Kenyan Banks_Anchor themes_regionalisation and mortgage lending_BUY KCB_SELL Coop

KENYAN BANKS

Our anchor themes: Mortgage lending and regionalisation We add to our coverage on Kenyan banks; BUY KCB;

SELL Cooperative: We initiate coverage on Barclays Bank Kenya [Barclays, HOLD]; Co-operative Bank of Kenya [Co-operative, SELL]; Kenya Commercial Bank Group [KCB, [BUY]; and Standard Chartered Bank of Kenya [StanChart, HOLD]. We also follow up our coverage on Equity Bank [BUY], bringing our coverage on Kenyan banks to 5, and covering the 5 biggest banks. KCB is the only stock that provides significant potential upside risk, in our view.

The industry is fragmented, but high liquidity level could protect deposit margins in the short-term: The Kenyan banking system has 44 registered commercial banks. While it is moderately penetrated, with a banking assets/GDP ratio of ~52%, we believe in the long-term competition is going to reduce spreads materially. However, sustained economic growth and current high liquidity levels suggests higher loan yields and controllable competition on deposits, thus cushioning banks from margin erosion, in the short-term. The moral suasion from the Central Bank of Kenya (CBK) for banks to reduce their lending rates remains a consequential risk.

Anchor themes: Mortgage lending and regionalisation: We believe the mortgage market is going to play a key role in the system’s loan growth given the low penetration level. Mortgage loans/GDP is a mere 2.48%. Banks are also seeking exposure to regional demand and KCB and Equity Bank already have regional footprints. The risk is that execution risks may be under-played. For e.g., KCB is yet to breakeven in most of the markets, while Equity bank suffered a loss of Kes700mn in Uganda.

Stock catalysts: The bottom line is: making money matters. Higher earnings growth supported by 1) a recovery in government paper yields as most of the banks carry significant government paper (i.e. lower LDR and higher liquidity ratio); 2) strong loan growth, particularly mortgage loans that still has material room for growth and 3) improvements in efficiencies and exploitation of non-interest income revenue streams should be key catalysts.

Key sector risks: 1) An adverse rain season always have a negative impact on a) loan growth from the agricultural sector and b) credit risk as default risks increases; 2) We also believe that political risks remain elevated, notwithstanding the GNU. The political risks can manifest themselves in poorer fiscal policies than expected; and 3) a weaker than anticipated global economic environment remains a major risk.

Peter Mushangwe Lawrence Madzwara +27 11 551 3675 [email protected]

March 17, 2011

African Markets

Sector View CONTRUCTIVE

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Table of Contents

1. Summary of conclusions 2 1.1 Valuations, recommendations & sensitivity analysis 2

1.2 ROE decomposition 8

1.3 CAMEL ratios analysis 9

1.4 Share price performances 11

2. Industry analysis 13 2.1 Overview: Fragmented; Locals gaining market share 13

2.2 Sizing up the Kenyan market: Future looks bright 18

2.3 Profitability: Resilience in face of global turmoil 22

2.4 System Liquidity: High liquidity, negative to margins 27

2.5 Asset quality: Our major source of vulnerability 30

2.6 Solvency: High capital; low capital management 33

2.7 Political risks: Strong GDP growth expectations 35

3. Companies 37

Initiating Barclays Bank, FY11 TP Kes62.8, HOLD 37

Initiating Cooperative Bank, FY11 TP Kes17.3, SELL 42

Initiating KCB Bank, FY11 TP Kes27.6, BUY 48

Initiating Standard Chartered, FY11 TP Kes265.8, HOLD 53

Follow up on Equity Bank, FY11 Kes27.9, Upgrade to BUY 59

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1. Summary of conclusions 1.1 Valuations, recommendations and sensitivity analysis

We initiate coverage on 4 more banks; now coverage

universe is Top 5 banks: We initiate coverage on Barclays Bank Kenya (Barclays, HOLD); Co-operative Bank of Kenya (Co-operative, SELL); Kenya Commercial Bank (KCB, BUY); and Standard Chartered Bank Kenya (StanChart, HOLD). We follow up on Equity Bank Limited (Equity, BUY (speculative), taking our coverage universe to 5 of the biggest banks in Kenya. The combined market value of our coverage is ~Kes398.4bn (~US$4.8bn). This makes up ~35% of the market capitalisation.

We subject all the banks to the same valuation methodology - the Justified Price/Book value ratio (PBVR) method. We estimate the Justified PBVR of each of the banks under our coverage using the equation: Justified PBVR = (ROE-CoE)/(CoE-g); where ROE = return on equity; CoE = cost of equity/required return and g is sustainable growth rate. We assign different CoE and g for each bank as we seek to capture specific risks. On average, g approximates expected nominal GDP growth. (~12% i.e. ~6% real growth rate + ~6% inflation rates). Our FY11 target price (TP) is a product of the Justified PBVR and our FY11 book value per share (BVPS) estimate. In some instances, sum-of-the parts method could be more appealing, but again at the core of valuing the various business segments is the estimation of the fair multiple anyway. (Price/Earnings ratio (PER) or PBVR in most instances).

Growth rates - Theory vs. our assumptions: Our assumptions of sustainable growth rates stay close to the expected nominal GDP growth rate of ~12%. We subjectively adjust the growth rates obtained using the classic sustainable growth rate formula of Retention ratio times ROE in order to capture our expectations. 1) Barclays’ theoretical growth rate is 8.6% but we increased it to 12% to capture growth that could be sustained by the high Capital Adequacy Ratio (CAR) and liquidity ratio. This growth rate matches the expected nominal GDP growth; 2) Cooperative’s theoretical growth rate is 15.1%. We reduce it to 14.75% due to the minimal regional exposure; 3) KCB’s theoretical growth rate is 11.3%. We have enlarged the growth rate to 12.5% to capture regional demand; 4) For Stanchart’s we use the theoretical sustainable growth rate of 11.83%. This is lower than Barclays’ growth rate (which we have assumed to grow at nominal GDP growth of 12%) due to lower CAR hence asset growth could be benign. This is the only bank which we apply a growth rate that is less than expected nominal GDP growth; and 5) Equity’s theoretical growth rate of 14.6% is reduced to 13.5% in order to reflect our concerns with further market share acquisition given the number of accounts the bank already hold.

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Why BUY KCB? Valuation risk is important to consider in addition to our anchor themes of regionalisation and mortgage financing. With a trailing PER and PBVR of 9.1X (2010 EPS) and 1.7X respectively, KCB is the “least expensive” in our coverage universe. (note that excluding exceptional items, Barclays’ PER is 11.5X). The share has also underperformed its peers (see section 1.3). But it does not end there. We do not see major risks to earnings growth, and we expect them to grow by 43% (vs. +77% for FY10) and a forward dividend yield of 7.8% for FY11. The CAMEL ratios are also strong. The bank has managed to grow its deposits by a compounded annual growth rate (CAGR) (07-10) of 28% (second highest to Equity Bank) while loans registered a growth rate of 32%. Non-interest income CAGR over the same period is an acceptable 25%. With a CAR of 14.9% (vs. statutory requirement of 12%) and a liquidity ratio of 28% (vs. statutory requirement of 20%), we believe the bank has room to grow its risk-weighted assets (RWAs), benefiting particularly from its regional penetration. Being the largest bank in terms of deposits with ~13.7% of system deposits enables it to create significant scale in different consumer products.

Why BUY Equity? For Equity Bank, our recommendation carries less conviction than before. We have a fair value of Kes25.1 using the Discounted Future Earnings model, and a FY11 TP of Kes27.9 using the Justified PBVR which we have applied in valuation of all the banks under our coverage. Our upgrade (from our previous HOLD recommendation) is pivoted on the recent share price decline which has taken our potential total return into a BUY territory (i.e. >15%). The share price has lost 7.5% on a Year-to-Date (YTD) basis. Considering that the share has ascended by 58.7% in the past 12 months, we are speculative BUYers. At the risk of sounding like a technical analyst, we believe the share price is susceptible to profit taking in the face of a negative market sentiment. But investors should never sell a good company!

Why SELL Cooperative? We like the diversified deposits base of the bank, and in our view, the CAMEL ratios are not significantly worse than peers. However, we believe a 5-year average ROE of <20% and a PBVR of 3.1X indicates meaningful disconnect between valuation and fundamentals. Our Justified PBVR is 2.3X. Our forward PER is 10.2X. We fail to identify the reason(s) for this premium valuation. The bank does not fare highly on our anchor themes – regional exposure yet to take off and a relatively small mortgage loan book. Its mortgage business is still small (market share 0.4%) that even an aggressive growth of the mortgage loan book should not make meaningful contribution in the short-term. The CAR is only better than StanChart’s. The bank carries the most NPL overhang risk given that provisions have only grown by a CAGR of 4.4% vs. loan growth of 31% between CY07 and CY10. Provisions/loan ratio averaged 1.1% between CY07 and CY10 vs. an average of 1.4% for the Top 5 banks. Structurally, we think Cooperative bank is inferior to peers as indicated by 1) higher cost

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of liabilities 2) relative low asset rotation and ROA and 3) relative higher leverage yet ROE remains average. (see section 1.2 – ROE decomposition for more detail). The share price has appreciated by 83.4% in the past 12 months and we do not see upside risk at the current valuation level and the risk of a pull-back is high.

Why HOLD Barclays and StanChart? For these two, regional play is out of question as we do not see them expanding outside Kenya. They have also been losing their market shares. (see section 2.1 and section 2.3). Deposits and asset growth has been highly constrained between CY07 and CY10. Barclays’ loan and advances CAGR is -6%; StanChart is 15% vs. 45% for ‘local banks’. (see Fig 2). The banks’ (Barclays and Stanchart) strategy of lower but quality credit growth is not necessarily bad as lost asset growth could be recovered with improving economy, but we doubt the willingness of these banks to play more in the less penetrated mass/consumer market. Banks with higher market shares benefit from scale and enjoy relative higher ROAs and ROEs, (see Fig 3). For both banks higher ROEs seem to have been more a result of capital management (i.e. higher dividend payout ratio (average of 78% for StanChart; Barclays increased its payout ratio to ~70% in FY10 from 55% in FY09. However, despite the higher valuation risks, we like 1) the higher ROA that are reflective of efficiency. The banks enjoy lower cost of liabilities at 1% for Barclays and 1.2% for StanChart (average for the other 3 banks is 1.8%). 2) the superior return/risk weighted assets – 7.3% and 6.6% (Barclays and StanChart in that order) which indicates efficient use of capital; and 3) the low expense ratio and cost/income ratio for StanChart.

We value Barclays at Kes62.8, (FY11 TP; Justified PBVR 3.2X using a CoE of 17.3%) and thus providing a potential total return of a meagre 1%. The share price is susceptible to a 5.5% decline, going by our valuation. However, the key attraction we indentify from Barclays is its ability to engage in active capital management through either share buy-backs or dividend hikes given the high level of capital. This already happened in CY10 where the payout ratio ascended to 69% from 55% in CY09. We maintain a payout ratio of 70% and our forward dividend yield of 6.6% is attractive.

For StanChart, our FY11 TP is Kes265.8, (Justified PBVR 3.9X; CoE of 17.5%) giving a potential total return of 7.9%. While StanChart continues to maintain a high payout ratio, the low CAR could hinder it going forward as the bank could choose to retain capital. Nonetheless we model a dividend payout ratio of 70%. (vs. average of 79% between FY05 and FY10).

Why we use the PBVR and Sensitivity analysis: The PBVR method is often preferred in valuation of finance companies and banks. There is also strong empirical evidence that differences in PBVR captures differences in the long-run returns of companies. For Kenya, we note that the Top 30 companies’ PBVRs display a positive relationship with returns (see Fig 5). We subject our CoE and the ROE to sensitivity analysis. (see Fig 6). There is no easy

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upside on Barclays and StanChart. KCB and Cooperative shares would benefit from an uptick in ROEs. It important to note that despite our SELL recommendation on Cooperative bank, we are not exceptionally critical of the business model, which we believe, should benefit from its consumer segment but we are concerned by the valuation risks.

Fig 1: Salient valuation metrics and our recommendations; BUY KCB, SELL Coop

Barclays Cooperative Equity KCBStandard Chartered

Current price 66.50 18.25 24.75 22.25 262.00FY11 target price 62.80 17.34 27.94 27.63 265.80Shares in issues 1,357,884.0 3,492,369.9 3,702,772.0 2,950,169.1 287,077.1Market cap (Kes,000) 90,299,286 63,735,751 91,643,607 65,641,263 75,214,209Current market value (US$, 1,078,845 761,479 1,094,906 784,244 898,617Trailing PER (2010 EPS) 8.5 13.9 12.9 9.1 14.0Forward PER (Legae est.) 10.7 10.2 8.0 6.4 10.8Trailing PBVR 2.9 3.1 3.4 1.7 3.7Forward PBVR 3.4 2.4 2.3 1.4 3.8Forward Div. Yield 6.6% 2.0% 5.0% 7.8% 6.5%Growth rate (RR times ROE) 10.1% 15.1% 14.6% 11.3% 11.8%ROA (2010) 6.1% 3.0% 5.0% 2.9% 3.8%Return on RWA 7.3% 4.1% 7.9% 4.7% 6.6%ROE (2010) 33.7% 22.4% 26.2% 18.4% 26.4%Cost/Income (2010) 54.0% 58.9% 59.6% 61.0% 42.6%Trailing 12‐month price cha 29.1% 83.4% 58.7% 4.4% 42.2%Potential upside 1.0% ‐3.0% 17.9% 32.0% 7.9%Recommendation HOLD SELL BUY BUY HOLD

Source: Company reports, Bloomberg, Legae Securities, prices cob 11/03/11

Fig 2: Growth rates: Strong for local banks; Coop’s provisions growth lags loans.

