June 30, 2016 SAUDI TELECOM SECTOR Hazy Future There are 54 million registered mobile subscribers making up KSA s telecom market as of 2015-end, having grown at a CAGR of 15% in the last 10 years. Current penetration rate stands at 171% (146% pre-paid and 25% post-paid). According to CITC numbers, there are 22 million internet users in the country, recording a CAGR of 25% over the last decade. While the telecom market has experienced rapid growth in the recent past, future outlook appears cloudy. We believe the market may face a lull as a consequence of implementation of new regulations. The drive for biometric verification has the potential to disrupt penetration numbers. While the telecom operators have commenced the herculean task of linking both new and existing subscribers to their finger-prints, market players expect a drop in subscribers when the deadline expires. Although it is difficult to estimate the impact, our initial estimates point to a potential 15-20% (mostly prepaid) decline in subscribers based on experience of other markets. However, we don t expect telecom companies revenue to face a commensurate drop as inactive SIMs are not revenue generating while users of active ones will either provide their biometrics or issue new SIMs. Furthermore, we believe the process of collecting finger-prints is time consuming and hence the deadline may need to be extended. The other major development in 2Q is the financial impact of the second round of reduction in termination fees by CITC. Second reduction in termination fees We believe that the impact of reduction in termination fees from SAR 0.15 to SAR 0.10 per minute varies across companies in the sector but expect a similar impact to the first round of reduction last year. The highest market share operator (STC in this case) is a net receiver and likely to encounter the most negative effect through revenue reduction and increase in cost while the lowest market share operator (Zain) is a net payer and stands to benefit the most through cost reduction. Looking back at 1Q2015 when CITC reduced the termination fees by -40% from SAR 0.25 to SAR 0.15 per minute, STC saw a +2% Q/Q increase in cost of services as a percentage of total revenues while the same metric depicted a decrease of -2% and -5% Q/Q for Mobily and Zain respectively. Mobily and Zain profited via decreasing cost of services by -7% and -4% Q/Q respectively. Table 1 below illustrates the financial impact of the first reduction. Table 1: 2015 Termination Fees Impact (SAR mln) Financial Figures STC Mobily Zain 1Q15 2Q15 Change 1Q15 2Q15 Change 1Q15 2Q15 Change Revenue 12,473 12,222-2% 3,643 3,568-2% 1,678 1,666-1% COGS 4,930 5,058 3% 1,743 1,619-7% 804 716-11% Gross Profit 7,543 7,164-5% 1,900 1,949 3% 874 950 9% GPM 60% 59% -2% 52% 55% 2% 52% 57% 5% In March, CITC revisited termination charges again and further lowered them by -33% from SAR 0.15 to SAR 0.10. We believe this will negatively impact STC as a net receiver, while Zain will benefit the most as a net payer, as was the case last time. Given Zain s market share, it is worth noting that Zain s major revenue comes from outgoing calls rather than incoming calls. Mobily is expected to be more neutral as it is positioned second in terms of market share implying Mobily may end up offsetting its lower revenue with lower costs. The reduction of termination fees and the increase in number of subscribers in the country allowed Zain to increase its subscribers by +7% in 2Q2015 and +12% in 3Q2015 versus 1Q2015. Muhammad Faisal Potrik Faisal Abaalkhail muhammed.faisal@riyadcapital.com faisal.s.abaalkhail@riyadcapital.com Riyad Capital is licensed by the Saudi Arabia +966-11-203-6807 +966-11-203-6812 Capital Market Authority (No. 07070-37)
Exhibit 1: Quarterly Gross Margins 2015 (%) 66.0% 64.0% 62.0% 60.0% 58.0% 56.0% 54.0% 52.0% 50.0% Q1 Q2 Q3 Q4 STC Mobily Zain Rating and target prices We maintain our target prices on STC (Buy) and Zain (Neutral) at SAR 73.00 and SAR 10.50 respectively using a combination of DCF and market-based multiples (P/E and P/EBITDA) for valuations. We reinitiate coverage on Mobily in this report with a 12- month target price of SAR 29.00 and a Neutral rating. Page 2 of 9
