SICO Research. GCC Equities. Bank Muscat. Worth the Premium Initiating Coverage (Overweight)

Transcription

1 GCC Equities SICO Research Sector Market Cap*: Primary Exchg Other Exchg Price: Target Price: Reuters: Bloomberg: Jan-04 Jun-04 Bank Muscat versus MSM30 Index BKMB - Rebased INDEX - Rebased Banking USD3.4 bn Muscat Bahrain RO1.415 RO1.679 BMAO.OM BMUS OM Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 VALUATION 2007E 2008E P / E x P / BV x P / Adj BV x Div Yld x TRADING DATA Daily Vol (6M Avg 000) 458 Daily T/o (6M Avg $ 000) 1,559 Issued Shares* (mn) *: Current O/s Shares = Shares post Placement = mn Jithesh K Gopi Tel. (973) (ext 5065) jithesh.gopi@sicobahrain.com Bank Muscat Worth the Premium Initiating Coverage (Overweight) September 17, 2007 Bank Muscat (BM), the largest bank in Oman, is expected to benefit significantly from the robust growth in Oman and USD48 bn of projects that are currently underway. With a domestic market share of over two and half times of its next competitor, BM is aggressively expanding to Saudi Arabia, India, Bahrain and Qatar with the aim of increasing the contribution of international business from 7% to 25% of net income by Key Financials RO Mn Net Int Income Net Income Tot Assets Net Loans Tot Deposits EPS (RO) ROE (%) ROA (%) FY06A ,994 1,835 1, FY07E ,955 2,512 2, FY08E ,160 3,395 3, FY09E ,139 4,340 4, FY10E ,268 5,260 5, FY11E ,387 6,214 6, CAGR (06-11) 25.1% 26.7% 29.9% 27.6% 27.2% 20.2% BM stands out as a well managed bank with healthy operational parameters and impressive growth prospects. Despite aggressive competition and a sharp rise in global rates, the bank has managed to protect Net interest margins which have fallen just 76 bps from its peak to 3.78% in 2007E. We expect NIMs to stabilise helping a 27.6% rise in loan book to drive Net Interest Income 25.1% p.a. over our forecast horizon. Non-interest income have been witnessing robust (sustainable) growth and expected to contribute as much as 22% of operating income by Gross NPAs at 4.8% in 2006 were the lowest among peers, with provision coverage already in excess of 120%. Rapid growth in assets led to the bank s capital adequacy dropping to 11.4% in H1-07, necessitating fresh capital to help sustain the banks growth ambitions. A proposed private placement in favour of Dubai Financial Group, making it the bank s second largest shareholder, will result in a 15% dilution of equity but a steep 68% hike in net worth. Net income expanded at 51% p.a. over the last five years, helping the bank improve ROE from 12.8% to 20.1%. Despite the proposed capital infusion, we estimate ROE will rise to 21.7% by 2011 driven by a 27% CAGR in net income. With plans to build a 15-strong branch network over the next five years, BM recently set up a branch in Saudi Arabia, a market 12 times bigger than Oman. The bank also applied for an investment banking license. Our forecasts assume that by the end of FY11, BM would secure a market share of 0.5% in credit and advances in the Saudi market, contributing approximately 6% to its net interest income. BM currently trades at a P/E of 18.8x its forecasted earnings for 2007 (a 43% premium to the peer average of 13.1x). However earnings are expected to grow at a CAGR of 27% over the next 5 years dropping its P/E to 14.6x for 2008E Including BM s unrealised gains of RO101.5 mn on its stake in CBoP drops its P/Adj BV to 2.0x 2008E. We initiate coverage on BM with an overweight rating and a fair price of RO1.679 (an upside of 18.7 %). Our rating reflects BM s strong fundamentals and the bank s new growth impetus due to the additional capital being introduced. We believe BM s entry into the lucrative Saudi Arabian market would add significant value and believe the bank deserves to trade at a premium to peers. SICO 2007 All Rights Reserved Attention is drawn to the disclaimer and other information on Page 30 1

2 Contents Investment Arguments... 3 Valuation... 6 Cost of Equity... 6 Sustainable Growth Rate... 6 Justified Price-to-Book Value... 6 Intrinsic Price-to-Earnings... 7 Surplus ROE Model... 7 Dividend Discount Model... 8 Blended Valuation... 9 Saudi Arabia - Attractive potential Bank Muscat s FY06 and H1-07 results Financial Analysis and Forecasts Operating Income Net Profits Loans Loan Quality Capital Adequacy Funding Business Background Description of Current Business Corporate History Current Ownership Governance Investor Relations Omani Banking Sector Growth drivers Government focus on diversification-driven growth Strong economic growth Interest rates Favourable demographics and low penetration levels Profitability and performance Changes in recent Regulations Competitive scenario Financials

