Executive Summary

• Fixed Income: As predicted in our Report #16 about a rake hike, the MPC raised the base-lending rate by 150 bps to 10.0% in support of the shilling. We continue to favour short durations;
• Equities: The stock market continues on a losing streak as large capitalization stocks decline. We remain neutral on equities due to stretched valuations and lower earnings growth prospects;
• Private Equity: Mergers & Acquisitions activities in insurance sector set to increase due to increased capital requirements;
• Real Estate: Attractive returns in Kenya?s real estate sector continue to attract international investors;
• Focus of the Week: The budget tabled in government is ambitious and there are number of questions on the assumptions used, but if achieved economic growth will accelerate.

Fixed Income

Treasury bills continued to be undersubscribed with a 48% overall subscription this week after a 45% subscription last week with most investors preferring the 91-day T-bill, which saw Kshs 2.45 billion subscription versus Kshs 1 billion on offer. The trend on T-bill yields was mixed as the 91-day and the 182-day saw an increase to 8.3% and 11.1% from 8.2% and 10.8%, respectively, while the 182-day was unchanged at 10.5%. The interbank rate corrected during the week to 10.2% from 13.6% the previous week as the market liquidity improved slightly.

In a bid to curb the shilling weakness, the Monetary Policy Committee brought their bi-monthly meeting earlier by one month and in the meeting raised the Central Bank Rate (CBR) to 10% from 8.5%. In our view the rate increase should have come in a bit earlier, in April, in which case they wouldn?t have needed to raise by 150 bps; a 25 bps raise in April would have been sufficient message to the marker that CBK is willing to defend the shilling. This would have discouraged any borrowing for exports or further speculation on the shilling. The delayed action then forced the MPC to meet earlier than usual and the magnitude of the rate increase was higher than the market expected. This might lead to a slowdown in economic growth due to reduced credit to the private sector. The market reacted negatively to the rate increase with the shilling depreciating by 1.1% during the week to close at 97.2 against the dollar. The fundamentals of the shilling remain weak among them being: widening current account deficit estimated at 9% of GDP for the FY2015/2016, increasing fiscal deficit at 5% of GDP and the reduced inflows from tourism and other foreign exchange earners. The key factors supporting the currency is low inflation rates and the high forex reserves held by Central Bank, but this has been depleted slightly over the last few weeks.

Following the increase in the CBR, we expect the yields on government securities to increase and this will negatively impact the valuation of Mark-to-Market bond portfolios. We hold our earlier recommendation that investors should invest in short duration fixed income instruments.

Equities

During the week, the equities market was on a losing streak with the NSE 20 declining by 0.4% while the NASI declined by 0.5%. The performance was due to a 2% decline in Safaricom as it accounts for 28% of the market capitalization, losses in CIC (5.0%), and Kenya Airways (14.3%) after investors reacted negatively to the news of the planned restructuring. There were however gains reported during the week in Eaagads (10.0%), CFC (6.9%) and Stanchart (6.8%), but on very low volumes.

With the increase in the CBR to 10.0%, we expect the KBRR, which is to be reset in July 2015, to increase. This will lead to commercial banks in the country raising their rates in a bid to maintain their net interest margins. With the exception of minimal increases in non-performing loans, we do not think the banking businesses will be impacted significantly by the increases and historically, Kenyan banks have been fairly good at protecting their margins regardless of the rate environment.

In order to fund Kenya?s largest budget, equivalent to Kshs 2.2 trillion for the fiscal year 2015/2016, the Treasury Secretary announced the removal of Capital Gains Tax (CGT) of 5.0% on listed shares, and instead proposed a 0.3% withholding tax of transaction value. The new proposal is efficient to administer but might be expensive for active traders. This spells good news for (i) stockbrokers who argued that the calculations for CGT is a burden and the difficulty in determining the adjusted cost of the shares they transferred and (ii) investors who had initially shied away due to the tax implications will look back into the Kenyan equities market as a potential investment destination.

In a bid to improve the financial soundness of financial sector, the minimum core capital requirement for banks is set to increase from Kshs 1 billion to Kshs 5 billion by 2018, while that of insurance companies is set to increase to Kshs 600 million and Kshs 400 million from the current Kshs 450 million and Kshs 150 million for general and life, respectively. The changes were proposed in a bid to ensure that banks and insurance companies are well capitalized and can absorb financial shocks. This is set to lead to increased private equity activity in the sectors through Mergers & Acquisitions.

We remain neutral on equities given stretched valuations and relatively lower earnings growth prospects and we do not think the changes in the Capital Gains Tax will have any major impact on the performance of the stock market. The market continues to be a stock-pickers market to derive value.

Private Equity

This week Barclays Africa Group acquired a 63.3% stake in First Assurance Company Ltd for Kshs 2.90 billion, as it seeks to diversify into the bancassurance business. Kshs 2.2 billion will be paid to the shareholders with the balance of Kshs 700 million injected as capital. The acquisition is in line with the group?s strategy of diversifying their operations, and a target to increase its revenues from other areas of business, other than banking, in Africa to 25.0%.

