Executive Summary

• Fixed Income: Yields on T-bills continued on a downward trend with the 91, 182 and 364-day dropping to 7.2%, 9.6% and 10.7%, respectively. The FOMC met during the week and maintained the United States Federal Funds Rate at 0.25% - 0.50%, citing global economic fears and domestic shortcomings;
• Equities: During the week the market was on a downward trend with NSE 20 and NSE 25 losing 1.3% and 0.5%, respectively. The Central Bank of Kenya (?CBK?) has approved the acquisition of a 51.0% stake of Oriental Commercial Bank by Bank M of Tanzania.
• Private Equity: The health and ICT sectors continue to witness increased private equity activity in East Africa, evidenced by General Electric?s (GE) commitment to invest Kshs. 1.3 bn in healthcare in Kenya, while ICT proves to be a key economic growth contributor according to the Africa Infrastructure Development Index 2016;
• Real Estate: The real estate sector continues to grow, with Helios Investment Partners announcing that it has set up a real estate unit that will manage property owned by Telkom Kenya, estimated to be worth Kshs. 13.0 bn;
• Focus of the Week: With the release of Q1?2016 results by banks, we examine the state of the banking sector in Kenya, the transition the sector is facing and the regulatory environment.

Company Updates

• To enhance client experience, we launched a Client Relationship and Investment Management System (CRIMS), where all the clients? transactions can be viewed and done online. To learn how to log into our online account, contact clients services at clientservices@cytonn.com
• Cytonn Investment Co-operative began its membership recruitment drive on Thursday 16^th To join, please contact us at coop@cytonn.com
• This week, we were joined by 3 new managers in Cytonn Real Estate, our development affiliate, which currently has Kshs 73 bn of real estate development projects under mandate. We are pleased to welcome such experienced managers to Cytonn, as we work to deliver unrivalled real estate investment products to our investors and clients. The new managers are:
  • Willis Ouma has joined the firm as a Senior Project Manager. Willis, together with the real estate leadership team, will oversee the development planning and execution across our entire portfolio of projects. Prior to joining Cytonn, Willis was the General Manager with National Housing Corporation, where he was in-charge of execution and delivery of housing. He has vast experience in real estate, having worked with Howard Humphreys in Nairobi as a Projects Manager, Turner International in Qatar as a Contracts Manager and Nakheel and Hamilton, both in Dubai, as a Contracts Manager.
  • Frank Ndubi has joined the firm as a Quality Assurance Manager. Frank will integrate himself with all project teams across our real estate developments, ensuring quality and consistency in design and execution of our real estate development projects. A registered Quantity Surveyor, Frank has over 30 years of experience as a Quantity Surveyor, as well as in quality control, having executed various projects in Kenya, Rwanda and Nigeria. Prior to joining Cytonn, Frank worked with Greenbill Quantity Surveyors and previously with Belgravia Services Limited.
  • Peter Karenju has joined the firm as a Project Manager. Peter will join the project management team, overseeing and actively managing real estate development projects from inception till completion and exit. Peter joins Cytonn with strong experience in project management, including Home Afrika as a Project Manager, as well as road construction projects in Tanzania.
• We continue to beef up the team with other ongoing hires: Careers at Cytonn.

Fixed Income

During the week, T-bills were oversubscribed with a performance rate of 136.2%, down from 182.9% recorded last week, given more focus on primary bonds. Subscriptions for the 91-day and the 182-day were at 190.9% and 143.9%, respectively, compared to 166.7% and 166.2% record the previous week, respectively. However, the 364-day was undersubscribed this week with a performance rate of 92.0%, compared to 210.0% the previous week. The drastic drop in subscription of the 364-day paper is due to investors preferring shorter term papers especially after the reading of the budget for 2016/17, which indicated a domestic borrowing target of Kshs 245.0 bn, up from Kshs 219.2 bn, which may result in volatility in interest rates. The yields however continued with their decline, coming in at 7.2%, 9.6% and 10.7% from 7.3%, 9.7% and 10.8% for the 91-day, 182-day and 364-day, respectively.

The 91-day T-bill is currently trading below its 5-year average of 10.5%, having witnessed significant stability in the last two months. The Central Bank of Kenya (?CBK?) is keen on interest rates reduction supported by the monetary policy stance of lowering the CBR by 100 bps to 10.5%. However, despite the reduction in CBR, we expect the rates to bottom out at the current levels as we close out on the current fiscal year.

