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UBS Investment Research
Federal Bank
At the inflection point
Expect turnaround under new management
Federal Bank (FB) has struggled with high non-performing asset (NPA) additions
and slow balance sheet growth over the past 18 months. However, we believe this
will change under its new management. We think FB has the potential to trade
between public and private bank levels following the implementation of new
strategies. We expect significant improvement in risk management systems and fee
income products to drive accelerated growth in FY12-13.
Strong, well-capitalised franchise, with a 15% Tier I capital ratio
FB has one of the sector’s highest NIMs (4.3% in Q3 FY11), supported by a lowcost
deposit base of 35% and a strong SME loan book. We think FB’s high credit
cost of 1.9% is offsetting its high margin and low cost-to-income ratio of 36%, and
expect ROA to reach 1.27% in FY11. However, we forecast ROA and ROE to
expand from 1.27% and 12%, respectively, in FY11E to 1.45% and 16% in FY13,
driven by lower loan loss provisions (LLP) and strong fee income growth.
Earnings growth and improvement in franchise could surprise
We expect earnings growth above consensus expectations as changes under new
management take hold. We forecast an FY11-13 earnings CAGR of 31% due to
lower LLP and an improving revenue profile. Our FY12 earnings estimates are 7%
above consensus.
Valuation: see significant room for multiple expansion
At 1.2x FY12E book and 9x FY12E PE, FB is one of the least expensive private
sector banks in India. We initiate coverage with a Buy rating and price target of
Rs600 (1.8x FY12E book). We value the bank using a residual income model,
which is the sum of BVPS for FY12E plus the present value of income generated
over and above the cost of equity. We assume a discount rate of 14.1%
Investment thesis
We initiate coverage on Federal Bank, a mid-sized private sector bank, with a
Buy rating and price target of Rs600. The bank is the largest of India’s older
generation of private sector banks in terms of assets, with 737 branches (60% in
Kerala) and a balance sheet of Rs428bn. We believe FB is on the verge of a
turnaround in its operations catalysed by a change in leadership and a cyclical
improvement in asset quality. We expect credit growth, which has been
subdued, to revive: we forecast 15% growth in FY11 and 25% in FY12. The
new CEO is focusing on improving the contribution of fee-based income (one of
the lowest in the industry), which we expect to offset the cyclical decline in
NIMs. We believe pick up in asset growth and a decline in credit costs will
support earnings growth of 31% over FY11-13E, one of our highest forecast
growth rates for the industry.
Asset quality has been under pressure at FB due to a cyclical downturn
accentuated by weak risk management practices. Growth has also been sluggish
due to an increasing NPA burden and lack of focus as leadership changed hands.
We view the change in CEO as an inflection point for the bank as we believe
management’s focus is now on risk management, and expect recoveries to lead
to significant reduction in NPA and consequently credit costs, over the next 12
months. We expect NPA to decline from 3.9% in December 2010 to less than
3% by end-FY12, supported by declining additions and improving recoveries.
We believe catalysts for a re-rating are in place as we expect: 1) NPA to decline;
2) credit growth to accelerate; and 3) fee income to improve. As in the rest of
the sector, we expect the bank’s NIM to decline from the current level of 4.3%
due to the increasing proportion of higher rated corporate loans in the portfolio
and the rising cost of funds.
At 1.2x FY12E book, valuations are at a significant 50-60% discount to private
sector peers. While direct comparisons with new generation private banks might
not be appropriate, we also view such a steep valuation discount as
unreasonable. We believe Federal Bank’s fair valuation lies between public
sector (PSU) banks and new generation private bank valuations, which forms the
basis of our target residual income-based P/BV multiple of 1.8x FY12E book.
Risks to our thesis are: 1) a marked slowdown in the Indian economy, which
would impact FB’s asset quality; FB has a high exposure to the SME sector (31%
of total loans), which is typically more vulnerable in a downturn; and 2) employee
unions, which have historically been a bottleneck in implementing change; any
inability of current management to convince employees to agree to changes would
be an impediment to medium-term improvement of the franchise, in our view.
Key catalysts
Improvement in asset quality: We think investors are extrapolating future
asset quality from current asset quality. However, we expect NPA levels to
improve with a slowdown in NPA additions and improvement in recoveries.
We estimate 33% growth in core operating profit (PBT less Treasury gains)
over FY11-13, which should drive a re-rating, in our view.
Expect loan book to grow 25%: FB is gradually accelerating loan growth
and is likely to expand its SME and large corporate book, according to
management. We expect an FY11-13 loan book CAGR of 25%. While we
think loan growth is likely to be below the industry average (at 15%) in
FY11, we expect above industry growth of 25% in FY12.
