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MFI stress dents earnings; NIM contraction broadly in line

Asset quality slightly deteriorates

*Federal Bank (FB) reported 1QFY26 earnings of INR8.6b (6% miss) amid a spike in provisions (up 177% YoY/190% QoQ), partly offset by contained opex.

* NII was in line, while reported NIM contracted 18bp QoQ to 2.94% (MOFSLe: 2.96%), amid repo rate cuts as well as interest reversal (4-5bp impact). FB remains focused on reorienting its asset mix to improve yields and CASA mix.

* Advances grew 9.2% YoY/2.7% QoQ, led by growth in SME (CoB + BuB), CV, and Gold. Deposits grew 8% YoY/1.3% QoQ. The CASA ratio stood at 30.4%.

* Slippages were elevated at INR6.6b (up 56% YoY/34% QoQ), amid elevated slippages from the MFI book. GNPA/NNPA ratios increased 7bp/ 4bp QoQ to 1.84%/0.44%. The bank’s credit costs increased 39bp QoQ to 0.65%.

* We reduce our earnings estimates by 7%/4% for FY26/27, factoring in a slight margin contraction and elevated provisions. We estimate FB to deliver an FY27 RoA/RoE of 1.18%/13.0%. Reiterate BUY with a TP of INR235 (based on 1.4x FY27E ABV).

CD ratio inches up to ~83.9%; retail deposit mix improves to 71.3%

* FB reported 1QFY26 earnings of INR8.6b (6% miss) amid accelerated provisions owing to MFI stress, partly offset by in-line NII and contained opex.

* NII stood in line at INR23.4b (down 1.7% QoQ/up 2% YoY), while NIM dipped 18bp QoQ (4-5bp impact due to interest reversal) to 2.94% as the bank has fully passed on the 100bp rate cuts (MOFSLe: 2.96%).

* Other income grew 21.6% YoY/10.6% QoQ to INR11.1b (inline), led by healthy treasury income as well as recovery from the written-off assets.

* Opex stood at INR18.9b (down 1.3% QoQ/up 11% YoY, 2.6% lower than estimates). FB expects the C/I ratio to remain in the mid-50s range in the near term. PPoP increased 3.7% YoY/ 6.2 QoQ to INR15.6b (7.5% beat on MOFSLe).

* On the business front, advances grew 9.2% YoY/2.7% QoQ to INR2.4t, while retail was largely flat QoQ. Within retail, credit cards grew faster at 8.5% QoQ (up 18.8% YoY), while housing/mortgages remained broadly flat/declined marginally on a sequential basis. Growth in SME stood at 3.6% QoQ.

* Deposits grew 8% YoY/1.3% QoQ, driven by SA deposits (up 4.2% QoQ), while the CA book declined 6.3% QoQ. The CASA mix improved marginally to 30.4% (up 12bp QoQ), while the LCR ratio contracted to 132.5% (down 9.5% QoQ).

* Slippages increased to INR6.6b vs INR4.9b in 4QFY25, amid higher slippages from MFI. GNPA/NNPA ratios increased by 7bp/4bp QoQ to 1.84%/0.44%, while the restructured book declined to 0.55% (down 6bp QoQ). Credit costs increased to 0.65%.

Highlights from the management commentary

* FB underwent faster repricing of loans due to the T+1 policy; the cost of funds has also significantly reduced. Management expects NIM contraction to be limited to 5-10bp in 2QFY26.

* Loan book pricing: 48% are EBLR-linked loans, and FB expects the same to reduce going forward. About 33% of the loan book is fixed-rate in nature.

* MFI stress has begun to show in 4Q and spurted in 1QFY26. June and July have seen a drop in slippages, while May recorded the highest slippages in MFI.

* The intention is to have growth at 1.2-1.5x of nominal GDP growth. Credit cost guidance is at 55bp for FY26. The C/I ratio will continue to remain in the mid-50s.

Valuation and view: Reiterate BUY with a TP of INR235

FB reported a weak quarter, impacted by higher-than-expected provisions and a sharp decline in NIM. Loan growth was primarily driven by strong traction in the SME segment (CoB + BuB), along with Gold and Agri portfolios, while the MFI book contracted due to rising stress. Deposit growth remained modest, supported by healthy traction in SA balances, although the seasonal outflow in the CA book (post 4Q) led to only a marginal improvement in the CASA mix. NIM contracted due to repo rate cuts and T+1 loan repricing, with the bank guiding a further 5-10bp dip in NIM in 2QFY26. Asset quality weakened due to stress in the MFI segment, resulting in elevated credit costs during the quarter, although the PCR ratio remained stable. We believe near-term headwinds will persist, but expect the trajectory to improve in the second half, supported by a recovery in margins and delinquency rate. We reduce our earnings estimates by 7%/4% for FY26/27, factoring in a slight margin contraction and elevated provisions. We estimate FB to deliver an FY27 RoA/RoE of 1.18%/13.0%. Reiterate BUY with a TP of INR235 (based on 1.4x FY27E ABV).

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