federal bank (fedban) - icici...

November 19, 2010

ICICIdirect.com | Equity Research

Initiating Coverage

Rating Matrix Rating : Strong Buy

Target : | 563 Target Period : 12-15 months Potential Upside : 24%

Performance highlights (| Crore) FY10 FY11E FY12E FY13E

NII 1411 1707 2065 2564

PPP 311 377 443 526

PAT 465 584 724 957

Stock Data Bloomberg Code FB:INReuters Code FED.BOFace Value (Rs) 10Market Cap (Rs cr) 7,78052 week H/L 501 / 223Sensex 19,865Average volumes (BSE) 1,058,391

Comparative return matrix (%) Company 1m 3m 6m 12mFDB 6.8 36 86.5 91.9South Indian Bank 1.3 30.8 86.5 91.9Dhanalakshmi Bank -5.3 -2 21.3 22.5Karnataka Bank 6.4 9.7 27.9 51.4 Price movement

1000200030004000500060007000

Oct-0

9

Dec-

09

Feb-

10

Apr-1

0

Jun-

10

Aug-

10

100

200

300

400

500

Nifty FDB

Analyst’s name

Kajal Gandhi [email protected]

Viraj Gandhi [email protected]

Mani Arora [email protected]

On the fast track… The Federal Bank (FDB), a Kerala-based private sector bank, is perfectly poised to enter into a high growth phase given the ongoing operational restructuring, strong focus on the high-margin retail and SME segment and expanding geographical presence. We forecast FDB will grow its business mix at 23% CAGR in FY10-13E. With the pick-up in the domestic credit market and stable macroeconomic outlook for Middle East countries, we expect the bank to improve its leverage. This will help FDB to increase its RoE to 18% in FY13E from a trough of 10% in FY10. We forecast NIMs will remain high at 4% in FY13E.

Process restructuring, change in management to improve return ratios FDB is rapidly changing into a new-age bank given the focus on diversified business portfolio, technology-driven operational processes and improvement in geographical presence. In our view, the stage is set for incumbent CEO Shyam Srinivasan to lead the bank into the next level of high growth phase. We expect FDB to show a strong operational performance with NII growth of 22% CAGR over FY10-13E, supported by high share of low cost deposits (~45% of total deposits). During FY10-13E, we forecast loan growth of 23% CAGR to | 49,786 crore and deposits posting 22% CAGR to | 66,256 crore.

Slippages likely to come down in FY12E-13E The management expects slippages to remain high in FY11E due to high system generated NPAs, leading us to forecast GNPA of 3.2% in FY11E vs. 3.1% in FY10. However, we expect asset quality concerns to recede in FY12E-13E due to the revamping of the bank’s credit disbursal policy and improving loan monitoring system. As a result, we forecast GNPA of 2.7% in FY13E. Also, the high provision cover of 82% in H1FY11 provides strong support to balance sheet growth, going forward.

Valuations At the CMP of | 455, the stock is trading at 1.5x FY13E P/ABV. The bank with higher return ratios (RoA of 1.3%) and branch profitability compared to peers (Exhibit 33) commands a premium multiple. We expect FDB to improve its RoE and RoA to 18% and 1.4%, respectively, in FY13E by leveraging its equity base and forecast NIM at 4%. We have valued the bank at 1.8x FY13E ABV and initiated coverage with a STRONG BUY rating and a target price of | 563.

Exhibit 1: Key Financials FY09 FY10 FY11E FY12E FY13E

Net Profit (| cr) 500 465 584 724 957EPS (|) 29.3 27.2 34.1 42.3 56.0Growth (%) 36.0 -7.2 25.6 24.1 32.2P/E (x) 15.5 16.8 13.3 10.7 8.1ABV (|) 248.6 266.4 274.0 291.1 313.1Price / Book (x) 1.8 1.7 1.6 1.5 1.4Price / Adj Book (x) 1.9 1.7 1.7 1.6 1.5GNPA (%) 2.6 3.0 3.2 3.0 2.7NNPA (%) 0.3 0.5 0.6 0.4 0.4RoNA (%) 1.4 1.1 1.2 1.3 1.4RoE (%) 12.1 10.3 12.2 14.4 17.9

Source: Company annual reports, ICICIdirect.com Research, *Standalone financials

Federal Bank (FEDBAN) | 455

ICICI Securities Limited


Company Background Incorporated in 1931 in Kerala, The Federal Bank (FDB) is a one of the oldest private sector banks in India with a network of 719 branches and 761 ATMs. The bank has a total business mix of | 63750 crore (H1FY11) and derives a majority of its business from Kerala (~47% of business mix). FDB has employee strength of 7,896 (March 2010).

In September 2006, FDB acquired Maharashtra-based Ganesh Bank of Kurundwad (with a branch network of 20) in order to diversify its geographical base. Although the bank has improved its presence across India, the majority of the branches are still concentrated in the southern states (~77%).

FDB entered into the insurance business in November 2006 by acquiring a 26% stake in a joint venture (JV) with India-based IDBI Bank (48% stake) and Belgium-based Ageas Insurance (erstwhile Fortis Insurance International NV). The total amount invested by the three companies was | 450 crore and the entity had issued over two lakh policies with combined sum assured of ~| 9,160 crore (Q1FY11). Further, FDB collaborated with Geojit BNP Paribas Financial Services (an India-based brokerage house) to introduce an online trading facility, Fed-e-Trade, for its customers in September 2008.

Key management change FDB received approval from The Reserve Bank of India (RBI) for the appointment of Shyam Srinivasan as the new MD and CEO of the bank after the retirement of M Venugopalan in July 31, 2010. Mr Srinivasan joined FDB in September 2010. Prior to joining FDB, he was the country manager at Standard Chartered Bank where he was responsible for its consumer business division. Mr Srinivasan has considerable experience in the consumer banking business such as retail lending, SME banking (FDB’s forte) and wealth management in the domestic as well as international market.

