A revival in loan growth accompanied by cost-controls and aided by a better asset-quality has fired up the long desired turnaround, reflected in the rerating of Federal Bank (FB). A sales approach to business transformation is currently underway, but the outcomes are showing up. As always, turnarounds are great stories but risky; a few gaps need to be addressed, but we like the new energy in the bank. We initiate at Buy and PT of Rs 140.
A new strategic intent for growth
A weakened asset profile and low profitability necessitated immediate transformation through stronger growth, and leveraging of existing capital base but with limited cost implications. To manage the turnaround, the bank made top-draw hires over the past 12-16 months, especially in the corporate and institutional banking space. Compensation structure has been modified to retain talent and institutionalise a performance-oriented culture — we draw a parallel to IndusInd Bank’s transition in the last decade.
Improving asset/revenue profile
Federal Bank suffers from a few obvious gaps — NIMs lag despite a strong funding cost support; fee income profile is weak while running costs are high and sticky. The new strategy addresses these through balance sheet growth, loan mix improvement, new fee sources and a sales model with performance-based compensation.
Liability franchise has headroom for improvement
The liability franchise is well positioned with CASA ratio of 33%. A late expansion to other geographies has created deficiencies (lower CA ratio) and dependence on specific deposit (NRI-CASA). The relationship manager (RM)-driven lending model and improving branch efficiency may help the liability cross-sell to attract CASA, thereby de-risking the overall funding profile.
Profitability to improve gradually
We expect the cost-growth dynamics and steady improvement in asset quality to drive the RoA of the bank to about 1% by FY20e. NIM should be stable while cost reduction could be significant. Lastly, with large ticket issues mostly taken care of, we expect provision costs to be relatively benign. We forecast 28% EPS and 16% BV CAGR over FY17-20e.
Our PT of Rs 140 is based on 2.2x adj. book (Sep’18E) and 16x forward EPS (12M to Sep’19E). Our valuation is based on an equal-weighted P/B, P/E and residual income model. While valuations are 2 standard deviation out versus the historical median multiples, we believe improvement trajectory is not yet priced in and has a longer tail. We are yet to see the full implication of the RM-driven business origination and liability cross-sell and its impact on the cost-growth dynamics or if the gaps on the liability franchise would narrow down – the headroom for improvement are very much there and intact. On a relative basis, however, most banks are trading within a narrow band around the forward RoE vs P/B trend and FB fits in well in this. Risks: weakness in NRI-CASA and domestic CA flows, inability to rein in costs, asset quality deterioration.