Saudi Telecom Sector

(1)

1

Saudi Telecom Sector-Mobily under the Spotlight

The Saudi Telecommunication sector in the last couple of years have seen its fair share of ups and downs. First STC had to clean it books and charge impairment losses on underperforming subsidiaries, however STC since then has come out strongly and has been posting strong results, and now Mobily has dented the investors’ confidence with the reclassification and readjustment of its financial statements. Although Zain Saudi is not in our coverage however it is imperative to mention the troubles the company has faced. The company since its inception has faced a number of issues like high licensing cost, heavy debt, operational inefficiencies, capital reduction and the cancelation of the MVNO deal. Then recently the arbitration by Mobily due to the disagreement over network coverage payments has added to the companies vows, where the company can potentially face a huge payment of SAR 2.2bn. Zain has also once again asked for reduction in its capital, which has put a lot of question marks over the company’s sustainability.

Valuation

In light of our reasoning we maintain our current recommendation for STC and Mobily. We believe STC is still on solid footing to maintain its growth rate. We revise our 2014 net income expectation based on 9M-2014 performance, we maintain our

“overweight” stance on the stock.

For Mobily we maintain our “under review” rating, given that the lack of disclosure still hinders us in appropriately gauging the impact of the above mentioned reasons. We will update our view on the company once 2014 annual results are issued since they will provide us with a better view of the company financial health.

Price Movement (rebased on 100)

Source: Bloomberg

Company

Name Net Income (mn) EPS (SAR) PE (x) PB (x) Div Yield (%) Price

Target Recomendation 2013 2014 YoY Growth 2013 2014 2013 2014 2013 2014 2013 2014

STC 9,987 10,955 9.7% 4.99 5.48 10.71 12.37 1.9 2.17 4.21% 3.32% 82.7 “Overweight”

Mobily 6282.1* UR - 8.16* UR** 10.48 9.8*** 2.76 1.65*** 5.60% UR** Under review Under review

Source: Financial Statement,Al Jazira Research * 9M-2013 readjusted and reclassified,4Q-2013 as reported

** Under review

*** Trailing 12 month

0 50 100 150 200 250

Mobily STC Z AI N

Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14

(2)

2

Mobilys’ 3Q-2014 result came as a surprise, as the company posted net earnings of SAR 472mn, depicting a fall of 71% YoY. The company attributed the fall in earnings to occurrence of non-reoccurring earning in 3Q-2013. However in 3Q-2014, the inability of the company to recognize such profitability ,higher depreciation expenses and an increase in provision resulted in the above mentioned decline. We believe this is normal, as such swings in profitability is part of normal business practice. We would be taking the issues out of proportions if we take this standalone result as a torch bearer for future performance. However for us the problem starts with the readjustment and reclassification of previous quarters, which has highlighted the weakness in the operational efficiency of the company.

The company’s early recognition of FTTH related revenues and net income, of SAR 1,232mn and 1,227mn respectively, in 2Q- 2014, and a subsequent re-adjustment in the 3Q-2014, highlighted a grave issue. The early recognition of revenues , in current circumstances shows that it was done without the necessary due diligence, it also highlighted the weakness in the company’s core activities, as Mobily in the last couple of quarters have been supporting its revenues growth by early recognition of revenues. Like the recognition of the loyalty program revenues for 2013.

In our assessment following are the key issues that have come to light

• Falling ARPU or a declining customer base: In light of the current situation a major key issue in our view is the operational efficiency of the company. As clear disclosure by the company is not available, we believe these issues were being camouflaged under the hood of other revenue sources, which were not disclosed appropriately. This make us question the depth of revenues and margins from the core activities (voice and data). In light of the current scenario we believe either the company was facing falling ARPU or

a decline in customer base or a combination of both. However we believe, that this was more the matter of a declining customer base on the back of the measures by the government to curb the use of unregistered SIM cards. This we believe impacted Mobily and Zain more than it impacted STC. We believe gauging the prime reason for the declining contribution to the bottom line from the core activities is still very difficult given the lack of disclosure. However this can be highlighted from the fact that the adjustment and reclassification of financial statements resulted in lower revenues.

Although we are not completely discounting the

possibility that the ARPU for the company also took a hit, if that is the case then we believe the issue will not be limited to Mobily alone as this will impact the sector as whole. If Mobily is facing falling ARPUs then we believe same is the case with STC which can also see declining profitability on the back of weak ARPUs .However, we believe the greater impact was due to the decline in customer base.

