There is a fable that tells of an argument between an elephant and a mouse about who is stronger. The mechanics of the tale are not important here; suffice to say they agree to disagree on their relative merits and in a conciliatory gesture the rodent accompanies his new friend on a walk. As they cross a rickety bridge that heaves under the pachyderm’s weight, the mouse – oblivious to its relative insignificance – whoops with delight: “Look how the bridge shakes as we cross it!”
Asia-focused HSBC’s interest in Nedbank is not that dissimilar from the old fable. HSBC is around 35 times the size of Nedbank – the smallest of South Africa’s Big Four banks. In terms of African footprint, the first two prizes – Standard Bank, tied to China’s ICBC, and Absa, which is married to Barclays plc – are spoken for. FirstRand isn’t currently on the block but is in the process of simplifying its control structure that could make it saleable at some point in the future.
Nedbank therefore is the last available belle at the ball – albeit not the most attractive. It has an as-yet-to-be-proven tie up with Togo’s Ecobank and a presence in just five African countries outside its home territory. However, it does have a strong corporate and investment banking franchise – a good starting point for an overseas bank looking for a foothold in Africa.
“It’s a good deal for Nedbank – but not for HSBC,” says international banks specialist Kokkie Kooyman, head of Sanlam Investment Management Global, who points to the fact that prospects for short-term domestic earnings for local banks are unattractive. “HSBC has to be taking a 15- to 20-year view.”
Citigroup analyst Ronit Ghose was also cautious and told clients in a note shortly after the news broke: “The transaction would look good on a PowerPoint slide with arrows pointing from China/Asia to Africa.”
That’s the attraction. African business is growing at a rapid rate, largely off the back of Asian investment in the continent. Confirmation of HSBC’s interest in Nedbank came as President Jacob Zuma led a 370-strong delegation – the biggest ever from SA – to Beijing in an effort to broaden Chinese interest in this country and, by extension, the continent beyond just the resources sector.
Trade between China and SA grew 56% to US$10,8bn in first-half 2010 over the corresponding period last year. Around 30% of SA’s exports go to China but we remain a greater importer of finished Chinese goods than it is a recipient of our raw materials.
“We all agree that in SA’s export market to China there’s a preponderance of primary products and in our imports from China there’s a preponderance of value-added goods,” says SA’s Trade Minister Rob Davies. “We want to work together with China to try to address that so we have a more equitable balance of trade.”
Standard Bank confirmed last week it had signed a memorandum of understanding with China Railway Group to help fund rail and infrastructure projects in Africa. The first among these could be a $30bn high-speed rail network – something mooted by Transport Minister Sbu Ndebele earlier this year. Talks with SA’s Government are under way. It’s significant for Standard Bank, whose CEO Jacko Maree conceded in an interview after the group’s half-year results that progress with ICBC had been slower than anticipated. Three years after Chinese bank ICBC bought 20% of Standard Bank, the link generates less than 1% of the local group’s revenues, suggesting theory is tough to put into practice.
That isn’t putting off HSBC. CEO Michael Geoghegan has made no secret of his ambition to do more business in Africa as an increasingly significant emerging markets player. Geoghegan coined the acronym Civets – Columbia, Indonesia, Vietnam, Egypt, Turkey and SA – to illustrate his view of what he sees as the world’s next big growth markets. He told Reuters earlier this year: “Each has a large, young, growing population. Each has a diverse and dynamic economy. And each, in relative terms, is politically stable.”
He further sang the praises of SA as having high levels of education relative to the rest of Africa and – despite its unique challenges – said he didn’t believe the country would fail, because of the global goodwill behind it to succeed.
An offer will hinge on whether HSBC is satisfied with its due diligence investigation, which will determine the price it’s prepared to pay for the asset. Nedbank would be small in the overall scheme of things for HSBC, which has a market capitalisation of $173bn. It made first-half profits of $11,1bn and paid dividends of $2,8bn – equivalent to about a third of Nedbank’s total market value before the deal was suggested. If a deal is consummated, Nedbank would represent 3% of HSBC assets.
HSBC is considering its options in the knowledge the “For Sale” sign is now indisputably in place over 135 Rivonia Road in Sandton. It knows emerging markets rival Standard Chartered – snubbed in its bid for Absa and sidelined in that process – is waiting in the wings to pick up a financially stable, well-run African banking business from under its nose. The stakes are high and the assets scarce.
