KESTREL CAPITAL. SAFARICOM LTD Recommendation: ACCUMULATE. September Member of the Nairobi Securities Exchange. Tickers

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1 Member of the Nairobi Securities Exchange September 2014 SAFARICOM LTD Recommendation: ACCUMULATE We maintain our ACCUMULATE recommendation on Safaricom with a Fair Value of KES 14.20, 8.1% above the current price. We estimate total return of 12.7% including our forecasted dividend of KES 0.60 for FY15F (a forward dividend yield of 4.6%). For FY15F, we forecast earnings to grow 31.7% y/y largely driven by growth in revenue on the back of additional subscribers and increased usage as costs remain stable. Safaricom s revenue growth over the last 3 years has largely been driven by growing subscriber numbers. However, as subscriber growth begins to taper off and the quality and variety of products continue to rise, we believe that growth in the long term will be driven by increased usage. Safaricom trades at a forward P/E of 17.4x, EV/EBITDA of 7.2 and dividend yield of 4.6%. While this is compares unfavourably to the regional median P/E of 11.8x and EV/EBITDA of 6.3x, Safaricom s M-PESA advantage and the expected growth in earnings and dividends justify the premium. Notably, Safaricom s forward dividend yield of 4.6% is higher than the regional median of 3.3%. Positives Growth in voice revenues (3 year forward CAGR of 10.5%) will be driven by increased minutes of use Non-voice revenue will contribute more to service revenue (41.8% in FY17 compared to 37.6% in FY14) due to faster growth (3 year forward CAGR of 17.1% ) Growth in M-PESA revenues (3 year forward CAGR of 15.8% ) will be supported by increased transactions per user and a rise in the average value of each transaction of M-PESA and its associated products SMS revenue growth (3 year forward CAGR of 16.0% ) will be driven by increased usage per subscriber as a result of lower pricing and promotions Increased data usage and subscribers on the back of faster internet and increased data coverage will be the drivers of mobile data revenue growth (3 year forward CAGR 22.3%) Fixed data revenue growth (3 year forward CAGR of 16.2%) will be driven by additional subscribers and increased usage Safaricom s strong distribution network (of 270,000 retailers, 43 shops, 3,000 dealer outlets and 81,025 M- PESA agents) will support airtime sales Contribution margins and EBITDA margins will continue to increase (+204bps and 251bps respectively over the next 3 years) as costs rise slower than revenue Increased finance income as a result of negative net debt will drive up earnings Capital expenditure (including the acquisition of Yu s infrastructure) will be focused on improving the network Negatives Dividends are likely to increase as capital expenditure remains relatively stable and debt declines Increased competition from MVNOs is expected slow growth in subscriber numbers and prevent any significant rise in prices of products and services Data-supported text applications are likely to subdue growth in SMS revenues in the long term Equity Bank s mobile banking system running on its MVNO license will be a strong competitor to M-PESA The interoperability of M-PESA agents will reduce some of Safaricom s competitive advantage FY10 FY11 FY12 FY13 FY14 FY15F FY16F FY17F Revenue (KES bn) y/y % ch EBITDA (KES bn) y/y % ch (2.4) EPS (KES) y/y % ch (13.2) (4.0) DPS (KES) y/y % ch EV/EBITDA (x) P/E (x) Div yield (%) Tickers Bloomberg: Reuters: Share Statistics SAFCOM KN SCOM NR Fair Value (KES) Price (KES) Issued shares (m) 40,044.6 Market cap (USD m) 5, Year end March Free Float % 25.0 Foreign ownership (%) 13.1 Av daily trading vol (USD) 1,847,836 Price Return Absolute Excess 3m 3.1% (3.7%) 6m 12.8% (0.6%) 12m 64.6% 34.4% Price Graph Source: NSE Analyst Kuria Kamau NSE All Share kuriak@kestrelcapital.com Safaricom

