Executive Summary

• Fixed Income: Yields for government securities were on an upward trend for the seventh week, indicating a rising rate environment;
• Equities: The market was on a decline during the week, with NASI, NSE 20 and NSE 25 declining 2.3%, 2.6% and 2.4%, respectively. From our research coverage universe, we release our list of best stocks to hold during the year, with financial services dominating the Cytonn 10 stocks to hold for 2016;
• Private Equity: 2016 has started off with increased PE activity in Sub-Saharan Africa, demonstrating the bullish view of the asset class;
• Real Estate: Old Mutual Property acquires a 50% stake of the Two Rivers Mall being undertaken by Centum, a testament to (i) the attractiveness of the real estate sector in Kenya & (ii) the increased participation of institutional investors in the sector;
• Focus of the Week: This week we focus on the ?Cytonn 10?. Following our 2015 year-end review, we then did a 2016 market outlook. We now introduce the Cytonn 10 equity portfolio recommendation for 2016.

Company Updates

• Our Investment Manager, Maurice Oduor, discussed Cytonn?s Kenya Business Outlook 2016 on CCTV: Kenya's Real Estate Outlook
• Our Chief Executive Officer, Edwin H. Dande discussed the opportunities in real estate on Citizen TV
• Our Head of Private Equity Real Estate, Shiv Arora, discussed Cytonn?s Kenya Business Outlook 2016 on KBC
• We continue to beef up the team with the ongoing hires: Careers at Cytonn.

Fixed Income

This week there was oversubscription in Treasury bill auctions, with overall subscription coming in at 183.8%, compared to 90.3% the previous week. The increased demand for government securities was as a result of (i) high liquidity due to high T-bill maturities totaling Kshs 20 bn, and (ii) investors? appetite for short-term instruments as opposed to longer dated bonds as they anticipate upward pressures on rates.

Yields on T-bills were on an upward trend with the 182-day and 364-day increasing to 13.7% and 14.3% from 13.2% and 13.8%, respectively, last week. The 91-day T-bill remained flat at 11.4%, leading to an even greater normalization of the yield curve with investors demanding a premium for relatively longer dated paper.

The shilling remained relatively flat during the week, to close at 102.4 to the dollar, from 102.1 last week despite the increase in liquidity as the Central Bank stood ready to support the shilling. The shilling remains supported as the forex reserves remain high at 4.5 months of import cover.

This month, the government is offering a 2-year and reopening a 10-year that was issued in 2013 (now a 7-year bond), to raise Kshs 35 bn for budgetary support. Currently the 10-year is trading at a yield of 14.0% and investors shall be seeking a premium. Consequently, we project that the bond shall average between 15.0% and 15.5%. A 2-year bond in the market is currently trading at a yield of 13.3%, and given the premium that investors demand due to the challenging economic environment, we expect bids to come in at between 14.0% and 14.5%.

According to World Bank?s Migration and Remittances Fact book 2016, Kenya emerged as the fourth highest African remittance recipient in 2015, receiving USD 1.6 bn, which is a growth of 16.6% from the previous year, falling behind Nigeria (USD 20.8 bn), Ghana (USD 2.0 bn) and Senegal (USD 1.6 bn). This is a strong indicator of the impact the diaspora have in funding economic growth. According to our Cytonn Report #40, the diaspora can benefit the Kenyan economy in (i) foreign exchange earnings, (ii) trade links, (iii) investments, (iv) real estate development, (v) skills transfer, and (vi) improving the standards of living. Despite strong growth in diaspora remittance, there is still vast potential that the Kenyan diaspora possess and it requires the engagement of both the Kenyan Government and the private sector to tap it. At Cytonn, we are at the forefront of this agenda, having opened a diaspora office in the DC Metro area in the United States as an avenue through which the Kenyan diaspora can find a trusted investment partner via whom they can engage with to invest back home.

Despite the Government being right at its target in its domestic borrowing programme, having borrowed Kshs 118.6 bn for the current fiscal year compared to a target of about Kshs 118.6 bn, (assuming a pro-rated borrowing throughout the financial year of the budgeted Kshs. 219 bn of total domestic borrowing for this year), the pressure on rates is expected to persist. Most of these borrowings are short-term instruments that mature within the current fiscal year and the Government will face pressure in refinancing the obligations as they mature. As a result, we maintain our view that investors should be biased towards short-term fixed income instruments given the uncertainty in the interest rate environment.

