Market traveler We believe South Africa has the potential to come back to life based on our recent visits to the country. Local companies are making pragmatic-yet-innovative moves to win consumers in a tough economy. Meanwhile, we think President Cyril Ramaphosa is the right person to lead the nation with a mandate to reform. South Africa rising: From state capture to state comeback The news out of South Africa has been relentlessly bad. Daily power outages, grinding poverty, anemic economic growth, and fears of a Zimbabwe-style land expropriation have led many investors to write off the country. We disagree. We think South Africa has the potential to come back to life. Our team visited South Africa twice in the past 18 months, and the difference on the ground is notable. With a fresh mandate after his recent reelection, President Cyril Ramapahosa continues to quietly and competently unravel the mess his corrupt predecessor, Jacob Zuma, left behind. It won’t be easy or quick; the region is indeed coming out of a difficult time, with myriad issues in its path. But we see a good opportunity for investors based on: l Ramaphosa’s postelection mandate to reform l Improving sentiment from the business leaders we met l Companies making pragmatic-yet-innovative moves to win consumers in a challenging economy In this piece, we’ll discuss what we learned in 2017 and 2019. But first, we’ll describe the region’s dire electric power situation and its decrepit state-run utility Eskom. Perhaps nothing encapsulates the problems in South Africa more than these two factors. Can you remember the last time you experienced a power outage? The lights go out, the local utility unleashes its bucket trucks, and a blinking alarm clock beckons you to fix it. Take that event and amplify it to a widespread blackout that shuts down entire cities, affecting traffic lights and eventually cell phone towers. This happens regularly in South Africa. Derrick Irwin, CFA Portfolio Manager, Berkeley Street Emerging Markets Equity Team Kary Keith, CFA Analyst, Berkeley Street Emerging Markets Equity Team July 2019
Transcript
Market traveler
We believe South Africa has the potential to come back to life based on our recent visits to the country.
Local companies are making pragmatic-yet-innovative moves to win consumers in a tough economy.
Meanwhile, we think President Cyril Ramaphosa is the right person to lead the nation with a mandate to reform.
South Africa rising: From state capture to state comebackThe news out of South Africa has been relentlessly bad. Daily power outages, grinding poverty, anemic economic growth, and fears of a Zimbabwe-style land expropriation have led many investors to write off the country. We disagree.
We think South Africa has the potential to come back to life. Our team visited South Africa twice in the past 18 months, and the difference on the ground is notable. With a fresh mandate after his recent reelection, President Cyril Ramapahosa continues to quietly and competently unravel the mess his corrupt predecessor, Jacob Zuma, left behind.
It won’t be easy or quick; the region is indeed coming out of a difficult time, with myriad issues in its path. But we see a good opportunity for investors based on:
l Ramaphosa’s postelection mandate to reform
l Improving sentiment from the business leaders we met
l Companies making pragmatic-yet-innovative moves to win consumers in a challenging economy
In this piece, we’ll discuss what we learned in 2017 and 2019. But first, we’ll describe the region’s dire electric power situation and its decrepit state-run utility Eskom. Perhaps nothing encapsulates the problems in South Africa more than these two factors. Can you remember the last time you experienced a power outage? The lights go out, the local utility unleashes its bucket trucks, and a blinking alarm clock beckons you to fix it. Take that event and amplify it to a widespread blackout that shuts down entire cities, affecting traffic lights and eventually cell phone towers. This happens regularly in South Africa.
Derrick Irwin, CFAPortfolio Manager, Berkeley Street Emerging Markets Equity Team
Kary Keith, CFAAnalyst, Berkeley Street Emerging Markets Equity Team
July 2019
On any given day in South Africa, you might wake up to a text message warning that load shedding (a forced, citywide blackout to save energy) will soon begin. But often there’s no warning. For more than a decade, this is what Eskom has done to offset a total collapse of South Africa’s grid.
