Abil stock plunges after further negative surprises, but RE:CM doesn’t see value yet

I think this interview deals with a very interesting question, which is when does a stock look like a "value buy" and when does it just look like a dog. African Bank is a stock that has lost a lot of ground over the last eighteen months or so, as a result of some pretty significant and worrying writedowns on the back of rising bad debts. Abil does a lot of unsecured lending, and as consumers have racked up debt and begun to struggle, Abil has seen a steady rise in bad debts. In some recent announcements, Abil has let investors know that the bad news continues, with yet more writedowns – a big disappointment to observers who thought that the worst was over.

So where does that leave Abil? Is it a great value play, or does it still have more ground to lose? Do investors take a chance at these levels, or wait to see if things get worse before they get better? – FD

ALEC HOGG: Well, to get a more in-depth look at the markets, and how they're trading today, we have Wilhelm Hertzog from Regarding Capital Management with us in our Cape Town studio. Wilhelm, it's good to have you on the program, as always. Again, to see ABIL plumbing further depths at over six percent today and eight percent yesterday, one wonders where the bottom might be on this one.

WILHELM HERTZOG: Yes, you do wonder where the bottom might be. I guess people were expecting the write-offs and the capital raising we saw towards the end of last year, to be the 'kitchen sinking' of the results and that you wouldn't see any further very negative surprises. I do think that the trading update, which they put out recently, definitely was a very negative surprise. Where the bottom might be is always difficult to tell in an environment like this where industry conditions are tough and where sentiment is negative. People tend to sell shares on the smallest suggestion of any further bad news and you're never quite sure how long a tough cycle will last. The big fear now is whether there might be any further capital raising in the offing at ABIL, so where the bottom is, is difficult to say I must admit.

ALEC HOGG: Wilhelm, you guys are deep value investors. If there's deep value anywhere… Well, if it's worth one cent or if it's not going to go bankrupt, then there has to be value in ABIL. Have you read this annual report many times and looked into the company?

WILHELM HERTZOG: Sure, we've kept quite close tabs on the company and our clients do own ABIL shares to a very limited extent. It's quite a small investment for our clients. We (or our clients) have a greater exposure to ABIL's debt, which we think is quite safe and offering attractive yields. We've therefore allocated more capital to ABIL's debt than to the equity, but we do think there's value. The value probably has eroded during the past year or so, the write-offs of the book, and the erosion of NAV has probably been a bit more severe than we even expected, and we did expect a very tough cycle. It's not as though we allocated capital to ABIL shares with the view that things will just be rosy henceforth. However, things have been a bit tougher and the write-offs have probably been a bit more severe than we even expected.

ALEC HOGG: Sasha Naryshkine and I were chatting yesterday, about how one gets into that…or how one makes an investment into the debt. Can you explain that to us? Secondly, what kind of yield are you now getting from buying ABIL debt?

WILHELM HERTZOG: Buying ABIL debt is really the domain of institutional investors. You really need to buy fairly large amounts of money by the standards of individual investors, so you need to be able to put in a couple of million Rand at a time. It's really a market where there's not much liquidity, so you often buy this debt in a primary issue, for example the company issuing new debt. In the secondary market, as I said, trading is fairly limited and the big banks do dominate trading in secondary debt markets in South Africa, so you'd need to phone up a bank and hear whether they're possibly aware of a seller or even have some of the debt on their own books, which they can sell to you.

ALEC HOGG: What yields are you getting now, Wilhelm?

WILHELM HERTZOG: The yields we're currently getting, varies. ABIL has a number of debt instruments in issue, but the inflation-linked debt instruments, which we rather like, are offering yields in the five/six/seven percent range. On the nominal debt, which doesn't estimate with inflation, you're looking at yields approaching 10/11/12 percent. Obviously, the most recently issued debt was a Swiss-denominated debt, which they had to hedge back into Rands etcetera, so the all-in cost of that debt – the yield you'll earn as an investor – was in the low double digits – 12 to 14 percent, depending on how you do the calculations. We think those are quite attractive yields, if you consider that long-term inflation will probably be in the vicinity of six percent. Earning 12 to 14 percent on debt gives you a six to eight percent real return, which is the type of return you historically earned on equities and not in debt, so we think it's quite attractive.

