NCB Capital continues to believe that the Saudi telecom sector has strong growth potential with profit growth largely driven by value-added services (namely broadband), costs efficiencies, and international operations for Saudi Telecom Co. (STC).

Farouk Miah, head of equity research at NCB Capital, said: “We believe that the corporate segment in general and the ICT segment in particular (e.g. data security, cloud computing) is a source of continued growth for the sector with it a key target for Mobily.”

In its new report, NCB Capital remained Overweight on STC, with a PT of SR 51.8 (upside of 30 percent), and Mobily with a PT of SR 81.9 (upside of 20 percent) and Neutral on Zain KSA, with a PT of SR 11.3 (downside of 5 percent). “Focus on the broadband market for all three players remains key, with expansion in network capabilities being sought as a point of differentiation. Valuations remain attractive with the sector trading at 8.0x 2013E P/E,” added Miah. “Although the upside on STC is greater, Mobily remains our preferred stock, given its strong fundamentals, excellent execution record and good dividend visibility.”

STC has benefited from improved local operations and higher than expected other income, whilst Mobily has benefited from margin expansion (in line with expectations), led by improved operational efficiencies. For Zain, NCB Capital reduced its PT by 30 percent, due to subdued revenue growth, leading to margin growth being held back. This is despite factoring in the balance sheet restructuring, completed in July 2012.

According to the report, the sector’s main concern is price-led competition, with voice ARPUs under significant pressure. NCB Capital believes this price-led competition is now also moving into the data segment with operators increasingly launching new offers and different packages to gain subscribers. The commencement of operations from Mobile Virtual Network Operators (MVNO) would be another source of pressure for existing operators.

NCB Capital expects total revenues for the three stocks under coverage to increase by 8 percent YoY to SR 46 billion in H2, 2012, driven by a higher broadband subscriber base and growth in Saudi Arabia’s corporate segment. Seasonal factors (Ramadan and Haj) take place in H2 and should aid sequential growth in the sector. Intense competition in the international call business notwithstanding, margins should be supported by the high-margin data segment and OpEx efficiencies. On the other hand, increased sales coming from handset items and the corporate segment may pressure margins for Mobily. Margin growth, coupled with higher revenues, is likely to result in EBITDA rising by 9 percent YoY to SR 16 billion in H2, and net income increasing 26 percent YoY to SR 7.4 billion. For Zain, on the one hand its financial outlook has improved post its balance sheet restructuring due to lower interest payments. However, it remains significantly behind STC and Mobily in terms of market share and available products, and the top-line performance has been muted in the past several quarters, holding back the pace of its recovery.

Stabilizing margins remains a key focus for all operators in the sector. STC’s focus in 2012 is on stabilizing margins, which for several years has been contracting due to higher competition, expenditure and investment. Mobily, on the other hand, continues to focus on increasing its operational leverage and spread costs over a wider user base to support margins. Zain’s margin focus is on increasing its EBITDA margin given the high depreciation and amortization which is holding back its move towards net profitability. Separately, interconnection charges for STC and Mobily continued to fall in Q2, 2012, owing to reduced competition in the international call segment. NCB Capital expects this trend to continue in H2, and support margins.

Broadband (mainly wireless - constituting 85 percent of all broadband users, remains the key source of growth for the telecom operators in the short to medium term. CITC’s latest update on the data segment indicates that broadband penetration rate increased to 41.4 percent of the population in Q1, 2012 (11.95 million users) from 39.6 percent (11.34 million users) in 2011. NCB Capital expects this segment to keep expanding in the coming years and support top-line growth in the sector, as the introduction of mid- and low-end smartphones and technology upgrades enable the use of richer media content, as well enabling lower income consumers access to data products. Mobily’s data segment accounted for 25 percent of its total revenues in Q2, 2012 compared to 22 percent in 2011, while STC reported an 88 percent YoY increase in KSA mobile broadband subscribers in Q2.

All operators are focusing on investing to enhance their network capacity and reach. All have identified this as a source of differentiation, particularly given the broadband segment is seen as the key growth market, thus needing constantly increasing technological requirements to support the needs of consumers. Given STC has the greatest scale, NCB Capital believes it is the best positioned to compete on the basis of network capacity and reach.

Although the Turkish and Malaysian businesses are performing relatively well, the other major international businesses under STC have had various struggles in the past six to twelve months. NCB Capital believes the potential for the international business remains significant, however continued investments and focus on synergies will need to be made in order to extract the maximum value for STC. NCB Capital believes there is a possibility STC may use its growing cash reserves to increase its stakes in its international business in order to have more control over day-to-day operations.

Over the past five years, “other income” for STC has varied significantly from contributing a positive 19 percent of EBIT to equating a negative 12 percent of EBIT.

With the voice segment mature and competition in data increasing, Mobily has highlighted the corporate segment as a key source of potential growth. As the ex-monopoly operator in Saudi Arabia, NCB Capital believes STC is the dominant player in the enterprise/corporate segment. With such a major hold in the market, largely due to lack of choice until now, NCB Capital believes Mobily is well positioned to offer corporate clients an alternative partner. To strengthen its service capabilities, Mobily recently signed a SR 1 billion strategic deal with IBM which will enable Mobily to offer ICT solutions to corporate clients such as data security and cloud computing. With its strong execution track record, NCB Capital believes Mobily will perform strongly in this segment, as well as developing new business in ICT.

Although NCB Capital believes the financial outlook for Zain KSA has improved after its balance sheet restructuring (mainly through lower financing charges), its operational outlook has deteriorated, as seen in the poor revenue growth figures in the past six months. Thus, despite the balance sheet restructuring, Zain faces a difficult road toward recording net profits. Additionally, high amortization costs from the SR 23 billion paid for its license fee, coupled with ongoing aggressive competition from STC and Mobily who dominate the market, will limit growth prospects for Zain and firmly keep it as the number three operator in the Saudi market.

Ratings:

STC

NCB Capital remains Overweight on STC and raises its PT by 1 percent to SR 51.8. Bottom-line gains in international operations and continued growth in the Saudi Arabian market are key drivers. Price competition at home and FX exposure are key risks. Use of its growing cash pile; either by increasing its dividend or increasing its stake in its international businesses is a key catalyst.

Mobily

NCB Capital remains Overweight on Mobily, with PT increasing by 4 percent to SR 81.9. It believes the company is well positioned to benefit from KSA’s broadband growth; the tie-up with IBM is also likely to enhance its ability to compete in the corporate segment and enhance its ICT potential. The 7 percent dividend yield expected in 2013 is another key strength and a downside support for the stock.

Zain KSA

NCB Capital remains Neutral on Zain KSA, with PT falling by 30 percent to SR 11.3. With the capital restructuring complete, it will lead to lower financing costs and higher capex, however we expect it to be net profitable only by 2016. Higher turnover is the key to margin growth. NCB Capital lowers its revenue/gross profit estimates given weaker than expected results.