DFCC Looking for growth through M and A activities

DFCC Bank is planning to strengthen its business model through external growth opportunities that may arise in the back of the recent regulatory changes on the minimum capital requirement of the banking industry.

DFCC's newly established commercial banking arm DFCC Vardhana Bank (DVB), which has a total capital of Rs. 325 million, will be affected by the new regulation thus the Bank is closely evaluating options available to overcome this issue.

At a recent company visit, the management emphasised that DFCC is open to M and A activities (Mergers and Acquisitions) that may add value to the overall growth strategy of the entity. Management believes that the recent signals from the regulator appear to favour consolidation in the industry. Management also expressed their commitment towards improved automation in its banking services, careful expansion and enhancing the treasury operations.

DVB, which started operations little over a year ago, is already generating profits on a monthly basis since November 2004. The DVB's loan book stood at Rs. 2.5 billion at the end of FY2004, which was below the original target of Rs. 3 billion. However management expressed their confidence that DVB's loan book would grow to Rs. 4 billion by the end of FY2005.

The DVB and DFCC function under different accounting periods where former is December company and the latter is a March company.

The DVB gradually expanded over the past two years and now possess 10 branches, eight of these being established within the DFCC's original branches. In addition DVB has two separate branches in Gangodawila and Malabe.

Management expects to increase the Vardhana branch network to 15 by the end of FY2006, focusing mainly on the suburbs. According to the management the Vardhana has a slight advantage over the other commercial banks in terms of resource utilisation, having only 3-4 additional staff members in DFCC branches (8 branches) to handle the commercial banking activities. This model is based on DFCC concentrating for the present on cross selling commercial banking products to its existing customers.

However, we believe that it's important to have separate staff, specialized in commercial banking activities in order to provide a quality service to the customers.

DVB had a Tier 1 capital level of Rs. 325 million at the end of FY2004, well below the revised minimum capital requirement of Rs. 2.5 billion. DVB has more than two years to achieve this target (before December 2007), and the management was optimistic on accomplishing this challenge. DFCC could support Vardhana in achieving this target but the management is of the view that DVB should try to cover as much ground as possible on its own.

We believe that infusion of such a mammoth capital into a bank that is at such an infant stage is not the most suitable strategy. Thus we are of the opinion that a merger between DFCC and DVB is also a more appropriate option, given DFCC's strong capital base.

DFCC is in the process of investing Rs. 140 million in enhancing its new banking software " Net Symbols" to enable Vardhana to operate on the same platform as DFCC. According to the management the new modules are expected to be in place in September 2005.

The enhancement will facilitate DFCC's core banking activities as well as DVB's commercial banking activities to operate in the same platform, enabling them to better serve the customers with improved efficiency and straight through processing between the two entities. The investment will be amortized over a period of five years resulting an annual charge of approximately Rs. 28 million.

DFCC has recognised the need to strengthen its investment banking arm and is taking step to add more muscle into this area. The Bank has already taken measures to exploit the potential in the debt market operations. The Company has been involved in the operations of short-term debt instruments such as commercial papers but the new dealing room is likely to enable trading in long-term debt instruments such as treasury bonds.

The Bank has increased its exposure to equity investments, thus the investments in listed equities currently stand at approximately Rs. 500 million. Working towards a single digit NPL ratio DFCC expect to improve its NPL ratio (NPL: gross loans), which stood at 10.8% as at March 31, 2004 and are keen on bringing the gross NPL ratio down to a single digit.

The performance based collection plan, which is already in place, would help DFCC to get close to this target. The Company was able to recover three large loans, which were classified as NPLs during FY2004, which is a positive sign, when looking at the heavy provisioning carried out by DFCC over the last 3 years, which averages to Rs. 404.7 million pa. DFCC points out that they classify loans as non-performing one month earlier when compared with most other banks.

DFCC expect a loan growth of 18% during FY2006 and we believe that this is within the Company's reach considering the expansion plans of Vardhana.

However, being a development bank the macro factors such as political stability and the economic environment in the county will play a vital role in achieving these targets in terms of loan growth and profitability. The dividend payout ratio of DFCC has been around 23% on average over the last three years and we believe that the Company will continue to maintain this ratio over the next 2-3 years.

An in-depth analysis into DFCC and its future in the Sri Lankan banking environment will be featured in our upcoming banking sector report.