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1 January

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3 EXECUTIVE SUMMARY Global economic activity and trade picked up substantially within the advanced economies towards the second half of 2013 raising hopes of a much stronger These hopes were premised largely on waning skepticism over the two major threats to global economic recovery at the time: the possible breakup of the Euro-zone and the reverberating effects of the US falling off the fiscal cliff. Although these two headwinds were summarily overcome early in 2014, the revival in global economic conditions remained largely unconvincing for the rest of the year. In the major high income areas, growth in private spending was at best tepid, as these economies began to slowly adjust to the hangovers of massive balance sheet adjustments in the previous year. Beyond the anticipated decline in oil prices, we believe the major challenge facing the global economy in 2015 will be the task of minimizing the volatility expected to ensue from broadly dissimilar fiscal and monetary regimes across the advanced economies. With the Bank of Japan possibly pursuing Quantitative Easing, the European Central Bank maintaining its aggressive balance sheet expansion, and the US tightening stance, we see larger scale volatility compared to The market is moving in the direction of a possible US rate hike... As the US economy continues its recovery, much stronger than before, the Fed is widely expected to begin raising interest rate in mid Our analysis of seven (7) previous US rate tightening cycles shows that rise in rate often creates volatility and slows the pace of gains in emerging markets. Some of the impacts of a tightening environment already occurred in While many emerging markets now appear to be better off, having raised rates and reduced current account deficits, some are still exposed to rate hike due to domestic economic conditions. The last time the US Fed hinted on Quantitative Easing tapering, global financial markets went into panic mode with emerging markets bearing the brunt of portfolio reversals, resulting in sharp depreciations in exchange rates. Although we expect many emerging markets to take measures to reduce their vulnerabilities to such externalities in 2015, having learnt their lessons the hard way, we still see a sizeable chunk of capital outflows from very volatile frontier economies particularly those with relatively lower risk adjusted real returns. Are oil prices assuming a new normal? Given the long backwardation history of oil price trading dynamics, current and anticipated supply-demand scenarios, there is no reason to expect oil prices to rebound sharply in the short to medium term. We see oil prices remaining 3

4 volatile especially in the first half of 2015 as the market digests the actions and inactions of oil producers. Notably, the outlook for oil prices in the medium to long term remains bleak against the background of the significant traction that alternative energy sources as well unconventional oil production has gained in the last decade. Nigerian economy and financial markets may be challenged in 2015 The Nigerian economy is set to face one of the most difficult times in history as global crude oil prices, a key anchor for fiscal strength and macroeconomic stability, continue on a downward trajectory in The financial markets are likely to be more challenging relative to 2014 as we expect 4 major factors to shape the markets in 2015: 1) Post-election scenarios 2) Aggressive tightening by the CBN, 3) Variability in foreign portfolio flows, and 4) the downward trajectory of crude oil prices. These factors are largely expected to dictate movements in both equity and fixed income markets albeit in different degrees during the year. This report contains a detailed review of the market in 2014 with projections for 2015, including expectations across different sectors; inherent opportunities as well as strategies for navigating the market at a time like this 4

5 CONTENTS Executive Summary 3 Abbreviations 7 Global Economic Review and Outlook 11 Global Economy: Quite a distance to recovery 12 United States: Turning off the stimulus tap 13 Other Advanced Economies 14 Emerging and Frontier Markets 15 Global Macro Themes for The BRICS 19 Africa Update and Outlook 21 South Africa: Slowly turning the corner? 22 Ghana: Growing but groaning 26 Kenya: Brighter medium term prospects 29 Oil Price Dynamics and Nigeria s 2015 Outlook 35 Domestic Macro Trends and Outlook for Monetary Policy 44 Real GDP 48 Inflation Rate 50 Exchange Rate Dynamics 51 Fiscal Plan 55 Politics and 2015 Elections 59 Capital Markets Review and Outlook 61 Fixed Income Market 62 Equities Market 67 Sector Reviews and Recommendations 76 Banking Sector 77 Insurance Sector 82 Consumer Goods Sector 91 Industrial Goods Sector 97 Oil and Gas Sector 101 List of Figures and Tables 107 5

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7 Analyst(s) Kayode Tinuoye Team Lead, Research Office: Ext: Kayode Omosebi Analyst Office: Ext: Securities Trading Asset Management Trusteeship Investment Banking Project Finance Mergers & Acquisitions Capital Markets 7

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9 Section 1 Global Economic Review and Outlook 9

10 Global Economic Review and Outlook 2014: The Year That Was Global Economy: Quite a Distance to Recovery A strong pick-up in global activity and trade within the advanced economies towards the second half of 2013 raised hopes of a much stronger These hopes were premised largely on waning skepticisms over the two major threats to global economic recovery at the time: the possible breakup of the Euro-zone and the reverberating effects of the US falling off the fiscal cliff. Although these two headwinds were summarily overcome early in 2014, the revival in global economic conditions remained largely unconvincing. In the three major high income areas, US, Euro Zone and Japan, the growth in private spending was at best tepid, as these economies began to slowly adjust to the hangovers of massive balance sheet adjustments in the previous year. In the Euro-zone and the US, a significant easing following sustained fiscal consolidation drove expectations of a recovery in demand and business confidence. Emerging economic data as early as April 2014 however suggested that all may not be rosy for the global economy. In its World Economic Outlook for April, 2014, the IMF noted the improvement in global economic outlook but maintained that output gaps largely existed especially in the advanced economies. It was therefore of necessity that the broadly accommodative monetary policies be sustained, even as fiscal consolidation needed to stay within the threshold that ensured that downsides risks to global growth were largely contained. Monetary Policy Divergence Fuels Market Volatility One noticeable theme in the global economy for the year was that for the first time in a long while, the US Fed pursued broadly dissimilar monetary policy to the ECB, a development which in our view contributed to the appreciation of the dollar against most currencies in The search for yield continued in key emerging markets with the attendant pressures on exchange rates especially for countries with more open economies and weak external trade positions. In the three major high income areas, US, Euro Zone and Japan, the growth in private spending was tepid, as these economies began to slowly adjust to the hangovers of massive balance sheet adjustments in The US fed policy decisions diverged significantly from the ECB s, leading to strong gains in the dollar Beyond the anticipated declines in oil prices, we believe the major challenge facing the global economy in 2015 will be the task of minimizing the volatility expected to ensue from broadly dissimilar fiscal and monetary policy regimes across the advanced economies. With the BOJ possibly pursuing QE, and the ECB maintaining its aggressive balance sheet expansion, we see a larger scale of volatility compared to That said the strong growth prospects of the US economy should provide some comfort. 10

11 Global Economic Review and Outlook 8% 6% 4% 2% 0% -2% -4% Fig. 1 Advanced economies seem to have turned the corner but lingering output gaps leave much ground to gain in 2015 y/y GDP growth in global and advanced economies Advanced Economies Emerging Economies f 2016f Source: IMF, United Capital Research Global Real GDP Growth ( ) %,q/q Q1 Q2 Q3 Q4 Advanced Economies United States Euro Area Japan Emerging Economies Latin America Emerging Europe Russia Asia/Pacific China World Source: IMF, United Capital Research United States: Turning off the stimulus Tap Economic fundamentals continue to support interest rate hike A disappointing Q1 14 saw the US economy contract by 2.1% q/q ( Vs. a growth of 2.6% q/q in Q4 13) as adverse weather effects and inventory overhang constituted a drag on the economy. We believe the decline in Q1, which was the first quarterly drop since 2009, re-enforced the vulnerability of the US economy, and effectively places a steeper hurdle on the growth path of the economy in the near term. The economy rebounded in Q2 with a strong 4.6% q/q but growth slowed to 3.3% in Q3 14 (annualized 3.5%) driven by an acceleration in private consumption spending. Motivated by some cheery trends in economic data, the US effectively ended its QE programme in October 2014 after a gradual cutback in debt purchase, beginning January As a result, a huge chunk of emerging market portfolio inflows was curtailed. Although most economic fundamentals continue to point to the recovery of the US economy, the FED has chosen to delay interest rate hike. We believe this is a precautionary stance taken to shield interest rate sensitive sectors such as housing and the financial markets. While the labor market improved significantly in Q1-Q4 14, signs of a re-emergence of labor market pressures resurfaced in Q4 14. FED s forward guidance points to the possibility of rates remaining at zero (0%) through mid Nonetheless, we expect the FED to begin to raise interest rate early in Q3 15 as a sustained acceleration in private spending is expected to spur growth while inflation remains at a comfortable sub-2% range. We believe the decline in Q1 14, which was the first quarterly drop since 2009, reenforced the vulnerability of the US economy. FED s forward guidance points to the possibility of rates remaining at zero (0%) through mid economy, and effectively places a steeper hurdle on the growth path of the economy in the near term 11

12 Global Economic Review and Outlook Fig. 2 US GDP growth to steady at 2.5% range in 2015 ) Q1'12 Q2 '12 Q3 ' Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 Q2 '14 Q3 '14 Q4 '14 F 2015F Source: Bloomberg, United Capital Research Other Advanced Economies Expect some volatility, but cheaper oil will support growth We continue to expect growth to strengthen further in advanced economies in 2015 albeit at varying momentum across countries. While the US is likely to record the strongest rebound due to robust private spending, growth in the Euro Zone will continue to be weighed down by the legacy of socio-political crisis. Although the recession in Europe can be placed against the backdrop of balance sheet deleveraging, the recent crisis within the region continues to suggest that further large capital outflow is not in any way impossible. This trend, in our view, will be further exacerbated by the accommodative monetary policy of the ECB expected to be sustained going into While the big economies are expected to bounce back to positive growth territory in 2015, the peripheral economies will continue to experience high unemployment rates While the big economies are expected to bounce back to positive growth territory in 2015, the peripheral economies will continue to experience high unemployment rates (more than 20% in some cases), with the attendant risk of social unrest. The possibilities of flare-ups in political risks concerning the capitalization of the ECB and the chance of further debt write-down particularly in Greece could cause the region s financial markets to be volatile in In the midst of all these, the outlook for the Euro is positive. As at October 2014, the IMF projected average growth rates of 0.8% and 1.3% for the region in 2014 and 2015 respectively. We believe this is achievable as the ECB s recently unveiled 12

13 Global Economic Review and Outlook set of stimulus packages, which are likely to be stepped up in 2015, will continue to support both growth and the regional currency. In line with market expectations, growth should remain stable in Japan in After the disruptions in the pattern of growth in Q1 14, occasioned by hike in consumption tax, we saw a mild recovery in Q3, largely attributable to improvement in labor market conditions. We think lower oil prices will support growth just as the BOJ s decision to extend and expand quantitative easing should provide strong support for the economy. Elsewhere, growth in Canada, Norway, and the UK are expected to be solid. The key drivers here will be improving credit and financial market conditions as well as healthy balance sheets. The IMFs recently unveiled set of stimuli which is likely to be stepped up in 2015 should propel the Euro Area economy Fig % Growth expected to be strongest in the US in 2015 Historical and Forecast GDP Growth for Advanced Economies (y/y, % ) 3.0% 2.0% 1.0% 0.0% -1.0% Canada France Germany Italy Japan Spain United Kingdom United States Euro Area In spite of the headwinds, occasioned by waning capital flows, EMs and FMs continue to offer exciting opportunities to investors, in our opinion. -2.0% -3.0% Source: IMF, United Capital Research Emerging and Frontier Markets Attractive Prospects constrained by commodity price pressures Emerging-market assets were under pressure in 2014 evidenced by the strength of the US economy, which should sooner rather than later lead to higher interest rates, and hence significant portfolio reversals. Softness in key commodity prices, particularly oil, is adding another dimension of risk to commodity-rich emerging market economies. In spite of the headwinds, occasioned by waning capital flows, EMs and FMs continue to offer exciting opportunities to investors, in our opinion. The major attractions for EM and FM s assets in 2015 will be continued high rates of economic growth that these regions enjoy and the likelihood that they could be sustained due to demographic benefits as well as 13

14 Global Economic Review and Outlook prospects of exploiting vast natural resources. Across EM s and FM s, equity market performance would be negatively impacted by falling oil prices and weakening growth trends. Fig Oil price decline might pressure Frontier equities MSCI Frontier Brent Crude The expected tightening in the US is on the back of improvement in economic performance, should ordinarily bode well for emerging and frontier economies Source: Bloomberg, United Capital Research Importantly, in light of recent events, challenges still exist for emerging markets. Socio-political instability in a number of regions as well as the prospects of tightening season in the US with attendant currency weaknesses in these economies might restrain FPIs. In fact, as early as Q1 15, we see investors beginning to adjust to the possibility of higher US treasury yields, in anticipation of a mid-2015 lift-off of monetary policy. However, it is critical to note that the expected tightening in the US is on the back of improvement in economic performance, and should ordinarily bode well for emerging and frontier markets, via increased exports, production and trade. In addition, while the US may be approaching a tightening phase, policy in Japan should remain very accommodative. Recovery in advanced economies poses prospects of higher export demand and investment flows, though weaker commodity prices will moderate growth. Within frontier markets, measures of economic and market reform in a number of key markets offer the prospects of both stable growth and improving profitability for corporates Within frontier markets, measures of economic and market reforms in a number of key markets, among them; Vietnam, Egypt, Pakistan and Nigeria, offer the prospects of both a stable growth and improving profitability for the corporate sector. Concerns however exist, notably conflict in Ukraine, Iraq and Northern Nigeria, as well as the outbreak of the Ebola virus in West Africa. Nonetheless, we believe that many of these markets possess strong potential for long-term growth. 14

15 Global Economic Review and Outlook Saudi Arabia to open its stock market to foreign investors in H1 15 As the only G-20 member closed to foreign investors, Saudi Arabia s decision to open up its stock market has the potential to deepen financial markets in the region. The Saudi Arabian stock market, known as the Tadawul is the Middle East largest and most liquid market. The 167 companies currently listed on the Tadawul have a combined market capitalization of US$531bn. The possible effect of this is increased exposure by foreign investors to the Gulf co-operation council region which may mean less exposure to competing frontier/emerging region markets in 2015 and beyond. Overall, we believe that these changes to equity market regulations in Saudi Arabia could have major ramifications, given the size of the market. Recovery in advanced economies poses prospects of higher export demand and investment flows, though weaker commodity prices will moderate growth. Fig Frontier equities outperformed others in 2014 MSCI Equity Indices for Advanced and Emerging Economies, 2014(%) MSCI Advanced MSCI Emerging MSCI Frontier Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Source: Bloomberg, United Capital Research Global Macro Themes for 2015 Our analysis of seven (7) previous US rate tightening cycles shows that rise in rate often creates volatility and slows the pace of gains in the emerging markets The market is moving in the direction of a possible US rate hike... As stated earlier, as the US economy continues its recovery, the US fed is widely expected to begin raising interest rate in mid Our analysis of seven (7) previous US rate tightening cycles shows that rise in rate often creates volatility and slows the pace of gains in the emerging markets. Some of the impacts of a tightening environment already occurred in While many EMs now appear to be better off, having raised rates and reduced current account deficits, some are still exposed to rate hike due to domestic economic conditions. The 15

16 Global Economic Review and Outlook last time the US Fed hinted on QE tapering, global financial markets went into panic mode. The EMs and FMs bore the brunt of portfolio reversals, resulting in sharp depreciations in exchange rates. Although we expect many EMs to take measures to reduce their vulnerabilities to such externalities in 2015, having learnt their lesions the hard way, we still see a sizeable chunk of capital outflows from very volatile emerging and frontier economies particularly those with relatively lower risk adjusted real returns. There is a high probability of QE in the Euro-Zone in 2015 even as the ECB scrambles to deal with low inflation... but expansionary policies by BOJ and ECB will cushion the effect In 2014, the ECB began a new asset purchase program. At its October 2 press conference, ECB President indicated that the new program would consist of asset-backed securities and covered bonds, and would lead to a sizable increase in the ECB s balance sheet. The program is scheduled to last for at least two years with the potential to add 1trn into the Euro-zone economy. Given these indications, there is a high probability of QE in the Euro-Zone in 2015 even as the ECB scrambles to deal with low inflation. This therefore provides cushion to the effect of tightening and interest rate hike in the US, as QE by the BoJ and ECB will sustain some level of funds flow into EMs and FMs. On another note, the possible effect of the ECB s QE could be Euro-zone banks lending more to EMs and FMs to earn higher yields. However, it is important to note the expected liquidity from the Euro-zone may not find easy outlets in Europe, in our view, as bonds in the region are expensive. The German and French 2-yr note yields dropped below zero in October Meanwhile, the pressure for Japan to continue its asset purchase program remains intense, especially after the sharp contraction in Q2 14 GDP and weak production data for Q3 14. In our view, the Bank of Japan (BOJ) will be forced to expand its balance sheet in 2015 at the same pace that it did in This would be the equivalent of increasing the balance sheet by another 15% of the GDP. The Bank of Japan (BOJ) will be forced to expand its balance sheet in 2015 at the same pace that it did in 2014 Fig. 6 Expansionary regime in the Euro-zone will bode well for the EMs and FMs 1600 MSCI Emerging MSCI Frontier ECB Rate Source: Bloomberg, United Capital Research 16

17 Global Economic Review and Outlook The BRICS Geo-political and country specific risks pose major challenges The outlook for oil prices is at the core of expectations around the economic performances of the BRICs countries in The downward trend in global oil prices, coupled with high inflation and currency pressures present challenges to the Brazilian economy. Also, as global demand falls, prices of Brazil s export commodities (mostly iron ore and petroleum) are expected to fall, further slowing down the economy. The outlook for oil prices is at the core of expectations around the economic performances of the BRICs countries in 2015 China also faces demographic pressures relating to an aging working-class population. For Russia, a major producer of oil, the increased production of shale as an alternative energy source will continue to pressure the economy with continued weakness in the domestic currency despite the country s robust foreign reserves. This is coming at a time when Russia faces sanctions from Europe and the US, limiting Russian firms access to western debt markets. Russia s retaliation of imposing high import tariffs on Western goods has further pushed up domestic prices, leading to higher level of inflation. We expect the low investors confidence in the economy to continue to pressure Russian stocks, further weakening the Russian Ruble. Given Putin s stance, which shows that he is not willing to give in to the sanctions imposed by the West, we expect to see more sanctions on Russia, leading to higher rate of inflation, and weakened currency, hence a slow-down in growth in India s successful transition in May 2014 portends better prospects for the country s business environment going into We already saw a 5.7% GDP growth in Q2 14 (versus 4.6% in Q1 14). We expect to see some level of increased spending in 2015, which should translate to economic growth in India, as long as the government continues with policies that support these investments. South Africa s economy continues to face internal challenges as the GDP contracted by 0.6% to 1% in Q1 14 from 1.6% in Q2 14. Amidst labor strikes, high interest rate, currency pressures, rising inflation and slowing demand, we expect further pressure on growth in the nearer term. 17

18 Global Economic Review and Outlook Fig % Amidst decreasing global demand, declining oil price,weak currencies, high imflation and sanctions on Russia, BRICS economies may continue their gradual decline in 2015 Real GDP Growth for BRICS Economies 15.0% 10.0% 5.0% 0.0% f 2015f 2016f -5.0% -10.0% BRAZIL RUSSIA INDIA CHINA SOUTH AFRICA Source: Bloomberg, United Capital Research 18

