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Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capitalmay have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

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THEMATIC September 02, 2014

Key Recommendations

HDFC SELL

Target Price: ` 795 Downside : 25%

HDFCB SELL

Target Price: ` 685 Downside: 19%

Potential cost of merger

SLR requirement of 22% on HDFC’sliabilities which could lead to a cost ofRs4.0bn in a worst-case scenario

CRR requirement of 4% on HDFC’sliabilities which could lead to a cost of

Rs6bn in a worst-case scenario Priority sector loan requirement on

HDFC’s loans which could lead to cost of

Rs2.9bn

Around 60bps higher tier-1 capitalrequirement as the combined entity mostlikely becomes the second-largest

systemic important bank in India

Moving to base rate regime could weaken the competitive positioning of

HDFC in home loans

Benefits of merger

Additional savings deposits which couldlead to cost benefits of Rs222mn

Some additional cross-selling benefits which are difficult to quantify

Analyst Details

Pankaj Agarwal, CFA+91 22 3043 [email protected]

Ravi Singh+91 22 3043 [email protected]

Aadesh Mehta

+91 22 3043 [email protected]

THIS NOTE CANNOT BE USED BY THE

MEDIA IN ANY SHAPE OR FORM

WITHOUT THE PRIOR CONSENT OF

NEGATIVE

Likely merger of HDFC with HDFCB -

No winners here Our analysis suggests that banks being allowed to raise 7-year maturitybonds is not a good enough incentive to merge HDFCB and HDFC.However, we believe that the forthcoming regulatory changes are likelyto drive the merger of these entities. The cost of such a merger would faroutweigh the benefits, which would have to be shared by one or bothsets of shareholders. Ideally, the merger cost should be borne by HDFC’sshareholders but in reality HDFCB’s shareholders could share the cost ofthis merger by paying more than what HDFC’s lending businessfundamentally deserves. Hence, we would recommend investors to SELLtheir shares in both entities.

There aren’t enough incentives for a merger…Given the regulatory exemptions HDFC Ltd (HDFC) enjoys (especially onCRR/SLR/PSL requirement), historically there was no incentive to merge HDFCand HDFC Bank (HDFCB), as there was a significant regulatory cost attached tothis merger. However, the Finance Minister’s 10 July announcement, allowingbanks to raise 7+ year maturity bonds to fund affordable housing loans (withexemptions on CRR/SLR/PSL), reduces the cost of this merger. Given that only50% of HDFC’s loan book falls under ‘affordable housing’ and give that therewould be intense competition amongst banks to raise 7-year bonds (only 5% ofHDFC’s current borrowings are 7+ year bonds), the cost of a merger would stillbe very significant. Hence, we think that a merger does not actually make sense

from a business standpoint.

…but a merger seems inevitable in the medium term

However, a merger seems inevitable in the medium term and we think thefollowing future regulatory changes could drive this merger: (i) The RBI’s recentdrive to close the regulatory arbitrage between different financial institutions(especially between banks and NBFCs) should gain pace. This would leave littleincentive for the HDFC Group to run the two entities separately. (ii) The RBI isnot allowing new bank licence candidates to run a bank and an NBFC under thesame group. This rule should eventually be applicable to existing banks andimply a forced merger of HDFC and HDFCB.

Merger structure and cost

In the scenario of a merger, only the lending business of HDFC need be merged

with HDFCB. The other businesses of HDFC (insurance, asset management, etc)can remain under HDFC. The cost of merger is significant and it arises fromHDFC’s lending business to comply with bank regulations on CRR/SLR/PSL (seethe right-hand margin). The benefits are modest and they largely arise due tocheaper liabilities from HDFC’s post-merger scenario (see the right-handmargin).

No winners here: SELL both entities

We would recommend that if such a merger is mooted, HDFCB’s shareholdersshould oppose it unless the valuation assigned to the lending business of HDFCis at a 20-40% discount to current valuations. On the other hand, HDFC’sshareholders should support the merger, as the current valuation is the best thatthey can get. There would be a regulatory cost of the merger of Rs263-Rs665bn

(9-22% of the combined current market cap of these two entities excludingHDFC’s 22.5% stake in HDFCB). Ideally, this should be borne by HDFC’sshareholders. However, in reality, HDFCB’s shareholders could share the cost bypaying more than what HDFC’s lending business fundamentally deserves.Hence, we would recommend investors to SELL both entities.



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September 02, 2014 Ambit Capital Pvt. Ltd.

Not enough incentives for a merger but avery strong possibility in the medium termSince the RBI allowed banks to raise bonds of 7+ year maturity bonds in July 2014 tolend to infrastructure and affordable housing, with an exemption on the statutoryliquidity ratio (SLR), cash reserve ratio (CRR) and priority sector loans (PSL), there hasbeen speculation in the market regarding a possible merger of HDFC and HDFCB.

HDFC is classified as a Housing Finance Company (HFC) and is governed by adifferent set of regulations than its associate, HDFCB.