2 Positives Voice Revenue versus Voice Subscribers 1H10 2H10 1H11 2H11 1H12 2H12 1H13 2H13 1H14 2H14 Fixed Service Revenue 2% Mobile Data Revenue 8% Voice Revenue (KES bn) (Source: Safaricom) Handset Revenue 3% M-PESA Revenue 20% SMS Revenue 10% Acquisition and other revenue 1% (Source: Safaricom) Voice Subscribers (m) Voice Revenue 56% Voice Revenue versus Non-voice Revenue Growth in voice revenues will be driven by increased minutes of use: In FY14, voice revenues grew 11.6% y/y largely driven by an 11.1% y/y increase in subscribers. The company was able to regain some of the subscribers that were lost in FY13 due to the switching off of counterfeit phones and unregistered lines. Voice ARPU, meanwhile, increased 0.5% y/y largely on the back of higher effective minutes yield (+2.2% y/y) as minutes of use declined (-1.6% y/y). The effective minutes yield increased on the back of more on-net outgoing calls and more emergency top-ups. The increase in subscriber market share (from 65.1% to 67.8% in FY14) and reduction in churn (from 30.5% in FY13 to 19.3% in FY14), helped raise the effective minutes yield as evidenced by the 2.6% y/y increase in outbound calls minutes by subscriber. The company introduced higher loan bands of KES 250, KES 500 and KES 1,000, for its emergency top-up service, Okoa Jahazi. This helped grow revenues on emergency top ups by 37.0% y/y. Also, in FY14, Safaricom entered into partnerships with MTN and UTL in Uganda, Vodacom in Tanzania and MTN in Rwanda to provide roaming bundles within the East Africa region. This helped encourage subscribers to make better use of their Safaricom airtime. The increase in effective minutes yield was despite a decline in mobile termination rates (MTRs). The Kenya telecommunications regulator, Communications Commission of Kenya (now Communications Authority of Kenya) announced a glide path for MTRs in MTRs declined 20.1% y/y on 1 July 2013 and were due to decline by a further 13.9% y/y on 1 July Minutes of use disappointed despite promotions including the top-up promotion, Tetemesha na Safaricom. The promotion was able to increase voice traffic by 6.0% y/y in 1Q14 but the higher minutes of use were not maintained for the rest of the year. In 1Q15, the company carried out a repeat of the promotion, increasing the number and amount of prizes. Safaricom s minutes of usage are at 92; much lower than Vodafone South Africa s minutes of usage of 122. This is despite the fact that Kenya s call rates are USD 0.10 cents per minute cheaper than South Africa s. We expect minutes of use to keep growing as real disposable income rises. On call quality, Safaricom s next phase of the Best Network in Kenya programme will focus on customer quality of experience and sustainability and increase population coverage to 93.5%. To reduce dropped calls, the company invested in new technology (pooling and Wavelength Switched Optical Networks) in FY14 that ensures that any failure of a network element is supported by other network capabilities, without the customer experiencing any service loss. Improved call quality and organic growth in minutes of use will be the drivers of voice revenue in the future. We forecast 3 year forward CAGR of 10.5% FY10 FY11 FY12 FY13 FY14 FY15F FY16F FY17F Voice Revenue Non-voice Revenue Non-voice revenue will contribute more to service revenue: In FY14, non-voice revenue grew 27.8% y/y compared to the 11.6% y/y growth recorded by voice revenue. As a result, non-voice revenue accounted for 37.6% of total service revenue in FY14 up from 34.5% in FY13. We forecast 3 year CAGR on non-voice revenue of 17.1% against 3 year CAGR on voice revenue of 10.1%. By FY17F, we expect non-voice revenue to account for 41.8% of total service revenue. (Source: Safaricom) 2

3 M-PESA Revenue versus M-PESA Subscribers FY10 FY11 FY12 FY13 FY14 M-PESA Revenues (KES bn) M-PESA Subscribers (m) (Source: Safaricom) Number of transactions versus Value of Transactions FY14 FY13 FY12 FY11 FY , , , , Value of Transactions (KES bn) Number of Transactions (m) (Source: Safaricom, Central Bank of Kenya) Growth in M-PESA revenues will be supported by increased number of transactions per user and a rise in the average value of each transaction of M-PESA and its associated products: M- PESA revenues accounted for 19.2% of total service revenues in FY14. Subscriber growth was the major contributor of the growth. M-PESA revenue grew 21.6% y/y while M-PESA subscribers grew 13.0% y/y. M-PESA ARPUs also grew after Safaricom increased M-PESA tariffs at the start of FY14 to factor in the new excise duty on mobile money transactions. For transactions below KES 100, it held the tariff stable but increased the tariff for transactions above KES 100. The number of transactions per subscriber remained relatively stable in FY14. This was in spite of a 23.6% y/y increase in the number of agents to 81,025. Safaricom has launched several products to help grow M-PESA revenue. The products include M-Shwari, Lipa Kodi, M-PESA IMT and Mymarket. As at the end of FY14, M-Shwari had 3.6 million active customers and Commercial Bank of Africa (Safaricom s partner on M-Shwari) had managed to attract deposits worth KES 4.0bn and issue KES 1.2bn in loans per month while maintaining a Non-Performing Loans ratio of 2.7%. Lipa Kodi has enabled 88 landlords/housing agents and tenants in 60,000 housing units monitor and access statements of rental payments for record keeping purposes. M-PESA International Money Transfer (M-PESA IMT) allows M-PESA subscribers to receive funds from over 100 countries worldwide via a Safaricom IMT partner at no fee. Safaricom Mymarket is an online merchandising platform introduced in December 2013, which offers free auction services through mobile phones. The service, which can be accessed via USSD, currently includes jobs, classifieds, automobiles, property, mobile phones and electronics. All payments are made through M-PESA. Furthermore, Safaricom has increased its cashless distributors to 158 with a total of 1,271 distribution points. Among the companies that have signed up are Coca Cola, Unilever, East African Breweries Ltd, British American Tobacco, Nation Media and Standard Group. With growth in subscriber numbers expected to taper off in the medium term due to saturation and increased competition, increasing the number of transactions per subscriber and the average value of each transaction are the only sustainable ways to grow M-PESA revenues in the long term. Safaricom has already been positioning itself for this. Safaricom launched a new merchant service, LIPA na M-PESA in FY14 which allows M-PESA subscribers to pay for goods and services from merchants with M-PESA till numbers. As at the end of FY14, Safaricom had signed on 122,000 merchants with 24,137 active on a 30-day period. To encourage the growth of the product, Safaricom reduced the transaction fee from 1.5% to 1.0% of the transaction value. Furthermore, Safaricom announced new M-PESA tariffs on 20 August 2014 to encourage increased usage, pass on cost savings from moving the M-PESA system to Kenya and also positioned itself ahead of expected competition from Equity Bank. The tariffs for transaction sizes below KES 1,500 were reduced by an average of 48.9% to an average tariff of KES The tariffs for transaction sizes of KES 1,500 and above (to the maximum transaction size of KES 70,000) increased by an average of 41.8% to an average tariff of KES M-PESA is an EBITDA dilutive product (it has an EBITDA margin of approximately 17.0% before the tariff change compared to the company EBITDA margin of 42.1%) and therefore it requires large volumes to generate good return. We forecast 3 year forward CAGR of 15.9% on M-PESA revenues. 3