3 Investment Arguments Investment Case Large infrastructure projects and new regulations for mortgage financing to drive growth Oman s economy is expected to see projects exceeding USD47.5 bn over the next five years. As a pioneer in the Omani project financing markets and as the Sultanate s largest bank, Bank Muscat (BM) is expected to play a major role in financing and advising on these projects. Additionally, the Central Bank of Oman s (CBO) relaxation of regulations on mortgage exposures now permits banks to disburse up to 5% of their loan portfolio as housing loans. This opens up new opportunities for BM. The bank s thwarted take-over attempt of Alliance Housing Bank (Oman s largest mortgage finance company) earlier this year and its alliances with major real estate developers are indicative of its interest in this business segment. We forecast a 27.3% CAGR in the banks loan portfolio during FY06 to FY11. Branch expansion and aggressive marketing to expand customer deposits Taking advantage of the growing liquidity in the Omani economy, BM expanded customer deposits at a CAGR of 17.4% from 2001 to In addition to a physical expansion of its network to 101 branches and 240 ATMs, the bank is also actively acquiring low-cost deposits through new promotional schemes and value-added customer services. We forecast a 27.2% CAGR in total customer deposits over the next five years. This coupled with strong loan growth and stable spreads will help net interest incomes grow at a CAGR of 25.1% during the same period. Growing contribution from non-interest income to boost total operating income We believe BM s non-interest income (derived from investment banking services, project finance, currency services, derivative incomes and collateral management), comprise a sustainable source of income. The contribution of non-interest income to total income has grown at a CAGR of 20.6% from 2001 to 2006 led by commission and fee-based income (which witnessed a 22.6% CAGR). We expect non-interest income to grow at a CAGR of 22% from FY06 to FY11. Chart 1: Trend in Non-Interest Income RO Million '01 '02 '03 '04 '05 '06 '07E '08E '09E '10E '11E Non-Interest Income Fees and Commission as a % of Non-Interest Income (RHS) 90% 85% 80% 75% 70% 65% 60% Source: SICO Research, Company Data Improved asset quality to reduce provisioning for credit losses Apart from growing its loan portfolio, BM has successfully reduced its gross nonperforming loans from 9.6% of gross loans in 2001 to 4.8% in The bank s gross NPL ratio is the lowest among the top four commercial banks in Oman. Note that at the net level, the banks NPAs have been more than fully provided for, with provision coverage in excess of 120% in We expect the banks gross NPL ratio will decline further to 3.7% by

4 Growth in net income to increase ROE BM s net income expanded at a 50.8% CAGR between 2001 and The growth in profit was supported by an improvement in the bank s ROE, which climbed from 12.8% to 20.1% over the period. The recently announced capital infusion by Dubai Financial Group will increase the paid in capital by 17.6%, but also hike net worth by 68%, thus putting pressure on ROE (due to the higher capital base). Nonetheless we expect ROE to rise to 21.7% by 2011 driven by a 26.7% CAGR in net income over the next 5 years. Interestingly, had the capital infusion not taken place, ROE would have exceeded 28% by Growing international business to contribute significantly to bottom line BM has recognised the importance of looking outside its domestic markets to support long term growth. The banks external growth engines are summarised below: Bank Muscat International (BMI) BM has a 49% stake in this Bahrain-based associate, a former ABN Amro division with a recent chequered and loss making history. BMI focuses on the retail/commercial business outside Oman and Saudi Arabia. In July 2007, BMI received approvals to establish its first branch in Qatar. BMI plans to service the GCC, MENA and South Asia regions. The bank is expected to shortly expand its capital base to USD600 mn. This would require BM to invest USD294 mn (RO113.5 mn) to retain its 49% stake in BMI. India BM holds a 20.71% stake in Centurion Bank of Punjab (CBoP) and recently acquired a 43% stake in Mangal Keshav Group, a securities firm, to gain entry into the Indian capital markets. Saudi Arabia BM is one of 10 new banks to have received commercial banking licenses in the Kingdom. It has already set up a branch in Riyadh, with plans to expand to 15 branches over the next 5 years. BM has applied for an Investment banking license (in line with the regulators recent guideline separating commercial from investment / asset management operations). Through these initiatives, BM expects to increase the contribution of international business in its net profit from the current 7% to 25% by Capital infusion enhances shareholder value BM capital adequacy ratio (CAR) dropped to 11.4% in H1-07 from 15.5% at the end of This was driven by a 17% growth in assets in H1-07 (a healthy 40% growth y-o-y). While the bank s CAR was higher than the regulatory requirement of 10%, it is lower than the banks internal target ratio of 12% 13%. In addition the bank would need additional capital to finance its rapid growth. In response, BM recently announced a private placement of a 15% stake in the bank to Dubai Financial Group (an investment arm of the Dubai Government). The stake sale involved the issue of mn shares at a price of OR This effectively resulted in a 15% dilution of equity but a sharp 68% hike in net worth of the bank. The price was in line with the prevalent market price at the time the deal was announced and represented a 21% premium to the bank s average share price in the preceding 6 months. Despite the capital infusion, we estimate that the banks ROE will rise to 21.7% by We forecast that the bank will not require to further dilute capital to finance growth at least until Expected contributions from Saudi business indicate brighter prospects BM was one of only 10 recipients of the new commercial banking license in Saudi Arabia. The bank recently opened its first branch in Riyadh. The Saudi market, with assets of over RO88.5 bn (USD230 bn) in 2006, is almost 12 times bigger than Oman. BM plans to establish a 15-strong branch network in the Kingdom over the next five years. In line with the Saudi regulator s new requirement that banks in Saudi Arabia separate their commercial banking and investment/asset management activities, BM recently applied for a (wholly owned) investment banking license. By the end of FY11, we have assumed the bank will garner a 0.5% market share in advances in the Saudi market and thus contribute 6% to BM s net interest income. 4

