Financial Institutions

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1 Sri Lanka Credit Analysis Lanka ORIX Leasing Company Ltd Ratings Lanka ORIX Leasing Company Limited National Long-Term A(lka) Outlook Stable Financial Data Lanka ORIX Leasing Company Limited 31 Mar Mar 04 Total Assets (USDm) Total Assets (LKRm) 8, ,616.7 Equity (LKR m) 2, ,844.4 Net Income (LKRm) ROA (%) ROE (%) Equity/Assets (%) Analysts Rukshana Thalgodapitiya rukshana.thalgodapitiya@fitchratings.lk Chanaka Wickramasuriya chanaka.wickramasuriya@fitchratings.lk Rating Rationale The rating of Lanka ORIX Leasing Company Ltd ( LOLC ) reflects its long operating history, strong customer franchise, dominant position in the leasing industry and good financial profile. Fitch Ratings Lanka also takes comfort in LOLC s long association with ORIX Corporation of Japan ( ORIX ), which owns 30% of LOLC s equity. The rating takes into account the less diversified funding sources available to specialised leasing companies such as LOLC, given Sri Lanka s under-developed debt markets and regulatory restrictions on accessing the deposit market. LOLC s funding is predominantly from borrowings (69% at end-march 2005), primarily from banks. The company has sourced funds from foreign agencies such as the OPEC Fund for International Development, the Netherlands Development Finance Company ( FMO ) and Renewable Energy for Rural Economic Development project ( RERED ). These borrowings accounted for 24% of total borrowings as at October 2005 and have enabled the company to reduce its dependence on banks and improve funding diversity somewhat. LOLC has hedged its foreign-exchange risk by retaining foreign currency and borrowing in LKR against this. Fitch expects portfolio growth to have remained moderate in the year to end-march 2006 ( FY06 ), having averaged around 18% per year in FY03-FY05. LOLC s net interest margin ( NIM ) rose from 11% in FY03 to 14.8% in FY05. The agency expects its NIM to fall bur remain healthy. Profitability as measured by ROA is high and compares well with peers. ROA has increased steadily, from 4.4% in FY03 to 6.9% in FY05. Fitch expects ROA to remain relatively high due to LOLC s comfortable capitalisation and the company s increasing exposure to high-margin segments. At FYE05 LOLC s ratio of gross non-performing loans ( NPLs ) to total lending was 10.5%. Loan loss reserve coverage was 83%, high compared with peers. LOLC has funded long-term leases with short-term funding to take advantage of lower interest rates at the short end of the yield curve. This has been clearly evident in NIM. At end-october 2005, almost 57% of the funding was at the short end of the yield curve. LOLC is comfortably capitalised, with an equity/assets ratio of 26% at FYE05, which is considerably above the industry average. The relatively high earnings retention policy should enable the company to maintain its capital position despite the expected portfolio growth. Support LOLC is a registered leasing establishment supervised by the Central Bank of Sri Lanka ( CBSL ). However, given its lower systemic importance compared with banks, it is unlikely that state support would be available. Rating Outlook and Key Rating Drivers The rating Outlook for LOLC is Stable. Given its relatively strong financial profile, the company will be well placed to manage any deterioration in market conditions. An improvement in its rating will be linked to growth and a broader funding base. Profile LOLC is a specialised leasing company with a market share of approximately 11%. The first leasing company in Sri Lanka, it has a 25- year operating history and well-established customer franchise in the market. Raja Nanayakkara and his family own 53% of LOLC s equity. 7 June

