STRATEGY. SAUDI BUDGET: ENHANCING EFFICIENCY AND DEVELOPMENT as

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1 STRATEGY SAUDI BUDGET: ENHANCING EFFICIENCY AND DEVELOPMENT as We believe the Saudi budget and accompanying regulatory changes reflect a strategy to strengthen the economy against key economic challenges. Although reducing subsidies in utilities and oil derivatives will drive efficiencies in the public and private sector, it will negatively impact the profitability of listed companies. We expect the profitability of listed companies to decline 8-10% on higher direct costs, specifically at the petrochemical sector. Moreover, lower disposable income and increased average prices will limit overall consumption. Saudi expects expenditures of SR860bn in 2016E, in-line with 2015 levels. The expected deficit will be around SR326bn. Accompanying the budget announcement, prices of utilities and oil derivatives have been revised. This includes electricity, water, petchem feedstock and gasoline. We believe lower subsidies will reduce wasted resources and increase the government s ability to diversify the economy. Provided around 2.5mn b/d of oil are consumed locally, an opportunity cost of SR120bn is lost. However in the short-run, this may lead to 1) lower disposable income, 2) slower growth in non-oil sector and 3) a general increase in prices of goods and services. We expect market earnings to decline 8-10% as a result of increased costs. This decline is driven primarily by the petchem sector, which is expected to record a decline of 15-20% in earnings. Despite being exposed to the price hikes, we expect a moderate impact on the cement sector. With HFO prices increasing from US$3/ton to US$ /ton, we expect gross margins to contract by 416 bps for covered stocks to 49.2% in 2016E and price targets to decline by up to 6.3%. For remaining sectors, we expect a mixed impact. Industrial companies are expected to experience a relatively higher impact while the retail, telecom and banking sector will not be impacted directly. In general, the impact will be dependent on the ability of each company to pass-on the additional costs. Impact of feedstock changes on Petrochemical sector 2016E - Old 2016E - New %Change GM(%) EPS (SR) GM (%) EPS (SR) GM (%) EPS (SR) Advanced (5.6) (18.9) Yansab (4.8) (21.6) Kayan 7.4 (0.15) (0.7) (0.63) (8.1) NM SAFCO (3.8) (6.4) Petrochem (3.6) (19.3) SIIG (3.6) (10.6) Sipchem (3.4) (17.8) SABIC (3.7) (14.1) Sahara (4.9) (17.2) Tasnee (2.7) (45.0) NCBC Research research@ncbc.com Please refer to the last page for important disclaimer

2 2016 Budget overview Government spending remains intact, despite low oil prices Saudi Arabia announced its 2016E budget with an estimated expenditure of SR840bn and estimated revenue of SR514bn. This reflects an expected deficit of SR326bn. The estimated expenditure of SR840bn reflects the government s plan to continue investing in the economy despite weak oil prices. The budget expenditure came in-line with the 2015 planned expenditure, but 16% below the actual figure. Exhibit 1: Historical expenditure by Sector SR bn E Education Health and Social Affairs Municipality Services Transportation and Infrastructure Water, Agriculture and Manufacturing Education Budget Support Provision Source: Ministry of Finance, NCBC Research The government recorded revenues of SR608bn in 2015, 15% lower than the estimated figure. The deterioration in oil prices contributed to this decline, as oil prices averaged US$54 in 2015 vs. US$93 in This comes despite the increase in oil production and higher non-oil income. In 2015, oil revenues represented 73% of total income, lower than 90% in Non-oil income increased significantly at 37% YoY to reach SR163bn. The deficit was financed by a combination of foreign reserves and debt issuances. In Oct-2015, foreign reserves stood at SR2.4tn, a decline of 14% YoY. Regarding public debt, current debt-to-gdp stands at 5.8%, remains one of the lowest rates globally. Exhibit 2: Debt to GDP (%) % Source: NCB Economics 2

3 Exhibit 3: Saudi Government Budget Summary SR bn 1,200 1, F Budgeted expenditure Actual expenditure Budget surplus/deficit Source: Ministry of Finance Price changes impact electricity, water and oil derivatives The government announced plans to gradually reduce subsidies over the next five years. MoF is planning to revise current fees and to introduce VAT and taxes on items such as cigarettes and soft drinks. Subsequently, the Council of Ministers revised prices for oil products and gas. Ethane will increase to US$1.75/mmbtu from US$0.75/mmbtu, while Natural gas will be priced at US$1.25/mmbtu from US$0.75/mmbtu. Fuel prices are set to increase by 50-67%, while diesel prices will increase by 80%. The government will also increase the electric tariffs by 20-30% across all users, including the governmental segment. Other utility prices such as water were increased, with new sanitation fees introduced. Exhibit 4: Change in prices Product Unit Currency New price Old price %Change Natural gas mmbtu US$ Ethane mmbtu US$ Propane BPD US$ 0.8X propane 0.72x naphtha Butane BPD US$ 0.8X butane 0.72x naphtha Gasoline BPD US$ 0.8X gasoline 0.72x naphtha Fuel 91 liter SR Fuel 95 liter SR Diesel liter SR H- fuel 180 Barrel US$ 4.25 NA H- fuel 380 Barrel US$ Source: SPA, NCBC Research 3