Mobily: Reinstating Coverage Mobily was established in 2004 by a consortium led by Etihad Etisalat, the UAE based telecom conglomerate and became the second mobile service provider in the country. The two major shareholders are Etisalat UAE at 27.5% and GOSI at 11.9% while the remaining shares are held by the public. Mobily has eight subsidiaries in four countries namely Saudi Arabia, Bahrain, India and the UAE. It was also the first Saudi communication company to get an operation license for 3rd generation services and beyond. Back on track We reinstate our coverage on Mobily, formulating our opinion based on publicly available information and meeting management. Management believes that they have put all accounting issues behind them and do not see any further back dated revisions in the financials. Latest Auditor notes also collaborate this. For 1Q2016, the Auditors did not have any amendments to the reporting and believe them to be in compliance with accounting standards. It is, therefore, reasonably safe to assume that Mobily is now back on track and focusing on business rather than accounting issues. -1% revenue decline in 2016 2015 witnessed intense competition within the telecom space in KSA on the back of regulatory changes, price cuts and the addition of MVNOS. We believe mobile data has started to become and would continue to be the key growth driver for telecom operators led by an explosion in smart phones users and proliferation of data heavy content. The biometric impact has started in 2016 and is likely to continue in 2017 as well. Furthermore, the reduction of SAR 0.05 per minute in termination fees will impact revenue in 2Q as well as the full year. For Mobily, the aftermath of revenue restatement has caused topline to decline at a CAGR of -8% between 2011-2015. We have forecasted revenues based on the last two years post restatement i.e. 2014 and 2015. For 2016, we forecast revenues to slightly dip by -1% Y/Y to SAR 14.2 billion. Thereafter, they are expected to grow at a CAGR of +3% to SAR 15.6 billion through 2019, slightly higher than the Saudi population growth rate of 2.6%, based on the latest statistic provided by the General Authority for Statistics. Exhibit 2: Restatement Impacted Revenues (SAR Million) 26,150 21,150 16,150 11,150 6,150 Restatement 30% 20% 10% 0% -10% -20% 1,150 2010 2011 2012 2013 2014 2015-30% Revenue Growth Page 3 of 9
According to management bio-metric verification is likely have a significant impact on the number of subscribers and revenues. Company has been sending teams to obtain fingerprints of higher ARPU users as a strategy to ensure their continuity as customers, which has been quite successful. Profitability and margins recuperating After peaking at 62% in 2013, gross margins dipped to 48% in 2014 before recovering to 55% last year. We anticipate this recovery in margins to continue going forward with a gradual rise from 55% in 2016 to 61% through 2019. We expect EBITDA margins to also revert back to the 30% levels from 2017 after an average of 18% for the last two year. Gross profit also suffered in 2014 falling to SAR 6.8 billion, down from SAR 10.3 billion in 2011 as the Company restated financials. Gross profits have started on the recovery path rising to SAR 7.9 billion last year but may drop to SAR 7.8 billion this year on the back of lower revenues and similar margins Y/Y. We expect Mobily to return to full year profitability from 2017 after posting two consecutive years of net losses over a billion riyals each in 2014 and 2015 and an expected loss of SAR (102) million this year. We do not expect Mobily to revert back to its previous bottomline levels of SAR 5-6 billion for the foreseeable future. Net margins are estimated to remain in single digits. Exhibit 3: Mobily's Quarterly Revenues (SAR mln) & Gross Margins (%) 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16E Revenue COGS GPM 62% 60% 58% 56% 54% 52% 50% 48% 46% Agreement with creditors As per auditor s report, Mobily was unable to meet a certain financial covenant under the long term financing facilities with various lenders in 4Q2014. However, subsequently Mobily has managed to reach an agreement with its Saudi and international creditors on debt payments. As of March 31, 2016, Mobily had total debt to SAR 14.3 billion, out of which SAR 9.3 billion is due this