June 3, 2010 Equity Report

INITIATION AFRICAN BANK INV. LTD

HOLD
Non-retail deposits taking strategy
clouds longterm growth outlook
Company Information
We initiate coverage on African Bank Investments Limited (ABIL)
Bloomberg ticker ABL SJ
with a HOLD recommendation. In section 1 of this report, we
Current price 31.9
FY11 Price Target 30.1 provide a company analysis, being a historical performance
Market Cap, Rbn 25.9 analysis, our forecasts as well as our valuation. We also provide
Shares outstanding,mn 804
our opinion on corporate governance and other ESG issues. In
Potential capital gain (loss) ‐6%
52 Week High,R 37.2 section 2 (Appendix 1) we provide a comparison between ABIL’s
52 Week Low,R 25.6 banking operations and Capitec Bank (Capitec). (we initiated
YTD return 9.8% coverage on Capitec in April; see Capitec Bank: Valuation looks
steep but growth outlook is the differentiating factor, dated April
Historical growth rates 19, 2010.) We look at earnings momentum given the balance
2006 2007 2008 2009 CAGR sheets structures, deposit mobilisation strategies, liquidity and
Gross margin on retail n/a n/a n/m 36% n/m
Interest on advances
Net assurance income
8%
19%
4%
75%
38%
176%
27%
2%
19%
55%
credit risks. We also provide a comparison of valuation metrics
Non‐interest income
Charge of doubtful debts
63%
24%
59%
36%
150%
126%
27%
35%
69%
51%
and our conclusion (on an exclusive basis, we prefer Capitec due
to our higher potential total return forecast). Lastly, in section 3
Interest expense ‐5% 37% 106% 54% 42%
Operating expense 10% 4% 242% 23% 48%
Profit before tax 17% 16% 17% 12% 16%

Net advances 15% 44% 88% 25% 40%

(Appendix 2) we provide a snapshot of the banking industry
Short‐term funding
Bonds and LT loans
‐29%
30%
81%
68%
318%
46%
‐8%
42%
49%
46% structure. We look at the levels of penetration, concentration and
Subordinated loans and bonds 3% 51% 68% 300% 79%
Total Equity 3% 10% 319% 2% 48% 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
Returns vs. Banks & ALS Indices - regulatory risk.
ABIL ALSI Banks Index While we liked the ABIL story, and the Group is still a proxy for
YTD 9.8% -1.0% 7.8%
3 months -4.9% -1.6% 0.2%
investing in banks with material exposure to the low-income
12 months 21.7% 15.2% 34.0% segment, we are concerned by:
7
ABIL
6 Banks Index
ALSI
ƒ the non-deposit taking strategy whose negatives outweigh
5
the benefits, in our view. Major among others is the
4
3
constraint to loan growth, limited ability to expand margins
2 through changes to the liability mix and inability to
1 supplement income from liability-related products.
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ƒ the modest historical earnings growth, exacerbated by low
2 3 3 4 5 5 6 6 7 8 8 9 9 0 earnings 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.

Peter Mushangwe Valuation: Our valuation model indicates a FY11 price target of
Puleng Kgosimore R30.1. We use the Sum-Of-The-Parts (SOTP) method that
+27 11 551 3675 allowed us to separately value African Bank and Ellerines. We
peterm@legae.co.za
valued African bank at R16.5bn and Ellerines at R7.6bn, giving a
Group per share value of R30.1. HOLD.
Please refer to the back of this report to
view our disclaimer and disclosure
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 with Capitec 37

2.1 Big vs. Small: We favour the micro-banks 37

2.2 Which bank to play? 37

3. Appendix 2: A snapshot of the industry 41

3.1 Industry structure and developments 41

3.2 ‘Basel III’ and Regulatory risks 50

Page 1 of 56
The Executive Summary.

ƒ Initiating coverage with a HOLD, our FY11 price target is

R30.1: We initiate coverage on ABIL [Bloomberg ABL SJ] with a
HOLD recommendation. In our opinion the Group does not provide
an appealing risk-return profile at the current price. The Group’s
Return on Equity (ROE) has reduced significantly, and although
leverage could amplify it, we are sceptical given the negative
impact leverage could have on interest spreads due to the
wholesale funding strategy. Management indicated that leverage
will average 6X, and ROE will be driven by ROA expansion. We
doubt the sustainability of high ROA at a target of 8% given 1) the
migration to low risk client base; 2) competition; 3) natural
convergence with the mainstream banks; and 4) low coverage
ratios relative to history. (at Group level).
ƒ Using the SOTP valuation, we obtain a FY11 fair value of R24.2bn
(R30.1 per share) being a sum of R16.5bn for African bank and
R7.6bn for Ellerines. Overall, we believe that ABIL is not well
positioned to build up earnings above industry average by a
material margin. Loans growth will be constrained by funding risks,
and non-retail deposit taking strategy holds back fee income
growth to an extent as the liability-side do not provide such
income. Our secondary method indicates a price that is in line with
current price at R32.2. Sensitivity analysis to our valuation
indicates no “easy upside”.
ƒ What we like about ABIL: We like 1) the 100% exposure (on
the asset-side) to the high-margins, low income segment which
shows better profit sustainability given the lower penetration and
higher Net Interest margins (NIMs). As a leading bank in this
segment, we believe there should still be some pricing power,
especially on higher risk products. ABIL is a proxy for investing in
banks with exposure to the low income segment, especially given
its higher market capitalisation (vs. Capitec). 2) the high dividend

Page 2 of 56
 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)
management’s 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.
ƒ 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 ratio
is 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

Page 3 of 56
 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.
ƒ African bank: CAMEL ratios mixed, liquidity ratios point to
the weakness 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 Capitec’s 27%.
ƒ Ellerines: Issues impairing 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 we
believe 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

Page 4 of 56
 ‘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.
ƒ 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.
ƒ Industry loan growth face significant risks: In addition to the
Basel Committee’s 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 natural
growth 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.
ƒ 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 investors
should 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.

Page 5 of 56
1. Initiation of coverage

1.1 Initiating coverage with a HOLD, FY11 price target is

R30.1; potential total return 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 (ROE–g)/CoE–g) 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

Page 6 of 56
 sustainable ROE of 27.5%, (for African bank) which is about 10pp above
the CoE. Theoretically, the ROE is expected to migrate towards the CoE
in the long-term; and 3) we use a sustainable growth rate of 9.5% for
the Ellerines business. A stronger recovery in this business segment in
the short- to medium-term could result in higher valuation assigned to
the business than we forecast.

