Executive Summary

Fixed Income: Yields on Treasury bills were unchanged with the 91-day, 182-day and 364-day papers coming in at 7.7%, 10.3% and 10.4%, respectively. Government accepted a yield of 13.2% on the infrastructure bond, accepting a premium of 2.7% over a similar tenor taxable bond;

Equities: During the week, the Kenyan equities market was on a downward trend with NASI, NSE 20 and NSE 25 losing by 1.3%, 2.0% and 1.4%, respectively. Kenya airways named Michael Joseph as the new Chairman, resulting in deferral of the planned pilots? strike; S&P upgraded KCB Bank outlook to stable in line with Kenya?s credit outlook;

Private Equity: SMEs continue to attract private equity funding in Africa, and this week The Islamic Corporation for the Development of the Private Sector (ICD) and the Deposit and Consignments Fund (DCF) of Gabon have partnered to launch a private equity fund for SMEs in Gabon and Central Africa;

Real Estate: We expect the Standard Gauge Railway Phase 2, which was launched despite the National Environmental Tribunal (NET) blocking the construction, to boost real estate development along its terminus. Cabinet waives title transfer fees for government adjudicated land in a bid to improve transparency in land ownership and increase real estate development activities;

Focus of the Week: Kenya?s vibrant and diverse economy is expected to deliver stellar growth supported by a favorable macroeconomic environment. However, the government needs to address the key hindrances to growth if we are to enjoy sustained economic progress;

Company Updates

• Cytonn Real Estate, our development affiliate, this week launched an innovative real estate investment product at an invitation-only event to a group of private high net-worth individuals and institutions. Coming on the back of the 100% sale of Amara Ridge, where investors achieved a 33% p.a. return, the innovative real estate investment product was very well received. For more information on the launch, see the event note
• Cytonn Real Estate has launched an innovative payment plan for The Alma, its aspirational apartment community development in Ruaka. The ?0% Down & 10-year Payment Plan? is targeted at enhancing ownership and affordability for both prospective home owners and real estate investors who may not be able to afford the monthly payments over a 3-year construction period. The 0% Down & 10-Year Payment starts as low as Kshs. 90,400 per month for 1-bedroom apartments. See table below for various plans:

• Shiv Arora, Our Head ? Private Equity Real Estate discussed Kenya Airways on CNBC Africa. See Link Shiv on CNBC
• This week, we released our Cytonn Hospitality Research report. See Cytonn Hospitality Report. The report received wide interest and coverage, see:
  • Standard Digital coverage on ?Serviced Apartments overtaking hotels in occupancy and revenue?
  • Standard Print coverage on ?Industrial Parks breaks new ground for Real Estate? and,
  • KTN News coverage on ?Hospitality Report on changing trends in tourism sector?
• 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
  • Amara Ridge is currently 100.0% sold. See Amara Ridge
  • We have 12 investment-ready projects, offering attractive development returns and buyer's returns of a minimum of 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-bill subscription decreased with the overall subscription coming in at to 100.6%, compared to 154.6% recorded the previous week. Subscription rates decreased across all tenors with the 91, 182 and 364-day papers coming in at 34.0%, 166.7% and 79.0% from 117.1%, 231.3% and 102.9%, respectively, the previous week. The decline in subscription for T-bills is attributed to investors concentrating on the issuance of the Kshs 30.0 bn infrastructure bond, which was oversubscribed with total subscription at 117.0% and a yield of 13.2%. The 182-day paper continues to be the most subscribed as it offers the highest return on a risk adjusted basis. The yields on T-bills were unchanged with the 91-day, 182-day and 364-day papers coming in at 7.7%, 10.3% and 10.4%, respectively.

The 91-day T-bill is currently trading below its 5-year average of 10.4%. The downward trend for the 91-day paper is mainly attributed to the expected low interest rate environment following (i) the operationalization of the Banking Act Amendment 2015, which has led to more liquidity in the market, and (ii) reduced pressure from the government borrowing program as they are currently ahead of the pro-rated domestic borrowing target of Kshs 75.1 bn, having borrowed Kshs 125.8 bn, which is 167.5% of the pro-rated target.

