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September 2, 2010 African Markets: Equity

Industry View: Positive UGANDAN BANKS


SBU: BUY
DFCU: HOLD
We reiterate our BUY on Stanbic;
Initiate DFCU with a HOLD
We look at the Ugandan banking system, Stanbic Bank Uganda
(Stanbic) and DFCU bank (DFCU). Key takeaways are:
ƒ Growth of the financial services sector and banking should
be supported by the growing wealth level and expanding
population. The low penetration level provides vast
potential, in our view. The banking assets/GDP is only
30.8% while deposits/GDP and loans/GPD ratios are 19.2%
and 13.1% respectively. The relatively strong GDP growth
provides a fillip to banks’ top lines.
ƒ The industry’s average Return on Equity (ROE) of 31%
(CY05-CY08) is supported by a relatively high Return on
Assets (ROA) rather than leverage. The high ROA is
underpinned by high net interest margins (NIM), averaging
11.5% (05-08). The system’s liquidity is fair, with a
loan/deposit ratio (LDR) of 72% vs. a cap of 80%.
ƒ The system remains largely inefficient with a low level of
non-interest income (NII) and a NII/operating income ratio
of below 20%. The industry carries ample capital, with a
total Capital Adequacy Ratio (CAR) of 21%. However, we
remain concerned with the credit risks and the “poor”
coverage ratio which impair the quality of earnings.
ƒ We revisit our Stanbic forecasts and valuation. We reiterate
our BUY recommendation with a new FY11 target price of
Ugx340, providing a potential total return of 49.8%. We
believe Stanbic is well placed to protect its market share.
ƒ We initiate coverage on DFCU Bank with a HOLD. Our FY11
Peter Mushangwe target price is Ugx833. Our primary concerns are the
Puleng Kgosimore
inconsistency in performance, relatively poor retail deposit
+27 11 551 3675
peterm@legae.co.za franchise and the comparatively lower ROE (vs. industry).
There is hope, but only after dealing with legacy issues in
their entirety in our view.
Contents page
Executive Summary 2

Salient country information 4

1. Industry Overview 5

1.1 Penetration, deposits and credit growth 5

1.2 Liquidity, profitability and efficiency 10

1.3 Credit risks and capital adequacy 18

1.4 Economics and politics 24

2. Stanbic Uganda, FY11 Ugx344, BUY 26

2.1 Company description: One of the strongest franchises 26

2.2 Analysis: Low cost deposit base is key 26

2.2 Valuation: A deserved premium 32

3. DFCU Initiation of coverage, FY11 Ugx833, HOLD 34

3.1 Company description: One of the oldest franchises 34

3.2 Analysis: Low CASA to affect margins 35

3.2 Valuation: Hope after addressing legacy issues 41

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Executive Summary

ƒ We like Uganda banking sector on structural growth...: The


Uganda banking system is lowly penetrated with deposit/GDP and
loan/GDP ratios of 19.2% and 13.1% respectively, yet population
and wealth levels (as measured by the GDP per capita income) are
increasing. The system’s LDR is 72% which provides some room
for NIM support through changes in asset mix in the short term.
Loans and advances were only 42% in CY08. The system carries
excessive capital in our view, with a total CAR ratio of 21%
(HY09). Despite having 22 commercial banks, the system is fairly
concentrated with the top 5 banks making up more than 50% of
the industry assets and deposits.
ƒ ...and positive macro-outlook...: We remain positive on
economic growth given the oil and mineral discoveries as well as
our expectations of continued government (central and municipal)
investment in infrastructure. We expect Uganda to maintain a GDP
growth rate at greater than 6% for the next 3 years. We remain
convinced that the difference between Kenya and Uganda in
banking will narrow, and as penetration and per capita move
towards convergence with Kenya, we foresee significant
opportunities in the Ugandan banking system given the higher
population growth.
ƒ ...but the credit risks and the volatile non-performing loans
(NPLs) coverage ratios are a worry, in addition to pressure
on NIMs: The industry’s NPLs have been growing at a faster rate
than loan growth since CY05. The NPL/loan ratio peaked at 4.1%
in CY07, declined to 2.1% in CY08 before rebounding to 4.0% in
H09. We note that the CY08 ratio decline was a result of an
enormous 33% reduction in NPLs in that year. As a result, the
provision/NPL ratio also recovered to over 100% in CY08 before it
worsened to 72% in HY09. While we believe there is some
cyclicality to NPLs, we are concerned with the volatility in the

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coverage ratio. We would prefer the Bank of Uganda (BoU) to
prescribe a minimum coverage level. We also see pressure on
NIMs. Vigorous deposit mobilisation strategies as a result of rising
competition will increase the cost of deposits. We anticipate an
increase in wholesale and fixed deposits in the system.
ƒ Follow up on Stanbic Bank Uganda with a BUY
recommendation: The high ROE, a strong retail deposit franchise
and high liquidity levels motivates our BUY recommendation. The
bank has room to change its assets mix (i.e. increasing the LDR)
to protect its interest spread and NIM. The bank’s ROA is high
(FY09 = 5.1%; our FY10 forecast is 3.5%). We expect the bank to
continue to widen the ‘jaws’. Our FY11 price target is Ugx340,
implying a potential total return of 49.8%. The ROE outlook is
positive despite a slowdown in earnings growth in FY10. BUY
ƒ Initiate DFCU bank with a HOLD recommendation: While we
believe that DFCU can be the local brand that can break the
hegemony of the international banks in the system, we remain
concerned with the poorer retail deposit franchise, the lower ROEs
(and ROAs) and the execution risks (the Group was restructured
and has witnessed a couple of Managing Directors and Board
Chairmen in the past five years). The jaws are also not opening up
fast enough, in our view, with operating income registering a
compounded annual growth rate (CAGR) of 18% versus a CAGR of
15% for operating expenses. Our fair Price-to-book value ratio
(PBVR) which we obtain using an ROE of 25.8%, growth rate of
15.7% and a Cost of Equity (CoE) of 18.95% is 2.1X. Our FY11
price target is Ugx833, which provides a potential total return of
8.4%. HOLD

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Salient country information.

Fig 1: Key country information

2001 2002 2003 2004 2005 2006 2007 2008


GDP at market prices (current),ugxbn 10,907 12,438 13,972 16,026 18,172 21,187 24,709 29,824
GDP, US$bn (current) 5.8 6.2 6.6 7.9 9.2 9.9 11.9 14.4
Real GDP growth,% 8.5% 6.5% 6.8% 6.3% 10.8% 8.4% 9.0% 7.0%
Population,mn 25.11 25.97 26.87 27.82 28.82 29.85 30.93 32.04
Per capita income, US$ 232.6 239.4 245.8 284.9 320.1 333.5 385.3 450.6
Household final consumption,ugxbn 8,396 9,587 10,291 11,818 14,139 16,303 18,835 23,963
Government consumption,ugxbn 1,820 1,959 2,133 2,326 2,568 2,695 2,721 3,014
Gvnt. C onsumption/GDP 16.7% 15.8% 15.3% 14.5% 14.1% 12.7% 11.0% 10.1%
Financial indicators
Bank rate,% 8.3% 19.6% 12.9% 15.7% 13.6% 16.6% 16.2% 10.7%
Lending rate,% 17.6% 18.3% 20.9% 18.1% 18.6% 19.4% 20.2% 22.2%
91-day TB rate,% 5.3% 17.7% 6.3% 8.9% 7.0% 9.4% 8.2% 7.9%
M2 growth,% 25.2% 17.5% 10.2% 12.1% 18.9% 16.8% 30.3% 26.1%
Private sector credit,ugxbn 661.7 848.6 1,010.0 1,150.2 1,475.5 1,812.9 2,830.5 3,654.7
Private sector credit growth,% 28% 19% 14% 28% 23% 56% 29%
UGX/US$, average 1,754.6 1,882.9 1,934.9 1,737.7 1,825.2 1,780.0 1,696.5 1,911.2
Macro indicators
Inflation,% (average p.a) -2.0% 5.7% 5.0% 8.0% 6.6% 7.4% 7.4% 14.1%
Imports/GDP 16.2% 17.1% 17.6% 17.2% 19.8% 21.0% 24.1% 25.3%
Exports/GDP 7.6% 7.7% 9.3% 9.6% 10.5% 12.6% 17.8% 19.4%
C urrent Acc/GDP (exc.grants) -12.8% -12.2% -8.5% -8.5% -11.1% -10.8% -9.6% -10.3%
Fiscal deficit/Surplus/GDP 7.4% 9.0% -10.4% -8.7% -7.1% -7.0% -4.6% 6.2%
GDP by economic activity
Agriculture, forestry and fishing 23.1% 22.1% 21.1% 20.2% 18.3% 22.3% 21.2% 23.7%
Mining and quarrying 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3%
Manufacturing 7.1% 7.0% 7.0% 7.2% 6.9% 7.1% 7.3% 7.5%
Electricity 1.4% 1.3% 1.3% 1.3% 1.1% 2.0% 2.0% 1.7%
Water 2.4% 2.3% 2.2% 2.2% 2.0% 2.5% 2.5% 2.4%
C onstruction 10.9% 11.7% 12.0% 13.0% 14.4% 13.2% 13.5% 12.3%
Services 48.3% 48.6% 49.1% 49.0% 49.6% 47.0% 47.3% 46.4%
o/w Financial services 2.0% 2.1% 1.9% 2.1% 2.5% 2.7% 3.2% 3.5%
o/w Post & telecommunications 1.2% 1.6% 1.9% 2.0% 2.3% 3.0% 3.2% 3.4%
Growth rates
Agriculture, forestry and fishing 7.1% 2.1% 1.6% 2.0% 0.5% 0.1% 1.3% 2.6%
Mining and quarrying 12.2% 9.5% 8.0% 11.6% 14.7% 9.6% 9.1% 3.8%
Manufacturing 6.7% 4.4% 6.3% 9.5% 7.3% 5.6% 7.6% 7.2%
Electricity -1.7% 3.7% 7.7% 2.1% -6.5% -4.0% 5.4% 4.2%
Water 3.0% 3.9% 4.2% 3.9% 2.4% 3.5% 3.8% 4.1%
C onstruction 10.1% 14.6% 10.0% 14.9% 23.2% 13.2% 10.8% 2.2%
Services 11.0% 7.4% 7.9% 6.2% 12.2% 8.0% 10.2% 9.4%
o/w Financial services 32.6% 13.2% 0.0% 13.0% 31.7% -11.9% 24.1% 21.1%
o/w Post & telecommunications 76.5% 40.4% 28.6% 11.8% 26.2% 29.2% 22.6% 32.2%