Exhibit 1:

Different sets of regulations govern HDFCB and HDFC

HDFCB HDFC

Minimum Total Capital Requirement 11.7%-14.8%* 12%

Minimum Tier 1 capital 9.7%-12.8%* 6%

Capital Calculation method BASEL-III NHB guidelinesCash reserve ratio (CRR) requirement - as a % of adjustedliabilities 4% 0%Statutory Liquidity requirement (SLR) ratio - as a % of adjustedliabilities 22% 12.5%**

Minimum priority sector loans (PSL) - as a % of loans 40% 0%

NPA recognition - number of days due 90+ 90+

Source: RBI, NHB, Ambit Capital research. Note: *Under Basel-III including counter-cyclical buffer and additionalcapital for systematically important banks ** Only on public deposits out of total borrowings

Most importantly, HDFC does not have regulatory requirements like CRR/SLR/PSL.Such requirements are applicable to HDFCB and are a major drag on its profitability.These regulatory requirements have historically kept HDFC from merging itsmortgage business with HDFCB because if merged/converted into a bank, HDFC’sprofitability would be much lower as compared to what it could generate as an HFC.

However, the recent regulatory exemption (first announced by the Finance Minister

on 10 July 2014 and then announced by the RBI on 16 July 2014) that banks canraise 7+ year maturity bonds to fund affordable housing loans with exemptions onSLR/CRR/PSL has refuelled the speculation that the two entities could be merged.

The basic premise behind this speculation is that by raising 7+ year maturity bonds,the combined entity could avoid a significant requirement of CRR/SLR/PSL on HDFC’sbalance sheet and hence the two entities could be merged without any merger cost.

Costs of merger far outweigh the benefits

Despite the regulatory exemptions on 7+ year maturity bonds, the merger, webelieve, still does not make sense for these two entities, as the cost of the merger still

remains very high for these two entities. Given the regulatory arbitrage that HDFCenjoys over banks, it always made sense for HDFC to remain outside the ambit of theRBI’s banking regulations.

Whilst banks being allowed to raise 7+ year bonds reduces the cost of the merger tosome extent, the cost of the merger and the negatives associated with the merger faroutweigh the positives. We say so because of the four reasons listed below:

Reason 1 – Only 50% of HDFC’s assets would be ‘eligible assets’: As per themedia statements made by the management of HDFC, 50% of HDFC’s assets areclassified under the affordable housing segment and are eligible assets for regulatoryexemptions. This translates into Rs985bn of eligible loans. Moreover, the eligibleassets are unlikely to go beyond 50% even in the future unless the company

lowers its growth and profitability by reducing the share of high-yield developer loans(~30% of loan book) and high ticket-sized home loans (~20% of the loan book).Hence, even if the combined entity is able to fund HDFC’s entire current loan book byraising 7+ year bonds, half of HDFC’s current loans would still attract the

There were economic benefits forHDFC to run the mortgagebusiness as an HFC due to theregulatory arbitrage

However, still there are not

enough incentives for these twoentities to merge, as still a large proportion of HDFC’s balance sheet would attract CRR/SLR/PSL

Only 50% of HDFC’s current loanbook qualifies for ‘affordablehousing’ loans



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requirements on priority sector loans and half of HDFC’s liabilities would still attractthe SLR/CRR requirements. Note that home loans fulfil only one-fourth of the total40% PSL requirements of banks and the rest 30% has to come from agriculture andother weaker sections.

Exhibit 2:

Only 50% of HDFC’s current loan book qualifies for affordable housing

Source: Ambit Capital using company data

Reason 2 – Eligible liabilities would not be abundant and economical: If welook at the liability side, only ~Rs83bn of HDFC’s liabilities at FY14 are 7+ yearbonds. Given that exemptions are applicable on the minimum eligible assets andeligible liabilities, only 4% of HDFC’s current balance sheet seems likely to getregulatory exemptions if it were to convert into a bank today.

Exhibit 3:

Only 4% of current liabilities are 7+ year maturity bonds

Source: Bloomberg, Ambit Capital using company data

To even get regulatory exemptions on 50% of its balance sheet, HDFC would have toincrease its 7+ year bonds by 12x. Given that all the banks would be rushing towardsraising such 7+ year bonds to get regulatory exemptions, the availability and cost ofsuch liabilities are unlikely to be in HDFC’s favour.

Currently, HDFC mostly borrows from less than 5-year maturity bonds. Whilst atpresent there isn’t a big gap between different maturity AAA bonds due to a flattishyield curve, historically, the yield on 10-year AAA bonds has been on average~50bps higher than the average yields on bonds below 5-year maturity. Henceshifting liabilities to 7-year bonds could translate into an increase in funding costs forHDFC.

Affordablehousing loans,

50%

Other housing

loans, 18%

Corporate/developer loans, 32%

Term Loans, 16%

Deposits, 32%

Other bonds anddebentures, 48%

7+ year maturitybonds, 4%

Only 4% of HDFC’s currentborrowings are 7+ year maturitybonds.



