MENA Construction Reinstatement of Coverage

Equity | MENA | Construction 18 September 2013 Buy scope over scale, reinstating on GCC contractors

Equity Research Faisal AlAzmeh, CFA >> +971 4 425 8217 Research Analyst „ Reinstating on GCC contractors; DSI stands out as a Buy Merrill Lynch (Dubai) Despite this year’s reacceleration of awards activity, we believe the market is (1) [email protected] overly optimistic on peak-cycle earnings power, and (2) ignoring the risk posed by Ilze Roux >> +27 11 305 5195 stretched receivables. We have an Underperform rating on Arabtec (UAE) and Al- Research Analyst Merrill Lynch (South Africa) Khodari (KSA), but an out-of-consensus Buy on DSI. Perplexingly, the market is [email protected] assuming a strong (and unrealistic) recovery in Arabtec and Al-Khodari’s earnings Macro Research growth while being overly cautious on DSI’s prospects. We believe this provides Jean-Michel Saliba +44 20 7995 8568 an opportunity as DSI’s higher-margin end-to-end solutions business model MENA Economist leaves it well positioned to surprise on the upside. MLI (UK)

[email protected] DSI – Buy (PO AED1.55): a premium player at a discount In our view, DSI offers the best exposure to the sector’s reaccelerating activity, which is mirrored in the 70% YTD backlog growth. The company’s experience in Table 1: Reinstated POs and Earnings high-margin end-to-end solutions is likely to allow DSI to increase its exposure to Al-Khodari DSI Arabtec power and rail projects, which have higher margins than civil contracts more U/P Buy U/P common at peers. We believe the market is underestimating DSI’s ability to share Rating C-3-8 C-1-8 C-3-8 in market growth and/or factoring in unsustainably low margins. DSI currently PO 31.0 1.55 2.0 trades at a 2014E P/E of 11.5x, reflecting an unjustified discount to peers. 2013E EPS 1.80 0.08 0.076 2014E EPS 2.30 0.10 0.082 Arabtec – U/P (PO AED2.0): Margin pressure underestimated 2015E EPS 2.79 0.11 0.107 We believe Arabtec’s share price implies unrealistic medium-term earnings 2013E EBITDA 253.9 354.8 541.8 growth given the structural pressure on margins from increasing competition and 2014E EBITDA 278.4 372.2 634.3 tighter regulation. As the recent improvement in Dubai’s solvency makes write- 2015E EBITDA 317.4 422.2 734.1 offs on disputed receivables less likely, we believe Arabtec’s recent capital Table 2: Current valuations increase provides scope for substantial M&A. However, we are sceptical on the Al- value accretion of potential transactions. Arabtec currently trades at a 2014E P/E Khodari DSI Arabtec 2013 P/E 20.7 14.4 32.2 of 20.0x (rights issue adjusted), significantly above its peers of 15x. 2014 P/E 16.2 11.5 29.8 Al-Khodari – U/P (PO SAR31): Risky assets at a premium? 2015 P/E 13.4 10.6 22.7 2013 EV/EBITDA 11.6 10.8 11.7 We see two negatives for Al-Khodari: (1) its sole focus on Saudi Arabia; and (2) 2014 EV/EBITDA 10.6 10.3 10.0 the scope for write-offs with unbilled receivables aging twice the regional peer 2015 EV/EBITDA 9.3 9.1 8.6 [email protected]. average. A 10% write-off in unbilled receivables would be equivalent to 14% of Table 3: BofAML vs Consensus the shareholders’ equity. Al-Khodari currently trades at a 2014E P/E of 16.2x, Co. Name Net income BofAML Cons. above the sector average of 15x, we believe it should be trading at a discount. Al-Khodari 2013 95.82 143.0 2014 122.40 162.0 Macro: Diversification remains strategic development goal DSI 2013 187.0 153.2 Top-down, we are most comfortable on Saudi Arabia and Qatari macro, which we 2014 236.4 195.0 This report is intended for see outperforming in terms of growth, liquidity and fiscal dynamics. The UAE is 2015 256.9 227.6 staging a moderate and gradual recovery from its excesses, and the 2020 Expo Arabtec 2013 238.2 245.0 bid provides upside risk. GCC breakevens remain sticky at US$80/bbl, though still 2014 257.2 289.0 provide cushion. This ensures GCC governments can deliver on their commitment Source: BofA Merrill Lynch Global Research estimates, Bloomberg to their continued economic diversification drive. We believe focus on infrastructure spending will be a key driver for construction awards going forward.

c58da9b710df662c >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. Unauthorized redistribution of this report is prohibited. BofA Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 67 to 70. Analyst Certification on Page 66. Price Objective Basis/Risk on page 64. Link to Definitions on page 65.11314681

MENA Construction 18 September 2013

Contents

Reinstating coverage 3

Valuation 9

Company Investment Thesis 18

Company financials 21

Balance sheet focus 27

Margin analysis 38

Macro outlook 41

Sector outlook 45

Company profile 52

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Reinstating coverage Chart 1: BofAML vs Consensus We reinstate coverage of GCC E&C companies with a negative bias based on exposed balance sheets, margin pressure and pricy valuations. Despite the reaccelerated construction activity in the region, we reinstate on Arabtec (UAE) Alkhodari and Al-Khodari (Saudi Arabia) with an Underperform rating. However, we have an out-of-consensus Buy on DSI (UAE) as we consider it the best way to gain exposure to the growth outlook of the MENA construction sector. We believe the DSI market is underestimating the company’s ability to expand its backlog in Saudi and the UAE, and potential to improve its working capital collection. Furthermore, in the light of potential M&A activity in the region, we view DSI as an attractive acquisition target as offers digestible scale in higher-margin segments. Arabtec Most stocks faired poorly in 2012, as the market absorbed the declining margins caused by aggressive bidding. The recent improvement in relative performance 0% 20% 40% 60% 80% 100% driven by the recovery in construction awards is likely to persist as more awards % Buy % Hold % Sel are anchored in. However, we choose to be selective as we think the market is overly optimistic on the earnings cycle, especially in the case of Arabtec and Al- Source: Bloomberg Khodari. Table 4 reflects our stock ratings, price objectives and initial earnings estimates.

Table 4: Comparable company analysis Equity FCF Price Total Return Market Cap. Div. Yield CY13E CY14E CY15E CY13E CY14E CY15E CY 13E CY 14E Stock FCF / Yield TKR Price Rating Objective To PO (Bil.) (%) EPS EPS EPS PE PE PE EV/EBITDA EV/EBITDA Exch FYE share (%)

Al-Khodari XULLF SAR37.3 UND 31.0 -17% 2.0 1.8 2.3 2.8 20.7 16.2 13.4 11.62 10.60 Saudi Dec 0.84 2.2 Drake & Scull XKEAF AED1.18 NEU 1.55 31% 2.7 0.1 0.1 0.1 14.4 11.4 10.5 10.78 10.28 Dubai Dec 0.03 2.7 Arabtec XARBF AED2.44 UND 2.00 -18% 7.7 0.1 0.1 0.1 32.2 29.8 22.7 11.67 9.97 Dubai Dec 0.09 3.5

22.4x 19.1x 15.5x 11.36x 10.28x 2.8 Source: BofA Merrill Lynch Global Research

Investment case of GCC E&C names We now give a brief synopsis of our views of the risk-reward prospects of the three E&C companies in our coverage cluster.

Drake & Skull (DSI): Buy/C-1-8; AED1.55 PO We reinstate on DSI with an out-of-consensus Buy rating and PO of AED1.55/sh (upside potential of 31%). In our view, DSI offers the best exposure to the sector’s reaccelerating activity, reflected in the 70% YTD growth in the company’s backlog. DSI’s experience in high-margin segments like MEP is likely to make it the key contractor in many infrastructure and rail projects. We believe the market is underestimating its key drivers: (1) 2014 consensus EPS is too conservative as it is still expecting below 1H13 annualised earnings; and (2) the market is inferring very little capacity to monetise its outstanding unbilled receivables, which we see as unjustified given the improved solvency for many entities in the region. On our 20% above consensus 2014 EPS, DSI is currently trading at a P/E ratio of 11.5x, reflecting a 20% discount to peer average.

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Arabtec (ARTC): Underperform/C-3-8; AED2.0 PO We reinstate on Arabtec with an Underperform rating and PO of AED2.0/sh (potential downside of 18%). Arabtec’s recent rights issue made it one of the largest contractors in the region by market cap. Despite the growth potential suggested by the newly added capital, we believe the market is over pricing the value of this corporate action. If we adjust the market cap for the rights issue cash of AED2.4bn, it implies organic earnings growth of 56% over 1H13 annualized, which we believe is unachievable in the current margin environment. Furthermore, it is unclear how Arabtec will use the cash raised by the rights issue; hence, we value the cash at book; semi-government owned entities in the region have a history of disappointing acquisitions. Arabtec currently trades at a 2014E P/E of 19.5x (rights issue adjusted), above the peer average of 15x

Al-Khodari (AlKHODAR): Underperform/C-3-8; SAR31 PO We reinstate coverage of Arabtec with an Underperform rating and a PO of SAR31/sh (potential downside of 18%). Al-Khodari is our least preferred name in the space for the following reasons: (1) Al-Khodari’s margins are still the highest, but decelerating among peers: increasing competition and a change in backlog mix towards lower-margin civil projects are likely to result in a continued margin crunch in the near term. (2) It has the worst collection cycle of the three companies, with unbilled revenue (receivables) reaching 263 days as of 2Q13. Unbilled revenue is a high and growing percentage of sales, which exposes the company to significant write-off risks in the even of disputes with project owners, and a consequent sharp drop in equity. (3). Valuation is also looking expensive at above-average 2014 P/E multiples of 16.2x. Sector-wide pressures Unbilled revenue, a tail risk ignored by the market In this note we highlight the key aspects of the GCC E&C balance sheet. We view it as riskier than other regions such as South Africa and Korean, as receivables and unbilled revenues have increased significantly as a percentage of revenue over the past five years. This has affected the companies’ ability to manage their working capital requirements effectively and led them to introduce patch-up measures through the use of debt. We believe the market is already aware of these issues, but is too optimistic on Al-Khodari and Arabtec’s ability to collect, while underestimating DSI’s ability to monetise these balance sheet items. The following table highlights the sensitivity of the companies to a 5%, 10%, 15% write-off in these assets and the impact on the equity base.

Table 5: Change in Total Equity vs the write-off in unbilled revenue Write Down in Unbilled Rev in 2013 -5% -10% -15% DSI -3% -6% -9% Arabtec -1% -2% -3% Al-Khodari -7% -14% -20% Source: BofAML Global Research Estimates

We believe the market is factoring in a degree of collection, which we describe in more detail on page 34. DSI has the most upside potential, in our view, as the market is assuming a long period before unbilled revenue is monetised.

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Table 6: The fair value is below the market capitalisation of all three companies ((Mcap as of September 12 2013)) DCF Equity value Market cap Variance Unbilled revenue As a % of variance Company (in mn) (in mn) % Absolute (in mn) (in mn) Arabtec (AED) 5,466.3 6,844.1 -20% 1,378 1,947 71% DSI (AED) 1,146.3 1,820.9 -37% 675 2,242 30% Al-Khodari (SAR) 1,226.6 1,811.6 -32% 585 1,137 51% Source: BofA Merrill Lynch Global Research

Margin crunch: market is implying peak margins for Arabtec Table 7: Sensitivity to Price vs EBIT Margin and EBIT margins of GCC E&C companies have plummeted in most countries in implied 2014E PE which they operate over the past five years. We believe this was driven by: (1) 2014 aggressive bidding from local and international companies to secure backlog +200 +100 +50 Base -50 -100 -200 growth; (2) fewer project awards in the Middle East post the financial crises; (3) bps bps bps Case bps bps bps regulation changes that affected labour costs in the region post the Arab Spring, EBIT 11.2 especially in Saudi Arabia; and (4) change in awards mix towards more lower- margin 5.7% 6.7% 7.2% 7.7% 8.2% 9.2% % Al- value civil projects. As the key drivers of profitability are the pace of order book Khodari growth and the level of competition, we believe a recovery in awards should allow (SAR) 22.3 27.3 29.8 32.3 34.7 39.7 49.6 margins of companies like DSI and Arabtec to return to more comfortable levels. EBIT However, industry margins have fallen by such a degree, they are highly unlikely margin 2.8% 3.8% 4.3% 4.8% 5.3% 6.3% 8.3% to return to pre-2009 levels, in our view. DSI (AED) 0.9 1.2 1.3 1.4 1.6 1.9 2.5 EBIT Our analysis indicates that the market is inferring that Arabtec and Al-Khodari’s margin 2.7% 3.7% 4.2% 4.7% 5.2% 6.2% 8.2% margins will revert towards their historical averages. Which we think is difficult to Arabtec achieve given the structural changes in staff cost the region is facing and the (AED) 0.8 1.0 1.2 1.3 1.4 1.7 2.2 increasing competition from foreign companies. Although we see room for Source: BofA Merrill Lynch Global Research improvement on the back of better awards activity, we believe these levels are too aggressive given increasing competition and greater focus on civil construction by most companies, which has a lower margin mix than the companies’ historical levels. DSI is the only company the market expects no margin improvement what so ever, a scenario we believe is unlikely if awards activity is to pick in the region.

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Table 8: DSI is cheaply valued by the market Chart 2: DSI looks the most attractive Arabtec DSI Al-Khodari 13.0% Share price 2.34 1.08 35.60 14.0% 12.0% Share in issue 3140 2285.0 53.0 9.0% 10.0% 8.0% 7.0% 8% Equity value 4,946 2,468 1,887 8.0% 6.7% 5.1% 4.8% Fair Multiple 14.1x 14.1x 14.1x 6.0% 4.6% Attributable earnings 351.6 175.4 134.1 4.0% Minorities 150.0 26.0 0.0 2.0% 0.0% EAT 501.6 201.4 134.1 Arabtec DSI Al-Khodari Tax 7.6 27.2 14.4 Interest paid/ (received) 48.0 39.9 25.0 Implied EBIT margin BofA ML margin Long run Margin av g EBIT 557.2 268.4 173.5 Revenue - BofA ML foreca 8,365 5,850 1,929 Source: BofA Merrill Lynch Global Research Estimates Implied EBIT margin 6.7% 4.6% 9.0% BofA ML margin 5.1% 4.8% 8% Long run Margin avg 7.0% 8.0% 13.0% Source: BofA Merrill Lynch Global Research Estimates

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Share price performance and catalysts Catalysts: We believe the market will be The GCC E&C companies have shown a mixed performance in 2013. While DSI disappointed with Arabtec’s and Al- (60% YTD absolute & outperformed DFM by 4%) and Al-Khodari (31.6% YTD Khodari’s 4Q13 results, as EPS growth is absolute return & outperformed the Tasi by 17%) have had a solid YTD likely to be lower than what the market is performance both in absolute and relative terms, Arabtec has been a laggard expecting. compared with the local Dubai Index (DFM). One of the reasons behind the recent rerating has been renewed positive sentiment on construction activity in the region. The backlog growth experienced by the three companies is 56% for Al-Khodari, 24% for Arabtec and 70% for DSI, which suggests we have reached inflection point in regional activity after bottoming in 2012. We believe the next catalyst for the overall sector is likely to be the possible award of the World Expo in November, which would revive interest in the stagnant UAE market. On the downside we believe the market will be disappointed with Arabtec’s and Al- Khodari’s 4Q13 results, as EPS growth is likely to be lower than what the market is expecting.

Chart 3: Arabtec’s performance has been impacted by the bursting of Chart 4: YTD Arabtec’s relative performance was negatively impacted the UAE real estate bubble in 2008 by the AED2.4bn rights issue

Arabtec DFM Arabtec DSI Alkhodari MSCI EM 500 190 170 400 150 300 130

200 110 90 100 70 0 50 Jul-13 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Apr-13 Jun-13 Jan-13 Feb-13 Mar-13 Aug-13 Sep-13 May-13 Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream

Chart 5: Since listing in 2009, DSI has performed in line with the market Chart 6: YTD DSI has shown a strong absolute performance of 60%

DSI DFM DSI DFM 190 200 170 180 150 160 130 140 110 90 120 70 100 50 80 Jul-13 Apr-13 Jun-13 Jan-13 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Aug-13 Sep-13 Feb-13 Mar-13 Mar-09 Sep-09 Dec-09 Mar-10 Sep-10 Dec-10 Mar-11 Sep-11 Dec-11 Mar-12 Sep-12 Dec-12 Mar-13 May-13 Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream

:

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Chart 7: Declining margins was the key reason for Al-Khodari’s Chart 8: Recent pick-up vs the market driven by strong backlog underperformance since 2012 growth in 2Q13 and 3Q13

Alkhodari Tadawul Alkhodari Tadawul 160 140 140 130 120 120 100 110 80 100 60 90 40 80 Jul-13 Apr-13 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Jun-13 Jan-13 Aug-13 Sep-13 Feb-13 Mar-13 May-13 Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream

Chart 9: GCC contractors have outperformed Korean names since Chart 10: YTD GCC contractors have outperformed the MSCI emerging 2010 markets index

Arabtec DSI Alkhodari Korean Const. Arabtec DSI Alkhodari MSCI EM 210 190 190 170 170 150 150 130 130 110 110 90 90 70 70 50 50 Jul-11 Jul-12 Jul-13 Jul-13 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Jan-11 Jan-12 Jan-13 Apr-13 Jun-13 Jan-13 Aug-13 Sep-13 Feb-13 Mar-13 May-13

Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream

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Valuation We use a fair P/E multiple to derive the POs We derive our POs for the GCC E&C companies using a trough to mid-cycle fair P/E multiple of 14.1x. We then apply a specific premium/discount for each company depending on their prospects. Given the very limited trading history of GCC construction names, we use the Korean long-term E&C sector average as a benchmark (reasons laid out below) and factor in a premium for the domestic connections of the regional players. We arrive at the following POs using a 14.1x fair P/E multiple:

„ DSI’s PO of AED1.55/sh implies upside potential of 31%. Higher-margin MEP work accounts for c.50% of DSI’s earnings: we apply a 16x multiple to that earnings base and the sector’s fair value of 14x to the other half, to give us a blended P/E of 15x.

„ Al-Khodari’s PO of SAR31/sh implies downside potential of 18%. We derive the company’s PO using a P/E multiple of 13.5x. This is a discount to the sector average to reflect the embedded balance sheet risk.

„ Arabtec’s PO of AED2.0/sh implies downside potential of 18%. We apply a 14.6x fair multiple to derive Arabtec’s fair value. We believe the new shareholder structure will make it easier for Arabtec both to secure projects at comfortable pricing, and collect its outstanding receivables.

Table 9: GCC Construction Companies should trade at 14.1x 2014 EPS Arabtec DSI Al-Khodari BofAML 2014 net income estimate (in mn) AED257 AED236 SAR122 Fair Multiple 14.6x 15.0x 13.5x BofA ML Equity Value* 6,152 3,545 1,652 PO AED2.0 AED1.55 SAR31 Upside (Downside) potential -18% 31% -18% Source: BofA Merrill Lynch Global Research estimates * Arabtec’s EV includes the AED2.4bn raised from the rights issue

Contrasting drivers require trough-mid cycle multiples Given the cyclical nature of E&C companies, we believe the best method of valuation is using the different cycle multiples. GCC construction companies have contrasting valuation drivers, which suggests that trough to mid-cycle multiples are most appropriate at this stage of the cycle.

Following the increase in GCC Strong project growth but secular downturn in margins construction awards, we believe the There are many indications of accelerating backlog growth at GCC contractors, market is inferring mid-peak valuation from the improved solvency of UAE entities and a healthier UAE real estate multiples. However, we believe margin market, to the pick-in Saudi and Qatari awards. In theory, the market applies peak pressure, increasing competition, and multiples in anticipation of earnings recovery in the long run, which we believe balance sheet risk require low-to-mid explains the rerating of the sector over the past 12 months. However, the above cycle multiples assumption overlooks the secular downturn in margins. While growth prospects are clearer than before, improving margins is a key challenge in our view. EBIT margins are likely to remain under pressure owing to: (1) growing competition from overseas companies such as Korean and Chinese, which will weaken pricing power in the region; and (2) new regulation that keeps increasing blue- collar labour costs. Hence, we believe it is unfair to price earnings at peak levels as they would be difficult to achieve with the margin crunch.

