Strategy report Saudi Arabia January 18, 2010 Key themes The Govt. has recently unveiled Fiscal Balance Program, which outlines a roadmap to balance the budget by 2019 in a baseline scenario. The key components of this program comprise rationalizing government expenditure, cost savings from energy and water price reform partially offset by household allowance pay-outs, new non-oil revenue sources and enabling private sector growth. Budget balance under various scenarios Labels for baseline scenario, in SAR bn * The expat levy comprises two parts one on the expat employee and the second on the dependants of the expat employee residing in the Kingdom. To calculate the impact, we have considered only the employee levy (first part of the levy), as the companies have the option to absorb or pass on the dependants levy to the employee. Please refer to Appendix for methodology and calculations ** Data on Establishments (revenue, number of employees etc. ) is based on the annual survey report published by General Authority for Statistics Research Department ARC Research Team Tel +966 11 211 9370, research@alrajhi-capital.com Saudi Arabia: Fiscal Balance Program Aiming for fiscal sustainability amid near-term pressures The Government unveiled its Fiscal Balance Program document post Budget 2017 announcement, outlining the path towards achieving budget balance by 2020. The key components of this program comprise rationalizing government expenditure, cost savings from energy and water price reform partially offset by household allowance pay-outs, new non-oil revenue sources and enabling private sector growth. Among these initiatives, higher non-oil revenue is a significant objective of the Fiscal Balance Program and the NTP 2020. Government has identified VAT, expat levy, municipal fee, excise tax on harmful products and luxury tariffs as major avenues for generating non-oil revenue. Apart from creating a new revenue stream for the government, the expat levy will also likely reduce labour arbitrage by narrowing the wage differential between nationals & expats, thereby encouraging private sector companies to adopt more value-added and skill-based models given the potential cost pressures. We estimate the total employee levy to be 1.4% of the establishments ** aggregate revenue (considering the peak levy applicable by 2020), while varying 0-4% of revenue for various sectors. The estimated impact will be higher at operating (3.5% of the aggregate operating profit) and net profit levels. Some of the labour intensive sectors are likely to face higher impact which may be further compounded by potential hikes in other input costs (fuel, electricity and water) during the same period. Targeting budget surplus by 2019: If all the reforms outlined in the Fiscal Balance Program are implemented within the set timeline, a budget surplus will be achieved by 2019 as per the baseline scenario outlined by the government. In the conservative scenario (assuming lower oil prices, execution delays in water/ energy price reforms etc.), the budget surplus will be achieved by 2020. However, as per the very conservative scenario, the budget surplus will not be achieved by 2020, but deficit narrows significantly to SAR121bn from SAR297bn in 2016. Higher non-oil revenue (2020 target: SAR152bn incremental revenue) and cumulative cost savings from energy and utility price reforms (2020 target: SAR209bn) are the key drivers for balancing the budget. Expat levy: Impact on broader economy/ TASI varies by sectors The impact of expat levy on TASI on an aggregate level will be lower than the broader economy, considering the relatively higher weightage for Petrochemicals and Banking sectors, which together account for 51% of TASI revenue vs. 18% for the broader economy. These sectors have lower impact from expat levy. However, firms with low margins and low proportion of local employees are likely to face higher impact on profitability. Nevertheless, the gradual implementation and road map provided by the Government will allow companies to optimise their resources and soften the impact over a longer period. Excluding SEC, only 43 companies (8.7% of TASI m. cap) had less than 5% EBIT margin in 2016. A few sectors such as Hotel & tourism, Building & construction, and Real estate, with both low proportion of local employees and low operating margins are likely to witness higher impact at 2.5-4% of revenue. However, the representation of these sectors is low in TASI (just 7% of revenue). 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.
