Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region

December 2017

HCM Viewpoint

hcm.com Introductory Note

Banks in the Gulf region have been gaining in importance Regardless of your industry, please contact us if you can in recent years, both locally and in foreign markets. Yet, in benefit from an approach that connects these topics to the current context of continuing pressure on oil prices sound business strategy and financial stewardship. and questions on regional stability, it is valid to ask how well Gulf banks are doing in terms of value creation, both on an Value Creation: External and Internal Metrics absolute and relative basis. It is equally valid to ask whether the share price movements of these banks in recent years As depicted in Figure 1, the market capitalization of the 46 accurately reflect the internal value creation taking place Gulf banks1 covered by this study lies between USD 379 and at these institutions. USD 37’570 million as of 31 December 2016. The banking sector represents a significant part of the stock market This HCM viewpoint provides a comparative overview of in the Gulf region – ranging from 26 (Saudi Arabia) to 69 46 banks in the Gulf region. It finds that value creation in percent (Bahrain) of public stock market capitalization. the Gulf banking sector has generally increased in recent years, though not at all banks. Further, it finds a plausible In general, company performance can be measured using correlation between internal value creation and changes external and internal indicators of value creation, which in share price for most banks. For others, however, should be seen as two sides of the same coin. stock returns cannot be fully explained by internal value creation. From an external perspective, one way to capture value is using Total Shareholder Return (TSR). In this viewpoint, Looking at 2016, it appears that internal performance we use TSR relative to the Dow Jones Islamic Market GCC of banks in the Gulf region was to a large extent linked to Index. Using this metric, we find that many banks in the macroeconomic fundamentals and the perceived ability Gulf region have significantly increased their market value of each country to sustain GDP growth and liquidity in recent years, particularly those from the UAE and Qatar. levels under the pressures mentioned above. The value The median TSR value relative to the Dow Jones Islamic perception by investors, as measured by TSR, further Market GCC Index was 9.8 percentage points (p.p.) above reflects shareholders’ views on the commodity markets the index in 2012-2016. and the resilience of Gulf economies in the near future. From an internal perspective, a widely used performance The goal of this study is not to provide any definitive measure is Economic Profit (EP). Because it also reflects performance evaluation of any bank or any sector, but risk, EP can have certain advantages over other measures of to illustrate alternative and complementary methods performance. Notably, it reflects managerial performance for measuring performance. It also aims at helping each and value added to shareholders’ wealth resulting from bank in its internal discussion on what key performance elements such as timely cost management decisions. indicators (KPIs) are most relevant to it. However, EP provides investors with an incomplete picture Measuring performance is beneficial not just for knowing of business results, particularly on a comparative basis: where one stands (ex-post value capturing), but perhaps more importantly for driving the desired value creation ■■ EP is an absolute measure. This complicates (ex-ante). HCM’s work in the Gulf and around the world is comparison of companies of different size without to help boards of directors and senior management work applying additional calculations and making on those factors that can impact value generation. This adjustments. includes strategies for governance, financial steering, compliance, and compensation. We use a variety of ■■ EP has a “past-looking” bias. It accumulates past financial and non-financial methodologies, including success (e.g, strong brand) or past failures (e.g., corporate culture. inefficient retail banking network). As an example,

1 This study uses as a basis the Top 50 GCC Banks compiled by the Gulf Business magazine. However, this study does not include four banks for which no comprehensive data was available for the 2011-2016 period.

