (assuming 3-5% effective interest cost). We believe the company will structure the product in such a way that there is minimal impact on profitability and RoEs. We expect core mortgage earnings to post 18% CAGR over FY09- 11E. We are also building in investment profit of INR 3-4 bn over FY10-11E and stake sale in life insurance by FY11E considering improved capital market sentiments. Our EPS estimate now stands revised at INR 94.9 for FY10E and at INR 114.8 for FY11E.

■ Outlook and valuations: ahead of fundamentals; maintain ‘REDUCE’
The outlook on mortgage growth and asset quality has improved since January with change in macro environment and increased availability of capital. We are revising our SOTP fair value for HDFC upwards to INR 2,387 per share for FY11E (equivalent to next 12 months fair value of INR 2,170 per share). As core mortgage book will appear distorted for the next two years due to significant investment in HDFC Bank’s warrants (with no corresponding increase in net worth), we are using equivalent P/E of 17x (as consequent impact on earnings will be minimal). Though we are positive on the improved business outlook, we believe the stock has run up ahead of our fair value estimates. We maintain our ‘REDUCE’ recommendation on the stock.

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