• Cytonn Asset Managers Ltd, our affiliate regulated by the Capital Markets Authority, CMA, and the Retirement Benefits Authority, RBA, has announced the launch of its individual pension plan product, Cytonn Individual Retirement Plan, CIRP. To register for CIRP, see here or just email pensions@cytonn.com;
• Phase 1 of The Alma achieved a milestone last week; it is now 100% sold with early buyers having achieved up to 55% capital appreciation. We are now running a promotion in Phase 2: Buy a unit in Phase 2 with a 15-year payment plan and 0% deposit. For inquiries, please email us on clientservices@cytonn.com. The site is open between 8 am - 5 pm, 7-days a week for site visits;
• Cytonn Money Market Fund closed the week at an average yield of 11.0% p.a. To subscribe, just dial *809#
• In line with increasing the product offering to our clients, we are happy to announce that Cytonn Asset Managers has received two more licenses to offer personal retirement benefits scheme with a monthly payment platform from the Retirement Benefits Authority (RBA). The licenses allow Cytonn Asset Managers to; manage segregated funds, personal pension funds and the income drawdown fund. https://bit.ly/2K6xs6u. For more information on the pension products, email us at pensions@cytonn.com;
• Interested in learning about real estate investments in a relaxing environment this weekend? Be sure to stop by our stand at the Lavington Mall next weekend, on the 21st and 22nd  June 2019 from 9:00 am - 6:00 pm and start your investment journey;
• Ian Kagiri- Investments Analyst was on KBC Channel 1 to discuss the expected 2019/2020 budget ahead of the budget reading. Watch Ian here;
• For an exclusive tour of Cytonn’s real estate developments, visit: Sharp Investor’s Tour and for more information, email us at sales@cytonn.com;
• Following the completion and handover of Amara Ridge in Karen, we have now launched our next Karen project, dubbed Applewood, a Kshs 2.5 bn residential development located in Miotoni, Karen. This signature development shall comprise luxury homes, each sitting on 1/2 acre. We invite you to the exhibition of Applewood which is ongoing at the Amara Ridge Clubhouse (Location pin: https://goo.gl/maps/B3GVnu8pHyn) or at the Applewood Sales Centre on Miotoni Road (Location pin: https://goo.gl/maps/ZfABuGjFo1z) from 9:00 am to 5:00 pm daily. Call 0709 101 000 or email resales@cytonn.com to reserve a villa! See Video here;
• We continue to hold weekly workshops and site visits on how to build wealth through real estate investments. The weekly workshops and site visits target both investors looking to invest in real estate directly and those interested in high yield investment products to familiarize themselves with how we support our high yields. Watch progress videos and pictures of The Alma, Amara Ridge, and The Ridge;
• We continue to see very strong interest in our weekly Private Wealth Management Training (largely covering financial planning and structured products). The training is at no cost and is open only to pre-screened participants. We also continue to see institutions and investment groups interested in the training for their teams. Cytonn Foundation, under its financial literacy pillar, runs the Wealth Management Training. If interested in our Private Wealth Management Training for your employees or investment group, please get in touch with us through wmt@cytonn.com. To view the Wealth Management Training topics, click here;
• For recent news about the company, see our news section here;
• We have 10 investment-ready projects, offering attractive development and buyer targeted returns. See further details here: Summary of Investment-Ready Projects.

Money Markets, T-Bills & T-Bonds Primary Auction:

T-bills remained oversubscribed during the week, with the overall subscription rate increasing to 130.6%, from 116.0% recorded the previous week. The continued oversubscription is attributable to favourable liquidity in the market supported by government payments that offset the tax payments. The yields on the 91-day and 364-day paper remained unchanged at 6.9% and 9.3% respectively, while the yield on the 182-day papers increased by 0.1% points to 7.7% from 7.6% recorded the previous week. The acceptance rate declined to 35.1%, from 62.2% recorded the previous week, with the government accepting a total of Kshs 11.0 bn of the Kshs 31.3 bn worth of bids received, lower than the weekly quantum of Kshs 24.0 bn. Investors’ participation remained skewed towards the longer-dated paper, with the continued demand being attributable to the scarcity of newer short-term bonds in the primary market. The 364-day recording improved subscription to 274.2%, from 261.1% the previous week. The subscription rates for the 91-day and 182-day papers also increased to 26.7% and 28.5% from 22.6% and 8.1% recorded the previous week, respectively.

The re-opened bonds for the month of June, issue numbers (FXD1/2012/15) and (& FXD1/2018/15) with effective tenors of 8.4-years and 13.9-years were oversubscribed, with the performance rate coming in at 214.0%. The market had a bias towards the FXD1/2018/15 that had been issued in 2018 generating total bids of Kshs 45.8 bn as investors eyed the higher yield with its coupon at 12.7%. The accepted yields for the FXD1/2012/15 and FXD1/2018/15 came in at 11.6% and 12.5% in line with our expectations. The acceptance rate for the issue came in at 45.5% with the Government accepting Kshs 38.9 bn of the Kshs 85.6 bn worth of bids received, signaling reduced appetite for domestic debt for the current financial year as the government snubbed expensive bids, being currently ahead of its domestic borrowing target.

In the money markets, 3-month bank placements ended the week at 9.0% (based on what we have been offered by various banks), 91-day T-bill at 6.9%, average of Top 10 Money Market Funds at 9.4%, with the Cytonn Money Market Fund closing the week at 11.0%.

Liquidity:

During the week, the average interbank rate declined to 3.2%, from 4.1% recorded the previous week, pointing to improved liquidity conditions in the money market supported by government payments, which offset tax remittances during the week. This saw commercial banks’ excess reserves coming in at Kshs 15.4 bn in relation to the 5.25% cash reserve requirement (CRR). The average volumes traded in the interbank market also declined by 26.9% to Kshs 4.4 bn, from Kshs 6.0 bn the previous week.

