Galfar Engineering and Contracting MSM Code: GECS Bloomberg Code: GECS OM Reuters Code: GECS.OM

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1 Kuwait Financial Centre Markaz R E S E A R C H Markaz Research is available on Bloomberg Type MRKZ <Go> Thomson Financial Reuters Knowledge Zawya Investor Noozz M.R. Raghu CFA, FRM Head of Research rmandagolathur@markaz.com Layla Al-Ammar Investment Analyst lammar@markaz.com Ext: 1205 Kuwait Financial Centre Markaz P.O. Box 23444, Safat 13095, Kuwait Tel: Fax: Stock Volatility Galfar Engineering and Contracting MSM Code: GECS Bloomberg Code: GECS OM Reuters Code: GECS.OM Low Medium High Current Market Price: OMR (As of 30 October 08) Expected Return Low Medium High Galfar Engineering and Contracting SAOG (Galfar) launched an IPO on 24 October Since then, the stock has lost 22%. On YTD basis, Galfar s stock declined 49% versus the Muscat Stock Market s 31% drop. The stock fell 18% in the last two trading days due to disappointing 3Q08 results. Galfar reported a 42% YoY decline in net profit to USD 9 Mn in 3Q08 and a 517 bps YoY contraction in net margins to 4% mainly due to lower margin on contract income and higher financing cost. In 9M08, the company s net income grew 3% YoY to USD 41 Mn, while margins tapered off 227 bps YoY to 6%. Capitalizing on rising industrial construction and infrastructure development activities in Oman, Galfar added new contracts worth USD 919 Mn in 9M08 to its order book which stood at USD 1.4 Bn at the end of FY07. Consequently, in 9M08, the company s contract income grew 41% YoY to USD 663 Mn with a 296 bps YoY decrease in contract margins to 10%. In 3Q08, Galfar s contract income grew 32% YoY to USD 225 Mn. However, due to rising material and sub-contracting costs, Galfar s contract margins declined 572 bps YoY to 8%. Revenues from the hire business line declined 1% YoY to USD 2 Mn in 3Q08 (up 12% YoY to USD 5 Mn in 9M08), while hire operating costs increased 525 bps YoY to 77% of hire revenues (dropping 79 bps YoY to 78% in 9M08). We share a mixed outlook on the prices of building materials and employee costs in the near term. Though we expect steel prices to decrease in Oman in line with the recent price cuts in other GCC countries (such as Saudi Arabia and UAE), we do not foresee any significant fall in cement prices in the country. Moreover, employee-related costs are likely to increase following the announcement of a staff HRA hike (in the range of 25 45%) in June Nevertheless, we believe the ongoing recession fears and decreasing oil prices are likely to lower building material costs in 4Q08. Given this scenario and continued growth in Galfar s contract order book, we expect its 2008 net income to rise 2% YoY to USD 59 Mn. Galfar s stock is trading at a P/E of 8.36, significantly lower than its short-term average of 16.81x. Based on our fair value P/E of 11.5x, we believe that the stock offers upside potential, although with high risk (as measured by the Markaz Volatility Index). However, in light of the current financial market turmoil, we remain concerned regarding the realization of this upside in the near term. USD Mn 2004# 2005# F Contract Income N/A Profit on Contracts N/A Operating Income N/A Net Income P/E (LFY) N/A N/A N/A P/B (LFI) N/A N/A N/A Market Cap N/A N/A N/A Stock Returns N/A N/A N/A 53% -49%* Shareholders Equity Note: 2008 figures PE, P/B and M.Cap as on 30 October 08, YTD: 2008 YTD returns # 2004 and 2005 figures are for parent co.; 2006 and 2007 financial data are consolidated figures Source: Galfar, Reuters Knowledge, Bloomberg Kuwait Financial Centre Markaz