Barclays Cooperative Equity KCBStandard Chartered

Key growth rates (CAGR 07‐10)Deposits 4% 31% 49% 28% 11%Loan and advances ‐6% 31% 53% 32% 15%Net Interest income 11% 27% 62% 32% 15%Non‐interest income 11% 20% 50% 25% 12%Pre‐provision earnings 11% 24% 56% 29% 14%Provisions 20% 4% 322% 42% 29%Earnings 29% 34% 56% 34% 16%

Source: Company reports, Legae Securities

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Fig 3: ROA vs. market share: Higher market share beneficial to ROAs and ROEs

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Source: CBK, Legae Securities

Fig 4: Salient income statement and balance sheet items growth rates and LDR

2009A 2010A 2011F 2012F 2013FBarclaysDeposits (growth) ‐0.4% ‐1.6% 10.0% 9.5% 7.5%LDR 74.3% 70.4% 75.0% 75.0% 80.0%Loans and advances (growth) ‐13.5% ‐6.8% 17.2% 9.5% 14.7%Earnings (growth) 10% 74% ‐20% 4% 4%

CooperativeDeposits (growth) 39.0% 35.4% 25.0% 20.0% 15.0%LDR 68.0% 69.9% 75.0% 75.0% 75.0%Loans and advances (growth) 17.7% 39.1% 34.1% 20.0% 15.0%Earnings (growth) 25.0% 54.3% 36.7% 15.2% 27.8%

EquityDeposits (growth) 38.8% 49.5% 20.0% 25.0% 15.0%LDR 90.7% 75.0% 80.0% 80.0% 80.0%Loans and advances (growth) 43.4% 23.5% 28.0% 25.0% 15.0%Earnings (growth) 8.3% 68.4% 61.4% 11.9% 9.0%

KCBDeposits (growth) 28.7% 20.8% 25.0% 15.0% 10.0%LDR 75.2% 75.2% 80.0% 80.0% 80.0%Loans and advances (growth) 31.2% 20.8% 33.0% 15.0% 10.0%Earnings (growth) ‐2.5% 76.5% 42.5% 12.7% 20.6%

StanChartDeposits (growth) 13% 16% 15% 15% 15%LDR 65% 60% 65% 70% 75%Loans and advances (growth) 31% 6% 25% 24% 23%Earnings (growth) 46% 14% 30% 10% 5%


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Fig 5: PBVRs vs. ROE and PERs vs. ROE of the Top 30 NSE companies

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Fig 6: Sensitivity analysis; No easy upside for StanChart and Barclays.

Barclays Cooperative

ROE ROECoE 15.00% 20.00% 28.80% 35.00% CoE 15.00% 23.20% 25.00% 35.00%15.00% 19.8 52.8 111 151.7 16.00% 1.5 52.0 63.0 124.017.30% 11.2 29.9 62.8 85.9 18.50% 0.5 17.3 21.0 41.520.00% 7.4 19.78 41.6 56.9 20.00% 0.4 12.4 15.0 29.622.50% 5.7 15.1 31.7 43.3 22.50% 0.2 8.4 10.2 20.1

KCB StanChart

ROE ROE

CoE 15.0% 22.5% 30.0% 35.0% CoE 20.0% 25.0% 33.8% 37.5%15.00% 15.6 67.5 119.4 154.0 15.00% 111.5 178.4 475.4 891.918.25% 6.4 27.6 48.8 63.0 17.75% 83 123.9 265.8 361.620.00% 4.8 21.0 37.1 47.8 20.00% 68.6 99.1 184.5 243.222.50% 3.6 15.6 27.6 35.5 22.50% 57.5 87.1 141.3 178.4

Source: Legae Securities

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1.2 ROE decomposition ROE decompositions: Below we decompose the 2010 ROEs of the

banks under our coverage (see Fig 7). The notable features are: 1) Barclays and StanChart enjoy the lowest cost of liabilities with interest expense/liabilities ratio of 1% and 1.2% respectively. This highlights their superior deposit franchises. While Cooperative has a diversified deposits base (lower deposit concentration risk), its liabilities cost is highest at 2%; 2) Cooperative bank has the highest volume of interest bearing liabilities at 85% of total assets; 3) Cooperative bank has the highest interest expense ratio at 1.7%, Barclays has the least at 0.8% and StanChart is 1.1%; 4) Equity has the highest expense ratio at 10.7% while StanChart has the least at 5.6%. Barclays’ expense ratio is also high at 9.7%. Given Barclays’ low interest expense ratio (low cost of deposits/liabilities), the bank’s efficiency is inferior, probably a residual/legacy of the expansion strategy in the previous years. 5) Equity has the highest asset rotation ratio at 16.9% while StanChart has the least at 11%. Equity’s high asset rotation is indicative of the strength of its target/mass market as well as technological capabilities; 6) Equity possesses the highest ROA while Cooperative and KCB have the least at 2.9%; and 7) Cooperative bank’s leverage is the highest at 7.5X while Equity bank has the least at 5.3X.

In general, the ROEs are pleasing: Barclays and Equity Bank, with lower leverage ratios relative to peers have better opportunities to lever their ROEs, especially given the fact that they also boast of higher CAR.

Fig 7: 2010 ROE decomposition; Cooperative ROE is structurally weaker

Barclays Cooperative Equity KCB StanChartCost of liabilities : int. exp/liabilities ‐1.0% ‐2.0% ‐1.8% ‐1.6% ‐1.2%Composition of liabilities: liab./TA 0.82 0.87 0.81 0.84 0.86Volume of int. bearing liabilities: IAL/TA 0.72 0.85 0.79 0.82 0.73Interest expense/Total assets ‐0.8% ‐1.7% ‐1.4% ‐1.4% ‐1.1%Non interest expense/Total assets ‐8.1% ‐6.0% ‐7.9% ‐7.4% ‐4.2%Provisions/Total Assets ‐0.7% ‐0.5% ‐1.3% ‐0.9% ‐0.3%Expense ratio: Expense/Total assets ‐9.7% ‐8.2% ‐10.7% ‐9.7% ‐5.6%Income tax/Total assets ‐1.7% ‐0.8% ‐1.3% ‐1.0% ‐1.6%Interest income/Total assets 9.9% 7.7% 9.6% 9.2% 6.9%Noninterest income/Total assets 6.0% 4.2% 7.3% 4.4% 4.0%Asset rotation: Revenue/Total assets 15.9% 11.9% 16.9% 13.6% 11.0%Return on Assets 4.5% 2.9% 4.9% 2.9% 3.8%Leverage 5.5 7.5 5.3 6.4 7.0Return on Equity (exc. exceptional items) 24.9% 21.7% 25.9% 18.4% 26.4%Return on Equity (inc. exceptional items) 33.7% 22.4% 26.2% 18.4% 26.4%


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1.3 CAMEL Analysis We believe the CAMEL ratios look strong in general. We discuss the

CAMEL ratios for our coverage below: Capital: Capital levels are generally strong with Barclays leading

the pack with a Core CAR of 26.6% vs. a statutory requirement of 8%. A decline in Barclays’ RWAs (-8% in FY10) aided in strengthening the capital position. StanChart has a relatively weak capital position with a Total CAR that is only 2pps above the minimum required at 14%, otherwise all other banks under our coverage have meaningful buffers. Leverage is also very low with all banks enjoying leverage ratios of <8%. An average leverage ratio of 10X for example, would amplify ROEs to ~35%. The banks under our coverage are all strongly capitalised.

Asset quality: Relative to history, asset quality continues to improve. StanChart enjoy the least provision/loans ratio at 0.7% while Equity has the highest at 2.4%. Barclays boast the highest NPLs coverage ratio at 83%, thus significantly reduce the risk of NPL overhang as well as implying greater flexibility to cover future losses. Equity bank has the least coverage ratio at 49%. Industry-wise, the coverage ratio is a source of concern to us having declined from 65% in CY06 to 53% in CY09. Despite the diversification, banks exposed to the mass market and SMEs indicates higher credit risks, and continued strong asset growth could elevate risks.

Management: We use the cost/income ratio and the multiple of net interest income/total operating income to measure management quality. On a cost/income ratio basis, StanChart and Equity bank indicate management efficiency with ratios of <50%. KCB has the highest ratio at ~60% although we believe there is room for improvement. Looking at the ability of banks to produce non-interest income, all the banks under our coverage have ~40% of their operating income in form of fees and commissions. We believe this is a fair ratio although it can be enhanced. We also note that on a profits/deposits ratio basis, Barclays shows efficiency in using customer deposits with a high ratio of 8.6% while Cooperative and KCB show the least at 3.7%.

Earnings: We take the ROA as the main indicator of banking profitability. Unadjusted, Barclays enjoyed the highest ROA in CY10 at 6.1%, but after adjusting for a once-off item (the disposal of the custody business), the ROA declined to 4.5%. Overall, the ROA is strong at an average of 3.6%. Adjusting for capital, Barclays has the highest return with a return on RWAs of 7.3% while Cooperative has the least at 4.1%. These returns are nonetheless still satisfying and are supported by strong interest spreads and NIM. The average NIM for our covered banks is 10% and the ROE is 23.4%. We believe banks still have ample room to leverage their balance sheets and sustain ROEs. The average leverage ratio is 6.3X.

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Liquidity: The banks show high levels of liquidity with an average LDR of 70%. KCB has the highest LDR at 75.2% while Stanchart has the least at 60%. For StanChart, ability to carry more RWAs could be compromised by the thinner capital buffer than others. Barclays has the highest liquidity ratio at 55.8%, and with its high level of capital it is well positioned to grow RWAs. Equity bank’s high liquidity ratio and CAR also allows it expand its loan book significantly (relative to peers). KCB has the highest LDR at 75.2% and the least liquidity ratio at 28.1%. Overall, we do not see material liquidity risks for the banks under our coverage.

Conclusion: To be fair, on an absolute basis all the banks show strong CAMEL ratios; hence our anchor themes (regionalisation/mortgage lending) and valuation play a fundamental role in identifying the likely winners. (see Fig 8).

Fig 8: CAMEL ratios: Generally strong for our universe

2010 CAMEL ratios Barclays Cooperative Equity KCBStandard Chartered

C: Core CAR 26.6% 16.2% 22.0% 23.1% 14.0%C: Total CAR 31.2% 16.5% 28.0% 23.2% 14.0%C: Leverage ratio 5.5 7.5 5.3 6.4 7.0A: Provision/loans 1.4% 0.9% 2.4% 1.4% 0.7%A: Coverage ratio 82.9% 61.4% 48.8% 53.4% 56.4%M: NII/Op. income 60.2% 58.6% 59.6% 64.0% 59.2%M: Cost/income 54.0% 58.9% 47.1% 61.0% 42.6%M: Profit/Deposits 8.6% 3.7% 6.8% 3.7% 5.3%E: NIM 10.9% 9.3% 12.7% 10.3% 7.0%E:ROA 6.1% 3.0% 5.0% 2.9% 3.8%E: Return on RWA 7.3% 4.1% 7.9% 4.7% 6.6%E: ROE 33.7% 22.4% 26.2% 18.4% 26.4%L: LDR 70.4% 69.9% 75.0% 75.2% 60.0%L: Liquidity ratio 55.8% 39.4% 40.0% 28.1% 55.0%

Source: Company reports, Legae Securities. ROAs include exceptional items

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1.4 Share price performances Cooperative Bank has strongly outperformed peers; KCB is

the laggard: Indexed to January 2010, Cooperative bank has outperformed its peers (only covered stocks considered) while KCB lagged the peers and the NSE20 materially. As we mentioned already, over the past 12 month, Cooperative share price has appreciated by 83.4%; Equity bank by 58.7%; and StanChart by 42.2% - all enormous movements by any measure. Barclays returned a rather muted 29.1% while KCB’s return of 4.4% was not just out of synch with peers but offered nothing material when adjusted for inflation, if at all.

YTD performance is mixed: On a YTD basis, Equity Bank is the worst performer with a negative return of 7.5%. Barclays is the best performer with a capital gain of 6.4%. KCB’s share price has appreciated by 2.3% only while Cooperative bank is down 3.9% and StanChart is marginally up at 1.6%. (see Fig 9 to Fig 10).

KCB continue to trade at a discount to peers: We note that KCB has been trading at a discount to the peers from around May 2010. We would think the discount is warranted if we carry earnings production concerns but given our bullish view on asset growth and earnings, we expect this discount to narrow at worst and disappear at best. The two key consequences are 1) KCB’s share price outperform in case of a bullish market; or 2) KCB’s share price lag others (downward) in case of a bearish market. Both are positive to the investor. (see Fig 11).

Fig 9: Share price performance: Coop share price strongly outperformed NSE20; KCB underperformed

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Fig 10: Share price performance: Coop outperformed peers on a 12-month basis

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Fig 11: Valuation: Coop PER diverged from peers, KCB’s PBVR continue to attract a discount

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Jan‐09

Mar‐09

May‐09

Jul‐09

Sep‐09

Nov‐09

Jan‐10

Mar‐10

May‐10

Jul‐10

Sep‐10

Nov‐10

Jan‐11

Mar‐11

PERBarclays Coop Equity KCB StanChart

0

1

2

3

4

5

6

7

Jan‐09

Mar‐09

May‐09

Jul‐09

Sep‐09

Nov‐09

Jan‐10

Mar‐10

May‐10

Jul‐10

Sep‐10

Nov‐10

Jan‐11

Mar‐11

PBVR Barclays Coop Equity KCB StanChart


Page 13 of 62

2. Industry analysis

2.1 Industry Overview: The market is highly fragmented, ‘local banks’ gaining market share.

System assets and liabilities growth: The private sector credit

has expanded by a CAGR of 9.9% between CY00 and CY10. The system’s total liabilities have grown by a CAGR of 10.6% to Kes1.073trn by end of CY09. The total liabilities expanded to Kes1.263trn by 3Q10. (see Fig 12). In our view, the asset side of the system’s balance sheet is going to benefit from low mortgage penetration, and we believe this is an anchoring theme for the Kenyan banking system going forward. The Small-Medium Enterprises (SMEs) and the mass markets are also crucial to the system in our opinion. Under normal economic circumstances, the SME and mass market provides diversification benefits. We also believe these sectors are important not just from a lending perspective but also from a transactional view point.

Fig 12: The system enjoyed stronger private sector credit growth since CY04

‐

200

400

600

800

1,000

1,200

1,400

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

1H10

Credit to private sector

Total banks liabilities

‐5%

0%

5%

10%

15%

20%

25%

30%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

1H10

Private creditTotal banks liabilities


The industry is highly fragmented..: The system has 44

registered commercial banks. In our view, the system is highly fragmented. The top 5 banks enjoy combined market shares of 51% and 50% on loans and advances and deposits respectively. The 10 biggest banks carve up a market share of ~75% on both deposits and loans and advances. (see Fig 13). This high level of industry fragmentation is detrimental to long-term profitability of the system. Competition on both assets, especially loan and advances and liabilities, particularly deposits would be harmful to interest spreads in the long-term. Interest spreads are likely to

Page 14 of 62

narrow as competition intensifies (lower/declining asset yields and rising cost of deposits) and penetration expands. In the short-term, the market leaders are likely to continue to take leadership in pricing, hence market share is important.

...but the new minimum capital requirement of Kes2bn to come into effect in CY12 could catalyse consolidation: We believe consolidation will be positive for the industry as there are many banks with market shares <1%. While regulators have not publicly indicated/signalled their intention to see a more concentrated system, the increase in new minimum capital to Kes2bn (~US$23.5mn) could be a catalyst for consolidation. Banks are expected to meet this new requirement by end of CY12. Fig 14 shows that only 19 banks would meet the new requirement (using CY09 capital and reserve positions). The remaining banks have combined capital and reserve position of Kes21.77bn which is less than the individual capital positions of three premier capitalised banks in shilling-terms, namely Barclays, Equity and KCB. This indicates the low level of scope for the lower tier banks. A more concentrated system than now could provide scope for scale, in our opinion.