• FTTH expansion slowdown to hurt growth: The sector’s next growth driver was the aggressive expansion in the FTTH business, where the sector as a whole was looking to reach more than 2.5mn housing units by the end of 2014. Mobily was looking to reach almost 1.0 mn housing units by the end of year. However the current disclosure by the company puts a lot of question marks on the sustainability of it growth in the coming years. Given that voice penetration has reached saturation level, high speed data (FTTH and FTTX) was being billed as the next growth driver for the sector. STC’s expansion in this field has been going smoothly where it was able to achieve its target of 1.5mn housing unit for 2013. Mobily on the other hand seems to be lacking behind in its expansion plans. We believe given the decreasing customer base and an incomplete FTTH network, Mobily has a number of challenges ahead in order for it to find its footing.

Mobile Penetration

Source:CITC 2.5 2.9 3.4 4.3 4.6 4.6 4.8 5.5 6.1 6.3 6.6 7.3 6.9 6.6

0 2.1 3.8 4.9 9.5 15.1 23.6 30.5 38.7 45.3 47.1 45.7 43.9 44.8 12% 23% 32% 40%

60%

81%

113%

138%

167% 186% 188% 182% 170% 169%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

0 10 20 30 40 50 60

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Q2-2014 P ostpaid -LHS P repaid -LHS Mobile penetration -RHS

(3)

3

• Sector CAPEX, Mobily needs to cut its plans: The sector as a whole was looking to spend above SAR 45bn from 2013- 2018 on its CAPEX, where Mobily was looking to spend around SAR 5bn per years for the coming 4 years along with an extra SAR 2.0bn CAPEX for a new head office tower. In

our recent assessment of the company’s financial what has come to light is that Mobily is financing 100% of its CAPEX through loan financing, which leaves just enough to distribute dividends. If this current trend continues, the company’s debt can grow up to SAR 38bn(Considering 100% debt financing of CAPEX). We believe this can raise a lot of red flags for the company, especially in light of the recent weak performance on the financial front. The company in our view can face solvency issues in the future. We believe Mobily will have to come up with a revised strategy where it will have to decide on the future expansion and the

dividend policy and it will have to make some hard choices in the near future.

In light of the above, there are challenges coming ahead for Mobily’s dividend policy. The high CAPEX is not leaving enough room for the company to maintain its dividend payout. What is of interest is that in 2013 and 9M-2014, the company maintained its dividend by financing 99% of its CAPEX through debt.

In light of the current scenario we believe the company will find it difficult to maintain its CAPEX plans and dividend policy.

Mobily D/E (Debt to Equity)

Source:CITC

Year Operating Cash Flow

(i)

CAPEX

(ii) FCF (iii) Loans Inflow (iv)

Loan Payment

(v)

Dividend Payments

(vi)

FCF v Dividends

(iii+vi)

Operating Cash Flow vs Outflows

(i+ii+v+vi)

Loan inflow/

CAPEX (iv/-ii)

Net Loan /Capex ((iv+v)/-ii)*

2009 4,246 (3,292) 953 1,626 (2,788) (525) 428 (2,360) 49% -35%

2010 5,357 (3,174) 2,182 1,927 (2,567) (875) 1,307 (1,260) 61% -20%

2011 6,673 (3,700) 2,973 870 (1,832) (2,275) 698 (1,134) 24% -26%

2012 6,173 (3,850) 2,323 7,415 (6,253) (3,500) (1,177) (7,430) 193% 30%

2013 5,535 (3,889) 1,646 3,852 (1,360) (3,619) (1,973) (3,333) 99% 64%

9M-2014 4,851 (5,488) (637) 5,406 (821) (2,888) (3,525) (4,346) 99% 84%

Source:Mobily Financial Statements, Aljazira Research.

*The negative sign depicts the loan outflows where higher then inflows, which shows that during 2009-2011 the company was maintaining its capital structure.

However Post 2011, weight of loans in the capital structure kept on increasing depicting a net inflow of loans.

Mobily Dividend Yield Mobily CAPEX

Source: Company Financial Report Source: Company Financial Report

0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70

- 2, 000 4, 000 6, 000 8, 000 10, 000 12, 000 14, 000 16, 000

2011 2012 2013 3Q-2014

In Mn SAR

Debt-LHS Debt / E q uity-RHS

0%

1%

2%

3%

4%

5%

6%

7%

8%

- 1.00 2.00 3.00 4.00 5.00 6.00

2008 2009 2010 2011 2012 2013

DP S-LHS Div Y ield-RHS

In SAR

- 1, 000 2, 000 3, 000 4, 000 5, 000 6, 000

2007 2008 2009 2010 2011 2012 2013

In Mn SAR

(4)

4

• Possible rate cut to prove challenging: With an increase in depreciation cost, due to high CAPEX, an increasing financial cost due to higher debt, and a probable decrease in customer base will prove further challenging if CITC ( Communication and Information Technology Commission) decides to force cuts in local calling rates or a ceiling is set. We believe this will further deteriorate Mobily’s earning potential in the long run. This will impact the sector as a whole as this can result in lower margins, however not necessarily lower ARPU, as the companies can revise their data and calling plans for the old pricing. For example if the company was providing 2GB of internet data for SAR 100, it will just start providing higher data for the same price. This will potentially impact the margins. A a lower price bracket will also hurt the sector as a whole. In contrast this will also attract the budget conscious consumers to mobile data usage, who previously were limiting their use to just voice services. This has the potential to improve revenues. The mobile internet penetration level is around 68.3%,there is still a lot of room for the companies to grab more customers.

