Sampath Bank PLC (SAMP.N0000)

Transcription

1 Sri Lanka Banks, Finance and Insurance EQUITY RESEARCH Initiation of coverage 25 July 214 Sampath Bank PLC (SAMP.N) Pawning woes nearing end: Focus on 215 We expect the overhang on Sampath Bank (SAMP) shares to recede further on the easing of concerns regarding its pawning portfolio and its ability to derive growth from alternative credit lines. SAMP is trimming its pawning portfolio to below 15% of total loans by 2Q14E (from 25% in December 212). The significant increase in customer contact following the near doubling of the number of branches (of which 95% are now profitable) should enable SAMP to derive greater revenue growth. We expect 215E and 216E to be turnaround years for SAMP, with double-digit credit and income growth, and a recovery in ROE. As the third-largest private commercial bank, with an asset base of LKR388bn and market cap of LKR36bn, SAMP should be a beneficiary of the low interest rate regime-driven recovery in credit growth. Tailwinds from improving macroeconomic fundamentals, favorable policies such as the Central Bank of Sri Lanka s (CBSL s) guarantee for gold loans, and benign inflation should provide further impetus. Our P/B- and P/Ebased analyses suggest a valuation range of LKR The underlying long-term economic growth story remains intact: Structural factors driving the banking sector s growth story remain solid, in our view. A simple back-of-theenvelope calculation supports the case for double-digit loan growth. GDP growth of 7% and inflation of 5% imply nominal economic growth of 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 213) compared with peers, low mortgage lending and personal credit levels, indicating further room for growth. The benefits of a low interest rate regime are yet to flow through: Restraints imposed by the CBSL to rein in over-lending on gold-based loans, combined with the timing difference as corporates and investors re-adjust to the low interest rate regime, appear to be behind the currently lackluster credit environment. The banking sector reported loan book growth of 8.8% in 213 and 5.1% in 1Q14. Furthermore, although policy rates have been on a downward trajectory since mid-213, banks have been slow to reduce lending rates (prime lending rates remained in the double digits as recently as in June 214). We expect credit growth to pick up in 2H14E as the benefits of a rate reduction flow through; the downward trajectory in rates should also benefit banks asset quality. More than one string to its bow: We expect SAMP to continue to show significant loan growth in segments other than pawning, in line with the sector s recovery (gross loans, excluding pawning, grew 17% YoY in 1Q14 on strong contributions from term loans, overdrafts and leases, enabling 14% YoY overall loan growth despite a LKR9bn contraction in pawning). We expect the cutback in gold-based loans to be less severe than projected given the lower interest rate regime and the guarantee scheme established by the CBSL, which should mitigate risks. We also expect continued improvements in the cost-to-income ratio as the new branches mature. Moreover, during the remainder of 214, reported earnings should receive a one-off boost from the reversal of the big-bath impairment provisioning in 213. We forecast loan growth at a 12% CAGR and EPS growth at a 17% CAGR over 214E-216E. We establish a valuation range of LKR21-243: SAMP s shares currently trade at a P/B multiple of 1.1x, in line with its two-year historical average. We expect the market to value SAMP at a higher multiple as current concerns ease; however, as a base case, we conservatively value SAMP at 1.1x one-year forward BVPS. We cross-check this value by assigning a P/E multiple of 9.3x to its one-year forward EPS, in line with the current multiple. A sensitivity analysis of the assigned base-case multiples yields a valuation range of LKR Key statistics CSE/Bloomberg tickers Share price (24 July 214) No. of issued shares (m) Market cap (USDm) Free float (%) 52-week range (H/L) Avg. daily vol. (shares, 1yr) Avg. daily turnover (USD ) SAMP.N/SAMP SL LKR % LKR218/ , Source: CSE, Bloomberg Note: USD/LKR=131. (average for the year ended 24 July 214) Share price movement Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 SAMP ASPI S&P SL 2 Source: CSE, Bloomberg Share price performance 3m 6m 12m SAMP 11.6% 19.1% 6.3% S&P SL % 9.3% All Share Price Index 9.8% 8.4% 11.6% Source: CSE, Bloomberg Summary financials LKRm (year-end 31 December) E 215E Net interest income 15,95 11,624 13,659 Net revenue 2,36 17,779 2,585 Operating profit 5,72 6,437 7,163 PBT 4,789 5,343 5,945 Net income 3,635 3,839 4,276 Recurrent EPS ROE (%) P/B (x) Source: SAMP, Copal Amba estimates 1

2 Table of Contents Overhang due to pawning woes is receding... 3 The largest pawning portfolio among private commercial banks... 3 A smaller impact from high-risk loans after 3Q14E... 3 Conservative provisioning and intensified collateral value realization... 4 More than one string to its bow... 6 Gross loans excluding pawning grew 35% YoY in Increased focus on non-interest income growth... 7 Efficiency gains to further support profitability... 8 Improvement in the CIR as new branches mature... 8 Technological innovation could support further cost reduction... 8 Sustainable growth in a low interest rate environment... 9 Double-digit loan growth and lower provisioning to compensate for NIM compression... 9 Current concerns about the banking sector are short-term Private sector credit growth rate declined due to a confluence of negative factors Stimulation from lower interest rate regime yet to gain momentum Pawning portfolio issues managed effectively Industry average measures mask wide variations in individual bank performance Lower SOE borrowings support private credit growth Improving liquidity levels ease pressure on interest rates Banking sector loan book well diversified Macroeconomic factors substantiate private sector credit growth story Credit as a percentage to GDP well below that of regional peer set IMF forecasts Sri Lanka s GDP to be the highest in the region Inflation targeted to remain at mid-single digit levels FDI inflows continue to rise... 2 Foreign remittances and exports increasing... 2 Exchange-rate stability a strong positive Fiscal deficit and current account deficit as a percentage of GDP improving Further improvement in savings necessary to narrow the savings-investment gap Factors that temper a positive outlook on credit growth We establish a valuation range of LKR for SAMP s shares Share price performance Earnings release focus areas Appendix 1: The Sri Lankan banking sector A competitive landscape Appendix 2: Company overview Appendix 3: Key financial data Fact sheet

3 Overhang due to pawning woes is receding SAMP underperformed the S&P SL 2 and the ASPI from 213 until mid-214. A primary concern that weighed down the ticker was its large pawning portfolio, which amounted to LKR59bn at its peak, and in which high delinquency rates were expected. In December 213, SAMP made extensive impairment provisions of LKR3.5bn against its pawning portfolio. Following this big-bath provisioning, and as gold prices have remained relatively stable in 214, SAMP recorded pawningrelated losses of LKR1.2bn against interest income and a corresponding LKR818m impairment reversal in 1Q14. Due to the short-term nature of the pawning loan, we believe further impact from the high loan-to-value (LTV) pawning triggered during the gold-price peak in is limited. Measures implemented in late 213 to reduce the risk on pawning loans should also help limit pawning-related issues to the next two to three quarters. We now see the beginning of a turnaround as investors start pricing in recovery from pawning issues and are looking beyond the weakness in 214. The largest pawning portfolio among private commercial banks Pawning was the fastest-growing product in SAMP s loan portfolio until mid-213; by December 212, the LKR55bn pawning portfolio accounted for 25% of total gross loans and grew further to LKR59bn by September 213. SAMP aggressively pursued growth in this segment, stating in its 212 annual report that its competitive advantage was the ability to offer the highest advance at lower rates. Although it was recognized that this increased the risk of the loan portfolio, it was expected that the low level of non-performing advances (NPAs) in the segment would mitigate the risk. SAMP s pawning portfolio was the highest among comparable private commercial banks in 212 [Commercial Bank s (COMB s) pawning portfolio stood at LKR11bn and Hatton National Bank s (HNB s) at LKR49bn]. The pawning portfolio contracted to 17% of gross loans by March 214 SAMP started to impose restrictions on the pawning portfolio only in late 213. It reduced the LTV ratio to 65% from 85%. At the end of 213, SAMP had reduced the portfolio slightly to LKR54bn (19% of gross loans). This was still well above that of comparable private commercial banks : pawning amounted to only 2% of COMB s and 13% of HNB s gross loans. The portfolio was reduced further to LKR44bn by March 214, and management expects to bring this down to below 15% of gross loans by June 214E. Figure 1: SAMP expected to reduce its pawning portfolio to less than 15% of gross loans by June 214E USD 2, 1,8 1,6 1,4 1,2 1, Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun -14E LKRbn Gold price (LHS) Pawning portfolio (RHS) Source: SAMP, Bloomberg, Copal Amba estimates A smaller impact from high-risk loans after 3Q14E As Figure 1 shows, growth in the pawning portfolio accelerated in 212 and in 1H13. These loans were granted when gold prices were around USD1,6-1,8/oz and the LTV ratio stood at 85%. Therefore, the total principal amount and accrued interest on these loans are likely to be 3