Fig 13: Top 5 banks enjoy ~50% market share on both loans and deposits

1.8%

3.0%

4.2%

4.3%

6.2%

7.9%

8.3%8.6%

13.0%

13.4%

Advances market shares, Top 10

NBK

Citibank

Comm. BoA

Diamond Trust

CFC Stanbic

Stanchart

Equity

Co‐op Bank

Barclays

KCB

3.3%3.6%

4.2%

4.4%

5.6%

6.5%

8.6%9.1%

12.5%

13.7%

Deposits market shares, Top 10

NBK

Citibank

Comm. BoA

Diamond Trust

CFC Stanbic

Stanchart

Equity

Co‐op Bank

Barclays

KCB


Page 15 of 62

Fig 14: Minimum capital requirements: As at end of CY09, many would not meet the new capital requirement of KES2bn

‐5.0

‐

5.0

10.0

15.0

20.0

25.0

Barclays Equity bank KCB Coop StanChart Citi CFC stanbic NBK

I&M

NIC

Commercial BoA

Diam

ond Trust Prim

e Bank Bank of Baroda Bank of A

frica Imperial bank

Ecobank Bank of India Develop. Bank of Ke Transnational Chase bank Fam

ily bank Fina bank Gulf A

frica bank ABC

K‐rep bank UBA

Kenya Oriental

Habibi bank

Victorira Comm. bank

Consolidated bank Middle East Bank

Giro bank

Guardian bank

Habibi bank ltd

Equatorial Credit bank First Com

munity

Paramount

Fidelity Comm. bank

Dubai bank

City finance Charter H

ouse bank Southern Credit

Excess/(Deficit)


‘Local banks’, especially Equity bank and KCB have been

acquiring market share; Barclays and StanChart have been losing market share: We note that ‘local’ banks have been growing market shares on both assets and deposits while the ‘international banks’, namely Barclays, StanChart and Citibank have been losing market shares. Relative high capital levels maintained by the ‘local banks’ allowed them to grow RWAs faster (see Fig 15). While some management teams accredit it to marketing strategies, others (competitor banks) seem to believe that some of the international banks were deliberately reducing their market shares. (and gleefully think they (international banks) misread the market). (see Fig 16). The salient features we note about the dynamics of market shares in the Kenyan system are: Barclays banks, which was #1 bank on both assets and

deposits market shares in CY05 and CY07 now ranks #2 to KCB. Barclays’ assets market share has declined to 12.2% in CY09 from 17% in CY05. Meanwhile, KCB’s asset market share has increased to 12.7% in CY09 from 12.1% in CY05. In terms of loans, Barclays owns 13% markets share, just below KCB’s 13.4%. This is in contrast to Barclays’ 20.2% market share in CY05. On the deposit side, KCB now leads with a market share of 13.7% vs. Barclays’ 12.5% (down from 16.7% in CY05)

Page 16 of 62

Other international banks have also lost significant market shares. While StandChart has remained #3 on both asset and deposit market share rankings, its market share has contracted from 11.8% in CY05 to 9.2% in CY09 on the asset side. On the deposits side, the bank’s market share has shrunk to 8.6% from 11.9% in CY05. But it is the loan and advances market share that has reduced worst with the bank now #5. Citibank now ranks #11 on the deposits side with a market share of 3.3% from 4.7%. The bank ranked #7 in CY05. On the assets side, Citibank ranks #9 with a market share of 3.8%, 1.2pp down from 5% in CY05.

Equity bank has gained the most market share in the period; Cooperative lost marginal market share on the asset side: Equity bank’s market share on the asset side has increased to 7.1% from just 1.9% in CY05. On the deposit side growth has also been phenomenal, with the market share increasing to 6.5% in CY09 from 1.8% in CY05. Equity bank now holds a respectable 8.6% market share of system loans and advances, (and ranked #4) a massive leap from 1.7% (and #10) in CY05. Cooperative bank’s market share on both asset and deposit side has remained rather stable. The market share on the asset side has declined marginally to 8.2% from 8.4% in CY05, while on the deposit side the bank has gained trivial market share from 8.7% in CY05 to 9.1% in CY09.

Fig 15: Capital: KCB and Equity bank maintained relative higher CAR, allowing growth of RWAs

Total Capital,Kesmn Growth Total Capital/RWAs Change (05 -09)

2005 2007 2009 2005 2007 2009

KCB 9,801.7 10,046.0 17,674.0 16% 18.4% 13.6% 14.8% ‐3.6%Barclays 11,433.0 18,280.0 27,619.0 25% 13.9% 13.0% 19.2% 5.3%StanChart 8,473.8 9,199.0 10,915.0 7% 14.6% 16.3% 14.1% ‐0.5%Cooperative 5,601.0 6,004.0 15,319.0 29% 17.7% 14.2% 20.3% 2.7%CFCStanbic n/a n/a 10,539.0 n/m n/m n/a 10.3% n/mEquity 1,413.0 17,625.0 22,488.0 100% 19.8% 45.7% 23.6% 3.8%Comm.BoA 2,228.0 3,622.0 4,821.0 21% 12.9% 13.5% 12.1% ‐0.7%NBK 2,854.8 859.0 7,396.0 27% 10.0% 37.2% 40.9% 30.8%Citibank 5,284.7 7,247.0 11,007.0 20% 17.0% 28.5% 29.0% 12.0%Diamond Trust 1,710.6 4,287.0 6,512.0 40% 14.2% 19.1% 15.4% 1.1%


Page 17 of 62

Fig 16: Summary of asset and deposit market shares in Kenya for the Top 11 banks (2009)

Institution Assets Market share Rank

2005 2007 2009 2005 2007 2009KCB 12.1% 11.8% 12.7% 2 2 1Barclays 17.0% 16.6% 12.2% 1 1 2StanChart 11.8% 9.6% 9.2% 3 3 3Cooperative 8.4% 6.9% 8.2% 4 4 4CFCStanbic n/a n/a 7.2% n/a n/a 5Equity Bank 1.9% 5.6% 7.1% 10 5 6Comm. Bank of Africa 4.8% 4.2% 4.3% 4 8 7NBK 5.3% 4.4% 3.8% 5 7 8Citibank 5.0% 5.0% 3.8% 6 6 9Diamond Trust 2.6% 3.2% 3.5% 9 10 10NIC 3.4% 3.3% 3.3% 8 9 11Total 72.3% 70.5% 75.2%

Institution Advances markets share Rank

2005 2007 2009 2005 2007 2009KCB 10.0% 11.4% 13.4% 3 2 1Barclays 20.2% 21.3% 13.0% 1 1 2Cooperative 8.9% 7.8% 8.6% 4 4 3Equity Bank 1.7% 4.4% 8.3% 10 6 4StanChart 10.4% 8.0% 7.9% 2 3 5CFCStanbic n/a n/a 6.2% n/a n/a 6NIC 4.34'% 4.5% 4.3% 6 5 7Diamond Trust 3.2% 4.0% 4.3% 8 7 8Comm.Bank of Africa 3.6% 3.2% 4.2% 7 8 9Citibank 3.1% 2.6% 3.0% 9 9 10NBK 7.4% 1.6% 1.8% 5 10 11Total 68.5% 68.6% 74.9%

Institution Deposits market share Rank

2005 2007 2009 2005 2007 2009KCB 12.1% 12.1% 13.7% 2 2 1Barclays 16.7% 15.4% 12.5% 1 1 2Cooperative 8.7% 7.7% 9.1% 4 4 3StanChart 11.9% 10.4% 8.6% 3 3 4Equity Bank 1.8% 4.4% 6.5% 10 7 5CFCStanbic n/a n/a 5.6% n/a n/a 6Comm. Bank of Africa 5.3% 4.7% 4.4% 6 6 7NBK 5.4% 4.9% 4.2% 5 5 8NIC 3.4% 3.5% 3.7% 8 9 9Diamond Trust 2.7% 3.4% 3.6% 9 10 10Citibank 4.7% 4.2% 3.3% 7 8 11Total 72.6% 70.7% 75.2%

KCB has overtaken Barclays as the biggest bank by asset. StanChart remain the #3biggest bank; Equity has moved up from #10 in CY05 to #5 while Citibank lost its market position to #9...

...KCB has also taken the lead in loans and advances market share. Again Barclays and StanChart have lost huge amounts of the market. StanChart now #5 from #2...

...again KCB now dominate the deposits market after displacing Barclays. Top 5 banks owns ~50% of the market. Equity shows strongest growth


Page 18 of 62

2.2 Sizing up the system: The future looks bright

Per capita incomes, level of penetration and population growth are the most important indicators of structural growth: The long-term opportunities in a system depend on volumes. Banking assets growth, which largely influence the structural profitability of a system depends on 1) Wealth levels which we measure using the per capita income. Wealth determines the level of credit demand and system liquidity. 2) The level of penetration as measured by the banking assets/GDP ratio. Systems with low levels of banking assets/GDP ratio show lower intermediation, or to an extent the impact of shadow banking industry, which is not good for banking systems. Nonetheless it provides opportunities. As intermediation increases, banking assets rise; and 3) Population growth. Population is crucial for volume growth in the system. However, we believe that while population plays a critical role it remains a long-term theme. Fig 17 below shows that the growth in system banking assets is a product of per capita income, (trend and growth) penetration (trend and growth) and population (growth).

Fig 17: How we identified the key factors to banking assets growth

Banking assets = GDP X Banking assets X Capita

capita GDP

= per capita penetration population

income

Source: Legae Securities

Per capita income is expected to rise...: Compared to other

Sub-Sahara systems, Kenya’s per capita income is expected to remain below peer countries like Angola, Botswana and Nigeria. However, Kenya’s per capita income is expected to register the highest growth rate between now and CY15, with a CAGR of 10.8%. Kenya’s per capita income is increasing and is expected to increase to US$1,483 by CY15, according to the IMF WEO. (see Fig 18). This is beneficial to banking assets growth.

Page 19 of 62

Fig 18: Per capita income: Kenya is growing and expected to outperform

244

577

699

727

751

1,244

1,483

1,801

1,856

6,412

7,389

8,437

‐

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

DRC

Uganda

Mozam

bique

Zimbabw

e

Tanzania

Ghana

Kenya

Nigeria

Zambia

Nam

ibia

Angola

Botswana

per capita income

2013

2014

2015

2.7%

3.3%

4.4%

5.2%

6.3%

6.7%

7.6%

8.1%

8.9%

9.0%

10.3%

10.8%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

Uganda

Namibia

Botswana

DRC

Nigeria

Tanzania

Zambia

Mozambique

Zimbabwe

Angola

Ghana

Kenya

2010‐2015 CAGR

Source: IMF, Legae Securities

...but penetration is rising...: Penetration as indicted by the banking assets/GDP ratio has increased materially between CY04 and CY09. Banking assets growth rate outpaced nominal GDP growth rate over the period despite a decline in CY09 due to the financial crisis. (see Fig 19). Despite the drag on the growth rate as a result of the financial crisis, penetration in Kenya still remained high relative to other East African countries. (see Fig 20). This also supports our regionalisation theme as Kenyan banks could benefit from low penetration in the regional markets.

Fig 19: Penetration: Rising, banking assets outpaced nominal GDP growth (CY00-CY09)

30%

35%

40%

45%

50%

55%

60%

65%

0

500

1000

1500

2000

2500

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

1H10

GDP,bn

Banking assets,bn

Banking assets/GDP; %

‐10%

‐5%

0%

5%

10%

15%

20%

25%

30%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1H10

Nominal GDP growth

Banking assets growth

Source: IMF, Legae Securities

Page 20 of 62

Fig 20: Penetration: Rising but still provides opportunities at a moderate level of ~52% ...

GDP US$mn Banking assets,US$mn Banking Assets/GDPTanzania 22,434 2,693 12%DRC 12,600 1,956 16%Uganda 17,121 3,998 23%Zambia 15,691 4,117 26%Mozambique 10,212 3,718 36%Kenya 32,417 16,919 52%Angola 74,474 39,450 53%Ghana 18,058 10,776 60%Nigeria 206,664 204,323 99%

Source: IMF, Central banks, Legae Securities. Estimates in US$.

...and system accounts are now more than 30% of the

country’s population..: The number of accounts in the system has continued to increase, reaching 11.142mn by the end of 3Q10. This is about 31% of the country’s estimated population, and ~4X Ugandan system accounts despite a difference of <4mn in population. The argument, which is plausible to a large extent, is that the number for bank customers (not accounts) is <5mn persons only, hence there is still a reasonable unbanked population given estimates of a bankable population of ~20mn. We believe there is a reasonable number of inactive persons in the bankable population estimate. The anchor to the increasing number in system accounts has been the banks’ expansions in branch network. The system’s branch network has expanded to 1,030 by 3Q10 from 575 branches in CY06. (see Fig 21). Telephones banking, which has been highly successful in Kenya means that penetration is increasing much faster.

Fig 21: ...as system accounts and branch network has increased.

3.33

4.12

6.45

8.45

11.142

0

2

4

6

8

10

12

2006 2007 2008 2009 3Q10

System accounts,mn

575

740

887

9961030

300

400

500

600

700

800

900

1000

1100

2006 2007 2008 2009 3Q10

Branch network


Page 21 of 62

...yet population, although a long-term theme, is not very encouraging: Kenya’s population growth profile is weaker when compared to neighbours, namely Tanzania and Uganda who are expected to outstrip Kenya’s population by CY50. In our view, this is one of Kenya’s macro-weaknesses. Kenya’s population is expected to increase to 56.5mn by CY25 and to 83.5mn by CY50. This is slow growth when compared to Uganda, for example, whose population is expected to rise to 51.8mn by CY25 and overtake Kenya’s by CY50 at 96.4mn. (see Fig 22).

Fig 22: Population: Growth is weaker and will lag Uganda and Tanzania by CY50

‐

50

100

150

200

250

300

Botswana

Zambia

Zimbabwe

Angola

M'mbique

Ghana

Uganda

Kenya

Tanzania

DRC

Nigeria

2025,mn 2050,mn

Source: Population Datasheet 2010, Legae Securities

Page 22 of 62

2.3 Profitability and efficiency: Resilience in the face of global turmoil Industry profitability rising, noninterest income/operating

income declining: The industry profitability has been strong, growing by a CAGR of 26.4% between CY04 and CY09. Profitability is underpinned by strong net interest income (NII) which grew by 22.2% CAGR over the same period. The non-interest income/total operating income, however, declined to 38.2%, the lowest level since CY04 (see Fig 23). Non-interest income grew by a lower rate of 17.1%. Industry profitability jumped to Kes62.6bn in 3Q10.

Superior ROA is supported by high interest spread: The industry enjoy relative high ROA, supported by stronger interest rate spreads. The industry interest spread is as high as 9.5%. (see Fig 24). While we believe there is downward pressure on interest spreads as competition and penetration increases, we believe in the medium term the spreads will support relatively stronger ROA. The high liquidity ratio means that 1) banks have room to change their asset mix in pursuit of higher yields/ROA; 2) depending on duration mismatches, high liquidity could allow banks to pick up government paper at higher yields as the probability of further reduction in interest rates look minimal. However, there is moral suasion from the CBK for banks to reduce their lending rates. This puts pressure on spreads. The pressure from the CBK for banks to adjust their lending rates in unison with changes to the policy rate could be a risk should the regulator determine an ‘optimal’ spread for banks.

