sound institutional framework, robust fiscal framework, supportive public sector
industrial policies, appropriate business climate and human capital are important factors
in enabling successful diversification away from the oil sector. A backdrop of low oil
prices exacerbates diversification challenges but also provides impetus for change.
Saudi comprehensive reforms follow standard template to shift gears
The Saudi NTP broadly follows the generally accepted template of comprehensive
macro- and micro- reforms needed to diversify beyond the hydrocarbon sector, in our
view. The literature suggests successful diversification entails ideally a combination of
three types of innovations: processes, products and organizations. Enhancement in
processes would enhance productivity, new products would support emergence of new
sectoral growth drivers, and improved micro- and macro-governance would help sustain
production gains. The key to furthering the development path would be to move from an
initial labour- and capital-intensive phase towards a phase focused on increasing
productivity growth through higher value-added sectors.
This will require the retention of white-collar workers, steady progress on institutionbuilding,
an increase non-hydrocarbon FDI, horizontal and vertical integration, a broader
manufacturing base including at first through sectors with competitive advantage
(downstream or energy-intensive ones), greater integration into the global value chain
through enhanced trade relations, as well as education and business climate reform to
overcome structural rigidities, in our view.
Medium-term diversification may require Fx reform
As diversification progresses, the case for increased Fx flexibility and making space for
autonomous monetary policy conduct is likely to gradually take shape. Presumably, such
a move would require putting in place a supportive institutional structure which is
currently broadly lacking. It would also await improvements in productivity growth and
the development of competitive local industries to minimize a potential Dutch disease
effect on infant or other sectors. A fairly valued real effective exchange rate (REER)
would support efficient allocation of production factors across sectors and improve
competitiveness of the tradable goods sector.
Malaysia case study highlights the role of supportive public sector
Malaysia’s diversification away from primary commodities relied on a series of National
Industrial Policies and Industrial Master Plans to promote the manufacturing sector.
Focus was given to sectors with high export potential, and efforts were taken to create
linkages with other sectors and to deepen interconnection with other industries. Growth
strategies also aimed to develop local technological capabilities and clusters of
industrial development, similar to the localization and industrial strategies spearheaded
by the Saudi National Transformation Plan.
GEMs Paper #26 | 30 June 2016 31
Chart 27: The launch of government industrial policies in the 1980s helped Malaysia diversify
35
Manufacturing value-added (% of GDP)
30
Manufactured exports (% of merchandise exports, rhs)
25
20
15
10
5
0
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
100
80
60
40
20
0
Source: Haver, BofA Merrill Lynch Global Research
Norway case study suggests institutions are paramount
While it is perilous to extend lessons that could overemphasize idiosyncracies, the case
of Norway highlights, if anything, the importance of sound institutions and macro
management when it comes to broader economic diversification. The case of Norway
has relevance for the Gulf Cooperation Council countries (GCC), including Saudi Arabia,
especially since oil discovery (late 1960s) and oil production (1970s) timelines were not
that sensibly different from the GCC.
That being said, outcomes were widely different as well as the starting point since
Norway was already a developed country with mature social, economic and political
institutions at the time of the discovery of oil. This allowed a distinction between the
management and ownership of natural resources uncommon in the GCC and several
other resource-based economies, in our view.
Four ways in which the supply-side matters for economic diversification
We believe that there are four lessons to learn from Norway’s outperformance:
1) The importance of human capital
Norway’s priorities from early on were to build human capacity, investing in education,
increasing labor force participation and supporting productivity growth.
2) Prudent conduct of fiscal policy
Current Norwegian oil revenue management puts considerable emphasis on stabilizing
the economy and facilitating a gradual phase-in of oil revenues over time (which crowds
out trophy projects and put onus on achieving productivity gains in the non-oil sector).
Following the 1970-80s boom-bust sequence and expansion of the welfare state,
Norway established in 1991 a Government Petroleum Fund to receive and invest oil
revenue (it received its first net transfer in 1996). The fiscal rule adopted in 2001
targets a central government structural non-oil budget deficit equal to 4% of GPF assets
(the latter assumed to be its estimated long-run real rate of return). That being said,
Saudi Arabia’s infrastructure requirements could have prevented adapting this part of
Norway’s model for long, in our view.
3) Institutional experience
Norway’s development has been characterized by continuous development and
integration of resource-based export-oriented industries, some of which were active
since 1950. While Norway is the world’s third largest exporter of natural gas and the
sixth largest of crude oil, it is also the second largest exporter of seafood, possesses the
fourth largest shipping fleet, is the sixth largest exporter of aluminium and the first
exporter of sub-sea technology products and services.
32 GEMs Paper #26 | 30 June 2016
4) Industrial policy
Norway’s active use and introduction of a national industrial strategy has helped shelter
infant industries and create linkages between the natural resource-based industries and
other sectors of the economy. For two decades (1972-1994), preference was given in a
transparent fashion to local content in procurement to help build supply industries, and
provisions were set in for international firms to train nationals, use domestic service
industries and cooperate in R&D with local institutions. Though Norway pre-dates the
GCC in this development, the region shares in many ways some of these policies,
leading to the emergence of national champions. The main difference appears to relate
to the scope, extent and degree of innovation involved in offshoot industries at this
stage, in our view.
Chart 28: Norway real GDP per capita growth outpaced GCC over the
past decades
300
250
200
150
100
Real GDP per capita (1970=100)
Norway
Saudi Arabia
Other GCC (1980=100)
Iran
50
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
Source: Haver, BofA Merrill Lynch Global Research
Chart 29: Norway outperforms Saudi indicators on a per capita basis
6
5
4
3
2
1
0
Real GDP growth
(%)
Saudi Arabia
Oil real GDP
growth (%)
Norway
Non-oil real GDP
growth (%)
Per capita non-oil
real GDP growth
(%)
Source: Haver, BofA Merrill Lynch Global Research. Data represents averages over 1979-2014.
Chart 30: Norway’s hydrocarbon sector share in real GDP has dropped
120
Oil prices (US$/bbl)
40
100
Oil sector (% of real GDP, rhs)
35
30
80
25
Chart 31: Human capital is Norway’s most important resource
7%
9%
2%
60
20
40
20
15
10
5
82%
0
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
0
Discounted value of labor
Discounted petroleum rent
Real capital
Financial assets
Source: Haver, BofA Merrill Lynch Global Research
Source: Norway Ministry of Finance, BofA Merrill Lynch Global Research
GEMs Paper #26 | 30 June 2016 33
Eurobond premium required for fiscal slippage risk
We expect large and regular sovereign eurobond issuance going forward to support FX
reserves and domestic liquidity but weigh on regional bond spreads if risk appetite does
not hold up or fiscal slips. EMBIG index inclusion is unlikely, in our view. Saudi Arabia
CDS premium to Qatar and likely larger issuance size suggests Saudi External Debt
(EXD) is likely to be issued at a premium to Qatar.
Saudi Arabia international bond issuance latest in wave of Gulf supply
Local press suggests that Saudi Arabia is gearing up for a large international bond
issuance program (US$10-15bn issuance target this year), which, if confirmed (the
government neither confirmed nor denied , should add to the sizeable sovereign bond
supply pipeline this year. So far, we have seen US$17.1bn in gross and net supply from
the Gulf Cooperation Council (GCC) countries. Assuming Saudi Arabia issues US$15bn
and accounting for planned issuance from Dubai and Bahrain and excluding Kuwait, the
rest of this year should see a further US$16.5bn in gross issuance and US$16.1bn in net
issuance. This would bring the total gross and net GCC sovereign bond issuance to
US$33.6bn and US$33.2bn this year respectively.
Seminal potential bond issuance has multi-pronged implications
If confirmed, this could be a seminal event and mark the first time for the Saudi
government to issue external bonds. It would allow for participation of foreign investors
as domestic debt is being sold to Saudi banks and funds. External issuance should
diversify funding sources, lock in still low interest rates, support SAMA's Fx reserves and
support domestic liquidity; the latter two macro variables have weakened this year.
External issuance would also imply the presence of an underlying asset that could
theoretically trigger CDS contracts, as opposed to the current situation.
Investment grade status to be retained despite likely further rating cuts
A prolonged oil price downturn is likely to continue to put downward pressure on Saudi
Arabia’s credit rating in the medium-term. On average, the GCC has benefited from
three notch rating upgrades over the period 2002-10 prior to the start of the Arab
Spring. Saudi Arabia was upgraded six times, from Baa3 to Aa3, by Moody's over the
period starting from 1999, while it was upgraded two and three notches by S&P and
Fitch over the period starting from 2003/2004 respectively. Moody’s has thus in the
past preserved Saudi Arabia’s investment grade rating at the bottom of the cycle, as
government debt to GDP stood at 103% of GDP and SAMA’s foreign assets at US$17bn
(10% of GDP) in 1999.
EMBIG Index inclusion is unlikely
EMBIG index inclusion is unlikely, in our view. Estimated 2013 (US$25,140) and threeyear
rolling GNI per capita (US$23,090) data likely suggests Saudi Arabia does not meet
EMBIG income index inclusion criteria, in our view. Saudi Arabia would however likely be
eligible for Barclays EM Hard Currency Aggregate Index, based on its IMF classification
as a non-advanced country (noting that the index provider has moved away from solely
using rating for EM country classification). This suggests that Saudi policy-makers need
to articulate a comprehensive, timely and credible medium-term fiscal policy to
facilitate wide take-up from domestic, regional and international investors, in our view.
Pricing matters
Saudi Arabia CDS premium to Qatar, relative credit metrics and likely larger planned
issuance size suggests Saudi EXD is likely to be issued at a premium to Qatar, in our
view. The closest regional peers to Saudi Arabia (A1/A-/AA-) are likely Qatar (Aa2/AA/AA)
and Abu Dhabi (Aa2/AA/AA). Qatar’s existing external debt curve makes it a potentially
34 GEMs Paper #26 | 30 June 2016
useful and relevant pricing benchmark in this regard, in our view. The Qatar 10-year
sovereign bond currently trades at yields of 3.0%. However, Saudi CDS has been trading
c65bps wider of Qatari CDS, which would suggest a 10-year Saudi bond yield of c3.65%.
Current CDS spread levels suggest potential for some notch downgrades from Saudi
Arabia’s current rating, as the market prices in issuance risk, volatile oil prices, hedging
flows relative to the USD peg and the banking sector off-balance sheet wrong-way
exposure risk.
Saudi forwards, rates and CDS remain under pressure
Domestic rates are under pressure with the 5y IRS spread over US at historically
elevated levels due to structurally tighter liquidity. Budget consolidation could help take
some of the pressure off as it would imply lower debt issuance needs. However, it would
also imply lower deposit formation in domestic banks as fiscal retrenchment will impact
private sector economic activity. Greater risk premium, issuance pressures and tighter
liquidity will also keep CDS spreads elevated until oil recovers.
Hedging against SAR devaluation risks remains strategically attractive given the riskreward
ratio. Data suggest a strained backdrop for external and domestic liquidity
reflecting the combination of private sector dollarization, possible capital outflows,
weakening deposit formation and the move higher in interbank rates. However, SAMA
has already intervened through macro-prudential tools and may do so again if needed.