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Arabtec and Al-Khodari are trading at peak multiples Arabtec and Al-Khodari’s currently valuation levels are not sustainable, in our view, as they reflect Mid to peak-cycle valuation multiples. We believe such levels would be difficult to achieve give the margin pressure the region is facing.

„ Arabtec: Arabtec currently trades at an adjusted (cash from rights issue) 2013-14E P/E ratio of 22x and 20x, respectively, significantly higher than its historical average of 11x and its peak valuation of 17.5x.

„ DSI: DSI has the most attractive valuation among the three companies as it trades at a 2013-14E P/E ratio of 14.5x and 11.4x, respectively, when factoring in the recovery of the business. These multiples are at the upper end of its short historical valuation levels. Hence we believe it’s optimal to compare it to the sector’s trough to mid-cycle multiple.

„ Al-Khodari: Al-Khodari also ranks expensive in our view as it currently trades at a 2013-14E P/E ratio of 20.7x and 16.2x, respectively, above its peak valuation multiples. The company has the most to lose as its margins remain unsustainably high.

Chart 11: Arabtec’s long run historical Chart 12: DSI’s long run historical forward Chart 13: Al-Khodari’s long run historical forward P/E P/E forward P/E

35 15 15 30 13 13 25 20 11 11 15

PE (x)PE 9 PE (x) 10 PE (x) 9 7 5 7 0 5 5 Jul/06 Jul/09 Jul/12 Oct/05 Apr/07 Oct/08 Apr/10 Oct/11 Apr/13 Jan/08 Jan/11 Nov/09 Nov/10 Nov/11 Nov/12 May/09 May/10 May/11 May/12 May/13 Jul/13 Jul/12 Jul/11 Mar/13 Mar/12 Nov/12 Nov/11 PE Avergae PE Avergae PE Av ergae +1 Std Dev -1 Std Dev +1 Std Dev -1 Std Dev +1 Std Dev -1 Std Dev

Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream

Chart 14: Arabtec’s Consensus earnings cuts Chart 15: Al-Khodari’s Consensus earnings Chart 16: DSI Consensus earnings cuts reached the lowest level cuts reached the lowest level reached the lowest level

0.5 10 0.2 0.4 8 0.15 0.3 6 0.2 4 0.1

0.1 2 0.05 0 0 0 7/1/09 7/1/11 7/1/13 6/26/11 6/26/12 6/26/13 1/26/10 1/26/11 1/26/12 1/26/13 Historical Mean 12/2013 Historical Mean 12/2013 Historical Mean 12/2013 Historical Mean 12/2014 Historical Mean 12/2014 Historical Mean 12/2014

Source: Bloomberg, BofA Merrill Lynch Global Research Source: Bloomberg, BofA Merrill Lynch Global Research Source: Bloomberg, BofA Merrill Lynch Global Research

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Look east for trading history As the companies have a short trading history (DSI and Al-Khodari were listed post 2009), we look the more mature Korean market, with significant exposure to region and a trading history that has factored in the full cycle. Korean E&C companies entered the region’s construction market in 2004: the region generates around c.52% of their sales and most of their new backlog growth.

Chart 17: Korean E&C revenue breakdown Chart 18: Korean E&C new orders breakdown by region

(USD mn) 80,000

60,000

45% 40,000

55% 20,000

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

ME Asia Africa South America EU North America & Pacific Domoestic Ov erseas Source: BofA Merrill Lynch Global Research, ICAK

Source: BofA Merrill Lynch Global Research, Company data

Chart 19: Korean E&C valuations vs ME contribution to revenues Chart 20: Trough to Mid-cycle long term P/E stands at 13 Hyundai Development 11.1 7.8 25.0 average of 52% 80% 20 20.0 60% 15 15.0 13 40% 15 10.0 11 5.0 20% 10 0.0 0% 5 E&C C C&T

Daelim 0 Hyundai GS E&C Industrial Samsung Samsung Engineering Daewoo E& P/E Median P/E Low Low -Mid Cy cle P/E Median P/E Low *11-12 ME contribution to total rev enues P/E Median P/E Low Low -Mid Cy cle

Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, Datastream

Table 10: GCC Low to Mid Cycle Valuation We use Korean E&C companies as a benchmark for our multiples To derive our fair trough-mid cycle multiple for the sector, we use the Korean Historical E&C long-term average P/E of 13x as a proxy, we then apply a 10% premium for P/Ex Target multiple Median Low the lower blended tax rates of GCC E&C companies and their better connections Korean E&C 15 10.8 13 and positioning that allow them to secure projects. We arrive at a fair low to mid- Premium 10% 10% cycle valuation multiple of 14x as a benchmark to derive our PO of the covered GCC E&C 16 12 14 companies. Source: BofA Merrill Lynch Global Research

11 MENA Construction 18 September 2013

„ DSI’s PO of AED1.55/sh implies upside potential of 31%. Higher-margin MEP work accounts for 50% of DSI’s earnings: we apply a 16x multiple to that earnings base and the sector’s fair value of 14x to the other half, to give us a blended P/E of 15x.

„ Al-Khodari’s PO of SAR31/sh implies downside potential of 18%. We derive the company’s PO using a P/E multiple of 13.5x. This is a discount to the sector average to reflect the embedded balance sheet risk.

„ Arabtec’s PO of AED2.0/sh implies downside potential of 18%. We apply a 14.6x fair multiple to derive Arabtec’s fair value. We believe the new shareholder structure will make it easier for Arabtec both to secure projects at comfortable pricing, and collect its outstanding receivables.

Table 11: GCC Construction Companies should close to 14.1x 2014 EPS Arabtec DSI Al-Khodari BofAML 2014 net income estimate (in mn) AED257 AED236 SAR122 Fair Multiple 14.6x 15.0x 13.5x BofA ML Equity Value* 6,152 3,545 1,652 PO AED2.0 AED1.55 SAR31 Upside (Downside) potential -18% 31% -18% Source: BofA Merrill Lynch Global Research estimates * Arabtec’s EV includes the AED2.4bn raised from the rights issue

What is the market implying? Having determined the most appropriate multiples for the region, we now back out what the market is implying for 2014 earnings using our fair valuation multiple.

DSI looks the least expensive The data in table 12 suggests that the market is implying 2014 net income of AED185mn, below 1H13 annualised earnings, which we think is unlikely given that the company’s backlog is up by 70% YTD. In our view, DSI offers the best exposure to the sector’s reaccelerating activity and the highest margin among peers. It also stands out as the most attractive target for M&A for anyone looking for regional exposure. Its experience in higher-margin segments such as MEP could also represent an attractive opportunity to larger local construction names to enhance their service portfolio.

Arabtec is pricy Arabtec’s recent rights issue made it one of the largest contractors in the region by market cap. Despite the growth potential suggested by this capital raising, we believe the market is over pricing the value of this corporate action. If we adjust the market cap for the rights issue cash of AED2.4bn, it implies organic earnings growth of 56% vs 1H13 annualised on a like-for-like basis, which we believe is unachievable in the current margin environment. Furthermore, it is unclear how Arabtec will use the cash raised by the rights issue; hence, we value the cash at book; semi-government owned entities in the region have a history of disappointing acquisitions.

Al-Khodari: the risk does not justify the reward, in our view We believe the market is currently either assuming significant growth in Al- Khodari’s 2014 sales or a return to pre-2012 margins. We believe this is unlikely at the current stage as: (1) lower-margin civil construction projects have been growing as a proportion of the backlog mix; and (2) regulation issues in Saudi

12 MENA Construction 18 September 2013

continue to result in higher SG&A costs. We therefore believe the company should be trading at a discount to the peer average.

Table 12: Implied earnings are high for Arabtec and Al-Khodari, DSI looks cheap

Arabtec DSI Al-Khodari Share price 2.44 1.18 37.30 Share in issue 3140 2285.0 53.0 Equity value* 5260 2696 1977 Fair Multiple 14.1x 14.1x 14.1x Implied earnings using fair multiple 374 192 141 Consensus (2014) 289 195 162 Implied Earnings vs Consensus 29% -2% -13% BoFAML Estimate 257 236 122 Implied Earnings vs BofAML Estimate 45% -19% 15% 1H13 annualized (excluding reversals) 236 200 87 Implied Earnings vs 1H13 annualized 59% -4% 61% Peak net income 958 290 240 Implied Earnings vs peak net income -61% -34% -41%

Peak margins 13% 12% 24% 2012 margins 1.9% 3% 9% 2Q13 margins 5%6%8% Source: BofA Merrill Lynch Global Research Estimates *Arabtec’s Equity value is adjusted by subtracting the AED2.4bn rights issue

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Sanity check: DCF analysis Drake & Skull

Table 13: DSI’s DCF Analysis DCF Assumptions Equity Assumptions Debt Assumptions Terminal Value Growth Rate 3% Risk Free Rate % 5% Cost of Debt 8% WACC 10.2% Equity Risk Premium % 7% Tax Rate 4% Adjusted Levered Beta 1.02 Debt / (Debt + Equity) 35% Cost of Equity % 12% Equity / (Debt + Equity) 65% Stock Price (AED) 1.1 Shares Outstanding (mn) 2,285 MV of Equity (AED mn) 2,582

Year - 1 2 3 4 5 6 7 8 9 10 Terminal 2012A 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E Sales 3,321 5,200 5,850 6,314 6,757 7,314 7,877 8,496 8,997 9,565 9,978 8% YoY % Change 57% 13% 8% 7% 8% 8% 8% 6% 6% 4% Operating Profit 106 272 281 322 338 380 410 459 481 507 549 8% YoY % Change 157% 3% 15% 5% 13% 8% 12% 5% 5% 8% Operating Margin 3% 5.2% 4.8% 5.1% 5.0% 5.2% 5.2% 5.4% 5.4% 5.3% 5.5% Plus Depreciation 80 83 91 100 110 121 129 133 137 138 141 6% Capex as % of depreciation -155% -88% -90% -88% -86% -91% -91% -77% -79% -83% -106% YoY % Change 4% 10% 10% 9% 10% 7% 3% 3% 1% 2% Less Capital Expenditures (125) (73) (82) (88) (95) (110) (118) (102) (108) (115) (150) 8% Capex as % of rev 4%1%1%1%1%2%2%1%1%1%2% Less Cash taxes (19) (45) (27) (32) (35) (39) (43) (48) (51) (54) (58) 3% Tax rate as % of EBIT 18% 16% 10% 10% 10% 10% 10% 10% 11% 11% 11% Change in Working Capital Requirements (680) (181) (74) (45) (45) (47) (43) (32) (23) (22) (22) -21% WC as % of change in sales -20% -3% -1% -1% -1% -1% -1% 0% 0% 0% 0%

Unlevered Free Cash Flow (638) 57 189 257 273 305 336 410 437 455 460 6,532 YoY % Change -109% 233% 36% 6% 12% 10% 22% 6% 4% 1%

Sensitivity Analysis NPV of FCF in Years 1-10 1,728 41% Terminal Growth Rate NPV of Terminal Value 2,462 59% 1.3 2% 3% 3% 4% 4% Total Enterprise Value 4,190 100% 9% 1.53 1.62 1.72 1.85 2.00 Less Total Debt (1,329) 9% 1.46 1.54 1.63 1.75 1.88 Less Minority interest (500) 9% 1.39 1.46 1.55 1.65 1.77 Plus Total Cash and Marketable Securi 731 10% 1.33 1.40 1.48 1.57 1.67 Plus non current assets (liabilities), net (34) 10% 1.27 1.33 1.40 1.49 1.58 Total Equity Value 3,058 WACC 10% 1.21 1.27 1.34 1.41 1.50 Equity Value Per Share 1.34 10% 1.16 1.22 1.28 1.35 1.43 11% 1.11 1.16 1.22 1.28 1.36 11% 1.07 1.11 1.17 1.22 1.29 11% 1.03 1.07 1.12 1.17 1.23 11% 0.99 1.02 1.07 1.12 1.17 Source: BofA Merrill Lynch Global Research Estimates

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Arabtec Table 14: Arabtec’s DCF Analysis DCF Assumptions Equity Assumptions Debt Assumptions Terminal Value Growth Rate 3% Risk Free Rate % 5% Cost of Debt 8% WACC 12.5% Equity Risk Premium % 7% Tax Rate 3% Adjusted Levered Beta 1.33 Debt / (Debt + Equity) 20% Cost of Equity % 13.6% Equity / (Debt + Equity) 80% Stock Price (AED) 2.370 Shares Outstanding (mn) 3,140 MV of Equity (AED mn) 7,441

Year - 1 2 3 4 5 6 7 8 9 10 Terminal 2012A 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E Sales 5,660 6,221 8,365 9,560 10,312 10,953 11,592 11,919 11,885 11,648 11,415 7.3% YoY % Change 10% 34% 14% 8% 6% 6% 3% 0% -2% -2% Operating Profit 108 302 389 483 561 617 663 693 689 686 665 9.2% YoY % Change 179% 29% 24% 16% 10% 8% 4% 0% 0% -3% Operating Margin 2% 4.9% 4.7% 5.1% 5.4% 5.6% 5.7% 5.8% 5.8% 5.9% 5.8% Plus Depreciation 281 240 245 251 258 265 270 276 281 287 294 2.3% Capex as % of depreciation -89% -86% -85% -95% -100% -103% -82% -82% -72% -81% -97% Less net Capital Expenditures (250) (205) (209) (239) (258) (274) (220) (226) (202) (233) (285) 3.7% Capex as % of rev 4% 3% 3% 3% 3% 3% 2% 2% 2% 2% 3% Less Cash taxes (2) (4) (6) (7) (9) (9) (10) (11) (11) (11) (11) 12.8% Tax rate as % of EBIT 1% 1% 1% 1% 2% 2% 2% 2% 2% 2% 2% Change in Working Capital Requirements (222) (92) (78) (141) (75) (80) (79) (40) (18) (17) (16) -18.0% WC as % of change in sales -3.9% -1% -0.9% -1% -1% -1% -0.68% -0.34% -0.15% -0.14% -0.14%

Unlevered Free Cash Flow (85) 241 341 347 477 518 623 691 739 712 647 7,043 YoY % Change -382% 42% 2% 37% 9% 20% 11% 7% -4% -9%

Sensitivity Analysis NPV of FCF in Years 1-10 2,661 55% Terminal Growth Rate NPV of Terminal Value 2,175 45% 2.0 2% 3% 3% 4% 4% Total Enterprise Value 4,836 100% 11% 2.07 2.11 2.15 2.20 2.25 Less Total Debt (800) 11% 2.04 2.07 2.11 2.15 2.20 Less: Minority interest (1,407) 12% 2.01 2.04 2.07 2.11 2.15 Plus Total Cash and Marketable Securities 3,317 12% 1.97 2.00 2.03 2.07 2.11 Plus: Long term investments & assets, net o 229 12% 1.94 1.97 2.00 2.03 2.07 Total Equity Value 6,176 WACC 12% 1.91 1.94 1.97 2.00 2.03 Equity Value Per Share 1.97 13% 1.89 1.91 1.94 1.96 2.00 13% 1.86 1.88 1.91 1.93 1.96 13% 1.84 1.86 1.88 1.90 1.93 13% 1.81 1.83 1.85 1.88 1.90 14% 1.79 1.81 1.83 1.85 1.87 Source: BofA Merrill Lynch Global Research Estimates

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Al-Khodari Table 15: Al-Khodari’s DCF Analysis DCF Assumptions Equity Assumptions Debt Assumptions Terminal Value Growth Rate 3% Risk Free Rate % 5% Cost of Debt 6% WACC 9.8% Equity Risk Premium % 6% Tax Rate 3% Adjusted Levered Beta 1.16 Debt / (Debt + Equity) 35% Cost of Equity % 12% Equity / (Debt + Equity) 65% Stock Price (SAR) 35.4 Shares Outstanding (mn) 53 MV of Equity (SAR mn) 1,881

Year - 1 2 3 4 5 6 7 8 9 10 Terminal 2012A 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E ^CAGR 13 Sales 1,524 1,586 1,929 2,264 2,484 2,766 2,858 3,065 3,265 3,379 3,485 9.1% YoY % Change 4% 22% 17% 10% 11% 3% 7% 7% 4% 3% Operating Profit 136 121 148 175 190 214 220 231 242 245 248 8.3% YoY % Change -11% 22% 18% 9% 12% 3% 5% 4% 1% 1% Operating Margin 8.9% 7.7% 7.7% 7.7% 7.7% 7.7% 7.7% 7.6% 7.4% 7.3% 7.1% Plus Depreciation 138 133 130 142 156 169 175 189 204 221 243 7.0% Capex as % of depreciation 80% 88% 94% 90% 87% 82% 82% 78% 83% 92% 105% YoY % Change -4%-2%10%9%9%3%8%8%9%10% Less Capital Expenditures (111) (116) (122) (128) (135) (139) (143) (147) (169) (203) (254) 9.1% Capex as % of rev 7% 7% 6% 6% 5% 5% 5% 5% 5% 6% 7% Less Cash taxes (9) (2) (3) (4) (4) (5) (5) (5) (5) (5) (5) 9.2% Tax rate as % of EBIT 7%2%2%2%2%2%2%2%2%2%2% Unbilled revenue (210) ------Change in Working Capital Requirements (46) (61) (35) (32) (35) (34) (26) (24) (15) (9) (5) -24.0% WC as % of change in sales -3% -4% -2% -1% -1% -1% -1% -1% 0% 0% 0% Unlevered Free Cash Flow (101) 74 118 153 172 206 221 244 255 249 226 3,425 YoY % Change -173% 59% 30% 12% 20% 7% 11% 5% -2% -9%

Sensitivity Analysis NPV of FCF in Years 1-10 1,098 45% Terminal Growth Rate NPV of Terminal Value 1,344 55% 27.7 2% 3% 3% 4% 4% 5% 5% 6% Total Enterprise Value 2,441 100% 9% 29.11 31.22 33.67 36.57 40.04 44.28 49.55 56.31 Less Total Debt (1,073) 9% 27.38 29.30 31.53 34.14 37.24 40.98 45.60 51.42 Plus Total Cash and Marketable Securi 156 10% 25.77 27.52 29.55 31.90 34.69 38.02 42.08 47.14 Less non-current assets (liabilities), net (52) WACC 10% 24.26 25.87 27.71 29.85 32.35 35.33 38.92 43.35 Total Equity Value 1,472 10% 22.84 24.32 26.00 27.95 30.21 32.88 36.08 39.97 Equity Value Per Share 28 10% 21.51 22.87 24.41 26.18 28.23 30.64 33.50 36.95 11% 20.26 21.51 22.93 24.55 26.41 28.58 31.15 34.21 Source: BofA Merrill Lynch Global Research Estimates

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Table 16: Comparable Analysis Market P/E EV/EBITDA EBITDA Margin (%) ROCE (%) Company Ticker Currency Price Cap (US$) EV (US$) 2012A 2013E 2014E 2015E 2012A 2013E 2014E 2015E 2012A 2013E 2014E 2012A 2013E 2014E DM 43.2x 18.0x 17.0x 15.2x 9.8x 10.1x 8.8x 8.0x 4.6 4.7 5.1 4.5 4.8 5.1 Balfour Beatty BAFBF UK GBP 277 3,046 4,409 8.0x 13.7x 11.0x 9.7x 14.6x 13.0x 8.8x 7.9x 2.0 2.4 3.5 2.9 4.3 6.6 Bilfinger BFLBF UK EUR 79 4,634 5,620 12.6x 14.3x 13.1x 12.2x 7.1x 7.6x 6.9x 6.6x 6.8 6.3 6.7 4.6 4.6 5.1 Kajima KAJMF Japan JPY 404 4,248 7,436 109.5x 17.9x 19.1x 15.5x 15.6x 20.0x 14.4x 13.6x 3.2 2.5 3.5 2.9 2.0 2.9 Leighton Holdings LGTHF Australia AUD 19 6,033 6,933 13.7x 11.9x 12.9x 13.6x 4.3x 3.7x 3.4x 3.5x 7.6 8.8 9.3 11.0 11.0 9.9 Obay ashi OBYCF Japan JPY 573 4,184 5,596 80.0x 31.2x 27.5x 21.7x 12.8x 12.0x 14.9x 12.3x 3.5 3.2 2.5 2.3 2.7 1.8 Strabag XSTBF Austria EUR 19 2,623 3,586 35.4x 19.1x 18.6x 18.6x 4.4x 4.2x 4.1x 4.1x 4.7 5.0 5.0 3.6 4.1 4.0