Epic mismanagement of Eskom is a prime example of how ineptitudecorruption, and greed of the Zuma regime eroded the South African economy. Just prior to Zuma taking office, Eskom made plans to build two new power stations aimed at generating enough electricity to avoid blackouts. Flash forward to now, and both sites:
,
l Took about a decade to complete
l Were delivered over budget by 100% to 200%
l Are estimated to operate with just 40% reliability
Years of mismanagement (operational and financial), graft, and distractions from investigations kept the agency from doing its job.
When I visited South Africa in 2017, the region was in disarray. Amid a stagnant economy, government debt ballooned and services failed. President Jacob Zuma and his cronies were on the verge of turning the country into a giant ATM, for the benefit of a corrupt few. Along the way, he had installed compromised and inept officials in key posts, ensuring state coffers would be bled dry of funding.
Zuma’s end game? State capture—a term used to describe not just mere petty corruption but total control of state resources for illicit gain. Only the presence of a small handful of high-quality government officials, a strong judiciary, and a fiercely independent media stood in his way. It was a dark time.
A recent report by the South African Reserve Bank (SARB) speculated on the impact of state capture on the country’s growth potential.1 Looking at long-term fixed capital formation trends, the SARB calculated that South African gross domestic product (GDP) growth should be as high as 2.9% instead of the 0.8% the economy grew in 2018 (and ignoring the dismal first-quarter 2019 GDP numbers). They concluded that much of this gap can be traced to unproductive investments related to state capture programs.
Zuma and his cronies literally stole the country’s economy.
I met with company leaders, industry groups, and government officials—all of whom were less than upbeat. In a memorable talk with local mining company leaders, they walked me through the process by which a large global miner was forced to sell its mine to a group affiliated with Zuma’s crooked confidants—who then received favorable deals from Eskom.
South African GDP growth should be as high as 2.9%, according to the South African Federal Reserve Bank.
1. South African Reserve Bank, Monetary Policy Review, April 2019 2
“How retailers manage the consumer experience during blackouts
I was touring retail stores in a South African shopping mall when the lights went out.
The breadth of darkness (and lack of emergency lighting) in an unfamiliar place triggered a flashback to 2003—when the U.S. East Coast lost power and terrorist events were terrifyingly top of mind.
Thankfully, I happened to be in a camping goods store where every employee wore battery-powered headlamps (no kidding). With a flick of a switch, they jumped into action, moving panels at the storefront to narrow its entrance. However, they weren’t closing up shop. This was a low-tech, anti-theft backup protocol. Some employees stood guard at the remaining opening. Others tried to maintain a sense of business as usual, encouraging customers to keep browsing … albeit in near-totaldarkness!
During my March visit, South Africa experienced its worst, most frequentpower outages in years. Retailers do their best to adapt, but a mall’s transition to backup generators is neither quick nor seamless. Even when the power is back on, commercial escalators often moveat 1/3 speed to conserve power. And some retailers use only half of their available lighting.
This happens regularly because load shedding is about more than just adjusting behavior for four-plus hours a day. The less energy residentsand businesses use, the higher the likelihood Eskom can prevent future unexpected outages.
— K. Keith
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Soon after, at a suburban Cape Town hotel, I sat in on a presentation by Standard & Poor’s point person for Sub-Saharan Africa. He lamented South Africa’s slow GDP growth, dismal politics, and lack of urgency to address rising deficits. Weeks later, S&P downgraded South Africa’s debt rating to junk. Investment ground to a halt, and investors voted with their feet. The stock market reflected this apprehension, barely moving in USD terms, from October 2014 to October 2017.
A new leader brings political integrity and business savvy
Thankfully, the political landscape changed dramatically soon after I left. In December 2017, voters narrowly ousted Zuma for a new president: Cyril Ramaphosa, a political figure respected by businesses and unions alike (a rare feat in a country where both groups clash repeatedly). His resume proved impressive:
l Key player in the Apartheid struggle and right-hand man to Nelson Mandela
l Former head of the National Union of Mineworkers, one of South Africa’s most powerful unions
l Almost next in line to succeed Nelson Mandela as president
l One of South Africa’s wealthiest citizens, buoyed in part by his ownership of McDonald’s South Africa franchise rights
On the surface, this was great news for South Africa and investors. The country’s stock market rallied sharply, and its currency hit its strongest level in two years. Investor excitement was so intense they deemed the rally Ramaphoria.
