Annual Highlights: December 2014

•  The Fund posted a negative return in December to close a weak year of performance
•  Annual performance attribution led by weakness in Nigeria
•  Optimistic with respect to the long-term earnings potential of our underlying portfolio holdings
•  Arabian Cement - Preparing for a Cyclical Rebound in Egyptian Construction and Development
•  Umeme - Stable Cash Flow and Potential for Outsized Returns Amid the Ongoing Electrification of Uganda

The Fund posted a negative return in December to close a weak year of performance

We anticipate 2015 will be a strong year for the companies in our portfolio as Africa is still in the very early stages of what will eventually be viewed as a long-term, multi-year cycle of productivity growth. From a bottom-up perspective, we find valuations to be most compelling in West and Southern Africa as heightened macroeconomic and political headwinds have caused asset prices to cheapen significantly. Although we remain mindful of such risks, these regions are well positioned to outperform once the operating environment improves. From a top-down perspective, we find North and East Africa to be most attractive although valuations have become expensive on a relative basis. Here, we are likely to increase exposure should sentiment weaken amid elevated risk of contagion from abroad. Although we are extremely disappointed by 2014’s lackluster performance, the valuation multiples which define our portfolio have cheapened considerably. Although we expect margins to improve for the vast majority of our underlying portfolio companies in FY15, the long-term impact of local currency depreciation is difficult to measure and will largely depend on the persistence of commodity price weakness. Indeed, commodity exporters such as Angola and Nigeria have been severely affected by an adverse terms of trade shock as falling energy and mineral prices weigh heavily on export revenue. Nevertheless, capital flows across the continent continue to improve with investors displaying a renewed appetite for North Africa, and Egypt in particular.

As fundamental value-driven investors, we seek to develop and maintain a strong understanding of the industries in which our portfolio companies operate. If we can be reasonably certain that a company’s earnings will materialize and express a high level of confidence around our forecasts of three-to-five year earnings growth, our portfolio will consistently deliver risk-adjusted absolute returns and outperform relevant benchmarks over time. Although FY14 was marred by local currency weakness, we remain encouraged by the performance of our portfolio holdings, many of which are well positioned to benefit from the current operating environment. Looking ahead, we favor companies with strong earnings growth, high payouts and low leverage. We believe that growth garners a premium, payouts will be rewarded and the low interest rate environment will keep credit flowing. By contrast, businesses with a negative beta to a stronger US Dollar are likely to perform poorly over the medium-term. These include industries where sales are tied to commodity prices or where inputs are tightly correlated with a stronger US Dollar.

At a time when global growth is uneven, financial market uncertainties tend to linger, and headwinds from excessive debt and aging infrastructure act as brakes to economic growth. African economies are relatively unburdened by debt and are aided by favourable demographics, rising incomes and an expanding middle class. Nevertheless, external shocks will continue and investors must be more discerning with regard to country, sector and security selection. In that regard, we continue to favor economies with attractive per capita income growth and favorable demographics. Such economies are more likely to generate self-sustaining momentum in domestic demand which will in turn enable them to more effectively weather external shocks.

Annual performance attribution led by weakness in Nigeria

Country attribution was largely mixed although West Africa’s negative contribution was the primary driver of FY14 performance. Unlike 2013, when West Africa contributed roughly 2,000bp of positive attribution, the region disappointed in FY14 and was responsible for -1,405bp of gross attribution on the year. Nigeria alone was responsible for nearly 80% of downside attribution in FY14 with much of the negative contribution occurring during 4Q14 when NGN/USD declined by -10.3%. Indeed, Nigeria accounted for 45.8% of negative attribution in 4Q14 of which roughly 40% or -303bp can be traced to Naira depreciation. At the total portfolio level, currency-related losses accounted for -650bp or 45.7% of gross performance in FY14. From a regional perspective, East Africa was this year’s primary contributor as portfolio gains were realized from Uganda (+227bp), Kenya (+184bp) and Tanzania (+151bp). North Africa also contributed positively as Egypt (+340bp) was the best performing country in terms of portfolio attribution.

