Federal Bank - BUY

Fresh investments with more than a two-year horizon can be considered in the stock of Federal Bank. The fourth largest in the private sector in terms of branch network, the bank trades at an attractive valuation.

At the current price of Rs 451, the stock trades at 1.1 times its estimated FY14 adjusted book value.

This is at a discount to new private banking peers as well of some of the old private banks. The price-earnings multiple works out to an undemanding 7.2 times (FY14 earnings) for a bank which grew its per share earnings at 20.5 per cent annually over the last five years.

Given the bank’s superior capital adequacy ratio, its earnings in the coming years should benefit from improving leverage and fee income growth (contribution from fee income is currently low). The management has guided improvement in return on equity from the current levels of 15 per cent to 19-20 per cent by 2015.

Federal Bank has some key positives. Its tier-1 ratio at 15.8 per cent is among the best in the industry.

The bank’s return on assets during the recent quarters is improving on the back of lower provisioning. Its non-performing asset (NPA) ratio is also declining on the back of improved risk management practices.

In spite of aggressive branch expansion, Federal Bank’s cost-to-income ratio remains below 40 per cent, indicating its operating efficiency. The branch expansion is predominantly outside its home State of Kerala. Branches in Kerala now account for 55 per cent of the branches as compared to 60 per cent a year ago.

Agriculture and SME loans

The bank is widening its geographic spread. It is increasing focus on States such as Tamil Nadu, Maharashtra, Karnataka, Gujarat and Punjab. In these regions, it is tapping small and medium enterprises, NRIs and agriculture borrowers.

At the same time, the bank’s loan book is well diversified. SME and agriculture advances now account for 29 per cent of the bank’s loan book; retail accounts for 27 per cent and corporates 44 per cent.

The share of loan against gold portfolio is rising rapidly and accounts for one-tenth of the loan portfolio as of March 2012. Gold financing is expected to incrementally drive credit growth. According to the bank’s management, the gold loan business is expected to rise from Rs 3,600 crore as on March 2012 to Rs 6,000 crore by March 2013.

Federal Bank may benefit from stricter regulation on gold-financing NBFCs. These include lower loan-to-value, higher capital adequacy requirement and lower funding from banks. This may shift business to banks such as Federal Bank, which plan to go aggressive on gold loans.

Better asset quality

Federal Bank, in line with most private banks, managed to lower its gross NPA ratio in FY-2012. That this ratio declined in spite of higher exposure to SME sector indicates improved risk management practices.

The gross NPA ratio of Federal Bank moderated to 3.35 per cent as of March 2012, from 3.49 per cent in March 2011. While the ratio still seems high, the bank’s high provision coverage at 81 per cent provides buffer. This has helped it reduce its net NPA ratio to 0.53 per cent from 0.6 per cent in March 2011.

The standard restructured assets currently account for 5.4 per cent of the bank’s loan book. However, majority of the restructured loans (around 70 per cent) pertains to government-linked accounts such as Air India and State electricity boards. These accounts may not completely default. This reduces the overall risk of the portfolio turning bad.

Margin pressure

Federal Bank’s net interest margins (NIMs) moderated to 3.79 per cent in March 2012 from 4.22 per cent a year ago. The March quarter was particularly bad, given the moderation in margins to 3.56 per cent.

This was due to rise in non-resident deposit costs and reversal of interest income on restructured loans. Increased share of large corporate accounts, which are lent at lower yields, also puts pressure on margins.

NIMs may rise from levels seen in March quarter due to decline in bulk deposit costs, additional liquidity due to cut in cash-reserve-ratio, and rising focus on loan against gold.

Yet, margins may not go back to the levels of 4 per cent till the SME funding environment, which is currently challenging, revives. Secondly, the NRI deposit rates which jumped sharply will continue to push cost of funds upwards. The low-cost deposit share is improving (27.4 per cent) but it still may not absorb the rise in non-resident deposit costs.

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