How Federal Bank can earn more than other PSU banks

At a time when most research firms are cautious on banking stocks, Goldman Sachs has initiated a report on Federal Bank with a ‘Buy’ call and a price target of Rs 470 in the next 12 months. The stock currently trades at Rs 383.

Following are the rationale for the Buy call along with the catalysts that can take the stock price higher, according to the report.

Operational changes

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Federal Bank is undergoing restructuring under its new management which involves revamping and improving products, business processes and strengthening risk management.

The bank is focusing on further strengthening its niche areas such as SME (small and medium enterprise), NRI (non-resident Indian) and gold-loan-related businesses over the next three to five years.

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The bank is expanding out of its home turf, Kerala, into select geographies while offering the same product profile.

Re-rating drivers

Lower Non-performing loans (NPL) and one of the highest coverage ratios of 84 percent within Goldman Sachs bank coverage universe. Coverage ratio is a measure of a bank’s ability to absorb potential losses from its non-performing loans.

One of the highest Tier 1 capital ratios, at 15.6 percent, which will help the company grow as economy recovers.

Healthy loan growth of 22 percent CAGR over the next two years, driven by corporate loans and retail gold loans.

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Restructuring can help reduce NPL, which is expected to drive earning 23 percent, higher than other PSU stocks which are expected to post a 20 percent growth.

Federal Bank is likely to have a respectable return on asset (ROA) of 1.2 percent with a potential to surprise on the upside. ROA is an indicator of how profitable a company is compared to its total assets.

Attractive Valuation

Federal Bank currently trades at 1.2 times its adjusted book value. The stock has a potential to be re-rated to 1.5 times its book value, given higher earning growth and better ROA.

Risks

Successful execution of re-structuring strategy.

Strong employee union which have created issues in the past.

Higher slippages, especially in the SME segment, which is already at 5.5 percent.