Chart 32: Market remains nervous on Saudi Arabia
3
2
1
0
-1
-2
-3
Implied appreciation in 1-yr SAR fwd (%)
Oil prices (US$/bbl, rhs)
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
Source: Bloomberg BofA Merrill Lynch Global Research.
160
140
120
100
80
60
40
20
0
Chart 33: A pronounced increase in SAR swap spreads vs USD
%
6
Spread (rhs)
SAR 5yr swap
bp
250
USD 5yr swap
5
200
4
3
2
1
0
0
Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16
Source: Bloomberg BofA Merrill Lynch Global Research.
150
100
50
GEMs Paper #26 | 30 June 2016 35
Exhibit 2: Saudi credit risk prices in rating downgrades
Source: Bloomberg BofA Merrill Lynch Global Research.
Commodities: NTP adds to medium-term oil
market tightness
Francisco Blanch
MLPF&S
francisco.blanch@baml.com
Peter Helles
MLI (UK)
peter.helles@baml.com
The Saudi National Transformation Plan (NTP) suggestion that production capacity is to
be maintained at the current level until 2020 reinforces our conviction of medium-term
oil market tightness. We continue to see a call on OPEC of 4.1mn bpd in the next five
years to “balance the market”, and see oil prices of US$55-75/bbl over 2016-2020.
Although the NTP incorporates a target of boosting domestic gas production by 50% to
18 bcf/d by 2020 which could crowd out oil demand, we expect Saudi Arabia’s ability to
switch to reduce oil burn in power generation to 2020 to be quite limited, in our view.
We see oil averaging US$55-75/bbl over 2016-2020
Real Brent prices are at one of the lowest levels in decades, and will likely encourage
very strong demand growth ahead, while we see supply falling across non-cartelized
producers. As such, we see global light sweet crude oil averaging US$55 to US$75/bbl
over the 2016-2020 period, depending on how much incremental production OPEC can
and will supply over the next five years. We think it likely that Saudi will dig into its
untested spare capacity to go for increased market share, though uncertainty over how
much Saudi can and will produce remains. We also remain concerned about output
sustainability among weaker cartel members given the rapid credit profile deterioration.
36 GEMs Paper #26 | 30 June 2016
Chart 34: Real Brent prices are at one of the lowest levels in decades,
and will likely encourage very strong demand growth ahead
140
120
100
80
60
40
20
Real and nominal yearly average Brent crude oil prices
US$/bbl
0
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15
nominal oil price
Source: BP, Bloomberg, BofA Merrill Lynch Commodities Research
2016YTD
real oil price, rebased to 2016YTD price level
Chart 35: We see global light sweet crude oil averaging US$55 to
US$75/bbl over the 2016-2020 period
110
100
90
80
70
60
50
40
Medium term oil supply & demand (2016-2020)
avg oil price
(US$/bbl)
mn bpd growth, 2016-20
2 3 4 5 6 7 8 9 10
supply (OPEC 2.9): low
supply (OPEC 4.2): base*
supply (OPEC 5.5): high
demand
Source: IEA, BofA Merrill Lynch Commodities Research
*4.2 mn b/d OPEC supply: Saudi: 1.3 mn b/d; Iraq: 0.8 mn b/d; other OPEC crude: 1.7 mn b/d; 0.4 mn
b/d OPEC NGLs.
Non-OPEC production will not reach 2015 levels before 2020 at the earliest…
Non-OPEC producers have massively reduced capex spending, down US$290bn or 42%
from 2014 to 2016, in response to the low price environment. Should capex start to
increase again in 2017, the effect on non-OPEC non-shale production is unlikely to be
felt before 2020 at the earliest. Most of the decline in the short term comes from nonconventional
output in the US, as shale is very price sensitive within a 12-month
horizon. With Brent prices set to increase from US$46/bbl this year to US$80/bbl in
2020 in our base case, we believe US shale production will grow again, albeit at a slower
rate than in the past four years. Total non-OPEC supply is set to drop to 56.4mn bpd in
2017 before rebounding to 57.5 mn bpd in 2020, a similar level as in 2015.
Chart 36: With Brent prices set to increase to US$80/bbl in 2020, we
believe US shale output will grow again, albeit at a slower rate
Non-OPEC oil supply growth by major country
3.0
2.5
mn b/d, YoY
2.0
1.5
BofAML f'cast
1.0
0.5
0.0
-0.5
-1.0
2010 2012 2014 2016F 2018F 2020F
US Canada Mexico
North Sea Russia Kazakhstan
Asia Brazil Sudan/So. Sudan
other
total non-OPEC
Source: IEA, BofA Merrill Lynch Commodities Research
Chart 37: Linking this with our 5-year price deck suggests marginal US
shale output grows in 2017 and acceleration thereafter
8
6
4
2
0
mn b/d
Shale production forecasts aligned with BofAML WTI
price assumptions
2013 2014 2015 2016 2017 2018 2019 2020
base 2016@$45/bbl 2017@$59/bbl 2018@$67/bbl 2019+@$75/bbl
Source: EIA, BofA Merrill Lynch Commodities Research
4.1mn bpd needs to be added by OPEC by 2020, namely Saudi, Iran and Iraq
The US is the only country able to ramp up production among non-cartelized players by
2020, so OPEC has to come to the rescue to provide the required incremental supplies.
We estimated that demand will grow by 5.9mn bpd in 2015-20. With the market
oversupply of 1.8mn bpd in 2015, OPEC needs to increase production by 4.1mn bpd in
the next five years to “balance the market”. Saudi Arabia could make up for half of this
given its c2mn bpd of spare capacity, and we believe it intends to at least increase its
market share. We would expect other OPEC countries to expand their capacity in the
GEMs Paper #26 | 30 June 2016 37
next five years, namely Iran and the UAE. As for Libya, the current turmoil needs to
come to an end, while the scale of any Iraqi long-term output increase remains the
biggest uncertainty.
Chart 38: We estimated that demand will grow by 5.9mn bpd in 2015-
20
105
100
95
90
85
80
75
70
65
mn bpd
Global oil consumption
BofAML
fcast
60
87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19
Source: IEA, BofA Merrill Lynch Commodities Research
Chart 39: Other than Saudi Arabia, some OPEC countries will also expand
their capacity in the next five years, namely Iran the UAE
Kuwait
Algeria
Qatar
Venezuela
Angola
Ecuador
Nigeria
UAE
Libya
Iran
Saudi Arabia
OPEC capacity growth, 2015-2020F
mn b/d
-0.3 -0.1 0.1 0.3 0.5
Source: IEA, BofA Merrill Lynch Commodities Research
Saudi plans to keep capacity flat add to medium term tightness
Saudi Arabia has 12.5mn bpd of crude production capacity, according to the
government, and the country suggested within the NTP that it plans to maintain
capacity at the current level to 2020. Saudi Arabia is the only material holder of spare
crude oil production capacity around the world. Spare capacity currently sits at c2mn
bpd, which is one of the lowest levels ever. Even if Saudi Arabia did start investing
today, it would take a number of years to be completed and would unlikely be ready
before 2020 in any case. Hence, as Saudi ramps up production over the medium-term by
digging into its spare capacity, the risk premium in the oil market will rise as the market
becomes increasingly less able to handle future supply disruptions.
Chart 40: The supply side in oil faces a lot of disruptions linked to
geopolitics and broad economic mismanagement
6
mn b/d
Major oil supply disruptions
(excluding disruptions due to OPEC policy changes)
5
post Arab spring
Kuwait,
4
3
2
Iraq,
Venezuela,
oil strikes
Nigeria
unrest
Iraq,
Gulf War
1
(and oil embargo)
0
90 91 92 93 94 95 96 97 98 99 00 01 03 04 05 06 07 08 09 10 11 12 13 14 16
Iraq, civil war
Libya, civil war
Nigeria, oil theft
Syria, civil war
Yemen, civil war
Iran, US/EU embargo
Source: IEA, BofA Merrill Lynch Commodities Research
Chart 41: Saudi Arabia has 12.5mn bpd of crude production capacity,
and currently is c2.0 of spare capacity over current production
4.5
4.0
3.5
3.0
2.5
2.0
1.5
mn b/d
Saudi Arabia spare crude oil production capacity
1.0
Jan-09 Nov-09 Sep-10 Jul-11 May-12 Mar-13 Jan-14 Nov-14 Sep-15
Source: IEA, BofA ML Commodities Research. IEA estimates Saudi production capacity at 12.2mn bpd
If Saudi gas production gets off the ground, it could crowd out oil demand…
The Saudi NTP plans to grow domestic gas production by 50% to 18 bcf/d by 2020, and
to use most of this gas to meet a 30% rise in domestic power demand and moreover
boost gas’ share in power generation to 70%, up from 50% currently. This implies that
oil burned for power generation could drop by 30% or 300 thousand bpd by 2020, most
of which would likely be crude which is more valuable in the export market than the
38 GEMs Paper #26 | 30 June 2016
residual fuel oil burned. Saudi Arabia has the world’s 4 th largest gas reserves, yet
reaching the 5.8 bcf/d production growth target by 2020 is not that straight forward.
…though boosting gas production to the NTP target poses significant challenges
The new Wasit project, which is due to come online in 2016 and ramp up to 2.5 bcf/d by
2020, meets about 40% of the gas production growth target. Other than that, Saudi
Arabia is focusing on getting unconventional production off the ground to meet the
remaining 3.3 bcf/d of the production growth target. The timing, cost and commercial
feasibly of which this unconventional gas is highly uncertain. The 2.5 bcf/d from the
Wasit project is about the amount of gas that would be needed to meet incremental
power demand and displace 300 thousand bpd of crude burn, assuming gas demand
does not grow in other sectors, which is unlikely. Hence, it is likely that Saudi’s ability to
switch significantly to reduce oil burn in power generation to 2020 will be quite limited,
explaining the new openness to consider gas imports, in our view.
Chart 42: Oil burned for power generation could drop by 30% or 300
thousand bpd by 2020, most of which would likely be crude
1,200
Saudi oil demand in power generation
k bpd
1,000
crude burn
resid
800
600
Chart 43: Other sectors like petrochemicals and industry will see their
gas demand grow as well
Saudi natural gas consumption, 2013
oil & gas
extraction, 0.3
bcf/d
industry, 2.6
bcf/d
petchems, 0.5
bcf/d
400
200
0
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
power
generation, 4.4
bcf/d
Source: IEA, BofA Merrill Lynch Commodities Research
Source: IEA, BofA Merrill Lynch Commodities Research
Equity Strategy: more clarity required, but
investible themes emerging
Hootan Yazhari, CFA >>
Merrill Lynch (DIFC)
hootan.yazhari@baml.com
More clarity required, but high level benefits becoming evident
The recent National Transformation Program (NTP) document provided a much awaited
articulated roadmap through 2020 of how the government is seeking to achieve its
highly ambitious Vision. However, we believe significantly more detail is still required
before the market can make more concrete conclusions on the key winners and losers
from the program as well as quantify the impact it could have on corporate earnings
(both positive and negative).
