KMEFIC Research Industry Analysis Report

GCC Telecommunications Sector Expected rate of return on equity in GCC

June 2012

KMEFIC Research Department ... Kuwait and Middle East Financial Investment Company K.S.C.C

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KMEFIC Research Industry Analysis Report

Table of Contents
OVERVIEW OF MOBILE TELECOMMUNICATIONS TECHNOLOGY ..................................................................... 3 THE TECHNO-TALK................................................................................................................................................................................... 3 MORE THAN JUST A HELLO ............................................................................................................................................................. 4 REPORT FOCUS......................................................................................................................................................................... 7 THE OWNERSHIP MAP OF GCC TELECOMS ............................................................................................................... 7 GOVERNMENTS.WHY? AND WHY NOT? .......................................................................................................................................... 7 SALES AND BUSINESS RISKS ........................................................................................................................................ 10 CAN WE TALK BUSINESS?? ................................................................................................................................................................ 10 TELECOMMUNICATION STOCKS ................................................................................................................................... 11 PRICE PERFORMANCE .......................................................................................................................................................................... 11 PRICE MULTIPLES .................................................................................................................................................................................. 12

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Overview of Mobile Telecommunications Technology

The Techno-Talk
The telecommunications industry moves at a lightning pace, and the industry is filled with technical language. One set of jargon that is constantly thrown around in adverts involves numbers followed by the letter G. Yet fundamentally, G simply stands for generation. More specifically, each G refers to a generation of mobile technology that is installed in phones, on cellular networks, and in connected devices (anything that is not a cell phone but has a cellular connection, such as an iPad 3G). New generations typically bring new base technologies and more network capacity; however, these technologies usually entail consumers to purchase new phones and network operators to make expensive upgrades. The International Telecommunications Union (ITU), an agency of the United Nations, is the body that sets telecommunications standards for the world, defines each generation, and establishes which technologies meet the requirements of a particular generation. The ITU coined the terms 3G and 4G and while it tried to issue requirements to call a network 4G, they were ignored by carriers and eventually the ITU backed down. This will be discussed later on as we begin our discussion of the very first generation of mobile and cellular network technologies. The early 1980s saw the introduction of several revolutionary network technologies: AMPS in the US and combination of TACS and NMT in Europe. In retrospect, these technologies were the first generation of mobile technology and were purely analog systems that were conceived and designed for voice calls and very little else. That is, no one was thinking about data services in those 1G days. While modems existed, their analog nature was very susceptible to noise and thus transfer speeds were very slow. This, coupled with the expensive per-minute rates, made mobile data usage very rare. The early nineties saw the rise of the first digital cellular networks, which are now called 2G. While the initial standards differed, GSM (Global System for Mobile Communications) became the predominant 2G standard. GSM and the other digital networks proved to be much better than the analogue networks they were replacing as they offered improved sound quality, better security, and higher total capacity. Still, these networks did not have proper support for data services woven into them. Many such networks supported text messaging and something called circuit-switched data or CSD. CSD allowed you to place a dial-up data call digitally but this call to connect meant that the service was not always available. The experience was very similar to using a dial-up modem at home: either you were online, or you were not. This changed however with the introduction of GPRS (General Pocket Radio Service), which offered a bolt-on for GSM networks that permitted alwayson data services, i.e., your headset was permanently connected to the internet. The innovation did not earn the right to add a full generational notch though; GPRS combined with 2G technology was occasionally referred to as 2.5G, despite some opposition by decimal-haters. 3G networks were launched commercially in the early part of the 21st century, though some pre-commercial launches took place before then. 3G did not take off though till around 2007. Now, a 3G connection can get you internet speeds anywhere from 400kbps to more than ten times that.

