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UBS Investment Research
Key Call: Federal Bank
L aunching Key Call
FB has all the ingredients of new age private sector bank
Federal Bank (FB) is an old private sector bank with 746 branches with access to
unique NRI customer base. At 1.0x FY13E book and 7x FY13E earnings, FB is
one of the cheapest private sector banks in India with potential to re-rate to new
age private sector bank peers in our view (which trades at 1.6x-3.3x book).
New management team all set to transform the bank franchise
FB earns high NIMs of 3.9% (Q1) supported by low cost deposit base of ~33% and
SME loan book. However it had been struggling with high NPL additions and
slower growth in past, which would change with new management team on board
in our view. We expect the new management team to significantly enhance the
bank franchise in coming years by improving risk management systems, adding fee
products and inculcating a performance based incentive culture among staff.
Expect improvement in franchise to drive re-rating
We expect LLP to decline (despite industry pressures) to 1.2% in FY13 from 1.8%
in FY11 and fee growth of 36% CAGR over FY11-13, supporting ROE expansion
to 16% by FY13E from 12% currently. We expect earnings to grow at 27% CAGR
on falling NPL provisions and improving revenue profile. The stock trades at 50-
60% discount to private sector banks which we believe would narrow in coming
years. We believe FB could be potential M&A play given RBI plan to award new
bank licences.
Valuation: Buy (UBS Key Call) rating with a price target of Rs550
We derive our price target of Rs550 based on a residual income model. Our price
target implies 1.5x FY13E P/BV and 10x FY13E earnings.
Investment Thesis
We launch Federal Bank as a Key Call with a Buy rating and price target of
Rs550. The bank is the largest old private sector bank with 746 branches (60%
based out of Kerala) and a balance sheet of Rs527bn with market cap of
US$1.4bn. We believe Federal Bank is at the brink of a turnaround in its
operations catalyzed by a change in leadership and a structural improvement in
asset quality. We expect new CEO focus on improving the contribution of fee
based income (which is one of the lowest in the industry) to offset the cyclical
decline in NIMs while pickup in asset growth and decline in credit costs will
support earnings growth of 27% over FY11-13E, which is one of the highest in
the industry.
Asset quality has been under pressure for the bank due to cyclical downturn
accentuated by weak risk management practices. Growth too became sluggish
due to increasing NPA burden and lack of focus as leadership changed hands.
Change in CEO is an inflection point for the bank in our view as we believe
management’s focus on risk management and recoveries will lead to significant
reduction in NPA and consequently credit costs over next 12 months. We expect
NPA to decline from 3.5% in March 2011 to 3.3% by March 2012 supported by
declining additions and improving recoveries.
In a recent road show FB management reiterated its stance of bringing down
Gross NPL below 3% by March 2012 and reducing NPL addition from 4% in
Q1 to less than 3% by Q2/3.
In our view catalysts for a re-rating are in place with 1) NPA set to decline from
Q2 onwards 2) growth set to accelerate 3) Fee income likely to improve. We
expect NIMs in line with rest of the sector would witness a decline from current
levels of 3.9% due to increasing proportion of higher rated corporate in the
portfolio and cost of funds increasing.
Aside from operational turnaround, Federal Bank remains our preferred play on
M&A theme in Indian Banks which we think could come into play with fresh
licenses being awarded in next 12-18 months.
Valuations at 1.0x FY13E book are at a significant 50-60% discount to private
sector peers. While direct comparison with new generation private banks may
not be appropriate, we also view such steep valuation discount as unreasonable.
In our view Federal Bank should trade between PSU and new generation private
bank valuations which forms the basis of our residual income based PB multiple
of 1.5x FY13E book.
Key catalysts
Improvement in asset quality from Q2FY12E – Q1FY12 NPLs were
marred by one-off incidences related to employee unrest and management
has since then take corrective action to improve the recovery effort. In our
view market is extrapolating current asset quality in future too; we expect
NPAs to improve with slowdown in NPA additions and improvement in
recoveries from Q2FY12 onwards.
Improvement in RoA – With declining credit costs, we expect ROA to
improve 1.4% in FY13 from 1.3% in FY11 despite building in decline of 40
bps in NIMs. We believe this will bring its return ratios in line with the best
in the industry and therefore prompt a re-rating.
Improvement in systemic liquidity – Banking segment has witnessed
severe liquidity crunch in Q4 which we think could see a reversal in H1FY12
with credit growth slowing and deposit growth picking up which would limit
increase in interest rates.
Potential M&A candidate – We believe new banking licences which could
be awarded in next 12-18 months could trigger M&A in the sector and FB
could be potential M&A play given it is a private sector bank at inexpensive
valuations.
Improving employee productivity – With change in leadership and various
HR initiatives initiated, employee productivity which is lower compared to
private peers is expected to improve in the medium term.
Risks
Key risk to our thesis is delay in execution by the new management due to non
co-operation of unionized employees. We believe friction between management
and employees has reduced over the years with open communication channels,
performance based incentives, technology implementation; however in our view
it still remains the biggest impediment for the bank to scale up in line with
private sector banks.
