Saudi Arabia a Guide to the Market by HSBC

MENA Research Team

After moves towards increased accessibility over the past seven years, the Saudi Arabian cabinet has now authorised the Capital Market Authority to allow foreign institutions to trade

stocks on the Saudi stock market, paving the way for potentially a complete opening of the market in 2015

We believe valuations should see a positive effect from the potential inclusion of the stocks in various equity indices, which could follow soon after the opening of the market

In this report we provide a macro overview of the market, and look at this new opportunity from an equity strategy, industry sector and stock perspective

Raj Sinha*Head of EEMEA equity researchHSBC Bank Middle East Limited, Dubai+971 4 423 6932 [email protected]

United Arab EmiratesAybek Islamov*AnalystHSBC Bank Middle East Limited, Dubai+971 4 423 [email protected]

Sriharsha Pappu*AnalystHSBC Bank Middle East Limited, Dubai+971 4 423 [email protected]

Vikram Viswanathan*AnalystHSBC Bank Middle East Limited, Dubai+971 4 423 [email protected]

Nicholas Paton*AnalystHSBC Bank Middle East Limited, Dubai+971 4423 [email protected]

Simon WilliamsChief Economist, Middle East and North AfricaHSBC Bank Middle East Limited, Dubai+971 4 423 [email protected]

Rana NasserSenior Economist, Middle East and North AfricaHSBC Bank Middle East Limited, Dubai+971 4423 [email protected]

EgyptShirin Panicker*AnalystHSBC Securities, Egypt, S.A.E.+202 2529 [email protected]

Saudi ArabiaPatrick Gaffney*, CFAAnalystHSBC Saudi Arabia Limited+966 11 299 [email protected]

Ammash Aljuraid*AnalystHSBC Saudi Arabia Limited+966 11 299 [email protected]

Sagar Kumar*AnalystHSBC Saudi Arabia Limited+966 11 299 [email protected]

Yazeed M Alturki*AnalystHSBC Saudi Arabia Limited+966 11 299 [email protected]

TelecomHerve Drouet*AnalystHSBC Bank Plc+44 20 7991 [email protected]

Oilfield servicesPeter Hitchens*AnalystHSBC Bank plc+44 20 7991 [email protected]

UtilitiesLevent Bayar*AnalystHSBC Yatirim Menkul Degerler A.S.+90 212 [email protected]

Equity StrategyJohn Lomax*Head of Equity Strategy, GEMsHSBC Bank plc, London+44 20 7992 [email protected]

Issuer of report: HSBC Bank Middle East Limited, Dubai

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.

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Saudi Arabia

By the MENA Research Team

A guide to the market

Disclosures and Disclaimer This report must be read with the disclosures and analystcertifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

EquitiesSaudi Arabia

July 2014

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Equities Saudi Arabia July 2014

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Middle Eastern markets continue to be a focus for global investors with the announcement from the Saudi Capital Market Authority that its equity markets could open to foreign investors in the first half of 2015. Should this occur, we would expect Saudi stocks to become eligible for admission to global benchmark indices, as such implying significant fund inflows both from active funds tracking FTSE, MSCI and other indices as well as from the passive funds. In this report we provide a guide to the structural drivers in the key equity sectors and details of 44 stocks we cover, and we include profiles on an additional 17 stocks with interesting profiles but lower liquidity. We have also provided the views of our Economics, Equity Strategy and Equity Quant teams.

Saudi Arabia's oil-funded expansionary fiscal stance will remain the prime driver of growth in the country, with current and capital spending set to rise from last year's record high. Longer-term, Saudi's demographics look attractive with 60% of the population under the age of 30 and a middle class set to grow from less than 20m today to 40m by 2050 (OECD). Furthermore, the local stock market is well-established, with a healthy return of 120% since 2004, buoyed by rising oil prices and a GDP that has averaged 6.4% per annum, albeit with a high level of volatility due to retail investors representing 90% of volumes.

In Saudi Arabia, both the cyclical and secular narratives remain attractive, in our view, with the announcement regarding the opening of market to foreign investors acting as an additional catalyst. The obstacles however relate more to valuations and more challenging bottom-up stock selection. Nevertheless, from an equity strategy perspective we continue to favour an off-benchmark exposure, emphasising the petrochemical sector as a whole as well as selected consumer and telecom stocks. We are also positive on the banks sector in the Kingdom again from an equity strategy perspective.

We see significant advantages in many of the sectors in the Kingdom, most of which are difficult to replicate. Saudi banks have access to one of the cheapest source of funds from low interest deposits while the vast energy resources of the Kingdom should help industrials to get cheap electricity and fuel. However petrochemical and fertiliser companies benefit the most as they have access to one the cheapest sources of feedstock globally. We also see strong growth potential for Saudi consumer-facing companies as they gain from Saudiasation (moves that encourage employers to hire more Saudis) and employment growth in the Kingdom. On the other hand telecom companies should see a growth rate that is among the highest in the world in data usage as other forms of entertainment are limited in the Kingdom.

Since 2007 the market has been open for investment for citizens of the Gulf Cooperation Council (GCC) and since 2008 it has been accessible to non-GCC investors via swap agreements. A formal opening to non-GCC investors would carry a much more significant impact from direct investment and the potential inclusion or upgrade in equity market indices. Should Saudi Arabia be admitted to the EM indices we estimate that it would constitute 4% of the MSCI EM index.

Summary

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HSBC Saudi Arabia coverage

Company Ticker Rating MCap CP TP _____ PE ______ _____ EV/EBITDA_______ ________ RoE __________ Perf. (USDm) 2013 2014e 2015e 2013 2014e 2015e 2013 2014e 2015e YTD

Abdullah Al-Khodari 1330.SE OW 722 51.00 44.00 42.1 28.2 17.6 16.2 13.7 11.1 8.1% 11.4% 16.3% 53.5%Abdullah Al Othaim 4001.SE N 1,302 108.50 82.00 25.4 19.5 17.1 16.4 12.8 11.4 25.8% 28.8% 29.5% 79.4%Advanced Petro Chem. 2330.SE N (V) 2,160 49.40 45.00 14.5 15.8 15.9 10.5 10.8 10.7 25.9% 22.2% 21.1% 28.0%Al Mouwasat Medical 4002.SE OW 1,443 108.25 126.00 26.9 25.9 20.2 21.2 19.4 14.5 24.4% 22.5% 26.1% 17.5%Alinma Bank 1150.SE N 7,939 19.85 21.30 29.3 24.5 21.5 NM NM NM 6.0% 6.9% 7.3% 0.0%Almarai 2280.SE N 11,678 73.00 67.00 29.2 25.0 18.0 16.7 14.5 12.2 17.0% 16.6% 20.9% 37.3%Alrajhi Banking 1120.SE N 29,354 67.75 74.00 14.8 14.2 13.4 NM NM NM 21.6% 20.6% 20.1% 0.0%Arab National Bank 1080.SE OW 7,759 29.10 37.00 11.5 10.0 9.1 NM NM NM 14.2% 14.8% 14.9% 0.0%Astra Industrial 1212.SE N 947 47.90 63.00 14.0 11.4 9.3 19.3 13.6 9.8 13.5% 15.9% 17.9% -6.3%Banque Saudi Fransi 1050.SE N 10,766 33.50 37.00 16.8 13.2 12.4 NM NM NM 10.7% 12.5% 12.0% 0.0%Dallah Healthcare 4004.SE OW 1,309 104.00 115.00 35.9 31.0 25.1 27.0 22.7 18.7 11.9% 12.9% 14.6% 52.3%Dar Al Arkan 4300.SE N 3,916 13.60 14.00 21.6 15.5 12.6 17.5 13.5 11.5 4.1% 5.4% 6.4% 40.9%Etihad Etisalat(Mobily) 7020.SE N 17,853 86.96 98.00 10.0 9.8 9.6 8.3 7.9 7.5 29.8% 26.9% 24.8% 2.9%Fawaz Alhokair 4240.SE N 6,019 107.50 90.50 36.5 28.6 23.0 30.7 22.6 17.2 36.1% 35.5% 36.8% 53.8%Herfy Food Services 6002.SE N 1,287 104.50 107.86 25.2 23.2 20.6 20.4 18.0 16.0 34.1% 32.4% 32.1% 31.2%Jabal Omar 4250.SE N 13,133 53.00 47.00 0.0 40.9 40.6 0.0 39.6 35.1 -0.4% 12.6% 11.3% 71.2%Jarir Marketing 4190.SE OW 4,799 200.00 237.00 27.6 23.8 20.4 27.2 23.0 19.3 59.3% 58.6% 57.4% 26.5%Maaden 1211.SE N 9,175 37.20 38.00 10.6 7.8 6.5 26.5 37.7 21.4 17.2% 22.0% 25.8% 17.7%Methanol Chemicals 2001.SE N (V) 531 16.50 16.00 27.6 14.8 16.1 10.6 8.1 8.0 4.6% 8.3% 7.4% 7.1%NIC (Tasnee) 2060.SE N 6,349 35.60 35.00 21.6 11.5 11.7 11.4 8.1 7.9 9.2% 16.6% 15.2% 7.0%National Medical Care 4005.SE N 879 73.50 78.00 35.6 28.8 25.3 26.0 22.5 19.5 13.0% 13.8% 15.1% 35.3%National Petrochemical 2002.SE N (V) 4,402 34.40 28.00 0.0 14.3 15.2 35.0 11.2 10.8 -1.6% 25.3% 20.6% 30.3%Qassim Cement 3040.SE N 2,328 97.00 101.00 14.9 14.6 16.7 11.4 11.1 12.7 29.4% 29.7% 25.6% 10.1%PetroRabigh 2380.SE OW 7,852 33.62 45.00 82.0 12.1 8.6 26.7 10.2 7.6 4.1% 25.0% 29.8% 33.3%Riyad Bank 1010.SE N 14,678 18.35 20.40 13.9 12.9 11.8 NM NM NM 12.5% 12.8% 13.3% 0.0%Sahara Petrochemical 2260.SE N 2,761 23.60 23.00 17.9 14.4 13.8 17.1 12.2 9.7 10.3% 12.0% 11.8% 22.8%Samba Financial Group 1090.SE OW 13,438 42.00 55.00 11.2 10.5 9.7 NM NM NM 14.0% 13.7% 13.6% 0.0%Saudi Airlines Catering 6004.SE OW 4,236 193.75 186.00 30.4 27.4 22.2 26.7 23.1 18.6 47.1% 47.4% 52.5% 34.8%Saudi Arabian Amiantit 2160.SE N 557 18.10 16.40 20.6 12.5 10.7 8.8 7.6 7.2 6.5% 10.6% 12.2% 16.8%Saudi Arabian Fertilizer 2020.SE OW 14,264 160.50 176.00 13.2 15.4 12.9 11.7 13.6 11.3 41.1% 32.7% 39.7% 2.4%Saudi Basic Industries 2010.SE OW 98,784 123.50 130.00 14.7 11.7 11.6 8.3 7.1 6.8 16.7% 19.2% 17.6% 13.4%Saudi Cement Company 3030.SE OW 4,508 110.50 130.00 15.0 14.8 13.3 12.6 12.3 11.2 35.3% 35.3% 38.7% 8.6%Saudi Electricity Co. 5110.SE N 17,997 16.20 15.90 22.2 20.4 17.7 9.9 10.4 10.8 5.5% 5.7% 6.2% 19.2%Saudi Industrial Invst. 2250.SE OW 4,487 37.40 41.00 23.6 10.4 10.9 35.2 11.1 10.8 11.4% 23.8% 20.1% 21.5%Saudi International Petro 2310.SE N 3,500 35.80 34.00 21.2 15.9 14.4 11.5 9.1 8.1 10.9% 13.8% 14.3% 18.0%Saudi Kayan 2350.SE N 6,039 15.10 16.00 0.0 13.9 13.2 20.5 10.6 9.8 -2.4% 11.0% 10.4% -3.4%Saudi Pharmaceutical 2070.SE N 1,529 47.80 47.08 21.2 17.7 15.1 12.4 11.0 9.3 8.0% 8.5% 9.8% 12.3%Saudi Real Estate 4020.SE N 1,389 43.40 40.00 29.0 31.9 29.7 26.8 23.6 21.9 5.5% 4.9% 5.3% 27.6%Saudi Steel Pipes 1320.SE N 480 35.30 37.50 21.0 15.5 12.9 14.4 11.9 10.0 10.6% 14.0% 16.4% -3.9%Saudi Telecom Co. 7010.SE OW 38,394 72.00 71.00 13.9 12.1 11.6 7.2 6.7 6.2 19.2% 19.9% 18.9% 31.5%Savola 2050.SE N 11,283 79.25 74.00 24.8 22.7 18.7 12.8 11.2 9.6 18.9% 18.4% 20.9% 31.2%Yamamah Cement 3020.SE N 3,334 61.75 70.00 15.1 16.4 18.0 10.5 10.8 11.5 22.2% 19.4% 17.6% 8.3%Yanbu Cement 3060.SE N 3,087 73.50 78.00 14.1 14.1 16.7 11.3 10.7 12.4 25.0% 24.9% 20.7% 10.8%Yanbu Petrochemical 2290.SE N 10,501 70.02 77.00 14.9 12.5 12.6 10.6 9.4 9.4 18.9% 20.4% 19.5% -2.9%Zamil Industries 2240.SE N 972 60.75 48.00 15.5 13.6 12.6 11.3 10.0 9.0 15.4% 16.1% 16.2% 42.4%Source: Thomson Reuters Datastream, HSBC estimates Note: Closing price as on 22 Jul 2014