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Exhibit 4: Borrowing costs from higher tenure bonds could be higher, looking at thehistorical bond yields (Average FY06-14)

Source: Bloomberg, Ambit Capital research

Reason 3 – Base rate constraints would kick in: Banks have a base ratemechanism where all floating rate loans are linked to the base rate and the banksare not allowed to lend below the base rate. On the other hand, HFCs like HDFChave their floating rate loans linked to their prime lending rate (PLR) and HFCs areallowed to lend below their PLR. This gives advantages to HFCs over banks andunlimited competitive advantages vs banks. For example, in response to SBI offeringhome loans at 10.1% to new customers, HDFC could easily match these rates withoutreducing its PLR (which is 16.75%) to which all its old floating rate loans are linked.On the other hand, Axis Bank is stuck at the home loan rate of 10.25% given that itsbase rate is 10.25% and it cannot lend below its base rate. If Axis Bank cuts the baserate (by ~15bps to match SBI’s rates), then it would in all likelihood have to reducethe rates on all the existing floating rate loans by 15bps, thus impacting its margins.

Exhibit 5:

PLR-based pricing gives an added advantage to HDFC over banksSep’11 Sep’14 Difference

Base RatesMortgage

RatesBase Rates

MortgageRates

Base RatesMortgage

Rates

SBI 10.00% 11.0% 10.00% 10.10% 0.0% (0.90%)

ICICI Bank 10.00% 11.0% 10.00% 10.15% 0.0% (0.85%)

Axis Bank 10.00% 11.0% 10.25% 10.25% 0.25% (0.75%)

HDFC 16.00% 10.75% 16.75% 10.15% 0.75% (0.60%)

Source: Company, online financial aggregators, Ambit Capital research

Reason 4 – Higher capital and more scrutiny under D-SIB: The merger of HDFCB and HDFC would create the second-largest bank in India and would make it

the second-largest systemically important bank in India. This could lead to morecapital (0.6%) requirement for the combined entity along with greater supervisionand scrutiny by the RBI. Moreover, given the higher systemic importance of themerged entity, there could be more regulatory supervision of the combined entity.

Exhibit 6:

A merger would lead to higher capital requirement and greatersupervision

Ranked as per balance sheetsize of Indian banks

Current rankingRanking postHDFCB-HDFC

merger

Additional tier-1capital required

1st SBI SBI 0.8-1.0%

2nd Bank of Baroda HDFC Mega Bank 0.6%

3rd ICICI Bank Bank of Baroda 0.4%

4th Punjab National Bank ICICI Bank 0.2%

Source: RBI, Company, Ambit Capital research

7.80%

8.00%

8.20%

8.40%

8.60%

8.80%

9.00%

9.20%

3months 6 months 1 yr 2 yr 3 yr 5 yr 10 yr

Average yield on AAA bonds over FY06-14

3months 6 months 1 yr 2 yr 3 yr 5 yr 10 yr

HDFC would have to migrate tobase rate (vs PLR) based pricingonce it becomes a bank, takingaway a key competitiveadvantage it has over banks



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On the other hand, we believe that the benefits of a merger would not be significantenough to offset the merger costs.

Potential benefit 1 – Cross-selling is already in place: The HDFC Group isalready using the strengths of its individual businesses for cross-selling.

HDFCB is originating ~25-30% of the individual home loans of HDFC using itsown customer database.

HDFCB is already buying loan portfolios from HDFC to meet its priority sectorneeds.

HDFCB already the biggest distributor of life insurance policies of HDFCInsurance and is already distributing asset management products of HDFC AssetManagement Company.

HDFC offers HDFC Life term insurance policies to its mortgage customers.

Hence, with such a common pool of customers, most probably the benefits of cross-selling are already being accrued by the group, which is already visible in most groupcompanies being market leaders in their respective product categories.

Given that HDFC’s customers are typically high-quality borrowers, with a propercredit history and an affluent background, such customers are likely to already havemost of the other financial products offered by HDFCB. To put this into perspective,the average age of a mortgage borrower in India is ~35 years and we think that sucha customer would have already have a savings account, credit card, car loan,insurance, wealth management etc., which HDFCB could offer.

Potential benefit 2 – Deposit costs unlikely to come down: Many investors haveargued that the funding cost of deposits for HDFC would come down as it folds into abank given that HDFCB’s term deposit costs are ~100bps lower than HDFCB.However, the term deposit costs of HDFCB are lower than HDFC’s, as HDFCB raisesdeposits for maturities even below 1 year where deposit rates are at 3.5-8.75% vsHDFC raising deposits only in the 1+ year maturity bucket. The difference betweenthe deposit rates of HDFCB and HDFC are not big for deposits of more than 1-yearmaturity.

Exhibit 7:

Arriving at the balance sheet of the standalone lending business

Deposit Rates (%)* HDFCB HDFC Difference

1 year 9.00% 9.10% 0.1%

2 year 8.75% 9.10% 0.35%

3 year 8.75% 9.0% 0.25%

5 year 8.75% 9.0% 0.25%

Source: Ambit Capital using company data. Note: * Deposit rates under quarterly income plan which are

comparable

Moreover, the depositors who are placing money with HDFC, most likely, want to put

money at a higher rate and higher tenure. These depositors have the option todeposit money at shorter durations with banks but they choose not to, as most ofthese customers are urban customers and are sourced by third-party financialadvisors. Moreover, given that HDFC’s deposits are not insured, it needs to payhigher deposit costs. Hence, if it converts into a bank, even it is able to retain itscustomers at lower deposit rates, the ~15bps deposit insurance cost (that it wouldhave to bear) would offset the benefits.

