Bulls n Bears Entrepreneurship Zone :: Finding value in frontier African markets

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Across corporate boardrooms in South Africa, a number of management teams
and institutional investors are grappling with a vexing question: Is
investing in frontier African markets worth the hassle? Nick Ndirituexplains
how Allan Gray has wrestled with the uncertainty of investing in frontier
markets.

Established South African industry leaders are struggling with the
well-known challenges of doing business in [the rest of] Africa. From
Nigeria to Uganda, the regulatory challenges faced by telecommunications
company MTN resemble a cruel game of whack-a-mole: As soon as you fix one,
another appears. Africa’s leading retailer, Shoprite, reported its largest
earnings decline in over a decade, citing currency devaluation in Angola as
the cause. In the financial services sector, Liberty Holdings is looking to
sell down loss-making African operations in asset management and health.

Newer entrants with less established African footprints, initially drawn to
the continent’s alluring growth prospects, are scaling back their ambitions.
South African property companies Attacq and Hyprop recently impaired the
value of their ‘rest of Africa’ assets and are looking to exit or pare down
a joint venture that owns shopping malls in Ghana, Zambia and Nigeria. Most
of their tenants are South African retailers who have scaled back their
Africa expansion plans and are unlikely to renew their leases. Their
concerns are valid. In 2013, retailer Woolworths exited Nigeria, citing high
rental costs and supply chain challenges as reasons. In 2016, fashion chain
Truworths also exited Nigeria due to high rentals and import restrictions.


There are success stories


On the other hand, there are compelling examples of South African
corporates who have thrived on the continent. Standard Bank’s footprint in
20 African markets is unrivalled. Their ‘rest of Africa’ business is
lucrative, earning a 24% return on equity (ROE) compared to the group’s 18%
ROE, and is now contributing a meaningful 29% to group earnings.

MTN’s operations in Nigeria are thriving despite all the regulatory
hullabaloo. At the end of 2018, revenues grew by 17%, with an 11% increase
in their subscriber base to 58 million, and their EBITDA (earnings before
interest, taxes, depreciations and amortisation) margin expanded by 4.5
percentage points (pp) to 43.5%, excluding once-off regulatory payments.
Shoprite remains a formidable competitor in Africa’s retail landscape
despite short-term macroeconomic challenges in Angola and Nigeria.
Battlefield scars are inevitable as these companies diligently build their
competitive positioning through the ups and downs.

South African corporates have also dispelled any doubts that new market
entrants can crack the challenging business environment in Nigeria. Brewer
SABMiller (prior to its merger with Anheuser-Busch InBev) entered Nigeria’s
beer market in 2009 and later invested US$100m to build a brewery in the
city of Onitsha. They pursued a differentiated regional marketing strategy,
championing regional brands which resonated with the traditions and culture
of the local communities. This strategy also avoided fierce nationwide
competition with dominant Heineken and Diageo.

SABMiller also specifically addressed affordability, focusing on the number
of minutes worked to earn a core beer. The company considers a beer to be
affordable at 30 minutes, but the majority of the population in Nigeria is
in the low- to mid-income range, where an individual needs to work for 72 to
140 minutes to earn a beer. Cheaper pricing expanded their reach into the
value-conscious segment, at the expense of peers like Diageo, who have
stumbled during Nigeria’s recent economic slump.

The results have been impressive, with SABMiller garnering a 22% market
share of Nigeria’s beer market. AB InBev is building on SABMiller’s
groundwork, recently commissioning a US$250m brewery to meet growing demand
and now expanding from a regional to a nationwide distribution footprint. At
a time when others may be considering exit options, AB InBev is unabashedly
betting on Nigeria’s beer market.


It is not easy doing business in Africa


These examples of success and failure highlight the fallacy of sweeping
narratives. The insistent story of a rising Africa underplays the challenges
of doing business on the continent. Progress in changing the business
environment has been uneven. One objective measure to track this progress is
the World Bank’s Doing Business rankings, which indicate the ease of doing
business in 190 countries. They score each country based on various
indicators that help determine the efficacy of the business environment: How
easy is it to start a business, deal with construction permits, get
electricity, register property, get credit, pay taxes, trade across borders,
enforce contracts and resolve insolvency. Using the same standard everywhere
enables comparability across economies.

Graph 1 shows the ease of doing business scores for select African
countries over the last five years. In 2015, South Africa was ranked 43rd
out of 189 economies, and was on a par with Rwanda as one of Africa’s
top-ranked economies. By 2019, South Africa has fallen behind, with the
Doing Business score having increased by only 2 pp compared to Rwanda’s 10
pp improvement. Over this period, Kenya has made the most progress, with a
16 pp gain and jumping from a rank of 136 to 61. Nigeria has also made
progress, but from a low base of being ranked 170th to 146th.



In aggregate, these scores highlight that in most frontier markets,
companies seeking opportunities there are barely welcomed by smooth and
efficient functioning of regulators, tax authorities and judiciaries, among
others. These challenges aren’t new or unique to Africa, but according to
the Doing Business 2019 report, sub-Saharan Africa has been the region with
the highest number of reforms each year since 2012. This past year, they
captured a record 107 reforms across 40 economies in sub-Saharan Africa.
Countries eager to lure investment are undertaking measurable pro-business
reforms.