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Saudi to open its equity market 5

Equity Market Strategy 10

Economics 16

Sectors & companies 17

Banks 19 Arab National Bank 23

Banque Saudi Fransi 26

Riyad Bank 29

Samba Financial Group 32

Alrajhi Banking & Investment 35

Alinma 38

Bank AlBilad 41

Bank AlJazira 43

Saudi Hollandi Bank 45

Saudi Investment Bank 47

Chemicals & fertilisers 49 Advanced Petrochemical 57

Methanol Chemicals Co (Chemanol) 60

Saudi Basic Industries Co (SABIC) 63

National Industrializatio (Tasnee (NIC)) 66

Saudi Industrial Investment (SIIG) 70

National Petrochemical Company (Petrochem) 73

Yansab 76

Kayan 79

Saudi International Petro (Sipchem) 82

Rabigh Refining and Petro (PetroRabigh) 85

Maaden 89

Saudi Arabian Fertiliser Company (SAFCO) 92

Cement & construction 95 Yamamah Cement Company 100

Saudi Cement Company (SACCO) 103

Qassim Cement 106

Yanbu Cement 109

Abdullah A. M. 112 Al-Khodari Sons

Saudi Arabian Amiantit Co. 115

Saudi Steel Pipes 118

Zamil Industries 121

Arabian Pipes Co. 124

Middle East Specialized Cables Co. 126

Saudi Cable Co. 128

Saudi Paper Manufacturing Company 130

Contents

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United Wire Factories Company 132

Consumers 135 Abdullah Al Othaim Markets 138

Almarai 141

Fawaz Abdulaziz Alhokair 144

Jarir Marketing Co. 147

Herfy Food Services 150

Savola 153

Saudi Airlines Catering 156

Al Khaleej Training & Education 159

Al Tayyar Travel Group 161

Budget (United International Transportation Co.) 163

eXtra (United Electronics Co.) 165

Farm Superstores (Saudi Marketing Co.) 167

Halwani Brothers 169

Saudia Dairy & Foodstuff Company 171

Saudi Automotive Services Co. 173

Saudi Ceramic Co. 175

Saudi Fisheries Co. 177

Shaker (Al Hassan Ghazi Ibrahim Shaker Co) 179

Healthcare 181 Astra Industrials Group 185

Dallah Healthcare 188

Al Mouwasat Medical Services Co 191

National Medical Care Co (NMCC) 194

Saudi Pharmaceuticals (SPIMACO) 197

Al Hammadi Dev. & Investment Co. 200

Real Estate 203 Dar Al Arkan 208

Jabal Omar 211

Saudi Real Estate Co. 214

Emaar Economic City 217

Insurance 219 The Mediterranean & Gulf Insurance & Reinsurance Co (Medgulf) 222

The Company for Cooperative Insurance (Tawuniya) 224

Malath Cooperative Insurance & Reinsurance Co (Malath) 226

Telecoms 229 Etihad Etisalat (Mobily) 233

Saudi Telecom Company 236

Zain KSA 239

Utilities 241 Saudi Electricity Company (SEC) 244

Disclosure appendix 249

Disclaimer 252

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Saudi stock market to open in 1H 2015 Saudi Arabias authorities announced on Tuesday, 22 July 2014, their plan to open the country's listed stock market to foreign investors in the first half of 2015. This is the first time the Saudi authorities are expected to allow foreign institutional investors to directly trade equities in the Tadawul, without restrictions. Since 2008, the Kingdom has only allowed foreign investors indirect access to the market through swaps and p-notes and investors needed AUM of at least USD 5bn to be considered.

Next steps for the Saudi authorities The Capital Market Authority has been given

scope to complete and publish the regulatory requirements over the next 30 days

Investors and Authorised Participants will have the opportunity to provide feedback in the following 90 days.

Market consultations to commence Index providers are expected to commence consultations on country / market classifications for the Saudi market based on the following criteria: openness to foreign ownership; ease of capital inflows and outflows; efficiency of the operational framework and stability of the institutional framework. In terms of market accessibility, factors that will need to be assessed will include: foreign ownership limits; equal rights to foreign investors; market regulations; competitive landscape of brokers; information

flow; clearing and settlement (T+0); custody and transferability with respect to the needs and requirements of global investors.

Potential global index benchmark impact Given the uncertainty regarding the potential market classification of Saudi Arabia; Developed, Emerging or Frontier, in the tables which follow, we simulate the potential impact to MSCI indices, on the basis of the following:

1) Saudi is classified as an Emerging Market

2) Saudi is classified as a Frontier Market

Scenario analysis In our analysis, we assume the following: the current domestic inclusion factor is equivalent to the investable free float for Saudi stocks; we apply minimum size criteria of USD1.4bn at the company level. Using these criteria we estimate the new opportunity set for Saudi Arabia will consist of 45 stocks.

Saudi to open its equity market

Vijay Sumon* Head of IndexationHSBC Bank plc+44 20 7991 [email protected]

Joaquim de Lima * Head of Equity Quantitative Research HSBC Bank plc+44 20 7991 [email protected]

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations

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Saudi as an Emerging Market We now examine, in detail, the potential impact on investors benchmarked to MSCI EM in the event of Saudi being classified as an Emerging Market. In what follows, we assume all passive funds will rebalance fully to match the new benchmark.

Impact of Saudi entering MSCI EM Country and Regional impact We find the Saudi market would account for 4% in terms of weight in MSCI EM and potentially be the ninth largest country in terms of weighting.

We would expect China, South Korea, Taiwan and Brazil to be the most negatively impacted in terms of weight changes and likely to see decreases of between 49-78 basis points individually.

In terms of regions, we believe EM Asia is set to be the most negatively impacted with a decrease of 260 basis points, followed by Latam with a decrease of 80 basis points whilst we would expect EMEA to experience an increase of 350 basis points.