However, the rally was short-lived. Ramaphosa was a lame duck leader—installed as a placeholder by the African National Congress until the scheduled national elections in 2019. It wasn’t long before investors wondered if he would have the political juice to make changes the country so urgently needed. As emerging markets fell broadly out of favor in early 2018, South Africa particularly felt the effects. Low growth, a persistent current account deficit, and a volatile currency put the country in the crosshairs of 2018’s bear market in emerging market equities.
Through 2018, Ramaphosa continued to be stymied by Zuma regime stragglers who remained in government. Meanwhile, Eskom’s situation grew worse by the day, with more rolling blackouts. Economic growth remained tepid at best. Some observers argued South Africa appeared to be on its way to becoming another failed African state.
We decided to see for ourselves, so Kary Keith, our analyst covering South Africa, traveled to South Africa for a firsthand look. Bottom line: We disagree with this superficial assessment.
Through 2018, Ramaphosa quietly installed a number of competent people to his cabinet, putting them in charge of quietly finding solutions to some of the country’s urgent challenges. Following his May 2019 reelection, he has continued putting the pieces in place for a revival of South Africa’s fortunes—and appears to be consolidating his grip on power. By the numbers, the region’s economy is still in dire condition. GDP growth, consumer confidence, and spending by businesses and consumers have all remained at weak levels.
However, we’ve noticed an encouraging sentiment emerging among local businesses:
“We have been through even tougher times.”
It’s true: Many publicly listed South African companies have existed for decades, and almost nothing compares with the challenges they faced running business as usual through events such as Apartheid’s end 25 years ago.
Key player in the Apartheid struggle and right-hand man to Nelson Mandela
Former head of the National Union of Mineworkers, one of South Africa’s most powerful unions
Almost next in line to succeed Nelson Mandela as president
One of South Africa’s wealthiest citizens, buoyed in part by his ownership of McDonald’s South Africa franchise rights
Earlier, we spoke about local companies’ unwillingness to deploy capital. This is now improving, and companies are arguably investing more wisely as well. Companies Kary met with are adapting to a slow economy and intermittent rolling blackouts by:
l Addressing structural challenges within their operations
l Being highly judicious about where they do deploy capital
We believe moves like these could set regional businesses up for success as the economy begins to improve. Over the next two pages, we’ll highlight case studies from South Africa’s mobile phone and supermarket retail industries.
Case study 1: Investing in new and old technologies to meet a local market’s needs
Smartphone penetration in South Africa has climbed to more than 50%. However, technology and data are very expensive for the average resident. About 53% of households, many of which include extended family, bring in an income of less than $13 a day. Meanwhile, an entry-level 4G device costs around $100, and data costs almost $10 per gigabyte (GB).
As consumers hit their pocketbooks’ limits, telecoms have had to find new ways to maintain revenue growth. Global telecommunications company MTN Group Ltd.’s strategy is to bring connectivity to lower-income users with a 3G smart feature phone that costs $20. While MTN is based in South Africa, the phone and operating software are Chinese-built and designed to be affordable and capable. The device comes with two cameras, is preloaded with key Google apps, and allows users to download WhatsApp for social media use.
I can attest to the phone’s practicality. It takes a little work to ready 4G-era apps on a 3G device. For example, without a touchscreen, a phone’s menu commands have to be accessible with actual buttons. And because an app like Google Maps can’t handle real-time navigation on a 3G device, users instead see something more like MapQuest’s turn-by-turn directions. Thankfully, the presence of Google Assistant makes usability easier with voice recognition.