The Central Bank?s weekly report revealed that the interbank rate rose by 0.3% to 3.8%, from 3.5% the previous week, despite increased liquidity in the money market attributed to Government Payments, T-bill Redemptions and Reverse Repo Purchases worth Kshs 33.4 bn, Kshs 20.2 bn and Kshs 4.7 bn, respectively, leading to a total injection of Kshs 60.5 bn, which more than offset the liquidity withdrawal of Kshs 38.5 bn.

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

According to Bloomberg, yields on the 5-year and 10-year Eurobond decreased by 0.2% and 0.4% week on week to 4.3% and 6.8% from 4.5% and 7.2%, respectively, the previous week. Since the mid-January 2016 peak, yields on the Kenya Eurobonds have declined by 4.5% points and 2.8% points, respectively for the 5-year and 10-year bond, on account of improving macroeconomic conditions. This is an indication that Kenya remains an attractive investment destination.

The Kenya Shilling was stable against the dollar closing the week at Kshs 101.4 as demand matched the supply in the market. On a year to date basis, the shilling has appreciated by 0.9% against the dollar. Going forward, we expect the shilling to remain stable at current levels for the remainder of the year given (i) the high levels of foreign exchange reserves, equivalent to 5.2 months of import cover, and (ii) improved diaspora remittances.

Last week, the Kenyan Government offered a 15-year infrastructure bond (with a weighted tenor of 11.25 years) in the primary market to raise Kshs 30.0 bn from the domestic market for partial funding of infrastructure projects in the following sectors: roads, energy and water. Yields for the bonds came in at 13.2%, which was above our recommendation as highlighted in Cytonn Weekly #40 of investors to bid between 11.7% and 12.3%. The key take-outs for this bond auction are:

1. Government accepted expensive money, having accepted a yield of 13.2% on a tax-free infrastructure bond, which equates to a 15.5% yield on an equivalent taxable bond, for a tenor of 11.25 years, when adjusting for the 15.0% tax rate,
2. Government bond with 11-years to maturity is currently trading at 12.8% in the secondary market, implying that Government paid a premium of 2.7%. This has resulted into a shift in the yield curve causing the yield on an 11-year bond to trade at 13.6%, 80 bps above last week?s yield,
3. Key to note is that the lending rate in the market has been capped at 4.0% above the Central Bank Rate (?CBR?), which is currently at 10.0%, implying a maximum lending rate of 14.0%. Infrastructure bonds would have maximum participation from banking institutions, who can now get 15.5% risk-free yield on their assets, without having to lend. If such a trend continues, we will witness reduced credit to the private sector, which will stifle economic growth.

We note the inconsistency between what CBK is forcing banks to do by reducing interest rates, and the higher yield that government is accepting in treasury securities in the auction market. It is hard to see why a banking institution would lend to an individual at 14% as opposed to the government at 15.5%.

We are projecting inflation for the month of October to rise slightly to the range of 6.4% - 6.6%, from 6.3% currently, driven by a rise in food prices and an increase in power bills due to the forex levy expense incurred by energy producers. Going forward, we expect inflationary pressure to be contained within the government target annual range of 2.5% - 7.5%, despite the possible upward pressure from the food component of the CPI basket. The food situation in the country has taken a hit following an audit report that claims over 754,000 bags of maize valued at Kshs 1.8 bn stored at the National Cereals and Produce Board (NCPB) depots is unfit for consumption.

