April 21, 2011

Production in Africa: Moving Up the Value Chain

In our continued effort to distill what was discussed at the African Investment Conference put on by Institutional Investor Magazine, we wanted to highlight the emphasis which was placed on Africa’s potential for moving up the production value chain. In many cases, African economies can be (often falsely) perceived as dominated by natural resources or agricultural products alone. Although this perception is often overstated, it is true that commodities and agriculture remain the majority of Africa’s exports to the remainder of the world. However, there is enormous potential for investment in productivity and technology that could transform the composition of a number of African economies. To us, this process has already begun in many countries and sectors across the Continent, as savvier governments, growing economies, and more capital and expertise have made it possible for movement up the ‘value chain.’

Briefly, the ‘value chain’ is the idea of bringing raw or unfinished goods closer to a final, finished product. In each step of this process, the value of the good which is produced (and therefore the price for which it is sold) increases, often substantially. For example, in the production of a cotton shirt, a number of steps must be taken for raw cotton to be transformed into a finished product:

Raw Cotton -> Processed Cotton ->Thread -> Fabric -> Shirt

This (simplified) diagram demonstrates a basic value chain. In this example, raw cotton would be sold at a price which is significantly lower than processed cotton, et. cetera, with companies profiting at each step from the improvements they make. Thus, a company which processes cotton will buy raw material, and sell an improved good for a profit. Industries which are built on bringing goods up a step in this process often provide higher paying sustainable jobs, economic growth, and increased profit potential, as well as help diversify an economy away from basic materials into more ‘value add’ industries.

In terms of Africa, we see a great deal of potential for movement up the value chain. As we mentioned before, Africa is a major producer of a number of raw goods, which are often exported to other countries for improvement. This is problematic for a number of reasons: for example, the value which is added during the processing of a raw material is lost if the processing happens abroad, as are the highly skilled (and higher wage) jobs this processing requires.

Although each country is unique, Africa as a whole has been historically perceived as a poor place for investment in value added processes or vertical integration. In many cases, a history of corrupt governance, coupled with low levels of expertise and limited infrastructure have often made it difficult for business ventures to be successful, which has made investors wary of allocating capital to the region. In addition, domestic demand for many goods and services has historically been too low to justify the development or relocation of production facilities.

However, we believe that the historical view of many African nations’ potential for value addition should be revisited, as a number of catalysts have been developing which makes investment in these sectors more compelling. First and foremost, it is important to note that, in many cases, governance has improved substantially. Improvements in macroeconomic stability and the legal framework have often made the climate easier for businesses to be successful on the continent.

In addition, governments have become more sophisticated in negotiating deals with firms that are bidding for local contracts. In previous years, Africa’s natural resources were often extracted by foreign firms, which would remove raw goods from the continent and improve them elsewhere. However, in more recent years, governments have begun to require that extractive firms add infrastructure or value-add components to their bids for contracts. For example, as you can see in the chart below from McKinsey, from 1991-2000 only 1% of Africa’s largest resource deals had a component which included investment in infrastructure or industrialization. In contrast, that number grew to 9% between 2001 and 2005, and had risen to 23% in the period from 2006 until 2010.

Resource Deals in Africa | African Investments
In addition, as industrialization increases the availability of better jobs in Africa, it also signifies the expansion of the middle class, creating greater domestic demand. This cycle reinforces itself, and as the African consumer class grows (and urbanization facilitates entry points in the retail market), demand for domestic production will grow as well.
So again, we return to what this means for how Nile looks at investing in Africa. We believe that there are a number of opportunities for selective investors to capitalize on the growth these catalysts will create. First, and perhaps most direct, there are gains to be made by investing in companies who are on the forefront of this trend. For example, firms that are investing in goods and services which satisfy growing domestic demand could have substantial potential. We seek to identify industries and firms which are investing in sectors where growth will be strong. This could include firms which are producing goods for export, but we also see potential in companies which are looking to capitalize on Africa’s growing consumer class (read more here).
However, there are also a number of opportunities for less direct investments which could capitalize on this trend. We had previously written about investing in infrastructure firms (read here), which we see as one of the key opportunities in Africa at this point. A firm which is able to provide infrastructure needs such as power and transportation makes it easier for these ‘value add’ sectors to develop and grow. In addition, opportunity may be found in financial firms which provide capital for emerging firms and industries to grow. These financial institutions tend to have a good local knowledge base and may generate substantial profits in tandem with the companies they fund.
As Africa’s infrastructure improves and its demand for more and better consumer goods continues to grow, we continue to believe that the opportunity for investment in the Continent remains substantial, and we are actively seeking ways to invest in companies that are well positioned to take advantage of it.

For more information about investing in Africa, please contact Nile Capital Management at (646)367-2820 or info@nilecapital.com.

We know Africa - from Cairo to Capetown.

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