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MSFL Research
Initiating Coverage Federal Bank
BUY Optimal leverage to aid growth
CMP 324
Target Price 400 RoE Expansion underway
Upside Potential 23% Federal Bank’s return on equity (RoE) had contracted by 770 bps in 2008 from about 20% on
Price Performance account of rights issue done However; the bank has delivered an average return on assets
52 wk Hi/Lo 355/213 (RoA) of 1.3% in the past five years. The deviation in the RoE and RoA is primarily due to the
All time Hi/Lo 498/28 lower leverage ratio of the bank vs its peers. With its business growth likely to gain traction
6 mnth Average Vol 552444
on the back of the economic recovery, the bank should be able to optimally leverage its
Stock Beta 0.79
equity base and hence improve its RoE.
16.5
14.2
13.2
12.4 11.9
11.2
7.7
However with Indian economy getting back on high growth trajectory, Federal Bank is likely to give
Average RoE of 13.3% over away its cautious approach as credit growth has seen revival since December 2009 and the same is
FY11-12P expected due to likely to continue going forward on the back of strong growth projections for the country. This implies
better deployable better deployment opportunities for the bank which should translate into optimal leverage and hence
opportunities better RoE for the bank. However we believe that RoE expansion will happen gradually over a period
and expect Federal Bank to deliver an average RoE of 13.3% over FY11-12P.
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MSFL Research
……….As business growth gains traction
Though the business mix for Federal Bank has grown at 19% CAGR for FY2008- 10, the growth is lower
Advance growth of CAGR 22%
than some of its peers that have grown at an average CAGR of 24% in the similar period. The primary
expected in FY11-12P
reason for the relatively slower balance sheet expansion is the cautious stance adopted by the bank in
the wake of the worldwide financial crisis in FY2009 and the more recent crisis in the Middle Eastern
countries. However, with the domestic economy getting back on track and the gradual recovery in
credit demand, we believe that the balance sheet expansion rate is likely to inch up in the coming
years.
The advance book of the bank primalrily comprises of Retail and SME segment, forming 62% of the
loan book and are typically high risk-high margin businesses while the balance portfolio is made up of
Corporate segment. The bank has a 10% exposure to gold loans out of its total retail loans; these are
high-yielding and secured loans. The unsecured assets such as Personal Loans (around 1% of Retail
book) and credit cards form a very negligible part of Federal Bank’s overall Retail book which are
typically more riskier assets.
SME
31%
Corporate
38% AAS/AAD
8%
Mortgage Hsg
4% 56%
Home Gold
O/D 10%
Retail 4%
31%
We expect the business of the bank to grow at CAGR of 22% over FY10-12P with Deposits and
Advances growing at CAGR 22.5% and 22% respectively for the similar period.
0 0.0%
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MSFL Research
Margins – Amongst the best in the industry
Federal Bank has been maintaining healthy margins of above 3% (calcualted basis) in past few years and
Has delivered average NIM of
is comparable to the top three private banks in the industry. The key reason for maintaining stable
3.3% over past five years – Key
margins over the period is access to low cost funds by the bank in the form of CASA as well as NRI
being access to low cost
deposits. The Savings deposits for the bank have grown at CAGR 22% in FY2006-10 while Current
deposits
deposits have grown by 17% for the similar period. The CASA ratio for FY10 stood at 26% for the bank.
With bank expanding its geopgraphic footprints over the country, we expect bank’s CASA deposits to
grow at CAGR 27% in FY11-12P.
CASA NRI
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
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MSFL Research
Adequately capitalized for Growth
Well capitalized for future Federal Bank had raised around Rs 21250 mln in 2008 through rights issue which was equivalent to its
growth networth. On account of this huge capital raising and conservative growth strategy adopted, Federal
Bank has been having highest capital adequacy ratio amongst its peers with the Tier-I capital at 15.27%.
This high proportion of Tier-I capital provides enough headroom for the bank to raise money by way of
Tier-II capital for funding its growth without straining its balance sheet. This high capital adequacy will
enable the bank to pursue its organic and inorganic growth initiatives in the next two to three years,
thereby improving its RoE by leveraging its capital position, which is low at present.
