capitec bank_valuation looks steep but growth outlook is the differentiating factor_final

8/9/2019 Capitec Bank_Valuation Looks Steep but Growth Outlook is the Differentiating Factor_final

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Company Information

BloombergTi cker CPISJ

CurrentPrice(cents) 10,100

12monthPriceTarget 12,162

MarketCap,Rbn 8.33

Shareso uts ta nd in g,mn 8 2.9 83

Potential capitalgain 20.42%ForwardDiv Yield 2.71%Forecasttotal return 23.13%

ImpliedPER,X 23.9ImpliedPBVR,X 6.4YTDcapitalreturn 27%

52WeekReturn 179%

Salient information

Rand,mn 2009 2010 2011F 2012F 2013F

NII, 943 1,273 1,598 2,055 2,427

Netfee i nco me 1, 036 1, 282 1, 605 2, 047 2, 457

EPS,cents 357 509 683 874 1,028

Loansandadvances 2,982 5,225 7,176 10,573 13,994

D ep os it s 3, 317 7, 360 9 ,568 12, 439 15, 549

BVPS,ce nts 1, 489 1,910 2,325 2,850 3, 466

NIM 19.0% 13.4% 13.1% 13.1% 12.4%

Cost/Income 54% 54% 53% 52% 51%

LDR 90% 71% 75% 85% 90%

ROE 25.5% 28.6% 31.5% 32.9% 31.8%

ForwardPER,X 14.8 11.6 9.8

ForwardPBVR,X 4.3 3.5 2.9

Returns vs. Banks & ALS Indices

12%

11%

13.5%

39.3%

7%

6%

12.9%

38.7%

27%

32%

60%

174%

0% 50% 100% 150% 200%

YTD

3Months

6Months

1Year

Capitec

ALSI

BanksIndex

CAPITEC BANK

Valuation looks steep, but grow th

outlook is the differentiating factor

We initiate coverage on Capitec Bank with a BUY

recommendation. In section 1 of this report, we provide an

analysis of the banking sector, comparing it to other

Emerging markets (EMs) and/ or history where necessary.

In section 2, we carry out our company analysis (Capitec

Bank), presenting our forecasts and their basis. We also

show our valuation model and provide an environmental,

social and governance (ESG) comment.

Overall, the banking industry structure, and the borrowers

profile, particularly households, are poor and w eak. In that

light, we do not like:

the high penetration rates. The loan/GDP and deposit/GDPratios are high at 96% and 93% respectively. This provides

little room for excess loan growth above GDP growth

without catalysing liquidity problems in the long-term;

the high debt/disposable income level which makes thehousehold borrowers profile poor in our view. South Africas

debt/disposable income ratio is around 80%, which does not

compare favourably against history and other EMs; the poor outlook for major loan growth factors. Only per

capita income screens positively for loan growth; and

the increasing funding gap that could create liquidityproblems in the long-term. The funding gap is R329bn, and

could grow to R500bn by 2012. The Loan-to-deposit ratio

(LDR) is already above 100% at 103% and the leverage

multiple is 15X.

Initiation of coverage: We initiate coverage on Capitec with a

BUY recommendation. Our 12-month price target is R122,

providing a potential total return of 23.1%. While the share price

has re-rated strongly from April last year, and has outperformedthe Banks Index and the All Share Index by wide margins, we

believe there is some value on the table. We are convinced that

the bank commands a strong position in its market segment. It

has strong capital and liquidity levels that can be deployed to

grow loans and profitability, and has an experienced management

team.

Peter Mushangwe

Puleng Kgosimore+27 11 551 [email protected]

Please refer to the back of this report to

view our disclaimer and disclosure

April 19 2010 Equity Report

RECOMMENDATION

BUY


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Contents page

Executive Summary 2

1. Industry Analysis 5

1.1 We loath high penetration, but we like high H-Index 5

1.2 Credit risks: Slower NPL formation to aid profitability 11

1.3 Liquidity risks: Funding gap is increasing 15

1.4 Capital risks: Adequate capital levels 19

1.5 Profitability: We carry loan growth worries 20

1.6 Why the micro-market could be the winner 23

1.7 The macro story: So far so good 27

2. In itiation of Coverage 31

2.1 Capitec Bank: Initiating with a BUY 31

2.2 Company Analysis 34

2.3 Financial Forecasts and Valuation 45

2.4 Corporate governance and other ESG issues 50


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The Executive Summary.

Initiating w ith a BUY, our 12-month price target is R122: We

initiate coverage on Capitec Bank, [Bloomberg CPI SJ] with a BUY

recommendation. Our primary method is the Justified

Price/Earnings ratio (PER), which we estimate at 17.8X. We

multiply the Justified PER by our FY11 earnings per share (EPS) to

get a 12-month price target of R122. This provides a potential total

return of 23.1%. Our secondary valuation method, the Discounted

Future Earnings (DFE) provides a fair value of R113, giving a

potential total return of 14.7% from the current price. We use aCost of Equity (CoE) of 17.5% to discount the earnings and an exit

PER of 13X for our terminal value (TV).

Good company, but bad stock?: To an extent, we were caught

between the high valuation risk argument and our earnings

outlook. Our analysis points out the strength of franchise and the

strong growth outlook. But the relatively high trailing PER created

some discomfort. However, we become more convinced that our

earnings outlook is a stronger argument for exposure. Our

recommendation is underpinned by our forecast of strong excess

earnings, in spite of our conservative estimates (relative to history

and management guidance). Our forward PER reduces to 9.8X in

FY13. For investors (and not speculators), the risk/reward profile is

still appealing, in our view.

What w e like about Capitec: We like the 100% exposure to the

high-margins, low income segment, and the experienced

management. The low income segment is less leveraged when

compared to the mainstream banks general customers. This,

supported by the recent pace of deposits gathering should provide

above system loan growth. The high cash level, low leverage and

low LDR provide room for stronger loan growth for Capitec when

compared to the industry. The Net Interest Income (NII) growth

rates are strong and Net interest margins (NIM) are healthy. Net


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fee income has increased materially, with high growth rates.

Management is also experienced in our opinion, and has managed

to control both credit and operating costs. The ROE outlook is solid

in our view.

What w e do not like about Capitec: The unwanted side-effects

of a rapid credit expansion, and to low income segments is the

higher credit risks. Capitecs overdue accounts/loan ratio is higher

than the industrys average. We also do not covet the apparent

high valuation risk of the share. The trailing PER of 19.7X does not

compare positively against the Banks Index PER (I-net) of 14.5X,

notwithstanding the strong earnings growth outlook.

The industrys high penetration is a significant negative in

our view : The high penetration rates provide modest upside

potential in system loan growth beyond GDP growth without

negative impact on the systems liquidity. The systems banking

assets/GDP and loans/GDP ratios are 126% and 96% respectively.

The deposit/GDP ratio is 93%. While both the loan/GDP and

deposit/GDP ratios are still below 100%, the loan/deposit ratio is

above 100% at 103%;

But the high concentration level reduces competitivepressures: The high concentration level reduces competition,

particularly for the Big 4 banks. The Herfindahl Index (H-Index) is

above 0.18 indicating high market share concentration. The Top 4

banks market share is 84.4% (2008, and based on banks balance

sheets). Theoretically, the system is oligopolistic;

System credit risks increased in CY2008-9 but we expect

slower non-performing loans (NPL) formation to aid

profitability hereafter: With the recovery of the economy, we

expect system NPL formation to reduce. There is increasingpositive management guidance in terms of credit risks,

(notwithstanding Standard Banks famous guidance that NPLs

have not peaked yet). Our view is that the pace of both rand and

percentage growth should slow this year. In our opinion, the major


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sector to watch is the real estate which makes up 44% of the

industrys loan book.

Sector liquidity risks worry us as the funding gap is

increasing and the LDR is now over 100% : The systems LDR

is high at 103% and the funding gap is increasing. The funding gap

is R329bn, about 14% of GDP. Our estimation indicates that by

2012, the funding gap will be close to R500bn. As the funding gap

increases, the system will depend more and more on foreign

funding and the interbank market, which are both volatile. The low

savings rate is also unconstructive to the systems long-term

liquidity. South Africas savings/GDP ratio is below 20% compared

to about 50% for China, for example.

The industry is profitable, and the average ROE is 15.8%

since FY02: The industrys average NIM ratio is stable at 3.3%

since FY00 while the average interest rate spread is 3.4%.

Industry profitability has increased by a compounded annual

growth rate (CAGR) of 19.4% between FY04 and FY08. The

industrys average ROE (CY02-CY08) is 15.8%.

