GCC Investment Strategy and Sectors Outlook for 2007

<?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Global Investment House - Kuwait - GCC Investment Strategy and Sectors Outlook for 2007 –

We remain bullish on the outlook for GCC equities in 2007. At current valuations, markets across GCC look attractive compared to other emerging market bourses. At current price levels, many stocks represent a good buying opportunity and provide a case of careful stock selection and accumulation. In particular, markets like Kuwait and Saudi Arabia are attractive at current valuations trading at 11.5x and 15.9x 2007E earnings and where market multiples have scope to expand further.

GCC markets have fallen over 49.3% in 2006 as measured by Global GCC-Investable 100 Index, in sharp contrast to the MSCI Emerging Market Index which has risen 25.5% and the MSCI Emerging Market BRIC countries Index has risen an impressive 47.7%. Oman’s MSM was the only GCC market to have registered positive returns in 2006 (up by  14.5% in 2006). Market valuations all across in GCC are now at very reasonable levels and the current valuations are closer to fundamental levels thus appearing cheaper than many other Emerging Markets. The recent fall in the market has given opportunity to the institutional as well as retail investors to do “bottom-fishing” in the markets and we believe that markets will turn corner in 2007.

Earlier concerns on corporate earnings growth during 2006 due to falling markets was not well supported as major corporates are expected to witness double digit growth rates in bottom line during the year. We project earnings growth rates ranging from 13.3% in Bahrain to 22.3% in Qatar. We believe Large-Cap stocks to perform better on the back of consolidation activity in the region and  expansion overseas. The call of the day is security selection based on fundamental analysis and professional research, strategic sectoral asset allocation, adequate diversification across markets/sectors and a longer-term investment horizon.

Key Investment themes remain liquidity driven infrastructure investments and rise in consumer related services. Corporate sector involved in hydrocarbons, logistics and transportation, real estate development & construction, retail and financial services are likely to be key beneficiaries. The improvement in the fertility rates, decline in infant mortality and increase in life expectancy augurs well for the education, pharmaceutical and insurance sector.

Sustained high oil prices support budget surpluses and high liquidity levels in GCC economies. This is accompanied by rising economic growth, rising government surpluses and increased investments in infrastructure development. Current account surplus is expected to cross US$170bn in 06E, which is about 25% of the combined GDP of GCC countries. Due to apprehensions on investing in the western markets, majority of this surplus is getting invested domestically and also finding investment opportunities in the Asian economies. Surplus status to last which will be well supported by high oil prices and high export levels. Rising surpluses to also allow GCC countries to go for sustainable expansion in public expenditure along with creation of new financial assets and repayment of past debt liabilities.

Clearly, key risk and stress factor remains the oil sector which contributes 80% of revenues and 50% of the nominal GDP of GCC countries. A decline in oil price will have a direct impact on macro-parameters such as current account surplus, fiscal balances and future government spending and would also lead to liquidity squeeze. This will eventually impact investments and growth. Also, massive growth in credit, rising at high double digits, which is directed towards construction, real-estate and infrastructure related industries create sector concentration risk. Any adverse effect will hamper the banking system and macro-prospects of the economies.

Investment Theme for Oil and Gas Sector

Huge investments are required in the oil sector and it is estimated that around US$500bn is needed in the Middle East alone for oil exploration, development, refining and pipelines/tankers during the next 20 years . Going forward, we also expect increased private sector involvement in the energy sector. We believe that there is going to be a wave of energy related IPOs and Funds as the government divests its stake in the sector as new private players enter the market.

Gulf countries are looking for ways to diversify their economies yet oil revenues remain a major contributor to the public finances. We believe that expanding oil production requires opening up the energy sector to foreign investments and private sectors. However, heavy dependence on oil in the GCC countries continues to remain a stress factor and concern especially considering the sustainability of this growth in the long term.

