Executive Summary

Fixed Income: Yields on Treasury bills were relatively unchanged with the 91-day, 182-day and 364-day papers coming in at 7.7%, 10.3% and 10.4% from 7.8%, 10.3% and 10.3%, respectively. The International Monetary Fund (IMF) will be visiting Kenya later this month to assess the Government?s commitment to conditions that were set out for the stand-by loan facility of Kshs 150.0 bn, one of which was to narrow its budget deficit to below 6.5% of GDP, but the budget deficit is projected to widen to 9.3% of GDP in 2016/2017 fiscal year;

Equities: During the week, the Kenyan equities market registered mixed performance with NASI loosing 0.5%, NSE 20 gaining by 0.2% and NSE 25 remaining flat. Bamburi Cement plans to expand its Athi River grinding plant and double its production capacity to 2.3 metric tons per year while KQ has revealed that it?s loss per share has declined by 58.3% to Kshs 5.0 bn from Kshs 12.0 bn reported in Q3?2015;

Private Equity: The health sector continues to drive private equity investments in the region as Catalyst Principal Partners acquires a controlling stake in Zenufa Laboratories, one of the leading pharmaceutical manufacturers in Tanzania;

Real Estate: Property prices in Nairobi recorded sustained growth as per the Q3? 2016 House and Land Prices Indices report by Hass Consult. Private sector complements the Kenyan Government?s efforts at increasing industrialization through setting up of industrial parks in the Special Economic Zones along the Standard Gauge Railway;

Focus of the Week: We focus on the Hospitality Sector Report, covering hotels and serviced apartments in Kenya, consumer sentiments on both hotel and serviced apartment use and analyzing the current state and future outlook for the sector;

Company Updates

• This week, we are launching our Hospitality Report. For more information, see link: Cytonn Hospitality Report
• Cytonn Real Estate has secured a Kshs 1.1 billion loan financing from Shelter Afrique which will go towards the ongoing construction of The Alma. ?With over 6,000 residential units in our pipeline, we continue to deepen and diversify our funding sources, particularly with international financing partners such as Pan-African Shelter Afrique and Taaleri of Finland.?
• Frank Ndubi, a seasoned real estate professional, was promoted to a Senior Manager for Cytonn Real Estate. For more information, see Frank Ndubi?s Promotion
• Cytonn Real Estate, has launched a real estate private wealth product, Cytonn Project Notes. Commenting on the new private wealth product, Elizabeth N. Nkukuu, CFA, Chief Investment Officer & Head of Cytonn Real Estate mentioned that ?Real Estate remains the largest asset class in the world, and the highest returning asset class in this region given the huge housing deficit. Cytonn is committed to reducing the housing deficit given the over 6,000 units we currently have in the pipeline. Cytonn Project Notes will directly match individual high net worth investors and institutional investors with projects that have assured cash flows from payment plans of end users.?
• 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:
  • The Alma, which is now 51.0% sold and has delivered an annualized return of 55.0% p.a. for investors who bought off-plan. See The Alma
  • Amara Ridge is currently 100.0% sold, see Amara Ridge
  • We have 12 investment-ready projects, offering attractive development returns and buyer's returns of a minimum of 25.0% p.a. See further details here: Summary of investment-ready projects
• We continue to beef up the team with several ongoing hires: Careers at Cytonn.

Fixed Income

During the week, T-bills were oversubscribed but overall subscription decreased to 154.6%, compared to 160.7% recorded the previous week. Subscription rates decreased with the 91-day and 364-day papers coming in at 117.1% and 102.9% from 151.0%, and 126.5%, respectively, the previous week, while the subscription rate for the 182-day paper increased to 231.3% from 201.2%, the previous week. The 182-day paper remains the most subscribed as it offers the highest effective return on a risk-adjusted basis especially given that its yield is marginally the same as the 364-day T-bill. Yields on Treasury bills were relatively unchanged with the 91-day, 182-day and 364-day papers coming in at 7.7%, 10.3% and 10.4% from 7.8%, 10.3% and 10.3%, respectively from previous week.

The 91-day T-bill is currently trading below its 5-year average of 10.4%. The downward trend for the 91-day paper is mainly attributed to the expected low interest rate environment following the operationalization of the Banking Act Amendment 2015 which has led to more liquidity in the market and also due to reduced pressure from the government borrowing program as they are currently ahead of the pro-rated domestic borrowing target of Kshs 70.6 bn having borrowed Kshs 108.9 bn.

According to Bloomberg, yields on the 5-year and 10-year bond were stable week on week at 4.5% and 7.2%, respectively. Since the mid-January 2016 peak, yields on the Kenya Eurobonds have declined by 4.3% points and 2.5% points, respectively for the 5-year and 10-year bond, on account of improving macroeconomic conditions. This is an indication that Kenya remains an attractive investment destination.

The Kenya Shilling remained stable against the dollar during the week to close at Kshs 101.4 from Kshs 101.3, the previous week, on account of demand by importers in the energy sector being matched by dollar inflows from offshore investors participating in government treasury auctions. On a year to date basis, the shilling has appreciated by 0.9% against the dollar. We expect the shilling to remain stable for the remainder of the year supported by (i) the high levels of foreign exchange reserves equivalent to 5.2 months of import cover, and (ii) improved diaspora remittances.

The Treasury has floated a 15-year infrastructure bond to raise Kshs 30.0 bn from the domestic market for partial funding of infrastructure projects in the following sectors: roads, energy and water. The coupon rate will be at 12%, lower than previously issued Infrastructure bond offer that had a coupon of 12.5%, attributed to the expectations of relatively low interest rates in the current environment. Given that the bond has a weighted tenor of 11.25 years after adjusting for partial redemptions, and a similar taxable bond with the same tenor is currently trading at a yield of 12.9%, we recommend to investors to bid at a yield of between 11.7% and 12.3%.

The International Monetary Fund (IMF) will be visiting Kenya later this month to assess whether the Treasury is complying with commitments made under the Kshs 150.0 bn precautionary financing facility arranged in March this year. One of the conditions for the government was to narrow its budget deficit to below 6.5% of GDP in the current fiscal year and to 5.0% in 2017/2018 fiscal year. However, Kenya projects its funding gap widening to 9.3% of GDP in the year to June 2017 from 7.9% in 2015/2016 fiscal year. The Treasury intends to spend Kshs 2.3 tn during this fiscal year, 11.2% more than it did last year. The Treasury plans to borrow Kshs 229.6 bn locally and another Kshs 401.7 bn externally to plug in the shortfall. Given the increased expenditure on infrastructure projects and the need to regain power in upcoming elections, chances of the government cutting back spending are slim. We are of the view that these differences between the government and the IMF on budget cuts may make it more difficult for Kenya to access the facility if need be and also might be difficult for Kenya to access funds from the global markets, and if they do it will be at very high rates like it happened in Ghana where they borrowed at 9.25%.

The IMF this week in its review on the economic outlook for sub-Saharan Africa, has projected the growth rate in the region to weaken after a year of solid growth. IMF forecasts the growth among the 45 countries that make up this region to drop to its lowest level in more than two decades with a drop of over 50% to 1.4% this year from 3.5% in 2015. The decline in growth is attributed to; (i) declining oil prices which has affected key commodity exporting economies, such as Nigeria, (ii) terrorism and humanitarian crimes, and (iii) critical drought particularly in Lesotho, Malawi and Zambia. These elements have contributed to a slowdown in flow of foreign direct investments into the region as well as creating uncertainties among investors who have flown to safety. Among the worst hit economies are; Nigeria, Cameroon, Angola and Chad. However, some economies in the sub-Saharan Africa region have continued to experience strong growth, such as Ethiopia, Senegal, Tanzania and Cote d?Ivoire. This forecast by IMF comes at a time when the World Bank also predicts a drop in growth in Sub Saharan Africa to 1.6% in 2016 from 3.5% in 2015. Of key note is that despite the challenges experienced by commodity dependent countries in the SSA region, the East Africa economies continue to record strong GDP growth with Kenya recording 6.2% growth in Q2?2016 and we project Kenya?s GDP growth for 2016 to come in at 6.0%.

Standard and Poor?s Rating Services revised Kenya?s sovereign credit outlook upwards to stable from negative and affirmed the credit ratings at B+ for long term debt and B for short term foreign and local currency sovereign credit. The revision was supported by:

1. The elevated risks seen towards the end of 2015, including the financing stress seen in the government?s financing conditions and the tight liquidity in the banking sector having eased
2. The expectation that Kenya?s strong growth performance, on average 6% per year over 2016-2019, will continue to offset more volatile fiscal and external performance
3. Oversight at the Public Debt Management Office (PDMO) being bolstered and new debt management systems have been introduced, supportive of the government?s credit worthiness

The stable outlook reflects expectations that strong growth prospects and favorable government financing conditions will facilitate fiscal consolidation and contain increases in foreign debt levels. Risks to the credit outlook are (i) an increase in Kenya?s fiscal deficit, (ii) political tensions flaring up in the run-up to the 2017 General elections, thereby undermining stability oriented economic policymaking, and (iii) if Kenya?s external liquidity or financial conditions markedly deteriorated and led to a significant loss of foreign exchange reserves and widening of the external financing gap.

The government is ahead of its domestic borrowing for this fiscal year having borrowed Kshs 108.9 bn for the current fiscal against a target of Kshs 70.6 bn (assuming a pro-rated borrowing throughout the financial year of Kshs 229.6 bn budgeted for the full financial year). Interest rates, which had reversed trends due to Government borrowing given the new fiscal year, an uptick in inflation rates and tight liquidity in the money market, are currently witnessing downward pressure owing to the enactment of The Banking Act Amendment, 2015. It is due to this that we advise investors to be biased towards short to medium-term papers.

Equities

During the week, the Kenyan equities market registered mixed performance with NASI loosing 0.5%, NSE 20 gaining by 0.2% and NSE 25 remaining flat, taking their YTD performances to (5.6%), (13.1%) and (19.1%) for NASI, NSE 25 and NSE 20, respectively. Since the February 2015 peak, the market has lost 40.6% and 22.5% for NSE 20 and NASI, respectively. This week?s performance was driven by losses in select large cap stocks such as KCB Group, Standard Chartered Bank and Safaricom shedding 2.7%, 2.2% and 1.5%, respectively, despite gains of 3.3% and 1.2% in Equity Group and Barclays Bank of Kenya.

Equities turnover increased by 38.1% to close the week at Kshs 2.9 bn from Kshs 2.1 bn the previous week.  Foreign investors were net sellers with net outflows of USD 9.0 mn, compared to a net inflow of USD 6.7 mn recorded the previous week, while foreign investor participation remained flat at 67.1%. Safaricom accounted for the largest share of net outflows at USD 7.6 mn compared to a net inflow of USD 1.0 mn recorded the previous week as its share price begun to decline after the stock closed at a one and a half month high of Kshs 20.3 the previous week. Safaricom and KCB Group were the top movers during the week jointly accounting for 56.3% of market activity. We maintain our expectation of stronger earnings growth in 2016 compared to 2015 supported by a favorable macroeconomic environment. However, the key risk is the volatility in the banking sector that may depress earnings for banks especially for the fourth quarter.

The market is currently trading at a price to earnings ratio of 12.0x, versus a historical average of 13.7x, with a dividend yield of 6.4% versus a historical average of 3.5%. The charts below indicate the historical PE and dividend yields of the market.

 Bamburi Cement is planning to expand its Athi River grinding plant, thus doubling production capacity to 2.3 mn metric tons annually from the current capacity of 1.2 mn metric tons per year. The project will cost an estimated Kshs 902.0 mn and is expected to (i) increase production thus enabling the cement manufacturer to widen its export market and increase supply in the country and, (ii) enable Bamburi to lower its cement prices and increase its competitive edge in the market. This will lead to increased supply of cement in the industry to meet the increasing demand supported by a vibrant real estate and construction industry that continues to grow driven by the large housing deficit and increased government infrastructural developments. We maintain a buy recommendation on Bamburi with a target price of Kshs 231.7, an upside of 48.2% given the current trading price of Kshs 165.

Kenya Airways announced before its official October 27^th, 2016 release date that its loss after tax had declined by 58.3% to Kshs 5.0 bn from Kshs 12.0 bn reported in the first half of the 2015/2016 financial year. The airline further revealed that the operating loss recorded a 75.0% reduction supported by a 4.0% rise in the number of passengers to 2.2 mn from 2.1 mn the previous period. The early revelation of key aspects of their financials was prompted by a threatened strike by its pilots through the Kenya Airline Pilot Association (KALPA), who issued a strike notice stating that they would only keep working after October 18^th, 2016 if the CEO and Chairman of the Board resigned by then. Kenya Airways management is of the opinion that the action was unjustified under Schedule VII of the Collective Bargaining Agreement (CBA) signed between KALPA and KQ. Despite this, threats of the strike have already begun to bring about negative effects to the airline as passengers have started cancelling flights which may likely result in reduced revenue from ticket sales and reduction of their customer base. Key to note is that the previous threat of strike by KALPA in April 2016 resulted in the same scenario, costing the airline Kshs 200.0 mn in revenue all in one day. Should the strike go through, KQ would suffer largely from reduced revenue that will result in a reduced operating profit.

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

• Equity Group has moved from a ?Buy? recommendation, with an upside of 21.7% to an ?Accumulate? recommendation with an upside of 18.0%, following a 3.3% w/w price rise
• Standard Chartered has moved from a ?Sell? recommendation, with a downside of 1.1% to an ?Lighten? recommendation with an upside of 1.0%, following a 2.2% w/w price decline

 We remain ?neutral with a bias to positive? for investors with short to medium term investments horizon and we have now turned ?positive? for investors with long-term investments horizon.

Private Equity

Catalyst Principal Partners, an East African focused private equity firm, has acquired a controlling stake in Zenufa Laboratories, one of the leading pharmaceutical manufacturers in Tanzania. Catalyst Principal Partners manages Catalyst Fund I, a USD 125 mn private equity fund that has invested in high growth mid-sized companies across Eastern Africa, including Tanzania, Ethiopia, Kenya, Uganda, Rwanda, Zambia and the Democratic Republic of Congo. Zenufa offers affordable, quality medication manufactured to the highest international best practice standards with a wide range of over-the-counter (OTC) and prescription medicines for the Tanzanian market, with leading brands including Zenadol, Zenkof, Zn-vital and Dr. Cold. This has presented the company as an attractive investment for Catalyst Principal Partners and the new capital injected will assist the firm compete in the healthcare sector as: (i) Zenufa will establish itself as a local pharmaceutical manufacturer, in a sector dominated by foreign imports representing majority of Tanzania?s medicine supply, (ii) the government of Tanzania has enhanced promotion of local manufacturing, and Zenufa will benefit from this government initiative, thereby boosting their revenues, (iii) the company has also partnered with a number of organizations to locally develop affordable medicines for neglected diseases and (iv) the company represents a platform for growth across Eastern Africa through development of cost-effective generic drugs. The health sector continues to attract private equity investments in the region due to the rising population growth and demand for quality, affordable and sustainable healthcare.

Fanisi Capital, an East African Private Equity firm, seeks to raise at least Kshs 4.0 bn from local investors as part of a Kshs 10.0 bn fund meant for regional investments in healthcare, agri-business, retail and education sectors. This is Fanisi?s second round of capital raising, with the firm having raised Kshs 5.0 bn between 2010 and 2015 in the first fund whose proceeds were invested in companies such as Haltons Pharmacy, Kijenge Animal Products in Arusha, ProDev/Minimex Group in Rwanda, Ad Life, Hillcrest Schools and European Foods Africa Ltd. The fund is targeting local institutional investors with a bias to pension funds who have in the recent past improved their investment capacity after the introduction of private equity as a stand-alone investment class for the schemes allowing up to 10.0% of their exposure in this asset class. The fund has also attracted interest from the International Finance Corporation (IFC), which plans to invest up to Kshs 750.0 mn in the new fund in exchange for an equity stake not exceeding 20.0%. Proceeds will be invested across Kenya, Tanzania, Uganda and Rwanda.

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, real estate, healthcare, education, and IT sectors although infrastructure, Fast Moving Consumer Goods (FMCG) industries 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

Properties in Nairobi and its satellite towns have recorded sustained growth in prices, albeit at a decreasing rate over the first three quarters of this year. According to the recently released Property Price Index for Q3? 2016 by Hass Consult, property prices and rents in Nairobi recorded quarter on quarter growth of 1.2% and 7.0%, respectively. Key take-outs from the report were:

• Asking prices for houses in the suburbs outpaced those of satellite towns, growing by 1.2% compared to the 0.9% growth in satellite towns during the third quarter;
• On the other hand, growth in land prices in satellite towns rose by 7.0% compared to that of land in Nairobi Suburbs at 1.4%. This is attributed to the fact that investor preference is skewed towards buying developed property in the suburbs with the intention of renting in the short-term and selling in the long-term, while land in satellite towns attracts investors who wish to benefit from the high land capital appreciation in the long term driven majorly by the ongoing infrastructural development; and,
• In Q3? 2016, Juja area recorded the highest price increase at 14.5% among satellite towns followed by Limuru at 12.4% and Ruiru at 11.2%. Price appreciation in these areas is majorly driven by impending infrastructural development.

Demand for real estate has continued to push prices as investors shy away from other asset classes with lower returns, and move towards real estate which offers returns of up to 25.0% p.a. on average for those who invest at development stage, and rental yields of up to 12.0% p.a. on commercial buildings built to let. In our view, land prices will continue to increase in areas experiencing infrastructural development such as the Western By-pass and the expansion of Machakos Junction ? Rironi highway which has already been commissioned. The areas that are likely to experience an increase in land prices include Kikuyu, Rironi, Gachie, Ndenderu and Ruaka.

The Kshs 12.5 bn, Infinity Industrial Park, being developed by Abacus Group, along the Eastern Bypass in Nairobi was launched during the week. The 200-acre development will feature manufacturing plants, wholesale outlets, go-downs and other support services such as banks and retail outlets. The project will not only create a conducive environment for local manufacturers and alternative locations compared to the congested Industrial Area but will also provide leasing space for SMEs and create job opportunities.

This is a positive step by the private sector towards achieving the Vision 2030, complementing the Government?s efforts to establish green industrial parks under Special Economic Zones along the Standard Gauge Railway from Mombasa to Western Kenya.  We have seen a trend with developers selling plots to firms, then providing infrastructure including sewer lines, power lines, data cables and roads. Other developments include Tatu City in Ruiru where we have seen companies such as Dormans and Kim-Fay launching constructions of manufacturing facilities; and Konza City.

City Hall has begun reviewing its valuation roll that will result in increased land rates paid to the Nairobi City County. Geomaps Africa Ltd., a geospatial survey firm, in association with Royal Valuers Ltd. have been contracted to undertake the process that will see the county government update the value of land across the city and determine how much in land rates should be paid.  Based on the 1980 Valuation Roll, property owners currently pay rates at 34.0% of the unimproved site value. Updating of the valuation roll will enable City Hall raise more in property rates for the areas whose property value has increased as well as the increased tax-base in the new GIS-based valuation roll 2016.

Hospitality Sector Report ? ?Sailing through the storm??

Kenya?s real estate sector has continued to attract both local and international investors who aim to tap into the potential brought about by robust economic growth of 6.2% as at Q2?2016 and projected to be an average of 5.0% over the next decade, the growing middle class with higher disposable incomes, and improving infrastructure, which has opened up satellite towns for development. The hospitality sector in specific has recorded increased investment as seen through the establishment of hotel and serviced apartment developments. Hotel bed supply has been increasing at a 3% CAGR over the last 5-years, while the supply of serviced apartments in Nairobi alone has grown at a CAGR of 23.6% over the last 4 years. Some of the hotels in the development pipeline include Park-Inn by the Carlson Rezidor Hotel Group in Westlands, Best Western?s Premier Collection, The Alba and the City Lodge at the Upcoming Two Rivers Mall, which are expected to add 253 hotel beds to the supply over the next 1 year. This is an indication of appetite for investment in hotels in Nairobi.

However, the performance of the hospitality sector in Kenya has been on the decline with occupancy levels, international arrivals and Total Revenue per Available Room declining by CAGRS of 7.8%, 10.3% and 5.8%, respectively, over the last 5-years. The decline is attributed to insecurity brought about by terrorist attacks, which in turn led to issuance of negative travel advisories, thus lowering demand for accommodation and other hotel-related services. Other challenges affecting the sector include heightened competition from both local and emerging markets in the region such as Ethiopia, with relatively low room rates.

We therefore conducted a research focused on hotels in Kenya and serviced apartments in Nairobi, to inform the market of the current trends in the industry pertaining to occupancy, demand and revenues, the outlook for the sector and thereafter to identify the ideal regions and sectors for investment.

From our survey, the best opportunity for investment lies in serviced apartments in Nairobi due to high occupancy. In addition, 3 and 5-star hotels in Maasai Mara stood out as the best performing in Kenya.

Performance of Hotels according to Star Rating was analyzed with the following results achieved;

Source: Cytonn Research

We also compared occupancy, rates and Total Revenue Per Available Room per region as shown below;

Source: Cytonn Research

Serviced apartments have become increasingly popular in the market, with Nairobi alone having more than 60 brands of serviced apartments with more than 2,500 apartment units. Increased supply of serviced apartments has largely been boosted by a number of factors including their relative affordability compared to hotels, home away from home feel, security and the fact that they tend to have more space than hotel rooms.

In Nairobi alone, Westlands has the largest supply of serviced apartments with a 38.7% market share, followed closely by Kilimani at 24.0%. These areas are attractive to both clients and investors due to the proximity to CBD and the presence of several corporate offices hence availability of a ready market especially from the expatriate community.

An analysis to find serviced Apartments Performance by Region in Nairobi is shown below;

Source: Cytonn Research

To establish the most lucrative investment in the hospitality sector, we compared the Average Daily Rate, Total Revenue Per Available Room as well as Occupancy Rates between hotels and serviced apartments.

Source: Cytonn Research

Consumer Sentiments

We went further to find out consumer?s sentiments on both hotel and serviced apartment use.

On hotels? consumer sentiments, the following were the key take outs:

• Most of the respondents were Kenyans with 39.7% visiting hotels on monthly basis with most visits being for business and leisure activities.
• 9% of the users visit gym, swimming pool & spa, bar and restaurants with Wi-Fi being pointed out as an important consideration in hotel rooms
• 1% of the hotel services consumers find the prices affordable with the 15.9% who find the prices high, suggesting affordable hotel charges to be less than Kshs 10,000 per day

On serviced apartments? consumer sentiments, the following were the key take outs:

• Majority of the respondents are Kenyans and had one bedroom as the most preferred serviced apartments, at 44.0%; three bedrooms is the least preferred at 2.0%
• 0% of respondents cited gym, swimming pool & spa, restaurant & bar as the most visited sections in a serviced apartment, while business lounge is the least visited
• Bar & restaurant, business services, conference facilities, gym, swimming pool & SPA are the basic facilities sought in serviced apartments
• The average charges per night are mainly between Kshs. 10,000 ? 20,000
• 0% of the consumer?s book for their services online, a process they deem convenient as compared to manual bookings

Hospitality Sector Outlook

We used hotel supply, market performance, consumers? sentiments and investment opportunities to determine the hospitality sector outlook.

Source: Cytonn Research

In conclusion, hotels are struggling to recover from insecurity challenges that have caused a decline in occupancy and revenues while increasing costs especially with regards to security and marketing; while serviced apartments are thriving, recording high occupancy levels and high returns. The opportunity in this sector thus lies in serviced apartments in Nairobi given the high returns to investors. For hotels, the 3 & 5-star rated hotels in Maasai Mara as well as 4 Star rated hotels in Nairobi offer the best investment opportunity. They should however be differentiated by either product offering, location or customer service to attract high occupancy levels as there is an oversupply in the market.   Cytonn Hospitality Report

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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.