Potential benefit 3 - Additional savings deposits from HDFC customers couldbe the only real benefit: However, if HDFCB is able to offer savings accounts toHDFC’s customers, this could lead to additional savings accounts deposits, as theborrowers are likely to keep some money in this account to serve their home loans. Inthe table below, we have tried to quantify all of these benefits.

The HDFC Group is already usingall the entities in the group forcross-selling products



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Exhibit 8: Savings to HDFC from additional savings deposits might not be meaningful

Comments

Total outstanding home loans (Rs mn) (A)1,592,150

Total individual loans including assignedloans

Ticket size per loan (Rs mn) (B) 2.2 Based on company disclosuresApproximate number of loan accounts(C=A/B) 723,705

Number of accounts which are HDFCaccounts (D=C*70%) 506,593

Excluding ~30% of the loans areoriginated by HDFCB

Approximate new savings accounts(E=D*50%)

253,297 Assuming 50% of these customers would keep some free money in theseaccounts

Savings deposits per account (Rs) 25,000 Assuming that borrowers keep onemonth’s EMI in this account

Additional savings deposits (Rs mn) 6,332

Savings on funding costs due to additionalsavings accounts (Rs mn), pre tax

222 Assuming cost of savings deposits at 6%including operations costs giving 3.5%advantage on funding costs

Post tax savings from additional SA deposits 162 Assuming 27% tax rate

Source: Company, Ambit Capital research

Future regulatory change could drive the merger

Whilst it is interesting to analyse the merger economics, at one level the economicsare somewhat beside the point. However, forthcoming regulatory seem likely to leadto a merger of the two entities. In particular, we expect the following regulatorychanges to lead to a merger of these two entities:

The closing of regulatory arbitrage: As the RBI closes the regulatory arbitragebetween different institutions (see our note dated 8 August, ‘Closing the regulatoryarbitrage’), there would not be any incentive for the two entities to run separateoperations. The closing of the regulatory arbitrage means: (i) CRR/SLR requirementsapplicable for certain liabilities of HFCs as well; (ii) higher tier-1 capital for HFCs, in

line with banks; and (iii) the introduction of the base rate regime for HFCs as well, inline with banks.

No two lending entities in the same group: Whilst allotting new bank licences inthe last round, a key condition of the RBI was that a bank and NBFC cannot co-existin the same group and all the lending operations should be done by the bank. Wethink that going forward the RBI would not allow existing banks to run both a bankand NBFC separately. Hence, we believe that it is only a matter of time before the RBIasks even existing banks to follow the same principle and merge their NBFCoperations in the bank. This we believe would lead to a merger of HDFCB and HDFC(unless HDFC sells its shareholding in HDFCB).

Future regulatory changes wouldclose the regulatory arbitragebetween NBFCs and banks

http://webambit.ambit.co/reports/Ambit_BFSI_Thematic_08Aug2014.pdf









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Structure of the mergerAt present, barring some holding by the management team, HDFC is completelyowned by public shareholders. HDFC owns ~60-100% in several of its subsidiaries.HDFC Ltd also owns 22.4% in HDFCB. HDFCB in turn owns 100% in its NBFC, HDBFinancial Services.

Exhibit 9:

Current structure of the HDFC Group

Source: Company, Ambit Capital research. Note: * A 100%-owned NBFC of HDFCB

In its guidelines for new banks(http://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=28191) and in variousforums, the RBI has advocated a holding company structure for banks where theother financial services businesses of the group are parallel to the bank. Hence,under this structure, the merger of two entities would mean that only the lendingbusiness of these two entities would be merged, where a portion of the lendingbusiness would be owned by HDFC and the remaining by HDFCB shareholders.

HDFC would continue to own its asset management and insurance business.

Exhibit 10:

Expected structure of the HDFC Group if both entities merge

Source: Company, Ambit Capital research; Note: * An entity which would consist of HDFCB, the lending business

of HDFC, Gruh Finance and HDB Financial Services

The combined Mega Bank would have HDFCB, HDB Financial Services (an NBFCcompletely owned by HDFCB), the lending business of HDFC and Gruh Finance Ltd.The percentage share of HDFC in the combined entity would depend on the valuationassigned to each of these lending businesses when the merger happens.

Public Shareholders of

HDFC Bank Public

100.0%

HDFC Ltd.

77.4%

22.5% 72.4% 59.8% 73.8% 59.2%

HDFC Bank HDFC Life HDFC AMC HDFC ERGO GRUH Finance

100%

HDB Financial

Services*

Public Shareholders of

HDFC Bank Public

100.0%

HDFC HoldCo

100%-X X 72.4% 59.8% 73.8%

HDFC

MegaBank*HDFC Life HDFC AMC HDFC ERGO



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Merger economicsAs explained in the previous section, the lending business of HDFC and HDFCBwould be merged and the rest of the businesses of HDFC would remain in the HDFCHoldco. Hence, the profitability and net worth of HDFC’s lending business have to beseparated to see what HDFC would bring to the table in this merger. For simplicity’s

sake: (i) we have taken the FY14 actual numbers for these calculations rather thanunnecessarily making calculations cumbersome by taking FY15 estimates; and (ii) wehave excluded Gruh Finance and HDB Financial Services from the merger equationgiven their miniscule size as compared to their parents.

