Commercial Bank of Ceylon (COMB.N0000) · Sri Lanka | Banks, Finance and Insurance EQUITY RESEARCH Initiation of coverage 30 June 2014 Commercial Bank of Ceylon (COMB.N0000) 1 A capital

Sri Lanka | Banks, Finance and Insurance EQUITY RESEARCH

Initiation of coverage 30 June 2014

Commercial Bank of Ceylon (COMB.N0000)

1

A capital market development initiative by the Colombo Stock Exchange in association with Copal Amba

Committed to efficiency Near-term challenges appear to be clouding the positive structural themes of the Sri Lankan banking sector. We view the current weakness as an adjustment to previous over-lending and believe the stage is set for improving macroeconomic fundamentals, based on a solid underlying economic growth story in the medium to long term. Credit growth stimulation from the current low interest rate regime should gain momentum in 2H14, further supported by tailwinds from favorable policies (e.g., government guarantees for gold loans) and benign inflation. As the third-largest commercial bank in Sri Lanka, with an asset base of LKR649bn and a market capitalization of LKR113bn, COMB has consistently been an industry leader in terms of efficiency and profitability. We expect COMB to continue to post above-industry-average growth in both loans and earnings; loan growth in the mid-teens should sustain EPS growth at an 18% CAGR over 2014E-2016E. Our P/B- and P/E-based valuation analysis suggests a valuation range of LKR138-166.

Underlying long-term economic growth story remains intact: Structural factors

supporting the banking sector’s growth story remain solid, in our view. A simple back-of-the-envelope calculation supports the case for double-digit loan growth. GDP growth at 7% and inflation at 5% imply nominal economic growth at roughly 12%. Credit growth is typically 2-3ppts higher than nominal growth; 14%-15% is thus feasible. This view is substantiated by Sri Lanka’s low private sector credit-to-GDP ratio (29% in 2013) compared with peers, low mortgage lending and personal credit levels, indicating further room for growth.

Beneficial impact of low interest rate regime yet to gain full momentum: Investor

concerns regarding loan growth and asset quality deterioration appear to weigh down sector valuations. Restraints on gold-based loans imposed by the Central Bank of Sri Lanka (CBSL) to rein in over-lending, combined with the timing difference as corporates and investors readjust to the low interest rate regime, are behind the current lackluster environment. Furthermore, although policy rates have been on a downward trend since mid-2013, banks have been slow to reduce lending rates. Double-digit prime lending rates at the two public banks that hold roughly 45% of market share as at June 2014 explain the stagnating loan books; the sector reported YoY loan book growth of 8.8% in 2013 and 0.6% in 1Q14. We expect credit growth to pick up in 2H14 as the benefits of rate reduction cascade with greater momentum. Furthermore, we expect the downward trajectory in rates to benefit bank asset quality.

Industry-leading asset quality and profitability metrics over the past five years:

COMB reported ROE, ROA and net profit margins higher than its peer commercial banks over the past five years, due mainly to its strong commitment to efficiency. COMB’s cost-to-income ratio (CIR) declined to 40% in 2013, down 5ppt since 2009, and has consistently been the lowest CIR among peers. COMB also reported the highest CASA ratio among peers (44% in 2013) – such low-cost funding enables lower lending rates, facilitating loan growth at a faster pace, while maintaining margins. We like COMB for its long-term aim of becoming a LKR1tn bank by 2016E, and we believe it has the vision and the clout to grow into a regional player of note; its success in Bangladesh provides proof of concept, Bangladesh now contributes about 13% of net profit.

We establish a valuation range of LKR138-166: COMB’s voting shares trade at a

current P/B multiple of 1.9x, at a slight premium to its two-year historical average of 1.7x. We expect the market to value COMB at a higher multiple as the current concerns ease; however, as a base case, we conservatively value COMB at 1.9x one-year forward BVPS. We crosscheck this value by assigning a P/E multiple of 9.3x, in line with the current multiple of 9.3x, to its one-year forward EPS. A sensitivity analysis against the assigned base-case multiples yields a valuation range of LKR138-166.

Key statistics CSE/Bloomberg tickers

Share price (27 June 2014)

No. of issued shares (m)

Market cap (USDm)

Free float (%)

52-week range (H/L)

Avg. daily vol. (shares,

1yr)

Avg. daily turnover

(USD‘000)

COMB.N0000/COMB SL

LKR140

808

865

99.5%

LKR140/111

402,169

373

Source: CSE, Bloomberg Note: USD/LKR=131.0 (average for the year ended 27 June 2014)

Share price movement

Source: CSE, Bloomberg

Share price performance

3m 6m 12m

COMB 17.1% 17.2% 23.7%

S&P SL 20 7.5% 8.6% 2.8%

All Share Price Index 6.2% 8.3% 4.1%


Summary financials

LKRm (year-end 31 December) 2013 2014E 2015E

Net interest income 25,322 29,111 34,181

Net revenue 35,619 40,034 45,362

Operating profit 16,655 19,481 23,369

PBT 14,693 17,015 20,571

Net income 10,563 12,155 14,807

Recurrent EPS 12.4 14.2 17.2

ROE (%) 18.5 19.0 20.6

P/B (x) 1.7 1.7 1.5

Source: COMB, Copal Amba estimates

80%

90%

100%

110%

120%

130%

Jun-13 Sep-13 Dec-13 Mar-14 Jun-14

COMB ASPI S&P SL 20

Commercial Bank of Ceylon PLC

2


Table of Contents

Industry-leading profitability and asset quality metrics......................................................................................................... 3

Highest net profit margin, ROE and ROA among commercial banks ................................................................................................... 3 Strong profitability due to low cost-to-income and high CASA ratios .................................................................................................... 3 Prudent approach to risk management helps maintain asset quality .................................................................................................... 4

Targeting an asset base of LKR1tn by 2016E ..................................................................................................................... 6

Low-margin, high-volume strategy to enable loan growth at above-industry-average levels ................................................................ 6 Regional ambitions: Bangladesh provides proof of concept ................................................................................................................. 7

Strong investor appeal ......................................................................................................................................................... 8

Highly liquid; average daily turnover double that of peers .................................................................................................................... 8 Dividend payout ratio of about 50% - highest among peers ................................................................................................................. 8 Twelve of the top twenty shareholders are foreign funds ..................................................................................................................... 9

Current concerns about the banking sector are short-term ............................................................................................... 10

Private sector credit growth rate declined due to a confluence of negative factors ............................................................................ 10 Stimulation from lower interest rate regime yet to gain momentum .................................................................................................... 12 Pawning portfolio issues managed effectively .................................................................................................................................... 13 Industry average measures mask wide variations in individual bank performance............................................................................. 14 Lower SOE borrowings support private credit growth ......................................................................................................................... 15 Improving liquidity levels ease pressure on interest rates .................................................................................................................. 16 Banking sector loan book well diversified ........................................................................................................................................... 16

Macroeconomic factors substantiate private sector credit growth story ............................................................................ 17

Credit as a percentage to GDP well below that of regional peer set................................................................................................... 17 IMF forecasts Sri Lanka’s GDP to be the highest in the region .......................................................................................................... 18 Inflation targeted to remain at mid-single digit levels .......................................................................................................................... 18 FDI inflows continue to rise................................................................................................................................................................. 19 Foreign remittances and exports increasing ....................................................................................................................................... 19 Exchange-rate stability a strong positive ............................................................................................................................................ 20 Fiscal deficit and current account deficit as a percentage of GDP improving ..................................................................................... 20 Further improvement in savings necessary to narrow the savings-investment gap ............................................................................ 21

Factors that temper a positive outlook on credit growth .................................................................................................... 22

We establish a valuation range of LKR138-166 for COMB’s voting shares ...................................................................... 23

P/BV analysis yields a valuation range of LKR141-166 per share ...................................................................................................... 23 P/E analysis gives a valuation range of LKR138-164 per share ......................................................................................................... 25

Share price performance .................................................................................................................................................... 26

Earnings release focus areas ............................................................................................................................................. 27

Appendix 1: The Sri Lankan banking sector – A competitive landscape ........................................................................... 28

Appendix 2: Company overview......................................................................................................................................... 37

Appendix 3: Key financial data ........................................................................................................................................... 41

Fact sheet ........................................................................................................................................................................... 43


3


Industry-leading profitability and asset quality metrics

COMB has consistently reported industry-leading profitability measures over the past three years – with the net profit margin, ROA and ROE higher than its listed commercial banking peers. Two main factors have contributed to this strong profitability: the lowest cost-to-income ratio (CIR) and the highest current account/savings account (CASA) ratio among peers. Asset quality measures more favorable than the industry average resulted from a prudent approach to risk management. A case in point is the pawning debacle of 2011-2013 – COMB was one of the least affected as its pawning portfolio as a percentage of total assets never exceeded 5%. This caution has not been at the cost of growth; following asset growth at a 17% CAGR over the past five years to LKR649bn as at 31 March 2014, COMB now targets reaching LKR1tn in assets by 2016E. Asset growth at an 18% CAGR over the next three years, required to reach LKR1tn, is feasible in our view, given its island-wide footprint and strong brand appeal. COMB’s regional ambitions should also enable it to achieve this target, with the further consolidation of its overseas operations in Bangladesh; COMB is also considering expansion into Myanmar, Indonesia and Nepal.

Highest net profit margin, ROE and ROA among commercial banks

COMB reported a net profit margin of around 30% consistently over the past three years, the highest reported margin among the large private commercial banking peers (Figure 1). Similarly, it reported ROE of around 20%, and ROA near 2% consistently over the past three years. We like COMB for this high profitability, as it was achieved while maintaining risk at a manageable level: due more to solid banking ventures such as corporate and high-quality SME loans rather than through low hanging fruits such as pawning. We believe the bank should be able to continue to show such industry-leading metrics due to the inherent advantages built up over the years.

Highest net profit margin among peers 2011-2013 Figure 1: Among the highest ROE and ROA levels 2012-2013 Figure 2:

Source: Bloomberg, Company reports Source: Bloomberg, Company reports

Strong profitability due to low cost-to-income and high CASA ratios

We attribute this strong profitability to two key features: the very low CIR and the industry leading CASA ratio.

Cost-to-income ratio comparable with that of efficient regional banks

Between 2009 and 2013, COMB reduced its cost-to-income ratio by 5ppt to 40.3%. This is at a comparable level with the most efficient regional banks (see Figure 85 on page 36), and indicates a strong commitment to efficiency in all aspects of its business. COMB’s reported CIR has consistently been the lowest reported ratio among commercial banking peers; in 2013, when COMB reported a CIR of 40%, all its commercial banking peers reported CIRs of between 56% and 63% (Figure 3).

-10%

0%

10%

20%

30%

40%

2008 2009 2010 2011 2012 2013

Net income margin

COMB HNB SAMP NTB SEYL

0.0%0.6%1.2%1.8%2.4%

ROA 2013 ROA 2012

0% 6% 12% 18% 24%

COMB

HNB

SAMP

NTB

SEYL

ROE 2013 ROE 2012


4


Given the significant improvement in the CIR over the past five years and the high levels of efficiency already achieved, we do not forecast similar levels of CIR reduction going forward. We expect the CIR to decline 2ppt to around 38% by 2016E.

The CIR decreases usually when non-interest income as a percentage of total income increases – however, such an increase in non-interest income raises the volatility of returns. In COMB’s case, non-interest income as a percentage of total income has remained stable at around 30% to total income, rendering COMB relatively less vulnerable to return volatility.

CIR lowest among peers and improving Figure 3: CASA ratio is the highest in peer group since 2009 Figure 4:


COMB has the highest CASA ratio among peers since 2009

COMB reported a CASA ratio of 44% in 2013. The CASA ratio has consistently been the highest reported among all listed commercial banks since 2009 (Figure 4). However, the ratio has declined notably from 56% in 2010, primarily due to increases in interest rates and the resulting mix-shift toward higher-yielding fixed deposits.

During the past few years, COMB has invested heavily to keep increasing its CASA ratio, by continuing to expand its branch and ATM network. We view the bank’s efforts to maintain its low-cost deposit base above the industry average level as a positive and as an important factor allowing COMB to weather changes in interest rates and minimize funding costs. Given the downward shift in interest rates, we expect the CASA ratio to start gradually improving over our explicit forecast period, to reach around 46% by 2016E.

