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1 Qatari Banks EQUITIES FIG Share prices running ahead of fundamentals Share prices of Qatari banks we cover are up 19% in the last three months despite fairly weak fundamentals Declining ROIC, marginal ROE and negative free cash flows suggest banks should retain profit to rebuild CET1 ratios Our combined earnings revisions are negative. Downgrade Qatar National Bank to Reduce from Hold on valuation Qatar Aybek Islamov*, CFA Analyst HSBC Bank Middle East Ltd * Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations We remain negative on Qatari banks: The average 19% increase in Qatari banks share prices in the last three months, partly triggered by the FTSE Russell index rebalancing expected on 19 September, is disconnected from weak company fundamentals. Funding quality has deteriorated. Qatar became the largest importer of foreign liquidity in the GCC region. The USD9bn Sovereign bond issue in May helped to slow the drawdown of deposits from banks, improving domestic liquidity. However, the prospect of slowing loan growth in response to extremely weak domestic deposit formation threatens the asset quality outlook, in our view. ROIC and marginal ROEs are declining; three banks generate negative free cash flows and are short of capital: The decline in ROIC and marginal ROE suggests Commercial Bank of Qatar and Doha Bank should return capital to shareholders. But low CET1 ratios suggest to us both should retain capital by lowering payouts and risk asset growth. Qatar Islamic Bank and Masraf were able to improve or maintain ROIC at the expense of higher asset gearing and, in the case of QIB, a substantial drop in CET1 ratio. Masraf is the only bank that can raise its payout ratio, to compensate for slowing EPS growth. We think QNB can consider reinvesting profits into the business. Its payout ratio cut in Q to 22% from 50% in 2015 was very timely. We expect an improvement in ROIC and marginal ROE in H as QNB booked almost no goodwill on completion of the acquisition of Finansbank in June We are comfortable with QNB s CET1 ratio, which should reach 13.9% by Q on our estimates. Earnings and target price changes: We cut our combined earnings estimates by 4% in 2016 and 6% in 2017 as we assume slower balance sheet growth, stronger NIM erosion and higher bad asset charges. We downgrade QNB to Reduce from Hold on valuation. The 22% increase in its share price in the last three months puts it on 11x EPS 2017e, which is a demanding valuation multiple vs EPS growth 2017e of only 4%. Doha Bank is the only bank where we have a Hold rating. We present a valuation summary in the following table, with new target prices for most stocks. Rating and target price revisions RIC code Company CMP (QAR) New TP (QAR) Old TP (QAR) New Rating Old Rating Upside/ downside PE 2017e EPS growth 2017e P/BVPS 2017e ROTE 2017e COMB.QA Commercial Bank of Qatar Reduce Reduce -39% 20.3x 4% 1.0x 5.1% DOBK.QA Doha Bank Hold Hold -7% 8.5x -1% 1.0x 12.2% MARK.QA Masraf Al-Rayan Reduce Reduce -41% 15.3x -9% 2.2x 14.5% QISB.QA Qatar Islamic Bank Reduce Reduce -36% 12.8x -3% 1.8x 14.3% QNBK.QA Qatar National Bank Reduce Hold -21% 10.8x 4% 1.8x 18.0% Source: Thomson Reuters Datastream, HSBC estimates. Based on closing prices as of 21 August 2016 Disclosures & Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it. Issuer of report: HSBC Bank Middle East Ltd View HSBC Global Research at:

2 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 EQUITIES FIG Investment summary Loan growth should slow more in response to weak deposits, which presents risks to asset quality Share prices are up 19% in the last three months but fundamentals remain weak. We look at ROIC, marginal ROE and free cash flows We cut our combined earnings estimates for 2016 and 2017; downgrade QNB to Reduce from Hold on valuation Investment summary We maintain a negative view on Qatari banks. We expect a further slowdown in credit growth, which in our view should trigger higher loan impairments across the sector. The introduction of IFRS 9, effective 1 January 2018, could be another trigger for higher impairment charges. We researched in depth the potential income statement impact of general provisions booked in shareholders equity, which over time can become a collective provision expense, in our report Asset quality outlook: it s time to get real published on 4 April Loan growth finally responding to weak deposits. Based on the latest Qatar Central Bank data, domestic credit growth finally slowed down in June to 13% y-o-y from the average 17% growth reported in the previous five months. The quality of funding deteriorated further. The share of more expensive and volatile non-resident deposits increased to 20% of total deposits in June from 13% in December Loan growth in Qatar finally responding to weak deposit growth. Banks liabilities are increasingly foreign and less domestic 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% (%) 25% 20% 15% 10% 5% 0% Foreign liabilities Domestic liabilities Loan growth (yoy, RHS) Deposit growth (yoy, RHS) Source: Qatar Central Bank 2

3 We view Qatar as the largest importer of liquidity in the MENA region and think that such loan growth will be hard to sustain in the current environment of low oil prices. We forecast combined loan growth of banks under coverage to slow to 8% in 2017 vs 13% in H Foreign interbank liabilities to banking sector assets. Qatar and Oman are biggest importers of foreign liquidity in GCC (%) Qatar Oman UAE Egypt Saudi Foreign interbank liability / total assets Data for Saudi and Qatar as at June 2016; Oman and UAE as of May 2016 and Egypt as at April 2016; data for Kuwait is not available Source: Central Banks, HSBC calculations The share prices of banks we cover are up on average 19% in the last three months. Improved sentiment post the USD9bn Sovereign bond issue in May and the expected FTSE Russell index rebalancing next month are the contributing factors to better share price performance, in our view. However, fundamentals remain weak as banks fund loan growth at the expense of eroding shareholder returns. Banks ROIC, marginal return on marginal equity and free cash flows In this report we link ROIC, marginal return on marginal equity and free cash flows generated in the process of growing risk-weighted assets and paying dividends. In our analysis, we follow the methodology presented in HSBC s research report on South African banks Linking free cash flow, marginal returns, ROEs and dividends, published on 29 September 2014 by Henry Hall. ROIC measures return on total shareholder capital deployed, not just equity. We view it as a better measure of shareholder value added. QNB and CBQ have had the worst drop in ROIC since 2010, mostly triggered by foreign acquisitions and, in the case of QNB, also a rights issue in

