Valuation gap between HDFC Bank and ICICI Bank narrowest after correction

HDFC Bank's asking rate has been twice ICICI Bank's in the past, but the trend is fast reversing

The correction in banking stocks since March has helped reduce the valuation premium that HDFC Bank commands over ICICI Bank. From 4.2 times FY19 book, HDFC Bank’s asking rate has currently dipped to 2.8 times FY21 estimated earnings. ICICI Bank’s valuations, on the other hand, has improved from 1.8 times FY19 to 1.9 times FY21 estimated book. The number for ICICI Bank is expected to remain stable or marginally improve going ahead. In other words, HDFC Bank’s valuation premium which was twice more than that of ICICI Bank for most years between FY10 - FY19 is fast melting. At about 37 per cent premium to ICICI Bank, the valuation gap with HDFC Bank is at a decadal low (see table). Even on FY20 basis, the figure is the lowest in a decade.

The difference between the two stocks now is just about mirroring their balance sheet size. HDFC Bank’s balance sheet at Rs 10.03 trillion in FY20 is 36 per cent larger than ICICI Bank's Rs 6.45 trillion.

So, what justifies the narrowing valuation gap and how sustainable is the trend? Here are some key parameters that could provide the answers.

Asset quality picture

Numbers indicate that the gap in asking rates between the two banks became pronounced from FY16, ever since ICICI Bank was caught neck-deep in cleaning up its books – an activity which came at the cost of the bank’s growth. Come FY20, when the bank had more or less taken care of its legacy loan issues, the Street started ascribing better multiples. On the other hand, HDFC Bank’s gross non-performing assets (NPA) ratio have been slowly inching up, breaching the bank’s sacrosanct one per cent mark. From FY17 till date, the bank’s gross NPA has risen from 1.1 per cent to 1.4 per cent as on June 30, 2020 (Q1 FY21), though its net NPA ratio is less than a per cent level. These numbers are still the best in the sector.

On the contrary, ICICI Bank’s gross NPA after peaking at 9.5 per cent in FY18 reduced to 6 per cent in Q1, while its net NPA at 1.5 per cent has fallen below its pre-asset quality review (AQR) level. Going forward, analysts at Kotak Institutional Equities feel ICICI Bank may see a further improvement in asset quality, while HDFC Bank’s may marginally deteriorate (see table).

Loan mix

The composition of retail and wholesale loans also have helped in improving the Street’s perception on ICICI Bank. Taking lessons from AQR, ICICI Bank now has a larger share of retail loans compared to HDFC Bank (see table). Primarily reckoned as a retail lender, HDFC Bank’s share of retail assets has steadily dropped over years and at 47.3 per cent in Q1, it is back to FY15 mark.

Also, ICICI Bank’s loan book leaning less towards unsecured portfolio is another advantage. Compared to HDFC Bank’s 16.6 per cent unsecured exposure out of retail book (5.5 per cent - credit cards and 11 per cent - personal loans), half of ICICI Bank’s retail assets come from home loans. And, unsecured portion is restricted to 9.4 per cent of ICICI Bank's retail book. Importantly, ICICI Bank continues to expand its retail book faster than the overall portfolio – up 20 per cent year-on-year in Q1, while HDFC Bank’s retail growth has slowed down – up 7 per cent year-on-year in Q1. That said, analysts at Axis Securities say, HDFC Bank’s selective lending parameters and strong risk management will keep its operating performance steady.

Valuation trend

Gautam Chhugani of Bernstein Research believes there is scope for further reduction in valuations. Any adverse asset quality surprises, though, could alter his expectations. Prakhar Sharma of Jefferies feels that as ICICI Bank has ticked all the right boxes it is well-placed to take on asset quality issues.

On Saturday, HDFC Bank will reveal its Q2 results and ICICI Bank’s numbers are anticipated by month-end. Upcoming results will determine if the valuation trend can sustain.