ABIL_Non-Retail Deposit Taking Strategy Clouds Long Term Growth Outlook_Initiating With a HOLD
Transcript of ABIL_Non-Retail Deposit Taking Strategy Clouds Long Term Growth Outlook_Initiating With a HOLD
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Company Information
Bloombergticker ABLSJCurrentprice 31.9
FY11PriceTarget 30.1
MarketCap,Rbn 25.9
Sharesoutstanding,mn 804
Potentialcapital gain(loss) 6%
52WeekHigh,R 37.2
52WeekLow,R 25.6
YTDreturn 9.8%
Historical growth rates2006 2007 2008 2009 CAGR
Grossmarginonretail n/a n/a n/m 36% n/m
Interestonadvances 8% 4% 38% 27% 19%
Netassuranceincome 19% 75% 176% 2% 55%
Noninterestincome 63% 59% 150% 27% 69%
Charge ofdoubtfuldebts 24% 36% 126% 35% 51%
Interestexpense 5% 37% 106% 54% 42%
Operatingexpense 10% 4% 242% 23% 48%
Profitbeforetax 17% 16% 17% 12% 16%
Netadvances 15% 44% 88% 25% 40%
Shorttermfunding 29% 81% 318% 8% 49%
BondsandLTloans 30% 68% 46% 42% 46%
Subordinatedloansandbonds 3% 51% 68% 300% 79%
TotalEquity 3% 10% 319% 2% 48%
Returns vs. Banks & ALS Indices
ABIL ALSI Banks Index
YTD 9.8% -1.0% 7.8%
3 months -4.9% -1.6% 0.2%
12 months 21.7% 15.2% 34.0%
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ABIL
BanksIndex
ALSI
AFRICAN BANK INV. LTD
Non-retail deposits taking strategy
clouds longterm grow th outlook
We initiate coverage on African Bank Investments Limited (ABIL)
with a HOLD recommendation. In section 1 of this report, we
provide a company analysis, being a historical performance
analysis, our forecasts as well as our valuation. We also provide
our opinion on corporate governance and other ESG issues. In
section 2 (Appendix 1) we provide a comparison between ABILs
banking operations and Capitec Bank (Capitec). (we initiated
coverage on Capitec in April; see Capitec Bank: Valuation looks
steep but growth outlook is the differentiating factor, dated April
19, 2010.) We look at earnings momentum given the balancesheets structures, deposit mobilisation strategies, liquidity and
credit risks. We also provide a comparison of valuation metrics
and our conclusion (on an exclusive basis, we prefer Capitec due
to our higher potential total return forecast). Lastly, in section 3
(Appendix 2) we provide a snapshot of the banking industry
structure. We look at the levels of penetration, concentration and
profitability as well as system liquidity and credit risks. We also
look at what we believe will be the key risk to the banking sector
- regulatory risk.
While we liked the ABIL story, and the Group is still a proxy for
investing in banks with material exposure to the low-income
segment, we are concerned by:
the non-deposit taking strategy whose negatives outweighthe benefits, in our view. Major among others is the
constraint to loan growth, limited ability to expand margins
through changes to the liability mix and inability to
supplement income from liability-related products.
the modest historical earnings growth, exacerbated by lowearnings visibility in the short-term. Profit after tax has
grown by a compounded annual growth rate (CAGR) of 16%
between FY05 and FY09, which is lower than competitors
like Capitec.
Valuation: Our valuation model indicates a FY11 price target of
R30.1. We use the Sum-Of-The-Parts (SOTP) method that
allowed us to separately value African Bank and Ellerines. We
valued African bank at R16.5bn and Ellerines at R7.6bn, giving a
Group per share value of R30.1. HOLD.
Peter Mushangwe
Puleng Kgosimore+27 11 551 3675
Please refer to the back of this report to
view our disclaimer and disclosure
June 3, 2010 Equity Report
INITIATION
HOLD
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Contents page
Executive Summary 2
1. Initiation of coverage 6
1.1 ABIL: Initiating with a HOLD 6
1.2 ABIL: Company Analysis 10
1.3 A look at African Bank 22
1.4 A look at Ellerines 27
1.5 Valuation: Sum-of-the-Parts Method 31
1.6 Corporate governance and other ESG issues 34
2. Appendix 1: A comparison w ith Capitec 37
2.1 Big vs. Small: We favour the micro-banks 37
2.2 Which bank to play? 37
3. Appendix 2: A snapsho t of the industry 41
3.1 Industry structure and developments 41
3.2 Basel III and Regulatory risks 50
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yield which could be a strong motivation for exposure in the short-
term given our profitability growth concerns. The share currently
trades at a trailing dividend yield of 5.4%. FY09 dividend payout
ratio was 82%! Management is comfortable with a dividend cover
of 1.5X, which indicates a payout ratio of about 67%; and 3)
managements awareness of the risks of over-leverage and
greedy loan growth. In banking, greediness can be bad!
Advances growth rate has been average after an excessive
expansion in FY08. Our impression is that management is ready to
take painful decisions, and lower levels of risk, leverage and even
size of balance sheet. Should regulatory risks hit hard, the pain
would be manageable due to such proactive actions.
What we do not like about ABIL: We do not like 1) the non-
retail deposit taking strategy. While it reduces the deposit-run
risk, we believe that it puts a constraint to funding and long-term
loan book growth. This strategy also increases the concentration
and roll-over risks. The increasing use of electronic delivery
system of banking services, especially on the deposit side, counter
the cost of branch network argument to a large extent. We just
could not ignore the funding risk despite funding having been well
managed so far; 2) the Ellerines business unit that brings non-
banking risk exposure to the Group. Furniture retail market risk
becomes a primary risk for the group and this component has a
different risk/return profile to the financial services. The furniture
merchandise business is more cyclical than banking as the
earnings volatility tends to be higher than for banks; 3) the less-
flexible balance sheet that would create a holdback to loan growth
and interest spread/margin expansion. This is because a) the
government securities and other liquidity assets/total assets ratiois 13.4%, providing limited room to change its asset mix (i.e.
selling down government securities for higher yielding assets when
necessary), thus inhibiting both loan and margin expansion
through asset mix, b) the liability side which is wholly wholesale
deposits, loans and bonds providing no room for the composition
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change between retail and wholesale deposits, in pursuit of higher
margins through cost of funds management; and 4) the low
earnings growth rate. Profit (before tax) growth has been subdued
at a CAGR of 15.7% (FY05-FY09). Ability to supplement interest
income with fee income is poor as a result of the non-retail deposit
strategy. This, in addition to our funding liquidity concerns result in
muted earnings forecasts (CARG 11% to FY12). The business
carries higher credit risks than the mainstreams as loans are
largely unsecured. Should the economy and employment remain
weak for a prolonged time, earnings visibility could be hurt.
African bank: CAMEL ratios mixed, liquidity ratios point to
the w eakness of the non-retail deposit gathering strategy:
The liquidity indicators we use, mainly the Loan/Deposit ratio
(LDR) and the liquid assets ratio (cash and cash equivalent/total
assets) are weak, in our opinion. Notwithstanding the
improvements in the LDR, declining from 129% in CY05 to 91% in
CY09, the ratio provides little margin for error. To grow the loan
book, the Group would need to raise funding. Despite past
successes, this is not guaranteed, hence our balance sheet
inflexibility concerns. The LDR declined to 82% for 1H10 partly
due to the deceleration in loan growth and partly due to the
aggressive funding exercise that was undertaken. The liquidity
ratio at 20% (declined to 18% for 1H10) is 7 percentage points
(pp) less than Capitecs 27%.
Ellerines: Issues impair ing past performance have been, and
are being addressed: Management has managed to 1) cut costs
2) increase efficiencies. Management is also 3) migrating the
Ellerines financial services to African bank. All the three should
provide Ellerines management time to focus on retailing and webelieve in the long-term the business could create material
symbiotic benefits with African bank. African bank will have access
to Ellerines branch network, which we feel is underutilised (in
terms of financial services) at the moment. We believe most of the
legacy issues are clearing out, and should Ellerines remain a
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problem child at year end, then in our view management would
have failed to integrate the two. A disposal would be in order, we
suppose, but as of now, dealing with legacy issues brings hope.
ABIL vs. Capitec: While Capitec is smaller (market cap =
R8.4bn), we prefer it to ABIL as a proxy to the micro-finance
space. In our opinion, Capitec has a more flexible balance sheet,
with relatively lower funding risks (i.e. stronger retail deposits
franchise; lower LDR; lower deposit concentration risk; higher
capital adequacy ratio (CAR) and higher liquidity ratio). Capitec
has more room to grow its fee income through product
development on the liability side of the balance sheet. We expect
loan growth to be sluggish (and therefore lower fee income related
to loans) and deposit-based fee income could be crucial in the near
term.