4 considerably higher than current gold values, reducing borrowers incentive to redeem these items and placing such loans at a high risk of default. However, we believe this applies only to a limited segment of loans, as sentimental value is attached to pawned gold jewelry, which traditionally limits the level of default. Pawning loans are 12-month products, and a bank can realize the value of the collateral almost immediately. Therefore, such high-risk loans have mostly already fallen due, and we estimate that the losses that SAMP recorded in 1Q14 pertain to such high-risk loans. We expect the impact of these high-risk loans to persist in the June and September quarters and to ease thereafter, as the new loans that fall due would have been granted at lower gold values and lower LTV ratios. Conservative provisioning and intensified collateral value realization Based on the historical experience of very low losses in pawning portfolios, SAMP had not made provisions for pawning loans in 212. However, as gold prices collapsed from USD1,6-1,8/oz levels, fallen-due loan levels started to increase significantly, and the bank started recording impairment charges specifically for pawning loans. Fallen-due loans for the bank remained at around 2 of the portfolio over the past year, rising to LKR11bn by end-213, but they dropped to LKR8.3bn by March 214 in line with a smaller pawning portfolio. Gold prices fell further by end-213, and SAMP recorded impairment allowances based on a gold price of USD1,2/oz. The total impairment allowance in 213 amounted to LKR3.2bn and direct write-offs to LKR28m. Figure 2: Fallen-due loans at the bank decreased in 214 Figure 3: Impairment allowance as a percentage of fallen-due loans on an upward trajectory LKRm Pawning portfolio Loans fallen due As a % of pawning port. Impairment allowance As a % of fallen-due loans As a % of pawning port. Dec-11 Dec-12 Jun-13 Sep-13 Dec-13 Mar-14 41,175 54,946 59,4 58,7 53,47 44,34 NA NA 8,4 11, 1,73 8,26 NM NM 14% 19% 2 19% ,43 3,23 2,14 NM NM 12% 19% 3 26% 2% 3% 6% 5% LKRbn Dec-11 Dec-12 Jun-13 Sep-13 Dec-13 Mar-14 Loans fallen due (LHS) Impairment allowance (LHS) Allowance as a % of fallen due loans (RHS) % Source: SAMP Source: SAMP SAMP, along with most other banks, manages the decline in the pawning portfolio size and the high level of delinquencies by encouraging borrowers to renew loans at the prevailing lower interest rates by paying the interest amount due on previous loans. Where this fails, similar to other banks, it has accelerated the pace of realizing the value of collateral by increasing the frequency of gold auctions. The auctions in 1Q14 mostly related to delinquencies in loans taken when both gold prices and LTV ratios were high; hence, the amount of loss on these was much higher, and the bank charged LKR1.2bn in auction related losses. The write-off amounted to LKR28m. There was a corresponding reversal of LKR818m to the collective impairment in the quarter, and the total impairment as of March 214 stood at LKR2.14bn (26% of total loans fallen due). With gold prices remaining stable and low LTV ratios, we expect a lower level of delinquencies; this charge should be sufficient to cover a lower amount of loss. As SAMP charges such losses against interest income, we expect further reversals of the impairment allowance during 214E. 4

5 A positive view on the recovery from pawning issues We have a positive view on SAMP s ability to recover from its pawning portfolio issues, based on 1) improvements in the overall economy, 2) the prevailing lower interest rate regime and 3) the bank s effective portfolio management. Gold prices have now increased about 1 from the trough levels in December 213. Such an increase is favorable to the bank in two different ways it decreases both the probability of default and the amount of the loss in the case of default (Loss, given default = Value of the collateral less capital less accrued interest). Similarly, a low interest rate environment would encourage loan renewals at a lower interest rate and reduce delinquency rates. Risks to the recovery theme However, this does not mean we view recovery as a blue-skies scenario. There are many associated risks; the primary and most obvious risk is further downside to gold prices, which will result in worsening delinquency levels. Another associated risk is the issue of restructured loans. While SAMP has not disclosed the details of the extent of its restructured loans, we believe a high proportion of the existing portfolio may well be loans that were restructured after the borrowers paid a portion of the interest. A further gold-price shock would render the repayment of a significant proportion of these loans not economically viable to borrowers. Auction-related losses are likely to persist during 214E, and could affect profitability in the next two to three quarters as they are charged against interest income. This is partly due to the remaining high-ltv loans at peak gold prices, and also due to the competitive environment as SAMP attempts to realize collateral value in an environment where banks such as the People s Bank (PB) and the Bank of Ceylon (BOC), which also have large pawning portfolios (PB LKR165bn and BOC LKR121bn as of March 214), conduct an extensive auctioning off of unredeemed pawned items. 5

6 More than one string to its bow Investor concerns surrounding SAMP centered on whether the bank would be able to generate revenue growth outside of pawning, which was the key top line driver prior to 213. An analysis of the loan portfolio and its movement over the past few years shows that pawning is not the only credit growth driver. We believe SAMP can achieve sustainable growth through continued focus on alternative revenue streams as business activity picks up in the currently low interest rate regime. Gross loans excluding pawning grew 35% YoY in 213 SAMP s ability to generate loan growth through multiple avenues was evident in 213, when it achieved 25% YoY growth in total gross loans, compared with industry loan growth of only 8.8%. The diversity in the sources of credit growth was further reflected in term loans, overdrafts, trade finance and leases all showing double-digit YoY growth. Gross loans excluding pawning grew 35% YoY in 213, whereas pawning advances dropped 2%. Similarly, in 1Q14, SAMP recorded 17% YoY growth in gross loans excluding pawning, driven by double-digit growth in term loans, overdrafts and leases. This helped SAMP record 14% YoY total loan growth, despite a LKR9bn contraction in pawning; the sector average stood at 5%. Figure 4: Gross loans excl. pawning show significant growth Figure 5: Rising contribution from corporate banking LKRbn YoY growth E 215E 216E -2 Gross loans (LHS) G. loans ex pawning (LHS) G. loans growth (RHS) G. loans ex paw. growth (RHS) Source: SAMP, Copal Amba estimates % 1 19% 18% 18% 17% 19% 8 17% 14% 14% 19% 17% 6 16% 16% 16% 16% 16% 4 22% 23% 25% 19% 17% 2 27% 3 27% 29% 31% Q14 Term loans Pawning Overdraft Trade finance Other Source: SAMP SAMP was able to compensate for the drop in pawning growth by concentrating on high-growth economic sectors. Corporate banking recorded 38% YoY growth in 213 through higher corporate credit, development banking, trade finance, and, foreign currency banking unit (FCBU) loans. Figure 6: The drop in pawning growth was mitigated by termloan growth Figure 7: Well-diversified portfolio supports loan growth % % 8% 7% 7% 36% 34% 3 34% 59% 58% 63% 59% 23% 6% 9% 13% 13% 5% 1 Agriculture & fishing Manufacturing Tourism Construction Traders Banks, financial serv Personal banking Corporate banking Other 22% Consumers Other Source: SAMP Source: SAMP 6

7 Corporate lending generated 18% of total interest income and amounted to 34% of total loans in 213. The development banking division contributed to this growth, with a 55% YoY increase in its advances portfolio, led by loans granted to the renewable-energy sector. Renewable energy constituted 56% of development banking loans. Furthermore, SAMP was able to record 3 growth in export trade volumes during 213. Total FCBU advances grew 22% during 213, despite relaxed exchange controls, which generally result in lower demand for foreign-currency loans. The pawning portfolio is likely to decline at a slower pace SAMP s pawning portfolio should be down by about 4 from peak levels to below LKR34bn by mid-214, in our view. However, under current conditions, we expect the pace of portfolio shrinkage to slow down. Due to the importance of pawning as a mechanism to ensure financial inclusion in the farming and fishing sectors, as well as in micro financing (particularly in the country s north and east), the CBSL established a new credit-guarantee scheme for pawning advances during June 214. Under this scheme, borrowers can extend the current bank LTV ratio of 65% to 8, and borrow up to a maximum value of LKR.5m; the risk of the additional 15% to the bank is covered by the CBSL s guarantee scheme. The CBSL has also imposed an interest rate cap of 15% for the first LKR.5m. SAMP, along with other commercial banks, has entered into an agreement with the CBSL under the new scheme. In addition, as the interest rate decline improves the affordability factor, we expect a significant proportion of existing borrowers to refinance their loans, enhancing the credit quality while maintaining the pawning advances volume. We therefore expect the contraction in the pawning portfolio to be less severe than previously projected. Increased focus on non-interest income growth Non-interest income accounted for nearly 4 of SAMP s total banking income prior to 213, when a contraction in foreign exchange income of nearly LKR1.5bn reduced the contribution to 26%. Following the strong rebound in 1Q14, we expect SAMP to intensify its focus on non-interest income over the next couple of years, particularly as the bank needs to adapt to a lower net interest margin scenario. We expect non-interest income to contribute about 35% to total income by 216E. Figure 8: Pawning to remain below 15% of loan portfolio Figure 9: Non-interest income to grow at a 16% CAGR over 214E-216E LKRbn % % % % Q14 Pawning portfolio (LHS) As a % of gross loans (RHS) Source: SAMP LKRbn E 215E 216E Non-interest income (LHS) Non-interest income growth (RHS) Source: SAMP, Copal Amba estimates YoY growth