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As we enter the 2nd decade of the 21st century, no two letters are hotter in the telecommunications industry than 4G. 4G comes in three different flavors: HSPA+, WiMax, and LTE (Long-Term Evolution). HSPA+ stands for Evolved High-Speed Packet Access, and although its marketed as a 4G connection by carriers and the ITU recently changed its 4G definition to include HSPA+ under the 4G umbrella, it is merely an upgrade to existing 3G GSM technologies. That is, it still uses the old interface and standards implemented years ago for 3G, and lacks the response time of LTE and WiMax. Yet, many carriers may stick with HSPA+ for a couple of years due to savings as it is relatively less costly and is speedy to upgrade a GSM network to HSPA+. WiMax stands for Worldwide Interoperability for Microwave Access, which is an ITU approved 4G mobile broadband technology that attempts to mimic the abilities of Wi-Fi, but over a mobile phone network. Lastly, LTE stands for Long-Term Evolution and is a 4G wireless broadband technology offering high-speed data access and was developed by the Third Generation Partnership Project (3GPP), an industry trade group. LTE is considered more of a successor to current mobile 3G standards than WiMax and the chief difference between the two is that LTE transmits data using radio waves, as opposed to WiMax that uses microwaves. Many expect LTE to be the standard for cellular networks for at least the next decade and possibly even beyond. A very important consideration for all mobile operators is spectrum, which is a term used to describe the radio airwaves that enable the wireless capabilities of cellular service. There are a wide variety of spectrums, with different radio waves running at different frequencies. Often referred to as the lifeblood of the industry, spectrum is a finite resource and is of vital importance to a wireless carrier because if a carrier does not have spectrum, then it cannot operate. MVNOs, or Mobile Virtual Network Operators, are companies that buy wireless capacity and service on a wholesale basis, and resell it to consumers. In the Gulf, only Oman has issued MVNO licenses but in December 2:11, Saudi Arabias telecoms regulator announced that they will issue three MVNO licenses in 2012. Doing this instead of granting a fourth telecoms license is a sign that Saudi operators are moving towards competing on service rather than focusing on building their own infrastructure.

More than just a Hello

Few decades back, the telecommunications industry was somewhat centralized around one core activity: successfully making phone calls. Isnt that what they called communication in those days? But what was an achievement back then has changed drastically. The industry has evolved into a super complicated one with virtual nets encompassing the entire planet. As complex as a cobweb, the telecommunications industry is far beyond the act of making a simple phone call; in fact, the latter activity is becoming a minor act within the telecommunications world. One cant help but picture the telecommunications industry as the world's largest virtual machine, and one that touches nearly everyone on the globe. From telephones to mobiles, complex networks and internet-linked PCs, we cannot communicate without this machine, and with it, we can communicate with almost anyone, anywhere on earth. Companies in this sector make all of this happen. Despite the domination of the data-revolutionary era, phone calls remain so far the industry's biggest revenue generator. However, this is changing thanks to developments in network technology. The role of voice calls is shrinking in favor of messaging, media related

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network activities, and internet connectivity, which provides users with gateways to a whole new world of data applications such as broadband information services and interactive entertainment. The industry houses a wide range of sub-industries ranging from simple retailers of phones and their accessories to major infrastructure providers. The not so old marriage between telecommunications and internet services created a range of support and data service providers. From the major telecommunications sector stems three sub-sectors: telecommunication services, equipment, and finally, investments. The first two sub-sectors are active and include companies operating directly in the field of telecommunication while the latter concerns investment companies passively allocating capital towards the main sector. Across the GCC are around 235 companies operating in the various industries within this sector. Looking at the relative size of those countries makes it no surprise that the Kingdom of Saudi Arabia tops the list with 89 companies, followed by the United Arab Emirates with 86 companies. Kuwait is home to 29 companies operating in this field while Oman, Bahrain, and Qatar together house 31 companies. If we are to exclude companies that work passively in the sector (Investments), we end up with a total 227 companies across the GCC with Saudi Arabia and the UAE sharing the top rank. Classifications of the various activities of the companies telecommunications sector are summarized in the following map: operating in the