Oil prices have reached record highs of US$78.49/b around mid August 2006. The main factors in this tremendous increase are the under-investment in this sector, structural changes on supply and demand sides and refining issues which has pushed prices higher. Geopolitical tensions with the Israeli attacks on Lebanon, uncertainty of oil production from Iran and supply disruption from west Africa are the other contributing factors for high prices. However, prices declined to reach  US$58.51/b by the end of 2006 and are currently hovering in the region of US$53/b.

We believe that oil prices anywhere above US$40/b will ensure adequate liquidity in the GCC. Oil prices are expected to range between US$50-55 in the medium term which will result in a remarkable economic growth for the region.

We believe that natural gas is going to be the next growth driver for the GCC Region. The GCC countries account for almost 25% of world’s natural gas proven reserves. Qatar , Saudi Arabia, UAE and Kuwait are among the top 20 countries in terms of natural gas reserves ranked 3rd, 4th, 5th and 20th respectively. In addition,  Saudi Arabia, UAE and Qatar are ranked 10th,11th and 19th in terms of production.

Natural gas in recent times is attracting the attention of oil majors which are pouring billions into a multitude of projects to meet a booming demand for the environmental friendly fuel. Oil will continue to reign supreme because of its dominance in the transportation sector, but we expect gas to find enough demand from power generation sector, overtaking coal and fuel oil because of  increasing awareness of environment friendly power generation.

Investment Theme for Banking & Financial Services

Stability in economic growth along with low inflationary environment has helped Central Banks to maintain a prudent and healthy banking system in the region. The interest rates of regional economies are pegged to the US dollar, but a rising interest rate scenario could cause margin improvement and could also have a fall-out on the volume borrowings from banks. Also, strong growth in non-interest income through fees and commissions is very likely for the GCC banks. Moreover, ample liquidity on the back of soaring oil revenues led to double digit growth in deposit base in the regional banking sector. We expect Banking Deposits to GDP to decline to around 50% levels due to increased investments in other asset classes. Also, rising loan to deposit ratio adds pressure to the risk-weighted assets impacting the capital adequacy ratios of individual banks.

Strong economic growth leads to an unprecedented loan growth in all GCC countries. Growth markedly evident especially in the higher-yielding consumer segment which experienced high double-digit growth. Banks will increase their focus on high-margin personal lending going forward. We expect lending to the private sector to increase the private sector funding for expansion of the corporates both regionally and internationally. Personal lending rise owing to demographic changes.  Construction lending on a rise owing to housing and other real estate projects. Asset quality robust in most of the banking sectors in GCC. However, provisioning seems to adequate with coverage ratio at comfortable levels. There is a visible trend towards Islamic banking and banks with strong franchises are likely to have an edge over their conventional counterparts. However, we expect increased convergence between Islamic and conventional banks as conventional banks increase their Islamic banking products. UAE and Bahraini markets seem over-banked and we expect consolidation activity in the medium term.

Investment Theme for Telecoms

In order to meet the current telecommunication needs, GCC countries are focusing on mobile telecommunications services. Most of GCC countries have low fixed line penetration rates due to a combination of factors such as monopolistic structure of state owned operators, lack of investments for infrastructure and technology upgrade, and lack of supply in fixed line situations. In GCC countries, mobile penetration rates exceed fixed-line penetration. Presence of mobile operators has also resulted in fixed-to-mobile substitution. We believe that liberalization of fixed-line markets will improve the penetration rates and attract further investments in the telecoms sector.

Telecom liberalization commitment is a requirement for WTO accession which makes it imperative for GCC countries to commit to open their telecommunications sector, which has impacted the sector significantly. Over the last 6 years GCC countries witnessed a wave of market liberalization which resulted in the privatization of many incumbent telecommunications operators. Also new operators were allowed to provide telecom services through the issuance of new licenses. Currently, Bahrain is the most liberalized country in the GCC telecom sector. UAE, Saudi Arabia and to some extent Kuwait are the few to show signs of liberalization activities. Oman already has 2 operators in mobile telecom services. Qatar has announced its plans to liberalize its telecom sector in 2007.