In terms of performance, eight of sixteen locally domiciled stock indices in Africa ex-South Africa were trading at lower levels when compared to 2013. On a year-over-year basis, the three largest declines in USD terms were the Nigeria All Share Index (-26.5%), Ghana Composite Index (-22.2%) and Zimbabwe Industrial Index (-19.5%). By contrast, the three largest advances were the Egypt EGX 30 Index (+27.8%), Tanzania All Share Index (+23.6%) and Uganda All Share Index (+15.6%). In terms of aggregate size, the overall market capitalization for Africa ex-South Africa declined by -2.7% year-over-year to US$270.64 billion in 2014.

In aggregate, daily average traded volume for Africa ex-South Africa rose by +26.7% year-over-year in USD terms. Yet on an individual country basis, eight of sixteen locally domiciled stock exchanges in Africa ex-South Africa exhibited a decline in daily volumes when compared to FY13. On a year-over-year basis in USD terms, the three largest declines in daily average traded volume were the Rwanda Stock Exchange (-19.4%), Ghana Stock Exchange (-18.6%) and Zimbabwe Stock Exchange (-14.3%). By contrast, the three largest advances were the Dar es Salaam Stock Exchange (+75.0%) Uganda Securities Exchange (+50.7%) and Egyptian Exchange (+41.7%).

Unlike the relatively mixed dispersion in country attribution, sector attribution was broadly weaker with seven of nine sectors contributing negatively in FY14. Consumer staples (-737bp) led the way lower as rising input costs weighed on margins and profitability. Energy (-436bp) and materials (-140bp) also contributed negatively as weaker commodities weighed on overall performance.

We remain overweight financials but have reduced our exposure and are taking a far more defensive approach to the sector. Despite low non-performing loans and relatively high levels of liquidity, we remain cautious as a number of African banking systems will see capital buffers erode and asset quality weaken amid tighter liquidity conditions. Indeed, the impact of lower oil prices will be negative for African banks operating in petroleum exporting nations (e.g. Nigeria, Angola) as non-performing loans are expected to rise noticeably. Looking ahead, we prefer financial companies with stable sources of non-interest revenue, low operating expenses, and little energy or public sector exposure. Similarly, we remain overweight consumer staples and prefer companies with greater control over input costs and margins. Although the net impact of declining commodity prices has thus far been inflationary, we believe this could change once local currency depreciation subsides. Although we are not forecasting a meaningful uplift in domestic consumption, we do see the potential for household spending on non-energy goods and services to rise over the medium-term. We are presently comfortable with the portfolio exposure to the energy and materials sectors, we hope to take advantage of near-term weakness by building exposure to undervalued companies at increasingly attractive prices. Within the energy sector, we prefer companies with the flexibility to scale back spending plans whilst maintaining enough capital investment to keep production growing. We are similarly comfortable with our existing exposure to the telecom and utilities sectors as current positioning is a function of individual company valuations. Looking ahead, we will actively seek to increase exposure during periods of market weakness.

Optimistic with respect to the long-term earnings potential of our underlying portfolio holdings

Looking to 2015, we are optimistic with respect to the earnings potential of our underlying portfolio companies. We remain mindful of political uncertainty as elections in Nigeria, Cote d’Ivoire, Tanzania and Zambia have the potential to affect both confidence and economic activity. It should however be noted that political change in Africa can no longer be viewed as a red flag, and in many places, the run-up to presidential elections is often accompanied by a high degree of spending and investment. Although conflicts, terrorism and related security disruptions continue to be a prevailing concern throughout the region, we remain encouraged by the performance of our portfolio holdings despite recent disturbances such as the Ebola crisis in West Africa and Boko Haram insurgency in Northern Nigeria. Overall, investor sentiment toward Africa remains on the upswing as evidenced by the rise in primary market activity as new equity and bond issuances have picked up considerably in recent months. It should be noted that the successful performance of recently-listed African IPOs has fueled a surge in demand and we expect a number of domestic companies to test the capital markets over the coming months.

