A value driver analysis

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APPENDICES TO

ABSA GROUP LIMITED

A value driver analysis

Appendix I to XI

Johannesburg, August 2005

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Absa Group Limited – A value driver analysis

This appendix gives an overview of Absa’s business units and shows the structure of the business units, which are evaluated in this research. Therefore this is not the complete structure of Absa Group Limited.

The Absa Group consists of business units primarily serving the personal, commercial and wholesale markets in South Africa. Approximately a decade ago, Absa segmented its market. The objective of this exercise was to understand customer attributes and tailor offerings to the Group’s identified segments. The segments identified were:

ABSA GROUP LIMITED

Commercial Banking Personal

Banking

Wholesale Banking

African Operations

Financial Services

Other Group Activities

*Absa Private Bank

*Personal Financial Services

*Retail Banking Services

*Flexi Banking Services

*Absa Home Loans

*Absa Card

*Small Business

*Meeg Bank Limited

*Business Banking Services

*MLS Bank Limited

*Absa Vehicle and Asset Finance

Domestic

*Absa Corporate and Merchant Bank

International

*Absa Bank London

*Absa Bank (Asia) Limited

*Bankhaus Wölbern & Co

*Absa Bank Singapore

*Banco Austral, Sarl

*National Bank of Commerce Limited

Life assurance Short-term insurance Advisory services Wealth management

*AllPay Consolidated Investment Holdings (Proprietary) Limited

Appendix I Structure of Absa Group Limited

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1. Personal Segment 2. Commercial Segment 3. Wholesale Segment 4. African Operations 5. Financial Services 6. Other Group Activities

Each of these segments consists of business units (SBU). According to Scott [1998] a SBU can be defined as a business where the nature of customer demand and the skills or competencies necessary to satisfy that demand are distinct.

Personal segment

Absa is a leading player in South African personal banking. The Group had about 6,1 million customers in this market segment in September 2004

¹

.

It has an extensive delivery reach, encompassing both physical and electronic delivery channels, and it provides a full array of products and services ranging from off-the-shelf savings products to tailored financial solutions for high net worth individuals.

The personal market can be divided into segment-focused SBUs and product-focused SBUs. The segment-focused SBUs are:

• Absa Private Bank (Private), that serves the high net worth market, with clients that have net investable assets of in excess R10 million per year

• Personal Financial Services (PFS), that serves the affluent market, with clients that have an income of R400 000 or higher per year

• Retail Banking Services (RBS), that serves the middle market, with clients that have an income of R4000 or higher per month

• Flexi Banking Services (Flexi), that serves the mass market, with clients that have an income of R4000 or less per month

• Small Business, that deals with small businesses, with a turnover of up to R5 million, and/ or facilities of up to R500 000

• MLS Bank Limited, that caters for the financial services needs of the medical industry

• Meeg Bank Limited, that provides a comprehensive range of banking and financial services to the personal market, small and medium sized corporates and the public sector in the Eastern Cape

The product-focused SBUs are:

• Absa Home Loans, that offers innovative residential property-related ownership solutions to Absa’s target market segments

• Absa Card, that provides global card acceptance, electronic payment and

financial solutions in selected market segments to individuals and businesses

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Commercial segment

The commercial market is an important component of the Group's franchise. Absa enjoys a dominant market position in agribusiness, public sector financing, new-enterprise banking, franchising and the pre-owned vehicle market.

As with the Personal segment, the commercial market can be divided into segment- focused SBUs and product-focused SBUs.

The segment-focused SBUs are:

• Business Banking Services (BBS), that deals with medium sized businesses, with a turnover of between R5 million and R50 million and/ or facilities of between R500 000 and R5 million

• Business Banking Services (BBS), that deals with large businesses, with a turnover in excess of R500 000 and/ or exposure of higher than R5 million (up to the point where ACMB addresses a company’s financial needs)

The product-focused SBU is Absa Vehicle and Asset Finance (AVAF) that offers customized products and services, ranging from tax-efficient finance and insurance to structured finance solutions to suit a customer’s particular needs.

Wholesale segment

Absa's wholesale banking operations offer financial solutions to the domestic corporate market and provide selected financial products and services in niche international markets, as well as institutional asset management. This business unit focuses on the industry types in the corporate market. The wholesale banking operations consist of domestic operations and international operations.

The domestic operations SBU is Absa Corporate and Merchant Bank (ACMB).

The international operations SBUs are:

• Absa Bank London in the United Kingdom

• Absa Bank Singapore in Singapore

• Absa Bank Asia Limited in Hong Kong

• Bankhaus Wölbern & Co in Germany

African operations

Absa's African operations offer personal and commercial banking as well as financial products and services to a broad customer base through an extensive branch network, agencies and ATMs. The banks are situated in major cities and rural communities, in keeping with the social and business imperatives of providing banking services to the majority of the population.

The Group presently has interests in four banks outside the borders of South Africa.

• Tanzania: National Bank of Commerce Limited (NBC)

• Mozambique: Banco Austral, Sarl

• Namibia: Capricorn Investment Holdings Limited (of which Bank Windhoek is a subsidiary)

• Zimbabwe: Commercial Bank of Zimbabwe Limited

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Financial services

Absa's financial services arm houses the Group's assurance, insurance and wealth management operations. These financial services offerings are provided to Absa customers via a well entrenched and fully integrated bancassurance model. The bancassurance model facilitates the seamless provision of plain vanilla insurance products of Absa companies to the bank’s customers. The sale of complex products is done by a broker force of 1600 selling best-of-breed products to ensure the fulfillment of customers’ needs.

Other Group Activities

Absa has a number of divisions that do not provide banking or financial services. The Group reports these divisions under "other Group activities". This section includes strategic subsidiaries or associates that are managed at Group level, shared services and specialist functions.