Industry loan grow th face significant risks: In addition to the
Basel Committees proposal to increase banks capital and liquidity
levels, the loan growth rate versus nominal GDP growth rates
widened significantly from CY00 to CY08. Loans have grown by a
CAGR of 17% while nominal GDP has expanded by a CAGR 12%
(real GDP 4.1%) between CY00 and CY08. In our view, the naturalgrowth of loan should be driven by nominal GDP growth, especially
given the high penetration rates. This presents risks to loan
growth, as we expect this spread to narrow in the medium term
instead of widening.
Regulatory risk to affect mainstream banks more than
micro-banks: The main guidelines issued by the Basel Committee
will mainly affect lending/liquidity; provisioning and over-the-
counter (OTC) products trading. So far emerging market banks
seem not to have priced in this risk. Our key idea is that investorsshould assume exposure to banks that will be least affected, i.e.
banks with higher capital levels, lower leverage, profit visibility and
ability to cut dividend and build up capital and lower exposure to
OTC products. Micro-banks look better placed than mainstream
banks in this regard.
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1. Initiation of coverage
1.1 Initiating coverage w ith a HOLD, FY11 price target isR30.1; potential total re turn is zero .
We initiate coverage with a HOLD: We use the SOTP valuation
method to estimate our FY11 price target. For African bank, we use the
Fundamental Price-to-book ratio (PBVR) method. We use a sustainable
ROE of 27.5%, a Cost of Equity (CoE) of 16.5% and a sustainable
growth rate of 12%. Using the (ROEg)/CoEg) method, we calculate a
fair PBVR of 3.5X. We multiply the fair PBVR by our FY11 book value
forecast to get our FY11 price target. The value for African bank is
R16.5bn.
For the Ellerines business, we believe the fair Price-to-Earnings ratio
(PER) should provide a reasonable valuation. We use a CoE of 17.5%, a
sustainable growth rate of 9.5% (upper range of inflation target, 6%
+3.5%) and a payout ratio of 65% (in line with the target dividend
cover). We obtain a fair PER of 9.0X which we multiply by our FY11
earnings to obtain our FY11 price target. The FY11 value for the
Ellerines business is R7.6bn.
The sum of the two business units is R24.2bn which gives a per share
value of R30.1. This gives a zero potential total return, hence our HOLD
recommendation.
Possible catalysts: The possible catalysts for outperformance (vs. our
potential total return) are 1) stronger loan growth supported by funding
at normal costs, than we have anticipated, 2) stronger performance
by Ellerines than we have forecasted, and 3) lower credit risk coverage
and costs than we have predicted.
Risks to our valuation: The major risks to our valuation are 1) the
error in funding liability forecast, which primarily affect the loan growth
and the resultant interest income. Because of the volatile nature of
wholesale deposits, forecasts carry higher margin of error 2) we apply a
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Fig 2: Share price performance in the recent past has been in line with the market
despite a strong out performance wh en indexed to Oct. 02
10%
4.9%
21.7%
10% 0% 10% 20% 30% 40%
YTD
3Months
12Months
BanksIndex
ALSI
ABIL
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04/09
10/09
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ABIL
BanksIndex
ALSI
Source: I-Net, Legae Securities
Dividend payout has been generous, averaging 96% since FY03;
dividend yield higher than the banks Index and ALSI : We note
that ABIL has been trading at a higher dividend yield than Banks Index,
ALSI and Capitec. This relationship has been holding since mid-03.
However, since FY07, the dividend in rand-terms has reduced by a
cumulative 19%. Forward looking, we believe that ABIL is reducing its
war chest, and improvements in dividend payout ratio are slender
going forward.
Fig 3: Dividend payout has been generous ( DY), limited improvements in payout ratio
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BanksIndex
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0%
20%
40%
60%
80%
100%
120%
2003 2004 2005 2006 2007 2008 2009
Div idends, RH S P ay outratio
Source: I-Net, Legae Securities
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Who is ABIL? ABIL has a fairly long history as a credit provider. In
CY98, the Theta Group Limited acquired African bank and the Boland
book of R1.7bn. The following year saw the acquisition of Stagen and
the change of the Groups name to African Bank Investments Limited
(ABIL). In CY02, the group acquired a R2.8bn loan book from Saambou.
The last acquisition was the Ellerines group, a furniture and appliance
retailer, in CY08. Currently ABIL operates through two businesses,
African bank and Ellerines. Both are wholly owned by ABIL.
ABILs strategy is to issue unsecured credit to consumers in the lower to
middle income market. In order to minimize branch network and other
retail-deposits related costs, African bank does not take retail deposits.
In our opinion, this argument is becoming less relevant particularly as
the use of electronic delivery system is gaining momentum. The two
businesses are meant to complement each other in building and
protecting market share.
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1.2 ABI L Group (the Group): Company Analysis
Balance sheet items show strong growth, but profit growth has
been average: Our major theme is the constraint to loan growth that
can be an undesirable effect of the non-deposit taking strategy.
Wholesale deposits and capital markets are volatile, and covenant
requirements by institutional lenders such as coverage of interest by
earnings and shareholder funds could be the main holdback. While
growth of funding liabilities is strong thus far, the historical profit growth
has been timid when compared to competitors in the micro-consumer
lending space. (see Fig 4)Fig 4: Group historical profitability growth has been average
2006 2007 2008 2009 CAGR
Grossmarginonretail n/a n/a n/m 36% n/m
Interestonadvances 8% 4% 38% 27% 19%
Netassurance income 19% 75% 176% 2% 55%
Noninterestincome 63% 59% 150% 27% 69%
Chargeofdoubtfuldebts 24% 36% 126% 35% 51%
Interestexpense 5% 37% 106% 54% 42%
Operatingexpense 10% 4% 242% 23% 48%
Profitbeforetax 17% 16% 17% 12% 16%
Netadvances 15% 44% 88% 25% 40%
Shorttermfunding 29% 81% 318% 8% 49%
BondsandLTloans 30% 68% 46% 42% 46%
Subordinatedloansandbonds 3% 51% 68% 300% 79%
TotalEquity 3% 10% 319% 2% 48%
Source: Company reports, Legae Calculations
The key issues to note about ABILs historical performances are:
Interest on advances growth rate in FY06 and FY07 was poor at
8% and 4% correspondingly. The rate jumped in CY08 to 38%
(advances were up 88% in this period) but receded in CY09 to
27%. The CAGR since FY05 is 19%. We expect margins and asset
yields to decline on restrained loan demand (deleveraging to an
extent), increasing competition and migration to low risk clients.
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Net assurance and other non-interest income have ascended
significantly as a result of strong insurance and fee income. Credit
cards fee and collection fee income has been strong at an average
growth rate that is greater than 100% since FY06. Loan origination
and collection fees are higher margin products when compared to
the credit card whose fee growth was a result of strong
penetration. The fact that the bank does not play in the retail
deposit space is a constraint to growth of non-interest income. (no
income from the liability-side of the balance sheet). Regulatory
risks to net assurance income are significant according to
management, although they have taken proactive steps through
pricing to minimize the possible impact;
Doubtful and bad debt charge, on average, grew by a higher rate
than the advances, indicating the higher credit risks. The charge
increased by a CAGR of 51% (05-09) vs. a CAGR of 40% for the
net advances.
On the funding side, the fluctuations of the growth rates reinforce
our concerns with the funding model to an extent. Short-term
funding responds to market liquidity position. However, the long-
term funding growth has been more stable. Short-term fundingwas reduced in FY09 as the Group increased its subordinated loans
and bonds (long term funding) by an enormous 300%.
Management considered it fit to increase longer term funding at
relatively lower costs (see Fig 4 above). Consequently the cost of
funds improved from 11.7% in 1H09 to 10.5% in 1H10. To an
extent, the volatility in short-term liabilities is partly explained by
asset and liability management strategies;
Net advances growth rate declined significantly in FY09 from 88%
for FY08 to 25%. The CAGR of advances is 40% (05-09) which is2.2X the 19% growth rate of the interest income from advances.
For the 1H10, the asset growth was weak, new loans and cards
sold were down 15%, and customer acquisition was also down
25%. We could not get a clear confirmation from management
that this is a cyclical issue (that we had assumed) ; and
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Fig 5: Liquidity ratios continue to worsen, and is lowest in 5 years
2005 2006 2007 2008 2009 2010F1HLiquidassets/TotalAssets 22.8% 21.1% 22.4% 14.9% 14.2% 13.4%
Liquidassets/Fundingliabilities 40.7% 35.4% 32.0% 29.1% 24.6% 21.8%
Source: Company reports, Legae Securities
The liability mix is shown below. (see Fig 6). The funding is dominated
by long-term loans and bonds (listed senior, and subordinated), which
we believe is invaluable particularly for funding reasons. Short-term
deposits constituted 9% (CY09) of the funding liabilities, with demand
deposits (institutional deposits) making up only 2%. We believe that
retail deposits have a high degree of inertia compared to the
wholesale/institutional deposits, notwithstanding the long-term nature of
ABILs funding liabilities. Wholesale deposits are more mobile due to the
lower switching costs and higher sensitivity to counterparty credit risks.