Prudent approach to risk management helps maintain asset quality

COMB adopts a conservative approach to new market trends; a case in point in the recent past is the pawning debacle. COMB entered the burgeoning pawning industry in 2011 and its pawning portfolio grew to LKR11bn, a fivefold YoY increase, yet pawning as a percentage of total loans remained at 4%. The NPA ratio for the pawning portfolio was low at 0.38%.

Gold prices started declining in 2012 and the bank increased the lending rates to 19% (from 13% previously), and brought down the loan-to-value ratios. The portfolio was allowed to run down as NPA levels rose to 3.1%, then to 15.5% by end-2013. The pawning portfolio stood at LKR4.9bn, accounting for 1.3% of total loans as at 31 March 2014; this is one of the smallest pawning portfolios in the industry. COMB’s overall NPA was contained to 3.9%, versus an industry average of 5.6% as at end-2013. By 1Q14, COMB’s overall NPA ratio had increased further to 4.4%, however, this was still at a lower level than the industry average of 6.2%, and licensed commercial bank (LCB) only average of 5.7%.

Given the self-limiting nature of the pawning business (the one-year loan that is usually written off after a further six-month period), and the early steps COMB took to avoid high loan-to-value ratios, we expect COMB to recover from the pawning portfolio-driven increase in NPA levels within the next two to three quarters. We have conservatively factored in a 40% YoY increase in the rupee

20% 30% 40% 50% 60% 70%

COMB

HNB

SAMP

NTB

SEYL

2013 2012

48%

56%

52%

45%

44%

0% 10% 20% 30% 40% 50% 60%

2009

2010

2011

2012

2013

COMB SEYL NTB HNB SAMP


5


amount of the NPA and expect COMB to end 2014 with NPA levels of roughly 4.5%, which should gradually decline thereafter.

COMB has one of the smallest pawning portfolios Figure 5: We conservatively forecast NPA levels at around 4% Figure 6:

Source: Bloomberg, Company reports Source: COMB, Copal Amba estimates

COMB reported lower NPA ratio than peer average Figure 7: NPA ratio is low in segments other than pawning Figure 8:

Source: COMB, Bloomberg, Copal Amba estimates Source: COMB

0%

10%

20%

30%


% of total loans

2012 2013

0%

2%

4%

6%

8%

10%

12%

0

5,000

10,000

15,000

20,000

25,000

30,000

2009 2010 2011 2012 2013 2014E 2015E 2016E

NPA ratio LKRm

NPA (LHS) NPA ratio (RHS)

0%

2%

4%

6%

8%

10%

12%

0

5,000

10,000

15,000

20,000

25,000

30,000

2009 2010 2011 2012 2013 2014E 2015E 2016E

NPA ratio LKRm

NPA (LHS) NPA ratio (RHS)

0%

4%

8%

12%

16%

Personalbanking

Corporatebanking

Pawning Internationaloperations

NPA ratio

2012 2013


6


Targeting an asset base of LKR1tn by 2016E

COMB reached an asset base of LKR649bn in March 2014, after displaying asset growth at an 18% CAGR over the past three years. It has a soft target of reaching LKR1tn in assets by 2016E. We believe this is a feasible target as it requires growth roughly at an 18% CAGR over the next three years; we expect to see the larger private commercial banks derive credit growth in the mid-teens as the timing mismatch between investor sentiment pickup and the lower interest regime eases. We also believe COMB has the potential to grow through organic growth expansion into investment banking and insurance businesses locally, as well as through consolidations and joint ventures in the South Asian region.

Low-margin, high-volume strategy to enable loan growth at

above-industry-average levels

COMB reported loan growth and total assets growth in the mid-high teens during 2010 – 2012; loan growth slowed down to 10% in 2013, as shown in Figure 9. Going forward, we expect to see lower net interest margins, coupled with stronger loan and asset growth.

Double digit growth in loans and assets 2010-2013 Figure 9: Highly diversified portfolio provides risk minimization Figure 10:

Source: COMB Source: COMB

Currently, the bank’s retail and corporate portfolios are almost equally balanced. We believe this is a favorable situation in the current economic scenario – as the retail exposure yielding higher margins (though with relatively higher risk), and the corporate portfolio with lower risk and margins. The portfolio is also highly diversified (Figure 10), which helps limit risk.

COMB was able to show NIMs consistently higher than the sector average since 2010, as shown in Figure 11. However, its NIM has been declining gradually since 2012 and we expect this trend to continue in the lower interest rate environment. Supported by this lower interest rate regime, we forecast double-digit growth in gross loans. Our forecasts are based on our expectations of a pickup in the credit growth momentum from 2H14 onwards. Management too stated that they expect to see growth in commercial real estate financing and private housing loans during this prolonged low interest rate environment.

We expect non-interest income to grow in line with the mid-teen growth rates as COMB explores new avenues such as investment banking and insurance, as well as proceeds with consolidating operations in the established businesses. For example, COMB believes it handles close to 20% of total inward remittances, and expects further growth in this segment. COMB estimates that it has the largest debit card portfolio in Sri Lanka, at 30% of total debit cards issued. Furthermore, we expect some contribution, though not material at the initial stages, to come from the consolidation of the smaller finance companies.

0%

5%

10%

15%

20%

-10%

0%

10%

20%

30%

2009 2010 2011 2012 2013

Asset growth

Gross loan growth

Gross loan growth (LHS) Asset growth (RHS)

10% 13%

4% 3%

9%

14%

2% 4%

3% 8%

30%

Agriculture & fishing

Manufacturing

Tourism

Transport

Construction

Traders

New economy

Financial and business services

Infrastructure

Other services

Other customers


7


COMB achieved NIMs above sector average Figure 11: We forecast flat NIMs and double digit loan growth Figure 12:

Source: COMB, CBSL Source: COMB, Copal Amba estimates

We forecast EPS growth at an 18% CAGR 2014E-2016E

With loan growth at a 17% CAGR, stable NIMs around 4.7%, lower credit costs and improving CIR, we forecast EPS growth at an 18% CAGR over the next two years.

Regional ambitions: Bangladesh provides proof of concept

COMB aims to become a regional player, with a presence in most countries in the region through own offices or joint ventures, in the mid to long term.

We believe COMB has the vision and the clout needed to grow into a strong regional player. COMB entered Bangladesh through the purchase of the Crédit Agricole Indosuez business in 2003 and its Bangladesh operations have been improving significantly with gross loans growing at a 13% CAGR since 2010 (Figure 13). Net income grew 25% YoY in 2012 and 33% YoY in 2013 (Figure 14). Currently, it has 18 branches in Bangladesh, and the country accounted for 13% of the group’s net profit in 2013.

COMB is in the process of setting up a representative office in Myanmar; after such a presence for a few years, it should be able to operate a comprehensive banking unit in the country. The COMB Chairman, in a recent press interview, also disclosed ambitions to enter Indonesia and Nepal, but considered India too high in entry costs and too intense in competition.

Bangladesh - Loan book growth at a 13% CAGR, Figure 13:2010-2013

Net profit grew at a 29% CAGR 2010-2013 Figure 14:


3.5%

3.9%

4.3%

4.7%

5.1%

2009 2010 2011 2012 2013

NIM

COMB LCB sector average

-10%

0%

10%

20%

30%

3.5%

3.9%

4.3%

4.7%

5.1%

2009 2010 2011 2012 2013 2014E 2015E 2016E

Loan growth NIM

NIM (LHS) Gross loan growth (RHS)

0

10,000

20,000

30,000

40,000

2009 2010 2011 2012 2013

LKRm

Gross loans

0

300

600

900

1,200

1,500

2009 2010 2011 2012 2013

LKRm

Net income


8


Strong investor appeal

COMB is one of the more appealing tickers in the S&P SL 20 due to features attractive to institutional and foreign investors.

Highly liquid; average daily turnover double that of peers

The COMB stock is highly liquid with a free float of 99.5%, and as a result it is one of the most traded stocks at the CSE. The average daily turnover for COMB stands at around USD375,000; this is against peer average of around USD120,000.

COMB has the highest liquidity among peers Figure 15:

Source: CSE, Company reports

Note: Average daily turnover is for 12m ending 27 June 2014. Free float is as of 31 March 2014.

Dividend payout ratio of about 50% - highest among peers

COMB’s dividend payout ratio is one of the highest among the listed banks at around 50%, and the dividend yield at 5.8%, is starting to look attractive in the current low interest rate environment. Despite the higher multiples the stock is trading at, based on 2013 reported numbers, COMB dividend yield was only second to HNB among the listed peers.

Dividend payout is the highest among peers Figure 16: Dividend yield starting to look attractive Figure 17:


0%

20%

40%

60%

80%

100%

0

100

200

300

400

500


Free float Avg daily turnover (USD'000)

Average daily turnover (LHS) Free float (RHS)

52%

44%

34%

23%

33%

0%

20%

40%

60%


Dividend payout

Dividend payout

5.8%

7.2%

4.2%

3.4% 3.5%

0%

2%

4%

6%

8%


Dividend yield

Dividend yield


9


Twelve of the top twenty shareholders are foreign funds

Foreign investors hold 36% of COMB’s shares and twelve of the top 20 shareholders are foreign funds. On the one hand, this reflects the level of interest and confidence in COMB and its management; on the other hand, it helps reduce price volatility of the stock. Lower price volatility is also supported by the higher level of institutional holdings of COMB; institutional investors account for 82% of the total shareholding.

Foreign investors hold 36% of COMB shares. Figure 18:

Source: COMB (as of 31 December 2013)

Capital adequacy ratios stable – no requirements for further fundraising

COMB reported a capital adequacy ratio (CAR) of 16.9% in 2013, well above the minimum regulatory requirement of 10%, and a Tier 1 ratio of 13.3% (also significantly above the stipulated minimum of 5.0%). In 2013, COMB strengthened its capital base further by raising about LKR10bn in subordinated term debt, which qualifies as Tier 2 capital, from the IFC.

The CBSL announced capital requirements as a minimum of LKR10bn of Tier 1 capital by 2016E, and the Basel III requirement is 4.5% in Tier 1 capital and a capital buffer of a further 2.5%. COMB’s capital levels are well within these requirements. Based on our forecasts including RWA growth at a 14% CAGR over 2014E-2016E, we believe capital adequacy should remain well above the regulatory requirements, with Tier 1 ratios stable at around 13.5% over 2014E-16E; we do not expect COMB to raise further equity over the period.

Individuals 18%

Institutions 82%

Resident 64%

Non-resident

36%


10


Current concerns about the banking sector are short-term

Private sector credit growth soared in the three years postwar in Sri Lanka: bank loan books grew 24%, 32% and 21% during 2010-2012, respectively. Consumption growth contributed significantly to this growth, fuelled by gold-based borrowing, as gold prices also continued to soar. As a result, the CBSL imposed a mandatory credit ceiling to rein in credit growth in mid-2012. This coincided with the collapse of gold prices, prompting banks to downsize their pawning portfolios, and lowered overall private sector credit growth to 7.5% by December 2013. As gold prices collapsed, the asset quality of pawning portfolios also declined, raising concerns about asset quality deterioration.

Once the excessive credit growth was under control, the CBSL eased monetary policy to re-stimulate growth. Policy rates started to decline since mid-2013; however, lending rates remain high as banks attempt to expand net interest margins (NIMs) at the expense of loan growth. The sharp cutback in pawning is also masking credit growth. Credit growth stimulation should pick up momentum in 2H14 as banks pass on the benefit of lower interest rates to customers and more investments become viable in the lower interest rate regime.

We believe the larger commercial banks including COMB, HNB and Sampath Bank are on a more sound footing and are better placed than state banks and smaller private banks to weather short-term stresses. These banks are early adapters, positioning themselves to cater to the pickup in loan demand by passing on the benefits of lower interest rates to customers and by changing the loan portfolio mix for better diversification.

