Shareholder Letters

Extract from 2010 Annual Report

It is my pleasure to write you for the first time since joining Bank of Georgia as Chairman of the Supervisory Board in June 2010. I joined the bank after retiring from a career at McKinsey and Company where I had the chance to work with financial institutions worldwide, though not in Georgia. Allow me this first time to share with you my thoughts with respect to the past year, the outlook for the future and most importantly the environment of Georgia, where the Bank of Georgia continues on its remarkable journey. 

During the past year I had a chance to observe how young and determined country like Georgia fares with the effects of global financial crisis and to appreciate its government’s resolve to stay on the free market path. It is this path that helped propel its once failing economy to the emerging economic success that it enjoys today. The most noteworthy accomplishment is the implementation of stunning reforms, which resulted in the eradication of corruption. This is a story that needs to be told to serve as an example for others. 

Also of note, is the government’s commitment to ensuring a business and investor friendly environment. These efforts were recognized by the international community, which in 2008, in the midst of global financial crisis, pledged US$ 4.5 billion, or 40% of Georgia’s GDP, helping the country cope with the crisis and providing it with the means to continue to invest in its future. 

Georgia ended 2010 with a respectable 6.4% real GDP growth, external debt level of 38% of GDP, stabilized currency and record level of foreign currency reserves at US$ 2 billion that continued to grow to US$ 2.5 billion by March 2011. With more than US$2.0 billion of donor funds still to flow into the country, Georgia is gearing to establish itself as a regional energy hub by utilizing the vast untapped hydro power potential. 

Having eliminated corruption, a plague still tormenting the countries in the region, Georgia, with its liberal tax regime and abundant growth opportunities, has the right elements in place to become the destination of foreign investments, as Georgian economy advances and once the perception of risks diminishes. To this end, 2011 started on a positive note. Only several weeks ago, Georgia successfully placed its second US$ 500 million 10-year benchmark Eurobonds. With the yield of 7.125%, the new Eurobond is 37.5 bps lower than the yield of the existing shorter term 2013 Eurobonds. The improved pricing and the strong demand reflected in the deal 5.3 times oversubscribed serve as a testament of the increased investor confidence towards the country. In line with the improved investor sentiment, Fitch Ratings and Standard & Poor’s, both of which have assigned ‘B+’ sovereign rating, have upgraded their respective outlooks from stable to positive in March and April 2011, respectively. 

For Bank of Georgia, the country’s largest bank, 2010 was a defining year in many ways. Having demonstrated its resilience in the times of global financial disruption, the bank weathered the tough economic environment without resorting to capital injection. More importantly, Bank of Georgia used its strength to capture the opportunities arising during the bad times and came out stronger from the crisis, reinforcing its leadership role on its home market. The sensible deployment of excess liquidity that we conservatively maintained during the downturn resulted in the healthy growth of the loan book and the improved loan quality in 2010. The country’s most trusted top brand, Bank of Georgia attracted a record volume of client deposits both locally and internationally. These accomplishments, coupled with the increased efficiency, have led to the significant market share gains to the record high 36% by assets and by loans and 32% by deposits by the end of the year. Also, notably, international credit rating agencies have revised their ratings of Bank of Georgia. In August 2010, Fitch Ratings upgraded the bank’s long-term foreign and local currency default ratings from ‘B’ to ‘B+’, the sovereign level. In January 2011, Moody’s Investor Services, rated Bank of Georgia at ‘B1’, an improvement from B3. As of today, all three global credit rating agencies maintain stable outlook for Bank of Georgia. 

The ability to align the strategy to the shifting trends in this fast-growing emerging market is one of the main success factors of Bank of Georgia. Acting upon the changed circumstances in our markets of operation, we made decisions that we believe will benefit our bank and our shareholders: the exit from the loss-making Ukrainian banking operation will not only improve the bank’s consolidated operating performance, but more importantly, it will free-up valuable management resource to allow us sharpen our focus on the considerable opportunities that the growing Georgian economy offers – the commitment we underlined as part of our strategy. 

With its undisputedly leading banking franchise, Bank of Georgia is well-poised to continue to grow organically as the country’s still modest banking sector loan penetration of less than 30% of GDP increases along with the expected growth of its economy. Furthermore, our new Georgia-focused strategy entails the continuation of the vertical integration of our market-leading insurance and healthcare businesses, aiming at capturing the opportunities that we envisage to come from the rapid growth of the underpenetrated insurance market, to be further boosted by the ongoing integration with the healthcare business. In addition, we have announced about our move into Georgia’s affordable housing sector through our real estate subsidiary. The already allocated capital through the repossessed properties allows us to fill in the gap between the demand driven by significant housing shortage and the inability of real estate developers to satisfy such demand. We expect the insurance and real estate to contribute meaningfully to your bank’s earnings over the next few years. You will get more details about the bank’s performance in 2010 in the CEO’s letter and other sections that follow in this report. 

