A Leader In Securities Settlement, Bank Tracks Indian Stock Market

Stock markets have soared in India for the last few years. HDFC Bank (NYSE:HDB) has held on for the ride.

The Indian bank (OOTC:INDIF) is the market leader in the brokerage transaction and settlement business, and booming markets bring money to the bank.

That cash, which it doesn't have to pay interest on, gives it cheap funds to lend out to the growing middle and business class in India.

It's a recipe for growth at Mumbai-based HDFC HDB.

"The stock market volumes have gone through the roof," said Anindya Chatterjee, an analyst at Jefferies (NYSE:JEF) & Co.

India's benchmark Sensex index has more than doubled since the beginning of last year. So has the market capitalization of India's listed stocks, to above $1 trillion.

Brokerage Industry

Chatterjee says there's $5 billion in cash transactions daily on the Bombay (OOTC:BBAO) and national stock exchanges. Six out of 10 brokerages have their accounts at HDFC Bank.

That access to cheap capital gives HDFC among the highest net interest margins of any bank in India. Net interest margin is the spread between a bank's cost of money and the rate it gets on loans. HDFC had a 4.3% margin in fiscal 2007, up from 4% in 2006.

The bank is also expanding its retail presence. In the U.S., it's hard to find a street corner without some sort of bank branch.

Not so in India.

There are still large swaths of suburban and rural areas of the country with few banking options. At the same time, rapid economic growth -- second only to China's -- is creating a growing middle class, with increasing demand for banking services.

Businesses with an eye toward expansion are also reaching out for loans.

To serve them, the bank now has more than 750 branches throughout the country, up about 60% from two years ago. The company is reaching out to the so-called "unbanked" in the rural areas. More than 60% of its branches are outside of the county's nine largest metro regions.

ATMs

HDFC also has about 1,800 ATMs in 327 cities. Those machines account for about half of its transactions.

"There is an Indian growth story, but they're also expanding their market share," said Ann Heffron, an analyst at Zacks Investment Research.

Analysts say HDFC is among the best-managed banks in India and has avoided pitfalls such as making bad loans.

It has also invested in technology platforms and infrastructures that give it a leg up in the lucrative securities transactions clearing and settlement business.

HDFC Bank was formed in 1994 by an Indian mortgage company, Housing Development Finance Corp. In the past five years, the bank has grown its customer base from 2.1 million to more than 10 million.

Earnings Growth

The bank's American depositary receipts started trading in the U.S. in 2001.

HDFC posted earnings of 79 cents per ADR in its second quarter, which ended in September. That was up 46% from a year ago. Sales of $717 million were up 66% from the year before.

In fiscal 2007, the company reported earnings of $2.41 per ADR. Analysts surveyed by Thomson Financial look for $3.61 per ADR this year.

HDFC has been careful so far.

"They've also been able to maintain a much better book of loans, qualitywise, than their competitors," Heffron said.

But Chatterjee says caution puts HDFC a step behind in some categories.

It ranks second or third in most retail loan segments, behind ICICI Bank (NYSE:IBN) IBN and others.

Chatterjee says HDFC is less aggressive than ICICI at chasing lucrative corporate business, particularly among Indian businesses expanding overseas. That's a potential growth area, though Chatterjee says ICICI has a head start on landing that business, plus the fee income that comes with it.

Indian banks seem to have little direct exposure to the subprime mortgage mess in the U.S.

"Often the emerging markets have taken it on the chin, but they seem not to have direct exposure to U.S. subprime investments," Heffron said.

HDFC still could be hurt if the U.S. subprime troubles cause economic ripples that slow the influx of investments in India.

Bumpy Market

The Sensex has been bumpy since first cracking the 20,000 mark in October. It fell, then rebounded, and is now just below that mark. HDFC Bank would feel the pinch if Indian stocks lost their luster.

Regulations could still hurt the bank, and other Indian ADRs too.

The Securities and Exchange Board of India took steps in October to tamp down on the use of offshore derivative instruments, a tool used by some hedge funds and other nonregistered investors in India. The idea was to increase transparency in the market, though some said it restricted liquidity.

HDFC is susceptible to the potential troubles of any fast-growing company. It could run low on capital, forcing it to issue new shares periodically.

That would raise the risk of earnings dilution, analysts say.