The system has enough capital: The strong capital position

allows further loan growth. The local system escaped the liquiditycrunch (2007-2009) without major victims. Banks remained

relatively well capitalised, despite the higher leverage (15X) when

compared to history. We believe there is no need for consolidation

in order to strengthen the system.

Why the Micro-finance market could be the winner: In our

view, the micro-finance sector can perform better than

mainstream due to 1) lower debt levels by the lower income

consumer which provide room for further borrowing, 2) the

defensiveness of assets when compared to the main streamsystem. Micro-banks exposure to structured credit products and

capital markets is minimal if not non-existent, 3) lower

concentration levels on both the asset (loans) and liability

(deposits) side of the balance sheet. This reduces credit and

liquidity risks, 4) higher NIM and interest rate spreads.


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1. Industry Analysis

1.1 We loath the high penetration rates, but we like thehigh H-Index.

The South African banking industry is highly penetrated. Both the

loan/GDP and deposit/GDP ratios are high, at 96% and 93%

respectively. (see Fig 1). The banking sector has experienced strong

growth, and the industry balance sheet has expanded significantly.

Loans and advances, particularly to households, pushed the systems

asset growth. Mortgage and credit card advances went up by a CAGR of

20.5% and 21.9% between CY03 and CY09 respectively. Theloans/banking assets ratio ascended by 11 percentage points (pp) from

70.1% in CY03 to 81.4% by CY06. The ratio slowed in CY08 to 73% but

has since recovered to 75.5% by CY09.

The banking sector assets/GDP ratio rose to 135% in CY08 from 85% in

CY00. South Africas penetration levels on both the asset and liability

side are high when compared to other EMs. In our view, this provides

modest upside potential to industry players in the long-term, particularly

when compared to other EMs...

...but the benefits come from a highly concentrated market. The

banking industry is highly concentrated with an H-Index of over 0.18.

(based on balance sheet size). The market share of the Big 4 banks

averages 84.4% since CY03. This is 14.9pp above the 69.5% market

share of the Big 4 banks in CY01 (see Fig 2). In our judgement, the

barriers to entry, particularly regulatory and capital requirements,

create further impediments to competition. Theoretically, the industry is

oligopolistic as the H-Index is above 0.18. When the industry is not

fragmented, one would expect it to carry less competitive pressures.

However, we believe the high concentration level does not bode well for

smaller competitors who should find it difficult to create necessary

economies of scale and compete hence a differentiated focus strategy

becomes imperative. For the Big 4, this is visibly an important

positive.


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Fig 1: The industrys penetration rates are high. Growth potential is w eaker 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: IMF, UNCTAD, Bloomberg, SARB, Legae Calculations

Fig 2: The Top 4 banks dominate the market... ... and the H-Index has worsened since 2002

69.5%

74.0%

87.0%

83.6% 83.4%84.1%

85.1%

84.4%

50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

2001 2002 2003 2004 2005 2006 2007 2008

0.175

0.170

0.182

0.184 0.184

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

Source: SARB, Legae Calculations


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South Africas debt/ disposable income ratio is high. The ratio rose

steeply from around 50% in 2002 to around 80% in 2007 and has since

stabilised around that value. Higher debt/disposable income levels make

the industry less appealing. The high levels of debt/disposable income

affect banks in two main ways; 1) it limits the expansion of loan books

as demand is constrained 2) it leads to higher default rates particularly

in times of economic stress as there would be little room for borrowers

to manoeuvre when income falls. Needless to say, both are detriment to

the bottom line. Compared to other EMs such as Russia and China,

South Africa screens poorly on the debt/disposable income ratio. For

example, Russias debt/disposable income ratio in 2008 is estimated at

23%. Our view is that this will have a negative impact on loan growth as

households have little capacity to carry more debt. (See Fig 3)

Fig 3: Debt/ disposable income ratio rose steeply in CY02... ...and compares poorly against EMs e.g Russia

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

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

2004 2005 2006 2007 2008

RSA

Russia

Source: SARB, IMF, Legae Calculations

Despite the relatively poor profile of the South African borrower,the system registered strong loan growth from CY2000 to

CY2009. Loan and advances went up by a CAGR of 17.5% over the

period. Deposits registered a weaker CAGR of 15.4% over the same

period. The LDR went up from 87% in CY00 to 103% by CY09. (see Fig

4).


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It is important to note that the loans and advances grow th rate

outpaced the deposits growth rate since CY2003 (see Fig 4).

Starting in 2H08, however, the deposit growth rate outpaced the loan

growth rate. The loan growth rate receded on 1) effects of a tighter

monetary policy, 2) stringent risk-based lending procedure that were

both self induced and National Credit Act (NCA) induced and 3) lower

loan demand as the economy started to show signs of weaknesses.

The systems total loans and advances grow th plunged in 2009,

and so did the deposit growth rate. While strong quarterly growth

in loans and advances was registered in CY06 and CY07 (29% and 22%

respectively), growth rate receded in CY08 to 12.3% and turned

negative in CY09 at -2.6%. The deposits growth rate also tumbled from

16.7% in CY08 to 0.4% in CY09. The simple average quarterly growth

rates for loans and advances and deposits since CY95 is 7.1% and 7.3%

correspondingly. (see Fig 5).

Anecdotal data indicates that banks have eased, or are easing

credit standards. Coupled with the expected recovery and the

relatively lower interest rate environment, we would expect loan growth

to recover somewhat, especially as demand from corporates may firm.

We do not expect loan growth to recover to pre-crisis levels, mainly

because the household borrowers profile is weak. Furthermore,

notwithstanding the recovery, consumer and business confidence levels

are still below the pre-crisis levels.


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Fig 4: Loan & deposit growth was strong upto 2007... ...LDR has been >100% since 2003

500

1,000

1,500

2,000

2,500

10%

0%

10%

20%

30%

40%

50%

60%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Loans,Rbn(RHS)

Deposits,Rbn(RHS)

Loangrowth

Depositsgrowth

87%

83%

79%

106%104%

106%

110%111%

106%

103%

70%

75%

80%

85%

90%

95%

100%

105%

110%

115%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009


Fig 5: Loan growth plunged in 2008... ... and so did the total deposit grow th

7.1%

2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

Feb95

Feb96

Jan97

Jan98

Dec98

Dec99

Nov00

Nov01

Oct02

Oct03

Sep04

Sep05

Aug06

Aug07

Jul08

Jul09

Totalloansgrowth,q/q

average

7.3%

2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

Mar95

Feb96

Jan97

Jan98

Dec98

Dec99

Nov00

Nov01

Oct02

Oct03

Sep04

Sep05

Aug06

Aug07

Jul08

Jul09

Totaldepositsgrowth, q/q

average


South Africas three major loan growth factors screen poorly, in

our opinion. The three major factors we identify are 1) penetration

level 2) population growth and 3) per capita income. South Africa

screens poorly on 1 and 2. The penetration rate is high, as we have

already indicated, and the high debt/disposable income ratio

exacerbates the situation. Population growth rate is also weak. South


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Africas population is expected to grow to 51.5mn by 2025, according to

the Population Data Sheet 2009. The country has one of the lowest

fertility rates in the Sub-Sahara Africa and the high HIV prevalence

negatively affects population growth. Population growth rate is a long-

term theme in our view, but it still screens poorly. The only constructive

factor is the per capita income with an expected growth of 19.3%

between 2009 and 2014, expanding from US$5,635.2 to US$6,724. This

also ranks relatively well against EMs. (IMF forecasts)

Loan growth faces substantial headwinds in our view . Even in this

relatively low interest rate environment, which should spur loan

demand, the high leverage level of the borrowers still provides

significant risk to loan growth. Strong household loan growth (between

CY03 and CY08) might lead to banks restraining their loan growth rates.

Credit cards loans, for example went up by a CAGR of 22.4% between

CY03 and CY09. The growth could be an indication of credit penetration

into less credit-worthy segments. It could also be a sign of growing

exposure to the existing clients. Both would not be good for credit risks.

Our view, therefore, is that taking loan growth for granted this year and

even next year, could be risky.

But deposits growth is better placed for a rebound. On the liability

side, we expect a stronger rebound in deposits than loans. Transaction

accounts could increase due to 1) slowdown in leverage by households

which should increase savings in the medium term 2) lazy deposits

amid diminished risk appetite due to the uncertainty in economic

recovery.


