Saudi Retail Sector Relatively better placed

Transcription

1 Saudi Retail Sector Retail Industrial Saudi Arabia January 18, 2010 Research Department Nivedan Reddy Patlolla Tel , patlollan@alrajhi-captial.com Key themes Saudi retail sector was one of the best performing sectors on the TASI until 2014 led by healthy revenue/ net profit growth on the back of store additions and strong LFL growth, as increasing government spending percolated to healthy on-theground demand. However, the sector has been underperforing TASI since 2015 due to expected slowdown in consumer spending, full foreign ownership rules and possible regulation on early closure of shops. The impact of slowing consumer spending was apparent in Q results, which were mostly below estimates. However, we believe the sector s long-term fundamentals remain intact and to take advantage of this, the retailers are focusing on improving efficiencies of existing assets and also investing in store network expansion to drive growth, albeit at a more measured pace than previously. Implications Retail sector s profitability will be impacted by lower consumer spending. However, the earnings trajectory is set to improve once the impact of low consumer spending normalises the base in Lower consumer spending should result in slower growth rates vs. previous few years and margin will be under pressure from lower LFL revenue growth (which impacts store level economics), and implementation of nitaqat rule. There will also be increased competition due to full ownership rules in some segments of retail. Further, early closure of shops, which is currently under discussion, is a downside risk in the short to medium term which may dent volumes. Overall, keeping in view the long term prospects, we believe the recent sharp fall in stock prices make it an attractive entry point for long term investors. We have Overweight rating on Al Othaim, Al Hokair, and Jarir, and Neutral rating on Extra. What do we think? Stock Rating Price Target (SAR) Al Hokair Overweight 57.7 Al Othaim Overweight Extra Neutral 29.3 Jarir Overweight Saudi Retail Sector Relatively better placed Stocks in Saudi retail sector (excluding Al Othaim) have underperformed TASI over the last one year on expectations of slowdown in consumer spending in a low oil price environment. Delay in oil price recovery has been cementing market expectations that expansionary fiscal policies, which translated to high consumer spending over the past few years, may not sustain going forward. Lower consumer spending will impact like for like (LFL) growth of stores, which will weaken the case for margin expansion and mute earnings growth in the short run. We have factored these into our estimates for all retail stocks under our coverage. However, grocery retailers such as Al Othaim will be relatively insulated in our view. To add to the jitters, rules have been further relaxed to allow 100% foreign ownership (75% previously) in retail, stoking concerns of increased competition. However, this will not have a significant impact on retail stocks in our view. Overall, even considering the negatives of broader slowdown in economy and full ownership rules, we believe the key drivers for retail sector (attractive demographics, rising employment with Saudization being one of the drivers and economic diversification away from oil) to remain strong over the medium term. We have Overweight rating on Al Othaim, Al Hokair and Jarir, and Neutral rating on Extra. Key risks: 1) Regulation to close shops by 9 PM will impact volumes, and 2) Prolonged slowdown in oil prices (our base case is a balanced oil market in 2017). Growth and earnings to be impacted in short term Prolonged slowdown in oil prices is building expectations that double-digit growth in government spending, which was the major driver of job growth and economic activity (key enablers for consumer spending), may not sustain going forward. The recent Q4 results of major retailers pointed to a trend of slowing consumer spending and we expect 2016 also to reflect this trend. Lower LFL growth will impact store level dynamics, which will weigh on margin and earnings. However, we expect the full impact of slowing consumer spending to be baked in 2016 financials and expect margin/ earnings trajectory to resume growth starting but key drivers intact: Favourable demographics (significant population aged <26, improving educational levels and tech savviness), rising disposable income, favourable policies (nitaqat, minimum wages, unemployment benefits and high spending to diversify economy) & shopping remaining a key source of entertainment are all structural factors which will continue to cushion short term slowdown and drive long term earnings growth for Saudi retailers. Valuations turn attractive: The Saudi retailers under our coverage are currently trading at average 2016E PE of 13.5x, lower than 5 year average of 15.3x. We believe the recent steep correction in retail stocks reflects expectations of sharp consumption slowdown not just for short term but also over the medium term. However, investors are neither considering resilience of companies through operational efficiencies nor accounting for possible upturn in oil prices over the medium term, which are both highly likely in our opinion. Hence, we believe this is an attractive entry point for long term investors to play one of the most secular stories of the Kingdom and the region. Please see penultimate page for additional important disclosures. Al Rajhi Capital (Al Rajhi) is a foreign broker-dealer unregistered in the USA. Al Rajhi research is prepared by research analysts who are not registered in the USA. Al Rajhi research is distributed in the USA pursuant to Rule 15a-6 of the Securities Exchange Act of 1934 solely by Rosenblatt Securities, an SEC registered and FINRA-member broker-dealer.

2 Saudi Retail Sector Retail Industrial Figure 1 Table of recommendation CMP (SAR) M.Cap (SAR mn) EPS (SAR) FY16e FY17e FY16e FY17e FY16e FY17e FY16e FY17e TP (SAR) Upside (%) Recommendation Al Hokair , Overweight Al Othaim , Overweight Extra Neutral Jarir , Overweight ; prices as on 10 March 2016 P/E (x) Risks to our view EV/E (x) RoE (%) Regulation concerning 9 pm closing of shops is a key risk going forward and should it be approved, it will result in meaningful impact on volumes. However, media sources indicate that even in case it is approved, it would not be a blanket approach and there will be some exclusions and further, there may be additional rules which can negate the impact of above. We have not considered the impact of this rule in our target prices as we await the approval and final rules. However, we have provided a sensitivity analysis of earnings to revenue/ margin decline in individual company sections of this note. 100% ownership in retail, continues to be a risk, however its impact is limited to a few segments in the sector, and by no means disruptive. The discretionary segments of retail such as electronics (media sources indicate major brands such as Apple have applied for license to open own shops in the Kingdom), apparel (especially top end brands) etc. may see increased competition. Among listed retailers, Extra due to its pure play on electronics and Jarir (having 60% of its revenue from electronics, computers and peripherals) will be impacted should brand owners (e.g. Apple, Samsung etc) expand presence through their owned stores. Disclosures Please refer to the important disclosures at the back of this report. 2

3 1/1/2014 2/1/2014 3/1/2014 4/1/2014 5/1/2014 6/1/2014 7/1/2014 8/1/2014 9/1/ /1/ /1/ /1/2014 1/1/2015 2/1/2015 3/1/2015 4/1/2015 5/1/2015 6/1/2015 7/1/2015 8/1/2015 9/1/ /1/ /1/ /1/2015 1/1/2016 2/1/2016 3/1/ Jan-14 5-Feb-14 5-Mar-14 5-Apr-14 5-May-14 5-Jun-14 5-Jul-14 5-Aug-14 5-Sep-14 5-Oct-14 5-Nov-14 5-Dec-14 5-Jan-15 5-Feb-15 5-Mar-15 5-Apr-15 5-May-15 5-Jun-15 5-Jul-15 5-Aug-15 5-Sep-15 5-Oct-15 5-Nov-15 5-Dec-15 5-Jan-16 5-Feb-16 5-Mar-16 Saudi Retail Sector Retail Industrial Investment thesis Retail weighed down by concerns The retail stocks have corrected significantly over the past year, primarily led by expectations of slowdown in consumer spending as oil prices have continued to stay lower for longer. As investors factor in implications of lower oil price, especially relating to slowing government spending, the expectations are being cemented that lower consumer spending will be the norm until oil prices commence an upswing. Figure 2 TASI & TASI Retail slumped 34% & 42% over last year Figure 3 TASI Retail trading ~30% below its 5 year mean PE multiple TASI TASI Retail (RHS) TASI Fwd P/E TASI Retail Fwd P/E (RHS) TASI 5 yr avg PE TASI Retail 5 yr avg PE (RHS) Source: Bloomberg Source: Bloomberg Figure 4 Indexed price chart Al Othaim insulated due to grocery retailing Figure 5 Fwd PE multiples correct in-line with expectation of slower earnings growth vs. previous years Source: Bloomberg Jarir Othaim Extra Hokair Source: Bloomberg JARIR EXTRA AOTHAIM ALHOKAIR Disclosures Please refer to the important disclosures at the back of this report. 3

4 Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct-08 Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12 May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15 Nov-15 Saudi Retail Sector Retail Industrial Figure 6 Absolute price performance steep correction over last one year CMP Price performance (%) 3M 6M 1Y 2Y Al Hokair % -38% -58% -50% Al Othaim % -13% -20% -2% Extra % -41% -70% -70% Jarir % -34% -44% -43% Source: Bloomberg; Note: prices as on 10 March 2016 Indeed, the Q4 results of retail sector stocks under our coverage have been below estimates, primarily impacted by volume growth in existing stores. We believe LFL growth of retailers will continue to be soft in 2016 and will gradually recover from 2017 led by oil price uptick. Figure 7 Aggregate revenue/ earnings growth to bottom out in , recover thereafter 30% 25% 20% 15% 10% 5% 0% FY11 FY12 FY13 FY14 FY15 FY16E FY17E -5% Aggregate revenue growth YoY Aggregate earnings growth YoY Source: Company data, Al Rajhi Capital We address the main concerns surrounding the retail sector currently, which provides the perspective to recent stock price correction: #1: Lower oil prices to impact consumer spending One of the main concerns which led to significant correction of retail stocks is the slowing discretionary spending on the back of sustained period of low oil prices. Rising oil prices over the past decade resulted in expansionary fiscal policies, which led to higher spending on infrastructure while also increasing employment in both public and private sectors. This led to a robust consumption boom resulting in outperformance by retail stocks over this period. Figure 8 Rising crude prices until 2014 Figure 9 led to increasing oil revenue ,400 1,200 1, % 95% 90% 85% 80% 75% 70% 65% % Oil revenue (SAR bn) Oil revenue as % of total revenue - RHS Source: Bloomberg Source: SAMA Disclosures Please refer to the important disclosures at the back of this report. 4