4 ROIC, marginal ROE and FCF. Our views by stock we cover QNB CBQ QIB Doha ROIC Marginal ROE FCF, payout and CET1 Conclusion ROIC down from the peak of Marginal ROE Acquisition of Finansbank is 28% in 2010 on rights issues satisfactory, improving capital-intensive, leading to and acquisitions to 17% in in H negative FCF of -131bp of H ROIC, RWA in 2016e however, improved on Finansbank acquisition ROIC declined from 15% in 2010 to 6% in H One of the worst performances in our Qatari coverage ROIC improved since 2012 at the expense of higher asset/equity ratio and lower CET1 Net profits shrank in 2015 and in H Marginal ROE looks very poor. Marginal ROE consistently above ROTE since 2013 Steady decline to 15.4% in H1 Marginal ROE 2016 from 22.1% in 2011 consistently below ROTE. Net profit has been declining since Masraf Stable ROIC from 2012 onwards at the expense of higher balance sheet gearing. Source: HSBC estimates Marginal ROE deteriorated to 10% in H from 34% in 2014 CBQ generated negative free cash flows since 2011, which resulted in a low CET1 ratio of 10.1% (2016e) Despite high marginal ROE we think QIB over-paid in dividends. CET1 ratio declined to 11.6% in 2016e from 15.7% in 2013 Bank generated negative FCF largely due to excessive dividend payments Volatile FCF, near breakeven in e. CET1 ratio is solid at 17.7% in 2016e but comes with low asset risk density QNB can reinvest in the business. Payout ratio cut in Q to 22% from 50% in Q was very timely and will help re-build CET1 ratio. While declining ROIC and Marginal ROE suggest CBQ can return capital, low CET1 ratio is a constraint. Bank can avoid capex and keep payout low. QIB can retain more profit in order to rebuild its CET1 ratio Doha Bank can minimise its dividend payout and avoid RWA growth to rebuild capital Masraf can raise its payout ratio due to reducing marginal ROE. Change in loan mix towards private sector away from public/government is a risk. Marginal return on marginal equity, or marginal ROE, measures the return on that portion of the last period s profit which was reinvested in the business. If marginal ROE is declining and/or stays consistently below return on tangible equity (ROTE), bank management should return capital to shareholders, within allowed regulatory limits. Apart from QIB and QNB, marginal returns of Qatari banks have been quite poor. This suggests they should return capital, but low CET1 ratios at QIB, Doha and CBQ imply these banks should retain profits to rebuild their capital ratios. Changes to our earnings estimates, ratings and target prices. We cut our combined earnings estimates by 4% in 2016 and 6% in 2017 due to our expectations of slowing balance sheet growth, reducing NIMs and rising cost of risk as we expect asset quality to deteriorate going forward. We downgrade Qatar National Bank to Reduce from Hold on valuation. The 22% increase in its share price in the last three months prices the stock at 11.0x our EPS estimate for 2017e, which is rather demanding in view of EPS growth for 2017e of just 4%. Doha Bank is the only stock in our Qatari banks coverage on which we have a Hold rating. We retain our Reduce ratings on Commercial Bank of Qatar, Masraf Al-Rayan and Qatar Islamic Bank. Qatari banks: EPS growth expectations, earnings revisions and how we compare vs consensus EPS growth (%) Net income revisions (%) HSBC vs. consensus (%) 2016e 2017e 2016e 2017e 2016e 2017e CBQ Doha Masraf QIB QNB Source: Bloomberg consensus estimates, HSBC estimates 4

5 ROIC, marginal ROE and FCF We view ROIC as a better measure of shareholder returns than ROE, especially for banks with a history of acquisitions Marginal ROE helps shareholders decide whether management should reinvest or return capital, in the form of dividends or share buybacks Free cash flow analysis helps identify banks that cannot return capital despite falling marginal ROEs Return on Invested Capital a better measure of value add Why look at ROIC? ROIC measures a return on total capital a bank has under its control, not just equity. It includes goodwill and adds back goodwill impairments/write-offs. Such adjustments to capital in particular help track management performance post acquisitions. Consequently ROIC provides a like-for-like comparison of banks that are growing organically and inorganically. It is fairly relevant for Qatari banks as many of them have a history of acquisitions. The nominator is the net income earned from both the core business and business acquired over time. We add back goodwill and intangibles amortisation charges as both are non-cash items. The denominator is capital including goodwill minus proposed dividends. Many Qatari banks used to include proposed dividends in shareholders equity; we adjust our invested capital accordingly. Please refer to Appendix 1 for the historical calculation of invested capital for banks under our coverage. QNB and CBQ show steepest declines in ROIC since 2010 QNB s ROIC dropped in 2011 to 23.8% from 27.5% the previous year as the bank increased capital through a USD3.5bn rights issue. ROIC failed to recover post 2011and fell further in 2013 when QNB acquired NSGB in Egypt. ROIC deteriorated slightly to 17.3% in 2015 from 17.6% in 2013, which implies QNB failed to improve shareholder returns post the acquisition of NSGB. We attribute the H improvement in ROIC to 18.6% from 17.3% in 2015 to the acquisition of Finansbank. There are two reasons why ROIC improved. First, there was almost no goodwill as QNB acquired the bank at nearly book value. Secondly, the QAR2,449m dividend payment in Q reduced invested capital and improved H ROIC on consolidation of Finansbank. If we add back dividend to invested capital, H ROIC would be 30bp lower at 18.3%, but still above ROIC of Q