The majority of the divisions in this section assist segment- and product-focused SBUs in

achieving their goals and objectives while ensuring continuous alignment with corporate

and functional strategies. Because of the fact that the divisions cannot be seen as SBUs,

we leave them out of the research, except for one, namely Allpay Consolidated

Investment Holdings (Proprietary) Limited. This subsidiary will be evaluated and her

financial performance will be measured in chapter 6.

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This appendix shows the strategic migration map that Absa has developed. In this map various strategic programmes are described. For the various Key Success Factors (KSF) there are programmes in place to support these KSFs. Every year there must be completed a certain part of a programme. Therefore the years 2006, 2007 and 2008.

It is stated that ‘Absa must take advantage of low hanging fruits and focus on long term growth and sustainability’

True Efficiencies in the CoreDiversificationCustomer CentricityBEE

• Implement Black Market Strategy to achieve leadership position and comply with FSC

• Develop the wholesale franchise into a significant contributor to the Group

• Organise and build a coherent wealth management business

• Strengthen and create innovative and value added solutions in the public sector sub segment

• Shape the wholesale bank into a consistent contributor to Group

• Streamline and achieve customer perceived efficiencies in the business value chain e.g. Credit approval in high value areas and fulfilment turnaround times

• Develop and improve performance management system linking rewards to customer service and economic value-add

• Attract and motivate diverse groups of top employees

• Build an acquisition pipeline and internal projects for deployment of excess capital

• Implement the Absa- Barclays integration both Phase 1 and Phase 2

• Enhance operational risk management

Now

Future

Lion of Africa Future Positioning

Capital and Risk management Human Capital Mgt. -

Leadership, talent and skills

F2007

F2006 F2008

• Maintain focus on CPF, public sector, liability income in BBS and develop a growth strategy for BBS

• Detail planning for the ABSA-Barclays integration

• Continue the acquisition of banks in the rest of Africa

• Perform internal business portfolio analyses

• Perform macro environmental and industry reviews to reveal key business drivers and levers

• Search for opportunities and make appropriate decisions timely

• Put more capital at risk in the incubation mechanism in the commercial bank and SMEs

• Leverage further business from the business already captured in the incubator fund

• Build transactional platform capability in wholesale and commercial banks

• Locking in our black customer base through innovation and cross selling

• Implement Retail Banking Programme to achieve leadership position to maintain leadership in the retail banking franchise (to grow market share)

• Intensify cross sell to maximise share of wallet by using more customer information analytics (data mining)

• Create differentiation through customer experience

• Appropriate and timeous management of capital to maximise ROE (dividend cover, preference shares, share buy backs, etc.)

• Continuous efficient deployment of capital using RAROC principles

• Dynamic risk management and leveraging off Basel II

• Improve training programme especially for banking skills and customer service

• Continued leveraging off our distribution network and establishing footprint where the markets are

• Continuous market segmentation and provide solutions anchored around core banking products

• Continuous innovation and renewal within the core

• Expansion into the areas adjacent to the core organically and through alliances/JVs

• Eliminate duplication through integrating the back office processes and getting the basics right in key product areas Homeloan, Card, Payments, AVAF

• Grow bancassurance franchise

• Entrench an image of diversity to create ethnic loyalty

• Develop early warning systems in order to see the future before it happens

• Continuous challenging of strategic assumptions

• Ensure that the Barclays transaction is successful - but should it fail, search for alternatives

• Sweat the assets

•Leading FS player in A frica

• Achieve black market leadership and dominance

• The most admired bank and the bank of choice

•Optimal capital + optimal risk appetite = superior rew

ards

• M agnet for talent

• Balanced business portfolio irons out cyclicality

• Running a large but sleek and cost efficient banking operation

•Absa ag ain positioned ahead

of

the cu rve

• Implement Basel II programme

• Implement the Corporate Performance Management programme

• Cost growth containment

• Retain and improve the quality and depth of leadership at senior management

• Create a working climate that retains and rewards top performers

• Continue implementing the current Absa Africa strategy

Appendix II Strategic migration map

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Drivers of change Calculation

Incremental value added Value added 2005 – value added 2004

Net asset growth Asset growth + change in average capital

Asset growth (Average assets 2005 – average assets 2004) x ROA 2004 Change in average capital due to

average asset growth

(Average assets 2005 – average assets 2004) x cost of equity 2004 x capital adequacy ratio 2004

Change in average capital due to a change in the capital adequacy ratio

(Capital adequacy ratio 2005 – capital adequacy ratio 2004) x average assets 2005 x cost of equity 2004 Average assets Total assets employed - client liabilities under acceptance Capital adequacy ratio Shareholder funds/ Average assets

Cost of equity Beta x market risk premium x risk free rate

Change in profitability (ROA 2005 – ROA 2004) x average assets 2005 Net interest (Net interest margin 2005 – net interest margin 2004) x

average assets 2005

Composition change of deposits

/ advances

(Composition change 2005 – composition change 2004) x average assets 2005

Pricing impact of advances (Pricing impact of advances 2005 – pricing impact of advances 2004) x average assets 2005

Pricing impact of deposits (Pricing impact of deposits 2005 – pricing impact of deposits 2004) x average assets 2005

Other (Other 2005 – other 2004) x average assets 2005

Non interest (Non-interest margin 2005 – non-interest margin 2004) x average assets 2005

Fees (Fees 2005 – fees 2004) x average assets 2005

Insurance related income (Insurance related income 2005 - Insurance related income 2004) x average assets 2005

Trading in knowledge-based income (Trading in knowledge-based income 2005 - trading in knowledge- based income 2004) x average assets 2005

Investment income (Investment income 2005 - Investment income 2004) x average assets 2005

Credit impairments (Credit impairments 2005 - Credit impairments 2004) x average assets 2005

Operating expenditure (Operating expenditure 2005 - Operating expenditure 2004) x average assets 2005

Appendix III Calculation of the drivers of change

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This appendix explains the sensitivity analysis that is shown in chapter 5. In that chapter, graph 5.6 shows the sensitivity of the value drivers.