Recent share price performance and valuation risks

Unlike Capitec, ABIL’s recent share price performance has been more
modest. The PER is close to the ALSI and Banks Index PERs. Although
above its average PER (from CY02), the share price shows
underperformance against the ALSI and Banks Index on a 12-month
basis. On a YTD basis ABIL’s capital gain is 9.8% versus the ALSI’s and
Banks Index’s -1.0% and 7.8% respectively. On a 12-month basis, ABIL
share price has gone up by 21.7%%, which is 12.3pp below the Bank
Index’s return of 34.0%. In our opinion, this underperformance could be
a catalyst for a price recovery in the short-term. (see Fig 1 and Fig 2)

Fig 1: ABIL is trading slightly above its average PER since Oct. 02
18
20

18 16

16 14

14 12 12.9
12 10 10.8
10
8
8 PER
Abil 6
6 Average
Banks Index
ALSI 4
4
2
2

0 0
2002/10
2003/03
2003/08
2004/01
2004/06
2004/11
2005/04
2005/09
2006/02
2006/07
2006/12
2007/05
2007/10
2008/03
2008/08
2009/01
2009/06
2009/11
2010/04
2002/10
2003/03
2003/08
2004/01
2004/06
2004/11
2005/04
2005/09
2006/02
2006/07
2006/12
2007/05
2007/10
2008/03
2008/08
2009/01
2009/06
2009/11
2010/04

Source: I-Net, Legae Securities

Page 7 of 56
Fig 2: Share price performance in the recent past has been in line with the market
despite a strong out –performance when indexed to Oct. 02

7
ABIL
Banks Index
6
ALSI 12 Months
5 21.7%

4
Banks Index
3 3 Months
ALSI
‐4.9%
2 ABIL

1
YTD
0 10%
10/02
04/03
10/03
04/04
10/04
04/05
10/05
04/06
10/06
04/07
10/07
04/08
10/08
04/09
10/09
04/10
‐10% 0% 10% 20% 30% 40%

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
12 120% 250
Abil
Capitec
10 ALSI 100%
Banks Index 200

8 80%
150

6 60%

100
40%
4

50
20%
2

0% 0
0
2003 2004 2005 2006 2007 2008 2009
09‐02
02‐03
07‐03
12‐03
05‐04
10‐04
03‐05
08‐05
01‐06
06‐06
11‐06
04‐07
09‐07
02‐08
07‐08
12‐08
05‐09
10‐09
03‐10

Dividends,RHS Payout ratio

Source: I-Net, Legae Securities

Page 8 of 56
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 Group’s 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.

ABIL’s 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.

Page 9 of 56
1.2 ABIL 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

Gross margin on retail n/a n/a n/m 36% n/m
Interest on advances 8% 4% 38% 27% 19%
Net assurance income 19% 75% 176% 2% 55%
Non‐interest income 63% 59% 150% 27% 69%
Charge of doubtful debts 24% 36% 126% 35% 51%
Interest expense ‐5% 37% 106% 54% 42%
Operating expense 10% 4% 242% 23% 48%
Profit before tax 17% 16% 17% 12% 16%

Net advances 15% 44% 88% 25% 40%

Short‐term funding ‐29% 81% 318% ‐8% 49%
Bonds and LT loans 30% 68% 46% 42% 46%
Subordinated loans and bonds 3% 51% 68% 300% 79%
Total Equity 3% 10% 319% 2% 48%

Source: Company reports, Legae Calculations

The key issues to note about ABIL’s historical performances are:

ƒ 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.

Page 10 of 56
ƒ 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;
ƒ 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.
ƒ 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 funding
was 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;
ƒ Net advances growth rate declined significantly in FY09 from 88%
for FY08 to 25%. The CAGR of advances is 40% (05-09) which is
2.2X 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

Page 11 of 56
ƒ While the advances growth was strong (CAGR = 40%), the
declining ROA resulted in significantly low earnings growth. Net
profit went up by a CAGR of 16%.

How will the growth be funded? This is our primary concern with the
Group – the non-retail deposits taking strategy. Assets and liabilities of
a bank are linked financial products, but ABIL can only sell asset
products. We debated as to whether we should analyse the bank within
the confines of its stated strategy or not. Because the bank is not
completely a ‘wholesale bank’ as it lends to the retail segment, we
thought it is important to highlight this mismatch. We have failed to
reconcile how the Group will flexibly fund its loan book, as that would
always depend on their ability to raise funding through bond issuance,
its treasury operations and other institutional funding arrangements.

We do not doubt the capability of the management to implement this

strategy, and to a large extent we buy management’s view that this
strategy allows them to manage the balance sheet (ALM) and liquidity
better as well as reducing costs related to deposit taking infrastructure.
Funding sources are being diversified. There are initiatives to tap into
off-shore markets. Management has also established relationships with
financiers, and has built a strong brand (to lenders). We do not believe
“taps will be closed” and we underscore that to date the Group has not
faced funding-related problems. We, however, believe that the strategy
will constrain the loan book growth, and limit opportunities on non-
interest income on the liability side of the balance sheet. Of importance
in raising funding will be the non-breach of current and subsequent loan
covenants. The LDR (using all funding liabilities) is already high at 96%
(1H10). Despite an increase in rand-terms to R5.1bn (for 1H10), cash
and short-term deposits/total assets ratio is only 13.4%. This limits the
bank’s ability to sell-down its liquid assets and grow loans. In addition,
the bank cannot easily increase its LDR without compromising its
liquidity position and its credit rating. In our view, the Group’s balance
sheet is not flexible enough to exploit opportunities.

Page 12 of 56
Fig 5: Liquidity ratios continue to worsen, and is lowest in 5½ years

2005 2006 2007 2008 2009 2010F 1H

Liquid assets/Total Assets 22.8% 21.1% 22.4% 14.9% 14.2% 13.4%
Liquid assets/Funding liabilities 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
ABIL’s 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.

Page 13 of 56
Fig 6: Funding composition, LT loans and bonds dominate the funding liabilities

2009 2% 1% 2008
6% 4% 2%
11%
13%

6%

42%
35%

45%
32%

Demand Fixed and notice NCDs Listed snr LT loans Subordinates

Demand Fixed and notice NCDs Listed snr LT loans 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.