Equities

During the week, the market registered declines, with NASI, NSE 20 and NSE 25 falling 2.3%, 2.6% and 2.4%, respectively. Declines were registered in EABL and KCB, which fell by 8.0% and 4.2%, respectively. On an YTD basis NASI, NSE 20 and NSE 25 index are already down 2.6%, 5.0% and 3.5%, respectively.

Equities turnover fell by 3.2% during the week to Kshs 2.8 bn from Kshs 2.9 bn the previous week. Foreign investors were net buyers for the second consecutive week, with net inflows rising 136.5% to Kshs 102.4 mn, compared to net inflows of Kshs 43.3 mn witnessed last week.

The market is currently trading at a price to earnings ratio of 12.4x, versus a historical average of 13.8x, with a dividend yield of 4.1% versus a historical average of 3.3%. The charts below indicate the historical PE and dividend yields of the market.

ARM Cement is in talks with India-based cement manufacturer UltraTech Cement over Kshs 12.7bn equity investment after ARM abandoned its plans to raise Kshs 10.7 bn through a 5-year private bond due to volatility in the interest rate environment. UltraTech Cement is the leading cement manufacturer in India and a member of the Aditya Birla Group, and also has operations in United Arab Emirates (UAE), Bahrain, Bangladesh and Sri Lanka. UltraTech?s equity investment in ARM Cement would potentially be in the form of convertible preference shares, and is expected to take a controlling stake in ARM, as the company currently has a market capitalization of Kshs 17.6 bn. In our view, the investment will be positive for ARM, as it will:

1. Be able to pay off its dollar obligations, which have become expensive to service given the 13% depreciation in Kenya shilling over the last 12 months, while all revenue remains in shillings, and
2. Benefit from a strategic investor with a wealth of experience and expertise in the sector. This will increase innovation and productivity, which is crucial given the impending arrival of Dangote Cement from Nigeria into the market, and the already saturated cement industry in Kenya, with 6 players currently operating in the market.

Kenya Airways announced the sale of 2 of its Boeing B777-200 ER aircraft to US-based airline Omni Air International following approval from its board. The airline announced its intention to sell the two aircraft in November 2014 as part of its turnaround strategy that consultancy firm Seabury helped in crafting. KQ also expects to sell two Boeing B777-300 aircraft and part of land property that it owns, reported to be about 30 acres and estimated to be worth approximately Kshs 2.0 bn, in its bid to raise a total of Kshs 14.6 bn from asset disposals. This is in line with our recommendation in Cytonn Weekly #45, which includes the sale of some of their assets and downsizing of their expansion strategy. However, what they have not demonstrated are solutions to their fuel hedging and currency risks, which appear to be the root of their issues. A good example of a company that was able to unwind their hedging strategy well is Kenol Kobil, which was able to turn around the company from a loss of Kshs 6.2 bn to a profit of Kshs 1.0 bn in 2014. For Kenya Airways to successfully turn around we recommend the following restructuring to their business:

1. Exit of loss making routes and concentrate on high margin routes, especially with competition increasing on regional routes where they have typically had a majority,
2. Restructuring of their capital structure,
3. Reduce reliance on derivatives hedging as a strategy, and
4. Continue downsizing of their expansion strategy.

We remain neutral on equities given the weak earnings growth prospects for this year. The market is now purely a stock pickers? market, with few pockets of value.We continue to be avid buyers of KCB and Equity on price dips.

Below is our recommendation for our stock coverage universe:

We revise downwards our valuation on Britam, from a Target Price of Kshs 16.10 to Kshs 13.4, a 13.8% upside from its current price of Kshs 11.7. We decided to revise our valuation downwards because Britam is very exposed to equities market, which performed poorly in 2015 and is expected to register lackluster performance in 2016. When Britam reported 1H?2015 earnings, they ascribed the 77% drop in profitability to ?the stock market generally has resulted in a significant drop in the performance?. However, the stock market had only been down 4% in the 1H?15. In the 2H?15, the stock market declined by 17.6%. With the second half stock market decline of 17.6% being over 4x the 4% stock market decline in 1H?15, we expect that the 2H?15 performance is likely drastically lower than 1H?15, hence we expect full year 2015 results to be dramatically lower, hence our lowered price target from 16.1 to 13.40. Our valuation is based on adjusting the last reported book value as of June 2015 downwards by about 17% and then applying an industry book value multiple of 1.5x. Britam is a strong brand but will remain significantly challenged during periods of muted or declining stock market performance until they address the following two key issues:

1. Diversification: Diversify their portfolio investments away from equities to more real estate and private equity. And also diversify the business contribution from 95% insurance to include greater contribution from investment management and real estate business. However, diversification will be very difficult because the company?s DNA is fundamentally an insurance DNA. Insurance is a business driven by regulation and capital as opposed to investment management and real estate development, which are fundamentally talent team businesses.
2. Expense Growth: Curb the rapid expense growth currently estimated to be about 40% year over year far outpacing core revenue growth.

