Executive Summary

• Fixed Income: Yields on government securities declined, with the interest rates of the 91-day treasury bill falling by 5% to 13.8%;
• Equities: The market was on a gaining trend with the NASI, NSE 20 and NSE 25 gaining by 2.1%, 0.1% and 1.2%, respectively, during the week. Safaricom and Co-operative Bank released their H1’2016 and Q3’2015 results posting EPS growth of 22.9% and 36.6% to Kshs. 0.5 and Kshs. 1.8, respectively;
• Private Equity: Private equity activity picks up with a focus on real estate in East Africa;
• Real Estate: Stanlib Fahari I-REIT launched with an estimated all return at 15% p.a.;
• Focus of the Week: Cytonn's H1'2015 Insurance Sector report analyzing the total return and franchise attractiveness, with a look at governance, of Kenyan listed Insurance companies.

Company Updates

• We released our H1’2015 Insurance Sector report analyzing the Kenyan listed Insurance companies. Download the full report here
• Maurice Oduor, our Investment Manager, discussed the entry of Choppies into the Kenyan market, and the partnership between Chase Bank & Safaricom. See clip here on CNBC Africa
• Shiv Arora, our Head of Private Equity Real Estate, discussed the Eurobond and Kenya’s debt levels. See clip here on Citizen TV
• This week we strengthened the management team with several key hires
  • Guarang Chavda joined the distribution team as the Head of Private Wealth. Mr. Chavda has extensive experience in investments advisory and consulting, both locally and in the U.K, and was most recently with Winton Investments
  • Edith Kerubo joined the distribution team as a Unit Manager, focused on real estate investments and sales. Ms. Kerubo has extensive experience with investments advisory and distribution, most recently at Genghis Capital
• We continue to beef up capacity, with ongoing hiring for Business Development Associates: See link

Fixed Income

Treasury bill auctions received record subscriptions with overall subscription rising to 1,065%, from a 776% subscription rate last week. The money market has continued to witness oversubscriptions, driven by:

1. Investors shifting money from deposits to high yielding Government securities,
2. “Yield chasers” i.e. global institutional investors looking to lock-in attractive risk-adjusted yields.

Despite the oversubscription, the Government accepted 17.1% of bids received, equal to Kshs 21.9 bn, compared to Kshs 12.0 bn they offered to the market. The government will remain under pressure to borrow from the market in the short term to refinance their obligations and for budgetary support. There was a substantial decline in yields to 13.8%, 16.5% and 17.1%, from 19.5%, 21.0% and 21.2% for the 91-day, 182-day and 364-day papers, respectively.  The increased liquidity in the market saw the interbank decline to 9.3%, from 12.8% the previous week.

Despite the huge increase in liquidity, the shilling weakened by only 0.3% during the week to close at 102.1, from Kshs 101.8 the previous week. There has been an increase in the foreign exchange reserves to 4.4 months of import cover supported by the syndicated loan inflows. Going forward the performance of the US dollar will largely determine the shilling’s performance, given expectations of a rate increase in the US.

As we highlighted in our Cytonn Report #42, we continue to re-iterate that Kenya should live within its means as a country, and adopt strict public expenditure management policies. Tax collection for the first quarter of the 2015/16 fiscal year missed targets; and given the difficult operating environment, we believe the government will again fail to meet collection targets, principally because revenue collection estimates were based on an ambitious GDP growth target of 7.0%. In addition, given the recent reports on misuse of public funds, we believe the fiscal deficit will continue widening, leading to further borrowing to finance the gap. As such, in order to contain the cash flow situation in the country, the government needs to (i) phase the large infrastructural projects, (ii) take concrete steps to curb corruption, and ensure prudence in fiscal management, and (iii) incorporate the private sector in policy decisions e.g. the domestic borrowings.

The Government’s borrowing programme for the current fiscal year, targeted at Kshs. 219 bn, has been stepped up, having borrowed Kshs 77 bn for the current fiscal year compared to a target of about Kshs 91bn assuming a pro-rated borrowing throughout the financial year. We note the improved money market liquidity levels, which has eased borrowing pressure on the Government. However, given that the Government has resorted to funding the budget through short-term borrowings, which mature within the current fiscal year, we expect the aggressive borrowing to continue, as pressure remains to re-finance their obligations within this fiscal year, may keep rates at elevated levels. 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 was on an upward trend with NSE 20, NASI and NSE 25 gaining 0.1%, 2.1% and 1.2%, respectively, on the back of gains in KCB and Safaricom, which gained 5.6% and 4.9%, respectively. Foreign investors participation was high during the week at 75.3%, 38.1% higher than last week, with the foreign investors being net sellers. Since the February peak, NASI and NSE 20 have been down 21.0%, and 29.6%, and down 13.9% and 24.3% on an YTD basis, respectively. NSE 25 has been down 1.7% inception to date.