Effect in incremental value added due to a percentage change in the value drivers

In 2006 1% 10% 20% 50% -1% -10% -20% -50%

Operating expenditure -3.72% -3.72% -3.38% -3.00% -1.88% -3.79% -4.13% -4.51% -5.63%

Value added (Rm) 2177 2285 3260 4343 7592 2068 1094 11 (3238)

Incremental value added 108 1083 2166 5415 (109) (1083) (2166) (5415)

Non interest margin 3.37% 3.40% 3.71% 4.04% 5.05% 3.33% 3.03% 2.69% 1.68%

Value added (Rm) 2177 2274 3148 4120 7035 2079 1205 233 (2682)

Net interest margin 3.07% 3.10% 3.38% 3.68% 4.61% 3.04% 2.76% 2.46% 1.54%

Value added (Rm) 2177 2265 3062 3948 6604 2088 1291 406 (2251)

Cost of equity 15.20% 15.05% 13.68% 12.16% 7.60% 15.35% 16.72% 18.24% 22.80%

Value added (Rm) 2177 2217 2575 2974 4170 2137 1778 1379 183

Capital Adequacy Ratio 6.88% 6.81% 6.19% 5.50% 3.44% 6.94% 7.56% 8.25% 10.31%

Value added (Rm) 2177 2217 2575 2974 4170 2137 1778 1379 183

Average Assets (Rm) 381433 385247 419576 457720 572150 377619 343290 305146 190717

Value added (Rm) 2177 2198 2394 2612 3265 2155 1959 1741 1088

Credit impairments -0.33% -0.33% -0.30% -0.27% -0.17% -0.34% -0.37% -0.40% -0.50%

Value added (Rm) 2177 2186 2273 2369 2658 2167 2080 1984 1695

Indirect tax -0.21% -0.21% -0.19% -0.17% -0.11% -0.22% -0.23% -0.26% -0.32%

Value added (Rm) 2177 2183 2238 2300 2484 2171 2115 2054 1869

Explanation of this appendix:

This appendix shows what impact a change of 1%, 10%, 20%, 50% (positive and negative) in each of the value drivers has in value added and incremental value added.

Appendix IV Sensitivity analysis

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The value added in 2006 will be R2 177 million and the ratios and values of the value drivers in 2006 are shown in table 5.1.

The formula that is used for the sensitivity analysis is the following:

Value added = Average Assets x {(net interest margin + non-interest margin + operating expenditure + credit impairments + indirect tax and other) x effective tax rate} – cost of equity x (Average Assets x Capital adequacy ratio)

The change in value added due to a 10% change in operating expenditure is calculated as follows:

Average Assets = 381433 Net interest margin = 3,07%

Non-interest margin = 3,37%

Operating expenditure = 3,38%

Credit impairments = -0,33%

Indirect tax and other = -0,21%

Effective tax rate = 24,38%

Cost of equity = 15,20%

Capital adequacy ratio = 6,88%

Value added = R3 260 million

Incremental value added = R1 083 million

If one wants to know what the impact of a 10% improvement in operating expenditure has in value added, the only variable in the formula that is changed is operating expenditure. For the other value drivers the values of 2006 are used.

Thus, if operating expenditure improves by 10%, this means that due to this change the

value added will be R3 260 million and this means an incremental value added of R1 083

million. If this value driver declines by 20%, this means that its change leads to a value

added of R11 million, leading to an incremental value added of –R2 166 million. Thus,

there is value destroyed.

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Of the various SBUs, 18 SBUs are evaluated in this research. The others are either too small or support services, so it makes no sense to evaluate these SBUs. Because of time constraints of the research, it is impossible to determine the key value drivers of all 18 SBUs. That is why the SBUs which create the most value are identified in chapter 6 and in this appendix the value added of all the 18 business units is given as can be seen below, in graph V.1. Table V.1, at the next page, shows the value.

Graph V.1 Value added per business unit

Value added per business unit

-300 -200 -100 0 100 200 300 400 500 600 700

2003 2004 2005 2006

Year

Value added (Rm)

A FS A CM B B B S Credit Card Flexi RB S P FS Ho me Lo ans A sia A llpay NB C Small B anco P rivate Wo lbern Singapo re A VA F Lo ndo n

Appendix V Value added per business unit

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Table V.1 Value added per business unit

Value added per SBU 2003 2004 2005 2006 Total VA

Rm Rm Rm Rm Rm

AFS 297 495 652 479 1924

ACMB 292 217 83 207 799

BBS 207 474 473 570 1723

Credit Card 201 294 387 493 1374

Flexi 160 102 212 227 701

RBS 155 183 332 472 1141

PFS 67 64 74 105 309

Home Loans 58 315 383 334 1090

Asia 86 -31 -17 -32 6

Allpay 52 57 53 46 208

NBC 32 7 6 -1 45

Small n/a n/a 252 289 540

Banco -1 -6 -9 -12 -28

Private -7 -25 -4 2 -34

Bankhaus Wolbern -15 3 -1 -9 -22

Singapore -16 -264 175 6 -100

AVAF -95 -2 123 136 162

London -115 40 1 -84 -158

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In this appendix, a value added-decomposition and sensitivity analysis is done for Absa Financial Services. Table VI.1 shows the value-added-decomposition of AFS.

