Federal Bank (FB) reported weak performance with earnings declining 96% y-o-y on the back of weak revenue growth (-2% y-o-y) and 10X rise in provisions which were mostly towards bad loans and loans to SEBs that recently got converted to bonds. However, strong NIM (above 3%), healthy growth in loans (13% y-o-y, 10% q-o-q), and reducing pressure of bad loans of the previous cycle give comfort as FB appears to be on the right track to deliver strong earnings growth and return to steady state RoEs over the next few years. Maintain BUY with a TP at Rs 70 (from Rs 75 earlier).
Credit costs and weak treasury income (high base) take a toll
FB reported a weak quarter with earnings declining 96% y-o-y led by high credit cost (2.2% annualised) and weak treasury gains. NII growth of 10% y-o-y was supported by one-off interest on IT refunds, even as strong loan growth of 13% y-o-y was offset by NIM (adjusted) decline of 20 bps y-o-y. Non-interest income declined 26% y-o-y. CASA ratio is healthy at 32.5% and grew 19% y-o-y. Gross NPLs declined ~40 bps q-o-q to 2.8%; restructured loans declined ~150 bps q-o-q to 2.7% of loans. The bank reported 4% slippages for the quarter but nearly 25% of the slippages have come from the restructured loan portfolio where the conversion to bonds of SEB loans has been taken as a second restructuring which forces banks to recognise it as bad loans.
Exit performance on key metrics is turning positive; cost ratios need to be addressed
Despite a fairly weak performance on earnings for the quarter, we like its performance in a few key areas: (i) Loan growth has picked up to a comfortable pace at 13% y-o-y, 10% q-o-q which gives comfort that revenue growth for FY2017 should be healthy at 15% y-o-y levels. Growth is getting balanced with corporate loan growth of 18% y-o-y, retail (ex-gold) growth of 18% y-o-y, and SME growth of 17% y-o-y (ii) despite pressure on slippages, NIM has been stable at over 3.1% levels (iii) the bank has not reduced provision coverage ratio despite slippages at over 4% of loans. The two areas of concern are (i) operating profit growth is still weak and the bank opex to assets has increased to 2.1-2.3% from 1.7-1.8% which is hurting return ratios and visibility, for improvement is an extremely slow process led by loan growth and better productivity of employees (ii) SME and retail slippages have been a bit high and partly led by the slowdown in the Middle East. It is still early and we hope it will not cascade down in a big way.
Maintain BUY rating; exit performance raises confidence for a strong show ahead
We maintain our positive view and value the bank at 1.3X book and 12X FY2017/18e EPS for RoEs (return on equities) in the range of ~13% in the medium term (17% in the long term) and strong earnings growth at ~50% CAGR (compound annual growth rate) in FY2017-18e (albeit off a low base). At our target multiple, we value the bank at Rs 70 (from Rs 75 earlier). Federal Bank is taking the right steps by moving the business model closer to that of new private sector banks which gives comfort to a higher multiple, even though it is unlikely to shed its old private sector bank image in the near-term.