Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region

December 2017 HCM Viewpoint Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region hcm.com

Introductory Note Banks in the Gulf region have been gaining in importance in recent years, both locally and in foreign markets. Yet, in the current context of continuing pressure on oil prices and questions on regional stability, it is valid to ask how well Gulf banks are doing in terms of value creation, both on an absolute and relative basis. It is equally valid to ask whether the share price movements of these banks in recent years accurately reflect the internal value creation taking place at these institutions. This HCM viewpoint provides a comparative overview of 46 banks in the Gulf region. It finds that value creation in the Gulf banking sector has generally increased in recent years, though not at all banks. Further, it finds a plausible correlation between internal value creation and changes in share price for most banks. For others, however, stock returns cannot be fully explained by internal value creation. Looking at 2016, it appears that internal performance of banks in the Gulf region was to a large extent linked to macroeconomic fundamentals and the perceived ability of each country to sustain GDP growth and liquidity levels under the pressures mentioned above. The value perception by investors, as measured by TSR, further reflects shareholders views on the commodity markets and the resilience of Gulf economies in the near future. The goal of this study is not to provide any definitive performance evaluation of any bank or any sector, but to illustrate alternative and complementary methods for measuring performance. It also aims at helping each bank in its internal discussion on what key performance indicators (KPIs) are most relevant to it. Measuring performance is beneficial not just for knowing where one stands (ex-post value capturing), but perhaps more importantly for driving the desired value creation (ex-ante). HCM s work in the Gulf and around the world is to help boards of directors and senior management work on those factors that can impact value generation. This includes strategies for governance, financial steering, compliance, and compensation. We use a variety of financial and non-financial methodologies, including corporate culture. Regardless of your industry, please contact us if you can benefit from an approach that connects these topics to sound business strategy and financial stewardship. Value Creation: External and Internal Metrics As depicted in Figure 1, the market capitalization of the 46 Gulf banks1 covered by this study lies between USD 379 and USD 37 570 million as of 31 December 2016. The banking sector represents a significant part of the stock market in the Gulf region ranging from 26 (Saudi Arabia) to 69 percent (Bahrain) of public stock market capitalization. In general, company performance can be measured using external and internal indicators of value creation, which should be seen as two sides of the same coin. From an external perspective, one way to capture value is using Total Shareholder Return (TSR). In this viewpoint, we use TSR relative to the Dow Jones Islamic Market GCC Index. Using this metric, we find that many banks in the Gulf region have significantly increased their market value in recent years, particularly those from the UAE and Qatar. The median TSR value relative to the Dow Jones Islamic Market GCC Index was 9.8 percentage points (p.p.) above the index in 2012-2016. From an internal perspective, a widely used performance measure is Economic Profit (EP). Because it also reflects risk, EP can have certain advantages over other measures of performance. Notably, it reflects managerial performance and value added to shareholders wealth resulting from elements such as timely cost management decisions. However, EP provides investors with an incomplete picture of business results, particularly on a comparative basis: EP is an absolute measure. This complicates comparison of companies of different size without applying additional calculations and making adjustments. EP has a past-looking bias. It accumulates past success (e.g, strong brand) or past failures (e.g., inefficient retail banking network). As an example, 1 This study uses as a basis the Top 50 GCC Banks compiled by the Gulf Business magazine. However, this study does not include four banks for which no comprehensive data was available for the 2011-2016 period. 2 2017 HCM International Ltd. All rights reserved.

