HDFC Bank reported 20% y-o-y earnings growth on the back of 10% y-o-y operating profit growth and 17% y-o-y decline in provisions. The bank reported a solid loan growth of 23% y-o-y and healthy return ratios of 2% RoA and 17% RoE. Asset quality metrics were stable. While we remain positive on the bank (unchanged FV), the near-term issue of the merger would continue to remain a key overhang as we need to have clarity on the various dispensations needed for a smooth transition.

Lower provisions drive earnings growth; loan growth strong across segments: Loan growth was solid at 23% and more balanced across subsegments. Fee income grew ~17% y-o-y but there was a marginal loss in treasury income leading to lower non-interest income growth. Cost-income ratio was at 41% as the retail business has started to accelerate well. NPL ratios were stable with gross NPL ratio at 1.2% and net NPLs at 0.3% of loans. Slippages were at ~1.6% and restructured loans were at 0.5% of loans.

The familiar two issues: short and medium term: We look at HDFC Bank through two lenses. The business performance lens where there is strong growth and solid return ratios. Cost growth acceleration is less worrying as it partly reflects recovery in the retail business and choices made to strengthen the franchise. One would be wary of building any positive levers because of concerns of rising competition and the bank’s own choice to be aggressive.

The medium-term lens is a well-discovered problem of the merger with its parent where we have broadly identified the issues that need to be dealt with. Based on the regulatory dispensation, it is easier to build the next stage of the investment thesis. The absolute return argument is currently resting partly on the ability of the bank to trade at higher multiples along with steady compounding as the bank has done in its past. The relative argument is more challenging. We find a convincing argument that ICICI Bank/others have fewer issues while HDFC Bank works through the merger, especially forecasting the deposit variable. We will work through this issue as the situation unfolds rather than building a strong view on the same.

Maintain BUY; FV unchanged: Playing for the long term: We maintain BUY rating with FV at Rs 1,750 (unchanged). At our FV, we value the bank at 2.5X book and 16X September 2023E EPS for RoEs at 15-16% levels and 15?GR (adjusted for merger). We believe that the long-term investment thesis of the bank looks quite solid.

However, we acknowledge the Street’s concern on the near-term overhang and availability of better alternatives to be justified as well. Hence, we do believe that the re-rating needs a longer time-frame in mind, especially given the strength of the franchise.