SICO Research. Saudi Telecom Company (STC) GCC Equities. BUY (Initiation of Coverage) The Giant Awakes. July 27, 2007

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1 GCC Equities SICO Research Saudi Telecom Company (STC) BUY (Initiation of Coverage) The Giant Awakes July 27, 2007 Sector Telecom Market Cap: US$ 36.1 bn Primary Exchg Tadawul (KSA) Other Exchg -NA- Price: SAR Target Price: SAR Reuters: 7010.SE Bloomberg: STC AB STC versus Tadawul Index STC - Rebased INDEX - Rebased Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Feb-05 Jun-05 Sep-05 Feb-06 Jun-06 Nov-06 Apr-07 VALUATION RATIOS 2007E 2008E P/E x P/BV x EV/EBITDA x Div Yld x TRADING DATA Daily Vol (6M Avg mn) 1.46 Daily T/o (6M Avg US$ mn) 26.2 Issued Shares (mn) 2,000 Jithesh K. Gopi Tel. (973) (ext 5065) jithesh.gopi@sicobahrain.com Bryan D Aguiar, CFA Tel. (973) (ext 5021) bryan.daguiar@sicobahrain.com Saudi Arabia is a key market in the MENA region with nearly 26 million inhabitants, characterized by a young population, a robust underlying economy, rising affluence levels, and increasing liberalization of the sector. Saudi Telecom Company (STC), the incumbent operator, has seen stiff competition from the second mobile operator Mobily, which has put pressure on revenue and profit growth. This is likely to increase with a third mobile operator and three new fixed-line operators in the pipeline. Key Financials Optg Net Profit EPS ROE ROA Revenues SAR bn Profit Income chg (%) (SAR) (%) (%) CY06A CY07E CY08E CY09E CAGR (06-09E) NA 0.6 NA NA STC is tacking competition by expanding and leveraging its infrastructure and coverage and bundling services to retail and enterprise customers. Saudi Mobile Market Penetration is forecasted to exceed 100% by end of While we expect STC s market share to fall to 52% by 2011, we forecast STC s customer base will grow at a CAGR of 7.4% over the horizon, benefiting from the expanding Saudi market. STC s attempts to expand outside Saudi finally seem to be paying off. We estimate STC could raise as much as $14 billion of debt to pursue its international acquisitions towards its objective of generating over 10% of revenues from outside KSA by STC s recent SAR 11 bn (US$3 bn) acquisition of a 25% stake in Malaysia s Maxis provides it access to over 14 mn customers in Malaysia, India and Indonesia. We estimate the deal will be value accretive and add ~5% to growth. Our analysis suggests that markets are being overly pessimistic with regards to STC s earnings potential and that downside potential on the stock is limited. We believe that scope for positive surprises are high and could come from change of perception about STC, improvements in core earnings as a result of cost optimization programs, better performance in domestic market, and incremental earnings from possible acquisitions. At current prices STC trades at a P/E ratio of 11.0x on 2007 s forecasted earnings - a steep discount to both Regional and Emerging market Telcos as also to Saudi equities (despite a significantly higher dividend yield and profitability). Company P/E (07E) RoE % D/Y % STC Saudi Equities MENA Telcos EM Telcos Our DCF provides a fair price of SAR 91.20, while a blended valuation arrives at a price target of SAR (factoring in a 15% discount to peers, which could diminish as the tide of investor pessimism turns). STC provides investors an attractive 8.5% dividend yield and our fair price has a further upside of SAR 5.4 if the company can demonstrate that this discount to peers is unwarranted. We initiate coverage of STC with a target of SAR per share (12.7% upside potential) and a BUY recommendation. We believe that the possibilities of positive surprises and further upsides are high, with downsides limited by the attractive dividend yield. SICO 2007 All Rights Reserved Attention is drawn to the disclaimer and other information on Page 37 1

2 Contents Investment Arguments... 3 Inorganic growth becomes a reality... 5 Analysis of Maxis Deal... 6 Detailed Valuation Methodologies Discounted Cash Flow Method Comparative Valuation based on Industry Multiples Blended Valuation Valuation Evolution Valuation versus Saudi, Regional & EM Peers Recent Developments Hikes Stake in AwalNet to increase internet market share STC in talks to secure debt facility for future acquisitions STC s Q2 FY07 Results Business Background Description of Current Business Group Operations Business Segments Saudi Telecommunications Sector Overview Set to become fully competitive There is still plenty of room for expansion in Wireless Internet and broadband poised for growth STC Business Strategy Moving F-O-R-W-A-R-D Preparing for fixed-line competition Broadening range of services and pricing is key to mobile market STC concentrating on improving Internet, Data businesses STC considers regional expansion as domestic competition increases Wholesale business to benefit from competition Corporate History Key Developments Current Ownership Dividend Policy Financial Performance and Analysis Key Profit and Loss Account Data and Ratios Balance Sheet and Cash Flow Financial Statements & Forecasts