Corporate Governance was the focus of much of the Supervisory Board’s attention in 2010. The move to a two-tier governance structure a year ago has aligned the Bank with international best practices. My fellow non-executive Supervisory Board members bring world-class investment, economic, legal and banking business expertise to the table, complementing the capable and talented group of executives that make up the Management Board of your bank. Building upon the bank’s established results-oriented culture of teamwork and openness, we have put in place an Executive Compensation Policy which implemented the decision to abandon cash-based bonus compensation to replace it with a share based compensation scheme with the long-term share vesting program. 

We started 2011 with confidence in our ability to continue building on our strength that will enable us capture the growth opportunities presented on our home market. Our short-to-medium term strategy entails aggressively pursuing these growth opportunities that we strongly believe will augment the Bank’s growth to translate into increased shareholder value for our fellow shareholders. While 2010 saw a stellar growth of the Bank’s share price of 142%, bringing it above its IPO price at the year-end, Bank of Georgia shares still trade at a substantial discount to CIS banks in terms of both PE and BV multiple. Having demonstrated the ability of turning challenges into opportunities, in 2011 we are looking forward to continue delivering results through superior execution of the strategy we believe will lead to fair valuation of your stock. 

In closing, I would like to congratulate each member of the Supervisory Board, the management and the employees with the strong 2010 results and thank them for the remarkable efforts that made Bank of Georgia’s success possible. In 2011 I am looking forward to working with this dedicated team and a highly engaged Supervisory Board as we continue to realize the full potential of your bank.

Neil Janin
Chairman of the Supervisory Board

Extract from 2010 Annual Report 

Focusing on the important

Dear Fellow Shareholders, 

It is my pleasure to present you Bank of Georgia’s results for 2010, which was a strong and important year for your bank. In 2010 the bank achieved a record operating income of GEL 346.9 million, a 17% increase from 2009, and earned a record net income of GEL 82.7, beating the announced management target of GEL 72 million. Looking back in the context of the past three challenging years, 2010 marks the end of the downturn and further strengthening your bank’s industry leading position on its home market. 

More importantly, these difficult times have demonstrated your bank’s ability to achieve a remarkable balance between size and efficiency. The country’s leading bank in terms of loans, deposits and other important metrics, tackled various challenges arising from difficult and changing environment by means of timely and decisive, yet sensible actions that only efficient companies with lean structures can afford. We ended 2010 with healthy revenue streams, positive operating leverage, reduced risks and our capital and liquidity levels remain strong. With these drivers of profitability in place we enter the future from a strong position. I would hereby like to share our vision for the next three years, which has been communicated to our shareholders at our Investor Days and various investor meetings. 

At the beginning of 2010 we set out to deliver results that were outlined as part of our strategic priorities for the year. These priorities were growing the loan book following the deleveraging in 2009, decreasing our funding costs and improving our operating efficiency. The superiority of our lending machine was demonstrated by the 41.6% growth of the loan book enabling us to take away 4% share from the rest of the market in Georgia, which grew 14% in terms of loans during the year. Notably, our cost of risk were reduced while loan yield remained largely flat. On the back of continuous inflow of funds into the country, our client deposits grew by GEL 732.2 million, or 57.5% to a record level of GEL 2.0 billion, also gaining 4% market share by client deposits. As a result of the stellar growth of the client deposits in Georgia, which was also supported by the successful attraction of funds internationally by our wealth management operations, we are happy to report the further strengthened balance sheet structure. As of the year-end, Net Loan to Client Deposit Ratio was down to 117.3% from 130.6% a year ago. The successful reduction of interest rates on deposits to the average of 6.6% at the year-end have led to the decline of our cost of funding as the composition of our liabilities changed with cheaper deposits replacing wholesale funding. These developments and the excess liquidity allowed us to announce a tender offer to buyback Eurobonds maturing in 2012, further diminishing our reliance on expensive external wholesale funding. 

2010 saw the improvement of the bank’s loan quality. Along with the recovery of Georgia’s economy, our non-performing loans represent 4.7% of the loan book compared to 7.7% in 2009 and our cost of risk of 1.8% is approaching the pre-crisis level. 

In 2010 we committed ourselves to a constant strife towards efficiency. The effectiveness of the cost cutting measures implemented across the board and the benefits arising from technological advancements made us more efficient as demonstrated in the decline of our Cost Income ratio from 93.3% last year to 58.9% in 2010, and the increase of operating leverage, despite the high-cost burden incurred by BG Bank, Ukraine’s operations. We are confident that the full advantages from the increased products offerings, distribution channels, full deployment of the new IT systems and the efficiencies of scale are yet to be realized, especially as retail lending accelerates. We remain committed to decreasing our expense base bringing our consolidated Cost/Income ratio below our current standalone Cost/Income ratio of 49%. 