The government this week issued a 2-year and a re-opened 15-year bond with 11-years to maturity (FXD 2/2016/2 and FXD 1/2012/15) for a combined amount of Kshs. 30.0 bn to be used for budgetary support. The bonds were oversubscribed with total bids of Kshs 50.8 bn, a performance rate of 169.4%, with the 2-year receiving 68.3% of the total bids. The yields for the 2-year and 15-year bonds came in at 11.5% and 14.3% compared to 12.0% and 15.0% from the last auction, respectively. In the secondary market, a 2-year and an 11-year bond is currently yielding 11.8% and 14.3%.

Based on the Central Bank weekly report, the interbank rate increased by 20 bps to 2.5%, from 2.3% the previous week, despite a net liquidity injection of Kshs 4.5 bn in the money market. This was due to banks trading cautiously in the interbank market in order to meet their CRR cycle ending June 15^th, 2016:

According to Bloomberg, yields on the 5-year and 10-year Eurobonds issued in 2014 have declined 231 bps and 127 bps from 8.8% and 9.6%, respectively, since their peak in mid-January 2016 on account of improving macroeconomic conditions. Week-on-week, the 5-year and 10-year rates rose to 6.5% and 8.4% from 6.2% and 7.9%, respectively.

Government is still ahead of its borrowing schedule having borrowed from the domestic market Kshs 368.2 bn for the current fiscal year against a pro-rated borrowing of Kshs 210.1 bn. The domestic borrowings will help plug the deficits in foreign borrowing of Kshs. 88.3 bn, as shown below.

Source - The Treasury/CBK

On a net basis, Government is not under pressure to fund the budget as the domestic borrowed funds more than compensate the shortfall in foreign borrowing. There is no updated data on the expenditure, but according to the last published data the expenditure is much slower than projected. As at December 2015, the total expenditure was Kshs 727.4 bn below the target of Kshs 997.0 bn, with recurrent expenditure of Kshs 416.5 bn, development of Kshs 204.4 bn and other expenditure of Kshs 106.5 bn.

The Kenya Shilling depreciated slightly against the dollar by 0.1%, to close the week at 102.1 compared to 102.0 the previous week, as a result of strong dollar demand by the energy sector, as the end-month demand from importers began. On a YTD basis, the shilling has appreciated against the dollar by 0.3% supported by (i) the high levels of foreign exchange reserves currently at USD 7.6 bn, equivalent to 5.0 months of import cover, and (ii) improved diaspora remittances, with cumulative 12 months inflows to March 2016 increasing by 10.2% to USD 1.6 bn from USD 1.5 bn in March 2015.

This week, the Energy Regulatory Commission (ERC) announced the price caps for petroleum for the period between 15^th June and 14^th July 2016. Prices for Super Petrol, Diesel and Kerosene increased by 2.3%, 4.0% and 8.1%, respectively, to Kshs. 86.2, Kshs. 73.2 and Kshs. 50.8 per litre, respectively. This comes after the Treasury Cabinet secretary announced the following tax proposals on petroleum products:

• Increment of the road maintenance levy to Kshs. 18.0 from Kshs. 12.0. The ERC is working hand in hand with the Kenya Roads Board and the Kenya Revenue Authority to establish an implementation date,
• The introduction of excise duty on Kerosene at Kshs. 7.2 per litre. This is aimed at reducing harmful practices such as its use in adulteration of other petroleum products, and,
• The postponement of the VAT on petroleum products to September 2017.

All the above proposals point to an increment of the prices of petroleum and petroleum related products even in the coming months, though the VAT will come much later. On a y/y basis, petrol, diesel and kerosene are down 11.4%, 11.5% and 17.8%, respectively. These should have some upward pressures on inflation in the coming months.