4 Investment in the M-PESA system will help improve processing time, capability and reliability: In 4Q14, a system upgrade to the M-PESA and M-Shwari platforms resulted in a significant increase in the processing capabilities and speeds to near real-time processing. Following the upgrade, the system can handle 440 airtime top-up transactions per second from 320. It has also increased speeds at which M-PESA subscribers can withdraw funds directly from their bank accounts in 30 different banks to M-PESA. The system upgrade also streamlined operations for the 160 business partners that disburse staff salaries through M-PESA, as well as those that receive payments through M-PESA and need to move cash to their bank accounts on a regular basis. Service availability of MPESA was 99.6% in FY14 with a peak average of 260 transactions per second. Safaricom s 2 year programme of transferring the M-PESA system to Kenya will be complete at the end of FY15. This will result in increased functionality, reliability and faster processing time of the system. This will help improve the customer experience ahead of the competition from Equity Bank. SMS numbers per operator (in millions) 7,000 6,000 5,000 4,000 3,000 2,000 1, Q13 4Q13 1Q14 2Q14 3Q14 4Q14 Safaricom Airtel Essar Yu Orange (Source: Communications Authority of Kenya) Number of mobile data/internet subscriptions Orange Yu Airtel Kenya Safaricom Safaricom Airtel Kenya Orange Yu (Source: Communications Authority of Kenya) SMS revenue growth will be driven by increased usage per subscriber as a result of lower pricing and promotions: In FY14, SMS revenues accounted for 9.8% of service revenues. Growth in SMS revenue was 34.2% y/y on the back of increased usage. The SMS usage per customer increased 129.0% y/y despite a 64.0% y/y decline in the average price per SMS. The increased usage was driven by the Bonyeza Ushinde promotion. Safaricom, through the Bonyeza Ushinde promotion, offered subscribers a free SMS for 3 questions answered, 2 free SMSes for 4 questions answered and 3 free SMSes for 5 questions answered. All questions were answered using SMSes charged at KES 5.00 compared to the normal SMS charge of KES The promotion has a sticky effect on SMS volumes as evidenced by the fact that the higher SMS volumes recorded during the quarter in which the promotion took place (7 August to 5 October) continued onto the following quarters. SMS volumes for the promotion quarter stood at 4.8bn and increased to 6.0bn in each of the following quarters. The sustained SMS volumes was also on the back of increased uptake of SMS bundles. The SMS bundles revenue grew 66% y/y to KES 2.5bn. Going forward, we expect Safaricom to grow its SMS revenues largely on the back of increased volumes by running promotions and maintaining prices low. Safaricom introduced, Chatitude, a product whereby subscribers access 10MB of data and 10 on-net SMS at a cost of KES 10. It combines data and SMS in bundles and helps customers with smartphones to make the best of both of these services. We forecast SMS revenue to grow at a 3 year CAGR of 16.0% y/y. Increased data usage and subscribers on the back of faster internet and increased data coverage will be the drivers of mobile data revenue growth (3 year forward CAGR 22.3%): Like most other business segments, mobile data revenue grew on the back of subscriber growth. Mobile data revenue grew 40.6% y/y while mobile data subscribers grew 34.1%. The growth in subscribers was supported by the Jisort na Smartphone promotion which involved selling entry level smartphones at affordable prices. The loyalty points system (Bonga Points) was revamped to enable subscribers to use part cash and points to purchase internet enabled devices. Safaricom is able to purchase a variety of smartphones at relatively low prices through its procurement partnership with Vodafone. The company then passes on the lower costs to subscrib- 4

5 Internet Penetration in Kenya 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 Internet Users in Kenya (in millions) 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% (Source: Communications Commission of Kenya) Telkom Kenya Access Kenya FIXED DATA MARKET SHARE Others Safaricom Liquid Telecom Internet Penetration Wananchi Telecom (Source: Communications Commission of Kenya) 0.0% ers through promotions. As a result of the promotions, Safaricom had 9.5m subscribers with data enabled phones of which 3.1m customers use 3G enabled devices and 1.9m use smartphones as at the end of FY14. Internet penetration in Kenya was at 53.3%, of which 73.6% of subscribers accessed the internet (mostly mobile data) via the Safaricom network. In order to increase mobile data interest from new potential subscribers, Safaricom launched a WiFi service on more than 3,000 public service vehicles called Vuma Online. The Wifi service has allowed subscribers to sample 3G internet for free on public service vehicles. Every day approximately 24.5 GB worth of data is consumed in the public service vehicles. In addition to this, the company hopes to introduce a Dynamic Discounting System (DDS) located in high youth density areas that will offer affordable options to young people. Mobile data usage was up 16.1% y/y while average price per MB declined 14.4% y/y. Safaricom has been encouraging its subscribers to convert from the more expensive Pay As You Go (PAYG) internet to the cheaper in-bundle browsing to drive increased usage. In FY14, the company expanded data 2G coverage to 91.0% of population coverage and 3G coverage to 61.0% of population coverage. The increased coverage will result in increased usage. Safaricom will have significant first mover advantage when it rolls out 4G. It would be able to attract new subscribers and drive increased usage. In exchange for building the government a security monitoring system, Safaricom will be handed USD 75.0m worth of spectrum on which it will set up 4G. In addition to this, the acquisition of Yu s assets will allow for more spectrum. 4G will be supported by the fibre network that Safaricom has been investing in. The company has already tested 4G at 10 sites and managed to record download speeds of 70 Mbps. We forecast 3 year CAGR of 22.3% on mobile data revenue. Fixed data revenue growth will be driven by additional subscribers and increased usage: In FY14, fixed data revenue grew 21.8% y/y on the back of increased fixed data ARPU (+16.8% y/y) as fixed data subscribers rose 4.3% y/y. To support fixed data growth the company is building a backbone fibre network in major towns and cities in Kenya. Safaricom has completed 770 km of fibre and is ready for service with 70% of the targeted 385 sites connected as at 31 March Another 640 km of fibre is under construction in Nairobi, Nakuru, Mombasa and Kisumu. Following the completion of the additional 640km, Safaricom intends to deploy fibre buildings in four large towns in Kenya. The company had already connected 119 buildings out of a target of 623 buildings in Nairobi and hopes to connect 934 buildings in Kenya by the end of March With connections to major buildings in Nairobi, Safaricom will be able to grow its fixed data subscriber numbers at a relatively low additional cost. The faster internet speeds will encourage increased usage. The company has migrated its services to its own fibre from leased lines giving it more power on pricing. Moreover, the fibre network will allow the company to have increased capacity for larger product offerings for both consumer and enterprise services. By having its own fibre network, Safaricom will be able to respond quickly to any damages on the line to avoid loss of revenue. We forecast 3 year CAGR of 16.2% for fixed data revenue. Innovative new products, M-PESA and increased coverage will help grow revenues from large enterprises and SME: Safaricom is the largest seller of bundled telecommunications services to business customers in Kenya. The company leverages on its subscriber numbers, network 5

