Hatton National Bank PLC (HNB.N0000) · diversification measure and to improve its risk profile. Contrary to investor misgivings, HNB was able to grow gross loans 17% YoY, compared

Sri Lanka | Banks, Finance and Insurance EQUITY RESEARCH

Initiation of coverage 17 June 2014

Hatton National Bank PLC (HNB.N0000)

1

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

High leverage to the Sri Lankan growth story HNB is the fourth-largest commercial bank in Sri Lanka, having an asset base of LKR537bn and a market capitalization of LKR50bn. Near-term challenges appear to be clouding the positive structural themes of the Sri Lankan banking sector. We view the current weakness as an adjustment to previous over-lending and believe the stage is set for improving macroeconomic fundamentals, based on a solid underlying economic growth story in the medium to long term. Credit growth stimulation from the current low interest rate regime should gain momentum in 2H14, further supported by tailwinds from favorable policies (e.g. government guarantees for gold loans) and benign inflation. HNB is well placed to benefit from such a macroeconomic upturn and should, in our view, be able to leverage its robust retail franchise to derive above-industry-average earnings growth. We look beyond the slowdown in 1H14 and expect loan growth in the mid-teens to sustain EPS growth at a 14% CAGR over 2014E-2016E. Our P/B- and P/E-based valuation analysis suggests a valuation range of LKR142-179.

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

supporting the growth story of the banking sector remain solid, in our view. A simple back-of-the-envelope calculation supports the case for double-digit loan growth. GDP at 7% and inflation at 5% imply nominal economic growth at roughly 12%. Credit growth is typically 2-3ppts higher than nominal growth; 14%-15% is thus feasible. This view is substantiated by Sri Lanka’s low private sector credit-to-GDP ratio (29.2% in 2013) compared with peers, low mortgage lending and personal credit levels, indicating further room for growth.

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

concerns regarding loan growth and asset quality deterioration appear to weigh down sector valuations. Restraints on gold-based loans imposed by the Central Bank of Sri Lanka (CBSL) to rein in over-lending, combined with the timing difference as corporates and investors readjust to the low interest rate regime, are behind the current lackluster environment. Furthermore, although policy rates have been on a downward trend since mid-2013, banks have been slow to reduce lending rates. Double-digit prime lending rates at the two public banks that hold roughly 50% market share even as at June 2014 explain the stagnating loan books; the sector reported YoY loan-book growth of 8.8% in 2013 and 0.6% in 1Q14. We expect credit growth to pick up in 2H14 as the benefits of rate reduction cascade with greater momentum. Furthermore, we expect the downward trajectory in rates to benefit bank asset quality.

HNB and large private commercial banks set to benefit from macroeconomic upturn: The larger private commercial banks, including HNB, have been more proactive

in tweaking lending rates; we therefore expect these banks to continue to see above-industry-average loan growth. HNB reported 17% YoY loan book growth in 2013, 18% YoY in 2012 and 3% QoQ in 1Q14. We expect HNB to be able to continue to achieve higher levels of growth by leveraging its premium brand name and strong lending franchise. We forecast loan growth coming in at roughly 13% in 2014E and rising thereafter to around 15%. In terms of asset quality as well, HNB is on a better footing, having trimmed its pawning portfolio by nearly 20% to 11% of total loans by 1Q14. Furthermore, the NPA ratio on HNB’s pawning portfolio stood at 1.1% (industry average: 12.7%) in December 2013.

We establish a valuation range of LKR142-179: Our P/B valuation suggests that

HNB’s voting shares trade at a current P/B multiple of 1.0x, an 18% discount to its two-year historical average P/B multiple of 1.2x, while on a P/E basis, it trades at 6.3x 2014E EPS. A sensitivity analysis considering changes to our assigned base-case multiples (on both P/B and P/E bases) gives a valuation range of LKR142-179.

Key statistics CSE/Bloomberg tickers

Share price (16 June 2014)

No. of issued shares (m)

Market cap (USDm)

Free float (%)

52-week range (H/L)

Avg. daily vol. (shares, 1yr)

Avg. daily turnover (USD ‘000)

HNB.N0000/HNB SL

LKR156

400

383

61%

LKR164/141

144,122

168

Source: CSE, Bloomberg Note: USD/LKR=131.0 (average for the year ended 16 June 2014)

Share price movement

Source: CSE, Bloomberg

Share price performance

3m 6m 12m

HNB 2.2% 9.6% -4.8%

S&P SL 20 9.8% 10.5% 0.5%

All Share Price Index 7.6% 9.5% 2.0%


Summary financials

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

Net interest income 25,050 26,005 29,186

Net revenue 32,590 34,595 39,020

Operating profit 12,448 12,681 15,932

PBT 10,916 11,385 13,686

Net profit 7,812 8,153 9,801

Recurrent EPS 19.2 19.9 23.9

ROE (%) 14.0 13.2 14.3

P/B (x) 0.8 1.0 0.9

Source: HNB, Copal Amba estimates

80%

90%

100%

110%

Jun-13 Aug-13 Nov-13 Jan-14 Apr-14 Jun-14HNB ASPI S&P SL 20

Hatton National Bank PLC

2


Table of Contents

We expect HNB to show above-industry-average loan and EPS growth ............................................................................ 3

Loan book growth at 13% - 15% a feasible target for HNB .................................................................................................................. 3 NIM at trough levels; set to gradually recover....................................................................................................................................... 4 Debentures and bank debt increase diversity in funding structure ....................................................................................................... 5 Significance of loan portfolio mix shift muted ........................................................................................................................................ 6 We expect a moderate decline in HNB’s NPA levels ............................................................................................................................ 7 Adequate loan-loss coverage levels to be maintained .......................................................................................................................... 8 Contribution from non-interest income should improve further ............................................................................................................. 9 Cost – income ratio has further room for improvement ......................................................................................................................... 9 Other operations – contribution small yet significant potential .............................................................................................................. 9 We forecast EPS growth at a 14% CAGR 2014E-2016E ................................................................................................................... 10 7.2% Dividend yield in 2013 - we forecast continued DPS growth ..................................................................................................... 10 Capital adequacy to remain strong; no requirement for further equity raising in the near term .......................................................... 10

Current concerns about the banking sector are short-term ............................................................................................... 12

Private sector credit growth rate declined due to a confluence of negative factors ............................................................................ 12 Stimulation from lower interest rate regime yet to gain momentum .................................................................................................... 14 Pawning portfolio issues managed effectively .................................................................................................................................... 15 Industry average measures mask wide variations in individual bank performance............................................................................. 16 Lower SOE borrowings support private credit growth ......................................................................................................................... 17 Improving liquidity levels ease pressure on interest rates .................................................................................................................. 18 Banking sector loan book well diversified ........................................................................................................................................... 18

Macroeconomic factors substantiate private sector credit growth story ............................................................................ 19

Credit as a percentage to GDP well below that of regional peer set................................................................................................... 19 IMF forecasts Sri Lanka’s GDP to be the highest in the region .......................................................................................................... 20 Inflation targeted to remain at mid-single digit levels .......................................................................................................................... 20 FDI inflows continue to rise................................................................................................................................................................. 21 Foreign remittances and exports increasing ....................................................................................................................................... 21 Exchange-rate stability a strong positive ............................................................................................................................................ 22 Fiscal deficit and current account deficit as a percentage of GDP improving ..................................................................................... 22 Further improvement in savings necessary to narrow the savings-investment gap ............................................................................ 23

Factors that temper a positive outlook on credit growth .................................................................................................... 24

We establish a valuation range of LKR142-179 for HNB’s voting shares ......................................................................... 25

P/BV analysis yields a valuation range of LKR147-179 per share ...................................................................................................... 25 P/E analysis gives a valuation range of LKR142-164 per share ......................................................................................................... 27

Share price performance .................................................................................................................................................... 28

Earnings release focus areas ............................................................................................................................................. 29

Appendix 1: The Sri Lankan banking sector – A competitive landscape ........................................................................... 30

Appendix 2: Company overview......................................................................................................................................... 39

Appendix 3: Key financial data ........................................................................................................................................... 43

Fact sheet ........................................................................................................................................................................... 45


3


We expect HNB to show above-industry-average loan

and EPS growth

HNB recorded loan growth well above industry average in 2013 and 1Q2014, and we expect such performance to continue in 2014E and beyond. It has already lowered lending rates to high single-digit levels, where they are likely to remain until the sector witnesses a significant uptick in loan growth. NIMs, which fell alongside the declining lending rates, are now at trough levels and should bottom out over the next two to three quarters. Given its very large retail franchise, HNB should be able to increase its current account and savings account (CASA) levels and is therefore better placed relative to most peers with regard to avoiding further extensive NIM contraction. Furthermore, loan growth, which we forecast at a 15% CAGR over 2014E-2016E, should help compensate for any NIM compression, in our view. We recognize the investor concerns regarding asset quality, but believe the issue is self-limiting and expect credit costs to recede after 3Q14E. The confluence of receding credit costs, loan growth, margin maintenance and cost reduction should enable HNB to report EPS growth at a 14% CAGR over 2014E-2016E.

Loan book growth at 13% - 15% a feasible target for HNB

We expect HNB to show loan book growth at a 15% CAGR during 2014E-2016E, on a conservative view. With optimal conditions, we believe this could increase to high double digits. We expect loan growth to pick up further in 2H14, as corporates and investors adjust to the lower interest rate regime and forecast 13% gross loan growth in 2014E, rising to 15% levels from 2015E onwards. We believe HNB should be able to achieve this target through increased lending to corporates and disciplined lending to small and medium enterprises (SMEs).