5 Saudi Retail Sector Retail Industrial Figure 10 which in-turn supported higher budget outlays Figure 11 leading to economic and employment gains 1,200 1, , Budget outlay (SAR bn) Total Labour force (mn) Govt employees (mn) Source: SAMA Source: SAMA However, with expectations now being cemented that expansionary fiscal policies will be difficult in a period of low oil prices, investors started factoring in lower consumer spending which will impact retailers. This excludes grocery retailers like Al Othaim, which we believe will be relatively insulated. Indeed, the retail stocks have witnessed flagging LFL growth in Q4 2015, which points to lower consumer spending impacting the retailers revenue. Further, another factor which supports the thesis of lower consumer spending is the partial roll-back of fuel and utilities subsidies, which impacts disposable income of households. The 2016 budget has raised fuel prices (both diesel and gasoline), water and electricity prices. This will reflect in an increasing slice of household income (although still a small percentage) being provisioned for fuel and utilities, which may lead to some impact on discretionary spending ability of households. Going forward too, the roll-backs may continue as has been indicated by the 2016 budget documents. However, we believe any roll-back will be gradual and its impact will already be priced into consumer expectations and hence should not result in a consumption shock. The Kingdom s monetary policy tracks that of the US Fed, due to currency peg. Hence, the interest rates will be raised in the Kingdom as and when they are announced by the US Fed. One rate hike is already through and there is a likelihood that further hikes may be in the offing, if the US economy shows sustained resilience. While our base case is that the interest rate uptick will be gradual, faster than expected rise in US interest rates will further weigh on consumption in the Kingdom, especially for discretionary products. Figure 12 US yields expected to tighten Current Yield Q Q Q Q Q Q Current and expected US interest rates (10 Yr note) Source: Bloomberg Disclosures Please refer to the important disclosures at the back of this report. 5

6 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Q1FY11 Q2FY11 Q3FY11 Q4FY11 Q1FY12 Q2FY12 Q3FY12 Q4FY12 Q1FY13 Q2FY13 Q3FY13 Q4FY13 Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 Q2FY15 Q3FY15 Q4FY15 Q1FY11 Q2FY11 Q3FY11 Q4FY11 Q1FY12 Q2FY12 Q3FY12 Q4FY12 Q1FY13 Q2FY13 Q3FY13 Q4FY13 Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 Q2FY15 Q3FY15 Q4FY15 Saudi Retail Sector Retail Industrial Below we depict a few charts which point to some of the indicators/ factors for slowing consumer spending. Figure 13 Slowing bank credit growth 18.0% 16.0% 14.0% 12.0% 10.5% 13.2% 16.2% 16.7% 15.8% 15.6% 15.1% 13.8% 12.0% 11.7% 11.8% 11.9% 11.6% 10.3% 10.0% 8.0% 6.0% 6.2% 7.2% 8.2% 8.9% 7.3% 8.9% 4.0% 2.0% 0.0% % YoY growth in bank credit Source: SAMA Figure 14 POS transaction value falls to 5 year low Figure 15 Significant slowdown in POS growth over last 3 quarters % 27% 30% 9% 28% 38% 24% 18% 18% 40% 35% 30% 25% 20% 15% 13% 10% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 46% 27% 37% 39% 38% 17% 23% 24% 26% 21% 22% 21% 20% 17% 15%12% 11% 10% 7% 10% 5% 0% % Value of transactions (SAR bn) % YoY (RHS) % YoY growth in POS transaction value Source: SAMA Source: SAMA Figure 16 Inflation rise reflects subsidy roll backs, expected to be elevated in the short to medium term Source: SAMA Inflation rate (%) Disclosures Please refer to the important disclosures at the back of this report. 6

7 Q12013 Q22013 Q32013 Q42013 Q12014 Q22014 Q32014 Q42014 Q12015 Q22015 Q32015 Q42015 Saudi Retail Sector Retail Industrial Figure 17 Slow aggregate revenue growth in 2015 (Q high due to two month bonus) 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% % YoY growth in aggregate revenue Source: Company data; Note: Aggregate revenue for retailers under our coverage We believe the notion of lower consumer spending is primarily associated with crude oil price assumptions. However, it is important to note that the consumer spending will pick pace even in an environment of sustained lower oil prices, but after a period of consolidating and forming a lower base, which we believe will happen in 2016 and may extend to early Hence, we factor in rising LFL growth from 2017-end onwards and this also coincides with our assumptions of gradual uptick in crude prices starting Faster than expected uptick in crude oil prices will lead to better than expected LFL growth, margin and earnings growth, which can lead to meaningful P/E expansion and consequent gains in stock prices. Figure 18 Brent crude prices expected to rebound from FY17. Figure 19 leading to uptick in revenue growth rates for retailers % 18% 16% 14% 12% 10% 8% 18.1% 13.9% 15.4% 8.9% 7.5% 8.2% 10.7% 11.1% % % 2% 0.0 Spot Q1 16 Q2 16 Q3 16 Q4 16 FY16 FY17 FY18 FY19 0% FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E Brent crude price median estimates (USD/bbl) Aggregate revenue growth YoY (%) Source: Bloomberg, Note: Aggregate revenue for retailers under our coverage As stated above, we believe that even in case of oil prices sustaining at lower levels going forward, we believe consumer spending will start to rise after a period of adjustment in 2016 and early Further, one must note that even though the negative impact of partial rollback in state subsidies will be impacting consumer spending initially, the government finances will improve over the long run and the consequent fiscal strengthening will improve employment and economic activity, leading to further uptick in consumption. Disclosures Please refer to the important disclosures at the back of this report. 7

8 Saudi Retail Sector Retail Industrial #2: FDI in retail potential risk for existing players The Kingdom is likely to permit 100% foreign ownership in retail sector, which could lead to increase in competition, with severity of impact depending on the retail segment. Grocery retailers such as Al Othaim will be least impacted as there is already significant competition in this segment along with presence of foreign chains through franchise agreements. Jarir & Extra may be impacted due to their exposure to electronics, as and when brand owners decide to set shop on their own. Jarir s higher-margin books/ stationary segment could also be indirectly impacted from relatively lower store footfalls. Al Hokair, by virtue of its presence in key locations, supply chain, merchandising, strong local tie up and distribution management, may not likely see its brand owners go alone. While we have stated the likely impact of increase in competition from foreign ownership rules being relaxed, our base case remains that the competition may not see a significant increase and hence we continue to believe that impact from these rules will be insignificant on the listed stocks in the retail sector. We outline below some of the reasons for this: Firstly, foreign players were already permitted majority ownership (75%) and hence, increase in ownership to 100% does not represent a paradigm shift in ownership pattern. Secondly, retailers esp. foreign brands may continue to be associated with a local partner, as local knowledge of customs and regulatory environment will be key attributes for successful and consistent operations. The Ministry of Commerce website suggests that the offers and bids from potential investors (wishing to own 100% of an enterprise) should include manufacturing plans with specific time limits, as well as technology transfer. While better clarity on the above will have to wait until the final policy comes out, it could probably point towards licenses being primarily issued to those players who benefit KSA with local manufacturing including creation of jobs and aiding in technology transfer. This casts uncertainty on which sub-sectors of retail may eventually get licenses or attract investment if the above conditions are deemed important. Essentially, the local players with investment in talent, infrastructure, operational excellence, understanding of business and consumer needs, and ability to deliver integrated development plans will continue to be business partners of choice (one such example being Al Hokair, a key partner for major international fashion brands in the Kingdom). #3: Regulation to close retail shops early under consideration The regulation to close retail shops by 9pm has been under consideration since 2013, but has gained momentum recently with increasing news-flow. Closing retail shops by 9 pm will encourage Saudi citizens to work in the retail sector and reduce unemployment among Saudi nationals. The Labour Ministry intends to provide 1.5 million jobs for Saudis in the retail sector (media sources), which is currently dominated by expats. Such a move will have a meaningful impact on volumes of retail sector, which will result in downgrades for earnings and valuation-multiples in the short term. However, the final details on rules and regulations governing this law i.e. what shops does it apply to and what exemptions are introduced remains to be seen. For e.g. during the fasting month of Ramadan (period of one of the highest sales densities for retailers), shops will reportedly be allowed to be open until 2 a.m. Further, restaurants and coffee shops are proposed to be open until midnight on weekdays and until 1 AM on weekends. The proposals on exemptions of which shops are granted to be operated 24 hours daily are as yet unknown. Hence, pending further clarity on rules, we do not include the impact of 9 PM closing rule in our target prices as yet. However, we make a rough cut guess on what could be the impact on earnings of major retailers should the rule be passed in the form as is being described by the media. Please refer to individual company sections for sensitivity analysis of earnings to the revenue/ margin decline induced by this rule. Disclosures Please refer to the important disclosures at the back of this report. 8