Exhibit 11:

Profitability of HDFC’s lending business

Rs mn unless stated otherwise FY14 Actuals Comments

Reported Standalone Net Profit 54,402

Less: Dividend received from subsidiariesand associates including HDFCB

5,254

From the FY14 Annual Report: Since thecombined entity would not have any rightson these cash flows, we are excluding thisfrom the calculations

Less: Interest on zero coupon bonds net oftaxes

3,571From the FY14 Annual Report

Adjusted Net Profit of lendingbusiness of HDFC

45,577

Reported Diluted EPS (Rs) 34.4

Adjusted Diluted EPS (Rs) 28.8 Adjusting reported diluted EPS in line withadjusted reported profits


Now, let’s look at what the adjusted net worth of HDFC would look like.

Exhibit 12:

Adjusted net worth of HDFC

Rs mn unless stated otherwise FY14 Actuals Comments

Reported standalone shareholder’sequity

279,552

Less: investments in subsidiaries andassociates 83,507

These investments (barring HDFCB) would

remain with HDFC Holdco and have to bededucted from the net worth

Adjusted Shareholder’s equity 196,045

Adjusted BVPS (Rs) 126


Now, let’s look at what value the market is assigning to HDFC’s lending business.

Exhibit 13:

Adjusted market cap of the lending business of HDFC

Rs mn Comments

Market cap of HDFC based @Rs1,070/share

1,677,118

Less: value of 22.5% stake in HDFCB 453,829 Value of HDFC’s 22.5% stake in HDFCB at ashare price of Rs836/share (this is the share price

as on 31 August 2014)Less: Value of 72.4% stake in HDFC LifeInsurance business

125,519 Valuation based on 2.5x FY14 embedded value

Less: value of 58.8% stake in GruhFinance

40,521 Value of HDFC’s 60.4% stake in Gruh Finance ata share price of Rs836/share (this is the shareprice as on 31 August 2014)

Less: Value of 59.9% stake in HDFC AssetManagement

38,946 Valuation based on 5% of AUM at June 2014

Less: Value of 74% stake in generalinsurance business

5,395 Valuation based on 1.5x BVPS

Implied Market cap of HDFC’s lendingbusiness

1,011,909

Outstanding number of shares 1,567

Value per share of core lendingbusiness of HDFC (Rs)

646

FY14 P/E of lending business 22.4x Based on EPS arrived in Exhibit 11

FY14 P/B of lending business 5.1x Based on BVPS arrived in Exhibit 12




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Hence, essentially HDFC would bring Rs45.5bn of profits, Rs196bn of equity and a22.5% stake in HDFCB to the table in this merger.

On the other hand, HDFCB’s shareholders would bring a 77.5% stake in HDFCB.

Exhibit 14:

Profitability and net worth of HDFCB

HDFCB Comments

Reported Profitability of HDFCB in FY14 (Rsmn) 84,784 Reported numbersReported net-worth of HDFCB at FY14 (Rsmn) 434,786 Reported numbers

Current market cap (Rsmn) 2,017,017Current market cap based on per shareprice of Rs836

FY14 P/E 23.8x

FY14 P/B 4.6x

Source: Ambit Capital research using company data.

The following table explains what each set of shareholders bring to the table.

Exhibit 15:

Who brings what to table?

HDFC HDFCB Combined

Rs mn

HDFC’s

lendingbusiness

22.5% share inHDFCB Total

77.5% share inHDFCB

Net Profits 45,577 19,076 64,653 65,707 130,558

Share incombined profits

34.9% 14.6% 49.5% 50.5% 100%

Net worth 196,045 97,826 293,871 336,959 630,830

Share incombined net-worth

31.1% 15.5% 46.6% 53.4% 100%

MarketCapitalisation

1,011,909 453,829 1,465,738 1,563,188 3,028,926

Share incombinedmarket cap

33.4% 15.0% 48.4% 51.6% 100%


The above tables shows that the current market cap of these entities is broadly in linewith what each set of shareholders is bringing to the table in terms of the current netprofit and current shareholders equity. Thus, if the merger happens at currentvaluations, no set of shareholders would gain or lose much. However, this is basedon the assumption that there are no merger costs and synergy benefits and that themerged entity’s valuations would be the sum of: (i) current implied valuation ofHDFC’s lending business; and (ii) the current market cap of HDFCB.

However, depending on what metrics are used whilst determining the stake in thecombined entity, there could marginal gains and losses for each set of shareholders,as shown in the table below.

