Structural concerns discounted
We have been toning down our expectation on Federal Bank (FB)’s
operating performance even as there has been a tangible
improvement in the bank’s asset quality, particularly for retail and
SME books. Our analysis of FB’s geographical concentration and its
impact on FB’s liability franchise, fee income generation and cost
efficiency show that any improvement from hereon would be gradual,
and the process could test the management’s and investors’ patience.
However, in the last three months, the stock has underperformed the
Bankex by 11% and current valuation of 0.63x FY14 BV seems to
discount these long-term structural concerns. Our target price of `312,
valuing FB at 0.75x FY14 BV, implies 21% upside.
Competitive position: WEAK Changes to this position: NEGATIVE
Deep-rooted inertia: As discussed earlier (page 13-15), geographical
diversification is the key to a bank’s liability franchise, as it leads to low cost of
funds, better income generation and cost efficiencies. FB’s management has
been focused on addressing asset quality issues but the need to evolve into a
more geographically diversified franchise has been neglected. For a bank of
FB’s size, its concentration in a small state (Kerala) has led to weak operating
performance - a low CA ratio (stuck at around 5% for the last 11 years), and a
meagre fee income to assets ratio of 0.6%. Weak income generation has led
to deterioration in cost ratios (cost to income of 35% in FY09 vs 45% in FY13).
The recent exit of a non-executive director suggests a degree of
disenchantment in the Boardroom with the bank’s progress
(http://goo.gl/NC7455). We believe further signs of discontent in the
Boardroom of FB cannot be ruled out and could be an overhang on the stock
Lacks levers for profitability improvement: The bank’s NIMs are already
structurally down (from 4.3% in FY09 to 3.4% in FY13), owing to: (1) derisking to lower-yielding assets; and (2) deregulation of the non-resident
deposits interest rates. The geographical concentration of the branch
expansion will hinder low-cost deposit mobilisation and limit the decline in the
cost of funds. Fee income to assets would remain subdued at ~0.6%, as
opportunities remain limited due to branch concentration. The pressure on
income generation, we believe, will keep cost to income at ~45%. Mediumterm trends in retail and SME asset quality have indeed improved but the
corporate loan segment remains a key risk in the current environment. We
build in FY14-15 average credit costs of ~75bps (vs 58bps in FY13 and 74bps
in FY12). Profitability will, hence, decline, with RoAs of ~1.1% in FY14-15 (vs
1.3% in FY13 and 1.4% in FY12).
Valuation and stance: The stock has underperformed the Bankex by 11%
and current valuation of 0.63x FY14 BV seems to discount these long-term
structural concerns. We cut our FY14/15 estimates by 25% and cut our TP by
47% to `312. Our TP implies 0.8x FY14 P/B and 6.5x FY14 P/E.
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We have been toning down our expectation on Federal Bank (FB)’s
operating performance even as there has been a tangible
improvement in the bank’s asset quality, particularly for retail and
SME books. Our analysis of FB’s geographical concentration and its
impact on FB’s liability franchise, fee income generation and cost
efficiency show that any improvement from hereon would be gradual,
and the process could test the management’s and investors’ patience.
However, in the last three months, the stock has underperformed the
Bankex by 11% and current valuation of 0.63x FY14 BV seems to
discount these long-term structural concerns. Our target price of `312,
valuing FB at 0.75x FY14 BV, implies 21% upside.
Competitive position: WEAK Changes to this position: NEGATIVE
Deep-rooted inertia: As discussed earlier (page 13-15), geographical
diversification is the key to a bank’s liability franchise, as it leads to low cost of
funds, better income generation and cost efficiencies. FB’s management has
been focused on addressing asset quality issues but the need to evolve into a
more geographically diversified franchise has been neglected. For a bank of
FB’s size, its concentration in a small state (Kerala) has led to weak operating
performance - a low CA ratio (stuck at around 5% for the last 11 years), and a
meagre fee income to assets ratio of 0.6%. Weak income generation has led
to deterioration in cost ratios (cost to income of 35% in FY09 vs 45% in FY13).
The recent exit of a non-executive director suggests a degree of
disenchantment in the Boardroom with the bank’s progress
(http://goo.gl/NC7455). We believe further signs of discontent in the
Boardroom of FB cannot be ruled out and could be an overhang on the stock
Lacks levers for profitability improvement: The bank’s NIMs are already
structurally down (from 4.3% in FY09 to 3.4% in FY13), owing to: (1) derisking to lower-yielding assets; and (2) deregulation of the non-resident
deposits interest rates. The geographical concentration of the branch
expansion will hinder low-cost deposit mobilisation and limit the decline in the
cost of funds. Fee income to assets would remain subdued at ~0.6%, as
opportunities remain limited due to branch concentration. The pressure on
income generation, we believe, will keep cost to income at ~45%. Mediumterm trends in retail and SME asset quality have indeed improved but the
corporate loan segment remains a key risk in the current environment. We
build in FY14-15 average credit costs of ~75bps (vs 58bps in FY13 and 74bps
in FY12). Profitability will, hence, decline, with RoAs of ~1.1% in FY14-15 (vs
1.3% in FY13 and 1.4% in FY12).
Valuation and stance: The stock has underperformed the Bankex by 11%
and current valuation of 0.63x FY14 BV seems to discount these long-term
structural concerns. We cut our FY14/15 estimates by 25% and cut our TP by
47% to `312. Our TP implies 0.8x FY14 P/B and 6.5x FY14 P/E.
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