Mobily played out; STC unfolding

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1 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Saudi Arabia Telecom Mobily played out; STC unfolding We initiate coverage on the Saudi telecom sector with an optimistic outlook. The Kingdom s telcos have been investing in network upgrades and are, in our opinion, well-placed to tap emerging broadband and data services opportunities. We see Saudi Telecom Company (71/STC AB), which is ahead in the capex cycle, offering a free cash flow yield nearly twice that of Etihad Etisalat (Mobily) (72/EEC AB), which is currently making considerable capital investments. We find STC s valuation most attractive, the risk perception around the shares to be overdone and the recent weakness in the shares as a lucrative entry point. Mobily, a pure play on the Saudi market, has recorded strong earnings growth and ROE well above peer average, however, shares had a phenomenal run and we see them as almost fairly valued at current levels. BUY STC with TP of SAR 51.1/share, HOLD Mobily: With STC regaining the domestic market initiative backed by an upgraded fixed broadband infrastructure capable of bringing interactive entertainment and high-speed data to every Saudi home and business, much of its capex spend behind coupled with some international operations turning EBITDA positive STC is undoubtedly our top-pick. We start STC with BUY recommendation and Target Price (TP) of SAR 51.1 per share implying an upside of 28%. Our initiation on Mobily is with HOLD recommendation and TP of SAR 8.6 per share, suggesting a moderate upside of 8%. With an EV/EBITDA 213 of 4.6x 213, STC is at a 17% discount to the Middle East and Africa (MEA) peers, while at 6.9x, Mobily is trading at a premium of 24% to MEA peers. Increasing broadband penetration and data revenue to drive top line: We expect STC to deliver a top-line CAGR of 3.9% versus Mobily s 5.4% for the period e. Broadband services is the main driver to revenue growth, with segment penetration (as a % of household) forecast to reach 6% in 217 compared to an estimated 45% in 212. Favorable demography (high percentage of a tech savvy, young population, ~57% under 3y), rising number of internet users, low levels of broadband penetration, increasing smartphone adoption in the Kingdom coupled with a potentially large appetite for data intensive entertainment solutions and a push towards e-government would primarily drive demand in the broadband market. Unlike voice services (where mobile services substituted fixed line), the emerging trend of data service adoption through Wi-Fi networks (vis-à-vis cellular network) is gaining traction across several developed markets. EBITDA margins to expand; earnings outlook positive: We forecast broadband to drive growth for Saudi telcos, with STC expected to leverage on its dominant market position in the fixed line/ftth operations (fiber ~1x Mobily), push into mobile broadband and pricing power while international market growth prospects convert into EBITDA contribution. Leadership position in mobile broadband space, management track record and superior ROE s are positives for Mobily. We expect EBITDA margins for both entities to expand ~12-25 bps to ~38-39% levels. Earnings are projected to grow at an average 4-7% yoy over the next five years. International markets offer long-term growth prospects for STC: International markets offer long-term growth opportunities and earnings diversification. However, in view of the ongoing political risks across the Middle East region and recent one-off hits, investors are likely to attach a discount to diversified telcos like STC. We believe the Saudi market is relatively well-insulated from various regional risks and domestic focused Mobily offer a better perceived risk profile vis-à-vis STC. However, we see that the attractive growth prospects of STC s international operations, including Kuwait (top line up ~127% during ) and Bahrain (up ~17% over the same period), have been overshadowed. Nevertheless, with an estimated ~77% of EBITDA coming from Saudi Arabia, the 33% discount on EV/EBITDA 213 on STC relative to Mobily is, in our opinion, excessive and should narrow in the coming year. Rating Summary Company Rating Price Saudi Telecom (STC) Etihad Etisalat (Mobily) Target Price Upside BUY % HOLD % Zain KSA NC* - - Prices as of February 11, 213; * Not covered Valuation Summary 213e Company Saudi Telecom (STC) Etihad Etisalat (Mobily) P/E EV/ EBITDA Dividend yield Cash flow yield % 12.8% % 7.3% Sources: Company, analysis Telecom stock movement vs TASI Source: Bloomberg TASI STC EEC Sector Coverage Roy Cherry rcherry@fransicapital.com.sa Refer to important terms or use, disclaimers and disclosures on back page.

2 Revenue (in SAR bn) Ebitda margin (%) EPS (in SAR per share) Net income margin (%) Capex (in SAR bn) Capex-Sales (%) Revenue (in SAR bn) Ebitda margin (%) EPS (in SAR per share) Net income margin (%) Capex (in SAR bn) Capex-Sales (%) Saudi Arabia Telecom STC: Key Forecast Revenue and EBITDA margin ( e) EPS vs Net income margin ( e) Capex vs Capex-Sales ( e) % % 6 38% % 3 34% 2 32% % 7 22% % % 3 16% 2 14% 1 12% 12 3% % 8 2% 6 15% 4 1% 2 5% 3% 1% % e 214e 215e 216e 217e e 214e 215e 216e 217e e 214e 215e 216e 217e Revenue Ebitda Margin (%) (RHS) EPS Net Income Margin (%) (RHS) Capex Capex-sales (%) (RHS) Sources: Company reports, analysis Note: Forecast based on existing accounting methodology, EBITDA and net income margins exclude one-off s. Mobily: Key Forecast Revenue and EBITDA margin ( e) EPS vs Net income margin ( e) Capex vs Capex-Sales ( e) 4 42% % % % 15 34% 1 32% 5 3% 14 29% % % % 6 25% 4 24% 2 23% 6 3% % 4 2% 3 15% 2 1% 1 5% 3% 22% % e 214e 215e 216e 217e Revenue Ebitda Margin (%) (RHS) e 214e 215e 216e 217e EPS Net Income Margin (%) e 214e 215e 216e 217e Capex Capex-sales (%) (RHS) Sources: Company reports, analysis Note: 212 EPS adjusted for 77mn shares Page 2

3 Saudi Arabia Telecom Summary financials and ratios STC and Mobily STC (in SARmn) e 214e Revenue 47,469 5,78 51,787 55,662 59,372 6,722 62,659 EBITDA 21,743 2,612 19,621 2,25 2,945 22,191 23,132 Net Profit 11,38 1,863 9,436 7,729 7,351 8,875 9,135 Earnings per share, SAR Dividend per share, SAR Total Assets 99,762 19,587 11, ,42 117, , ,97 Total Debt 36,321 36,19 33,697 33,598 34,823 37,526 38,36 Total Equity 42,562 5,833 53,464 54,82 58,969 64,543 69,467 Key Ratio and Valuation EBITDA margin (%)* 45.8% 4.6% 37.9% 36.% 35.3% 36.5% 36.9% Capex/ Sales 34.3% 3.8% 21.9% 14.1% 14.8% 16.% 15.% ROAA (%) 13.3% 1.7% 9.1% 7.1% 7.% 7.8% 7.5% ROAE(%) 3.5% 28.% 23.1% 17.2% 16.3% 17.8% 16.9% Cash flow yield (%) 6.1%.4% 12.3% 1.8% 4.2% 12.8% 14.1% P/Earnings P/Book EV/ EBITDA P/Sales Mobily (in SARmn) e 214e Revenue 1,795 13,58 16,13 2,52 23,642 25,553 26,461 EBITDA 3,794 4,837 6,165 7,454 8,591 9,267 9,66 Net Profit 2,92 3,14 4,211 5,83 6,18 6,46 6,797 Earnings per share, SAR Dividend per share, SAR Total Assets 27,192 3,926 33,43 37,51 38,623 42,617 46,468 Total Debt 9,79 8,595 7,972 7,73 8,258 9,39 9,468 Total Equity 9,754 12,243 15,58 18,388 2,96 23,769 26,88 Key Ratio and Valuation EBITDA margin (%) 35.1% 37.% 38.5% 37.2% 36.3% 36.3% 36.5% Capex/ Sales 27.4% 25.2% 2.5% 18.5% 2.6% 17.5% 16.% ROAA (%) 8.9% 1.4% 13.1% 14.3% 15.8% 15.8% 15.3% ROAE(%) 26.7% 27.4% 3.3% 29.9% 3.6% 28.7% 26.9% Cash flow yield (%) 1.% 1.7% 3.8% 5.2% 3.8% 7.3% 8.6% P/Earnings P/Book EV/ EBITDA P/Sales Sources: Bloomberg, Company reports, analysis Note: Per share data for Mobily based on 77mn shares; * Excluding One-off charges Historical multiples based on closing prices as of February 11, 213 Page 3

4 Saudi Arabia Telecom TABLE OF CONTENTS Mobily played out; STC unfolding... 1 Summary financials and ratios STC and Mobily... 3 Investment Thesis... 6 Mobily mostly played-out, STC still unfolding... 6 Saudi Arabian Telecom Market Mobile revenue accounts for 8% of Saudi market Saturated mobile penetration in Saudi Arabia with three operators, STC leading Similar prices for mobile services leave little to differentiate on pricing front Competitive pricing for iphones; most players attracting customers through free offers STC s dominance in fixed line to continue Broadband opportunity untapped; attractive growth prospects for data services STC s superior pricing power for high-speed FTTH services Internet usage in Saudi Arabia has substantial room for growth Trend reversal of fixed-mobile substitution could unfold in data service; STC at a competitive advantage Intensifying competition; STC enjoys pricing power in FTTH Margins under pressure; high ARPU data services to drive EBITDA High bad debt provision for STC, potential to improve exists Potential value creation opportunity through network sharing for both STC and Mobily STC ahead in capex cycle; opportunity to drive asset returns higher Moderate regulatory risks & stable royalty fees Regulatory cost pressure easing, room for margin expansion as data revenue mix increase Strong balance sheet position; capital return prospects are high... 3 STC: Investment Highlights Investment Thesis STC s background: Leader among GCC telecoms Well established network infrastructure; competitive advantage in fixed broadband International markets offer long-term growth for STC, but investor concerns exist Change in reporting method starting 1Q New international opportunities for STC Morocco, Algeria and Libya... 4 Margin outlook positive Improving core operating environment to drive earnings Legacy PSTN a drag on STC s returns Capex program mostly behind for STC Strong balance sheet to support dividends Our forecast vs. consensus Q 212 results: One-off charges impact bottom line In a worst case scenario, STC could take upto 32% knock on earnings Valuation Page 4

5 Saudi Arabia Telecom We arrive at a fair value of SAR 51.1 per share for STC Mobily: Investment Highlights Investment Thesis Mobily establishing itself as market leader from being market challenger Solid mobile infrastructure; but behind in fixed broadband Data services the key margin driver, EBITDA outlook positive Earnings outlook is positive Management track record and superior ROE are positives for Mobily Mobily to continue its ambitious capex program Mobily is a key asset for Etisalat; a case for future stake increase exists... 6 Mobily expected to continue with the shareholder-friendly policy... 6 Our forecast vs. consensus Q 212 results: Continuous business momentum Valuation We arrive at a fair value of SAR 8.6 per share for Mobily Appendix: Telecom sector Appendix: Saudi Telecom Company... 7 Appendix: Etihad Etisalat Company (Mobily) Recommendation Framework Research & Advisory Department Disclaimer Page 5

6 Saudi Arabia Telecom Investment Thesis Mixed performance by Saudi telcos; Mobily outperforms on strong fundamentals Mobily mostly played-out, STC still unfolding While Etihad Etisalat (Mobily) has outperformed the Tadawul All-Share Index (TASI), Saudi Telecom Company (STC) has been an obvious long-term under-performer. STC s underperformance was initially warranted based on concerns about: 1) growing domestic competition, 2) under-performing acquisitions, 3) burden of fixed line network, 4) perceived lack of agility and innovation compared to newcomers, and 5) exposure to regional countries facing instability. STC underperforms market; Mobily a clear outperformer (27 to February 11, 213) 22 2 TASI STC Mobily Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Sources: Bloomberg, analysis Today STC has absorbed the initial shock to its business, regrouped and is, in our view, back on the offensive on multiple fronts. In our opinion, STC is regaining the domestic market initiative backed by an upgraded fixed broadband infrastructure capable of bringing interactive entertainment and high-speed data to every Saudi home and business coupled with international operations delivering growth and starting to turn EBITDA positive STC is undoubtedly our top-pick. In short, we believe the stock is at a turning point and initiate our coverage with a BUY recommendation and a target price (TP) of SAR 51.1 implying an upside of 28% to the last of SAR 39.9 per share. In contrast, we believe Mobily is almost fairly valued at current price levels and start our coverage of the stock with a HOLD recommendation and a TP of SAR 8.6, suggesting a moderate upside of 8% to the most recent closing price of SAR 74.8 per share. Page 6

7 Saudi Arabia Telecom While Mobily, is a more purist play, continuing to command a sector premium, we believe the regained traction at STC will shrink the gap in 213. We see the recent weakness in STC s shares, on the back of the one-off expenses recorded in 4Q 212, as an attractive entry point. STC is down ~8% YTD, compared to a rise of around 8% for Mobily. International diversification prospects overshadowed by ongoing tension in the region; a drag on STC s valuation STC is our top pick Company Rating Investment merits Investment risks Saudi Telecom Company (STC AB) BUY Well established infrastructure to support broadband demand Pricing power in high-speed broadband services Attracting customers through bundled service offerings International growth avenues; diversified income streams Attractive dividend yield Legacy PSTN network to drag company s ROE Near-term risks attached with international operations Bahrain/Kuwait and India Declining market share in mobile services Recent management changes pose near term risks Etihad Etisalat/ Mobile (EEC AB) HOLD Industry leading ROE s Market leadership in Mobile broadband A priced asset for Etisalat s regional growth ambition Attractive dividend yield Faster migration of broadband data into fixed networks Source: analysis Both STC and Mobily are trading at a P/E of 9.x on 213 earnings in line with GCC peers, but at a discount of 1% to their counterparts in the Middle East and Africa (MEA). On EV/ EBITDA basis, STC is trading at 4.6x on 213 EBITDA, a 17% discount to MEA and 1% discount to GCC peers, while Mobily trades at a 24% premium to MEA peers and 48% premium to GCC peers Current valuation under prices improving growth/risk profile of telcos Saudi Telecom Index valuation trend (Past P/E and P/B based on historical prices/ forward multiples based on current prices) Saudi Telecom Index valuation trend (Past EV/EBITDA and EV/ Sales based on historical prices / forward multiples based on current prices) Current 213e 214e Price/Earnings (x) Price/Book Value (x) Linear (Price/Earnings (x)) Linear (Price/Book Value (x)) EV/Sales Current 213e 214e EV/EBITDA Linear (EV/Sales) Linear (EV/EBITDA) Page 7

8 Price- B ook 213e EBITDA Margin (%) 211 Saudi Arabia Telecom Size of bubble indicates market cap Mobily Du Omantel Qtel Batelco STC Turkcell Etisalat Vodacom Zain Kuwait Maroc Telecom MTN Jordan Telecom Price- Earnings 213e Size of bubble indicates market cap Du Qtel Omantel STC Etisalat Batelco MTN Mobily Turkcell Maroc Telecom Zain Kuwait Jordan Telecom Vodacom EV / EBITDA 213e Sources: Bloomberg, analysis Potential to drive asset returns higher; capex cycle is mostly behind especially for STC The declining capex-to-sales ratio augurs well for the sector s asset return. We expect STC s capex-to-sales to moderate further to 13% during the forecast period, while Mobily is expected to maintain an average 16% capex-tosales for the next five years. Mobile network coverage is well in place for both STC and Mobily (>95% in Saudi Arabia) and services such as ADSL, FTTH and 3G/4G are being made network ready. With the international operations of STC gaining traction and FTTH services taking off in Saudi Arabia, STC is thus expected to see its capex-to-sales decline from a peak 15% expected in 213 to 13% by 217. In comparison, mature global players have capex-to-sales ratios of around 1-13% - implying our assumption is on the conservative side. However, for STC, the legacy PSTN network is expected to remain a drag on returns, which explains the gap in ROE/ROA between Mobily and STC. This would continue to be a structural gap between the telcos, with Mobily warranting a sector premium. ROE/ROA of Saudi telcos vs. MEA peers MEA - Median Maroc Telecom MTN Vodacom Turkcell Jordan Telecom Qtel Zain Kuwait Omantel Batelco Du Etisalat Mobily STC Return on Equity (%) (LFY)* MEA - Median Maroc Telecom MTN Vodacom Turkcell Jordan Telecom Qtel Zain Kuwait Omantel Batelco Du Etisalat Mobily STC Return on Assets (%) (LFY) *LFY: Last Fiscal Year Sources: Bloomberg, analysis Page 8

9 Saudi Arabia Telecom STC offers ~2x higher free cash flow yield than Mobily Although Mobily enjoys a superior ROE, STC s attractive free cash flow yield (~2x that of Mobily) is a positive in our view. As a percentage of free cash flows, we believe that Mobily would re-invest 8 9% in the business as it commences network upgrade/fiber rollout; for STC, however, we see this proportion being relatively lower with most of its FTTH expansion completed. STC generates ~2x higher free cash flows than Mobily STC free cash flows (SAR bn) STC Capex as a % of free cash flows (%) % % 8% 95.2% 83.4% 79.1% 75.% 64.9% 8 6% 4 4% 2% % 213E 214E 215E 216E 217E 213E 214E 215E 216E 217E Mobily free cash flows (SAR bn) Mobily Capex as a % of free cash flows (%) 12% 15.7% 1% 85.2% 81.8% 79.9% 78.1% 8% 4 6% 3 2 4% 1 2% % 213E 214E 215E 216E 217E 213E 214E 215E 216E 217E Sources: analysis STC 213e free cash flows offer a yield of 12.8% compared with Mobily s 7.3%. Therefore, at current prices, we would prefer buying STC s cash flows to Mobily s. Page 9

