Thursday, March 27, 2014

Housing Development Finance Corporation - High quality home loans, insurance, banking, asset management at a high price

BSE: 500010 | NSE: HDFC | ISIN: INE001A01036

For those interested in learning how to analyze complex companies this is a good example. It is primarily a home lender than owns asset management businesses, a bank, insurance companies, a BPO company and publishing companies!

There are several ways of doing this. The most common being taking the public shareholding and subtracting that from the market cap. Then valuing the rest as a running business. In this approach the issue is that you first need to have a opinion on the underlying stocks. Fortunately we have already reviewed the largest underlying which is HDFC Bank. The unlisted insurance companies and GRUH (listed) are yet to be covered but do not form a large part of the earnings.

1. How big is the moat?

Grade B moat assuming HDFC Bank to be an independent entity from HDFC
Grade A+ moat assuming HDFC Bank to be in control of HDFC

  • Brand: The HDFC brand in India is very strong but when it comes to loans people shop around. The brand is unlikely to get HDFC higher rates on the loans.
  • Sales and distribution: Sales and distribution network of HDFC is only 331 outlets. Rest of the loans are distributed by third parties including HDFC Bank. Essentially the deal with HDFC Bank is that all home loans go the HDFC and HDFC Bank has the option of purchasing 70% (55% in the case of priority sector) of these back from HDFC. The entire moat lies with HDFC Bank.
  • Efficiency versus margins - HDFC Bank enjoys a net interest margin of 4.5% whereas HDFC has a spread on loans only of 2.3% or so. This is primarily because HDFC funds its balance sheet only 33% from deposits (even those they pay a fee on). So their cost of funds is much higher than HDFC Bank. This enables HDFC to have a massive profit per employee of 265 lakhs versus HDFC Bank at 10 Lakhs. And lending per employee of 100 Crores+ versus HDFC Bank at 3.5 Crores or so.
  • Funding - the fund size moat of HDFC is weak as it is raising expensive funds from subordinated debt, Term loans from NHB and other financial institutions and from deposits from agents. Now I dont understand why HDFC and HDFC Bank dont merge into 1 large entity that will have a far lower cost of funds.
  • Insurance companies - there 2 insurance companies owned by this company which are of significant size. I might do a full article on each in the future but they seem to be decent - but not of the quality of HDFC Bank.

2. Risks

  • Real estate prices could hit the collateral values
  • Subsidiary financials are not stated in detail but overall high level numbers are present. The big 3 non-listed ones are HDFC Standard Life Insurance, HDFC ERGO General Insurance, HDFC Asset management.
  • Interest rate risk - the company claims its hedged. DVO1 risk is not really talked about.
  • If ever HDFC looses control over HDFC Bank - their margins may take a hit because their sales side might vanish.
  • If the insurance company provisioning for losses are not done well this might be in for some trouble. The good news is that catastrophe risk and home loan defaults are likely to be fairly uncorrelated.

3. Financials

  • Gross Non performing loans are at 0.7%
  • Capital to risk assets ratio (CRAR) and tier 1 capital is fairly healthy
  • Net margin for HDFC's home lending business is 23% versus HDFC Bank at 16% - cost side is very low - Interest expense is high at 66% but the rest of the costs are only 6% or so. Whereas for HDFC Bank the interest cost is around 45% of income but the other costs are massive at 30% or so.
    • Provisioning for HDFC is lower as housing loans are collateralized by homes and there seems to be lesser default in this.
  • Overall equity % of assets for HDFC is at 16% which for the bank is 9% to 10%. The ROE numbers are similar around 17% to 19%. So the ROE for HDFC's home loan business is similar to the bank with lower risk.
  • Dividend % of earnings is hovering around 43% to 46% which is a healthy number but signals that the management does not see fit avenues for 40%+ of the capital generated. Given the growth potential in the housing loans market I am a bit confused as to why the dividend percentage of earnings is so high.

4. Soft factors

  • The company has no promoter! I don't understand how its properly motivated and driven forward. This is the first time I have seen a promoter less company.
  • Largely owned by foreign institutional investors (over 70%), individuals and Indian institutional investors.
  • Growth is slower than HDFC but overall fairly good at 17% a year or so. India's housing to GDP ratio is still low at 9% and the NHB says that the housing loan growth in 2013 was 30%+. This shows there is room to grow and HDFC is poised to do so.

5. Pricing

  • Current market cap stands at around 136.4 K crores. When you back out the market cap of HDFC Bank and GRUH stakes (42.6K Crores) you are left with around 93.5K Crores which essentially is trading at around 16.5 times earnings.
  • If we were to assume that the list subsidiaries are reasonably priced then this bank is available for far cheaper than HDFC Bank - but the growth is also slower.
  • Overall I would classify this as a value investment around the 700 INR/share region. Currently HDFC and its public underlying stocks are a bit rich. I would not be selling this though at current prices as its a high quality company that is likely to do well. Also if the insurance companies end up being the same quality as the bank and the HFC business then this might be poised to be the financial blue chip stock of the future. Of course the flip side is that bad management on the insurance side could take it under.


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