One of our larger investments is in Nigeria.
You read that correctly: Nigeria – a country that is utterly irrelevant to most global investors.
Are we deeply worried, then, about the roughly 40% decline in the Naira in June? Yes, Nigeria’s currency is called the Naira, and No, we are not concerned. In fact it is something we have been waiting for now for a number of years. It is a giant step forward in the process of taking Nigeria out of the economic and financial markets deep freeze, as well as avoiding a sovereign default.
On June 14 the Central Bank of Nigeria (‘CBN’), having seen its governor of the past decade suspended and subsequently arrested (I know, I know, why can’t WE arrest every Western monetary policy miscreant of the past 30 years????), collapsed its various managed foreign exchange windows into a single rate to be determined by willing buyers and sellers. In other words, the currency went from a peg that has been in place for years, to a managed float. The Naira immediately collapsed by 39%, from 462 to 753 to the U.S. dollar by month end.
For most of the past decade under president Muhammadu Buhari and his unconventional central bank governor, Godwin Emefiele, Nigeria has been “uninvestible”. By all accounts the president is a decent, honest and disciplined man, but his prescription for addressing Nigeria’s ills seems to have been misguided. Not that I envy having to make those difficult decisions. One of his key policies involved keeping the local currency from depreciating in line with market forces based on the view – a view not entirely without merit – that a weaker exchange rate led to high inflation that hurt the average citizen. Governor Emefiele reached for his bag of highly unorthodox monetary policy tricks in an attempt to fix the value of the Naira despite a sharp decline in oil prices in 2015, falling oil export revenue (the largest source of foreign currency), and unceasing demand for U.S. dollars. At the same time, the government continued to subsidize domestic fuel prices, which was a constant drain on foreign exchange and the federal budget given the need to import refined petroleum products.
Governor Emefiele's solution involved the creation of different foreign exchange rates for different purposes, rationing the limited amount of foreign currency obtained by the central bank at elevated Naira rates to certain businesses or for certain activities. The “official” Naira exchange rate held its value to a degree, but at the cost of liquidity. Supply and demand were not able to clear at the official exchange rate. The true market rate was better reflected by the “parallel” or black market rate, which was published on certain websites. Which of course the CBN tried to censor and shut down. Funny how that works.
The foreign exchange restrictions put in place by the CBN made life even more challenging than it already was for Nigerians, and they are used to dealing with a lot! Consumer goods companies were unable to pay for key raw materials that aren’t produced domestically. Foreign airlines stopped flying to Nigeria because they were unable to repatriate revenues from domestic tickets sales. And foreign capital avoided Nigeria like the plague, fearful that any U.S. dollars or Euros exchanged for Naira would never be allowed to exchange back again. This starved the economy of desperately needed investment.
To make matters worse (and as a colleague used to quip: it’s always darkest right before it turns pitch black), Governor Emefiele then attempted the audacious gambit of replacing all of Nigeria’s physical currency with a central bank issued digital currency. For the millions of Nigerians without a smartphone and unable to use a digital currency it was a disaster, causing untold distress as they were unable to access banknotes for their daily needs.
As I sat down to write a first draft of this post, the official Naira exchange rate was 462 to the U.S. dollar, but the parallel market rate was closer to 750 – a near 40% discount. When the central bank released its grip the currency moved immediately to 750, weakened toward 800 and as of this writing is back at 753. It will take some time to find its natural level, and probably that’s not quite as bad as 750 as the fear subsides and dollars are more willing to convert back into Naira. Higher interest rates would help.
We didn’t know when this currency policy dog’s breakfast would come to an end, but Buhari’s second term was constitutionally mandated to end in May of this year. Assuming that the country didn’t actually fall apart in the interim along ethnic and religious lines (and before you judge Nigeria, just Google “Texit”), Buhari’s successor was likely to follow a more orthodox and market-friendly course. Partly this was a necessity. Nigeria’s young and growing population needs jobs and real GDP growth at or below the rate of working age population growth just won’t cut it.