Improvement in ROA: With declining credit costs, we expect ROA to
improve to 1.4% in FY12 from 1.3% in FY11E, despite building in a decline
of 30bp in NIM. We believe this will make FB’s return ratios among the best
in the industry.
Improvement in systemic liquidity: The banking segment has witnessed a
severe liquidity crunch in Q4 FY11, which we think could reverse in H1
FY12. Slowing credit growth and the pick up in deposit growth should limit
increase in interest rates, in our view.
Fall in government yields could support bottom line: Federal Bank has an
investment portfolio of Rs950bn, of which 25% is in the available for sale
securities (AFS) category, with duration of nearly 1.7. A decline in bond
yields could lead to Treasury gains, which could provide upside potential to
our estimates.
Improving employee productivity: Employee productivity is low compared
to private peers. However, we expect this to improve with the change in
leadership and various HR initiatives.
Risks
The key risk to our thesis is a delay in execution by the new management due to
non-cooperation of unionised employees. We believe friction between
management and employees has declined over the years with improved
communication channels, the introduction of performance-based incentives, and
technology implementation. However, we think it remains the biggest
impediment to the bank scaling up in line with other private sector banks. We
believe delay in asset quality improvement could be a risk to earnings recovery
as we expect NPA to recover from the current 3.9% to below 3% by end-FY12.
A sustained tight liquidity environment and interest rate hikes could negatively
impact credit growth and margins, while a sustained economic slowdown could
increase NPA risk due to the bank’s high SME exposure.
Valuation and basis for our price target
We value the bank using a residual income model, which is the sum of BVPS
for FY12E plus the present value of income generated over and above the cost
of equity. Our key assumptions are: a discount rate of 14.1% (a risk-free rate of
8%, beta of 1.2 and a risk premium of 5%); terminal ROE of 14.1%; and a
terminal year growth rate of 5%.
Federal Bank
Federal Bank, established in 1931, is the largest old private sector bank in India
in terms of assets. It was listed on the National Stock Exchange in 1998. At end-
2010, it had a total asset base of Rs462bn and 737 branches in 24 states
(approximately 60% in Kerala). It had a deposit base of Rs369bn and a loan
book of Rs282bn. Non-resident Indians (NRIs) contributed 26% of retail
deposits and the bank's CASA ratio stood at 29%. Federal Bank also holds 26%
equity in a JV life insurance company with IDBI Bank and Fortis Insurance
International. FIIs held a 38% stake in the bank as at December 2010.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
Federal Bank
At the inflection point
Expect turnaround under new management
Federal Bank (FB) has struggled with high non-performing asset (NPA) additions
and slow balance sheet growth over the past 18 months. However, we believe this
will change under its new management. We think FB has the potential to trade
between public and private bank levels following the implementation of new
strategies. We expect significant improvement in risk management systems and fee
income products to drive accelerated growth in FY12-13.
Strong, well-capitalised franchise, with a 15% Tier I capital ratio
FB has one of the sector’s highest NIMs (4.3% in Q3 FY11), supported by a lowcost
deposit base of 35% and a strong SME loan book. We think FB’s high credit
cost of 1.9% is offsetting its high margin and low cost-to-income ratio of 36%, and
expect ROA to reach 1.27% in FY11. However, we forecast ROA and ROE to
expand from 1.27% and 12%, respectively, in FY11E to 1.45% and 16% in FY13,
driven by lower loan loss provisions (LLP) and strong fee income growth.
Earnings growth and improvement in franchise could surprise
We expect earnings growth above consensus expectations as changes under new
management take hold. We forecast an FY11-13 earnings CAGR of 31% due to
lower LLP and an improving revenue profile. Our FY12 earnings estimates are 7%
above consensus.
Valuation: see significant room for multiple expansion
At 1.2x FY12E book and 9x FY12E PE, FB is one of the least expensive private
sector banks in India. We initiate coverage with a Buy rating and price target of
Rs600 (1.8x FY12E book). We value the bank using a residual income model,
which is the sum of BVPS for FY12E plus the present value of income generated
over and above the cost of equity. We assume a discount rate of 14.1%
Investment thesis
We initiate coverage on Federal Bank, a mid-sized private sector bank, with a
Buy rating and price target of Rs600. The bank is the largest of India’s older
generation of private sector banks in terms of assets, with 737 branches (60% in
Kerala) and a balance sheet of Rs428bn. We believe FB is on the verge of a
turnaround in its operations catalysed by a change in leadership and a cyclical
improvement in asset quality. We expect credit growth, which has been
subdued, to revive: we forecast 15% growth in FY11 and 25% in FY12. The
new CEO is focusing on improving the contribution of fee-based income (one of
the lowest in the industry), which we expect to offset the cyclical decline in
NIMs. We believe pick up in asset growth and a decline in credit costs will
support earnings growth of 31% over FY11-13E, one of our highest forecast
growth rates for the industry.