3 Investment Arguments Investment Case Ability to provide bundled services is a key competitive advantage - Saudi Telecom Company (STC) is the only player in Saudi Arabia offering fixed, mobile and data services. This unique positioning provides the company a competitive edge to offer bundled services and comprehensive service offerings to both retail and enterprise customers. STC is now focusing on expanding its physical coverage as well as its Internet and Data services businesses by upgrading its infrastructure and introducing WiMax. Contrary to perception, STC s wholesale business will benefit from increased competition, though the impact will not be significant given its relatively minor contribution to STC s financials. Well placed to capitalize on new inorganic growth plans - STC is changing its approach towards inorganic growth and is now looking to acquire stakes in carriers operating in multiple geographies with a subscriber base of million. STC is well placed to follow such a strategy given its lack of leverage (currently zero debt on books) and significant cash flow generation potential (in 2006 alone, STC generated SR 16 bn ($4.3 bn) from operations). Excessive pessimism built into price - Recent M&A deal may signal a turn in the tide - STC s recent acquisition of a 25% stake in Malaysia s Maxis Communications and 51% direct stake in Maxis' Indonesian unit Natrindo for US$ 3.04 bn, heralds the company s first aggressive move outside the region. We view the deal positively as it provides STC a much needed growth impetus. STC s current share price, in our view, reflects an excessive level of pessimism. This deal could possibly signal the turning of the tide as STC aggressively ramps up its inorganic growth plans, given its access to significant funding and a strong domestic franchise. Competition set to increase but impact expected to be less dramatic on market share and ARPU assumptions - Competition in STC s home market is set to intensify, with news flow likely to impact sentiment. Following the launch of Mobily s (Saudi s second mobile operator) services in 2005, STC s market share declined to 69% in In Mar 07, a third mobile license was granted to a consortium led by Kuwait s Mobile Telecommunications Co (MTC). STC s monopoly in the fixed-line market will shortly be broken as three new fixed-line licenses are in final stages of being awarded. Going forward, we expect growing competition to weaken STC s market share and competitive position in its home market. None the less, Saudi Arabia s large population base (25.3 mn) and its young demographic profile, should enable competition to drive penetration levels higher and lead to demand for higher end services, enabling STC to hold on to a market share of 52% by 2011 with decline in ARPUs significantly less severe than in recent years. Furthermore, we do not expect the third mobile operator to launch an aggressive price war and weaken the overall market in the longer term due to the significantly higher license fee (US$ 6.1 bn) it paid and the pressures it will face to break even once the entity gets listed. Business / Broadband segments to cushion pressures on growth - STC s wholesale business will benefit from the increasing competition. We believe that growth in STC s wholesale business and broadband services will alleviate the pressures on growth in revenues and margins from other services. 3

4 Savings on recent cost control initiatives are yet to be built into forecasts - STC has launched a cost optimization program aimed at sustaining margins at current levels. This includes significant reduction in manpower and an organization wide rollout of shared services. We have not factored in the savings potential from these initiatives and any positive developments on this front would provide upside potential. Recent results reflect our views on likely pressures on margins and profitability in the medium term - In 1H FY07, the company s top line declined 2.2% to SAR16.8 bn. The decline in revenues coupled with higher costs led to a 14.5% decline in the net income during 1H FY07. Profitability is under pressure since the second half of 2006 when the company s net income declined 8.3% (y-o-y) due to lower pricing and higher costs. However in 2Q-07, the net income improved 14% sequentially (after four continuous quarters of decline) benefiting from cost savings (though it fell 8.6% y-o-y). Going forward, we expect pricing to come under pressure in key markets including Mobile, Internet and Data services resulting in pressure on margins and net income. Market price is overly pessimistic and provides investors with a high reward for any positive surprises - Our analysis suggests that the current price fully reflects (and even overstates to some extent) the pessimism related to STC s domestic earnings potential. We have modeled STC s declining profitability versus peers by factoring in discounts to STC s base case valuations. We believe that scope for positive surprises are high and could come from sources such as operational improvements in STC (e.g. its cost control measures), delays in roll-out by competition, quicker market penetration of telecom services in the Kingdom, better than expected market position of STC in domestic markets and any further M&A activity by STC. Key Risks Pricing of M&A deals & impact on dividend payouts - In its bid to aggressively expand its reach to regional markets, STC may end up paying steep prices for licenses or/and acquisitions. This could be detrimental in the medium term. Another risk is the lack of a track record for STC s management in integrating large acquisitions. Note that significant M&A deals could impact cash flow requirements of STC putting pressure on the company to reduce dividend payouts to conserve cash. While this may be in the best interests of shareholders (in cases where acquisitions are earnings accretive in the long run), this could impact sentiment in the short term. Speed of Competitors roll-out in Saudi - We have already factored in the presence of a third mobile operator in Saudi Arabia from 2008, and the addition of three other fixed line operators two wireless fixed operators from 2008 and one wire line operator from Any acceleration (to this base case) in roll outs by competitors could negatively impact STC s prospects and profitability. Regulatory risks - As the dominant player in Saudi, STC may require regulatory clearance for new products. Any unfavorable decisions aimed at promoting competition could impact STC negatively. News flow may result in short term volatility in STC s share price - Announcements from new operators about major developments in their operational plans can cause temporary negative sentiment in the market about STC, though most of these factors are already priced in our forecasts and valuation. 4