Even we were surprised at the pace. Nigeria’s new septuagenarian president moved with lightning speed to free the currency and dismantle the fuel subsidies. And he had style. At his inauguration address President Tinubu announced an end to the country’s fuel subsidy policy – a policy in place since 1977 – in an off hand manner that would make a Lacedaemonian proud: “the fuel subsidy is gone”.
The fuel subsidy is reported to have cost the budget 4.4 trillion Naira (roughly $9.7bn) in 2022, one of the largest government expenditures. Much of that subsidy doesn’t even help Nigeria’s citizens, with cheap Nigerian fuel smuggled across borders to the benefit of its neighbors. And it’s highly regressive even within Nigeria, helping the top 3% of income earners. Time will tell if President Tinubu is able to withstand the political and social backlash. In 2012 President Goodluck Jonathan did a u-turn on subsidy removal after massive protests. Given Nigeria’s fiscal situation, this time there is more urgency.
The currency decline and removal of subsidies might cause significant hardship for long-suffering Nigerians in the short term, driving up inflation. Inflation was already running at 22% as of March in any case, and as the IMF points out, inflation already largely reflected the parallel market FX rate rather than the official one. A short burst of inflation might be worth the suffering for medium term stability. As the famous German saying goes: “Besser ein Ende mit Schrecken asl ein Schrecken ohne Ende” (better a horrible end than horror without end).
We have owned shares in one of the country’s leading banks for a number of years via its London-listed GDRs (global depository receipts). These GDRs trade in U.S. dollars, so we had no direct exposure to the Naira. We received our dividends faithfully every year in U.S. dollars. Guaranty Trust Bank is one of the largest, most profitable and most reputable banks in the country. It generates high returns on assets and equity, with an excellent history of managing credit risk (in an environment that would scare the pants off most western loan officers), and it is managed by one of Nigeria’s most respected and capable CEOs. We are in the fortunate position of having a small amount of capital at our disposal and therefore the complete lack of liquidity in the GDRs has not bothered us one iota.
The price of Guaranty’s GDRs came under significant pressure in anticipation of the devaluation. In our view the stock was undervalued at US$4 and was a steal at US$2.1, even when translating that price (each GDR representing 50 underlying shares) at the parallel Naira rate of 750 to the dollar. That translated to a Naira price of 31.8, which was almost precisely the value of the bank’s equity and approximately 4x earnings based on the company’s first quarter results (annualized). That valuation represents a bargain for a bank generating a return on equity of 24% despite holding ample amounts of regulatory capital (as well as extraordinary amounts of non-interest earning assets, as we discuss below).
In the mists of times past, before Mahammadu Sanusi was anointed His Highness, the 14th Emir of Kano, and instead moonlighted as the Central Bank Governor of the year (worldwide, according to The Banker), Guaranty Trust's stock used to trade for more than 2x its book value of equity. And for good reason. Its high returns on assets and capital were matched by some of the most attractive growth prospects of any bank on the planet – did I mention Nigeria’s population is on track to nearly double to 400m people by 2050? A large proportion of whom remain unbanked. In fact, a large proportion of that 2050 population aren’t even born yet, and the unborn are by definition unbanked.
In reality, that translation impact of a weaker Naira on the U.S. dollar share price of Guaranty’s GDRs is actually not that bad.
How so, you ask?
Guaranty has been prepared for a significant devaluation for many years, holding a large stock of U.S. dollar assets on its balance sheet, while its liabilities are largely denominated in Naira. At the end of 2022 the bank held 2.08 trillion Naira in U.S. dollar assets (34% of total assets or US$4.5bn at the old exchange rate of 462), split roughly 50:50 between cash and loans, with loans only to customers with dollar revenues. The bank had only 1.4 trillion Naira in U.S. dollar liabilities. In other words, the bank ran a net long U.S. dollar position to the tune of US$1.5bn. And apparently there is a further ~US$560m in swaps giving further long dollar exposure. The bank also had modestly net long positions in the Euro and Sterling, and was actually short Naira (liabilities exceeded assets) to the tune of 97 billion Naira or around $210m. We calculate that a decline in the Naira from 462 to 750 would entail something on the order of 440bn in Naira FX translation gains (before tax), increasing book value per share to 50.6 Naira (up 61%, and perhaps more depending on the terms of the FX swaps). And when translated back to U.S. dollars at a rate of 750 would give a value of 7 US cents per share or $3.37 per GDR. That is only an 11% decline from the $3.77 per GDR pre-devaluation, and still well above where the GDR’s traded early in the quarter.