A report released by Common Market for East & Southern Africa (?COMESA?) indicates that Kenya accounts for the second largest share of exports in COMESA behind Egypt, highlighting the importance of the trading bloc to the local economy, a position it has held in 2012 as well. Kenya accounts for 17.3%, compared to Egypt, which accounts for 22.0%. The goods from Kenya mainly comprises of agricultural produce, largely tea and tobacco, animal products and consumer goods to countries such as Uganda, DRC Congo, Rwanda and South Sudan. Most of the countries in the trading bloc are land-locked, forcing them to rely on countries with ports such as Kenya, Tanzania and Mozambique. According to the report, Kenya is the leading exporter of black tea in the world, the commodity with the second highest value in the export market after copper worldwide. However, given the release by the IMF of the World Economic Outlook, which indicated that Sub Saharan African growth will be 50% slower at 1.4% compared to the 3.5% recorded in 2015, we expect a slow-down in demand from the COMESA states. Kenya recently released a GDP growth of 6.2% for Q2?2016, we believe that strong export growth will propel Kenya to achieving a sustainable strong GDP growth in the coming years. However, this must be coupled with strong growth in the manufacturing sector to (i) improve the current account, and (ii) diversify the sources of growth away from agriculture.

The Government is ahead of its domestic borrowing for this fiscal year having borrowed Kshs 125.8 bn for the current fiscal against a target of Kshs 75.1 bn (assuming a pro-rated borrowing throughout the financial year of Kshs 229.6 bn budgeted for the full financial year). 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 medium-term papers.

Equities

During the week, the Kenyan equities market was on a downward trend, with NASI, NSE 20 and NSE 25 losing by 1.3%, 2.0% and 1.4%, respectively, taking their YTD performances to (6.8%), (20.7%) and (14.3%), respectively. Since the February 2015 peak, the market has lost 41.8% and 23.5% for NSE 20 and NASI, respectively. The week?s performance was driven by losses in select large cap stocks such as Safaricom, Equity Bank and EABL, which lost 1.3%, 1.6% and 2.5%, respectively, despite marginal gains of 0.9%, 2.2% and 3.3% in KCB, Standard Chartered Bank and BAT, respectively.

Equities turnover decreased by 58.6% to close the week at Kshs 1.2 bn from Kshs 2.9 bn the previous week.  Foreign investors turned net buyers with net inflows of USD 0.2 mn, compared to a net outflow of USD 9.0 mn recorded the previous week, with foreign investor participation decreasing to 59.0% from 67.0% recorded the previous week. Safaricom was the top mover during the week accounting for 41.3% of market activity and losing 1.3% during the week. We maintain our expectation of stronger earnings in 2016 compared to 2015 supported by a favorable macroeconomic environment. However, the key risk is the volatility in the banking sector that may depress earnings for banks, especially during the fourth quarter.

The market is currently trading at a price to earnings ratio of 12.3x, versus a historical average of 13.7x, with a dividend yield of 6.5% versus a historical average of 3.5%. The charts below indicate the historical PE and dividend yields of the market.

Negotiations held this week between Government and Kenya Airline Pilots Association (KALPA) resulted in a deferral of the planned pilots? strike, with some demands of KALPA having been met, including replacement of the Chairman. A new Chairman, Mr. Michael Joseph, was named after the talks to replace Mr. Dennis Awori. His appointment to the board raises expectation of better governance in the face of tough financial times for Kenya Airways (?KQ?), following his track record of growing Safaricom to become one of the most profitable corporate organizations in East Africa. KQ can seldom afford another pilots strike, with the airline still reporting losses of Kshs 5.0 bn, and as per our Cytonn Weekly Report #41, any strike costs the airline Kshs 200.0 mn in revenue a day.

As indictated in our Cytonn Report #41, S&P revised Kenya?s sovereign credit outlook upwards to stable from negative, citing stable growth and sustained public debt. This week, S&P revised its outlook on KCB Group from negative to stable, in line with their outlook for Kenya. This is on account of attractive and stable profitability metrics, a strong domestic retail and corporate franchise, strong capital buffers, a well-structured and low-cost deposit-based funding model with a cost of funds of 4.3% and a high level of liquid assets at 14.9% of total assets. S&P projects that the Kenyan economy will continue to grow at 6.0% and that Kenya?s largest bank by asset base is well-positioned to benefit from this. We maintain our BUY recommendation on KCB, with an upside of 63.5%, from the current price of Kshs 27.25 per share.