Kenya Eurobonds:

The yield on the 10-year Eurobond issued in 2014 remained unchanged at 6.1%, while that of the 5-year declined by 0.7% points to 5.0% from 5.7% recorded the previous week. Key to note is that these bonds have 9-days and 5.0-years to maturity for the 5-year and 10-year, respectively.

For the February 2018 Eurobond issue, yields on the 10-year and 30-year Eurobond both gained by 0.1% points to 7.5% and 8.6%, respectively from 7.4% and 8.5% recorded the previous week.

For the newly issued dual-tranche Eurobond with 7-Years and 12-years tenor, priced at 7.0% for the 7-year tenor and 8.0% for the 12-year tenor, respectively, the yield on the 7-year bond remained unchanged at 7.0% while the 12-year bond declined by 0.2% points to 7.8% from 8.0% recorded the previous week.

The Kenya Shilling:

During the week, the Kenyan Shilling depreciated by 0.2% against the US Dollar to close at Kshs 101.5, from Kshs 101.3 the previous week, due to a spike in dollar demand from oil and merchandise importers. The Kenya Shilling has appreciated by 0.5% year to date in addition to the 1.3% appreciation in 2018, and in our view, the Shilling should remain relatively stable to the dollar in the short term, supported by:

1. The narrowing of the current account deficit with data on balance of payments indicating continued narrowing to 4.5% of GDP in the 12-months to April 2019, from 5.5% recorded in April 2018. The decline has been attributed to the resilient performance of exports particularly horticulture and coffee, strong diaspora remittances, and higher receipts from tourism and transport services. Growth of imports also slowed mainly due to lower imports of food,
2. Improving diaspora remittances, which have increased cumulatively by 3.8% in Q1’2019 to USD 665.6 mn, from USD 641.5 mn recorded in a similar period of review in 2018. The rise is due to:

1. 1. Increased uptake of financial products by the diaspora due to financial services firms, particularly banks, targeting the diaspora, and,
   2. New partnerships between international money remittance providers and local commercial banks making the process more convenient,

3. CBK’s supportive activities in the money market, such as repurchase agreements and selling of dollars, and,
4. High levels of forex reserves, currently at USD 10.1 bn (equivalent to 6.4-months of import cover), above the statutory requirement of maintaining at least 4-months of import cover, and the EAC region’s convergence criteria of 4.5-months of import cover.

Highlights of the Week

The National Treasury released the 2019/2020 fiscal year (FY) budget on 13^th June 2019. Below are some of the highlights with the revenue and expenditure estimates remaining unchanged as outlined in our FY 2019/20 Pre-Budget Discussion Note:

Key take-outs from the table;

• Total revenue collected is expected to increase by 14.2% to Kshs 2.1 tn from the Kshs 1.9 tn as per the revised FY’2018/2019 revised Budget mainly driven by a 12.2% rise in ordinary revenue to Kshs 1.9 tn from an estimated Kshs 1.7 tn in the revised FY’2018/2019 budget
• Total expenditure is set to increase by 10.1% to Kshs 2.8 tn from Kshs 2.5 tn as per the revised FY’2018/19 Budget
• The fiscal deficit is projected at 607.8 billion (5.6% GDP) which will be financed through 324.3 billion in terms of external financing, domestic borrowing of 289.2 billion and other domestic receipts worth 5.7 billion

Of interest, however, were the various measures put in place to improve revenue collection, with the Government having an ambitious target of Kshs 2.1 tn, a 14.2% rise from the FY’2018/2019 budget. Some of the measures, as highlighted in the budget, that the Government intends to introduce through the Finance Bill, 2019, expected to generate an additional Kshs 37.0 billion, in tax revenue to the Exchequer include:

1. An increment in the Capital Gains Tax from 5.0% to 12.5%. Transfer of property necessitated by restructuring of corporate entities, will however be exempt from this tax to allow for seamless restructuring of corporate entities with the aim of increasing efficiency and market penetration.
2. Excise duties on cigarettes and alcohol will be increased by 15.0% in efforts to boost excise revenues which have been on a declining trend.
3. Introduction of Excise duty on betting activities, where a rate of 10.0% will be charged on the amount staked. This is to curb the negative social effects brought about by betting in the country.
4. Expanding the scope of application of withholding tax by subjecting additional services such as security services, cleaning and fumigation services, catering services offered outside hotel premises, sales promotion, marketing and advertising services and transportation of goods excluding air transport to withholding tax. It will enhance compliance by those offering the services.

We expect continued underperformance in revenue collections as per the historical trend with the worst year being FY’2017/2018 where it only managed to raise 89.6% of the targeted total revenue mainly due to a shortfall of Khs 195.0 bn in ordinary revenue.

Despite the measures put in place to enhance revenue collection, we believe that they will not yield a significant growth in ordinary revenue as they are expected to generate only an additional Kshs 37.0 bn in tax revenue which is meagre compared to the expected Kshs 263.3 mn rise in total revenue as per the budget.

