Saudi Arabia: Robust growth at earnings but 2008 will be a year of consolidation

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Saudi Arabia: Robust growth at earnings but 2008 will be a year of consolidation 08 - Jan - 2008

Kuwait Financial Centre "Markaz" in its latest research report expects Saudi Arabian stock market to move up by 6% in 2008. The target index level for 2008 is 11842, from the year end value of 11176. “The aggregate earnings of Saudi Arabian companies are expected to witness a growth of 15% in 2008, a level similar to 2007 growth” notes M.R. Raghu, Head of Research and Amrith M, Research Analyst. The Price to Earnings multiple significantly declined from its peak of 52x in 2005 to 18x in 2006. However, the resultant run up in the markets during 2007, ensured the PE multiple move into the hot zone yet again at 24x. This will mean a PE contraction 8% in 2008 forecasts. SABIC will see strong earnings growth and therefore tops our prospect list. Other blue chips may have normal/sub-par earnings growth and may experience some p/e contraction. Stock Market Performance in 2007 The spike in December 2007 (18%) is a significant contributor to the overall yearly gains, so much so that it accounts for 40% of the total gains. (Table: 2) We observe that this is the largest monthly spike during the recent history. Similar significant monthly gains were observed in Feb-07 (+16%), Jun-06 (+17.4%) & Mar-05 (+15%). It is significant to note that even during the bull year of 2005, we did not witness a monthly spike as high as Dec-07. In spite of this, the overall volatility level in the market reduced by more than 50% indicating strong momentum in the market. The Saudi stock market continues to provide long-term value with $1 invested at the beginning of year 2001, growing to nearly $5 by the end of 2007. Stock market’s economic representation (measured by Market Cap/GDP ratio) has once again increased from 93% (2006) to 139%(2007) thanks to the strong stock market performance. Activity After a three fold increase in volume traded during 2006, year 2007 saw a flat trend with volume traded increasing only by 6%. Services sector (37%) and industrial sector (36%) continues to be the most actively traded sectors. Electricity and Cement sectors gave in and saw their volume traded declined by more than 50%. While volume traded increased marginally, value traded declined by 50% indicating dominance of mid cap and small cap stocks in the trading segment. Except Insurance, which is a new sector, all sectors witnessed a fall in value traded. Industrial and Services sector continue to dominate the value traded by accounting for 70% of total value traded. IPO Windfall 2007 proved to be yet another year providing windfall gains to Saudi investors in the form of IPO’s. There were 25 IPO’s, 14 of which is in the Insurance sector. All of them were over subscribed with the highest over subscription noticed in Alahli Takaful Co (11 times) and the lowest being Saudi Printing and Packaging (1 time). The average over subscription level stood at 5.3 times. Bulk of the IPO’s (22) were priced at a nominal value of SAR 10 thus providing the windfall. Average 1 day gain on IPO’s stood at a staggering 411%, while gain during the immediate one month stood even higher at 548% indicating that the pricing frenzy is not short-lived. However, the year to date gain stood at the same level as one month gain indicating that bulk of the profits are creamed within one month. These returns look staggering when benchmarked at market return whose average stood at 38%. Blue Chips Sabic: SABIC witnessed a 90% appreciation in its stock price during 2007. The growth in the price of the stock was supported by a robust growth in earnings coupled with positive news flows. The 2007 annualized net income growth was 32%, considerably higher than 6% net income growth recorded in 2006. The stock price was predominantly driven by event related news flows especially mergers and acquisitions. SABIC acquired GE’s plastic business for USD 11.6 Bn in August 2007. SABIC through its business unit signed a loan agreement for USD 6.1 Bn with Arab Bank Group to fund GE plastic unit’s acquisition. Furthermore, SABIC raised debt equivalent to USD 5.4 Bn to fund the acquisition. SABIC acquired UK based Huntsman Petrochemical Limited for USD 685 Mn in January 2007. The earnings are expected to witness a growth of 32% for 2008. The stock price is currently discounting the FY06 earnings by 24x, which is close to its historic average, if the extreme valuations witnessed in 2004 and 2005 are excluded. This provides less room for any further PE expansion. We expect the PE to expand by 0.42% and an earnings growth of 32% providing a fair value of SAR 263.46 per share, providing an upside potential of 33%. Al-Rajhi Bank: Al