Saudi Arabia's waiting game

The IPO market appears to be picking up, yet overall investment banking activity in the kingdom remains subdued, especially for international players. Despite that, the market’s potential means most will stick around. Published in Euromoney, April 2014

Investors in the Saudi stock market are enjoying a boom at the moment. In mid-March the Tadawul All Share Index (Tasi) was trading at around 9,300 points, more than 2,300 points up on the same time a year ago and its highest level since July 2008.

High valuations make it a good time to issue shares and, after several years of disappointing deal flow on the equity markets, many company owners are doing just that. Perhaps the most important to emerge so far this year has been the initial public offering of National Commercial Bank (NCB), the country’s largest bank. The government is hoping to sell 15% of the shares to the public before the end of the year.

That deal has been expected for many years and should help to add more depth to the stock market and greater transparency to the banking sector. But NCB is far from alone. Numerous other firms are being linked to flotations this year, ranging from home improvement retailer Saudi Company for Tools & Hardware to hospital operator Sulaiman Al Habib Medical Group and Saudia Cargo Company, a subsidiary of the national airline.

It makes for quite a contrast to 2013, when just five companies made the jump on to the Tadawul, raising SR1.9 billion ($507 million) in the process. The year before there were seven IPOs, which raised a total of SR5.3 billion. The expected surge in new issues this year is a welcome boost for investment banks.

"Last year was bad for the equity capital markets, but the debt capital markets saw some improvement," says Yasir al Rumayyan, chief executive of Saudi Fransi Capital. "This year you’ll have both doing well. In addition to some M&A transactions, the regulator is encouraging more deals and valuations are much better, so I think you will see a couple of IPOs in the next few months and then one or two more every quarter for the rest of the year. The listing process is getting better and smoother."

But no one is getting too excited just yet. For one thing, a lot of banks are competing for the mandates. The Capital Market Authority (CMA), which regulates the kingdom’s investment banking sector, currently licenses around 90 companies, ranging from subsidiaries of local commercial banks to standalone local institutions, regional investment banks and the arms of large global banks.

"For investment banks it’s a tough market," says John Sfakianakis, chief investment strategist of Masic, a privately owned investment group. "The IPOs come once in a blue moon, and that can’t sustain all these investment banks. You have a lot of competition, so it’s not as easy a market as some people might think."

Of course not all the deals that are planned will go ahead. Astra Food cancelled its IPO in November last year after telling the CMA it was unable to confirm "the estimates and expectations of the company’s future especially in the coming 12 to 18 months". So far this year the only company to list has been supermarket chain Saudi Marketing Company, which was advised by the local Falcom Financial Services.

Local banks dominate the financial advisory work on IPOs, with Saudi Fransi Capital doing particularly well in recent years. Over the course of 2012 and 2013 it had four advisory mandates, twice as many as Samba Capital and Riyad Capital. Six other banks all had just one apiece, with Morgan Stanley the only non-Saudi bank among them. The dominance of local banks is matched in terms of lead managers and underwriters too.

Although the IPO market is growing, albeit from a limited base, the situation for rights issues is less promising. In 2013, Middle East Specialized Cables Company was the only company to launch a rights issue, selling SR200 million-worth of shares, with GIB Capital, a subsidiary of Bahrain’s Gulf International Bank, acting as financial adviser, lead manager and underwriter.

So far this year only one company looks certain to follow. Alahlia Insurance Company is planning a SR220 million issue, advised by Saudi Hollandi Capital. There isn’t much sign of many more. The board of Tabuk Agriculture Development Company approved plans for a SR300 million rights issue in July last year, but the CMA says the company has yet to formally submit its application.

Khalid al Muammar, CEO of Saudi Hollandi Capital, says part of the problem is that regulations around rights issues were altered last year. However, he predicts activity will now pick up. "I think there will be more rights issues this year," he says. "Last year there was just one, partly because the rules were changed so it took time for companies to adjust. But more insurance companies need to boost their capital."

All this adds up to slim pickings on the equity markets for local investment banks, but at least they more or less have this area of the market to themselves, as international banks are rarely willing to compete with them on fees. In terms of equity issues, global players are better placed to advise on cross-border, dual-market listings, but there is so much liquidity available in the Saudi market that there is little need for companies to look abroad.