The biggest obstacle to any deal in SA’s banking sector is the securing of regulatory approvals. It won’t hurt HSBC’s cause that current SA Reserve Bank Governor Gill Marcus chaired Absa in the aftermath of the Barclays plc takeover and will be aware of the benefits a foreign shareholder can bring to a local banking operation.
Banking regulator Errol Kruger has proven fiercely independent in his decision-making as part of his oversight of SA’s banking sector – a deal would need his seal of approval. He regards Old Mutual as a foreign shareholder, despite the fact the group still earns about two-thirds of its profits in this country and the Nedbank stake is held via Old Mutual South Africa (OMSA). “We look at this much like lawyers would. As regulators we pierce the corporate veil to see who is ultimately the power behind the throne,” says Kruger, upon whose final approval a deal will hang. “We’d see this as substitution of one foreign shareholder for another.”
That means the regulator isn’t straying from the stated policy position that it’s comfortable with foreign control over a maximum of two of the country’s Big Four banking groups.
HSBC would be wasting its time on due diligence if it wasn’t at least certain its application would be given sympathetic consideration. The mere fact the group has embarked on the investigation is a tacit acknowledgement by the Reserve Bank that – provided HSBC meets its criteria – approval is likely.
Among the key non-negotiable criteria will be that the CEO of the group remains a South African and that the Reserve Bank remains the lead regulator. However, the group’s brand isn’t sacrosanct. HSBC is likely to want to have its brand showcased throughout Africa but faces a couple of challenges on that front. In terms of corporate identity, Standard Bank and FNB co-exist in the “blue” spectrum, while Absa has a “monopoly of association” on fire-engine red in financial services. The reds used by both Absa and HSBC are indiscernible to the untrained eye.
While the detail of any deal will need to be hammered out, the facts of the matter are simple: Old Mutual is a willing seller and HSBC an eager buyer. Old Mutual management under CEO Julian Roberts has promised to unlock the value tied up in the group, which trades at a substantial 30% discount to embedded value – an insurance industry measure of the real value of a business in that industry.
Nedbank makes up almost 25% of the Old Mutual valuation and delivered an average return on equity of 16,6% over the past three years – although pressure on SA’s banking system means that number is likely to come under pressure for the foreseeable future. Analysts have expressed concern the sale might dilute Old Mutual’s earnings, as it will struggle to achieve similar returns to those it will likely receive from its Nedbank stake.
Should a deal be done, Nedbank CEO Mike Brown will find himself in a position akin to that experienced by former Absa CEO Steve Booysen, who within a short period of taking the helm at the group found his business subject of a foreign takeover bid. As speculation has done the rounds, Brown has been careful not to nail his colours to any particular mast and has made it clear that if Old Mutual were to sell to a respected global bank, Nedbank would be amenable to working with the new shareholder.
Just how much discussion between Nedbank and potential foreign shareholders happened before Old Mutual gave HSBC a right to exclusivity in terms of negotiations is unclear – if there were talks, Brown isn’t saying, but he does acknowledge having met Geoghegan in the “normal course of business”.
“We received the documents on Friday and held a board meeting as soon as we could on Friday evening. All conflicted directors recused themselves and the meeting was chaired by an independent director,” said Brown in an emailed response to questions on the mechanics of the approach. “There was a general sense of excitement, notwithstanding that this was only at proposal stage.”
In the hours immediately after Nedbank issued its cautionary and HSBC made its intentions known, the bank saw its share rally around 6% to 13 950c, giving it a market capitalisation of almost R70bn. However, it does imply the market isn’t anticipating Old Mutual – as an eager seller – will push for a substantial premium.
But analysts’ estimates vary considerably. Analysts at RMB and Keefe, Bryette & Woods say the stake would be worth around R60bn, assuming a 30% premium on the closing price on the Friday before the deal was announced. Sanlam’s Kooyman says the deal might command a premium of as much as 20% to 25% on the ruling price, considering Old Mutual would be unable – over the short term at least – to achieve the 12% return on investment it currently receives from Nedbank. That premium would value Nedbank around R170/share, while Deutsche Securities estimated an acceptable offer to be closer to R150/share, based on the fact it would be Old Mutual who would make the price, with minorities likely to have to go along for the ride. That would give HSBC a 7% control premium – ordinarily inadequate to entice shareholders to forego future earnings.
While Old Mutual is keen to sell, it’s by no means a desperate seller. The new management team’s actions to date have given it strong market credibility. That would be undermined if it didn’t secure a good price for its asset. It’s a difficult balancing act: Old Mutual wants to reduce its debt and prove its commitment to simplifying its unwieldy group structure on its path to becoming a focused savings and asset management business. Banking simply doesn’t fit its stated profile and it will be mindful of its failed sale of Mutual & Federal, which obliged it to make an offer to minorities. That isn’t an option in the case of Nedbank, which sits at the opposite end of the risk spectrum risk-averse Old Mutual wants to portray.