Market Capitalization Economic Profit Change in EP Relative TSR Company Country (USD million) (EP) Dynamic (USD thousand) (p.p) 31.12.2016 2012-2016 2011-2016 2012-2016 Qatar National Bank Qatar 37'570 14% 736 32 Al Rajhi Banking Corporation KSA 27'303 -3% -129 -20 First Gulf Bank UAE 15'748 15% 413 199 National Bank of Abu Dhabi UAE 14'296 3% 90 61 Samba KSA 12'988 -4% -88 10 Emirates NBD UAE 12'850 18% 804 202 National Bank of Kuwait Kuwait 11'994 -10% -271 -44 Abu Dhabi Commercial Bank UAE 10'513 4% 118 171 Saudi British Bank KSA 10'001 0% 7 8 Kuwait Finance House Kuwait 9'267 5% 176 -27 Riyad Bank KSA 9'241 -3% -71 8 Banque Saudi Fransi KSA 8'390 -1% -24 -18 Masraf Al Rayan UAE 7'745 13% 102 22 Dubai Islamic Bank UAE 7'496 20% 318 256 Qatar Islamic Bank Qatar 6'743 6% 59 12 Alinma Bank KSA 6'041 36% 234 36 Arab National Bank KSA 5'907 4% 60 -20 Ahli United Bank Bahrain 4'381 -5% -66 28 Alawwal Bank KSA 4'253 -11% -96 70 Commercial Bank of Dubai UAE 3'968 1% 9 181 Commercial Bank of Qatar Qatar 3'441 -35% -520 -49 Union National Bank UAE 3'402 -7% -80 71 Bank Albilad KSA 3'304 11% 59 76 Abu Dhabi Islamic Bank UAE 3'278 7% 92 69 Bank Muscat Oman 3'064 -3% -46 -34 Mashreq UAE 2'997 10% 192 -54 Saudi Investment Bank KSA 2'847 1% 10 12.5 Boubyan Bank Kuwait 2'802 28% 84 -59 Qatar International Islamic Bank Qatar 2'611 2% 6 15 Doha Bank Qatar 2'477 -27% -236 -40 Gulf Bank Kuwait 2'395 2% 12 -83 RAKBANK UAE 2'260 -22% -210 36 National Bank of Bahrain Bahrain 2'220 -13% -36 65 Burgan Bank Kuwait 2'047 -2% -27 -47 Commercial Bank of Kuwait Kuwait 2'009 28% 159 -75 Al Khalij Commercial Bank Qatar 1'681 -9% -35 -8 National Bank of Fujairah UAE 1'655 -5% -16 -2 Al Ahli Bank Kuwait Kuwait 1'590 -15% -78 -80 Bank AlJazira KSA 1'515 14% 92 -19 Arab Banking Corporation KSA 1'151 -13% -189 -24 Bank of Bahrain and Kuwait Bahrain 1'150 -5% -21 14 Bank Dhofar Oman 1'136 -4% -14 -38 Sharjah Islamic Bank UAE 1'017 18% 53 102 National Bank of Oman Oman 909 -11% -41 0 Al Baraka Bank Group Kuwait 563 -2% -26 -58 Ithmaar Bank Bahrain 379 13% 70 56

EP2016 - EP2011 EP Dynamic = Average Trailing Revenue2011-2015

EP = Net Income - (Total Equity x Cost of Equity)

EP does not sufficiently capture the efforts of a bank also be a drawback. For example, some inconsistencies that has moved from a situation of negative EP to a can arise when using net income as a proxy for value after breakeven point. From an EP perspective, such bank debt capital charge. Furthermore, even though all six will still be seen as performing poorly when compared countries reviewed in this viewpoint require listed financial to a bank that started with a positive EP. The latter institutions to use IFRS standards, this does not exclude would be perceived as more successful even if it is only the possibility of a bank using some form of short-term harvesting its past success. income management as a way to give the appearance of better performance. Thus, we find the EP Dynamic Thus, rather than using EP as the sole internal measure indicator to be more valid when used with at least five- of value creation, in this study we use EP Dynamic. This year time horizon, in order to limit the effect of short-term approach is widely used by economic professionals. HCM income management. successfully uses EP Dynamic with its clients, making in each case relevant adjustments. Value Creation Measured by EP Dynamic

