KCB Analysis

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BANKING SECTOR OVERVIEW Kenyas banking sector has recorded marked growth over the past half decade. Increased lending has seen assets grow from Kshs.515bn in 2003 to Kshs.950bn in 2007 and these are expected to exceed Kshs.1trn in 2008. Profitability has followed suit to stand at Kshs.24.6bn in FY07 from Kshs.9.6bn in 2003. Interest rates remained range bound between 2003 and 2007 owing to a deliberate attempt by the Government to lower the cost of borrowing and boost economic growth. Following the disputed 2007 election, inflation rose to record highs of 32% in May 2008 owing to general disruption of food supplies and other commodities as well as sky rocketing crude oil prices. Oil prices have plummeted to levels below $70 a barrel on global recession woes. Kenyas cost of living is expected to remain high until food supplies return to normalcy and lower costs of fuel are passed on to consumers. The high inflationary environment has put upward pressure on interest rates with most banks revising their cost of lending upwards. The graph below depicts the industrys growth in terms of deposits and loans.

CFCStanbic Centre, Chiromo Road Nairobi,Kenya Tel: +254 020 3638900 Fax: +254 020 3752951

Source: CBK Banking Supervision Reports CFCFS Research

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Kenya Commercial Bank (KCB) Investment Summary We maintain our Accumulate recommendation on KCB during the current bearish market conditions. At the current price of Kshs.24.50, it is trading at a
Price Trailing PE Forward PE Book Value(Kshs) P/BV ROE 24.50 18.2x 11.1x 6.44 3.8x 23%

forward PE of 11x and forward P/BV of 2.6x. Further, our DDM model indicates that the share is fairly priced at current levels as it assumes a 4 year CAGR of 18.4% between FY09 - FY2013 which we believe is achievable under favorable economic conditions and given the banks regional expansion plan. KCBs turnaround strategy adopted in 2003 has been a success with earnings turning from a loss of Kshs.3bn in FY02 to a net profit of Kshs.2.9bn in FY07. Nonperforming loans which were eating into the banks profits have also reduced dramatically from Kshs.25.1bn in FY 02 to Kshs.2.2bn in FY 07. The bank has expanded regionally namely in Uganda, Tanzania and Sudan and plans to spread further to Rwanda. As a result, KCB is set to benefit from increased cross border trade in the Eastern African region. BALANCE SHEET SUMMARY Deposits As a result of wide branch network, KCB boasts of commanding significant market share in the banking sector with total deposits standing at Kshs.110bn by 3Q 08. The bank has registered a compounded annual growth rate in deposits of 15% between FY04 and FY07.The graph below depicts growth in deposits vis--vis that of the banking sector. KCBs

Source: Company Financial Statements and Central Bank CFCFS Research

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Loans and advances The bank has managed to clean out its bad loans to Kshs.2.2bn in FY07 from Kshs.25bn in FY 02 when the banks earnings were undermined by significant bad debt write offs. KCBs loans book has grown in tandem with that of the banking sector with its gross loans book increasing at a compounded annual growth rate of 13% between FY 04 and FY 07. In a bid to boost its capital base the bank raised Kshs. 5.3bn in a rights issue during the current financial year. With new capital KCB has the leeway to increase lending without a corresponding increase in deposits by raising its loans to deposits ratio which has previously been below industry norms.

Source: Company Financial Statements and Central Bank

Loans Structure The banks loan portfolio is largely dominated by the private sector, which accounted for 91% of loans in FY07 with Government and Parastatals accounting for the remainder. The bulk of the banks loans are medium term with 70% of most loans maturing between 1 to 5 years as of FY 07.

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P&L Summary 3Yr 2005 2006 2007 CAGR

(04-07)

3Q 08

%
Growth

Kshs. Millions Interest Income Interest Expense Net Interest Income Non Interest Income Operating Income Provision For Loss Operating Expenses Profit After Tax 5,725 597 5,127 4,298 9,426 591 6,887 1,326 7,064 750 6,313 5,433 11,747 752 7,827 2,431 9,373 921 8,451 6,392 14,844 1,213 9,404 2,974 30% 33% 30% 12% 21% 5% 15% 55% 9,991 1,946 8,045 7,183 15,229 1,147 8,880 3,764 46% 223% 29% 69% 45% 57% 35% 68%

Source: Company Reports and CFCFS estimates

Interest income has grown at a 3 year CAGR of 30% to Kshs.9.3bn in FY07. 3Q 08 interest income has surpassed that of previous full financial year to stand at Kshs.9.9bn owing to increased loans book.