If monetary policy returns to normal (as in orthodox, not what has been "normal" for Nigeria!), the stock could well trade back towards historical valuation levels, or as much as 2x book. That math looks pretty good to us.
The three drivers of bank equity valuation are 1) return on equity, 2) the cost of equity and 3) growth.
Growth is not an issue given Nigeria’s growing working age population and low banking penetration. Assuming long-term growth on the order of 5% does not seem unreasonable given population growth of 2.4%, working age population growth higher than that, some increase in real income per capita as well as rising banking penetration.
The cost of equity, on the other hand, is very elevated as it is partly determined by the yield on the local 10-year government bond, which currently stands at 14.75%. If policymakers can bring inflation back below double digits, that yield could come down to around 12.5% (it has been as low as 10.5% in the past), which would give a cost of equity of 17.5% assuming a 5% equity risk premium.
Finally there is the bank’s return on equity. In years past Guaranty was able to deliver returns on assets of over 5% and a return on equity north of 30%. With a return to monetary policy normality, Guaranty should be able to get back to those levels.
One major step on that path would be a reduction in the required Cash Reserve Ratio (“CRR”) as well as higher interest rates. For years the Nigerian banks have suffered from a different kind of Governor Emefiele’s monetary policy sorcery, which was to force commercial banks to hold a very large proportion of their deposits as non interest-bearing deposits at the central bank. The CBN raised the CRR from 12.5% in 2014 to 32.5% in September of last year. As at 31 March, Guaranty Trust Bank’s core Nigerian operation held 1.2 trillion Naira as restricted deposits with the central bank, nearly 34% of its Nigerian deposits and nearly 18% of its total assets. This leads to a significant shortfall in net interest income. A return to monetary orthodoxy would see the central bank reduce the CRR and hike interest rates to levels that promise a real expected return from holding the local currency, in order to support the Naira. The ability to earn interest on those assets, and potentially at higher rates across the book, would go a long way to boosting net interest income and returns on equity.
Plugging those figures into our bank valuation equation, gets us to 2x book value:
ROE – g / COE – g = 0.25 / 0.125 = 2x
As we mentioned, a return to 2x book value would be highly attractive even if the Naira continues to decline to below 800 or so. In fact, it's more than 3x what the shares were trading for part way through the second quarter. Only time will tell, and despite Buhari's unseemly pace of policy reform in his first two weeks, there is still much wood to chop. But the direction of travel looks promising. And more than just bullish on Guaranty Trust, we are excited for Nigeria as a country.
President Buhari’s eight year record may not be stellar, but he did have some notable wins.
One such success was the signing of the long-debated and long-awaited Petroleum Industry Act (‘PIA’) in 2021, which resets the playing field for Nigeria’s all important oil sector. One feature of the new Act is that it makes offshore oil production in particular much more attractive, given it is no longer subject to a 50% petroleum profit tax.
And so it was also by sheer coincidence that this quarter we also acquired shares in a small oil producer called Africa Oil Corporation, with interests in two producing license areas in deep water offshore Nigeria. Those assets are held by a company called Prime, in which Africa Oil has a 50% interest.
One of those licenses, OML130, was renewed in May for 20 years under the new terms set by the PIA. Both assets are operated by oil majors and generate free cash flow of a little over $30 per barrel, with exceptionally low lifting costs of just $8-$9/bbl. Africa Oil’s entitlement share of production from these assets was 29.7kboepd (barrels of oil equivalent per day) in 2021 and 25.6kboepd in 2022, equating to 10.8MMboe and 9.3MMboe for the full years respectively. This saw Prime pay Africa Oil $200m and $250m in dividends in 2021 and 2022 respectively, with 2022 supported by significantly higher oil prices despite weaker volume.