HNB pursued growth quite aggressively in the immediate post war period, posting 20% and 26% loan book growth in 2010 and 2011, respectively. Increases in pawning and SME lending contributed significantly to this growth (these segments accounted for 50% of the loan book in 2011, as shown in Figure 1). This raised the question of whether HNB will be able to replicate such growth going forward, once risk management measures require reining in SME loans and pawning.

SME and pawning 50% of HNB loan book (2011) Figure 1: 71% of HNB new credit in 2013 from corporate loans Figure 2:

Source: HNB Source: HNB

In 2013, HNB made a concentrated effort to increase its exposure to corporate lending, both as a diversification measure and to improve its risk profile. Contrary to investor misgivings, HNB was able to grow gross loans 17% YoY, compared with an industry average loan book growth of 9% in 2013. Its corporate loan portfolio grew 41% YoY in 2013, and by December 2013 corporate loans accounted for 35% of the loan book, a 9ppt increase from 2011. Corporate lending accounted for 71% of new credit in 2013, as shown in Figure 2 above. By December 2013, SME lending had dropped to 32% (from 37% in 2011) and the pawning portfolio had dropped to 13% of total loans.

Over the past five quarters, HNB has seen consistent double-digit YoY growth in its loan book, as NIMs declined (Figure 4). 1Q14 saw this above-industry-average performance continue, with 18%

36%

26% 14%

8%

8%

5%

2% SME

Corporates

Pawning

Housing

Leasing

Micro finance

Personal Loans

-20% 0% 20% 40% 60% 80%

Corporates

SME

Microfinance

Pawning

Housing

Leasing

Personal loans

New credit in 2013 (%)


4


YoY loan book growth. The loan book grew 3% QoQ compared with an industry average of 0.6%. Corporate lending was the main contributor to loan growth in 1Q14, whereas the pawning portfolio fell 12% QoQ, an LKR5.5bn decline. Pawning accounted for 11% of total loans by end-1Q14.

Corporate loans grew to 35% of loan book in 2013 Figure 3: Loan growth rates rose with NIM decline 1Q13-1Q14 Figure 4:


HNB had already laid the ground work for this growth through the improvement of its retail penetration during 2009-2011. It embarked on a rapid expansion program following the end of the war – it opened 20 new branches on average per year during 2009-2011 and 5 new outlets on average during 2012-2013. HNB’s focus now is on consolidating its position in the industry, with management targeting increasing revenue per existing branch as opposed to branch expansion. We believe that this, together with its established presence in the industry, would assist in securing loan growth stemming from industry opportunities in the current macro-environment.

NIM at trough levels; set to gradually recover

HNB reported one of the highest NIMs in the industry in December 2013, as shown below in Figure 6. The bank reduced lending rates well in line with policy rates and, along with the other large private commercial banks, contributed to lowering sector average weighted prime lending rate (AWPLR) levels. By 1Q14, lending rates were down to single-digit levels at HNB, and in tandem with this decline the NIM levels also declined, reaching 4.7% by 1Q14. We do not expect HNB’s lending rates to decline much further over the next few quarters, as its lending rates are already well below those of large peers such as Bank of Ceylon PLC and Peoples Bank.

HNB reduced lending rates in line with sector rates Figure 5: HNB’s NIM one of the highest in the sector at 5.5% Figure 6:

Source: HNB, CBSL Source: HNB, CBSL, Bloomberg, Company reports

Note: LCB = Licensed commercial banks average for 2013 is as at 30 September 2013

32%

35%

13%

7%

6%

4%

3%

SME

Corporates

Pawning

Housing

Leasing

Micro finance

Personal Loans 10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

1Q13 2Q13 3Q13 4Q13 1Q14

YoY growth NIM

NIM (LHS) Gross loan growth YoY (RHS)

8%

10%

12%

14%

16%

18%

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14

%

HNB AWPR HNB's average lending rate

Sector AWPR

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

2009 2010 2011 2012 2013

NIM

HNB COMB SAMPSEYL NTB NDBDFCC LCB average


5


As HNB has already taken the brunt of interest rate declines, we believe the impact of declining rates on NIM contraction is now at its tail end for the bank. We expect NIMs to come in at 5.0% for 2014E and factor in a moderate improvement of 20bps over 2015E-2016E.

Customer deposits make up almost the entirety of HNB’s funding base (accounting for 87% of total loan funding in 1Q14). Funding costs also declined in line with declining interest rates, with the average interest cost declining to 6.7% in 1Q14 from over 8% a year ago. HNB should, in our view, be able to leverage its considerable retail franchise to fund borrowing at low costs. We calculate a CASA ratio of 38.6% in 1Q14 based on reported data. This is the second highest CASA ratio among peers, and is testimony to HNB’s ability to attract low-cost funding. We expect HNB’s CASA ratio to improve gradually over our explicit forecast period and reach 42% by 2016E, as the low interest-rate environment continues and the mix shift moves away from time deposits along with a decline in the propensity to save.

Robust retail franchise drives high CASA ratio (39%) Figure 7: We forecast HNB’s CASA ratio to increase slightly Figure 8:

over 2014E-2016E

Source: HNB, CBSL, Bloomberg, Company reports, Copal Amba estimates

Note: COMB = Commercial Bank of Ceylon PLC, SAMP = Sampath Bank, SEYL = Seylan Bank PLC, NTB = Nations Trust Bank, NDB = National Development Bank


Debentures and bank debt increase diversity in funding structure

While customer deposits remain the primary funding source for HNB, it has also been diversifying the funding sources over the past few years. Bank borrowings grew 50% YoY in 2013, with the USD49m loan from the China Development Bank; an extension of a previous loan intended to provide long-term project financing. HNB’s foreign currency borrowings now account for 58% of total bank debt (compared with 26% in 2009).

Rising levels of foreign borrowings could help reduce overall funding costs Figure 9:

Source: HNB

10%

20%

30%

40%

50%

60%

2009 2010 2011 2012 2013

CASA ratio

HNB COMB SAMPSEYL NTB NDBDFCC LCB average

30%

40%

50%

60%

-

200,000

400,000

600,000

2009 2010 2011 2012 2013 2014E2015E2016E

CASA ratio LKRm

Time deposits (LHS) Savings deposits (LHS)

Current deposits (LHS) Other deposits (LHS)

HNB's CASA ratio (RHS)

26%

43% 41% 54% 58%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2010 2011 2012 2013

%

Local borrowings Foreign borrowings


6


Although not much data is available about these foreign currency loans, we believe it is likely that they help reduce overall funding costs as dollar loans are currently at lower interest rates.

HNB has also issued a series of debentures, mostly at high cost ranging from 11% to 16.75%. However, the most recent fundraising of LKR1.35bn in August 2013 was a deep discounted bond issue at a much lower rate of 8%.

HNB’s debt securities in issue as at December 2013 Figure 10:

Type of long-term debt Issue date Maturity date Amount (LKRm) Interest rate (%)

Subordinated debentures April 2006 March 2021 225 11.00%

Subordinated debentures April 2006 March 2024 457 11.25%

Subordinated debentures August 2007 July 2017 540 16.00%

Subordinated debentures August 2007 July 2022 759 16.75%

Subordinated debentures September 2011 September 2021 2,000 11.50%

Subordinated loan April 2012 April 2020 3,249 NA

Preference shares issued through JV December 2012 September 2014-2017 131 AWPR+0.5%

Subordinated debentures June 2013 June 2018 4,252 14.00%

Senior debentures August 2013 August 2023 1,399 8.00%

Source: HNB

Management stated that there are several opportunities presented by development finance institutions, such as the World Bank, and that HNB will focus on securing longer-term facilities at concessionary rates.

Significance of loan portfolio mix shift muted

As the loan portfolio mix changes with corporate and SME lending taking greater prominence, we expect the overall average lending rate for HNB to decline. Generally, corporate lending carries lower interest rates than SME lending and pawning. The latest available reported figures for lending rates as at September 2013 (shown in Figure 11) indicate the wide disparity and range in lending rates among the various segments.

Wide disparity and range in lending rates among the various lending segments of HNB Figure 11:

Source: CBSL

Note: Latest available data as of September 2013

As the proportion of corporate loans increases, the overall average lending rates for the bank should decline. The CBSL-imposed interest cap of 16% on pawning, applicable from mid-2014, would further contribute to this decline.

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15%

20%

25%

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7


However, we believe the overall impact of this decline on HNB’s profitability would be mitigated by the lower credit costs associated with the corporate loan portfolio. As seen below in Figure 13, HNB’s non-performing advances (NPA) levels in the corporate portfolio are well below its overall NPA levels, and in 2013 they fell slightly, reaching 2.82%.

Exposure to SME loans has reduced over the past few years, as shown before in Figures 1 and 3. SME loans show relatively higher delinquency rates but this too has been declining: the 2013 NPA ratio for the SME portfolio declined to 5.4% in 2013 from 6.7% in 2012. This should also help reduce overall NPA levels.

Corporate banking – loans and advances Figure 12: Delinquencies lower than average in the corporate Figure 13:

loan portfolio

Source: HNB, Copal Amba estimates Source: HNB, Copal Amba estimates

Note: HNB’s average gross NPA ratio is for three years

We expect a moderate decline in HNB’s NPA levels

HNB has been actively shrinking its pawning portfolio, which is down nearly 20% to LKR40.7bn as at March 2014, compared with LKR49.3bn in 2012. Gold-based loans accounted for approximately 11% of gross loans as of March 2014. HNB lowered its loan-to-value (LTV) ratio on pawning from 85% to 70% and placed a cap on gold-based lending at 17.5% of loans in 2012, and lowered it further at end-2013 to 12.5%.

As shown below in Figure 14, gross NPA levels at HNB have been falling gradually since 2010. 2013 showed a marginal decline to 3.64% from 3.66% in 2012. Gross NPA levels in HNB’s pawning portfolio increased marginally to 1.1% in 2013 (from 1.0% in 2012); however, they remain well below that of the industry average at 12.7% as at end-2013. The overall gross NPA rose to 4.5% in 1Q14, and we expect this off-trend increase in NPAs to continue for another two to three quarters, as the impact of the high LTV gold-based loans issued in early 2013 persists.