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Figure 1: Classification of telecommunication companies activities

Fixed-Line Voice Services

Fixed-Line Telecom Operators

Resellers

Providers Internet & Online Services Providers Resellers

Telecommunications Services Mobile Telecom Operators

Wireless Communication Services Telecommunications Infrastructure Development Other Telecommunications Services

Other Wireless Communication Services

Resellers

Mobile Phones & Related Accessories

Telecommunications

Wireless Telecommunications Equipment

Wireless Switching & Transmission Equipment Corporate Telecommunications Equipment Wire-Line Telecommunications Equipment

Distributors

Telecommunications Equipment

Support Services Telecommunications Equipment Satellite & Broadcast Network Equipment Other Telecommunications Equipment

Conventional Investment Companies Telecommunications Islamic

Source: KMEFIC Research, Zawya

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Report Focus
This report is intended to provide general information and basic statistics on the publicly traded telecommunication companies in the GCC. We start our presentation with the ownership structure of GCC telecoms to discuss later on the ownership restrictions concerning those companies. Sales and business risks of the sector will also be discussed. We will also touch upon the returns of the telecommunication stocks and their price multiples.

The Ownership Map of GCC Telecoms

Governments.why? and why not?
It is not rocket science: unless you are one of the richest people on the planet and are lucky and powerful enough to get a license, you better think of another sector. That is the way it works. A big no-no for solos in this field. Why? The telecommunications industry requires huge capital expenditures and a complicated chain of licensing processes. Simply due to the aforementioned reasons, a starting company usually begins as a government monopoly. However, deregulation soon follows and the telecom monopolies get privatized, an act that puts companies into a more challenging and competitive environment. Customers then benefit from better services and lower costs. In the telecommunications industry, size matters. Partnership candidates have to be big enough to support the sufficient cash flow needs of telecom companies as the life span of infrastructure is very short. But do the big partners need to be governments? Not necessarily In a recent interview, Saad Al-Barrak, ex-CEO of Zain Group said that the Middle East governments should divest their stakes in national telecom companies to help spur consolidation in an industry battling intense competition amongst incumbents and dwindling revenue from voice operations. Governments will try to cling to what they think is a money maker for them, which is wrong as they can recover more money and more value if they just devolve the ownership to the private sector. He added that the telecoms industry in the Middle East needs a dramatic transformation of mindset, culture, and skills to compete not just on price but on value, and to bring more services and applications to the customer. Al-Barrak also called for telecom regulators in the region to become more autonomous. (Zawya.com) There are twelve listed telecom companies in the GCC. The following table exhibits the companies basic details:

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Short Name BATELCO ZAIN WATANIYA OMANTEL NAWRAS QTEL VODAFONE QATAR MOBILY ZAIN-Saudi STC DU ETISALAT Country of Domicile Bahrain Kuwait Kuwait Oman Oman Qatar Qatar Saudi Arabia Saudi Arabia Saudi Arabia UAE UAE

Company Name Bahrain Telecommunications Company Mobile Telecommunications Company National Mobile Telecommunications Company Oman Telecommunications Company Omani Qatari Telecommunications Company Qatar Telecom Vodafone Qatar Etihad Etisalat Company Mobile Telecommunications Company Saudi Arabia Saudi Telecom Company Emirates Integrated Telecommunications Company Emirates Telecommunications Corporation

Governments of the wealthy GCC countries have different levels of ownership in these companies. In fact, telecom stakes owned by governments range from 0% (Zain-Saudi Arabia) to a substantial 84% (Saudi Telecom Company-STC). Thats not all; governments ownership is not bound by geographical periphery. For instance, the government of the UAE owns 10% of Qatar Telecom. Governments of the GCC countries invest in telecom companies through their pension funds, sovereign wealth funds, ministries, and other government-owned entities.
Figure 2: Governments ownership levels in GCC Telecoms
ZAIN-Saudi NAWRAS VODAFONE QATAR MOBILY WATANIYA ZAIN Average GCC BATELCO DU ETISALAT OMANTEL QTEL STC 0% 20% 40% 60% 80% 0% 5% 10% 11% 24% 25% 40% 57% 59% 60% 70% 78% 84% 100%