2 Profile LOLC, Sri Lanka s first specialised leasing company, was established in 1980 by the International Finance Corporation ( IFC ) and Bank of Ceylon in technical collaboration with Orient Leasing Company of Japan, the predecessor to ORIX, a Tokyo-based financial services group. Raja Nanayakkara, a leading vehicle importer, and his family own 53% of the company s equity, having acquired a controlling interest in ORIX owns 30%, an investment it has maintained since inception. LOLC is listed on the Colombo Stock Exchange and the remaining stake is widely owned. Historically, LOLC focused on the less risky segments of the leasing market, such as multinational and large corporates. Management appointed in 2002 has been more willing to expand and started to penetrate the lower segments of the market, including microfinance. LOLC enjoys a strong customer franchise in the leasing industry and its mainstay has been providing finance for motor vehicles. Portfolio growth has been steady and moderate, averaging around 18% for FY03-FY05. The company intends to use its strong franchise and increase its network from 15 branches to 30 branches by FYE09. LOLC generates significant volumes from repeat business to existing clients. It maintains a network of agents to canvass new business and has developed strong relationships with vehicle importers, which refer customers. The management estimates that the agents and vehicle dealers contribute around 60% of the new originations. The company recently entered into exclusive agreements with importers of light commercial vehicles to provide leasing facilities to customers. In addition, it selectively grants short-term loans and mortgage loans secured on property mortgages. LOLC has ventured into the microfinance segment by participating in refinance schemes designed to help rural households. Its participation in this segment has assisted the company in establishing relationships with several foreign funding agencies, such as FMO and the OPEC Fund. LOLC carries out debt factoring through a fully owned subsidiary, Lanka ORIX Factors Limited ( LOFAC ), which was initially set up in collaboration with the IFC in LOFAC is the largest factoring company in Sri Lanka with an estimated market share of around 60%. As at September 2005 it had a factoring portfolio of LKR1 billion. LOFAC s main target markets are small and medium-sized enterprises and factoring debts owed by large companies such as multinationals and supermarkets to their suppliers. It makes a modest contribution to group revenue but provides LOLC with a database of 20,000 customers financial profiles, which could be used to cross-sell leasing products. LOLC established Lanka ORIX Finance Company Limited ( LOFIN ) in 2003 with the objective of diversifying its funding base and gaining direct access the retail public for funding. LOFIN will also engage in leasing but will focus on the lower end of the market, which LOLC does not target, such as providing microfinance facilities to rural customers. Gradually it will undertake other forms of consumer lending and property development. LOLC carries out insurance brokering through its fully owned subsidiary, Lanka ORIX Insurance Brokers Limited, and stockbroking through its associate, Lanka ORIX Securities (Private) Limited. LOLC is also considering establishing leasing operations in Cambodia and Vietnam, possibly in partnership with ORIX. In addition LOLC will consider small infrastructure investments, for instance investments in renewable energy generation projects such as mini hydro plants, in collaboration with other investors. Fitch expects commercial banks to lay greater emphasis on the retail and consumer market, including leasing, in order to offset declining margins in corporate banking. This would further intensify competition and add downward pressure on the interest margins. As such, specialised leasing companies such as LOLC will have to defend their market positions by offering better service and maintaining existing customer relationships. LOLC is expanding in rural areas, where competition from the banking sector is still somewhat lower. Performance LOLC s overall financial performance improved in FY03-FY05, driven by improved margins and expansion in the loan book. ROA increased from 3.9% in FY02 to 6.9% in FY05. The improving Financial Perfomance of LOLC (%) Day T Bill Spread Avg Lending Rate Avg Borrowing Cost ROA FY00 FY01 FY02 FY03 FY04 FY05 Source: LOLC Annual Reports 2