19 South Africa Section 2 Africa Update and Outlook South Africa, Ghana, Kenya 19

20 South Africa South Africa: Slowly turning the corner? For most part of 2014, labour market unrest and global macroeconomic headwinds led to a slowdown in the South African economy. The economy almost slid into a recession in H1 14 as the protracted strike in the mining sector constrained industrial activities, culminating in a marginal 0.6% growth in GDP for Q2 14 (Vs. -0.6% in Q1 14 and 3.2% in Q2 13). The mining and quarrying sector witnessed a 9.4% decline in q/q output due to prolonged industrial actions which stifled platinum production. Agriculture grew by 4.9% while transport, storage and communication expanded by 4.0%. However, the economy showed some signs of rebound in Q3 with a GDP growth of 1.4% albeit below consensus estimate of 1.5%. Q3 14 growth was driven largely by acceleration in the services and agricultural sectors. Growth in the mining sector rebounded to positive territory though manufacturing output continued to fall. Manufacturing output continued to fall as effects of prolonged industrial actions lingered on the economy s growth path With a rebased GDP (from 2005 base year to 2010), South Africa s economy is now 4.4% bigger than earlier estimated in 2013 with an increase in the share of services sector and a reduction in the share of manufacturing. Growth may continue to be challenged in We nonetheless expect a modest recovery provided disruptions to industrial activities can be avoided. Also, the expected alleviation of infrastructural constraints as the new power generating capacity comes on stream should further support growth. This should provide some scope for a rebound in export though the weaknesses in the Euro zone which serves as the destination for most of South African exports will offset any gains that weakening of the Rand might imply for export. The expected normalization in monetary policy in the US also portends some downside risks for the South African economy in The weakness in the Euro Zone still portends downside risk for the South African economy in 2015 Fig In spite of the recent pressure on output, long term outlook points to a positive trend q/q Real Growth Trend for SA (%) With the manufacturing sector in negative territory, a strong rebound in mining is needed for a sustainable recovery of the broader economy 0 Q1 '09 Q3 '09 Q1 '10 Q3 '10 Q1 '11 Q3 '11 Q1 '12 Q3 '12 Q1 '13 Q3 '13 Q1 '14 Q3 ' Source: National Accounts, United Capital Research Source: National Accounts, United Capital 20

21 South Africa Exchange Rate: Economic Uncertainties Drive Rand Volatility Intermittent emerging market sell-offs pressured the Rand significantly in The currency lost 10.5% y/y Vs. USD as portfolio reversals heightened against the backdrop of a cut back in US QE. Although the volatility in portfolio capital flows into high yielding emerging markets was a key drag on the Rand in 2014, the currency was further weakened by concerns around the strength of the domestic economy. The exchange rate broke the ZAR11 resistance on two occasions in 2014: February and October. Portfolio reversals from emerging markets pressured the Rand significantly in 2015 The pass-through on the price level was quite notable, as inflation rate also broke the Reserve Bank s target range of 3-6%. We see more pressure on the Rand in 2015 largely on account of anticipated tightening in the US. However, the modest growth outlook for the South African economy should support the currency and provide cushion to shocks from portfolio reversals. Fig Tougher Days Ahead for the Rand USD/ZAR, We see more pressure on the Rand in 2015 largely due to expected tightening in the US Jan-12 Jun-12 Nov-12 Apr-13 Sep-13 Feb-14 Jul-14 Dec-14 Source: Bloomberg, United Capital Research Interest Rate: The SARB Dilemma In spite of the weak growth of the South African economy, SARB was compelled to shelve accommodative monetary policy measures for the most part of In a bid to control spiraling inflation, the SARB raised interest rate twice by a total of 75bps to 5.75% as at November We think interest rates are likely to be further increased in 2015, as we see inflation tracking above the SARB s target. Unless oil prices fall throughout 2015, which is very much unlikely, the expected weakness in the Rand will continue to fuel imported inflation. This should necessitate tighter policy measures geared towards maintaining a positive real interest rate especially in light of the expected tightening in the US. If Oil prices continue to decline for a large part of 2015, the SARB may delay tightening as inflation pressure may be somewhat muted. 21

22 South Africa Fig I Inflation remains untamed despite successive rate hikes S.A Inflation Rates Vs. Policy Rate (%) Inflation Rate Policy Rate 3 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 Oct-12 Feb-13 Jun-13 Oct-13 Feb-14 Jun-14 Oct-14 Source: SARB, Bloomberg, United Capital Research Equities Market: Stretched valuation cum macro headwinds SA equities closed the year positive with a y/y appreciation of 7.6% in the benchmark JSE All Share Index. Consumer goods stocks, especially food retailers were the main outperformers while resource stocks closed the year in the negative. Industrial and Basic materials sectors declined by 17.8% and 16.1% respectively while financials, Consumer Services and Consumer goods sectors returned 22.0%, 27.8% and 11.6% respectively. We expect further correction is SA equities in 2015 particularly if the underlying macroeconomic fundamentals do not improve The bullish run of the JSE in 2014 contrasted sharply with the backdrop of weak macroeconomic fundamentals. Valuations now look stretched as the JSE attained record highs especially in Q1 and Q2 14, necessitating a significant selloff especially in Q3-Q4 14. Historically, the SA equity market has benefited from healthy liquidity levels relative to other African bourses. We expect some more correction in the market going into 2015, particularly if underlying macro fundamentals do not improve significantly. Fig. 11 Widening Valuation Gaps Relative to Emerging Market Peers 21 JSE Valuations Vs EMs (P/E(x)) JSE P/E 7 MSCI P/E 5 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Declining EM funds flows and attendant currency pressure were key themes that dominated the SA fixed income space in 2014 Source: Bloomberg, United Capital Research 22

23 South Africa Fixed Income: Fairly priced, Waiting on Funds Flow Declining EM fund flows and attendant currency pressures were key factors that shaped the SA fixed income market in Early in the year, expectations of increasing Rand weaknesses led foreign investors to sell off on local currency debt resulting in negative returns in the SA bond market. However, the corporate bond segment remained quite strong given lower liquidity feeds. For the most part of 2014, the market traded mostly sideways in spite of S&P s downgrade of SA s foreign credit rating to BBB- (one notch above subinvestment grade). South Africa issued 3 bonds in 2014 raising a total of US$2.2bn. Looking ahead, we think progress on fiscal consolidation will bear on SA s credit rating in the foreseeable future. With already huge current account deficit, a further deterioration in fiscal health could feed through bond yields in With an already huge current account deficit, a further deterioration in fiscal health could feed through bond yields in 2015 Fig Yields tapered considerably after the bearish run early in the year SA 10yr bond yields (%) Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Source: Bloomberg, United Capital Research 23

24 Ghana Ghana: Growing but groaning The slowdown in Ghana s economic growth, which commenced in Q3 2013, persisted in GDP growth in Q3 14 came in at 5.1% (vs. 5.3% in Q2 14, 4.4% in Q3 13 and 10.8% in Q2 13). Macroeconomic instability continues to weigh on the real economy. The sluggish growth in GDP had earlier led to an official revision in the country s growth expectation to 6.9% for 2014 (Vs. 7.3% in 2013). The country s significant current account deficit (13.2% of GDP), driven by a wide trade deficit of US$2.2bn and high government spending continue portend downside risks to economic growth. However, we expect the current account deficit to ease to 9.0% in 2015 (BoG target is 8.8%) Q4 14 data suggests trade deficit have narrowed to US$495mn. We expect the current account deficit to ease to 9.0% in 2015 (BoG s target is 8.8%) as recent data suggests trade deficit have narrowed to US$495mn In terms of managing the level of fiscal deficits, our expectations remain slightly bleak in the medium to long term, for 2 major reasons: 1) fiscal revenues appear to be inert on the back of weak economic growth as well as the constraints limiting oil production, 2) Large capital outlays needed to propel the oil and gas sector will continue to put pressure on the current account. In 2015, we expect growth to be anchored by agriculture largely due to higher price for cocoa, the rehabilitation farms over the last few years, as well the distribution of fertilizers and pesticides. Having ramped up oil production capacity modestly, Ghana is expected to produce around 120,000 b/d in 2015 but a significant growth in output is not expected until 2017 when the Jubilee field, expected to double output, begins operation. However, modest oil revenue despite falling prices is expected to reduce fiscal deficits appreciably in 2015, giving further support to growth. Most importantly, striking a sustainable deal with IMF will be critical to Ghana s macroeconomic progress and restoration of investor confidence in Striking a sustainable deal with IMF is key to Ghana s progress and restoration of investor confidence in Fig % Macro Headwinds Threaten GDP Outlook Ghana y/y Real GDP Growth 20% 19.1% 15.9% 15% 14.1% 10% 5% 11.2% 9.4% 9.9% 6.7% 9.5% 9.0% 10.8% 4.4% 6.4% 6.5% 5.3% 5.1% 5.5% 5.1% 0% 2015e 2014 Q4e 2014 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q1 Source: BOG, United Capital Research 24

25 Ghana Exchange Rate: Dollar Inflows should cushion pressure on the Cedi Developments in the Ghanaian foreign exchange markets indicate a generally weaker domestic currency in 2014 relative to For the first ten months of the year, the cedi cumulatively depreciated by 31.2% against the USD in the interbank market, compared to 7.4% in the corresponding period of previous year. However, the currency appreciated sharply against the USD in Q3, moderating the significant losses recorded earlier in the year. November 2014 MPC meeting showed that the country s gross foreign reserve rose to US$6.6bn, implying barely 3 months of import cover. Developments in the Ghanaian Foreign Exchange market in 2014 indicate a weaker domestic currency relative to 2013 The successful issuance of a US$ 1bn Eurobond and the signing of a US$ 1.7bn cocoa finance facility supported the Cedi during the year. We expect the currency to depreciate further in 2015 driven by domestic macro-economic concerns which will lead to portfolio reversals, though we see some support from policy measures by the BoG. Also, the news flow on a potential deal with the IMF that may be finalized in 2015 should further support the Cedi. Fig. 14 Currency remains under pressure 4.5 USD/Ghana Cedi Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 We expect some pressure on the currency in 2015 driven by domestic macroeconomic concerns which will lead to substantial portfolio reversals Source: Bloomberg, United Capital Research Fixed Income: Yields likely to remain high, reflecting domestic macroeconomic and global concerns The country s fixed income market is concentrated at the short end of the yield curve and limited in terms of depth and volume when compared to Nigeria and other frontier markets. Although the introduction of foreign participation in less than 3-year maturities boosted foreign transactions in the market, yields remain higher than most frontier markets in The Cedi is expected to depreciate in 2015, and FX shortages will complicate a market exit in the foreseeable future 25

26 Ghana Looking ahead, yields will continue to remain strongly influenced by monetary policy stance, BoG liquidity management efforts, and exchange rate developments. The policy rate would remain high at current levels on the back of high inflation. The Cedi is expected to depreciate in 2015, and FX shortages will complicate a market exit in the foreseeable future. In addition, should bond yields fall to the high or mid-teens, an increasing number of investors could take profit. The rally in the market pushed valuations high to 17.9x P/E relative (vs.15.5x for comparable Frontier markets Fig GHS fixed Income Instrument still offers attractive yields Average yields on fixed income instrument in Ghana May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Source: Bloomberg, United Capital Research Ghana Equities: Losing Steam The Ghanaian equities market slowed dramatically in 2014 with the benchmark, GSE Composite Index, gaining 5.4% for the year (Vs. 78.8% in 2013). The unprecedented rally in 2013 has pushed valuations high to 17.9x P/E (vs. 15.5x for comparable Frontier markets). However, we still expect a relatively modest performance in the equities market in 2015, driven by the gradual recovery in economic growth as well as the positive outlook for companies in the financial services sector. That said, we note that there is a growing concern among foreign investors on the macroeconomic environment in Ghana, especially the rapid depreciation of the local currency. This could adversely affect their participation in the Ghanaian equity market in Also, the poor depth and liquidity in the market will be a limiting factor to foreign players as there are just 36 companies listed on the Ghana Stock Exchange; many of them are subsidiaries of multinationals where the mother company holds the bulk of the shares. What s more, the biggest investor on the stock exchange, Ghana s Social Security and National Insurance Trust (SSNIT), the state-owned pension fund has a stake in every listed We note that there is a growing concern among foreign investors on the macroeconomic environment in Ghana, especially the rapid depreciation of the local currency. 26

27 Ghana company and is inactive. The market may ride on this relative illiquidity to deliver modest returns in Fig. 16 3,000 Ghana Composite Stock Market Index 2,500 2,000 1,500 1, Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Kenyan Bureau of Statistics, United Capital Research Kenya: Brighter medium term prospects Kenya towed the line of Nigeria, rebasing its GDP in September 2014 by changing its base calculation year to 2009 from This sent the East African nation into the continent s top 10 economies, becoming the fourth largest economy in Sub-Saharan Africa after Nigeria, South Africa and Angola. Its GDP post-rebasing increased to US$55.2bn in 2013 from US$44.1bn a 25.3% jump surpassing the government s prediction of 20.6%; GDP per capita now stands at US$1,245 from US$999. Agriculture, Manufacturing and the real estate sector accounted for most of the change in the level of GDP, contributing 19.9%, 11.4% and 5.9% respectively. The new GDP showed a growth rate of 5.7% in 2013 versus a flat growth of 4.7% under the old series. Post-rebasing, Kenya s fiscal ratio looks better as deficit as a % of GDP now stands at 6.0% (Vs 7.4% before rebasing). We expect annual growth in 2014 to be tepid following the poor raining season in H1 (GDP expanded by 5.8% in H1 14 GDP Vs. 7.1% in H1 2013). In the medium term, the rebasing exercise is expected to provide the much needed boost to the Kenyan economy even as the government attempts to spur economic growth in light of the challenges facing the tourism industry. Manufacturing, construction and services will continue to be the main drivers of growth. Agriculture, which remains the backbone of the economy and the main employer, is growing at a steadier pace of around 4.1%. We expect increased 27

28 Kenya pace of growth from the Services sector on the back of modest recovery in tourism as well as technological-based financial inclusion. Looking ahead, one of the biggest challenges for the Kenyan economy will be its large fiscal deficit. Post-rebasing however, Kenya s fiscal ratio looks better as its deficit as a % of GDP now stands at 6.0% (Vs 7.4% before rebasing). We expect the fiscal deficit to narrow to 5.0% levels in 2015, as recent measures introduced by the government to reduce wage burden begin to gain traction. However, capital spending still falls below target which might hamper growth, as capacity constraints and corruption will continue to be major hindrances to public investment. Fig. 17 Growth path signals modest recovery Kenya Real GDP growth ( y/y, %) Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q3e 2014 Q Q Q Q4e 2015F Sectoral Growth in Real GDP for Kenya (%) Q4'13 Q1'14 Q2'14 Q3'14 Agric Mining (15.8) Manufacturing Construction (2.8) Services Kenyan Bureau of Statistics, United Capital Research Kenyan Bureau of Statistics, United Capital Research Exchange Rate: KES weakens though performs better than peers Kenyan s shilling has been less vulnerable to external shocks compared to its peers; KES dipped by 4.7% in 2014 to KES90.6/US$ a modest performance when compared with the Naira, Cedi and Rand. Corporate demand has been the major driver on the exchange rate pressure driven by growth momentum and improved economic activity, as credit to private sector grew at an annualized rate of 26.7% as of October Although we expect the KES to weaken in 2015, we do not see a significant decline and expect the local currency to hover around KES levels. Furthermore, the country s reserve recorded considerable accretion reaching a record high of US$7.3 in September, 2014 representing c.4.7 months of import cover, driven by Eurobond issuance proceeds. In spite of expected portfolio reversal in 2015, we think the KES will hold steady relative to peer currencies, as Although we expect the KES to weaken in 2015, we do not see a significant decline and expect the local currency to hover around KES levels. 28

29 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Kenya foreign participation in Kenya s domestic fixed income market stands at just 7.0%. Fig The Kenyan Shilling was pressured in 2014 as increased importation fuelled significant dollar demand In spite of expected portfolio reversal in 2015, we think the KES will hold steady relative to peer currencies, as foreign participation in Kenya s domestic fixed income market stands at just 7.0%. 84 Sept'13 Nov'13 Jan'14 Mar'14 May'14 Jul'14 Sept'14 Kenyan Bureau of Statistics, United Capital Research Inflation: Still in check with a benign outlook. Inflation rate in Kenya stood within the central bank s target corridor of 5.0% ± 250bps for most part of Inflation rate in Kenya stood within the central bank s target corridor of 5.0% ± 250bps for most part of After temporarily breaching the upper limit of the band in July and August, y/y CPI growth fell to 6.43% in the month of October 2014 from 6.6% in September largely due to VAT base effects and lower electricity and fuel price pressures (in the middle of September 2014, the Energy Regulatory Commission (ERC) announced a drop in the price of Super Petrol, kerosene and diesel). We think the central bank will be lose on monetary policy in H1 15 with inflation in single digits though underlying fundamentals of a huge current account deficit will spur some weakness in KES, putting mild pressure on inflation. Core inflation should however remain within the 5%-6% range. Fig Inflation has been well tamed amidst broadly accommodative Policy Rates MPR and Headline Inflation in Kenya (y/y, %) The government has indicated that it would seek to reduce domestic borrowing in 2015 to around KES101.7bn from KES190.0bn; focusing more on external borrowing following its successful Eurobond issuance 5 0 Inflation Policy Rate Kenyan Bureau of Statistics, United Capital Research 29

30 Kenya Fixed Income market: Yields likely to sit lower in 2015 In terms of outstanding issuance, Kenya is the fifth-largest bond market in Africa with a total size of US$10.3bn as at October Banks held 52.5% of the total debt holdings, followed by institutional investors (25.7%) and insurance companies (10.2%). It has been widely speculated that Kenyan bonds may be included in the GBI-EM index, given the foreign interest they have generated and their critical size. We think the inclusion will eventually happen at some point, but not in the foreseeable future. The liquidity of KES bonds is still too low at this stage and even the outstanding size would need to increase. Kenya raised US$2bn Eurobond in 2014, the largest African Eurobond debut so far. The government has indicated that it would seek to reduce domestic borrowing in 2015 to around KES101.7bn from KES190.0bn; focusing more on external borrowing following its successful Eurobond issuance. This is likely to expose Kenya more to foreign exchange risk given the sensitivity of the KES. Overall, we think the yield environment will be somewhat lower in 2015 as positive inflationary expectations would necessitate sustained accommodative policy stance. The government has indicated that it would seek to reduce domestic borrowing in 2015 to around KES101.7bn from KES190.0bn; focusing more on external borrowing following its successful Eurobond issuance Fig A combination of lower expected domestic borrowing and benign inflation expectations should keep yields lower in 2015 Kenya Sovereign Yield Curve (%) M 6M 1YR 2YR 5YR 10YR Kenyan Bureau of Statistics, United Capital Research Equities: On a bullish run The Kenyan equities market maintained a bullish run in The market returned 4.5%, 5.3%, 8.7% and -0.34% in Q1, Q2, Q3, and Q4 respectively, culminating in a y/y return of 19.20%. Share price rallies in heavily weighted stocks such as Safaricom, Kenya Commercial Bank (KCB) and Equity Bank pushed the benchmark index north. The market also experienced increased trading activity as investors remained bullish. The strong trading activity was underscored by a stable currency, a generally stable macro-economic environment and positive H1 and Q3 14 results released by listed companies. The strong trading activity was underscored by a stable currency, a generally stable macro-economic environment and positive H1 and Q3 14 results released by listed companies 30