Exhibit 16:

Not much gain or loss if the merger happens at current valuations and if there are no merger costs/synergiesBasis on whichstake is shared inthe combinedentity

Value of holding in combined entityCurrent valuation assigned by the

marketGain (loss)

Rs mn HDFC shareholdersHDFCB

ShareholdersHDFC shareholders

HDFCBShareholders

HDFC shareholdersHDFCB

Shareholders

Net profits 1,499,318 1,519,608 1,465,738 1,563,188 2% -3%

Shareholders’ Equity 1,411,480 1,617,446 1,465,738 1,563,188 -4% 3%

Market Cap 1,465,738 1,563,188 1,465,738 1,563,188 0% 0%

Source: Company, Bloomberg, Ambit Capital research

So, essentially the market is factoring in: (i) that there would be no costs or synergies

from the merger; and (ii) that the market cap of the combined entity would be thesum of market cap of the individual lending businesses of HDFC and HDFCB.



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But the merger will come at a costWhilst banks being allowed to raise 7+ year bonds to fund housing loans couldreduce the cost of the merger for HDFCB and HDFC, still there are a lot of costsrelated to the merger.

Assuming that HDFC converts into a bank, the following table explains the cost of the

merger. Here, we have taken the impact of CRR/SLR/PSL requirements on HDFC’sprofitability. However, we have not taken into account: (i) negative impact on HDFC’sgrowth and margins, as it moves to the base rate regime, (ii) negative impact from higher funding cost from bonds, as 7+ year bonds would cost more than the currentborrowing cost of HDFC from bonds, and (iii) positive impact from any additionalCASA deposits once HDFC becomes a bank, as they should cancel each other at best.

Exhibit 17:

Regulatory costs of becoming a bank for HDFC

HDFC Rs mn Comments

Total borrowings of HDFC at Mar’14 1,842,900 Reported numbers

Additional borrowings required to meetSLR requirement.

405,438

HDFC already maintains 12.5% SLR on itspublic deposits (31% of liabilities). Henceadditional SLR requirement would be 18% of its

current liability base (vs 22% requirement).However, it would fund SLR through additionalliabilities, and these additional liabilities wouldfurther require SLR. So overall new borrowingsrequired to meet SLR would be 22% of existingliabilities.

Negative hit because of SLR (A) 4,054 Assuming that the company would borrow at9.5% and park these funds in GSec at 8.5%

Additional borrowings to meet CRRrequirement

63,565CRR requirement of 4% on non-bank liabilities,as inter-bank borrowings are exempted fromCRR requirement.

Negative hit because of CRR (B) 6,039 Assuming that the company would borrow at9.5% and park these funds at 0%.

Additional borrowings to meet PSLrequirement 5,91,300

Home loans meet only 10% of the total prioritysector requirement so the rest 30% has to be

met through other priority sector loans. As thePSL requirement is on the loan book last year,the company needs 30% of its loan book lastyear to meet PSL requirement.

Negative hit because of PSLrequirement (C)

2,957 Assuming that the company would borrow at9.5% and buy portfolio from other NBFCs at9%.

Total regulatory impact on profits(a+b+c), pre tax

13,050

Total post tax impact on profits,assuming tax rate of 27% (d)

9,526

FY14 Adjusted profits of lendingbusiness

45,577From Exhibit 11

Adjusted profits after regulatorycosts f=(d-e)

36,051

Decrease in profitability of lending

business 21%

Source: Ambit Capital research using data from the company

In terms of impact on RoAs, RoRWA (return on risk-weighted assets), RoE and tier-1capital, the following table explains the impact of these metrics if HDFC becomes abank without any regulatory exemptions.



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Exhibit 18: Impact on HDFC’s RoAs, RoRWA, RoE and Tier-1, if HDFC becomes a bank

Rsmn FY14 Actuals Addition/reduction

Adjusted FY14 Comments

Adjusted Asset base of HDFC,net of investments insubsidiaries & associates (a)

2,174,006 1,060,303 3,234,369 Addition of assetsbecause of CRR/SLR/PSL.From the table above.

Risk weighted assets (b)

1,676,000 5,91,300 2,267,300

Since G-Secs and CRR iszero risk assets, the

addition in RWA wouldonly come fromadditional priority sectorloans where risk weights

would be around 100%.Adjusted profits of lendingbusiness (c)

45,577 (9,526) 36,051Calculations from thetable above.

Adjusted shareholder’s equity(d)

196,045 196,045From the table above,adjusted for investmentsin subsidiaries.

ROA (%) (c/a) 2.1%100bps

reduction1.1%

RORWA (%) (c/b) 2.7%110bps

reduction1.6%

ROE (%) (c/a) 23.2%480bps

reduction

18.4%

EPS (Rs) 28.221%

reduction22.8%

Adjusted Tier 1 capital 12.5%320bps

reduction9.3%

Due to 35% increase inRWA.

