Description

Investment Overview: Trustco Group Holdings (TTO – JSE) is a high return, diversified, small-cap 20%+ growth compounder in an expanding local market with a large TAM and undervalued real estate holdings, selling at less than half of intrinsic value and which could appreciate 3x-4x in the next 3-4 years. The following key points underscore our investment thesis:

• The company has a high return business model, with a ~40% EBITDA margin, ~20%+ ROE, and a solid track record of growth;

• Since it went public in 2006, revenues have grown at a CAGR of ~24%, EPS have grown about 9x from R0.06 to R0.55 and book value per share has expanded roughly 12x (29% annualized);

• The company has property holding assets that should sustain earnings over the next 20+ years, the expected fair value of which is in excess of the share price today, providing downside protection for the stock,

• Run by an owner/operator CEO with significant skin in the game (virtually his entire net worth is in the company)

• Trustco currently trades at about 6.0x trailing EPS. Based on our analysis, we believe the shares are selling at half of current intrinsic value and could be valued in 3-4 years at R10.00 or more vs. R3.30 today, equating to a 30%+ IRR.

• The major reason why the shares are mis-priced is due to the poor optics associated with a transaction between the founder and the company, and how it has been mishandled by management and mis-portrayed in the press. This transaction (detailed below), is actually structured in a shareholder friendly manor, and if successful, could provide significant earnings accretion.

• We believe the shares will re-rate and the ~38% recent decline in the share price provides investors an attractive buying opportunity to own this high quality growth compounder.

Key Statistics:

Ticker: TTO – JSE

Date: 9/7/16

Price: R3.30

52 Week Range: R2.80- R5.40

Shares Out.(fd): 772.1m

Market Capitalization: 2,548m

Net Debt: R1,080m

Enterprise Value: R3,628m

Revenue (ttm): R1,172m

EBITDA (ttm): R480m

EPS (ttm): R0.55

EV/EBITDA: 7.6x

P/E: 6.0x

Note: (through this report, all currency expressed South African Rand; 1USD = 14.5 Rand)

A Broad Portfolio Of Products, With Healthy Demand, In A Growing Market: Trustco is a conglomerate based in Namibia, with its shares trading on the main board of the JSE. Trustco is a diversified business, focusing on banking, insurance, student lending, online education, mining, and property development. Trustco is one of the largest companies in Namibia and has an established brand in its local market; providing a sustainable competitive barrier. While the company has a diversified business portfolio, there are some cross fertilization synergies, which are aided by the Trustco brand.

The company’s operations are grouped into three divisions:

• Investments (66% of revenues; 75% of profits) – Within this division, the main profit contributor is Trustco Properties, which owns a significant property portfolio of roughly 42,300,000 square meters of sellable land. Also contained in this division is the company’s educational centers and the newly formed resources division (discussed below), which currently contribute a diminutive amount of profits.
• Banking & Finance (18% of revenues; 14% of profits) - Trustco Finance provides student loans for low income consumers, while Trustco Capital provides mortgages for residential properties. Noteworthy, Trustco is one of only eight registered banks in Namibia, which provides the company a source of low-cost funding and can be leveraged to help finance property sales and fuel growth in higher margin education and residential loans businesses.
• Insurance (16% of revenues; 11% of profits) – Provides insurance coverage for funeral and hospital services as well as life insurance.

Granted Trustco is somewhat of a more complicated story due to its diversified business model. However, none of the businesses in Trustco are inherently complex or difficult to understand, rather there are many different business lines. We find there is a huge advantage to doing work where others will shy away from investing time, and we think Trustco is a perfect example. The following is a link to the company’s 2016 annual report, which contains more information on the company and its various businesses: http://www.tgh.na/wp-content/uploads/2016/07/IAR-2016.pdf

The key driver of growth within Trustco’s broad business portfolio is the combination of a healthy growing economy within Namibia, with education being one of the priorities of the government. These factors are enabling more of the country’s population to move out of poverty and into the rapidly growing middle class with higher disposable income levels, where they are seeking a higher standard of living and better services. One of the factors that distinguish Trustco and helps provide a healthy competitive barrier is its access to capital through its banking operations. Access to capital has been one of the key elements to Trustco’s ability to support its rapid growth and diversify into a number of complementary areas.