The Federal Open Market Committee (FOMC) met on 15^th June 2016, and opted to hold rates at the current 0.25% - 0.5% band. It is clear that the initially expected rate hiking cycle will be reduced given the global and the US economic performance. Below are the main reasons for holding the rates:

• Global Economy ? The possibility of Brexit given the recent polls indicating that it may go to the wire will most likely disrupt the financial market, a disruption that will trickle down to the US market. China, which is the largest export market for the United States, is experiencing a transition from an industrial based economy to a serviced based, which may lead to lower demand for US goods further posing a risk to US economic growth
• Poor Employment Numbers ? The three month payroll average fell to 116,000 per month from the average projections of 146,000 according to the Fed, plus the recent negative revisions indicates that the US economy is not as strong as earlier thought
• Low Growth ? The Fed believes that the US economy is stuck in the ?neutral zone? with the Q1?2016 GDP growth coming in at 0.8%

With inflation firming up at 0.2% and GDP growth stuck in the ?neutral zone?, the Fed is not likely to raise rates any time soon as they try to foster growth and anchor inflationary expectations. This may be positive for the Kenyan Shilling, but the slow global economy might impact the economy slightly.

Government is ahead of its domestic borrowing schedule, having borrowed Kshs 368.2 bn for the current fiscal year compared to a target of Kshs 210.1 bn (assuming a pro-rated borrowing throughout the financial year of Kshs 219.2 bn budgeted for the full financial year). With only two weeks left to the end of the current fiscal year, the government has surpassed its local borrowing target. The additional Kshs 158.2 bn above the target will go towards plugging the foreign borrowing deficit. The government will look to shift their attention to achieve the foreign borrowing target and start front-loading for the next fiscal year. With interest rates still coming down, but showing signs of bottoming out at the current levels, we advise investors to lock in funds in short to medium term paper for tenors between six months and one year as the rates are attractive on a risk-adjusted basis.    

Equities

During the week, the equities market was on a downward trend with NSE 20 and NSE 25 losing 1.3% and 0.5%, respectively, while NASI gained 0.3%, taking the YTD performance to -6.3%, -1.2% and 1.2%, respectively. The downward trend was on the back of losses in large caps led by KCB and Barclays, which lost 3.5%, and 1.5%, respectively. Since the February 2015 peak, the market has been down 31.2% and 16.9% for NSE 20 and NASI, respectively.

Equities turnover fell by 30.0% during the week to KES 4.1 bn from KES 5.8 bn last week, on the back of reduced foreign investors? activity despite being net buyers with net inflows of USD 2.3 mn, compared to net inflows of USD 3.2 mn witnessed the previous week. We still expect earnings growth to improve in 2016 compared to 2015 supported by a favorable macroeconomic environment despite the negative start to the year. Given the low valuations, long-term investors should gradually be taking positions in the market.

The market is currently trading at a price to earnings ratio of 12.1x, versus a historical average of 13.8x, with a dividend yield of 4.5% versus a historical average of 3.4%. The charts below indicate the historical PE and dividend yields of the market.

Plum LLP, a privately held limited liability partnership, announced that they served notice to Britam Holdings Limited of their intention to acquire 452,504,000 ordinary shares, effectively giving them a 23.3% shareholding in the company at an undisclosed price. If completed, Plum LLP and associated companies will effectively control 38.5% of Britam. Plum LLP is however seeking an exemption from delisting, as their stated intention is not to take over Britam, but to incubate the shares until they find a suitable strategic investor to acquire the shares citing that it is of the best interest of the shareholders that Britam remains listed. Interesting to note is that the top 4 individual shareholders, directly and indirectly, already own 47.2% of Britam. After acquiring the 23.3% stake, they will own 70.5%, which is close to becoming a super majority.

In our view, in the event that the 23.3% stake is offered to an institutional investor, especially a global or private equity firm, it will be a positive for Britam as it will bring a new owner to the table who can help drive shareholder value and also improve Britam's corporate governance ranking, currently at 38 out of 50 ? see CGI link. However, we don?t expect the sale to happen soon as Britam is a closely held company with a free float of only 19.4%, and consequently the long-term holders will be very careful as to whom they bring in. It is also not clear why an open sale process was not conducted to get potential buyers to compete for the 23.3%, rather than the current position where Plum LLP, a close associate of the majority shareholders, effectively single sourced the stake, an event that, arguably, could be prejudicial to the public minority shareholders.  