3 trend continued in the first half of FY06, with ROA increasing to 7.8%. The ROA also benefited from a zero effective tax rate. However, ROA will come under pressure from declining margins and Fitch expects LOLC s effective tax rates to trend back to normal levels. Notwithstanding these developments, the agency expects LOLC s profitability to remain healthy. Net Interest Revenue LOLC s net interest revenue has been on an increasing trend, growing at an average of 27% in FY03-FY05, surpassing the average portfolio growth of 18%. This has been due to the widening of interest spreads from 7.9% in FY02 to 12.8% in FY05. The wider spread is explained by lower borrowing cost due to lower market interest rates. The loan book continued to expand in the first half of FY06. However, the interest spread was somewhat weaker at 12.4%, due to higher market interest rates. The NIM is likely to come under pressure from higher market interest rates as the bulk of LOLC s funding is in the form of short-term or floating-rate borrowing (almost 57% at end-october 2005). However, the impact would be somewhat mitigated by the high level of free capital used to fund the lease portfolio, which will earn a higher return when interest rates rise. Non-Interest Revenue LOLC earns fee-based income on factoring, insurance brokering and securities brokering carried out through subsidiary and associate companies. However, the contribution to overall net income is modest (around 7% in FY05). Operating Expenses LOLC s cost/income ratio is reasonably good, standing at 45.3% for FY05. Operating costs grew at an average rate of 22% in FY03-FY05. However, this is partly on account of investment in infrastructure and distribution. LOLC s cost base includes a relatively high level of depreciation (33% of total costs in FY05). This includes depreciation on assets used in operating leases. Since the pricing of LOLC s operating leases does not factor in a high residual value, depreciation in this context is probably overstated and would reverse as income when the operating asset is disposed. Risk Management Operating Risk LOLC manages operating risk through clear procedures developed with the assistance of ORIX and subsequently refined. Adherence to the procedures is ensured through the hierarchical review and approval procedure and by the internal audit department. LOLC s operational procedures are further strengthened by the oversight provided by ORIX through daily, weekly and monthly reporting requirements. Credit Risk Credit risk management is structured around procedures for credit evaluation, approval, monitoring and recovery. The evaluation procedure is further categorised according to the approving authority. Each application is submitted for approval following the receipt of the required documentation. Facilities are approved on a hierarchical basis based on the respective delegated authority limits. On average the lease/value ratio is around 70%-80%. Facilities in excess of LKR2 million for new clients are referred to the executive committee for approval, while exposures in excess of LKR50m are referred to ORIX for approval. The average size of a lease is about LKR2m. LOLC s credit risk stems mainly from finance leases and hire purchase, which accounted for 76% of the portfolio at end-september The credit risk in the finance leasing and hire purchase portfolio is mitigated to an extent by the absolute ownership of the lease asset. Sundry and mortgage loans accounted for 24% of the portfolio. Fitch considers the risk profile of such loans to be relatively higher due to difficulties in realising collateral in the event of defaults. Credit risk management is supported by systems developed by ORIX and refined over time. LOLC also benefits from the expertise and infrastructure of Ishara Traders, the vehicle import business owned by the Nanayakkara family, which improves efficiency in the disposal of repossessed vehicles. LOLC has strengthened its credit risk management, placing more focus on monitoring and follow-up. The recovery strategy has been strengthened with the appointment of dedicated recovery managers to handle the portfolios of a designated number of marketing officers. The legal department has been streamlined to expedite legal recoveries. Certain recovery functions have also been outsourced to improve effectiveness. Better credit risk management has improved asset quality: the gross NPL ratio fell from 15.9% at FYE03 to 10.5% at FYE05, due largely to the 20% decline in absolute NPLs during the period despite a 67% growth in the portfolio. At end-september

4 the gross NPL ratio stood at 7.5% due to a 16% decline in absolute NPLs from the position at FYE05. Movement in NPLs (LKRm) 10,000 8,000 6,000 4,000 2,000 0 Portfolio FY03 FY04 FY05 H106 Source: LOLC Management Information NPL Ratio (%) 18 The ageing of NPLs reflects that 75% of the NPLs have been in arrears for over 12 months. Given the high provision cover against these NPLs, however, the potential impact will not be significant. LOLC is exposed to some concentration risk. While customer concentrations at LOLC were comfortable, (the top 10 customer exposures accounted for around 25% of equity) LOLC has somewhat high counterparty exposure to the Ceylinco Group. This largely stems from deposits placed by LOLC with a bank owned by the Ceylinco Group. To mitigate exchange rate risk, LOLC retains the funds borrowed from multilateral agencies as foreign-currency deposits without converting to LKR and then borrows LKR from the bank against these deposits. LOLC has hedged its foreign-exchange risk with this arrangement, but Fitch considers it to be exposed to a relatively high level of counterparty risk. LOLC s management argues that these arrangements are structured such that LOLC is always a net borrower; hence the risk is minimal. The agency is of the view that this level of counterparty exposure (75% of equity), notwithstanding that it is at the gross level, is not conservative from a risk management perspective. Fitch expects customer concentrations to increase somewhat as LOLC expands its short-term and mortgage loan portfolios, where the ticket size is larger than in the traditional lease products. In terms Table 1: Analysis of NPLs (%) FY03 FY04 FY05 H106 Leasing Portfolio Loan Portfolio Total Portfolio Source: LOLC Management Information of asset concentrations, commercial vehicles accounted for 54% in FY05 followed by private vehicles and equipment at 33% and 13% respectively. Table 2: Age Analysis of NPLs Months in Arrears (%) FY03 FY04 FY05 H Over Total Source: LOLC Management Information Loan Loss Reserves The Finance Leasing Act brought the activities of all registered finance leasing establishments under the purview of the CBSL in August The CBSL has issued directions on NPL classification and provisioning, which took effect in January According to Direction No. 2 of 2005 on Provisioning for Bad and Doubtful Debts, advances are classified as non-performing only after six months. A 100% provision is only made after the lapse of 18 months. In addition, the direction allows for deduction of the value of seized but unsold assets and any primary mortgages on property when making provisions. In Fitch s opinion these classification and provisioning norms are lax, but represent an important starting point in the development of the regulation of the leasing industry. LOLC has been following a provisioning policy that is more conservative than the provisioning policy mandated by the CBSL. LOLC provides 50% for all advances in arrears for months and 100% for all advances in arrears for over 25 months. The provisioning is calculated based on the capital outstanding without taking any credit for the possible realisable value of leased assets held as collateral. LOLC had set aside a fairly high level of provisions against NPLs. Provisions covered 83% of the NPLs at FYE05, consistent with the age analysis of its NPLs; at end-september 2005 provision cover increased to 95%. Benefiting from the high coverage and strong equity position, solvency was good, with net NPLs/equity at 5.6% at FYE05 and 1.3% at end- September 2005, which compares well with peers in the local context. Market Risk LOLC has historically followed a fairly aggressive funding strategy by funding long-term leases with short-term funding to take advantage of the lower interest rates in the short term. This strategy has benefited LOLC over the last few years due to the declining market interest rates. At end-october

