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GEMs Paper #26
Saudi Arabia: beyond oil but not so fast
30 June 2016 Corrected
Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.com
Transforming Saudi Arabia, but challenges abound
The Saudi National Transformation Plan (NTP) bodes well for comprehensive reform
efforts to diversify the economy in line with Vision 2030. The NTP a) identifies key
sectors with high growth potential; b) starts to articulate supportive public sector
industrial strategies; and c) seeks to foster higher value-added through enhancements to
processes, products and organizations. Still, ambitious targets in a number of sectors are
unlikely to be reached and medium-term macro sustainability is not yet clear.
USD peg holds but NTP inconsistent with stable FX policy
Our view is still that the USD peg holds. However, the NTP provides a mixed message.
On the one hand, it blurs policymaking incentives given the need for a competitive Fx if
diversification progresses. On the other, unrealistic fiscal targets mean consolidation is
likely to fall short of easing imbalances materially without oil price recovery. Energy
policy thus likely needs to become less aggressive to support macro and FX policies.
Eurobond premium required for fiscal slippage risk
We expect large and regular sovereign Eurobond issuance to support FX reserves and
domestic liquidity but to weigh on regional bond spreads if risk appetite does not hold
up or fiscal balance slips. EMBIG index inclusion is unlikely, in our view. Saudi forwards,
CDS and rates are likely to stay under pressure due to issuance and tight liquidity.
Commodities: NTP adds to medium-term oil tightness
The NTP suggestion that production capacity is maintained until 2020 reinforces our
conviction of medium-term oil market tightness. The NTP gas production target that
could displace domestic crude demand and boost export capacity is challenging.
Equity Strategy: six investible themes on the back of NTP
We see a number of investible themes emerging from the NTP which investors can use
to identify potential beneficiaries. These themes include rising availability of affordable
housing, increased access to healthcare, down-trading as the consumer comes under
pressure, a surge in telecom infrastructure and significant opportunities in the
downstream petrochemical arena. Buy-rated names with access to these themes
include: Al Hammadi, Savola, Al Othaim, STC, Zain KSA and SABIC.
Partial NTP success & MSCI inclusion could drive rerating
The Saudi market trades on a 12m fwd P/E of c.13x, an 11% discount to the long-term
average and its lowest premium to GEMs since 2010. We believe that with earnings
momentum gradually reaching an inflection point a relatively negative outlook is already
being priced in. Given our view that oil prices will gain strong momentum in 2017, even
a partial success of the NTP along with CMA market reforms to expedite inclusion in the
MSCI EM index could be sufficient to improve confidence and thus drive a rerating.
Trading ideas and investment strategies discussed herein may give rise to significant risk and are not
suitable for all investors. Investors should have experience in FX markets and the financial resources to
absorb any losses arising from applying these ideas or strategies.
>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under
the FINRA rules.
Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take
responsibility for this report in particular jurisdictions.
BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a
result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report. Investors should consider this report as only a single factor in making
their investment decision.
Refer to important disclosures on page 82 to 85. Analyst Certification on page 81. Price Objective
Basis/Risk on page 77. 11643724
GEM Fixed Income Strategy & Economics
Global
Jean-Michel Saliba
MENA Economist
MLI (UK)
+44 20 7995 8568
jean-michel.saliba@baml.com
Hootan Yazhari, CFA >>
Research Analyst
Merrill Lynch (DIFC)
+971 4 4258218
hootan.yazhari@baml.com
Francisco Blanch
Commodity & Deriv Strategist
MLPF&S
+1 646 855 6212
francisco.blanch@baml.com
Faisal AlAzmeh, CFA >>
Research Analyst
Merrill Lynch KSA Company
+966 11 299 3741
faisal.alazmeh@baml.com
Abdelrali El Jattari >>
Research Analyst
Merrill Lynch (DIFC)
+971 4 4258231
abdelrali.eljattari@baml.com
Jamie Clark, CFA >>
Research Analyst
MLI (UK)
+44 20 7995 1300
jamie.clark@baml.com
Ali Dhaloomal
Research Analyst
MLI (UK)
+44 20 7996 9107
ali.dhaloomal@baml.com
Celine Fornaro >>
Research Analyst
MLI (UK)
+44 20 7996 5515
celine.fornaro@baml.com
See Team Page for Full List of Contributors
A Transforming World
This report ties into the enterprise-wide Investment
Themes recently introduced in A Transforming World. In
particular, the Saudi National Transformation Plan is
likely to span the themes of Markets (Frontier),
Government (Reform) and Earth (Energy Efficiency)
Contents
Macro: charting the way forward 3
Towards better governance 3
Public Investment Fund to gain prominence 7
Historic energy sector liberalization 10
National Transformation Plan: many promises, few details 13
Lessons in diversification 31
Eurobond premium required for fiscal slippage risk 34
Commodities: NTP adds to medium-term oil market tightness 36
Equity Strategy: more clarity required, but investible themes emerging 39
Six key investible themes from the NTP are emerging 40
Saudi market valuation not testing 42
Taking positive steps to accelerate MSCI inclusion 45
A higher weighting in international indices 45
Telecom: supporting a move to higher connectivity 48
NTP helps increase penetration of higher margin offerings 48
Health: Not Tremendously Prescriptive 51
Vision 2030 a start but Needs Transparent Proposals 51
Healthcare implications of National Transformation Plan 51
Consumer: a necessary pain 58
Prefer staples over discretionary 58
Rationalization of subsidies for water and electricity 60
Saudi Arabia approves 100% foreign ownership rules 61
Real estate: NTP positive but not enough 64
Key strategic objectives and KPIs to watch 64
Land tax - gradual revenue source 65
Metals & Mining: ambitious growth target 67
Government focus on mining to boost jobs and growth 67
Oil & gas/petchems: focus on downstream 69
Focus on downstream expansion is a priority 69
Refining capacity target: almost there 71
Ambitious natural gas expansion 72
Utility sector: sharing the capex burden and achieving cost reflective tariffs 73
Eight strategic objectives aimed at being self-funding 73
Defence: Vision 2030 supports defence spending 75
Saudi Arabia to build out military industrial base 75
Research Analysts 86
2 GEMs Paper #26 | 30 June 2016
Macro: charting the way forward
Jean-Michel Saliba
MLI (UK)
jean-michel.saliba@baml.com
The Saudi Vision 2030 and National Transformation Plan (NTP) present a
comprehensive roadmap for change and augur for committed diversification efforts, in
our view. Announced reforms can help sustain higher potential growth if fully realized as
new sectoral sources of growth are developed. Positively, the NTP borrows elements
from other successful strategic case studies. Still, we find a number of targets
ambitious or unrealistic on the fiscal and diversification fronts, and the sequencing and
details of the fiscal measures are left nebulous.
In terms of the other pillars of the macro view, namely energy and Fx policy, the NTP
presents a mixed picture, in our view. Energy policy is likely to be less aggressive, as the
NTP suggests a constant oil production capacity. To remain consistent with the targeted
government debt accumulation path, we estimate that oil prices have to average at least
US$50/bbl in 2016-20 along with no growth in spending (excluding the additional cost
of NTP initiatives). Partial implementation could require oil prices of cUS$65/bbl.
Fiscal consolidation remains imperative to support the Fx peg, in line with stability and
economic imperatives. However, as diversification progresses, the case for increased Fx
flexibility to support competitiveness could likely gradually take shape. Policy-making
growth-focused plans may conflict with needs to deflate Fx demand in the economy.
Towards better governance
The comprehensive economic blueprint unveiled by the Saudi Vision 2030 and the
National Transformation Plan (NTP) confirms the economic reform credentials of the
current administration. It is likely to improve government culture, accountability and
transparency, in our view. The NTP will be implemented across 24 government bodies
and has been presented through a number of press conferences with high-level
ministerial presentations. The Governance Framework details steps to institutionalize
and coordinate implementation through restructuring the government. It proposes a
number of committees and bodies to report to the Council for Economic and
Development Affairs (CEDA). It also introduces an escalation mechanism to rapidly
resolve bottlenecks, which could see matters escalated to CEDA in 42 days.
A wide-ranging policy-making reshuffle
In line with ongoing Saudi Vision 2030 implementation efforts, a wide-ranging
restructuring of the Saudi Cabinet and government bodies was announced in May to
drive change in the government. King Salman issued 51 Royal Decrees restructuring the
Cabinet, various government bodies and appointing a number of officials into various
government roles. A statement concurrently issued by the Royal Court suggested these
changes are in line with the recently announced Saudi Vision 2030 and aim to support
its implementation. This follows from the January 2015 restructuring of the bodies
affiliated to the Council of Ministers, which saw the creation of CEDA and the Council
for Political and Security Affairs. We list a few major changes below.
New Oil Minister represents technocratic experience and policy continuity
The appointment of Khalid Al-Falih to the Ministry of Energy, Industry and Mineral
Resources is not surprising, given that former Minister of Petroleum and Mineral
Resources Al-Naimi has previously suggested he was approaching retirement due to old
age. Al-Falih’s appointment continues the tradition of non-Royals heading the Ministry,
while simultaneously holding the Chairmanship role of Saudi Aramco. Furthermore,
according to local press, Al-Falih appears close to Deputy Crown Prince Mohamed bin
Salman, and his appointment likely confirms the recently assertive Royal influence over
energy policy, in our view. New Minister of Energy, Industry and Mineral Resources Al-
Falih’s past official pronouncements are consistent with stable Saudi energy policy, in
our view.
GEMs Paper #26 | 30 June 2016 3
Expanded role for the Oil Ministry under Vision 2030
The Ministry of Petroleum and Mineral Resources has been expanded to become the
Ministry of Energy, Industry and Mineral Resources. It will be dedicated for energy, in
addition to expanding to encompass responsibilities relating to electricity and industry.
It will also undertake the management of the National Industrial Cluster Development
Program (NICDP). The new Minister will chair the board of directors of the Royal
Commission for Jubail and Yanbu, the Industrial Development Fund, the Saudi
Organization for Industrial Estates and Technology Zones, the Saudi Geological Survey,
the King Abdulaziz City for Science and Technology, the Saudi Exports Development
Authority and the King Abdullah City for Atomic and Renewable Energy.
Energy sector liberalization drives non-oil diversification
The wider role for the Ministry of Energy, Industry and Mineral Resources is in line with
the expanded industrial responsibilities foreseen for Saudi Aramco in the Vision 2030. It
may also suggest a continued desire to liberalize the energy sector. The National
Industrial Cluster Development Program (NICDP), established in October 2012 by the
Ministry of Petroleum and Mineral Resources and the Ministry of Commerce and
Industry, could likely gain further importance in the industrialization strategy adopted in
the Vision 2030. The NICDP will be managed by the Ministry of Energy. It seeks to
leverage Saudi Arabia’s comparative advantage in energy, petrochemicals and minerals
to create sustainable export oriented industries, initially focused on the automotive,
construction material, appliances, metal processing and flexible packaging sectors.
Restructuring the Cabinet and other government bodies
The Ministry of Commerce and Industry will become the Ministry of Commerce and
Investment and sees the appointment of a new Minister. The new Minister will chair the
board of directors of the General Authority for Investment, the General Authority for
Small and Medium Enterprises and the Saudi Standards, Metrology and Quality
Organization. The Ministry of Labor will be merged with the Ministry of Social Affairs to
form the Ministry of Labor and Social Development, and sees the appointment of a new
Minister. The Ministry of Water and Electricity has been disbanded. The Ministry of
Agriculture was renamed the Ministry of Environment, Water and Agriculture and
expands its responsibilities into these areas. Two new Ministers for Transport and
Health were appointed. The Ministry of Hajj has been renamed the Ministry of Hajj and
Umrah and sees the appointment of a new Minister.
The Saudi Fund for Development will now report to the Council for Economic and
Development Affairs. The General Authority for Entertainment and the General Authority
for Culture have been created. The Department of Zakat and Income Tax was renamed
the General Authority for Zakat and Income, and will report to the Ministry of Finance.
New Central Bank Governor maintains commitment to USD peg
Saudi Arabian Monetary Agency (SAMA) Governor Al-Mubarak has been replaced in his
post by SAMA Deputy Governor for Research and International Affairs Dr. Al-Kholifey. A
number of officials were also appointed into various government and advisory roles.
New SAMA Governor Al-Kholifey’s past policy pronouncements suggest continued
commitment to the USD peg.
Watch the Saudi Fund for Development
The Saudi Fund for Development (SFD) new direct link to the Council for Economic and
Development Affairs likely concentrates further authority in the Deputy Crown, in our
view. Given that the Public Investment Fund (PIF) last saw similar links being established
prior to plans being made for it to be turned into a Sovereign Wealth Fund (SWF), this
could suggest further strategic changes may take place at the SFD.
4 GEMs Paper #26 | 30 June 2016
Exhibit 1: Saudi Vision 2030 Governance Model
Source: Saudi Vision 2030
A web of Strategic Programs
Saudi Vision 2030 incorporates a number of Executive Programs and initiatives, with
implementation carried out by several government entities. The Vision continues to
centralize decision-making into CEDA, chaired by Deputy Crown Prince Mohammed bin
Salman, and reporting to the Council of Ministers. The Ministry of Economy and
Planning also retains an important role, with lower emphasis being put on the Ministry
of Finance. The Project Management Program also suggests emphasis on ongoing
review of capital expenditures, whereby existing review served to examine their approval
process, and control their level. From a macro perspective, the three most important
programs for now are: a) the re-shaping of the Public Investment Fund (PIF) into a
US$2trn Sovereign Wealth Fund (SWF); b) the new corporate strategy for Saudi Aramco
to transform it into an energy and industrial conglomerate; and, c) the National
Transformation Plan (NTP) which encompasses medium-term growth boosting
initiatives and fiscal consolidation measures (alongside the Fiscal Balance and
Privatization Programs). We discuss these three elements in turn below.
Table 1: Strategic Programs introduced by the Saudi Vision 2030
Strategic Program
Comment
Government Restructuring Program
Supreme Councils have already been implemented, and the Council of Political and Security Affairs and the Council of
Economic and Development Affairs (CEDA) have been established
Strategic Directions Program
Strategic directions determined by state agencies and approved by the government
Regulations Review Program
Several laws have been reviewed or enacted already such as the Company Law, the Non-Governmental Organizations Law,
the White Land Law, and the General Authority for Endowments (Awqaf) Law
Performance Measurement Program
Center for Performance Management of Government Agencies has been established
Human Capital Program
Aims to measure, assess, analyze and support the efficiency of civil service
Program for Strengthening Public Sector Governance Strategic Management Office reporting to CEDA as well as a Decision Support Center at the Royal Court are to be established
Strategic Partnerships Program
Aims for stronger ties with economic partners to enhance exports
"Daem" Program
Aims to enhance the quality of cultural activities and entertainment
Private Sector Growth Stimulation Program
Under consideration
Regional Development Program
Under consideration
Fiscal Balance Program Likely target of achieving fiscal balance by 2020
Project Management Program
Expert Project Management Offices (PMOs) and a Central Delivery Unit have been established
Saudi Aramco Strategic Transformation Program
Aims to position Saudi Aramco as a leader in more than one sector
Public Investment Fund (PIF) Restructuring Program
Aims to transform the PIF into the largest Sovereign Wealth Fund (SWF) in the world
Privatization Program
Comprehensive privatization program; targets under study
National Transformation Plan Program Interim Key Performance Indicators (KPI) targets to achieve by 2020
Source: Saudi Vision 2030, BofA Merrill Lynch Global Research
GEMs Paper #26 | 30 June 2016 5
Table 2: Initiatives introduced by the Saudi Vision 2030
Initiative Current Target
Religious tourism
Number of yearly Umrah visitors per year (mn) 8 30
Building the largest Islamic museum in the world - -
Culture
Number of Saudi heritage sites registered with UNESCO 4 8
Number of Saudi cities recognized in the top-ranked 100 cities in the world 0 3
Household spending on cultural and entertainment activities (%) 2.9 6
Social
Average life expectancy (years) 74 80
Unemployment rate (%) 11.6 7
Female labour force participation (%) 22 30
Household savings ratio (% of household income) 6 10
Ranking in the Social Capital Index 26 10
Ratio of individuals exercising at least once a week (%) 13 40
Number of volunteers per year 11,000 1,000,000
Localization
Localization of oil and gas sectors (%) 40 75
Localization of defence industry (%) 2 50
Renewable energy value chain (%) - -
Sovereign Wealth Fund
Public Investment Fund assets (SAR bn) 600 7,000
Economy
Global ranking of the economy in terms of size 19 15
Ranking in the Global Competitiveness Index 25 10
Ranking in the Logistics Performance Index 49 25
Private sector contribution to GDP (%) 40 65
Foreign Direct Investment (% of GDP) 3.8 5.7
Non-oil exports share in non-oil GDP (%) 16 50
SME contribution to GDP (%) 20 35
Non-profit sector contribution to GDP <1 5
Improving the business environment and pursuing public-private partnerships - -
Rehabilitating economic cities and restructure King Abdullah Financial District - -
Establishing special zones such as logistic, tourist, industrial and financial ones - -
Revise energy subsidies and redirect support to eligible citizens and economic sectors - -
Ease restrictions on ownership and foreign investment in the retail sector - -
Fiscal
Non-oil government revenue (SAR bn) 163 1,000
Governance
Ranking in the Government Effectiveness Index 80 20
Ranking in the E-Government Survey Index 36 5
Source: Saudi Vision 2030
6 GEMs Paper #26 | 30 June 2016
Public Investment Fund to gain prominence
The restructuring of the Public Investment Fund (PIF) is likely to allow greater focus on
achieving a diversified foreign asset base which could support in turn the build-up of
non-oil revenues. According to Deputy Crown Prince Mohammed bin Salman,
government ownership of Saudi Aramco would be transferred to the PIF, which will be
transformed into a SWF that will look to increase its overseas assets (from 5% of total
to 50% of total by 2020) following its recapitalization and the proceeds of Aramco IPO.