10 Saudi Arabia Telecom STC s attractive free cash flow yield Free cash flow yield STC (%) 213e-17e Free cash flow yield Mobily (%) 213e-17e 2% 18% 16% 14% 12% 1% 8% 12.8% 14.1% 15.1% 16.% 18.% 14% 12% 1% 8% 6% 7.3% 8.6% 9.5% 1.2% 11.% 6% 4% 2% 4% 2% % % 213E 214E 215E 216E 217E 213E 214E 215E 216E 217E Sources: analysis Higher risk premium for regionally diversified STC to remain a near-term stock overhang Despite prospects of earnings diversification and growth opportunity in international operations, the ongoing regional tension is likely to remain an investor concern on STC for the near term. STC is relatively less exposed (than GCC peers) to the various Middle East countries currently undergoing political tension (Egypt, Syria, Libya, Yemen and Iraq). However, uncertainty in Bahrain and to a much lesser extent Kuwait poses a risk for STC s Viva operations in the GCC region. In our view, the Saudi market is relatively well insulated from regional tension and Mobily offers a better risk profile than STC. One-off charges (totaling SAR 1.2bn) during 4Q 212 have renewed investor concerns over STC s international operations. Growth at home Key market forecasts We expect Saudi telcos to deliver healthy earnings growth over the next five years (average growth of 5.1% to 8.5% during the forecast period to 217), led by attractive growth prospects in the domestic market. Expected increase in broadband penetration in the Kingdom and a better mix of high ARPU data services with growing post-paid customer base should support EBITDA margins. Penetration of high ARPU data services is expected to arrest the downtrend in EBITDA margins; our margin projection is in the range of 36-39% over the forecast period. Both STC and Mobily are operating at margins below the MEA average. Broadband and data services to drive revenue growth Favorable environment for adoption of high ARPU data services We project single-digit yoy revenue growth for STC and for Mobily over the next five years. Increasing broadband penetration is expected to drive the top line. The broadband opportunity in the Kingdom is currently untapped. A young, tech-savvy population and growing internet user base bode well for data services. With broadband penetration as low as 5.7% of population, the Kingdom offers significant long-term potential, compared to a GCC average of 9%. While Mobily is expected to lead the mobile broadband market, we expect STC to benefit from a trend of increasing data traffic through fixed line networks. Mobile broadband is witnessing a competitive pricing environment, but we see STC commanding higher pricing power for home broadband services through its FTTH network and ability to offer bundled services including, in addition to broadband, IP TV and landline. Mobily to attain 4% market share in mobile by 217; STC to dominate fixed lines We expect Mobily to garner 4% market share (of subscribers) by 217, inching closer to market leader STC, while Zain KSA is forecasted to capture 15% of the total market. While ongoing challenges at ZAIN KSA are expected to Page 1

11 Saudi Arabia Telecom translate into near-term gains for both STC and Mobily, we have conservatively projected some growth in Zain KSA s long-term market share. We expect STC to continue leading the fixed line market with 9% share. Telecom penetration levels Target market penetration* estimate (%) 217e 25% 2% 186% 21% 15% 1% 5% 67% 7% 45% 6% 43% 7% % Fixed Line Fixed Broadband Mobile Mobile Broadband 212e 217e Source: analysis *Fixed line/ Fixed broadband penetration as a % of households STC is expected to gain mobile market share and lose some of its advantage in fixed broadband market to Mobily. Market share forecast Fixed line target market share estimate (%) 217e 12% 1% 8% 6% 4% 2% % 48% 46% 44% 42% 4% 38% 36% 34% 97% 9% 3% Mobile market share estimate (%) 217e 1% 212e 217e 212e 217e STC Others 47% 45% 39% 4% 212e 217e 212e 217e STC Mobily Fixed broadband target market share estimate (%) 217e 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Mobile broadband market share estimate (%) 217e 8% 7% 6% 5% 4% 3% 2% 1% % 95% 9% 5% 1% 212e 217e 212e 217e STC Mobily 23% 35% 73% 55% 212e 217e 212e 217e STC Mobily Source: analysis Page 11

12 Saudi Arabia Telecom Key investment risks Downside risks Aggressive price-based competition could impact telcos profitability: We see high degree of competition in the telecom sector, especially in the mobile and broadband markets, with Zain KSA fast establishing its market presence. New MVNO licenses could see higher levels of competition for customer acquisition and aggressive pricing strategies could negatively impact profitability of operators. Political tension in the region could drive equity risk premium higher for telecom: We fail to see investors attaching a premium for international market opportunities of Saudi telcos considering the ongoing political tension in various Middle East/African nations. Although Saudi Arabia is well insulated from these risks and STC operations are less exposed (than peers) to crisis-hit regions, investors could attribute a higher risk to regional exposure. Also, poor track record of Zain and Etisalat is expected to remain a concern over the prospects of international strategies by GCC telcos. However, at this stage, we do not foresee any risk to STC s operations in Turkey due to Syria s ongoing crisis and Turkey s response to the same (missile deployment at the border). Risks attached to technology changes: The telecom market is characterized by rapid technology changes, and adoption of new market technologies could impede operator returns. STC had to scale back its WiMax operations due to emergence of alternate technologies. Data traffic could increasingly turn to fixed Wi-Fi from cellular network. Such trends could significantly change operator profitability and impact asset turnover in the sector. Moderate regulatory risks, renewed investor concern for regional telcos: Besides, new MVNO license considerations at CITC, there could be potential new telecom licenses issued in the Kingdom however, this seems unlikely at the moment. In event such a development would materialize, it would be detrimental to the prospects of existing players and could significantly alter the competitive landscape and impact sector profitability and our forecasts. The recent regulatory action in the UAE (royalty fee structure changes for Etisalat/ Du) renewed investors concerns over regulatory risks for regional telcos, however, our understanding is that no such plans are in the making in Saudi Arabia. Escalation of Euro area crisis could lead to a market sell-off: While the telecom sector in Saudi Arabia is well insulated from the Euro area crisis, renewed concerns in Europe could trigger a return of risk aversion and lead to a market sell-off, thereby impacting overall stock market performance, including that of the telecom sector. Upside risks Continued challenges at Zain KSA could be positive for both STC and Mobily: We see Zain KSA s corporate restructuring as a near-term challenge that the management is attempting to sort out. However, any further delay in restructuring could benefit both STC and Mobily. The resulting decrease in the level of competition within the sector could bring about positive changes to risk/ growth profile and drive STC/ Mobily s valuation higher. Higher uptake of new broadband services, more sustainable ARPU s: Higher than expected up take of new broadband services in the Kingdom could sustain ARPU s higher for both STC and Mobily. Reduction in Government charges, especially Mobile services could provide further upside: While we do not expect any changes in the royalty fee structure, we note that CITC had earlier reduced the fixed line royalties from (15% to 1%) post introduction of new licenses. Mobile services are charged at 15% currently and any reduction of the same could drive margins and hence valuation positively. Increased disclosure, especially on STC s international operations, could help reduce perceived investment risks attached into the sector: Investor have limited insight into STC s international operations and Page 12

13 Saudi Arabia Telecom are therefore attaching a risk premium to the business, something we could see decline significantly in case of increased disclosure. Saudi Arabian Telecom Market Mobile services key driver of telecom Mobile revenue accounts for 8% of Saudi market Revenues from domestic telecom services (comprising mobile/gsm, fixed and data) rose at a CAGR of 13.2% to SAR 65.7bn during The total sector revenue, including international operations, increased at a CAGR of 17.7% to SAR 83.9bn during the same period. Dominance of mobile; STC commands ~55% revenue share 1% 8% 6% 4% 2% % Revenue market share (28 217e) Segment-wise trends in sector revenue (in SAR bn) (Total excluding international revenue) Mobily Zain KSA STC- Saudi Arabia Mobile Fixed & Data International Sources: CITC, analysis Revenues from mobile services have increased at a CAGR of 13% since 25 and account for 8% of the Saudi telecom market. Amongst all operators, STC was the most negatively impacted initially, having lost considerable subscriber share. Nonetheless, STC commands a lead over Mobily in terms of revenue share (an estimated 55% in Saudi Arabia in 212). Saturated mobile penetration in Saudi Arabia with three operators, STC leading Saturated mobile market in Saudi Arabia Mobile services have been the key driver of the Saudi telecom sector. Mobile penetration increased to 191% in 211 from 61% in 25, reflecting a mature market. Currently, the Saudi penetration rate exceeds that in the rest of GCC, baring the UAE. Emergence of new players such as Etihad Etisalat (Mobily) and Zain KSA ended STC s monopoly. However, STC continues to lead the market with ~47% subscriber share. We forecast this share to decline to 45% over the next five years due to increased competition. Mobily has acquired 39% market share in its seven years of operations; we forecast its share to stabilize at 4% by 217. The third operator Zain KSA was fast establishing its market presence, but has more recently been facing financial and growth challenges, Zain KSA is likely to hold 15% share over the next five years. We estimate penetration to rise to 21% and mobile subscriber base to 66.5mn by 217. Page 13

14 e 217e Saudi Arabia Telecom Mobily and Zain KSA expanded market presence Mobile penetration Saudi Arabia vs. MEA/ BRIC (211) Tunisia Jordan Morocco Algeria Egypt Oman Bahrain UAE Kuwait Qatar Saudi Arabia China India Russia Brazil 73% 74% 116% 12% 114% 99% 14% 156% 15% 135% 13% 124% 191% 18% Sources: ITU, IMF, CITC, analysis 218% % 4% 8% 12% 16% 2% 24% Market share by subscribers Mobile (25 17e) 1% 6% 12% 17% 16% 14% 9% 14% 15% 31% 8% 39% 41% 7% 41% 37% 39% 39% 4% Led by rapid penetration of mobile services, the share of new prepaid connections in the total subscriber base increased to nearly 88% in 211 from 67% in 25. However, with saturation of penetration levels, operators are focusing on improving the post-paid customer mix. Furthermore, CITC s stricter regulation on SIM card registration brought down the number of prepaid subscribers to 45.4mn in 3Q 212 from 47.1mn in 211. Accordingly, we expect prepaid to account for 85% of the total subscribers by 217. On the other hand, the share of postpaid subscribers is expected to improve moderately to 15% by 217. Postpaid subscribers to increase; STC and Mobily benefit from weakness at Zain KSA 1% 8% 6% 4% Prepaid/Postpaid mix Mobile (25 17e) YoY revenue growth (29 4Q 212) 67% 77% 83% 85% 86% 88% 88% 87% 85% 6% 5% 4% 3% 2% 1% % 4% 3% 2% 1% % 83% 69% 61% 53% 48% 47% 47% 47% 45% e217e 21% 7% 23% 25% STC Mobily Zain KSA 33% 17% 17% 13% 12% 11% 6% 8% 9% 2% 3% 1% 2% 2% -1% -4% 33% 23% 17% 15% 14% 12% 12% 13% 15% % -2% -15% Mar 12 Jun 12 Sep 12Dec 12 Post-Paid (%) Pre-Paid (%) Mobily Zain KSA STC- Saudi Arabia Sources: Company reports, analysis Increasing accessibility due to better affordability intensified competition and rapidly expanded the mobile segment. Consequently, ARPUs declined to less than SAR 8 per month in 212 (estimated) from ~SAR 15 per month in 25. We expect the mobile ARPU s to decline further amid the prevailing competition, segment maturity and possible inclusion of MVNOs in the coming years. We estimate ARPU in the mobile segment to decline 1 4% annually during our forecast period. Page 14

15 Subscribers (mn) ARPU (SAR per month) Saudi Arabia Telecom Subscriber additions at the cost of ARPU contraction Mobile subscriber additions at the cost of declining ARPU levels Mobile subscribers vs. ARPU (25 17e) Sources: CITC, analysis e Mobile ARPU STC/ Mobily (211 17e) in SAR per month Given STC s better postpaid subscriber mix (postpaid mix of 2 3% is high compared with the regional benchmark of 1 15%), we continue to assign it a mobile ARPU premium of 4 7% over Mobily for the near term. However, over the long term, we expect STC s ARPU to be in line with Mobily as it protects mobile market share by lowering tariffs. Meanwhile, Mobily would increasingly chase postpaid customers, which is expected to support ARPU. Thus, we expect faster contraction in mobile ARPU for STC over the forecast period (~4% annual) than Mobily (~1% annually) e 213e 214e 215e 216e 217e STC - Mobile ARPU Mobily - Mobile ARPU Similar prices for mobile services leave little to differentiate on pricing front With focus increasingly shifting toward the broadband space, there is little differentiation on the pricing front among players providing traditional mobile services (Voice/SMS). Analysis of basic plans (STC - Sawa, Mobily 7ala and Zain KSA Hala) indicates that prepaid pricing is mostly comparable between players, while there are differences in postpaid offerings. For instance, all players charge prepaid customers with 55 halalas per minute for voice calls and 25 halalas for SMS. For postpaid customers, Zain KSA (Mazaya Light plan) and STC (Jawal Easy) offer voice calls at 25/35 halalas respectively, while Mobily (Khatty) offers the same for 45 halalas. Competitive pricing for mobile services Mobile - Prepaid pricing Basic offers Mobile - Postpaid pricing Basic plans Fee (SAR) Voice Call SMS STC - Sawa Mobily - 7ala Zain KSA - Hala Voice call: in halalas per minute; SMS: in halalas per message Fee (SAR) Voice Call SMS STC -Jawal Easy Mobily - Khatty Zain KSA - Mazaya Light Voice call: in halalas per minute; SMS: in halalas per message Sources: analysis Page 15

16 Saudi Arabia Telecom We note players are competing through free benefits plans to make free calls/sms, with STC s pricing being more attractive. For instance, STC charges SAR 99 for monthly free benefits compared to SAR 14 by Mobily and Zain KSA. Overall, we find Zain KSA playing the pricing game, while STC is drawing customers through free benefits offers. Zain KSA remains the most aggressive offering attractive pricing plans. STC s attractive pricing of free benefits plan Free benefits plans - Charge by validity (in SAR) STC - Sawa Mobily - 7ala Zain KSA - Hala 1 day 1 Week 1 Month Free benefits include unlimited free calls (within network) and free SMS Sources: analysis Competitive pricing for iphones; most players attracting customers through free offers Besides competitive pricing for Voice/SMS, telcos are offering attractive pricing plans for smartphones. iphone offerings are competitively priced in the Kingdom, with Zain KSA triggering a competition by recently slashing prices by 15 35% across variants. However, most players are pushing the product free of cost to monetize through high APRU postpaid connections. For instance, STC offers entry level 8GB iphone free to customers who sign up for 12 months at SAR 249 per month, and most iphone variants (except 64GB) free for a 18-month period. Zain offers iphone 4 (8GB) for just SAR 45 in its SAR 15 per month plan, while it offers iphone free of cost in the SAR 45 per month plan(mazaya Elite). Mobily s offer of 8/16 GB free with SAR 349 per month plan appears the least attractive. STC also offers iphone 5 (16Gb) free of cost for customers who sign-up for 18 months. Overall, we note that while Zain KSA has attractively priced iphone products, STC s free offerings are drawing relatively more customer sign ups. Zain KSA aggressively pricing iphone offerings iphone product pricing (in SAR) Starting plans for free iphone offers (in SAR per month) NA. 4-8GB 4S - 16GB 4S - 32GB 4S - 64GB STC Mobily Zain* STC Mobily Zain 4-8GB 4S - 16GB 4S - 32GB * Zain has attractively priced the iphone 4 (8 GB) at just SAR 45 Sources: analysis Page 16

17 Saudi Arabia Telecom Introduction of mobile number portability (MNP) has also increased the level of competition in the Kingdom. Although operators are focusing on converting a share of prepaid to post-paid mix to reduce subscriber churn, we expect service quality to determine operator switching than competitive pricing. In our view, STC has a slightly better edge over Mobily due to its better network coverage and bundled services offerings that may inhibit operator switching. In addition, STC can draw operational experience from Turkey (through Oger Telecom), where MNP was introduced few years back. Quality of Service All players meet CITC benchmarks Service quality 211 Voice quality standards (score) % <2% <2% 2.% 1.5% 1.% 1.% 1.% 1.%.61%.41%.5%.%.% Unsuccessful Call rate Call drop rate STC Mobily Zain KSA CITC Standards >3.5 STC Mobily Zain KSA CITC Standards Sources: CITC, analysis Operators are also cashing in on the high traffic during the Hajj season (Islamic pilgrimage) in the Kingdom. STC launched two types of SAWA Haj SIM cards for the Haj season. STC also provided IP based Virtual Private Network (IPVPN) connectivity to all railway stations. Mobily too is investing for Hajj traffic adding 15 new towers at Makkah and Mashair. In addition, Mobily provided free internet access to pilgrims via WiFi in select regions. Mobily also tied up with Bahrain Air for distribution of free pre-paid SIMs for travelers. Overall, we find STC at a relative competitive advantage over Mobily due to its operating presence in Muslim populated countries such as Malaysia / Indonesia, who are frequent travelers for Hajj season. Note that the Hajj season which in recent years has been commencing in the fourth quarter and will continue to do so for the next couple of years has some impact on earnings seasonality. Typically, the quarter accounted for an average 27% of total annual revenue in 211 and 212. Due to differences between the lunar and solar year/calendar the starting date for the pilgrimage will be 1-11 days earlier each year. The Hajj is expected to move into the third quarter (both commencements and finalization) starting 215. STC s dominance in fixed line to continue Fixed line market in Saudi Arabia relatively less competitive; STC to dominate the segment The Kingdom had 4.7mn fixed line subscribers in 3Q 212 (please see Appendix A for subscriber data across fixed, mobile and broadband services). An estimated 72% (3.4mn) are connected to households, with the balance 28% (1.4mn) attributed to businesses. Most notably, fixed line subscriptions are turning the tide and delivering growth again. Total subscribers picked up to 4.7mn, supported by growth in both segments, after an initial stagnation around the 4-4.2mn level during We believe, this offers further indication of STC s renewed push which has been enhanced by better offers and bundling services and thus bringing supposedly dying assets/capabilities back to life as part of a comprehensive customer experience. STC currently holds an estimated 97% market share of fixed lines. Page 17

