JMMB to Acquire CCFG

JMMB has offered to purchase all the outstanding shares of CCFG at a price of $4.55 per share or $4.22 billion. The offer is pending the approval from local regulators and could see JMMB gaining CCFG’s Merchant Banking and Unit Trust Licences as well as its portfolio of loans, deposits and investments & repo portfolio.

Regulatory Approval of Acquisition

Both CCFG and JMMB are multijurisdictional firms and will have to undergo various stages of approval. The main regulators will be the Financial Services Commission (FSC) and the Bank of Jamaica (BOJ). The BOJ will have decision-making authority on the Merchant Bank Licence of CCFG, while the FSC maintains oversight of the Investment Banking Operations which includes CCFG’s Unit Trust Licence. Both companies are also listed on the Trinidad & Tobago Stock Exchange and Jamaica Stock Exchange (JSE), while JMMB is listed on the Barbados Stock Exchange. The stock exchange layer of the approval process should not be a major impediment since core operations of both entities are domiciled in Jamaica.

We anticipate the BOJ will approve the acquisition despite their refusal to grant JMMB a commercial banking licence back in 2008. In 2008, JMMB was significantly impacted by the collapse of Lehmann Brothers which weakened their capitalisation. However, the company has strengthened its capitalisation levels since and is much better positioned to undertake this opportunity. Therefore, the expected timeline of approval of the deal is reasonably placed at December 2011 in our analysis.

Merchant Bank Licence

The Merchant Bank Licence will enable JMMB to offer services they have long sought to offer since they applied for a commercial bank licence back in 2008. The merchant bank licence is in fact a good substitute and permits them to offer credit card and debit card facilities. In addition, it opens up an avenue to get cheaper balance sheet funding while allowing them to expand their loan offerings.

Unit Trust Licence

An additional benefit of a JMMB/CCFG deal is that JMMB will be able to delve into the restricted unit trust market with CCFG’s three established products. This is in addition to JMMB’s two indexed funds which are both incorporated as companies in Cayman. The attractiveness of this business line is that it enables the company to deleverage its massive balance sheet in light of tighter capital requirements by the FSC. JMMB is the most leveraged of all players in its peer group.

JMMB spreads higher than CCFG

Currently, JMMB enjoys better investment spreads than CCFG on its repurchase agreement portfolio. JMMB’s interest spread is approximately 2.43 per cent while CCFG’s was calculated at 1.77 per cent for the June quarter. The reason for the smaller spread at CCFG is due to the higher cost of funding than JMMB. Thus, with the combination of the two entities, we anticipate JMMB will re-price CCFG’s portfolio to match JMMB’s rate structure as client liabilities mature. Notably, maturities are concentrated in a one-to-three-months band and the full effect of the re-pricing will therefore be visible approximately three months after the deal is done.

CCFG Loan Portfolio Challenged

Prior to the announcement of the intention to acquire CCFG, JMMB’s management hinted at the possibility of partnering with a commercial bank to widen its product offering. However, acquiring a merchant banking licence by buying out CCFG is equally valuable. At the onset, JMMB would be acquiring a relatively challenged loan portfolio, which would provide the first major obstacle for management. However, the tremendous opportunity to expand the loan portfolio considering JMMB’s large client base and relatively large balance sheet far outweighs the poor quality of the loan portfolio being inherited. Additionally, JMMB’s fledgling loan business can be funded by lower cost deposits instead of its more expensive capital.

Extraordinary Gain on Acquisition?

Based on the offer, JMMB is acquiring CCFG significantly below its book value as at June 2011. Additionally, based on CCFG’s audited financials as at December 31, 2010, we are unable to detect any major impairment to the balance sheet, with the exception of the loan portfolio’s quality. In the best case scenario, there will be no write-down on the loan portfolio and JMMB would make an extraordinary gain of $2.94 billion. The absolute worst case would be to write off both those loans categorised as ‘Doubtful’ and ‘Loss’ which would result in a mere gain of $188 million. However, the likely case seems to be a write-off of those categorised as ‘Loss’ and maybe half of ‘Doubtful’ which still results in a gain of $971 million.