Establishing a competitive edge remains important


Painting the Africa narrative with broad brushes also obscures the role of
competition. There will always be winners and losers. Successful market
leaders are honing their strategies and ability to compete effectively
despite the well-known challenges.

Take the case of Nestlé in Nigeria. To critics, Nigeria’s emerging consumer
class is elusive, premised on an oil-dependent economy: Any downswings in
oil markets trickle down to constrain household consumption patterns.
Undeterred, Nestlé has operated in Nigeria for close to 60 years, selling an
ever-growing basket of consumer goods. The competitive environment has
intensified in practically all their product categories and brands –
sometimes new entrants, and in other cases, existing companies expanding
into other categories.

Their competitive edge has come from building a distribution chain that
delivers their products to over 300 000 points of sale across a country
renowned for poor infrastructure. Modern retailing formats (e.g.
supermarkets) account for less than 2% of Nestlé’s sales. Nearly 80% of
their raw materials are sourced locally, providing some relief from import
restrictions and currency fluctuations. In addition, through the ups and
downs, they have invested in building local products like Maggi seasoning
cubes, which has limited import substitution based on the purchasing
preferences of generations of discerning Nigerian taste buds.

In 2018, which was a difficult year for many consumer goods companies in
Nigeria, Nestlé grew earnings by 28% and expanded EBITDA margins by 150
basis points to 27%, the highest on record over the last two decades.
Nestlé’s five-year average ROE is an astounding 65%, and this during a
period of significant macroeconomic challenges in Nigeria.


Our investment approach


As institutional investors in Africa’s frontier capital markets over the
past decade, we have wrestled with uncertainty driven by macroeconomic
factors, and we have had to contend with periods of illiquidity in currency
markets. From our experience, the most critical driver of long-term
investment returns is finding great businesses with a competitive edge and
trading at a discount to our estimate of intrinsic value. Asset prices tend
to be heavily discounted when sentiment is negative during periods of
uncertainty, presenting an attractive buying opportunity for long-term
investors. Having the patience and courage to follow this contrarian
approach often yields attractive long-term returns.

As an illustration, Graph 2 shows the US dollar returns for various market
indices relative to Standard Bank’s listed subsidiary in Nigeria, Stanbic
IBTC. From 2010 to March 2019, South Africa’s FTSE/JSE All Share Index
(ALSI) has been flat in US dollars, barely outperforming MSCI Nigeria and
slightly behind MSCI Africa ex-SA. Over this period, Stanbic IBTC has
outperformed, but with noticeably higher volatility.



At the peak in 2014, Stanbic IBTC was trading at a 15.2x price-to-earnings
(PE) ratio and a 3.3x price-to-book (PB) ratio, which was above our estimate
of fair value. Subsequently, oil prices collapsed, and the macro outlook was
bleak. Stanbic IBTC also faced heightened regulatory risks. In October 2015,
Nigeria’s Financial Reporting Council suspended its chairman, CEO and two
directors over allegations that the company had misstated financial
statements related mainly to the accrual of franchise fees. The dispute was
finally resolved in December 2016, but the lengthy delay prevented the
company from releasing financial statements for the 2015 financial year to
September 2016.

Despite the distraction from external risk factors, Stanbic IBTC’s
management continued to enhance their strong competitive positioning in
Nigeria’s pension fund industry. The company’s market share of Nigeria’s
pension fund assets has risen to 31% by the end of 2018, up from 24% in
2010. Stanbic IBTC has grown its market share of retirement savings accounts
to 21% from 18% in 2010. The company has a top-rated corporate and
investment banking franchise and has steadily built a competitive retail
banking franchise. It generated a 34% ROE in 2018, bouncing back strongly
from Nigeria’s economic slump in 2015, when it generated 13% ROE.

Stanbic IBTC’s share price also bounced back strongly in 2017 as the macro
outlook improved after the introduction of a new foreign exchange regime and
a steady recovery in oil production and prices. More recently, investors’
concerns about Nigeria’s outlook have resurfaced, but Stanbic IBTC’s
long-term prospects are still very attractive. At the end of 2018, Nigeria
had 8.4 million retirement savings accounts relative to the estimated 70
million working-age adults. Pension fund assets have risen to US$24bn, which
is a paltry 6% of GDP compared to 57% in South Africa and 135% in the US.
The company is attractively priced at 6.5x PE, 2.0x PB and 5.8% dividend
yield for a market leader with a trusted brand in a promising industry. As
long-term investors, Stanbic IBTC is one of our top holdings in Africa and
we are prepared to wait through the inevitable periods of economic and
political uncertainty.


Conclusion


The challenges of operating in Africa aren’t new or exceptional. Multiple
global companies have steadily built thriving businesses in countries across
the continent: Unilever, Nestlé, MTN, Shoprite and Standard Bank.
Undoubtedly, there are countless others that didn’t survive. What
differentiates the winners in frontier markets? From Lagos to Hanoi, success
often owes much to the openness and willingness to adapt business models and
products to fit constrained household budgets and appeal to the familiar yet
aspirational ways of life.

We continue to find attractively valued opportunities and believe frontier
African markets are well-suited to a patient, contrarian investment
approach.

Nick Ndiritu is a portfolio manager for the Allan Gray Africa ex-SA Equity
Fund and Africa ex-SA Bond Fund.—Howwemadeitinafrica 



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