Source: BoU, IMF, Legae Securities

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1. Industry overview

1.1 Penetration, deposit and credit growth.

ƒ Healthy fundamentals; low penetration, growing per capita


income and increasing population: In our view, exposure to
the Ugandan banks is motivated by the low penetration level.
Despite the recent improvements in penetration and levels of
intermediation (i.e. in the past decade), the banking assets/GDP
ratio and other penetration indicators remain low. The banking
assets/GDP, the deposit/GDP and the loans/GDP ratios are 31%,
19% and 13% respectively. Banking assets have grown by a CAGR
of 27% between FY05 and FY08, to reach UGX7.6trn. Loans and
advances showed stronger growth with a CAGR of 39% over the
same period to reach UGX3.2trn (FY08). System deposits, which in
our view is critical to supporting loan growth, went up by a lower
rate of 22% (reasonably high nonetheless), to UGX4.7trn. (see Fig
2)
ƒ While the penetration level has increased in Uganda, as indicated
by the private sector credit/GDP ratio that doubled from CY02 level
of around 6% to around 12% by CY09 (see Fig 3), the penetration
remains low when compared to economies/markets like Kenya and
Nigeria. In our opinion, the low level of private debt is the principal
attraction to assuming banking assets risks in the country.
ƒ We expect further penetration to be supported by the growing per
capita income and the growing population. As we have mentioned
in some of our reports, we favour banking systems (and banks
that operate) in markets with 1) growing per capita income, 2) low
penetration rates; and 3) growing population. Uganda boasts one
of the youngest populations in the world. About 48% of its
population is under the age of 15 years. Population Datasheet
expects Uganda’s population to grow to 53.4mn by 2025 before
leaping to 91.3mn by 2050. The per capita income is expected to

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increase by 40% between now and 2015. In our view, these
factors should support relatively stronger growth in the system.
(see Fig 4).
ƒ Already, we notice strong private sector credit growth. Private
credit has registered strong annual growth rate, peaking at 56% in
CY08 before declining to 29%. (HY09). This is about 7pp above the
average growth rate of 22% from CY95. (see Fig 5). Despite the
global economic weakness, the system still manages to grow
private sector credit. This indicates muted external-driven demand
as the low debt levels of the households support strong internal
demand, to a large extent. We do not see concerns relating to
deleveraging at both private sector and public sector level. Short-
term loan growth, however, could be impaired by the Credit
Reference Bureau implementation which lengthens loan processing
time frame.
ƒ Loans and deposits have also maintained strong growth rates.
Between CY00 and CY08, shilling denominated deposits and loans
and advances have expanded by CAGR of 19.7% and 21.4%
respectively. Foreign currency based liabilities has increased to
US$667mn (HY09) from US$213mn in HY00 – a CAGR of 46%.
(see Fig 6). In our view, the growth of foreign deposits indicates
increasing confidence in the system, to an extent.
ƒ The system’s LDR increased gradually, as growth of loans and
advances outpaced the growth of deposits. The LDR reached 71%
in 3Q08 before retreating to 69% for FY08. (see Fig 7). The shilling
LDR has since increased to 74% (HY09) although the US$LDR is
lower at 59%. We estimate the system’s LDR at 72%. Our
discussions with various bank managers indicate a general target
LDR of 75%, 5pecetange points (pp) below the maximum of 80%
allowed by the BoU.

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Fig 2: The low penetration is the major attraction

35% 8,000 
Banking assets/GDP Banking assets,UGXbn
Deposit/GDP 30.8%
30% 7,000  Deposits,UGXbn
Loans/GDP Loans and advances,UGXbn
26.5%
24.5% 6,000 
25%
23.0%
5,000 
20% 19.2%
17.1%
16.2% 16.3% 4,000 
15%
13.1%
3,000 
10.0%
10% 9.0%
7.5% 2,000 

5%
1,000 

0% ‐
2005 2006 2007 2008 2005 2006 2007 2008

Source: BoU, Legae Securities

Fig 3: Penetration has increased but remains low

12% 17%
Private sector credit/GDP M2/GDP
17%
11%
16%

10% 16%

15%
9%
15%
8%
14%

7% 14%

13%
6%
13%

5% 12%
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009

Source: BoU, Legae Securities

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Fig 4: Growing per capita income and population should support industry growth
Banking assets = Banking assets X Capita 5.0
Capita
banking  UK
4.5
assets/GDP
Per capita  GDP X Banking assets X Capita 4.0
income Capita GDP
expected to 3.5
increase by US
over 40% per capita penetration population
to US$667 income 3.0

2.5

2.0 China
Population Japan
Low is expected
penetration to reach 1.5 South Africa Korea
provides 53.4mn by
incumbents 2025. Nigeria Brazil
with relatively Uganda's 1.0
Chile
higher returns 48% of the
for longer population 0.5 Kenya
is<15 years
Uganda per capita income, US$
0.0

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000
5,000
0
Source: BoU, Population Datasheet 2010, Legae Securities

Fig 5: Private sector growth spiked between ’07 and ’08.


60%
private sector credit growth 40% M2 growth

50% 35%

30%
40%
25%

30% 20%

15%
20%
10%
10%
5%

0% 0%
Dec‐00
Aug‐99

Oct‐07
Apr‐02
Nov‐96

Jan‐05
Sep‐03
Jun‐95

Jun‐06
Mar‐98

Mar‐09
Apr‐02

Sep‐03
Jun‐95

Jun‐06
Mar‐98

Dec‐00

Mar‐09
Oct‐07
Aug‐99
Nov‐96

Jan‐05

Source: BoU, Legae Securities

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Fig 6: Loans and deposits have maintained strong growth since ’96.

4,000  800
Private sector loans,ugxbn Forex liabilities, US$mn

3,500  shillings deposits,ugxbn 700 Forex Assets,US$mn

3,000  600

2,500  500

2,000  400

1,500  300

1,000  200

500  100

‐ 0

Jan‐95

Jan‐96

Jan‐97

Jan‐98

Jan‐99

Jan‐00

Jan‐01

Jan‐02

Jan‐03

Jan‐04

Jan‐05

Jan‐06

Jan‐07

Jan‐08

Jan‐09
Jan‐96

Jan‐97

Jan‐98

Jan‐99

Jan‐00

Jan‐01

Jan‐02

Jan‐03

Jan‐04

Jan‐05

Jan‐06

Jan‐07

Jan‐08

Jan‐09
Source: BoU, Legae Securities

Fig 7: Incremental liquidity is 8pp, but the system has room to grow deposits

18%
80% Quarterly growth rates loans and advances
System LDR 16% deposits

14%
70%
12%

10%
60%
8%

6%
50%
4%

2%
40% 0%

‐2%
30% ‐4%
Dec‐05

Dec‐06

Dec‐07

Dec‐08

Sep‐05

Sep‐06

Sep‐07

Sep‐08
Sep‐05

Sep‐06

Sep‐07

Sep‐08

Jun‐05

Jun‐06

Jun‐07

Jun‐08
Jun‐05

Jun‐06

Jun‐07

Jun‐08

Dec‐05
Mar‐06

Dec‐06
Mar‐07

Dec‐07
Mar‐08

Dec‐08
Mar‐05

Mar‐06

Mar‐07

Mar‐08

Source: BoU, Legae Securities

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1.2 Liquidity, Profitability and Efficiency

ƒ Liquidity; LDR has deteriorated but remains well below


80%: The system’s LDR has increased to 72%. The shilling LDR
moved from 39% in HY02 to 47% in HY05 and 50% in HY07. It
reached 74% in HY09. Deposits grew faster than credit between
CY01 and CY06 but have since lagged loan growth since HY08. In
increasing their loan books, banks have been depleting their liquid
assets. The industry liquid assets/total assets ratio shrunk by 10pp
from 27% in HY97 to 17% in HY09 (see Fig 8). Notwithstanding
the deterioration on LDR to 72%, the system is one of the few that
is structurally strong and can still sell down government securities
to fund loan growth, even though its only 8pp. Most systems
depend on capital raising to fund loans.
ƒ We note that the system’s dependence on demand deposits
continues to reduce. We believe this is an indication of a general
awareness in financial products in the market; hence more
deposits are turning into time or savings deposits. The savings
deposits earn a slightly higher interest rate at 2.4% (vs. 1.3% for
demand deposits), while time deposits earn a materially higher
rate of around 10%. (see Fig 9 and Fig 10). However, we do not
think that the days of relatively cheap deposits for banks with
strong franchises are over. The system has not yet exhausted the
positive effects of consumer banking to the cost of its liabilities. As
a result banks that can continue to gain CASA market share,
particularly by providing rural banking and services outside major
cities, should be able to support interest spreads and NIMs.