Source: KMEFIC Research, Zawya

As it is the case for government stakes in GCC telecoms, the corporate ownership level varies from one company to another. For example, four of the twelve listed telecom companies have no corporations amongst their owners while the share of corporate ownership in the other eight companies ranges from 16% (Zain-Kuwait) to 55% (NawrasOman). Saudi Arabias STC and UAEs Etisalat, in addition to Qatars QTEL and Omans Omantel, have no corporate investors. The same set of companies along with UAEs DU and Bahrains Batelco have a level of government ownership that exceeds the average in the GCC, which stands at 40%.

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Figure 3: GCC telecoms ownership allocation (Gov.-Corporate-Public)

100% 16% 22% 21% 23% 30% 90% 80% 70% 60% 50% 84% 70% 16% 40% 30% 20% 10% 0% BATELCO WATANIYA STC OMANTEL DU ETISALAT QTEL ZAIN 78% 60% 59% 57% 40% 24% 40% 40%

59%

20%

20%

53%

61%

50%

55%

25%

24%

27%

VODAFONE 10% QATAR

MOBILY 11%

NAWRAS 5%

GOVERNMENT

CORPORATE

PUBLIC

Source: KMEFIC Research, Zawya

When it comes to corporate and public ownership, it is worth mentioning that these companies have different levels of ownership openness. In other words, while some companies allow ownership up to 100% for both GCC nationals and foreigners, other companies reserve ownership exclusively to citizens. In between, various levels of restrictions can be found. The following chart exhibits ownership restrictions for the listed telecom companies in the GCC.
Figure 4: GCC telecoms - ownership restrictions map
Ownership is fully open for GCC nationals & foreigners 100% open for GCC nationals 49%-70% for foreigners

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

ZAIN-Saudi

50%

50%

Resticted to citizens

High ownership restrictions

OMANTEL

NAWRAS

ZAIN

STC

VODAFONE QATAR

DU

WATANIYA

GCC Nationals

ZAIN-Saudi

Foreigners

Source: KMEFIC Research, Zawya

Bahrains Batelco and Kuwaits Zain and Wataniya have no ownership restrictions; foreigners and citizens can possess 100% ownership in them. Ownership in the second set of telecom companies, three Saudi companies and two Omani, is fully open to GCC citizens while permitted foreigner ownership levels are restricted to 49% in Omantel, Mobily, Zain-Saudi, and STC. An exception is Nawras which is 70% open to foreigners. In Qatar however, the practice is tighter; Qatari telecom companies allow only up to 25%

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MOBILY

QTEL

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ownership to both GCC citizens and foreigners. UAEs DU is part of this group with high ownership restrictions by permitting only 22% of it to be owned by GCC citizens and foreigners. Finally, solo in this category resides UAEs Etisalat which has full ownership restrictions; Etisalats shares can only be owned by Emirati nationals.

Sales and Business Risks

Can we talk business??
In this section we touch upon both the business risk and financial risk of GCC telecoms in order to shed some light on the uncertainty of future income flows for the firms. Five to ten-year data sets are required to perform the two-part risk analysis; therefore, only nine out of the twelve telecom companies will be studied herein. Business risk is the uncertainty of income caused by the industry. This uncertainty is due to the firms variability of sales caused by its products, customers, and the way it produces its product. By definition, a firms earnings vary over time because its sales & production costs vary. The earnings variability is measured by the standard deviation of the companys historical operating income. We divide this measure by the mean operating income during the period that the analysis covers in order to derive the business risk. This calculation returns the coefficient of variation (CV) of earnings. The CV allows for comparisons between standardized measures of business risk for firms of different sizes. The following table lists companies in descending order of operating profit risk (business risk). The exhibit allows comparisons of business risk and sales risk levels across this set of companies.
Company DU MOBILY QTEL WATANIYA ZAIN ETISALAT STC BATELCO OTEL Listing DFM SSE QE KSE KSE ADSM SSE BB MSM Business Risk 5.587 0.790 0.764 0.574 0.519 0.361 0.257 0.213 0.207 Rank 1 2 3 4 5 6 7 8 9 Sales Risk 0.711 0.567 0.934 0.496 0.634 0.410 0.296 0.248 0.286 Rank 2 4 1 5 3 6 7 9 8