17.26
14.91 15.39 14.49
12.99 12.37
The non-interest income (excluding treasury) of Federal bank has grown at a healthy pace of CAGR 24%
New initiatives could result to
over the past five years on the back of various fee generating revenue streams and a strong remittances
traction in core fee income
business. The overall non-interest income for the bank in past three years has grown at CAGR 20.6%,
while the Non-Treasury portion has grown by 18.6%. The bank has various fee revenue streams such as
foreign exchange (forex), distribution of third party products and cash management services. The bank
also has a tie-up with BNP Geojit Paribas Financial Services to offer online trading facilities known as Fed-
e-Trade. It provides insurance services through its life insurance joint venture with IDBI Bank and Fortis
Insurance International N.V. wherein it holds a 26% stake. In its first year of operations itself, as on March
31, 2009, the joint venture company collected more than Rs3280 mln in premiums through over 87,000
policies and over Rs28250 mln in sum assured. In view of the strong branch expansion ahead, the foray
into wealth management and the optimal leveraging of technology, we believe that the core fee income
could gain further traction from hereon.
150%
100%
50%
0%
2004 2005 2006 2007 2008 2009 2010
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MSFL Research
Coupled with healthy non-interest income growth and lower operating expenses, the Burden ratio (Non
Interest Income covering opex) for the bank stands at 78% as compared to peer average of 72%. While
opex of the bank will inch up as it is adding new branches to expand its geographical footprints, CAGR
growth of 13% in Non Interest Income in FY11-12E would maintain burden ratio at above 70% level.
Burden Average
100% 100%
90%
80% 80%
70%
60% 60%
50%
40% 40%
30%
20% 20%
10%
0% 0%
FedBank KVB IVYB CUB DhanBk K'ka Bk
Exhibit 11: Asset base comparison (peer banks) Exhibit 12: Asset base comparison (South based banks)
Total Assets (in bln)
Total Assets (in bln)
4000 500
400
3000
300
2000
200
1000 100
0
0
LVB
INVYB
K'tka
KVB
CSB
SIB
Fed Bk
Dhan. Bk
IndusIn
HDFC
INVYB
K'tka
Fed Bk
J&K
Kotak
ICICI
Axis
Yes
Bk
Bk
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MSFL Research
Enviable franchise network….
Highest low cost deposits per Due to its geographical presence, Federal Bank has been able to build an enviable franchise network
branch ratio amongst its with low cost deposits forming 46.4% of the total deposits on account of strong NRI customer base
peers combined with CASA deposits. With a strong branch network of 672 branches, the low cost deposit per
branch matrix stands most valuable compared to peers.
250.00
200.00
150.00
100.00
50.00
0.00
Fed Bank IVYB SIB KVB K'ka Bk DhanBk
Source: Company, MSFL Research
Inspite of having the most valuable franchise network amongst the peers, Federal Bank’s franchise
Certain concerns keep
valuation doesn’t reflect similar strength. The most important reason we believe is the overhang of the
valuation depressed
Catholic Syrian Bank (CSB) merger while the other reason was asset quality concerns which weighed
heavily on bank’s performance in past one year. We believe that the inherent strength of the franchise
network cannot be ignored and should command adequate valuation over a period of time.
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
KVB IVYB Fed Bank K'ka Bk DhanBk SIB
Source: Company, MSFL Research
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MSFL Research
Operational Efficiency – Best amongst the peers
Early adoption of technolgy is Federal bank is one of the oldest private sector banks in India and in spite of which it has been
bearing fruits now for the technologically at par with many new-aged private sector banks. The bank has made substantial
bank investments in technology over the last three to four years. It was the first “traditional” private sector
bank to computerise all its branches (as early as in January 2004) and amongst the earliest banks in India
to implement real-time gross settlement (RTGS) in all branches. This has given Federal bank an edge
over the other banks in terms of fee income stream, service quality and efficiency. The bank also
completed the roll-out of the Core Banking Solution (CBS) in less than a year, which is commendable,
especially for an old generation private sector bank. This largely reflects in the cost to income ratio
which over the past five years stands at an average of around 38%. Also given the size of the bank, the
opex/branch ratio is below average to that of peers thus making it the most efficient bank down south
in terms of operational effeciency. Having said that, we believe that the cost-income ratio of the bank is
likely to inch up in FY2011 and FY2012 on account of the aggressive branch expansion.