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1.2 Credit risks analysis: Slower NPL formation to aidprofitability

The systems credit quality deteriorated starting CY07. Credit

quality started to deteriorate in 2H07, and by CY08 the rand amount of

the overdue accounts had increased by a CAGR of 41% from R21.9bn in

CY04. As a percentage of advances, the overdue accounts ratio went up

from a low of 1.1% in 2H06 to 3.8% in 2H09. The average overdue

accounts/total advances ratio from CY04 to CY08 is 1.8%. (see Fig 6)

As the economy recovers, leverage becomes a more important

factor to profitability. As the economy move from recession to

recovery, the differentiating factors in banking move from strength of

balance sheets to leverage, in our opinion. Recovery in loan demand,

albeit low, would be both constructive to NIM expansion, but banks that

can leverage stand a better chance to exploit it.

NPL formation to peak in 1H10, in our view . Slower NPL formation

due to better and improving economic conditions and the low interest

rate environment mean credit risks going forward should be soft,

especially when compared to the CY08 and CY09 levels. There is

increasing positive management guidance on asset quality despite

Standard Banks famous guidance that the NPLs have not peaked yet.

The low interest rate environment allows banks to restructure

problematic loans at lower cost and/or expanding the tenors of loans.

We expect NPL formation to peak in 1H10.

Provision levels have started to reduce. Systems overdue accounts

should still remain above the average 1.8% this year, but the pace of

growth should reduce. We, therefore, believe that CY10 will show an

improvement, but remain a fairly tough year due to the poor profile of

South Africas household borrowers. The restructuring of loans,

especially where tenors are extended effectively understate the NPLs.

While we could not get data to provide an insightful analysis concerning

the systems restructuring portfolio, academic research in the US has

shown than about 50% of the loan restructured become NPLs a year

later.


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Real estate sector is the key focus area for credit risk

monitoring: For CY10, our view is that loan recovery is inescapable,

albeit slow. Already, the loan/total assets ratio has rebounded although

it is still below the 2005-2007 levels. The key focus area in our

judgment is the real estate sector. The systems highest exposure is in

this segment as indicated by the high weight it represents as a

percentage of total loans and advances. Credit card exposure is the

smallest despite general concerns about its quality. Credit card loan

growth declined from a peak of 47.4% in CY05 to 2.8% in CY09. In rand

term, the exposure enlarged by a CAGR of 21.9% from R16.9bn in CY03

to R55.7bn in CY09. The growth in this segment could be greatly

hampered by high household debt levels. The highest credit risk

exposure for banks is the real estate as about 44.5% of loans are

mortgage loans. The mortgage loans/GDP ratio has increased from 26%

in CY03 to 43% in CY09, despite the decreasing growth rate of

mortgage loans since CY2006. (see Fig 7 and Fig 8). Nonetheless, the

recovering real estate sector should reduce risk.

Regulatory risk is one of the greatest risks in the short- to

medium-term, in our opinion. In our view, despite our expectation of

improving credit risks, the key headwind will come from regulatory risks.

As we indicated, our opinion is that at this stage of the recovery,

leverage is more important to banks in order for them to capture the

recovery and enhance bottom line. How much leverage banks will be

allowed to assume by regulators is the major question, not only in the

local market but even internationally. We do not expect regulatory risk

in the Developed Markets (DM) to have the same and immediate impact

to the local market but the international banking sector faces long-term

structural changes that should eventually affect local banks in the long-

term.Basel committee consultative documents already point to

regulatory changes: In December 2009, the Basel Committee

governing body issued key elements of the reform programme for

consultations. The key elements were:


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raising the quality, consistency and transparency of banks

capital bases;

strengthening the framework of the risk coverage of capital;

introduction of leverage ratio as a supplementary measure to

Basel ii risk-based framework;

introduction of a series of measures to promote the building of

capital buffers in good times; and

introduction of a global minimum liquidity standard for

internationally active banks that include a 30-day liquidity

coverage ratio underpinned by a longer-term structural liquidity

ratio.

The major aim is to strengthen, and potentially raise the minimum

capital requirements and maintaining ample liquidity. Higher capital

levels and higher liquidity levels than is the case now would

result in lower credit growth.

Fig 6: Overdue accounts/ advances went up in 2008... ...and in rand-term it reached R87.3bn

0

10

20

30

40

50

60

70

80

90

100

2004 2005 2006 2007 2008

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



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Fig 7: Total loans/ total assets ratio is recovering... ...and mortgages continue to dominate loan book

60%

65%

70%

75%

80%

85%

2003 2004 2005 2006 2007 2008 2009

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%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003 2004 2005 2006 2007 2008 2009

Mortgage l oan s Cr ed itcardsdebto rs o ver dr af ts o ther


Fig 8: The mortgage loans/ GDP ratio has stabilised at >40% . Growth in credit card loans tumbled in 2008-9

24.9%

47.4%

40.8%

25.5%

4.0%2.8%

10%

0%

10%

20%

30%

40%

50%

60%

2004 2005 2006 2007 2008 2009

26%

29%

34%

39%

43% 42% 43%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

2003 2004 2005 2006 2007 2008 2009

Mortgageloans/GDP

Mortgageloangrowth



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1.3 Liquid ity risks analysis: The funding gap is increasing

Funding gap is growing fast, and LDR is high . The South African

banking system stood the 2008-2009 liquidity tsunami with no

noticeable victims. Liquidity positions of banks remain strong, but we

are beginning to be concerned with the growing funding gap, (customer

loans and advances less customer deposits) which has now grown to

R329bn. The LDR at 103% is not beneficial to liquidity and loan growth

in the short-term. The local interbank markets have become crucial in

funding the systems loan book. Needless to say, the interbank market

is volatile as a source of funding, and we recall the demise of LehmanBrothers among others who became victims of over-reliance on the

interbank market. We also highlight that during the last credit cycle

downturn (2001-mid 2003), both the funding gap and the LDR dropped

but this time around they held up.

Funding gap could reach R500bn by 2012 . The current funding gap

is R329bn, which is about 14% of GDP. The industry funding gap will

grow to R491bn should it continue to grow at 7.8% which is the average

growth rate since CY02. Assuming that the funding gap will grow at a

subdued rate of 1.8%, like was the case in CY09, then the gap willincrease to R466bn by CY12. (see Fig 9)

The system heavily relies on wholesale deposits. The industry

currently relies heavily on wholesale deposits, which is a concern to us

in terms of liquidity and impact to NIM. Wholesale deposits are not only

actively managed, and thus more volatile and more expensive, but they

also increase the degree of concentration risk. Investor-awareness,

where people invest their savings through money market funds instead

of ordinary deposit products could partly explain this high reliance on

the wholesale market. The comforting feature of the system funding

structure is that long-term deposits continue to rise, increasing from

13.9% in CY02 to 23.3% in CY09. (see Fig 10).

Low household savings rate could aggravate liquidity risks in the

long term. The lower savings ratio for South Africa is a negative for the

sectors long-term liquidity. Lower savings in a market that has had high


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loan growth rates in the recent past leads to higher LDR. This could

ultimately result in liquidity problems. Countries with high savings

ratios, like China, tend to have lower LDR. The high savings rate(s) in

China (Asia) act(s) as a buffer to leverage. (see Fig 11).

We note that some of the major local banks (i.e. Standard Bank and

First Rand) established relationships with Chinese banks. Although this

has often been analysed in terms of possibilities of deal flows, especially

of trade finance and corporate finance nature, the other invaluable

benefit we identify is access to liquidity. Liquidity could be accessed

through direct credit lines or syndicated loans. We believe no-one will

drop the cash out of a helicopter, especially in light of the 2008-09

liquidity crunch, but the benefits will outweigh the costs, in our opinion.

