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Transformation into neo-gen private bank, better RoAs to aid re-rating

* Federal Bank (FB) continued to report healthy in-line PAT of Rs4.6bn (est: Rs4.5bn), driven by contained provisions and recovery from DHFL, partly offset by higher opex. Headline asset quality improved as GNPA was down 26bps qoq to 3.2%, but restructuring was slightly higher than expected at Rs34bn or 2.6% of loans.

* FB clocked 9% yoy credit growth in H1 and expects growth to improve in H2 amid better traction in retail/SME and agri book. Within retail, mortgages and vehicle loans remain the key drivers of growth, while some softness was seen in PL book. FB continues to build MFI organically and remains open to inorganic acquisition as business normalizes.

* The bank remains confident of 1%+ exit RoA by Q4FY22. We estimate 0.9-1.1% RoA and 11-14% RoE over FY22-24E, driven by better margins (led by higher share of retail portfolio, including CV, MFI, P and Card), structural improvement in cost ratios due to digital adoption and lower LLP.

* FB remains our preferred pick in the small/mid-cap space, given its better liability/asset quality profile, management stability, digital adoption and expected improvement in return ratios. Maintain Buy with a revised TP of Rs130, rolling forward to 1.2x Dec’23E ABV (vs. 1x Sep’23E ABV earlier). Potential value unwinding in subsidiary FedFina adds to the comfort.

Higher retail orientation to support growth, drive up margins:

Overall credit growth came in at a six-quarter high of 9% yoy/4% qoq to Rs1.3trn in Q2. Retail growth remains healthy at 11% yoy, led by mortgages and vehicle loans, and should accelerate further in the run up to festive cheer and waning risk aversion. The concern regarding the suspension of MasterCard by the RBI is now behind as the bank launched credit cards with Rupay/Visa and has also tied up with One Card to source cards. Additionally, its BC Micro-lending platform FedMi went live in Q2 and should help in sourcing high-margin MFI business. CASA stands at an all-time high of 36%, reflecting in the lower cost of deposits and thus better NIMs (up 5bps qoq) to 3.2%. Management expects that a better business mix and lower interest reversal should drive up margins to 3.2-3.25% on a sustainable basis.

NPAs down, but restructuring slightly higher than expected:

The GNPA ratio improved by 26bps qoq to 3.2%, led by lower slippages at Rs3.4bn (Slippage ratio 1% vs. 2.3% in Q1) and significant recoveries from the slipped pool of Q1. However, Covid-specific restructuring has come out slightly higher at Rs34bn, 2.6% of loans (vs. 2% in Q1FY22) - a trend seen across banks due to a liberal approach adopted by financiers to tide over transient stress. FB expects a relapse rate of 25-30% from the pool in 2-3 years and would maintain a 65% PCR on the same as a prudent measure. Currently, it holds Rs4.5bn of restructured provisions, i.e. 0.3% of loans/ 45% PCR on anticipated stress. On an overall basis, the bank carries a healthy PCR of 66%, which should contain incremental credit costs.

Outlook and valuations:

We estimate the bank’s RoA/RoE to improve to 0.9-1.1%/11-14% over FY22-24E from 0.8%/10% in FY21, driven by better margins (led by higher share of retail portfolio, including CV, MFI, PL and Card), structural improvement in cost ratios due to digital adoption and lower LLP. Maintain Buy with a revised TP of Rs130, rolling forward to 1.2x Dec’23E ABV (vs. 1x Sep’23E ABV earlier). Key risks: impact on growth/asset quality, if any, of recent floods in Kerala and higher-than-expected relapse rate in the restructured pool.

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