Value added-decomposition

Table VI.1 Value added-decomposition AFS

2003 2004 2005 2006

2003-2006 Incremental change

Value added (Rm) 265 457 745 479

Year on year growth (Rm) 192 288 (266) Year on year growth (%) 72.45% 63.02% (35.70%)

Headline earnings (Rm) 601 819 1182 922 Year on year growth (Rm) 218 363 (260) Year on year growth (%) 36.27% 44.32% 22.00%

Capital charge (Rm) 336 362 437 443

Average Equity (Rm) 2 195 2 474 3 224 3 117

Cost of Equity % (COE) 15.30% 14.62% 13.54% 14.23%

Return on Equity (ROE) 27.38% 33.11% 36.65% 29.60%

Capital Adequacy Ratio 47.51% 29.78% 27.05% 25.21%

Equity Multiplier 2.10 3.36 3.70 3.97

Return on Assets (ROA) 13.01% 9.86% 9.91% 7.46% (5.55%) Net interest margin 3.16% 2.08% 1.20% 0.93% (2.23%) Non-interest margin 23.92% 18.53% 17.11% 14.57% (9.35%) - Fees and trading income 8.18% 7.11% 4.80%

- Insurance related income 10.94% 10.34% 10.24%

- Investment income (0.59%) (0.33%) (0.48%)

Credit impairments (0.24%) (0.11%) (0.02%) (0.04%) 0.20%

Operating expenditure (11.75%) (7.52%) (5.82%) (6.15%) 5.60%

Indirect tax and other (0.17%) (0.10%) (0.08%) (0.10%) 0.07%

Tax (1.91%) (3.02%) (2.48%) (1.75%) 0.16%

Appendix VI Absa Financial Services

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Balance Sheet Performance

Average Assets (Rm) 4620 8308 11 919 12 365 Year on year growth (%) 79.83% 43.46% 3.74%

Advances (Rm) 100 158 172 126

Year on year growth (%) 58% 8.86% (26.74%)

Deposits (Rm) 0 0 0 0

Year on year growth (%) n/a n/a n/a

Although the value added-decomposition is the basis used in identifying the value drivers, it is difficult to identify them by just looking at the data shown in table VI.2.

In table VI.2, at the next page, the data as mentioned is converted into absolute figures to indicate each value driver’s contribution to incremental value added. This facilitates the process of identifying the key value drivers for AFS. First, in graph VI.1 the incremental value added of BBS from 2003 to 2006 is shown.

Graph VI.1 Incremental value added AFS from 2003 to 2006

Incremental value added AFS from 2003 to 2006

192

288

-300 -266 -200 -100 0 100 200 300 400

2003 to 2004 2004 to 2005 2005 to 2006

Year

Value (Rm)

The incremental value added shows an increase from 2003 to 2005 and a sharp decline

from 2005 to 2006. The reason for the change in these incremental value added is the

value drivers that affect the value added. In graph VI.3 these drivers are shown.

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Table VI.2 Drivers of change in incremental value added of AFS

2003 to 2004 2004 to 2005 2005 to 2006

Rm Rm Rm

Incremental value added 192 288 (266)

Incremental value added due to:

Net asset growth 212 199 28

- Asset growth 480 356 44

- Change in average capital due to

average asset growth (268) (157) (16)

Change in average capital due change in the capital adequacy

ratio 225 47 31

Change in profitability (262) 6 (303)

- Net interest (90) (105) (33)

- Non-interest² (447) (169) (314)

Fees and trading income (128) (285)

Insurance related income (72) (12)

Investment income 31 (18)

- Credit impairments 10 11 (2)

- Operating expenditure 352 203 (42)

- Indirect tax and other 6 2 (2)

- Tax (93) 65 91

Change in cost of equity 17 35 (22)

2 The non-interest margin split is based on analysis done by Absa Group Finance, which explains the high-level reasons for the movement in the Group’s non-interest margin

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As can be seen on the previous page in graph VI.2, the improvement in incremental value added from 2003 to 2004 was mainly due to the net asset growth of R212 million and because of a change in capital adequacy ratio of R225 million. The change in cost of equity was R17 million. The change in profitability was R262 million negative. Thus, for this year the asset growth was big, but it seems that it was unprofitable growth.

Graph VI.2 Drivers of change of incremental value added of AFS

Drivers of change of incremental value added of AFS

-400 -300 -200 -100 0 100 200 300

Net asset growth Change in capital adequacy ratio

Change in profitability Change in cost of equity

Driver of change

Value (Rm) 2003 to 2004

2004 to 2005

2005 to 2006

From 2004 to 2005 net asset growth, change in capital adequacy ratio, change in profitability and change in cost of equity contributed to the improvement in incremental value added. The net asset growth showed an increase of R199 million, the change in capital adequacy ratio R47 million, and the change in profitability contributed R6 million, a significant improvement compared to the previous year, but still very low if one looks at the asset growth. The change in cost of equity contributed R35 million.

From 2005 to 2006 it is expected that incremental value added declines, mainly due to the change in profitability. This change will have an impact of –R303 million.

The change in cost of equity will have a negative impact of R22 million. The contribution

of net asset growth will be much lower than the previous year, with an expected

contribution of R28 million to the incremental value ‘added’. The change in capital

adequacy ratio will contribute R31 million. Thus, because of the lower net asset growth

and the fact that the change in profitability is expected to be big and negative it will have

a negative impact on incremental value added for year 2005 to 2006, thus it will be

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Reflecting table VI.2 one can see the drivers of net asset growth and of the change of profitability and the impact each of these has on the profitability. The drivers of net asset growth are asset growth and change in average capital.

The value drivers of profitability are net interest margin, non-interest margin, operating expenditure, credit impairments, and indirect tax and other.