Source: Ambit Capital research using company data

The table above demonstrates how meaningful the impact is if HDFC folds into abanking umbrella without regulatory exemptions. Please note that we are excludingfrom this table the large liability requirement (~50% of current liability base) to meetadditional CRR/SLR/PSL requirements. Such a requirement could hurt the mergedentity’s growth for some years. Hence, the actual impact on future profitability couldbe more severe than what is shown in the table above. HDFC might need to stopgrowing its balance sheet over the next two years (similar to what IDFC has been

doing) to realign its balance sheet to meet regulatory requirements.Exhibit 19:

Conversion into a bank could impact HDFC’s growth in the near term

Rsmn FY14 Actuals FY16 Estimates Comments

Adjusted current profits 45,577 65,630 Assuming 20% CAGR

Adjusted profits postregulatory exemptions

36,051 36,052 Assuming constraints on growingthe balance sheet due torealignment of balance sheet

% negative hit on profitability 21% 45%


Scenario analysis under regulatory exemptionsWithout getting into specifics of how much of HDFC’s balance sheet could beexempted from regulatory requirements, in the following table we have shownsensitivity of HDFC’s RoA, RoRWA, RoE, Tier-1 and EPS to the percentage of itsbalance sheet getting exempted from regulatory requirements. Moreover, given theconstraints on HDFC’s balance sheet growth for a couple of years post the merger,the impact on future RoEs and EPS growth would be even more pronounced thanwhat it is visible in FY14.



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Exhibit 20: Sensitivity of key operating metrics of HDFC’s lending business if it converts into a bank

% of liabilities exempted from regulations

Key Operating MetricsFY14

Actuals0% 10% 20% 30% 40% 50% 100%

RoA (%) 2.1% 1.1% 1.2% 1.3% 1.3% 1.4% 1.5% 2.1%

RoRWA (%) 2.7% 1.6% 1.7% 1.8% 1.9% 2.0% 2.1% 2.7%

RoE (%) 23.2% 18.4% 18.9% 19.4% 19.9% 20.4% 20.9% 23.2%Adjusted Tier-1 capital 12.5% 9.6% 9.8% 10.0% 10.3% 10.5% 10.8% 12.3%

% decrease in FY14 EPS 28.8** -21% -19% -17% -15% -13% -10% 0%

% decrease in FY16 EPS* 41.5** -45% -43% -40% -36% -32% -28% -2%

FY16 RoE 14.2% 14.8% 15.6% 16.3% 17.1% 17.9% 22.6%

Source: Company, Ambit Capital research; Note: * Assuming that liability side of the balance sheet could support only 20% growth in the balance sheet over thenext two years ** FY14 adjusted EPS of lending business and assumed 20% CAGR in EPS over FY14-16 if HDFC remains in its current form

So how should we factor in the decline in RoEs and EPSin HDFC’s valuation?

At present, the market is assigning a valuation multiple of 5.1x FY14 P/B and 22.4x

FY14 P/E and valuing HDFC’s lending business at Rs646/share. If we assume that themarket is rational and would assign multiples based on the revised profitability of thebusiness, the lower profitability of HDFC’s lending business under the merged bankshould reflect in a lower valuation as well. In the following table, we have capturedthe revised valuation of HDFC’s lending business based on the assumption that theFY16 P/E multiple of the lending business remains constant.

Exhibit 21:

Sensitivity of valuation of HDFC’s lending business if it converts into a bank

% of liabilities exempted from regulations

Forward Estimates and valuationsCurrent

Estimates0% 10% 20% 30% 40% 50% 100%

FY16 EPS estimates (Rs mn)* 41.5** 22.3 23.7 25.1 26.6 28.2 30.0 40.9

FY16 ROE 23.2% 14.2% 14.8% 15.6% 16.3% 17.1% 17.9% 22.6%

Valuation per share (Rs) of HDFC based onP/E multiple of 15.5x

646 346 367 389 413 438 465 633

Total Valuation of HDFC’ lending business(Rsmn)- P/E Method

1,011,909 542,242 574,681 609,274 646,241 685,837 728,350 991,503

P/B based valuation per share (Rs) of HDFCbased on (ROE-growth)/(Cost of Equity-growth) formula assuming growth of 10% andcost of equity of 13%

646 210 244 280 318 358 399 635

Total Valuation of HDFC’ lending business (Rsmn)- P/B Method

1,011,909 328,756 382,773 439,213 498,250 560,078 624,910 994,428

Source: Company, Ambit Capital research; Note: * Assuming that the liability side of the balance sheet could support only 20% growth in the balance sheet overthe next two years ** FY14 adjusted EPS of the lending business and assumed 20% CAGR in EPS over FY14-16 if HDFC remains in its current form

Hence, if HDFCB pays the current valuations for HDFC’s lending business, the mergercost would have to be borne by HDFCB’s shareholders. On other hand, if HDFCBpays valuations based on revised profitability of HDFC then HDFC’s shareholderswould bear cost of the merger.

If HDFC’s shareholders get the revised valuation for their business, as per revisedprofitability, the impact on HDFC’s shareholders is quite clear. The negative return forHDFC’s shareholders could be anywhere between 17% and 40% (as compared tocurrent share price of Rs1,070 on 31 August 2014). HDFC’s shareholders could onlymake money from current valuations if HDFCB pays a premium to HDFC’s currentprice, which looks unlikely.



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Frequently asked questions (FAQs) HDFC’s cost-to-income ratio at 8% is much lower than HDFCB’s cost-to-incomeratio of 45% and hence HDFCB would gain from HDFC’s better operationalefficiency if it acquires HDFC. Is this true?