Exhibit 2: Region-wise branch network (H1FY11)

Rural 17%

Semi-urban46%

Urban22%

Metro15%

Source: Company quarterly presentation,,ICICIdirect.com Research

Exhibit 3: Region-wise ATMs network (H1FY11)

Metro14%

Urban29% Semi-

urban46%

Rural 11%

Source: Company quarterly presentation,,ICICIdirect.com Research

Share holding pattern (Q30)

Shareholder Holding (%)Promoters -Institutional investors 51.3General public 48.7

FII & DII holding trend (%)

37 4037 36

14 14 13 12

10

20

30

40

50

Q3FY10 Q2FY10 Q1FY10 Q4FY09

(%)

FII DII

Shareholding pattern (H1FY11)

Shareholders Holding (%)Institutional Investors 60.7Others 39.3

Institutional holding trend (%)

3436 37 37

2326

1824

0

10

20

30

40

Q3FY10 Q4FY10 Q1FY11 Q2FY11

(%)

FII DII




Exhibit 4: Business segment – FDB Tie

Source: Company quarterly presentation, ICICIdirect.com Research

Exhibit 5: Evolution of FDB


1931 1959 1970 1989 1994 2002 2002 2006 2006 2008 2008

Commenced operation

Became a Scheduled

Commercial Bank

Came with an IPO which was

oversubscribed 60 times, Started

leasing business

Bonus share of 2:1

Acquired Ganesh Bank of Kurundwad in

Sept 2006 and entered into Life

Insurance JV with IDBI & FORTIS in Nov

2006

Association with M/s Geojit Financial Services to provide online stock trading

facility in Sept 2008

Completed 1:1 rights issue in

January 2008 and opened first

representative Office at Abu Dhabi, UAE

Licensed under Section 22 of the

Banking Companies Act, 1949

Commenced merchant banking

operations

All the 412 branches were fully

computerised

FDB issued 18 million GDR (for US$ 71.5

million) and 2 million GDR with green shoe option (for ~US$ 8.5 million) in Jan 2006.

Each GDR were priced at US$ 3.97 (| 175)

2010

Appointment of Mr. Shyam Srinivasan

(ex- Standard Chartered) as CEO

and MD

FDB

Core Business

2% stake each in South Indian, Catholic

Syrian and Laxmi Vilas bank

Capital Markets

26% stake in a JV with IDBI and Ageas

Insurance

5% stake in United Stock Exchange

Tie-up with Geojit BNP Paribas for retail

broking

Life Insurance



Investment Rationale We believe FDB’s return ratios are set to improve during FY11E-13E driven by the induction of a new CEO, improving credit standards and the ongoing operational restructuring, which is expected to improve product focus and enhance productivity. As a result, we forecast RoE and RoA at 18% and 1.4% in FY13E, respectively. FDB witnessed a healthy RoE of 23% during FY05-07, which successively deteriorated during the next three years and bottomed at 10% in FY10. The decline was triggered after the rights issue (worth | 2,142 crore in the ratio of 1:1) offered by the bank in January 2008.

With ~45% of total deposits as low cost deposits, high margins of 4% and decline in GNPA to 2.7% in FY13E despite high dependence on retail and SME sectors, FDB presents a significantly attractive franchise as compared to its peers. We expect the business mix to grow higher than industry at 23% CAGR to | 116,043 crore and PAT to grow at 27% CAGR to | 957 crore in FY10-13E.

Improving return ratios backed by better business fundamentals FDB enjoys superior business fundamentals vis-à-vis its peers in terms of better RoA (1.3% in Q2FY11), healthy NIM (4.4%), low-cost deposits franchise (~45% of the total deposits) and strong CAR (17.2%). Further, the bank is currently undergoing operational restructuring. This is aimed at streamlining business processes, improving the product focus and strengthening credit quality, which is expected to fuel robust growth starting FY12E.

Also, with the rising opportunities in the domestic market, a stable macroeconomic environment in the Middle East and high C/D ratio (76% in H1FY11), we believe the bank will be able to leverage its equity base (asset to equity ratio to rise to 13% in FY13E vs. 9% in FY10). As a result, we expect FDB’s RoE and RoA to improve to 18% and 1.4% in FY13E, respectively.

FDB’s topline was negatively impacted by the global economic slowdown (during 2009-10) and the subsequent Middle East crisis, which led the bank to adopt a conservative growth strategy. With significant pressure on the topline and rising taxes, FDB’s PAT declined by 7% to | 465 crore in FY10. Now, with the induction of a new CEO and the bank’s aggressive plans ahead, we see better capital utilisation in a growing economy. As a result, we expect FDB’s PAT to grow at 27% CAGR to | 957 crore in FY10-13E. This would push up the RoE to 14% in FY12E and 18% by FY13E.

Return ratios to gain significant traction in FY13E after witnessing a slow down during FY08-10

Exhibit 6: Higher return ratio expected in FY13E due to improving leverage and…

5.0

10.0

15.0

20.0

25.0

FY05 FY06 FY07 FY08 FY09 FY10 FY11E FY12E FY13E

(%)

0.4

0.8

1.1

1.5

(%)

ROE (LHS) ROA (RHS)

Source: Company annual reports, ICICIdirect.com Research

PAT to grow at 27% CAGR during FY10-13E driven by the strong business fundamentals, improvement in leverage and new leadership on board



The bank always managed to maintain RoA of over 1% but the leverage was high during FY05-07, which warranted dilution in FY08. The dilution coupled with a slowdown in business growth during FY08-10 led to lower RoE of 10%. We anticipate a turnaround in the business growth cycle and expect RoA of 1.4% and RoE of 18% for FY13E.