18 Saudi Arabia Telecom STC loses share to competition; room for growth in fixed lines Fixed line penetration Saudi Arabia vs. MEA/ BRIC (211) Tunisia Jordan Morocco Algeria Egypt Oman Bahrain UAE Kuwait Qatar Saudi Arabia China India Russia Brazil 2.7% 11.4% 7.4% 11.1% 8.5% 1.8% 9.3% 15.8% 17.3% 16.4% 21.2% 24.5% 22.1% 34.% 31.% % 1% 2% 3% 4% Market share trends in fixed line segment (25 17e) 1% 1% 1% 2% 3% 98% 96% 94% 92% 9% 88% 86% 84% 1% 1% 1% 1% 1% 99% 99% 97% 1% 9% e217e STC Others Sources: CITC, Company reports, analysis Nevertheless, faster adoption of mobile services in the Kingdom suppressed the subscriber base for fixed lines, which grew at a CAGR of just 3.9% since 25 vis-à-vis 25% for mobile. In line with regional trends of fixed to mobile substitution, we forecast a moderate increase in fixed line penetration. STC is expected to continue to lead with 9% market share until 217, while new operators such as Etihad Atheeb ( Go brand) is expected to capture the rest. We forecast the number of residential lines in Saudi Arabia to increase at a CAGR of 5.5% during and reach 4.1mn toward the end of our projection period. In addition to growth in the consumer market, the enterprise/corporate sector offers key opportunities for Saudi telcos. We expect STC to sustain its competitive advantage in this segment. The company accounts for the majority of the Kingdom s backbone infrastructure capacity (please see Appendix B for STC s infrastructure details of STC); in fact, even competitors rely on this capacity. We expect the number of business lines to increase at a CAGR of 9.3% to 2.2mn between 211 and 217. Unlike the mobile segment, fixed line is less competitive. However, faster penetration of mobile services (subsititution effect) has dented ARPU in the fixed line segment. We estimate ARPU in residential fixed line to have declined to less than SAR 125 per month in 212 from ~SAR 21 per month in 25. We expect ARPU in the residential sector to continue falling due to competition from mobile offerings. STC, which dominates the fixed line market in the Kingdom, is now offering bundled services (broadband) to fixed line subscribers to arrest the fall in ARPU. Through its Jood packages, STC offers high-speed internet services along with unlimited fixed local/national calls and attractive discounts on calls to international numbers. Unlike residential fixed line, business line yields relatively better ARPU (estimated at ~1.5x), stemming from higher minute usage/ data. We estimate ARPU in business fixed line to have declined to less than SAR 19 per month in 212 from ~SAR 315 per month in 25. During our forecast horizon, we expect ARPU in fixed line to decline 1 4% annually for both residential and business lines. Page 18

19 Residential lines (mn) ARPU (SAR per month) Business lines (mn) ARPU (SAR per month) Saudi Arabia Telecom Fixed line subscriber growth picking up, sharp decline in ARPU levels Residential fixed line subscribers (25 17e) Business line subscribers vs. ARPU (25 17e) e e Residential lines ARPU (RHS) Business lines ARPU (RHS) Sources: CITC, Company reports, analysis The wider economic development in Saudi Arabia, is translating into establishment of new economic cities, and favorable investment climate is driving new business establishments, thereby creating robust demand for connectivity. Development initiatives in the ICT sector by the government also bode well for enterprise sector demand. The increasing number of new establishments in the Kingdom is a positive for the segment growth prospects. STC has long enjoyed competitive advantage over peers due to its long-standing relationship with large corporations. The favorable investment climate for new enterprises in the Kingdom and demand from SMEs are expected to drive uptake in the business lines. While the global economy has been in turmoil, Saudi GDP growth has run between % over the past three years and it is projected to expand by 4.2% in 213 according to IMF. Meanwhile, bank lending continues to expand at a rate of 17% (3Q 212) - providing further indication of the growth underway and prospects for expansion in business line uptake. STC s current focus is on medium and large-sized businesses, while SME is considered an attractive growth market, going forward. The company has more than 55 corporate sales outlets in the Kingdom and has won several prestigious smart city projects such as KEC, ITCC, KAFD, and Olaya Towers & Knowledge City. However, new players Zain KSA, Etihad Atheeb and Mobily are increasingly capitalizing on enterprise market opportunities in Saudi Arabia. Despite challenges, Zain KSA could make inroads into the enterprise segment (specifically targeting global players having presence in the Kingdom) through its strategic partnership with Vodafone. According to Mobily, the size of the ICT market for enterprise segment in Saudi Arabia is estimated to reach SAR 29bn by 215. Broadband opportunity untapped; attractive growth prospects for data services The Saudi mobile market is saturated with a penetration of 191% in 211, higher than the GCC average. Furthermore, increasing competition from new players is clouding growth prospects. However, we expect opportunities in broadband and data to drive Saudi telcos. Broadband penetration in the Kingdom is currently low at 6% of the population and below the GCC average. Increasing internet users, favorable demographics (high percentage of tech-savvy young population, ~57% are below 3 years), and rising smartphone uptake in the Kingdom would drive the broadband market. Internet users in the Kingdom increased to 15.2mn in 3Q 212 from just 3mn in 25, reflecting an average annual growth rate of 27%. Page 19

20 Fixed Broadband Subscribers (mn) ARPU (SAR per month) Mobile Broadband Subsrciber (mn) ARPU (SAR per month) Saudi Arabia Telecom Mobily a clear leader in mobile broadband; STC closing in Mobile broadband Subscribers vs. ARPU Mobile broadband Mrket share (%) e 215e 217e Subscribers ARPU (RHS) % 8% 6% 4% 2% % 1% 2% 3% 4% 5% 7% 8% 9% 1% 83% 85% 77% 73% 69% 66% 62% 59% 55% 16% 13% 2% 23% 25% 28% 3% 33% 35% e 215e 217e STC Mobily Zain KSA Sources: CITC, Company reports, analysis We forecast the mobile broadband subscribers to reach 22.3mn towards the end of our projection period, implying a CAGR of 11.9% for the period We expect Mobily to lose out its initial advantage in the mobile broadband space to STC/ competition and expect, STC to make market share gains (to 35% by 217) as against an estimated 23% in 212 while Mobily is expected to retain its leadership position with 55% share of the market in 217. For the fixed broadband market we forecast subscribers to reach 3.5mn towards the end of our projection period, implying a CAGR of 1.5% for the period STC dominates the fixed broadband segment and is expected to retain 9% of the market share during the forecast period. However, competition from Mobily is expected to remain high given its plans for an aggressive fixed broadband strategy, posing a long-term threat to STC s dominance in this segment. STC to dominate the fixed broadband market Fixed broadband Subscribers vs. ARPU Fixed broadband Market share (%) e 215e 217e Subscribers ARPU (RHS) % 8% 6% 4% 2% % % 2% 4% 5% 6% 7% 8% 9% 1% 1% 98% 96% 95% 94% 93% 92% 91% 9% e 215e 217e STC Mobily Sources: CITC, Company reports, analysis We estimate ARPU in broadband to have declined to less than SAR 1 per month in 212 from ~SAR 18 per month in 27. We expect a moderate 1 4% decline annually in ARPU during the forecast period. In terms of pricing in mobile broadband, STC and Mobily are comparable; however, the former commands a 18 25% premium on home broadband. We do not expect Zain s aggressive pricing to remain sustainable in the mobile broadband segment. Page 2

21 Saudi Arabia Telecom Competitive pricing for broadband, but STC holds substantial advantage in fixed Mobile broadband plans SAR per month Home broadband plans SAR per month GB/ 2GB 5 GB Unlimited STC - QUICKnet Mobily - Connect Zain KSA - Speed 4G NA 2/4 MBps 1MBps 512Kbps STC - Jood Mobily - home Etihad Atheeb - Go Sources: Company, analysis Zain KSA competes on pricing in mobile broadband; STC commands pricing power in high-speed broadband STC s superior pricing power for high-speed FTTH services STC enjoys superior pricing power for FTTH services, which offers speeds up to 2 Mbps, significantly higher than its peers. The company priced high-speed offerings at ~2-3x that of the current 2/4 Mb offerings of competitors. We consider this sustainable in the near term, as competitor Mobily is behind STC in terms of cable reach in the kingdom (FTTH coverage ~1/1 that of STC) and expect STC to enjoy the first mover advantage in the near term. However, we expect a significant fall in FTTH broadband pricing over the long term. STC s superior pricing power for high-speed FTTH offerings STC s FTTH pricing for various speeds (in SAR per month) Average pricing of competitors Mbps 2 Mbps 4 Mbps 2 Mbps Sources: analysis Page 21

22 Saudi Arabia Telecom Internet usage in Saudi Arabia has substantial room for growth Benchmarked with the MEA region, we believe internet usage in Saudi Arabia is low, indicating the growth momentum would continue in the near term. Also keep in mind that in the absence of entertainment options like cinema, we believe the significance of broadband as an entertainment gateway is potentially much higher than less conservative markets. Similarly, access to computers in the Kingdom leaves room for growth and government initiatives toward overall Information Communication and Technology (ICT) development bode well for the sector. Room for further penetration of computers/internet users in Saudi Arabia Internet users Saudi Arabia vs. MEA/BRIC (211) Computer access Saudi Arabia vs. MEA/BRIC (211) Tunisia Jordan Morocco Algeria Egypt Oman Bahrain UAE Kuwait Qatar Saudi Arabia China India Russia Brazil 14.% 1.1% 39.1% 34.9% 51.% 35.6% 47.5% 38.3% 49.% 45.% 68.% 77.% 7.% 74.2% 86.2% Tunisia Jordan Morocco Algeria Oman Bahrain UAE Kuwait Qatar Saudi Arabia China India Russia Brazil 19.1% 51.4% 34.2% 2.% 58.% 87.% 76.% 69.% 87.% 57.3% 35.4% 6.1% 55.% 45.4% % 2% 4% 6% 8% 1% % 2% 4% 6% 8% 1% Sources: ITU, IMF, CITC, analysis Increasing internet users and tech-savvy, young population in Saudi Arabia positives for broadband uptake According to Communications and Information Technology Commission (CITC), there were 11.7mn mobile broadband subscribers in 3Q 212 compared with just 1.4mn at the end of 29. The Kingdom s mobile broadband penetration reached 41% at the end of 3Q 212, and is comparable with that of the developed world. While the traditional voice market is on the decline, broadband opportunities through ADSL and FTTH services offer growth opportunities in the fixed line market. Fixed line technologies offer superior speeds compared to Mobile broadband. (See Appendix C for more details of technologies in Fixed/ Mobile). STC has a comprehensive strategy of bundling content and applications into its high-speed network infrastructure and is positioning itself through triple play offers as a one-stop shop for communication and entertainment. Through Interactive TV services (InVision), STC is successfully playing up the entertainment appeal, which is strong in Saudi Arabia. The company also owns 71% stake in Dubai based Intigral, now a leading regional provider of content services and digital media serving several regional operators. Besides distributing content, Intigral s main competitive advantage is its proprietary methods of content management allowing content to be tailored and facilitate user censoring. For example, InVision users will get a heads-up if an upcoming scene could be unsuitable by Saudi norms, through the movie or tv show turning into slow-motion seconds before thus allowing the user to skip if they desire. Page 22

23 Saudi Arabia Telecom Low broadband penetration levels in the Kingdom; rising trend of net users positive Broadband penetration Saudi Arabia vs MEA/ BRIC (211) Trend in internet users (25-3Q 212) Tunisia Jordan Morocco Algeria Egypt Oman Bahrain UAE Kuwait Qatar Saudi Arabia China India Russia Brazil 5.1% 3.2% 1.8% 2.8% 2.3% 1.7% 1.3% 1.1% 5.7% 9.2% 8.6% 11.6% 12.2% 16.2% 16.1% % 4% 8% 12% 16% 2% Q 212 Internet Users % of Population (RHS) 55% 45% 35% 25% 15% 5% Sources: ITU, IMF, CITC, analysis With increasing internet users, social network usage in the Kingdom has grown. The number of users on Twitter and Facebook in the Kingdom is growing across all age and social groups. According to CITC, there were an estimated 4.8mn users of Facebook in Saudi Arabia at the end of 211, a penetration rate of 16.8% and 35.3% of total internet users. High per capita GDP and young population positives for sector Tunisia Jordan Morocco Algeria Egypt Oman Bahrain UAE Kuwait Qatar Saudi Arabia China India Russia Brazil % population under 3 years Per capita GDP 211 (USD) 44.% 54.7% 47.% 47.8% 48.9% 62.9% 49.5% 49.6% 54.4% 44.8% 57.% 43.2% 57.9% 37.1% 5.9% Tunisia Jordan Morocco Algeria Egypt Oman Bahrain UAE Kuwait Qatar Saudi Arabia China India Russia Brazil 4,317 4,618 3,84 5,53 2,932 23,572 22,918 63,626 43,723 21,196 5,417 1,514 12,993 2,493 98,144 3% 4% 5% 6% 7% 2, 4, 6, 8,1, Sources: UN, IMF, analysis Alongside growing internet users, Smartphone penetration in the Kingdom is picking up. Industry sources cite one in every two handsets sold in the Kingdom is a smartphone. According to Informa Telecoms and Media, Saudi Arabia had a smartphone penetration rate of 17.1% in 211, which is expected to reach 44.8% by 215. Besides, driving demand for data services, higher smartphone penetration is expected to increase overall mobile penetration rate due to the presence of some dual-sim models and many Saudis carrying more than one handset. Industry surveys point toward high adoption of smartphones, tablets and laptops in the Kingdom, well ahead of many developed markets. Page 23

24 Saudi Arabia Telecom High penetration of tablets & smartphones in KSA; data traffic to multiply by 216 Tablet/Smartphone/Laptop usage Data traffic forecast (MB per month) by type of device Smartphones and tablets are well penetrated in the Kingdom; data traffic set to surge Spain 7% 44% 49% France 7% 38% 5% Italy 6% 28% 3% Egypt 5% 26% UAE 24% 61% 68% Saudi Arabia 16% 6% 63% % 2% 4% 6% 8% Tablet Smartphone Laptop/ Notebook Laptop/ Netbook Tablet Portable gaming console Smartphone Non smartphone device ~25x ~17x ~8.2x 216e 211 ~3.3x In MB per month per device 2, 4, 6, 8, Sources: Cisco, Google survey(212), analysis The high penetration of data-centric devices in the Kingdom is expected to drive data traffic multi-fold. According to Cisco, globally the average monthly data traffic of smartphones is forecasted to surge 17 times (from 15Mb per month per device in 211 to average 2.6Gb per month by 216). Data usage levels in laptops/notebooks would continue to remain the highest and multiply by 3.3x between 211 and 216 (from 1.5Gb per month per device in 211 to average 6.9Gb per month by 216). While the demand environment for broadband services in the Kingdom is well in place, the access route toward the same is likely to determine operators success over the long term. STC is aggressively rolling out both mobile broadband and fixed line networks for offering broadband services, while Mobily is riding on the fast adoption of mobile broadband services in the Kingdom. According to Cisco, global data traffic is carried predominantly through fixed network, but mobile is expected to increase its share to 17% by 216 from 5% in 211. Driven by rising smartphone penetration and net users, the consumer space is forecasted to account for 77% of data traffic compared with 51% in 211. Fixed networks dominate global data traffic; Consumer segment to surge Data Traffic forecast by type of network 211 & 216e Data Traffic forecast by segment 211 & 216e Globally, fixed networks carry higher data traffic than mobile; consumer segment to outpace business demand in data usage 1% 8% 6% 4% 5% 95% 17% 83% 1% 8% 6% 4% 49% 23% 77% 2% 2% 51% % % e Fixed Mobile e Consumer Business Sources: Cisco, analysis STC accounted for an estimated 9% of the total daily Internet and data traffic, which exceeded 1,6Tb in Saudi Arabia, in 211. Moreover, the company s superior and upgraded fixed broadband network, which now extends to nearly 3, km in the Kingdom (compared to an estimated 3, km for Mobily), is a further testament to its strong position in the high-growth data segment. Page 24

25 Saudi Arabia Telecom Trend reversal of fixed-mobile substitution could unfold in data service; STC at a competitive advantage Wi-Fi access gains prominence in Saudi Arabia; STC may monetize fixed network investments Unlike voice services (where mobile services substituted fixed lines), emerging technology trend of data service adoption through Wi-Fi networks (vs. using a cellular network) is gaining traction across many developed markets. We expect data market adoption trends in Saudi Arabia to be characterized by regional/global trends. According to Cisco, data traffic volumes in the MEA region were mostly through fixed lines, accounting for 95% in 211 and expected to reach 83% by 216, reflecting a CAGR of 53%, while mobile data traffic is expected to outpace fixed traffic with a CAGR of 13%, during the same period, from a much lower base. Tablet users prefer WiFi/WLAN; Smartphone users prefer mobile networks 1% 8% 6% 4% 2% % Data access mode Tablet/ Notebook 75% 79% 55% 48% 42% 38% 64% 16% 83% 62% 23% 2% Saudi Arabia UAE Russia Italy France Spain WiFi/ home UMTS/3G/4G/LTE Sources: Google survey (212), analysis 1% 8% 6% 4% 2% % Data access mode Smartphones 65% 69% 6% 57% 4% 97% 77% 53% 48% 41% 45% 63% Saudi Arabia UAE Egypt Italy France Spain WiFi/ home UMTS/3G/4G/LTE The evolving trend of mobile traffic getting offloaded through fixed networks offers significant long-term prospects for fixed line operators such as STC. The drivers of mobile-fixed transition include bandwidth constraints for mobile in highdensity population areas, spectrum constraints limiting scalability of services, and relatively poor indoor connectivity of mobile broadband. Fixed broadband connectivity, thus, offers a better technology option to address the growing demand for data services in the long term. According to a Google survey, in Saudi Arabia, WiFi/WLAN is the preferred data access route among tablet users, while mobile is being mostly used for smartphones. Thus, STC would potentially look to monetize its fixed network investments by tapping Wi-Fi opportunities. STC is successfully adding customers through service bundling (triple-play offerings) and is thus placing data-heavy entertainment services into its high-speed fixed broadband network. More than 3, km of fiber-optic cable are already operational in the Kingdom and STC s FTTH services, branded as VERVE, offer broadband speeds up to 1 GBps far greater than any other competitor. In addition to attractive service offerings, STC attracts customers through integrated services and billing across fixed line and broadband services. Besides opportunities in the residential market, an anticipated shift toward e-government/e-health in Saudi Arabia is likely to benefit Saudi telcos, primarily STC. Page 25