Share Swap and Dilution

The company is expected to finance the deal with 70 per cent cash and pay the remaining 30 per cent by issuing new JMMB shares. JMMB shareholders’ recently approved an increase in authorised share capital at their September 2011 AGM. The issued shares are expected to be valued at $1.26 billion based on the structure of the offer. However, there is still the question as to what ratio they will be exchanged at and what value will be placed on the new JMMB shares. (see table on — Page 12)

From our perspective, the JMMB shares can be valued anywhere between $7.00/share and $12.00/share. Before the announcement, JMMB shares were valued just above $8 on the market, on the heels of very strong first-quarter results. At the time, the book value of JMMB’s shares was $7.54. Since the announcement, the JMMB shares have traded as high as $12.25 before settling around $9.50. In our view, the sweet spot for the deal will be somewhere between $7 and $9 per share. At that price range, a maximum of between 141 million and 181 million new shares will be issued. The resulting book value of the new entity would be between $8.66 and $8.88. Additionally, with the synergies garnered and expected extraordinary gain on acquisition, March 2012 EPS should surface between $2.05 and $2.11.

What if CCFG minority refuses?

There is a possibility that some of CCFG minority shareholders will not accept the offer. However, with the main shareholders accounting for more than 78 per cent of the shares outstanding, the worst case is that CCFG will be a strongly controlled subsidiary of JMMB. Therefore, JMMB would still have voting rights, which guarantees decision making and control of CCFG.

Capital Adequacy

JMMB is adequately capitalised based on the current FSC requirements and using their most recent June 2011 results. However, JMMB will be required to maintain increasing amounts of regulatory capital as the risk weighting on US$ GOJ assets is increased. Currently, the risk weighting of US$ GOJ assets is 25 per cent but this is slated to be increased (by the FSC) to 100 per cent over the next two years. Assuming the company grows it balance sheet no more than 1 per cent to 2 per cent over the next 4 years, our capital adequacy model suggests a balance sheet which is 117 per cent — 118 per cent of required capital (including CCFG). The FSC’s warning level is 110 per cent and we think anything above 115 per cent provides reasonable room to handle shocks.

As at March 2011, JMMB had as much as JMD equivalent of $50 billion US denominated assets backing repurchase agreements. CCFG had as much as JMD equivalent of J$21 billion US denominated assets backing repurchase agreements as at December 2010.

The increased regulatory capital going forward affects the entire securities dealer industry; this is one of the reasons we find the potential addition of a Unit Trust Licence so attractive. It provides an avenue for the company to deleverage its massive balance sheet (should the need arise) by migrating repo clients to suitable unit trust products.

Evaluation of the Offer

From a book value perspective, CCFG is worth about $7.21, but when the bad loans (doubtful and loss) are removed, the adjusted book value is J$4.75. Therefore, JMMB would be getting CCFG’s portfolio at a discount to their carrying value. From this perspective, JMMB’s offer price gives their shareholders’ good value in offsetting the dilutive effects of issuing new shares.

From an earnings perspective, CCFG’s intrinsic value is $1.71/share and therefore JMMB is paying a significant premium of $2.84. It also equates to a $0.89 premium above the market price, the day before the offer was made. The going concern price of $1.71 is not real since CCFG will be absorbed by JMMB. Therefore, JMMB’s offer seems like a fair one based on our calculations.

Projections & Valuation

In anticipation of a closed deal by the end of December 2011, we project year end Revenues at $6.17 billion with Net Interest Income contributing $3.75 billion and Non-Interest Income $2.42 billion. Administrative expenses of the combined entity should total $2.91 billion resulting in Operating Profit of $3.26 billion. Taking into account an expected extraordinary gain $971 million, Net Profit should surface at $3.38 billion at the March 2012 year end.

In March 2013, we expect some normalisation of revenues (especially a reduction in securities trading) and we conservatively project net profit at $1.75 billion. Over the last few years, the company’s dividend payout ratio (dividends/earnings) has fallen to 18 per cent, but we expect this will improve to between 20 per cent and 25 per cent.

Therefore, we utilise a two stage dividend discount model to value the company. The model takes detailed projections of earnings and dividends to 2016, after which we expect long-term growth of 10 per cent. The model produces a valuation of J$14.50. The stock therefore could appreciate by 53 per cent from its last closing price of $9.50. With the expected improvement in fundamentals, dividends and capital appreciation JMMB is recommended as a BUY.

Mario Ahjahorie is a Financial Analyst at ScotiaDBG