The PIF would hold on-paper a vast amount of wealth post-IPO (US$2trn, according to
the Deputy Crown Prince, the bulk of which would be Saudi Aramco) as ownership of
Saudi Aramco is transferred to the PIF, but it would only be able to deploy the cash
proceeds of the monetized Aramco stake in the near-term, in our view. We think the
PIF’s transformation is still at a relatively early stage for now.
Room to grow PIF stature and budget contribution
The restructuring of the PIF is likely to allow further diversification of foreign assets,
which will in turn increase the share of investment income in the budget over time. We
estimate that in 2015 investment income transferred to the budget stood at US$9.9bn
(1.5% of GDP), which entails transfers of US$4bn from the PIF and US$5bn from SAMA.
These transfers pale in comparison to the estimated budgetary contributions among
main GCC peers. We estimate that the rate of return (investment income) on foreign
assets of SAMA, government entities and the private sector averaged c2% over the past
8 years, which already suggests some exposure to riskier asset classes, in our view. As
the PIF gains importance, it will become more prominent in the examination of the
breakdown of the Saudi Net International Investment Position .
Transitioning to an Abu Dhabi model
It will be interesting to see how the restructuring of the PIF into an SWF works out in
practice. We hypothesise that it may be that, on top of the monetization of Aramco's
stake sale, PIF could get a portion of the assets of SAMA. In this scenario, we would
effectively transition to the Abu Dhabi and Kuwait model where the central bank holds
little reserves and non-transparent SWFs are what matters both in terms of flow and
stock. Foreign assets purchases of the PIF would also have to be managed within the
overall Balance of Payments (BoP) framework as they could lead to drains on SAMA
reserves in the near term. Over time, Saudi Arabia could decide to emulate the Norway
model, which would entail a more prudent use and conduct of fiscal policy, in our view.
Chart 1: PIF budget contributions small versus GCC SWF contributions
40
35
30
25
20
15
10
5
US$bn % of GDP % of total revenues
0
Qatar Abu Dhabi Kuwait Saudi Arabia Dubai
Source: Haver, IMF, Saudi Ministry of Finance, BofA Merrill Lynch Global Research. 2015 data,
Investment income and transfer of profits of public entities for Kuwait. Investment income from
public enterprises (incudes Qatar Petroleum’s net income) for Qatar.
Chart 2: High rate of return suggests foreign assets well diversified
10
Implied rate of return with respect to IIP assets (%)
Implied rate of return with respect to SAMA reserve assets (%)
3.0
Net income balance (% of GDP, rhs)
2.5
8
2.0
6
4
2
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: Haver, BofA Merrill Lynch Global Research. Implied rate of return on SAMA reserve assets
simplistically assumes all investment income is earned by SAMA (instead of being earned by SAMA,
government entities and the private sector).
1.5
1.0
0.5
0.0
-0.5
-1.0
GEMs Paper #26 | 30 June 2016 7
PIF largely a domestic inward-looking entity until recently
The IMF reports that the PIF had assets of 11.1% of GDP in 2014 (c.SAR310bn). PIF has
foreign assets of SAR14.1bn as of end-2015. It has outstanding loans of SAR103.9bn as
of 3Q15 (excluding electricity loans of SAR14bn that PIF administers). According to
Bloomberg, PIF had stakes in publicly listed companies on Tadawul worth SAR934bn as
of April 2016. According to the MoF, PIF held equity worth SAR63.3bn in 41 Saudi
companies in total at end-2011, as well as stakes worth SAR14.9bn in a number of pan-
Arab corporations.
In July 2014, the cabinet authorized the PIF to establish companies inside and outside
Saudi Arabia, alone or in partnership with other institutions from the public or private
sectors. It also bought a US$1.1bn stake in a South Korean company and recently
announced in early June it took a US$3.5bn stake in Uber, denying in the process that it
was considering a US$3bn loan to fund the acquisition. PIF has been asked to co-invest
US$10bn in Russia or the Middle East with the RIDF. Note that PIF has established
Sanabil investments with SAR20bn in capital. The PIF has paid dividends to the budget
last year (SAR15bn). It now reports directly to the Council of Economic and
Development Affairs headed by the Deputy Crown Prince, after reporting to the Ministry
of Finance in the past.
JASTA bill not a hurdle for further Saudi investment in the US
We expect that the deep and liquid US financial markets will remain a prominent
destination for Saudi foreign asset holdings. The potential passage of the “9/11” bill
(Justice Against Sponsors of Terrorism Act, JASTA) in US Congress raises the possibility
that Saudi Arabia would choose to liquidate up to US$750bn in assets in the US,
according to Saudi Foreign Minister Adel al-Jubeir. A forced and rapid liquidation of USbased
Saudi foreign assets may expose SAMA and other government entities to markto-market
losses, and require changes to Fx reserve management
The language of the JASTA bill as it currently stands does not suggest an imminent
Saudi sell-off of US assets, in our view. The “Stay of Actions Pending State
Negotiations” section inserted into the bill allows a stay to be granted for an indefinitely
renewable 180-day period. This would be subject to court petition by the Attorney
General and repeated certification by the Secretary of State that the US is “engaged in
good faith discussions with the foreign state defendant concerning the resolution of the
claims against the foreign state”. The certification thus depends on the current and
future US administration foreign policy inclinations, in our view. Separately, we note
that the White House spokesman said US President Obama did not support the
legislation and likely would not sign it. (A potential presidential veto may however still
be overruled if Congress assembles the necessary two–thirds vote of each house). We
continue to expect a close relationship between the US and Saudi Arabia given the
confluence of interests in a broad range of matters.
8 GEMs Paper #26 | 30 June 2016
Table 3: Breakdown of Saudi Arabia Net International Investment Position (US$bn)
2007 2008 2009 2010 2011 2012 2013 2014 2015
Net International Investment Position 380 471 435 479 585 685 763 792 703
% of GDP 91 91 101 91 87 93 103 105 108
Net Foreign assets (excluding SAMA) 74 28 24 34 41 28 37 59 87
% of GDP 18 5 6 6 6 4 5 8 13
Assets 495 631 636 708 824 936 1,028 1,069 993
Non-reserve assets 190 188 226 262 280 279 302 337 376
by holder:
Investment funds 7 4 4 5 5 5 6 8 7
Commercial banks 39 41 56 52 56 57 56 67 84
Public Investment Fund (PIF) foreign investment 1 2 2 4 4 5 4 4 4
Saudi Fund for Development (SFD) cumulative loan disbursements 6 6 6 7 7 7 8 8 -
Public Pension Agency (PPA) and General Organization for Social Insurance (GOSI) net foreign assets - 49 - - - 98 112 - -
of which, managed by SAMA (e) 43 48 51 59 65 69 75 80 78
PPA net foreign assets - 24 - - - 63 72 - -
GOSI net foreign assets - 25 - - - 35 40 - -
Development funds and other government (exc. PPA/GOSI) entities’ foreign assets managed by SAMA (e) 15 17 18 20 22 23 25 27 26
Other - 69 - - - 85 92 - -
by instrument:
Direct investment abroad 17 20 23 27 30 34 39 45 63
Portfolio investment 105 99 122 146 158 168 178 199 202
Equity securities 53 50 59 79 82 92 99 111 109
Debt securities 52 48 63 68 77 75 79 88 94
Other investment 68 69 82 90 92 77 85 93 111
Loans 3 4 4 3 3 2 2 1 1
Currency and deposits 55 63 73 76 78 69 76 85 105
Other assets 10 3 5 11 11 6 7 6 5
SAMA Reserve assets 306 443 410 445 544 657 726 732 616
Currency and deposits 93 132 111 117 148 197 191 187 204
Foreign securities 211 308 286 315 380 444 519 532 400
Other assets 2 3 13 13 16 16 15 13 12
Liabilities -116 -160 -201 -228 -239 -251 -265 -278 -289
Direct investment in reporting economy -73 -113 -148 -176 -187 -199 -208 -216 -224
Portfolio investment 0 -3 -4 -4 -6 -10 -17 -17 -17
Equity securities 0 0 0 0 0 -9 -15 -15 -15
Debt securities 0 0 0 0 0 -1 -2 -2 -2
Other investment -42 -44 -49 -48 -46 -42 -40 -45 -48
Loans -13 -14 -13 -13 -12 -11 -9 -10 -12
Currency and deposits -28 -28 -25 -25 -23 -20 -19 -25 -26
Other assets -1 -1 -11 -10 -11 -11 -11 -11 -11
memo:
Identified Saudi Arabian and Middle Eastern holdings in the US
Saudi Arabia US Treasury (UST) holdings 51 46 83 69 68 76 80 91 109
Long-term securities 50 45 82 68 67 74 78 88 107
Short-term securities 1 1 1 1 1 2 2 3 2
Saudi Arabia holdings of US equities 45 42 31 36 53 65 68 78 52
Saudi Arabia holdings of US Agency debt securities 8 42 14 7 5 5 7 6 6
Long-term securities 8 41 14 7 5 5 7 6 6
Short-term securities 0 1 0 0 0 0 0 0 0
Saudi Arabia holdings of US corporate debt securities 7 14 17 12 12 9 15 19 15
Long-term securities 5 9 11 9 8 6 10 13 13
Short-term securities 2 5 6 3 4 3 5 5 3
Middle East Foreign Direct Investment (FDI) position in the US (cost basis) 9 9 10 8 10 11 12 11 -
Middle East oil exporters gross claims on US banks 81 122 106 101 136 132 134 129 120
Saudi Arabia deposits in Bank for International Settlements (BIS) reporting banks
Cross-border deposits with BIS reporting banks 163 180 169 167 188 244 224 210 212
of which, implied deposits from banks and others 102 142 128 113 135 180 174 158 170
of which, deposits from nonbanks 60 39 41 54 53 64 50 52 42
Saudi Fund for Development
Cumulative signed loans 7 8 8 9 10 11 11 12 -
Cumulative disbursements 6 6 6 7 7 7 8 8 -
Government entities foreign assets managed by SAMA off-balance sheet 58 66 69 79 87 92 100 107 104
Deposits with banks abroad 4 5 3 2 2 6 13 10 5
Foreign securities 55 61 66 77 85 85 87 97 98
Source: Haver, SAMA, IMF, SFD, BofA Merrill Lynch Global Research. Middle East oil exporters consist of Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.
GEMs Paper #26 | 30 June 2016 9
Historic energy sector liberalization
Partial privatization of energy sector assets could represent one of the cornerstones of
the ambitious medium-term diversification strategy, and, if confirmed, serve as a highly
visible and historic milestone. Such privatizations could ease key macro concerns
regarding unsustainable debt accumulation and Fx reserves drawdown. We believe it
would also confirm the government’s macro reform credentials, its preparedness for a
prolonged period of low oil prices and likely signal no near-term energy policy
capitulation. The NTP suggestion of a flat production capacity through 2020 suggests
less aggressive market share strategy, in our view.
Privatization of energy sector could start by 2018
In a recent interview with Bloomberg, Saudi Deputy Crown Prince Mohammed bin
Salman outlined an array of measures the Saudi government could introduce to help
diversify the economy, reduce its reliance on the hydrocarbon industry and ultimately
support medium-term fiscal consolidation in a low oil price environment. Amongst these
measures, the Deputy Crown Prince included a potential Initial Public Offering (IPO) of
Saudi Aramco (at the parent level, and including various subsidiaries). With close to
250bn bbls of oil reserves, more than 10mn bbls per day of production and the world’s
4th largest gas reserves, Saudi Aramco is the leader in hydrocarbon access among state
owned, private and public Oil & Gas (O&G) companies alike. Saudi Aramco is the world’s
largest Oil & Gas Company by production and arguably the Kingdom’s most important
asset. Specifically, he outlined a plan that would see “less than 5%” of the company
being sold to investors on the Saudi stock exchange no later than 2018 (but potentially
as soon as 2017). Furthermore, he indicated the Kingdom is seeking to transform
Aramco into an “energy-industrial company”. The high profile stake sale would provide a
highly visible anchor to diversification efforts and capitalize its newly restructured SWF.
Energy assets form a major and strategic sector for the economy
It is hard not to understate the central role the energy sector plays in the Saudi
economy. The hydrocarbon sector represented 43.0% of the economy in real terms in
2015. Deputy Crown Prince Mohammed bin Salman suggested a US$2trn price tag for
Saudi Aramco in his Bloomberg interview. Aramco is deeply intertwined with the Saudi
state, and its workforce Saudization has increased over the years to 83%. Furthermore,
it is the foundation of its state’s domestic and international energy policy. As such, a
decision to partially privatize the energy sector will be a momentous one to be carefully
examined by the technocratic and political leadership, in our view.
More questions than answers at this stage
Deputy Crown Prince Mohammed bin Salman’s initial suggestion in an interview with
The Economist that a Saudi Aramco IPO could be considered has raised market
expectations. Ensuing comments from Aramco’s management did not make clear
whether a listing would occur, and if so, in what form (upstream versus downstream),
although the Deputy Crown Prince’s subsequent Bloomberg interview suggested further
impetus being given to studying the matter.
A listing of the entity itself may force much more transparency regarding hydrocarbon
reserves (broadly unchanged for several years), lifting costs (local crude oil sales suggest
cUS$5/bbl if no loss is incurred) and the fiscal regime (estimates in the press have
suggested that Aramco’s profits are taxed at 85%, with royalties set at 20%, but we
also note from fiscal data that the fiscal transfer ratio in oil revenues to the Ministry of
Finance appears to drop in years of low oil prices). It may also conflict with noncommercial
ventures or strategic aspects of Saudi Aramco. This would include the
maintaining of spare capacity and state policy matters (including energy policy). Note
for instance that the US is the second regional destination for Saudi crude oil exports
(17.5% of total Saudi crude oil exports) behind Asia. This was due to a strategic
geopolitical decision to remain an important crude oil supplier to the US and was
achieved through the buying of stakes in refineries in 1988.
10 GEMs Paper #26 | 30 June 2016
Chart 3: Saudi Arabia proven crude oil reserves
bn bbl
Saudi Aramco Others
300
250
200
150
100
50
Chart 4: Saudi Arabia proven gas reserves
trn cf
300
Saudi Aramco Others
250
200
150
100
50
0
1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
0
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: SAMA, Bank of America Merrill Lynch Global Research
Source: SAMA, Bank of America Merrill Lynch Global Research
Oil sector privatization could slow debt build-up and support Fx reserves
Potential energy sector asset partial privatization could raise a substantial amount for
the Saudi government, in our view. A share sale would be a non-debt creating financing
flow for the budget, which would lessen the need to borrow domestically or externally. A
share sale could also increase Saudi Arabia’s ability to project soft power and influence
regionally and internationally. However, it would only support the build-up of Fx reserves
in the case of foreign investor participation. Assuming a US$2trn valuation suggested
by the Deputy Crown Prince as the value for the SWF, the vast majority of which would
be Aramco through a possible 5% listing, such a listing could raise up cUS$100bn, which
would represent the current annual government borrowing requirements and associated
Fx reserves drawdown. We expect further administered energy price adjustments over
the next five years, which should increase state revenues, in our view.
A share sale may also facilitate international borrowing on the back of Saudi Aramco’s
balance sheet. Saudi Aramco also announced it would look to set up a corporate debt
program to fund its NTP initiatives, although issuance does not appear to be an
immediate prospect. A corporate debt program, alongside a sovereign one, could allow
the government to simultaneously tap a new pool of liquidity through corporate bond
investors, upstream proceeds if needed and support Fx reserves. This could be achieved
without impacting central government debt ratios and without saturating the
government debt issuance room with sovereign debt investors. Saudi Aramco raised a
US$10bn syndicated loan in late March 2015 in part to fund acquisitions. The loan
replaced US$4bn in existing facilities agreed to in 2010, and includes a US$6bn fiveyear
tranche with two 1-year extension options, a US$1bn 1-year renewable facility, a
non-interest bearing SAR7.5bn (US$2bn) five-year tranche with two 1-year extension
options and a SAR3.75bn (US$1bn) 1-year tranche renewable yearly.
Very roughly, taking the US$2trn Deputy Crown Prince potential valuation for Aramco,
and assuming an optimal 10% net-debt-to-equity medium-term target, it would suggest
that Aramco could manage leverage of up to US$200bn (c30% of GDP) in domestic and
external debt on its balance sheet. Within a corporate setting, possible higher gearing
needs to be justified to shareholders and could reflect financing of acquisitions or NTP
costs. From a macro angle, international issuance would support Fx reserves.
Three aspects of energy policy to consider going forward
Energy sector privatization is likely to raise questions on the future path of energy
policy, though we believe the latter will stay the course for now. We believe that are
three aspects that are central to energy policy in Saudi Arabia: a) competition for global
market share in upstream operations; b) future investment decisions and maintaining of
spare capacity buffer; and c) integration and expansion of downstream ventures to
create domestic jobs, secure captive crude demand and make operations less volatile.
GEMs Paper #26 | 30 June 2016 11
Targeting a stable oil price
As a matter of Saudi policy, we would expect a preference for oil market stability over
volatility, in line with recent official pronouncements. Although volatility makes it more
difficult for high cost unconventional producers to operate, volatility is also damaging
for Saudi Arabia and long-term planning domestically. For instance, no budget was
announced for 1986 due to uncertainties in the world oil market, with monthly current
appropriations set at one-twelfth of estimated actual expenditures for the prior year.
We think Saudi authorities view possible eventual sharp upward price spikes in the oil
price as damaging to both oil-consuming and oil-producing countries.
Future investment decisions will be critical for oil prices
Spare capacity is an important policy parameter for Saudi Arabia. In addition to its
influence on prices through its ability to adjust production, Saudi can decide on the pace
of its reserves development which would potentially affect future supply. There are
distinct trade-offs in this decision. If Saudi Arabia is producing at close to its maximum
capacity, it will have little control over sharp upside movements in oil prices. If excess
capacity is large, oil prices are likely to be under downward pressure.