The rising contribution of the corporate loan portfolio to total loans in 2014 and beyond should, on the other hand, help lower NPA levels, as asset quality is higher in this portfolio; we forecast HNB bringing NPA levels under control by 2015E.

HNB took LKR11.4bn, 13.2bn and 16.9bn in impairments in 2012, 2013 and 1Q14, respectively. As the pawning portfolio ages and collateral can be realized, HNB should be able to bring down impairment levels after the next two to three quarters.

69

90

127

0

20

40

60

80

100

120

140

2011 2012 2013

LKRbn

Corporate banking loans and advances

4.30%

3.05% 2.82%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

2011 2012 2013

NPA ratio

NPA ratio HNB's average gross NPA ratio


8


We expect an off-trend increase in NPAs in 2014 Figure 14: HNB’s pawning portfolio shrinking; NPA levels still low Figure 15:

Source: HNB, Copal Amba estimates Source: HNB

Adequate loan-loss coverage levels to be maintained

HNB’s reported loan loss provisioning coverage declined to 62.5% in 2013 from 74.0% in 2012, in line with an industry-wide decline both in credit quality and in provisioning. The increase in delinquencies was primarily in the pawning portfolios, where the underlying collateral is gold and its value can be realized relatively easily. As a result, HNB and other banks did not make full provisioning for the losses, causing loan loss coverage levels to decline. While we would prefer higher provisioning as a more prudent measure, we do not expect a significant negative impact from this coverage ratio decline. HNB management also disclosed that a significant proportion of high LTV loans granted had been shifted to lower scales through requiring part settlement of capital and interest, thus reducing the overall credit risk.

We expect the provisioning requirements to drop as the impact of the pawning-related losses softens. The new loans falling due in the remainder of 2014 would be those initiated in 2Q13 and thereafter. By 2Q13, HNB had taken the strategic decision to reduce LTV ratios, and to reduce the size of the pawning portfolio. Therefore, the quantum of potential losses is lower, and we expect the provisioning requirement to be lower and the coverage levels to increase.

HNB’s provisioning coverage reported at 62.5% in 2013 is well above industry average Figure 16:

Source: HNB, CBSL, Company reports, Copal Amba estimates

Note: LCB average for 2013 is as at 30 September 2013

3.0%

3.4%

3.8%

4.2%

4.6%

2010 2011 2012 2013 2014E 2015E 2016E

Gross NPA ratio

Gross NPA ratio

0%

2%

4%

6%

8%

10%

0

10,000

20,000

30,000

40,000

50,000

60,000

2009 2010 2011 2012 2013 1Q2014

Gross NPA ratio

LKRbn

Gross pawning portfolio - LKRbn (LHS)

Reported pawning NPA as a % of total pawning portfolio (RHS)

0%

20%

40%

60%

80%

100%

2009 2010 2011 2012 2013

Provision cover ratio

HNB COMB SAMP SEYL NTB LCB average


9


Contribution from non-interest income should improve further

Non-interest income of LKR7.5bn accounted for approximately 23% of HNB’s total banking income in 2013, and this proportion has remained quite stable over the past few years. Fee income, the main contributor to non-funded income, grew 15.4% YoY in 2013.

The growth rate of HNB’s non-interest income has been on an upward trajectory, at 9.6% YoY in 2013 compared with 5.5% in 2012, based on our calculations. While this income tends to be volatile due to the inclusion of foreign exchange gains and losses, we believe it is an important way for private banks to improve their performance measures.

Management states that HNB’s non-interest income division will continue to focus primarily on its insurance business (through its 60%-owned subsidiary HNB Assurance PLC), an industry with strong growth catalysts due to the low penetration levels. It will also focus on its 25-year-old micro-financing arm operating under the ‘Gami Pubuduwa’ brand name (which it hopes can be spun-off as a separate strategic investment unit in line with the CBSL’s consolidation initiative). In line with this, we believe HNB will continue to focus on these non-interest income streams; we forecast non-interest income growth at a 12% CAGR over 2014E-2016E. Islamic banking, although it is yet a very small segment with LKR2.5bn in deposits, is another potential source of significant growth and profitability for HNB. Both deposits and loans nearly doubled over the past year and the CASA ratio in the segment is at 60%.

Cost – income ratio has further room for improvement

HNB’s cost-to-income ratio (CIR) has been improving over the past three years, falling 194bps to reach 56.3% at the end of 2013 (our calculations exclude the one-off impact of a provision reversal in relation to an employee share-based payment scheme). HNB reported CIR levels of 53% in 2012 and 47.8% in 2013. Although HNB’s CIR is near the licensed commercial bank (LCB) average, there is further room for improvement, and the benefit of a declining CIR would be directly transmitted to the bottom line.

HNB’s cost-to-income ratio well above that of closest peer COMB Figure 17:

Source: HNB, Blomberg, CBSL, Company reports, Copal Amba estimates

Note: LCB average for 2013 is as at 30 September 2013

We expect this improvement to stem from HNB’s streamlined operational processes and economies of scale enjoyed due to its large scale of operations, resulting in improved efficiency across the group. We expect this efficiency to continue to improve over our explicit forecast period, reaching close to 50% by 2016E, as management remains focused on its efforts to contain costs and also moves towards automation (via mobile and e-banking services).

Other operations – contribution small yet significant potential

HNB also derives income from Acuity Partners (its JV with NDB) and its privately owned property development arm Sithma Development Ltd. We believe these operations, together with insurance income (as discussed above), contribute approximately 7% on average to HNB’s bottom line (we

25%

35%

45%

55%

65%

75%

85%

2009 2010 2011 2012 2013

Cost-to-income

HNB COMB SAMP SEYL NTB NDB DFCC LCB average


10


calculated the net profit earned from these operations as the difference between the net profit of HNB Group and that of its banking operations) and expect this modest contribution to continue. This includes associate income growth forecasted at a 4% CAGR over 2014E-2016E.

We forecast EPS growth at a 14% CAGR 2014E-2016E

With loan growth at a 14% CAGR, stable NIMs around 5%, growing contribution from non-interest income, lower credit costs and improving CIR, we forecast EPS growth at a 14% CAGR over the next two years. We expect muted growth in 2014E but expect to see strong recovery in 2015E and beyond. We believe this will above industry average levels, as we expect to see muted growth in 2014 in the larger state banks.

7.2% Dividend yield in 2013 - we forecast continued DPS growth

HNB has continuously maintained a dividend yield of around 7.0% over the past three years, one of the highest dividend yields among the peer set, as shown in Figure 18 below. We believe HNB would increase its dividend payout ratio to above 45% (44% in 2013), resulting in DPS growth at a 14% CAGR over 2014E-2016E.

HNB had one of the highest dividend yields among domestic listed banks in 2013 Figure 18:

Source: Company reports, Bloomberg

Capital adequacy to remain strong; no requirement for further

equity raising in the near term

HNB’s reported a capital adequacy ratio (CAR) of 16.5% in 2013, well above the minimum regulatory requirement of 10%, and a Tier 1 ratio of 13.0% (also significantly above the stipulated minimum of 5.0%). In 2013, HNB took measures to strengthen its Tier 2 capital base, with the issuance of LKR4bn in debentures in June 2013. The CBSL announced capital requirements as a minimum of LKR10bn of Tier 1 capital by 2016E, and the Basel III requirement is 4.5% in Tier 1 capital and a capital buffer of a further 2.5%. HNB’s capital levels are well within these requirements. Based on our forecasts including RWA growth at a 13% CAGR over 2014E-2016E, we believe capital adequacy should remain well above the regulatory requirements, at 16.6% over 2014E-16E, without HNB needing to raise further equity over the period.

0%

1%

2%

3%

4%

5%

6%

7%

8%

COMB HNB DFCC SAMP NTB SEYL

Dividend yield (%)

2012 2013


11


Capital adequacy to remain strong in line with historical trends Figure 19:


HNB management provided further details on the resilience of the capital adequacy ratios to a number of potential external shocks, as shown below in Figure 20.

HNB capital adequacy levels appear resilient to external shocks Figure 20:

Magnitude of shock 50% 80% 100%

Original CAR CAR after change

1) A negative shift in NPA categories on the Bank's credit portfolio * 16.52% 16.27% 16.12% 16.02%



2) Increase in NPAs in the loan book

16.52%

16.32% 16.12% 15.72%

3) Increase in NPAs in the pawning portfolio ** 16.36% 16.14% 15.59%

4) Top 20 customer default scenario *** 15.27% 13.99% 11.30%



5) Negative shift in NPAs due to fall in forced-sale value of mortgaged 16.52% 16.33% 16.14% 15.75%

collateral in credit portfolio

Source: HNB

* Composition of NPA categories: Special Mention 14%, Substandard 19%, Doubtful 8% and Loss 59%.

** Impact of a reduction in gold prices and increase in NPAs on pawning portfolio

*** Impact of top 20 customers falling into NPA (based on outstandings)

11.1% 11.0% 12.8% 13.9% 13.0%

13.2% 12.6% 14.5%

16.6% 16.5%

0%

5%

10%

15%

20%

25%

30%

35%

2009 2010 2011 2012 2013

Capital adequacy

Tier 1 ratio - HNB Total CAR - HNB Tier 1 ratio - regulatory minimum Total CAR - regulatory minimum


12


Current concerns about the banking sector are short-term

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

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

We believe the larger commercial banks including HNB are on a more sound footing and are better placed than state banks and smaller private banks to weather short-term stresses. HNB is an early adapter, positioning itself to cater to the pickup in loan demand by passing on the benefits of lower interest rates to customers and by changing its 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 banking loan books, driven primarily by consumption-driven lending. The sector’s annual loan growth ranged between 21% and 32% during 2010-2012 – one of the highest growth rates recorded in the emerging markets. Escalating gold prices supported gold-based lending, which was the key growth driver in lending, as seen below in Figure 21. YoY growth in pawning loans exceeded 50% in 2011 and early 2012.