Table 1: Simulated MSCI Emerging Market regional indices + Saudi Arabia

_______Current EM Index_______ ____Potential EM regional Indices + Saudi Arabia____ Region Number of stocks Weight % Number of stocks Weight % Weight change % Net flow USDm

Asia 535 62.2% 535 59.6% -2.6% -5,480 EMEA 159 18.1% 204 21.6% 3.5% 7,215 Latam 140 19.7% 140 18.9% -0.8% -1,735

Total 834 100% 879 100% 0.0% 0 Source: MSCI, HSBC estimates. Data as of 21 July 2014

Table 2: Simulated MSCI Emerging Market country indices + Saudi Arabia

______ Current EM Index______ ______Potential EM country Indices + Saudi Arabia ______ Country Number of stocks Weight % Number of stocks Weight % Weight change % Net flow USDm

Saudi Arabia 0 0.0% 45 4.2% 4.2% 8,808 Egypt 4 0.2% 4 0.2% 0.0% -18 Hungary 3 0.2% 3 0.2% 0.0% -18 Czech Republic 3 0.2% 3 0.2% 0.0% -19 Peru 3 0.4% 3 0.4% 0.0% -38 Qatar 10 0.5% 10 0.4% 0.0% -41 UAE 9 0.5% 9 0.5% 0.0% -47 Greece 10 0.7% 10 0.7% 0.0% -62 Philippines 20 1.0% 20 0.9% 0.0% -86 Colombia 14 1.0% 14 1.0% 0.0% -90 Chile 20 1.5% 20 1.4% -0.1% -130 Poland 23 1.6% 23 1.6% -0.1% -143 Turkey 25 1.8% 25 1.7% -0.1% -155 Thailand 29 2.3% 29 2.2% -0.1% -201 Indonesia 30 2.7% 30 2.6% -0.1% -235 Malaysia 43 3.9% 43 3.7% -0.2% -342 Russia 22 4.9% 22 4.6% -0.2% -428 Mexico 30 5.2% 30 5.0% -0.2% -461 India 68 6.6% 68 6.3% -0.3% -584 South Africa 50 7.5% 50 7.2% -0.3% -661 Brazil 73 11.5% 73 11.0% -0.5% -1,016 Taiwan 101 12.1% 101 11.6% -0.5% -1,067 Korea 103 15.2% 103 14.6% -0.6% -1,340 China 141 18.4% 141 17.7% -0.8% -1,624


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Sector impact We believe Materials, Financials and Telecoms sectors could be positively impacted in terms of weight changes, up 110, 50 and 20 basis points respectively. We believe these sectors combined could account for 35 of the 45 Saudi stocks that could potentially enter MSCI EM.

The Information Technology, Energy, Consumer Discretionary and Industrial sectors could potentially experience weight decreases, in the range of 20-70 basis points.

Table 3: Simulated MSCI Emerging Market sectors + Saudi Arabia

_______Current EM Index_______ ____Potential EM sectors + Saudi Arabia____ Sector Number of

stocks Weight % Number

of stocks Weight

% Weight

change % Net flow USDm

Materials 98 8.80% 114 9.90% 1.10% 2,313 Financials 210 27.10% 226 27.60% 0.50% 968 Telecom. Services 46 7.10% 49 7.20% 0.20% 338 Consumer Staples 81 8.30% 83 8.20% -0.10% -262 Health Care 30 1.90% 30 1.80% -0.10% -164 Utilities 52 3.60% 53 3.50% -0.10% -143 Consumer Discretionary 88 9.10% 91 8.90% -0.20% -453 Industrials 112 6.50% 114 6.30% -0.20% -353 Energy 51 10.50% 53 10.20% -0.40% -735 Information Technology 66 17.10% 66 16.40% -0.70% -1,510 Total 834 100% 879 100% 0.0% 0 Source: MSCI, HSBC estimates. Data as of 21 July 2014

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Saudi as a Frontier Market In this section we detail the potential impact on investors benchmarked to MSCI FM in the event of Saudi being classified as a Frontier Market. In what follows, we assume all passive funds will rebalance fully to match the new benchmark.

Impact of Saudi Arabia entering Frontier Markets Country and regional impact We find the Saudi market would dominate the MSCI FM index, accounting for 62% in terms of weight. We would expect Kuwait, Nigeria, Argentina and Pakistan to be the most negatively

impacted in terms of weight changes and could see decreases ranging between 5 and 15%.

Regionally, this could lead to potential distortions in MSCI Frontier Market representation with EMEA accounting for at almost 92%, Asia dropping to 5% and Latam at 3%.

Table 4: Simulated MSCI Frontier Market regional indices + Saudi Arabia

_______Current EM Index_______ ____Potential EM regional Indices + Saudi Arabia____ Region Number of stocks Weight % Number of stocks Weight % Weight change % Net flow USDm

Asia 34 14.3% 34 5.4% -8.9% -99 EMEA 87 77.6% 132 91.5% 14.0% 156 Latam 6 8.1% 6 3.1% -5.1% -57


Table 5: Simulated MSCI Frontier Market index + Saudi Arabia

_______ Current FM index ________ ___________New FM Index + Saudi Arabia ___________ Country Number of stocks Weight % Number of stocks Weight % Weight change % Net flow USDm

Saudi Arabia 0 0.0% 45 62.2% 62.2% 695 Lithuania 2 0.2% 2 0.1% -0.1% -1 Bulgaria 2 0.2% 2 0.1% -0.1% -1 Ukraine 2 0.2% 2 0.1% -0.1% -2 Serbia 2 0.3% 2 0.1% -0.2% -2 Estonia 2 0.4% 2 0.2% -0.3% -3 Tunisia 2 0.6% 2 0.2% -0.3% -4 Jordan 3 0.7% 3 0.3% -0.5% -5 Mauritius 2 1.2% 2 0.5% -0.8% -9 Bahrain 3 1.4% 3 0.5% -0.8% -9 Croatia 3 1.7% 3 0.6% -1.1% -12 Bangladesh 4 1.8% 4 0.7% -1.1% -12 Sri Lanka 3 1.9% 3 0.7% -1.2% -13 Romania 4 2.2% 4 0.8% -1.4% -15 Lebanon 4 2.2% 4 0.8% -1.4% -15 Slovenia 4 2.7% 4 1.0% -1.7% -19 Vietnam 12 3.5% 12 1.3% -2.2% -24 Kazakhstan 3 3.7% 3 1.4% -2.3% -26 Oman 9 4.6% 9 1.7% -2.8% -32 Kenya 5 4.9% 5 1.9% -3.1% -34 Morocco 9 6.1% 9 2.3% -3.8% -42 Pakistan 15 7.2% 15 2.7% -4.5% -50 Argentina 6 8.1% 6 3.1% -5.1% -57 Nigeria 18 19.6% 18 7.4% -12.2% -137 Kuwait 8 24.8% 8 9.4% -15.4% -172


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Sector impacts We believe the Materials and Consumer Discretionary sectors could be positively impacted in terms of weight changes, up 18% and 2% respectively.

Financials, Energy and Consumer Staple could experience the largest negative impacts with potential weight decreases of between 3 and 7%.

Table 6: Simulated MSCI Frontier Market sectors + Saudi Arabia

_______Current FM Index_______ ____Potential FM sectors + Saudi Arabia____ Sector Number of

stocks Weight % Number of

stocks Weight

% Weight change

% Net flow USDm

Materials 15 5.70% 15 24.00% 18.30% 204 Consumer Discretionary 3 0.50% 3 2.70% 2.10% 24 Utilities 2 0.40% 2 1.40% 1.00% 11 Information Technology 0 0.00% 0 0.00% 0.00% 0 Industrials 5 3.40% 5 2.90% -0.60% -6 Health Care 3 2.70% 3 1.00% -1.70% -19 Telecom. Services 14 14.50% 14 12.30% -2.20% -25 Consumer Staples 11 10.50% 11 7.30% -3.20% -36 Energy 16 12.10% 16 5.90% -6.20% -69 Financials 58 50.10% 58 42.60% -7.50% -84 Total 127 100% 127 100% 0.0% 0 Source: MSCI, HSBC estimates. Data as of 21 July 2014

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For EM and FM investors, we recommend an off-benchmark exposure to Saudi Arabia In Saudi Arabia, both the cyclical and secular narratives remain attractive. The obstacles relate more to valuations and more challenging bottom-up stock selection. Nevertheless, we continue to favour an off-benchmark exposure, emphasising the petrochemical sector as a whole as well as selected consumer and telecom stocks. We are also positive on the bank sector.

The long-term, secular dynamic in Saudi Arabia, is grounded in demographics and middle class growth (see Frontier Market Equity Strategy: Frontier markets and the rise in middle class spending, 23 July 2014). The total middle class population is forecast to grow from less than 20m today to 40m by 2050 (OECD). This would be the fourth-largest middle class population in the frontier index.

Simon Williams, our Chief Middle Eastern Economist, remains upbeat on the Kingdoms near-term economic prospects, and continues to look for strong growth in domestic demand, underpinned by high oil receipts and two more years of fiscal and current account surplus.

The governments oil-funded expansionary fiscal stance will remain the prime driver of growth, with current and capital spending set to rise from last years record high. The government will also be a prime driver of a raft of other large industrial and infrastructure development projects (such as the Riyadh metro) which are state sponsored but not directly state financed.

With inflation low and the dollar peg in place, we also expect the Saudi Arabian Monetary Agencys (SAMAs) monetary stance to remain loose.

In aggregate, the equity market is not very expensive, with the PE relative (compared with GEM) trading a little above its five-year history. However, neither is it very cheap, and stock selection is becoming more complicated.

In the domestically-focussed part of the market we like selected consumer, telecom and banks stocks. For the consumer sector, sales growth should continue to rebound this year. In aggregate Saudisation initiatives (policies favouring the employment of locals) should ultimately help the sector by enhancing purchasing power. The undertow from the long-term secular story works in the sectors favour. The impediment is that the discount to the peer group has closed, so there is less valuation support. The telecoms sector is another way to play the theme.

Equity Market Strategy Saudi Arabia has a strong cyclical and secular position

Prospective market liberalisation should provide an additional catalyst Prefer petrochemicals and selected consumer, telecoms and

bank exposure

John Lomax* Head of Global Emerging Market Equity Strategy HSBC Bank plc+44 20 7992 [email protected]

Kishore Muktinutalapati* AssociateBangalore


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The case for the banks is also slowly coming into view. The first rise in US interest rates, which positively impacts them, is no longer extremely distant (Q3 next year in the view of HSBCs US economist). Sectoral earnings in any case should pick up on the back of falling loan loss provisions and domestic macro is supportive. Valuations are looking increasingly attractive.

