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Spark Capital: Federal Bank: Valuations largely price in the negatives; Upgrade to BUY




Spark Capital Advisors(India) Private Limited


17 Apr 2013





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Federal Bank: Valuations largely price in the negatives; Upgrade to BUY We have stubbornly held the contrarian view over the past 18 months that the right price to pay for the slow nature of turnaround in the Federal Bank story is ~1x forward ABV and not more. We had questioned the street’s extrapolation of the improvement in the incremental loan book quality brought about by the new management to the entire loan book. Our last Buy rating was in Oct’11 at Rs. 352 (1x FY13 ABV) and since our downgrade in early 2012 at Rs. 399, the stock has underperformed on an absolute/ relative basis right through. We think the recent correction in the stock price, for reasons we do not attach material impact (explained in ensuing slides), again presents an attractive entry price. Though the stock is priced marginally above our most preferred price of 1x FY14E ABV, it is in our comfort zone and we would recommend investors to buy now. Upgrade to Buy. The reason we have had this selective positive stance on Federal Bank is because of the ‘two steps forward, one step back’ nature of turnaround that the bank has been witnessing, which we expect to continue going forward as well. This means that the direction is positive but the pace of change should be slow and as a result, investors are better off not paying elevated multiples as a structural re-rating of multiples would unlikely to be swift. To put it in perspective, when the current management team took over, the RoA during the quarter ended Sept’10, was 1.3% with NIMs of 4% and credit costs of 2.3% whereas, more than 2 years later, for the quarter ended Dec’ 12 the RoA remained at 1.3% with lower NIMs of 3.2% and improved credit costs of 1.2%. This, in our view, reflects the management’s well intentioned but highly challenging restructuring strategies of transforming the bank’s economics and risk-reward framework from a high risk customer-high margin-high credit costs way of doing business to a low risk customer-low margin-low credit cost model. We see the bank getting the jugglery act between growth-NIMs-credit costs-RoA right over an extended period of time and believe that current valuations factor the reality fairly enough. We think the reasons which have contributed to the stock’s recent correction, 1) gold price fall and 2) Saudi Arabia’s Nitaqat program are not material enough to impact the financial performance. Gold needs to fall another 25% for RoAs to be meaningfully impacted and the Nitaqat program, even if extended to more Middle-East countries is unlikely to have a material impact on the remittance flows to the bank.

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