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

Gold based lending – the key driver of exuberant credit growth during 2011-2012 now losing importance Figure 21:

Source: CBSL

-20%

0%

20%

40%

60%

80%

2011 Q

2

2011 Q

3

2011 Q

4

2012 Q

1

2012 Q

2

2012 Q

3

2012 Q

4

2013 Q

1

2013 Q

2

2013 Q

3

2013 Q

4

YoY growth

Credit to the private sector Pawning loans by commercial banks


13


As a result, credit growth slowed while interest rates rose 454bps during this period, peaking at 14.4% in February 2013. After the significant decline in January 2014, private sector credit growth has been gradually picking up and showed 4.3% YoY growth in March 2014.

Private sector credit growth continues at moderate Figure 22:pace

Banking sector asset growth – 17% CAGR 2008-2013 Figure 23:

Source: CBSL Source: CBSL

Banking sector assets have grown at a 17% CAGR over the past five years. However, in 2013, the proportion of gross loans as a percentage of total assets declined to 58%, as credit growth eased. The comparatively higher asset growth in 2013 was due to an increase in investments made by the banks sector (mainly in government securities). Investments accounted for 29% of sector assets in 2013 versus 24% in 2012 (as shown in Figure 23).

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

Loan growth of the top five banks eased in 2013… Figure 24: … while total asset growth ranged from mid-teens to Figure 25:

high-twenties

Source: Bloomberg, CBSL, Company reports

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

This growth rate moderation can be partly explained by the lag effect of the tight monetary policies and the higher interest rate environment. The CBSL also cited sluggish global economic growth, which led to lower levels of credit being required for international trade-related activities, as a reason for lower growth rates. The ability to access alternative sources of funding, such as

2,000

2,100

2,200

2,300

2,400

2,500

2,600

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

LKRbn

53% 56% 61%

62% 58% 31%

30%

25%

24% 29%

16% 14%

14%

14%

14%

-

1,000

2,000

3,000

4,000

5,000

6,000

2009 2010 2011 2012 2013

LKRbn

Gross loans Investments Other

-20%

0%

20%

40%

60%

2009 2010 2011 2012 2013

YoY growth

COMB HNBSAMP BOCPB Industry average

0%

10%

20%

30%

40%

2009 2010 2011 2012 2013

YoY growth

COMB HNB SAMP

BOC PB Industry average


14


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.

Stimulation from lower interest rate regime yet to gain momentum

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

Policy rates started to decline in mid-2013 Figure 26:

Source: CBSL

As shown below in Figure 27, the prime lending rates of the banks remain high, and rates at the two key state banks, Bank of Ceylon and Peoples Bank, with over 50% market share, remain double-digit figures.

Prime lending rates remain high even in June 2014 Figure 27: Rate decline supports growth – but with a lag Figure 28:


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

5

7

9

11

13

15

17

19

21

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

%

BOC PB HNB COMB SAMP SEYL DFCC NDB

0%

2%

4%

6%

8%

10%

12%

14%

PB

BO

C

DF

CC

SE

YL

AB

PA

BC

UB

SA

MP

CO

MB

HN

B

ND

B

NT

B

%

-10%

0%

10%

20%

30%

40%

0%

4%

8%

12%

16%

20%

2001 2003 2005 2007 2009 2011 2013

YoY growth

AWPLR

AWPLR Private sector credit growth YoY


15


Historical data shows that declining interest rate regimes promote lending growth, but with a time lag, as seen in Figure 28 above. Small but clear indications of a pick-up are beginning to appear. Overall credit to the private sector amounted to LKR2,498bn in March 2014, a marginal increase from February. The CBSL reported that lending by domestic banking units to the private sector increased by LKR15.3bn in March 2014, but that the net credit level dropped due to repayments by BOI companies to offshore banking units.

The larger private commercial banks including HNB have been early movers in this regard; they reduced lending rates relatively early and, as a result, were able to show above-industry-average growth in 2013 and 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 2014 for the sector. We believe this is quite ambitious for the sector, but expect the larger private commercial banks to reap the benefits of the rate decline and to grow at double-digit rates by leveraging their brand name and strong retail penetration.

Pawning portfolio issues managed effectively

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

Gold-based lending declined LKR156bn since 2012 Figure 29: 20%-33% of gold-based loans used to fund SMEs Figure 30:

LKRm 2010 2011 2012 2013

Total gold based lending

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

Pawning for personal loans

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

(%) 71% 68% 67% 80%

Pawning for industrial/trading activities

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

(%) 29% 32% 33% 20%


The issue is further complicated by a factor specific to Sri Lanka and other South Asian countries: the practice of using gold as collateral for loans for 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; therefore, gold is the one of the few available and acceptable sources of collateral for lending.

Industrial activity-related lending as opposed to consumer debt accounted for 33% and 20% of total pawning in 2012 and 2013, as seen above in Figure 30. As the banks tighten lending criteria, increase interest rates and limit loan-to-value (LTV) ratios, such constraints on gold-based lending affect the ability of rural communities to obtain banking facilities for economic activities and lead them towards informal lending sources.

To counteract this financial exclusion and to enable credit growth at a structured pace, the government introduced a gold-backed loan guarantee scheme in May 2014, whereby a government guarantee is available on new pawning loans. The CBSL expects this scheme to allow banks to

19.2%

24.7% 25.4%

17.5%

0%

5%

10%

15%

20%

25%

30%

-

100

200

300

400

500

600

2010 2011 2012 2013

% of total loans

LKRbn

Gold-based loan portfolio As a % of total loans


16


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

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

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

Industry average measures mask wide variations in individual bank

performance

Asset growth and asset quality vary widely among banks, and this variation is masked when quoting industry average numbers. Although overall industry loan book growth declined to 8.8% in 2013, the larger private banks showed significantly higher growth, as seen in Figure 31. Sampath Bank grew roughly 25% YoY in 2013 and HNB 17%. DFCC, NDB and Commercial Bank each grew by double-digit numbers. Furthermore, although Peoples Bank’s loan book grew only 3.2% YoY in 2013, incremental credit to other industries amounted to LKR74bn, close to 10% of its loan book. However, this growth was masked by the LKR54bn decline in its pawning portfolio.

Double-digit loan growth in 2013 at private LCBs Figure 31: Pawning portfolio as a % of total loans varies widely Figure 32:

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

Similarly, exposure to gold-based lending varies widely among the banks. Figure 32 shows the pawning portfolio as a percentage of total loans, at 11 LCBs in 2012 and 2013. The highest exposures are at Bank of Ceylon (BOC) and Peoples Bank, the two largest state banks. Peoples Bank had the largest pawning portfolio of LKR250bn, amounting to 38% of total loans in 2012, which it trimmed down to LKR197bn by 2013. HNB trimmed its pawning portfolio to 13% of total loans by December 2013 and further to 11% by the end of 1Q14. Commercial bank, NDB, DFCC and NTB all kept their exposures at below 10% of total loans. Sampath Bank was the only

28.0%

25.2%

18.6%

17.0%

16.8%

10.3%

5.7%

3.2%

0% 10% 20% 30%

DFCC

SAMP

NDB

SEYL

HNB

COMB

BOC

PB

Loan growth

0%

10%

20%

30%

40%

CO

MB

HN

B

SA

MP

ND

B

NT

B

DF

CC

SE

YL

PA

BC

UB

BO

C

PB

% of total loans

2012 2013


17


systemically important private bank with a high pawning exposure at 19.7% of total loans in December 2013; its exposure was also reduced to 17% by the end of 1Q14.

The industry average NPA level rose to 5.6% in 2013 from 3.7% in 2012, mainly due to pawning-related losses. Given the lower level of residual risk on the new NPAs (being primarily gold-backed), banks made fewer provisions on the new NPAs, resulting in lower levels of provisioning coverage. Figure 34 shows the reported loan loss coverage levels in 2013. We believe the increased credit risk as portrayed by lower provisioning may not be as severe as it appears, due to the low LTV ratio (55%-65%) on new loans and the ease of realizing the value of the underlying collateral in gold-backed loans. However, a prudent approach requires higher levels of provisioning.

Gross NPA levels rose in 2013 Figure 33: Reported loan loss coverage levels fell at most banks Figure 34:

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

Lower SOE borrowings support private credit growth

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

Private sector credit - 60% of total credit in 2013 Figure 35: Credit to SOEs declining Figure 36:

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

0%

4%

8%

12%

16%

20%

CO

MB

HN

B

SA

MP

ND

B

NT

B

DF

CC

SE

YL

PA

BC

UB

BO

C

PB

Gross NPA ratio

2012 2013 Sector average

0%

20%

40%

60%

80%

COMB HNB NDB DFCC PABC PB

Provision coverage

ratio

2012 2013 Sector average

0

1,500

3,000

4,500

2009 2010 2011 2012 2013

LKRbn

Credit to public corporations Credit to the private sector

0

50

100

150

200

250

300

350

400

Jan

-13

Fe

b-1

3

Ma

r-13

Ap

r-13

Ma

y-1

3

Jun

-13

Jul-1

3

Au

g-1

3

Se

p-1

3

Oct-

13

Nov-1

3

Dec-1

3

Jan

-14

Fe

b-1

4

Ma

r-14

LKRbn


18


Improving liquidity levels ease pressure on interest rates

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

Liquidity ratios in the banking sector improving Figure 37: Domestic private sector credit – a well-diversified Figure 38:

portfolio


Banking sector loan book well diversified

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

20%

40%

60%

80%

2008 2009 2010 2011 2012 2013

%

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

16%

14%

12%

12%

11%

6%

4%

3%

3%

19%

Trading

Construction

Agriculture andfishingConsumption

Manufacturing

Infrastructure

Financial services

Tourism

Transport

Other


19


Macroeconomic factors substantiate private sector credit

growth story

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

Sri Lanka’s private sector credit as a percentage of the GDP is relatively low – remaining at an average of 30% over the past three years, as shown below in Figure 39. 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 40). Sri Lanka’s GDP per capita rose to USD3,282 in 2013 and is forecast to rise to USD4,000 by 2016. The projected increase in disposable income that accompanies per capita income growth should allow for significant increase in personal consumption and provide an opportunity for increased personal lending, leading to growth in bank loan books.

