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Housing Development Finance Corporation (HDFC) has received an in-principle nod from its Board of Directors for a combined offering of secured redeemable non-convertible debentures (NCDs) along with detachable warrants. The issue size is pegged at Rs4,000 crore. The NCDs together with the warrants will be issued on a qualified institutional placement basis.

Investment in HDFC Bank and business growth

The capital raising is likely aimed at funding HDFC’s proposed investment in HDFC Bank as well as future growth in the mortgage business. Following the acquisition of Centurion Bank of Punjab (in a share-swap deal), HDFC’s stake in HDFC Bank has come down to ~19%. With a view to maintaining its ~23% stake, HDFC had purchased warrants (each convertible at Rs1,530) and made a 10% upfront payment. The remaining 90% (Rs3,600 crore) is to be paid by December 2009. Besides funding the warrant conversion, the fund raising would help finance growth in the mortgage business. However, the proportion of funds to be diverted towards HDFC Bank’s warrant conversion can be less than Rs3,600 crore. Maximum dilution seen at 3.5% According to the management, if and when the warrants are exchanged, the maximum dilution that could take place in future would not exceed 3.5% of the expanded equity. The fund raising structure (NCD + detachable warrant) would enable HDFC to raise near-term debt without diluting its near-term earnings. Importantly, the dilution would occur later (most likely after FY2011) and hence does not call for any change in our assumptions.

Right timing

According to media reports on the development, the tenure of the secured redeemable NCDs is three years with a coupon rate of 7.25-7.50%. The fund raising seems well timed considering that the corporate spreads have normalised to pre-Lehman Brothers levels. As evident below, the spread between the AAA banking company yields and government securities (G- Secs) for three years maturity is currently at ~160 basis points down from +400 basis points in November-December 2008. Moreover, the warrant conversion option would act as a sweetener from investors’ perspective.

Valuation

At the current market price of Rs2,350, the stock trades at 20.8x its FY2011E earnings per share (EPS) and 4.9x its FY2011E adjusted book value (ABV). As we await further clarity over the terms of the issue and the price at which the warrants would be issued, we keep our earnings estimates unchanged. Consequently,we maintain our Hold recommendation on the stock with a price target of Rs2,517

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