5 Inorganic growth becomes a reality Recently STC had become more vocal about its acquisitions plans to boost growth by leveraging its strong balance sheet. STC has set its sights on bigger carriers operating in multiple geographies with a subscriber base of million (as small operators will not have a significant impact on STC s consolidated operations). STC recently announced the first such deal by acquiring a 25% stake in Maxis Communications which has foothold in three geographies (Malaysia, India and Indonesia) with about 14 mn subscribers. We believe STC still has the potential to make further acquisitions to reach its target of generating 10% of revenues from overseas markets by Domestic competition forces STC to look outward STC has largely remained a domestic operator even as its regional peers expanded beyond their home markets. Over the past decade countries in the Middle East and North Africa (MENA) region have opened-up their markets to competition. Incumbents, faced with rising competition and stagnating markets in their domestic countries have expanded aggressively outside their home markets through acquisitions and new licenses in new geographies. By adopting aggressive inorganic growth strategies Etisalat (UAE), MTC (Kuwait), Orascom (Egypt), and Q-Tel (Qatar) have emerged as large regional players. These operators have successfully mitigated falling market share in their domestic markets through growth in external markets. Etisalat and MTC for instance now aim at becoming not just regional but international players. STC, in comparison, awoke late to the necessity to grow outside its home markets. Perhaps in part due to the fact that competition was introduced late in Saudi Arabia (only in 2005) and in sharp comparison to its neighbors, penetration rates are yet to hit the 100% plus levels that characterize the region. Other regional operators had very little choice but to expand beyond their home markets. After Mobily s entry in to Saudi market, STC made several attempts (though unsuccessful) to grow beyond its domestic borders. In March 2006, it withdrew prematurely from its bid for a 35% stake in Tunisie Telecom. Later in June 2006, STC s bid for the third mobile license in Egypt was rejected. We believe acquisitions are likely to emerge as an important source of growth for STC going forward. Balance sheet strength to enable regional expansion STC is considering inorganic growth opportunities in Asia, Africa and the Middle East. STC officials have indicated that they are looking at carriers operating in multiple geographic areas with subscriber base in the range of million. STC, which currently has no debt on books, has the ability to make sizeable acquisitions by leveraging its balance sheet. STC recently announced plans to borrow SAR 6 bn (USD 1.6 bn) from a consortium of banks. We believe that STC could potentially raise a war chest of as much as SAR 52 bn ($ 13.8 bn) to fund acquisitions given its current zero-debt structure and the levels of leverage by its peers in the region. In the section that follows we look at the extent of leverage of six telecom operators in the region (who aggressively expanded their geographic reach). Qatar Telecom has the highest leverage on its balance sheet whereas Etisalat has resorted to least proportion of debt to fund expansion. Qatar Telecom (Q-Tel) took on additional debt in Q1-FY07 to fund its 51% stake in Wataniya Telecom. 5

6 Debt Position of MENA's Aggressive Telecom Operators Total Total Wireless No of Equity** Debt** Subscribers countries D/E in reported currencies (bn) (bn) (mn) present Etisalat* NA 14 44% Orascom Telecom % MTN % Q-Tel % Wataniya Telecom % MTC % Average 152% Least multiple (Etisalat) Source: Company reports, SICO Research *Etisalat does not disclose group subscriber numbers ** 2006 figures except for QTel which is based on 1QFY07 44% In 2006, STC s net worth stood at SAR 34.1 bn. Based on the average debt / equity multiple, STC can potentially leverage its balance sheet by as much as SAR 52 bn (US$13.8 bn). On a conservative estimate assuming the lowest multiple (Etisalat), STC could still raise SAR15.2 bn which is still significantly higher than its proposed borrowing of SAR 6.0 bn. The potential of leverage coupled with substantial free cash flow generation capacity and a possibility to retain earnings (rather than paying out dividends, if a lucrative deal comes its way) provides STC with the ability to look at large acquisitions in the coming years. Analysis of Maxis Deal Described as "a deal of a lifetime" by the STC Chairman, this acquisition marks STC s foray outside Saudi Arabia. Even though we do not expect the contribution from this acquisition to be significant in terms of earnings and valuation, the deal demonstrates STC s seriousness in finding opportunities outside its home markets to boost growth and we expect this will help reduce (the perhaps excessive) pessimism lingering on the company s share price. On June 26, 2007 STC announced a deal to buy 25% of Malaysia's Maxis worth SAR11 bn (US$3.04 bn) that would give STC access to Malaysia, Indonesian and Indian markets. STC would fund the deal using a debt facility of SR 6 bn while the rest would be met from internal funds. STC would buy the stake by investing in Malaysian tycoon Ananda Krishnan's firm Binariang (Maxis Communications' largest shareholder). Binariang had recently teamed up with other Maxis shareholders to buy the 41% of Maxis they did not own in a successful $4.7 bn bid which took the group s holding to 98%. Binariang is expected to take Maxis Communications private (currently listed in Malaysia) by acquiring the remaining 2%. As part of the deal, STC will acquire a 51% stake in Maxis' Indonesian unit Natrindo. STC and Binariang's other shareholders will together underwrite a US$ 900 mn loan to expand in India where Maxis operates through its Aircel unit. As of Mar 07 Maxis had a subscriber base of mn (8.5 mn in Malaysia and 5.5 mn in India). This would value the deal at about US$ 841 per subscriber. The blended ARPU in Malaysia was about US$ 37 while in India ARPUs were much lower at US$ 14.8 The acquisition consists of two transactions: a 25% stake in Maxis parent and a 51% stake in Maxis operation in Indonesia. 6