Exhibit 7: …strong growth of 27% CAGR in PAT during FY10-13E

90

225293

368

500 465

584

724

957

0

200

400

600

800

1000

1200

FY05 FY06 FY07 FY08 FY09 FY10 FY11E FY12E FY13E(|

Cro

re)


Exhibit 8: RoE decomposition FY05 FY06 FY07 FY08 FY09 FY10 FY11E FY12E FY13E

Net interest income/ avg total assets 6.0 3.2 3.1 3.0 3.7 3.4 3.6 3.6 3.7

Non-interest income/ avg total assets 2.5 1.2 1.3 1.4 1.4 1.3 1.2 1.1 1.1

Net total income/ avg total assets 8.5 4.4 4.5 4.4 5.1 4.7 4.8 4.7 4.7

Operating expenses/ avg total assets 3.7 1.9 1.8 1.6 1.6 1.6 1.7 1.7 1.7

Operating profit/ avg total assets 4.8 2.4 2.7 2.8 3.5 3.1 3.1 3.0 3.1

Provisions/ avg total assets 3.4 0.9 0.9 1.0 1.3 1.0 1.3 1.1 1.0

Return on avg assets 1.1 1.2 1.3 1.3 1.4 1.1 1.2 1.3 1.4

Leverage (avg assets/ avg equity) (x) 23.2 19.0 16.6 10.6 8.6 9.2 10.0 11.5 13.0

Return on equity 24.9 22.8 21.3 13.6 12.1 10.3 12.2 14.4 17.9 Source: Company annual reports, ICICIdirect.com Research



…supported by pick-up in business momentum

FDB is aiming to grow its business mix at a higher growth rate than the industry in the next two or three years. We expect the bank’s business mix to grow at 23% CAGR to | 116,043 crore in FY10-13E (vs. 19% CAGR for the industry). This will be backed by 23% CAGR growth in advances (vs. 20% CAGR for industry) to | 49786 crore and 22% CAGR growth in deposits (vs. 18% CAGR for industry) to | 66256 crore.

SME and retail segment to drive growth in advances During FY05-10, FDB’s net advances grew at 25% CAGR to | 26950 crore, which was higher than the industry credit growth of 24% CAGR. The growth in advances was driven by the bank’s well-diversified loan portfolio, primarily divided into large corporates (38% of gross advances in FY10), SME (31%) and retail (31%) segments. According to the management, the SME and retail segments are expected to drive the loan book, going forward, given the bank’s strong focus on these high-margin segments.

Exhibit 10: Loan book growth path

8823 11

736

1489

9

1890

5

2239

2

2695

0

3281

0 4033

1 4978

6

0

10000

20000

30000

40000

50000

60000

FY05

FY06

FY07

FY08

FY09

FY10

FY11

E

FY12

E

FY13

E

(| C

rore

)


Exhibit 11: Break up of loan book

4213

0

4958

0 6763

0 8474

0 1052

30

4971

0

6099

0

6955

0

7382

0

8497

0

2996

0

4220

0

5609

0

7051

0 8614

0

0

20000

40000

60000

80000

100000

120000

FY06 FY07 FY08 FY09 FY10

(Rs

cror

e)

Corporate SME Retail


Further, we believe the significant effort by the bank to streamline its credit disbursal mechanism through central processing centres will improve its credit quality and facilitate better loan disbursement. Also, FDB is planning to introduce specialised corporate credit branches in metros primarily to improve its opportunity as lead banker (vs. traditional role in consortiums) and increase its market share in the non-fund

Business mix to grow higher than the industry during FY10-13E

Exhibit 9: FDB’s business mix to grow higher than industry at 23% CAGR in FY10-13E

2401

5

2961

5

3648

4

4481

8

5459

0

6300

8 7684

0 9416

1 1160

43

0

30000

60000

90000

120000


(| C

rore

)

0.5

0.6

0.7

0.8

0.9

1.0

(%)

Business Mix (LHS) Market Share (RHS)


SME and retail segments are the primary growth drivers of FDB’s loan portfolio



business. The bank has already opened two corporate branches each at Delhi and Mumbai and is planning to open more branches in other metros. With the strong pick-up in the domestic credit environment and comfortable CAR ratio, we forecast FDB’s loan book will grow at 23% CAGR to | 49,786 crore in FY10-13E.

FDB’s retail loan portfolio is tilted towards the housing segment, which constituted ~57% of the total retail portfolio in H1FY11. The high share of housing loans provides stability to the bank’s retail portfolio as they are considered to be secured loans. Unsecured retail loans such as personal and credit card loans form a very small proportion (~1%) of the total loans. Also, gold loans constitute 10.5% of the total retail portfolio, which are secure loans and yield high-margin (~11-12% vs. ~9% on traditional retail loans).

Robust deposit franchise, dominated by low cost deposit About 50% of the FDB’s total deposit accounted for low cost deposit, (~28% CASA and ~22% NRI deposits). Traditionally, the bank has been able to maintain low cost deposits in the range of ~45-50%. This helps them to consistently maintain NIM of ~4% in the last few quarters.

In our view, FDB’s deposit mobilisation will gather pace driven by rising interest rates and the bank’s focus on retail customers through branch expansion plans. The bank has added 60 new branches in FY10 and is expected to add ~200 branches in FY11E-13E. According to the management, the bank is concentrating on Tier II and Tier III cities in order to diversify its deposit base. As a result, we expect FDB’s total deposit to grow at 22% CAGR to | 66,256 crore in FY10-13E.

High share of housing loans provides stability to the bank’s retail loan portfolio

Exhibit 12: FDB’s loan book break up (H1FY11)

Large Corporate

38%

SME31%

Retail 31%


Exhibit 13: Break-up of retail portfolio (H1FY11)

11 5 4 8 6 3 17

57

0

20

40

60

80

Hous

ing

Gold

Over

draf

t

Mor

tgag

e

AAS/

AAD

Car

Educ

atio

nal

Pers

onal

Othe

rs

(%)


Low cost deposit constitutes ~50% of the bank’s total deposit franchise

Exhibit 14: Deposit base to expand by 22% CAGR in FY10-12E

17879 2158425913

5383066256

44031

3605832198

0

15,000

30,000

45,000

60,000

75,000

FY06 FY07 FY08 FY09 FY10 FY11E FY12E FY13E

(| C

rore

)

0

8

15

23

30

(%)

Total deposits (LHS) Growth YoY (RHS)




Strong branch expansion to expand CASA base FDB expanded its branch network from 456 in FY05 to 672 in FY10 and further to 719 by H1FY11. As the bank accounts for ~10% of the total industry branches in Kerala, we believe further branch expansion in the home state is limited. Also, FDB is highly susceptible to concentration risk as ~60% of the bank’s branches are located in Kerala. According to the management, the bank is planning to add ~200 branches in FY11E-13E. Out of this, ~75-80% of the branches will be outside Kerala. This will boost CASA accumulation as the state account for the lowest CASA per branch. Consequently, we expect FDB’s CASA ratio to improve to 30% in FY13E vs. 26% in FY10.