Private sector credit growth rate declined due to a confluence of

negative factors

The postwar years in Sri Lanka have been characterized by extensive growth in the bank loan books, driven primarily by consumption-based lending. The sector’s annual loan growth ranged between 21% and 32% during 2010-2012 – one of the highest growth rates recorded in the emerging markets. Escalating gold prices supported gold-based lending, which was the key growth driver in lending, as seen below in Figure 19. YoY growth in pawning loans exceeded 50% in 2011 and early 2012.

This rapid credit growth prompted the CBSL to intervene by increasing benchmark interest rates and imposing a mandatory credit growth ceiling of 18% starting mid-2012, as part of its policy decision to stabilize inflation and curb excessive credit growth. Rising rates coincided with the collapse in gold prices and drove a significant increase in pawning portfolio non-performing loan levels in most banks. This led to the subsequent reining in of gold-based lending, leading to a deceleration in the private sector credit growth rate.

Gold based lending – the key driver of exuberant credit growth during 2011-2012 now of lesser importance Figure 19:

Source: CBSL

-20%

0%

20%

40%

60%

80%

2011 Q

2

2011 Q

3

2011 Q

4

2012 Q

1

2012 Q

2

2012 Q

3

2012 Q

4

2013 Q

1

2013 Q

2

2013 Q

3

2013 Q

4

YoY growth

Credit to the private sector Pawning loans by commercial banks


11


As a result, credit growth slowed (Figure 20) while interest rates rose 454bps during this period, peaking at 14.4% in February 2013.

Private sector credit growth at a moderate pace Figure 20: Banking sector asset growth – 17% CAGR 2008-2013 Figure 21:

Source: CBSL Source: CBSL

Banking sector assets have grown at a 17% CAGR over the past five years. However, in 2013, the proportion of gross loans as a percentage of total assets declined to 58%, as credit growth eased. The comparatively higher asset growth in 2013 was due to an increase in investments made by the banks (mainly in government securities). Investments accounted for 29% of sector assets in 2013 versus 24% in 2012 (as shown in Figure 21).

In line with the sector’s credit demand trend, the five largest domestic banks also showed easing credit growth in 2013, down from the peak levels seen over 2010-2012. However, the three largest private banks (Commercial Bank, HNB and Sampath Bank) continued to show double-digit growth in 2013, while the two government banks recorded growth in single digits. Excluding People’s Bank, the top five LCBs grew their assets in the mid-teens to high-twenties range in 2013.

Loan growth of the top five banks eased in 2013… Figure 22: … while total asset growth ranged from mid-teens to Figure 23:

mid-twenties

Source: Bloomberg, CBSL, Company reports

Note: BOC = Bank of Ceylon, PB = People’s Bank Source: Bloomberg, CBSL, Company reports

This growth rate moderation can be partly explained by the lag effect of the tight monetary policies and the higher interest rate environment. The CBSL also cited sluggish global economic growth, which led to lower levels of credit being required for international trade-related activities, as a reason for lower growth rates. The ability to access alternative sources of funding, such as domestic debenture issues with tax incentives, and international fund raising at lower rates due to the gradual liberalization of forex regulations further impacted bank lending volumes.

2,000

2,100

2,200

2,300

2,400

2,500

2,600

Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14

LKRbn

53% 56% 61%

62% 58% 31%

30%

25%

24% 29%

16% 14%

14%

14%

14%

-

1,000

2,000

3,000

4,000

5,000

6,000

2009 2010 2011 2012 2013

LKRbn

Gross loans Investments Other

-20%

0%

20%

40%

60%

2009 2010 2011 2012 2013

YoY growth

COMB HNBSAMP BOCPB Industry average

0%

10%

20%

30%

40%

2009 2010 2011 2012 2013

YoY growth

COMB HNB SAMP

BOC PB Industry average


12


Stimulation from lower interest rate regime yet to gain momentum

Starting mid-2013, the CBSL relaxed its monetary policy stance, and in a string of policy rate amendments revised down its interest rates to mid-single digits with the aim of stimulating economic growth. However, the decline in lending rates has not been as pronounced as the decline in policy rates; banks have been protecting margins at the expense of loan growth.

Policy rates started to decline in mid-2013; decline in bank lending rates finally gaining some headway in June 2014 Figure 24:

Source: CBSL

As shown below in Figure 25, the prime lending rates of the banks remain high, and rates at the two key state banks, Bank of Ceylon and Peoples Bank, with around 45% market share, remained at double-digit figures even as at May 2014.

Prime lending rates remain high even in June 2014 Figure 25: Rate decline supports growth – but with a lag Figure 26:


Partly due to this lag effect, despite the policy rate decline, statistics reveal that credit pick-up has been slow, as shown previously in Figure 20. Private sector credit grew only 7.5% YoY in 2013, compared with 17.6% YoY in 2012 and an average YoY growth rate of 25.7% during 2010-2012. 1Q2014 has been similarly lackluster. The CBSL specified in its May 2014 Monetary Review press release that banks were expected to “pass on the benefit of eased monetary policy stance to borrowers without further delay”.

It is only in June that there were some signs of policy rate decline being passed on to creditors; People’s Bank brought down prime lending rates to 9.1% in late June 2014, from 13% previously and BOC prime lending rates have declined by about 200bps now from over 12% in January 2014.

5

7

9

11

13

15

17

19

21

24-May-13 23-Jul-13 21-Sep-13 20-Nov-13 19-Jan-14 20-Mar-14 19-May-14

%

BOC PB HNB COMB SAMP SEYL DFCC NDB

0%

2%

4%

6%

8%

10%

12%

BO

C

DF

CC

AB

PB

PA

BC

UB

SE

YL

HN

B

SA

MP

ND

B

NT

B

CO

MB

%

-10%

0%

10%

20%

30%

40%

0%

4%

8%

12%

16%

20%

2001 2003 2005 2007 2009 2011 2013

YoY growth

AWPLR

AWPLR Private sector credit growth YoY


13


Historical data shows that declining interest rate regimes promote lending growth, but with a time lag, as seen in Figure 26 above. Small but clear indications of a pick-up are beginning to appear. After a significant decline in January 2014, private sector credit growth has been gradually picking up. Overall credit to the private sector amounted to LKR2,498bn in March 2014, a marginal increase from February. The CBSL reported that lending by domestic banking units to the private sector increased by LKR15.3bn in March 2014, but that the net credit level dropped due to repayments by BOI companies to offshore banking units. April 2014, despite usually being the slowest month for credit due to the long New Year holiday, showed 3.3% YoY growth, though it was a 0.6% MoM decline.

The larger private commercial banks including COMB, HNB and Sampath Bank, have been early movers in this regard; they reduced lending rates relatively early and, as a result, were able to show above-industry-average growth in 2013 and in 1Q2014. As the lending rate decline gains momentum, we expect investment appetite within the private sector to gradually improve starting 2H14. The CBSL expects overall loan growth at 14% for 2014 for the sector. We believe this is quite ambitious for the sector, but expect the larger private commercial banks to reap the benefits of the rate decline and to grow at double-digit rates by leveraging their brand name and strong retail penetration.

Pawning portfolio issues managed effectively

The significant impact from the pawning portfolio decline has raised the question as to whether banks will be able to grow their loan books amid de-growth in gold-based lending. A large component of the banking industry credit growth in 2011 and 2012 was derived through gold-based lending, which grew 78% in 2011 and peaked in 2012 at LKR508bn, accounting for 25.4% of total LCB loans (including loans for purposes other than consumption). As gold prices declined, gold-based lending too declined, by LKR144bn in 2013, and the CBSL estimates that gold loans have declined by LKR156bn in total since the peak in 2012. The significance of this decline is clear when considered against the fact that total incremental private credit for 2013 amounted to LKR176bn.

Gold-based lending declined LKR156bn since 2012 Figure 27: 20%-33% of gold-based loans used to fund SMEs Figure 28:

LKRm 2010 2011 2012 2013

Total gold based lending

234,008 416,805 508,417 364,714

Pawning for personal loans

166,315 281,909 339,355 292,873

(%) 71% 68% 67% 80%

Pawning for industrial/trading activities

67,693 134,896 169,062 71,841

(%) 29% 32% 33% 20%


The issue is further complicated by a factor specific to Sri Lanka and other South Asian countries: the practice of using gold as collateral for loans to fund small and medium enterprises in the agricultural, fishing and trading sectors, rather than for personal consumption. Pawning is particularly important in the North and East of Sri Lanka. Verification of land ownership is quite difficult following the destruction of land registries in this region; therefore, gold is the one of the few available and acceptable sources of collateral for lending.

Industrial activity-related lending as opposed to consumer debt accounted for 33% and 20% of total pawning in 2012 and 2013, as seen above in Figure 28. As the banks tighten lending criteria, increase interest rates and limit loan-to-value (LTV) ratios, such constraints on gold-based lending affect the ability of rural communities to obtain banking facilities for economic activities and lead them towards informal lending sources.

19.2%

24.7% 25.4%

17.5%

0%

5%

10%

15%

20%

25%

30%

-

100

200

300

400

500

600

2010 2011 2012 2013

% of total loans

LKRbn

Gold-based loan portfolio As a % of total loans


14


To counteract this financial exclusion and to enable credit growth at a structured pace, the government introduced a gold-backed loan guarantee scheme in May 2014, whereby a government guarantee is available on new pawning loans. The CBSL expects this scheme to allow banks to increase the LTV in gold-based lending to roughly 80%, up from the current 65%. The CBSL has allocated LKR500m in initial funding for the new guarantee scheme. The scheme is likely to remain self-funded, as the banks are to contribute a 1% premium annually on their new pawning loans. The interest rate on new pawning advances is capped at 16%. Although this is limited to new loans, the possibility of refinancing old loans through the new finance scheme, which would be at lower rates, should help ease loan quality deterioration and the deceleration of the pawning portfolio of banks.

A fine balance is required between risk mitigation for the banks and the provision of access to credit for an important segment. Credit rating agencies have pointed out the risk of banks aggressively pursuing pawning-based business growth; concerns center on the zero risk weighted assets (RWA) for gold, leaving no specific capital buffer for risk in the pawning portfolio and the absence of the requirement to report defaulters on pawning loans to the Credit Information Bureau. Our discussions with the CBSL indicate that while the CBSL will continue to closely monitor the banks’ pawning business, it is unlikely to raise the RWA on gold loans to avoid further constraints on gold based lending, given the importance of this line of credit.

The nature of gold-based lending itself sets an automatic time limit on the concerns regarding pawning portfolios. A pawned article is redeemable within 12 months. Banks are able to realize assets on overdue loans usually after a further six months’ waiting period. Since pawning loan growth peaked in 2012, a significant proportion of overdue loans would already have fallen due and been provided for. Our discussions with the CBSL indicate that it expects the concerns related to the pawning portfolios to recede within the next three to six months.

Industry average measures mask wide variations in individual bank

performance

Asset growth and asset quality vary widely among banks, and this variation is masked when quoting industry average numbers. Although overall industry loan book growth declined to 8.8% in 2013, the larger private banks showed significantly higher growth, as seen in Figure 29. Sampath Bank grew roughly 25% YoY in 2013 and HNB 17%. DFCC, NDB and Commercial Bank each grew by double-digit numbers. Furthermore, although Peoples Bank’s loan book grew only 3.2% YoY in 2013, incremental credit to other industries amounted to LKR74bn, close to 10% of its loan book. However, this growth was masked by the LKR54bn decline in its pawning portfolio.

Double-digit loan growth in 2013 at private LCBs Figure 29: Pawning portfolio as a % of total loans varies widely Figure 30:

Source: Company reports, Bloomberg Source: Company reports, Bloomberg

Similarly, exposure to gold-based lending varies widely among the banks. Figure 30 shows the pawning portfolio as a percentage of total loans, at 11 LCBs in 2012 and 2013. The highest exposures are at Bank of Ceylon (BOC) and Peoples Bank, the two largest state banks. Peoples Bank had the largest pawning portfolio of LKR250bn, amounting to 38% of total loans in 2012,

28.0%

25.2%

18.6%

17.0%

16.8%

10.3%

5.7%

3.2%

0% 10% 20% 30%

DFCC

SAMP

NDB

SEYL

HNB

COMB

BOC

PB

Loan growth

0%

10%

20%

30%

40%

CO

MB

HN

B

SA

MP

ND

B

NT

B

DF

CC

SE

YL

PA

BC

UB

BO

C

PB

% of total loans

2012 2013


15


which it trimmed down to LKR197bn by 2013. HNB trimmed its pawning portfolio to 13% of total loans by December 2013 and further to 11% by the end of 1Q14. NDB, DFCC and NTB all kept their exposures at below 10% of total loans. Commercial bank had the lowest exposure, with the pawning portfolio brought down to 1.8% of total loans in 2013 (from 3.2% in 2012). Sampath Bank was the only systemically important private bank with a high pawning exposure at 19.7% of total loans in December 2013; its exposure was also reduced to 17% by the end of 1Q14.