In this study, we have slightly modified the formula to reflect Figure 2 shows cumulative EP Dynamic for the Gulf banks certain 2012-2016 changes in value creation.1 EP Dynamic under review. The median EP Dynamic level is 0.9 percent, is based on two variables: (1) EP, which after deducting which is significantly lower than in the previous two years.3 capital charge, becomes a pure economic measure of net In particular, EP growth in 2015-2016 was positive only for value to investors, and (2) revenue, which corrects EP for 14 banks under review (mostly from UAE and Kuwait). size differences.2 The performance of the banking sector in the Gulf region A deeper look into EP Dynamic sheds light on its two reflects adverse economic conditions due to the pressure underlying components: change in the EP margin (EP of lower oil prices. Being largely dependent on oil exports, divided by revenue) and growth in economic profitability. the Gulf economies experienced a low economic growth, This approach captures how efficiently the value was which led to liquidity shortage and weak loan growth in the created, rather than the mere fact that EP was positive or banking sector. negative. This permits looking beyond any success or failure that may have been experienced before the performance The deterioration of the banking sector performance was period in question. It also allows focusing on future results the least evidenced in the UAE. The vast majority of UAE and prospects. In addition, EP Dynamic captures internal banks under review actually had a positive EP Dynamic value creation and is less impacted by market inefficiencies. for 2012-2016. The superior relative performance of UAE banks is explained by the fact that the economy is Some company analysts favor EP Dynamic as it uses more diversified compared to other Gulf countries, which readily available accounting data and does not require provides an opportunity for non-oil growth and thus sensitive assumptions. However, this convenience can supports credit growth.

1 A common way to calculate EP Dynamic is to divide absolute yearly changes in the EP by trailing revenue. 2 In the context of the banking industry, total revenue represents a sum of interest and non-interest bearing revenues of the bank. 3 See HCM “Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region” for 2015 and 2016. 4 © 2017 HCM International Ltd. All rights reserved. Figure 2: EP Dynamic 2012-2016

Alinma Bank Commercial Bank of Kuwait Boubyan Bank Dubai Islamic Bank Emirates NBD Sharah Islamic Bank First Gulf Bank Qatar National Bank Bank AlJazira Masraf Al Rayan Ithmaar Bank Bank Albilad Mashreq Abu Dhabi Islamic Bank Qatar Islamic Bank Kuwait Finance House Abu Dhabi Commercial Bank Arab National Bank National Bank of Abu Dhabi Gulf Bank Qatar International Islamic Bank Saudi Investment Bank Commercial Bank of Dubai Saudi British Bank Banque Saudi Fransi Al Baraka Bank Group Burgan Bank Bank Muscat Riyad Bank Al Rahi Banking Corporation Bank Dhofar Samba Ahli United Bank Bank of Bahrain and Kuwait National Bank of Fuairah Union National Bank Bahrain Al Khali Commercial Bank National Bank of Kuwait KSA National Bank of Oman Kuwait Alawwal Bank Arab Banking Corporation UAE National Bank of Bahrain Qatar Al Ahli Bank Kuwait Oman RAKBANK Doha Bank Commercial Bank of Qatar Median 0.9% -40% -30% -20% -10% 0% 10% 20% 30% 40%

Calculated using USD values. Data source: Thomson Reuters. Analysis: HCM

© 2017 HCM International Ltd. All rights reserved. 5 Most Saudi Arabian banks demonstrated steady value share buybacks). In addition, investors often judge on creation in 2012-2015, however their EP decreased by 28 their investment performance in relation to alternatives percent on average in 2016. Indeed, the local Saudi Arabian available in the market. For this reason, many investors and banks were consistently supported by significant dollar analysts see TSR measured on a relative basis as a good reserves and an expansive monetary policy, however, the performance indicator for aligning owners’ and managers’ economy faced large budget deficits in 2015 and 2016. As interests. a result, Saudi Arabia was downgraded by the major credit agencies in early 2016, followed by a downgrade of most Figure 3 presents TSR over a five-year period for the Gulf Saudi banks under review. These impairments represented banks relative to a benchmark, the Dow Jones Islamic a reputational threat affecting banking revenues and Market GCC Index. The five-year cumulative return for this attraction of international investors. index was 36% as of the end of 2016.

