Executive Summary

Fixed Income: The level of T-bills subscription, though still high, continued to reduce as this week?s total subscription decreased to 113.5%, compared to 162.1% recorded the previous week. Yields on the 91, 182 and 364-day T-bills remained unchanged at 8.3%, 10.4% and 10.8%, respectively;

Equities: During the week, the equities market was on a downward trend with NSE 25, NASI and NSE 20 declining by 1.2%, 1.0% and 0.8%, respectively, driven by declines in large cap stocks such as Equity Group, DTBK and Co-op Bank, which lost 5.5%, 5.2% and 1.8%, respectively. Housing Finance Group, NIC Bank, I&M Bank and Stanbic Bank Kenya released Q3?2016 results recording core EPS growth of 7.8%, (6.4%), 16.5% and 24.1%, respectively, while Family Bank and Nairobi Securities Exchange issued profit warnings for FY?2016;

Private Equity: Financial services and health sectors continue to witness increased private equity activity in Kenya, with SBM Holdings of Mauritius acquiring Fidelity Commercial Bank in a Kshs 2.7 bn transaction, and Catalyst Principal Partners selling its majority stake in Goodlife Pharmacy to LeapFrog Investments, a UK based venture capital firm, in a transaction valued at USD 22.0 mn (Kshs 2.2 bn);

Real Estate: The Land Index Report by Property Reality Company (PRC) indicated that Ruaka Town recorded a 125.0% land price appreciation over the last one-year due to the infrastructure development in Kiambu County, while the Tourism Regulatory Authority classified eight additional hotels in Nairobi under the five-star rating, raising the number of five-star hotels in Kenya to fifteen;

Company Updates

• Caleb Mugendi, our Investments Analyst, discussed the move by Treasury to set up a single financial services regulator and the Kshs 203.6 bn investment into the steel industry. See Caleb on CNBC
• John Ndua, our Investment Analyst, discussed the acquisition of Kenyan Fidelity Commercial Bank by Mauritius-listed SBM Holdings, and insolvency fears that have driven East Africa Portland Cement shares down 22.0%. See John on CNBC
• Shiv Arora, our Head of Private Equity, discussed Family Bank?s profit warning and the revision of Kenya?s 2017 GDP growth forecast to 6.0%. See Shiv on CNBC
• Cytonn Investments has this week started implantation of an Enterprise Resource Planning (ERP) Software, SAP Business One, aimed at streamlining finance, risk and procurement across the entire organisation. The implementation of this system is in line with Cytonn Investments? key strategies of continually enhancing the delivery of services to its clients by improving processes. See Event Note
• Cytonn eHub, an initiative of Cytonn Foundation, is inviting entrepreneurs to submit applications to be considered for pitching their businesses for funding. The pitching will be done to a panel of investors at the Cytonn eHub Investors Forum, scheduled for Thursday, 8^th December 2016 at the Sarova Panafric Hotel at 6.00 pm. Apply Here
• This week, our Managing Partner and CEO Edwin H. Dande, Board Member Mr. James Maina, and Chief Investment Officer & Head of Real Estate Elizabeth N. Nkukuu, CFA, led a team for a fundraising and benchmarking trip to Dubai. This is part of Cytonn?s strategy of delivering institutional grade real estate products to our clients and investors, and there is a lot of interest in investing in Kenya and also entering into the real estate development in Kenya; market players should expect global market entrants into the sector in the near-term.
• Cytonn Private Wealth held a wealth management training focusing on planning for retirement. The wealth management trainings, which are at no cost, are held biweekly by Cytonn Private Wealth but are open only to pre-screened participants. To register for the training kindly use this link: See training
• To invest in any of our current or upcoming real estate projects, please visit Cytonn Real Estate. We continue to see very strong interest in our products:
  • The Alma, which is now 55.0% sold and has delivered an annualized return of 55.0% p.a. for investors who bought off-plan. See The Alma. We will be having site visits to showcase this iconic development every two weeks, right after the wealth management trainings. If interested in attending the site visit, email clientservices@cytonn.com
  • Amara Ridge is currently 100.0% sold. See Amara Ridge
  • We have 12 investment-ready projects, offering attractive development returns and buyer's targeted returns of around 25.0% p.a. See further details here: Summary of investment-ready projects
• We continue to beef up the team with several ongoing hires: Careers at Cytonn.

Fixed Income

During the week, T-bills remained oversubscribed, however there was a decline in subscription, with overall subscription decreasing to 113.5%, compared to 162.1% recorded the previous week. The drop in subscription levels for T-bills can be attributed to investors participating in the bond market for the re-opened 15-year and 20-year bonds, whose combined subscription rate came in at 76.3%, with the government accepting Kshs 22.2 bn, versus a target of Kshs 30.0 bn. Subscription rates on the 91-day paper remained relatively flat during the week, coming in at 147.8% from 146.1% the previous week, whereas the 182-day and 364-day papers subscription rates decreased to 115.6% and 88.6% from 182.5% and 105.2%, respectively, the previous week. This can be attributed to investors looking to lock-in attractive yields on the re-opened bonds in the primary auction market. Yields on the 91, 182 and 364-day T-bills remained unchanged at 8.3%, 10.4% and 10.8%, respectively.