HDFCB’s cost-to-income ratio is higher due to other deposit-taking and lending

operations. If we look at the marginal cost of the housing finance business, webelieve HDFCB can do this business at a much lower cost than HDFC, if not lower.Origination cost is one of the biggest expenses in the mortgage business and giventhat HDFCB can cross-sell mortgages to its existing customers (which it is alreadydoing by originating one-fourth of HDFC’s loans), in fact HDFCB can do the housingfinance business at much lower operating costs vs HDFC.

Mortgages have lower risk weight, and so would the merger release capitalfor HDFCB given that HDFC has excess capital?

Risk weights for home loans and commercial real estate loans are identical for bothbanks and HFCs and hence just converting HDFC into a bank would not release any

capital for the combined entity. Moreover, though prima facie, HDFC’s tier-1 capitallooks higher than HDFCB, adjusting for HDFC’s investment in HDFCB, the tier-1capital of HDFC is just marginally higher than HDFCB.

Moreover, investors should note that whilst HDFCB’s tier-1 capital calculation isbased on the more stringent Basel-III norms, HDFC’s tier-1 capital calculations arebased on the dated NHB norms and hence in fact under Basel-III, the tier-1 capital ofHDFC could be even lower.

Exhibit 24: The combined entity does not get significant benefits on the regulatorycapital front

FY14 Actuals HDFCB HDFC Combined

Reported Tier 1 Capital (%) 11.8% 15.4%

Adjustments for investments (%) 3.3%

Adjusted Tier 1 capital (%) 11.8% 12.1% 11.9%


If HDFC sells its stake in HDFCB, then would this release a lot of capital forHDFC and lead to higher tier-1 capital for HDFCB?

HDFC selling its stake to the public would lead to a realisation of Rs453bn for HDFC.This would bump up HDFC’s tier-1 capital to ~40.7% for HDFCB and 21% for thecombined entity.

Exhibit 25: Significant boost to tier-1 capital

FY14 Actuals HDFCB HDFC Combined

Current Tier 1 capital (Rs mn) 406,545 202,976* 609,341

Addition to tier 1 capital from stakesell in HDFCB

0 454,115

Adjusted Tier 1 Capital (Rs mn)(a) 656,911 406,545 1,063,456

Current RWA (Rs mn) 1,676,000 3,453,008 5,129,008

Reduction in RWA 62,826

Adjusted RWA (Rs mn) (b) 1,613,174 3,453,008 5,066,182

Adjusted Tier 1 capital 40.7% 11.8% 21.0%

Source: Ambit Capital research using company data. Note: * Based on Ambit Capital calculations

However, this new capital would be a significant drag on the RoEs of the combinedentity and would bring down RoEs to 14.9%.



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Exhibit 26: So what should be done with this capital?

FY14 Actuals - Rsmn HDFCB HDFC Combined

Current Net worth 434,786 196,045 630,831

Profits from stake in sell in HDFCB 454,115

Adjusted Net-worth (a) 434,786 650,160 1,084,946

Current Profits- FY14 84,784 45,577 130,361

Addition in profits due to interestsavings by paying back liabilities,net of taxes*

31,493

Adjusted profits ((b) 84,784 77,070 161,854

ROE (%) 19.5% 11.9% 14.9%

Source: Company, Ambit Capital research

We are not sure about the motives for HDFCB to shore up its capital to 21% tier-1capital and bring down its RoEs to 14.9%. If we take the cost of the merger, RoEscould further fall to ~14%. To get back to RoEs of 20%, it would take at least threeyears even if the combined entity expands it loans book at 35% CAGR. If the growthdoes not happen, RoEs could drag for years to come (similar to what happened toIDFC) and depress valuations.

Will HDFCB get the benefit of priority sector loans?

Home loans can at best form only 10% of the total priority sector requirement. This isthe reason HDFCB only retains only a certain portion of home loans it originates forHDFC and the rest resides with HDFC. Hence, HDFCB would not get any addedbenefits of priority sector loans if it acquires HDFC.

Could HDFCB have longer tenure assets on its books in terms of home loans?

If this was the incentive, HDFCB could have retained more home loans which it

originates for HDFC. With liability duration of 1-2 years, we do not see why HDFCBwould like to load its balance sheet with low-yielding long tenure (5-7 years) on itsbooks.

Wouldn’t the merger create India’s biggest financial institution, which ispositive for the group?

If size was synonymous with profitability, SBI would not have been struggling withRoEs of 11% and 0% EPS growth over FY08-14.



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Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta Banking / Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected]

Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Real Estate (022) 30433205 [email protected]

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave Healthcare (022) 30433212 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Pratik Singhania Retail (022) 30433264 [email protected]

Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Midcaps – Chemical / Retail (022) 30433242 [email protected]

Ritesh Vaidya Consumer (022) 30433246 [email protected]

Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected] Shekhar Economy / Strategy (022) 30433229 [email protected]

Tanuj Mukhija, CFA E&C / Infra / Industrials (022) 30433203 [email protected]

Utsav Mehta Technology (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

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