8 Efficiency gains to further support profitability We expect the cost-to-income ratio (CIR) to improve given the dual impact of new branches maturing and generating incremental top-line growth, and efficiency gains derived from further investment in technology. Improvement in the CIR as new branches mature We expect the CIR to improve over the next few years as operations at the bank s new branches reach maturity and technological advances enable further cost savings. SAMP added 1 branches over the past five years, nearly doubling the number of branches to 215 by June 214 (including 8 super branches). Most of these additions were in 21 (4 branches) and 211 (35 branches), and this affected the CIR, as business generation at a new branch takes time, whereas fixed costs need to be incurred from inception. The CIR should improve as the new branches bring in incremental revenue. Operating expenses increased in 213, partly owing to refurbishment costs, bringing the reported CIR to 59% in 213, and to 71% in1q14 as revenue growth slowed. However, when VAT on financial services is excluded from operating expenses, to calculate a CIR more comparable with peers, the CIR declines to 53% and 63% for 213 and 1Q14 respectively. Figure 1: Further room for efficiency improvements Figure 11: Average staff per branch is low at Branches CIR No. of employees Q14 SAMP branches SAMP CIR COMB CIR HNB CIR COMB HNB SAMP SEYL BOC PB Avg. no. of employees per branch Avg. no. of employees per branch ex head office staff Source: Company reports Note: Operating expenses exclude VAT on financial services. CIRs are calculated for the group. Source: Company reports Note: Head office staff is estimated when data is not available. We like SAMP s present focus on improving efficiency; it has one of the lowest staff-per-branch ratios in the sector, with employees per branch (Figure 11). We expect an improvement over the next two years, as management reported in 213 that 95% of its branches had now reached profitability. We forecast that the CIR will return close to 5 by 216E. Technological innovation could support further cost reduction SAMP has pioneered technological innovation in banking. We believe there is further room for cost savings to be generated through the use of new technology, specifically through the digitalization of banking processes. Although consumers increasingly use digital technology in many other financial-related services such as holiday, travel and online purchasing, banks have tended to limit digital applications to front-end features such as mobile apps and cheque/cash deposits. A Mckinsey study published in July 214 estimated that a shift to automating servicing and processes that reduce manual intervention and bringing in a coherent and integrated front-end to back-end digital process could yield up to a 25% reduction in the cost base. We expect SAMP to continue to be a frontrunner in embracing such new technology. 8

9 Sustainable growth in a low interest rate environment We expect the current low interest rate environment to prevail in the short to medium term; banks will therefore need to adjust to lower net interest margins (NIMs) as a business reality. Banks in Sri Lanka currently enjoy an NIM of 5-6%, one of the highest in the region, and the CBSL aims to bring it down by 1-2bps to 4-5%. Banks would therefore need to operate more efficiently, and we believe SAMP is one of the better-run banks that will be able to trim excesses to run a lean operation and generate profitability. The impact of pawning portfolio de-growth, combined with restrained loan growth in 1H14, is likely to limit earnings expansion potential for SAMP in 214, in our view. Once loan growth momentum accelerates amid a favorable low interest rate regime, we believe SAMP will report double-digit loan growth and enhanced profitability, resulting in a return to high double-digit ROE levels. Double-digit loan growth and lower provisioning to compensate for NIM compression We estimate that the pawning segment s decline wiped off nearly LKR25bn (about 9% of loans) from SAMP s balance sheet between 3Q13 and 2Q14E. Strong growth in other segments of the loan portfolio partly compensated for this shrinkage; however, we believe overall loan growth will be limited to the high single digits during 214, owing to the added impact of constrained loan growth in 1H14. SAMP should be able to return to double-digit loan growth in 215E as the business environment adjusts to the low interest rate conditions. We expect the strong pick-up in corporate banking in 213 and 1Q14 to continue to drive loan growth at a 12% CAGR during 214E-216E. Figure 12: Loan growth at a 12% CAGR during 214E-216E Figure 13: Structurally lower NIMs are likely to persist LKRbn LKRbn NIM E 215E 216E Gross loans E 215E 216E Net interest income (LHS) NIM (RHS) Source: SAMP, Copal Amba estimates Source: SAMP, Copal Amba estimates Interest income as a percentage of average interest-earning assets fell to below 1 in 1Q14 from around 12% in ; we use rates below 1 in our forecasts. The net interest income (NII) decline was partly due to LKR1.2bn of losses incurred in the realization of collateral value; we expect the impact of such losses to persist until 3Q14E. Interest expenses are relatively higher partly due to SAMP s lower current account and savings account (CASA) ratio. Management aims to increase the CASA ratio following its network expansion; this should be further facilitated by the smaller disparity between time-deposit and savings-deposit rates. We forecast that the CASA ratio will reach 37% by 216E. 9

10 Provisioning requirements are lower owing to big-bath provisioning in 213 The bank reported one of the lowest NPA figures in % (Figure 72 on page 33). However, this figure is not comparable to peers, as it excludes delinquencies in the pawning portfolio. The bank disclosed a further LKR3.23bn charged as a collective impairment allowance against the pawning portfolio of LKR53bn. Also, past due but not impaired loans were high at LKR97bn in December 213, amounting to nearly 35% of gross loans (up from LKR72bn in December 212). Of this, LKR6bn was overdue for more than 9 days. Figure 14: Past due but not impaired loans remain high Figure 15: We forecast EPS growth at a 17% CAGR over 214E-216E LKRm Bank Less than 3 days Past due but not impaired 31 to 6 days 61 to 9 days More than 9 days Total Individu ally impaired ,652 13,21 2,259 6,346 97,278 4, ,62 8,26 12,667 3,453 72,388 4,153 Group ,589 13,872 2,767 6,893 11,121 4, ,545 8,451 12,75 3,583 73,284 4,27 LKR YoY growth E 215E 216E EPS EPS growth Source: SAMP Source: SAMP, Copal Amba estimates SAMP incurred an impairment charge of just over LKR3.5bn against its pawning portfolio in 213, raising the total impairment allowance on the group balance sheet to LKR1bn LKR3.2bn against the pawning portfolio, LKR6.7bn against loans, and the remaining LKR.2bn against leasing. As losses arose on realizing collateral value, they were charged to interest income, and reversals were recorded against the impairment allowance in 1Q14. We expect two to three quarters more of such auction-related losses and corresponding reversals in impairment charges. As the impact of the high-ltv pawning loans issued at peak gold prices wanes, we expect lower losses and lower impairment charges. This reduction in delinquencies and the corresponding decline in provisioning should be further facilitated by the prevailing lower interest rate regime. We forecast structurally lower NIMs over 215E-216E, but expect such lower provisioning charges and further cost tightening to compensate for lower NIMs, thus protecting profitability. We therefore expect EPS growth at a 17% CAGR over 214E-216E. Dividend distribution to return to pre-213 levels SAMP paid one of the highest dividends among peer banks prior to 213, at a payout ratio close to 4. We expect the dividend payout to increase from 214 onwards as profitability increases to reach pre-213 levels. ROE to recover to high double-digits SAMP reported ROE of 2+ before 213, one of the highest levels in the industry, but this fell significantly in 213 with the decline in profitability. We expect ROE to recover to above 15% by 216E following the recovery in profit. Capital ratios well above regulatory requirements SAMP reported a Tier 1 ratio of 9.8% and a capital-adequacy ratio (CAR) of around 13.6% in 1Q14. These were below the industry averages of 13.8% and 17., respectively, although well above the regulatory requirements of 5% and 1. We forecast that its capital ratios will improve as profitability improves, and therefore do not expect SAMP to engage in any dilutive capital raising. 1

11 211 Q2 211 Q3 211 Q4 212 Q1 212 Q2 212 Q3 212 Q4 213 Q1 213 Q2 213 Q3 213 Q4 Sampath Bank PLC 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 , 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-212. 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 213. As gold prices collapsed, the NPA ratios of pawning portfolios also increased, raising concerns about asset quality deterioration. Once the excessive credit growth was under control, the CBSL eased monetary policy to restimulate growth. Policy rates started to decline since mid-213; however, lending rates remain high as banks attempt to expand 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 SAMP 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 rate ranged between 21% and 32% during 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 16. YoY growth in pawning loans exceeded 5 in 211 and early 212. 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-212, 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. Figure 16: Gold based lending the key driver of exuberant credit growth during now of lesser importance YoY growth Credit to the private sector Pawning loans by commercial banks 11