6 coverage and extensive M-PESA ecosystem to provide these services to corporates in Kenya. Safaricom Enterprise Business Unit s market share grew from 37% in FY13 to 42% in FY14, largely driven by 35.0% y/y growth in total business unit revenue to KES 10.2bn. The increase in revenues was supported by 28.0% y/y growth in enterprise data to KES 4.2bn, 70.0% y/y growth in business related M-PESA revenue to KES 1.5bn and 32.0% y/y increase in voice to KES 3.7bn. The growth in business related M-PESA revenue was driven by cashless distribution for corporates. Other enterprise services added KES 0.8bn to revenues. The company hopes to extend its product offering outside just enterprise telecommunications to managed services; and a host of advanced IP, data, voice, video collaboration and security solutions. Small and medium sized enterprises are the next corporates and Safaricom is leveraging on its Zidisha Biashara product to attract SMEs. The Zidisha Biashara product provides an integrated bundled offering of voice, data, cloud SAAS services for SMEs (payroll, accounting, domain and webhosting), Lipa na M- PESA and Unified Communications for SMEs. In FY14 the product helped bring an additional 11,500 SMEs raising the number of SMES using products and services to 30,500. The company s focus in FY15 is to grow the number of customers to 64,000 and Average Revenue Per Account. The acquisition of Yu s telecommunications infrastructure will result in improved call quality and faster internet speeds: Despite the fact that Safaricom has more than 2.0x the number of base stations as Airtel and an equal amount of spectrum, it has 4.0x as many subscribers. As a result, Safaricom s network infrastructure is stretched resulting in dropped calls and network downtime which lead to lost sales. The acquisition of Yu s network infrastructure (approximately 400 base stations) will help alleviate the pressure on Safaricom s infrastructure. The Communications Authority of Kenya received a joint bid from Safaricom and Airtel Kenya to acquire the assets of the third largest telecommunications company in Kenya by subscriber numbers, Essar Yu mobile. In the joint bid, Airtel will take Yu s subscribers and Safaricom will take its network infrastructure including staff. Yu s network infrastructure includes 7.5MHz paired of 900MHz spectrum and 10MHz paired of 1800MHz spectrum. It s not clear if Safaricom will also acquire Yu s option to purchase an additional 10MHz of 2100MHz spectrum for USD 10.0m. The acquisition of the spectrum (still under review by CAK) as well as approximately 400 base stations will allow Safaricom to improve its call quality and internet speeds. The 900MHz will allow Safaricom increase its reach while the 1800MHz will allow the company increase data speeds. The company will, however, need to spend more to modernize and optimize the base stations that it will acquire from Yu. The renewal of Safaricom s operating license will eliminate any uncertainty relating to noncompliance of meeting the minimum quality standards: The regulator had threatened not to renew Safaricom s licence until it had meet its minimum Quality of Service (QoS) standards. However, the regulator renewed Safaricom s license but increased the penalties for noncompliance from KES 500,000 to 0.2% of gross turnover of the offending licensee. Safaricom commissioned independent drive tests in October 2013 to measure key quality metrics such as dropped calls, voice quality and data speeds. The results of the tests showed that its network delivers the best data services and comparative voice services. 6