Clunky keypad typing and slow data connections may have felt like traveling back in time for this U.S. user. But for an emerging market communications company, it reflects a smart approach to meeting consumers where they are.
MTN’s next ambition: Develop a WeChat app for Africa, whose use transcends social media, with an augmented platform for digital payments and businesses. Both initiatives fit nicely within MTN’s African footprint, notably in Nigeria, where the company is working to roll out its Mobile Money offering in an environment of much lower smartphone (and banking) penetration.
— K. Keith
Meeting South African consumers where they areThe market landscape for affordable mobile devices and connectivity
51% of South African adults own a smartphone (Pew Research Center, 2018)
28.9 million active mobile internet users (Statista, 2019)
53% of households live on less than $13 a day (Statistics South Africa, 2019)
51%
53%
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Reflections on economic potential and sound policy
When Kary and I traded notes about our 2017 and 2019 trips, one of the most significant differences was how South Africans felt about their leadership. Local businesses and consumers agree South Africa is fortunate to have Ramaphosa in charge. His experience with business, unions, and early progress unwinding corruption gives supporters from diverse backgrounds much to like. South Africa is a country with mind-boggling levels of long-standing divisions: racially, socioeconomically, linguistically, and tribally.
Amid these differences, the president’s popularity says a lot.
The extreme pessimism of 2017 appears to have improved, and economic data appears—for now, at least—to have bottomed out. Underpinning this improvement is Ramaphosa’s commitment to improving state institutions’ governance and accountability. He’s also accelerating reforms and reducing the size of his cabinet (which had become bloated under Zuma).
Growth for grocery retailers amid South Africa’s economic challenges
1.5% growth in South Africa’s supermarket retail category in Q1 2019
27.6% unemployment rate, combined with wage pressures, causes challenging times for South African shoppers(Statistics South Africa)
Case study 2: How supermarket retailers engage consumers on both sides of the economic spectrum
Grocery retailers are operating in a climate of 27.6% unemployment and rising wage pressures that affect South Africa’s shoppers. And yet, the country’s retail category that includes supermarkets posted 1.5% growth in the first quarter compared with a year ago, according to Statistics South Africa.
In particular, Shoprite is taking innovative steps to appeal to the customer in a difficult environment. At the low-income end, they’ve rolled out affordable workman’s lunch options to draw foot traffic. Each store has 30 productsat or below 5 ZAR (about $0.35) that easily serve as inexpensive meals—including soup, dumplings, and sandwiches. Shoprite’s scale and efficiency allow it to offer these products without the campaign being a loss leader.
For higher-income consumers who’ve also felt wage pressures, Shoprite is working to capture market share from South Africa’s leading high-end grocer, Woolworths, through its Checkers sub-brand. To use a U.S. example, Woolworths combines the product innovation of Trader Joe’s with Whole Foods’ pricing. In turn, Shoprite is updating its Checkers stores to become upscale, adding:
l Fresh ready-to-eat and ready-to-cook options
l Coffee shops and sushi bars
l Elevated levels of service
We believe that Checkers has managed to do this all while keeping price points materially below those of Woolworths.
Shoprite is also developing private label products with similar levels of quality to third-party brandsfor 10% to 20% lower price points. Historically, domestic capacity to produce food products in South Africa has been limited. The company has begun sourcing internationally with ambitions to increase private label sales to 30% of total revenue. The company now imports from about 80 countries to supply its private label offerings.
— K. Keith
27.6%
For the cabinet seats he has kept, the president has installed other capable ministers at the Revenue Service, Finance Ministry, and National Prosecuting Authority. I mentioned the latter for this reason: While the public has been calling for arrests and retribution for Zuma-era crimes, Ramaphosa has instead worked to restore due process and rule of law.
This is essential, as it is the foundation of South Africa’s ability to address its structural problems.