System ROA and ROE compares favourably against our select systems: The Kenyan system shows superior ROA against our select systems, with only the Ghanaian system showing higher ROA. (see Fig 25). The superior ROE is even amplified when one pinpoints to the low leverage. We expect pressure on ROA in the long-run (competition on both assets and liability sides of balance sheets, rising penetration that naturally comes with declining spreads), but we expect ROA to display considerable strength in the next 3 years.

Page 23 of 62

Fig 23: Profitability: Satisfying growth in profit, system’s NIR declined

35.0%

36.0%

37.0%

38.0%

39.0%

40.0%

41.0%

42.0%

43.0%

44.0%

2004 2005 2006 2007 2008 2009

NIR/Total income

14.7 18.9

26.4

35.1

42.6

47.6

62.6

0%

10%

20%

30%

40%

50%

60%

‐

10.0

20.0

30.0

40.0

50.0

60.0

70.0

2004 2005 2006 2007 2008 2009 3Q10

Pre‐tax profit,bn

Growth rate,RHS


Fig 24: Profitability: The ROA relatively high, supported by strong interest rate spread.

22.5% 23.9% 28.3% 28.0% 26.6% 25.0%

2.1%

2.4% 2.4%

2.7%

2.6% 2.6%

1.5%

1.7%

1.9%

2.1%

2.3%

2.5%

2.7%

2.9%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

24.0%

26.0%

28.0%

30.0%

2004 2005 2006 2007 2008 2009

ROE

ROA, RHS

7.5%8.4%

8.8%9.2%

9.7% 9.5%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

2004 2005 2006 2007 2008 2009

Yield on assets

Cost of depositsSpread


Page 24 of 62

Fig 25: Profitability: The system boasts superior ROA and ROE relative to selected systems

0%

5%

10%

15%

20%

25%

30%

35%

Canada

USA

Australia

Russia

Mexico

Ugan

da

Malaysia

RSA

Arge

ntin

a

Chile

Turke

y

Ghana

Brazil

Kenya

ROE

0%

1%

1%

2%

2%

3%

3%

4%

4%

5%

Canada

USA

Australia

RSA

Russia

Chile

Mexico

Brazil

Ugan

da

Arge

ntin

a

Turke

y

Kenya

Ghana

ROA

Source: IMF Financial Stability report, Legae Securities

Mortgages to support industry loan growth and profitability:

As penetration increases, we believe mortgages lending will be key in supporting growth and profitability. 1) the penetration is still very low as indicated by the mortgage loans/GDP ratio which is only 2.48%. (see Fig 26). Despite Kenya enjoying a relative higher penetration when compared to Uganda and Tanzania, (1% and 0.2% respectively), the 2.5% is not comparable to >40% that is obtained in relatively mature systems like South Africa and over 50% for the developed world. Mortgage loans make only ~6% of the system’s loan-book. Mortgage loan demand has mainly been dominated by high-income clients and Diasporans. Generally, basic pick-up in housing demand is driven by increasing populace seeking owner-occupation. As per capita increases, the population seeking owner-occupation will increase correspondingly. 2) the mortgage lending rate has been fairly stable over business cycles when compared to other asset classes, namely government bonds, loans and advances and interbank loans. (see Fig 27). This should support margins for banks that enjoy advantageous market shares, particularly in periods when government bonds and interbank rates decline. The mortgage rate ranges from 12.5% to 16.5%.

Liquidity and duration matching concerns could reduce competition in the mortgage segment: We also believe that competition in the mortgage segment is less intense; hence banks that are strong in this market segment can enjoy pricing power benefits. Smaller banks are unlikely to be able to compete in assuming relatively higher liquidity and asset/liability mismatches. According to the Central Bank of Kenya, (ref Mortgage Finance in Kenya: Survey Analysis, dated November 2010) the mortgage market is dominated by the large banks (90% of the outstanding loans) and the top 5 lenders represent over 80% of total mortgage portfolio. In the same report, the major constraint to mortgage lending indicated by banks is inability to access long-term funds.

Page 25 of 62

Banks that can raise long-term funding (i.e. to include capacity to exploit Tier 2 capital) stand at an advantage. Stronger deposit franchises are also key as banks are allowed to extend mortgage loans to a maximum of 40% of their total deposits.

Credit risk fears in the mortgage sector heighted by high property prices: The Kenyan property market has performed strongly in the past 3 years, and there are fears that it could be overheating, particularly in the middle- and top-income groups. We note that on average banks impose a Loan/value (LTV) ratio of 90%. Several management teams indicated that they reduce the LTV ratio to around between 70% and 75% for mortgage loans in areas they deem overvalued or expensive.

Housing Finance Company of Kenya (HFCK), Barclays and Stanchart are losing market share though: HFCK expectedly dominates the mortgage market. Cooperative bank and Equity bank have the least market shares but they have registered strong growth rates in mortgage loans in 1H10 – >300% for Cooperative bank but from a low base of only Kes55.5nm; and 25% for Equity Bank from a reasonable base of Kes229.3mn in FY09 to Kes673.3mn by 1H10. KCB has continued to build its mortgage business, despite a relatively higher base. Between FY09 and 1H10, KCB’s mortgages loans went up by 14.7% (to Kes17.974bn). Stanchart and Barclays grew their mortgage loans by 1.3% and 4.9% respectively (to Kes4.960bn and Kes3.055bn in that order). HFCK, Barclays, and StanChart have been losing market shares since CY06. (see Fig 28).

Fig 26: Mortgage market: Penetration is low in both Kenya and the region

19.5

26.6

39

53.8

61.4

0

10

20

30

40

50

60

70

2006 2007 2008 2009 1H10 est.

Mortgage loans, Kesbn2.48%

1%

0.20%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Kenya Uganda Tanzania

Mortgage loans/GDP


Page 26 of 62

Fig 27: Mortgage market: Lending rates are less responsive to business cycles

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1H10

Mortgages

Interbank

Loans and davnces

0%

2%

4%

6%

8%

10%

12%

14%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1H10

91‐TB rate


Fig 28: Mortgage market: HFCK, StanChart and Barclays losing market shares

0.4% 1.1%

4.9%

7.9%

27.1%28.8%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

Coop. Bank Equity Bank Barclays Bank StanChart Bank

HFCK KCB Limited

Market shares of Top 5 banks and HFCK

2006

2007

2008

2009

1H10

NM NM

19%22%

44% 45%

57%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Coop. Bank Equity Bank

StanChart Bank

HFCK Barclays Bank

Total KCB Limited

CAGR (06‐09)


Page 27 of 62

2.4 System Liquidity risks: Low LDR provides scope but compresses margins in the short-term System carry ample liquidity, the 20% Statutory liquidity

ratio mean an implied cap on the LDR of 80%: Generally, the system carries ample liquidity. The LDR has declined to 69% (excluding non-residence deposits) while the funding gap continue to build up, breaching the Kes200bn by 1H10. (see Fig 29). The regulatory requirement of 20% liquid assets (vs. customer deposits) means that for all intends and purposes the LDR is capped at 80%. Banks that have a liquidity ratio closer to 20% would have to fund RWAs through borrowed funds or other debt instruments than deposits. Such alternatives could be more expensive and unconstructive to the interest spread. However, with the LDR 11pps below the maximum required, it is fair to say the system is liquid and carries enormous capacity to grow RWAs. The excess liquid assets (i.e. liquid assets less the minimum required) has also been building up since CY02. As a ratio of deposits, the excess liquid assets held by banks have increased to ~25%. (see Fig 30). The system holds more than double the liquid assets required. The high level of liquid assets allows banks to re-price their assets (loans) yields (hopefully upwards) without necessarily re-pricing their deposits rates. (in order to maintain internal funding).

The nature of system deposits is also important in liquidity analysis. Demand deposits have been growing faster than time and savings deposits. By 1H10, demand deposits made up ~32% of system deposits (from ~17% in CY00) while time and savings deposits contribution declined slightly to 40% (from ~45% in CY00). (see Fig 31). While demand and savings deposits tend to be cheaper and less mobile, time deposits can be mobile and more expensive. The cost of savings deposits is ~1.75% while time deposits attracted ~4.5% as at 1H10, according to the CBK.

While the system’s liquidity position is impressive, the high level of liquid assets generally has a depressive impact to system NIM, and consequently the system ROA. This is compounded by the low levels of yields on government securities (90-day TB rate has declined to 2.9% by 1H10 from 8.5% in 1Q09). However, it is important to note that these liquid assets consume less capital. As long as the system maintain the interest spreads high as is the case currently, banks still have opportunities to improve NIMs by increasing the ratio of interest bearing assets. In fact the system’s resilient interest spread meant that profits continued to rise despite increasing funding gap. The profit/funding gap ratio has increased from 14% in CY02 to 31%. (see Fig 32). However, in CY09, the profit/funding gap ratio declined by 2pps from 33%.

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Fig 29: Liquidity: LDR is low and the funding gap is positive and growing

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Fig 31: Liquidity: More system deposits are on demand

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Page 29 of 62

Fig 32: Liquidity: Profitability continue despite high funding gap

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2.5 Credit risks: The major source of vulnerability System credit risks have improved but the coverage ratio

has worsened: The system credit risks have vastly improved with the NPL/loan ratio having declined from >10% pre-2006 to ~5%. Given that the stock of industry NPLs continue to show stubbornness, increasing by Kes6.5bn in CY08 and reaching Kes61.2bn by end of 3Q10, we hold some concerns with the falling coverage ratio. The coverage ratio has reduced from a satisfying 65% in CY06 to a contentious 53% in CY09. (see Fig 33); Comparing the NPL/loans and provision/loans ratios against other systems, we note that Kenya depicts a sub-optimal situation where the former is relatively higher while the latter is lower. (see Fig 33). In our view, the stock of provisions should increase faster than NPL in order to raise coverage levels, creating headwinds to earnings growth.

Personal credit remains the highest credit exposure: The system’s highest credit exposure is personal/household loans. They make up 28.3% of the system loan book (as at 3Q10). With our expectation of rising mortgage lending, household lending should continue to drive loan growth in the medium term. Agriculture, which is often cited by bank management as a key sector of the economy (and demand for loans) makes up 5.1% of the system loan book as at end of 3Q10 (see Fig 34). Banks that bank on trade, particularly the ability to finance regional trade and/or trade across the region should benefit as this is the second biggest credit exposure.

Tourism and agriculture sector carry highest credit risks although system exposure is minimal: Tourism and agriculture sectors carry the highest credit risks with NPLs/Loans ratio for these sectors at >10%. However, the two sectors makes up <10% of the system loan-book. Nonetheless, banks with higher exposure to these sectors face higher levels of credit risks. Personal credit, which carries the highest exposure, has a NPLs/loans ratio of 7.7%. (see Fig 35).

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Fig 33: Credit risks: Improved vastly but we are concerned by worsening coverage ratios

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Fig 34: Credit risks: Relatively higher NPL/Loans and lower coverage ratios

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Fig 35: Credit risk: Personal loans and trade related loans dominate the system’s credit risk...

11.2 19.8 23.6 29.144.6 45.4

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Fig 36: ...but the most risk sectors are tourism and agriculture

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2.6 Solvency risks: High capital levels; no pick-up in capital management anticipated for ‘local banks’ System capital level is high but we do not see ‘local banks’

“giving back” capital to shareholder due to regionalisation: The system’s level of capitalisation is high, with a core capital/RWA and total capital/RWAs ratios of 18% and 21% respectively. Leverage is low at <10X. (see Fig 37). We believe the system is well placed to increase capital levels through earnings retention (given the high levels of profitability) than dilutive capital raising. However, capital raising could be required to support growth of RWAs in the medium term. We also note that most of the banks in the system have not yet full exploited their Tier 2 capital (e.g. use of bonds and hybrid capital is limited).

As a result, we do not anticipate aggressive capital management, by local banks. In fact, the system still enjoy relatively higher level of ROE and we believe banks management are going to continue to maintain capital buffers as they expand into the region. Higher regional asset growth means that no capital could possibly be paid back to shareholders.

The system ranks among the best capitalised...: Comparing Kenya to our select systems, Kenya is one of the best capitalised. (see Fig 38). Of course this could also be a result of elevated credit risks hence regulators and banks are happy to maintain higher levels of capital and maintain reasonable buffers.

...but the low coverage ratio is a risk to capital, especially if provision policies change: Given our concerns with system’s low provision/NPL ratio, should provision policies change with a view to increases the coverage ratio, this could be a risk to the current excess capital position.

Basel 3 is not an issue: We do not think the Basel 3 will have an impact to banks operations in Kenya. Currently Basel 2 is not fully implemented although some banks apply it for internal objectives/purposes. Nevertheless, there could be other regulatory risks whose mitigants we are unable to identify at this point, to include regulations related to cell-phone banking and continual metamorphosis of regulatory framework related to deposit taking micro-finance institutions. Regulators are also likely to be tougher and to seek tougher standards than was the case pre-crisis.

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Fig 37: Solvency: Strong buffer to minimum capital required; Leverage low

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Fig 38: Solvency: The Kenyan system compares favourably against other systems

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Source: IMF Financial stability report, Legae Securities

Page 35 of 62

2.7 Political risks: Still high but high GDP growth expectations nonetheless. The political risk remains elevated in our view; real GDP

growth expected to average 6.3% for the next 5 years: We believe that the political risks in Kenya are still significant despite the conciliatory tone between the two parties of the GNU. Issues of corruption remain distasteful. Political risks often manifest in poorer fiscal policies. The Kenyan shilling, which generally is a measure of confidence or lack of it, is depreciating. (see Fig 39). The negative impact to the inflation rate often leads to inflated risks to the banking system in both 1) low demand for credit if rates are high to maintain positive real interest rates; and 2) increased default risks. However, GDP growth is expected to average a rewarding 6.3% between CY11 and CY15. (see Fig 39). This is supportive to banking through the credit multiplier as well as the positive effect to NPL formation.

Fig 39: The shillings is under pressure; GDP growth expected to remain strong at av. 6.3%

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Page 36 of 62

Company analysis/profiles

Anchor themes: Mortgage lending and regionalisation

Valuation: No easy upside for Barclays and StanChart; BUY KCB and Equity bank; SELL Cooperative; HOLD StanChart and Barclays

Page 37 of 62

Initiation: Barclays Bank Kenya - HOLD Risk averse but able to engage in active capital management; FY11 Target Price Kes62.8; HOLD Business and company brief: Barclays Bank Kenya has had

presence in Kenya since 1925. The bank has a network of 113 branches. The main business segments are 1) retail banking which offers personal banking services to individuals and corporates. Main products are transactional accounts, loans, mortgages and asset finance; 2) Premier banking that concentrates on preferential banking services to eligible customers, mainly on the high-end; 3) corporate banking which offers business services to include trade finance; and 4) Barclaycard which offers a range of international credit card facilities. Barclays is the #2 bank in Kenya by assets, loans and deposits.