The petrochemical sector should benefit from both demand and supply support. Chinese polymer demand should receive support from the ongoing strength of the Chinese economy. Unlike, other parts of the global material sector, Saudi petrochemicals will not be negatively impacted by the rebalancing of the Chinese economy towards consumption and away from infrastructure spending since packaging and autos are the key demand drivers. On the supply side, the developing supply vacuum should allow room for margin expansion from current levels. Dividend yield, which has scope to be enhanced by these developments, is an additional source of sectoral support.

Saudi Arabias Equity Market The Saudi equity market has performed strongly over the last 10 years. The main index, the Tadawul All-Share Index (TASI), has returned a healthy 121% since 2004, buoyed by rising oil prices and GDP growth that has averaged 6.4% per annum. However, the volatility has been significant in a market with over 90% of trading volumes accounted for by Saudi retail investors. The TASI returned a 720% from early 2002 to February 2006, but investors who bought at the peak in February 2006 have lost 53%, even though the market has returned 95% since early 2009. The market has been open for investment since 2007 for citizens of the nations within the Gulf Co-operation Council (which also includes the UAE, Kuwait, Qatar, Bahrain and Oman). Since 2008, non-GCC investors have been able to access the market via swap agreements.

The Saudi equity market tends to trade at a premium to the MSCI emerging markets index, reflecting its vast hydrocarbon wealth and one of the most attractive demographic profiles globally, including a very young population and a labour force growing at nearly 3% per annum. The Saudi bourse, the largest in the Middle East, is open for trading in equities between 11.00am and 3.30pm (one session) Sunday through Thursday.

164 stocks are listed on the Tadawul exchange. SABIC and Saudi Telecom both account for c25% of the Tadawul All Share Index, with the top 5 names representing c38% of the market. The top 10 names account for about 52% of the index total market capitalization, and have an average free float of about 30%. This means that the Saudi market is more diversified than most other regional exchanges but it is still is fairly concentrated by developed-market standards. The materials sector (which includes petrochemical companies) accounts for 34.6% of the market, followed by a 33.8% weight for Financials by market capitalisation.

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The Saudi equity market is one of the most heavily traded in the emerging markets space, with average daily turnover at USD1.4bn in 2013 and USD2.5bn currently. At times, the market turnover has been higher than the combined turnover in all other CEEMEA equity markets, even though volumes are still far below the market peak in 2005/06. The ratio of market capitalisation to GDP, at about 51%, is decent by emerging-market standards.

The Saudi market has exhibited a low correlation to global equity benchmarks, partly because the market is currently closed for direct foreign investment. Non-GCC parties can only invest in Saudi equities through swap contracts and via a limited selection of exchange traded funds. Several local Saudi brokerage firms offer swap contracts to international investors. These contracts enable the investor to

obtain economic exposure while the legal ownership remains with a Saudi-registered entity.

Market liberalisation According to Reuters (Saudi Arabia prepares to open $530 billion bourse to foreigners, 22 July 2014), the Saudi Arabian cabinet authorized the Capital Market Authority (CMA) at a time it sees as appropriate to allow foreign financial institutions to buy and sell stocks on the Saudi stock market, according to rules to be laid down by the CMA.

Sector composition of TADAWUL All Share index Major stocks in TADAWUL All Share index

Source: Tadawul, Thomson Reuters Da tastream, HSBC Source: Tadawul, Thomson Reuters Da tastream, HSBC

Tadawul All Share price index Tadawul trading volumes

Source: Tadawul, Thomson Reuters Da tastream Source: Tadawul, Thomson Reuters Da tastream

Sector Weight (%)Materials 34.6%Financials 33.8%Telecommunication Services 11.0%Consumer Staples 5.5%Consumer Discretionary 4.5%Industrials 3.9%Utilities 3.6%Energy 2.1%Health Care 1.0%Total 100.0%

Rank Stock Name Weight (%)1 Saudi Basic Industries 17.5%2 Saudi Telecom 7.1%3 Al Rajhi Bank 5.4%4 Kingdom Holding 4.5%5 Saudi Electricity 3.4%Top 5 37.8%6 Etihad Etisalat Co. 3.2%7 Riyad Bank 2.7%8 Saudi Arabia Frtz. 2.7%9 The Saudi British Bk. 2.5%10 Samba Financial Group 2.4%Top 6-10 13.5%

0

1000

2000

3000

4000

5000

6000

01 02 03 04 05 06 07 08 09 10 11 12 13 14

TADAWUL All Share Index (USD)

0.00.51.01.52.02.53.03.54.0

07 08 09 10 11 12 13 14Tadawul Index 6m ADTV (USDbn)

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If Saudi opens its market to direct foreign investment, it may potentially be included in the MSCI Emerging Markets index. According to Sebastien Lieblich, executive director in the index research team at MSCI, the index provider would wait for the changes to be implemented before consulting investors, with a decision as to whether to include it as emerging market unlikely to be made before June 2015. However, should this materialise, the Saudi market could take up about 4% of the MSCI EM index. However, adjusted for the foreign ownership caps, the weight should be lower.

The high turnover of the Saudi market suggests that it could be a key constituent of this key benchmark. Inclusion in the MSCI EM (or even Frontiers EM) index, were it to happen, could be important for at least two reasons: first, it should allow Saudi to tap the broad international pool of EM liquidity; second, it has the potential to stimulate more efficient behaviour from Saudi equities, allowing them to better reflect market fundamentals.

Implications for equity markets Below we examine the possible consequences of the decision by the Saudi Arabian Capital Markets Authority (CMA) to allow limited foreign equity ownership on the Kingdoms Tadawul Exchange.

The results we would expect include a decrease in the volatility of returns, and the crowding-out of irrational trading behaviour. This should push prices to increasingly reflect fundamentals and to move in line with their intrinsic values.

We believe allowing foreign ownership would render the Saudi market less volatile, and consequently more efficient. Additionally, as investors are given greater insight into companies decision-making processes, financial disclosure and corporate transparency should also improve while foreign investment, we think, will also bring additional analyst coverage to the regions equities, thereby improving the quality of information available.

The CMA opened Saudi Arabias stock exchange to limited foreign investment in late 2008. Non-nationals were given the right to trade shares listed on the exchange by entering into swap agreements.

We expect market efficiency to have improved since this liberalisation process. However, given the high transaction costs associated with this indirect trading mechanism, we believe market efficiency would further improve once direct foreign ownership is permitted.

Volatility, liquidity and market efficiency In order to examine market efficiency, we look at changes in volatility of returns by comparing the standard deviation of returns for the two-year pre- (partial) liberalisation period with that of the subsequent two-year period. (For more details on the methodology see Mispriced: CEEMEA equity projections, 12 December 2011). Changes in liquidity are examined by measuring average daily traded volumes (ADTV) and turnover by volume for the year preceding the (partial) liberalisation process and comparing them with levels for the following two-year period. Finally, market efficiency is measured by investigating the relationship between current and past returns. A market is more efficient when current returns depend less on their previous values.

After limited foreign trading was allowed, the weekly standard deviation of returns decreased substantially from 0.056 to 0.030 a 47.3 % decrease. After December 2008, large spikes in returns have decreased both in frequency and intensity. We believe this to be attributable in part to increased market efficiency as a result of allowing limited foreign investment. However, the period around the decrease in volatility coincides with a time when the CMA greatly increased market surveillance in an effort to discourage market manipulation by groups of wealthy investors. This development may also serve as a partial explanation for the decrease in volatility.

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Prior to the liberalisation, the Saudi turnover ratio was much higher than in many developed and emerging markets, as shown above. We believe this drop in turnover ratio indicates that herd behaviour and noise trading in the market decreased after the liberalisation process.

We calculate a drop in average ADTV from USD1.77bn in the first period to USD1.07bn after the liberalisation process. However, we note that these measures were implemented at the peak of the 2008 financial crisis, so the decrease in ADTV may be explained by the drying-up of international liquidity. However, the countrys turnover ratio has consistently converged towards levels seen in developed and emerging markets, which leads us to believe that foreign investments are also responsible for this drop in liquidity.

When assessing the impact of the liberalisation on market efficiency, we found current daily returns to be significantly correlated with past returns during the two-year period before the liberalisation process. In the subsequent two-year period, however, there was a noticeable drop in the significance level of the coefficients. The table below summarises these results.

After foreign trading was permitted by the exchange, the test was unable to detect any significant pattern among daily returns, except for t-2, which still influences current returns.

There has clearly been an improvement in the level of efficiency in the Saudi market since the liberalisation process took place. We expect further improvements once direct foreign ownership is allowed.

TASI market efficiency

___________ Coefficients ____________ Time period Pre liberalisation Post liberalisation

t-1 0.073** -0.006t-2 -0.047* 0.104**t-3 0.043* 0.000t-4 0.066** -0.041t-5 -0.021 -0.016t-6 -0.042* -0.051t-7 0.017 0.032** 1% significance level; * 5% significance level Source: Thomson Reuters Datastream, HSBC

Weekly returns of Tadawul index pre and post partial liberalisation in December 2008

Turnover ratios*

Source: Tadawul, Thomson Reuters Datastream Notes: *Turnover ratio is the total value of shares traded during the period divided by the

average market capitalisation for the period. Source: Tadawul, Thomson Reuters Datastream

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Oct-10

Pre liberalisation Post liberalisation 0%

50%

100%

150%

200%

250%

300%

1992 1995 1998 2001 2004 2007 2010

Saudi Arabia DM EM GCC

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Earnings and valuations

Price/Earnings ratio Earnings growth and equity performance

Source: Tadawul, Bloomberg Source: Tadawul, Bloomberg

Price/Sales ratio Price/Book ratio


Earnings yield Dividend Yield


8.0x

12.0x

16.0x

20.0x

24.0x

28.0x

06 07 08 09 10 11 12 13 1412 month trailing PE 12 month forward PE

-60%

-40%

-20%

0%

20%

40%

60%

0%

10%

20%

30%

40%

50%

60%

07 08 09 10 11 12 13 1412 month forward Earnings growthy-o-y returns (RHS)

2.0x

3.0x

4.0x

5.0x

6.0x

08 09 10 11 12 13 1412 month trailing P/S 12 month forward P/S

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

08 09 10 11 12 13 14

12 month trailing PB 12 month forward PB

4.0%5.0%6.0%7.0%8.0%9.0%

10.0%11.0%12.0%

06 07 08 09 10 11 12 13 1412 month forward Earnings Yield

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

08 09 10 11 12 13 1412 month trailing DY 12 month forward DY

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Slowing, but still strong We remain upbeat on the Kingdoms near-term economic prospects, and continue to look for strong growth in domestic demand, underpinned by high oil receipts and two more years of fiscal and current account surplus. The impact that unrest in Iraq, Libya and Ukraine has had on global energy prices represents upside risk to this view.