The reliance on institutional deposits is not constructive to the cost of
deposits, yet longer dated instruments such as subordinated debts
generally carry higher funding costs as well. Unlike the retail deposits,
wholesale deposits rates are largely set by the market liquidity
conditions. As competition intensifies in this space, ABIL will be less able
to manage margin and spread erosion when compared to retail deposit
taking competitors.
We should, however, highlight that the decision by management to issue
longer term debt at this low point of an interest rate cycle is plausible. It
should put a buffer to the interest spread compression to an extent (i.e.
if deposit rates pick up, and lending rates (for this market segment)
come down on competition, regulatory changes, etc, ABIL will be better
placed to protect margins in the short term.
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Fig 6: Funding composition, LT loans and bonds domin ate the funding liabilities
2% 6%1%
35%
45%
11%
2009
Demand Fixedandnotice NCDs Listedsnr L Tloans Subordinates
2%13%
6%
32%
42%
4%2008
Demand Fixedandnotice NCDs Listedsnr L Tloans Subordinates
Source: Company reports, Legae Securities
Funding liquidity risks likely to increase as bonds and loans
mature: In less than 12 months, loans and advances worth R3.2bn will
mature, and needless to say, it would need to be refinanced, unless if
some assets are shed off. The cumulative maturity within the next three
(3) years is R7.2bn. (see Fig 7). The Group could face liquidity
pressures, in our judgment. We should, nonetheless, highlight that to
this end, the bank has been successful in rolling-over its maturing
liabilities, with a historical retain rate of 85% of the maturing liabilities.
The chief problem is the amplified roll-over risk, given the active
management of deposits by institutional investors. The dependence on
institutional funding also results in the cost of funding that is more
responsive to the local and global markets liquidity positions, making
the net interest income more volatile. However, according to
management, this potential volatility in interest income is offset by
yields in other revenue streams. The problem is, currently, both yields
on advances and insurance products have been coming down in order to
increase volume.
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Fig 7: Short-term maturities do not look excessive, but LDR is high already
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
1,costoffundsrespondedtothe
liquiditycrunch
(2008
2009)
LDR(LHS)
costoffunding
Source: Company reports, Legae Securities
Credit risks are high, well managed, although ratios are
gravitating upwards: The banks higher exposure is exclusive to
retails loans. This is a deliberate position given the banks strategy and
vision to enable our customers to improve their lives through access to
unsecured credit. The retail loans carry higher yields, but the attendant
credit risks are also higher. The 100% exposure to the high margin;less leveraged and less penetrated market segment is valuable, despite
the more capital it carries as a result of higher risk-weighting to the
non-secured consumer loans. Looking at the loan book composition, the
important exposures are:
Retail loans constitute 65%, a 2pp increase from 63% in CY08;
The credit card exposure make up 7.6% of the loan book, about
2pp rise from 5.4% in CY08; and
The mining industry exposure declined in CY09 to 4.7% from 5.1%
in CY08. (see Fig 8)
As we mentioned already, the credit card sales declined by 15% in
1H10.
In our opinion, management has adequate knowledge and experience to
deal with and manage the risks. The recent uptick in the NPLs has
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mainly been ascribed to the legacy issues with Ellerines and the upturn
in unemployment that hit the economy in CY09, just after a lofty growth
in loan writing in the FY08.
Fig 8: Loan book is dominated by retail loans. Credit card exposure rose to 7.6% in CY09
64.8%
2.5%
7.6%
4.7%
0.2%
20.1%
2009
Retail Payroll Creditcar d Mining EHLretail EHLgroup
62.8%
2.8%
5.4%
5.1%
0.0%
23.9%
2008
Retail Pay roll C reditc ar d M in in g EH Lr etail EHLgroup
Source: Company reports, Legae Securities
NPL formation and provisioning issues: The current low interest rate
environment should lead to lower NPL formation, although this could
worsen should interest rates rebound. Loan restructuring in CY08 and
CY09 should also aid the slowing of NPLs. (i.e. negating the
unemployment effects). Although the banks lending rates is not very
responsive to changes in the policy rate, (charges are more influenced
by the clients risk profile) complete ignorance of the changes to the
policy rate would make the bank uncompetitive. NPLs/Loans ratio
increased in CY09, as did the systems, but we expect it to peak this
year.
Provisions/provisions ratio, however went up by a lower rate in CY09
than the NPL/advances ratio. This resulted in the coverage ratio
declining to its lowest level since CY05 (at 61.2%). This relative under-
provision (vs. CY09) reduces the quality of earnings to an extent.
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In rand-terms, the NPLs went up by a CAGR of 54.1 (05-09) from
R1.6bn in CY05 to R9.3bn in CY09. This screen poorly against the CAGR
of 50.0% and 41.9% for provisions and gross advances respectively.
Note: there was a restatement of NPLs. The FY09 amount as published
in FY annual report included the residual value of the written off book.
This was reversed in 1H10 interim results, but only for African bank
business unit, so we maintain the ratio for Group, but make adjustment
for African bank.
Fig 9: The coverage ratio at Group level deteriorated in FY 09 compared to FY 08...
2005 2006 2007 2008 2009 CAGR
Grossadvances 6,454 7,727 10,890 20,908 26,181 41.9%
Growthrate 19.7% 40.9% 92.0% 25.2%
Totalimpairmentprovisions 1,117 1,435 1,892 4,376 5,661 50.0%
Growthrate 28.5% 31.8% 131.3% 29.4%
TotalNPLs 1,642 2,213 3,004 6,239 9,253 54.1%
Growthrate 34.8% 35.7% 107.7% 48.3%
Impairment/Grossloans 17.3% 18.6% 17.4% 20.9% 21.6%
NPLs/Grossloans 25.4% 28.6% 27.6% 29.8% 35.3%
Provisions/NPLs 68.0% 64.8% 63.0% 70.1% 61.2%
Source: Company reports, Legae Securities
Ellerines financial services carry higher credit risks, mostly from
legacy loans. We also note that Ellerines has a higher
provision/Advances ratio at 16% versus 12% for African bank. The
NPLs/Advances for Ellerines is 7pp above African banks 34%. Since
provision are meant to be forward looking (i.e. based on managements
expectations on bad and doubtful debts), management invariably expect
higher credit risks for the Ellerines business segment to continue in the
short-term. Post integration of the financial services to African Bank, we
expect the credit costs to reduce. This will mainly be a result of the use
of African banks platform e.g. scorecard.
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Fig 10: ...and Elleri nes carries h igher credi t risks
50%
55%
60%
65%
70%
75%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2002 2003 2004 2005 2006 2007 2008 2009
NPLs/Grossloans
Provisions/Grossloans
Provisions/NPLs(coverageratio)
20,994
5,153
7,158
2,095
34%
41%
10,000
5,000
5,000
10,000
15,000
20,000
25,000
5%
10%
15%
20%
25%
30%
35%
40%
45%
ABIL Ellerines
Advances(RHS) Pr ovisions(R HS) NP Ls /A dv an ce s
Source: Company reports, Legae Securities
Revenue and profitability analysis
The major contributor to the groups revenue is interest income. (see Fig
11) As we mentioned before, the interest income growth rate has been
average. Non-interest income and assurance income has shown stronger
growth, but we believe the two revenue streams face higher regulatory
risks. Given the Groups strategy, we also doubt the sustainability of
non-interest income growth rate at above industry growth rate as it
solely depends on the asset side products. Product offering on the
liability side of the balance sheet in order to produce fee and
commission income is non-existent. We note that:
African bank is integral to the Groups revenue growth as interest
income constitute 47% of the revenue and 78% of the Groups
interest income comes from African bank. We see compression on
interest spreads as the yield decline (with the Bank moving into
low risk segment, competition, and possible upturn in wholesale
deposit rates, even though the long-term funding was increased);
Non-interest income make up 19% of the Groups revenue, (FY09
vs. 34% [fee and commission] for the industry), and African bank
contributes 72% of it. Assurance income represents 18% of the
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Group revenue, and again, African bank contributes the most at
60%. The instability in the job market creates headwinds to
assurance income in the short-term;
Gross margin on retail sales makes up 15% of the Groups
revenue. It wholly comes from the Ellerines retail business.
In our view, the integration of Ellerines loan book to African bank
should be value accretive to the Group.
Fig 11: Interest income dominates revenue and ABI L has the higher contribution
78%
60%71%
22%
40%29%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Interest Assurance Noninterest
ABIL Ellerine
15%
47%
18%
19%
2009
Marginonretail Interestona dv ances Netassurance Noninterest
Source: Company reports, Legae Securities
Jaw are not widening fast enough, in our opinion: The Groups
profitability growth has been muted in our opinion, despite a high ROE
up-to FY07. The jaws have not been widening fast enough, with risk
adjusted income growing by a CAGR of 33% (05-09) while operating
costs went up by a CAGR of 48% over the same period. The interest
expense has grown by 2X interest income between FY05-FY09. (see Fig
12). However, we expect the jaws to widen on additional revenue
growth from the Ellerines as it becomes more efficient and legacy
issues wane.
