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MENA Construction Reinstatement of Coverage 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 Reinstating on GCC contractors; DSI stands out as a Buy Research Analyst 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 2 MENA Construction 18 September 2013 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. 3 MENA Construction 18 September 2013 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.
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