5 57% of the borrowings were on a short-term basis, exposing LOLC to a rising interest rate risk. However, due to the increased reliance on foreign borrowings including from FMO, the OPEC Fund, the German development finance group DEG, Société de Promotion et de Participation pour la Coopération Economique ( PROPARCO ) and Belgische Investeringsmatschappij Voor Ontawikkelingslanden NV ( BIO ) LOLC s NIM is less vulnerable to increases in market interest rates. Further, the reasonably high NIM allows LOLC to earn an attractive spread notwithstanding rising interest rates. Funding and Capital Similar to other leasing companies, LOLC s funding is predominantly through borrowings from the banking sector. However, the company s leverage was at the low end of the industry, at 2.7x equity at end-september LOLC s leverage compares very favourably with the regulatory limit of 10x. Since 2002 LOLC has obtained direct funding from multilateral agencies such as the OPEC Fund and FMO. Such funding accounted for 22% of total borrowings in October The company intends to gradually develop a retail deposit base through its fully owned subsidiary, LOFIN. Fitch expects such initiatives to diversify LOLC s funding mix, allowing the management greater flexibility and reducing its dependence on banks. Capital LOLC was well capitalised at end-september 2005 with an equity base of LKR2,628m. The core equity/assets ratio was 25.6%, which is considerably above the industry average. The relatively high earnings retention policy will enable LOLC to maintain its comfortable capital position in light of the expected portfolio growth. Fitch believes LOLC must maintain its strong financial profile, given its reliance on institutional lenders in the absence of a stable retail deposit base. The agency sees LOLC remaining reliant on institutional lenders for funding in the long term due to the absence of alternative sources, such as a developed debt market. Further diversification initiatives, such as project finance, would require a somewhat higher capital allocation relative to core leasing assets.. 5

6 Balance Sheet Analysis LANKA ORIX LEASING COMPANY LIMITED Year End Year End As % of Average Year End As % of Year End As % of Year End As % of USDm LKRm Asset s LKRm LKRm Asset s LKRm Asset s LKRm Asset s A. LOANS 1. Customer Loans , , , , Other Loans (Loan Loss Reserves) (Interest in Suspense) TOTAL A , , , , B. OTHER EARNING ASSETS 1. Deposits with Banks Treasury Bills Other Securities Equity Investments TOTAL B , , C. TOTAL EARNING ASSETS (A+ B) , , , , D. FIXED ASSETS E. NON-EARNING ASSETS F. TOTAL ASSETS , , , , G. CUSTOMER AND SHORT TERM FUNDING 1. Time Deposits Certificate ofdeposits TOTAL G H. BORROWINGS I. OTHER (Non-int. bearing) J. TOTAL LIABILITIES , , , , K. EQUITY , , , , M. TOTAL LIABILITIES & EQUITY , , , , Exchange Rate USD1 = LKR USD1 = LKR USD1 = LKR USD1 = LKR