2 Analyst Discussion Notes Higher input costs dent margins despite rise in contract income Net Income (USD Mn) Source: Galfar Figure 1: Net Income and Net Margin Trend Net Income (USD Mn) Net margin (%) 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 Galfar s net profit declined 42% YoY to USD 9 Mn in 3Q08 primarily due to significant increase in contract costs and higher financing costs. Consequently, the company s net profit margin declined 517 bps to 4% in 3Q08 (Figure 1). 10% 8% 6% 4% 2% 0% Net Profit Margin (%) Contract income grew 32% YoY to USD 225 Mn in 3Q08, driven by a strong order book Galfar s margins under pressure due to absence of escalation clause in contracts Contract income, which represents Galfar s main business line, grew 32% YoY to USD 225 Mn in 3Q08 and rise 41% YoY to USD 663 Mn in 9M 08. The rise was primarily on account of continued growth in the order book. Galfar s order book moved up 19% YoY to USD 1.4 Bn in FY2007. The company received new contracts worth USD 919 Mn (OMR 354 Mn) in 9M08. Galfar benefits from increased public expenditure, which mainly comprises oil development projects undertaken by the Omani government. Public expenditure stood at USD 15 Bn in 2007 and is expected to increase 19% in However, rising material and sub-contracting costs continue to exert pressure on Galfar s contract margins which declined 296 bps YoY to 10% in 9M08. In 3Q08, the company s contract costs increased 41% YoY to USD 208 Mn. As a percentage of contract income, contract costs stood at 93%, the highest since 2004, primarily due to an increase of 297 bps YoY in material costs to 37% and 239 bps YoY in sub-contracting costs to 18% in 3Q08. Growing demand for key building materials (including steel, cement, bitumen, and copper), high oil prices, and increasing labor costs were the prime reasons for the rise in material and sub-contracting costs. In addition, the terms and conditions of contracts in Oman do not completely protect contractors from input cost escalation. As a result, these firms (including Galfar) are unable to pass on completely the increase in raw material costs to their customers. Consequently, Galfar s profit margin on contract income tightened 572 bps YoY to 7.5% in 3Q08, compared to 10% in 2Q08. Profit from contracts decreased 25% YoY to USD 17 Mn in 3Q08, while it grew 8% YoY to USD 66 Mn in 9M08. Galfar s other business line, which consists of hiring out cranes, equipment, and other vehicles, recorded a growth of 12% YoY in revenues to USD 5 Mn with a 79 bps YoY drop in hire operating costs to 78% of hire revenues in 9M08. The company s hiring activities are mainly carried out through its subsidiary Al Khaleej Heavy Equipment & Engineering (52.17% stake), which was acquired through an OMR0.6 Mn deal in January Revenues Kuwait Financial Centre Markaz 2

3 from this business decreased 1% YoY to USD 2 Mn. Moreover, hire operating costs, as a percentage of hire revenues, increased 525 bps YoY to 77%. Hire operating costs increased 6% YoY to USD 1 Mn in 3Q08. Net margin fell 517 bps YoY to 4% in 3Q08 Galfar, however, succeeded in bringing down its G&A expenses in 3Q08. These expenses, as a percentage of contract income, decreased 56 bps YoY to 1.7%, lowest since This reduction did not help much in improving profitability, which took a massive beating due to lower profitability in the contract business. Operating profit margin contracted 527 bps YoY to 6% in 3Q08. Operating profit declined 30% YoY to USD 13 Mn. Profitability was further impacted by an 82% increase in financing expenses to USD 3 Mn. Galfar s long term portion of term loans stood at OMR 29 Mn as on 30 September 2008, up 84% YoY. Bank borrowings also increased 99% YoY to OMR 43 Mn during the same period. The consequent increase in financing costs, coupled with a 60% reduction in other income, led to a 42% decrease in net profit to USD 9 Mn. Net profit margin declined 517 bps to 4% in 3Q08. In 9M08, Galfar s net margins contracted 227 bps to 6%. Lower raw material prices to ease cost pressures in near term As evident in figure 2, Galfar s margins in FY2007 and 9M08 were dented by an increase in the cost of raw materials and higher sub-contracting costs. A sharp rise in global prices of construction materials and significant growth in domestic construction activities led to an increase in material and subcontracting costs in Oman. Figure 2: Contract Income and Cost Trend Contract Income (USD Mn) Contract Income (LHS) Sub-contracting cost (RHS) Material cost (RHS) M08 40% 30% 20% 10% Cost as % of Contract Income Source: Galfar Weakening global commodity prices to lower cost pressure on contractors Moreover, the company s announcement of a staff HRA hike (in the range of 25 45%) in June 2008 is likely to increase its employee-related cost in the near term. However, in recent months, commodity prices have declined due to the slowing down of business activities worldwide on account of a weakening global economy. Bloomberg WTI Cushing crude oil spot price decreased 47% to USD 66 per barrel while LME steel billet Far East 3 months contract price fell 74% to USD 265 per metric tonne during 01 Aug- 30 Oct As a result, construction costs are likely to reduce in the near term. Prices of a few building materials have already commenced a downward trend in some GCC countries. For example, steel prices in Abu Dhabi fell nearly 20% in September 2008 after declining 15% in August 2008, according to the data released by the Abu Dhabi Department of Planning and Economy. Also, prices of other construction materials decreased during Kuwait Financial Centre Markaz 3