The CASA ratio will improve by ~382 bps to 30% in FY10-13E driven by a rising branch network outside Kerala

Exhibit 15: FDB’s CASA ratio to improve to 30% in FY12E

456 472536

603 612672

772822

872

0

250

500

750

1000


(No

of b

ranc

hes)

20.0

25.0

30.0

35.0

40.0

(%)

Branches CASA ratio (RHS)


Exhibit 16: Kerala accounts for lowest CASA per branch

1013 13 12 12

20

29

0

7

14

21

28

35

Kerala North-East East Central South North West

(| C

rore

)

Source: RBI trend and progress, ICICIdirect.com Research

Area of operation



The share of Kerala in FDB’s business mix is expected to decline steadily as it moves out of the regional tag. We expect the share to decline in the next two or three years as FDB is trying to improve its pan-India presence.

NRE deposits as hidden CASA FDB has significantly benefited from its presence in Kerala due to the state’s large NRI population (~40% of India’s total NRI population) that is primarily responsible for the huge remittances received by the state. As a result, NRI deposits constitute ~22% of the total deposits of the bank on which the interest costs are in the range of 1.8-3.1%. On the other hand, FDB’s retail deposit costs ~7.5-8% at present. The cost savings from NRI deposits coupled with high CASA deposits translates into a significant source of inexpensive funds for FDB.

Exhibit 17: FDB has higher CASA ratio as compared to its peers

28.5

25.6

24.2

21.4

20.4

20.0

22.5

25.0

27.5

30.0

FDB SIB* Karnataka DLB# City Union (%

)

Source: Company quarterly presentation, ICICIdirect.com Research, *SIB-South Indian, #DLB-Dhanalakshmi

Declining share of Kerala in the bank’s total business mix reduces concentration risk

Exhibit 18: Contribution of Kerala in FDB’s business mix to reduce, going forward

47 46 46 47 4753 54 54 53 53

0

20

40

60

80

Q2FY10 Q3FY10 FY10 Q1FY11 Q2FY11

(%)

Kerala Outside Kerala


NRE deposit provides an inexpensive funding source to the bank



With the slowdown witnessed in the Middle East countries (which constitutes majority of the remittances in Kerala) and resultant job losses, we are expect the growth of FDB’s NRE deposits to moderate in the next few years. As a result, we expect the share of NRE deposits in FDB’s total deposits to moderate to 15% in FY13E vs. 20% in FY10.

Exhibit 19: Low deposit rates on NRE and FCNR deposits provides support to NIMs FCNR (B) Deposit Rate (%)

Period USD GBP EURO1 year to less than 2 years 1.8 2.5 2.4 2 years to less than 3 years 1.6 2.3 2.5 3 years to less than 4 years 1.9 2.5 2.6 4 years to less than 5 years 2.2 2.8 2.85 Years only 2.5 3.1 3.0

RFC Deposits (%)Period USD GBP EURO6 months to Less than 1 Year 1.8 2.5 2.41 Year to Less than 2 Years 1.8 2.5 2.42 Years to Less than 3 Years 1.6 2.3 2.53 Years only 1.9 2.5 2.6

NRE Term Deposit Rate (%)Period1 Year to less than 2 years 2.52 years to less than 3 years 2.43 years and above 2.6

Retail Deposit Rate (%)

PeriodLess than Rs.15

LakhsBetween 15-100

lakhs 1 Year to Less than 2 Years 7.5 7.52 Years to Less than 3 Years 7.5 7.53 years to less than 5 years 7.8 7.8

5 years and above 8.0 8.0 Source: Company quarterly presentation, ICICIdirect.com Research

The slowdown in the Middle East markets will negatively impact the FDB’s NRE deposit base



…driven by operational restructuring and quality of new management In our view, FDB is in the process of successfully implementing the business transformation roadmap suggested by the Boston Consultancy Group (BCG), which is expected to help the bank in cementing its position as a new generation private sector bank. The result of the key policy changes are as follows:

• FDB has established six key business verticals in order to bring a strong focus to business processes and products and also to improve decision making standards. SME, retail and recovery verticals are headed by PR Kalyanaraman and other verticals such as NRI, large corporate and treasury are headed by PC John

• The bank has established a centralised loan sanctioning process where each regional office is responsible for the credit assessment and appraisal of loans between | 10and | 25 lakh. For a loan amount greater than | 25 lakh, approval is taken from the head office. This is in sharp contrast to the earlier system where individual branches were disbursing every kind of loans without any central monitoring system. This process was adopted primarily to improve the appraisal and monitoring system in order to reduce slippages. At the same time, product delivery (disbursement and servicing) is managed at the branch level to improve the turnaround time

• Specialised corporate banking branches have been established in Delhi and Mumbai to focus on corporate clients and improve fee-based income. According to the management, the bank is expected to open ~11 new centres in different metros in FY11E

• FDB is planning to provide differentiated services to the large NRI population in Kerala in order to tap the low-cost of deposits

• Plans to launch Esops and variable pay packages to inculcate a performance-based culture. Also, the bank has started recruiting locally for branches that are opened outside Kerala

Further, the appointment of Shyam Srinivasan as the CEO of the bank is expected to complement FDB’s traditional strength in the SME and retail segments as Mr Srinivasan has significant experience in retail, SME and wealth management markets in India, Middle-East and South East Asia. In our view, FDB is expected to leverage its strength under the new leadership by aggressively focusing on the SME and retail sector. This will drive the business mix growth of the bank in the next two or three years.

Strong initiative to streamline operating processes in order to boost business parameters.



NIM to expand to 4% in FY12E

With higher focus on the SME and retail segment, we expect FDB’s yields on advances to expand by 30 bps to 11.9% in FY13E (vs. 11.6% in FY10). Although deposit rates are also expected to remain firm, the high share of low cost deposit is expected to strengthen FDB’s margins, going forward. As a result, we expect the bank’s NIMs to improve by 25 bps to 4% in FY13E vs. 3.7% in FY10.

