ANDREW LAPPING | Allan Gray
Wow, that valuation changed quickly!
A few years ago investors were very excited about investing in Africa outside of South Africa. People spoke of Africa rising, the growing middle class, financial deepening, less reliance on commodities etc. Now the popular refrain is, “How do I get my money out?” The “Get me out” sentiment applies both to corporates that invested in plant and machinery and financial market investors. Andrew Lapping questions this mentality as he discusses where we are finding value in Nigeria.
As you can imagine, the valuations investors put on assets vary widely, depending on whether everyone is desperately trying to buy or rushing for the door. But to what degree do asset prices change? Let’s consider a few Nigerian examples.
Beta Glass is a Nigerian glass bottle business. People generally know how long it takes and what it costs to build a glass bottle facility, so it is a fairly easy asset to value.
In May 2015, private equity company GZI agreed to buy 70% of Beta Glass from its parent company at a price that valued 100% of Beta Glass at US$265m. The deal fell through when GZI could not secure US dollar funding. Move forward to today: the enterprise value for Beta Glass on the Nigerian stock exchange is US$33m. A valuation change from US$265m to US$33m is substantial for an easy-to-value physical asset.
Nestlé Nigeria (NN) is a very well-run business and the blue chip of the Nigerian stock market. At its peak in December 2013, investors valued NN at 40 times historic earnings on the back of vast growth potential: the Nigerian middle class was growing and Nestlé was only selling a handful of its 50 000 products in Nigeria. As retail formalised, investors anticipated that the company would sell more products to more people at higher prices with lower costs. When a business trades on 40 times earnings, investors are looking at least 10 to 15 years into the future and factors such as recessions and currency fluctuations should make almost no difference to the underlying business value. In December 2013 investors thought NN was worth US$6.2bn. Three years later, after a period when the underlying value should have increased as the business reinvested and grew production, investors think NN is worth US$1.6bn. For us, despite the 75% valuation cut, NN now only looks reasonably valued.
Focus on financials
Our area of interest in Nigeria is the financial sector, where the sentiment is truly extreme. The price level and valuation are one measure of sentiment, the very low volumes traded are another, but the best indicator is the incredulous looks on people’s faces when you mention buying Nigerian banks.
Nigeria is a country of 175 million people with a Gross Domestic Product (GDP) supposedly larger than that of South Africa. The potential for Nigerian GDP growth is huge if the Buhari government can get a few things right. The government is focused on reducing corruption, sorting out the electricity supply, growing the non-oil economy and broadening the tax base. Even partial improvements in a few of these areas will have a very positive impact on economic growth.
Nigerian banks: Out of favour
Banks are an important part of any economy and tend to do better in good times rather than bad. The Nigerian banking sector is well developed and far more consolidated than only 10 years ago. The quality of lending and oversight is also vastly improved from pre-2008, where the main business of banks was lending money to management to invest in the stock market. Needless to say that ended badly, with a number of banks going bust and most of the remainder being bailed out to some degree.
Investors dislike Nigerian banks for many reasons. It is not currently possible to get money out of Nigeria. Investors are unlikely to put new money into a country when they have no idea if they will be able to get cash out and at what rate. The naira is marked at NGN307/US$, but the expectation is for the currency to weaken sharply if the government allows a free float. It is possible to get small amounts of money in and out of Nigeria at a rate of NGN410/US$ by buying and selling Seplat Petroleum, which is listed in both Nigeria and the UK. Given the recovering oil production, higher oil price and weak domestic demand, I think a fair rate is probably somewhere between the NGN410/US$ and the official NGN307/US$. The naira is already substantially weaker than the NGN163/US$ of October 2014.
A sector-specific reason for the dislike of Nigerian banks is the distrust of the balance sheets. Given the tough economic times and low oil revenues, the Nigerian banks’ non-performing loans (NPLs) seem to be understated. Zenith, the largest Nigerian bank, discloses NPLs of only 3% and took a bad debt charge of 1.5% last year. The most trusted balance sheet belongs to Stanbic IBTC, a subsidiary of Standard Bank, which disclosed NPLs of 6.4% and took a bad debt charge of 5.6% in 2016. Despite this substantial charge Stanbic was comfortably profitable and trades on 7 times historic earnings.