I. Higher non-oil revenue Achieving budget surplus has two key components as outlined in the earlier section: 1) Higher non-oil revenue (2020 target: SAR152bn incremental revenue), and 2) cumulative cost savings from energy and utility price reforms (2020 target: SAR209bn). In this section we address the drivers for higher non-oil revenue: Higher non-oil revenue is premised on the following: 1. Expat levy (to be implemented in July 2017) 2. VAT (to be implemented in early 2018) 3. Other fees such as higher visa fees, municipality and rural fees, excise tax on harmful products and luxury tariffs Among the above, expat levy is likely to be a key contributor of non-oil revenue growth, accounting for 45-50% of the incremental non-oil revenue in 2020 as per our estimates. Our incremental non-oil revenue estimate does not include potential receipts from the proposed white land tax. We discuss the structure and impact of the expat levy below: Expat levy: Understanding the structure Given the structure of expat levy, the collection process is likely to be efficient and the incremental costs to implement are likely to be very low. As the Government already has necessary infrastructure to charge existing visa charges linked to Iqama renewal, we believe that the new levy can be implemented with minimal changes to the same. The expat levy is scheduled to be effective from July 2017 onwards, progressively increasing until 2020. The levy has two parts: First is at the employee level and the amount of levy that needs to be paid depends on the number of expats and whether the number of expats are greater than the nationals employed by the company. Second is the levy based on the number of dependents of the expat employee residing in the Kingdom. We have considered only the employee levy while calculating the impact as the companies have the option to absorb or pass on the levy on dependants to the employee. Figure 1 Schedule of levy to be introduced on sponsors/ dependents in Saudi Arabia Levy on expats per dependent 2017 SAR 100 per month; July onwards Levy on companies with no. of expats equal/less than no. of Saudis Levy on companies with expats more than Saudis 2018 SAR 200 per month; July onwards 300 per month; January onwards 400 per month; January onwards 2019 SAR 300 per month; July onwards 500 per month; January onwards 600 per month; January onwards 2020 SAR 400 per month; July onwards 700 per month; January onwards 800 per month; January onwards document Impact on broader economy varies by sectors Our analysis indicates that the impact on broader economy will be 1-2% of the aggregate establishments revenue, considering the peak levy on employees by 2020. However, a few sectors such as Hotel & tourism, Building & construction, and Real estate, with both low proportion of local employees and low operating margins are likely to witness higher impact at 2.5-4% of revenue. Disclosures Please refer to the important disclosures at the back of this report. 2
Hotel & Tourism Building & Construction Real Estate Cement Industrial Agri & Food Media and Publishing Transport Energy & Utilities Insurance Petrochemical Banking Telecommunications Saudi All Industries Sector Figure 2 ARC estimate of employee levy and dependents levy 80.0 74.9 70.0 60.0 51.6 18.8 50.0 40.0 30.0 20.0 28.2 9.4 14.1 37.4 56.1 10.0 18.8-2018 2019 2020 ARC estimate of employee levy (SAR bn) ARC estimate of dependents levy (SAR bn) Source: CDSI data, Fiscal Balance Program document, Al Rajhi Capital Figure 3 Employee levy: Sector-wise impact (as % of revenue) 4.5% 4.1% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 2.9% 2.4% 2.0% 1.6% 1.5% 1.4% 1.3% 1.1% 0.6% 0.4% 0.2% 0.1% 0.1% Source: CDSI, Fiscal Balance Program, Al Rajhi Capital Employee levy impact (as % of sector revenue) As per our estimates, the impact of employee levy at an aggregate level is 1.4% of total revenue of the establishments based on the CDSI survey for 2015. According to the survey, the total revenue of Saudi establishments, excluding revenue from crude oil extraction, stood at SAR2,278bn, while operating surplus stood at SAR899bn. Sectors and companies with lower operating margins may have to improve efficiency and/ or witness productivity gains to offset the potential margin erosion arising from the levy. Many of the sectors with lower proportion of nationals are also labour intensive sectors with lower levels of average revenue per employee, limiting their ability to absorb incremental costs. In such a scenario, some of the incremental costs are likely to be passed on to the end users in certain sectors considering the incremental impact from the planned increase in other input costs such as fuel, electricity and water. Nevertheless, the gradual implementation and clarity on potential fee and other input costs are likely to allow the companies to manage the impact and find a new operating normal in a changed environment. Disclosures Please refer to the important disclosures at the back of this report. 3