EM 14.7x 75.8x 12.2x 10.1x 13.2x 14.4x 9.7x 8.3x 5.4 4.0 6.8 6.8 3.1 6.9 Daelim Indus Co DERXF Korea KRW 102,500 3,296 3,145 8.8x 8.1x 7.1x 6.6x 6.2x 5.8x 5.0x 4.6x 5.3 5.6 5.8 5.7 6.4 7.0 Samsung Engineering SGRGF Korea KRW 91,800 3,393 4,013 7.0x 408.3x 13.3x 10.6x 5.5x 28.7x 8.7x 7.5x 6.9 1.4 4.9 27.4 2.1 11.4 Hy undai Eng&Con HYEHF Korea KRW 64,700 6,657 6,982 14.1x 11.2x 9.0x 7.4x 9.0x 8.1x 6.6x 5.6x 6.3 6.6 7.1 9.6 10.0 11.4 GS Engineering GSNGF Korea KRW 39,050 1,840 4,285 16.8x NM 14.1x 8.7x 19.8x NM 13.6x 10.4x 2.5 (8.6) 3.6 1.9 (8.9) 3.2 Samsung C&T SSGFF Korea KRW 61,100 9,082 14,845 21.8x 27.3x 23.0x 19.2x 24.7x 25.5x 22.3x 19.4x 2.6 2.1 2.2 2.6 1.9 2.2 Hy undai Dev elop. HYHVF Korea KRW 24,050 1,635 3,609 NM 35.8x 9.2x 7.8x 27.4x 15.3x 10.4x 9.6x 4.3 6.7 7.9 1.2 2.8 4.6 Enka Insaat EKIVF Turkey TRY 6 8,823 6,557 16.5x 13.9x 12.4x 11.7x 8.6x 6.7x 6.6x 6.2x 12.9 15.2 15.2 10.1 9.9 9.6 Tekfen Holding AS XTNKF Turkey TRY 5 907 610 11.2x 26.3x 9.9x 8.9x 4.3x 10.4x 4.0x 3.4x 6.9 3.0 7.3 7.1 0.8 6.2

Average 29.0x 46.9x 14.6x 12.7x 11.5x 12.2x 9.2x 8.2x 5.0 4.3 5.9 5.7 4.0 6.0

MENA 23.5x 22.4x 19.1x 15.5x 15.9x 11.4x 10.3x 9.0x 11.8 11.4 10.4 4.0 5.2 5.6 Arabtec XARBF UAE AED 2.4 2,083 1,719 27.5x 32.2x 29.8x 22.7x 16.2x 11.7x 10.0x 8.6x 6.9 8.7 7.6 2.3 4.7 4.8 Drake & Scull XKEAF UAE AED 1.2 733 1,042 28.2x 14.4x 11.4x 10.5x 20.6x 10.8x 10.3x 9.1x 5.6 6.8 6.4 3.0 5.6 6.0 Al-Khodari XULLF Saudi SAR 37.3 528 787 14.7x 20.7x 16.2x 13.4x 10.8x 11.6x 10.6x 9.3x 18.0 16.0 14.4 6.6 5.3 6.2 Source: BofA Merrill Lynch Global Research Estimates

Risks to our view Upside risks „ Higher-than-expected backlog growth in higher-margin segments would be likely to result in better-than-expected margins and higher valuation multiples.

„ Dubai wining the bid to host the World Expo in 2020 would result in upside potential in UAE awards.

Downside risks „ Increasing competition from overseas could take a decent portion of the existing high-margin business.

„ A political shock could put some projects on hold creating lower growth opportunities.

„ Higher levels of unbilled revenue could result in significant use of leverage, and thus hurt profitability.

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Company investment thesis Drake & Scull (XKEAF): Buy – PO AED1.55 Premium player trading at a discount We reinstate coverage on DSI with a Buy rating and PO of AED1.55/sh (upside potential of 31%). In our view, DSI offers the best exposure to the sector’s reaccelerating activity, which is mirrored in the 70% YTD backlog growth. The company’s experience in high-margin segments like MEP is likely to place it as a key contractor in most infrastructure and rail projects. We believe that the market is underestimating two key drivers: (1) 2014 consensus EPS is too conservative as it still expecting below 1H13 annualised earnings; (2) the market is implying very little capacity to monetise outstanding unbilled revenue, which we see as unjustified given the improvement in solvency for many entities in the region.

Chart 21: Backlog Since 2008 „ Premium player: In our view, DSI offers the best exposure to the MENA

15 11.70 construction market with operations in most key countries in the region. It is 9.10 8.98 licensed as a grade 1 contractor in most key areas, especially in Saudi, 10 6.70 5.40 which has allowed it be a key contractor in many projects (Saudi contribution 2.69 2.74 AED Bn 5 to backlog 52% as of 2Q13). We view the company’s rich experience in the 0 high-margin MEP segment as conducive to winning bids in the Saudi rail 2008 2009 2010 2011 2012 1Q'13 2013E Backlog market, (around US$23.5bn worth of rail projects were awarded YTD and around US27.8 bn is likely to be awarded through 2016). Furthermore, we Source: Company Reports, BofA Merrill Lynch Global Research Estimate consider the company the most attractive target for potential M&A activity: it is big enough to access all markets but is still digestible in comparison with the other large listed contractors like OCI and Arabtec.

„ Market inferring low levels of earnings: We believe the market is unjustifiably assuming very low earnings levels for 2014: our calculations show that the market is assuming that 2014 earnings will be lower than the 1H13 annualised amount. We believe this is unlikely given the recent increase in the company’s backlog (1H revenues are up 72% YoY). We also disagree with the market’s assumption that DSI is highly unlikely to be able to collect its unbilled revenue. If the market is proved wrong, it would allow the stock to rerate in our view.

„ Valuation: DSI currently trades at a 2014E P/E of 11.5x, ie, a trough-cycle multiple. In our view, this is unjustified in light of the company’s ability to secure high-margin business and the recent improvement in backlog growth.

Table 17: Estimates and Valuation DSI 2011A 2012A 2013E 2014E 2015E EPS 0.09 0.04 0.08 0.10 0.11 YoY growth 25% -54% 96% 26% 9% EBITDA 255.1 186.0 354.8 372.2 422.2 YoY growth 37% -27% 91% 5% 13% EV/EBITDA 15.0 20.57 10.78 10.28 9.06 P/E 13.11 28.19 14.42 11.41 10.51 Source: BofA Merrill Lynch Global Research Estimates

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Arabtec (XARBF): Underperform – PO AED2.0 Table 18: Key Awards in 2012 & YTD 2013 Peak multiples unwarranted Share in We reinstate coverage on Arabtec with an Underperform rating and a PO of Key contracts awarded in 2012 & Project (AED AED2.0/sh (18% downside potential). We believe the market is overly optimistic 2013 Mn) on earnings growth and is currently factoring in peak-cycle multiples, which we Abu Dhabi Plaza, Astana, Kazakhstan 2,000 view difficult to achieve given the ongoing margin crunch in the sector. Arabtec Fairmont Hotel, Abu Dhabi 1,100 Louvre Abu Dhabi Museum, UAE 800 has recently doubled its equity base to exploit organic and acquisitive growth Saraya Aqaba, Aqaba, Jordan 770 areas, albeit management has not provided detailed guidance on this. We prefer St. Regis Amman, Amman, Jordan 720 being on the target’s side of the equation in an acquisition scenario as the current Arabian Ranches, Dubai, UAE 240 peak multiples the market is pricing in could prompt value-diluting transactions. Aldara Hospital, Riyadh, Sadi Arabia 240 Cedre Villas, Dubai, Dubai, UAE 180 „ Growth over margins: We do not doubt Arabtec’s ability to secure projects Silicon Oasis, UAE 180 Midfield Terminal Building at Abu Dhabi in the region. We believe its new government-owned major shareholder International Airport, UAE 3,600 Abaar will definitely make it easier for the company to secure projects as Phase 2 of Msheireb Downtown Doha, construction activity in the region reaccelerates. However, as Arabtec does Qatar 2,300 not have the same scope as DSI in high-margin segments, we believe most Enabling works at Lakhta Tower, St. of the organic growth will be in low-margin areas (civil projects). This is Petersburg, Russian Federation 450 Arabian Ranches 95 villas and reflected in Arabtec subcontracting part of its MEP awards to DSI on several townhouses, Dubai, UAE 110 projects recently. Our preference is for companies with scope to price in Nile Towers, Cairo, Egypt 275 better margins in the future. 411 villas in Baniyas Residential Development, UAE 425 „ Balance sheet: Arabtec currently has the best cash conversion cycle of the Residential Development, Najmat, Abu three covered GCC contractors, but a growing presence in Saudi goes hand Dhabi, UAE 225 Structural works for Dubai International in hand with an increased exposure to the kingdom’s long collection period. Airport expansion 560 As its current relaxed payable structure seems unsustainable, we believe the Source: MEED, Company Data conversion cycle is likely to increase over the medium term, forcing the company to follow peers in using more leverage to fund working capital requirements.

Chart 22: Lower levels of DSO for DSI „ Valuation: Arabtec has recently doubled its equity and halved its ROEs. We believe the market is too positive on the company’s growth prospects, 300 factoring in mid-to-peak multiples. The stock trades at a 2014E adjusted P/E 250 of 20x, significantly above our fair sector average of 14x and global peers on 200 15x. We believe such a valuation is difficult to sustain in the current weak 150 margin environment. 100 50 Table 19: Estimates & Valuation Arabtec DSI Al-Khodari Arabtec 2011A 2012A 2013E 2014E 2015E Day s of Unbilled rev enues Day s of receiv ables Days payable EPS 0.14 0.09 0.08 0.08 0.11 Source: BofA Merrill Lynch Global Research Estimate YoY growth -42% -37% -14% 8% 31% EBITDA 411.2 389.1 541.8 634.3 734.1 YoY growth -43% -5% 39% 17% 16% EV/EBITDA 15.37 16.24 11.67 9.97 8.61 P/E 17.32 27.52 32.17 29.78 22.72 Source: BofA Merrill Lynch Global Research Estimate

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Al-Khodari (XULLF): Underperform – PO SAR31 Balance sheet risks prompt a discount We reinstate coverage of Al-Khodari with an Underperform rating and PO of SAR31/sh (18% downside potential). Al-Khodari is a pure play on the Saudi construction theme, with a strong history of securing projects in the kingdom. The company’s exposure to unbilled revenue is alarming at close to 263 days or 472 days including receivables compared to 245 days for DSI. Although management is confident on collection, we view the potential of increasing short-term debt to finance working capital as a clear risk to earnings, in addition to the possibility of write-downs.

Chart 23: Al-Khodari’s outstanding unbilled „ Unbilled revenue: Al-Khodari has the longest cash conversion cycle in our revenues are the highest coverage universe. This is mainly due its exposure to Saudi, which tends to have a longer-than-average collection period. Although being a key 500 contractor in Saudi creates strong growth potential, the price for this is 400 greater use of short-term debt to finance working capital requirements. 300 Unbilled revenue as a percentage of sales has increased significantly over 200 the past three years to a historical high. These receivable represent 44% of 100 total market cap. Any disputes between the company and consultants on 0 these projects will result in a considerable amount of provisions, in our view. As an example, a 10% write-down on unbilled revenue has -13% impact on Arabtec DSI Al-Khodari Day s of Unbilled rev enues equity, which suggests the current peak valuation multiples are unjustified. Day s of trade receiv ables Day s current and LT of receiv ables „ Growth vs margins: We see no reason why Al-Khodari will not be able to Days payable secure backlog growth over the next three years. However, we believe that Conv ersion the growth will come at the expense of margins. Al-Khodari’s backlog mix continues to move towards lower-margin projects, which has resulted in a Source: BofA Merrill Lynch Global Research severe decline in margins since 2010. With the majority of awards likely to be concentrated in infrastructure and civil work, we believe margins are likely to be sacrificed to secure growth. Furthermore, there has been increased regularity scrutiny of the Saudi labour market recently; if the authorities enforce tighter employment regulations it could have a significant impact on the company’s costs and therefore margins.

„ Valuation: We believe the company’s current 2014E P/E of 16.2x reflects mid to peak-cycle multiples. Given the risks embedded in Al-Khodari’s balance sheet and the current unsustainable high margins, we believe Al- Khodari should trade at a discount.

Table 20: Estimates & Valuation Al-Khodari 2011A 2012A 2013E 2014E 2015E EPS 3.72 2.54 1.80 2.30 2.79 YoY growth -9% -32% -29% 28% 21% EBITDA 293.2 274.3 253.9 278.4 317.4 YoY growth -15% -6% -7% 10% 14% EV/EBITDA 10.06 10.76 11.62 10.60 9.30 P/E 10.03 14.68 20.68 16.19 13.38 Source: BofA Merrill Lynch Global Research Estimate

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Company financials Arabtec Table 21: Income Statement Income Statement 2007A 2008A 2009A 2010A 2011A 2012A 2013E 2014E 2015E AED in mn unless stated otherwise Revenues 4,273 9,722 7,665 5,464 4,924 5,660 6,221 8,365 9,560 YoY % change 128% -21% -29% -10% 15% 10% 34% 14%

Gross profit 739 1,492 1,327 827 548 576 703 920 1,052 YoY % change 102% -11% -38% -34% 5% 22% 31% 14% Gross margin 17% 15% 17% 15% 11.1% 10.2% 11.3% 11.0% 11.0%

SG&A (293) (586) (785) (449) (446) (485) (460) (611) (660) As a % of sales 7% 6% 10% 8% 9.1% 8.6% 7.4% 7.3% 6.9% Other op. inc./(exp.) 98 167 70 47 37 17 59 79 91 Operating income 544 1,073 611 425 139 108 302 389 483 YoY % change 97% -43% -31% -67% -22% 179% 29% 24% Operating margin 13% 11% 8.0% 7.8% 2.8% 1.9% 4.9% 4.7% 5.1%

EBITDA 664 1,333 925 721 411 389 542 634 734 YoY % change 101% -31% -22% -43% -5% 39% 17% 16% EBITDA margin 16% 14% 12% 13% 8% 7% 9% 8% 8%

Finance costs (4) (24) (56) (42) (34) (42) (48) (52) (56) Other non-operating inc./(exp.) 39 47 76 55 162 123 78 36 43 Profit before tax 579 1,096 631 438 266 190 331 373 470

Taxes (1) (16) (39) (6) (2) (2) (4) (6) (7) Minority interest (42) (122) (97) (124) (42) (49) (89) (110) (126) Net income 535 958 495 307 221 139 238 257 337 YoY % change 79% -48% -38% -28% -37% 71% 8% 31% Net income margin 13% 10% 6% 6% 4% 2% 4% 3% 4%

EPS 0.426 0.763 0.394 0.245 0.141 0.089 0.076 0.082 0.107 Source: BofA Merrill Lynch Global Research, company financials

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Table 22: Balance Sheet Balance sheet 2007A 2008A 2009A 2010A 2011A 2012A 2013E 2014E 2015E AED in mn unless stated otherwise

Cash and cash equivalents 998 850 821 766 839 917 3,587 3,913 4,247 Receivables & prepayments 1,933 4,983 4,678 4,172 3,856 4,145 4,172 5,585 6,522 Due from related parties 126 278 720 724 1,058 1,061 1,061 1,061 1,061 Inventories 184 1,017 648 369 319 203 378 510 583 Other current assets 122 158 149 155 111 162 162 162 162 Total current assets 3,363 7,286 7,016 6,185 6,183 6,487 9,360 11,230 12,574

PP&E 750 1,381 1,363 1,272 1,181 1,108 1,073 1,037 1,025 Goodwill & intangible assets 514 495 448 391 343 293 293 293 293 Other LT assets 214 298 284 832 1,015 1,063 1,063 1,063 1,063 Total LT assets 1,477 2,173 2,094 2,495 2,539 2,465 2,430 2,394 2,381

Total assets 4,840 9,460 9,110 8,680 8,722 8,952 11,789 13,624 14,955

Payables 2,923 5,732 4,847 4,155 3,866 3,930 4,040 5,507 6,375 Current debt 209 1,102 770 627 468 647 467 467 467 Other current liabilities 128 176 384 353 819 572 572 572 572 Total current liabilities 3,261 7,010 6,001 5,135 5,153 5,148 5,079 6,546 7,414

LT debt 20 154 187 110 56 153 333 333 333 Other LT liabilities 171 178 195 332 218 305 305 305 305 Total LT liabilities 191 332 382 442 274 458 638 638 638

Minority interest 138 225 336 404 398 399 488 598 724 Shareholders' equity 1,250 1,893 2,392 2,698 2,896 2,947 5,585 5,842 6,179

Total Liabilities and Shareholders' equity 4,840 9,460 9,110 8,680 8,722 8,952 11,789 13,624 14,955 Source: BofA Merrill Lynch Global Research, company financials

Table 23: Cash Flow Statement Cash Flow Statement 2007A 2008A 2009A 2010A 2011A 2012A 2013E 2014E 2015E AED in mn

Profit before tax 579 1,096 631 438 266 190 331 373 470 Depreciation 121 260 314 297 273 281 240 245 251 Change in working capital 741 (1,462) (887) (290) (77) (222) (92) (78) (141) Other 71 176 339 (84) 41 (32) (4) (6) (7) Net cash from operating activities 1,511 70 397 361 503 217 475 534 573

Capex (314) (868) (300) (222) (195) (288) (205) (209) (239) Other (281) (36) 64 87 70 38 - - - Net cash from investing activities (595) (903) (236) (135) (125) (250) (205) (209) (239)

Net cash used in financing activities (114) 687 (284) (272) - 158 - - -

Net increase/(decrease) in cash 803 (147) (123) (46) 378 124 270 325 334

Cash and cash equivalents at EOY 904 757 634 588 688 812 3,483 3,808 4,142 Source: BofA Merrill Lynch Global Research, company financials

22 MENA Construction 18 September 2013

Drake & Scull Table 24: Income Statement 2009A 2010A 2011A 2012A 2013E 2014E 2015E AED in mn unless stated otherwise Revenues 1,917 1,855 3,110 3,321 5,200 5,850 6,314 YoY % change 11% -3% 68% 7% 57% 13% 8%

Gross profit 388 347 437 383 546 573 631 Gross margin 20% 19% 14% 12% 11% 10% 10%

SG&A (138) (179) (202) (265) (270) (292) (309) Other op. inc./(exp.) (53) (48) (53) (12) (4) - - Operating income 198 120 182 106 272 281 322 YoY % change 40% -39% 52% -42% 157% 3% 15% Operating margin 10% 6% 6% 3% 5% 5% 5%

EBITDA 272 186 255 186 355 372 422 YoY % change 73% -32% 37% -27% 91% 5% 13% EBITDA margin 14% 10% 8% 6% 7% 6% 7%

Finance costs (15) (33) (26) (17) (35) (40) (42) Interest income 83 47 44 34 26 34 12 Other non-operating inc./(exp.) 28 23 18 12 - 15 25 Profit before tax 294 156 219 134 262 290 317

Taxes (1) 5 (11) (19) (45) (27) (32) Minority interest (3) (7) (15) (21) (30) (26) (29) Net income 290 155 193 94 187 236 257 YoY % change 40% -47% 25% -51% 98% 26% 9% Net income margin 15% 8% 6% 3% 4% 4% 4%

EPS 0.127 0.068 0.085 0.041 0.082 0.103 0.112 Source: BofA Merrill Lynch Global Research, company financials

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Table 25: Balance sheet 2009A 2010A 2011A 2012A 2013E 2014E 2015E AED in mn unless stated otherwise

Cash and cash equivalents 1,160 622 525 731 957 1,146 1,383 Receivables & prepayments 1,230 1,429 1,787 1,771 1,700 1,896 1,981 Inventories 13 25 26 27 38 43 47 Other current assets 715 1,197 1,407 2,067 2,067 2,067 2,067 Total current assets 3,118 3,273 3,746 4,595 4,762 5,152 5,478

PP&E 212 250 423 504 530 556 580 Goodwill & intangible assets 822 1,149 1,174 1,136 1,100 1,065 1,029 Other LT assets 249 198 398 194 194 194 194 Total LT assets 1,282 1,597 1,995 1,835 1,824 1,815 1,803

Total assets 4,401 4,871 5,741 6,430 6,587 6,967 7,281

Payables 786 963 1,399 1,518 1,278 1,406 1,449 Current debt 503 787 722 1,209 1,138 1,138 1,138 Other current liabilities 372 525 725 699 699 699 699 Total current liabilities 1,661 2,275 2,846 3,426 3,115 3,243 3,286