31 Kenya Given the relatively higher level of domestic participation (60% of transaction volumes), we expect headwinds from the global financial space to have a limited effect on the Kenyan equities market in We are positive on the outlook of the market in 2015 expected to be buoyed by strong earnings performance. We expect the revolution in the country s mobile payments industry to bode well for the banks who should continue to drive the market. The Nairobi Stock Exchange Limited after a successful IPO (which was oversubscribed in excess of 600%) launched a new bond trading system. The new system will enable online trading of treasury and corporate bonds, foreign currency bonds and improve the speed of settlement. We expect this to further deepen the market and boost the NSE s revenue in Given the relatively higher level of domestic participation (60% of transaction volumes), we expect headwinds from the global financial space to have a limited effect on the Kenyan equities market in Fig Nairobi Stock Exchange on a steady bullish ride since 2013 Movement in NSE All Share Index Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Source: Bloomberg, United Capital Research 31

32 Key Macro Variables for Select African Markets Fig. 22 Fig. 23 Local Currency Returns: 2013, 2014 Inflation Rates: Kenya Ghana SA Nigeria -12.1% NAIRA -2.7% % -25.3% CEDI % -0.1% KES 8-5.4% RAND -24.1% -40% -30% -20% -10% 0% 4 0 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Fig year Average Real GDP Growth Fig. 25 Monetary Policy Rates 10% 8% 6% 4% 2% 0% 8.6% 6.9% 5.6% 1.9% KENYA GHANA NIGERIA SOUTH AFRICA 25% 20% 15% 10% 5% 0% 21.0% 13.0% 8.5% 5.8% GHANA NIGERIA SOUTH AFRICA KENYA Fig Year Bond Yields Fig. 27 Equity Market Indices (Rebased to 100) 16 SA Kenya Ghana Nigeria 2.5 Kenya Ghana SA Nigeria Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Source: Bloomberg, United Capital Research 32

33 Section 3 Oil Price Dynamics and Nigeria 2015 Outlook 33

34 Oil Price Dynamics and Nigeria 2015 Outlook The Tragedy of Oil Price Slump Tumbling oil prices was the dominant theme across the globe in the second half of Stemming from huge supply-demand disequilibrium, Brent crude tanked 54.2% in 2014 after reaching a year peak of $113.41d/p in June on the heels of ISIS offensive in Iraq. Broadly, the imbalances in global oil demand and supply in the year could be attributed to two factors: 1) the energy sufficiency strides of the US demonstrated in the significant ramp-up of capacity in shale oil production 2) the stickiness of Saudi Arabia s crude oil supply in the face of sizeable excess capacity. Perhaps, it could be argued that the moderating force of shale oil production in a year that saw little progress in the crisis within the oil rich Middle East, political upheavals and production stoppages in Iran and Libya, was necessary to fill an important gap in a market with very strong attributes of an oligopoly. Stemming from significant supply-demand disequilibrium, Brent crude tanked 48.3% in 2014 Supply glut aside, demand moderated considerably in 2014 According to the IEA, global oil demand has weakened since mid This compounded the impact of a much stronger dollar compared to the trends seen in 2013, as well as unconventional supply especially from the US. Beside the usual seasonal factors behind demand patterns, the sluggish growth of the global economy in 2014 also led to a slowdown in energy demand. While demand appeared to have bottomed out during the year, having touched a 5- year annual low, the slower-than expected recovery in Europe did little to push deliveries especially in H We posit that a mild recovery in global economic growth in 2015 should give comfort to oil demand especially from the OECD though the seemingly weakening of the non-oecd demand led by marked declines in gasoline and diesel demand in both China and India is expected to trim global oil demand. Looking farther ahead however, we think oil demand is gradually approaching a plateau and could well be seen as a major pressure source for hydrocarbon prices in the next decade. We posit that a mild recovery in global economic growth in 2015 should give comfort to oil demand especially from the OECD Fig Quarterly Trends in Global Oil Demand and Supply Fig. 29 Non OPEC output has outpaced OPEC production since OPEC and Non-OPEC share of oil production ( rebased to 2010) Q Q Q Q Q1 Demand 2012 Q3 Supply 2013 Q Q Q Q Q Q Q Q3 OPEC 2012 Q Q Q1 NON OPEC 2013 Q Q Q3 Source: EIA, United Capital Research Source: OPEC, United Capital Research 34

35 Oil Price Dynamics and Nigeria 2015 Outlook Oil Supply War: US Vs Saudi Arabia; and the winner is... Conspiracy theories and the quest to hold firmly to market share were at the heart of postulations around the downward trajectory of oil prices in Saudi Arabia, the biggest producer in OPEC, with 32.0% and c.90.1% of the Cartel s production volumes and excess capacity respectively, held firmly to its volumes despite pressure from other members to cut output in order to support price. Saudi s motivation to defend market share in the face of declining prices did not come as a surprise given the country s relatively strong fiscal position as well as its disproportionate market share in OPEC. With c. $740.4bn in excess reserves, we estimate that Saudi still has significant cushion to accommodate oil prices as low as $30p/b. In its last meeting in 2014, OPEC chose to stay action as members looked to Saudi to cut output with Gulf members having reached a consensus prior to the meeting. The Cartel s second option which was to convince members to stick to production quota was also not pushed through. We note that OPEC members have historically overshot their quota largely due to fiscal pressures arising from deficit budgets, slow growth and high cost of alternative energy sources as well as the need to defend fragile market shares. We think it will be more challenging for OPEC to rein in excess production from members in 2015, as a handful of fringe producers with huge dependence on oil had already experienced currency devaluation, placing further pressure on their fiscal buffers. What s more, Saudi s quest to hold on to market share is seen as both politically and economically motivated, with an overweight on the former. This could well be sustained as long as crisis in the Middle East, and Russia cum Iran tensions persist. Complicating the supply side dynamics was the remarkable growth witnessed in US Shale oil production. Having increased output volumes by 1 million barrels in 2014, the US now holds largest share of global crude oil production. In fact, tight oil production from shale has grown 6-fold in 5 years. The Fed has made note of the fact that drilling activity in Shale production districts is expected to increase steadily for the next two years, even with much lower oil prices. We believe that the rapid growth of shale production will continue to create excess oil. Imports from West Africa have already been edged out and we expect further reduction from other markets in With c. $740.4bn in excess reserves, we estimate that Saudi still has significant cushion to accommodate oil prices as low as $30p/b. We think it will be more challenging for OPEC to rein in excess production from members in Saudi s quest to hold on to market share is seen to be both politically and economically motivated, with an overweight on the former From the foregoing, we are inclined to think that the market will have to patiently wait for the convergence of oil prices with the production cost of most of US shale wells. In our view, this is the only point at which oil prices can find a support in

36 Oil Price Dynamics and Nigeria 2015 Outlook Fig US non-conventional oil production has increased 5-folds in the last 6 years and could yield the same volume as crude oil as early as 2017 US Oil Production Volumes (mn b/pd) Fig Q 2001 Saudi's output variations account for 37% of the changes in crude oil prices 2Q 2002 WTI and Saudi's production 3Q Q Q Q Q Q Q Q Q Total Oil Production Tight Oil Crude Oil Source: EIA, United Capital Research Saudi Production Change Source: EIA, United Capital Research WTI Price Change Are oil prices assuming a new normal? Given the long backwardation history of oil price trading dynamics as well as current market trends, there is no reason to expect oil prices to gain some respite in the short to medium term. We see oil prices remaining volatile especially in the first half of 2015 as market digests the actions and inactions of oil producers. Our bull case scenario would be a $35-$40p/b in H1 and an average of $55-$60p/b for We see oil prices remaining volatile especially in the first half of 2015 as market digests the actions and inactions of oil producers Notably, the outlook for oil prices in the medium to long term remains bleak against the background of the significant traction that alternative energy sources as well unconventional oil production has gained in the last decade. Beside the US, several other countries, notably Canada, Argentina Australia e.t.c are also on the path of shifting reliance to shale and other unconventional resources for the majority of their oil and gas production. Argentina, with declining production from conventional gas fields, is investing heavily in its tight and shale gas resources; Australia with large shale gas and methane resources looks to steadily transit away from gas production even as significant leasing and exploration for shale gas and oil are underway in Algeria, China, Poland, Columbia and Mexico. Although the economic viability of producing these shale gas and shale oil rests significantly on favourable oil prices, we think scale advantages of rapid production build-up will improve cost effectiveness, combining with the efficiency of the extraction of technology to render demand fairly inelastic. The possibility that we could see some fiscal interventions in the form of price subsidies by the US, the largest producers of shale is also a huge concern. On 36

37 Oil Price Dynamics and Nigeria 2015 Outlook the geo-political scene however, no respite is in site as far as conflicts in the oil producing region is concerned, with 2015 looking even more likely to be as volatile as 2014 given recent development in the region. That said, the risk of oversupply looks more likely to outweigh the downsides from geopolitical tensions, in our view. Top Ten Countries in Shale/Tight Oil and Gas Resources We see oil prices remaining volatile especially in the first half of 2015 as market digests the actions and inactions of oil producers Oil Gas Country Technically Recoverable (Billion Barrels) Country Technically Recoverable (Tcf) Russia 75 U.S 1161 U.S. 48 China 1115 China 32 Argentina 802 Argentina 27 Algeria 707 Libya 26 Canada 573 Australia 18 Mexico 545 Venezuela 13 Australia 437 South Mexico 13 Africa 390 Pakistan 9 Russia 285 Canada 9 Brazil 245 Others 65 Others 1535 Source: EIA So what does cheaper oil mean for Nigeria s macro stability? The fall in oil prices is already taking a heavy toll on a number of countries globally. Most oil producing Sub-Saharan and emerging economies with external trade imbalances remain unfavorably exposed to a continuous slide in crude oil prices. While countries who are net energy importers will continue to benefit, via a reduction in their current account deficits (if any), net energy exporting countries are particularly vulnerable to the extent that their balance of payments positions can sustain them. Also, cheaper oil may impact positively on inflation, with an indirect positive effect on economic growth in these countries. The fiscal and monetary strain on Nigeria remains severe, more so with its crawling peg exchange rate system. Relative to the size of its economy, Nigeria is the second biggest net energy exporter in Africa after Angola. Based on spending plans for 2015, the breakeven oil price for Nigeria is well above $100 p/b and among the highest 37

38 Libya Iran Algeria Nigeria Venezuela Saudi Iraq Angola Ecuador UAE Qatar Kuwait Oil Price Dynamics and Nigeria 2015 Outlook within the OPEC, after Algeria and Iran. This implies that the fiscal strain on Nigeria remains severe, more so with its crawling peg exchange rate system. As shown in figure 33 below, Nigeria falls within the quadrant of vulnerable countries that could be severely impacted by a continuous decline in oil prices. In fact, the country s current account surplus, estimated at 4% of GDP could be completely wiped out if oil prices continue to fall. Relative to other OPEC countries (all of whom are net exporters), Nigeria s vulnerability is quite low when the size of its GDP is considered Fig OPEC Countries still require oil prices in excess of $100p/b to balance their budgets Break even Oil Prices Average Source: IMF, National Finance Ministries In order to correctly gauge the vulnerabilities of different countries to current oil price shocks, we have separated the winners (net oil importers) from the losers (net oil exporters). Oil importers are expected to save on their energy costs while oil exporters will lose revenue. However, the final impact will depend on the relative sizes of their economies (measured by GDP) as well as the share of export receipts in the general government revenues of these countries. We have assumed that fiscal buffers (i.e. external reserves) would be held constant as most countries would lean towards a more flexible exchange rate regime in view of current market dynamics. When placed against the backdrop of total government revenue, Nigeria s vulnerability rises significantly We found that relative to other OPEC countries (all of whom are net exporters), Nigeria s vulnerability is quite low when the size of its GDP is considered. We attribute this to the relatively strong growth in non-oil GDP witnessed over the last decade especially the growing contribution of the services sector. However, when placed against the backdrop of total government revenue, Nigeria s vulnerability rises significantly. This didn t come as a surprise to us given the 38

39 Current Account/GDP Oil Price Dynamics and Nigeria 2015 Outlook skeweness of government revenue to oil receipts. Perhaps, what is more instructive to note is that among the Non-OPEC members, US remains one of the least exposed largely due to the strengths and diversities of her economy, while Saudi Arabia is modestly vulnerable, a development we can link to the recent pressure on its fiscal expenditure. Russia on the order hand could leverage on its massive external reserves position despite its low current account surplus (2013 est. 1.6% of GDP). The import of all these is that US and Russia are less likely to succumb to pressure to support prices in 2015 while we might see some ground shifting from Saudi Arabia when the going gets tougher sometime in the second half of 2015, by our estimate. From a balance of payments perspective, most OPEC members, including Saudi Arabia are vulnerable to continuous declines in oil prices Fig % 40% 30% Not Vulnerable Nigeria Vulnerable Saudi Kuwait 20% 10% 0% -10% -20% Neutral -30% -40% Highly Vulnerable -50% -60% -40% -20% 0% 20% 40% 60% Net Energy Exports/GDP OPEC Members Source: WTO, IMF, United Capital Research 39

40 Oil Price Dynamics and Nigeria 2015 Outlook Austerity Measures: How far can they go? In 2014, the Nigerian government introduced some austerity measures to cushion the effect of declining oil prices on the economy. These include cut in subsidy provisions for petrol and kerosene from N971.1bn and N250.0bn to N458.6bn and N156.0bn respectively, introduction of surcharges on luxury goods and a freeze on foreign travel by civil servants and government officials. We think these measures are insufficient in light of the expected fiscal strain that a persistent decline in oil prices portend for the Nigerian economy. We expect the Naira to continue to be under pressure. This suggests that monetary policy would be tighter than ever in

41 Domestic Macro Trends and Outlook for 2015 Section 4 Domestic Macro Trends and Outlook for

42 Domestic Macro Trends and Outlook for 2015 Monetary Policy Across the globe, central banks monetary policies were broadly and overly aggressive in In a debt-ridden post crisis world, central banks continued to expand the size of their balance sheets while adjusting short term interest rates to zero or near zero in some cases. The multi-step unwinding of the US monetary policy was effectively concluded with interest rates closing at zero levels at the end of the year. As we stated earlier, the divergence in monetary policies between the ECB and the Fed engendered a significant bout of volatility of in asset prices and yields especially in the advanced economies with spillovers to most emerging markets. The multi-step unwinding of the US monetary policy was effectively concluded with interest rates closing at zero levels at the end of the year Fig Monetary Policy Rates Broadly Accommodative Select Policy Rates : Annual Averages, % FED ECB Canada SA Brazil India Source: Bloomberg, United Capital Research Nigeria: Caught in the web of emerging market portfolio reversals In the past year, the Nigerian financial markets saw fair share of portfolio reversals largely due to moderating impact of funds flow to emerging markets. The US tapering of quantitative easing that effectively began in Q1, 2014 impacted liquidity in the Nigerian fixed income space, distorting valuations across naira denominated assets. While we note that the expansionary policy stance of the Euro-Area somewhat moderated the negative impact of these tapering, we believe Nigeria s ability to maintain a positive real rate environment in 2014 remained key to retaining a healthy dose of FPIs in the economy. Also, we think the clarity of timing and length of these monetary adjustments especially from the Fed was critical to ensuring that market expectations were closely linked to valuations at each point in time, helping to minimize volatility in domestic market rates. The US tapering of quantitative easing that effectively began in Q1, 2014 impacted liquidity in the Nigerian fixed income space, distorting valuations across naira denominated assets 42

43 Domestic Macro Trends and Outlook for 2015 Domestic Monetary Conditions Interest Rates and Money Supply: Eye on liquidity The Nigerian monetary authority maintained a fairly tight interest rate policy in 2014 as the benchmark rate, MPR, was kept at 12% for most part of the year. The need to keep inflation in check given the anticipated elevated spend in the run-up to the 2015 elections was prominent in the policy discussions at the various MPC meetings held during the year. Also, elevated system liquidity led to a record increase in the Cash Reserve Ratio (CRR) for public sector funds from 50% to 75% at the January 2014 MPC meeting followed by an increase in the private sector CRR from 12% to 15% in its March meeting. The combined impacts of these aggressive policies signaled the CBN s intention to rein in excess liquidity in the system and curb speculative and non-core banking activities of Nigerian banks The combined impacts of these aggressive policies signaled the CBN s intention to rein in excess liquidity in the system and curb speculative and non-core banking activities of Nigerian banks. The suspension of the former CBN Governor, Lamido Sanusi Lamido however surprised the market, leading to considerable volatility in money market rates. Fig. 35 CBN kept the benchmark unchanged for the most part of 2014, resorting to administrative changes for monetary policy adjustments 14 Nigeria Monetary Policy Rate (MPR, %) Nov-14 Jul-14 Mar-14 Nov-13 Jul-13 Mar-13 Nov-12 Jul-12 Mar-12 Nov-11 Jul-11 Mar-11 Nov-10 Jul-10 Mar-10 Nov-09 Jul-09 Mar-09 Nov-08 Jul-08 Mar-08 Nov-07 Jul-07 Mar-07 Source: CBN, United Capital Research There were however two noticeable trends in the movement of monetary aggregates (narrow and broad money) in 2014: 1) a sharp reversal in the downward growth trend of money supply and credit growth compared to the trend in 2013; 2) Increasing 12-month rolling correlation between money supply and credit growth (see figure 36). We see this trend as evidencing the effectiveness of monetary expansion in stimulating credit growth. That said, we note the transmission could have been a lot stronger with lesser pressure on banks balance sheets and a relatively more de-risked lending environment. A much stronger transmission mechanism could have been achieved with lesser pressure on banks balance sheet and a more de-risked lending environment 43

44 Domestic Macro Trends and Outlook for 2015 Fig % 15% 10% 5% Broad Money Supply and Credit Growth show intandem movements, resuming an upward trend in A much stronger transmission mechanism could have been achieved with lesser pressure on banks balance sheet and a more de-risked lending environment 0% 0.4 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14-5% -10% Source: CBN, United Capital Research Money Supply Growth Credit Growth 12-month rolling correlation The various administrative measures employed by the CBN in 2014 meant that there were lower volumes of OMO auctions relative to However, a more elevated system liquidity reflected in a substantial gap between offerings and subscription levels in H2 14 in spite of relatively flat rates at the auctions especially towards H2. (See figure 37). Fig OMO Auctions tapered significantly in 2014 relative to 2013 CBN OMO Activities, 2013 Vs Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Offer Subscription Rate Source: CBN, United Capital Research 44

45 Domestic Macro Trends and Outlook for 2015 Outlook for Monetary Policy in 2015 Tighter still but waiting on crude oil prices The Nigerian benchmark interest rate (MPR) closed the year at 13% with a symmetric corridor of +-200ps as the MPC voted for a hawkish rate environment in its last meeting of the year following persistent downward pressure on crude oil prices. To a large extent, the trajectory of crude oil prices will shape the monetary policy environment in We expect a tighter interest rate regime in 2015 for 3 major reasons: 1) There are greater downsides to inflation in the medium term given the recent devaluation of the Naira and Nigeria s precarious balance of payments position 2) Oil prices are likely to fall through H with attendant pressures on the domestic currency; 3) A reversal to a tighter interest rate environment especially in US by H2 15 will further compound the pressure on the Naira, raising the possibility of further tightening. The Nigerian benchmark interest rate (MPR) closed the year at 13% with a symmetric corridor of +-200ps as the MPC voted for a hawkish rate environment in its last meeting of the year It is also worth noting that the proposed fiscal spending cuts in the 2015 budget could moderate structurally induced inflation, effectively shifting the monetary policy anchor to exchange rate even as the recent devaluation feeds through domestic price level as early as Q1 15. We are inclined to believe that the CBN will be even more aggressive if oil price do not find a floor early enough in 2015 and we look to see more administrative measures, increased OMO auctions as well as more direct liquidity controls in H1 relative to 2014 levels. 45

