Authors: Abhinav Mishra & Abhishek Murarka
“As the son grows older, he acquires the father’s business”
One cannot sum up the mega-merger announcement better than the above statement. If you are new to the market, the news may have been a surprise. For seasoned investors, it was not. We will talk about everything related to the merger in this article.
Outline
Looking back at history
You must have heard of Aditya Puri and how he single-handedly made HDFC Bank what it is today. A few of you may know about Deepak Parekh (Chairman of HDFC Group).
On one side, Aditya Puri was taking the HDFC bank to newer heights, and parallelly over the years, Deepak Parekh was taking care of the mighty HDFC group. If you want to read about the history, I recommend Tamal Bandyopadhyay’s book on HDFC Bank.
The news of both entities getting merged was floating since 2015 (and even before). However, it never materialised for the below reasons:
- The boards were not too serious about the merger.
- HDFC Bank, under Aditya Puri, had gradually overtaken HDFC in terms of size and wanted a valuation favouring the bank.
- HDFC Ltd thought otherwise. It suggested that without the support of the HDFC group, the HDFC bank would not have made much progress.
- The regulatory environment would have made the process not so easy as it is today.
The merger question was not really IF but WHEN the merger would happen. I wonder who would have headed the merged entity in 2015?
Why is the merger happening now?
RBI has been tightening the regulatory framework for NBFCs. It has also narrowed the gap with the banking regulatory framework. The RBI last year came out with new scale-based regulations for the NBFC sector, which would be applicable from October 2022. Under the new framework, the regulatory structure has four layers based on size, activity, and perceived riskiness. Not going into the details, I will give you the gist of it – the new regulation would have meant enhanced regulatory requirements for HDFC Ltd. Merging with the bank makes more sense at this stage.
Adding a long duration retail loan book gives stability to HDFC Bank. Lending business is like running on a treadmill. As loans get repaid, banks must keep lending fresh to maintain growth. This is where the duration of loan comes into play. HDFC Bank needs a long-duration book (such as housing loan) given its own size today.
The balance sheet of the bank has grown at a much faster pace, which makes the acquisition much easier to digest than before.
In FY2008, HDFC Bank’s loan book was lower than HDFC Ltd by ~15%. By FY2014, it was ~50% higher and by FY2022 we see this higher by ~2.4X.
From a macro level, it was the need of the hour – a transformation in the Indian financial sector was a real need. Indian economics is becoming bigger, technology is changing, and the demand is increasing. To cater to the increase in demands of India of tomorrow, the merger could not have happened at a better time.
Shareholding post-merger
Most likely, you would have figured out the updates on the merger. I will summarise it for you in short:
- Shareholders of HDFC Ltd will receive 42 equity shares of HDFC Bank for every 25 shares held by them.
- After the merger, HDFC Bank will be completely owned by the public shareholders. The existing shareholders of HDFC Ltd will hold 41% in the HDFC Bank.
- All the subsidiaries of HDFC Ltd – HDFC Life Insurance and HDFC Asset Management Company would become subsidiaries of HDFC Bank.
- The merged entity can receive an additional 7 to 8% from FII.
How big is the merger?
HDFC Bank was already the third-largest company in India wrt a market cap. With the merger, the merged entity is likely to surpass TCS and become the second biggest company in India.
HDFC Limited has a total asset of Rs 6.23 lakh crore, and HDFC Bank has a total asset of Rs 19.38 lakh crore (calculate asset value of merged entity!!)
The merger will create a goliath with Rs 17.8 lakh crore loan book, Rs 3.3 lakh crore net worth, and nearly Rs 50,000 crore in annual profits with strong capital adequacy and asset quality ratios. For those who understand these numbers – MASSIVE.
Who will benefit more?
It is a difficult question to answer. Analysis suggests that the Bank tends to gain more. The valuation multiple for HDFC Ltd has come off in the past few years. While this is true for the bank as well given that the growth trajectory has decelerated, it has been much more for the parent. Hence, the delay of the merger has largely been favourable as the bank is able to get a best-in-class mortgage book at a relatively inexpensive valuation, at least when compared to its own history.
Post-merger, the HDFC Ltd entity will no longer be there, but the business will continue. The NBFC wing of the merged entity will get access to low-cost deposits of HDFC Bank. NBFCs have to raise capital for lending, while banks have savings and current account deposits (CASA). HDFC Bank has a huge CASA, and HDFC Ltd will get access to it.
For HDFC Bank, the mortgage was not the core product. It only had 11% exposure to a mortgage. Post-merger, the company would have 33% exposure (based on Q3 result numbers). It is a massive 200% jump.
Only 30% of HDFC’s customers are account-holders in HDFC Bank. It is expected that post-merger HDFC Bank will transition from a predominantly corporate lender to one with an over 50% exposure to retail and mortgage loans.
When a customer comes for a mortgage, he gets associated with a bank for 10 to 20 years. Their other banking needs are most likely to be fulfilled by the same bank (given that customers are happy). HDFC Bank has many products, and now it can cross-sell very conveniently to HDFC Ltd customers.
If you are looking for my answer – I would say the bank has more advantages, and it has the opportunity to re-write its success story again – in totally new colors.
Investors happy, not so happy mutual funds
Investors are happy with the merger. Mutual funds houses are already doing some maths and not enjoying the other side of the equation. Let us understand the reason.
The combined weight of HDFC Bank and HDFC will be approximately 14% of the benchmark NIFTY50 index. However, diversified mutual fund schemes are not allowed to invest more than 10% in individual stocks. The problem is this –
- Many mutual funds hold 6 to 9.99% in these companies (separately). There are 16 equity schemes with more than 10% combined allocation in the HDFC twins.
- Now they won’t be able to hold (they may have to sell a percentage of the merged entity).
- Not owning weightage equivalent to the index is a cause of worry for fund managers. It can put active fund managers in a situation where they find it difficult to beat the market benchmark Nifty50.
The dark side
As of today, no one is talking about the dark side. Is there any dark side? Well, there are a few areas of concern I see.
RBI and other regulators now have a company to look after that is too-big too fail and could pose systemic risks. In the merged entity, there could be issues related to succession (in the future). The bank will be held as a public entity – there is no private promoter or government that has skin in the game.
Today, let us not discuss more on this. It is a milestone day for Indian investors, and we will look at the dark side some other time.
Should you hold?
If you have invested in large-cap mutual funds (I hope you do), you get the advantage – most mutual funds have good exposure to these companies. You benefit indirectly.
HDFC Bank has always been a must-own for a serious investor. Now, it will become even bigger must own.
Can you buy it now? HDFC Bank was going through a time correction as it has only increased 4% compared to a 20% increase in NIFTY50. So, it is still available at a decent valuation (Not investment advice).
Do let me know if you have any more questions about the merger.