In the near-term, given the uncertainty in the market, in our view, there is likely little
incentive for Saudi Arabia to embark on a program to invest and increase capacity from
the current level. New investments may still be made to offset declines in existing
fields. Over time however, our commodities research medium-term oil balances suggest
that Saudi’s spare capacity would be eroded over time unless further increases in spare
capacity take place. Our BofAML commodities research medium-term supply-demand
balances suggest an increased call on OPEC and need to increase production capacity. In
2004-09, Aramco invested cUS$100bn into its largest-ever capacity expansion program,
which increased total capacity from 10mn bpd to 12.5mn bpd. For now, Aramco has
suggested it will not slow down its hydrocarbon capex program for the next three years
as cuts were achieving through savings in drilling costs and supplier discounts.
Energy policy is likely to be less aggressive going forward
We expect a less aggressive energy policy going forward, particularly as the NTP
suggests a constant oil production capacity and an increase in gas production
domestically. This is in line with Saudi Minister of Energy, Industry and Mineral
Resources Al-Falih’s pronouncements during the June Ordinary OPEC meeting. While his
comments served to project increased OPEC institutional credibility and increased
rapprochement with fellow OPEC members, he suggested that Saudi Arabia will remain
responsive to customer needs but dismissed fears that increasing Saudi market share
would take place in an aggressive manner (that could drive prices lower again).
Downstream operations - increased focus
Saudi Aramco’s downstream integration drive is likely being pursued for two core
reasons: (1) to support demand for Saudi crude (placing own crude in own refining
capacity) and (2) a risk reduction mechanism in a highly volatile oil environment (having
an integrated value chain allows capture of margins from well to the forecourt,
promoting stability). In reflection, Saudi Aramco is building highly sophisticated
refineries domestically, in addition to already completed joint-ventures and stakes in
refineries abroad (China, US, Japan, South Korea, Indonesia). Domestic joint-venture (JV)
refineries Satorp and Yasref added 400k bpd each of capacity in 2H14. With the
completion of the fully-owned Jazan 400k bpd refinery in 2018/19, overall total refinery
capacity would stand at 5.7mn bpd, of which Saudi Aramco’s share would be 3.3mn bpd.
This would allow Saudi Arabia to guarantee security of demand for its heavy crude,
increase domestic job creation and diversification, build an export base of refined
products (likely middle distillates to the EU) and lower imports of refined products.
12 GEMs Paper #26 | 30 June 2016
National Transformation Plan: many promises, few details
The National Transformation Plan (NTP) released by the Saudi government is a further
step towards execution of Saudi Vision 2030 through a set of ambitious interim targets
to achieve by 2020 by 24 government bodies. The NTP is a comprehensive program
encompassing medium-term growth boosting initiatives and fiscal consolidation
measures. The sequencing and details of the fiscal measures are however still left
nebulous. Implementation of growth-boosting initiatives will require a challenging
crowding in of private sector investment, particularly from domestic sources.
The NTP is likely to introduce a number of one-off supply-side shocks to inflation
through its fiscal or labor measures, which could negatively impact Real Effective
Exchange Rate (REER) competitiveness. Discretionary consumption growth and real
incomes are likely to remain under pressure. We find the diversification measures
encouraging, although they appear too ambitious to be met within the time frame
envisaged in the NTP, in our view. The focus on diversification could introduce mediumterm
incentives to adopt a more competitive exchange rate, while also detracting from
the binding fiscal constraint under which the government has to operate. Energy policy
is likely to be less aggressive and support oil prices. Fiscal targets are difficult to reach,
but medium-term oil prices of at least US$50-65/bbl could support NTP progress.
Table 4: Selected macro Key Performance Indicators (KPIs) under the National Transformation Plan
Regional
b’mark
Government entity Key Performance Indicator (KPI) Unit Baseline 2020 target
Ministry of Finance
Total non-oil revenues SARbn 163.5 530 10.9 691.0
Budgeted salaries and wages SARbn 480 456 N/A N/A
Salaries and wages as a percentage of the budget % 45 40 30 12
Approved projects according to criteria and timeline (% of total) % 0 40 30 78
Credit rating - A1 Aa2 Aa2 Aaa
Government debt as percentage of gross domestic product (%) % 7.7 30 35 54
Total recorded non-oil assets SARtrn 3 5 N/A N/A
Ministry of Economy & Planning
Total revenue resulting from privatization projects Under Study Under Study Under Study N/A N/A
Value of water and electricity subsidy decrease SARbn 0 200 N/A N/A
Percentage decrease in non-oil subsidy % 0 20 N/A N/A
Value of private sector contribution to GDP SARbn 993.3 Under Study 122.6 14,133.8
Ministry of Energy, Industry and Mineral Resources
Value of exports of non-oil commodities SARbn 185 330 Under Study Under Study
Value of the mining sector's contribution to GDP SARbn 64 97 13 262
Local content in expenditure of public and private sectors % 36 50 Under study 57
Petroleum production capacity mn bpd 12.5 12.5 3.8 11
Dry gas production capacity bn cf pd 12 17.8 5.7 16
Refining capacity mn bpd 2.9 3.3 1.1 1.9
Ministry of Labor and Social Development
Unemployment rate for Saudis % 11.6 9 Under Study 5.8
Cost of employment of Saudis compared to expatriates % 400 280 N/A N/A
Proportion of female labor force % 23 28 Under Study Under Study
Ministry of Hajj and Umrah
Number of formal Hajj pilgrims (domestic and foreign) mn 1.5 2.5 N/A N/A
Number of Umrah Pilgrims from abroad mn 6 15 N/A N/A
Number of Umrah pilgrims (domestic and GCC nationals) mn Under Study Under Study N/A N/A
Commission for Tourism and National Heritage
% contribution of tourism sector to GDP % 2.9 3.1 4.9 5.4
Ministry of Civil Service
% decrease in the payroll and benefits expenditure % Under Study 20 Under Study 22
% of workers reduction in the civil service sector % Under Study 20 Under Study 18
Saudi Arabian General Investment Authority
Foreign Direct Investment (FDI) SARbn 30 70 45 481
Time needed to issue work visas for new expat employees Day 30 10 10 3
Time needed to issue new business permits Day 19 1 8 0.5
Source: National Transformation Plan
Global
b’mark
GEMs Paper #26 | 30 June 2016 13
Ambitious diversification agenda is not without risks
Diversification initiatives will require material participation from the private sector.
Vested interests and the large bureaucracy could act as a dampener on timely reform
implementation going forward. The large size of the NTP program may mean some of
its outcomes are internally inconsistent, in our view. Cultural and entertainment changes
could be opposed by conservative or clerical factions. Slippage could occur due to
execution risk or reform fatigue, particularly due to the socio-economic impact of fiscal
consolidation. Any material changes to subsidies or wages could be difficult to
implement in the absence of a social safety net. While fiscal consolidation measures are
unprecedented in scope, they appear too ambitious or difficult to reach and may leave a
financing gap. As such, the measures may still fall short if oil prices do not stabilize,
which suggests a need for a less aggressive energy policy going forward, in our view.
Government leaders continue to show focus on delivery
The US visit of Deputy Crown Prince Mohammed bin Salman and finalization of various
Memoranda of Understanding (MoUs) with prominent US corporates helps provide a
highly visible anchor for foreign investment and instil business confidence in regards to
government focus. It also helps boost the profile of the Deputy Crown Prince both
domestically and internationally. This is in line with our view that the government is
likely to target rapid implementation of several ‘low-hanging’ reforms to spearhead the
program and boost confidence. Energy sector liberalization could also serve as another
highly visible anchor to the reform program, in our view.
Table 5: Announced US corporates plans during the US visit of the Saudi Deputy Crown Prince
Company Sector Outcome
Six Flags Entertainment Company has been allowed to operate in Saudi Arabia
Pfizer Pharmaceuticals Company has been awarded a direct investment license
3M Manufacturing Company has been awarded a direct investment license
Dow Chemical Chemicals Company has been awarded a direct investment license
Microsoft IT Memorandum of Understanding signed
Cisco IT Memorandum of Understanding signed
Apple IT Discussions on entry to Saudi market possibly under way
Source: Press reports, Saudi Press Agency, BofA Merrill Lynch Global Research
Diversification drive is a step in the right direction
The comprehensive medium-term diversification drive introduced by the NTP follows
the typical macro template, in our view. We discuss in a later section diversification
lessons from Malaysia and Norway and conclude that the NTP contains elements from
these successful case studies. In particular, it a) identifies key sectors with relatively
high growth potential (mining, petrochemicals, manufacturing, retail and wholesale
trade, religious and other forms of tourism, healthcare, real estate and finance); b), it
starts to articulate supportive public sector industrial strategies, including through
localization policies; and, c) it seeks to foster higher-value added in the economy
through enhancements to processes, products and organizations.
14 GEMs Paper #26 | 30 June 2016
Chart 5: More sustained private non-oil sector growth needed in Saudi
25
20
15
10
5
0
-5
Oil Sector
Private Non-Oil Sector
Government Non-Oil Sector
Real GDP growth (%yoy)
Chart 6: Oil sector large; government controls 60% of real economy
16.9%
43.0%
39.3%
-10
-15
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Oil Sector Private Non-Oil Sector Government Non-Oil Sector
Source: Haver, BofA Merrill Lynch Global Research. Series uses contributions to growth from real GDP
data with 1999 base year prior to 2010.
Source: Haver, BofA Merrill Lynch Global Research. Data as of 2015.
Human capital is critical and takes time to build
In our view, improvements to human capital, rather than business climate supply-side
reforms, are the critical barriers to overcome. While building the appropriately qualified
workforce takes time, Saudi Arabia has been making progress in this area. c25% of
Saudi tertiary graduates complete humanities and arts programs, but this is down from
39.4% in 1999. Graduates from social sciences, business and law represented the
largest share of graduates at 27.2% of total in 2014, up from 15.5% in 1999. Still, as we
discuss in later sections, diversification prospects are mixed across sectors and will
likely depend in part on providing the appropriate incentives to the private sector.
Chart 7: Distribution of Saudi tertiary graduates by field of study (%)
40
35
1999 2014
30
25
20
15
10
5
0
Humanities and arts
Education
Social sciences,
business, law
Science
Engineering,
manufacturing
Health and welfare
Agriculture
Others
Services
Source: UNESCO, BofA Merrill Lynch Global Research
Mobilizing domestic resources is key
The NTP makes clear that part of the NTP costs (40%) will need to be shouldered by the
private sector. Out of a total estimated NTP cost of SAR447bn (US$119bn; 18.4% of
GDP), the NTP implies that the private sector will need to contribute about SAR179bn
over the coming five years (US$47.6bn; 7.4% of GDP). Implementation of growthboosting
initiatives will require a challenging crowding in of private sector investment.
The NTP expects only a SAR40bn increase in the level of Foreign Direct Investment
(FDI), meaning that the bulk of private sector investment could have to come from
domestic sources. While the government investment is generally in retrenchment mode,
the NTP may be suggesting that selective and strategic projects are likely to go ahead.
Authorities have also suggested a number of projects could be structured as Public-
Private Partnerships (PPP).
GEMs Paper #26 | 30 June 2016 15
Chart 8: Saudi government non-hydrocarbon and private sector
investment growth are relatively correlated
110
90
70
50
30
10
-10
Government non-oil GFCF (3yma, %yoy)
Private sector GFCF (3yma, %yoy)
Chart 9: Crowding in domestic private sector investment when the
government sector retrenches can be challenging
20
Government non-oil nominal GFCF (% of GDP)
Private sector nominal GFCF (% of GDP)
Oil prices (US$/bbl, rhs)
15
10
5
120
100
80
60
40
20
-30
0
0
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
Source: Haver, BofA Merrill Lynch Global Research. GFCF refers to Gross Fixed Capital Formation.
Source: Haver, BofA Merrill Lynch Global Research. GFCF refers to Gross Fixed Capital Formation.
Ambitious non-oil export and tourism targets, but little details
The NTP targets increasing non-oil exports by SAR145bn (US$38bn, 6.0% of GDP) to
SAR330bn (US$88bn, 11.4% of 2020f GDP) over the next five years. Although
implementation details are lacking, we anticipate that part of the increase could be
linked to the higher mining output targeted. These would nevertheless be dependent on
the global economic cycle. Higher exports of refined oil products, if all of the additional
capacity to be installed by 2020 is exported, could add cUS$7.3bn to exports at current
price levels (but not qualify towards non-oil exports targets under the NTP as they are
classified as hydrocarbon exports). Currently, 61% of Saudi non-oil exports represents
chemicals and plastics, and maintains a correlation with oil prices, and re-exports
account for another 17% of total non-oil exports and have little added-value.
Chart 10: Chemicals, plastics, re-exports form bulk of non-oil exports
SARbn other
200
food
machinery
100
metals
150
re-exports
80
plastics
100
chemicals
Brent (US$/bbl, rhs)
60
non-oil exports (% of total, rhs)
40
50
20
Chart 11: Non-oil exports are diversified in terms of destination
19%
26%
12%
14%
29%
0
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
0
Asia GCC MENA EU Other
Source: Haver, BofA Merrill Lynch Global Research.
Source: Haver, BofA Merrill Lynch Global Research.
Likewise, the focus on religious tourism is appropriate given its importance in Saudi
Arabia but NTP targets appear ambitious to us with a targeted 20%yoy CAGR increase
in Umrah pilgrims. Religious tourism accounted for c40% of total tourist expenditure in
Saudi Arabia in 2015, bringing in proceeds of SAR33.4bn (US$8.9bn; 1.4% of GDP). Note
that, for balance of payment purposes, total tourism revenues stood instead at
SAR37.9bn (US$10.1bn; 1.6% of GDP). The NTP targets would thus imply religious
tourism external revenues/expenditures to increase to US$10-US$20bn (1.3-2.6% of
2020f GDP). This would be helpful on the external front but not a game changer on its
own, in our view.
16 GEMs Paper #26 | 30 June 2016
Chart 12: Breakdown of expenditure on inbound tourist trips
SARbn
80
60
40
20
Other
Religious
Business
Family visits
Holidays
religious tourism (% of total, rhs)
80
70
60
50
Chart 13: Inbound tourist trips to Saudi Arabia by country of origin
1%
7% 5%
45%
25%
17%
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: SAMA, BofA Merrill Lynch Global Research.
40
GCC Middle East Asia Europe Africa America
Source: SAMA, BofA Merrill Lynch Global Research. Data as of 2015.
Mixed prospects for fiscal consolidation
The apparent redistribution of part of the proceeds of the flagship fiscal measures
towards funding the NTP initiatives suggests that the fiscal consolidation efforts could
fall short of the necessary requirement to narrow imbalances materially in the absence
of a sustained oil price recovery. We calculate that the NTP targets a total net
cumulative fiscal consolidation effort of SAR648bn (US$172.8bn) or c1% of GDP
annually, assuming progressive and full implementation of the non-oil revenue targets.
Energy policy needs to support economic transformation
Energy policy is likely to be less aggressive going forward, particularly as the NTP
suggests a constant oil production capacity as well as an increase in gas production
domestically which could free up domestic crude for exports. To remain consistent with
the targeted government debt accumulation path, we estimate that oil prices have to
average at least US$50/bbl in 2016-20 along with no growth in spending from 2016
levels (excluding the additional cost of NTP initiatives but including implementation of
the NTP non-oil revenue measures). Oil prices of at least cUS$65/bbl would be required
if spending is not disciplined or revenue targets are missed by c50%, in our view.
Blueprint for fiscal measures lacks details
The approved NTP initiatives will have a total fiscal cost of SAR268bn (US$71.5bn;
11.6% of GDP) spread over five years (annually, SAR54bn equivalent to US$14.3bn or
2.3% of GDP). Government financing could represent 60% of total funding needs for the
NTP initiatives, with total NTP costs of SAR447bn (US$119bn; 18.4% of GDP). Against
that, the NTP envisages raising SAR366bn in non-oil revenues and cut the wage bill by
5% or SAR24bn (US$6.4bn or 1% of GDP). Non-oil revenue is seen rising to SAR530bn
(US$141bn, 23% of 2016f GDP) by 2020 from SAR163.5bn (7% of GDP).
Wage bill measure unclear but may carry profound social implications
In an unprecedented austerity measure, the share of the wage bill in total spending
would fall by 5ppt to 40% (SAR456bn, from SAR480bn) by 2020. It is yet unclear how
this could be achieved in practice. Furthermore, note that the MoF budget
announcement estimated the wage bill in 2015 to stand at SAR450bn, blurring the
target. Privatizations of government entities are likely to lead to a natural drop in the
public sector number of employees and wage bill. Yet we note that the Ministry of Civil
Service has two Key Performance Indicators (KPIs) directly linked to a decrease in the
payroll and benefits expenditure, and to a reduction in workers in the civil service sector.
This would likely be a contentious and unpopular measure to implement, and its
implementation and success appear challenging to us.
GEMs Paper #26 | 30 June 2016 17
Spending path is unclear and is flattish (excluding NTP costs) in the best case
The spending path targeted or assumed by the NTP is unclear and does not appear to
match realized outturns. It may suggest that spending is likely to remain flattish,
excluding NTP costs. However, the indicative level spending would settle at is around
peak 2014 expenditures levels and well above the 2015 realized spending and 2016
budgeted levels. While 2015 spending could have been understated and may be revised
higher, at least SAR88bn from the 2015 spending is non-recurrent as it relates to the
one-off Saudi Royal edicts decreed upon King Salman’s accession.
Going by the indicated 2020 target for the share of the wage bill in total spending, this
would suggest that government spending is targeted at SAR1,140bn in 2020. This
represents a 2.7% increase over peak 2014 spending levels and 16.5% increase over
2015 actual spending levels. Excluding the NTP annual costs, this suggests that
government spending should still increase by 11% over 2015 levels and drop by 2% over
2014 spending in nominal terms.
In our view, given the lack of precise spending targets, one way of remaining consistent
is to use the two NTP figures for wages and infer the NTP fiscal spending from the
stated share of wages in total expenditures. This would suggest that fiscal expenditures
would reach SAR1,140bn in 2020, from SAR1,067bn in the base year (unstated in the
NTP). This is a 6.8% increase, but excluding the NTP costs, is just 1.8% higher. As such,
in the best case scenario, we think the NTP suggests flattish spending, excluding NTP
costs. If we instead take the NTP level of spending inferred to be the correct amount,
this would materially widen the fiscal deficit by SAR190bn (8.0% of GDP) and would be
deeply negative for the sustainability of the fiscal and Fx stance, in our view.