46 US China Japan Germany France UK Brazil Russia Italy India Canada Australia Spain Korea Mexico Indonesia Netherlands Turkey Saudi Arabia Switzerland Argentina Sweden Nigeria Poland Norway Belgium China Austria UAE Thailand Colombia Iran South Africa Denmark Malaysia Singapore Israel Chile Hong Kong Philippines Egypt Nigeria (Old) Finland Greece Pakistan Ireland Kazakhstan Iraq Venezuela Portugal Domestic Macro Trends and Outlook for 2015 Real GDP Structurally clearer, fundamentally weakening The rebasing of the GDP dominated discussion around Nigeria s economy early in With support from the IMF, World Bank and AfDB, Nigeria s GDP was rebased in April 2014 as the base year for the computation of GDP was changed from 1990 to This effectively increased the size of the economy by 89.2% to N80.2trn ($US 509.9billion) in nominal terms. A further breakdown of the numbers showed that the services sector is not only the biggest contributor to the GDP (with, 35.8% Vs. 20.0% in the old series), it also contributed the most to the jump in the base year GDP numbers. We attribute this to the various reforms that have been instituted in the Telecomms, Real Estate, Finance and Insurance sectors over the last decade. We note that the marked difference in the sectoral contributions to GDP post the rebasing exercise underscores the diversification of the Nigerian economy, giving a clearer picture on the structure of the economy, distribution and performance necessary for more effective policy decision making. A breakdown of the numbers showed that the services sector is not only the biggest contributor to the GDP (with, 35.8% versus 20.0% in the old series), it also contributed the most to the jump in the base year GDP numbers Notably, the rebased GDP numbers have thrown up the headroom for significant fiscal adjustments within the next couple of years. More than ever before, it is now imperative to grow the financial sector and widen the tax net. Although the exercise triggered improvements in fiscal ratios such as total debt to GDP and fiscal deficit to GDP, it also revealed weakness and leakages in Nigeria s tax collection system while also highlighting the need to deepen the financial system as indicators such as market capitalization to GDP, Credit to GDP, M2 to GDP are now extremely poor by emerging market standards. Fig ,000 12,000 Post-rebasing, Nigeria's GDP jumped 19 places to 23rd highest in the world Top 50 Economies Globally: nominal GDP (US$ million) 8,000 4,000 0 Source: IMF, United Capital Research 46

47 Domestic Macro Trends and Outlook for 2015 Real GDP: Now anchored on buoyant services sector On rebased GDP numbers, the Nigerian economy recorded quarterly growth rates much higher than 2013 trend. Real GDP grew by 6.23% in Q3 14 (Vs. 5.4% for Q3 13). The non-oil sector continued on its strong growth trajectory buoyed largely by the services sector growing from 6.8% in Q2 to 7.6% in Q3 14 though slowed y/y relative to Q3 13 (10.5%). This was largely on account of a tepid growth from the Real Estate sector which expanded by 5.9% as at Q3, 14 relative to Q3 13 (13.3%). Finance and Insurance (7.9% of the services GDP) also slowed with a growth rate of 8.6% relative to Q3 13 (9.43%). The Oil and Gas sector slipped back into negative growth territory that has been characteristic on the sector in for the past 3 years on of account declining production due to continued crude oil theft. The Oil and Gas sector slipped back into negative growth territory that has been characteristic on the sector in for the past 3 years on account declining production due to continued crude oil theft. Outlook Growth is likely to slow to below 5.0% in 2015 Tighter fiscal and monetary policies are the key downside risks we see to real GDP growth in We do not expect a drastic reversal in government revenue mix in the short to medium term, largely due to current heavy reliance on oil. What s more, government s recurrent expenditure has historically remained sticky, making a scale back in capital spend more likely in a bid to prevent a ballooning of fiscal deficit. With additional currency weakness on the horizon, the need to maintain a tight monetary policy stance will keep interest rates high, thereby shaving bps off real GDP by our estimates. We expect the services sector to continue to drive growth as we look to see appreciable progress in reforms to key sectors namely agriculture and power. Tighter fiscal and monetary policies are the key downside risks to GDP growth in 2015 Fig % 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 4.5% 2014 Real GDP Growth Tracks Higher than 2013 levels 5.4% 5.2% 6.8% 6.2% 6.5% 6.2% 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 Source: NBS, United Capital Research Fig % 20.0% 10.0% 0.0% -10.0% -20.0% Volatile growth trends from Manufacturing even as Oil and Gas slips back into negative territory Nigeria GDP Sectoral Growth Trends 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 Agriculture Manufacturing Oil and Gas Services Source: NBS, CBN, United Capital Research 47

48 Domestic Macro Trends and Outlook for 2015 Inflation Rate Single digit out of the radar In line with our expectation, headline inflation remained firmly in single digits in 2014, averaging 8.1% (Vs. 8.5% in 2013). The broad declines in global commodity prices and relatively favourable harvest seasons helped ease pressure non-core inflation in the year as food inflation averaged 9.5% y/y (Vs. 9.7% in 2013). Although the conflict prone areas of the North East continued to experience significant disruptions to farming activities, favourable main harvests was witnessed across much of the rest of the country leading to increased inventory, and declining staple food prices. Notably, the aggressive tightening stance of the CBN moderated the impact of election related spend even as exchange rate stability in the first half of the year provided cushion to domestic prices In line with our expectation, headline inflation remained firmly in single digit in 2014, averaging 8.1% (Vs. 8.5% in 2013). The downside risks to inflation in 2015 include the escalations in insurgency in the northern part of the country especially in a post election scenario given the recent spread in the geographical reach of the Boko Haram insurgents. The current and expected pressure on the Naira given the declines in oil prices is another risk factor that is yet to fully crystallize, in our view. We expect to see the full impact of the recent devaluation of the Naira from Q1 15, even as a possible further adjustment of the currency in the near term portends greater downside risks to inflation in We forecast and average inflation rate of 10.5% in 2015 as we expect core inflation to average 9.5%, and food inflation 11.5% Fig Headline Inflation stood firmly within CBN's target range in 2014 Target Range Fig ,000 16,500 16,000 15,500 15,000 14,500 14,000 13,500 13,000 Core Inflation held steady despite modest increase in Money Supply Money Supply(Nbn) Vs. Core Inflation Money Supply (M2) Core Inflation Source: NBS, CBN, United Capital Research Source: NBS, CBN, United Capital Research 48

49 Domestic Macro Trends and Outlook for 2015 Exchange Rate Dynamics Battling for the Soul of the Naira The Naira came under severe pressure in 2014, as the N/USD weakened by 12.6% (Vs. -2.6% in 2013) with -11.5% of the depreciation recorded in Q4 14 when the Naira was devalued in the Official market. Early in the year, much of the bearish trends in the Naira were driven by reduced foreign portfolio inflows (FPIs) as the Fed decided to cut back its bond buying programme effective Q This was evident in a huge spike in official forex demand supply gap which had shot up to a 2-year high as early as January leading to 1.6% depreciation in the currency, the highest monthly change pre-devaluation. Much of the bearish trends in the Naira were driven by reduced foreign portfolio inflows (FPIs) as the Fed decided to cut back its bond buying programme effective Q Domestic macroeconomic uncertainties heightened by the suspension of the former CBN governor in February 2014 raised concerns about the fate of the Naira. This led to sharp outflows in FPI (m-o-m, -43.3% in February). Consequently, the Naira depreciated by 1.4% in February. However, a rebound in FPI inflows in April especially in the equity segment lent some respite to the Naira, with an appreciation of 2.7%, the highest monthly gain in The last quarter saw a market-induced devaluation which coincided with tamer foreign inflows and significant net outflows from debt and equity securities as uncertainties around the 2015 elections heightened. Fig. 43 FPI Changes tracks closely in line with Naira Returns 160.0% Changes in FPIs Vs. Naira Returns 3.0% 120.0% 80.0% 40.0% 0.0% -40.0% -80.0% Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct % 1.0% 0.0% -1.0% -2.0% The aggressive tightening policy of the CBN as well as the various control measures employed by the Apex bank to ease supply bottlenecks across the various segments of the market provided some support for the currency FPI Changes Naira Returns Source:, CBN, United Capital Research Hawkish Stance Moderates Naira Volatility The aggressive tightening policy of the CBN as well as the various control measures employed by the Apex bank to ease supply bottlenecks across the various segments of the market provided minimal support for the currency in the 49

50 Domestic Macro Trends and Outlook for 2015 face of slow accretion to external reserves, especially in Q2. Notably, the revision in the minimum capital base for the operation of the BDC to N35mn, from N10mn as well as the prohibition of the ownership of multiple BDCs, helped restrict forex dealers from round tripping the Naira, with the intent to close the arbitrage gaps in the market. However, the decision of the CBN to simultaneously reduce weekly sales to BDCs to $US15,000 from $US15,000 created some pressure in that segment of the market, thus widening the gap between the parallel and official rates. CBN s late intervention in the interbank market also supported the Naira to a large extent in 2014 even as the removal open positions for banks in Q4 14 created additional support to the currency. Aggressive tightening cum administrative measures failed to close arbitrage gaps in H1 14 Fig Administrative measures failed to substantially close arbitrage gaps NGN/USD Rates in Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Fig. 45 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 In spite of CBN's strong defense of the Naira, demand outweighed supply by 30% in 2014 Total FX Demand Versu Total FX supply ( $US, millions) 0 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Official Interbank BDC Source: FMDQ, CBN, United Capital Research Demand Source: CBN, United Capital Research Supply The Imperative of Devaluation The CBN s resolve to continue to defend the Naira was tested in the face of the sharp declines external reserves as oil prices began to tank in beginning H2 14. The reserves, which reached a 2 year low in October 2014, with an import cover of 7.3 months based on latest available data. One of the strongest cases for a drastic exchange rate adjustment was the precarious state of the country s external trade position. By Q2 14, current account surprise had weakened to 1.1% of GDP (Vs. 3.6% in 2013), largely on account of higher import bills from crude oil trade as well as increased repatriation of profits and dividends in light of macro-economic uncertainties. Compounding the situation was heightened speculative demand for the dollar induced by high system liquidity. A key demand management policy One of the strongest cases for a drastic exchange rate adjustment was the precarious state of the country s external trade position 50

51 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Domestic Macro Trends and Outlook for 2015 introduced by the CBN was the restriction of certain import items from being funded at the rdas window, a move that was intended to effectively cut demand by more than half at the official window. Despite these restrictive measures, demand for the greenback continued unabated as total dollar demand was 1.3x total supply in Q3, reaching a high of 1.6x in September. Having breached the existing target band to forex sales at the Official window due to unabated demand, the Committee members in its last meeting for the year, resorted to a drastic downward adjustment to the midpoint of the Official window of the foreign exchange market from N155/US$ to N158/US$ and widened the band around the midpoint of the exchange rate from +/-3 to +/-5 per cent. The key question on the minds of investors and market participants is whether another round of devaluation might be witnessed in 2015 if the pressure on oil prices does not abate Fig. 46 Falling Oil Prices exerting significant pressure on the naira Average Monthly External Reserves and Brent Crude Price 50, , , , , ,000 20,000 External Reserves Source: FMDQ, CBN, United Capital Research Brent 20 0 We estimate that oil prices would need to fall to between $20-$25p/bd for import cover to touch months levels compared to the internationally accepted standard of 3 months Outlook for the Naira in 2015: Is further devaluation on the Cards? The key question on the minds of investors and market participants is whether another round of devaluation might be witnessed in 2015 if the pressure on oil prices does not abate. We estimate that from the onset of the decline in oil prices, a 1% drop in Brent crude prices has led to 0.24% decline in gross external reserves. Using an average monthly imports value of US$4.9bn (the mean imports value per annum), we estimate that oil prices would need to fall to 51

52 Domestic Macro Trends and Outlook for 2015 between $20-$25p/bd for import cover to touch months levels compared to the internationally accepted standard of 3 months. This brings to the fore the robustness of Nigeria s external reserves in containing pressure on the domestic currency. While the strength of the external reserves remains appreciable, the same cannot be said about Nigeria s trade position. Given Nigeria s high oil import bill placed against the backdrop of a fast depreciating Naira, the current meager current account surplus will be wiped out in no distant time. Our view is reenforced by the expected increase in portfolio reversals especially as yields in key emerging markets move in the direction of market expectation of Fed tightening by H What s more, funds flow from Sovereign Wealth Funds from key OPEC countries will taper as oil prices continue to recede, leading to tighter liquidity as resultant higher rate environment in key advanced economies becomes more attractive to yield hungry investors. We believe that oil prices are not likely to touch levels seen at the height of the global financial crisis ( ), given the current strong performance posted by the advanced economies compared to the era of global financial crisis We believe that oil prices are not likely to touch levels seen at the height of the global financial crisis ( ), given the current strong performance posted by the advanced economies compared to the era of global financial crisis. Based on the foregoing, any further adjustment in the exchange rate in 2015 (which is likely to be lower than the 8% devaluation in 2014) will not entirely be due to consideration of the depletion in external reserves but rather on the shaky state of Nigeria s trade position. 52

53 Domestic Macro Trends and Outlook for 2015 Fiscal Plan 2015: Budgeting in the midst of Uncertainty The 2015 budget is predicated on a spending plan of N4.4trn (Vs. N4.7trn in 2014), with an estimated revenue of N3.6trn (Vs N3.7trn in 2014), implying a budget deficit of N756bn, equivalent to 0.8% 2015E GDP. The benchmark crude oil price was set at US$65p/b, after multiple revisions on the back of the continued downward trend in global oil prices as well as bearish outlook for the commodity in the short to medium term. We reiterate that alternative approach could have been a scenario based budgeting that allows the fiscal authority to assume different benchmark prices given the uncertainty around crude oil prices. We think some level of flexibility should have been built into the budget to prevent recourse to the legislative arm in the event that the volatility in oil prices heightens in Importantly, we do not think the benchmark of $65p/bd is the bear case scenario for oil prices in We think some level of flexibility should have been built into the budget to prevent recourse to the legislative arm in the event that the volatility in oil prices heightens in Change Total Federally Collectible Revenue (N'trn) % Estimated Revenue % Total Expenditure % Oil Production (mbpd) % Benchmark Oil Price (p/b) % GDP growth rate 5.50% 6.75% % Exchange Rate(N/USD) % Non oil Revenue(N'bn) % Fiscal Deficit (N'bn) % Fiscal Deficit (% of GDP) 0.79% 1.90% % Domestic Borrowing (N'bn) % Fig. 47 5,000 4,000 3,000 2,000 1,000 0 Capex accounts for 9% of entire budget Outlay Breakdown of expenditure plans for 2015 (N'bn) 412 Statutory Transfer 634 Capital Expenditure 943 Debt Service 2,616 4,605 Recurrent Expenditure Total Expenditure* Source: Federal Ministry of Finance, United Capital Research Source: Federal Ministry of Finance, United Capital Research We think that the oil production benchmark is overly optimistic given the leakages that have characterized oil production in recent times. Data from OPEC shows that average crude oil production in 2014) stood at 1.93m bpd, 23.7% lower than the budgeted volumes in the 2014 budget. However, having widened the band around the official exchange rate, the exchange rate assumption of $165p/b clearly lies within the range of possible values for the N/USD at the Official market in However, the possibility of further devaluation before the end of the year constitutes a downside to this assumption 53

54 Domestic Macro Trends and Outlook for 2015 Fig. 48 3,000 2,500 Budgeted Production volumes have historically been below target due to persistent leakages Nigeria Crude Oil Actual Volumes Vs. Budget The 2015 budget is predicated on an historic shift to the nonoil sector as a significant revenue source 2,000 1,500 1,000 Actual Daily Oil Production (mbpd) Budgeted Production Source: OPEC (Monthly Oil Market Reports), Federal Ministry of Finance, United Capital Research Non-Oil Revenue: A realistic transition? The 2015 budget is predicated on an historic shift to the non-oil sector as a significant revenue source. This was largely anticipated given the expected strain on petro-dollar inflows in Notably, the non-oil revenue to total revenue is budgeted to increase to 46.7% in 2015 (Vs. 33.0% in the 2014 budget estimates). We note that the recent rebasing of the GDP has not only given a clearer picture to the structure of the economy, it currently gives the fiscal authority enough elbow room to transit from an oil dependent revenue base to a more diversified structure, taking into consideration the increasing growth profile, post rebasing, of previously under-estimated services sector. Historically, the strong growth in the non-oil sector has not translated into significant non-oil revenue accretion for the government, even if we back out the large informal sector not integrated into the mainstream economy. We estimate that the expected revenue from these sources despite the various luxury charges introduced will be insufficient to cover the shortfall oil revenue While we welcome the renewed focus on non-oil revenue streams, we estimate that the expected revenue from these sources despite the various luxury charges introduced will be insufficient to cover the shortfall oil revenue if we hold the benchmark oil price constant for the entire fiscal year. More so, non-oil revenue has been constrained by the government s fiscal policy that has recently tilted more in favour of import substitution, with the attendant declines in non-oil receipts. On another note, the challenges across the non-oil revenue 54

55 Domestic Macro Trends and Outlook for 2015 generating sectors have been further exacerbated by the recurring incidences of smuggling across the borders. Fig. 49 Non Oil Revenue Targeted at 46.7% of total revenue Non -Oil Vs. Oil Revenue Split 100% 80% 60% 71.3% 61.4% 59.8% 67.4% 64.8% 69.8% 67.4% 53.3% 40% 20% 28.7% 38.6% 40.2% 32.6% 35.2% 30.2% 32.6% 46.70% 0% * 2015e Non Oil Oil Revenue Source: CBN, United Capital Research * Budgeted estimates; e= expected Plugging the Deficits: How Plausible is a reduction in domestic borrowing? The proposed budget is based on a deficit of N755.0bn (0.79% of GDP (Vs. 1.9% in 2014 o) with domestic borrowing plan of N570.0bn expected to finance 75.5% of total deficit. While the recourse to domestic borrowing as a means of financing budget deficits can easily be regarded as the norm in Nigeria s budgeting cycles, we were surprised to see a reduced borrowing plan relative to 2014 levels. Given that we expect government revenue to come in lower than estimated in 2015, we anticipate a higher level of domestic borrowing compared to We think the required traction in non-oil revenue growth may be delayed beyond 2015 as the economy adjusts to a new fiscal regime, making a reduction in borrowing unlikely. Also, we expect borrowing to be at a much higher cost, given the uncertainties around Nigeria s fiscal revenue stream. The government s recent efforts at diversifying borrowing sources to offshore funding may also be challenged given the expected increase in sovereign risk premiums on oil producing countries with relatively weak or precarious balance of payments position such as Nigeria s. These expectations are partly reflected in the 32.4% increase in estimated debt service expense despite a 0.21% decline in expected domestic borrowing. The government s recent efforts at diversifying borrowing sources to offshore funding may also be challenged given the expected increase in sovereign risk 55

