Why Federal Bank is our top pick among mid-cap banks
Federal Bank reported a solid quarter in Q4 FY19, largely putting to rest concerns about the quality of its book due to the bad loan crisis in the corporate space and impact of Kerala floods. The result ticked all the right boxes with the bank reaching 1 percent RoA as per its earlier guidance. With attractive valuation at 1.2X FY21 book, Federal Bank remains our top pick in the mid-cap banking space.
Asset quality showed remarkable improvement. Slippage declined significantly in the quarter and recovery was strong. Consequently, the ratio of gross and net NPA declined to 2.92 percent and 1.48 percent respectively from 3.14 percent and 1.72 percent respectively in the previous quarter. Credit cost declined to a low of 51 basis points despite an increase in provision coverage ratio (the amount of provision held against NPA). The total quantum of stressed assets (including restructured and Security Receipts) also fell to 1.71 percent of average assets.
The bank’s largest exposure to IL&FS (Rs 210 crore) is in an operating asset; on its relatively smaller exposure of little over Rs 32 crore in two other assets, the bank is carrying provision of Rs 21 crore. The management has clarified that it has no exposure to Essel group, Jet Airways or Reliance ADAG.
Core performance remained satisfactory with net interest income growing by 17 percent aided by good growth in advances and YoY improvement in interest margin by 6 basis points to 3.17 percent. Margin remained stable over the previous quarter.
Non-interest income growth of 31 percent was supported by decent growth in core fees at 21 percent as well as good show from treasury. Recovery from written off accounts also contributed meaningfully and the bank expects this trend of strong recovery to sustain.
Business growth remains healthy. While the bank has an absolute share of 1.1 percent both in system’s advances and deposits, its share of the incremental market is higher, thereby pointing to market share gains.
In the quarter gone by, advances grew 20 percent driven by retail as well as corporate. The bank targets to have a balanced portfolio between retail, corporate and SME (small & medium enterprises). While growing in a balanced manner, the book is getting de-risked, which is evident from the decline in the ratio of risk weighted assets to total assets.
Deposits growth too was healthy at 20.5 percent resulting in a very respectable credit to deposit ratio of 83 percent, which is one of the best amongst its peer group banks.
Strong core performance and reduction in credit cost as a result of improvement in asset quality enabled the bank to report 1 percent RoA (return on assets) in the final quarter of FY19 and it expects 10-15 basis points RoA improvement every year.
The improvement in the risk profile of the book has resulted in lower capital consumption. Consequently the bank is sitting on a healthy capital adequacy ratio of 14.14 percent that can take care of its growth for next couple of years without raising fresh capital.
Deposits have grown well, but the low cost-deposits (CASA, current and savings accounts) have shown a lower growth. While current account has grown faster than overall deposits growth, savings account has lagged, and management attributed the same to a slowdown in the key market of Kerala post flood.
The CASA share has fallen 110 basis points YoY and sequentially to 32.2 percent. This is an area that merits attention as a strong liability profile will remain the key differentiator in this highly competitive market where every bank is targeting better quality of assets.
There was a spike in the gross NPA in the agricultural portfolio which too was largely attributed to the Kerala market.
On its guided path, Federal Bank has been gradually improving its RoA. It is taking initiatives to counter the falling yields by foraying into relatively high margin businesses like unsecured retail credit and CV (commercial vehicle) financing, While keeping an eye on the quality of the book. Hence, we expect earnings to receive support from declining credit costs in the future. The strategic focus on improving non-interest income (stake in Equirus Capital – a boutique investment firms and getting a partner in its non-banking subsidiary FedFina to scale up the business) should stand it in good stead. We derive comfort from the current valuation and would strongly recommend adding the stock to the portfolio of investors.