Figure 1: Overview of Gulf banks performance Company Country Market Capitalization (USD million) 31.12.2016 Economic Profit (EP) Dynamic 2012-2016 Change in EP (USD thousand) 2011-2016 Relative TSR (p.p) 2012-2016 Qatar National Bank Qatar 37'570 14% 736 32 Al Rajhi Banking Corporation KSA 27'303-3% -129-20 First Gulf Bank UAE 15'748 15% 413 199 National Bank of Abu Dhabi UAE 14'296 3% 90 61 Samba KSA 12'988-4% -88 10 Emirates NBD UAE 12'850 18% 804 202 National Bank of Kuwait Kuwait 11'994-10% -271-44 Abu Dhabi Commercial Bank UAE 10'513 4% 118 171 Saudi British Bank KSA 10'001 0% 7 8 Kuwait Finance House Kuwait 9'267 5% 176-27 Riyad Bank KSA 9'241-3% -71 8 Banque Saudi Fransi KSA 8'390-1% -24-18 Masraf Al Rayan UAE 7'745 13% 102 22 Dubai Islamic Bank UAE 7'496 20% 318 256 Qatar Islamic Bank Qatar 6'743 6% 59 12 Alinma Bank KSA 6'041 36% 234 36 Arab National Bank KSA 5'907 4% 60-20 Ahli United Bank Bahrain 4'381-5% -66 28 Alawwal Bank KSA 4'253-11% -96 70 Commercial Bank of Dubai UAE 3'968 1% 9 181 Commercial Bank of Qatar Qatar 3'441-35% -520-49 Union National Bank UAE 3'402-7% -80 71 Bank Albilad KSA 3'304 11% 59 76 Abu Dhabi Islamic Bank UAE 3'278 7% 92 69 Bank Muscat Oman 3'064-3% -46-34 Mashreq UAE 2'997 10% 192-54 Saudi Investment Bank KSA 2'847 1% 10 12.5 Boubyan Bank Kuwait 2'802 28% 84-59 Qatar International Islamic Bank Qatar 2'611 2% 6 15 Doha Bank Qatar 2'477-27% -236-40 Gulf Bank Kuwait 2'395 2% 12-83 RAKBANK UAE 2'260-22% -210 36 National Bank of Bahrain Bahrain 2'220-13% -36 65 Burgan Bank Kuwait 2'047-2% -27-47 Commercial Bank of Kuwait Kuwait 2'009 28% 159-75 Al Khalij Commercial Bank Qatar 1'681-9% -35-8 National Bank of Fujairah UAE 1'655-5% -16-2 Al Ahli Bank Kuwait Kuwait 1'590-15% -78-80 Bank AlJazira KSA 1'515 14% 92-19 Arab Banking Corporation KSA 1'151-13% -189-24 Bank of Bahrain and Kuwait Bahrain 1'150-5% -21 14 Bank Dhofar Oman 1'136-4% -14-38 Sharjah Islamic Bank UAE 1'017 18% 53 102 National Bank of Oman Oman 909-11% -41 0 Al Baraka Bank Group Kuwait 563-2% -26-58 Ithmaar Bank Bahrain 379 13% 70 56 2017 HCM International Ltd. All rights reserved. 3

EP Dynamic Insight EP Dynamic = EP2016 - EP2011 Average Trailing Revenue2011-2015 EP = Net Income - (Total Equity x Cost of Equity) EP does not sufficiently capture the efforts of a bank that has moved from a situation of negative EP to a breakeven point. From an EP perspective, such bank will still be seen as performing poorly when compared to a bank that started with a positive EP. The latter would be perceived as more successful even if it is only harvesting its past success. Thus, rather than using EP as the sole internal measure of value creation, in this study we use EP Dynamic. This approach is widely used by economic professionals. HCM successfully uses EP Dynamic with its clients, making in each case relevant adjustments. also be a drawback. For example, some inconsistencies can arise when using net income as a proxy for value after debt capital charge. Furthermore, even though all six countries reviewed in this viewpoint require listed financial institutions to use IFRS standards, this does not exclude the possibility of a bank using some form of short-term income management as a way to give the appearance of better performance. Thus, we find the EP Dynamic indicator to be more valid when used with at least fiveyear time horizon, in order to limit the effect of short-term income management. Value Creation Measured by EP Dynamic In this study, we have slightly modified the formula to reflect certain 2012-2016 changes in value creation.1 EP Dynamic is based on two variables: (1) EP, which after deducting capital charge, becomes a pure economic measure of net value to investors, and (2) revenue, which corrects EP for size differences.2 A deeper look into EP Dynamic sheds light on its two underlying components: change in the EP margin (EP divided by revenue) and growth in economic profitability. This approach captures how efficiently the value was created, rather than the mere fact that EP was positive or negative. This permits looking beyond any success or failure that may have been experienced before the performance period in question. It also allows focusing on future results and prospects. In addition, EP Dynamic captures internal value creation and is less impacted by market inefficiencies. Some company analysts favor EP Dynamic as it uses readily available accounting data and does not require sensitive assumptions. However, this convenience can Figure 2 shows cumulative EP Dynamic for the Gulf banks under review. The median EP Dynamic level is 0.9 percent, which is significantly lower than in the previous two years.3 In particular, EP growth in 2015-2016 was positive only for 14 banks under review (mostly from UAE and Kuwait). The performance of the banking sector in the Gulf region reflects adverse economic conditions due to the pressure of lower oil prices. Being largely dependent on oil exports, the Gulf economies experienced a low economic growth, which led to liquidity shortage and weak loan growth in the banking sector. The deterioration of the banking sector performance was the least evidenced in the UAE. The vast majority of UAE banks under review actually had a positive EP Dynamic for 2012-2016. The superior relative performance of UAE banks is explained by the fact that the economy is more diversified compared to other Gulf countries, which provides an opportunity for non-oil growth and thus supports credit growth. 1 A common way to calculate EP Dynamic is to divide absolute yearly changes in the EP by trailing revenue. 2 In the context of the banking industry, total revenue represents a sum of interest and non-interest bearing revenues of the bank. 3 See HCM Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region for 2015 and 2016. 4 2017 HCM International Ltd. All rights reserved.