Fig 9: The industry funding gap has worsened to >R300bn... ...and could hit R500bn by 2012

350

300

250

200

150

100

50

0

Jun

95

Jan

96

Aug

96

Mar

97

Oct97

May

98

Dec

98

Jul99

Feb

00

Sep

00

Apr

01

Nov

01

Jun

02

Jan

03

Aug

03

Mar

04

Oct04

May

05

Dec

05

Jul06

Feb

07

Sep

07

Apr

08

Nov

08

Jun

09

550

500

450

400

350

300

250

200

2010/06

2010/12

2011/06

2011/12

2012/06

2012/12

1.8%growth, av.for09

6.8%growth, av.since06

7.2%growth, av.since02

Source: SARB, Legae Securities


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Fig 10: Wholesale deposits make the highest contribution to funding but lon g-term deposits are rising

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 2009Otherdemandde p. Savi ngs Shor tte rm M ed iumte rm L ongterm

47%

28%

18%

3%3%

2%

Wholesaledeposists

Commercialdeposits

Householddeposits

Localcapitalmarkets

Foreignfunding

Other


Fig 11: The gross savings/ GDP ratio is low for RSA... ...but the LDR is high

0%

20%

40%

60%

80%

100%

120%

140%

LATAM CEE RSA Asiaex Japan

LDR

Average

0%

10%

20%

30%

40%

50%

60%

China India Japan Europe Australia USA RSA

Source: IMF, UNCTAD, SARB, Legae Calculations

Interbank assets increased from CY04 levels, but reduced in

CY09. The ratio of interbank assets/total deposits peaked in 2007-2008

before softening in CY09. In our view, the decline in this ratio could

have been catalysed by some form of risk aversion in the interbank


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market during the peak of the global crisis, notwithstanding the

soundness of the local system when compared to the DMs. The volatility

of the interbank market deposits, negatively affect Asset and Liability

management (ALM) strategies which could have an indirect impact on

profitability while the higher cost of such deposits have a direct impact

through lower NII.

Non-residents deposits/ total deposits increased in 2008-9. The

ratio of non-residents deposits/total assets, which was below its average

of 4.6% (between 1992 and 2009) also started to migrate upwards

towards the average in CY06. By CY09, the ratio slightly exceeded the

average at 4.7%. The other period when the system had a ratio higher

than 4.6% was from 1997 to 2001 when the ratio peaked at 6.9% in

1998. (see Fig 12). Given South Africas relatively higher ranking in

banking soundness, one may assume this was a confidence indication,

but we note that in rand terms non-resident deposits declined by 28.9%

from R102.9bn to R73.2bn in CY09.

Fig 12: Interbank assets/ total deposits ratio Non-residents deposits/ total deposits

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

2003 2004 2005 2006 2007 2008 2009

0%

1%

2%

3%

4%

5%

6%

7%

8%

90%

91%

92%

93%

94%

95%

96%

97%

98%

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

residents deposits/total deposits,LHS

nonresidentsdeposits/total deposits

average(nonresidentsdeposits/total deposits)



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1.4 Capital risks: Capital is adequate, no need forarranged marriages

The system is well-capitalised, and did not seek capital during

the 2008-2009 crisis. In order to retain assets and more-so grow

them on the balance sheet, the bank must be optimally funded by

capital. Because government debt is zero-risk weighted asset, during

periods of liquidity crisis, banks buy government bonds in order to

improve capital levels. While the credit profile deteriorated in South

Africa, there was no stampede for quality as was witnessed in the DMs.

The systems capital position worsened in CY08 as capital fell in rand-

terms from R202.1bn in CY07 to R175.9bn. The capital/assets ratio

declined in unison. However, in CY09, the systems capital recovered

and increased to R198.1bn. (see Fig 13)

We believe in the near-term there is no need for consolidation in

order to strengthen the system.

But the system is more leveraged relative to history. System

leverage increased by 5.4 points in CY08. The leverage ratio that was

relatively stable at around 12.5X since between CY03 and CY07 climbed

to 18X in CY08 before it declined slightly to 15.0X in CY09. (see Fig 13)

Fig 13: Industry capital level has recovered,Rmn but leverage is high relative to history

50,000

80,000

110,000

140,000

170,000

200,000

230,000

2003 2004 2005 2006 2007 2008 2009

12.812.2

12.7 12.7 12.6

18.0

15.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

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



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1.5 Profitability analysis: Better earnings to come withbetter times but we carry loan growth w orries

Profitability was strong between 2004 and 2008. The system

profitability has increased materially during the past five years, pushing

up ROAs and ROEs. System net profit jumped from R17.4bn in CY04 to

R35bn in CY08, a CAGR of 19.1%. This is the period when loan growth

was highest since CY95, with an average annual growth rate of 9.9%

versus average growth rates of 7.6% since CY95 and 7.9% since CY00.

Although loan growth reduced in 2H08, the growth was in excess of

10% since 2H04, peaking at 15.1% in 2H06.

Profitability declined in CY2009. In 2009, profitability slumped but

we expect a rebound driven by accelerating revenue growth and falling

bad debts. Costs could be a headwind should rehiring recover, otherwise

efficiencies and cost management benefits of 2009 should be tailwinds.

System average ROE is 15.8 since CY02, despite a material jump

in 2008. The systems ROE jumped significantly in CY08 to 28.7% from

18.1% the previous year. The average ROE from CY02 to CY08 is

15.8%. The ROA also rose strongly to 1.6% in CY08 from 0.8% in CY02.

In our opinion, the oligopolistic nature of the industry could sustain ROE

around the 2003-2007 level. (see Fig 14). It is also important to

highlight that the system average ROE, and more-so 2008 ROE is

greater than the cost of funds, which allows the sector to create value to

its shareholders.


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Fig 14: The systems net profit rose by CAGR19.1% (CY04-08) (Rbn). ROA and ROE w ent up accordingly

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

2002 2003 2004 2005 2006 2007 2008

ROE

average ROE

ROA,RHS

17.4218.58

26.38

31.80

35.00

5

10

15

20

25

30

35

40

2004 2005 2006 2007 2008

CAGR=19.1%


Average system NIM is 3.3%. System NIM has shown a steady

decline over the years, from 4.1% in CY00 to 2.7% in CY06 before

recovering to 3.6% in CY08. We see headwinds in CY10 NIM due to

lower loan growth and lower interest rates, despite the relative stable

interest spread.

Interest rate spread is stable at 3.4%.The interest rate spread has

remained largely stable, oscillating around 3.4% since CY00. (see Fig

15). The ability by banks to maintain this spread regardless of the

interest rate policy indicates the importance of loan growth and credit

management to profitability in the system. However, with the prime rate

now at 10%, and the REPO at 6.5%, we would expect pressure on

interest spread this year, particularly as liquidity is not plentiful as

indicated by the growing funding gap and LDR.


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Fig 15: The NIM (% ) average 3.3% since 2000 Interest spread average 3.4%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008

interestrate

earned

interestratepaid

interestspread

3.3

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2000 2001 2002 2003 2004 2005 2006 2007 2008

NIM

average


Major long-term profitability factors screen indifferently. The

major factors to profitability in our view are 1) loan growth, 2) interest

margins/spreads, 3) credit costs and operating costs i.e. management

of the cost/income ratio. These items drive the ROE in the long-term.

We investigate how these drivers may play out in the short-term.

Loan growth: As we indicated already, we believe loan growthwill be muted this year. Corporate lending could recover, but

households are still carrying a lot of debt. A sticky

unemployment rate reduces the potential for strong loan

growth.

Interest rate spreads: We expect the interest rate spread to

remain stable. The holdback to spread and NIM expansion even

when interest rates start to go up is the currently fixed spread

of the prime rate at 3.5% above REPO rate. The SARB and

Banking Association recently confirmed that there is no need tochange this policy. However, borrowers continue to be price

takers even when credit standards are loosening. The spread

could therefore slightly improve should interest rates rise.

Credit and operating costs: As we mentioned before, we

expect an improvement in credit costs. Our opinion is that


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Page 23 of 54

lower NPL formation and write-backs could aid profitability,

especially in 2H10. Banks that suffered most in CY2009 should

benefit better on write backs. Banks have managed also to

contain operating costs. We do not expect significant rehiring

that could negatively affect the cost/income ratios.

System earnings could rebound impressively this year. We,

however, believe that it will be invariably associated with recovery in

capital markets and trading conditions than core commercial banking

operations. Groups with investment banks should benefit more in our

view. However, trading income tend to be more volatile.

1.6 Why the micro-market could be the winner?

The micro-finance institutions principally provide financial services to

low-income consumers, including self-employed and small business

enterprise (SMEs) as well as those that are out of formal employment.

Below we indicate what we believe to be the major phases of banking

products, and the relationship to income levels. (see Fig 16). On a global

scale, countries with higher per capita incomes have higher demand for

products in phases 3 in addition to products in phases 1 and 2 while

those with low show a higher concentration in phases 1 and 2.

Taking the same concepts to the local market, higher income earners

have higher demand for products in phases 3 and 4 in addition to

products in phases 1 and 2. Low income earners have higher demand

for products in phases 1 and 2.