7 Contribution and EBITDA margins Safaricom s strong distribution network will support airtime sales: In FY14, the company recorded a 17.0% y/y growth in airtime sales on the back of the company s large distribution network. Safaricom s retail reach increased to 270,000 retailers, 43 retail shops and a dealership network of 3,000 outlets. The company ran several dealer promotions to encourage more sales and better distribution. The M-PESA agent network has also expanded to 81,025 agents countrywide ensuring that M-PESA services and M-PESA top-ups in particular are available throughout the country. Safaricom supported M-PESA agents by arranging agent loan bank facilities to assist them purchase float for their outlets on a daily basis. The amount given to agents as part of this scheme, was over KES 600.0m in FY14. The large airtime distribution network ensures 98.0% availability in the market. Going forward the company intends to refurbish its shops which provide customer care and products including headsets and tablets. It also plans on rolling out 73 Safaricom care desks at selected dealers, which will be manned by Safaricom staff and provide the same level of service as the retail shops. The company introduced an online self -service platform to reduce traffic at its shops H10 2H10 1H11 2H11 1H12 2H12 1H13 2H13 1H14 2H14 Contribution Margin EBITDA Margin (Source: Safaricom, Kestrel Capital Research) Net Debt/(Cash) FY10 FY11 FY12 FY13 FY14 FY15F FY16F FY17F (10.00) (20.00) (30.00) (40.00) (50.00) (60.00) (Source: Safaricom, Kestrel Capital Research) Contribution and EBITDA margins will continue increase as costs rise slower than revenue: In FY14, direct costs and operating costs grew 10.2% y/y and 14.0% y/y respectively, compared to the 16.4% y/y increase in total revenue. This resulted in a 204bps y/y and 251bps y/y rise in the contribution margin and EBITDA margin respectively. In FY14, 34.0% of all top-up were carried out on M-PESA resulting in savings on scratch card production costs, airtime commissions and logistics costs. Network operating costs (including fuel) declined after the company adopted energy saving batteries in 11% of their sites resulting in a 15% y/y decline in unit power utilization. IT operational costs fell after the company upgraded its information systems. Going forward, we expect savings from more M-PESA top ups, reductions in network operation costs and the implementation of the new ERM system. Increased finance income due to negative net debt will drive up earnings: As at the end of FY14, Safaricom had long term borrowings worth KES 5.1bn after it reclassified part of its corporate bond (worth KES 7.5bn) from non-current liabilities to current liabilities ahead of the repayment in November This debt cost the company 12.25% per annum. Once this portion of the corporate bond is paid, the effective interest on borrowing will decrease significantly. The remaining borrowings include the 2 nd tranche of the corporate bond which is worth KES 4.5bn at 7.75% per annum and a 2 year bank loan worth KES 615.4m at 91-day T-Bill minus 1.0%. The 2 nd tranche of the corporate bond is due for payment in December Safaricom has cash worth KES 17.6bn and according to our forecasts will generate an additional KES 34.5bn in EBITDA in 1H15. Of this KES 52.1bn of cash, KES 18.8bn will be used to pay dividends and approximately KES 10.5bn will be used to acquire Yu s assets. The rest will be maintained for capital expenditure and supporting the construction of the government s security system. After the repayment of the corporate bond and the 2 year bank loan, we see no immediate need to take up additional borrowings. Therefore, we believe that the company will earn net finance income from FY15 as opposed to paying net finance costs as it has done in the past. 7

8 Capital expenditure including the acquisition of Yu s infrastructure will be focused on improving the network: Safaricom spent 90.0% of its KES 27.8bn capital expenditure on network quality, capacity and coverage. The company invested in an additional 235 base stations as well as the modernisation and optimisation of 267 existing base stations and 500 microwave links for the transmission platform. The company has upgraded core elements on its 3G network to technology that will allow for internet speeds of 21 and 42 Mbps. As a result, over 95% of Safaricom sites are able to achieve data speeds of 21 Mbps. It has 1,847 3G-enabled base stations mostly in the major cities. Furthermore, it upgraded 78% of its transmission network to Internet Protocol (IP). This will improve the quality of the network, activate certain features and capabilities that would otherwise be unavailable and increase capacity to handle the customer growth. Following investments over the last 2 years, Safaricom has now modernized 85% of its radio network. It has also increased the bandwidth of its existing network. By doing this, the company has expanded data 2G coverage to 91.0% of population coverage and 3G coverage to 61.0% of population coverage. The company has also invested in back-up power solutions to avoid any loss of service during grid power interruptions. It also installed 70 hybrid energy systems, solar and wind energy solutions in areas where grid power is not accessible. Furthermore, the company invested in new technology (pooling and Wavelength Switched Optical Networks) in FY14 that ensures that any failure of a network element is supported by other network capabilities, without the customer experiencing any service loss. During the year, the company completed 770km of fibre and began construction of 640km of fibre in Nairobi, Nakuru, Mombasa and Kisumu. Going forward, Safaricom will spend approximately KES 10.5bn to acquire Yu s infrastructure and employees. It will spend additional money to modernize and optimise the base stations. The acquisition will give the company more spectrum to improve voice quality as well as the ability to roll out faster internet. Despite the fact that Safaricom has modernized and optimized most of its network, we expect similar amounts of capital expenditure over the next 3 years as the company acquires and modernizes Yu s network. DPS (KES) FY10 FY11 FY12 FY13 FY14 FY15F FY16F FY17F DPS (KES) (Source: Safaricom, Kestrel Capital Research) Dividends are likely to increase as capital expenditure remains flat and debt declines: Capital expenditure is likely to remain stable over the next couple of years as the company continues to build network infrastructure organically and through acquisitions. With debt declining to KES 0.6bn after December 2015 and no immediate need for significant amounts of capital, we believe that the company will be able to pay higher dividends. We forecast that DPS will increase 27.7% y/y to KES 0.60 in FY15, 33.3% y/y in FY16 and 6.3% y/y to KES 0.85 in FY17. Safaricom will be a major beneficiary of the consolidation of existing industry players: Safaricom and Airtel announced that they would put in a joint bid to acquire Yu s assets. Safaricom is to acquire Yu s infrastructure and staff while Airtel was acquire Yu s subscribers. Furthermore, media reports suggested that Orange could pull out of Kenya. This would likely be through sale to another multinational which will leave the industry with 3 players. Safaricom s independent drive test showed that it had the best data network in Kenya and similar voice quality as other payers in the market. On quality, it appears that Safaricom is better than its competitors. Service delivery and customer support are likely to be the key differentiators. The 8