KenGen Company Ltd

KenGen released their full year results, recording a decline in core EPS by 41.4% y/y to Kshs 3.1 per share from Kshs 5.2 in H1?2015. This is as a result of a tax charge of Ksh 4.5 bn for the year, compared to a tax credit in H1?2015, when the company benefited from investment allowances of Ksh. 2.8 bn, following the completion of the Olkaria 280 MW plants. Key points to note include:

• Operating revenue increased 24.3% y/y to Kshs 36.4 bn from Kshs 29.3bn, which outpaced growth in operating expenses that increased 5.9% y/y to Kshs 8.9 bn from Kshs 8.4 bn in H1?2015,
• The growth in revenue was supported by rising electricity sales that rose by 11.0% to 7,819 GWh from 7,027 GWh in 2015, while operating expenses grew due to increased operational scope and capacity building, which cost KenGen Kshs 8.9 bn,
• Earnings before interest, tax, depreciation and amortization (EBITDA) increased by 48.6% y/y to Kshs 26.4 bn from Kshs 17.8 bn in H1?2015, due to new revenue streams from new geothermal capacity, steam and commercial drilling services and optimization of expenses. Depreciation and armotization charges increased by 57.8% to Kshs 10.2 bn from Kshs 6.5 bn, mainly due to revaluation of assets, thereby increasing the value of depreciable assets, and full-year depreciation of the Olkaria 280 MW power plant,
• Profit before tax recorded a growth of 29.6% to Kshs 11.2 bn from Kshs 8.6 bn. However, net income declined 41.4% to Kshs 6.7 bn from Kshs 11.5 bn, owing to the tax charge of Kshs 4.5 bn, whereas the previous year benefitted from a tax credit of Kshs 2.8 bn,
• Total assets increased by 7.2% to Kshs 367.2 bn from Ksh 342.5 bn as a result of investment in 15 units of wellheads and drilling of additional wells. KenGen plans on delivering an additional 706 MW by 2020. The project pipeline comprises of 10 MW wellheads to be completed in the first quarter of 2016/17 and the construction of the 140 MW Olkaria V which is expected to commence in the first half 2016/17,
• KenGen successfully raised Kshs 26.4 bn through a rights issue, a performance rate of 92% of their target Kshs 28.7 bn, which improved its equity base and will support future growth and expansion,
• The Board of Directors did not recommend the payment of dividends for the year, the first time they are not paying dividends since going public in 2006.

Moving forward, we expect sustained earnings for KenGen given Kenya?s growing demand for power, which has surpassed 1,600 MW. According to the Energy Regulatory Commission (ERC), electricity consumption hit 1,618 MW in September and is expected to reach 2,800 MW by 2020, which is a 70% growth over the next 4-years. KenGen has a robust expansion project pipeline which when completed, will be geared towards meeting this demand.

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

• BAT has moved from a ?Buy? recommendation, with an upside of 23.4% to a ?Accumulate? recommendation with an upside of 19.7%, following a 3.3% w/w price increase
• CIC has moved from a ?Hold? recommendation, with an upside of 8.5% to an ?Accumulate? recommendation with an upside of 12.5%, following a 3.6% w/w price decline

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

Private Equity

The Islamic Corporation for the Development of the Private Sector (ICD - PS) - a multilateral organization and member of the Islamic Development Bank (?IDB?) Group - and the Deposit and Consignments Fund (DCF) -  a Gabon-based fund, have partnered to start an SME-focused private equity fund, concentrating on Central Africa region and Gabon in West Africa. ICD has a mandate to support and promote private sector growth in its member countries through financing and investing in upcoming private companies in a bid to contribute to economic development. Through this partnership, ICD hopes to (i) strengthen its relations with the Central African region and Gabon, and (ii) contribute largely to the development of Islamic financing for SME?s in the region. According to the European Investment Bank (?EIB?), nearly half the SMEs in developing countries rate access to finance as a major challenge and this has impaired growth thus bringing about negative effects in terms of innovation and economic growth. International Finance Institutions (?IFIs?) are therefore better placed to support SME?s as they are more cost-efficient as compared to government programs with the same function.