20.00 100.00%
80.00%
15.00
60.00%
10.00
40.00%
5.00 20.00%
0.00 0.00%
Bus/Employee Bus/Branch
K'ka Bk
DhanBk
IVYB
KVB
SIB
Fed Bank
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MSFL Research
Asset Quality – Tad Apprehension…….
Federal Bank’s asset quality deteriorated in line with the industry trend in the last fiscal due to its high
Slippages of 3.3% on account exposure to sectors such as Retail and SME. For Q4FY10, the GNPA on relative basis was stable at 2.97%,
of Corporate and Retail though on absolute basis it showed deterioration with 3.8% addition. Of the Rs 3.2 bln slippages during
segment the quarter, Rs 1.6 bln was contributed by four large corporates however retail formation (especially
Housing) is coming off (Rs. 0.6 bln). The Net NPA for the bank has improved by 8 bps sequentially to
0.48% on account of increase in provisions. Mangement has guided that stress on assets could likely
persist for couple of quarters; however with economy showing signs of revival, the pressure could
relatively ease out in couple of years. Also the provision coverage ratio (PCR) which currently stands at
~91% (including technical write-offs) augurs well for the bank and provides comfort in terms of impact
on the bottomline. Though the current GNPA stands higher than the average of the peers( Average –
2.25%), the PCR stands out for the bank.
On restructured assets front, Federal Bank has restructured assets worth Rs 650 mln during Q4FY10 thus
Restructured assets 4.1% of
taking the cumulative restructuring to Rs 10930 mln, forming 4.1% of the advances. Of the assets
Advances; in line with
restructured, accounts worth Rs 610 mln slipped into NPA during Q4FY10 while for FY10 the slippages
Industry trend
amounted to Rs 1200 mln forming 11% of the total restructured assets.
3000
2000
1000
0
Q1FY10 Q2FY10 Q3FY10 Q4FY10
1QFY09
2QFY09
3QFY09
4QFY09
1QFY10
2QFY10
3QFY10
4QFY10
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MSFL Research
….but could be managed
High PCR and necessary steps One of the key reasons for the higher slippages is the crisis in the Middle Eastern countries, which had a
taken by bank could keep strong impact on the income levels of the NRIs residing there and hence led to stress on the bank’s
asset quality under control housing loan portfolio. While the housing loan portfolio of the bank is likely to remain under stress in
the near term as the bank holds a huge restructured loan portfolio (4.1% of total loans), the pressure is
likely to taper off as the concerns related to Dubai and the other Middle Eastern countries are abating,
thus resulting in coming off of slippages in Retail segment.
One of the major reason for Federal bank stock’s underperformance in the past two years is the
Comparative weak
apprehension which was loominng large over its proposed merger with Catholic Syrian Bank (CSB). The
fundamentals of CSB – A
talks of CSB acquisition were initiated by Federal bank way back in 2008 and since then the acquisition
major concen over the
has been in a limbo. The basic idea of acquiring CSB was to consolidate Federal Bank’s dominating
merger
position in Kerala to withstand any future competition in the state. However while initially CSB had
agreed on the acquistion plans, the plan could not be consummated due to various resistances faced
such as valuation differences, strong reservations from the Archbishop of the Diocese of Thrissur (a
major stakeholder) over the loss of identity, employee dissent and so on.