26 Saudi Arabia Telecom Intensifying competition; STC enjoys pricing power in FTTH Broadband and data being the next leg of growth for telecom, operators are increasingly chasing the market across segments. STC dominance in fixed broadband is being challenged by Mobily. Through its acquisition of Bayanat Al Oula, Mobily is targeting the demand for high-speed Internet by offering service through its 3.5G network. Fixed line broadband competition in the Fiber-to-home market is also expected to intensify with new players deploying competing networks and have strong support from GCC incumbents Batelco and Etisalat. However, STC is expected to retain its competitive advantage of attracting customers through bundled service offerings. In addition, we see the recent slowdown in Zain KSA (sales down on YoY basis) benefitting both STC and Mobily. While overall revenue growth for the sector is showing moderate signs of improvement, we belive ARPUs would be supported by: a) Expected pick up in postpaid customer mix: Operators are focusing on prepaid to postpaid conversion. For instance, STC continued to push for prepaid to postpaid migration in 29 by offering 2G SAWA customers an upgrade option to a 3G postpaid plan for no additional fees while retaining the number. In fact, we see postpaid subscribers increasing at a faster pace than prepaid, indicating that operators are successfully migrating the user base. b) Challenges at Zain KSA offer near-term advantage for both STC and Mobily: Aggressive pricing by Zain KSA may not be a sustainable business strategy for the company currently. Zain has priced its mobile broadband offerings (Speed 4G) at a discount to STC/Mobily rates. c) Uptake in data services to support ARPUs: Current pricing plans for mobile broadband are ~1.5 2x the estimated sector ARPU. We estimate fixed line ARPUs to deteriorate at a much slower pace than mobile ARPUs. While the traditional voice market is on a decline, broadband opportunities through ADSL and FTTH services offer scope for growth in the fixed line market. In fact, we see STC enjoying pricing power through its bundled services and ability to offer a one-stop shop for communication, business and gradually also entertainment The ongoing gradual shift to e-government and e-health services coupled with existing links to government provide further strength to the story. EBITDA margins under pressure; falling ARPUs and increasing acquisition costs impact margins Margins under pressure; high ARPU data services to drive EBITDA Amid growth opportunities, the high degree of competition amongst telcos in Saudi Arabia is impacting operator margins. EBITDA margins have contracted to low 3s from high 4s over the past 5 6 years. While the entry of new players pushed mobile penetration higher, sector profitability was impacted by a) downward pressure on ARPUs resulting from competitive pricing and b) higher sales and marketing costs subscriber acquisition costs. However, telcos have focused on cost cutting measures to partly offset the negative impact on margins by reducing General and Administration expenses. Margin trend less favorable; competition impacts margins EBITDA margin trend for Saudi Telcos (27 4Q 212) Gross margin trend for Saudi telcos (27 4Q 212) 5% 65% 46% 6% 61% 45% 6% 59% 41% 56% 4% 55% 54% 55% 55% 54% 53% 36% 35% 34% 35% 35% 35% 33% 5% 3% 3% 45% 25% 4% Mar 12 Jun 12 STC Mobily Industry Sep 12 Dec Mar 12 Jun 12 STC Mobily Industry Sep 12 Dec 12 Sources: Company reports, analysis Page 26

27 Saudi Arabia Telecom High acquisition costs; telcos focus on cutting overhead costs Selling and marketing as a % of revenue (27 4Q 212) General and Admin. as a % of revenue (27 4Q 212) 16% 16% 14% 14% 14% 14% 14% 13% 13% 13% 13% 12% 12% 12% 1% 8% 6% 4% 2% % 6% 7% Mar 12 Jun 12 Sep 12 STC Mobily Industry Sources: Company reports, analysis We expect increased adoption of data services to drive EBTIDA margins. The reasonably affluent characteristic of the population (high per capita income) makes Saudi Arabia a market that could adopt high ARPU value-added services such as online gaming, video streaming and other data heavy applications. High bad debt provision for STC, potential to improve exists STC incurred SAR 1.6bn as bad debt provision in 212, significantly higher than SAR 236mn incurred at Mobily. As a percentage of sales STC incurred a cost of 2.7% as a result of high bad debt provision in 212 compared to just 1.% in Mobily. While this reflects Mobily s superior management of receivables, we see this as an area STC could potentially improve going forward. However, we note that receivable days at STC is significantly lower at STC (~6 days) compared to Mobily (~9 days) in 212. Mobily is thus offering extended credit days to ensure a more profitable operation than STC. Dec 12 1% 8% 6% 4% 2% % 8% 8% 7% 7% 8% 8% 7% 7% Mar Jun STC Mobily Industry Sep 12 Dec 12 STC incurs bad-debt costs ~ 6-7x that of Mobily, room for improvement Bad debt provisions as % of sales: STC vs Mobily Receivable DSO s: STC vs Mobily 5% 4% 3% 2% 1% 3.% 3.% 3.1% 2.4% 2.7% 1.9% 1.5% 1.1%.9%.8%.9% 1.% % STC Mobily Sources: Company reports, analysis STC Mobily Tower sharing opportunity could reduce operating expenses by 12 15% a potential margin driver. Potential value creation opportunity through network sharing for both STC and Mobily Amid high competition impacting profitability, we see asset sharing opportunity for both STC and Mobily potentially driving cost synergies. In fact, STC currently offer mobile site sharing services, allowing competitors to put their base station antennas on STC towers. STC's network consists of around 5, base stations covering around 97% of the population. In addition, industry sources cite potential capex savings for new installations through tower sharing, a positive for cash flows. Competitor Mobily has already initiated development in network sharing. The company recently Page 27

28 Saudi Arabia Telecom announced infrastructure sharing with Atheeb Telecom in the fixed broadband segment. Synergistic opportunities thus exist for Saudi telcos through potential sharing of each other s assets to tap the broadband market opportunity, an arrangement that could gather prominence in the near future. However, we highlight that there is no decision yet on this topic and note that a key driver for tower sharing globally has been funding requirements (through selling towers to third party). STC and Mobily do not have the same urge for new funds. In addition, we sense that there is a degree of uncertainty surrounding the comparative gains from this. STC ahead in capex cycle; opportunity to drive asset returns higher In order to tap the emerging opportunities in data and broadband services in the Kingdom, Saudi telcos are aggressively investing in building a network infrastructure to support these services. Mobile network coverage is well in place for both STC and Mobily (>95% in Saudi Arabia). Services such as ADSL, FTTH and 3G/4G is been made network ready. STC launched commercial 4G Long Term Evolution (LTE) mobile broadband networks in 2H 211 and has presence in over 38 cities. STC aims to achieve 4G mobile broadband network coverage of 95% of the population by 214. Similarly, Mobily s 4G LTE network, operated by subsidiary Bayanat Al-Oula, has coverage in 31 cities and is targeted to cover 85% of the Saudi population. STC is also fast rolling out its fiber-based internet services in the Kingdom. The sector s capex-to-sales ratio is on decline (24% in 27 to ~16% in 4Q 212). We expect ROA for both STC and Mobily to be driven by these investments. Thus, capex is mostly lower for STC, with the potential to improve asset turnover. Ex-acquisitions, STC s capex-to-sales declined from 17% in 27 and is expected to reach 13% by 217, while for Mobily, capex-to-sales is estimated to be relatively higher at ~18% over the next three years and thereafter decrease to 16% by 217. In comparison, mature global players are typically sustaining a capex/sales ratio of 1-13% - our figures on Saudi operators are more conservative. Capex cycle mostly behind; network deployed for value-added services STC s Capex-to-sales ( ex-acquisitions) (27 217e) Mobily s Capex-to-sales (ex- acquisitions) (27 217e) 18% 16% 14% 12% 17% 12% 12% 1% 16% 14% 15% 15% 15% 14% 13% 3% 25% 2% 27% 25% 24% 21% 21% 18% 17% 16%16%16%16% Decreasing capex-to-sales ratio a positive; network coverage well in place across technologies 1% 8% 6% 4% 2% % E 215E 217E 15% 1% 5% % E 215E 217E Sources: Company reports, analysis Moderate regulatory risks & stable royalty fees Post the introduction of Zain KSA, the third mobile operator, we believe the regulatory environment has moderated significantly. While CITC is pursuing an overall developmental goal for the telecom sector, we see limited risks ahead for the sector. The CITC is working on introducing MVNO licenses, and recently requested proposals from interested parties with a deadline set for May 4 th 213. In a scenario of new MVNO licenses, we expect entry of well-established regional operators into Saudi Arabia. For instance, players such as Du (UAE) have already expressed interest in exploring the MVNO opportunity in the Kingdom. Q-tel amongst other telcos, which was outbid by Zain KSA for the third mobile license, could look to participate in the MVNO opportunity. Considering that MVNO typically chases the low ARPU/untapped customer segments, we see Zain KSA at a larger risk than STC/Mobily. Furthermore, considering the ongoing challenges at Zain KSA, the new entrants are likely to target its customer base. European experience of MVNO s indicate that a potential 5-1% share, could be captured by the new players. STC is expected to be at a competitive advantage over Mobily, as it Page 28

29 Saudi Arabia Telecom could draw operational and managerial expertise from Oger Telecom (35% stake) which runs a successful MVNO in South Africa Virgin Mobile through its holdings in Cell C. Also, MVNO could present STC with a wholesale business opportunity, allowing it to sell excess bandwidth to new players. Overall, we see moderate regulatory risks to the sector, which are overshadowed by strong market and growth fundamentals underpinned by growing demand for data services and we find STC at a relative competitive advantage over its peers. We also highlight, that Saudi Arabian regulatory environment has typically enjoyed a more balanced and structured approach than some GCC markets. Moreover, unlike some key markets in the region Saudi Arabia already satisfies the WTO s requirement of three mobile operators. Regulatory cost pressure easing, room for margin expansion as data revenue mix increase Royalties/ Government charges are regulated by CITC for telecom operators in the Kingdom. Besides, license fee and fee for usage of frequency spectrum, Saudi based operators are required to pay commercial service provisioning fee to the regulator. CITC has a fee structure of 15% of net revenue (revenue less interconnection costs) for mobile services, 1% of net revenue for landline services and 8% of net revenue for data services. While we do not expect any changes to the fee structure in our forecast period, there exists room for moderating the same, especially in the mobile services. Royalty fee charges for telecom services in Saudi Arabia Service Type As a % of net revenue (revenue less interconnection costs) Mobile services 15% Landline services 1% Data services 8% Sources: CITC, company reports, analysis In fact for both STC and Mobily, the government charges (as % of sales) is witnessing a declining trend indicating lower regulatory costs as a result of increasing mix of data revenue, where royalty fee is relatively lower. For STC government charges (% of sales) have declined from 14% (in 27) to 9.4% in 212 while for Mobily it declined from 12.4% (in 27) to 5.7% (in 212). Regulatory costs (as a % of sales) on a decline, a positive for margins STC s government charges ( % of sales) (27 212) Mobily s government charges ( % of sales) (27 212) Room for margin expansion exist through lower government charges as data revenue mix increases 16% 14% 12% 1% 8% 6% 4% 2% % 14.% 11.7% 11.2% 11.1% 11.3% 9.4% 14% 12% 1% 8% 6% 4% 2% % 12.4% 12.6% 9.6% 8.7% 7.8% 5.7% Sources: Company reports, analysis Government charges include : Royalty, license and frequency usage charges Revenue include handset sales and others Page 29

30 Saudi Arabia Telecom Strong balance sheet position; capital return prospects are high While new international opportunities exist for Saudi telcos, in light of the ongoing regional tension, any investments are likely to be highly selective. In fact, any international investments are likely to emanate from STC as we believe other operators are restricted from expanding beyond Saudi, by their main stakeholders and license restrictions. Following the global financial crisis and the Arab spring, companies focused on consolidating existing operations (STC recently increased its stake in Axis, Indonesia to 8% from 51% earlier). The declining net debt/ebitda in the sector is, overall, a positive, in our view. The net debt-to-ebitda has declined to.5x in 4Q 212 from a high 2.8x for Mobily in 27, while for STC the ratio came down to.6x in 4Q 212 from 1.2x historically. There could be a likely capital return phase in the near term than chasing new growth avenues. We, thus, expect STC to balance out growth/returning cash to shareholders. Furthermore, the current dividend yields are attractive for both STC and Mobily, though moderately below peers in GCC/ MEA. Saudi telcos are well capitalized Net Debt EBITDA ratio ( 27-4Q212) STC / Mobily dividend yield (%) vs GCC/ MEA peers Mar 12 Jun Sep STC Mobily Industry.7 Dec 12 MEA - Median Maroc Telecom MTN Vodacom Jordan Telecom Qtel Zain Kuwait Omantel Batelco Du Etisalat Mobily STC Sources: Company reports, analysis Page 3

31 SAUDI TELECOM COMPANY STC: Investment Highlights Rating Summary STC BUY We initiate coverage on Saudi Telecom Company (71/ STC AB) with a BUY rating and a TP of SAR 51.1, implying an upside of 28% to the last close of SAR 39.9 per share. At 4.6x EV/EBITDA ratio on 213 estimates, STC is trading in line with GCC peers but at a 17% discount to MEA comparables. While one-off charge in 4Q 212 (in its International operations) and the recent management changes are of concern, we see a misplaced risk perception on the counter not crediting the attractive long-term growth prospects both in Saudi Arabia and international markets. We forecast EPS 213 of SAR 4.4, 8.5% higher YoY (ex-one off items). Assuming maintained DPS, the implied dividend yield is 5.%. However, we see upside potential on dividends as cash continues to pile up. We believe the company is well placed to benefit from the emerging trend of mobile-fixed convergence in broadband services: STC dominates the Kingdom s fixed line market (~9% share). The company has aggressively rolled out its high-speed fixed line network across the Kingdom (3, km, ~1x Mobily) and enjoys a competitive advantage over peers. STC is well placed to exploit the emerging opportunity of broadband access via tablets/smartphones through both fixed lines (Wi- Fi) and mobile. We expect STC s revenue to grow at a low single-digit average of 3.9% YoY during We forecast 213e top-line of SAR 6.7bn, 2.3% higher YoY. 65% from Saudi Arabia and 35% from international operations. Pricing power in broadband; attractive opportunity in service bundling: STC enjoys pricing power in high-speed broadband services through its Jood and VERVE brand, an FTTH service with download speed up to 1Mbps. While we are cautious about competitor GO fast rolling out its services, we expect STC to maintain its competitive advantage through bundled service offerings (InVision) and superior fixed broadband speed, which is successfully adding new customers. STC added 1, new customers into its fiber optic network (home and business) in 4Q 212, an increase of more than 1% over 4Q 211. The company also achieved a 15% growth in subscribers for the bundled services in 4Q 212. International diversification a long-term positive; currently overshadowed by regional tension: Besides acquisition-led international presence (Oger and Maxis), STC has made successful inroads into the saturated Kuwaiti and Bahraini markets (capturing an estimated mobile share of 2% and 35%, respectively in 211) through green field operations, which is noteworthy. Yet we would like to stress that despite the ongoing protests in Bahrain, Viva Bahrain saw revenues spike by some 166% and Viva Kuwait 127% during the two years of compared to 21 and have turned EBITDA positive. All in we forecast, a 5.6% yoy growth in STC s EBITDA in 213 to reach SAR 22.2bn. CAGR for our forecast period is 5.3%. We expect EBITDA margins of 36.5% in 213e, 127bps higher yoy. Legacy PSTN networks to remain a drag on ROE; penetration of data services to drive asset returns: The traditional PSTN network (14% of revenue) remains a structural drag on the company s return profile (ROA of -.8% in 212 versus 6.4% for the company). Consequently, we forecast STC s ROE to range in the high teens until 217 driven by a high mix of data services, which are expected to account for nearly 26% of total revenue by 214 compared to 23% in 212. Near-term catalysts for the stock include traction in FTTH services and potential value unlocking in tower assets. TARGET PRICE (SAR) 51.1 Upside/(Downside) 28.% Stock Details Current Price* SAR 39.9 Market Capitalization SAR Mn 8, Shares Outstanding Mn 2 52-Week High SAR Week Low SAR 35.8 Price Change (YTD) % -7.6 EPS 213e SAR 4.4 Beta (1 Year Adj.).68 Ticker (Reuters/ Bloomberg) * Price as of February 11, 213 Key Shareholders 71.SE STC AB Public Investment Fund 7.% Public Pension Agency 6.6% General Organization for Social Insurance 7.% Publicly Held 16.4% Source: Zawya Price Multiples Current 213e P/E(x) EV/ EBITDA (x) Dividend Yield (%) Sources: Bloomberg, analysis STC vs. TASI Source: Tadawul STC TASI Sector Coverage Roy Cherry rcherry@fransicapital.com.sa Page 31

32 SAUDI TELECOM COMPANY FINANCIALS & RATIOS Key Financials (in SAR mn) E 214E Revenue 47,469 5,78 51,787 55,662 59,372 6,722 62,659 EBITDA 21,743 2,612 19,621 2,25 2,945 22,191 23,132 EBIT 12,42 12,13 1,977 8,488 9,281 1,387 1,699 Net Profit 11,38 1,863 9,436 7,729 7,351 8,875 9,135 Balance Sheet (in SARmn) Current Assets 18,946 22,663 18,74 21,967 28,783 38,57 46,128 Property Plant and Equipment 44,382 52,737 55,127 55,85 56,5 56,972 56,957 Net intangible assets 31,695 29,222 31,837 29,318 28,162 26,843 25,585 Total Assets 99,762 19,587 11, ,42 117, , ,97 Total Debt 36,321 36,19 33,697 33,598 34,823 37,526 38,36 Total Equity 42,562 5,833 53,464 54,82 58,969 64,543 69,467 Total Liabilities 99,762 19,587 11, ,42 117, , ,97 Cash Flow Statement Net cash provided by operating activities 21,149 15,956 21,185 16,488 12,16 23,682 23,749 Cash flows from Investing Activities (35,468) (13,542) (13,175) (8,264) (9,31) (9,321) (8,996) Cash flows from Financing Activities 14,763 (2,765) (9,669) (7,686) (4,278) (4,6) (6,869) Key Ratio E 214E Gross margin (%) 62.4% 61.% 58.6% 56.3% 56.6% 57.2% 57.6% EBITDA margin (%) 45.8% 4.6% 37.9% 36.% 35.3% 36.5% 36.9% Revenue growth (%) 37.8% 7.% 2.% 7.5% 6.7% 2.3% 3.2% Growth in EBITDA (%) 3.1% -5.2% -4.8% 2.1% 4.6% 5.9% 4.2% Growth in earnings (%) -8.2% -1.6% -13.1% -18.1% -4.9% 2.7% 2.9% Debt/ Equity (x) Capex/ Sales 34.3% 3.8% 21.9% 14.1% 14.8% 16.% 15.% ROAA (%) 13.3% 1.7% 9.1% 7.1% 7.% 7.8% 7.5% ROAE(%) 3.5% 28.% 23.1% 17.2% 16.3% 17.8% 16.9% Cash flow yield (%) 6.1%.4% 12.3% 1.8% 4.2% 12.8% 14.1% Per Share Ratios E 214E Earnings per share Dividend per share Valuation Ratios E 214E P/Earnings P/Book EV/ EBITDA P/Sales Sources: Bloomberg, Company reports, analysis Historical multiples based on closing prices as of February 11, 213 Page 32