4 Changes to support diversification Despite Saudi s low level of public debt and strong foreign reserve levels, the dependency on oil remains a concern. We believe muted oil prices signals the need to diversify sources of income and reducing excessive usage and waste of resources. Based on McKinsey, Saudi s consumption of electricity is equivalent to major industrial economies. Water consumption per capita is among the highest globally, despite the sacristy of water supplies. Moreover, we believe around 2.5mn barrels/day of oil are consumed locally at low costs. This results in an opportunity loss of around SR120bn, at current oil prices. Lower subsidies and introducing new fees will allow the economy to mitigate the impact of low oil prices, increase efficiencies and create globally competitive industries. In 2015, non-oil revenues contributed 27% of total revenues. This is higher than 10% in 2014, recording a 36% growth. We believe this trend will continue, reflecting the government focus on non-oil revenues and enhancing productivity. Exhibit 5: 2015 Revenue Breakdown Exhibit 6: Total Foreign Reserve % SR bn Other revenues 16% Others 37% Investments 23% Customs duties 15% Petroleum products tax 10% Oil revenues 73% Source: McKinsey 4

5 Impact on the economy Slowdown in non-oil segment reflected through PoS The increase of fuel and utility prices across residential and commercial segments in Saudi may lead to 1) lower disposable income levels, 2) slower growth in the non-oil sectors and 3) a general increase in prices of goods and services. We believe PoS data is a proxy for disposable income trends. Analyzing the historical trends, we note a clear correlation between spending levels at points of sale and regulatory/macroeconomic changes. Decreasing gasoline prices in 2006 and the 2-month bonus salary had positive impact on PoS growth. However, the implementation of Saudisation programs and the end of the amnesty period on expats negatively impacted PoS growth. We believe the hike in gasoline and utility prices will negatively impact PoS growth levels. We expect PoS will grow 13% YoY in 2015E vs. historical levels of 22% YoY. Moreover, we expect inflation to accelerate in the short term before reverting to equilibrium as consumers adjust their spending habits. Exhibit 7: Overview of PoS data trends 40% 35% 30% 25% 20% 15% 10% 5% 0% Economic slowdown 2-month bonus salary + Hafiz programs Weak oil prices E POS (% YoY growth) Exhibit 8: Overview of PoS data trends 45% 2-month bonus salary 40% 35% Saudisation Nitaqat program Saudisation concerns begin to ease Weak oil prices 30% 25% 20% 15% 10% 5% 0% Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 POS (% YoY growth) 5

6 Higher utility and gasoline prices to enhance efficiencies Total consumption of electricity has been increasing at an average rate of 7.2% YoY in Saudi since 2009, with the main driver being the residential and commercial segments. Governmental sector consumption contributed around 12.3% of total consumption, growing at an average of 3.1% YoY. In 2015, electricity consumption reached a record high of 62,260 megawatt. According to McKinsey, gasoline consumption is correlated to its affordability, classified as the % of daily wage needed for 1 liter of gasoline. We believe the hike in prices will reduce unnecessary spending and encourage higher energy efficiency. Higher prices are expected to encourage the private sector to invest in power generation, reducing the burden on government. It will also increase the investment in power efficiency industries. We believe restructuring efforts and cost reviews will also be conducted by the private sector, as a result of the increased prices and lower overall spending. Electricity consumption in the industrial sector accounts for around 18.6% of total consumption, and grew at a rate of 7.8% YoY. Moreover, we believe lower subsidies on fuel will encourage higher efficiency initiatives aiming to reduce the dependency on fuel and subsidies. Such measures have been taken by several cement companies for example, which installed heat recovery systems. For Yanbu Cement, we expect fuel efficiencies of at least 5% from installing such technology. We expect most of the listed companies to start significant cost reviews in 2016E. Exhibit 9: Gasoline consumption vs. affordability Exhibit 10: Overview of Saudi electricity consumption Units as specified % Gasoline consumtion 800 United States % 20.0% Kuwait Saudi Arabia New Zealand Iran Brazil Affordability Bulgaria Nigeria Philippines India % 10.0% 5.0% 0.0% YoY consumtion growth Government-to-total Industrial-to-total Source: McKinsey 6