Mobile Broadband Subscribers

Source:CITC

• SAR 1.1bn provision to hurt Mobily: Mobily in its recent announcement has declared that it has requested referral to arbitration with regard to Mobily due receivable amounts resulted from the service agreement signed with Zain KSA on 6 May 2008. This agreement is about providing services that include national roaming, site sharing, transmission links, and international traffic. Mobily and Zain both have not been able reach an amicable solution, regarding the pricing of the services provided, due to which Mobily has had to file for an arbitration. Mobily is expecting to be paid SAR 2.2bn, whereas Zain is of the view that the charges should be around SAR 13mn only. In light of the current situation Mobily reserved SAR 1.1bn for provision. We believe the company will book the provision in this quarter. This once again highlight a grave issue, that the company booked profitability without the necessary due diligence. If Mobily is able to get the decision in its favor for the arbitration, Zain will be looking at a huge bill of SAR 2.2bn. However if Mobily loses,it will have to book an impairment of the net amount, where SAR 2.2bn will be adjusted for the payment due from Zain. This will significantly impact Mobily’s profitability in the coming quarters.

• STC benefitting from Mobilys’ loss: Mobily so far seems to be on the receiving end of couple of sour deals, which has in turn benefitted STC, as it has grabbed onto these revenue generating opportunity. First, Mobily lost Etihad Atheeb IRU(Indefeasible Rights of Use ), which resulted in cancellation of SAR 338.7mn of profit. STC was quick to grab the Atheeb deal once no agreement was reached between Mobily and Etihad Atheeb. This has once again impacted Mobily, as Zain has signed an agreement with STC to lease its network, given the long dispute with Mobily on using their networks. The conflict between Zain and Mobily rose due to the difference in calculation by both firms in regard to the payments in lieu of services provided by Mobily, where Mobily is of the opinion that Zain owes around SAR 2.2bn and according to Zain its owes only SAR 13mn.

0.2 0.5 1.31 2.7 4.28 4.22 4.59 5.66

7.06 8.07 9.68

15.09

0.2% 1.1% 4.9% 9.7%

39.6% 42.1% 47.60%

68.30%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

0 5 10 15 20 25

2007 2008 2009 2010 2011 2012 2013 Q2-2014

SAR million

Standard Mobile subscription -LHS Dedicated Mobile data subscription -LHS Mobile Broad Band Teledensity -RHS

(5)

5

Company Name Challenges Suggested Counter measures

Saudi Telecom

• The changing environment of the telecom industry has made it more challenging for the sector as a whole to sustain growth.

• The high CAPEX can become challenging in the future if expansion does not generate appropriate revenues.

• Due to the fast developing nature of the telecom industry’s technology, expansion run the risk of becoming obsolete before its full returns are realized.

• STC needs new innovative ideas.

• CAPEX Plans should be reviewed and projects prioritized.

• STC has to bring only technologies that suits the local consumer base.

Mobily

• Mobily is facing multiple issues on the operational front.

• The company is not able to generate enough cash to sustain its dividend and CAPEX policy.

• The company will have to find ways of increasing its customer base.

• Operations have to be reviewed and priorities have to be set.

• Dividend Policy has to be revised

• New segment of clients should be considered

Zain

• Since inception, Zain has been facing number of issues, like high debt and licensing fees, small customer base and depleting capital base.

• Zain needs a brand new business model (i.e. niche segment)

Challenges Facing Major Saudi Telecoms

(6)

Asset Management

|

Brokerage

|

Corporate Finance

|

^Custody

|

^Advisory

Head Office: King Fahad Road, P.O. Box: 20438, Riyadh 11455, Saudi Arabia، Tel: 011 2256000 - Fax: 011 2256068

Aljazira Capital is a Saudi Investment Company licensed by the Capital Market Authority (CMA), license No. 07076-37

RESEARRESEARCH DIVISIONRATING TERMINOLOGYBROKERAGE AND INVESTMENT CENTERS DIVISION

Disclaimer

AlJazira Capital, the investment arm of Bank AlJazira, is a Shariaa Compliant Saudi Closed Joint Stock company and operating under the regulatory supervision of the Capital Market Authority. AlJazira Capital is licensed to conduct securities business in all securities business as authorized by CMA, including dealing, managing, arranging, advisory, and custody. AlJazira Capital is the continuation of a long success story in the Saudi Tadawul market, having occupied the market leadership position for several years. With an objective to maintain its market leadership position, AlJazira Capital is expanding its brokerage capabilities to offer further value-added services, brokerage across MENA and International markets, as well as offering a full suite of securities business.