12 As a result, credit growth slowed while interest rates rose 454bps during this period, peaking at 14.4% in February 213. Figure 17: Private sector credit growth at a moderate pace Figure 18: Banking sector asset growth 17% CAGR LKRbn 2,6 2,5 2,4 2,3 2,2 2,1 2, Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 LKRbn 6, 14% 5, 14% 29% 4, 14% 24% 14% 3, 25% 16% 3 2, 31% 62% 58% 61% 1, 53% 56% Gross loans Investments Other Banking sector assets have grown at a 17% CAGR over the past five years. However, in 213, the proportion of gross loans as a percentage of total assets declined to 58%. As credit growth eased, banks increased investments made, mainly in government securities, leading to this mix-shift. Investments accounted for 29% of sector assets in 213 versus 24% in 212 (as shown in Figure 18). In line with the sector s credit demand trend, the five largest domestic banks also showed easing credit growth in 213, down from the peak levels seen over However, the three largest private banks (COMB, HNB and SAMP) continued to show double-digit growth in 213, while the two government banks recorded growth in single digits. Excluding PB, the top five licensed commercial banks (LCBs) grew their assets in the mid-teens to high-twenties range in 213. Figure 19: Loan growth of the top five banks eased in 213 YoY growth COMB HNB SAMP BOC PB Industry average Source: Bloomberg, CBSL, Company reports Figure 2: while total asset growth ranged from mid-teens to mid-twenties YoY growth COMB HNB SAMP BOC PB Industry average 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 credit growth. 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. 12

13 BOC DFCC AB PABC SEYL UB PB SAMP NDB HNB NTB COMB Sampath Bank PLC Stimulation from lower interest rate regime yet to gain momentum Starting mid-213, 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 bank lending rates has not been as pronounced as the decline in policy rates; banks have been protecting margins at the expense of loan growth. Figure 21: Policy rates started to decline in mid-213; decline in bank lending rates finally gained some headway in June 214 % May Jul Sep-13 2-Nov Jan-14 2-Mar May Jul-14 BOC PB HNB COMB SAMP SEYL DFCC NDB Note: SEYL = Seylan Bank, DFCC = DFCC Bank, NDB = National Development Bank As shown in Figures 21 and 22, the average weighted prime lending rates (AWPLR) of the banks remained high, and rates at the two key state banks, BOC and PB, with around 45% market share in lending, remained at double-digit figures even as at June 214. July 214 finally saw further rate declines, and, as at 18 July, most banks had reduced prime lending rates to high single digits. Figure 22: Prime lending rates remained high even in June 214 Figure 23: Rate decline supports growth but with a lag % 12% 1 8% 6% 4% AWPLR 2 16% 12% 8% YoY growth % 4% AWPLR Private sector credit growth YoY Note: AB = Amana Bank, PABC = Pan Asia Banking Corporation, UB = Union Bank, NTB = Nations Trust Bank 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 17. Private sector credit grew only 7.5% YoY in 213, compared with 17.6% YoY in 212 and an average YoY growth rate of 25.7% during Q14 has been similarly lackluster. The CBSL specified in its May 214 Monetary Review press release that banks were expected to pass on the benefit of eased monetary policy stance to borrowers without further delay. 13

14 It is only in June that there were some signs of policy rate decline being passed on to creditors; PB brought down prime lending rates to 9.1% in late June 214, from 13% previously and BOC prime lending rates have declined by about 2bps now from over 12% in January 214. Historical data shows that declining interest rate regimes promote lending growth, but with a time lag, as seen in Figure 23 above. Small but clear indications of a pick-up are beginning to appear. After a significant decline in January 214, private sector credit growth has been gradually picking up. The CBSL reported that lending by domestic banking units to the private sector increased by LKR15.3bn in March 214, but that the net credit level dropped due to repayments by BOI companies to offshore banking units. April 214, despite usually being the slowest month for credit due to the long New Year holiday, showed 3.3% YoY growth, though it was a.6% MoM decline. Overall credit to the private sector amounted to LKR2,474bn in May 214, a 2.2% YoY increase. The larger private commercial banks including COMB, HNB and SAMP, have been early movers in this regard; they reduced lending rates relatively early and, as a result, were able to show aboveindustry-average growth in 213 and in 1Q14. 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 214 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 211 and 212 was derived through gold-based lending, which grew 78% in 211 and peaked in 212 at LKR58bn, accounting for 25.4% of total LCB loans (including loans for purposes other than consumption). As gold prices declined, goldbased lending too declined, by LKR144bn in 213, and the CBSL estimates that gold loans have declined by LKR156bn in total since the peak in 212. The significance of this decline is clear when considered against the fact that total incremental private credit for 213 amounted to LKR176bn. Figure 24: Gold-based lending declined LKR156bn since 212 Figure 25: 2-33% of gold-based loans used to fund SMEs LKRbn % of total loans % 25.4% 25% 19.2% 17.5% 2 15% 1 5% Gold-based loan portfolio As a % of total loans LKRm Total gold based lending Pawning for personal loans 234,8 416,85 58, , , ,99 339, ,873 (%) 71% 68% 67% 8 Pawning for industrial/trading activities 67, , ,62 71,841 (%) 29% 32% 33% 2 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 2 of total pawning in 212 and 213, as seen above in Figure 25. As the banks tighten lending criteria, increase interest rates and limit loan-to-value (LTV) ratios, such constraints on gold-based lending 14

15 COMB HNB SAMP NDB NTB DFCC SEYL PABC UB BOC PB Sampath Bank PLC affect the ability of rural communities to obtain banking facilities for economic activities and lead them towards informal lending sources. 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 214, 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 8, up from the current 65%. The CBSL has allocated LKR5m in initial funding for the new guarantee scheme, which is likely to remain self-funded, as the banks are to contribute a 1% premium annually on their new pawning loans. The CBSL has also imposed an interest rate cap of 15% for the first LKR.5m. 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 the pawned collateral usually within a few weeks after the loan falls due. Since pawning loan growth peaked in 212, 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 213, the larger private banks showed significantly higher growth, as seen in Figure 26. SAMP grew roughly 25% YoY in 213 and HNB 17%. DFCC, NDB and COMB each grew by double-digit numbers. Furthermore, although Peoples Bank s loan book grew only 3.2% YoY in 213, incremental credit to other industries amounted to LKR74bn, close to 1 of its loan book. However, this growth was masked by the LKR54bn decline in its pawning portfolio. Figure 26: Double-digit loan growth in 213 at private LCBs Figure 27: Pawning portfolio as a % of total loans varies widely PB 3.2% BOC 5.7% COMB 1.3% HNB 16.8% SEYL 17. NDB 18.6% SAMP 25.2% DFCC 28. % of total loans Loan growth Source: Company reports, Bloomberg Source: Company reports, Bloomberg 15

16 COMB HNB SAMP NDB NTB DFCC SEYL PABC UB BOC PB Sampath Bank PLC Similarly, exposure to gold-based lending varies widely among the banks. Figure 27 shows the pawning portfolio as a percentage of total loans. Peoples Bank had the largest pawning portfolio of LKR25bn, amounting to 38% of total loans in 212, which it trimmed down to LKR197bn by 213. HNB trimmed its pawning portfolio to 13% of total loans by December 213 and further to 11% by the end of 1Q14. Commercial bank had the lowest exposure, with the pawning portfolio brought down to 1.8% of total loans in 213 (from 3.2% in 212). SAMP was the only systemically important private bank with a high pawning exposure at 19.5% of total loans in December 213; its exposure was also reduced to 17% by the end of 1Q14. The industry average non-performing advances (NPA) level rose to 5.6% in 213, and to 6.2% in 1Q14, from 3.7% in 212, 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 29), 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 collateral value. However, a prudent approach would certainly require higher provisioning. Figure 28: Gross NPA levels rose in 213 Figure 29: Reported loan loss coverage levels fell at most banks Gross NPA ratio 16% 12% 8% 4% Sector average Provision coverage ratio COMB HNB NDB DFCC PABC PB Sector average Source: Company reports, Bloomberg Source: Company reports, Bloomberg Lower SOE borrowings support private credit growth Private sector credit declined to 6 of total domestic credit in 213, from a peak of 66% in 21, 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. 16

17 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Sampath Bank PLC Figure 3: Private sector credit - 6 of total credit in 213 Figure 31: Credit to SOEs declining LKRbn 4,5 3, LKRbn , Credit to public corporations Credit to the private sector 1 Credit to SOEs Note: Public corporations include govt. and state-owned enterprises Improving liquidity levels ease pressure on interest rates Furthermore, we note that liquidity in the banking sector improved in 213, with the liquidassets-to-total-assets ratio improving by 53bps and the liquid-assets-to-deposits ratio by 8bps. This is due to the mix shift towards investment assets on the back of slow loan growth during the year. Figure 32: Liquidity ratios in the banking sector improving Figure 33: portfolio Domestic private sector credit a well-diversified % 8 12% Trading Construction % 12% 11% 6% 4% Agriculture and fishing Consumption Manufacturing Infrastructure Credit to Deposits & Borrowings Liquid Assets to Total Assets Liquid Assets to Total Deposits 16% 19% 3% 3% Financial services Tourism Transport Other 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 213, while credit growth in the consumption segment declined during the year. 17