From 2003 to 2004 asset growth was huge with R480 million. The change in average capital was R268 million negative, what resulted in a net asset growth of R212 million.

As graph VI.3 shows, the value drivers of profitability that created incremental value from 2003 to 2004 are operating expenditure, credit impairments, and indirect tax.

Operating expenditure was the key value driver, because it contributed the most to the (change in) profitability. Non-interest margin and net interest margin can also be seen as important value drivers, but these drivers did not contribute positively to the (change in) profitability. It was because of these drivers that the change in profitability was R262 million negative. Thus from 2003 to 2004 a big asset growth is shown that seems unprofitable, due to the net interest and non-interest margin.

Graph VI.3 Drivers of change of profitability of AFS

Drivers of change of profitability AFS

-500 -400 -300 -200 -100 0 100 200 300 400

Net interest No n-interest Credit impairments

Operating expenditure

Indirect tax and o ther

Value driver

Value (Rm) 2003 to 2004

2004 to 2005

2005 to 2006

Asset growth was again huge from 2004 to 2005 with R356 million. The change in average capital was again negative with R157 million, what resulted in a net asset growth of R199 million.

Non-interest and net interest destroyed value again from 2004 to 2005 with respectively

R169 million and R105 million. This poor result did not lead to a negative change in

profitability due to operating expenditure that contributed R203 million and therefore was

the key value driver. But again, it can be concluded that profitability was poor.

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From 2005 to 2006 net asset growth, due to asset growth of R44 million and a change in average capital of R16 million, is R28 million. The change in profitability was negative due to non-interest that is the value destroyer with R314 million.

As can be seen it is expected that non-interest margin and net interest margin will show a decline, and because of the expected decline in credit impairments and operating expenditure the change in profitability will be R303 million negative. Thus, now credit impairments and operating expenditure do not contribute as much as previously and because growth is expected to be lower, the incremental vale added will be R266 million negative.

As stated above, one can say that non-interest margin and net interest margin have a big negative impact on the (change in) profitability and thus on value added from 2003 to 2006. Net interest margin declines from 3,16% in 2003 to an expected 0,93% in 2006, a total decline of 2,23%. Non-interest margin is 23,92% in 2003 and will decline to 14,57%

in 2006, a total decline of 9,35%. This decline is mainly caused by a decline in fees and trading income from 8,18% in 2004 to an expected 4,80% in 2006, as can be seen in table VI.1.

Reflecting the previous graphs and explanations, a conclusion about the value drivers can be made. Outcome is that the key value drivers are:

• Operating expenditure

• Average assets

• Non-interest margin

• Net interest margin

Conclusion is that AFS shows a strong asset growth, but it seems that it is unprofitable

growth, what is the same as could be seen for the Group. AFS has problems with two

drivers of profitability, namely non-interest margin and net interest margin. The

profitability from 2003 to 2004 would have shown a worse negative change if it wasn’t

for operating expenditure. From 2004 to 2005 profitability is saved by operating

expenditure (due to asset growth), and the asset growth (although it seems that this

growth is unprofitable), but from 2005 to 2006 it is expected that operating expenditure

(and credit impairments) also will decline. Non-interest margin and net interest margin

will have a negative incremental value again, but this will not be off-set by the other

drivers. End result will be that the incremental value added from 2005 to 2006 will be

R266 million negative.

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Sensitivity analysis

A sensitivity analysis is done to confirm the key value drivers identified in the value added-decomposition and identify possible additional key value drivers to focus on. If management is aware of the sensitivity of the value drivers it can consider the projections of sensitive value drivers carefully and not worry so much about insensitive value drivers.

In graph VI.4, the sensitivity of the various value drivers of AFS to the value added are indicated.

Graph VI.4 Sensitivity of the value drivers of AFS

Sensitivity of the value drivers of AFS

-300 0 300 600 900 1200 1500

-60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%

Percentage

Non interest

Operating expenditure Average Assets

Cost of equity %

Capital Adequacy Ratio Net interest

Indirect tax

Credit impairments

Table VI.3 Incremental change of value added due to a percentage change in the value drivers of AFS

Incremental change in value Percentage by which the value drivers are changed

added from R479 million to X

due to: 1% 10% 20% 50% -1% -10% -20% -50%

Non-interest margin 15 146 292 730 (15) (146) (292) (730) Operating expenditure 6 62 123 308 (6) (62) (123) (308)

Average Assets 5 48 96 239 (5) (48) (96) (239)

Cost of equity % 4 44 89 222 (4) (44) (89) (222)

Capital adequacy ratio 4 44 89 222 (4) (44) (89) (222)

Net interest margin 1 9 19 47 (1) (9) (19) (47)

Indirect tax 0 1 2 5 0 (1) (2) (5)

Credit impairments 0 0 1 2 0 0 (1) (2)

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Graph VI.4 shows the sensitivities of the value drivers of AFS. The incremental impact on value added can be seen in table VI.3. Table VI.3 shows the change of value added due to a percentage change in the value drivers.

The value added for 2006 will be R479 million and the expected value of the ratios in 2006 can be seen in table VI.1. Table VI.3 shows that a 1% change in the non-interest margin will lead to an incremental value added of R15 million.

Just bear in mind that a positive percentage change (thus a decline in the percentage) in operating expenditure, cost of equity, capital adequacy ratio, credit impairments and indirect tax means an improvement of these value drivers an thus a positive impact on value added.

The most sensitive value driver is non-interest margin as it has the steepest slope and thus the biggest impact on the value added. Reflecting the table it can be seen that a 10%

improvement in non-interest margin will lead to an incremental value added of R146 million, what means an increase of 30,48% in total value added. On the other hand, credit impairments is the least sensitive as it has the flattest slope and thus a little impact on the value added. A negative change of 50% in this value driver will lead to an incremental value destroyed of R2 million, what means a decrease of only 0,42% in total value added.