Page 14 of 56
Fig 7: Short-term maturities do not look excessive, but LDR is high already

Cummulative maturities  within the next 3 yrs is R7.2bn 1.7 The LDR declined but is still >1, cost of funds responded to the 

liquidity crunch  (2008‐2009) 
15%
‐
1.5
<12 Months <3yrs >3yrs
‐2,000 
13%
1.3
‐4,000 

11%
‐6,000  1.1

‐8,000  9%
0.9
‐10,000 
LDR (LHS)
0.7 cost of funding 7%
‐12,000 

‐14,000  0.5 5%
2002 2003 2004 2005 2006 2007 2008 2009
‐16,000 

Source: Company reports, Legae Securities

Credit risks are high, well managed, although ratios are

gravitating upwards: The bank’s higher exposure is exclusive to
retails loans. This is a deliberate position given the bank’s 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:
ƒ Retail loans constitute 65%, a 2pp increase from 63% in CY08;
ƒ The credit card exposure make up 7.6% of the loan book, about
2pp rise from 5.4% in CY08; and
ƒ The mining industry exposure declined in CY09 to 4.7% from 5.1%
in CY08. (see Fig 8)
ƒ 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

Page 15 of 56
 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

2009 2008

20.1%
23.9%

0.2%

4.7%
0.0%
5.1%
7.6%
64.8% 5.4% 62.8%

2.5%
2.8%

Retail Payroll Credit card Mining EHL retail EHL group Retail Payroll Credit card Mining EHL retail EHL group

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 bank’s lending rates is not very
responsive to changes in the policy rate, (charges are more influenced
by the client’s 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 system’s, 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.

Page 16 of 56
 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 FY09 compared to FY08...

2005 2006 2007 2008 2009 CAGR

Gross advances 6,454 7,727 10,890 20,908 26,181 41.9%
Growth rate 19.7% 40.9% 92.0% 25.2%
Total impairment provisions 1,117 1,435 1,892 4,376 5,661 50.0%
Growth rate 28.5% 31.8% 131.3% 29.4%
Total NPLs 1,642 2,213 3,004 6,239 9,253 54.1%
Growth rate 34.8% 35.7% 107.7% 48.3%
Impairment/Gross loans 17.3% 18.6% 17.4% 20.9% 21.6%
NPLs/Gross loans 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 bank’s 34%. Since
provision are meant to be forward looking (i.e. based on management’s
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 bank’s platform e.g. scorecard.

Page 17 of 56
Fig 10: ...and Ellerines carries higher credit risks

45% 75% 45% 25,000 

20,994 
40% 41%
40% 20,000 
35% 70%
35%
34% 15,000 
30%
65% 30%
25% 10,000 
25% 5,153 
20%
60% 5,000 
20%
15%
‐
10% NPLs/Gross loans 15%
55%
Provisions/Gross loans  ‐2,095 
5% 10% ‐5,000 
Provisions/NPLs (coverage ratio)
0% 50% ‐7,158 
5% ‐10,000 
2002 2003 2004 2005 2006 2007 2008 2009 ABIL Ellerines
Advances (RHS) Provisions (RHS) NPLs/Advances

Source: Company reports, Legae Securities

Revenue and profitability analysis

The major contributor to the group’s 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 Group’s 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:

ƒ African bank is integral to the Group’s revenue growth as interest

income constitute 47% of the revenue and 78% of the Group’s
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);
ƒ Non-interest income make up 19% of the Group’s revenue, (FY09
vs. 34% [fee and commission] for the industry), and African bank
contributes 72% of it. Assurance income represents 18% of the

Page 18 of 56
 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;
ƒ Gross margin on retail sales makes up 15% of the Group’s
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 ABIL has the higher contribution

2009 100%
90% 22%
15% 29%
19% 80% 40%
70%
60%
50%
40% 78%
18% 71%
30% 60%
20%
47% 10%
0%
Interest Assurance Non‐interest
Margin on retail Interest on advances Net assurance Non‐interest ABIL Ellerine

Source: Company reports, Legae Securities

“Jaw” are not widening fast enough, in our opinion: The Group’s
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.

Page 19 of 56
Fig 12: The “JAWS” are not widening fast enough. Interest expense has grown at 2X interest
income

10,000  4.5
Risk adjusted income CAGR =33%  Interest income CAGR = 42.4%
Operating cost 4.0 Interest expense
8,000  NII
3.5

3.0
6,000 
2.5
CAGR = 48% 
CAGR =20.3%
4,000  2.0

1.5
CAGR =12.8%
2,000  1.0

0.5
‐
0.0
2005 2006 2007 2008 2009
2005 2006 2007 2008 2009

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 bank
carries 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 Group’s
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):

Page 20 of 56
ƒ Ellerienes is not leveraged enough. FY09 leverage is only 1.8X.
This negatively affect the Group’s ROE, whose leverage ratio for
FY09 is only 2.7X;
ƒ 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
Group’s ROE in the short-term.
ƒ 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 not
supporting ROE.

% of total assets 2005 2006 2007 2008 2009

Total revenue 46.3% 47.1% 38.7% 32.0% 33.7%
Charge for doubtful advances ‐6.7% ‐7.4% ‐7.0% ‐6.3% ‐7.3%
Other interest income 2.1% 1.4% 1.4% 1.2% 1.1%
Interest expense ‐6.7% ‐5.7% ‐5.4% ‐4.5% ‐5.9%
Operating costs ‐13.0% ‐12.8% ‐9.3% ‐12.7% ‐13.4%
BEE charge 0.0% 0.0% 0.0% ‐1.0% 0.0%
Indirect tax ‐0.7% ‐0.6% ‐0.3% ‐0.2% ‐0.1%
Capital items 0.0% 0.5% 0.0% 0.0% 0.0%
Associate income 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

Page 21 of 56
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:

ƒ The bank’s leverage ratio has increased from 3.4X in CY 05 to 6.8X

in CY09. In our forecast we increase the leverage ratio beyond
management’s guidance. Our view is that ROE will be boosted
more by leverage than ROA given issues we highlighted already.
ƒ 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;
ƒ 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.
ƒ 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.
ƒ Non-interest income/operating income ratio developed from 9% in
FY05 to 30% in FY09. As we mentioned elsewhere, non-interest

Page 22 of 56
 income contribution to operating income will be suppressed by the
asset-led approach; and
ƒ 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:Total assets/Total equity 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/Income ratio 33% 31% 28% 26% 25% 29% 31% 30%
M:Budern ratio 17% 18% 15% 14% 13% 11% 12% 11%
E:NIM 33% 32% 22% 13% 11% 9% 9% 8%
E:Non‐int. 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
Impairment provision         1,117        1,425         1,892        2,867         4,239
Gross advances         6,454        7,727       10,890      16,042       20,224
NPLs/Gross advances 25% 29% 28% 28% 32%
Provision/Gross advances 17% 18% 17% 18% 21%
Coverage ratio: Impairment/NPLs 68% 64% 63% 64% 66%

Source: Company reports, Legae Securities

Page 23 of 56
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
bank’s 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 management’s target) is an

uphill task, in our opinion. 1) African bank’s ROA is on the top end
against the industry and its peers (Capitec’s 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. Management’s target leverage ratio is 6X. The unsecured
personal 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.

