ABIL_Non-Retail Deposit Taking Strategy Clouds Long Term Growth Outlook_Initiating With a HOLD

8/9/2019 ABIL_Non-Retail Deposit Taking Strategy Clouds Long Term Growth Outlook_Initiating With a HOLD

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Company Information

Bloombergticker ABLSJCurrentprice 31.9

FY11PriceTarget 30.1

MarketCap,Rbn 25.9

Sharesoutstanding,mn 804

Potentialcapital gain(loss) 6%

52WeekHigh,R 37.2

52WeekLow,R 25.6

YTDreturn 9.8%

Historical growth rates2006 2007 2008 2009 CAGR

Grossmarginonretail n/a n/a n/m 36% n/m

Interestonadvances 8% 4% 38% 27% 19%

Netassuranceincome 19% 75% 176% 2% 55%

Noninterestincome 63% 59% 150% 27% 69%

Charge ofdoubtfuldebts 24% 36% 126% 35% 51%

Interestexpense 5% 37% 106% 54% 42%

Operatingexpense 10% 4% 242% 23% 48%

Profitbeforetax 17% 16% 17% 12% 16%

Netadvances 15% 44% 88% 25% 40%

Shorttermfunding 29% 81% 318% 8% 49%

BondsandLTloans 30% 68% 46% 42% 46%

Subordinatedloansandbonds 3% 51% 68% 300% 79%

TotalEquity 3% 10% 319% 2% 48%

Returns vs. Banks & ALS Indices

ABIL ALSI Banks Index

YTD 9.8% -1.0% 7.8%

3 months -4.9% -1.6% 0.2%

12 months 21.7% 15.2% 34.0%

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ABIL

BanksIndex

ALSI

AFRICAN BANK INV. LTD

Non-retail deposits taking strategy

clouds longterm grow th outlook

We initiate coverage on African Bank Investments Limited (ABIL)

with a HOLD recommendation. In section 1 of this report, we

provide a company analysis, being a historical performance

analysis, our forecasts as well as our valuation. We also provide

our opinion on corporate governance and other ESG issues. In

section 2 (Appendix 1) we provide a comparison between ABILs

banking operations and Capitec Bank (Capitec). (we initiated

coverage on Capitec in April; see Capitec Bank: Valuation looks

steep but growth outlook is the differentiating factor, dated April

19, 2010.) We look at earnings momentum given the balancesheets structures, deposit mobilisation strategies, liquidity and

credit risks. We also provide a comparison of valuation metrics

and our conclusion (on an exclusive basis, we prefer Capitec due

to our higher potential total return forecast). Lastly, in section 3

(Appendix 2) we provide a snapshot of the banking industry

structure. We look at the levels of penetration, concentration and

profitability as well as system liquidity and credit risks. We also

look at what we believe will be the key risk to the banking sector

- regulatory risk.

While we liked the ABIL story, and the Group is still a proxy for

investing in banks with material exposure to the low-income

segment, we are concerned by:

the non-deposit taking strategy whose negatives outweighthe benefits, in our view. Major among others is the

constraint to loan growth, limited ability to expand margins

through changes to the liability mix and inability to

supplement income from liability-related products.

the modest historical earnings growth, exacerbated by lowearnings visibility in the short-term. Profit after tax has

grown by a compounded annual growth rate (CAGR) of 16%

between FY05 and FY09, which is lower than competitors

like Capitec.

Valuation: Our valuation model indicates a FY11 price target of

R30.1. We use the Sum-Of-The-Parts (SOTP) method that

allowed us to separately value African Bank and Ellerines. We

valued African bank at R16.5bn and Ellerines at R7.6bn, giving a

Group per share value of R30.1. HOLD.

Peter Mushangwe

Puleng Kgosimore+27 11 551 3675

[email protected]

Please refer to the back of this report to

view our disclaimer and disclosure

June 3, 2010 Equity Report

INITIATION

HOLD


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Page 1 of 56

Contents page

Executive Summary 2

1. Initiation of coverage 6

1.1 ABIL: Initiating with a HOLD 6

1.2 ABIL: Company Analysis 10

1.3 A look at African Bank 22

1.4 A look at Ellerines 27

1.5 Valuation: Sum-of-the-Parts Method 31

1.6 Corporate governance and other ESG issues 34

2. Appendix 1: A comparison w ith Capitec 37

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

2.2 Which bank to play? 37

3. Appendix 2: A snapsho t of the industry 41

3.1 Industry structure and developments 41

3.2 Basel III and Regulatory risks 50


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yield which could be a strong motivation for exposure in the short-

term given our profitability growth concerns. The share currently

trades at a trailing dividend yield of 5.4%. FY09 dividend payout

ratio was 82%! Management is comfortable with a dividend cover

of 1.5X, which indicates a payout ratio of about 67%; and 3)

managements awareness of the risks of over-leverage and

greedy loan growth. In banking, greediness can be bad!

Advances growth rate has been average after an excessive

expansion in FY08. Our impression is that management is ready to

take painful decisions, and lower levels of risk, leverage and even

size of balance sheet. Should regulatory risks hit hard, the pain

would be manageable due to such proactive actions.

What we do not like about ABIL: We do not like 1) the non-

retail deposit taking strategy. While it reduces the deposit-run

risk, we believe that it puts a constraint to funding and long-term

loan book growth. This strategy also increases the concentration

and roll-over risks. The increasing use of electronic delivery

system of banking services, especially on the deposit side, counter

the cost of branch network argument to a large extent. We just

could not ignore the funding risk despite funding having been well

managed so far; 2) the Ellerines business unit that brings non-

banking risk exposure to the Group. Furniture retail market risk

becomes a primary risk for the group and this component has a

different risk/return profile to the financial services. The furniture

merchandise business is more cyclical than banking as the

earnings volatility tends to be higher than for banks; 3) the less-

flexible balance sheet that would create a holdback to loan growth

and interest spread/margin expansion. This is because a) the

government securities and other liquidity assets/total assets ratiois 13.4%, providing limited room to change its asset mix (i.e.

selling down government securities for higher yielding assets when

necessary), thus inhibiting both loan and margin expansion

through asset mix, b) the liability side which is wholly wholesale

deposits, loans and bonds providing no room for the composition


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change between retail and wholesale deposits, in pursuit of higher

margins through cost of funds management; and 4) the low

earnings growth rate. Profit (before tax) growth has been subdued

at a CAGR of 15.7% (FY05-FY09). Ability to supplement interest

income with fee income is poor as a result of the non-retail deposit

strategy. This, in addition to our funding liquidity concerns result in

muted earnings forecasts (CARG 11% to FY12). The business

carries higher credit risks than the mainstreams as loans are

largely unsecured. Should the economy and employment remain

weak for a prolonged time, earnings visibility could be hurt.

African bank: CAMEL ratios mixed, liquidity ratios point to

the w eakness of the non-retail deposit gathering strategy:

The liquidity indicators we use, mainly the Loan/Deposit ratio

(LDR) and the liquid assets ratio (cash and cash equivalent/total

assets) are weak, in our opinion. Notwithstanding the

improvements in the LDR, declining from 129% in CY05 to 91% in

CY09, the ratio provides little margin for error. To grow the loan

book, the Group would need to raise funding. Despite past

successes, this is not guaranteed, hence our balance sheet

inflexibility concerns. The LDR declined to 82% for 1H10 partly

due to the deceleration in loan growth and partly due to the

aggressive funding exercise that was undertaken. The liquidity

ratio at 20% (declined to 18% for 1H10) is 7 percentage points

(pp) less than Capitecs 27%.

Ellerines: Issues impair ing past performance have been, and

are being addressed: Management has managed to 1) cut costs

2) increase efficiencies. Management is also 3) migrating the

Ellerines financial services to African bank. All the three should

provide Ellerines management time to focus on retailing and webelieve in the long-term the business could create material

symbiotic benefits with African bank. African bank will have access

to Ellerines branch network, which we feel is underutilised (in

terms of financial services) at the moment. We believe most of the

legacy issues are clearing out, and should Ellerines remain a


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problem child at year end, then in our view management would

have failed to integrate the two. A disposal would be in order, we

suppose, but as of now, dealing with legacy issues brings hope.

ABIL vs. Capitec: While Capitec is smaller (market cap =

R8.4bn), we prefer it to ABIL as a proxy to the micro-finance

space. In our opinion, Capitec has a more flexible balance sheet,

with relatively lower funding risks (i.e. stronger retail deposits

franchise; lower LDR; lower deposit concentration risk; higher

capital adequacy ratio (CAR) and higher liquidity ratio). Capitec

has more room to grow its fee income through product

development on the liability side of the balance sheet. We expect

loan growth to be sluggish (and therefore lower fee income related

to loans) and deposit-based fee income could be crucial in the near

term.

