Motilal Oswal has recommended a BUY rating for Federal Bank, setting a target price of Rs 230, which reflects a 23% upside from the current market price of Rs 187. Federal Bank has demonstrated consistent growth with a focus on increasing its mix of high-yielding products such as credit cards and microfinance loans. Under new leadership, the bank is poised for significant expansion, supported by its fintech partnerships and a robust deposit base. Despite challenges like funding costs and the loan-to-deposit ratio, Federal Bank remains well-positioned to achieve sustainable profitability and improve return ratios by FY27.

Strong Growth Trajectory Over FY22-24

Federal Bank has delivered impressive growth over the last three fiscal years. The bank's loan book grew at a 20% CAGR during FY22-24, supported by a 20% growth in retail loans and significant contributions from high-yielding segments like:

73% growth in credit cards
107% growth in microfinance loans
52% growth in commercial vehicle loans (CV/CE)
The bank's commercial banking vertical has also seen robust expansion, driven by a focus on high-margin products and supply chain financing. The bank’s strategic shift towards high-yielding segments has improved the overall portfolio mix, contributing to enhanced margins.

Rising Contribution of High-Yielding Products

Federal Bank’s cautious approach towards unsecured loans has differentiated it from larger peers, which hold higher shares of personal loans and credit cards. By focusing on high-margin products, Federal Bank has steadily increased its proportion of high-yielding assets. As of FY24, these products, excluding business banking, accounted for 7% of its portfolio, compared to 2.4% in FY22.

This growth in high-yielding products is expected to bolster the bank’s net interest margins (NIMs), which contracted slightly to 3.16% in 1QFY25 due to rising funding costs. However, Motilal Oswal anticipates that NIMs will stabilize at 3.2% as the product mix continues to shift toward more profitable assets.

Fintech Partnerships and Strategic Expansion

Federal Bank views fintech partnerships as a vital growth lever for product distribution, technology integration, and expanding its customer base. The bank’s collaboration with fintech companies is crucial for enhancing cross-selling opportunities and boosting profitability. The lifting of regulatory restrictions on card issuance, expected soon, will further support the bank's growth in this area.

In addition, Federal Bank has been expanding its branch network, adding 146 branches between FY23 and 1QFY25. This expansion, along with continued investments in digital infrastructure, reflects the bank’s commitment to growth and innovation.

Challenges with Loan-to-Deposit Ratio (LCR)

Despite its strong deposit growth, which aligned with loan growth at 18% YoY in FY24, Federal Bank faces challenges with its loan-to-deposit ratio (LCR). The current LCR stands at 112.6%, slightly below the optimal range. The Reserve Bank of India’s proposed regulations, which could increase the run-off factor for deposits linked to mobile and internet banking, may impact the bank’s LCR by ~1,240 basis points.

Motilal Oswal estimates that, if the bank raises additional deposits to restore its LCR to 110%, it will face a 3 basis point reduction in return on assets (RoA) and 8 basis points decline in margins. Nevertheless, the bank's overall liquidity position remains manageable, with an 82% credit-deposit (CD) ratio providing ample room for loan growth.

Cost Ratios and Efficiency Improvements

Federal Bank has historically faced elevated operational expenses due to investments in technology, compliance, and wage costs. However, the bank's cost ratios are expected to gradually improve as it optimizes its operations. The cost-to-income (C/I) ratio, which stood at 54.5% in FY24, is projected to decline to 50% by FY27, driven by improved operating leverage and revenue growth outpacing cost growth.

Additionally, the bank's employee productivity has shown improvement, with business per employee increasing to Rs 304 million in FY24, up from Rs 255 million in FY22.

Asset Quality and Credit Cost Management

Federal Bank has maintained a strong asset quality, with its gross non-performing assets (GNPA) and net non-performing assets (NNPA) ratios improving to 2.1% and 0.7% in FY24, respectively. The bank’s success in maintaining low slippages and robust recoveries reflects its strong underwriting standards.

Credit costs are expected to remain manageable at 30-40 basis points over FY25-27, as the bank continues to maintain a lower unsecured loan mix compared to its larger peers. The estimated GNPA/NNPA ratios are projected to further improve to 1.9%/0.6% by FY27, ensuring stability in the bank’s asset quality.

Valuation and Investment Thesis

Federal Bank has demonstrated a robust return on assets (RoA) of 1.3% in FY24, up from 0.9% in FY22, despite pressures on NIM and higher operational expenses. The bank’s ability to maintain strong fee income growth and low credit costs has been instrumental in achieving this performance.

Motilal Oswal expects Federal Bank to deliver an RoA of 1.3% and a return on equity (RoE) of 15.2% by FY27, supported by:

An increase in high-margin products,
Improved operating leverage,
Continued growth in fee income.
The current valuation of Federal Bank at 1.2x FY26 book value presents an attractive opportunity for long-term investors. The bank’s strong balance sheet, wide customer base, and focus on profitability make it a compelling alternative to larger private sector banks. Backed by the new leadership of Mr. KVS Manian, who brings extensive banking expertise, Federal Bank is expected to drive the next leg of growth and profitability.

Motilal Oswal has reiterated its BUY rating on Federal Bank with a target price of Rs 230, representing an upside potential of 23% from the current market price.