Higher yields on advances due to rising interest rates and large source of inexpensive funds will help FDB to maintain healthy NIMs

Exhibit 20: NIM expansion in FY11E-13E

3.4 3.3 3.3

4.13.7 3.8 3.9 4.0

0.0

1.2

2.4

3.6

4.8

FY06 FY07 FY08 FY09 FY10 FY11E FY12E FY13E

(%)

Source: Company annual report, ICICIdirect.com Research

Exhibit 21: FDB has better NIM as compared to its peers (Q1FY11)

4.2

3.7 3.6 3.4

2.6

1.7

0.0

1.3

2.5

3.8

5.0

FDB LVB City Union KVB DLB Karnataka

(%)

Source: Company quarterly presentation, ICICIdirect.com Research, ^Lakshmi Vilas, ~Karur Vysya, #Dhanalakshmi,



Improvement in asset quality expected in FY12-13E FDB’s loan book is dominated by SME and retail loans that collectively accounted for ~61% for the total gross advances in H1FY11. During the last few quarters, the bank has increasingly witnessed stress on its advances. FDB’s GNPA deteriorated to 3.8% in H1FY11 vs. 3.0% in H1FY10 and NNPA to 0.7% in H1FY11 vs. 0.5% in H1FY10. FDB reported total gross slippages of | 327crore in Q1FY11, out of which ~40% (| 132 crore) was contributed by the retail segment and ~37% by the SME segment. In the retail loan segment, higher slippages were reported in the NRI housing segment primarily due to the negative fallout of the slowdown witnessed in Middle East countries, resulting in job losses and lower wages for NRI. Also, the slowdown witnessed in the domestic market led to higher slippages in the SME segment. The stress on the loan portfolio was aggravated by the loose credit disbursal policy of the bank where individual branches were responsible for sanctioning loans without adequate appraisal skills. This coupled with the aggressive system-generated NPA, which resulted in early recognition of bad loans, added further to the woes of the credit quality of the bank. However, FDB has strengthened its credit disbursement system with centralised processing centres (for better credit assessment) and is in the process of revamping its recovery mechanism. According to the management, the slippages will continue to remain high in FY11E system-generated NPAs. However, the situation is expected to improve from FY12E onwards. As a result, we forecast FDB’s GNPA will increase to 3.2% in FY11E (vs. 3.1% in FY10) and then improve to 3% in FY12E and 2.7% in FY113E (in line with the expectation of the management).

As on H1FY11, FDB reported total restructured assets of | 1,140 crore, representing ~4% of the total loan book. This is in line with the other players in the industry. Additionally, the bank has maintained a significantly high provision cover in order to adequately handle any shock on the asset quality. We believe FDB will continue to maintain a high provision coverage ratio (PCR) in FY11E-12E given high slippages expected by the management in FY11E.

Asset quality concerns to remain high in FY11E. However, the situation is expected to normalise from FY12E onwards

Exhibit 22: FDB’s GNPA ratio to improve to 2.7% in FY13E

0.0

1.0

2.0

3.0

4.0

5.0

Q1FY

09

Q2FY

09

Q3FY

09

Q4FY

09

Q1FY

10

Q2FY

10

Q3FY

10

Q4FY

10

FY10

H1FY

11

FY11

E

FY12

E

FY13

E

(%)

0

25

50

75

100

(%)

GNPA (LHS) NNPA (LHS) PCR* (RHS)

Source: Company quarterly presentation, ICICIdirect.com Research, *Provision coverage ratio

High provision cover allays fear of asset quality for the bank



Core fee-based income to drive non-interest income During FY05-10, FDB’s non-interest income grew by 20% YoY to | 531 crore aided by high remittances inflow, healthy fee-based income and strong trading gains. However, we expect the growth in non-interest income to moderate to 12% CAGR to | 741 crore in FY10-13E due to lower trading gains. Nevertheless, we believe the core non-interest income (excluding trading gains) will grow at a healthy rate of 15% CAGR to | 640 crore in FY10-13E driven by improving fee-based income due to strong product focus on corporate, SME and retail segment at the branch level. Also, FDB’s tie-up with IDBI-Ageas Insurance and Geojit BNP Paribas Financial Services is expected to augment the fee-based income for the bank in FY11E-13E.

Further, FDB is focusing its marketing efforts on the NRI segment primarily to capture the huge remittances inflow in India and presents significant wealth management and forex opportunities. According to the World Bank, remittances inflows in the country increased to US$ 52 billion in FY08 from US$22 billion in FY05. It declined in FY09 due to the global economic slowdown. As reported by the World Bank, Indian expatriates are expected to remit about $55 billion into the country in FY11 as the number of emigrants rises to 11.4 million. The report expects India to be the top receiver of remittances followed by China. We believe FDB will be the primary beneficiary of remittances inflows into India due to its strong presence in the southern states of the country, which traditionally receive higher remittances inflow.

FDB has initiated tie-ups with non-life insurance and financial services companies to boost its fee-based income

Strong remittances inflow in India provides opportunity in wealth management and forex opportunity for FDB

Exhibit 23: Core fee-based income to grow at healthy 15% CAGR in FY10-13E

212 217

303

395

516 531598

643

741

0

200

400

600

800


(| C

rore

)




Financials CAGR growth of 22% expected in NII in FY10-13E During FY05-09, FDB’s net interest income (NII) witnessed a robust growth of 27% CAGR to | 1,315 crore driven by healthy NIMs at 3.6% during the period. However, NII grew by merely 7% YoY in FY10 due to the global economic slowdown and the subsequent Middle East problem. As a result, FDB adopted a cautious business approach resulting in moderate balance sheet growth of 12% YoY in FY10 vs. growth of 23% CAGR during FY05-09. We believe the ongoing restructuring, high C/D ratio (76% in H1FY11) and strong capital base will put FDB into a higher growth trajectory starting FY13E. We expect FDB’s business mix to grow higher than the industry resulting in NII growth of 22% CAGR to | 2,564 crore in FY10-13E.

Investment in technology and people bearing fruit - controlling cost FDB has immensely benefited from the continuous investment in technology in the last five or six years leading to lowest cost-to-income ratio among its peers. FDB has been one of the earliest adopters of new-age banking services such as core banking solutions (CBS), real time gross settlement (RTGS) services and channels for online remittances such as Fed India Remit Service and SWIFT. Also, the bank has collaborated with Tata Communications Banking Infra Solutions for deploying point-of-sale (POS) terminals at merchant locations in order to improve its presence in the SME segment in a cost-efficient manner.