33 SAUDI TELECOM COMPANY Investment Thesis STC s background: Leader among GCC telecoms STC is a leader among GCC telecoms; presence in more than 1 countries and has ~16mn customer base. Established in 1998, Saudi Telecom Company is the incumbent telecom operator in Saudi Arabia, offering services across fixed, mobile, data and internet to both consumer and enterprise users. STC, which enjoyed monopoly in Saudi Arabia until 24, is now competing in the domestic market with new players that are backed by other leading GCC operators such as Etisalat (Mobily), Zain (Zain KSA) in mobile and Batelco (Atheeb Telecom) in fixed lines. STC has successfully diversified its business into other regional and international markets such as Turkey (Oger Telecom), Kuwait and Bahrain (Viva operations) in the MEA region and Malaysia, Indonesia (Maxis) and India in Asia (please see the company s timeline in Appendix A). STC is the largest telecom operator based out of GCC with a customer base of ~16mn across 1 countries in MEA and Asia. STC s interests in various operations are detailed below. STC Company structure Sources: Company reports, analysis Page 33

34 SAUDI TELECOM COMPANY Well established network infrastructure; competitive advantage in fixed broadband Infrastructure assets across fixed, mobile and data applications in both Saudi and international markets We have a positive outlook on STC considering the expected domestic market growth led by data segment demand and its diversified and growing international business. In our opinion, well-established telecom networks are a key competitive advantage for STC, which holds infrastructure assets across fixed, mobile and data operations in both domestic and international markets. The company also provides backbone infrastructure capacity for IP-based services to other operators. In addition, the company is now positioned in the Saudi market as the only one-stop communication/entertainment shop. Besides a comparable mobile offering, it has a dominant presence in fixed line that it is gradually being able to reposition and bring back to life as value added in its bundled offers. The roll-out of IP-TV and FTTH internet with speeds reaching up to 2 Mb/sec is also another first on this scale in the Kingdom. The trend of fixed-mobile substitution in Saudi Arabia impacted STC the most. Nonetheless, the company remains the market leader with an estimated share of 47% in mobile services and dominates the fixed line segment with its 97% share. STC s high mix of postpaid customers (~2 3% versus regional benchmark of 1 15%) is a key positive. Until 214, we expect the company to retain 46% market share in mobile operations as well as its leadership position in fixed line (with 9% share). Demand for broadband in the Kingdom has been mostly mobile based (in terms of subscribers, while traffic volumes are predominantly over fixed lines), but we see an emerging global trend of mobile-fixed convergence in accessing the Internet. STC is positioning itself through fiber roll-outs across Saudi Arabia (3, km of fiber, 1x Mobily/Bayanat). Furthermore, STC is aggressively rolling out the fiber network to provide high-speed internet services (speed up to 2 Mb/sec) and aims to cover more than 1.5mn homes by 214. Its fixed broadband subscribers grew 19% in 4Q 212 compared to 4Q 211. We expect the company to make inroads in the mobile broadband segment, which is currently dominated by Mobily. STC launched commercial 4G Long Term Evolution (LTE) mobile broadband networks in 2H 211 and has presence in over 38 cities. The company aims to achieve 4G mobile broadband network coverage of 95% of the population by 214. We forecast STC s revenues to reach SAR 6.7bn in FY 213 and increase to SAR 62.7bn by 214, (ex-accounting change). Segment-wise, while mobile services remain the major revenue source, we see an increasing trend of data contribution to the company s business mix. Data segment is expected to account for 31% of total business compared to 23% in Increasing contribution from Data segment Revenue Breakup Segment (in SAR bn) Revenue Breakup Segment (%) % 8% 6% 4% 2% 12% 14% 14% 17% 23% 24% 26% 28% 3% 31% 19% 18% 2% 15% 14% 15% 14% 14% 13% 13% 69% 67% 66% 68% 64% 62% 61% 6% 58% 57% % GSM PSTN Data Others Sources: Company reports, analysis Note: Based on current accounting method -2% GSM PSTN Data Others Page 34

35 Subscribers (mn) ARPU (SAR per month) Fixed broadband (mn) ARPU (SAR per month) Subscribers (mn) ARPU (SAR per month) Subscribers(mn) ARPU (SAR per month) SAUDI TELECOM COMPANY We forecast STC s mobile subscribers in Saudi Arabia to reach 25.9mn in 213 and increase to 27mn by 214, while mobile ARPU are expected fall 4% annually to SAR 69 per month by 214. In the fixed line segment, we expect a total 5.2mn lines in 214 (Home + Residential), while blended ARPU are conservatively estimated to contract to SAR 138 per month by 214. Steady growth in mobile and fixed lines market Mobile segment - Subscribers vs ARPU (21-217e) Fixed lines - Subscribers vs ARPU (21-217e) STC Subscribers ARPU (RHS) STC Subscribers ARPU (RHS) Sources: Company reports, analysis In the broadband market, we expect STC to make market share gains. Mobile broadband subscribers for STC are forecast to reach 3.6mn in 213 and increase to 4.5mn by 214. In the fixed broadband segment, we expect STC to continue its dominance with an estimated 2.6mn subscribers in 214, while ARPU s are expected fall 4% annually to SAR 88 per month by 214. Broadband market STC is well placed for growth, especially fixed broadband Mobile broadband - Subscribers vs ARPU (21-217e) Fixed broadband - Subscribers vs ARPU (21-217e) STC Subscribers ARPU (RHS) STC Subcribers ARPU (RHS) Sources: Company reports, analysis Besides growth prospects within the Kingdom, we expect company s International markets to increase their contribution to 4% by 217 compared to 32% in 212 (based on the current accounting method). In 212, STC delivered a 4% yoy growth revenue in its controlled subsidiaries (Viva Bahrain, Viva Kuwait and PT Axis - Indonesia) and added new subscribers across post-paid, pre-paid and wireless broadband services. Page 35

36 SAUDI TELECOM COMPANY Increasing contribution of international revenues Revenue Breakup Geography (in SAR bn) Revenue Breakup Geography (%) E 214E 215E 216E 217E Saudi Arabia STC Bahrain (Viva) Gulf Digital Media Holding Kuwait Telecom (Viva) Oger Telecom PT Axis Sources: Company reports, analysis Note: Based on current accounting method 1% 7% 7% 7% 7% 7% 7% 7% 7% 8% 22% 2% 18% 17% 17% 18% 18% 18% 6% 4% 68% 68% 68% 67% 66% 64% 62% 61% 2% % Saudi Arabia E 214E 215E 216E 217E STC Bahrain (Viva) Gulf Digital Media Holding Kuwait Telecom (Viva) Oger Telecom PT Axis Due to increasing competition in the domestic telecom market, the company ventured internationally, chasing both growth and business diversification. International operations contributed around 32% to STC s top line in 212. The company executed a strategy of adding a mix of both existing and green field operations. While stake purchase in Oger (35%) and Maxis (65%) was into existing operations, STC won third mobile licenses in Kuwait (26% stake) and Bahrain (1%) to commence green field operations. International markets offer long-term growth for STC, but investor concerns exist In anticipation of growing domestic competition, STC forayed into international markets as early as 25 through its stake purchases in Oger Telcom and Maxis in Southeast Asia. This was soon followed by regional expansions. Despite near-term concerns in Viva operations, STC s international growth prospects remain attractive While GCC telecom companies had mixed fortunes with their expansions, barring Etisalat s successful venture in Saudi Arabia (Mobily) and Q-tel operations in Oman and Kuwait, expansion by regional players has met significant challenges. Zain had to exit Africa due to excessive leverage, while Etisalat could take impairment charges in PTCL (Pakistan) and has recently announced stake sale in XL Asiata, Indonesia. Similar to other GCC telcos, STC leveraged its balance sheet to chase international growth prospects for stakes in Maxis and Oger and licenses in Kuwait and Bahrain. What was a bumpy ride initially, has more recently begun to bring rewards to STC as some of these businesses start gaining considerable traction and turn EBITDA positive (Bahrain & Kuwait). We also understand that both the Indian and Indonesian operations are heading in the same direction in the next two years. Consequently, we see attractive growth prospects for STC s international operations (which represented ~32% of total revenue in 212) Oger, Maxis, Kuwait and Bahrain. However, these are currently under looked by investors due to the ongoing tension in the region, limited disclosure and consequently ability to assess and value. We highlight that unlike its GCC peers, STC is relatively less exposed to regions that are undergoing a political crisis. However, we note investor concerns exist for STC s Viva operations in Bahrain and to a much lesser degree Kuwait. Yet we would like to stress that despite the ongoing protests in Bahrain, Viva Bahrain saw revenues spike by some 155% and Viva Kuwait 121% during the two years of compared to 21 and have turned EBITDA positive. With regards to increased disclosure, we understand that efforts are being undertaken to facilitate a more accurate understanding of the international business at STC. Page 36

37 SAUDI TELECOM COMPANY STC relatively less exposed to conflict regions than GCC peers, but risks exist Company Algeria Egypt Sudan Bahrain Jordan Iraq Palestine Tunisia Yemen Pakistan Countries STC Y 1 Batelco Y Y Y 3 Etisalat Y Y Y 3 Qtel Y Y Y Y 4 Zain Y Y Y Y 4 STC has minimal exposure to Jordan through Cyberia (Oger Telecom) Sources: analysis However, STC has a minority shareholder status in most of its international operations, providing an opportunity to further raise its stake in select regions. It is no secret that STC remains highly interested in upping its stake in Oger Telecom and the dialog is likely ongoing. Such a move, would boost international contribution and present additional growth prospects for the company. We note that STC has the first right of refusal on Oger. Overall STC group has more than 123mn subscribers in its international network with a target population of 1.6bn and average penetration of 127%. STC s international revenues are generated, in order of contribution, from the following subsidiaries Oger Telecom (~18% of revenue, Turkey and South Africa), Binariang Holdings (~7% of revenue, Malaysia and India), Viva operations (~5% of revenue, Kuwait and Bahrain) and PT Axis (~2% of revenue, Indonesia). International market presence for STC Market Summary Pop. (mn) Penetration (%) Operator Subscribers (mn) Turkey Market share Fixed % Turk Telekom % Mobile % Avea % South Africa % Cell C % Malaysia % Maxis % Indonesia % PT Axis % Bahrain % Viva Bahrain.6 35% Kuwait % Viva Kuwait 1. 2% India 1, % Aircel % STC Group 1, % 123. Sources: Company reports, analysis Oger Telecom (35% stake) forms 18% of revenue Presence in Turkey and South Africa through stake in Oger; making inroads in Mobile segment In 27, STC purchased 35% stake in Oger Telecom for USD 2.6bn. Oger holds telecom assets in Turkey (55% of Turk Telekom) and South Africa (75% of Cell C, South Africa s third largest mobile operator). In addition, the company provides ISP services in Saudi Arabia, Lebanon and Jordan through Cyberia. Turk Telecom, through its 81.1% holding in Avea, has diversified operations beyond traditional fixed line services (a market which is on the decline in Turkey). Avea is the third largest mobile operator in Turkey with about 2% market share in 211. Page 37

38 SAUDI TELECOM COMPANY Leadership in fixed line/broadband; Avea holds ~2% share in mobile Turkey Market Summary/Forecast (%) Turkey 28A 29A 21A 211A 212E 213E 214E Population (mn) Fixed Line Subscribers (mn) Penetration Levels (%) 98% 91% 88% 81% 79% 77% 75% ARPU (TRY) Turk Telecom Subscribers (mn) Turk Telcom Market Share (%) 1% 1% 99% 99% 91% 9% 89% Broadband Subscribers (mn) Penetration Levels (%) 32% 36% 39% 4% 47% 53% 6% ARPU (TRY) Turk Telecom Subscribers (mn) Turk Telecom Market Share (%) 99% 96% 93% 9% 79% 79% 8% Mobile Subscribers (mn) Penetration Levels (%) 93% 87% 85% 87% 9% 93% 96% ARPU (TRY) Avea Subscribers (mn) Avea Market Share (%) 19% 19% 19% 2% 2% 2% 21% Sources: IMF, ITU, company reports, analysis Cell C has made steady inroads into a market dominated by telco majors such as MTN and Vodacom (a subsidiary of UK-based Vodafone Group). The company holds around 2% market share in South Africa, offering services to ~12.8mn subscribers in 211. In addition, Cell C runs a successful MVNO, Virgin Mobile, in the country through its 5% holding in the company. MVNO trends are gaining traction in GCC markets, and STC would look to leverage its expertise of MVNO operations through Oger Telecom. Cell C fast establishing presence in South Africa South Africa Market Summary/Forecast (%) South Africa - Cell C 28A 29A 21A 211A 212E 213E 214E Population (mn) Mobile Subscribers (mn) Penetration Levels (%) 92% 94% 11% 127% 132% 138% 143% ARPU (USD) Cell C Subscribers (mn) Cell C Market Share (%) 8% 12% 16% 2% 2% 21% 22% Sources: IMF, ITU, company reports, analysis Page 38

39 SAUDI TELECOM COMPANY Binariang (25% stake) contributes 7% to revenue Increasing presence in Malaysia and Indonesia; high Muslim population provides synergies during Hajj STC entered the Asia-Pacific market through a USD3.bn deal for 25% minority stake in Binariang, which owned 1% interest in Maxis Telecom (Maxis) at that time. Following Maxis IPO, Binariang s stake came down to 65%. Maxis have presence in Malaysia, Indonesia and India. Malaysia a growth market for STC Malaysian Market Summary/Forecast (%) Malaysia - Maxis 28A 29A 21A 211A 212E 213E 214E Population (mn) Mobile Subscribers (mn) Penetration Levels (%) 11% 18% 12% 128% 13% 132% 134% ARPU (MYR) Maxis Subscribers (mn) Maxis Market Share (%) 35% 35% 35% 35% 36% 36% 36% Sources: IMF, ITU, company reports, analysis Viva brand well established in Kuwait and Bahrain Viva operations contribute ~5% to revenue; Kuwait (26% stake) and Bahrain (1%) Through successful bids for third mobile licenses, STC entered the Kuwaiti and Bahraini markets in 28 with its Viva brand. Despite being well-penetrated mobile markets and dominated by regional majors such as Zain and Qtel (Kuwait) and Batelco (Bahrain), Viva captured an estimated 2% share in Kuwait and 35% in Bahrain in 211. STC successfully penetrates GCC markets through Viva brand Kuwaiti Market Summary/Forecast (%) Kuwait - Viva 28A 29A 21A 211A 212E 213E 214E Population (mn) Mobile Subscribers (mn) Penetration Levels (%) 81% 83% 18% 135% 136% 138% 14% ARPU (USD) Viva Subscribers (mn) Viva Market Share (%) 4% 13% 18% 2% 25% 26% 27% Bahraini Market Summary/Forecast (%) Bahrain - Viva 28A 29A 21A 211A 212E 213E 214E Population (mn) Mobile Subscribers (mn) Penetration Levels (%) 185% 135% 142% 15% 157% 163% 17% ARPU (USD) Viva Subscribers (mn) Viva Market Share (%) % % 3% 35% 36% 37% 38% Sources: IMF, ITU, company reports, analysis Viva Bahrain saw revenues spike by some 166% and Viva Kuwait 127% during the two years of and have turned EBITDA positive. Page 39

40 SAUDI TELECOM COMPANY PT Axis (8.1% stake) accounts for less than 2% of revenue Besides its presence in Asia through Binariang, STC made direct investments in the region and holds 8.1% stake in PT Axis, an Indonesian mobile operator. PT Axis holds an estimated 5% market share in Indonesia, but offers synergies to STC s operations in the form of the country s large Muslim population base (~23mn plus) that travels regularly to Saudi Arabia for the Hajj. In addition, STC is looking at potential value unlocking in tower assets through a USD2mn deal. Small presence, but synergistic market for STC Indonesian Market Summary/Forecast (%) Indonesia - PT Axis 28A 29A 21A 211A 212E 213E 214E Population (mn) Mobile Subscribers (mn) Penetration Levels (%) 61% 7% 89% 98% 12% 15% 19% ARPU (USD) PT Axis Subscribers (mn) PT Axis Market Share (%) % 2% 5% 6% 7% 7% 8% Sources: IMF, ITU, company reports, analysis Change in reporting method starting 1Q 213 STC is adopting a new accounting policy effective January 213. Currently, STC treats joint-venture projects using the proportionate consolidation method according to IAS 31. Following the introduction of the International Accounting Standards Board s IFRS 11 in place of IAS 31, STC would change its accounting method from proportionate consolidation to the equity method. Oger Telecom (35%) and Binariang Holdings (25%) would be the major assets impacting the accounting change. While revenue accounting will change, we highlight that there will be no impact at Net income level. We will update our numbers once the new standard is fully adopted. For now, we have included a pro-forma estimate of the company s financials (both Pre-equity method and Post-equity method). (See following table). Pro forma estimates - STC In SARmn Pre-Equity 212 Post-Equity 212 Pre-Equity 213e Post-Equity 213e Revenue 59,372 44,745 6,722 45,771 Net Income 7,35 7,35 8,875 8,875 Total Assets 117,912 82, ,512 89,278 Total Liabilities 58,943 31,314 62,969 33,453 Sources: Company reports, analysis New international opportunities for STC Morocco, Algeria and Libya Strong balance sheet position of Saudi telcos; could be frontrunner in upcoming license/ stake opportunities. Amid regional tension, there exist new opportunities, especially for STC. French group Vivendi announced plans to offload its 53% stake in Maroc Telecom. Oman, Libya and Lebanon are considering new telecom licenses and Algeria could potentially see the much delayed privatization of its incumbent Algerie Telecom. Considering the current low risk appetite for the Middle East region among international investors, GCC-based telcos could well participate in these opportunities with lesser risks of overpaying for assets. Outbidding for regional licenses and operator stakes has negatively impacted operator returns in the past (including Zain KSA), and a similar scenario is less likely to be repeated in the current geopolitical environment. Page 4