Rajhi recorded a 42% increase in its stock price during 2007. The bank is expected to record a decline of 11% in its annualized 2007 earnings. The bank doubled its share capital to SAR 13.5 Bn in 2007. The bank embarked upon an “Establishment of 160 Branches within 18 Months” project in 2007. Under this project, the bank plans to expand its branch network to 180 branches in Saudi Arabia by mid-2008. RJHI plans to further expand its presence in the Malaysian market. The bank intends to expand its branch network to 50 in Malaysia by 2010. RJHI opened its first branch in east coast of Malaysia in November 2007, taking the total tally of branches to 19 in Malaysia. We expect a 15% growth in 2008 earnings. As witnessed in SABIC, the bank traded at its peak multiples in 2004 and 2005. If we exclude these extremes, then the current PE multiples are at a premium to its historic averages. We expect a PE contraction of 2% leading to a fair value estimate of SAR 147.31 per share, which provides an upside potential of 13%. Saudi Telecom: The Saudi Telecom Company is expected to close the year with a decline in net profits by 7%. The 9 month earnings of the company declined by 10% to USD 2.39 Bn from USD 2.66 Bn in the previous corresponding period. This decline in net profits of the company had impacted the stock price negatively during the year, wherein the stock provided a return of 2%. The increasing competition in its home turf due to increase in the number of players can be attributed to the decline in earnings. However, the company has been able to grow geographically in 2007. Saudi Telecom won 26% of the communication license in Kuwait. The amount of the deal is approximately USD 900 million. In the recent release, the company unveiled its plans to come out with an IPO, wherein it will sell a 50 percent stake to the public for 105 Kuwait fills per share. The IPO is expected to hit the markets in February 2008. Post the issue, the company is expected to start its operations in Kuwait. This is expected to provide the necessary fillip to the sagging top line. We expect the earnings to improve by 7% during 2008. The stock is currently trading at 12.8x its earnings, while the long-term average P/E is about 13x. Thus, we believe that there is a scope for a PE re – rating to an extent of 7%, providing an upside potential of 10% in its price. Samba: It has been more or less a disappointing year if the earnings performance is taken into consideration. In the first quarter, the bank reported an 11% fall, this trend continued all the way thru till the 3rd quarter of 2007. In the second quarter, a decline in incomes from stock market operations due to the lack luster trading in the Saudi Arabian stock markets till almost August resulted in a 7.5% decline in earnings on a yearly basis. In the 3rd quarter, the bank reported another decline of 7.1% leading to the 9M earnings falling by 9.5%. We expect the bank to close the financial year with a decline in bottom line to an extent of 1%. However, the stock price witnessed an appreciation of 34% during 2007, mainly on the back of positive news flows. The bank announced that it is expected to start operations of the Samba Financial Group investment and brokerage unit in early 2008 with a capital of SAR 500 Million ($134.06 million). Samba Capital will provide brokerage, asset management, and financial advisory services. Apart from this, the bank also unveiled its plans to expand its operations through acquisitions during the year. The bank is also setting up new branches as part of the expansion plan. The consensus estimates point out to a 16% growth in bottom line for 2008. However, the bank is already trading close to its average PE levels if the outliers in 2004 & 2005 are excluded. We expect the PE to contract by 16% in 2008, thereby resulting in a fair value of SAR 175.21 per share, with a downside of 3%. Saudi Electricity: Saudi Electricity is expected to close the year 2007 with an estimated 11% growth in earnings on a YoY basis. Going forward, we expect this growth rate to decline to 5% in 2008. This is taking into consideration, the higher volatility in earnings growth of the company in the last six years. The stock is up 23% for the year, which is not even a 50% retraction from the 54% decline witnessed in 2005. During the current year, the company had announced major expansionary plans to boost its capacities. The company awarded contracts worth SAR 3.8 Mn ($1.01 Bn) to boost power generation at its Rabigh facility. For 2008, Saudi Electricity would spend SAR 27.6 Bn ($7.4 BN) on projects, its largest ever budget outlay. The company is investing heavily to cope with the rise in demand, but has been affected by the global rise in contracting costs for its maintenance and operations. The board approved the 2008 budget which