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Fig 8: The system’s liquidity has weakened as penetration increased

0.8% LDR for LC and US$ "balance sheets" 40%


Liquid assets/total assets
0.7% 35%

0.6% 30%

0.5% 25%

0.4% 20%
LDR,LC
0.3% LDR,US$ 15%

0.2% 10%

0.1% 5%

0.0% 0%

Jun‐97

Jun‐98

Jun‐99

Jun‐00

Jun‐01

Jun‐02

Jun‐03

Jun‐04

Jun‐05

Jun‐06

Jun‐07

Jun‐08

Jun‐09
Jun‐96

Jun‐97

Jun‐98

Jun‐99

Jun‐00

Jun‐01

Jun‐02

Jun‐03

Jun‐04

Jun‐05

Jun‐06

Jun‐07

Jun‐08

Jun‐09
Source: BoU, Legae Securities

ƒ The ill-developed pension sector also inadvertently force depositors


to shift more of their ‘savings’ deposits to fixed/term deposits in
order to earn relatively higher interest income. As the financial
markets deepen, more “savings” deposits will reach the system
through institutions (i.e. unit trusts, life plans contributions etc)
thus further increasing the percentage of fixed deposits in the
system.
ƒ The ratio of the demand deposits/total deposits has continued to
decline. About 61% of the system deposits were demand type in
CY95 and this has since reduced to 34% in HY09. (see Fig 9). The
costs of time deposits have also increased considerably, indicating
the effects of competition in deposit gathering. The cost of shilling-
denominated time deposits has increased from 5.3% in HY04 to
10.7% in HY09. US$ denominated time deposits cost has also
increased from 2.7% to 3.9% over the same period. (see Fig 10).
ƒ Overall, we believe the system does not face major liquidity and
funding issues. In our view, the 80% cap on LDR is a prudent
measure. The system’s LDR is still below the 80%. The low
exposure to external funding and capital markets is also a major
advantage for the system’s liquidity as they both tend to be
volatile.

Page 11 of 44
Fig 9: The system is increasingly becoming depended on time deposits

65% Time & Savings/Total  deposits Demand/M2


43%
Demand/Total deposits Time & Savings/M2
60% 41%

55% 39%

50% 37%

35%
45%

33%
40%

31%
35%
29%
30%
27%
25%
25%
Jun‐95

Jun‐96

Jun‐97

Jun‐98

Jun‐99

Jun‐00

Jun‐01

Jun‐02

Jun‐03

Jun‐04

Jun‐05

Jun‐06

Jun‐07

Jun‐08

Jun‐09

Jun‐95

Jun‐96

Jun‐97

Jun‐98

Jun‐99

Jun‐00

Jun‐01

Jun‐02

Jun‐03

Jun‐04

Jun‐05

Jun‐06

Jun‐07

Jun‐08

Jun‐09
Source: BoU, Legae Securities

Fig 10: The cost of time deposits has increased the most

25.0% 12.0%
Costs of deposits andlending rates: shilling Costs of deposits and lending rates: US$
10.0%
20.0%

8.0% Jun‐09

15.0% Jun‐04
6.0%
Jun‐09

10.0% Jun‐04 4.0%

2.0%
5.0%

0.0%
0.0% Demand Savings Time Lending
Demand Savings Time Lending

Source: BoU, Legae Securities

Page 12 of 44
ƒ Profitability; high but there are headwinds: The Ugandan
system has managed to consistently grow profitability, rising from
Ugx30bn in CY05 to Ugx70bn in CY08, a CAGR of 34.5%. The
system enjoys an average quarterly growth rate of 5% (CY05-
CY08). (see Fig 11).
ƒ The system’s strong profit level is underpinned by strong interest
spreads and NIM, and a low level of consumer debt. The interest
spread on local currency is as high at 18% while on the US$ it is
around 9.2%. The ROE is high at an average of 31% (CY03-CY08).
ROE declined to 25% for FY08, which we feel is still relatively
plausible given the high level of capital. In our view, the reduction
was a result of the lag between the ingress new equity (i.e. new
banks) and the time they will take to lever their balance sheets.
This under-leverage depresses the ROE. The ROA remain strong at
3.5% (FY08), slightly below the average ROA of 3.7% (03-08).
(see Fig 12). Even for HY09, ROA and ROE remain strong at 3.2%
and 20.3% respectively.
ƒ The major headwinds come from pressure on NIM. The
system’s NIM has reduced from levels >14% pre-2006 to oscillate
around 11%. Liabilities interest rates have relatively been sticky,
despite a slight uptick. However, interest rates on assets are more
volatile. So far, banks seem to be able to neutralise the increasing
cost of deposits by hiking their lending rates. (see Fig 13).
However, we are not very bullish on NIM expansion given the
moral suasion by the BoU to encourage commercial banks to
reduce their lending rates and stimulate economic growth. The
lending rate is also 1.5pp higher than its average (04-08) which
points to limited upward potential, particularly as inflation outlook
remains benign.
ƒ The other risk comes from little room for expansion in the LDR. At
72%, and with an implied LDR of 75% (as guided by most bank
managers in our discussions), there is little room for banks to
carry more loans (higher yields = better NIMs) on their balance
sheets without growing their deposits. The vigorous deposit

Page 13 of 44
gathering which we expect could continue to push up the cost of
deposits, compounding the risks of NIM compression. We do not
anticipate the cost of deposits (in particular fixed deposits)
reversing the current upward trend. We expect NIM to narrow to
levels between 5% and 7% from the current 11.3% by CY12.
ƒ The system’s high ROA is not sustainable in our view. Uganda’s
banking system has one of the highest ROAs (see Fig 14).
Pressure is evident, with the ROA having declined from 4.3% in
CY04, to 3.5% in CY08 and 3.2% in HY09. We expect the
industry’s narrowing spread to put pressure on ROA. Due to
pressure on the ROA, leverage becomes important, and banks with
capacity to increase leverage should get premium valuations.
Lower leverage has resulted in relatively subdued ROE.

Fig 11: System profitability grew by a CAGR of 34.5% between CY05 and CY08

80 25%
Profits, UGXbn Quarterly profit growth,% Growth rate

70 20% average

15%
60
10%
50
5%
40
0%
30
‐5%
20
‐10%
10
‐15%
0
Dec‐05

Dec‐06

Dec‐07
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Jun‐05

Jun‐06

Jun‐07

Jun‐08
Mar‐06

Mar‐07

Mar‐08
2005 2006 2007 2008

Source: BoU, Legae Securities

Page 14 of 44
Fig 12: High ROA and ROE, NIM is still healthy
40% 5.0% 17%
ROA,RHS NIM
ROE 4.5%
35%
4.0% 14%

30%
3.5%
11%
25% 3.0%

2.5%
20% 8%
2.0%
15%
1.5%
5%

Dec‐05

Dec‐06

Dec‐07

Dec‐08
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Mar‐05
Jun‐05

Mar‐06
Jun‐06

Mar‐07
Jun‐07

Mar‐08
Jun‐08
10% 1.0%
2003 2004 2005 2006 2007 2008

Source: BoU, Legae Securities

Fig 13: Interest spreads remain wide but we expect cost of deposits to put pressure

25% 12%
Interest rates in shilling Interest rates on US$
10.4%
21.2%
10%
20%

18.8% 9.2%
8%
15%

6%

10% Weighted deposit rate Weighted deposit rate


Lending rate 4% Lending rate
interest spread interest spread

5%
2% 1.2%
2.4%

0% 0%
Sep‐04

Sep‐05

Sep‐06

Sep‐07

Sep‐08
Mar‐04
Jun‐04

Dec‐04
Mar‐05
Jun‐05

Dec‐05
Mar‐06
Jun‐06

Dec‐06
Mar‐07
Jun‐07

Dec‐07
Mar‐08
Jun‐08

Dec‐08
Mar‐09
Jun‐09
Dec‐04

Dec‐05

Dec‐06

Dec‐07

Dec‐08
Sep‐04

Sep‐05

Sep‐06

Sep‐07

Sep‐08
Jun‐04

Jun‐05

Jun‐06

Jun‐07

Jun‐08

Jun‐09
Mar‐04

Mar‐05

Mar‐06

Mar‐07

Mar‐08

Mar‐09

Source: BoU, Legae Securities

Page 15 of 44
Fig 14:The system has one of the highest ROAs, subdued ROE on low leverage (HY2009)

40% 4%
ROE ROA
35% 3%

30%
3%

25%
2%
20%
2%
15%
1%
10%

1%
5%

0% 0%

Mexico

Morocco
China

Nigeria

Indonesia
India

Chile

RSA

Kenya
Ghana
Rwanda

Brazil

Uganda
Egypt
Morocco

Chile

Kenya
RSA
Brazil

Mexico

Moza'que
Egypt
Nigeria

India

Ghana

Indonisia
Uganda

Source: IMF, Legae Securities

Page 16 of 44
ƒ Efficiency; the major weakness of the system: The Uganda
banking systems remains relatively inefficient. The cost/income
ratio is 8pp above the generally accepted 60% with an average of
68% between 2005 and 2008. The NII/total income ratio continue
to decline, despite it being low already when compared to other
frontier banking systems. (see Fig 15). For FY08, the NII/total
income ratio was only 15%. The low penetration in cheaper
banking products that encourage volumes in transactional services
(e.g. credit cards, internet and telephone banking) is the primary
hindrance, in our view. Expansion of fees on loans and advances
face resistance given the high interest rates. The overdependence
on interest income could lead to higher volatility in earnings
despite the spread being relatively stable thus far. We are rather
surprised at the deterioration of the NII contribution to operating
income as we expected technology and launching of retail products
to provide a fillip to NII. We also foresee banks benefiting
somewhat from new technological platforms (mobile money
transfers, for example), enhancing NII.