41 SAUDI TELECOM COMPANY Maroc Telecom: All major regional telcos Qtel, Etisalat and MTN South Africa could be serious competitors for this stake. However, we highlight that STC has not indicated a recent interest in this stake. The company had showed interest to enter into Meditel (Morocco s second-biggest player) back in 29. The Maroc Telecom stake is estimated to be worth USD 7.1bn (~SAR 26bn 1 ). Margin outlook positive Data services reverse downtrend in EBITDA margin STC s EBITDA margins contracted significantly following its international foray amid competitive pressure in the domestic market. We expect the company s ARPU to contact 3 4% over our forecast period (through to 217e). However, increasing contribution from data services, expected pricing power in FTTH and bundled services (InVision and IP TV) coupled with improving returns for the international business should translate into higher EBITDA margins for the company. STC s subscribers in bundled services increased 15% yoy during 4Q 212. We expect margins to recover to the 38% level by 217. Positive EBITDA outlook EBITDA outlook 28-14e (in SAR bn) (excluding one-off s) E 214E 5% 45% 4% 35% 3% 25% EBITDA margin outlook 28-14e (%) 45.8% 4.6% 37.9% 36.% 35.3% 36.5% 36.9% E 214E Sources: Company reports, analysis Improving core operating environment to drive earnings Improving operating environment and a positive margin outlook are expected to translate into earnings growth of 19% for STC in 213. We forecast that the company s net income in 213 would be SAR 8.8bn. This translates into an EPS of SAR 4.4 (a conservative estimate, 2% below consensus). Foreign currency fluctuations have negatively impacted earnings in the past, and we advise caution considering STC s increasing exposure to international markets. However, we expect net income margins to expand to 15-16% levels over the long term (forecast period through 217e). In fact, excluding one-off items (Foreign exchange/ impairment charges) 1 Estimated value for 53% stake in Maroc Telecom as on December 26, 212, based on South Korea based KT Corp s bid. Page 41

42 SAUDI TELECOM COMPANY Positive outlook on earnings front EPS outlook 28-14e (in SAR) Net income margin forecast 28-14e (%) % 2% 15% 23.3% 21.4% 18.2% 13.9% 14.5% 14.5% 12.4% 3 1% 2 1 5% E 214E % E 214E Sources: Company reports, analysis Excluding one-off s Net Income outlook 28-14e (in SAR bn) Net income margin forecast 28-14e (%) % 27.1% % 2% 15% 1% 2.4% 15.7% 15.7% 13.8% 14.6% 14.6% 2 5% % E 214E E 214E Sources: Company reports, analysis Page 42

43 SAUDI TELECOM COMPANY Legacy PSTN a drag on STC s returns Strong balance sheet; potential to scout new market opportunities, especially Morocco STC s legacy PSTN operations remain a drag on ROA. These operations contribute 14% to revenue, but are lossmaking with an ROA of -.8% in 212 versus 6.4% for the company. Nonetheless, we forecast STC s ROE to range in the high teens until 217 driven by a high mix of data services (ROA of 49.2% in 212). Revenues from data services are expected to account for nearly 3% of the total by 217 compared with 17% in 211. PSTN network a drag on ROA s; Rising share of Data to drive ROE s Segment wise ROA (%) RoE Outlook 28-14e(%) 6% 35% 49.2% 3.5% 5% 3% 28.% 39.2% 4% 25% 23.1% 3% 22.6% 2% 17.2% 17.8% 16.3% 17.3% 2% 8.7% 1.4% 15% 1% 6.4% 1% % -1.3% -.8% 5% -1% GSM PSTN Data Total % E 214E Sources: Company reports, analysis Page 43

44 SAUDI TELECOM COMPANY Capex program mostly behind for STC STC has introduced 4G Long Term Evolution (LTE) mobile broadband services in over 38 cities and is targeting to cover 95% of the population by 214. Given the completion of a majority of network rollouts (fiber network in the Kingdom), we expect the capex-sales ratio to be at 15-16% levels till 214. This ratio is projected to decrease to 13% over the long term. Capex program to continue until 214 Capex outlook 28-14e (in SAR bn) Capex-Sales 28-14e (%) % 35% 3% 25% 34.3% 3.8% 21.9% 6 2% % 14.1% 14.8% 16.% 15.% 1% E 214E E 214E Sources: Company reports, analysis With majority of STC s capex program behind, we expect STC to generate free cash flows of SAR1-14bn annually in our forecast period. At current prices, STC offers a superior free cash flow yield of 12.8% on 213 estimates. Attractive free cash flow yield for STC Free cash flow outlook e (in SAR bn) Free cash flow yield e (%) E 214E 215E 216E 217E Sources: Company reports, analysis Strong balance sheet to support dividends STC has a strong balance sheet with SAR 5.1bn in cash as of 4Q 212 and SAR 8.7bn in Short term investments. The company offers an attractive dividend yield of 4.8% at the current market price. At a DPS of SAR 2. per share, the payout ratio of 45% for 213e is currently lower than the average of 62% during Although neither the management nor the Board of Directors have hinted at an increase, given the absence of new acquisitions or stake increases, we believe that an increase in payout is bound to happen sooner or later. Cash has been piling up, and net cash per share stood at SAR 6.9 at the end of 4Q 212, a YoY increase of 53%. 2% 18% 16% 14% 12% 1% 8% 6% 4% 2% % 12.8% 14.1% 15.1% 16.% 18.% 213E 214E 215E 216E 217E Page 44

45 SAUDI TELECOM COMPANY Our forecast vs. consensus Our forecasts are conservative compared to Bloomberg consensus estimates. For 213, we forecast revenue of SAR6.7bn, 3.2% lower to consensus while our earnings forecast is 2.% lower. However, we see STC sustaining higher EBITDA margins (than consensus) going forward reflecting our view of a higher business mix from data services. Conservative forecast compared to consensus Forecast 213e 214e Saudi Fransi Capital Consensus Difference (%) Saudi Fransi Capital Consensus Difference (%) Revenue (SAR mn) 6,722 62,7-3.2% 62,659 65, % EBITDA ( SAR mn) 22,191 22, % 23,132 23, % EBITDA margin (%) 36.5% 35.9% 63bps 36.9% 35.8% 112bps EPS (SAR per share) % % *Consensus forecast as of February 11, 213 Sources: Bloomberg, analysis 4Q 212 results: One-off charges impact bottom line STC s earnings surprisingly declined 8% in 4Q 212. The company reported one-time non-recurring, non-cash charges of SAR 1.2bn in its International operations. The bottom line was impacted by the SAR 641mn charge related to the revaluation of investments fair value in Cell C (South Africa) and Aircel (India). In addition, STC shared a one-off charge of SAR 544mn in Binariang Holdings which led to a deferred tax charge for its investments in Aircel, India. However, excluding these charges, the company s net income grew 1.2% YoY in 212. Results snapshot 4Q and FY212 In SAR mn 4Q 211 4Q 212 Difference (%) Difference (%) Revenue 15,249 14, % 55,662 59, % Gross profit 7,935 8, % 31,328 33, % Operating income 2,814 1,9-32.5% 11,171 11,252.7% EBITDA 5,21 4, % 2,25 2,35 1.4% Net income 2, % 7,729 7,35-4.9% Sources: Company reports, analysis In a worst case scenario, STC could take upto 32% knock on earnings Considering the uncertainty over one-off charges in STC s international operations, we look at potential scenario s to assess the impairment risks attached to some of its key international assets Binariang, Oger and PT Axis. Our analysis indicates a potential 32% knock on 213 earnings at a worse case scenario (1% impairment of the goodwill recorded for these investments). On a per share basis this translates to SAR 1.4 per share negative impact for STC. Scenario: Impact on earnings resulting from one-off impairment charges Goodwill Impairment Charge (%) Binariang Holdings Oger Telecom PT Axis Total Impact On 213 Earnings Per Share Impact (SAR) 1% -19.8% -7.2% -4.6% -31.5% 1.4 8% -15.8% -5.7% -3.7% -25.2% % -11.9% -4.3% -2.7% -18.9%.84 4% -7.9% -2.9% -1.8% -12.6%.56 2% -4.% -1.4% -.9% -6.3%.28 Sources: analysis Page 45

46 SAUDI TELECOM COMPANY Valuation We arrive at a fair value of SAR 51.1 per share for STC Mispricing of STC s stock; a buying opportunity We have valued STC using the Weighted Average approach. The methods used include Discounted Cash Flow (DCF) Sum-of-the-parts and relative valuation. We assigned higher weight to DCF approach, and arrived at a target price of SAR 51.1 per share for STC, indicating a 28% upside from current levels. Valuation summary of STC Fair Value Weights DCF Valuation SAR % EV/EBITDA SAR % Fair P/E Multiple SAR % Sum-of-the-parts (SOTP) SAR % Weighted Average Fair Value SAR 51.1 Upside/(Downside) from current market price % 28.% Sources: analysis Valuation - Scenario Analysis Fair Value estimate at different scenario s Base Case Mobile penetration rate in Saudi Arabia expected to reach 21% by 217e 3 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Bull Case Base Case Bear Case Initiating coverage with a BUY rating Overall, we find STC shares attractive at current levels; upside potential of 28% STC shares offer a good margin of safety; limited downside Sources: Bloomberg; analysis SAR 59.3 SAR 5.8 SAR 46.7 Fair Value Bull Case STC to retain 45% market share in mobile and 9% in fixed line and fixed broadband Price-based competition to dent ARPU by 4% yoy Capex-sale to moderate to 13% over the long term Mobile penetration rate in Saudi Arabia to reach 23% by 217e STC to increase market share in mobile to 48% and retain 9% in fixed line and fixed broadband Operators to focus more on service differentiation beyond price-based competition; ARPU down 1% yoy Capex-sale to moderate to 12% over the long term Bear Case Little room for increase in mobile penetration rate in Saudi Arabia; to touch 195% by 217e STC unable to maintain market position in mobile and fixed line services ( down to 4%/ 85% respectively) Aggressive price-based competition to significantly hurt ARPU; down 5% yoy Evolving technological changes push STC to continue at higher capex levels Page 46

47 SAUDI TELECOM COMPANY Discounted Cash Flow (DCF) Our DCF model is based on a five-year explicit forecast period until 217. We arrived at a WACC of 11.1% for STC, slightly higher than what we used for Mobily. In terms of terminal growth, we applied a 2.5% terminal growth rate to estimate the terminal value. With this terminal growth rate being in line with what we used for Mobily, we believe it to be on the conservative side specifically given STC s presence in several potentially high growth international markets. Our DCF approach yields a fair value of SAR 58.8/share. STC: Discounted cash flow valuation summary In SAR mn 213e 214e 215e 216e 217e EBIT * (1-t) 11,189 11,52 12,158 12,881 13,692 Add: Depreciation and Amortization 1,69 1,671 11,254 11,847 12,45 Less: Minority interests (699) (727) (756) (786) (817) Changes in Working capital (642) (781) (1,142) (1,548) (1,615) Capital expenditure (9,716) (9,399) (9,51) (9,597) (9,333) Free Cash flow to Equity 1,21 11,267 12,14 12,798 14,376 Present Value of the free cash flow 9,35 9,263 8,92 8,544 8,651 Terminal Value 174,378 PV of future cash flows 44,666 PV of terminal value 14,936 Total Enterprise Value 149,61 Add: Cash & Equivalents 13,792 Less: Debt 34,823 Less: Minority Interest 7,575 Less: Other liabilities 3,449 Equity Value 117,547 Number of shares (mn) 2, Fair value per share SAR 58.8 Upside/(Downside) % 47.3% Sources: analysis Fair Price-Earnings (P/E) multiple approach We use a Fair P/E multiple approach using the formula (RoE-g)/(RoE*(Ke-g)), which in our view best captures the risk/return and growth prospects of the company. We arrive at a Fair P/E multiple of 1x for STC, a 1% discount to MEA 213 median P/E multiple based on a ROE assumption of 15.9%, growth of 2.5% and a discount rate of 11%. Our Fair value estimate using P/E approach is SAR 44.1 per share derived by applying a 1x P/E multiple to 213 earnings forecast of SAR 4.4 per share. Page 47

48 SAUDI TELECOM COMPANY Relative valuation For STC s market approach based relative valuation, we used EV/EBITDA multiples, which we believe is the most suited for valuing STC. We selected a peer group of telcos operating within the GCC region and operators based outside of the GCC but with operations in the MENA region (MTN, Vodacom, and Maroc Telecom). Our comparative valuation is summarized in the following table. We expect STC s multiples to trade in line with the median valuation multiples of its peer group. Relative Valuation Market Cap (USD mn) Price/Earnings (x) EV/ EBITDA (x) Company 212e 213e 214e 212e 213e 214e Saudi Telecom 21, Etihad Etisalat 15, Etisalat 2, Du 4, Batelco 1, Omantel 2, Zain Kuwait 12, Qtel 1, Jordan Telecom 1, Turkcell 14, Vodacom 19, MTN 37, Maroc Telecom 1, Median Multiple for Saudi Arabia (Ex- Zain KSA) Median Multiple for GCC Median Multiple for MEA Sources: Bloomberg, analysis Note: Relative valuation based on closing prices as of February 11, 213 EV/EBITDA approach: We apply MEA peer EV/EBITDA to reflect the company s risk/return and growth prospects. This however is conservative as STC offers international growth opportunity, especially in fast growing Asia region, while it remains less exposed (relatively) to conflict regions in the Middle East. Our Fair value estimate using EV/EBITDA approach is SAR 47.6 per share derived by applying a 5.6x EV/EBITDA to 213 EBITDA forecast of SAR 22.2bn and deducting net debt, minority interests and liabilities of SAR 32.1bn. Page 48

49 SAUDI TELECOM COMPANY Sum-Of-The-Parts (SOTP) We have also valued STC on a sum-of-the-parts (SOTP) basis. We considered each operation and arrived at an EV/EBITDA-based approach value for individual assets. We applied EV/EBITDA multiples for each region into the forecasted EBITDA (for unlisted entities Cell C, Viva operations in Kuwait and Bahrain, Axis, Aircel and other assets of STC) and on consensus estimates (for listed entities Maxis and Turk Telecom). We arrived at an SOTP value of SAR 45.9 per share for STC. STC: Sum of the Parts Value Entity Effective interest (%) of STC shareholder Type EV/ EBITDA multiple EBITDA 213e Currency Enterprise Value (in SAR mn) Share to group (%) STC - Saudi Arabia 1% ,268 SAR 96, % Oger Telecom Turk Telecom 19% Listed 5.6 5,38 TRY 11,93 9.6% Cell C 26% Unlisted USD 1, % Viva Kuwait 26% Unlisted USD 626.5% Bahrain 1% Unlisted USD 1,24 1.% Binariang Maxis 16% Listed 7.6 4,526 MY 6,73 5.4% Aircel 19% Unlisted USD 1,46.8% Axis Indonesia 84% Unlisted USD 3, % Other Assets Unlisted SAR 1,154.9% Total 123,775 1% Enterprise Value 123,775 Add: Cash 13,792 Less: Debt 34,823 Less: Minority Interests 7,575 Less: Other liabilities 3,449 Equity Value 91,721 Number of shares (mn) 2, Fair value per share SAR 45.9 Upside/(Downside) % 14.9% Exchange rates used Sources: Bloomberg, analysis USD:SAR: 3.75 ; Turkish Lira TRY:SAR: 2.11; Malaysian Ringgit MYR:SAR:1.2 Page 49

50 SAUDI TELECOM COMPANY FINANCIALS INCOME STATEMENT Income Statement (in SAR mn) E 214E Revenue from services 47,469 5,78 51,787 55,662 59,372 6,722 62,659 Cost of services (17,837) (19,779) (21,464) (24,334) (25,775) (25,983) (26,578) Gross Profit 29,633 31,1 3,323 31,328 33,597 34,739 36,8 Gross profit margin (%) 62.4% 61.% 58.6% 56.3% 56.6% 57.2% 57.6% Selling & marketing expenses (2,128) (6,866) (7,83) (7,424) (8,489) (8,29) (8,554) General & administrative expenses (5,762) (3,522) (3,619) (3,879) (4,162) (4,258) (4,394) Depreciation & amortization (6,48) (7,799) (8,642) (8,854) (9,53) (1,69) (1,671) Impairment provisions (641) - - Total Operating Expenses (14,297) (18,187) (19,344) (2,157) (22,345) (22,616) (23,619) Operating Income 15,335 12,814 1,978 11,171 11,252 12,122 12,461 EBITDA ( Ex-One Off) 21,743 2,612 19,621 2,25 2,945 22,191 23,132 EBITDA margin (%) (Ex-One off) 45.8% 4.6% 37.9% 36.% 35.3% 36.5% 36.9% Cost of early retirement program (675) (811) (66) (414) (313) (319) (325) Finance costs (1,432) (1,385) (1,781) (2,238) (2,53) (2,548) (2,599) Commissions and interest Other Income (1,89) 1,151 2,76 (481) Other income and expenses, net (3,293) (683) (1) (2,683) (1,971) (1,736) (1,762) Income before Zakat 12,42 12,13 1,977 8,488 9,281 1,387 1,699 Zakat (376) ( 335) (118) (118) (247) (286) (294) Provision for tax (457) ( 642) (82) (479) (1,11) (527) (543) Net Income 11,21 11,154 1,39 7,891 8,23 9,574 9,862 Non-controlling interests (172) (29) (62) (163) (672) (699) (727) Net Income for the year 11,38 1,863 9,436 7,729 7,351 8,875 9,135 Basic EPS on net income DPS No: of shares 2, 2, 2, 2, 2, 2, 2, Sources: Company reports, analysis Page 5