Private sector credit as a % of GDP stable and low Figure 39: Household debt as a % of GDP – further room for Figure 40:

growth


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

Private sector credit as a % of GDP – Sri Lanka well Figure 41:below regional peers

Household debt as a % of GDP – Sri Lanka well Figure 42:below regional peers

Source: CBSL, Bloomberg, World Bank

Source: CBSL, Bloomberg, World Bank

24.7% 26.5%

30.7% 31.1%

29.2%

-

2,000

4,000

6,000

8,000

10,000

2009 2010 2011 2012 2013

LKRbn

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

GDP (excluding domestic credit to the private sector)

6.3%

7.2%

8.8%

9.3%

7.9%

3,000

4,000

5,000

6,000

7,000

8,000

9,000

2009 2010 2011 2012 2013

LKRbn

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

0%

40%

80%

120%

160%

Sri L

anka

India

Indonesia

Ma

laysia

Th

aila

nd

Ph

ilippin

es

7.9% 8.3% 10.3%

86.8% 81.7%

6.2%

0%

20%

40%

60%

80%

100%

Sri L

anka

India

Indonesia

Ma

laysia

Th

aila

nd

Ph

ilippin

es

%

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


20


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

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

Loan growth tracks GDP and is usually higher than GDP growth Figure 43:

Source: CBSL

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

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

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

Inflation targeted to remain at mid-single digit levels

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

1%

4%

7%

10%

13%

-10%

0%

10%

20%

30%

40%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

YoY growth YoY growth

Sector loan growth (LHS) GDP growth (RHS)


21


Low inflation rates enable a low interest rate regime Figure 44: Foreign direct investment nearly tripled over past Figure 45:

three years


FDI inflows continue to rise

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

Foreign remittances and exports increasing

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

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

Foreign remittances rose over 50% during 2010-2013 Figure 46: Earnings from export of goods rising Figure 47:


3.6%

6.2% 6.7%

7.5%

6.9%

4.4%

0.0%

2.0%

4.0%

6.0%

8.0%

2009 2010 2011 2012 2013 2014(April)

%

Headline inflation

889

601 516

1,066

1,338 1,421

-

200

400

600

800

1,000

1,200

1,400

1,600

2008 2009 2010 2011 2012 2013

USDm

Foreign direct investments

1,414

2,502

4,116

6,407

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2003 2007 2010 2013

USDm

Foreign remittances

5,133

7,640

8,626

10,394

2,000

4,000

6,000

8,000

10,000

12,000

2003 2007 2010 2013

USDm

Earnings from export of goods


22


Earnings from tourism increased… Figure 48: …as did earnings from export of IT and Telecom Figure 49:

services

Source: Ministry of Finance Source: Ministry of Finance

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

Exchange-rate stability a strong positive

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

Currency fluctuation in LKR the lowest among regional peers over the past twelve months Figure 50:

Source: Bloomberg

Fiscal deficit and current account deficit as a percentage of GDP

improving

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

454 385 576

1,715

0

500

1,000

1,500

2,000

2003 2007 2010 2013

USDm

Earnings from tourism Expon. (Earnings from tourism)

110

182

348

719

0

200

400

600

800

2003 2007 2010 2013

USDm

Earnings from export of IT and telecommunication services

90

100

110

120

130

Ma

y-1

3

Jun

-13

Jul-1

3

Se

p-1

3

Oct-

13

Nov-1

3

Dec-1

3

Jan

-14

Ma

r-14

Ap

r-14

Ma

y-1

4

Index

LKR/USD INR/USD IDR/USDTHB/USD PHP/USD PKR/USD


23


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

Fiscal deficit as a % of GDP improving Figure 51: Current account deficit improving Figure 52:

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

Further improvement in savings necessary to narrow the savings-

investment gap

Gross domestic savings as a % of GDP rose to 20% in 2013, rising from multi year lows of 15.4% in 2011. The savings-investment gap too has been improving consistently as seen in Figure 54. Sustaining high levels of economic growth requires further increase of the savings rate in Sri Lanka, failing which Sri Lanka would have to depend excessively on foreign investment for growth.

Gross domestic savings on the rise Figure 53: Savings – investment gap started to improve in 2011 Figure 54:

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

-6.9%

-6.5%

-5.9%

-550 -500 -450 -400

2011

2012

2013

LKRbn

-7.8%

-6.7%

-3.9%

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

2011

2012

2013

USDm

15.4% 16.9%

20.0%

0%

5%

10%

15%

20%

25%

2011 2012 2013

%

Gross domestic savings

-12%

-8%

-4%

0%2005 2006 2007 2008 2009 2010 2011 2012 2013

%

Savings - investment gap


24


Factors that temper a positive outlook on credit growth

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

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

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

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

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


25


We establish a valuation range of LKR142-179 for HNB’s

voting shares

We establish a 12-month valuation range of LKR142-179 per share, based on our current outlook for HNB shares, compared with the current share price of LKR156 as of 16 June 2014. We arrive at our valuation range by applying a sensitivity analysis to a P/BV valuation, and validate it further by cross-checking against a P/E multiple-based valuation. We also compare HNB’s valuation levels relative to a domestic peer group.

Valuation range analysis provides a range of LKR142-179 per share (current share price: LKR156) Figure 55:

Source: HNB, Bloomberg, Copal Amba estimates

P/BV analysis yields a valuation range of LKR147-179 per share

Our primary valuation for HNB is on a P/BV basis, considering its historical trend. At peak valuations, HNB traded at a trailing 12-month P/BV of 3.1x in January 2011; trading multiples have declined since then and after January 2012, the stock has been traded between 0.9x to 1.5x P/BV.

HNB has traded at between 0.9x-3.1x on a P/BV basis, since January 2011 Figure 56:

Source: HNB, Bloomberg Copal Amba estimates

The stock currently trades at a P/BV multiple of 1.0x (based on our forecasts) – at an 18% discount to its two-year historical average of 1.2x, and in line with its domestic peer average.

142

147

141 164

164

179 156

130 160 190

52-week range

P/E

P/B

0

100

200

300

400

500

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

LKR/share

0.9x 1.5x 2.0x 2.6x 3.1x MPS


26


P/E and P/BV comparison with domestic peers Figure 57:

Company P/BV P/E

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

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

COMB 1.8x 1.6x 1.7x 1.5x 1.2x 10.1x 8.5x 9.7x 8.6x 7.3x

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

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

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

Source: HNB, Bloomberg, Company annual reports, Copal Amba estimates

ROE and ROA analysis of domestic peer set Figure 58:

Company ROE ROA

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

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

COMB 20.2% 20.8% 18.5% 18.7% 18.2% 2.0% 2.1% 1.9% 2.0% 2.1%

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

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

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


As shown in Figure 58, on an ROE and ROA basis, HNB appears placed in a mid-range compared with its peers. Although HNB reports one of the highest NIMs in the sector, this does not translate into higher than peer average ROE/ROA levels due to its high cost-to-income ratio. The market appears to be penalizing HNB for this weakness; we believe HNB’s management would be able to gradually improve operational metrics, leading to improving ROE/ROA levels.

Our P/B-based valuation range is derived considering the sensitivity of the stock price to changes in the base-case P/B multiple of 1.0x, based on the current trading multiple, which yields a one year forward valuation of LKR163 for the share.

We believe investors would look beyond the immediate weakness and assign a higher trading multiple to HNB as it continues to deliver above industry average loan and earnings growth. Valuing HNB at a conservative 1.1x P/BV multiple on a one year forward basis yields a value of LKR179.

Our bear case scenario considers the valuation for HNB in a situation where the valuations further decline; trading at a 0.9x one year forward P/BV multiple would result in a price of LKR147. Thus our derived valuation range stands at LKR147-LKR179.


27


P/E analysis gives a valuation range of LKR142-164 per share

We cross checked our P/BV valuation by valuing HNB on a P/E basis too, as a secondary measure. Over the past three years, HNB traded at a one-year forward P/E multiple ranging between 4.8x to 12.0x. The stock currently trades at a 2014E multiple of 6.3x (based on our forecasts) – at a 11% discount to its two-year normalized historical average of 7.0x.

HNB has traded at between 4.8x and 12.0x on a P/E basis, since January 2011 Figure 59:

Source: HNB, Bloomberg, Copal Amba estimates

We use the average of the one year normalized forward P/E multiple HNB has been trading at over the past two years, 7.0x as our base case multiple, yielding a P/E based price of LKR153. Our bear case assigns a 6.5x 2014E EPS multiple to HNB, and the bull case a 7.5x 2014E EPS multiple, yielding a price range of LKR142-164.

Non-voting shares currently trade at a 23% discount

As shown in Figure 60, HNB’s non-voting shares currently trade at LKR127, a 23% discount to the voting shares. In theory, this discount narrows or widens depending on the probability of a change in management structure/ownership (arising from the threat of a takeover) and can also vary based on the potential upside performance of a company. As can be seen below, the discount to the voting share has been quite consistent since mid – 2012.