6 QNB: ROIC 2004-H We highlight key rights issue and/or acquisitions below (%) H QNB Note: 2011 is the year of the rights issue, 2013 is the year of NSGB acquisition in Egypt, H is the acquisition of Finansbank in Turkey Source: Company data, HSBC calculations CBQ s ROIC has performed rather poorly. It was stable at 15%-16% during and declined after the acquisition of a 71% stake in ABank in Turkey in We note a further decline in ROIC in H as a result of poor core business performance. CBQ: ROIC since CBQ bought ABank in Turkey in (%) H CBQ Source: Company data, HSBC estimates QIB s ROIC troughed at 11.8% in 2012, and improved thereafter. Management achieved this mostly through increasing balance sheet gearing, or asset/invested capital multiple, to 10x in H from 5.9x in Hence, QIB s ROIC gains are partly at the expense of capital adequacy ratios. Looking at the free cash flows in the following section, QIB was free cash flow negative in four out of five years, which means management did not retain enough profit to fund its capex spend. 6

7 QIB: ROIC over time (%) H QIB Source: Company data, HSBC estimates Doha Bank s ROIC declined steadily to 15.4% in H from 22.1% in The improvement in ROIC during H over 2015 was due to increased balance sheet leverage, as shareholders equity declined in H by QAR174m on a QAR774m dividend payment. However, H net profit declined too, by QAR93m. Hence, we treat it as a low quality gain in ROIC. Doha Bank: ROIC lower over time. ROIC gain in H was due to decline in shareholders' equity (%) H DOHA Source: Company data, HSBC estimates Masraf s ROIC has been fairly steady at 17%-18% since 2012 on the back of increasing balance sheet gearing, similar to QIB. Masraf delivers a superior ROA north of 2% as the bank hardly books loan loss provision expenses. However, we do not think this above-sector ROA is sustainable and forecast it to drop to 1.8% by

8 Masraf Al Rayan: ROIC stable since 2012 but at the expense of rising balance sheet gearing (%) H MARK Source: Company data, HSBC estimates Marginal ROE: reinvest or pay dividends? Marginal return on marginal equity, or marginal ROE, measures the returns a bank is generating on that portion of the previous period s profit that has been reinvested back in the business. If such returns are poor and consistently below return on tangible equity (ROTE), management can consider returning capital to shareholders and not reinvesting. We now look at our coverage. QNB: marginal ROE down since 2014 QNB s marginal ROE was depressed in as the bank raised USD3.5bn in new equity capital. Marginal ROE, which does not add back goodwill, improved in 2013 following the acquisition of NSGB. QNB s ROIC, which adds back goodwill to total capital, has barely recovered since. In H1 2016, QNB improved both ROIC and marginal return on marginal equity as it booked almost no goodwill when it consolidated Finansbank. When calculating QNB s marginal ROE in H we add back QAR2.4bn of dividends to equity. This is because the consolidated net profit of Finansbank added in H has nothing to do with QNB s dividends paid out from last year s net profit. The latest marginal ROE trend suggests QNB should reinvest in the business; the trend is in line with the payout ratio cut in H QNB: marginal return on marginal equity since 2007 (QARm) H1 2016* Change in earnings 512 1, ,503 1, ,140 1, ,318 Change in average equity 2,575 4,093 3,009 4,075 11,380 11,598 5,546 4,987 4,164 5,737 Marginal return on marginal equity (%) ROTE (%) *We add back QAR2,449m dividend paid in Q to have a like-for-like annualised comparison of marginal ROE Source: Company data, HSBC calculations 8

9 CBQ: net profit fell in 2015 and H CBQ s marginal return on marginal equity was below ROTE in , 2012, 2015 and H We think CBQ did the right thing by paying out dividends, however, the payout ratio was rather high, averaging 70% since This led to substantial capital erosion. We discuss the bank s free cash flows later in the report. CBQ: marginal return on marginal equity below ROTE in , 2012, 2015 and H1 16 (QARm) H Change in earnings (179) (405) 205 (455) (565) Change in avg. equity 275 2,174 2,891 1,261 1,110 1,220 (134) (320)* Marginal return on marginal equity (%) (6) NA 461 NA NA ROTE (%) *Average equity lower due to payment of dividend in Q1 2016: QAR980m. Payout ratio = 75% Source: Company data, HSBC calculations QIB: marginal ROE recovered since 2013 on higher net profits and dividend payments Until 2012 QIB s marginal return on marginal equity constantly lagged ROTE, a sign that the bank should have paid more dividends. As we show in the following section, the payout ratio since 2011 has averaged a very high 70%. QIB boosted its payout ratio to 84% as early as 2008 from 19% in We estimate the high payout ratio and improved net profit generation allowed QIB to raise its marginal ROE. Although its marginal ROE has been falling since 2014, it remains substantially above ROTE. Our concern though is that the payout ratio was too high, resulting in QIB underfunding its riskweighted asset growth and materially reducing its CET1 ratio. We discuss this later in the report. Given the high profit generation and propensity to offer high payout ratios, we think QIB will maintain a high payout in We forecast a 55% payout based on 2016 profit, slightly higher than 51% in the previous period. QIB: marginal return on marginal equity below ROTE in but better thereafter (QARm) H Change in earnings (320) (60) 103 (111) Change in average equity 1,267 1,444 2, ,099 1, * Marginal return on (15) (6) 9 (9) Marginal equity (%) ROTE (%) *We add back QAR1,004m of dividends paid in H to have a like for like comparison in marginal ROEs Source: Company data, HSBC calculations Doha Bank: very poor history of marginal ROEs Doha Bank s marginal return on marginal equity was almost permanently below its ROTE. The reason was rather poor net profit growth rather than bank management retaining excess amounts of capital. Net profit shrank in 2014, 2015 and H