Fiscal adjustment burden shifts to raising revenue, oil prices and exports
The possible flattish spending implication of the NTP would tend to indicate that the
bulk of the spending cuts are now beyond us. Government projects are likely to continue
to be prioritized, likely according to their economic benefits and relevance to the NTP.
Flattish spending will thus shift the burden of forthcoming fiscal adjustment on raising
non-oil revenues, raising hydrocarbon exports and a sustained recovery in oil prices.
Table 6: National Transformation Plan-related spending across government entities (2016-2020)
Cost (SARbn) Cost (US$bn) % of total
Ministry of Housing 59.2 15.8 22.0
Royal Commission for Jubail and Yanbu 41.6 11.1 15.5
Ministry of Education 24.4 6.5 9.1
Ministry of Health 23.1 6.1 8.6
Ministry of communications and IT 14.9 4.0 5.6
Ministry of Agriculture 13.9 3.7 5.2
Ministry of Water and Electricity 12.9 3.4 4.8
Saudi Commission for Tourism & National Heritage 10.5 2.8 3.9
King Abdulaziz City for Science and Technology 8.3 2.2 3.1
Ministry of Labor 7.9 2.1 3.0
General Presidency of Youth Welfare 7.8 2.1 2.9
Ministry of Transport 5.6 1.5 2.1
Ministry of Social Affairs 5.4 1.4 2.0
King Abdullah City for Atomic and Renewable Energy 5.2 1.4 1.9
Ministry of Commerce and Industry 4.3 1.1 1.6
Ministry of Municipality and Rural Affairs 4.2 1.1 1.6
Ministry of Finance 3.4 0.9 1.3
Ministry of Culture and Information 3.3 0.9 1.2
Ministry of Economy and Planning 3.3 0.9 1.2
Ministry of Justice 3.2 0.9 1.2
Ministry of Petroleum and Mineral Resources 2.7 0.7 1.0
Saudi Arabian General Investment Authority 1.1 0.3 0.4
Others 2.3 0.6 0.9
Total 268.4 71.6 100.0
Source: National Transformation Plan
18 GEMs Paper #26 | 30 June 2016
Focus on increasing non-hydrocarbon fiscal revenue could fall short of target
The breakdown of measures to raise non-oil revenues is not given. However, the tally is
close to the US$100bn targeted in the Vision 2030 and is thus likely to include
measures discussed then: hikes to administered energy prices, review of current levels
of fees and fines, introduction of new fees, land tax (we estimate annual revenues of
1.5-2% of GDP in its first phase when fully implemented). In this regard, the NTP
suggests forthcoming privatizations, imposition of taxes on harmful products (likely
tobacco and soft drinks), introduction of a Value-Added Tax (VAT) for which we estimate
annual revenues of up to 2% of GDP, implementation of a unified income tax and of an
income tax on residents (although official comments later clarified there were no plans
to tax nationals but stayed equivocal regarding expatriates).
Although there is no direct budgetary impact, water and electricity subsidies are
targeted to decrease by SAR200bn. Non-oil subsidies are targeted to decrease by 20%
by 2020. The latter, we believe, consists largely of subsidies for social and sports clubs,
private education, private hospitals, and other agricultural subsidies. They were
budgeted at SAR3.9bn (US$1.0bn; 0.2% of GDP) in 2016, down from SAR15.0bn
(US$4.0bn; 0.6% of GDP) in 2015. A 20% cut to these on-budget non-oil subsidies would
thus generate minimal savings of US$0.2-US$0.8bn (0.1-0.5% of GDP) depending if the
reference base year was 2015 or 2016.
According to the Deputy Crown Prince pronouncements early in the year, medium-term
plans are also likely to target the introduction of US$400bn of unutilized state assets
(land, etc) to state-owned funds, with the latter in turn in charge of developing them
into projects and companies than can be IPOed to the public. In our view, this may be
linked to the Ministry of Finance assigned KPI of increasing total recorded non-oil
assets (real estate, etc) from SAR3trn to SAR5trn.
The Deputy Crown Prince provided a breakdown of the government target of raising
US$100bn in additional non-oil revenue annually by 2020. The bulk of this increase in
non-oil revenue would come from the restructuring of subsidies which could generate
US$30bn per year (4.9% of GDP), according to the Deputy Crown Prince. VAT
implementation, a Green Card-like program and a plan to allow corporates to hire
foreign workers in excess of their official quotas could bring in US$10bn (1.6% of GDP)
a year by 2020, according to the Deputy Crown Prince.
Chart 14: US$100bn in additional non-oil revenue targeted by 2020
Source: Bloomberg
US$10bn
US$10bn
US$40bn
US$10bn
US$30bn
Other measures
Subsidy reform
Fees to excees foreign worker quotas
Green Card-like program
Value-Added Tax
Chart 15: Government to focus on raising non-hydrocarbon revenue
SARbn
1,500
1,000
500
-
Source: Haver, BofA Merrill Lynch Global Research
Non-oil revenue
Oil revenue
Oil revenue (% of total, rhs)
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
100
90
80
70
60
50
GEMs Paper #26 | 30 June 2016 19
Chart 16: Breakdown of non-hydrocarbon fiscal revenues
40
35
30
25
20
15
10
5
0
Investments
Other revenues
Customs duties
Petroleum products tax
Documents fees
Zakat
Other income taxes
Source: MoF, BofA Merrill Lynch Global Research. Data as of 2015.
Non-oil revenues (SARbn)
% of total non-oil revenues
Telecom revenues
Fees of port services
Visa fees
General service fees
Rents and sales
Mining fees
Chart 17: Budgeted non-oil subsidies form a small portion of spending
SARbn
50
45
40
35
30
25
20
15
10
5
0
Budgeted subsidies
% of total budgeted spending (rhs)
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: SAMA, MoF, Bank of America Merrill Lynch Global Research.
7
6
5
4
3
2
1
0
Further energy subsidy reform is likely
The figures announced by the Deputy Crown Prince regarding proceeds of subsidy
reform suggests material changes over the next 3-4 years, with annual savings close to
the landmark first round of administered price changes in late 2015. However, his
suggestion that the changes could be accompanied by partially offsetting cash transfers
to poor households suggests policy-making caution. We do not think such a
redistributive system could be technically put in place in a short time span.
Recall that concurrently with the 2016 budget, a first round of energy subsidy reform
saw sweeping energy, water and electricity administered price changes being instituted
in late December. We estimated the 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$3.8bn to central government
revenues if fully passed to the budget (a combined 1.2% of GDP). Impact of continued
similar policies on domestic prices would be a further 1.5-2ppt annual increase in
headline inflation, and a gradual squeeze to household incomes (where gasoline, water
and electricity likely represented c.1.5%, c0.4% and 1.6% respectively of consumer
spending basket prior to the late December 2015 administered price adjustments).
Table 7: Administered energy price adjustments carried out in December 2015
Product Price prior to Dec 2015 Current price % change
Methane (US$/mn BTU) 0.75 1.25 66.7
Ethane (US$/mn BTU) 0.75 1.75 133.3
Arab light (US$/bbl) 4.24 6.35 49.8
Arab Heavy (US$/bbl) 2.67 4.4 64.8
Diesel (US$/bbl) 9.8 14 - 19.1 68.5
Heavy Fuel Oil (HFO) 380cst 2.08 3.8 82.7
Heavy Fuel Oil (HFO) 180cst 2.08 4.25 104.3
Propane (USD/metric ton) - - -
Naphtha (USD/metric ton) - - -
Butane (USD/metric ton) - - -
Natural gasoline (USD/metric ton) - - -
Kerosene (US$/bbl) 25.7
95 octane gasoline (SAR/ltr) 0.6 0.9 50.0
91 octane gasoline (SAR/ltr) 0.45 0.75 66.7
Source: SPA, BofA Merrill Lynch Global Research. Propane, naphtha, butane and natural gasoline used to be: price using the following
formula: Japanese Naphtha price less transportation from Saudi multiplied by 0.72. The formula now is differentiated by product and is as
follows: Japanese price of the underlying product less transportation from Saudi multiplied by 0.8.
Fiscal consolidation plan looks challenging to fully achieve
The US$100bn target in additional non-oil revenue through 2020 appears difficult to
reach and is likely to leave a sizeable financing gap based on the current proposals, in
20 GEMs Paper #26 | 30 June 2016
our view. This would thus imply that fiscal consolidation is likely to fall short of
narrowing imbalances materially without a sustained oil price recovery.
The fees on excess foreign worker quotas and the green-card like program targeted
proceeds are difficult to reach, in our view. We calculate that to raise US$10bn from a
green-card like program, authorities will need to set the program fees at US$1,500 (in
line with upper bound of similar programs elsewhere) and have all expatriate workers
applying to enrol in the program. This appears an unrealistic target to meet, particularly
as it is not clear how these proceeds would be recurrent yearly. As for the foreign
worker quotas proceeds, we calculate that, based on private sector expatriate figures
and the stated 85% overall compliance with Nitaqat sector quotas, that the fees would
need to be set at a large cUS$10,500 per non-compliant worker to be consistent with
the NTP target. The large fee amount would likely be a material disincentive to private
sector corporates and a squeeze on their profits.
One of the obstacles to meeting the subsidy reform target is likely to be political in
nature given the impact on inflation and household incomes. We calculate nevertheless
that the target could be reached through a combination of a administered prices
changes. We do not think there is major room to increase natural gas feedstock prices
to petrochemical firms, given the NTP focus on the petrochemical sector as a source of
future growth. We estimate raising natural gas prices to US spot levels in an oil price
environment of US$50/bbl would bring in revenues to the central government of just
US$2.5bn (0.4% of GDP) if fully passed to the budget. This is likely to suggest that the
bulk of the future adjustments are likely to center on hikes to administered price
adjustments for domestic crude oil sales, diesel and gasoline. Selling domestic crude at
US$25/bbl rather than an average of US$5.4/bbl would bring in US$20.8bn in revenues.
Gasoline and diesel prices could rise by the same percentage as in December 2015 to
bring in additional revenues for a minimum inflation pick-up cost of 0.5ppt.
The most difficult part would be meeting the US$40bn in other non-oil revenues target,
in our view. Given that the latter’s breakdown was not provided, we have attempted to
group several measures being studied (according to local press) to provide a tentative
decomposition. Still, our analysis suggests the need for a further US$16.8-US$20.7bn in
financing to meet the US$40bn target. Land tax proceeds of US$11bn in the first phase
of implementation are the largest item, in our view. We calculate that a 20% sin tax on
tobacco and sugary drinks would raise US$2.1bn (0.3% of GDP) at a 0.5ppt cost to
inflation. A remittance tax being studied, according to local press, and could impose a
tax of 6% gradually decline to 2% over a number of years. At the upper bound of the tax
rate (6%), we calculate that the remittance tax would raise US$2.3bn (0.4% of GDP). We
calculate that a 10% income tax on expatriates would raise at least between US$3.9-
US$7.8bn (0.6-1.2% of GDP), depending on the assumed annual overall expatriate
earnings. That being said, measures to tax expatriates could be detrimental to
diversification and labor force prospects and were opposed to politically in the past.
GEMs Paper #26 | 30 June 2016 21
Table 8: Fiscal consolidation measures through 2020 leave undisclosed financing gap
Fiscal measure Annual revenue raised (US$bn) Annual revenue raised (% of GDP) Impact on inflation (ppt) Remark
Non-oil revenue measures 100 15.8 - NTP target
Fees on excess foreign worker quotas 10 1.6 - NTP target
Green-card like program 10 1.6 - NTP target
VAT 10 1.6 5 NTP target
Subsidy reform 30 4.7 NTP target
Natural gas feedstock for petrochemicals 2.5 0.4 - BofA ML assumption
Domestic crude 20.8 3.3 - BofA ML assumption
Gasoline 1.4 0.2 0.5 BofA ML assumption
Diesel 1.9 0.3 - BofA ML assumption
Other measures 40 6.3 - NTP target
Land tax 11 1.7 - BofA ML assumption
Remittance tax 2.3 0.4 - BofA ML assumption
Income tax on expatriates 3.9-7.8 0.6-1.2 - BofA ML assumption
Sin tax on tobacco 0.7 0.1 0.1 BofA ML assumption
Sin tax on sugary drinks 1.4 0.2 0.4 BofA ML assumption
Memo:
Undisclosed revenue financing gap 16.8-20.7 2.7-3.3 - BofA ML assumption
Cost savings Annual savings (US$bn) Annual savings (% of GDP)
20% cut to on-budget non-oil subsidies 0.2-0.8 0.1-0.5 - BofA ML assumption
5% cut to the wage bill 6.4 1.0 - NTP target
Cost increases Annual cost increase (US$bn) Annual cost increase (% of GDP)
NTP costs (US$71.5bn) 14.3 2.2 NTP target
Source: National Transformation Plan, BofA Merrill Lynch Global Research
Chart 18: Breakdown of electricity consumption by sector
Chart 19: Water consumption by sector
4%
2%
11%
16%
50%
Municipal,
9%
Industry, 3%
17%
Residential Commercial Industry
Government Other Agriculture
Source: SAMA, BofA Merrill Lynch Global Research. Data as of 2015.
Agriculture,
88%
Source: UN, BofA Merrill Lynch Global Research. Data as of 2010.
Budgeted defence spending – up or down
Localization policies in the defence industry could help cut imports (total defence
imports of US$9.8bn equivalent to US$1.5bn or 6% of total imports in 2015, according
to consultancy IHS) and conserve Fx reserves, but we expect this to be a slow and
gradual process. We think that large defense imports are typically amortized over a
number of years. Defence spending is an important part of fiscal spending in Saudi
Arabia, accounting for c30% of total budgeted spending. Defence spending in 2016 was
budgeted at SAR213bn (US$56.9bn; 9.0% of GDP), down from SAR307bn (US$81.8bn;
12.7% of GDP) in 2015. Increased military and security projects in 2015 saw an
additional overspend of SAR20bn last year. It is unclear to us if all of the regional
military costs have been recognised on-balance sheet. A negotiated settlement to the
Yemen conflict through the ongoing political negotiations in Kuwait could help contain
security spending near-term.
22 GEMs Paper #26 | 30 June 2016
Chart 20: Budgeted spending – up or down?
SARbn
Budgeted Defense & Security spending
% of total budgeted spending (rhs)
350
300
250
200
150
100
50
0
45
40
35
30
25
20
15
10
5
0
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: SAMA, Ministry of Finance, Bank of America Merrill Lynch Global Research.
Privatization comes back to the government’s agenda
The consideration of a privatization program is not surprising at the current juncture, in
our view. Recall that the Saudi privatization program was initially started in 1999 with
the creation of the now-dissolved Supreme Economic Council, following the drop in oil
prices in 1998. Small-scale privatizations took place in the early 2000s, and 2002 saw
large privatization in the telecommunication sector and postal services.
Selling public sector stakes is one of the non-debt creating financing options for the
government that would help minimize the direct drain on Fx reserves, encourage private
sector development and improve services delivery. That being said, given the lack of
non-oil taxation, this would only contribute to one-off financing flows alongside savings
from a drop in budgetary allocations to the privatized entities, in our view.
The 2015 budgetary appropriations for public institutions totalled SAR163.7bn
(US$43.7bn; 19.0% of total budgeted spending and 6.8% of GDP). We calculate that the
public institutions related to the entities that appear to have been slated for
privatization according to press reports account for budgetary appropriations of
SAR124.8bn (US$33.3bn; 5.2% of GDP. This is likely to be the upper bound of fiscal
savings possible under the privatization program. In our view, this is unlikely to be
realized fully as it includes a large number of universities and because most timelines
appear to center around 2020.
Table 9: Privatization / Public Private Partnerships (PPPs) planned
Entity Date Comment (press reports and Saudi Vision 2030/NTP, unless stated otherwise)
Airports 2016-2020 Targeted sale of 11 airport units by 2020
Saudi General Grains Organisation 1Q17 A financial advisor has been appointed
Saudi Aramco by 2018 A stake of less than 5% could be sold
Stock exchange (Tadawul) by 2018 A financial advisor has been appointed
Saudia Medical Services -
Saudi Arabian Airlines appointed a financial adviser for the privatization of its unit Saudia Medical Services and had its
Board of Directors restructured in June
Saudi Electricity (SEC) by 2020
SEC’s generation assets are likely to be split into four separate regional companies where minority stakes would be sold to
major global utilities or sold in the public market
Saline Water Conversion Corporation (SWCC) - Investment partners are likely to be sought to buy a stake in production assets, with the holding company to be listed later
General Port Authority by 2020 Commercialization program to be completed by 2020
Saudi Post by 2020
Saudi Post to be turned into a holding company with six subsidiaries. The NTP aims to transform it to a commercially viable
company with government subsidies (SAR2bn) to be phased out by 2020.
Education / schools - Official pronouncements have suggested this could be considered, but there does not appear to be concrete plans for now
Healthcare / hospitals -
The 2030 vision suggests no privatisations in the near-term, in our view. Authorities are likely to look to improve
management and quality of service before considering privatisation, in our view.
Road, railway and port projects - NTP suggests PPPs are planned with percentage in private sector contribution to development and operation to increase
Source: Press reports, Saudi Vision 2030, National Transformation Plan
GEMs Paper #26 | 30 June 2016 23
Table 10: Public institutions budget appropriations
SARbn US$bn % of GDP
Universities 55.7 14.8 2.3
Saudi Arabian Airlines 28.5 7.6 1.2
Saline Water Conversion Corporation 15.6 4.2 0.6
General Authority of Civil Aviation (GACA) 15.5 4.1 0.6
Saudi Post Organization 3.2 0.8 0.1
Grain Silos and Flour Mills Organization 2.9 0.8 0.1
Saudi Ports Authority 1.8 0.5 0.1
Saudi Railways Organization 1.7 0.4 0.1
Other 38.9 10.4 1.6
Total 163.7 43.7 6.8
of which, public institutions in sectors that could be privatized 124.8 33.3 5.2
Source: SAMA, Ministry of Finance, Bank of America Merrill Lynch Global Research. Data as of 2015 budget.