9 Saudi Retail Sector Retail Industrial #4: Deteriorating opex structure due to subsidy roll-backs The government announced partial roll back of energy and utility subsidies as part of 2016 budget, to help alleviate deficit caused by sharply lower oil price as compared to previous few years. While we have already mentioned that this will lead to lower disposable incomes for the average Saudi household which will impact consumption demand, another factor to note will be the rise in opex for the retailers as their fuel (logistics cost) and utility costs (mainly store costs) will rise. However, the subsidy roll-backs for 2016 in itself is not significant. Among the retailers under our coverage, Al Othaim and Extra have declared an impact of SAR16mn (7% of 2015 net profit) and SAR4.4mn (9% of 2015 net profit) respectively. What concerns the investors more is the extent of subsidy roll backs which are yet to be announced over the next few years, as has been mentioned in 2016 budget about possible measures in the next few years. We have built for modest margin uptick over the medium term for all the retailers under over coverage as slower revenue growth and rising opex for retailers will remain headwinds. Figure 20 Majority margin correction through, expect modest uptick from FY FY13 FY14 FY15 FY16E FY17E FY18E FY19E (50) (100) (150) (200) (250) Margin expansion YoY in bps Al Hokair Al Othaim Extra Jarir but long term thesis remains intact Despite a slew of concerns which have been weighing down retail sector stocks, the long term drivers which have underpinned strong consumer demand in the Kingdom remain intact, which will usher in healthy earnings growth post the period of adjustment to lower oil prices. We point to a few statistics and drivers which remain the key to retail sector s continued growth over the medium to long run, even though the sector may be impacted in the short term due to headwinds as mentioned in earlier sections. Ample headroom for growth Retail sector s contribution to GDP in the Kingdom is one of the lowest globally, which points to ample headroom available for retail sector growth over the medium to long term. The retail sector is a cornerstone for every economy s diversification attempts to knowledge and services based economy. Similarly, we expect that the economic diversification attempts by the Kingdom will lead to healthy growth of retail sector. Disclosures Please refer to the important disclosures at the back of this report. 9

10 France UK Italy Brazil Australia Germany Russia India China KSA Kuwait Oman Qatar Saudi Retail Sector Retail Industrial Figure 21 Oil contribution continues to remain high, leaving much scope for economy diversification (retail will be beneficiary) Figure 22 recent govt. initiatives (relaxing FDI rules in various sectors) will increase FDI inflows supporting diversification 60% 35,000 50% 30,000 29,233 40% 25,000 30% 20% 10% 0% 20,000 15,000 10,000 5,000-16,308 12,182 8,865 8, Source: SAMA % Oil contribution to GDP Source: World Bank KSA FDI (USD mn) Figure 23 Services contribution of KSA and GCC peers is below global DMs & EMs Services as % of GDP Source: World Bank We believe the organized retail industry will continue to grow its share at the expense of unorganized retail, helping large retailers (including the listed retailers in the Kingdom) grow faster than the industry. Industry estimates peg the unorganized retail segment at 60-70% in electronics (opportunity for Jarir and Extra) and at 70-75% in grocery segment (opportunity for Al Othaim). Organized retail set for strong performance As has been the case in other developed and emerging market peers, consumer preferences over time shift to large formats and hence the large retailers and big box formats gain share from unorganized players. We expect the same to be replicated in the Kingdom. Further, shopping is one of the most important leisure activities in the Kingdom which directly benefits organized retail players. Improving infrastructure (large new economic cities under construction in the Kingdom, GCC wide rail corridor expected to commence in medium term, inter-city high speed rails within the Kingdom, new road networks linking various cities within GCC) helps drive faster urbanization, which is one of the key drivers for organized retail. Further, improving logistics network (one of the backbones for organized retailers and e-commerce) will follow improving infrastructure within the Kingdom and that of GCC. Disclosures Please refer to the important disclosures at the back of this report. 10

11 Saudi Retail Sector Retail Industrial We further expect the low per capita GLA (Gross Leasable Area) of the Kingdom (vs. GCC peers as well as developed markets) to improve going ahead. This helps drive organized retails space growth which in-turn drives revenue growth. Figure 24 GLA per capita and other metrics have huge scope for improvement in KSA cities Abu Dhabi Dubai Riyadh Jeddah Cairo USA Current Stock (mn Sq mt) Vacancy (%) Rent (USD/ Sq m) 662 1, , GLA/ Capita (Sq mtr) Source: JLL Demographic dividend to drive growth Saudi Arabia has one of the most attractive demographics which supports organized retail players in the Kingdom. More than 50% of population is under the age of 25 and more than 75% of population is under the age of 40. This is the primary driver for increasing consumption over the medium to long run, as a younger demography has a much higher propensity to spend on retail. In the listed space, this should augur well for discretionary product retailers such as Jarir, Extra (significant exposure to electronics) and Al Hokair (fashion retailer). Figure 25 Demography skewed towards young population Population (mn) Source: CDSI Favourable government policies: We believe the government s policies such as Nitaqat (minimum % of employees in private sector to employ Saudi s, based into bands depending on which the differential benefits accrue to private enterprises), minimum wage rate and other initiatives will help drive solid employment gains for young Saudi nationals in the private sector. This should reflect well on the disposable incomes of the younger generation which in turn will drive discretionary spending and benefit retailers. Figure 26 Nitaqat bands Size No. of employees Green Low % Green Medium % Green High % Platinum % Before After Before After Before After Before After Small Medium Big 500-2, Mega >3, Source: Ministry of Labour, Media Disclosures Please refer to the important disclosures at the back of this report. 11

12 Saudi Retail Sector Retail Industrial Figure 27 Healthy private sector employment growth over the last decade % % % 5.0% 0.0% % % % Pvt sector employment (mn) % YoY growth (RHS) Source: SAMA Rising female workforce participation: The Kingdom s well educated female workforce is rising at a healthy pace and is also projected to increase much further following favourable policies to encourage their employment. This is another key driver for increasing disposable incomes and benefit retail especially in the discretionary segment. Figure 28 Strong growth in private sector female workforce Figure 29 Rising private consumption led by disposable income ,000 60,000 50,000 40,000 30,000 20,000 10,000 61,465 63,016 59,464 48,722 50,926 53,386 54,890 57,709 56,036 45,499 12,000 10,000 8,000 6,000 4,000 2, e 2015e 2016e 2017e 2018e 2019e 0 Public sector('000) Pvt sector ('000) GDP per head (US$ at PPP) Private consumption per head (US$) - RHS Source: SAMA Source: EIU Religious tourism to be a key driver Religious tourism in the Kingdom is in a sweet spot and is expected to witness a significant inflow of tourists going forward. The Kingdom has embarked on plans to expand the Grand mosque (currently underway) and once complete the government intends to increase the number of Umrah visas. We believe the rise in religious tourists, who spend on electronics, food and telecoms will immensely benefit these sectors going forward. Further, a new visa scheme plan Umrah plus Tourism was announced early this year by the Saudi Commission for Tourism and Antiquities (SCTA) which allows Umrah pilgrims to travel domestically after completing their religious rituals by extending their visit for 30 days instead of requiring them to depart immediately after completing their pilgrimage. This could also promote non-religious tourism in Saudi and result in higher tourist spending within the Kingdom which should result in higher retail spends overall. Disclosures Please refer to the important disclosures at the back of this report. 12

13 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Saudi Retail Sector Retail Industrial Figure 30 Steady growth in number of religious tourists (recent slowdown due to expansion work) From outside the Kingdom (mn) Total (mn) Source: Ministry of Hajj Correction offers attractive entry point It must be noted that of the concerns listed, full foreign ownership rules and early shop closing time are both one time in nature (but likely to result in a new normal, depending on the final rules) and their impact will wane post adjustment to the new rules. The major concern i.e. consumer spending, is a function of price swings in crude oil price (as the economy s dependence on oil is still significant), which is a cyclical commodity. The consumer spending will pick pace as crude oil market rebalances (likely in 2017) and prices start to gain momentum on the upside. The steep correction in stock prices resulted in average forward P/E of the four retailers under our coverage dropping to 13.5x FY16E EPS, which is 12% below 5 year mean of 15.3x. We believe the correction is overdone and offers an attractive entry point for long term investors, who can benefit from strong consumption drivers (refer above sections) as they play out over the long term. Figure 31 Al Hokair Fwd PE Figure 32 Al Othaim Fwd PE ALHOKAIR FWD PE ALHOKAIR 5 YR AVG AOTHAIM FWD PE AOTHAIM 5 YR AVG Source: Bloomberg Source: Bloomberg Disclosures Please refer to the important disclosures at the back of this report. 13

14 RoE (%) Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Saudi Retail Sector Retail Industrial Figure 33 Extra Fwd PE Figure 34 Jarir Fwd PE EXTRA FWD PE EXTRA 5 YR AVG JARIR FWD PE JARIR 5 YR AVG Source: Bloomberg Source: Bloomberg Further, the retail sector stocks have strong RoE (which is set to improve from 2017 onwards, post adjustment to lower oil prices in 2015/16), low leverage, healthy FCF yields and most of them pay dividends, attributes which make them attractive to be held over the long term. Figure 35 Strong attributes make retail stocks attractive bets for long term P/E RoE Div Yield FCF Yield Debt/ Equity FY16e FY17e FY16e FY17e FY16e FY17e FY16e FY17e FY16e FY17e Al Hokair Al Othaim Extra Jarir Figure 36 Saudi retailers have favourable P/E RoE matrix as compared to developed market peers WH Smith 60.0 JARIR BEST BUY OFFICE DEPOT M&S STAPLES GAP INC DEBENHAMS MACY'S ALHOKAIR DIXONS SAINSBURY CARREFOUR JB HI-FI HUGO BOSS ALOTHAIM URBAN OUTFITTER EXTRA CASINO GUICHARD WALMART DELHAIZE H&M WM MORRISON P/E (x) Source: Bloomberg, Al Rajhi Capital TESCO INDITEX Disclosures Please refer to the important disclosures at the back of this report. 14