5 Investment in CBoP to penetrate large NRI market in the GCC The bank s investment in CBoP is expected to enable it to partly capture the large NRI market in the region. Furthermore, CBoP is expected to gain from its pending merger with Lord Krishna Bank (LKB) in terms of network expansion in south India, the most active NRI market targeted by BM. The bank plans to allow Indians across the GCC to access their accounts with Centurion Bank in India through its network in the Gulf. Hidden gains in CBoP BM s investments in CBoP were reflected at a book value of RO20.10 mn as of 30 June In comparison, its stake in the bank is worth over RO121.6 mn (based on current market capitalisation). This implies that the bank is sitting on an unrealised capital gain of over RO101.5 mn (adds 30% to the net worth of the bank). With the proposed merger of LKB and CBoP and the recent announcement of plans to raise INR5 bn capital through a Qualified Institutional Placement (QIP) offering, BM s holding is expected to fall further. The bank therefore plans to invest an additional USD50 mn to maintain its holding above 20%. Recent developments improve upside potential We are bullish on the business prospects for BM. The recent infusion of capital is expected to help the bank fund expansion plans and grow its assets base. In addition, we believe BM s entry into the lucrative (though highly competitive and challenging) Saudi market, would add significant value to its business. In our opinion these recent developments would enable BM to grow its earnings at a compounded rate of 26.7% over the next 5 years. Key Risks Economic slowdown in Oman The banking sector in Oman and the region are proxies on the regional economies. Therefore, any slowdown in economic growth in the Sultanate will have a direct impact on the bank s prospects. Any geo-political tension in the area could also impact oil prices and economic development over the longer term. Rising competition The buoyant economy and the upcoming large scale industrial projects in Oman have attracted many local and foreign players to the domestic banking sector. The entry of three new banks as well as CBO s approval to convert Alliance Housing Bank into a commercial bank is expected to intensify competition in the commercial banking segment. This might further put pressure on BM s interest margins and increase the cost of funds. Entry into foreign markets The bank faces risks in terms of its efforts to establish operations in new and competitive foreign markets. In a sense the expensive teething problems faced with BMI, which had to have additional capital injected into it in 2005, may have provided valuable lessons for BM s management. The success or failure of such efforts can have a material influence on its financials and investment case. 5

6 Valuation We valued BM using four valuation methodologies: o Justified Price-to-Book Value o Intrinsic Price-to-Earnings o Surplus ROE Model o Dividend Discount Model In view of the bank s announcement to raise equity via private placement with Dubai Financial Group, we considered the Post-Capital Increase scenario while valuing BM. Cost of Equity We calculated BM s cost of equity as explained below: Beta: BM s raw beta using weekly returns for the last two years compared to Oman s MSM-30 Index is The adjusted beta (assuming the bank s beta will tend towards the market beta over a longer term) is calculated as Risk Free Rate: Given the peg of the Omani Rial to the USD, we used the US 10-year Treasury yield as the benchmark risk free rate. As of 12th September 2007, the US 10-year yield stood at 4.36%. Equity Risk Premium: Based on Oman s Sovereign credit rating and spreads on sovereign debt for such a rating, we have assumed an equity risk premium of 5.81%. Based on these assumptions its cost of equity works out to 11.60%. Sustainable Growth Rate The bank s implied sustainable growth rate as computed using its sustainable ROE of 21.1% (i.e. average ROE between ), cost of equity (11.6%), and expected dividend payout (50%) translates to 10.5%. In comparison Oman s GDP growth over the next 5 years has been forecasted at 4.6% p.a. by Business Monitor International. Considering the high growth potential of their international business plan, particularly the Saudi operations, we expect BM will be able to sustain a higher growth of 7% in the longer term. We have based our valuation on this estimate. Justified Price-to-Book Value We believe the Justified Price-to-Book Value (P/BV) is an appropriate valuation methodology for banks like BM. Based on our assumption of sustainable growth rate (g), cost of equity (Ke) and ROE, we arrived at a Justified P/BV multiple of 3.1x based on the formula (ROE-g/Ke-g) Based on the 2008 adjusted book value estimate, this multiple yield a target value per share of RO1.916, which represents an upside potential of 35%. The Justified P/BV multiple depends on the sustainable growth rate and ROE. We have therefore provided a sensitivity analysis to reflect changes to the target price due to a change in these assumptions. Sensitivity of Valuation to ROE and Terminal Growth Return On Equity Terminal Growth Rate Source: SICO Research % 19.1% 21.1% 23.1% 25.1% 3.0% % % % %

7 Intrinsic Price-to-Earnings We have utilized an Intrinsic Price-to-Earnings (P/E) Valuation model for BM given the bank s dominant position in Oman as a leading bank and its profitability levels that are higher than its peers. To derive the Intrinsic Price-to-Earnings multiple, we compute BM s franchise factor and then added it to the bank s tangible P/E. The Franchise P/E is a function of both the franchise factor and the growth factor. The franchise factor accounts for the required returns from the new investments, while the growth factor considers the present value of excess returns from new investments. The tangible P/E used in this approach is the reciprocal of the bank s cost of equity. Based on this, our intrinsic P/E multiple for BM stands at 14.5x. Using this intrinsic P/E multiple and the bank s 2008E EPS, we arrived at a target price of RO1.404, which is 1.1% lower than the current price. Note that the bank s 27% CAGR in net incomes over the next 5 years implies that if we shift the base an additional year to 2009, the price target rises to OR (representing an upside of 35.1%). Our model is sensitive to changes in the ROE and terminal growth rate assumptions, as these reflect the bank s ability to generate higher profits in the long term. Hence, we have carried out a sensitivity analysis to changes in our assumption on terminal growth rates and ROE as detailed below: Sensitivity of Valuation to ROE and Terminal Growth Return On Equity Terminal Growth Rate Source: SICO Research Surplus ROE Model % 19.1% 21.1% 23.1% 25.1% 3.0% % % % % Given BM s ability to generate ROE significantly higher than the cost of equity, the surplus ROE valuation method would be appropriate to value the bank. We created an excess ROE model for a five-year forecast period. The model forecasts the value of BM s equity by discounting excess returns over and above cost of equity. This is achieved by deducting the imputed cost of equity in Oman Rials from the bank s net income. We then find the present value of intermediate and terminal surplus generated, discounted at the required rate of return (in this case the cost of equity of 11.60%). This is then divided by the number of outstanding shares to arrive at a target price of RO1.824 (28.5% upside). Terminal Growth Rate Source: SICO Research Sensitivity of Valuation to COE and Terminal Growth Cost of Equity % 10.60% 11.60% 12.60% 13.60% 3.0% % % % % The above table analyses the sensitivity of our model to changes in the terminal growth rate and the cost of equity. 7