Standard Chartered Plc CEO, Mr. Bill Winters was recently in Kenya to discuss the bank?s Kenyan business and the Africa expansion strategy. Some of the key highlights include;

1. The bank is looking to double their exposure in Africa, by investing Kshs 101.0 bn across the continent over the next 2 to 3 years,
2. Kenya is a key focus area since it has attractive GDP growth and due to its low dependence on the commodity markets,
3. Standard Chartered Kenya will be allowed flexibility on their decision making, with relatively little involvement from London, and,
4. The Africa operation will be focusing on digitizing their banking systems, including the opening of digital account systems, as well as strengthening mobile money operations.

CBK has approved the acquisition of Oriental Commercial Bank by Bank M of Tanzania. This is a further case of consolidation in the banking industry, with banks such as Oriental Commercial Bank, who are uncompetitive in the market, being bought out or merging. As indicated in our FY?2015 banking report, we are entering a period of natural consolidation in the banking sector. With CBK placing a moratorium on the licensing of new banks, given the volatility experienced in the sector, all international banks and investors looking for exposure to the Kenyan banking sector will have to enter via way of acquisition.

The transaction details are as below:

1. M Bank is acquiring a 51% stake in Oriental Commercial Bank,
2. Acquisition is through the purchase of 42,281,893 ordinary shares at Kshs 30 each, valuing the transaction at Kshs 1.3 bn,
3. Oriental Commercial Bank has a book value of Kshs 1.8 bn, and with 82,905,672 issued shares, has a book value per share of Kshs 21.2,
4. As such, the transaction is being carried out at a 1.4x price-to-book valuation, a 9.0% premium on the market price-to-book of 1.3x, representing the premium M Bank had to pay to enter the Kenyan banking space. This is an attractive price for M Bank given that they managed to take control of Oriental Bank without paying typical acquisition premiums of 30% above market. The last acquisition of Giro Bank by I&M Bank was at a premium of 30.8% to market.

However, away from the need for consolidation, such transactions highlight the attractive opportunity in financial services in Kenya, with the industry having a return on equity of 21.4%, and registering a core EPS growth of 13.6% as at Q1?2016. Growth in the financial services sector in Kenya is driven by (i) a growing middle-class seeking access to financial products, (ii) a booming real estate and construction sector, which requires financing, (iii) increased use of alternative distribution channels, and (iv) use of technology in cost-containment initiatives.

Family Bank are seeking to raise Kshs 4.4 bn by way of rights issue in order to bolster the banks capitalization, an offering that launched on 31^st May 2016, set to close on 27^th June 2016. The offering will be through a rights issue of 199,229,951 new ordinary shares by way of private placement, with 4 new shares being offered for every 25 shares held, at an exercise price of Kshs 22 per share. Details of the offering are as below:

• The price of Kshs 22 per share is a 12.0% discount from the current Over The Counter market price of Kshs 25 per share, with the Family Bank shares trading in a privately managed Over the Counter platform,
• With a book value per share of Kshs 9.9, and an exercise price of Kshs 22.0 per share, the rights are being offered at a price to book multiple of 2.2x, and,
• Family Bank currently trades at a price to book multiple of 2.5x.

Key points to note from this offering are:

• The offering at a 2.2x price to book multiple is a 61.5% premium from the current price to book of listed banks in the Kenyan market, which are trading at a 1.3x multiple; it appears like a pretty frothy valuation,
• The offering is at a 12.0% discount from the pre-money valuation of 2.5x price to book, and if the capital raising is successful, the post-money valuation will be 2.1x price to book, and,
• For Family Bank to seek to raise Kshs 4.4 bn by way of private placement to grow their loan book and provide capitalization highlights the current banking environment. Banks have struggled to gather deposits, with deposit growth at a 5-year CAGR of 15.1%, versus loan growth at a CAGR over the same period of 18.7%, forcing banks to borrow to fund their loan book. Additionally, this is the second large rights issue to be announced after KCB, which have planned to raise Kshs 10.0 bn. In this volatile banking environment, banks are looking to shore up their capital to provide a buffer above the statutory ratios. Those unable to raise capital will be forced to merge or be bought out in a period of natural consolidation, which we expect to happen over the next 3 to 5 years.