7 Income Statement Analysis LANKA ORIX LEASING COMPANY LIMITED Incom e As % of Income As % of Income As % of Incom e As % of Expenses Total AV Expenses Total AV Expenses Total AV Expenses Total AV LKRm Asset s LKRm Asset s LKRm Asset s LKRm Asset s 1. Interest Income Interest Expense NET INTEREST REVENUE Other Operating Income TOTAL INCOME Provision for Loan Losses Provision Others Personnel Expenses Other Non Int. Expenses TOTAL EXPENSES PRE-TAX PROFIT Taxes NET PROFIT Ratio Analysis LANKA ORIX LEASING COMPANY LIMITED I. PROFITABILITY LEVEL 1. Net Interest Margin % Pre-tax Profit/Total Assets (av.) % Net Income/Equity (av.) % Net Income/Total Assets (av.) % Total Non-Int. Expense (excl.prov.)/ % Net Int. Rev.+ Other Operating Income 6. Net Interest Rev./Total Assets (av.) % II. CAPITAL ADEQUACY (year end) 1. Equity/Total Assets % Equity/Loans % Capital/Risks - Tier 1 % Net NPLs/Equity % n.a. III. LIQUIDITY (year end) 1. Liquid Assets/Customer Deposits % n/a n/a n/a n/a 2. Loans/Customer Deposits + Borrowings % n/a n/a n/a n/a IV. ASSET QUALITY 1. Loan Loss Provisions/Loans (av.) % Loan Loss Reserves/Loans % Loan Loss Reserves/NPLs % n.a. 4. Non Performing Loans/Gross Loans % n.a. 7

8 Balance Sheet Analysis LANKA ORIX LEASING COMPANY LIMITED (CONSOLIDATED) Year End Year End As % of Average Year End As % of Year End As % of Year End As % of USDm LKRm Asset s LKRm LKRm Asset s LKRm Asset s LKRm Asset s A. LOANS 1. Customer Loans , , , , Other Loans (Loan Loss Reserves) (Interest in Suspense) TOTAL A , , , , B. OTHER EARNING ASSETS 1. Deposits with Banks , , Treasury Bills Other Securities Equity Investments TOTAL B , , C. TOTAL EARNING ASSETS (A+ B) , , , , D. FIXED ASSETS E. NON-EARNING ASSETS F. TOTAL ASSETS , , , , G. CUSTOMER AND SHORT TERM FUNDING 1. Time Deposits Certificate ofdeposits TOTAL G H. BORROWINGS I. OTHER (Non-int. bearing) , , J. TOTAL LIABILITIES , , , , K. EQUITY , , , , M. TOTAL LIABILITIES & EQUITY , , , , Exchange Rate USD1 = LKR USD1 = LKR USD1 = LKR USD1 = LKR

9 Income Statement Analysis LANKA ORIX LEASING COMPANY LIMITED (CONSOLIDATED) Incom e As % of Income As % of Incom e As % of Income As % of Expenses Total AV Expenses Total AV Expenses Total AV Expenses Total AV LKRm Asset s LKRm Asset s LKRm Asset s LKRm Asset s 1. Interest Income Interest Expense NET INTEREST REVENUE Other Operating Income TOTAL INCOME Provision for Loan Losses Provision Others Personnel Expenses Other Non Int. Expenses TOTAL EXPENSES PRE-TAX PROFIT Taxes NET PROFIT Ratio Analysis LANKA ORIX LEASING COMPANY LIMITED (CONSOLIDATED) I. PROFITABILITY LEVEL 1. Net Interest Margin % Pre-tax Profit/Total Assets (av.) % Net Income/Equity (av.) % Net Income/Total Assets (av.) % Total Non-Int. Expense (excl.prov.)/ % Net Int. Rev.+ Other Operating Income 6. Net Interest Rev./Total Assets (av.) % II. CAPITAL ADEQUACY (year end) 1. Equity/Total Assets % Equity/Loans % Capital/Risks - Tier 1 % Net NPLs/Equity % n.a. III. LIQUIDITY (year end) 1. Liquid Assets/Customer Deposits % n/a n/a n/a n/a 2. Loans/Customer Deposits + Borrowings % n/a n/a n/a n/a IV. ASSET QUALITY 1. Loan Loss Provisions/Loans (av.) % Loan Loss Reserves/Loans % Loan Loss Reserves/NPLs % n.a. 4. Non Performing Loans/Gross Loans % n.a. 9

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