4 August September 2008 in Abu Dhabi. Moreover, Saudi Basic Industries Corporation (SABIC), one of the largest steel producers in the GCC region, lowered the prices of steel rebar by 43% during September October We expect a similar downtrend in material costs in Oman, thus, reducing the pressure on Galfar s margins in 4Q08. Continued growth in government spending to drive expansion in order book Benefiting from higher oil revenues, the Oman government has undertaken several development projects in the country, thereby providing a fillip to the construction sector. In February 2008, infrastructure projects worth USD 21 Bn were under progress in the country. Capitalizing on this, Galfar bagged new projects worth USD 919 Mn in 9M08, thereby enhancing its order book. Galfar s contracts are diversified across 5 main sectors including Oil & Gas, Structures and Buildings, Roads and Bridges, Utilities, and Environment. Table 1 gives list of Galfar s key projects and their scheduled completion dates which varies between 4Q08 and Table 1: Details of Galfar s key projects Description Value (OMR Mn) Expected completion North Oman ODC Contract Q10 Southern Expressway project Q09 A Seeb Coastal Strip Vacuum Sewer Network Harweel Camp (Utilities and Sewage Treatment) Q10 Ship Repair Yard & Dry Dock Complex at Duqm Port Q10 Hasik to Shuwaymiyah Highway Q11 Qarm Alam Steam Proj. Service Facilities Off-Plot EPC Q09 Nizwa-Thumrait Road rehabilitatation project Q10 Barka Desalination plant Q10 BankMuscat - BankMuscat Head Office Q09 Saud Bahwan Group Corporate Centre at Wattayah Q08 Source: Galfar, MEED projects The government maintained its focus on infrastructure development in the 2008 budget Construction activities in Oman are expected to continue rising, going forward. Under its 2008 budget, the Oman government has earmarked a total expenditure of USD 15.1 Bn (OMR 5.8 Bn) in 2008 (USD 15.3 Bn in 2007). Though the recent plunge in oil prices raises concern, we believe the government s capex plans are intact as the 2008 budget was prepared with a very conservative oil price assumption of USD 45 per barrel. Omani crude averaged USD 96.2 per barrel in the international markets during January- August We believe the rise in government expenditure would strengthen Galfar s order book, thus providing strong revenue visibility in 2008 and Kuwait Financial Centre Markaz 4

5 Valuation At the current price of OMR 0.757, the stock trades at 8.54x and 8.36x 2007 earnings and LTM earnings, respectively (figure 4). We expect the continued growth in infrastructural development and construction activities in oil & gas sector undertaken by the Oman government to reflect in Galfar s order book size. Though higher raw material prices dented Galfar s net income growth in 9M08, anticipated easing of cost pressures in 4Q08 might offer some relief. Therefore, we estimate Galfar s net income to increase 2% YoY in FY2008. At our fair value PE of 11.5x, we expect the stock to provide high returns, although current regional and global market turmoil may prevent this from materializing in the near term. According to the Markaz Volatility Index, Galfar depicts a high risk profile compared to the benchmark (figure 5). The stock has witnessed increased volatility during the past three weeks and reached its high on 30. On the liquidity front, about 137 Mn shares of the company were traded on MSM between October 2007 (when the stock was listed) and December The stock s turnover velocity reached 42% the same year. Figure 4: Share Price & Traded Volume Galfar Traded Volume ('000) Galfar Stock Price Rebased 250 MSM Index Rebased 30, Figure 5: Stock PE Trend Galfar PE Fair Value PE Price (rebased) ,000 18,000 12,000 6,000 Traded Volume (in '000) PE (TTM) Oct Feb Jun Oct-08 Source: Bloomberg 4 24-Oct Feb Jun Oct-08 Source: Bloomberg and Markaz Research Figure 6: Markaz Volatility Index () High Low Current Value 16, , MVX-MSM Source: Markaz Research MVX-Galfar 1,000 Kuwait Financial Centre Markaz 5