Petrochemical Telecommunications Banking Insurance Energy & Utilities Transport Agri & Food Media and Publishing Industrial Cement Building & Construction Real Estate Other services Hotel & Tourism Saudi All Industries Sector Figure 4 Sectors which are labour intensive (low revenue/ employee) have higher proportion of expats; will witness higher impact from expat levy 250 200 150 100 50-81.4% 207 159 54.0% 76.9% 123 54.7% 71 58.4% 50 33.0% 37 32.6% 24.0% 18.1% 34 31 30 19.6% 21.8% 30 24 41.6% 32.6% 19.8% 13.2% 18 17 12 12 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Revenue/ employee per month (SAR '000) % of local employees Source: CDSI, Fiscal Balance Program, Al Rajhi Capital TASI to have lower impact than broader economy As mentioned in our recently released Yearbook Outlook 2017, our analysis suggests that TASI is not a close barometer of the broader economy due to meaningful deviations in composition of the broader economic activities and representation in the Tadawul. Figure 5 Broader economy*: Revenue composition Wholesale & 30% Petrochemical 13% Banking 6% Telecom 6% Figure 6 Tadawul: Revenue composition Agri & Food 8% Wholesale & 6% Petrochemical 37% Building & Construction 10% Industrial 10% Energy & Utilities 3% Agri & Food 8% Petrochemical Banking Telecom Energy & Cement Utilities Agri & Food Insurance Hotel & Tourism Real Estate Transport Energy & Utilities 7% Telecom 12% Banking 15% Petrochemical Banking Telecom Energy & Cement Utilities Agri & Food Insurance Hotel & Tourism Real Estate Transport Industrial Building & Construction Wholesale & Source: CDSI, Bloomberg, Al Rajhi Capital; *Note: Excludes crude oil extraction Industrial Building & Construction Source: CDSI, Bloomberg, Al Rajhi Capital Wholesale & However, these deviations make Tadawul companies at an aggregate level better placed than the broader economy to weather the impact from expat levy. This is because the sectors, which have lower impact from expat levy (such as Petrochemicals, Banking, Telecom, Utilities) are overrepresented in the Tadawul, while sectors expected to have relatively higher impact (such as, Building & construction, Real estate, Hotels and Transport) are under-represented compared to the broader economic activities. The sectors, which have lower impact from expat levy account for approximately 70% of Tadawul s revenue vs. only 27% for the broader economy. Due to these deviations in composition, we believe that the overall impact of levy on TASI companies at an aggregate level will be lower than the broader economy. Disclosures Please refer to the important disclosures at the back of this report. 4
Petrochemical Banking Telecom Energy & Utilities Cement Agri & Food Insurance Hotel & Tourism Real Estate Transport Industrial Building & Construction Wholesale & Difference in revenue weights - TASI vs. broader economy Saudi All Industries Sector Figure 7 TASI has lower impact from expat levy vs. broader economy 30.0 24.6 Low impact from expat levy High impact from expat levy 20.0 10.0-9.0 5.5 4.0 0.6 0.1 (10.0) (0.6) (1.4) (1.8) (2.9) (5.1) (5.9) (20.0) (30.0) Over - represented sectors vs. actual economy Neutral sectors vs. actual economy Under- represented sectors vs. actual economy (23.1) Source: CDSI, Fiscal Balance Program, Al Rajhi Capital TASI: Varying Impact There are few companies in TASI that have lower margins by virtue of their business model or due to the current business cycle. Companies with low margin are likely to witness more impact from expat levy depending on the labour intensity and employee mix. There are 44 companies in TASI which account for 15% of TASI s current market cap with lower profit (EBIT margin less than 5%) margins. However, excluding Saudi Electricity Company, 43 remaining companies with lower profit account for just 8.7% of TASI s market cap Apart from higher impact (relative to peers), the companies with lower margins are also likely to find it difficult to absorb other impending cost increases such as VAT, market linked fuel, energy and utility prices. 2020 target: SAR152bn incremental non-oil revenue The Government s new non-oil revenue measures such as expat levy, municipal/ rural fees, VAT implementation, higher visa fees, excise tax on harmful products and luxury tariffs, are expected to result in SAR152bn incremental non-oil revenue by 2020. Figure 8 Incremental non-oil revenues forecasts 160 152 140 120 100 102 127 80 60 40 42 20 0 2017 2018 2019 2020 Incremental Non-Oil revenues estimate (SAR bn) Disclosures Please refer to the important disclosures at the back of this report. 5