Real Estate Holdings Provide An Engine Of Growth, With A Value Well In Excess Of The Stock Price: Currently, real estate comprises the largest portion of value in Trustco, accounting for close to three-quarters of corporate profits. The company has huge land holdings in a valley in the capital city of Windhoek. This fact means that there is no geographic way to expand, in an area where demand significantly outstrips supply. This geographic situation, coupled with the economic growth in the country, has led to double-digit, year-over-year increases in the value of TTO’s land holdings over the last couple of years. Namibia has a housing shortage of roughly 80,000 homes for capable buyers in a country with only 2 million people. This has led Namibia to be one of the fastest growing property markets in the world during the past decade. The following is a link to one of the many stories that can be found on-line regarding rising property values in Namibia over the last couple of years: 

http://allafrica.com/stories/201601181946.html

Trustco is one of the largest owners of zoned residential, commercial and industrial land in Namibia. The company’s land bank consists of four developments, including: Elisenheim, Lafrenz, and Herboths Blick.

• Elisenheim – At 11.86 million sq. meters, Elisenheim is one of the largest residential turnkey projects in southern Africa. The project consists of 21 extensions and will be developed in 13 phases over 10-15 years. The development will include about 6,000 single family homes, 75 large residential buildings, 3 schools, a nature preserve and significant land for commercial buildings such as shopping centers, offices and clinics/hospital. We expect this will generate ~R14 billion in revenues and ~R4.5 billion in EBITDA over the next 15 years. Our estimate of the NPV of this development is ~R2.3 billion.
• Lafrenz – The Lafrenz development is zoned for commercial use, with two phases providing a combined 3.4 million square meters. This will accommodate about 116 industrial buildings, which are currently being sold. We expect this will generate ~R4.5 billion in revenues and ~R1.5 billion in EBITDA over the next decade. Our estimate of the NPV of this development is ~R700 million.
• Herboths Blick – The company recently acquired 27 million square meters of additional property just outside of Windhoek, called Herboths Blick. The land will not start adding revenue for another 3-5 years, but will be their largest project when it does begin. Our NPV estimate of this property is ~R1 billion.

The following chart illustrates the current and future revenue opportunity from Trustco’s land bank (assumes 12% discount rate).

The base case above assumes a 15 year sell-off of the Elisenheim and Lafrenz developable land with 2% annual price appreciation, utilizing a 12% discount rate.

Management’s goal is to sell one phase of residential or commercial property per year. Notably, the current property holdings of the company have the potential to support earnings for Trustco over 15+ years. Additionally, our NPV of the land, excluding Herboths Blick is ~R3.0 billion, which is equal to the market cap of the entire company. Thus, property holdings provide a significant growth engine for the company over the next decade as well as tangible downside protection for the stock price.

Run By An Owner/Operator, With An Outstanding Track Record And Lots Of Skin In The Game: Trustco is ultimately a bet on the company’s founder and managing director, Quinton Van Rooyen. Mr. Van Rooyen is a successful entrepreneur who acquired the forbearer of the company in 1992 for only N$100, and has done an impressive job of building a multi-faceted business and growing Trustco at a very rapid rate over the past 25 years. Mr. Van Rooyen owns 51% of the company and has maintained his ownership over the last couple of years. Thus, he has a significant amount of skin in the game and is clearly aligned with shareholders. Additionally, he has also put in place a stable and high quality management team. The intellectual capital associated with the Trustco management team is another key differentiator of the company within the region. While it is hard to place a value on corporate culture, we think Trustco has an outstanding corporate culture that helped recruit the best and the brightest in the region. Noteworthy, Trustco was awarded by Deloitte in the large company category as “The Best Company To Work For” in the 2015 survey in Namibia.

A High Return Business Model & History of Healthy Growth: Trustco has a high return business model, with a ~40% EBITDA margin, ~20% ROE, and a solid track record of growth. The following table illustrates the healthy growth in revenues and profitability that Trustco has recorded since it went public in 2006. Over this period, revenues have grown at a CAGR of ~24%, earnings have grown about 9x from R0.06 to R0.55 and book value per share has expanded roughly 12x to R2.84 per share in the last reporting period. The only blemish on the company’s financial track record was in FY13, when revenues and profitability were impacted by: trimming some operations in South Africa that were yielding marginal returns and timing issues which resulted in minimal land sales. It is important to realize that in 2013 normalized earnings were still growing, but there were short term, one time addbacks in order to arrive at normalized earnings.  Trustco also pays a dividend to shareholders, which amounted to an annual rate of R0.08 in the last reporting period, equating to a yield of about 2.2%.