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MSFL Research
Exhibit 20: Comparative Study of Financials
*Comparative Analysis
(in mln) Federal Bank CSB
Networth 43258.7 3883
Deposits 321981.9 63328.3
Advances 223918.7 36838.4
Net Profit 5004.9 371.9
EPS 29.3 19.7
Book Value 252.9 184.1
GNPA (%) 2.6 4.6
NNPA (%) 0.3 2.4
PCR (%) 88.4 48.8
RoE (%) 12.1 12.2
RoA (%) 1.4 0.6
NIM (%) 3.7 2.5
Cost to Inc (%) 31.2 70.3
Branches 612.0 363.0
Business/Branch 892.0 275.9
Profit/Branch 8.2 1.0
Business/Employee 72.1 37.4
Profit/Employee 0.7 0.1
Source: Company, MSFL Research
* As of 31 March 2009
The comparative analysis as above (Exhibit) validates the concerns of the Federal Bank-CSB merger on
account of the following grounds
Overall, the merger possibility with CSB has diminished substantially due to strong reservations from
various stakeholders and this we believe is positive for Federal Bank as it is far more superior bank and
the possible merger would only have strained the profitablity of Federal Bank.
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MSFL Research
Inherent Fundamentals remain Strong
While Federal Bank’s RoE has been strained by excess liquidity on the balance sheet post rights issue,
Thriving on strong
bank has delivered an average RoA of 1.3% in the past five years thus exhibiting the superior quality of
Fundamental parameters
sustainable earnings on account inherently strong fundamentals of the bank. Low cost deposits, strong
margins, focus on high yielding sectors and valuable franchise network are some of the positives which
outweigh the burden of high provisions (due to exposure to riskier segments).
Further, the comparative study of RoA decomposition suggests that Federal Bank has been above
Return on Assets (RoA) stands
average on all key operating performances with its RoA for FY10 being 1.13% (calculated) compared to
out amongst peers
peer average RoA of 0.9%. The performance on RoA could have been better had not the bank had to
make higher tax provisions (46%) for an exceptional item. This exceptional item is on account of an
impending tax case with Income Tax department for which the bank has made full provisions and
expects a normalised tax rate of 33-34% going ahead. Nevertheless, the sustainable RoA deliverance of
the bank points out towards the strong fundamentals of the bank and going forward we expect Federal
Bank to deliver an average RoA of 1.3% for FY11-12E.
Exhibit 22: RoA Breakdown – Federal Bank Exhibit 23: RoA Breakdown – Peer comparison
10.0% 10.0%
9.0% 9.0%
8.0% 8.0%
7.0% 7.0%
6.0% 5.5% 6.0%
5.0% 1.3% 5.0%
8.9% 5.4%
4.0% 1.6% 4.0% 7.5% 1.3%
3.0%
1.0%
3.0%
2.0% 2.0% 1.9% 0.4%
3.4% 1.0% 0.3%
1.0%
1.1%
1.0% 2.1%
0.9%
0.0% 0.0%
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MSFL Research
Peer Comparison
The divergence in RoA and RoE as well as concerns on possible CSB merger has played heavily on
Trading at ~20% discount on Federal Bank’s stock and as a result of which the stock has been trading at shallow band of 0.5-1x of its
1-year forward P/ABV basis one year forward P/ABV in the past 2 years. However, the strengths of the bank such as superior
when compared to peers
technological network, valuable franchise network, high yielding loan book exposure and contained cost
of funds outweigh the concerns on provisioning burden for the bank. Inspite of higher tax expense
(46% for FY10) due to exceptional item, Federal Bank reported RoA of 1.13%, higher than peer average
of 0.9%, thus reflecting the soundenss of the earnings quality of the bank. Considering all these factors,
we believe that the bank is trading at a significant discount to its peers across important parameters.
1.80 KVB
DhanBk
1.60
1.40 IVYB CUB
1.20 K'ka Bk
FedBank
P/ABV
0.60
0.40
Avg: 1.1%
0.20
0.00
0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% 1.6% 1.8% 2.0%
ROA
The core profitability of the bank and growth outlook has been above average compared to peers.
While till recently Federal Bank was grappling with depressed RoE due to low leverage on account of
economic crisis, the same same we believe is set to change. Federal Bank could be a a key beneficiary of
the economic upcycle in light of sustained economic recovery and the conducive environment for the
banking sector ahead as bank can now leverage its capital position for growth. In addition to the
conducive macro environment, we believe that the bank would maintain the lead over its peers across
operating parameters. Against this backdrop, we strongly believe that below the peer average valuation
of the bank are unjustified considering the scale and superior quality of earnings of the bank.