The industry average NPA level rose to 5.6% in 2013, and to 6.2% in 1Q2014, from 3.7% in 2012, mainly due to pawning-related losses. Given the lower level of residual risk on the new NPAs (being primarily gold-backed), banks made fewer provisions on the new NPAs, resulting in lower levels of provisioning coverage. We believe the increased credit risk as portrayed by lower loan loss coverage ratios (Figure 32), may not be as severe as it appears, due to the low LTV ratio (55%-65%) on new loans and the relative ease of realizing the value of the underlying collateral in gold-backed loans. However, a prudent approach would certainly require higher provisioning.

Gross NPA levels rose in 2013 Figure 31: Reported loan loss coverage levels fell at most banks Figure 32:

Source: Company reports, Bloomberg Source: Company reports, Bloomberg

Lower SOE borrowings support private credit growth

Private sector credit declined to 60% of total domestic credit in 2013, from a peak of 66% in 2010, as lending to the government and state-owned enterprises (SOEs) increased. Lending to SOEs, primarily to the Ceylon Electricity Board and the Ceylon Petroleum Corporation (CPC), started to ease during 2H13. As these two SOEs returned to profitability, credit growth to SOEs declined, helping to release significant liquidity to the market. This, in turn, led to a milder crowding out impact on private sector credit, and assisted in easing demand-driven pressure on interest rates. SOEs repaid LKR35bn of debt during 1Q14. On the other hand, total credit to the government has been increasing, as the government continues to invest in infrastructure projects.

Private sector credit - 60% of total credit in 2013 Figure 33: Credit to SOEs declining Figure 34:

Source: CBSL Note: Public corporations include govt. and state-owned enterprises Source: CBSL

0%

4%

8%

12%

16%

20%

CO

MB

HN

B

SA

MP

ND

B

NT

B

DF

CC

SE

YL

PA

BC

UB

BO

C

PB

Gross NPA ratio

2012 2013 Sector average

0%

20%

40%

60%

80%

COMB HNB NDB DFCC PABC PB

Provision coverage

ratio

2012 2013 Sector average

0

1,500

3,000

4,500

2009 2010 2011 2012 2013

LKRbn

Credit to public corporations Credit to the private sector

0

100

200

300

400

Jan

-13

Fe

b-1

3

Ma

r-13

Ap

r-13

Ma

y-1

3

Jun

-13

Jul-1

3

Au

g-1

3

Se

p-1

3

Oct-

13

Nov-1

3

Dec-1

3

Jan

-14

Fe

b-1

4

Ma

r-14

Ap

r-14

LKRbn

Credit to SOEs


16


Improving liquidity levels ease pressure on interest rates

Furthermore, we note that liquidity in the banking sector improved in 2013, with the liquid-assets-to-total-assets ratio improving by 530bps and the liquid-assets-to-deposits ratio by 800bps. This is due to the mix shift towards investment assets on the back of slow loan growth during the year.

Liquidity ratios in the banking sector improving Figure 35: Domestic private sector credit – a well-diversified Figure 36:

portfolio


Banking sector loan book well diversified

Sri Lanka’s banking sector loan portfolio is well balanced across a number of sectors, reducing the reliance on any single sector. This lowers the risk of bubbles from unsustainable loan growth in specific segments such as property, personal consumption etc. According to CBSL data, the construction, trading, infrastructure, manufacturing and transportation segments posted double-digit growth rates in 2013, while credit growth in the consumption segment declined during the year.

20%

40%

60%

80%

2008 2009 2010 2011 2012 2013

%

Credit to Deposits & BorrowingsLiquid Assets to Total AssetsLiquid Assets to Total Deposits

16%

14%

12%

12%

11%

6%

4%

3%

3%

19%

Trading

Construction

Agriculture andfishingConsumption

Manufacturing

Infrastructure

Financial services

Tourism

Transport

Other


17


Macroeconomic factors substantiate private sector credit

growth story

Credit as a percentage to GDP well below that of regional peer set

Sri Lanka’s private sector credit as a percentage of the GDP is relatively low – remaining at an average of 30% over the past three years, as shown below in Figure 37. Private sector credit as a percentage of GDP is an indicator of financial depth and is both a causal factor and a result of economic growth. An excessive, sudden increase in the ratio is also a risk factor for the economy as it can cause inflationary pressures. Household debt as a percentage of GDP also remains at very low levels (Figure 38). Sri Lanka’s GDP per capita rose to USD3,282 in 2013 and is forecast to rise to USD4,000 by 2016. The projected increase in disposable income that accompanies per capita income growth should allow for significant increase in personal consumption and provide an opportunity for increased personal lending, leading to growth in bank loan books.

Private sector credit as a % of GDP stable and low Figure 37: Household debt as a % of GDP – further room for Figure 38:

growth


Sri Lanka’s private sector credit to GDP (Figure 39) and the household debt as a percentage of GDP (Figure 40) ratios are well below that of its regional counterparts, indicating sufficient room for growth as economic growth gains momentum.

Private sector credit as a % of GDP – Sri Lanka well Figure 39:below regional peers

Household debt as a % of GDP – Sri Lanka well Figure 40:below regional peers

Source: CBSL, Bloomberg, World Bank

Source: CBSL, Bloomberg, World Bank

24.7% 26.5%

30.7% 31.1%

29.2%

-

2,000

4,000

6,000

8,000

10,000

2009 2010 2011 2012 2013

LKRbn

Domestic credit to the private sector (as a % of GDP)

GDP (excluding domestic credit to the private sector)

6.3%

7.2%

8.8%

9.3%

7.9%

3,000

4,000

5,000

6,000

7,000

8,000

9,000

2009 2010 2011 2012 2013

LKRbn

Household debt (as a % of GDP) GDP (excluding household debt)

0%

40%

80%

120%

160%

Sri L

anka

India

Indonesia

Ma

laysia

Th

aila

nd

Ph

ilippin

es

7.9% 8.3% 10.3%

86.8% 81.7%

6.2%

0%

20%

40%

60%

80%

100%

Sri L

anka

India

Indonesia

Ma

laysia

Th

aila

nd

Ph

ilippin

es

%

Household debt (as a % of GDP) GDP (excluding household debt)


18


IMF forecasts Sri Lanka’s GDP to be the highest in the region

We believe there are solid underlying factors supporting the medium- to long-term economic growth story in Sri Lanka. Loan growth generally trends with GDP and is a few percentage points higher in a stable economy. Sri Lanka saw credit growth well above that of GDP growth in the immediate postwar period, explained partly by the pent-up demand for credit following a 30-year war.

Loan growth tracks GDP and is usually higher than GDP growth Figure 41:

Source: CBSL

We expect economic growth to track around 7%-8%, the CBSL forecasts 7.8% GDP growth for 2014E, whereas GDP 1Q14 was reported at 7.6%. The World Bank’s Global Economic Prospects report issued in June 2014, forecasts Sri Lanka’s economic growth to remain broadly stable at 7.2% in 2014. It forecasts the growth rate to moderate slightly to 6.9% in 2015 and 6.7% in 2016. These projections position Sri Lanka as the fastest growing South Asian nation, ahead of the regional average of 5.3% and that of India at 6.3%.

The CBSL also targets maintaining inflation at mid-single digit levels; headline inflation has remained below 6% over the past seven months. This implies nominal GDP growth at low double-digit levels in 2014 and beyond. Assuming credit growth at 2-3 percentage points higher than nominal GDP growth levels would still suggest credit growth at mid-teen levels in the near term.

We briefly discuss below other factors that support the case for economic growth in the medium to long term in Sri Lanka.

Inflation targeted to remain at mid-single digit levels

Inflation remained at single-digit levels for the fifth-consecutive year despite supply disruptions, due to adverse weather conditions and fuel price increases. The CBSL targets maintaining inflation at mid-single-digit levels, and such low levels would support a low interest rate regime.

1%

4%

7%

10%

13%

-10%

0%

10%

20%

30%

40%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

YoY growth YoY growth

Sector loan growth (LHS) GDP growth (RHS)


19


Low inflation rates enable a low interest rate regime Figure 42: Foreign direct investment nearly tripled over past Figure 43:

three years


FDI inflows continue to rise

Foreign direct investment inflows, including loans, rose to USD1.4bn in 2013, nearly tripling from 2010 levels. Originating mainly from China, Malaysia and Hong Kong, 56% of this investment was directed to infrastructure development. We view continued FDI inflows as a vote of confidence in the Sri Lankan growth story.

Foreign remittances and exports increasing

Foreign remittances rose over 50% from 2010 levels to USD6.4bn in 2013. This was attributed to an increase in more skilled and semi-skilled Sri Lankans being employed abroad. The Treasury projects foreign remittances increasing to USD7.6bn by 2016E.

Similarly, revenue from the export of goods showed accelerating growth to USD10.4bn by 2013, fuelled primarily by the export of high-value apparel products and a shift in tea exports to value-added branded products.

Foreign remittances rose over 50% during 2010-2013 Figure 44: Earnings from export of goods rising Figure 45:


3.6%

6.2% 6.7%

7.6%

6.9% 5.3%

0.0%

2.0%

4.0%

6.0%

8.0%

2009 2010 2011 2012 2013 2014(May)

%

Headline inflation

889

601 516

1,066

1,338 1,421

-

200

400

600

800

1,000

1,200

1,400

1,600

2008 2009 2010 2011 2012 2013

USDm

Foreign direct investments

1,414

2,502

4,116

6,407

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2003 2007 2010 2013

USDm

Foreign remittances

5,133

7,640

8,626

10,394

2,000

4,000

6,000

8,000

10,000

12,000

2003 2007 2010 2013

USDm

Earnings from export of goods


20


Earnings from tourism increased… Figure 46: …as did earnings from export of IT and Telecom Figure 47:

services

Source: Ministry of Finance Source: Ministry of Finance

Revenue from the export of services more than doubled to USD719bn between 2010 and 2013, with significant contributions from port and shipping-related earnings, tourism and the export of IT services. Such changes in the structure of the economy help to reduce the reliance on traditional exports and to de-risk the economy.

Exchange-rate stability a strong positive

The Sri Lankan rupee has showed the lowest fluctuation levels compared with the currencies of regional peers during the past twelve months. Such stability is critical to exporters and to encourage foreign investments. We believe the rupee will continue to depreciate at a low-single-digit level going forward as well.

Currency fluctuation in LKR the lowest among regional peers over the past twelve months Figure 48:

Source: Bloomberg

Fiscal deficit and current account deficit as a percentage of GDP

improving

The fiscal deficit amounted to LKR516bn in 2013, as against LKR489bn in 2012. However, the fiscal deficit as a percentage of GDP has been improving steadily. The Ministry of Finance stated in its annual review that its target was to reduce the fiscal deficit to below 5%.

The current account deficit too has been narrowing continuously, improving to -3.9% of GDP in 2013 from -6.7% in 2012.

454 385 576

1,715

0

500

1,000

1,500

2,000

2003 2007 2010 2013

USDm

Earnings from tourism Expon. (Earnings from tourism)

110

182

348

719

0

200

400

600

800

2003 2007 2010 2013

USDm

Earnings from export of IT and telecommunication services

90

100

110

120

130

Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14

Index

LKR/USD INR/USD IDR/USD THB/USD PHP/USD PKR/USD


21


Fiscal deficit as a % of GDP improving Figure 49: Current account deficit improving Figure 50:

Source: Ministry of Finance and CBSL Source: Ministry of Finance and CBSL

Further improvement in savings necessary to narrow the savings-

investment gap

Gross domestic savings as a % of GDP rose to 20% in 2013, rising from multi year lows of 15.4% in 2011. The savings-investment gap too has been improving consistently as seen in Figure 52. Sustaining high levels of economic growth requires further increase of the savings rate in Sri Lanka, failing which Sri Lanka would have to depend excessively on foreign investment for growth.

