Markaz Research: Rate of Earnings growth declines in Saudi Arabia, markets currently at fair value


Markaz has revised its earnings and price estimates for Saudi Arabia. There has been a stark decline in the rate of growth of earnings in the current year as compared to 2007, notes M.R. Raghu, Head of Research, and Amrith Mukkamala, Senior Analyst, the authors of the report. In its January outlook report, “Markaz” had expected the TASI Index to have an upside potential of 6%.

 However, the index in the YTD period has witnessed a 44% decline, which has wiped out all the gains made in the year 2007. “Markaz” was expecting a 6% upside based on a 15% earnings growth and a PE discounting the 2007 earnings by 22x. Till 1H08, the aggregate earnings of Saudi Arabian companies have witnessed a YoY growth of 12% and the bottoms – up approach in earnings estimation points to similar growth for the full year 2008, which is a 200 bps reduction to the previous estimate. From a sectoral perspective, Chemicals earnings forms the bulk of the total earnings of Saudi Arabia at 39%, this segment is expected to witness a 20% growth in 2008E. Sabic forms 82% of the earnings in the chemicals segment and is expected to grow at a rate of 13% for 2008 on a YoY basis; this indicates a decline in the rate of growth from 33% in 2007. The factor that has impacted the index target call the most has been a significant contraction in the price to earnings.

The markets have witnessed a contraction in Forward PE from 23x as at the end of 2007 to 12x at current market prices. This lead to low premium over expected growth. As at the end of 2007, the Saudi Arabian markets were trading at a PEG (Forward earnings and growth) of 2.52, this has contracted significantly to 1.06 at the current market rates. “Markaz” estimates the fair value PEG for emerging markets to be at 1 (base case - provides no premium over forward earnings growth), which provides to a down side risk of -6% and an index fair value of 5,804. Muted Earnings Growth Table: 1 – Earnings Trend & Outlook USD Mn 2002 2003 2004 2005 2006 2007 2008E % Change 2008E Chemicals 839 1,949 4,108 5,779 6,265 8,333 10,019 20% Banks 2,202 2,514 3,549 5,847 7,738 6,449 6,858 6% Telecom 945 2,272 2,483 3,044 3,602 3,582 3,820 7% Real Estate 45 225 357 563 555 715 1,003 40% Others 1,141 1,505 2,042 3,055 3,200 4,208 4,297 2% Total 5,173 8,465 12,538 18,287 21,360 23,287 25,997 12% Source: Thomson Reuters Knowledge, Zawya Investor, Markaz Research Chemicals: The Chemicals segment, accounted for 36% of total earnings in 2007 and 40% of 2008E earnings. The sector’s earnings are expected to grow at a rate of 17% for 2008, which will result in a reduction in growth rate by 13pps. Sabic alone provides to 86% of the chemical sector earnings. For 1H08, Sabic posted a 14% YoY increase in earnings at USD 3.86 Bn. “Markaz” expects the company to post USD 8.18 Bn in earnings for 2008, which will result in a full year growth of 13%, a decline in growth rate as compared to 2007 full year growth of 33%. Sabic – a crucial determining factor for aggregate earnings Sabic is expected to provide 31% of the aggregate 2008E Saudi Arabia earnings, therefore an earnings call on Sabic is a crucial determining factor on the aggregate Saudi Arabian corporate earnings. The call for a 13% earnings growth is based on the fact that there has been a softening in the gross margins of the company, the impact of which is more profound in its petrochemical segment, which is the main stay of the company. The overall gross margins have declined to 34.25% in 2Q08 as compared to 34.49% and 38.61% in 1Q08 and 2Q07, respectively.

The petrochemical gross margins have declined from 39.06% in 1H07 to 30.61% in 1H08. This can be primarily attributed to the inclusion of SIP (erstwhile GE plastics) numbers. The net margin of the petrochemicals segment witnessed a significant decline to 6.21% in 1H08 as compared to 19.03% in 1H07. SIP produces high - end plastics (polycarbonates) for which the basic raw material is Bisphenol-A. Bisphenol-A is produced from Phenol and Acetone, derived basically from Benzene. Benzene prices are impacted significantly by Naptha prices. Benzene, which is the key raw material has witnessed a 37% increase in the YTD period and on a YoY basis has increased by 22% (Benzene, Europe CIF Rdam Spot $/MT Prices), Naptha on the other hand has witnessed a 39% increase on a YTD period and 76% increase on a YoY basis (Naphtha Far East CFR Japan Prices).