year. After a second agreement (May 2015) a portion of its SAR 9.3 billion short term debt will be reclassified to long term debt. Mobily has not announced the financial impact yet. According to management, debt levels are back to normal, which we believe implies that they are back to the pre-4q2014 level. In 3Q2014, total debt to equity stood at 67%. Mobily s debt to equity and debt to capital ratio is at 92% and 48% respectively as of 1Qend. As per our understanding, the Company s current debt will be in a range between 7-8% of total debt. Despite what they went through, Mobily were able to show their cash flow strength by making a repayment of SAR 2.9 billion in 2015. Page 4 of 9
Exhibit 4: CAPEX Spending (SAR mln) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 40% 30% 20% 10% 0% -10% -20% Exhibit 5: Loans Proceeds and Repayments (SAR mln) 8,000 6,000 4,000 2,000 0-2,000-2010 2011 2012 2013 2014 2015 CAPEX Growth rate -30% -4,000 2010 2011 2012 2013 2014 2015 Proceeds Repayments Source: Riyad Capital, Company's Financial Statement Source: Riyad Capital, Company's Financial Statement 2015 and 2014 financials point to a need for further improvement in cash flow conditions as debt coverage ratio remained flat at 0.34 (significantly below 1.0). Moreover, debt payment ratio worsened to 1.68 in 2015 as compared to 2.80 in 2014 due to an increase in debt payments by SAR 838 million while cash flow from operations (CFO) declined by SAR 937 million. We also analyzed CFO coverage to investing and financing activities to measure the company s ability to purchase assets, satisfy debts and pay dividends, if any. Despite the decrease in cash flow from operations, the ratio managed to improve from 0.53 in 2014 to 0.74 in 2015 due to reduced Capex (27%) and no dividend payment (66%) of the SAR 4.4 billion decrease. We believe cash flow from operations is being used for Capex and to pay debt for the last two years, which forced suspension of dividend payments in 2015. We anticipate a reduction in Capex spending going forward. As the cash flows are likely to be weak in the next couple of years with debt payments continuing, we do not expect dividend payments. Zain arbitration will take time Mobily went into arbitration with Zain in 3Q2014 on disagreements with regards to dues from the Service Agreement. This agreement covers services that include national roaming, site sharing, transmission links and international traffic. An amount of SAR 2.2 billion has been claimed by Mobily as of 30 November 2013. With provisions taken by the Company (latest being SAR 800 million in 2Q2015), accumulated provision stand at SAR 2 billion, 91% coverage for this arbitration. We believe the case would take time to resolve and it is premature and not prudent to predict an outcome of judicial matters. Valuations and Recommendation We have valued Mobily using Discounted Cash Flow (DCF) valuations as we believe market based valuation approach is not appropriate for the Company at this stage. As illustrated in the table below, we have used a risk free rate of 3.30% and a market risk premium of 6.30% to arrive at a cost of equity of 9.85%. We assume a cost of debt of 6.00% and 70:30 equity to debt ratio to reach a WACC of 8.70%. Discounting free cash flows at WACC and adjusting for net debt leaves us with a fair value of SAR 29.10 for Mobily. Page 5 of 9
Table 2: Discounted Cash Flow Valuation SAR mln, except per share 2016E 2017E 2018E 2019E Cash Flow to the Firm (161) 1,748 1,945 2,188 Discount Factor - 1.09 1.18 1.28 Discounted Cash Flows 1,608 1,646 1,704 LT sustainable growth rate 2.5% Cost of equity 9.9% Saudi Risk Free Rate 3.3% Cost of debt 6.0% Beta 1.04 WACC 8.7% Total Equity Value (SAR mln) 22,410 Debt 29% Number of shares (mln) 770 Equity 71% Fair Price per share (SAR) 29.10 Source: Riyad Capital We reinstate coverage on Mobily with a target price of SAR 29.00. As the stock is trading in the vicinity of our target, we recommend a Neutral rating. Financial summary The table below summarizes the key financials for Mobily, two years historical and our forecasts through 2019. Table 3: Mobily Key Financials FY Dec31 (SARmln) 2014 2015 2016E 2017E 2018E 2019E Revenue 14,004 14,425 14,239 14,666 15,106 15,560 COGS 7,225 6,467 6,467 6,072 6,103 6,130 GPM 48% 55% 55% 59% 60% 61% EBITDA 2,246 2,941 3,958 4,506 4,945 5,250 EBITDA Margin 16% 20% 28% 31% 33% 34% EPS (SAR) (2.05) (1.42) (0.13) 0.51 1.03 1.19 Page 6 of 9