The governments oil-funded expansionary fiscal stance will remain the prime driver of growth, with current and capital spending set to rise from last years record high. The government will also be a prime driver of a raft of other large industrial and infrastructure development projects (such as the Riyadh Metro) which are state sponsored, but not directly state financed.

With inflation low and the dollar-peg in place, we also expect SAMAs monetary stance to remain loose, with funding from domestic sources enhanced by improving access to global debt and equity markets. Saudi Arabias demographic profile 60% of the population are under the age of 30 will support gains in consumption. With

reserves equivalent to some 90% of GDP and a public debt at less than 5% of GDP, the Kingdom is also well placed to weather even a pronounced increase in regional political risk or prolonged fall in oil earnings.

In this context, though, we see some signs that the economy is decelerating with markers of consumption and investment growth all easing over the first half of the year. Though driven in part by the short-term disruption caused by the expulsion of a large number of expatriates in late 2013, it also marks the Kingdoms increased fiscal caution as the budget surplus continues to decline. We see signs that alongside more modest gains in spending, there is also a greater commitment to economic liberalisation and structural reform. In our view, however, the pace of change as yet lacks the urgency required if the Kingdoms long-term demand for goods, services and employment is to be met in an environment of more modest public spending gains.

Economics

Simon Williams EconomistHSBC Bank Middle East Ltd+971 4423 [email protected]

Razan Nasser EconomistHSBC Bank Middle East Ltd+971 4423 [email protected]

Key data and forecasts

2008 2009 2010 2011 2012 2013e 2014f 2015f

GDP (% y-o-y) 8.2 2.0 7.5 8.6 5.8 4.1 4.2 3.9 Current account (% GDP) 24.4 3.5 13.4 22.8 21.8 17.1 13.4 9.2 Budget Balance (% GDP) 29.8 -5.4 4.4 11.6 13.7 6.4 3.7 2.3 Trade Balance (% GDP) 40.9 24.6 29.3 36.6 34.0 30.1 26.6 23.7 CPI (% end year) 9.0 4.2 5.4 5.3 3.9 3.0 3.5 4.3 Public Debt (% GDP) 12.1 14.0 8.5 5.4 3.6 2.7 2.9 3.1 External debt (% GDP) 18.5 23.2 19.7 16.6 15.8 15.3 14.4 14.1 Policy rate (% end year) 1.50 0.25 0.25 0.25 0.25 0.25 0.25 0.25 USD/SAR (end year) 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 EUR/SAR (end year) 5.22 5.40 5.02 4.87 4.94 5.13 4.79 4.68 Source: Saudi Arabia Monetary Agency, Central Department of Statistics and Information (CDSI), HSBC estimates and forecasts

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Sectors & companies

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Banks

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Sector view Core revenue growth will struggle to recover in 2014e and 2015e A combination of low interest rates, a cap on loan to deposit ratios of 85% and the strong capitalisation of Saudi banks means that the sector will struggle to substantially improve its core revenue growth in 2014e and 2015e, in our view. Alinma Bank and Riyad Bank are the exceptions due to faster and more stable loan growth, mainly as a result of their surplus capital positions. We forecast sector core revenues to increase 9% in 2014e and 2015e. Q2 2014 earnings results confirmed our full year expectation. An increase in interest rates will be a key driver of improvement. We factor in a 20bp increase in 2015e and expect Saudi banks core revenue growth to recover to 13% in 2016e.

Saudi banks' y-o-y core revenue* growth: latest trends and our forecasts

(%) Q2 13 Q3 13 Q4 13 Q1 14 2014e 2015e 2016e

Alinma 12 15 20 15 16 15 15 Alrajhi 1 (2) 2 0 4 5 8 ANB 2 4 15 10 9 8 10 BSF (1) 2 3 12 9 9 20 Riyad 5 7 12 15 9 12 16 Samba (0) 4 7 (3) 8 9 16 Avg. 3 5 10 8 9 9 13 Source: Company data, HSBC estimates; Note: *core revenue = net interest income + fees; latest core revenue figures for Q2 14 are not out yet

In the meantime, as core revenue growth remains below 10%, Saudi banks will have to rely increasingly on other non-interest income, such as gains on trading and investments, and FX revenue. These are more volatile sources of earnings, which dilute earnings quality. As we illustrate in the next table, the average contribution from these sources to total revenue was 9 to 12% over the last six quarters.

Aybek Islamov* AnalystHSBC Bank Middle East+ 971 4423 [email protected]


Banks We do not expect core revenue growth to rise above 10% during

2014e-15e; we factor in a 20bp increase in interest rates in 2015e and expect core revenue growth to recover to 13% in 2016e Balance sheets are asset-driven in a market with ample deposit

funding; we estimate banks can sustain 10-15% pa increase in loans but should also raise collective provisions in the medium term We have Overweight ratings on Samba (TP SAR55) and ANB (TP

SAR 37), Neutral ratings on Alinma (TP SAR21.3), Alrajhi (TP SAR74.0), BSF (TP SAR37.0) and Riyad (TP SAR20.4)

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Contribution of other non-interest income (FX, trading and investment gains) to total revenue

(%) Q4 12 Q1 13 Q2 13 Q3 13 Q4 13 Q1 14

Alinma 1 7 2 3 3 5 Alrajhi 16 10 9 13 15 10 ANB 13 15 13 10 12 16 BSF 9 9 10 9 15 9 Riyad 7 6 12 8 10 11 Samba 9 14 11 12 6 17 Average 9 10 10 9 10 12 Source: company data, HSBC estimates, Q2 14 details are not out yet

Loan growth pipeline remains healthy As was recently discussed in the initiation report on GCC construction contractors Ride the next order wave (17th April 2014, Nicholas Paton et al), cUSD100bn of projects are still to be awarded in 2014 in Saudi Arabia. These are concentrated in the power, transportation, oil & gas, water and construction sectors of the economy.

Assuming that a quarter of these projects, ie cUSD25bn, are funded with bank loans, this translates into an 8-10% increase in the sector loan book. We estimate that the capitalisation and liquidity positions of Saudi banks can easily sustain a 10-15% annual increase in sector loans.

The risk is that contractors may not be getting paid on time, thereby causing asset quality risks to banks. In 2013, there was much discussion of the potential introduction of a new law in Saudi to enable companies to claim compensation for work that has not been paid for. If such a law were to be introduced, it would not only reduce the ratio of receivables to sales for construction contractors (which is running north of 120% in Saudi), but would also give more confidence to investors in Saudi banks.

Banks need to deal with the structural deficit in collective provisions With loan growth remaining in the low teens in 2014, we see increasing pressure on Saudi banks to improve loan loss reserves. Most banks we cover tend to write off NPLs immediately against specific loan loss reserves. Hence, quite often, it is not the NPL ratio which is indicative of real asset quality, but the write-offs to loans ratio.

Specific reserves to loan ratios averaged 1.1% in 2013 and were as high as 2.2% in 2010, at a time of rising impairments

2010 2011 2012 2013

Albilad 4.4% 4.4% n/a 1.7% Alinma 0.0% 0.0% 0.2% 0.4% Alrajhi 1.0% 0.9% 1.5% 0.9% ANB 2.8% 2.9% 2.5% 1.7% BSF 1.0% 0.9% 0.7% 1.1% NCB 3.4% 2.8% 2.7% 1.3% Riyad 1.1% 0.8% 1.2% 0.6% SABB 2.7% 1.2% 1.1% 1.1% Samba 2.6% 1.9% 1.3% 1.1% SHB 2.3% 2.0% 1.6% 1.3% SIB 4.5% 6.0% 0.6% 0.5% Total 2.2% 1.8% 1.5% 1.1% Source: Company data, HSBC estimates

The problem is that, with a low buffer of portfolio provisions (also known as collective provisions), such write-offs require banks to take specific provision charges which, in turn, dampen earnings growth. The collective provision reserve works as a counter-cyclical buffer in the event of unexpected impairments, absorbing negative earnings shocks.

The table above illustrates that most banks have reduced their specific reserves to loan ratios over the last 3 years. In the meantime, collective provision to loans ratios were generally steady, with the exceptions of SIB, Samba, and Riyad where this ratio declined (see table below). However, 5 out of the 8 banks currently have a collective provision to loans ratio that is below 1%.

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Collective provisions to loans ratio - below 1% for 5 out of 8 banks in 2013 (grey colour coded)

2010 2011 2012 2013

Albilad 0.5% 1.7% n/a 2.0% Alinma 0.0% 0.5% 0.5% 0.7% Alrajhi 2.0% 1.6% 1.3% 1.3% ANB 0.4% 0.6% 0.5% 0.5% BSF 0.9% 0.7% 0.7% 0.8% NCB 1.2% 1.4% 1.5% 1.3% Riyad 1.0% 0.9% 0.9% 0.8% SABB 0.7% 1.2% 1.3% 1.0% Samba* 1.8% 1.8% 1.6% 1.3% SHB 0.9% 0.8% 0.8% 0.8% SIB 1.5% 1.6% 1.7% 1.0% Total 1.2% 1.2% 1.1% 1.1% Source: Company data, HSBC estimates; Note *Samba does not disclose total collective provisions. We only include the collective provisions which the company reports in its Tier 2 capital

We therefore think that, even in the absence of further impairments, banks will need to improve their collective provision reserves. We model our cost of risk forecasts accordingly, which we show in the table below.