6 Appendix 1: Key Statistics All Figures in USD Mn Parent Parent Consolidated Consolidated Income Statement Contract Income Profit on Contracts Operating Income Operating Margin % 5% 8% 12% 10% Net Income Balance Sheet Assets Total Current Assets Total Assets Cash % of Total Assets Liabilities & Equity Current Liabilities Total Liabilities & Provisions Short Term Debt % of Total Assets LT Debt % of Total Assets Total Shareholder's Equity Key Ratios ROE % N/A ROA % N/A Contract Income Growth % N/A 25% 67% 63% Operating Income Growth % N/A 121% 140% 39% Net Income Growth % N/A 86% 134% 34% Hist. EV (USD Mn) N/A N/A N/A 1,110 P/E (LFY) N/A N/A N/A P/B (LFI) N/A N/A N/A 5.30 EPS (USD) DPS (USD) N/A N/A N/A 0.10 Dividend Yield % N/A N/A N/A 2.66 Market Price (OMR) N/A N/A N/A 1.49 Market Cap. (USD Mn) N/A N/A N/A 975 Book Value per Share (USD) Traded Volume ( 000) N/A N/A N/A 136,848 Traded Value (USD Mn) N/A N/A N/A 406 Turnover Velocity % N/A N/A N/A 42% Source: Reuters Knowledge, Company Accounts, Bloomberg; Per share data is calculated using number of shares outstanding as on 31 December * Galfar was listed at MSM on 24 October Kuwait Financial Centre Markaz 6

7 Kuwait Financial Centre Markaz R E S E A R C H Markaz Research Process Markaz Expected Return & Risk Analyst Call On Projected Stock Return Markaz Volatility Index (MVX) Company in relation to Benchmark Identification of Positive/Negative Drivers to the stock price from its current level Business Analysis (Company broken down to various segments for in-depth analysis and identification of growth drivers) Management Meet (Optional, where ever interest is shown by both parties Markaz & Company Analyzed) Analyst Calls (Optional, where ever analyst tracking the company are available) Preliminary Model Building Journals providing forecasts on Industry (price of commodity forecasts/intere st rate forecasts/trend forecasts etc) Analyzing International & Macro economic trends impact the company Annual Report Screening Quantitative Simulations Indicative Growth Guidance Probable Extent of PE Expansion /PE Contraction Earnings Growth P/E Weight 25 50% Short Term Profile (Last four quarters average growth rate) Short Term Profile (Last 12 Month average PE) Weight 60% 10 25% Medium Term Profile (Last three years average growth rate) Medium Term Profile (Last 24 Month Average PE) 40% 25 50% Analyst Consensus estimates 7

8 Kuwait Financial Centre Markaz R E S E A R C H Analyst Certification Each research analyst(s), strategist(s) or research associate(s) responsible for the preparation and content of this research report hereby certifies that, with respect to each issuer or security that the research analyst, strategist or research associate covers in this research report, all of the views expressed in this research report accurately reflect their personal views about those issuer(s) or securities. Each research analyst(s) strategist(s) or research associate(s) also certify that no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendation(s) or view(s) expressed by that research analyst, strategist or research associate in this research report. Important Disclosures Analysts' compensation is determined based upon activities and services intended to benefit the investor clients of Kuwait Financial Center S.A.K. Markaz ("the Firm"). Like all Firm employees, analysts receive compensation that is impacted by overall firm profitability, which includes revenues from other business units including Investment Banking. Investment ratings are determined by the ranges described herein at the time of initiation of coverage, a change in investment and/or risk rating,. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock's expected performance and risk. Definitions - Return Low Where the potential return is less than 10% Medium Where the potential return is between 10% and 25% High Where the potential return is greater than 25% Definitions Volatility (Risk) High Where the Current MVX and band width of stock is more than benchmark Medium Where the current MVX is lower than benchmark and band width higher than or lower than benchmark Low Where the current MVX is lower than the benchmark and the band width lower than the benchmark MVX refers to Markaz Volatility Index calculated by Markaz based on in-house proprietary model Disclaimer This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by the Central Bank of Kuwait. The report is intended to be circulated for general information only and should not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable but no representation or warranty, expressed or implied, is made that such information and data is accurate or complete, and therefore should not be relied upon as such. Opinions, estimates and projections in this report constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinion of Markaz and are subject to change without notice. This report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors are urged to seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and to understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security s price or value may rise or fall. Investors should be able and willing to accept a total or partial loss of their investment. Accordingly, investors may receive back less than originally invested. Past performance is historical and is not necessarily indicative of future performance. Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals, with companies covered in its research reports. This report may provide the addresses of, or contain hyperlinks to, websites. Except to the extent to which the report refers to website material of Markaz, Markaz has not reviewed the linked site and takes no responsibility for the content contained therein. Such address or hyperlink (including addresses or hyperlinks to Markaz s own website material) is provided solely for your convenience and information and the content of the linked site does not in any way form part of this document. Accessing such website or following such link through this report or Markaz s website shall be at your own risk.

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