The 91-day T-bill is currently trading below its 5-year average of 10.4%. As stated in our Cytonn Weekly #46, the decline on the 91-day paper is largely attributed to the expected low interest rate environment as a result of (i) reduced pressure from the government borrowing program given they are ahead of their pro-rated domestic borrowing target, and (ii) increased liquidity in the market brought about by the enactment of the Banking (Amendment) Act, 2015. The government has this far borrowed Kshs 145.9 bn domestically, against a pro-rated target of Kshs 97.1 bn considering the current domestic borrowing target of Kshs 229.6 bn. However, it is important to note that the government is in the process of revising its domestic borrowing target upwards to Kshs 294.6 bn, which if passed by Parliament will take the pro-rated borrowing target to Kshs 124.6 bn, meaning that the government will still be ahead of the borrowing target. Key to note is that as indicated in our Cytonn Weekly #42, the interest rates have bottomed out and we expect them to persist at the current levels.

Last week, the Kenyan Government re-opened two bonds, a 15-year and 20-year with effective tenors of 6.0 years and 11.6 years, respectively, to raise Kshs 30.0 bn for budgetary support. Yields on the bonds came in at 13.6% and 14.3% against our recommended bidding range of between 13.0% - 13.5% and 13.8% - 14.2% for the 15-year and 20-year, respectively. As recommended in our Cytonn Weekly #46, investors participation was skewed towards the 15-year which received bids worth Kshs 14.5 bn, compared to Kshs 8.4 bn for the 20-year bond since it offers the best returns on a risk-adjusted basis. We continue to note the inconsistency between what Central Bank is forcing banks to do by reducing interest rates, and the higher yield that government is accepting in treasury securities auction. For this auction, it is hard to see why a banking institution would lend to an individual at 14.0% as opposed to the government at 14.3%. This will lead to further crowding out of the private sector, as the government is a safer investment, further reducing credit growth to the private sector. As noted in our Cytonn Weekly #42, the same was witnessed in the 15-year infrastructure bond auction whereby the government accepted a yield of 13.2% on a tax-free infrastructure bond, which equated to a 15.5% yield on an equivalent taxable bond, for a tenor of 11.25 years, adjusting for the 15.0% tax rate.

The latest Central Bank Weekly report dated 18^th November, 2016 revealed that the interbank rate increased by 130 bps to 5.2%, from 3.9% registered the previous week, despite a liquidity injection of Kshs 41.5 bn. Increased market liquidity can be attributed to (i) payment of Kshs 1.4 bn in T-bond interest, (ii) an increase in reverse repo purchases which rose 44.8% to Kshs 23.9 bn, from Kshs 16.5 bn the previous week, (iii) repos maturities of Kshs 27.3 bn, (iv) a decline in reverse repo maturities by 74.5% to Kshs 4.9 bn from Kshs 19.2 bn the previous week, and (v) an 80.6% decline in repos to Kshs 5.3 bn from Kshs 27.3 bn the previous week. As highlighted in our Cytonn Weekly Report #28 the interbank rate is often determined by the liquidity distributions within the banking sector as opposed to the net liquidity position in the interbank market.

Below is a summary of the money market activity during last week:

According to Bloomberg, yields on the 5-year and 10-year Eurobonds increased slightly week on week to 4.9% and 7.5% from 4.7% and 7.4%, respectively, the previous week as a result of global strengthening of the dollar, leading to rising investor demand for frontier market investments. Since the mid-January 2016 peak, yields on the Kenya Eurobonds have declined by 3.8% and 2.1%, respectively, for the 5-year and 10-year bond due to improving macroeconomic conditions in the country.

The Kenya Shilling remained relatively stable against the dollar, closing the week at Kshs 101.9, from Kshs 101.8 the previous week. This was despite increase in demand for the dollar from oil importers. On a YTD basis, the shilling has appreciated by 0.4% against the dollar. In recent weeks, we have seen the months of import cover decline below the 1-year average of 4.9 months, and is currently at 4.76 months, down from 4.80 months the previous week. Just 1-month ago, on 6^th October 2016, there was 5.2 months of import cover. As stated in our Cytonn Weekly #45, this is quite worrying as the rate of decrease in the reserve could be an indication that the CBK is using a lot of reserves to support the shilling.

The Monetary Policy Committee (MPC) is set to meet on Monday 28^th November to review the prevailing macroeconomic conditions and give the direction of the Central Bank Rate (CBR). In their previous meeting held in September, MPC lowered the CBR for the second time in 2016 by 50.0 bps to 10.0% on account of (i) the persistent slowdown in private sector credit growth, which stood at 5.5% against the CBK target of 18.3%, and (ii) the fairly stable core inflation that declined from 6.4% in July to 6.3% in August 2016, indicating that inflationary pressure remains at bay. We are expecting the MPC to retain the CBR at 10.0% due to the macroeconomic conditions holding steady since the last meeting, and we are projecting that they will maintain the rate at 10.0% for the remaining part of the fiscal year. See MPC Note

Lending to the private sector in Kenya slowed for the 14^th consecutive month in September with the International Monetary Fund (IMF) warning that this will probably act as a drag on the country?s economic expansion next year. Credit to the private sector grew 5.3% in September, the slowest pace since June 2008, the year that the economy grew just 0.2%. The significant decline in private sector credit growth can be attributed to the following reasons;

• Commercial lending rates have been persistently high averaging 17.5% for the past one-year compared to 16.0% in 2015,
• The increase in NPLs discouraged banks from lending to private sector and preferred risk free Government paper. According to Central Bank?s Credit Officer Survey Report as at June 2016, the industry?s NPLs increased by 12.6% y/y from Kshs 169.4 bn to Kshs 190.7 bn in June 2016, and,
• The enactment of the Banking (Amendment) Act, 2015, which capped lending rates at 4.0% above the Central Bank Rate, which has seen banks prefer to lend to government at higher yields than at 14.0% to the private sector, an example being the recent bond auction that saw the 20-year bond yield 14.3%, leading to crowding out of the private sector.