Sales of PIF assets could help replenish fiscal reserves but not Fx reserves
Secondary sales of domestic assets could be a faster way than Initial Public Offerings
(IPOs) and privatizations for the Ministry of Finance (MoF) to raise its fiscal reserves at
SAMA, in our view. We look at this possibility to assess the potential for the MoF to use
it as an option to support its fiscal reserves at SAMA and prevent a debt build-up in
response to ongoing fiscal deficits.
If this were to take place, this could occur through holdings of the PIF rather than the
pension funds who are large institutional investors in the domestic equity market, in our
view. We calculate that the PIF could sell stakes worth around SAR200bn (US$53.6bn)
domestically through liquidating existing minority stakes and selling down majority
holdings while retaining control. If the PIF holdings are above 50%, we assume
arbitrarily that the holding is strategic, and thus calculate the current value of the stake
that the PIF (using the current stock price in the market) can sell down so it retains a
controlling 51% ownership share. If the PIF holdings are below 50%, we arbitrarily
assume that the holding is not strategic, and thus calculate the current value of the
stake that the PIF holds (using the current stock price in the market) as we assume it
could be fully liquidated.
The proceeds of sales domestically (without foreign participation) would increase
central government deposits at SAMA, decrease other domestic liabilities of SAMA but
keep Fx reserves unchanged. Because of the latter, because such large coordinated sales
could weigh on the market and as the PIF is targeted to become the largest SWF by
Saudi authorities, we doubt this is going to be a course policy-makers are likely to be
considering in the near term.
24 GEMs Paper #26 | 30 June 2016
Table 11: Public Investment Fund listed domestic assets and their monetization potential in regards to replenishing fiscal reserves at SAMA
Potential value of
secondary offering if a
government stake is sold,
but with the government
still retaining 51% control
Potential value of
secondary offering if
government’s
existing minority
stake is liquidated
Entity Sector Current government stake (%) Free-float (%) (US$bn)
(US$bn)
Saudi Basic Industries Corporation (SABIC) Chemicals PIF: 70.0%; GOSI: 5.7% 24.3% 12.3 0.0
Saudi Telecom (STC) Telecom PIF: 70.0%; GOSI: 7.0%; PPA: 6.77% 16.2% 6.5 0.0
Saudi Electricity (SEC) Power Government: 74.3%; Aramco: 6.9% 18.8% 5.1 0.0
Saudi Ground Services Travel Saudi Arabian Airline: 52.5%; National Aviation: 14.7% 30.0% 0.4 0.0
Saudi Real Estate Company Real estate PIF: 64.57% 35.5% 0.1 0.0
National Commercial Bank (NCB) Banks PIF: 44.3%; GOSI: 10%; PPA: 10.04% 35.7% 0.0 9.5
Maaden Mining PIF: 49.99%; GOSI: 7.98%; PPA: 7.45% 34.6% 0.0 5.9
Samba Banks PIF: 22.91%; GOSI: 11.76%; PPA: 15.04% 73.2% 0.0 2.4
Yanbu National Petrochemical Co (Yansab) Chemicals SABIC: 51%; GOSI: 11.92% 37.1% 0.0 2.2
Saudi Arabian Fertilizer Company (SAFCO) Chemicals SABIC: 42.99%; GOSI: 12.2% 44.8% 0.0 2.0
Riyadh Bank Banks PIF: 21.75%; GOSI: 16.72%; PPA: 9.18% 46.6% 0.0 1.9
Southern Province Cement Cement PIF: 37.43%; GOSI: 15.82% 46.8% 0.0 1.1
National shipping company Transport PIF: 22.55% 80.0% 0.0 0.9
Saudi Catering Transport General Airline Services KSA: 35.7% 39.8% 0.0 0.8
Kayan Chemicals SABIC: 35% 65.0% 0.0 0.6
Alinma Bank Banks PIF: 10%; GOSI: 5.10%; PPA: 10.71% 74.1% 0.0 0.5
Qassim cement Cement PIF: 23.35%; GOSI: 15.09%; PPA: 5.67% 79.2% 0.0 0.4
Yanbu cement Cement PIF: 10%; GOSI: 12.37% 68.5% 0.0 0.2
National Agriculture Development Agriculture PIF: 20% 85.1% 0.0 0.1
Saudi Fisheries Agriculture PIF: 39.99% 38.5% 0.0 0.1
Saudi Public Transport Transport PIF: 15.72% 100.0% 0.0 0.1
Eastern Province Cement Cement PIF: 10%; GOSI: 10.65% 89.4% 0.0 0.1
National Gas and Industrialization Chemicals PIF: 10.91% 88.0% 0.0 0.1
Saudi Ceramic Consumer PIF: 5.94%; GOSI: 16.19% 83.8% 0.0 0.0
Petro Rabigh Chemicals Aramco: 37.5%; Sumitomo: 37.5% 25.0% 0.0 0.0
Total 24.3 28.6
Source: Bloomberg, Bank of America Merrill Lynch Global Research. PIF = Public Investment Fund. GOSI = General Organization for Social Insurance. PPA = Public Pension Agency. Based on stock prices as of 28 June 2016.
Material fiscal consolidation would be necessary to narrow macro imbalances
There is no substitute for fiscal consolidation to maintain Fx policy unchanged. We map
out below paths for several macro variables depending on fiscal policy and oil prices,
with higher oil prices easing the adjustment requirement.
In a worst case scenario where US$25/bbl oil prices would persist for the next five
years, sustainability of the Saudi Fx policy rests on material fiscal consolidation, which
we believe is achievable based on the mix of revenue-raising and spending restraint
plans likely or announced to date. This would require a total 5-year cumulative
adjustment of SAR500bn (US$133bn; 20% of 2015 GDP or 4ppt of GDP annually) from
2016 onwards, which is close to what the NTP appears to be targeting in non-oil
revenue measures (US$100bn, excluding NTP costs). We think 75% of the adjustment
can take place through revenue-raising measures. The remainder of the adjustment
would need to take place through capex cuts and is similar in size to the capex
retrenchment of the 1980-90s. However, note that if one assumes that the 2015 budget
deficit will be revised higher to 18.9% of GDP, this adds a need for a further 4ppt of
GDP cumulative fiscal adjustment to maintain the same trajectory of Fx reserves.
An overhaul of fiscal policy will likely be required
In line with the 2016 budget announcement, we would expect tight budgets to be
passed. We expect a VAT with 5% yield to be implemented in 2018, alongside further
administered price adjustments for energy, water and electricity. Implementation of the
land tax is likely, but it is unclear whether the proceeds will be ring-fenced to be used
solely for housing projects. Using solely the recurring existing proceeds of the
December administered price adjustments and a VAT introduction, we still see a need
for further fiscal restraint in the order of 1ppt of non-oil GDP annually. The latter would
GEMs Paper #26 | 30 June 2016 25
be equivalent to a SAR100bn cumulative spending cut, which we believe can be
accommodated from capex retrenchment. On the basis of the above, fiscal consolidation
would likely drive real GDP growth lower to an average of just around 1% of GDP. This
estimate is based on a ST GCC fiscal multiplier of 0.2 for real spending to real non-oil
GDP, in line with academic literature.
Fx policy stays the course; NTP blurs medium-term incentives
We do not believe Deputy Crown Prince Mohammed bin Salman is considering Fx reform
in the near-term. We have expressed here our view that the Fx peg would hold as fiscal
policy undergoes a sizeable multi-year adjustment. In a bearish scenario for oil prices,
the NTP is unlikely to be implemented as deep budget cuts are likely to be required to
sustain the Fx policy. We believe an oil price of at least US$50/bbl is broadly consistent
with full and timely NTP implementation, but fiscal policy still needs to be disciplined. If
fiscal non-oil revenue targets are missed, a higher oil price is likely to be needed.
However, if the NTP is successful in diversifying the economy, it will make the costs of
running an overvalued exchange rate more prohibitive, particularly as the external
accounts are likely to become more responsive to an Fx shock. It also introduces a progrowth
bias for policy-makers in charge of diversifying the economy, which may conflict
with the implementation of unpopular fiscal reforms or the depth of fiscal consolidation
needed at weak levels of oil prices. The NTP diversification initiatives may suffer from a
timing mismatch when it comes to net external receipts generated. This is because the
sectors that would generate Fx receipts (non-oil exports, religious tourism) or
localization policies are likely to be slow to ramp-up, while Fx demand in the economy is
likely to be supported (rather than deflated) by government diversification policies. Last,
the desire to build a large SWF may suggest a desire to conserve Fx reserves.
Chart 21: Illustrative paths of Saudi government deposits at SAMA
% of GDP
60
10
-40
US$50/bbl oil - nominal spending flat
US$50/bbl oil - modest fiscal adjustment
US$50/bbl oil - ambitious fiscal adjustment
US$25/bbl oil - modest fiscal adjustment
US$25/bbl oil - ambitious fiscal adjustment
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
Source: , Haver, BofA Merrill Lynch Global Research estimates
Chart 22: Illustrative paths of SAMA foreign assets
100 % of GDP
90
80
70
60
50
40
30
20
10
US$50/bbl oil - nominal spending flat
0
US$50/bbl oil - modest fiscal adjustment
US$50/bbl oil - ambitious fiscal adjustment
-10
US$25/bbl oil - modest fiscal adjustment
-20
US$25/bbl oil - ambitious fiscal adjustment
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
Source: Haver, BofA Merrill Lynch Global Research estimates
26 GEMs Paper #26 | 30 June 2016
Chart 23: Illustrative paths of Saudi fiscal balance
Chart 24: Illustrative paths of Saudi government debt
% of GDP
30
% of GDP
100
20
10
0
-10
75
50
25
-20
0
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
US$50/bbl oil - nominal spending flat
US$50/bbl oil - modest fiscal adjustment
US$50/bbl oil - ambitious fiscal adjustment
US$25/bbl oil - modest fiscal adjustment
US$25/bbl oil - ambitious fiscal adjustment
Source: Haver, BofA Merrill Lynch Global Research estimates
2018
2020
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
US$50/bbl oil - nominal spending flat
US$50/bbl oil - modest fiscal adjustment
US$50/bbl oil - ambitious fiscal adjustment
US$25/bbl oil - modest fiscal adjustment
US$25/bbl oil - ambitious fiscal adjustment
Source: Haver, BofA Merrill Lynch Global Research estimates
2018
2020
Consumer to face mixed trends
Labour policies are likely to remain a major focus for the Saudi government. Low oil
prices have dented the government’s direct ability to support the consumer compared
to the boom years. Furthermore, negative to flat public sector wage growth is likely to
dampen income and consumption trends, although Specialized Credit Institutions (SCIs)
could alleviate tightening banking sector household lending standards.
The NPT suggests a focus on boosting female employment as well as increasing the
cost of foreign labor relative to national labor. The latter implies a negative impact on
corporate margins and profits, in the event higher labor costs are not reflected in higher
consumer prices and inflation). The negative near-term cost and efficiency implications
of continued labour market reforms are mitigated by the fact that eventual increase in
private sector employment of higher-paid Saudi labour should prove supportive for
consumption trends once the dust settles.
The NTP targets increasing the cost of employment of Saudis compared to expatriates
from 400 to 280. We calculate that the ratio of private sector wages of Saudis
compared to non-Saudis stood at 3.64 and 1.29 for males and females respectively in
2015. The NTP target is thus akin to increasing non-Saudi private sector wages by 43%
over the period to 2020, a CAGR increase of 7.4%. This would squeeze corporate profits,
lead to inflationary pressures in the economy, and lead to annual additional Fx outflows
through remittances of US$2.8bn (0.4% of GDP). As such, it is more likely that the
employment cost of non-Saudis is likely to be increased through measures such as fees
for government services, taxes and levies. It is unclear that the NTP target can be met
solely through this route, but it would avoid additional Fx outflows despite still having a
negative impact on corporate margins and inflation, in our view.
The Nitaqat Saudization program is likely to be extended in the near-future through the
forthcoming launch of the “balanced Nitaqat” initiative. While employment quotas are
likely to be tightened, they will also take into account wage levels, job quality and
women employment ratios, according to local press. A likely target is likely to be
increased job creation for Saudis in the retail sector through higher quotas, in our view.
GEMs Paper #26 | 30 June 2016 27
Table 12: Selected drivers of Saudi consumer
Direction
Comment
Oil prices Volatile Indirect impact through economic activity and confidence
Population growth Decreasing Direct impact through lower number of expatriates and national birth rate
Public sector wage growth Flat to contracting Freeze in government wage bill
Private sector wage growth Flat to minor increase Some sectors to contract (construction), others resilient (retail, staples)
Saudi private sector male employment Mixed Saudization helps, but economic slowdown and supply-side factors impact negatively
Saudi private sector female employment Increasing NTP aims to increase it through several measures
Consumer leverage Decreasing Banking sector liquidity and lending standards are tightening
Real estate finance Increasing NTP measures are supportive in this area
Specialized Credit Institutions (SCIs) Flat SCIs can continue to support the economy
Saudization Increasing Negative impact short-term, positive impact medium-term
Subsidies Decreasing Timing and breadth unclear as of yet
Other fiscal consolidation measures (VAT, etc) Likely forthcoming Direct and indirect negative impact on consumer
Source: BofA Merrill Lynch Global Research
Chart 25: Private sector average monthly wages are increasing
SAR/month
2004 2005 2006 2007 2008 2009
3,500
2010 2011 2012 2013 2014 2015
3,000
2,500
2,000
1,500
1,000
500
0
Male Female Total
Source: SAMA, BofA ML Global Research. SAMA wage data coverage appears incomplete.
Chart 26: Wedge between Saudi and non-Saudi private sector salaries
SAR/month
7,000
2014 2015
6,000
5,000
4,000
3,000
2,000
1,000
0
Male Female Male Female
Saudis
Non-Saudis
Source: General Organization for Social Insurance (GOSI), BofA ML Global Research.
Banks and contractors will require supportive policies to realize NTP benefits
The banking sector is targeted to benefit from the NTP initiatives through greater
disintermediation (SMEs, real estate financing, non-oil export financing) and greater
household savings. However, domestic liquidity is likely to remain structurally tight, in
our view. The NTP targeted increase in non-oil fiscal revenue is likely to tighten
domestic liquidity, all else being equal, as it would have the effect of extracting
resources from the non-hydrocarbon private sector (as opposed to government
domestic spending that injects liquidity).
Linked to liquidity trends and banking sector asset quality, the issue of government
arrears to contractors is likely to take centre stage, in our view. Resolving this is likely to
be required if the capex projects under the NTP are to be executed on a timely fashion,
in our view. We think the government’s proposal to issue "I Owe You' notes (IOUs) could
be a step in this direction.
Government looks to issue IOUs
According to the press, the Saudi government has paid contractors some cash on its
arrears, and is considering to issue "I Owe You' notes (IOUs) to them. Contractors would
receive these notes to cover their outstanding dues, which they could hold until maturity
or sell on to banks. The government has been highlighting it wanted to settle the
contractor sector dues, and recently a high-profile domestic contractor has made mass
redundancies. In the previous downturn in the 1980s, arrears to domestic contractors
were also likely to have been accumulated. We highlighted that the fiscal deficit was
likely under-reported last year. Also, construction was one of the fastest growing sector
last year both in terms of domestic activity and of domestic credit.
28 GEMs Paper #26 | 30 June 2016
Government arrears to contractors could be significant
We estimate the range of unpaid capex for 2015 to be SAR23bn-SAR100bn (US$6bn-
US$27bn or 1-4.3% of 2015 GDP). At the very minimum, unpaid capex could be around
SAR23bn. This is the amount of additional loans taken out by construction contractors
over 2015 compared to 2014. Total construction loans were SAR106bn in 2015 versus
SAR83bn in 2014. Contractors likely did not go to obtain alternative bank funding for
the same amount as the delayed payments from the government, suggesting delayed
payments should be larger than SAR23bn, in our view.
By the same token, the 2015 budget outturns imply capex was down by 45% to
SAR205bn versus 2014 levels of SAR370bn. This is of course unlikely as construction
grew by 5% in real terms in 2015. Correcting the 2015 budget by the likely
underreporting (an additional SAR100bn in spending, assuming it was all capex-related),
then capex spending was likely down by SAR65bn (17%) in 2015. This would be in line
with the c15%yoy drop in construction awards as reported by MEED.
In comparison, government overdues in the healthcare sector are much smaller. Based
on the disclosures of two listed healthcare groups, we estimate the growth of
government receivables owed to them alone is SAR0.4bn. We estimate the total sector
government overdues to private healthcare operators could be 2-3 times this level.
IOUs to serve multiple purposes
IOUs could support simultaneously the multiple needs of the government, domestic
banks and contractors, in our view. The government will be able to conserve fiscal
reserves and restructure the maturity of its outstanding dues. Domestic banks would
substitute corporate credit risk with sovereign risk and improve asset quality, while
contractors could improve their liquidity and working capital position by cashing in early
on the IOUs. We believe most of the contractors impacted could be domestic ones, and
we presume these IOCs would be issued in domestic currency. Furthermore, to the
extent these IOUs are structured as tradable instruments, this could better distribute
risk in the financial sector to those agents more capable or willing to hold it.
Domestic liquidity could be eased, but Fx outflows may not subside
The impact of IOUs on domestic liquidity will likely depend on the issuance mechanism,
of which we have little visibility for now, though this could likely ease domestic liquidity.
We would however expect subsequent Fx reserves losses due to an increase in demand
for Fx consequent to the liquidity injections (a 50% leakage would for instance lead to
US$13.5bn loss in Fx reserves at the high-end of the estimated arrears range).