Key differentiating factor(s): In our opinion, the major differentiating factor for Barclays bank is its strong brand, and the support from its international parent. We believe the bank has also managed to curve itself a niche in its premier banking and it could enjoy relatively higher margins (fees). The low exposure to SME and mass market is constructive to its credit risk profile.

Valuation and risks: Our FY11 target is Kes62.8. We establish a Justified PBVR of 3.2X using a CoE of 17.3% (slightly lower than most ‘local banks’ on brand strength; lower credit risks i.e. lower NPL overhang risk due to high coverage ratio; and higher CAR); a growth rate of 12% i.e. expected nominal GDP growth (lower than most peers on concentration to corporate banking and no regional play; theoretical sustainable growth rate is 8.6%); and an ROE of 28.8%. Our FY11 dividend yield is 6.6%, assuming a 70% dividend payout ratio. The potential total return is a minute 1%, with the potential capital loss of 5.5% being fully compensated for by the dividend yield. The current PER ratio (FY10 EPS) at 8.5X is below average PER since CY05 of 15.8X, and outside the volatility range. Even our forward PER of 10.7X is outside this range. It looks like investors are now expecting continued muted growth from Barclays (understandably so given the performance of the last three years) and taking the low PER (relative to history) as undervaluation could be misleading. The high dividend yield remains an attractive incentive though.

The primary risks to our valuation includes 1) slower earning growth than anticipated due to heightened competition in the Kenyan market, particularly as the bank is not extensively playing the consumer mass market where penetration is significantly lower; 2) continued stress on corporate Kenya and thus maintenance of elevated provisions.

Share price catalyst(s): We have an in-line performance outlook. However, the bank has ample room to engage in active capital management. With a Core CAR of 26.6% and a Total CAR of

Page 38 of 62

31.2% the bank is well positioned to return capital to investors either through a share-buyback or a dividend hike. Already in FY10, the bank increased its payout ratio from 55% in the previous year to 69%. We note that capital management is an important catalyst for this share. A more risk tolerant strategy than the current one which would increase the probability of earnings growth could also be an important catalyst.

CAMEL Analysis: Like most of the banks in the system, the CAMEL ratios are strong. 1) Capital: The bank has a very high CAR of 31.2%. Except in the change of strategy (apparent risk aversion and avoidance of the mass market and highly selective SME lending), we do not see a material increase in the RWAs in our forecast period. As a result, capital level is likely to remain high. We expect the equity/loans ratio to average 27% in the next 3 years. We expect leverage to remain muted too; 2) Asset quality: We anticipate a down-trending impairment costs/loans ratio. As we mentioned already, Barclays is pursuing a low but quality credit growth, and this is not necessarily a wrong decision given the economic weaknesses in the past 3 years. We also treasure the high NPLs coverage ratio which significantly reduced the NPLs overhang risk to earnings; 3) Management: We continue to see the bulk of operating income coming from interest income – contributing an average of 62% in our forecast period. Nonetheless, new products in telephone and internet baking should continue to provide a fillip to non-interest income; 4) Earnings: We expect an increase in NIM with a strong impetus coming from rising interest rates in our forecast period, thus expanding interest spreads. We also increased the bank’s RWAs by increasing the LDR to 75% for FY11 and FY12 and 80% for FY13. The ROA excluding exceptional items increases to 4.7% from 4.5%; 5) Liquidity: In the face of lower growth in RWAs (relative to peers) we continue to see high levels of liquidity, with an average liquidity ratio of 40.7% in the next 3 years. Should the bank grow its loan book in a significant way, we believe the deposits franchise is still strong to support asset growth. The comparative low cost of liabilities would create headroom for the bank to price away deposits from competitors.

ROE decomposition: We forecast an average ROE of 28.8% for the next three year. We expect asset yield and margin to decline slightly but leverage should pick up despite remaining at <10X.

Major assumptions: Our key assumptions are 1) Balance sheet related: We modelled an average deposit growth rate of 9% (vs. a 4.6% growth in the past 3 years) and a LDR of 75% for FY11 and FY12 and 80% for FY13; 2) Income statement related: We increased the interest/interest earning assets to 12.5% (vs. 12% for FY10) on expectation of an upward trend in interest rates. We reduce the interest expense/interest bearing liabilities due to the bank’s high level of liquidity. We reduce the non-interest income/total assets ratio to 4% (vs. 4.5% for FY10). We decrease the impairments costs/loans ratio to 1% (vs. 1.4% for FY10) as we

Page 39 of 62

expect profitability and credit improvements as the economy gains traction. We reduce this ratio to 0.9% for FY12 and FY13. We grow operating expenses by an average of 6.3% over the period (estimate of average inflation rate). Overall, our assumptions crystallise to a pre-exceptional items earning increase of 12.1% for FY11.

Source: Bloomberg, Legae Securities, price as at c.o.b 11/3/11

Fig 40: Share price performance: Acceptable return in the past 12m; PER within history

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Fig 39: Valuation: Justified Price/Book valuation model

Sustainable ROE 28.82%Sustainable growth rate 12.00%ROE less growth rate 16.82%CoE less growth rate 5.30%Justified PBVR 3.2 FY11 BVPS 19.78 FY11 Target price 62.8Current price 66.5Potential capital gain ‐5.56%FY11 forecast Div Yield 6.55%Potential total return 0.99%

Trailing PER 8.5 Forward PER 10.7

Page 40 of 62

Fig 41: CAMEL ratio: Strong in absolute terms

2007 2008 2009 2010 2011F 2012F 2013FC: Equity/Loans 16.7% 18.9% 25.9% 36.1% 26.3% 27.5% 27.3%C: Leverage ratio 9.0 8.2 6.8 5.5 6.7 6.5 6.4A: Impairement costs/Loans ‐0.7% ‐1.2% ‐0.5% ‐1.4% ‐1.0% ‐0.9% ‐0.9%M: NII/Op. income 60.3% 59.3% 63.1% 60.2% 63.6% 63.4% 60.2%M: Cost/income ‐58.8% ‐60.6% ‐59.3% ‐54.0% ‐50.9% ‐53.8% ‐53.9%E: NIM 8.5% 10.1% 10.7% 10.9% 11.1% 11.1% 9.8%E: ROA 3.1% 3.3% 3.7% 6.1% 4.7% 4.4% 4.1%L: Loans/Deposits 96.6% 85.5% 74.3% 70.4% 75.0% 75.0% 80.0%L: Liquid assets/depoists 33.5% 33.2% 42.6% 55.8% 38.4% 39.2% 44.6%

Source: Company reports, Legae Securities; ROA includes exceptional items.

Fig 42: Profitability: ROA strong; Leverage decline but we expect a rebound

2007 2008 2009 2010 2011F 2012F 2013FAsset yield: Revenue/Assets 12.0% 14.0% 14.2% 15.1% 14.7% 14.7% 13.9%Margin: Profit/Revenue 26.0% 23.4% 26.0% 40.7% 31.7% 30.0% 29.6%ROA 3.1% 3.3% 3.7% 6.1% 4.7% 4.4% 4.1%Leverage 9.0 8.2 6.8 5.5 6.7 6.5 6.4ROE 28.0% 27.0% 25.2% 33.7% 31.5% 28.7% 26.3%

Source: Company reports, Legae Securities; ROA includes exceptional items

Fig 43: Assumptions: No materially deviation from history

2007 2008 2009 2010 2011F 2012F 2013FBalance sheet modelDeposit growth 16.3% 15.9% ‐0.4% ‐1.6% 10.0% 9.5% 7.5%LDR 97% 86% 74% 70% 75% 75% 80%Income statement modelInterest income/IEAs 10.2% 12.9% 12.7% 12.0% 12.5% 12.5% 12.0%Interest expense/IPL ‐2.0% ‐2.9% ‐2.1% ‐1.2% ‐1.5% ‐1.5% ‐2.5%Fees and commission income/TA 0.0% 4.2% 4.1% 4.3% 4.0% 4.2% 4.1%Fees and commission expense/TA 0.0% ‐0.2% ‐0.3% 0.0% ‐0.5% ‐0.5% ‐0.3%Net fee and commission income/TA 3.8% 3.9% 3.8% 4.3% 4.5% 4.1% 4.1%Foreign exchange income/TA 0.9% 1.5% 1.3% 1.4% 1.7% 1.5% 1.5%Other operating income/TA 0.0% 0.3% 0.1% 0.4% 0.2% 0.2% 0.2%Impairments/Loans ‐0.7% ‐1.2% ‐0.5% ‐1.4% ‐1.0% ‐0.9% ‐0.9%Operating expenses/TA ‐7.0% ‐8.5% ‐8.4% ‐8.1% ‐7.5% ‐7.9% ‐7.5%Taxation/PBT ‐30.6% ‐31.1% ‐32.3% ‐27.4% ‐30.0% ‐30.0% ‐30.0%


Page 41 of 62

Fig 44: Earnings model

2007 2008 2009 2010 2011F 2012F 2013FInterest income 13,634 17,821 17,517 17,130.6 19,180.9 21,119.8 22,852.2 Interest expense ‐2,253 ‐3,811 ‐2,747 ‐1,457.1 ‐2,218.7 ‐2,423.6 ‐4,179.1 Net interest income 11,381 14,010 14,770 15,673.4 16,962.2 18,696.2 18,673.1 Fees and commission income 6,996 6,705 7,374.6 7,241.3 8,404.1 9,240.3 Fees and commission expense ‐412 ‐450 ‐ ‐905.2 ‐1,000.5 ‐677.5 Net fee and commission incom 5,984 6,584 6,255 7,374.6 6,336.2 7,403.6 8,562.8 Foreign exchange income 1,478 2,567 2,193 2,345.9 3,077.6 3,001.5 3,310.3 Other operating income 17 466 179 629.8 299.3 370.8 491.6 Total non‐interest income 7,479 9,617 8,627 10,350.3 9,713.0 10,775.9 12,364.6 Operating income 18,860 23,627 23,397 26,023.7 26,675.2 29,472.1 31,037.7 Impairment on loans and advan ‐687 ‐1,282 ‐513 ‐1,199.7 ‐1,021.6 ‐1,006.8 ‐1,154.4 Operating expenses ‐11,095 ‐14,329 ‐13,882 ‐14,048.6 ‐13,577.5 ‐15,851.2 ‐16,743.2 Profit before exceptional item 7,078 8,016 9,002 10,775.4 12,076.1 12,614.1 13,140.1 Exception Items 2,777.3 ‐ ‐ ‐ Profit before tax 7,078 8,016 9,002 13,553 12,076 12,614 13,140 Taxation ‐2,168 ‐2,491 ‐2,911 ‐2,953.7 ‐3,622.8 ‐3,784.2 ‐3,942.0 Profit /loss for the year 4,910 5,525 6,091 10,599 8,453 8,830 9,198 EPS 3.60 4.10 4.50 7.81 6.23 6.50 6.77

Source: company reports, Legae Securities

Fig 45: Abridged Balance Sheet model

2007 2008 2009 2010 2011F 2012F 2013FCash and balances with CBK 10,774 13,695 9,751 13,131 12,153 13,487 15,935 Government securities 25,721 28,307 43,861 55,996 40,092 44,967 55,611 Loans and advances 105,346 108,086 93,543 87,147 102,157 111,862 128,268 Total assets 157,656 168,510 164,876 172,415 181,034 200,099 223,242

Customer deposits 109,097 126,408 125,869 123,826 136,209 149,149 160,335 Total liabilities 140,092 148,047 140,666 140,950 154,169 169,330 188,282 Total shareholders' equity 17,564 20,463 24,210 31,465 26,865 30,769 34,961 Liabilities + Equity 157,656 168,510 164,876 172,415 181,034 200,099 223,242


Page 42 of 62

Initiation: Cooperative Bank - SELL A strong deposit franchise provides scope for growth but valuation risks are high; FY11 Target Price Kes17.3; SELL Company and business brief: The history of Cooperative bank

dates back to 1965 when it was registered under the Cooperative Societies Act. In 2008, the bank was incorporated under the Companies Act and listed on the NSE in December of the same year. The major shareholder, CoopHoldings Co-operative Society Limited owns 64.56% of the Group. In addition to retail banking, the group runs three subsidiaries, namely 1) Kingdom Securities Limited which provides stock-broking services (shareholding 60%); 2) Co-op Trust Investment Services Limited which is a fund management subsidiary and is wholly owned by the bank; and 3) Co-operative Consultancy Services (K) Limited which provides advisory and corporate finance services and is wholly owned by the bank. The bank has 88 branches. The Group has a 25.5% ownership in Cooperative insurance Company Limited. Cooperative is the #4 biggest bank by assets, and #3 by loans and deposits.

Key differentiating factor(s): The ability to mine cooperatives (Savings and credit cooperatives (SACCOs) who have developed capacity be a source of deposits and loan demand is a primary differentiating factor for Cooperative bank, in our view. The bank is well-placed to wring-fence the business of SACCOs to a very large extent, and given the size of the informal market is Kenya, SACCOs play an important role. Knowledge banking could enable Cooperative bank to develop domain expertise which would help to understand the captive market of the SACCOs that is estimated to have a membership of ~7mn people.

Valuation and risks: Our FY11 TP is Kes17.3. Our Justified PBVR is 2.3X, obtained by applying a CoE of 18.5%, a sustainable growth rate of 14.75% (theoretical sustainable growth rate is 15.1% using a payout ratio of 35%; but we discount it to capture no exposure to regional markets yet and peer inferior CAR); and an ROE of 23.2%. The trailing PER of 13.9X (2010 EPS) is lower than the average of 14.8X, although we caution the risk of subjectively using the average PER as the share’s trading history is short (listed in 3Q08). A forward PER of 10.2X (Legae EPS estimate) is not attractive when compared to KCB and Equity.

Why we are sceptical on Cooperative: There are 4 primary reasons that make us agnostic on Cooperative. 1) The PER is high relative to peers and doesn’t provide reasonable a ‘safety margin’ when compared to history. After a strong rally in the past 12-months (relative to peers), the trailing PER shot beyond 20X before a retreat in recent times. The trailing PER using the recently announced FY10 results of 13.9X which is the highest vs. peers except StanChart. We think in case of disappointments, (earnings, economics, politics etc), Cooperative faces higher downside risks than peers; 2) a peer inferior CAR on the face of regionalisation

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and mortgage lending growth is not appealing. While the CAR is high on a stand-alone basis, Cooperative’s CAR of 16.2% is only better than StanChart. This means its peers posses the ability to expand their RWAs at a higher rate. Taking into consideration that the bank has established a subsidiary in Southern Sudan (70% stake, remainder owned by Government of Southern Sudan), the capital buffer could run thin should the loan book expand. Nevertheless, we applaud the decision to establish partnerships with incumbent banks in various East African countries rather than establishing subsidiaries as that could allow the bank to access these markets at a lower cost; 3) lower efficiency as indicated by the poorer profits/deposits ratio and lower return on RWAs. The bank’s profits/deposits at is 3.7%. (lowest alongside KCB) and Cooperative has the highest liabilities cost as well as the highest interest expense. Asset rotation is low at 11.9% (only better than StanChart) hence and poorer ROA. Capital-risk adjusted return of 4.1% is the least among the peers. To us, a combination of relatively more expensive liabilities and low asset rotation are structural issues that could impair future profitability. Nevertheless, we highlight that the bank’s pre-exceptional items profitability has been very consistent. (CAGR of 45.6%); and 4) the low provision growth rates vs. loans and advances that could create risks to earnings in future. Cooperative’s provisions have significantly lagged loan growth at 4.4% vs. loan growth of 31% between CY07 and CY10.