56 Domestic Macro Trends and Outlook for 2015 Capex Spending: The Fiscal lamb The ratio of capital expenditure to total expenditure in the budget stands at an all-time low, bringing to the fore the stickiness of recurrent expenditure. While planned recurrent expenditure remained largely unchanged compared to prior year, capex ratio declined to 9.0% of total expenditure (i.e Capex plus Recurrent expenditure), and 13.8% of the entire spending plan. The ratio becomes much lower if capex is adjusted for expenditure on SURE-P. The lingering infrastructure gaps in the economy calls for urgent steps to rationalize government agencies, and drastically cut unproductive expenditure In our view, this high cost of governance is not sustainable. The lingering infrastructure gaps in the economy calls for urgent steps to rationalize government agencies, and drastically cut unproductive expenditure. Given this drastic cut in capex, a resort to greater Public Private Partnerships (PPP) arrangements as well increased privatization of government enterprises may be the most feasible means of augmenting these significant capex shortfalls in 2015, if the projected medium term real GDP growth rate is to be achieved. Fig % 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% Capital Spending set to an historic low 35.1% Ratio of Capital to Total Expenditure 31.2% 32.50% 22.1% 21.7% 20.8% 23.70% 9.00% * 2014* 2015e Source: CBN, United Capital Research * Budgeted estimates; e= expected Fig Top Priority sectors in the 2015 budget Total allocation ( Capital +Recurrent, N'bn ) 9.6% % allocation of total spending 8.2% 7.7% % % % 1.6% 1.4% 1.2% 1.1% 0.9% 0.9% 0.7% 0.6% 0.6% 0.5% 0.5% 0.4% 0.4% 0.3% Agric Works Foreign Aff SGF Pet. Res Youth Dev NSA Interior Health Police Defence Education Power Science & Tech Presidency Information Justice Tourism Environ Water res. 12% 10% 8% 6% 4% 2% 0% Source: Federal Ministry of Finance, United Capital Research 56

57 Domestic Macro Trends and Outlook for 2015 Politics and 2015 Elections Bracing up for a fierce contest The political tunes of 2014 were dictated by a strong quest for power shift away from the dominance of the ruling political party, PDP. From defections of elected public office holders to the opposition s surprise loss of key political strong holds during the year, the 2015 elections stage is currently being set up for a fiery contest. We believe it is all the more critical now for Nigeria to scale this hurdle given the vast negative global predictions that have trailed the 2015 polls as well as the seemingly unrelenting trend of insurgency in the last 5 years. The lingering infrastructure gaps in the economy calls for urgent steps to rationalize government agencies, and drastically cut unproductive expenditure In major emerging markets, it is now commonplace for politics and election dynamics to form a central theme informing direct investment decisions and even portfolio flows. Across our 2015 outlook, we emphasized the impacts that exogenous capital flows have had and will continue to have on the Nigerian financial markets going into We believe a successful conduct of the 2015 elections is crucial in this regard. Historically, Nigeria has enjoyed the strongest growth in FDI inflows in election years but that growth has slowed down significantly since the peak of In fact in the last two years: 2012 and 2013, FDI flows declined by 20.1% and 21.3% respectively. Clearly, the nexus between political stability and foreign investment and investor confidence cannot be waved aside. Defining themes for 2015 Elections: the Odds not totally in favour of PDP On paper, the ruling party seems to have lost appreciable ground since the last elections in With the opposition getting stronger and about to field a personality that is arguably the strongest opposition in current day political permutations, the elections may well be decided at the polls against an a-priori expectation of a landslide victory characteristic of Nigerian polls in the past. This is on the assumption that voting patterns are similar to 2011elections. The Northern and South Western strongholds of the opposition party will be critical to the outcome of the polls That the opposition will win more votes compared to 2011 is probably not in doubt given the series of defections that we have seen post 2011 elections. However, the probability that the opposition s additional votes in 2015 elections would be sufficient to cover the c.8.2 million votes gap in 2011 elections is at best up in the air. The Northern and South Western strongholds of the opposition party will be critical to the outcome of the polls. However, wherever the pendulum swings, we expect to see a slim margin of victory by the eventual winner. We think this could throw up some post election resistance, and a possibility of legal tussle that could heat up the polity. A key risk is the possibility of a run-off should 57

58 Domestic Macro Trends and Outlook for 2015 President Jonathan fail to secure at least 25% of the votes in two-thirds of the states. Fig. 52 History of Nigeria s Presidential Election Results 6.60% 11.46% 9.12% 32.20% 61.20% 18.72% 31.98% 58.90% % 2011 PDP ANPP Others PDP ANPP Others PDP CPC Others Source: INEC, United Capital Research 58

59 Capital Markets Review and Outlook Section 5 Capital Markets Review and Outlook 59

60 Capital Markets Review and Outlook THE FIXED INCOME MARKET FPI volatility, domestic liquidity shaped yields in 2014 To a considerable extent, the Nigerian fixed income market mirrored sentiments that impacted emerging markets fund flow in With the US Fed s tapering in full gear, foreign portfolio inflows into the fixed income market receded sharply in Q1 pressuring yields to the upside. However, the stability witnessed in the N/USD as well as the sustained single digit inflation level ensured sizeable amounts of FPI flow into naira fixed income assets. The stability witnessed in the N/USD as well as the sustained single digit inflation level ensured sizeable amounts of FPIs flow into naira fixed income assets On account of market expectations of higher yields during the year which was premised partly on the anticipation of a continuous cut back in US QE after an initial US$10bn reduction in January, the yield curve sustained its inverted slope in Q1, with higher rates in short dated maturities. The gradual re-pricing of the curve was however noticeable after a series of CBN liquidity mop-up exercises which, combined with a shift in investors horizon to shorter term maturities against the backdrop of political uncertainties, eventually pressured long end yields. Summarily, a higher level of domestic liquidity pressured fixed income yields for most part of 2014; but increased paper issuances as well as balance sheet sterilization via frequent CRR adjustments by the CBN created a floor for yields during the year after temporary concerns arising from the suspension of the erstwhile CBN Governor. While the termination of US Fed QE tapering early in Q4 pressured yields to the upside, elevated system liquidity stemming from AMCON maturities served as liquidity boost to the market. Fig. 53 Performance of long term maturities diverge on heigtened uncertainties Increased paper issuances as well as balance sheet sterilization via frequent CRR adjustments by the CBN created a floor for yields during the year 125 Nigerian Bonds Index Performance for Different Maturities ( rebased to 100) Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec yr >5 yr 3 yr Source: FMDQ, United Capital Research 60

61 Capital Markets Review and Outlook Nigerian fixed Income: Increasingly Attractive On local currency basis, the Nigerian bonds market offered one of the most attractive returns in the Frontier/emerging market space in The inclusion of the Nigeria March 2024 bond in the GBI-EM Global Diversified Index in August 2014 provided additional momentum to Nigerian bonds in the year, with an estimated additional inflow of around US$200m. On local currency basis, the Nigerian bonds market offered one of the most attractive returns in the Frontier/emerging market space in 2014 As a result of the increase in monthly inflows to pension funds, and less participation by banks in the long end of the curve, pension funds investment in fixed income securities increased significantly compared to As of Q3 14, PFAs investment in FGN bonds as a portion of total stock of FGN securities stood at 78.8% (Vs. 74.2% for Q3 13). Also, bond holdings as a percentage of total Investment had reached 47.4% (Vs. 44.2% for Q3 13) by October. Fig. 54 On local currency basis, Nigerian bonds outperfomed in 2014 FGN Bonds Vs. Emerging Markets Bonds ( rebased, 100) Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Emerging Markets Bond Index* FGN bond Index Source: FMDQ, Bloomberg, United Capital Research * JP Morgan Government Bond Index Emerging Market Global Fig % 14.0% 12.0% 10.0% 8.0% Yields rose 282 bps in 2014 Nigeria Sovereign Yield Curves: 2013 Vs M 2M 3M 6M 9M 1Y 3Y 5Y 7Y 10Y 20Y Quarterly Trends in Yields Q1 Q2 Q3 Q4 3M 13.2% 11.0% 11.0% 14.0% 6M 13.9% 11.0% 11.0% 14.5% 9M 14.4% 11.2% 11.2% 14.5% 1Y 15.0% 11.2% 11.6% 14.7% 3Y 13.9% 11.4% 12.0% 15.3% 5Y 13.8% 11.4% 12.1% 15.4% 7Y 13.9% 12.0% 12.3% 15.4% 10Y 13.9% 12.2% 12.4% 15.1% 20Y 13.7% 12.2% 12.4% 15.0% Average 14.0% 11.5% 11.8% 14.9% Source: Bloomberg, United Capital Research 61 Source: FMDQ, United Capital Research

62 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Capital Markets Review and Outlook Primary Market Offerings: Sustained Robust Demand The N970.0bn deficit built into the 2014 budget was financed partly with a total of c.950bn worth of bond issuances in 2014 (Vs. N900.0bn in 2013). A significant portion of the bond auction was concentrated in Q2, with generally reduced marginal rates. We note that a higher level of domestic liquidity helped to moderate the yield impact of volatile FPI inflows in 2014 as increased participation by PFAs and inflows from AMCON maturities combined to ease liquidity in the face of regulatory-induced reduction in fixed income holdings of banks. We note that in spite of the variations in system liquidity levels, there was very little difference in the level of demand in the primary segment of the market relative to While subscription rates average 2.1x in 2013, average subscription level stood at 2.2x in Notably, oversubscriptions were concentrated more in the longer tenured instruments in 2013 compared to 2014 suggesting that investors preferably took a shorter term view of the expected socio political environment in We expect this trend to change in 2015 as political uncertainties wane after the elections. More importantly, we believe the yield curve is still up for further reprising especially if further exchange rate adjustment materializes. A significant portion of the bond auction was concentrated in Q2, with generally reduced marginal rates We believe the yield curve is still up for further reprising especially if further exchange rate adjustment materializes. There were much slower activities in the State and corporate segments as concerns over election related spending capped regulatory approvals for subnational bonds issuances while relatively high rate environments limited corporate bond issuances. Fig. 56 Primary Market Issuance Volumes of FGN Fig. 57 bonds in Volatile FPI flows in bonds and money market instruments Capital Importation into Bonds and Equities (US'm) Bonds Money Markets Instruments Source: FMDQ, CBN, United Capital Research Source: CBN, United Capital Research 62

63 Capital Markets Review and Outlook Secondary Market Trading: Vastly Improving The FMDQ OTC trading platforms continued to enhance liquidity with robust trading activities in 2014 compared to By Q4 2014, market turnover of bonds and treasury bills had shot up significantly from c.1700 deals and N314.1bn per week at the beginning of the year to c.3800 deals and N755.1bn per week. Rates sensitivity of long term maturities was pronounced as only the April-2015 showed a price appreciation of 9.3% yielding a total return of 13.3%, while the biggest price decline of -9.2% was recorded in the Jul instrument with a total return of 0.8%. (see chart 59) The biggest price decline of - 9.2% was recorded in the Jul-2030 instrument with a total return of 0.8%. Fig. 58 Fixed income Trading picked in Q4 on account Fig. 59 of bearish trends in equities 15.0% 200,000 Nigeria Fixed Income Average Daily Traded Volumes 9.3% 10.0% (N'bn) 160, % 120, % FGN Bond Returns in 2014 ( Price changes only) 0.0% 80,000 40, % -10.0% -15.0% -3.2% -5.3% -2.1% -4.4% -4.6% -4.4% -7.2%-6.7% -6.1% -8.4% -9.6% -9.2% - Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 FGN Bonds T-Bills Source: FMDQ, United Capital Research Source: FMDQ United Capital Research Returns were computed as at Dec 23, 2014 Yield Outlook and Fixed Income Strategy for 2015 In summary, there were 3 major factors that shaped the Nigerian fixed income market in 2014: 1) Aggressive tightening by the CBN, 2) Heightened volatility in FPI inflows, and 3) the downward trajectory of crude oil prices. We expect these factors to continue to dictate yield movements in 2015 albeit in different degrees during the year. With respect to the first factor, more or sustained tightening is on the cards in 2015 for reasons we have highlighted earlier in this report. Although we do not see significant adjustments to monetary aggregates on account of policy pronouncements early in the year, we believe market expectations will still drive rates upward in Q1 15. In the last 2 years, the impact of interest rate movements have been less pronounced the further out you go along the yield curve. This implies that short-dated maturities tend to be more elastic to rate changes. While this appears to be a normal trend, we believe Although we do not see significant adjustments to monetary aggregates on account of policy pronouncements early in the year, we believe market expectations will still drive rates upward in Q

64 Capital Markets Review and Outlook effective timing is all the more imperative now given the bleak macroeconomic outlook. In keeping with our investment themes for 2015, we advise investors to hold less duration in 2015 especially in Q1. Our outlook for reduced structural liquidity, increased domestic borrowing in the face of declining oil revenue through H1 as well as expected tighter monetary policy environment continue to lend credence to an elevated yield environment in However, historical trend analysis suggests that yields might have peaked in Dec 2014, as expectations of naira devaluation sparked sell-offs on fixed income instruments, pegging average bond yield at 16.5%. That said, we think that the CBN may be nearing the healthy limits of administrative measures with no chance of policy reversals given current and anticipated headwinds, leaving rates adjustment very likely. This suggests that yields could remain within sight of 2014 year end levels, especially in H1. Specifically, our anticipation of a successful transition on the political landscape implies that shorter maturity preferences will wane as we move further into H1, leaving N/USD and interest rate dynamics as key considerations for position taking in the fixed income market. Regardless of this, cautious play will still prevail as oil price scrambles for a support. However, beyond H1 15, we expect to see relative stability with duration risk shifting to longer-dated maturities. More so, subject to an appreciable repricing of the yield curve, likely to be triggered by further exchanged rate adjustment, there is the possibility of increased participation from the PFAs compared to the currently insignificant exposure of banks to bonds given their preference for the short end of the curve. In keeping with our investment themes for 2015, we advise investors to hold less duration in Nigeria in 2015 especially in Q1 We envisage that the market may place some pressure on the CBN to minimize capital flight and protect already depressed Naira in light of ensuing Fed s tightening in H2 Overall, we expect average bond yield to sit at 14.5%-15% range in H1. Baring major shifts in the US Fed s policy stance; we expect the domestic monetary policy scene to normalize in H2. Although, the market may place some pressure on the CBN to minimize capital flight and protect already depressed Naira in light of ensuing Fed s tightening in H2, our anticipation of reduced FPI outflows and stronger oil prices post election translates to a relatively lower yield environment in H2. Fig Bond yields peaked in December, 2014 Daily average bond yields ( , %) Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Source: FMDQ, United Capital Research 64

65 Capital Markets Review and Outlook EQUITIES MARKET An eventful 2014 The local bourse recorded the worst performance post market resurgence in Coming from a bullish close to 2013 (47.2% return), the equities market in 2014 was shaped by events ranging from the increase in CRR of banks; suspension of the ex-cbn governor; weak earnings by companies; Oil price fall; further tightening by the CBN; Naira devaluation; as well as fiscal challenges. These headwinds dragged the NSE to close the year with a negative return of -16.1%. Equities close the year with worst performance post market 2012 market resurgence Fig. 61 Trajectory of the ASI in ,000 GDP Rebasing by the NBS New CBN Governor resumes 40,000 Ebola Outbreak 35,000 30,000 QE Tapering and the Increase in CRR Suspension of the ex-cbn Governor Oil Price Shock Further Tightening by the CBN, Naira Devaluation and OPEC "no cut" decision 25,000 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 The market kicked off 2014 on a positive note on the back of robust macroeconomic fundamentals. However, CRR adjustments, QE Tapering by the Fed and the suspension of the ex-cbn Governor shoved the positive in the market in Q1 14, resulting in 5.3% loss in the period. Outflow of portfolio capital was largely responsible coupled with market-distorting activities. Consequently, the All Share Index return was negative all through the period with -1.8%, -2.5% and -2.0% returns in January, February and March respectively. The bearish mood witnessed in the 1 st quarter rolled in the start of the 2 nd quarter with a -0.7% return The market kicked off 2014 on a positive note on the back of robust macro- economic fundamentals 65

66 in April. This however was short-lived as the GDP rebasing exercise which positioned Nigeria as the largest economy in Africa triggered a market rebound even as the appointment of the new CBN governor, Godwin Emefiele, who upon assumption committed to defending the local currency and achieve price stability, gave investors a breather. In the same period, volume and value of transactions increased by 69.3% and 213% to 6.7bn shares and N11.9bn respectively. The appointment of the new CBN Governor who committed to defending the Naira gave investors some breather Market however reversed its bullish run in Q3 14 on the back of weak sentiments stemming from the weak H1 14 results by companies, Ebola outbreak, Oil price shock and steep depreciation in the Naira, this led to a 3% and 15.9% decline in the equities market in Q3 14 and Q4 14 respectively. Fig. 62 Monthly Returns on the NSE Fig. Quaterly Returns on the NSE 12% 8% 4% 0% 7.8% 2.4% 0.3% 20% 10% 0% 9.6% -4% -8% -12% -1.8% -2.5% -2.1% -0.7% -0.9% -1.3% -0.8% -8.9% -8.0% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec -10% -20% -5.3% -3.0% -15.9% Q1'14 Q2'14 Q3'14 Q4'14 NSE, United Capital Research NSE, United Capital Research Foreign Players still dominate Activities in the local bourse were largely dominated by foreign investors in The disposition towards the equities market by foreign investors was due to the attractiveness of the exchange when compared with other frontier markets. Foreign participation from January to November was 58.5% as against domestic participation of 41.5%. Foreign players accounted for 58.5% of trades from January to November, 2014 Fig. 64 Foreign Vs. Domestic Participation on the NSE 100% 80% 60% 40% 20% 0% Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 NSE, United Capital Research Foreign % Domestic % 66

67 Small cap stocks defy the bearish sentiment Small cap stocks were the best performers in 2014 with a 32.8% growth, followed by the mid-cap stocks which were up by 23.5%. However, the large cap stocks were down by 21.4% which shows the negative market sentiment can be largely attributed to sell-offs in the market s heavyweights. The impressive performance of small cap stocks can be attributed to strategic positioning in attractive names Shares of small cap stocks, especially in the consumer names were the top gainers in 2014; Small cap stocks are rarely patronized by foreign and institutional investors for lack of liquidity, hence they were less susceptible to capital flight and global investor sentiment. Eight (8) out of the top 10 gainers for 2014 were small cap stocks with market capitalization of less than N25.0bn. The gains in small cap stocks can be largely attributed to strategic position taking by investors as some of these stocks portend values especially the Insurance and Consumer goods names. We still expect to see long-term bargain hunting and strategic buying in these stocks in 2015 following disappointing performance of the large cap counters. Fig. 65 Small cap stocks outperformed the Market in 2014 Union Dicon YTD Returns of select small cap stocks in % Golden Guine 35.3% Fidson I.H.S Beta Glass 39.8% 40.7% 92.5% We still expect to see long-term bargain hunting and strategic buying in select small cap stocks in 2015 Ikeja Hotels Premier Breweries 374.0% 392.2% 0% 100% 200% 300% 400% 500% NSE, United Capital Research New Listings: Relatively flat Following the twin stellar performance of the equities market in 2012 and 2013, the market saw two major listings in 2014 by Seplat and Caverton in April and May respectively. The dual listing of Seplat Petroleum Development Company Plc (Seplat) on the NSE and the London Stock Exchange (LSE) in April 2014 marked the first IPO on the NSE since the market crash in Seplat listed its shares on the main board 67