GUGULETHU MFUPHI:  Wilhelm, ABIL is a company that you're focused on. Are there any other companies in a situation similar to ABIL's, where you found an opportunity to invest in their debt? I was thinking…maybe JD Group.

WILHELM HERTZOG: Our clients do own shares of JD Group and we did take a close look at the debt, but at the time that JD Group's debt was issued, the negativity and the circumstances surrounding the sector wasn't as severe as it currently is, so the debt wasn't issued at what we thought was a particularly attractive rate. As a result, we never bought into JD Group's debt. The debt did sell off substantially prior to the announcement that Steinhoff would be acquiring full control/making an offer to acquire full control of JD Group. At that point, there was a brief window where it did offer potentially attractive yields, but we never allocated capital to JD Group's debt. Yes, they were certainly in a somewhat similar situation.

ALEC HOGG: Well, if you're looking at a 10 to 12 percent yield and you think that's attractive, then clearly you don't think ABIL are going to hit the wall.

WILHELM HERTZOG: No, we don't think ABIL will hit the wall. Even if you're an equity holder and you lose money as equity holders have done to date, that doesn't mean that the debt will be subject to…suffering any losses. Clearly, there has been support for ABIL and ABIL today, does in fact have a fairly strong shareholder bases – we think of the likes of Coronation being the largest shareholder there. There are deep pockets that can back ABIL to see it through the tough cycle. We think that from a debt holder's perspective, that's actually quite positive, the debt will be quite safe, and you're not exposed to any risk of material loss by owning ABIL's debt.

ALEC HOGG: Wilhelm, just explain that if you would. Equity holders could lose what they put in, but you say you don't think debt holders are at risk. How is that so?

WILHELM HERTZOG: Sure. If you take the capital invested in ABIL as a business, then it consists of equity and debt, as I mentioned, and equity carries greater risk of loss. If it turns out that ABIL's loan book is of even worse quality than the market or management thought and they have to take even more severe write-offs, the first providers of capital to take a loss and to take a hit to the money they put into the business, are the equity holders. It's only after the equity has been wiped out, that debt holders will have to start writing down their debts if the company comes to a scenario where there has to be a restructuring of sorts to make the capital structure more sustainable. Equity holders are therefore at risk first, and only after equity has been wiped out, do debt holders in fact, carry risk of loss.

GUGULETHU MFUPHI:  Wilhelm, you mentioned that investing in debt is a secondary market, one that institutional investors can take advantage of. Doesn't this put them on a better footing versus retail investors who often choose to invest in equities?

WILHELM HERTZOG: Sure…potentially. Equities are more accessible as a direct investment for retail investors, but you can also access the debt markets via collective investment schemes, which focuses on the debt market. Therefore, it isn't totally off-limits or totally out of bounds for retail investors, but buying debt directly from companies is a bit difficult.

ALEC HOGG: Moving onto another subject – and thanks for those insightful views on ABIL – Grand Parade and Sun International… You've been big holders of Sun International. I don't know if you're still involved there, but if you are, you would have looked at this deal carefully.

WILHELM HERTZOG: Absolutely. Yes, our clients are still substantial shareholders of Sun International. In fact, our clients are shareholders of all three parties that are part of these transactions, which were announced this morning. Our clients therefore, own shares in Sun International, Tsogo Sun, and Grand Parade, so we've watched this deal quite carefully. We do think it's a very positive development, specifically from Sun International's side. The great risk that Sun International was facing – and I guess to some extent, Grand Parade as a fellow shareholder in GrandWest – was that Tsogo Sun would move one of their casino licenses (currently in Langebaan or Caledon) into the Cape Metropole because there is opportunity for a second casino in Cape Town. That was a material risk facing Sun International, who is the largest shareholder in GrandWest, and GrandWest is a flagship asset in the Sun International stable. It is probably the best casino asset in South Africa. The fact that Tsogo Sun has now bought into GrandWest – because that is essentially the outcome of the set of transactions – is a huge positive for Sun International. It means that it's far less likely that Tsogo will open up a second casino in the Cape Metropole. Tsogo is the only player of any significant scale or really, the only player in the market who could realistically have opened a second casino of size and substance in the Cape Metropole. The fact that Tsogo Sun now owns a stake in GrandWest means they have no real interest in opening up a second casino in the Cape Metropole and that should largely protect the earnings that Sun International receives from GrandWest, for as long as Tsogo is a shareholder in GrandWest.