7 The Indonesian operation is not yet fully operational and reported losses during In April 2007, Maxis acquired 44% of the Indonesian subsidiary (PT Natrindo Telepon Seluler) for US$ mn increasing Maxis stake to 95%. This deal implies a valuation of US$ 281 mn for the Indonesian subsidiary and values STC s 51% stake at US$ 144 mn (less than 5% of the deal). We have chosen not to consider separately the impact of the Indonesian operation because of its small contribution. Note the subsidiary is already embedded in the valuation (and earnings estimates) of Maxis. Analysis of the Deal in US$ million Consideration paid by STC 3,040 Stake bought by STC 25% Implied Valuation 12,160 Ratios 2006A 2007E EV/Subscriber (US$) 841 Price/Revenue Price/Earnings Price/BV EV/EBITDA Source: SICO Research, Reuters, Bloomberg, Company Reports Note: Susbcriber base as on 1Q 2007, 2007 estimates from Reuters Impact of Indonesian subsidary not included seperately STC s offer for Maxis (MYR 16.6 / share) represents a 9% premium to the last traded price of MYR 15.2 and a 6% premium to the take-over offer price of MYR 15.6 offered by Maxis parent company Binariang. Note that the price paid by Binariang already included a 20% premium over Maxis trading price prior to their take-over deal, implying STC s total premium at about 25%. This deal compares favorably to Q-Tel s acquisition of Wataniya where Q-Tel paid 11.8x EBITDA and 28.9x earnings for a 51% stake in Wataniya. Excluding the Iraqi operation (which is now under liquidation) the multiples increase to 17.4 and 39.8, respectively. A key distinction is that Q-Tel acquired a majority stake, which would attract a premium for control. Going by recent deals such as the acquisition of Investcom by MTN (US$ 950 per subscriber), Umniah by Batelco (US$ 800), Celtel by MTC (US$ 594), Wataniya by Q-Tel (US$ 1,325 per proportionate subscriber) STC s consideration for Maxis of US$ 841 per subscriber seems reasonable. A sweetener to the deal is Maxis strong foothold in India, which is considered to be the fastest growing telecom market in the world. Impact on STC We expect that STC s stake in Maxis will be treated as an Investment in associates while the stake in Indonesian operation will be fully consolidated. The Indonesian operation will not have any significant impact in the near term as the operation is yet to become fully operational. In order to consider the financial impact we have taken the earnings estimates available for Maxis (it is a well researched company listed on the Kuala Lumpur Stock Exchange). Based on consensus estimates (average of between broker estimates) provided by Reuters, we estimate that the incremental increase in STC s earnings from this deal will be about 5%. 7

8 STC also stands to gain from the higher growth rate of Maxis (CAGR of 16% during ) thus increasing contribution to incomes (6% in 2009 compared to 4.7% in 2007). Since STC plans to use a mix of debt and internal funds (50:50 i.e. about SAR 6 bn debt) to finance the deal, the net benefit would depend on the financing cost. We estimate the net benefit would be about half of the total projected contribution from Maxis. Performance of Maxis based on Analyst Forecasts and Impact on STC in US$ mn 2005A 2006A 2007E 2008E 2009E Revenue 1,846 2,233 2,647 3,041 3,464 % Growth 21% 19% 15% 14% EBITDA 1,010 1,125 1,237 1,360 1,501 % Growth 11% 10% 10% 10% Margin (%) 55% 50% 47% 45% 43% Net Income (GAAP) % Growth 26% -5% 9% 11% Margin (%) 26% 27% 22% 21% 20% STC's Share of Profit (25%) STC's Current Profit* 3,319 3,413 3,120 3,121 3,221 Incremental Contribution (Pro) 3.7% 4.5% 4.6% 5.1% 5.5% Incremental Interest Cost Net Increase in Earnings Source: SICO Research, Company reports, Reuters estimates Note: *based on SICO forecasts excluding share of income from Maxis, 2007 considered for 5 months Impact of consolidation of Indonesian operation not considered Results for 2005 and 2006 are given for comparative purpose only Interest expense based on SR 6 bn 5.5% annum In addition to the above STC can also derive cost savings in their international operations in Saudi Arabia. India and Indonesia are two of the top three international calling destinations from Saudi Arabia. STC now with direct footing in these countries through Maxis is in a better position to get attractive rates in these countries thus saving on STC s costs in Saudi Arabia. 8

9 Our Views on Valuation Limited Downside with high potential for positive surprises We believe that the market has already priced in the worst case scenario as far as STC s share price is concerned. Our valuation which is based on a worst-case scenario indicates that the current price level of STC almost fully reflects STC s earnings potential as a domestic player facing rising competition and the significant risks associated with a market which is changing as new operators commence their operations. Scenario analysis indicates limited downside risks We have assumed STC s market share will drop from the current 66% to about 52% by 2011 while the ARPU is forecasted to drop to SAR 105 per month (US$ 28 per month) by 2011 from the current SAR 133 per month. According to our scenario analysis if STC s market share drops by another 10% (to 42% by 2011) the DCF valuation will drop by only 7%. Similarly a SAR 10 drop in ARPU (to SAR 95 by 2011) will also have a similar 7% decline on DCF valuation. A combination of these factors will reduce DCF valuation by about 13%. This analysis shows the limited downside for STC from the current valuations. In our comparative valuation method, we have assigned a discount of 15% to STC s target multiples from peer group averages in both 2007 and 2008 in order to reflect its weakening position in the Saudi market and lack of diversification outside the domestic market. However if we were to remove this discount as a result of re-rating of STC s opinion in the market, our fair value will increase to SAR 81.7, an upside of 21% from the current level. This translates to an increase of 7% from our current fair value target price for STC. We believe that the above two examples represents the worst case scenarios for STC and note that our fair price for STC is only marginally higher from the current price. Also note that at current price STC offers an attractive dividend yield of about 8.5%. We believe the market has already priced in a worst case scenario for STC with limited downside possibility from the current level. Positive Surprises to provide Upside Possible upsides to STC can come from three sources, a change of perception about STC, improvement in core earnings as a result of cost optimization programs and better performance in the domestic market, and incremental earnings from possible acquisitions. We expect that any positive surprise from STC can lead to a change in perception of STC and an improvement in target multiples as a result of lower discounts from peers. We believe that that the downside potential is limited due to the company s high dividend yield (about 9%) which we believe is sustainable, assuming there are not further M&A deals that would provide the company a reason to conserve cash or repay debt. 9