68 Capital Markets Review and Outlook at N576.0 ( 2.10) per share, making it the first upstream oil and gas company listed on the NSE. Following this, Caverton Offshore Support Group (Caverton) listed its 3.35bn shares at N9.30 per share, adding N32bn to the total market capitalization of the exchange. Company Seplat Petroleum Development Company Caverton Offshore Support Group Omoluabi Savings & Loans Plc Vetiva Griffin 30 (VG30) Stanbic IBTC ETF 30 NSE, United Capital Research Listing Main Board Main Board ASEM ETF ETF The market for new listings remained relatively unchanged in 2014 with only five (5) new equity listings; two (2) on the main board, one (1) on the ASEM Overall, the market for new listings remained relatively unimpressive in 2014 with only five (5) new equity listings; two (2) on the main board, one (1) on the ASEM, and two (2) ETFs. The present market sentiment which is expected to be sustained in H1 15 does not support any market listing or IPO in Though we expect to see capital raising exercise by listed companies, a public offer is not expected. Valuations: Still attractive among peers The equities market closed the year as the 2 nd worst performer among its peers with -16.1% y/y return. Negative sentiments and macro headwinds have depressed valuations to a 3-year low. The market closed the year with a P.E ratio of 10.95x compared to 14.5x and 14.8x among its African peers and global market average respectively. We see value in select stocks and find them attractive at current prices especially for domestic investors with long-term horizon and zero currency risk. Fig % Nigerian Equities: Market Valuations Vs Peers Nigeria Ghana 20% 0% South Africa Egypt Kenya -20% Frontier Market EMEs -40% Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Developed Market Bloomberg, United Capital Research 68

69 Capital Markets Review and Outlook Fig. 67 Nigerian market: Too cheap to ignore P/E Ratios of Select markets S/Africa Dev. Mkt Egypt Kenya Frontier Mkt EMEs Nigeria NSE, United Capital Research Strides of the NSE in 2014 The NSE signed a capital markets agreement with the LSE Group (LSEG) to strengthen cooperation and promote mutual development between the two exchanges. The agreement also supports African companies seeking dual listings on the Lagos and London bourses. The NSE completed a study to assess market readiness, the infrastructure requirements, and sequencing for the launch of risk management products in the Nigerian capital market. The NSE unveiled a new set of minimum operating standards for all three (3) classes of market intermediaries in an effort to develop sustainability and augment protection for investors and stakeholders. The deadline for complying with the standards was December 31, The Exchange has since announced the Minimum Standards Implementation Plan, which kicks off with inspections of all market intermediaries in April The NSE launched direct market access (DMA) as a first step to the implementation of sponsored access under the West African Capital Markets Integration (WACMI) program, thereby giving global investors more control over final execution of their orders, as well as the ability to exploit price and liquidity opportunities. 69

70 Capital Markets Review and Outlook The NSE was admitted to full membership in the World Federation of Exchanges. The NSE, in partnership with the Convention on Business Integrity (CBI), launched the Corporate Governance Rating System (CGRS). The CGRS is designed to rate companies listed on the Exchange based on their corporate governance practices, thereby improving the overall perception of and trust in Nigeria's capital market. The Exchange launched an on-line whistle blowing portal, X-Whistle, for the secure and effective submission of tips and referrals regarding violations of the rules, regulations and laws of the Nigerian capital market by listed companies and market intermediaries. NSE Moves to achieve Emerging market status The NSE in 2014 took remarkable moves to deepen the market, enhance global visibility and improve the market. The NSE s focus from 2011 to 2013 has been on revamping corporate governance, improving human capacity, cleansing and restructuring the market, improving technology, product development and advocacy for changes to policy. The management of the NSE has recently shifted gear in 2014 with focus on driving innovation centered on increasing global visibility for the capital market; developing a larger footprint on the African continent and targeting emerging market status. Equities in election years: Can history repeat itself? Fig. 68 Equities Market returns F The market will not be all doom and gloom in % 65.6% 74.7% 30% 7.9% -10% -16.3% -4.5% -50% F NSE, United Capital Research 70

71 Capital Markets Review and Outlook A trend analysis of the market direction during election in the last 15 years revealed stellar performance by the market in 2003 and 2007, and a negative performance in We think the impressive performance of the market in 2003 and 2007 can be traced to the relatively higher predictability of election results in those years as the ruling party (PDP) still had a firm grip on the political landscape with no strong opposition on a national level. However, the tide changed from 2011 election on the back of a more robust opposition, ethnic interest and heightened security challenges. This tide has gotten deeper as we roll into the 2015 general elections. We therefore expect a weak sentiment in the market for H1 15 and a better outlook for H2 15. The equities market will not be all doom and gloom in A trend analysis of the market direction during election in the last 15 years revealed stellar performance by the market in 2003 and 2007, and a negative performance in 2011 Expected market Returns in 2015: a closer look at our Crystal Ball The equities market in 2015 will be shaped by key global and domestic factors, ranging from; Interest rate hike in the US and UK. Falling oil prices Exchange rate instability and possibility of further devaluation of the Naira Effect of falling oil prices on government finance, expenditure and consumption and the ripple effect on company s earnings Effect of the CBN;s tightening stance on banks performance and earnings Pass-through effects of devaluation of cost of imports and inflation Bearish sentiment Attractive pricing and dividend yield Given the dominance of foreign investors in the equities market, the impact of a capital flight from frontier and emerging markets on the back of interest rate hike in the US and UK will have a significant impact on the market. The benchmark rate which have been at a low of 0.25% since 2009 coupled with liquidity boost from Quantitative easing drove capital flows into emerging and frontier markets. A hike in interest rate by the US Fed coupled with impressive numbers in the US which could lead to a better performing US equities market would lead to capital flight and also reduce inflow into Nigerian equities. The UK which has considerable interest in the Nigerian equities market, is also expected to raise its interest rates from 0.5% to 0.75% in Q3 15 according to the British Chambers of Commerce. We expect this rate hike to also spur fund reversals to the UK. 71

72 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Capital Markets Review and Outlook The possibility of a further devaluation in the Naira and bleak outlook for exchange rate will weigh heavily on foreign investors interest in the equities market, limiting foreign inflows. We have anchored our forecast of the performance of the Nigerian stock market in 2015 on the trajectory of oil prices and by extension, the Naira. Given that we are yet to see considerable traction in domestic participation on the bourse, we believe foreign portfolio flows will continue to dictate the direction of the market. We have anchored our forecast of the performance of the Nigerian stock market in 2015 on the trajectory of oil prices and by extension, the Naira In the last 10 years, 2014 had been the year with the strongest correlation readings between Brent crude and Nigerian All Share Index after a series of distortions occasioned by major reforms in the Nigerian banking industry. (See chart 69 below). It is easy for us to see the likelihood of a repeat performance of the co-movement of the ASI and global oil price in 2015, but we have also adjusted our forecasts to reflect political uncertainties that drove equity prices in Our base case expectation for oil prices remains $55-60 p/b on average in Fig ,000 60,000 50,000 40,000 30,000 20,000 10, year movement in ASI and Brent Crude Banking reforms NGSE ASI Brent Crude Bloomberg, United Capital Research We have also modeled the reactionary impact of exchange rate on FPI, as well as the expectation of a tighter monetary policy environment which will 72

73 Capital Markets Review and Outlook undoubtedly impinge on the banks performances. The table below summarizes our expectations for the year: Brent Crude Scenario ( $/p/b) ASI Market Return , % First Half , % , % , % , % Second Half , % , % , % 2015e returns -4.47% 73

74 Section 6 Sector Reviews and Recommendations 74

75 Banking Sector BANKING SECTOR Nigerian banks: Little progress in a year of many changes Nigerian banks have had to operate under a fast changing regulatory environment within the last two years, with 2014 marking a strategic shift in supervision landscape. The attendant pressure on the lenders earnings generating capacity significantly shaped sentiments around banking counters during the year, leading to heightened returns volatility relative to The year started with the guidelines by the banks to comply with the full Basel II approach. This incited a flurry of capital raising exercises and dented the prospects of dividend payment by the banks. The numerous policy pronouncements during the year was capped with the bold tightening move by the CBN via the hike in Cash Reserve Ratio (CRR) on private sector deposit to 20% and an 100bps increase in MPR to 13% in the last quarter of the year. Although short term earnings visibility appears distorted for Nigerian lenders, we continue to expect that the resilience of the sector in the face of numerous opportunities in the economy will lead to modest growth in deposits and risk assets in the medium to long term. Although short term earnings visibility appears distorted for Nigerian lenders, we continue to believe in the resilience of the sector Fig % 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% Deposit growth remains weak Nigerian banks' quarterly deposit growth, % 8.56% 6.50% 5.59% 4.50% 1.95% 1.25% Q Q Q Q Q Q Q FY 2014e % -4.20% Banks Financials, United Capital Research Navigating the rough patch of rate hikes Banks that have grown noninterest income contribution to total earnings will be less impacted by the hike in CRR As at H1 14, Nigerian banks had already adjusted to the CRR hike in the public/private sector deposit, especially the tier 2 banks which showed more resilience. Banks aggressively drove their retail deposit strategy which helped in stabilizing Net Interest Margin (NIMs), though cost of funds inched up by 20bps to 4% in this period. However, we expect that the 500bps hike in CRR on private 75

76 Banking Sector sector deposit to 20.0% will put the banks in a tough operating environment in 2015 having sterilized an additional N450.0bn of banks deposit liabilities which implies a cumulative debit of c.n4.3trn with the CBN. This in our opinion will hamper the income generating capacity of the banks and also dip liquidity ratio to about 36%-38% level, further affecting banks capacity to create risk assets. We expect an 8.1% decline in bank s gross earnings going into H1 15. The 500bps hike in CRR on private sector deposit to 20% will put the banks in a tough operating environment in 2015 Fig % 30% Earnings remain pressured on higher funding costs Nigerian banks' annualised ROEs, e 29% 25% 20% 15% 20% 22% 18% 17% 15% 18% 18% 17.30% 16.20% 10% 5% 0% Q Q Q Q Q Q Q Q FY 2014e 2015 Banks Financials, United Capital Research Loan Growth should moderate to 10% in 2015 We have cut our 2015 loan growth forecast for our coverage banks from 15% to 10% (versus 12.8% as at Q3 14), to reflect the recent rate hike and the possibility of further tightening in We however expect the current capital injections from Eurobond and Rights Issues to continue to drive loan growth across our coverage banks as lending opportunities continue to unfold post 2015 elections. We expect loan growth in FY 14 to remain largely flat at Q3 14 levels even as we expect to see a rise in cost of funds across the board though with less impact in the Tier 1 names due to economies of scale and access to less expensive deposit. The rise in Cost of funds and the idle cash with the CBN will continue to pressure NIMs in We have cut our 2015 loan growth forecast for our coverage banks from 15% to 10% (versus 12.8% as at Q3 14), 2015 Earnings on a Quandary Higher liquidity constraint and lower loan growth will pressure earnings of the banks as assets reduce. The impact is expected to be most felt by the Tier 1 names due to the volume of deposit to be sterilized but a few of them with sufficient liquidity cushion should be less impacted. Also, banks that have shown 76

77 Banking Sector strong growth in non-interest income contribution to total earnings will be less hit by the hike in CRR. We have therefore revised our coverage banks gross earnings growth forecast for FY 15 to 12% driven by a weak loan growth, higher cost of funds and strain on margins. We also cut our dividend payout expectations across our coverage as we expect the banks will retain more earnings to manage liquidity in the face of the tight monetary stance. We also cut dividend payout as we expect the banks will retain more earnings to manage liquidity in the face of the tight monetary stance Fig. 72 Loan growth to remain muted at FY '14 12% 10% Nigerian banks' quarterly loan growth, % 9.80% 8% 6% 4% 2% 0.98% 6.01% 6.00% 5.45% 5.56% 4.12% 2.26% 0% Q Q Q Q Q Q Q FY 2014e 2015 Banks Financials, United Capital Research Oil Price Declines: Measured impact on currency obligations Nigerian banks total exposure to the oil and gas sector has averaged 23.1% in the last four years (Vs. 13.2% between 2007 and 2011). With a high oil price regime and rising indigenous participation in IOCs divestment activities, Nigerian banks have shown increasing appetite for financing oil and gas projects especially those in the upstream segment. In the last two years, exposures have peaked to 24.0% of industry risk asset portfolio. We think the recent declines in oil prices have taken a huge bite off banks ability to grow loan books in 2015, as most oil and gas projects especially upstream, which often accounts for more than half of banks total oil and gas exposure, become unprofitable at sub-$70p/b oil prices. On another note, existing significant FCY asset liability mismatch will necessitate restructuring and repricing which could come at an additional cost to the banks with a negative impact on margins. A quick look at our coverage names (see chart 73 below) reveals that FBN, Fidelity, FCMB, Stanbic, Skye Bank and Guaranty have net FCY funding gaps that are quite significant relative to their shareholders funds. This also exposes their NIMs to further currency devaluation within the year. Nigerian banks total exposure to the oil and gas sector has averaged 23.1% in the last four years (Vs. 13.2% between 2007 and 2011). 77

78 Banking Sector Also, the persistent fall in oil prices which is expected to be sustained in H1 15 may result in reluctance by foreign banks to extend credit lines to Nigerian banks; Credit lines by foreign banks to Nigerian banks have always been strongly correlated with oil prices. Banks will therefore be faced with the challenge of managing short term foreign currency obligations. Fig % Nigerian banks have significant net FCY funding liabilities FCY Exposures (Assets Vs. liabilities) The sector ended the year with only two stocks trading higher relative to their respective closing prices in % 60% 46.6% 52.5% 69.2% 49.6% 54.1% 54.0% 47.9% 42.2% 44.3% 54.8% 47.3% 40% 20% 0% 53.4% 47.5% 50.4% 45.9% 46.0% 52.1% 57.8% 55.7% 45.2% 52.7% 30.8% FirstBank Zenith UBA GTBank Access Diamond Skye Fidelity FCMB Sterling Stanbic FCY loans FCY Deposits Banks Financials, United Capital Research Market Performance and Outlook The sector ended the year with only two stocks trading higher relative to their respective closing prices in 2013, as persistent regulatory guidelines and policies instigated negative sentiment towards the banks. The banking sector returned % in 2014 with the biggest loss in ACCESS (-31.3%) while STANBIC (26.5%), ETI (14.7%) and STERLNBANK (1.6%) were the only three stocks to close the year positive. We anticipate more policies will be instituted to regulate operations, whilst we also envisage the relaxation of some to offset the expected restrictions. As such our expectations for the sector in 2015 are tempered, though we estimate that downside risks are overpriced, creating significant long term opportunities at current prices. Fig. 74 YTD Performances of Nigerian banking stocks, % 20% 0% 1.6% 14.7% 26.5% -20% -40% -60% -51.7% -46.0% -39.8% -39.5% -32.8% -32.5% -31.3% -24.1% -21.3% -11.7% -6.8% 78

79 Banking Sector Fig Sector Performance Vs ASI Banking Index NSE ASI Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 NSE, United Capital Research Recommendations Sector Coverage Names: BANKING Name Mkt Cap (NGN) Liquidty Price* ACCESS , ,083, % BUY GUARANTY , ,974, % HOLD FBN , ,421, % BUY ZENITH , ,801, % BUY ETI , ,575, % BUY SKYE , ,137, % BUY FCMB , ,965, % HOLD DIAMOND , ,667, % HOLD FIDELITY , ,222, % BUY STERLING , ,527, % SELL STANBIC , ,245, % SELL * Prices as at Dec 31, 2014 Banks Financials, United Capital Research Daily Val. EPS Million Traded Trailing 2014e Trailing P/E (x) P/BV ROE (%) 2014e Current 2014e Current 2014e Target Price Upside/ Downside Rating 79

80 Insurance Sector INSURANCE SECTOR The Untapped Gold Mine Nigeria remains a huge potential market for insurance business in Africa. The under penetration story is glaringly a strong investment case for the country s largely undeveloped risk market. By sheer demographic advantages and current economic size, Nigeria can undoubtedly be described as holding the biggest potential in insurance business in Africa. By sheer demographic advantages and current economic size, Nigeria can be undoubtedly described as holding the biggest potential in insurance business in Africa. In spite of lingering challenges, the Nigerian Insurance Industry has witnessed appreciable progress in the last decade most of which was regulation driven as market participants are yet to fully exploit the inherent potential in the industry, in our view, however, opportunities still abound in this space. Our core investment case for the sector is that growth will continue to be driven by Nigeria s attractive demographics, government reforms and increase in business activities in the country. We continue to believe this sector portends a wide array of opportunities given the very low insurance penetration rate compared to other countries. Fig. 76 Nigeria's Insurance Penetration one of the lowest globally Insurance pentration and density in select African Counties Density (LHS) Pentration (RHS) 9% 270 6% Namibia Morocco Tunisia Angola Nigeria Algeria Kenya Egypt 3% 0% SwissRe, United Capital Research Industry Growth: Riding on Reform Initiatives In the face of challenges facing the industry, past and current reforms by NAICOM have given hope, as the sector begins a bumpy ride to a positive change. Various initiatives by NAICOM and hunger for increased market share by insurance companies pegged the industry gross premium at N105.5bn in Q3 14, implying c.6% increase from N99.6bn posted in Q3 13. In the same vein, PAT rose by c.40% to N14.7bn from N10.5bn recorded in corresponding period of previous year just as return on equity (ROE) and return on asset (ROA) surged, Various initiatives by NAICOM and hunger for market share by insurance companies pegged the industry gross premium at N105.5bn in Q

81 Insurance Sector albeit marginally by 1.6% and 0.7% y/y respectively. According to NAICOM, an annual growth of 17% in gross premium earned was recorded between 2009 and 2013 even as the industry regulator expects this to double within 3 5 years. Much as we believe the industry has huge potential for growth, we are not overly optimistic in the short term, given that the sector was unable to achieve the target of N1trn set by NAICOM between 2008 and 2012 (achieved N234bn) in its Market Development and Restructuring Initiative (MDRI) project. Also, our discussions with industry players revealed that the N6trn objective by 2020 appears bullish and unrealistic. Notwithstanding, we expect the sector s growth trajectory to expand in the coming years, a position governed by the various actions of the players to expand their balance sheet size through mergers and acquisitions and rights issue. This will avail them the opportunity to underwrite big ticket transactions as insurers cannot expose more than 5% of their net assets (shareholders fund) to such transactions as required by the guideline on Oil and Gas insurance by NAICOM. This said, the recent risk-based supervision by NAICOM which was developed to ensure that insurance companies only underwrite insurance contracts which their assets can support will make insurance companies to further expand their balance sheet. According to NAICOM, an annual growth of 17% in gross premium earned was recorded between 2009 and 2013 even as the industry regulator expects this to double within 3 5 years Weak Demand for Insurance: Public Apathy or Public Poverty? Fundamentally, the demand for Insurance as an economic product thrives on the purchasing power of the consumer. While opportunities for premium expansion on the corporate side rests significantly on domestic economic size, life insurance products and to a sizeable extent, general insurance is strategically linked to an individual s living standards. In our view, the perception of insurance by Nigerians is distorted by their economic power. We argue that there is little evidence to support the notion that there is public apathy towards insurance services A panel review of per capita incomes stacked against insurance premiums across emerging markets suggests that there is a strong positive correlation between per capita income and gross premium incomes across countries (see chart 77) Based on the foregoing, we argue that there is little evidence to support the notion that there is public apathy towards insurance services; rather we believe the low standard of living and longstanding income inequality remain key drags for the industry. 81