Asset quality has been under pressure at FB due to a cyclical downturn
accentuated by weak risk management practices. Growth has also been sluggish
due to an increasing NPA burden and lack of focus as leadership changed hands.
We view the change in CEO as an inflection point for the bank as we believe
management’s focus is now on risk management, and expect recoveries to lead
to significant reduction in NPA and consequently credit costs, over the next 12
months. We expect NPA to decline from 3.9% in December 2010 to less than
3% by end-FY12, supported by declining additions and improving recoveries.
We believe catalysts for a re-rating are in place as we expect: 1) NPA to decline;
2) credit growth to accelerate; and 3) fee income to improve. As in the rest of
the sector, we expect the bank’s NIM to decline from the current level of 4.3%
due to the increasing proportion of higher rated corporate loans in the portfolio
and the rising cost of funds.
At 1.2x FY12E book, valuations are at a significant 50-60% discount to private
sector peers. While direct comparisons with new generation private banks might
not be appropriate, we also view such a steep valuation discount as
unreasonable. We believe Federal Bank’s fair valuation lies between public
sector (PSU) banks and new generation private bank valuations, which forms the
basis of our target residual income-based P/BV multiple of 1.8x FY12E book.
Risks to our thesis are: 1) a marked slowdown in the Indian economy, which
would impact FB’s asset quality; FB has a high exposure to the SME sector (31%
of total loans), which is typically more vulnerable in a downturn; and 2) employee
unions, which have historically been a bottleneck in implementing change; any
inability of current management to convince employees to agree to changes would
be an impediment to medium-term improvement of the franchise, in our view.
Key catalysts
Improvement in asset quality: We think investors are extrapolating future
asset quality from current asset quality. However, we expect NPA levels to
improve with a slowdown in NPA additions and improvement in recoveries.
We estimate 33% growth in core operating profit (PBT less Treasury gains)
over FY11-13, which should drive a re-rating, in our view.
Expect loan book to grow 25%: FB is gradually accelerating loan growth
and is likely to expand its SME and large corporate book, according to
management. We expect an FY11-13 loan book CAGR of 25%. While we
think loan growth is likely to be below the industry average (at 15%) in
FY11, we expect above industry growth of 25% in FY12.
Improvement in ROA: With declining credit costs, we expect ROA to
improve to 1.4% in FY12 from 1.3% in FY11E, despite building in a decline
of 30bp in NIM. We believe this will make FB’s return ratios among the best
in the industry.
Improvement in systemic liquidity: The banking segment has witnessed a
severe liquidity crunch in Q4 FY11, which we think could reverse in H1
FY12. Slowing credit growth and the pick up in deposit growth should limit
increase in interest rates, in our view.
Fall in government yields could support bottom line: Federal Bank has an
investment portfolio of Rs950bn, of which 25% is in the available for sale
securities (AFS) category, with duration of nearly 1.7. A decline in bond
yields could lead to Treasury gains, which could provide upside potential to
our estimates.
Improving employee productivity: Employee productivity is low compared
to private peers. However, we expect this to improve with the change in
leadership and various HR initiatives.
Risks
The key risk to our thesis is a delay in execution by the new management due to
non-cooperation of unionised employees. We believe friction between
management and employees has declined over the years with improved
communication channels, the introduction of performance-based incentives, and
technology implementation. However, we think it remains the biggest
impediment to the bank scaling up in line with other private sector banks. We
believe delay in asset quality improvement could be a risk to earnings recovery
as we expect NPA to recover from the current 3.9% to below 3% by end-FY12.
A sustained tight liquidity environment and interest rate hikes could negatively
impact credit growth and margins, while a sustained economic slowdown could
increase NPA risk due to the bank’s high SME exposure.
Valuation and basis for our price target
We value the bank using a residual income model, which is the sum of BVPS
for FY12E plus the present value of income generated over and above the cost
of equity. Our key assumptions are: a discount rate of 14.1% (a risk-free rate of
8%, beta of 1.2 and a risk premium of 5%); terminal ROE of 14.1%; and a
terminal year growth rate of 5%.
Federal Bank
Federal Bank, established in 1931, is the largest old private sector bank in India
in terms of assets. It was listed on the National Stock Exchange in 1998. At end-
2010, it had a total asset base of Rs462bn and 737 branches in 24 states
(approximately 60% in Kerala). It had a deposit base of Rs369bn and a loan
book of Rs282bn. Non-resident Indians (NRIs) contributed 26% of retail
deposits and the bank's CASA ratio stood at 29%. Federal Bank also holds 26%
equity in a JV life insurance company with IDBI Bank and Fortis Insurance
International. FIIs held a 38% stake in the bank as at December 2010.
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