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Digital adoption, changing portfolio mix to drive up RoA

Federal Bank is transforming itself into a next-gen private bank via its neo-banking tie-ups across assets, liabilities, and payments businesses. This should not only help the bank thrive in the new era of banking, but also reduce the incremental cost of business and garner better fees/revenues in the long run.

* The bank’s retail portfolio has traditionally been dominated by secured mortgages and gold loans. However, it has now diversified into higher-margin CV, MFI, PL and Card businesses, which should drive up NIMs and thus RoA>1% (otherwise been a key irritant) in the long run.

* In our view, the three-year extension of the MD & CEO term provides management stability (missing among peers) and strategic continuity. The bank’s NBFC unit Fedfina has built a healthy loan book (>Rs47bn) and could potentially see value unwinding as it gains scale.

* Federal Bank remains our preferred pick in the small/mid-cap space, apart from Equitas, given its better liability/asset quality profile, management stability, digital adoption and expected improvement in return ratios. Retain Buy with a TP of Rs110 (1x Sep’23E ABV).

Healthy liability profile despite being branch light; digital adoption to help reduce sticky opex ratios:

The bank has a relatively better liability profile, with retail deposits in excess of 90% and a reasonable CASA ratio of 35%, reflecting in lower CoF among peers at 4.5%. Despite being branch-light, the bank’s cost ratios remain high due to lower revenues (mainly NIMs) and sticky costs. We believe that margin improvement will be more a function of a change in the portfolio/product mix. However, the bank has adopted a digital sourcing model to reduce the cost of acquisition (CAC) and to improve sticky cost ratios. The bank has already been sourcing gold loans via Rupeek and has largely built a digitally-sourced PL book (Rs15bn) with negligible delinquencies. It has also entered into neo-banking partnerships with epiFi, Jupiter and BharatPe to offer digital services (asset, liability, and payment). We believe that this should not only help the bank to compete and thrive in the new era of banking, but also reduce the incremental cost of business and garner better fees/revenues in the long run.

Better asset quality performance, provision cover among peers: Despite the second Covid wave and prolonged lockdowns in Kerala, the bank’s asset quality performance has been better than expected, with GNPA/RSA at 3.5%/1.9% of loan book. It has also further accelerated its specific PCR to 66% vs. 45-50% seen across old age PVBs. We believe that the bank’s high share of secured & seasoned mortgages/gold loan book and better underwriting practice in corporate book for the past few years should limit any future asset quality risks.

Better margins driven by change in portfolio mix; moderation in credit cost to boost RoA: The bank has long struggled to cross the 1% RoA hurdle due to lower margins, sticky & higher opex and the recent surge in credit costs due to Covid-induced exogenous factors. However, we expect margins to improve gradually as the bank focuses on high-yielding products such as CV, MFI, PL and Cards. Re-pricing of mortgage book in a rising interest cycle will provide backend support. This, coupled with steady moderation in opex on the back of digital adoption and credit costs, should drive up RoA on a sustainable basis beyond 1% by FY24E.

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