Gross domestic savings on the rise Figure 51: Savings – investment gap started to improve in 2011 Figure 52:

Source: Ministry of Finance and CBSL Source: Ministry of Finance and CBSL

-6.9%

-6.5%

-5.9%

-550 -500 -450 -400

2011

2012

2013

LKRbn

-7.8%

-6.7%

-3.9%

-5,000 -4,000 -3,000 -2,000 -1,000 0

2011

2012

2013

USDm

15.4% 16.9%

20.0%

0%

5%

10%

15%

20%

25%

2011 2012 2013

%

Gross domestic savings

-12%

-8%

-4%

0%2005 2006 2007 2008 2009 2010 2011 2012 2013

%

Savings - investment gap


22


Factors that temper a positive outlook on credit growth

We also note some concerns within the sector that could temper our positive credit growth outlook.

Firstly, the trend for deleveraging following bubbles of credit growth (as was the case during 2010-2012) typically leads to credit growth contraction in subsequent periods. We note that some larger corporates, which are over-leveraged due to acquisitions, have started to reduce their debt exposure. This could limit overall credit growth.

Secondly, credit growth could also be restrained by the cautious attitude banks are likely to take, given the high NPA levels in the sector. The sector’s NPA reached a four-year high of 5.6% in 2013, and rose further to 6.2% in 1Q2014.

Another factor that could affect the overall NPA quality of bank loan books is the increasing disintermediation. Blue chip corporate clients are now venturing in to debt raising at capital markets: for example, Hayleys Plc raised LKR2bn through a debenture issue at the CSE in 2013 and John Keells Ltd appointed bankers to raise medium term finance through foreign debt in May 2014. Further momentum in corporate debt markets would force banks to look for alternative means of growth, seeking growth in riskier sectors and client segments.

Therefore, we expect to see a moderate pick-up in credit growth towards 2H14 and overall sector credit growth to come in at the low- to mid-teens range in 2014. Furthermore, we believe sector credit growth in the low teens allows a favorable balance between growth and risk management.


23


We establish a valuation range of LKR138-166 for COMB’s

voting shares

We establish a 12-month valuation range of LKR138-166 per share, based on our current outlook for COMB shares, compared with the current share price of LKR140 as of 27 June 2014. We arrive at our valuation range by applying a sensitivity analysis to a P/BV valuation, and validate it further by cross-checking against a P/E multiple-based valuation. We also compare COMB’s valuation levels relative to a domestic peer group.

Valuation range analysis provides a range of LKR138-166 per share (current share price: LKR140) Figure 53:

Source: COMB, Bloomberg, Copal Amba estimates

P/BV analysis yields a valuation range of LKR141-166 per share

Our primary valuation for COMB is on a P/BV basis. At peak valuations, COMB traded at a trailing 12-month P/BV of 2.9x in January 2011; trading multiples have declined since then and after December 2011, the stock has been range bound at 1.4x to 1.8x P/BV.

COMB has traded at between 1.4x-2.9x on a P/BV basis since January 2011 Figure 54:


The stock currently trades at a P/BV multiple of 1.9x (based on our forecasts) – at a premium to both its two-year historical average of 1.7x, and to domestic peers (Figure 55). We believe the market has assigned a premium valuation to COMB to account for the higher ROE and ROA consistently displayed (Figure 56) and expect valuation to remain at a premium as COMB continues to report industry leading return metrics.

111

138

141

140

164

166 140

100 120 140 160 180

52-week range

P/E

P/B

0

50

100

150

200

250

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 May-13 Aug-13 Nov-13 Feb-14 May-14

LKR/share

1.4x 1.8x 2.2x 2.5x 2.9x MPS


24


P/E and P/BV comparison with domestic peers Figure 55:

Company P/BV P/E

2011 2012 2013 2014E 2015E 2011 2012 2013 2014E 2015E

COMB 1.8x 1.6x 1.7x 1.7x 1.5x 10.1x 8.5x 9.7x 9.3x 7.6x

HNB 1.1x 0.9x 0.8x 1.0x 0.9x 6.9x 5.9x 6.1x 6.3x 5.2x

SAMP 1.3x 1.2x 0.9x 0.9x 0.8x 8.5x 6.2x 7.9x 6.2x 5.0x

SEYL 1.3x 1.0x 1.0x NA NA 30.6x 9.1x 9.5x 8.2x NA

NTB 1.5x 1.3x 1.2x 1.2x 1.0x NM 6.7x 6.7x 6.5x 5.7x

Source: Bloomberg, Copal Amba estimates for COMB and HNB

ROE and ROA analysis of domestic peer set Figure 56:

Company ROE ROA

2011 2012 2013 2014E 2015E 2011 2012 2013 2014E 2015E

COMB 20.2% 20.8% 18.5% 19.0% 20.6% 2.0% 2.1% 1.9% 1.8% 1.9%

HNB 19.1% 17.0% 14.0% 13.2% 14.3% 1.9% 1.9% 1.6% 1.4% 1.5%

SAMP 16.2% 21.3% 12.2% 15.1% 17.0% 1.7% 1.9% 1.0% 1.4% 1.6%

SEYL 4.4% 11.4% 11.4% NA NA 0.4% 1.2% 1.2% NA NA

NTB 20.8% 20.8% 19.5% 19.4% 19.6% 1.7% 1.7% 1.6% NA NA

Source: Bloomberg, Copal Amba estimates for COMB and HNB

Our P/B-based valuation range is derived considering the sensitivity of the stock price to changes in the base-case P/B multiple of 1.9x, based on the current trading multiple, which yields a one year forward valuation of LKR160 for the share.

We believe investors would look beyond the immediate weakness in the sector and assign a higher trading multiple to COMB as it continues to deliver above industry average earnings and profitability growth. Valuing COMB at a conservative 2.0x P/BV multiple on a one year forward basis yields a value of LKR166.

Our bear case scenario considers the valuation for COMB in a situation where the valuations further decline; trading at a 1.7x one year forward P/BV multiple would result in a price of LKR141. Thus our P/B multiple based valuation range stands at LKR141-LKR166.


25


P/E analysis gives a valuation range of LKR138-164 per share

We cross checked our P/BV valuation by valuing COMB on a P/E basis too, as a secondary measure. The one-year forward P/E multiple range of COMB has shown a wide variation since January 2011 – ranging from 18.0x at peak levels in 2011 to lows of 7.5x in 2012. The stock currently trades at a 2014E multiple of 9.3x (based on our forecasts) – at a 13% premium to its two-year historical average of 8.2x.

COMB has traded at between 7.5x and 18.0x on a P/E basis, since January 2011 Figure 57:


We use the one year forward P/E multiple COMB has been trading at over the past two years, 9.3x as our base case multiple, yielding a P/E based price of LKR145. Our bear case assigns an 8.8x 2014E EPS multiple to COMB, and the bull case a 10.5x 2014E EPS multiple, yielding a price range of LKR138-164.

Non-voting shares currently trade at a 24% discount

As shown in Figure 58, COMB’s non-voting shares currently trade at LKR106, a 24% discount to the voting shares. COMB’s non-voting shares have traded at a discount of 20% to 40% to the voting counter over the past five years.

COMB’s non-voting shares have generally mirrored the movement of its voting shares Figure 58:


0

50

100

150

200

250

300

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 May-13 Aug-13 Nov-13 Feb-14 May-14

LKR/share

7.5x 10.1x 12.8x 15.4x 18.0x MPS

0

40

80

120

160

Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14

LKR

Voting share price Non-voting share price


26


Share price performance

COMB voting-shares closed at LKR140 on 27 June 2014, LKR27 higher than 12 months earlier, an increase of 24%, compared to a 3% increase in the S&P SL 20 and a 4% increase in the All Share Price Index (ASPI).

COMB.N0000 share performance over the last three years Figure 59:


COMB vs. key indices over 2011-2014 Figure 60:

3m 6m 1 year 2 years 3 years

COMB 17.1% 17.2% 23.7% 44.4% 17.7%

S&P SL 20 7.5% 8.6% 2.8% 23.7% -3.3%

ASPI 6.2% 8.3% 4.1% 27.4% -7.7%


60%

80%

100%

120%

Jun-11 Oct-11 Feb-12 Jun-12 Oct-12 Feb-13 Jun-13 Oct-13 Feb-14 Jun-14

COMB ASPI S&P SL 20


27


Earnings release focus areas

Following is a checklist of items that investors should track in the next quarterly earnings release and subsequent releases. We will closely track COMB’s performance across these key areas, revise our forecasts and update our valuation range in future earnings update notes.

Focus areas on company specific data

1. Loan book growth: total loan book growth rate QoQ and YoY, segmental growth rates – particularly corporate loans, SME loans and the pawning portfolio; composition of the loan book

2. Change in funding structure: CASA ratio, change in bank borrowings and debentures, if any

3. Net interest margin and net interest spread; composition of the net interest margin

4. Impairment levels: overall impairment and impairment levels in key segments and the provision coverage level

5. Cost – to – income ratio

6. Profit margins: operating profit margin and net profit margin

7. Dividend payout ratio

8. Capital adequacy levels – Tier 1 and Tier 2 ratios

9. Change in branch and ATM network

10. Operations in Bangladesh, and ventures in to other regional countries

11. Any announcements regarding the acquisitions of NBFIs to be undertaken in view of the CBSL proposed consolidation program.

Focus areas on macroeconomic data

1. CBSL imposed policy changes – policy rates, repo rates, lending ceilings, rate ceilings etc.

2. CBSL monthly data issues - Domestic private sector credit levels, inflation, sector loan growth data etc

3. CBSL weekly data issues - LCB prime lending rates

4. GDP, FDI inflow, Fiscal and Current Account deficits – as disclosed periodically by the CBSL


28


Appendix 1: The Sri Lankan banking sector – A

competitive landscape

The Sri Lankan government envisages an USD100bn economy in the country over the medium term. The CBSL is implementing structural changes to the country’s banking sector in an effort to further strengthen it and make it globally competitive, so that the financial system will be able to support such a large economy. At present, the Sri Lankan banking industry is an oligopoly dominated by two government banks (Bank of Ceylon and People’s Bank) and three large private commercial banks (Commercial Bank, Hatton National Bank and Sampath Bank), which collectively control nearly two-thirds of total banking-sector assets. The remainder is fragmented, leading to intense competition. We also believe the sector needs to increase in size so as to take on big-ticket transactions.

The structure of Sri Lanka’s banking sector

There is a fair amount of over-banking in the sector, with 34 banks accounting for LKR5.9tn (roughly USD45bn) in assets. The banking sector (excluding Central Bank assets) accounts for close to 58% of total financial-sector assets, while the sector’s assets as a percentage of GDP stood at roughly 68% in 2013.

12 domestic licensed commercial banks are they key players in the industry Figure 61:

Source: CBSL Note: Excludes Cargills Agricultural and Commercial Bank which commenced operations in May 2014

12 Foreign LCBs operate in Sri Lanka Figure 62:

Axis Bank Indian Overseas Bank

Citibank MCB Bank

Deutsche Bank Public Bank Berhad

Habib Bank Standard Chartered Bank

ICICI Bank State Bank of India

Indian Bank HSBC

Source: CBSL

The 25 licensed commercial banks (LCBs) accounted for roughly 85% of total banking-sector assets and 90% of gross loans in 2013. The nine licensed specialized banks (LSBs) focus on savings and development activities, and are not authorized to accept demand deposits (current accounts) or deal in foreign currency; these banks accounted for 15% of total banking-sector assets and 10% of gross loans in 2013. Of the 25 licensed commercial banks (LCB), the two largest are the government banks, Bank of Ceylon and Peoples Bank, cumulatively accounting for nearly 50% of total commercial banking sector credit as at December 2013. The largest private LCB is Commercial Bank of Ceylon, accounting for roughly 14% of total commercial banking sector credit.

