August 30, 2012

SSA ex|Equity|Banks

Industry Themes

KENYAN BANKS
[You] work a lifetime to pay off a house. You finally own it and there is no one to live in it*

Recommendations
BCBL Current price FY13 Price Target Potential return to FY13 Recommendation Trailing PER (FY11 EPS) Forward PER (FY13 LS est.) Trailing PBVR (FY11 BVPS) Forward PBVR (FY13 LS est. BVPS) Justified PBVR Forward Div. Yield (FY13 LS est.) 14.8 16.3 18.3% HOLD 10.0 8.7 2.8 2.6 2.8 8.1% COOP EQBNK 11.6 12.7 16.7% HOLD 7.6 5.3 1.9 1.2 1.3 7.6% 22.5 29.0 36.5% BUY 8.1 5.3 2.4 1.5 1.9 7.5% KNCB 25.5 31.6 35.5% BUY 6.9 4.3 1.7 1.2 1.5 11.5% SCBL 200.0 218.6 19.5% HOLD 9.8 6.4 2.8 2.0 2.2 10.2%

Share prices performances, YTD

1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 KCB Barclays Coop StanChart Equity

Mortgage penetration, 2010

Mortgage loans/GDP vs. Per capita income
120% Mortgage loans/GDP Netherlands 100% R = 0.7604

80% UK USA 60% Ireland Spain 40% South Africa Malaysia 20% India 0% Kenya - Uganda 5 000 Thai land China Chil e Mexico Brazil 10 000 15 000 20 000 25 000 30 000 Hungary Pol and Czech per capita income 35 000 40 000 45 000 50 000 South Korea

NPLs formation expectations

Rise Personal/Household 39% Building and construction 38% Trade 37% Real Estate 35% Transport and Communication 28% Tourism and Hotels 23% Manufacturing 21% Agriculture 20% Financial Services 16% Mining and quarrying 8% Energy and water 5% 1H2012 Remain constant 42% 45% 34% 38% 48% 55% 52% 49% 66% 81% 79% Fall 19% 18% 29% 28% 25% 23% 27% 31% 18% 11% 16% Rise 64% 58% 51% 66% 41% 31% 36% 26% 21% 19% 14% 1Q2012 Remain constant 24% 26% 31% 22% 46% 53% 54% 55% 68% 70% 78% Fall 12% 16% 18% 12% 13% 17% 10% 19% 11% 11% 8%

Peter Mushangwe

+27 11 551 3675 peterm@legae.co.za

Mortgages and region remain our key long-term themes for Kenyan banks: We have recommended exposure to Kenyan banks that are building strong footprints in regional and mortgage markets rather than pure Kenyan plays. We maintain that stance for now. However, after KNCB indicated possible weaknesses in the mortgage sector, we look at one of our key themes the mortgage sector. Investors are worried by credit risks in Kenya and rightly so as loan and NPL growths remain out of kilter: Our recent discussions with investors point to a general concern on credit risks in Kenya. We had indicated our fears before (see NPL growth < Loans growth > GDP growth higher risks: A critique on credit risks, dated March 6 2012) but we should also highlight that there are structural improvements in the system as procedures and the regulatory framework have vastly improved. The mortgage sector still lowly penetrated and Loans/Value (LTV) ratio at ~82% is fair: The mortgage loans remain a small fraction of the system loan book (~8% in CY10) and only an insignificant ~3% of GDP. The opportunities remain ample but structural constraints remain. In addition, comparisons vs. countries with higher per capita income could be misleading. Nonetheless, we believe the ~82% LTV is fair despite being slightly above the general rule of thumb of 80%. But the system has a high number of variable rate loans and the mortgage payment/income ratio at ~50% is above rule of thumb of 40%: In CY10, variable interest rate loans made up ~73% of the systems mortgage loans. When interest rates increase, NPL formation spikes, and when rates decline, there is pressure on spreads. Both are unconstructive to banks. The mortgage payment/income ratio at 50% is also high which fuels asset quality concerns. Banks expect NPL formation to recede in 1H12: The Credit Officer Survey indicates that banks expect NPL formation to recede in 2H12 as interest rates decline (and we believe restructuring has had a positive impact too). About 19% of the banks expect household NPLs to decline in 1H12 vs. 12% who expected a decline when surveyed in 1Q12. Banks are generally tightening the credit standards to Building and construction and Real estate sectors. Stock calls: We BUY KNCB, FY13 PT Kes31.6 and EQBNK, FY13 PT Kes29. We maintain our HOLD on all pure domestic Kenyan banks we cover - BCBL FY13 PT Kes16.3 and SCBL FY13 PT Kes218.6. We also HOLD COOP FY13 PT Kes12.7. *Arthur Miller, Death of a Salesman

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1.

