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On the right path

Slow and steady wins the race; initiate with O-PF

Federal Bank is the largest ‘old private sector’ bank in India, with a dominant presence in the southern state of Kerala. While the bank has done well in the past decade, it has been a relatively ‘local’ bank with average profitability. Its strengths lie in its large non-resident deposit franchise and its conservative lending practices. With a new MD and CEO at the helm, the target is to gradually transform into a larger bank with return metrics closer to those of the six large private sector banks. While the near-term outlook is muted, we expect the bank to pluck low-hanging fruit and improve returns over the next three years (~14% ROE in FY27/28CL versus an average of 11% over the past decade). The stock is inexpensive at 1.1x PB/9x PE (FY27). We initiate coverage with an O-PF rating and TP of Rs230 (1.4x PB).

Historically decent performance with strong asset quality

Federal Bank is the largest among the ‘old private sector’ banks in India, having grown faster than peers over the past decade. What makes Federal unique is its strong non-resident (NRE) deposit base, which contributes to 30% of total deposits. The bank also has lesser reliance on bulk deposits than other medium-sized private sector banks. Despite having meaningful corporate exposure, the bank sailed through the corporate credit crisis of the past decade thanks to its low-risk lending philosophy. Its average credit costs of the past 5/10 years are in line with those of high-quality private sector banks like HDFCB.

Focus on capturing low hanging fruit over the next three years

While Federal has a unique deposit franchise, it lags peers in its CASA ratio, particularly CA deposits. With the new CEO at the helm, there is particular emphasis on scaling up current account deposits, with a branch outreach. At the same time, Federal is under-indexed to retail loans compared with large private sector banks. Unlike peers, Federal has barely leveraged its strong deposit base to cross-sell retail loan products. Management will look to tap the opportunity to cross-sell retail loans as well as para-banking products like insurance more actively. These initiatives should help to improve NIM and fees by 25-30bp over FY26-28, in our view

Near-term NIM pressure from rate cuts; profitability to improve from FY27

FY26 will likely be a year of recalibrating the business model as the bank prioritises profitability over loan growth. Coincidentally, NIM will likely also compress in this period, as c.50% of loans are linked to the repo rate. We expect NIM to decline c.20bps over the next three quarters and then improve, as cost of deposits reprice with a lag. We model 17% loan growth over FY25-28 with ROE improving 200bp over the same period. We initiate with an O-PF rating and Rs230 target price. The key risk is a miss on execution in CASA deposits, leading to PAT downgrades.

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