Industry loan grow th face significant risks: In addition to the

Basel Committees proposal to increase banks capital and liquidity

levels, the loan growth rate versus nominal GDP growth rates

widened significantly from CY00 to CY08. Loans have grown by a

CAGR of 17% while nominal GDP has expanded by a CAGR 12%

(real GDP 4.1%) between CY00 and CY08. In our view, the naturalgrowth of loan should be driven by nominal GDP growth, especially

given the high penetration rates. This presents risks to loan

growth, as we expect this spread to narrow in the medium term

instead of widening.

Regulatory risk to affect mainstream banks more than

micro-banks: The main guidelines issued by the Basel Committee

will mainly affect lending/liquidity; provisioning and over-the-

counter (OTC) products trading. So far emerging market banks

seem not to have priced in this risk. Our key idea is that investorsshould assume exposure to banks that will be least affected, i.e.

banks with higher capital levels, lower leverage, profit visibility and

ability to cut dividend and build up capital and lower exposure to

OTC products. Micro-banks look better placed than mainstream

banks in this regard.


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1. Initiation of coverage

1.1 Initiating coverage w ith a HOLD, FY11 price target isR30.1; potential total re turn is zero .

We initiate coverage with a HOLD: We use the SOTP valuation

method to estimate our FY11 price target. For African bank, we use the

Fundamental Price-to-book ratio (PBVR) method. We use a sustainable

ROE of 27.5%, a Cost of Equity (CoE) of 16.5% and a sustainable

growth rate of 12%. Using the (ROEg)/CoEg) method, we calculate a

fair PBVR of 3.5X. We multiply the fair PBVR by our FY11 book value

forecast to get our FY11 price target. The value for African bank is

R16.5bn.

For the Ellerines business, we believe the fair Price-to-Earnings ratio

(PER) should provide a reasonable valuation. We use a CoE of 17.5%, a

sustainable growth rate of 9.5% (upper range of inflation target, 6%

+3.5%) and a payout ratio of 65% (in line with the target dividend

cover). We obtain a fair PER of 9.0X which we multiply by our FY11

earnings to obtain our FY11 price target. The FY11 value for the

Ellerines business is R7.6bn.

The sum of the two business units is R24.2bn which gives a per share

value of R30.1. This gives a zero potential total return, hence our HOLD

recommendation.

Possible catalysts: The possible catalysts for outperformance (vs. our

potential total return) are 1) stronger loan growth supported by funding

at normal costs, than we have anticipated, 2) stronger performance

by Ellerines than we have forecasted, and 3) lower credit risk coverage

and costs than we have predicted.

Risks to our valuation: The major risks to our valuation are 1) the

error in funding liability forecast, which primarily affect the loan growth

and the resultant interest income. Because of the volatile nature of

wholesale deposits, forecasts carry higher margin of error 2) we apply a


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Fig 2: Share price performance in the recent past has been in line with the market

despite a strong out performance wh en indexed to Oct. 02

10%

4.9%

21.7%

10% 0% 10% 20% 30% 40%

YTD

3Months

12Months

BanksIndex

ALSI

ABIL

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ABIL

BanksIndex

ALSI

Source: I-Net, Legae Securities

Dividend payout has been generous, averaging 96% since FY03;

dividend yield higher than the banks Index and ALSI : We note

that ABIL has been trading at a higher dividend yield than Banks Index,

ALSI and Capitec. This relationship has been holding since mid-03.

However, since FY07, the dividend in rand-terms has reduced by a

cumulative 19%. Forward looking, we believe that ABIL is reducing its

war chest, and improvements in dividend payout ratio are slender

going forward.

Fig 3: Dividend payout has been generous ( DY), limited improvements in payout ratio

0

2

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6

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12

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0203

0703

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1004

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Abil

Capitec

ALSI

BanksIndex

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50

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20%

40%

60%

80%

100%

120%

2003 2004 2005 2006 2007 2008 2009

Div idends, RH S P ay outratio

Source: I-Net, Legae Securities


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Who is ABIL? ABIL has a fairly long history as a credit provider. In

CY98, the Theta Group Limited acquired African bank and the Boland

book of R1.7bn. The following year saw the acquisition of Stagen and

the change of the Groups name to African Bank Investments Limited

(ABIL). In CY02, the group acquired a R2.8bn loan book from Saambou.

The last acquisition was the Ellerines group, a furniture and appliance

retailer, in CY08. Currently ABIL operates through two businesses,

African bank and Ellerines. Both are wholly owned by ABIL.

ABILs strategy is to issue unsecured credit to consumers in the lower to

middle income market. In order to minimize branch network and other

retail-deposits related costs, African bank does not take retail deposits.

In our opinion, this argument is becoming less relevant particularly as

the use of electronic delivery system is gaining momentum. The two

businesses are meant to complement each other in building and

protecting market share.


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1.2 ABI L Group (the Group): Company Analysis

Balance sheet items show strong growth, but profit growth has

been average: Our major theme is the constraint to loan growth that

can be an undesirable effect of the non-deposit taking strategy.

Wholesale deposits and capital markets are volatile, and covenant

requirements by institutional lenders such as coverage of interest by

earnings and shareholder funds could be the main holdback. While

growth of funding liabilities is strong thus far, the historical profit growth

has been timid when compared to competitors in the micro-consumer

lending space. (see Fig 4)Fig 4: Group historical profitability growth has been average

2006 2007 2008 2009 CAGR

Grossmarginonretail n/a n/a n/m 36% n/m

Interestonadvances 8% 4% 38% 27% 19%

Netassurance income 19% 75% 176% 2% 55%

Noninterestincome 63% 59% 150% 27% 69%

Chargeofdoubtfuldebts 24% 36% 126% 35% 51%

Interestexpense 5% 37% 106% 54% 42%

Operatingexpense 10% 4% 242% 23% 48%

Profitbeforetax 17% 16% 17% 12% 16%

Netadvances 15% 44% 88% 25% 40%

Shorttermfunding 29% 81% 318% 8% 49%

BondsandLTloans 30% 68% 46% 42% 46%

Subordinatedloansandbonds 3% 51% 68% 300% 79%

TotalEquity 3% 10% 319% 2% 48%

Source: Company reports, Legae Calculations

The key issues to note about ABILs historical performances are:

Interest on advances growth rate in FY06 and FY07 was poor at

8% and 4% correspondingly. The rate jumped in CY08 to 38%

(advances were up 88% in this period) but receded in CY09 to

27%. The CAGR since FY05 is 19%. We expect margins and asset

yields to decline on restrained loan demand (deleveraging to an

extent), increasing competition and migration to low risk clients.


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Net assurance and other non-interest income have ascended

significantly as a result of strong insurance and fee income. Credit

cards fee and collection fee income has been strong at an average

growth rate that is greater than 100% since FY06. Loan origination

and collection fees are higher margin products when compared to

the credit card whose fee growth was a result of strong

penetration. The fact that the bank does not play in the retail

deposit space is a constraint to growth of non-interest income. (no

income from the liability-side of the balance sheet). Regulatory

risks to net assurance income are significant according to

management, although they have taken proactive steps through

pricing to minimize the possible impact;

Doubtful and bad debt charge, on average, grew by a higher rate

than the advances, indicating the higher credit risks. The charge

increased by a CAGR of 51% (05-09) vs. a CAGR of 40% for the

net advances.

On the funding side, the fluctuations of the growth rates reinforce

our concerns with the funding model to an extent. Short-term

funding responds to market liquidity position. However, the long-

term funding growth has been more stable. Short-term fundingwas reduced in FY09 as the Group increased its subordinated loans

and bonds (long term funding) by an enormous 300%.

Management considered it fit to increase longer term funding at

relatively lower costs (see Fig 4 above). Consequently the cost of

funds improved from 11.7% in 1H09 to 10.5% in 1H10. To an

extent, the volatility in short-term liabilities is partly explained by

asset and liability management strategies;

Net advances growth rate declined significantly in FY09 from 88%

for FY08 to 25%. The CAGR of advances is 40% (05-09) which is2.2X the 19% growth rate of the interest income from advances.

For the 1H10, the asset growth was weak, new loans and cards

sold were down 15%, and customer acquisition was also down

25%. We could not get a clear confirmation from management

that this is a cyclical issue (that we had assumed) ; and


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Fig 5: Liquidity ratios continue to worsen, and is lowest in 5 years

2005 2006 2007 2008 2009 2010F1HLiquidassets/TotalAssets 22.8% 21.1% 22.4% 14.9% 14.2% 13.4%

Liquidassets/Fundingliabilities 40.7% 35.4% 32.0% 29.1% 24.6% 21.8%

Source: Company reports, Legae Securities

The liability mix is shown below. (see Fig 6). The funding is dominated

by long-term loans and bonds (listed senior, and subordinated), which

we believe is invaluable particularly for funding reasons. Short-term

deposits constituted 9% (CY09) of the funding liabilities, with demand

deposits (institutional deposits) making up only 2%. We believe that

retail deposits have a high degree of inertia compared to the

wholesale/institutional deposits, notwithstanding the long-term nature of

ABILs funding liabilities. Wholesale deposits are more mobile due to the

lower switching costs and higher sensitivity to counterparty credit risks.

