Capitec: be afraid of what you cannot see

• South Africa
• Capitec, Credit loss ratio, Impairment, Interim earnings, Lockdown, Quarterly earnings
• July 5, 2020

Back in March, Capitec suffered a price drop so severe that management released a SENS announcement to try and stop the bleeding.

They highlighted that earnings growth still looked reasonable and that only 9% of Capitec’s customers have credit from the bank, so it isn’t the high-risk lender that the market sees it as.

They also noted that the bank’s transaction revenue is enough to break-even, so the lending is just the cream on top.

The problem with this cream is that it can go sour. Awfully sour, awfully quickly.

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At the time, I wrote:

“As strong as Capitec is, a major upswing in bad debts would certainly hurt them, even if only 9% of the customers have credit.

Capitec’s business is highly exposed to the fortunes of ordinary South Africans, so they bear the brunt of actions taken in relation to the COVID-19 crisis. Investors who see value in Capitec’s shares will have to be willing to sign up for a bumpy ride.”

Capitec has now released a trading update, so let’s see what happened over lockdown:

It’s ugly

For the quarter ended May, Capitec incurred a R404m loss. Ouch.

I wish I could tell you that I fully understand their financial update, but I don’t. I have to make a few guesses in arriving at this concern, but that’s investing. You have to work with whatever is publicly available.

A few important facts:

• Profit before tax for 12 months ended Feb 2020: R8bn
• Profit before tax for 6 months ended August 2019: R3.8bn
• Therefore, profit before tax for second half of year: R4.2bn (the difference)

Capitec makes more money in the second half than the first half of the financial year, which is to be expected (festive season impact and general business growth over a year), but the point is that the business isn’t highly seasonal. That means we can make an educated guess that the first quarter of a financial year is similar to the second quarter. Put differently, the first quarter is half of the interim 6 month result.

I don’t understand the swing

For the first quarter of this financial year, March to May 2020, Capitec made a R404m loss before tax as already noted.

By taking the prior year’s interim period of R3.8bn, we can guess that the comparable quarter was a profit before tax of R1.9bn (half). Now, let’s put 15% growth on that to assume that Capitec should’ve made a R2.2bn profit this quarter, had lockdown not happened.

In round numbers, the swing is negative R2.6bn (R400m reported loss vs. R2.2bn expected profit). That’s fine, but now we must use the Capitec announcement to explain the swing.

Capitec wrote off a further R3.3bn in loans since February. That’s a number they wouldn’t have expected. We haven’t just explained the full swing now, we’ve weirdly explained more than the swing. This implies that the rest of the business actually did well, as the -R3.3bn negative impact on the loans was reduced to a -R2.6bn impact by a positive result of R700m elsewhere in the business.

Except, the rest of the business didn’t do well at all…

Annoyingly (and probably deliberately), Capitec notes performance vs. “expectation” rather than vs. prior period, which is about as useful as a toothpick in a knife fight. I have no idea what the expectation was, so we have to just guess what’s going on.

Let’s pick out a few other comments from this trading update:

• Retail loan sales 43% below expectation
• Business loan sales 25% below expectation
• R6bn worth of loans required rescheduling or payment breaks (representing 8% of total gross loans and advances of R73bn)
• 26% of the total retail book and only 4% of the total business banking book have been written-down as provisions (i.e. Capitec expects that R17bn won’t be recovered and has accounted for that loss already)
• Transaction revenue was 20% below expectation, driven by lower transaction volumes on individual accounts and merchant acquiring (i.e. business clients accepting card payments)

The only revenue highlight, if you can call it one, was funeral insurance income coming in 17% above expectation because premiums went up. Profit was also assisted by operating expenditure coming in 12% below expectation, as Capitec must’ve cut every expense that it possibly could.

Perhaps I’m missing something and please tell me if I am, but this doesn’t sound like it explains a R700m positive swing vs. expectation.

What is going on here?

Leaving aside a first quarter result that I can’t get my head around, management has guided the market that headline earnings should drop more than 70% for the 6 months ended August 2020.

Headline earnings in the prior comparable period was R2.9bn, so this suggests the group may achieve headline earnings for this period of up to R870m (70% less).

Now, we cannot directly compare profit before tax to headline earnings because there are adjustments in the middle, but we can make a simplifying assumption that profit after tax approximates headline earnings.

A quick calc looks like this:

• Loss before tax of R404m equates to roughly R291m loss after tax (it improves because the loss can be offset against future profits for tax – don’t lose any sleep over understanding this)
• To achieve profit after tax of R870m, Capitec must achieve R1.16bn profit after tax for the quarter from June to August to offset the R291m loss

I know Capitec said “more than 70%” and so that’s the best possible result, but even putting 70% into the market feels extremely reckless to me. I don’t believe for one second that a R1.16bn profit after tax for June to August is possible, unless they relax the credit provisions and become less conservative about the risk of default.

A further read of the trading update shows just how good the stuff is in Stellenbosch that this management team is smoking. They expect that “results for the second half of the year could normalize” which is enough for me to never buy Capitec shares again.

Our unemployment rate is rocketing. People have no money and too much debt. There are no jobs for the people getting retrenched. It’s terrible out there.

But hey, Capitec will normalize. Also, I’m the Tooth Fairy, not just the Finance Ghost.

I bought Capitec in the March dip and I sold it after Tito’s hippopotamus speech for a small gain, as I decided to shift more of my equity exposure offshore.. Thank goodness I did. You’ll never again see Capitec in my brokerage account.

It’s one thing when a business is under pressure. It’s another altogether when management puts reckless commentary into the market and treats us like fools.