Federal Bank Gets ‘Buy’ Rating from Motilal Oswal with ₹230 Target

Motilal Oswal is positive on Federal Bank and has given it a “Buy” rating, with a target price of ₹230, as stated in their report dated October 11, 2024.

High-Yield Products to Boost Profits

Federal Bank (FB) has shown strong growth from FY22 to FY24, with its loan book growing at a 20% annual rate, and deposits increasing by 18%. From FY25 to FY27, the bank is expected to maintain an 18% growth rate in loans, thanks to good risk management and partnerships with fintech companies.

The bank is working with fintech firms to expand its product distribution, improve technology, and reach more customers. It expects to benefit from upcoming changes that will allow it to issue cards again.

Although new rules related to the Liquidity Coverage Ratio (LCR) could affect the bank’s LCR by about 12.4%, Federal Bank could restore its LCR back to 110% by raising deposits. In that case, the bank’s return on assets (RoA) and profit margins would decrease slightly.

In July 2024, the Reserve Bank of India (RBI) approved KVS Manian as the new Managing Director and CEO, starting in September 2024. With his banking experience, Mr. Manian is expected to drive new growth and increase the bank’s profitability.

By FY27, Federal Bank is estimated to achieve a return on assets of 1.3% and a return on equity of 15.2%. Given the bank’s current valuation, it presents an attractive long-term investment opportunity. Therefore, Motilal Oswal maintains its “Buy” rating with a target price of ₹230, based on 1.5x of the bank’s expected FY26 adjusted book value.

Growth in Loans and High-Yield Products

Federal Bank achieved a solid 20% growth in its loans in FY24, with retail loans increasing by 20% and high-yield segments like credit cards growing by 73%. Microfinance loans also saw a significant rise of 107%. The bank is focusing on high-margin products, which now make up nearly 25% of its total portfolio.

The bank’s cautious approach to unsecured loans, compared to larger banks, positions it well to continue boosting its high-yield loan mix and profit margins. Therefore, an 18% growth rate in loans is expected from FY25 to FY27.

Strong Deposit Growth, But LCR Remains a Concern

Federal Bank’s deposits grew by 18% in FY24, in line with its credit growth. Most of this growth came from a 24% rise in term deposits, while CASA (current account savings account) deposits showed more modest growth, making up about 30.1% of the total.

The bank’s collaboration with fintech firms remains a crucial part of its strategy to cross-sell products and bring in new partners. Despite some challenges, like the RBI’s halt on its partnership with OneCard, Federal Bank is well-positioned for future growth.

The bank’s LCR stood at 112.6%, but potential regulatory changes could reduce this by 12.4%. If the bank raises enough deposits to meet the 110% LCR target, its return on assets and margins would only be slightly affected.

Margins Supported by High-Yield Loans

Federal Bank’s net interest margin (NIM) dropped to 3.16% in Q1 FY25, mainly because of rising funding costs due to a lower CASA ratio. However, the rate of decline in margins has been slowing. The bank is focusing on increasing its high-yielding loans to strengthen its margins, which are lower than those of its bigger competitors.

Cost Efficiency Expected to Improve

Despite limited branch additions from FY16 to FY22, Federal Bank faced higher operating expenses due to investments in technology and higher wage costs. However, from FY23 to Q1 FY25, the bank added 146 branches, showing its commitment to growth. The cost-to-income ratio is expected to gradually decline to 50% by FY27 from 54.5% in FY24.

Strong Asset Quality

Federal Bank has maintained strong asset quality, with its gross non-performing asset (GNPA) ratio improving to 2.1% and net NPA (NNPA) ratio improving to 0.7% in FY24. This improvement was driven by controlled loan defaults and good recoveries. The bank’s careful customer selection and strong lending practices have kept its loan quality high. With an estimated credit cost of 30-40 basis points, the GNPA and NNPA ratios are expected to improve further by FY27.

Valuation and Outlook

• Federal Bank’s loan book grew at a 20% annual rate between FY22 and FY24, and its return on assets improved to 1.3% in FY24, despite pressure on margins.
• With new leadership and a focus on growth, the bank is expected to continue improving profitability. Its return on equity is projected to reach 15.2% by FY27.
• Federal Bank’s current valuation at 1.2 times its expected FY26 book value makes it an attractive investment. As a result, Motilal Oswal recommends buying the stock with a target price of ₹230.