Private Equity

Silvertree Internet Holdings, a South African-based venture capital firm has set aside USD 10 mn to invest in Kenyan startups mainly focusing on tech firms that serve the consumer goods sector. The market has been seen as attractive due to (i) the growing number of consumers migrating to online platforms for business transactions, (ii) Kenya establishing itself as the hub for innovation in East Africa, and (iii) the rising middle-class population that depend on technology.

French telecom Orange has expanded its African reach with the recent acquisition of Cellcom for an undisclosed amount. The company based in Liberia will broaden Orange?s reach in West Africa with presence in Cote d?ivoire, Guinea, Mali, Senegal, Cameroon, CAR, DRC and Niger. Cellcom is one of the largest mobile operators in Liberia with 1.3 mn customers and a market share of 45%.

MTN, a South African telecom company has finalized on acquisition of Nigerian internet provider Visafone. The move is aimed at improving MTN?s broadband services in its biggest market. The details of the transaction were undisclosed. Visafone?s 2.2 mn subscribers will be part of the 60 mn subscribers that MTN has in Nigeria and the merger will see new broadband services rolled out in 2016. Telecommunications sector remains a ripe area of investment driven by an increased demand for communication services supported by a youthful population.

The Abraaj Group announced acquisition of a minority stake in Algerian Celulose Processing (CEPRO) through their second generation North Africa Fund. CEPRO is the leading company in the baby diapers segment and has brands such as BBCool Premium, BBCool and Poupoune as well as female sanitary pads under the brand Finesse in its portfolio. The investment is seen as timely given Algeria?s high population growth rate of 1.9% y/y and fertility rates of 3 births per woman according to World Bank. Abraaj, which has developed a track record in FMCG investments in Africa, looks to increase production and diversify products through new branding strategies.

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 private markets, and (iii) better economic growth projections compared to global markets.

Real Estate

Old Mutual Property, a subsidiary of Old Mutual plc, has invested Kshs. 6.4 bn in Two Rivers Lifestyle Centre (TRLC), the holding company for the Two Rivers Mall, which sits on 10.2 acres of the 100-acre development. This is aimed at acquiring a 50 % stake in the company and to that effect it has acquired a 10% stake in the shares in cash and the remaining 40% has been given as a convertible loan. This comes after the Aviation Corporation of China (Avic) invested an equivalent Kshs 6.4 bn in April 2015 in Two Rivers Development Limited (TRDL) for a 38.9% stake, which is the holding company for the entire development, which constitutes a, b c and d, developments on the 100 acres development. Of keynote is that (i) the value of Two Rivers seems to be appreciating, as the entire development was valued at Kshs 16.4 bn in April last year when Avic purchased, to Kshs 12.8 bn for the 50% stake purchased by Old Mutual in the mall alone now, and (ii) Old Mutual would be looking at Two Rivers mall as a yielding asset, given it is nearing completion.

The Two Rivers development sits on 100 acres of land with the mall occupying 10.2 acres. The project is a phased development that when complete will encompass retail, entertainment lifestyle and office segments and will be the largest in East and Central Africa. TRDL has been the sole shareholder of TRLC previously, and the TRDL shareholding structure will remain the same post the purchase by Old Mutual Property in TRLC, with Centum holding 58%, Avic 38% and ICDC holding the balance.

The key take-aways from the transaction are:

1. Attractiveness of Real Estate: Clear indication of the attractiveness of the real estate sector in Kenya and the retail sector in particular. Retail sector is seen as an attractive investment market that offers high yields of 11% in high-end areas of Nairobi, and
2. Ability to Exit: Centum have been able to successfully exit a significant percentage of the mall.

President Uhuru Kenyatta officially launched the Marina in Mombasa this week, a project set to boost tourism in the country and is the first of its kind in East Africa, and is part of the government?s tourism flagship projects. The development comprises of 26 hotel rooms, a conferencing facility, roof-top and sea-front restaurants, a casino, swimming pool, 96 serviced apartment rooms, gym, spa, a boardwalk with retail outlets, water-sports center and a fully serviced 88-berth marina.