10 Detailed Valuation Methodologies We valued STC using the Discounted Cash Flow (DCF) and relative valuation methodologies. In the relative valuation method, we use the EV/EBITDA, PER and P/BV multiples to derive a fair value. We arrived at the target price by considering both valuation methods and weighing them appropriately. Cost of Equity Since STC has zero debt, its weighted average cost of capital equals the cost of equity. We calculated STC s cost of equity as below: Beta: STC s raw beta using weekly returns for the last one year compared to the Tadawul All Share Index is The adjusted beta (assuming the company s beta will tend towards the market beta over a longer term) is calculated as Risk Free Rate: Given the peg of the Saudi Riyal to the USD we use the US 10-year Treasury yield as the benchmark Risk Free Rate. As of 24 th July 2007, the US 10-year yield stood at 4.93%. Equity Risk Premium: We have assumed an equity risk premium of 6.1%. Based on the above STC s Cost of Equity is calculated as 10.4%. Weighted Average Cost of Capital (WACC): We have assumed a debt of SR 6 billion to finance the Maxis deal (assumed interest rate of 5.5% per annum) resulting in a weighted average cost of capital (WACC) of 10.2%. In the long run, STC is expected to further leverage its balance sheet which provides the potential to lower WACC further (depending on level of leverage) and increase our estimate of the fair value. Discounted Cash Flow Method Given STC s ability to generate relatively stable cash flows in the coming years, DCF would be the most appropriate valuation method. Our DCF model is based on a detailed five-year forecast period, which in our view is a reasonable period of analysis for this region. We have assumed a perpetual growth of 3% to derive the terminal value of the company to reflect the weakening position of STC in the home market. This represents a discount to both the expected 3-4% population growth rate in Saudi Arabia which will be a key driver of growth in the segment, and the longer term real GDP growth of the Kingdom (which is yet another margin of safety from a potential investor s view-point). Based on these assumptions, the equity value of the company stands at SAR billion, translating to SAR 91.2 per share (35% higher than its current price). STC - Details of DCF Valuation as a % of Value (Figures in SAR billion unless specified Total Present Value of next 5-yrs Cash Flow % Cash and Cash Equivalents % Present Value of Terminal Value % Debt % Year End Adjustment % Total Equity Value

11 About 67% of STC s value comes from the terminal value (based on a terminal growth rate of 3.0%). We thus believe it is important to focus our sensitivity analysis to changes in our assumption on perpetual growth rates and cost of equity (as provided in the table below). Our valuation is more sensitive to change in the terminal growth rate and less sensitive to change in the cost of capital. The valuation ranges from a low of SAR 67.3 per share to a maximum of SAR per share validating our contention that downsides in STC are limited. The possibility of upside potential is higher in case of drop in cost of equity due to leverage or increase in growth rates due to change in perception about the prospects of the company. Terminal Growth Rate Sensitivity of Valuation to Cost of Capital and Terminal Growth Cost of Capital 8.2% 9.2% 10.2% 11.2% 12.2% 2.0% % % % % The contribution of mobile segment is significant to STC s overall revenue. Accordingly we have performed a sensitivity analysis to ascertain the impact of STC s estimated mobile market share and ARPU on STC s valuation. This demonstrates the limited downside risk due to further reduction in STC s expected market share and ARPU levels. Expected ARPU in 2011 (SR per month) Sensitivity of Valuation to Mobile Market Share and ARPU Source: SICO Research Expected Market Share in % 47% 52% 57% 62% Comparative Valuation based on Industry Multiples In order to derive the comparison-based value for STC s shares, we have used the PER, PBV and EV/EBITDA multiples based on regional companies that have operations in the fixed-line as well as wireless segments. Valuation Metrics - Comparable Telecom Operators Company P/E P/BV EV/EBITDA A 07E 08E 06A 07E 08E 06A 07E 08E Fixed Line and Wireless Operators Etisalat Qatar Telecom Batelco Jordan Telecom Oman Telecom Maroc Telecom Saudi Telecom Overall Average Average (excluding STC) Premium/ (Discount) -28.6% -14.7% -10.7% -7.7% -13.4% -7.4% -10.6% 8.1% 6.1% Source: SICO Research, Company Reports, Reuters and Bloomberg The valuation for STC based on peer multiples is provided in the table that follows. As things stand at the moment, we expect STC s multiples will trade at a discount to the average valuation multiple of its peer group. 11