Going forward, as highlighted in Cytonn Weekly #46, we do not expect the credit growth to pick up and concerns arise on how much impact the declining credit growth will have on economic growth for the year, which is projected at 6.0%.

Below is a chart highlighting private sector credit growth against commercial lending to government, and the recent addition being the September 2016 growth number at 5.3% year-on-year:

In a bid to remedy this low credit growth to the private sector, the Cabinet has this week approved a Bill that would allow borrowers to use household items as collateral for commercial bank loans, a move aimed at widening the bracket of those able to access debt from commercial lenders. The Bill will provide for the creation of a centralised electronic registry for movable goods, which will: (i) have a unique identification number allowing for tracking of those that have been used to secure bank loans, (ii) allow borrowers to use a single asset to access credit from different lenders, as a new lender will know whether there is headroom for additional lending, and (iii) ease transfer of loans across the industry for the borrower. This will be beneficial to borrowers and commercial banks, as it will increase the collateral pool for borrowers and lenders. However, the success of this Bill is dependent upon the establishment of the centralised registry, which will be a long and protracted process to get functional.

Kenya is set to install 609 km of electric railway track between Nairobi and Mombasa in a deal reached with Uganda and Rwanda, that will cost nearly Kshs 49.0 bn. The electric upgrade will be done within 5-years, and ahead of Uganda linking its Standard Gauge Railway line to the Kenyan one. An electric track will (i) lead to faster movement of goods and passengers cutting on cost of transport, (ii) boost regional trade, and (iii) boost East Africa?s competitiveness as an investment destination. Once the SGR is fully operational, cargo transportation through railway is set to increase to 32.0% from the current 3.0%. In addition, the SGR is also set to reduce the cost of transportation to Kshs 8.0 from Kshs 20.0 a tonne per kilometre.

The Government is ahead of its domestic borrowing for this fiscal year having borrowed Kshs 145.9 bn for the current fiscal year against a target of Kshs 97.1 bn (assuming a pro-rated borrowing throughout the financial year of Kshs 229.6 bn budgeted for the full financial year). It is important to note, however, that the government is in the process of revising its domestic borrowing target upwards to Kshs 294.6 bn which will take the pro-rated borrowing target to Kshs 124.6 bn, in line with what it has borrowed thus far. Interest rates, which had reversed trends due to the enactment of The Banking Act Amendment, 2015, appear to have bottomed out and we expect them to persist at the current levels. It is due to this that we think it is prudent for investors to be biased towards short-term fixed income instruments given the prevailing interest rates environment.

Equities

During the week, the equities market was on a downward trend with NSE 25, NASI and NSE 20 declining by 1.2%, 1.0% and 0.8%, respectively, taking their YTD performances to (13.0%), (5.7%) and (19.2%), respectively.  Since the February 2015 peak, the market has been down 40.6% and 22.6% for the NSE 20 and NASI, respectively.

This week?s performance was driven by losses in select large cap stocks such as Equity Group, DTBK and Co-op Bank, which lost 5.5%, 5.2% and 1.8%, respectively. Equities turnover declined by 5.9% to close the week at Kshs 1.9 bn from Kshs 2.0 bn the previous week.  Foreign investors turned net buyers with net inflows of USD 1.4 mn, compared to net outflows of USD 0.4 mn recorded the previous week, with foreign investor participation increasing to 69.5% from 51.2% recorded the previous week. Safaricom was the top mover during the week accounting for 56.9% of market activity.

The market is currently trading at a price to earnings (P/E) ratio of 10.9x, versus a historical average of 13.7x, with a dividend yield of 6.4% versus a historical average of 3.5%. The charts below indicate the historical P/E and dividend yields.

 

Company Results:

NIC Bank of Kenya released Q3?2016 results:

NIC Bank released Q3'2016 earnings, posting a 6.4% decline in core earnings per share (EPS) to Kshs 5.3 from Kshs 5.6 in Q3'2015, against our projected EPS of Kshs 5.8. The decline in earnings was driven by a 56.6% growth in operating expenses due to the 363.7% increase in loan provisioning, which outpaced the 23.7% growth in operating income.

Key highlights for the performance from Q3?2015 to Q3?2016 include:

• Total operating income grew by 23.7% to Kshs 12.5 bn from Kshs 10.1 bn in Q3?2015, faster than our estimate of a 14.2% growth. This was supported by a 34.1% growth in Net Interest Income despite Non-Funded Income remaining flat,
• Net Interest Income increased by 34.1% to Kshs 9.4 bn from Kshs 7.0 bn, supported by Interest Income that grew by 21.8% to Kshs 14.7 bn from Kshs 12.1 bn, faster than the 4.8% growth in Interest expense to Kshs 5.3 bn, from Kshs 5.1 bn. As a result, the Net Interest Margin (NIM) improved to 8.3%, from 7.0% previously,
• Non-Funded Income remained flat at Kshs 3.1 bn. Other fees and commissions grew by 28.8% to Kshs 0.6 bn from Kshs 0.5 bn in Q3?2015, while foreign exchange trading income declined by 22.9% to Kshs 0.9 bn from Kshs 1.1 bn in Q3?2015. The current revenue mix stands at 75:25, Funded to Non-Funded Income, respectively, from 69:31 in Q3?2015,
• Operating expenses grew by 56.6% to Kshs 7.7 bn from Kshs 4.9 bn, driven by a 363.7% rise in Loan Loss Provision (LLP) to Kshs 3.2 bn from Kshs 0.7 bn and a 2.4% y/y growth in staff costs to Kshs 2.3 bn from Kshs 2.2 bn. Without LLP, operating expenses grew by 6.8% to Kshs 4.5 bn, from Kshs 4.3 bn,
• The cost to income ratio deteriorated to 62.0% from 49.0% in Q3?2015. Excluding LLP, cost to income ratio stood at 36.4%, from 42.1% in the same period last year,
• The faster growth in operating expenses compared to operating revenue resulted in a 6.4% decline in profit after tax to Kshs 3.4 bn from Kshs 3.6 bn,
• Customer deposits grew by 2.4% to Kshs 108.4 bn from Kshs 105.8 bn, while loan and advances remained flat recording a growth of 0.7% to Kshs 110.5 bn from Kshs 111.2 bn. This led to a decline in the loan to deposit ratio to 101.9% from 103.2%, which is quite high compared to the industry average of 86.1%, and our preferred range of 80% - 90%.

While positively growing deposits faster than loan disbursement, NIC Bank?s cost to income ratio has risen significantly to 62.0% from 49.0% in Q3?2015 on account of the bank increasing LLPs by quite a large margin as compared to a similar period last year, where LLP increased by 235.3%, leading to concerns over loan quality. Going forward, we expect NIC Bank?s growth will be driven by increased efficiency through: (i) cutting down of costs through reducing redundant roles across all branches thus cutting down on staff costs; NIC Bank plans to retrench 32 senior-level employees, which represents 2.9% of its workforce of 1,111 employees, and (ii) reducing on the non-performing loans through improved credit risk management and loan recovery efforts.

For a more comprehensive analysis, see NIC Bank Q3?2016 Earnings Note.

Housing Finance Group released Q3?2016 results

Housing Finance (HF) Group released Q3'2016 earnings posting a 7.8% growth in core EPS to Kshs 2.4 from Kshs 2.2 in Q3'2015, against our projected EPS of Kshs 2.7. The growth in earnings was driven by a 21.0% growth in operating revenue despite a 25.7% growth in operating expenses, with the absolute gain in revenue being higher than the gain in expenses.

Key highlights for the performance from Q3?2015 to Q3?2016 include;

• Operating revenue grew by 21.0% to Kshs 3.8 bn from Kshs 3.1 bn, faster than our estimate of 8.3%. This was supported by a 14.2% growth in Net Interest Income and 67.1% growth in Non-Funded Income,
• Net Interest Income growth of 14.2% to Kshs 3.1 bn from Kshs 2.7 bn was supported by a 14.6% growth in Interest Income to Kshs 6.7 bn from Kshs 5.8 bn, despite a faster growth in Interest expense of 15.0% to Kshs 3.6 bn from Kshs 3.1 bn in Q3?2015. As a result of growth in NII, the Net Interest Margin improved to 6.7% from 6.5% previously,
• Non-Funded Income grew by 67.1% to Kshs 0.7 bn from Kshs 0.4 bn. The growth in NFI was driven by an increase in other income that recorded a 223.2% growth to Kshs 0.4 bn from Kshs 0.1 bn, attributed to property sales, which is an indication of increased uptake in the group?s real estate projects. The revenue mix stood at 82:18, Funded to Non-Funded Income, from 87:13 in Q3?2015,
• Operating expenses grew by 25.7% to Kshs 2.6 bn from Kshs 2.0 bn previously. The growth in operating expenses was driven by a 16.7% rise in Loan Loss Provision (LLP) to Kshs 0.5 bn from Kshs 0.4 bn and other expenses, which rose 20.9% to Kshs 0.9 bn from Kshs 0.7 bn. Staff costs grew 8.0% to Kshs 843.7 mn from Kshs 781.5 mn. Without LLP, operating expenses grew by 28.1% to Kshs 2.1 bn from Kshs 1.6 bn,
• The cost to income ratio deteriorated to 68.1% from 65.6%. Without LLP, cost to income ratio stood at 55.0% from 52.0% in the same period last year,
• Profit after tax increased by 7.8% to Kshs 837.7 mn from Kshs 777.5 mn in Q3?2015,
• Customer deposits rose by 10.8% to Kshs 41.6 bn from Kshs 37.6 bn while loans and advances increased by 4.3% to Kshs 53.9 bn from Kshs 51.7 bn. This led to a decrease in the loan to deposit ratio to 129.6% from 137.6%, which is quite high compared to the industry average of 86.1%, and a preferential range of 80% - 90%.

HF?s performance was below our expectations, as LLP continues to rise following the Central Bank?s push to ensure banks provide sufficiently for non-performing loans. Going forward, we expect HF group to continue channelling resources to alternative sources of income, which include property & investments through its subsidiary, HF Development and Investment (HFDI), and bancassurance through HF Insurance Agency. HF?s property and investments subsidiary, HFDI, is in a joint venture agreement with Clay Works Limited, with plans to launch Clay City, a Kshs 5.0 bn development that will see 1,520 apartments come up along Thika Road, further supporting the bank?s growth in Non-Funded Income.