HNB’s non-voting shares have mirrored the movement of its voting shares Figure 60:

Source: HNB, Bloomberg

0

50

100

150

200

250

300

350

400

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

LKR/share

4.8x 6.6x 8.4x 10.2x 12.0x MPS

0

50

100

150

200

250

300

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

LKR

Non-voting share price Voting share price


28


Share price performance

HNB voting-shares closed at LKR156 on 16 June 2014, LKR8 lower than 12 months earlier, a decrease of 4.8%, compared to a 0.5% increase in the S&P SL 20 and a 2.0% increase in the All Share Price Index (ASPI).

HNB.N0000 share performance over the last three years Figure 61:


HNB vs. key indices over 2011-2014 Figure 62:

3m 6m 1 year 2 years 3 years

HNB 2.2% 9.6% -4.8% 5.4% -31.0%

S&P SL 20 9.8% 10.5% 0.5% 24.1% -8.3%

ASPI 7.6% 9.5% 2.0% 27.1% -13.8%


40%

60%

80%

100%

120%

140%

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

HNB ASPI S&P SL 20


29


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 HNB’s performance across these key areas, revise our forecasts and update our valuation range in future earnings update notes.

Focus areas on company specific data

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

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

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

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

5. Growth in Non-interest income and associate income: fee based / trading income level and performance of Sithma Development and Acuity Partners.

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

10. 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 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


30


Appendix 1: The Sri Lankan banking sector – A

competitive landscape

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

The structure of Sri Lanka’s banking sector

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

34 banks (including 12 foreign banks) operate in Sri Lanka (circles denote asset size) Figure 63:

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

12 Foreign LCBs operate in Sri Lanka Figure 64:

Axis Bank Indian Overseas Bank

Citibank MCB Bank

Deutsche Bank Public Bank Berhad

Habib Bank Standard Chartered Bank

ICICI Bank State Bank of India

Indian Bank HSBC

Source: CBSL

The 25 licensed commercial banks (LCBs) accounted for roughly 85% of total banking-sector assets and 90% of gross loans in 2013. The nine licensed specialized banks (LSBs) focus on savings and development activities, and are not authorized to accept demand deposits (current accounts) or deal in foreign currency; these banks accounted for 15% of total banking-sector assets and 10% of gross loans in 2013. Of the 25 licensed commercial banks (LCB), the 2 largest are the government banks, Bank of Ceylon and Peoples Bank, cumulatively accounting for nearly 50% of total commercial banking sector credit as at December 2013. The largest private LCB is Commercial Bank of Ceylon, accounting for roughly 14% of total commercial banking sector credit.

Amana

UB

PABC

DFCC Vardhana NTB

NDB

SEYL

SAMP

HNB

COMB

PB

BOC


31


State- and privately owned LSBs (circles denote asset size) Figure 65:

Source: CBSL

As Figure 66 shows, only 5 of the 22 domestic banks have an asset base greater than LKR500bn (USD4bn), while most banks have an asset base less than LKR50bn. Foreign banks accounted for roughly 10% of the sector’s assets, and most have an asset size less than LKR50bn.

Five domestic banks hold a market share of 66% Figure 66: Most foreign banks have an asset base < LKR50bn Figure 67:

Asset size Number of banks

Total assets (LKRbn)

Market share

More than LKR500bn 5 3,891 66.3%

LKR250bn to LKR500bn 1 370 6.3%

LKR100bn to LKR250bn 3 541 9.2%

LKR50bn to LKR100bn 4 309 6.6%

Less than LKR50bn 9 251 4.3%

Asset size

Number of banks

Total assets (LKRbn) Market share

LKR250bn to LKR500bn 1 297 5.1%

LKR100bn to LKR250bn 1 107 1.8%

Less than LKR50bn 10 174 3.0%


According to our calculations, the top five LCBs accounted for roughly 66% of total banking-sector assets (Figure 68) and 76% of gross loans in 2013 (Figure 69). Owing to this concentration, we focus on these five banks in our sector discussion to depict industry growth trends.

The top five LCBs accounted for 66% of total banking-Figure 68:sector assets …

… and 76% of gross loans Figure 69:



Lankaputhra Development Bank

HDFC

Sanasa Development Bank

Regional Development Bank

DFCC Bank

NSB

6.6%

8.8%

10.2%

17.4%

20.6%

36.4%

SAMP HNB COMB PB BOC Other

8.4%

10.8%

11.1%

22.6%

22.7%

24.4%

SAMP HNB COMB PB BOC Other


32


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 12-24.

Funding – Sourced primarily through retail deposits

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

Foreign funding as a percentage of total borrowings increased as dollar-denominated debt increased starting from 2012, after the CBSL relaxed regulatory limits on foreign borrowing for LCBs. Several government- and privately owned banks explored this option. For example, National Savings Bank (NSB) raised USD750m in September 2013 and DFCC bank raised USD100m in October 2013. The BOC also raised USD500m through the issuance of a five year bond overseas.

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

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

Deposit and borrowings growth declined in 2013 Figure 70:

CASA ratio declining; foreign borrowings on the rise Figure 71:


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

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

However, we note that the NIM has continued to trend downwards – the current average is well below the past-five-year average of 5.69%. We believe this is mainly attributable to intense competition within the sector and lower interest rates. The CBSL aims to maintain lower interest spreads and requires that banks narrow their NIMs over the coming years. The central bank’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.

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

10%

12%

14%

16%

18%

20%

22%

2009 2010 2011 2012 2013

YoY growth %

Deposit growth (LHS) Borrowings growth (RHS)

0%

10%

20%

30%

40%

50%

2009 2010 2011 2012 2013

CASA ratio Foreign borrowings as a % of total borrowings


33


Sector-average NIM of 5.02% is the second-highest Figure 72:among regional peers

Sri Lankan banks’ NIMs range from 3.9% to 6.3% Figure 73:

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 structural issues, such as the relatively large number of small banks, and bank-specific inefficiencies. Compared with regional peers’, the Sri Lankan banking sector’s average cost-to-income ratio was relatively high at 50.3% in 2013. Although DFCC and Commercial Bank posted cost-to-income ratios in the mid-40s, the very high ratios (70-80%) reported by smaller banks create an upward bias on the overall average.

High cost-to-income ratio impedes profitability (Sri Figure 74:Lankan peers)

Sri Lankan banks have the highest cost structure Figure 75:among regional peers


The burden of high cost-to-income ratios is further exacerbated by high provisioning costs, due to high NPA ratios at some local banks. In 2013, the sector’s gross NPA ratio stood at 5.6%, the highest over 2009-2012, due to increasing NPAs in the pawning portfolio and slow credit growth. Of the LKR74bn increase in NPAs in 2013, LKR56bn was related to pawning advances. Furthermore,

0%

2%

4%

6%

8%

2008 2009 2010 2011 2012 2013

NIM

India Philippines ThailandIndonesia Malaysia Sri Lanka

0%

1%

2%

3%

4%

5%

6%

7%

COMB HNB SAMP NTB SEYL BOC PB

NIM

2012 2013

0%

10%

20%

30%

40%

50%

60%

70%

80%

COMB HNB DFCC NDB SAMP NTB SEYL UB PABC

Cost-to-income

2012 2013

30%

40%

50%

60%

70%

2008 2009 2010 2011 2012 2013

Cost-to-income

India Philippines ThailandIndonesia Malaysia Sri Lanka


34


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

NPA ratios are at their highest in four years Figure 76:

The sector’s total provisions-to-NPA ratio declined Figure 77:


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 higher in the more recent loans against which impairments are now being recorded. However, a prudent approach would require closer monitoring of the provision levels of each bank.

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

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

High NPAs concentrated in a few banks, with most large banks reporting healthy provisioning Figure 78:

Source: Bloomberg, Company reports

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

0

50

100

150

200

2009 2010 2011 2012 2013

NPA ratio LKRbn

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

Net NPA ratio (RHS)

58.0 48.5 45.7 48.3 62.1

13.8 13.7 11.0 13.9

15.2

0%

20%

40%

60%

80%

0

50

100

2009 2010 2011 2012 2013

LKRbn

General provisions (LHS)Specific provisions (LHS)Specific provisions to NPA ratio (RHS)Total provisions to NPA ratio (RHS)

0%

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40%

60%

80%

100%

120%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

COMB HNB DFCC NDB SAMP NTB SEYL UB PABC BOC PB

Provisioning cover Gross NPA ratio

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


35


ROE and ROA have headroom to improve

We believe measures of efficiency, such as ROE and ROA, have room for improvement. The sector’s ROE has been trending downwards since 2010 and is now at 16%. Similarly, the sector’s ROA declined to 1.3% in 2013 from 1.7% in 2011. Commercial Bank and NTB report the highest ROEs at around 19%; they also report ROAs higher than the sector average. Figure 80 compares listed Sri Lankan banks in terms of ROE versus P/B values.

ROE and ROA of domestic banks Figure 79:

Listed Sri Lankan banks’ P/B vs. ROE, 2013 Figure 80:


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

Sri Lankan banks need to improve further on ROE Figure 81:

… and ROA levels Figure 82:


COMB

HNB DFCC

NDB

SAMP

NTB

SEYL

UB

PABC

0.8x

0.9x

1.0x

1.1x

1.2x

1.3x

1.4x

1.5x

1.6x

1.7x

1.8x

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

P/B

ROE

0%

5%

10%

15%

20%

25%

30%

2008 2009 2010 2011 2012 2013

ROE

India Philippines Thailand

Indonesia Malaysia Sri Lanka

0%

1%

1%

2%

2%

3%

3%

2008 2009 2010 2011 2012 2013

ROA



0.0%0.6%1.2%1.8%2.4%

ROA 2013 ROA 2012

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

COMB

HNB

DFCC

NDB

SAMP

NTB

SEYL

UB

PABC

ROE 2013 ROE 2012


36


The sector is attractive due to relatively high dividend yields

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

Dividend yields of domestic listed banks remain relatively high Figure 83:


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 at 5.0% and capital adequacy ratio (CAR) at 10.0%. Sri Lankan banks are among the best capitalized in the region, with an average CAR of 14.1% against a regional average CAR of 12.5%.