8 Dividend Discount Model Our final basis of valuation was the dividend discount model (DDM). Given that the bank has a consistent dividend track record, this is an appropriate valuation tool. We base our DDM on a five-year forecast of annual dividends ( ) and used the Gordon Growth Model to calculate the terminal value. We then calculate the net present value (NPV) to shareholders discounted at the cost of equity. DDM Valuation in R0 ' E 2008E 2009E 2010E 2011E Term Val Expected Dividend Payments 40,636 52,060 71,087 85,799 98,690 2,295,979 Years Discounting Factor Present Value of Dividends 39,326 45,145 55,238 59,740 61,573 1,432,483 Sum of PV of Dividends 1,693,506 Shares Issued 1,077,133,621 Price Per Share Upside 11.1% Source: SICO Research Considering cost of equity at 11.6% and a terminal growth rate of 7%, we arrived at a target price of RO1.572 (10.8% upside). We present below a sensitivity analysis estimating changes to the fair value based on differing Cost of Equity and Terminal Growth Rate assumptions. Terminal Growth Rate Source: SICO Research Sensitivity of Valuation to COE and Terminal Growth Cost of Equity % 10.60% 11.60% 12.60% 13.60% 3.0% % % % % Justified Price-to-Earning Model not suitable While valuing BM, we did not use the Justified Price-to-earning (PE) method to evaluate the stock price. Justified PE is based on the assumption that the company is at a stable point of its business cycle and its business is expected to have constant growth going forward. This would be more applicable for valuing companies in mature industries, unlike BM whose external business initiatives are likely to result in higher growth than that in its domestic environment. Accordingly we believe Justified PE would not be an appropriate valuation method to use in this case. 8

9 Blended Valuation We used a blended approach to derive the target price for BM. We have assigned an equal weight (25% each) to all the four approaches Justified Price-to-Book Value, Intrinsic Price-to-Earnings, Surplus ROE Model and Dividend Discount Model. Based on our blended valuation approach, the fair value estimate for BM works out to RO1.679 per share, 18.7% higher than the current price. Blended Valuation BKMB Valuation Approach Price (in RO) Weightage Justified P/B % Intrinsic P/E % Surplus ROE Model % Dividend Discount Model % BKMB -Share Price, RO Source: SICO Research Calculation of Upside (Downside) BKMB's Fair Value Per Share, RO Current Market Price, RO % Up (Down) Side from Current Price 18.7% Source: SICO Research 9

10 Investment potential in Saudi Arabia BM was one of the 10 banks to receive the new commercial banking license in Saudi Arabia. BM recently opened its first branch in Riyadh. The Saudi market, with assets of over RO88.5 bn (USD230 bn) in 2006, is almost 12 times bigger than Oman. BM plans to establish 15 branches in the Kingdom over the next five years. In line with the new requirement in Saudi Arabia that banks in the Kingdom split commercial banking from investment/asset management, BM recently applied for a (wholly owned) investment banking license. The bank is targeting a 1 % share in the Saudi market by the end of FY11. In our model, we have conservatively assumed the bank would be able to increase its market share of total advances from 0.05% in FY07E to 0.5% by FY11E. We also assumed that the bank would be able to increase its share of deposits in Saudi Arabia from 0.04% in FY07E to 0.49% in FY11E (reflecting a credit to deposit ratio of 1 in line with the peer average). The table below illustrates the contribution of the Saudi business to BM s net interest income. Contribution from Saudi Business (RO '000 Unless Specified) FY07 FY08 FY09 FY10 FY11 Mkt Share in Tot. Credit (%) 0.05% 0.15% 0.30% 0.40% 0.50% Market Share in Tot. Deposits (%) 0.04% 0.13% 0.29% 0.40% 0.49% Total Credit and Deposits 27,402 92, , , ,956 Net interest income (NII) 628 2,631 7,173 12,719 18,264 % Contribution to Total NII 0.5% 1.6% 3.4% 4.9% 6.0% Source: SICO Research According to our estimate, the Saudi business has the potential to add approximately 6% to the bank s total net interest income by the end of FY11. In addition, if BM is granted the license to operate as an investment bank in the Saudi market, its total operating income from this region could increase further. In our opinion, the anticipated increase in contributions from Saudi operations makes BM an attractive investment prospect. 10