At the current market price of Rs324, Federal Bank trades at 1.1x and 1.0x of its FY2011E and FY2012E
ABV per share. Historically, the stock has traded in the range of 0.5-1.4x its one-year forward price/ ABV
multiple. We value the bank at 1.24x FY2012E ABV per share, considering the bank's potential to grow
above the industry average in future. We initiate coverage on Federal Bank with a Buy recommendation
and a price target of Rs400.
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MSFL Research
500
450 1.75
400 1.50
350
1.25
300
250 1.00
200 0.75
150
0.50
100
50
0
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Apr-08
Oct-08
Apr-09
Oct-09
Jun-05
Feb-06
Jun-06
Feb-07
Jun-07
Feb-08
Jun-08
Feb-09
Jun-09
Feb-10
Aug-05
Aug-06
Aug-07
Aug-08
Aug-09
Source: Company, MSFL Research
Asset quality
In line with the industry trend, the bank's asset quality improved substantially from FY2002 onwards.
Going forward, we believe that the bank may continue to face asset-quality pressures for the next few
quarters, in view of its higher exposure to the retail and SME segments. Though we have factored in the
stabilising/improving trend in its asset quality from 2011 onwards, unforeseen events
(globally/domestically) could materially change the near-term outlook on its asset quality.
CSB acquisition
While the acquisition of CSB is not expected to fructify in near future, a sudden turn of events on this
front leading to an eventual acquisition would have a significant impact on some of our key assumptions
(due to reasons discussed already) and could materially alter our near-term outlook on the bank.
Company Background
Incorporated in 1931, Federal Bank is an old private-sector bank with a dominant presence in the
southern state of Kerala. It currenlty operates with 672 branches and 732 ATMs across the country with a
customer base of over 5 mln including NRI clientele base of over 0.4 mln. Federal Bank’s business has
grown at CAGR 21.3% over FY2006-10 while the current asset base of the bank is Rs. 436757 mln. Bank’s
advances are primarily dominated by SME and Retail segment which form 30.7% and 31.2% of the loan
book respectively. The bank completed the acquisition of Ganesh Bank in 2006 and added 32 branches
to its existing network, thereby increasing its foothold in Western India. The bank holds a 4.99% stake
each in CSB, South Indian Bank and Lakshmi Vilas Bank—all south-based banks with a strong presence in
Kerala.
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MSFL Research
Subsidiaries, Joint Ventures and Other Initiatives
Fed-e-Trade
Federal Bank also has launched its retail broking business known as - FED-e-TRADE - in association with
BNP Geojit Paribas Financial Services.
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MSFL Research
Profit & Loss
Particulars (Rs in mn) 2008 2009 2010 2011P 2012P
Interest Income 25,154 33,154 36,732 44,493 54,849
Interest Expense 16,474 19,999 22,624 27,846 35,173
Net Interest Income (NII) 8,680 13,155 14,108 16,648 19,676
Other Income 3,950 5,158 5,309 5,962 6,758
Net Total Income 12,630 18,312 19,417 22,610 26,435
Operating Expenses 4,689 5,715 6,769 7,913 9,252
Pre-Provisioning Profit (PPP) 7,941 12,598 12,649 14,696 17,183
Provisions & Contingencies 2,940 4,668 4,053 5,582 5,410
PBT 5,002 7,930 8,596 9,115 11,772
Tax 1,321 2,925 3,950 3,092 3,008
PAT 3681 5005 4646 6107 7887
Net Interest Margin (NIM) 3.0% 3.7% 3.4% 3.4% 3.3%
EPS 21.5 29.3 27.2 35.7 46.1
NII Growth (%) 21.1% 51.5% 7.2% 18.0% 18.2%