2Q2016 expectations Table 4: 2Q2016 Estimates (SAR mln, except per share data) 2Q would be the first quarter affected by the reduction in termination fees to SAR 0.10 per minute. Costs related to the aggressive drive on biometrics would also need to be taken into account by the Companies. While industry insiders expect a significant reduction in subscribers once unregistered SIMs are blocked, impact on revenues and profitability is uncertain but definitely likely to be less than the percentage reduction in subscribers. Table 4 below details our 2Q forecasts for the telecom stocks. Company 2Q2015 2Q2016E Y/Y Chg 2Q2015 2Q2016E Chg 2Q2015 2Q2016E Y/Y Chg 2Q2015 2Q2016E Y/Y Chg STC 12,222 12,707 4% 59% 57% -1% 2,560 2,348-8% 1.28 1.17-9% Mobily 3,568 3,474-3% 55% 54% -1% (901) 3 - (1.17) 0.00 - Zain 1,666 1,740 4% 57% 61% 4% (201) (285) - (0.34) (0.43) - Group Total 17,456 17,921 - - - - 1,458 2,066 - - - - Revenue Gross Profit Margin Net Income Earning Per Share STC: Solid top-line, margins to shrink As compared to peers, STC has managed to present a solid top-line during the last 3 years, thanks to its loyal subscriber s base and aided by international operations, especially VIVA Kuwait. We believe the incumbent telecom operator s strong standing will persist. For 2Q2016, we estimate revenues of SAR 12.7 billion (+4% Y/Y, -0.4% Q/Q), driven mainly by the GSM segment with a contribution of 63% followed by data at 11%. Gross profit is expected at SAR 7.3 billion implying a 57% gross margin for the quarter, a -1.4% decline over 2Q2015 but a 60bps rise over the previous quarter. Decline in termination fees as well as increasing costs would be the culprits. After accounting for costs related to biometric verifications and other business expenses, we expect an operating profit of SAR 2.8 billion, -6% Y/Y. Net income is expected at SAR 2.3 billion for the quarter, -8% lower than for the same period last year but a minor decline Q/Q. The stock price has suffered at the Tadawul since CITC s termination fee announcement. However, we believe STC provides an attractive investment opportunity providing a total return of 20% (14% upside to our earlier target price of SAR 73.00 and a dividend yield of 6%). We maintain our Buy rating. Mobily: Normalizing financials We expect topline to decline -3% Y/Y but grow by a minor +1% Q/Q for 2Q2016 at SAR 3.5 billion. EBITDA margins have started to normalize in the preceding two quarters at 32%, which we expect to persist in 2Q2016 as well. 2Q2015 EBITDA margins of 2% were beaten down by SAR 800 million provisions against Zain arbitration, the Company has now built in a total of SAR 2 billion in provisions. Mobily has been concentrating on cost control and rationalizing its spending. Our gross margin forecast call for a 100 bps and 200 bps drop Y/Y and Q/Q respectively at 54%. With a token net profit, net margins are likely to stand at 0% versus a loss last year. Margin growth has started from 2Q2015 reflecting the impact of the first reduction in termination fees. Net income is expected at SAR 3 million for the quarter as compared to a SAR (901) million net loss last year. Zain: Rising subscriber numbers Revenues for the quarter are predicted to be at SAR 1.7 billion for Zain, a decline of -1% Q/Q but a rise of +4% Y/Y. As stated earlier, the Company is likely to be the primary beneficiary of the new termination fees issued by CITC. Zain s subscriber base has witnessed a solid rise, increasing by a CAGR of 7% over the past 5 years and currently stands at 11.5 million as of March-end. We expect a further growth to 11.7 million by June-end and market share at 23% as we approach the end of the year. Page 7 of 9