This has a negative impact on SIP. The report notes that SIP does not have the similar cost advantage in feed stock as Sabic does. The rest of the segments - fertilizers and steel have performed exceptionally well in the current quarter. Steel revenues were up by 66% and net profits were up by 145% in 1H08 as compared on a YoY basis. Going forward, “Markaz” expects to see a negative impact on margins due to declining global margins and its impact on SIP. Natural gas prices and Naptha (Naphtha Far East CFR Japan) have increased by 76% and 39% respectively in the YTD period. This might have a slight negative impact on the margins of the petrochemical segment. However, steel prices continue to hold up. Banking: The Saudi Arabian banking sector continues to witness low to negative earnings growth rates. In 2007, aggregate bank earnings fell by 17%. This was mainly due to an increase in provisioning and lower value traded in the markets. Both these factors spilled over into 2008. Four banks have announced their results for 9M ending September 2008.

The aggregate earnings of these four banks – Samba, BSF, Al Rajhi and ANB formed 68% of the total earnings of banks in 2007 and the growth for 9M08 has been flat at 1% on a YoY basis. Going forward, “Markaz” expects the depressed sentiment on the Tadawul exchange to negatively impact banking earnings by reducing the fees and commissions incomes. Credit growth has till now been the driver of earnings growth. SAMA statistics as at the end of June 2008 points to a credit growth of 32% on a YoY basis for the sector. Given the increasing control to tame the money supply growth which is currently at more than 20% by increasing reserve requirements for banks, “Markaz” believes that credit growth will also witness a decline.

 “Markaz” expects a 6% growth in earnings for the banking sector as compared to a -17% growth witnessed in 2007. Telecom: The telecom segment in Saudi Arabia comprises of three listed telecom companies with aggregate market capitalizations and 2007 earnings of USD 38.35 Bn and 3.5 Bn, respectively. The Saudi Telecom company (STC) with 2007 earnings of USD 3.21 Bn forms 89% of the total earnings of the segment. STC witnessed robust growth in earnings of 18% in 1H08 to USD 1.83 Bn. “Markaz” expects the company to post an earnings growth rate of 4% for the full year 2008. Some of the major trends supporting the telecom segment earnings were the 33% YoY growth in subscribers and 18% increase in mobile Average Revenue Per User (ARPU) in 1H08. By the end of June 2008, the subscriber base in Saudi Arabia had increased to 30 Mn from 22.5 Mn. The mobile ARPU also increased from USD 24.9 in June 2007 to USD 29.5 in June 2008. However, with the Saudi government opening up the telecom sector, new telecom players like Saudi Mobile Telecommunications Company (Saudi Zain) have entered the Saudi market. This is likely to increase competition among players operating in the telecom space and push ARPU down. The earnings growth of telecom companies is likely to moderate in the second half of the year. “Markaz” expects the sector to close the year with 7% growth in earnings. Real Estate: The real estate segment, which contributed 3% to 2007 earnings, is expected to record a strong 40% growth in earnings for 2008. Companies in the real estate space reported healthy growth in earnings for 1H08. The earnings of companies such as Taiba Holding Co., Dar Al Arkan Real Estate Development Co. and Saudi Real Estate Company grew 90%, 27% and 17%, respectively, on YoY basis. Market Cap Segmentation Corporate earnings in Saudi Arabia are driven by the performance of Large Cap stocks that account for 71% of total earnings.

Earnings of large cap stocks grew at a rate of 13% in 2007. “Markaz” expects large cap stocks to witness an increase in earnings by 10% in 2008E; the rate of growth is lesser as compared to 2007. Saudi Basic Industries Corporation and Saudi Arabia Fertilizers Co. are likely to drive large cap earnings in 2008. Saudi Basic Industries Corporation is estimated to post 13% growth in earnings, while Saudi Arabia Fertilizers Co is set to record 55% growth in its bottom-line. Mid caps, which contributed 15% of Saudi Arabia’s corporate earnings in 2007, are expected to grow by 9%. Saudi Hollandi Bank is expected to lead mid caps, in terms of earnings in 2008.

