|Shares Out. (in M):||804||P/E||13.0x||10.0x|
|Market Cap (in $M):||3,000||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||2,100||EBIT||0||0|
In Europe GAAP financials are shunned by analysts of insurance companies. Instead investors use Appraisal Values to value insurance companies. For some strange reason "Appraisal Values" have not caught on in the US which is a little confusing since it such a logical and eloquent approach compared to the traditional valuation models based on GAAP. I have corresponded with various US Actuaries to establish a reason for this reluctance and have included an excerpt of this correspondence in the Appendix.
What is an Appraisal Value ?
The Appraisal value is the sum of the embedded value plus the value of new future business.
The embedded value (EV) is the PV of the existing business on the books. Basically the PV of cash flows (premiums - claims - operating expenses) from business already on the books. European Insurance companies publicly disclose their EV to investors in addition to the assumptions on which the calculation is based. Sensitivities are also disclosed.
The value of future new business is essentially the earnings power of the business times by an appropriate multiple. Again, like embedded value, the earnings power is determined in PV terms. New business margins are disclosed by the insurance company, therefore, all the analyst must do is estimate the annual business to be written in a year to establish the earnings power of the operations. The value of the operating assets is then determined by multiplying this earnings power by a chosen multiple.
African Bank (ABL SJ) is a micro lender. It also sells furniture for cash and on credit. ABL is listed on the South African Stock market with a market cap = R23 600mil or $3 000mil.
(Note all amounts are in South African Rands. 1USD is currently worth R7.90)
I will use the Appraisal Value's to determine a separate value for the micro lending and furniture operation. The reason I have chosen the Appraisal Value route is that the internal decision making models are based on this methodology. ABL only generate GAAP financials for regulatory purposes. If you are a sell side analyts obsessed with projecting EPS I suppose the GAAP statements are useful. But, for those more concerned with determining a value for the business then the Appraissal Value route makes a lot more sense.
I am going to start by determining the "value for future new business" as it captures the essence of the micro lending business model. I will then determine the embedded value (EV) of the existing business.
Value of Future New Business
The micro lending operation "swaps cash for the PV of an instalment loan." On average ABL swap R1 for the PV of R2 before taking bad debt into account.
For the TTM ended March 2010 African Bank sold R9 500 mil in loans. The average loan amount was R7 696 and the average term 40 months. Assuming that R10 000mil is representative of the annual amount of loans the platform can write and using a swap ratio of 2 implies that every year the bank is able to swap R10 000mil for the PV of R20 000mil.
Over the last 18months bad debt expenses have averaged just over 10% of the book with NPL's averaging 30% of the book. These metrics reflect historic underwriting criteria which were much looser compared to the tighter credit score cards currently in use. The current score cards predict that 10% of the business written will go bad. This implies that only R18 000mil of the R20 000mil will be collected.
ABL incurred operating expenses of R1 397mil for the TTM ended March 2010. These expenses need to be split between costs incurred to generate new business (sell loans) and costs incurred to collect the existing book. Assuming that collection costs equal R500mil (2.5% of the R20 000 book) implies that R897mil was spent generating new loans. As a result of inflation assume a R1 000mil per annum operating expense run rate to generate future business.
The final calculation shows that the operating assets are capable of generating R7 000mil per annum. (R10 000mil out, R18 000mil in less R1 000mil operating expenses)
Using a conservative multiple of 3 implies that the Value of Future New Business = R21 000mil. (A multiple of 3 is currently very conservative for SA stocks whose ratings have been driven recklessly driven up by foreigner investors chasing the emerging markets theme. African Bank was one of the early favourites of these investors, but, is now a little neglected as investor's storm off to chase stocks with 20 PE because they supposedly promise a steeper growth vector. Lets see.)
Embedded Value (EV)
EV is a superior valuation methodology to NAV as the GAAP debtor's book only includes the principle outstanding. Remember, ABL swap R1 for R2. The R1 represents principle and is recognised by the accountant. The remaining R1 consists of interest and credit life insurance which is only recognised when earned. The unearned amounts are, therefore, effectively off balance sheet and hidden from investors even though they are contractually due as part of the instalment sales agreement.
As the embedded value discounts all the cash streams flowing from the existing business (business already on the books) these hidden unearned balances are included in the PV calculation. Unfortunately ABL do not disclosed the payment profile or the EV of these cash flows and as a result I have had to model the instalment loans to determine the timing of the cash flows for the DCF calculation.