Our cost of risk expectations

(bp) 2012 2013 2014e 2015e 2016e 2017e

Alinma 49 66 61 67 72 76 Alrajhi 142 141 110 93 83 88 ANB 63 70 53 53 58 85 BSF 46 88 57 58 58 58 Riyad 100 50 50 60 78 91 Samba 30 32 37 37 46 54 Average 72 74 61 61 66 75 Source: Company data, HSBC estimates

Searching for relative value in a sector with pedestrian EPS growth While the near-term earnings growth that we expect for most Saudi banks is somewhat sluggish, we still see pockets of value, which we identify on the basis of PEG. As can be seen from the table below, although both ANB and Samba are expected to post below-average earnings growth over the next two years, their valuations are sufficiently low that they still show up as best value on a PEG basis. ANB and Samba are our only OW-rated Saudi banks.

PE and PEG multiples

PE 2015e EPS CAGR 13-15e

PEG

Alinma 21.4 17% 1.3 Alrajhi 13.4 5% 2.7 ANB 9.1 12% 0.8 BSF 12.5 16% 0.9 Riyad 11.8 9% 1.3 Samba 9.7 7% 1.4 Average 12.8 9% 1.4 Source: HSBC estimates

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ARNB AB, Price SAR29.1, Overweight, TP SAR37 Company description ANB was established in 1979. Arab Bank (Jordan) is the majority shareholder, with a 40% stake. In 2000 it was the first bank to offer internet banking services in Saudi Arabia. The bank provides a full range of retail and corporate banking services. On our estimates, it had 8% market share of loans and deposits, as at March 2014. ANB teamed up with Dar Al Arkan, the real estate developer, to set up the Saudi Home Loan Company, in order to gain a foothold in the housing finance market.

Investment thesis Good improvement in core revenue despite weak loan growth. Recent quarters confirm that ANB has been able to grow its net interest income and fees faster than customer loans. This is due to it optimising its asset mix. In 2012 and 2013, despite weak loan growth, the loan to asset ratio continued to improve, reaching 64% in Q4 13, up from 62% in Q4 11. We expect this trend to continue and forecast net interest income and fees to grow by 7% and 11%, respectively, in 2015e. We estimate ANB can grow its pre-provision income by 8% in 2014e, and by 10% in 2015e.

Cut in pay-out ratio saves more capital. As ANB has now rebuilt its capital buffer, we expect the bank to re-accelerate its loan growth from 2015. ANB reduced its pay-out ratio to 17% in 2013 from 36% in 2012. The cut delivered a 130bp improvement in the capital adequacy ratio, to 16.3% in Q1 14 from 15% in Q1 13. While

ANBs loan growth may lag the sector this year at only 8% we expect it to recover to 11% and 14% in 2015e and 2016e, respectively.

Financials We forecast Arab National Bank to report earnings of SAR2.9bn (before zakat) in 2014e, an increase of 15% over 2013, on the back of 5% and 7% increases in non-interest income and net interest income respectively and a 20% decline in bad asset charges, generating an ROE of 14.8%. Our earnings estimates are 11% and 12% above Bloomberg consensus for 2014e and 2015e respectively.

Valuation We derive our target prices for Saudi banks using a residual income methodology, using an inflation differential model to calculate the cost of equity. The residual income valuation approach calculates the fair value of the company as the sum of its current net asset value and the present value of its future residual income. The residual income is measured as an excess return over cost of equity.

To calculate the cost of equity by the inflation differential method, we assume cost of equity as the sum of the US risk-free rate (3.0%), the inflation differential between Saudi Arabia and the US (2.6%) and the equity risk premium (5.5%) multiplied by the stock beta (1.0 for Saudi banks we cover). Our estimated cost of equity for ANB is 11.1%. Under our research model, for stocks without a volatility indicator, the Neutral band is 5 percentage points above and below the hurdle rate for Saudi stocks of 9.0%. Our target price of SAR37 implies a potential return of 27%,

Arab National Bank



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which is above the Neutral band of 4%-14% for non-volatile Saudi stocks; therefore, we rate the stock Neutral. The stock is currently trading at 1.4x 2014e book value, for an ROE of 14.8%.

Potential return equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated. We do not include dividend yields in our potential returns for the Saudi banks, since we use residual income methodology to value our stocks.

Risks Key downside risks include: Downside risks centre on stronger-than-expected cost of risk as a result of weaker asset quality, as well as slower loan growth.

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Financials & valuation: Arab National Bank Overweight Financial statements

Year to 12/2013a 12/2014e 12/2015e 12/2016e

P&L summary (SARm)

Net interest income 3,375 3,613 3,860 4,215Net fees/commissions 1,053 1,194 1,326 1,473Trading profits 65 18 0 0Other income 616 604 663 719Total income 5,110 5,428 5,848 6,407Operating expense -1,994 -2,070 -2,162 -2,258Bad debt charge -627 -499 -547 -671Other 36 42 48 52HSBC PBT 2,525 2,900 3,188 3,530Exceptionals 0 0 0 0PBT 2,525 2,900 3,188 3,530Taxation 0 0 0 0Minorities + preferences -3 -3 -3 -4Attributable profit 2,522 2,897 3,185 3,526HSBC attributable profit 2,522 2,897 3,185 3,526

Balance sheet summary (SARm)

Ordinary equity 18,655 20,425 22,369 24,522HSBC ordinary equity 18,655 20,425 22,369 24,522Customer loans 88,456 95,875 105,963 120,284Debt securities holdings 28,248 34,762 35,679 36,660Customer deposits 106,373 115,946 127,541 144,121Interest earning assets 133,787 139,836 151,966 168,001Total assets 137,935 148,853 162,392 181,126

Capital (%)

RWA (SARm) 123,778 136,476 148,392 164,996Core tier 1 15.1 15.0 15.1 14.9Total tier 1 15.1 15.0 15.1 14.9Total capital 16.0 15.9 15.9 15.6 Ratio, growth & per share analysis

Year to 12/2013a 12/2014e 12/2015e 12/2016e

Year-on-year % change

Total income 7.4 6.2 7.7 9.6Operating expense 5.4 3.8 4.4 4.4Pre-provision profit 8.8 7.8 9.8 12.6EPS 6.4 14.9 9.9 10.7HSBC EPS 6.4 14.9 9.9 10.7DPS -50.0 36.5 9.9 10.7NAV (including goodwill) 10.0 9.5 9.5 9.6

Ratios (%)

Cost/income ratio 39.0 38.1 37.0 35.2Bad debt charge 0.7 0.5 0.5 0.6Customer loans/deposits 83.2 82.7 83.1 83.5NPL/loan 1.1 1.1 1.1 1.1NPL/RWA 0.8 0.8 0.8 0.8Provision to risk assets/RWA 1.7 1.4 1.3 1.3Net write-off/RWA 1.0 0.5 0.3 0.3Coverage 204.7 172.0 169.7 166.1ROE (including goodwill) 14.2 14.8 14.9 15.0

Per share data

EPS reported (fully diluted) 2.52 2.90 3.18 3.53HSBC EPS (fully diluted) 2.52 2.90 3.18 3.53DPS 0.43 0.58 0.64 0.71NAV 18.66 20.42 22.37 24.52NAV (including goodwill) 18.66 20.42 22.37 24.52

Core profitability (% RWAs) and leverage

Year to 12/2013a 12/2014e 12/2015e 12/2016e

Net interest income 2.7 2.8 2.7 2.7Trading profits 0.1 0.0 0.0 0.0Other income 0.5 0.5 0.5 0.5Operating expense -1.6 -1.6 -1.5 -1.4Pre-provision profit 2.5 2.6 2.6 2.6Bad debt charge -0.5 -0.4 -0.4 -0.4HSBC attributable profit 2.1 2.2 2.2 2.3Leverage (x) 6.9 6.7 6.7 6.7Return on average tier 1 13.5 14.1 14.2 14.3 Valuation data

Year to 12/2013a 12/2014e 12/2015e 12/2016e

PE* 11.5 10.0 9.1 8.3Pre-provision multiple 9.3 8.7 7.9 7.0P/NAV 1.6 1.4 1.3 1.2Equity cash flow yield (%) 8.3 6.9 8.1 8.1Dividend yield (%) 1.5 2.0 2.2 2.4Note: * = Based on HSBC EPS (fully diluted) Issuer information

Share price (SAR)29.10 Target price (SAR)37.00 (%)

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Reuters (Equity) 1080.SE Bloomberg (Equity) ARNB ABMarket cap (USDm) 7,804 Market cap (SARm) 26,605Free float (%) 34 Country Saudi Arabia Sector COMMERCIAL BANKSAnalyst Aybek Islamov Contact +9714 423 6921

Price relative

Source: HSBC, price at close of 22 July 2014

15171921232527293133

15171921232527293133

2012 2013 2014 2015Arab National Bank Rel to TADAWUL ALL SHARE INDEX

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BSFR AB, Price SAR33.5, N, TP SAR37 Company description Banque Saudi Fransi established in 1977 is among the top 5 banks in Saudi Arabian banking sector by loan market share. It controls 11% of the total loan market & 9% of assets in Saudi Arabia as of the end of March 2014. Credit Agricole CIB, the corporate and investment banking entity of Credit Agricole Group (ACA FP, Price EUR10.3, OW), is the largest stakeholder in the bank, with a 31.1% stake, followed by the Government of Saudi Arabia with a 13.2% stake.

Banque Saudi Fransi is the leading commercial bank in KSA serving both national and international clientele. It provides conventional and Islamic commercial banking services including asset management services, credit cards and corporate banking solutions. It has a fully owned subsidiary, Saudi Fransi Capital, which mainly provides investment banking services.

As of December 2013, BSF had a distribution network of 83 branches across Saudi Arabia with an employee base of 2,660.