Besides non-interest margin, operating expenditure and average assets have a steep slope and a big impact on value added. Thus management must concentrate on accurate estimations of these value drivers.

Reflecting the graphs and explanations above, the outcome of the sensitivity analysis is that the key value drivers of AFS are:

• Non-interest margin

• Operating expenditure

• Average assets

A small change in each of these key value drivers will lead to a large change in the value added. Thus now management is aware of the sensitivity of these key value drivers they can pay more attention to these sensitive drivers and consider the projections of these value drivers carefully and not worry so much about insensitive value drivers (but still pay attention to these insensitive value drivers as well).

The next step is to evaluate the probability of changing the value drivers by a certain

percentage. To determine the probability of a change in the value driver we look at the

value added-decomposition to evaluate the historical performance (in 2003, 2004 and

2005) and the expected performance (budget figures of 2006) of the value driver. So, by

looking at the history, if AFS wants to achieve an increase in value added of 10%, is it

possible to increase, for example, operating expenditure by X%?

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To determine the probability of a change in the value driver that will lead to an X%

increase in value added it is necessary to have information about the absolute change in the value driver

³

. Table VI.4 gives this information.

Table VI.4 Change of the value drivers to achieve a certain increase in value added AFS

Value driver

Value/ratio

in 2006 Percentage change in value added

1% 10% 20% 50% -1% -10% -20% -50%

Non-interest margin 14.57% 14.62% 15.05% 15.53% 16.96% 14.52% 14.09% 13.62% 12.18%

-fees and trading income 4.80% 4.85% 5.28% 5.76% 7.19% 4.75% 4.32% 3.84% 2.41%

-insurance related income 10.24% 10.29% 10.72% 11.20% 12.63% 10.19% 9.76% 9.28% 7.85%

-investment income (0.48%) (0.43%) 0.00% 0.48% 1.91% (0.53%) (0.96%) (1.44%) (2.87%)

Operating expenditure (6.15%) (6.10%) (5.68%) (5.20%) (3.76%) (6.20%) (6.63%) (7.11%) (8.54%) Average assets 12 365 12 489 13 601 14 838 18 547 12 241 11 128 9892 6182 Cost of equity % 14.23% 14.08% 12.69% 11.16% 6.55% 14.38% 15.77% 17.30% 21.91%

Capital adequacy ratio 25.21% 24.93% 22.48% 19.76% 11.60% 25.48% 27.93% 30.65% 38.81%

Net interest margin 0.93% 0.98% 1.41% 1.89% 3.32% 0.92% 0.78% 0.62% 0.16%

Indirect tax (0.10%) (0.05%) 0.38% 0.86% 2.29% (0.15%) (0.58%) (1.06%) (2.49%) Credit impairments (0.04 %) 0.01% 0.44% 0.92% 2.35% (0.09%) (0.52%) (1.00%) (2.43%)

To achieve an increase of 10% in value added by only improving non-interest margin, this value driver must change from 14,57% to 14,62%. This is an incremental increase of 0,05% that, reflecting the historical performance of this value driver in table VI.1, can be achieved. But this increase must be achieved by increasing the value drivers of non- interest margin; fees and trading income, insurance related income, and investment income. Reflecting the historical figures of these drivers it can be concluded that all value drivers are able to increase by the percentage needed to achieve a non-interest margin of 14,62% that will lead to an increase in value added of 10%.

To achieve an increase of 10% in value added by improving the operating expenditure, this value driver must change from -6.15% to -6.10% or an incremental increase of 0,05%. Reflecting the historical performance of this value driver this increase seems a possible one.

Average assets must change from R12 365 million to R12 489 million to achieve an increase of 10% in value added, what seems possible reflecting the historical figures.

Cost of equity % must change from 14,23% to 14,08% to achieve an increase of 10% in value added. This is an incremental decline (improvement) of 0,15% what seems possible by reflecting the historical performance of this value driver in table VI.1, and is also not unlikely to happen if one looks at the interest rate outlook.

3 The probabilities are determined by reflecting the historical figures in table VI.1 and by looking at the future outlook provided by Absa Group Finance

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If only the capital adequacy ratio is changed, this value driver must decline from 25,21%

to 24,93% to achieve an increase of 10% in value added. This means an incremental improvement of 0,28%, what is difficult to achieve reflecting table VI.1, and is also highly unlikely to happen.

Net interest margin must change from 0,93% to 0,98% to achieve an increase of 10% in value added. This means an incremental improvement of 0,05% what is possible if one looks at the historical figures of this value driver in table VI.1.

Indirect tax and other must change from -0,10% to -0,05% to achieve an increase of 10%

in value added. This means an incremental decline (improvement) of 0,05% what is impossible to achieve reflecting the historical figures of this value driver in table VI.1.

To achieve an increase of 10% in value added by only improving credit impairments, this value driver must change from -0,04% to 0,01%. This means an incremental improvement of 0,05% what is impossible, because this figure cannot be positive.

Conclusion is that it is possible for AFS to increase her value added by 10% by focusing on the following value drivers:

• Non-interest margin

• Operating expenditure

• Average assets (asset growth)

• Cost of equity%

• Net interest margin

Thus, the outcome of the sensitivity analysis is that the key value drivers of AFS are non- interest margin, operating expenditure and average assets. Furthermore, Absa needs to focus on the cost of equity and credit impairments, because if things go wrong and these drivers decline a lot, what is possible, it will have a huge negative impact on value added.

The outcome of the value added-decomposition is that non-interest margin, net interest margin, and operating expenditure are the key value driver of AFS.