12 We believe that the discount is justifiable considering the threat to STC s competitive position in the Saudi market, limited growth opportunities, lack of diversification outside the domestic market and the pressure on margins. Accordingly we have assigned a 15% discount to peer group average while calculating STC s target multiples. We believe that this discount may diminish as sentiment improves (driven by the three factors we outlined in our earlier section in valuation views). On incorporating this discount, we arrive at target P/E multiples (based on 2007 estimates) of 11.0, target P/BV of 3.8 and target EV/EBITDA of 6.4 compared to peer group averages of 12.9, 4.5 and 7.5 respectively. STC - Valuation Based on Multiples 2007E 2008E EBITDA (mn SAR) 16,370 16,939 EV/EBITDA Multiple Premium/Discount -15% -15% Peer group average Price based on EV/EBITDA, SAR Earnings Per Share (SAR) PER Multiple Premium/Discount -15% -15% Peer group average Price based on PER, SAR Book Value Per Share (SAR) PBV Multiple Premium/Discount -15% -15% Peer group average Price based on PBV, SAR Annual weighting Source: SICO Research 50% 50% Blended Valuation We used a blended approach to derive the target price for STC. Given the greater rigor and suitability of the DCF approach, we assigned it a higher weightage (50%), and assigned equal weightage (16.7% each) to the PER, PBV and EV/EBITDA approaches. Based on our blended valuation approach, the fair value estimate for STC is SAR per share, 12.7% higher than the current price. STC - Blended Valuation (price in SAR) Price Weightage DCF % Price/ Earnings % EV/EBITDA % Price/ Book Value % STC - Share Price, SAR Source: SICO Research Calculation of Upside (Downside) STC Fair Value per share, SAR Current Price, SAR % Up (Down) Side from Current Price 12.7% Also note that STC currently has an attractive annual dividend yield of about 8.5%. 12

13 Valuation Evolution As the only operator in the Saudi telecom sector, STC was the only avenue for investors to participate in the Saudi telecom sector. As a result, the stock historically traded at a high P/E multiple of 16x earnings. The company recorded strong growth in its subscriber base between 2004 and 2005 and the valuation soared to abnormal levels during this period. However, the opening up of the telecommunications industry and the changing competitive landscape has led to a fall in valuation multiples. The stock currently trades at a forward multiple of 10.7x earnings, a significant discount to its historical multiples. Chart 1: STC Trading Pattern STC PER Bands 8x 12x 16x 20x STC Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Feb-05 May-05 Sep-05 Feb-06 Jun-06 Nov-06 Mar-07 Source: SICO Research, Company Data STC has been one of the most liquid and highly traded stocks on the Saudi bourse. The recent correction in regional markets led to a contraction in STC s volume, as evident in the chart below. Average volumes declined significantly in the past few months. Note that GCC investors are allowed to invest in STC directly (while foreigners can invest in the company only through a fund route). Chart 2: STC Trading Pattern Price (SAR) Volume 30-day Moving Average (Volumes) Price Jan May Sep Jan May Sep Feb May Sep Feb Jun Nov Mar-07 Volume (mn shares) Source: SICO Research, Company Data 13

14 Until 2004, the STC stock moved broadly in line with the market. However, the stock began underperforming the market following the entry of Mobily in July The reduction in market share and deteriorating operational performance contributed to the negative sentiment surrounding STC. In the past few months, while most shares witnessed a correction, the STC stock declined more than the broader market. Over the past month, however, the stock has outperformed the markets as investors realized that perhaps the markets are being too pessimistic on the outlook for the company. On a relative basis, STC has significantly underperformed the Tadawul All Share Market Index during the last one year. However in the recent months STC outperformed the market. STC - Price Performance relative to Index Absolute Relative Market 1 m m m (32.3) (5.8) (26.4) Valuation versus Saudi, Regional & EM Peers The table below summarizes STC s investment merits in comparison to both regional peers and international emerging market Telcos: Company P/E (07E) RoE % D/Y % STC Saudi Equities MENA Telcos EM Telcos Source: SICO Research, Bloomberg, Reuters STC represents a steep discount to Saudi markets, peer averages and EM Telco averages in terms of both forward P/E and Dividend Yield (despite having superior levels of profitability). 14

15 Recent Developments Hikes Stake in AwalNet to increase internet market share On March 19, 2007, STC purchased a majority stake in local Internet provider, AwalNet. The acquisition, a first for the company in the internet space, aims to boost STC s share in the internet market. AwalNet has a 20% market share, and is the leading ISP in Saudi Arabia. AwalNet had earlier pulled out of the bidding process for the second fixed-line license. The acquisition is in line with the STC s newly established corporate strategy, which prioritizes external growth and greater penetration in the home communications market. STC in talks to secure debt facility for future acquisitions STC is in talks with a consortium of local banks to secure a loan facility that will allow it to borrow up to SAR6 bn (USD1.6 bn). A formal agreement on the five-year loan is expected over the next few weeks. According to information currently available, terms of the loan would be drafted under Islamic Banking laws that ban lending on interest, and the deal would be a commodity-linked transaction. We expect the deal would be used to finance the Maxis Communications deal. 15