Ongoing operational restructuring and strong business fundamentals to build the base for higher growth after one or two years

Exhibit 24: CAGR growth of 22% in NII in FY10-13E

502 600716 868

1315 1411

17072065

0

1100

2200

3300

4400

5500

FY05 FY06 FY07 FY08 FY09 FY10 FY11E FY12E

(| C

rore

)

Interest Income Interest Expenses NII


Emphasis on technology has helped the bank to control its costs

Exhibit 25: FDB leads in terms of cost efficiency among its peers (Q1FY11)

88.4

59.851.7 50.1

41.736.8 35.9

0

25

50

75

100

DLB# Karnataka LVB^ SIB* KarurVysya City Union FDB

(%)

Source: Company, ICICIdirect.com Research,, #Dhanalakshmi, ^Lakshmi Vilas,*South Indian, ~Karur Vysya



Exhibit 26: Business per employee

562670

778 832915

10301203

461

0

375

750

1125

1500

FY06

FY07

FY08

FY09

FY10

FY11

E

FY12

E

FY13

E

(| L

akhs

)

Source: Company presentation, ICICIdirect.com Research

Exhibit 27: Profit per employee

3.54.4

5.46.9

5.9 6.67.7

9.7

0

2

4

6

8

10

12

FY06

FY07

FY08

FY09

FY10

FY11

E

FY12

E

FY13

E

(| L

akhs

)

Source: Company presentation, ICICIdirect.com Research

In order to shed its regional tag and improve its pan-India presence, FDB is increasingly expanding its branch network outside Kerala (~75-80% of 200 branches in FY11E-13E to come outside Kerala) and is planning to recruit ~1000 new employees in FY11E. Further, the bank has introduced a new appraisal system for its employees that requires rigorous training and skill development. In our view, the rising investment in people and branch expansion plans will lead to a deteriorating cost structure in FY11E. As are result, we forecast FDB’s cost-to-income ratio will inch up to 36% in FY11E vs. 31% in FY09.

Operating expenses expected to inch up in FY11E We expect FDB’s operating expenses to increase at 20% CAGR to | 1,159 crore in FY10-13E (vs. 17% CAGR to | 677 crore in FY05-10) primarily due to the strong branch expansion plans (~200 new branches in FY11E-13E) and business-related expenses such as establishment of centralised processing centres in metros (~11 centres expected in FY11E) and point of sale terminals (targeted at current account customers). Further, we expect the employee costs to shoot up as the bank is planning to recruit ~1000 new employees in FY11E. As a result, we expect the bank’s cost to income ratio to deteriorate to 36% in FY11E vs. 35% in FY10.

Introduction of performance based pay structure to

enhance employee productivity going ahead

The cost-to-income ratio will increase in FY11E due to strong branch expansion plans and rising recruitment expenses

Exhibit 28: Cost to income ratio inches up in FY10 on lower income

43.9 44.639.8

37.1

31.234.9 36.0 36.2 35.1

0

13

25

38

50


(%)


Operating expenses on the rise in FY11E as a result of

strong expansion plans and investment in new

technologies



Nevertheless, we believe the investment in technology and people is yielding benefits to the bank as FDB has the lowest cost to income ratio as compared to its peers. Also, the bank has witnessed a continuous improvement in its business on a per branch and employee basis. We expect this to continue in our forecast period.

MTM hit limited due to high share of HTM securities FDB is well-placed in the current rising interest rate environment due to the high share of HTM securities (73%) in its investment book of |12,816 crore in H1FY11. The duration of HTM securities was reported at 2.5 years. The rest of the investment book is divided into AFS (23%) and HFT (4%) categories where each has duration of ~1.6 years.

Exhibit 29: Cost to income ratio to deteriorate to 36% in FY11E vs. 35% in FY10

0

300

600

900

1200

1500


(| C

rore

)

0

13

25

38

50

(%)

Employee costs (LHS) Total operating costs (LHS) Cost to income (RHS)


Exhibit 30: Business per employee to improve ~1.4x in FY10-12E

0

30

60

90

120


(| C

rore

)

0

3

6

9

12

15

(| C

rore

)

Business/Branch Business/Employee


Limited impact of rising interest rates in FDB’s investment portfolio in FY10-12E



During January-July 2010, the WPI index rose at an average of 10% YoY primarily driven by higher food prices. As a result, yields of government securities (G-sec) have also spiked up during this period. However, we have observed that the rise in the yields of 10-year government bonds has been more prominent than the five-year bonds. In our view, the movement in five-year bond yields will be stable as compared to the 10-year government yields, leading to limited impact on FDB’s investment book (~77% SLR securities).

Exhibit 31: HFT securities dominates FDB’s investment book in H1FY11

(Rs Crore)HFT, 554 , 4%

AFS, 2,890 , 23%

HTM, 9,372 , 73%

Source: Company, ICICIdirect.com Research, HTM-Held till Maturity, AFS-Available for Sale, HFT-Held for Trading



Risks and concerns High concentration risk With ~60% branches in Kerala, FDB faces high concentration risk. Although the bank is planning to reduce its dependence on the home state by planning to open new branches in other states, aggressive expansion in other parts of India remains a challenge. Inability to develop a branch network outside Kerala can make the bank vulnerable to region-specific risks. Asset quality concern remains FDB’s management expects slippages to continue in FY11E and believes it will reduce once the centralised loan appraisal system is fully operational. Any delay in the implementation of the system is expected to pose a significant challenge to the growth of the loan portfolio in our forecast period. Continuance of economic slowdown A slower than expected improvement in the domestic as well as international credit market can negatively impact our growth estimates for FDB. Further, the bank is heavily dependent on the NRI population primarily in Middle East countries. A delay in recovery in these markets will impact the bank’s business growth and profitability. Delay in implementing BCG growth plan We have assumed that FDB will be able to successfully implement the recommendation put forward by BCG in order to propel itself to a high growth trajectory starting FY13E. Any delay in implementing the plan can derail our assumptions resulting in lower growth prospects for the bank. Regulatory measures may impact Insurance venture FDB has 26% ownership in IDBI Fortis Life JV with its investment of | 117 crore. Currently the JV has done well on NBP (new business premium), however with increasing pressure on products, cap on charges and commission etc, the business may grow slower than anticipated. This may hurt future returns from the venture.