1. Overweight: This rating implies that the stock is currently trading at a discount to its 12 months price target.

Stocks rated “Overweight” will typically provide an upside potential of over 10% from the current price levels over next twelve months.

2. Underweight: This rating implies that the stock is currently trading at a premium to its 12 months price target.

Stocks rated “Underweight” would typically decline by over 10% from the current price levels over next twelve months.

3. Neutral: The rating implies that the stock is trading in the proximate range of its 12 months price target. Stocks rated “Neutral” is expected to stagnate within +/- 10% range from the current price levels over next twelve months.

4. Suspension of rating or rating on hold (SR/RH): This basically implies suspension of a rating pending further analysis of a material change in the fundamentals of the company.

The purpose of producing this report is to present a general view on the company/economic sector/economic subject under research, and not to recommend a buy/sell/hold for any security or any other assets. Based on that, this report does not take into consideration the specific financial position of every investor and/or his/her risk appetite in relation to investing in the security or any other assets, and hence, may not be suitable for all clients depending on their financial position and their ability and willingness to undertake risks. It is advised that every potential investor seek professional advice from several sources concerning investment decision and should study the impact of such decisions on his/her financial/legal/tax position and other concerns before getting into such investments or liquidate them partially or fully. The market of stocks, bonds, macroeconomic or microeconomic variables are of a volatile nature and could witness sudden changes without any prior warning, therefore, the investor in securities or other assets might face some unexpected risks and fluctuations. All the information, views and expectations and fair values or target prices contained in this report have been compiled or arrived at by Aljazira Capital from sources believed to be reliable, but Aljazira Capital has not independently verified the contents obtained from these sources and such information may be condensed or incomplete. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on the fairness, accuracy, completeness or correctness of the information and opinions contained in this report. Aljazira Capital shall not be liable for any loss as that may arise from the use of this report or its contents or otherwise arising in connection therewith. The past performance of any investment is not an indicator of future performance. Any financial projections, fair value estimates or price targets and statements regarding future prospects contained in this document may not be realized. The value of the security or any other assets or the return from them might increase or decrease. Any change in currency rates may have a positive or negative impact on the value/return on the stock or securities mentioned in the report. The investor might get an amount less than the amount invested in some cases. Some stocks or securities maybe, by nature, of low volume/trades or may become like that unexpectedly in special circumstances and this might increase the risk on the investor. Some fees might be levied on some investments in securities. This report has been written by professional employees in Aljazira Capital, and they undertake that neither them, nor their wives or children hold positions directly in any listed shares or securities contained in this report during the time of publication of this report, however, The authors and/or their wives/children of this document may own securities in funds open to the public that invest in the securities mentioned in this document as part of a diversified portfolio over which they have no discretion. This report has been produced independently and separately by the Research Division at Aljazira Capital and no party (in-house or outside) who might have interest whether direct or indirect have seen the contents of this report before its publishing, except for those whom corporate positions allow them to do so, and/or third-party persons/institutions who signed a non-disclosure agreement with Aljazira Capital. Funds managed by Aljazira Capital and its subsidiaries for third parties may own the securities that are the subject of this document. Aljazira Capital or its subsidiaries may own securities in one or more of the aforementioned companies, and/or indirectly through funds managed by third parties. The Investment Banking division of Aljazira Capital maybe in the process of soliciting or executing fee earning mandates for companies that is either the subject of this document or is mentioned in this document. One or more of Aljazira Capital board members or executive managers could be also a board member or member of the executive management at the company or companies mentioned in this report, or their associated companies.

No part of this report may be reproduced whether inside or outside the Kingdom of Saudi Arabia without the written permission of Aljazira Capital. Persons who receive this report should make themselves aware, of and adhere to, any such restrictions. By accepting this report, the recipient agrees to be bound by the foregoing limitations.

+966 11 2256115

[email protected] +966 11 2256046

[email protected] +966 11 2256248

[email protected]

General manager - brokerage services and sales Ala’a Al-Yousef

+966 11 2256000

[email protected]

AGM-Head of international and institutional brokerage

Luay Jawad Al-Motawa +966 11 2256277

[email protected]

AGM- Head of Western and Southern Region Investment Centers & ADC Brokerage

Abdullah Q. Al-Misbani +966 12 6618400