Whilst at this juncture it is difficult to quantify the size of the NTP opportunity for
individual companies, we feel more confident in highlighting the sectors that we see
could benefit from Saudi Arabia ambitious plans. We have detailed the sectors that we
see as likely benefiting most in the table below. We also highlight the sectors which
could face the most negative impact from the roll out of the NTP.
GEMs Paper #26 | 30 June 2016 39
Table 13: Summary of key sectors likely benefiting from and impacted by the National Transformation Program
Sectors likely benefiting from NTP
Petrochemicals
Healthcare
Insurance (healthcare)
Real estate
Consumer staples
Telecom
Metals and mining
Defence
Rationale
With US$ 11bn being allocated to project development, downstream chemicals second largest focus of NTP; significant increase
in natural gas availability (indigenous and imported); expansion opportunities
Volume growth opportunities for private healthcare providers (management contracts); private health insurance growing;
participation in privatisations; significant increase in local pharmaceutical production
Private insurance coverage to increase to 31mn from 10.5mn currently; rising availability of private healthcare facilities
Higher home ownership targeted; improved access to financing/housing subsidies to both developers and buyers; volumes set to
expand as NTP targets higher real estate sector growth; increased opportunities for private sector investment
Demand growth from religious tourists; formalisation and Saudisation of retail sector; growth in locally produced poultry sales;
longer-term private sector job creation
Government spending US$2bn to enhance FTTH and Mobile networks; focus on increasing internet usage; religious tourism will
boost demand
Provision of new mining licenses; potential investment opportunities for international mining companies
Increased localization will cut imports, develop local industrial capabilities and create jobs
Sectors likely negatively impacted by NTP Rationale
Consumer discretionary Near-term squeeze on consumer disposable income and sentiment; increased competition as foreign entities given 100%
ownership entitlement; development of Saudi postal system possibly a precursor to online shopping increase
Petrochemicals
Potential reduction in feedstock subsidies; potential for increased competition from international companies
Real estate
Land tax on white land could impact cost base and prices in urban areas; higher competition from new entrants
All sectors
Source: National Transformation Program, BofA Merrill Lynch Global Research,
Six key investible themes from the NTP are emerging
Using this frame work we believe a number of investible themes are emerging including:
Rising costs on reduced subsidies (particularly water and energy); higher wage costs; increased financing burden on private
sector as government partially shoulders NTP costs
1. Ambitious plans to grow religious tourism: with Hajj visitors set to increase
from 1.5mn to 2.5mn and Foreign Umrah Pilgrims from 6mn to 15mn per
annum, we see significant potential for the travel & tourism, transport sectors,
consumer discretionary and telecom services sectors to benefit.
2. Down trading as pressure mounts on the consumer: With the NTP looking
to reduce subsidies on energy (including transport fuels) and water, we see
pressure on the disposable income of Saudi consumers rising in the short- to
medium-term (although in the longer term, we expect higher employment
levels, growing home ownership and accelerating growth to offset these
factors). These issues could be further augmented by a slowdown in public
sector wage growth and growth in the proportion of residents employed by the
private sector,
In reflection, we believe that the consumer will likely become more value
conscious in the near- to medium-term as stress on consumer discretionary
spend mounts. As such, we continue to prefer the consumer staples and the
grocery retailers in this environment. We also believe the grocery retailers will
benefit from the government’s focus on formalising the sector (it is highly
fragmented currently and dominated by smaller independent stores) in an
effort to increase Saudi participation. That said, we believe consumer
discretionary companies which offer more affordable and economic goods
could benefit as they take market share.
3. Rising focus on healthcare provision: Saudi Arabia is focused on significantly
growing accessibility to healthcare for its residents. The provisions in the NTP
include a significant increase in medical centres (hospitals and clinics), wider
provision of private health insurance and an increase in the level of
40 GEMs Paper #26 | 30 June 2016
pharmaceuticals manufactured locally. We thus see potentially strong
opportunities for the private hospital operators, the health insurance providers
and local pharmaceutical manufacturers.
4. An improvement in the availability of affordable housing for Saudi
nationals: The Saudi housing shortage has been a persistent issue for the
country; with the shortfall currently standing at an estimated 1.2mn units, in
our view. Looking forward, we believe this shortfall will likely intensify given
strong demand formation. The NTP is seeking to introduce greater numbers of
affordable housing units and greater availability of financing. Indeed, the
ministry of housing is looking to invest cUS$16bn in achieving these aims by
2020. Whilst we do not believe these measures go far enough to fully resolve
the housing shortage, we nevertheless see material opportunities for Saudi real
estate developers.
5. Growth in telecom/fibre infrastructure: The NTP is seeking to greatly
enhance connectivity in the country, largely through increased usage of
internet. Reflecting that, the government has pledged approximately US$2bnn
to significantly increase the availability of high speed FTTH networks in remote
areas, increase mobile broadband coverage and density in urban centres
(3G/4G) and allocate an increased amount of bandwidth to the mobile service
providers. We thus see significant volume growth potential for the telecom
service providers (particularly with regards to mobile data, where we see scope
for price increases). Furthermore, we expect much of the capital expenditure
required to expand the FTTH and Mobile networks to be provided by the
private sector, which in our view will accelerate the case to spin off their tower
portfolios (as a method of funding capex expansions).
6. Significant growth in downstream petrochemicals capacity and metals &
mining: The NTP’s drive to diversify revenues away from the oil sector has
seen it focusing on exports of non-oil commodities. In particular, we highlight
the significant investment it has earmarked for the downstream industries
including petrochemicals and oil refining, as well as aggressively growing the
country’s metal and mining operations (likely through national champion,
Maaden). Examples include the expansion of the country’s base metals
production (e.g. bauxite and phosphates) and the construction of an oils-toolefins
project. The further development of capital intensive industries also
provides some scope for Saudi Arabia to develop service industries and
increase local content provisions, in our view. These could be facilitated
through joint-ventures with global service providers, who may consider
manufacturing plants in Saudi Arabia.
How to gain exposure to NTP themes
In reflection of the themes articulated above (and in the sections that follow), we
highlight the sectors and companies which have exposure to each of these themes in
the table below. The companies highlighted in green represent the companies which are
currently Buy rated by our fundamental analysts and also fit in with our theme of
gaining exposure to the NTP.
GEMs Paper #26 | 30 June 2016 41
Chart 44: Summary of sectors and companies with exposure to key NTP themes (companies highlighted in green are rated Buy and represent our top picks)
Theme 1 Theme 2 Theme 3 Theme 4 Theme 5 Theme 6
Religious Tourism Downtrading Healthcare provision
Growth in Affordable
housing
Telco infrastructure
growth
Increase in none-oil
commodity exports
Sectors to
benefit
Travel & Tourism Consumer staples Private Hospitals Real Estate Telecoms Petrchemicals
Transport Consumer Disc. Insurance co's Construction Training & Education Metals & Mining
Consumer staples Training & Education Pharma Banks Industrials
Training & Education Training & Education Training & Education Training & Education
BofA ML
coverage with
exposure
STC Savola Al Hammadi Dar al Arkan STC SABIC
ZAIN KSA Almarai Dallah Zain KSA Maaden
Savola Al Othaim Yansab
Almarai Al Hokair Safco
Al Othaim
Jarir
Other Companies with
exposure
Mobily Sadafco Mouwasat Emaar Economic city Mobily Petrorabigh
Sadafco Halwani Brothers Care Saudi Banks Al Khaleej Training Zamil
Al Tayyar Nadec MEAHCO Al Khaleej Training Al Khaleej Training
Dur Hospitality Saudi Marketing Spimaco
Saudi Ground Serv . Al Khaleej Training Bupa
Saudi Catering
Tawuniya
Al Khaleej Training
Med Gulf
Source: BofA Merrill Lynch Global Research
Saudi market valuation not testing
The Saudi market has been one of the poorest performing emerging markets year-todate,
underperforming the MSCI EM indices by approximately 10% (and c20% since
August 2015). A combination of weak oil prices and their inevitable impact on the Saudi
economy including slowing economic growth, rising operational risks and fiscal
consolidation (including subsidy removals) have been the key drivers. The
underperformance has left the market trading on a 12mth P/E of c.13x, an 11% discount
to its long term average and its lowest premium to GEMs since 2010 (Saudi trades on a
7% percent premium vs long run average of c. 30%). Furthermore, Saudi trades on
12mth FWD P/B ratio of 1.5x, a 20% discount to long run averages, but a 15% premium
to GEMs on 1.3x, justified by the market’s higher ROE’s (Saudi’s long term P/B premium
has been c.25%). Finally, Saudi trades on 12mth FWD EV/EBITDA multiples of 9x, a
c.11% discount to long run averages.
42 GEMs Paper #26 | 30 June 2016
Chart 45: Saudi 12m fwd. P/E vs. EM
22
MSCI Saudi 12m Fwd PE
19
16
13
10
7
EM 12m Fwd PE
Average
4
07 08 09 10 11 12 13 14 15 16
Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch Global
Research
Chart 46: Saudi 12m fwd. P/B vs. EM
2.7
MSCI Saudi 12m Fwd PB
2.5
EM 12m Fwd PB
Average
2.3
2.1
1.9
1.7
1.5
1.3
1.1
0.9
09 10 11 12 13 14 15 16
Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch Global
Research
Chart 47: Saudi 12m fwd. EV/EBITDA
17
MSCI Saudi 12m Fwd EV-EBITDA
16
15
14
13
12
11
10
9
8
Average
7
06 07 08 09 10 11 12 13 14 15 16
Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch Global
Research
Interestingly, not all sectors within the Saudi market trade at a premium to GEM peers,
with both consumer discretionary and consumer staples trading at a material discount.
The remaining sectors all trade at a modest premium to their GEM counterparts, with
the industrial and utility sectors trading at a substantial premium on 12mth FWD P/E
Chart 48: Consumer sectors trade at a discount relative to GEM averages. Industrials and Utilities are
relatively expensive vs. GEM peers, other sectors trade at small premium
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Financials
Consumer Dscrt.
Materials
Consumer Stpls
Telco
Industrials
Health Care
Utilities
Saudi Arabia 12m fwd P/E
GEM 12m fwd P/E
Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch Global Research
Weaker economic outlook largely priced in as ERR shows inflection
A further consequence of the weakening economic outlook for Saudi Arabia has been
the collapse in market expectations, with earnings estimates having posted their longest
sustained period of downgrades on record. We note however, the Saudi Earnings
Revision Ratio (ERR) has reached an inflection point, with a slowdown in the rate of
earnings downgrades. (ERR is a ratio of number of companies enjoying earnings
upgrades vs number of companies suffering downgrades. A ratio above one, therefore,
indicates more upgrades than downgrades). Consequently, we believe the relatively untesting
valuations of the Saudi market indicate that a high level of negativity is already
being priced in.
GEMs Paper #26 | 30 June 2016 43
Chart 49: Saudi ERR’s are showing signs of inflecting despite one of the most protracted periods of
earnings downgrades.