One possibility for the mechanism would be for banks to extend more secured credit to
contractors using the IOUs as collateral. In this case, domestic liquidity is likely to
remain tight as the banking sector balance sheet would stay stretched. Another, perhaps
more likely, option would be for banks to accept IOUs as deposits. Contractors would
then be able to transfer IOUs to their trade creditors and withdraw cash regularly, with
the total amount being likely a portion of the face value of the IOUs. Banks would hold
new government instruments on the asset side of their balance sheet. This mechanism
could also be structured as a simple sale of the IOUs to domestic banks (with a haircut),
which domestic banks would accommodate through equivalent changes on the asset
side of their balance sheet, without the creation of additional liabilities.
In the latter option, to avoid straining the banking sector liquidity, the deposits
withdrawal or in effect the increased money in circulation would likely require monetary
accommodation from SAMA, in our view. We believe this could take the form of liquidity
injection, possibly through repo operations for the IOUs. Although unconventional, this
GEMs Paper #26 | 30 June 2016 29
possible source of easing of domestic liquidity would still be consistent with Article 6
Saudi Arabia’s Currency Law which imposes a 100% currency backing by Fx reserves,
such that that currency issued cannot exceed foreign reserve assets. The full cover
requirement would still be in force as reserve money currently represents just 14% of
foreign reserve assets, down from c100% throughout the period 1996-2000.
30 GEMs Paper #26 | 30 June 2016
Lessons in diversification
There are only few examples of countries that successfully managed diversification
away from primary dependence. The examples of Malaysia and Norway suggest that a
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
immature profile of the real estate market in Saudi Arabia. Sovereign actions in
neighbouring countries, like the UAE, have boosted the sector (land granted to
developers, capital flows from international investors). We see big developers becoming
more active in the Kingdom but the effects on supply will not be immediate, in our view.
So far, they represent only 15% of the total market.
Key strategic objectives and KPIs to watch
• The Ministry of Housing is looking to: 1) improve performance of the real estate
sector and increase its contribution to the GDP; and, 2) enable citizens to obtain a
suitable residence. The ministry targets by 2020 to: 1) double the real estate sector
64 GEMs Paper #26 | 30 June 2016
contribution to GDP from 5% to 10%; 2) reduce the average time required to
approve and license new residential real estate; 3) reduce the housing unit cost
from 10x to 5x of the gross individual annual income; and, 4) increase the real
estate financing to non-oil GDP ratio from 8% to 15%.
• The Saudi Commission for Tourism and National Heritage is looking to increase and
develop hospitality facilities and tourism services. The ministry targets by 2020 to
increase the number of hotel rooms/apartments by 39% to 621.6k.
Positive government ambitions but…
The rise of real estate finance to non-oil GDP from 8% to 15% implies an incremental
funding of US$32bn which could finance c212k additional units by 2020 or c53k
additional units p.a. This compares to an estimated annual demand of 181k units which
come on the top of the existing c1.2mn shortage of housing.
…needs to be combined with land tax and sukuk issuance initiatives
Based on the target Key Performance Indicators (KPIs) set for the Ministry of Housing,
we estimate the initiative to be supportive but not sufficient to cater to the natural
annual demand which is 3.5 times more elevated than the implied additional supply
funded by the programme. We understand this initiative has to be combined with the
land tax initiative and the potential sukuk issuance from the Ministry of Housing which
could add further liquidity to the REDF to finance more units.
Land tax - gradual revenue source
Land tax among flagship measures adopted by the Saudi government
We expand more below on our understanding of the land tax initiative which was
recently approved by the Cabinet to tackle the housing shortage and raise government
revenues. Saudi Arabia’s Cabinet announced in November 2015 that it will gradually levy
a 2.5% tax on undeveloped land plots owned by persons or private entities in urban
areas, after the country’s Shura council approved a proposal to impose taxes on the socalled
white lands. The draft law was amended to include gradual taxes in accordance
with a specific timetable to force landlords to sell land, thus increasing land supply.
The regulations adopted in mid-June define undeveloped land as all vacant land
dedicated to residential use or commercial residential use within the urban boundary
limits. Fees will be applied to in a gradual series of stages; first, to owners of
undeveloped land with areas exceeding 10,000 square metres; second, to single owners
of developed land of more than 10,000 square metres in one master development plan;
third, to single owners of developed land of more than 5,000 square metres in one
master development plan; and, last, to single owners of land of more than 10,000 square
metres in one city. The Ministry of Housing will determine the land locations where the
tax will apply. The extension of the tax in later phases to developed land, from
undeveloped ones at first, will broaden the tax base and minimize tax evasion.
Tax proceeds will be deposited in SAMA
The taxes and fines collected by the Ministry of Housing shall be deposited in the
central bank, the Saudi Arabian Monetary Agency, and will be used to develop the
country’s infrastructure for new housing projects, according to the state-owned news
agency.
Law could be effective this month, but gradual implementation likely
Under the new system, the housing ministry has been in charge of issuing executive
procedures and rules for the new legislation within 180 days. The law will be effective
180 days after publication in the official gazette. The housing ministry is finalizing
necessary amendments to the decree by end-June 2016 and aim for implementation by
17 January 2017 (including a 1-3 year grace period).
GEMs Paper #26 | 30 June 2016 65
Tax on land: a lever to lower real estate prices in urban areas
Given that the government is giving landlords a grace period in order to either develop
or sell land to developers, we perceive the newly approved land tax as a lever to lower
real estate prices. Ultimately, this would improve household affordability, reduce social
tensions and indirectly tackling energy subsidies as it frees up potential household
income to spend on electricity and gasoline.
Land tax could generate up to US$11bn/yr from the major urban cities
We estimate that the government could potentially collect up to US$11bn per annum of
tax related to undeveloped land in the top 5 urban Saudi cities which accommodate
more than 50% of the Saudi population. While the law will not be effective until end-
2016, we do not expect the tax proceeds to be significant early on.
Table 20: Land tax proceeds estimates for the 5 major urban cities
Land tax could generate up to US$11bn per annum in first phase
City Selected urban land area (sqm) White land value (SARbn)
Annual Land tax proceeds
@ 2.5% (SARbn)
Riyadh 1,300,000,000 494 12.4
Jeddah 1,686,000,000 481 12
Mecca 850,000,000 485 12.1
Medina 293,000,000 88 2.2
Dammam 200,000,000 48 1.2
Total 4,329,000,000 1,595 39.9
Source: SAMA, BofA Merrill Lynch estimates for white land and proceeds
Table 21: NTP objectives and KPIs affecting the real estate sector
Strategic objective
KPI
Unit Baseline 2020 target Regional
b'mark
Int'l
b'mark
Ministry of Housing
Enable citizens to obtain a house Real estate sector contribution to GDP % 5 10 13 20
Improve performance of real estate Average time required to license new
sector
residential new projects
Day/ Permit 730 60 44 26
Enable citizens to obtain a house Housing unit cost multiples of gross
individual annual income
x 10 5 6.7 3
Enabling citizens to obtain suitable Real estate financing to non-oil GDP
housing financing
% 8 15 16 75
Source: Saudi National Transformation Plan
Table 22: NTP government costs related to the consumer and real estate sectors
Consumer SAR (000)
Ministry of Economy and Planning 3,293,255
Ministry of Commerce and Industry 4,313,050
Ministry of Environment, Water and Agriculture 13,942,405
Ministry of Haj and Umrah 333,600
Ministry of Labor and Social Development 7,931,710
Total 29,814,020
Real Estate SAR (000)
Ministry of Housing 59,166,666
Source: Saudi National Transformation Plan
66 GEMs Paper #26 | 30 June 2016
Metals & Mining: ambitious growth target
Faisal AlAzmeh, CFA >>
Merrill Lynch KSA Company
faisal.alazmeh@baml.com
The NTP has focused on several areas relating to domestic drivers, i.e., housing, retail,
trade and finance. However, a core part of the Saudi government’s transformation
strategy is to focus on expanding the Kingdom’s mining potential. Saudi Maaden has
historically been Saudi’s mining champion, but the mining sector currently contributes
only around 2% to the Kingdom’s GDP. The NTP has set a high target for the sector: its
contribution to GDP growing by 50% to SAR97bn by 2020 and sector employment
increasing by 40% to 90k. While the first target could be achieved given the amount of
capital that is currently being deployed in the sector, the latter part is questionable in
our view as capital intensive projects are not the best means for employment
generation.
Government focus on mining to boost jobs and growth
The focus on mining is driven by the ample and growing resources available. The
Kingdom’s largest mined products are phosphates, bauxite and gold. It supplies around
8% of global DAP production and has the largest integrated aluminium company in the
world. Ma’aden continues to discover new gold and copper sites as well. We believe the
outlook for mining is encouraging and the contribution to GDP targeted by the
government could be achieved. We believe investments in this sector faces two hurdles:
1. Diversification – the base metal cycle lags that of oil but is eventually driven by the
same global drivers (global growth). Furthermore, the NTP has currently set a low
number for its capital commitments to the industry (US$82mn), achieving the
targeted diversification and job creation at the moment seems to be highly
dependent on attracting private sector capital. This would require attractive
incentives schemes such as energy subsidies, tax exemptions or ease of issuing
work permits for expats. However, at the moment, these have not been addressed
by the Saudi authorities.
2. High capital intensity – for example, the government has spent close to US$21bn
on Saudi Maaden but the company employs only around 6,000 permanent workers,
of which Saudis account for nearly a third. While the build-up of this capacity does
create a multiplier effect of almost 10x during the construction phase, most of the
added jobs are usually low income blue-collar jobs that tend not to attract Saudis.
Domestic services sectors create more jobs than mining for dollars spent
We argue that capital spent on domestic services sectors is likely to yield more
employment for dollars spent. A key example is Saptco, the Saudi Public transport
Company, which has spent around US$450mn on assets and currently employs around
the same number of permanent employees as Maaden, of which 1,200 are Saudis. We
acknowledge that the technology and technical transfer will be different in an
investment like Maaden versus Saptco, yet we believe the economic efficiency of using
the mining sector as a means of generating employment is questionable.
NTP is already happening: Saudi Aramco has project to create 2,000 jobs
The plan to develop the mining industry is moving forward. Saudi Aramco has already
announced its plans to build a downstream industrial complex along with GE and
Cividale SpA. The complex will include the first-of-its-kind high-end forging & casting
manufacturing facility and will serve the region’s maritime and energy industries. The
project will cost around US$400mn and likely generate around 2,000 jobs.
GEMs Paper #26 | 30 June 2016 67
Exports will largely depend on market conditions
Part of the NTP relies on growing Saudi exports, including that of the mining industry.
While it is easy build a plant, the timing of when there projects come online and how it
coincides with the cycle matters. The ability to dump will largely depend on the position
on the cost curve, which seems to be fading with the recent reduction of subsidies.
The conglomerate model to continue
Saudi Arabia has historically adapted the conglomerate model to build up its industrial
sectors, such as petrochemicals (SABIC), metals & mining (Maaden) and steel (Hadeed).
We believe the government continues to focus on this model in its NTP plan and will use
a number of vehicles to expand the sectors in question: Maaden in metals & mining and
the new military company in defence.
Maaden has transformed from a pure gold producer to one of the largest conglomerates
in Saudi Arabia at the moment. Through three key Joint-Ventures (JVs), the company is a
top producer of DAP (Diammonium Phosphate) and gold and aluminium. The NTP clearly
sets the stage for Maaden to grow even further but is unclear on how this is to be
achieved and what it would mean for shareholders. Also, in our view, the all-in-one
model has delivered subpar returns globally and the trend is towards the streamlining of
operations and specialised vehicles. As an example, the largest petrochemical and
agrichem companies, Dow and Dupont, plan to merge and then split into three different
businesses, providing more specialisation. We can see the advantages of the specialised
entity model as it provides cost synergies, efficiency and a clear strategy for the
company. Also, in the conglomerate model, certain parts of the company are often
dwarfed as other revenues streams represent a larger contribution to returns. Board and
management could be more or solely focused on the sub-segment had if it is a standalone
entity they have to monitor and manage, in our view.
Table 23: National Transformation Plan objectives in the mining sector
Baseline Target 2020 Regional benchmark Global benchmark
Overall kingdom:
Number of jobs created 65k 90k 75k 210k
Contribution to GDP SAR64bn SAR97bn SAR13bn SAR262bn
Number of localized technologies Under study 125 NA NA
Less developed regions in Saudi:
Number of jobs created 0 12k NA NA
Expected contribution from private sector 0 SAR28bn NA NA
memo:
Initiative cost to the government: SAR310mn (US$83mn)
Source: Saudi National Transformation Plan
68 GEMs Paper #26 | 30 June 2016
Oil & gas/petchems: focus on downstream
Faisal AlAzmeh, CFA >>
Merrill Lynch KSA Company
faisal.alazmeh@baml.com
Focus on downstream expansion is a priority
An increased focus on downstream expansion is a strategic development priority in
Saudi Arabia, with the aim of exploiting competitive advantages on feedstock costs and
the strategic location. Furthermore, the government sees it as a mechanism to create
job opportunities for nationals. We see the NTP natural gas target as optimistic as it
faces many hurdles, while imports could be a better alternative which authorities now
suggest they could be open to eventually.
Downstream chemicals represents the second largest focus of the NTP
The NTP is firmly focused on the integration of chemicals/refining/mining capacity into
value-add downstream operations that would limit imports of certain products and
provide technology transfer into the Kingdom. This accompanies the government’s plans
to expand its natural gas and refining capacity by 48% and 13%, respectively.
The NTP includes a sizeable allocation to the Royal Commission for Jubail and Yanbu,
the government body that overlooks, promotes and develops the
petrochemicals/energy-intensive/mining sectors in the Kingdom. The government plans
to spend around US$10.9bn on developing various areas including: 1) the oil-to-olefins
(OTC) complex in Yanbu; 2) colleges and institutes in Jubal Industrial area; 3) the
necessary infrastructure in the community area of Yanbu Industrial City; and 4) valueadd
transformation industries in Raas AlKhair Industrial City.
Table 24: NTP focus for the Royal Commission of Jubail and Yanbu
Key focus areas
US$mn
Development of the OTC project 772
Development of colleges and institutes in Jubail Industrial City 731
Development of infrastructure in Yanbu 1,003
Development of residential areas in Jubail Industrial City 642
Development of Multi-Modal Logistics Hub in Yanbu Industrial City 543
Development, protection and rehabilitation of public facilities in Jubail Industrial City 954
Development of value-added transformation industries in Raas Alkhair Industrial City 805
Construction of Housing in Jubail Industrial City 538
Development of Mineral industries port in Yanbu Industrial City 556
Other infrastructure and projects (38 projects, size between 100mn to 500mn) 4,557
Total 11,101
Source: Saudi National Transformation Plan
Subsidies are likely to be needed
A key obstacle to building more refining capacity and a large OTC complex is the high
capital intensity of such projects and the subsidies required to ensure an acceptable rate
of return. We see the natural gas target as optimistic with many hurdles; importation
could be a better alternative. We believe the government plans to reduce subsidies in
water and electricity, but maintain them for feedstock prices as intensive natural gas
production requires cheap gas to thrive. However, a move towards benchmarking to US
gas prices is a likely and logical step, in our view. An alternative scenario would to mark
natural gas prices in the Kingdom to the LNG netback out of Qatar. This would facilitate
an additional US$2.5bn from the sector but would also put several companies at risk of
becoming loss making (especially companies with a high content of heavy feed in their
input mix). Should such a scenario take place, we believe implementation would be
carried out over phases in order to allow companies to cope with the new pricing order.
GEMs Paper #26 | 30 June 2016 69
Table 25: Additional costs on petrochemical producers of higher feedstock prices
Current scheme
(US$50/bbl)
US Spot/(US$50/bbl)
Government revenues raised
(US$bn)
Ethane 950 1,411 461
Methane 201 457 256
Propane 3,918 4,898 980
Butane 789 986 197
Naphtha 2,348 2,934 587
Ammonia 64 132 69
Feedstock cost 8,269 10,819 2,550
Electricity & water 1,039 2,053 1,014
Total 9,309 12,872 3,564
Source: IHS Chemical, BofA Merrill Lynch Global Research. US spot refers to natural gas prices of US$2.6/mn BTU. The US$2.5bn feedstock
price rise could directly accrue to the central government through Saudi Aramco, while higher electricity and water charges would not.
Moving further down the value chain
Downstream operations in Saudi have historically been international Joint-Ventures (JVs)
and government-owned entities like SABIC. In July 1993, the government issued a Royal
Decree that merged all the state-owned refineries, distribution activities and marketing
operations under Saudi Aramco.
This resulted in a transfer of the government’s stake in three key refineries and
international refining and petrochemical operations to one state-owned company.
Today, Saudi Aramco is one of the largest crude oil refiners in the world and aims to
become a top-three petrochemical producer through standalone petrochemicals
facilities like Sadara, downstream integration at its many refineries, and potential
acquisitions. The recent announcement of the US split with Shell was followed by
comments that the breakup was due to different strategies by both companies with
Aramco increasing its focus on petrochemicals.
Petrochemicals - a route to diversification
Saudi Arabia is emerging as one of the largest petrochemicals producers globally. The
country initially started with integrated refining leading to petrochemical production
through its multiple JVs in Saudi and other regions, and is now building the largest
petrochemical complex globally. One of the goals is to maximise the value of the Saudi
hydrocarbon chain. Ultimately, this expansion into petrochemicals should further support
the diversification drive and thus support the stated goals for the Saudi economy.
Saudi Arabia (potentially through Saudi Aramco) aims to become a leader not only in
commodity chemicals, but also downstream petrochemical conversion. In the cities of
the Jubail and Rabigh, the Ministry of Energy, Industry and Mineral Resources (along
with Saudi Aramco) is constructing value-parks next to upstream chemical facilities. The
aim is to provide integration and the infrastructure for SMEs to operate and produce
value-added products in the Kingdom. This diversification into specialty chemicals could
increase returns from the current US$500/ton level to around US$2000/ton by 2040,
according to local press citing senior Aramco officials. Saudi Arabia could also look to
grow its international refining footprint to provide further integration opportunities, as
was suggested by the recent split of the Motiva JV (Saudi is more keen to expand its
downstream operations, whilst Shell is looking to reduce them).