Bahrain and Oman were also subject to a credit downgrade Decreasing oil prices had a strong negative impact on in 2016, while almost all Bahraini and Omani banks in the economy and stock returns, in particular for the the sample had a negative change in EP as compared to banking sector. However, stock markets in the Gulf region revenue over 2012-2016. demonstrated moderate recovery in 2016 and the majority of banks under review had a positive TSR performance Banks in Kuwait and Qatar showed mixed results in terms for 2012-2016, relative to the Dow Jones Islamic Market of EP Dynamic. Despite the pressure of low oil prices, GCC Index. The largest returns (more than 100 p.p. above government spending in these countries remained at a index) were achieved by six Emirati banks. The bottom of high level in 2015-2016 with investment flows towards the list in Figure 3 is composed of Kuwaiti banks, which non-oil sectors. This situation was possible given low demonstrated stock returns of 58 to 83 p.p. below the fiscal breakeven oil prices compared to other countries index. in the Gulf region. Moreover, central banks in these countries preserved liquidity, even though their foreign It is interesting to note that negative TSR was often not reserves decreased significantly in 2016. All of the above supported by corresponding changes in bank net assets. suggest that the banking system in these countries faced Price-to-book ratio, which is the most common valuation ambiguous conditions, but still had the opportunity to multiple for banks, has significantly decreased over a five- sustain pre-crisis profit levels. year period and almost half of the banks were traded at a value below the value of their net assets as of end-2016. “Best” Measure of Value Creation However, assessing the performance of a bank using TSR For the purpose of analyzing the value created by Gulf only can be incomplete or even misleading, because TSR banks, should TSR or EP Dynamic be favored? can sometimes be distorted by market conditions. Further, to the degree that TSR also reflects future expectations Clearly, TSR remains of foremost importance to of investors, it can get ahead of or lag the actual value investors – it is simple, intuitive, and easily observable. creation of a bank. Stock prices directly mirror performance as perceived by financial markets. In efficient markets, stock appreciation Some of these issues can be overcome with the use of is an outcome of expected future company performance, EP Dynamic. Its advantage is that it captures the actual while a stock price decrease suggests that the market internal value being created. As such, EP Dynamic can also negatively views the prospects of a company. be used to assess the rise or decline in enterprise value. And if accurately determined, EP Dynamic should also be Investment performance is typically measured by the reflected in stock returns when markets are operating increase in company value either in the form of share efficiently. Thus, there should be a correlation between price appreciation or income distribution (dividends, TSR and EP Dynamic.

Dubai Islamic Bank Emirates NBD First Gulf Bank Commercial Bank of Dubai Abu Dhabi Commercial Bank Sharah Islamic Bank Bank Albilad Union National Bank Alawwal Bank Abu Dhabi Islamic Bank National Bank of Bahrain National Bank of Abu Dhabi Ithmaar Bank Alinma Bank RAKBANK Qatar National Bank Ahli United Bank Masraf Al Rayan Qatar International Islamic Bank Bank of Bahrain and Kuwait Saudi Investment Bank Qatar Islamic Bank Samba Saudi British Bank Riyad Bank National Bank of Oman National Bank of Fuairah Al Khali Commercial Bank Banque Saudi Fransi Bank AlJazira Al Rahi Banking Corporation Arab National Bank Arab Banking Corporation Kuwait Finance House Bank Muscat Bank Dhofar Bahrain Doha Bank National Bank of Kuwait KSA Burgan Bank Kuwait Commercial Bank of Qatar Mashreq UAE Al Baraka Bank Group Qatar Boubyan Bank Oman Commercial Bank of Kuwait Al Ahli Bank Kuwait Gulf Bank Median 9.3% -100 p.p -0 p.p 0 p.p 0 p.p 100 p.p 10 p.p 200 p.p 20 p.p

Calculated using USD values . Data source: Thomson Reuters. Analysis: HCM

In Figure 4, we present both TSR and EP Dynamic in a current level of internal value due to external threats, e.g. two-dimensional graph. In addition, we define a trend line, economic weakness related to oil prices or other external which shows a positive correlation between EP Dynamic factors. and TSR between 2011 and 2015, with a 1% change in EP Dynamic translating into a 1.7% change in stock returns Getting the Incentives and Governance Right (on average). Overall, the regression analysis confirms the validity of looking at bank performance both from an Whatever may explain the gap between value creation and external (TSR) and internal (EP Dynamic) perspective. market valuation of a particular bank, what is clear is that each bank needs to understand how it can create value and For the Qatari banks the correlation is robust with most manage investors’ expectations. In that sense, many steps of the banks being located close to the trendline. On the can help in addressing the gap. This includes improving the other hand, the stock price of many UAE banks increased quality of communication with shareholders and analysts, more than explainable by EP Dynamic alone. Given the but also giving attention to underlying factors that can economy is more diversified and faces less issues related undermine shareholder confidence, such as uncertainties to dollar supply, investors seem to have more positive about corporate culture, corporate governance or compliance, expectations about the Emirati banks. or an insufficient link of performance to executive pay.