2
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
Jan-11
More downgrades than upgrades
Jan-12
Jan-13
More upgrades than downgrades
Jan-14
Jan-15
Jan-16
160
140
120
100
80
60
40
20
0
ERR (LHS)
Brent Crude (US$/bbl- RHS)
Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch Global Research
Off benchmark and out of mind? Growing confidence could drive rerating
With Saudi Arabia remaining off benchmark (it is not currently part of any major indices
such as the MSCI EM or FM), GEM funds allocation to Saudi Arabia remains relatively
low at just 0.25% (of total GEMs AUM). Whilst allocation levels are relatively high versus
history, they are still significantly below the levels implied by MSCI EM inclusion (1.4%)
or suggesting a level of apathy towards the market.
Chart 50: GEM fund allocation in Saudi (asset-weighted)*
0.35 % GEM funds, allocation in Saudi MSCI Saudi market cap as % of MSCI EM (rhs) %
0.30
0.25
0.20
0.15
0.10
0.05
16
14
12
10
8
6
4
2
0.00
06 07 08 09 10 11 12 13 14 15 16
0
Source: EPFR, BofA Merrill Lynch Global Research.*Market cap as % of MSCI EM represents and artificially constructed benchmark weight
assuming that this market was a member of MSCI EM index
With the NTP looking to diversify the Saudi economy away from the oil sector (and
reduce its reliance on a higher oil prices), we believe confidence in the longer term
economic outlook could improve, ultimately driving earnings momentum and a market
rerating. Given our view that crude oil prices will likely post growing momentum in 2017,
moving substantially above US$50/bbl, even a partial success of the NTP program would
likely be sufficient to improve market confidence.
CMA reforms (likely linked to the NTP), a potential catalyst for market rerating
Furthermore, reforms being introduced by the Saudi Capital Markets Authority (CMA) to
attract greater foreign participation in the Saudi market (see below) indicate Saudi is
44 GEMs Paper #26 | 30 June 2016
seeking an expedited path to inclusion within the major Stock indices. Given the NTP is
seeking heavy involvement/investment from the private sector, we believe the measures
introduced by the CMA to attract direct capital inflows to the country are likely linked
with the larger NTP process. Growing confidence in the CMA’s market reforms and the
potential for inclusion in the major indices could prove to be a meaningful basis for the
market to rerate upwards.
Taking positive steps to accelerate MSCI inclusion
The Saudi Capital Markets Authority recently announced extensive changes to the
Qualified Financial Investor (QFI) program, which should ultimately increase the ease of
foreign access to the Saudi market. In particular:
(1) Individual foreign investors will now be allowed to own up to 10% of the equity in a
company (up from 5%). The total limit on foreign ownership remains at 49%.
(2) CMA decreased the minimum AUM of QFIs to US$1bn from US$5bn (although funds
with AUM’s below this level will be considered by the CMA).
(3) CMA introduced stock lending & covered short selling;
(4) CMA extended the settlement cycle to T+2 from T+0, effectively eliminating prefunding;
(5) CMA effectively removed the concept of a QFI client, which would have prevented
investors from using multiple fund managers to gain exposure to Saudi Arabia. This
highly restrictive clause was a significant reason why many global institutions did not
seek to gain QFI status; and
(6) CMA significantly reduced the amount of bureaucracy required to apply for and
retain QFI status.
MSCI inclusion one step closer as accessibility increases
In our view, the range of measures the CMA is looking to adopt greatly enhances the
accessibility of the Saudi Stock exchange and as such bring Saudi Arabia one step closer
to inclusion in the MSCI EM index. Whilst we continue to see inclusion most likely from
2019 (with an announcement in 2018), the new changes indicate that a 2018 inclusion
(with an announcement in 2017) is by no means out of the question. Indeed, whilst the
timing of introduction of these new measures is likely to be 1H2017, a recent release of
the draft proposals from the CMA suggested it could come as soon as 3Q16; although
we await further clarification.
A higher weighting in international indices
Saudi Arabia is currently under consideration for inclusion in the MSCI EM index,
potentially as soon as May/June 2018; although we believe 2019 is more likely. Saudi
Arabia is currently not included in any of the Major global indices and as such its
inclusion would have a profound effect on the market as it:
(1) leads to significant inflows of capital in to the market from both active and passive
funds following the MSCI EM index and;
(2) significantly increases interest in the Saudi market as it gains profile and is no longer
seen as off benchmark.
We see these factors as compatible with the NTP aim to boost capital markets.
Currently Saudi would be 1.4% of MSCI EM = US$10.9bn of inflows.
As per MSCI’s guidance, we use MSCI’s standalone Saudi market index as a template
(released May 12th 2015) for Saudi stocks to be included in the MSCI EM index. The
MSCI Saudi index currently contains 19 stocks (all listed entities on the Tadawul market)
which are likely for inclusion in the MSCI EM index (were Saudi to be included). By
taking the total market cap of these companies and multiplying them by the foreign
GEMs Paper #26 | 30 June 2016 45
inclusion limit articulated by the MSCI (currently 0.2), we are able to decipher the
relative weighting of Saudi Arabia if it were to be included the MSCI EM index.
This analysis suggests that Saudi’s potential weighting in the MSCI EM Index (were it to
be included today) would be c1.4%. Furthermore, it would likely trigger net inflows (from
other MSCI EM markets) of US$10.9bn when including all passive and benchmarkneutral
active funds tracking MSCI EM. Importantly, our analysis is based on EPFR data,
which respectively indicates US$405bn and US$354bn of active and passive funds
following the MSCI EM index.
Table 14: Provisional MSCI Saudi Arabia constituents stand to gain as much as $10.9bn of total passive and benchmark-neutral active funds on inclusion
Potential
passive Potential
buying passive days
(US$m) buying
Total US$m
active +
passive days
buying
Total days
active +
passive days
buying
Provisional Provisional
Potential Potential
weight in MSCI weight in MSCI ADTV active buying active days
Saudi
EM (US$m) (US$m) buying
AL RAJHI BANK 9.5% 0.1% 37.2 546.5 14.7 477.7 12.8 1,024 27.5
ALINMA BANK 2.0% 0.0% 223.0 116.9 0.5 102.2 0.5 219 1.0
ALMARAI 4.4% 0.1% 7.7 255.8 33.1 223.6 28.9 479 62.0
ARAB NATIONAL BANK 2.0% 0.0% 1.4 113.6 81.7 99.3 71.4 213 153.2
BANQUE SAUDI FRANSI 2.8% 0.0% 1.3 163.1 122.7 142.6 107.2 306 229.9
ETIHAD ETISALAT CO. 2.2% 0.0% 11.9 126.1 10.6 110.2 9.2 236 19.8
RABIGH REFN.& PETROCH. 1.0% 0.0% 9.2 59.1 6.5 51.7 5.6 111 12.1
RIYAD BANK 3.4% 0.0% 2.0 195.6 100.3 170.9 87.7 367 188.0
SAMBA FINANCIAL GROUP 4.0% 0.1% 5.0 232.9 47.0 203.5 41.1 436 88.2
SAUDI ARABIA FRTZ. 2.6% 0.0% 4.4 148.2 33.5 129.5 29.2 278 62.7
SAUDI ARABIAN MINING 4.5% 0.1% 17.2 260.8 15.1 228.0 13.2 489 28.3
SAUDI BASIC INDUSTRIES 25.3% 0.4% 170.9 1459.4 8.5 1275.6 7.5 2,735 16.0
SAUDI ELECTRICITY 8.4% 0.1% 6.3 485.3 77.3 424.2 67.6 910 144.8
SAUDI TELECOM 13.4% 0.2% 9.5 774.7 82.0 677.1 71.7 1,452 153.6
SAVOLA GROUP 2.0% 0.0% 6.9 114.4 16.6 100.0 14.5 214 31.2
YANBU NAT.PETROCH. 2.3% 0.0% 6.7 134.5 20.2 117.6 17.7 252 37.9
FAWAZ ABDULAZIZ ALHOKAIR 1.0% 0.0% 5.7 55.5 9.7 48.5 8.5 104 18.1
ALTAYYAR 0.8% 0.0% 33.5 44.4 1.3 38.8 1.2 83 2.5
NATIONAL COMMERCIAL BANK 8.2% 0.1% 6.8 474.8 70.1 415.0 61.3 890 131.4
TOTAL 5,762 5,036 10,798
Source: BofA Merrill Lynch Global Research, MSCI and DataStream
Chart 51: If included today, Saudi Arabia would be the thirteenth largest constituent of the MSCI EM,
accounting for 1.4% of the index.
CHINA
KOREA
TAIWAN
INDIA
SOUTH AFRICA
BRAZIL
MEXICO
RUSSIA
MALAYSIA (EM)
INDONESIA
THAILAND
PHILIPPINES
SAUDI
TURKEY
CHILE
POLAND
QATAR
UAE
COLOMBIA
PERU
GREECE
HUNGARY
EGYPT
CZECH REPUBLIC
Source: : BofA Merrill Lynch Global Research, MSCI and DataStream
46 GEMs Paper #26 | 30 June 2016
Privatisations & ownership limits could increase weighting
However, our analysis of Saudi Arabia’s weighting could be significantly understated for
two reasons, including: (1) our analysis currently uses a foreign ownership limit (FOL) of
0.2 (as previously guided by the MSCI). This could be understating Saudi’s weighting
given the increase in foreign ownership introduced in the CMA’s announcement. Indeed,
if we increased our FOL factor to 0.4, Saudi would be 2.8% of the MSCI and could
attract US$21.3.bn of inflows; and, (2) Saudi Arabia (according to local press and the
NTP) is seeking a number of privatisations in the coming 24 months, including a
potential IPO of Aramco. Inclusions of these companies would likely increase Saudi’s
weighting in the MSCI EM index and thus attract higher inflows to the market.
Inclusion of energy assets could see Saudi accounting for 4.1% of MSCI EM
By way of example, we believe inclusion of Saudi Aramco in the Saudi market would
profoundly affect the weighting of Saudi Arabia in the MSCI EM in our view. Indeed, if
we were to replicate the analysis above using the Deputy Crown Prince hypothetical
valuation of US$2tn for Saudi Aramco and a 5% inclusion factor (given 5% or less of
Saudi Aramco would be listed according to interviews with the Deputy Crown Prince),
Saudi Arabia would account for 4.1% of the MSCI EM index and likely attract cUS$31bn
of inflows from passive and active funds. We note, our calculations are highly sensitive
to the inclusion factor that MSCI would ultimately use (we assume 5%, in line with its
estimated free float of 5%). An inclusion factor of 10% for example, would see Saudi
Arabia accounting for 6.6% of the MSCI EM index.