Two petrochemical projects are also being built. The first is the Sadara project in Jubail,
which is expected to become the world’s largest integrated chemicals complex with
3MMt of output. It will use naphtha as feedstock. The second is Petro Rabigh II, which is
the expansion project of the existing Petro Rabigh plant that will process 4MMt (93kb/d)
of naphtha feedstock, and is planned to be launched in 2016.
NTP includes the long discussed Oil-to-Olefins (OTC)
Saudi’s national transformation plan includes the development of a US$770mn
industrial cluster whereby expansion to the Aramco refinery is likely to take place,
providing the platform for the long discussed OTC, Oil-to-Olefins, project. Saudi
70 GEMs Paper #26 | 30 June 2016
authorities have highlighted in several press releases that Aramco and SABIC are looking
at potential oil-to-olefins projects. The Kingdom has a proprietary technology that
enables it to maximise the yield of olefins per ton of oil used. According to SABIC's
management, this project has been carried out on a small scale at test sites and it is
conducting feasibility studies at a larger-scale facility. Aramco has also highlighted plans
in this area. While both companies declined to comment, Bloomberg highlighted that
sources indicate they are assessing the possibility of embarking on a project together.
Such a step would be the first of its kind in Saudi Arabia, with Aramco and SABIC
working alongside each other on such a large scale.
Refining capacity target: almost there
The NTP aims to increase the refining capacity to 3.3mn bpd per day by 2020 from
2.9mn bpd today. Saudi has recently completed and launched two large refining projects
with 400kbpd installed refining capacity each: (1) SATORP in Jubail launched in June
2014; and (2) YASREF in Yanbu – first shipment made in January 2015 and inaugurated
in January 2016. In addition, it is building a new refinery, Jazan, which should process
400kb/d of Arabian heavy and medium crude oil; launch is expected in 2019.
Table 26: Saudi Arabia government refining assets
Name Location Completion Refining Saudi Aramco's Saudi Aramco's Partner
capacity, kb/d share in capacity, kb/d ownership (%)
Wholly-owned domestic refineries
Jeddah Jeddah 1967 90 90 100% n/a
Yanbu Yanbu 1979 240 240 100% n/a
Riyadh Riyadh 1981 126 126 100% n/a
Ras Tanura Ras Tanura 1986 550 550 100% n/a
Total 1,006 1,006
Domestic refining JVs:
SAMREF Yanbu 1983 400 150 50.0% ExxonMobil
SASREF Jubail 1986 305 114 50.0% Shell
Petro Rabigh I Rabigh 1990 400 150 37.5% Sumitomo (37.5%, free float 25%)
SATORP Jubail 2014 400 250 62.5% Total (37.5%)
YASREF Yanbu 2015 400 250 62.5% Sinopec (37.5%)
Total 1905 914
Total in Saudi Arabia 2,911 1,920
International refining JVs:
S-Oil South Korea 1991 669 424 63.4% S-Oil
Motiva USA 2002 1070 535 50.0% Shell
Showa Shell Japan 2004 445 67 15.0% Shell
Fujian China 2007 280 70 25.0% Sinopec, ExxonMobil
Total 2464 1096
Total capacity globally 5,375 3,016
Source: Saudi Aramco, Energy Policy, BofA Merrill Lynch Global Research
Table 27: Saudi Arabia petroleum product output in 2014 (mn bpd)
Saudi Aramco LPG Naphtha Gasoline Jet Fuel Diesel Fuel oil Asphalt Total
ownership (%)
Wholly-owned domestic refineries
Jeddah 100% 0.9 2.9 4.0 0.0 2.4 9.2 6.4 25.8
Yanbu 100% 2.4 3.2 11.5 -0.4 29.3 30.9 0.0 77.0
Riyadh 100% 1.8 0.0 10.9 2.7 19.2 0.0 6.5 41.2
Ras Tanura 100% 5.0 15.0 43.9 7.8 76.1 32.5 7.2 187.4
Subtotal 10.1 21.1 70.3 10.0 127.1 72.6 20.1 331.3
Saudi Aramco share in domestic JVs
SAMREF 50% -1.1 0.0 25.0 11.1 18.8 14.4 0.0 68.2
SASREF 50% 1.3 11.7 2.2 9.4 14.2 13.3 0.0 52.2
Petro Rabigh 38% 1.3 7.3 6.9 4.9 11.7 13.4 0.0 45.5
SATORP 63% 1.3 3.9 11.1 8.2 31.6 7.5 0.0 63.7
Subtotal 2.9 22.9 45.2 33.7 76.3 48.6 0.0 229.5
Total 13.0 44.0 115.6 43.7 203.4 121.2 20.1 560.9
Source: Saudi Aramco, BofA Merrill Lynch Global Research
GEMs Paper #26 | 30 June 2016 71
Chart 59: Saudi government refining assets (effective stake in k bpd)
1,006
Chart 60: Saudi refining breakdown per region (effective stake)
23%
2,464
914
56%
21%
Domestic fully owned
Share in domestic JVs
Domestic fully owned
Share in domestic JVs
Share in JVs overseas
Share in JVs overseas
Source: Saudi Aramco, BofA Merrill Lynch Global Research
Source: Saudi Aramco, BofA Merrill Lynch Global Research
Exports are geared towards Asia and Far East
Saudi Arabia exported c.1mbpd of oil products in 2014, mainly to Asia and the Far East
(56%), other Middle Eastern countries (19%) and Western Europe (12%).
Chart 61: Oil product export volumes split per region in 2014
1% 1%
11%
Chart 62: Saudi Arabia oil product slate in 2014
20.1
13.0 44.0
56%
19%
12%
203.4
121.2
115.6
43.7
North America South America Western Europe
Middle East Middle Africa Asia and Far East
Source: Ministry of Energy, Industry and Mineral Resources.
LPG Naphtha Gasoline Jet Fuel
Diesel Fuel oil Asphalt
Source: Company data, BofA Merrill Lynch Global Research
Ambitious natural gas expansion
The NTP also focuses on expanding natural gas production. The government aims to
grow the existing production by 48%, largely through non-traditional routes. According
to the minister of Energy, Industry and Mineral Resources, natural gas accounts for 50%
of energy production and the target is to increase this to 70% by 2020 through
expanding local production or importing if necessary. The government’s priority will be
to explore the option of local production, although imports were, for the first time, not
excluded. We consider this as an interesting development as importing LNG into Saudi
costs the same as producing it internally through non-traditional routes, in our view. The
Saudi statement acknowledges that Saudi Arabia is willing to be open to the possibility
should imports provide a more economic means for this purpose.
Table 28: National Transformation Plan objectives in the petrochemicals, oil, and refining sectors
Base line Target 2020 Regional benchmark Global benchmark
Oil production capacity (mn bbls/day) 12.5 12.5 3.8 11
Dry gas production capacity (bn scf per day) 12 17.8 5.7 16
Refining capacity 2.9 3.3 1.1 1.9
memo:
Initiative cost to the government (total SAR491mn or US$131mn):
Energy
SAR216mn
Oil & Gas
SAR200mn
Gas network
SAR75mn
Source: Saudi National Transformation Plan
72 GEMs Paper #26 | 30 June 2016
Utility sector: sharing the capex burden and
achieving cost reflective tariffs
Ali Dhaloomal
MLI (UK)
ali.dhaloomal@baml.com
Eight strategic objectives aimed at being self-funding
The electricity sector is mentioned in eight strategic objectives of the NTP 2020. The
two most important measures in our view are the one related to subsidies cuts and the
one on the liberalisation of the sector which should free out financial resources to fund
the future capex burden as well as the other targets under the NTP. This is even more
relevant as the NTP doesn’t provide any additional funding for the sector.
Unanswered questions as to impact on electricity sector
While we think these initiatives should be welcomed as they would reduce the financial
burden on Saudi Electricity Company (SEC) from its ambitious capacity expansion plan
(SAR240bn / US$64bn to be spent over the 2016-21, mostly in generation), some
questions remain unanswered, especially in regards to SEC’s capital structure and
financial sustainability on a standalone basis. It remains unclear if the proceeds from the
disposals of the minority stakes in the GenCos will be used to fund future capex plans or
to alleviate SEC’s commercial debt (US$16.3bn as of FYE15) and government and
government-related debt and payables (c.US$46bn as of FYE16). Also, it remains unclear
if on the back of the NTP, SEC would start paying its current payables (fuel sourced
from Aramco, electricity sourced from SWCC and fees owed to municipalities) instead of
accruing these amounts as it does now.
1. Saving SAR200bn annually by cutting the water and electricity subsidies: The
current print of the NTP doesn’t give any detail about how this target will be split
between water and electricity subsidies, but we note that the plan aims to reach full
cost reflective water tariffs by 2020 (from 30% cost coverage at the moment).
Recall that starting from January 1st, electricity prices have been increased by a
weighted average of close to 20%, with residential prices (half of the consumption)
now ranging SAR 0.05-0.30 / KWh vs SAR 0.05-0.26 previously. The highest
increases are for the commercial sector, the governmental entities and the
agricultural sector. SEC’s management recently indicated to us that they expect a
neutral impact over the long term from this decision as it mirrors an increase in
feedstock price charged by Aramco. However, over the short to medium term, SEC
cash flows are expected to benefit from the tariff decision given that the company
books all its fuel costs in payables without disbursing any amount to Aramco.
2. Increasing the percentage of power generation through strategic partners to
100% from 27% now: We believe that the aim here is to bring industrial or
financial partners in all SEC’s and Saline Water Conversion Corporation (SWCC)
generation units, in line with the electricity sector reform which expected to be
implemented by late 2016 / early 2017. According to SEC’s management, the most
likely scenario involves SEC’s generation assets to be split into four separate
regional GenCos where minority stakes would be sold to major global utilities or
sold in the public market.
3. Increasing the efficient use of “fuel” in power generation to 40% from 33%
now: We think that this objective entails increasing the share of efficient combined
cycle gas turbines (CCGT) plants. Given that SEC currently represents 73% of the
country’s installed capacity and that 19% of its electricity is generated via efficient
combined cycle gas turbines (CCGT), this means that 71% of the remaining tier
party capacity is “efficient”. We note that another 39% of SEC’s installed
generation capacity is made of less efficient open cycle gas turbines (OCGT).
GEMs Paper #26 | 30 June 2016 73
4. Increasing the reserve to peak demand to 12% from 10% now: This reserve
margin was just at 2.3% back in 2012 and SEC was assigned a target of 10% which
management expects to fulfil. In light of the recent improvements and SEC’s
ambitious capacity expansion plan (SAR240bn / (US$64bn in capex over the 2016-
21), the target looks realistic to us.
5. Reducing the outages of more than 5min to 3.0 per year from 6.4 per year now
and the average outage time to 120 minutes from 262 minutes now. This goal
will likely be achieved through the ongoing investments in expanding and improving
SEC’s transmission and distribution network (half of the overall capex incurred in
2015 went to these two segments).
6. Increasing the access to electricity to 99.5% of the population from 99% now:
It is hard to quantify the cost of this objective, but we believe that it entails
increasing the reach to the remote Eastern and Southern regions of the country
where the economics of expanding the transmission network are not relevant.
7. Reach 86 GW of installed capacity vs. 69 GW at the end of 2015 (incl. 50 GW
at SEC alone): The target is in line with SEC own current ambitious expansion plan
(22.8GW to be added over five years to reach 68.3 GW by the end of 2018) and
factors in additional capacity from SWCC and IPPs as well.
8. Generate 4% of the electricity from renewables (equiv. to 3.45 GW): we would
expect the projects to be primarily based on onshore wind and solar. It is likely that
these projects will be fully developed by IPPs under long term power purchase
agreements where SEC would be the offtaker and assume the higher cost of the
electricity from these ReIPP. While SEC has currently no renewable generation
capacity at all, it has recently invited expressions of interest for potential lead
developers for two 50MW solar photovoltaic projects, which we see as a (modest)
step towards the NTP target. Based on the KACARE study on grid impact, Saudi
Arabia’s electricity network should be able to integrate up to 14GW of renewables
capacity by 2020. Finally, we note that ACWA Power, the largest privately-owned
utility company in Saudi Arabia and one of the main IPP players in the country
(along with Engie), has developed a proven expertise in wind and solar projects
internationally. ACWA is likely to be one of the main players in the upcoming
liberalisation plans.
Chart 63: SEC’s debt and payables to the gov.
& GREs grew at 17.4% CAGR since 2009
(US$bn)
50
40
30
20
10
Chart 64: Saudi Arabia power generation
installed capacity split in 2015 (total: 69 GW)
10%
18%
72%
Chart 65: Saudi Electricity Company (SEC) fuel
mix for electricity generation
19%
39%
1%
41%
0
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Saudi Electricity Company (SEC)
Saline Water Conversion Corp. (SWCC)
IPPs and others
Heavy & light fuel
Natural Gas - CCGT
Natural Gas - OCGT
Other
Municipality fee payables
SWCC purchased power payables
Saudi Aramco net payables for fuel cost
Government soft loans
Long-term government payables
Source: SEC, BofA Merrill Lynch Global Research
Source: SEC, BofA Merrill Lynch Global Research
Source: SEC
74 GEMs Paper #26 | 30 June 2016

Defence: Vision 2030 supports defence
spending
Celine Fornaro >>
MLI (UK)
celine.fornaro@baml.com
Benjamin Heelan >>
MLI (UK)
benjamin.heelan@baml.com
Saudi Arabia is increasing its regional role as a Security and Defence nation in the
Middle East region. The 2030 Vision includes a higher local content in defence
procurement which can be achieved through new contract awards and increased
cooperation with large Original Equipment Manufacturers (OEMs). BAE is best
positioned, in our view: it has been the in the country since 1966 with 5,000 local
employees and Saudi Arabia represents 21% of BAE’s group sales.
Saudi Arabia to build out military industrial base
Defence is one of the key industries that Saudi is pinpointing for investment as part of
its future strategy plans, and one where it is well placed to become a global leader, in
our view. Saudi Arabia has one of the largest defence budgets globally, and we expect
its focus on defence investment to remain broadly intact regardless of the price of oil.
Due to regional tensions, defence spending will likely remain high for the foreseeable
future, in our view. Saudi Vision 2030 and the associated National Transformation Plan
(NTP) will likely increase focus on use of defence to achieve their economic
diversification goals. This is likely to take place through capability deployment and
employment in partnership with long term defence partners. Saudi authorities aim to
raise the locally-sourced defence procurement from 2% today to 50% in 2030.
Much of the countries’ defence spending is for foreign imports. According to
consultancy IHS, 1 out of every 7 dollars spent on defence imports in 2015 was spent by
Saudi Arabia, which was predicted by IHS to increase its defence imports by 52%yoy to
US$9.8bn in 2015.
In our view, Saudi strategy to increase locally manufactured defence content is justified,
given their level of purchasing power with international contractors. However, this could
trigger a round of new contracts’ awards to set up new terms. The State owned Taqnia
company has been signing some contracts with international companies but this
remains very limited at this stage.
Saudi commitment to defence spending positive for European Defence
Saudi Arabia’s Ministry of Finance 2016 defence budget spending remains high at
SAR213bn (cUS$57bn) which is 25% of the total budget. In 2015, the budgeted defence
spending reached SAR307bn (US$82bn). Despite the large decrease in headline defence
and security expenditure, budgetary figures suggest the allocation for the Ministry of
Interior, Ministry of National Guard, Ministry of Defence, General Intelligence
Directorate, and Saudi Royal Guard Regiment could be heavily supported from elsewhere
in the budget, if required. Figures released by the Ministry of Finance suggest that
SAR183.0bn of the state budget for 2016 - c21% of total budgeted spending - will be
allocated through a new 'Budget Support Provision' that is to be used "to give more
flexibility to the budget and redirect capital and operational expenditure in line with
national priorities and to fulfil spending requirements". In our view, the commitment to
defence spending is positive for companies who have presence in the area, BAE (Buy,
600p) & Thales (Buy, €87).
BAE Systems ties to Saudi Arabia go as far back as 1966, when the company was
contracted to Lightning and Strikemaster aircraft and equipment in a programme called
the ‘Magic Carpet’. In 1985, a new government-to-government (UK/Saudi Arabia)
agreement was signed covering supply and support of Tornado, Hawk and PC-9 aircraft.
A new government-to-government agreement, known as the Saudi British Defence Cooperation
Programme, was inaugurated at the start of 2007. Salam Project, which
GEMs Paper #26 | 30 June 2016 75
provides for the acquisition of 72 Typhoon aircraft in a programme aimed at the
modernisation of the Saudi Armed Forces, was launched in September 2007. This
carries substantial packages of work and expertise transfers, aimed at developing the
Saudi industrial defence sector. BAE Systems has made a major commitment to the
training of local nationals to bring them into management, technical and other qualified
positions. Saudis constitute 21% of BAE’s group sales, 57% of the total BAE Systems'
workforce in Saudi Arabia making the Company one of the largest private sector
employers of Saudis with 5,000 employees based locally. The UK and Saudi have
discussed in the past moving the final assembly of some of the 72 Typhoons in Saudi
Arabia but it failed. Now, the two countries may be trying to have locally produced
Hawks on the back of the 22 trainer order at the end of 2015, according to local press.
Thales (10% of group sales in the Middle East, mainly in defence) has an established
presence in the Kingdom of Saudi Arabia, with 750 employees and a diversified portfolio
of activities. The company has built a mature relationship with Saudi Arabia based on
solid, country-wide partnerships. Thales’s major commercial successes include the
Shahine and Crotale air defence contracts with logistic support. In naval defence, Thales
is the prime contractor for the Sawari II contract (three frigates), that follows on from
the successful Sawari I programme (four frigates) for which Thales now provides logistic
support. In 2007, Thales was selected by the Saudi Arabian Ministry of Defence to
supply a major electronic protection system to the Royal Saudi Air Force.