LT debt 160 2 106 119 391 391 391 Other LT liabilities 64 51 70 115 132 151 171 Total LT liabilities 224 53 177 235 523 541 562

Minority interest 39 72 32 53 84 110 138 Shareholders' equity 2,477 2,470 2,685 2,716 2,865 3,073 3,294

Total Liabilities and Shareholders' equity 4,401 4,871 5,741 6,430 6,587 6,967 7,281 Source: BofA Merrill Lynch Global Research, company financials

Table 26: Cash Flow Statement 2009A 2010A 2011A 2012A 2013E 2014E 2015E AED in mn

Net income 276 156 219 134 262 290 317 Depreciation 28 33 35 43 47 56 64 Amortization 46 34 38 38 36 36 36 Change in working capital (326) (358) (424) (680) (181) (74) (45) Other (151) 37 48 55 17 33 55 Net cash from operating activities (174) (132) (121) (448) 146 305 391

Capex (16) (61) (135) (125) (73) (82) (88) Other (417) (241) 160 359 26 34 12 Net cash from investing activities (433) (302) 25 234 (47) (48) (77)

Net cash used in financing activities 23 (264) 276 617 127 (68) (77)

Net increase/(decrease) in cash (584) (699) 180 403 226 189 237

Cash and cash equivalents at EOY 743 40 224 182 408 597 835 Source: BofA Merrill Lynch Global Research, company financials

24 MENA Construction 18 September 2013

Al-Khodari

Table 27: Income Statement 2006A 2007A 2008A 2009A 2010A 2011A 2012A 2013E 2014E 2015E SAR in mn unless stated otherwise Revenues 523 1,059 1,159 1,048 1,074 1,189 1,524 1,586 1,929 2,264 YoY % change 10% -10% 2% 11% 28% 4% 22% 17%

Gross profit 113 319 335 295 289 257 225 219 266 310 Gross margin 22% 30% 29% 28% 27% 22% 14.8% 13.8% 13.8% 13.7%

SG&A (39) (45) (61) (59) (59) (82) (89) (98) (118) (135) SG&A as a % of revenue 7% 4% 5% 5.6% 5.5% 6.9% 5.9% 6.2% 6.1% 6.0% Operating income 74 274 274 236 230 175 136 121 148 175 YoY % change 0% -14% -3% -24% -22% -11% 22% 18% Operating margin 14% 26% 24% 23% 21% 14.7% 8.9% 7.7% 7.7% 7.7%

EBITDA 162 399 412 352 345 293 274 254 278 317 YoY % change 3% -15% -2% -15% -6% -7% 10% 14% EBITDA margin 31% 38% 36% 34% 32% 25% 18% 16% 14% 14%

Finance costs (28) (45) (34) (21) (14) (15) (25) (25) (25) (26) Other income 6 4 6 7 12 2 33 2 2 3 Profit before tax 52 233 246 223 229 162 144 98 126 152

Taxes (2) (6) (7) (6) (11) (4) (9) (2) (3) (4) Net income 51 227 240 217 218 158 135 96 122 148 YoY % change 6% -9% 0% -27% -15% -29% 28% 21% Net income margin 10% 21% 21% 21% 20% 13% 9% 6% 6% 7%

EPS 1.19 5.34 5.64 5.11 5.13 3.72 2.54 1.80 2.30 2.79 Source: BofA Merrill Lynch Global Research, company financials

25 MENA Construction 18 September 2013

Table 28: Balance sheet 2007A 2007A 2008A 2009A 2010A 2011A 2012A 2013E 2014E 2015E SAR in mn unless stated otherwise

Cash and cash equivalents 41 90 33 33 71 79 128 163 247 364 Receivables & prepayments 304 340 474 573 696 718 835 673 634 608 Inventories 25 29 27 20 37 73 83 94 114 134 Other current assets - - 7 12 7 28 23 23 23 23 Total current assets 436 547 699 937 1,379 1,824 2,207 2,090 2,156 2,266

PP&E 484 705 628 502 434 519 485 469 462 448 Investments in subsidiaries 4 4 4 4 4 4 4 4 4 4 Other LT assets 0 - 9 7 10 5 8 8 8 8 Total LT assets 488 709 641 513 448 529 498 482 474 460

Total assets 924 1,256 1,340 1,450 1,826 2,353 2,706 2,572 2,631 2,726

Payables 174 225 201 251 250 256 377 307 289 278 Current debt 226 207 172 152 241 527 631 545 556 570 Other current liabilities 55 107 197 6 11 400 302 152 117 91 Total current liabilities 454 539 569 410 501 1,184 1,310 1,004 962 939

LT debt 280 375 396 503 511 408 441 541 552 566 Other LT liabilities 49 25 27 31 226 102 182 186 186 186 Total LT liabilities 329 400 423 534 737 509 623 726 738 752

Shareholders' equity 140 317 348 506 588 660 773 842 931 1,036

Total Liabilities and Shareholders' equity 924 1,256 1,340 1,450 1,826 2,356 2,706 2,353 2,631 2,726 Source: BofA Merrill Lynch Global Research, company financials

Table 29: Cash Flow Statement 2007A 2007A 2008A 2009A 2010A 2011A 2012A 2013E 2014E 2015E SAR in mn

Net income before Zakat 52 233 246 223 229 162 144 98 126 152 Depreciation 88 126 138 114 111 114 130 133 130 142 Amortization - - - 2 3 4 8 - - - Unbilled revenue (30) (21) (70) (142) (268) (360) (210) - - - Change in working capital 39 68 (218) (55) 49 213 (46) (61) (35) (32) Other (13) (10) (23) (9) 1 0 20 (9) (2) (3) Net cash from operating activities 137 396 74 131 121 130 39 161 218 259

Capex (276) (378) (123) (59) (89) (220) (111) (116) (122) (128) Other 38 32 50 68 46 (1) 8 - - - Net cash from investing activities (238) (346) (74) 8 (44) (221) (103) (116) (122) (128)

Net cash used in financing activities 116 0 (57) (140) (39) 99 114 (10) (11) (14)

Net increase/(decrease) in cash 15 50 (57) (1) 38 8 50 34 85 116

Cash and cash equivalents at EOY 41 90 33 33 71 71 128 163 247 364 Source: BofA Merrill Lynch Global Research, company financials

26 MENA Construction 18 September 2013

Balance sheet focus In this note we focus on the balance sheets of the GCC construction companies we cover – DSI and Arabtec (UAE) and Al-Khodari (Saudi Arabia). We address working capital issues, and receivables collection, and what we believe the market is pricing in terms of risks and opportunities.

In summary, the GCC E&C (engineering & construction) companies under our coverage have stretched working capital collection cycles, higher-than-average receivables exposure, and face continuous disputes over historical collection. We believe this is all known by the market and conduct several exercises to determine whether the market is correct in its assessment. The following are our key findings:

1. Arabtec currently has the best cash conversion cycle, but growing its exposure to Saudi will increase its exposure to the kingdom’s long collection period. As its current relaxed payable structure seems unsustainable, we believe the conversion cycle is likely to increase over the medium term.

2. Al-Khodari has the highest exposure to accrued (unbilled revenue/receivables), and relies on short-term financing to fund its working capital requirement. As the company wants to continue growing its Saudi exposure, the interest burden is likely to increase as well, putting bottom-line margins at risk in the short term.

3. The market appears to consider it highly unlikely that DSI will collect its unbilled revenue. An unlikely scenario which if proved wrong, would allow the stock to rerate to new multiple levels.

Unbilled revenue exposure is high: Al-Khodari is the worst Chart 24: Unbilled revenue days outstanding On page 31, we lay out the key elements of each company’s working capital. Unbilled revenue, which relates to completed work yet to be certified by the 300 companies’ consultants, has been accounting for an increasingly higher portion of total receivables for all three companies. The collection period has also stretched 250 out significantly since 2008. While this is largely owing to the growing exposure to 200 Saudi government projects, which tend to have longer collection periods, we 150 believe this exposure is underestimated by the market, specifically Al-Khodari. 100 The increase has been fast for both DSI (200 days) and Al-Khodari (close to 280 50 days). But the latter has recently reached alarming levels that prompts a red flag - in our view. Should disputes arise between the project consultants and the main contractors, the collectability of this account could be at risk. As a proportion of

2006A 2008A 2010A 2012A market cap, Al-Khodari is the most exposed at 60%. Arabtec’s exposure is the least worrying as it only represents 30% of its pre-rights issue market cap. Alkhodari Arabtec DSI Another risk to earnings is the increasing leverage that both Al-Khodari have been using to meet the gap in their working capital needs. Source: BofA Merrill Lynch Global Research

27 MENA Construction 18 September 2013

Chart 25: Exposure to receivables is for companies with higher Saudi Chart 26: The exposure to the Middle East results in higher collection exposure, especially when removing debt from the equation periods due to government delays

150% 80% 500 80% 120% 400 60% 60% 300 90% 40%

40% Days 200 60% 100 20% 20% 30% - 0% 0% 0% GCC South Africa Arabtec DSI Al-Khodari Korea DSO Receivables & unbilled revenue as a % of Mcap (RHS) Trade working capital as a % of market cap* (LHS) DPS Working capital as a % of market cap** (LHS) Net Trade w orking capital as a % of market cap

Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research *trade working capital = Total current & non current receivables – total current & current payables & accruals *trade working capital = Total current & non current receivables – total current & current payables & accruals ** Net Working capital = current assets (includes cash) – current liabilities (includes debt)

Above average cash conversion cycle Chart 27: Days outstanding is highest for Al- When looking at the days outstanding of trade receivables and payables vs Khodari peers, for all three companies, trade receivables are above average with the longest exposure in Saudi. The companies have been matching this long cycle 500 either with the support of debt, at DSI and Al-Khodari, or through stretching 400 payables to above-average limits. Arabtec clearly stands out for stretching payables, with its current trade payables outstanding lasting up to 257 days, even 300 after excluding disputed payables. 200 100 While Arabtec’s cash conversion cycle (CCC) looks the most optimal, we believe 0 this is unsustainable as the reason behind the stretched CCC of DSI and Al- Khodari is their growing exposure to Saudi Arabia. As mentioned above, the high Arabtec DSI Al-Khodari concentration of government projects in Saudi awards is a key driver of the longer Day s of Unbilled rev enues Day s of trade receiv ables collection period. We believe that as Arabtec capitalises on the opportunities in Day s current and LT of receiv ables Saudi, the mix of its receivables will start moving towards the longer days of Days payable outstanding receivables (DSO), increasing its CCC. Also the current payables Total current DSO - DPO cycle that Arabtec enjoys is likely to continue declining as it reverts towards the Source: BofA Merrill Lynch Global Research, Bloomberg regional mean (335 in 2009).

The market is inferring the highest probability of collection To assess what the market is inferring in terms of collection, we run a DCF exercise using simplified growth and margin assumptions for all three companies (highlighted on page 35). When then compare the variance between our FV and market cap with the unbilled revenue outstanding as of December 2012. In our view, the market is assuming a faster collection for Arabtec and Al-Khodari than DSI. This provides rerating potential for DSI as the market implies an unjustifiably weak collection ability.

Table 30: The fair value is below the market capitalisation of all three companies (Mcap as of September 12 2013) Company DCF Equity value Market cap Variance Unbilled revenue As a % of variance (in mn) (in mn) % Absolute (in mn) (in mn) Arabtec (AED) 5,466.3 6,844.1 -20% 1,378 1,947 71% DSI (AED) 1,146.3 1,820.9 -37% 675 2,242 30% Al-Khodari (SAR) 1,226.6 1,811.6 -32% 585 1,137 51% Source: BofA Merrill Lynch Global Research

28 MENA Construction 18 September 2013

GCC E&C companies balance sheet Contractors provide a service (engineering & construction) based on contracts with finite timeframes and set frameworks. Accordingly, the nature of the contractual agreement and the parties involved have a considerable impact on the balance sheet. We look at the following categories of contractors:

„ Main contractors: Although the definition of a main contractor varies across countries, generally it is the party responsible for all aspects of the project, from costing and planning to project management and execution. To bid as a main contractor, a company needs a grade A (or 1) licence in the country in which it operates, which itself requires a certain scale (balance sheet) and scope (experience). The key names in the Middle East that fall into this category are Bin Laden and Saudi Oger in Saudi, Arabtec, DSI and CCC in the UAE, and OCI in North Africa.

„ Subcontractors: A subcontractor is usually hired by the main contractor to carry out certain agreed assignments. Subcontractors are not necessarily small: some are specialists in their field while some lack the grade A (or 1) licence in some jurisdictions needed to be a main contractor. The main contractor on mega projects sometimes takes on sizeable peers as subcontractors because it lacks the capacity to complete the project alone.

In terms of risk, main contactors tend to deal directly with the project owners or Chart 28: NAV breakdown for GCC E&C their consultants, usually limiting their receivables risk to a single party but companies exposing themselves to the liability risk and potential errors of their 15% 9% subcontractors. Balance sheet items 12% Depending on the type of construction work, a generic contracting business tends to be more labour intensive than industrials, which implies a smaller portion of 5% fixed assets in total assets. The largest component on the asset side is usually trade working capital related items, ranging from large items like receivables and unbilled (accrued) revenue to smaller items like inventories. We take a closer look 59% at the key balance sheet items:

Cash Receiv ables* Other C A PPE

Other Non C.A.

Source: BofA Merrill Lynch Global Research, Bloomberg

29 MENA Construction 18 September 2013

Fixed assets: shorter cycles and recurring asset sales In general, an E&C company’s fixed assets are usually machinery, equipment Chart 29: Historical CAPEX as a % of sales and vehicles used for construction work. In addition to temporary workers (GCC vs South Korean E&C companies) accommodation and buildings on construction sites. The life cycle (depreciation) of contractors’ property and equipment (P&E) tends to be significantly shorter than for other industries, ranging from 4-9 years. Capital expenditures related to GCC P&E depends on two major issues: (1) the location of the contractor and/or (2) the (since type of project. If a contractor is awarded several projects in nearby areas, it 2005) could use the same machinery, especially one project ends as another begins. Furthermore, capex is higher in more complex projects, eg in the oil & gas and petrochemicals sectors, which tend to require complicated equipment. Korean Methods of financing capex vary from one producer to the next, but include cash, (since leasing and bank loans. Usually a company assesses P&E requirements during 2000) the bidding stage; once a contract is awarded the contractor receives an advance payment from the project owner ranging from 10-20% of the contract size. This is 051015 usually used to finance part of the capital expenditures and the initial working capital requirements. If a contractor already has nearby idle machinery it can use, a higher portion of the advance payment is usually devoted to working capital Source: BofA Merrill Lynch Global Research, Datastream requirements.

The short depreciation cycle of these assets usually results in frequent asset sales by E&C companies. The general trend in the region is that a special assets team or committee assesses the durability of these items; once a sizeable portion of the assets is fully depreciated, the company holds an auction. The size of the auction obviously depends on the nature of previous projects as complex projects tend to end up with large auctions, due to their asset intensity. Sizeable auctions tend to recur every 3 to 4 years for contractors that operate in different scopes.

Chart 30: DSI proceeds from fixed assets Chart 31: Arabtec proceeds from fixed assets Chart 32: Al-Khodari proceeds from fixed sales as a % of sales sales as a % of sales assets sales as a % of sales

0.40% 2% 8%

0.30% 6% 1% 0.20% 4% 1% 0.10% 2%

0.00% 0% 0% 2006 2008 2010 2012 2006 2008 2010 2012 2006 2008 2010 2012

DSI Arabtec Alkhodari

Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Datastream

30 MENA Construction 18 September 2013

Working capital: it’s all in the detail Working capital cycles and collection periods tend to vary by project type/ sector/country. For example, oil & gas projects tend to be more complex with longer timeframes than civil projects. Even within a single sector the complexity of the project results in different collection periods depending on the type of deliverable. A metro project with routes above or underground would have a different lifespan for its different routs. As an example, the underground lines are more complex and even more expensive than above ground routes and the timing spent underground also tends to be higher than above the ground. These factors tend to usually result in long outstanding days for receivables and payables. There are times where this would be a concern, especially if financing payables is being done through debt or debt-like items rather than internal funding.

A normal cycle does not require external financing The best practice is that a contractor would never depend on leverage to finance its regular trade working capital requirements. In an ideal scenario, once the bidding process is complete, it takes two to three weeks before an award letter is granted and contracts are signed. Once the site is received, the project owner, in many cases the government, grants a pre-payment to the main contractor ranging from 10-20% of the total project cost, which ends up as a liability on the construction company’s balance sheet that is amortised gradually throughout the project. Upon completion of the different phases of the project and before issuing any bills, the contractor debits its balance sheet with unbilled revenue and records revenues accordingly. The amount recorded is equal to the percentage complete times the contract’s price tag.

The consultant then assesses the deliverables and submits its approval, only then does the contractor issue the invoice, and the amount is then credited from the unbilled revenue account and debited under receivables. The consultant then makes the necessary payments in accordance with the bills issued, which takes approximately 15-25 days. However, 10% of the contract cost (phases cost) is retained by the project owner (or consultant) until the project is complete, handed over, and tested for a lockup period (a year in most cases). Once the project is finished, a final invoice is issued and approved, and the project site is delivered to the owner. The consultant then releases the retention, if everything has gone according to plan. In theory, as work is delivered, consultants approve and pay their bills, resulting in a full working capital cycle that does not require external financing.

31 18 September 2013 2013 September 18 32 Exhibit 1: GCC construction projects working cycle

Pre-Bidding Post bidding

Key stages Timeline Financing: Other:

- Feasibility study - +/- 6 Months - Pre-payments - Purchase agreements of new assets - Design and Drawings - +/- 12 months - Bank loan Stage 1 - submitting of visas to import labor - FEED - 6 – 18 months - Quotations & Bidding - 6 – 9 months

Assets mobilization and initial payments - Upon receiving the award letter, the contractor Impact on balance sheet:

receives the site and initiates the mobilization process - Machinery and equipment are inflated by the new asset purchases Construction MENA (staff, assets etc). Stage 2 - The project owner grants a prepayment ranging Prepayments: between 10-20% as a means to finance the - Amortized throughout the project each time invoices are issued through working capital usage. Or contractor’s initial working capital requirement. amortized immediately if all the funds are used for fixed assets purchases (rarely happens). 1-3 months

Execution - Upon completion of the different project phases and before issuing any bills, the contractor debits its balance sheet with unbilled revenue and records revenues accordingly. The amount recorded is equal to the percentage of completed work times the project’s price. - Upon receiving the approval of the consultant for the completed work, the contractor issues the invoice (which generally takes around 25-30 days to be approved) and credits the unbilled revenue account and debits its receivables. Stage 3 - The consultant then makes the necessary payments in accordance with the billed issued, which takes approximately 15-25 days. However, 10% of the contract cost is retained by the project owner (or consultant) until the project is complete handed over and tested for 1 year. - Once the project is complete, a final invoice is issued, approved and the project site is delivered to the owner. After testing the site for a single year, the consultant then releases the retention if everything goes as planned. 30-46 months

Source: BofA Merrill Lynch Global Research, MEED, Company

MENA Construction 18 September 2013

What raises a red flag? A key concern regarding this cycle for GCC E&C companies is the length of unbilled revenue (accrued revenue) and the aging of the receivables. Unbilled revenue is a current asset that relates to work carried out and but yet to be approved by the client or consultant. In our view, there are two aspects that govern the collection period and aging of these items on the balance sheet:

Client orientation and specification issues Project owners tend to be divided into three categories in the region:

„ Government entities: This includes a broad range of entities, from ministries to fully state-owned companies. Examples include Saudi Aramco and Qatar Petroleum.

„ Semi state-owned companies: This comprises listed or private companies with a large government stake, such as SABIC, EMAAR and Saudi Maaden.

„ Private sector companies: This classification varies significantly from one sector to another and depends on the project owner’s size and field of work.

When it comes to unbilled revenue, there are two key reasons behind delay in collection. First, bureaucracy at the project owner (client), which can significantly delay collection and usually relates to the first two categories. These entities tend to have lower solvency issues and as the relationship with them is crucial for backlog growth, contractors tend to be very patient.

Second, if the project owner’s consultant disputes the deliverables or output with the contractor, which then lengthens the collection period. The roots of these problems start at the tendering phase. A lack of clarity in the RFPs (request for proposals) tends to result in E&C companies underestimating the costs associated with the project. This causes some contractors to misprice the contract and find short cuts later on to maintain the profitability of the project. This comes at the expense of quality and leads to disputes over the deliverable. Which effectively results in prolonged aging of the unbilled account on the balance sheet.