10 Doha Bank: marginal ROEs rather poor (QARm) H Change in earnings (74) (35) (93) Change in average equity 609 1,072 1, , (7) (102)* Marginal return on (9) NA NA marginal equity (%) ROTE (%) *Equity declined due to QAR775m dividend payment. Payout ratio was 64% Source: Company data, HSBC calculations Masraf Al Rayan: rapid erosion in marginal ROE since 2015 Recent trends are negative as a result of slowing net profit generation. Marginal ROE declined to 10% in H from 34% in This suggests Masraf could increase its dividend payout ratio. Masraf Al Rayan: recent marginal returns on marginal equity are deteriorating (QARm) H Change in earnings 994 (190) (36) Change in average equity ,271 1,235 1, * Marginal return on 184 (23) (9) marginal equity (%) ROTE (%) *We add back QAR1,313m of dividends paid in H to have a like for like comparison in marginal ROEs Source: Company data, HSBC calculations Free cash flows, payouts and CET1 ratios What is free cash flow for a bank? For a typical industrial company, free cash flow generation is profit minus capex. Although the definition of capex is clear for industrial companies, for banks it is not. Following the methodology presented in the report on South African banks Linking free cash flow, marginal returns, ROEs and dividends, published on 29 September 2014 by Henry Hall, we define capex for Qatari banks as the capital that needs to be set aside to finance RWA growth, thus satisfying regulators and credit rating agencies. We calculate free cash flow (FCF) per year for our coverage. To arrive at FCF we deduct capex and dividends from net profit. Why deduct dividends? Because for banks dividends represent a fixed payment (see the above report for further details on the methodology we use). We present our findings for our coverage below. QNB: Finansbank acquisition boosts RWAs in 2016, leading to a negative free cash flow We estimate QNB will need QAR15.4bn to fund growth in risk-weighted assets in We estimate that c70% of incremental RWAs come from the acquisition of Finansbank in Q We think the payout ratio cut to 22% from 50% announced in Q is quite timely as it allows the bank to build capital ratios and reinvest in the business with improved marginal return on marginal equity and ROIC. Some investors may have concerns about the seemingly low 11.8% CET1 ratio reported in Q2 2016, but we highlight that according to local regulations QNB capitalises only the net profit for the full year once it is fully audited. 10

11 QNB: free cash flow analysis, payout ratio and CET1 (QARm) 2011a 2012a 2013a 2014a 2015a 2016e 2017e Growth in RWA 44,379 17,044 55,444 43,622 45, ,157 41,464 Target CET1 ratio 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% Capital required to grow capex 5,547 2,130 6,930 5,453 5,735 15,395 5,183 Attributable earnings 7,508 8,339 9,479 10,455 11,264 12,341 12,880 Less: Capex (5,547) (2,130) (6,930) (5,453) (5,735) (15,395) (5,183) Ordinary dividends (2,544) (4,198) (4,898) (5,227) (2,449) (2,715) (2,833) Free cash flow (584) 2,010 (2,350) (225) 3,080 (5,769) 4,863 Free cash flow % RWA (bps) (37) 116 (103) (8) 97 (131) 101 Payout ratio 34% 50% 52% 50% 22% 22% 22% CET1 ratio* NA NA NA 16.1% 16.3% 13.9% 14.8% *CET1 ratio not available pre 2014 Source: Company data, HSBC estimates We remain comfortable with a lower post-acquisition CET1 ratio. A lower dividend payout implies QNB can rebuild CET1 to 14.8% in 2017e from 13.9% this year. CBQ: negative free cash flows hurt capital ratios Persistent negative free cash flow resulted in capital erosion at CBQ over time, a point we have highlighted in our previous research reports. Although the CET1 ratio is not available pre-2014, the Tier 1 ratio, which unlike CET1 adds Tier 1 debt, fell to 11.8% by Q from 16.4% in CBQ: free cash flows mostly negative and CET1 ratio quite low (QARm) 2011a 2012a 2013a 2014a 2015a 2016e 2017e Growth in RWA 11,467 5,800 28,048 3,883 6,708 4,229 6,161 Target CET1 ratio 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% Capital required to grow capex 1, , Attributable earnings 1,884 2,012 1,604 1,760 1, Less: Capex (1,433) (725) (3,506) (485) (838) (529) (770) Ordinary dividends (1,485) (1,485) (494) (1,039) (980) (479) (214) Free cash flow (1,034) (197) (2,395) 236 (513) (323) (270) Free cash flow % RWA (bps) (169) (29) (252) 24 (49) (29) (23) Payout ratio 79% 74% 31% 59% 75% 70% 30% CET1 ratio NA NA NA 11.0% 9.9% 10.1% 10.0% Source: Company data, HSBC estimates We think that the 75% payout ratio offered in Q was too high and assume management will cut the payout ratio to 30% in 2017e. QIB: free cash flow negative most of the time, it s time to reduce payout ratio QIB ran down its CET1 ratio to 11.8% by Q from 15.7% in Unlike CBQ, however, QIB delivered a much better marginal ROE and ROIC during this period. We think the payout ratio has been excessive in recent years and we expect management to cut it in