The reliance on institutional deposits is not constructive to the cost of

deposits, yet longer dated instruments such as subordinated debts

generally carry higher funding costs as well. Unlike the retail deposits,

wholesale deposits rates are largely set by the market liquidity

conditions. As competition intensifies in this space, ABIL will be less able

to manage margin and spread erosion when compared to retail deposit

taking competitors.

We should, however, highlight that the decision by management to issue

longer term debt at this low point of an interest rate cycle is plausible. It

should put a buffer to the interest spread compression to an extent (i.e.

if deposit rates pick up, and lending rates (for this market segment)

come down on competition, regulatory changes, etc, ABIL will be better

placed to protect margins in the short term.


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Fig 6: Funding composition, LT loans and bonds domin ate the funding liabilities

2% 6%1%

35%

45%

11%

2009

Demand Fixedandnotice NCDs Listedsnr L Tloans Subordinates

2%13%

6%

32%

42%

4%2008

Demand Fixedandnotice NCDs Listedsnr L Tloans Subordinates


Funding liquidity risks likely to increase as bonds and loans

mature: In less than 12 months, loans and advances worth R3.2bn will

mature, and needless to say, it would need to be refinanced, unless if

some assets are shed off. The cumulative maturity within the next three

(3) years is R7.2bn. (see Fig 7). The Group could face liquidity

pressures, in our judgment. We should, nonetheless, highlight that to

this end, the bank has been successful in rolling-over its maturing

liabilities, with a historical retain rate of 85% of the maturing liabilities.

The chief problem is the amplified roll-over risk, given the active

management of deposits by institutional investors. The dependence on

institutional funding also results in the cost of funding that is more

responsive to the local and global markets liquidity positions, making

the net interest income more volatile. However, according to

management, this potential volatility in interest income is offset by

yields in other revenue streams. The problem is, currently, both yields

on advances and insurance products have been coming down in order to

increase volume.


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

16,000

14,000

12,000

10,000

8,000

6,000

4,000

2,000

1,costoffundsrespondedtothe

liquiditycrunch

(2008

2009)

LDR(LHS)

costoffunding


Credit risks are high, well managed, although ratios are

gravitating upwards: The banks higher exposure is exclusive to

retails loans. This is a deliberate position given the banks strategy and

vision to enable our customers to improve their lives through access to

unsecured credit. The retail loans carry higher yields, but the attendant

credit risks are also higher. The 100% exposure to the high margin;less leveraged and less penetrated market segment is valuable, despite

the more capital it carries as a result of higher risk-weighting to the

non-secured consumer loans. Looking at the loan book composition, the

important exposures are:

Retail loans constitute 65%, a 2pp increase from 63% in CY08;

The credit card exposure make up 7.6% of the loan book, about

2pp rise from 5.4% in CY08; and

The mining industry exposure declined in CY09 to 4.7% from 5.1%

in CY08. (see Fig 8)

As we mentioned already, the credit card sales declined by 15% in

1H10.

In our opinion, management has adequate knowledge and experience to

deal with and manage the risks. The recent uptick in the NPLs has


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mainly been ascribed to the legacy issues with Ellerines and the upturn

in unemployment that hit the economy in CY09, just after a lofty growth

in loan writing in the FY08.

Fig 8: Loan book is dominated by retail loans. Credit card exposure rose to 7.6% in CY09

64.8%

2.5%

7.6%

4.7%

0.2%

20.1%

2009

Retail Payroll Creditcar d Mining EHLretail EHLgroup

62.8%

2.8%

5.4%

5.1%

0.0%

23.9%

2008

Retail Pay roll C reditc ar d M in in g EH Lr etail EHLgroup


NPL formation and provisioning issues: The current low interest rate

environment should lead to lower NPL formation, although this could

worsen should interest rates rebound. Loan restructuring in CY08 and

CY09 should also aid the slowing of NPLs. (i.e. negating the

unemployment effects). Although the banks lending rates is not very

responsive to changes in the policy rate, (charges are more influenced

by the clients risk profile) complete ignorance of the changes to the

policy rate would make the bank uncompetitive. NPLs/Loans ratio

increased in CY09, as did the systems, but we expect it to peak this

year.

Provisions/provisions ratio, however went up by a lower rate in CY09

than the NPL/advances ratio. This resulted in the coverage ratio

declining to its lowest level since CY05 (at 61.2%). This relative under-

provision (vs. CY09) reduces the quality of earnings to an extent.


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In rand-terms, the NPLs went up by a CAGR of 54.1 (05-09) from

R1.6bn in CY05 to R9.3bn in CY09. This screen poorly against the CAGR

of 50.0% and 41.9% for provisions and gross advances respectively.

Note: there was a restatement of NPLs. The FY09 amount as published

in FY annual report included the residual value of the written off book.

This was reversed in 1H10 interim results, but only for African bank

business unit, so we maintain the ratio for Group, but make adjustment

for African bank.

Fig 9: The coverage ratio at Group level deteriorated in FY 09 compared to FY 08...

2005 2006 2007 2008 2009 CAGR

Grossadvances 6,454 7,727 10,890 20,908 26,181 41.9%

Growthrate 19.7% 40.9% 92.0% 25.2%

Totalimpairmentprovisions 1,117 1,435 1,892 4,376 5,661 50.0%

Growthrate 28.5% 31.8% 131.3% 29.4%

TotalNPLs 1,642 2,213 3,004 6,239 9,253 54.1%

Growthrate 34.8% 35.7% 107.7% 48.3%

Impairment/Grossloans 17.3% 18.6% 17.4% 20.9% 21.6%

NPLs/Grossloans 25.4% 28.6% 27.6% 29.8% 35.3%

Provisions/NPLs 68.0% 64.8% 63.0% 70.1% 61.2%


Ellerines financial services carry higher credit risks, mostly from

legacy loans. We also note that Ellerines has a higher

provision/Advances ratio at 16% versus 12% for African bank. The

NPLs/Advances for Ellerines is 7pp above African banks 34%. Since

provision are meant to be forward looking (i.e. based on managements

expectations on bad and doubtful debts), management invariably expect

higher credit risks for the Ellerines business segment to continue in the

short-term. Post integration of the financial services to African Bank, we

expect the credit costs to reduce. This will mainly be a result of the use

of African banks platform e.g. scorecard.


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Fig 10: ...and Elleri nes carries h igher credi t risks

50%

55%

60%

65%

70%

75%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

2002 2003 2004 2005 2006 2007 2008 2009

NPLs/Grossloans

Provisions/Grossloans

Provisions/NPLs(coverageratio)

20,994

5,153

7,158

2,095

34%

41%

10,000

5,000

5,000

10,000

15,000

20,000

25,000

5%

10%

15%

20%

25%

30%

35%

40%

45%

ABIL Ellerines

Advances(RHS) Pr ovisions(R HS) NP Ls /A dv an ce s


Revenue and profitability analysis

The major contributor to the groups revenue is interest income. (see Fig

11) As we mentioned before, the interest income growth rate has been

average. Non-interest income and assurance income has shown stronger

growth, but we believe the two revenue streams face higher regulatory

risks. Given the Groups strategy, we also doubt the sustainability of

non-interest income growth rate at above industry growth rate as it

solely depends on the asset side products. Product offering on the

liability side of the balance sheet in order to produce fee and

commission income is non-existent. We note that:

African bank is integral to the Groups revenue growth as interest

income constitute 47% of the revenue and 78% of the Groups

interest income comes from African bank. We see compression on

interest spreads as the yield decline (with the Bank moving into

low risk segment, competition, and possible upturn in wholesale

deposit rates, even though the long-term funding was increased);

Non-interest income make up 19% of the Groups revenue, (FY09

vs. 34% [fee and commission] for the industry), and African bank

contributes 72% of it. Assurance income represents 18% of the


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Group revenue, and again, African bank contributes the most at

60%. The instability in the job market creates headwinds to

assurance income in the short-term;

Gross margin on retail sales makes up 15% of the Groups

revenue. It wholly comes from the Ellerines retail business.

In our view, the integration of Ellerines loan book to African bank

should be value accretive to the Group.

