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Saudi bank valuations stretched as kingdom awaits status upgrade

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Saudi bank valuations stretched as kingdom awaits status upgrade

Saudi Arabia's heavyweight bank stocks, along with the broader banking sector, have surged this year as investors bet that stock market index provider MSCI will upgrade the kingdom to emerging market status, stretching valuations as earnings fail to keep pace with share price gains.

Historically hostile to direct foreign ownership of Saudi stocks, the government has taken huge steps to attract overseas funds in recent years, a process accelerated as Crown Prince Mohammed bin Salman cemented his control over the world's largest oil exporter and launched wide-ranging reforms aimed weaning the kingdom off its hydrocarbon dependence.

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Improvements to stock trading mechanisms and fewer restrictions on foreign investors led MSCI to announce in January that it may grant Saudi Arabia emerging market status. Should Saudi be accepted in its June review, MSCI estimates that up to $40 billion of funds will flow into Saudi stocks.

MSCI has said the Saudi decision will not take into consideration the likely $100 billion listing of Saudi Aramco, which some fund managers have reportedly said might be too big for the local market to absorb easily. The government hopes to sell 5% of the state oil firm by the end of the year.

In March, rival FTSE-Russell said it would add Saudi to its own EM benchmark in 2019, giving it a weighting of 2.7%.

Large bank sector

Five of the 10 largest listed Saudi companies by market value are banks and so the sector should be a chief beneficiary. This quintet — National Commercial Bank, Al Rajhi Banking & Investment Corp., Samba Financial Group, Riyad Bank and Saudi British Bank — have a combined capitalization of 415.4 billion riyals, or roughly $110.8 billion, as of May 27, about 22% of the total market.

NCB and Al Rajhi dominate and have outperformed the broader banking index's 21.0% gain this year, with NCB's shares up 26.0% and Al Rajhi rising 28.6% between Jan. 1 and May 30, despite relatively lackluster year-over-year first-quarter profit growth of 10.5% and 7.3%, respectively.

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"Saudi bank shares have made gains mainly on expectations of passive inflows should MSCI follow FTSE in upgrading the kingdom," said Shabbir Malik, a bank analyst at investment bank EFG Hermes.

Rising net interest margins boosted banks' profits as U.S. interest rate hikes — replicated in Saudi due to the riyal's dollar peg — helped lenders offset slowing loan growth. Saudis widely opt to keep their deposits in zero-interest accounts due to religious concerns, meaning banks' funding costs are often negligible.

"On most metrics, Saudi banks are trailing their peers but on valuations they are commanding a premium," said Asim Bukhtiar, head of research at investment manager Saudi Fransi Capital.

Markets in Qatar and the United Arab Emirates rallied ahead of joining MSCI's EM index but slumped immediately afterwards. But it is not a given that Saudi would endure a similar slide.

"I don't see a particular reason for a sharp pull-out of money after the MSCI decision. Some fast money did come in and that will withdraw, but the market is not going to do what some other emerging markets have done and fall massively — Saudi's reform agenda is intact," said Ashish Marwah, chief investment officer of ADS Investment Solutions, the asset management division of Abu Dhabi's ADS Securities.

"There is a decent amount of allocation-driven money coming into Saudi and that will continue, especially if Saudi is upgraded," he said.

Resilient banks

Real GDP fell 0.7% in 2017, according to the International Monetary Fund, which predicts Saudi's economic growth will expand 1.7% in 2018 and has lauded the kingdom's reform program to reduce energy subsidies, expand and diversify the private sector and enlarge the tax base.

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"Despite Saudi's economic downturn over the last two to three years, banks' credit costs have increased very little, proving their resilience," said Marwah.

He said the price-to-book ratios of some banks are high and slightly ahead of return on equity, but that RoE should increase as money starts flowing back into the economy and demand for credit starts to rise again.

"In terms of valuations, if you take a static view banks might seem expensive, but you have to factor in that the economy has begun a decent upturn," he said.

NCB and Al Rajhi are trading at trailing price-to-earnings ratios of 13.6 and 14.5 respectively, while price-to-book ratios are also elevated with NCB at 2.4 and Al Rajhi at 2.7. The combined bank sector PE is 12.4 and price-to-book is 1.7. That compares with a price-to-book of 1.8 for large-cap Middle Eastern banks excluding Saudi.

"Compared to other Gulf markets, Saudi bank valuations are on the high side," said EFG's Malik. "UAE banks are much cheaper, for example, but that market lacks catalysts and foreign investors already have significant positions. Saudi banks have more potential, even if valuations are less attractive, and there should be buying support for the rest of the year."

Saudi Fransi's Bukhtiar is less convinced, noting that corporate bankers to whom he has spoken do not expect an imminent increase in lending activity.

"The backdrop of continued austerity measures, tighter consumer spending and slower earnings growth versus peers in other emerging markets point to a weak Saudi market performance in the second half of 2018," he said.

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