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Growth outlook steady; getting future-ready under new leadership

Rising mix of high-yielding products to boost margins

* Federal Bank (FB) has demonstrated a strong business growth trajectory over FY22-24, with a 20% CAGR in its loan book and 18% deposit growth. Over FY25- 27, we believe the bank is set to deliver an 18% loan CAGR, backed by effective risk management and fintech partnerships, despite facing regulatory challenges.

* The bank views fintech partnerships as vital for product distribution, tech integration and network expansion to boost customer acquisition in FY25, as it is optimistic about the lifting of regulatory restrictions on card issuance soon.

* We reckon that the implementation of LCR draft guidelines in their current form will impact FB’s LCR by ~1240bp. As per our calculation, FB’s RoA and margins would be impacted by 3bp and 8bp, respectively, if the bank were to raise required deposits to improve its LCR to 110%.

* In Jul’24, FB received the RBI's approval for Mr. KVS Manian as the new MD and CEO starting Sep’24. With his extensive banking expertise, Mr. Manian is expected to drive strategic changes and a potential turnaround for the bank.

* We estimate FB to achieve RoA/RoE of 1.3%/15.2% by FY27, making its current valuation at 1.1x FY26 BV attractive for long-term growth; thus, we maintain our BUY rating with a TP of INR230 (1.5x FY26E ABV).

Growth outlook steady; business mix shifting toward high-yielding products

Robust deposit franchise; LCR ratio remains a concern

FB’s deposit growth was aligned with credit growth and stood at 18% YoY in FY24, driven mainly by 24% YoY growth in term deposits. CASA deposits saw modest growth, accounting for ~30.1% of the mix in 2QFY25. Despite the RBI’s embargo on its partnership with OneCard, FB’s strong fintech collaborations remain vital for enhancing cross-selling opportunities and attracting strategic partners. With a CD ratio of ~83%, the bank is well-positioned for growth, although its LCR at 112.6% raises concerns, especially with potential RBI regulations that could reduce it by ~1240bp. As per our calculation, if the bank raises necessary deposits to achieve a 110% LCR, its RoA and margins would be affected by 3bp and 8bp, respectively.

Pace of NIM moderation to ease supported by high-yielding mix

Cost ratios to improve gradually; estimate C/I ratio of 50% by FY27

Despite minimal branch additions between FY16 and FY22, FB faced high operational expenses due to significant investments in technology, compliance, and rising wage costs. However, from FY23 to 1QFY25, the bank added 146 branches, demonstrating its commitment to growth and digital infrastructure, resulting in a higher C/I ratio of 54.5% in FY24. With ongoing technology investments and branch expansion, the C/I ratio is expected to remain ~54% in FY25 before gradually declining to 50% by FY27.

Strong underwriting enables healthy asset quality; est. credit cost of 30- 40bp

FB has maintained strong asset quality, with its GNPA/NNPA ratios improving to 2.1%/0.7% in FY24, driven by controlled slippages and robust recoveries. This success is attributed to strategic customer selection and strong underwriting practices, which remain effective even in co-lending partnerships. Under Mr. Srinivasan's leadership, the bank has enhanced its underwriting standards, leading to a gradual decline in gross slippages, particularly in corporate and SME segments, while maintaining a lower unsecured loan mix. With credit costs estimated to be around 30-40bp, we expect GNPA/NNPA ratios at 1.9%/0.6% by FY27.

Valuation and view

* FB posted a 20% CAGR in its loan book during FY22-24 and improved its RoA to ~1.3% in FY24 from 0.9% in FY22, despite NIM pressure and higher cost ratios.

* In Jul’24, FB received the RBI’s approval for Mr. Manian as the new MD and CEO starting Sep’24. With his extensive banking expertise, Mr. Manian is expected to bring strategic improvements and a turnaround at the bank under his leadership.

* We estimate FB to achieve RoA of 1.3% and RoE of 15.2% by FY27, driven by improved margins and a continued shift toward higher-yielding products. As revenue growth outpaces cost growth, we expect the C/I ratio to decrease to ~50% by FY27, down from 54.5% in FY24.

* With current valuations at 1.1x FY26 book value presenting an attractive longterm investment opportunity, FB is well-positioned to leverage its strong balance sheet and extensive customer base for sustainable profitability. Supported by new leadership’s focus on growth, we maintain our BUY rating on the stock with a TP of INR230 (1.5x FY26E ABV).

Business growth robust; est. 18% CAGR in loans

Improving mix of high-yielding products to enable profitable growth

* FB delivered a robust 20% YoY credit growth during FY24, driven by healthy traction across segments. Retail loans grew 20% YoY and the new higheryielding segment posted robust growth, i.e., 73% YoY growth in credit cards, 52% YoY growth in CV/CE, 40% YoY growth in personal loans, and 107% YoY growth in microfinance loans.

* FB aims to enhance its commercial banking vertical by focusing on supply chain growth and high-yielding segments while upholding high-quality risk management to ensure healthy growth in advances. Thus, the share of highermargin products in the portfolio mix improved to 24.8% in FY24 from 19.8% in FY22 (excluding business banking, the high-yielding book stands at ~7% vs. 2.4% in FY22).

* FB's relatively calibrated approach to unsecured loans contrasts with larger private peers, which have a double-digit share of unsecured loans (PL+CC). This presents FB an opportunity to improve its share of high-yielding loans, thereby benefitting on margins. We estimate FB to deliver healthy traction in business growth, enabling it to deliver 18% loan CAGR over FY25-27E.

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