Why The Shares Are Mis-Priced; Trustco’s Location in Namibia: The first question many investors will have in the forefront of their mind in deciding whether to look at TTO as a possible investment; why Namibia, and can I establish a relationship with management. Namibia is a small country in Southern Africa, that gained its independence from South Africa in 1990 and has a stable democratic government, English-speaking, strong pro-business banking/financial sector and a shareholder friendly investment climate.

Namibia’s currency, the Namibian dollar, is directly tied to the South African Rand. The Namibian economy is very robust, and is growing at roughly 5%-6% annualized. The capital city of Windhoek (see photos below), where Trustco is headquartered, is a modern metropolis of ~365k people located in a valley in the Namibian highlands at 1,650 meters (5,400 feet), with a German heritage and all of the modern luxuries and conveniences of any city its size in the world. The point I am trying to make is that this is far from the “wild west” of investing and that potential Trustco investors should not get scared off due to the location of the company. One of the positive aspects of looking at a company in Namibia is that this is somewhat of a fertile ground for investment ideas and you will definitely not be following the pack.  With the US equity markets trading at new highs and valuations being stretched, wouldn’t it be nice to fish for investment ideas in a much less crowed pond?

Windhoek, the capital of Namibia

Trustco Corporate Headquarters

Another point to mention is that the shares of Trustco trade on the main board of the JSE. As such Trustco is compelled to follow all of the regulations of the exchange relative to disclosures and business practices, which are among the strictest and highest regarded in the world. Noteworthy, the Global Competitiveness Report (2015-2016) by the World Economic Forum ranks South Africa as #2 in the world for Securities Market Regulation (U.S. ranked 24th).

As for Trustco, the company has a shareholder friendly management team that is receptive to potential new investors and open to discussing all aspects of their diversified businesses. We have found that Trustco management is one of the most open among all our portfolio holdings.

Why The Shares Are Mis-Priced; The Mining Transaction: Aside from the geographic location of the company, the main reason the shares are mis-priced and the primary reason for the recent pullback in the share price is the controversy surrounding Trustco’s diversification into the mining business and its recent purchase of Huso Investments diamond mining operations. As illustrated in the following chart, since climbing to a high of N5.40 per share in November following a multi-year period of solid growth, the stock has declined ~38% despite subsequently reporting earnings growth of +40% y/y in the recently reported FY16 year.

Share Price of Trustco Group Holdings (JSE – TTO)

July 2013- Present

We think this concern is due to the optics of the transaction and management’s mishandling of how it was communicated, leading to a misunderstanding of the rationale and structure of the deal.

Concern has been misplaced in our opinion. The Huso transaction was a negotiation between Quinton Van Rooyen (the majority shareholder and founder of Trustco) and minority shareholders. Mr. Van Rooyen personally owned the mine, and wanted all of his assets in Trustco so that he never had a conflict of interest, and therefore wanted to sell and consolidate the mine into Trustco.  He wanted to make sure that this was fair for minority shareholders, therefore only minority shareholders were able to vote on the deal. After some negotiation, the minority shareholders voted in favor of the deal (ourselves included). We view the deal as fair to all shareholders and believe the transaction has three potential outcomes:

• In one scenario, if the diamond mine does not work out, Trustco shareholders can put back the mine to Quinton within the first 3 years of the mines operation. (Huso circular pages 15-16 on “Warranties”). The transaction agreement (pg. 14 of circular) lays out the annual profitability targets that must be met by the mine or shareholders can terminate and reverse the purchase agreement. 

• In the second scenario, the mine does reasonably well. We estimate a teens IRR on the acquisition in this case based on the minimum profitability hurdles that are outlined in the agreement.

• In the final scenario, the mine is a home run. Management believes there is a potential for the mine to 10x in volume from their initial estimates, and while the purchase price would be adjusted to some degree for this increase in volume, the purchase price does not increase anywhere close to 10x, therefore value significantly accrues to Trustco shareholders.