15 RoE (%) Saudi Retail Sector Retail Industrial Figure 37 similar is the case as compared to emerging market peers too JARIR 40.0 MR PRICE MAGNIT TRUWORTHS 30.0 M VIDEO ALHOKAIR LOJAS RENNER FOSCHINI SHOPRITE APRANGA ALOTHAIM CCC 20.0 X5 RETAIL LPP WALMART MEXICO LEWIS GROUP EXTRA GRUPO BIMBO LOTTE HIMART GOME ELECTRICAL FOMENTO 10.0 VIA VAREJO CENCOSUD CHEDRAUI TRINITY GRUPO FAMSA RESTOQUE P/E (x) Source: Bloomberg, Al Rajhi Capital Risks While we have addressed concerns and concluded that the long term benefits of investing in retail sector outweigh the medium term headwinds, following are a few risks which can impact the short term attractiveness of the sector by making the entry points lower than the current market prices (degree varies by the impact of risks): #1: Regulation to close retail shops early This remains the key risk to our investment thesis. If the final regulation stipulates that all retail shops should close by 9 p.m. and the retailers are not given exceptions (to make up some of the lost volumes), it could lead to a meaningful hit on volumes of retailers. Since the proposed rules are still under consideration, we do not factor in the impact from the same. Please refer to individual company sections for earnings sensitivity to decline in revenue/ margin from implementation of this rule. #2: Sharper than expected hit on consumer spending While we have factored in slowing LFL growth on the back of expected hit on consumer spending, higher than expected slowdown in consumer spending will meaningfully impact margin and earnings for retailers under our coverage. #3: E-commerce players gaining share E-commerce is gaining market share from the tradition brick-and-mortar players in developed countries like the US as well as developing nations like China and India. It poses a risk for the retail companies which do not embrace this latest trend in the industry. Though it is primarily expected to take away market share from small standalone players, it may also impact big-box players. Interest in e-commerce players in the region is also rising in this backdrop. Recently, souq.com has reportedly raised USD250mn from leading international private equity players. Extra, Jarir and Al Hokair have all embarked on online strategies and this should shield them from impact from standalone e-commerce players. Further, the ecosystem for e-commerce is yet to develop in the Kingdom with logistics capability under penetrated due to issues with house addresses etc. Disclosures Please refer to the important disclosures at the back of this report. 15

16 RSI10 Fawaz Alhokair ALHOKAIR AB: Saudi Arabia Rating Target price Current price OVERWEIGHT SAR57.7 (29.4% upside) SAR44.6 Key themes & implications Fawaz Al Hokair has been growing at a fast clip through organic and inorganic routes. However, post the acquisitive phase, the focus is now shifting to improving sales densities and operational efficiencies among the existing portfolio and turning around US & Blanco operations. This will likely result in better FCF generation as capex (store additions) will be lower than before. The stock has sharply corrected on expectations of lower consumer spending and concerns over the impact of 100% foreign ownership in the Saudi retail sector. We believe the concerns are overdone and maintain Overweight rating due to attractive valuation, with target price of SAR57.7 per share. Share information Market cap (SAR/US$) 9.37bn / 2.498bn 52-week range Daily avg volume (US$) Shares outstanding 5.79mn 210.0mn Free float (est) 30% Performance 1M 3M 12M Absolute 5.0% -32.9% -57.6% Relative to index -7.3% -26.8% -23.2% Major Shareholder: Fas Company 49.0% Abdulmajeed Abdulaziz Alhokair 7.0% Valuation 03/14A 03/15A 03/16E 03/17E P/E (x) P/B (x) EV/EBITDA (x) Dividend Yield 2.5% 5.0% 4.9% 5.3% Source: Company data, Al Rajhi Capital Performance Price Close Relative to TADAWUL FF (RHS) /15 06/15 09/15 12/15 Source: Bloomberg, Company data, Al Rajhi Capital Company summary Fawaz Al Hokair is a leading fashion retailer in Saudi Arabia, and also has international presence in US, Europe, CIS countries and Balkans. Fawaz Al Hokair is a franchisee for more than 80 international brands such as Zara, Gap, Marks & Spencer, and Aldo Research Department Nivedan Reddy Patlolla Tel , patlollan@alrajhi-captial.com Fawaz Al Hokair Asset sweating offers value Al Hokair s expansion phase over the last 4 years led to more than doubling of stores to approx. 2,100 (end of FY15) primarily through acquisitions both in KSA (Nesk, Dana group) and overseas (Blanco, Strasburg Jarvis and Delta). This led to strong revenue/ net profit CAGR of 28%/ 26% respectively over FY Going forward, despite our base case of lower consumer spending in KSA and currency pressure in CIS countries, we believe management s focus on improving operational efficiency among existing assets, supply chain optimization (central distribution centre in Dubai will start operations in early 2016), turnaround of US & Blanco operations, merchandizing and productivity improvements in KSA, will all lead to an improving operating profile (9.2% CAGR in net profit over FY16-18e vs. -1% in FY14-16e). This, along with lower capex should lead to healthy FCF generation going forward. We believe the risk from full foreign ownership in retail is not high, as Fawaz Al Hokair offers significant value to its major brand partners running large franchise operations, store locations in prime areas (parent company owns and builds malls), logistics and distribution capabilities and local market knowledge. We are Overweight on Al Hokair with a target price of SAR57.7 per share. Efficiency of existing assets targeted: Post the aggressive inorganic expansion over the last few years, the company is focused on improving operational efficiencies, which can offer better value addition in our view, as compared to new store investments in an environment of slowing consumer spending. Supply chain optimization, sales productivity and merchandizing will be key thrust areas. Restructuring at Blanco (Spain) is almost complete and US restructuring will be through in H1 2016, measures which can drive topline and nudge operations towards profitability in these geographies. Expansion to continue, albeit at a slower pace: The company targets to reach a total of 3,200 stores by FY19, by increasing its presence in international markets (including through franchising Blanco) and targeting Tier II cities within KSA. However, we model for approx. 2,730 stores by FY19, building in 290 net stores over FY15-17e, and 365 stores over FY We expect slower pace of store additions to factor in longer breakeven and sub-par productivity from new stores due to slowing consumer spending and tight liquidity. Margin to bottom out in FY16e/17e: Supply chain optimization and working with brand partners will lead to significant step up in merchandizing, which will improve customer footfalls, sales density along with better full sale through, thus minimizing overall price discounts and cushioning margin over FY16-18e from impact of slower consumer spending. Period End (SAR) 03/13A 03/14A 03/15A 03/16E 03/17E Revenue (mn) 4,659 5,482 6,899 7,343 8,135 Revenue Growth 45.5% 17.7% 25.8% 6.4% 10.8% Gross profit margin 24.3% 25.5% 25.9% 26.6% 26.3% EBITDA margin 16.3% 17.3% 16.4% 16.2% 15.9% Net profit margin 13.3% 14.1% 11.6% 10.4% 10.1% EPS EPS Growth 38.4% 24.5% 4.1% -5.2% 7.7% ROE 36.2% 34.7% 33.3% 29.8% 28.6% ROCE 20.0% 23.9% 18.5% 17.1% 17.5% Capex/Sales 10.6% 6.9% 9.0% 5.6% 5.9% Source: Company data, Al Rajhi Capital Please see penultimate page for additional important disclosures. Al Rajhi Capital (Al Rajhi) is a foreign broker-dealer unregistered in the USA. Al Rajhi research is prepared by research analysts who are not registered in the USA. Al Rajhi research is distributed in the USA pursuant to Rule 15a-6 of the Securities Exchange Act of 1934 solely by Rosenblatt Securities, an SEC registered and FINRA-member broker-dealer.

17 Fawaz Alhokair Key trends in performance KSA on strong footing; productivity in focus KSA has been the key growth engine for Al Hokair and still accounts for 75% of revenue as of FY15, despite international foray. The profitable expansion has been aided by strong local market demand, exclusive franchising of international brands with strong consumer appeal (e.g. Inditex group) and steady supply of premium locations from the group company, which owns and builds malls. Key acquisitions like Nesk have also been profitable in KSA, apart from adding key brands to the overall portfolio. However, going forward we believe that the store additions will likely slow down, owing to slowing consumer spending, which will prolong the new-store breakeven periods. We factor in approx. 150 new stores in KSA in each FY16e and FY17e. This is still a robust pace of store roll-outs supported by steady supply of new real estate space from the parent group (Arabian centre), however it is lower than that targeted by the company. Our store roll out assumptions result in total retail space growth in KSA at 8.5% CAGR over FY16-18e. Figure 38 Snapshot of store roll-outs Figure 39 New Arabian centres 2,000 1, , ,400 1, , ,550 1,700 1, ,149 1, FY13 FY14 FY15 FY16e FY17e FY18e Existing stores Net new additions Western Area Location Opening date Area (Sq mtrs) GLA (Sq mtrs) Al Yasmin Mall Jeddah ,672 58,311 Al Qalam Mall Jeddah ,692 70,000 Prince Sultan Oasis Jeddah ,571 90,000 Jawharat Jeddah Jeddah , ,500 Central Area Salboukh mall Riyadh NA 456, ,337 Al Malaz Mall Riyadh ,562 50,556 Al Hamra Mall Riyadh ,969 51,787 Al Khaleej Mall Riyadh ,656 43,028 Najd Mall Riyadh ,000 57,000 Mall of Arabia Riyadh , ,000 Al Nakheel Mall Extension Riyadh ,000 39,036 Eastern Area Dammam Mall Damman ,911 58,555 Dhahran Boulevard Damman ,251 NA Total 1,958,697 1,109,110 Source: Company data Private labels and new brands/ products drive growth Private labels: Apart from the retail space growth, we believe Al Hokair will also tap private labels to improve margin. In late 2014, the company launched its value oriented retail brand INC, and currently has 10 stores in KSA according to the company website. Usually, private labels have better margin than those on franchisee models and hence a healthy performance in private labels will translate into better margins for the company. New products: Apart from private labels, we also see expansion to new products to drive growth. For e.g. Models Own (Europe s cosmetic brand specializing in nail polishes) acquisition in late 2014 and launch of Bijou Brigitte (jewelry accessories) recently enabled Al Hokair to tap into the fast growing women s accessories segment. Apart from apparel retailing, we see such expansion into adjacent Beauty & Food segments to offer further growth potential going forward. New brands: Launch of new brands will also drive sales densities by increasing the overall quality of merchandizing, partly by replacing older brands with stalling consumer interest. Recently, the company added brands such as Undiz, Lorna Jane, Ipekyol, some of which have witnessed higher sales densities compared to incumbent brands in the same categories. Disclosures Please refer to the important disclosures at the back of this report. 17