The GAAP book = R22 000mil before a 20% provision for bad debt. I estimate the unearned balances to be R11 000mil to get a total gross balance of R33 000mil. Applying the 20% provision implies that only R26 400mil will be collected. The timing of the collection will be 28% in first 6months, followed by 26%, 19%, 13%, 8%, and 6% in 6 month intervals. The DCF of this book is R23 000mil using a 10% discount rate.
A further haircut is required for collection costs (2.5% * book) and 30% tax on interest plus insurance less collection costs and bad debt. Following these cuts I value the book at R21 500mil.
Subtracting Net Debt of R13 947mil implies an EV of R7 553mil for the bank.
Adding the EV of R7 553mil to the R21 000mil value of future new business gives an Appraisal Value of R28 553mil for the micro loan business. This compares to the current market cap of R24 000mil and I still have to determine a value for the furniture business.
The Furniture Business
The furniture business, which trades as Ellerines, is a mirror image of the micro lending business except that instead of swapping cash for a loans Ellerines swap furniture for an instalment loans. Again the swap ratio is 2 and the average loan size and terms are very similar.
Value of Future New Business
Ellerines trade out of 1 030 stores and generated sales of R4 242mil over the 12 months ended March 2010. Of these sales R1 815mil were cash sales and R2 427mil credit sales. Multiplying credit sales by the swap ratio of 2 implies a PV of R4 854mil for the credit sales.
The PV created of new business calculated below
+Cash Sales R 1 815mil
+NPV Credit Sales R 4 854mil
- COS R 2 444mil
- Bad debt R 485mil (Assume 10% credit sales not collected base on new score cards )
- Operating Expense R 2 861mil (Excludes a 7% cost for collecting existing book)
PV Created R 879mil
Using an conservative multiple of 3 implies a value of R2 637mil for the value of future new business.
Embedded Value (EV)
The GAAP book = R5 458milmil before a 25% provision for bad debt. I estimate the unearned balances to be R2 729mil to get a total gross balance of R8 187mil. Applying the 25% provision implies that only R6 140mil will be collected. With a similar payment profile as the bank book the DCF of the book is R5 477mil.
A further haircut is required for collection costs (7% * book) and 30% tax on interest plus insurance less collection costs and bad debt. Following these cuts I value the book at R4 843mil.
After subtracting net debt of R2 616mil I get an EV of R2 227mil for the furniture business.
Adding the EV of R2 227mil to the R2 637 value of future new business gives an Appraisal Value of R4 864mil for the furniture operations.
I must stress that this is a very conservative value as I have only used a multiple of 3 to determine a value for the operating assets potential to generate value into the future. Lewis Stores (LEW SJ), a direct competitor, with half the sales has a market cap of R5 700mil. Because the businesses are so similar there is no reason not to extrapolate the market cap to derive a value of over R10 000mil for Ellerines.
Adding the Appraisal Value of the bank (R28 553mil) to a conservative R5000mil value for Ellerines implies a total market cap for the group of R33 533mil or R41.70 per share. As highlighted above a more reasonable value for Ellerines would push this value to over R47 per share.
The current share price is R30 which implies a potential upside between 33% and 57%.
The ABL stock price has underperformed it's peers by more than 2 standard deviations. The main reason for this is that the bank did not sell as many loans as initially targeted. The reason the target was missed was because the expected improvement in the economy was more tepid than originally predicted and the bank did not see an opportunity to loosen it's underwriting standards.
This is behavior is typical of the market. Punish a stock because management did the right thing by not lending money to dead beats. As many of you know these situations usually resolve themselves over time particularly as less disciplined and foolish competitors hit the wall.
Management have also guided that conditions are improving and that business has picked up subsequent to the 31 March 2010 reporting period.
Appendix: Correspondence with US Actuary
It is no surprise that you have not found much published EV material from US companies. As you already know, EV reporting is currently big in Europe and has been big in the UK for a very long time. About 10 years ago, EV reporting was adopted by Canadian companies. [Note: Speaking solely from XXXX's perspective, we had assumptions and methodology reviewed and opined on by an external consulting firm, but actual numbers were never officially audited. Subsequently, we stopped the external review and opinion entirely.]
Regarding US companies, most of the EV reporting is performed by those with foreign parent companies, which report company-wide on an EV basis. For example, a Swiss or Dutch parent company might ask its US subsidiary companies to report on an EV basis. However, EV reporting would not generally be performed by domestic US companies, which seem entrenched in US GAAP. US analysts are comfortable assessing the value of a company's stock as a multiple of US GAAP earnings, and would need an education and change of mindset to convert to a multiple of EV (or combination of adjusted net worth, in-force business value, and value of new business, ANW, IBV, and VNB, respectively).