7 Impact on stock market In general, reducing oil/gas subsidy and increasing utility prices will increase operating costs for listed companies. Therefore, we expect the market profitability to decline 8-10%. Companies that rely heavily on subsidized fuel are expected to be impacted. The petrochemical sector is expected to be the most impacted, reducing its profitability by around 15-20% in 2016E. However, we expect the remaining sectors profitability to decline 1-10%. We will analyze the impact on different sectors in the market taking into consideration the ability to pass the extra cost to end user. Petrochemical sector The increase in feedstock costs will significantly impact the sector profitability. Ethane and natural gas prices increased from US$0.75/mmbtu to US$1.75/mmbtu and US$1.25/mmbtu, respectively. Propane, butane and gasoline discounts were reduced to 20% from 30-32%. This is compared to the current natural gas prices of US$2.25/mmbtu. This will largely reduce the sector s global cost advantage. The sector will not be able to pass the extra cost to the buyers as petrochemicals are global commodities with many suppliers and currently weak demand. One of the key benefits of the new prices is the change of the naphtha linkage to the respective feed price which better reflects the dynamics of the underlying products. Upon the implementation of new prices, the sector s gross margin is expected to decline by bps. Net income will also decline by 15-20% while the ability to pay dividends will deteriorate further. Loss making companies such as Tasnee and Kayan will deal with higher feedstock costs, operational issues and weak market conditions. To date, seven petrochemical companies announced the impact on its COGS. SABIC, Yansab, Kayan and SAFCO announced an estimated increase of 5-8.5% in COGS. Tasnee and PetroRabigh estimated a decline in net income of SR190mn and SR300mn. Alujain provided a range of SR10-30mn From the stocks under coverage, we expect the net income of Advanced, Yansab and Petrochem to decline by 18.9%, 20.4% and 19.3%, respectively. On the other hand, Kayan will return to report negative margins. Exhibit 11: The impact of feedstock change on petrochemical profitability 2016E - Old 2016E - New %Change EPS Gross EPS Gross (SR) Margins (%) (SR) Margins (%) Gross Margins (%) EPS (SR) Advanced (5.6) (18.9) Yansab (4.8) (21.6) Kayan 7.4 (0.15) (0.7) (0.63) (8.1) NM SAFCO (3.8) (6.4) Petrochem (3.6) (19.3) SIIG (3.6) (10.6) Sipchem (3.4) (17.8) SABIC (3.7) (14.1) Sahara (4.9) (17.2) Tasnee (2.7) (45.0) 7

8 Cement sector Saudi Cement companies mainly use HFO in production. We believe companies use a mix of both HFO-180 and HFO-380, at a historical average cost of US$3/barrel. The prices of these fuels increased to US$4.25/barrel and US$3.8/barrel, respectively. We believe the increase in the cost/ton will be up to SR10/ton. Accordingly and as reflected in the scenario analysis below, we expect the negative impact on price target to be up to 6.3%, with gross margins contracting by around 416 bps for covered stocks to 49.3% in 2016E. Exhibit 12: Fuel price impact on Price Targets Exhibit 13: Gross margin and subsidy scenario analysis Price targets (SR) Gross margin (%) % -5.5% -4.3% 60% % 55% % -5.1% 50% 45% Yanbu Saudi Eastern Soutern Qassim Yamama 40% 2016E with subsidy 2016E no subsidy 2019E with subsidy 2019E no subsidy Retail sector We believe the direct impact on the retail sector will be limited. Based on our analysis, utilities-to-revenues for the sector is less than 1%. However, we expect organic growth and the pace of new store expansion to be negatively impacted as the disposable income is expected to shrink. This will impact discretionary names such as Jarir and Al Hokair. The impact is expected to be limited on staple companies such as Othaim and Farm superstores, because the demand on necessary goods tend to be inelastic. In the short term, we expect electronic suppliers to benefit as consumers will replace energy inefficient appliances and ACs. Thus, Extra, Shaker and SACO are expected to be key beneficiaries. Banking Sector The impact on the banking sector s cost structure is expected to be limited. However, the overall decline in companies profitability and the expected decline in disposable income are expected to impact the banking sector indirectly via lower loan growth and lower demand deposits. Other sectors The impact on other sectors costs will depend largely on companies ability to pass the cost to the end users. We expect the food sector s ability to pass prices to vary. Fresh milk prices are fixed by the government while the prices of juice and long life milk are not. The transportation sector may have a limited ability to increase prices. This is due to the long term contracts with large corporations such as SABIC, Almarai, Aramco and Saudi Airlines. We believe the Industrial sector to have a limited ability to pass the extra cost too due to the weakness in the construction sector and the long term contracts. The real estate and hospitality sectors are expected to be able to pass-on the extra costs. On the other hand, the impact on the insurance and telecom sector will be limited both on direct cost and demand. 8

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