12 QIB: free cash flow negative most of the time (QARm) 2011a 2012a 2013a 2014a 2015a 2016e 2017e Growth in RWA 3,575 22,004 (4,234) 19,249 26,741 10,486 11,534 Target CET1 ratio 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% Capital required to grow RWA 447 2,750 (529) 2,406 3,343 1,311 1,442 Attributable earnings 1,365 1,241 1,335 1,601 1,954 2,145 2,087 Less: Capex (447) (2,750) 529 (2,406) (3,343) (1,311) (1,442) Ordinary dividends (1,063) (886) (945) (1,004) (1,004) (1,180) (835) Free cash flow (145) (2,395) 920 (1,809) (2,393) (345) (190) Free cash flow % RWA (bps) (35) (380) 156 (232) (228) (30) (15) Payout ratio 78% 71% 71% 63% 51% 55% 40% CET1 ratio NA NA 15.7% 14.6% 11.8% 11.6% 11.5% Source: Company data, HSBC estimates Doha Bank: time to retain more capital Doha Bank s free cash flows have been mostly negative since We think that management prudently cut payout ratios from 89% in 2013 to 64% in Similar to QIB, we expect management to lower the payout in the medium term to preserve capital. Doha Bank: free cash flows mostly negative since 2011 (QARm) 2011a 2012a 2013a 2014a 2015a 2016e 2017e Growth in RWA 7,867 2,007 12,198 4,310 11, ,273 Target CET1 ratio 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% Capital required to grow capex , , Attributable earnings 1,241 1,305 1,313 1,239 1,204 1,219 1,211 Less: Capex (983) (251) (1,525) (539) (1,462) (57) (659) Ordinary dividends (930) (930) (1,163) (1,033) (775) (731) (484) Free cash flow (672) 124 (1,375) (334) (1,033) Free cash flow % RWA (bps) (135) 24 (214) (49) (129) 53 8 Payout ratio 75% 71% 89% 83% 64% 60% 40% CET1 ratio NA NA 11.2% 11.8% 10.5% 11.0% 11.2% Source: Company data, HSBC estimates Masraf Al Rayan: volatile free cash flow generation An almost stable dividend payout during and largely positive free cash flows explain the strong CET1 ratios compared to other Qatari banks. The negative trend in marginal return on marginal equity suggests to us that Masraf can increase its payout ratio. We see room to do so, unless Masraf plans to lend more to a more capital-intensive private sector, rather than the public sector. We expanded on this in more detail in our report High and low capital ratio gains, published on 9 June

13 Masraf Al Rayan: volatile free cash flow and visibly solid CET1 ratio (QARm) 2011a 2012a 2013a 2014a 2015a 2016e 2017e Growth in RWA 1,731 7,359 (5,861) 17,682 3,188 6,906 7,735 Target CET1 ratio 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% Capital required to grow capex (733) 2, Attributable earnings 1,408 1,504 1,702 2,002 2,073 2,027 1,898 Less: Capex (216) (920) 733 (2,210) (399) (863) (967) Ordinary dividends (375) (750) (1,125) (1,313) (1,313) (1,277) (1,234) Free cash flow 817 (166) 1,310 (1,521) 362 (113) (302) Free cash flow % RWA (bps) 232 (39) 357 (280) 63 (18) (42) Payout ratio 27% 50% 66% 66% 63% 63% 65% CET1 ratio NA NA 20.5% 18.4% 18.5% 17.7% 16.7% Source: Company data, HSBC estimates 13

14 Valuation and revisions We revise our earnings estimates for all the Qatari banks we cover We downgrade QNB to Reduce from Hold; revise target prices for QNB, QIB, Doha and CBQ The Qatari banks we cover trade at average 1.8x/12.2x BVPS/EPS for 2017e versus the MENA banks averages of 1.4x/9.8x Earnings estimate changes Commercial Bank of Qatar: Reduce TP to QAR27.0 from QAR28.0; maintain Reduce Cutting earnings estimates. We cut our net income estimates by 43% and 35% in 2016e and 2017e respectively. We are now more conservative on fee income and NII (see table below), which leads to our lower total income estimate. CBQ s NPL ratio increased to 4.8% in Q from 4.2% in 2015 resulting in NPL coverage of 78.5%. We think CBQ could target 100% NPL coverage, which will keep provisions high going forward to bridge this gap. This explains the 58% y-o-y increase in loan loss provision expense in 2016e. We raise our cost of risk estimate by 58bps in 2016e and 42bps in 2017e. We expect CBQ to show better cost control and so reduce our operating expenses estimate by 6% in 2016e. We reduce our target price to QAR27.0 from QAR28.0 due to our lower earnings estimates. Our new target price implies downside of 39% from the current share price hence we maintain our Reduce rating on the stock. CBQ: changes in estimates (QARm) New forecasts (QARm) y-o-y growth New vs old (%) _ CAGR 2015a 2016e 2017e 2016e 2017e 2016e 2017e e NII 2,534 2,465 2,521 (3) 2 (2) (1) (0) Fee income (20) 8 (21) (21) (7) Other non-int inc (10) (15) 4 1 (13) Total revenues 3,949 3,639 3,697 (8) 2 (6) (6) (3) Operating exp (1,705) (1,654) (1,673) (3) 1 (6) (8) (1) Pre-prov inc 2,244 1,985 2,024 (12) 2 (7) (4) (5) Loan loss prov. (814) (1,282) (1,225) 58 (4) Net income* 1, (48) 4 (43) (35) (26) Loans 76,602 80,896 85, Investment sec 15,854 16,495 16, Total assets 123, , , (2) 4 RWA 105, , , (1) 5 Customer Dep 69,788 73,873 78, (3) (6) 6 Wholesale funding 32,980 32,291 32,715 (2) (0) NIM 2.32% 2.13% 2.07% -19bps -6bps -6bps -1bps -25bps NPL ratio 4.17% 5.25% 5.75% 108bps 50bps 67bps 87bps 158bps COR 1.06% 1.57% 1.40% 51bps -17bps 58bps 42bps 34bps ROAE 9.2% 4.9% 5.1% -433bps 22bps -357bps -250bps -411bps Note: *After interest on AT1 notes Source: Company data, HSBC estimates 14