Valuations At the CMP of | 455, the stock is trading at 1.5x P/ABV for FY13E. We believe that the current operational restructuring will strengthen FDB’s business fundamentals and propel it into the next level of growth phase. We forecast RoE and RoA of 18% and 1.4%, respectively, for the bank in FY13E. This is expected to improve further to ~20% in FY14E. Also, we have assumed that asset quality concerns will decline, going forward, driven by the implementation of a centralised loan sanctioning process and a new credit appraisal system. This is expected to facilitate better monitoring of loans and boost the asset quality. We expect GNPA of 2.7% in FY13E (vs. 3.2% expected in FY11E). We have valued the bank at 1.8x FY13E P/ABV and arrived at a target price of | 563. We initiate coverage on the stock with a STRONG BUY rating.

FDB is the fourth largest private bank in terms of asset size with a dominant market position in Kerala. The bank is currently undergoing an organisational restructuring, which is expected to put it into the next level of growth trajectory from FY13E. With the huge low-cost deposits franchise (~50% of the total deposits), strong capital base and ability to generate high NIMs as compared to its peers, FDB is an attractive play in the domestic banking space. In our view, the improvement in the domestic credit environment and high C/D ratio (78% in Q1FY11) will help the bank to optimise its leverage (asset to equity of 13% in FY13E vs. 9% in FY10) in the next two or three years. As a result, we believe the bank will be able to improve its RoE to 18% in FY13E and ~20% in FY14E.

Exhibit 33: Comparative matrix

Bank FY10 FY11E FY12E FY10 FY11E FY12E FY10 FY11E FY12E FY10 FY11E FY12ESouth indian Bank 0.4 0.4 0.5 1.1 1.0 1.1 17.9 17.8 19.5 2.1 1.8 1.5Federal bank 0.7 0.8 0.9 1.1 1.2 1.3 10.3 12.2 14.4 1.7 1.7 1.6Dhanlaxmi Bank 0.1 0.2 0.3 0.3 0.4 0.6 5.4 6.5 11.5 2.9 2.0 1.9IOB 0.3 0.5 0.6 0.6 0.7 0.8 11.5 14.6 16.4 2.0 1.5 1.2Syndicate bank 0.4 0.5 0.6 0.6 0.7 0.8 15.3 18.2 20.5 1.9 1.6 1.5

Profit/branch (Rs crore) RoA (%) RoE (%) P/ABV (%)

Source: Company specific presentation, ICICIdirect.com Research

However, FDB faces significant asset quality concerns with GNPA standing at 3.7% of total gross advances in Q1FY11 vs. 2.7% in Q1FY10. Further, the bank also faces high concentration risk as ~60% of the bank’s branches are located in Kerala.

We have valued FDB at 1.8x FY13E P/ABV and arrived at a

target price of | 563/share

In our view, FDB commands premium valuation than its

peers given the bank’s strong business fundamentals.

Further, with the change in management and ongoing

operational restructuring, we expect the bank’s return

ratios to improve significantly from FY13E

Exhibit 32: P/ABV band chart

0

100

200

300

400

500M

ar-0

5

Jun-

05

Sep-

05

Dec-

05

Mar

-06

Jun-

06

Sep-

06

Dec-

06

Mar

-07

Jun-

07

Sep-

07

Dec-

07

Mar

-08

Jun-

08

Sep-

08

Dec-

08

Mar

-09

Jun-

09

Sep-

09

Dec-

09

Mar

-10

Jun-

10

Sep-

10

(Rs)

Price Average 1.8x 1.4x 0.8x

Source: Company, NSE, ICICIdirect.com Research



Exhibit 34: Ratios* FY09 FY10 FY11E FY12E FY13E

Valuation

No. of Equity Shares 17.1 17.1 17.1 17.1 17.1

EPS (Rs.) 29.3 27.2 34.1 42.3 56.0

BV (Rs.) 252.6 273.9 284.9 301.2 324.2

BV-ADJ (Rs.) 245.7 263.7 271.4 286.6 307.8

P/E 15.5 16.8 13.3 10.7 8.1

P/BV 1.8 1.7 1.6 1.5 1.4

P/ABV 1.9 1.7 1.7 1.6 1.5

Div. Yield (%) 1.3 1.3 1.5 1.9 2.5

DPS (Rs.) 5.9 5.8 6.7 8.5 11.4

Yields & Margins (%)

Yield on avg int earning assets 10.2 9.6 9.8 10.1 10.1

Avg. cost on funds 6.5 6.3 6.7 6.8 6.7

Net Interest Margins 4.1 3.7 3.8 3.9 4.0

Avg. Cost of Deposits 6.4 6.4 6.3 6.4 6.3

Yield on average advances 12.4 11.6 11.7 11.9 11.9

Profitabilty (%)

Interest expense / total avg. assets 5.6 5.5 5.6 5.8 5.7

Interest income/ total avg. assets 9.3 8.9 9.1 9.3 9.4

Non-interest income/ avg. assets 1.4 1.3 1.2 1.1 1.1

Non-interest income/ Net income 28.2 27.3 26.0 23.8 22.4

Net-interest income/ Net income 71.8 72.7 74.0 76.2 77.6

Cost / Total net income 31.2 34.9 36.0 36.2 35.1

Quality and Efficiency (%)