Fig 15: Ugandan banking system remain largely inefficient

76%
cost/income 350 25%
74% average 23%
300
72% 21%

70% 250 19%

68% 17%
200
15%
66%
150 NII,UGXbn 13%
64% Total income,UGXbn
100 11%
62% NII/Total income,  RHS
9%
60% 50
7%
58% 0 5%
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Jun‐05

Jun‐06

Jun‐07

Jun‐08
Mar‐05

Dec‐05
Mar‐06

Dec‐06
Mar‐07

Dec‐07
Mar‐08

Dec‐08

Dec‐05

Dec‐06

Dec‐07

Dec‐08
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Jun‐05

Jun‐06

Jun‐07

Jun‐08
Mar‐05

Mar‐06

Mar‐07

Mar‐08

Source: BoU, Legae Securities

Page 17 of 44
1.3 Credit risks and capital adequacy

ƒ Credit risks; our primary concern: The system’s credit risk


profile worsened during the period of gluttony (between 2006 to
2008), peaking at 4.1% in CY07. It then declined to 2.2% in FY08
before rebounding to 4.0% in HY09. NPLs have outpaced loan
growth by a wide margin before a significant improvement in CY08
that saw NPLs receding by 33%, hence the reduction in the
NPLs/Gross loans ratio. (see Fig 16 and Fig 17). We are sceptical
of the massive drop in the NPLs level in CY08 given the rebound in
the ratio. System NPLs reduced from Ugx100bn in 1Q08 to
Ugx74.8bn in 4Q08 while advances went up from Ugx2.3trn to
Ugx3.2trn over the same period.
ƒ The system’s NPLs coverage ratio has also been declining, with the
improvement registered in 4Q08 being an effect of the colossal
drop in NPLs. In our view, a low coverage ratio is better than a
high one that is a result of low NPLs. The system’s coverage ratio
ricocheted to over 100% (CY08) before it declined to 72% in
HY09. (see Fig 18). This is a major concern to us. Uganda is one
of the systems with poor coverage ratios, well below the
theoretical 100%. We are unsure if there is a delay in NPLs
recognition, leading to the decline in NPLs (i.e. NPLs
underreporting) or it was an aggressive release of reserves when
cycle of excessive lending (CY05-CY08) faded. As shown below
NPLs have been growing at a faster rate than loans provisions until
CY08. (see Fig 16).
ƒ Large loans/total loans ratio has, however, improved, which in our
view is commendable as it diversifies the system credit risks. Large
loans/total exposure ratio has reduced from 42% in CY05 to 24%
in CY08. Insider loans/core capital has not really improved in a
material manner. Insider loans tend to be concentrated in banks
that have weak corporate governance (ignoring genuine staff
loans). While this ratio indicated an improvement between CY06
and CY08, the ratio is above its mean. (see Fig 19). Higher

Page 18 of 44
profitability levels in that period led to the improvement rather
than insider loans abating in absolute value. Between 1Q08 and
4Q08, insider loans increased by a higher rate than system loans
at 51% versus 39%.
ƒ In terms of sector exposures, 20% of the loans and advances is
trade related. Manufacturing constitute 15.2% of the industry book
while building and construction is 11.4%. We expect oil and gas,
transport and electricity to support growth going forward in
addition to the other sectors. The system credit risk is well
diversified in our opinion. (see Fig 20).

Fig 16: The system is well capitalised, leverage ratio has been falling

600% NPLs growth
4.5%
Growth of NPLs vs. loans
NPLs/Gross loans Loans growth
4.0% 500%

3.5%
400%
3.0%

2.5% 300%
2.0%
200%
1.5%

1.0%
100%
0.5%

0.0% 0%
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Mar‐05
Jun‐05

Dec‐05
Mar‐06
Jun‐06

Dec‐06
Mar‐07
Jun‐07

Dec‐07
Mar‐08
Jun‐08

Dec‐08
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Mar‐05
Jun‐05

Dec‐05
Mar‐06
Jun‐06

Dec‐06
Mar‐07
Jun‐07

Dec‐07
Mar‐08
Jun‐08

Dec‐08

Source: BoU, Legae Securities

Page 19 of 44
Fig 17: NPL coverage ratio have reverted to >100%, but mainly as a result of NPLs

140 NPL coverage
NPLs,UGXbn 1.3
Provisions,UGXbn
120 1.2 1.2
1.1 1.1
100
1.0
80 0.9
0.8
60
0.7 0.7
40 0.6
0.5
20
0.4
0 0.3
Dec‐05

Dec‐06

Dec‐07

Dec‐08

Dec‐05

Dec‐06

Dec‐07

Dec‐08
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Jun‐05

Jun‐06

Jun‐07

Jun‐08
Mar‐05

Mar‐06

Mar‐07

Mar‐08

Sep‐05

Sep‐06

Sep‐07

Sep‐08
Mar‐05
Jun‐05

Mar‐06
Jun‐06

Mar‐07
Jun‐07

Mar‐08
Jun‐08
Source: BoU, Legae Securities

Fig 18: Low coverage levels of the system, and most African banking systems is a concern

16%
NPL/Loans 200% Provisions/NPLs
14% 180%

12% 160%

140%
10%
120%
8%
100%

6% 80%

60%
4%
40%
2%
20%

0% 0%
Mexico

Morocco
China

Nigeria

Indonesia

Mexico
Chile

India

RSA

Kenya

Ghana

Morocco
Uganda

Brazil

Rwanda

Nigeria

Indonesia

China

Chile
Egypt

RSA

Rwanda

Uganda

Swaziland

Brazil
Egypt
Namibia

Source: IMF, Legae Securities

Page 20 of 44
Fig 19: The system is well capitalised, leverage ratio has been falling

45% Large loans/Total exposure 7.0%


Insider loans/core capital 

6.0%
40%
5.0%
4.2%
35%
4.0%

3.0% 3.5%
30%

2.0%

25%
1.0%

20% 0.0%

Sep‐05

Sep‐06

Sep‐07

Sep‐08
Mar‐05

Jun‐05

Mar‐06

Jun‐06

Mar‐07

Jun‐07

Mar‐08

Jun‐08
Dec‐05

Dec‐06

Dec‐07

Dec‐08
Sep‐05

Sep‐06

Sep‐07

Sep‐08
Mar‐05

Jun‐05

Mar‐06

Jun‐06

Mar‐07

Jun‐07

Mar‐08

Jun‐08
Dec‐05

Dec‐06

Dec‐07

Dec‐08
Source: BoU, Legae Securities

Fig 20: System industry exposure (2009)

Industry exposure, UGXbn Industry expsoure, %
10.7  163.1 
4.5%
233.3 
15.2%

414.7 
41.5%
1,504.0 

20.6%
549.3 

6.4%
746.6  11.4%
0.3%

Min. & Quarrying Agric. Agriculture Manufacturing


Trans. & Electricity Build. & construction Trade Transport & Electiricity
Manufac. Trade Buidling & construction Mining and Quarrying
Other Other

Source: BoU, Legae Securities

Page 21 of 44
ƒ Capital adequacy; excessive levels, but it is not a new thing:
We believe the industry carries enough capital buffer above the
minimum required by the regulator (which also carries a buffer
against the Basel 2 requirements). At the end of CY08, the system
had a total CAR of 21% versus a regulatory requirement of 12%
and 2pp higher than CY07. For HY09, the total CAR remained at
21%. (see Fig 21 and Fig 22). Given the global financial system
weakness, this is understandable to a greater extent although we
believe that the 9pp buffer is too high. This could also be a result
of new capital flows from the new banks that has not yet been
sweated. We nonetheless note that excess capital is not a new
issue in Uganda. The banking crisis of the late 90s/early 00s could
be the reason for fear of low capital levels.
ƒ The system’s leverage ratio has continued to decline, again being a
result of new banks that have not yet levered their balance sheets
enough, in our opinion. However, the leverage ratio has gradually
declined from 15X in CY03 to 11X in CY07. The leverage ratio
reduced to 7.5X in HY09, making Uganda one of the least
leveraged systems. (see Fig 22). The key benefits of this low
leverage are 1) there is lower risk of equity issuance that could
create headwinds to ROE, or even erode it (i.e. dilution), and 2)
new entrance’s ability to gain market share would be constrained
as the incumbents are well capitalised and can expand their
balance sheets to protect market share on both the asset and
liability side.

