Federal Bank

Investors with a penchant for risk can consider buying the Federal Bank stock at the current levels. The stock seems to be undervalued despite the bank displaying strong growth in earnings in the last few quarters.

At the current market price of Rs 246, the stock is trading at a FY10 earnings multiple of 7.6 and FY10 price-to-adjusted book value of 0.9. This is at a steep discount to other private banks. Though the discount is partly justified due to the geographical concentration of risk and reliance on remittances, it is still significantly cheap and has huge upside.

Federal Bank may see a modest earnings growth this year due to lower credit demand and some slippages. However the bank's earnings may outperform peers' beyond next fiscal as the credit off-take improves due to its superior net interest margin and as the asset quality improves.

The bank has historically posted better-than industry average credit growth and may continue to do so, going forward. In addition, the acquisition of Catholic Syrian Bank may significantly increase the size of the total branches which the bank can leverage to improve low-cost deposit base.

High credit-deposit ratio of 77 per cent, superior margins and high levels of operating efficiency (cost-income ratio of 35 per cent) support the earnings growth. Federal Bank is the fourth largest private sector bank. Around 60 per cent of its branches are in Kerala which contribute to 51 per cent of its total deposits and 42 per cent of total advances.

Comfortable levels of capital adequacy (capital adequacy of18.5 per cent), high levels of provision coverage (83 per cent) and strong return on assets (1.3 per cent) are the other key positives for the bank.

Business

As of September 30, 2009, the loan book of the bank was well-diversified and comprised corporate credit (40 per cent), retail (29 per cent), and SME (31 per cent). Majority of the retail loan portfolio is home loans. The top industry exposures for the bank are in infrastructure, petrochemicals and iron and steel sectors, which are seeing signs of recovery.

On the liability side, one-fourth of the total deposits are current account and savings account deposits and 28 per cent of retail deposits are NRI deposits, resulting in a low cost of funds. The investment-deposit ratio is as high as 35 per cent which puts pressure on the net interest margin (NIM) as the yields on investment are low. NIM fell from 4.1 per cent to 3.5 per cent in a year, which is still at relatively healthy levels. The net profit of the bank saw an annualised growth of 30 per cent in the period between 2005 and 2009, thanks to a 24 per cent growth in advances during the same period. For the half year ended September 2009, the advance growth moderated to 20 per cent and net profit grew by 30 per cent.

The net profit growth in the latest half was aided by other income, which grew by 40 per cent, even as the net interest income remained flat. Though the net NPA/ advances of the bank have deteriorated to 0.54 per cent from 0.3 per cent in last six months, it is still low compared with most of its peers.

Capital adequacy may moderate once the bank acquires Catholic Syrian Bank (CSB). Federal Bank also has scope to improve its capital adequacy in form of Tier-2 capital which is relatively untapped.

The proposed acquisition of CSB may turn out to be advantageous for the bank despite CSB having higher net NPAs, cost of deposits and lower business per branch. Federal Bank's better efficiencies and ratings may stand the latter's business in good stead.

The acquisition may increase the branch network of Federal Bank by more than 50 per cent. Though CSB's business size is only 18 per cent of Federal Bank's, the latter can be scaled up using the branch network and offers an opportunity for Federal Bank to improve the operational parameters of CSB, while gaining low cost deposits.

Outlook

Going forward, the banking industry may take a hit on earnings as the yields harden. The hit may be severe in case of Federal Bank as 31 per cent of the total investment book is available for sale or held for trading portfolio. The investment book has increased by 44 per cent for the bank due to deployment of excess cash in these investments.

Even if larger corporates are able to seek out other avenues of credit, off-take is likely to improve from the retail and SME segments. Margins may not improve from current levels for the next couple of quarters despite the re-pricing of deposits and demand for credit increasing.

Yield on advances is likely to come under pressure due to predatory pricing of certain loans and the bank's continued reliance on wholesale deposits (22 per cent of the total deposits including the certificate of deposits).

However, over the medium term, as the bank sets up more branches, the dependence on wholesale and certificate of deposits will fall which would in turn reduce the cost of funds. The NIMs may also improve over medium-term as excess investments shift to meet the demand for credit.

via BL