Solvency issues If the project owner faces difficulties in paying its suppliers, ie, the contractor, it usually leads to write offs by the contractor or restructuring of payments/court disputes. At this stage, contractors would start provisioning for these receivables as collection is looking increasingly unlikely.

33 MENA Construction 18 September 2013

Unbilled revenue, a potential risk? Chart 33: GCC collection periods to tend be the In the GCC, receivables and unbilled revenue aging are among the highest in the highest as most of the project owners in the region and compared with South Korean E&C companies. We attribute this partly region are government entities to the high contribution of government projects in the backlog mix, which as 400 80% mentioned above, tends to have a longer-than-average cash conversion cycle. However, disputed receivables and payables prolong the working capital cycle of 300 60% the three companies. We now take a closer look at each of the company’s receivables and unbilled revenues: 200 40% Days 100 20% Collection is longest for Al-Khodari, Arabtec’s disputes are the highest We assess the aging and cash conversion cycle of the three companies under - 0% coverage. First, we separate unbilled revenue from total receivables and calculate the conversion cycle with the disputed assets and liabilities; we then remove the GCC South Africa Korea disputed assets and finally we assess if the company is using debt to finance its DSO working capital requirements. DPS When looking at receivables without unbilled revenue, ie, only factoring in Trade w orking capital as a % of market cap amounts due from clients for construction work certified by the consultants,

Source: Source: BofA Merrill Lynch Global Research Arabtec tends to have the most effective conversion cycle of the three *trade working capital = Total current & non current receivables – total current companies. Although Arabtec’s payables are stretched when compared with the & current payables & accruals other two names, the days of trade receivables outstanding, including the Meydan

disputed amount of AED551, shows that it takes around 106 days to collect receivables and 231 days including unbilled revenue. Even when we include LT receivables the DSO is 310. Al-Khodari stands out as the worst on this comparison, with the highest conversion cycle (286 days) and highest days outstanding for all balances. This requires the company to secure debt to finance its working capital requirements, which consider as unsustainable.

Chart 34: Days outstanding is highest for Al-Khodari

500 400 300 200 100 0 Arabtec DSI Al-Khodari Day s of Unbilled rev enues Day s of trade receiv ables Day s current and LT of receiv ables Day s pay able Conv ersion

Source: BofA Merrill Lynch Global Research, Company financials

When we adjust Arabtec’s longer-than-average days payables for disputes it moves close to that of DSI, putting it close the UAE average. However, as Arabtec enforces its operation in the fast-growing Saudi market will increase its exposure to the kingdom’s long collection period. As its current relaxed payable structure seems unsustainable, we believe the conversion cycle is likely to increase over the medium term.

34 MENA Construction 18 September 2013

Chart 35: Arabtec has the best cash conversion cycle Chart 36: Exposure to receivables is highest companies with higher consternation in Saudi especially when removing debt from the equation 300 250 150% 80% 200 120% 60% 150 90% 40% 100 60% 50 30% 20% Arabtec DSI Al-Khodari 0% 0%

Day s of Unbilled rev enues Day s of receiv ables Days payable Arabtec DSI Al-Khodari Receivables & unbilled revenue as a % of Mcap (RHS) Trade working capital as a % of market cap* (LHS) Source: BofA Merrill Lynch Global Research Working capital as a % of market cap** (LHS)

Source: BofA Merrill Lynch Global Research *trade working capital = Total current & non current receivables – total current & current payables & accruals ** Net Working capital = current assets (includes cash) – current liabilities (includes debt)

Disputes likely to be around for a while Arabtec In Q4 2009, Arabtec booked an increase in allowances for doubtful accounts of AED229.3mn, or 6% of the trade and other receivables balance. Approximately 46% of contract and trade receivables (AED1,318mn of AED2,288mn) were past due but not impaired. No provisioning related to these past due receivables was booked as the company considered these amounts recoverable. Also included in these receivables is AED1.4bn related to the Meydan dispute. As of 2012, only 34% of total receivables were past due and not impaired. The Meydan dispute amount has gone down to AED552.4mn, the company has around AED345.2mn related to the Nad Al Sheba racecourse project. Our forecast does not account for the risk of a receivables write-down of past due balances or a write-down on the Meydan project. However, we believe their collection is likely to be prolonged and that a favourable settlement would only be tied to a broader Dubai recovery. When assessing these receivables, the amount due represents 12% of Arabtec’s post rights issue market cap and when netting the receivables with the associated payables it comprises around 5% of the company’s market cap.

Drake & Skull DSI has already filed arbitrations with certain clients for settlement of part of their receivables and retentions for a total AED135.5mn. This relates to projects that were completed and handed over (unbilled revenue). According to the company’s financial statements, the outcome of the arbitrations is uncertain. Management is of the opinion that the balances are fully recoverable. The company has not provided for any of these receivables as of yet. These receivables comprise 7.4% of the company’s market cap.

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What is the market inferring? To assess what the market is inferring, we derive each company’s fair value using simple DCF assumptions applied across the three companies:

„ Growth: We assume a revenue CAGR of 2x GDP growth. This implies 7% for DSI and Arabtec and 8% for Al-Khodari. We then apply a terminal growth rate of 3% in both countries.

„ Margins: We assume margins decline to closer to those of South Korean E&C companies. We use a terminal operating margin of 3.5% and 4.8% for Arabtec and DSI (the latter’s is higher owing to its specialised business focus). We assume Al-Khodari remains the most profitable in the region, as SG&A costs in Saudi are likely to stay low, and the higher awards forecast suggests stronger pricing power for Saudi contractors.

„ Capex: We expect capex to remain around historical averages and then move to above-depreciation levels to accommodate the high growth.

„ Discount rates: We use a beta of 1, a risk free rate of 5% and an equity risk premium of 6% for the three companies. We use a target capital allocation of 75% equity for all three. Finally, we use each company’s effective tax rate.

„ Working capital: We assume the change in working capital would be close to each companies’ historical levels, with no major collection of the outstanding items.

Findings: market is putting a price tag on unbilled revenue We believe the market is assuming a Our assumptions imply a relatively aggressive growth outlook partly offset by lower potential for DSI to collect its lower pricing (margins), which we consider reasonable for the region. However, receivables, providing potential rerating even under these assumptions, our DCF analysis for all three companies yields a upside if proven otherwise lower-than-market fair value. We believe the only item that the DCF omits is unbilled revenue on the balance sheet. This distorts the DCF analysis, in our view, as the companies use leverage to fund the longer-than-average working capital cycle. We then compare the difference between our fair value and the current market price and divide by unbilled revenue to assess how much the market is implying on collection. In our view, market confidence is highest for Arabtec, followed by Al-Khodari and finally DSI.

Table 31: The fair value of the three companies are all below the market capitalisation of all three companies (Mcap as of September 12 2013) DCF Equity value Market cap Variance Unbilled revenue As a % Company in mn In mn % Absolute In mn of variance Arabtec (AED) 5,466.3 6,844.1 -20% 1,378 1,947 71% DSI (AED) 1,146.3 1,820.9 -37% 675 2,242 30% Al-Khodari (SAR) 1,226.6 1,811.6 -32% 585 1,137 51% Source: BofA Merrill Lynch Global Research

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Table 32: DCF inputs Arabtec DCF 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E CAGR 13-22 Sales 6,056 6,480 6,934 7,419 7,938 8,494 9,089 9,725 10,406 11,134 7.0% YoY % Change 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% Operating Profit 303 323 344 367 391 416 444 389 364 390 13.7% YoY % Change 180% 7% 7% 7% 7% 7% 7% -12% -6% 7% Operating Margin 5% 5% 5.0% 4.9% 4.9% 4.9% 4.9% 4.0% 3.5% 3.5% Capex as % of depreciation 95% 96% 96% 97% 97% 98% 98% 99% 99% 99.50% Capex as % of rev 2%2%2%2%2%2%2%2%2%2% Tax rate as % of EBIT 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% WC as % of change in sales -2% -2% -1% -1% -1% -1% 0% -1% 0% 0% Unlevered Free Cash Flow 171 181 249 293 338 363 404 339 332 352 5,400 YoY % Change -183% -35% 111% 35% 18% 4% 0% 5% 15% -2% Total Equity Value 5,466 Equity Value Per Share 1.74 DSI DCF 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E CAGR 13-22 Sales 5,314 5,447 5,583 5,723 5,866 6,012 6,133 6,255 6,380 6,508 7.0% YoY % Change 60% 2.5% 2.5% 2.5% 2.5% 2.5% 2.0% 2.0% 2.0% 2.0% Operating Profit 266 271 277 283 289 295 299 304 309 314 11.5% YoY % Change 152% 2% 2% 2% 2% 2% 2% 2% 2% 2% Operating Margin 5% 5% 5.0% 4.9% 4.9% 4.9% 4.9% 4.9% 4.8% 4.8% Capex as % of depreciation 95% 96% 96% 97% 97% 98% 98% 99% 99% 99.50% Capex as % of rev 2%2%2%2%2%2%2%2%2%2% Tax rate as % of EBIT 18% 18% 18% 18% 18% 18% 18% 18% 18% 18.30% WC as % of change in sales -4% -3% -2% -2% -2% -1% -1% -1% -1% -0.51% Unlevered Free Cash Flow 5 58 113 122 139 191 216 219 221 224 2,943 YoY % Change -96% -229% 171% 44% 26% 41% 15% 2% 2% -12% Total Equity Value 1,146 Equity Value Per Share 0.73 Alkhodari DCF 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E CAGR 13-22 Sales 1,646 1,777 1,920 2,073 2,239 2,418 2,612 2,820 3,046 3,290 8.0% YoY % Change 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Operating Profit 148 160 172 185 200 215 222 231 244 247 6.1% YoY % Change 9% 8% 8% 8% 8% 8% 3% 4% 5% 1% Operating Margin 9% 9% 9.0% 8.9% 8.9% 8.9% 8.5% 8.2% 8.0% 7.5% Capex as % of depreciation 95% 96% 96% 97% 97% 98% 98% 99% 99% 99.50% Capex as % of rev 8% 8% 8% 8% 8% 7% 7% 7% 7% 7% -0.7% Tax rate as % of EBIT 7% 7% 7% 7% 7% 7% 7% 7% 7% 6.76% WC as % of change in sales -4% -3% -2.1% -2.0% -1.7% -0.9% -1% -0.50% -0.50% -0.51% Unlevered Free Cash Flow 78 101 127 138 153 184 198 205 214 215 3,245 YoY % Change -72% -353% 62% 15% -13% 39% 19% 21% 3% -6% Total Equity Value 1,227 Equity Value Per Share 23.09 Source: BofA Merrill Lynch Global Research Estimates

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Margin analysis EBIT margins for GCC E&C companies have dropped considerably since 2008 in most countries in which they operate. We believe this was driven by: (1) aggressive bidding from local and international companies to secure backlog growth; (2) fewer project awards in the Middle East post the financial crises; (3) regulation changes that affected labour costs in the region post the Arab Spring, especially in Saudi Arabia; and (4) changes in the awards mix to include more lower-value civil projects.

Competition pressures margins Among the key drivers of profitability are Award activity has not been immune to the slowdown caused by the financial the pace of order book growth and the crises, meaning that aggressive bidding to secure projects between 2009 and level of competition. 2012 led to a fall in margins. For example, to secure backlog growth, DSI focused heavily on civil construction, which generates lower margins than its traditional MEP work. Also, higher margins have led to an increase in foreign contractors, which lowered the pricing power of many local contractors. Even within the region itself, weaker activity in the UAE drove local companies to bid heavily in Saudi to secure volume growth, which resulted in lower margins for Saudi contractors.

Chart 37: Saudi, Qatar and UAE awards were Chart 38: Overseas new orders of Korean Chart 39: Overseas new orders of Korean down by 27% in 2012 since 2009 peak E&C companies increased heavily in MENA E&C companies competed in most segments

Aw ards ($bn) Grow th (USD mn) (USD mn) 80,000 80,000 160 140 130 60,000 60,000 110 115 111 110% 120 114 111 94 100 88 40,000 40,000 60% 80 20,000 20,000 60 40 10% 0 0 20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 0 -40% ME Asia Africa South America EU North America & Pacific Refineries Gas Petrochem, Chemicals Power Infra Building Others 2005 2007 2009 2011 Source: MEED Projects, BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research

Chart 40: GCC margins revering to global Chart 41: EBIT Sector average at lowest Chart 42: Margin pressure persists average levels 14.7% 20% 16.0% 9% 14.0% 11.1% 15% 12.0% 7% 10.0% 6.4% 10% 5% 8.0% 5.9% 6.0% 3.7% 4.5% 5% 3% 4.0% 2.0% 1% 0% 0.0% 2006 2008 2010 2012

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Arabtec Drake & Alkhodari DM Av g Sector Av g Scull EM Av g Middle East Av g 1+Stdev 1-Stdev 2011 2012

Source: BofA Merrill Lynch Global Research Estimates, Datastream Source: BofA Merrill Lynch Global Research, Datastream Source: BofA Merrill Lynch Global Research, Bloomberg

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Margins to improve on healthier award activity In our view, gross profit margins are driven by the health of the market’s order book pipeline. Bidding becomes less aggressive in times of high project tenders and awards, as the contractors have more project choice and greater pricing power. Due to the short time frame of available data on MENA construction companies, as the majority are privately held, we plot three of the UAE’s net income margins vs awards activity in the region, we see higher margins during active time periods. Our Asian E&C team also plotted Japanese construction companies’ margins vs new orders. As the chart shows, profitability tends to move in tandem with the growth in total orders.

Chart 43: UAE project awards vs Arabtec and DSI net income profit Chart 44: Chiyoda’s total orders and OP margin (%) margins (%) 1,000,000 (mn of Yen) 10 70 14% 800,000 8 60 12% 50 10% 600,000 6 40 8% 400,000 4 30 6% 20 4% 200,000 2 10 2% - 0 0 0% 2004/3 2005/3 2006/3 2007/3 2008/3 2009/3 2010/3 2011/3 2012/3 2006 2007 2008 2009 2010 2011 2012 Total orders Oper margin (%) Aw ards NI Margin Source: BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

As we expect increasing award activity in 2014-15 (please refer to page 45 for more details on growth), we believe the companies will be able to enhance their gross profit margins through better pricing over the next two years.

Employment regulation changes a key risk to EBIT margins A key reason behind the region’s declining EBIT margins is the ongoing changes in labour regulations, which are having a severe impact on staff costs. Employment in most GCC countries follows a sponsorship system (Kafallah) where the employee is sponsored by and beholden to the employer, this had resulted in the ability to import cheap labour and maintain their cost at very low levels. Stricter employment rules are being imposed in several countries in the region, mainly requiring companies to employ a higher proportion of locals. Saudi Arabia is the most active on this front as it tries to meet its rising employment needs. The first Saudi regulation was points programme Nitaqat, which colour- codes companies based on their ‘Saudiization’ rate (percentage of Saudis of total employees). When a company falls under the red category, it is prevented from importing foreign labour. This has driven many companies to hire more local workers. Construction is a blue-collar intensive industry that has historically depended on migrant workers as it has been hard to attract Saudi workers in light of the low pay it offers. Therefore, companies have had to increase wage levels to meet the government’s hiring requirement.

Another development was the imposition of the SAR2,400 fee last year. This regulation requires companies to pay SAR2,400 annually for each foreign

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employee if they outnumber Saudi workers. Another potential cost increase related to the change of the Saudi weekend in the private sector, which will also have an impact on the costing of projects in the current backlog. Currently, private companies work six days a week, but the government is planning to cut this to five days. Hence, should a company exceed the five-day limit it would have to pay overtime. For projects priced on a six-day-week cost base, this would have a significant impact on margins.

Even when looking at other countries in the region, governments like Dubai are now imposing an annual health care card of AED500, which in theory seems small but is decent enough for labour intensive businesses. Finally another angle that companies are facing is the difficulties to import labour from the usual countries like Egypt, Syria and Lebanon. As the political tensions in those countries have forced most GCC countries to stop issues residency permits at some point for the nationals off these countries.

What is the market inferring for overall margins? In order to get a better understanding of what market is assuming, we back out the margins implied by the current share price. We use a three-pronged approach (1) long-run forward PE multiple of 14.1x to derive earnings; (2) we then move backwards through the below operating line using the company’s respective tax and minority interest rates; and (3) the pre-rights issue book value for Arabtec (ie, we adjust the current book value by subtracting the AED2.4bn raised).Our analysis indicates that the market is inferring that Arabtec and Al-Khodari’s margins will revert towards their historical averages. Which we think is difficult to achieve given the structural changes in staff cost the region is facing and the increasing competition from foreign companies. Although we see room for improvement on the back of better awards activity, we believe these levels are too aggressive given increasing competition and greater focus on civil construction by most companies, which has a lower margin mix than the companies’ historical levels. DSI is the only company the market expects no margin improvement what so ever, a scenario we believe is unlikely if awards activity is to pick in the region.

Table 33: DSI is cheaply valued by the market Chart 45: DSI looks the most attractive Arabtec DSI Al-Khodari 13.0% Share price 2.44 1.18 37.30 14.0% 12.0% 10.6% Share in issue 3140 2285.0 53.1 9.0% 10.0% 8.0% 8% 7.0% Equity value 7660.38 2696.30 1981.56 8.0% 4.8%4.8% Fair Multiple 14.1x 14.1x 14.1x 6.0% 4.7% Attributable earnings 543.3 191.2 140.5 4.0% Minorities 150.0 26.0 0.0 2.0% 0.0% EAT 693.3 217.2 140.5 Arabtec DSI Al-Khodari Tax 7.6 27.2 14.4 Interest paid/ (received) 48.0 35.0 25.0 Implied EBIT margin BofA ML margin Long run Margin av g EBIT 749.0 279.4 180.0 Revenue - BofA ML foreca 8364.6 5850.0 1703.5 Source: BofA Merrill Lynch Global Research Estimates Implied EBIT margin 9.0% 4.8% 10.6% Long run margin average = historical long run average BofA ML margin 4.7% 4.8% 8% Long run Margin avg 7.0% 8.0% 13.0% Source: BofA Merrill Lynch Global Research Estimates

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Macro outlook Jean-Michel Saliba Top-down, we are most comfortable on Saudi Arabia and Qatari macro, which we +44 20 7995 8568 see outperforming in terms of growth, liquidity and fiscal dynamics. While hydrocarbon-sector growth has tapered off, non-oil GDP growth is likely to stay solid and fastest in Qatar, followed by Saudi. The UAE is staging a moderate and gradual recovery from its excesses, and the 2020 Expo bid provides upside risk. GCC breakevens remain sticky at US$80/bbl, though still provide cushion.

Saudi Arabia – fiscal expansion supports growth The Saudi government has issued a solidly expansionary budget for 2013, the highest on record, which should support both consumption and investment growth in our view. Both government spending and economic growth appear to have been above our expectations in 2012, and, along with an another upward revision to growth outturns for 2011, bode well for continued strong momentum in the economy. Government spending remains affordable as our preliminary spending projections for 2013 place the fiscal breakeven oil price at cUS$80/bbl. Nevertheless, fiscal flexibility space has decreased given the budget rigidities related to Arab-Spring induced permanent current spending (the budget breakeven was US$41/bbl in 2008).

2013 expenditures are conservatively projected at SAR 820bn for a budgeted surplus of SAR9bn. Capital expenditures are budgeted at SAR285bn (7%yoy) and current expenditures are thus budgeted at SAR535bn (25%yoy), a reflection of the Arab Spring increase in current spending. We see room for expenditures to grow 6% in 2013 to just north of SAR900bn, leading to overspending of 10% versus budgeted levels. As per previous budgets, the largest appropriations of government spending, apart from the defense sector, will be the education sector (SAR204bn budgeted), health and social affairs (SAR100bn budgeted) and infrastructure and transportation (SAR65bn budgeted) .

In total, three factors to note: 1) current expenditures are likely to remain at record levels, a reflection of the Arab Spring increase in social spending (increases in salaries, unemployment program); 2) capital expenditures are likely to remain solid and we expect steady progress on housing appropriations; and, 3) the Specialized Credit Institutions have been budgeted to disburse SAR68.2bn in loans in 2013, the second largest appropriation after the 2012 one, and should stimulate further the Saudi consumer and non-oil economy.