CAMEL analysis: That is the dilemma we face. On a standalone basis, CAMEL indicators for the Top 5 banks are strong. However we note the following: 1) Capital: Cooperative bank’s 16.2% Total CAR and a Core CAR of 16.2% are not mean measures at all. However, as we have indicated above, the CARs are lower than most of it peers except StanChart. It is important however, to indicate that in relation to solvency risk, the bank is well buffered. We have forecast an average equity/loans ratio of 23.5% for the next 3 years. We expect the leverage to remain below 8X; 2) Asset quality: We should indicate that we are impressed by the coverage ratio for Cooperative bank that rose to 61% from 46% in FY09. The provisions/loans ratio also declined to 0.9% from 1% in the previous year. Coming from 1.8% in FY07, we believe the ratio has normalised and we model an average ratio of 1% for the next 3 years; 3) Management: The cost/income ratio is still high at ~60%. Management indicated that they rationalised their headcount, and about 300 positions (people) where retrenched in order to reign in on costs, but we maintain the ratio ~60% on expansion (Southern Sudan and branch network costs). We admit this could be a key catalyst to the bottom line should the bank become more efficient; 4) Earnings: We expect a minor rebound in NIM on the back of expanding spreads. The impact is a small improvement in the ROA from 3% in FY10 to 3.2%. Leverage should however, decrease slightly on capitalisation of the Southern Sudan subsidiary; and 5) Liquidity: Like most of the indicators, on a standalone basis they ratios are strong. The bank’s LDR of

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~70% and a liquidity ratio of 39.4% (we calculate it at 35.8%) provides significant room for changes in asset mix. Given the bank’s captive deposit market, we do not see material risks to liquidity.

Major assumptions: Our primary assumptions are: 1) Balance sheet: We have assumed a deposit growth rate of 25% for FY11 (vs. average 27% since FY07) before subsequently reducing it to 20% and 15% for FY12 and FY13. We increased the LDR to 75% throughout our forecast period; 2) Income statement: We increased the interest/interest earning assets to 8.7% (vs. 8% for FY10; 8.7% is also the average yield since FY07). We increased the interest expense/interest bearing liabilities to 2.2% (vs. 2.0% for FY10) on increasing competition; particularly should there be consolidation that could give merged entities scale. We also raised the provisions/loans ratio to 1% (vs. 0.9% for FY10)

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Fig 46: Valuation: The Justified Price/Book valuation model

Average ROE 23.2%Sustainable growth rate 14.75%Cost of Equity 18.5%

ROE less growth rate 8.5%CoE less growth rate 3.8%Justified Price/Book Value ratio 2.3

FY11 Book Value 7.7FY11 Target price 17.3 Current price 18.25Potential capital gain ‐5.0%Dividend yield 2.0%Potential total return ‐3.0%


Source: Bloomberg, Legae Securities, prices as at c.o.b 11/3/11

Fig 47: Share price performance: High PER on expectations of robustly earnings growth

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Fig 48: CAMEL ratios: Strong on a stand-alone basis.

2006 2007 2008 2009 2010 2011F 2012F 2013FC: Equity/Loans 18.4% 17.8% 25.7% 26.0% 23.6% 23.1% 22.9% 24.3%C: Leverage ratio 11.12 9.58 6.13 6.84 7.54 7.25 7.28 6.94A: Provision/Loans 5.0% 1.8% 0.8% 1.0% 0.9% 1.0% 0.9% 1.0%M: NII/Op. income 48.3% 54.6% 59.0% 57.8% 58.6% 59.9% 58.9% 60.9%M: Cost/Income 61.2% 63.5% 61.0% 62.8% 58.9% 58.7% 59.3% 56.9%E: NIM 9.4% 10.4% 10.8% 9.7% 9.3% 10.9% 10.5% 10.8%E: ROA 1.5% 2.4% 2.8% 2.7% 3.0% 3.2% 3.1% 3.4%L: Loans/Deposits 59.0% 70.2% 80.3% 68.0% 69.9% 75.0% 75.0% 75.0%L: Liquid asssets/Deposits 38.5% 28.6% 23.8% 33.5% 35.8% 32.0% 32.4% 34.9%


Fig 49: ROE decomposition: We expect asset rotation to increase and boast ROA

2006 2007 2008 2009 2010 2011F 2012F 2013FAsset yield: Revenue/Asse 11.9% 12.6% 11.6% 10.6% 10.2% 11.8% 11.3% 11.5%Margin: Profit/Revenue 12.5% 18.7% 24.6% 25.3% 29.2% 27.4% 27.4% 29.8%ROA 1.5% 2.4% 2.8% 2.7% 3.0% 3.2% 3.1% 3.4%Leverage 11.1 9.6 6.1 6.8 7.5 7.2 7.3 6.9ROE 16.6% 22.6% 17.4% 18.3% 22.4% 23.4% 22.6% 23.7%Direct ROE 16.6% 22.6% 17.4% 18.3% 22.4% 23.4% 22.6% 23.7%


Fig 50: Assumptions: Generally in line with history

2007 2008 2009 2010 2011F 2012F 2013FBalance sheetDeposit growth 13.7% 20.2% 39.0% 35.4% 25.0% 20.0% 15.0%LDR 70.2% 80.3% 68.0% 69.9% 75.0% 75.0% 75.0%Income statementInterest income/IEA 8.9% 9.4% 8.7% 8.0% 8.7% 8.7% 8.5%Interet expense/IPL 1.7% 2.5% 2.4% 2.0% 2.2% 2.4% 2.3%Fee income/TA 6.4% 5.7% 5.2% 4.8% 5.5% 5.4% 5.2%Provisions/Loans 1.8% 0.8% 1.0% 0.9% 1.0% 0.9% 1.0%Staff cost/Assets 4.1% 4.2% 4.1% 3.4% 3.9% 3.9% 3.8%Tax/PBT 27.3% 30.9% 20.8% 18.1% 24.3% 23.5% 21.7%


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2007 2008 2009 2010 2011F 2012F 2013FLoans and advances 4,085.719 5,869.019 7,441.411 9,274.912 13,355.642 15,765.461 18,218.321 Government securities 1,290.586 1,227.857 1,501.757 2,519.198 3,715.340 4,063.329 5,458.754 Deposits and placements 37.373 36.258 49.307 32.636 90.709 94.659 161.728 Other interest income 106.147 291.513 71.153 ‐ 258.925 290.682 223.214 Total interest income 5,519.825 7,424.647 9,063.628 11,826.746 17,420.616 20,214.130 24,062.016 Customer deposits 889.908 1,530.165 2,192.508 2,414.470 3,210.382 4,060.852 4,596.158 Deposits and placements 61.764 159.081 62.184 83.769 386.748 494.009 465.135 Other interest expense 48.760 39.510 39.647 139.893 125.371 142.098 171.465 Total interest expense 1,000.432 1,728.756 2,294.339 2,638.132 3,722.501 4,696.959 5,232.758 Net interest income 4,519.393 5,695.891 6,769.289 9,188.614 13,698.115 15,517.171 18,829.257 Fees and commissions on loans 509.831 524.377 639.482 908.281 1,244.945 1,603.785 1,673.599 Other fees and commissions 2,399.296 2,694.722 2,775.992 3,476.237 5,641.348 6,397.601 6,982.943 Foreign exchange dealing 414.221 493.581 375.887 621.201 837.406 1,036.984 1,084.954 Dividend income ‐ ‐ 7.154 6.563 5.228 7.823 11.260 Other income 433.114 242.102 1,150.383 1,471.019 1,424.037 1,761.865 2,336.022 Total non‐interest income 3,756.462 3,954.782 4,948.898 6,483.301 9,152.965 10,808.057 12,088.778 Total operating income 8,275.855 9,650.673 11,718.187 15,671.915 22,851.080 26,325.229 30,918.036 Loan loss provision 699.891 403.262 628.384 798.666 1,161.360 1,286.775 1,544.354 Staff costs 2,419.776 2,933.547 3,844.312 4,493.620 6,591.440 7,801.722 8,806.746 Directors emoluments 55.678 70.789 75.512 89.887 143.666 167.544 182.693 Rental charges 196.207 342.396 400.973 551.904 695.407 873.408 974.372 Depreciation on property 332.854 425.419 605.392 853.251 1,027.392 1,253.770 1,453.284 Amortization charges 56.337 58.592 83.692 97.434 142.818 165.714 190.132 Other operating expenses 2,196.588 2,057.649 2,344.226 3,144.511 4,820.015 5,341.314 5,988.713 Total operating expenses 5,957.331 6,291.654 7,982.491 10,029.273 14,582.097 16,890.246 19,140.295 Profit/loss before exceptional items 2,318.524 3,359.019 3,735.696 5,642.642 8,268.983 9,434.982 11,777.741 Exceptional items ‐ ‐ ‐ 129.977 ‐ ‐ ‐ Profit and loss before tax 2,318.524 3,359.019 3,735.696 5,772.619 8,268.983 9,434.982 11,777.741 Current tax 632.241 1,037.496 777.409 1,045.792 2,006.938 2,219.208 2,553.368 Deferred tax 136.678 ‐52.315 ‐9.676 146.128 ‐ ‐ ‐ Profit (loss) 1,549.605 2,373.838 2,967.963 4,580.699 6,262.045 7,215.774 9,224.372 EPS 0.799 0.850 1.312 1.793 2.066 2.641


Fig 52: Abridged Balance Sheet model

2007 2008 2009 2010 2011F 2012F 2013FBalances due from CBK 3,619.3 3,172.6 4,348.8 8,735.3 9,431.0 10,865.1 13,216.0 Kenya Gvnt Securities 9,666.6 9,131.5 22,081.3 30,329.0 32,775.3 40,399.0 51,158.4 Gvnt and other securities for dealing 3,278.5 3,725.5 4,362.5 4,030.3 3,484.1 7,560.3 3,346.7 Loans and advances 38,429.5 52,908.5 62,274.2 86,618.3 116,136.0 139,363.2 160,267.7 Total assets 65,708.9 83,485.9 110,678.1 154,340.0 194,415.9 232,526.7 269,876.8

Customer deposits 54,775.4 65,853.7 91,518.7 123,878.4 154,848.0 185,817.6 213,690.3 Total liabilities 58,853.4 69,876.7 94,386.5 133,743.9 167,481.2 200,473.1 230,843.7 Total shareholder funds 6,855.5 13,609.2 16,185.0 20,477.4 26,816.0 31,934.9 38,914.4 Total liabilities and shareholder funds 65,708.9 83,485.9 110,678.1 154,340.0 194,415.9 232,526.7 269,876.8


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Initiation : KCB Limited - BUY A solid franchise at an attractive valuation level; FY11 Target Price Kes27.6; BUY Business and company brief: KCB is one of the oldest banks in

the system with a history that stretched back to 1896. After going through different phases, the Government of Kenya (GoK) acquired 100% of National Grindlays bank in 1970 and renamed it Kenya Commercial Bank. The GoK has since reduced its shareholding to 17.1%. Besides Kenya, KCB has operations in Southern Sudan (11 branches), Uganda (13 branches), Tanzania (11 branches) and Rwanda (9 branches). In CY2010, the Group merged with S&L in order to grow its mortgage offering. The bank boasts the highest number of branches in Kenya at 168. KCB is the biggest bank by assets, loans and deposit.

Key differentiating factor(s): In our view, KCB is the only mainstream banks with a material regional play. Equity Bank is another, but it is more of an MFI than otherwise. In a region that is increasingly becoming integrated, regional presence should bode well for KCB, particularly in the areas of trade finance. KCB is well placed to enjoy benefits of increasing scale.

Valuation and risks: Our 12-month price target of Kes27.6 implies upside potential of 24.2%. We forecast a potential total return of 32%. (Forward dividend yield of 7.8%). Applying a CoE of 18.25%, a sustainable growth rate of 12.75% (we adjust the theoretical growth rate of 11.3% to capture value accretion from the regional markets and the high CAR) and an ROE of 22.5%, we obtain a Justified PBVR of 1.8X. Looking at the PER since CY05, the current trailing PER of 9.1X (2010 EPS) is below the average of 18X. We think that even this relatively long-term PER of 18X is expensive anyway, but at our forward PER of 6.4X, we believe the risk return profile is attractive. Given our constructive stance on earnings, (+43% for FY11) we question the discount to peers that KCB is attracting.

The key risks to our valuation include 1) slower recovery on loan loss provisions and 2) higher costs in its regional expansion programme (i.e. execution risks). Management indicates that Uganda and Rwanda may require more capital to ensure ability to underwrite higher value loans.

Share price catalysts and why we are constructive: Over the past 12 months, KCB share price has returned a derisory 4.4%. This is against capital gains of 29.1%, 83.4%, 58.9% and 42.2% for Barclays, Cooperative, Equity and StanChart respectively. Bad and doubtful debts provisions have increased by 199% in FY10, and the ratio climbed to 1.4% of loans and advances. Normalisation to 1% should support ROA. Management expects Tanzania, Uganda and Rwanda to break-even this year. Southern Sudan is already profitable through transactional banking services alone as regulations related to lending are yet to be promulgated.

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Overall, we are positive on KCB because 1) all the regional markets, at least according to management, should either break even or turn profitable this year. Management’s decision to consolidate the current regional exposure than expanding into new markets, means that no further risk is assumed in the short-term; 2) the high CAR level ensure ability to expand RWAs. Management expect mortgage growth of 40%, and will introduce mortgage products in some of its regional markets; and 3) relative structural strength against local peers (i.e. excluding Barclays and StanChart). Compared to Equity bank and Cooperative, KCB attracts the cheapest liabilities (cost of liabilities is 1.6% vs. 1.8% for Cooperative and 2% for Equity). The asset rotation at 13.6% is higher than Cooperative’s 11.9% although it is lower than Equity bank’s exceptional 16.9%. Improvements in the expense ratio as a result of no further regional expansion and extremely controlled headcount expansion (as per management guidance) should provide a boost to ROA.