Chart 52: If energy assets were included, Saudi Arabia would be the seventh largest constituent of
the MSCI EM, accounting for 4.1% of the index
CHINA
KOREA
TAIWAN
INDIA
SOUTH AFRICA
BRAZIL
SAUDI
MEXICO
RUSSIA
MALAYSIA (EM)
INDONESIA
THAILAND
PHILIPPINES
TURKEY
CHILE
POLAND
QATAR
UAE
COLOMBIA
PERU
GREECE
HUNGARY
EGYPT
CZECH REPUBLIC
Source: BofA Merrill Lynch Global Research, MSCI and DataStream
GEMs Paper #26 | 30 June 2016 47
Telecom: supporting a move to higher
connectivity
Hootan Yazhari, CFA >>
Merrill Lynch (DIFC)
hootan.yazhari@baml.com
Table 15: Key NTP objectives for the Ministry of Communications and Information Technology
1
2
3
No. Strategic objective Key Performance Indicator (KPI) Unit Baseline
Provide critical resources, especially frequency
spectrum for Information telecommunications
and Technology services
Provide broadband services to all KSA regions
by stimulating investment in infrastructure and
developing tools, technical and regulatory
frameworks
Develop and activate smart government
transactions based on a common infrastructure
2020
target
Regional
b'mark
Int’l
b’mark
Percentage of frequency spectrum available for
telecommunication services out of the total allocated
telecommunication services
% 42 80 NA >90
Percentage of FTTH coverage in densely
populated urban areas
% 44 80 >95 >90
Percentage of FTTH coverage in urban areas % 12 55 >90 >80
Percentage of wireless broadband networks’ coverage (more
than 10 Mbps) in remote areas
% 12 70 NA 74
Maturity level of the government services transformation to
e-services
% 44 85 NA NA
KSA’s rank in the United Nations index for the development
of e-government
% 36 25 18 11
4 Bridge the digital gap in the skills of ICT users Percentage of internet users in KSA % 63.7 85 90.4 87.9
Source: National Transformation Plan
NTP helps increase penetration of higher margin offerings
We believe the National Transformation Plan will herald significant change for the Saudi
telecom sector over the next five years. In particular, its focus on increasing access to
high speed internet (via wireless and fibre) should underpin a material uplift in data
usage and broadband penetration levels. Given these offerings represent the highest
margin services provided by the telecom service providers, we believe the move towards
a more data intensive society should be supportive for industry margins. Furthermore,
with the NTP’s plans relying heavily on private sector investment (including STC), we
believe it could accelerate the spin out of tower portfolios from the three telecom
players in the Kingdom (as a way of raising financing).
Government investment set to exceed US$2bn
As part of the National transformation plan, the government is seeking to invest more
than US$2bn in the expansion of wireless (3G & 4G) and fibre infrastructure (FTTH)
across the kingdom. Whilst the finer details on how this expenditure will be deployed
(e.g. via grants or via direct investments?) have yet to be disclosed, details of the NTP
suggest it will be used to expand connectivity in the remote areas of Saudi Arabia (given
the telecom companies have largely avoided such expenditure in the past given low
returns), as well as increasing network density in developed and urban areas.
Spectrum increases an indication of ambitious growth
The government is also looking to significantly enhance the availability of spectrum to
the telecom industry (from 42% to 80% of total spectrum allocated), highlighting the
expected surge in data usage in the Kingdom to 2020 and beyond. Whilst data usage in
the Kingdom has been rapidly growing in recent years on the back of high speed rollouts
(3G & LTE), demand still lags global and regional averages (as indicated by data as a
percentage of total mobile revenues). Ultimately, we believe this will have a number of
effects including: (1) Saudi Arabia will further increase its focus on high speed offerings,
(LTE/LTEA and eventually 5G); (2) capex cycles will likely lengthen as telecom companies
intensify their rollout of coverage; and, (3) tower density will likely have to increase
across the key demand centres.
48 GEMs Paper #26 | 30 June 2016
Chart 53: Data as % of mobile service revenues
GDP/capita US$, 2015
50,000
45,000
40,000
UAE
Kuwait UK
Germany
35,000
30,000
Saudi
Spain
25,000
20,000
15,000
Argentina Chile
Turkey Brazil
10,000
5,000
Sudan Nigeria
India
China
Russia
South Africa
0
Moro
0% 10% cco 20% 30% 40% 50%
Data as % of service revenues
Source: BofA Merrill Lynch Global Research, Telegeography and company data
Chart 54: Household Broadband penetration
GDP/capita US$, 2015
50,000
Kuwait
45,000
UAE
40,000
35,000
30,000
Saudi
25,000
Oman
Czech
20,000
15,000
Poland
Turkey
10,000 South Africa
Hungary
Algeria
Indonesia Egypt Brazil
5,000
Romania
China Russia
India
Tunisia
Nigeria
0
Morocco
0% Pakistan 20% 40% 60% 80%
Broadband household penetration
Source: BofA Merrill Lynch Global Research, Telegeography and company data
Private sector participation and investment will be crucial…
Whilst the government has earmarked cUS$2bn for the expansion of FTTH and wireless
infrastructure (with a view to ultimately increasing internet usage), we believe this will
likely be insufficient to meet the needs of the NTP’s ambitious targets (based on costs
of rolling out existing wireless and FTTH networks). As such, we believe the private
sector (Zain KSA, Mobily and STC) will be key contributors to the financing of the
expansion plan.
…intensifying the case for creation of a Saudi tower company
The Saudi telecom service providers have invested heavily in rolling out high speed
wireless networks and, in the case of Mobily and STC, FTTH networks (not to mention
license costs). This has seen the balance sheets of both Mobily and Zain KSA reaching
relatively high gearing levels; thereby limiting their ability to step up capital expenditure
for a sustained period. Consequently, we believe the focus on raising capital (to fund the
expansion programmes) from the spin out of their Tower portfolios will only increase.
We see Zain KSA as the key beneficiary of this given they have the most highly geared
balance sheet amongst Saudi Telco peers.
Mobile market share gains for Zain KSA and Mobily increasingly important
Whilst the Saudi government has taken steps to introduce competition in the
telecommunications industry, its moves to open the market have thus fallen short of
this objective. Specifically, government-owned STC retains more than 60% revenue
market share in Saudi Arabia, giving it a dominant position in the market, whilst Mobily
and Zain KSA have only managed to achieve c25% and 15% revenue market share
respectively.
This, in our view, has likely been driven by a number of factors including: (1) the
relatively high cost of market entry (ie licenses) for both Mobily and Zain KSA, which has
lumbered both with high operating costs; (2) high royalty costs, which amount to c16%
of revenues generated in Saudi Arabia (with some exceptions, including data), arguably
inhibiting requisite marketing and infrastructure spend. We note both Mobily and Zain
KSA remain loss making; and, (3) the relatively high mobile termination rates, which
arguably afford an advantage to STC and prevent Zain or Mobily from competing more
aggressively on price.
For the realisation of the NTP, we believe it is important that all private sector players
are realising sufficient rates of return and FCF generation to be able to finance the
requisite growth in infrastructure. We note both Mobily and Zain KSA were loss making
in 2015 and are expected to return sub 5% ROE’s in both 2016 and 2017 (according to
GEMs Paper #26 | 30 June 2016 49
Bloomberg consensus estimates) vs. STC at 17% (consensus). It is thus arguably crucial
for Zain and Mobily to be allowed to increase market share in the mobile arena. We thus
believe the regulator (CITC) regulator will have to consider further steps to afford
market share to the second and third entrants including asymmetric competition
measures (pricing, MTRs), license extensions or differentiated royalty rates.
STC the likely beneficiary of FTTH expansion
Whilst we argue that STC could lose further market share in the Mobile market as a
result of regulatory moves, we believe the negative impact will be offset by growing
revenues from FTTH, IPTV and the corporate market. Indeed, we believe STC, given its
market leading FTTH network and IPTV offering, will likely benefit most acutely from
the growth in the number of FTTH customers. Furthermore, with government grants
likely to be provided for FTTH roll out in less economical areas (as part of the NTP), we
believe returns will likely not suffer from the additional capital deployment. Mobily could
also benefit (given its well-developed FTTH infrastructure), although we expect it to lag
STC who has a first mover advantage and arguably a stronger FTTH/Triple play offering.
We note, Zain KSA will unlikely participate in the rollout of the FTTH expansion given its
constrained balance sheet and strategic focus on the wireless market. That said, the
company could benefit from the rollout of high speed internet solutions over its wireless
network (ie fixed broadband over its 4G network), particularly in areas where the
construction of FTTH networks maybe be difficult or uneconomical.
Royalty rate increases unlikely, particularly for Zain KSA and Mobily
Admittedly, an increase in royalties could be an easy way of raising much needed
revenues for the government. After all, each 1% increase could raise income by more
approximately SAR500mn (cUS$130mn). However, we would argue that this is unlikely
given the lack of sufficient competition in the market and the obstacles to increased
competition higher royalty rates would introduce. In the same vein, we also believe it
highly unlikely that the government would seek to introduce a fourth mobile operator
license given the lack of sufficient market capacity between the second and third
operators.
Religious tourism a material opportunity for telecom providers
Saudi Arabia’s ambitious growth targets for religious tourism provide a material
opportunity for the telecom providers in our view. More specifically, if the number of
religious tourists (for Hajj and Umrah) increases by an estimated 10mn per annum by
2020, we believe demand for roaming services (voice and data) and sim purchases will
increase significantly. Indeed, on our estimates, we see the 10mn visitors potentially
providing a SAR2bn-SAR4bn opportunity, representing a c4-8% uplift in total wireless
revenues for service providers. We particularly believe Zain KSA will benefit strongly
from this given they provide the most competitive Pay as you go packages currently and
have the largest spare capacity on their network.
50 GEMs Paper #26 | 30 June 2016
Health: Not Tremendously Prescriptive
Vision 2030 a start but Needs Transparent Proposals
The Saudi government’s Vision 2030 document calls for an improvement in healthcare
in Saudi Arabia. The private healthcare sector has some role to play; the National
Transformation Plan (NTP) targets the private sector to be responsible for funding 35%
of healthcare spend in 2020, up from 25% today. How it intends to do this is uncertain.
We believe the incumbent private hospital operators, including listed companies (Al
Hammadi, Care, Dallah, MEAHCO and Mouwasat) should be beneficiaries of increased
private sector funding, although increased investment would be needed to meet growth
in demand longer-term.
Improve public facilities, work towards privatisation
The government wants to step back from financing and providing healthcare and adopt
an oversight and regulatory role. Firstly the government wants to improve the quality of
care offered in the public sector, with the eventual aim of working towards privatisation
of public assets and healthcare provision. This implies no privatisations short-term.
Near-term: Management contracts for public hospitals
In the near-term the government could seek to improve healthcare provision in the
public system by using private sector expertise, through, e.g. contracting management
of public facilities to the private sector. Individual such contracts are unlikely to
transform company earnings, and the small size of existing Saudi hospital groups limits
the depth of management available to capture large contracts, in our view.
Long-term: insurance coverage up to 31m from 10.5m
In the long-term a widespread adoption of private health insurance is likely to raise
volumes, spurring an increase in private healthcare capacity, either from organic
investment or participation in privatisations. In Saudi currently, 10.5m/31m people have
insurance. We assume a more universal scheme would offer lower pricing than that
today, and listed incumbents would need to make a cultural shift towards addressing
this market. Such a market could attract new competitors, domestic or foreign.
Type of insurance system and reimbursement uncertain
We believe reimbursement levels would need to be known before privatisations can
occur so bidders can budget and estimate their return on capital. It is still uncertain
whether the government would seek to introduce insurance through the incumbent
private operators (Bupa Arabia, Medgulf and Tawuniya) or set up its own insurance
company e.g. an Abu Dhabi-style Daman. Nor whether it would subsidise premiums or
simply force the private sector to employ more Saudis.
