Acquisition of Ellerine Holdings Limited (“Ellerines”)

ACQUISITION OF ELLERINE HOLDINGS LIMITED (”ELLERINES”) – NET ASSET VALUE AS AT EFFECTIVE DATE (INCLUDING ALIGNMENT OF ACCOUNTING POLICIES) AND PURCHASE PRICE ALLOCATION
Introduction
This announcement has been released in order to give investors an insight into the acquisition date financial statements of Ellerines and to provide a more meaningful understanding of the effect that Ellerines will have on the interim results of the consolidated ABIL group to be published on 26 May 2008. 
 
The acquisition date of Ellerines has been set at 7 January 2008, being the nearest practical Ellerines month-end to when ABIL gained effective control of the Ellerines group. As a result, the ABIL group will consolidate the Ellerines balance sheet into its financial statements as at the above date, and will include three months of Ellerines earnings into its interim results for the six month period to 31 March 2008. 
 
The process in determining the acquisition date financial statements has involved the following steps: 
1.   The preparation of the Ellerines financial statements for the four month period from 31 August 2007, being its last published year end, to 7 January 2008, based on the consistent application of the accounting policies of the Ellerines group. 
2. Adjustments applied to the Ellerines financial statements as at 7 January 2008 in order to align them with ABIL’s accounting policies. 
3. The calculation of the purchase price based on the issue of ABIL shares in exchange for 100% of the Ellerines ordinary shares. 
4. The application of IFRS 3 – Business Combinations, in order to determine the allocation of the purchase price to the acquired assets and liabilities and residual goodwill. 
 
The following sections contain a detailed description of the above steps and the attached annexures reflect the financial effects thereof. 
1.   Financial statements of Ellerines for the four month period ended 7 January 2008.
  Ellerines last published financial statements were for the 12 months ended
31 August 2007, in which the net asset value, including intangible assets and goodwill, was reported as R5 160 million. During the four month period ended 7 January 2008, using consistently applied Ellerines accounting policies, the group earned a net profit after tax of R406 million. In addition, a net dividend of R135 million (117.3 cents per share final dividend for 2007) was paid and there was a further R9 million reduction in reserves for items charged directly to equity. This resulted in an increase in the net asset value for the four month period to 7 January 2008 of R262 million to R5 422 million, prior to realignment of the accounting policies and the application of IFRS 3.
2. Adjustments for the realignment to ABIL’s accounting policies
  ABIL has conducted a detailed review of the Ellerines accounting policies and the application thereof, and has made a number of adjustments to the financial statements as at 7 January 2008, in order to bring these in line with ABIL’s accounting policies. The adjustments set out below are included on the attached annexures below which reflects their impact on the Ellerines consolidated balance sheet as at 7 January 2008.
  a)   Insurance income recognition – pre introduction of the National Credit Act (“NCA”)
    Prior to the introduction of the NCA, credit life and product insurance was charged as a single upfront premium and this was capitalised into the debtors loan account and repaid by the customer over the term of the loan. A major portion of the premiums received by the insurance company were then reinsured, and based on Ellerines’ interpretation of this reinsurance policy, a significant portion of the premium income was recognised immediately as revenue.
     
    ABIL, at the time of the due diligence, reviewed the terms of the reinsurance contracts, and was of the view that the nature of these contracts were more akin to stop loss / catastrophe cover, and in substance very little underwriting risk is transferred to the reinsurer. Consequently, since Ellerines retains nearly all the underwriting risk, ABIL believes that the insurance premiums should be amortised over the term of the policies. The effect ofthis change is to reverse a portion of the income previously recognised, by raising a provision of R339 million for unearned premiums, based on the unexpired portion of the premiums as at 7 January 2008. Since no new single premium policies were issued after the introduction of the NCA, this unearned premium provision will unwind through the income statement over the remaining 15 month average term of the policies.
  b) Insurance income recognition – post NCA
    The NCA requires that credit life and short term product insurance policies be based on monthly premiums charged over the term of the underlying credit agreement. Thus whilst the insurance company has a conditional contract for a future string of premiums, the debtors account will only be charged for premiums as and when they fall due.
     