CAMEL analysis: Below we highlight the key CAMEL ratios for KCB. 1) Capital: The bank’s capital position is strong with a Core CAR of 23.1% as at end of FY10. Leverage is also low at 6.4X although we expect it to increase somewhat to ~7X. From FY07 to FY09, the bank’s ROA has declined steadily before it’s recovered strongly to 2.9% in FY10. Our forecasts maintain the ROA ~3%; we forecast equity/loans ratio to decline permanently by about 3pps as loan book growth accelerates in regional markets; 2) Asset quality: Bad debts expense/loans ratio went up in FY10 to 1.4% from 0.6%. Coverage ratio also rose moderately from 49% in FY09 to 53%. We expect the bad debts/loans ratio to improve on economic improvement to 1% over our forecasting period. The low coverage ratio (only better than Equity bank) is our main source of worry. On the other hand, growth in provisions at 34% between CY07 and CY10 matches the 32% growth in loans and advances; 3) Management: We expect the cost/income ratio to improve to 57% (vs. 61% for FY10). Management indicated no intention to increase staff and we also believe efficiency benefits will begin to come through from regional markets. We expect net interest income to continue to make ~60% of operating income though; 4) Earnings: The ROA improved moderately from 2.1% in FY09 to 2.9% in FY10. We expect this moderate upward movement in the ROA to continue as regional markets contribution becomes positive. We expect the NIM to remain relatively stable at an average of 10.2% in our forecast period; and 5) Liquidity: The LDR remained stable at ~75%. While we increase it to 80% for our forecasting period, the bank has ample liquidity. The disclosed liquidity ratio as at end of FY10 was 28% (our calculation shows ~30%). It is also important to highlight that the bank’s deposit franchise is strong. Deposits have grown by a CAGR of 27% between FY07 and FY10.

Primary assumptions and financial forecasts: The important assumptions to mention are 1) Balance sheet: we grow deposits

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by 25% for FY11 (management guidance is 30%) and maintain a LDR of 80%. 2) income statement: we increased the interest income/interest earnings assets slightly to 12.5% for FY11 (vs. 12.3% for FY10) before reducing it to 12% in FY13; We increase the interest expense/interest bearing liabilities to 2% (vs. 1.7% for FY10; management indicates a possible cost of deposits of 1.9%). We maintain the fee/total assets ratio slightly at 2.8% for FY11 but increased it to 3% on expectation of rising regional penetration by the bank. We also maintain the operating expenses/total assets ratio at 7.5% throughout our forecast period (vs. average of 7.3% from FY07 to FY10).

Our assumptions lead to the following important income statement effects. 1) Operating income grows by 25% for FY11; 11% and 14% for FY12 and FY13 respectively; 2) EPS grow by 43% for FY11; 13% in FY12; and 21% for FY13. Fig 53: Valuation: The Justified PBVR model

Sustainable ROE 22.51%Sustainable growth rate 12.75%ROE less growth rate 9.76%CoE less growth rate 5.50%Justified PBVR 1.8 FY11 BVPS 15.57 FY11 Target price 27.6Current price 22.25Potential capital gain 24.17%FY11 forecast Div Yield 7.83%Potential total return 32.00%


Source: Company reports, Bloomberg, Legae Securities, price as at c.o.b 11/3/11

Fig 54: Share price performance: Valuation risk looks low

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Fig 55: CAMEL ratios: Robust on a stand-alone basis

2007 2008 2009 2010 2011F 2012F 2013FC: Equity/Loans 20.5% 22.5% 18.4% 26.4% 23.3% 23.1% 24.3%C: Leverage ratio 9.1 9.1 8.6 6.4 7.3 7.0 6.7A:Bad debts expense/Loans 1.2% 1.5% 0.6% 1.4% 1.0% 1.0% 1.2%M:NII/Op. income 59.8% 60.6% 64.0% 64.0% 64.0% 65.7% 66.5%M: Cost/income 64.8% 61.8% 68.9% 61.0% 56.7% 55.4% 53.2%E:NIM 9.9% 10.3% 10.1% 10.3% 10.2% 10.1% 10.4%E:ROA 2.5% 2.2% 2.1% 2.9% 3.1% 3.2% 3.4%L:Loan/deposit 68.1% 73.8% 75.2% 75.2% 80.0% 80.0% 80.0%L:Liquid assets/deposits 40.2% 33.1% 24.4% 30.9% 31.6% 30.1% 31.5%


Fig 56: ROE decomposition: ROA and leverage to marginal improve and support ROE

2007 2008 2009 2010 2011F 2012F 2013FAsset yield : Revenue/Assets 11.7% 10.2% 11.6% 12.2% 11.4% 11.6% 12.0%Margin: Profits/Revenue 21.0% 21.6% 18.1% 23.5% 26.7% 27.2% 28.8%ROA 2.5% 2.2% 2.1% 2.9% 3.1% 3.2% 3.4%Leverage 9.1 9.1 8.6 6.4 7.3 7.0 6.7ROE 22.5% 19.9% 18.1% 18.4% 22.4% 22.1% 23.1%


Fig 57: Assumptions: We model below management guidance for prudence

2007 2008 2009 2010 2011F 2012F 2013FIncome statementInterest income/Interest earning assets 11.0% 12.9% 12.5% 12.2% 12.5% 12.3% 12.0%Interest expense/interest earning liabilities ‐0.9% ‐1.8% ‐2.1% ‐1.7% ‐2.0% ‐2.0% ‐1.5%Fees and commission income/Total assets 3.8% 3.0% 3.0% 2.8% 2.8% 3.0% 3.0%Fees and commission expense/Total assets ‐0.2% ‐0.1% ‐0.2% ‐0.1% ‐0.1% ‐0.1% ‐0.1%Dividend income/total assets 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Foreign exchange income/trading assets 0.7% 0.9% 0.8% 1.1% 1.1% 1.1% 1.1%Other operating income/total assets 0.4% 0.2% 0.5% 0.6% 1.0% 0.7% 0.8%Bad and doubtful debts expense/loans ‐1.2% ‐1.5% ‐0.6% ‐1.4% ‐1.0% ‐1.0% ‐1.2%Other operating expenses/total assets ‐7.6% ‐6.3% ‐8.0% ‐7.4% ‐7.5% ‐7.5% ‐7.5%Taxation/PBT ‐29.6% ‐30.3% ‐35.2% ‐26.7% ‐30.0% ‐30.6% ‐29.1%

Balance sheetDeposit growth n/m 34% 29% 21% 25% 15% 10%Loan/Deposit ratio 68% 74% 75% 75% 80% 80% 80%


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2007 2008 2009 2010 2011F 2012F 2013FInterest income 9,373.39 14,745.59 17,968.46 23,109.79 30,213.92 34,080.73 37,268.49 Interest expense ‐921.82 ‐2,970.47 ‐3,499.73 ‐3,464.47 ‐5,621.16 ‐6,109.67 ‐5,001.88 Net interest income 8,451.57 11,775.12 14,468.72 19,645.33 24,592.75 27,971.06 32,266.61 Fees and commission income 4,524.18 5,778.50 5,849.69 7,159.88 8,126.20 9,438.60 10,325.17 Fees and commission expense ‐243.88 ‐229.35 ‐310.14 ‐340.75 ‐401.21 ‐454.14 ‐479.72 Net fee and commission income 4,280.30 5,549.16 5,539.55 6,819.13 7,724.99 8,984.46 9,845.45 Dividend income 23.96 6.72 1.14 1.19 ‐ ‐ ‐ Foreign exchnage income 838.89 1,628.57 1,648.23 2,775.49 3,192.44 3,460.82 3,785.90 Other operating income 540.04 467.98 936.15 1,450.80 2,902.21 2,158.10 2,596.36 Total non‐interest income 5,683.19 7,652.43 8,125.07 11,046.61 13,819.64 14,603.38 16,227.70 Operating income 14,134.76 19,427.54 22,593.79 30,691.93 38,412.39 42,574.44 48,494.31 Bad and doubtful debts expense ‐748.15 ‐1,408.51 ‐717.92 ‐2,144.43 ‐1,969.75 ‐2,290.22 ‐2,990.08 Other operating expenses ‐9,160.62 ‐12,006.17 ‐15,575.49 ‐18,719.10 ‐21,766.61 ‐23,596.50 ‐25,812.93 Profit before tax 4,225.98 6,012.86 6,300.38 9,828.41 14,676.03 16,687.72 19,691.30 Taxation ‐1,251.41 ‐1,822.17 ‐2,216.49 ‐2,620.00 ‐4,402.81 ‐5,108.54 ‐5,728.20 Profit after tax 2,974.57 4,190.69 4,083.89 7,208.41 10,273.22 11,579.18 13,963.11 EPS 1.84 2.44 3.48 3.93 4.73


Fig 59: Abridged Balance sheet model

2007 2008 2009 2010 2011F 2012F 2013FHeld for trading 4,399.1 3,765.4 2,628.8 847.9 4,426.6 3,747.4 3,716.1 Held to maturity 21,279.8 20,940.9 21,285.0 42,051.3 44,736.7 51,689.2 61,397.8 Loans and advances to customers 64,278.1 93,522.1 122,659.1 148,113.4 196,974.7 226,520.8 249,172.9 Total assets 120,479.6 191,211.6 194,777.8 251,356.2 336,160.6 366,992.9 404,746.4

Due to banks 5,828.6 38,506.0 6,668.4 9,557.4 34,839.8 22,332.5 21,992.6 Customer deposits 94,392.4 126,691.1 163,029.4 196,974.7 246,218.3 283,151.1 311,466.2 Total liabilities 107,274.9 170,124.6 172,207.6 212,347.3 290,221.5 314,620.0 344,172.5 Total equity + liabilities 13,204.7 21,087.0 22,570.2 39,129.8 45,939.1 52,373.0 60,573.9 Total equity + liabilities 120,479.6 191,211.6 194,777.8 251,477.1 336,160.6 366,992.9 404,746.4


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Initiation: Standard Chartered - HOLD Opportunities to constrained by lower relative CAR; FY11 Target Price Kes265.8; HOLD Business description and management: StanChart has 97

years Kenyan experience having opened its first branch in 2011. The bank divides its banking services into 1) Wholesale banking which provides trade finance, cash management, foreign exchange dealing and corporate finance services; and 2) Personal banking which provides consumer banking services to individuals and SMEs. StanChart has 32 branches and is the #3 biggest bank by assets, but only ranks #5 by advances and #4 by deposits.

Key differentiating factor(s): Standard Chartered is a strong franchise, with an international parent that provides a global network. The low provision/loans ratio also indicates that the bank has been acquiring top quality assets when compared to competitors. This ratio has been constantly below 1% from FY07. The coverage ratio is also fair at 56%. The efficiency as indicated by the low cost/income ratio is important. StanChart has the lowest expense ratio at 5.6% (vs. average of 8.8% for the Top 5 banks). A competitive ROA of 3.8% when the bank’s asset rotation is comparatively low connotes the benefits of efficiency (optimal cost control).

Valuation and risks: We estimate a 12-month target price of Kes265.8, just ~1.5% above the current price. We apply the same methodology we have been subjecting other banks to i.e. the Justified PBVR. We use a CoE of 17.5% (higher than Barclays due to relative lower coverage ratio and lower CAR); a sustainable growth rate of 11.83%, which is its theoretical sustainable growth rate. Our Justified PBVR is 3.9X, which to a large extent reflects the greater ROE that StanChart enjoys. A look at the long-term average PER indicates that the share was trading close to its average. However, using 2010EPS (recently released), the PER shrinks to 14X. Our forward PER is 10.8X. We see limited immediate potential in the share price, and with a lower CAR, (only 2pps buffer) catalysts are thin and few, although a capital raising could be a catalyst. Meanwhile, the high payout ratio (and dividend yield) remain a major incentive for exposure although we doubt its sustainability given the low CAR, unless if the bank sheds off assets.

The key risks to our valuation includes 1) a deterioration in the credit quality than we have forecasted; 2) a deterioration in efficiency (cost/income) ratio than we anticipate. On the upside risk, 3) a higher than expected asset growth could lead to outperformance.

CAMEL analysis: Like most of the big banks, the indicators are strong except for the capital position for StanChart (and that is relative to peers under analysis): 1) Capital: That is our greatest concern for StanChart - a CAR of 14%, just 2pp above the

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minimum required. We do not imply that it is a low level. In some systems, especially in the pre-crisis period, banks with CAR of 14% were reckoned to be using capital inefficiently. However, valuation is relative. In Kenya, of the Top 5 banks under our coverage, this is the lowest CAR. The concern is that StanChart’s ability to grow market share (RWAs) is greatly hindered when compared to its peers. However, it is important to highlight that the bank increased its dividend payout ratio from 69% in FY09 and 72% in FY10, which indicates its unwillingness to build up capital and aggressively grow its RWAs. Alternatively, the bank could be banking on its ability to raise other forms of capital. 2) Asset quality: The seemingly controlled asset growth is reflected in low provisions/loans ratio when compared to peers. A coverage ratio of 56% is not particularly substandard although we would prefer to see coverage ratio of 65% at the minimum. We give management the benefit of doubt and assume the recovery rate is comparably higher; 3) Management: Again, in efficiency StanChart shows strong ratios. The cost/income ratio has averaged 45% between FY05 and FY10. With no regional expansion, cost pressures only come from inflation and local expansion (branch network, ATMs) and technology based; 4) Earnings: The NIM lost >3pps from an average of 11% pre-2008 to settle around 7%. We expect it to grow upward mildly due to expansion in interest spreads and asset allocation (we increase the LDR). We expect the ROE, which has averaged 28.7% between FY05 and FY10 to average 33.5% as a result of a positive boost from ROA and an increase in leverage (more of capital management due to a high dividend payout) in the next 3 years; and 5) Liquidity: Despite a low CAR, the bank is liquid. The liquidity ratio is more than 2X the minimum required at 55% (we estimate 53%) while the LDR is 60%, the lowest among banks under coverage in this report. Between FY06 and FY10, deposits growth has averaged 11.8%, and we have modelled a 15% growth (vs. FY10’s 15.8%). We do not think the bank faces immense liquidity risks, especially given a constraint in its RWAs growth due to a comparatively low 2pps capital safeguard.

ROE breakdown: The ROE declined to 26% for FY10 despite a strong ROA of 3.8%, as leverage declined to 7X from 8.8X in FY09. Notwithstanding our CAR concerns, we expect leverage to take a slight uptick in FY11 and thus amplify the ROE back to >30s. We forecast an average ROE of 33% in the next 3 years if the bank continues with a payout ratio of 70%.

Primary assumptions and financial forecasts: Below we show the primary assumptions for our model 1) Balance sheet model: we assumed a deposit growth rate 15% throughout our forecasting period. We model a LDR of 65% for FY11, 70% for FY12 and 75% for FY13; 2) Income statement: We raise the interest income/interest earning assets to 9.5% for FY11 (vs. 8.2% for FY10) on our expectation of improving economic conditions and up-trending interest rates. We maintain the interest expense/interest bearing liabilities ratio at 1.5% for FY11 as we do

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not see reasons for a vigorous deposit mobilisation strategy by the bank, given its high liquidity ratio and low CAR (which constrain RWAs growth). We raised the provisions/loan ratio slightly to 0.9% and maintained it at that level for the next 3 year. (this is also the average ratio between CY06 and CY10).

