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2019-10-19 06:04:03

Several Indian banks saw their stock prices decline in recent weeks amidst rising concerns over credit quality and exposure to shadow banking. In this time, certain banks such as HDFC Bank (HDB) have remained resilient and continued to see strong stock price performance. Bullish investors have expressed the view that the bank's stock is set to continue performing well as investors, who have grown wary of smaller competitors, flee to higher-quality names.

In my previous article on HDB, I also highlighted the bank's long history of maintaining its NPLs (Non-Performing Loans) at a level well below that of the majority of its peers. This strong history is again used by investors in the stock in favour of arguments for continued outperformance. Much as I also believe that the bank is set to benefit from its competitors' woes, the valuation increasingly seems somewhat high to initiate a new position.

The Macro Environment

The World Bank recently cut India's GDP growth rate projection to 6% for 2019 as the economy seems set to present its second consecutive year of slower growth. In the first quarter, the economy experienced a substantial growth deceleration largely brought about by a decline in private consumption on the demand side and the weakening of growth in both industry and services on the supply side. The recent tax cut could aid in improving the economic outlook, but for the time being, it appears that economic growth will be somewhat more muted.

With inflation remaining below RBI's (Reserve Bank of India) targeted range, due in large part to persistently low food prices, the RBI has adopted an accommodative monetary policy, which brought about a number of rate cuts. Substantial rate cuts have the potential to have a negative impact on banks' NIM in certain instances, although they can also act to ease pressure on consumers and lower default rates. In the case of India, DBS has indicated that this more accommodative monetary policy is likely to play a significant role in easing growth headwinds and supporting increased consumption. Inflation has also more recently edged upwards, and it remains to be seen if this trend will continue heading into the last quarter of the year.

Asset Quality and Capital

With concerns over asset quality for Indian banks even more prevalent than at the time of my previous article, investors would be well served to monitor this area closely. Although, strictly speaking, there has been a decline in NPLs for most Indian banks - concerns have arisen as a result of a substantial increase in the number of defaults in the real estate industry and bankruptcy filings among firms in this industry doubling.

In September this year, Moody's issued a report noting that banks such as Yes Bank (OTC:YYBKY) and IndusInd Bank had the most significant exposure to the real estate sector and is likely to be affected more than other competitors. HDB's comparatively lower exposure to this increasingly stressed sector has only served to further support the stock at trading at a premium to its peers. HDB's NPL ratio at 1.4% also remains the lowest among Indian banks as depicted in the chart below.

(Source: Company Fillings)

This lower-than-peers NPL ratio is also not a new occurrence, with the bank having a long history of maintaining a below-average NPL ratio. Please note that Indian banks use the term NPA (Non-Performing Assets). There is generally no difference between NPAs and NPLs; I use the term NPLs simply because it appears that many investors are more familiar therewith.

The bank's CAR (Capital Adequacy Ratio) at 16.9% is also the second-highest of the Indian banks depicted in the chart below. These strong capital levels position the bank well to weather the short-term economic headwinds within India and enable it to continue expanding whilst some public sector banks are forced to reduce lending.

(Source: Company Fillings)

In my previous article, I mentioned public sector bank weakness as an opportunity for strong private banks such as HDB. Although progress in this respect still remains slow, recent studies clearly show an increased favouring of private sector banks. This study obtained its results by surveying 557 India-based companies and foreign subsidiaries between Q4 2018 and Q1 2019. Of those surveyed, 149 are large corporates with annual turnover of at least INR30Bn and 408 are middle-market businesses with turnover between INR3Bn to INR30Bn. The results indicated:

Due to their struggles with NPAs and other issues, India's PSU banks are losing valuable lead banking relationships with the country's largest companies. As of 2016, 20% of large Indian corporates said they used at least one PSU bank as a lead corporate bank, meaning they considered the bank one of their top two corporate banking providers. By 2018, that share had fallen to just 15%. The bulk of those relationships went to private sector banks.

The opportunity for HDB and its private sector peers to benefit from weakness among the public sector banks has thus played out to a degree, and the potential for further benefits in this area remains. With a weaker economic outlook, one cannot, however, ignore HDB's significant exposure to consumer lending which makes up about a third of its total portfolio. Although the bank's portfolio has continued to perform well despite the weaker economic environment and higher unemployment rate, the risk of these factors negatively impacting the bank going forward remains.

Management's good track record of effectively steering the bank through credit cycles acts to alleviate these concerns somewhat. Investors would nevertheless be well served to monitor these events closely particularly as management succession concerns have also arisen over the planned departure of Aditya Puri who has led the bank since 1994.

Loan Growth and NIM

The latest figures from the RBI indicate that loan growth has dropped to its lowest level in two years. Borrowing among businesses has declined the most whilst banks have largely depended on consumer lending to support loan growth in recent months. With the head of Retail Banking at one private bank noting in an interview with Reuters:

In certain retail loans we're seeing customers delaying the payments by a few days over the due date.

In this somewhat worsening credit environment banks such as HDB might pull back on lending to consumers somewhat. Growth in Indian banks overall loan portfolio is likely to remain below 10% for 2020. However, HDB's loan growth has exceeded that of many of its peers with the bank most recently depicting a 17.1% YoY increase in total loans, which for example compares well with a 13% increase at Axis Bank.

Importantly, the bank's total deposit growth at more than 18% also slightly exceeded its loan growth. Strong deposit growth remains important as many Indian banks are unable to meet increased demand for loans from formal banks, as borrowers move away from the shadow banks, largely as a result of their own high loan-to-deposit ratios. HDB's loan-to-deposit ratio at close to 87% does not currently give rise to concern although it, like that of many of its peers, is also relatively high. The bank also saw its NIM (Net Interest Margin) increase by around 10 basis points, with expectations that it will remain broadly stable for the rest of this year.

Valuation and Conclusion

HDB's better-than-peers asset quality and history of strong growth are supportive of the stock trading at a premium to that of its peers. The chart below aptly demonstrates the bank's long history of continuously delivering strong growth in Net Profit.

(Source: Company Fillings)

However, its stock price trades at more than 4.0 times book value per share, which increasingly seems somewhat excessive. The current weak economic environment only serves to add to my concern that the current valuation is too high. Although high profits (and ROE) can in many instances justify a bank's stock trading at a high price to book value, the P/E ratio at HDB of nearly 30 also indicates a stock trading at an elevated valuation.

(Source: Reuters)

Notwithstanding these concerns, I would not consider shorting the stock either. The bank's overall performance remains strong, and it is likely to continue showing signs of strong earnings growth. With reduced loan demand in the Indian market overall, this growth may slow down somewhat, although the bank seems set to continue gaining market share from the beleaguered public sector banks and Non-Bank Financial Companies (NBFCs). Accordingly there seems to be little reason for existing holders to exit their positions en masse.

Disclosure: I am/we are long HDB. 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. @
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