Loans vs. NPLs: Out of the kilter

Mortgage market and regionalisation remain our key longterm themes for Kenyan banks: We have recommended Kenyan banks that are building strong exposure to the region and the mortgage sector instead of those that are purely Kenyan plays. We maintain that stance. However, post KNCBs teleconference and managements indications that the mortgage sector could see weaknesses in credit quality, and our general concern on the systems credit risks, we provide a brief on the Kenyan mortgage sector. (see Section 2). NPLs declined in Kes-terms while loans grew strongly and the relationship seems out of kilter: The NPLs declined from Kes90.2bn in CY00 to Kes44.8bn in May 2012. Meanwhile net loans (Gross loans less suspended interest) expanded to Kes1,279bn in May 2012 from Kes272.9bn in CY00. Looking from 1H06 and employing monthly data, the divergence is still phenomenal. However, suspended interest also reduced from Kes37.5bn in 1H06 to Kes11.7bn in May 2012. (see Fig 1). In our opinion, this indicates concrete structural improvements in asset quality as suspended interest is generally more difficult to game than NPLs. Nonetheless, we remain sceptical despite the improvements. The NPL ratio has improved as NPLs reduce but investors should remain watchful: The NPL ratio reduced to <5% in May 2012 from >30% in CY00. There are legacy issues, of course, but this is a solid improvement nonetheless. Given the fact that NPLs in Kes-term are declining while loans and advances are increasing at a strong rate, the decline in the ratio is natural. However, we expect investors to keep eyes on 1) Write-offs: Faster write-off reduces NPLs leading to a better a NPL ratio (which is often the most watched); 2) Restructuring: This delays recognition of NPLs and to an extreme extent can result in reclassification of loans. Restructuring may have negative effects to earnings (e.g. haircuts) and in some cases restructured agreements may not be realistic; 3) Foreclosure and liquidation: The banks would exchange the NPLs with the security/title. Depending on type of security, impact to earnings could be limited yet the NPLs would have reduced. The differentiating factors: We wish disclosure related to NPLs could be better i.e. classifications of NPLs, disclosure of write-offs, write-backs etc. Nevertheless, we believe investors should be wary of banks that 1) continue to raise capital as that could indicate higher write-offs which investors may not notice as the NPL ratio would remain suppressed; 2) have higher levels of restructured loans. We are assuming management teams will be willing to provide information on such important issues.

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Fig 1: While system loans have expanded, suspended interest and NPLs have reduced in absolute terms
3.5 Gross advances Suspended Interest Net Loans 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Sep-11 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-12
85% 80% 40% 20% 0% -20% -40% -60% -80% 30% 75% 25% 70% 65% 60% 15% 55% 50% 45% 5% 40% 0% 35%

Net loans

NPLs

3.0

2.5

2.0

1.5

1.0

0.5

0.0
Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Source: CBK, Legae Calculations

Fig 2: and the out of kilter in growth is supporting a solid improvement in the system NPL ratio.
60% Loans Suspended interest NPLs 35% NPLs/Net Loans, LHS Provisions/NPLs

20%

10%

Source: CBK, Legae Calculations

2000 2003 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12

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2.