The Energy and Petroleum Regulatory Authority released their monthly statement on the maximum retail fuel prices in Kenya effective from 15th June 2019 to 14th July 2019. Below are the key take-outs from the statement:

1. Petrol prices have increased by 2.7% to Kshs 115.1 from Kshs 112.0 per litre previously, while diesel prices have increased by 0.4% to Kshs 104.8 from Kshs 104.4, previously,
2. Kerosene prices however declined by 0.3% to Kshs 104.3 from Kshs 104.6 per litre

The changes in prices are attributable to:

1. An increase in the average landing cost of imported super petrol by 4.5% to USD 538.1 per cubic metre in May 2019, from 514.7 per cubic metre in April 2019,
2. An increase in the average landing costs of imported diesel by 0.5% to USD 535.8 per cubic metre in May 2019, from 533.1 per cubic metre in April 2019, and Kerosene decreasing by 0.4% to USD 532.9 per cubic metre in May 2019, from 535.2 per cubic metre in April 2019, and
3. The Free on Board (FOB) price of Murban crude oil lifted in May 2019 declined by 1.0% to USD 72.4 from USD 73.1, per barrel in April 2019,

Consequently, we expect a rise in the transport index, which carries a weighting of 8.7% in the total consumer price index (CPI), due to the increased petrol and diesel prices. We shall publish our inflation projections in next week’s report.

Rates in the fixed income market have remained relatively stable as the government rejects expensive bids as they are currently 11.1% ahead of its domestic borrowing target for the current financial year, having borrowed Kshs 345.5 bn against a pro-rated target of Kshs 311.0 bn. A budget deficit is likely to result from depressed revenue collection with the revenue target for FY’2019/2020 at Kshs 2.1 tn, creating uncertainty in the interest rate environment as additional borrowing from the domestic market goes to plug the deficit. Despite this, we do not expect upward pressure on interest rates due to increased demand for government securities, driven by improved liquidity in the market owing to the relatively high debt maturities. Our view is that investors should be biased towards medium-term fixed income instruments to reduce duration risk associated with long-term debt, coupled with the relatively flat yield curve on the long-end due to saturation of long-term bonds.

During the week, the equities market was on an upward trend with NASI, NSE 20 and NSE 25 gaining by 0.1%, 1.1% and 0.6%, respectively, taking their YTD performance to gains/(losses) of 6.8%, (4.5%), and 2.4% for NASI, NSE 20 and NSE 25, respectively. The gain in the NASI was driven by gains in NIC Group, Standard Chartered Bank Kenya and BAT which gained by 4.1%, 2.1% and 1.6%, respectively. The gains were however subdued by declines in large cap stocks such as Bamburi, Barclays Bank Kenya (BBK), Diamond Trust Bank Kenya (DTBK) and Co-operative Bank, which declined by 3.7%, 1.9%, 1.5% and 1.2%, respectively.

Equities turnover increased by 186.9% during the week to USD 37.0 mn, from USD 12.9 mn the previous week, taking the YTD turnover to USD 717.0 mn. Foreign investors turned net sellers for the week, with a net selling position of USD 5.9 mn, from last week’s net buying position of USD 0.3 mn.

The market is currently trading at a price to earnings ratio (P/E) of 11.8x, 11.4% below the historical average of 13.4x, and a dividend yield of 5.1%, above the historical average of 3.8%. With the market trading at valuations below the historical average, we believe there is value in the market. The current P/E valuation of 11.8x is 11.5% above the most recent trough valuation of 9.7x experienced in the first week of February 2017, and 37.3% above the previous trough valuation of 8.3x experienced in December 2011. The charts below indicate the historical P/E and dividend yields of the market.

Weekly Highlights

During the week, Equity Group opened a commercial representative office in Addis Ababa, Ethiopia, which is expected to commence operations in July. This is in line with the bank’s strategy to expand into 10 African countries within the year.  Expansion into the Ethiopian market is the first phase of the regional expansion drive to attain Pan African status. With a strong retail and digital banking expertise, the Ethiopian market presents a vast untapped market for the bank to exploit, with an estimated population of 105.0 mn. The ongoing shift in reforms to more liberal policies by the current regime should see more banks venture into the country, with KCB Group also highlighting its plan to venture into the market. Equity Goup intends to venture into other African countries through an acquisition of various subsidiaries of Atlas Mara Ltd, an estimated Ksh 10.7 bn deal, which we analyzed in our April monthly note. The venture will affirm the bank’s position as the biggest bank in Kenya by customers. Kenyan banks have been expanding their operations into neighbouring countries in search for growth, to diversify their earnings as competition intensifies in the local market, as margins remains compressed under the current interest cap regime.

The Central Bank of Kenya (CBK) instructed commercial banks to file weekly reports on individuals exchanging old notes, in an effort to curb the circulation of counterfeit money. As noted in our note the ongoing demonetization exercise is expected to be conducted until October 2019, in an attempt at (i) clean up circulation of counterfeit currency, (ii) cleaning up proceeds of corruption held in cash, and, (iii) bring back into circulation monies held in cash. The Central Bank has increased its oversight of the banking sector, with the enforcement of strict anti-money laundering rules, with banks expected to comply with the strict regulations, as they mitigate reputation damage and downside regulatory risks. We are of the view that during the transition period to the new currency, banks may see increased demand for digital banking services, as customers increase their preference of digital transactions. This should presumably lead to higher transactional revenue for banks during that period.

Universe of Coverage

Below is a summary of our SSA universe of coverage:

We are “Positive” on equities for investors as the sustained price declines has seen the market P/E decline to below its historical average. We expect increased market activity, and possibly increased inflows from foreign investors, as they take advantage of the attractive valuations to support the positive performance.

During the week, AfricInvest, an investment and financial services firm based in Tunisia, announced a further investment of Kshs 273.0 mn in insurance group Britam, acquiring an extra Kshs 32.5 mn shares at Kshs 8.4 per share, a stake of 3.3%. The firm has invested in 150 companies across 25 African countries in high growth sectors such as financial services, agribusiness, consumer/retail, education and healthcare. To date, AfricInvest’s cumulative Assets Under Management total to USD 1.2 bn (Kshs 121.9 bn) which are managed across 18 funds and invested in sectors such as Fintech, logistics, artificial intelligence, agri-business, customer/retail, healthcare, financial services and education.