Government needs to improve private sector relations
At present the government has not paid private hospitals for the treatment of public
patients referred to them for over a year. Until the relationship improves, engaging with
the private sector could be difficult.
Healthcare implications of National Transformation Plan
The Saudi government’s Vision 2030 document calls for an improvement in healthcare
in Saudi Arabia. The private healthcare sector is likely to be a beneficiary both in the
short-term and long-term. In the short-term the National Transformation Plan (NTP)
targets the private sector to be responsible for funding 35% of healthcare spend in
2020, up from 25% today. In the longer-term, the Saudi government wants to remove
itself from directly providing and financing healthcare, instead focussing on public
health and the regulation of the healthcare sector. Raising private sector funding
thresholds to 35% appears possible if a number of measures are used, e.g. more
rigorous enforcement of requirement that Saudis working in private sector hold
insurance could increase penetration by 6% alone. The quality targets set for the public
sector do not appear unduly onerous in theory, but execution remains key.
GEMs Paper #26 | 30 June 2016 51
What the Vision 2030 announcement said on healthcare
Transfer the responsibility for health care provision to a network of public
companies
Promote competition and transparency between public and private companies to
enhance the standard and quality of health care services
Prepare for privatisation in the longer term.
Work towards developing private medical insurance to improve access to medical
services and reduce waiting times
Table 16: National transformation Plan objectives for the Ministry of Health
No. Strategic objective Key Performance Indicator (KPI) Unit Baseline 2020 target Regional
b’mark
Int’l
b’mark
1 Increase private sector share of spending through alternative Percentage of Private sector contribution in total
% 25 35 37 60
financing methods and service provision
healthcare spend
2 Increase the efficient utilization of available resources Opex for every new inpatient admission SAR 33,000 33,000 39,000 NA
3 Improve the efficiency and effectiveness of the healthcare
sector through the use of information technology and digital
transformation
4 Increase training and development both locally and
internationally
Percentage of Saudi citizens who have a unified
digital medical record
Number of resident Saudi physicians who are
enrolled in training programs
5 Increase the attractiveness of nursing and medical support staff Number of qualified Saudis in the field of nursing
as a preferred career path
and support staff for every 100,000 people
6 Improve healthcare provision before hospitalization and in the
main hospitals (ER & ICU)
Percentage of patients who received emergency or
urgent care with medical decision made (admission/
transfer/ discharge) in less than 4 hours in key
hospitals
% 0 70 NA 100
Number 2,200 4,000 NA NA
For every
70 150 460 1,106
100000
% 40 75 Under study 95
7 Improve integration and continuity in service provision by Number of primary healthcare visits per capita Number 2 4 3.4 7
developing the primary care
8 Improve the infrastructure, facility management, and safety Number of licensed medical facilities ( affiliated with % 40 100 100 100
standards in healthcare facilities
the Ministry of Health and private)
9 Attain acceptable waiting times across all stages of service % of appointments received in specialized medical % <40 70 Under study 83
delivery
disciplines within 4 weeks (average for all
specialties in key hospitals)
10 Improve governance in the health system in order to enhance % of Healthcare facilities reporting comprehensive % 10 100 NA 100
accountability with regards to quality issues and patient safety performance and quality measures
11 Adopt a national plan for emergency response to public health
threats per international standards
WHO emergency preparedness assessment score
– average score for Riyadh, Jeddah and Eastern
Score Calculation
In Progress
4-5 Under study Under
study
Province
12 Identify additional sources of revenues Total revenue generated from private sector for SAR bn 0.3 4 NA NA
utilizing government health resources
13 Improve public health services with focus on obesity and Increase in percentage of smoking incidence % Calculation Reduce by2% 12.5* 10.5*
smoking
In Progress from baseline
Increase in percentage of obesity incidence % Calculation Reduce by1% 19.4* 5*
In Progress from baseline
14 Improve the quality of life and healthcare service provided to
patients outside hospitals
The percentage of patients who get health care
after critical care and longterm hospitalization within
4 weeks
% 25 50 NA 65
15 Improve quality and safety principles as well as skills of service
providers
Source: Saudi National Transformation Plan
Percentage of hospitals that meet the US median
for patient safety culture
SAR23bn budget allocated for the MoH’s NTP programmes
The Ministry of Health (MoH) has been allocated SAR23bn for the transformation plan
over the next five years, with any contribution from the private sector on top. Over half
(56%) of the funds have been allocated to reform of primary healthcare and to the
establishment of electronic medical records. Only 4% of funds (SAR937m) have been
allocated to health insurance.
% 10 50 NA 50
52 GEMs Paper #26 | 30 June 2016
Chart 55: The MoH has been allocated SAR23bn over five years under NTP
7%
4%
5%
6%
32%
20%
26%
Primary healthcare reform
Develop ER and intensive care
Building standards of public facilities
Other
Electronic health records
Public health
Health insurance scheme
Source: BofA Merrill Lynch Global Research, NTP
Government currently payor and provider
The government currently directly funds public hospitals, which provide free healthcare
for citizens. The typical flaw with a unified system is that increased efficiency is not
necessarily sought or rewarded. Employer-provided healthcare insurance is mandatory
for both Saudis and expats working in the private sector, as well as their dependents.
Significant scope for increase in insurance coverage from 10.5m to 31m people
Saudi currently has a population of 31m, of which 10.5m have health insurance, a 34%
penetration rate. Bupa Arabia believes another 2.5m Saudis who work in the private
sector (including dependents) don’t have health insurance but should have. Assuming the
government increases enforcement, near-term penetration could increase to 42% of the
population even with extra reforms.
Strain in relations between government/private sector
The government has not paid private providers who have treated government patients
for a year, which is hardly going to encourage the private sector's further involvement,
particularly those companies that have seen the biggest increase in their receivables (Al
Hammadi and Dallah). However, the government can still put considerable pressure to
bear on the sector to achieve its aims if it so wishes.
Increased Saudisation could be used as a policy
The easiest way for the government to increase private financing of healthcare to 35%
from 25% would be to raise Saudisation requirements. Under Saudisation, the
government sets a minimum proportion of a company’s staff that must be Saudi
citizens, which differs by industry sector. Increased Saudi employment in the private
sector short-term would put the onus of financing healthcare onto employers. However,
such a move would likely pressure private sector margins.
Increase pressure on employers to trade down on insurance
The impact of Saudisation as a mechanism would likely be negative for pricing although
positive for volumes, assuming the hospital has the capacity to accept more patients.
Employers would likely seek to trade down in terms of the insurance schemes they offer
in a bid to reduce their involuntarily raised expenditure. Insurers would seek better deals
with hospitals as a result and could seek restricted network arrangements to curtail
GEMs Paper #26 | 30 June 2016 53
costs. Hospitals would be under pressure to be more flexible on prices to avoid any
pressure should lower-cost packages impact their volumes.
Vision implies a long process
To us, the government's vision implies a two stage process over a long time-frame:
• In the short-term: improve the quality of care offered in the public sector,
potentially with the assistance of private healthcare
• In the long-term: Only when public facilities have improved, privatise such facilities
(although one medical city is to be privatised under a public-private partnership)
• Concurrently: Prepare for a roll-out of private health insurance to finance private
provision
Abu Dhabi and Dubai are probably not parallels
In Abu Dhabi and Dubai, private healthcare was encouraged to avoid expats relying on
public facilities. The large expat population in proportion to the locals (85:15) supported
the creation of private facilities that it was then possible for the governments to fully
fund Emiratis to use. The quality of public facilities was not a cause for concern - many
Emiratis still prefer to use government facilities for more serious problems.
Expat population and quality of public system differ in Saudi
The proportion of expats (33% of the population) is not large enough to drive the
establishment of a large, high quality private hospital base sufficient to serve the entire
Saudi population. Additionally, the quality of both care and infrastructure in the public
system is seen as lacking, suggesting additional investment in facilities is required.
Degree to which private sector will benefit is uncertain
Given the lack of detail provided to date, it is hard to assess the benefits, or risks to the
incumbent private hospital operators in detail. We see two main ways the private sector
can participate in healthcare reform:
• Win contracts to run and improve public health facilities
• Benefit from volume growth any roll-out of private health insurance could spur
• Participate in privatisations
In the long-term, volumes up but pricing down, likely to benefit nonetheless
At present there is limited supply of quality private hospitals and the incumbents are in
a strong bargaining position with insurers. Greater private hospital supply, and
competition, would likely pressure pricing, and margins in the longer-term, albeit offset
by increased volumes. Assuming only basic services are offered to most citizens under
any government-driven scheme, there would still be a place for offering higher-quality
accommodation for example, to higher-income patients.
Private sector could win public hospital contracts
Private operators could be allocated management contracts for public hospitals to
improve efficiency of existing hospitals, train public sector administrators and raise
clinical standards. Presumably reimbursement under such contracts would be based on a
fixed fee, potentially with performance clauses for improved outcomes or lowering
costs. More substantive contracts, where the private operator is responsible for all
aspects of operating the hospital could be more accretive, but bring greater financial
risk.
54 GEMs Paper #26 | 30 June 2016
Table 17: Examples of management contracts
Company Contracts
Dallah Dallah has had two types of hospital contracts.
One, which just involves management expertise, was worth SAR4.5m over five years and 10% of the
hospitals income.
The other was worth SAR89m over five years but in this Dallah was responsible for all staffing and
supplies and infrastructure operation and maintenance.
Mouwasat Mouwasat managed Najd consulting hospital in Riyadh in return for management fees of c.SAR3m per
year; this was subsequently changed to receiving a share of revenues and net profits.
NMC
NMC was awarded a contract to manage a government hospital in Umm Al Quwain, UAE. The five year
contract sees it earn $5m (SAR18m) in fees per year, subject to certain performance criteria being met.
During the term of the contract NMC is to train government staff to which it will hand over administration
at expiration.
Source: BofA Merrill Lynch Global Research, company report
Private groups may lack capacity to undertake such contracts
The private hospital groups in Saudi Arabia are small. Habib Medical Group, Mouwasat
and Middle Eastern Healthcare group are the largest, with only 8, 5 and 4 hospitals
respectively. We would question whether any company has the depth of management to
undertake management of a large number of government hospitals. Potentially the
government could seek to import foreign expertise.
Insurance roll-out likely to boost private volumes
Longer-term, the roll-out of private insurance would likely have a positive impact on
volumes available for incumbent operators to capture. This will depend though on the
available capacity of private operators at that time and level at which reimbursement is
set. The current listed operators typically target high income patients and a lot of the
growth in volumes would likely be in the low-to-middle income spectrum.
Cultural shift would be needed to target larger population at lower price point
It would require a clear cultural shift for the incumbent listed hospital operators to
switch from offering a high quality service to high income individuals to operating
facilities that served the wider population at what we presume would be a much lower
price point.
Investment is difficult until pricing and reimbursement is clarified
Until reimbursement levels are clarified, existing private operators/investors will not be
able to make decisions on investing in private healthcare facilities.
