HDFC Bank: Market’s Attention Is On Pending Merger (NYSE:HDB)

Elevator Pitch

My investment rating for HDFC Bank (NYSE:HDB) stays as a Hold.

I reviewed HDFC Bank’s financial performance for the first quarter of fiscal 2022 with my earlier September 24, 2021 write-up for the bank.

With expectations that HDFC Bank’s merger with HDFC Limited will be completed this year, it is timely to assess how the market has responded to the proposed merger, and evaluate the merits and risks associated with this M&A deal.

On one hand, I am concerned about HDFC Bank’s near-term net interest margin and ROE outlook, and its increased capital requirements once the merger is concluded. On the other hand, I like the cross-selling synergies and asset mix optimization benefits that the merger brings. Considering the pros and cons of the merger, I continue to rate HDB’s stock as a Hold.

HDB’s Valuation Multiples Have Compressed Following Merger Announcement

On April 4, 2022, HDFC Bank disclosed that it was proposing a merger with its parent, HDFC Limited, which it described as “India’s largest housing finance company” in the announcement. The Indian stock market exchanges have given the go-ahead for the merger in December 2022, and this deal is expected to be concluded in Q2/Q3 of fiscal 2024 ended March (the second half of calendar year 2023).

In the month following the merger announcement, HDFC Bank’s stock price fell by as much as -25% from $67.67 as of April 4, 2022 to reach an one-year trough of $50.61 during intra-day trading on May 9, 2022. While HDB’s shares subsequently recovered to close at $67.40 as of January 6, 2023, this also means that HDFC Bank’s share price is roughly back at the same level it was at nine months ago when the merger was revealed.

More importantly, HDFC Bank’s valuation multiples have compressed to a considerable extent in the last nine months. Based on valuation data sourced from S&P Capital IQ, HDFC Bank’s consensus forward next twelve months’ normalized P/E multiple de-rated from 22.1 times as of April 4, 2022 to 18.0 times at the end of the January 6, 2023 trading day. In the same time period, HDFC Bank’s trailing twelve months’ price-to-tangible book valuation ratio declined from 3.89 times to 3.42 times.

It is clear from the de-rating of HDB’s valuation multiples that investors have reservations about the merits of the merger between HDFC Bank and HDFC Limited.

In my view, there are both pros and cons associated with the merger as detailed in the subsequent sections of the article.

Positives Associated With The Proposed Merger

On the positive side of things, HDFC Bank can realize cross-selling synergies, optimize its asset mix, and achieve greater economies of scale.

Firstly, there is room for HDFC Bank and HDFC Limited to cross-sell more products to each other’s client base. Even though HDFC Bank is HDFC Limited’s subsidiary, roughly seven in 10 of HDFC Limited’s customers don’t have any banking relationships with HDFC Bank, as highlighted in HDB’s April 2022 investor presentation. On the flip side, only a mere 2% of HDFC Bank’s clients take up mortgage loans with HDFC Limited, while four times as many of HDB’s customers are actually doing business with HDFC Limited’s competitors in the Indian mortgage banking space.

Secondly, the combined entity created with the merger of HDFC Bank and HDFC Limited will have a more balanced mix. As indicated in its April 2022 investor presentation, HDFC Bank on a stand-alone basis had the commercial & rural banking and corporate banking segments account for a majority or 61% of its total loans. Following the proposed merger with HDFC Limited, the percentage of HDB’s loans derived from the commercial & rural banking and corporate banking segments will drop to 42%. This change in asset mix will come about as the merged entity’s exposure to mortgages (as a proportion of total loans) grows from 11% to 33% after the proposed merger is completed.

Thirdly, HDFC Bank is in a position to benefit from more substantial economies of scale in a high-fixed cost business like banking with the merger. The pro-forma numbers for the merged entity disclosed in HDFC’s April 2022 presentation slides suggest that HDFC Bank’s deposits and gross advances can potentially expand by +44% and +33%, with the integration of HDFC Limited’s operations after the conclusion of the merger.

The Merger’s Key Risk Factors

On the negative side of things, there are concerns that the proposed merger with HDFC Limited will pose risks to HDFC Bank’s margins and growth outlook.

HDFC Bank acknowledged in the bank’s April 2022 investor presentation slides that the combined entity’s overall net interest margin or NIM will be lower than that of HDB on a stand-alone basis due to a higher mix of lower-margin mortgage loans. In addition, HDB also recognized the fact that the merged entity’s overall Return on Equity or ROE might be initially depressed by the significant expansion in the equity base immediately following the merger completion.

Separately, HDFC Bank has to meet additional Statutory Liquidity Ratio and Cash Reserve Ratio requirements following the merger. As such, there are worries that HDB’s will have to increase its borrowings in a meaningful way to be in compliance with such requirements. A sharp increase in HDFC Bank’s borrowings-to-liabilities ratio could affect its ability to fund future growth plans such as branch network expansion.

Closing Thoughts

There are both risks and rewards relating to HDFC Bank’s pending merger, and HDB’s valuation de-rating has already priced in investors’ concerns relating to the deal to some degree. Therefore, I choose to leave my Hold rating for HDFC Bank unchanged.