Chart 46: Budgetary practices more realistic, but still conservative Chart 47: Government projects signed with the private sector – increased involvement in procurement and contracting Budgeted spending Ov erspending SARbn Number Value (SARbn, rhs) 900 50 3,500 200 800 Ov erspending (%, rhs) 40 3,000 700 150 600 30 2,500 500 2,000 20 100 400 1,500 300 10 1,000 200 50 0 100 500 0 -10 0 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Haver, MoF, SAMA, BofA ML Global Research. Source: MoF, BofA ML Global Research.

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Qatar – defensive from a top-down macro perspective We view Qatar as defensive from a top-down macro perspective in terms of growth, fiscal and liquidity dynamics. Qatar’s heavy investment in vertically integrated LNG infrastructure, location, cost advantage and economies of scale have allowed it to become the world's largest LNG exporter, enjoy a decade of double digit real GDP growth and boast the world's second highest GDP per capita (US$98,144/person).

Growth is likely to hover around 5%+ over the next few years, led by the non- hydrocarbon sector (average non-oil growth of 10% in 2012) supported by expansionary government spending policies. Likewise, fiscal and current account surpluses (11.8% and 30.1% of GDP in 2012e) will likely remain sizeable over the medium-term, though erode slowly given the high-import content of capital expenditure plans.

The introduction of multi-year fiscal budgeting is likely to ensure visibility and delivery of the medium-term capex pipeline, with World Cup 2022 related spending to gradually increase over the period. Note that the planned US$65bn in infrastructure spending slated for the World Cup represents c.80% of completed projects in Qatar since 2002, and 33% of 2012f GDP.

The FY2014 budget underpins robust stimulus to consumption and investment growth, in our view. While capex spending appears to have undershot its target in FY2013, we view the large subsequent FY2014 appropriation as highlighting the government’s drive to meet its large medium-term infrastructure plans. Expenditures are budgeted at QAR210.6bn (up 18% yoy on the initial FY2013 budget) while revenues are projected at QAR218.1bn (up a meager 5.7% yoy on the FY2013 budget). The budgeted oil price assumption remains conservative, at US$65/bbl.

In our base case scenario, shale gas would not put pressure on LNG pricing and traditional oil-linked contracts as US exports remain limited by political and economic reasons. We estimate a 40% drop from forecast hydrocarbon price levels to US$66/bbl and US$6.6/mnBTU would essentially wipe out our projected FY14 fiscal surplus. Modelling the tail risk of an isolated sustained 40% drop to Qatari LNG export prices, we find this would still leave medium-term capex plans broadly affordable with projected small fiscal surpluses, in our view.

Chart 48: Higher oil prices, LNG revenues have increased fiscal space Chart 49: Higher proportion of capex likely in coming years QARbn QARbnCapital ex penditure % 250 Oil and gas rev enues Inv estment rev enues 180 Other current ex penditure 45 Salaries and w ages Other rev enues 160 capex as % of total spending (rhs) 40 200 140 35 120 30 150 100 25 80 20 100 60 15 50 40 10 20 5 0 0 0 FY75 FY77 FY79 FY81 FY83 FY85 FY87 FY89 FY91 FY93 FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY75 FY77 FY79 FY81 FY83 FY85 FY87 FY89 FY91 FY93 FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY13e FY13e

Source: Haver, QCB, IMF, BofA Merrill Lynch Global Research. Note that the drop in investment income from Source: Haver, QCB, IMF, BofA Merrill Lynch Global Research. Capital expenditure is proxied by major public Qatar Petroleum (QP) in FY11 is due to QP retaining QAR25bn of its profits to increase its capital. sector projects spending chapter

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Dubai - steadily recovering from the excesses The UAE is staging a moderate and gradual recovery from the excesses that led to the 2009 bust. Recovery is helped by still high oil prices, some support from the external sector, accommodative monetary policy, a gradual drag form real estate sector, progress on GRE restructuring and a mild fiscal consolidation drive. The wave of maturing restructured debt from 2015 on (Dubai World, Nakheel) is the challenge, but there is little visibility and enough time for now. The key risks are a deterioration in the global liquidity conditions, as well as potential further GRE bailouts that would shift liabilities to the sovereign balance sheet.

Overall, Dubai has shown an ability to grow again, with a respectable 4% pace easing deleveraging strains, and a perception the real estate market has bottomed and undergoing a V shape recovery in some segments. Following ICD’s refinancing, we expect the remaining important 2013 maturities (Borse Dubai) to be met, Dubai Group restructuring to progress slowly and a chance Dubai makes a modest payment on its US$20bn Abu Dhabi debt to buoy sentiment.

Little filtrated from Dubai World’s progress on asset sales to meet its US$4.4bn March 2015 loan. This maturity is a key one in the overall Dubai Inc structure. On current trends, the key question to monitor for maturities from 2015 onwards will be asset sales, we believe. That has been largely missing up until now. Questions remain on the likelihood, structure or necessity of repeat bailouts (Nakheel, etc).

In the event of the 2020 Expo bid being won in November, we expect the award activity pipeline to show strong improvement. The UAE mentions plans to invest AED25bn through the development of comprehensive infrastructure-related areas of the exhibition. While a number of recently announced projects have failed to materialize, a win would provide a firm deadline and new impetus, we think. We would expect a material boost to growth through increased tourist flows and consumption around the timeline of the event taking place, should the bid be won. The main downside risk remains regarding funding of the projects, particularly as a number of these projects are likely to be funded through the Dubai sovereign balance sheet, delaying capex rationalization and fiscal consolidation.

Chart 50: Dubai government debt dynamics are more contained on Chart 51: Dubai tourist arrivals are posting a strong showing growth recovery mn Passengers Freight (rhs) 000' tons % of GDP GRE bailout Interest, grow th shock 6.5 220 70% Ambitious consolidation AD equitization 6.0 Baseline 200 60% 5.5 50% 5.0 180 4.5 40% 4.0 160 30% 3.5 140 20% 3.0 10% 2.5 120 0% Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- 2005 2007 2009 2011 2013 2015 2017 2019 2021 09 09 10 10 11 11 12 12 13 13

Source: IMF, DoF, ENBD, Dubai prospectus, BofA Merrill Lynch Global Research. Source: Dubai Airport, BofA Merrill Lynch Global Research.

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Abu Dhabi - safe and sound Gradual fiscal consolidation is bringing the Abu Dhabi central government fiscal oil breakeven price lower, after the spike due to exceptional support to Dubai, banks and government-related entities (GREs). This should then allow capital spending to gradually increase while lowering the current elevated central government fiscal breakeven oil price of cUS$100/bbl. The new debt management policy institutionalizes an oversight framework and does not represent a shift in the sovereign support to strategic GRES, in our view. This is especially so after the announced large capital projects that underscore the emirate’s commitment to its diversification drive.

Over the last decade, the Government of Abu Dhabi has taken on an active diversification and liberalisation strategy to reduce the UAE’s reliance on the hydrocarbon sector as its single major revenue source. The strategy focuses on three core principles: 1) an economy-wide effort to raise productivity, including through privatisation and public/private partnerships; 2) development of a high- end tourism market; and, 3) diversification within the oil and gas sector with a focus on downstream activities, and into other manufacturing and industrial activities.A significant element of Abu Dhabi’s long-term economic strategy involves expansion of the Emirate’s industrial base, including building basic, export-oriented large-scale industries closely linked to Abu Dhabi’s oil and gas resources and of strategic importance to Abu Dhabi and the UAE in general, including hydrocarbon-based chemicals and basic metal industries, such as aluminium and steel.

While the lack of recent budgetary data on Abu Dhabi prevents an accurate assessment of the underlying fiscal stance, note that after a review of the project pipeline, the Abu Dhabi Executive Council approved a number of large development projects in January 2012 and 2013. The latter announced AED330bn would be injected in capital projects over 2013-17, including through building projects, housing loans for nationals, as well as continued focus on transport, infrastructure and diversification ventures. The IMF suggests central government subsidies and transfers increased while capital expenditures were reduced last year, and we expect on-budget capital expenditures to remain in check this year as project execution will largely be carried by the broader public sector.

Chart 52: Abu Dhabi government fiscal oil breakeven price has soared Chart 53: Capital contributions to GREs rise with diversification drive

30 Breakev en oil price (US$/bbl, rhs) 120 AEDbn IPIC Mubadala TDIC 60 100 20 50 Fiscal balance (% of GDP) 80 10 40 60 30 0 Brent (US$/bbl, 40 20 -10 rhs) 20 10

-20 0 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2012f 2014f Source: IMF, DoF, BofA Merrill Lynch Global Research. Source: Annual reports and prospectuses, BofA Merrill Lynch Global Research.

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Sector outlook Overview of the sector Due to years of underinvestment, increasing urbanisation and economic diversification initiatives, GCC countries and their construction markets have been driven predominantly by infrastructure spending. From the early 2000s, the oil boom in the region allowed governments to boost spending, especially in areas deemed necessary to diversify their economies away from oil and gas exports, and build up the underdeveloped real estate market to support population growth. Although the countries had similar aims, the implementation of the initiatives has been quite different, with some lagging on both plans and execution. However, two themes have been common across the region.

Build it and they will come This mainly started in the UAE and in particular in Dubai, which led a differentiated diversification model that stood out in the region. The state achieved world-class competiveness, making itself a key hub for several industries such as transportation, logistics and financial, after massive development in real estate infrastructure. Abu Dhabi and, to a lesser extent, Qatar have followed focused on job creation and developing the real estate platform to support a similar goal, but have not been as successful.

Massive government spending Saudi Arabia is a key proponent of this theme. Over the past decade, the kingdom has consistently rolled over massive annual budget schemes to diversify the economy. This increased the focus on developing the petrochemical industry in the region, which currently accounts for 65% of non-oil exports (35% of non-oil exports are chemicals and 30% are plastics), and enhancing infrastructure spending in many ways. This objective was also tackled through the move to establish key economic cities, which was then quietly scrapped post the 2008 financial crises. Following the political instability driven by the Arab Spring, Saudi Arabia, the biggest economy in the region, went on a spending spree to avoid potential social unrest. In 2011, the government announced several schemes to accelerate the development of the country’s social infrastructure, including a massive housing plan that involves building 550k units for a total cost of SAR250bn (US$67bn). It also started to tackle other areas such as education and unemployment, with the latter being a key focus in 2013. MENA construction geared to spending The key points mentioned above of economic diversification and urbanisation/infrastructure build-up were obvious drivers of the GCC construction market. Political instability in the region also affected the GCC construction market, as it was a blow to MENA contractors which have been attempting to diversify their order book regionally and away from the stagnant Dubai construction market. It also put several potential growth areas like Iraq on hold for some companies until the situation improves, and increased competition in more stable economies, particularly Qatar and Saudi Arabia.

We look at the largest and fastest-growing economies in GCC (Gulf Cooperation Council Countries); namely, Saudi Arabia, the UAE and Qatar, as they offer the best opportunity in terms of growth and have relatively stable political environments.

45 MENA Construction 18 September 2013

According to MEED Projects, total 2012 construction awards in these three Gulf countries reached US$32.2bn in 2012. Award activity has experienced two major pull-backs, the obvious one followed the financial crises in 2008, with awards dropping by 34% YoY in construction sector in 2009. The second took place after the political instability in 2011, which caused governments to rethink their spending plans in accordance with the political changes that took place in the region. We summarise the award areas that we expect to be the most active from 2013:

Civil projects to pick up in real estate and infrastructure Saudi to head the way, starting with Riyadh Metro Under civil construction we include all projects related to infrastructure, real estate and public structures. We believe Saudi Arabia is likely to lead the activity awards in this segment over the next three years. According to MEED, Saudi is likely to award US$105bn in Construction sector & US$46.5bn in Infrastructure through 2017E. The projects will have a focus on the following:

„ Transportation: Focus has shifted towards building the Saudi transportation platform, in particular its rail infrastructure. Historically, spending on this front was limited to projects in certain areas, such as the Maaden train route, or the Haramain high speed track (US$10bn). However, the recent award of the US$22bn Riyadh Metro project was a huge development in the sector. According to MEED, activity is likely to increase even further as the government is focusing on a public transport system in Dammam and a Metro system in Mecca. The western province’s biggest cities, Jeddah and Madinah, are also planning their own rail routes. MEED estimates around US$37.9bn is to be awarded in the transportation segment.

„ Increasing focus on the housing market: To address the kingdom’s undersupplied housing market, we believe progress is likely to accelerate on the 550k-unit housing scheme launched in 2011. As part of the initiative, the Saudi government recently signed contracts worth US$4bn to build around 40k homes across the kingdom, in addition to the US$208mn awarded to Al- Khodari in April to provide the infrastructure for housing areas in several cities in Saudi. MEED estimates around $88.1bn is to be spent on this area through 2016.

„ Education: Education funding remains a key target of the government, as it has allocated around US$54.4 to build 539 schools and 15 collages, and fund scholarship programmes. For example, MEED estimates around US$3.6bn worth of projects to be awarded by Ministry of Housing & Education in this segment through 2016 with 22% concentrated in 2014.

Qatari awards activity to pace up, but remain below expectations Activity in Qatar is mainly centred on the infrastructure for the 2022 World Cup. The country plans to spend around US$70bn on infrastructure, hotels and stadiums. Although speculation on whether the Qatar will host the cup has resurfaced recently, as some Fifa officials are highlighting the difficulty in playing football in the summer heat, our base case scenario assumes the world cup will take place. We also believe the infrastructure projects planned, such as the metro and roads, are likely to be given the green light regardless of whether the tournament takes place, as has been highlighted by several government officials recently. In the near term, MEED estimates around US$50bn worth of projects to be awarded over the next few years (2013-17E) mainly concentrated in transport and infrastructure.

46 MENA Construction 18 September 2013

The UAE – potential upside to our estimates The UAE has been one of the region’s most active construction markets during the past decade. This was attributable mainly to the rise of the country’s real estate market, which, like many others, reached a speculation stage before crashing after the financial crises in 2008. The pick-up in the economy, better financing conditions and confidence in the market have led to a visible recovery in awards. The increasing demand for property by local and international investors has driven an uplift in prices, which, in turn, has brought developers back to the market. This has boosted award activity in real estate from 2012-1H13. High oil prices have also restored the focus on infrastructure and housing development in Abu Dhabi, the largest Emirate. Projects put on hold post 2008 have been revived, for example, the recent award of the Louvre Museum and MidField Terminal, according to MEED. In our view, a driver of activity in the construction market and the economy as a whole is the winning of the 2020 World Expo, which is likely to increase spending on roads, airports and other infrastructure projects. Currently, MEED estimates around US$24.9bn worth of projects to be awarded through 2016 with 34% in 2014.

High oil prices to support oil & gas, petchem spending Activity in this field remains a focus for the oil-rich GCC countries. High oil revenues and low EPC costs have been key drivers of construction awards in this field, eg, downstream projects to diversify economies through rising exports or the construction of LNG hubs. Since 2005, the three countries have spent around $171.7bn on Oil & Gas with the highest spending in Saudi (US$75.3bn). The petrochemical industry accounted for 27% of awarded projects, as the availability of associated natural gas in Saudi Arabia ignited a massive spending spree on petchem projects from 2005-12. The surge in the region’s power consumption limited new allocation to the sector, but recent MEED reports indicate a renewed focus on the sector in Saudi based on naphtha (oil) based production. The kingdom is planning a new programme worth around US$70bn on building several plants in the Eastern and Western provinces. Although this has yet to be confirmed, we believe a decent portion of the projects will go ahead. Excluding this plan, MEED estimates around US$19.4bn to be spent on these sectors, with the highest awards being in 2015.

Power: electricity demand on the run so are projects The GCC region is struggling to keep up with rising power demand, owing to years of underinvestment coupled with fast population growth, and feedstock (natural gas) supply shortage. According to MEED, power generation capacity in MENA reached 185MMW at end-2012; at the current rate of demand around 120MMW of additional capacity would be needed to meet the region’s requirements. For the three countries, MEED estimates around US$66bn worth of projects to be awarded through 2015.

47 MENA Construction 18 September 2013

GCC (UAE + Saudi Arabia + Qatar)

Chart 54: Award activity has picked up in the three main GCC Chart 55: Civil and infrastructure have been the key areas of focus in countries with YTD 2013 awards standing close to 2012 the region

140 Aw ards Total 130.2Grow th 160% 100% 114.7 110.6 140% 120 114.1 105.0 111.3 120% 80% 93.7 91.4 100 87.8 100% 60% 80 80% 60% 40% $ Bn 60 40% 40 20% 20% 0% 20 0% -20% 0 -40% 2005 2006 2007 2008 2009 2010 2011 2012 2013 Construction Industry Infrastructure 2005 2006 2007 2008 2009 2010 2011 2012 2013 Oil & Gas Petrochemicals Pow er

Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 56: Contracts awarded, Cancelled & On Hold Table 34: The execution ratio has picked up post 2010

1,600 (bn)Canceled / onhold Cumulativ e 450 (bn) Announced Cumulative Awarded Awarded 400 1,400 Completed 350 1,200 300 1,000 250 800 200 600 150 100 400 50 200 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: MEED Projects, BofA Merrill Lynch Global Research

Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 57: Key growth areas are Qatar and Saudi Arabia Chart 58: Contract awards by sector – Historical & Pipeline

300 100% 100% Aw arded Grow th 250.9 250 80% 80% 180.1 60% 200 60% 40% 150 40% $bn 110.6 93.7 20% 100 0% 20% 50 -20% 0%

0 -40% 2011 2012 2013 2014 Construction Industry Infrastructure 2011 2012 2013 2014 Oil & Gas Petrochemicals Pow er

Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

48 MENA Construction 18 September 2013

Saudi Arabia

Chart 59: Saudi award activity has recovered post the drop it Chart 60: Annual awards by sector experienced in 2012, (2013 reflects YTD awards as of August) 100% 80 Aw ards Total Grow th 73.4 600% 80% 70 61.1 500% 52.3 53.7 60% 60 55.6 400% 50 40% 35.3 300% 40 40.2 $ Bn 28.6 200% 30 30.6 20% 100% 20 0% 0% 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 0 -100% Construction Industry Infrastructure Oil & Gas Petrochemicals Pow er 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 61: Contracts awarded, Cancelled & On Hold Chart 62: Contracts announced vs executed & completed vs cancelled Canceled / 800 (bn) Cumulativ e 3,000 (bn) Announced Cumulative onhold Awarded Awarded 700 2,500 Completed 600 2,000 500 1,500 400 300 1,000

200 500 100 0 0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 63: Contract award & growth – Historical & Pipeline Chart 64: Contract awards by sector – Historical & Pipeline

160 Aw arded Grow th 144.3 100% 100% 140 80% 80% 120 60% 93.3 60% 100 73.4 40% 80 40% $bn 52.3 20% 60 0% 20% 40 20 -20% 0% 0 -40% 2011 2012 2013 2014 Construction Industry Infrastructure 2011 2012 2013 2014 Oil & Gas Petrochemicals Pow er

Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

49 MENA Construction 18 September 2013

UAE

Chart 65: 2013 YTD awards have shown a decent increase but still Chart 66: Annual awards by sector lags that of 2012 100% Aw ards Total Grow th 70 65.7 100% 56.4 80% 60 58.2 80% 60% 60% 50 48.1 42.3 40% 40% 40 31.7 26.1 20% $ Bn 30 22.9 20% 20.7 0% 20 -20% 0% 10 -40% 2005 2006 2007 2008 2009 2010 2011 2012 2013 Construction Industry Infrastructure 0 -60% Oil & Gas Petrochemicals Pow er 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: MEED Projects, BofA Merrill Lynch Global Research

Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 67: Cancelled and on hold projects cooled down in 2011 Chart 68: Contracts announced vs executed & completed vs cancelled Canceled / 800 (bn) Cumulativ e 1,400 (bn) Announced Cumulative onhold Awarded Awarded 700 1,200 Completed 600 1,000 500 800 400 600 300 400 200 200 100 0 0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 69: Award acitivty pipeline shows strong improvement, Chart 70: Contract awards by sector – Historical & Pipeline especially if the UAE wins the 2020 WorldExpo 100% 70 Aw arded Grow th 100% 59.3 80% 60 80% 48.0 60% 50 60% 40% 40 20% 40%

$bn 26.1 30 22.9 0% 20% 20 -20% 10 -40% 0% 0 -60% 2011 2012 2013 2014 Construction Industry Infrastructure 2011 2012 2013 2014 Oil & Gas Petrochemicals Pow er

Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

50 MENA Construction 18 September 2013

Qatar

Chart 71: Qatar’s award activity has improved significantly in 2013 Chart 72: Historical focus was mainly on real estate and civil work, with YTD 2013 awards (US$16.9bn) exceeding 2012 full year awards infrastructure is now taking the lead

30 Aw ards Total Grow th 60% 100% 25.7 25 40% 80% 20.7 20.0 22.5 20% 20 60% 16.9 14.3 15.4 0% 15 11.3 40% $ Bn -20% 10 8.9 20% -40%

5 -60% 0% 2005 2006 2007 2008 2009 2010 2011 2012 2013 0 -80% Construction Industry Infrastructure 2005 2006 2007 2008 2009 2010 2011 2012 2013 Oil & Gas Petrochemicals Pow er

Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 73: Contracts awarded, Cancelled & On Hold Chart 74: Contracts announced vs executed & completed vs cancelled

250 (bn) Canceled / Cumulative 400 (bn)Announced Cumulativ e onhold Awarded Awarded 350 Completed 200 300 250 150 200 100 150 100 50 50 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

Chart 75: Estimated awards for 2013 and 2014 show a strong Chart 76: Infrastructure projects to be the key focus in 2013-2014 improvement in awards 100% 50 Aw arded Grow th 47.3 160% 80% 38.8 140% 40 120% 60% 100% 30 40% 80% $bn 20 14.3 15.4 60% 20% 40% 10 0% 20% 2011 2012 2013 2014 0 0% Construction Industry Infrastructure Oil & Gas Petrochemicals Pow er 2011 2012 2013 2014 Source: MEED Projects, BofA Merrill Lynch Global Research Source: MEED Projects, BofA Merrill Lynch Global Research

51 MENA Construction 18 September 2013

Company profile Drake & Scull Company profile Drake & Scull International PJSC (DSI) is a UAE-based end-to-end contractor that provides integrated services across the entire project management value chain, including design, engineering, construction and commissioning. The company was spun off from Drake & Scull Group (DSG) and listed in March 2009 on the Dubai Financial Market.