Amana

UB

PABC

DFCC Vardhana NTB

NDB

SEYL

SAMP

HNB

COMB

PB

BOC


29


State- and privately owned LSBs (circles denote asset size) Figure 63:

Source: CBSL

As Figure 64 shows, only 5 of the 22 domestic banks have an asset base greater than LKR500bn (USD4bn), while most banks have an asset base less than LKR50bn. Foreign banks accounted for roughly 10% of the sector’s assets, and most have an asset size less than LKR50bn.

Five domestic banks hold a market share of 66% Figure 64: Most foreign banks have an asset base < LKR50bn Figure 65:

Asset size Number of banks

Total assets (LKRbn)

Market share

More than LKR500bn 5 3,891 66.3%

LKR250bn to LKR500bn 1 370 6.3%

LKR100bn to LKR250bn 3 541 9.2%

LKR50bn to LKR100bn 4 309 6.6%

Less than LKR50bn 9 251 4.3%

Asset size

Number of banks

Total assets (LKRbn) Market share

LKR250bn to LKR500bn 1 297 5.1%

LKR100bn to LKR250bn 1 107 1.8%

Less than LKR50bn 10 174 3.0%


According to our calculations, the top five LCBs accounted for roughly 66% of total banking-sector assets (Figure 66) and 76% of gross loans in 2013 (Figure 67). Owing to this concentration, we focus on these five banks in our sector discussion to depict industry growth trends.

The top five LCBs accounted for 66% of total Figure 66:banking-sector assets …

… and 76% of gross loans Figure 67:



Lankaputhra Development Bank

HDFC

Sanasa Development Bank

Regional Development Bank

DFCC Bank

NSB

6.6%

8.8%

10.2%

17.4%

20.6%

36.4%

SAMP HNB COMB PB BOC Other

8.4%

10.8%

11.1%

22.6%

22.7%

24.4%

SAMP HNB COMB PB BOC Other


30


Loan book growth in the banking sector set to pick up in 2H14

We discuss the factors that in our view should drive the pick-up in credit growth in pages 10-22.

Funding – Sourced primarily through retail deposits

Deposits made up roughly 70% of the banking sector’s funding in 2013, while the remainder was sourced through domestic and international borrowing. For domestic commercial banks, deposits accounted for 84% of total liabilities. However, deposit growth in domestic commercial banks moderated to 16%, while borrowings growth decelerated to 10% in 2013. This was in line with the slowdown in credit growth owing to the lag effect of the high interest-rate environment during 2012.

After the CBSL relaxed regulatory limits on foreign borrowing for LCBs in 2012, several banks raised dollar-denominated debt, increasing the level of foreign funding as a percentage of total borrowings within the system. For example, National Savings Bank (NSB) raised USD750m in September 2013 and DFCC bank raised USD100m in October 2013. The BOC also raised USD500m through the issuance of a five year bond overseas.

Furthermore, both banks and non-banking financial institutions (NBFIs) showed a significant increase in sourcing funding through the local debt capital market, after the government incentives offered in the 2013 budget. During 2013, 21 banks and NBFIs raised LKR57.3bn through listed debentures on the CSE.

The banking sector’s CASA ratio continues to decline; it decreased to 34% in 2013 from a high of 44% in 2010, increasing the cost of funding. We believe the declining CASA ratio will negatively affect the sector’s net interest margins (NIMs).

Deposit and borrowings growth declined in 2013 Figure 68:

CASA ratio declining; foreign borrowings on the rise Figure 69:


Sri Lankan banking sector NIM - one of the highest in the region

Sri Lanka’s banking sector reports the second-highest NIM (5.02%) among regional peers (peer average: 3.78% in 2013). We believe this is mainly due to the combination of high-yielding loan portfolios and cost-effective funding structures.

However, we note that the NIM has continued to trend downwards – the current average is well below the historical five-year average of 5.69%. We believe this is mainly attributable to intense competition within the sector and the lower interest rate regime. The CBSL aims to maintain lower interest spreads and requires that banks narrow their NIMs over the coming years. The CBSL’s soft target is NIMs of 3-4%, versus the current 5-6%. We believe declining NIMs will continue to pressure the industry’s overall profitability if transaction volume does not pick up.

-40%

-20%

0%

20%

40%

60%

10%

12%

14%

16%

18%

20%

22%

2009 2010 2011 2012 2013

YoY growth

Deposit growth (LHS) Borrowings growth (RHS)

0%

10%

20%

30%

40%

50%

2009 2010 2011 2012 2013

CASA ratio Foreign borrowings as a % of total borrowings


31


Sector-average NIM of 5.02% is the second-highest Figure 70:among regional peers

Sri Lankan banks’ NIMs range from 3.9% to 6.3% Figure 71:


For regional peer comparison, we use the largest five/six banks in a country based on asset size. In some countries (e.g., Malaysia and India), the asset base of some banks is considerably greater than those of Sri Lankan banks.

High NIMs are not translating into high profitability due to high cost

structure

The high NIMs Sri Lankan banks currently enjoy do not always translate into high profitability. This is because of both structural issues, such as the relatively large number of small banks, and bank-specific inefficiencies. Compared with regional peers’, the Sri Lankan banking sector’s average cost-to-income ratio was relatively high at 50.3% in 2013. Although DFCC and Commercial Bank posted cost-to-income ratios in the mid-40s, the very high ratios (70-80%) reported by smaller banks create an upward bias on the overall average.

High cost-to-income ratio impedes profitability (Sri Figure 72:Lankan peers)

Sri Lankan banks have the highest cost structure Figure 73:among regional peers


The burden of high cost-to-income ratios is further exacerbated by high provisioning costs, due to high NPA ratios at some local banks. In 2013, the sector’s gross NPA ratio stood at 5.6%, and rose to 6.2% in 1Q2014, a five year high, due to increasing NPAs in the pawning portfolio and slow credit growth. Of the LKR74bn increase in NPAs in 2013, LKR56bn was related to pawning

0%

2%

4%

6%

8%

2008 2009 2010 2011 2012 2013

NIM

India Philippines ThailandIndonesia Malaysia Sri Lanka

0%

1%

2%

3%

4%

5%

6%

7%

COMB HNB SAMP NTB SEYL BOC PB

NIM

2012 2013

0%

20%

40%

60%

80%

COMB HNB DFCC NDB SAMP NTB SEYL UB PABC

Cost-to-income

2012 2013

30%

40%

50%

60%

70%

2008 2009 2010 2011 2012 2013

Cost-to-income

India Philippines ThailandIndonesia Malaysia Sri Lanka


32


advances. Furthermore, the sector posted a decline in the coverage ratio in 2013. The total provisions-to-NPA ratio for the sector came in at 40.4% in 2013, having steadily declined from 60.9% in 2008.

NPA ratios are at their highest in four years Figure 74:

The sector’s total provisions-to-NPA ratio declined Figure 75:


The CBSL stated that the decline in the coverage ratio was mainly due to lower provisioning against new NPAs, which mostly relate to gold-backed loans. Most banks considered residual risk for gold-backed assets to be low and therefore made lower provisioning against their gold-based lending portfolios. We believe the apparent increase in credit risk, as indicated by lower provisioning cover, may not be as severe as it appears, as LTV ratios are lower in the more recent loans against which impairments are now being recorded. However, a prudent approach would require closer monitoring of the provision levels of each bank.

Some smaller banks report higher NPAs than the sector average; however, their impact on the overall system is low, as they account for less than 5% of total sector assets.

NDB, HNB and Commercial Bank record the lowest NPA ratios, at below 4%. They also have healthy coverage ratios. The two state banks have reduced their NPA levels to below the sector average and maintain strong coverage ratios.

High NPAs concentrated in a few banks, with most large banks reporting healthy provisioning Figure 76:

Source: Bloomberg, Company reports, Copal Amba estimates

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

0

50

100

150

200

2009 2010 2011 2012 2013

NPA ratio LKRbn

Gross NPA volume (LHS) Gross NPA ratio (RHS)

Net NPA ratio (RHS)

58.0 48.5 45.7 48.3 62.1

13.8 13.7 11.0 13.9

15.2

0%

20%

40%

60%

80%

0

20

40

60

80

100

2009 2010 2011 2012 2013

LKRbn

General provisions (LHS)

Specific provisions (LHS)

Total provisions to NPA ratio (RHS)

0%

20%

40%

60%

80%

100%

120%

0%

4%

8%

12%

16%

COMB HNB DFCC NDB SAMP NTB SEYL UB PABC BOC PB

Provisioning cover Gross NPA ratio

Gross NPA ratio 2012 Gross NPA ratio 2013 Provisioning cover 2012 Provisioning cover 2013


33


ROE and ROA have headroom to improve

We believe measures of efficiency, such as ROE and ROA, have room for improvement. The sector’s ROE has been trending downwards since 2010 and is now at 16%. Similarly, the sector’s ROA declined to 1.3% in 2013 from 1.7% in 2011. Commercial Bank and NTB report the highest ROEs at around 19%; they also report ROAs higher than the sector average. Figure 78 compares listed Sri Lankan banks in terms of ROE versus P/B values.

ROE and ROA of domestic banks Figure 77:

Listed Sri Lankan banks’ P/B vs. ROE, 2013 Figure 78:


There is further room for improvement in terms of profitability for Sri Lankan banks, when compared with regional peers. Thailand and Indonesia, for example, report ROEs of over 20%; Indonesia reports an ROA over 2%. One of the targets of the proposed consolidation measures is for larger Sri Lankan banks to report returns similar to those of larger regional peers.

Sri Lankan banks need to improve further on ROE Figure 79:

… and ROA levels Figure 80:


COMB

HNB DFCC

NDB

SAMP

NTB

SEYL

UB

PABC

0.8x

1.0x

1.2x

1.4x

1.6x

1.8x

0% 5% 10% 15% 20% 25%

P/B

ROE

0%

5%

10%

15%

20%

25%

30%

2008 2009 2010 2011 2012 2013

ROE

India Philippines Thailand

Indonesia Malaysia Sri Lanka

0%

1%

1%

2%

2%

3%

3%

2008 2009 2010 2011 2012 2013

ROA



0.0%0.6%1.2%1.8%2.4%

ROA 2013 ROA 2012

0% 6% 12% 18% 24%

COMB

HNB

DFCC

NDB

SAMP

NTB

SEYL

UB

PABC

ROE 2013 ROE 2012


34


The sector is attractive due to relatively high dividend yields

One of the reasons driving the higher demand and the consequent higher liquidity of listed banks is the relatively high dividend yield. This would appear more attractive in a lower interest rate scenario.

Dividend yields of domestic listed banks remain relatively high Figure 81:

Source: Bloomberg, Company reports

The sector is well positioned in terms of risk-mitigation measures

Sri Lankan banks maintain capital at well above the regulatory requirements of Tier 1 capital ratio of 5% and capital adequacy ratio (CAR) of 10%. Sri Lankan banks are among the best capitalized in the region, with an average CAR of 14.1% against a regional average CAR of 12.5%.

Most banks maintain Tier 1 capital well above Figure 82:regulatory requirements

Sri Lankan banks are among the best capitalized in Figure 83:the region


Additionally, Sri Lankan banks measure up well in terms of loan-to-deposit ratios (LDR). With the exception of DFCC and NDB, development banks which are funded by large project loans from local and international funding institutions, the other banks report LDR between 80%-90%, a health range within which the liquidity risk is well managed, while maintaining profitability.

0%

2%

4%

6%

8%

10%

12%

COMB HNB DFCC NDB SAMP NTB SEYL

Dividend yield

2012 2013

0%

5%

10%

15%

20%

25%


Tier 1 capital ratio CAR

0%

5%

10%

15%

20%

2008 2009 2010 2011 2012 2013

Tier 1 capital




35


Loan-to-deposit ratios are relatively low Figure 84:

Source: Bloomberg, Company reports

Sector consolidation could propel Sri Lankan banks to the next level of

profitability

In comparison with regional peers, Sri Lankan banks face the disadvantage of small size. The country’s largest bank, Bank of Ceylon, is the only bank with assets of over LKR1tn (close to USD10bn), while the three largest private commercial banks have assets of roughly USD3.0bn-4.5bn. This makes it difficult for Sri Lankan banks to take on large-ticket transactions to achieve greater operating efficiency, and impedes the sector’s competitiveness in the global market.