Kenya Airways has received interest from other airlines, looking to purchase a majority stake in the distressed national carrier. However, as per the Transport and Infrastructure Cabinet Secretary, interested parties are yet to firm up their commitments on the proposed purchase. As indicated in our Cytonn Weekly #16 of 2016, Kenya Airways is currently facing (i) restructuring difficulties due to losses in its operational business, (ii) record debt levels of over Kshs 167.9 bn, and (iii) growing losses currently at Kshs 12.0 bn. The airline currently has a negative equity position at Kshs 33.9 bn due to accumulated losses over the past 4 years. Any stake purchase by a reputable airline operator will be a step in the right direction, and we have advocated the need for privatization of companies with large government stakes such as Mumias and Kenya Airways. A full privatization would bring private sector discipline to these companies.

In a move that will deepen the capital markets in Kenya, Nairobi Business Ventures, a Kenyan based shoe retailer that operates a chain of shoe stores under the KShoe brand, is seeking to list on the NSE?s Growth Enterprise Market Segment (GEMS), and awaiting regulatory approval for the same. Listing on GEMS will allow the firm to access capital vital for (i) opening new stores and outlets, and (ii) converting working capital and additional raised capital to venture into leather footwear and accessories manufacturing. Key takeaways are:

1. With only 62 listed stocks on the Nairobi Securities Exchange, GEMS offers an avenue to firms looking to raise capital and go public on the main segment at a date in the future, leading to deepening of the capital markets, and,
2. Firms expanding into manufacturing are vital for the Kenyan economy, which will work to reduce our dependence on imported products, create jobs, and improve the standards of living in the country.

Below is our equities recommendation table. Bank valuations have been adjusted as per our Cytonn Q1?2016 banking report. Key changes to note from our previous recommendation table are:

• Cooperative bank and NIC bank have dropped from an ?Accumulate? recommendation with upsides of 13.1% and 19.4% to a ?Sell? recommendation with downsides of 1.3% and 0.2%, respectively

 We remain neutral on equities given the low earnings growth prospects for this year. The market is now purely a stock picker?s market with few pockets of value.

Private Equity

General Electric (GE) has committed to invest Kshs 1.3bn in healthcare in Kenya over the next ten years, as part of its global commitment to invest over USD 1bn (KES 101 billion) in the development and delivery of localized offerings for the healthcare sector. The investment will be through setting up a training school in Karen, Nairobi that will serve as GE?s first dedicated skills development facility in Africa, intended to serve Kenya and the wider East African region. The facility is expected to be operational by November 2016 and will offer biomedical and clinical applications training courses and then eventually expanded to offer leadership, technical and clinical education courses. Interesting to note is that they can only commence in November 2016 if they already have existing operations with local hospitals. In the event infrastructure to support the facilities will be built afresh, a November 2016 deadline is ambitious. The investment will see the region improve immensely in (i) reducing the shortage of qualified healthcare professionals, through the reduction of skill gaps in the training centre, (ii) developing a pipeline of future biomedical engineers, radiologists and technicians, and (iii) delivering sustainable healthcare development by offering specialized medical care to the people as it has done previously through installation of over 100 diagnostic imaging units across the country partnering with all of Kenya?s 18 referral hospitals to formulate oncology strategy for breast, cervical and prostate cancer. This investment will go a long way in driving the economy of the region as improved healthcare provision is one of the focus for Kenya and East African as a whole.

ICT and transport helped improve Kenya to position 18 out of 54 nations in Africa from position 23 in 2013, according to the Africa Infrastructure Development Index (AIDI) by the African Development Bank (AfDB). ICT has proven to be a key economic driver in the country for the past three years underpinned by the steady growth of the internet and broadband market, resulting to competitive data services. The demand for uptake of ICT in the country has also been further heightened by the commitment of the Kenyan government in the implementation of e-government so as to increase its effectiveness and efficiency in service delivery to its citizens. With the increase in mobile phone subscriptions leading to a rise in market penetration from 78.3% in 2014 to 85.4% in 2015, we expect private capital investments to also increase which has already been evident with Helios? entry into the telecommunications industry through its purchase of a 70% stake in Telkom Kenya as it sees immense potential in the sector. In the AIDI, Kenya?s position to 18 out of 54 was boosted by a rise in ranking in the ICT metric ranking used in the index, where Kenya was ranked 10^th with a composite score of 26.69, from 14^th with a score of 9.06 in 2013, highlighting that ICT as a sector has continued to attract private equity investors in the country. The sector has proven to have an impact in economic growth of the country and the continent as a whole as seen in the correlation from South Africa which ranked 1^st in the sector with 71.59 points and the country boasts of having one of the attractive investment destination in the emerging markets due to well-developed ICT infrastructure.