Table:1

Source: Global Research

High ARPUs, the Average Revenue Per User, in markets such as Qatar, Kuwait, UAE etc. provide the players operating in these countries a strong base for cash flow generation. Also, strong macroeconomics and demographic profile support the telecom sector growth. With booming economies due to skyrocketing oil prices and a small population, the GCC countries have the highest mobile spend per capita. The UAE and Qatar are neck to neck with the first having a mobile spend per capita of US$557.2 and the second with US$541.7. Kuwait, Saudi Arabia, Bahrain and Oman have a mobile spend per capita ranging between US$185 to US$492.

Mobile segment is witnessing competition as new entrants are entering the GCC telecom market. Advent of competition (new operator “du” in UAE in 2006, “Nawras Telecom” in Oman in 2005) is also likely to affect market share of incumbent operators. Mobile competition accompanied by a surge in market penetration, leading to decreased ARPUs and increased growth in subscriber numbers. Prepaid category driving growth in subscriber acquisition. Increased usage of value-added services e.g. Data and content to add to the growth in voice segment. Increased multimedia convergence would lead to cross-selling of service offerings. Going forward, we foresee ARPU dilution which will directly affect the margins of telecom players.

Investment Theme for Real Estate

The GCC real estate sector grew at unprecedented levels over the past few years fuelled by high oil prices and abundant levels of liquidity in the region. Construction projects planned or under development in GCC have crossed the US$ 1 trillion mark. Recent regulations allowing freehold ownership for foreigners in certain areas or projects across GCC have also opened up the market. Strong GCC economies contributed to the increase in employment opportunities and the huge inflow of expatriates in the region which rendered the market short of housing space, and led to spiraling prices and rents.

Within the residential segment, activity has been concentrated in high end residential apartments, while there has been a clear shortage of housing for lower income groups all across GCC. A correction in prices and rents for high end residential developments is expected in Dubai, Kuwait, and Bahrain in the medium term. Investors' interest has been recently diverted to the commercial segment which is currently experiencing a shortage of high quality office space all across GCC. Office rentals have more than doubled increasing the yields on commercial property to range between 10-12% compared to a yield of 8-10% for the residential segment. Higher purchasing power in the region has sparked activity in the retail segment with an expected growth of 150% in the current retail space in GCC with the majority of that increase expected in the UAE and Kuwait followed closely by Qatar. We believe that the GCC real estate sector still holds huge potential especially in untapped segments such as commercial and tourism.

Going forward, an anticipated diversion of investments is expected from current favored destinations like Dubai and Bahrain to Abu Dhabi, Qatar and Oman. Allocation to segments like logistics, hotels and industrial segments are expected to increase. Government initiatives to improve the landscape in places such as Doha and Abu Dhabi could lead to forced housing shifts, worsening the supply crunch in this segment. High quality office space continues to be in short supply, especially in Dubai, Qatar and Saudi Arabia. Shortage of hotels is acute in most of the GCC, more so in Dubai, Doha, Kuwait and Muscat. Industrial property is set to bring huge returns in the next few years, with the unwavering focus on manufacturing in countries such as Qatar and Saudi Arabia and places such as Abu Dhabi and Sharjah.

With the diversity in investments and maturing of markets, it is expected that investments in the future would have lower risk and consequently lower returns.  And with the introduction of REIT as an investment tool in GCC, we are expecting to witness increased activity in the market as small investors would be allowed to access the market that was previously available only with significant capital outlays.

Investment Theme for Pharmaceutical Sector

The growth of the pharmaceutical market in the GCC market in coming years will be driven by rising purchasing power, record per capita GDP and the expansion of the private healthcare sector. The private sector has been expanding in recent years due to the government no longer providing free medical assistance to expatriates in some GCC nations. A number of recent reforms and simplifications to regulations, such as those allowing private insurers to recommend particular therapies to clients, should also drive growth in the market.

The steady increase in lifestyle-related diseases, commonly reported in Western countries,  is also contributing to the growth of the sector. As the GCC countries adopt a more mature epidemiological profile, sales of high-value treatments for diseases such as cancer and heart disease should continue to expand steadily. Drug majors such as GSK, Wyeth, Novartis, Abbott Laboratories and Johnson & Johnson have expanded their operations in the region. Large-scale development projects such as the DubaiHealthcareCity and DuBiotech are expected to bring in substantial investment from foreign multinationals and increase the technological capabilities of the sector. Local manufacturing industry expansion is another key factor in the market’s development.

