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Hi Caglar, welcome back, let’s get right into it: With Nigeria trading at 13x forward numbers (on 2015 estimates) and in a historic range between 8x to 12x since 2009, the market is not exactly cheap. What kind of positive expectations is the market impounding in this immediate post election period?
Thanks Alex, good to be back. Whenever I travel to Nigeria I’m always struck by the enormity of the infrastructure challenges and it’s definitely the biggest issue facing the country. The Nigerian government commissioned a report that said they will need $2.8 trillion of investment over the next thirty years, but you can pretty much put any number you want on that problem, so long as it’s a big one. Both the external and internal pressures to seriously embrace reform have been ratcheted up in the most recent election cycle and the market probably reflects those expectations. One thing is for certain, things can’t stay the way they are, hence some of the optimism. That said I’d prefer to see prices come down a bit more in order to feel comfortable with the story.
What’s the most pressing aspect of the infrastructure challenge and what’s your view there?
In a country of roughly 170 million people to have 5,000mw of electrical generation capacity, when by comparison just New York State has summer capacity of around 40,000mw for 20 million people, it’s obviously a critical problem, especially for business; forget about how tough it is on the average Nigerian. If you have a factory or commercial building, access to 15,000mw is probably a minimum requirement. As a result of this capacity problem Nigerians burn diesel fuel for power and this has created smog over most major cities and is horrendously expensive. The savings on that alone could provide a productivity boost…
… this has been a perennial problem, right? NEPA (Nigeria’s National Electric Power Authority) was known by the people as “Never Expect Power Always” and when they changed their acronym to PHCN in 2014, the people changed their slogan to “Problem Has Changed Name”.
Absolutely. In fact, it was high on the agenda for the Jonathan administration as well and ultimately went nowhere, which is part of the reason for caution this time around. A good start would be passing an energy bill that is friendly to foreign investment. There are early indications that Buhari is enthusiastic about public-private partnerships, which is positive, but we need more concrete elements to point to in order to feel genuine optimism on the issue.
Since November the Naira has dropped from about 168 to 198 per USD, is further Naira devaluation priced in? If not, what impact will that have on the market, as well as inflation and consumer spending?
Good question. The gap between the official rate and the black market rate has narrowed considerably in part due to oil price stabilization but also talk surrounding a “new era”, but markets probably expect an additional 10% devaluation. Inflation may go up because of the devaluation but because the economy is slow it doesn’t seem like it will be a major, “sticky” type of inflation. By the beginning of next year I think there is a possibility that they we might even see lower rates from the central bank. Consumer spending will certainly be depressed in the current environment due to lower subsidies and higher taxes and that combined with some inflation is a negative for consumer product companies – there are some that continue to sport hefty valuations without much margin of safety. I’d be a little cautious on the bearish story though simply because most of the consumption comes from consumer staples. For an economy continuing to grow in real terms, 10-15% inflation is not a shock, it’s something that the average Nigerian has dealt with in the past. However, one variable that is currently being talked about that might spell pain for brewers in particular is the current excise tax. Nigerian brewers currently get taxed at 7%, while the rest of Africa, for example Zimbabwe and Kenya, get taxed at 15-50%. Given some of the fiscal issues the administration faces, it would be an obvious area for them to look. In addition, there is talk of introducing GST, all of which will pressure the more vulnerable consumer product companies.
For the first time Nigeria is facing the ugly prospect of twin deficits in both its fiscal position and current account? Seems like the market is pricing this in as a blip rather than a sustained downward trend, is that an appropriate assumption?
At $55 oil, Nigeria is expecting a 2-3% budget deficit in 2015 and around the same with its current account deficit at roughly 2.5% to 3%. These are not huge adjustments. The recent stabilization in oil prices has also firmed up some assumptions about Nigeria for the year, but we’re cautious about this as we could see some continued erosion in oil prices in the short to intermediate term. Government fiscal consolidation may cause further slowdown in the economy as well.