82 Insurance Sector Fig. 77 PCI ($) 60,000 Per capita income shows high correlation with Insurance Penetration Gross Premium Income and Per capital income of select countries R² = ,000 40,000 Netherlands Italy Germany France United Kingdom 30,000 Spain 20,000 Russia Mexico Mauritius Argentina Brazil Turkey Tunisia Algeria Namibia South Africa 10,000 Morocco Egypt Indonesia Angola India Nigeria Kenya , , , , , , ,000 Nigeria Premium (US$m) IMF, Swiss Re, United Capital Research The Rising Middle Class: Can they come to the rescue? Anecdotal evidence suggests that there is a bourgeoning middle class in Nigeria and indeed, the broader emerging market space, with the potential to foster economic growth across different sectors and push the weak demand for insurance products. By nature, the middle class is seen as a predominantly young active population with upward mobility in income, consumption, and purchasing power. We note that there has been a consistent upward trajectory in real per capita income (PCI) in Nigeria. Although statistics on income distribution is limited, the upward swing in income per head can be a lagging indicator of middle income growth. That said, it is pertinent to find a nexus between middle income expansion and demand for insurance services in Nigeria. Nigeria s geographical advantage of fewer records of natural disasters coupled with her citizens subconscious mindset of optimism makes a case for close linkage between PCI and GPI difficult to accept, at least from a time series perspective. We believe the expansion in middle class creates opportunities for highly innovative insurers We believe the expansion in middle class creates opportunities for highly innovative insurers to take advantage of changing lifestyle, consumption patterns and social dynamics of a new generation of spenders. We believe that to capture a substantial share of this insurable market, innovation and 82

83 Insurance Sector adaptability will be very critical. However, Nigerian insurers are offering too little in this regard. NAICOM: Pushing the frontiers of market expansion National Insurance Commission (NAICOM) which was established in 1997 with the responsibility of regulating and supervising Insurance business in Nigeria has made some remarkable contributions to shaping the Insurance industry. However, the regulator s intent to solidify the sector s configuration has led to new regulatory measures such as recapitalization regulation, and premium expansion programs via the Market Development and Restructuring Initiatives (MDRI) and the No Premium No Cover policy as well as the adoption of IFRS reporting style and guidelines on Micro and takaful Insurance. We estimate that the enforcement of the No Premium No Cover policy boosted insurers premium generation by 10-12% in In 2014, the Regulator continued the enforcement of the No Premium No Cover policy which commenced in 2013, stating that no valid Insurance contract can exist without the receipt of an Insurance premium. Prior to enforcement of this premium, Insurers were holding a large chunk of receivables in their balance sheet, increasing the credit risk of Insurers and of their capacity to meet obligation coupled with inability to invest these premium and generate income. The enforcement of this policy has helped boost profitability of Insurers and the confidence of the public. It has also helped in managing cash flows, thereby improving balance sheet quality. We estimate that the enforcement of this policy boosted insurers premium generation by 10-15% in but bargaining power is still in the hands of the brokers About 90% of corporate business for Insurance companies is generated by brokers/agents, and with over 2400 brokers/agents servicing 48 Insurers and 2 reinsurers, it is not surprising to see the brokers/agents having a strong bargaining power. Given the nature of Insurance in Nigeria, where demand for Insurance is driven marginally by corporate entities relative to private individuals, the brokers/agents hold a strong force in the Industry. This unhealthy dominance leads to late remittance and sometimes non-remittance of premium. Consolidation, M&A s expected in the Short to medium term The rich fundamentals of the Nigerian industry continue to endear it to foreign investors who are looking for exposure to Nigeria s massive growth markets and a profitable haven for investible funds in Africa and other emerging economies. The capital requirement of entry into the Insurance business (N2bn, N3bn, N5bn and N10bn for life, non-life, composite and re-insurance respectively) makes it easy for foreign players to gain entry into the Industry though NAICOM s current The rich fundamentals of the Nigerian industry continue to endear it to foreign investors who are looking for exposure to Nigeria s massive growth markets 83

84 Insurance Sector policy does not issue fresh Insurance license to any interested party. We believe that Merger & Acquisition is the only way foreign players or other interested parties can play in the industry. A number of foreign players have made entry into the Industry via acquisition; 5 foreign Insurance companies currently own significant stake in local insurers. A number of foreign players have made entry into the insurance industry via acquisition Sanlam Emerging Markets acquired 35% stake in FBN Life Insurance AXA Insurance Plc acquired 77% ownership stake in Mansard Insurance Plc. New India Assurance has 51% stake in Prestige Assurance. Old Mutual owns 70% in Oceanic Life (Old Mutual Life) Greenoaks Global acquired 92.8% in Union Assurance Others who have expressed interest are Prudential Plc, Liberty Holdings, among others. Local Insurers have also embarked on consolidation and M&A s in recent times in an attempt to increase market share. The more recent merger and acquisition in this space was between Custodian and Allied Insurance Plc and Crusader Nigeria Plc, as well FBN Life Assurance 100% acquisition of Oasis Insurance Plc. Similarly, Universal Insurance Plc and African Alliance Plc have expressed their intent to merge and form a new entity Universal Insurance Plc. Market Structure: The Big 5 control 34% of the market The Industry remains fragmented, as no Insurer holds above 12% of market share. The top 5 Insurance players control 34% of the market with the largest Insurer, Leadway Assurance holding 11% of the market. The top 5 players in the industry (measured by GPI) are local players save for AIICO insurance which has a substantial foreign ownership. Fig. 78 Market Share of Top 5 Players, 2013 Fig. 79 Gross Premium of top 5 market players, 2013 Mansard 4.6% IGI 4.9% Leadway 11.0% AIICO 8.5% Custodian and Allied 4.6% N18.4bn AIICO N10.1bn Custodian and Allied N24.1bn N10.0bn N10.6bn Leadway Mansard IGI NIA, United Capital Research NIA, United Capital Research 84

85 Insurance Sector Motor Insurance to remain a major driver of premium income We believe that for a long time to come, motor insurance will continue to account for the biggest share of premium income in the industry. The compulsory third party insurance enforced by the NAICOM and government enforcement agencies will continually support premium generation by Insurers. Also, the increase in the volume of comprehensive insurance policies by corporate and individuals have been significant in recent years. Looking ahead, the consumer lease financing and the automotive policy by the federal government portends opportunities for growth in the Motor insurance segment. We however note that the market still expects significant improvement in claims settlements. Gross Premium Income of Insurers By Class of Business N'000 Class of Business Fire 9,817 10,383 15,618 16,536 19,293 as % of total premiums 11.90% 10.30% 10.40% 9.20% 10.40% Motor 17,108 25,220 38,118 45,215 42,039 as % of total premiums 20.80% 25.10% 25.41% 25.27% 22.63% General accident 11,945 16,191 22,536 23,912 28,592 as % of total premiums 14.50% 16.10% 14.99% 13.36% 15.39% Marine and Aviation 7,841 11,256 17,231 16,728 20,097 as % of total premiums 9.50% 11.20% 11.64% 9.35% 10.82% Workmen's compensation , as % of total premiums 1.10% 1.00% 0.47% 0.95% 0.49% Oil and Gas 14,907 12,981 17,403 31,577 26,092 as % of total premiums 18.10% 12.90% 11.58% 17.65% 14.05% Miscellaneous 5,393 7,822 9,137 8,982 8,945 as % of total premiums 6.60% 7.80% 6.07% 5.02% 4.82% Others 1, as % of total premiums 2.00% Life 12,743 15,783 29,328 34,292 39,761 as % of total premiums 15.50% 15.70% 19.54% 19.17% 21.41% Total 82, , , , ,730 NIA, United Capital Research 85

86 Insurance Sector Industry Outlook: 2014 and beyond Opportunities abound in the Insurance Industry Our outlook for the industry is positive in the medium to long term. We believe there are opportunities yet untapped for growth as penetration rate is expected to inch higher in the next 4 years. Should penetration rate meet the average emerging market rate of 2.7% in 2019, gross premiums should rise to a high of N2.9trn (US$17.6bn) over this period. In our view, the possible drivers of this growth are: Should penetration rate meet the average emerging market rate of 2.7% in 2019, gross premiums should high N2.9trn (US$17.6bn) over this period Credit Facilities: The recent influx of consumer and retail credit and the prospect for more growth in that space given the growing number of working and middle class Nigerians as well as the drive by banks and other finance institutions to penetrate this space, will help support the Insurance sector. Typically insurance products accompany some consumer loans such as mortgage and car loan. Nigeria s Attractive Demography: The high rate of urbanization and the rising middle class portends prospects for the Insurance Industry. This effect of this will be high demand for Insurable products like car, home, personal items, as well as Life Insurance. Regulation and Enforcement: NAICOM efforts at boosting confidence in the sector and supporting growth via regulatory policies will continue to shape the sector. The regulator has also shown its drive to grow the insurance sector by enacting new laws and ensuring stricter enforcement of existing ones. We expect to see more policies and support from NAICOM in the future to support sector growth. Innovative Solutions and Micro Insurance: Given the poor penetration of insurance products relative to the population, we expect insurers to come up with increasingly novel ways to grab a share of the vastly untapped market. We expect insurers to leverage on technology in their bid to increase insurance penetration and make the insurance experience more convenient for the customer. Examples of such innovative solutions include MTN 'Y'ello cover' in collaboration with Mansard Insurance, Airtel's 'Padi 4 Life' in collaboration with FBN Life Assurance as well as the development of mobile insurance apps for quick and convenient insurance transactions 86

87 Insurance Sector Operating statistics of Select Insurance Companies Insurance co. OPEX Margin Net Margin Underwriting Margin Claims Ratio Expense ratio Reinsurance Rate Return on Invst. Assets Investment Assets/Total Assets Current Ratio Net working Capital Ratio AIICO 47.7% 4.1% 15.0% 37.2% 47.7% 21.8% 9.4% 65.5% % 336.6% ARM Life 131.9% % -46.0% 141.8% 131.9% 15.3% 11.9% 52.6% 136.0% 71.6% CHI 63.5% % 25.3% 63.5% 38.1% 7.0% 41.9% 167.0% 102.6% Continental Reinsurance 43.0% 13.1% 12.6% 46.9% 43.0% 11.2% 11.8% 54.8% 200.4% 50.0% Cornerstone 48.9% 32.0% 32.2% 43.1% 48.9% 41.9% 9.1% 58.1% 164.4% 51.4% Custodian 26.8% 42.8% 127.7% 53.8% 26.8% 55.2% 17.6% 50.1% 144.2% 64.7% Equity 70.6% -13.6% 50.7% 29.7% 70.6% 21.4% 7.2% 24.5% 156.3% 55.0% FBN Life 46.4% 11.8% 23.5% 16.9% 46.4% 5.8% 11.6% 94.0% 299.9% 116.3% Guinea 74.0% 4.1% 101.5% 33.2% 74.0% 9.5% 0.0% 38.2% 296.0% 249.3% KBL 46.7% 7.3% 17.7% 30.9% 46.7% 20.0% 5.4% 54.7% 251.8% 198.5% Lasaco 54.0% 7.6% 38.9% 52.1% 54.0% 32.4% 8.6% 42.6% 149.1% 48.0% Law Union 63.9% 16.4% 56.1% 25.2% 63.9% 21.6% 9.0% 42.4% 169.2% 67.8% Leadway 19.2% 21.4% 40.0% 48.3% 19.2% 42.8% 5.4% 64.0% 114.6% 28.2% Linkage 65.3% 26.1% 11.5% 40.7% 65.3% 25.6% 9.0% 87.6% 936.4% 111.9% Mansard 97.6% 27.8% 32.5% 46.8% 97.6% 39.8% 1.8% 57.6% 184.3% 45.3% Mutual Benefits 92.0% 8.3% 37.7% 41.8% 92.0% 12.4% 6.9% 51.8% 96.4% 15.0% NEM 52.3% 5.3% 24.7% 41.4% 52.3% 4.7% 10.6% 64.6% 151.2% 77.3% Niger 64.6% 6.5% 49.3% 38.6% 64.6% 9.3% 7.5% 25.3% 59.8% 30.5% Oasis 7.4% -6.9% 60.9% 13.1% 7.4% 17.8% 10.1% 44.7% 305.2% 111.6% Prestige 43.1% -5.2% -5.9% 65.6% 43.1% 63.0% 4.4% 38.8% 165.2% 55.1% Regency 42.5% 18.6% 54.1% 27.9% 42.5% 26.9% 7.4% 55.2% 255.6% 142.3% Royal Exchange 52.6% 15.3% 17.1% 47.3% 52.6% 27.1% 7.4% 26.5% 123.3% 23.9% STACO 75.5% 9.1% 43.1% 59.8% 75.5% 13.5% 6.1% 29.7% 80.6% 46.1% Standard Alliance 67.5% -28.5% 32.5% 34.6% 67.5% 18.1% 10.3% 37.0% 195.9% 11.2% STI 36.5% 8.1% 43.7% 40.7% 36.5% 42.1% 8.6% 34.0% 137.5% 42.6% UBAMET 57.7% 24.6% -16.4% 62.6% 57.7% 9.8% 12.0% 92.3% 216.8% 54.9% WAPIC 96.3% -7.8% -4.0% 80.1% 96.3% 28.8% 11.3% 60.3% 330.6% 132.8% Company filings, United Capital Research Sector Performance and Returns Expectations The sector returned 17.6% in 2014 (Vs. 40.5% in 2013) despite generally bearish sentiments in the Nigerian equities market in the year. The sector s performance was boosted by the contribution by it s the most capitalized stocks, Custody Insurance and MANSARD as they returned 74.0% and 30.6% respectively. Their performances were however not unconnected to the business combinations they witnessed during the year. Notwithstanding the sector s positive return performance in 2014, c.67% (20 out of 30 listed companies) of insurance counters still closed the year at their nominal values reflecting investors weak appetite for insurance counters regardless of the impressive fundamentals of a few of them. However, we are of the opinion that even if the upside potential from insurance stocks look unattractive relative to other sectors from absolute stance, low volatility of returns remains a valid investment case. 87

88 Insurance Sector Return performance of selected insurance stocks in % 74.0% 60% 40% 30.6% 20% 0% -20% -17.1% -16.7% -13.3% -10.7% -7.4% -5.7% -3.6% -40% CUSTODYINS MANSARD CONTINSURE PRESTIGE NEM CORNERST INTENEGINS ROYALEX AIICO Source: NBS, United Capital Research Fig Nigeria Insurance Sector Vs. NSE ASI Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Insurance Index NSE ASI Source: NBS, United Capital Research Recommendations Sector Coverage Names: INSURANCE Name Mkt Cap (NGN) Liquidty EPS P/E (x) P/BV ROE (%) Daily Val. Target Upside/ Price Million Traded Trailing 2014e Trailing 2014e Current 2014e Current 2014e Price Downside Rating MANSARD , ,435, % 10.8% % SELL CUSTODIAN , ,723, % 21.2% % BUY Continental Re , ,672, % 13.0% % BUY * Prices as at Dec 31, 2014 Source: NBS, United Capital Research 88

89 Consumer Goods Sector CONSUMER GOODS SECTOR Attractive demographics clogged by operating challenges The consumer goods sector in Nigeria has been thriving on the back of the country s huge mass market and macroeconomic stability. But consumption expenditure has been slowing. According to the NBS, average household income spent on food consumption is estimated at 64.7% of the total expenditure. However, recent pressure on the consumer wallet continues to reflect in dwindling consumer spend in Nigeria as aggregate consumption expenditure declined by 0.3% and 11.0% in Q3 13 and Q1 14 respectively even as the major consumer names continue to face distribution challenges arising from security threats in Northern Nigeria, including obstacles along export routes. Consumption expenditure has slowed significantly since 2013 Fig. 82 Consumer Spending in Nigeria; pressured in 2014 Fig ,000 25,000 Quarterly Aggregate Consumption Expenditure in Nigeria, ,000 20,000 15,000 10,000 10,000 5,000 5,000 Geographic Distribution of consumption spending in Nigeria South West 37% North East 6% North Central 13% North West 12% 0 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q Consumer spend( N'bn) Disposable Income Source: NBS, United Capital Research 0 South South 18% South East 14% Source: Euro monitor, United Capital Research Food and Beverage Sector: Keeping pace with rising demand The consumption pattern of Nigerians has been historically skewed towards food compared to non-food item as c.36.0% of Nigeria s GDP is driven by food consumption expenditure. Having recorded population-induced growth over the last 10years, players are now ramping up CAPEX in order to shore up capacity on the back of growing demand and market. We estimate that the flour milling subsector in particular has shored up capacity considerably from 22,000MT/day in 2012 to about 25,000MT/day presently. The sugar refining capacity have also increased significantly from 2.170MMTp/a to 2.920MMTp/a. Players in the Food and Beverage sector are ramping up capacity to meet increasing demand 89

90 Consumer Goods Sector Nestle and other players have hinted on plans to invest heavily in boosting its capacity, Nestle plans to invest N100bn over the next 10yrs to expand capacity to meet the growing demand for its product in the region. Fig. 84 Strong Growth in Food and Beverage Sector The volatile prices of agricultural inputs especially wheat prices remains a serious challenge for players in this sector. 16.0% Food and Beverage Sector Revenue Growth f 12.0% 8.0% 4.0% 0.0% e 2015f Source: NBS, United Capital Research Elevated Cost Structure remains a serious challenge The volatile prices of agricultural inputs especially wheat prices remains a serious challenge for players in this space. Wheat prices globally are usually very volatile and highly susceptible to internal price movements. These inputs account for the bulk of flour millers revenue (c.90% of turnover). Although cocoa is locally sourced, prices vary in line with international movement. Players however enter into some form of futures contract of up to 3 months with suppliers to hedge against price volatility. However, the recent devaluation of the Naira coupled with raise in the MPR to 13% will continue to affect companies in this sector especially those who largely import their raw materials. Also, cost of borrowing due to interest rate hike and tight liquidity will pose a major challenge to profitability. Food and Beverage Sector: Cost and Profitability Metrics e 2015f Cost to Sales 74.7% 76.0% 72.6% 75.0% 77.1% 76.5% 75.4% 74.4% 74.1% OPEX Margin 10.1% 8.6% 9.4% 10.3% 10.2% 11.0% 11.8% 11.4% 11.2% EBIT Margin 12.5% 12.5% 14.7% 12.5% 10.5% 10.7% 11.3% 12.6% 13.1% EBITDA Margin 11.2% 14.3% 14.2% 14.4% 10.9% 11.7% 10.7% 11.3% 12.8% Net Margin 8.9% 8.5% 9.2% 7.3% 6.5% 7.1% 7.4% 7.6% 8.6% ROE 25.7% 26.3% 27.4% 22.7% 19.0% 21.0% 22.4% 22.9% 25.4% ROA 12.2% 11.6% 12.1% 9.5% 7.8% 8.4% 8.7% 8.7% 9.8% Leverage 2.1x 2.3x 2.4x 2.4x 2.5x 2.5x 2.6x 2.6x 2.6x Asset Turnover 1.4x 1.4x 1.3x 1.3x 1.2x 1.2x 1.2x 1.1x 1.1x Companies Financials, United Capital Research 90

