Federal Bank BUY the Change; maintain ‘BUY says Edelweiss,

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Federal Bank (FB IN, INR 438, Buy)

We recently met the management of Federal Bank (FB) to get insights into the bank’s strategy and growth plans. Mr. Shyam Srinivasan (ex-Stan C) has been inducted as the MD & CEO of the bank taking over from Mr. Venugopalan. The bank is currently undergoing a restructuring exercise on Boston Consultancy Group’s (BCG) advice. We believe post restructuring, under the dynamic leadership, FB is geared to step up the growth momentum and improve RoE—the only missing link in an otherwise attractive franchise (characterised by best-in-class RoA and productivity metrics).

n  Laying foundation for growth

Currently, FB has undertaken a restructuring exercise to transform itself from an old generation to a new generation private sector bank. Over the next six-nine months, before embarking on the high growth path, management focus will be on developing/standardizing processes (both operational and HR), addressing asset quality and employee motivation issues. The essence of the entire restructuring exercise is to increase product focus, improve credit standards, and instill a performance-driven work culture. Key initiatives in this direction include:

a)    To inculcate specialization and capitalize on synergies, six new verticals have been created under two groups, each headed by an ED.

b)    Set up centralized underwriting hubs (facilitating better control over underwriting) and decentralized delivery mechanisms (to improve turnaround time).

c)    FB has intensified recovery efforts by employing independent recovery agencies; further regional hubs have been created to control NPLs in retail and SME segments effectively.

n  Outlook and valuations: BUY the Change; maintain ‘BUY’

FB enjoys an attractive franchise characterized by high return ratios and employee/branch productivity compared to regional peers. The bank is currently undertaking restructuring exercise putting people and processes in place to further enhance productivity and achieve growth while maintaining high credit standards. Near term trigger for the stock will be decline in slippages and consequent reduction in credit cost which act as a buffer for the bank to undertake the restructuring exercise without disturbing higher RoAs. With credit growth at 24% and margins at 3.5% (calculated) over FY10-12E, we expect earnings CAGR of 31%, with RoE improving to ~15% by FY12E from 10.3% currently. Despite the outperformance of 1.4% (over bankex) in the past three months, the stock is trading at attractive valuations of 1.3x FY12E book (discount to peers) and 9.4x earnings. We believe as benefits of restructuring gather pace over the next 9-12 months, the stock will re-rate to 1.7/1.8x book. We maintain ‘BUY’ recommendation and rate it ‘Sector Outperformer’ on relative return basis.