18 Sri Lanka India Indonesia Malaysia Thailand Philippines Sri Lanka India Indonesia Malaysia Thailand Philippines Sampath Bank PLC 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 3 over the past three years, as shown below in Figure 34. 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 35). Sri Lanka s GDP per capita rose to USD3,282 in 213 and is forecast to rise to USD4, by 216E. 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. Figure 34: Private sector credit as a % of GDP stable and low Figure 35: growth Household debt as a % of GDP further room for LKRbn 1, 8, 6, 4, 2, % 26.5% 3.7% 31.1% 29.2% Domestic credit to the private sector (as a % of GDP) GDP (excluding domestic credit to the private sector) LKRbn 9, 8, 7.9% 7, 9.3% 6, 8.8% 5, 7.2% 6.3% 4, 3, Household debt (as a % of GDP) GDP (excluding household debt) Sri Lanka s private sector credit to GDP (Figure 36) and the household debt as a percentage of GDP (Figure 37) ratios are well below that of its regional counterparts, indicating sufficient room for growth as economic growth gains momentum. Figure 36: Private sector credit as a % of GDP Sri Lanka well below regional peers Figure 37: Household debt as a % of GDP Sri Lanka well below regional peers % % % 8.3% 1.3% 86.8% 81.7% 6.2% 4 2 Household debt (as a % of GDP) GDP (excluding household debt), Bloomberg, World Bank, Bloomberg, World Bank 18

19 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 3-year war. Figure 38: Loan growth tracks GDP and is usually higher than GDP growth YoY growth YoY growth 1 7% 4% % Sector loan growth (LHS) GDP growth (RHS) We expect economic growth to track around 7-8%, the CBSL forecasts 7.8% GDP growth for 214E, whereas 1Q14 GDP was reported at 7.6%. The World Bank s Global Economic Prospects report issued in June 214, forecasts Sri Lanka s economic growth to remain broadly stable at 7.2% in 214. It forecasts the growth rate to moderate slightly to 6.9% in 215 and 6.7% in 216. 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 214 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. 19

20 Figure 39: Low inflation rates enable a low interest rate regime Figure 4: FDI nearly tripled over past three years % % 6.2% 6.7% 7.6% 6.9% 4.9% USDm 1,5 1, ,66 1,338 1, (June) Headline inflation Foreign direct investments FDI inflows continue to rise Foreign direct investment (FDI) inflows, including loans, rose to USD1.4bn in 213, nearly tripling from 21 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 5 from 21 levels to USD6.4bn in 213. 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 216E. Similarly, revenue from the export of goods showed accelerating growth to USD1.4bn by 213, fuelled primarily by the export of high-value apparel products and a shift in tea exports to valueadded branded products. Figure 41: Foreign remittances rose over 5 during Figure 42: Earnings from export of goods rising USDm 7, 6, 5, 4, 3, 2, 1, 1,414 2,52 4,116 6,47 USDm 12, 1, 8, 6, 4, 5,133 7,64 8,626 1, Foreign remittances 2, Earnings from export of goods 2

21 Figure 43: Earnings from tourism increased Figure 44: services as did earnings from export of IT and Telecom USDm 2, 1,715 USDm ,5 6 1, Earnings from tourism Expon. (Earnings from tourism) Earnings from export of IT and telecommunication services Source: Ministry of Finance Source: Ministry of Finance Revenue from the export of services more than doubled to USD719bn between 21 and 213, 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-singledigit level going forward as well. Figure 45: Currency fluctuation in LKR the lowest among regional peers over the past twelve months Index Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 LKR/USD INR/USD IDR/USD THB/USD PHP/USD PKR/USD Source: Bloomberg Fiscal deficit and current account deficit as a percentage of GDP improving The fiscal deficit amounted to LKR516bn in 213, as against LKR489bn in 212. 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 213 from -6.7% in

22 Figure 46: Fiscal deficit as a % of GDP improving Figure 47: Current account deficit improving -5.9% % % % % % 211 LKRbn USDm -5, -4, -3, -2, -1, Source: Ministry of Finance and CBSL Source: Ministry of Finance and CBSL Further improvement in savings necessary to narrow the savingsinvestment gap Gross domestic savings as a % of GDP rose to 2 in 213, rising from multi year lows of 15.4% in 211. The savings-investment gap too has been improving consistently as seen in Figure 49. 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. Figure 48: Gross domestic savings on the rise Figure 49: Savings investment gap started to improve in 211 % 25% 2 15% 15.4% 16.9% 2. % % 1 5% -8% Gross domestic savings -12% Savings - investment gap Source: Ministry of Finance and CBSL Source: Ministry of Finance and CBSL 22

23 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 ) 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 213, and rose further to 6.2% in 1Q14. 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 PLCc raised LKR2bn through a debenture issue at the CSE in 213 and John Keells Ltd appointed bankers to raise medium term finance through foreign debt in May 214. 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 214. Furthermore, we believe sector credit growth in the low teens allows a favorable balance between growth and risk management. 23

24 We establish a valuation range of LKR for SAMP s shares We establish a 12-month valuation range of LKR per share, based on our current outlook for SAMP shares, compared with the current share price of LKR213 as of 24 July 214. 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 SAMP s valuation levels relative to a domestic peer group. Figure 5: Valuation range analysis provides a range of LKR per share (current share price: LKR213) P/B P/E week range Source: SAMP, Bloomberg, Copal Amba estimates P/BV analysis yields a valuation range of LKR per share Our primary valuation for SAMP is on a P/BV basis. At peak valuations, SAMP traded at a trailing 12-month P/BV of 2.x in January 211, trading multiples declined thereafter. As loan growth and earnings picked up in , the stock re-rated in line with peers, and the ticker traded at around 1.4x P/BV, until the gold price decline resulted in lower valuations. The stock has traded at between.8x - 1.1x P/BV since late 213. Figure 51: SAMP has traded at between.8x-1.1x on a P/BV basis since 2H13 LKR/share Jan-11 Apr-11 Aug-11 Nov-11 Mar-12 Jun-12 Oct-12 Jan-13 May-13 Aug-13 Dec-13 Apr-14 Jul-14.8x 1.1x 1.4x 1.7x 2.x MPS Source: SAMP, Bloomberg, Copal Amba estimates We view SAMP as a geared play on credit growth recovery in the Sri Lankan banking sector and expect to see a corresponding increase in the valuation multiples in the near-term. However, to be conservative, we use the 2 year average P/BV multiple of 1.1x as our base case valuation, which yields a one year forward valuation of LKR22 for the share. Our P/B-based valuation range is derived considering the sensitivity of the stock price to changes in the base-case. 24

25 We believe investors would look beyond the immediate weakness in the sector and the bank and assign a higher trading multiple to SAMP as it recovers from the weakness resulting from the pawning portfolio issues. Assigning a P/BV multiple 1 higher than the base case multiple, yields a value of LKR243. Our bear case scenario considers the valuation for SAMP in a situation where the valuations further decline; trading at a 1.x one year forward P/BV multiple would result in a price of LKR21. Thus our P/B multiple based valuation range stands at LKR21-LKR243. Figure 52: P/E and P/BV comparison with domestic peers Company P/BV P/E E 215E E 215E SAMP 1.3x 1.2x.9x 1.1x 1.x 8.3x 6.x 7.9x 9.3x 8.4x COMB 1.8x 1.6x 1.7x 1.8x 1.6x 1.1x 8.5x 9.7x 9.6x 7.9x HNB 1.1x.9x.8x.9x.8x 6.9x 5.9x 6.1x 6.8x 5.7x SEYL 1.3x 1.x 1.x NA NA 3.6x 9.1x 9.5x 8.9x NA NTB 1.5x 1.3x 1.2x 1.3x 1.1x 8.1x 6.7x 6.7x 7.2x 6.x Source: Bloomberg, Copal Amba estimates for SAMP, COMB and HNB Figure 53: ROE and ROA analysis of domestic peer set Company ROE ROA E 215E E 215E SAMP 16.1% 21.3% 12.2% 11.7% 12.1% 1.7% 1.9% 1..9%.9% COMB 2.2% 2.8% 18.5% % % 1.9% 1.8% 1.9% HNB 19.1% % 14.3% 1.9% 1.9% 1.6% 1.4% 1.5% SEYL 4.4% 11.4% 11.4% NA NA.4% 1.2% 1.2% NA NA NTB 2.8% 2.8% 19.5% 18.9% 2.3% 1.7% 1.7% 1.6% NA NA Source: Bloomberg, Copal Amba estimates for SAMP, COMB and HNB 25

