Federal Bank: Buy

Fresh investments with a long-term horizon (more than three years) can be considered in the stock of Federal Bank. The current valuation of the bank seems attractive, as the bank has low cost-to-income ratio (38 per cent for the June quarter), high core capital contribution (low leverage), superior net interest margin (NIM) and pricing power to maintain its NIM. These metrics are on a par with other new-age private banks.

At its current price of Rs 360, the Federal Bank stock discounts its estimated FY-13 adjusted book value by 1.01 times. The estimated price-earnings multiple for FY-13 is 7.

This positions the bank at a steep discount to new private banks such as Yes Bank and IndusInd Bank, which trade above two times the book value.

The bank, however, falters on account of low return ratio (11.5 per cent in FY-11), due to higher asset quality slippages.

Higher provisioning for this, while impacting profitability, has ensured that the bank's net non-performing assets (NPA) remain under-check.

Diversified business

The bank, in the last fiscal, embarked on a restructuring exercise, including appointment of the new management, which should yield benefits. New management plans to further focus on the bank's strengths, that is, SME and NRI businesses, and improve risk management systems.

Return on equity may improve as credit costs moderate over the next two-to-three years and fee income contribution improves. Despite having only 40 per cent branches outside Kerala , the Federal Bank's share in advances outside Kerala to the total advances stood at 61 per cent. The bank plans to add another 250 branches by December 2012 to take its branch network to 1,000.

Federal Bank is the fifth largest private sector bank with loan book size of Rs 31,971 crore.

The business is well diversified with large corporates accounting for 42.3 per cent of the total advances followed by SME (29 per cent share) and retail (28.6 per cent).

Retail finance segment is mostly secured in nature, with housing, gold loans and loan against deposits/securities accounting for majority of the book. Federal Bank plans to focus on the SME segment not only on the asset side but also to tap current account deposits. CRISIL has estimated that the SME lending opportunity in the country is Rs 50,000 crore over and above the current lending.

Federal Bank, apart from lending through its book, also operates through its subsidiary, Fedbank Financial Services. This non-banking finance company (NBFC), in addition to disbursing gold loans, also distributes Federal Bank's retail products. Given that the NBFCs have no restriction on the expansion of the branch network, this move will help bring in more business for Federal bank.

Federal Bank is in unique position of being a market leader in handling NRI businesses in Kerala. As of June 2011, low-cost NRI deposits account for close to 7 per cent of the total deposits. The bank wants to tap SME and NRI customers for fee income opportunities as well. Core fee income at 11.5 per cent of total revenues is low and offers scope for improvement.

Healthy Margins

The NIM of Federal Bank for the quarter ended June 2011 was at 3.87 per cent. Thanks to high levels of capital adequacy and competitive low-cost resource base, the bank managed to maintain margins at healthy levels.

However, the NIM was lower than in the March 2011 quarter (4.22 per cent) given that the hikes in the bank's base rate in the recent quarter came with a lag. The bank has also expanded large-corporate loan book where the margins are lower. The current account-savings account and low-cost NRI deposits collectively account for 32.5 per cent of the total deposits.

While the share of current account deposits is low, the abovementioned SME initiative may improve current account deposit proportion.

Margins can be maintained at the current levels, as more than 90 per cent of the loans are floating rate in nature. Additionally, according to the management, most of the retail loans are now seasoned, which means asset quality slippages are not a significant threat in this segment.

Asset quality concerns

Strong NIMs, coupled with low operating expenses, have led to higher pre-provision profits; however, the credit quality slippages have resulted in higher provisioning.

The new management stares at an uphill task of reducing non-performing asset (NPA) proportion. The gross NPA ratio stood at 3.94 per cent, while the net NPA is 0.74 per cent. The restructured assets proportion is also high at 3 per cent of total advances.

While the management has the internal target of reducing the absolute NPAs by 5 per cent every quarter, disruption in banking operations due to constant strikes last quarter derailed the process.

NPAs may also rise for the banking system due to a combination of moderating GDP growth and rising lending rates. Therefore, while near-term concerns may continue to weigh on asset quality, management initiatives over the long term should result in improvement in the situation.

The bank also plans to plug slippages right from the pre-sanctioning stage by having centralised risk management system. This would improve transparency in appraising loans.

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