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Fig 12: The JAWS are not widening fast enough. Interest expense has grown at 2X interest
income
CAGR=33%
CAGR=48%
2,000
4,000
6,000
8,000
10,000
2005 2006 2007 2008 2009
Riskadjusted income
Operatingcost
CAGR=42.4%
CAGR=20.3%
CAGR=12.8%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
2005 2006 2007 2008 2009
Interestincome
Interestexpense
NII
Source: Company reports, Legae Securities
Interest rate risk is minimal at this point. The Group swaps the
floating/variable interest rate on its liability-side to match the fixed rate
on the asset side. We could not get access to the full maturity profile in
order to subject the maturity gaps to a gap analysis, but we note that
1) management does not take a view on interest rates, and as a result
the liabilities carrying floating rates are swapped for fixed rate.
However, the book is not 100% swapped yet; 2) we believe the bankcarries an asset sensitive balance sheet. This should be constructive to
interest income should interest rates rebound. More maturing assets will
be re-priced at favourable rates, boasting interest income despite the
low responsiveness to policy rates.
Ellerines carries a high level of capital, further depressing the
Group ROE: We note that Ellerines shareholders equity is R4.1bn
(1H10) while African bank has R3.4bn. The higher equity level for
Ellerines would have created a war-chest for the Group, but the Groups
high dividend payout ratio has eliminated opportunities for upside
potential in the payout ratio in the future. We get the takeaways as
below (see Fig 13):
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Ellerienes is not leveraged enough. FY09 leverage is only 1.8X.
This negatively affect the Groups ROE, whose leverage ratio for
FY09 is only 2.7X;
Both ROA declined sharply in FY08 due to a 3.4pp increase in
operating costs/total assets ratio. The total revenue/total assets
ratio is also declining, indicating falling yields. With the asset
growth slowing, and ROA deteriorating, we are not bullish on the
Groups ROE in the short-term.
Management pointed out that the yield reduction is a deliberate
strategy to increase volume and market share.
Fig 13: Group ROA has been falling. Poor leverage level at Group level is notsupporting ROE.
%oftotalassets 2005 2006 2007 2008 2009Totalrevenue 46.3% 47.1% 38.7% 32.0% 33.7%
Chargefordoubtfuladvances 6.7% 7.4% 7.0% 6.3% 7.3%
Otherinterestincome 2.1% 1.4% 1.4% 1.2% 1.1%
Interestexpense 6.7% 5.7% 5.4% 4.5% 5.9%
Operatingcosts 13.0% 12.8% 9.3% 12.7% 13.4%
BEEcharge 0.0% 0.0% 0.0% 1.0% 0.0%
Indirecttax 0.7% 0.6% 0.3% 0.2% 0.1%
Capitalitems 0.0% 0.5% 0.0% 0.0% 0.0%
Associateincome 0.0% 0.0% 0.0% 0.0% 0.0%
Taxation 8.4% 8.0% 6.4% 3.2% 2.7%
ROA 12.9% 14.4% 11.7% 5.3% 5.4%
Leverage 2.8 3.0 4.0 2.4 2.7
ROE 36.1% 43.7% 46.4% 12.6% 14.7%
Source: Company reports, Legae Securities
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1.3 A look at African Bank
Below we look at the CAMEL indicators for African bank. Profitability for
the bank has been strong, with an average ROE of 50% between CY05
and CY09 and a profit CAGR of 14% (05-09). However, the interest
spreads has narrowed from 30% in CY05 to 12% in CY09. The NIM
declined from 33% (CY05) to 11%. (CY09). The efficiency ratio
(cost/income) and burden ratio have both improved between CY05 and
CY09. Key takeaways in our CAMEL analysis are:
The banks leverage ratio has increased from 3.4X in CY 05 to 6.8X
in CY09. In our forecast we increase the leverage ratio beyond
managements guidance. Our view is that ROE will be boosted
more by leverage than ROA given issues we highlighted already.
The provisions/loan ratio increased in CY09 to 20% from an
average of 18% between CY05 and CY08. The NPL/advances ratio
increased by 9pp from 25% in CY05 to 34% in CY09. We expect
this ratio to decline on improved credit quality;
Both the cost/income ratio and the burden ratio have improved,
reducing from 33% to 25% and 17% to 13% for FY05 and FY09
respectively. The relatively high burden ratio indicates the low
extent to which non-interest income covers non-interest expense.
Assurance income supports this coverage in the medium term.
NIM has slowed from 33% in CY05 to 11% in CY09. We expect the
NIM ratio to decline on narrowing interest spreads. The pressure
should mainly come from 1) leverage (should the bank increase it)
that is likely to negatively affect interest spreads since deposits are
wholesale; 2) competition and slowing loan demand that puts
pressure on lending rates, notwithstanding the positive industry
structure; and 3) the deliberate migration to a low risk client
base.
Non-interest income/operating income ratio developed from 9% in
FY05 to 30% in FY09. As we mentioned elsewhere, non-interest
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income contribution to operating income will be suppressed by the
asset-led approach; and
The LDR has improved, reducing from 129% in CY05 to 91% in
CY09. Cash and cash equivalents/total assets ratio has, however,
worsened by 3pp from 23% in CY05 to 20% in CY09. We see little
room for improvement in this ratio due to the non-retail deposits
taking strategy. We slightly reduced the LDR to 87% for FY11 and
FY12.
Fig 14: CAMEL indicators for African Bank
2005 2006 2007 2008 2009 2010F 2011F 2012F
C:Totalassets/Totalequity 3.4 3.7 4.7 6.7 6.8 7.9 8.0 7.9
C:Equity/Loans 56% 49% 34% 22% 20% 17% 16% 16%A:Provisions/Loans 17% 18% 17% 18% 20% 18% 18% 18%
A:NPL/Loans 25% 29% 28% 28% 34% 29% 29% 30%
M:Cost/Incomeratio 33% 31% 28% 26% 25% 29% 31% 30%
M:Budernratio 17% 18% 15% 14% 13% 11% 12% 11%
E:NIM 33% 32% 22% 13% 11% 9% 9% 8%
E:Nonint.income/Op.income 9% 13% 18% 27% 30% 34% 33% 35%
L:LDR 129% 125% 107% 95% 91% 87% 88% 87%
L:Cash+equivalents/Total assets 23% 21% 22% 22% 20% 15% 12% 13%
Source: Company reports, Legae Securities
In terms of credit risks, the NPLs have increased by a CAGR of 40%
from R1.6bn to R6.4bn. (CY05 and CY09). The gross loans and advances
have, however, grown at a slower pace by 7pp lower, with a CAGR of
33% to R20.2bn. We are not overly concerned by the higher growth in
NPL when compared to advances as the coverage ratio remained fairly
in line with the average (66% vs. 65%). (see Fig 15)
Fig 15: Credit risks, the coverage ratio worsened from 68% (CY05) to 59% (CY09)
2005 2006 2007 2008 2009
NPL 1,642 2,213 3,004 4,455 6,381
Impairmentprovision 1,117 1,425 1,892 2,867 4,239
Grossadvances 6,454 7,727 10,890 16,042 20,224
NPLs/Grossadvances 25% 29% 28% 28% 32%
Provision/Grossadvances 17% 18% 17% 18% 21%
Coverageratio:Impairment/NPLs 68% 64% 63% 64% 66%
Source: Company reports, Legae Securities
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ROE supported by leverage, but we are sceptical of stronger
leverage going forward; yields declining on competition and
migration to lower risk client base: As we pointed out already, the
banks ROE has been strong. From CY05 to CY09, the average ROE is
50%. The ROA shows a declining trend, moving from 13% in CY05 to
7% in CY09. Both components of the ROA, the yield and the margin
declined from 46% to 31% and 27% to 22% in that order. 1H10 results
show that about 40% of the debit order distribution is now in what
management considers low risk client base. This is against 10%
exposure to this low risk client base in 1Q09. This rapid change in risk
exposure will compress yields as the low risk clients should demand
lower interest rates.
We also note that ordinary equity and total equity shows mundane
growth rate (CAGR =12% FY05-FY09). The Group pays out capital in
excess of its forecasted optimal requirements, hence the high Group
payout ratio. The effect is that ROE is sustained at high levels, more as
a result of capital management than earnings growth.
Maintenance of a high ROA (8% is managements target) is an
uphill task, in our opinion. 1) African banks ROA is on the top end
against the industry and its peers (Capitecs ROA = 5%); 2) the
declining margins and spread due to reasons highlighted before; and 3)
the absence of strong fee income growth outlook as it is only asset
driven.
The ROE improved from 43% in CY05 to 46% in FY09 on rising leverage.