Safaricom released their H1’2016 results, recording earnings per share (EPS) growth of 22.9% y/y to Kshs. 0.45, from Kshs 0.37 in H1’2015, versus our estimate of Kshs. 0.41 per share. Revenue grew by 22.5% to Kshs. 97.2 bn from Kshs. 79.3 bn in H1’2015, driven by growth in service revenue by 12.3% y/y to Kshs. 84.9 bn from Kshs. 75.6 bn in H1’2015.  However, direct costs went up by 33%, driven by a Kshs 8.4 bn cost of constructing the national police security network. Operating costs also grew by 10.7% to Kshs. 19.2 bn from Kshs. 17.4 bn in H1’2015 effectively leading to an increase in the EBITDA margin by 1.8% to 43.8%.

We remain bullish on the top line growth driven by aggressive growth in Mpesa and data revenue line. The ongoing integration of Lipa na Mpesa will support expansion of Mpesa usage. The recent launch of the 4G platform in major cities will further grow data revenue line, supported by a fast growing and wide demographic youth space, who are heavy consumers of data especially on social media platforms. On the cost side, we expect Safaricom to maintain low cost margins going forward, while increasing capital expenditure in upgrading and launching new infrastructure. We recommend an accumulate on the Safaricom stock with a target price of Kshs. 16.2 representing an upside of 12.4% given a dividend yield of 5.1%.

Co-operative bank released its Q3’2015 results recording an impressive 36.6% y/y rise in EPS to Kshs. 1.8, versus our estimate of Kshs 1.6. Net interest income grew by 15.6% y/y to Kshs. 17.4 bn, from Kshs 15.0 bn in Q3’2014. Their non-funded income grew by 8.2% to Kshs. 9.2 bn, from Kshs 8.4 bn in Q3’2014, supported mainly by a 59.6% growth in forex income to Kshs. 1.7 bn.  Earnings were supported by a high growth in loans of 20.7% to Kshs. 212.4 bn, versus deposit growth of 26.5% to Kshs 253.5 bn, resulting in a loan to deposit ratio of 82.5%, from 87.8% in Q3’2014. Operating income grew by 13.4% to Kshs. 26.6 bn, outpacing operating expenses growth, which grew by 1.1%, subsequently lowering their cost to income ratio by 6.6% to 54.8%. The improvement in cost to income ratio is mainly attributable to its Soaring Eagle initiative to improve overall efficiency. However, given that Co-operative bank is trading at price to book of 1.8x, higher than the banking sector average of 1.5x, we recommend a sell on the stock with a target price of Kshs 15.5 representing a downside of 5.9% given a dividend yield of 3.5%.

We remain neutral with a bias to negative on equities given the significantly lower earnings growth prospects for this year. The market is now purely a stock pickers’ market, with few pockets of value.

Below is our investor equity recommendations for the stocks under our research coverage. Please note that we have been aggressive buyers of financial services, especially KCB and Equity, with our last purchase of KCB at Kshs 38.8 when it dropped to a 2 year low last week. We strongly recommend that investors should buy Standard Chartered, KCB and Equity stocks on any significant price dips.

Private Equity

This week witnessed a high level of private equity activity in Kenya and the region, spread across FMCG and real estate deals. In Kenya, Choppies Enterprise, a leading Botswana supermarket chain, which is listed on the Botswana Stock Exchange with a market capitalisation of USD 473 mn, was given a go ahead by the Competition Authority of Kenya, to acquire Ukwala supermarkets at Kshs 1 bn, effectively valuing each branch at Kshs 100 mn. The deal will see Choppies acquire 10 retail stores with 6 of them located in Kisumu, 3 in Nairobi and a single outlet in Nakuru. Given the lack of transaction data, especially the unavailability of financials for Ukwala, we do not have much more transaction multiple data other than the Kshs. 100 mn per branch valuation. We think this is a poor move by Choppies, given that Ukwala is not a prominent brand in the retail sector, which is saturated by Uchumi, Nakumatt, Naivas, and Tuskys, not to mention the entry of other strong global brands such as Carrefour & Game. The most appropriate entry strategy currently for a new brand is through acquisition of one of the existing big brands. It is possible that Choppies is using the Ukwala acquisition as the first step to a bigger acquisition strategy.

PE firm Helios Investment Partners has entered into a joint venture with property developer Acorn Group, as the firm seeks to develop a new deal pipeline following its ugly and messy divorce with its former partner, Britam. The deal will be on a 50:50 partnership, with Helios acting as the fund raising arm for Acorn’s real estate developments, owing to the capital-intensive nature of the industry. Acorn is a well developed, and skilled developer with a focus on institutional grade real estate. This deal with Helios 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. As indicated in our Cytonn Report #23, other examples include Centum Investment, a financing platform, creating and coupling up with Athena Properties a wholly owned development affiliate, and Cytonn Investments, a financing platform, creating and coupling up with Cytonn Real Estate, a wholly owned development affiliate. In as much as the strategy for coupling financing and development is positive for creating a market with institutional grade real estate developments and further deepening of the capital markets, it is very hard to align the interest of each party hence very hard to manage. It remains to be seen how Helios and Acorn will align their partnership.

Real Estate

Stanlib Investments has launched the first REIT in Kenyan Market. The STANLIB- Fahari I-REIT is an income-REIT, a real estate investment scheme which owns and manages income generating real estate for the benefit of its investors. The STANLIB- Fahari I-REIT will invest at least 75% of its Total Asset Value in real estate in Kenya with a maximum of 25% invested in cash investments or cash-like instruments, and the units will be listed on the Nairobi Securities Exchange (NSE).

The STANLIB- Fahari I-REIT will seek to invest in real estate sectors ranging from mixed-use developments, retail, commercial, industrial, hospitality, residential, specialized buildings, schools, manufacturing facilities and hospitals. The identified properties are (i) The Greenspan Shopping Mall with a lettable areas of 173,353sqf, (ii) Bay Holdings Industrial Area with a lettable area of 27,329sqf, and (iii) Signature International, a commercial property with a lettable area of 8,489sqf.

Data on the identifiable properties has not been made available, however, given the known rates in the real estate market, we believe that the rental yield on the properties is expected to be 5 - 8%, with an estimated capital appreciation rate of 10%, which gives an investor a total return of 15% p.a. To have a view as to whether the I-REIT is a good investment, we would need to have visibility on the rental yield on each of the properties going into the REIT portfolio and also get to yield payments that investors should expect. We currently have no view on the transaction.  

The HF Group launched a countrywide drive to develop houses for county government staff as part of its ambitious business development plan. This is in the wake of the MoU that the group signed with the county government of Kakamega to undertake development of housing for its civil servants. Based on the agreement, Kakamega County will provide HF with exclusive access to public land set aside for the construction of the houses, while HF will develop the houses and provide all requisite financing for the projects. As part of the deal, the HF group will also finance all mortgages at a lower interest rate while at the same time provide banking services to the county government staff. Phase 1 of the Kakamega housing project is expected to commence before the end of the year and will constitute 1000 apartment units. We will track the initiative to see how it evolves.

Focus of the Week: Analysis of listed Insurance Companies in Kenya

Cytonn Investment has completed an analysis of all listed insurance companies in Kenya, which aimed at assessing the attractiveness of both the insurance sector and the specific listed insurance companies, which we officially released on 2^nd November 2015. As part of increasing our listed equities coverage, we turned our attention to the insurance sector. In our analysis of listed insurance companies, we seek to recommend to our investors which insurance companies are the most attractive for purchase, and stable from a franchise value and from a future growth opportunity perspective.

In Kenya there are a total of 50 insurance companies, 3 reinsurance companies, 198 insurance brokers, 4 reinsurance brokers and 5,155 insurance agents. Kenya’s insurance penetration stands at 3.0% compared to its peer-countries in the Sub-Saharan Africa region. Kenya has remained under-tapped in insurance, particularly within the middle to low-income bracket, which still remains informal.

The insurance sector has seen several regulatory changes in the last one year. The revised Insurance Act seeks to introduce new capitalization requirements for the (re) insurance companies in Kenya. The minimum paid-up-capital have been set at Kshs. 600 mn, Kshs. 400 mn, Kshs. 1.0 billion and Kshs. 500 mn for the general, long term, general business reinsurance and long term business reinsurance.

In general, the sector has continued to post growth. The Insurance balance sheet stood at Kshs 455.5 bn as of June 2015. The balance has recorded a 16.1% year-on-year growth compared to June 2014. Increased investment into the insurance sector, driven by mergers & acquisitions and capital injection has been the key driver for the balance sheet growth.