Figure 2: EP Dynamic 2012-2016 Alinma Bank Commercial Bank of Kuwait Boubyan Bank Dubai Islamic Bank Emirates NBD Sharjah Islamic Bank First Gulf Bank Qatar National Bank Bank AlJazira Masraf Al Rayan Ithmaar Bank Bank Albilad Mashreq Abu Dhabi Islamic Bank Qatar Islamic Bank Kuwait Finance House Abu Dhabi Commercial Bank Arab National Bank National Bank of Abu Dhabi Gulf Bank Qatar International Islamic Bank Saudi Investment Bank Commercial Bank of Dubai Saudi British Bank Banque Saudi Fransi Al Baraka Bank Group Burgan Bank Bank Muscat Riyad Bank Al Rajhi Banking Corporation Bank Dhofar Samba Ahli United Bank Bank of Bahrain and Kuwait National Bank of Fujairah Union National Bank Al Khalij Commercial Bank National Bank of Kuwait National Bank of Oman Alawwal Bank Arab Banking Corporation National Bank of Bahrain Al Ahli Bank Kuwait RAKBANK Doha Bank Commercial Bank of Qatar Bahrain KSA Kuwait UAE Qatar Oman Median 0.9% -40% -30% -20% -10% 0% 10% 20% 30% 40% Calculated using USD values. Data source: Thomson Reuters. Analysis: HCM 2017 HCM International Ltd. All rights reserved. 5

Most Saudi Arabian banks demonstrated steady value creation in 2012-2015, however their EP decreased by 28 percent on average in 2016. Indeed, the local Saudi Arabian banks were consistently supported by significant dollar reserves and an expansive monetary policy, however, the economy faced large budget deficits in 2015 and 2016. As a result, Saudi Arabia was downgraded by the major credit agencies in early 2016, followed by a downgrade of most Saudi banks under review. These impairments represented a reputational threat affecting banking revenues and attraction of international investors. share buybacks). In addition, investors often judge on their investment performance in relation to alternatives available in the market. For this reason, many investors and analysts see TSR measured on a relative basis as a good performance indicator for aligning owners and managers interests. Figure 3 presents TSR over a five-year period for the Gulf banks relative to a benchmark, the Dow Jones Islamic Market GCC Index. The five-year cumulative return for this index was 36% as of the end of 2016. Bahrain and Oman were also subject to a credit downgrade in 2016, while almost all Bahraini and Omani banks in the sample had a negative change in EP as compared to revenue over 2012-2016. Banks in Kuwait and Qatar showed mixed results in terms of EP Dynamic. Despite the pressure of low oil prices, government spending in these countries remained at a high level in 2015-2016 with investment flows towards non-oil sectors. This situation was possible given low fiscal breakeven oil prices compared to other countries in the Gulf region. Moreover, central banks in these countries preserved liquidity, even though their foreign reserves decreased significantly in 2016. All of the above suggest that the banking system in these countries faced ambiguous conditions, but still had the opportunity to sustain pre-crisis profit levels. Best Measure of Value Creation For the purpose of analyzing the value created by Gulf banks, should TSR or EP Dynamic be favored? Clearly, TSR remains of foremost importance to investors it is simple, intuitive, and easily observable. Stock prices directly mirror performance as perceived by financial markets. In efficient markets, stock appreciation is an outcome of expected future company performance, while a stock price decrease suggests that the market negatively views the prospects of a company. Investment performance is typically measured by the increase in company value either in the form of share price appreciation or income distribution (dividends, Decreasing oil prices had a strong negative impact on the economy and stock returns, in particular for the banking sector. However, stock markets in the Gulf region demonstrated moderate recovery in 2016 and the majority of banks under review had a positive TSR performance for 2012-2016, relative to the Dow Jones Islamic Market GCC Index. The largest returns (more than 100 p.p. above index) were achieved by six Emirati banks. The bottom of the list in Figure 3 is composed of Kuwaiti banks, which demonstrated stock returns of 58 to 83 p.p. below the index. It is interesting to note that negative TSR was often not supported by corresponding changes in bank net assets. Price-to-book ratio, which is the most common valuation multiple for banks, has significantly decreased over a fiveyear period and almost half of the banks were traded at a value below the value of their net assets as of end-2016. However, assessing the performance of a bank using TSR only can be incomplete or even misleading, because TSR can sometimes be distorted by market conditions. Further, to the degree that TSR also reflects future expectations of investors, it can get ahead of or lag the actual value creation of a bank. Some of these issues can be overcome with the use of EP Dynamic. Its advantage is that it captures the actual internal value being created. As such, EP Dynamic can also be used to assess the rise or decline in enterprise value. And if accurately determined, EP Dynamic should also be reflected in stock returns when markets are operating efficiently. Thus, there should be a correlation between TSR and EP Dynamic. 6 2017 HCM International Ltd. All rights reserved.