Credit/Deposit ratio 69.5 74.7 74.5 74.9 75.1

GNPA 2.6 3.0 3.2 3.0 2.7

NNPA 0.3 0.5 0.6 0.4 0.4

RoNW 12.1 10.3 12.2 14.4 17.9

RoA 1.4 1.1 1.2 1.3 1.4

Source: Company annual report, ICICIdirect.com Research *Standalone financials

Exhibit 35: ROE decomposition*

(%) FY09 FY10 FY11E FY12E FY13E

Net interest income/ Avg. assets 3.7 3.4 3.6 3.6 3.7

Non-interest income/ Avg. assets 1.4 1.3 1.2 1.1 1.1

Net total income/ Avg. assets 5.1 4.7 4.8 4.7 4.7

Operating expenses/ Avg. assets 1.6 1.6 1.7 1.7 1.7

Operating profit/ Avg. assets 3.5 3.1 3.1 3.0 3.1

Provisions/ Avg. assets 1.3 1.0 1.3 1.1 1.0

Return on Avg. assets 1.4 1.1 1.2 1.3 1.4

Leverage (Avg assets/ Avg equity) (x) 8.6 9.2 10.0 11.5 13.0

Return on equity 12.1 10.3 12.2 14.4 17.9




Exhibit 36: Profit and loss account* Rs Crore FY09 FY10 FY11E FY12E FY13E

Interest Earned 3315 3673 4374 5387 6560

Interest Expended 2000 2262 2668 3322 3996

Net Interest Income 1315 1411 1707 2065 2564

growth (%) 51.5 7.3 21.0 21.0 24.2

Non Interest Income 516 531 598 643 741

Fees and advisory 101 105 126 149 179

Trading Gains 83 108 92 96 101

Other income 332 318 381 398 461

Net Income 1831 1942 2305 2708 3305

Employee cost 317 366 454 537 633

Other operating Exp. 254 311 377 443 526

Gross Profit 1260 1265 1475 1729 2147

Provisions 467 405 604 648 718

PBT 793 860 871 1081 1429

Taxes 293 395 287 357 472

Net Profit 500 465 584 724 957

growth (%) 36.0 -7.2 25.6 24.1 32.2


Exhibit 37: Balance sheet*

Rs Crore FY09 FY10 FY11E FY12E FY13E

Liabilities

Capital 171 171 171 171 171

Reserves and Surplus 4155 4519 4707 4986 5379

Networth 4326 4690 4878 5158 5550

Deposits 32198 36058 44031 53830 66256

Borrowings 1219 1547 1892 2287 2740

Subordinated Debt 0 0 0 0 0

Other Liabilities & Provisions 1108 1380 1559 1647 1761

Total 38851 43676 52360 62921 76307

Assets

Fixed Assets 281 290 348 384 432

Investments 12119 13055 15192 17721 20793

Advances 22392 26950 32810 40331 49786

Other Assets 622 658 709 471 437

Cash with RBI & call money 3437 2723 3301 4014 4859

Total 38851 43676 52360 62921 76307




RATING RATIONALE ICICIdirect.com endeavours to provide objective opinions and recommendations. ICICIdirect.com assigns ratings to its stocks according to their notional target price vs. current market price and then categorises them as Strong Buy, Buy, Add, Reduce and Sell. The performance horizon is two years unless specified and the notional target price is defined as the analysts' valuation for a stock. Strong Buy: 20% or more; Buy: Between 10% and 20%; Add: Up to 10%; Reduce: Up to -10% Sell: -10% or more;

Pankaj Pandey Head – Research [email protected]

ICICIdirect.com Research Desk, ICICI Securities Limited, 7th Floor, Akruti Centre Point, MIDC Main Road, Marol Naka, Andheri (East) Mumbai – 400 093

[email protected]

ANALYST CERTIFICATION We /I, Kajal Gandhi CA Viraj Gandhi MBA-CM Mani Arora MBA research analysts, authors and the names subscribed to this report, hereby certify that all of the views expressed in this research report accurately reflect our personal views about any and all of the subject issuer(s) or securities. We also certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report. Analysts aren't registered as research analysts by FINRA and might not be an associated person of the ICICI Securities Inc.

Disclosures: ICICI Securities Limited (ICICI Securities) and its affiliates are a full-service, integrated investment banking, investment management and brokerage and financing group. We along with affiliates are leading underwriter of securities and participate in virtually all securities trading markets in India. We and our affiliates have investment banking and other business relationship with a significant percentage of companies covered by our Investment Research Department. Our research professionals provide important input into our investment banking and other business selection processes. ICICI Securities generally prohibits its analysts, persons reporting to analysts and their dependent family members from maintaining a financial interest in the securities or derivatives of any companies that the analysts cover.

The information and opinions in this report have been prepared by ICICI Securities and are subject to change without any notice. The report and information contained herein is strictly confidential and meant solely for the selected recipient and may not be altered in any way, transmitted to, copied or distributed, in part or in whole, to any other person or to the media or reproduced in any form, without prior written consent of ICICI Securities. While we would endeavour to update the information herein on reasonable basis, ICICI Securities, its subsidiaries and associated companies, their directors and employees (“ICICI Securities and affiliates”) are under no obligation to update or keep the information current. Also, there may be regulatory, compliance or other reasons that may prevent ICICI Securities from doing so. Non-rated securities indicate that rating on a particular security has been suspended temporarily and such suspension is in compliance with applicable regulations and/or ICICI Securities policies, in circumstances where ICICI Securities is acting in an advisory capacity to this company, or in certain other circumstances.

This report is based on information obtained from public sources and sources believed to be reliable, but no independent verification has been made nor is its accuracy or completeness guaranteed. This report and information herein is solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments. Though disseminated to all the customers simultaneously, not all customers may receive this report at the same time. ICICI Securities will not treat recipients as customers by virtue of their receiving this report. Nothing in this report constitutes investment, legal, accounting and tax advice or a representation that any investment or strategy is suitable or appropriate to your specific circumstances. The securities discussed and opinions expressed in this report may not be suitable for all investors, who must make their own investment decisions, based on their own investment objectives, financial positions and needs of specific recipient. This may not be taken in substitution for the exercise of independent judgment by any recipient. The recipient should independently evaluate the investment risks. The value and return of investment may vary because of changes in interest rates, foreign exchange rates or any other reason. ICICI Securities and affiliates accept no liabilities for any loss or damage of any kind arising out of the use of this report. Past performance is not necessarily a guide to future performance. Investors are advised to see Risk Disclosure Document to understand the risks associated before investing in the securities markets. Actual results may differ materially from those set forth in projections. Forward-looking statements are not predictions and may be subject to change without notice.

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