Our assumptions lead to the following important income statement effects. 1) Operating income grows by 30.7%% for FY11; 11.3% and 7% for FY12 and FY13 respectively; 2) earnings per share pick up by 29.5% for FY11 before growth declining to 10.4% in FY12.

Fig 60: Valuation: The Justified PBVR model

Average ROE 33.8%Sustainable growth rate 11.83%Cost of Equity 17.5%

ROE less growth rate 22.0%CoE less growth rate 5.7%Justified Price/Book Value ratio 3.9

FY11 Book Value 68.6FY11 Target price 265.8Current price 262Potential capital gain 1.5%Dividend yield 6.5%Potential total return 7.9%

Trailing PER 14.0Forward PER 10.8

Source: Company reports, Legae Securities, price c.o.b 11/3/11

Fig 61: Share price performance: It is within fair valuation

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Fig 62: CAMEL ratios: Strong but lower capital buffer constrain growth relative to competitors

2006 2007 2008 2009 2010 2011F 2012F 2013FC: Equity/Loans 28.3% 27.7% 26.6% 24.7% 33.7% 26.2% 24.2% 22.2%C: Leverage 8.0 8.3 8.6 8.8 7.0 8.1 8.2 8.4A: Provisions/Loans ‐1.4% ‐0.5% ‐0.8% ‐0.8% ‐0.7% ‐0.9% ‐0.9% ‐0.9%M: Cost/Income ‐46% ‐46% ‐50% ‐41% ‐43% ‐39% ‐40% ‐42%M: NII/Op. income 62.9% 57.1% 58.1% 59.9% 59.2% 61.3% 59.8% 58.0%E:NIM 13.8% 13.0% 12.7% 7.0% 7.0% 8.1% 7.9% 7.4%E: ROA 3.3% 3.8% 3.3% 3.8% 3.8% 4.4% 4.1% 3.8%E: ROE 26.0% 31.8% 28.3% 33.8% 26.4% 35.3% 34.2% 31.8%L:LDR 55.1% 53.5% 56.3% 65.3% 60.0% 65.0% 70.0% 75.0%L: Liquid assets/Deposits 8.9% 13.5% 11.7% 50.8% 53.7% 45.5% 42.0% 35.6%


Fig 63: The ROE decomposition; Leverage to pick up and ROA to remain strong

2006 2007 2008 2009 2010 2011F 2012F 2013FAsset yield: Revenue/Total assets 9.8% 10.5% 10.2% 9.9% 9.9% 10.9% 10.6% 10.3%Margin: Income/revenue 33.2% 36.3% 32.2% 38.6% 38.0% 40.2% 39.1% 36.9%ROA 3.3% 3.8% 3.3% 3.8% 3.8% 4.4% 4.2% 3.8%Leverage: Assets/Equity 8.0 8.3 8.6 8.8 7.0 8.1 8.2 8.4ROE 26.0% 31.8% 28.3% 33.8% 26.4% 35.4% 34.2% 31.8%


Fig 64: Assumptions: Divergence from historical performance is minimal

2007 2008 2009 2010 2011F 2012F 2013FBalance sheet modelDeposit growth 13.8% 4.1% 12.8% 15.8% 15.0% 15.0% 15.0%LDR 53.5% 56.3% 65.3% 60.0% 65.0% 70.0% 75.0%Earnings modelInterest income/IEA 16.6% 16.1% 9.0% 8.2% 9.5% 9.5% 9.3%Interest expense/IPL ‐2.1% ‐2.0% ‐2.1% ‐1.5% ‐1.5% ‐1.8% ‐2.0%Fee & commission/TA 2.4% 2.3% 2.0% 1.9% 2.5% 2.5% 2.5%Fee & commission expense/TA ‐0.2% ‐0.1% 0.0% ‐0.1% ‐0.1% ‐0.1% ‐0.1%Trading income/TA 1.7% 2.1% 1.7% 1.1% 1.5% 1.6% 1.6%Other operating income/TA 0.5% 0.0% 0.3% 1.1% 0.3% 0.3% 0.3%Staff costs/TA ‐2.8% ‐3.0% ‐2.3% ‐2.4% ‐2.5% ‐2.5% ‐2.5%General administrative costs/TA ‐1.3% ‐1.3% ‐1.1% ‐1.4% ‐1.1% ‐1.1% ‐1.2%Net impairment losses /Advances ‐0.5% ‐0.8% ‐0.8% ‐0.7% ‐0.9% ‐0.9% ‐0.9%Taxation/PBT ‐29.3% ‐31.1% ‐29.7% ‐30.0% ‐30.2% ‐30.1% ‐30.2%


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2006 2007 2008 2009 2010 2011F 2012F 2013FInterest income 6,555.621 6,977.075 7,445.466 9,347.475 9,912.435 12,431.515 14,197.968 15,987.867 Interest expense ‐1,570.646 ‐1,527.460 ‐1,568.347 ‐2,010.197 ‐1,529.125 ‐1,818.398 ‐2,448.295 ‐3,244.871 Net interest income 4,984.975 5,449.615 5,877.119 7,337.278 8,383.310 10,613.117 11,749.673 12,742.996 Fee and commission income 2,069.370 2,224.576 2,232.359 2,424.706 2,770.199 3,974.754 4,631.412 5,320.886 Fee and commission expense ‐98.195 ‐138.775 ‐75.596 ‐42.492 ‐139.443 ‐153.223 ‐169.335 ‐168.624 Net fee and commission income 1,971.175 2,085.801 2,156.763 2,382.214 2,630.756 3,821.531 4,462.077 5,152.262 Net trading income 958.076 1,532.306 2,058.143 2,128.392 1,622.154 2,405.199 2,875.002 3,434.001 Other operating income 16.172 481.677 18.045 398.548 1,513.868 476.970 555.769 638.506 Operating income 7,930.398 9,549.399 10,110.070 12,246.432 14,150.088 17,316.818 19,642.521 21,967.765 Staff costs ‐1,896.582 ‐2,586.318 ‐2,998.390 ‐2,840.833 ‐3,402.827 ‐3,974.754 ‐4,631.412 ‐5,408.997 Premise and equipment cost ‐406.579 ‐449.375 ‐538.344 ‐539.964 ‐261.132 ‐686.157 ‐773.472 ‐856.419 General administrative costs ‐1,153.903 ‐1,228.761 ‐1,263.592 ‐1,364.669 ‐2,055.292 ‐1,748.892 ‐2,037.821 ‐2,561.870 Depreciation and amortization ‐160.729 ‐168.738 ‐224.581 ‐297.583 ‐302.273 ‐282.952 ‐375.135 ‐493.374 Operating expenses ‐3,617.793 ‐4,433.192 ‐5,024.907 ‐5,043.049 ‐6,021.524 ‐6,692.755 ‐7,817.840 ‐9,320.660 Operating profit before impairment and tax 4,312.605 5,116.207 5,085.163 7,203.383 8,128.564 10,624.062 11,824.682 12,647.105 Net impairment losses ‐502.178 ‐206.019 ‐365.349 ‐474.936 ‐446.680 ‐653.302 ‐837.375 ‐1,031.765 Profit before tax 3,810.427 4,910.188 4,719.814 6,728.447 7,681.884 9,970.760 10,987.307 11,615.339 Taxation ‐1,176.127 ‐1,440.311 ‐1,469.001 ‐1,995.693 ‐2,305.693 ‐3,011.139 ‐3,303.491 ‐3,509.353 Net profit/loss 2,634.300 3,469.877 3,250.813 4,732.754 5,376.191 6,959.621 7,683.816 8,105.986 EPS 9.69 12.76 11.95 17.40 18.73 24.24 26.77 28.24


Fig 66: Abridged balance sheet

2007 2008 2009 2010 2011F 2012F 2013FKenya governemnt securities 2,397.72 1,615.56 41,159.85 51,353.79 45,076.07 46,520.82 42,990.22 Kenya governemnt securities 2,397.72 1,615.56 41,159.85 51,353.79 45,076.07 46,520.82 42,990.22 Loans and advances to customers 39,468.52 43,298.82 56,694.88 60,336.83 75,126.79 93,041.64 114,640.59 Total assets 91,121.94 99,019.57 123,778.97 142,746.25 159,122.45 185,422.55 212,911.76

Deposits from customers 73,840.56 76,898.46 86,773.65 100,504.07 115,579.67 132,916.63 152,854.12 Total liabilities 80,205.93 87,520.76 109,786.82 122,415.13 139,427.19 162,916.27 187,423.95 Total shareholders' equity 10,916.01 11,498.81 13,992.16 20,331.12 19,695.26 22,506.28 25,487.81 Total Equity and Liabilities 91,121.94 99,019.57 123,778.97 142,746.25 159,122.45 185,422.55 212,911.76


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Follow up: Equity Bank Limited – HOLD Price weakness provides opportunities; FY11 Target Price Kes27.9; (Speculative) BUY Upgrade recommendation as the potential return move into

our BUY territory: In December 2010, we downgraded our recommendation to a HOLD as the potential return to our target price had reduced materially. (see Could Equity Bank be a victim of its success, dated December 7 2010). In our view, Equity Bank is a premier micro-finance institution in the region, having entered the Ugandan market and Southern Sudan. However, the conviction in our BUY recommendation is watered down by the robust share price rally (+58%) in the past 12 months. Our outlook (and valuation) is broadly intact, and the change in recommendation is a result of the recent price decline that has improved the potential return.

Key differentiating factor(s): In our opinion, Equity bank’s market segment is its key advantage. Equity bank has managed to institutionalise micro-finance in Kenya and is moving into the regional markets. The bank’s strong IT system is also a key strength in the micro finance sector and Equity has managed to benefit from its technological advantages in telephone banking to further penetrate its market segment. The bank has >4mn accounts in Kenya. In Uganda, management indicates ~400,000 customers while Southern Sudan has ~30,000 profitable customers.

A look at FY10 results: 1) Balance sheet: Deposits registered a strong growth rate of 50% to Kes104.4bn. Loan growth of 20% was low relative to history leading to a LDR of 75%. We consider it to be fair nonetheless, given the high base growth is now coming from. Government securities and other securities for dealing purposes jumped massively to Kes22.6bn from Kes6.8bn in FY09. Total shareholders’ funds went up by 19% while the balance sheet expanded by 42% to Kes143bn; 2) Interest income and NIM: Interest from loans and advances increased by 20% (vs. 54% in FY09) to Kes11.4bn, while interest from government securities jumped by 234% to Kes2.3bn as the holdings in government securities increased by 20%. Placements with banks remain immaterial. Interest expense (in shilling-terms) on deposits went up by 78% in response to deposit growth. Interest income contribution to operating income declined to 52.9%. The NIM increased slightly to 12.7% from 12.5% in FY09, in spite of the high level of government securities. 3) Asset quality: The provisions/loan ratio deteriorated to 2.4% from 1.6% in FY09. Loan loss provision in shilling-term increased by 84% to Kes1.9bn. Net NPLs in shilling-terms declined by 19% to Kes3.9bn, improving the coverage ratio to 48% (still lower than our preferred minimum of 65%). Provisions in shilling-terms have increased by 322% vs. a growth rate of 53% in loans and advances; 4) Expenses: Staff

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costs were up 22%. Other operating expenses were also up by 20% although total expenses grew by 26% (vs. 37% in FY09); 5) Earnings and ROE: Earnings rose by 68% to Kes7.1bn. The ROE improved to 26.3% (vs. 18.5% in FY09) on improvements on both leverage and ROA. ROA increased to 5% (vs. 4.2% for FY09) while leverage inched up to 5.3X from 4.4X in FY09.

Valuation and recommendation rationale: Our rational for a BUY is the price weakness that has seen the share price decline by a 7.5% YTD. Our Justified PBVR is 2.6X. We applied a sustainable growth rate 13.5% (theoretical growth rate is 14.6% but we adjust it downwards, given the higher penetration (accounts) that Equity experienced in the recent past), CoE of 18% and ROE of 26.5%). This Justified PBVR provides a FY11 TP of Kes27.9. However, for consistency, our Discounted Future Earnings method (the method we used on initiation shows a fair value of Kes25.1 (upside potential reduced to 1.4% only). Our BUY recommendation is speculative.

Share price catalysts: The bottom line is to make money. We are banking on continued strong earning production. (Our Forward PER is 8X). Uganda which made a loss contribution of Kes700mn in FY10 is expected to deliver better performance this year. Southern Sudan is expected to continue to perform well after making a positive contribution of Kes300mn in FY10. Headwinds could come from regional expansion as management targets to open in Rwanda and Tanzania.

Fig 67: Valuation: The Justified PBVR model

Sustainable ROE 26.5%Sustainable growth rate 13.5%ROE less growth rate 13.0%CoE less growth rate 5%Justified PBVR 2.60 FY11 BVPS 10.73 FY11 Target price 27.9Current price 24.75Potential capital gain 13%FY11 forecast Div Yield 5.0%Potential total return 18%


Source: Company reports, Legae Securities, prices as at c.o.b 11/3/11

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Fig 68: Price performance: Rallied strongly in CY10, high earnings expectations

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Legae Securities (Pty) Ltd

Member of the JSE Securities Exchange

1st Floor, Building B, Riviera Road Office Park, 6-10 Riviera

Road, Houghton, Johannesburg, South Africa

P.O Box 10564, Johannesburg, 2000, South Africa

Tel +27 11 551 3601, Fax +27 11 551 3635

Web: www.legae.co.za, email: [email protected]

Analyst Certification and Disclaimer

I/we the author (s) hereby certify that the views as expressed in this

document are an accurate of my/our personal views on the stock or sector

as covered and reported on by myself/each of us herein. I/we furthermore

certify that no part of my/our compensation was, is or will be related,

directly or indirectly, to the specific recommendations or views as expressed

in this document

This report has been issued by Legae Securities (Pty) Limited. It may not be

reproduced or further distributed or published, in whole or in part, for any

purposes. Legae Securities (Pty) Ltd has based this document on information

obtained from sources it believes to be reliable but which it has not

independently verified; Legae Securities (Pty) Limited makes no guarantee,

representation or warranty and accepts no responsibility or liability as to its

accuracy or completeness. Expressions of opinion herein are those of the

author only and are subject to change without notice. This document is not

and should not be construed as an offer or the solicitation of an offer to

purchase or subscribe or sell any investment.

Important Disclosure

This disclosure outlines current conflicts that may unknowingly affect the

objectivity of the analyst(s) with respect to the stock(s) under analysis in

this report. The analyst(s) do not own any shares in the company under

analysis.

Disclaimer & Disclosure

Documents

Kenyan Banks_Anchor themes_regionalisation and mortgage lending_BUY KCB_SELL Coop