Friday, June 15, 2012

>HDFC Ltd – SWOT Analysis

■ Structural de-rating in the making; Downgrade to UP
We downgrade HDFC Ltd to an anti-consensus Underperform rating from Outperform with a TP of Rs550, which offers 17% downside. We believe a structural de-rating is likely because the quality of earnings and ROE reported is being driven more by its corporate book and aggressive accounting practices. Mortgage profitability is declining structurally and regulations have become adverse. All this would make it tougher for HDFC Ltd to sustain its super-normal multiples/valuations. Though near-term catalysts are absent, the de-rating call is more a longer-term view as the stock appears fundamentally overvalued.

■ ROE driven by corporate book; getting riskier structurally
Over the past eight years, HDFC has increased the share of the corporate book (loans to real estate developers, lease rentals etc) in the overall loan portfolio from 29% to 37%. The issue is that housing loan profitability has been falling structurally and the company has been resorting to higher-risk non-retail categories to drive up ROE. We estimate the non-retail book now generates more than 30% of ROE and contributes more than 65% to HDFC’s profits.

■ Retail housing loan profitability falling structurally
Over the past several years, competition in retail housing has picked up, and some of HDFC’s peers have grown at exceptional rates. The premium product pricing that HDFC Ltd used to enjoy no longer exists. Competition is intense and likely to increase since banks have limited opportunities in the corporate segment this year. Retail business ROE has also been affected by regulatory changes and we estimate the retail business now generates a poor ROE of around 13-14% compared with 20%-plus five years ago.

■ Accounting practices used to inflate earnings and ROE
Over the past two years, HDFC Ltd has been adopting aggressive accounting practices by passing provisioning through reserves and also making the adjustments for zero-coupon bonds (ZCBs) through reserves. We believe FY11 and FY12 earnings are overstated by 38% and 24% respectively and reported ROE would have been 600 and 400 bps lower at 16% and 18% respectively if the adjustments had been made through the P&L. In other words, earnings growth has been managed, in our view.

■ Regulations – another overhang
We also think investors are underestimating the longer-term implications of regulatory changes and consequently this also presents a strong case for derating in our view. The regulator has increased the provisioning requirements, has banned pre-payment charges, and asked for re-alignment of rates for old and new customers, all of which could have an impact, especially in a predatory pricing environment. We also expect capital requirements to be increased, similar to the banking and NBFC sector, and this is one big event risk (with a high probability of happening) that the market is not factoring in, in our view.

■ TP cut by 30%, driven by sharp cut in multiples
We cut our TP by 30% to Rs550 on account of a sharp reduction in our target multiple. We are now valuing the core business at 2.0x P/BV compared to 4.0x previously. The reduction in multiple is on account of: i) lower retail business ROE driven by lower spreads in the retail business and higher capital requirements; and ii) a sharp reduction in corporate business ROE driven by factoring in credit losses and higher capital requirements.

To read report in detail: HDFC