AfricInvest has been accumulating Britam’s stocks since its initial investment of Kshs 5.7 bn, acquiring 360.8 mn shares, equivalent to a 14.3% stake in May 2018 at Kshs 15.9 per share. With this new acquisition, AfricInvest’s cumulative investment in Britam now pools to over Kshs 6.4 bn, and a stake of 17.8%.  This continued accumulation of Britam stocks by the firm is driven by the insurance company’s compelling asset base, a solid regional presence, a strong distribution network and a diversified business strategy. Below is a pro-forma summary of Britam’s ownership post this transaction:

Earlier in the week, Emerging Capital Partners (ECP) a Pan-African US-based private equity firm announced the acquisition of a majority stake in Mauritius-based Inter Africa Transport Forex (IATF), a Fintech platform that enables transport companies, especially those operating across African borders, to better procure, manage and track their costs, for an undisclosed amount through its ECP Africa Fund IV. Transport Forex, a multi-currency and multi-country system, is an online ordering and payment system that allows transport companies to make central electronic payments online instead of giving cash to drivers. This service is currently active in South Africa, Namibia, Botswana, Zimbabwe, Mozambique, Zambia, DRC and Tanzania. Partnering with ECP is expected to assist IATF deepen its presence in its existing markets and to expand its network across Burundi, Uganda, Kenya, Angola and other African countries.

To date ECP has raised over USD 3.2 bn (Kshs 325.0 bn) in growth capital through funds and co-investment vehicles and the firm has made over 60 investments, completed 40 exits across 44 African countries. In Africa, ECP has strategically positioned its offices in major hub economies such as Tunisia, Ivory Coast, Nigeria, Cameroon, Kenya and South Africa. In East Africa, ECP has investments in Kenya, Uganda, Tanzania, Rwanda and South Sudan.

 Notable Investments in Kenya

Source: ECP Website

Exits made by the Group

Source: ECP Website

Private equity investments in Africa remains robust as evidenced by the increasing investor interest, which is attributed to; (i) rapid urbanization, a resilient and adapting middle class and increased consumerism, (ii) the attractive valuations in Sub Saharan Africa’s private markets compared to its public markets, (iii) the attractive valuations in Sub Saharan Africa’s markets compared to global markets, and (iv) better economic projections in Sub Sahara Africa compared to global markets. We remain bullish on PE as an asset class in Sub-Sahara Africa. Going forward, the increasing investor interest and a stable macroeconomic environment will continue to boost deal flow into African markets.

1. Industry Reports

During the week, the National Treasury read the FY 2019/20 Budget statement themed Creating Jobs, Transforming Lives - Harnessing the “Big Four” Plan. According to the budget, the real estate sector is set to benefit through the funds allocation made to some of the sectors;

1. In housing, the affordable housing sector was allocated Kshs 10.5 bn, compared to the Kshs 6.5 bn allocated in 2018/2019. The amount was distributed as follows;
   • Kshs 3.2 bn for social housing and construction of affordable housing units, including staff housing units for the Police Service and Kenya Prisons,
   • Kshs 2.3 bn for the Public Servants Housing Mortgage Scheme, and
   • Kshs 5.0 bn set aside as the government’s 1.5% contribution to the National Housing Development Fund (NHDF).

The fund is expected to act as a saving for employees aimed towards house ownership, and we expect that this capital from the government’s end is not only to facilitate operationalization of the fund, but also motivate employees and stakeholders to contribute towards the same. Despite being set to commence in May 2019, the implementation of the policy is currently on hold as the matter was challenged by various parties that include, Central Organization of Trade Unions (COTU), Trade Union Congress of Kenya, Consumers Federation of Kenya (CoFeK) and the Federation of Kenyan Employers (FKE) challenging the levy. For more details on the structure and operationalization of the fund, see our National Housing Development Fund Note 2019,

2. The infrastructure sector was allocated Kshs 324.7 bn, 22.5% lower than the 418.8 bn allocated in the 2018/2019 budget. The funds will be mainly channeled towards the ongoing road construction projects as well as road rehabilitation and maintenance, completion of Phase 2A of the Standard Gauge Railway, the Lamu Port-South Sudan-Ethiopia-Transport (LAPSSET) Corridor project and the Mombasa Port Development Project. According to the Cabinet Secretary for the National Treasury, the funds allocated in the budget for infrastructure development are not adequate to meet the growing need for quality and sustainable services and to support the “Big Four” Plan, and therefore, the government will continue to leverage on the private sector to fund infrastructure development through public private partnership arrangements. Real estate development is intrinsically linked to infrastructure development, and we are therefore of the view that the improving infrastructure will continue opening up areas for development. However, we expect the reduced budget allocation, mainly due to the government decline on development expenditure aimed at containing the public debt that is currently estimated to be approximately 60.0% of GDP, 10.0% above the East African Community (EAC) Monetary Union Protocol, the World Bank Country Policy and Institutional Assessment Index, and the IMF threshold of 50.0%, to result in reduced real estate activities especially in areas that are yet to witness the much needed infrastructural development such as roads and electricity connection.

Below is the budget allocation to infrastructure over the last 6 years:

Source: National Treasury

3. On capital gains, there is a proposed increase in the rate of Capital Gains Tax (CGT) from 5.0% to 12.5%, excluding the transfer of properties necessitated by restructuring. The increase in CGT is likely to negatively impact on the real estate sector by resulting in;

1. 1. “Lock in effect” - the investors may result to holding properties that have appreciated to avoid paying the CGT on the same if the margins are low. This will, therefore, interfere with free flow of transactions, resulting to decline in number of property listings and sales, and,
   2. Increased burden to the already struggling real estate sector- the real estate sector has continued to record decreased activities fuelled by the existing oversupply in some sectors such as the commercial office and retail sector, in addition to the unavailability and unaffordability of financing for both offtakers and developers. The increase in CGT will thus be an additional burden to the already struggling sector,
   3. Increased property prices in the long run - increased CGT will lead to increased tax liability for investors realizing capital gains on disposal of property. This cost is most likely to be transferred to the buyer hence increased property prices.