II. Cost savings program The cost savings program is another major component of the fiscal balance program. While higher non-oil revenue is expected to contribute SAR152bn incremental revenue by 2020, the cumulative cost savings from energy and utility price reforms are expected to yield SAR209bn by 2020. The cost savings program will be majorly driven by energy and water price reforms. According to the Fiscal Balance Program, the Kingdom s energy benefits reached close to SAR300bn in 2015, given the oil export price at that time. Further, energy and water benefits have typically accounted for the vast majority (~80%) of the overall subsidies in KSA. However, to mitigate the impact of higher energy and water prices on Saudi households, a household allowance scheme (direct cash transfer to low and mid income households) will be implemented. It is pertinent to note that Phase 1 of the program has already been rolled out in 2016, when electricity and fuel price increases took effect. However, water price increases were kept on hold until the metering and billing infrastructure is in place. Going forward, following will be the guiding principles for energy and water price reform. Figure 9 Guiding principles for energy and water price reform Phase 1 (2016) Future Phase (2017-2020) Marginal correction to current energy & water prices Phased increase in prices towards international market price Limited impact on low income, compensation not necessary Compensation for effected consumers Limited impact on inflation Industrial support Energy Efficiency programs Roadmap for next phase of reform The Fiscal Balance Program states the following: The second phase of reforms will involve a steady change in prices from 2017 to 2020. Domestic prices of products will be linked as a percentage to the reference export price of the respective product, and will fluctuate according to fluctuations in the international market. The prices of those products will be revised periodically, based on increasing the percentage linkage with the international market prices of these products. Figure 10 Roadmap for the next phase of reform Households 2017 Link electricity 100% to reference prices Non Households 2018 Link electricity 100% to reference prices 2019 Based on the readiness of the water infrastructure, gradually link water prices to reach reference prices 2020 Bring all products to reach 100% of reference prices Source: Company data, Al Rajhi Capital Gradually link all unpegged products to reach reference prices (except for butane, propane & natural gas) Target Savings The combined energy and water price reforms are expected to lead to savings of SAR209bn per year by 2020. Of these, SAR38bn will be from the savings implemented during the first phase in 2016. During this period, when the energy and water prices will be aligned to international reference prices, the government intends to provide targeted support for industries in their bid to become globally cost competitive. Disclosures Please refer to the important disclosures at the back of this report. 6
Figure 11 Gross savings from energy and water price reform (SAR bn) 250 209 200 38 150 100 50 0 142 107 38 30 59 171 27 30 104 77 27 29 Household allowance program Gross savings from FIRST PHASE of energy and water price reform (SAR bn) Gross savings from NEW energy and water price reform (SAR bn) The national household allowance program has been developed to help vulnerable lowincome and mid-income households to manage the impact of energy and water price reforms (and mitigate other expected levies such as VAT) over 2017-2020. The primary objectives for the Household Allowance program are: 1. Protect low and medium income households against the direct and the indirect impact of different reforms 2. Improve targeting of government benefits by developing a mechanism that will direct the benefits to the eligible segments only 3. Promote sensible consumption of energy & water by households The allowance amount is determined by the direct and indirect impact of energy and water price changes, along with the indirect impact of other reforms. The amount will be revised frequently to reflect any in increased burden on households, resulting from changes in the energy and water prices or other reforms. The allowance amount will be determined on the following: 1. Energy & Water: Entitlement will be based on sensible consumption, which is defined as average consumption of a household of 6 members who consume 398 liters of gasoline per month if they have 2 cars, and 2,594 Kwh electricity per month. 2. Other Basic goods: Entitlement will be based on median Saudi HH incremental inflation of basic goods The basic level of the allowance that a household is entitled to will be determined by the size of the household. The larger the size of the household, the greater the basic entitlement. In addition, the entitlement amount will be reduced for households with higher income levels and those on the highest incomes will not have any entitlement. Disclosures Please refer to the important disclosures at the back of this report. 7