Private equity investment activity in Africa has continued to attract capital, as evidenced by the increase in the number of deals and deal volumes into the region, with funds continuing to prefer financial services, energy, real estate, healthcare, education, and IT sectors although infrastructure, Fast Moving Consumer Goods (FMCG) and natural resources are gaining ground. We remain bullish on PE as an asset class in Sub-Saharan Africa given (i) the abundance of global capital looking for investment opportunities in Africa, (ii) attractive valuations in the private sector, and (iii) better economic growth projections compared to global markets.

Real Estate

During the week, President Kenyatta launched Phase 2A of the Standard Gauge Railway (?SGR?) expected to run from Nairobi to Naivasha, a distance of 120.0 km. This is despite the National Environmental Tribunal (?NET?) blocking the construction of the railway due to environmental reasons given that 6.0 km of the railway is expected to cut across the Nairobi National Park. The railway is part of the SGR running from Mombasa to Malaba and the Mombasa - Nairobi section is already 90% complete. The Nairobi - Naivasha section of the railway is expected to costs Kshs 105.0 bn and is being financed 90.0% by Chinese Exim Bank and 10.0% by the Government of Kenya. It is expected to be operational from December 2017. The SGR will offer several economic benefits including opening-up of economic zones, faster transportation across the country, provision of employment opportunities and revenue generation locally. The development of the railway is expected to have a positive impact on the real estate sector in Kenya. Previous experience with infrastructure development and especially transport networks have a strong positive correlation with real estate development and specifically land prices as shown in the table below:

Source: Hass Consult

We thus expect the main terminus of the SGR including Athi River, Syokimau, Mai Mahiu and Suswa in Naivasha to witness rapid price appreciation and increased real estate development.

Property transactions in Kenya are set to be cheaper and easier after the cabinet approved a proposal waiving all fees on transfer of government adjudicated property in Kenya. Previously, to acquire a land title, the buyer had to pay a fee calculated based on the land value and the surveying, adjudication and planning fees all dependent on the land sizes. These amounted to a minimum of Kshs 20,000 for inherited land, a figure unaffordable to most unemployed Kenyans, especially in rural areas. The result was that most Kenyans owned large tracts of land without titles, hence inhibiting transfer of the land parcels. The waiver will thus lead to increased development as it will enable easier and cheaper transfer of land. It will also lead to reduced incidences of land grabbing, a common vice in Kenya. This is the latest milestone in a number of government initiatives aimed at improving land transparency and real estate development in general, with the others being reestablishment of land boards and tax reduction for large scale low-cost housing production, all aimed at increasing transparency and reducing cases of corruption with land titles.

Our outlook for real estate remains positive with increased infrastructural development, government incentives and the lowering of interest rates in the country.

Kenya?s Economic Growth

This month S&P, a global ratings agency, upgraded its credit outlook for Kenya from negative to stable, for both local and foreign currency long-term debt citing (i) sustained economic growth, (ii) reduced political tension, and (iii) stabilizing public debt, which is currently at 58.0% of GDP. This follows the IMF downgrading its Sub-Saharan Africa economic growth prospects to 1.4%, representing a 50% drop from the 3.5% recorded in 2015, attributing the drop mainly to:

1. Declining oil prices, which has affected key commodity exporting economies such as Nigeria,
2. Terrorism and humanitarian crimes, and,
3. Critical drought particularly in Lesotho, Malawi and Zambia, as the main concerns.

Despite the expected drop in GDP growth for Sub-Saharan Africa, Kenya continues to record strong GDP growth, most recently coming in at 6.2% for Q2?2016. For our focus of the week, we highlight Kenya?s economic growth path: the expectations at the beginning of the year, the journey so far and finalize with our outlook.