DSI established its first office in Abu Dhabi in 1966, and now has a presence in Dubai, Egypt, Kuwait, Libya, Oman, Saudi Arabia, Qatar, India, Jordan, Algeria and Thailand, and manages projects in Europe and other parts of North Africa.

DSI is divided largely into three operating segments: MEP, IWP and civil contracting sectors.

„ MEP: MEP stands for Mechanical Electrical and Plumbing. This segment is DSI’s largest division, contributing 51% of revenue in 2012. This division carries out contracting work in the construction industry, such as mechanical, electrical, plumbing and sanitation work.

„ IWP: I.W.P stands for Infrastructure, Water & Power. The segment contributed 15% to 2012 consolidated revenue. IWP carries out contracting work in the construction industry, such as infrastructure, water treatment plants, district cooling plants and power plants.

„ Civil & others: The civil segment represented 34% of revenues in 2012. This segment carries out contracting work relating to the construction industry, such as property construction, sanitation work and real estate activities.

DSI operates six main businesses to address the varying needs of the region’s industry, namely Drake & Scull Engineering, which offers MEP and WP solutions; Drake & Scull Construction (DSC), which acts as the General Civil Contracting unit; Drake & Scull Rail, focusing on Rail networks and rail stations; Drake & Scull Oil and Gas focusing on Onshore and Offshore Oil facilities; Passavant-Roediger, engaged in Water and Waste water treatment; and Drake & Scull Development, which is involved in Public Private Partnerships (PPP) in the Infrastructure sector.

Chart 77: Revenue by segment – 2012 Chart 78: Segment Profit for 2011 & 2012

175 Civ il w orks 200 150 34% 150 100 M.E.P 21 19 50 3 51% AED mn 0 -50 -7 I.W.P M.E.P I.W.P Civ il w orks 15% 2011 2012

Source: DSI, BofA Merrill Lynch Global Research Source: DSI, BofA Merrill Lynch Global Research

52 MENA Construction 18 September 2013

Order book growth The order book grew to AED9.1bn in 2012, up 36% YoY, and we expect it to reach AED12.7bn by the end of 2013. The backlog has been highly concentrated on the KSA, which made up 46% of the total in 2012.

Chart 79: Order Book since 2008 Chart 80: Order book by Geography

15 11.70 2012 1Q'13 5 9.10 8.98 10 6.70 4 5.40 3 2.69 2.74 AED Bn 5 2 AED Bn 1 0 0 2008 2009 2010 2011 2012 1Q'13 2013E Iraq KSA Qatar Backlog Abu Dubai Eqypt Others Algeria Dhabhi Kuwait Source: DSI, BofA Merrill Lynch Global Research Source: DSI, BofA Merrill Lynch Global Research

Chart 81: 1Q’13 Backlog by Business In 1Q13 the backlog from the civil business accounted for 45% or AED4.01bn and MEP made up 36% with AED3.22bn. The 1Q13 profit margin was 5% for the civil WP PR business and 7% for the MEP segment. The 2Q13 backlog was AED11.74bn. 7% 4% O&G Table 35: Awards in 1Q & 2Q'13 8% Civil Announced Date Name Project Size (AED mn) 45% Q1 2013 Musheireb Downtown Doha Project Phase 1C 304 Q1 2013 KAUST Perimeter Security System 450 Q1 2013 Al Rajhi Cash Center 22 MEP Q1 2013 Al Rajhi Operations Center 167 Q1 2013 Al Rajhi Data Centre 98 36% Q1 2013 Asset Enhancement Scheme Stage - 1 82 Source: Company data Q2 2013 Private Residential 180 Q2 2013 Maliha Hospital for G.h.q. UAE armed forces 137 Q2 2013 Maliha Hospital for G.h.q. UAE armed forces 138.5 Q2 2013 Mecca Government Complex 265 Q2 2013 AUH Airport – South Airfield Development 91.2 Q2 2013 ITCC 180 Q2 2013 Cross Country Coal Conveying System 205 Source: Company Reports

Key management Chairman: Mr Majid Saif Al Ghurair is the Chairman of DSI. He is also the CEO of Al Ghurair Private Company and Managing Director of Gulf Extrusions Co. and President of Burjuman Centre LLC and Reef Mall. He is a co-founder and current Chairman of the Middle East Council of Shopping Centres and the Dubai Shopping Malls Group. He is also Chairman of Planet Pharmacies LLC and Dubai Wings, as well as a board member of Amwal, Invest Corp Bank, NASDAQ Dubai, National Paint Company, Dubai Statistics Centre, Dubai Economic Council and Dubai Financial Support Fund.

Vice Chairman & CEO: Mr Khaldoun Rashid Tabari is the Vice Chairman and CEO of Drake & Scull International. Mr Tabari also serves as a Non-Executive Chairman and Director of EMCOR Facilities Services Group, Non-Executive Chairman Vision Investments, Board Member of Walltech, Director of EHC Cooperation and Board Member of Energy Central, UAE.

53 MENA Construction 18 September 2013

Table 36: Management & Board Members Chairman Majid Saif Al Ghurair Vice Chairman & CEO Khaldoun Rashid Tabari COO Michael Salmon Board Member Talal Jassim Al-Bahar Board Member Yusuf AL Nowais Board Member Tawfiq Abu Soud Board Member Saleh Muradweij Board Member Ivor Mark Goldsmith Board Member Jamal Al Nuaimi Board Member Khalaf Sultan Al Daheri Source: DSI

Key shareholders DSI was listed on 16 March 2009 on Dubai Financial Market. As at 12 September 2013, it had a market cap of AED2.56bn. Khaldoun Rachid S. Tabari (8.3%) is one of the key shareholders with 8.3% stake in the company and is also the Chairman of the Board and CEO of DSI. HSBCHPB-HSBC Private Banking Holdings (Suisse) SA which holds 6.32% stake in DSI is into providing private banking and trustee services to individuals worldwide & is headquartered in Geneva, Switzerland

Chart 82: Shareholders

HSBC Praiv ate KRT3 Ltd Bank 8.6% 6.3% KRT II Ltd 9.2%

Khaldoun Rachid S. Tabari Free float* 8.3% 67.6%

Source: Bloomberg

54 MENA Construction 18 September 2013

Arabtec Company profile Arabtec Holding is a UAE-based civil construction company with presence across the MENA region. The company has a solid track record on major projects of architectural interest, including Burj Khalifa (the world’s tallest building), Ocean Heights, Sky Gardens Tower at DIFC, Infinity Tower, and the newly awarded Louvre Abu Dhabi (main contract works). Arabtec’s shares were listed on the Dubai Financial Market in 2004.

The group’s main business lines are high-rise developments; airports, commercial buildings; hotels and hotel interiors; mixed use development; infrastructure /industrial projects; offshore oil & gas installations; residential complexes including the largest communities in the area such as Emirates Hills, Arabian Ranches and Silicon Oasis in Dubai, and Al Waab City in Doha. Recently, it has also ventured into stadium construction, namely Dubai Sports City (Stadium 1 & 4). Other activities include the manufacturing of ready-mix concrete, the fabrication of steel structures, and trading and leasing of construction equipment.

Arabtec’s operations are divided across three main reportable segments:

„ Building Construction: In 2012, this segment accounted for 73% of revenues and 72% of the total backlog. Its primary activity includes the construction of high-rise buildings and villas.

„ Drainage and Electro-Mechanical Works: This division contributed 19% of group revenue in 2012 and represented 27% of the backlog at the end of 2012.

„ Marine, Precast and Trading: This segment is engaged in the production of ready-mix concrete and serves as a supporting unit to the Building Construction division, including dredging and the construction of marine projects, such as ports and shipbuilding facilities. In 2012, the segment contributed 8% of total revenues.

Chart 83: Revenue by Segment - 2012 Chart 84: Backlog by Segment - 2012

Marine, Marine, precast, Drainage & precast, trading EM Works trading Drainage & 8% 27% 1% EM Works Building/ Building/ 19% Construction Construction 73% 72%

Source: Company Reports Source: Company Reports

55 MENA Construction 18 September 2013

Chart 85: Order Book Since 2008 Chart 86: Revenue by geography, increasing focus on KSA

30 28.5 24.4 22.9 4 3.5 19.7 17.6 3 20 13.3 14.2 1.8 2 1.4 0.8 AED Bn 10 AED Bn 1 0.5 0.3 0.4 0.2 0 0 2008 2009 2010 2011 2012 1H 2013 2013E UAE KSA Qatar Other Backlog 2012 1H'13

Source: Company Reports Source: Company Reports

Table 37: Key contracts awarded in 2012 & YTD 2013 Year Key contracts awarded in 2012 & 2013 Share in Project (AED mn) 2013 Abu Dhabi Plaza, Astana, Kazakhstan 2,000 2013 Fairmont Hotel, Abu Dhabi 1,100 2013 Louvre Abu Dhabi Museum, UAE 800 2013 Saraya Aqaba, Aqaba, Jordan 770 2013 St. Regis Amman, Amman, Jordan 720 2013 Arabian Ranches, Dubai, UAE 240 2013 Aldara Hospital, Riyadh, Sadi Arabia 240 2013 Cedre Villas, Dubai, Dubai, UAE 180 2013 Silicon Oasis, UAE 180 2012 Midfield Terminal Building at Abu Dhabi International Airport, UAE 3,600 2012 Phase 2 of Msheireb Downtown Doha, Qatar 2,300 2012 Enabling works at Lakhta Tower, St. Petersburg, Russian Federation 450 2012 Arabian Ranches 95 villas and townhouses, Dubai, UAE 110 2012 Nile Towers, Cairo, Egypt 275 2012 411 villas in Baniyas Residential Development, UAE 425 2012 Residential Development, Najmat, Abu Dhabi, UAE 225 2012 Structural works for Dubai International Airport expansion 560 Source: Company Reports

Bidding pipeline heavily weighted towards Abu Dhabi According to MEED Projects, the total value of the projects in Arabtec’s bidding pipeline is AED4.01bn as listed below. Abu Dhabi-based projects represent 75% of Arabtec’s bidding pipeline, followed by Qatar (25%).

Table 38: Value of Bidding pipeline by expected award date (US$ mn) Project Name Stage Country Sector Budget Value (US$ mn) Award Date Arabtec DCA - Dubai International Airport Expansion: Cargo Mega Terminal Expansion Bidding UAE Infrastructure 160 Sep-13 Al Zorah Development Company - Al Zorah: Package II: Phase I Bidding UAE Construction 500 Sep-13 Aabar Properties - Maysan Towers C12 & C13 Bidding UAE Construction 150 Sep-13 Abu Dhabi Health Services Company (Seha) - Al Ain Hospital Bidding UAE Construction 708 Sep-13 TDIC - Saadiyat Island: Cranleigh School Bidding UAE Construction 70 Sep-13 Dubai Aviation City Corporation - Staff Accommodation Complex: Phase I Bidding UAE Construction 70 Sep-13 Musanada - Al Falah Residential Units Bidding UAE Construction 50 Sep-13 Police Projects Committee - Reformatory and Penal Buildings at Al Wathba Bidding UAE Construction 272 Oct-13 QRAIL - QIRP: Doha Metro: Red Line South: Elevated / At Grade Section Bidding Qatar Infrastructure 1000 Dec-13 Seha - Sheikh Khalifa Medical City Bidding UAE Construction 681 Dec-13 TDIC - Saadiyat Island: Sheikh Zayed National Museum Pre-qualified UAE Construction 200 Feb-14 Etihad Airways - Headquarter Expansion Pre-qualified UAE Construction 204 Apr-14 Source: MEED Projects

56 MENA Construction 18 September 2013

Vertical integration through subsidiaries Arabtec Holdings has strategically diversified through the building cycle away from construction contracting to supplying concrete and facilities management services. This has been achieved through investing in subsidiaries with a strong track record in different countries. Arabtec Construction LLC is Arabtec Holding’s largest subsidiary (accounts for c.70% of Arabtec’s revenue). It is a leading construction company in UAE and has diversified geographically into Qatar, Jordan, Syria, Palestine, Pakistan, Russia, the KSA, Egypt, Bahrain, Kuwait, Angola and Kazakhstan. It has completed numerous projects including but not limited to high-rise developments, hotels and hotel interiors, commercial and industrial projects, major airport developments, stadiums, infrastructure and drainage works, offshore oil and gas installations, residential complexes including the largest communities in the area such as Emirates Hills, Arabian Ranches and Silicon Oasis in Dubai, and Al Waab City in Doha. Below is the list of subsidiaries with ownership and area of business.

Table 39: Subsidiaries List Subsidiary Stake Line of Business Arabtec Construction L.L.C. 100% Construction of high-rise commercial, and residential projects, planned villa, etc House of Equipment (HOE), L.L.C. 67% Provides for the purchasing and hiring of construction equipment. Austrian Arabian Ready Mix Concrete (ACC) 100% Engaged in production and delivery of concrete Arabtec Construction, W.L.L. 49% Current operations are based around the construction of the Al Wa’ab City development Arabtec Precast, L.L.C. 100% Manufacturer and supplier of pre-cast products NBK Ready Mix Company 49% Produces and delivers concrete Arabtec Engineering Services (AES), L.L.C. 80% Specializes in engineering services related to infrastructure works Arabtec International Co Ltd 100% Have presence in Republic of Mauritius Emirates Falcon Electromechanical 55% Engaged in Building Maintenance Facilities, electrical, HVAC, Drainage & Plumbing installation Arabtec Construction Syria 100% Construction in Syria Arabtec Pakistan Private Limited 60% Caters to the undersupplied Construction market in Pakistan Target Engineering Construction Company 60% EPC contractor with stand alone specialties. Gulf Steel Industries (GSI), FZC 100% Engaged in steel work, design, fabrication and installation. Arabtec Saudi Arabia L.LC 45% Construction of commercial, retail and hospitality property in Saudi Arabtec Egypt for Construction SAE 55% Contractor in the Egyptian construction and infrastructure markets Arabtec Construction LLC (Foreign Co) 100% Have presence in Palestine Arabtec-Musawa W.L.L. (Bahrain) 100% Construction in Bahrain EFECO Saudi LLC 39% Provides MEP services to the construction industry, building owners and end users in Saudi EFECO Qatar W.L.L 27% Provides MEP services to the construction industry, building owners and end users in Qatar EFECO L.L.C 100% Provides MEP services Arabtec Construction Machinery 58% Specializes in managing, trading, servicing and rental of construction equipment Saudi Austrian Arabian Readymix Concrete Co. LLC 62% It’s a ready mix company in Saudi Arabia Arabtec Envirogreen Facility Management Services 51% Facility, asset, energy management operations & consultancy Arabtec Construction India(Pvt) limited 63% Have presence in India Idrotec SRL Italy 48% Italian marine and coastal engineering company to provide design engineering services Polypod Middle East, L.L.C. Minority Engaged in prefabrication in the design, development and installation of “pod” units Arabtec Construction LLC Russian Federation Branch Engaged in civil and engineering construction of high rise, residential, commercial, industrial & infrastructure dev. Depa Ltd 24% Turnkey fit-out and furnishing of five-star luxury hotels, yachts, and apartments Source: Arabtec website, DFM

Saudi: Arabtec has a presence in KSA through Arabtec Saudi Arabia, a partnership with CPC Services Company, a member of the Bin Lad Group, and Mawrid Holding Co. Arabtec Saudi Arabia can tap the KSA market with a decent volume of projects announced by The Custodian of the Two Holy Mosques King Abdulla Bin Abdul Aziz Al Saud to be completed over the next few years.

Qatar: Strategic partnerships play a key role in Arabtec’s global expansion plans. In Qatar, Arabtec has partnered with Nasser Bin Khaled Al Thani & Sons Holding Company with a 49% stake for providing end-to-end concrete solutions in Qatar.

57 MENA Construction 18 September 2013

Acquisition of Depa Ltd: Arabtec acquired a 24% stake in Depa Limited, a Dubai-based leading interiors contractor for AED239.7mn in 2012. This acquisition will provide synergies as Depa develops interiors, which will complement Arabtec’s construction business.

Arabtec‐Samsung Engineering: Arabtec (60% interest) and Samsung Engineering (40%) are launching a new EPC JV company in oil gas, power and related infrastructure. This alliance will enable Arabtec to expand into large-scale projects in the oil & gas, power and related infrastructure sectors in MENA. Table 38 shows that future bidding is heavily weighted towards the construction sector.

Key management Chairman: Mr Khadem Al Qubaisi was elected as the Chairman of the Board in May 2012. He is the Managing Director of International Petroleum Investment Company (IPIC), a position he has held since May 2007. He is also the Chairman of Aabar’s Board of Directors and the Chairman of various international companies in the oil and gas and petrochemical industries including NOVA Chemicals, Borealis and CEPSA. He holds a B.Sc. in Economics.

Managing Director and CEO: Mr Hasan Abdullah Ismaik is the Managing Director and CEO of Arabtec Holding PJSC and Chairman of Arabtec Construction since 2012. Ismaik is also Chairman of Al-Ashmal Real-Estate Investment Co. in Jordan, and Hirmas Investments Group.

Table 40: Board of directors and executive management Board of Directors Arabtec Chairman Khadem Al Qubaisi CEO & MD Hasan Abdullah Ismaik Vice Chairman Riad Burhan Kamal Member Mohamed Hamad Al Mehairi Member Mohamed Ali Al Fahim Member Khalifa Hamad Al Mehairi Member Wassel Issa Al Fakhoury Member Dr. Tareq Ahmad Abu Shreehah Member Raja Hani Ghanma Source: Arabtec

Key shareholders Arabtec was founded by Mr Riad Kamal and listed on 4 January 2005 on the Dubai Financial Market. The company was the first private construction firm to go public in Dubai. In April 2010, Arabtec and Aabar Investments abandoned a deal whereby the latter would have acquired a 70% stake in the former. However, Aabar accumulated Arabtec shares through the market until Aabar held around 20% in 2012. This allowed Aabar to secure management control in May 2012 and appoint Khadem Al-Qubaisi as the new chairman of Arabtec, along with four Aabar executives to Arabtec’s board. As of 12 September 2013, Aabar has a controlling stake in Arabtec, with a AED7.35bn market cap. The key shareholders are Hasan Abdulla Ismaik (8%), Aabar Real Estate (5.18%), Aabar Investments (5.23%), Aabar Petroleum (5.32%) and Aabar Real estate (5.2%). The free float comprises the remaining 70.4%. Hasan Abdulla Ismaik is the MD and CEO of Arabtec Holdings.

