Mr. Gaurav Jani, Research Analyst at Prabhudas Lilladher
- HDFC Ltd. with AuM of Rs5.26trn would merge into HDFC Bank having a total loan book of Rs12.6trn as at Dec'21. Subsidiaries and associates of HDFC Ltd. will become the same of HDFC bank.
- Shareholders of HDFC Ltd. as on record date will receive 42 shares of HDFC Bank (FV Re. 1) for 25 shares of HDFC Ltd. (FV Rs2).
- Post the above, HDFC Bank will be 100% owned by public shareholders and existing shareholders of HDFC Limited will own 41% of HDFC Bank.
The Indian banking space witnessed a historic event today with HDFC Ltd. deciding to merge into HDFC Bank and the transaction would take ~18 months to complete. The rationale of the merger is that regulatory arbitrage between banks and NBFCs has been reducing while the time was opportune owing to a softer interest rate environment coupled with lower liquidity requirements. As at Dec'21, the total loan size of the merged entity would be ~Rs18trn with the share of mortgages expected to increase from 11% to 33%. Since a chunk of HDFC Ltd.'s customers do not have a banking relationship, this would provide tremendous cross-sell opportunities. While the merger makes sense in terms of scale, we are watchful that margins could compress post the merger which could be a drag on the RoE. We maintain multiple at 3.6x but roll forward to FY24 ABV to arrive at a TP of Rs. 2,000. Maintain 'BUY'.
Rationale for the merger: Recent regulatory changes for banks and NBFCs have reduced the barriers for a potential merger. In 2020, RBI had laid out a roadmap for conversion of large NBFCs (with over Rs500bn in assets) into a full scale bank. RBI further mandated that within a group only 1 entity can be engaged in a single product line. Asset quality reporting between banks and NBFCs have also been harmonized. In addition to SLR, NBFCs are also required to maintain LCR. Hence the gap between the liquidity requirements of a bank and NBFC have reduced. Currently, CRR & SLR requirements are much lower which is coupled with a softer interest rate regime. Hence, NBFCs would be required to maintain lesser LCR while the impact of negative carry on raising funds for CRR/SLR would also be lower.
Implications of the deal: Transaction is subject to shareholders, creditors and regulatory approvals (RBI, IRDAI, CCI, SEBI and stock exchange) and closing is expected within ~18 months. CEO of the Bank, Mr. Jagadhishan would continue to be CEO of the merged entity while Mr. Mistry would turn 69 years by the time merger is in place (retirement age at HDFC-70 years). However, Mr. Mistry may continue to be a part of the board (not in full time service). Rest of the management at HDFC Ltd. would continue to be a part of the merged entity. There would be CRR/SLR and PSL requirements for HDFC Ltd. (post-merger). HDFC Ltd. holds affordable housing bonds of Rs800bn which would be exempt from CRR/SLR requirements subject to RBI approval. HDFC Ltd's branches would convert into full time bank branches.
Likely synergies: Post the merger, Bank would be second largest entity in terms of advance share (15%), after SBI (~20%). HDFC Bank currently has 11% in mortgages and post-merger the same would reach 33%. HDFC Ltd was prohibited from taking CASA Deposits, however with the merger, CASA accretion would be possible resulting in lower funding cost that would improve spreads in the mortgage business. The merger would further mitigate single product risk for HDFC Ltd and opens up avenues for cross selling to a larger customer base as well as enhance product diversity while the bank's exposure to unsecured loans would also reduce. HDFC would benefit from the lower funding cost of the banks and its large distribution franchise while HDFC bank would gain from the former's expertise in real estate and efficient loan processing. As of now 70% of HDFC Ltd. and its subsidiaries customers do not bank with HDFC Bank which would provide tremendous cross-sell opportunities to the merged entity.
Valuation and view: While the merger would seem attractive purely from a scale perspective we need to factor in some key variables. Firstly, the merged entity would need to adhere to CRR/SLR and PSLC requirements which would be a slight drag on the margins. Secondly, HDFC Bank may not underwrite a chunk of developer loans that HDFC Ltd. used to onboard which could be countered by addition of below prime housing customer loans. Hence overall yields might compress. This would be offset by lower cost of funds owing to the bank's access to CASA deposits. On an operating level branches in similar locations might be merged which could save on costs although for branches not present in common locations, transition costs would be incurred. Hence prima facie it seems that RoE for HDFC Bank could drop from current levels, immediately following the merger, although the merger would be positive from a scale and cross-sell standpoint. Rolling forward to FY24ABV we maintain multiple at 3.6x but raise TP to 2,000. Maintain BUY.