Page 22 of 44
Fig 21: The system is well capitalised, leverage ratio has been falling
core capital/RWA 8000 Total assets,UGXbn 17
23.0% total capital/RWA Total equity,UGXbn
Min. core capital
Min. total capital 21% 7000 Leverage ratio, RHS
21.0% 15
19%
19.0% 18% 18% 6000
17% 18.7% 13
18.8%
17.0% 17.7% 5000
16.8% 16.4% 11
15.0%
14.1% 4000
13.0% 9
12% 3000
11.0%
7
2000
9.0%
8% 5
7.0% 1000

5.0% 0 3
2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008

Source: BoU, Legae Securities

Fig 22: One of the best capitalised systems (June 2009).

23% 20
Capital/RWA Leverage
21% 18

16
19%
14
17%
12
15%
10
13%
8
11%
6
9%
4
7% 2

5% 0
Mexico
China

Morocco

Indones…

Nigeria
India

Chile

Kenya
RSA

Ghana

Rwanda

Uganda
Brazil
Egypt

Morocco
Kenya

Chile
RSA
Mexico

Brazil

Egypt
Nigeria

Indonesia

China
Ghana
Rwanda

Uganda

Malaysia

Source: IMF, Legae Securities

Page 23 of 44
1.4 Economics and Politics

ƒ Sterling growth so far, we remain positive: Uganda has


registered sterling GDP growth rates between CY00 and CY09
within an average real growth rate of 7.4%. While the growth rate
comes from a low base, IMF’s expectations of an economy of
>US$25bn by CY15 would make Uganda an important market in
the region. The per capita income is also expected to show a
strong growth rate, exceeding US$600 by CY15. The demographic
makeup provides support to a robust upward growth trend.
ƒ Sources of vulnerability are poor infrastructure, donor
dependence and political risks: Poor infrastructure (road
network, electivity and power, sanitation etc) is a major holdback
to growth despite it being a growth theme that investors can ride
on. The twin deficit of a current account and fiscal deficits is a risk
to currency stability in our view. The country heavily depends on
donor support, notwithstanding the improvements that have been
made in that space so far. Current account deficit in CY09
deteriorated to 10.3% from 7.8% when grants are excluded. A
reduction in the donor support could lead to a depreciation of the
local currency, which inevitably would increase inflationary
pressures given the imports dependence.
ƒ Relationship with the West intact, recent terror attacks
could strengthen them: The key to donor support is the
relationship with the Western countries. In our view, the
incumbent president, Mr Museveni has played it well so far. Mr
Museveni is expected to seek re-election in 2011. Relationship
with major donor countries is generally non-antagonistic. Recent
terror attacks in Uganda could strengthen the relationships.
ƒ We remain concerned by the benign global economic
recovery though. Our economist expects globally recovery to be
protracted, although he does not see higher chances of a double-
dip. We think that agriculture and trade will be the major
casualties, and this will filter into the system’s loan book.

Page 24 of 44
Fig 23: The Ugandan economy is expected to continue grow strongly.

12 800 30
GDP real growth
GDP,US$bn
700
per capita income, US$,LHS 25
10
600
20
8 500

400 15
6
300
10
4
200
5
2 100

0 0

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

2011
2012
2013
2014
2015
0
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015
Source: IMF, Legae Securities

Fig 24: Inflation rate expected to remain <10%, current account deficit to reduce

16
Inflation rate,% 1 current account % of GDP
14
0
12
2000 2002 2004 2006 2008 2010 2012 2014
‐1
10

8 ‐2

6 ‐3

4
‐4
2
‐5
0
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

‐6
‐2

‐4 ‐7

Source: IMF, BoU, Legae Securities

Fig 25: Population is the bright spot for Uganda


100
Population,mn 91.3 51% World's youngest population; Ages<15yrs
90 50%
80 49%
70 48%

60 47%
53.4
50 46%
45%
40 33.8
44%
30
43%
20
42%
10
Niger

Burkina 

Chad
DRC

Somalia
Uganda

Zambia

Malawi

Afghanista

Tanzania
Faso

0
n

2010 2025 2050

Source: Population Datasheet 2010, Legae Securities

Page 25 of 44
2. Stanbic Uganda, Follow up, BUY

2.1 Company description: One of the strongest franchises

Stanbic Bank Uganda is a subsidiary of Stanbic Africa Holdings, which is


in turn owned by Standard Bank Group. The bank has the widest branch
network in Uganda, and is the biggest bank by assets and deposits
(estimated market share of >20%). The bank entered into a
partnership with MTN and has launched the first mobile transfer services
in Uganda.

The bank’s main operating segments are 1) the Corporate and


Investment bank which involves corporate banking, investment banking,
global markets and trade finance operations, and 2) the personal and
business banking which involves transactional products, vehicles asset
finance, mortgage finance, card products, bancassurance and SMEs
banking operations.

Stanbic is the biggest local listed company with a market cap of


US$550mn. The free float is 20%.

2.2 Analysis: low cost deposits base is key; high ROE that
can still be levered

Fig 26: CAMEL analysis

2005 2006 2007 2008 2009 2010F 2011F 2012F


C:C AR 15.5% 15.5% 13.0% 14.2% 16.3% 12.6% 13.2% 14.1%
C:Leverage ratio 10.5 12.5 10.8 9.8 8.9 11.6 10.4 9.9
A:Impairement charge/Advances 0.0% 0.8% 0.8% 0.5% 1.0% 1.8% 1.1% 0.8%
A:Provisions/NPL n/m 249.6% 139% 67.6% 60.1% 60.0% 60.0% 60.0%
M:C ost/Income 65.4% 64.9% 60.3% 52.2% 50.9% 53.0% 51.0% 51.0%
M:Burden ratio 18.8% 15.7% 17.3% 16.8% 17.5% 14.1% 14.0% 13.7%
E:NIM 12.8% 8.5% 10.5% 11.7% 13.5% 9.4% 9.8% 9.2%
E:NIR/Total Income 34.9% 40.9% 41.2% 40.1% 36.7% 45.0% 42.4% 46.3%
L:LDR 33.4% 38.0% 44.5% 56.7% 63.5% 65.0% 70.0% 75.0%
L:C ash +equiv./C ustomer deposits 66.6% 62.4% 58.9% 48.0% 50.5% 49.4% 51.2% 54.9%

Source: Company reports, Legae Securities

Page 26 of 44
ƒ Capital adequacy: In our view, Stanbic is a well capitalised bank
with a CAR of 16.2% (HY10). This is 4.2pp above 12%, the
minimum required by the regulator. The Tier 1 capital is also
strong at 13.5%, which is 5.5pp above the minimum requirement
of 8%. The bank is not highly leveraged. In fact, leverage ratio
has declined from 10.5X in FY05 to 8.9X in FY09. The leverage
ratio is largely in line with the system’s ratio. In our view, Stanbic,
just like the system, is not materially exposed to the regulatory
risks related to leverage limits that could be brought about by
Basel 3.
ƒ Asset growth and quality deteriorated in HY10, but we think
it has peaked: While seemingly good, as the numbers are still
low, we are concerned by the growing credit risks. We note that
the impairment charge has grown at 51% while loans and
advances have only expanded by 40% between CY06 and CY09.
This is 11pp higher. For HY10, credit impairment went up by 17%.
As a percentage of loans and advances, we expect the ratio to
peak at 1.8% this year before declining to 1.1% in FY11 and 0.8%
in FY12.
ƒ Coverage ratio worsened, but still fair at 60%: The declining
coverage ratio is also a major apprehension although it is still fair
at 60% (FY09). The problem is our inability to know the Stanbic’s
acceptable coverage ratio as management did not provide
guidance. We note that had coverage ratio been maintained at a
theoretical level of 100%, provision would have grown by 79%,
almost double the growth rate of the loan and advances. The profit
would decline to UGX88.9bn, a knock of UGX6.4bn, reducing
earnings growth rate to a mere 13% rather than the reported
21%. Should the bank increase the coverage ratio to a generally
acceptable range of between 70% and 80%, the knock on earnings
could be material. In our opinion, cutting coverage ratios is equal
to re-risking, which would therefore imply an increase in our
discount rate.

Page 27 of 44
Sector exposures indicate a significant increase in mortgage
loan writing; exposure to corporates continue to grow at a
lower rate: Property loans and mortgage showed the strongest
growth rates (ignoring other loans) escalating by 71.5% and
57.6% respectively between CY08 and CY09. Both are relatively
coming from low bases, with property loans increasing from a
mere Ugx28bn (<5% of gross loans) to UGX48bn. (5.1% of total
loans). Mortgage loans’ base is also low, being UGX42.4bn. (6.6%
of gross loans). Mortgage loans went up by 19% from FY09’s
Ugx62.2bn to Ugx73.8bn in HY10. Growth of corporate loans is
muted at just 0.7% from Ugx344.7bn to Ugx347.2bn. (CY08-
CY09). Corporate loan growth recovered in HY10 to grow by 5.8%
to Ugx418bn but continue to lag mortgage loan growth. In our
view, building strong relationships with the SMEs and households
is important for the bank to diversify its credit risks. We continue
to be concerned with the possible excessive multi-borrowing at
corporate level.