Page 24 of 56
 Fig 16: ROE decomposition. We expect ROE to downtrend on ROA

2005 2006 2007 2008 2009 2010F 2011F 2012F

Asset yields: Revenue/Total assets 46% 47% 39% 33% 31% 25% 28% 26%
Margin: Net Income/Revenue 27% 30% 29% 25% 22% 20% 19% 20%
ROA 13% 14% 11% 8% 7% 5% 5% 5%
Leverage: Total assets/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
45% 9.0 ROE 70%
Asset yields ROA
40% Funding cost Leverage (LHS)
8.0
Interest spread 60%
35% 7.0
50%
30% 30% 30% 6.0

25% 5.0 52% 40%

54%
56%
43%
20% 21% 4.0
46% 30%
42% 41%
3.0 39%
15%
13% 12% 20%
10% 2.0
10% 10% 9%
10%
1.0 14%
5% 13% 11% 8% 7% 5%
5% 5%
0.0 0%
0%
2005 2006 2007 2008 2009 2010F 2011F 2012F
2005 2006 2007 2008 2009 2010F 2011F 2012F

Source: Company reports, Legae Securities

Page 25 of 56
 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:

ƒ 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;
ƒ 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;
ƒ increased the expense/advances ratio to 11% as we anticipate
interest rates rebounding within our forecasting period.
ƒ 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 2012F

Interest income/Advances 49.1% 49.0% 35.4% 25.2% 25.3% 23.2% 23.0% 22.5%
Net assurance income/Advances 6.8% 7.0% 8.5% 9.0% 7.4% 4.9% 6.0% 5.0%
Non‐interest income/Advances 5.2% 7.4% 8.1% 9.4% 9.5% 8.1% 8.0% 8.0%
Charge of doubtful debts/Advances ‐9.2% ‐10.0% ‐9.4% ‐10.3% ‐11.5% ‐11.2% ‐10.0% ‐9.5%
Intra‐group assets yield 0.0% 0.0% 0.0% 0.0% 0.0% 25.0% 25.0% 25.0%
Other interest income/Cash and stat 9.4% 6.6% 6.5% 8.9% 7.9% 0.0% 6.0% 7.5%
Interest  and op.expense assumptions
Interest expense/Funding liabilities ‐12.0% ‐9.6% ‐7.7% ‐8.2% ‐9.8% ‐8.9% ‐11.0% ‐11.0%
Operating expenses/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%
Growth rates, funding forecasting
Short term funding ‐29.4% 80.8% 271.2% ‐43.3% 1.1% 10.0% 20.0%
Bonds and other long‐term funding 29.5% 68.2% 45.4% 42.4% 45.3% 25.0% 15.0%
Subordinated bonds 2.5% 51.0% 67.5% 300.0% 40.6% 30.0% 30.0%
LDR (net loans/funding liabilities) 129% 125% 107% 95% 91% 87% 88% 87%

Source: Company reports, Legae Securities

Page 26 of 56
Fig 19: Earnings model, Rmn

2005 2006 2007 2008 2009 2010F 2011F 2012F

Interest income on advances         2,752        2,974         3,098        3,323         4,245        4,764        6,540         7,402
Net assurance income            357            424             742        1,191         1,243        1,104        1,706         1,645
Non‐Interest income            274            446             707        1,244         1,591        1,835        2,275         2,632
Total revenue         3,383        3,844         4,547        5,758         7,079        7,703      10,521      11,679
Charge for bad and doubtful advanc           ‐488          ‐606           ‐823       ‐1,361        ‐1,929      ‐2,391       ‐2,669       ‐2,916
Risk adjusted revenue         2,895        3,238         3,724        4,397         5,150        5,312        7,852         8,763
Other interest income            156            113             170            261             328            480            280            436
Intra‐group income             ‐             ‐             ‐             ‐              ‐            410            472            542
Interest expense           ‐492          ‐465           ‐636       ‐1,136        ‐1,816      ‐2,308       ‐3,555       ‐4,160
Operating costs           ‐951       ‐1,048       ‐1,091       ‐1,209        ‐1,330      ‐1,562       ‐2,159       ‐2,278
BEE charge             ‐             ‐             ‐             ‐              ‐            ‐             ‐             ‐
Indirect tax: VAT             ‐50             ‐46             ‐38             ‐54              ‐18            ‐24             ‐             ‐
Profit from operations         1,558        1,792         2,129        2,259         2,314        2,308        2,890         3,304
Profit on sale CVF and other items             ‐              37             ‐             ‐              ‐              15             ‐             ‐
Profit before taxation         1,558        1,829         2,129        2,259         2,314        2,323        2,890         3,304
Direct taxation: STC             ‐          ‐118           ‐138          ‐132              ‐86          ‐104             ‐             ‐
Direct taxation: SA normal           ‐616          ‐535           ‐616          ‐636           ‐651          ‐608          ‐809           ‐925
Profit for the year            942        1,176         1,375        1,491         1,577        1,611        2,081         2,379
Preference shareholders             ‐28             ‐36             ‐41             ‐49              ‐52            ‐53             ‐69             ‐78
Ordinary shareholders            914        1,140         1,334        1,442         1,525        1,558        2,012         2,300

Source: Company reports, Legae Securities

Page 27 of 56
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

Page 28 of 56
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:

ƒ 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.
ƒ 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

Page 29 of 56
ƒ 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. Management’s return on sales
target is 10%.
...but execution risk remains high in the retail segment;
management’s 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.

Ellerines Group 2008 2009 2010F 2011F 2012F

Sale of merchandise            3,092          4,196          5,245          6,556             7,868
Cost of sales           ‐1,779        ‐2,405         ‐2,963         ‐3,737           ‐4,524
Gross profit            1,313          1,791          2,282          2,819             3,344
Gross margin 42.5% 42.7% 43.5% 43.0% 42.5%
Growth of gross profit 36.4% 27.4% 23.6% 18.6%
Interest income on advances                962          1,192          1,185          1,503             1,824
Net Assurance Income                854              838              647              974             1,170
Non‐interest income                524              660              665              849             1,033
Income from operations            3,653          4,481          4,779          6,145             7,371
Operating income growth 23% 7% 29% 20%
Charge for doubtful debts              ‐495            ‐582            ‐603            ‐724               ‐861
Charge of doubtful debts growth 18% 4% 20% 19%
Risk adjusted income            3,158          3,899          4,175          5,421             6,511
Other interest and inv. Income                  84                78                96              123                 150
Interest expense              ‐180            ‐248            ‐351            ‐562               ‐744
Operating costs           ‐2,536        ‐3,246         ‐3,316         ‐3,791           ‐4,558
Indirect Taxation                   ‐2              ‐               ‐               ‐                 ‐
Profit from operations                524              483              604          1,190             1,359
Operating profit margin 14% 11% 13% 19% 18%
Operating profit growth ‐8% 25% 97% 14%
Capital Items                 ‐                 ‐7               ‐               ‐                 ‐
Profit before tax                524              476              604          1,190             1,359
Taxation              ‐164            ‐198            ‐171            ‐337               ‐385
Profit after tax                360              278              433              853                 974
Net profit margin 10% 6% 9% 14% 13%

Source: Company reports, Legae Securities

Page 30 of 56
1.5 Valuation: We prefer The SOTP method

We value the different business segments with valuation methodologies

we believe to bring about better valuations. We use the Fundamental
PBVR method for African bank, and the Fundamental PER for the
Ellerines business segment. We then obtain the sum of the two
segments to estimate our FY11 price target. Below we explain the main
valuation assumptions.