We share the outlook for two individual holdings, namely Arabian Cement Company and Umeme. These were two of our best performing positions in 2014, and we are extremely excited about their long-term potential. Arabian Cement is one of Egypt’s leading cement manufacturers and is well positioned to benefit from the nation’s rapidly improving macroeconomic environment. Umeme is one of East Africa’s largest utilities and the leading electricity distribution company in Uganda. When taken together, the two companies contributed nearly 500bp of positive attribution in FY14.

Arabian Cement - Preparing for a Cyclical Rebound in Egyptian Construction and Development

Arabian Cement Company (ACC) is amongst the top five cement producers in Egypt with market share of approximately 7.5% and total production capacity of 5.0mtpa across two production lines. Founded in 1997, Arabian Cement’s commercial operations began in 2007 and are focused on the production of clinker and sale of high quality cement for local and international consumers. The company has since emerged as one of Egypt’s most profitable, cash-generating companies with an average return-on-equity of 33.3% over the three-year period to date. In terms of positioning, Arabian Cement is viewed as a premium, high quality brand focused on infrastructure development and residential housing in Greater Cairo and the Delta region. The company’s shares are majority owned by Spanish producer Cementos La Union who presently maintains a 60% equity stake. We first invested in May 2014 and Arabian Cement shares have subsequently returned +93.5% in USD terms.

Our investment thesis is grounded in margin expansion and an increased payout ratio amid rising utilisation and a recovery in demand. Arabian Cement is at the forefront of diversifying its fuel requirements and will be in a position to subsidize almost 100% of its energy needs by year-end. Energy accounted for 40% and 33% of the company’s cost of goods sold in FY13 and FY14 respectively. After completing its US$35 million capex plan, Arabian Cement will have the flexibility to substitute natural gas with coal and refuse-derived fuel as alternative energy sources which will translate into improved margins, higher utilisation rates, and greater profitability going forward. As a result, we believe there is scope for management to increase its payout ratio and project significant dividend growth over the coming years. Furthermore, the company will continue to focus on the expansion of its in-house distribution (Express Wassal) and near-demand warehousing for bulk and packaged products. This should reduce dependency on third party providers and enable Arabian Cement to more successfully control product flow, price positioning and penetration into fragmented markets. Although a full recovery in demand will take time to materialise, the improved operating environment coupled with government stimulus packages and a renewed focus on low- to middle-income housing should provide medium-term support to Egyptian cement consumption. Over the long-term however, we expect Egyptian cement demand to increase exponentially with Arabian Cement positioned to be a primary beneficiary given its higher utilisation rate and more optimal fuel mix.

The Egyptian cement industry is the 12th largest producer in the world, accounting for approximately c.1.3% of FY14 production. The market is primarily driven by local consumption, particularly residential real estate construction (78% of total consumption), which has been relatively stable over the past few years despite supply disruptions stemming from power outages, energy supply cuts, labor strikes and rising fuel costs. The industry is presently in the early stages of development and comprised of 19 companies with combined annual capacity of 67mtpa. Bagged cement sales continue to dominate although bulk sales are expected to rise amid increased government stimulus and a rise in infrastructure spending. It should be noted that Egypt has historically suffered from low levels of investment in infrastructure. As such, the general state of Egypt’s infrastructure is poor and in need of maintenance. Given Egypt’s high rate of urbanisation and recent migration to sizeable communities East and West of Cairo, the impact of inadequate infrastructure has been magnified considerably. Moreover, the Egyptian Government has committed itself to infrastructure spending as evidenced by recent adoption of two fiscal stimulus packages totaling more than US$9.2 billion.

