Georgia Capital — Benefiting from strong macro tailwinds in Georgia

The Georgian economy maintains its exceptionally strong momentum, with the IMF recently revising its 2022 real GDP growth forecast to 9.0% (according to its World Economic Outlook report published in October 2022), from 3.2% expected back in April 2022. Economic growth is supported by healthy external demand, including growth in exports (up 40% y-o-y in September, outpacing imports growth of 13% y-o-y), a positive effect from immigration (predominantly from Russia, with 83.5k new migrant bank accounts since the start of the Ukraine war) and a strong rebound in remittances (up 65% y-o-y in the first nine months of 2022 (9M22), or 19% excluding Russia). Tourism revenues rebounded close to pre-COVID-19 levels, although this also captures the above-mentioned migration effect (which in the case of immigrants from Russia is coupled with certain socio-political risks). All the above has led to the fifth consecutive month of a positive external balance. The Georgian Ministry of Finance expects a budget deficit of 3.2% of GDP in 2022 and public debt to fall below pre-pandemic levels as at end-2022 (39.5%). The IMF expects the Georgian economy to further grow by 4.0% in 2023 and 5.2% annually by 2027. We note that international institutions have until recently underestimated the prospective Georgian growth (as highlighted by the recent 2022 growth revision by the IMF).

The tight monetary policy of the National Bank of Georgia (NBG), with cumulative interest rate hikes of 300bp since March 2021 to 11% as of November 2022, is expected to curb inflation to 6.0% in 2023 (according to the IMF), with the current headline CPI inflation at 10.6% in October (12.3% on average in the first 10 months of 2022). As NBG has been ahead of the curve in terms of monetary tightening compared to most other central banks globally, it now sees room for monetary policy normalisation once a clear trend of decreasing inflation is observed and does not rule out rate cuts as soon as Q123. Meanwhile, despite the high interest rates, credit expansion continues at 13.7% yoy in September 2022 (without the exchange rate effect). In particular, lending in foreign currencies has been steadily increasing since April 2021, due to a substantial interest rate differential, supported by ample foreign exchange liquidity in the banking sector.

The overall good condition of Georgian economy is reflected in the strong appreciation of the Georgian lari, which has increased by 13% in the year to 25 November 2022 against the US dollar, despite the strengthening of the US dollar against other major currencies (the US dollar index, which compares the US dollar to a basket of global currencies, increased by 13% in the same period). While economists expect further healthy growth from the Georgian economy, the most commonly cited risk factors are: (1) a potentially slower than anticipated decrease in the Georgian inflation rate driven by global commodity price pressures; (2) potential global recession and; (3) uncertain further developments of the Russo-Ukrainian war.

BoG reported strong Q322 results, with a 51.4% y-o-y increase in operating income to GEL527m, assisted by an expansion of net interest margin to 5.3% from 5.0% in Q321 and a 3.7% y-o-y increase in the loan book (12.9% on a constant currency basis). Together with a cost-income ratio of 30.6% (vs 36.8% in Q321), this translated into a 56.6% y-o-y increase in net profit to GEL290m (see Exhibit 4) and a 32.4% annualised return on average equity (ROAE). While the annualised cost of risk increased to 100bp in Q322 from 20bp in Q321 (driven mostly by unsecured consumer and micro portfolios in the retail banking segment), BoG’s loan portfolio remains resilient, with a non-performing loan (NPL) ratio of 2.4% and an NPL coverage ratio of 89.4% at end-September 2022. The bank retained a strong capital base, with CET-1 and total capital ratios of 14.8% and 20.3%, respectively (well above the minimum regulatory requirements of 11.6% and 17.2%, respectively). A good financial performance from BoG and a favourable outlook for the banking sector was reflected in the 52% increase in BoG’s share price in Q322, with a further 20% rise post quarter-end to 25 November 2022. The current share price of 2,570p compares with the current range of analyst target prices of 1,720p to 4,437p, with an average target price of c 3,000p.

The pharmacy chain continues to grow, adding 27 pharmacies and four franchise stores over the last 12 months, including the first store in Azerbaijan. As at end-September 2022, the chain operates a total of 368 pharmacies and 10 franchise stores. This has driven a moderate increase in 9M22 GEL revenues and EBITDA of 3% and 5% y-o-y, respectively, with same store sales up 2.2% y-o-y (after 10.6% y-o-y l-f-l growth in 9M21). Having said that, same store sales were down 3.1% in Q322 due to the Georgian lari’s appreciation against foreign currencies (c 70% of the inventory purchases are denominated in foreign currencies and product prices are recalibrated in line with the change) and the gradual transfer of the procurement department of GCAP’s hospitals business from pharmacy to hospitals. The EBITDA margin was broadly flat year-on-year in 9M22 at 9.7%, whereas Q322 saw a 1.1pp contraction year-on-year (9.5% compared to 10.6% in Q321) due to cost inflation related to salaries and utilities. As a result, Q322 revenue and EBITDA were 2% and 12% lower y-o-y, respectively. It is also worth noting that margins also reflect the costs of the ongoing expansion. The business was revalued slightly by 3.3% versus end-June 2022 (underpinned by good demand prospects), and the end-September 2022 valuation implies last 12 months EV/EBITDA multiple of 8.6x (vs 8.3x at end-June 2022).

