When You Are A Contrarian

HDFC AMC is a market favourite but, with falling market-share and profitability, can it justify its high valuation?

I sold the HDFC Asset Management Company (AMC) stock on the very first day with a gain of nearly 55%. The market was on an upswing and I wanted to cash in on the listing gain,” says Venkatesh Venkatram, a marketing professional. Like Venkatram, several IPO investors made handsome gains on August 6, the day HDFC AMC listed. After listing at 59% premium from its issue price of Rs.1,100, the stock further surged to Rs.1,844 on the same day. Post the stellar debut, the asset manager commanded a market cap of Rs.375 billion. 

On September 19, however, the initial exuberance turned into gloom as the stock tanked 8.55% on a single day to its record low of Rs.1,408,following the regulator’s diktat that all mutual fund schemes with assets over Rs.500 billion will have to slash management fee from the 2.50% charged for equity funds to 1.05%. Ever since, the stock has continued to be on a losing streak, closing at Rs.1,398 after hitting a low of Rs.1,248, as of September 25, when this edition went to press. 

While fears that the Sebi ruling will impact the profitability of HDFC AMC has gripped the counter, the steep reaction is also an outcome of high expectations riding on the stock. The momentum around HDFC AMC started building up well before its debut on the stock market. The issue was oversubscribed 83x with investors seeing it as a potential multi-bagger. “Two members of my family including me applied for three lots, but were allotted only one,” says Venkatram. According to company filings, currently, 685,409 retail investors hold 30 million shares, which adds up to 17% stake in the company. 

Earlier, one saw similar enthusiasm around the listing of Reliance Nippon Life Asset Management, the only other AMC which went public in November 2017. It was valued at Rs.154 billion at its IPO, with the issue oversubscribed 81x. The stock listed at a 17% premium, but slumped below its issue price of Rs.220 in June 2018, despite registering a net profit growth of 30% in FY18. After the Sebi ruling, Reliance further tanked to Rs.183. 

Given that investors couldn’t get enough of it during the IPO, should you buy into India’s No. 1 asset manageras it gets closer to the issue price once again?

Big brand

HDFC AMC is one of the most profitable asset management companies in India. Through a combination of brand strength, impressive performance and prudent marketing, its business and profits have grown every year ever since its launch in 2001. The firm has been one of the top two mutual funds in India in terms of assets under management (AUM) since August 2008. Currently, this joint venture between Housing Development Finance Corporation (HDFC) and Standard Life Investments manages assets worth Rs.2,920 billion as of March 31, 2018 and has customers across 200 cities. 

Brokerages and analysts share the bullishness of retail investors like Venkatram because of the brand equity HDFC AMC enjoys, which has helped it build a strong base of small investors who do not move in and out every now and then, giving it a stable corpus. Even though the share of retail AUM in HDFC AMC’s equity mix is only around 45%, marginally lower than the industry average, its ticket sizes are about 27% lower than the industry, which gives it a distinct advantage. As Ambit Capital’s report reveals, 50% of lower-ticket retail and SIP investors stay on with HDFC AMC’s schemes for two years or more, as opposed to only 30% in the case of HNIs.

This retail reach has been possible because of the AMC’s extensive distribution network built over the years. The AMC has one of the biggest distribution channels in the industry with 4,837 branches, next to SBI AMC with 13,161 and ICICI AMC with 4,970. “But HDFC AMC gets more bang for its marketing buck,” says Sanjiv Bhasin, executive VP-markets and corporate affairs, IIFL.

Thanks to its prudent strategies and the inherent nature of the asset management business itself, the company is highly profitable. Asset management is a great business — it is capital-light, which means while the asset manager earns higher fee with rising AUM, costs don’t rise in proportion, resulting in fatter profits. Over the past five years, the AMC has consistently delivered a Return on Equity (RoE) of more than 40%. As of FY18, the company’s PAT stood at Rs.7.21 billion, delivering an RoE of 40%. 

While these numbers look great, they camouflage the challenges HDFC AMC has been facing over the past five years though. According to Ambit Capital’s pre-IPO report, HDFC AMC’s earnings saw CAGR of 15% over FY13-17, lagging behind Reliance Nippon’s earnings’ CAGR of 26% over the same period. During the period, its RoE declined from 49% to 40% and, more importantly, its core income declined sharply (see: Slipping returns). 