Nigeria seems to have some problems that never disappear from the scene. Fractious politics, the boko-haram insurgency and lawlessness in the oil-producing Niger delta are all sources of constant instability. Any sustained peace on these fronts is really tied to prolonged economic development. How does this play out?
My sense is that Buhari is picking advisors that are quite market friendly and emphasizing public-private partnerships. Although he comes from a military background he knows he needs a strong private-sector team. In his first go-around, as essentially a military dictator in the 80s, he gained a reputation for being a strong leader, but also untouchable from a corruption standpoint. His transition team is already reaching out to big business. If evidence continues to emerge that this administration will adopt a pro-business orientation it could be a powerful driver for the market. The sheer number of improvements from first generation reforms, historically frustrated by entrenched interests, is really immense. Just building a road will add to GDP and create jobs. Swapping some agricultural and even refined hydrocarbon imports for local production is all in the cards. All the hot button election issues, whether it’s infrastructure, transparency, governance or fighting terrorism seem to be on Buhari’s “first 100 day” agenda. And so far, he’s been able to cobble together an APC party that is really fragmented, with many different voices. However, it will be a challenge to keep everyone in line and moving forward.
Speaking of hot button political issues, we haven’t broached the subject of the oil price decline, subsidies and the tremendous corruption “uncovered” at the Nigerian National Petroleum Company (NNPC). How is this impacting the fiscal agenda?
I don’t know if you caught the FT piece by Lamido Sanusi recently. He was obviously suspended from his position during the Jonathan regime after shedding some Jeffersonian light on all the corruption at NNPC. The PwC report was ambiguous enough to provide some cover for Jonathan, even though critical questions and accounting assumptions were not answered by the authorities, but Sanusi put a number on the corruption figure in the FT piece at $10-15 billion over a random 19-month period. That gives us some concrete figures to consider if this “leakage” can be plugged up under Buhari and could offset some of the fiscal pressures of the oil price decline if successful. As you know the fiscal budget is set on the calendar year and the Jonathan regime already removed the fuel subsidy from the budget. It’s a good time to remove the subsidy with the oil price drop and many other countries have taken advantage of this, including India, Pakistan and Indonesia. One big risk to the Nigeria story, of course, is further deterioration in oil prices. Again though, the biggest hit to the consumer in Nigeria is what they pay for diesel power to run electricity, not necessarily what they pay at the pump for transportation. The people around Buhari have stated that his number one priority hitting the ground is addressing corruption and fixing the NNPC. A possible downside here is that Buhari spends all his energy and time combating corruption, shortchanging a necessary infrastructure focus.
In some shape or form, oil seems to insinuate itself into the investment story. This includes the banking industry where many loans to the oil and gas segment face restructuring. How are you currently viewing the banking industry in Nigeria?
Banks are one liquid way to access the Nigerian consumer. However, there is a big divide between the five largest banks and all the rest. Consolidation since 2008 has shrank the industry, but only a little, Nigeria is in the unusual situation of being underpenetrated from an overall credit standpoint but still overbanked generally. With regard to energy, the small-to-mid size banks are suffering because they tend to also have small-to-mid size customers; the large corporates usually go with the large banks. Electricity and oil and gas represent between 20-30% of the Nigerian bank loan book, so big restructurings in the energy portfolio are meaningful. While budget cutting in the E&P segment is a risk, just like the rest of the world, midstream and downstream are suffering the most right now in Nigeria because they rely heavily on government funds and smaller banks are bearing the brunt of it. Large banks dedicate only 2-3% of their loan book to this area — with plenty of capital buffers and provisioning to cover in the event of problems. If oil drops further due to increasing supply, say if an Iran deal comes to pass, then bank npls will rise. Over the summer, the government could also force banks to conduct stress tests. The segment would definitely take a hit under these scenarios and there could be an opportunity to selectively accumulate some strong names at decent valuations.
Alexander Schay is a Managing Director at Ultima Thule, an equity research company focused on developing markets and an equity partner at WK Associates, a boutique energy consulting firm with a specialization in emerging market oil and gas.
Alex holds both an MS in Risk Management and an MBA from the Stern School of Business at New York University.