Fig 11: Interest income dominates revenue and ABI L has the higher contribution

78%

60%71%

22%

40%29%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Interest Assurance Noninterest

ABIL Ellerine

15%

47%

18%

19%

2009

Marginonretail Interestona dv ances Netassurance Noninterest


Jaw are not widening fast enough, in our opinion: The Groups

profitability growth has been muted in our opinion, despite a high ROE

up-to FY07. The jaws have not been widening fast enough, with risk

adjusted income growing by a CAGR of 33% (05-09) while operating

costs went up by a CAGR of 48% over the same period. The interest

expense has grown by 2X interest income between FY05-FY09. (see Fig

12). However, we expect the jaws to widen on additional revenue

growth from the Ellerines as it becomes more efficient and legacy

issues wane.


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Page 20 of 56

Fig 12: The JAWS are not widening fast enough. Interest expense has grown at 2X interest

income

CAGR=33%

CAGR=48%

2,000

4,000

6,000

8,000

10,000

2005 2006 2007 2008 2009

Riskadjusted income

Operatingcost

CAGR=42.4%

CAGR=20.3%

CAGR=12.8%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2005 2006 2007 2008 2009

Interestincome

Interestexpense

NII


Interest rate risk is minimal at this point. The Group swaps the

floating/variable interest rate on its liability-side to match the fixed rate

on the asset side. We could not get access to the full maturity profile in

order to subject the maturity gaps to a gap analysis, but we note that

1) management does not take a view on interest rates, and as a result

the liabilities carrying floating rates are swapped for fixed rate.

However, the book is not 100% swapped yet; 2) we believe the bankcarries an asset sensitive balance sheet. This should be constructive to

interest income should interest rates rebound. More maturing assets will

be re-priced at favourable rates, boasting interest income despite the

low responsiveness to policy rates.

Ellerines carries a high level of capital, further depressing the

Group ROE: We note that Ellerines shareholders equity is R4.1bn

(1H10) while African bank has R3.4bn. The higher equity level for

Ellerines would have created a war-chest for the Group, but the Groups

high dividend payout ratio has eliminated opportunities for upside

potential in the payout ratio in the future. We get the takeaways as

below (see Fig 13):


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Ellerienes is not leveraged enough. FY09 leverage is only 1.8X.

This negatively affect the Groups ROE, whose leverage ratio for

FY09 is only 2.7X;

Both ROA declined sharply in FY08 due to a 3.4pp increase in

operating costs/total assets ratio. The total revenue/total assets

ratio is also declining, indicating falling yields. With the asset

growth slowing, and ROA deteriorating, we are not bullish on the

Groups ROE in the short-term.

Management pointed out that the yield reduction is a deliberate

strategy to increase volume and market share.

Fig 13: Group ROA has been falling. Poor leverage level at Group level is notsupporting ROE.

%oftotalassets 2005 2006 2007 2008 2009Totalrevenue 46.3% 47.1% 38.7% 32.0% 33.7%

Chargefordoubtfuladvances 6.7% 7.4% 7.0% 6.3% 7.3%

Otherinterestincome 2.1% 1.4% 1.4% 1.2% 1.1%

Interestexpense 6.7% 5.7% 5.4% 4.5% 5.9%

Operatingcosts 13.0% 12.8% 9.3% 12.7% 13.4%

BEEcharge 0.0% 0.0% 0.0% 1.0% 0.0%

Indirecttax 0.7% 0.6% 0.3% 0.2% 0.1%

Capitalitems 0.0% 0.5% 0.0% 0.0% 0.0%

Associateincome 0.0% 0.0% 0.0% 0.0% 0.0%

Taxation 8.4% 8.0% 6.4% 3.2% 2.7%

ROA 12.9% 14.4% 11.7% 5.3% 5.4%

Leverage 2.8 3.0 4.0 2.4 2.7

ROE 36.1% 43.7% 46.4% 12.6% 14.7%



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1.3 A look at African Bank

Below we look at the CAMEL indicators for African bank. Profitability for

the bank has been strong, with an average ROE of 50% between CY05

and CY09 and a profit CAGR of 14% (05-09). However, the interest

spreads has narrowed from 30% in CY05 to 12% in CY09. The NIM

declined from 33% (CY05) to 11%. (CY09). The efficiency ratio

(cost/income) and burden ratio have both improved between CY05 and

CY09. Key takeaways in our CAMEL analysis are:

The banks leverage ratio has increased from 3.4X in CY 05 to 6.8X

in CY09. In our forecast we increase the leverage ratio beyond

managements guidance. Our view is that ROE will be boosted

more by leverage than ROA given issues we highlighted already.

The provisions/loan ratio increased in CY09 to 20% from an

average of 18% between CY05 and CY08. The NPL/advances ratio

increased by 9pp from 25% in CY05 to 34% in CY09. We expect

this ratio to decline on improved credit quality;

Both the cost/income ratio and the burden ratio have improved,

reducing from 33% to 25% and 17% to 13% for FY05 and FY09

respectively. The relatively high burden ratio indicates the low

extent to which non-interest income covers non-interest expense.

Assurance income supports this coverage in the medium term.

NIM has slowed from 33% in CY05 to 11% in CY09. We expect the

NIM ratio to decline on narrowing interest spreads. The pressure

should mainly come from 1) leverage (should the bank increase it)

that is likely to negatively affect interest spreads since deposits are

wholesale; 2) competition and slowing loan demand that puts

pressure on lending rates, notwithstanding the positive industry

structure; and 3) the deliberate migration to a low risk client

base.

Non-interest income/operating income ratio developed from 9% in

FY05 to 30% in FY09. As we mentioned elsewhere, non-interest


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income contribution to operating income will be suppressed by the

asset-led approach; and

The LDR has improved, reducing from 129% in CY05 to 91% in

CY09. Cash and cash equivalents/total assets ratio has, however,

worsened by 3pp from 23% in CY05 to 20% in CY09. We see little

room for improvement in this ratio due to the non-retail deposits

taking strategy. We slightly reduced the LDR to 87% for FY11 and

FY12.

Fig 14: CAMEL indicators for African Bank

2005 2006 2007 2008 2009 2010F 2011F 2012F

C:Totalassets/Totalequity 3.4 3.7 4.7 6.7 6.8 7.9 8.0 7.9

C:Equity/Loans 56% 49% 34% 22% 20% 17% 16% 16%A:Provisions/Loans 17% 18% 17% 18% 20% 18% 18% 18%

A:NPL/Loans 25% 29% 28% 28% 34% 29% 29% 30%

M:Cost/Incomeratio 33% 31% 28% 26% 25% 29% 31% 30%

M:Budernratio 17% 18% 15% 14% 13% 11% 12% 11%

E:NIM 33% 32% 22% 13% 11% 9% 9% 8%

E:Nonint.income/Op.income 9% 13% 18% 27% 30% 34% 33% 35%

L:LDR 129% 125% 107% 95% 91% 87% 88% 87%

L:Cash+equivalents/Total assets 23% 21% 22% 22% 20% 15% 12% 13%


In terms of credit risks, the NPLs have increased by a CAGR of 40%

from R1.6bn to R6.4bn. (CY05 and CY09). The gross loans and advances

have, however, grown at a slower pace by 7pp lower, with a CAGR of

33% to R20.2bn. We are not overly concerned by the higher growth in

NPL when compared to advances as the coverage ratio remained fairly

in line with the average (66% vs. 65%). (see Fig 15)

Fig 15: Credit risks, the coverage ratio worsened from 68% (CY05) to 59% (CY09)

2005 2006 2007 2008 2009

NPL 1,642 2,213 3,004 4,455 6,381

Impairmentprovision 1,117 1,425 1,892 2,867 4,239

Grossadvances 6,454 7,727 10,890 16,042 20,224

NPLs/Grossadvances 25% 29% 28% 28% 32%

Provision/Grossadvances 17% 18% 17% 18% 21%

Coverageratio:Impairment/NPLs 68% 64% 63% 64% 66%



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ROE supported by leverage, but we are sceptical of stronger

leverage going forward; yields declining on competition and

migration to lower risk client base: As we pointed out already, the

banks ROE has been strong. From CY05 to CY09, the average ROE is

50%. The ROA shows a declining trend, moving from 13% in CY05 to

7% in CY09. Both components of the ROA, the yield and the margin

declined from 46% to 31% and 27% to 22% in that order. 1H10 results

show that about 40% of the debit order distribution is now in what

management considers low risk client base. This is against 10%

exposure to this low risk client base in 1Q09. This rapid change in risk

exposure will compress yields as the low risk clients should demand

lower interest rates.

We also note that ordinary equity and total equity shows mundane

growth rate (CAGR =12% FY05-FY09). The Group pays out capital in

excess of its forecasted optimal requirements, hence the high Group

payout ratio. The effect is that ROE is sustained at high levels, more as

a result of capital management than earnings growth.

Maintenance of a high ROA (8% is managements target) is an

uphill task, in our opinion. 1) African banks ROA is on the top end

against the industry and its peers (Capitecs ROA = 5%); 2) the

declining margins and spread due to reasons highlighted before; and 3)

the absence of strong fee income growth outlook as it is only asset

driven.