The mortgage sector: Salient features

Mortgage exposure remain one of our key long-term themes: While we still believe that mortgage lending is a key long-term theme to our investment thesis on Kenyan banks, we highlight that KNCB indicated that the mortgage sector is an area of concern to them. Property prices are deemed excessive and would therefore be expected to weaken, eroding buyers equity in some instances and providing opportunities for lower rental alternative in others. We still believe that the low penetration (mortgage loans/GDP ~3% and mortgage loans/total loans ~10%) provides strong potential for banks and mortgage lenders despite some key concerns we highlight below (see Fig 3). From a regulatory capital perspective, the lower capital requirements (to support mortgages) i.e. lower risk weight, is an incentive for banks to expand mortgage loan books in a system that has grown its exposure to consumers meaningfully. Yet we take note of the concerns: The general assumption is that high-income properties/houses segment is overvalued while the middle to low income properties/houses segment is not. Banks (and KNCB in particular) indicate that they avoid high-income areas where property prices are deemed excessive. However, we note that the average mortgage loan size and the average size of new loans are increasing. (see Fig 4). House price inflation is the primary reason for the rising average loan size. However, it could also indicate that, contrary to management guidance, borrowers are still mainly looking for high-income properties. But we believe mortgage the default rate should be lower than other household loans: While disclosure is limited, we expect the mortgage default rate to be lower than general household default rate mainly because 1) borrowers have little incentive to willingly default on mortgages as most of them use the properties for residence purposes. Cheaper rentals that could be an alternative are not common in Kenya and East Africa, in general; 2) the high property prices are largely due to supply constraints rather than excessive demand, hence to an extent, we do not expect banks to carry a lot of poor quality borrowers that could have been enticed by reckless lending. The LTV ratio looks fair but the system has a high number of variable rate loans: In 1H10, the LTV ratio was 82%. This is slightly above the rule of thumb of 80%. Additionally, ~73% of the system mortgage loans carry variable interest rates while only 9% carry fixed rates (see Fig 4). The effects are two-fold 1) when interest rates rise, customers will struggle to meet new adjusted payments, leading to high delinquencies and/or NPLs; 2) when interest rates reduce, the banks will have a spread squeeze. Both are unconstructive to banks, particularly given the high interest and inflation rates volatility. However, the high level of variable contracts reduces the prepayment risks that banks face when rates drop.
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and the mortgage payment/income ratio of 50% is worryingly above the generally acceptable ceiling of 40%: The other worrying ratio is the mortgage payment/income ratio which at 50% in 1H10 was already higher than the generally acceptable ratio of 40%, in spite of the low penetration. (see Fig 4). This raises critical questions about affordability, hence we understand KNCBs asset quality concerns. We also underscore the relationship between mortgage penetration and per capita income. Despite our (and other commentators) euphoric analysis on growth opportunities, Kenyas penetration is in line when one considers per capita income. Other systems with higher per capita incomes like Brazil and Poland still show relatively low penetration. (see Fig 5). Banks expects NPL formation to recede in 1H12 after strong NPL formation in 1H12: Despite the restructuring, 1H12 saw stronger NPL formation due to the level of interest rates. Most banks believe NPLs will reduce in 2H12 as rates are expected to decline (and we believe restructuring will have a positive impact to NPLs as well). However, NPL formation in the household segment is expected to remain stubborn, despite the improvements, with 39% of banks expecting the household NPLs to rise. Household NPL ratio is the highest in the system at 6%. According to the Credit Officer Survey, banks are tightening credit standards to Building and construction and Real estate sectors. If one assumes that the above sectors are fair proxies of the mortgage sector, then we note that Banks are generally concerned. (see Fig 6 and Fig 7) KNCB has been increasing its market share in mortgage lending: KNCB has increased its market share in mortgage lending, overtaking a traditional mortgage lender, Housing Finance (HFCK) with its mortgage loans constituting 29.3% of the system mortgage loan book in 2010. The mortgage loans constituted ~12% of the banks total loan book. On the other hand, SCBL reduced the mortgage market share. (see Fig 8).
Fig 3: The mortgage sector is still lowly penetrated but mortgage loans/total loans ratio is increasing.
35% 30% 25% 20% 15% 10% 5% 0% Tanzania Uganda Kenya Brazil Poland India China South Africa 0.0% 2006 2007 2008 2009 2010 May

Mortgage loans/GDP

8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0%

Mortgage loans/Total loans

Source: CBK, IMF, Legae Calculations

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Fig 4: The average loan sizes are increasing but the ability-to-pay indicator is weak. Interest rate volatility can stoke payment problems given the high level of variable mortgage rate loans.

Average loan Average new Average Fixed rate Variable rate Average size loan size Mortgage rate contracts contracts LTV 2006 2007 2008 2009 2010 1H 2 510 613 2 914 440 3 377 385 3 993 020 4 000 204 n/a 4 916 047 5 083 298 7 540 801 6 628 832 12.2% 12.7% 13.5% 14.1% 14.0% n/a n/a n/a n/a 9% n/a n/a n/a n/a 73% n/a n/a n/a n/a 82%

Tenor n/a n/a n/a n/a 5-15yrs

Av. Mortgage PMT/Income n/a n/a n/a n/a 50%

Source: CBK, Legae Calculations

Fig 5: Despite the low penetration, the low per capita income suppresses Notwithstanding the opportunities, the mortgage loans/GDP ratio is in line with peers.

affordability.