    Ellerines entered into reinsurance contracts for the total future premiums and recognised the majority of these future premiums as revenue. As a consequence, a receivable (actuarial insurance asset) was created against which the future premiums would be set off as and when they were received. Based on ABIL’s interpretation of the reinsurance contracts as set out above, the acquisition date financial statements of Ellerines have incorporated an adjustment of R628 million, being the reversal of the actuarial insurance asset, thereby derecognising the unearned premium income. Given that VAT was paid on the income previously recognised, a consequential change is the creation of a VAT receivable asset of R124 million.
     
    The net effect of the adjustments in paragraphs 2(a) and 2(b) reinstates the future income stream on all insurance policies, such that there is a constant yield earned over the term of a loan agreement and related insurance policy, rather than the previously front-end skewed income profile. Due to the short-term nature and wide diversification of the insurance portfolio, ABIL has traditionally not considered it appropriate to enter into reinsurance contracts within its insurance subsidiary, and accordingly in line with this principle Ellerines has cancelled all reinsurance arrangements with effect from the end of March 2008.
  c) Income recognition – loan origination fees
    Ellerines charges an origination fee on all credit agreements, as contemplated under the NCA, and recognised the income upfront on origination of the loan. ABIL charges similar origination fees for its loans granted, but raises a deferred administration fee provision, which is then amortised over the term of the loan such that this income is recognised as an effective yield over the term of the loan.
     
    In order to align this accounting policy, the acquisition date financial statements incorporate a provision for deferred administration fees of R109 million as at 7 January 2008, with a related deferred tax asset. All origination fees raised after 7 January 2008 will be accounted for on an effective yield basis, and thus the provision for deferred administration fees will roll forward in proportion to the advances book on which these fees are raised.
  d) Provisions for doubtful debts
    ABIL has conducted a detailed evaluation of the underwriting models and loan portfolio as at 7 January 2008, compared to the view that was obtained at the time of the due diligence, including vintage charts and collection data on a basis similar to that which ABIL uses.
     
    During this process, and evident from the vintage charts, it has become clear that, as a result of changes to the underwriting models introduced at the time of the NCA, the probability of default on loans written by Ellerines post-NCA has risen sharply. In addition to this, cash collection rates in Ellerines have also fallen during the period leading up to December 2007.
     
    Accordingly, a detailed evaluation of the adequacy of provisions on impaired loans was performed, using ABIL’s IAS 39 provisioning models.
     
    The Ellerines IAS 39 provisioning models are less conservative than ABIL’s in that they are slower to reflect the impact of a deterioration in cash collections and the discount factor used to present value the expected cash flows needs to incorporate the total yield earned on a loan (as adjusted above), rather than just the interest rate earned on a loan. As a result, the acquisition date financial statements contain a further increase of R340 million in provisions for impaired loans.
  Since gaining control of the Ellerines business, ABIL has implemented certain initial underwriting changes to correct the high default rates that emerged in the second half of 2007, and expects benefits from these to begin to feed through during the latter part of the 2008 financial year. 
3. Calculation of the purchase price
  The acquisition of Ellerines was based on an equity-for-equity exchange, and therefore in accordance with IFRS 3 – Business Combinations, the fair value of the purchase consideration needs to be determined.
   
  The total purchase consideration of 306 263 893 ABIL ordinary shares was split into two parts, namely 294 706 784 ABIL ordinary shares issued to Ellerines shareholders, and a further 11 557 109 ABIL ordinary shares reserved for issue to facilitate a BEE programme similar to ABIL’s.
   
  In accordance with IFRS 3, the ABIL share price on the acquisition date, was R31.01, and therefore the fair value of the purchase consideration for the 294 706 784 ABIL ordinary shares issued to Ellerines shareholders was R9 139 million. In addition, costs borne by ABIL in relation to the acquisition of Ellerines of R24 million will be allocated to the purchase price.
   
