ICICI Bank, HDFC Bank: Neither a Buyer Nor a Seller Be

I looked at ICICI Bank (IBN) and HDFC Bank (HDB) today; both are interesting, unfortunately I came up with a simple hold vidw. The numbers discussed below are based on data contained in “The Quant Report”; you can access the quant report here.

Operating risk

History tells the tale of management competence, and management competence is a key indicator of operational risk. No one can predict growth accurately, and using very long term nominal GDP growth rates results in disciplined and conservative buy targets. History is important - for instance no one can tell you the future but history tells the tale of how a company exploited the growth opportunity when it arose. Historic data tells the story of how individual companies responded to survive crisis situations.

Both IBN and HDB have had changes in senior management during 2009. In my opinion, the teams post-change are just as strong as they were previously. As far as earnings growth is concerned, IBN drove earnings growth at over 20% annualized during the fiscal years 2000 to 2009. Annualized growth is expected to remain at over 20% at the end of fiscal year 2010. HDB on the other hand grew at near 16% annualized during fiscal 2000 to 2009, with annualized growth expected to accelerate to 18% by the end of fiscal 2010. Over the period, IBN has outperformed HBD. However consider this - between fiscal 2005 and fiscal 2009, IBN’s 6 year median EPS has grown at an annualized rate of 15.3% compared with HDB’s annualized growth rate of 20.2%. IBN significantly outperformed on growth until fiscal 2004, but since 2005 HDB has pulled ahead.

Over the long term, the management of both groups demonstrated the ability to grow at a pace higher than nominal GDP. I would assess the operating risk to future growth as low, assuming a growth target of 12% annualized.

Future Growth Potential

Future growth potential combined with purchasing at reasonable valuation often provides a very powerful gain potential combination. The problem with the future is that it is unpredictable - or is it? Mark Twain is believed to have said “History does not repeat itself, It rhymes”. While historic performance does not necessarily assure future performance, it is certainly indicative. All of the criteria of the operating risk section thus help in forming an expectation level for the future. But eventually, The Quant Report believes integrates conservative methodologies in looking at future potential. Using a standard growth rate eliminates analyst bias, and this is important. The future growth estimates used in the Quant Report are set at a rate at which nominal GDP has grown and can be expected to grow in the foreseeable future. In India, I believe the nominal GDP growth can clock in at a long term rate of 12%.

Over the next few years, demand for credit can be expected to rise. Both banks have done a reasonably good job in expanding the deposit base. Both banks have expanded the number of branches and have enormous potential in expanding the number of branches further.

I believe IBN has the better balance sheet to drive near future growth. In addition, HDB’s rapid expansion in retail is viewed as carrying incremental risk.

Creation and return of shareholder value

Shareholders of both companies have made just over 28% annualized on a dividend reinvested basis between fiscal year 2000 and present. HDB has delivered dividend growth of near 14% annualized while IBN has grown at an annualized rate of 27% during the period from fiscal 2000 to fiscal 2009. Median payout ratios have been at 35% and 43% for IBN and HDB respectively. Ignoring share count, HDB is expected to have grown at over 20% between fiscal 2000 and fiscal 2010 while IBN is expected to have grown 43%. Share count at IBN has increased at an annualized rate of 18.92% compared with 1.79% at HDB. At IBN, the June 2007 ADR issue and public issue were certainly timely; they served to strengthen IBN balance sheet ahead of a period of severe stress. The growth trigger expected from this capital raising has in my view been forfeited in favor of a better balance sheet - in my view this is the better end result.

Financial Risk

I believe that IBN has the stronger balance sheet and this shall be an advantage as they can increase risk to drive growth as the expansion takes hold.

Economic Risk

The financial crisis which occurred will not leave us behind for a while yet. In my view, financial risks will remain elevated for at least another 4 to 5 years. However, at the present time, an economic expansion is taking hold in India. While the yield curve can be expected to flatten, the rising demand for credit will drive earnings growth forward.

Valuation Risk

Both IBN and HDB trade at a significant premium to fair value. IBN trades at a valuation which offers a better return on my forward cycle price target; however the total return potential is not great. At this point, there is long term upside benefit; but buying at premiums to fair value creates long term downside too. I would neither a buyer nor a seller be! I would look to add small speculative short term positions (12 month horizon) at Rs 1,450 ($100) for HDB and Rs 625 ($28) for IBN. Long term positions in Reliance Infrastructure Limited and Grasim provide better cycle return potential. I will post on these two companies in the coming days.

Disclosure: Author has indirect long positions in HDB & IBN.