24 May 2018
Viceroy Research Group
RE: OPEN LETTER TO THE AUDIT COMMITTEE
We refer to your open letter to the Audit Committee of Capitec Bank Holdings Limited ("Capitec") dated 16 May 2018.
Before we deal with the substance of the six questions you pose to the audit committee, we would like to make some general comments regarding the broader interaction between yourselves and Capitec to date:
We believe that external parties such as auditors, regulators, analysts etc. are important role players in public equity markets and have a valuable role to play in exposing financial wrongdoing. At the same time, it is expected of all market participants to behave in a responsible manner that will enhance the public's trust in the functioning of public markets. In assessing the way you have chosen to engage with Capitec, we have come to the conclusion that you should have engaged differently, which would have avoided a lot of the misunderstanding which has characterised the whole affair thus far.
You chose to start off with launching a public campaign, appealing to regulators with strongly-worded and emotive demands and then only writing a letter to the board at a later stage, followed by the latest letter to the audit committee, all the while refusing to meet face-to-face with Capitec management. In our own experience, you would have gained a lot by first engaging with management, then escalating any unanswered questions to the audit committee, then addressing the whole board and only when you had exhausted all other avenues appealing to regulators in a public campaign.
In every instance of the allegations made by yourselves, Capitec management has professionally responded in detail and have painstakingly pointed out where you misunderstood certain concepts or made certain errors in calculation. The audit committee is satisfied that management has comprehensively refuted all your allegations to date.
Most of the six questions you pose are quite technical in nature, which is to be expected given the complexity of banking and accounting disclosures. What follows are simple answers to your questions, referenced to an appendix with the more technical substantiation of the answers.
1. Can the audit committee justify management's analysis that Capitec loans are trending towards the long-term?
Yes, we can. Your analysis in Figure 2 is incorrect due to the effect of the credit card on the shorter end of the loan book. If you repeat the analysis excluding the credit card, which is fundamentally different in nature to a term loan, your answers would correspond with management's analysis that Capitec loans are trending towards the long-term.
We also note that your analysis in Figure 5 does not take into account the reclassification of loans that are subject to consolidation between the <6 months and >6 months term categories. This also applies to the more detailed term categories as disclosed in the Integrated Annual Report. Capitec Management has taken this into account in the data which supports their claim.
2. Can the audit committee elaborate on the nature of internal consolidations and provide analysis into the net loan sales executed to customers who have consolidated existing loans?
Internal consolidations occur in some cases where a client with an existing Capitec loan applies for further credit. A consolidation loan would always be a result of a full credit assessment process that all clients (both new and existing) go through when applying for new credit, to check whether the client can afford the additional credit applied for. The outcome of that full credit assessment process is either a consolidation loan, a new separate loan or no new loan granted. Only the incremental portion is counted toward loan sales. As per slide 19 of the 2018 annual financial results presentation, only 3.3% of loan sales for the second half of the financial year were to 'Frequent Maximum Borrowers', i.e. clients who had taken over 80% of the maximum amount of credit that they qualified for during that six-month period, and then took out more credit again later.
3. What is the rationale in decreasing bad debt provisions while bad debt is increasing exponentially?
The increase in bad debt you refer to (the write-off component) is backward-looking, while the bad debt provision is forward-looking, based on the more recent performance of the loan book. It is a common occurrence for the one to increase while the other one decreases (or vice versa) at turning points in economic cycles. It would be more useful if you had analysed the bad debts on a six-monthly basis, rather than an annual basis, to see the recent improvement in the loan book performance more clearly. Note that your own analysis in Figures 11 and 12 ignores the significant increase in bad debts recovered. If you do the same analysis with 2015 as a base rather than 2016, and use net bad debts written off (not gross}, which is more appropriate, the gross loan book has grown by 31% and net bad debt written off by a not-too-dissimilar 42%.
4. Why have Capitec changed their provisioning method?
Capitec has not changed the provisioning methodology whatsoever. The narrative of the provisioning model in the 2017 CFO report was written in relation to a monthly instalment frequency, which represent more than 95% of the loan book. For a client that pays instalments monthly, CD1 would mean one instalment in arrears and CD3 would mean 3 instalments in arrears. For weekly instalments, CD1 would mean any of the instalments of the first month where after the client would go into CD2 in month 2.
5. Can the audit committee elaborate on management's analysis of loan book quality?
The audit committee is comfortable with management's analysis of loan book quality and would highlight the following in terms of Viceroy's own analysis as per Figure 18:
Of the R1,215 billion increase in bad debts written off between 2017 and 2018, R639m was due to the increase in debt review balances written off. Given the relative sizes of the total gross loan book to the debt review book (roughly 20x}, the significant contribution of the debt review book to the increase in total bad debts written off does indicate causation, as per management's commentary. For your thesis to be true, the relative contributions of the total gross loan book and the debt review book to bad debts written off should be similar to the relative sizes of the two, which it is not.
On bad debt recovery - given the longer-term nature of debt review recoveries, it will take time for the recovery efficiency ratio to increase, but you can already see the increase when comparing 2018's H2 to H1. The absolute value of bad debts recovered did indeed increase, supporting management's comments.
On curing - Your analysis muddles 'flow' amounts with period-end balances, a fundamental error you have made before. Your analysis in Figure 22 should not divide the total balance falling into arrears by the gross loan book, but rather by the gross loan book plus the flow of new loans (as represented by loan sales) and fees, as written off balances includes fees charged to the accounts. Following this procedure will indicate an improvement in balances falling into arrears as a proportion of the total balances that could fall into arrears (opening value of the loan book plus loan sales).
6. Can the company elaborate on the effects of IFRS 9 implementation?
IFRS9 implementation is a comprehensive project that all banks are obliged to implement for financial years commencing from 1 January 2018 onwards, therefore, in the case of Capitec, the 2019 financial year is the year of adoption. In addition to what was already disclosed in the CFO report, more on this will be disclosed at the first-half results to August 2018, The direction of the financial impact is to debit retained earnings and to credit provisions, i.e. it will lead to an increase in provisions, which is to be expected given the lifetime expected credit loss principle applied in the accounting standard.
Jean Pierre Verster
Audit Committee Chairman Capitec Bank Holdings Limited