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Navigating through the challenges

Pursuing profitable growth; return ratios to improve gradually

* HDFC Bank (HDFCB)’s Annual Report emphasizes the institution's commitment to achieving sustainable growth over the medium term as it continues to invest in strengthening both its physical infrastructure and digital prowess.

* While the near-term growth is likely to remain soft due to constraints on the CD ratio, the increased threshold on loan pricing, which enables improved asset mix and gradual retirement of high-cost borrowings, will nevertheless fuel margin recovery.

* HDFCB has posted a healthy traction in Retail + Commercial and Rural Banking portfolio, with the mix of these two segments improving ~300bp over the past one year to ~81%. This has helped address the PSL shortfall and the bank became a net seller of PSLCs during FY24 (though the segmental gap persists) after reporting consistent shortfalls in prior years.

* The bank has effectively reduced its borrowings by ~INR600b over the past two quarters, including significant repayments of commercial papers. ~INR600b worth of HDFC’s high-cost borrowings will mature in FY25 and will thus get replaced with deposits. This strategic shift is set to strengthen the balance sheet and aid margins.

* Asset quality has remained stable post-merger, with GNPA/NNPA at 1.3%/0.4%. The bank's prudent provisioning strategy, including a floating provision buffer of INR124b and a contingency buffer of INR145b, provides comfort.

*  While slower loan growth than peers may remain an overhang on the near-term stock performance, we believe that HDFCB is structurally well poised to deliver steady growth and profitability in the medium to long term. We estimate HDFCB to deliver an FY26E RoA/RoE of 1.86%/14.9%. We reiterate our BUY rating on the stock with a TP of INR1,850 (premised on 2.3x FY26E ABV + INR256 for subsidiaries).

Loan mix gaining granularity; Retail + CRB mix rises ~300bp since merger

HDFCB has posted a healthy traction in Retail + Commercial and Rural Banking portfolio, with the mix of these two segments improving ~300bp over the past one year to ~81%. The CRB segment has reported a steady 28% YoY growth in FY24 (+~27% YoY in 1QFY25). Home Loans led retail growth with 14% YoY improvement. The bank is strategically focusing on profitable growth with a distinct focus on higher-yielding segments. The bank aims for balanced growth aligning with its internal benchmark and priorities and remains confident in delivering profitable growth. We estimate a loan CAGR of ~10% over FY24-26, while deposit CAGR to sustain at ~16% over the same period.

Focus on granular deposit growth while avoiding rate war

HDFCB has faced challenges in mobilizing adequate liabilities to fund growth and replace existing borrowings that are coming up for maturity. In 1QFY25, the deposit growth fell short of expectations owing to unexpected outflows, particularly from the current accounts, even though the average deposit growth has been steady over time. Granular and high-quality liability franchises remain a key priority, while HDFCB does not want to compete on rates in the market. The bank has been shedding the high cost deposits of HDFC Ltd that were inherited during the merger. It will not be bidding for a higher price to keep the large ticket-size deposits. The CASA mix has deteriorated to 36% in 1QFY25, and we remain watchful on the near-term trajectory due to the widened SA and TD rate differential. The bank's focus remains on enhancing customer engagement and converting mortgage clients into primary banking customers to aid deposit inflows.

Replacement of high-cost borrowings to boost profitability

HDFCB has effectively reduced its borrowings by ~INR600b over the past two quarters, including significant repayments of commercial papers. The bank aims to gradually replace high-cost (HDFC Ltd.) borrowings with lower-cost deposits. Looking ahead, ~INR600b of HDFC Ltd’s high-cost borrowings will mature in FY25, of which, ~INR250b has already been paid in the June quarter. This strategic shift is set to enhance liquidity and support margin improvement as high-cost borrowings get replaced with lower-cost deposits.

NIM recovery to be gradual; staggered PSL compliance to limit P&L impact

The bank is shifting its portfolio towards retail assets and replacing HDFC’s high-cost borrowings with deposits to improve margins, thereby aiming for a gradual recovery in NIMs from the current 3.47% to ~4.0% in 2-3 years. Despite pressures from increased cost of funds and merger impact, the bank is focused on stabilizing NIMs through disciplined deposit pricing and enhanced customer engagement. It is also addressing its PSL compliance challenges by exploring acquisitions and improving performance in critical segments (CRB), including the SMF and agricultural sectors. The bank became a net seller of PSLCs in FY24 after several years. Given HDFCB's strong market presence and extensive distribution network, management remains optimistic about achieving the necessary trajectory in PSL compliance.

Leveraging expanded customer base for enhanced cross-selling and growth

HDFCB’s operational strategy focuses on enhancing efficiency through digital technology and effective resource utilization. This approach helps the bank maintain stable cost ratios despite significant investments in the business. By integrating three million e-HDFC customers and leveraging new-to-bank mortgage customers who have opened savings accounts with substantially higher SA balances, the bank is poised for sustainable growth. The improved productivity per branch and employee, coupled with strategic cross-selling opportunities from low mortgage penetration, positions HDFCB well to deepen customer relationships further, thus driving future growth and operational efficiency.

Asset quality stable; strong contingency buffer provides comfort

Asset quality remains stable post-merger, with GNPA/NNPA ratios at 1.3%/0.4%. HDFCB's prudent provisioning strategy, including a floating provision buffer and a strong overall CAR of ~19.3%, supports stability despite some seasonal pressures. In 1QFY25, its slippages inched up to INR79b, but recoveries and write-offs were managed effectively. The bank's improved RWA density and reduced concentration of top exposures highlight its robust risk management, while the significant countercyclical provision created in FY24 will ensure asset quality resilience.

Valuation and view

Amid persisting challenges on business growth and an intense focus on accelerating liability mobilization, HDFCB has been delivering a resilient performance in margins & asset quality. During the past two quarters, the bank has reported 7bp expansion in margin to 3.47% led by conscious improvement in the asset mix and the retirement of high-cost borrowings. Asset quality remains broadly stable while PCR stands at ~71.2%, which is closer to the levels it used to be before the announcement of the merger.

* The bank holds a healthy pool of provisions (floating + contingent) at INR269b/1.1% of loans. While the bank has not given any specific guidance on the C/D ratio, management has indicated that it will actively focus on bringing the ratio down at an accelerated pace.

* Consequently, we have factored in softer loan CAGR at ~10% over FY24-26E, while deposit CAGR to sustain at ~16%. However, the gradual retirement of high-cost borrowings, along with an improvement in operating leverage, will provide some support to margins and return ratios over the coming years.

* We thus estimate HDFCB to deliver an FY26E RoA/RoE of 1.86%/14.9%. We reiterate our BUY rating on the stock with a TP of INR1,850 (premised on 2.3x FY26E ABV + INR256 for subsidiaries).

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