HDFC Bank’s first-half 2014 earnings were up 29% on the prior comparable period, with pretax, pre-provision earnings up 27%. These results exceeded expectations, with growth in provisions and operating expenses (up 4% and 17%, respectively) significantly trailing the 22% growth in net revenues. However, this divergence between income and cost growth is not unusual given that loan loss provisions typically lag loan origination by around two years.

Two key metrics in our DCF model–provisions and operating expenses–have come in much lower than our full-year estimates: 0.7% instead of 1%, and 47.2% instead of 50%, respectively. We will be making upward revisions to both our near-term forecast and, most likely, our fair value estimate of INR 658. With an expectation of enhanced scale benefits going forward, HDFC Bank remains our top pick within the Indian banking sector. That said, we continue to keep a watching brief on loan arrears, which will rebound if the Indian economy continues to slow.

During the six months ending September 2013, net revenue growth was 22%, and comprised 21% growth in interest revenue (70% of revenue), and 26% growth in non-interest, or fee-based revenue (30% of revenue). Provisions and loan losses increased just 4%, well below the corresponding 16% loan growth.

This is likely to be part cyclical and/or a timing issue associated with loan seasoning, but could also reflect good loan writing discipline, with loan losses (as a percentage of average net loans) falling 100 basis points, to 0.7%, despite slowing GDP growth. Operating expenses (as a percentage of net revenue) also fell by 2.2% to 47.2%. This is due to operational leverage from increased scale, despite branch count having increased by 24% over the past year, to 3,251.

Overall, the bank has outperformed our estimates, with lower loan losses and better-than-expected cost performance. We will be revising our near-term forecasts shortly.