Final thoughts: Recovering from state capture to shine in better times
In 2017, I had coffee with Professor Haroon Bhorat from the Development Policy Research Unit at the University of Cape Town. He was co-authoring a paper, now published, to tell the outside world how Zuma was destroying his country. Here’s an excerpt from that paper, Betrayal of the Promise: How South Africa Is Being Stolen:
“… a symbiotic relationship has emerged between a constitutional state with clear rules and laws, and a shadow state comprising well-organised clientelistic and patronage networks that facilitate corruption and enrichment of a small power elite. The latter feeds off the former in ways that sap vitality from formal institutions and leave them empty shells incapable of executing their responsibilities.”
In the science community, there are a few types of symbiotic relationships. The above example falls into parasitism, when one entity gains while the other suffers—truly emblematic of the Zuma years. In a more hopeful 2019, we think South Africa is on the path toward a symbiotic relationship in which all partners havethe opportunity to thrive. To that effect, we’re optimistic that President Ramaphosa is the right person to lead the nation forward.
There are, to be sure, massive challenges ahead. Eskom will be a major drag on government resources and will put a cap on growth until electricity supplies can keep up with demand. Furthermore, South Africa still needs to address structural issues such as insufficiently skilled labor, poor education, and wealth inequality. These issues cannot be fixed overnight. Indeed, they may take a generation to fully resolve.
But South Africa is getting back on its feet.
As emerging market investors, Kary and I look for high-quality companies that can preserve value in times of adversity and shine when times are better. This brings tomind another, more hopeful meeting from my travels.
In our view, one of Ramaphosa’s smartest appointments is a man named Pravin Gordhan, a shining and rare light of integrity from the Zuma era, where he served as finance minister. Zuma fired Gordhan—to no surprise—for a more pliable minister. But prior to his dismissal, I had lunch with him. As we spoke, I was impressed by his integrity and ability to build bridges with the South African business community despite the culture of corruption he faced daily.
I mention this because Gordhan is back, now serving as Ramaphosa’s lead on troubleshooting issues at state-owned enterprises such as South African Airways and Eskom. His return is symbolic of the nation’s resilience. He never gave up, and when a better climate arose, he got back to work with a focus on results.
From state capture to state comeback. Over time, this is how we see the story playing out in South Africa.
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Appendix: The Eskom challenge
Eskom’s challenges are operational and financial. Operationally, the state-owned enterprise (SOE) has had years of inadequate maintenance, poor capital allocation, lousy execution, and departure of experienced personnel. As mentioned earlier in this piece, Eskom’s two newest power stations took too long to complete, were delivered far over budget, and are estimated to operate with low reliability (Source: South Africa’s Department of Public Relations).
Further hampering electricity in South Africa this year were recent input procurement delays and an inability to import power from Mozambique following damage from a recent cyclone. In coping with the lack of supply, South Africans have had to endure the aforementioned stage-four load shedding events, where to prevent a nationwide blackout, power goes out in select regions for hours, often unannounced.
Financially, Eskom has debilitating cash flow problems. Eskom’s annual financial statements show that its earnings before interest, tax, depreciation and amortization (EBITDA) have failed to cover capital expenditures for years—let alone interest payments. Counterintuitively, while many experienced employees have left, Eskom remains exceptionally overstaffed (estimates range from 66% to 100%), and there are difficulties correcting this without uproar from labor unions. Now the SOE’s debt level is overwhelmingly high: Net debt is well over 2x revenue and 8.5x EBITDA. Moreover, cash problems elsewhere in the economy further worsen Eskom’s position. Though residents have been paying their electricity bills, the SOE has about 30 billion rand in uncollected payments from municipalities.
The National Energy Regulator has approved electricity tariff increases, and the National Treasury confirmed that it has committed 69 billion rand in capital over the next three years to improve the financial standing of the company, according to government reports. Still, these measures are not enough. Eskom leadership is also exploring voluntary retirement programs, and longer term, the Ministry of Public Enterprises says it is working on a plan to split the SOE up into three divisions (generation, transmission, and distribution) to improve performance and accountability.
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