51 SAUDI TELECOM COMPANY FINANCIALS - BALANCE SHEET Balance sheet (in SAR mn) E 214E Cash and cash equivalents 8,61 7,71 6,51 6,589 5,115 13,936 21,819 Short term investments ,446 8,677 8,677 8,677 Accounts receivable, net 8,12 11,461 8,77 8,755 9,89 1,624 1,128 Prepayment and other current assets 2,765 3,492 3,561 4,177 5,11 5,333 5,53 Total Current Assets 18,946 22,663 18,74 21,967 28,783 38,57 46,128 Investments in equity & others 2,452 2,533 2,54 2,682 2,732 2,786 2,842 Property, plant and equipment, net 44,382 52,737 55,127 55,85 56,5 56,972 56,957 Intangible assets, net 31,695 29,222 31,837 29,318 28,162 26,843 25,585 Other non-current assets 2,287 2,433 2,572 2,349 2,23 2,341 2,458 Total Non Current Assets 8,816 86,924 92,77 89,435 89,128 88,942 87,842 Total Assets 99,762 19,587 11, ,42 117, , ,97 LIABILITIES & EQUITY Accounts payable 6,649 7,657 7,36 5,19 6,569 6,868 7,87 Other credit balances - current 4,335 4,819 3,59 3,667 3,987 4,149 4,315 Accrued expenses 5,762 6,25 6,58 8,576 7,785 8,139 8,412 Deferred revenues - current portion 2,248 2,81 1,568 1,858 2,185 2,229 2,273 Murabahas and loans - current portion 3,95 8,579 8,447 5,972 4,712 5,1 5,22 Total Current liabilities 22,899 29,341 26,618 25,263 25,237 26,485 27,289 Murabaha and loans - non current portion 28,81 22,711 21,741 23,96 26,124 28,277 28,843 Provisions for end of service benefits 2,738 2,844 2,995 3,62 3,449 3,733 3,88 Other payables - non current portion 3,482 3,859 5,962 5,35 4,133 4,474 4,563 Total Non Current Liabilities 34,31 29,414 3,698 32,56 33,76 36,484 37,214 Share capital 2, 2, 2, 2, 2, 2, 2, Statutory reserve 8,233 9,299 1, 1, 1, 1, 1, Retained earnings 9,783 13,552 16,287 19,516 22,866 27,742 31,94 Other reserves - - (1,269) (1,133) (671) (671) (671) Financial statements' translation differences (378) (816) (22) (1,474) (81) (81) (81) Total Shareholders' equity 37,638 42,35 44,996 46,98 51,394 56,269 6,467 Non-controlling interests 4,924 8,798 8,468 7,174 7,575 8,274 9, Total liabilities and equity 99,762 19,587 11, ,42 117, , ,97 Sources: Company reports, analysis Page 51

52 SAUDI TELECOM COMPANY FINANCIALS CASH FLOW Cash flow statement (in SAR mn) E 214E Net cash provided by operating activities 21,149 15,956 21,185 16,488 12,16 23,682 23,749 Net cash flows from investing activities (35,468) (13,542) (13,175) (8,264) (9,31) (9,321) (8,996) Net cash generated from financing activities Net increase/ decrease in cash and cash equivalents Cash & cash equivalents at the beginning of the period Cash & cash equivalents at the end of the period Sources: Company reports, analysis 14,763 (2,765) (9,669) (7,686) (4,278) (4,6) (6,869) 443 (351) (1,659) 538 (1,473) 1,356 7,883 7,618 8,61 7,71 6,51 6,589 5,115 13,936 8,61 7,71 6,51 6,589 5,115 13,936 21,819 Page 52

53 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 ETIHAD ETISALAT COMPANY Mobily: Investment Highlights Rating Summary MOBILY HOLD We initiate coverage on Mobily (72/ EEC AB) with a HOLD rating and a TP of SAR 8.6, implying an upside of 7.8% to the last close of SAR 74.8 per share. At 6.9x EV/EBITDA on 213 estimates, Mobily is trading at a premium to GCC and MEA peers. Mobily has created strong market presence in Saudi Arabia, and it is poised to benefit from the growing demand for broadband in the Kingdom. It has aggressively rolled out mobile networks across Saudi Arabia and is gaining on market leader STC. We forecast EPS 213 of SAR 8.3, an earnings growth of 6.4% YoY. Assuming maintained DPS (at SAR 1.15 per share), the implied dividend yield of 6.2% makes the counter attractive to hold. Mobily leads fast-growing mobile broadband market in Saudi Arabia: Mobily currently holds an estimated 4% share in Saudi Arabia s mobile market in terms of subscribers; additionally, it is the leader in the mobile broadband market with more than 8.7mn subscribers (estimated ~7% market share). Apart from tapping the mobile broadband opportunity, Mobily is positioning itself as a provider of fixed broadband services through the purchase of Bayanat. This would enable the company to compete more effectively with STC s bundled service offerings. Revenues from the fiber optic and 4G networks grew more than 7% YoY. Overall, we expect Mobily s revenue to grow at a CAGR of 5.4% during We forecast 213e top-line of SAR25.6bn, 8.1% higher YoY. Increasing contribution from data services; EBITDA outlook positive: Mobily is capitalizing on the rising broadband penetration trend in the Kingdom. High ARPU data services accounted for 3% of the company s revenues in 4Q 212 which is expected to reach 34% by 214. Increasing contribution from data services and anticipated pricing power through 4G services could translate into higher EBITDA margins for Mobily. We expect a 7.9% yoy growth in Mobily s EBITDA in 213 to reach SAR 9.3bn. CAGR for our forecast period is 6.7%. Management s track record and superior ROE warrant sector premium: Mobily operates at an industry leading ROE (~3% in 211), second only to Maroc/Vodacom from among the leading Middle East and Africa (MEA) telcos. Considering the greenfield operations of the company (unlike the incumbent advantage enjoyed by Maroc/Vodacom), the management s track record of delivering profitable growth at high ROE s is notable. Mobily warrants a premium to its peers, in our view. We forecast Mobily s ROE to average 25.4% in our forecast period till 217. Shares fully priced with limited upside potential: While the ongoing business momentum is a positive for Mobily, we see Mobily s shares fully priced at current levels. Mobily is rewarding its shareholders through a bonus issue (1:1), which was recently approved by the board. Mobily also announced a dividend of SAR 1.15 per share in 4Q 212, taking its total dividend distribution in 212 to SAR 2.99bn. Mobily s shares have outperformed TASI owing to the former s ongoing business momentum and are expected to command a premium valuation. TARGET PRICE (SAR) 8.6 Upside/(Downside) 7.8% Stock Details Current Price* SAR 74.8 Market Capitalization SAR Mn 57, 58 Shares Outstanding Mn Week High SAR Week Low SAR 53. Price Change (YTD) % 8.2 EPS (213e) SAR 8.3 Beta (1 Year Adj.).8 Reuters Code / Bloomberg Symbol *Price as of February 11, 213 Key Shareholders 72.SE EEC AB Etisalat 27.5% GOSI 11.4% Other Saudi Investors and Public 61.1% Sources: Company reports, Zawya Price Multiples Current 213e P/E(x) EV/EBIDTA (x) Dividend Yield (%) Sources: Bloomberg, analysis Mobily vs. TASI Mobily TASI Source: Tadawul Sector Coverage Roy Cherry rcherry@fransicapital.com.sa Refer to important terms or use, disclaimers and disclosures on back page.

54 ETIHAD ETISALAT FINANCIALS & RATIOS Key Financials ( in SAR mn) E 214E Revenue 1,795 13,58 16,13 2,52 23,642 25,553 26,461 EBITDA 3,794 4,837 6,165 7,454 8,591 9,267 9,66 EBIT 2,99 3,45 4,279 5,138 6,88 6,497 6,893 Net Profit 2,92 3,14 4,211 5,83 6,18 6,46 6,797 Balance Sheet (in SAR mn) Current Assets 6,621 8,577 9,415 9,893 1,427 12,68 14,868 Property Plant and Equipment 8,117 1,37 12,457 16,412 17,255 19,646 21,818 Net intangible assets 1,923 1,45 1,28 9,665 9,412 8,833 8,252 Total Assets 27,192 3,926 33,43 37,51 38,623 42,617 46,468 Total Debt 9,79 8,595 7,972 7,73 8,258 9,39 9,468 Total Equity 9,754 12,243 15,58 18,388 2,96 23,769 26,88 Total Liabilities 27,192 3,926 33,43 37,51 38,623 42,617 46,468 Cash Flow Statement Net cash provided by operating activities 3,546 4,246 5,47 6,673 7,37 8,833 9,332 Cash flows from Investing Activities (5,571) (2,889) (3,227) (3,48) (5,86) (4,465) (4,234) Cash flows from Financing Activities 2,586 (1,687) (1,516) (3,237) (2,338) (2,761) (3,329) Key Ratio E 214E Gross margin (%) 55.8% 57.8% 54.9% 51.5% 5.9% 5.9% 51.1% EBITDA margin (%) 35.1% 37.% 38.5% 37.2% 36.3% 36.3% 36.5% Revenue growth (%) 27.9% 21.% 22.6% 25.2% 17.9% 8.1% 3.6% Growth in EBITDA (%) 28.7% 27.5% 27.5% 2.9% 15.2% 7.9% 4.2% Growth in earnings (%) 51.6% 44.1% 39.7% 2.7% 18.4% 6.4% 6.1% Debt/ Equity (x) Capex/ Sales 27.4% 25.2% 2.5% 18.5% 2.6% 17.5% 16.% ROAA (%) 8.9% 1.4% 13.1% 14.3% 15.8% 15.8% 15.3% ROAE(%) 26.7% 27.4% 3.3% 29.9% 3.6% 28.7% 26.9% Cash Flow Yield (%) 1.% 1.7% 3.8% 5.2% 3.8% 7.3% 8.6% Per Share Ratios Earnings per share Dividend per share Valuation Ratios P/Earnings P/Book EV/ EBITDA P/Sales Sources: Bloomberg, Company reports, analysis Note: Per share data for Mobily based on 77mn shares; Historical multiples based on closing prices as of February 11, 213 Page 54

55 ETIHAD ETISALAT Investment Thesis Mobily establishing itself as market leader from being market challenger Mobily is the second-largest telco in the Kingdom Etihad Etisalat Company (Mobily) was established in 24 in the monopolistic Saudi Telecom market, and it launched commercial services in May 25. Backed by the UAE-based Etisalat, which paid USD 3.5bn for the mobile licenses (2G and 3G) in 24, Mobily currently has a mobile subscriber base of over 11.1mn. It holds an estimated 4% share of the mobile market and nearly 77% share in the mobile broadband space. Mobily has been in the forefront of introducing new technologies in the Kingdom; it recently became the first operator to launch TDD-LTE (4G) services in the Middle East and North Africa region through its subsidiary Bayanat Al Oula. We forecast Mobily s revenue to reach SAR 25.6bn in 213 and increase to SAR 26.1bn by 214, a growth of 8.1% yoy. We expect company s data revenues to increase their contribution to SAR 8.3bn or ~31% by 214 compared to SAR 6.5bn or ~27% in 212 while the contribution from Mobile / Others (which include product distribution / Smartphones) is expected to decline to 69% by 214 from 73% in Increasing contribution from data services for Mobily 5 Revenue trend Mobily (28-14e) in SARbn Sources: Company reports, analysis e 213e 214e Broadband / Data Mobile/ Others Solid mobile infrastructure; but behind in fixed broadband 1% 8% 6% 4% 2% % 9% Mobily revenue mix (28-14e) 91% 86% 82% 78% 73% 7% 69% 14% 18% 22% 27% 3% 31% e 213e 214e Broadband / Data Mobile/ Others The strategic Bayanat Al Oula acquisition offers Mobily entry into the mobilefixed data convergence market We expect Mobily to continue its leadership position in the mobile broadband market; additionally, Mobily is positioning itself in the fixed broadband market through key acquisitions. The SAR 2.9bn acquisition of Bayanat Al Oula, a regional WiMax broadband player, in 21 was a step in this direction. Mobily thus introduced broadband services, branded as broadband@home, to compete with STC in the household market. Similarly, through the SAR 8mn acquisition of Zajil, a local internet service provider Mobily strengthened its presence in Saudi Arabia s broadband market. However, we highlight that Mobily (3, km of fiber) is significantly behind STC (3,km of fiber) in the fixed broadband space. Mobily has more than 8.7mn mobile broadband subscribers and an estimated ~77% market share in Saudi Arabia in 211. Although STC is expected to make inroads into the mobile broadband space, we see Mobily continuing its leadership position in Saudi Arabia. The company has completed the deployment of its 4G LTE network across the Kingdom, and it is poised to compete with STC. Mobily intends to cover more than 32 cities and 85% of the population in Saudi Arabia under its 4G network. Mobily is increasingly tilting its business mix towards high-arpu data services, a positive for margins Furthermore, the favorable broadband penetration trends in the Kingdom are advantageous for Mobily. The company is increasingly shifting its business mix toward high-arpu data services. From accounting for only 9% of the company s total income in 28, data revenues are expected to reach 33% by 217. In fact during 4Q 212, Mobily s data revenue grew 41% year over year with data traffic volumes of 75 Tb per day as against 163 Tb in 211. We expect Mobily s market share in mobile broadband to reach ~71% by 214 and 65% by 217. Page 55

56 Subscribers (mn) ARPU (SAR per month) Subscribers (mn) ARPU (SAR per month) ETIHAD ETISALAT Mobile and broadband segment forecast Mobile segment Subscribers vs ARPU (21-217e) Mobile broadband - Subscribers vs ARPU (21-217e) e 213e 214e 215e 216e 217e e 213e 214e 215e 216e 217e Mobily Subscribers ARPU (RHS) Mobily Subscribers ARPU (RHS) Sources: analysis We forecast Mobily s mobile subscribers in Saudi Arabia to reach 22.1mn in 213 and increase to 23.2mn by 214, while mobile ARPU is expected to contract marginally by 1% annually to SAR 67 per month by 214. In the broadband market, we expect Mobily to lose some of its market share, mostly to STC and Zain KSA. Mobile broadband subscribers for Mobily are forecast to reach 1.4mn in 213 and increase to 12.5mn by 214, while ARPU is expected fall 1% annually to SAR 6 per month by 214. For the fixed broadband segment, we expect the company to make steady inroads as it completes its FTTH roll-out over the next five years. We forecast Mobily to have a 1% share of the market by 217 with an estimated.3-.5mn subscribers by 217. Data services the key margin driver, EBITDA outlook positive Mobily expected to sustain EBITDA margin levels in the high 3 s over our forecast period. While we see Mobily s ARPU contract 1% over our forecast period, increasing contribution from data services and the expected pricing power through 4G services should translate into higher EBITDA margins for the company. Mobily is expected to benefit from fiber-optic and 4G data service revenues, which increased by more than 7% in 4Q 212. The company invested in the advanced 4G network through Bayanat; this network covers more than 4,5 sites across the Kingdom. In addition, it is rapidly establishing its presence in the Enterprise segment, the revenues of which grew 71% yoy in 4Q 212. Overall, we expect long term operational gearing, data business growth, impact of lower government royalties (8% versus 15% for mobile) to boost EBITDA margins by 2 22 bps over our forecast period (217e). Positive EBITDA outlook EBITDA Margin Outlook 28-14e (in SAR bn) EBITDA Margin Outlook 28-14e (%) % 39% 37% 35% 33% 31% 38.5% 37.% 37.2% 36.3% 36.3% 36.5% 35.1% E 214E 29% 27% 25% E 214E Sources: Company reports, analysis Page 56

57 ETIHAD ETISALAT Earnings outlook is positive We expect Mobily s earnings to grow 6.4% in 213 and forecast its 213 net income to touch SAR 6.4bn. This translates into an EPS of SAR 8.3 (on 77mn shares outstanding). The net profit margin is expected to remain around the ~25% level during the forecast period (217e). Earnings outlook positive Earnings per share* outlook 28-14e (in SAR) Net Income margin 28-14e (%) % 25% 2% 19.4% 23.1% 26.3% 25.4% 25.5% 25.1% 25.7% % % 5% 2 % E 214E E 214E *EPS adjusted for 77mn shares Sources: Company reports, analysis Page 57

58 ROE (%) 211 ETIHAD ETISALAT Management track record and superior ROE are positives for Mobily Mobily enjoys industryleading ROE; management track record is a positive In 211, Mobily extended its management agreement with Etisalat (UAE) for five years. This irons out any management-related concerns, unlike the case with STC. The company management has also laid down a stretched T-Strategy framework that focuses on growth, efficiency, and differentiation (GED). (See Appendices A & B for details of Executive Management/Corporate Strategy) Mobily operates at a superior 3%+ RoE (MEA average of 22%), which in our view is a key positive for this name. Its policy of quarterly dividend distribution as against half-yearly is also a positive for the stock. We forecast Mobily ROE to average 25.1% in our forecast period (217e). Mobily s return profile is industry-leading; ROE outlook positive Mobily vs select MEA peers - ROE 211 (%) Mobily- ROE Outlook (%) Size of bubble indicates market cap STC Qtel Turkcell Etisalat Du MTN Batelco Zain Kuwait Vodacom Maroc Telecom Mobily Omantel Jordan Telecom ROA (%) % 3% 29% 28% 27% 26% 25% 24% 26.7% 27.4% 3.3% 29.9% 3.6% 28.7% 26.9% E 214E Sources: Bloomberg, Company reports, analysis Page 58

59 ETIHAD ETISALAT Mobily to continue its ambitious capex program According to management, the company plans to invest around SAR 22.bn in network infrastructure development over the next five years. Mobily recently awarded contracts worth SAR 963mn (USD 256mn) to Huawei and Ericsson for upgrading its 3G and 4G networks. Besides investing in the mobile broadband space, Mobily aims to strengthen its fiber optic network to cover 5, residential units by 213. In light of the capex program, the company s capexsales ratio is expected to remain ~16% in our forecast period. Aggressive Capex plan at Mobily Capex outlook 28-14e (in SAR bn) Capex-Sales 28-14e (%) % 27% 25% 23% 21% 19% 27.4% 25.2% 2.6% 19.8% 18.5% 17.5% 1 17% 16.% E 214E 15% E 214E Sources: Company reports, analysis Mobily s high capex program is expected to dent free cash flows for the near term. We forecast Mobily to generate SAR4-6bn annually in our forecast period. Mobily offers a free cash flow yield of 7.3% on 213 estimates. Capex plans to dent free cash flows in the near term Free cash flow outlook e (in SAR bn) Free cash flow yield e (%) % 12% 1% 8% 7.3% 8.6% 9.5% 1.2% 11.% 3 6% 2 4% 1 2% 213E 214E 215E 216E 217E % 213E 214E 215E 216E 217E Sources: Company reports, analysis Page 59

