Buy Federal Bank - Edelweiss

After a subdued FY12 where banks were beaten down for multiple reasons like high interest rates and inflation, going forward earnings trajectory is expected to pick up over the next two years for following reasons. (1)Utilisation of excess capacity and pent up demand will boost corporate capex, reviving credit demand in FY11; (2) multiple levers for margins improvement: continued re-pricing of high cost liabilities, improving CD ratio and, stable bond spreads; (3) improvement in asset quality. We expect banks core earnings (ex-treasury) to increase by 15 - 20% over FY12-14.

Federal Bank is one of the best regional-based private banks in the country. We like the bank for its strong regional presence, good technology network, possible M&A play, robust loan growth and best in class margins. SME and retail loans, which constitute a bulk of the bank's loan book, are likely to continue to lead its growth in future. The loan book is expected to grow at 18-20% (CAGR) over the next two years through network expansion and increased penetration.

FEDBAN is adequately capitalised with tier-1 capital at 15%, it has one of the highest capital adequacy ratios of 15.8%, as of Q2FY12 in the sector that can be deployed to ramp up business as the economic scenario improves.

FEDBAN generates best in class net interest margins of ~3.6% on the back of its structurally strong deposit franchise. .Around 28.7% of its deposits comprise low-cost current account and savings account (CASA) deposits, (where the bank pays ~4 to 6%), which collectively enable the bank to contain its deposit costs. Going forward, after NRE deposits hike.

Federal Bank enjoys an attractive franchise, characterized by high return ratios and employee/branch productivity against regional peers. It is currently undergoing a restructuring, putting people and processes in place to further enhance productivity and growth while maintaining high credit standards. After touching a peak of 1.5x, the stock has significantly corrected and is currently trading at 1.2x FY14E ABV. We believe, as benefits of restructuring flow in, it has the potential to deliver stronger returns and trade closer to 1.6-1.8x book.

Investment Risks:

Asset quality: In this current scenario, there is a greater risk of NPA accretion for FEDBAN than its peers. System wide economic slowdown will lead to a sharp deterioration in asset quality and lower than anticipated recoveries.

The bank's high dependence on the NRI segment (20% of its deposits come from the segment) exposes it to regulatory risks.

Outlook and Valuations:

FEDBAN is moving in the right direction addressing two key concerns – profitable growth and asset quality. On our FY13E and FY14E EPS estimate of Rs. 52.8 and Rs. 65.2, the stock is currently trading at a P/E of 9.0x and P/ABV of 1.3x on FY13E basis and at a P/E of 7.3x and P/ABV of 1.2x on FY14E basis. Given these attractive valuations and its growth prospects, we believe the stock offers upside potential in the near term.

Source : Equity Bulls

Keywords