Source: KMEFIC Research

Although UAEs DU tops the list with a relatively high 5.587 CV in business risk, the number is somewhat negligible. Why? Because DU is a new company which started operations in December 2005 and was bearing losses from 2006 to 2008. Financially speaking, DU managed to shrink its losses drastically over the mentioned three-year period before switching to minor profitability in 2009. Profits hiked in 2010 before showing slower growth in 2011. In fact, this will be the case of any start-up company. The conclusion is, although DUs data places it high on the business risk table above, the comparison is not precise and DU should remain out of the comparison span. However, Saudi Arabias Mobily is another example worth mentioning in this analysis. The company went operational in August 2::4 which gives us access to a set of seven years worth of

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data for operating profits. Mobily ranked second in the list after bearing only one year of losses in 2005 before rebounding into profitability ever since. Although Mobily started off with high rates of growth for operating profits, growth rates smoothed slightly later on and as a result, Mobily has a much lower CV at :.79: as compared to DUs 5.587. If we keep DU and Mobily out of the picture, we end up with a group of seven telecom companies with available data for the past ten years. Applying the risk analysis of operating profit on these companies, we find that the level of business risk varied from a low of :.2:7 for Omans OTEL to a high of :.764 for Qatars Qtel. Once again, volatility levels in operating profits are the sole responsibility for the varied measures across companies. The greatest impact is when companies profits swing sharply between growth and decline over the years. Furthermore, the sharper these percentage movements, the higher the companies business risk. Besides measuring the overall business risk, we can examine another factor that contributes to the variability of operating earnings: the sales variability, which is the prime determinant of earnings and is more affected by the overall industry than by the firms management. Qatars QTEL crowns the list in terms of sales risk; however, a closer look at the figure reveals the reason. Qtel has experienced a sharp rise in sales between 2006 and 2008. Sales growth percentages were 135% and 96% in 2007 and 2008 respectively. DU came second on this list mainly due to aforementioned reasons. However, ZAIN out-ranked Mobily and settled in third place while the latter came in at fourth place. Sales risk levels ranged from a low of :.248 for Bahrains Batelco to a high of :.935 for Qatars Qtel.

Telecommunication Stocks
Price performance
The ongoing financial turmoil has depressed stock prices around the world, including those of the GCC telecom companies. Only until just recently did stock prices begin to recover. However, most GCC telecom companies saw their stocks decline over the past 7 years, with CAGRs ranging from -19.4% to 5%. The most significant and double digit declines came from Nawras, STC, and DU. Only 2 stocks, Wataniya & Vodafone Qatar, broke the trend and witnessed an increase over the mentioned period, growing at a CAGR of 5.01% and 2.54% respectively. The composite CAGR of the GCC telecom stocks was -7.43%, calculated by weighing each telecom stock by its market capitalization.
Figure 5: Compounded annual growth rates (CAGR) of the GCC telecom stocks
10% 5.0% 5% 0% -0.1% -5% -10% -15% -20% -11.3% -16.3% -19.4% -7.8% -5.3% -4.5% -6.6% -5.7% -3.2% 2.5% NAWRAS STC DU MOBILY BATELCO ZAIN ETISALAT ZAIN-Saudi OMANTEL QTEL VODAFONE QATAR WATANIYA