Sri Lankan banks target both organic and inorganic growth to increase asset size. However, rapid internal growth is generally viewed as a high-risk strategy due to the risk associated with the potential diminishing quality of the asset base.

Sri Lanka aims to establish a strong, globally competitive and dynamic financial sector through a regulator-driven consolidation process. The CBSL targets reducing the number of banks and non-banking financial institutions (NBFIs) in the system, and creating at least five banks with an asset size of LKR1tn each. It has directed domestic banks with asset sizes of less than LKR100bn to increase their size through organic or inorganic growth. The CBSL also aims to create one large regional bank to focus on regional activities. We believe this will narrow the gap in development activity between the Western Province and the other parts of the country.

As a first step in this process, two development banks, NDB and DFCC, are moving toward consolidation. The consolidation of these two groups [comprising NDB, DFCC and DFCC Vardhana Bank (DFCC’s commercial-banking arm)] will likely result in a bank with an asset size of roughly LKR380bn (USD3bn).

Consolidation in the NBFI sector has already commenced. The sector accounts for roughly 7% of total financial-sector assets, and comprised 58 NBFIs as of end-2013. The sector is dominated by a few large NBFIs – 10 companies have asset sizes greater than LKR20bn (accounting for roughly 62% of market share), 7 companies have between LKR8bn and LKR20bn, and the remaining 41 have less than LKR8bn. The CBSL aims to reduce the number of NBFIs to around 20 and strengthen the balance sheets of these players in order to improve stability. It has also directed that smaller NBFIs should be acquired by large NBFIs or banks, or merge to reach an asset size of over LKR8bn. The regulator expects this consolidation process to be market-driven and be completed by March 2015. The first acquisition under this program came about at the end of June 2014, with Assetline Securities, a subsidiary of the David Peiris Motor Company acquiring Lisvin Investments Ltd.

The uncertainty over the consolidation process has also been weighing on Sri Lanka’s banking sector. However, we believe this will be a low-impact event for larger banks, as the asset size of the NBFIs to be acquired is less than LKR8bn (well below 5% of the banks’ overall asset sizes).

Many countries in the region (including Malaysia, Singapore, Indonesia, Thailand and Taiwan) faced similar regulator-driven consolidation processes, particularly following the Asian financial

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%


Loans to deposits

2012 2013


36


crisis in the late ’90s. Several international rating agencies have viewed this consolidation process as positive, as they concur with the CBSL that it will produce stronger players in the financial sector and enhance development in the long term.

Figure 85 lists the key profitability metrics of some regional banks; we believe Sri Lankan banks have the potential to achieve performance in line with regional peers’ once they show a significant increase in asset size.

Key metrics of some regional banks Figure 85:

Name of bank Country NIM CIR ROE ROA CAR Asset size

(USDm)

Tisco Financial Thailand 2.6% 39.5% 20.6% 1.3% NA 10,983

Bank Mandiri Indonesia 5.4% 40.6% 22.5% 2.7% 14.9% 60,238

Siam Commercial Thailand 3.3% 38.3% 21.8% 2.1% 14.5% 77,470

Public Bank Malaysia 2.1% 30.4% 21.2% 1.4% 13.8% 93,166

Source: Bloomberg

Although we are largely positive about the consolidation process, we believe there are challenges that the industry has to overcome. Initially, the sector has been instructed that there can be no retrenchment of staff during the consolidation process: only a voluntary retirement scheme (VRS) may be enforced. We believe this will cap any material cost synergies achievable during the process, and are also concerned about the relatively short timelines.

In addition to the proposed consolidation, the CBSL has increased capital requirements for the existing banks and NBFIs. LCBs will have a minimum capital requirement of LKR10bn each by 2016 and LSBs a minimum requirement of LKR5bn (due to increase by 2018). Furthermore, NBFIs will be required to have minimum capital of LKR1bn by 2016 and LKR1.5bn by 2018. Banks would be required to adopt Basel III capital standards, increase the quality and quantity of capital, introduce a capital conservation buffer and a counter-cyclical buffer to reduce pro-cyclicality, and to prevent excessive credit growth.

We believe these development initiatives will help Sri Lanka build a strong financial sector over the medium to long term.


37


Appendix 2: Company overview

Commercial Bank of Ceylon PLC (COMB) is the largest listed banking and finance institution on the S&P SL 20 index, with a market capitalization of LKR113bn as of 27 June 2014, and the fourth-largest listed company overall. COMB was incorporated in 1969, and is a licensed commercial bank offering a multitude of banking services to both personal and corporate clients. The bank accounted for 12% of asset market share in the banking sector, and 14% of loans in 2013. COMB’s banking segment is the mainstay of its operations, contributing 87% of revenue in 2013, while its leasing activities remain the fastest-growing segment, accounting for 8% of revenue in 2013. COMB operates one of the largest and most extensive branch and ATM networks in the country, comprising 235 branches and 585 ATMs island wide, and has the largest asset base among all domestic listed banks, at LKR649bn as at March 2014.

COMB has the distinction of being the sole Sri Lankan bank in the Top 1000 World Banks for the past three years, as chosen by UK-based “The Banker” magazine. US-based “Global Finance Magazine” has also acclaimed COMB as the best bank in Sri Lanka for the past 16 years.

COMB has also ventured outside Sri Lanka, in to Bangladesh, which accounted for about 8% of revenue and assets in 2013. The bank ventured into Bangladesh in 2003 when it bought over the operations of Crédit Agricole Indosuez, a French bank, and currently operates 18 branches and 19 ATMs in the country across four districts.

The bank recorded growth in loans and advances at a 15% CAGR over 2009-2013, although YoY growth has been declining since 2010, reflecting COMB’s conservative lending strategy. Meanwhile, deposits grew at a 17% CAGR, with time deposits being the key growth driver.

Loan growth at a 15% CAGR over 2009-2013… Figure 86: …while deposits increased at a 17% CAGR Figure 87:


In 2013, COMB recorded 11% YoY growth in its net interest income (NII) to reach LKR25.3bn, at a 14% CAGR, during 2009-2013. The bank’s net interest margin (NIM) grew to 5.0% in 2012 (from 4.3% in 2009), and subsequently contracted 29bps to 4.7% in 2013, as the bank started reducing lending rates in line with the policy decline in rates. COMB’s continuous efforts to improve efficiency has yielded favorable results, with the cost-to- income (CIR) ratio visibly improving, contracting about 500bps since 2009 to 40.3% in 2013. This has translated into enhanced profitability with the ROE widening 321bps from 15.3% in 2009 to 18.5% in 2013.

-5%

5%

15%

25%

-

100,000

200,000

300,000

400,000

2009 2010 2011 2012 2013

YoY growth

LKRm

Long-term loans (LHS) Overdrafts (LHS)Trade finance (LHS) Short-term loans (LHS)Housing loans (LHS) Others (LHS)YoY growth (RHS)

5%

10%

15%

20%

25%

-

100,000

200,000

300,000

400,000

500,000

2009 2010 2011 2012 2013

YoY growth

LKRm

Time deposits (LHS) Savings deposits (LHS)Current deposits (LHS) Other deposits (LHS)YoY growth (RHS)


38


COMB’s key business units

COMB offers many banking and financing services through the following strategic business units (SBUs).

Personal banking

This division primarily caters to individual and small and medium-sized enterprises (SMEs), in addition to managing COMB’s branch and ATM network. Services offered by the unit include deposit products (such as current and savings accounts), advances (personal, housing and auto loans) and fee-based services (debit/credit cards, internet and phone banking, and utility bill payments).

Corporate banking

This unit provides enterprise clients with corporate services such as term loans, leasing and factoring, term deposits, and savings and current accounts, among others. COMB also offers corporate finance products (managing IPOs and private placements, syndicated loans and project financing - a division the bank plans to expand in the future) and trade finance services (import/export financing and shipping guarantees). The bank additionally provides Islamic banking, bullion trading and internet banking facilities to its corporate clients.

Treasury

COMB’s treasury operation is a standalone profit center within the bank and overlooks the management of its liquidity, funding, interest rates, capital health and foreign exchange exposure. Products offered by this unit include derivatives, interest rate products and foreign exchange products. Profits from foreign exchange products are the main source of income for this division.

International operations

This SBU comprises primarily of COMB’s operations in Bangladesh, where it offers a range of deposit products and advances, as well as the bank’s range of remittance services; COMB holds a 17% market share of total worker remittances to Sri Lanka. The bank’s offshore banking operations in the Maldives also fall under this category.

NII grew at a 14% CAGR over 2009-2013; NIM Figure 88:compression seen as lower interest rate regime takes effect

CIR ratio has continued to improve since 2009, Figure 89:supporting ROE growth over the period


3.8%

4.0%

4.2%

4.4%

4.6%

4.8%

5.0%

5.2%

0

5,000

10,000

15,000

20,000

25,000

30,000

2009 2010 2011 2012 2013

NIM LKRm

Net interest income (LHS) NIM (RHS)

0%

5%

10%

15%

20%

25%

40%

41%

42%

43%

44%

45%

46%

2009 2010 2011 2012 2013

ROE CIR ratio

CIR ratio (LHS) ROE (RHS)


39


Shareholding structure

Domestic investors own 64% of COMB’s voting shares as of 31 December 2013, while institutional shareholders (both Sri Lanka-based and international) hold 82%. DFCC Bank PLC is the largest shareholder, with a 14.8% stake of voting ordinary shares, while the top 20 shareholders accounted for 69% of the total shareholding as of 31 December 2014. COMB’s directors hold less than 1% of total voting shares.

Institutional investors hold a majority stake of 82% of Figure 90:COMB’s voting shares…

… while resident shareholders own 64% of the bank Figure 91:with the top 20 investors accounting for 69%



The top five shareholders as of 31 March 2014 are presented below:

Name of shareholder Description Stake

DFCC Bank A/C 1 A leading domestic development bank 14.83% Employees Provident Fund The largest pension fund in Sri Lanka 9.75% HSBC INTL Nominees Ltd JPMCB – Franklin Templeton Investment Funds

A prominent global asset management group 6.48%

Mr. YSHI Silva A domestic high-net-worth investor 5.53% Sri Lanka Insurance Corporation Ltd – Life Fund

The largest government-owned insurance company in Sri Lanka 5.06%

Source: COMB

Board of directors

As of December 2013, COMB’s board comprised eight directors. Their details are provided below:

Name of Director Description

Mr. Dinesh Weerakkody Chairman. He was appointed to COMB’s board in July 2005, and has held the position of chairman since December 2011. He was formerly a director of DFCC Bank PLC, as well as an advisor to the Sri Lankan prime minister during 2002-2004.

Mr. Dharma Dheerasinghe Deputy chairman. He has held this position since December 2011 and is a prominent economist with 39 years of experience in the banking sector. Prior to joining COMB, he was the senior deputy governor of the Central Bank of Sri Lanka (CBSL).

Mr. Ravi Dias Managing director/CEO. He was initially appointed to the board in December 2010 and has occupied this position since April 2012. He was previously the COO of the bank for four years. He is also the managing director of Commercial Development Company PLC, a COMB subsidiary.

Prof. Uditha Liyanage Independent non-executive director. He is the chairman of the board’s technology committee and holds several directorships in domestic companies in various sectors.

Mr. Lakshman Hulugalle Independent non-executive director. He has been on COMB’s board since March 2011 and serves in several government committees and posts.

Individuals 18%

Institutions 82%

Resident 64%

Non-resident

36%


40


Mr. Preethi Jayawardena Independent non-executive director. He was appointed to the board in December 2011 and holds board positions in several public and private companies. He is also a member of the CBSL’s monetary policy consultative committee.

Mr. S. Swarnajothi Independent non-executive director. He is the chairman of COMB’s audit committee and has been on the board since August 2012. He was formerly the auditor general of Sri Lanka during 2008-2010.

Mr. Jegan Durairatnam Executive director/COO. He has held this position since April 2012, having previously served in numerous management positions within COMB.

