When looking at India from the outside, it seems like a natural growth story: a potential market of 1.2 billion people, a growing middle class, and cheaper labor costs than China. However, India's GDP growth has shrunk to 5.0% in 2013 from 6.2% in 2012 and 9.3% in 2011. The slowing growth is reflective of the cumbersome regulatory environment that India has created: the country has earned the infamous moniker of the "license raj," referring to the numerous business licenses required for even the simplest of businesses. Since its independence in 1947, a member of the Gandhi family, descendants of India's first Prime Minister, Jawaharlal Nehru, has governed India. Manmohan Singh, the last Prime Minister (2004-2014) was widely seen as a puppet for the Gandhi family's matriarch, Sonia Gandhi.
Sonia Gandhi's son, Rahul Gandhi - a symbol of the establishment, ran against Narendra Modi, a reformer from India's most prosperous state (this assertion is widely debated), and was harshly defeated - Gandhi's National Party only won 44 out of 543 seats, while Modi's pro-business BJP won 282 on the hopes that Modi would bring economic reforms to India.
India's first national budget, released two weeks ago, includes measures making it easier for banks to access long-term funding by issuing long-term debt in local markets.
The rupee-denominated bonds will have a minimum maturity of seven years and will be free from cash reserve and statutory liquidity ratio requirements, as well as so-called priority sector lending targets, the Reserve Bank of India said yesterday."
A growing asset-liability mismatch has grown out of the regulatory roadblocks that exist, preventing banks from issuing long-term debt. Nearly 80% of India's banks' liabilities are deposits, which are short-term funding sources, but their loans are largely infrastructure-related, which are longer-term commitments. The asset-liability mismatch is clear in HDFC Bank's (NYSE:HDB) balance sheet. In one of the footnotes, HDFC lists its asset-liability mismatch; for assets and liabilities over 5 years, HDFC has an asset mismatch of 418,236 MM (~ $7.7 BB), about 11% of their total assets at year-end 2013.
The Modi government, in an effort to free up long-term capital for lending, made it easier for banks like HDFC to borrow long-term debt from local capital markets. While HDFC's cumulative asset-liability mismatch is positive, some Indian banks have negative asset-liability mismatches, and could benefit greatly from the opening of local capital markets. Still, making additional LT-debt available to HDFC will increase its ability to make new loans, and generate new Net Interest Income, and reduce its cost of capital - boosting its valuation.
Banks in the United States often use long-term debt as funding for long-term loans. At the moment, HDFC's long-term debt is 7.02% of total liabilities, while US banks like Bank of America and JP Morgan have 13.28% and 12.31% LT-debt / total liabilities, respectively. This suggests that given the opportunity, HDFC will increase its LT-debt / total liabilities ratio.
According to Reuters,
"A flat-to-inverted rupee yield curve is likely to provide a further catalyst for long-term issues. At current benchmarks, an Indian company with a local Triple A rating can expect to raise 15-year money at a yield only 25bp higher than for one-year funding."
HDFC's 20-F (the equivalent of a 10-K for an ADR), shows that it pays 5.9% on its short-term debt, suggesting that new LT-debt would cost 6.15%.
HDFC, being a bank, benefits from higher levels of debt, as long as that debt is converted to interest-earning assets - loans. Our valuation of HDFC must also take into account that HDFC's earnings before interest and taxes, EBIT, a key figure in the traditional DCF, is negative, since all of HDFC's income is interest income, and expenses are interest expenses and non-interest expenses (branch operating costs, salaries, etc.). Thus, instead of using a DCF, we should use a Free Cash Flow to Equity model. An FCFE model mimics a DCF's discounting of future cash flows; however, instead of using Free Cash Flows, we use Free Cash Flows to Equity (i.e. after debt service), and cost of equity instead of WACC.
FCFE = NI - Δ Assets + Δ Liabilities
The main catalyst to HDFC's value is an upcoming change in capital structure, not necessarily increasing cash flows, although HDFC benefits from secular tailwinds in the Indian infrastructure sector, given PM Modi's commitment to infrastructure spending. We must focus our valuation on changing capital structure, not changing cash flows. Therefore, we construct an FCFE model (a DCF with Free Cash Flow to Equity instead of Discounted Cash Flow), with 5% terminal growth rate and 10.57% cost of equity. We calculate the Cost of Equity using CAPM with RF of 2.70%, Beta of 1.22, and Market Return of 9.15%. In an FCFE model we use Cost of Equity since FCFE calculates residual value flowing to equity holders, and the sum of discounted future cash flows is equity value, and debt does not need to be subtracted again. Given these parameters, and parameters regarding the ADR (2,390 MM ADR outstanding with 3:1 ADS:ADR ratio), we see that to justify Friday's price of $48.24 with no growth premium, shareholders expect Rs. 91,864 MM (~$1.7 BB) of Free Cash Flow to Equity in 2014.
If we take that FCFE as given and change the amount of LT-debt, we see that HDFC's valuation shoots up in value. We assume that every dollar added in debt is either turned into a loan, which earns the average interest rate of 10.1% and costs 6.15%, or is held as cash, which earns 5.1% but costs 6.15%. If HDFC brings its LT-debt / Total Liabilities ratio in line with most American banks, say, Bank of America's 13.28%, an additional Rs. 236,368.20 (~$5.3 BB), its intrinsic value rises to $50.78, a 5.26% premium. If HDFC raises only enough long-term debt to cover its over-5-year asset-liability gap, Rs. 418,236 MM (~ $7.7 BB), it needs to convert 5.56 % of its new debt to interest-earning loans. For every loan issued beyond the 5.56% threshold, HDFC's share price builds in value. If HDFC converts the entire Rs. 418,236 MM into loans, its intrinsic value rises to $52.71 - a 9.3% premium over its Friday's closing price.
However, a 9.3% premium is insufficient for any intelligent investor; thankfully, HDFC presents additional alpha opportunities owing to the exchange rate effect between the US Dollar and Indian Rupee. Following Wednesday's FOMC minutes, the market can expect QE buying to end towards the end of the year, which means that the Fed will be pumping no dollars into the market, sending rupees back to their pre-QE levels of 55, or even lower to 50.
If the rupee returns to 55, HDFC's ADRs shoot up in value to $54.24, and if it falls to 50 on hopes of Indian growth, then the intrinsic value rises to $59.66, a 23.7% upside.
HDFC is a growing bank with strong fundamentals, and clear catalysts to a growth in share price. Unlike other companies, this company's value lies not in growth, but rather in identifiable catalysts that arise from the changing regulatory environment in both India and the United States.
Disclosure: The author is long HDB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.