KCB has enjoyed low cost of deposits as a result of its wide branch network as shown by relatively low interest expense compared to interest income. However going by 3Q 08 results, cost of deposits could rise sharply in the current financial year probably owed to the liquidity crunch witnessed during the Safaricom IPO.

Net Interest income has grown at a CAGR of 30% over the past 3 years to Kshs.8.4bn owing to the twin effects of increased interest income and low costs of deposits.

The bank enjoys diversified sources of income with non interest income accounting for 43% of operating income in FY07. Non funded income in 3Q 08 has edged up to 47% owing to increased forex and other undisclosed income.

KCB has improved cost efficiency as evidenced by reducing cost to income ratio to stand at 63% in FY 07 from 73% in FY03. The banks profit after tax (PAT) has improved at a CAGR of 55% over the past three years to stand at Kshs.2.9bn in FY07. This expected to grow further going by 3Q 08 results which posted a 68% increase in PAT to Kshs.3.7bn.

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Bad Books The banks year on year bad books shrunk by 45% in FY 07 to Kshs.2.2bn from kshs.4bn in previous year. Meanwhile, provisions for loss increased to Kshs.1.2bn in FY07 from Kshs.1.6bn in FY 06 in line with new CBK provisioning guidelines. VALUATION Dividend Discount Model (DDM) Our DDM valuation model indicates that the current share price of Kshs.24.50 is justified under the assumption that the banks earnings will grow by a four year CAGR of 18.4% between FY09 - FY2013 while gradually increasing dividend payout to 60% from 47% in FY07.Thereafter a long term growth rate of 8% is assumed into perpetuity with a dividend payout rate of 80%. The discount rate used is 16.6%. KCBs regional expansion will enable the bank to benefit from increased trade between the Eastern African countries and attract more deposits, a crucial factor in supporting earnings growth. As such a 4 year earnings CAGR of 18% is possible as long as economic conditions remain favorable. The sensitivity analysis below indicates the estimated share price under different scenarios of cost of capital and 4 year CAGR while long term growth remains constant at 8%. Sensitivity Analysis Cost of 16.60% 4Year CAGR 15% 19% 25% 30%
Source: CFCFS Estimates

Capital (k)

17%

18%

20%

22.4 25.08 29.77 36.72

21.33 23.77 28.18 34.72

18.88 20.99 24.8 30.47

15.25 16.88 19.8 24.2

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EARNINGS MULTIPLES Price to Book Value (P/BV) KCB is currently trading at a trailing P/BV of 3.8x using FY 07 book value and a forward P/BV of 2.6x using estimated book value for FY 08 after factoring in the rights issues proceeds. Price to Earnings Ratio (P/E) At the current price of Kshs.24.50, KCB is trading at a trailing and forward PE of 18x and 11.5x respectively. Risks Economic Risk Sustained growth of the banks earnings is pegged on favorable economic conditions. Market Risk An overall equity market downturn has the potential of dampening the share price sometimes significantly. Credit Risk Risk emanating primarily from loans and advances made by the bank turning out to be non-performing. Inflation Risk Kenya is currently experiencing double-digit overall inflation levels last experienced in the mid-1990s. High levels of inflation weaken the purchasing power of the Kenya shilling, which subsequently reduces the amount of savings. High rates of inflation could increase costs and reduce operating margins. Strengths Strong brand name across all market segments. Regional expansion to support growth in the medium term. Enjoys low cost of deposits. Has increased cost efficiency Benefits from high levels of non funded income

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Weakness High concentration of medium term loans increases credit risk exposure.

In view of the above, we maintain our Accumulate recommendation on KCB during the prevailing bearish market conditions.

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About CFC Financial Services Ltd

CfC Financial Services Limited (CfCFS) is a wholly owned subsidiary of CfC Stanbic Holdings Limited. CfCFS commenced operations in March 2000 as a licensed investment advisor and dealer/market maker at the Nairobi Stock Exchange, and is regulated by the Capital Markets Authority of Kenya. CfCFS principal business activity is the provision of investment banking and stockbrokerage services in addition to developing long-term relationships based on trust, confidentiality, and ability to implement trading strategies that address the strategic and financial objectives of individuals and businesses. CfCFS is an investment banking and stockbroking firm in Kenya with 7 branches countrywide. Our unmatched reach into interior urban centers has made CfCFS the frontrunner in bringing the Nairobi Stock Exchange to the people through out the country.

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