15 Doha Bank: raise TP to QAR37.0 from QAR33.0; maintain Hold rating Raising earnings estimates. We raise our net income forecasts by 5% each in 2016e and 2017e. The main drivers of our positive earnings revisions are our higher NII and other noninterest income estimates. We raise our NII forecasts by 2% and 4% in 2016e and 2017e on the back of the better-than-expected performance in NIM during H We now expect NIMs to decline more gradually than before (see table below). We raise our other non-interest income forecasts by 18% each in 2016e and 2017e due to higher gains from foreign currency transactions. Good NPL coverage reaching 117% in Q and lower loan growth lead us to reduce our loan loss provision estimate by 3% in 2016e. We raise our target price to QAR37.0 from QAR33.0 on the back of our higher earnings estimates. Our revised target price implies downside of 6.9% from the current level. We maintain our Hold rating on the stock as we think Doha Bank s earnings can surprise positively on reducing wholesale funding costs. Doha Bank: changes in estimates (QARm) New forecasts (QARm) y-o-y growth New vs old (%) CAGR 2015a 2016e 2017e 2016e 2017e 2016e 2017e e NII 2,048 2,083 2, Fee income Other non-int inc (5) (1) Total revenues 2,812 2,869 2, Operating exp (1,031) (1,047) (1,084) Pre-prov inc 1,781 1,822 1, Loan loss prov. (293) (289) (389) (1) 35 (3) 2 20 Net income 1,204 1,219 1,211 1 (1) 5 5 (1) Loans 55,615 55,671 59, (6) (6) 4 Investment sec 12,198 13,764 13, Total assets 83,304 87,824 92, RWA 80,152 80,607 85, (6) (6) 5 Customer Dep 52,767 54,350 57, (2) (2) 5 Wholesale funding 14,816 17,186 18, NIM 2.67% 2.50% 2.45% -17bps -5bps 4bps 8bps -27bps NPL ratio 3.26% 3.89% 4.38% 63bps 49bps 22bps 25bps 167bps COR 0.54% 0.50% 0.65% -4bps 15bps 0bps 5bps 26bps ROAE 13.0% 12.9% 12.2% -13bps -67bps 57bps 46bps -203bps Source: Company data, HSBC estimates Masraf Al Rayan: Maintain Reduce rating and target price of QAR23.0 Cutting our earnings estimates. We reduce our net income forecasts by 3% and 4% in 2016e and 2017e respectively, due to our lower NII estimates. We forecast NII declining by 9% y-o-y in 2016e as we expect NIMs to decline by 38bps y-o-y and 25bps lower than our previous forecast. This is offset to an extent by higher other non-interest income and lower operating expenses. We expect higher other non-interest income as we forecast Masraf to report gains from investment securities against a loss in We expect Masraf to show better cost discipline amid tougher revenue generation and reduce our operating cost expenses by 5% and 7% in 2016e and 2017e. Our unchanged QAR23.0 target price implies 40.6% downside and we maintain our Reduce rating on Masraf. We see Masraf as the most exposed to asset quality risks in our coverage. It has the lowest cost of risk in our Qatari coverage, which only carries downside risks in a tightening liquidity environment. 15

16 Masraf: changes in estimates (QARm) New forecasts (QARm) y-o-y growth New vs old (%) CAGR 2015a 2016e 2017e 2016e 2017e 2016e 2017e e NII 2,024 1,839 1,950 (9) 6 (10) (8) (2) Fee income Other non-int inc (53) (15) Total revenues 2,544 2,533 2,443 (0) (4) (4) (5) (2) Operating exp (552) (567) (593) 3 5 (5) (7) 4 Pre-prov inc 1,992 1,966 1,849 (1) (6) (4) (5) (4) Loan loss prov. 1 - (16) n.a. n.a. n.m. 3 n.a Net income 2,073 2,027 1,898 (2) (6) (3) (4) (4) Loans 67,030 74,393 82, Investment sec 14,625 14,647 15, (2) (2) 2 Total assets 83,026 90,901 99, RWA 57,552 64,458 72, Customer Dep 55,623 62,298 69, (4) (8) 12 Wholesale funding 13,345 13,745 13, NIM 2.53% 2.15% 2.08% -38bps -7bps -25bps -22bps -44bps NPL ratio 0.09% 0.09% 0.10% 0bps 0bps 0bps 0bps 1bps COR 0.00% 0.00% 0.02% 0bps 2bps -1bps 0bps 2bps ROAE 17.7% 16.8% 14.5% -97bps -223bps -4bps -49bps -320bps Source: Company data, HSBC estimates Qatar Islamic Bank: increase TP to QAR73.0 from QAR72.0; maintain Reduce rating Raising our earnings estimates. We raise our 2016e net income forecast by 8% but our 2017e forecast is unchanged. The increase in 2016e is mainly due to a 28% increase in our other non-interest income forecast in 2016e due to higher gains from foreign currency and investment income. We also raise our loan loss provision expense, which is offset by lower investment impairments in 2016e and 2017e. On the back of these estimate increases we raise our target price to QAR73.0 from QAR72.0. Our revised target price implies 35.5% downside from the current levels. We maintain our Reduce rating on the stock. QIB: changes in estimates (QARm) New forecasts (QARm) y-o-y growth New vs old (%) CAGR 2015a 2016e 2017e 2016e 2017e 2016e 2017e e NII 2,567 2,848 3, (0) (0) 8 Fee income Other non-int inc (33) 28 (2) (12) Total revenues 3,361 3,755 3, (0) 7 Operating exp (1,044) (1,123) (1,198) 8 7 (1) (1) 7 Pre-prov inc 2,317 2,632 2, Loan loss prov. (105) (207) (284) Net income 1,954 2,145 2, (3) 8 (0) 3 Loans 98, , , Investment sec 18,840 19,275 19, Total assets 127, , , RWA 104, , , Customer Dep 91,521 96, , Wholesale funding 16,650 23,369 26, NIM 2.48% 2.28% 2.21% -20bps -7bps 0bps 0bps -27bps NPL ratio 0.58% 0.63% 0.69% 5bps 6bps 0bps 0bps 11bps COR 0.13% 0.20% 0.25% 7bps 5bps 5bps 10bps 12bps ROAE 15.6% 15.8% 14.3% 26bps -149bps 106bps -13bps -123bps Source: Company data, HSBC estimates 16

