Banking on Dr Brown’s cure
Three-pronged strategy for building on its retail base
WHEN MERCANTILE LISBON Bank’s R555m rights issue was almost totally ignored by minorities in 2004 – taking the holding of the Portuguese Caixa Geral de Depositos, which underwrote the issue, to 91,75% – the market was in effect saying that it didn’t think the troubled bank would survive.
That wasn’t an unreasonable assumption, given that bad debts of the old Bank of Lisbon, control of which Caixa acquired through its takeover of BNU, that company’s own parent, had wiped out R1bn of shareholders’ equity. However, it turned out to be premature.
Though results are still far from satisfactory the bank is back in profit. A share price of 33c, while off the year’s high of 38c, is almost double the 18c at which the rights issue was pitched, let alone the subsequent low of 11c. Most of the benefit, of course, accrues to Caixa, which in rand terms is showing a healthy profit on its investment.
The rights issue was a core element of the recapitalisation and recovery strategy devised by CEO David Brown, who was in effect installed as a company doctor by Caixa in 2003 though he joined full-time only with effect from 31 March 2004. A year later a five-year plan was introduced, involving both internal and external rebranding and dropping the tainted “Lisbon” from the company’s name.
In 2003 and 2004 Mercantile chalked up a combined loss of R270m. Helped by the recovery of loans previously impaired, a headline profit of R68m was reported in 2005, which advanced further to R101m last year. However, with a massive 3,9bn shares in issue (something else crying out for attention), headline earnings per share were only 1,7c and 2,6c respectively in those years.
And there’s still some way to go. The cost:income ratio of 71% in 2006 was much better than 2005’s 91%, but the first hurdle under the five-year plan is to bring it down to 60%. By most banking standards, even that will still be on the high side. And there’s still an accumulated loss of R619m.
Mercantile did better with its other targets. Return on equity was 16,5% against the target of at least CPIX + 10%, and return on assets was 2,5%, against the target 1%. Both those targets will, as planned, be revisited this year.
One of Mercantile’s problems is that its predecessors primarily served SA’s ethnic Portuguese market. Brown points out that whereas in the Sixties the clientele were firstgeneration immigrants, now their descendants are South Africans with a Portuguese cultural heritage. Their ties to “Portuguese” institutions have weakened.
Mercantile can’t – and wouldn’t want to – jettison that market, especially as a subsidiary of Portugal’s dominant bank. So the key is to try and keep that base but use it as a platform for expansion into other areas of business.
And Portuguese state-owned Caixa, whose growth opportunities in its home market are limited, itself has a strategy of international expansion, particularly in areas that were Portuguese colonies and where there are Portuguese-speaking populations. SA still fits that template and Caixa has committed itself to remaining the controlling shareholder.
The five-year plan accepts that Mercantile is a niche bank and has a three-pronged strategy for building on its retail banking base: business banking, treasury operations and alliance banking. Brown cites as an example of the last-mentioned the potential economies of scale from using the payments and credit card infrastructure for partners that want to issue credit cards but not become banks. By way of example, it processes the Woolworths Visa card and Metropolitan debit cards.
The retail network now has 15 branches, which aren’t running at full capacity. Taking up the shortfall is the priority, though if the right opportunity comes up Brown would be happy to extend the bank’s footprint. He reckons that about 50% of its retail business still comes from the Portuguese community, though that’s falling.
So where does Mercantile go from here? Extending profit growth this year may be harder than you might imagine, as there’s little legacy debt left, and more normal provisions will replace recent years’ recoveries. But there will be benefits from continued expansion into new areas and a further improvement in the cost:income ratio.
However, fundamental issues have to be faced. Specifically, Mercantile is committed to SA’s Financial Services Charter so needs to implement a black empowerment deal, and the chronic illiquidity in the share detracts from its market rating.
Whether both should be addressed simultaneously or separately is a matter of tactics. But Brown points out that, whatever local management proposes, Caixa will take the final decision. There are ongoing discussions with Caixa on those issues. And he argues that the identity of an empowerment partner is as important as getting the structure right.
Moreover, until Mercantile had shown that it had turned the corner it didn’t have much to offer a prospective empowerment partner. So, not unnaturally, it was really only last year that significant interest developed. It follows that interest should build up further this year.
Both an empowerment deal and increasing liquidity in the share in practice will entail Caixa diluting its stake and it would surely make sense to do both at the same time? As the matter is ultimately out of his hands, Brown is reluctant to commit to a timetable. However, you sense that he’d like to see some action this year.
So, should SA investors who shunned the rights issue at 18c now climb in at 38c? Net
asset value is 17c and the price:earnings ratio 14,8, which suggests that the share price is discounting a measure of further recovery. And dividends are unlikely until the accumulated loss is extinguished – which could also be a factor in structuring an empowerment deal.
As so often, it was the contrarian thinkers who did buy the share at the bottom – when sentiment was at its worst – that have made the real money. And those who draw lines on charts may argue that 38c has more than once proved a barrier on the upside.
But what’s clear is that the recovery phase is over and that Mercantile will in future be judged on much the same criteria as its bigger SA rivals. And both Caixa and management deserve acclaim for their persistence in not walking away from a basket case but nursing it back to health.