Total gross premium stood at Kshs 88 billion at June 2015, with general business accounting for 66.4% of the total gross written premium. Life business has registered a much stronger growth in premium, posting a 20.2% 4-year CAGR compared to 18.8% growth in general business. The much stronger growth in Life business is majorly driven by the increased uptake of insurance, particularly in the middle to upper income levels, a bracket that continues to support the overall insurance sector growth. The industry Retention Ratio for the life business stands 92.1% while the general business stands at 73.7%. Gross reinsured premium accounts for 10.5% of the total industry written premium.

The Kenyan insurance sector lags behind in penetration, and the inherent opportunity for growth remains high. This growth is supported by a number of drivers, which remain both common to the Kenyan and wider Sub-Saharan market:

1. Insurance Products Innovation: The industry players have continued to innovate products. With increased competition in the insurance sector, companies have come up with a number of insurance products to tap the narrow client base
2. Favourable Demographics: The Kenyan and regional population has a middle-class, which continues to demand insurance products and services. With increase in income levels and disposable, the population bracket is the key demographical driver for insurance industry growth
3. Adoption of alternative channels: Insurance players have been dynamic and fast in adopting to the new alternative channels for both distribution and premium collection. Banc-assurance, mobile and internet platforms have been the primary alternative channels which will drive down the cost of premium collection. For instance Britam collected 47% of gross written premium through bancassurance in 2014. The amendment in the Insurance Act has further allowed foreign banks to run the bancassurance model
4. Regional Expansion: Synonymous to Kenya, the general Sub-Saharan Africa insurance penetration remains low. Kenyan Listed insurance companies are looking to tap into this low penetration to drive further growth. However, we hold the view that Kenya has remained under-tapped and more emphasis should be put in growing insurance penetration in Kenya

Cytonn’s analysis covers the health and future expected performance of the financial institution, by highlighting their performance using metrics to measure Profitability, efficiency, diversification, risk appetite and solvency. In our analysis, we ranked the insurance companies based on two approaches:

1. Franchise value: which ranked the companies based on their Loss Ratio, Expense Ratio, Combined Ratio, Return on Average Tangible Equity, Ceded Premium Ratio, Solvency Ratio, Underwriting Leverage, Reserve Leverage Ratio, and Governance Score. In this ranking, the insurance are ranked by health, by looking at metrics for profitability, efficiency, diversification and risk appetite. The insurance companies are then assigned scores ranging from 1, which is the best performing (re)insurer in the metric, till 6, which is the worst performing (re)insurer. The scores from each (re)insurer are then summated, with the (re)insurer with the lowest total score emerging on top, and that with the highest score emerging at the bottom.
2. Total return: We used our analyst’s projections of the future performance, intrinsic valuation, of the insurance companies and dividend yield to derive total return.Potential upside for each (re)insurer based on the intrinsic valuation, and the current market price. The (re)insurer with the highest upside was ranked 1st, and that with the lowest upside, or greatest downside, was ranked last. Cytonn’s Analysts carry out this valuation, arriving at the actual value of each (re)insurer based on an underlying perception of its true value, including all aspects of the business, in terms of both tangible and intangible factors, and future growth expectations. This value may or may not be the same as the current market value.

We have introduced a Governance Score in our analysis. Governance Score measures the company’s internal controls, strength, integrity and experience of the board and management, and quality of strategic shareholders.

Based on the two approaches, Kenya Re ranked the highest driven by steady growth in earnings and low loss, expense and combined ratio. Kenya Re also ranked the best in underwriting & reserve leverage and solvency ratios. On intrinsic valuation, Kenya Re ranked the highest, with an expected total return of 21.2%. Pan Africa Insurance holdings ranked the lowest in the overall ranking underpinned by high loss and combined ratios and the lowest solvency ratio.

The table below shows the overall ranking of the two approaches.

We have identified the following themes as key drivers of the Kenyan Insurance sector:

• Risk Based Supervision: With the proposed risk based supervision framework, we expect a consolidation of insurance companies, as the industry players synergize their books to meet the required statutory minimum requirements,
• Micro insurance: We expect the insurance players to progress towards tapping into this segment. The Kenyan informal sector offers a rich platform to tap into, with increasing disposable incomes. We expect the industry players to innovate on products that will be affordable and relevant to this segment,
• Devolved government: With the establishment of a devolved system of governance, we expect insurance uptake to increase at the county level, with (i) county governments taking up insurance services, and (ii) increased economic activity in the county level, driven by more economic activities at the county level,
• Mergers & Acquisitions: We expect mergers and acquisitions in the industry to accelerate in the medium term owing to the increase in the minimum capital requirements as highlighted in the finance bill 2015. Already a number of players have already merged and restructured to meet this new requirements.

*- For the detailed report, please download it here: Insurance Report


--------------------------
Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.