includes 331 new projects in electricity generation, transport and distribution as well as some support services, costing a total SAR 27.642 Bn. The projects would expand generating capacity by 2669 megawatts and allow the state controlled energy firm to supply 255,000 new customers and in 248 urban areas it has not served before. We expect earnings and PE expansion to drive stock prices. The current price of the stock discounts the FY06 EPS by 48x and FY07E EPS by 43x. We expect the stock to trade at a PE of 47.5x its FY08E EPS, thereby providing a fair value of SAR 17.31, providing an upside of 15%. Regulatory Developments It has been an action packed year for Saudi Arabia from many points of view. Regulators were busy cracking down erring companies and promulgating new guidelines, while companies were busy getting listed and raising capital. Mega acquisitions were lending the added excitement. The year 2007 will be remembered for bring some discipline to the market place in terms regulatory actions with Capital Market Authority (CMA) initiating investigation on more than 80 companies for cheating. This was preceded by delisting ailing agricultural companies that were the darling of traders for a long time. The regulators provided green light for mutual funds to participate in IPO’s which augurs well from institutionalizing the market place. Saudi market has been predominantly a retail market with frenzy surrounding IPO’s. The regulators also released guidelines on mergers and acquisitions, probably the first in the gulf region. Another notable regulatory development included allowing GCC investors into Saudi market, a step just short of allowing other foreign nationals to invest directly in Saudi stocks. Mega M&A deals marked the year 2007 with Sabic’s acquisition of GC Plastic at $12 billion being the highlight and will easily rank as one of the largest global deals. Saudi Telecom’s acquisition of 25% of Maxis at $3 billion is also a notable development. Economy Growth: Backed by strengthening hydrocarbon segment Saudi Arabia is expected to record strong GDP growth in 2008. Nominal GDP is expected to grow 14% to $414 billion. While hydrocarbon GDP is expected to increase 14% in 2008 compared to 3% decline in 2007, non-hydrocarbon GDP is expected to increase 14% in 2008 on the back of a 12% increase in 2006. The nominal GDP growth in 2008 is in line with the average annual growth during 2003 to 2006 and is triple of expected nominal GDP growth in 2007. Fiscal Situation :The government derives more than 90% of its total revenues from hydrocarbons. With the hydrocarbon prices likely to remain strong, Saudi Arabia is expected to have fiscal surplus in 2008. Government revenues are expected to increase 12% in 2008. However, the government expenditures are expected to increase 15% in 2008 compared to 12% increase in 2007. Current Account: Saudi Arabia’s current account surplus is expected to increase 14% in 2008 to $90 billion. The increase in current account surplus can be primarily attributed to anticipated increase in hydrocarbon exports, which are likely to increase 13% in 2008, and higher income receipts. However, the current account balance as a percentage of GDP is expected to remain flat YoY at 22% in 2008. Inflation: Inflation, which was negative in Saudi Arabia during 1998-2001, has started to rise at an alarming rate. Inflation averaged meager 0.8% during 2002-2006. However, inflation level in 2008 is expected to be 3.9%, almost five times of historical average. Deprecation of US dollar vis-à-vis other currencies , peg of Saudi Riyal to US dollar and surging food prices are leading to a spike in inflation level. However, in order to check the rising inflation, the Saudi Arabian government intends to cut its expenditure. Exchange Rate: Saudi Arabia has pegged its currency to US dollar since 1986. While this served well during times when dollar was a strong currency, it is now hurting the economy as it is importing inflation. . Unlike Kuwait, Saudi Arabia is not anticipated to snap its dollar peg. However, revaluing upwards the currency may provide some interim solution to the inflation problem. Interest Rates: Saudi Arabia has to maintain interest rates similar to US due to the currency peg. However, in September 2007, Saudi Arabia did not cut its interest rates for the first time in spite of the 50 basis point cut by the US Federal Reserve. Nevertheless, on 12 December 2007, Saudi Arabia reduced its benchmark rate by 25 basis points, in line with the US Fed rate cut on 11 December 2007. ### About Markaz Kuwait Financial Centre S.A.K. 'Markaz', with total assets under management of over KD1.4 billion as of September 30, 2007, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997; and was awarded a BBB+ corporate rating by Capital Intelligence Ltd.