The ROE improved from 43% in CY05 to 46% in FY09 on rising leverage.

The leverage ratio increase from 3.4X in CY05 to 6.8X in CY09. We do

not think leverage will grow strongly on both regulatory constraints and

the internal constraints brought about by the non-deposit taking

strategy. Managements target leverage ratio is 6X. The unsecuredpersonal loans would require higher risk-weighting, and thus more

capital which could inhibit leverage benefits. (see Fig 16 and Fig 17).

Leverage is imperative to support ROE despite the constraints

highlighted above. We increased it to 8.0 and 7.9 for FY11 and FY12,

which is slightly above management guidance.


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Fig 16: ROE decomposition. We expect ROE to dow ntrend on ROA

2005 2006 2007 2008 2009 2010F 2011F 2012F

Assetyields:Revenue/Total assets 46% 47% 39% 33% 31% 25% 28% 26%Margin:NetIncome/Revenue 27% 30% 29% 25% 22% 20% 19% 20%

ROA 13% 14% 11% 8% 7% 5% 5% 5%

Leverage:Totalassets/Equity 3.4 3.7 4.7 6.7 6.8 7.9 8.0 7.9

ROE 43% 52% 54% 56% 46% 39% 42% 41%


Fig 17: Interest spreads narrowed significantly from CY05 level, but leverage supported ROE

30% 30%

21%

13% 12%

10% 10% 9%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

2005 2006 2007 2008 2009 2010F 2011F 2012F

Assetyields

Fundingcost

Interestspread

13% 14% 11%8% 7% 5% 5% 5%

43%

52%54%

56%

46%

39%42% 41%

0%

10%

20%

30%

40%

50%

60%

70%

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

2 00 5 2 00 6 20 07 2 008 20 09 20 10 F 2 01 1F 2 01 2F

ROEROALeverage(LHS)



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Major assumptions - Earnings and balance sheet models: Below

we highlight the salient assumptions we used in our earnings and

balance sheet models. Relative to history our forecasts are more like in

line than otherwise. We have:

reduced doubtful debts charge ratio to 10% and 9.5% for FY11 and

FY12 respectively as we expect lower delinquencies due to the

migration to the lower risk segment;

reduced the operating expenses ratio to 26% by FY12 due to our

expectation of efficiency benefits due to cross-selling of African

bank products through Ellerines branches;

increased the expense/advances ratio to 11% as we anticipateinterest rates rebounding within our forecasting period.

trimmed down the yield (interest/advances) ratio to 22.5% for

FY12 on assumption of competition and the migration to lower risk

clients.

Fig 18: Salient assumptions

Major assumptions 2005 2006 2007 2008 2009 2010F 2011F 2012FInterestincome/Advances 49.1% 49.0% 35.4% 25.2% 25.3% 23.2% 23.0% 22.5%

Netassuranceincome/Advances 6.8% 7.0% 8.5% 9.0% 7.4% 4.9% 6.0% 5.0%

Noninterest

income/Advances 5.2% 7.4% 8.1% 9.4% 9.5% 8.1% 8.0% 8.0%

Chargeofdoubtfuldebts/Advances 9.2% 10.0% 9.4% 10.3% 11.5% 11.2% 10.0% 9.5%

Intragroupassetsyield 0.0% 0.0% 0.0% 0.0% 0.0% 25.0% 25.0% 25.0%

Otherinterestincome/Cashandsta 9.4% 6.6% 6.5% 8.9% 7.9% 0.0% 6.0% 7.5%

Interest andop.expenseassumptionsInterestexpense/Funding liabilities 12.0% 9.6% 7.7% 8.2% 9.8% 8.9% 11.0% 11.0%

Operatingexpenses/Op. revenue 32.8% 32.4% 29.3% 27.5% 25.8% 29.4% 27.5% 26.0%

Taxation 39.5% 29.3% 28.9% 28.2% 28.1% 26.2% 28.0% 28.0%

Growthrates,fundingforecastingShorttermfunding 2 9.4% 80.8 % 271.2 % 43.3% 1.1% 10.0% 20.0%

Bondsandotherlongtermfunding 29.5% 68.2% 45.4% 42.4% 45.3% 25.0% 15.0%

Subordinatedbonds 2.5% 51.0% 67.5% 300.0% 40.6% 30.0% 30.0%

LDR(netloans/fundingliabilities) 129% 125% 107% 95% 91% 87% 88% 87%



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Fig 19: Earnings model, Rmn

2005 2006 2007 2008 2009 2010F 2011F 2012F

Interestincome

on

advances 2,752

2,974

3,098

3,323

4,245

4,764

6,540

7,402

Netassuranceincome 357 424 742 1,191 1,243 1,104 1,706 1,645

NonInterestincome 274 446 707 1,244 1,591 1,835 2,275 2,632

Totalrevenue 3,383 3,844 4,547 5,758 7,079 7,703 10,521 11,679

Chargeforbadanddoubtfuladvanc 488 606 823 1,361 1,929 2,391 2,669 2,916

Riskadjustedrevenue 2,895 3,238 3,724 4,397 5,150 5,312 7,852 8,763

Otherinterestincome 156 113 170 261 328 480 280 436

Intragroupincome 410 472 542

Interestexpense 492 465 636 1,136 1,816 2,308 3,555 4,160

Operatingcosts 951 1,048 1,091 1,209 1,330 1,562 2,159 2,278

BEEcharge

Indirecttax:VAT 50 46 38 54 18 24

Profitfromoperations 1,558 1,792 2,129 2,259 2,314 2,308 2,890 3,304

ProfitonsaleCVFandotheritems 37 15

Profitbefore taxation 1,558 1,829 2,129 2,259 2,314 2,323 2,890 3,304

Directtaxation:STC 118 138 132 86 104

Directtaxation:SAnormal 616 535 616 636 651 608 809 925

Profitfortheyear 942 1,176 1,375 1,491 1,577 1,611 2,081 2,379

Preferenceshareholders 28 36 41 49 52 53 69 78

Ordinaryshareholders 914 1,140 1,334 1,442 1,525 1,558 2,012 2,300



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1.4 A look at Ellerines

Ellerines provides a different risk-return profile to the group...

Ellerines is a furniture and appliances retailer which targets the formally

employed, the banked and the informally employed people. The

business unit was acquired in CY07 and the rationale of the acquisition

was to offer scale to the Group as the retail market offered a channel to

grow the loan-book. The Ellerines offered a conduit to gain access to

the clients with a risk profile that fit(ted) into the ABIL target market.

However, according to management, the Ellerines brand customers, who

make the highest number of credit sales to the Ellerines business unit,has a higher risk profiles that resulted in higher credit costs to this unit.

In addition, the retail sales tend to be more cyclical than financial

services revenues.

...but the key issues that impaired past performance have been,

and are being addressed in our view : Ellerines retail division was

the problem child of the Group, with net losses of R252mn and

R185mn for FY08 and FY09 respectively. The retail side of the business

was not creating optimal turnover, while the financial side, although

profitable, was suffering from colossal bad loans and massive suspended

interest due to the in duplum rule. In 1H10, the retail division made a

turnaround, with headline earnings of R132mn for 1H10 (return on sales

of 5.6%).

Management has addressed primary issues that we believe are key to

stronger performance of the Ellerines in future. These are 1) the

realignment of costs to sustainable levels. For example, staff costs were

reduced from R736mn in 1H09 to R710mn for 1H10. Administrative

expenses declined to R228mn for 1H10 from R348mn for 1H09.

Management is exploring more ways to cut costs where possible; 2) the

improvement in efficiency as indicated by the sales/employee and

sales/store. The sales/employee and sales per store growth rates turned

positive in 3Q09. Some of the loss-making branches were closed

although about 100 branches remain loss making; 3) the migration of


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the financial services to African Bank. Although not completed yet, the

migration of financial services to African bank is a positive thing as it

would allow Ellerines to focus on retailing. According to management,

the African bank system has already been rolled out to 90% of all

Ellerines brands and full completion is expected by September 2010;

and 4) the greedy loan growth has been put to a halt. In our opinion,

growth for the sake of it is dangerous. Loans written in FY08 still present

problems to the Group, and a sizeable sum of interest was suspended as

a result of the in duplum rule. Gross advances yield decreased from

50% in 1H09 to 39.4% in 1H10 and about half of this decline is a direct

result of the in duplum rule. Growth of the Ellerines loan book has been

better managed for 1H10, which we believe should strengthen the

quality of earnings. This is not to underplay the need to grow the

advances book and maintain a market share. In our discussion with

management, there was indication that 1) growth was controlled given

the high growth in FY08 and consequent risks, 2) there is need to roll

out products and increase catchment area.