Figure 3: TSR for 2012-2016, relative to Dow Jones Islamic Market GCC Index Dubai Islamic Bank Emirates NBD First Gulf Bank Commercial Bank of Dubai Abu Dhabi Commercial Bank Sharjah Islamic Bank Bank Albilad Union National Bank Alawwal Bank Abu Dhabi Islamic Bank National Bank of Bahrain National Bank of Abu Dhabi Ithmaar Bank Alinma Bank RAKBANK Qatar National Bank Ahli United Bank Masraf Al Rayan Qatar International Islamic Bank Bank of Bahrain and Kuwait Saudi Investment Bank Qatar Islamic Bank Samba Saudi British Bank Riyad Bank National Bank of Oman National Bank of Fujairah Al Khalij Commercial Bank Banque Saudi Fransi Bank AlJazira Al Rajhi Banking Corporation Arab National Bank Arab Banking Corporation Kuwait Finance House Bank Muscat Bank Dhofar Doha Bank National Bank of Kuwait Burgan Bank Commercial Bank of Qatar Mashreq Al Baraka Bank Group Boubyan Bank Commercial Bank of Kuwait Al Ahli Bank Kuwait Gulf Bank Bahrain KSA Kuwait UAE Qatar Oman Median 9.3% -100 p.p -50 p.p 0 p.p 50 p.p 100 p.p 150 p.p 200 p.p 250 p.p Calculated using USD values. Data source: Thomson Reuters. Analysis: HCM 2017 HCM International Ltd. All rights reserved. 7

Putting It All Together In Figure 4, we present both TSR and EP Dynamic in a two-dimensional graph. In addition, we define a trend line, which shows a positive correlation between EP Dynamic and TSR between 2011 and 2015, with a 1% change in EP Dynamic translating into a 1.7% change in stock returns (on average). Overall, the regression analysis confirms the validity of looking at bank performance both from an external (TSR) and internal (EP Dynamic) perspective. For the Qatari banks the correlation is robust with most of the banks being located close to the trendline. On the other hand, the stock price of many UAE banks increased more than explainable by EP Dynamic alone. Given the economy is more diversified and faces less issues related to dollar supply, investors seem to have more positive expectations about the Emirati banks. current level of internal value due to external threats, e.g. economic weakness related to oil prices or other external factors. Getting the Incentives and Governance Right Whatever may explain the gap between value creation and market valuation of a particular bank, what is clear is that each bank needs to understand how it can create value and manage investors expectations. In that sense, many steps can help in addressing the gap. This includes improving the quality of communication with shareholders and analysts, but also giving attention to underlying factors that can undermine shareholder confidence, such as uncertainties about corporate culture, corporate governance or compliance, or an insufficient link of performance to executive pay. The relationship between EP Dynamic and TSR for the Saudi banks appears weaker. Indeed, credit downgrades and a large budget deficit coupled with the on-going low oil price environment unveiled investors uncertainty regarding the resilience of Saudi economy and local banks. A mismatch between internal value creation and external valuation is observed for Kuwaiti and Bahraini banks: Specifically, all Kuwaiti banks demonstrated negative relative TSR even though most of them created value internally. By contrast, most Bahraini banks showed a positive relative TSR despite credit downgrades and a negative EP Dynamic. As discussed above, the main difference between EP Dynamic and TSR is that EP Dynamic reflects wealth actually being created by the bank, while TSR reflects the perception of value creation by investors. If a bank s stock price grew more than the wealth actually created, this would mean that investors are confident about the company s future. In this case, TSR will continue to overestimate the bank s actual performance until the bank either increases its internal value creation or the share price decreases. It is a great challenge to identify the right performance indicator that captures all aspects of value creation. This study focuses on two possible metrics, TSR and EP Dynamic. Which metric or combination of metrics are appropriate for a particular bank depends on many factors, including its owner strategy and strategic goals, as well as the external market and country-specific conditions. HCM has deep experience working with companies around the world on these and related challenges. In each case, we factor in each company s individual situation and complexity. As compensation and governance experts, HCM also supports companies in ensuring that the managerial incentives and the governance system are properly calibrated to promote sustainable financial and corporate success. Please contact us if we can be of help to your institution in addressing any of these areas. The inverse situation will occur where TSR is disproportionally low vis-à-vis EP Dynamic. In such case, the cause may relate to ineffective communication by the bank to investors. Moreover, the market might not have confidence that the company can continue creating the 8 2017 HCM International Ltd. All rights reserved.