Investment thesis One-off normalisation in bad asset charge should lift 2014e ROE to 12.5% from 10.7% last year. We forecast a 28% drop in bad asset charges in 2014e. As a result, we expect a sharp improvement in ROE, to 12.5% in 2014e from 10.7% in 2013. BSF has made positive progress in terms of portfolio provisions, increasing them to 0.8% in 2013 from 0.7% in 2012. However, we still think the ratio will need to improve further from here. We forecast cost of risk of 57bp and 58bp in 2014e

and 2015e, respectively, and expect the majority of future loan loss provisions to be directed into the collective provision reserve.

Recovery in fee income growth. The pick-up in off balance sheet business (+17% yoy in 2013) should lead to better fee growth. We expect BSF to grow its total fees 9% in 2014e and 8% in 2015e.

Financials We forecast BSF to report earnings of SAR3.07bn (before zakat) in 2014e, increasing 27% y-o-y with ROE of 12.5%. Our earnings estimates are inline with Bloomberg consensus for 2014e and 6% below consensus for 2015e.

Valuation We derive our target prices for Saudi banks using a residual income methodology, using an inflation differential model to calculate the cost of equity. The residual income valuation approach calculates the fair value of the company as the sum of its current net asset value and the present value of its future residual income.

To calculate the cost of equity by the inflation differential method, we assume cost of equity as the sum of the US risk-free rate (3.0%), the inflation differential between Saudi Arabia and the US (2.6%) and the equity risk premium (5.5%) multiplied by the stock beta (1.0 for Saudi banks we cover). Our estimated cost of equity for BSF is 11.1%. Under our research model, for stocks without a volatility indicator, the Neutral band is 5 percentage points above and below the hurdle rate for Saudi stocks of 9%. Our target price of SAR37 implies a potential return of 10%, which is within the Neutral band of 4%-14% for

Banque Saudi Fransi



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non-volatile Saudi stocks; therefore, we rate the stock Neutral. The stock is currently trades at 1.6x 2014e book value, for an ROE of 12.5%.


Risks Key downside risks include: Downside risks centre on further deceleration

in loan growth, largely driven by weak corporate demand.

Key upside risks include: Upside risks centre on lower bad asset

charges than we estimate. A 10bp reduction in cost of risk versus our base case would lead to an additional 7ppt of EPS growth in 2014e.

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Financials & valuation: Banque Saudi Fransi Neutral Financial statements

Year to 12/2013a 12/2014e 12/2015e 12/2016e

P&L summary (SARm)

Net interest income 3,363 3,697 4,041 4,981Net fees/commissions 1,150 1,251 1,350 1,465Trading profits 106 150 40 0Other income 434 428 447 417Total income 5,053 5,526 5,878 6,863Operating expense -1,684 -1,776 -1,853 -1,976Bad debt charge -957 -688 -768 -865Other -5 3 4 4HSBC PBT 2,406 3,066 3,261 4,026Exceptionals 0 0 0 0PBT 2,406 3,066 3,261 4,026Taxation 0 0 0 0Minorities + preferences 0 -2 -2 -2Attributable profit 2,406 3,064 3,259 4,023HSBC attributable profit 2,406 3,064 3,259 4,023



Capital (%)


Year to 12/2013a 12/2014e 12/2015e 12/2016e


Total income 0.9 9.4 6.4 16.8Operating expense 8.5 5.4 4.3 6.6Pre-provision profit -2.6 11.3 7.3 21.4EPS -20.2 27.4 6.4 23.5HSBC EPS -20.2 27.4 6.4 23.5DPS -66.7 27.4 6.4 23.5NAV (including goodwill) 6.1 11.1 10.6 11.9

Ratios (%)

Cost/income ratio 33.3 32.1 31.5 28.8Bad debt charge 0.9 0.6 0.6 0.6Customer loans/deposits 84.6 85.3 84.6 84.6NPL/loan 1.3 1.2 1.0 1.1NPL/RWA 0.9 0.8 0.7 0.8Provision to risk assets/RWA 1.3 1.4 1.4 1.4Net write-off/RWA -0.2 -0.2 -0.2 -0.3Coverage 146.2 168.0 194.4 176.6ROE (including goodwill) 10.7 12.5 12.0 13.3

Per share data



Year to 12/2013a 12/2014e 12/2015e 12/2016e


Year to 12/2013a 12/2014e 12/2015e 12/2016e


Share price (SAR) 33.50 Target price (SAR)37.00 (%)

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Reuters (Equity) 1050.SE Bloomberg (Equity) BSFR ABMarket cap (USDm) 10,766 Market cap (SARm) 30,737Free float (%) 40 Country Saudi Arabia Sector COMMERCIAL BANKSAnalyst Aybek Islamov Contact +9714 423 6921

Price relative


1618202224262830323436

1618202224262830323436

2012 2013 2014 2015Banque Saudi Fransi Rel to TADAWUL ALL SHARE INDEX

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RIBL AB, Price SAR18.35, Neutral, TP SAR20.5 Company description Riyad Bank was established in 1957. It has the third-largest branch network in Saudi Arabia and is currently mainly owned by Saudi shareholders.

We estimate it had market share of around 12% in loans and 11% in deposits as of March 2014. Riyad bank is engaged in a wide array of retail and corporate banking services. The bank is primarily a corporate bank with corporate loans forming 74% of the total loan book end of Q1 2014. In December 2013, SAMA issued the first license for real estate financing and lease financing to Riyad Bank.

Investment thesis Good growth in core revenue. Stable increases in the customer loan portfolio provide a good base for core revenue to grow. Core revenue improved sequentially in both Q4 13 and Q1 14 and we forecast growth of 9% in 2014e and 12% in 2015e, which is above the sector averages.

Funding cost optimisation remains a strategic priority. Riyad Bank has the second highest funding costs in our coverage (after BSF) at 57bp as at Q1 14 (peer group average = 40bp). While funding costs do not appear to be an issue within a very liquid banking sector and low interest rate environment, Riyad Bank does need to improve its collection of demand deposits. The ratio of demand deposits reduced to 42% in Q1 14, down from 47% the year before.

Collective provisions too low in view of the current loan growth. Similar to BSF, we think Riyad Bank should reconsider the adequacy of its collective provision reserves, which reduced to 0.8% of gross loans in 2013, from 1% in 2010. In fact, the size of Riyad Banks collective provision reserve has not changed since 2010, despite a 23% increase in the loan book. We forecast cost of risk of 50bp and 60bp in 2014e and 2015e, respectively, and, in the absence of large impairments, expect the bulk of provisions to flow into the collective provision reserve. Financials We forecast Riyad bank to report earnings of SAR4.26bn (before zakat) in 2014e, an increase of 8% over 2013, on the back of 11% and 8% increases in non-interest income and net interest income respectively, generating an ROE of 12.8%. Our earnings estimates are 2% and 1% above Bloomberg consensus for 2014e and 2015e respectively.


To calculate the cost of equity by the inflation differential method, we assume cost of equity as the sum of the US risk-free rate (3.0%), the inflation differential between Saudi Arabia and the US (2.6%) and the equity risk premium (5.5%) multiplied by the stock beta (1.0 for Saudi banks

Riyad Bank



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we cover). Our estimated cost of equity for Riyad bank is 11.1%. Under our research model, for stocks without a volatility indicator, the Neutral band is 5 percentage points above and below the hurdle rate for Saudi stocks of 9%. Our target price of SAR20.5 implies a potential return of 12%, which is within the Neutral band of 4%-14% for non-volatile Saudi stocks, therefore we rate the stock as Neutral. The stock is currently trading at 1.6x 2014e book value, for an ROE of 12.8%.


Risks Key upside risks include: Upside risks centre on stronger loan growth,

exceeding our base case forecast of 13% in 2014e. Also, an increase in the dividend pay-out ratio would accelerate ROE recovery at Riyad Bank. The bank currently has a pay-out ratio of 56%.

Key downside risks include:

Downside risks relate to worse-than-expected asset quality and a stronger decline in NIM than we forecast

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Financials & valuation: Riyad Bank Neutral Financial statements

Year to 12/2013a 12/2014e 12/2015e 12/2016e

P&L summary (SARm)

Net interest income 4,697 5,058 5,692 6,704Net fees/commissions 1,821 2,019 2,196 2,416Trading profits -4 0 0 0Other income 559 616 592 590Total income 7,074 7,693 8,479 9,710Operating expense -2,578 -2,789 -2,901 -3,078Bad debt charge -627 -710 -966 -1,434Other 79 62 69 76HSBC PBT 3,947 4,257 4,681 5,274Exceptionals 0 0 0 0PBT 3,947 4,257 4,681 5,274Taxation 0 0 0 0Minorities + preferences 0 0 0 0Attributable profit 3,947 4,257 4,681 5,274HSBC attributable profit 3,947 4,257 4,681 5,274



Capital (%)


Year to 12/2013a 12/2014e 12/2015e 12/2016e


Total income 4.2 8.7 10.2 14.5Operating expense 9.7 8.2 4.0 6.1Pre-provision profit 1.3 9.1 13.8 18.9EPS 13.9 7.8 10.0 12.7HSBC EPS 13.9 7.8 10.0 12.7DPS 11.5 7.6 10.0 12.7NAV (including goodwill) 5.3 5.2 5.5 5.9

Ratios (%)


Per share data



Year to 12/2013a 12/2014e 12/2015e 12/2016e


Year to 12/2013a 12/2014e 12/2015e 12/2016e



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Reuters (Equity) 1010.SE Bloomberg (Equity) RIBL ABMarket cap (USDm) 14,677 Market cap (SARm) 49,500Free float (%) 31 Country Saudi Arabia Sector COMMERCIAL BANKSAnalyst Aybek Islamov Contact +9714 423 6921

Price relative


9

11

13

15

17

19

21

9

11

13

15

17

19

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2012 2013 2014 2015Riyad Bank Rel to TADAWUL ALL SHARE INDEX

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SAMBA AB, Price SAR42.0, OW, TP SAR55 Company description Samba was established in 1980 and was branded the Saudi American bank until 2003. Samba is primarily a corporate bank. As of March 2014, Samba had a network of 72 branches. Samba has 10% market share in loans & 11% in assets in Saudi Arabia as of the end of March 2014.