17 Qatar National Bank: Downgrade to Reduce from Hold; lower TP to QAR131.0 from QAR133.0 Cutting our earnings estimates. We lower our net income estimates by 3% and 6% in 2016e and 2017e respectively. These reductions are due to our lower NII and fee income estimates, down by 3% and 9% in 2016e and 2017e respectively due to lower loan growth assumptions. We also lower our fee income estimates, by 6% and 8% in 2016e and 2017e on the back of slower loan growth. However, this is to an extent offset by higher other non-interest income and lower operating expenses (see table below). A higher gain from financial investments and foreign currency income drives growth in non-interest income. We reduce our target price to QAR131.0 from QAR133.0 due to our lower earnings estimates. Our revised target price implies downside of 20.8% from the current levels. We downgrade our rating to Reduce from Hold on valuation grounds. QNB: changes in estimates (QARm) New forecasts (QARm) y-o-y growth New versus old (%) CAGR 2015a 2016e 2017e 2016e 2017e 2016e 2017e e NII 12,746 18,639 19, (3) (9) 23 Fee income 2,243 4,180 4, (6) (8) 39 Other non-int inc 914 1,306 1, (12) Total revenues 15,902 24,125 24, (1) (7) 25 Operating exp (3,505) (7,366) (7,525) (9) (15) 47 Pre-prov inc 12,397 16,759 17, (2) 18 Loan loss prov. (433) (2,429) (2,429) 461 (0) (2) (8) 137 Net income 11,264 12,341 12, (3) (6) 7 Loans 395, , , (3) (4) 16 Investment sec 81,157 82,193 91, (9) (10) 6 Total assets 538, , , (3) (5) 18 RWA 318, , , (7) (10) 23 Customer Dep 395, , , (4) (6) 15 NIM 2.60% 3.01% 2.83% 41bps -18bps 2bps -6bps 23bps NPL ratio 1.41% 1.69% 1.89% 28bps 20bps 9bps 9bps 48bps COR 0.12% 0.55% 0.47% 43bps -7bps 1bps -1bps 36bps ROAE 20.6% 20.0% 18.0% -61bps -205bps -47bps -122bps -266bps Source: Company data, HSBC estimates 17

18 18 PB 2017e EQUITIES FIG EEMEA banks valuation chart based on one-year forward price to book value multiples and ROE/COE differential (2017e) COMI FSR Expensive MARK CBQ PEO BZW GTB KFIN PKO Burgan Alinma AKBNK Sberbank Riyad GARAN ZENITH UNB BKM YKBNKISCTR VAKBN UBA HALKB BOC SBK BGA NED OTP NBK NBAD Doha Samba BSF NBO ANB AUDI QIB QNB Al Rajhi CAE KOMB FGB BGEO DIB NCB ADCB ENBD Cheap FBNH ROE/COE 2017e Source: Thomson Reuters Datastream, HSBC estimates

19 Valuation methodology and risks Commercial Bank of Qatar CBQK QD CP: QAR44.35 TP: QAR27.0 Rating: Reduce Valuation Risks We derive our fair value target price for CBQ using a residual income methodology, which Upside risks include: Potential sale of financial comprises three stages. For Qatari banks we use an inflation differential model to subsidiaries, for example in Oman and UAE, can calculate the cost of equity. To this end, we assume the cost of equity to be the sum of release capital and improve the CET1 ratio. the US risk-free rate (3%), and the inflation differential between the country and the US Easing cost of funding after Qatar raises (3.5%) plus the equity risk premium (4.5%) multiplied by the stock beta of 1.0. We use a sovereign debt can reduce pressure on NIM in cost of equity of 11.0% for CBQ. We lower our target price to QAR27.0 from QAR28.0 the near term. due to our earnings estimate changes. Our revised target price implies 39.1% downside from current levels for CBQ. We have a Reduce rating on the stock. Doha Bank DHBK QD CP: QAR39.75 TP: QAR37.0 Rating: Hold We derive our fair value target price for Doha using a residual income methodology, which comprises three stages. For Qatari banks we use an inflation differential model to calculate the cost of equity. To this end, we assume the cost of equity to be the sum of the US risk-free rate (3%), and the inflation differential between the country and the US (3.5%) plus the equity risk premium (4.5%) multiplied by the stock beta of 1.0. We use a cost of equity of 11.0% for Doha. We raise our target price to QAR37.0 from QAR33.0 due to our higher earnings estimates. Our revised target price implies 6.9% downside from current levels and we have a Hold rating as we believe NII can surprise positively due to higher-than-expected loan growth. Downside risks include: Strong deterioration in asset quality should loan growth slow down significantly in Qatar. Another downside risk is the transition to IFRS 9 in January 2018 which may result in sustainably higher cost of risk. Upside risks include: lower cost of funding from easing pressure on liquidity, any easing of liquidity ratios by the central bank, which may also lower the cost of funding and may drive up NII. Masraf Al Rayan MARK QD CP: QAR38.70 TP: QAR23.0 Rating: Reduce Qatar Islamic Bank QIBK QD CP: QAR TP: QAR73.0 Rating: Reduce Qatar National Bank QNBK QD CP: QAR TP: QAR131.0 Rating: Reduce We derive our fair value target price for Masraf using a residual income methodology, which comprises three stages. For Qatari banks we use an inflation differential model to calculate the cost of equity. To this end, we assume the cost of equity to be the sum of the US risk-free rate (3%), and the inflation differential between the country and the US (3.5%) plus the equity risk premium (4.5%) multiplied by the stock beta of 1.0. We use a cost of equity of 11.0% for Masraf. Our unchanged target price of QAR23.0 implies 40.6% downside from current levels for Masraf. We reiterate our Reduce rating. Upside risks include: Repayments from staterelated entities have negatively affected Masraf s credit growth in the recent past and should they decline there is upside risk to our credit growth estimates. We derive our fair value target price for QIB using a residual income methodology, which Upside risks include: Substantial easing in cost comprises three stages. For Qatari we use an inflation differential model to calculate the of funding on the back of sovereign debt cost of equity. To this end, we assume the cost of equity to be the sum of the US risk-free issuance by Qatar, increase in payout ratio and rate (3%), and the inflation differential between the country and the US (3.5%) plus the regulatory easing on liquidity and capital equity risk premium (4.5%) multiplied by the stock beta of 1.0. We use a cost of equity of adequacy regulations. We view such risks as low 11.0% for QIB. We raise our target price for QIB to QAR73.0 from QAR72.0 on the back probability events. of our earnings estimate changes. Our revised target price implies 35.5% downside from current levels for QIB. We have a Reduce rating on the stock. We derive our fair value target price for QNB using a residual income methodology, which Upside risks include: Lower-than-expected comprises three stages. For Qatari banks we use an inflation differential model to funding costs in 2016 and higher NII on the back calculate the cost of equity. To this end, we assume the cost of equity to be the sum of of stronger loan growth. the US risk-free rate (3%), and the inflation differential between the country and the US (3.5%) plus the equity risk premium (4.5%) multiplied by the stock beta of 1.0. We use a cost of equity of 11.0% for QNB. We lower our target price for QNB to QAR131.0 from QAR133.0 due to our lower earnings estimates. We downgrade the stock to Reduce from Hold on valuation grounds. The share price is up 14% in the last three months, valuing the stock at 11.0x EPS for 2017e, which we find rather demanding in view of EPS growth in 2017e of just 4%. Our revised target price implies 20.8% downside from current levels for QNB. Source: HSBC estimates; stocks priced as at 21 August