Fig 27: Sector exposures show strong growth on mortgages and property loans
450
Sector exposures,UGXbn Growth =58% Sector exposures,% 5% 7%
400
Growth =0.7% 10%
350 2009

300 2008

250 37%
200

150
Growth =19%
100 Growth =47%
Growth =72% 41%
50 mortgage
installment and lease finance
0 other loans
mortgage installment and  other loans corporate loans Property finance corporate loans
lease finance Property finance

Source: Company reports, Legae Securities

ƒ Cost management and earnings composition: The bank’s


cost/income ratio (efficiency ratio) had a balanced improvement,
reducing from 65.4% in FY05 to 50.9% in FY09. This is
comfortably above the industry’s average of 68% (CY05-08) and

Page 28 of 44
66% (FY08). It is also 9pp above the general rule of thumb of
60%. We are impressed by the bank’s high NII which provides a
supplement to earnings. NII/total income is a satisfying 36% for
FY09 and we expect it to increase to 45% in FY10. The NII/total
income ratio has an average of 39% between CY05 and CY09 – a
superior number to the industry average by a wide margin. The
burden ratio also indicates the bank’s non-interest expenses that
are covered by non-interest income. It shows an improvement
from 18.8% in FY05 to 17.5% in FY09. The declining burden ratio
indicates that the non-interest income is growing at a faster rate
than the non-interest expense, albeit faintly.
ƒ We should also highlight that the bank’s available-for-sale (AFS)
portfolio has remained stable at an average of 23% of total assets.
(FY05-FY09). The held-to-maturity (HTM) portfolio has been run
down to zero in FY09. The trading portfolio, which has income
statement effects, remains below 5% of total assets, and is also
fairly stable. We believe that the absence of major movements in
these portfolios as a way to manipulate earnings and the book
value highlights better earnings quality, to an extent.
ƒ NIM: the edge in low-cost deposits is key: The bank’s NIM is
high at 13.5% for FY09. This is 70bp above 12.8% that the bank
enjoyed in CY05, and 2.5pp above the industry average. In our
view, the bank is well positioned to continue to enjoy high NIM, as
it can benefit from its widespread branch network for relatively
cheaper deposits. The bank has managed to increase its current
and demand deposits/total deposits ratio by 2pp from 69% in FY08
to 71% in FY09. (see Fig 28). The caveat, in our view, is that it
could enjoy the benefit of charging a lower rate (weighted) on its
loans and advances as it seeks to gain or maintain market share
on the asset side. Nevertheless, we expect NIM to reduce to 9.4%
for FY10 and remain below 10% in our forecast period.
ƒ Liquidity: high but government securities to put pressure on
spreads as TB rates continue to decline: In our view, the bank
carries ample liquidity to support its loan book growth. The LDR of

Page 29 of 44
63.5% (FY09) provides sufficient cushion to the regulators’ cap of
80%. This is notwithstanding the fact that the LDR has increased
significantly from 33.4% in FY05. The bank’s liquid assets/total
assets ratio is also healthy at 32.9%. We also believe that the
bank has capacity to raise more debt, having successfully issued
the first tranche of UGX30bn. Subordinated debt/total equity is
only 18.5%. There are no debt maturities to put pressure on
funding as the issue matures post CY15.

Fig 28: With increasing competition, SBU’s access to cheaper deposits is key

Amount, UGXbn Contribution,%
198.61  14%

230.97  16%

1,029.85 
71%

Current  and demand accounts  Savings accounts Fixed deposits Current  and demand accounts  Savings accounts Fixed deposits

Source: Company reports, Legae Securities

ƒ ROE decomposition: Below we provide a decomposition of the


ROE, principally indicating the asset yields, margins and leverage
levels. Stanbic has enjoyed strong outperformance against the
industry. For example, the bank’s ROE in CY05 was 50.4% against
the industry’s 28.6%; in CY07 the Stanbic had an ROE of 43.3%
versus the industry’s 31.4%; and for FY09, the bank attained an
ROE of 45.1% compared to the system’s 25%.
ƒ The bank has enjoyed strong ROAs: This has been on the
back of high asset yields and high margins. Although we expect
asset yields to remain relatively high, we expect them to decline
when compared to history. In our view, yields will fall to below
12%.

Page 30 of 44
ƒ Leverage should support ROE going forward, otherwise
ROE to decline: We expect the bank to slightly increase its
leverage in order to maintain the ROE at around 40%. Our
forecasts indicate a decline of the ROE to 40.3% for FY10, which
is still relatively high. (see Fig 29).
ƒ The bank’s “Jaws” has been opening, with operating
income growing by a CAGR of 19.1% versus a CAGR of 11.8%
for operating expenses. Net interest income, however, shows
strain as interest expense grew by a higher rate than interest
income. (see Fig 30)

Fig 29: ROE decomposition

2005 2006 2007 2008 2009 2010F 2011F 2012F


Asset yield: Revenue/Total Assets 13.8% 12.0% 13.8% 14.0% 14.4% 11.7% 11.8% 11.9%
Margin: Net income/Revenue 34.6% 26.0% 29.0% 35.1% 35.3% 29.8% 33.3% 34.2%
ROA 4.8% 3.1% 4.0% 4.9% 5.1% 3.5% 3.9% 4.1%
Leverage: Total Assets/Equity 11 12 11 10 9 12 10 10
ROE 50.4% 39.0% 43.3% 48.3% 45.1% 40.3% 40.9% 40.2%

Source: Company reports, Legae Securities

Fig 30: “JAWS” continue to widen, but interest expense growth has outstripped
interest income growth.

300  250 25
Operating income,UGXbn CAGR = 19.1% 
Interest income,UGXbn
Operating costs,UGXbn CAGR =21.4%
250  interest expense, UGXbn,  RHS
200 20

200  CAGR = 19.0%
150 15
150  CAGR = 11.8% 

100 10
100 

50  50 5

‐ 0 0
2005 2006 2007 2008 2009 2005 2006 2007 2008 2009

Source: Company reports, Legae Securities

Page 31 of 44
2.3 Valuation: A deserved premium

Below we highlight our salient assumptions in our earnings and balance


sheet models. (see Fig 31). We:
ƒ reduce the interest income/interest earning assets to 10.5% for
FY10 and decrease it to 10% by FY12. Interest income grows by
9% for FY10. The high level of government securities on the bank’s
balance sheet have the natural consequence of putting a drag on
interest income;
ƒ increase the cost of interest paying liabilities to 1.8% from 1.3%
FY10 and maintained it at 1.5% thereafter. We see increasing
competition on the liability side (the growth in fixed deposit type is
an indication of the competition to an extent);
ƒ raise our impairments/advances ratio to 1.8% for FY10 before
reducing it to 1.1% for FY11 and 0.8% for FY12. In our opinion,
there is still some stress in the system credit-wise;
ƒ enlarge the operating expenses/operating income to 35%. The
bank continues to invest in distribution channels (37 new ATMs
and 3 branches are expected this year).
ƒ increase the LDR slightly to 65% for FY10 before it sequentially
progressed to 70% and 75% for FY11 and FY12. We see deposits
increasing by a 35% this year. We grow net profit by -4% for
FY10, before recovering by 29% and 24% for FY11 and FY12 in
that order.
Fig 31: Our key assumptions
2005 2006 2007 2008 2009 2010F 2011F 2012F
Interest income/IEA 12.3% 9.2% 10.7% 12.0% 13.1% 10.5% 10.5% 10.0%
Interest expense and similar charges/IPL -1.1% -1.0% -1.0% -1.2% -1.3% -1.8% -1.5% -1.5%
Net fee and Commission/TA 4.7% 4.1% 4.5% 3.9% 3.5% 2.8% 3.0% 3.5%
Net Trading Income/TA 0.2% 0.8% 1.2% 1.8% 1.8% 2.5% 2.0% 2.0%
Other Operating Income/TA 0.2% 0.1% 0.1% 0.0% 0.0% 0.0% 0.1% 0.1%
Impairment charge for credit/Advances 0.0% -0.8% -0.8% -0.5% -1.0% -1.8% -1.1% -1.3%
Employee benefits and expense/Operating -20.6% -20.1% -19.2% -17.6% -17.6% -18.0% -18.0% -18.0%
Other operating expenses/Operating incom -44.8% -44.8% -41.1% -34.6% -33.3% -35.0% -33.0% -33.0%
Share of profit of associate/TA 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Taxation/PBT 0.0% -21.7% -23.1% -24.4% -22.9% -25.0% -25.0% -25.0%

Deposit growth 11% 13% 20% 20% 13% 35% 12% 13%
Loan/Deposit ratio 33% 38% 45% 57% 64% 65% 70% 75%

Source: Company reports, Legae Securities

Page 32 of 44
ƒ Valuation; high ROE and ability to protect market share
deserve premium valuation: We use the fundamental PBVR to
estimate the value of Stanbic. Using an average ROE of 40.5%,
(within our forecast period), a growth rate of 14.5% and a CoE of
18.8% we obtain a fair PBVR of 6X. This ratio looks excessive
prima facie, but we believe the high ROE and ability to protect
market share (indicated by the growth rate) warrant a premium
valuation. Investors should not be overly concerned by our
negative growth in earnings for FY10; the ROE outlook remains
intact!
ƒ Our FY10 price target is Ugx267; FY11 is Ugx340: We
multiply out justified PBVR with our book value estimates for FY10
and FY11. Our FY11 price target of Ugx340 provides potential total
return of 49.8%. We therefore reiterate our BUY recommendation
on the stock.