Samba was established as a joint-stock company with the takeover of Citibank branches in Jeddah and Riyadh, under a Saudi programme that forced all foreign banks to share ownership, with local Saudi nationals acquiring 60% ownership. In 1999, Samba merged with United Saudi Bank (USB) through a share exchange. Citibank sold its 20% ownership stake in Samba in 2003 to the General Organization of Social Insurance (GOSI). In 2007 Samba acquired majority ownership in the then-named Crescent Commercial Bank, now known as Samba Bank Limited Pakistan. The subsidiary provides commercial banking services and turned profitable in 2011 for the first time. Samba increased its ownership in the subsidiary in 2010, from 68% to 81% currently.

Investment thesis Strong capacity to improve asset mix in favour of loans. Sambas loan to asset ratio improved to 57% in Q2 14 from a low of 43% in 2010. We see further scope for improvement, as the bank focuses on loan-driven growth. We normalise Sambas loan to asset ratio at 60%, and see scope for it to rise further. For comparison, peer banks in Saudi have loan to asset ratios of 65% on average.

Core revenue growth and strong funding franchise. As a result, we expect core revenue growth at Samba to recover to 8% in 2014e and 9% in 2015e from -3% in 2013. Sambas competitive advantage centres on its strong funding franchise. Demand deposits make up 67% of total deposits at the bank and the absolute funding cost was just 68bp in Q1 14. This gives Samba strong capacity to grow its customer loans without large upside risk to funding costs. Sambas loan to deposit ratio remains low at 72% and we normalise this to 75% going forward.

Generous collective reserve keeps cost of risk low. While the bank does not fully disclose its collective provision reserves, the portion of the collective reserve disclosed in Tier 2 (SAR1,566m), is equivalent to 1.3% of the loan book. This makes Samba the bank with highest collective provision ratio within our Saudi coverage. Although, similar to Alrajhi bank, Samba appears to have a shortfall in terms of specific loan loss reserves, Samba can cover any shortfall by using its collective provisions. Hence, rich collective provision should prevent volatility in cost of risk, which is so common to other Saudi banks.

Financials We forecast Samba to report earnings of SAR4.8bn (before zakat) in 2014e, an increase of 7% over 2013, on the back of 7% increases in non-interest income and net interest income respectively, generating an ROE of 13.7%. Our earnings estimates are 2% and 1% above Bloomberg consensus in 2014e and 2015e, respectively.

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To calculate the cost of equity by the inflation differential method, we assume cost of equity as the sum of the US risk-free rate (3.0%), the inflation differential between Saudi Arabia and the US (2.6%) and the equity risk premium (5.5%) multiplied by the stock beta (1.0 for Saudi banks we cover). Our estimated cost of equity for Samba is 11.1%. Under our research model, for stocks without a volatility indicator, the Neutral band is 5 percentage points above and below the hurdle rate for Saudi stocks of 9%. Our target price of SAR55 implies a potential return of 31%, which is above the Neutral band of 4%-14% for non-volatile Saudi stocks; therefore, we rate the stock Overweight. The stock is currently trading at 1.4x 2014e book value, for an ROE of 13.7%.

Potential return equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated. We do not include dividend yields in our potential returns for the Saudi banks, since we use a residual income methodology to value our stocks.

Risks Key downside risks include: Downside risks to our rating and target price

include stronger aversion to loan risk as a result of negative pressure on loan pricing, in particular in the corporate banking segment.

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Financials & valuation: Samba Financial Group Overweight Financial statements

Year to 12/2013a 12/2014e 12/2015e 12/2016e

P&L summary (SARm)

Net interest income 4,528 4,727 5,240 6,152Net fees/commissions 1,600 1,813 2,011 2,231Trading profits 293 215 140 0Other income 579 730 659 639Total income 7,001 7,485 8,049 9,022Operating expense -2,137 -2,221 -2,346 -2,541Bad debt charge -353 -451 -507 -703Other 0 0 0 0HSBC PBT 4,510 4,812 5,197 5,778Exceptionals 0 0 0 0PBT 4,510 4,812 5,197 5,778Taxation 0 0 0 0Minorities + preferences 0 0 0 0Attributable profit 4,510 4,812 5,197 5,778HSBC attributable profit 4,510 4,812 5,197 5,778



Capital (%)


Year to 12/2013a 12/2014e 12/2015e 12/2016e


Total income 4.6 6.9 7.5 12.1Operating expense 3.6 3.9 5.6 8.3Pre-provision profit 5.0 8.2 8.4 13.6EPS 4.2 6.7 8.0 11.2HSBC EPS 4.2 6.7 8.0 11.2DPS 0.3 6.7 8.0 11.2NAV (including goodwill) 10.1 8.4 8.4 8.6

Ratios (%)


Per share data



Year to 12/2013a 12/2014e 12/2015e 12/2016e


Year to 12/2013a 12/2014e 12/2015e 12/2016e



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Reuters (Equity) 1090.SE Bloomberg (Equity) SAMBA ABMarket cap (USDm) 13,437 Market cap (SARm) 49,485Free float (%) 51 Country Saudi Arabia Sector COMMERCIAL BANKSAnalyst Aybek Islamov Contact +9714 423 6921

Price relative


222732374247525762

222732374247525762

2012 2013 2014 2015Samba Financial Group Rel to TADAWUL ALL SHARE INDEX

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RJHI AB, Price SAR67.75, Neutral, TP SAR74 Company description Al Rajhi was established in 1957 and was established as a Saudi share holding company in 1988.

Al Rajhi bank is run by a management organization that includes the headquarters in Riyadh and six regional departments. The bank has the largest network of branches (over 500 branches) in the Kingdom and largest ATM network. The bank also has a presence in Malaysia, Kuwait and Jordan.

Investment thesis Core revenue growth will struggle to improve. Slowing loan growth and a declining NIM will constrain core revenue growth at Alrajhi Bank. We estimate net interest income and fee income will grow at a 4% CAGR 2013-2015e.

Pressure on operating costs constrains pre-provision income growth. In addition to slow core revenue growth, we expect Alrajhi bank to see upward pressure on operating costs. A relatively heavy reliance on remittance business where the bank has to rely on outsourced labour means upside risk to operating costs in light of the recent labour crackdown in Saudi Arabia. We believe that outsourced labour costs could more than double as the supplying companies either have to employ more Saudis or pay up for work permits for expat

employees. Growth in operating costs already accelerated to 12% yoy in Q1 14, from 7% in 2013. We therefore expect pre-provision income in 2014e to remain flat on last year.

Specific provisions may need to rise further. The low 2.3% collateral to loan ratio means the specific provisions may continue to surprise negatively as and when impairments occur at Alrajhi. We note that the sum of disclosed collateral against individually impaired loans of SAR971m and specific loan loss reserves of SAR1,789m fell short of NPLs of SAR3,008m by SAR248m as at Q4 13. This shortfall is equivalent to 2% of 2013 pre-provision income. We factor in a cost of risk of 110bp and 93bp in 2014e and 2015e, respectively.

Financials We forecast Al Rajhi to report earnings of SAR7.75bn (before zakat) in 2014e, an increase of 4% over 2013, on the back of 5% increase in net interest income, generating an ROE of 20.6%. Our earnings estimates are 1% and 6% below Bloomberg consensus in 2014e and 2015e, respectively.

Valuation We derive our target prices for Saudi banks using a residual income methodology, using an inflation differential model to calculate the cost of equity. The residual income valuation approach calculates the fair value of the company as the sum of its

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current net asset value and the present value of its future residual income. The residual income is measured as an excess return over cost of equity.

To calculate the cost of equity by the inflation differential method, we assume cost of equity as the sum of the US risk-free rate (3.0%), the inflation differential between Saudi Arabia and the US (2.6%) and the equity risk premium (5.5%) multiplied by the stock beta (1.0 for Saudi banks we cover). Our estimated cost of equity for Al Rajhi is 11.1%. Under our research model, for stocks without a volatility indicator, the Neutral band is 5 percentage points above and below the hurdle rate for Saudi stocks of 9%. Our target price of SAR74 implies a potential return of 9%, which is within the Neutral band of 4%-14% for non-volatile Saudi stocks; therefore, we rate the stock Neutral. The stock is currently trading at 2.8x 2014e book value, for an ROE of 20.6%.


Risks Key downside risks include: Downside risk includes further cuts in the

dividend pay-out ratio. Note that Alrajhi Bank reduced its pay-out ratio to 50% based on 2013 profit from 62% a year ago.

Key upside risks include: Upside risks centre on stronger lending

volumes, in particular in the corporate segment. Also, a stronger-than-expected decline in bad asset charges may lead to stronger EPS growth than we forecast.

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Financials & valuation: Alrajhi Banking & Investm Neutral Financial statements

Year to 12/2013a 12/2014e 12/2015e 12/2016e

P&L summary (SARm)

Net interest income 9,606 10,056 10,474 11,341Net fees/commissions 2,846 2,916 3,095 3,302Trading profits 0 0 0 0Other income 1,663 1,507 1,553 1,622Total income 14,115 14,480 15,122 16,265Operating expense -4,057 -4,474 -4,804 -5,152Bad debt charge -2,619 -2,253 -2,109 -2,051Other 0 0 0 0HSBC PBT 7,438 7,752 8,209 9,062Exceptionals 0 0 0 0PBT 7,438 7,752 8,209 9,062Taxation 0 0 0 0Minorities + preferences 0 0 0 0Attributable profit 7,438 7,752 8,209 9,062HSBC attributable profit 7,438 7,752 8,209 9,062


Ordinary equity 36,155 39,274 42,586 45,942HSBC ordinary equity 36,155 39,274 42,586 45,942Customer loans 186,813 208,452 228,708 250,527Debt securities holdings 16,117 16,843 17,618 18,445Customer deposits 231,589 257,064 287,912 322,461Interest earning assets 264,634 281,249 308,377 343,460Total assets 279,871 306,430 340,801 379,

Documents

Saudi Arabia a Guide to the Market by HSBC