11 Bank Muscat s FY06 and H1-07 results Bank Muscat s financial results in 2006 reflect its aggressive growth strategy. On a y-o-y basis, the bank s net loan portfolio grew 33.7%, while its net interest income grew 27.5%. Although operating expenses rose due to its expansion efforts, higher non-interest income helped net incomes rise by 33.0%. The results are summarized in the table below: Key Highlights - FY06 results & H1-07 (In RO '000 ) FY06 FY05 % Chg H1-07 H1-06 % Chg Net Loans 1,834,678 1,371, % 2,199,052 1,555, % Total Assets 2,954,858 1,993, % 3,455,662 2,387, % Customer Deposits 1,817,107 1,291, % 2,152,125 1,524, % Total Deposits 2,211,059 1,388, % 2,605,416 1,728, % Net Interest Income 99,505 78, % 59,298 46, % Net Income 60,432 45, % 40,212 28, % EPS (RO) % % Source: Company Financials, SICO Research Key highlights of BM financial results are as follows: Driven by the strong growth in gross loans, interest income grew 36.9% y-o-y to RO158.9 mn in FY06 and 48% y-o-y to RO103.7 mn in H1-07. Faster growth in deposits, especially term deposits, which carry a higher interest, led to an increase in interest expense (56.4% y-o-y in FY06 and 84.6% y-o-y in H1-07). The net interest income grew 27.5% y-o-y to RO99.5 mn in FY06 and 31.3% y-o-y to RO61.7 mn in H1-07. Led by the 47.1% y-o-y increase in commission and fee-based income, non-interest income grew 33.8% to RO31.14 mn in FY06. Commission and fee-based income expanded 35% to RO15.7 mn, while non-interest income grew 39% to RO20.7 mn in H1-07 versus H1-06. The opening of new branches increased operating expenses by 25% to RO60.69 mn in FY06 and 28% in H1-07. Employee and administrative expenses are expected to continue growing as BM plans to expand its presence in Saudi Arabia. However, operating efficiency continues to remain strong as reflected by the cost to income ratio, which fell to 39.5% in H1-07 from 40.5% in H1-06. On account of lower provisions and increased recoveries, profits increased 33% to RO60.4 mn in FY06 and 44% y-o-y in H1-07. The bank s asset quality improved considerably as the NPL ratio decreased from 6.5% in FY05 to 4.8% in FY06. Consequently, the bank reduced its provision for credit losses by 24.5% to RO18.4 mn. Further improvements in asset quality will translate to decline in provisions and, consequently, higher earnings for the bank. Led by the strong economic activity and an aggressive marketing strategy, BM s loan book increased 33.7% y-o-y in 2006 and a further 20% in H1-07 to RO1,834 mn. Customer deposits grew 40.7% to RO1,817 mn in FY06 from RO1,291 mn in FY05. Customer deposits increased a further 18.4% in H1-07 to RO2, mn. Deposits from banks also increased significantly by 558.4% y-o-y to RO mn in FY06 and to RO433.9 mn in H1-07. BM s capital adequacy ratio decreased from 17.8% in 2005 to 15.4% in FY06 and further to 11.4% in H1-07. This indicates faster growth in the bank s asset base compared to the increase in its incremental capital base. The proposed capital increase in favour of Dubai Financial Group will help the bank s CAR rise to 18.87%. We forecast the banks CAR to rise to 19.5% by the end of 2007 and progressive decline to 10.9% by 2011 (implying the bank will not need additional capital over the next 5 years at the very least). 11

12 Financial Analysis and Forecasts Operating Income Driven by healthy growth on assets, BM s interest income increased at a CAGR of 8% during FY01 to FY06. However, interest expenses grew just 0.1% on a compounded basis. Consequently, BM s net interest income expanded at a CAGR of 14.9% during the period. Income Composition % y-o-y CAGR RO Million FY01 FY02 FY03 FY04 FY05 FY06 Gr(FY06) (FY01-06) Interest Income % 7.9% Interest Expenses % 0.1% Net Interest Income % 14.9% Fees and Commission % 22.6% Other Non-interest Income % 14.9% Total Non-interest Income % 20.6% Total Operating Income % 16.1% Source: SICO Research, Company Data Increased lending rates coupled with robust growth in loans and advances helped BM s interest income grow 36.9% y-o-y to RO158.8 mn in FY06 and 48% y-o-y to RO103.7 mn in H1-07. However, due to intense competition and higher costs of funding, the bank s interest expense expanded 56.4% y-o-y in FY06 and 84.6% y-o-y in H1-07. This translated into 27.5% growth in net interest income to RO99.5 mn in FY06 and 28.9% y-o-y growth in H1-07. Bank Muscat s net interest margin expanded just 7 bps from FY05 to FY06. The increase in BM s asset base due to robust economic growth, higher investment in development projects and expansion into Saudi market is expected to benefit the bank going forward. During FY06 11, BM s net interest income is expected to grow at a CAGR of 25.1%. Intense competition is expected to put pressure on the bank net interest margins (NIM) in the short term. However, increased loan portfolio would improve its NIM to 4.0% in FY11 from 4.27% in FY06. Chart 2: Trend in Net Interest Income and Margin RO Million % 4.5% 4.5% 4.2% 4.3% 3.8% 3.8% 3.7% 3.9% 4.0% 4.0% FY01 FY02 FY03 FY04 FY05 FY06 FY07E FY08E FY09E FY10E FY11E Net Interest Income Net Interest Margin 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Source: SICO Research, Company Data Non Interest income on the other hand was buoyed by growth in commission and fee-based income. Non-interest income rose at a CAGR of 20.6% during , a robust 33.8% in 2006 and a further 39% y-o-y to RO 21 mn in H

13 A key driver is the bank s success at winning several key mandates to advise the government in its privatisation efforts. These include Golden Tulip in the hospitality sector, Botswana Power Corporation, acting as the Sole Financial Advisor for the Solid Waste Management restructuring project, National Mineral Water Company, and the Salalah Free Zone. We forecast a rise of 22.0%p.a. in non-interest incomes during FY Chart 3: Composition of Non-Interest Income in 2006 Profit on sale of Non- Trading Investments 4% Dividend Income 3% Other Income 5% Foreign Exchange 10% Commission and fees 78% Source: SICO Research, Company Data Led by growth in interest as well as non-interest income, the bank s total operating income grew at a CAGR of 16.2% from FY01-FY06. Growth in 2006 was a smart 28.9%. We expect the trend to continue and total operating income to expand at a CAGR of 24.4%. Net Profits BM s net profits increased at a CAGR of 51% during FY01 06 on account of Chart 4: Trend in Net Profits and Return on Equity % 17% 19% 19% 20% 18% 17% 20% 21% 22% 25% 20% RO Million % % 10% 5% 0% FY01 FY02 FY03 FY04 Net Profits FY05 FY06 FY07E ROE (RHS) FY08E FY09E FY10E FY11E Source: SICO Research, Company Data increased recoveries, lower provision for credit losses, and improved operating efficiency. BM s ROE increased to 20% in FY06 from 12.8% in FY01. Due to increased operating incomes, improved efficiencies and higher income from associates, we forecast a 26.7% CAGR in BM s net profits during FY Despite the capital infusion in 2007, ROE and ROA are both expected to rise over the next five years. 13