Africa is a focus for a growing number of investors who see the continent as a largely untapped economy with almost 1bn potential consumers. It’s an enticing prize. Link deal flow to Asia and the prospects are most appealing.
But Kooyman cautions: “If they do the deal, it will be a long, hard slog. Many of their Asian clients will already have existing banking relationships in Africa, and if you’re going to win those you have to sacrifice margin and be patient. It takes a long time.”
Victims of their own success
Why SA banks are a lousy short-term proposition
HSBC’S PROPOSED acquisition of Nedbank stands to alter the shape of not only South African banking but will also have a significant impact on the economic future of the African continent. The Hong Kong-based bank is seeing the potential long-term value in a sector where private and institutional investors are focusing on a lack of short-term earnings visibility.
Medium-term revenue growth for South African banks is muted at best. Concomitantly, banks are struggling to contain their costs. Banks, in the words of one analyst, have “become victims of their own success” because they’ve grown rapidly and migrated increasing numbers of clients to lower cost channels but have failed to adequately address the expenses line.
“It’s all well and good to offer cheaper channels,” says analyst Chris Steward, at Investec Asset Management. “If you offer someone an electronic transaction at a fraction of the price of doing the same thing through your branch network, you need a commensurate saving on the cost line.”
OMIGSA banks analyst Tracy Brodziak agrees there’s a trend to move clients to cheaper channels and that banks need to look at their structures to find ways of recovering costs, including the possibility of refining branch numbers. However, that’s a politically fraught issue banks are having to grapple with. However, she’s optimistic banks may have seen the worst of the bad debt cycle and consumers are starting to borrow more at greater profit margins for the banks.
But profits are hard to come by. Standard Bank was bolstered in first half 2010 by a reversal in bad debts after taking aggressive provisions 12 months ago. And there was more than a R1bn turnaround at Liberty, although its core banking business slipped 10%. Nedbank’s earnings were flat and Absa squeezed out a marginal increase in earnings.
The challenges facing SA’s banks aren’t unique. Banking worldwide has changed over the past two decades. As The Ascent of Money author Niall Fergusson puts it: “Previously (banking) was about relationships and the trust those built – after the Eighties more and more banking has become the story of transactions: pile ’em high and sell ’em cheap. It’s all about volume, volume, volume. How many bank customers have a relationship with their branch manager? Not many, I would guess.”
By taking clients out of the branch, the dynamic between client and bank has changed. Standard Bank South Africa CEO Sim Tshabalala cautions against overstating the importance of the changes in the dynamic. “We’re banking more clients and that increase in volumes gives economies of scale, freeing up more branch staff to cross-sell and up-sell to clients,” he says.
About four years ago, Barclays tried to entice consumers back to branches with a clever marketing campaign in Britain, after it found it harder to reach its clients.
Historically, growth in retail banking fees and commission income was between 10% and 15%: it’s currently likely to be between 4% and 7%, with more limited pricing power and lower volumes impacting revenue growth – and a sluggish economy isn’t helping. Non-interest revenue is around half of bank revenues, and most of that comes from fees and commission income – implying about 30% of the revenue line is under pressure.
First National Bank CEO Michael Jordaan agrees with the principle but says new technology means banks can service considerably more clients than they could previously. “We’ve noticed a tipping point in the migration from expensive manual transactions to electronic channels,” says Jordaan. “Our cellphone banking transaction volumes are now multiples of our cheque volumes and debit cards exceed credit cards. We like this, as electronic channels scale much better than physical ones.”
Cost-to-income ratios are likely to worsen before they improve, courtesy of lower returns on capital, weak credit demand, depressed transaction levels, ongoing margin pressure and increasingly tough local and global regulatory issues, which are likely to push up the cost of administration. Absa reported a 46% increase in cash-handling costs to R335m for the six months to end-June. Part of that was the cost of security for cash-in-transit vehicles to and from its banks and corporate clients, plus the cost of keeping cash in secure depots.
And the worst may not be over in terms of declines in endowment income. In a posting on social networking site Twitter last week, Jordaan forecast a September rate cut off the back of disappointing GDP figures of 3,2%. Another rate cut would affect banks negatively over the short term. Nedbank disclosed (in its most recent results) that every 50 basis points cut in rates costs it around R600m/year in lost interest.