Given that, we expect Ellerines to be value accretive in the long-

term... Our view is that with the problem child being fixed, the unit

should be value accretive going forward. We are concerned with the

elasticity of the furniture retail business given the macro situation that

remains uncertain, but we take comfort in the improvements already

shown by Ellerines (highlighted above). Key issues to note are:

the business unit has net advances of R5.4bn. The biggest

exposure is to Ellerines brand that has an advances book of

R3.6bn. The Beares, Furniture City and Geen & Richards have a

combined loan book of R1.8bn.

Ellerines has the highest credit sales when compared to the other

brands (Beares, Funicture City, Geen & Richards, Wetherlys and

Dial-a-Bed) in the retail segment. Ellerines has the lowest average

loan value at R5,355 which we believe could aid in managing credit

i.e. greater diversification


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The Ellerines gross margins remain stable (at around 42.5%) and

as management get a grip on operating costs and turnover, we

expect the net margin to improve. Managements return on sales

target is 10%.

...but execution risk remains high in the retail segment;

managements FY14 sales target revised downwards:

Management have revised the FY14 sales target from R9bn-10bn to

R9bn-8bn. The profit margin target has been increased to >10%, with

the stock turn having been increased to 5X. For the financial services,

revisions are immaterial, hence we think there is still reasonably higher

execution risks related to Ellerines retail business.

Fig 20: Ellerines Earnings model.

EllerinesGroup 2008 2009 2010F 2011F 2012FSaleofmerchandise 3,092 4,196 5,245 6,556 7,868

Costofsales 1,779 2,405 2,963 3,737 4,524

Grossprofit 1,313 1,791 2,282 2,819 3,344

Grossmargin 42.5% 42.7% 43.5% 43.0% 42.5%

Growthofgrossprofit 36.4% 27.4% 23.6% 18.6%

Interestincomeonadvances 962 1,192 1,185 1,503 1,824

NetAssuranceIncome 854 838 647 974 1,170

Non

interest

income 524

660

665

849

1,033

Incomefromoperations 3,653 4,481 4,779 6,145 7,371

Operatingincomegrowth 23% 7% 29% 20%

Chargefordoubtfuldebts 495 582 603 724 861

Chargeofdoubtfuldebtsgrowth 18% 4% 20% 19%

Riskadjustedincome 3,158 3,899 4,175 5,421 6,511

Otherinterestandinv.Income 84 78 96 123 150

Interestexpense 180 248 351 562 744

Operatingcosts 2,536 3,246 3,316 3,791 4,558

IndirectTaxation 2

Profitfromoperations 524 483 604 1,190 1,359

Operatingprofitmargin 14% 11% 13% 19% 18%

Operatingprofitgrowth 8% 25% 97% 14%

CapitalItems 7

Profitbefore

tax 524

476

604

1,190

1,359

Taxation 164 198 171 337 385

Profitaftertax 360 278 433 853 974

Netprofitmargin 10% 6% 9% 14% 13%



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Fig 21: Valuation model

AfricanBankValuation

SustainableROE 27.5%

CoE 16.5%

Sustainablegrowthrate 12%

ROEless growthrate 16%

CoEless growthrate 4%

FairvaluePBVR,X 3.5

FY11Bookvalue,Rmn 4,749

FY11Targetvalue,Rmn 16,541

Ellerines Valuation

Targetpayout

ratio 65%

Sustainablegrowthrate 9.5%

CoE 17.5%

CoEless growth 7.95%JustifiedPER 9.0

FY11Earnings,Rmn 853.5

FY11targetvalue,Rmn 7,640.9

FY10targetvalue(Group),Rmn 24,182

Numberofshares,mn 804

FY11Targetprice,R 30.1

Currentprice,R 31.9

Forecastdiv.yield 5.7%

Potentialtotalreturn 0.0%

Weincreased

Ellerines'CoE dueto

itshigher

risk

profile

Thesum of

Ellerines and

African

Bank

Source: Legae Securities

Relative method indicates fair valuation, with potential total

return of 6.8% : Our secondary valuation method uses the long-term

PER, which we adjust to reflect our risk assumptions for the three

business segments. For African Bank and Ellerines financial services weuse the average Banks Index PER (CY00-date). We discount the PER by

12% and 15% for African bank and Ellerines respectively. For Ellerines

retail, we use the General retailers PER (discounted by 20%). We

multiplied the adjusted PER by out FY earnings forecast. The Group

value is R25.9bn which is R32.2 per share. (see Fig 22)


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Fig 22: Long-term average PER indicates fair valuation at best.

EllerinesValuation AfricanBankValuationBanks

Index

Average

PER

(00

date) 10.3 Banks

Index

average

PER 10.3

Discount 15% Discount 12%

FairPERforEllerinesfinancialservices 8.8 FairPERforAfricanBank 9.1

FY11Earnings 427 FY11Earnings 2,012

FY11ValueforEllerinesFinancials 3,743 FY11ValueforAfricanBank 18,237GeneralRetailersAveragePER(00date) 11.6 TheGroupValuationDiscount 20% EllerinesValuation(FY11) 7,691

FairPER 9.3 AfricanBankValuation(FY11) 18,237

FY11EarningsforEllerinesretail 426 GroupValuation 25,928

FY11ValueforEllerinesRetail 3,949 Numberofshares 804TotalValueforEllerines 7,691 PriceTargetFY11 32.2

CurrentPrice 31.9

Potentialtotal

return 6.8%


Valuation risks and Sensitivity Analysis.

The major valuation risks are 1) our funding liability forecast carry high

error due to the volatility of wholesale deposits 2) our sustainable ROE

for African bank (27.5%) is high relative to CoE.

Potential positive return kicks in only at very generous CoE and

ROEs: We provide a sensitivity analysis (ROE and CoE) to African banks

value. In our view, there is no easy upside. As shown below (see Fig

23), potential return only turn positive at 1) low CoE of 15% and higher

ROEs of 27.5% to 35%; 2) high ROEs of 30% and 35% only if the CoE

is 16.5%. For a CoE of 18%, the potential total return is negative for all

ROEs, except when ROE is 35%.


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Fig 23: Sensitivity analysis. There is no easy-upside.

Share price vs. AB's ROEs and CoE

ROE

CoE 15.0% 20.0% 27.5% 30.0% 35.0%

15.0% 15.4 25.3 40.0 44.9 54.8

16.5% 13.5 20.1 30.1 33.4 40.0

18.0% 12.5 17.4 24.8 27.2 32.1

Pos itive return requires high ROEs and low CoE

ROE

CoE 15.0% 20.0% 27.5% 30.0% 35.0%

15.0% 46.0% 15.0% 31.1% 46.4% 77.5%

16.5%

52.0%

31.3% 0.0% 10.4% 31.1%18.0% 55.1% 39.8% 16.6% 9.1% 6.3%


1.6 Corporate governance and other ESG issues

Corporate governance is critical to implementation of risk management

procedures. In turn, we believe risk management procedures and

processes are crucial for the sustainability of competitive advantage. In

this section, we analyse the corporate governance, and other ESG

issues. We note the following about the governance of the company:

The Board of Directors is dominated by Non-Executives. One of the

Non-Executive directors, Mr A Tugendhaft is, however, a legal

advisor to ABIL. This, in our view, compromises his position to an

extent. Mr Mutle Mogase is the Board Chairman. We note that

most of the non-executive directors hold directorship with various

institutions which could diminish their dedication to ABIL, in spite

of the experience they could acquire from other boards.

The Audit Committee is made up of four (4) members, who are

elected by the Board from among the non-executive directors. We

think Executive directors could have an influential role in

determining the members of this committee. The Audit committee


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has unlimited access to external auditors, management, and

compliance.

We also underscore that the Group has an excellent investor

communication system, in our view. The Group has empowerment

and sustainability reports on its website that are often updated.

The website provides investors with a reasonable amount of

information.

Other ESG issues: Empowered at shareholding level, but senior

management has fewer Previously Disadvantaged Individuals

(PDI s). The business has a positive impact to society despite the

high interest rates.

Environmental issues:

In our opinion, African bank has no significant exposure to risks

that have a material negative impact to the environment. Loans

are exclusively to individuals, instead of corporates that can

expose the bank to environmental risk through project financing,

for example;

The Ellerines business has what we think is negligible impact to the

environment. In addition to owning a number of trucks, they also

do some manufacturing of furniture. Management pointed out that

they will outsource the transport division. This makes the risk

residual.

Social issues:

Generally, ABILs activities have a positive social impact. The

Group provides services to segments of society that are generally

overlooked by the mainstream banks. About 96% of the Groupscustomers are PDIs. The loans are mainly for basic requirements

such as education, accommodation, furniture and food. About 60%

of the customers are women. The main issue, on the other hand, is

the high interest rates charged (which we believe is defensible


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given the high credit risks), that often leads to the Groups clients

falling into a debt-trap.

The Group has two BEE partners who have a 6.5% shareholding.

Staff also own shares through a scheme, while options are granted

to middle and high level managers.