Cost of Equity (CoE): We apply different discount rates for the two
business segments. We believe the two segments provide different risk
profiles, with the Ellerines business being more responsive to macro
environment than African bank. We use the R208 as the proxy for a
long-term risk free rate. (8.7% at the time of writing). We apply an
equity risk premium of 6% and a company specific risk premium of
1.75%, getting a CoE of 16.5% for African bank. We add an arbitrary
1% for the Ellerines business to reflect our assumption of higher risks.

Sustainable growth rates: We use a long term growth rate of 9.5%

for Ellerines. We make use of the upper range of the SARB’s 3%-6%
inflation target and an average real GDP growth rate of 3.5%. For
African bank, we believe the industry has stronger growth opportunities
and apply a sustainable growth rate of 12%.

Sustainable ROE: We believe the ROE will move towards the CoE in
the long-term. We have assumed African bank’s ROE will decline to 39%
in FY10, and we have used a sustainable ROE of 27.5%.

Dividend payout ratio: For our Fundamental PER calculation, we

employ a payout ratio of 65%. This is guided by the 1.5X dividend cover
target.

Our FY11 price target shows zero potential return; we

recommend a HOLD: Our model indicates a FY11 price target of 30.1.
(see Fig 21). The potential capital loss is 5.7% and our forecast dividend
yield is 5.7%. Potential total return is 0.0%. We recommend a HOLD.

Page 31 of 56
Fig 21: Valuation model

African Bank Valuation
Sustainable ROE 27.5%
CoE 16.5%
Sustainable growth rate 12%

ROE less  growth rate 16%

CoE less  growth rate 4%
Fair value PBVR,X             3.5
FY11 Book value,Rmn         4,749
FY11 Target value,Rmn      16,541
We increased 
Ellerines  Valuation Ellerines' CoE due to 
Target payout ratio its higher risk profile 65%
Sustainable growth rate 9.5%
CoE 17.5%
CoE less  growth 7.95%
Justified PER 9.0
FY11 Earnings,Rmn 853.5
FY11 target value,Rmn     7,640.9
FY10 target value (Group),Rmn        24,182
Number of shares, mn              804
FY11 Target price, R The sum of              30.1
Ellerines and 
Current price,R African Bank
            31.9
Forecast div. yield 5.7%
Potential total return 0.0%

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 we
use 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)

Page 32 of 56
Fig 22: Long-term average PER indicates fair valuation at best.

Ellerines Valuation African Bank Valuation
Banks Index Average PER (00‐date) 10.3 Banks Index average PER 10.3
Discount  15% Discount 12%
Fair PER for Ellerines financial services 8.8 Fair PER for African Bank 9.1
FY11 Earnings                427 FY11 Earnings             2,012
FY11 Value for Ellerines Financials            3,743 FY11 Value for African Bank           18,237

General Retailers Average PER (00‐date) 11.6 The Group Valuation

Discount 20% Ellerines Valuation (FY11)             7,691
Fair PER 9.3 African Bank Valuation (FY11)           18,237
FY11 Earnings for Ellerines retail                426 Group Valuation           25,928
FY11 Value for Ellerines Retail            3,949 Number of shares 804
Total Value for Ellerines            7,691 Price Target FY11               32.2
Current Price 31.9
Potential total 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 bank’s
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%.

Page 33 of 56
 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

Positive 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:

ƒ 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.
ƒ 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

Page 34 of 56
 has unlimited access to external auditors, management, and
compliance.
ƒ 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
(PDIs). The business has a positive impact to society despite the
high interest rates.

Environmental issues:

ƒ 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;
ƒ 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:

ƒ Generally, ABIL’s 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 Group’s
customers 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

Page 35 of 56
 given the high credit risks), that often leads to the Group’s clients
falling into a debt-trap.
ƒ 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.
ƒ 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;
ƒ 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.

Page 36 of 56
2. Appendix 1: A comparison with
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:

ƒ the targeted sectors enjoy lower penetration and lower debt levels
that should create relatively more lending opportunities;
ƒ the more defensive assets (lower exposure to capital markets)
hence less volatility in earnings when compared to the mainstream
banks;
ƒ the recent improvements in assets quality in general despite higher
NPLs than the mainstream banks; and
ƒ 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 the

mainstream 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 ABIL’s 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

Page 37 of 56
primarily driven by slowing NPLs at this stage of the NPLs cycle. The key
issues in this comparison are:

ƒ 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).
ƒ 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. AB’s
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.
ƒ 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. Capitec’s impairment/advances ratio is
lower than AB’s at 10% vs. 34% respectively. Both banks have
relatively low coverage ratios. The coverage ratio for both banks
worsened in FY09.
ƒ Efficiency and non-interest income growth: The cost/income
ratio for Capitec has improved materially to 54% from 73% in
FY05. We calculate AB’s cost/income ratio at 25% for FY09. AB’s

Page 38 of 56
 cost/income ratio is significantly lower than Capitec’s. We,
however, draw attention to the fact that Capitec has managed to
reduce its cost/income ratio by a higher 19pp vs. AB’s 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.
ƒ 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 management’s 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 Capitec’s to go up while AB’s slows down.
ƒ 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).
ƒ 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 AB’s asset-led strategy to change.

Page 39 of 56
 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
We see better room for C apitec to increase its leverage than African bank. However,
Leverage 6.8 6 higher risk weighting could require more capital and inhibit leverage. Risk capital excess
could grow thinner.
Both banks seem content and have a target of around 10%. Deterioration in employment
Impairments/loans 10% 10%
could hurt the ratio
AB enjoys lower cost/income ratio. C apitec has room to improve, target ratio is 40%. After
C ost/income 25% 54%
full integration of Ellerines' financial services, the ratio is likely to increase for AB
AB has a lower NIM, indicative of its wholesale deposit gathering strategy. We expect NIMs
NIM 11% 13%
to continue to narrow for both banks to around 8%
African bank's liquidity looks tighter. C apitec has more room to increase its LDR. AB's LDR
LDR 91% 71% declined to 82 for 1H10

Concentration risk and efficiency indicators

C oncentration risk on the liability side is higher for AB than C apitec, and so would be
10 largest depositors >50% <50%
funding risks
C oncentration risk is negligible. Average loan value: just above R2,000 for C apitec; R7,696
10 largest borrowers n/m n/m for AB
AB has a higher loan/branch, reflecting its leadership in the industry. AB/C apitec ratio is
Loan/branch 47,871 13,030
3.7X
Loan/employee 4,820 1,258 Higher for AB at more than 2X that of C apitec
AB's deposit/branch ratio to C apitec is lower, indicating a lower deposit franchise for AB.
Deposit/branch 52,680 18,355
AB/C apitec ratio is 2.9X (vs. 3.7X on the loan side)
Deposit/employee 7,463 1,772 AB's deposit/employee ratio to C apitec is also lower.

