10 March 2011 Real Estate Navigating the downturn The UAE property sector continues to undergo a price correction that began in late 2008. We believe while there is more downside risk to property prices, much of this is priced in to the stocks. Emaar and DSI offer up to 16% upside potential from current levels, while Aldar, Sorouh and Arabtec offer neutral risk-reward. Table 1 : Key forecasts Close PTRec Potential PER PBR (Dh) (Dh) upside/ 2010 2011F 2012F 2010 2011F 2012F downside Aldar 1.32 1.4 Hold 6.1% NM 4.5 7.5 0.3 0.2 0.2 Arabtec* 1.36 1.45 Hold 6.6% 5.1 6.3 6.9 0.6 0.5 0.5 DSI 0.95 1.10 Buy 15.8% 12.4 9.5 9.1 0.8 0.8 0.7 Emaar 2.68 3.10 Buy 15.7% 6.7 7.1 7.4 0.5 0.5 0.5 Sorouh 1.08 1.15 Hold 6.5% 7.6 7.6 6.1 0.5 0.4 0.4 Priced as close 9 March 2011 *2010 EPS and BPS used for Arabtec are estimated Source: Company reports, Zawya pricing data, Rasmala forecast Equity | United Arab Emirates Range-bound outlook given ‘3D’ challenge We believe UAE house prices are likely to decline by an additional 25-30% (nominal terms) after a peak-to-date 45-55% drop largely due to the ’3D’ challenge of depopulation, deleveraging and deliveries. We believe equity valuations largely account for systemic challenges, but in the absence of significant catalysts – including consolidation, privatisation, banking and immigration reforms, etc – we expect the UAE property sector to remain range- bound in the foreseeable future. Despite our positive view on strong secular trends in the region, the current socio-political unrest in MENA may lead to higher investor risk aversion in the near term, which in turn may be reflected in higher volatility. Our thesis is conservative and may entail upside potential A key component of our thesis is the reasonable probability of depopulation risk, which, if proven contrary, may provide upside to our estimates and sector view. Our proprietary framework is based on historical case studies like Singapore and Hong Kong, where economic downcycles have coincided with a decline in population growth and depopulation. Stick with relative quality – we initiate with Buy ratings on Emaar and Drake & Scull We recommend names with relatively stronger balance sheets, stable cash flow trends and above-par execution histories that are likely to drive outperformance. Our preferred picks are Emaar and Drake & Scull (DSI) given their best-in-class growth, margin and funding profiles. We believe risk/reward is largely neutral on Aldar and Sorouh because despite their Analysts discounted valuations, financing and execution challenges have not yet troughed in the Abu Dhabi market. We believe Arabtec will remain a show-me story for the foreseeable future. Saud Masud United Arab Emirates Dubai property appears more attractive, Abu Dhabi more stable +971 55 725 8596 [email protected] Despite Abu Dhabi’s property premium of 25-30% compared with Dubai, we believe both Divya Arora markets are largely correlated in price trends. In our view, Dubai offers broader available United Arab Emirates property options at relatively lower price points, while the Abu Dhabi market has inherent +971 4 424 2784 [email protected] economic cushions in terms of lower oversupply and a stickier population dynamic. However, both markets face near-term liquidity and net new demand challenges, although, in our view, Dubai International Financial Centre, solvency is not a concern. The Gate Village, Building 10, Level 1, P.O. Box 31145, Dubai, United Arab Emirates Important disclosures can be found in the Disclosures Appendix. Distributed outside MENA by The Royal Bank of Scotland N.V. and its affiliates under a strategic www.rasmala.com alliance with Rasmala Investment Bank Ltd. Contents Executive summary 2 We believe the UAE property sector is undergoing mid-cycle dynamics; house prices have corrected by 45-55%, but rising oversupply could see a further 25-30% drop in the next two years. We expect continued economic headwinds despite strong long-term secular trends. Risks to our thesis 4 Volatile market conditions provide meaningful risks to our view. We see the main downside risks as worsening liquidity and end demand, while Key themes and observations 5 We believe the peak-to-trough price decline for Dubai property is around 70%, which translates into an average clearing price down to approximately Dh650 per sq ft, implying another 30% potential downside to house prices from current levels. Market dynamics and performance snapshot 9 Depopulation challenge 12 Financing equation still a headwind 25 Peer comparison 34 In the following section, we summarise key metrics for our UAE coverage peer comparison, which include sales dynamics, margin structure, geographical exposure, leverage and sectoral composition. Valuation methodology 45 We value