A marina is basically a dock with provisions for yachts and small boats; this is what makes it different from other ocean-side resorts. It is set to appeal to the luxury yacht market and the high-end international ocean traveler. Walcon Marine, a Fareham-based company and market leader in design construction and installation of luxury yacht marinas, yacht harbours and berthing facilities around the world was the designer. The same company has also worked on two other projects on the Indian Ocean both being in Seychelles. The developers are Alnoor and Amyn Kanji.

Ground breaking took place in 2010 with an initial aim to complete construction and launch in December 2012. This was however delayed for three years due to (i) the fact that it is the first of its kind in the region hence it experienced shortcomings in sourcing for the expertise needed to pull off such a project, (ii) a number of construction elements had to be redone as they had been done wrongly with the contractors having erred a few times seeing as they were locally sourced and hadn?t had experience dealing with such a design, and (iii) the construction costs went up to Kshs 5.1bn from Kshs 4.8bn as had initially been estimated.

The development being a pioneer in such developments in the region is likely to set the pace for other similar developments targeting the same markets and banking on increased tourism in the region spanning from this government initiative. Developers who wish to venture into similar projects will also learn from the challenges faced by the English Point Marina in order to avoid similar delays and rise in construction costs. We expect that more developers will look into embarking on like-minded ideas.

Equities Portfolio Recommendation From Our Coverage Universe ? ?The Cytonn 10?

We began 2016 by carrying out a Year in Review for 2015, where we analyzed the markets in 2015 and the macroeconomic environment, from both a global and local perspective. We noted 2015 was a year characterized by a challenging macroeconomic environment as a result of (i) a volatile and high interest rate environment, (ii) depreciation in the shilling, and (iii) corruption and mismanagement of public funds. Following the release of the Year in Review, we proceeded to the release of our Cytonn Markets Outlook 2016, where we provided our investors with key insights and analyzed the trends that we expect to shape the investments landscape over the next 12 months in Kenya. Based on our outlook for the macroeconomic environment alongside asset class recommendations, we recommended to the average investor a balanced portfolio, consisting of 40% fixed income, 30% equities, 20% alternative investments (real estate and private equity) and 10% in offshore investments.

For this week, we aim to go further and introduce to our investors our Cytonn 10 portfolio recommendation, which will give our investors actionable recommendations in the equities markets in 2016. The aim is to answer the question: given Cytonn?s focus areas on financial services and technologies, from an equity investor point of view, which is are most attractive listed counters to invest in 2016?

In order to construct the portfolio, we looked at our listed equities coverage and applied weightings to 3 key areas:

1. Total Expected Return: This is the intrinsic value of the listed equity, as per Cytonn analyst recommendations, plus the expected dividend yield on the counter. Total expected return received an 80% weight in the allocation,
2. Market Capitalization: This is the total market value of the shares outstanding of a publicly traded company; it is equal to the share price times the number of shares outstanding. Market capitalization is a proxy for market representation, and received a 10% weight in the allocation, and
3. Free Float: It describes the proportion of shares of publicly traded companies that are tradable in the stock market, and are not closely held by strategic investors, and available for active trading. Free float is a proxy for liquidity of the listed counter, and received a 10% weight in the allocation.

Based on the above weights and the team rationalization, we came up with stocks that investors can invest in with respective weights and the potential target return for 2016 is 29.6% from 15^th January 2016. KCB received the highest allocation at 21.0% based on their total expected return of 54%. Safaricom received among the lowest weighting at 9% owing to their low potential upside at 8%, despite their market capitalization being 32% of the total listed market. We have also highlighted the key value drivers and issues in the listed stocks that we have considered when undertaking our analysis.

Below is a fundamental review of the stocks in the Cytonn 10:

Despite the attractive return of the portfolio, there are significant factors that may cause significant deviations in our estimated market returns, as described below:

1. Political Environment: Given the Kenyan elections scheduled for 2017, and campaigns expected to begin by the end of January 2016, intense negative rhetoric may negatively affect the performance of the equities market. However, we believe that the business environment will decouple from the political noise, and

2. Emerging Risks from Global Trends: The Kenyan stock market is more foreign investor driven, and any events that affect the global economic outlook might lead to poor performance of the market. This has come to the forefront with the global stock market declines since the start of 2016, given China?s decision to devalue their currency, leading to a selloff in all developed markets as investors raise alarm over the true state of the Chinese economy. Next week, we shall be discussing China?s effect on global markets and the reason behind the poor start to stock markets in developed economies.