26 P/E analysis gives a valuation range of LKR per share We cross checked our P/BV valuation by valuing SAMP on a P/E basis, as a secondary measure, since it is a method popular among Sri Lankan investors. The one-year forward P/E multiple range of SAMP has shown a wide variation since January 211 ranging from 13.x at peak levels in 211 to lows of 5.x in 212. The stock currently trades at a 214E multiple of 9.3x (based on our forecasts). Figure 54: SAMP has traded at between 5.x and 13.x on a P/E basis, since January 211 LKR/share Jan-11 Apr-11 Aug-11 Nov-11 Mar-12 Jun-12 Oct-12 Jan-13 May-13 Aug-13 Dec-13 Apr-14 Jul-14 5.x 7.x 9.x 11.x 13.x MPS Source: SAMP, Bloomberg, Copal Amba estimates We expect to see re-rating of SAMP shares as current concerns ease, however, we conservatively use the one year forward P/E multiple, 9.3x as our base case multiple, yielding a P/E based price of LKR223. Our bear case assigns an 8.7x 214E EPS multiple to SAMP, and the bull case a 1.x 214E EPS multiple, yielding a price range of LKR

27 Share price performance SAMP shares closed at LKR213 on 24 July 214, LKR16 higher than 12 months earlier, an increase of 8%, compared to an 11% increase in the S&P SL 2 and a 12% increase in the All Share Price Index (ASPI). Figure 55: SAMP.N share performance over the last three years Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14 SAMP ASPI S&P SL 2 Source: CSE, Bloomberg Figure 56: SAMP vs. key indices over m 6m 1 year 2 years 3 years SAMP 11.6% 19.1% 6.3% 44.4% -2.7% S&P SL % 9.3% 36.4% 8.7% ASPI 9.8% 8.4% 11.6% 39.1% 3.7% Source: CSE, Bloomberg 27

28 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 SAMP 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 personal loans; composition of the loan book 2. Pawning portfolio 3. Change in funding structure: CASA ratio, change in bank borrowings and debentures, if any 4. Net interest margin and net interest spread; composition of the net interest margin 5. Impairment levels: overall impairment and impairment levels in key segments and the provision coverage level 6. Cost to income ratio 7. Profit margins: operating profit margin and net profit margin 8. Dividend payout ratio 9. Capital adequacy levels Tier 1 and Tier 2 ratios 1. Change in branch and ATM network 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

29 Appendix 1: The Sri Lankan banking sector A competitive landscape The Sri Lankan government envisages an USD1bn 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 (BOC and PB) and three large private commercial banks (COMB, HNB and SAMP), 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 213. Figure 57: 12 domestic licensed commercial banks are they key players in the industry BOC PB COMB NTB DFCC Vardhana NDB SAMP SEYL HNB Amana UB PABC Note: Excludes Cargills Agricultural and Commercial Bank which commenced operations in May 214 Figure 58: 12 Foreign LCBs operate in Sri Lanka Axis Bank Citibank Deutsche Bank Habib Bank ICICI Bank Indian Bank Indian Overseas Bank MCB Bank Public Bank Berhad Standard Chartered Bank State Bank of India HSBC The 25 licensed commercial banks (LCBs) accounted for roughly 85% of total banking-sector assets and 9 of gross loans in 213. 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 1 of gross loans in 213. Of the 25 licensed commercial banks (LCB), the two largest are the government banks, BOC and PB, cumulatively accounting for nearly 5 of total commercial banking sector credit as at December 213. The largest private LCB is COMB, accounting for roughly 14% of total commercial banking sector credit. 29

30 Figure 59: State- and privately owned LSBs (circles denote asset size) HDFC Lankaputhra Development Bank Regional Development Bank Sanasa Development Bank DFCC Bank NSB As Figure 6 shows, only 5 of the 22 domestic banks have an asset base greater than LKR5bn (USD4bn), while most banks have an asset base less than LKR5bn. Foreign banks accounted for roughly 1 of the sector s assets, and most have an asset size less than LKR5bn. Figure 6: Five domestic banks hold a market share of 66% Figure 61: Most foreign banks have an asset base < LKR5bn Asset size Number of banks Total assets (LKRbn) Market share More than LKR5bn 5 3, % LKR25bn to LKR5bn % LKR1bn to LKR25bn % LKR5bn to LKR1bn % Less than LKR5bn % Asset size Number of banks Total assets (LKRbn) Market share LKR25bn to LKR5bn % LKR1bn to LKR25bn % Less than LKR5bn According to our calculations, the top five LCBs accounted for roughly 66% of total banking-sector assets (Figure 62) and 76% of gross loans in 213 (Figure 63). Owing to this concentration, we focus on these five banks in our sector discussion to depict industry growth trends. Figure 62: The top five LCBs accounted for 66% of total banking-sector assets Figure 63: and 76% of gross loans 6.6% 8.8% 24.4% 8.4% 1.8% 36.4% 1.2% 11.1% 2.6% 17.4% 22.7% 22.6% SAMP HNB COMB PB BOC Other SAMP HNB COMB PB BOC Other Source: Bloomberg, CBSL, Company reports Source: Bloomberg, CBSL, Company reports 3

31 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 Funding Sourced primarily through retail deposits Deposits made up roughly 7 of the banking sector s funding in 213, 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 1 in 213. This was in line with the slowdown in credit growth owing to the lag effect of the high interest-rate environment during 212. After the CBSL relaxed regulatory limits on foreign borrowing for LCBs in 212, 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 USD75m in September 213 and DFCC raised USD1m in October 213. The BOC also raised USD5m 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 213 budget. During 213, 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 213 from a high of 44% in 21, increasing the cost of funding. We believe the declining CASA ratio will negatively affect the sector s NIMs. Figure 64: Deposit and borrowings growth declined in 213 Figure 65: CASA ratio declining; foreign borrowings on the rise YoY growth 22% % 2 16% 14% 12% Deposit growth (LHS) Borrowings growth (RHS) CASA ratio Foreign borrowings as a % of total borrowings Sri Lankan banking sector NIM - one of the highest in the region Sri Lanka s banking sector reports the second-highest NIM (5.2%) among regional peers (peer average: 3.78% in 213). 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. 31

32 Figure 66: Sector-average NIM of 5.2% is the second-highest among regional peers Figure 67: Sri Lankan banks NIMs range from 3.9% to 6.3% NIM 8% 6% 4% 2% India Philippines Thailand Indonesia Malaysia Sri Lanka NIM 7% 6% 5% 4% 3% 2% 1% COMB HNB SAMP NTB SEYL BOC PB Source: Bloomberg, Company reports Source: Bloomberg, Company reports 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 (CIR) was relatively high at 5.3% in 213. Although DFCC and COMB posted CIRs in the mid-4s, the very high ratios (7-8) reported by smaller banks create an upward bias on the overall average. Figure 68: High CIR impedes profitability (Sri Lankan peers) Figure 69: Sri Lankan banks have the highest cost structure among regional peers CIR CIR COMB HNB DFCC NDB SAMP NTB SEYL UB PABC India Philippines Thailand Indonesia Malaysia Sri Lanka Source: Bloomberg, Company reports Source: Bloomberg, Company reports The burden of high CIRs is further exacerbated by high provisioning costs, due to high NPA ratios at some local banks. In 213, the sector s gross NPA ratio stood at 5.6%, and rose to 6.2% in 1Q14, a five year high, due to increasing NPAs in the pawning portfolio and slow credit growth. Of the LKR74bn increase in NPAs in 213, LKR56bn was related to pawning advances. Furthermore, 32

33 the sector posted a decline in the coverage ratio in 213. The total provisions-to-npa ratio for the sector came in at 4.4% in 213, having steadily declined from 6.9% in 28. Figure 7: NPA ratios are at their highest in four years Figure 71: The sector s total provisions-to-npa ratio declined LKRbn 2 NPA ratio 1. LKRbn Gross NPA volume (LHS) Gross NPA ratio (RHS) Net NPA ratio (RHS) General provisions (LHS) Specific provisions (LHS) Total provisions to NPA ratio (RHS) 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 COMB 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. Figure 72: High NPAs concentrated in a few banks, with most large banks reporting healthy provisioning Gross NPA ratio Provisioning cover 16% % 8 8% 6 4 4% 2 COMB HNB DFCC NDB SAMP NTB SEYL UB PABC BOC PB Gross NPA ratio 212 Gross NPA ratio 213 Provisioning cover 212 Provisioning cover 213 Source: Bloomberg, Company reports, Copal Amba estimates 33