Fig 32: Price/Book Valuation

Price/Book Valuation

Average ROE 40.5%


Average growth rate 14.5%
CoE 18.8%
Justified PBVR 6.04
FY11 BV 56.3
Price Target 340.4
Current Price 235.0
Potential capital gain 44.9%
FY11 Div. Yield forecast 4.9%
Potential total return 49.8%

CoE calculation
R208 Yield 8.3%
ERP 6.0%
14.3%
Country risk 3.0%
Specific risk 1.5%
18.80%

Source: Legae Securities

Page 33 of 44
3. DFCU Limited, Initiate, HOLD

3.1 Company Description: One of the oldest franchises

DFCU Limited is commercial bank offering a wide range of products. The


company was registered in 1964 as a development finance institution. In
2002, the company bought Global Trust Bank and renamed it DFCU
Bank, and thus commenced to offer commercial banking services.

The bank has 24 branches, with considerable a concentration of the


branches in Kampala (12 branches). The Bankom interbank switch,
however, allows its clients to have access to other banks’ ATMs, at a
cost of course.

The bank has built a relatively strong franchise in long-term loans and
finance. DFCU’s partnerships with developmental institutions such as
OPEC Fund for International Development, PROPARCO, NORFUND, IFC,
European Investment Bank, Netherlands Developmental Finance
Company, NSSF among others has made it a strong source of long-term
finance and loans from local borrowers. As at the end of CY09,
Ugx158.9bn, about 30% of the Group’s total liabilities, and 45% of total
customer deposits were “borrowed funds”, mainly from the above
institutions.

As at the end of CY09, the Group’s major shareholders were 1) CDC


Group plc (60.02%); 2) National Social Security Fund (10.93%); 3)
NORFUND (10.06%); 4) National Insurance Corporation (2.82%) and 5)
Investec Asset Management (2.27%).

We are a bit concerned with the high turnover at senior management


level. Messrs Cormick, Katuntu, Kibirige and Mortimer assumed leading
roles at the bank within the past 5 years. Board chairmanship has also
transferred from Dr Kalema, to Dr Moyo and now to Mr Irwin (in an
acting capacity). While there has been restructuring, this apparent
instability clouds long-term strategy.

Page 34 of 44
3.2 Analysis: Low CASA to affect margins; earnings
momentum and coverage ratios a plus though

Fig 33: CAMEL analysis

2004 2005 2006 2007 2008 2009 2010F 2011F 2012F


C: Equity/Loans 33.2% 26.5% 25.3% 27.1% 22.1% 23.5% 19.1% 18.1% 17.5%
C: Assets/Equity           7.24          6.58         7.43          7.25         7.92         7.99          9.24           9.25          9.51
A: Provisions/Loans 0.3% 0.7% 2.1% ‐0.7% 2.8% 1.4% 1.0% 0.8% 0.8%
A: Provision/Impairments n/a n/a 30.2% 14.2% 49.9% 67.6% 70.0% 70.0% 70.0%
M:Cost/Income 56.1% 54.1% 66.6% 72.9% 57.5% 56.3% 57.0% 57.0% 55.0%
M:Burden Ratio 7.5% 8.9% 9.2% 10.2% 7.9% 7.0% 6.8% 6.6% 6.0%
E:NIM 11.2% 14.4% 15.5% 15.8% 14.0% 14.0% 13.5% 12.8% 12.0%
E:NIR/Income 25.6% 22.8% 20.6% 17.3% 13.9% 12.8% 14.1% 13.7% 15.0%
L:LDR 53.9% 75.1% 65.4% 62.5% 68.0% 63.3% 66.0% 70.0% 70.0%
L:Cash+equi./Total deposits 13.6% 11.4% 18.5% 32.8% 33.1% 34.4% 24.7% 27.6% 30.4%

Source: Company reports, Legae Securities

ƒ Capital adequacy; like most it is well capitalised: The Group


is well capitalised, with a total CAR and core CAR of 18% and 17%
respectively. Despite a 16% increase of capital in the absolute
value, mounting from Ugx65.8bn in FY08 to Ugx76.6bn in FY09,
the risk weighted assets (RWA) increased accordingly, maintaining
the CAR constant. RWA increased to Ugx388.9bn in FY09 from
Ugx331.3bn in FY08. In terms of leverage, the bank has room to
perk up, in our view. While there has been a steady increase in the
leverage, from 7.2X in FY04 to 7.9X in FY09, we believe the
balance sheet can be leveraged further to levels around 10X.
ƒ Asset growth, credit risks and profitability: The Group lost
significant market share in FY07 when its loans and advances
declined by 6% from Ugx206.4bn to Ugx193.7bn. This was the
year when the system registered a year-on-year growth rate of
26%. Currently, DFCU has the 7th biggest loan book.
We believe that DFCU needs to build a strong retail deposit
franchise. In order to do that, the Group would need to rump up
its branch network. We believe that convenience will become a key
issue as system penetration increases. DFCU has 26 branches,
with two more expected to be opened this year. Management’s
target is 45 branches by FY14. The fact that the bank still need to

Page 35 of 44
build a branch network could affect earnings growth in the medium
term. However, we expect internet and mobile banking platforms
to aid penetration to the retail segment. According to
management, internet banking will be launched 3Q10 while mobile
banking will be launched 1Q11. In our view, there is hope in
deposit mobilisation, despite our concerns with increasing fixed
deposits. Deposits ascended by 21% from Ugx364.6bn in FY09 to
Ugx419.4bn in HY10.
ƒ In terms of credit risks, the bank’s increasing coverage ratio
is a positive...: The Group benefited from poor coverage ratio of
below 50% upto-FY08. The coverage ratio has since increased to
an acceptable 67% in FY09. The impairments/loans ratio also
increased materially in FY08 to 2.8%. It has since improved to
1.4% for FY09. We expect impairments on new and recent loans
(2008 onwards) to remain higher than the historical average of
1.1%. The increase in the loans related to trade could also see
some delinquencies coming through in the future due to the slow
recovery in the global economy.
ƒ ...and the write-backs from a written-off book of about
Ugx19.6bn lessen the pressure on earnings: According to
management, the recovery of the written off book (the corollary of
the pre-2006 gluttony when the loan-book grew by 45%) is
proceeding as per their expectations. As a result, management
expects write-backs to outweigh allowances for bad debts this year
and provides an impetus to earnings. For HY10, the allowance for
impairments of loans and advances was a positive Ugx680mn.
ƒ Loan book well diversified by sector: In terms of sector
exposure, the loan book is well diversified. The biggest exposure is
trade related with a 19% exposure. (FY09). (see Fig 34).

Page 36 of 44
Fig 34: Sector exposures, well diversified

Sector exposures,2009 2% Sector exposures,2008 3%
6%
5%
7% 9%

8% 41%
46% 10%

13%
12%

19% 19%

Agriculture Construction Manufacturing Transport Agriculture Transport Manufacturing Construction


Mortgages Trade Other Mortgages Trade Other

Source: Company reports, Legae Securities

ƒ Deposit/liability structure will be key in sustaining NIM and


spreads: One of our main concerns with the Bank is the
substantial rise in the fixed deposits. Fixed deposits increased by
80.4% in FY09 to Ugx140.4bn. Fixed deposits now constitute 41%
of the bank’s deposits, a 10pp increase from 31% in FY08. (see Fig
35 and Fig 36). Our worry is that fixed deposits are expensive and
as we mentioned before, the cost of time deposits has increased
by 5.3pp from 5.29% in FY08 to 10.72%. Additionally, fixed
deposits increases funding risk, albeit manageable. This is because
they are more actively managed than retail deposits. We are
concerned that once DFCU build a reputation as the “better
paying” bank in the industry, it will be difficult for it to source
cheaper deposits. The consequence is the narrowing interest
spreads and interest margins. The borrowings from developmental
institutions, while long-term and less expensive on an absolute
basis, are generally less profitable. The borrowings enjoy an
average spread of 6% (versus 10% for ordinary deposits). They,
nonetheless, provide stability to the interest spreads. Management
indicates an intention to grow savings deposits in their HY10 result
presentation.