Source: COMB

Corporate holding structure Figure 92:

Source: COMB


41


Appendix 3: Key financial data

Summary group financials (LKRm)

INCOME STATEMENT 2011 2012 2013 2014E 2015E 2016E

(For the year ended 31 December)

Net interest income 18,678 22,852 25,322 29,111 34,181 41,128

Net revenue 25,764 33,014 35,619 40,034 45,362 52,840

Operating profit 12,492 16,288 16,655 19,481 23,369 28,179

Earnings before income taxes 10,980 14,313 14,693 17,015 20,571 24,804

Net income available to equity holders 7,932 10,080 10,563 12,155 14,807 17,732

BALANCE SHEET 2011 2012 2013 2014E 2015E 2016E

(As at 31 December)

Assets

Cash and dues from banks 24,609 35,915 18,395 27,304 29,554 31,990

Treasury bills 100,125 102,926 180,819 224,464 242,967 262,995

Net loans 278,043 330,238 363,450 417,904 494,001 590,452

Premises and equipment 8,616 9,059 9,286 9,472 9,691 9,916

Goodwill and intangible assets 475 506 478 457 435 407

Total assets 441,598 512,221 607,192 718,031 817,621 939,458

Liabilities

Total deposits 323,698 390,569 451,099 524,218 615,456 708,929

Bank borrowings 19,942 20,717 32,206 36,257 40,808 46,113

Other borrowings 42,193 32,718 47,042 64,767 70,106 75,885

Total liabilities 397,429 459,220 545,707 651,189 740,875 851,763

Equity

Common share capital 16,474 18,009 19,587 21,194 21,194 21,194

Retained earnings 2,588 4,173 4,360 6,236 14,936 25,132

Minority interest 30 32 39 42 46 49

Total equity 44,169 53,001 61,485 66,842 76,746 87,695

Total liabilities and equity 441,598 512,221 607,192 718,031 817,621 939,458


42


Key ratios

KEY RATIOS 2011 2012 2013 2014E 2015E 2016E

Growth

Loan growth (%) 28.3% 18.8% 10.1% 15.0% 18.2% 19.5%

Net interest income growth (%) 14.1% 22.3% 10.8% 15.0% 17.4% 20.3%

Operating profit growth (%) 4.1% 30.4% 2.3% 17.0% 20.0% 20.6%

EBT growth (%) 18.1% 30.4% 2.7% 15.8% 20.9% 20.6%

Net profit growth (%) 44.0% 27.1% 4.8% 15.1% 21.8% 19.7%

Recurrent diluted EPS growth (%) 31.8% 28.3% 2.8% 14.1% 20.9% 19.7%

Margins and profitability

Net interest margin (%) 4.8% 5.0% 4.7% 4.6% 4.6% 4.8%

Operating profit margin (%) 48.5% 49.3% 46.8% 48.7% 51.5% 53.3%

PBT margin (%) 30.8% 30.5% 29.7% 30.4% 32.7% 33.6%

Net profit margin (%) 30.8% 30.5% 29.7% 30.4% 32.6% 33.6%

ROE (%) 20.2% 20.8% 18.5% 19.0% 20.6% 21.6%

ROA (%) 2.0% 2.1% 1.9% 1.8% 1.9% 2.0%

Capital adequacy and allocation

Tier 1 ratio (%) 12.1% 12.6% 13.3% 12.9% 13.3% 13.5%

Tier 2 ratio (%) 0.9% 1.2% 3.6% 3.2% 2.8% 2.4%

Total CAR ratio (%) 13.0% 13.8% 16.9% 16.1% 16.0% 15.9%

Total equity/total assets (%) 10.0% 10.3% 10.1% 9.3% 9.4% 9.3%

Leverage ratio (%) 8.6% 8.8% 8.5% 8.0% 8.2% 8.3%

Asset quality and liquidity

NPA ratio (%) 5.5% 3.2% 3.7% 4.5% 4.3% 4.2%

Reported loan loss coverage ratio (%) 39.5% 45.5% 45.4% - - -

Loans to deposit ratio (x) 89.5% 88.0% 84.1% 83.1% 83.4% 86.2%

Deposits to interest bearing funding ratio (x) 83.9% 88.0% 85.1% 83.8% 84.7% 85.3%

Valuation

P/BV (x) 1.8x 1.6x 1.7x 1.7x 1.5x 1.3x

P/E (x) 10.1x 8.5x 9.7x 9.3x 7.6x 6.4x

Dividend yield (%) 6.4% 6.7% 5.8% 5.1% 5.4% 6.7%

PER SHARE DATA 2011 2012 2013 2014E 2015E 2016E

Reported diluted EPS (LKR) 9.42 12.09 12.43 14.18 17.15 20.53

Common dividend per share (LKR) 5.89 6.51 6.50 6.69 7.07 8.73

Book value per share (BVPS) 54.00 63.55 72.37 77.36 88.82 101.50

Source: COMB, Copal Amba estimates


43


Fact sheet

Sri Lanka investment environment overview

Sri Lanka’s economy has been on an upward trajectory since the end of the three-decade civil war in May 2009. Sri Lanka currently boasts South Asia’s highest GDP growth, conducive fiscal and monetary policy, and favorable socio-economic conditions, which together create an attractive investment destination.

Sri Lanka's GDP projected to increase to 8% by Figure 93:2014E

GDP per capita to increase 22% by 2016E Figure 94:

Source: CBSL, Department of Census and Statistics Source: Central Bank of Economic and Social Statistics of Sri Lanka 2012, Road Map 2013 - CBSL

Annual core inflation post-war has averaged 6.7%, Figure 95:government targeting mid-single digit levels in the medium term

CBSL expects the rupee to stabilize in the medium Figure 96:term despite recent volatility

Source: Department of Census and Statistics, CBSL Source: Bloomberg

Fiscal deficit target of 5.2% of GDP for 2014E Figure 97: Debt-to-GDP to fall to 71% by 2015E Figure 98:


6.8 6.0

3.5

8.0 8.2

6.4 7.3

8.0 8.3 8.5

0

2

4

6

8

10

2007

2008

2009

2010

2011

2012

2013

2014

E

2015

E

2016

E

%

0

1,000

2,000

3,000

4,000

5,000

2006

2007

2008

2009

2010

2011

2012

2013

2016

E

USD

8.5

7.7

13.6

7.0 7.0 6.9 5.8

6.9

0

2

4

6

8

10

12

14

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2006 2007 2008 2009 2010 2011 2012 2013

%

100

150

200

250

Jan-07 Jan-08 Feb-09 Mar-10 Apr-11 Apr-12 May-13 Jun-14

LKR/USD LKR/EUR LKR/GBP

0%

4%

8%

12%

0

200

400

600

2006

2007

2008

2009

2010

2011

2012

2013E

2014E

LKRbn

Fiscal Deficit LKR bn As a % of GDP

102 102 91 88 85 81 86 82 79 79 78 75 71

0

20

40

60

80

100

120

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

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2014E

2015E

%


44


The Sri Lankan equity market offers a rare and attractive alternative to investors in an investment era impacted by economic growth worries. Backed by the country’s robust economic growth, the Sri Lankan capital market is well set to offer attractive returns to investors who are keen to be a part of this emerging market success story. There are several strong incentives for entering the Sri Lankan capital market.

Post war, the ASPI has significantly outperformed Figure 99:global and developed market indices

Post war, the ASPI has also outperformed some Figure 100:of the best-performing regional indices

Source: Bloomberg *Note: All figures re-based to 1 July 2009

Source: Bloomberg *Note: All figures re-based to 1 July 2009

The CSE’s market capitalization has doubled since Figure 101:2009

The government anticipates FDI inflows to reach Figure 102:USD2bn in 2014

Source: Bloomberg, CBSL Source: Ministry of Finance and Planning, Board of Investment of Sri Lanka

Most sector P/Es are below market average and Figure 103:historical valuations

Trend is similar on a P/BV multiple Figure 104:

Source: Colombo Stock Exchange Source: Colombo Stock Exchange

0

80

160

240

320

400

Jul-09 Mar-10 Nov-10 Aug-11 Apr-12 Jan-13 Sep-13 Jun-14

ASPI Dow Jones FTSE 100

MSCI World DAX

0

100

200

300

400

Jul-09 Mar-10 Nov-10 Aug-11 Apr-12 Jan-13 Sep-13 Jun-14

ASPI Bombay (BSE 500)

Jakarta (JCI) Philippines (PASHR)

Thailand (SET) Hanoi (VNINDEX)

MSCI Emerging Market Index

1,092

2,211 2,214 2,168 2,418

2,667

0

400

800

1,200

1,600

2,000

2,400

2,800

2009 2010 2011 2012 2013 2014(June)

LKRbn

601 516

1,066

1,338 1,420

0

200

400

600

800

1,000

1,200

1,400

1,600

2009 2010 2011 2012 2013

USDm

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2011 2012 2013 Average market P/BV 2010-2013


45


IMPORTANT DISCLAIMER

This document has been prepared on behalf of the Colombo Stock Exchange (“CSE”) by Amba Research Lanka Private Limited (“Amba”) and is sponsored by the CSE. The views expressed in this document are those of the authors based on available and accessible information from the public domain and do not represent those of the CSE. Please note, inter alia, that with the publication of this document on the CSE website, www.cse.lk, neither Amba , as author, nor CSE (as sponsor) intend to assume and are not assuming any responsibility or liability (including under contract, common law or tort) to any party arising out of or with respect to this document. This document is not intended to, and does not form part of any contract with anyone (including a contract between author and reader/recipient) and no one shall have any right (contractual or otherwise) to enforce any claim in relation to the document either directly or indirectly.

Except as otherwise indicated, you may only view and print one copy of the document for your own personal, non-commercial use. You may not copy, store [either in hardcopy or in an electronic retrieval system] transmit, transfer, broadcast, publish, reproduce, create a derivative work from, display, distribute, sell, license, rent, lease or otherwise transfer any of the contents to any third person (including, without limitation, to others in your company or organization) whether for direct or indirect commercial or monetary gain or otherwise without the prior written permission of Amba and CSE.

This document does not contain any investment advice nor does it constitute an offer to buy, sell or hold any of the investment product(s)/asset class (es) mentioned herein. Prospective investors are required to possess sufficient knowledge when evaluating the advantages and risks inherent to such investment product(s)/asset class(es) mentioned herein and to take into consideration their circumstances and financial position when assessing the suitability of such investments.. Prior to making an investment decision, prospective investors are strongly advised to obtain independent advice from competent legal, financial, tax, accounting and other professionals. Amba and CSE shall not be held liable in any manner for any direct, indirect or consequential loss that may arise as a result of investing in the investment product(s)/asset class (es) mentioned herein. Amba and CSE expressly disclaim any fiduciary responsibility or liability for any consequences, financial or otherwise from any reliance placed on the information in this document. The investment product(s)/asset class (es) described in this document may not be eligible for sale or subscription within a particular jurisdiction or to particular categories of investors. This document is not intended for distribution to a person or, within a jurisdiction where such distribution would be restricted or illegal. It is the responsibility of any person reading this document to observe all applicable laws and regulation of the relevant jurisdiction. Neither Amba, nor CSE, shall be responsible for any error which may have occurred at the time of printing of this document. The information set out in this document is subject to change without notice.

The information contained herein has been obtained from sources believed to be reliable and Amba and CSE make no warranty, expressed or implied, as to the accuracy, timeliness, completeness or correct sequencing of the information.

This document does not purport to list all of the terms and conditions, nor to identify or define all or any of the risks that would be associated with the purchase or sale of the investment product(s)/asset class (es) described herein. Please note that any price levels, rates, simulations, illustrations, terms or conditions contained herein are indicative only, and may vary in accordance with changes in market conditions. All the information included in this document is current at the time of preparing this document and subject to change at any time. Any forecast, projection or forward looking statement made in this document embodies assumptions and predictions about future events that by their nature cannot be verified as facts. They are not necessarily indicative of future or likely performance, of investment product(s)/asset class (es), countries, markets or companies. Any past market conditions or product performances may not be representative of future market conditions or product performances.

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Commercial Bank of Ceylon (COMB.N0000) · Sri Lanka | Banks, Finance and Insurance EQUITY RESEARCH Initiation of coverage 30 June 2014 Commercial Bank of Ceylon (COMB.N0000) 1 A capital