“HDFC AMC enjoys the best-reported profitability compared to peers and by a wide margin, but its core profitability is better than its peers only marginally,” says Aadesh Mehta, analyst at Ambit Capital, adding that this is because of the high share of treasury revenue (which the company makes from its own pool of cash by making short investments) and prepaid expenses. 

For HDFC AMC, treasury assets are higher than peers at 87% of its net worth and 0.4% of its AUM. Also, prepaid expenses are pretty high at 22% of its PBT. Therefore, HDFC AMC’s core profitability ratio (core PBT to AUM) was 0.25% in FY17, which is only marginally superior to those of ICICI AMC’s, SBI AMC’s and Reliance Nippon’s at 0.23%, 0.21% and 0.16% respectively. In fact, HDFC AMC’s core PAT has declined from 0.28% in 2013 to current levels of 0.24%. 

Explaining the contribution of treasury assets, HDFC AMC says that they have over Rs.20 billion of investment on their balance sheet which is primarily invested in fixed income investments including their own debt-oriented schemes. “The return generated on these investments is shown as other income in our profit and loss account. By end of FY18, other income was less than 6% of our total revenue,” adds HDFC spokesperson.

Even its overall profitability as a percentage of AUM over the past five years has fallen to 0.25% (PAT of Rs.7.21 billion to AUM of Rs.2,920 billion) in FY18 (it was 0.27% for FY17) from 0.33% in FY13. Its listed peer Reliance Nippon Life Asset Management, on the contrary, maintained its profitability at 0.20% and ICICI Prudential AMC managed to increase it from 0.12% to 0.20% during the same period.

HDFC AMC attributes the fall to higher profits from FY14 to FY16 (and relatively lower profits thereafter) on account of the performance fees received from real estate portfolio. “The tenure of the real estate portfolio ended in year 2015-16 and that business does not rest with our company any more. It would be optimal to look at our profits post removing these non-recurring fees,” says HDFC AMC’s spokesperson.

While that is true, analysts are concerned over the drop in AMC’s market share in the equity segment to 12% in FY18 from 20% in FY13. That said, its AUM has a larger slice of equity-oriented schemes still at 51.3%, compared with the industry average of 43.2%, as of March 31, 2018. 

Ambit Capital’s Mehta points out that HDFC AMC’s steep market-share losses in equity-oriented schemes over the past five years have coincided with under-performance of its schemes. 

However, HDFC AMC’s spokesperson defends the drop in market share, claiming that it is normal to see market share drop when inflows in the industry surge substantially. “Mutual funds and especially equity-oriented funds have seen unprecedented flows in past four years. Also, there was an upsurge in new fund offers. We are of the opinion that new fund offers should be launched only when the product is distinct from our existing suite of products and have refrained from launching new schemes frequently,” said the spokesperson. 

According to the data, compiled by Ambit Capital, schemes rated 3-star and plus by Value Research comprise only 45% of HDFC AMC’s total AUM. While rivals ICICI AMC, SBI AMC and Reliance AMC have 79%, 77% and 54% of AUM in equity rated 3-star and above. According to Morningstar, 66.7% of HDFC AMC’s schemes have underperformed the markets over the past three years. The Value Research Fund Rating of three or more stars is considered above average in terms of risk-adjusted return.

Says Dhirendra Kumar, CEO, Value Research, “Between 2002 and 2013, HDFC AMC was really good. They managed money well and also leveraged distribution effectively. Thus, they enjoyed a higher margin. But their underperformance since 2013 has been dragging down their profitability.” Annual return data from Value Research bears out the middling performance after 2013 (see: Downturn in performance). HDFC’s schemes had a golden period till 2006, consistently beating their peers and benchmarks with a wide margin. Their relative performance stood out even between 2006-08 when their absolute performance suffered because of the overall market condition. Since 2013, however, their rate of outperformance has slipped considerably. 

This slip has come on the back of certain contrarian calls, especially the bet on PSU banks, which failed to pay off. The markets have shunned PSU banks because of the mountain of non-performing assets and related write-offs that are dragging down their earnings. Since FY14, while the Nifty 50 gained 65%, the PSU banks’ index has gone down by 4.42%. Instead of downsizing these positions, the fund manager has continued to keep faith in their turnaround, perpetuating the underperformance. The two funds had 11% and 14% of its net assets invested in PSU banks as of March 31, 2018. 