  In substance the 11 557 109 reserved BEE shares formed part of the gross purchase consideration offered to Ellerines shareholders and were sacrificed by them in order to facilitate a BEE programme in favour of Ellerines stakeholders. However, since there was no irrevocable committment to issue the reserved BEE shares to known parties prior to the acquisition date, these shares will fall within the scope of IFRS 2 (Share based payments), when issued.
   
  As a result, when the BEE reserved shares are issued during the second half of the current financial year, the fair value of these shares as determined at the time of issue will be recorded as an expense through the income statement with the corresponding credit to shareholder equity, and thus has no effect on the net asset value of ABIL.
4. Purchase price allocation in terms of IFRS 3 – Business combinations
  In terms of IFRS 3, when allocating the purchase price (as calculated above), certain adjustments are required to be made to the balance sheet of Ellerines on the acquisition date in order to consolidate the entity into ABIL’s group financial statements and calculate the resulting goodwill on acquisition. The primary steps relevant to Ellerines to complete this exercise were to;
  Prepare a consolidated balance sheet for the Ellerines group as at 7 January 2008, being the acquisition date. 
  Value all the assets and liabilities on the balance sheet at their fair values as at the acquisition date. 
  Recognise as an asset all identifiable intangible assets that meet the definition of such in terms of IAS 38 – Intangible assets. 
  Recognise as a liability all contingent liabilities, where the fair value of that contingent liability can be reliably measured. 
  Recognise goodwill as an asset, being the excess of the fair value of the purchase price over the net asset value of Ellerines, after making the above adjustments. 
  The adjustments set out below are included on the attached annexures, which reflects the impact of these preliminary adjustments on the Ellerines consolidated balance sheet (adjusted for accounting policy alignment) as at 7 January 2008. In terms of IFRS 3, ABIL has a period of 12 months from date of acquisition to finalise the determination of these adjustments. Some of these adjustments are best estimates at this stage based on determinations which are still in the process of being finalised. 
  a) Fair value of assets and liabilities
    i)   Owner occupied properties have been increased by R93 million to reflect the market valuation of these properties as at the acquisition date and a corresponding deferred taxation liability of R26 million has been raised. Future depreciation charges will be based on the increased valuations. 
    ii) In terms of IFRS, existing property leases must be evaluated at current market rentals and an asset or liability created to reflect the present value of the differential rental over the remaining term of the lease. In Ellerines’ case, certain leases are currently below equivalent market rentals and accordingly an asset of R94 million has been raised, with a corresponding deferred taxation liability of R27 million. This asset and deferred tax liability will be amortised through the income statement over the remaining term of the leases. 
    iii) As discussed in paragraph 2(d) above, ABIL’s analysis of the loans underwritten during the period from June 2007 to December 2007 indicate a higher level of expected default than that which was assumed in the Ellerines underwriting and pricing models.
       
      ABIL anticipates that the actual credit losses that will emerge out of this portfolio will be approximately 10% higher than previous levels and those assumed in the pricing models. Loans that have already defaulted are included in NPLs and therefore the IAS 39 provisioning model has been updated to take into account the lower expected cashflows. 
  However, loans that are classified as performing do not carry full provisions and therefore these known but future losses will only be recognised in future periods. Accordingly, ABIL has made a further fair value adjustment to the carrying value of performing advances of R403 million, based on a detailed model evaluating future expected cashflows and comparing these to the underwriting assumptions.
   