Conclusion is that the key value drivers of Absa Financial Services are; non-interest

margin, operating expenditure, net interest margin and average assets (asset growth) as

can be seen in table VI.5 that shows the importance of all the value drivers.

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Table VI.5 Importance of the value drivers of AFS

High importance Medium importance Low importance

Cost of equity % X

Capital adequacy ratio X

Net interest margin X Non-interest margin X

Credit impairments X

Operating expenditure X

Indirect tax X

Tax X

Asset growth X

Management influence on the value drivers

According to Arnold et al [2000], it is essential that managers throughout the organisation understand which value drivers they can control. Which drivers could have the greatest impact on value and how do they interrelate with other value drivers? With this information the manager can then take the operational decisions which maximize value.

In chapter 5 a value driver matrix is given, which shows the management influence on the

value drivers and value impact of the value drivers. The management of the SBUs have

the same influence on the value drivers as Absa Group’s management. So the only

comment to make is that AFS must focus on the value drivers with the high impact and

the the ones they can influence, what means that they must focus on their key value

drivers non-interest margin, net interest margin, operating expenditure, and average

assets. As shown in chapter five, figure 5.2, the highest management influence is on

average assets.

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In this appendix, a value added-decomposition and sensitivity analysis is done for Business Banking Services. Table VII.1 shows the value-added-decomposition of BBS.

Value added-decomposition

Table VII.1 Value added-decomposition of BBS

2003 2004 2005 2006

2003-2006 Incremental change

Value added (Rm) 207 474 473 570

Year on year growth (Rm) 267 (1) 97 Year on year growth (%) 128.99% (0.21%) 20.51%

Headline earnings (Rm) 771 822 854 1 005 Year on year growth (Rm) 51 32 151 Year on year growth (%) 6.61% 3.89% 17.68%

Capital charge (Rm) 564 348 381 435

Average Equity (Rm) 3 411 2 190 2 496 2 829

Cost of Equity % (COE) 16.53% 15.87% 15.29% 15.39%

Return on Equity (ROE) 22.60% 37.50% 34.24% 35.54%

Capital Adequacy Ratio 6.75% 3.77% 4.59% 5.33%

Equity Multiplier 14.81 26.53 21.79 18.76

Return on Assets (ROA) 1.53% 1.42% 1.57% 1.89% 0.36%

Net interest margin 4.57% 4.49% 4.05% 4.44% (0.13%) Non-interest margin 2.89% 2.90% 2.27% 2.46% (0.43%)

- Fees 2.82% 2.20% 2.38%

- Insurance related income 0.03% 0.04% 0.04%

- Investment income 0.05% 0.04% 0.05%

Credit impairments (0.97%) (0.87%) (0.72%) (0.46%) 0.51%

Appendix VII Business Banking Services

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Balance Sheet Performance

Average Assets (Rm) 50 527 58 090 54 369 53 085 Year on year growth (%) 14.97% (6.41%) (2.36%) Advances (Rm) 28056 30092 32438 33311 Year on year growth (%) 7.26% 7.80% 2.69%

Deposits (Rm) 46285 52672 47900 46661 Year on year growth (%) 13.80% (9.06%) (2.59%)

Although the value added-decomposition is the basis used in identifying the value drivers, it is difficult to identify them by just looking at the data shown in table VII.1.

In table VII.2, at the next page, the data as mentioned is converted into absolute figures to indicate each value driver’s contribution to incremental value added. This facilitates the process of identifying the key value drivers for BBS. First, in graph VII.1 the incremental value added of BBS from 2003 to 2006 is shown.

Graph VII.1 Incremental value added BBS from 2003 to 2006

Incremental value added BBS from 2003 to 2006

267

-1

97

-50 0 50 100 150 200 250 300

2003 to 2004 2004 to 2005 2005 to 2006

Year

Value (Rm)

The incremental value added shows an increase from 2003 to 2004, a decline from 2004

to 2005 and an increase again form 2005 to 2006. The reason for the change in these

incremental value added is the value drivers that affect the value added. In graph VII.2

these drivers are shown.

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Table VII.2 Drivers of change in incremental value added of BBS

2003 to 2004 2004 to 2005 2005 to 2006

Rm Rm Rm

Incremental value added 267 (1) 97

Incremental value added due to:

Net asset growth 31 (31) (11)

- Asset growth 115 (53) (20)

- Change in average capital due to

average asset growth (84) 22 9

Change in average capital due to

change in capital adequacy ratio 286 (70) (60)

Change in profitability (65) 85 171

- Net interest (51) (239) 207

- Non-interest⁴ 3 (338) 100

Fees and trading income (336) 96

Insurance related income 4 2

Investment income (5) 2

- Credit impairments 53 83 141

- Operating expenditure (89) 569 (213)

- Indirect tax and other 9 0 (2)

- Tax 10 10 (62)

Change in cost of equity 14 14 (3)

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Graph VII.2 Drivers of change of incremental value added of BBS

Drivers of change of incremental value added of BBS

-100 -50 0 50 100 150 200 250 300 350

Net asset growth Change in capital adequacy ratio

Change in profitability Change in cost of equity

Driver of change

Value (Rm) 2003 to 2004

2004 to 2005

2005 to 2006

As can be seen in the graph, the improvement in incremental value added from 2003 to 2004 was mainly due to the change in capital adequacy ratio of R286 million and net asset growth of R31 million. Change in cost of equity was R14 million. The change in profitability was R65 million negative. In this year BBS has the same problem as AFS. It shows a big net asset growth, but a negative impact of the change in profitability. Thus, an asset growth that is unprofitable.