"We don’t focus on the IPO market at all," says Abdulaziz Hassan, CEO of Credit Suisse Saudi Arabia. "We can’t compete with the local banks in terms of fees. We focus on areas where we can add value in terms of particular expertise that is not available in the local market. And we can also come in strongly with cross-border transactions when a Saudi company wants to acquire businesses either in the region or internationally."

Other international bankers say they are adopting a similar strategy. "International banks will always struggle to be competitive for IPOs in Saudi Arabia compared with what the local banks are prepared to do," says an executive at another European bank in Riyadh. "For very large IPOs and those involving listing on more than one exchange, the international banks would have a value proposition. But I think for a plain-vanilla IPO on the Tadawul without a great deal of input being required in terms of valuation or tapping specific investor pools, it is likely that the international bank would not be very competitive. The same goes for rights issues."

Of course, equity markets are not just about new share issues for investment banks. As the growth of the Tasi index highlights, the demand among investors to buy existing shares looks strong, and that offers opportunities in terms of brokerage and related asset management services. After the stock market crash in 2008 investors fled, but they are starting to return. With interest rates low there is less to be gained from the money markets and it is questionable how much local real estate and land prices can keep on rising, so the stock market looks increasingly attractive to investors.

"Brokerage is the most lucrative part of the market," says Al Rumayyan. "It is the biggest contributor to profits. However it is volatile. The most stable revenue stream is asset management."

International banks are able to get involved in this area too. "For the most part we are serving our customers in Asia, Europe and the Americas and giving them access to the Saudi market," says Jamal al Kishi, chief country officer for Deutsche Bank. "The interest in Saudi Arabia has improved significantly in the wake of the situation in other emerging markets in recent months, simply because of the perceived stability of Saudi Arabia, its sound macroeconomic fundamentals and its currency."

That situation is likely to accelerate if the authorities ever open up the market to greater international participation, something that has been on the cards for many years. For now, foreign investors account for little more than 1% of trades by value according to data from the Tadawul. Local banks would get an even greater boost were more Saudis to use them to buy and sell shares rather than do so much trading themselves. In January and February more than 88% of the trades by value were carried out by individuals, according to the Tadawul.

That helps to explain the muted interest in things like mutual funds. "Our mutual funds are performing well and are outperforming the benchmarks," says Saudi Hollandi Capital’s Al Muammar. "But the market for mutual funds is not yet growing as it should. After the falls of 2006 and 2008 investors moved their funds into other asset classes such as real estate. Some of that is now coming back to equities, and we should, therefore, expect to see a growth in assets under management."

If stock markets aren’t yet providing enough work for the country’s investment banks, the debt capital markets, including Islamic bonds (sukuk), are at least showing some promising signs of life. According to data from Thomson Reuters, underwriting fees for DCM in Saudi Arabia rose from $5.8 million in 2012 to $42.3 million last year.

Again, given the number of banks in the market, relatively little has to be shared out between a lot of competitors, but at least there are some grounds for optimism, particularly as the range of companies issuing paper is increasing.

"The sukuk market is very much alive and very active," says Walid Khoury, CEO of HSBC Saudi Arabia. "Interest rates are low and they are going to be low for the foreseeable future, so it’s another avenue that companies are exploring. The large companies are always on the lookout for issuing sukuk, but you also have smaller names that are looking to diversify their sources of funding.

"Among investors there is a lot of appetite given the liquidity that needs to find a home. On the domestic front you always find people hungry for sukuk, and on the international front there’s a lot of appetite for Saudi names."

There has also been some interest among Saudi companies in issuing sukuk in dollars, which offers a way into the market for the big global banks. More than $12 billion-worth of international sukuk has been issued in Saudi Arabia since 2003, according to Saudi Hollandi Capital.

"There is huge demand for sukuk, and there is not a lot available," says Hassan at Credit Suisse. "Whenever an issue comes out it is always oversubscribed. Last year most of the local banks issued some bonds and sukuk. I think it will continue. Even second-tier companies are now looking for issuance as part of their financing. We’re not focusing on Saudi riyal-denominated issuance, but when it comes to non-riyal issuance we’re always there. More issuers are looking at foreign-currency issuance. It’s part of their diversification to have more than one currency on their books."