When dollar funding was readily available many banks made the mistake of taking dollar deposits and term lending these dollars to oil companies. As the dollar shortage developed the banks had to pay back the dollar deposits but could not get the dollar term loans back, leading to an acute funding squeeze.
The investment case for Nigerian banks
There is clearly a lot not to like, so why do we own Nigerian banks in the Allan Gray Africa ex-SA Equity Fund? Clearly we think the businesses will survive. Consider Zenith, our largest position. Zenith’s total loans are only 3.3 times that of its equity. This is a very low ratio by global standards. In South Africa the ratio is closer to 8 times. The low advances to equity ratio means Zenith can take a huge bad debt charge and still have a substantial equity buffer. The large Nigerian banks are also very profitable, which allows for a greater margin of error. In 2016 Zenith could have taken an 8.9% bad debt charge and still broken even. A bad debt charge of that magnitude would bankrupt most developed market banks.
A further positive is that the founders own around 9% of both Zenith and Access Bank, another large Nigerian bank. This level of insider ownership is very unusual in the banking industry. When a person owns 10% of a large business they usually care far more about long-term sustainability than a manager who is just trying to get an annual bonus. The tough times in Nigeria are culling some of the weaker banks leading to a better, more consolidated industry.
Even if the Nigerian economy does not grow much the banks have plenty of growth potential. The Nigerian mortgage and retail lending market is practically non-existent and the vast majority of transactions are still cash rather than electronic. Previously retail lending was difficult as Nigeria did not have a national identity (ID) system. This is changing as a biometric ID system is introduced. According to the World Bank, Nigerian bank loans equate to 23% of GDP, compared to 179% in South Africa and 45% in Kenya.
…THE NIGERIAN BANKING SECTOR IS WELL DEVELOPED AND FAR MORE CONSOLIDATED THAN ONLY 10 YEARS AGO….
Zenith’s return on equity (ROE) has averaged 16.5% over the past 10 years, which includes the recent down cycle and a very difficult 2009. In future Zenith should be able to achieve a similar ROE to that achieved historically. If this is the case, the bank will earn NGN3.63 per share; the current price is NGN14.00. Zenith pays out 50% of its earnings as dividends; this indicates a 13% dividend yield – an attractive prospect.
What investors are willing to pay for a unit of Zenith’s net asset value (NAV) has fallen from 1.4 to 0.6 despite Zenith consistently growing its NAV, as shown in Graph 1.
A reasonability check
The 10 largest banks in Nigeria have a market capitalisation of US$6.5bn. These 10 banks account for almost the entire sector, so it is possible to buy the Nigerian banking sector for US$6.5bn. Yes, some of these banks may be insolvent, but if they close down the deposits and customers will move to one of the other banks in the top 10. These banks have value for a few reasons: they hold US$50bn in customer deposits; they have significant infrastructure and provide banking services to the largest economy in Africa with a population of 175 million and they generated US$1.5 billion in profits over the past 12 months. To me US$6.5bn seems fairly cheap. In 2008, investors thought these 10 banks were worth US$35bn when they were much smaller, inferior businesses.
For context Capitec, a bank that offers low-cost transactional banking and microloans to the low and middle market segment in South Africa, is valued at US$7.5bn, 15% more than the entire Nigerian banking sector, as shown in Graph 2. Capitec generated US$240m in profits in the year to August 2016, only 16% of the profits of the top 10 Nigerian banks. Either Capitec is somewhat expensive or Nigerian banks are very cheap. Will Capitec or the sum of the current largest 10 Nigerian banks be worth more in 2027? I know where my money lies.
Some may argue that all banks in Africa ex-SA deserve to trade on low valuations because the risks are so great. Consider Commercial International Bank (CIB), commonly regarded as the best Egyptian bank. During the Arab Spring in 2011 when risks were high and there was literally blood on the streets, CIB traded on 1.3 times net asset value. Now that investors like Egypt, CIB trades at 4.2 times NAV.
When is the best time to buy a share?
The time to buy a share is when earnings are low, those earnings are on a low multiple and the currency the asset is denominated in is weak. These opportunities don’t arise when things are going swimmingly, but rather when the risks seem overwhelming. Fortunately the risks to Nigerian banks are well reflected in the extremely depressed valuations.