9 loyalty points system ( Bonga Points ) was revamped allowing customers to use part cash and points to purchase internet enabled devices. Also, Safaricom has partnered with third party service providers (like DSTV and Kenya Airways) which allow subscribers with a small cash amount to redeem loyalty points for services and Safaricom headsets and tablets. These factors contributed to a reduction in churn rate from 30.5% in FY13 to 19.3% in FY14. Therefore, apart from the competition on M-PESA from new players using MVNO licences, we believe that Safaricom could be a beneficiary of the industry consolidation. 9

10 Negatives Increased competition from MVNOs is expected to slow growth in subscriber numbers and prevent any significant rise in prices of products and services: In FY14, voice revenue grew 11.6% y/y largely on the back of an 11.1% y/y growth in the number of subscribers. In FY13, Safaricom lost subscribers after the regulator switched off counterfeit phones and unregistered SIMs. The return of these lost subscribers helped drive the increase in subscriber numbers. In FY14, a change in regulation allowed for the formation of Mobile Virtual Network Operators (MVNOs). Following the change, several companies announced that they would apply to become MVNOs. While these companies are not expected to outperform Safaricom in the traditional telecommunications products, they are likely to have an upper hand in mobile money linked services. Companies with existing spare IT capacity may consider setting up MVNOs as non-core activity to support their existing operations and bring down costs. Equity Bank is mostly focused on the mobile money aspect of telecommunications. It sees it as a channel to access its banking products and bring down its operating expenses. Equity Bank s MVNO will be supported by the bank s existing IT infrastructure and will leverage off of the distribution network through its branches and agents. The bank has also negotiated a variable rate with Airtel, Equity Bank s host for the MVNO. As a result, Equity Bank s initial cost of investment and operating costs will be lower than the conventional telecommunications company. Therefore, as a non-core business that leverages off of existing infrastructure, Equity Bank will be able to offer similar services as a telecommunications company at the same rates. Kenya already has the lowest call rates and mobile termination rates in Africa and any further cut could be detrimental to the industry as whole. Increased competition could prevent significant rises in the prices of telecommunications services. Data-supported text applications subdue growth in SMS revenues in the long term: As at the end of FY14, there were 9.5m mobile data subscribers most of whom have access to datasupported text applications. These applications are downloadable for free and allow subscribers to send text messages and media files to each other using an internet connection. The text messages sent using these applications are not limited by the number of characters as SMSes are. Each SMS costs KES 1.00 while a subscriber with KES 5.00 can access 4.0MB of data which gives the subscribers an almost an unlimited number of texts on the application. As a result, data could cannibalise SMS. In order to reduce this cannibalization, Safaricom introduced data bundles which significantly reduce the price per SMS. For KES 5.00 a subscriber can send 20 SMSes. Furthermore, Safaricom introduced, Chatitude, a product whereby subscribers access 10MB of data and 10 on-net SMS at a cost of KES 10. It combines data and SMS in bundles and helps customers with smartphones to make the best of both of these services. In the longer term, we expect data to cannibalise SMS. Also, there could be additional cannibalization on voice from data applications like Viber, Skype and Wifi calling) 10

11 Equity Bank s mobile banking system running on its MVNO license is expected to be a strong competitor to M-PESA: On 26 May 2014, Equity Bank gave details on its rationale for acquiring MVNO licences. Equity Bank is essentially looking at the mobile phone as a channel to distribute all of its banking products. There will be no need for a virtual M-PESA account as customers will be connected directly to their bank accounts. Using credit pre-scoring, customer will be able to borrow pre-approved amounts at a maximum of 2.0% per month for 30 days or more compared to the M-Shwari s interest rate of 7.5% and credit period of 30 days. Using Equity Bank, subscribers will be able to make payments from their phones to bank accounts, merchants with POS terminals, PayPal, Google wallet and directly to cardholders of the major card companies. The charges to access the mobile system will be the lower of 1.0% of the value of the transaction and KES 25.00; the same using the bank s agents. This is significantly cheaper than M-PESA. On the face of it, Equity Bank proposition seems to be attractive compared to M- PESA and other M-PESA linked products (including M-Shwari) both in terms of product offering and price. The company had moved to court to block the slim SIMs which Equity Bank customers will attach to their Safaricom SIM cards. The slim SIMs will automatically convert single SIM phones into dual SIM. Equity Bank were granted a trial period of 1 year during which the regulator would monitor whether the slim SIM interfered with the working of the normal SIM. As mentioned above, Safaricom announced new M-PESA tariffs on 20 August This was likely to pass on some of the savings generated from the migration of the M-PESA system and bring pricing to a more sustainable level given the level of competition that is expected and also to encourage more transactions per user. M-PESA s EBITDA margin (at 17.0%) is already lower than the company EBITDA of 42.1%. The price cut will further lower the group s EBITDA margins unless the company had been able to generate the requisite cost savings. The interoperability of M-PESA agents will reduce some of Safaricom s competitive edge in M -PESA: Safaricom has 81,025 M-PESA agents across the country as of 31 March The fact that M-PESA is available virtually everywhere is part of the reason for its success. Subscribers can be sure that they will be able to carry out M-PESA deposits and withdrawals virtually anywhere in the country. One of the conditions for acquiring Yu assets was to open up the M-PESA system to its competitors. By doing this, Safaricom will lose part of its competitive advantage on M-PESA. The same accessibility of its M-PESA agents will be available to competitor mobile money transfer systems. While Safaricom still has a competitive advantage in that fact that it has more innovative products that ride on M-PESA (like M-Shwari, Lipa na M-PESA, M-Benki, Paybill etc), we feel that in the longer term this advantage will continue to narrow unless innovation on M-PESA continues. 11