For a more comprehensive analysis, see Housing Finance Group Q3?2016 Earnings Note.

I&M Bank released Q3?2016 results

I&M Bank released Q3'2016 earnings, posting a 16.5% growth in core earnings per share to Kshs 172.6 from Kshs 148.2 in Q3'2015. The growth in earnings was despite a 21.6% increase in total operating expenses outpacing an 18.3% growth in total operating revenue to Kshs 12.5 bn, with the absolute gain in revenue being higher than the gain in expenses.

Key highlights for the performance from Q3?2015 to Q3?2016 include;

• Total operating revenue grew by 18.3% to Kshs 12.5 bn from Kshs 10.6 bn. The growth was as a result of a 20.8% growth in Net Interest Income and a 11.0% growth in Non-Funded Income,
• Net Interest Income grew by 20.8% to Kshs 9.5 bn from Kshs 7.9 bn previously. This was supported by 13.1% growth in Interest Income to Kshs 15.8 bn from Kshs 14.0 bn, outpacing a 3.4% growth in interest expense to Kshs 6.3 bn from Kshs 6.1 bn. As such, the Net Interest Margin improved to 8.0% from 7.3% previously,
• Non-Funded Income grew by 11.0% to Kshs 3.0 bn from Kshs 2.7 bn. The increase in NFI was supported by an 11.1% growth in other fees and commissions to Kshs 1.1 bn from Kshs 967 mn and a 3.8% increase in foreign exchange trading income to Kshs 1.0 bn from Kshs 973.3 mn, previously. The current revenue mix stands at 76:24, Funded to Non-Funded Income from 75:25 in Q3?2015,
• Total operating expenses grew by 21.6% to Kshs 5.1 bn from Kshs 4.2 bn driven by a 54.0% rise in Loan Loss Provision (LLP) to Kshs 0.9 bn from Kshs 0.6 bn, and a 7.9% growth in staff costs to Kshs 2.0 bn from Kshs 1.8 bn. Without LLP, operating expenses grew by 16.7% to Kshs 4.2 bn from Kshs 3.6 bn
• Cost to income ratio rose to 41.2% from 40.0%, while without LLP, the cost to income ratio improved to 33.8% from 34.4% in the same period last year
• Profit after tax increased by 16.5% to Kshs 5.0 bn from Kshs 4.3 bn,
• Customer deposits grew by 9.9% to Kshs 129.0 bn from Kshs 117.4 bn, while loans and advances recorded a growth of 4.5% to Kshs 121.5 bn from Kshs 116.2 bn. This led to a decline in the loan to deposit ratio to 94.2% from 99.0%, which is still higher than the preferential range of 80%-90% and the industry average of 86.1%

I&M Bank posted good growth in earnings despite the rise in provisions leading to an increase in operating expenses. The rise in provisions in turn took a toll on the lender?s cost to income ratio, which has been historically one of the lowest in the industry. We shall release an Earnings Note with more comprehensive analysis once I&M Group Holdings release their Q3?2016 financial results.

Stanbic Bank Kenya released Q3?2016 results

Stanbic Bank Kenya released Q3'2016 earnings posting a 24.1% growth in core earnings per share to Kshs 20.0 from Kshs 16.1 in Q3'2015. The growth in earnings was despite a 27.5% increase in total operating expenses outpacing a 23.5% growth in total operating revenue to Kshs 14.4 bn, with the absolute gain in revenue being higher than the gain in expenses.

Key highlights for the performance from Q3?2015 to Q3?2016 include;

• Total operating revenue grew by 23.5% to Kshs 14.4 bn from Kshs 11.6 bn in Q3?2015. The growth was as a result of a 22.4% growth in Net Interest Income and a 24.9% growth in Non-Funded Income,
• Net Interest Income grew by 22.4% to Kshs 8.3 bn from Kshs 6.8 bn. This was supported by a 25.5% growth in Interest Income to Kshs 13.2 bn from Kshs 10.5 bn, despite being outpaced by a 31.1% growth in interest expense to Kshs 4.9 bn from Kshs 3.7 bn, with the absolute gain in revenue being higher than the gain in expenses. Net Interest Margin improved to 7.8% from 6.5% in Q3?2015,
• Non-Funded Income (NFI) grew by 24.9% to Kshs 6.1 bn from Kshs 4.9 bn. The increase in NFI was supported by an 11.9% growth in foreign exchange trading income to Kshs 2.1 bn from Kshs 1.9 bn. The current revenue mix remains unchanged at 58:42, Funded to Non-Funded Income from Q3?2015,
• Operating income benefited from a boost in other income by 76.2% to Kshs 2.1 bn from Kshs 1.2 bn in Q3?2015,
• Total operating expenses grew by 27.5% to Kshs 9.5 bn from Kshs 7.4 bn previously, driven by a 110.9% rise in Loan Loss Provision (LLP) to Kshs 1.2 bn from Kshs 0.6 bn, and a 6.4% growth in staff costs to Kshs 3.7 bn from Kshs 3.5 bn. Without LLP, operating expenses grew by 20.6% to Kshs 8.3 bn from Kshs 6.9 bn,
• Cost to income ratio deteriorated to 66.0% from 63.9%. Without LLP, cost to income ratio improved to 57.7% from 59.0% in the same period last year,
• Profit after tax increased by 24.1% to Kshs 3.4 bn from Kshs 2.8 bn. Without gains from deferred tax, PAT grew by 5.3% to Kshs 2.9 bn,
• Customer deposits grew by 22.8% to Kshs 139.4 bn from Kshs 113.6 bn, while loans and advances recorded a growth of 1.9% to Kshs 106.7 bn from Kshs 104.7 bn. This led to a decline in the loan to deposit ratio to 76.5% from 92.2% previously, which is lower than our preferred range of 80%-90% and the industry average of 86.1%