Growth rates (since 05) Note: African Bank (AB) year end is September, Capitec is February. Year-end values were used
C apitec shows strong growth, we are skeptical of AB's given the funding constraints.
Interest income 11% 26.5% Narrowing spreads to affect NII for both banks
AB lags C apitec. Lack of fee-earning products on the liability side has a negative impact.
Non-interest income 55% 210.0% Slowing loan demand to affect fee income. C apitec can roll-out savings and other deposit
related products
Operating costs 9% 28.8% AB has lower cost growth. Branch network growth for C apitec spurred costs growth.
C apitec has managed to grow PBT at a higher rate than AB. Profitability to continue to be
Operating profit 10% 54.4%
high, but lower than recent history
C apitec's retail deposits support loan book growth. Growth should continue to be > AB's.
Loans & Advances 33% 90.6% C apitec 's growth seem natural (i.e. LDR = 71%), but we also like AB's apparent "controlled
growth" nonetheless
AB's funding is constrained by the dependence on the wholesale market. C apitec can roll-
Deposits 46% 101.3%
out an aggressive deposit gathering strategy if need be

ROE decomposition
African bank has a higher ROA. Higher asset yields due to fewer branches. Target is 8% for
ROA 7% 5%
AB which we believe may not be sustainable
C apitec has slightly lower leverage. Better opportunities to increase it than AB but higher
Leverage 7 6
capital requirements for "risky' assets could limit it
ROE 46% 30% We are mildly bullish on C apitec's ROE, but bearish on AB's

Valuation, vs. ABIL (not AB)

PER 12.8 18.2 C apitec'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
ABIL has a higher dividend yield. C apitec's payout ratio is 40%; ABIL >70% although target
Div. yield 6% 4%
is 60%
Price/Deposit 1.21 1.10 On this metric, ABIL is trading at a slight premium to C apitec

Source: Company reports, Bloomberg, Legae Calculations

Note: We used ABIL’s funding liabilities as a proxy for deposits.

Page 40 of 56
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 by
CY09. 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:

ƒ loan growth should recover, but may not revert to the recent past
levels in the short term because of 1) 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.

Page 41 of 56
 ƒ 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 will be muted in the short to medium term.
Fig 25: South Africa GDP growth expected to recover, but we see poor loan growth factors

5.0% Major loan growth factors
Bloomberg consensus Banking assets   =        Banking assets X Capita
4.0% 3.8% Capita
IMF forecasts 3.5%
2.9%
3.0%

2.0%
GDP X Banking Assets X Capita
2.0% Capita GDP

1.0% per capita 
income penetration population
0.0%
2009 2010 2011
‐1.0%

‐2.0% ‐1.8%
‐2.2%
‐3.0%

Source: Bloomberg, IMF, Legae Securities

Page 42 of 56
 The industry is highly penetrated. Loans/GDP and deposits/GDP
is at 96% and 93% respectively.

Fig 26: The system’s penetration rate is higher relative to other EMS.

110% 1.15 
2009
Loans/GDP
Loans/GDP Deposits/GDP
90% Deposits/GDP 1.05 

70% 0.95 

50% 0.85 

30% 0.75 

10% 0.65 

Nigeria Turkey Russia Brazil Chile RSA

‐10% 0.55 
2003 2004 2005 2006 2007 2008 2009

Source: Company reports, Legae Calculations

Industry registered strong growth since CY00, LDR exceed 100%

since CY04.
Fig 27: Negative growth was registered in loans for the first time this decade. LRD remained high

2.50 Lending assets,LHS 60% 1.20

LDR
Deposits,LHS
Loan growth rate
Deposits growth rate 50% 1.10
2.00

40% 1.00

1.50 0.90
30%

0.80
20%
1.00

0.70
10%

0.50
0.60
0%

0.50
0.00 ‐10%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: SARB, Legae Calculations

Page 43 of 56
 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

0.195
90.0%
Big 4 market share H‐Index

87.0% 0.190
0.190 0.189
84.6%
85.0%
83.4%
0.185 0.184 0.184
80.0% 0.182

0.180
75.0%
74.0% 0.175
0.175
70.0% 69.5% 0.170
0.170

65.0%
0.165

60.0%
2001 2002 2003 2004 2005 2006 2007 2008 2009 0.160
2002 2003 2004 2005 2006 2007 2008

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

140%
‐350 Funding gap, Rbn
LDR Average

120%
‐300

100%
‐250

80%
‐200

60%
‐150

40%
‐100

20%
‐50
Feb‐96

Feb‐98

Feb‐00

Feb‐02

Feb‐04

Feb‐06

Feb‐08
Oct‐96

Oct‐98

Oct‐00

Oct‐02

Oct‐04

Oct‐06

Oct‐08
Jun‐95

Jun‐97

Jun‐99

Jun‐01

Jun‐03

Jun‐05

Jun‐07

Jun‐09

0%
0 LATAM CEE RSA Asia ex Japan

Source: SARB, IMF, UNCTAD, Legae Calculations

Page 44 of 56
 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 worst savings
culture as indicated by the savings/GDP ratio

90.0 60%
Debt/disposable income Savings/GDP ratio

80.0 50%

70.0
40%

60.0
30%

50.0
20%

40.0

10%

30.0
1980/01

1982/03

1985/01

1987/03

1990/01

1992/03

1995/01

1997/03

2000/01

2002/03

2005/01

2007/03

0%
China India Japan Europe Australia USA RSA

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

100%
3% 13.9% 11.7% 12.9% 14.2%
3% 90% 16.3% 17.6% 20.2% 20.6%
2%
80%

70%
18%
Wholesale deposists 60%
Commercial deposits
47% 50%
Household deposits
Local capital markets 40%

Foreign funding 30%
Other
20%

10%
28%
0%
2002 2003 2004 2005 2006 2007 2008 2009
Other demand dep. Savings Short‐term Medium‐term Long‐term

Source: SARB, Legae Calculations

Page 45 of 56
 The mortgage industry constitutes the highest exposure
Fig 32: Mortgage loans make up 44.5% of the industry loan book

