FEDERAL BANK -High margins coupled with low slippages:: Edelweiss

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Federal Bank (FB) reported NII of INR 4.3 bn (up 33% Y-o-Y, 6.1% Q-o-Q) ahead of
our estimate (INR 4.16 bn) aided by a strong 27bps expansion in NIMs compensating
for moderate loan book growth (2% Q-o-Q). NIMs stood at 4.44%, comparing
favourably with the best in class. Other income (ex-treasury) recorded a robust
growth of 21% Y-o-Y, 39% Q-o-Q led by strong recoveries. PAT came in at INR 1.4
bn, in line with our estimate, as higher credit costs (211bps) counter balanced high
NII/fees income. Slippages during the quarter came down to INR 2.6 bn (3.79%
annualized) from INR 3.3 bn in Q1FY11 (against 5% runrate over past five quarters).
Headline asset quality improved with gross NPLs rising only 5% Q-o-Q to 3.84%,
while net NPLs declined 7% Q-o-Q to 0.68%. Provision coverage improved 220bps
sequentially to 83%. Management made adequate provisions for second pension
option (INR 160 mn) and gratuity during the quarter. CASA growth at 6.8% Q-o-Q
continued to impress.
􀂃 NIMs improve 27bps Q-o-Q to 4.4%
Led by 40bps improvement in yield on advances offsetting 6bps increase in cost
of funds and 107bps decline in CD ratio (77%), the bank’s NIMs improved 27bps
sequentially to 4.44%, in the top league. Strong improvement in NIMs helped FB
record robust NII of INR 4.3 bn (up 33% Y-o-Y, 6.1% Q-o-Q) against our
estimate (INR 4.16 bn), despite a moderate growth in loan book (2% Q-o-Q).
Management expects NIMs to come off slightly over the next two quarters due to
increase in deposit rates. We are building in 3.8% NIM (cal) over FY11-12.
􀂃 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 18% (over bankex) in the past three
months, the stock is trading at attractive valuations of 1.4x FY12E book
(discount to peers) and 10.1x 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.