12 Annual Financials KES bn FY10 FY11 FY12 FY13 FY14 FY15F FY16F FY17F Income Statement Voice revenue Messaging revenue Mobile Data revenue Fixed Data revenue M-PESA revenue Service revenue Handset revenue Acquisition and other Total Revenue Direct costs (28.50) (37.24) (43.47) (47.17) (51.96) (60.39) (69.81) (75.12) Contribution Operating Costs (18.85) (21.87) (26.03) (27.88) (31.77) (36.25) (41.90) (45.08) EBITDA Depreciation & amortization (13.99) (16.33) (17.35) (22.14) (25.79) (27.11) (27.70) (28.03) Net financing (costs) (1.64) (1.04) (2.78) (1.65) (0.16) Taxation (5.82) (5.20) (4.74) (7.91) (11.97) (13.39) (16.64) (18.79) Net Income EPS (KES) DPS (KES) Balance Sheet Equity & Minority Interest Borrowings (0.00) (0.00) Other liabilities Net assets Non-current assets Current assets Current liabilities (33.82) (34.12) (37.62) (36.59) (38.26) (37.29) (37.94) (40.83) Net assets Cash flow statement Net operating cash flows Net investing cash flows (18.97) (26.85) (25.68) (25.36) (28.85) (29.51) (30.23) (30.13) Free cash flows Net financing cash flows 1.34 (9.62) (4.01) (7.58) (19.66) (26.33) (29.12) (28.51) Change in cash 6.41 (5.46) Cash at the start Cash at the end (Source: Company, Kestrel Capital Research) 12

13 Semi Annual Financials 1H14 2H14 1H15F 2H15F 1H16F 2H16F 1H17F 2H17F Income Statement Voice revenue Messaging revenue Mobile Data revenue Fixed Data revenue M-PESA revenue Service revenue Handset revenue Acquisition and other Total Revenue Direct costs (24.85) (27.11) (29.11) (31.28) (33.63) (36.18) (38.94) (41.94) Contribution Operating Costs (15.5) (16.27) (17.47) (18.78) (20.19) (21.71) (23.37) (25.17) EBITDA Depreciation & amortization (12.7) (13.09) (13.6) (13.51) (13.9) (13.8) (14.23) (14.07) Net financing (costs) (0.24) Taxation (4.65) (7.32) (6.27) (7.11) (7.82) (8.82) (9.98) (11.57) Net Income EPS DPS Balance Sheet Equity & Minority Interest Borrowings Other liabilities Net assets Non-current assets Current assets Current liabilities (44.89) (38.26) (38.04) (37.29) (39.76) (37.94) (40.83) (43.97) Net assets Cash flow statement Net operating cash flows Net investing cash flows (10.51) (18.34) (12.97) (16.55) (13.11) (17.12) (13.01) (17.51) Free cash flows Net financing cash flows (8.23) (11.43) 0 (26.33) (0.62) (28.51) - (32.03) Change in cash Cash at the start Cash at the end (Source: Company, Kestrel Capital Research) 13

14 Financial Ratios FY10 FY11 FY12 FY13 FY14 FY15E FY16F FY17F Profitability Ratios Contribution margin EBITDA margin Operating margin Pre-tax margin PAT margin Return on investment Operating ROA ROaA ROCE ROaE Activity Ratios Inventory Turnover Receivables Turnover Payables Turnover Working capital turnover (8.0) (7.4) (9.0) (13.7) (23.3) Fixed asset Turnover Total asset Turnover Liquidity Ratios Current Ratio Quick Ratio Cash Ratio Solvency Ratio Net Debt/Assets (3.7) (10.9) (19.8) (30.9) Net Debt/Capital (5.2) (14.8) (26.1) (39.9) Net Debt/Equity (5.5) (14.9) (26.1) (39.9) Financial Leverage Interest coverage (174.8) (100.7) (85.4) Net Debt/EBITDA (0.1) (0.2) (0.4) (0.6) (Source: Company, Kestrel Capital Research) 14

15 Valuation EV/EBITDA Method FY15 EBITDA EV/EBITDA 8.00 EV less net debt 5.00 Equity No of shares Price P/E Method FY15 EPS 0.76 P/E 19.0 Price FCFE Method Risk free rate 11% Beta 1.0 Risk premium 6% Cost of equity 17% Exit P/FCFE 9.0 FY15 FY16 FY17F Post FY17F Free cash flows plus Net borrowings FCFE Time Discounted FCFE Total Discounted FCFE No of shares Price Blended Value EV/EBITDA Method P/E Method FCFE Method Fair Value Price Current Price Upside

16 Peer Comparison Country P/E P/B Dividend Yield EV/EBITDA SAFARICOM Kenya AIRTEL ZAMBIA Zambia n/a ECONET WIRELESS Zimbabwe MTN GROUP South Africa VODACOM GROUP South Africa STARCOMMS Nigeria n/a n/a (Source: Bloomberg) Safaricom Global Median Global Mean Regional Median Regional Mean P/E P/B Dividend Yield EV/EBITDA (Source: Company, Kestrel Capital Research) 16