Most banks maintain Tier 1 capital well above Figure 84:regulatory requirements

Sri Lankan banks are among the best capitalized in Figure 85:the region


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

0%

2%

4%

6%

8%

10%

12%

COMB HNB DFCC NDB SAMP NTB SEYL

Dividend yield

2012 2013

0%

5%

10%

15%

20%

25%


Tier 1 capital ratio CAR

0%

5%

10%

15%

20%

2008 2009 2010 2011 2012 2013

Tier 1 capital




37


Loan-to-deposit ratios are relatively low Figure 86:


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

profitability

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

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

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

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

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

The 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 ’90s. Several international rating agencies have viewed this consolidation process

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%


Loans to deposits

2012 2013


38


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 87 lists the key profitability metrics of some regional banks with asset bases of about USD10bn each; we believe Sri Lankan banks have the potential to achieve performance in line with regional peers’ once the consolidation process is complete.

Key metrics of some regional banks Figure 87:

Name of bank Country NIM Efficiency ROE ROA CAR Asset size

(USDm)

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

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

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

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

Source: Bloomberg

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

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

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


39


Appendix 2: Company overview

Hatton National Bank PLC (HNB) is the second-largest banking and finance institution listed on the S&P SL20 Index (following Commercial Bank PLC), with a market capitalization of LKR50bn as of 16 June 2014, and the fourth-largest bank overall based on asset market share.

Established in 1888 as Hatton Bank, primarily to service plantation workers in the hill station of Hatton (located in Sri Lanka’s Central province, approximately 120km from Colombo), the bank was acquired by Brown & Company PLC in the late 1940s and renamed Hatton National Bank. HNB started as a single branch operation and transformed into an island-wide network. HNB currently comprises 250 customer centers and 415 ATMs across Sri Lanka, and has an overseas representative office in Chennai, India (set up in 2008).

HNB saw loan growth at a 14.5% CAGR over 2009-2013, while customer deposits grew at a 15.6% CAGR over the same period. The bank’s net interest margin (NIM) ranged from a high of 6.2% in 2009 to trough levels of 5.2% in 2011 (based on our calculations). The cost-to-income ratio improved significantly over the same period, reaching 56.3% in 2013 by our calculations (excluding the one-off impact of a provision reversal in relation to an employee share-based payment scheme). This was from peak levels of over 70% in 2009.

HNB’s loans and advances grew at a 14.5% CAGR Figure 88:over 2009-2013

Customer deposits are largely made up of time Figure 89:deposits, and grew at a 15.6% CAGR over 2009-2013


NIM narrowing in a low interest rate scenario Figure 90: The cost-to-income ratio declined over 2009-2013 Figure 91:


-10%

0%

10%

20%

30%

-

100,000

200,000

300,000

400,000

2009 2010 2011 2012 2013

YoY growth LKRm

Term loans Overdrafts

Pawning advances Housing loans

Short term loans Lease receivable

Others YoY growth

0%

5%

10%

15%

20%

25%

-

100,000

200,000

300,000

400,000

500,000

2009 2010 2011 2012 2013

YoY growth LKRm

Time deposits Savings deposits

Current account deposits Certificates of deposits

YoY growth

4.6%

4.8%

5.0%

5.2%

5.4%

5.6%

5.8%

6.0%

6.2%

6.4%

2009 2010 2011 2012 2013

Net interest margin

50%

55%

60%

65%

70%

75%

2009 2010 2011 2012 2013

Cost-to-income ratio


40


HNB’s key businesses

Apart from its core banking business, HNB offers a variety of non-banking services through its subsidiaries and joint venture operation.

Banking services

Under its banking business, HNB’s operations cover a broad spectrum of verticals, including but not limited to the following:

Corporate banking: This vertical targets large and mid-market corporates by offering customized

funding solutions for working capital, trade and term finance in sectors including construction, agriculture, manufacturing and retail. Corporate banking services also include Internet banking and electronic data interchange solutions to assist in supply chain management.

SME: Focusing on customers and enterprises with an annual turnover of less than LKR600m, this

vertical targets industries such as agriculture and fishing, food processing, horticulture, wholesale and retail trading, transport, tourism and service industries. Services offered to SME businesses include funding for working capital and investments, advance payment guarantees, leasing facilities, revolvers and import/export facilities.

Personal financial services: This vertical comprises lending products to individuals (including

leasing, pawning, housing and personal loans and credit card services); investment products targeting children, students, adults and senior citizens (including savings, fixed deposits and current accounts); and priority banking services to high-net-worth individuals. It also facilitates deposit mobilization through overseas markets, such as the Middle East and Italy.

Micro-financing / development banking: With a base of 37,000 customers, including 20,000

customers for microfinance, development banking targets the rural and agricultural communities, seeking to provide affordable financial services such as micro-savings, micro-lending, micro insurance and money transfer services. It also facilitates basic transaction processing, including deposits and ATM access for withdrawals.

Other services: Other services under the banking arm include Islamic banking, the facilitation of

international remittances, trade services and treasury operations.

HNB Assurance PLC (HNBA)

Incorporated in 2001 and listed on the CSE since 2003, HNBA is a 60%-owned subsidiary of HNB, focusing on the provision of both life and non-life insurance policies (52% of operations target life insurance). It is 1 of 12 composite insurance providers in the industry. Provisional statistics from the Insurance Association of Sri Lanka state HNBA’s overall market share [based on gross written premiums (GWP)] had come in at 4.0% – 5.0% in the life insurance sector and 3.3% in the non-life sector. HNBA targets combined (life and non-life) GWP of LKR4.2bn for 2014 (compared with LKR3.9bn in 2013), PAT of over LKR430m (compared with LKR389m in 2013) and to maintain its dividend payout above 30%.

Sithma Development Private Limited (SDL)

SDL, a 100% privately owned subsidiary of HNB, focuses on providing premium (‘A’-grade) office space and building and facilities management services. SDL’s flagship project was the construction of the HNB Towers (HNB’s current head office building in the heart of Colombo’s commercial center) 10 years ago. SDL continues the maintenance and development of these premises, and is seeking to obtain ISO certification for this property in 2014. Its most recent project was the completion and sale of 48 apartments (Spathodea Residencies) in late 2012. While there are no major projects currently underway, SDL continues to explore available opportunities.

Acuity Partners (Pvt) Ltd (APL)

APL is a joint venture between HNB and DFCC Bank (each owning 50%). APL is a full-service investment banking firm providing stockbroking, fixed income servicing, corporate finance, asset management and venture capital services to its clients.


41


Shareholding structure

Domestic investors hold 76% and institutional investors (both domestic and international) hold 82% of HNB’s shares. Sri Lanka Insurance Corporation Ltd (SLIC) is the largest shareholder, with an 11.9% shareholding in HNB.

HNB is 76% owned domestically; SLIC is the largest Figure 92:shareholder (11.90%)

Institutional investors hold 82% of HNB’s shares Figure 93:

Source: HNB (as of December 2013)

Note: 18,684,164 of unregistered shares in respect of an entity whose name has been removed from the register of shareholders with effect from 19 August 2010 on a direction given by the CBSL. These shares have been excluded from the above calculations.

Source: HNB (as of December 2013)

Note: 18,684,164 of unregistered shares in respect of an entity whose name has been removed from the register of shareholders with effect from 19 August 2010 on a direction given by the CBSL. These shares have been excluded from the above calculations.

The top five shareholders as of 31 March 2014 are listed below.

Name of shareholder Description Stake

Sri Lanka Insurance Corporation (SLIC) Ltd The largest state-owned insurance company 11.90% Employees Provident Fund A state-controlled pension fund in Sri Lanka 7.96% Milford Exports (Ceylon) Limited Manufactures and exports tea. A subsidiary of Stassen Exports Ltd of Sri Lanka 6.45% Mr. Sohli Edelji Captain A domestic high-net-worth investor 5.92% Stassen Exports Ltd Part of the Stassen Group; specializes in the manufacture and export of tea 5.59%

Source: HNB

Note: the % stake is on total capital

We note that the total collective voting rights of Milford Exports (Ceylon) Limited, Stassen Exports Ltd. and the Distilleries Company of Sri Lanka (HNB’s eighth-largest shareholder), who collectively hold 18.21% of HNB’s voting shares, are limited to 10% of total voting rights (effective 15 March 2012), in line with stipulations in the Banking Act.

Board of directors

As of December 2013, HNB’s board comprised ten directors. Their details are provided below.

Name of Director Description

Dr. Ranee Jayamaha Non-executive director (NED); appointed as director and chairperson in March 2011. A veteran in the banking industry with over 40 years of experience in economics, banking and finance, regulation, and administration, Dr. Jayamaha currently also serves as an advisor to the president of Sri Lanka.

Mr. Jonathan Alles Executive director; appointed managing director/CEO in July 2013. Mr. Alles counts over 25 years of experience in the banking industry (including several years overseas), and also serves in the capacity of director in companies within the group.

Ms. M.A.R Cooray NED. A retired deputy governor of the CBSL, Ms. Cooray has served in various policy and decision-making positions in government-based financial, economics and banking organizations throughout her career. Having been appointed as director in February 2010, she was designated as senior director in May 2013.

Domestic 76%

International 24%

Individual 18%

Institutional 82%


42


Dr. Willie W Gamage NED. Dr. Gamage has over 30 years of experience in public, private and non-government organizations, having served in different capacities over his career. Currently serves as secretary to the Ministry of Botanical Gardens and Public Recreation.