The leverage ratio increase from 3.4X in CY05 to 6.8X in CY09. We do
not think leverage will grow strongly on both regulatory constraints and
the internal constraints brought about by the non-deposit taking
strategy. Managements target leverage ratio is 6X. The unsecuredpersonal loans would require higher risk-weighting, and thus more
capital which could inhibit leverage benefits. (see Fig 16 and Fig 17).
Leverage is imperative to support ROE despite the constraints
highlighted above. We increased it to 8.0 and 7.9 for FY11 and FY12,
which is slightly above management guidance.
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Fig 16: ROE decomposition. We expect ROE to dow ntrend on ROA
2005 2006 2007 2008 2009 2010F 2011F 2012F
Assetyields:Revenue/Total assets 46% 47% 39% 33% 31% 25% 28% 26%Margin:NetIncome/Revenue 27% 30% 29% 25% 22% 20% 19% 20%
ROA 13% 14% 11% 8% 7% 5% 5% 5%
Leverage:Totalassets/Equity 3.4 3.7 4.7 6.7 6.8 7.9 8.0 7.9
ROE 43% 52% 54% 56% 46% 39% 42% 41%
Source: Company reports, Legae Securities
Fig 17: Interest spreads narrowed significantly from CY05 level, but leverage supported ROE
30% 30%
21%
13% 12%
10% 10% 9%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2005 2006 2007 2008 2009 2010F 2011F 2012F
Assetyields
Fundingcost
Interestspread
13% 14% 11%8% 7% 5% 5% 5%
43%
52%54%
56%
46%
39%42% 41%
0%
10%
20%
30%
40%
50%
60%
70%
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
2 00 5 2 00 6 20 07 2 008 20 09 20 10 F 2 01 1F 2 01 2F
ROEROALeverage(LHS)
Source: Company reports, Legae Securities
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Major assumptions - Earnings and balance sheet models: Below
we highlight the salient assumptions we used in our earnings and
balance sheet models. Relative to history our forecasts are more like in
line than otherwise. We have:
reduced doubtful debts charge ratio to 10% and 9.5% for FY11 and
FY12 respectively as we expect lower delinquencies due to the
migration to the lower risk segment;
reduced the operating expenses ratio to 26% by FY12 due to our
expectation of efficiency benefits due to cross-selling of African
bank products through Ellerines branches;
increased the expense/advances ratio to 11% as we anticipateinterest rates rebounding within our forecasting period.
trimmed down the yield (interest/advances) ratio to 22.5% for
FY12 on assumption of competition and the migration to lower risk
clients.
Fig 18: Salient assumptions
Major assumptions 2005 2006 2007 2008 2009 2010F 2011F 2012FInterestincome/Advances 49.1% 49.0% 35.4% 25.2% 25.3% 23.2% 23.0% 22.5%
Netassuranceincome/Advances 6.8% 7.0% 8.5% 9.0% 7.4% 4.9% 6.0% 5.0%
Noninterest
income/Advances 5.2% 7.4% 8.1% 9.4% 9.5% 8.1% 8.0% 8.0%
Chargeofdoubtfuldebts/Advances 9.2% 10.0% 9.4% 10.3% 11.5% 11.2% 10.0% 9.5%
Intragroupassetsyield 0.0% 0.0% 0.0% 0.0% 0.0% 25.0% 25.0% 25.0%
Otherinterestincome/Cashandsta 9.4% 6.6% 6.5% 8.9% 7.9% 0.0% 6.0% 7.5%
Interest andop.expenseassumptionsInterestexpense/Funding liabilities 12.0% 9.6% 7.7% 8.2% 9.8% 8.9% 11.0% 11.0%
Operatingexpenses/Op. revenue 32.8% 32.4% 29.3% 27.5% 25.8% 29.4% 27.5% 26.0%
Taxation 39.5% 29.3% 28.9% 28.2% 28.1% 26.2% 28.0% 28.0%
Growthrates,fundingforecastingShorttermfunding 2 9.4% 80.8 % 271.2 % 43.3% 1.1% 10.0% 20.0%
Bondsandotherlongtermfunding 29.5% 68.2% 45.4% 42.4% 45.3% 25.0% 15.0%
Subordinatedbonds 2.5% 51.0% 67.5% 300.0% 40.6% 30.0% 30.0%
LDR(netloans/fundingliabilities) 129% 125% 107% 95% 91% 87% 88% 87%
Source: Company reports, Legae Securities
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Fig 19: Earnings model, Rmn
2005 2006 2007 2008 2009 2010F 2011F 2012F
Interestincome
on
advances 2,752
2,974
3,098
3,323
4,245
4,764
6,540
7,402
Netassuranceincome 357 424 742 1,191 1,243 1,104 1,706 1,645
NonInterestincome 274 446 707 1,244 1,591 1,835 2,275 2,632
Totalrevenue 3,383 3,844 4,547 5,758 7,079 7,703 10,521 11,679
Chargeforbadanddoubtfuladvanc 488 606 823 1,361 1,929 2,391 2,669 2,916
Riskadjustedrevenue 2,895 3,238 3,724 4,397 5,150 5,312 7,852 8,763
Otherinterestincome 156 113 170 261 328 480 280 436
Intragroupincome 410 472 542
Interestexpense 492 465 636 1,136 1,816 2,308 3,555 4,160
Operatingcosts 951 1,048 1,091 1,209 1,330 1,562 2,159 2,278
BEEcharge
Indirecttax:VAT 50 46 38 54 18 24
Profitfromoperations 1,558 1,792 2,129 2,259 2,314 2,308 2,890 3,304
ProfitonsaleCVFandotheritems 37 15
Profitbefore taxation 1,558 1,829 2,129 2,259 2,314 2,323 2,890 3,304
Directtaxation:STC 118 138 132 86 104
Directtaxation:SAnormal 616 535 616 636 651 608 809 925
Profitfortheyear 942 1,176 1,375 1,491 1,577 1,611 2,081 2,379
Preferenceshareholders 28 36 41 49 52 53 69 78
Ordinaryshareholders 914 1,140 1,334 1,442 1,525 1,558 2,012 2,300
Source: Company reports, Legae Securities
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1.4 A look at Ellerines
Ellerines provides a different risk-return profile to the group...
Ellerines is a furniture and appliances retailer which targets the formally
employed, the banked and the informally employed people. The
business unit was acquired in CY07 and the rationale of the acquisition
was to offer scale to the Group as the retail market offered a channel to
grow the loan-book. The Ellerines offered a conduit to gain access to
the clients with a risk profile that fit(ted) into the ABIL target market.
However, according to management, the Ellerines brand customers, who
make the highest number of credit sales to the Ellerines business unit,has a higher risk profiles that resulted in higher credit costs to this unit.
In addition, the retail sales tend to be more cyclical than financial
services revenues.
...but the key issues that impaired past performance have been,
and are being addressed in our view : Ellerines retail division was
the problem child of the Group, with net losses of R252mn and
R185mn for FY08 and FY09 respectively. The retail side of the business
was not creating optimal turnover, while the financial side, although
profitable, was suffering from colossal bad loans and massive suspended
interest due to the in duplum rule. In 1H10, the retail division made a
turnaround, with headline earnings of R132mn for 1H10 (return on sales
of 5.6%).
Management has addressed primary issues that we believe are key to
stronger performance of the Ellerines in future. These are 1) the
realignment of costs to sustainable levels. For example, staff costs were
reduced from R736mn in 1H09 to R710mn for 1H10. Administrative
expenses declined to R228mn for 1H10 from R348mn for 1H09.
Management is exploring more ways to cut costs where possible; 2) the
improvement in efficiency as indicated by the sales/employee and
sales/store. The sales/employee and sales per store growth rates turned
positive in 3Q09. Some of the loss-making branches were closed
although about 100 branches remain loss making; 3) the migration of
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the financial services to African Bank. Although not completed yet, the
migration of financial services to African bank is a positive thing as it
would allow Ellerines to focus on retailing. According to management,
the African bank system has already been rolled out to 90% of all
Ellerines brands and full completion is expected by September 2010;
and 4) the greedy loan growth has been put to a halt. In our opinion,
growth for the sake of it is dangerous. Loans written in FY08 still present
problems to the Group, and a sizeable sum of interest was suspended as
a result of the in duplum rule. Gross advances yield decreased from
50% in 1H09 to 39.4% in 1H10 and about half of this decline is a direct
result of the in duplum rule. Growth of the Ellerines loan book has been
better managed for 1H10, which we believe should strengthen the
quality of earnings. This is not to underplay the need to grow the
advances book and maintain a market share. In our discussion with
management, there was indication that 1) growth was controlled given
the high growth in FY08 and consequent risks, 2) there is need to roll
out products and increase catchment area.