Figure 4: Link between EP Dynamic and relative TSR 250% Size of the bubbles corresponds to the market capitalization as of 31.12.2016 200% 150% Relative TSR 2012-2016 100% 50% 0% -50% -100% -40% -30% -20% -10% 0% 10% 20% 30% 40% EP Dynamic 2012-2016 Bahrain KSA Kuwait UAE Qatar Oman Data source: Thomson Reuters. Analysis: HCM 2017 HCM International Ltd. All rights reserved. 9

About the authors Olga Beregova is a Partner with HCM International Ltd. During her 13 years of professional experience in consultancy she has successfully steered extensive compensation and governance changes for Swiss and international companies, both private and public. Her expertise extends across multiple industries which include manufacturing, consumer products, energy, financial services, technology, telecommunications and transportation. Olga Beregova holds a Master s degree in Finance and Capital Markets from University of Zurich and in Linguistics from Kiev State University of Foreign Languages. olga.beregova@hcm.com Anastasiia Medianovska is a research analyst primarily dealing with the analysis and evaluation of executive compensation frameworks, including assessment of risk/ payout profiles and calibration of short- and long-term variable compensation plans. Ms. Medianovska holds a Master of Science in Finance from the Universities of Neuchatel, Lausanne and Geneva, as well as a Master s degree in International Economics from Kiev National Economic University. She passed all three levels of the CFA Program and may be awarded the charter upon completion of the required work experience. anastasiia.medianovska@hcm.com For further information on HCM services for the Gulf Countries, please contact the HCM Partner responsible for the Gulf region: Gabe Shawn Varges Senior Partner Tel. +41 44 560 33 20 gabe.shawn.varges@hcm.com 10 2017 HCM International Ltd. All rights reserved.

About HCM International HCM International (HCM) is a leading independent international advisory firm specializing in the strategic aspects of Governance, Compliance, Finance, and Compensation, with deep experience across various industries and in the advising of boards, board committees, senior management, and control functions. HCM s partners, managers, and analysts work in its offices in Zurich, Geneva and Kiev. They are bolstered by our global partners in the US, UK, France, Australia, Singapore, and China, which allow us to reach all major markets and support companies of all sizes, from large multinationals and public institutions, to mid-sized and smaller companies, including those preparing for an IPO. Our mission is to support companies and other organizations tackle the ever important question: How to measure, steer and allocate value creation? We also cover governance, risk and compliance as these also affect value. The value question is of core interest not only to Owners, Board of Directors and Senior Management, but also increasingly to institutional investors, proxy advisors, HR and control functions, regulators, and international standard setters. HCM is Chair of the Global Governance and Executive Compensation Group. Swiss Offices Zurich Muehlebachstrasse 23/25 CH-8008 Zurich Phone +41 44 560 33 33 international@hcm.com Geneva 8 rue des Charmilles CH-1203 Geneva Phone +41 22 339 88 50 geneva@hcm.com 2017 HCM International Ltd. All rights reserved. 1 1

HCM International Ltd. Muehlebachstrasse 23/25 CH-8008 Zurich Phone: +41 44 450 33 33 contact@hcm.com hcm.com