Kotak Securities maintains ‘buy’ on Federal Bank with unchanged fair value of Rs 80

Holding up well in tough times. Federal Bank reported ~25% YoY earnings decline despite a solid 40% YoY operating profit growth primarily on account of higher provisions, strengthening the balance sheet ahead of the Covid-related slowdown. The balance sheet is well-positioned to handle the Covid stress, in our view. Maintain ‘buy’ (fair value unchanged at Rs80) but we see near-term business performance relatively volatile. Our view that it is likely to emerge stronger post-Covid remains unchanged.

Federal Bank reported ~25% YoY earnings decline mainly driven by high provisions with most of the provisions used to improve coverage ratio and build contingent provisions for Covid. Operating profits grew ~40% YoY led by 22% YoY growth in operating income and 7% YoY cost growth. NII grew 23% YoY while NIM improved marginally QoQ at ~3.1%. Loan growth has slowed to 6% YoY. Asset quality showed improvement with net NPLs at a 5.5-year low at <1%. The bank has indicated that its collections have moved back closer to pre-Covid levels.

Similar to the previous quarter, there is not much to discuss the near-term outlook on asset quality. The bank has provided some early comments on the performance of its loan book with collection levels reaching where it was prior to Covid-19. The bank indicated that it would most likely restructure 2-3% of loans this quarter. These loans mostly are in the SME and retail business. Investors’ scepticism can be addressed if the bank is able to restrict its restructured loan book to the estimates provided by the bank. We are still taking a more conservative approach in our estimates and build in higher credit costs in the medium term but it is quite likely that the bank’s focus on being conservative in recent years would help in delivering better-than-expected performance on asset quality. In our view, the bank should come out of the Covid-19 crisis relatively better.

We maintain ‘buy’ with an unchanged Fair Value (FV) of Rs80. At our FV, we are valuing the bank at 1X book for RoEs on the lower side due to Covid. There has not been much of a price action after bouncing back from the lows seen in March 2020. Valuations are quite undemanding and do not reflect the strength of the franchise. One of the challenges has been its weak return ratios that have been partly hampered by a high cost-income ratio. However, performance on this front is quite positive in the recent quarter, which raises expectations of a faster RoE normalisation as Covid gets behind the bank.

Investors probably would want to get a final assessment of the economic recovery as well as the bank’s own performance on slippages or restructured loans, which implies that there is some room before a possible expansion in multiples takes place. We remain comfortable as the bank is progressing on expected lines.