45%
100%
43% 42% 43%
40% 90%
39%
31.1% 28.5%
34.5% 34.9% 34.4% 32.9%
35% 80% 37.5%
34%
70%
30% 30%
29% 29%
60% 24.5%
25% 26% 25% 23.0% 24.5%
25% 25.9% 23.0% 22.7%
50% 27.1%
2.5%
20% 2.6% 2.7% 2.5%
40% 2.4%
2.0%
1.8%
15% 30%
Mortgage loans/GDP 14%
20% 41.4% 41.9% 44.5%
10% Mortgage loan growth 37.7% 39.8% 40.3%
33.6%
10%
5%
3% 0%
0% 2003 2004 2005 2006 2007 2008 2009
2003 2004 2005 2006 2007 2008 2009 Mortgage loans Credit cards debtors overdrafts other

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

4.0% 160
overdue acc/advances
Overdue amounts, Rbn
3.5% average 140

3.0% 120

2.5% 100

2.0% 1.8% 80

1.5% 60

1.0% 40

0.5% 20

0.0% 0
Dec‐04

Dec‐05

Dec‐06

Dec‐07

Dec‐08
Sep‐04

Sep‐05

Sep‐06

Sep‐07

Sep‐08
Jun‐04

Jun‐05

Jun‐06

Jun‐07

Jun‐08
Mar‐04

Mar‐05

Mar‐06

Mar‐07

Mar‐08

2004 2005 2006 2007 2008 2009

Source: SARB, Legae Calculations

Page 46 of 56
 Rising NPLs were 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

35%
ROE 14%
NPL/Loans ratio
30%
12% 2004
25% 2005
2006
20% 10%
2007
2008
15% 8% 2009

10%
6%
5%
4%
0%
2004 2005 2006 2007 2008 2009
‐5% 2%

‐10% 0%
UK USA Russia Brazil India RSA UK USA Russia Brazil China India RSA
‐15%

Source: IMF, Global Financial Stability Report April 2010

...South Africa’s banking system credit risks were manageable

despite the spike in NPLs...
Fig 35: NPLs/Loans ratio for RSA was greater than most DM and major EMs like Brazil, China and
India

16% 200%
Nonperforming loans/total loans,2009 Provisions/NPL, 2009
180%
14%
160%
12%
140%
10%
120%

8% 100%

80%
6%
60%
4%
40%
2%
20%

0% 0%
Greece
Mexico

Nigeria
China

Indonesia
India
Argentina

Turkey
USA
Australia

Malaysia
Brazil

Russia
Poland
UK

Chile

RSA
Spain

Egypt 

Greece

Mexico
USA

Indonesia
China
Turkey

Argenti…

Chile
RSA
UK

Poland

Spain

Brazil
Australia

Malaysia
Egypt 
Russia

Source: IMF, Global Financial Stability Report April 2010

Page 47 of 56
 ...and the system remained well 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

230,000  14.0% 20
Total system capital, Rmn
18.0  18
12.0%
200,000 
16
15.0 
10.0% 14
170,000  12.8  12.7  12.7  12.6 
12.2  12
8.0%

140,000  10
6.0%
8

110,000  6
4.0% capital/total  loans
capital/total  assets
leverage ratio,RHS 4
80,000  2.0%
2

0.0% 0
50,000 
2003 2004 2005 2006 2007 2008 2009
2003 2004 2005 2006 2007 2008 2009

Source: SARB, Legae Calculations

Relatively stronger profitability 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

Return on Equity, 2009 25%
40%
Capital/RWA,2009

35%
20%
30%

25% 15%

20%

10%
15%

10%
5%
5%

0%
0%
Mexico
USA

Nigeria

Indonesia
India

RSA

Chile

Turkey

Argentina
UK

Poland

Brazil
Russia

Australia

Malaysia

Egypt 

Greece

Mexico

Nigeria
China

Indonesia
India

Argentina
Turkey
USA
Australia

Malaysia
Poland

Brazil

Russia
RSA

Chile
Spain

UK

Egypt 

‐5%

Source: IMF, Global Financial Stability Report April 2010

Page 48 of 56
 Profitability has been strong since CY2004, with ROE jumping to
28.7% in CY08 and declined to 17.5% in CY09...
Fig 38: Profitability has been strong in the recent past

40  35.0% 1.8%

Profits, Rbn
35.00  ROE
35  average  ROE 1.6%
30.0% 28.7%
31.80  ROA, RHS
1.4%
30  CAGR = 19.1%
25.0%
26.38 
1.2%
25 
20.0% 18.3% 18.1% 1.0%
17.5%
20  18.58 
17.42  14.7% 14.5% 0.8%
15.0%

15  10.9% 0.6%

10.0%
10  0.4%
5.6%
5.0%
0.2%
5 

0.0% 0.0%
‐
2002 2003 2004 2005 2006 2007 2008 2009
2004 2005 2006 2007 2008

Source: SARB, Legae Calculations

...and despite a dip in NIM in CY09, stable interest rate spreads

remain stable.
Fig 39: NIM average 3.3% and interest spreads are stable at 3.4%

14.0% interest rate earned
4.5
interest rate paid
interest spread
12.0%
4.0

10.0%
3.5
8.0%
3.3
3.0 NIM
6.0%

2.5
4.0%

2.0 2.0%

1.5 0.0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: SARB, Legae Calculations

Page 49 of 56
3.2 ‘Basel III’ and Regulatory risks

In our view, the international banking system faces immense regulatory

risks, catalysed by the various responses to the 2008-2009 credit crisis.
We admit that there is strong divergence in opinion among regulators,
and the divergence may continue as regulators disagree on what
measures to take in order to ensure non-repetition of the 2008-2009
banking crisis. Countries that came out of the global liquidity crisis in a
better shape are likely to oppose stringent capital and liquidity measures
proposed by those that endured the wrath of more lenient regulation,
mainly the US and European banking systems. Reasons will mainly
hinge on the negative impact on loan growth, and the attendant risks to
GDP growth. It is a Catch-22 for some regulators!