Privatisations seem unlikely in the near-term
Given the stated intention to improve the quality of hospitals prior to privatisations, it
seems unlikely there will be any near-term, although the NTP does call for privatisation
of one of the medical cities in a public-private partnership. Saudi operates a number of
medical cities, which are typically collections of hospitals that act as tertiary referral
centres. The largest of these is the King Fahad medical city in Riyadh, with 1,095 beds.
It is uncertain which city is planned for privatisation. As with further investment by
private operators in new facilities, the level of reimbursement would need to be clarified
so potential bidders can estimate their return on investment from participating.
270 public hospitals in Saudi currently
Latest available data (2014) from the Saudi Ministry of Health discloses 270 public
hospitals with 40,300 beds. Of these, 47 hospitals are in Riyadh, with 25% of the
population, and 13 hospitals are in Jeddah, which holds 14% of the population.
Presumably these assets would be the most valuable during a privatisation process, not
only because of the population sizes, but also because the provision of beds hasn’t kept
up with population growth, ensuring high demand. Both areas also host the highest
number of private hospitals in the country.
GEMs Paper #26 | 30 June 2016 55
Table 18: Public and private hospital and bed distribution
Riyadh Jeddah Other
Population 7,717,467 4,224,568 18,828,340
Public
Hospitals 47 13 210
Beds 7,937 2,993 29,370
Beds/hospital 169 230 140
Private
Hospitals 34 33 74
Beds 4,554 3,109 8,001
Beds/hospital 134 94 108
Total
Hospitals 81 46 284
Beds 12,491 6,102 37,371
Beds/hospital 154 133 132
Source: BofA Merrill Lynch Global Research, Ministry of Health
Chart 56: Public and private hospital and bed distribution
100%
80%
60%
40%
20%
0%
Riyadh Jeddah Other
% population % public hospitals % public beds
% private hospitals % private beds % hospitals
% beds
Source: BofA Merrill Lynch Global Research, Ministry of Health
Hospital quality would be key to attracting private buyers
The government has not invested in hospital infrastructure and some hospitals may
require substantial investment by any buyer, if they are acquired at all. One Saudi
hospital operator has said that there is no way it would seek to acquire government
hospitals for that reason.
Bidders would likely want to obtain scale benefits from multiple purchases
Operating hospitals has benefits of scale in terms of centralising certain non-medical
services (e.g. purchasing, catering, laundering) and allocating central costs over a greater
revenue base. The greatest financial benefit would come from acquiring groups of
hospitals to maximise these benefits. There would likely be cases where staff, and/or
high net worth individuals chose to bid for individual assets.
Privatisation proceeds could defray some of NTP cost
Amounts raised from any privatisation would reflect the degree of competition for
individual assets as well as level of reimbursement and the profits any acquirer could
generate. In terms of pure asset values we assume the Riyadh and Jeddah hospitals (60)
would be worth more than those elsewhere (210), simply because of the greater
population currently and higher expected future growth. Government hospitals are likely
lower cost than that of private facilities given they are not competing on the quality of
accommodation offered. Arbitrarily assuming US$100m for hospitals in Jeddah and
Riyadh and US$50m elsewhere would imply proceeds of $16.5bn (SAR61bn). If every
hospital were sold then it could more than cover the SAR23bn allocated to the MoH for
the NTP. That seems unlikely however; there will be hospitals that require substantial
investment and aren’t worth the indicative figures we have used above, or are in areas
where profitability means there will be no return for the private sector at that level of
acquisition.
Reforms could attract additional competition
Incumbent private hospital operators are best placed to expand and are seen as the
natural buyers of any privatised assets. However, any substantial privatisation process,
or the potential created by widespread adoption of private health insurance in general,
could attract interest from foreign investors or operators. We note only a small number
of international hospital groups to date have experience of successfully operating in
multiple countries (IHH, Mediclinic), and we think Saudi Arabia could be too challenging
as a first step for those yet to operate outside their domestic market.
Structure of insurance market needs to be set
There are a number of ways the government could roll-out private health insurance
more widely:
• Set up its own insurance company
56 GEMs Paper #26 | 30 June 2016
• Work with existing private insurers
• Use a back-door approach and just force private employers to hire more Saudis
The government could set up a state insurance company
The government could set up a single-state insurer that is either funded through direct
contributions or through general taxation. The government would likely need to get
external help from a party knowledgeable in insurance and risk, which could be an
insurer, Saudi or otherwise. Daman, Abu Dhabi's health insurer is owned 80% by its
government and 20% by German insurance company Munich Re.
Existing private insurers may not have capacity if they were made responsible
The government could decide to execute any financing scheme through existing private
insurers, or give citizens the option of choosing either a government or private insurer.
The existing private healthcare insurers in Saudi Arabia are unlikely to have the
resources (both people and systems) in place to provide cover for an additional 20m
people immediately and will need some time to prepare. Any large scale immediate
expansion could put them at risk of substantial underwriting losses that they would
presumably seek to have back-stopped by the government in the initial stages.
Chart 57: Health insurers by share of claims (1H15)
28%
25%
4%
7%
16%
20%
Bupa Arabia Tawuniya Medgulf Malath Axa Other
Source: BofA Merrill Lynch Global Research, CCHI
GEMs Paper #26 | 30 June 2016 57
Consumer: a necessary pain
Abdelrali El Jattari >>
Merrill Lynch (DIFC)
abdelrali.eljattari@baml.com
The Saudi government initiatives taken in the National Transformation Plan (NTP) will
transform the Saudi consumer landscape. We note a mixed effect on the sector:
• On the positive side, we anticipate 1) job creation for Saudi nationals in the private
sector with a big focus on Small and Medium Enterprises (SMEs); 2) a strong
emphasis on education; 3) an ongoing increase of the participation of women in the
workforce; 4) an increase of the percentage of self-sufficiency in broiler production
which should ultimately support local producers; and, 5) a significant pick-up of the
religious tourism during Haj and Umrah.
• On the negative side, we anticipate 1) a rationalization of subsidies for water and
electricity; and, 2) a more competitive retail environment, more open to
international players, attracting foreign direct investment (FDI).
Prefer staples over discretionary
While slowing consumer credit and weaker private sector consumption growth amid a
young population do not support Saudi spending in both staple and discretionary items,
we expect staple-related stocks such as Al Othaim and Savola to be better positioned to
capture the marginal consumption. This is principally due to their exposure to
necessities (food items) in a very fragmented market. Having said that, we expect more
pressure on the opex of all Saudi consumer corporates, while revenue growth outlook
will remain subdued in the short-term given the weaker consumer confidence and
disposable income.
A more moderate growth outlook; Saudi female workforce drives private sector
Following a 12% 10-year CAGR fuelled by the rise in household income, we conclude
that the retail sector will continue to play an important role in the rising participation of
the Saudi workforce, women in particular (10,000 in 2010 vs 120,000 in 2014 according
to the Ministry of Labor) supporting their disposable income in the long-term. Overall,
the Saudi retail sector is one of the largest employers in Saudi Arabia with 1.5mn
workers (17% of the Saudi workforce) of which low-cost foreign workers represent 80%.
This implies that Saudis working in the retail account for 300,000 (40% are female),
doubling in 4 years.
Needed reforms: better macro at the expense of micro
While we acknowledge that the targets set by the government are paving the way for
the right reforms (development of the private sectors, a more competitive economic
landscape, attraction of FDI), we expect the Saudi retail outlook to be marked by a
slower growth in the coming years. In particular, we highlight few major challenges for
the effective implementation of the plan: 1) incentives to enrol Saudis into consumerrelated
jobs suggesting rising opex pressure for consumer stocks; and, 2) 20% public
payroll cut will put pressure on Saudi disposable income in the short-term given than
c80% of the Saudi workforce is in the public sector.
Key strategic objectives and Key Performance Indicators (KPIs) to watch
The National Transformation Plan (NTP) outlays several strategic objectives and related
KPIs to watch by ministry which we believe will impact the Saudi consumer universe:
• The Ministry of Economy and Planning is looking to 1) expand privatization of
governmental services; 2) increase the efficiency of government subsidy programs;
3) establish specific zones with competitive advantages to enhance investments;
58 GEMs Paper #26 | 30 June 2016
and, 4) develop tourism and entertainment sector. To do so, the ministry mainly
targets to decrease the subsidy for water and electricity by SAR200bn by 2020 and
to expand the private sector contribution to GDP from 40.5%.
• The Ministry of Commerce and Investment is looking to 1) reinforce the protection
of the Saudi consumers; and, 2) develop SMEs by incentivizing the culture of
entrepreneurship and supporting productive families. The ministry targets by 2020
to 1) more than double the number of established entities from 50k to 104k; and, 2)
increase the contribution of SME to non-oil GDP from 33% to 35%.
• The Ministry of Environment, Water and Agriculture is looking to 1) optimize the
use of renewable water resources for agricultural purposes; and, 2) support national
companies. The ministry targets by 2020 1) to consume more than twice less water
in the agricultural sector, which should be reflected in a lower percentage of water
used in the agricultural sector relative to the total available renewable water
resources (191% vs 416% today); and, 2) to reinforce the Saudi independence to
the broiler production by increasing the percentage of self-sufficiency in broiler
production to 60% from 42%.
• The Ministry of Haj and Umrah is looking to provide the opportunity for the largest
number of Muslims possible to perform Haj and Umrah. The Ministry targets by
2020 the number of Haj pilgrims to increase from 1.5mn to 2.5mn and the number
of Umrah Pilgrims from abroad to increase from 6mn to 15mn.
• The Ministry of Labor and Social Development is looking to 1) improve education
and enable more Saudi nationals to enter the job market; and, 2) to increase the
participation of women in the workforce. The ministry targets by 2020 to 1) create
1.2mn jobs in the private sector (men and women); 2) reduce the unemployment
rate to 9% from 11.6%; 3) reduce the cost of employment of Saudis compared to
expatriates to 280% from 400% today, which implies a higher cost of expatriates;
and, 3) to increase the proportion of female force to 28% vs 23% today.
Table 19: National Transformation Plan objectives and Key Performance Indicators (KPIs) affecting the consumer sector
Strategic objective Key Performance Indicators (KPIs) Unit Baseline 2020 target Regional b'mark Int'l b'mark
Ministry of Economy & Planning
Increase efficiency of government subsidy programs Value of water and electricity subsidy decrease SARbn 0 200 N/A N/A
Expand privatization of governmental services Private sector contribution to GDP % 40.5 N/A 20/27 36.4
Ministry of Commerce and Investment
Boost entrepreneurship Number of established entities (LLC) # 50000 104000 N/A 347015
Boost SMEs Contribution of SME to non-oil GDP % 33 35 60 N/A
Ministry of Environment, Water and Agriculture
Optimize the use of renewable water resources for
agricultural purposes
Water used in the agricultural sector relative to total
renewable water resources % 416 191 42.76 19.1
Maintain security of vital resources of the country % of self-sufficiency in broiler production % 42 60 80 140
Ministry of Haj and Umrah
Accommodate larger number of Muslims to perform Haj Number of formal pilgrims (domestic and foreign) mn 1.5 2.5 N/A N/A
Accommodate more Muslims to perform Umrah Number of Umrah Pilgrims from abroad mn 6 15 N/A N/A
Ministry of Labor and Social Development
Provide suitable jobs for citizens Number of suitable private sector job opportunities for Saudis 000 0 1200 N/A N/A
Provide suitable jobs for citizens Saudi unemployment rate % 11.6 9 N/A 5.8
Provide suitable jobs Cost of employment of Saudis vs expatriates % 400 280 N/A N/A
Empower women Proportion of female labor force % 23 28 N/A N/A
Source: Saudi National Transformation Plan
GEMs Paper #26 | 30 June 2016 59
Rationalization of subsidies for water and electricity
The sweeping energy, water and electricity administered price changes introduced in
December 2015 are a first step in the five-year fiscal consolidation and economic
transformation strategy. We expect further reviews of energy, water, and electricity
prices over the medium-term. Furthermore, the likely government review of current
levels of fees and fines, introduction of new fees, application of a VAT and introduction
of excise taxes on tobacco and soft drinks will also impact the Saudi consumer.