16 STC s Q2 FY07 Results STC announced its Q2 FY07 results on July 18, According to preliminary numbers, the company s revenues declined 2.1% to SAR8.4 bn in Q2-07. EBITDA margin declined to 49.6% in Q2-07 from 51.2% in Q2-06 (a marked improvement over 46% during Q1-07). Net profit fell 8.7% to SAR 3.1 bn in Q2-07 however increased 14% compared to the previous quarter. STC s earnings improved sequentially during the second quarter, after four quarters of continuous decline in profits. The results are summarized in the table below. Key Highlights Q2-07 results & CY 2006 Results STC Consolidated Results (3-Months ended June 2007) Q2 FY07 Q2 FY06 % Change Q1 FY07 % Change (Figures in SAR billions unless specified) Y-o-Y Q-o-Q Revenues % % EBITDA % % Net Income % % EBITDA Margin 49.6% 51.2% -1.6% 46.2% 3.4% Net Income Margin 36.8% 39.4% -2.6% 32.7% 4.1% Source: SICO Research and Company Report STC s FY06 and subsequent Q2-07 results reflect the competitive pressure faced by STC after Mobily s entry (and the subsequent end of the company s monopoly in the wireless segment). Revenues grew 3.8% to SAR33.8 billion in FY06. Price cuts and rising marketing expenses dented profitability. In our opinion, the decline in EBITDA margins and net income is likely to continue. Key highlights of STC results for FY06 Revenues increased 3.8% to SAR33.8 bn in FY06 from SAR32.5 bn in the preceding year. Fixed line revenues increased 8.2% y- o-y to SAR9.8 bn in FY06 driven by broadband and wholesale services. However, wireless revenues increased a modest 2.2% y- o-y to SAR24.0 bn in FY06. STC s subscriber base is estimated to have grown 12.7% to 13 mn in FY06. However, the overall market size is estimated to have grown 26.4% in FY06. The company s market share declined to 69% in FY06 from 83% in the earlier year. Reductions in tariffs, increased promotional discounts and increasing penetration have led to lower Average Revenue per User (ARPU). Wireless ARPU declined 14.8% to SAR158/month in FY06. Higher marketing expenses coupled with lower ARPU dented profitability. The net income grew 2.8% to SAR12.8 bn in FY06. This compares to a CAGR of 52.0% between FY02 and FY05 and a y-o-y growth of 33.6% in FY05. On a q-o-q basis, STC s net income declined for three straight quarters in FY06 Q2, Q3 and Q4 reflecting the challenge faced by the company. However we expect the earnings to marginally improve in FY07 as they have already fallen in corresponding quarters in FY06. 16

17 Business Background Description of Current Business Saudi Telecom Company (STC) is the leading telecom service provider in Saudi Arabia. Until 2005, STC was the sole telecommunications provider in the country. In 2005, Saudi Arabia granted a second GSM license to Etihad Etisalat (Mobily), thus ending STC s monopoly. STC is still, however, the monopoly provider of wireline telecommunications in Saudi Arabia. It is also the sole provider for internet connectivity to all local ISPs. STC s subscriber base comprises 4.3 million fixed line users and over 13 million mobile subscribers, making it one of the largest telecommunications providers in the Middle East. STC is set to lose its monopoly over the fixed line market very shortly with the regulator (CITC) in final stages to grant three additional wireline licenses. CITC granted a third GSM license this year to Kuwait based MTC paving way for increased competition in the wireless segment. Group Operations STC s operations can be broadly classified into wire line and wireless services. Services such as telephone calls (local, national, and international), public telephone services, prepaid card calling, directory services, internet, and business services are provided under the wireline business. Wireless services relate to GSM services such as pre-paid and post-paid connections, SMS, MMS and WAP. The wireless segment contributed 71.1% to total revenues in FY06, while the balance 28.9% came from wireline services. Usage charges contributed 79.3% of STC s revenues, subscription and activation fees contributed 15.2% and 1.7%, respectively and other revenues accounted for the balance 3.7%. Chart 3: STC Revenue trend SAR billions Wireless Wireline Source: SICO Research, Company Data 17

18 Business Segments STC conducts its operations through four divisions, each catering to one part of the telecommunications business. These divisions are outlined below: Chart 4: STC Group Chart STC Wireline Wireless ALHATIF (Fixed-line voice) Sau d i Dat a (Data Solutions) Sau d i Net (Internet Service Provider) ALJAWAL (GSM Services) Source: SICO Research, Company Data ALHATIF This division caters to the fixed-line business. Apart from the main landline telephone service, ALHATIF offers value-added services such as call hot line, voice mail, caller id, and conference call services. Internet and data services are also provided through the landline network. To its business customers, ALHATIF offers services such as toll-free numbers and direct dialing. Currently, ALHATIF is the monopoly provider of landline telecommunications in KSA. STC s network, comprising fiber optic and copper cables, is spread across the nation. Global links are established via submarine cables. Fixed-line penetration has remained steady at approximately 16% for the past five years. ALJAWAL The ALJAWAL division is the leading GSM services provider in KSA. ALJAWAL offers both prepaid and post-paid connections. Most plans include basic bundled services such as call alerts, call divert, and call waiting. ALJAWAL also offers special packages such as Family ALJAWAL, and the SAWA Friends and Family service to its retail customers and ALJAWAL Business Discount, ALJAWAL Banking, and Bulk SMS to business customers. Through platforms such as WAP and Jawalnet, the company provides data services. SaudiNet STC provides internet services to corporate customers, small and medium businesses in Saudi Arabia through SaudiNet, its internet service provider division. SaudiNet developed its IP network and systems jointly with Telia and currently provides dial-up and ADSL services. Post the acquisition of AwalNet, STC offers direct internet access through approximately 38% of the country s connections. The balance is provided by 21 private Internet Service Providers (ISP). For all practical purposes, these ISPs can be looked at as a connecting link between customers, as the ISPs customers pay an ADSL access charge to STC in addition to connection charges paid to the ISP. 18