Source: KMEFIC Research, Reuters Eikon

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The total market capitalization of the 12 GCC telecom companies is USD 90.8 billion. The weighted market capitalization for 7 of the 12 stocks did not exceed 5%; the smallest companies were Nawras (1%), Batelco (2%) and Vodafone Qatar (2.3%). On the other hand, only two companies had a weighted market capitalization exceeding 20%: STC (23.6%) and Etisalat (20.7%).
Figure 6: Weighted market capitalization
ETISALAT 20.7% BATELCO 2.0%

ZAIN 11.9%

WATANIYA 4.1% OMANTEL 2.9% NAWRAS 1.0% MOBILY 13.0%

DU 4.1% VODAFONE QATAR 2.3%

QTEL 10.9% STC 23.6%

ZAIN-Saudi 3.7%

Source: KMEFIC Research, Reuters Eikon

Price multiples
With price multiples lower than the overall GCC stock market, the GCC telecom companies appear to be attractive at current price levels. The average price-to-earnings (P/E) ratio of the GCC telecom companies is 9.63, lower than the P/E ratio of the overall GCC stock market. Omani Qatari Telecommunications Co. (Nawras) has the lowest P/E ratio of all the companies and Emirates Telecommunications Co. (Etisalat) has the highest. The average price-to-book ratio of the GCC telecom companies is 1.9, with Vodafone Qatar having the lowest ratio and MTC Saudi Arabia (Zain KSA) having the highest ratio.
Company BATELCO ZAIN WATANIYA OMANTEL NAWRAS QTEL VODAFONE QATAR MOBILY ZAIN-Saudi STC DU ETISALAT
Simple Average Weighted Average*
*Weighted according to market cap

P/E 8.67 9.52 9.80 8.68 7.41 11.58 NEG 8.30 NEG 8.99 11.35 11.99
9.63 9.45

P/B 1.328 1.609 1.313 2.238 2.193 1.702 1.188 2.414 3.054 1.590 2.367 1.818
1.901 1.842

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This report is being provided for informational purposes only and on the condition that it will not form a primary basis for any investment decision. This report is not an offer to buy or sell any of the securities that may be referred to herein. In no event will KMEFIC be liable for any loss occurring from investment decisions made based on the recommendation here-enclosed. Past performance is not necessarily a guide to future performance. Investors should make their own decision on whether or not to buy or sell the securities covered herein based upon their specific investment goals and in consultation with their financial advisor. KMEFIC has no obligation to update, modify or amend this report or to otherwise make any notification or announcement thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. The inclusion of any opinions/estimates does not necessarily imply a recommendation or endorse the views expressed within them. Many areas of the report contain opinions and/or analysis that represent the involved analysts' views; neither the analysts nor KMEFIC shall be in any way liable for their opinions expressed in the report. KMEFIC may or may not have ownership or interest in companies mentioned in this report. This report has been prepared and issued by the Research Department @ Kuwait & Middle East Financial Investment Co. K.S.C.C. (KMEFIC), a licensed Kuwaiti investment company regulated by the Central Bank of Kuwait and the Capital Markets Authority. KMEFIC prepared this report using publicly available information, internal data, and other sources considered reliable; however, KMEFIC makes no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability with respect to the report or the information, analysis, opinions, or related graphics contained on the report for any purpose. While great care has been taken to ensure that the facts stated are accurate, neither KMEFIC nor any of its employees shall be in any way responsible for the contents. Neither this document nor any of its contents may be distributed in any jurisdiction where its distribution is restricted by law. Neither this document nor its content may be copied, transmitted or distributed without the prior written consent of KMEFIC. Additional information on the contents of this report is available on request.

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Research Team: Safaa Zbib, CVA Snr. Manager Research Department s.zbib@kmefic.com.kw Ali Al-Moussawi Equity Analyst Research Department a.almoussawi@kmefic.com.kw Reda Farran Asst. Equity Analyst Research Department r.farran@kmefic.com.kw

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