60 ETIHAD ETISALAT Mobily is a key asset for Etisalat; a case for future stake increase exists Etisalat could look to expand its participation in Saudi Arabia beyond its current 27.5% interest. With the growth outlook for Mobily being positive, we look at the business case for Etisalat to consider increasing its stake in Mobily beyond 27.5%. We expect the following factors as being favorable from Etisalat s perspective: a) Mobily is a high-roe operation in a low risk, high-growth market; b) High degree of competition in the domestic market UAE Du has successfully penetrated the market is pushing the company to chase growth outside the UAE; c) Etisalat s other international operations are at high risk in the current geopolitical climate, for example Egypt (Etisalat Misr), Pakistan (PTCL) and Sudan Mobily expected to continue with the shareholder-friendly policy The recent Board approval for a bonus share (1:1) indicates management s focus on rewarding shareholders. Despite the resultant increase in its capital base (77mn shares), we expect the company to raise the payout ratio (55% over the forecast period). Mobily s shares offer an attractive dividend yield of 6.4% at the current market price. The company is paying a dividend of SAR 1.15 per share each quarter and is expected to increase its full year dividend to SAR 5. per share in 213. This translates into a post-bonus payout ratio of 55%. Mobily has a strong balance sheet with SAR 5.1bn in cash as of 4Q 212 and SAR 8.7bn in Short term investments. Our forecast vs. consensus Our forecasts for Mobily are broadly in line with the Bloomberg consensus estimates. For 213, we forecast revenue of SAR 25.6bn and EPS of SAR 8.3, in line with consensus. However, we expect a lower EBITDA margins (than consensus) going forward reflecting our more conservative view on the pace of margin improvement and increasing competition in the mobile broadband space (Mobily expected to lose market share). Broadly in line with consensus Forecast 213e 214e Saudi Fransi Capital Consensus Difference (%) Saudi Fransi Capital Consensus Difference (%) Revenue (SAR mn) 25,553 25,68 -.2% 26,461 27, % EBITDA ( SAR mn) 9,267 9, % 9,66 1,42-3.8% EBITDA margin (%) 36.3% 36.8% -48bps 36.5% 36.7% -23bps EPS (SAR per share) % % *Consensus forecast as of February 11, 213 Sources: Bloomberg, analysis Page 6

61 ETIHAD ETISALAT 4Q 212 results: Continuous business momentum Mobily continued to witness strong business momentum and reported a solid set of numbers for 4Q 212. Leveraging on Hajj season activities, the company s top line grew 16.7% yoy to SAR 6.8bn, while EBITDA increased 1.3%. Data revenue (up 4%) continued its double-digit trajectory and accounted for 3% of total revenue in 4Q 212. Earnings were up 1.7% yoy for the quarter to reach SAR 1.7bn. Results snapshot 4Q and FY212 In SAR mn 4Q 211 4Q 212 Difference (%) Difference (%) Revenue 5,82 6, % 2,52 23, % Gross profit 3,87 3, % 1,326 12, % Operating Income 1,754 1,92 8.4% 5,35 6, % EBITDA 2,35 2, % 7,454 8, % Net Income 1,697 1, % 5,83 6, % Sources: Company, analysis Page 61

62 ETIHAD ETISALAT Valuation We arrive at a fair value of SAR 8.6 per share for Mobily Mobily looks fully priced at current levels, limited upside seen. We valued Mobily using the Weighted Average approach. The methods used include discounted cash flow, Fair P/E and EV/ EBITDA multiple. We assigned higher weight to DCF approach, and arrived at a fair value a fair value of SAR 8.6 per share for Mobily, indicating a 7.8% upside from current levels. Valuation summary of Mobily Fair Value Weights DCF Valuation % EV/ EBITDA % P/E Multiple % Weighted Average Fair Value 8.6 Upside/(Downside) from current market price % 7.8% Sources: analysis Valuation - Scenario Analysis Fair Value estimate at different scenario s 4 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Overall, we find Mobily shares to be almost fully priced at current levels; 7.8% upside potential seen. We would wait and observe Mobily s progress in penetrating Saudi Arabia s fixed broadband market. Initiating coverage with a HOLD rating Sources: Bloomberg; analysis SAR 92.4 SAR 8.6 SAR 71. Fair Value Bull Case Base Case Bear Case Base Case Bull Case Bear Case Mobile penetration rate in Saudi Arabia expected to reach 21% by 217e. Mobily to retain 4% market share in mobile services and 65% share in mobile broadband. Price-based competition to affect ARPU, expected to decline of 1% yoy. Capex-sales to moderate to 16% over the long term. Mobile penetration rate in Saudi Arabia expected to reach 23% by 217e. Mobily to emerge market leader in Mobile service with 45% market share; to hold 7% market share in mobile broadband. Operators to focus more on service differentiation beyond price-based competition; ARPU expected to decline of remain flat yoy. Capex-sales to moderate to 14% over the long term. Penetration rates in Saudi Arabia expected to reach only 195% by 217e. Mobily is unable to maintain market position and loses out to competition STC and Zain KSA. Aggressive price-based competition to deteriorate ARPUs considerably; decline of 2% yoy. Cost overruns in Fiber rollout to increase capex; deployment of emerging technological changes. Page 62

63 ETIHAD ETISALAT Discounted Cash Flow (DCF) Our DCF model is based on a five-year explicit forecast period until 217. We arrived at a WACC of 1.7% for Mobily, slightly lower than what we used for STC. In terms of terminal growth, we applied a 2.5% terminal growth rate to estimate the terminal value. Our DCF approach yields a fair value of SAR 79.2/share. Mobily: Discounted cash flow valuation summary In SAR mn 213e 214e 215e 216e 217e EBIT * (1-t) 6,55 6,95 7,388 7,718 8,38 Add: Depreciation and Amortization 2,653 2,643 3,15 3,368 3,74 Changes in Working capital (514) (389) (469) (56) (543) Capital expenditure (4,465) (4,234) (4,468) (4,698) (4,926) Free Cash flow to Equity 4,224 4,97 5,465 5,882 6,39 Present Value of the free cash flow 3,862 4,15 4,79 3,965 3,843 Terminal Value 79,113 PV of future cash flows 19,854 PV of terminal value 48,19 Total Enterprise Value 68,45 Add: Cash 1,32 Less: Debt 8,258 Less: Other liabilities 137 Equity Value 6,951 Number of shares (mn) 77 Fair value per share SAR 79.2 Upside/(Downside) % 5.9% Sources: analysis Page 63

64 ETIHAD ETISALAT Fair Price-Earnings (P/E) multiple approach We use a Fair P/E multiple approach using the formula (RoE-g)/((RoE*(Ke-g)), which in our view best captures the risk/return and growth prospects of the company. We arrive at a Fair P/E multiple of 11x for Mobily, a moderate premium to MEA 213 median P/E multiple (reflecting the company s superior ROE) based on a ROE assumption of 25.4%, growth of 2.5% and a discount rate of 1.7%. Our Fair value estimate using P/E approach is SAR 91.8 per share derived by applying 11x P/E multiple to 213 earnings forecast of SAR 8.3 per share. Relative valuation For Mobily s market approach based relative valuation, we used the EV/EBITDA multiple, which we believe are the most-suited for valuing Mobily. We selected a peer group of telcos operating within the GCC region as well as those based outside of the GCC but with operations in the MEA region (MTN, Vodacom, Maroc Telecom). Our comparative valuation is summarized in the following table. We expect Mobily to continue commanding a premium over GCC peers and trade in line with the median valuation multiples of its MEA peer group. Relative Valuation Market Cap Price/Earnings (x) EV/ EBITDA (x) Company (USD) 212e 213e 214e 212e 213e 214e Saudi Telecom 21, Etihad Etisalat 15, Etisalat 2, Du 4, Batelco 1, Omantel 2, Zain Kuwait 12, Qtel 1, Jordan Telecom 1, Turkcell 14, Vodacom 19, MTN 37, Maroc Telecom 1, Median Multiple for Saudi Arabia (Ex- Zain KSA) Median Multiple for GCC Median Multiple for MEA Sources: Bloomberg, Analysis Note: Relative valuation based on closing prices as of February 11, 213 EV/ EBITDA approach: We apply a 2% premium to MEA peers EV/EBITDA to reflect the company s risk/return and growth prospects of Mobily and our applied EV/ EBITDA multiple of 6.7x. We justify this premium with the fact that Mobily offers a significantly above average ROE. Our Fair value estimate using the EV/EBITDA approach is SAR 71.4 per share; this was arrived at by applying a 6.7x EV/EBITDA to the 213 EBITDA forecast of SAR 9.3bn and deducting net debt and liabilities of SAR 7.1bn. Page 64

65 ETIHAD ETISALAT FINANCIALS INCOME STATEMENT Income Statement (in SAR mn) E 214E Revenues 1,795 13,58 16,13 2,52 23,642 25,553 26,461 Cost of Services and sales (4,768) (5,512) (7,23) (9,726) (11,68) (12,547) (12,928) Gross Profit 6,26 7,547 8,783 1,326 12,34 13,6 13,533 Gross margin (%) 55.8% 57.8% 54.9% 51.5% 5.9% 5.9% 51.1% Selling & Marketing Expenses (815) (1,93) (1,59) (1,173) (1,397) (1,518) (1,572) General & Administrative Expenses (1,417) (1,617) (1,559) (1,699) (2,46) (2,221) (2,3) Depreciation & Amortization (1,299) (1,629) (1,81) (2,149) (2,399) (2,653) (2,643) Total Operating Expenses (3,531) (4,339) (4,429) (5,21) (5,842) (6,392) (6,515) Operating Income 2,495 3,28 4,355 5,35 6,192 6,614 7,18 EBITDA 3,794 4,837 6,165 7,454 8,591 9,267 9,66 EBITDA margin (%) 35.1% 37.% 38.5% 37.2% 36.3% 36.3% 36.5% Finance expenses (437) (24) (146) (213) (169) (183) (192) Other Income Income before Zakat 2,99 3,45 4,279 5,138 6,88 6,497 6,893 Zakat (7) (31) (67) (54) (7) (91) (96) Net Income 2,92 3,14 4,211 5,83 6,18 6,46 6,797 Basic EPS (SAR) DPS (SAR) No: of shares Sources: Company reports, analysis Note: Per share data for Mobily based on 77mn shares; Page 65

66 ETIHAD ETISALAT FINANCIALS - BALANCE SHEET Balance sheet (in SAR mn) E 214E Cash and cash equivalents 1, ,661 1,69 1,32 2,715 4,483 Short Term Investments 1, Accounts Receivable, net 3,98 5,481 5,748 6,323 5,94 6,445 6,815 Due from Related Parties, net Inventories, net Prepaid Expenses & Other assets 1,63 1,361 1,237 1,399 2,493 2,669 2,764 Total Current Assets 6,621 8,577 9,415 9,893 1,427 12,68 14,868 Property, plant and equipment, net 8,117 1,37 12,457 16,412 17,255 19,646 21,818 Licenses, Acquisition fees, net 1,923 1,45 1,28 9,665 9,412 8,833 8,252 Goodwill 1,53 1,53 1,53 1,53 1,53 1,53 1,53 Total Non Current Assets 2,57 22,349 24,15 27,67 28,197 3,9 31,6 Total Assets 27,192 3,926 33,43 37,51 38,623 42,617 46,468 Short-term loans 1, , Current portion of long term debt 1,286 1,777 1,843 4, Accounts Payable 4,367 6,167 6,225 7,88 5,58 5,639 5,872 Due to related parties Accrued expenses and other liabilities 3,155 3,663 3,37 3,949 3,69 3,865 4,2 Total Current liabilities 1,749 12,189 12,256 18,47 1,75 1,556 1,955 Long term loans 6,642 6,448 5, ,56 8,124 8,53 Provisions for end of service benefits Total Non Current Liabilities 6,688 6,495 5,595 1,66 7,643 8,291 8,75 Authorized, issued and outstanding share capital 7, 7, 7, 7, 7, 7,7 7,7 Statutory reserve ,7 1,578 2,18 2,82 3,5 Retained earnings 2,47 4,595 7,51 9,81 11,726 13,249 15,68 Total Shareholders equity 9,754 12,243 15,58 18,388 2,96 23,769 26,88 Total liabilities and equity 27,192 3,926 33,43 37,51 38,623 42,617 46,468 Sources: Company reports, analysis Page 66

67 ETIHAD ETISALAT FINANCIALS CASH FLOW STATEMENT Cash flow statement (in SAR mn) E 214E Net cash provided by operating activities 3,546 4,246 5,47 6,673 7,37 8,833 9,332 Net cash flows from investing activities (5,571) (2,889) (3,227) (3,48) (5,86) (4,465) (4,234) Net cash generated from financing activities Net increase/ decrease in cash and cash equivalents Cash & cash equivalents at the beginning of the period Cash & cash equivalents at the end of the period 2,586 (1,687) (1,516) (3,237) (2,338) (2,761) (3,329) 561 (331) (387) 1,66 1, , ,661 1,69 1,32 2,715 1, ,661 1,69 1,32 2,715 4,483 Sources: Company reports, analysis Page 67

68 Saudi Arabia Telecom Appendix: Telecom sector Appendix A Telecom sector snapshot Key parameters e 217e Mobile subscribers (mn) Mobile penetration (%) 114% 14% 168% 187% 191% 192% 21% Fixed line subscribers (mn) Fixed line penetration* (%) 65% 65% 63% 63% 66% 67% 7% Fixed broadband subscribers (mn) Fixed Broadband penetration* (%) Market share Mobile (%) % 23% 3% 35% 39% 45% 6% STC 61% 53% 48% 47% 47% 46% 4% Mobily 39% 41% 41% 37% 39% 4% 45% Zain KSA % 6% 12% 16% 14% 14% 15% Mobile broadband subscribers (mn) Mobile Broadband penetration (%) * as a % of households Sources: CITC, ITU, analysis Appendix B Telecom Infrastructure STC/ Mobily STC % 1.3% 5.4% 9.8% 4.3% 43.% 7.% Technology Generation Platform Frequency Launch 2G GSM G GSM G GSM G W-CDMA G W-CDMA G W-CDMA G W-CDMA G LTE Sources: Company reports, analysis Mobily Year Aug-26 May-27 Dec-28 Mar-29 Feb-29 Apr-29 Dec-29 Sep-212 Technology introduced by Mobily UMTS UMTS/ HSDPA HSDPA Trial HSPA Launch HSPA+ Trial LTE Trial HSPA+ Launch TDD LTE Launch Sources: Company reports, analysis Page 68

69 Saudi Arabia Telecom Appendix C Fixed/ Mobile Technologies Fixed Network Download Speed Mobile Network Download Speed Technology Technology ADSL 1 Mbps GPRS 8 Kbps ADSL+ 24 Mbps EDGE 384 Kbps VDSL 52 Mbps UMTS 2 Mbps FTTH I Mbps LTE 3 Mbps FTTx GPON I Gbps IMT Advanced I Gbps Sources: Telefonica, analysis Page 69

70 Saudi Arabia Telecom Appendix: Saudi Telecom Company Appendix A: Executive Management Executive Title Eng. Abdulaziz A. Alsugair Dr. Khaled Abdulaziz Al Ghoneim Jameel Bin Abdullah Al Molhem* Krishnan Ravi Kumar Dr. Fahad Hussain Mushyat Eng. Mohammad Bin Nasser Al Jasser Eng. Ibrahim Bin Abdulrahman Al Omar Eng. Mazid Bin Nasser Al Harbi Ameen Bin Fahed Al Shiddi Dr. Mahmoud Abdulkarim Al Khatib Dr. Homoud Mohammed Al Kusayer Eng. Bandar Mohammad Al Gafari Eng. Omar Abdullah Al Nomany Chairman of The Board Chief Executive Officer (CEO) of STC Group CEO of STC Saudi Arabia* Group Chief Financial Officer (CFO) Vice President (VP) of Strategy Affairs VP of Enterprise Services VP of Personal Services VP of Home Services VP of Finance VP of Regulatory Affairs VP of Wholesale VP of Network Sector VP of Information Technology Sources: Company reports, Zawya * CEO of STC Saudi Arabia Jameel Bin Abdullah Al Molhem resigned recently Appendix B: Timeline STC Year Development 1998 Established in Saudi Arabia 22 Goes public via IPO 23 DSL services launched in Saudi Arabia 25 Introduces 3/3.5G services 27 Purchases stake in Maxis Communications 27 Wins third mobile license in Kuwait 28 Acquires 35% stake in Oger Telecom 28 Launches operations in Indonesia PT Axis 29 Wins third mobile license in Bahrain 21 Launches IP TV and triple play services in Saudi Arabia 211 Increases stake in Indonesia to 8.1% Sources: Company reports, Zawya Page 7

71 Saudi Arabia Telecom Appendix: Etihad Etisalat Company (Mobily) Appendix A: Executive Management Executive Abdulaziz Saleh Al Saghyir Khaled Omar Alkaf Abdulaziz Al Tamami Thamer Al Hosani Abdulrahman Ghaleb Marwan Al Ahmadi Hamed Al Kharji Ahmed Al Hashimi Mohammed Saad Beseiso Medhat S Amer Mohammed Basafi Nasser Al Nasser Taher Bin Ammar Bin Taher Al Dabbagh Fadi G Kawar Dr Fahed Moussa Al Zahrani Sami Nashwan Nader Nuwayhid Title Chairman Chief Executive Officer and Managing Director Chief Operating Officer Chief Financial Officer Chief Contracts and Administrative Officer Chief Business Officer Chief HR Officer Chief Marketing Officer (Acting) Chief Sales & Customer Relations Officer Chief Information Officer Chief Technical Officer (Fixed and Broadband Network) Chief Technical Officer (Mobile Radio Network) Senior Vice President, Partnership Strategy and Development Senior Vice President, Finance Strategy Senior Vice President, Human Resources Senior Vice President, Consumer Marketing Vice President, Investor Relations and Corporate Governance Sources: Company reports, Zawya Appendix B: GED strategy framework - Mobily Strategic Frame Development Growth (G) Efficiency (E) Differentiation (D) Action Mobily plans to tap the broadband market opportunity in the Kingdom and focus on developing international wholesale. Mobily seeks to leverage on its existing base of both consumer and corporate businesses. Optimizing Capex/Opex through network outsourcing and infrastructure sharing and aims to realize synergies by process optimization. Differentiation aspect revolves around a focus on improving customer experience, drive innovation, service standardization across product offerings and focus on developing skilled staff. Sources: Investor Presentation December 212, Mobily, analysis Page 71

72 Recommendation Framework Recommendation Framework BUY: The analyst recommends a BUY when our fair value estimate is at least 1% higher than the current share price. HOLD: The analyst recommends a HOLD when our fair value estimate ranges within ±1% of the current share price. SELL: The analyst recommends a SELL when our fair value estimate is lower by more than 1% from the current share price. Page 72

73 Research & Advisory Department Research & Advisory Department Head of Research & Advisory Roy Cherry Call centre Website: Page 73

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