19 Saudi Data IP-VPN enables customers to connect multiple sites through the creation of virtual private networks (VPNs) that facilitate interconnection of sites through the STC infrastructure. It also offers communications technologies such as data framework relay and digital leased lines to enterprise customers. The company also participates across the telecommunication value chain through equity stakes in three companies Arab Satellite Communication Organization, Arab Submarine Cables Company, and Tejari Saudi Arabia. Arab Satellite Communication Organization (36.7% stake) Arabsat, established in 1976, offers a number of services in the Middle East. These services include regional telephony (voice, data, fax and telex), broadcasting (television and radio), and capacity leasing. Arab Submarine Cables Company (44.3% stake) This company constructs, leases, manages and operates a submarine cable between KSA and Sudan. Tejari Saudi Arabia (50.0% stake) Tejari was formed in November 2006 with the aim of providing electronic platforms and services related to e-commerce dealings. 19

20 Saudi Telecommunications Sector Overview The Saudi telecommunications sector is one of the most attractive in the Gulf Cooperation Council (GCC) region and, in our opinion, offers significant potential for growth. Rising economic prosperity coupled with the positive demographics of a young growing population and large number of expatriates is driving the demand for telecommunication services in the Kingdom. Furthermore, Saudi Arabia, the most populous GCC country, is one of the most under penetrated markets in the region. Set to become fully competitive Saudi Arabia is on its way to becoming one of the most competitive and liberalized markets in the GCC region. The mobile market was opened-up in 2004 when Etihad Etisalat won a license to operate the second GSM service. CITC continued its liberalization agenda by awarding MTC the third GSM license and is expected to grant three new fixed-line licenses in MTC is expected to begin operations in Of the three new wireline carriers, two will offer fixed-line services through radio spectrum and are expected to begin operations by end of The third fixed-line carrier will operate a cable network in select cities and is expected to start operations by mid There is still plenty of room for expansion in Wireless Although rising, mobile penetration is still low Liberalization has led to an expansion in mobile subscription in Saudi Arabia. Demand improved as consumers were offered choice in service providers, plans, and pricing. Rising economic prosperity also contributed to higher consumer spending on mobile services. The mobile subscriber base grew by 37.1% (y-o-y) to 19.6 million subscribers in Mobile penetration was 78% in 2006 compared to 58% in 2005 and 39% in Chart 5: Mobile subscriber base and penetration ( ) % 58% 39% 33% % Subscribers (millions) Penetration (%) 100% 80% 60% 40% 20% 0% Source: SICO Research, CITC The use of multiples connections has inflated the actual penetration level in the Kingdom. Based on conservative estimates, the actual penetration may be 15-25% lower than the reported population penetration. 20

21 Despite an average subscriber growth of 40% over the past two years, the Saudi mobile market remains under-penetrated. Yet, this compares well with Saudi Arabia s GCC peers. Chart 6: Saudi Arabia s mobile market is under-penetrated 140% 120% 100% 80% 60% 126% 114% 110% 100% 78% 62% 40% 20% 0% UAE Bahrain Qatar Kuwait KSA Oman Source: CITC, TRA Qatar, SICO Research The currently under-penetrated Saudi Arabian mobile market is likely to register robust growth in subscribers, going forward. Three factors likely to drive expansion in subscriber base, in our opinion, are as follows: Positive macroeconomic dynamics of a large, young and relatively wealthy population are expected to result in higher spending on wireless services. Chart 7: Saudi Arabia s very lucrative demographic profile Population Structures Median Age (Yrs) as in 2000 % of Population below the age of 40 (in 2000) Bahrain Oman Qatar Saudi UAE Kuwait India China USA Japan Source: CIA, SICO Research The demand for advanced mobile offerings such as 3G and 3.5G services is increasing. Higher competition is leading to improvement in services and reduction in tariffs. The implementation of Mobile Number Portability (MNP) is likely to ease the difficulties in switching between carriers and enhance competition. 21

22 Fixed line market to have four operators by 2009 In April 2007 CITC announced it has approved three applicants Optical Communication Company Consortium (led by USA s Verizon), Al- Mutakamilah Consortium (led by PCCW of Hong Kong) and Atheeb Consortium (led by Bahrain s Batelco) to receive fixed-line licenses. The multiple licenses will, subject to approval from the Council of Ministers, result in the fixed-line market opening from a monopoly to full competition with four carriers within a span of two years. The new licenses will improve the telecommunications infrastructure in the nation. Al-Mutakamilah and Atheeb have applied for radio spectrum licenses which will allow the two consortia to operate wireless fixed-line networks. Such networks take less time and are more cost effective to set up. We expect Al-Mutakamilah and Atheeb to begin operations in The Optical Communications Company, which plans to operate a wireline network, is expected to begin operations only by We believe, in the fixed-line market demand for voice has reached stagnation in Saudi Arabia and fixed-to-mobile substitution is likely to gain momentum. Fixed line penetration was 70% of households (about 16% of the population) in Although this is relatively lower than penetration in the GCC region, Saudi Arabia s terrain, low population density and large household size limit the potential of household penetration reaching 100%. In our opinion, going forward, demand for fixed-line is likely to come mainly from demand for internet and data services and business users. Chart 8: Fixed-line penetration GCC (as % of households) 140% 120% 100% 80% 60% 40% 20% 0% 117% 98% 85% 83% 70% 54% Qatar Bahrain UAE Kuwait KSA Oman Source: CITC, SICO Research Internet and broadband poised for growth We expect the broadband market to grow rapidly given the renewed focus from CITC and STC, coupled with the entry of three new operators. Mobile broadband is also expected to gain ground in Saudi due to the difficulties in providing wire line broadband access across the kingdom. Low internet and broadband penetrations At the end of 2006, internet penetration in Saudi Arabia stood at 18.6%. Internet users have grown from 1 million in 2001 to 4.7 million in