Subsidy cuts on energy and utilities to add up to 1.5ppt to CPI inflation only
We estimate the December natural gas price hike on petrochemical firms, domestic
crude oil price hike as well as the combined gasoline and diesel price hike introduced
could add US$2.2bn, US$2.0bn and US$3.8bn to central government revenues if fully
passed to the budget (a combined 1.2% of GDP). We estimate the direct impact of these
higher gasoline, water and electricity prices to add 1.3-1.5ppt to CPI inflation due to
their low basket weights (c.1.5%, c0.4% and 1.6% respectively). We think a 5% VAT tax
could add c2% of 2015 GDP in fiscal revenues over the medium-term.
Chart 58: Consumer Price Index (CPI) basket– consumer expenditure breakdown
Food and non-alcoholic beverages
0.47%
Tobacco
6.83%
2.69%
3.50%
5.75%
21.70%
Clothing and footwear
Housing, water, electricity, gas, and other
fuels
Furnishings, household equipment &
8.10%
8.40%
routine household maintenance
Health
Transport
10.44%
Communication
2.56%
9.09%
20.45%
Recreation and culture
Education
Restaurants and hotels
Source: Haver, BofA Merrill Lynch Global Research
Subsidies account for 15% of Almarai’s net income; 40% are related to poultry
Almarai continues to receive subsidies from the Saudi government, amounting to
SAR295mn in 2015. This represents 15% of the Almarai’s 2015 net income. The
government pays subsidies based on price of subsidized feed importer, which means it
may increase or decrease naturally. Regarding the breakdown by business (poultry,
dairy), it is unfixed, depending on the price of feed and ingredients. As of 2015,
subsidies for poultry accounted for 40% and dairy for 60%.
60 GEMs Paper #26 | 30 June 2016
Saudi Arabia approves 100% foreign ownership rules
• Saudi Arabia’s cabinet has approved rules governing foreign ownership of retail and
wholesale businesses in the Kingdom. The regulations, which were first discussed
last year, allow foreign investors to own 100% of retail and wholesale businesses in
the country. Earlier, the ownership ceiling for foreigners was set at 75%. This
initiative is aimed at attracting more regional and international brands to Saudi
Arabia, creating more jobs, and boosting non-oil revenue. This has raised concerns
regarding the sustainability of the business model of Saudi retailers.
• Real estate is key to entering a market: unlike its peers, Al Hokair enjoys favourable
access to prime locations in well-located shopping malls owned by its parent
shareholder, Al Hokair Group. Fashion retailers such as Inditex continue to compete
for good-quality real estate in shopping centres and on high streets.
• Jarir and Extra are more vulnerable to the entry of international retailers such as
Apple as barriers of entry are very low for consumer electronics and appliances.
Furthermore, the government emphasis on developing tourism and family
entertainments (Six Flags, Sea World) represents a potential threat to Jarir and
Extra’s business models which still play an ‘entertaining’ role in Saudi Arabia.
• Such initiatives would result in (1) reducing the number of stores; (2) a rapid
modernization of the sector; and, (3) a significant increase in labor productivity by
adopting merchandising best practices.
Rationale for liberalization
The rationale for permitting FDI in retail trading is (1) attracting investments in
production and marketing; (2) improving the availability of such goods for the consumer;
(3) encouraging increased sourcing of goods from Saudi Arabia; and, (4) enhancing
competitiveness of Saudi enterprises through access to global designs, technologies and
management practices.
Typically, global retailers follow a 100%-ownership business model, which explains their
reluctance to establish their presence in Saudi Arabia because of the restrictive policy
environment. This has been reflected in the little amount of FDI received in the Saudi
retail sector.
However, we do not believe that such decision will provide foreign investors more ability
to have control of a company as the current ownership ceiling of 75% already allows
them to pass both ordinary and special resolutions.
Key opportunities of 100% foreign ownership initiative:
We perceive several opportunities emerging from such an initiative:
1) Capital infusion: FDI is one of the major sources of investments for a
developing country like Saudi Arabia wherein it expects investments from
multinational companies to improve economic activity, create jobs, share their
expertise, back-end infrastructure and research and development in the host
country.
2) Boost competition and dampen inflation: the entry of the many multinational
corporations will promise intense competition between the different
companies offering their brands in a particular product market. This will result
in availability of many varieties, reduced prices, and convenient distribution of
the marketing offers.
3) Improvement of supply chain: Improvement of supply chain/distribution
efficiencies, coupled with capacity building and introduction of modern
technology will help arrest wastages, particularly in the food supply chain.
GEMs Paper #26 | 30 June 2016 61
4) Jobs creation: the entry of foreign companies into retailing in Saudi Arabia will
not only create job opportunities but will also ensure quality in them, improving
standards of living and life styles.
Al Hokair: Eased restrictions on foreign investors: perception vs reality
The liberalization of the Saudi retail industry raised concerns among Al Hokair investors
regarding the potential loss of the Inditex franchise, which we estimate accounts for 8%
of its total stores. We think this risk is overstated for the following reasons:
• Relationship with parent: Unlike its peers, Al Hokair enjoys favourable access to
prime locations in well-located shopping malls owned by its parent shareholder, Al
Hokair Group. The group owns and operates 13 shopping malls across Saudi Arabia
(1.2m sqm of prime real estate) through its subsidiary Arabian Centres Company.
However, we understand that rents are currently negotiated on commercial terms,
thereby limiting the risk of a conflict of interest. We do not think the situation will
change.
• Real estate is key to entering the market: Fashion retailers continue to compete
for good-quality real estate in shopping centres and on high streets. Going forward,
there is likely to be significant competition between these companies for new sites,
especially in prime shopping centres, as they all require similar locations, typically
prominent, wide-fronted premises. Zara, in particular, uses its shop windows to
advertise its products.
• Local manufacturing and distribution network would add execution risks and
costs to international retailers such as Inditex: While Saudi Arabia has not yet
provided the details and conditions of the potential eased restrictions on foreign
investors, we understand that the government is looking to attract investments,
diversify its economy and improve Saudization. This means foreign retailers could
be asked to set up local manufacturing and distribution networks within Saudi
Arabia, which we believe could discourage retailers such as Inditex from entering
the market directly.
More malls, less bargaining power with international retailers
The accelerating pace of mall developments in Saudi Arabia by regional competitors to
Al Hokair’s parent company suggests a rising risk of diminishing bargaining power for Al
Hokair with its international brand partners such as Inditex. We expect Shumoul Holding
55% owned by Mabanee, the Kuwaiti mall operator, to develop a 400k sqm mall in
Riyadh while Dubai-based Majid Al Futtaim recently announced that it is looking to
develop two malls in Riyadh of 300k and 100k sqm of GLA respectively resulting in four
times more stores (300) in the next five years. Such new entrants can then
accommodate foreign retailers (such as Inditex), which could question the sustainability
of Al Hokair’s franchise model.
Jarir: exposed to NTP innovations
What if Apple enters Saudi Arabia
Should Apple enter Saudi Arabia, it would negatively impact the Apple resellers such as
Jarir as the majority of the sales would be transferred to the Apple-branded stores. As
such, we highlight 2 key risks to Jarir that would ultimately deteriorate earnings outlook:
(1) rising competition from Apple resulting in a weaker footfall trend due to weaker
electronic sales, which are key for store traffic; and, (2) intensifying competition from
organised retail space (malls), reducing the market share of specialist retailers such as
Jarir.
Jarir’s earnings sensitive to electronics business
With c40% of revenues and c20% of gross profit derived from the electronics segment,
Jarir remains vulnerable to the threat of foreign retailers entering directly Saudi Arabia.
62 GEMs Paper #26 | 30 June 2016
We estimate that a 20% decline in electronic sales would result in a 5% direct decline in
gross profit. However, this ignores the other negative effects of other product
categories due to a weaker footfall trend.
More entertainment in KSA, less attraction for Jarir’s stores
In line with the guidance of the NTP, we expect Saudi Arabia to develop the
entertainment sector (theme parks, cinemas). This signals the emergence of new
aspirations and social changes for Saudis. While these developments will support
implementation of Saudi Vision 2030, they will pose threats to the existing business
models of Saudi retailers such as Jarir and Extra that are currently substituting for the
lack of entertainment opportunities in the country.
GEMs Paper #26 | 30 June 2016 63
Real estate: NTP positive but not enough
The Saudi residential sector is suffering an acute housing shortage which we estimate
at c1.2mn homes. Key reasons are:
• 1) Land is expensive: land constitutes as much as 50% of the cost of a housing
unit which is more than double the typical 20-25% in more affordable areas
globally.
• 2) Affordability issue: banks are reluctant to provide mortgages to workers from
the private sector.
• 3) Limited financing: the Real Estate Development Fund (REDF) which used to
provide interest-free loans to eligible Saudis for home purchase or construction, has
been unable to cope with the demand for new loans and has a backlog of about
450,000 applicants. The housing ministry is looking to issue Islamic bonds to help
fund the country’s REDF at the end of 2017.
• 4) Overrun development costs: Long delays for construction approval and permits
translate to overrun costs which create obstacles for developers to launch
economically feasible projects.
A persisting shortage of affordable residential supply
The shortage of housing is not a new phenomenon – it has been ongoing for decades.
The demand outlook from end-users is solid. Domestic household formation (marriages)
is a large component: newly married Saudi couples need an affordable place to live. With
market demand growing by 105K units pa (BofAMLe), we believe the shortage of supply
will persist for the following reasons:
• The limited scalability of residential projects – Dar Al Arkan is the largest
residential developer with only a 1% potential market share (delivery capability of
1,100 units pa).
• The capital-intensive Saudi financing model – without funding support from the
government and a virtually non-existent off-plan sales market, Saudi developers
have to secure funding to undertake larger residential projects. Dar Al Arkan is
having to lever up, as land sales, which were once the primary source of funding,
are no longer enough to enable it to scale up.
• A lack of incentives for large regional developers to enter the market – the
dearth of off-plan sales has dried up the cash flows of developers and limited their
ability to finance new projects and, in the worst cases, ongoing projects.
Furthermore, the profitability of affordable housing projects is not compelling
enough to attract developers to the Kingdom.
Fragmented Saudi residential market
Some 75% of new housing supply is from individuals and micro-home builders. This
trend highlights Saudis’ preference for building their own homes and illustrates the