  This fair value adjustment will be netted off against gross advances and amortised over the remaining term of the performing portfolio. The effect of the above adjustment ensures that the carrying value (after impairment and fair value adjustments) of the loans acquired on the 7 January 2008, will earn a market related yield to maturity. 
  b) Intangible assets
    i) The Ellerines consolidated balance sheet contains trademarks of R311 million raised on the purchase of Relyant, which were deemed to have an indefinite life. These have been reversed and the total trademark values for all businesses within Ellerines have been provisionally evaluated for the purposes of the ABIL purchase price allocation. 
    ii) ii) Valuations of all the brands within the Ellerines group are being conducted by external experts and accordingly a provisional asset of R1 002 million has been raised. In addition, in terms of IFRS 3, a deferred tax liability of R291 million has been raised against these trademarks. The trademarks (together with related deferred tax) will be amortised through the income statement based on their estimated useful lives which ranges between 10 and 15 years (an average life of 12.5 years). Should the final valuations and the audit thereof reveal any differences from the above provisional value, adjustments will be made at the year-end with a corresponding adjustment to goodwill. 
  c) Contingent liabilities
    Contingent liabilities, as defined under IAS 37 – Provisions, contingent liabilities and contingent assets, of R75 million have been raised as at 7 January 2008, together with a related deferred tax asset of R14 million. 
  d) Residual goodwill on acquisition of Ellerines
    After adjusting for the above items, the net asset value of Ellerines as at 7 January 2008, as reflected on the attached annexures, was R4 604 million. Against the purchase price of R9 163 million, the goodwill arising from the acquisition of Ellerines is R4 559 million in addition to the historic goodwill of R767 million recorded in the Ellerines balance sheet as at 7 January 2008. 
   
  Conclusion
  The above adjustments, with the exception of the increased impairment provisions, were anticipated at the time of the acquisition, and have resulted in the establishment of a base for the accrual of income earned from financial assets. The increased impairment provisions raised over and above that considered necessary at the time of the due diligence, have resulted in the net asset value of Ellerines on the acquisition date financial statements being approximately R450 million lower than that which was previously envisaged, and consequently the goodwill is higher by the equivalent amount. The adjustments contained in this document creates the platform to enable the measurement of the financial results of the Ellerines business since its acquisition on a basis consistent with that of ABIL. 
 
This announcement is available on the African Bank Investments Limited website at http://www.africanbank.co.za.
 
CONFERENCE CALL
Leon Kirkinis, ABIL’s CEO, will conduct a conference call for investors, fund managers and analysts on Wednesday 07 May 2008. The conference call will take the form of a short walk through of the announcement, followed by questions. 
 
CONFERENCE CALL TIMES
South Africa: 16:00pm
United States: 09:00am Eastern Time
United Kingdom: 14:00pm
 
Access numbers for participants dialling from their country:
South Africa Toll 011 535 3600
  Toll Free 0800 200 648
United States Toll 1 412 858 4600
  Toll Free 1800 860 2442
United Kingdom Toll Free 0800 917 7042
 
PLAYBACK
A replay of the recording will be available for 48 hours should you be unable to participate in the call and wish to listen to the trading update.
 
To access the replay please call:
South Africa +27 11 305 2030
Code 2134#
USA 1 412 317 0088
Code 2134#
UK 0808 234 6771
Code 2134#
 
Midrand
7 May 2008
 
Sponsor
RAND MERCHANT BANK (A division of FirstRand Bank Limited)
 
ANNEXURE A:
Ellerine Holdings Limited
Reconciliation of net asset value from 31 August 2007 to 7 January 2008 (acquisition date) 
 
R’million Gross Less taxation effect Net
Net asset value as at 31 August
2007
    5,160
Normal trading movements – 4
months to 7 January 2007
    262
Net profit for the period     406
Dividends distributed     (135)
Other movements in statement of changes in equity     (9)
Adjustments to align Ellerines accounting policies (1,416) 411 (1,005)
Insurance income recognition – pre
NCA loans
(339) 98 (241)
Insurance income recognition – post
NCA loans
(628) 182 (446)
Income recognition – loan
origination fees
(109) 32 (77)
Provisions raised on impaired loans (340) 99 (241)
Net asset value before PPA
adjustments
    4,417
Purchase price allocation
adjustments
400 (213) 187
Fair value adjustment for land and
buildings
93 (26) 67
Fair value adjustment for operating
leases
94 (27) 67
Fair value adjustment for
performing advances
(403) 117 (286)
Intangible assets (trademarks and customer relationships)      
Reversal of carrying value in Ellerines (311)   (311)
Fair value of intangible assets
recognised
1,002 (291) 711
Provision for contingent
liabilities
(75) 14 (61)
Net asset value as at 7 January
2007 (acquisition date)
    4,604
 