developers primarily using a SOTP approach and contractors primarily using DCF. Our secondary valuation methodology entails supporting the SOTP with price-to-NAV for developers and the DCF with an EV-backlog multiple for contractors. Company profiles Aldar Properties 47 Arabtec Holding 61 Drake & Scull 77 Emaar Properties 91 Sorouh Real Estate 107 Real Estate | Table of Contents | 10 March 2011 11 Executive summary We believe the UAE property sector is undergoing mid-cycle dynamics; house prices have corrected by 45-55%, but rising oversupply could see a further 25-30% drop in the next two years. We expect continued economic headwinds despite strong long-term secular trends. Initiating on UAE property sector Despite economic and systemic The key headwinds we see for UAE property are depopulation risk, deleveraging and heavy challenges, we see value in pipeline-delivery schedules leading to demand/supply imbalances. While supply dynamics may be Emaar and DSI somewhat different for Dubai and Abu Dhabi in terms of volumes, their demand dynamics almost mirror each other – a low appetite for new housing as financing remains tight and negative equity concerns linger. As we see it, the good news is that much of the property correction is already accounted for in current asset transactions – ie house prices and equity prices in the stock market down 50% and 75%, respectively, from peak levels. Furthermore, developers from Emaar to Aldar are currently trading at a 50-75% discount to respective adjusted net asset value (NAV). Going forward, we expect UAE property stocks to take cues from global markets and local catalysts – the latter tied primarily to recapitalisation of banks, master developers, corporate and quasi-sovereign balance sheets – which may involve sovereign support, consolidation and/or privatisation. In the foreseeable future, as the market digests both systemic issues and micro news flow, we expect the UAE property stocks to exhibit range-bound performance. We believe market valuations and stock performance will be driven first by balance sheet metrics and second by earnings growth. Companies with higher self-financing capacity and access to capital, with the ability to manage free cash flow within a predictable and consistent range, and diversified revenue streams, will likely drive market premiums and lead in both fundamental and risk-driven equity rallies. We initiate coverage on three property developers and two contractors, as follows. Emaar Properties (Buy, Dh3.10 price target) Our sum-of-the-parts valuation of Emaar suggests 75% of fair value is driven by recurring revenues, which helps mitigate business model risk. Low leverage, adequate self-funding capacity and access to international revenue streams make Emaar a solid pick among peers, in our view. Aldar Properties (Hold, Dh1.40 price target) Strong rerating to the downside in the past 12 months and a recent liquidity injection by the Abu Dhabi government position the stock attractively, but we remain cautious on demand health in the Abu Dhabi property market, NAV growth prospects and the rate of deleveraging. Sorouh Real Estate (Hold, Dh1.15 price target) Despite successful refinancing efforts, we believe Sorouh may face near-term risk due to potential handover delays in 1H011. We believe foreseeable growth prospects are limited, similar to Aldar, and currently the stock appears fairly valued. Arabtec Holding (Hold, Dh1.45 price target) The company’s ability to increase backlog depends on its success rate in markets such as Saudi Arabia, where new award activity remains the strongest. Low-margin wins and uncertainty on receivables provisioning could dilute earnings and limit stock from trading at a premium to its book value. DSI (Buy, Dh1.10 price target) We believe that with Dh7.3bn in estimated backlog and our estimated annual growth of 12% until 2014 (vs company guidance of 20-25%), DSI offers the strongest growth potential for earnings in our coverage universe. Despite execution risk given recent and planned M&A, we believe DSI should be able to benefit from a presence in Saudi Arabia and primary exposure to the infrastructure end-market vs residential. Real Estate | Executive Summary | 10 March 2011 22 Table 2 : Global comp sheet Type Name Country PE P/BV EV/EBITDA EV/Sales Developer Emaar Properties UAE 6.70 0.53 9.30 2.10 Developer Aldar Properties UAE NM 0.25 NM NM Developer Sorouh Real Estate UAE 7.60 0.47 10.60 3.20 Contractor Arabtec UAE 5.10 0.60 24.00 0.43 Contractor Drake & Scull UAE 12.40 0.83 19.50 1.30 Developer Union properties UAE NM 0.19 NM NM Developer Deyaar UAE NM 0.21 NM NM Developer RAK Properties UAE 4.00 0.22 3.02 2.03 Developer Dar Al Arkan Saudi Arabia 5.23 0.60 9.19 3.68 Developer Hang Lung Properties Hong