We have been following Arabian Cement since May 2008 when the company commissioned its very first clinker line. Today, the company has a 2.8km limestone conveyor belt located on c.1.5 million sqm of land and supported by two production lines, each consisting of: a vertical grinding mill, clinker silo, five-stage pre-heater kiln and cooler system, two horizontal cement mills, two cement silos, a packing unit and four bulk loading assets. We have followed the Egyptian cement industry for some time, and have developed a strong working knowledge of the industry and its underlying participants. Over the years, we have developed a relationship with the Egyptian Ministry of Trade and Industry and this has enabled us to gain a better understanding of the industry’s operating licenses, supply agreements, O&M contracts, and distribution agreements, among other governing contracts. Although we had hoped to invest in the industry some years back, rich valuations (pre-Arab Spring) followed by increased political uncertainty (post-Arab Spring) prevented us from making an investment.

We initiated an investment in Arabian Cement in May 2014 when the company’s shares were trading at 8.1x FY13 earnings and 6.9x FY13 EV/EBITDA. Our valuation approach employs Discounted Cash Flow (DCF) methodology. In our DCF model, we discount free cash flow over the three-year period 2015 - 17 based on internal projections of corporate earnings. We then apply a decelerating growth rate from 2018 - 20 before applying a terminal growth rate in perpetuity. We have used a WACC of 14.2% and terminal growth rate of 3% for our calculations. Shares of Arabian Cement are currently trading at 13.2x forward 12m earnings, 7.6x forward 12m EV/EBITDA with FY15 return on equity of 34.5%. Given our target price, this implies roughly 36% upside from current levels.

Umeme - Stable Cash Flow and Potential for Outsized Returns Amid the Ongoing Electrification of Uganda

Umeme is the largest electricity distribution company in Uganda with over 20,000 km of medium- and low-voltage lines covering all major hubs and concentrated in the southeast portion of the country. The company is focused on electricity supply and after-sales service, which involves connection of new customers, meter reading, billing, revenue collection, marketing, customer care and power restoration. Umeme was formed in 2004 and took over management of Uganda’s network for distribution and supply of electricity under a 20-year concession from Uganda Electricity Distribution Company Limited (UEDCL). At the time, Uganda’s distribution network suffered from dilapidated infrastructure due to years of neglect and under-investment. The UEDCL concession was part of the World Bank’s power restructuring program and Umeme has since entered into numerous privatisation agreements, obtaining licenses from the Electricity Regulatory Authority (ERA) for distribution and supply of electricity throughout Uganda. Management of the distribution system in Uganda requires that Umeme maintain and operate the distribution network, collect revenue from customers based on the ERA tariff, invest in maintenance of the network’s assets, and to return control of the distribution network (including new investments) to UEDCL at the end of the concession period (1 March 2025). It should be noted that Umeme is protected by a Support Agreement with the Government of Uganda which entitles the company to 105% of the value of any un-depreciated investments which have not been recovered through the ERA tariff at the end of the concession period. We first invested in May 2014 and Umeme shares have subsequently returned +35.9% in USD terms.

Our investment thesis is underpinned by Uganda’s strong fundamentals and supported by the company’s success in expanding its distribution network. Over the next three years, Ugandan GDP growth is projected to average 6.5% as a result of increased activity in the construction, transportation, telecommunications and energy industries. The Government of Uganda is committed to national growth as evidenced by recent spending plans and further supported by the roll-out of large scale oil production in FY18. At present, Uganda has only 800MW of available capacity - the bulk of which is consumed by processing industries for raw commodities, e.g. coffee, tea, cotton, fish and horticulture products. As such, the penetration level in Uganda is extremely low (c.89%) as approximately 31 million individuals do not currently have access to electricity. Given the nation’s vast reserves of untapped renewable resources, demand for electricity in Uganda is poised to rise exponentially over the coming years. We believe Umeme is well positioned to capitalize on this dynamic as it presently controls c.95% of electricity distribution in Uganda. From an economic standpoint, Umeme bears all of the risk in achieving the ERA tariff targets, including distribution losses, uncollected debt and O&M expenses. Yet assuming Umeme’s operational performance matches the targets used in setting the ERA tariff, Umeme is entitled to any outperformance including entitlement to a contracted USD return of 20% p.a. for un-depreciated, ERA-approved investments on Uganda’s distribution network. We believe this is an attractive feature as it provides a level of comfort and predictability surrounding the company’s future earnings.