Given that, we expect Ellerines to be value accretive in the long-
term... Our view is that with the problem child being fixed, the unit
should be value accretive going forward. We are concerned with the
elasticity of the furniture retail business given the macro situation that
remains uncertain, but we take comfort in the improvements already
shown by Ellerines (highlighted above). Key issues to note are:
the business unit has net advances of R5.4bn. The biggest
exposure is to Ellerines brand that has an advances book of
R3.6bn. The Beares, Furniture City and Geen & Richards have a
combined loan book of R1.8bn.
Ellerines has the highest credit sales when compared to the other
brands (Beares, Funicture City, Geen & Richards, Wetherlys and
Dial-a-Bed) in the retail segment. Ellerines has the lowest average
loan value at R5,355 which we believe could aid in managing credit
i.e. greater diversification
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The Ellerines gross margins remain stable (at around 42.5%) and
as management get a grip on operating costs and turnover, we
expect the net margin to improve. Managements return on sales
target is 10%.
...but execution risk remains high in the retail segment;
managements FY14 sales target revised downwards:
Management have revised the FY14 sales target from R9bn-10bn to
R9bn-8bn. The profit margin target has been increased to >10%, with
the stock turn having been increased to 5X. For the financial services,
revisions are immaterial, hence we think there is still reasonably higher
execution risks related to Ellerines retail business.
Fig 20: Ellerines Earnings model.
EllerinesGroup 2008 2009 2010F 2011F 2012FSaleofmerchandise 3,092 4,196 5,245 6,556 7,868
Costofsales 1,779 2,405 2,963 3,737 4,524
Grossprofit 1,313 1,791 2,282 2,819 3,344
Grossmargin 42.5% 42.7% 43.5% 43.0% 42.5%
Growthofgrossprofit 36.4% 27.4% 23.6% 18.6%
Interestincomeonadvances 962 1,192 1,185 1,503 1,824
NetAssuranceIncome 854 838 647 974 1,170
Non
interest
income 524
660
665
849
1,033
Incomefromoperations 3,653 4,481 4,779 6,145 7,371
Operatingincomegrowth 23% 7% 29% 20%
Chargefordoubtfuldebts 495 582 603 724 861
Chargeofdoubtfuldebtsgrowth 18% 4% 20% 19%
Riskadjustedincome 3,158 3,899 4,175 5,421 6,511
Otherinterestandinv.Income 84 78 96 123 150
Interestexpense 180 248 351 562 744
Operatingcosts 2,536 3,246 3,316 3,791 4,558
IndirectTaxation 2
Profitfromoperations 524 483 604 1,190 1,359
Operatingprofitmargin 14% 11% 13% 19% 18%
Operatingprofitgrowth 8% 25% 97% 14%
CapitalItems 7
Profitbefore
tax 524
476
604
1,190
1,359
Taxation 164 198 171 337 385
Profitaftertax 360 278 433 853 974
Netprofitmargin 10% 6% 9% 14% 13%
Source: Company reports, Legae Securities
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Fig 21: Valuation model
AfricanBankValuation
SustainableROE 27.5%
CoE 16.5%
Sustainablegrowthrate 12%
ROEless growthrate 16%
CoEless growthrate 4%
FairvaluePBVR,X 3.5
FY11Bookvalue,Rmn 4,749
FY11Targetvalue,Rmn 16,541
Ellerines Valuation
Targetpayout
ratio 65%
Sustainablegrowthrate 9.5%
CoE 17.5%
CoEless growth 7.95%JustifiedPER 9.0
FY11Earnings,Rmn 853.5
FY11targetvalue,Rmn 7,640.9
FY10targetvalue(Group),Rmn 24,182
Numberofshares,mn 804
FY11Targetprice,R 30.1
Currentprice,R 31.9
Forecastdiv.yield 5.7%
Potentialtotalreturn 0.0%
Weincreased
Ellerines'CoE dueto
itshigher
risk
profile
Thesum of
Ellerines and
African
Bank
Source: Legae Securities
Relative method indicates fair valuation, with potential total
return of 6.8% : Our secondary valuation method uses the long-term
PER, which we adjust to reflect our risk assumptions for the three
business segments. For African Bank and Ellerines financial services weuse the average Banks Index PER (CY00-date). We discount the PER by
12% and 15% for African bank and Ellerines respectively. For Ellerines
retail, we use the General retailers PER (discounted by 20%). We
multiplied the adjusted PER by out FY earnings forecast. The Group
value is R25.9bn which is R32.2 per share. (see Fig 22)
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Fig 22: Long-term average PER indicates fair valuation at best.
EllerinesValuation AfricanBankValuationBanks
Index
Average
PER
(00
date) 10.3 Banks
Index
average
PER 10.3
Discount 15% Discount 12%
FairPERforEllerinesfinancialservices 8.8 FairPERforAfricanBank 9.1
FY11Earnings 427 FY11Earnings 2,012
FY11ValueforEllerinesFinancials 3,743 FY11ValueforAfricanBank 18,237GeneralRetailersAveragePER(00date) 11.6 TheGroupValuationDiscount 20% EllerinesValuation(FY11) 7,691
FairPER 9.3 AfricanBankValuation(FY11) 18,237
FY11EarningsforEllerinesretail 426 GroupValuation 25,928
FY11ValueforEllerinesRetail 3,949 Numberofshares 804TotalValueforEllerines 7,691 PriceTargetFY11 32.2
CurrentPrice 31.9
Potentialtotal
return 6.8%
Source: Company reports, Legae Securities
Valuation risks and Sensitivity Analysis.
The major valuation risks are 1) our funding liability forecast carry high
error due to the volatility of wholesale deposits 2) our sustainable ROE
for African bank (27.5%) is high relative to CoE.
Potential positive return kicks in only at very generous CoE and
ROEs: We provide a sensitivity analysis (ROE and CoE) to African banks
value. In our view, there is no easy upside. As shown below (see Fig
23), potential return only turn positive at 1) low CoE of 15% and higher
ROEs of 27.5% to 35%; 2) high ROEs of 30% and 35% only if the CoE
is 16.5%. For a CoE of 18%, the potential total return is negative for all
ROEs, except when ROE is 35%.
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Fig 23: Sensitivity analysis. There is no easy-upside.
Share price vs. AB's ROEs and CoE
ROE
CoE 15.0% 20.0% 27.5% 30.0% 35.0%
15.0% 15.4 25.3 40.0 44.9 54.8
16.5% 13.5 20.1 30.1 33.4 40.0
18.0% 12.5 17.4 24.8 27.2 32.1
Pos itive return requires high ROEs and low CoE
ROE
CoE 15.0% 20.0% 27.5% 30.0% 35.0%
15.0% 46.0% 15.0% 31.1% 46.4% 77.5%
16.5%
52.0%
31.3% 0.0% 10.4% 31.1%18.0% 55.1% 39.8% 16.6% 9.1% 6.3%
Source: Company reports, Legae Securities
1.6 Corporate governance and other ESG issues
Corporate governance is critical to implementation of risk management
procedures. In turn, we believe risk management procedures and
processes are crucial for the sustainability of competitive advantage. In
this section, we analyse the corporate governance, and other ESG
issues. We note the following about the governance of the company:
The Board of Directors is dominated by Non-Executives. One of the
Non-Executive directors, Mr A Tugendhaft is, however, a legal
advisor to ABIL. This, in our view, compromises his position to an
extent. Mr Mutle Mogase is the Board Chairman. We note that
most of the non-executive directors hold directorship with various
institutions which could diminish their dedication to ABIL, in spite
of the experience they could acquire from other boards.
The Audit Committee is made up of four (4) members, who are
elected by the Board from among the non-executive directors. We
think Executive directors could have an influential role in
determining the members of this committee. The Audit committee
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has unlimited access to external auditors, management, and
compliance.
We also underscore that the Group has an excellent investor
communication system, in our view. The Group has empowerment
and sustainability reports on its website that are often updated.
The website provides investors with a reasonable amount of
information.
Other ESG issues: Empowered at shareholding level, but senior
management has fewer Previously Disadvantaged Individuals
(PDI s). The business has a positive impact to society despite the
high interest rates.
Environmental issues:
In our opinion, African bank has no significant exposure to risks
that have a material negative impact to the environment. Loans
are exclusively to individuals, instead of corporates that can
expose the bank to environmental risk through project financing,
for example;
The Ellerines business has what we think is negligible impact to the
environment. In addition to owning a number of trucks, they also
do some manufacturing of furniture. Management pointed out that
they will outsource the transport division. This makes the risk
residual.
Social issues:
Generally, ABILs activities have a positive social impact. The
Group provides services to segments of society that are generally
overlooked by the mainstream banks. About 96% of the Groupscustomers are PDIs. The loans are mainly for basic requirements
such as education, accommodation, furniture and food. About 60%
of the customers are women. The main issue, on the other hand, is
the high interest rates charged (which we believe is defensible
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given the high credit risks), that often leads to the Groups clients
falling into a debt-trap.
The Group has two BEE partners who have a 6.5% shareholding.
Staff also own shares through a scheme, while options are granted
to middle and high level managers.