The following is a link to the circular: http://www.tgh.na/wp-content/uploads/2015/02/1.-TRUSTCO_HUSO-Transaction-Circular-11-Sep-15.pdf

To be clear, we do not like mining. We do not think it’s historically been a good business, but in this particular case we are comfortable because we have performance related goals for the mine over the next 10 years, and we will only be paying for performance. So this transaction is a rare case where we are comfortable with a mining asset because we realize we will only pay for actual results.

The press has taken a skeptical and somewhat one-sided view of the transaction, leaving out significant covenants and profitability targets that must be met for the deal to close. This has been a further catalyst for the selloff in the share price.

• Click here for article: “Trustco Group: No Debate On Diamond Deal”
• Click here for article: “Fine Print: The Trouble With Trustco”
• Click here for article: “Trustco Is Still Hard To Assess”

Our analysis (see below) of the transaction shows how accretive we expect the Huso transaction to be for shareholders in the base case scenario. Noteworthy, the transaction begins to be accretive at the very low end of management’s expected profitability range, and increases to about a 24% rate at the upper end of the range. Keep in mind that management expects to significantly exceed these targets, yielding a commensurately higher level of accretion.  

Conversely, should earnings not materialize as projected; the size of any payments by Trustco will be commensurately less, thus protecting shareholders’ interests. Stated another way, Quinton personally benefits from the sale of his interests in Huso only if the shareholders benefit. Additionally, any payments made to Quinton will be in the form of Trustco shares. Quinton’s alignment of incentives with Trustco shareholders underscores our confidence that he has placed all of his focus on Trustco’s overall future, not just Huso.

Following the Huso acquisition, Trustco announced that it was pursuing an acquisition of a diamond mine in Sierra Leone. Given Mr. Van Rooyen’s knowledge and experience in the region, he believes there’s an opportunity for this asset to be very sizeable and there is potentially significant investment opportunity for shareholders. Trustco’s head of resources has 25 years of operating experience in Sierra Leone, and built up a previous asset they were planning on IPO’ing for $2.5 billion USD. This asset is adjacent to the property that they just purchased, and therefore should have similar economic characteristics. While Trustco believes there is huge value in their mine in Sierra Leone, shareholders made it clear we did not want any of the risk of developing the asset. Therefore, there will be $25m USD that could potentially be spent on this asset, if it is successful, Trustco will bear the fruits of the gain, and if it is not successful, the Van Rooyen family will pay for the entire loss. Thus, the structure of the deal is somewhat similar to the Huso transaction, providing healthy minority shareholder protection.

Why The Shares Are Mis-Priced; Complicated Story: We have tried to present Trustco in as simplistic a manner as possible (but this is admittedly difficult as there are several moving pieces).  We think that many investors shy away because there are several different business lines and segments to understand. To simplify things, here is the bottom line: you are buying a collection of good businesses at 6x earnings run by a management team that through disciplined capital allocation has compounded value at a 25% CAGR for over 20 years. This is the reason to spend time on the company and understand it; we have not seen any company with similar growth characteristics anywhere in the world trade at this cheap of a multiple.

Profits Should Grow 20%+, with EPS Power Of R1.00-R1.20 in 3-4 years: We estimate Trustco will generate R1.00-R1.20 of EPS in 3-5 years. We believe Trustco has the ability to continue its historical earnings growth rate, and drive earnings growth at a 20%+CAGR over the next 5 years. The key drivers will include the following:

• Management’s goal is to sell one phase of residential property per year and one phase of commercial property every two years. Given the scarcity of available land for building in and around the capital of Windhoek, it is likely that property values will continue to rise in the foreseeable future. Our research shows that over the past 30 years, real estate prices have risen at a 6% real rate.

• Trustco’s Insurance Division should continue to see healthy growth in premiums as a result of continued demand for its funeral, hospital & life insurance products in Namibia. Noteworthy, Trustco expects to double its insurance operation in the next 3 years.

• Growth in the company’s Banking & Finance Division will be driven by healthy demand for student loans, and SME & mortgage financing. The addition of Trustco Bank Namibia will provide Trustco additional capital to grow its loan portfolio in the future. Trustco is rolling out a full service retail bank, which it will use to finance many of the homes in its property segment and also market to many of its insurance clients, creating a virtuous cycle where its property segment, insurance business, and bank cross sell services. This is particularly effective in Namibia because it is a small population where Trustco has very strong brand recognition.