The problem is that Prime’s key Egina oil field within OML130 has seen production declining faster than expected since first oil in 2018 given a complicated geology, but TotalEnergies, the operator, is planning a series of nine in-fill and tie-in wells in 2023 in order to boost output. This program will raise Africa Oil’s capex contribution from around $25m in 2022 to around $90m in 2023, but company guidance still suggests free cash flow of between $150m to $250m with entitlement production of around 20kboepd, down around 15% y/y. Development of the Preowei discovery that will tie back to the Egina FPSO (floating production, storage and offloading vessel) should add around 60kboepd (gross, or 4,800boepd net to Africa Oil) starting in 2026, helping to bring overall production levels back up.
The free cash flow impact of lower production and higher capex in the near term is at least partially offset by the better fiscal terms under the new PIA. The royalty rate should rise slightly from around $5.0/bbl to $7.5/bbl (at current oil prices), but with no Petroleum Profit Tax, we estimate the tax take per barrel to drop from around $30/bbl to around $18/bbl. With production stabilising around that lower 20kboepd level, we estimate Africa Oil should still be able to take out $215m in dividends on average over the next five years, or nearly $1.1bn in the aggregate. The OML130 license renewal in May allowed Africa Oil’s Nigerian operating company to refinance its debt facilities as well, increasing its capacity to $1bn (from a current drawn amount of $720m) and extending the maturity to six years. The re-financing freed up cash, allowing Prime to pay a $125m dividend or $62.5m net to Africa Oil in the June quarter.
If we are right on the economics, Prime’s dividends to Africa Oil would be equal to the company’s entire market capitalization over the next five years. Some of that cash flow will be returned to shareholders via a $25m dividend and there is currently a ~US$70m buyback ongoing, which we think will be renewed in 2024. Some of that cash flow will likely be deployed in acquiring other producing assets to grow production.
Those calculations assume an oil price of $75/bbl in line with current spot pricing, which is of course a large unknown and a risk to our investment case. A recession would clearly be a negative, but even at $50 per barrel, aggregate dividends over five years would likely come to $550m or just over half of the company’s current market value. Our view of the sector overall, although probably not sufficiently well-researched, is that investment in new production over the past several years has not kept pace with the levels of ongoing demand.
We think those numbers are still quite attractive as a standalone investment case for Africa Oil.
But there's more. Africa Oil also has a 6% indirect interest in oil block 2913B in deep water offshore Namibia, the same block where TotalEnergies drilled the Venus-1 well early last year, discovering 87 meters of light sweet crude net pay, with estimates suggesting a discovery of more than three billion barrels. That would make it the largest discovery of 2022.
As of this writing Total is drilling an appraisal well to firm up the estimates of the resource before moving on to drill a further exploration well to the west. Estimates from Wood Mackenzie suggest an NPV of US$6.3bn for a phase one development of that asset, which would equate to around US$380m net to Africa Oil. Other rule-of-thumb estimates we have seen tend to assign $2-$3/bbl in value to the estimated resource, or somewhere between $360m to $630m net to Africa Oil, depending on the actual resource and the multiple. Either way, it is highly likely that the value of Africa Oil’s indirect interest in block 2913B is worth a substantial fraction of its market cap, ranging from 1/3rd to 3/5ths. And in all likelihood there is more oil there. Shell has made two discoveries in a block adjacent to Total’s license area, suggesting a larger working petroleum system or several systems. Africa Oil’s indirect interest extends to Total’s block 2912, adjacent to 2913B as well as a significant 20% direct interest in two blocks on-trend to the south, which Africa Oil is likely to farm out to cover exploration costs.
Either way, with a market value of US$1bn and zero net debt (consolidated parent plus 50% share of its Nigerian operating subsidiary), we believe Africa Oil is valued at a significant discount to the value of its producing assets in Nigeria, even conservatively valued, as well as what has already been discovered in Namibia.
As we said at the beginning, Nigeria (and Namibia for that matter) matter very little to investors focused on AI and big trends in mega-cap U.S. Tech stocks. But they might be a little less irrelevant going forward. They are certainly not irrelevant to our portfolio.