17 FY14 Results Safaricom released its FY14 results recording growth in EPS of 30.1% y/y to KES The rise in profits was driven by strong growth in both voice (+11.6% y/y) and non-voice revenue (+27.8% y/y) as well as improvements in cost efficiency (EBITDA margin: +255bps to 42.1%). The growth in non-voice revenue was driven by mobile data (+40.6% y/y) and SMS (34.2% y/y). As a result of higher revenues and better cost efficiency, EBITDA grew 23.8% y/y. The higher EBITDA, a relatively subdued increase in capital expenditure and less debt meant more cash was available to pay dividends. DPS increased 51.7% y/y to KES The results were largely in line with our expectations. Below are key highlights of the results: KES bn FY14 FY13 FY14E y/y % ch % var Income Statement Voice revenue (0.9) Messaging revenue (9.6) Mobile Data revenue Fixed Data revenue M-PESA revenue Service revenue (1.2) Handset revenue Acquisition and other (7.7) Total Revenue (1.2) Direct costs (51.96) (47.17) (52.22) 10.2 (0.5) Contribution (1.6) Operating Costs (31.77) (27.88) (32.76) 14.0 (3.0) EBITDA (0.9) Depreciation & amortisation (25.79) (22.14) (27.03) 16.5 (4.6) Net financing income/ (costs) (0.16) (1.65) 0.61 (90.3) (126.2) Taxation (11.97) (7.91) (10.34) Net Income (7.0) EPS (7.8) DPS Balance Sheet Equity & Minority Interest Borrowings Net assets Non-current assets Current assets Current liabilities (38.26) (36.59) (36.27) Net assets

18 Cash flow statement Net operating cash flows Net investing cash flows (27.78) (24.88) (27.47) Free cash flows Net financing cash flows (20.07) (8.32) (20.63) (2.7) Change in cash (0.15) (57.6) (1,862.2) Cash at the start Cash at the end Total Customers (2.3) M-PESA Customers (0.5) Mobile Data Customers Fixed Data Customers (4.4) Voice ARPUs SMS ARPUs (7.5) M-PESA ARPUs Mobile Data ARPUs (2.3) Fixed Data ARPUs 30,508 26,123 28, Service ARPU Contribution margin (0.27) EBITDA margin Net profit margins (0.98) ROE (5.65) (Source: Company, Kestrel Capital Research) Key Highlights: The growth in voice revenue (11.6% y/y) was driven by 11.1% y/y growth in subscribers: The 11.6% y/y growth in voice revenue was largely driven by an 11.1% y/y increase in subscribers. While the number of industry subscriptions increased 1.9% y/y and mobile penetration remained unchanged at 76.9%, Safaricom was able to increase its subscriber market share from 66.7% to 67.9% due to a decline in the churn rate and acquisition of subscribers from some of its competitors. The subscriber churn rate declined from 30.5% to 19.3%. Even more importantly, Safaricom currently has 78.2% of the industry voice minutes and its higher prices relative to its competitors (KES 4.00 while most of competitors are at around KES 3.60) mean that its revenue market share is even higher. Also impressive was the fact that Safaricom managed to keep its voice ARPUs stable at KES 333 despite the 13.9% decline in mobile termination rates (MTRs) to KES 0.99 which took effect on 1 July The slight decline in effective yield was made up for by a 3.0% increase in usage. 18

19 With no further cuts in MTRs expected going forward, we believe organic growth in minutes of use will drive growth in voice ARPUs. Following the news that both Essar Yu and Telkom Kenya could exit the margin (probably replaced by one new player), we believe there s room for more subscriber growth for Safaricom. SMS revenues increased 34.2% y/y driven by a 129% rise in usage due to the Bonyeza Ushinde promotion and a cut in SMS prices (-64%): Safaricom cut prices on its SMS by 64.0% and as a result managed to record a 66% increase in revenues from SMS bundles. This along with the successful Bonyeza Ushinde helped drive SMS usage up 129 % y/y. The 11.1% y/y increase in subscriber numbers also contributed to some of the growth. As a result of the increase in SMS usage, Safaircom s SMS market share increased to 95.8%. The Bonyeza Ushinde promotion appears to have a sticky effect on volumes which remain high even after the promotion period comes to an end. We expect the company to keep running the promotion to drive SMS volumes. As long as mobile data applications continue to cannibalize SMS, there will continue to be room to cut SMS prices to encourage use. The increase in mobile data customers (+34.1% y/y) and usage (+16.1% y/y) drove the 40.6% y/y growth in mobile data revenues: As at the start of FY14, Safaricom was the largest mobile data provider with 74.4% of all mobile data subscriptions. Despite this, it was able to grow its active mobile data subscriptions in FY14 by 34.1% y/y. Mobile data usage also managed to grow 16.1%. The growth in subscribers and increase in usage was supported by 14.4% cut in the average price per MB. Country wide, internet penetration is still relatively low at 52.3%. Safaricom has 44% of its customer base connected onto its mobile data network, there is still room to keep growing subscribers. With improved coverage (91.0% of the population is covered by 2G and 61.0% of the population is covered by 3G) and increased data infrastructure (an 8.1% y/y increase in 2G sites of which 59.0% are 3G enabled), it makes sense to take advantage of operating leverage by cutting prices to grow revenues. M-PESA revenues rose 21.6% y/y on increased active subscribers (15.4% y/y) and higher average transaction value: The rise in M-PESA revenues (+21.6% y/y) was largely due to increased subscribers. Total M-PESA subscribers grew 13.0% y/y while the number of 30- day active subscribers was up 15.4%. To support this increase in subscribers the number of M-PESA agents increased 23.6% to 81,025. The number of transactions per user, however, remained relatively unchanged. Safaricom s M-PESA tariffs differ by the value of transactions. During the period, the monthly value of person-to-business and business-to -person transactions grew 73% and 70% respectively while person-to-person transactions grew 16.0%. The effect may have been higher fees generated per transaction per user. During the year, Safaricom acquired 122,000 merchants for its M-PESA linked payment processing system, Lipa Na M-PESA, but only 24,137 were active as at the end of the year. Lipa Na M- PESA continues to have a lot of potential and promotions should help encourage usage. 19