„ Aabar Investments is a private joint stock company based in Abu Dhabi, UAE. The company invests in various industries, from commodities and oil &

58 MENA Construction 18 September 2013

gas to infrastructure. The company is owned by the International Petroleum Investment Company (IPIC), which is owned by the Government of Abu Dhabi. The company has a sizable ownership in Daimler AG, Falcon Private Bank, Tesla Motors, and Aabar Properties.

„ Aabar Energy is engaged in investing in land and sea oil wells and gas drilling, in addition to buying or investing in other oil & gas companies. Aabar Real Estate is also headquartered in Abu Dhabi, and is a subsidiary of Aabar Investm.

Chart 87: Shareholder

Aabar Aabar Real Aabar Energy Inv estments Estate 5.8% 5.2% 5.2% Aabar Petroleum 5.3% Hasan Abdulla Ismaik 8.0%

Free float 70.4%

Source: Bloomberg

Rights issue Arabtec completed its Right issue on 28th July 2013 raised AED2.4bn ($653.4m) in a rights issue by issuing 1.56 bn new shares at AED1.55/share and the issue was oversubscribed by 30%. The proceeds of this right issue would be used to implement the company’s growth strategy.

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Al-Khodari Company profile Chart 88: Shareholders Al-Khodari is a Saudi-based contracting, engineering and construction company with a presence across many sectors: general contracting works related to civil Free engineering, roads and bridges, railways, buildings and infrastructure. The Float company also provides city cleaning environmental control contracts. Established 35% in 1966 as a sole proprietorship, the company has a solid record of securing and Alkodari executing government contracts and is classified as a “Grade 1” contractor, Franklin Holding allowing it to bid for major government projects with total limit of SAR500mn. Al- Resourc Co, Khodari was listed on the Saudi Tadawul Exchange in June 2010, with a 30% es 60% free float and as of 12 September 2013 had a market cap of SAR1.8bn. 5% Al-Khodari divides its operating segments into: Source: Bloomberg „ Contracting: This segment represented 99.7% of 2012 revenues with gross margin of 15%. Its main activities include the construction of highways, roads and bridges, earthwork and civil works related to railway projects, the construction of public facilities and large residential and recreational projects, logistical and transportation services to the oil, gas and petrochemical industries, and environmental projects. The highest concentration historically was on transportation projects (50%), this has changed recently with most awarded projects falling under civil work on buildings and real estimate (currently at 35% vs only 5% in 2007). In general the latter is a lower margin business and more competitive.

„ Trading: The trading segment represented 0.3% (vs 5.2% in FY2011) of consolidated revenue with a gross margin of 26% in 2012. Its main activities include the trading of the company’s used contracting equipment and vehicles (typically five years and older), scrap and outdated spare parts through sale and auctions. Al-Khodari holds on average two auctions per year.

Chart 89: Revenue concentration moved from transportation projects Chart 90: Gross Margin by Segment since 2010 towards civil construction (lower magins) 60% 49% 38% 100% 40% 26% 24% 21% 15% 50% 20%

0% 0% 2010 2011 2012 Contracting Trading 2007 2009 2Q11 4Q11 2Q12 4Q12 Source: Company Reports Buildings Infrastructure

Roads Rails Bridges Env iromental O&M Serv ices Water treatment, pow er

Source: Company Reports

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Order book growth Al-Khodari’s order book was at SAR3.3bn on 31 March 2013, compared with SAR3bn at the end of 2011. Since 2007, the order book has grown at a CAGR of c.10%, reflecting the company’s ability to secure major government projects as well as the pick-up in contract awards in Saudi Arabia. We expect the order book to grow to US$$4.8bn in 2013 based on the construction & infrastructure boom in Saudi (2014 award forecast for Saudi construction sector is US$63bn and US$$28.7bn for infrastructure sector).

Chart 91: Backlog growth reached SAR3.3bn in Q1 2013 Chart 92: Civil work on buildings has increase as a percentage of total backlog Order book 7,000 100% 6,000 80% 5,000 60% 4,000 40% 3,000 20% 2,000 1,000 0% 0 2006 2008 2010 2Q11 4Q11 2Q12 4Q12 Buildings Industrial Infra 2006 2007 2008 2009 2010 2011 2012

2013E 2014E Roads, rail & bridges Env iro Srv s O&M Water, w astew ater & pow er Source: BofA Merrill Lynch Global Research Estimates, Al-Khodari IR Presentation Source: Al-Khodari IR Presentation, BofA Merrill Lynch Global Research Estimates

Table 41: Pipeline Project Name Stage Country Sector Budget Value (US$ mn) Award Date Al-Khodari MOHE - Tabuk University: Infrastructure & Support Facilities Bidding Saudi Infrastructure 177 Sep-13 MOHE - Taibah University: College of Engineering for Men Bidding Saudi Construction 50 Sep-13 MOHE - Salman Bin Abdulaziz University in Kharj: College of Medicine Bidding Saudi Construction 33 Sep-13 GACA - King Abdulaziz International Airport: Apron 6 Rehabilitation Bidding Saudi Infrastructure 350 Oct-13 GACA - King Abdullah bin Abdulaziz Airport in Jazan Bidding Saudi Infrastructure 900 Oct-13 Source: MEED Projects

Table 42: Top ten Projects Awarded in 2012 & YTD 2013 Year Name Contract val ($ Mn) 2013 Security Compound: KAP 4: Package 1 1,200 2013 Saudi Housing Project: Phase 1,Package 5 208 2012 Saudi Landbridge: Ras Al Khair Jubail Railway 177 2012 Roads B and C linking Ras Al Khair Highway North: Phase 2 119 2012 Northern Border University in Arar: Phase 3 116 2012 Fourth Ring Road Intersection with Sail Road 112 2012 Arar University Hospital 109 2013 Qatif Obstetrics & Gynaecology Hospital 107 2012 Tabuk University Hospital 105 2012 Northern Border University: Faculty Accommodation: Phase 2 97 Source: Meedprojects.com

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Solid record of winning government contracts The Saudi government is Al-Khodari’s biggest client, representing majority of the contracting order book. The company has a long history of securing and executing government awards, including projects such as the construction of the main roads in Dammam and Khobar in 1975 and the first highway maintenance contract in Saudi Arabia in 1978.

Shareholders The Al-Khodari family is the largest shareholder of Al-Khodari, with a combined stake of 60%. Abdullah A. M. Al‐Khodari Sons Investment Holding Co holds the 60% of the company’s stake which is primarily owned by the Al-Khodari family. The Al-Khodari family share was subject to a lock-up period that expired in June 2012. It has a free float of 35%.

Chart 93: Ownership structure

Free Float 35%

Alkodari Holding Co, 60% Franklin Resources 5%

Source: Bloomberg

Key management Chairman: Ali Al-Khodari is the chairman of the Board. He joined the company as a mechanical engineer from King Fahd University of Petroleum & Minerals in Dhahran, Saudi Arabia and worked for two years on the oil tanks project in Kuwait, before becoming Managing Director of Al-Khodari Heavy Industries in 1994. In 1997, he assumed the role of Deputy General Manager. He was appointed Chairman of the Board post the IPO.

Chief Executive Officer: Fawwaz Al-Khodari is CEO and Member of the Board. He joined the company in 1988 as Deputy General Manager before becoming General Manager in 1991 and in 1996, he took over as President/Chairman. He assumed the position of CEO post the IPO of the company. After studying Accountancy at the College of London, he studied Business Studies from 1985-87 at the Business Studies Centre in Greenwich UK.

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Table 43: Board of directors and executive management Board of Directors Chairman Ali Al-Khodari CEO Fawwaz Al-Khodari Member Jamil Al-Khodari Member Naif Al-Khodari Member Ibrahim Al-Mutrif Member Munir Al-Borno

Executive Management CEO Fawwaz Al-Khodari COO Engr Ibrahim Mahlab CFO Kailash Sadangi Director, Tendering Ahmed Kanawati Director, Human Resources Sulaiman Al-Hejji Director, Business Development Brian Caesar Advisor, Technical Iftikhar Alam Khan Director, Industrial & Infrastructure Nadim Daher Director, Buildings Ali Hashem Director, Rail & Roads Abdulaziz Al-Khodari Director, Planning & Cost Control Mohamed Osman Director, Corporate Development Abraham Samuel Source: Al-Khodari

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Investment thesis Al-Khodari We believe the market is currently assuming margins will return to pre-2012 levels. We view scenario unachievable at the current stage as (1) lower-margin civil construction projects have been growing as a proportion of the backlog mix and (2) regulation issues in Saudi continue to result in higher SG&A costs. We therefore believe the company should be trading at a discount to the peer average.

Arabtec We believe Arabtec's share price implies unrealistic medium-term earnings growth given the structural pressure on margins from increasing competition and tighter regulation. As the recent improvement in Dubai's solvency makes write- offs on disputed receivables less likely, we believe Arabtec's recent capital increase provides scope for substantial M&A. However, we are sceptical on the value accretion of potential transactions given the expensive multiples the sector is currently trading at.

Drake & Scull DSI offers the best exposure to the sectors reaccelerating award activity. its experience in high-margin end-to-end solutions is likely to make it the key contractor in most power and rail projects. We believe the market is underestimating two key aspects: (1) the ability to improve margins going forward (2) its capacity to monetise its outstanding unbilled receivables.

Price objective basis & risk Al-Khodari (XULLF) Our price objective for Al-Khodari is SAR31/sh. Our price objective is derived using a target P/E ratio of 13.5x, which reflects a discount to our justified trough mid-cycle earnings of GCC construction companies. We believe this discount is justified in order to reflect the embedded balance sheet risk. Our 2014 EPS estimate is derived using an EBIT margin of 7.7% and sales growth of 22%.

Upside risks to our view: Higher-than-expected backlog growth in higher-margin segments would be likely to result in better-than-expected margins and higher valuation multiples. Higher-than-expected awards in Saudi Arabia would result in better-than- expected sales growth. Better collection of receivables would lead us to increase our multiple on lower risk prospects.

Downside risks to our view: Increasing competition from overseas could take a decent portion of the existing high-margin business. A political shock could put some projects on hold, leading to fewer growth opportunities. Higher levels of unbilled receivables could result in higher leverage to finance working capital needs, and thus hurt profitability

Arabtec (XARBF) Our price objective for Arabtec is AED2.0/sh. Our price objective is derived using a fair P/E ratio of 14.6x. reflecting a premium to our justified trough mid-cycle earnings of GCC construction companies.

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We believe the new shareholder structure will make it easier for Arabtec both to secure projects at comfortable pricing, and collect its outstanding receivables, Hence justifing a premium to the sector average.

The multiple reflects a discount to the global peer group. Our 2014 EPS estimate is derived using an EBIT margin of 4.7% and sales growth of 34%.

Upside risks to our view: Higher-than-expected backlog growth in higher-margin segments would be likely to result in better-than-expected margins and higher valuation multiples. Higher-than-expected awards in Saudi Arabia would result in better-than- expected sales growth. Using the cash raised from the rights issue in a value-accretive transaction.

Downside risks to our view: Increasing competition from overseas could take a decent portion of the existing high-margin business. A political shock could put some projects on hold, leading to fewer growth opportunities. Higher levels of unbilled receivables could result in higher leverage to finance working capital needs, and thus hurt profitability. Deploying the cash raised from the rights issue in a value-dilutive transaction.

Drake & Scull (XKEAF) Our price objective for Drake & Skull is AED1.55/sh. Our price objective is derived using a fair value P/E ratio of 15.0x, a premium to our justified trough mid-cycle earnings of Saudi construction companies. Higher-margin MEP work accounts for 50% of DSIs earnings: we apply a 16x multiple to that earnings base and the sectors fair value of 14x to the other half, to give us a blended P/E of 15x Our 2014 EPS estimate is derived using an EBIT margin of 5% and sales growth of 13%.

Upside risks to our view: Better collection of receivables would lead us to increase our multiple on lower risk prospects Higher-than-expected backlog growth in higher-margin segments would be likely to result in better-than-expected margins and higher valuation multiples. Higher-than-expected awards in Saudi Arabia and North Africa would result in better-than-expected sales growth.

Downside risks to our view: Increasing competition from overseas could take a decent portion of the existing high-margin business. A political shock could put some projects on hold, leading to fewer growth opportunities. Higher levels of unbilled receivables could result in higher leverage to finance working capital needs, and thus hurt profitability.

Link to Definitions Industrials Click here for definitions of commonly used terms.

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Analyst Certification I, Faisal AlAzmeh, CFA, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.

EEMEA - Industrials & Healthcare Coverage Cluster Investment rating Company BofA Merrill Lynch ticker Bloomberg symbol Analyst BUY Aeroflot XLRFF AFLT RM Victor Dima Aspen Pharmacare APNHF APN SJ Jamie Clark, CFA Barloworld Ltd. BRRAF BAW SJ Ilze Roux Barloworld Ltd. BRRAY BRRAY US Ilze Roux Dangote Cement XGBAF DANGCEM NL Wael Menhem Dogan Yayin Holding DYYHF DYHOL TI Gizem Bodur Dogus Otomotiv DOMVF DOAS TI Gizem Bodur Drake & Scull XKEAF DSI UH Faisal AlAzmeh, CFA Enka Insaat EKIVF ENKAI TI Ali Yavuz Birdal Globaltrans XGIPF GLTR LI Mark Manduca, CFA Imperial Holding IHLDF IPL SJ Ilze Roux Life Healthcare LTGHF LHC SJ Jamie Clark, CFA Mabanee XTYQF MABANEE KK Abdelrali El Jattari Mediclinic XMDEF MDC SJ Jamie Clark, CFA Sabanci Holding HOMJF SAHOL TI Ali Yavuz Birdal TAV Holding TAVHF TAVHL TI Ali Yavuz Birdal Tekfen Holding AS XTNKF TKFEN TI Ali Yavuz Birdal Turk Traktor TTRKF TTRAK TI Gizem Bodur Yamamah Cement Company XYARF YACCO AB Wael Menhem NEUTRAL Akcansa AKCMF AKCNS TI Ali Yavuz Birdal Arabian Cement Company XRBAF ARCCO AB Wael Menhem Aselsan ASNAF ASELS TI Gizem Bodur Bidvest Group BDVSF BVT SJ Ilze Roux Bidvest Group BVGLY BDVSY US Ilze Roux DP World DPWRF DPW DU Wael Menhem DP World XWLPF DPW LN Wael Menhem Ford Otosan FOVSF FROTO TI Gizem Bodur Koc Holding KHOLF KCHOL TI Ali Yavuz Birdal Saudi Cement Company XDSUF SACCO AB Wael Menhem Super Group SSPGF SPG SJ Ilze Roux Tofas TKOFF TOASO TI Gizem Bodur Trakya Cam TKYCF TRKCM TI Fırat Topal Turkish Airline TKHVF THYAO TI Ali Yavuz Birdal Yanbu Cement Company XYDHF YNCCO AB Wael Menhem UNDERPERFORM Al-Khodari XULLF ALKHODAR AB Faisal AlAzmeh, CFA Arabtec XARBF ARTC UH Faisal AlAzmeh, CFA Hurriyet Gazetecilik HURRF HURGZ TI Gizem Bodur Nampak NMPKF NPK SJ Ilze Roux Netcare NWKHF NTC SJ Jamie Clark, CFA PPC Limited PPCMF PPC SJ Marco Efstathiou, CFA Turk Sise Cam TSSCF SISE TI Fırat Topal

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Important Disclosures

XULLF Price Chart 1-Jun:B 16-May 13-Jan:N Khalil PO:SAR58 PO:SAR32 PO:SAR88 100 1-Aug 24-Jul 90 El Jattari PO:SAR48 80 2-Nov PO:SAR72 70 60 50 40 30 20 10 0 1-Jan-11 1-Jan-12 1-Jan-13 XULLF B : Buy, N : Neutral, U : Underperform, PO : Price objective, NA : No longer valid, NR: No Rating The Investment Opinion System is contained at the end of the report under the heading "Fundamental Equity Opinion Key". Dark grey shading indicates the security is restricted with the opinion suspended. Medium grey shading indicates the security is under review with the opinion withdrawn. Light grey shading indicates the security is not covered. Chart is current as of August 31, 2013 or such later date as indicated.

XARBF Price Chart 30-Sep:N 16-May:U 11-Mar 13-Jan Khalil PO:AED1.00 PO:AED1.03 PO:AED1.47 PO:AED1.37 4.00 1-Aug 3.60 El Jattari 3.20 2.80 2.40 2.00 1.60 1.20 0.80 0.40 0.00 1-Jan-11 1-Jan-12 1-Jan-13 XARBF B : Buy, N : Neutral, U : Underperform, PO : Price objective, NA : No longer valid, NR: No Rating The Investment Opinion System is contained at the end of the report under the heading "Fundamental Equity Opinion Key". Dark grey shading indicates the security is restricted with the opinion suspended. Medium grey shading indicates the security is under review with the opinion withdrawn. Light grey shading indicates the security is not covered. Chart is current as of August 31, 2013 or such later date as indicated.

XKEAF Price Chart 30-Sep:B 16-May 15-May:N 13-Jan:U Khalil PO:AED1.28 PO:AED0.91 PO:AED0.65 PO:AED1.14 1.60 3-Aug El Jattari 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 1-Jan-11 1-Jan-12 1-Jan-13 XKEAF B : Buy, N : Neutral, U : Underperform, PO : Price objective, NA : No longer valid, NR: No Rating The Investment Opinion System is contained at the end of the report under the heading "Fundamental Equity Opinion Key". Dark grey shading indicates the security is restricted with the opinion suspended. Medium grey shading indicates the security is under review with the opinion withdrawn. Light grey shading indicates the security is not covered. Chart is current as of August 31, 2013 or such later date as indicated.

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Investment Rating Distribution: Building Group (as of 05 Aug 2013) Coverage Universe Count Percent Inv. Banking Relationships* Count Percent Buy 46 48.42% Buy 26 56.52% Neutral 24 25.26% Neutral 11 45.83% Sell 25 26.32% Sell 12 48.00%

Investment Rating Distribution: Engineering & Construction Group (as of 05 Aug 2013) Coverage Universe Count Percent Inv. Banking Relationships* Count Percent Buy 20 40.82% Buy 13 65.00% Neutral 8 16.33% Neutral 6 75.00% Sell 21 42.86% Sell 11 52.38% Investment Rating Distribution: Global Group (as of 05 Aug 2013) Coverage Universe Count Percent Inv. Banking Relationships* Count Percent Buy 1660 48.55% Buy 1244 74.94% Neutral 868 25.39% Neutral 641 73.85% Sell 891 26.06% Sell 590 66.22% * Companies that were investment banking clients of BofA Merrill Lynch or one of its affiliates within the past 12 months. For purposes of this distribution, a stock rated Underperform is included as a Sell.

FUNDAMENTAL EQUITY OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential price fluctuation, are: A - Low, B - Medium and C - High. INVESTMENT RATINGS reflect the analyst’s assessment of a stock’s: (i) absolute total return potential and (ii) attractiveness for investment relative to other stocks within its Coverage Cluster (defined below). There are three investment ratings: 1 - Buy stocks are expected to have a total return of at least 10% and are the most attractive stocks in the coverage cluster; 2 - Neutral stocks are expected to remain flat or increase in value and are less attractive than Buy rated stocks and 3 - Underperform stocks are the least attractive stocks in a coverage cluster. Analysts assign investment ratings considering, among other things, the 0-12 month total return expectation for a stock and the firm’s guidelines for ratings dispersions (shown in the table below). The current price objective for a stock should be referenced to better understand the total return expectation at any given time. The price objective reflects the analyst’s view of the potential price appreciation (depreciation). Investment rating Total return expectation (within 12-month period of date of initial rating) Ratings dispersion guidelines for coverage cluster* Buy ≥ 10% ≤ 70% Neutral ≥ 0% ≤ 30% Underperform N/A ≥ 20% * Ratings dispersions may vary from time to time where BofA Merrill Lynch Research believes it better reflects the investment prospects of stocks in a Coverage Cluster. INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure), 8 - same/lower (dividend not considered to be secure) and 9 - pays no cash dividend. Coverage Cluster is comprised of stocks covered by a single analyst or two or more analysts sharing a common industry, sector, region or other classification(s). A stock’s coverage cluster is included in the most recent BofA Merrill Lynch Comment referencing the stock.

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