14 Loans Loan growth over the last 5 years has been a healthy 10.6% CAGR. What is even more impressive is the banks success at increasing market share from 33.9% in 2001 to 39% in Chart 5: Trend in Bank Muscat s Loan Composition 2,000 1, RO Million 1, FY01 FY02 FY03 FY04 FY05 FY06 Total Corporate Loans Personal loans (Including Mortgage) Source: SICO Research, Company Data In 2006 BM s loan book grew 32% to RO 1,953 mn, led by a 37% expansion in personal loans and 29% growth in corporate loans. The corporate sector accounted for 57.4% of the loans disbursed by the bank at the end of FY06 (of which services and manufacturing sectors garnered a significant portion). The bank has a diversified corporate loan mix with no single sector accounting for more than 10%. Given the surge in real estate development in Oman, we believe, the sector s importance will grow in BM s loan mix in the coming years. Loans to the real estate sector represented 2.9% of the total loan portfolio in FY06, compared to 1.8% in FY05. Retail lending (including mortgages) accounted for 42.6% of the bank s total loan portfolio in 2006 compared to 41.1% in With this, BM breached the upper limit on exposures to personal loans (including mortgages) as a percentage of total loans, set by the CBO at 42.5%. Composition of Loans Proportion of Total Loans In RO'000 unless specified FY06 FY05 % Change FY06 FY05 Corporate and other loans Services 163, , % 8.4% 7.3% Manufacture 136, , % 7.0% 8.5% Financial institutions 136,183 91, % 7.0% 6.1% Import trade 127, , % 6.5% 9.9% Others 125, , % 6.4% 6.8% Utilities 114,997 89, % 5.9% 6.0% Construction 70,485 68, % 3.6% 4.6% Mining and quarrying 65,354 23, % 3.3% 1.6% Real estate 56,738 26, % 2.9% 1.8% Transport 51,435 21, % 2.6% 1.4% Wholesale and retail trade 47,480 42, % 2.4% 2.9% Government 13,805 17, % 0.7% 1.2% Agriculture and allied activities 7,235 7, % 0.4% 0.5% Export trade 3,642 3, % 0.2% 0.3% Total Corporate Loans 1,120, , % 57.4% 58.9% Personal loans 832, , % 42.6% 41.1% Total Loans 1,953,204 1,481, % 100.0% 100.0% Source: SICO Research, Company Data 14

15 From 2007, CBO has recommended caps in exposures to mortgages (cap of 5%) and personal loans (cap of 40%) with corporate exposures comprising the balance. Mortgages on a standalone basis accounted for 2.61% of Bank Muscat s total loans in H1-07. Taking advantage of the changed regulations, BM has forged agreements with real estate developers such as Al-Argan Towell Investment, Al Madina Real Estate Company, The Wave and Hamptons International to provide the Baituna suite of home loans for their projects. Its failed attempt to acquire (and merge) Alliance Housing Bank (Oman s largest specialised mortgage finance company) earlier this year is yet another affirmation of the bank s keen interest in the segment. We forecast BM s gross loan book will grow at a CAGR of 27.3% during FY Loan Quality BM s asset quality is well above that of the other three major commercial banks in Oman both in terms of lower gross NPAs as well as provision coverage (note that in the chart below AHB is a specialised mortgage finance bank, and is thus not comparable). Chart 6: BM s Asset Quality versus Peers Oman Banks - NPAs & Provision Coverage (2006) Gross NPL Ratio (%) AHB BMUS BDHOFAR NBO OIB 160% 140% 120% 100% 80% 60% 40% 20% 0% Provision Coverage (%) Gross NPL Ratio (%) Coverage (RHS) Source: SICO Research, Company Data The bank s NPLs to gross loan ratio improved to 4.8% in FY06 from 9.6% in FY01. The provisional coverage also improved to 126.8% from 73%. The adoption of prudent lending mechanisms is expected to help bank further to improve its asset quality. We expect the gross NPL ratio to improve to 3.7% by FY11. Capital Adequacy BM reported a healthy capital ratio of 15.42% in 2006, higher than the BIS minimum of 8% and CBO mandate of 12% (currently reduced to 10%). However, given the banks rapid growth in assets, its capital adequacy ratio decreased to 11.37% by June Since 2001, the bank had maintained a ratio above 15%. The decrease is indicative of the rapid growth the bank s risk-weighted asset base has been witnessing in recent times. The bank initially proposed to raise fresh funding possibly through a second GDR late in 2007, but subsequently announced a private placement of a 15% stake to Dubai Financial Group (an investment arm of the Dubai Government). The stake sale involved the issue of mn shares at a price of OR This effectively translates to a 15% dilution of equity but a sharp 68% hike in net worth of the bank. 15

