Why Federal Bank could remain the preferred mid-cap banking stock?

Despite the marginal blip in Q3, the bank scores ahead of its peers such as Karnataka Bank and South Indian Bank

Mid-sized banks have in the past year caught substantial investor attention, because of the benign valuations and improving performance metrics. Among them, Federal Bank emerged as the preferred mid-cap banking stock. 

The bank’s robust leadership, ability to retain its dominance on home ground (Kerala) and yet effectively grow its presence in the retail and small business loan categories have been well-accepted by investors. This is why, even if investors could be a tad disappointed with the bank’s December quarter (Q3) results, which have marginally trailed the Street’s expectations, a majority of analysts remain positive on the stock. 

Net interest income at Rs 9.5 billion grew by 20 per cent year-on-year (y-o-y), while net profit expanded by 26 per cent to Rs 2.6 billion in the December quarter. Q3’s net interest income is the strongest performance by Federal Bank in recent times. Considering peers such as South Indian Bank and Karnataka Bank, which have so far declared Q3 results, Federal Bank’s show is more convincing on all key parameters.

The bank’s ability to broad-base its loans and grow its deposits to a reasonable size over a period of a time are aiding growth. Wholesale or corporate loans account for a chunk of the loan book (40 per cent), while the rest is contributed by retail loans and loans to small and medium enterprises (SMEs), which have played a key role in aiding the bank's overall loan growth at 22 per cent y-o-y in Q3. While Kerala remains a key market, Federal Bank has seen reasonable success in expanding its presence outside the state too, a factor which is pronounced in the SME and retail loans segments. Federal Bank needs to keep pace with this trend to drive growth.

A strong liability franchisee is also helping the bank. While the share of low-cost Casa (current account savings account) deposits at 33 per cent may be lower than that of front-line banks, it hasn’t quite upset the lender’s profitability. This is despite yield on advances remaining unchanged at 9.5 per cent in Q3. For one, blended cost of deposits at 5.7 per cent is among the lowest in the industry and is helping it maintain net interest margins (NIMs) at over three per cent. An improvement in Casa ratio to 35 per cent, as planned by the management, could further support NIMs.

The two worrisome points, though, are the wavering cost-to-income ratio and asset quality. Q3’s cost-to-income ratio climbed to over 52 per cent after hovering at less than 51 per cent for the most of FY18. Faster progress with its distribution model is essential to curb the ratio at sub-50 per cent. Likewise, if surprises such as waiver on education loans announced by the Kerala government in July 2017 don’t occur too often, asset quality should also improve in the coming quarters.

These factors should help the bank stay ahead of its peers and remain a preferred mid-cap banking stock, says R Sreesankar, head of institutional equities at Prabhudas Lilladher. “Federal Bank has got most of its act right,” he says.