91 Consumer Goods Sector Brewery Sector: Changing drinking patterns... The Brewery sector accounts for about 45.3% of the beverage market in Nigeria, however, the recent decline in discretionary spend has been most noticeable in this space. The beer sector grew by 3.0% in 2012 and declined by 2.1% in A breakdown of the brewery market indicates that of the total beer consumption in Nigeria, Lager beer has the largest market share of 58.3%, stout has 27.2% and Malt has 14.5%. We think the brewery sector is witnessing an historic shift in drinking patterns, a development that is hitting hard on the premium brands. We believe that the next stage in the industry life cycle will see shrinkage in market shares for players in this segment, forcing many players to play at the low end. We think the brewery sector is witnessing an historic shift in drinking patterns, a development that is hitting hard on the premium brands continue to prompt acquisitions and inorganic growth strides The two (2) major players, Nigerian Breweries (NB) and Guinness control about 90% of the industry market share having seen significant investments in capacity and product chains to penetrate the vast changing beer market landscape. Heineken NV which owns majority stake in NB, Consolidated Breweries and Champion Breweries control c % of the market while Diageo owns majority stake in Guinness controls 27.0% of the market. Heineken NV recently concluded its merger of Consolidated Breweries and NB to exist as NB with a wide product portfolio in the premium and value segment of the market. SAB Miller (SABM) a more recent entrant to the brewery market has had a growing and significant stake in the industry and has built up its capacity to about 1.8mhl, which includes Pabod Breweries in Port-Harcourt, International Breweries in Ilesa and Onitsha. The entry of SABM has put a threat to future dominance of NB and Guinness. SABM acquired international Breweries in Jan 2012 and has made other acquisition since then which includes Intafact Beverage in Onitsha and Voltic Nigeria Ltd in Lagos. The company recently invested US100mn to penetrate effectively and aggressively in the Nigerian market through strategic regional approach. The two (2) major players, Nigerian Breweries (NB) and Guinness control about 90% of the industry market share Fig. 85 Breweries sector revenue trend, 2000 Fig e Segment Distribution of Nigerian Brewery Market Malt 27% Stout 15% Lager 58% Company filings, United Capital Research Heineken, United Capital Research 91

92 Consumer Goods Sector Global Brewers in Nigeria Global Brand Subsidiaries Installed Capacity (mhl) Nigerian Breweries 15.4 Heineken NV Consolidated Breweries 3.7 Champion Breweries 0.5 Diageo Guinness Nigeria Plc 5.5 International Breweries 1.8 Pabd Breweries Ltd SABMILER Intafact Beverages Ltd. Voltic Nigeria Ltd. N/A The FMCG players, many of whom are net manufacturers, continue to feel the pinch of tighter credit flows and high operating costs Heineken, United Capital Research FMCG sector: Striving hard to push sales The FMCG players, many of whom are net manufacturers, continue to feel the pinch of tighter credit flows and high operating costs in an era of cautious bank lending and lingering infrastructural bottlenecks. Given the ongoing distribution challenges, exercabated by volatile security situation, the route to market for these players have been rather tortuous. This has been further complicated by wholesalers difficulties in obtaining credits to fund working capital position, reflecting in pressured liquidity positions for key players. NESTLE has particularly done well in the face of rising competition from imported substitutes with largely volume driven growth buoyed by efficient supply chain management. Also, its highly domesticated input sources have stabilized cost of production and margins offsetting the impact of increased promotional spend. PZ on the other hand has struggled to hold on to market share in the face of stiff competition. Management has frequently attributed the recent weak earnings performance to security challenges in the North, but we believe wider industry headwinds from heightened domestic and external competitive pressures are largely responsible for its continued underperformance especially in the HPC segment. Given the ongoing distribution challenges, exercabated by volatile security situation, the route to market for FMCG players have been rather tortuous 92

93 Consumer Goods Sector Sector Outlook for 2015 and Beyond The expectation of a decline in consumer spending in 2015 largely on the back of recent devaluation of the Naira, as well as lingering security threats remain key downside risks to the sector in We estimate that aggregate consumer spend for 2014 at 65.1% of national disposable income down from 70.1% as at Q1, 2014, suggesting increased deleveraging by the Nigerian consumer. We expect to see a shift to necessity as a result as spending and credit conditions tighten. We would therefore look to pitch our tent with the defensive names in the sector. That said, we believe new product offerings, product innovation and capacity expansion will drive the sector s revenue this year. While we do not expect a quick recovery in consumer spend in 2015 due to lingering macro headwinds as well as overall decline in government spending, we continue to believe Nigeria will remain an increasingly attractive frontier consumer market in the medium to long term on account of positive developments in demographics, rapid urbanization and robust growth outlook. We estimate that aggregate consumer spend for 2014 at 65.1% of national disposable income down from 70.1% as at Q1, 2014 Market Analysis and Returns Expectation The sector under-performed the market in 2014, returning -17.9% compared to the market return of -16.1%. The poor performance of the sector was largely driven by losses of large cap stocks like FLOURMILL (-50.4%), PZ (-35.7%), UNILEVER (-33.5%), GUINNESS (-28.7%) and NESTLE (-15.7%). The poor sentiment was swept across all stocks in the sector save for 7UP and UNIONDICON which appreciated 131.6% and 33.5% y/y respectively. Fig % 131.7% Returns Performances of Selected consumers, YTD % 50% 33.49% 0% -50% -1.5% -5.7% % -28.8% -32.2% -33.5% -35.7% -45.7% % % -55.6% -100% NSE, United Capital Research 93

94 Consumer Goods Sector Fig Consumer Goods Sector Vs. NSE ASI 1.0 Consumer Goods Index NSE ASI 0.6 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 NSE, United Capital Research Sector Coverage Names: CONSUMER GOODS Name Mkt Cap (NGN) Liquidty EPS P/E (x) P/BV ROE (%) Price* Million Daily Val. Traded Trailing 2014e Trailing 2014e Current 2014e Current 2014e Target Price Upside/ Downside Rating 7UP , ,152, % 26.7% % HOLD CADBURY , ,073, % 20.7% % SELL DANGFLOUR , ,626, nm nm nm nm % HOLD DANGSUGAR , ,739, % 21.6% % BUY FLOURMILLS , ,618, % 5.3% % SELL HONEYWELL , ,377, % 12.1% % BUY NASCON , ,933, % 46.5% % BUY NESTLE , ,986, % 66.8% % SELL PZ , ,555, % 7.9% % BUY UNILEVER , ,198, % 5.4% % SELL * Prices as at Dec 31, 2014 NSE, United Capital Research Sector Coverage Names: BREWERIES Name Mkt Cap (NGN) Liquidty Price* GUINNESS , ,137, % 23.1% % BUY NB ,250, ,952, % 36.1% % HOLD INDUSTRIAL GOODS S * Prices as at Dec 31, 2014 NSE, United Capital Research Million EPS P/E (x) P/BV ROE (%) Daily Val. Traded Trailing 2014e Trailing 2014e Current 2014e Current 2014e Target Price Upside/ Downside Rating 94

95 Industrial Goods Sector CEMENT SECTOR A fast changing competitive landscape The dynamics of the Nigerian cement industry is rapidly changing. We have observed that in the last 2 years, attention has shifted from capacity and distribution linkages to pricing and quality. The demand drivers for the sector however remain unchanged - individual home owners given the long delays in large scale infrastructural projects. The history of strong domestic demand versus capacity constraints is now giving way for efficiency and strong market power with players seeking to leverage on scale to improve efficiency. The cement market grew by 1.3% to 16.2MT in Q3 14, largely driven by a growing building and construction market as well as a robust economy. Furthermore, total installed capacity increased by 9MMTp/a while capacity utilization stood at 85% as companies in this sector have geared towards gas supply and other alternative power measures. Dangote Cement maintained its dominance of the Nigerian cement market in 2014, though its ambitious pan African expansion plans were slower than earlier anticipated. In the last 2 years, attention has shifted from capacity and distribution linkages to pricing and quality Lafarge Consolidation: Standing up to the giant In a bid to measure up to the competitive pressures from Dangote, Lafarge worldwide concluded the consolidation of its Nigerian and South African operations into one entity in The combined entity known as Lafarge Africa, now has a market capitalization of N486bn (US$3 billion) and will be listed on the Nigerian Stock Exchange, becoming the 6th largest company by market capitalization. The transaction involved the transfer of Lafarge S.A.'s interests in Lafarge South Africa Holdings (LSAH), UniCem, Ashaka Cement and Atlas Cement to Lafarge WAPCO. Consequently, the enlarged entity Lafarge Africa now owns 100.0% of LSAH, 58.6% of Ashaka Cement, 100.0% of Atlas Cement and an indirect holding of 35.0% in UniCem. Lafarge Africa now has a combined capacity of c.12mmtp/a in Nigeria and South Africa and with a 5.5MMTp/a capacity expansion already underway in UniCem and Ashaka Cement. Lafarge Worldwide consolidated its Nigerian and South African operations into one entity in 2014 LAFARGE WAPCO LAFARGE AFRICA Subsidiary Wapco Wapco, Ashakacem, Unicem, Lafarge SA, Installed Capacity 4.5MMT 12MMT Market Presence South-West South-West,North-East, South Africa Company Disclosures, United Capital Research 95

96 Industrial Goods Sector Two Dominant players still face fierce competition The consolidation of the shares and businesses of Lafarge group in South Africa and Nigeria into one entity, Lafarge Africa Plc, has led to a more intense competition in the cement industry. While Dangote Cement controls 64% of the market, Lafarge Africa currently controls 33% of the market. The Intense competition among these two manufacturers is leading to stable and lower prices amid increased capacity by the firms as they position to meet burgeoning demand. The competition has gotten fierce with price as one of the weapons most commonly deployed. The biggest player in the industry, Dangote Cement Plc, announced on November 2, 2014 that it had pegged the price of its 32.5 cement grade at N1,000 per 50kg bag, while it noted that the higher 42.5 grade would sell for N1,150 per bag. The new prices, exclusive of the VAT, represent about 40% discount on the prevailing market prices of the product, which was selling for N1, 700 across the country, irrespective of the grade. The intense competition among players is expected to lead to stable and lower prices New cement standard: Raising the bar on quality The Standard Organization of Nigeria (SON) following allegations of poor cement quality and the increased incidence of building collapse, proposed the adoption of a new cement standard 42.5 grade, hence limiting the previously used 32.5 grade to plastering. Based on the new standard, only the 42.5 grade can be used for block making, thus necessitating a major shift to production of the new and better quality grade. A direct implication of the new standard on cement producers is the increase in cost of producing 42.5 grade as the cement mix requires a higher and purer amount of clinker thus impacting negatively on raw material and power costs. Dangote Cement had recently launched its 42.5R cement grade, though Lafarge Wapco was the first producer of the 42.5 grade (CEM II 42.5N) but failed to take first mover advantage through proper advertisement and product visibility. Gas Supply Challenges: Energy efficiency still at risk Cement producers struggled with inadequate gas supply in 2014, which was exacerbated by the increased demand for gas by the recently privatized power generating companies. This disruption affected cement production with local producers having to resort to more expensive sources of fuel - Low Pour Fuel Oil (LPFO). With the increased demand for gas putting a strain on the existing system and the expected addition of new capacities, the gas situation may get worse in However, some players are already opting for other fuels like coal which is cheaper than LPFO. For example, Dangote Cement is planning to switch to coal, even as the company disclosed that significant With the increased demand for gas putting a strain on the existing system and the expected addition of new capacities, the gas situation may get worse in

97 Industrial Goods Sector progress has been made in completing the coal mill with order already placed for the import of coal consignments. Although coal is more expensive than gas at the moment, the price of gas is expected to converge to the price of coal based on the planned increases in gas price, as conveyed in the Gas Master Plan. Market Performance and outlook We see medium to long term potential upside in this sector, especially within the cement space as we recognize the strength of the underlying market opportunity The Industrial goods sector closed the year with a negative return of -10.4% despite the year-end rally witnessed in this space. BERGER and ASHAKACEM were the only stocks that closed in the green with a return of 12.5% and 4.3% respectively. The sector s heavyweights, DANGCEM and WAPCO, closed the year with a negative return of -8.7% and -28.1% respectively, driven by poor earnings growth on the back of high production cost. We see medium to long term potential upside in this sector, especially within the cement space as we recognize the strength of the underlying market opportunity. Therefore we will be bullish on companies with strong, and in some instances, spare production capacity, which we think will remain a long term strategic advantage for players. More importantly, we will favour companies with stable sources of gas supply to power operations. Notably, our expectation of reduced government spending will cap volume uptake for players in What s more, the fall in discretionary income will reduce demand from individual home owners who remain the key drivers of demand, with further pressure on revenue growth of cement producers. The lingering gas supply constraints has exposed players to the vagaries of exchange rate as the major input, clinker, which requires over 90.0% of total production energy requirements, has been the hardest hit. By and large, we expect a modest slow down in earnings for players in the cement sector, largely due to elevated and erratic energy costs as well as reduction in volumes. Current valuations however still portend long term opportunities, on our estimates. On our estimates, current valuations portend significant long term opportunities 97

98 Industrial Goods Sector Fig % 10% 0% 12.90% Returns Performances of Select Industrial Goods Players 4.3% -10% -20% -30% -40% -8.7% -11.6% -22.6% -29.1% -30.0% BERGER ASHAKACEM DANGCEM CCNN CAP PORTPAINT WAPCO NSE, United Capital Research Fig Industrial Goods Sector Vs NSE ASI 1.0 Industrial Goods Index NSE ASI 0.6 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 NSE, United Capital Research Sector Coverage Names: INDUSTRIALS Name Mkt Cap (NGN) Liquidty EPS P/E (x) P/BV ROE (%) Daily Val. Target Upside/ Price* Million Traded Trailing 2014e Trailing 2014e Current 2014e Current 2014e Price Downside Rating DANGCEM ,408, ,217, % 32.3% % SELL WAPCO , ,046, % 23.6% % BUY * Prices as at Dec 31, 2014 NSE, United Capital Research 98

99 Oil and Gas Sector OIL AND GAS SECTOR Nigerian Hydrocarbon: robust reserves, little exploration Exploration activities have been at their lowest levels in the last few years According to BP statistical review 2014, Nigeria had about 37.2bn barrels of proven crude oil reserves as of end of 2013 the 2 nd largest deposit in Africa, after Libya. Proven oil reserves estimates have however been inactive over the past few years with exploration activities at their lowest levels. The long delay in the passage of the PIB, oil theft and pipeline vandalism continue to play a major role in the low exploration of hydrocarbon, especially in the onshore.. Fig. 91 Nigeria has the 2 nd Largest crude oil deposit in Africa World s 2013 oil reserves (Bn bbls) Nigeria USA Libya Russia UAE Kuwait Iraq Iran Canada Saudi Arabia Venezuela NSE, United Capital Research Production leakages and theft: Here to stay? According to the Nigerian Extractive Industries Transparency Initiative (NEITI), Nigeria lost over 136mn barrels of crude oil estimated at US$10.9bn through pilfering and sabotage from 2009 to 2011, while 10mn barrels valued at US$94mn were also lost to pipeline vandalism in the downstream sector within the same period. We believe that operational risks will continue to grow in Nigeria s oil and gas sector over the next few years Oil theft, pipeline vandalism and other security challenge led to significant volatility in oil production and heightened exploration risks in 2014, with production volume falling below the long term average of 2m bp/d. We believe that operational risks will continue to grow in Nigeria s oil and gas sector over the next few years as long as these bottlenecks are not effectively removed. In addition, the low level of transparency in oil revenue, local tensions and 99

100 Oil and Gas Sector negative environmental impacts of oil exploration will remain key risks to investment in the sector, constituting a clog on the realization of the country s aspiration to increase production to 4mnbp/d by 2020 Fig. 92 Nigeria Oil Production trend (Mn bbls) 3 2 Nigeria did not import any barrel of crude to US refiners in July 2014, ending over 4 decades of exports. 1 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 BP, United Capital Research World Energy in 2014: The Great Shale Revolution One of the most astonishing transformations in the history of the global economy has taken place almost overnight in the oil industry. From an output low of 5mnbp/d in 2008, the least since 1946, US oil production skyrocketed to 8.864mnbp/d in September 2014, the most in nearly 30 years. This incredible 77% surge in only 6years was generated by the recent technology development of hydraulic fracturing in natural gas production from shale formation in the US. This development has influenced not only energy dependence in the US but also global energy prices. The US has vast reserves of shale formation, which often extend our conventional natural oil and gas basins, but are generally deeper and more difficult to exploit. The implication of the vast improvement in US shale production is a drop in import from Nigeria. According to US Department of Energy, Nigeria did not export any barrel of crude to US refiners in July 2014, ending over 4 decades of exports. 100

101 Fig US crude oil production has witnessed significant growth in the last 4 years US Oil Production (Mn bbls) The delayed passage of the PIB has capped industry capacity and reserves BP, United Capital Research Delayed PIB meets increased propensity to divest The delay in the passage of the PIB has continued to stall huge investment in the oil industry, placing a cap on industry capacity and reserves. In 2014, Shell Petroleum Development Company (SPDC) had to put on hold investment decisions on two key offshore oil and gas projects estimated at US$30bn pending the passage of the PIB. Major Oil and Gas projects affected by the PIB include the Trans-Sahara gas pipeline project, the Olokola Liquefied Natural Gas (OKLNG) project, Brass LNG project and Russian Gazprom US$25bn gas project, and the US$12bn Bonga South West Aparo development. A number of IOCs divested their upstream assets in response to the high level of oil theft, pipeline vandalism, operational and security challenges in the Niger Delta as well as elevated cost of doing business in Nigeria. Chevron sold some of its oil blocks in shallow waters while SPDC, Total and ConocoPhillips have earlier sold their Interests. Given that IOCs account for more than 70% of Nigerian daily crude production, these divestments continued to command interest from different stakeholders in the Nigerian Oil and Gas industry. The divestment programme by the IOCs has significantly changed the Oil & Gas industry dynamics in Nigeria, providing opportunities for smaller players The divestment programme by the IOCs has significantly changed the Oil & Gas industry dynamics in Nigeria, providing opportunities for smaller players. The demand from smaller players for divested onshore blocks is likely to remain high as new divestments may prove attractive plays for Nigerian companies to gain access to viable oil discoveries located onshore, in swamp land or in shallow waters, and achieve material increases in scale. We expect the IOCs to continue with the process of divesting oil blocks in 2015, albeit at a slower pace than 2014, particularly those located onshore and in shallow waters. In an effort 101

102 Oil and Gas Sector to rationalise portfolios and achieve economies of scale, most of the large international oil companies have shifted their operational focus gradually to larger discoveries, often taking them further offshore and in deeper water ranges where they still possess technological and capital advantages over domestic oil companies. Company Disclosures, United Capital Research Stalled Privatization of Refineries: Posing a Challenge for Growth Nigeria s grossly inadequate refining capacity continued to stifle growth in the oil and gas industry in The Bureau of Public Enterprises (BPE) and the Ministry of Petroleum Resources had earlier indicated plans to sell the existing four (4) refineries, with a combined capacity of 445,000bp/d, with an average capacity utilization of 31% once the PIB is passed. While a number of private 102