The performance of Bank of Georgia and the markets where we operate prompted us to revisit our strategy over the short-andmedium term and gave us the foundation to put in place a structure and a strategy in the context of our strengths, weaknesses and opportunities. First and foremost, our new strategy is based on our strong belief in investing sensibly where we see opportunities and where we are confident of our execution capabilities. The continuity of the Georgia’s economic advancement and the ample growth opportunities it offers calls for our laser-sharp focus on our home market. This focus, we believe is the foundation of our strength and our ability to deliver to our clients and shareholders. 

In line with the new strategy, we sold our equity interest in BG Bank in Ukraine, a decision that we believe will further improve our efficiency and allow us concentrate on the profitable growth of our Georgian business. The strong balance sheet, superior retail and corporate banking and insurance franchise positions the bank strongly to leverage on the growth of the Georgian economy, which will ultimately benefit our shareholders more than the pursuit of international expansion. 

Our new strategy aims at delivering a ROAE of more than 20% and doubling our loan book by year-end 2013. Having grown by 6.4% in 2010, Georgia’s real GDP is estimated to grow by 5.0% on average over the next three years. The decreasing interest rate environment and the growing corporate sector is expected to boost the banking sector lending, which is estimated to reach at least 40% of GDP from as low as current 29%. These reasonable and conservative assumptions provide us with immense role to play in the advancement of the country and our track record of execution and the market leading position puts us in the right place to capitalize on the organic growth of Georgian banking sector. 

Bank of Georgia includes businesses that have strong positions in their respective promising sectors, but are not entirely central to our core business. Aldagi BCI (ABCI), the bank’s insurance subsidiary and the country’s leading insurance services provider, has made remarkable progress over the past several years. The backward integration of its rapidly growing health insurance business with healthcare business contributed considerably to ABCI’s strong performance in 2010, producing 26% return on equity. Georgia’s fragmented and underpenetrated health and life insurance sector is now gearing up for growth strongly supported by government programs, which envisage the establishment of small and mid-sized hospitals by private insurance companies. With healthcare spending accounting for 8% of Georgia’s GDP and only 0.8% of GDP currently being spent through health insurance, ABCI, the country’s top insurer, is strongly positioned to capture most of the healthcare spending and up-sell insurance products creating synergies between insurance business and healthcare provider. To this end, we decided to further enhance the vertical integration of ABCI with the view to enlarge the current business model currently consisting of six outpatient clinics and one mid-sized hospital operated by ABCI. The advantages that come from the advancements in the vertical integration and the increased insurance penetration are expected to raise ABCI’s contribution to your bank’s net income from five per cent in 2010 to more than 10% by 2013. 

Another growth opportunity we are well-positioned to capitalize on is presented to us by the housing shortage, legacy of the Soviet era, and the near absence of primary supply to satisfy a large and growing demand for housing, as the financial crisis negatively affected the country’s top three real estate developers. Such unsatisfied demand for new housing has translated into the slowdown of our mortgage book growth, an issue we are prepared to address by making a move into affordable housing business through SBRE, our real estate subsidiary. As a result of the crisis, we couldn’t avoid allocating the capital through number of repossessed land plots, and we are successfully implementing a pilot project selling studio apartments. We intend to outsource architecture and construction works and plan to engage in the project management and sales of these apartments through our superior distribution channels of 143 branches and 1,500 sales force. We estimate to sell up to 2,000 units over the next three years, which will not only help boost our mortgage lending, but is expected to contribute more than 10% to our consolidated net income in the next few years. 

Our drive for value creation has prompted us to consider a move to a holding structure. As Bank of Georgia’s shareholder you have exposure to non-banking businesses, such as insurance and real estate, which have already grown and will continue to grow to the levels that will contribute more meaningfully to your bank’s earnings. The separation of these businesses from banking operations and bringing them together under one holding structure, will not only free up capital of the core banking franchise, but will help maximize the value of each one of them separately. The new structure, we believe, will result in greater accountability of performance and will help fully realize your company’s earnings power. We are working with our advisors on the optimal structure and the procedures for such move to ensure that it serves the best interests of our businesses and our shareholders. We will report on our progress as we move along this path. 

In conclusion, strong performance in 2010 has positioned us strongly to capture the growth opportunities in our priority market and emphasized our task to ensure even better performance in the years to come. 

Finally, I would like to thank our world-class supervisory board members for their support and invaluable guidance, my fellow management board members and the employees for their dedicated work and congratulate them with our achievements.

Irakli Gilauri
Chief Executive Officer