Page 37 of 44
Fig 35: The bank’s has increased its fixed income deposits

180,000  90%
Deposit type growth,2009 
Deposit structure,2009 160,288  80.4%
160,000  80%
140,400 
140,000  70%

120,000  60%

100,000  50%

80,000  40%

60,000  30% 25.1%


45,950 
40,000  20% 14.4%

20,000  10%

‐ 0%
Savings Fixed Demand Demand Savings Fixed

Source: Company reports, Legae Securities

Fig 36: The bank’s has increased its fixed income deposits

Deposits structure,09 Deposits structure,08
13% 14%

46%

55%
31%
41%

Savings Fixed Demand Savings Fixed Demand

Source: Company reports, Legae Securities

ƒ Liquidity; LDR below the 80%, plenty liquidity despite our


concerns with the liability structure: Notwithstanding our
concerns with the deposits/liability structure of DFCU, which we do
not envy, the Bank has ample liquidity to grow its loan book. We
calculate two LDRs, one excluding the borrowed funds (from
developmental institutions), and both LDRs show improvements.
The LDR (using pure customer deposits) shows an improvement
from 101% to 90%. Including borrowed funds, the LDR is a
pleasing 60% from 70% in FY08. (62% for HY10). The cash and
cash equivalents/customer deposits ratio is also high at 35%,
despite a deterioration from 55% in FY08. (see Fig 35). In FY09,

Page 38 of 44
customer deposits grew by 36% versus a 15% growth rate in
loans and advances and this trend continues as deposits surpassed
loans growth in HY10 by 9pp.

Fig 37: The ‘two LDRs’ are converging

70%
1.5  LDR (customer deposits)
LDR (funding liabilities)
60%
1.3 
50%
1.1 
40%

0.9 
30%

0.7  20%
Cash+equiv./Customer deposits
0.5  10% Cash+equiv./Funding liabilities

0.3  0%
2004 2005 2006 2007 2008 2009 2010F 2011F 2012F 2004 2005 2006 2007 2008 2009 2010F 2011F 2012F

Source: Company reports, Legae Securities

ƒ ROE decomposition: DFCU has enjoyed relatively weaker ROEs


than the industry. For example, in CY04 industry ROE was 37.6%
vs. 20.8% for DFCU; CY06 system ROE was 25.7% against DFCU’s
13.7%; and in CY08 again the industry outperformed DFCU with
ROEs of 25% and 21% for the industry and DFCU in that order.
Management’s target ROE is 30%.
ƒ ROA has been weaker than the industry: The ROA has
been the main differentiator to ROE. DFCU’s ROA has been
weaker at an average of 2.7% versus the industry’s average
ROA of 3.6% (CY04-CY08). This has mainly been a result of the
lower asset yields and margins when compared to the industry
(and Stanbic). In our view, the poor retail franchise, and
therefore higher costs of deposits have negatively affected
margins.
ƒ Leverage has room to pick up, and management
indicates a target ROA of 4%: We would have expected
management to work on leveraging the balance sheet further
and enhance ROE. However, management indicated that their
target ROA is 4%. We are unconvinced, given the industry

Page 39 of 44
concerns we highlighted before, but management points to
efficiency benefits that should improve yields and margins.
ƒ The jaws have not opened up as fast (when compared to
Stanbic). Operating income has grown by a CAGR of 18%, just
3pp above the CAGR of 15% for operating expenses (FY04-
FY09). Growth of net interest expense has also outpaced growth
of interest income with CAGR of 24% and 22% respectively. In
our view, a stronger retail franchise would have been supportive
of operating income through NII. Management guidance shows
a target of 45% as NII/operating income ratio within the next 5
years. Regional expansion is expected to aid.

Fig 38: ROE decomposition


2004 2005 2006 2007 2008 2009 2010F 2011F 2012F
Asset yield: Revenue/Assets 9.7% 12.1% 10.7% 11.6% 11.2% 10.3% 9.8% 9.4% 8.7%
Margin: Net income/Revenue 29.6% 31.0% 17.2% 19.3% 23.6% 30.6% 29.8% 28.4% 29.6%
ROA 2.9% 3.7% 1.8% 2.2% 2.6% 3.2% 2.9% 2.7% 2.6%
Leverage:Assets/Equity 7.2 6.6 7.4 7.3 7.9 8.0 9.2 9.2 9.5
ROE 20.8% 24.6% 13.7% 16.3% 21.0% 25.2% 26.8% 24.8% 24.7%

Source: Company reports, Legae Securities

Fig 39: “JAWS” are not very impressive

70,000  3.5
Ugx,bn
CAGR = 18% 
60,000  3.0 CAGR = 24%

50,000  2.5 CAGR = 22%

40,000  CAGR = 15%  2.0

30,000  1.5

20,000  1.0 Interest income


Operating revenue
Operating expenses interest expense
10,000  0.5

‐ 0.0
2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Source: Company reports, Legae Securities

Page 40 of 44
3.2 Valuation: There is hope after addressing the legacy
issues.

Below we draw attention to the major assumptions we employed in our


earnings and balance sheet models. (see Fig 40). We:

ƒ reduce the interest income/interest earnings assets ratio by


100bps to 13% for FY10. We expect yields to continue to decline
to reach 12% by FY12. Interest income increase by 15% in FY10;
ƒ increase the interest cost of interest paying liabilities to 6% on
account of increasing competition. Interest expense increases by
44% for FY10. The interest spread declines to 6.5% by FY12;
ƒ raise the fee and commission income/loans from 2.3% in FY09 to
2.5% in FY10. This grows fee income by 39% for FY10.
Management is implementing strategies to increase non-interest
income, and internet and mobile platforms should provide a lift;
ƒ increase the operating expenses/operating income to 57% and
reduce it by 2pp to 55% in FY12;
ƒ note our effective tax rate is relatively low (when compared to
corporate tax rate of 30%). DFCU is enjoying tax benefits on three
main ways 1) the high investment in government securities which
subjects interest income to a 15% tax rate; 2) the tax losses
carry-forward that still provides tax benefits. According to
management, about Ugx1bn tax loss is yet to be exploited.

Fig 40: Key assumptions

2004 2005 2006 2007 2008 2009 2010F 2011F 2012F


Interest income/IEA 11.2% 14.4% 15.5% 15.8% 14.0% 14.0% 13.0% 12.5% 12.0%
Interest expense/IEL ‐3.7% ‐4.4% ‐5.7% ‐6.5% ‐4.6% ‐5.2% ‐6.0% ‐5.5% ‐5.5%
Fee and commission/Loans 4.9% 4.1% 3.9% 3.4% 2.6% 2.3% 2.5% 2.8% 3.3%
Other income/Loans 1.5% 2.0% 0.7% 0.9% 1.2% 1.1% 1.2% 1.2% 1.2%
Op. expense/Op. Income ‐56.1% ‐54.1% ‐66.6% ‐72.9% ‐57.5% ‐56.3% ‐57.0% ‐57.0% ‐55.0%
Provisions/Loans ‐0.3% ‐0.7% ‐2.1% 0.7% ‐2.8% ‐1.4% ‐1.0% ‐0.8% ‐0.8%
Taxation/PBT ‐30.4% ‐27.0% ‐25.7% ‐31.6% ‐16.0% ‐15.6% ‐15.0% ‐20.0% ‐25.0%

Deposit growth ‐15.2% 7.8% 8.5% 56.4% 36.1% 35.0% 23.9% 28.2%


Loan/Funding liabilities  54% 75% 65% 62% 68% 63% 66% 70% 70%

Source: Company reports, Legae Securities

Page 41 of 44
ƒ Valuation; a PBVR of 2.1X is fair for lower ROE in our view:
We apply the same valuation method we used for Stanbic. The
only difference is that we increased DFCU’s CoE to 18.95% to
reflect our concerns with its relatively poor retail deposit franchise
and inconsistent performance. (execution/strategic risks). We
obtain a fair PBVR of 2.1X.
ƒ FY11 price target is Ugx833; potential total return is not
good enough: We obtain a FY11 price of Ugx833, which provides
a potential total return of 8.4%. (see Fig 41). In our view, the
bank is well placed to break the hegemony of the international
banks in the system, and offers a turnaround story, but we do not
envisage it happening within our forecast period. We would be
happier to BUY when the legacy issues are addressed and there is
clarity on regional expansion. We expect DFCU’s ROE to lag
Stanbic despite a stronger earnings momentum.

Fig 41: Price/Book Valuation Model

Average ROE 25.8%
Average growth rate 15.7%
CoE 19.0%
Justified PBVR 2.1
FY11 BVPS 390.5
Price Target 832.7
Current Price 805
FY11 Div. Yield 5.0%
Potential total return 8.4%

CoE Calculation
R208 Yield 8.20%
ERP 6%
14.20%
Country risk 3.0%
Specific risk 1.75%
18.95%

Source: Legae Securities

Page 42 of 44
Disclaimer & Disclosure

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Member of the JSE Securities Exchange

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Road, Houghton, Johannesburg, South Africa

P.O Box 10564, Johannesburg, 2000, South Africa

Tel +27 11 551 3601, Fax +27 11 551 3635

Web: www.legae.co.za, email: research@legae.co.za

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document are an accurate of my/our personal views on the stock or sector
as covered and reported on by myself/each of us herein. I/we furthermore
certify that no part of my/our compensation was, is or will be related,
directly or indirectly, to the specific recommendations or views as expressed
in this document

This report has been issued by Legae Securities (Pty) Limited. It may not be
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representation or warranty and accepts no responsibility or liability as to its
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purchase or subscribe or sell any investment.

Important Disclosure
This disclosure outlines current conflicts that may unknowingly affect the
objectivity of the analyst(s) with respect to the stock(s) under analysis in
this report. The analyst(s) do not own any shares in the company under
analysis.