The relationship between EP Dynamic and TSR for the It is a great challenge to identify the right performance Saudi banks appears weaker. Indeed, credit downgrades indicator that captures all aspects of value creation. and a large budget deficit coupled with the on-going low This study focuses on two possible metrics, TSR and EP oil price environment unveiled investors’ uncertainty Dynamic. Which metric or combination of metrics are regarding the resilience of Saudi economy and local banks. appropriate for a particular bank depends on many factors, including its owner strategy and strategic goals, as well as A mismatch between internal value creation and external the external market and country-specific conditions. valuation is observed for Kuwaiti and Bahraini banks: Specifically, all Kuwaiti banks demonstrated negative HCM has deep experience working with companies around relative TSR even though most of them created value the world on these and related challenges. In each case, internally. By contrast, most Bahraini banks showed a we factor in each company’s individual situation and positive relative TSR despite credit downgrades and a complexity. As compensation and governance experts, negative EP Dynamic. HCM also supports companies in ensuring that the managerial incentives and the governance system are As discussed above, the main difference between EP properly calibrated to promote sustainable financial and Dynamic and TSR is that EP Dynamic reflects wealth corporate success. Please contact us if we can be of help actually being created by the bank, while TSR reflects the to your institution in addressing any of these areas. perception of value creation by investors. If a bank’s stock price grew more than the wealth actually created, this would mean that investors are confident about the company’s future. In this case, TSR will continue to overestimate the bank’s actual performance until the bank either increases its internal value creation or the share price decreases.

The inverse situation will occur where TSR is disproportionally low vis-à-vis EP Dynamic. In such case, the cause may relate to ineffective communication by the bank to investors. Moreover, the market might not have confidence that the company can continue creating the

20% Size of the bubbles corresponds to the market capitalization as of 31.12.2016 200%

10% 6 1 0 2 - 2

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-100% -40% -30% -20% -10% 0% 10% 20% 30% 40%

EP Dynamic 2012 -2016

Bahrain KSA Kuwait UAE Qatar Oman

Data source: Thomson Reuters. Analysis: HCM

Olga Beregova is a Partner with HCM International Ltd. During her 13 years of professional experience in consultancy she has successfully steered extensive compensation and governance changes for Swiss and international companies, both private and public. Her expertise extends across multiple industries which include manufacturing, consumer products, energy, financial services, technology, telecommunications and transportation. Olga Beregova holds a Master’s degree in Finance and Capital Markets from University of Zurich and in Linguistics from Kiev State University of Foreign Languages.

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Anastasiia Medianovska is a research analyst primarily dealing with the analysis and evaluation of executive compensation frameworks, including assessment of risk/ payout profiles and calibration of short- and long-term variable compensation plans. Ms. Medianovska holds a Master of Science in Finance from the Universities of Neuchatel, Lausanne and Geneva, as well as a Master’s degree in International Economics from Kiev National Economic University. She passed all three levels of the CFA Program and may be awarded the charter upon completion of the required work experience.

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For further information on HCM services for the Gulf Countries, please contact the HCM Partner responsible for the Gulf region:

Gabe Shawn Varges Senior Partner

Tel. +41 44 560 33 20 [email protected]

HCM International (HCM) is a leading independent Our mission is to support companies and other international advisory firm specializing in the strategic organizations tackle the ever important question: “How aspects of Governance, Compliance, Finance, and to measure, steer and allocate value creation?” We also Compensation, with deep experience across various cover governance, risk and compliance as these also affect industries and in the advising of boards, board committees, value. The “value question” is of core interest not only to senior management, and control functions. Owners, Board of Directors and Senior Management, but also increasingly to institutional investors, proxy advisors, HCM’s partners, managers, and analysts work in its HR and control functions, regulators, and international offices in Zurich, Geneva and Kiev. They are bolstered standard setters. by our global partners in the US, UK, France, Australia, Singapore, and China, which allow us to reach all major HCM is Chair of the Global Governance and Executive markets and support companies of all sizes, from large Compensation Group. multinationals and public institutions, to mid-sized and smaller companies, including those preparing for an IPO.

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