Stanbic Bank Kenya posted good growth in earnings despite the rise in the Loan Loss Provision (LLP), reflecting a tough operating environment. The challenging environment in South Sudan has also impacted on the bank?s performance, though this has not been captured in its financial statements as at Q3?2016 as the bank is yet to adopt a standard on accounting for hyper-inflation. We shall release an Earnings Note with more comprehensive analysis once CFC Stanbic Group Holdings release their Q3?2016 financial results.

Of the 7 listed banks that have released Q3?2016 results, Co-operative Bank has recorded the highest core EPS growth of 22.3%, while NIC Bank earnings declined 6.4%. The average growth in core earnings across the banking sector stands at 12.6%, attributable to a rise in net interest margins. On average, deposit growth has outpaced loan growth with deposits growing by 8.4%, higher than the 5.9% loan growth.

Other than industry NIMs, which the banks have been able to protect, every other metric looks worse this year compared to last year.

Below is a summary of the key metrics;

Family Bank released Q3?2016 results

Family Bank Group released Q3'2016 earnings posting a 48.2% decline in core earnings per share to Kshs 11.5, from Kshs 22.2 in Q3'2015. The decline in earnings was as a result of a 29.3% increase in total operating expenses, which outpaced the 0.8% growth in total operating revenue to Kshs 7.3 bn.

Key highlights for the performance from Q3?2015 to Q3?2016 include:

• Total operating revenue was relatively unchanged growing marginally by 0.8% to Kshs 7.3 bn. The growth was as a result of a 9.0% growth in Net Interest Income despite a 17.5% decline in Non-Funded Income,
• Net Interest Income grew by 9.0% to Kshs 5.5 bn from Kshs 5.0 bn. This was supported by 24.5% growth in Interest Income to Kshs 8.8 bn from Kshs 7.1 bn despite being outpaced by a 62.7% growth in interest expense to Kshs 3.3 bn from Kshs 2.0 bn with the absolute gain in revenue being higher than the gain in expenses. Net Interest Margin improved to 8.6% from 7.2%,
• Non-Funded Income declined by 17.5% to Kshs 1.9 bn from Kshs 2.3 bn. The decline in NFI was on account of a 36.5% decline in fees and commissions on loans to Kshs 0.4 bn from Kshs 0.6 bn, despite a 33.3% increase in other fees and commissions to Kshs 1.5 bn from Kshs 1.1 bn. The current revenue mix stands at 75:25, Funded to Non-Funded Income from 69:31 in Q3?2015,
• Total operating expenses grew by 29.3% to Kshs 5.9 bn from Kshs 4.5 bn driven by a 405.0% rise in Loan Loss Provision (LLP) to Kshs 0.6 bn from Kshs 0.1 bn, and a 9.4% growth in staff costs to Kshs 2.1 bn from Kshs 1.9 bn. Without LLP, operating expenses grew by 19.7% to Kshs 5.3 bn from Kshs 4.4 bn,
• Cost to income ratio rose to 80.1% from 62.5% while without LLP, cost to income ratio stood at 72.3% from 60.9% in the same period last year,
• Profit after tax decreased by 48.2% to Kshs 1.0 bn from Kshs 1.9 bn,
• Customer deposits declined by 15.8% to Kshs 53.5 bn from Kshs 63.5 bn, while loans and advances recorded a growth of 5.7% to Kshs 55.8 bn from Kshs 52.8 bn. This led to an increase in the loan to deposit ratio that jumped to 104.3% from 83.1%, a 21.2% spike, quite higher than the preferential range of 80%-90%.

Family Bank has issued a profit warning for the full year 2016. Family Bank has registered a decline in profit with 32.9%, 39.8% and 48.2% y/y declines being recorded in Q1, Q2 and Q3?2016, respectively. The bank sights reasons for the profit warning as (i) increased funding costs, (ii) rising expenses which led to their announcement to lay off an unrevealed number of employees and in turn reduce on staff costs, and (iii) the move by the government to enact the Banking (Amendment) Act, 2015. This comes after the Tier II lender published a press statement urging its customers to remain steadfast in light of social media propaganda bringing into question Family Bank?s liquidity position and stability.

