Fitch Ratings has downgraded Sri Lanka-based Senkadagala Finance PLC's (Senka) National Long-Term Rating to 'BBB(lka)' from 'BBB+(lka)'. The Outlook is Stable. Fitch has also downgraded Senka's subordinated debt rating to 'BB+(lka)' from 'BBB-(lka)', and removed the Rating Watch
Negative (RWN) from all of Senka's ratings.
KEY RATING DRIVERS
Weakened Asset Quality Drives Downgrade: Senka's exposure to more economically vulnerable borrowers has led to greater asset-quality deterioration in recent years, against its better-than-peer performance in the past. Its reported 90-day past-due loan ratio climbed to 19.8% in 1QFY24 (financial year end-March) amid weakened borrower repayment capacity, and we expect asset-quality pressure to persist for some time even as
the economy gradually recovers.
Still, Senka's higher capitalisation than the industry and longer-tenor funding structure support its credit profile.
RWN Resolved: The removal of the RWN reflects our view that further downside to Senka's ratings is less imminent following the completion of the local-currency portion of the sovereign's domestic debt optimisation (DDO), which addresses one element of risk to sector funding and liquidity.
The operating environment will remain weak in light of strained household finances and fragile investor confidence, but should stabilise on a gradual economic recovery with easing inflation and interest rates.
Eased macroeconomic risk will temper the pressure on the sector's operating performance and liquidity profile although the pace of recovery may vary depending on individual entities' business mix and franchise strength.
Fitch expects sector growth to remain weak with lingering asset-quality pressure in FY24, but this may improve in FY25 as economic growth recovers. Declining interest rates should ease pressure on funding costs but could hit asset yields for lenders with shorter asset-repricing cycles.
Modest Franchise in Vehicle Financing: Senka is a mid-sized finance and leasing company (FLC) with about 2% share of sector assets and 1% of deposits. Its main business is in vehicle financing with a higher exposure than peers to commercial vehicles, such as buses, lorries and tractors.
These segments are more susceptible to economic weakness and have driven greater asset-quality deterioration for Senka in recent years.
Senka also focuses on lower- to middle-income self-employed individuals, and small- to mid-sized enterprises. Management has developed enhanced tools to identify better-quality customer profiles and price for higher credit risk, although the effectiveness of the tools is yet to be tested.
Volatile Profitability: Gradually easing funding costs should benefit its net interest margin (NIM), but lingering asset-quality pressure may continue to weigh on credit costs and profitability. Pretax profit/average assets narrowed to 2.3% in FY23 (FY22: 4.1%) amid higher funding costs and operating expense inflation, while interest-earning assets
also contracted.
Management aims to maintain operating cost control while expanding the
branch network gradually to tap newer growth areas.
Reduced Leverage: Senka's leverage declined to around 3.4x debt/tangible equity by FYE23 (FYE22: 4.0x) with its core capital ratio increasing to 25.5% by end-1QFY24 (industry: 21.8%) due to more contained growth. This provides a reasonable buffer to absorb credit and other losses. We expect management to maintain relatively conservative capitalisation and modest growth in the near term.
Confidence-Sensitive Funding, Liquidity: Funding conditions are gradually improving relative to the stress over the past 12-18 months, but remain susceptible to shocks. Senka has lower reliance on short-term funding and roughly 45% of total liabilities were due beyond one year at FYE23. Its greater usage of wholesale funding leaves it more sensitive to lender confidence, but it has also contributed to a positive short-term asset-liability
maturity profile, which many peers lack.
RATING SENSITIVITIES
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade
The National-Long-Term Rating is sensitive to changes in Senka's standalone credit profile relative to Fitch-rated issuers on the Sri Lankan national scale. A downgrade could result from higher leverage or a substantial erosion of capital buffers due to asset-quality deterioration and weakening profitability. Increased risk appetite, as evident in a shift of
business mix towards riskier products and more vulnerable customer segments, could also lead to negative rating action.
Fitch may also take negative rating action if there is renewed weakness in market variables or funding and liquidity conditions, leading to increased risk to the company's asset exposures, profitability and balance-sheet buffers. Such stresses if extreme could result in a multiple-notch downgrade.
Factors that Could, Individually or Collectively, Lead to Positive Rating
Action/Upgrade
An improved operating environment, together with enhancement in the company's credit profile relative to peers on the Sri Lankan national scale could lead to an upgrade of the company's ratings. A significant shift towards less-risky asset classes with sustained asset-quality performance, profitability and adequate capital buffers could also lead to positive rating action.
DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS
Senka's Sri Lankan rupee-denominated subordinated debt is rated two notches below its National Long-Term Rating.
This reflects our expectation of high loss severity and poor recoveries for such debt in the event of default. We apply the Bank Rating Criteria in
rating this instrument, as we view the prudential capital framework for finance companies to be closer to that for banks in Sri Lanka.