16 This price was in line with the prevalent market price at the time the deal was announced and represented a 21% premium to the bank s average share price in the preceding 6 months. The banks proposed capital increase in favour of Dubai Financial Group will help the bank s CAR rise to 18.87%. We forecast the banks CAR to rise 19.5% by end of 2007 and progressive decline to 10.9% by Funding High levels of liquidity in the Oman Economy, a series of mergers and acquisitions by the bank, and its wide branch and ATM network has helped BM to rapidly grow and diversify its funding base. Over the years deposits have remained the main source of funds for the bank comprising between 87 to 96% of external funds over the period FY We expect the proportion of total deposits in the total funding base to increase to 96.4% by FY11. Chart 7: Trend in Customer Deposit Structure (RO Mn) 100% % % % 60% % 40% 30% % % % FY01 FY02 FY03 FY04 FY05 FY06 Current Accounts Savings Accounts Other Customer Deposits Deposits from Banks Certificate of Deposits External Debts Source: SICO Research, Company Data The bank s customer deposits expanded at a CAGR of 17.4% during FY BM s market share in customer deposits also grew to 38.8% in 2006 from 30.4% in Funds from current accounts and savings accounts increased 31.3% and 26%, respectively, whereas those from call account fell 20% in FY06. The bank s successful Al Mazyona deposit scheme enabled it to grow its savings deposits. BM s customer deposits grew 40.7% y-o-y to RO1,817 mn in FY06 and further expanded to RO2,152 mn in H1-07. The bank recently revamped the Al Mazyona scheme, adding a variety of new features. This is expected to further boost the deposit rates. We forecast customer deposits to increase at a CAGR of 27.2% during FY To support its long-term funding, the bank raised a USD100 mn subordinated loan from International Finance Corporation (IFC) in FY06. 16

17 Business Background Description of Current Business BM is the largest provider of financial services in Oman. It offers retail, corporate, treasury, investment and private banking, and asset management services. The bank operates 101 branches and the Sultanate s largest network of 240 ATMs. As of Dec 06, BM accounted for 40.75% of the total assets, 39% of the total credit and 38.8% of the total customer deposits. Chart 8: Trend in Market Share 42% 40% 38% 36% 34% 32% 30% 28% Assets Loans Deposits Source: SICO Research, Company Data The bank is actively pursuing geographical diversification and expanding its presence in the GCC region. It set up Bank Muscat International (BMI), an independent banking entity, in Bahrain and has recently secured approvals to set up its first branch in Qatar. Recently, BM opened a branch in Riyadh (Saudi Arabia), offering specialised consumer and corporate banking services initially. Gradually, it plans to expand into private banking and investment banking services in the region. BM also acquired a strategic stake in CBoP, the ninth-largest private sector bank in India. Through this alliance, BM plans to provide services to the large NRI population in the Gulf region. BM currently holds a 20.71% stake in CBoP. This is expected to decline further following CBoP s proposed merger with Lord Krishna Bank. Consequently, BM has applied for permissions to invest an additional USD50 mn to retain its stake at above 20% levels. BM also acquired a 43% stake in Mangal Keshav Group, a securities house in India, to gain entry in the Indian securities market. BM expects corporate banking to be a major growth driver going forward. With several government-supported projects in the pipeline in Oman over the next three years, BM expects project financing to constitute a lion s share of its corporate lending activities. Furthermore, its fee and commission-based income is also expected to benefit from the bank s involvement as an advisor to the government in its privatisation drive. The bank s activities come under four segments Corporate Banking, Consumer/ Retail Banking, Investment Banking & Treasury, and International Operations. The chart below illustrates the contribution of each business to the top and bottom lines. 17

18 Chart 9: Operating Income and Net Income by Business Group Share of Operating Income (FY06) Wholesale Banking 18% Corporate 31% Wholesale Banking 24% Share of Net Income (FY06) International 7% Corporate 39% Retail 51% Retail 30% Source: SICO Research, Company Data * In 2005, the bank converted its Bahraini operations into an independent bank in which it has a 49% stake. Thus its income is shown as income from associate. Corporate Banking s contribution to net income increased to 38.7% in FY06 from 36.9% in FY05. The bank, through this division, is increasing its focus on the tourism and real estate sectors that reflect the direction of economic growth in Oman. BM also intends to provide funding at various levels to the region s planned, large-scale infrastructure and tourism projects. Retail Banking accounts for nearly 51% of the operating income (though a smaller 30% share of net incomes). BM offers a wide range of value-added personal banking products and services to its retail customers. Wholesale Banking is engaged in investment banking and asset management. The bank has increased focus on commission and fee-based income in recent years. This is expected to result in higher interest income. Recently, BM was awarded various mandates by the Government of Oman to further strengthen its privatisation efforts. The mandates were already highlighted earlier in this report. BM has embarked on a drive to increase its presence in the GCC region. BMI, in which BM holds a 49% stake, set up an Islamic Bank in Kenya in partnership with a consortium of investors. BM also commenced operations in Saudi Arabia. It has also made considerable investments in India, where it holds stakes in CBoP and the Mangal Keshav Group. 18

19 Corporate History BM was founded in 1982, the year Hong Kong-based Overseas Trust Bank, in partnership with Bahraini investors, established Oman Overseas Trust Bank. In 1986, the investment arm of the Sultanate of Oman acquired a major share in the bank, having bought the shares of the Bahraini investors. That year it was renamed Bank Muscat. Since then, the bank has grown considerably through a series of acquisitions. 1989: Bank Muscat acquired Oman Banking Corporation. 1993: BM merges with Bank Al Ahli Al Omani to become the 4th largest bank. Société Générale and the Royal Court Affairs become shareholders. 1993: The bank listed on Muscat Securities Market (MSM). 2000: Bank Muscat merged with Commercial Bank of Oman, becoming the country s largest bank. 2001: Bank Muscat acquired Industrial Bank of Oman. 2002: The bank listed on the Bahrain Stock Exchange. The bank acquired Al Ahlia Securities, a broking house with more than 15% share in the Omani Exchange. The bank acquired ABN Amro s Bahraini operations, diversifying geographically. 2003: The bank acquired the personal loan business of Citibank, which exited the market, and purchased HSBC s merchant-acquiring business. 2004: BM acquires a strategic stake of 35% in CBoP, which was later diluted to 21.95% following the latter s merger with Bank of Punjab. The stake is expected to be diluted further to 16.5%, post CBoP s merger with Lord Krishna Bank. BM announces its intention to merge with National Bank of Oman, Oman s second-largest bank by assets, but the merger is called off in Q1-05 due to disputes on valuation. 2005: The bank converted its Bahraini branch operations into an independent bank, BMI. It was registered as an independent bank and BM continues to hold a 49% stake in it. BM launches a GDR floating 14.4% of its equity to become the 1st bank in the region to be listed on the London Stock Exchange. 2007: BM acquires a 43% stake in Mangal Keshav Group, one of the top 20 securities houses in India. Unsuccessful attempt to make a hostile take over of Alliance Housing Bank (Oman s largest mortgage finance institution) BMI secures approvals for first branch in Qatar The bank opened its first branch in Riyadh, Saudi Arabia and applies for an investment banking license BM announces private placement of a 15% stake to Dubai Financial Group (the investment arm of the Dubai Government) making it the second largest shareholder. 19