Real Estate

During the week, the real estate scene saw increased interest in serviced apartments with developers launching projects in Watamu and Thika Road.  Hemmingways announced its plans to put up a 39-room boutique hotel and 15 luxury apartments at its Hemmingways Watamu Resort. The facelift of the already existent 74-key resort will be at a cost of USD 9 million and it is scheduled to be opened in February 2018. The need to undertake the improvement was to match the standards of the other developments by Hemmingways in Nairobi and Olseki Mara so as to retain tourists who would otherwise opt to go to Zanzibar seeking 5-star facilities. Along Thika Road, Mr. Karigi Kamatu, a local investor has launched a Kshs 1.7 bn project known as the ?Vantage Mall?, a few hundred meters from Garden City. The development will consist of 90 serviced apartments, a 70-key 4-star hotel, a supermarket, a movie theatre, restaurants and line shops. The serviced apartments targeting long stay guests will be available in 1, 2 and 3 bedroom sizes at a cost of Kshs 15 mn, Kshs 18 mn and Kshs 20 mn, respectively. Best Western will manage the apartments and the hotel on behalf of the owners who will buy the units on a leaseback agreement. The idea of the project, which is financed by Housing Finance, was conceived in 2010 but over the years, the concept has changed in line with the changing economic landscape.

The concept of serviced apartments which target long stay guests has seen tremendous growth in areas within Nairobi over the past 5 or so years. The supply of the apartment complexes grew by 24.6% per annum between 2011 and 2015. Gigiri, Runda and Kasarani areas however have the lowest supply of these units, which were estimated to be 67 in 2014 as shown in the table below.

Source: Proliferation of Serviced Apartments in Nairobi, Kenya, HVS ? March 2015

On Tuesday, Helios Investment Partners announced that it had set up a real estate unit that will manage the properties owned by Telkom Kenya, estimated to be worth Kshs 13 bn. The company has reorganized its business structure into four business divisions: mobile, fixed telephone, wholesale and real estate though it is not clear how the real estate division will operate. The Investors Information report indicates that Telkom has 335 properties priced at Kshs 9.4bn, including 39.1 ha of land, 11 residential buildings, a sports club and offices along Nairobi?s Ngong road. Helios is a UK private equity firm that is looking for attractive investment opportunities in Africa. It currently holds a 70% stake in Telkom.  Investment in real estate by Telkom Kenya, a telecommunications operator, accentuates companies in Kenya that have diversified from their main business lines into real estate to boost earnings.

In other news, amendments in the Finance Bill 2016 could see the scrapping off of Capital Gains Tax (CGT) for the transfer of property from parents to their own children and those of a former spouse. In the past, only spouses and immediate family members in cases of divorce settlements were exempted from CGT. Approval of the bill will correct the anomaly in taxation of land whose gains had not been realized. The move will ease succession process which traditionally would take a much longer period to effect property transfers. This could encourage more Kenyans to plan for their succession and avoid court battles over inheritance disputes that ensue soon after the demise of parent(s). While this will reduce revenue sources for the government, approval of the bill will go a long way in easing land ownership as a large majority of Kenyans own land through succession. However, this will further aggravate the equitability in the Kenyan society where heirs will get assets without paying any taxes into the public.

Overall, we expect continued investment in real estate as investors ride on demand for housing, and accommodation facilities for business travelers. While there may be a slowdown in uptake as elections draw near, investors are likely to lock in on projects at lower prices, then exit them at increased prices after the elections.

Kenyan Banking Sector Q1?2016 Report

Following the release of the Q1?2016 results by banks, we undertook an analysis on the Kenyan Banking sector to point out any material changes from the FY?2015 banking report. In our report, we recommend to investors which banks are the most attractive and stable for investment from a franchise value and from a future growth opportunity perspective.