The Basel Committee has already issued guidelines (which we discuss

below) that seek to apply more rigour, transparency and consistency in
banks’ capital, and higher liquidity levels. Needless to say, this provides
headwinds to loan growth, and consequently to banks’ profitability in the
short-term. Again in our view, even these proposals will face strong
divergence in opinion from regulators, especially on impact to economic
growth. Estimates by the Chairman of the Basel Committee on Bank
regulation, Mr Wellink, is that their proposals would reduce global
economic growth by between 0.5% and 1% if implemented. Industry
estimates higher costs (to the global economy) than 1% (refer to FT,
May 3, 2010). The key proposed guidelines are:

ƒ raising the quality, consistency and transparency of the capital

base. In our opinion, raising capital levels is meant to ensure
banks’ ability to absorb losses. The “transparency” part could see
some of the components of capital, particularly Tier 1 and Tier 2
being disqualified as such. By and large, local banks look well
placed due to their high levels of capitalisation. SARB requires a
minimum CAR of 9.5% (150 basis points above Basel II’s
requirement of 8%), and in CY09, the system enjoyed a CAR for

Page 50 of 56
 Tier 1 of 14.1% (13% for FY08) and 11% (10.2% for FY08)
respectively.
ƒ strengthening the risk of coverage of capital framework. This is
meant to minimises “shock transmission” when banks’
counterparties on derivatives and other OTC products face
problems. By strengthening capital requirements for counterparty
credit risk exposure from derivatives, this rule will act as a
disincentive to use of OTC derivatives by banks. The belief is that
exchange traded products have reduced counterparty risks and
therefore lower systemic risks. Risk weighting to OTC derivatives
assets could take higher haircuts in our opinion.
ƒ inclusion of the leverage ratio as a supplementary measure to
Basel II risk-based framework. This will help contain the build up
of excessive leverage in the banking system. To ensure
comparability, the leverage ratio will be harmonised
internationally, fully adjusting for any remaining differences in
accounting. Our view is that there could be a cap on leverage
ratios. Fortunately, we believe that the South African banks are
not excessively leveraged, notwithstanding the increase in this
ratio in the recent past.
ƒ introduction of a series of measures to promote the build up of
capital in good times that can be drawn upon in periods of stress.
A counter cyclical framework will contribute to a more stable
banking system, which will help dampen instead of amplify
economic and financial shocks. In addition, the Committee is
promoting more forward looking provisioning based on expected
losses, which captures actual losses more transparently and is also
less pro-cyclical than the current model. We believe this could
increase provisioning levels in banks.
ƒ Introduction of a global minimum liquidity standard for
internationally active banks that includes a 30-day liquidity
coverage ratio requirement underpinned by a longer term
structural liquidity ratio. In our opinion, banks will be required to
carry more liquid assets on their books, namely government bills

Page 51 of 56
 and bonds. We also believe that there would be a requirement that
the holdings be unencumbered. This will have a drag on NIM and
interest spreads.

The Basel Committee is not a formal supervisory authority. It formulates

broad supervisory standards and guidelines and the individual
supervisory authorities in various countries will implement in a manner
best suited to them. In most cases, statutory instruments are used to
effect implementation.
South Africa implemented Basel II with effect from January 1, 2008. As
at end of CY08, fifteen (15) local registered banks implemented the
Standardised Approach, while one (1) implemented the Foundation
Internal Ratings Based. Three (3) used the Advanced Internal Ratings
based. Key questions for investors would be 1) are the new proposals
likely to be effected? and 2) will they be taken abode by the local
regulators? We believe the answers are a YES to both questions.

The political will by US politicians to ensure that banks carry lower risks
is clear. In Europe, the “threat to democratic institutions existence” that
has been brought about by the “irresponsible behaviour of financial
markets” has strengthened the will to tighten regulation of the financial
markets. The motivation to punish excessive OTC counterparty risk by
banks is also strong in our opinion. Banks that carry higher levels of OTC
derivatives products therefore face the greatest risks. We believe there
might be negotiations on liquidity and capital changes proposed
guidelines as they will have a direct bearing on lending, and consequent
economic growth. We do not expect the guidelines to be dropped, but
they could be revised. The 30-day liquidity cover, for example, would
require banks to hold significant government bonds and other high
quality assets that can be converted to cash to meet the bank’s liquidity
needs for the 30 days horizon under acute liquidity stress scenario. In
our view, banks will carry excessively high levels of liquidity. The
damage to income will be obvious, particularly as the proposal could

Page 52 of 56
lead to stronger demand for government owned papers, further reducing
the yields.

We expect the local regulators to adopt changes and additions to Basel

II (deemed Basel III) in its entirety. While Basel implementation can
vary markedly in different countries and jurisdictions, avoidance of
specific requirements would only give a high risk market perception,
especially to international banks that could provides lines of credit to the
local banks. In other words, employment of Basel III in its entirety
would be expected to positively affect the creditworthiness of local
banks.
We view the impact of Basel III being generally unconstructive to banks’
profitability in the short- to medium-term. However, the proposed
guidelines should strengthen bank balance sheets and reduce cyclicality
in provisions as well as strengthening liquidity positions in the long-
term. In the short term effect to banks are negative:
ƒ Lending: growth will be anaemic, constrained by both regulation
(proposed higher capital and liquidity levels) and some
deleveraging that may take place. Higher capital levels also mean
higher cost of debt, and companies are likely to keep liquidity in
order to avoid borrowing;
ƒ Provisions: should increase due to regulation that could trigger
more conservative approaches to credit risks coverage. Basel
Committee’s Accounting Task Force and the International
Accounting Standards Board has had extensive dialogue on this
issue;
ƒ OTC products exposure: should reduce due to regulation (i.e. it
would require more capital); and
ƒ Investment banking activities: particularly trading of fixed
income and equities could reduce materially due to regulation.

Page 53 of 56
The main issue is how much regulatory risks are priced into the
local stocks? We think the difference performance between the local
bank index and Europe banks as well as EM could provide an insight.
The assumption is that European banks responded to the Basel
proposal, which could be wrong. It is only a superficial screen. We
excluded the US banks that carry a lot of noise given the fact that they
face additional risks to the Volcker rule.

Fig 40: On face value, EM and local banks seem not to have priced in the
risk

MSCI Euro banks MSCI EM banks JSE banks

1Q09 -27% -11% -12%
2Q09 54% 49% 15%
3Q09 39% 25% 11%
4Q09 -7% 7% 8%
1Q10 -7% 3% 11%
Jan 09-date 8% 64% 26%

It is difficult to identify a single cause of

negative returns in 4Q09 and 1Q10, especially
after strong performance in Q309, (i.e. it could
be the famous "profit taking"). We note that it
coincide with the time the debate on Basel
Committee proposals started to gather
momentum (after September and December
follow ups). Prima facie, EM and RSA banks
seem not to be pricing in the risk

Source: Bloomberg, Legae Calculations

Our key idea in response to the impending regulatory changes:

Regulatory uncertainty should create an overhang in weaker banks
valuations in the short-term. We expect banks that are ahead of the
impending and possible regulatory changes to create headroom for
growth and flexibility to adapt to such changes. Banks with 1) higher
CAR, 2) higher liquidity levels, 3) lower leverage levels, 4) profit
visibility and ability to cut dividends and thus build capital; and 5) lower
exposure to OTC products, should trade at a premium in our opinion.

Page 54 of 56
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