Despite the above, the increase will have a positive impact on the nation, as it will;

1. 1. Enhance tax equity given that it targets property owners who make up the wealthy individuals in the economy,
   2. Increase revenue collection from the real estate sector to the government, and
   3. Result in a decline in speculative demand – The speculators will shy away from purchasing property (land and buildings), expecting to gain from capital appreciation given the increase in CGT. This will lead to price stability in the market as speculation distort the property pricing.

2. Residential Sector

During the week, Fairdeal Group of Companies, a Nairobi based real estate company, announced that it had begun the construction of a Kshs 2.5 bn estate in Kikambala, Kilifi County. The project dubbed Sandy Shores Apartments, will see the development of approximately 196 residential apartments, a conference facility, swimming pools, a restaurant and sea sports facility, on a 6- acre parcel of land. The project will comprise of approximately 74 SQM- 1-bedroom units, 102 SQM- 2 bedroom, 149 SQM- 3 bedroom and 223 SQM- 4-bedroom units, selling at Kshs 6.75 mn, Kshs 11.0 mn, Kshs 17.5 mn and Kshs 28.0 mn, respectively translating to Kshs 110,517 per SQM. Other key projects in Kilifi include, i) Vipingo Estate, a 1.2 bn facility which is part of the mixed use Vipingo Development sitting on 10,254-acres of land, and comprises of an industrial park that covers 250-acres, Palm Ridge residential apartments on 20-acres and Awali Estate on 30-acres. See Cytonn Weekly #45/2018 for more details on the project, and ii) Sultan Palace, a 198- 4 bedroom villas beach project by Chinese firm, Sultan Development Limited. We attribute the investor interest in the coastal location to;

1. Proximity to sandy beaches creating demand for residential and serviced apartments from tourists,
2. Affordability of development land with an average price per acre at Kshs 115.4 mn in Mombasa County according to Cytonn Research, compared to other major towns such as Nairobi with an asking price of up to Kshs 400 mn per acre, translating to lower development cost hence lower exit prices,
3. Improvement in infrastructure such as construction of the Mombasa-Malindi Highway in 2018 and the expansion of the Mombasa port, opening up the area for development,
4. Devolution has continued to open up the 47 county headquarters for development, attracting government institutions thus creating demand for office space, retail space and residential units.

Kilifi County, like Mombasa County, has witnessed an influx of real estate developments as investors aim to satisfy demand for housing by the growing coastal population and for accommodation by mid to long-term stay tourists. According to Cytonn’s report, Mombasa Investment Opportunity 2018 Report, residential properties in Mombasa generated an average rental yield of 4.4% and an average price appreciation of 2.5%, in 2018. The upper mid- end market was the best performing segment in the residential sector during that year recording average returns of 8.1%, made up of an average rental yield of 5.5% and a capital appreciation of 2.6%, with investors in the region purchasing apartments with the aim of renting them to the growing middle class as well as long-stay visitors in the county.

The table below shows a summary of performance of the Mombasa market in 2018:

All values in Kshs unless stated otherwise

Source: Cytonn Research 2018

We expect the real estate sector to continue recording activities fuelled by the government’s focus on the affordable housing initiative, the improving infrastructure and the existing demand for housing units in the middle- and low-income bracket.

Following the release of Q1’2019 results by Kenyan banks, the Cytonn Financial Services Research Team undertook an analysis on the financial performance of the listed banks and identified the key factors that shaped the performance of the sector, and our expectations of the banking sector for the rest of the year.

The report is themed "Consolidation and Diversification to Drive Growth”, as we assess the key factors that influenced the performance of the banking sector in the first quarter of 2019, the key trends, the challenges banks faced, and areas that will be crucial for growth and stability of banking sector going forward. As a result, we seek to answer the questions, (i) “what were the trends witnessed in the banking sector in Q1’2019?” (ii) “what influenced the banking sector’s performance?”, and, (iii) “what should be the focus areas for the banking sector players going forward?”. As such, we shall address the following:

1. Key Themes that Shaped the Banking Sector in Q1’2019;
2. Performance of the Banking Sector in Q1’2019; and,
3. Outlook and Focus Areas of the Banking Sector Players Going Forward.

Section I: Key Themes that Shaped the Banking Sector in Q1’2019:

Below, we highlight the key themes that shaped the banking sector in Q1’2019, which include consolidation, regulation, asset quality and improved earnings:

1. Consolidation – Consolidation activity remained one of the key highlights witnessed in Kenya’s banking sector, as players in the sector are either acquired or merged leading to formation of relatively larger, well capitalized and possibly more stable entities. Ongoing consolidation transactions include:

1. 1. KCB Group also issued its proposal to acquire 100.0% of all the ordinary shares of National Bank of Kenya (NBK) on 18^th April 2019, through a share swap of 1 ordinary share of KCB for every 10 NBK shares. The swap will be after the conversion of 1.135 bn preference shares in NBK, to ordinary shares. The transaction has been ratified by the Boards of Directors of both banks, and the shareholders of both banks. The transaction will create the largest bank by assets in East Africa. Using current the Q1’2019 financial results, KCB would have a pro-forma asset base of Kshs 830.4 bn, in line with the bank’s strategy to grow its balance sheet to more than Kshs 1.0 tn by 2021. We note that this would enable KCB to increase its customer base and product offerings, which should result in a steady growth in profitability. The transaction is expected to be completed by 8^th October 2019, upon which the additional shares of KCB will be issued and listed at the Nairobi Securities Exchange (NSE). Both the Central Bank of Kenya (CBK) and the Competition Authority of Kenya (CAK) are expected to grant their approvals by 30^th July 2019.
   2. In January 2019, the directors of NIC Group and Commercial Bank of Africa (CBA) announced their agreement to a proposed merger between the two banks that was first announced on 6^th December 2018, with the shareholders of both banks accepting the merger proposition during the respective Annual General Meetings (AGMs). The Competition Authority of Kenya has also granted its approval of the transaction citing that the proposed transaction is unlikely to lead to lessening of competition in the relevant product market for both the retail and corporate banking segments. The proposed merger is expected to be completed upon fulfilment of a certain set of conditions, with the merged entity expected to commence its operations at the onset of Q3’2019. The proposed transaction will be executed through a share swap in the ratio of 53:47 between CBA and NIC, implying that shareholders of CBA Group will be entitled to own 53.0% of the merged entity’s issued shares while shareholders of NIC Group will be allotted 47.0% of the combined entity. Given that NIC Group has 703.9 mn issued shares, it will have to issue 793.8 mn new shares to CBA shareholders, in order to adhere to the 53:47 share swap ratio. The merged company, is set to remain listed on the Nairobi Securities Exchange (NSE). Mr. John Gachora, who is currently the Group Managing Director of NIC Group will become the Group Managing Director and Chief Executive Officer of the combined entity, while Isaac Awuondo who is currently the Group Managing Director of CBA will become Chairman of the Kenyan banking subsidiary, and will maintain direct oversight over the Digital Business. The appointments are in line with our expectations, which we highlighted in our Cytonn January 2019 Monthly Report. With digital banking being a core aspect in the merger, a separate digital banking unit will be created, and it will be overseen by its own distinct board. We note that the transaction has been progressing with some of the requisite approvals being granted. Pending approvals include that of the Central Bank of Kenya (CBK). Both banks are preparing for a merger on the day to day operations, with an Integration Management Office having been set up and a detailed integration work plan developed. We expect the merger to be completed with the set-out timelines, with the merged entity expected to commence operations in August 2019. CBA Group issued Jamii Bora owners with a buyout offer of Kshs 1.4 bn, to acquire a 100.0% stake in the bank. With Jamii Bora’s equity position of Kshs 3.4 bn as at Q1’2018, without further injection, it would imply the transaction would happen at a P/Bv ratio of 0.4x. As highlighted in our note on the CBA Acquisition of Jamii Bora Note, we are of the view that the huge discount to equity was largely due to Jamii Bora’s deteriorating financial performance, whose genesis can be traced to the enactment of the Banking (Amendment) Act 2015 that capped interest chargeable on loans, as shown by the steep 21.0% decline in the loan book in the first full year of implementation of the Banking (Amendment) Act 2015. The declining performance impacted Jamii Bora’s liquidity, with its liquidity position declining to (11.1%) as at Q1’2017, indicating its inability to meet any short-term obligations. The performance consequently enables CBA to offer a buyout at the huge discount to the book.
   3. Kenyan banks continued to pursue their inorganic growth strategies beyond Kenya, with a key example being Equity Group Holdings, who entered into a binding term sheet with Atlas Mara Limited to acquire certain banking assets in 4 countries in exchange for shares in Equity Group. These include:
      1. 62.0% of the share capital of Banque Populaire du Rwanda (BPR);
      2. 100.0% of the share capital of Africa Banking Corporation Zambia (ABCZam) Ltd.;
      3. 100.0% of the share capital of Africa Banking Corporation Tanzania (ABCTz); and,
      4. 100.0% of the share capital of Africa Banking Corporation Mozambique Ltd (ABCMoz).

Equity will also pursue acquiring additional share capital in BPR from some or all of the remaining shareholders. The transaction will be funded by a share swap whereby Atlas Mara will be allotted 252.5 mn new shares of Equity Group, which translates to 6.3% of the pro-forma expanded issued share capital. This is equivalent to Kshs 10.0 bn using the closing price of Kshs 39.5 on 13^th June 2019. Atlas Mara and Equity have also highlighted that there may be an additional capital injection by Atlas after the consummation of the transaction. The aggregate consideration to be paid by Equity remains subject to the completion of the confirmatory due diligence. The completion of the transaction is subject to the approval of various regulatory bodies such as the Central Bank of Kenya, Competition Authority of Kenya, and the respective central banks and competition authorities of the subsidiaries’ domicile. Atlas has its holdings spread out across Sub Saharan region. A successful completion of the transaction would likely see Equity expand its regional footprint, aiding the bank’s performance which has in the recent past been constrained by thin margins due to the existent caps on loans. By expanding into markets where credit pricing is unrestricted, Equity would be able to leverage on its strong retail banking expertise as well as its strong digital banking capability via its subsidiary-Finserve. This would enable Equity to expand both its funded and Non-Funded Income (NFI) revenue streams.

As noted in our focus note titled Consolidation in Kenya’s Banking Sector to Continue, we  expect more consolidation in the banking sector, as the relatively weaker banks that probably do not serve a niche become acquired by the larger counterparts who have expertise in deposit gathering, or serve a niche in the market. Consolidation will also likely happen, as entities form strategic partnerships, as they navigate the relatively tougher operating environment that is exacerbated by the stiff competition among the various players in the banking sector. We maintain our view that Kenya continues to be overbanked when compared to other countries in Africa as shown in the chart below, necessitating a reduction in the number of players in the sector. 