The report is themed ?Transition continues, but to a new and different landscape? as the issues facing the banking sector, which is undergoing a transition, still persist. There are some key areas of transition, which will change the banking landscape in Kenya going forward:

1. Continued Sector Realignment ? In Q1?2016 we still are of the view that the industry is divided into the ?haves? and ?have-nots? which still poses a risk to the sector. During the month, Barclays bank expressed their wish to exit their African business selling 12.2% to a consortium while Giro Bank, Oriental Commercial Bank and Equatorial Commercial Bank have been acquired. Key to note is that banks with clear strategy and well defined market niche will survive while those with unclear strategies will either have to adapt or die,
2. Flight to Quality - With the jitters in the banking system previously witnessed, especially after the placement in receivership of 3 banks, there is a large ?flight to quality? happening in the Kenyan market, with large volumes of deposits and business moving from smaller banks to larger, and perceived less risky Tier I banks. As this continues, small banks will be forced to consolidate or be bought out, as they face liquidity pressures and low business volumes; this all will end up in a fewer number of banks, but stronger and more robust banks,
3. Firmer Regulator ? There is now a much firmer, and much more trusted, regulator in place at CBK. Going forward, increased emphasis is going to be placed on corporate governance, professional ethics, as well as deep levels of supervision on asset quality and levels of provisioning. This increased levels of supervision, and low levels of tolerance, for banks that do not adhere to the highest standards of governance and ethics, and safe banking practices, will lead to their closure, and,
4. Capital Requirement and Regulation ? As per the budget statement for the fiscal year 2016/17 the Government wishes to re-introduce the Kshs. 5.0 bn capital requirement for banks. With growing public exposure towards financial institutions, it is imperative that banks are well capitalized. Higher capital levels will create a more stable banking system, and will force consolidation, and banks such as KCB Group & Family Bank already raising capital in the markets. Banks looking to raise capital will have to do so at attractive valuations for investors, and for those banks unable to raise capital from the markets, they will be forced to merge or be acquired.

All in all, there are a number of areas of transition ahead for Kenyan banks. What is important is that, after we pass through this phase of transition, the landscape will look different; we shall have fewer banks, as can be seen from the table below, Kenya is overbanked, but much stronger, more robust, transparent and well-governed banks, which is good for the economy.

Below are the operating metrics for listed banks in Kenya:

With GDP growth prospects for 2016 at 5.8%, Kenya?s listed banks recorded improved EPS growth in Q1?2016 of 13.6% compared to the Q1?2015 growth of 8.9%. This was on the back of an improved macroeconomic environment, which saw interest rates decline to below historical average levels as evidenced by the interbank and the 91 day T-bill rates declining to 2.3% and 7.1%, respectively. With the banking sector contributing 10.1% to GDP, a strong growth exhibited by the sector is beneficial to drive the economy as the private sector is not crowded out, as banks can afford to take up some risk and loan out more to the sector. The growth witnessed in the sector is as a result of the sector?s ability to develop products that respond to the needs of Kenyans, such as (i) convenience and efficiency through alternative banking channels such as mobile and agency banking, (ii) increased financial inclusion and banking the informal market, and (iii) a demographic boost in Kenya, such as a growing middle class, which has led to increased demand for intermediary services such as banking.

There are three takeaways from the table above:

• The sector recorded a 13.6% core EPS growth, with HF Group, Standard Chartered, Equity Group and I&M Bank recording double-digit growths. Only NIC Bank and National Bank recorded core EPS declines,
• Banks still registered high growth non-performing loans, with the NPL ratio at 8.7% in Q1?2016 compared to 4.9% in Q1?2015, and,
• NBK was the only bank that reported negative return on equity.

As per our analysis on the banking sector, from a franchise value and from a future growth opportunity perspective, below is the comprehensive ranking of the listed banks. Major changes include:

• Co-operative bank moving up the ranks to position three from position 5 as per the FY?2015 Banking Sector report,
• DTBK dropping to position six from position 3 in FY?2015 as per the FY?2015 Banking Sector report,
• CfC Stanbic dropping to position 9 from position 6 as per the FY?2015 Banking Sector Report,

For a comprehensive analysis on the ranking and methodology behind it, see our Cytonn Q1?2016 Banking Sector Report

After the above highlighted transition areas are achieved, we are likely to have a more efficient, stable and well capitalized banking sector with strict adherence to prudential guidelines and hence safe and sound banking practices. This will spur increased confidence, which is a key pillar in any financial services sector.

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes