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Focus on Structured Products, & Cytonn Weekly Report #12

By Cytonn Research Team, March 27, 2016

Executive Summary

  • Fixed Income: Yields on government securities declined for the eighth consecutive week. The MPC maintained the CBR rate at 11.5% citing the need to anchor inflationary pressures as well as enhance the credibility of its policy stance; this was in line with our MPC note prior to the meeting. MPC Meeting Note.
  • Equities: The market was on an upward trend during the week, with NASI, NSE 25 and NSE 20 gaining 1.3%, 1.4% and 0.9%, respectively. During the week, Standard Chartered Bank Kenya, Nation Media Group and Nairobi Securities Exchange reported their FY’2015 results, registering declines in EPS growth of 28.7%, 3.6%, and 4.5%, respectively;
  • Private Equity: Increased interest in Financial services in Kenya has seen Duet Group provide Kshs 1.9 bn of debt funding to Fidelity Bank;
  • Real Estate: A directive issued by the CMA compels listed Property Developer, Home Afrika, to refund to investors Kshs 300 mn raised through a corporate bond in 2014, deepening their financial woes;
  • Focus of the Week: Our focus of the week is on structured products as a high returning alternative investments asset class in Kenya.


Company Updates

  • This week, we launched The Cytonn Real Estate Franchise, an initiative that enables entrepreneurs to operate real estate businesses under the Cytonn brand. The advantage of the franchise is that it shall let the individuals or the company operate under the Cytonn Brand, share our execution platform & technology, have access to development finance and work with the team to get superior designs. In addition to extending our brand, this initiative will accelerate the building of safe neighborhoods for families and create employment opportunities for entrepreneurs in real estate. The franchise application process remains open at: Franchise Application Process
  • We received coverage from the launch of our Cytonn Real Estate Franchise Cytonn Real Estate Franchise Launch
  • We continue to beef up the team with other ongoing hires : Careers at Cytonn


Fixed Income:

Overall T-bill subscriptions remained high this week, with the subscription rate coming in at 135.4%, but lower than 269.5% the previous week. There was a significant decline in the subscription rate for the 91-day and the 182-day treasury bills to 61.2% and 28.9%, from 61.9% and 212.6%, respectively while the subscription rate on the 364-day T-bill came in at 270.5%, up from 202.0% the previous week. The decline in participation in 91-day and 182-day treasuries is an indication that investors are expecting rates to remain low and stable in the short term. The increasing interest in the 364-day indicates that investors expect rates to increase in the next fiscal year, thus the bias towards longer dated paper, an expectation that is in line with our fixed income recommendations. Yields on the 91-day and 364-day T-bills continued on a downward trend, coming in at 8.4% and 11.9%, down from 8.6% and 12.0%, respectively, while the 182-day T-bill yield rose marginally by 16 basis points to 10.7% from 10.5% in the previous auction. In our view yields on the treasuries could have bottomed out and we could see them oscillate around the current levels in the short term.

There was tight liquidity in the money market, which resulted in an increase in interbank rates to 4.1% from 3.8% last week mainly due to reduced government maturities, which stood at Kshs 8.3 bn from Kshs 14.3 bn the previous week.

The shilling remained stable against the dollar during the week to close at 101.5 on account of (i) Monetary Policy Committee decision to hold the Central Bank Rate (CBR) at 11.5%, (ii) low dollar demand from corporates, and (iii) Fed’s decision to cut by half the number of rate increases for the year 2016. The shilling has appreciated by 0.7% on a YTD basis, and we expect the shilling to hold stable against the dollar on the back of (i) improved forex reserves currently at USD 7.4 bn, equivalent to 4.7 months of import cover, (ii) approval of a precautionary facility by IMF amounting to USD 1.5 bn, and (iii) improved diaspora remittances. However, in the short-term, we expect mild pressure on the Kenya Shilling as we enter into dividend payment season which may result into an increase in dollar demand by foreign investors seeking to expatriate their dividends.

The Monetary Policy Committee (MPC) met this week and maintained the Central Bank Rate (CBR) at 11.5% in line with our projections. The committee retained the rate and sighted the following reasons:

  1. Low inflation which declined to 6.8% in February from 7.8% in January, falling within the CBK target range of 2.5% - 7.5%. We expect inflation for the month of March to come in lower at 6.5%, still within the CBK target range. However, we also expect inflationary pressures in the short-term from the new excise duty of Kshs 1.50 on producers of excisable goods,
  2. Stability in foreign exchange rate as the shilling has held stable on the account of a (i) narrowing current account deficit to 6.9% of GDP, (ii) improved exports, (ii) increased diaspora remittances and (iv) a low oil import bill
  3. Improved foreign exchange reserves by 5.1% to USD 7.4 bn from USD 7.0 bn in January 2016, and,
  4. Improved stability of the banking sector with increased supervision by the CBK

In light of Kenya’s second review by IMF under the Standby Credit Arrangement, the IMF has revised downwards the real GDP growth forecast for 2016 by 80 basis points to 6.0% from 6.8% previously. This is on the back of (i) increased volatility of capital flows from global markets indicating that in the event of another global financial instability, net capital inflows could drop by USD 5 bn over the next 2 years, including a USD 3 bn reduction in portfolio flows and USD 1.2 bn in foreign direct investment (FDI), (ii) uncertainty on the impact of weather-related effects of El Nino on agriculture, (iii) vulnerabilities in the banking system, (iv) residual security challenges, (v) significant uncertainty about FDI in oil and gas exploration and (vi) possible pressure for higher current and capital spending ahead of the August 2017 General elections on immediate benefits to voters at the expense of public investment. We project the FY’2016 GDP growth rate to come in at 5.8% underpinned by (i) high government expenditure on infrastructure, (ii) recovery of tourism, and (iii) growth in both energy and agriculture sectors. Our view is that IMF’s initial growth forecast was very ambitious and their revised figures are more relatable to the current environment in Kenya, which has witnessed stability in key macro indicators.

The Banking (Amendment) Bill 2015, that is going through its second review, proposes a cap on interest rates charged by commercial banks on loans to a ceiling of 4.0% above the CBR rate, and a floor of 70.0% of the CBR rate on customer deposits rates. This is an attempt to reduce the spread between lending rates and deposits rates. It is our view that capping interest rates will be detrimental to the economy as (i) it will reduce credit availability as banks will only lend to individuals and business with lower risk profiles and exclude individuals with higher risk profiles. Effectively, the high risk profiles, which are more likely to be in the informal sector, will find it very hard to access credit; excluding an important segment of the economy, such as the informal sector, from accessing credit will hamper economic growth, (ii) open up avenues for unsecured parallel lending at higher rates, and (iii) fixing interest will expose the local financial institutions to regional price movements of inflation and opening opportunities for arbitrage. Our strong view is that market forces should determine rates. The best way to address the high rates is to (i) increase transparency through such a move as CBK’s move to publish quarterly bank’s lending rates, (ii) improve information on borrowers such as through credit bureau information reporting, and (iii) encouraging the development of alternative and capital markets return and loan products to compete with banking products. In summary, the populist bill would be very bad for our vibrant economy.

The government is ahead of schedule with its borrowing programme, having borrowed Kshs. 208.8 billion for the current fiscal year compared to a target of Kshs. 164.3 billion (assuming a pro-rated borrowing throughout the financial year of Kshs. 219 billion budgeted for the full financial year). Interest rates have been dropping since the beginning of February due to (i) reduced pressure on government borrowing, and (ii) high liquidity in the market. The government will continue borrowing locally to bridge the external financing deficits to date and the expected shortfall in collection by KRA. With Interest rates coming down, we advise investors to lock in their funds in short to medium-term papers of tenors between six months and one-year, as the rates are attractive, compared to long-term, on a risk-adjusted basis. 


Equities

During the week, the market was on an upward trend with NASI, NSE 20 and NSE 25 gaining 1.3%, 1.4% and 0.9%, taking their YTD performance to 1.3%, (1.0%) and 1.7%, respectively. The increase this week was on the back of gains in large cap stocks such as Standard Chartered Bank, Barclays Bank and Safaricom, which gained 8.2%, 5.5% and 2.4%, respectively. Safaricom was the top mover for the 5th week accounting for 29.2% of market turnover, while Equity Bank recorded the highest net foreign inflows of USD 1.3 mn, with investors taking advantage of a 4.9% price correction, following the stock going ex-dividend. Since the peak in February 2015, NASI and NSE 20 are down 16.9% and 27.2%, respectively.

Equity turnover fell by 46.2% during the week to USD 21.4 mn from USD 39.74 mn last week due to (i) a shorter trading week, and (ii) decreased foreign investors participation in large cap stocks. Foreign investors were net sellers but the outflows declined by 80.1% to Kshs 149.2 mn compared to net outflows of Kshs 742 mn witnessed last week.

The market is currently trading at a price to earnings ratio of 13.1x from 12.4x last week versus a historical average of 13.8x, with a dividend yield of 4.0% versus a historical average of 3.3%.

The charts below indicate the historical PE and dividend yields of the market.


Standard Chartered released their FY’2015 results

Standard Chartered Bank reported FY’2015 results, registering a decline in EPS growth of 39.2% y/y to Kshs 20.2, from Kshs 33.2 in 2014 driven by a 2.7% y/y decline in operating revenue and a 38.2% y/y increase in operating expenses. However, stripping off the one-off gain of Kshs 1.5 bn in 2014 from the sale of land, core EPS growth declined by 28.7% y/y to Kshs 20.2, from Kshs 28.3 in 2014. Key points to note are:

  1. Operating revenue declined by 2.7% y/y to Kshs 25.4 bn from Kshs 26.1 bn in 2014, while total operating expenses rose by 38.2% y/y to Kshs 16.2 bn. This lead to an increase in the cost to income ratio to 63.9% from 45.0% in 2014
  2. Decline in operating revenue was driven by a decline in loans and advances uptake by 6.2% to Kshs 115.1 bn from Kshs. 122.7 bn in FY’2014 which subsequently reduced the interest charged on loans by Kshs 0.8 bn. Non-funded income declined by 11.3% to Kshs 7.2 bn from Kshs 8.2 bn in FY’2014 resulting into a revenue mix of 76%:24% funded to non-funded income, respectively
  3. Operating expenses rose by 38.2% on the back of (i) a higher increase in staff costs, which rose by 8.6% y/y to Kshs 6.1 bn from Kshs 5.6 bn in FY’2014, and (ii) an increase in loan loss provision (LLP) by 274.2% to Kshs 4.9 bn from Kshs 1.3 bn in FY’2014 driven by the increase in non-performing loans; it appears Standard Chartered Bank must have experienced some lumpy loan losses to almost quadruple LLP from Kshs. 1.3 bn to Kshs. 4.9 bn
  4. Interest income grew 3.4% to Kshs 22.8 bn from 22.1 bn in FY’14 while Interest expense grew 13.4% to Kshs 4.7 bn from Kshs 4.2 bn in FY’14, resulting in a net interest margin of 9.73% from 9.77% in FY’14
  5. The bank reported an 11.7% y/y increase in customer deposits to Kshs 172.0 bn from Kshs 154.0 bn in FY’2014. Unlike the trend of banks that have reported so far, deposit growth outpaced loan growth, which declined 6.2% y/y to Kshs 115.1 bn from Kshs 122.8 bn in FY’2014. This resulted in a decline in the loan to deposit ratio to 66.9% from 79.7%
  6. Non-performing loans rose significantly by 36.7% to Kshs 14.7 bn, from Kshs 10.8 bn resulting into an increase in NPL to total loans ratio to 12.8% from 8.8% in FY'2014
  7. The bank’s total capital to risk weighted assets ratio came in at 21.2% in 2015 from 19.8% in 2014, 6.7% above the statutory requirement of 14.5%

Standard Chartered Bank’s results were poor, owing to increase in non-performing loans. Moving forward, the bank needs to (i) address the risk framework of the its customers so as to reduce loan default rates that are impeding the growth of the bank, and (ii) rework on their deposit gathering, and loan disbursement capabilities, especially to the corporate and SME sector. However, similar to Barclays, the bank will suffer from not adapting to local methods of deposit mobilization e.g. agency banking, which has seen them overtaken by local banks such as Equity and KCB, which have successfully embraced this deposit gathering, and loan disbursement model to remain competitive. For more details on Standard Chartered, please see our earnings note Standard Chartered Earnings Note.

Of the banks that have reported so far, Standard Chartered Bank joins Co-op Bank as the only bank so far to report deposit growth greater than loan growth, though Standard Chartered went a step further to be the only bank so far to register a decline in loan growth. The average growth in core EPS across the banking sector stands at 3.3% compared to 9.3% last year, with the slowdown attributed to the tough operating environment in 2015.

Bank

Core EPS Growth

Deposit Growth

Loan Growth

Net Interest Margin

Co-op Bank

25.1%

21.9%

16.2%

8.8%

KCB Group

12.1%

12.5%

21.9%

7.9%

DTB

11.5%

20.6%

29.0%

6.5%

Equity Group Holdings

1.0%

23.1%

26.0%

10.5%

Barclays

(0.2%)

0.2%

15.9%

10.2%

NIC

(2.6%)

11.9%

13.7%

6.1%

CFC

(13.7%)

18.7%

26.6%

6.4%

HF

(18.5%)

15.4%

17.2%

6.3%

Standard Chartered

(28.7%)

11.7%

(6.2%)

9.4%

Weighted Average*

3.3%

16.2%

19.3%

8.8%

*Averages are market-cap weighted


Nation Media Group Released FY’2015 Results

Nation Media Group (NMG) announced FY15 earnings, with EPS declining 9.7% y/y to Kshs 11.8 from Kshs 13.1, as a result of a decline operating revenue of 7.6% y/y, despite operating expenses declining by 2.2% y/y. Key to note:

  1. The decline in operating revenue outpaced that of operating expenses, declining by 7.6% to Kshs 12.3 bn from Kshs 13.4 bn in FY’2014, while operating expenses shrunk 2.2% to Kshs 9.5 bn from Kshs 9.7 bn in FY’2014. Its flagship product, the Daily Nation, saw its revenue decline 5.0% y/y as a result of reduced print readership, with the revenues from TV also adversely affected by the analogue switch off during the digital migration
  2. Revenue from other East African countries declined by 19.0% y/y given the paper had been barred from circulation in Tanzania for most of the year, although business is slowly reverting to normal and the sales picked up greatly during the elections period in Tanzania. Revenues from the “Business Daily” rose only 1.0% y/y
  3. Gross profit margin declined marginally from 81.0% to 80.1%, however, given the commissioning of the printing press, which is set to reduce their newspaper production costs by at least 25%, the margin is expected to improve in 2016
  4. The commissioning of the USD 20 mn ultra-modern printing press also presented to them an investment deduction allowance on their taxes and the tax expenses declined 48.1% y/y to Kshs 601.0 mn
  5. Other items that affected the business in 2015 included losses on forex currency translations of Kshs 132.3 mn and an increase in provisions of doubtful debts of Kshs 192.2 mn, although these were mostly due to delays in payment by the government which accounts for almost 25% of their top line advertising revenues and the ban on the East African in Tanzania which dragged on for several months.
  6. The Board resolved to maintain the dividend of Kshs 10.0 a share for the fourth year running, with a final dividend of Kshs 7.50 being declared, after the Kshs 2.50 Interim dividend was paid earlier in 2015

Moving forward, our view of the company is that its profitability will benefit greatly from the more efficient printing press. How effectively they are able to harness advertising revenues from their digital platforms will also be a major contributor to their revenue growth, given online viewership of Daily Nation has grown from just over 20 mn page views in 2012 to almost 90 mn in 2016, while that of Business Daily has grown from just over 1 mn page views in 2012 to about 2.7 mn currently. However, it remains a concern that the company’s core revenue line, print media, has been on a downward trajectory due to competition and a shift to digital media by the youthful population, a trend that is expected to continue. This raises huge concerns, considering the company has invested in a Kshs 2.0 bn new plant.


NSE Limited Released FY’2015 Results

NSE Limited recorded a decline in core EPS of 4.4% y/y to Kshs 1.57 from Kshs 1.64 in FY’2014 driven by a 3.9% decline in the company’s operating revenue and a 15.1% rise in operating expenses from FY’2014. Key points to note include:

  • Operating revenue decreased 3.9% y/y to Kshs 616.8 mn from Kshs 641.7 mn in FY’14 driven by decline in turnover, with equities turnover declining by 3% to Kshs 419 bn from Kshs 431 bn in FY’14, while the secondary fixed income markets turnover declined by 39.7% to Kshs 610 bn from Kshs 1,012 bn in FY’14. This was mainly due to the poor performance of the stock market in 2015, as a result of interest rate and currency volatility, as well as the re-introduction of the capital gains tax.
  • Earnings before tax declined 13.7% y/y to Kshs 381.5 mn from Kshs 441.8 mn in FY’2014 driven by a 15.1% rise in the administration expenses to Kshs 448.3 mn from Kshs 389.5 mn, following the development of new products like the derivatives markets to be launched in 2016

Moving forward, the exchange will be looking to increase the number of listings on all market segments with a focus on Growth Enterprise Market Segment (GEMS), the Real Estate Investment Trusts (REITs) and an upgrade of the Automated Trading System (ATS) which will enhance the new product and service offering and improve on availability to its trading members. This should improve investor participation in the capital markets, which will translate to higher revenues for NSE.

Below is our Equities recommendation table: The key changes for the week include:

  • Pan Africa has moved from accumulate to buy given the 15.8% price drop during the week. This follows the company’s earnings announcement last week where they announced a 32.1% decline in core EPS. 
  • Given the recent developments in Uchumi, with (i) the closing of 5 branches, and (ii) lawsuits with suppliers seeking a winding down over non-payment, we have suspended Uchumi from our recommendations list pending comprehensive review. See our latest summary note on Uchumi

No.

Company

Price as at 18/03/16

Price as at 24/03/16

w/w Change

Target Price*

Dividend Yield

Upside/ (Downside)**

Recommendation

1.

KCB

41.3

42.0

1.8%

59.1

5.5%

46.1%

Buy

2.

Barclays

11.8

12.4

5.5%

15.5

7.8%

32.8%

Buy

3.

Pan Africa

47.5

40.0

(15.8%)

52.8

0.0%

32.0%

Buy

4.

Centum

45.0

45.0

0.0%

57.2

0.0%

27.1%

Buy

5.

Equity

41.8

40.8

(2.4%)

48.6

5.2%

24.4%

Buy

6.

Britam

10.9

11.0

0.5%

13.4

1.3%

23.7%

Buy

7.

Stan Chart

207.0

210.0

1.4%

247.9

5.5%

23.5%

Buy

8.

Kenya Re

20.0

19.8

(1.0%)

23.5

3.3%

22.0%

Buy

9.

DTBK

211.0

210.0

(0.5%)

250.1

1.3%

20.4%

Buy

10.

NBK

15.0

14.6

(2.7%)

16.8

0.0%

15.7%

Accumulate

11.

NIC

40.0

40.8

1.9%

45.4

2.7%

14.1%

Accumulate

12.

I&M

100.0

100.0

0.0%

110.5

2.6%

13.1%

Accumulate

13.

Liberty

16.5

16.0

(2.7%)

16.7

0.0%

4.6%

Lighten

14.

Safaricom

16.5

16.9

2.4%

16.6

5.1%

3.4%

Lighten

15.

HF Group

20.5

21.0

2.4%

20.1

5.7%

1.4%

Lighten

16.

CIC Insurance

6.1

6.0

(2.5%)

5.8

1.8%

(0.9%)

Sell

17.

Jubilee

472.0

468.0

(0.8%)

440.7

1.5%

(4.3%)

Sell

18.

Co-op bank

20.3

20.8

2.5%

18.0

3.8%

(9.3%)

Sell

19.

CfC Stanbic

86.5

94.0

8.7%

77.2

0.0%

(17.9%)

Sell

*Target Price as per Cytonn Analyst estimates

**Upside / (Downside) is adjusted for Dividend Yield

Accumulate – Buying should be restrained and timed to happen when there are momentary dips in stock prices.

Lighten – Investor to consider selling, timed to happen when there are price rallies

Data: Cytonn Investments

We remain neutral on equities given the low earnings growth prospects for this year. The market is now purely a stock picker’s market, with few pockets of value.


Private Equity

According to a Business Daily article, Fidelity Bank has received Kshs 1.9 bn debt funding from Duet Group through its Duet Private Equity Fund, to fund the bank’s planned regional expansion as well as to shore up the bank’s core capital. The deal, if it closes, will see the Tier 3 bank grow its capital base to Kshs 3.8 bn as it works towards listing on the Nairobi bourse. Fidelity’s total risk weighted assets stood at 16.4% as at Q3’2015, against Central Bank requirement of 14.5% putting a strain on the bank’s lending business due to the narrow buffer. The bank indicated that they will now (i) have the capacity to expand from the current 14 to 28 branches across East Africa by 2018, and (ii) fund the planned construction of its headquarters offices valued at Kshs 700 mn in Westlands. In our view, the bank should focus on attracting deposits and mobilising their branches to increase deposits per branch, rather than a focus on opening new branches and building corporate headquarters.

The East Africa Venture Capital Association in conjunction with consulting firm RisCura this week published the East Africa Private Equity Dashboard report. The report highlighted the tough operating environment investors experienced in East Africa as a result of high interest rates, increase in inflation and currencies depreciation as well as exogenous factors such as the China slowdown and US Fed policy which led to the increase in the benchmark rate to 0.25% to 0.50% that started at the end of 2015. Nevertheless, the survey which involved 16 funds operating in East Africa, showed over half of funds were focused on growth capital injection at 51%, with 5% of investments going into venture capital initiatives. Kenya also emerged as the top investment destination in the region followed by Tanzania and Ethiopia which has witnessed more deals since the World Trade Organization Forum that called for the country to be more open to external investors. Deals have also been focused on the financial, FMCG sectors and energy sectors which took up 81% of total invested capital in the region driven by the favourable demographics in the region and the growing middle class with more disposal income as well as higher demand for more diversified energy solutions.

The Private equity sector continues to gain lots of prominence given that (i) private equity continues to give a higher return to investors compared to traditional investments like equities and fixed income, (ii) East Africa has proven a safe investment haven given the recent peaceful elections in the region, (iii) the infrastructure projects that have been rolled out by the government such as the standard gauge railway, (iv) anticipated oil exploration initiatives, and (v) the regions high GDP growth projection at 5.5%.

Private equity investment 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 private sector, and (iii) better economic growth projections compared to global markets.


Real Estate

According to a Standard digital article, the Capital Markets Authority has ordered Home Afrika to refund amounts raised from a bond issued in 2014, citing that the company was in contravention of the terms of approval through marketing the bond as a partially secure bond and purporting to revise the coupon rate to 17%, to make the bond more appealing to potential investors. Home Afrika, the only property development company listed on the NSE, issued the 5-year bond aiming to raise Kshs 900 mn with a return rate of 13.5%. The issue was however unsuccessful as it did not meet the minimum subscription level of Kshs 500 mn, managing to secure Kshs 301 mn after revising the return rate to 17%. The revised rate was an indication of investor’s perception of Home Afrika’s instruments as highly risky.

Proceeds from the issue were expected to fund three real estate projects, namely Migaa in Kiambu, Lakeview Heights in Kisumu and Llango in Kwale. However, the undersubscription caused delays, forcing the company to obtain a Kshs 500 mn facility from commercial banks. Home Afrika has since recorded a 90% fall in Profit after Tax from Kshs 80 mn in 2013 to Kshs 9 mn in 2014, and has issued a profit warning for the year ended December 2015.

The fact that Home Afrika had to offer a higher rate in order to get the Kshs 301 mn participation indicates that book building approach to placing orders, where investors indicate the price at which they are willing to participate, is an offering feature we should consider incorporating into our capital market.

State to fund Local Builders

The Government has proposed to fund local contractors to the tune of 20% of project cost for large projects as the industry faces a surge of South African and Chinese firms. The National Construction Authority has noted that Chinese Companies have taken over most multi-billion projects in Nairobi with only 22 local firms registered as category one providers (contractors capable of handling projects of above Kshs 500 mn). 70% of Kenyan firms are registered as fit to handle small projects that are mostly found in counties.

In order to support local contractors, the National Contractors Development and Guarantee Fund will enable them compete for multibillion projects by providing them with a project guarantee of up to 1/5th of the project costs. The fund will also enable them to lease equipment at a fee to compete with well-endowed foreign firms.

The real estate sector contributes up to 9% of Kenya’s GDP. The increased activities in the sector in terms of volume and magnitude have attracted multinational construction firms. Judging from setting up of one-stop shops in Kenya, these firms have a positive take in the industry’s outlook, indicating sustained activities in the sector for the foreseeable future. The funding of the local contractors is also set to make the industry more competitive, as the foreign companies may seek to lower their charges and adopt innovative techniques to maintain their competitive advantage. Development companies are therefore likely to benefit from reduced construction costs in the near future. Local contractors ought to consider partnering with other local or international firms so as to have an advantage in terms of expertise and funding, enabling them clinch large contracts.

However, we need to recognize that with globalization, we will not be able to sustainably protect or subsidize local contractors. In the longterm, the winning contractors will be those who are able to both execute efficiently and attract the cheapest capital. In addition to funding local builders, the state needs to consider requiring knowledge transfer and also minimum employment of locals.

Eastern Bypass attracts Industrial Development

Vikken 30 Industrial Park Ltd has announced plans to start construction of 250 go-downs on a 48-acre piece of land along the Eastern Bypass. Their objective is to create space for industrial and manufacturing activities as well as storage of raw and finished goods.

The main advantages of its location include:

  1. Proximity to the Eastern Bypass that connects to Mombasa Road, a major transport route for goods, and,
  2. Proximity to international airports, such as JKIA, making them convenient for storage of exports as well as imports that use air transport

The development is backed by the ever-increasing demand from new establishments and expansion of existing manufacturing entities. Data from KNBS indicates that the Kenyan manufacturing sector is currently growing at a rate of 3.4%.

We expect an increase in the setting up of more warehouses, especially with infrastructural developments along the bypasses, the Standard Gauge Railway (SGR) and the Lappset Corridor. Furthermore, we expect an increase in demand for warehouse space, with establishment of Special Economic Zones (SEZs), once the pending Special Economic Zones Bill is approved. The Bill proposes numerous tax incentives for the SEZs, which encompass manufacturing, commercial, service, agricultural as well as horticultural activities. These incentives are likely to attract numerous businesses, which will in turn require storage space for their export goods.

Our team carried out a research on warehouses in main industrial nodes within the Nairobi region, that is, Mombasa Road, Industrial Area and Baba Dogo. The average rental yield in this sector is 6.2% with the key determinant of the yield being location. Baba Dogo area recorded the highest rental yields at 7%, the main driving factor being high occupancy and rental charges due to its proximity to the Thika Superhighway. Nairobi’s Industrial area emerged as the best for investment with total returns of up to 11%, driven by its proximity to the JKIA, the Eastern Bypass as well as presence of many manufacturing companies in this location.

 For a more comprehensive insight into the real estate warehouse market, please see our Real Estate Warehouse Note

Focus on Structured Products

In reference to our Focus of the week in May 2015, where we focused on structured products, it was in the investors’ best interest to discuss the topic again considering the recent poor performance of the traditional investments (equities and fixed income, where we are neutral on their performance). This has led to investors seeking investment opportunities in the alternative asset classes such as structured products, which deliver above average returns over the long term.

Having discussed our view on equities and fixed income investments last week, we will now delve into alternative investments, starting with structured products: we will describe what they are, how the products are able to achieve higher returns, discuss the benefits and challenges of structured products, and give an investable example.

Structured products are investment solutions that are packaged by investment professionals to enable an investor access a return, supported by the performance of an underlying investment, in a form that meets an investor’s need, which would not be met from the standardized financial products broadly available in the market. Structured products tend to have the following characteristics:

  1. They involve adding layers or features, the so called “structuring”, to traditional products such as stocks, bonds and bank deposits, as well as alternative products like real estate and private equity, the so called “underlying investment” so that the layers or features converts the underlying into a product that meets the risk appetite of the investor,
  2. They generally deliver higher returns than comparable traditional investments,
  3. The most popular structured products tend to have principal protection, coupled with an above average yield return, and,
  4. They are generally traded in the private markets to qualified or sophisticated investors through alternative investment managers such as private equity managers.

Examples of structured products include structured notes, structured deposit placements, convertible bonds, equity linked notes and cash management solutions, “CMS”.

Structured products tend to offer higher returns because the alternative investment manager, based on their understanding of a riskier and more volatile underlying asset, repackages the asset into a form that an investor is accustomed to but at a higher return than similar alternatives, and the manager enjoys the difference between what is offered to the investor and the actual return of the underlying asset. For example, an investor seeking yield with a one-year investment horizon would get a better return in a CMS product compared to a bank or a money market product:

Locally, private equity firms have resorted to the development of structured products as a source of raising funds for financing high return projects in private equity and real estate and distribute them through private offers, as defined in the capital markets regulatory framework. Examples of such products offered locally include private commercial paper, real estate backed Medium Term Notes (MTN’s) that enable real estate developers to access affordable funds for their projects, and the Cash Management Solutions that take advantage of economies of scale and get better returns for High Net Worth Investors. Specific local examples of successful structured funding through private markets include:

  1. Nakumatt’s private commercial paper programme has been an important and significant source of funding the company’s growth even as it has delivered above average return for the investors. With an estimate of over Kshs. 6 bn programme, this demonstrates the potential depths of capital markets in Kenya, we don’t think Nakumatt would have managed the kind of growth that it has managed without access to structured products
  2. Centum’s Equity Linked Note (“ELN”) placement to investors was done in a relatively short period of time to raise capital in a timeframe that would not have been possible with a registered offering. ARM has also issued ELNs to investors.
  3. Cooperative societies, anchored under the Co-operative Societies Act, have also participated in structured products - Safaricom Investments Cooperative issued a real estate backed MTN yielding 21% for 18-month duration to finance their Ngong Ololua Villas
  4. Cytonn Real Estate, our development affiliate, has successfully issues billions of shillings of structured notes, mainly to global institutional investors, to fund developments. The amount of money raised and the speed could not have been possible through mainstream public markets
  5. The various privately offered Cash Management Solutions, CMS, structured by various investment houses

The above examples demonstrate that the market for structured products is significant, is gaining broad acceptance and is critical to funding growth.

The attractiveness of structured products to investors is due to a number of reasons namely,

  1. Potential for Principal Protection: Structured products are designed to secure the principal of the investor, unlike traditional investments like equities, which may reduce the investor’s principal. Structured products are backed by an underlying asset, which doesn’t negatively affect the principal, such as fixed deposits and real estate, and the structuring manager typically holds the risk incase the underlying asset underperforms,
  2. Enhanced Returns: The alternative products manager, given their skills and experience, is able to take an underlying riskier asset, such as real estate, structure it into a yield product, offer a higher return to the investor that is greater than other yield products such as fixed deposits or money market funds,
  3. Reduced Volatility: Structured products are usually backed by alternative assets, such as real estate and private equity, which are not subject to market volatility, which in turn reduces volatility over the period of investment, with most structured products offering fixed rates of return to their investors,
  4. Inflation Hedge: Structured products have consistently generated returns above inflation rate, ensuring investors are earning a “real return” and increasing the purchasing power of the investor,
  5. Diversification: They enable the investors to diversify their portfolio away from traditional assets, which reduces investment risk, and,
  6. Enhanced Self Regulation and Protection: Given that the participants in private markets and structured products tend to be more sophisticated and discerning, the due diligence, evaluation and analysis of products tends to be more rigorous.

Structured products are not just critical for investors for the attractiveness discussed above, they are also critical to capital markets development and the economy for several reasons;

  1. Attracting local capital seeking high yielding investments: Since they have high risk-adjusted returns, they provide an alternative to investors who have a high-risk appetite for higher returns than they would otherwise get in public markets. Local investors previously had to go offshore for attractive opportunities such as structured notes, but with the recent development of structured products in Kenya, local investors have been able to find attractive investment opportunities,
  2. Increase Foreign investments into the country: Structured products have also opened up the Kenyan market to global institutional investors seeking above average returns,
  3. Capital market and private markets deepening: Over half of the Kenyan economy is not in the listed markets, which account for only 49% of the economy. The balance of the markets is in the private markets. An active private market, fueled by structured financing, is crucial to the accessing of funding by the private economy,
  4. Product development and innovation: The complexity, speed and innovation that accompany structured products helps with product development, enhancement and pricing in the public markets since both markets are complementary,
  5. Growth of the capital intensive sectors e.g. real estate. Most of the major real estate developments in the country currently are being funded, in some part, by structured products to sophisticated investors, as a form of fund raising for the various projects. This has in turn led to creation of jobs and improving the living standards of people as well as growing the economy in general. In fact, various banks have recently made a decision to reduce or simply stop funding real estate developments. Without structured products, the already under-financed real estate sector would face further financing challenges

However, like any other initiative, structured products face various challenges:

  1. They tend to be complex, opaque and hard to value or even understand. This then limits their growth,
  2. Continuous education of potential investors to understand the products and returns prospects of the product and how they fit into their portfolios,
  3. The urge to bring the industry under the frameworks of public markets can be tempting, however, this would end up driving away private market capital that is not seeking to play in the widely accessible and generic returns of the public markets

In conclusion, there is significant room for growth of the structured products markets and they shall significantly contribute to the deepening of the capital markets as well as the growth of the economy. We cannot achieve our goal of being a financial services hub without active and vibrant structured products and private markets activity, which are crucial to financing a growing economy and complementary to mainstream bank debt financing.

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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.

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© 2017 Cytonn Investments Management Ltd