The hospitals business remains affected by the suspension of COVID-19 contracts by the government in Q122 (and the associated cost base restructuring) and therefore reported declines of 7.2% and 32.5% y-o-y in revenue and EBITDA in 9M22, respectively (18% and 44.9% declines yoy in Q322, respectively). Hospitals are still in the process of rebuilding bed occupancy to pre-COVID-19 levels, with Q322 occupancy at 43.6% (8.8pp lower than Q319, and 24.1pp lower than Q321) amid slower admissions during summer. GCAP’s management expects a full occupancy rebound in the coming quarters, though not until end-2022. This would help improve the business’s EBITDA margin from 14.9% (excluding IFRS 16) in Q322, versus 21.9% in Q321. Similarly, the clinics business was affected by the termination of COVID-19 contracts in Q122, and on top of that, the diagnostics business was affected by a substantially lower number of COVID-19 tests (amid a decline in cases). As a result, the revenue and EBITDA of the combined clinics and diagnostics business were down 30% and 79% y-o-y in Q322, respectively (nevertheless 9M22 results are roughly twice higher than pre-pandemic). Consequently, the carried value of the healthcare-related businesses was adjusted downwards by 6.0% in Q322 (hospitals by 6.9%; clinics and diagnostics by 2.6%; see Exhibit 3).

GCAP’s insurance business consists of property and casualty insurance (P&C, 7.5% of portfolio value) and medical insurance (1.4% of portfolio). The insurance business posted strong 9M22 results, with net premiums earned increasing by 10% y-o-y to GEL128.1m. GCAP’s P&C insurance business represents roughly a quarter of the Georgian insurance market and its 9M22 revenue increase reflects the good macroeconomic environment (as discussed in ‘High momentum of Georgia’s economy continues’ section). The growth in the banking sector (as seen in the increase in portfolios of mortgage, consumer and other loans) resulted in higher credit life and credit unemployment insurance revenues. At the same time, the significant recovery in tourism and sizeable migration translated into higher motor third-party liability revenues. Revenues from agricultural insurance also increased significantly (gross premiums written doubled in the period) as GCAP’s holding is increasing its market share in this subsector. Management believes that its market share growth is due to the competitors’ difficulties in obtaining reinsurance approvals and general lack of expertise in claims settlement. The recent performance of the medical insurance business reflects a c 5% increase in the price of insurance policies and a related decrease in the number of insured clients, which has led to a 2% y-o-y increase in net premiums earned in 9M22 and a 21% y-o-y decrease in net profit. Overall, the insurance business’s net profit in 9M22 amounted to GEL18.0m, up 11% y-o-y. In turn, the valuation of the business was increased by 6.4% during the quarter to GEL255m.

With the recent US$80m green bond issue completed in October 2022, GCAP concluded the carve-out of the renewable energy business from Georgia Global Utilities (GGU; formerly comprising the water utility and renewable energy units, as discussed in our January 2022 note). The valuation of the business was raised by 4.5% versus end-June 2022 in US dollar terms (and 2.2% in Georgian lari term due to the latter’s appreciation) on the back of improving financial results. Due to higher average electricity selling prices and higher electricity generation, the business’s revenue increased by 12% and EBITDA by 16% in 9M22 in US dollar terms.

The education business added a further 590 learner places in Q322 (2,840 since embarking on the expansion programme in Q321), bringing its total capacity to 5,650 learners. This was coupled with an increase in utilisation rate to 73% at end-September 2022 (up 10.6pp y-o-y), driven by a strong intake for the 2022–23 academic year (up 31% y-o-y). The business recorded a 48% y-o-y increase in revenues and a 65% y-o-y increase in EBITDA in 9M22. The education business has invested GEL16m into capacity expansion (of which GEL6m was provided by GCAP) in the year-to-date and the balance of GCAP’s planned investments over the next two to three years stands at GEL64m. The good operating performance and expansion has led to an increase in the carrying value of 4.8% q-o-q.

GCAP’s portfolio includes four ‘subscale’ businesses: auto service, beverages, housing development and hospitality. While GCAP’s management recognises the profitability and growth prospects of these businesses, it considers them unlikely to reach sufficient value to attract international investors. In 9M22, the combined revenues of the four businesses increased 47% yoy (to GEL350m) and EBITDA grew 10% y-o-y to GEL30m.

Source: GCAP. Note: *Excluding the water utility business. **Net interest income for BoG; net premiums earned for insurance businesses. ***Net income for BoG and insurance businesses. ****US dollar reporting, recalculated to Georgian lari with 9M22 and 9M21 averages of GEL/US$ of 0.3402 and 0.3099 respectively.