The management incentive policy is guided by the economic value
(earnings less cost of equity calculated at 16%). A maximum of
20% of the economic value is distributed to staff. General staff and
middle managers receiving more cash bonus while top
management receive most of their bonus in share options with a
four-year tenor;
The majority of the low-level staff members are PDIs while the top
management is predominantly white. Out of the 6 (six) members
of the top management, 1 (one) is African and another is Indian.
Of the 107 senior managers, 14 are Africans, and 23 are PDIs. In
our view, this situation would need to be addressed.
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2. Appendix 1: A comparison w ith
Capitec Bank
2.1 Small vs. Big: We favour the micro-banks
At the moment we prefer banks with exposure to the micro-finance to
mainstream banks. ABIL and Capitec are prime exposures to the micro
finance sector. The anchor themes for these banks, in our view, are:
the targeted sectors enjoy lower penetration and lower debt levels
that should create relatively more lending opportunities;
the more defensive assets (lower exposure to capital markets)
hence less volatility in earnings when compared to the mainstream
banks;
the recent improvements in assets quality in general despite higher
NPLs than the mainstream banks; and
lower ESG related risks as they lend to individuals as well as
providing valuable financial services to the under-banked and un-
bankable population.
It is however important to note that gap in operating ratios between themainstream banks and the micro-banks is narrowing, despite still being
wide. The micro-banks are gravitating towards the mainstream in terms
of credit risk management and NIMs.
2.2 Which Bank to Play? Performance and Valuation
metrics
The PER for ABIL and Capitec are 12.8X and 18.2X respectively. Below
we compare and contrast the major performance and valuation
indicators between ABILs banking business, African Bank (AB) and
Capitec. Overall we prefer a bank that would be in a better position to
exploit opportunities and enhance stronger top-line growth (interest
income and non-interest income) rather than earnings recovery that is
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primarily driven by slowing NPLs at this stage of the NPLs cycle. The key
issues in this comparison are:
Liquidity and loan growth momentum: Unlike other industries,
banks balance sheets drive earnings more directly. The
relationship between the balance sheet and income statement is
more clear-cut: deposit growth asset growth earnings
growth. Of course, the relationship is contained within tolerable
risk levels. In our view, Capitec has a more liquid and flexible
balance sheet due to its 1) lower LDR (Capitec =71%, AB = 91%),
2) higher assets in cash and cash equivalents when compared to
AB (Capitec = 27%, ABIL =18%). The higher cash and cash
equivalents allows Capitec to sell down government securities and
other liquid assets to grow its loan book. (compared to AB).
NIM and interest spread: The non-deposit taking strategy
affects AB in two main ways 1) inability to change the liability mix
(retail deposits vs. wholesale deposits) in order to manage the
spread and margins; 2) limited ability to change the asset mix to
enhance the spread as the liability side is not as flexible as of
those that take retail deposits. The lower cash and equivalents
means restricted ability of asset mix changes in pursuit of margin
and spread growth. Capitec enjoys a higher NIM at 13% vs. ABs
11%. We think room to improve the margins are slender for both
banks. We believe the downward bias to margins will persist even
though management is of the view that it has reached the floor.
Asset quality: Our view is that the credit risk profiles of the two
banks are similar. It is the management of the risk that becomes
a differentiating factor. Capitecs impairment/advances ratio is
lower than ABs at 10% vs. 34% respectively. Both banks have
relatively low coverage ratios. The coverage ratio for both banks
worsened in FY09.
Efficiency and non-interest income growth: The cost/income
ratio for Capitec has improved materially to 54% from 73% in
FY05. We calculate ABs cost/income ratio at 25% for FY09. ABs
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cost/income ratio is significantly lower than Capitecs. We,
however, draw attention to the fact that Capitec has managed to
reduce its cost/income ratio by a higher 19pp vs. ABs 8pp
improvement from 33% in CY05 to 25%. We also believe that
technology will be important in order to integrate platforms that
would enhance fee revenues. Capitec has an added advantage of
earning technological and economies of scale benefits on the
liability side (deposit products) while AB could see some benefits
through the Ellerines integration.
ROE decomposition: A bank that would be able to maintain or
grow margins, and therefore its ROA would be preferred, but given
the competition, we would expect margins to progressively narrow.
As a result, banks that can take more leverage to support the ROE
would be our preferred. Both banks are lowly leveraged at 7X for
AB and 6X for Capitec (narrow deposit base makes them risk
averse). Capitec appears well positioned to further lever its
balance sheet by its retail deposits. AB managements view is to
increase the ROE through ROA expansion (which we like) and not
leverage. We are just concerned that given the high ROA already,
this could be an aggressive target, and holding ROA at levels
around 8% could not be sustainable. On ROE outlook, we favour
Capitec as we expect Capitecs to go up while ABs slows down.
Valuation: Capitec trades at a higher PER and PBVR, probably
confirming the expected stronger growth. Trailing PERs shows rich
valuation for Capitec, trading at 18.2X while ABIL is at 12.8X. We
highlight that ABIL trades at a slight premium to Capitec in terms
of the price/deposit ratio (1.2X vs. 1.1).
Conclusion: We believe Capitec represents a better risk-return
profile, as reflected by the solid growth in both loans and deposits.Valuation prima facie looks excessive, but forward looking, we
believe Capitec enjoy a more flexible balance sheet, which allows it
to manage its interest spreads and margins better. Capitec has
more room to manage its funding mix, while AB chances are
limited. We do not expect ABs asset-led strategy to change.
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Volume (on loans and deposits) will be a central driver of earnings
(value) as competition increases.
Fig 24: Capitec fares better in most of the indictors, except valuation
AB Capitec Our comments
CAMEL indicators
Leverage 6.8 6
We see better room for Capitec to increase its leverage than African bank. However,
higher risk weighting could require more capital and inhibit leverage. Risk capital excess
could grow thinner.
Impairments/loans 10% 10%Both banks seem content and have a target of around 10%. Deterioration in employment
could hurt the ratio
Cost/income 25% 54%AB enjoys lower cost/income ratio. Capitec has room to improve, target ratio is 40%. After
full integration of Ellerines' financial services, the ratio is likely to increase for AB
NIM 11% 13%AB has a lower NIM, indicative of its wholesale deposit gathering strategy. We expect NIMs
to continue to narrow for both banks to around 8%
LDR 91% 71%
African bank's liquidity looks tighter. Capitec has more room to increase its LDR. AB's LDR
declined to 82 for 1H10
Concentration risk a nd efficiency indicators
10 largest depositors >50% AB's.
Capitec 's growth seem natural (i.e. LDR = 71%), but we also like AB's apparent "controlled
growth" nonetheless
Deposits 46% 101.3%AB's funding is constrained by the dependence on the wholesale market. Capitec can roll-
out an aggressive deposit gathering strategy if need be
ROE decomposition
ROA 7% 5%African bank has a higher ROA. Higher asset yields due to fewer branches. Target is 8% for
AB which we believe may not be sustainable
Leverage 7 6Capitec has slightly lower leverage. Better opportunities to increase it than AB but higher
capital requirements for "risky' assets could limit it
ROE 46% 30% We are mildly bullish on Capitec's ROE, but bearish on AB's
Valuation, vs. ABIL (not AB)
PER 12.8 18.2 Capitec's PER is higher than ABIL. Both PERs are above their LT average though
PBVR 2.1 5.2 ABIL trades at low PBVR, which could be motivated by low growth in equity
Div. yield 6% 4%ABIL has a higher dividend yield. Capitec's payout ratio is 40%; ABIL >70% although target
is 60%
Price/Deposit 1.21 1.10 On this metric, ABIL is trading at a slight premium to Capitec
Source: Company reports, Bloomberg, Legae Calculations
Note: We used ABILs funding liabilities as a proxy for deposits.
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3. Appendix 2: A snapshot of the
industry structure and regulatory risk
Note: We expanded our analysis on regulatory risks (section 3.2).
However, the major part of this industry analysis (section 3.1) is also
carried in our Capitec initiating report.
3.1 Industry structure and developments
The South African banking industry has registered remarkable growth
post CY00 with system lending assets rising from R500bn to R2.25tn byCY09. The Loans/GDP and Deposits/GDP ratios also went up, reaching
0.96 and 0.93 by CY09 respectively. The level of debt in households also
shot up; the debt/disposable income level increased from 54.2% in
CY00 to 80.1% in CY09, for example. The liquidity position of the
system worsened due to the strong growth. The funding gap (local
deposits less loans and advances) rose to about 14% of GDP by CY08.
