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HDFC issues 4000 cr. debentures, 300 cr. worth warrants

HDFC is looking to sell a 4000 cr. non convertible debt issue to institutions. There are two parts – two year debt of 2000 cr. at a yield of 7.15% annualized, and a 2000 cr. issue at a yield of 7.85%.

These are zero coupon debentures – meaning you don’t get paid during the tenure. In this case you get a lumpsum principal plus “premium” at the end. The premium is such that your yield is at the rates mentioned. HDFC will really be paying out Rs. 296 cr. for the 2 year debenture and Rs. 508 cr. for the 3 year debenture as total interest.

From an interest outgo basiss, that’s about 800 cr. in three years; 317 cr. for the first two years, and 170 in the third. They need to make at least that much to pay for the loan.

In addition, HDFC is issuing warrants – that give you the right to buy an HDFC share at Rs. 3,000 anytime in the next three years, for an upfront non-refundable payment of Rs. 275. This sounds like an American stock option, and it is. So can it be valued that way? Using the Black Scholes model, a three year term with a 3000 “strike” price and a current market price of Rs. 2440, I get a valuation of Rs. 375. (Volatility of 25% assumed)

(Note: Black Scholes is a notoriously unreliable model for valuing long term options – it either overstates or understates prices dramatically. The implicit assumptions of volatility and distribution are totally wrong as observed. The basic underlying assumption of Black-Scholes is that markets are efficient; any observer will tell you that is bunkus. Specifically, you might see “efficiency” work in the short term, but over a long term the model simply doesn’t apply)

Still, HDFC gets 300 cr. it doesn’t have to pay back, for issuing these warrants. They’ll dilute just 3.5% – consider that there is a 4.5% dilution with the total outstanding stock options remaining and another 1% from FCCB conversion. (Heck, that’s a lot of dilution – but different story).

They will use the money to buy out 3% of stake in HDFC Bank. HDFC had paid 400 cr. as an advance last year for buying 4000 cr. worth stake at Rs. 1520 per share – this is valid till Dec 2, 2010. Current HDFC price is at 1480 – but if they choose not to buy shares they lose the 400 cr. advance. So they have to pay out Rs. 3600 cr. to say hello to the 3% extra share in HDFC Bank.

While this is good for HDFC bank, the share of HDFC in it goes up from 19 to 22%. That’s not much really – a rough calculation shows that even if HDFC Bank grew 20% a year, HDFC’s extra stake will only give it Rs. 80-90 cr. a year as increased profit share.

HDFC benefits from the warrants it sells – the 300 cr. it receives can be used to pay for the first year’s interest on the debenture. Since it’s borrowing to buy HDFC bank shares, it can’t really generate cash from that avenue (and it plans to NOT sell HDFC bank shares at all) – so where do they get the money to return this loan after two/three years? I don’t know. Maybe they’ll borrow again. Scary strategy, that. What if the lenders say F.O.?

Now the extra interest outgo is about 30-40 bps (0.3% to 0.4%). (Of a total borrowing of 80,000 cr. the extra interest is 300 cr.) That may not sounds like a large amount, but they had a net interest margin (inflow minus outgo) of only 2.1% or 210 bps. This extra 30 bps will hurt, from 2011 onwards.

But their prospects are good, no doubt? Well, they have a higher cost of funds than, say, banks. Their insurance and mutual fund subsidiaries are not going to do well in the next few years, considering new tax laws, lowered commissions to agents and higher competition. The new tax law may hurt housing too – tax exemptions are due to go away in 2011, and that will hurt prices. (Housing is where HDFC makes its core money) There is likely to be a revision of NHB provisioning too – current levels say 90 day delinquent loans need to provision just 10%, upto 15 months of delinquency (!!!). Even at 50 months or more of non-payment, the provisioning needs to only be 50%. These rates will change once loans go “underwater” – a situation we haven’t quite seen yet, but I believe we’ve overbuilt enough to see it in the next few years.

The other point is price. HDFC is valued at more than 30x past earnings (it had an EPS of 78 in FY 09, and an EPS of Rs. 19 in Q1 FY10). It’s price to book is close to 4 – while most regular banks are quoting at close to book values (p-to-b of 1 or less). It’s dramatically overpriced. (It’s a good trading stock though – has decent volatility)

You and I can’t subscribe, so I won’t even talk about what I would do. Still, one has to have some direction. At a 7.5% yield the debentures look pricey – why would I go there, when L&T Finance or a Tata Capital gives me a 10% yield? And the warrants – if I think the equity is overpriced the warrants are a joke. But there are enough takers for the issue, apparently. When the music is playing you have to dance, no?

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