Executive Summary

Fixed Income: Yields on Government securities were on an upward trend during the month. Kenya?s inflation rate for the month of August came in at 6.3%, down from the 6.4% recorded in July and the President assented to The Banking Act (Amendment) Bill, 2015;

Equities: The equities market was on a downward trend with NASI, NSE 20 and NSE 25 declining by 5.2%, 8.9%, and 10.6%, respectively, taking their YTD performances to -7.4%, -21.3% and -16.1%, respectively. Kenyan listed banks released their H1?2016 results recording core earnings per share growth of 15.8% from same time last year;

Private Equity: Energy, ICT, and FMCG sectors continued to witness increased private equity activity in Africa during the month driven by high fundraising activities, competition and the continent?s expanding middle class;

Real Estate: The cost of real estate development is likely to reduce following increased production of alternative building technology, tax incentives for mass developments and the introduction of caps on environmental audit charges.

Focus of the Week: With the release of H1?2016 results by banks, we examine the state of the banking sector in Kenya, the transition the sector is facing and the regulatory environment.

Company Update

• This week, we began our annual 6-week US Diaspora Road Show, where we shall meet and interact with investors across several states. Join the team for a presentation and Q&A session on investment opportunities in Kenya available to the US Diaspora community. Find out where we will be next here and register: US Diaspora Road Show
• Cytonn Real Estate would like to introduce Taraji Heights, an integrated lifestyle development located approximately 2 km from Ruaka town center on a 2.8-acre site touching Limuru road. This is one of our investment ready products offering between 25% - 30% return to buyers. The project, whose estimated value is Kshs 2.5 bn, will comprise of (i) residential apartments with 2 and 3 bedroom options, (ii) a retail component, and (iii) a borehole and sewer treatment facility. We are currently at the design stage and are targeting to break ground in Q1?2017. Our clients are our number one agenda and as such we are extending a special offer open only to them. This will be for a limited number of units at 15% discount from the introductory price. Early stage investors in our other Ruaka Development, The Alma, have recorded capital gains as high as 55%, annualized, since purchasing their units less than one year ago. See introductory prices outlined below:

• To invest in any of our current or upcoming real estate projects, please visit Cytonn Real Estate. We continue to see very strong interest in our products, particularly The Alma, which is now 50% sold and has delivered an annualized return for 55% p.a. for investors who bought off-plan. We have 12 investment ready projects, offering attractive development returns and buyer's returns of a minimum of 25% p.a. See further details here: Summary of investment ready projects
• Our Senior Investment Analyst, Duncan Lumwamu, discussed the performance of the Banking Stocks following the signing of The Banking Act (Amendment) Bill, 2015, which capped interest rates in Kenya. See the Link: Duncan Lumwamu on CNBC Africa
• We are coming up with a quarterly newsletter ? Sharp Cents, which seeks to inform the market about different trends in the market. The next quarter?s edition is themed ?Alternative Investments ? The Next Frontier?. We invite you to share with us content (700 -1,000 words) in line with the above theme and we shall be awarding the winning article(s) of the quarter. Please send in your articles to communications@cytonn.com by 16^th September 2016
• We are currently carrying out a survey on the hospitality industry in Kenya for a report, which we are working on, that will aid in understanding the consumer?s needs, tastes and preferences. Kindly assist us by filling out the questionnaire here: Questionnaire: Hospitality
• We continue to beef up the team with several ongoing hires: Careers at Cytonn.

Fixed Income

Treasury bills subscriptions increased during the month of August, with overall subscriptions coming in at 144.1% compared to 95.5% in July. Yields on 182-day and 364-day T-bills increased during the month by 65 bps and 13 bps, to close the month at 11.1% and 11.5%, from 10.5% and 11.4%, respectively at the end of July. The 91-day T-bill remained unchanged at 8.3%, having witnessed a 35 bps decline, with a 200% subscription rate in the last week of the month. The increase in yields during the month was on account of Government borrowing given the new fiscal year. However, at the tail end of the month, yields declined by 35 bps, 6 bps and 48 bps for the 91-day, 182-day and 364-day papers following the enactment of The Banking Act (Amendment) Bill, 2015, which is likely to lead to more demand for Government Securities in the medium term as banks shy away from lending to the more risky sectors of the economy.

The 91-day T-bill is currently trading below its 5-year average of 10.4%, having witnessed a downward trend in the previous three months towards the close of the last financial year. The trend for the 91-day paper, however, reversed this week after the signing of The Banking Act (Amendment) Bill, 2015, a probable indicative direction of interest rates in the coming months despite the pressure from Government borrowing given the new fiscal year.

In the primary bond market, the government issued a 10-year fixed coupon bond to raise Kshs 25.0 bn for budgetary support. The bond was oversubscribed with a performance rate of 105.2%. Yields on the bond came in at 15.0%, in line with our recommendation that investors should bid within the range of 14.6% - 15.5%. The yields on government bonds remain high driven by (i) the upward pressure on interest rates as a result of government borrowing for the 2016/2017 fiscal year, and (ii) the disparity in liquidity distribution in the money market.

In the secondary market, bond turnover increased by 5.9% to Kshs 21.7 tn from Kshs 20.5 tn in July. This is attributed to improved liquidity that saw the interbank rate decline slightly to 5.4% at the end of August, from 5.6% at the end of July. In the month of August, the most active bond was IFB/1/2016/9, with its yield dropping from 13.5% at issue to 12.6% at the end of the month, as investors crystallized their gains. The NSE FTSE bond price index declined by 0.2% during the month as the yields on government bonds rose.

During the month the interbank rate was relatively unchanged ending the month at 5.4% from 5.6% at the close of July, despite a net liquidity reduction of Kshs 36.5 bn. The liquidity reduction was as a result of T-bill primary issues, payment of taxes by banks and reverse repo maturities of Kshs 81.3 bn, Kshs 79.3 bn, and Kshs 54.5 bn, respectively. We noted in our Cytonn Weekly #28 that the interbank rate is often determined by the liquidity distributions within the banking sector as opposed to the net amount and it further indicates that all banks do not trade freely with each other in the money market.

According to Bloomberg, yields for the 5-year and 10-year Eurobonds issued in 2014 decreased month on month by 0.7% and 0.5% to 4.9% and 7.2% from 5.6% and 7.7% last month, respectively. Since the mid ? January 2016 peak, yields on Kenyan Eurobond have declined by 3.9% and 2.4% on account of improving macro-economic conditions. However, owing to the signing of The Banking Act (Amendment) Bill, 2015 investors immediately reacted to the news negatively as indicated by the week on week rise in the yields on the 5-year and 10-year Eurobonds as they increased by 0.1% and 0.3%, respectively.

In August, the Kenya Shilling was stable against the US dollar, closing the month at Kshs 101.4, on account of dollar demand from importers, especially from the energy sector being offset by (i) dollar inflows from the tourism sector, and (ii) inflows from diaspora remittances. On a year to date basis, the shilling has appreciated by 0.9% against the dollar. Going forward, the shilling is likely to come under pressure in the short term as foreign investors exit banking stocks listed on the Nairobi Securities Exchange, following the signing of The Banking Act (Amendment) Bill, 2015, which is likely to affect the banks? profitability. We, however, expect the Central Bank of Kenya (CBK) to utilise the foreign exchange reserve, which currently stands at 5.1 months of import cover, to support the currency in case of an adverse forex market movement.

Inflation for the month of August came in at 6.3%, down from 6.4% recorded in July 2016, contrary to our projection of 6.7%-6.9%. This fall was driven by a 0.2% decline in both food and non-alcoholic beverage prices coupled with a higher base effect of last year. Going forward, we expect inflation to be stable throughout the year following the postponement of the levy on petroleum products, which would have had an uptick effect on food and fuel prices.

Parliament passed The Banking Act (Amendment) Bill, 2015, which sought to put a cap on interest rates, which was eventually signed by the President on 24th August 2016. The amendment placed a cap on (i) lending rates at 4.0% above the base rate, and (ii) deposit rates at 70.0% of the base rate. As highlighted in our Cytonn Report #33, we are of the view that the move was not the best and is highly likely that it will lead to more economic problems in the longer-term, bigger than the one the bill intends to fix. In our weekly topical on the Impact of the Interest Rate Cap, we looked at the potential impact the Act might have on the overall economy and compiled a list of the potential losers and winners of this regime. What stood out was that eventually, the end-consumer, whom the amendment sought to protect might eventually end up being the biggest loser. However, banks are seeking clarity on the operationalisation of the Act from the CBK given that it is not clear what the ?base rate? is and if on implementation, whether the banks will re-price all existing facilities or just the new ones. CBK has given banks an ultimatum on implementing the new law, with a deadline of 14^th September. Our view is that banks will most likely cut down on taking interest earning deposits and push consumers to transaction accounts, lend to a smaller segment of prime clients and direct more funding to government securities; we will likely see strong growth in non-bank finance sector, which is not under the ambit of the bill capping rates.

The Parliament has passed a bill that requires Treasury to be consulted by CBK before a bank is placed under receivership. This demonstrates public dissatisfaction with the processes and disclosures leading to the recent bank receivership, hence an attempt to tame the Governor?s powers.

The government is ahead of its domestic borrowing target for this fiscal year, 2016/2017, having borrowed Kshs 53.2 bn for the current fiscal year against a target of Kshs 29.8 bn (assuming a pro-rated borrowing throughout the year of Kshs 229.6 bn budgeted for the full fiscal year). Interest rates, which had reversed trends due to Government borrowing given the new fiscal year, characterized by an uptick in inflation rates and tight liquidity in the money market, are likely to witness downward pressure owing to the signing of The Banking Act (Amendment) Bill, 2015. It is due to this uncertainty that we advise investors to be biased towards short to medium-term papers.

Equities

During the month of August, the equities market witnessed significant volatility and ended in a downward trend with NASI, NSE 20 and NSE 25 declining by 5.2%, 8.9%, and 10.6%, respectively, taking their YTD performances to declines of 7.4%, 21.3%, and 16.1%, respectively. The monthly equities market performance was driven by losses in banking stocks, with all the listed banks declining. The biggest losers in the banking sector were Equity, HF Group, Co-op, and I&M Holdings, which declined by 34.6%, 31.5%, 30.8% and 28.6%, respectively.

During the week, the equities market was on a downward trend with NASI, NSE 20 and NSE 25 declining by 0.7%, 0.9%, and 1.9%, respectively. The top movers for the week were Safaricom, KCB Group, and Equity, cumulatively accounting for 81.3% of the market turnover. Since the February 2015 peak, the market has been down 42.2% and 24.0% for the NSE 20 and NASI, respectively.

Equities turnover increased by 29.6% during the month to USD 174 mn from USD 134.3 mn in July 2016. Foreign investors were net buyers for the month of August, with net inflows of USD 36.7 mn, compared to net inflows of USD 9.7 mn witnessed in July 2016, taking advantage of the relatively lower stock prices during the month. Key to note, foreigners were net sellers at the beginning of the last week of August following the signing of The Banking Act (Amendment) Bill 2015, but later came back to the market towards the end of the month, taking advantage of the low market prices, particularly in banking stocks. We maintain our expectation of stronger earnings growth in 2016 compared to 2015, with an estimated earnings growth of 12.5%, supported by a favorable macroeconomic environment.

The market is currently trading at a price to earnings ratio (PE) of 11.9x, versus a historical average of 13.7x, and a dividend yield of 4.8% versus a historical average of 3.4%. The charts below indicate the historical PE and dividend yields of the market. The last time the market dividend yield approached 5% was in December 2011, and from there we experienced about 3 years of strong market recovery. We believe we are not too far from the onset of another market recovery and we will be re-evaluating our equities recommendation in the next weekly.

Listed Banks H1?2016 Results.

During the month of August, Kenyan listed banks released their H1?2016 results recording core earnings per share growth of 15.8%, up from a growth of 4.7% in H1?2015. In summary, the listed banks can be categorized into four main buckets:

• The strong growth banks: Banks with above 20% earnings per share growth. Standard Chartered, HF Group, I&M Holdings, and CFC Stanbic. It?s notable that these banks are more focused on corporate clientele. Standard Chartered has recovered from poor H1?2015 performance
• The stable growth banks: Banks with 10% and above in earnings per share growth. Co-op, Equity, KCB Group, and DTB Bank
• Anaemic growth banks: Banks with below 10% earnings per share growth. NIC Bank
• Negative growth banks: Barclays and National Bank.

Below is a summary of the key metrics:

Key highlights for the results are:

• Loan growth vs deposit growth: Average industry deposit growth was faster than loan growth, indicating the slow uptake and issue of loans during H1?2016. Tier one banks registered faster growth in deposits indicating the flight-to-safety following the placement of Chase Bank under receivership, with a similar stronger faster growth in loans, year on year
• Increase in loan loss provisions: Banking sector's profitability was affected by high levels of non-performing loans, leading to increased loan loss provisions with an average growth of 122.4% from H1?2015. The prevailing high levels of non-performing loans are as a result of spill-over effects of the expensive cost of financing loans witnessed in the latter part of 2015 and in Q1?2016. CBK has stepped in to offer increased oversight that will see banks become more disciplined in provisioning, which will see the level of provisioning remain high this year
• Exposure to South Sudan: Due to the devaluation of the South Sudanese Pound, banks that operate in the country i.e. Equity Bank, KCB Group and CFC Stanbic have lost significant value on their assets hence recording lower than expected return.

For detailed earnings notes for each of the listed banks, see link: Cytonn Research

Listed Insurance Companies? H1?2016 Results.

Listed insurance companies, with the exception of Liberty Holdings, released their H1?2016 results in August, recording core earnings per share decline of 10.0%, down from a decline of 3.9% in H1?2015.

Below is a summary performance of listed insurance companies: H1?2016 Core EPS growth vs H1?2015

Following the release of the H1?2016 results by listed insurance companies, we are updating our coverage of the companies, which will be releasing in the coming weeks.

For detailed earnings notes for each of the listed insurance companies, see link: Cytonn Research

During the month we had several earnings releases:

• Bamburi released their H1?2016 results, which we already covered, see Bamburi Cement Earnings Note H1?2016.
• ARM Cement released their H1?2016 results. For a more comprehensive analysis, see our ARM Cement Earnings Note H1?2016.

As indicated in our Cytonn Weekly #33, Chase Bank (In Receivership) attained approval from the CBK to resume its term deposit-taking and lending activities. Following the lender being placed under receivership in April 2016, KCB Group was appointed by Kenya Deposit Insurance Corporation (KDIC) as the receiver manager to help revive its operations. KCB Group planned to scale back 50.0% of its resources from Chase Bank (IR) by the end of August 2016 and finally 100.0% in September. This month, the CBK is expected to call upon investors to bid for the buyout of a majority stake in Chase bank in order to revive its activities fully. We applaud the regulator, CBK for the expedited move to reopen Chase Bank, the first time ever a bank has been closed, put under receivership and re-opened, increasing confidence in the Kenyan Banking system. However, the market expects more transparency in terms of conditions and considerations leading up to a Receivership decision and the process of appointing a receiver manager.

The UK Government development fund, CDC Group, announced it will acquire a 10.68% stake in I&M Holdings following approval by the Competition Authority of Kenya (CAK) during the month, joining the top four largest shareholders list. CDC Group will purchase 6.25% and 4.43% from DEG ? a German investment and development company - and PROPARCO ? a Paris-based development financial institution, respectively as detailed in our Cytonn Weekly Report #16. CDC?s financial sector experience and expertise will play a role in improving I&M Holding?s strategy.

During the month, CBK released their bank supervision Annual report for 2015, which indicated that, Diamond Trust Bank (DTB) and Commercial Bank of Africa (CBA) had a market share of 5.3% and 5.6%, which is above the CBK benchmark of 5.0% for Tier I banks thus qualifying for Tier I classification. The two banks grew their customer deposit bases to Ksh 148.3 bn and Kshs 126.6 bn in FY?2015 from Kshs 122.0 bn and Kshs 102.1 bn in FY?2014 for CBA and DTB, respectively. DTB and CBA move to Tier I led to an increase in Tier I banks? combined market share to 58.2% in FY?2015 from 49.9% in FY?2014. Tier II banks? combined market share declined to 32.4% in FY?2015 from 41.7% in FY?2014. DTB moved up two ranks to seventh in 2015 from ninth in 2014. This move highlights the aggressive strategy by DTB to grow both the funding of its balance sheet and disbursement of loans. As indicated in our Cytonn Weekly #31, DTB is pursuing sustainable growth of its subsidiaries in Tanzania, Uganda, and Burundi, which contributed approximately 26.0% of the bank?s revenues in FY?2015.

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

• We have finalised on our coverage of the Listed Kenya Banking Sector. Please find the report here: H1?2016 Banking Sector Report
• BAT (K) has moved from an ?Accumulate? recommendation, with an upside of 19.1% to a ?Buy? recommendation with an upside of 23.2%, following a 1.4% w/w price decline
• Sanlam Kenya has moved from an ?Accumulate? recommendation, with an upside of 16.2% to a ?Buy? recommendation with an upside of 22.9%, following a 14.2% w/w price decline.

We are neutral with a bias to positive on Equities given the higher earnings growth prospects, supported by a favorable macroeconomic environment.

Private Equity

There has been a lot of interest in Africa by private equity (PE) investors and the month of August witnessed a number of transactions in energy, infrastructure, financial services, and technology. Of interest is that some of the deal sizes have been relatively small compared to what typically most PE firms seek to take up. These deals include:

The Rockefeller Brothers Fund joined the investor consortium backing Lekela Power, the renewable energy joint venture between private equity firm Actis and developer Mainstream Renewable Energy, by committing to invest USD 10.0 mn. Lekela power is looking to invest in four more wind farms in South Africa, a wind farm and two solar plants in Egypt, as well as wind farms in Senegal and Ghana with a goal to construct over 1.3 GW of new power capacity across the continent by 2018.

According to Preqin?s report on the infrastructure deals market in Africa, the energy sector continues to dominate infrastructure investments in Africa. The majority of deals in Africa since 2013 have been for energy infrastructure at 60.0% as the emphasis on electricity generation and transmission in Africa intensifies. The majority of the energy deals at 92.0% were transacted for renewable assets, including the USD 2.8 bn Batoka Gorge Hydroelectric Project in Zambia, the largest infrastructure deal completed since 2013, as domestic and international fund managers attempt to harness the geographical potential for renewable energy in Africa.

Emerging Africa Infrastructure Fund (?EAIF?), loaned USD 20.0 mn to Helios Towers Africa (?HTA?), as part of syndicated loan worth USD 105.0 mn, to finance the purchase of approximately 950 telecommunications towers in the Democratic Republic of Congo (DRC). EAIF is a leading investor in digital communications infrastructure in Sub-Saharan Africa, with this being its fifth partnership with HTA due to its skilled, dependable, reliable and wholly supportive management.

The International Finance Corporation (IFC), has this week committed to lend up to USD 4.5 mn to Tropical Heat Limited, a spices and snacks maker in Kenya, in order to assist the company to finance their expansion plans, which include the construction of a new factory on an eight-acre piece of land in Limuru.

Zoona, an African financial technology company that offers emerging entrepreneurs a platform to provide money transfer and other services to unbanked consumers, successfully raised USD 15.0 mn in the second round of financing, with its main participants being IFC, Accion and Quona Capital, 4Di Capital, Omidyar Network and The Lundin Foundation. This fund will be channeled towards scaling up Zoona?s operations as the technology firm aims to reach 10 markets and 30 million active consumers across Africa by 2020.

Old Mutual Investments Group (OMIG) and Nigeria's Sovereign Investment Authority (NSIA) have agreed to set up two funds to invest in real estate and agriculture in Nigeria. This would be done through jointly raising USD 500.0 million fund to invest in real estate and another USD 200.0 million to invest in agricultural projects. The investment venture comes as a result of a slump in oil revenues in Nigeria, which has had negative impacts on Nigeria?s GDP for the first quarter of 2016, declining by 0.4%.

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

Real Estate

Real estate continues to be one of the key drivers of growth in the economy. Despite the sector being lucrative, capital raising into the sector has remained a challenge and that is why we have seen many developers seek alternative sources of capital. In the month of August, we saw two firms seek to fund raise from the capital market markets through the issuance of REITs and Equity listings prospects.

1. Superior Homes announced plans to list on the Growth Enterprise Market Segment (GEMS) of the NSE, subject to regulatory approval. If the bid succeeds, the developer behind the Green Park Estate in Athi River Machakos County will be the 2nd real estate company to list on the bourse after Home Afrika, which listed in 2013. Superior Homes has a good track record in real estate development and we think the company might be able to list if they are to get the timing right.
2. Fusion Capital failed to list its REIT in the market as it did not meet the threshold for listing of a minimum of 7 investors and 50% subscription rate. The REIT recorded a 37.9% subscription rate raising Kshs 873.8 mn out of the targeted Kshs 2.3 bn from only 4 investors. Fusion Capital will, therefore, have to raise additional capital through private placement and only use debt as a last resort to fund a mixed-use development in Meru. As per our Cytonn Weekly #32 ? Real Estate Listings in Kenya, we believe the successful fundraising from the market shall be supported by (i) institutional support before launching, (ii) increase product-knowledge to the wider market, (iii) improve corporate governance around issuances, and (iv) provide a minimum return guarantee to the buyers and clarity regarding exit strategies to build investor confidence.

Innovation into the real estate sector continues and the adoption of the use of Alternative Building Technology (ABT) for construction is likely to increase in future. In August, China Wu Yi broke ground on construction of a Kshs 10.0 bn factory along Mombasa Road Kenya. In the past, uptake of ABT in Kenya has been low due to insufficient information of technology and mistrust on its quality and durability. However, in our view, use of the technology will solve the undersupply of the residential housing through enabling faster construction and at lower costs. The use of pre-cast blocks significantly reduces construction periods by up to 50% as the pre-cast blocks come ready for assembly, while the use of EPS lowers construction costs as its use results in lighter structures making them ideal for construction of high rise buildings. Through sensitization, uptake for this technology will enable mass housing construction and meet the housing needs of the Kenyan population.

As an incentive to increase development and thus bridge the housing gap in the country, Parliament has tabled a proposal that seeks to lower the number of units required to qualify for a tax rebate from 1,000 to 400 units. Through amendment of The Finance Bill 2016, developers will pay 15.0% in income taxes for constructing at least 400 residential units annually. By doing these, we expect increased investment in the residential sector, as developers seek to benefit from the incentives issued. The number of units is much lower and we have a couple of developers who are set to benefit from this.

On the statutory front, projects will now pay for environmental audits based on their risk level after NEMA disregarded the Treasury?s declaration abolishing these charges in June this year. Investors have since September 2013 been paying a minimum of Kshs 10,000 or 0.1% of project cost without an upper limit, making it costlier for large projects. Under new regulations, developers will pay a maximum of 0.1% of project costs but within the following price ranges:

1. High-Risk Projects ? These include mega real estate projects, roads, large hotels, mining and energy plants and will attract a maximum of Kshs 40.0 mn and a minimum of Kshs 50,000
2. Medium-Risk Projects ? These include hotels less than 150-bed capacity, petrol stations, shopping centers, office blocks and stores not exceeding 10,000 square meters. The developers will pay a minimum of Kshs 20,000 and a maximum of Kshs 10.0 mn, while
3. Low-Risk Projects ? These include churches, bus parks, and stadia, which will attract a fee of between Kshs 10,000 and Kshs 3.0 mn.

The hospitality sector received a boost in August as hotels recorded full bookings when Nairobi hosted the Tokyo International Conference on African Development (TICAD). The growing MICE tourism in Nairobi has been driven by its stature as a regional hub, infrastructural development, and presence of multi-national firms in the country. We expect increased investment in the sector driven by improved security, lifting of travel advisories and improving infrastructure. Construction of a double-decker highway linking JKIA to the Nairobi-Nakuru Highway is likely to create opportunities for hotel development. The elevated dual-carriageway will ease access to Westlands and Rironi areas for internationals travellers and reduce snarl-ups along the Mombasa Highway. In addition, the government has allocated Kshs 1.5 bn for promotion and marketing of Kenya?s tourism, which if well-utilised will increase the profitability of the sector.

Property transactions resumed following the appointment of Land Control Boards (LCB) in Nairobi, Kajiado, Kiambu, Nakuru and 6 other counties. The Government had disbanded all LCBs on corruption allegations in April 2016. The move will enable property dealers and developers obtain consent for sale, transfer, partitioning and amalgamation of agricultural land, and continuity of projects, which would have otherwise stalled. However, transactions are still frozen in 21 other counties.

We expect increased development activity as developers are likely to take advantage of the recent introduction of a cap on interest rates at 4% above the base rate as well as the tax incentives for development of housing units. In addition, the rise in property prices is likely to slow down due to reduced cost of borrowing for development.

Kenya Banking Sector H1?2016 Report

Following the release of the H1?2016 results by banks, we undertook an analysis on the Kenyan Banking sector to point out any material changes from the Q1?2016 banking report. In this report, we recommend to investors which banks are the most attractive and stable for investment from a franchise value and from a future growth opportunity perspective.

The report is themed ?Transition continues, to a more regulated, yet innovative environment? as the issues facing the banking sector, which is undergoing a transition, still persist. There are some key areas of transition, which will change the banking landscape in Kenya going forward:

1. Increased Regulation ? There has been a number of regulatory developments that seek to introduce more regulation within the banking sector. These include;
   1. The Banking Act (Amendment) Bill, 2015 - The bill was signed into law effectively capping loan rates at 4.0% above the base rate with a floor on deposit pricing at 70% of the base rate. As highlighted in our Cytonn Report #34, we analysed the potential impact of the law to the general economy and came up with the potential winners and losers of this regime,
   2. Amendment of The Kenya Deposit Insurance Corporation Act ? The Parliament has passed a bill that requires Treasury to be consulted by CBK before a bank is placed under receivership,
   3. Internal Capital Adequacy Assessment Process (ICAAP) - The Central Bank of Kenya (CBK) has developed draft guidelines on ICAAP that seeks to enable banks and mortgage finance institutions in determining the level of capital adequate to cover for their respective risks. Under the guideline all banks and mortgage finance institutions are required to formulate their own ICAAP that ensures that overall internal capital levels are adequate and consistent with their strategies, business plans, risk profiles and operating environments.
2. Sector Realignment? The banking sector continues to be characterised by sector realignment, through;
   1. Strategic Initiatives - Banks have continued to diversify their businesses into non-bank services; I&M Holdings has acquired Burbidge Capital, as it seeks to grow its business into transaction advisory. KCB Group has opened KCB Capital to tap into the same space
   2. Innovative Banking ? In order to continue recording strong revenue growth, in post interest rate cap environment, banks will have to come up with innovative products, with possibilities of focus on transaction based banking, which could be targeted towards meeting specific customer needs and hence protecting their NIMs. In our view, we see innovation in terms of product offerings and cost containment being the key differentiator in this regime of price control.

Based on the above, we think consolidation is going to happen in the near-term to acquire the weaker banks. But we think the strong banks will be able to protect their margins by simply limiting any interest paying accounts in favour of transaction accounts, and limiting loans to prime clients and investing balance of deposits in government. Subprime clients will need to find non-bank financial solutions.

Below are the operating metrics for listed banks in Kenya: 

With GDP growth prospects for 2016 at 5.8%, Kenya?s listed banks recorded improved EPS growth in H1?2016 of 15.8% compared to the H1?2015 growth of 4.7%. This was on the back of an improved macroeconomic environment, which saw interest rates decline to below historical average levels as evidenced by the interbank and the 91-day T-bill rates declining to 2.3% and 7.1%, respectively. With the banking sector contributing 10.1% to GDP, a strong growth exhibited by the sector is beneficial to drive the economy as the private sector is not crowded out and as banks can afford to take up some risk and loan out more to the sector. However, as a result of the interest rate cap, we might witness contraction of the private sector credit growth as banks opt to loan to the government which is considered risk free.

The growth currently witnessed in the sector is as a result of the sector?s ability to develop products that respond to the needs of Kenyans, such as (i) convenience and efficiency through alternative banking channels such as mobile and agency banking, (ii) increased financial inclusion and banking the informal market, and (iii) a demographic boost in Kenya, such as a growing middle class, which has led to increased demand for intermediary services such as banking. Going forward, banks will most likely cut down on taking interest earning deposits and push consumers to transactional accounts, lend to a smaller segment of prime clients and direct more funding to government securities; we will likely see growth in non-bank finance sector, which is not under the ambit of the Banking Act.

There are three takeaways from the table above:

• The sector recorded a 15.8% core EPS growth, with all banks recording double digit growth except NIC Bank, Barclays Bank and National bank which grew at 2.9%, (10.2%) and (70.0%), respectively,
• Banks registered high growth in non-performing loans, with the NPL ratio at 6.7% in H1?2016 compared to 3.5% in H1?2015, and,
• National Bank was the only bank that reported negative return on equity.

As per our analysis on the banking sector, from a franchise value and from a future growth opportunity perspective, below is the comprehensive ranking of the listed banks.

Major changes include:

• Barclays bank dropped to position 7 from position 4 as per the Q1?2016 Banking Sector report, mainly driven by a poor total return score, having an upside of 4.6%
• Equity Group emerged top, having been position 2 as per the Q1?2016 Banking Sector report driven by a strong franchise score, where it emerged top.

For a comprehensive analysis on the ranking and methodology behind it, see our Cytonn H1?2016 Banking Sector Report

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