Fitch puts Merchant Credit on rating watch

Fitch Ratings Lanka has placed Merchant Credit of Sri Lanka Ltd.’s (MCSL) ‘BBB(lka)’ National Long-term rating on Rating Watch Evolving (RWE).

The rating action follows Merchant Bank of Sri Lanka Plc’s (MBSL) 4 May 2011 announcement that the Central Bank of Sri Lanka has provided “in principle approval” for the issuance of a specialised banking licence to MBSL subject to its amalgamation with MCSL and another two entities of the Bank of Ceylon (BOC; ‘AA(lka)’/Positive) group.

MBSL is a 72% held subsidiary of BOC. The announcement follows the 26 August 2010 announcement by MBSL that it was considering a proposal to merge with MCSL and another subsidiary of the BOC group.

The RWE reflects uncertainty regarding the modalities of the intended merger, the profile of the merged entity, and the shareholding of BOC in the merged entity.

The rating reflects MCSL’s association with its main shareholder, state-owned BOC, in terms of the latter’s effective shareholding of 86% and representation on MCSL’s board, and could be affected by a change in circumstances that would warrant a review of Fitch’s opinion on the expectations of support from BOC. MCSL’s core business of vehicle finance in the form of finance leases (21% of the loan book) and hire purchase (HP; 39% of the loan book) continued to account for the majority loan book at end-2010, while loans accounted for the remaining 40%.  However, with the management’s recognition of the relatively problematic recoverability of loans, and alongside the growth in leases and HP, the proportion of loans is expected to decrease (38% at Q1FY11 — the three months ended 31 March 2011).

MCSL’s gross non-performing loan (NPL) ratio (defined as advances in arrears for three months or more) fell to 16.8% at end-2010 (end-2009: 28.1%) driven by loan expansion of 35.7% in 2010 and write-off of NPLs. However, asset quality could deteriorate should growth take place to the detriment of credit standards.

MCSL’s profitability in terms of return on assets (adjusted for gains on equity investments) increased to 2.4% (annualised) in Q1FY11 (2010: 1.5%), with wider interest margins, reduced credit costs and lower effective taxes.

 The retention of all profits in 2010 supported equity accretion.

Nevertheless, its net NPL/equity remained high at 111% at end-2010. Further, Fitch notes that equity investments for trading made with a view to harnessing the stock market performance represented 18% of equity at Q1FY11 (end-2010: 15%).

Deposits remain the main source of funding for MCSL (83.7% at end-2010). Fitch notes that deposit concentrations have been gradually reducing, with the 10 largest deposits accounting for 20% of total deposits at end-2010.

MCSL is required, as a registered finance company (RFC), to be listed on the Colombo Stock Exchange by end-June 2011. However, the regulator has exempted MCSL from this requirement until end-March 2012. MCSL is an RFC that accounted for 1.9% of total RFC assets at end-2010. It has a network of 10 branches. The company is jointly held by BOC (49%) and MBSL (51%).