US contractors such as Lockheed Martin (supplier of F16 jets, C130J transport planes),
General Dynamics (military vehicles) and Raytheon (missiles) have some local presence
in Saudi Arabia, but BAE is by in large the largest and historical local presence.
76 GEMs Paper #26 | 30 June 2016
Table 29: Stocks mentioned
Name Symbol Opinion Q-R-Q Price PO
Al Hammadi XBQYF Buy C-1-7 SAR 40.19 SAR 64.0
Al Othaim XWPJF Buy C-1-7 SAR 99.99 SAR 121.0
BAE SYSTEMS BAESF Buy A-1-7 GBP 483.4 GBP 600
BAE SYSTEMS BAESY Buy A-1-7 USD 26.17 GBP 34.26
SABIC XAUBF Buy C-1-8 SAR 80.87 SAR 99.5
Saudi Telecom XUTUF Buy C-1-7 SAR 63.95 SAR 81.0
Savola XSAVF Buy C-1-7 SAR 35.95 SAR 46.0
THALES THLEF Buy C-1-7 EUR 73.5 EUR 87.0
YANSAB XUYNF Buy C-1-7 SAR 40.28 SAR 48.0
Zain KSA XOCTF Buy C-1-9 SAR 7.83 SAR 12.2
Almarai XALRF Neutral B-2-7 SAR 53.7 SAR 61.0
Jarir XJRIF Neutral C-2-7 SAR 118.64 SAR 134.0
SAFCO XDUAF Neutral C-2-8 SAR 59.73 SAR 72.0
Dallah Healthcare XJEFF Underperform C-3-7 SAR 86.12 SAR 79,0
Dar Al Arkan XARKF Underperform C-3-9 SAR 6.49 SAR 7.0
Extra XYDUF Underperform C-3-7 SAR 26.72 SAR 24.0
Source: BofA Merrill Lynch Global Research
Price objective basis & risk
Al Hammadi (XBQYF)
Our SAR64 PO for Al Hammadi is based on our DCF-derived valuation. This is equivalent
to 32x FY17E EPS. Strong earnings growth means out-year valuations appear much
more reasonable than near-term valuations (e.g. implied 13x FY20E EPS). Company
specific risks are: lower-than-expected growth resulting from delays in executing on
expansion plans, inability to raise prices to offset cost inflation, failure to manage
growth without impacting margins, pricing pressure from insurers, new competition,
sustained delays to government payments, and any potentially dilutive acquisitions.
General/macro risks are: sustained low oil prices and any resultant slow-down in the
economy, civil unrest, ongoing failure of the government to pay bills.
Al Othaim (XWPJF)
We use a combination of DCF, DDM and peer group analysis to value Al Othaim. We
have taken a weighted average of values implied by our DCF, DDM and peer group
analyses. We attribute a 50% weight to the DCF and 25% weights for both the DDM and
the P/E multiple, which points to a PO of SAR121. We attribute a greater weight to the
DCF valuation as we believe food retailers offer good visibility on cash flow generation.
In the case of Al Othaim, we think DCF better reflects the stock's growth opportunity.
We assume a perpetuity growth rate of 2% and WACC of 9.1% in our DCF.
The downside risks to our investment case are:
- Weaker-than-expected margin performance
- Cannibalisation effect in Saudi Arabia
- Competition: We expect competition to intensify among the large organized players,
such as Savola-owned Panda which have aggressive retail expansion plans growth plan
- Saudization: Most of Al Othaim's labors are low level staff working in the warehouses
and branches which depends heavily on expatriate labors. This suggests the Saudization
of the staff could put further pressure on margins.
Almarai (XALRF)
We arrive at our SAR61/share price objective using a combination of P/E multiples and
DCF valuation, taking the average yielded by the two methods. More specifically:
GEMs Paper #26 | 30 June 2016 77
On a multiples basis, we value Almarai on 21x 2017E EPS, a 15% premium to Global
(blue chip) food producer averages. We believe that at this level it is fairly valued given
it is trading at a premium to its historical trading average and the weaker consumer
outlook.
Our DCF analysis yields a valuation of SAR59/share, based on a WACC of 8% and
terminal growth rate of 3.5%.
Risks to our PO are company specific factors such as plant outages, disease outbreaks
in its biological assets, delays in the investment program and factors affecting suppliers.
Macro level risks are commodity prices, government regulation, subsidy removals and
price pressures from growing competition.
BAE SYSTEMS (BAESF / BAESY)
Our PO of 600p (US$34.26/ADR) is an average based on DCF, 2016-17E P/E and
EV/EBITA and Sum-of-Parts. We regard as BAE's peers Lockheed Martin, LLL, General
Dynamics, Northrop Grumman, Raytheon, QinetiQ, Cobham, Ultra Electronics.
Our DCF valuation (8.7% WACC and 1.8% long-term growth rate in line with defence
peers and 10.7% long term margin) implies a 550p share price. Our SOP suggests at
valuation range of 592-595p, using peer group EV/EBITA multiples of 12.7-13.7x and
EV/sales of 1.2x. Applying EU and US peers multiples on EV/EBITA and P/E yields a
valuation range of 671-679p.
At 600p BAE would be trading on 14.6x 2016E P/E and at 13.9x 2016E EV/EBITA. This
P/E is in the middle of the historical range of c.20x to c.6x, and the EV/EBITA is near the
high end of the historical range of c.12x to c.4x.
Upside risks are: 1) An export contract for Typhoons, in particular an order for 60+
airplanes from Saudi, 2) USD strength against the UK, 3) development of a large scale
and long term conflict.
Downside risks are: 1) significant decrease to the US or UK defence budgets, below our
current assumptions, 2) significant weakness of the US$ vs Sterling.
Dallah Healthcare (XJEFF)
We set a SAR79 price objective for Dallah, which is equivalent to 23x FY17E EPS. We
expect earnings to double between FY15A and FY20E as beds triple. The multiple
therefore falls quickly and on FY20E earnings, when some of this growth is likely to
have come through, the stock trades in-line with other hospital stocks, both EM and
Saudi.
Upside risks are: greater price increases than assumed in forecasts, faster uptake of
new capacity, accretive M&A activity.
Down side risks are: Slowdown in the economy, lower-than-expected growth resulting
from delays in executing on expansion plans, inability to raise prices to offset cost
inflation, failure to manage growth without impacting margins
Dar Al Arkan (XARKF)
Our PO of SAR7.0/share is based on sum-of-the-parts methodology. We
employ a WACC of 10.7%, derived from a COE and COD of 11.1% and 9.0%,
respectively. Our SOTP includes (1) the NPV of the current development portfolio
to 2016E, (2) the NPV of recurring cash flows from investment portfolio + the NPV
of its terminal value minus incremental capex to complete the investment
programme, (3) the NPV of land sales from the developed land bank, and (4) the
book value (valued at cost) of DAAR s remaining land bank.
Downside risks: (1) Deterioration of demand for land would increase
the perceived liquidity risk (2) Deterioration of credit environment (3) Emergence
78 GEMs Paper #26 | 30 June 2016
of sub-developers which would inflate the acq. cost of land and consequently
depreciate the residual value of land due to lower margins (4) Mismanagement of
cash flows: a mismanagement of the resources (overspending in CAPEX for land
for example) could arise liquidity concerns because of over-exposure to land
sales mkt. Upside risks: A lower-than-expected borrowing cost: We
forecast an incremental cost of debt of 9%, A improvement in the credit
environment sensitive to exogenous factors such as liquidity and the risk appetite
of the international mkt. would lower DAAR s cost of funding, We see upside
valuation risk in the value of the land bank should the company manages to
develop housing units with the support of the Ministry of Housing. debt-financed
acquisition to boost its recurring income.
Extra (XYDUF)
We derive a PO of SAR 24 using a DCF valuation model which we believe best captures
differing capital costs and growth profiles across the MENA region. Key assumptions are
an 11% WACC and a 2% perpetuity growth rate. Upside/downside risks to our PO are
better/worse returns from better/worse like-for-like sales and shorter/longer break even
times from new international markets.
Jarir (XJRIF)
We derive a PO of SAR134 using a DCF valuation model which we believe best captures
the company's plan to add c.60% new stores by 2017. Key assumptions are: - a 5-year
CAGR in sales of 11% followed by an five-year CAGR of 6% and a perpetuity growth rate
of 2%, - an average EBIT margin of 13%, - a WACC of 9.5% with a beta of 0.9x. Our
WACC is calculated using a RFR of 5.0% and an ERP of 6.0%. We used a 2% terminal
growth rate.
The risks to our PO are company-specific issues such as a failure to deliver the expected
11% top-line growth or a faster-than-expected deterioration in electronics margins. In
addition, there are risks associated with a slowdown in the economy or consumer
spending.
Saudi Arabian Fertilizer Company (XDUAF)
We apply a justified P/E multiple to derive SAFCO's PO of SAR72. The P/E is based on a
normalized RoE of 30.2%, Cost of Equity of 10.4% and payout of 93.5%.
Upside risks to our price objective are: (1) delays in global nitrogen fertilizers capacity
expansions, which would result in a tighter supply of urea and effectively higher prices,
(2) Stronger demand for fertilizers and effectively prices, (3) An increase in the marginal
producer cost that effectively leads to a higher urea price floor.
Downside risks are: (1) lower prices of urea due to weaker than expected demand, (2)
Delay in SAFCO 5 expansion project, (3) an increase in natural gas cost.
Saudi Basic Industries Corporation (XAUBF)
We apply a justified P/E multiple to derive SABIC's PO of SAR99.5. The P/E is based on a
normalised RoE of 15.8%, Cost of Equity of 11.5% and payout of 65.0%
Downside risks to our price objective are a decline in the supply of low-cost feedstock, a
lower-than-expected recovery in petrochemicals prices, delays in the ramp-up of newly
established subsidiaries, or weakness in steel demand in Saudi Arabia.
Saudi Telecom Company (STC) (XUTUF)
We derive our SAR81/share PO for STC on a sum of the parts basis, using a combination
of DCF and market valuations for its core subsidiaries and associates, adjusting for
ownership stakes. Specifically, we use DCF to value its core operations in Saudi Arabia
(9.5% WACC), Viva Kuwait (10.5% WACC), and other subsidiaries (10.1% WACC). We
GEMs Paper #26 | 30 June 2016 79
assume a terminal growth rate of 2% across all of the markets, starting from 2023. For
STC's associates, we value its holdings in Oger Telecom and Binariang using a
combination of our Research team's valuation (for Oger's stake in Turk Telecom) and
book value. We then add STC's net cash position at YE 2015 in deriving our PO.
Risks to our PO come from potential market share loss as both Mobily and Zain KSA,
plus several MVNO's are aiming to take market share from STC domestically, following
recent cut in MTR's. Additionally, we see ongoing risk from FX exposure at their
subsidiary investments, especially their indirect stake in Turk Telekom.
Savola (XSAVF)
Given the diversified nature of the Savola group, we use a sum of the parts valuation in
deriving our SAR46/share price objective for Savola. Specifically, we:
Value the food business on 12x 2016 earnings, a 30% discount to global peers on
account have having slightly slower growth and risks presented by having a significant
position in Iran (which accounts for 13% of revenues).
Value retail(Panda) at 15x 2016 earnings, a c.10% discount to global peers on account of
having slower near term growth. we believe near term growth will be impacted by
continued aggressive expansion and slowing demand trends in the Saudi market
(following the introduction of the 2016 budget).
The investments business is valued using a variety of methods. For its stake in Almarai,
we value it in line with our price objective for the shares. Savola's interests in other
listed entities (Herfy, KEC and EEC) are valued at current market valuation given we do
not have research coverage on the names. The stakes in none listed entities including
the real estate book and private equity holdings are valued at 2x book value (YE2015).
Downside risks to our PO include higher cost escalation than we forecast, further
adverse moves in commodity prices , adverse FX movements in countries outside of
Saudi Arabia where Savola does business and any disruptions to its material Iranian
business.
THALES (THLEF)
To derive our Thales price objective of €87, we use a 2017E sum of the parts valuation,
using Rockwell Collins, Raytheon, Northrop Grumman, Ultra, and the EU Civil Aerospace
peer group as peers for the Aerospace/defence segments, and Ansaldo STAS as a peer
for the transport business.
At €87 Thales would trade on 18.1x 2017E P/E and 12.3x EV/EBITA which we think is
appropriate given balance sheet/ portfolio optionality and building order momentum.
Upside/Downside risks to our price objective are: 1) changes in the company's free float,
2) assets swap and portfolio changes could add more value than we currently estimate
3) lower/more French defence cuts than we currently estimate.
YANSAB (XUYNF)
We apply a justified P/E multiple to derive YANSAB's PO of SAR48. The P/E is based on
a normalized RoE of 14.5%, Cost of Equity of 11% and payout of 70%
Downside risks to our price objective are: 1. Lower-than-expected demand for polyester
would adversely impact MEG prices and effectively earnings 2. Unexpected change in
feedstock prices could negatively impact earnings 3. Unexpected shutdowns that would
result in lower production.
80 GEMs Paper #26 | 30 June 2016
Zain KSA (XOCTF)
We use a DCF valuation model to derive our price objective of SAR 12.2. Key
assumptions are a discount rate of 11.0%, underpinned by a risk free rate of 5.5%, a
cost of equity of 29% and a 6.5% cost of debt. We explicitly forecast free cash flows
until 2022 and then assume perpetuity growth of 3%, as we do when valuing other Gulf
operators. Our forecasts take in to account the repayment of the deferred royalty loan
afforded to Zain in 2013 (repayments starting from 2021).
Downside risks are greater pricing pressure from MVNOs, the loss of its appeal against
a SAR620mn tax claim, an unfavourable ruling against Zain KSA in its arbitration process
with Mobily and an inability to grow market share and margins, which in turn would
threaten capital requirements.
Analyst Certification
We, Abdelrali El Jattari, Ali Dhaloomal, Anton Fedotov, Benjamin Heelan, Celine Fornaro,
Faisal AlAzmeh, CFA, Francisco Blanch, Hootan Yazhari, CFA, Jamie Clark, CFA and Jean-
Michel Saliba, hereby certify that the views each of us has expressed in this research
report accurately reflect each of our respective personal views about the subject
securities and issuers. We also certify that no part of our respective compensation was,
is, or will be, directly or indirectly, related to the specific recommendations or view
expressed in this research report.
Special Disclosures
Some of the securities discussed herein should only be considered for inclusion in
accounts qualified for high risk investment.
GEMs Paper #26 | 30 June 2016 81
Disclosures
Important Disclosures
Credit opinion history
Bahrain / BHRAIN
Sovereign Date^ Action Recommendation
Bahrain / BHRAIN 12-Nov-2015 Initial Marketweight
Table reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of the
report under the heading "BofA Merrill Lynch Credit Opinion Key."
Dubai / DUGB
Sovereign Date^ Action Recommendation
Dubai / DUGB 12-Nov-2015 Initial Marketweight
08-Jan-2016 Downgrade Underweight
28-Apr-2016 Upgrade Marketweight
Table reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of the
report under the heading "BofA Merrill Lynch Credit Opinion Key."
Qatar / QATAR
Sovereign Date^ Action Recommendation
Qatar / QATAR 12-Nov-2015 Initial Marketweight
08-Jan-2016 Downgrade Underweight
26-Feb-2016 Upgrade Marketweight
25-May-2016 Restricted NA
Table reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of the
report under the heading "BofA Merrill Lynch Credit Opinion Key."
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Sovereign Investment Rating Distribution: Global Group (as of 31 Mar 2016)
Coverage Universe Count Percent Inv. Banking Relationships* Count Percent
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Hold 28 71.79% Hold 12 42.86%
Sell 6 15.38% Sell 6 100.00%
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Neutral ≥ 0% ≤ 30%
Underperform N/A ≥ 20%
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82 GEMs Paper #26 | 30 June 2016
INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure), 8 - same/lower (dividend not considered to be secure) and 9 - pays
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GEMs Paper #26 | 30 June 2016 83
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84 GEMs Paper #26 | 30 June 2016
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GEMs Paper #26 | 30 June 2016 85
Research Analysts
Economics
Jean-Michel Saliba
MENA Economist
MLI (UK)
+44 20 7995 8568
jean-michel.saliba@baml.com
MENA & FM equity
Hootan Yazhari, CFA >>
Research Analyst
Merrill Lynch (DIFC)
+971 4 4258218
hootan.yazhari@baml.com
Healthcare
Jamie Clark, CFA >>
Research Analyst
MLI (UK)
+44 20 7995 1300
jamie.clark@baml.com
Chemicals & Mining
Faisal AlAzmeh, CFA >>
Research Analyst
Merrill Lynch KSA Company
+966 11 299 3741
faisal.alazmeh@baml.com
Real Estate & Consumer
Abdelrali El Jattari >>
Research Analyst
Merrill Lynch (DIFC)
+971 4 4258231
abdelrali.eljattari@baml.com
Credit Research
Ali Dhaloomal
Research Analyst
MLI (UK)
+44 20 7996 9107
ali.dhaloomal@baml.com
Commodities
Francisco Blanch
Commodity & Deriv Strategist
MLPF&S
+1 646 855 6212
francisco.blanch@baml.com
Peter Helles
Commodity Strategist
MLI (UK)
+44 20 7996 8154
peter.helles@baml.com
Aerospace, Defence & Satellite Services
Celine Fornaro >>
Research Analyst
MLI (UK)
+44 20 7996 5515
celine.fornaro@baml.com
Benjamin Heelan >>
Research Analyst
MLI (UK)
+44 20 7996 5723
benjamin.heelan@baml.com
Energy
Anton Fedotov >>
Research Analyst
Merrill Lynch (Russia)
+7 495 662 6079
anton.a.fedotov@baml.com
Trading ideas and investment strategies discussed herein may give rise to significant risk and are not suitable for all
investors. Investors should have experience in FX markets and the financial resources to absorb any losses arising from
applying these ideas or strategies.
>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules.
Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for
this report in particular jurisdictions.
86 GEMs Paper #26 | 30 June 2016