HDIL

HDFC's performance in 1QFY09 was largely in line with our expectations and we remain sanguine about its prospects. The marginal slippage in asset quality seems to be a seasonal factor. We reiterate Buy with a lower target price of Rs2,405.80, which reflects the increase in our cost of equity assumption.

1QFY09 margin dips more than expected, but we remain sanguine
HDFC's reported net interest income in 1QFY09 was about 10% below our estimate, led largely by subdued growth in interest income. The reported spread increased from 2.22% in 1QFY08 to 2.26% in 1QFY09. NIM (on our calculations) increased to 3.2%, from 3.1% in 1QFY08. In FY08, HDFC reported NIM of 3.9%, while we forecast 3.4% for FY09 and 3.3% for FY10. We expect margins to stabilise in the quarters ahead as volume growth has remained strong.

Business fundamentals healthy; we maintain estimates
Loan growth rebounded in 1QFY09 after a slight dip in 4QFY08 (see chart 2). We believe the competitive position of HDFC also stands enhanced, given the uncertainties in financial markets, BASEL II requirements and the expansion in network following the merger of HDFC Bank with Centurion Bank of Punjab. We maintain our estimates for FY09 and FY10.

Concerns about asset quality are unwarranted, in our view
HDFC's asset quality deteriorated slightly in 1QFY09, but it continues to be significantly better than that of peers. We believe this slippage is mostly seasonal and we are not unduly concerned (see Chart 3). Also note that HDFC's gross NPLs at 1.09% in 1QFY09 is among its lowest levels in two years.

Higher cost of equity, lower target price
The increased uncertainty for the banking sector has led us to increase our cost of equity assumption for HDFC from 13.5% to 14.0%. Accordingly, our fair value for the company has declined to Rs1,627 (from Rs1,838.10). Adding the value of subsidiaries, we arrive at a target price of Rs2,405.80 (down from Rs2,685.40). At our target price (excluding the value of subsidiaries), the HDFC stock will trade at 20.7x FY09F EPS and 3.4x FY09F adjusted book value. We maintain our Buy recommendation.