18 Fawaz Alhokair Productivity enhancement a key source of operating leverage: The company s focus on productivity enhancement (targets to increase productivity by 10% p.a. over the next 4 years) will be a key source of margin enhancement as incremental sales will directly be margin accretive. However, in an environment of slowing consumer spending, it is difficult to achieve meaningful productivity enhancement and hence, we do not model for any major upside from this. However, should the company achieve this, out net income estimates will have potential upside. E-commerce strategy being put in place Worldwide, e-commerce has been one of the key channel for driving sales of consumer goods, and apparel sales have been one of the primary products retailed online. Al Hokair is in the process of finalizing its online retail strategy and may tie-up with established e-tailers in the region. We will update our forecasts to include this as and when a clear strategy is outlined by the management and platform has gone live. No significant downside from nitaqat implementation Al Hokair has already fulfilled the required nitaqat levels and hence we do not see any major opex risks from this going forward. No significant impact from full ownership in retail One of the major investor concerns in the recent times was the government s decision to allow 100% foreign ownership in the Saudi retail sector. One of the key concerns of the investors was the exclusive brands (e.g. Inditex, which has own operations in majority markets) that Al Hokair retails in KSA, can now make a direct entry to the market. This has the potential to cannibalize the brand s sales from Al Hokair managed outlets. However, we believe the probability of this risk playing out is not significant. Firstly, Al Hokair has a real estate portfolio comprising prime locations, thanks to its group company Arabian Centres, which is the largest builder, owner and operator of shopping malls in the Kingdom. Further, with 80 brands and more than 2,000 stores, Al Hokair has developed a sizeable logistics and distribution capability, which will be difficult for brands to operate on a standalone basis. The company also has strong operational knowledge of the region, which is one of the key factors that retailers require for efficient operations and low risk to business continuity. Finally, the Kingdom has already allowed 75% foreign ownership in the retail sector, and hence lifting the cap to 100% will not change the equation for most retailers as they already had an option for majority ownership before this rule was announced. US/ Blanco turnaround to aid profitability The acquisition of the loss-making Blanco, Balkans acquisition, expansion in US markets and depreciation of most currencies against the Saudi Riyal (e.g Kazakhstan, Egypt), led to a dent in profitability. However, the company has been restructuring its various international operations and has outlined a strategy to turn around these operations. While our base case forecasts build for a moderate turnaround in the near term, faster than expected turnaround can result in significant upside to our net income estimates. US & Blanco operations in perspective: US & Blanco are probably the most important operations which need to be restructured. For FY15, US & Blanco together reported SAR93mn loss, excluding which reported FY15 net profit (SAR803mn) would have been higher by 12%. While Blanco contributed 8.9% of consolidated revenue and reported SAR32mn loss, US with revenue contribution of just 1.3% reported a higher loss of SAR61mn. Hence, faster turnaround in both US & Blanco will augur well for Al Hokair s profitability. Disclosures Please refer to the important disclosures at the back of this report. 18

19 Fawaz Alhokair Figure 40 Net profit FY2015 breakdown 1,000 SAR mn KSA US Blanco CIS Others Reported Net Profit Source: Company data Blanco expected to turnaround by end of FY16 Al Hokair acquired Blanco in early Al Hokair undertook major restructuring at the Spain-based firm, changing the management (new CEO has been appointed in April 2015), reducing staff, rationalizing stores, changing supply chain for faster replenishment and deliveries. The restructuring is almost complete, according to our discussions with the management. The company s performance has been improving on a quarterly basis (excluding the one-off restructuring losses), and is expected to finally turn profitable by FY2016-end (although expect full year profitability only in FY17). Key initiatives undertaken during restructuring and which will result in better operating results include 1) New collection starting from November, 2015 with all stores being merchandized with new collection by March 2016, 2) Signed consolidated buying deal and relocation of buying office to a tax free environment, 3) Entering South American and Far East markets through franchisees to drive the firm s top-line, and 4) Shift to third party logistics US restructuring underway, operational improvement on the horizon The US market will witness peak losses in FY16e (SAR56.2mn loss in 9MCY16 vs. SAR60mn loss during FY15) due to ongoing restructuring, including one-off charges. However, closure of unprofitable stores (closed 39 stores in 2015), working with brand partners and increasing productivity for higher sales/sqm, introducing Billy Beez Kids entertainment parks (9 operational as at Q3FY16) are steps which will improve profitability. Figure 41 Blanco: Sales and net profit trends Figure 42 US: Sales and net profit trends (20) FY12 FY13 FY14 FY15 (13) (100) 56 FY14 10 FY15 (32) (40) (60) (80) (32) (62) (61) Revenue Net Profit Revenue Net Profit Source: Company data Source: Company data Disclosures Please refer to the important disclosures at the back of this report. 19

20 12/1/2010 3/1/2011 6/1/2011 9/1/ /1/2011 3/1/2012 6/1/2012 9/1/ /1/2012 3/1/2013 6/1/2013 9/1/ /1/2013 3/1/2014 6/1/2014 9/1/ /1/2014 3/1/2015 6/1/2015 9/1/ /1/2015 Fawaz Alhokair CIS & Eastern Europe: Currency shocks impact performance CIS countries (Kazakhstan and Armenia, cumulative revenue contribution of 3.5% in FY15) and Eastern Europe countries (Azerbaijan and Georgia, cumulative revenue contribution of 5.1% in FY15) have been victims of sharp currency depreciation (vs. USD) over the last couple of years. Currency depreciation in international operations impacts Al Hokair as its topline from those regions gets shaved off by the amount of currency depreciation and in cases where the depreciation is sharp it results in spiraling inflation in the economy, impacting consumer demand for discretionary products. Following are the currency depreciation stats in these markets: Figure 43 Currency return against US Dollar 1M 6M 1Y 2Y Kazakhstan -6% 80% 92% 93% Armenia 2% 4% 3% 20% Azerbaijan -2% 49% 51% 99% Georgia 3% 7% 15% 44% Source: Bloomberg Figure 44 Azerbaijan Manat vs. USD Figure 45 Georgia Lari vs. USD /2/ /2/ /2/ /2/ /2/ /2/2015 Source: Bloomberg; As at March 1, 2016 Source: Bloomberg; As at March 1, 2016 Figure 46 Kazakhstan Tenge vs. USD Figure 47 Armenia Dram vs. USD /2/ /2/ /2/ /2/ /2/ /2/ /2/ /2/ /2/ /2/ /2/ /2/2015 Source: Bloomberg; As at March 1, 2016 Source: Bloomberg; As at March 1, 2016 Disclosures Please refer to the important disclosures at the back of this report. 20

21 12/1/2010 3/1/2011 6/1/2011 9/1/ /1/2011 3/1/2012 6/1/2012 9/1/ /1/2012 3/1/2013 6/1/2013 9/1/ /1/2013 3/1/2014 6/1/2014 9/1/ /1/2014 3/1/2015 6/1/2015 9/1/ /1/ /1/2010 3/1/2011 6/1/2011 9/1/ /1/2011 3/1/2012 6/1/2012 9/1/ /1/2012 3/1/2013 6/1/2013 9/1/ /1/2013 3/1/2014 6/1/2014 9/1/ /1/2014 3/1/2015 6/1/2015 9/1/ /1/2015 Fawaz Alhokair FY16 the most impacted: As we see, most of the currencies have depreciated against the USD in early 2015 (which is near the end of FY15 for Al Hokair). Hence, we are likely to witness the majority impact of currency depreciation in FY16 for Al Hokair. Bottoming out? A key question in this context would be whether the bulk of currency depreciation would be behind in FY16. While significant depreciation may already have been through (pricing in key factors of tumbling commodity prices including oil and US Fed rate hike), there is a possibility of further depreciation going forward as currency plays a significant role in economy s adjustment for the pain inflicted from lower commodity prices and also compete against each other s exports to stay competitive. Following is the expected currency deprecation for Kazakh Tenge according to Bloomberg: Figure 48 Kazakh Tenge - Expectations vs. USD FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E Tenge vs. USD Source: Bloomberg; As at March 1, 2016 Other MENA markets: Strong growth; currency overhang remains Among non-ksa MENA markets, Egypt (2.4% of revenue in FY15) and Jordan (2.7% of revenue in FY15) are sizeable markets for Al Hokair. However, like CIS and Eastern Europe countries, these countries have also witnessed meaningful currency depreciation. Figure 49 Currency return against US Dollar 1M 6M 1Y 2Y Egypt 0.0% -0.1% 3.2% 12.4% Jordan 0.2% 0.1% 0.0% 0.1% Source: Bloomberg; As at March 1, 2016 Figure 50 Egypt Pound vs. USD Figure 51 Jordan Dinar vs. USD Source: Bloomberg; As at March 1, 2016 Source: Bloomberg; As at March 1, 2016 Disclosures Please refer to the important disclosures at the back of this report. 21