The table below summarises the deals that have either happened or announced and expected to be concluded:               

2. Regulation - Regulation remained a key aspect that affected the banking sector, with the regulatory environment evolving and becoming increasingly stringent. Key changes in the regulatory environment in Q1’2019 include:

1. 1. Banking Sector Charter: The Central Bank of Kenya proposed to introduce a Banking Sector Charter in 2018, which will guide service provision in the sector. The Charter which came into effect in March 2019, aims to instill discipline in the banking sector in order to make it responsive to the needs of the banked population. It is expected to facilitate a market-driven transformation of the Kenyan banking sector, thereby considerably improving the quality of service provided, as well as increase the access to affordable financial services for the unbanked and under-served population. The impending implementation of the charter will likely introduce risk-based credit scoring, which requires banks to extend credit on the basis of their credit scores, as determined by licensed credit reference bureaus. The charter is largely centered on consumer protection, by requiring banks to make full disclosure on the terms of the issuance of credit. In a bid to improve credit extension to Micro, Small and Medium Enterprises (MSMEs), the Banking Sector Charter prescribes that banks should have at least 20.0% of the loans extended to MSMEs. The CBK requires strict compliance with the charter, as banks may be imposed with administrative sanctions should they fail to comply with the charter,
   2. Banking (Amendment) Act 2015: During the quarter, the High Court suspended the Banking (Amendment) Act 2015 for 1-year, terming it as unconstitutional.The court found the provisions of sections 33 b (1) and (2) of the Banking Act, which capped interest at 4.0% above the Central Bank Rate (CBR) to be vague, imprecise and ambiguous. Furthermore, in the Finance Bill 2019, there is the proposition by the Cabinet Secretary of The National Treasury to repeal the Act, citing that since its enactment, the law has failed to meet its objective of improved credit access, especially to MSMEs. As shown in the graph below, private sector credit growth has remained below 5.0% in the regime of capped interest, with banks unable to price a majority MSMEs within the set margins. We however are not optimistic that the law would be repealed, as The National Assembly has always been huge proponents of the law, and has always maintained that the law is to the benefit of the common Kenyan. At best, we expect a revision of the margins set by the law, such a 6.0% margin above the 4.0% upper limit set by the current law. We note that the CBK has been proactive in implementing policies aimed at consumer protection and increased credit access, with the policies yielding minimal results. We thus maintain our view that a repeal of the law remains the best course of action to spur credit extension to MSMEs, which should consequently spur economic growth.

3. Asset Quality – The banking sector continued to record a deterioration in its asset quality in Q1’2019, as indicated by the rise in the Gross Non-Performing Loans (NPLs) ratio to 10.4%, from 9.6% in Q1’2018, much higher than the 5-year average of 8.4%. The chart below highlights the asset quality trend:

Economic recovery from the harsh operating environment experienced in 2017 and the first quarter of 2018, has been slower than anticipated, which resulted in an increase in the number and value of bad loans. The major sectors touted by banks as leading in asset quality deterioration include trade, retail, manufacturing and real estate. Delayed payments by the government was also identified as a contributing factor, which affected various sectors, with small to mid-sized entities affected the most. Owing to the deteriorating asset quality, banks continued to implement their stringent lending policies in a bid to curb the relatively rising NPLs, and consequently the associated impairment charges. Furthermore, banks have been investing heavily in adopting the use of advanced credit scoring method to pre-identify delinquencies before they occur. In addition, several bank have set up remediation teams that help distressed clients to restructure, and consequently regain their debt-servicing capability. We however expect the industry’s asset quality to deteriorate in the near-term as businesses continue to cite a relatively tight environment. Banks will thus continue to focus largely on (i) lending to relatively larger corporate entities, (ii) secured lending and, (iii) working capital financing to financially sound businesses.

4. Revenue Diversification: Listed banks continued their revenue diversification drive by growing the Non-Funded Income (NFI) segment, with various banks launching several initiatives as highlighted below:
   1. Co-operative Bank of Kenya launched the Co-op Bank Property Hub under its mortgage division, which will offer property sales and mortgage origination to its clients. The Property Hub intends to serve the clients who have property to sell and connect them to the Co-operative Bank clients who want to buy property. The bank will also offer mortgages to the buyers of the property as it expects to leverage on its contacts with key institutions and the cooperative movements that largely own the bank to boost the property sales for its clients. For more information, please see our Kenya Mortgage Refinancing Company Update & Cytonn Weekly #17/2019. Co-operative Bank also highlighted its plan of growing the business of its leasing-focused subsidiary Co-op Bank Fleet, which intends to leverage on the synergies created by Co-operative Bank’s client base to grow its business, with the main business case of the subsidiary being the easing of the cash flow constraints of acquisitions of fleets, repair and maintenance, thus allowing businesses to focus on their core business. For more information, please see our report here,
   2. Diamond Trust Bank Kenya (DTBK) announced that it has partnered with SWIFT, a leading provider of secure financial messaging services, in order to provide real time cross border payments to its clients. DTBK will be the first East African Bank to go live on the SWIFT global payment innovation service, a service that is carrying out over USD 30.0 bn worth of transactions a day, in over 148 currencies. For more information, please see our Kenya Mortgage Refinancing Company Update & Cytonn Weekly #17/2019, and,
   3. Standard Chartered Bank Kenya (SCBK) launched an innovation hub lab in Nairobi dubbed Xcelerator in a bid to boost its revenue streams and diversify by riding on financial technology. SCBK plans to allocate Kshs 10.0 bn into supporting Financial Technology (FinTech) startups to scale up and generate innovative solutions to problems in the banking sector. StanChart views FinTech firms as partners amid their growing disruption of the local financial sector, a move likely to aid the bank in generating additional revenue. For additional information, please see our Cytonn Weekly #15/2019

We expect more forays by banks into the NFI segment, as players seek to alleviate the effects of the compressed funded income regime.

Section II: Performance of the Banking Sector in Q1’2019:

The table below highlights the performance of the banking sector, showing the performance using several metrics, and the key take-outs of the performance.