The development of regional harmonization will be an another important factor in market growth. The GCC countries plans to implement a unified pricing policy and drug regulation system. Such harmonization should establish stronger regional trade links, and bring regulations closer in line with international norms, leading to improved trade links with the West and boosting market development. The planned FTA with the US will also require stringent adherence to intellectual property regime, possibly including the imposition of a five-year data-exclusivity period to protect undisclosed information.

Stock Market Outlook:

It’s interesting to see how easily does the questions asked by investor community changes. Earlier in the year,  it was: “Have we reached the peak?”, and now it is “Are we touching the bottom?”. Although difficult to answer this in the currently sentiment driven market, where all the good news is discounted and the bad news create more flutter in the markets, we can say that we are nearing the bottom where valuations are looking fairly or attractively valued at current levels. We expect institutional investors to start taking positions in the market taking into account the valuation prevailing in selecting stocks. for example, the P/E of Saudi Arabia which at one point reached mid-40s is now trading at more stable mid teens, comparable with other emerging markets.

Table 2 : Trading Indicators in GCC Stock Markets

Source: Global Research

While economic fundaments continue to remain positive in the region, the market participants seem worried about growing concerns on increased volatility in stock prices. This has led to a bearish mindset in many of the regional stock markets based on expected slowdown in corporate earnings this year and a possible liquidity squeeze. Liquidity is only one of the factors, which has been driving the markets, but important thing is the overall fundamentals and structural changes in the economy which is keeping this liquidity in the economy and is going to be the key factor in driving the stock markets further from the current levels. Oil price seems to be stabilizing above US$50, putting the GCC economies on a sound footing. Governments have also become reforms oriented, which augurs well for the longer term overall growth of the economies.

Table 3: Corporate Earnings Growth in GCC

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Source: Global Research

The strong interest in the primary markets is likely to stay as investors continue to scout for quality issues. Liquidity is not going to be major problem as long as the oil prices and investment spending remains at high levels. However, it is the re-entry of retail investors, those very individuals who burnt their hands in the market correction, which would be interesting to watch.

Going forward, we believe that the robust state of the economy has created enough wealth to offset any medium term bearish trend in the markets. Apart from these fundamental factors, we expect the market to get a much-needed leg-up from a more stable geopolitical situation. GCC Union, Intra-regional investments and common investment projects etc. are providing and will provide more trading and investment opportunities. Also, with the capital expansions and new issues lined up in 2007, the free float is likely to increase in the market making the markets more liquid and deep.

We reiterate the fact that the fundamentals of GCC economies and particularly that of the corporates remain strong. The volatility in the markets are the part and parcel of any emerging capital market growth story but it is the ability to absorb these shocks which will determine the strength of the respective markets. The financial sector is awash with funds and corporates are taking advantage of easy availability of capital to fund expansion, both regionally as well as internationally. The investment funds and private equity players are getting strong support from the investors in terms of increased investment in both Islamic as well as conventional funds to fund the deal flows. Apart from looking at the interesting opportunities in the region, the investment companies/corporates are looking at other promising markets outside the MENA region to diversify their investment base/revenues. This is crucial as it will hedge their risk of operating in a single market.

In summary, we expect regional markets to show stable growth next year, and we project Kuwait, Saudi Arabia and UAE to show more than 25% growth in 2007. We expect that this will be in-line with the earnings growth that we expect from these market in 2007. Buoyed by the positive sentiment driven from the above markets, we expect Oman, Qatar and Bahrain to register moderate growth rates in the range of 17%-23% next year. The forward P/E are expected to be in the range of 10x-12x for Kuwait and Oman while for UAE and KSA it will be in the range of 14x-16x. The recent fall in the market has given opportunity to the institutional as well as retail investors to do “bottom-fishing” in the markets and we believe that markets will turn corner in 2007.