22 Fawaz Alhokair However, Egypt and Jordan have been performing strongly as seen from adjusted revenue growth. In the following table, depicted is the revenue growth in local currency, which is adjusted for currency depreciation. Egypt and Jordan accordingly recorded strong growth of 22% and 15% respectively in their local currencies, ahead of KSA revenue growth of 13% Figure 52 Revenue growth (reported vs. local currency) FY13 FY14 FY15 Egypt (reported) 54.7% 3.5% 17.4% Egypt (local currency) 61.1% 15.4% 22.0% Jordan (reported) 164.0% -1.2% 14.8% Jordan (local currency) 163.9% -1.2% 14.9% Source: Bloomberg However, Egyptian pound may depreciate further according to Bloomberg, thus impacting the SAR revenue growth. Figure 53 Egypt Pound vs. USD FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E Egypt Pound vs. USD Source: Bloomberg (forwards data); As at March 1, 2016 We build in average depreciation of 12% for FY16e and 3% for FY17e for Al Hokair s international revenue, to account for currency depreciation in CIS, Eastern Europe and other MENA countries. Supply chain optimization One of the key pillars of Al Hokair s fast paced growth over the last 5 years has been inorganic expansion, which resulted in having distribution centres in most of the countries of its operations. This led to inefficient working capital which bloated to 158 days of inventory vs. 135 in FY13. Net working capital increased to 30% of revenue in FY15 from 24% in FY13. However, to streamline the supply chain and have a centralized distribution centre (DC) to serve all its markets in MENA and CIS regions, Al Hokair is setting up a centralized DC in Dubai (14,000 Sq mtrs) involving an investment of SAR46mn, which is expected to become operational by end of FY16e. This central DC will in-turn be networked to cross docks in all other countries (ex- KSA, which will have 2 DCs of its own in view of large scale operations), which will help in faster dispatch/ returns collection without inventory remaining in local DC s. The central DC will cater to the companies stores across the MENA region. The facility is expected to lead to significant costs savings and working capital requirements. Once the distribution center becomes operational, the company will be able to ship products every week, instead of once every 3-4 weeks currently, giving a big push to improving the quality of merchandize, which will in turn result in higher full sale through. This will both increase margin and lower working capital requirements. Disclosures Please refer to the important disclosures at the back of this report. 22

23 Fawaz Alhokair Supply chain optimization Source: Company data We forecast inventory days to fall to 140 days by FY17e, from 158 in FY15. This will lower net working capital to 26% of revenue in FY17e vs. 30% in FY15. While the company targets higher reduction in working capital, we will start building for the same once the Dubai DC becomes operational and we have more details regarding the same. Figure 54 Inventory days and networking capital % % 25% 20% 15% % 125 5% 120 FY13 FY14 FY15 FY16e FY17e FY18e 0% Inventory days Net working capital as % of revenue (RHS) Disclosures Please refer to the important disclosures at the back of this report. 23

24 WACC (%) WACC (%) Fawaz Alhokair Valuation Al Hokair s stock has witnessed a steep correction over the last one year, primarily due to expectations of slowdown in consumer spending which will hurt LFL growth going forward. Apart from underperformance of broader market, we believe investors were also concerned over the potential risk of foreign brands entering the Saudi market directly after the government allowed 100% foreign ownership in retail. Other concerns include company s exposure to developing market currencies which have witnessed steep depreciation. However, we have addressed our views on these in previous section and view the current stock price as an attractive entry point for long term investors. The stock is currently trading at 12.3x its FY2016E EPS and 11.4x its FY2017E EPS, for an expected 11.5% CAGR in net profit over FY16-19E. We value Al Hokair at an average of fair values derived from both DCF and relative valuation (P/E). We use equal weight for both the methods. The key assumptions for DCF are as follows, which yields a fair value of SAR59.7: Figure 55 Table of DCF assumptions Parameter Risk-free Rate Country Risk Premium Equity Market Risk Premium Comment 3.8% Based on US 10 yr avg rate and adjusted default spread 1.4% Based on default premium and equity/ debt market volatility 6.0% 175 bps over US market risk premium WACC 8.5% Based on adjusted beta of 1, and target debt at 33% of assets However, using target P/E multiple, fair value stands at SAR55.8. We use a target multiple of 14.3x, which is at 20% premium to the median multiple of emerging market peers. The premium is to factor in Al Hokair s exclusivity to retail leading int l brands in the Kingdom. Using an equal weighted average of both methodologies, we arrive at a target price of SAR57.7, which implies 29% upside from CMP of SAR44.6. We are Overweight on Al Hokair. Figure 56 Equal weighted target price Method Valuation Weight Value/ share FCFF plus terminal growth % 29.8 Relative % 27.9 Target Price (SAR) 57.7 Figure 57 Sensitivity to DCF assumptions Terminal Growth Rate (%) % 1.0% 2.0% 3.0% 4.0% 5.0% 6.5% % % % % Figure 58 Sensitivity of equal weighted TP to DCF and Relative valn Target PE Multiple (x) % % % % % Key upside risks: Better than expected LFL growth, faster than expected improvement in working capital with start of Dubai distribution centre, sustained uptick in crude oil prices Key downside risks: Any negative impact on existing franchise partnerships arising from full ownership rules in retail is the primary downside risk, higher than expected impact on LFL growth from slowdown in consumer spending, delay in turnaround of US & Blanco operations and further depreciation in CIS countries/ Baltics currencies. We try to quantify the impact from 9 pm regulation below. We assume a certain range of revenue decline due to impact on volumes from reduced peak-time working hours. In-line with revenue decline, the margin decline would majorly be a function of fixed costs (typically Disclosures Please refer to the important disclosures at the back of this report. 24

25 Margin decline Fawaz Alhokair a portion of SG&A costs). Together with revenue and margin-decline assumptions, we depict the impact on earnings from implementation of this rule. Please note that these are not our assumptions of expected decline in volumes (which depends on the final set of rules governing this law which are yet to be released), but only a sensitivity analysis of earnings decline to that of revenue and margin decline. Figure 59 Al Hokair - Earnings sensitivity to revenue/ margin decline from 9 pm regulation Revenue decline 2.5% 5.0% 10.0% 15.0% 20.0% 0.0% 3% 5% 11% 16% 21% 0.5% 7% 10% 15% 20% 25% 1.0% 12% 14% 19% 24% 29% 1.8% 18% 20% 25% 30% 34% 2.5% 25% 27% 31% 35% 40% Disclosures Please refer to the important disclosures at the back of this report. 25

26 Fawaz Alhokair Figure 60 International peer comparison M. Cap EV RoE (%) NPM (%) P/E (x) EV/E (x) ($ mn) ($ mn) CY15 CY16E CY17E CY15 CY16E CY17E CY15 CY16E CY17E CY15 CY16E CY17E KSA JARIR MARKETING KSA 2,822 2, UNITED ELECTRONI KSA Average Median Emerging Markets THE FOSCHINI GRO SA 1,595 2, TRUWORTHS INTL SA 2,452 2, MR PRICE GROUP SA 2,492 2, TRINITY LTD HK (0.9) (2.4) (65.4) APRANGA PVA Lithuania LOJAS RENNER SA Brazil 2,754 3, RESTOQUE COM Brazil LPP Poland 2,342 2, CCC SA Poland 1,200 1, Average Median Developed Markets SPECIALTY FASHIO Australia IC GROUP A/S Denmark HENNES & MAURI-B Sweden 51,070 49, INDITEX Spain 96,193 90, GAP INC/THE US 9,642 10, MACY'S INC US 12,465 19, DEBENHAMS PLC UK 1,332 1, MARKS & SPENCER UK 9,523 12, NEXT PLC UK 13,539 14, MYER HOLDINGS Australia ESPRIT HLDGS Europe 1,919 1,271 (3.0) (2.1) (41.1) TED BAKER PLC UK 1,799 1,884 na na na HUGO BOSS -ORD Germany 5,318 5, MEN'S WEARHOUSE US 663 na na na na na na na URBAN OUTFITTER US 2,803 2, Average Median Source: Bloomberg, Al Rajhi Capital Disclosures Please refer to the important disclosures at the back of this report. 26

27 Fawaz Alhokair Financials Margin set to bottom out in FY16-17 While revenue growth has maintained momentum, led by both organic and inorganic expansion over the last few years (16.4% revenue CAGR over FY13-16e), margin has been impacted due to 1) Blanco and Danah acquisitions in FY14 and FY15, 2) increase in Saudization, 3) currency depreciation in CIS, Eastern Europe and Egypt, and 4) US restructuring and investments in smaller acquisitions such as Delta (Balkans) and Multi trends (Morocco) However, EBIT margin is set to remain flattish over FY16-18e. Tailwinds from better sales/ sq mtr, due to increased sales force productivity and better full price sale on the back of better merchandising, improved distribution post operationalization of the central DC, and better performance in US & Blanco will be negated by lower LFL induced margin pressure. Figure 61 Margin to bottom out in FY16-17 Figure 62 Net profit estimates 10,000 9,000 8, % 14.0% 1, ,000 6, % , , % 400 3, , % 200 1, FY12 FY13 FY14 FY15 FY16e FY17e FY18e 6.0% 0 FY12 FY13 FY14 FY15 FY16e FY17e FY18e Revenue EBIT EBIT margin (RHS) Net Profit (SAR mn) Expect strong FCF generation We believe Al Hokair s phase of major acquisitions may be behind as the company already has leading market share in KSA and has a wide international footprint thanks to a series of acquisitions. With this, we believe that peak capex phase may be behind. Figure 63 Acquisitions over the last few years Date Acquisition Amount paid (USD mn) Total stores Figure 64 High capex due to acquisitions 1, % 2014 Dana group (Saudi Arabia) Delta Fashion (Balkans) Blanco (Spain, Portugal)* Multi trends (Morocco) NA NESK (Saudi Arabia) Strasburg Jarvis (US) ,200 1, , , % 20.0% 15.0% 10.0% % - FY12 FY13 FY14 FY15 0.0% Capex (SAR mn) Capex/ revenue (RHS) Source: Company data, Al Rajhi Capital (*Blanco includes 74 franchise stores and 43 own stores) Source: Company data Disclosures Please refer to the important disclosures at the back of this report. 27