The management incentive policy is guided by the economic value

(earnings less cost of equity calculated at 16%). A maximum of

20% of the economic value is distributed to staff. General staff and

middle managers receiving more cash bonus while top

management receive most of their bonus in share options with a

four-year tenor;

The majority of the low-level staff members are PDIs while the top

management is predominantly white. Out of the 6 (six) members

of the top management, 1 (one) is African and another is Indian.

Of the 107 senior managers, 14 are Africans, and 23 are PDIs. In

our view, this situation would need to be addressed.


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2. Appendix 1: A comparison w ith

Capitec Bank

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

At the moment we prefer banks with exposure to the micro-finance to

mainstream banks. ABIL and Capitec are prime exposures to the micro

finance sector. The anchor themes for these banks, in our view, are:

the targeted sectors enjoy lower penetration and lower debt levels

that should create relatively more lending opportunities;

the more defensive assets (lower exposure to capital markets)

hence less volatility in earnings when compared to the mainstream

banks;

the recent improvements in assets quality in general despite higher

NPLs than the mainstream banks; and

lower ESG related risks as they lend to individuals as well as

providing valuable financial services to the under-banked and un-

bankable population.

It is however important to note that gap in operating ratios between themainstream banks and the micro-banks is narrowing, despite still being

wide. The micro-banks are gravitating towards the mainstream in terms

of credit risk management and NIMs.

2.2 Which Bank to Play? Performance and Valuation

metrics

The PER for ABIL and Capitec are 12.8X and 18.2X respectively. Below

we compare and contrast the major performance and valuation

indicators between ABILs banking business, African Bank (AB) and

Capitec. Overall we prefer a bank that would be in a better position to

exploit opportunities and enhance stronger top-line growth (interest

income and non-interest income) rather than earnings recovery that is


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primarily driven by slowing NPLs at this stage of the NPLs cycle. The key

issues in this comparison are:

Liquidity and loan growth momentum: Unlike other industries,

banks balance sheets drive earnings more directly. The

relationship between the balance sheet and income statement is

more clear-cut: deposit growth asset growth earnings

growth. Of course, the relationship is contained within tolerable

risk levels. In our view, Capitec has a more liquid and flexible

balance sheet due to its 1) lower LDR (Capitec =71%, AB = 91%),

2) higher assets in cash and cash equivalents when compared to

AB (Capitec = 27%, ABIL =18%). The higher cash and cash

equivalents allows Capitec to sell down government securities and

other liquid assets to grow its loan book. (compared to AB).

NIM and interest spread: The non-deposit taking strategy

affects AB in two main ways 1) inability to change the liability mix

(retail deposits vs. wholesale deposits) in order to manage the

spread and margins; 2) limited ability to change the asset mix to

enhance the spread as the liability side is not as flexible as of

those that take retail deposits. The lower cash and equivalents

means restricted ability of asset mix changes in pursuit of margin

and spread growth. Capitec enjoys a higher NIM at 13% vs. ABs

11%. We think room to improve the margins are slender for both

banks. We believe the downward bias to margins will persist even

though management is of the view that it has reached the floor.

Asset quality: Our view is that the credit risk profiles of the two

banks are similar. It is the management of the risk that becomes

a differentiating factor. Capitecs impairment/advances ratio is

lower than ABs at 10% vs. 34% respectively. Both banks have

relatively low coverage ratios. The coverage ratio for both banks

worsened in FY09.

Efficiency and non-interest income growth: The cost/income

ratio for Capitec has improved materially to 54% from 73% in

FY05. We calculate ABs cost/income ratio at 25% for FY09. ABs


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cost/income ratio is significantly lower than Capitecs. We,

however, draw attention to the fact that Capitec has managed to

reduce its cost/income ratio by a higher 19pp vs. ABs 8pp

improvement from 33% in CY05 to 25%. We also believe that

technology will be important in order to integrate platforms that

would enhance fee revenues. Capitec has an added advantage of

earning technological and economies of scale benefits on the

liability side (deposit products) while AB could see some benefits

through the Ellerines integration.

ROE decomposition: A bank that would be able to maintain or

grow margins, and therefore its ROA would be preferred, but given

the competition, we would expect margins to progressively narrow.

As a result, banks that can take more leverage to support the ROE

would be our preferred. Both banks are lowly leveraged at 7X for

AB and 6X for Capitec (narrow deposit base makes them risk

averse). Capitec appears well positioned to further lever its

balance sheet by its retail deposits. AB managements view is to

increase the ROE through ROA expansion (which we like) and not

leverage. We are just concerned that given the high ROA already,

this could be an aggressive target, and holding ROA at levels

around 8% could not be sustainable. On ROE outlook, we favour

Capitec as we expect Capitecs to go up while ABs slows down.

Valuation: Capitec trades at a higher PER and PBVR, probably

confirming the expected stronger growth. Trailing PERs shows rich

valuation for Capitec, trading at 18.2X while ABIL is at 12.8X. We

highlight that ABIL trades at a slight premium to Capitec in terms

of the price/deposit ratio (1.2X vs. 1.1).

Conclusion: We believe Capitec represents a better risk-return

profile, as reflected by the solid growth in both loans and deposits.Valuation prima facie looks excessive, but forward looking, we

believe Capitec enjoy a more flexible balance sheet, which allows it

to manage its interest spreads and margins better. Capitec has

more room to manage its funding mix, while AB chances are

limited. We do not expect ABs asset-led strategy to change.


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Volume (on loans and deposits) will be a central driver of earnings

(value) as competition increases.

Fig 24: Capitec fares better in most of the indictors, except valuation

AB Capitec Our comments

CAMEL indicators

Leverage 6.8 6

We see better room for Capitec to increase its leverage than African bank. However,

higher risk weighting could require more capital and inhibit leverage. Risk capital excess

could grow thinner.

Impairments/loans 10% 10%Both banks seem content and have a target of around 10%. Deterioration in employment

could hurt the ratio

Cost/income 25% 54%AB enjoys lower cost/income ratio. Capitec has room to improve, target ratio is 40%. After

full integration of Ellerines' financial services, the ratio is likely to increase for AB

NIM 11% 13%AB has a lower NIM, indicative of its wholesale deposit gathering strategy. We expect NIMs

to continue to narrow for both banks to around 8%

LDR 91% 71%

African bank's liquidity looks tighter. Capitec has more room to increase its LDR. AB's LDR

declined to 82 for 1H10

Concentration risk a nd efficiency indicators

10 largest depositors >50% AB's.

Capitec 's growth seem natural (i.e. LDR = 71%), but we also like AB's apparent "controlled

growth" nonetheless

Deposits 46% 101.3%AB's funding is constrained by the dependence on the wholesale market. Capitec can roll-

out an aggressive deposit gathering strategy if need be

ROE decomposition

ROA 7% 5%African bank has a higher ROA. Higher asset yields due to fewer branches. Target is 8% for

AB which we believe may not be sustainable

Leverage 7 6Capitec has slightly lower leverage. Better opportunities to increase it than AB but higher

capital requirements for "risky' assets could limit it

ROE 46% 30% We are mildly bullish on Capitec's ROE, but bearish on AB's

Valuation, vs. ABIL (not AB)

PER 12.8 18.2 Capitec's PER is higher than ABIL. Both PERs are above their LT average though

PBVR 2.1 5.2 ABIL trades at low PBVR, which could be motivated by low growth in equity

Div. yield 6% 4%ABIL has a higher dividend yield. Capitec's payout ratio is 40%; ABIL >70% although target

is 60%

Price/Deposit 1.21 1.10 On this metric, ABIL is trading at a slight premium to Capitec

Source: Company reports, Bloomberg, Legae Calculations

Note: We used ABILs funding liabilities as a proxy for deposits.


42/56

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3. Appendix 2: A snapshot of the

industry structure and regulatory risk

Note: We expanded our analysis on regulatory risks (section 3.2).

However, the major part of this industry analysis (section 3.1) is also

carried in our Capitec initiating report.

3.1 Industry structure and developments

The South African banking industry has registered remarkable growth

post CY00 with system lending assets rising from R500bn to R2.25tn byCY09. The Loans/GDP and Deposits/GDP ratios also went up, reaching

0.96 and 0.93 by CY09 respectively. The level of debt in households also

shot up; the debt/disposable income level increased from 54.2% in

CY00 to 80.1% in CY09, for example. The liquidity position of the

system worsened due to the strong growth. The funding gap (local

deposits less loans and advances) rose to about 14% of GDP by CY08.

The LDR jumped from an average of 82% before CY03 to 103% by

CY09. However profitability remained relatively strong, supported by 1)

a high concentration level that reduces competitive pressures and 2)

stable interest spreads due to the cap on prime to REPO rate. ROE

increased due to higher system leverage. System leverage ratio rose to

18X in CY08, from an average of 12.6 (between CY03 and CY07) before

declining to 15X in CY09. The system, in our opinion, remains well

capitalised. Given the structure of the industry, we believe that:

loan growth should recover, but may not revert to the recent past

levels in the short term because of1) high penetration rates, 2)

high debt/disposable income level, 3) deteriorating structural

liquidity position, and 4) poor loan growth factors. Medium to long

term, the poor population growth rate also diminishes our industry

growth expectations although rising per capita income should be

constructive to banking services demand.


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We also emphasize that over the previous decade, the rate of loan

growth versus nominal GDP growth widened significantly. Industry

loans and advances have grown by a CAGR of 17% while nominal

GDP gas grown by a CAGR of 12%. In our view, the natural

growth of industry loans is driven by the nominal GDP growth rate.

We believe that the spread in growth rate between nominal GDP

and system loans and advances will narrow, and this represents

risks to loan growth in the short- to medium-term.

Despite the favourable economic outlook, we believe that

loan growth w ill be muted in the short to medium term.

Fig 25: South Africa GDP grow th expected to recover, but we see poor loan grow th factors

Majorloangrowthfactors

Bankingassets = Bankingassets XCapita

Capita

GDP X BankingAssets X Capita

Capita GDP

percapita

income pe ne trati on popul ation

1.8%

2.9%

3.5%

2.2%

2.0%

3.8%

3.0%

2.0%

1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

2009 2010 2011

Bloombergconsensus

IMFforecasts

Source: Bloomberg, IMF, Legae Securities


44/56

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The industry is highly penetrated. Loans/GDP and deposits/ GDP

is at 96% and 93% respectively.

Fig 26: The systems penetration rate is higher relative to other EMS.

10%

10%

30%

50%

70%

90%

110%

Nigeria Turkey Russia Brazil Chile RSA

2009

Loans/GDP

Deposits/GDP

0.55

0.65

0.75

0.85

0.95

1.05

1.15

2003 2004 2005 2006 2007 2008 2009

Loans/GDP

Deposits/GDP

Source: Company reports, Legae Calculations

Industry registered strong growth since CY00, LDR exceed 100%

since CY04.

Fig 27: Negative grow th was registered in loans for the first time this decade. LRD remained high

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

20 00 2 00 1 2 002 20 03 20 04 2 00 5 2 00 6 20 07 20 08 2 00 9

LDR

10%

0%

10%

20%

30%

40%

50%

60%

0.00

0.50

1.00

1.50

2.00

2.50

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Lendingassets,LHS

Deposits,LHS

Loangrowth rate

Depositsgrowthrate

Source: SARB, Legae Calculations


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The high industry concentration should support profitability. Top

4 banks enjoy over 80% of the market.

Fig 28: Top 4 banks enjoyed >80% market share since CY03. Oligopolistic industry, H-Index >0.18

0.175

0.170

0.182

0.1 84 0 .18 4

0.1900.189

0.160

0.165

0.170

0.175

0.180

0.185

0.190

0.195

2002 2003 2004 2005 2006 2007 2008

HIndex

69.5%

74.0%

87.0%

83.4%

84.6%

60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

2001 2002 2003 2004 2005 2006 2007 2008 2009

Big4marketshare


System liquidity position worsened, the funding gap (local

deposit less advances) went up to R329bn, and average LDR

close to EM average

Fig 29: The Funding gap worsened to R329bn in CY09. LDR close to EM average despite being >1

0%

20%

40%

60%

80%

100%

120%

140%

LATAM CEE RSA AsiaexJapan

L DR A ve rage

350

300

250

200

150

100

50

0

Jun95

Feb

96

Oct96

Jun97

Feb

98

Oct98

Jun99

Feb

00

Oct00

Jun01

Feb

02

Oct02

Jun03

Feb

04

Oct04

Jun05

Feb

06

Oct06

Jun07

Feb

08

Oct08

Jun09

Fundinggap,Rbn

Source: SARB, IMF, UNCTAD, Legae Calculations


46/56

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High household debt levels and low savings should be a negative

to the long-term system liquidity.

Fig 30: Debt/ disposable income rose steeply in CY03; RSA households have one of the w orst savings

culture as indicated by the savings/ GDP ratio

30.0

40.0

50.0

60.0

70.0

80.0

90.0

1980/01

1982/03

1985/01

1987/03

1990/01

1992/03

1995/01

1997/03

2000/01

2002/03

2005/01

2007/03

Debt/disposableincome

0%

10%

20%

30%

40%

50%

60%

China India Japan Europe Australia USA RSA

Savings/GDPratio

Source: SARB, IMF, Legae Calculations

The system primarily depends on wholesale funding. However,

more deposits are taking longer tenors.

Fig 31: Wholesale deposits constitute 47% of the system loan book; 21.6% of the deposits are long

term

13.9% 11.7% 12.9% 14.2% 16.3% 17.6% 20.2% 20.6%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2002 2003 2004 2005 2006 2007 2008 2009Otherdemandd ep . S av in gs S ho rtt er m M ed iu mte rm L ongterm

47%

28%

18%

3%3%

2%

Wholesaledeposists

Commercialdeposits

Householddeposits

Localcapitalmarkets

Foreignfunding

Other



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Page 46 of 56

The mortgage industry constitutes the highest exposure

Fig 32: Mortgage loans make up 44.5% of the industry loan book

33.6%37.7% 39.8% 40.3% 41.4%

41.9% 44.5%

1.8%2.0%

2.4% 2.6% 2.7%2.5%

2.5%27.1%

25.9% 23.0% 22.7%23.0% 24.5%

24.5%

37.5% 34.5% 34.9% 34.4%32.9% 31.1%

28.5%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003 2004 2005 2006 2007 2008 2009

Mortgage loan s C re ditcardsd eb to rs o ve rd ra ft s o th er

26%

29%

34%

39%

43% 42% 43%

25%

29%30%

25%

14%

3%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

2003 2004 2005 2006 2007 2008 2009

Mortgage loans/GDP

Mortgage loangrowth


Credit risks went up materially in CY08 as the system came

under acute stress due to the recession

Fig 33: Overdue accounts/ loans is above long-term average

0

20

40

60

80

100

120

140

160

2004 2005 2006 2007 2008 2009

Overdueamounts,

Rbn

1.8%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Mar04

Jun

04

Sep

04

Dec

04

Mar05

Jun

05

Sep

05

Dec

05

Mar06

Jun

06

Sep

06

Dec

06

Mar07

Jun

07

Sep

07

Dec

07

Mar08

Jun

08

Sep

08

Dec

08

overdueacc/advances

average



48/56

Page 47 of 56

Rising NPLs w ere more of a global phenomenon in CY09...

Fig 34: ROEs tumbled in CY08, triggered by heavy credit costs. Only China managed to registered

slowing NPL/ Loans ratio in CY09

15%

10%

5%

0%

5%

10%

15%

20%

25%

30%

35%

2004 2005 2006 2007 2008 2009

ROE

UK USA Russia Brazil India RSA

0%

2%

4%

6%

8%

10%

12%

14%

UK USA Russia Brazil China India RSA

NPL/Loansratio2004

2005

2006

2007

2008

2009

Source: IMF, Global Financial Stability Report April 2010

...South Africas banking system credit risks were manageable

despite the spike in NP Ls...

Fig 35: NPLs/ Loans ratio for RSA was greater than most DM and major EMs like Brazil, China and

India

0%

2%

4%

6%

8%

10%

12%

14%

16%

Australia

China

India

Argentina

UK

Mexico

Indonesia

Malaysia

Brazil

Chile

Spain

USA

RSA

Turkey

Nigeria

Poland

Greece

Russia

Egypt

Nonperformingloans/totalloans,2009

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

UK

Greece

Poland

USA

Spain

RSA

Australia

Turkey

Malaysia

Egypt

Russia

Argenti

Indonesia

China

Brazil

Mexico

Chile

Provisions/NPL,2009

Source: IMF, Global Financial Stability Report April 2010


49/56

Page 48 of 56

...and the system remained w ell capitalised in our opinion.

Fig 36: Capital is adequate in our view , but proposal by Basel II if implemented could require more

capital for banks

50,000

80,000

110,000

140,000

170,000

200,000

230,000

2003 2004 2005 2006 2007 2008 2009

Totalsystemcapital,Rmn

12.812.2

12.7 12.7 12.6

18.0

15.0

0

2

4

6

8

10

12

14

16

18

20

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

2003 2004 2005 2006 2007 2008 2009

capital/total loans

capital/total assets

leverageratio,RHS


Relatively stronger profitabi lity and capital levels is a positive for

the local system

Fig 37: RSA banks ROE fares well despite a 10pp decline in CY09. Most banking systems are well

capitalised, after recapitalisation in some markets, especially the DM

5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

UK

US

A

Ru

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