Dr. L.R. Karunaratne NED. Appointed in October 2011, Dr. Karunaratne is a consultant engineer by profession, with over 27 years of experience in civil engineering, building construction, engineering consultancy, construction training, lecturing in civil construction, designing and planning.

Mr. L.U.D Fernando NED. Appointed in April 2012, Mr. Fernando was the former executive director of SLIC and the Lanka Hospitals Corporation PLC. He has also served on the board of the Distilleries Company of Sri Lanka and in several of its subsidiaries.

Mr. D.T.S.H Mudalige NED. Appointed in April 2012, Mr. Mudalige is currently the chairman of the Sri Lanka Accounting Standards Committee. A former member of the S in Sri Lanka, he is also on the Sri Lanka Accounting and Auditing Standards Monitoring Board and is a member of Financial Systems Stability Consultative Committee of the CBSL.

Miss D.S.C Jayawardena NED. Appointed in April 2012, Ms. Jayawardena also holds directorships in several other domestic dairy companies.

Mr. R.S. Captain NED. Appointed in April 2012, Mr. Captain is also the managing director of several domestic companies including Paints & General Industries Ltd. He also holds directorships in companies in the agriculture, garments and software sectors.

Mrs. K.A.L. Thushari Ranaweera

A lawyer by profession and counting over 20 years of banking experience over her career, Mrs. Ranaweera was appointed as company secretary in January 2012. She is also the assistant general manager – legal.

Source: HNB

Corporate holding structure Figure 94:

Source: HNB

Corporate banking


Banking

Insurance

Property development

SME

Personal financial services

Development banking

Other services

Joint-venture operation

HNB Assurance (60%)

Sithma Development Ltd. (100%)

Acuity Partners (Pvt.) Ltd. (50%)


43


Appendix 3: Key financial data

Summary group financials (LKRm)

INCOME STATEMENT 2011 2012 2013 2014E 2015E 2016E

(For the year ended 31 December)

Net interest income 16,920 22,424 25,050 26,005 29,186 35,063

Net revenue 23,440 29,304 32,590 34,595 39,020 45,634

Operating profit 10,296 11,755 12,448 12,681 15,932 19,987

Earnings before income taxes 9,056 10,523 10,916 11,385 13,686 16,139

Net profit 6,900 8,102 7,812 8,153 9,801 11,558

Net income available to equity holders 6,819 7,942 7,650 7,966 9,576 11,293

BALANCE SHEET 2011 2012 2013 2014E 2015E 2016E

(As at 31 December)

Assets

Cash and due from banks 15,820 20,516 14,611 16,074 17,674 19,441

Treasury bills 61,820 72,219 89,369 102,753 115,649 124,323

Net loans 257,435 303,271 352,499 398,425 460,140 530,848

Premises and equipment 15,416 17,815 17,770 17,684 18,041 18,384

Goodwill and intangible assets 671 690 1,049 853 1,012 1,172

Total assets 391,297 459,453 522,879 587,745 668,180 753,881

Liabilities

Total deposits 290,912 340,848 385,067 429,618 486,160 556,819

Bank borrowings 19,885 22,956 34,508 39,711 45,658 52,506

Insurance provision - life and non-life 3,966 4,596 5,360 6,133 6,638 6,771

Subordinated liabilities 4,989 7,729 11,782 12,515 13,546 13,817

Total liabilities 348,940 406,435 464,508 523,439 596,385 674,865

Equity

Common share capital 11,451 12,579 12,830 12,893 12,893 12,893

Retained earnings 3,504 5,322 5,210 10,238 16,302 22,456

Minority interest 782 969 809 842 1,067 1,333

Total equity 42,357 53,017 58,371 64,306 71,795 79,016

Total liabilities and equity 391,297 459,453 522,879 587,745 668,180 753,881


44


Key ratios

KEY RATIOS 2011 2012 2013 2014E 2015E 2016E

Growth

Loan growth (%) 26.3% 17.7% 16.8% 13.4% 15.5% 15.4%

Net interest income growth (%) 7.2% 32.5% 11.7% 3.8% 12.2% 20.1%

Operating profit growth (%) -39.5% 14.2% 5.9% 1.9% 25.6% 25.5%

EBT growth (%) -46.8% 16.2% 3.7% 4.3% 20.2% 17.9%

Net profit growth (%) 42.5% 16.5% -3.7% 4.1% 20.2% 17.9%

Recurrent diluted EPS growth (%) 38.0% 11.9% -7.6% 3.9% 20.3% 17.9%

Margins and profitability

Net interest margin (%) 5.2% 5.8% 5.5% 5.0% 5.0% 5.2%

Operating profit margin (%) 43.9% 40.1% 38.2% 36.7% 40.8% 43.8%

PBT margin (%) 38.6% 35.9% 33.5% 32.9% 35.1% 35.4%

Net profit margin (%) 29.1% 27.1% 23.5% 23.0% 24.5% 24.7%

ROE (%) 19.1% 17.0% 14.0% 13.2% 14.3% 15.2%

ROA (%) 1.9% 1.9% 1.6% 1.4% 1.5% 1.6%

Capital adequacy and allocation

Tier 1 ratio (%) 12.8% 13.9% 13.0% 13.1% 13.3% 13.3%

Tier 2 ratio (%) 1.8% 2.8% 3.6% 3.5% 3.3% 3.4%

Total CAR ratio (%) 14.5% 16.6% 16.5% 16.6% 16.6% 16.6%

NPAs-LLR/common equity (%) 8.8% 7.2% 4.5% 5.5% 4.9% 4.4%

Total equity/total assets (%) 10.6% 11.3% 11.0% 10.8% 10.6% 10.3%

Leverage ratio (%) 8.1% 8.2% 8.0% 8.0% 8.1% 8.1%

Asset quality and liquidity

NPA ratio (%) 3.9% 3.7% 3.6% 4.1% 4.0% 3.9%

Loan loss coverage ratio (%) NA 74.0% 62.5% 79.5% 81.7% 84.0%

Loans to deposit ratio (x) 88.5% 89.0% 91.5% 92.7% 94.6% 95.3%

Deposits to interest bearing funding ratio (x) 91.0% 90.2% 87.8% 87.7% 87.7% 88.1%

Valuation

P/BV (x) 1.1x 0.9x 0.8x 1.0x 0.9x 0.8x

P/E (x) 6.9x 5.9x 6.1x 6.3x 5.2x 4.4x

Dividend yield (%) 6.2% 7.2% 7.2% 5.9% 7.2% 8.6%

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

Reported diluted EPS (LKR) 18.51 20.72 19.15 19.90 23.93 28.22

Common dividend per share (LKR) 7.97 8.82 8.52 8.78 10.76 12.84

Book value per share (BVPS) 106.99 131.02 144.06 158.61 176.76 194.14



45


Fact sheet

Sri Lanka investment environment overview

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

Sri Lanka's GDP projected to increase to 8% by Figure 95:2014E

GDP per capita to increase 22% by 2016E Figure 96:

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

Annual core inflation post-war has averaged 6.7%, Figure 97:government targeting mid-single digit levels in the medium term

CBSL expects the rupee to stabilize in the medium Figure 98:term despite recent volatility

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

Fiscal deficit target of 5.2% of GDP for 2014E Figure 99: Debt-to-GDP to fall to 71% by 2015E Figure 100:


6.8 6.0

3.5

8.0 8.2

6.4 7.3

8.0 8.3 8.5

0

2

4

6

8

10

2007

2008

2009

2010

2011

2012

2013

2014E

2015E

2016E

%

0

1,000

2,000

3,000

4,000

5,000

2006

2007

2008

2009

2010

2011

2012

2013

2016

E

USD

8.5

7.7

13.6

7.0 7.0 6.9 5.8

6.9

0

2

4

6

8

10

12

14

16

2006 2007 2008 2009 2010 2011 2012 2013

%

100

150

200

250

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

LKR/USD LKR/EUR LKR/GBP

0%

4%

8%

12%

0

200

400

600

2006

2007

2008

2009

2010

2011

2012

2013E

2014E

LKRbn

Fiscal Deficit LKR bn As a % of GDP

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

0

20

40

60

80

100

120

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013E

2014E

2015E

%


46


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

Post war, the ASPI has significantly Figure 101:outperformed global and developed market indices

Post war, the ASPI has also outperformed Figure 102:some of the best-performing regional indices

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

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

The CSE’s market capitalization has doubled Figure 103:since 2009

The government anticipates FDI inflows to Figure 104:reach USD2bn in 2014

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

Most sector P/Es are below market average and Figure 105:historical valuations

Trend is similar on a P/BV multiple Figure 106:

Source: Colombo Stock Exchange Source: Colombo Stock Exchange

0

80

160

240

320

400

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

ASPI Dow Jones FTSE 100

MSCI World DAX

0

100

200

300

400

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

ASPI Bombay (BSE 500)Jakarta (JCI) Philippines (PASHR)Thailand (SET) Hanoi (VNINDEX)MSCI Emerging Market Index

1,092

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

2,659

0

400

800

1,200

1,600

2,000

2,400

2,800

2009 2010 2011 2012 2013 2014(June)

LKRbn

601 516

1,066

1,338 1,420

0

200

400

600

800

1,000

1,200

1,400

1,600

2009 2010 2011 2012 2013

USDm

0

20

40

60

Ba

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2011 2012 2013 Average market P/E 2010-2013

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2011 2012 2013 Average market P/BV 2010-2013


47


IMPORTANT DISCLAIMER

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

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

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

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

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

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Documents

Hatton National Bank PLC (HNB.N0000) · diversification measure and to improve its risk profile. Contrary to investor misgivings, HNB was able to grow gross loans 17% YoY, compared