28 Fawaz Alhokair However, lower capex going forward and better cash generation (focus on improving the operating efficiency in all markets, including turning around of US and Blanco operations), will lead to healthy FCF generation in our view. With growing cash flows and no major capex requirement, there may be corresponding growth in dividend in our view. Figure 65 Stable capex and growing FCFs FY16e FY17e FY18e Capex (SAR mn) FCF (SAR mn) Disclosures Please refer to the important disclosures at the back of this report. 28

29 Fawaz Alhokair Appendix About the company Al Hokair is a leading fashion retailer in the Kingdom of Saudi Arabia and has expanded to other geographies through organic and inorganic means. Al Hokair is a franchise & brand operator, operating across 18 countries, which are mainly frontier markets. It currently has over 15,000 employees; 2,100 stores; 500,000 sqm of retail space and over 80 leading brands across women s wear, menswear, children s wear, shoes, accessories, beauty products, food, and department stores. Following is the store and retail area split by country (Arabian centres) Figure 66 Stores Country Stores % of total Space (m2) % of total Employees KSA 1,424 68% 377,832 69% 6,879 Iraq 7 0% 1,101 0% Jordan 81 4% 17,494 3% 585 Egypt 92 4% 16,395 3% 628 Morocco 28 1% 5,158 1% 230 Total MENA 1,632 78% 417,980 76% Kazakhstan 75 4% 22,987 4% 707 Azerbaijan 31 1% 13,614 2% 436 Georgia 42 2% 17,524 3% 656 Armenia 38 2% 16,473 3% 490 Macedonia 4 0% 592 0% 23 Serbia 38 2% 4,823 1% 260 Montenegro 3 0% 295 0% 23 Bosnia 1 0% 105 0% 6 Total CIS, Baltics and others % 76,413 14% UK 9 0% 162 0% Spain 122 6% 35,831 7% 1,225 Portugal 9 0% 3,252 1% 92 Total Europe 140 7% 39,245 7% US 53 3% 16,947 3% 632 Suite Blanco Franchise stores 35 2% Total 2, % 550, % 12,872 Source: Company data Disclosures Please refer to the important disclosures at the back of this report. 29

30 Fawaz Alhokair Income Statement (SARmn) 03/13A 03/14A 03/15A 03/16E 03/17E Revenue 4,659 5,482 6,899 7,343 8,135 Cost of Goods Sold (3,528) (4,084) (5,111) (5,391) (5,995) Gross Profit 1,130 1,398 1,787 1,952 2,139 Government Charges S.G. & A. Costs (546) (678) (941) (1,106) (1,208) Operating EBIT Cash Operating Costs (3,901) (4,536) (5,764) (6,153) (6,841) EBITDA ,135 1,190 1,294 Depreciation and Amortisation (174) (226) (289) (344) (363) Operating Profit Net financing income/(costs) (32) (37) (69) (102) (98) Forex and Related Gains Provisions Other Income Other Expenses Net Profit Before Taxes Taxes (31) (42) (20) (14) (34) Minority Interests 1 (0) (9) 1 (4) Net profit available to shareholders Dividends (158) (236) (473) (457) (492) Transfer to Capital Reserve 03/13A 03/14A 03/15A 03/16E 03/17E Adjusted Shares Out (mn) CFPS (SAR) EPS (SAR) DPS (SAR) Growth 03/13A 03/14A 03/15A 03/16E 03/17E Revenue Growth 45.5% 17.7% 25.8% 6.4% 10.8% Gross Profit Growth 43.1% 23.7% 27.8% 9.2% 9.6% EBITDA Growth 37.0% 24.9% 20.0% 4.9% 8.8% Operating Profit Growth 32.9% 23.3% 17.4% 0.0% 10.0% Net Profit Growth 38.4% 24.5% 4.1% -5.2% 7.7% EPS Growth 38.4% 24.5% 4.1% -5.2% 7.7% Margins 03/13A 03/14A 03/15A 03/16E 03/17E Gross profit margin 24.3% 25.5% 25.9% 26.6% 26.3% EBITDA margin 16.3% 17.3% 16.4% 16.2% 15.9% Operating Margin 12.5% 13.1% 12.3% 11.5% 11.4% Pretax profit margin 13.9% 14.8% 12.1% 10.5% 10.6% Net profit margin 13.3% 14.1% 11.6% 10.4% 10.1% Other Ratios 03/13A 03/14A 03/15A 03/16E 03/17E ROCE 20.0% 23.9% 18.5% 17.1% 17.5% ROIC 36.6% 22.9% 24.1% 16.6% 17.3% ROE 36.2% 34.7% 33.3% 29.8% 28.6% Effective Tax Rate 4.7% 5.2% 2.4% 1.8% 4.0% Capex/Sales 10.6% 6.9% 9.0% 5.6% 5.9% Dividend Payout Ratio 25.4% 30.6% 58.8% 60.0% 60.0% Valuation Measures 03/13A 03/14A 03/15A 03/16E 03/17E P/E (x) P/CF (x) P/B (x) EV/Sales (x) EV/EBITDA (x) EV/EBIT (x) EV/IC (x) Dividend Yield 3.4% 2.5% 5.0% 4.9% 5.3% Source: Company data, Al Rajhi Capital Disclosures Please refer to the important disclosures at the back of this report. 30

31 Fawaz Alhokair Balance Sheet (SARmn) 03/13A 03/14A 03/15A 03/16E 03/17E Cash and Cash Equivalents Current Receivables Inventories 1,103 1,534 2,016 2,188 2,214 Other current assets ,164 1,286 1,333 Total Current Assets 1,903 2,512 3,460 4,016 4,386 Fixed Assets 1,350 1,616 2,047 2,112 2,225 Investments Goodwill Other Intangible Assets Total Other Assets Total Non-current Assets 2,168 2,504 3,309 3,374 3,487 Total Assets 4,070 5,016 6,770 7,390 7,874 Short Term Debt ,029 1,083 1,033 Trade Payables Dividends Payable Other Current Liabilities Total Current Liabilities 1,090 1,927 2,111 2,375 2,469 Long-Term Debt ,163 2,213 2,263 Other LT Payables Provisions Total Non-current Liabilities ,242 2,295 2,352 Minority interests Paid-up share capital 700 1,050 2,100 2,100 2,100 Total Reserves 1,322 1, Total Shareholders' Equity 2,022 2,426 2,399 2,704 3,032 Total Equity 2,043 2,453 2,417 2,720 3,052 Total Liabilities & Shareholders' Equity 4,070 5,016 6,770 7,390 7,874 Ratios 03/13A 03/14A 03/15A 03/16E 03/17E Net Debt (SARmn) 1,176 1,238 2,912 2,755 2,457 Net Debt/EBITDA (x) Net Debt to Equity 57.6% 50.5% 120.5% 101.3% 80.5% EBITDA Interest Cover (x) BVPS (SAR) Cashflow Statement (SARmn) 03/13A 03/14A 03/15A 03/16E 03/17E Net Income before Tax & Minority Interest Depreciation & Amortisation Decrease in Working Capital (441) (171) (798) (84) 71 Other Operating Cashflow (36) (127) (84) (11) (27) Cashflow from Operations ,023 1,266 Capital Expenditure (494) (376) (621) (409) (477) New Investments (660) (5) (467) - - Others (26) (61) Cashflow from investing activities (1,180) (442) (1,088) (409) (477) Net Operating Cashflow (834) 300 (849) Dividends paid to ordinary shareholders - (368) (578) (457) (492) Proceeds from issue of shares Increase in Loans , Effects of Exchange Rates on Cash Other Financing Cashflow (1) 6 (248) - - Cashflow from financing activities 770 (333) 1,028 (353) (492) Total cash generated (64) (33) Cash at beginning of period Implied cash at end of year Ratios 03/13A 03/14A 03/15A 03/16E 03/17E Capex/Sales 10.6% 6.9% 9.0% 5.6% 5.9% Source: Company data, Al Rajhi Capital Disclosures Please refer to the important disclosures at the back of this report. 31