Cost of service is likely to decline by -5% Y/Y in 2Q2016 on the back of lower termination charges leading to a gross profit of SAR 1.06 billion, +12% higher Y/Y but -2% lower than 1Q. Operating expenses are expected to rise as Zain exerts greater marketing efforts to enhance its market share, hence expect a +6% Q/Q increase in distribution and marketing expenses. Loss at the operating level is estimated to persist in 2Q as well leading to a net loss of SAR (285) million for the quarter, an increase over the SAR (201) million loss last year. We estimate EBITDA at SAR 381 million versus SAR 436 million in 2Q2015. Zain is gradually gaining market share but debt and high initial licensing fee continues to hold it back. The stock has performed well recently with investors keeping an eye on debt repayment and pending legal battle with Mobily. We maintain our SAR 10.50 target price for now with a Neutral rating. Mixed stock performance Stock performance of the telecom companies has been a mixed bag as illustrated in exhibit 6 below. Exhibit 6: 2Q Telecom Sector vs. TASI Performance 6.0% 4.0% 2.0% 0.0% -2.0% STC Mobily Zain TASI -4.0% TTI -6.0% -8.0% -10.0% Source: Tadawul Page 8 of 9
Stock Rating Buy Neutral Sell Not Rated Expected Total Return Greater than 15% Expected Total Return between -15% and +15% Expected Total Return less than -15% Under Review/ Restricted * The expected percentage returns are indicative, stock recommendations also incorporate relevant qualitative factors For any feedback on our reports, please contact research@riyadcapital.com Disclaimer The information in this report was compiled in good faith from various public sources believed to be reliable. Whilst all reasonable care has been taken to ensure that the facts stated in this report are accurate and that the forecasts, opinions and expectations contained herein are fair and reasonable. Riyad Capital makes no representations or warranties whatsoever as to the accuracy of the data and information provided and, in particular, Riyad Capital does not represent that the information in this report is complete or free from any error. This report is not, and is not to be construed as, an offer to sell or solicitation of an offer to buy any financial securities. Accordingly, no reliance should be placed on the accuracy, fairness or completeness of the information contained in this report. Riyad Capital accepts no liability whatsoever for any loss arising from any use of this report or its contents, and neither Riyad Capital nor any of its respective directors, officers or employees, shall be in any way responsible for the contents hereof. Riyad Capital or its employees or any of its affiliates or clients may have a financial interest in securities or other assets referred to in this report. Opinions, forecasts or projections contained in this report represent Riyad Capital's current opinions or judgment as at the date of this report only and are therefore subject to change without notice. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or projections which represent only one possible outcome. Further, such opinions, forecasts or projections are subject to certain risks, uncertainties and assumptions that have not been verified and future actual results or events could differ materially. The value of, or income from, any investments referred to in this report may fluctuate and/or be affected by changes. Past performance is not necessarily an indicative of future performance. Accordingly, investors may receive back less than originally invested amount. This report provides information of a general nature and does not address the circumstances, objectives, and risk tolerance of any particular investor. Therefore, it is not intended to provide personal investment advice and does not take into account the reader s financial situation or any specific investment objectives or particular needs which the reader may have. Before making an investment decision the reader should seek advice from an independent financial, legal, tax and/or other required advisers due to the investment in such kind of securities may not be suitable for all recipients. This research report might not be reproduced, nor distributed in whole or in part, and all information, opinions, forecasts and projections contained in it are protected by the copyright rules and regulations. Riyad Capital is a Saudi limited liability company, with commercial registration number (1010239234), licensed and organized by the Capital Market Authority under License No. (07070-37), and having its registered office at Al Takhassusi Street, Prestige Building, Riyadh, Kingdom of Saudi Arabia ( KSA ). Website: www.riyadcapital.com Page 9 of 9