*Market cap weighted as at 31^st May 2019

** Loans to Loanable funds used owing to nature of the business

Key takeaways from the table above include:

1. Kenya Listed Banks recorded a 12.2% average increase in core Earnings Per Share (EPS), compared to a growth of 14.4% in Q1’2018, with the relatively lower performance attributed to the base effect, as the sector was coming from a relatively poor performance in Q1’2017,
2. Deposit growth came in at 11.0%, faster than the 9.4% growth recorded in Q1’2018. Despite the relatively fast deposit growth, interest expenses rose by 2.5% compared to 11.4% in Q1’2018 indicating that banks have been mobilizing relatively cheaper deposits. Furthermore, in September 2018, an implementation of the Finance Act 2018 saw the removal of the minimum interest rate payable on deposits, which stood at 70.0% of the Central Bank Rate (CBR). This helped mitigate high increments in interest expense, despite the relatively fast deposit growth,
3. Average loan growth came in at 7.7%, which was faster than the 6.1% recorded in Q1’2018, indicating that there was an improvement in credit extension, with banks targeting select segments such as corporate entities, and Small and Medium Enterprises (SMEs). Government securities on the other hand recorded a growth of 16.1% y/y, which was faster compared to the loans, albeit slower than 25.0% recorded in Q1’2018. This highlights banks’ continued preference towards investing in government securities, which offer better risk-adjusted returns. Interest income increased by 3.6%, compared to a growth of 9.3% recorded in Q1’2018. The slower growth in interest income despite the increased allocations to both loans and government securities may be attributable to the decline in yields on loans owing to the 100-bps decline in the CBR, and the decline in yields on government securities, and consequently, the Net Interest Margin (NIM) declined to 8.0% from 8.1% in Q1’2018,
4. Non-Funded Income grew by 10.7% y/y, faster than 9.5% recorded in Q1’2018. The growth in NFI was supported by the 11.2% average increase in total fee and commission income, albeit slower than the 12.2% growth recorded in Q1’2018. The fee and commission income growth continues to be subdued by the implementation of the Effective Interest Rate (EIR) model under IFRS 9 in 2018, which requires banks to amortize the fees and commissions on loans, over the tenor of the loan. The relatively slower loan growth, a majority of which is to corporates, also inhibited the growth in fee and commission income loans, as corporates tend to be charged relatively lower commission rates, and,
5. The sector continued to record an improvement in operating efficiency, as shown by the improvement in the Cost to Income Ratio (CIR) to 53.8%, from 56.6% in Q1’2019, indicating that the raft of cost rationalization measures adopted by banks in the onset of the capped interest rate regime, have borne fruit. Without LLP, the CIR also improved y/y, declining to 48.0%, from 49.0% in Q1’2018.

Section III: Outlook and Focus Areas of the Banking Sector Going Forward:

In summary, the banking sector had a slower growth compared to a similar period last year, largely due to base effect as the sector was coming from a relatively low base in Q1’2017, and a slower expansion of funded income segment, as NII rose by 4.5% in Q1’2019, slower than 8.1% in Q1’2018. Funded income continues to record relatively slower growth, affected by the declining yields in both loans and government securities. We maintain our view that the interest rate cap has not achieved its intended objectives of easing the access to credit and reducing the cost of credit, and thus needs to be repealed, so as to spur economic growth, as MSMEs that have continued to struggle access the much needed credit. We also continue to be proponents of promoting competing sources of financing, which should reduce the overreliance on bank funding in the economy, currently between 90.0% to 95.0% of all funding. By having various competing sources of financing, this would trigger a self- regulated pricing structure, in the event of a repeal of the law.

Thus, we expect the following:

1. A review of the Banking (Amendment) Act 2015, with a proposition to repeal the law included in the Finance Bill 2019. Given that The High Court suspended the law terming it as unconstitutional, and a Member of Parliament proposing a revision of the law to include a ceiling of 6.0% above the limit set by the Banking (Amendment) Act, 2015 for the high risk borrowers, we expect parliament to maintain their stance of a no repeal, and instead opt for an amendment of the margins, as pressure from various institutions such as the National Treasury and the CBK, mounts,
2. As the interest rate cap law remains in place, we continue to expect relatively low credit extension, and expect private sector credit growth to remain below 5.0%, as banks continue to skew their asset allocation in government securities that yield higher risk-adjusted returns, and,
3. The ongoing demonetization exercise will likely result in a possibly stronger deposit growth for banks especially in Q4’2019, as money flows into banks, especially in the run up to the 1^st October deadline. Furthermore, during the current transition period, we expect an increase in the number and value of transactions, as demand for digital transactions rises, with a majority of people prioritizing digital transactions to avoid handling fake currency. This should presumably lead to a relatively better performance of the Non-Funded Income (NFI) segment.

We expect banks to continue focusing on the following:

1. Asset quality management: Banks will look to manage the industry-wide deteriorating asset quality, which may involve further tightening of credit standards as banks cherry pick low risk credit consumers and increase focus on secured, collateral-based lending,
2. Revenue diversification: In the current regime of compressed interest margins focus on Non-Funded Income (NFI) is likely to continue, as banks aim to grow transactional income via alternative channels such as agency banking, internet and mobile technologies,
3. Operational efficiency: Cost containment is likely to continue being a focus area. We thus expect continued restructuring, possible leading to staff layoffs, as staff headcount demands reduce, on increased usage of mobile and internet channels, and,
4. Downside regulatory compliance risk management: With increased emphasis on anti-money laundering and fraudulent transactions, we expect banks to be keener on streamlining their operational processes and procedures in line with global standards and regulatory requirements.

For more information, see our Cytonn Q1’2019 Banking Sector Review

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.