Figure 12 Total estimated allowance (SAR bn) 70 60-70 60 50-60 50 40 35-45 30 20-25 20 10 0 2017 2018 2019 2020 Total estimated allowance (SAR bn) III. Budget balance by 2019 We believe higher non-oil revenue (2020 target: SAR152bn incremental revenue) and cumulative cost savings from energy and utility price reforms (2020 target: SAR209bn) are key drivers for balancing the budget over the medium term. Apart from higher non-oil revenue and cost savings implementation, the government also intends to target spending/ capex rationalization and stimulus to private sector growth as key focus areas. Following are summary of outcomes through implementation of fiscal balance program: If all the reforms outlined in the Fiscal Balance Program are implemented within the set timeline, the budget surplus will be achieved by 2019 in a baseline scenario. In a conservative scenario (assuming lower oil prices, execution delays in water/ energy price reforms etc), the budget surplus will be achieved by 2020. However, in a very conservative scenario, the budget surplus will not be achieved by 2020, but will significantly narrow to just SAR121bn deficit (SAR297bn was deficit in 2016). In the below section, we outlined the outcome from three scenarios as mentioned in the fiscal balance program document. Disclosures Please refer to the important disclosures at the back of this report. 8
Fiscal Balance Program s baseline scenario Figure 13 Baseline scenario: Revenue/ Expenditure forecasts Figure 14 Baseline scenario: Budget deficit/ surplus forecast 1200 1100 1000 900 800 825 890 928 889 1,050 969 950 953 150 100 50 0-50 -100 (39) 19 97 700 600 500 528 692-150 -200-250 -300 (297) (198) 400-350 Revenue (SAR bn) Expenditure (SAR bn) Budget surplus/ deficit (SAR bn) Fiscal Balance Program s conservative scenario Figure 15 Conservative scenario: Revenue/ Expenditure forecasts Figure 16 Conservative scenario: Budget deficit/ surplus forecast 1200 1100 50 0 18 1000 900 800 825 890 804 928 869 971 950 953-50 -100-150 (124) (82) 700 654-200 (236) 600 500 528-250 -300 (297) 400-350 Revenue (SAR bn) Expenditure (SAR bn) Budget surplus/ deficit (SAR bn) Fiscal Balance Program s very conservative scenario Figure 17 Very conservative: Revenue/ Expenditure forecasts Figure 18 Very conservative: Budget deficit/ surplus forecast 1200 1100 0-50 1000 900 800 700 600 528 825 554 890 680 928 751 950 953 832-100 -150-200 -250-300 (297) (336) (248) (199) (121) 500-350 400-400 Revenue (SAR bn) Expenditure (SAR bn) Budget surplus/ deficit (SAR bn) Disclosures Please refer to the important disclosures at the back of this report. 9
Appendix Expat Levy: Assumptions and methodology Following are the key assumptions and methodology for our analysis: 1. Revenue, wages, operating surplus and number of employees of establishments sourced from annual CDSI economic survey. The classifications into sectors is based on our understanding, but for the most part it is clear from the CDSI classification of the industry. Note: Our analysis excludes the crude oil extraction segment, for a better representation of non-oil economy. 2. Calculations of impact from expat levy is based on the schedule of levies as presented in the Fiscal Balance Program document. The impact as presented in this report refers only to the additional burden on employers, not the total burden and also does not include the levy on dependents. Note: For employers where non-local employees are more than half the total employees, employers are already paying SAR200 per month per nonlocal employee. 3. The second component of expat levy refers to fees to be paid by non-local employees for their dependents. Since this may not be borne by the employer, we do not classify this as part of the impact as presented in this report. However, we have quantified the impact of this levy as well for illustrative purposes. 4. To calculate the total levy on dependents, we used an average multiplier of 0.9 dependents per each non-local employee, based on the available demographic data from SAMA and CDSI. 5. We have based the peak impact of expat levy on 2015 revenue data, the last published revenue data for establishments by CDSI. 6. We assume the absolute number of expat employees in the Kingdom to remain the same going forward for our analysis and have used number of expats and dependants as published by CDSI at the end of Q3 2016. Disclosures Please refer to the important disclosures at the back of this report. 10
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Contact us Jithesh Gopi, CFA Head of Research and Financial Institutions Tel : +966 1 211 9332 Email: gopij@alrajhi-capital.com Al Rajhi Capital Research Department Head Office, King Fahad Road P.O. Box 5561, Riyadh 11432 Kingdom of Saudi Arabia Email: research@alrajhi-capital.com Al Rajhi Capital is licensed by the Saudi Arabian Capital Market Authority, License No. 07068/37. Disclosures Please refer to the important disclosures at the back of this report. 12