34 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 21 and is now at 16%. Similarly, the sector s ROA declined to 1.3% in 213 from 1.7% in 211. COMB and NTB report the highest ROEs at around 19%; they also report ROAs higher than the sector average. Figure 74 compares listed Sri Lankan banks in terms of ROE versus P/B values. Figure 73: ROE and ROA of domestic banks Figure 74: Listed Sri Lankan banks P/B vs. ROE, % 1.8% 1.2%.6% ROA 213 ROA 212 PABC UB SEYL NTB SAMP NDB DFCC HNB COMB. 6% 12% 18% 24% ROE 213 ROE 212 P/B 1.8x 1.6x COMB 1.4x 1.2x UB PABC NDB NTB 1.x SEYL DFCC HNB.8x SAMP 5% 1 15% 2 25% ROE Source: Bloomberg, Company reports Source: Bloomberg, Company reports 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 2; 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. Figure 75: Sri Lankan banks need to improve further on ROE Figure 76: and ROA levels ROE 3 25% 2 15% 1 5% India Philippines Thailand Indonesia Malaysia Sri Lanka Source: Bloomberg, Company reports ROA 3% 3% 2% 2% 1% 1% India Philippines Thailand Indonesia Malaysia Sri Lanka Source: Bloomberg, Company reports 34

35 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. Figure 77: Dividend yields of domestic listed banks remain relatively high Dividend yield 12% 1 8% 6% 4% 2% COMB HNB DFCC NDB SAMP NTB SEYL 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 1. 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%. Figure 78: Most banks maintain Tier 1 capital well above regulatory requirements Figure 79: the region Sri Lankan banks are among the best capitalized in 25% 2 15% 1 5% Tier 1 capital 2 15% 1 5% COMB HNB DFCC NDB SAMP NTB SEYL UB PABC Tier 1 capital ratio CAR India Philippines Thailand Indonesia Malaysia Sri Lanka Source: Bloomberg, Company reports Source: Bloomberg, Company reports 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 8-9, a health range within which the liquidity risk is well managed, while maintaining profitability. 35

36 Figure 8: Loan-to-deposit ratios are relatively low Loans to deposits COMB HNB DFCC NDB SAMP NTB SEYL UB PABC 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, BOC, is the only bank with assets of over LKR1tn (close to USD1bn), while the three largest private commercial banks have assets of roughly USD3.bn-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 LKR1bn 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 LKR38bn (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-213. The sector is dominated by a few large NBFIs 1 companies have asset sizes greater than LKR2bn (accounting for roughly 62% of market share), 7 companies have between LKR8bn and LKR2bn, and the remaining 41 have less than LKR8bn. The CBSL aims to reduce the number of NBFIs to around 2 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 215. The first acquisition under this program came about at the end of June 214, with Assetline Leasing, a subsidiary of the David Peiris Motor Company acquiring Lisvin Investments Ltd. Subsequently, COMB announced in July 214 that it plans to acquire Indra Finance for LKR87m; news reports indicated that Indra Finance had LKR57m in equity, LKR73m in profits and LKR2bn in assets. Two further acquisitions - TKS Finance acquiring Asian Finance and Deshodaya Finance acquiring George Stuart Finance for LKR5m are also progressing. Asia Asset Finance, on the other hand, announced a 1:2 Rights issue to raise about LKR45m, so as to increase the core capital to LKR1bn. 36

37 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 crisis in the late 9s. 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 81 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. Figure 81: Key metrics of some regional banks Name of bank Country NIM CIR ROE ROA CAR Asset size (USDm) Tisco Financial Thailand 2.6% 39.5% 2.6% 1.3% NA 1,983 Bank Mandiri Indonesia 5.4% 4.6% 22.5% 2.7% 14.9% 6,238 Siam Commercial Thailand 3.3% 38.3% 21.8% 2.1% 14.5% 77,47 Public Bank Malaysia 2.1% 3.4% 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 LKR1bn each by 216 and LSBs a minimum requirement of LKR5bn (due to increase by 218). Furthermore, NBFIs will be required to have minimum capital of LKR1bn by 216 and LKR1.5bn by 218. 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

38 Appendix 2: Company overview Sampath Bank PLC (SAMP) is the third largest private commercial bank in Sri Lanka with an asset base of LKR388bn, with a market capitalization of LKR36bn as of 24 July 214. SAMP was incorporated in 1986, and is a licensed commercial bank offering a multitude of banking services to both personal and corporate clients. The bank accounted for 6% of asset market share in the banking sector, and 8% of loans in 213. The bank operates a large and extensive branch and ATM network in the country, comprising 215 branches and 283 ATMs island wide, with 3,884 employees. SAMP was acclaimed the Best Banking Group in Sri Lanka at the World Finance Awards in 212. The Banker magazine of the Financial Times awarded SAMP The bank of the year award for Sri Lanka in 29 and 21. SAMP was the first bank in Sri Lanka to introduce a multipoint network of automated teller machines in The group recorded growth in loans and advances at a 23% CAGR over , Meanwhile, deposits grew at a similar rate of 22% CAGR, with time deposits being the key growth driver. Figure 82: Loan growth at a 23% CAGR over Figure 83: while deposits increased at a 22% CAGR as well LKRbn 3 YoY growth 4 LKRbn 3 YoY growth Term loans (LHS) Pawning (LHS) Overdraft (LHS) Trade finance (LHS) Lease & HP (LHS) Other (LHS) Gross loans growth (RHS) Current deposits (LHS) Savings deposits (LHS) Time deposits (LHS) Other deposits (LHS) Deposits growth (RHS) Source: SAMP Source: SAMP In 213, SAMP recorded 25% YoY growth in its NII to reach LKR15bn. The NII grew at an 18% CAGR, during SAMP s net interest margin (NIM) declined to 4.5% in 212 (from 5.5% in 29), and subsequently remained flat at 4.5% in 213, as the bank started reducing lending rates in line with the policy decline in rates. Over the past five year period, SAMP s cost-to-income ratio (CIR) has fluctuated between 44-56% due to technology and branch upgrades, asset writedowns etc. This has translated into a volatile ROE for SAMP, ranging between 12-22% during Figure 84: NIM compression in a lower interest rate regime Figure 85: CIR ratio volatile since 29, ROE similarly volatile LKRbn 16 NIM 6. CIR 6 ROE 25% % 5 45% 2 15% Net interest income (LHS) NIM (RHS) CIR (LHS) ROE (RHS) 1 Source: SAMP Source: SAMP 38

39 Effective foreign fund raising SAMP has been able to raise significant levels of foreign funding over the past few years; in effect foreign borrowings accounted for a greater proportion of the total funds raised in both 212 and 213. Figure 86: Foreign borrowing levels increasing Figure 87: Over 5 of debt raised sourced from abroad LKRbn % Foreign borrowings Local borrowings % 43% 68% 1 63% 57% 32% Foreign borrowings Local borrowings Source: SAMP Source: SAMP SAMP s key business units SAMP offers many banking and financing services through the following strategic business units (SBUs). Personal banking This division primarily caters to a wide range of individuals, facilitating management of personal finances through a range of products. 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 delivers financial solutions tailored to meet corporate investment and operational needs corporate entities. The division comprises of a number of sub-divisions, namely Corporate Finance, Trade Services, Development Banking, Corporate Credit and Foreign Currency Banking. Treasury Operations This unit engages in local and foreign currency fund management activities and inter-bank operations, to manage SAMP s exposure to exchange rate, interest rate and liquidity risk from normal operating activities. Further, the Primary Dealer Unit and Investment Department carries out investment and sales of Government Securities. International Operations This unit is responsible for Trade Services, International Operations (centralized processing unit for Inward and Outward Telegraphic Transfers of the Bank) and the Bank Notes Operations. E-Banking This unit develops and maintains technology solutions for SAMP and its customers. 39

40 Shareholding structure Domestic investors owned 85% of SAMP s voting shares as of 31 December 213, while institutional shareholders (both Sri Lanka-based and international) held 65%. Vallibel One PLC is the largest shareholder, with a 15% stake of voting ordinary shares, while the top 2 shareholders accounted for 65% of the total shareholding as of 31 December 213. SAMP s directors hold less than.1% of total voting shares. Figure 88: Institutional investors hold a majority stake of 65% of SAMP s voting shares Figure 89: while resident shareholders own 85% of the bank with the top 2 investors accounting for 65% Individuals 35% Non- Resident 15% Institutions 65% Resident 85% Source: SAMP Source: SAMP The top five shareholders as of 31 March 214 are presented below: Name of shareholder Description Stake Vallibel One PLC A leading domestic Conglomerate 14.96% Mr. Y.S.H.I. Silva A domestic high-net-worth investor 9.98% Employees Provident Fund The largest pension fund in Sri Lanka 9.98% Rosewood (Pvt) Ltd A large investment holding company 6.97% HSBC INTL Nominees Ltd-BBH Matthews Int Funds Source: SAMP A prominent global asset management group 4.2 Board of directors As of December 213, SAMP s board comprised twelve directors. Their details are provided below: Name of Director Mr. Dhammika Perera Mr. Aravinda Perera Mr. Channa Palansuriya Description Chairman; appointed to the SAMP s board in August 27, and appointed non-executive Chairman in January 212. He serves on the boards of many public quoted enterprises in Sri Lanka, including Vallibel One PLC, Hayleys PLC, Royal Ceramics Lanka PLC, Dipped Products PLC. Managing Director (MD); first appointed to the board in November 28 an executive director (ED) and appointed MD in January 212. He has over 26 years of experience with SAMP. Currently, he is a director at Institute of Bankers of Sri Lanka and Lanka Financial Services Bureau Limited and was appointed a director of the Colombo Stock Exchange in July 214. Deputy Chairman (Non-executive); appointed a non-executive director (NED) in January 212. He presently serves as the Chairman/ MD of Orit Group and the Deputy Chairman of the Joint Apparel Association Forum and as an Executive Committee Member of Apparel Exporters Association of Sri Lanka. 4