20 Current Ownership The Royal Court Affairs, with a 20.1% stake in Bank Muscat, is its single largest shareholder. The charts below depict the change in shareholding pattern over the last 5 years. Chart 10: Ownership Patterns (2003 & 2007) Others 41.9% MOD Pension Fund 6.7% Shareholding in 2003 Royal Court Affairs 24.4% Sheikh Mustahail Ahmed Al Mashani Group 15.8% Societe Generale 11.2% Shareholding in 2007 Royal Court Affairs 20.1% Others 44.0% GDR 19.0% Societe Generale 9.2% MOD Pension Fund 7.8% Source: SICO Research, Company Website The bank recently announced a private placement in favour of Dubai Financial Group, which would become the third-largest shareholder with a 15% stake. This would also dilute the stake of present shareholders by 15%. For instance, Royal Court Affairs share is expected to decrease to 17% from 20.1% currently. Chart 11: Ownership Patter Post Private Placement of Equity Others 37.4% Royal Court Affairs 17.0% GDR 16.1% Source: SICO Research MOD Pension Fund 6.6% Societe Generale 7.8% Dubai Financial Group 15.0% Governance - The bank is known to have high standards of corporate governance. It has consistently provided timely and detailed financial statements. Furthermore, the levels of disclosure, relative to peers, are fairly good. Investor Relations - In our view, the management is fair and transparent to its investors. BM has paid dividends to its shareholders regularly with average payouts in the last 4 years at 50%. The management has also issued stock dividends four times since We expect the bank to maintain its dividend payout at these levels in the coming years as well. 20

21 Omani Banking Sector The banking sector in Oman comprises six local banks, nine foreign banks and three specialised banks. Together, these banks have a 373-strong network of branches across the Sultanate. Oman is the only GCC country without an Islamic bank. The region s banking sector witnessed substantial consolidation in the 1990s. Consequently, as foreign banks exited the industry, the number of banks decreased from 16 in 1999 to 14 in List of Banks in Oman Sr. No. Name of the Bank Branches Local Banks 1 Bank Muscat Oman International Bank 82 3 National Bank of Oman 51 4 Bank Dhofar 48 5 Oman Arab Bank 39 6 Bank Sohar 1 Foreign Banks 1 Habib Bank Ltd. 9 2 HSBC Bank Middle East 6 3 Bank of Baroda 3 4 National Bank of Abu Dhabi 2 5 Standard Chartered Bank 1 6 Bank Melli Iran 1 7 Bank Saderat Iran 1 8 State Bank of India 1 9 Bank of Beirut 1 Specialized Banks 1 Oman Development Bank 10 2 Oman Housing Bank 9 3 Alliance Housing bank 7 Total 373 Source: Central Bank of Oman, Company Websites, SICO Research Oman s banking sector is highly consolidated, with the top four banks accounting for nearly 78% of the total assets, 76.6% of the total loans and 81.4% of the total deposits. Among the top four banks, BM is the largest in all categories and is over two and a half times bigger than the second largest bank. BM has a market share of nearly 40.75% in assets, 39% in loans and 38.8% in deposits. The market share of the second and third largest banks National Bank of Oman (NBO) and Oman International Bank (OIB) have declined substantially over the last few years due to their high level of NPAs and aggressive competition within the Sultanate. The entry of new banks in 2007 is expected to increase competitive pressures in the sector. 21

22 Chart 12: Market Share of Omani Banks in Total Assets (FY06) Others 19.65% AHB 2.42% Bank Muscat 40.75% Bank Dhofar 9.58% OIB 12.68% NBO 14.93% Source: SICO Research, Central Bank of Oman, Quarterly Bulletin, Q4, 2006, SICO Research & Company Financials BM s Impressive Incremental Market Share The chart below shows how BM has been able to capture an exceptionally high share of the expansion in Oman s banking system over the last 5 years ( ). Both in advances and deposits, BM has weaned away market share from other smaller banks. This high incremental share has arisen in part due to the various acquisitions made by BM, as also by its aggressive growth strategies and products. Chart 13: Impressive Incremental Market Shares ( ) Incremental Market Share (%) 60% 50% 40% 30% 20% 10% 0% -10% 50% 50% Bank Muscat 13% -1% 10% 4% 11% 20% NBO OIB Bank Dhofar Mkt Share- Customer Deposits 18% 12% 8% 4% AHB Others Mkt Share- Credit Source: SICO Research, Company Data Competition in the sector is expected to intensify with at least three new banks expected to commence operations in In addition Alliance Housing Bank has received approval from the CBO to convert into a Commercial Bank. The government is taking measures to strengthen the financial position of banks and make them more competitive. Recently, the CBO increased the minimum capital requirements to RO100 mn for new local commercial banks and RO20 mn for new foreign banks. This is also expected to act as a barrier for new players keen on entering the sector. 22