Himanshu Srivastava, senior fund analyst at Morningstar, however, believes that this is a temporary blip as HDFC Mutual Funds have been able to beat the benchmark indices consistently in the past. In his note, Srivastava states that the fund’s chief investment officer Prashant Jain is a firm believer that the market is driven by cycles. “He was extremely aware that the stressed accounts would keep NPA levels rising for a few years. That did not deter him because he sees the banking sector as the catalyst for the country’s economy and believes that the growth of the overall economy is intrinsically correlated to the health of the banking industry,” says Srivastava.

Value Research’s Kumar also believes that once the economy picks up pace, the PSU bank stocks will bounce back helping HDFC AMC’s funds to clock better returns. “They will be able to turn around, it’s just that some cycles are longer,” he says.

But then, the fund’s woes are not confined to its key sectoral bets going awry — it’s also structural, feels Kumar. “All HDFC Funds did well in the past and were able beat the benchmark indices when they were smaller. But as funds grew in size, it became more challenging to maintain performance,” he says. As AUM goes up, the efficiency of the fund has to be that much more higher to deliver better returns from the schemes. 

Growth Traps

Big assets is a problem not just because it makes a manager less nimble. The regulatory cap on expenses for large funds will now radically alter the profitability profile of large asset managers including HDFC AMC.

Consequent to the new Sebi norms, foreign brokerage firm Morgan Stanley has reduced HDFC AMC’s equity gross revenue assumption by 20 basis points and cut the target price to Rs.1,765 from Rs.2,050 per share. “We assume six bps to be the overall savings in distribution costs, as some hit will likely be passed on to distributors. This will be one of the key variables in determining upside or downside to our earnings forecasts,” says Subramanian Iyer, equity research analyst, Morgan Stanley, in his report dated September 18.

All this means is that HDFC AMC’s June quarter results with a net profit growth of 25% y-o-y to Rs.2.05 billion that lifted the spirits of investors may not repeat in the near future. Even so, two things will have to fall in place for the company to get onto the fast lane it was on some years ago — turnaround in the performance of its schemes, followed by sustained inflows into its equity-schemes. But then, regulatory downers including the cut in expense ratio, stringent rules for incentivising geographical penetration, re-categorisation of schemes, implementation of capital gains on equity and balanced funds are headwinds that could dent the profitability of the entire industry. 

On the brighter side, the mutual fund industry is growing at a healthy pace. Crisil predicts that the industry’s AUM will grow by 19% annually over the next five years — rising from Rs.20.6 trillion (excluding gold ETFs and Fund of Funds) as of March 2018 to Rs.48.4 trillion by March 2023. Systematic Investment Plan (SIP) has gained significantly with monthly flows increasing to Rs.71.2 billion as of March 2018 from Rs.31.2 billion in April 2016, and the trend will only continue. 

“There is no doubt that SIP flows are now a sizeable chunk of the total monthly flows. An SIP investor benefits from market drops and gets to participate on both sides. This thought is slowly seeping in. While tactical flows will keep seeking attractive market levels, flows have been very strong after the start of financialisation of assets,” says Navin Chandani, chief business development officer, BankBazaar. 

Added to that, the case for active fund management in India remains stronger given that the markets still offer great mispricing opportunities to be exploited. 

Given HDFC AMCs stronghold in the mutual fund business, and the secular trend of growing mutual fund investments, the moot question is about the right entry point to invest in the stock. At its current price of Rs.1,396, HDFC AMC trades at 39x trailing-twelve-month earnings and 33x FY19 estimated earnings. That’s certainly not cheap, but not expensive either compared with businesses that offer similar earnings and growth potential. 

Yet Ambit Capital’s Mehta remains cautious. He warns that such high multiples on an absolute basis, will only be justified by prospects of earnings growth, stronger than the 15% HDFC AMC has delivered in the past five years.

He asserts that materialisation of such hopes will depend on a combination of factors such as equity market inflows sustaining; sharp reversal of market share losses led by turnaround in scheme performance; and steep improvement in profitability by lowering of distribution costs and reduction in cash on the balance sheet. 

Considering that the new Sebi ruling only alters the earnings profile of the company, a dip below the IPO price will be in order before one can start reconsidering the stock.