Between calendar 2012 and 2022, HDFC Bank Ltd grew its balance sheet by 22.5 percent on a compounded annual growth rate basis. Its stock returned 19.5 percent CAGR, beating peers State Bank of India, ICICI Bank and Axis Bank. The private sector lender’s stock topped the list of every analyst’s buy ratings, be it during times of crisis or recovery.
Ever since the bank announced the merger with its parent HDFC in April last year, its stock has barely kept up with peers. Note that swallowing HDFC would instantly add more than 40 percent to the bank’s assets.
Morphing from David to Goliath isn’t easy and has costs. What complicates the matter for HDFC Bank is the management’s indication of a regulatory dispensation for the merger.
Analysts at Kotak Institutional Equities summed this up perfectly. They noted that the bank is taking on high fixed costs through branch expansion, almost guaranteeing an elevated cost-to-income ratio.
Further, the ability to increase deposits post-merger “is still not yet established.” Lastly, key questions pertaining to the merger on regulatory dispensation are “still unanswered.”
Gearing for merger
Since a non-bank finance company would merge into a bank, regulatory costs such as cash reserve ratio (CRR) and statutory liquidity ratio (SLR) would be significant. Along with the merger announcement, the bank’s management alluded to discussions with the Reserve Bank of India over dispensations such as a glide path to adhere to CRR and SLR and even priority sector norms.
Most analysts said these are key aspects to the stock’s re-rating as they gave HDFC Bank an edge on earnings visibility.
“The merger outcome may take precedence over business performance, near term, with uncertainty from: a) liability-side transition, b) uncertain cost and c) PSL (priority sector lending) requirement. Given the nature of these, the impact is hard to gauge, and the outcome contingent on regulatory action/market condition,” analysts at Elara Capital wrote in a note.
To be sure, chief financial officer Srinivasan Vaidyanathan made it clear to analysts during the Q2 earnings that the dispensations are good to have but are not reflected in the balance sheet projections of the bank post-merger.
“The merger is not predicated on this, the models are not necessarily assumed that these need to come. These are good to have, not necessary as such,” he said.
But when you are as consistent a performer as HDFC Bank, investors tend to take stellar numbers for granted and look for an additional earnings boost. A regulatory dispensation is just that.
Embracing an assets pile of Rs 7.01 lakh crore consisting mainly of long-term home loans entails changes to the liabilities side. HDFC’s borrowings totalled Rs 5.43 lakh crore as of December, of which 30 percent were from deposits.
Once merged with HDFC Bank, this would result in the share of borrowings in the bank’s liabilities growing to almost 20 percent. Also, the deposits would attract CRR and SLR.
That’s not all. HDFC Bank would need to garner deposits at a fast pace to keep up with the growth on an outsized asset pile now. This explains the bank’s efforts to get deposits over the past one year.
This was also where HDFC Bank won investors’ hearts through its performance in Q4 of FY23. The lender added Rs 1.5 lakh crore worth of deposits during the quarter, its biggest ever.
It hasn’t slowed its pace of branch expansion, either. The flipside? A surge in operating expenses, which analysts said will continue to stay elevated.
“Bank would continue to ramp up its branch network/customer addition to stock up deposits which may keep funding and sourcing costs elevated and the NIMs/core-PPoP (pre-provisioning operating profit) growth in check,” analysts at Emkay Global Financial Services noted in a report.
Those at Prabhudas Lilladher pencilled in operating expenses rising at a 21 percent CAGR in FY22-25.
As liabilities churn, it all comes down to margins for earnings growth.
That margin call
The biggest selling point of the merger is the benefit of cost of funds through deposits of HDFC Bank. But this will happen over time. Meanwhile, HDFC Bank could face a short-term squeeze on margins as higher-cost borrowings come on board. Further, it is grabbing deposits during an elevated interest rate cycle.
Net interest margin shrank by 14 basis points sequentially in Q4, a sign that the bank is facing pressure on margins. Analysts at Kotak warned that most banks are mobilising deposits aggressively and that would be a big challenge for HDFC Bank.
The management has said margins will remain in a range as the bank’s fixed rate loans will get repriced, offsetting the higher cost of deposits somewhat. That said, analysts are concerned about the extent of margin pressure that may come from pursuing deposits aggressively.
“Increased competitive intensity, especially given the benign asset quality environment, will be another drag on NIM,” Kotak pointed out.
The merger with HDFC will determine the stock’s performance over the next few months. Beyond that, the odds of HDFC Bank growing at a fast pace become lesser as it gains critical mass.
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