• As previously discussed, we believe the Huso mining operations offer Trustco a relatively low risk growth opportunity that should be accretive to EPS over the next few years. The recent acquisition of a mine in Sierra Leone will likely have a diminutive impact on near tem profitability, but could benefit earnings in the mid-to-long term.

Attractive Valuation Should Translate Into A Healthy IRR: From our perspective, a business as diversified and rapidly growing as Trustco, with a ~20-25% ROE business model, and selling at 6. 0x TTM earnings is a rare find. We generally see high quality, high growth US based conglomerates trade at anywhere between 15x-25x earnings. On one hand, Trustco has a higher growth rate that some of these other diversified companies. However, considering Trustco’s smaller size and location, suggests a valuation discount; maybe more appropriate at the lower end of this range. As illustrated in the following valuation charts, Trustco’s valuation on both a trailing P/E and price/book value had been in the process of re-rating to levels closer to 10x-12x and 2.4x respectively, prior to the mining issue controversy. Thus, we believe the shares of Trustco have the potential to re-trace back to these levels as management begins to address the controversy tied to its mining transaction and investors better understand the details and potential upside opportunity. We also think in the longer term, as investors get more comfortable with Trustco’s consistent growth, the PE might approach that of the average JSE company in the 15-20x earnings range (even though it should trade at a premium to the JSE given the business quality). Assuming the shares trade at these previous multiples, translates into a share price in the R6.60-R6.80 range on trailing financials.

We believe the shares are selling at roughly half of the company’s SOTP intrinsic value. As illustrated in the analysis below, an appropriate way to value the shares is to value Trustco’s land holdings on a NPV basis and the company’s Banking & Finance and Insurance divisions on a P/E of near-term earnings. Adding these two pieces together adds up to a valuation of R7.20, versus the current R3.30 share price.

As stated previously, looking out 3-4 years, we believe Trustco could produce earning of R1.00-R1.20 in 3-4 years. Assuming the low end of our forecast and that company trades in the upper end of its historical P/E multiple range of 10x-12x earnings, that would translate into a share price of R10.00-R12.00. From a more optimistic perspective, should EPS come in at the upper end of our range and the stock trade at the upper end of its recent trading range the shares could trade closer to R14.00. Note, for conservative reasons and the unproven nature of the operations, we have not assumed any contribution from Trustco’s new mining operations in our forecast. Thus, any success from these operations would provide additional upside to the share price. With investors justifiably not paying for any success here, and given the put-like structure of the transaction, we would view this as a free call option at this time. Thus, even assuming the more conservative view of EPS growth and the multiple accorded the shares, this still represents about 3x appreciation over the next 3-4 years, representing a IRR of 30%+.

Potential Risks:

• Economy – Probably the biggest risk to the company achieving our growth projections would be a prolonged decline in the economy in Namibia. A decline in economic growth could impact both the pace of new home purchases and the appreciation in the value of Trustco’s land portfolio. While the Namibian economy is still vibrant and expanding, recent indications are that economic growth has been trailing behind the 5%-6% level recorded in the last few years. Given the extent of the housing shortage discussed previously, short of a recession in the country, demand for new housing should continue to grow, albeit at a more moderate rate.   

• f/x impact – Given that the Namibian Dollar is tied to the South African Rand and the shares trade on the JSE, currency translation is an issue that investors should be aware of. Beginning in the second half of 2015, the Rand, recorded a meaningful decline relative to the US Dollar, due to a softening in the South African economy and fears of a possible downgrade in the country’s debt rating. A further decline in the Rand would negatively impact returns for international investors. Thus, a hedging strategy should be contemplated. Given, the appreciation in the share price we expect, the net IRR after hedging, should still be very significant.

• Majority Shareholder – As pointed out previously, Trustco is ultimately a bet on the company’s founder and managing director, Quinton Van Rooyen, who is the majority shareholder, with a 51% ownership position. While Mr. Van Rooyen has demonstrated a track record of both good strategic decisions and being shareholder friendly, his ownership position allows him to control the direction of the company.   

Catalyst

• Continued strong growth in profitability and book value.
• Increased exposure to international investors.
• Profitability from the company's mining operations.