We also did a comparison of listed banks and non-listed banks that have so far released their Q3?2016 results, and the metrics are as indicated below;

In this analysis, we note that;

• Non-listed banks emerged more profitable than the listed banks with an average PAT growth of 25.5% compared to 12.0% growth for listed banks. However, listed banks rank higher both in return on assets and return on equity, indicating more levels of efficiency and higher return to shareholders,
• Non-listed banks were also able to attract deposits faster than listed banks, experiencing a growth of 6.5% against the listed banks growth of 4.6%,
• Listed banks have become more aggressive in loan disbursement with their loan book growing at 5.9% compared to the 4.0% growth in non-listed banks. Following the enactment of the Banking Act (Amendment) 2015 that puts a cap on interest rates charged on loans, the banks aim to issue out more loans to compensate for a decline in interest margins,
• Loan Loss Provisions for non-listed banks have increased faster at 184.5% compared to 98.5% for non-listed banks, noting the increased level of credit risk across the whole sector
• Listed banks are slightly more efficient in cost management with Cost to Income ratio at 57.2% compared to non-listed at 57.7%

Nairobi Securities Exchange also issued a profit warning for FY?2016. NSE sighted the decline in prices of stock trading on the equities market, whose activity contributes approximately 53.0% of NSE?s total income, as the main reason for the decline in profit. Key to note is that the securities exchange also experienced a 4.5% decline in growth in FY?2015. Despite the two profit warnings, we still expect stronger earnings growth in 2016 as compared to 2015 supported by a more favourable macroeconomic environment, with our expectations for earnings growth being 12.5%, with even listed banks to date reporting core EPS growth of 12.6% on average.

Diamond Trust Bank (DTB) Kenya, a Tier I bank with presence across East Africa, is set to receive a Kshs 7.5 bn credit facility from African Development Bank (AfDB) split into Kshs 5.0 bn for on-lending credit and the remaining Kshs 2.5 bn as subordinated debt. The funds will be used to (i) finance SMEs among other locally-based companies with a bias to those in the manufacturing, construction, trading and transport sectors, (ii) enable DTB grow its loan book and explore other similar markets in the region, and (iii) add to the lender?s Tier II capital hence strengthening its balance sheet. With AfDB?s main objective being to contribute to the socio-economic progress of its 78 member states, funding SME lending in Kenya through DTB is well aligned to its mandate. We are of the view that this move will hasten DTB?s strategy of expanding further across the region and will see the bank thrive in its efforts to focus on extending credit facilities to the SMEs in this region.

See Private Equity section on the discussion of Fidelity Bank acquisition and what it means for the banking sector.

Below is our equities recommendation table. Key changes from our previous recommendation are:

• NIC Bank has moved to an ?Accumulate? recommendation with an upside of 11.6%, from a ?Lighten? recommendation, with an upside of 2.1%, following an 8.8% w/w price decrease

We remain ?neutral with a bias to positive? for investors with a short to medium-term investments horizon and ?positive? for investors with long-term investments horizon.

Private Equity

The week was marked by two large acquisition announcements in Kenya, as shown below:

SBM Holdings to Acquire Fidelity Bank

SBM Holdings Ltd, the second largest bank in Mauritius with a market share of about 25%, is set to acquire Kenya?s Fidelity Commercial Bank Ltd, subject to regulatory approvals in Kenya and Mauritius. SBM Group has an asset base of Mauritian Rupee 146.2 bn as at Q3'2016, (with 1 MRP at 2.85 Kshs, this equates to around Kshs 416.7 bn), and its banking arm, SBM Bank, has an international footprint in India, Madagascar, and a representative office in Myanmar, and is looking to expand into East Africa. Fidelity bank started as a commercial bank 20-years ago, has 14 branches in Kenya and is ranked 31 out of 41 Kenyan lenders with a market share of 0.4%.

The transaction details are as below;

1. SBM Holdings is acquiring the entire share capital of Fidelity Commercial Bank for Kshs 1.3 bn,
2. SBM Holdings will additionally inject Kshs 1.5 bn as growth capital into the bank,
3. Hence the total consideration is Kshs. 2.8 bn, comprising both payments to shareholders of Fidelity and the new capital injection,
4. As at Fidelity Bank?s last reporting, Q1?2016, the bank had a book value of Kshs 1.8 bn,
5. As such, the transaction is being carried out at a 1.6x price-to-book valuation, a 57.0% premium book, representing the premium SBM Holdings had to pay to enter the Kenyan banking space.

The table below indicates the previous banking acquisition deals that went through and their transaction multiples in the Kenyan banking industry;

We note that for local bank acquisitions, the average price-to-book multiple is at 2.0x, with an average acquisition stake of 77%. Given that SBM Holdings is going for a 100% stake at a 1.6x price-to-book valuation, we feel that the 57% premium above the market is an attractive price, given that (i) the listed market is at a historic low valuation of 1.0x book value, against a historical average of 1.9x, and (ii) the acquisition is at a time when CBK has placed a moratorium on the licensing of new banks, thus operating banks have additional negotiating power, and those looking to purchase private banks will have to pay premiums to the listed market.

Fidelity Commercial Bank had a liquidity position of 11.0% as at Q1?2016, 9.0% lower than the minimum statutory ratio of 20.0%, and was looking to sell a stake to a strategic investor to bolster its liquidity and capital position. This is a further case of consolidation in the banking industry, with banks such as Fidelity Commercial Bank, who are uncompetitive in the market, being bought out, and highlights the attractive investment opportunity in financial services in Kenya.

Key take-aways from this transaction:

1. Consolidation in the banking sector will only gather pace going forward. There are many limping players that need to merger or be acquired. Consolidation will lead to a more stable and safe banking sector, as indicated in our Cytonn H1?2016 Banking Report,
2. There is value in the banking sector. Sophisticated players like SBM are willing to pay 1.6x book for a sector trading at 1.0x book value, and,
3. We shall see more foreign entries into the market, following M Bank and SBM.