The major takeaway is the fact that the phases are inversely related to

population. There are more people needing phases 1 and 2 products

than there are requiring phase 4 products. This often makes phases 1

and 2 lower margin products as banks would benefit from higher

transaction volumes. However, the oligopolistic nature of the local

market ensures that relatively higher margins can be sustained in


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Page 24 of 54

phases 1 and 2 as well. Lower penetration in the low income segment

also enables micro-banks to enjoy relatively strong margins.

Micro-banks and other micro-finance institutions, on the

contrary provide unsecured products in phases 1 and 2, and that

often gives them a competitive advantage.

Fig 16: The Banking phases and relationships to income levels

Mainstreambanking,dominatedbytheBig4.

Savingsandloanaccounts Currentaccounts Creditcards Wealthmngmnt

Paymentservices Debitcards Consumerfinance Advisoryservices

Mortgages Otherunsecuredproducts

Othersecuredproducts

Lowendinstitutionse.g.MFIs,Abil,Capitec Topendbankse.g.Investec

Phase1 Phase2 Phase3 Phase4

Asincomeincreases,demand for newproducts,advisoryandwealthmanagementservicesincreases...

...butthe numberofpeople, whichaffectsvolumes,decreasesasonemovesupthe phases

Source: Legae Securities

There are various reasons why we believe that the microfinance market

may stand to benefit, and end up the winner given the high leverage

levels of the consumers. We highlight them below:

Lower debt levels for lower income consumers: As indicated on Fig

17 below, the lower income segments are less leveraged when

compared to the middle and upper income groups. Stringent risk-based

lending by the main stream banks often result in the exclusion of the

lower income group. Mostly, they lack collateral and require more tailor-

made products than generic ones. The lower debt levels in this income

group provide room for banks that are willing to assume higher credit

risks to expand their loan books.


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Page 25 of 54

Fig 17: Lower income people are less leveraged. Debt/ disposable income

0%

20%

40%

60%

80%

100%

120%

140%

160%

0to50 51to100 101to300 301to500 501to750 750+incomeperyear inrands,000

Source: FirstRand results presentation, Legae Calculations

Defensiveness of assets: Micro-banks assets tend to be defensive

when compared to main stream banks. Micro-lending, especially to

Small and Medium Enterprises (SMEs) focus on basic requirements oflife, e.g. food, education, shelter etc. The Micro-banks also have limited

exposure to structured and credit products which were principal drivers

of losses in the DMs banking system in CY09. Exposure to capital

markets and investment banking which is suffering from legacy risk is

also minimal. Micro-borrowers also tend to have an incentive in

maintaining a good repayment history and relationships as they have

few sources of finance. In our view, earnings visibility is crucial given

the sub-par economic growth.

Higher NIM and interest spreads: Micro-banks NIM and spreads arehigher than the mainstream banks. Lending rates are higher due to

obvious reasons of elevated risks of the borrowers, but lower coverage

of the micro-borrowers by the mainstream banks also provide pricing

power to the micro-banks. Average NIM for MFI is around 8% while for

mainstream banks the average is less than 4%.


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Page 26 of 54

Lower concentration risks: Most micro-banks are not dominated by a

few big depositors or borrowers. Due to the small value of deposits and

loans, concentration risk on both the asset and liability side is materially

reduced. The fragmentation of depositors and borrowers also works in

favour of micro-banking as it reduces the pricing power of both

borrowers and depositors.

Less volatile deposits: The tenors of micro-deposit tend to be longer

than deposits in the mainstream banking. There is also less reliance, if

at all, on the inter-bank market. This, combined with the lower

concentration risks, makes effecting Asset and Liability Management

(ALM) strategies easier than for mainstream banks. The other benefit is

that local depositors are becoming more concerned with banking fees,

and in a downturn, such worries are elevated. Micro-banks tend to be

more efficient and less expensive in term of banking fees when

compared to mainstream banks.

There are risks nonetheless. The major risks we perceive are:

Downscaling by mainstream banks: The Big 4 banks have capacity

and ability to downscale into the lower income segment. In fact some of

the banks have launched products that intend to capture this market

segment, especially on the liability side of the balance sheet.

Inability to benefit from government spending: The micro-banks

stand least to benefit from government expenditure. Exposure to

government infrastructure projects in terms of lending is almost nil.

Higher risk customers: The risk profile of the customers carry higher

risks notwithstanding the defensiveness of SMEs industries and other

micro-borrowers. SMEs tend to suffer worse during recession or

economic downturn periods as they have thin capital and cash flow

levels.Regulatory risks: The Micro-finance industry is broad and regulatory

changes continue to take place. For most micro-finance institutions that

are registered banks, the risk is however cowed.


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1.7 The macro story: So far so good, but nothing extra-ordinary

The macro-story of South Africa is good thus far, having started to pick

up the steam, and confidence levels rising. GDP growth is expected to

recover to 2.9% (Bloomberg consensus) (IMF = 1.8%). Along with it we

would expect a positive effect to 1) loan demand and 2) loan provision

levels. (see Fig 18)

The high loans/GDP ratio of South Africa relative indicates that the

economy is more leveraged than its peers. The question that becomes

important is: would the economy manage to increase its leverage in a

deleveraging world? There is still capacity to leverage, (Spain, one of

the so-called PIIGS had a ratio of about 160% in CY09), but we are

cautious of this leverage.

The feared double-dip risk seems to have waned. Internationally,

consumer and jobs data remain mixed, but with risk on the upside.

Locally, customers are happier than in 2008-2009. The confidence index

has rebounded and so has the Kagiso purchasing managers index.

Capacity utilisation level has also recovered. (see Fig 20 and Fig 21)

Our worry is that the double deficit that the country carries could

create risks, especially to the currency in the medium term. The

positive is that the current account deficit has narrowed. The relatively

high interest rates when compared to other EMs are also supportive of

the famous carry-trade. The fiscal deficit hit its highest at 20.5% of

GDP in 2Q09. To an extent, this was not a deliberate deficit expansion,

but a cyclical one. (expenditure/GDP ratio rose, but revenue fell much

worse hence creating a wider deficit). We would expect it to narrow as

the economy gain traction and revenue recover. (see Fig 22 and Fig 23)


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Economies are becoming healthy again ...

Fig 18: South Africas GDP growth expected to recover... ...along with the rest of the world

2008 2009 2010 2011

World 3.0% 0.8% 3.9% 4.3%

Advancedeconomies 0.5% 3.2% 2.1% 2.4%

USA 0.4% 2.5% 2.7% 2.4%

Euro 0.6% 3.9% 1.0% 1.6%

Germany 1.2% 4.8% 1.5% 1.9%

Japan 1.2% 5.3% 1.7% 2.2%

UK 0.5% 4.8% 1.3% 2.7%

EM 6.1% 2.1% 6.0% 6.3%

China 9.6% 8.7% 10.0% 9.7%

India 7.3% 5.6% 7.7% 7.8%

Brazil 4.2% 2.3% 3.7% 3.8%

Russia 5.6%9.0% 3.6% 3.4%

Africa 5.2% 1.9% 4.3% 5.3%1.8%

2.9%

3.5%

2.2%

1.8%

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: IMF, Bloomberg, Legae Calculations

...and GDP recovery should see some recovery in loans

Fig 19: GDP growth vs. loan growth Loans and deposit outpaced GDP growth since 2000

0.01

0.02

0.03

0.04

0.05

0.06

0.05

0.10

0.15

0.20

0.25

0.30

199

3

199

4

199

5

199

6

199

7

199

8

199

9

200

0

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

Loansandadvancesgrowth

GDPgrowth,RHS

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2000 2001 2002 2003 2004 2005 2006 2007 2008

Loans

GDP

Deposits



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Page 29 of 54

Happy customers are good for business...

Fig 20: Business confidence is increasing... ...and leading indicators show a better future

20

15

10

5

0

5

10

15

20

25

0

10

20

30

40

50

60

70

80

90

100

1995/

12/01

1996/

11/29

1997/

11/29

1998/

11/29

1999/

11/29

2000/

11/29

2001/

11/29

2002/

11/29

2003/

11/29

2004/

11/29

2005/

11/29

2006/

11/29

2007/

11/29

2008/

11/29

2009/

11/29

BusinessConfidenceindex,RMB

ConsumerConfidence,FNB,RHS

8%

6%

4%

2%

0%

2%

4%

6%

8%

10%

70

80

90

100

110

120

130

1995/12/01

1996/08/01

1997/04/01

1997/12/01

1998/08/01

1999/04/01

1999/12/01

2000/08/01

2001/04/01

2001/12/01

2002/08/01

2003/04/01

2003/12/01

2004/08/01

2005/04/01

2005/12/01

2006/08/01

2007/04/01

2007/12/01

2008/08/01

2009/04/01

2009/12/01

Leadingindicators index

change,%,RHS

Source: I-Net, Legae Calculations

...and the cash registers are recovering after the 2008-9collapse.

Fig 21: Kagiso PMI has rebounded... ...and capacity utilisation shows some recovery

72

74

76

78

80

82

84

86

88

90

1999/06

2000/03

2000/12

2001/09

2002/06

2003/03

2003/12

2004/09

2005/06

2006/03

2006/12

2007/09

2008/06

2009/03

2009/12

30

35

40

45

50

55

60

65

1999/10

2000/04

2000/10

2001/04

2001/10

2002/04

2002/10

2003/04

2003/10

2004/04

2004/10

2005/04

2005/10

2006/04

2006/10

2007/04

2007/10

2008/04

2008/10

2009/04

2009/10

Source: Bloomberg, Legae Calculations


31/54

Page 30 of 54

...but reliance on debt to finance the appetite of customers,business and government could be a risk

Fig 22: But we are concerned with the tw in deficit, % of GDP and the Current account deficit,Rmn q/ q

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

2.0%

4.0%

15.0%

17.0%

19.0%

21.0%

23.0%

25.0%

27.0%

29.0%

31.0%

33.0%

2004:Q4

2005:Q1

2005:Q2

2005:Q3

2005:Q4

2006:Q1

2006:Q2

2006:Q3

2006:Q4

2007:Q1

2007:Q2

2007:Q3

2007:Q4

2008:Q1

2008:Q2

2008:Q3

2008:Q4

2009:Q1

2009:Q2

2009:Q3

Surplus/(Deficit),RHS

Revenue

Expenditure

30000

25000

20000

15000

10000

5000

0

5000

10000

2003/03

2003/06

2003/09

2003/12

2004/03

2004/06

2004/09

2004/12

2005/03

2005/06

2005/09

2005/12

2006/03

2006/06

2006/09

2006/12

2007/03

2007/06

2007/09

2007/12

2008/03

2008/06

2008/09

2008/12

2009/03

2009/06

2009/09

2009/12

2010/03


...and unemployment rate remains high. Negative hiringis yet to rebound despite some stabilisation

Fig 23: Unemployment rate remain sticky, %, although gross earnings grow th rate seem to have rebounded.

10.0%

5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

2005/02

2005/09

2006/03

2006/10

2007/04

2007/11

2008/06

2008/12

2009/07

grossearnings

numberofemployees

20

22

24

26

28

30

32

2000/03

2000/09

2001/03

2001/09

2002/03

2002/09

2003/03

2003/09

2004/03

2004/09

2005/03

2005/09

2006/03

2006/09

2007/03

2007/09

2008/03

2008/09

2009/03

2009/09



32/54

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2.1 Initiation of coverage

2.1 Capitec Bank: In itiating w ith a BUY, fair value of R121.Short term valuation risks are evident, but better growth

outlook is the differentiating factor, our potential upside is

22.7%.

Fig 24: Company and salient balance sheet and income statement information

RECOMMENDATION BUY Rand,mn 2009 2010 2011F 2012F 2013F

BloombergTicker CPISJ NII, 943 1,273 1,598 2,055 2,427

CurrentPrice(cents) 10,100 Netfee i ncome 1, 036 1,282 1, 605 2,047 2,457

Fair

Value

(cents) 12,121 EPS,

cents 357 509 683 874 1,028MarketCap,Rbn 8.33 Loansandadvances 2,982 5,225 7,176 10,573 13,994

Sharesoutstanding,mn 82.983 Deposi ts 3,317 7,360 9,568 12,439 15,549

Potentialcapitalgain 20.01% BVPS,cents 1,489 1,910 2,325 2,850 3,466

ForwardDivYield 2.71% NIM 19.0% 13.4% 13.1% 13.1% 12.4%

Forecasttotalreturn 22.72% Cost/Income 54% 54% 53% 52% 51%

ImpliedPER,X 23.8 LDR 90% 71% 75% 85% 90%

ImpliedPBVR,X 6.3 ROE 25.5% 28.6% 31.5% 32.9% 31.8%

YTDcapitalreturn 27% ForwardPER,X 14.8 11.6 9.8

52WeekReturn 179% ForwardPBVR,X 4.3 3.5 2.9

Source: Company reports, Bloomberg, Legae Calculations

We in itiate coverage w ith a BUY recommendation, our fair value

is R121 giving a potential total return of 22.7%: We use the

Discounted Future Cashflow (DFE). Our terminal value is R13.6bn which

we obtain by growing the FY13 earnings by our long-term growth rate

and capitalise it by the exit PER of 13X. We estimate a CoE of 17.5%,

(vs. 17.6% implied by the Dividend Discount Model (DDM)). Our DFE

method indicates a fair value of R113, offering a potential total return of

14.7%. Our DFE value gives an implied PER of 22X which is higher than

our Justified PER of 17.8X. The Forward PER ratio, however, declines to

9.8X by FY13.

Our recommendation is also motivated by the high excess earnings

which we forecast in the next three years and the potential total return

that is greater than our CoE. In our view, the exposure to the low

income segment that has lower debt levels compared to the middle and


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upper class should deliver stronger top line growth compared to the

mainstream banks. In our opinion, the risk-reward profile is appealing

for investors (and not speculators!).

Possible catalysts: The possible catalysts for the share price are 1)

continued stronger loan growth, and profitability as the bank run down

its cash resources and further deploy its capital; 2) stronger recovery in

the economy that should lead to strong loan growth and material

reduction in bad debts, and 3) higher NII and transaction fee income

than we have anticipated.

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

the exit PER is higher than a general rule of thumb of between 7X and

10X for mainstream banks, 2) we estimate our long-term growth rate at

14.9%. This is higher than the expected nominal GDP growth rate,

assuming inflation rate is contained within the target band of 3% to 6%.

Risks to share price performance in the short-term : Capitecs

share price has rallied, and rallied strongly since January 2009. Over the

past 12 months, the share price has outperformed the Banks Index (I-

Net) and the All share index by 134.6% and 135.3% respectively. On a

year-to-date basis, the outperformance is also strong at 12% and 7%

against the Banks Index and All Share Index in that order. This out-

performance is greater when one considers that Capitec is part of the

Banks Index. (see Fig 25). In our opinion, the base of valuation is

always relative. Even the so-called absolute valuation models are

effectively relative due to the use of the market metrics as a proxy.

(e.g. beta coefficient when calculating the CoE is relative to the market).

A de-rating by the market could be explained by this concern. Local

sector sell-off catalysed by the Goldman Sachs growing investigations

could also create headwinds to the price.

Capitecs PER is trading above its historical average: The trailingPER chart for Capitec looks intimidating. The current trailing PER at

19.7X is 42% above its long-term average PER of 13.9X. The long-term

relationship between the Banks Index PER and Capitec, however, seems

to be holding up. In January 2009, Capitecs PER was 1.38X that of the

Banks Index. By the end of 2009, the ratio has expanded to 1.48X but


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it reduced to 1.36X currently. (see Fig 26).We doubts further multiple

expansions for both the industry, given the muted economic recovery.

Fig 25: Capitecs share has significantly outperformed the m arket and could create sh ort-termrisks to the share price

27%

32%

60%

174%

7%

6%

12.9%

38.7%

12%

11%

13.5%

39.3%

0% 50% 100% 150% 200%

YTD

3Months

6Months

1Year

Capitec

ALSIBanksIndex

0.9

1.0

1.1

1.2

1.3

1.4

2009/12 2010/01 2010/02 2010/03

BankIndex

ALSI

Capitec

Source: I-Net, Legae Calculations, prices as cob 15/04/10

Fig 26: The PER is above its average since listing, but the relationships against other banks is

holding up.

0

5

10

15

20

25

30

35

2002/09

2003/02

2003/07

2003/12

2004/05

2004/10

2005/03

2005/08

2006/01

2006/06

2006/11

2007/04

2007/09

2008/02

2008/07

2008/12

2009/05

2009/10

2010/03

PER

Average

0

5

10

15

20

25

30

35

2002/09

2003/02

2003/07

2003/12

2004/05

2004/10

2005/03

2005/08

2006/01

2006/06

2006/11

2007/04

2007/09

2008/02

2008/07

2008/12

2009/05

2009/10

2010/03

CapitecPER

BanksIndex

PER



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Who is Capitec? Capitec Bank Holdings Limited (Capitec or the Group)

is a holding company for Capitec Bank. Capitec Bank is a registered

commercial bank that targets the micro-borrowers. The bank focuses on

providing retail banking services based on the principles of simplicity,

affordability, accessibility and personal service. Loans are granted to

employed individuals (no corporate loans) and strictly on an unsecured

basis. The average loan amount is R2,239 (FY10). Deposits are also

strictly from individuals, with the exception of deposits raised by

issuances of bonds and from other bilateral organisations. The bank has

401 branches (FY10) and a network of 1,238 ATMs, comprising of 417

own ATMs and 821 partnership ATMs. As at the end of FY10, the bank

had no loss-making branches. New branches often turn to profit within

4 months. The 38 branches that were added in FY09 are already

profitable a major accomplishment in our opinion!

2.2 Company analysis

Strong market position: Capitec enjoys a strong position in the lower

income segments of retail banking. It has also managed to create a

reputation and set out industry standards (e.g. paperless banking)

which, in our opinion, are important traits to reduce competitive

pressure. We believe that Capitec has developed advantageous

relationships with its customers that competitors could find difficult to

imitate in the short- to medium-term. Nonetheless, we expect growth in

both asset and profitability to slow when compared to history in the next

3 years. Our expectations are contradictory to managements outlook on

this matter.

Profitability growth has been excellent so far: Historical

performance has been excellent with a 5-year CAGR of 33% and 46%

for income from operations and profit after tax respectively. The

profitability has been supported by a strong growth in both NII and fee

income at a CAGR of 19% and 210% in that order. In rand-terms, net

profit (before preference dividends went up from R67.4mn in FY05 to


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R449.2mn in FY10. The NII ascended from R527.1mn to R1,273.3mn

between FY05 and FY10.

Balance sheet growth supported profitability: The banks total

assets climbed from R805mn in FY05 to R9.5bn in FY10 a CAGR of

64%. Given the lower penetration ratio in the low-income segment, we

expect stronger growth when compared to the industry average in the

medium term. In our view, Capitec can gain market share in two main

ways: 1) by consolidating its position in its low-income segment market

and reduce market share erosion, particularly from main stream banks

that are downscaling 2) by providing products to the relatively higher

income levels than its current market concentration, especially on the

liability side. Management has indicated that they could pursue the

relatively well-off market. The bank intends to open branches in more

affluent areas in order to provide convenience to its middle-income

customers. Loan and advances indicated a strong expansion, with a

CAGR of 91% between FY05 and FY10. Deposits growth was also strong

over the period with a CAGR of 101%.

Fig 27: Historical performance has been excellent

Incomestatement 2006 2007 2008 2009 2010

CARG

(0510)

InterestIncome 44.1% 23.4% 23.5% 63.9% 45.4% 26.5%

interestexpense 137.3% 74.2% 45.3% 165.8% 82.0% 96.2%

Netinterestincome 41.1% 20.7% 28.9% 47.7% 35.0% 19.3%

Netfee income 237.8% 646.6% 485.7% 58.5% 23.7% 210.7%

Nonbankingincome 47.0% 22.3% 36.3% 66.6% 13.9% 36.0%

Incomefromoperations 36.9% 27.5% 27.9% 40.0% 32.4% 32.8%

Bankingexpense 29.4% 21.3% 25.7% 39.5% 28.6% 28.8%

Profitaftertax 71.1% 44.8% 37.2% 39.4% 40.7% 46.1%

Balancesheet

Cashandequivalents 60.5% 79.2% 40.8% 145.0% 69.5% 47.9%

Loan

&

Advances 118.7% 76.7% 151.4% 47.7% 75.2% 90.6%Totalassets 55.4% 75.2% 34.0% 69.2% 90.9% 63.8%

Depositsatamortizedcost 141.8% 56.6% 75.2% 123.5% 123.1% 101.3%

Totalliabilities 107.2% 56.3% 60.0% 107.3% 117.8% 87.8%

Totalequity 19.1% 98.2% 8.9% 15.5% 22.9% 29.6%

Source: Company reports, Legae Calculations


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The banks capital position is excessive, in our view , but ample

capital should support loan growth. The bank is well capitalised, to

an extent that we are concerned by under-utilisation of the capital. In

FY09, the capital adequacy ratio was 43%. The ratio reduced to 37% in

FY10, but remains high in our view. Managements target ratio is 25%,

and they are convinced that as a small bank they need a strong buffer.

To an extent we agree. The leverage ratio is also low at only 5.5X

(FY10) against the systems average of 15X. The positive takeaway is

that both situations provide the bank with ample room to grow its loan

book at a higher rate than the industry.

Quality of assets - short-term loans reduces the risks : The quality

of assets is weaker when compared to the mainstream banks,

notwithstanding the defensiveness of the assets in the micro-finance

industry. For example, the loans past due/advances is 10.1% versus the

industrys 3.9% (FY09). The ratio declined to 6.2% in FY2010.

Recoveries are however significantly higher due to the stringent

collection methods and better understanding and working relationships

with clients.

The bank writes off the total amount (capital + interest) for all loans

whose instalments are in arrears for 90 days. The impairment

charge/instalments ratio grows with tenor. For example, in FY10, the

ratio for 6-month loans was 3.8% (an improvement from 4.3% the

previous year) while for 36-month loans the ratio stands at 14.4% (an

improvement from 21.7% in FY09). (see Fig 28). We are not overly

concerned with the asset quality.


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Fig 28: impairment charges/ instalments ratio has improved

1.4%3.8%

5.2%

10.9% 10.8% 11.5%

14.4%

50.8%

1.4%

4.3%

6.7% 12.7% 11.4%12.7%

21.7%

0%

10%

20%

30%

40%

50%

60%

0 3 6 9 12 15 1 8 21 24 2 7 30 33 36 3 9 42 4 5 48

months

2010

2009

19.0%

11.6%11.2%

10.1%

6.2%

0%

4%

8%

12%

16%

20%

2006 2007 2008 2009 2010


Management boasts strong experience: The Chairman of the board

is the founder, and boasts strong experience in the commercial banking

industry going back to 1995. The CEO and the Financial Director joined

the group in 2000 (the founding year). Most members of the executive

committee have been with the group since 2000. Looking at the ratiosthat we think provide insight to management ability, the cost/income

ratio and the efficiency ratio are showing improvements. The

cost/income ratio (banking activities) declined from 73% in FY05 to 54%

in FY10. Managements long-term target is a maximum of 40%. This will

be achieved through both efficiency and revenue enhancement. The

Efficiency ratio improved from 74% in FY05 to 62%, just 2pp above our

preferred ratio of 60% (generally accepted as the optimal ratio). The

loan/employee and deposit/employee expanded by a CAGR of 60% and

61% respectively between FY05 and FY10, pointing to management

capability.

Revenues and earnings - transaction fee income and loan fee

income will be key: The NIM has reduced materially, from 65% in

FY05 to 13% in FY10. It is, however, still close to 10pp above the

industry average. The profitability is driven by the high interest spread


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(16% for FY2010). The contribution of the non-interest income to the

banks revenue has increased significantly to 50% from 11% in FY07,

showing rising volumes. (see Fig 29). This is the impact of the

increasing branch network and consequent customer volumes. For

example, savings accounts jumped by 201% from 375,000 in FY06 to

1,129,000 in FY09. Active clients stood at 2.1mn by end of FY10.

Number of loans written also climbed from 2.65mn in FY06 to 3.86mn in

FY10. In our opinion, transaction fee income and loan fee will be key for

revenue and earnings growth, given the falling interest spread.

Fig 29: Fee income contribution has improved substantially. NIM and int. spread have reduced

98% 94%84%

46% 44% 46%

2%0%

7%

42% 42% 36%

0% 6% 9% 12% 13% 18%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2005 2006 2007 2008 2009 2010

Transactionfee

Loanfee

NII

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2005 2006 2007 2008 2009 2010

NIM

Interestspread


Liquidity is abundant, and asset composition is used to manage

liquidity and credit risks: High liquidity was good during the crisis

period, but we expect it to be deployed. The banks liquidity level is

high. Cash as a percentage of total loans and assets is 51% and 31%

respectively. The banks LDR at 71% (FY10) is 32pp below the systems

average. Managements deposit gathering strategy is centred on long-

term fixed deposits. The fixed deposit products now make up 16% of

the total deposits from 8% in FY09. (see Fig 30). The negative is that

some products are expensive time deposits that could depress NIM.

There is a concern of higher dependence in wholesale deposits but it is

consistent with the current industry pattern. The wholesale deposits are


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also fixed in nature, and have a minimum tenor of 6 months. Wholesale

deposit constitutes 50% of the total deposits. Retail savings type of

deposits has also increased from 32% in FY09 to 40% in FY10. In our

view the bank has plenty liquidity.

Concentration risk is insignificant on both the asset and liability

side: Concentration risk could be harmful to liquidity. Retail deposits

concentration risk is negligible as the bank deposits gathering strategies

are not targeted at mainstream corporate deposits. Management

estimate the highest value from a single retail depositor at R2.8mn. On

the asset side, where concentration risk could be harmful to credit risk

exposure, it is also unimportant. Loans are spread over many small-

value borrowers.

Fig 30: Retail fixed deposits/ total deposits ratio increased from 8% in 09 to 16% in 10.

50%

32%

16%

3%

wholesale

retailsavings

retailfixed

other51%

40%

8%1%

wholesale

retailsavings

retailfixed

other


About 26% (25% net) of the loan book has a maturity of 90 days or

less. Before 2010, no loan tenor exceeded 36 months, but the bank

introduced a 4-year loan in 2009. (i.e. FY10 for Capitec). This 4-year

product now constitutes 5% of the banks loan sales. (see Fig 31).


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Fig 31: Maturity profile of loans in Rmn and as % of total loans. High concentration on ST

2,2

65

1,019

494

1,049

646

1,063

1,635

473

500

1,000

1,500

2,000

2,500

1m 3m 6m 12m 18m 24m 36m 48m

R,mn

months

2008

2009

2010

26%

12%

6%

12%

7%

12%

19%

5%

0%

5%

10%

15%

20%

25%

30%

35%

0 3 6 9 12 15 18 2 1 24 2 7 30 33 36 3 9 42 45 4 8months

20082009

2010


Interest rate risk analysis The gap is positive and will benefit

from rising interest rates: The Banks liability duration is longer than

its asset duration. The objective of an asset sensitive balance sheet is

the flexibility in liquidity and credit risks management. Managements

strategy of trying to reduce deposit volatility by attracting long-term

deposits intensifies the gap. R1.035bn of the R2.522bn deposits raised

between March 2008 and November 2009 carries a floating interest rate,

which is linked to the JIBAR 90-day rate. The positive gap is

unconstructive to interest rate declines as more assets are exposed to

re-pricing risk than liabilities, negatively affecting NII. The consoling

factor is that further interest rate decline probabilities have significantly

reduced, in our view. As interest rate start going up, the bank will

benefit from this positive gap.

Positive gap could aid profitability by about R36.5mn should

rates go up by 2.0% . We simulate the gap effect to NII by a 200 basis

points upward interest rate change. Our calculations indicate that the

positive gap will enhance profitability by about R36.5mn, should interest

rate rebound by 2% this year. (see Fig 32).


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Fig 32: The positive Gap will enhance profitability if interest rates rise.

12m

Assets,Rmn 2,680 1,663 3,151 2,013

Liabilities,Rmn 3,062 523 849 3,495

PeriodicFundinggap,Rmn 382 1,140 2,302 1,482

Cumulativegap,Rmn 382 758 3,060 1,578

Ratechange 2.0% 2.0% 2.0% 2.0%

ImpacttoNII,Rmn 7.33 12.67 31.02 0.09

CumulativeNII,Rmn 7.33 5.34 36.36 36.45


Balance sheet funding and dividend policy: The banks ability to

finance growth is important. The balance sheet is currently 78% deposit

funded (vs. 66% in FY09). As we already mentioned, the banks

deposits, especially loans and bonds are fairly of long-term nature,

providing stability to funding. Some of the long bonds include 1) R90mn

with 14 years to maturity 2) R250mn unlisted bond with a 12year

tenor and 3) a R150mn 7-year bond.

Ordinary equity makes up 17% while preference shares form 2%. (see

Fig 33).The dividend payment policy is guided by a 2.5X earnings coverage

ratio. This means a retention ratio of 60%. We believe this will be an

important source of funding for the banks balance sheet as well.


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Fig 33: Deposits/ total liabilities and equity has increased from 66% in FY09 to 78% in FY10

66%

25%

3%5%

Deposits Ordinaryequity Prefer enc eshares O ther

78%

17%

2%4%

Deposits Ordinaryequity Prefer ences har es O th er


CAMEL indicators are strong, in our view : Below we present some of

the CAMEL analytical ratios. In our opinion, the CAMEL ratios are strong,

despite the fact that the banks asset quality is worse than the

mainstream banks. The management of bad debts is tighter and the

efficiency ratio has improved considerably. (see Fig 34)

Fig 34: Selected CAMEL ratios. The bank strong in our view

CAMELRatios 2005 2006 2007 2008 2009 2010 2011F 2012F 2013F

C:TotalAssets/TotalEquity 1.7 2.2 2.0 2.4 3.5 5.5 5.8 6.2 6.5

C:Equity/Totalloans 228% 124% 139% 60% 47% 33% 29% 24% 22%

A:Recoveries/Baddebts 33% 38% 14% 17% 10% 20% 20% 20% 20%

A:Impairmentcharge/Loans 19% 21% 20% 11% 16% 10% 9% 8% 8%

M:Cost/Income(bankingactivities) 73% 66% 60% 59% 54% 54% 53% 52% 51%

M:Efficiencyratio 74% 70% 66% 66% 61% 62% 63% 62% 62%

E:NIM 65% 59% 41% 22% 19% 13% 13% 13% 12%

E:Feesandcomm./Op.income 1% 2% 11% 51% 52% 50% 50% 50% 50%

L:Loans/Deposits 74% 76% 90% 132% 90% 71% 75% 85% 90%

L:Cash

&

Equiv./Total

assets 45% 47% 48% 21% 30% 27% 25% 20% 18%

Source: Company reports, Legae Calculations. Total Equity includes preference equity


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ROE decomposition: Our ROE calculations show a different ROE, lower

than reported by the company. We calculate our Du-Pont ROE based on

year-end figures instead of average values or beginning values. While

average and beginning values are theoretically more robust for purposes

of performance measurement, ending values are consistent with

industry practice. The equity multiplier increased from 1.7X in FY05 to

6X in FY10 while the ROA has gradually decreased from 8% in FY05 to

5% in FY10. The asset turnover component of the ROA has fallen faster

than the expense ratio between FY05 and FY10, hence the falling ROA.

The ROE improved from 14.2% in FY05 to 28.6% in FY10 due to the

rising equity multiplier. We expect the ROE to increase slightly to 31.8%

by FY13 due to further leverage. (see Fig 35)

The interest spread has declined from 89% in FY05 to 16% in FY10. We

expect the spread to reduce to 13% by FY13. (see Fig 35).

Fig 35: ROE decomposition and interest rate spreads. Leverage has been constructive to R OE.

2005 2006 2007 2008 2009 2010 2011F 2012F 2013F

Operatingincome/Total assets 61% 54% 39% 37% 31% 21% 21% 21% 19%

Expenses/Total assets 49% 40% 28% 26% 22% 15% 14% 14% 13%

Taxes/Totalassets 4% 4% 3% 3% 3% 2% 2% 2% 2%

ROA 8% 9% 8% 8% 6% 5% 5% 5% 5%

TotalAssets/Equity 1.7 2.2 2.3 2.8 4.0 6.0 6.3 6.6 6.8

ROE 14.2% 20.4% 17.3% 21.6% 25.5% 28.6% 31.5% 32.9% 31.8%

Interestspread

Interestincome/Earningasse ts 95.3% 75.6% 52.4% 28.1% 27.0% 22.6% 23.0% 22. 5% 21.3%

Int.expense/Int.bearingliabilities 6.0% 6.7% 7.8% 6.6% 8.1% 6.7% 8.0% 8.3% 8.3%

Interestspread 89.3% 68.9% 44.6% 21.4% 18.9% 16.0% 15.0% 14.3% 13.0%

Source: Company reports, Legae Calculations. Equity excludes preference equity

Expense decomposition: Looking at the banks cost structure, the

major highlight is the increase in the interest expense/total assets ratio

from 2.1% in FY05 to 5.4% in FY09. The ratio declined marginally in

FY10 to 5.2%. The provisions/total assets ratio also went up to 9.4% in

FY09 from 7.9% in the previous year, but reduced significantly in FY10

to 5.8%. The non-interest expense/total assets ratio improved from

capitec bank_valuation looks steep but growth outlook is the differentiating factor_final

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