| Summary of Contents STOCK IDEAS Federal Bank
Cluster: Ugly Duckling
Recommendation: Buy
Price target: Rs344
Current market price: Rs258
A re-rating candidate Key points - A strong southern play: Federal Bank (FED), the fourth largest private sector bank in India in terms of asset size, has traditionally been a strong player in the southern region especially Kerala. However, it has taken initiatives to expand its geographic footprint by increasingly opening new branches outside Kerala to achieve a pan-India presence. It is well placed to capitalise on the revival in credit growth with a comfortable level of capital adequacy (18.5%) and a low-cost deposit base (CASA + NRI deposits form 47% of its total deposit base).
- Return to optimal leverage to drive return ratios: FED?s return on equity (RoE) has dipped since the rights offering in 2008 from about 20% to around 12% currently. However, the return on assets (RoA) has continuously improved and stood at 1.4% in FY2009 (vs 1.06% in FY2006). The divergence in the RoE and RoA is primarily due to the lower leverage ratio of the bank vs that of its peers. With its business growth likely to gain traction on the back of the economic recovery, the bank should be able to optimally leverage its equity base and hence improve its RoE.
- Asset quality concerns valid but manageable: Owing to a higher exposure to the retail and small and medium enterprise (SME) segments, FED has experienced stress on its loan book with its gross non performing assets (GNPAs) now at 2.97% (in line with the peer average of 2.87%). Though the concerns related to its asset quality are valid, we believe the situation is manageable considering (1) the bank?s credit assessment and monitoring mechanisms are being revamped; (2) its recovery mechanism is in the process of getting restructured; (3) the retail segment (the primary source of slippages) is witnessing a revival; and (4) its provisioning coverage is high at +90% (including technical write-offs). During Q3FY2010 the bank reported a stable GNPA on a sequential basis.
- Possibility of CSB merger has ebbed: The possibility of a merger with Catholic Syrian Bank (CSB) has diminished substantially due to strong reservations from Archdiocese of Thrissur (a major stakeholder). This, we believe, is a positive as FED is superior to CSB in most aspects and the merger would only have strained the profitability of FED.
- Value pick at a discount: In light of the sustained recovery in the Indian economy and the conducive environment for the banking sector ahead, we believe that FED would be a key beneficiary of the economic upcycle. The key areas that are expected to see an improvement are: (1) the return on equity (RoE) as the bank optimally leverages its equity to fund its balance sheet growth; and (2) the asset quality due to the easing cyclical asset-quality pressures. Given its relatively better operational parameters and the expected improvement in its RoE, we strongly believe that sub par one- year forward estimated book value and below the peer average valuation of the bank are unjustified. Currently, FED trades at 0.9x FY2011E adjusted book value (ABV) per share. Considering the bank's potential to grow above the industry average, we value the bank at 1.1x FY2012E ABV per share. We initiate coverage on the stock with a Buy recommendation and price target of Rs344.
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