In October 2022 Irakli Gilauri contract as CEO and chairman of the board of GCAP was extended to December 2025 (from May 2023 previously). Simultaneously, GCAP continues its efforts in terms of CEO succession planning and as it announced earlier this year, the planned separation of the two roles. Recently GCAP’s board of directors was also extended to include Neil Janin as an independent non-executive director. He was chair and non-executive director of BoG until March 2022 and he also acts as counsel to both for-profit and non-profit organisations, including McKinsey & Company, where he acted as a director for over 37 years until his retirement.

During its capital markets day in May 2022, GCAP announced its strategic focus on deleveraging and introduced the NCC ratio to measure its net debt, guarantees and future investment commitments relative to portfolio value (as described in our May 2022 note). During Q322, GCAP’s NCCs remained broadly stable at US$249m (down 0.2% q-o-q), while the NCC ratio decreased 2.6pp to 24.4% on the back of higher portfolio value (driven especially by BoG’s share price performance; see above). GCAP’s holding-level debt was also reduced in Q322 through a reduction in guarantees (€8.4m to €6.4m) on the borrowings of the beer business on the back of the latter’s recent strong operating performance (assisted by the lifting of lockdowns and tourism revival).

GCAP targets an NCC ratio of 15%, with management being confident this could be achieved within two to three years. At the current portfolio value, this implies NCCs of c US$153m, ie US$93m below the current level (or c GEL253m at the current FX rate). We believe that this extent of deleveraging could be achieved through the disposal of some of GCAP’s ‘subscale’ portfolio companies (which at end-September 2022 were valued at GEL287m in aggregate). This could be further supplemented by GCAP’s dividend income from portfolio companies, which during 9M22 amounted to GEL66m, with the largest payments received from BoG (GEL23m), its pharmacy business (GEL16m) and hospitals (GEL13m). GCAP also expects further GEL27.6m in dividends to be received in Q422 (of which GEL18.1m from BoG was already collected in October 2022), which would bring the FY22 dividends to c GEL94m (26% above FY21). Dividends received by GCAP in 9M22 were GEL9m higher than its operating and financial costs (including non-cash costs of share-based compensation).

Alongside deleveraging, GCAP has been gradually repurchasing its holding-level debt consisting of US$365m worth of 6.125% Eurobonds (maturing in March 2024). To date, it has repurchased US$102m of the outstanding bonds (US$73m in the open market, US$29m through a tender offer in October 2022) and cancelled US$65m in October 2022. Given the c 11–12% yield to maturity at which the bonds have been recently trading, GCAP has bought back these bonds at a discount to par (12% during the tender offer). We note that GCAP’s pro-forma cash and liquid funds at end-September 2022 stood at c US$115m versus gross debt at c US$261m (both figures excluding repurchased but not cancelled Eurobonds), suggesting that GCAP has a certain headroom to continue buying back its bonds outstanding (subject to retaining a cash buffer for planned investments, buybacks and a contingency/liquidity buffer). Management expects that, based on current liquidity, GCAP will have to roll over c US$200m of the Eurobonds before/upon maturity.

Moreover, GCAP has also been actively refinancing debt at the portfolio company level recently. During Q322, GCAP’s renewable energy business successfully placed US$80m worth of bonds and the housing development business placed US$35m worth of bonds. This allowed the renewable energy business to repay post Q322 the majority of the US$95.4m shareholder loan. GCAP provided the loan in January 2022 as a part of water utility business disposal, as described in our January 2022 note. The remaining US$10m of the shareholder loan will be converted into a quasi-equity type instrument in Q422. The green bonds bear a 7% fixed coupon (compared to 7.75% of the redeemed US$250m GGU bonds) and have a five-year maturity (callable after two years). The business placed the bond on the local market, which is the first domestically listed green bond, and the largest bond to be listed on the Georgian Stock Exchange (the GGU bond was placed on the Irish Stock Exchange). The US$35m bond placed by the housing development was used to refinance the former US$35m local bonds, which matured in October 2022. The terms of the issue reflect tightening credit markets since October 2019 (the issue date of the refinanced debt) with the coupon increased to 8.5% (from 7.5% previously; we note that the increase in coupon rate is significantly below the aggregate increase in the key policy rate of the National Bank of Georgia of 450bp since September 2019) and the maturity shortened to two years (from three years). After the Q322 refinancings, 42% of the underlying portfolio’s debt matures in 2025 and beyond.

Additionally, GHG (comprising GCAP’s healthcare businesses) secured a US$35m five-year financing package with the European Bank for Reconstruction and Development. Of the US$35m, US$10m will replace former financing from EBRD signed in 2020 to support the response to the COVID-19 pandemic, US$15m is designated to buy out the minority (11%) shareholder of the pharmacy business and the remaining US$10m will allow for upgrading 15 hospitals with medical equipment to enhance their value proposition.