The Barclays - First Assurance transaction was done at a 1.6x multiple of price to tangible book value. The valuation appears fair compared to recent deal valuations in the insurance sector that range from 1.3x to 2.2x acquisition price to tangible book:

• Pan African Insurance acquired 51.0% controlling stake in Gateway Insurance for Kshs 561 million and a price to tangible book value of 1.3x.
• Old Mutual also acquired a 66.7% stake in UAP at Kshs 23.1 billion and a price to tangible book value of 2.2x
• Listed companies are trading at an average multiple of 2.1x, hence the 1.6x valuation for the deal implies a private company liquidity discount of 24%, indicating a fairly priced deal

We expect increased M&A activity in the financial sector as the sector remains attractive, is still highly fragmented with too many players, and the increase in the minimum core capital requirements should catalyse M&A discussions.

Real Estate

Real estate developers AMS Properties and Hass Consult have entered into a deal with a Mauritian private equity firm, Xterra Capital Advisors, to develop residential units, commercial properties and hotels worth Kshs 9.7 billion in the East African region. This deal continues to affirm the business model of coupling up financing capability and development capability to form an end to end real estate finance and development platform. Other examples include Centum Investment creating and coupling up with Athena Properties, Cytonn Investments creating and coupling up with Cytonn Real Estate, and attempted Britam Asset Managers coupling up with Acorn Properties. While the financier-developer coupling strategy enables faster and more responsive execution, it is very hard to align the interest of each party hence very hard to manage. It remains to be seen how Xterra will align with the two developers.

Nairobi County has issued a tender notice for redevelopment of old residential estates around the city to improve on the density and maximize returns on the properties and help achieve Vision 2030. The County is seeking partners for a joint redevelopment of old estates located on seven sites measuring a total of 46.4 acres. The redevelopment is to provide affordable housing for low-income households, with the pilot project expected to deliver 14,000 units.

Focus of the Week: The Kenyan 2015/2016 Budget

Treasury Secretary Henry Rotich presented Kenya?s FY 2015/2016 Budget of Kshs 2.2 trillion to Parliament on the 11^th of June 2015. Total expenditure increased by 22.7% to Kshs 2.2 trillion and is expected to be financed by Kshs 1.3 trillion of tax collections, Kshs 567 billion of borrowings (both local and foreign) as well as project grants.

As was expected, the lion?s share of the budget was allocated to the Social Sector, 28% of total expenditure, with the bulk being spent on education. The constant investment in education and security is important to improving the attractiveness of Kenya as an investment destination. Another large beneficiary category is the Energy, Infrastructure and ICT sector, which has been allocated 27% of the budget, with the increment primarily to road and railway construction to fund the Standard Gauge Railway. The increase in energy allocation will fund geothermal power generation, power transmission and rural electrification. We are of the view that the increased allocation to development expenditure projects will spur economic activity and improve economic growth in the medium term to long term but only if these funds are well and fully utilised.

The county governments will also get a large share of the budget, with a 25% increase in allocation to Kshs 287 billion, with Kshs 259 billion as shareable revenue. This will go a long way towards enhancing devolution in the country. However, we need to see better spending management and more allocation to development funding in counties for county allocations to have the optimal outcome.

On the budget?s financing, tax revenue is expected to increase by 16.5% to Kshs 1.3 trillion in the upcoming financial year. To help improve the tax collection, KRA is in the process of digitising all tax collections and also broadening the tax base.

The 8.7% budget deficit is set to financed through both foreign financing (340.9 billion) and local domestic borrowing (219 billion).

While the ambitions and aspirations of the budget are admirable, below are some concerns to be aware of and to try and mitigate early:

1. Tax collection has recently been constantly below target; with the increased target in the budget, we are yet to see a clear path to ensuring tax collection becomes a success;
2. The GDP growth estimates of 7% are highly ambitious given that majority of our produce is rain-fed agriculture and given that most recently IMF revised the GDP growth to 6.5%;
3. Despite huge allocation to security, insecurity remains a key concerns and negatively impacting sectors like tourism;
4. Increased fiscal deficit will lead to a huge debt burden for the country; we should seek alternative means of funding the budget to reduce excessive borrowing;
5. If the government borrowing ends up crowding out the private sector and making it harder for the private sector to access capital, this could lower economic growth;
6. Currency volatility is a key threat especially given the servicing of the foreign debt, which opens up the country to shocks in the global markets;
7. Over the past year the government has not been too disciplined with following the budget, leading to constant tabling of supplementary budgets before the end of the year. It would be helpful for the government to try and stick to the initial budget estimates.

Key to note from the budget is that the government is open to the deepening of the capital markets as can been seen by (i) the reversal of capital gains tax on shares, (ii) changes to RBA regulation to allow for private equity and venture capital, (iii) raising minimum capital for banks and insurance companies and giving some time for compliance.

In summary, we like the emphasis on infrastructure development, providing social services and investments in education, but we need to be disciplined and stick to the budget and be careful not to borrow excessively.

--------------------------