If there is a problem in the local sukuk market for banks, it is the lack of a secondary market. In Saudi Arabia investors tend to buy and hold sukuk, and banks are as guilty of that as any group. For issuers that isn’t a problem because they get the money they want, but it does mean that another line of potential business for investment banks – the trading of sukuk – is effectively closed off.

"The sukuk market is doing well, but it needs further development," says a corporate finance executive at a local bank in Riyadh. "You can issue sukuk and there’s a good market to buy them at competitive rates, but there’s no liquidity in the market. People buy them and hold on to them, so some of the downstream market development in DCM that we’d like to see hasn’t developed."

Even so, the sukuk market looks to be a bright spot for investment banks in Saudi Arabia. The same cannot be said about M&A activity however, which is rather moribund. As one local finance industry professional says: "Companies don’t want to merge and they don’t want to acquire."

One deal stands out in the current market. In April 2013 two of the country’s largest petrochemicals firms, Saudi International Petrochemical Company (Sipchem) and Sahara Petrochemical Company, signed a memorandum of understanding for what they described as a "merger of equals". In reality it looks more like a takeover, with Sipchem handing over 300 million shares and Sahara becoming its subsidiary in return. The deal has yet to be finalized. Sipchem has appointed HSBC Saudi Arabia as its financial adviser, while Sahara is using Morgan Stanley Saudi Arabia.

Such large deals are clearly an area where the international banks can come into their own in the Saudi market. Most of them have fairly limited teams on the ground, with perhaps a couple of dozen permanent staff. They don’t have the same reach in the market as local banks and their fees are relatively high, but for complex deals like this they have something to offer.

Unfortunately for them, such deals are few and far between. Some bankers claim they are seeing interest from international investors wanting to tap into the Saudi economy, from around the Gulf and from companies in Asia, Europe and north America. Sectors that are attracting the most interest include retail, hospitality and healthcare. But when asked for the particulars of any deals they tend to go quiet. In a similar way, bankers say clients in Saudi Arabia are more willing to listen to M&A suggestions these days, including international deals, in a way that they wouldn’t have just a few years ago, yet the number of deals that move from talk to action remains small.

In a way this is surprising. For at least the last decade bankers had been expecting a rise in M&A activity, particularly among large family-owned conglomerates, but it simply hasn’t happened.

"There is not a lot going on in the M&A market," says the corporate finance executive. "The theory was there would be a lot of M&A activity because the family-owned conglomerates are not business-rational. They’re successful but they’re in different areas and they’re difficult to manage and it might make more sense to split them up. We’ve been forecasting this for a long time. There’s been a little activity but not nearly as much as some people expected."

The limited opportunities in the market might force some banks to change their approach, according to a senior figure in the industry. In particular, smaller institutions might have to start focusing more on particular niches.

"I don’t think that the investment banks should just be divided between domestic and international. In both groups there are some that are doing well and others that are doing less well," says Khoury. "But I think the future is towards specialization. You’re going to have a few firms that are active in different lines of business, with more investment firms specializing in, say, asset management or other activities. The larger banks will continue to do everything, but I think the smaller firms will specialize more."

The limited opportunities in the market are less of a problem for the investment banking subsidiaries of local banks. The healthy state of the economy means that retail banking profit levels are strong and the banks are also well capitalized.

"Banks posted record profits in 2013," says Fahad Alturki, head of research at Jadwa Investment. "Deposits are growing, which is supporting banks’ liquidity. The loan-to-deposit ratio is just below 80%, which is a very strong position compared with other GCC markets. There is no reliance on foreign lending. I think they are in a very good position to continue supporting private-sector growth through lending."

For international banks the nature of the market is perhaps more troubling, but they may feel they have little option but to remain, if only so that they are well placed when activity does pick up.

"It’s an important market to be based in," says Sfakianakis. "If you’re not in Saudi today then you’ve got a major problem because it will continue to do exceptionally well. It’s the largest economy in the Middle East. You want to be here today and to participate in the story of how this economy grows. You don’t want to be completely outside this market. You don’t want to come in 10 years’ time and say: ‘I’m here!’ You want to maintain a profile in the country. It’s a long-term investment for the banks."

Just how long they might have to wait for that investment to pay off is anyone’s guess.

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