Fundamental profitability comes full circle

The year 2012 began with multiple headwinds for the Gulf Cooperation Council (GCC) markets, which raised concerns over provisions pertaining to the financial sector, corporate growth and profitability. The equity markets remained under the dark shadow of geopolitical situations which were persistent in the Middle East, especially Iran and the on going unrest across other countries.

Uncertain times
From the figures pre and post the financial crisis, we can see that earning prospects have been constantly improving since 2008. A pool of 585 listed entities across the seven GCC markets demonstrates that earnings in 2007 – which rose to $62.95bn and fell drastically to reach a mere $34.68bn in 2008 – went on to remain stagnant in 2009.

However, a series of constructive measures from various governments provided comfort to corporate companies, in a bid to encourage trade and start various projects as many marked better profitability from 2010. In the past three years GCC has added $17.6bn to its bottom line, where its total earnings reached $52.15bn by the end of September 2012.

On the contrary, investors continued to receive fragile news on the global economic development, which was specifically sourced through Europe and the US. The fiscal situation in Greece and the election in the US, together with the reduction of Asia’s economic powerhouses in China and Japan, and unending political unrest in a few MENA countries, forced investors to refrain from building new positions. Sustainability in earnings remains a primary cause among investors, because of which GCC markets witnessed quick erosion in their market cap, despite better than expected
earnings announcements.

By exploring specific data, it is revealed that the overall profitability was reduced by the mid and small cap companies, as heavyweights stocks including the ‘one billion club’ improved its profitability on a year-on-year basis. In fact, the club had a superior performance as its bottom line inflated by 4.7 percent when compared to figures in 2007, yet with the deteriorating market, sentiments and investors were cautious to approach new positions in markets.

Total market capitalisation was near $1.06trn by 2007, and profitability expectations were on the rise. UAE’s bold policy of owning properties in the emirate by any individual provided a new impetus to the real estate industry. Unending constructions sites in the GCC – especially in Dubai, which had excessive work in relation to various infrastructure projects – steered all industries to grow at an exceptional pace.

When the financial crisis erupted in 2008, a global pessimism ensued, which weighed down heavily on GCC stocks

It was a boom time for the industrial and construction sector, In addition, an ease of lending from financing institutions and higher oil prices, were further driving GCC economies to grow at an extra ordinary rate.

Driven profitability
When the financial crisis erupted in 2008, a global pessimism ensued, which weighed down heavily on GCC stocks as well. The GCC market lost 48 percent of its value alone in 2008, while earnings went down by 45 percent. The freefalling markets also severely affected the club. Despite a restricted drop of 31 percent in its earnings, the club lost around 49 percent of its value on the floor.

There was no respite for any stocks, as investors pressed panic buttons across the board. Barring a few, almost all GCC stocks reported a drop in their FY 2008 earnings, as of which many stocks were seen trading at a price far below their book value.

After the financial crisis, many global corporations adopted a series of strategies to curb losses and costs. Mergers, acquisitions, restructurings to mitigate negative effects of borrowing and declining provisions provided some stability to markets and earnings. Moreover, companies with a strong and solid core-business oriented model – mostly large caps – laid down a growing path for the overall GCC market. By 2010, total profit sparked to reach $41.61bn, a jump of $9.45bn over the previous year. The club shared around 85 percent of this new profit, by contributing $7.99bn to it.

The club further added another $9.37bn to a total of $10.19bn in 2011, and maintained its earnings contribution above 90 percent in total GCC profit. However, in 2012 – amid various constructive steps taken by other large, mid and small cap stocks – overall contribution of the club slipped to 94.5 percent by
September 2012.

In the club, 27 stocks witnessed a growth in market caps, while 88 entities reported a drop from their 2007 level or listing date, prior to 2012. Saying so, the Price to Earnings (P/Ex) multiple, which stood at 17.72 in 2010, came under pressure to reach the current level of 14.27, figuring out a pressure on market prices despite improving earnings. The lowering of the P/Ex multiple clearly indicates a lack of confidence among investors, and poses uncertainty over future earnings growth – which is well supported by the overall GCC TTM earnings, where in September 2012 they grew by a mere 0.5 percent over FY 2011.

Wealth creators or destroyers 
In the past four years, most of the GCC stocks have been trapped, especially those which are burdened with huge debt or investments on their balance sheet. Surprisingly, the top 10 stocks of the GCC – which are running on a prudent business model and carry a strong balance sheet – paint a different story.

For instance, SABIC, the biggest GCC stock in terms of market cap, witnessed an erosion of 45 percent of its market value from 2007. However, its net profit reported a negative growth of only 11 percent over the similar period. In 2012 SABIC’s rising cost of sales cost dearly as its net profit margin shrank to 13 percent from 16.5 percent a year ago. Similarly, Al Rajhi Bank – whose net profit grew by 22 percent in the similar period – saw an erosion of 44 percent in
its market value.

Among the top 10, only Qatar National Bank, Industries Qatar and Etihaad Etisalat managed to excel in difficult times. Qatar National Bank almost quadrupled its net profit from 2007 and the impact is clearly visible, as its market capitalisation jumped to $24.97bn from $10.89bn in 2007. On the valuation part, with a correction wave spread across the globe, overall P/Ex of Club-10 slipped and reached 12, way down from 19 in 2007.

In general, all corporate houses are looking to expand their business in view of limited opportunities in the GCC, especially banks. Many of the GCC banks have concluded various deals of acquisitions and mergers across Europe and Asia Pacific to infuse momentum in their overall revenues. GCC economies are attempting to diversify their economic parameters partly away from oil.

Saudi Arabia, UAE and Qatar have taken a lead role in this. Billion-dollar projects across the various sectors, including healthcare, insurance, infrastructure and city-wide mega projects are empowering economies to sustain growth momentum, despite a vulnerability in oil prices.

With inflation becoming reduced and taking on encouraging financial policies by GCC governments – which are key sources for the bullish economic growth – the system cannot become isolated from global economic and demand growth, which may hamper future expectations and market sentiments.

Billion-dollar projects across the various sectors, including healthcare, insurance, infrastructure and city-wide mega projects are empowering economies to sustain growth momentum, despite a vulnerability in oil prices

In recent years, UAE, Qatar, Saudi Arabia and even Kuwait have opened their doors to foreign investments. Considering attractive valuations of many businesses, such a step is bound to enhance fund flows towards these new emerging markets. The time has come to adopt more liberal policies and become competitive, which is the only way to increase confidence among global investors, and attract them for long-term foreign direct investment flows, instead of just portfolios flows.

Despite new elections held last December, Kuwait’s political strife remains a major concern, causing delays in the implementation of economic policy and overall development of projects. On the market side – despite lowering the interest rate by 25 bps – the market remained dismayed as the investors’ community believed that any such step may not conclude anything positive for overall profitability, considering large single-party and industry
credit concentrations.

Also, the issue of weak corporate governance continues to play a part, which further restricted any enthusiasm in the market. Towards the end, it is important to restart the reform process, improve governance standards, overhaul social and physical infrastructure, and remove other bottlenecks to make Kuwait an attractive place to do business.