From 2004 to 2005 the change in profitability and change in cost of equity contributed to incremental value added, but net asset growth showed a negative of R31 million, and the change in capital adequacy ratio R70 million, which resulted in incremental valued destroyed. The change in profitability contributed R85 million and the change in cost of equity equaled the contribution of the previous year, namely R14 million. This year shows the opposite of the previous year, because net asset growth is negative and the change in profitability is positive, but not enough to achieve an incremental value added.

From 2005 to 2006 it is expected that incremental value added increases again, completely due to the change in profitability. This change will have an impact of R171 million. Net asset growth is negative with R11 million and the change in capital adequacy ratio will be R60 million negative. The change in cost of equity will have a negative impact of R3 million.

It looks that BBS becomes more profitable from 2004 to 2006. The profitability increases

from 2004 to 2005 and will increase from 2005 to 2006 as well. What the reason is for

this change is shown in graph VII.3.

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From 2003 to 2004 the asset growth contributed R115 million and change in average capital (not shown in the graph, because these are no drivers of profitability) had a negative impact of R84 million to net asset growth.

The change in profitability had a negative impact of R65 million, due to the value drivers.

Graph VII.3 gives the graphical view of the drivers of the change in profitability.

Graph VII.3 Drivers of change of profitability of BBS

Drivers of change of profitability BBS

-400 -300 -200 -100 0 100 200 300 400 500 600 700

Net interest Non-interest Credit impairments

Operating expenditure

Indirect tax and other

Value driver

Value (Rm) 2003 to 2004

2004 to 2005

2005 to 2006

As the graph shows, the value drivers that contributed positively to the change in profitability from 2003 to 2004 are credit impairments, indirect tax and non-interest margin. Credit impairments was the key value driver, because it contributed with R53 million the most to the incremental value added.

Operating expenditure and net interest can also be seen as important value drivers, even though these drivers destroyed incremental value with respectively R89 million and R51 million. Thus, in this period BBS showed a big asset growth that is unprofitable due to net interest margin and operating expenditure.

From 2004 to 2005, asset growth showed a negative incremental value what leaded to a negative net asset growth. The change in average capital was with R22 million positive.

Credit impairments and operating expenditure contributed to the (change in) profitability.

Operating expenditure shows the biggest contribution with R569 million. Non-interest

with R338 million and net interest with R239 million, on the contrary, had a negative

impact on the (change in) profitability, but this was off-set in total by the positive impact

of operating expenditure. Thus incremental value added was negative due to a decline in

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Net interest margin, non-interest margin, and credit impairments will have a positive contribution to the (change in) profitability. Operating expenditure will have a negative impact again with R213 million.

Thus the decline in net asset growth is expected to continue, but non-interest margin and net interest margin will have a significant positive impact on the change in profitability and therefore on incremental value added. Operating expenditure, on the contrary, will have a negative impact, but this impact is off-set by the improvement in margins and credit impairments.

As stated above, one can say that non-interest margin and net interest margin had a big negative impact on the (change in) profitability from 2003 to 2005 and thus on value added from 2003 to 2005. It is expected that these margins improve from 2005 to 2006.

Net interest margin declines from 4,57% in 2003 to 4,05% in 2005 and is expected to increase in 2006 to 4,44%. Non-interest margin is 2,89% in 2003 and declined to 2,27%

in 2005. In 2006 it is expected that this margin increases to 2,46%. This increase is mainly caused by an improvement in fees and trading income that is expected to be 2,46% in 2006 compared to a 2,27% in 2005, as can be seen in table VII.1.

Reflecting the previous graphs and explanations, a conclusion about the value drivers can be made. Outcome is that the key value drivers are:

• Net interest margin

• Non-interest margin

• Credit impairments

• Operating expenditure

Conclusion is that BBS shows a decline in the asset growth, but that profitability is improving. BBS has problems with the asset growth, but the good news is that two of the drivers of profitability, non-interest margin and net interest margin are expected to improve in 2006. Thus, margins seem to be under control, but a challenge for BBS is the costs. The impact of operating expenditure is expected to be negative in 2006. If BBS can improve and control this value driver and stabilize or improve the margins, the (change in) profitability will increase and as a result the incremental value added will increase as well (if credit impairments don’t show a significant negative change).

Sensitivity analysis

A sensitivity analysis is done to confirm the key value drivers identified in the value added-decomposition and identify possible additional key value drivers to focus on. If management is aware of the sensitivity of the value drivers it can consider the projections of sensitive value drivers carefully and not worry so much about insensitive value drivers.

In graph VII.4 the sensitivity of the various value drivers of BBS to the value added are

indicated. The incremental impact on value added can be seen in table VII.3.

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This table shows the change of value added due to a percentage change in the value drivers. The value added for 2006 will be R570 million and the expected value of the ratios in 2006 can be seen in table VII.1.

Graph VII.4 Sensitivity of the value drivers of BBS

Sensitivity of the value drivers of BBS

-400 0 400 800 1200 1600

-60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%

Percentage

Net interest

Operating expenditure No n interest

A verage A ssets

Co st o f equity %

Capital A dequacy Ratio Credit impairments Indirect tax

Table VII.3 Incremental change of value added due to a percentage change in the value drivers for BBS

Incremental change in value Percentage by which the value drivers are changed

added from R570 million to X

due to: 1% 10% 20% 50% -1% -10% -20% -50%

Net interest margin 16 164 328 821 (16) (164) (328) (821) Operating expenditure 14 136 273 682 (14) (136) (273) (682)

Non-interest margin 9 91 182 456 (9) (91) (182) (456)

Average Assets 6 57 114 285 (6) (57) (114) (285)

Cost of equity % 4 44 87 218 (4) (44) (87) (218)

Capital adequacy ratio 4 44 87 218 (4) (44) (87) (218)

Credit impairments 2 17 34 84 (2) (17) (34) (84)

Indirect tax 0 2 3 8 0 (2) (3) (8)