The LDR jumped from an average of 82% before CY03 to 103% by
CY09. However profitability remained relatively strong, supported by 1)
a high concentration level that reduces competitive pressures and 2)
stable interest spreads due to the cap on prime to REPO rate. ROE
increased due to higher system leverage. System leverage ratio rose to
18X in CY08, from an average of 12.6 (between CY03 and CY07) before
declining to 15X in CY09. The system, in our opinion, remains well
capitalised. Given the structure of the industry, we believe that:
loan growth should recover, but may not revert to the recent past
levels in the short term because of1) high penetration rates, 2)
high debt/disposable income level, 3) deteriorating structural
liquidity position, and 4) poor loan growth factors. Medium to long
term, the poor population growth rate also diminishes our industry
growth expectations although rising per capita income should be
constructive to banking services demand.
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We also emphasize that over the previous decade, the rate of loan
growth versus nominal GDP growth widened significantly. Industry
loans and advances have grown by a CAGR of 17% while nominal
GDP gas grown by a CAGR of 12%. In our view, the natural
growth of industry loans is driven by the nominal GDP growth rate.
We believe that the spread in growth rate between nominal GDP
and system loans and advances will narrow, and this represents
risks to loan growth in the short- to medium-term.
Despite the favourable economic outlook, we believe that
loan growth w ill be muted in the short to medium term.
Fig 25: South Africa GDP grow th expected to recover, but we see poor loan grow th factors
Majorloangrowthfactors
Bankingassets = Bankingassets XCapita
Capita
GDP X BankingAssets X Capita
Capita GDP
percapita
income pe ne trati on popul ation
1.8%
2.9%
3.5%
2.2%
2.0%
3.8%
3.0%
2.0%
1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
2009 2010 2011
Bloombergconsensus
IMFforecasts
Source: Bloomberg, IMF, Legae Securities
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The industry is highly penetrated. Loans/GDP and deposits/ GDP
is at 96% and 93% respectively.
Fig 26: The systems penetration rate is higher relative to other EMS.
10%
10%
30%
50%
70%
90%
110%
Nigeria Turkey Russia Brazil Chile RSA
2009
Loans/GDP
Deposits/GDP
0.55
0.65
0.75
0.85
0.95
1.05
1.15
2003 2004 2005 2006 2007 2008 2009
Loans/GDP
Deposits/GDP
Source: Company reports, Legae Calculations
Industry registered strong growth since CY00, LDR exceed 100%
since CY04.
Fig 27: Negative grow th was registered in loans for the first time this decade. LRD remained high
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
20 00 2 00 1 2 002 20 03 20 04 2 00 5 2 00 6 20 07 20 08 2 00 9
LDR
10%
0%
10%
20%
30%
40%
50%
60%
0.00
0.50
1.00
1.50
2.00
2.50
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Lendingassets,LHS
Deposits,LHS
Loangrowth rate
Depositsgrowthrate
Source: SARB, Legae Calculations
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The high industry concentration should support profitability. Top
4 banks enjoy over 80% of the market.
Fig 28: Top 4 banks enjoyed >80% market share since CY03. Oligopolistic industry, H-Index >0.18
0.175
0.170
0.182
0.1 84 0 .18 4
0.1900.189
0.160
0.165
0.170
0.175
0.180
0.185
0.190
0.195
2002 2003 2004 2005 2006 2007 2008
HIndex
69.5%
74.0%
87.0%
83.4%
84.6%
60.0%
65.0%
70.0%
75.0%
80.0%
85.0%
90.0%
2001 2002 2003 2004 2005 2006 2007 2008 2009
Big4marketshare
Source: SARB, Legae Calculations
System liquidity position worsened, the funding gap (local
deposit less advances) went up to R329bn, and average LDR
close to EM average
Fig 29: The Funding gap worsened to R329bn in CY09. LDR close to EM average despite being >1
0%
20%
40%
60%
80%
100%
120%
140%
LATAM CEE RSA AsiaexJapan
L DR A ve rage
350
300
250
200
150
100
50
0
Jun95
Feb
96
Oct96
Jun97
Feb
98
Oct98
Jun99
Feb
00
Oct00
Jun01
Feb
02
Oct02
Jun03
Feb
04
Oct04
Jun05
Feb
06
Oct06
Jun07
Feb
08
Oct08
Jun09
Fundinggap,Rbn
Source: SARB, IMF, UNCTAD, Legae Calculations
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High household debt levels and low savings should be a negative
to the long-term system liquidity.
Fig 30: Debt/ disposable income rose steeply in CY03; RSA households have one of the w orst savings
culture as indicated by the savings/ GDP ratio
30.0
40.0
50.0
60.0
70.0
80.0
90.0
1980/01
1982/03
1985/01
1987/03
1990/01
1992/03
1995/01
1997/03
2000/01
2002/03
2005/01
2007/03
Debt/disposableincome
0%
10%
20%
30%
40%
50%
60%
China India Japan Europe Australia USA RSA
Savings/GDPratio
Source: SARB, IMF, Legae Calculations
The system primarily depends on wholesale funding. However,
more deposits are taking longer tenors.
Fig 31: Wholesale deposits constitute 47% of the system loan book; 21.6% of the deposits are long
term
13.9% 11.7% 12.9% 14.2% 16.3% 17.6% 20.2% 20.6%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2002 2003 2004 2005 2006 2007 2008 2009Otherdemandd ep . S av in gs S ho rtt er m M ed iu mte rm L ongterm
47%
28%
18%
3%3%
2%
Wholesaledeposists
Commercialdeposits
Householddeposits
Localcapitalmarkets
Foreignfunding
Other
Source: SARB, Legae Calculations
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The mortgage industry constitutes the highest exposure
Fig 32: Mortgage loans make up 44.5% of the industry loan book
33.6%37.7% 39.8% 40.3% 41.4%
41.9% 44.5%
1.8%2.0%
2.4% 2.6% 2.7%2.5%
2.5%27.1%
25.9% 23.0% 22.7%23.0% 24.5%
24.5%
37.5% 34.5% 34.9% 34.4%32.9% 31.1%
28.5%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2003 2004 2005 2006 2007 2008 2009
Mortgage loan s C re ditcardsd eb to rs o ve rd ra ft s o th er
26%
29%
34%
39%
43% 42% 43%
25%
29%30%
25%
14%
3%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2003 2004 2005 2006 2007 2008 2009
Mortgage loans/GDP
Mortgage loangrowth
Source: SARB, Legae Calculations
Credit risks went up materially in CY08 as the system came
under acute stress due to the recession
Fig 33: Overdue accounts/ loans is above long-term average
0
20
40
60
80
100
120
140
160
2004 2005 2006 2007 2008 2009
Overdueamounts,
Rbn
1.8%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Mar04
Jun
04
Sep
04
Dec
04
Mar05
Jun
05
Sep
05
Dec
05
Mar06
Jun
06
Sep
06
Dec
06
Mar07
Jun
07
Sep
07
Dec
07
Mar08
Jun
08
Sep
08
Dec
08
overdueacc/advances
average
Source: SARB, Legae Calculations
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Rising NPLs w ere more of a global phenomenon in CY09...
Fig 34: ROEs tumbled in CY08, triggered by heavy credit costs. Only China managed to registered
slowing NPL/ Loans ratio in CY09
15%
10%
5%
0%
5%
10%
15%
20%
25%
30%
35%
2004 2005 2006 2007 2008 2009
ROE
UK USA Russia Brazil India RSA
0%
2%
4%
6%
8%
10%
12%
14%
UK USA Russia Brazil China India RSA
NPL/Loansratio2004
2005
2006
2007
2008
2009
Source: IMF, Global Financial Stability Report April 2010
...South Africas banking system credit risks were manageable
despite the spike in NP Ls...
Fig 35: NPLs/ Loans ratio for RSA was greater than most DM and major EMs like Brazil, China and
India
0%
2%
4%
6%
8%
10%
12%
14%
16%
Australia
China
India
Argentina
UK
Mexico
Indonesia
Malaysia
Brazil
Chile
Spain
USA
RSA
Turkey
Nigeria
Poland
Greece
Russia
Egypt
Nonperformingloans/totalloans,2009
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
UK
Greece
Poland
USA
Spain
RSA
Australia
Turkey
Malaysia
Egypt
Russia
Argenti
Indonesia
China
Brazil
Mexico
Chile
Provisions/NPL,2009
Source: IMF, Global Financial Stability Report April 2010
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...and the system remained w ell capitalised in our opinion.
Fig 36: Capital is adequate in our view , but proposal by Basel II if implemented could require more
capital for banks
50,000
80,000
110,000
140,000
170,000
200,000
230,000
2003 2004 2005 2006 2007 2008 2009
Totalsystemcapital,Rmn
12.812.2
12.7 12.7 12.6
18.0
15.0
0
2
4
6
8
10
12
14
16
18
20
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
2003 2004 2005 2006 2007 2008 2009
capital/total loans
capital/total assets
leverageratio,RHS
Source: SARB, Legae Calculations
Relatively stronger profitabi lity and capital levels is a positive for
the local system
Fig 37: RSA banks ROE fares well despite a 10pp decline in CY09. Most banking systems are well
capitalised, after recapitalisation in some markets, especially the DM
5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
UK
US
A
Ru