41 Mr. Sanjiva Senanayake Independent non-executive director (INED); He has been on SAMP s board since January 212 and holds several directorships in domestic companies in various sectors. Mr. Deepal Sooriyaarachchi INED; He has been on SAMP s board since August 21 and holds several directorships in domestic companies. Previously, he was the MD of Aviva NDB Insurance PLC. Prof. Malik Ranasinghe Mrs. Dhara Wijayatilake Ms. Annika Senanayake Mr. Deshal De Mel Mr. Ranil Pathirana Mrs. Saumya Amarasekera Mr. Ranjith Samaranayake Source: SAMP INED; He was appointed to the board in August 211. He is a senior Professor in civil engineering at the University of Moratuwa and an independent director of Textured Jersey Lanka PLC and Access Engineering PLC. INED; She was appointed to the board in August 211. She is currently the Secretary to the Ministry of Technology & Research and a member of the Sri Lanka Law Commission. INED; She was appointed to the SAMP s board in January 212. She is the Chief Executive Officer of ART Television Broadcasting Co (Pvt) Ltd. NED; He was appointed to the SAMP s board in January 212. He is currently a senior economist at Hayleys PLC. NED; He was appointed to the SAMP s board in January 212. He is the group finance director of Hirdramani group of companies and a non-executive Director of Hayleys PLC. INED; She was appointed to the SAMP s board in June 212. She is a Legal practitioner and a member of the Bar Association of Sri Lanka. Group Chief Financial Officer/ ED. He has held this position since January 29. He has over 38 years of experience in the financial services sector in Sri Lanka. Figure 9: SAMP s corporate holding structure Source: SAMP 41

42 Appendix 3: Key financial data Summary group financials (LKRm) INCOME STATEMENT E 215E 216E (For the year ended 31 December) Net interest income 9,288 12,39 15,95 11,624 13,659 15,421 Net revenue 15,128 18,38 2,36 17,779 2,585 23,642 Operating profit 6,293 8,829 5,72 6,437 7,163 9,79 Earnings before income taxes 5,376 7,653 4,789 5,343 5,945 8,58 Net income available to equity holders 3,683 5,437 3,635 3,839 4,276 5,797 BALANCE SHEET E 215E 216E (As at 31 December) Assets Cash and due from banks 16,84 19,23 1,132 17,783 19,249 2,19 Treasury bills 25,94 37,228 51,45 51,12 52,548 53,73 Net loans 172, , , , , ,316 Premises and equipment 6,691 6,764 8,327 8,498 8,71 8,92 Goodwill and intangible assets Total assets 251, ,55 391,34 431,41 483, ,3 Liabilities Total deposits 195,94 243,88 3, ,99 384,45 439,15 Bank borrowings 19,444 28,751 38,41 24,614 26,124 28,475 Other borrowings 4,11 2,751 3,55 4,223 4,394 4,658 Total liabilities 228, , , ,7 446,812 55,594 Equity Common share capital 2,744 3,564 4,46 4,47 4,47 4,47 Retained earnings 2,632 3,197 3,31 5,565 7,799 11,28 Minority interest Total equity 23,311 27,819 31,76 34,33 36,672 4,76 Total liabilities and equity 251, ,55 391,34 431,41 483, ,3 42

43 Key ratios KEY RATIOS E 215E 216E Growth Loan growth (%) 38.1% 23.7% % 17. Net interest income growth (%) 6.9% 29.6% 25.4% % 12.9% Operating profit growth (%) -2.2% 4.3% -35.2% 12.5% 11.3% 35.5% Net profit growth (%) 5.7% 47.6% -33.1% 5.6% 11.4% 35.6% Recurrent diluted EPS growth (%) 2.7% 42.2% -33.4% 5.5% 11.4% 35.6% Margins and profitability Net interest margin (%) 4.5% 4.5% 4.5% % 3.1% Operating profit margin (%) 41.6% % 36.2% 34.8% 41.1% PBT margin (%) 24.5% 29.6% 17.9% 21.6% 2.8% 24.5% Net profit margin (%) 24.3% 29.6% 17.9% 21.6% 2.8% 24.5% ROE (%) 16.1% 21.3% 12.2% 11.7% 12.1% 15. ROA (%) 1.7% 1.9% 1..9%.9% 1.1% Capital adequacy and allocation Tier 1 ratio (%) 1.5% 11.9% 1.1% 9.6% 9.5% 1.2% Tier 2 ratio (%) 1.3% 1.9% 4.1% 3.6% 3.5% 3.3% Total CAR ratio (%) 11.8% 13.8% 14.1% 13.2% % Total equity/total assets (%) 9.2% 8.8% 8.1% 7.9% 7.6% 7.4% Leverage ratio (%) % 5.9% 5.8% 5.9% Asset quality and liquidity NPL ratio (%) % 2.7% 2.4% 2.3% 2.2% Loans to deposit ratio (x) 92.3% 9.7% 92.1% 87.1% 87.8% 89.6% Deposits to interest bearing funding ratio (x) 87.9% 87.2% 85.7% 9.8% 91.4% 91.9% Valuation P/BV (x) 1.3x 1.2x.9x 1.1x 1.x.9x P/E (x) 8.3x 6.x 7.9x 9.3x 8.4x 6.2x Dividend yield (%) 4.6% % 4.4% 5.7% 7.2% PER SHARE DATA E 215E 216E Reported diluted EPS (LKR) Common dividend per share (LKR) Book value per share (BVPS) (LKR) Source: SAMP, Copal Amba estimates Note: All figures are for the group unless otherwise stated. Also, we have used bank data where group data is not available. 43

44 E 214E E 214E 215E E 215E 216E E Sampath Bank PLC 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 29. 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. Figure 91: 214E Sri Lanka's GDP projected to increase to 8% by Figure 92: GDP per capita to increase 22% by 216E % USD 5, 4, 3, 2, 2 1,, Department of Census and Statistics Source: Road Map CBSL Figure 93: Annual core inflation post-war has averaged 6.7%, government targeting mid-single digit levels in the medium term % Figure 94: CBSL expects the rupee to stabilize in the medium term despite recent volatility Jan-7 Jan-8 Feb-9 Mar-1 Apr-11 May-12 Jun-13 Jul-14 LKR/USD LKR/EUR LKR/GBP Source: Department of Census and Statistics, CBSL Source: Bloomberg Figure 95: Fiscal deficit target of 5.2% of GDP for 214E Figure 96: Debt-to-GDP to fall to 71% by 215E LKRbn % 8% 4% % Fiscal Deficit LKR bn As a % of GDP 44

45 Banks, Finance & Insurance Beverage, Food & Tobacco Chemicals & Pharmaceuticals Construction & Engineering Diversified Hotels & travels Investment Trusts Land & Property Manufacturing Plantations Power & Energy Services Telecommunication Trading Banks, Finance & Insurance Beverage, Food & Tobacco Chemicals & Pharmaceuticals Construction & Engineering Diversified Hotels & travels Investment Trusts Land & Property Manufacturing Plantations Power & Energy Services Telecommunication Trading Sampath Bank PLC 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. Figure 97: Post war, the ASPI has significantly outperformed global and developed market indices Jul-9 Mar-1 Dec-1 Sep-11 May-12 Feb-13 Nov-13 Jul-14 Source: Bloomberg *Note: All figures re-based to 1 July 29 Figure 99: 29 ASPI Dow Jones FTSE 1 MSCI World DAX The CSE s market capitalization has doubled since Figure 98: Post war, the ASPI has also outperformed some of the best-performing regional indices Jul-9 Mar-1 Dec-1 Sep-11 May-12 Feb-13 Nov-13 Jul-14 Bombay (BSE 5) Philippines (PASHR) Hanoi (VNINDEX) ASPI Source: Bloomberg *Note: All figures re-based to 1 July 29 Jakarta (JCI) Thailand (SET) MSCI Emerging Market Index Figure 1: The government anticipates FDI inflows to reach USD2bn in 214 LKRbn 3, 2,5 2, 1,5 1, 5 1,92 2,211 2,214 2,168 2,418 2, (July) USDm 1,6 1,338 1,42 1,4 1,2 1,66 1, Source: Bloomberg, CBSL Source: Ministry of Finance and Planning, Board of Investment of Sri Lanka Figure 11: Most sector P/Es are below market average and historical valuations Figure 12: Trend is similar on a P/BV multiple Average market P/E Average market P/BV Source: Colombo Stock Exchange Source: Colombo Stock Exchange 45