32 RSI10 Abdullah Al Othaim Markets AOTHAIM AB: Saudi Arabia Rating Target price Current price OVERWEIGHT SAR104.6 (20.0% upside) SAR87.2 Key themes & implications Al Othaim is a good defensive bet in the current low oil price environment, which increases the risk of slowdown in consumer spending (already visible in Q results of retail sector companies) on the back of rationalization in government spending and subsidies. However, Al Othaim being a pure play on grocery retailing, will be relatively insulated. The stock is currently trading at 15.3x its FY16E EPS, which is attractive considering 15.5% EPS CAGR over FY15-17E and 20% RoE. We are Overweight on Al Othaim with target price of SAR104.6 per share. Share information Market cap (SAR/US$) 3.922bn / 1.046bn 52-week range Daily avg volume (US$) Shares outstanding 2.47mn 45.00mn Free float (est) 66% Performance 1M 3M 12M Absolute 8.9% -1.3% -19.1% Relative to index -3.4% 4.8% 15.3% Major Shareholder: Alothaim company 27.6% Abdullah Saleh Alothaim 6.0% Valuation 12/14A 12/15A 12/16E 12/17E P/E (x) P/B (x) EV/EBITDA (x) Dividend Yield 2.0% 2.3% 2.6% 2.9% Source: Company data, Al Rajhi Capital Performance Price Close Relative to TADAWUL FF (RHS) /15 06/15 09/15 12/15 Source: Bloomberg, Company data, Al Rajhi Capital Company summary Abdullah Al Othaim Markets is the second largest grocery retailer in Saudi Arabia, with a market capitalization of ~US$1bn. The company is an extension of Saleh Al-Othaim company, which was founded in Al Othaim operates around 139 stores that sell food products & grocery supplies, household equipment, electrical & mechanical equipment and other products Al Othaim Good defensive bet Research Department Nivedan Reddy Patlolla Tel , patlollan@alrajhi-capital.com Al Othaim, a leading grocery retailer in the Kingdom, will continue to post double digit top-line growth and improvement in margin over the mediumterm, led by steady store additions of ~10 p.a. Although there is a risk of consumer spending slowing in the near future due to lower government spending and rationalization of subsidies, we believe Al Othaim is mostly insulated due to largely non-discretionary nature of grocery retailing, making it the stock with the highest revenue and earnings visibility among all retail stocks under our coverage. Roll out of 2 hypermarkets, start of rental income from the upcoming Hail Mall, monetization of Mueen recruitment and Al Baik JV should all support higher margin and profitability. We also expect the bulk of opex increase is already through (price investments, transaction surcharge, and nitaqat push) and expect the margin to bottom in 2016 before recovering from We believe the recent correction in stock price provides a good opportunity for long-term investors. Based on our estimates, we arrive at a target price of SAR104.6 and maintain our Overweight rating. Double digit top-line growth to sustain: We expect the company to roll out stores p.a. going forward including roll-out of 2 hypermarkets in the next 2 years. Space addition will partially be negated by lower LFL growth to result in 12.8% revenue CAGR over FY15-17e. Importantly, we see little downside risk to our estimates due to product mix being highly skewed towards nondiscretionary items. Revenue may surprise on the upside if our thesis of lower LFL growth (~4% vs. 7-9% in last two years) on the back of lower govt spending does not materialise. Strong brand loyalty and several promotions will drive healthy customer footfalls in our view. Margin pressure in core business set to ease: EBIT margin in Q sunk to 2.4%, the lowest in last 4 years. This is due to multiple factors, major ones being nitaqat implementation, transaction surcharge for POS being levied on retailers and continuing price investments due to high competition. We believe that a higher opex base has been created in 2015 and margin is set to gradually recover from 2017, after bottoming out in Rental and investment income to support bottom-line growth: Hail mall is expected to open in H1 FY16, and by our calculations should yield a net rental income of SAR 10 mn p.a (beginning in H2 FY16 in our model). In addition, the company has invested in a JV (25% stake) to open Al Baik restaurants in the Al Qassim region. Al Othaim has also set up a recruitment firm (Mueen recruitment, 67.5% stake). Once operational, we believe both the above will be margin accretive (core business EBIT margin at 3-4%). Period End (SAR) 12/13A 12/14A 12/15A 12/16E 12/17E Revenue (mn) 4,580 5,284 6,036 6,823 7,686 Revenue Growth 11.6% 15.4% 14.2% 13.0% 12.7% Gross profit margin 16.8% 16.5% 16.5% 16.3% 16.4% EBITDA margin 5.7% 5.8% 5.6% 5.5% 5.8% Net profit margin 4.2% 4.1% 3.8% 3.8% 4.0% EPS EPS Growth 12.1% 11.6% 7.5% 11.2% 20.9% ROE 25.9% 24.4% 22.4% 21.7% 22.9% ROCE 18.3% 18.6% 13.3% 14.3% 16.1% Capex/Sales 4.5% 4.4% 6.6% 4.5% 4.3% Source: Company data, Al Rajhi Capital Disclosures Please refer to the important disclosures at the back of this report. Powered by EFA Platform 32

33 Abdullah Al Othaim Markets Key trends in performance Revenue growth led by store additions Al Othaim s store additions have fallen short of guidance in 2015 due to multiple issues including delays in securing visas for labour as well as some permits. Al Othaim s investment in its own recruitment agency and management s focus on space addition may result in stores being added every year going forward, in our view. Further, organized retail in the Kingdom still has significant headroom to expand without cannibalizing existing sales. However, we prefer to remain conservative and factor in 10 store additions every year over the next 3 years. Figure 67 Store additions trend FY12 FY13 FY14 FY15 FY16E FY17E FY18E Old stores New stores LFL growth likely to slow: We believe LFL growth, which has been 7.4% and 9.5% in 2013 and 2014 respectively, will likely decline to ~3.5-4% over the next 3 years on account of slowing consumer spending due to lower government spending and sustained competitive intensity, especially with Panda (Savola s retail unit) drawing up aggressive expansion plans. We believe revenue growth will clock 12.8% CAGR over FY15-17E, majorly led by new store roll-outs. While majority of store roll-outs will be Supermarkets, roll-out of two hyper markets (in the malls developed by sister company OREIDCO) in the next two years will also aid revenue growth and cushion margin from nitaqat implementation and opex inflation. Figure 68 Revenue growth to remain healthy % % % 12.0% 10.0% 8.0% % % % - FY12 FY13 FY14 FY15 FY16E FY17E FY18E 0.0% Revenue (SAR bn) % YOY (RHS) Disclosures Please refer to the important disclosures at the back of this report. 33

34 Abdullah Al Othaim Markets Margin bottoming out Al Othaim s margin has been under pressure lately due to increased price investments which we believe is a result of aggressive investments by market leader Panda (Savola s retail unit), apart from nitaqat implementation (which is set to continue) and start of levy of transaction surcharge on the retailers. With a higher opex base in 2015, we believe margin will bottom out in Further opex inflation is likely in 2016 led by nitaqat push and store roll-out expenses. We expect margin to gradually recover from 2017 led by scale efficiencies in existing portfolio. Figure 69 Gross margin and EBIT margin trends Figure 70 Salary as % of revenue 18.0% 17.5% 4.0% 3.8% 3.6% 7.80% 7.70% 7.60% 7.70% 17.0% 3.4% 3.2% 7.50% 7.40% 7.36% 7.44% 7.39% 16.5% 3.0% 7.30% 16.0% 2.8% 2.6% 7.20% 7.10% 15.5% 2.4% 2.2% 7.00% 6.90% 15.0% FY12 FY13 FY14 FY15 FY16E FY17E FY18E 2.0% 6.80% FY12 FY13 FY14 FY15 Gross margin EBIT margin (RHS) Salary as % of revenue Source: Company data We expect gross margin to remain flat over the next two years, as benefits of increased supplier rebates (as Al Othaim grows in scale) and increased share of private labels will likely be negated by continuing price investments to attract footfalls in a time of declining consumer spending. Any scale down in price investments will give a strong fillip to gross margin and will be a key stock price trigger. Gross margin improvement will be the primary driver for EBIT margin over the medium term, as nitaqat implementation will remain a drag on operating margin. Further, the impact from roll back in subsidies (which are likely to continue in the medium term, as has been mentioned in the budget document) will also weigh down margin in the medium term. Al Othaim declared that the impact of the partial roll back in subsidies will increase its costs by SAR16mn in Monetization of investments to aid bottom-line Mueen recruitment: Al Othaim invested in Mueen recruitment for 67.5% stake, which has received the final operating license from the ministry of labor in October 2015 and is likely to start operations in early 2016, with financial impact slated to reflect in Q We believe this venture will have a healthy margin given the high demand for recruitment of workers in both public and private sectors. We believe Al Othaim will also benefit due to its own requirement for labour in its retail outlets. Al Baik JV: Al Othaim s JV (25% stake) to roll out Al Baik restaurants in the Al Qassim region will start operations in Both the above ventures will start reflecting in financial statements starting We will start including the impact of these once they go live and we have more details on the scope of their operations and opportunity potential. Disclosures Please refer to the important disclosures at the back of this report. 34

35 Abdullah Al Othaim Markets Another catalyst is the start of operations of Hail Mall in 2HFY16, which will add to the rental income. By our estimate, Hail mall should result in net rental revenue of SAR 10 mn p.a. going forward. We believe the above monetization of investments will give fillip to non-retail revenue and drive better profitability. Figure 71 Strong growth in rental revenue FY12 FY13 FY14 FY15 FY16E FY17E FY18E Rental income (SAR mn) We believe our estimate for rental revenue is conservative. Al Othaim can further tap into the opportunity to increase rental revenue, by leasing out space for smaller shop-in-shop formats within the store and also the upcoming hypermarkets can generate better rental revenue as compared to supermarkets. Growing private label share, a key margin catalyst Al Othaim s investment in private labels is a solid strategy to lock in higher margin and increase its ability to better compete on price points with other retailers (especially considering price investments are becoming a source of driving customer footfalls). Al Othaim s private labels contribute 5% of revenue in 2014, and the management intends to increase the share to 15% in the next 5 years, which if achieved could meaningfully increase its gross and operating margins. Figure 72 Al Othaim s private labels portfolio Figure 73 High awareness of Al Othaim s Private labels 25% 21% 21% 20% 15% 10% 8% 7% 5% 0% Othaim Panda Bin Dawood 2% 2% 1% Watani Al Danoub Tamimi Al Raya Source: Company data Source: Company data Disclosures Please refer to the important disclosures at the back of this report. 35