Having said that, with so many multinational companies operating in the US,there has been increased interest in EV reporting (next to be MCEV
reporting). Whether domestic US companies embrace EV in the near future and report values externally is still questionable. However, if, in the future, US companies do begin to routinely report EV, it will likely lead to audited results (after some transitional period of unaudited results).
I hope this gives you a feel for the status of US companies regarding EV and validates why you have not found much published financial reporting material on EV.
|Entry||05/24/2010 09:29 PM|
This write-up is academic, full of assumptions, and very reliant on management statements. There is very little in the way of real analysis and unfortunately, I still have very little sense of African Bank's actual operations and profile. What's its personality and competitive edge? How many employees? What about branches or distribution? Who are the key leaders? Are they buying stock? I know none of this after reading your write-up.
And I'd love clarification, but I thought embedded value, which is primarily used for European insurance companies, included the present value of future profits plus NAV, net asset value (or tangible book value if you prefer). I've never heard of "appraisal value" before. Furthermore, as I understand it, most European banks do not use EV or AV. African Bank is presumably a bank, so doesn't NAV or a P/E ratio make sense?
In short, I thought this write-up was terrible.
|Subject||Pay R14bil to make R11bil per annum|
|Entry||05/25/2010 12:11 PM|
I could have gone into the gory details that analysts love to focus on, but, I wanted to move straight in to the valuation. I also wanted to focus on the economics of the business model which seems to fly over the heads of most GAAP analysts I know .ie sell side pointlessly trying to predict next years EPS.
I also stongly disagree with your comments that GAAP EPS is of any value. Come on!! If you were buying a business that lent our $10 000 a year (money out) and received back a PV of $20 000 would you would be foolish to use GAAP to value the business. Let me put it another way how could you possibly use gaap to get to a value. I am all ears.
I did take some short cuts on the calculation of EV which understated the amount I calculated. You are correct that EV = NAV + VIF. I assumed the NAV to be zero and focused only on the VIF. Value in Force (VIF) represents the present value of cash flows from existing business portfolio.
The above step gives me a value for the existing business or a value the tooth fairy would give you for the current portfolio of existing business. But, everyday the workers in the business go out to generate new loans and I have to put a value on this. This is technically the Value of Future New Business.
Added together I get an appriasal value.
I have justc come back from meeting managment and to my astonishment find that the loans they are currently writing have a swap ratio of 2.5 times versus 2 that I used in the model. Assuming the bank lend out R10bil over 12 months implies that they will expect to receive back R25bil. Subtract bad debt of R2.5bil and operating expenses of R1.0bil means that they will earn R11.5bil in PV terms from 1 years work.
Assuming Ellerines is worth R10bil you are only paying R14bil for the bank stub. The stub will generate R11.5bil in PV a year in value.
|Entry||05/25/2010 12:17 PM|
I appreciate your comments on embedded value and appraisal value. Part of the reason for the write-up was to introduce the concept to VIC because I have never understood why this methodlogy is not popular in the US. I would like to encourage debate on this.
The funny thing is that I am aware of a US insurance companies which is to be sold in the private market. The bids for the company are all based on AV so it seems that in the real world AV is important and that it is only analysts who mostly live in lala land who find gaap reporting interesting.
|Entry||05/25/2010 01:01 PM|
I do not think that Appraisal Values are better than GAAP, and I can see immediately why Appraisal Value will never be adopted in the US. Between FASB and the SEC, the utility of GAAP is to present a picture in time of the financial condition of a company. It makes no attempt to project what values will be in the future, and for good reason. Appraisal value relies on a number of assumptions, such as discount rate and mutliples, that are subjective.
|Entry||05/26/2010 06:56 AM|
To be clear GAAP financials are still produced. The EV calculation is an additional disclosure. The point I wanted to make is nobody looks at GAAP.
There are numerous reasons for this including
1) An investment is a discounted cash flow. The EV is essentially a discounted cash flow of the existing business and future business. If I gave you these expected cash flows why would you ignore them and rely on GAAP numbers?
2) Internal models on whether to write insurance or loans are all based on DCF calculations. Again cash-in cash-ouy calculations trump GAAP. By focusing on EV and cash flows you get amazing insights into the business versus the opaque view using GAAP.
You are right that EV is a mark-to-maybe and hopefully you did not fall for the GOS tricks. The key difference is that all the assumtions on which the DCF are disclosed in addition to sensitivities for different ranges.
These assumptions can get complicated when it comes to insurance companies, but, are a doodle when it comes to businesses that sell installment loans.