Mortgage loans/GDP vs. Per capita income

120% Mortgage loans/GDP

R = 0.7604

Netherlands 100%

80% UK USA 60% Ireland Spain 40% South Africa Malaysia 20% India 0% Kenya - Uganda 5 000 Thailand China Chile Mexico Brazil 10 000 15 000 20 000 25 000 30 000 Hungary Poland Czech per capita income 35 000 40 000 45 000 50 000 South Korea

Source: CBK, IMF, Legae Calculations

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Fig 6: While banks expect NPL formation to ease in Q312, higher NPL formation in 1H12 would still be negative to the system for FY12 earnings

Rise Personal/Household Building and construction Trade Real Estate Transport and Communication Tourism and Hotels Manufacturing Agriculture Financial Services Mining and quarrying Energy and water 39% 38% 37% 35% 28% 23% 21% 20% 16% 8% 5%

1H2012 Remain constant 42% 45% 34% 38% 48% 55% 52% 49% 66% 81% 79%

Fall 19% 18% 29% 28% 25% 23% 27% 31% 18% 11% 16%

Rise 64% 58% 51% 66% 41% 31% 36% 26% 21% 19% 14%

1Q2012 Remain constant 24% 26% 31% 22% 46% 53% 54% 55% 68% 70% 78%

Fall 12% 16% 18% 12% 13% 17% 10% 19% 11% 11% 8%

Source: CBK, Legae Calculations

Fig 7: Households loans NPL ratio is the highest. While mortgage loans are general classified under household loans, Building and Con. sectors is also under pressure

1H12 Personal/Household Trade Manufacturing Real Estate Transport and Communication Agriculture Financial Services Building and Construction Energy and Water Tourism and Hotels Mining and Quarrying

Loans, NPLs, Kes Bn % of total Kes bn % of Total NPL ratio 326.8 257.1 174.8 168.6 102.8 64.7 51.7 51.9 42.3 32.5 16.1 25.3% 19.9% 13.6% 13.1% 8.0% 5.0% 4.0% 4.0% 3.3% 2.5% 1.2% 19.7 12.3 5.0 6.5 3.8 4.1 1.3 2.3 0.3 2.1 0.1 34.3% 21.4% 8.7% 11.3% 6.6% 7.1% 2.3% 4.0% 0.5% 3.7% 0.2% 6.0% 4.8% 2.9% 3.9% 3.7% 6.3% 2.5% 4.4% 0.7% 6.5% 0.6%

Source: CBK, Legae Calculations

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Fig 8: KNCB has increased its market share in mortgage sector, eclipsing HFCK, while SCBL has reduced.
CFC Stanbic Mortgage loan book, Kesmn 2006 4 077 8 330 625 2007 6 264 8 960 2 725 2008 9 703 11 300 5 350 2009 15 640 15 100 6 137 2010 17 974 16 900 6 497 KCB HFCK 2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 Market share 20.9% 42.8% 23.6% 33.7% 24.9% 28.9% 29.1% 28.1% 29.3% 27.5% Number of loans 2 077 3 478 2 518 3 441 3 170 3 805 4 176 3 869 4 051 3 988 3.2% 10.3% 13.7% 11.4% 10.6% 149 421 743 869 939 StanChart Barclays 2 910 3 646 4 425 4 898 4 960 14.9% 13.7% 11.3% 9.1% 8.1% 941 1 019 1 118 1 122 1 107 3 092 322 3 578 090 3 957 786 4 365 279 4 480 960 969 1 702 2 366 2 914 3 055 5.0% 6.4% 6.1% 5.4% 5.0% n/a 449 618 726 742 n/m 3 790 461 3 828 377 4 013 544 4 117 615 CBK 362 447 911 1 113 1 159 1.9% 1.7% 2.3% 2.1% 1.9% 49 77 150 220 238 7 384 776 5 804 039 6 076 587 5 060 259 4 868 954 I&M Bank 246 323 503 686 732 1.3% 1.2% 1.3% 1.3% 1.2% 78 70 121 132 135 3 160 205 4 619 614 4 156 512 5 199 273 5 425 281 Equity n/a 30 300 538 673 n/m 0.1% 0.8% 1.0% 1.1% n/a 4 70 129 151 NBK n/a n/a 273 543 568 n/m n/m 0.7% 1.0% 0.9% n/a n/a 14 36 57 Coop n/a n/a n/a 56 246 n/m n/m n/m 0.1% 0.4% n/a n/a n/a 5 27

Average loan value, Kes* 1 963 101 2 395 055 4 197 416 2 487 817 2 603 894 6 473 045 3 060 907 2 969 777 7 200 447 3 745 117 3 902 817 7 062 414 4 437 017 4 237 713 6 919 518

n/m n/m n/m 7 390 000 n/m n/m 4 283 957 19 477 429 n/m 4 168 209 15 075 083 11 103 000 4 458 722 9 969 772 9 122 852

Source: CBK, Legae Calculations

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Legae Securities (Pty) Ltd

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