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%.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
Key Call: Federal Bank
L aunching Key Call
FB has all the ingredients of new age private sector bank
Federal Bank (FB) is an old private sector bank with 746 branches with access to
unique NRI customer base. At 1.0x FY13E book and 7x FY13E earnings, FB is
one of the cheapest private sector banks in India with potential to re-rate to new
age private sector bank peers in our view (which trades at 1.6x-3.3x book).
New management team all set to transform the bank franchise
FB earns high NIMs of 3.9% (Q1) supported by low cost deposit base of ~33% and
SME loan book. However it had been struggling with high NPL additions and
slower growth in past, which would change with new management team on board
in our view. We expect the new management team to significantly enhance the
bank franchise in coming years by improving risk management systems, adding fee
products and inculcating a performance based incentive culture among staff.
Expect improvement in franchise to drive re-rating
We expect LLP to decline (despite industry pressures) to 1.2% in FY13 from 1.8%
in FY11 and fee growth of 36% CAGR over FY11-13, supporting ROE expansion
to 16% by FY13E from 12% currently. We expect earnings to grow at 27% CAGR
on falling NPL provisions and improving revenue profile. The stock trades at 50-
60% discount to private sector banks which we believe would narrow in coming
years. We believe FB could be potential M&A play given RBI plan to award new
bank licences.
Valuation: Buy (UBS Key Call) rating with a price target of Rs550
We derive our price target of Rs550 based on a residual income model. Our price
target implies 1.5x FY13E P/BV and 10x FY13E earnings.
Investment Thesis
We launch Federal Bank as a Key Call with a Buy rating and price target of
Rs550. The bank is the largest old private sector bank with 746 branches (60%
based out of Kerala) and a balance sheet of Rs527bn with market cap of
US$1.4bn. We believe Federal Bank is at the brink of a turnaround in its
operations catalyzed by a change in leadership and a structural improvement in
asset quality. We expect new CEO focus on improving the contribution of fee
based income (which is one of the lowest in the industry) to offset the cyclical
decline in NIMs while pickup in asset growth and decline in credit costs will
support earnings growth of 27% over FY11-13E, which is one of the highest in
the industry.
Asset quality has been under pressure for the bank due to cyclical downturn
accentuated by weak risk management practices. Growth too became sluggish
due to increasing NPA burden and lack of focus as leadership changed hands.
Change in CEO is an inflection point for the bank in our view as we believe
management’s focus on risk management and recoveries will lead to significant
reduction in NPA and consequently credit costs over next 12 months. We expect
NPA to decline from 3.5% in March 2011 to 3.3% by March 2012 supported by
declining additions and improving recoveries.
In a recent road show FB management reiterated its stance of bringing down
Gross NPL below 3% by March 2012 and reducing NPL addition from 4% in
Q1 to less than 3% by Q2/3.
In our view catalysts for a re-rating are in place with 1) NPA set to decline from
Q2 onwards 2) growth set to accelerate 3) Fee income likely to improve. We
expect NIMs in line with rest of the sector would witness a decline from current
levels of 3.9% due to increasing proportion of higher rated corporate in the
portfolio and cost of funds increasing.
Aside from operational turnaround, Federal Bank remains our preferred play on
M&A theme in Indian Banks which we think could come into play with fresh
licenses being awarded in next 12-18 months.
Valuations at 1.0x FY13E book are at a significant 50-60% discount to private
sector peers. While direct comparison with new generation private banks may
not be appropriate, we also view such steep valuation discount as unreasonable.
In our view Federal Bank should trade between PSU and new generation private
bank valuations which forms the basis of our residual income based PB multiple
of 1.5x FY13E book.
Key catalysts
Improvement in asset quality from Q2FY12E – Q1FY12 NPLs were
marred by one-off incidences related to employee unrest and management
has since then take corrective action to improve the recovery effort. In our
view market is extrapolating current asset quality in future too; we expect
NPAs to improve with slowdown in NPA additions and improvement in
recoveries from Q2FY12 onwards.
Improvement in RoA – With declining credit costs, we expect ROA to
improve 1.4% in FY13 from 1.3% in FY11 despite building in decline of 40
bps in NIMs. We believe this will bring its return ratios in line with the best
in the industry and therefore prompt a re-rating.
Improvement in systemic liquidity – Banking segment has witnessed
severe liquidity crunch in Q4 which we think could see a reversal in H1FY12
with credit growth slowing and deposit growth picking up which would limit
increase in interest rates.
Potential M&A candidate – We believe new banking licences which could
be awarded in next 12-18 months could trigger M&A in the sector and FB
could be potential M&A play given it is a private sector bank at inexpensive
valuations.
Improving employee productivity – With change in leadership and various
HR initiatives initiated, employee productivity which is lower compared to
private peers is expected to improve in the medium term.
Risks
Key risk to our thesis is delay in execution by the new management due to non
co-operation of unionized employees. We believe friction between management
and employees has reduced over the years with open communication channels,
performance based incentives, technology implementation; however in our view
it still remains the biggest impediment for the bank to scale up in line with
private sector banks.
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%.
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