20 Appendix 1: Calculation of invested capital Commercial Bank of Qatar QARm H Equity 12,500 14,230 14,939 13,963 15,028 14,753 14,389 (+) goodwill & intangibles (-) proposed dividend 1,588 1,485 1, Invested capital 10,912 12,746 13,455 14,959 15,888 15,392 15,057 Source: Company data Doha Bank QARm H Equity 6,034 7,081 7,551 9,271 9,288 9,257 9,083 (+) goodwill & intangibles (-) proposed dividend , Invested capital 5,087 6,151 6,621 8,108 9,288 9,257 9,083 Source: Company data Masraf Al Rayan QARm H Equity 7,126 8,504 9,596 10,523 11,353 12,044 13,073 (+) goodwill & intangibles (-) proposed dividend 1, Invested capital 5,150 8,129 9,596 10,523 11,353 12,044 13,073 Source: Company data Qatar Islamic Bank QARm H Equity 9,052 11,202 11,474 11,860 12,478 13,426 14,375 (+) goodwill & intangibles (-) proposed dividend 1,083 1, ,004 1,004 - Invested capital 7,969 10,355 10,838 11,233 11,849 12,833 14,824 Source: Company data Qatar National Bank QARm H Equity 24,793 42,635 47,989 53,727 57,962 62,055 63,297 (+) goodwill & intangibles ,550 5,461 5,378 5,693 (-) proposed dividend 1,957 2, Invested capital 22,835 40,233 48,250 59,277 63,423 67,433 68,990 Source: Company data 20

21 + ) 7. 1 % EQUITIES FIG Financials & valuation: Commercial Bank of Qatar Reduce Financial statements Year to 12/2015a 12/2016e 12/2017e 12/2018e P&L summary (QARm) Net Interest Income 2,534 2,465 2,521 2,648 Non-interest Income 1,415 1,174 1,176 1,237 Net fees/commission Trading profits Other Total Operating income 3,949 3,639 3,697 3,886 Operating expense -1,705-1,654-1,673-1,753 Staff costs Other oper expenses PPOP 2,244 1,985 2,024 2,133 Provisions ,282-1,225-1,052 Bad debt ,282-1,225-1,052 Other Other non-oper profit(loss) HSBC PBT 1, ,303 Exceptionals Profit-before tax 1, ,303 Taxation PAT 1, ,271 Minorities + pref dividend Attributable profit 1, ,031 HSBC attributable profit 1, ,031 Balance sheet summary (QARm) Total assets 123, , , ,284 Customer loans (net) 76,602 80,896 85,430 90,727 Debt investment assets 14,951 15,549 15,860 16,177 Other assets 31,868 32,244 33,136 34,379 Total Liabilities 108, , , ,229 Customer deposits 69,788 73,873 78,845 84,332 Debt securities issued 20,524 23,821 23,821 23,821 Other liabilities 17,811 15,993 16,522 17,075 Total capital 15,299 15,003 15,238 16,055 Ordinary equity 14,753 14,458 14,693 15,509 Minorities + other capital IEA (avg) 109, , , ,749 IBL (avg) 98, , , ,526 Capital (%) RWA (QARm) 105, , , ,316 Total tier Total Capital Per share data (QAR) EPS HSBC EPS (fully diluted) DPS NAV (incl intangibles) NAV (tangible) ROA analysis (%) Net interest income Total interest income Total interest expense Net fees & commission Other income Operating income Operating expenses Staff costs Other oper exp PPOP Provisions Non-op items PBT Taxation Minorities + pref dividend PAT Growth, ratios and valuation data Year to 12/2015a 12/2016e 12/2017e 12/2018e Y-on-y % change Net interest income Non-interest income Operating expense PPOP Provisions PBT PAT Net loans Total assets RWA Customer deposits Ratios (%) NIM Gross yield Cost of funds Spread NPL/gross loans Credit cost Coverage NPL/RWA Provision/RWA NPL/NTA Net loans/assets RWA/assets Loans/deposits Avg IEA/avg assets Avg IBL/avg liabilities Cost/income Non-int inc/total inc ROAA (incl goodwill) ROAE (incl goodwill) Return on avg tier Leverage (x) Valuation data P/E (diluted EPS) P/PPOP P/BVPS Dividend yield (%) P/Deposit P/Asset * Based on HSBC EPS (diluted) Issuer information Share price (QAR) Target price (QAR) 27.0 (% Reuters (Equity) COMB.QA Bloomberg (Equity) CBQK QD Market cap (USDm) 4,033 Market cap (QARm) 14,679 Country Qatar Sector Commercial Banks Analyst Aybek Islamov Contact Notes: Priced at close of 21 August