PAT Growth (%) 25.7% 36.0% -7.2% 31.5% 29.2%
Balance Sheet
Particulars (Rs in mn) 2008 2009 2010 2011P 2012P
Liabilities
Equity 1,710 1,710 1,710 1,710 1,710
Reserves & Surplus 37,547 41,548 45,194 50,229 56,732
Networth 39,257 43,259 46,905 51,940 58,443
Deposits 259,134 321,982 360,580 443,513 541,086
Borrowings 7,920 7,489 15,468 13,981 22,648
Other Liabilities & Provisions 18,755 15,779 13,804 22,019 22,680
Total Liabilities 325,065 388,509 436,757 531,453 644,858
Assets
Cash & balances with RBI 23,557 22,144 23,189 25,200 33,255
Balances with banks & money
3,898 12,227 4,045 12,037 7,655
at call
Investments 100,266 121,190 130,546 150,886 188,801
Advances 189,047 223,919 269,501 331,486 401,099
Fixed assets 2,328 2,808 2,898 4,372 5,628
Other assets 5,969 6,221 6,577 7,471 8,421
Total Assets 325,065 388,509 436,756 531,453 644,858
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MSFL Research
Ratios
Valuation Ratios 2008 2009 2010 2011P 2012P
P/E 15.1 11.1 11.9 9.1 7.0
P/BV 1.4 1.3 1.2 1.1 0.9
P/ABV 1.4 1.3 1.2 1.1 1.0
P/PPP 7.5 4.7 4.7 4.0 3.4
EPS 21.5 29.3 27.2 35.7 46.1
DPS 4.0 5.0 5.0 5.4 6.9
Book Value (BV) 229.5 252.9 274.2 303.7 341.7
Adjusted Book Value (ABV) 226.6 248.6 266.4 290.2 326.9
Profitability Ratios
ROE 13.6% 12.1% 10.3% 12.4% 14.3%
ROA 1.3% 1.4% 1.1% 1.3% 1.3%
Leverage (x) 6.9 7.7 8.1 8.9 9.7
Spread Analysis
Yield on Advances 10.8% 12.4% 11.6% 11.7% 11.9%
Yield on Investments 7.3% 6.3% 6.2% 6.3% 6.4%
Cost of Deposits 6.4% 6.4% 6.3% 6.5% 6.7%
Cost of Funds 6.7% 6.7% 6.5% 6.7% 6.9%
Net Interest Margin (NIM) 3.0% 3.7% 3.4% 3.4% 3.3%
Asset Quality
Gross NPA (%) 2.4% 2.6% 3.0% 3.0% 2.9%
Net NPA (%) 0.2% 0.3% 0.5% 0.7% 0.6%
Provision Coverage Ratio 90.8% 88.4% 84.3% 77.9% 79.2%
Slippage Ratio 1.8% 3.0% 3.3% 3.0% 2.8%
Effeciency Ratios
Cost/Income Ratio 37% 31% 33% 35% 35%
Burden 84% 90% 78% 75% 73%
Business per Branch (in mln) 836 905 938 1044 1175
Business per Employee (in mln) 64 72 81 98 116
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MSFL Research
MSFL Disclaimer:
All information/opinion contained/expressed herein above by MSFL has been based upon information available to the public and
the sources, we believe, to be reliable, but we do not make any representation or warranty as to its accuracy, completeness or
correctness. Neither MSFL nor any of its employees shall be in any way responsible for the contents. Opinions expressed are
subject to change without notice. This document does not have regard to the specific investment objectives, financial situation
and the particular needs of any specific person who may receive this document. This document is for the information of the
addressees only and is not to be taken in substitution for the exercise of judgement by the addressees. All information contained
herein above must be construed solely as statements of opinion of MSFL at a particular point of time based on the information as
mentioned above and MSFL shall not be liable for any losses incurred by users from any use of this publication or its contents.
Analyst declaration
I, Laxmi Ahuja, hereby certify that the views expressed in this report are purely my views taken in an unbiased manner out of
information available to the public and believing it to be reliable. No part of my compensation is or was or in future will be linked
to specific view/s or recommendation(s) expressed by me in this research report. All the views expressed herewith are my personal
views on all the aspects covered in this report.
Key ratings:
18