The bank’s earnings increased 59% to USD 162 Mn in H108 compared to USD 102 Mn in 1H07. Small caps, accounting for a meager 11% of total earnings, are expected to record 29% growth in earnings. Companies such as Advanced Polypropylene Company and Emaar The Economic City are expected to lead small caps in terms of earnings growth in 2008. Table: 2 - Corporate Earnings Trend – Market Cap Segmentation Earnings (USD Mn) 2004 2005 2006 2007 2008E YoY Change 2008 Avg Market Cap (USD Mn) Number of Companies Large 9218 13105 14413 16292 17904 10% 24239 9 Mid 1650 2480 3691 3463 3792 9% 5464 16 Small 1151 1568 2236 2220 2853 29% 1745 21 Ultra Small 519 1134 1021 1312 1449 10% 768 73 Total Earnings 12538 18287 21360 23287 25997 12% 119 Note: Segment classification: Large: Market Cap >USD 11.5 Bn, Mid: Market Cap >USD 3.2 Bn & Market Cap< USD 10.1 Bn Small: Market Cap> USD 1.0 Bn & Market Cap < 3.2 Bn Ultra Small: Market Cap> USD 550 Mn & Market Cap < USD 1100 Mn Source: Thomson Reuters, Markaz Research Stock Market – 2008 Performance: Stock markets reversed the upward trend seen last year until September this year. The Tadawul All Share Index (TASI) declined 33% after rising 41% last year.

The Insurance (-46%), Banking (-45%) and Cement (-34%) sectors underperformed the TASI on YTD basis in 2008. Some of the sectors that outperformed the TASI, but yielded negative returns for investors were Agriculture (-8%) and Telecom (-21%). % change YoY Table 3: Performance trends 2002 2003 2004 2005 2006 2007 2008* Agricultural 23% 81% 112% 285% -61% 19% -8% Telecom 50% 52% -45% 7% -21% Electricity 6% 147% 32% 9% -55% 13% -29% Industrial 0% 101% 150% 154% -61% 79% -32% Services 19% 58% 70% 202% -68% 17% -33% TASI** 4% 76% 85% 104% -53% 41% -33% Cement 17% 28% 36% 87% -46% 26% -34% Banking -1% 30% 97% 105% -43% 31% -45% Insurance -25% 62% -46% Source: Stock Exchange, SAMA and Markaz Research 2008 indices return have been calculated using market cap weighted returns on the constituents of the indices ** TASI 2008 value as on 28 Sep 2008 Historically (2001-2007 CAGR), the Industrial (44%) and Agricultural (43%) sectors have provided handsome returns to investors, surpassing TASI’s 29% gain. Activity: By August 2008, close to 40 bn shares changed hands on the TASI.

This is about 70% of the full year volumes on TASI in 2007. Going by current trends, volumes for the full year are likely to remain almost in line with the levels seen last year. The Telecom sector drew a lot of investor attention in 2008 as volumes traded in YTD 2008 were dominated by companies from this industry. In all, 4.5 bn Telecom shares (accounting for 11% of total volume) changed hands. On annualized basis, this works out to 6.8 bn shares, about 12 times higher than 2007 levels. The Banking sector also recorded a robust increase in trading volumes relative to 2007. The sector accounted for 10% of total volumes traded in 2008 relative to just 3% last year. Trading volume declined across other sectors. For instance, the Agricultural sector (1.9 bn shares in 2008 – annualized) is set to witness a sharp decline in volume traded for 2008. The sector accounted for 14% of total trading volume in 2007, but may account for just about 3% in 2008. At USD 416 bn, the total value traded, till August this year is set to decline by 9% on full year basis, going by the trend seen so far. Value traded has seen a sharp drop of 51% during 2007. On YTD basis, the value of trade in Telecom and Banking stocks increased in 2008. On annualized basis, the Telecom sector is all set to record the maximum rate of growth in turnover (5 times to USD 50 bn in 2008). The Industrial sector dominated other sectors in terms of value traded with a share of 36% in 2007. Other sectors are set to decline this year. At 128%, turnover velocity in the Saudi market is lower compared to last year (161%).

About Markaz Kuwait Financial Centre 'Markaz', with total assets under management of over KD1.4 billion as of June 30, 2008, 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 recently awarded a BBB+ corporate rating by Capital Intelligence Ltd.