East Africa as a region offers investors, developers, and entrepreneurs a host of opportunities, with low commodity dependence and vibrant capital markets. Of the various countries in East Africa, Kenya stands out due to the diversity and vibrancy of its economy; the hub for innovation, technology, financial services and real estate development.

At the beginning of 2016, the economic expectations were bullish, and pointed towards a stable macroeconomic environment supportive of growth, underpinned by expectations of a strong performance in the energy, construction, information and communication sectors, and the recovery of the tourism sector. The only concern was that the Kenya Shilling was expected to remain under considerable pressure because of increased capital expenditure to finance large-scale infrastructural projects but this was countered by the support from IMF through the Stand by Facility and the increased inflows to the country.

During the first and second quarter of 2016, GDP grew by 5.9% and 6.2%, respectively, driven by growth in the Agriculture, Transportation and Storage, Real Estate, Tourism and Wholesale & Retail trade, against expectations of 5.2% and 5.7% for the first and second quarter of 2016, respectively, as shown in the table below:

This year, the sectors that supported the growth include Agriculture, Transportation and Storage, Real Estate and Wholesale & Retail trade. Tourism (Hotels and Restaurants) has shown positive growth, an indication that it is well on track for recovery recording a growth of 15.3% in Q2?2016. Growth will continue to be driven by (i) Infrastructural spending by the government in the infrastructural and energy sectors, (ii) the devolved system of governance, which is expected to improve economic activities in different counties, (iii) a young and growing population, which will lead to (a) increased demand for basic services, including food, water and shelter, (b) increased number of people joining the workforce, increasing the disposable income levels in the economy while and contributing to the growth and development of consumer markets, and (c) increased appetite for investments by a younger, more educated population; and (iv) the growth of the middle class whose demand for goods and services, and hence an increase in their spending power, translates into a significant opportunity driven by consumption expenditure.

However, key hindrances to economic growth present themselves in the form of:

1. Security: In recent years, terrorism has escalated in Kenya with Al-Shabaab causing havoc. The constant threat of terrorism has driven away tourists, causing certain countries to issue travel advisories against Kenya, which has led to loss in revenue for one of the country?s biggest GDP contributors, tourism. However, the government has invested a lot in security and terror events have significantly reduced improving external perception about the country?s safety;
2. Political Stability: Economic growth and political stability are deeply interconnected. Political instability is often riddled by frequent switch of policies, creating uncertainty, which may reduce investment and hence negatively affecting macroeconomic performance. With the Kenyan Election scheduled for 2017, uncertainty still exists;
3. Corruption: Kenya ranked poorly in the 2015 Corruption Perception Index released by Transparency International, coming in at 139 out of 168 countries. Per the index, Kenya retained the same score, 25 points of a possible 100, that it had in 2014. This score was attributed to Kenya?s continued dismal performance on the back of ineffective anti-corruption agencies;
4. Export Growth: With improved exports, especially from tea and horticulture the country is set to benefit through (i) forex income which will eventually go into supporting the currency, and (ii) improved current account position which will reduce reliance on debt and spur sustainable growth.

For the economy to grow, the Kenyan Government needs to put up initiatives and processes to counter the above. We commend the government for improving the security situation in the country as well as cooling off the political temperatures through diplomacy. However, corruption is still a problem and the government needs to have a strong stance and act on it. The issue lies with sincerity of purpose, genuine efforts and the overall operating climate. Kenya has the structures, systems and processes in place but unless there exists a genuine will on the leadership?s part to succeed, any anti-corruption programme will remain a passive declaration. It is much more a mindset challenge rather than a question of fixing the system.

Our GDP growth outlook for Kenya for 2016 is estimated to come in at 6.0%, against expectations at the start of the year of 5.7%. This growth will largely be driven by Agriculture, tourism, energy and the Real Estate sector which are expected to grow at 2.8%, 7.0%, 7.4% and 9.0%, respectively.
 

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted. This publication, which is in compliance with Section 2 of the Capital Markets Authority Act Cap 485A, is meant for general information only, and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.