LeapFrog buys into Goodlife Pharmacy

Private equity firm Catalyst Principal Partners has sold its majority stake in Goodlife Pharmacy to LeapFrog Investments, with Catalyst having only purchased Goodlife 2-years ago, purchasing the brand then known as Mimosa Pharmacies. LeapFrog paid USD 22.0 mn to acquire the unknown majority stake in the Kenyan Pharmaceutical company from Catalyst. Key to note is that:

1. Goodlife Pharmacy had 12 branches in the country as at March 2015 and planned to increase this number to 20 by December 2015. Goodlife currently has 16 stores country wide and as stated in our Cytonn Weekly Update #12, 2015, the firm plans to invest Kshs 1.7 bn in the next 5-years to open up 80 pharmacies. This strategic expansion will now be taken over the LeapFrog and not Calatyst,
2. Catalyst Principal Partners on the other hand, divested their stake in order to actualise returns for their Fund I investors, on the eve of the PE firm seeking to raise USD 197 mn for their 2^nd fund to invest in consumer driven sectors across the Sub-Saharan Africa region.
3. Leapfrog Investments also holds a controlling stake in Resolution Insurance, a medical insurer, giving them a unique opportunity to provide both healthcare products and healthcare insurance.

The move by LeapFrog to invest in healthcare was driven by among other factors, (i) low health insurance penetration, (ii) increased utilisation of services, and (iii) limited access and affordability of quality health care.

Real Estate

According to the Land Index Report by Property Reality Company (PRC), Ruaka town recorded a 125.0% land price appreciation over the last one year due to infrastructure development in Kiambu County, which includes the construction of the Northern Bypass 4-years ago, and increased housing development. However, land prices in the rest of Kiambu appreciated 3.0% over the same period.

Other satellite areas such as Kiserian and Utawala also recorded rapid land price appreciation of 42.0% and 32.0%, respectively. At the same time, the land prices rose moderately in the rest of satellite areas and recorded price stagnation only in Kamulu and Malili towns.

The report indicated that the demand for land in satellite towns has also been boosted by an increase in financing options, and the demand is set to increase significantly due to the incentive offered by the law capping interest rates. The key take outs from the report are:

• Ruaka, Kiambu, Kikuyu and Syokimau have the highest relative prices of land due to proximity to Nairobi while Joska, Isinya and Kiserian recorded the lowest average prices as shown below;

• Most property sold have access roads and are fully beaconed with electricity & water on site to increase their value,
• Access to finance is the key setback to land investors. Only 24% of real estate companies have financial partners providing financing to clients for their products, and,
• 0% of the real estate companies allow instalment payments and discounts on either bulk or cash purchases.

The PRC report is just in line with the recently released report dubbed ?Property Price Index for Q3? 2016? by Hass Consult, which indicated a 21.4% land price appreciation for the satellite towns of Nairobi. The land prices in satellite towns are growing at a tremendous rate and there is no expectation of a decline in the short to medium term. In our view, the land in satellite towns in Nairobi are an attractive investment due to high capital appreciation and increase in demand due to increase in middle class income earners buying land for home ownership mainly in satellite towns to avoid congestion in Nairobi suburbs. 

In other focus areas this week, the government is now expected to factor in its lost revenue from the National Construction Authority (NCA) and the National Environment Management Authority (NEMA) fees in the 2017/2018 Budgetary Allocations. The Transport and Infrastructure Secretary James Macharia indicated that the funding mechanism would ensure the two institutions run optimally but will also be expected to generate alternative revenue streams. The directive is expected to take effect immediately with concerned ministries working to strengthen the regulations. The Transport and Infrastructure Secretary noted that the Ministry will find mechanisms to ensure the cabinet decision on scraping NCA and NEMA fees is complied with, which is good for the construction sector and the country in efficiency and ease of doing business.

Over the week, the Tourism Regulatory Authority ranked over 80 hotels, with only 30 establishments qualifying for star ratings. The report indicated that the number of hotels with five- star rating have doubled to 15-hotels following the previous ranking exercise that had identified 7 five-star hotels in exclusion of Nairobi area. The hotels classified under five-star rating were Villa Rosa Kempinski, Hemingways Nairobi, Sankara Nairobi, Fairmont The Norfolk, The Sarova Stanley, Radisson Blu Hotel, Dusit D2 and Tribe Hotel, while ten hotels were ranked four ? star, six were ranked as three -star and six were ranked as two-star hotels in Nairobi.

The classification and rating of hotels was mainly through the following criteria;

• Quality of facilities
• Quality of the location
• Rooms and Conference sizes
• Quality of the décor and
• Linguistic diversity of the staff among others

This ranking of the hotels and restaurants brings about various advantages and differentiation of hotels. The key advantages being (i) hotels peg their facilities pricing on the rating, and (ii) the rating is used as the marketing tool since international guests rely on these international standards classifications when booking for hotel services.

The increased number of five-star hotels in Nairobi is mainly informed by the intensive investments in the hospitality sector over the last five-years. We remain positive on hospitality sector performance and investment in Nairobi, since the opportunity in this market lies in Maasai Mara followed by Nairobi area, which offers high returns to investors as per our Cytonn Hospitality Report, boosted mainly by (i) MICE tourism, and  (ii) the growing eco-tourism and health tourism involving environmental conservation.

The investors should however be differentiated by either product offering, location or customer service to attract a bigger market share. For more insight into the hospitality industry, see our Hospitality Sector Report.