IGI Logo

Navigating Near-term Challenges; On Track to Deliver 1.4% RoA by FY28

Est. Vs. Actual for Q1FY26: NII – INLINE; PPOP – BEAT; PAT – MISS

Changes in Estimates post Q1FY26

FY26E/FY27E (in %): NII: -1.8/-3.7; PPOP: -2.4/-3.7; PAT: -7.7/-6.5

Recommendation Rationale

• Rate Cuts Largely Priced In; Lower NIM Compression in Q2: FB’s NIMs declined sharply by 18bps sharply owing to a 27bps drop in yields and a 4-5bps impact of interest reversals. This was partially offset by a 20bps decline in CoD. With the bulk of the repo rate cut impact reflecting in the yields (given pass-on is on a T+1 basis), the quantum of NIM compression in Q2 is expected to be significantly lower at 5-10bps. Resultantly, NIMs will bottom out in Q2, assuming no further rate cuts. The SA rate cut taken in mid-Jun’25 is yet to reflect in the CoF, and should enable the bank to cushion the dent on margins. With TD repricing kicking in from the forthcoming quarters, NIMs are expected to improve gradually over H2. FB has seen a gradual shift in its portfolio mix from EBLR loans declining to 48% vs 52% in Mar’24 and a corresponding increase in the fixed rate portfolio to 33% from 27%. Going ahead, the management sees levers to further decrease the share of EBLR loans, as the growth in the fixed-rate Gold, CV, and Car Financing portfolio gathers pace. Moreover, the gradual shift towards mid-yielding segments (mix improvement of 50-60bps in Q1) along with improving mix of CASA deposits, should also provide support to NIMs. We expect FB’s margins to range between 3.0-3.3% over FY26-28E.

• MFI Stress Peaks Out, Overall Asset Quality Not Worrisome: In Q1, elevated credit costs were primarily owing to the higher MFI agri slippages. ~20% of the MFI portfolio is concentrated in KA, a major contributor to the stress. Kerala (KL) constitutes ~30% of the MFI portfolio, where asset quality metrics remain under control. However, FB has proactively tightened its underwriting norms in KL. The management has highlighted that MFI slippages have peaked in May’25 and have been trending downwards MoM over JunJul’25. Similarly, the SMA pool and Collection Efficiency in the MFI book have been on an improving trend, possibly indicating that the worst is now behind. In the Business Banking and CV portfolio, the bank has seen a slight increase in stress; however, it is not alarming. FB continues to tightly monitor these portfolios for any emerging signs of stress. Apart from these portfolios, asset quality continues to remain largely stable. The management has guided for 55bps credit costs for FY26

Sector Outlook: Positive

Company Outlook: The bank’s strategy re-orientation under the new management is seeing green shoots across most key metrics. While growth is expected to be slightly muted in FY26, largely owing to unfavourable macros, we expect credit growth to bounce back from FY27 onwards. While near-term challenges will keep RoA/RoE delivery subdued in FY26 at ~1.1%/~11%, we expect FB’s RoA/RoE to improve and between 1.3-1.4%/13-15% over the FY27-28E. This is likely to be driven by (1) Healthy risk-adjusted credit growth, (2) Margin improvement levers playing out with portfolio mix shift towards better-yielding segments and lower CoF, (3) Strong Deposit Franchise with improved CASA Mix, (4) Strengthened Fee income profile, and (5) Stable asset quality metrics, keeping credit costs under control. We believe the risk-reward is favourable at

current valuations. Current Valuation: 1.4x FY27E ABV Earlier Valuation: 1.3x FY27E ABV

Current TP: Rs 240/share. Earlier TP: Rs 230/share

Recommendation: We maintain our BUY recommendation on the stock.

Alternative BUY Ideas from our Sector Coverage

DCB Bank (TP – Rs 165); City Union Bank (TP – Rs 270); IDFC First Bank (TP – Rs 83)

Financial Performance:

? Operating Performance: Federal Bank’s (FB) credit growth continued to remain muted, growing at 9/3% YoY/QoQ. Deposit growth was slower at 8/1% YoY/QoQ. SA deposit growth was strong at 11/4% YoY/QoQ, while CA grew by 17/-6% YoY/QoQ. Overall, CASA deposits grew by 12/2% YoY/QoQ and TDs grew by 6/1% YoY/QoQ. Thus, the CASA ratio remained steady at 30% vs 30.2% QoQ. LDR stood at 85.1% vs 84.0% QoQ

? Financial Performance: NII grew by 2/-2% YoY/QoQ, with NIMs compressing sharply by 18bps QoQ. Yields declined sharply by 27bps QoQ, while CoD/CoF improved by 20/21bps. Reported NIMs stood at 2.94% vs 3.12%. Non-interest grew by 22/11% YoY/QoQ, led by treasury gains. Core fee growth (+21/-2% YoY/QoQ) was muted, in line with soft business growth. Opex growth was modest at 11/-1% YoY/QoQ., led by lower other expenses. C-I Ratio improved to 54.9% vs 56.7% QoQ. PPOP grew by 4/6% YoY/QoQ. Provisions grew significantly QoQ with credit costs at 67 bps vs 27/24bps YoY/QoQ. This was higher owing to higher provisions for MFI slippages. Earnings growth decelerated and PAT de-grew by 15/16% YoY/QoQ.

? Asset quality deteriorated marginally with GNPA/NNPA at 1.91/0.48% vs 1.84/0.44% QoQ. Slippages during the quarter were elevated at Rs 658 Cr vs Rs 483 Cr QoQ. Slippage ratio for the quarter stood at 1.1% vs 0.8% QoQ. Slippages were higher in the retail (seasonal) and agri MFI book.

Key Takeaways

Growth Momentum to Pick up Pace in H2: In line with the strategic initiative, the bank has realigned its growth in the retail portfolio and is ready to push for strong growth from H2 onwards. Similarly, the bank will also look to pursue strong growth in the mid-yielding segments. As the macro environment turns favourable, FB will look to accelerate growth in the higher-yielding segments. While the business banking segment, which is the lower-end SME segment, is not seeing any worrisome asset quality trends thus far, the bank has been growing cautiously. FB has strengthened the leadership and sales team in this vertical and will look to resume growth. The company believes the risk-reward in the commercial banking portfolio (upper-end SME) is more favourable, thereby facilitating higher growth in the segment. Given uncertain macros, FB expects to grow at 1.2x of nominal GDP in FY26. However, supported by improving consumption demand and favourable macros, FB will aim at growing the book at 1.2-1.5x nominal GDP on a steady state basis. We expect FB to deliver a healthy 16% CAGR credit growth over FY25-28E.

Fee Income Profile Strengthening Underway: In line with the bank’s revamped strategy to strengthen the core fee income profile, FB has recalibrated its fees to align with peers and also renegotiated with certain partners' fee structures. The bank has started to see green shoots in terms of a healthy pick-up in fee income and expects the trend to sustain. Moreover, disbursement momentum is improving, a pick-up in the credit card vertical, scale-up of wealth management and bolstering of the trade and forex vertical should support sustainable core fee income growth for the bank.

Opex Ratios to remain at Mid-50%: FB continues to remain in the investment phase and expects this to reflect in the Opex ratios. However, focus will remain on optimising resources and improving efficiency, driving the cost ratio. The management has guided for the C-I Ratio to remain steady at mid-50%.

Outlook

We expect credit growth to pick up healthily and the strategy around the deposit franchise to deliver, thereby driving strong 16% CAGR credit/deposit growth each over the medium term. The strategic and conscious shift towards midyielding segments and the ability to gradually scale up the higher-yielding segments augur well from a margin perspective. Assuming near-term headwinds and unfavourable macros dampening growth momentum, we trim our growth estimates for FY26 by ~3%, while building a strong growth rebound from FY27E onwards. s We trim our NII/Earnings estimates by ~1-4%/6-7% over FY26-27E. We expect credit costs to gradually normalise and settle at 50bps (+/-5bps) over FY26-28E, considering which we revise our earnings estimates lower by 6-7% over FY26-27E. We factor in robust Credit/Deposit/NII/Earnings growth of 16/16/17/18% CAGR over FY25-28E.

Valuation & Recommendation We value the stock at 1.4 x FY27E ABV vs. current valuations of 1.2x FY27E ABV and valuing the subsidiary at Rs 10/share to arrive at a target price of Rs 240/share, implying an upside of 22% from CMP. We recommend a BUY on the stock. At current valuations, risk-reward appears favourable.

Key Risks to Our Estimates and TP

• The key risk to our estimates remains a slowdown in overall credit momentum, which could potentially derail earnings momentum for the bank.

For More Axis Securities Disclaimer https://simplehai.axisdirect.in/disclaimer-home SEBI Registration number is INZ000161633