The Ugandan power industry involves the production and delivery of electricity through a grid connection, and may be broken into three stages: generation, transmission and distribution. Electricity generation in Uganda is most often conducted at a power station and primarily driven by hydro or thermal energy. The primary generation companies in Uganda are operated by Eskom, Bujagali, Jacobsen and Electro-Maxx, among others. Electricity transmission in Uganda involves the delivery of high voltage electricity (above 33kV) from the generating facility to substations located throughout the country. Uganda Electricity Transmission Company Ltd is the only transmission company in Uganda. Electricity distribution in Uganda involves the delivery of low voltage electricity (below 33kV) from substations to commercial and residential consumers. Although “power island” operators such as Ferdsult and Wenreco manage small operations, Umeme remains the dominant player with a virtual monopoly on electricity distribution throughout Uganda. Since FY06, new connections have risen by 64.7% and distribution losses have fallen by -29.7% on account of Umeme’s efforts. Moreover, collection rates have increased materially with the number of prepaid customers rising by more than 30% per quarter over the past two years.

We have been following Umeme since the company was initially awarded the UEDCL concession back in 2005. At the time, the company was jointly-owned by Globeleq (a subsidiary of CDC) and Eskom. Over the coming years, we kept track of Umeme’s progress as CDC purchased Eskom’s stake in 2006 before transferring 100% ownership to Actis in 2009. In so doing, we gained familiarity with Umeme’s contractual framework, most notably the Lease & Assignment Agreement, Power Sales Agreement, Support Agreement and License for Supply & Distribution. We also gained comfort with the Uganda Electricity Act, tariff mechanism and underlying concession terms. It should be noted that we have long maintained a strong professional relationship with the team at Actis and although liquidity concerns prevented us from participating in the company’s Uganda Stock Exchange (USE) initial public offering (November 2012), we have long admired management’s success in achieving both its operational and financial goals. It should be noted that Umeme receives over 70% of its revenue from industrial, commercial and government customers. As such, the company’s cash flow is extremely secure and supported by a high quality customer base consisting of blue chip clients, including: Coca Cola, Diageo, Lafarge, MTN, SAB Miller and Unilever, among others. Further, the company’s high dividend payout policy offers additional protection for defensive-minded investors. Thus, when we learned of Actis’ intention to sell an additional 45.1% of its remaining 60.1% equity stake at a discount to the USE market price, we elected to participate in the placement.

We initiated an investment in Umeme in May 2014 when the company’s shares were trading at 6.6x FY13 earnings and 1.9x FY13 EV/EBITDA. Our valuation approach to Umeme employs both Discounted Cash Flow (DCF) and Dividend Discount Model (DDM) methodologies. In our DCF model, we discount free cash flow over the three-year period 2015 - 17 based on internal projections of corporate earnings. We then apply a decelerating growth rate from 2018 - 20 before applying a terminal growth rate in perpetuity. In our DDM, we incorporate explicit earnings forecasts over the three-year period 2015 - 17, a decelerating growth rate from 2018 - 20 and perpetual growth thereafter. Shares of Umeme are currently trading at 7.0x forward 12mo earnings, 5.1x forward 12mo EV/EBITDA with FY15 ROE of 32.5%. Given our blended target price, this implies roughly 60% upside from current levels.

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