 
Calculation of purchase price and goodwill R’m
Purchase price  
No of share issued (excluding BEE
reserved shares)
294,706,784
ABIL ordinary share price on date
of acquisition (Rands)
31.01
Fair value of purchase consideration 9,139
Capitalisation of ABIL’s
acquisition costs
24
Total purchase consideration 9,163
Net asset value of Ellerines on
acquistion date
(4,604)
Goodwill arising on the acquisition
of Ellerines
4,559
 
 
ANNEXURE B:
Ellerines Holdings Limited
Consolidated balance sheet walkforward from 31 August 2007 to 7 January 2008 (acquisition date) 
 

R million
Consolidated Normal
Balance
sheet as at 31 Aug 07
Consolidated Pre-trading Movements fot the 4 months to 7 Jan 08 Balance sheet as at 7 Jan 08 (before adjustments) Acquisition adjustments to align accounting policies Consolidated Balance sheet as at 7 Jan 08
Assets          
Property and equipment 403 7 410   410
Goodwill 767   767   767
Intangible assets
(Trademarks etc)
311   311   311
Deferred tax asset 87 (84) 3 411 414
Inventories 598 212 810   810
Net advances 4,995 1,007 6,002 (1,540) 4,462
Gross advances 5,569 1,233 6,802 (1,091) 5,711
Deferred administration fees       (109) (109)
Impairment
provisions
(574) (226) (800) (340) (1,140)
Other assets 159 (14) 145   145
Taxation 3 (3) 0   0
Statutory assets -
bank and insurance
505 73 578   578
Short-term
deposits and
cash
160 (87) 73   73
Total assets Liabilities and equity 7,988 1,111 9,099 (1,129) 7,970
Bonds and other
long-term funding
457 (4) 453   453
Short-term
funding
885 367 1,252   1,252
Trade payables
& other liabilities
1,235 386 1,621 (124) 1,497
Deferred tax
liability
151 (50) 101   101
Taxation 100 150 250   250
Total
liabilities
2,828 849 3,677 (124) 3,553
Ordinary
shareholders’
equity
5,160 262 5,422 (1,005) 4,417
Total
liabilities
and equity
7,988 1,111 9,099 (1,129) 7,970
 
 
R million Consolidated Balance sheet as at 7 Jan 08 Purchase price allocation adjustments (IFRS3) Consolidated Balance sheet as at 7 Jan 08 (ABIL take on position)
Assets      
Property and equipment 410 93 503
Goodwill 767   767
Intangible assets (Trademarks etc) 311 691 1,002
Deferred tax asset 414 131 545
Inventories 810   810
Net advances 4,462 (403) 4,059
Gross advances 5,711 (403) 5,308
Deferred administration fees (109)   (109)
Impairment provisions (1,140)   (1,140)
Other assets 145 32 177
Taxation 0   0
Statutory assets – bank and
insurance
578   578
Short-term deposits and cash 73   73
Total assets 7,970 544 8,514
Liabilities and equity      
Bonds and other long-term
funding
453   453
Short-term funding 1,252   1,252
Trade payables & other liabilities 1,497 13 1,510
Deferred tax liability 101 344 445
Taxation 250   250
Total liabilities 3,553 357 3,910
Ordinary shareholders’ equity 4,417 187 4,604
Total liabilities and equity 7,970 544 8,514
 
Date: 07/05/2008 07:01:02
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AFRICAN BANK INVESTMENTS LIMITED
(Incorporated in the Republic of South Africa)
(Registered bank controlling company)
(Registration number 1946/021193/06)
Ordinary share code: ABL ISIN: ZAE000030060
Preference share code: ABLP ISIN: ZAE000065215
(”ABIL”)