GUGULETHU MFUPHI:  Wilhelm, your thoughts on Life Healthcare… They published their results today. The numbers are up across the board, but not much movement regarding the share price today.

WILHELM HERTZOG: Look, I haven't had a chance to look at those results in great detail, but they've certainly managed to deliver very good results ever since they came to market a few years ago. Having said that, the fact that the share price didn't react much to the good results, is probably partly a reflection of valuations or prices in the healthcare sector being fairly elevated. Our assessment is that prices of the private hospital companies on the share market are quite elevated and lofty, and their great expectations are largely already built into the share price. That typically, is what the case is when you see companies delivering very good results, but share prices not really reacting to those. Currently, our clients don't own any of the private hospital operators. Although we think they're fantastic business as I've said, we think the prices being paid and assigned to them by the market, are currently just too lofty.

ALEC HOGG: You've been sitting with your Sun International shares for quite some time. It was a fascinating insight you gave us there on why this is such a good deal for Sun International. Are you going to be doubling-up? As your colleague, Piet Viljoen often says 'if hamburgers go for half-rice, you buy two rather than run away'.

WILHELM HERTZOG: We'll take a careful look at our assessment of GrandWest''s fair value, following this transaction. We were quite conservative in how we valued GrandWest because of this risk of a second casino entering Cape Town. The fact that that risk has now been removed will certainly affect how we value GrandWest, and GrandWest is quite a material chunk of our assessment of Sun International's overall fair value. To the extent that this transaction increases Sun International's fair value, it may well mean that the margin of safety or the discount to fair value, that the current share price offers increases and that could well result in us increasing our stake, yes.

GUGULETHU MFUPHI:  Would the situation be similar in Grand Parade?

WILHELM HERTZOG: I think from Grand Parade's point of view, the price Grand Parade is receiving for their stakes in Sun West, the Worcester casino, and for Grand Slots, in fact… Those prices are very close to what we were valuing those assets at in any case. Despite the share price reaction, which was quite positive today as we saw, we don't think the value uplift in Grand Parade has been massive. Remember, they're not getting any further benefit from GrandWest as an asset, so the fact that GrandWest is now a much lower risk proposition, creates fair value and the value we ascribe to their assets, going forward. From Grand Parade's point of view, there's not much in it between what the assets are being sold for and what we thought they were worth, so our fair value doesn't change much following this transaction. We're unlikely to make any material adjustments to what we have done with our clients' interests in GrandWest or in Grand Parade, at this stage.

ALEC HOGG: That was Wilhelm Hertzog from RECM. Gugu, it's quite interesting. I was at the PSG Consult annual bash with 'Die Boere Buffett'. It was quite funny. You go from the one Buffett, to the Boere Buffett, Jannie Mouton. He speaks like that, in a very deep voice. Sun City though, was an absolute surprise – a pleasant surprise. I left there, saying to Jeanette (my wife) that we need to look at Sun International as an investment prospect because you see is. You see it. When you feel, when you go somewhere and you feel if there's an underlying enthusiasm amongst the staff… Remember, if you buy minerals you're investing in rocks. If you buy companies, you're investing in human beings and the ability of human beings to transform their ideas into profit really, and I always get a good feeling when I go into a business and you see staff who are really 'jacked-up'. They were smiling. They were very different to years gone by, and then you look back at Sun International and you remember they've had some serious management changes. Marco [von Oerlink? 0:13:26.5] only went in as CEO, and now he's cleaned up the top management structure – not long ago. You get this (on top of it), where their big risk factor in Sun International was that someone else would open a casino in the Cape Metropole and affect GrandWest, which is the most profitable casino in South Africa. Put that all together…it's only gone up one percent in the past year, so it certainly isn't overvalued.

GUGULETHU MFUPHI:  Indeed, that's a very interesting observation you make there. One for the portfolio indeed, Alec, as well as the investment we're seeing Tsogo Sun making alongside the Durban beach Promenade – a strong investment there. One wonders. I haven't felt or experienced the human being element of it yet, but as you mentioned…

ALEC HOGG: Tsogo is different. Sun International… I don't know, but I really do like Sun International. I think something's happening there that is good, and there's no doubt – listening to Wilhelm, as well.