Robust growth for UAE banks

Goldman Sachs, the world’s largest global investment bank, has forecast robust structural momentum in the UAE banking sector.

The global investment bank, which began coverage of nine UAE banks, in its report “Oiling a virtuous banking cycle”, said UAE banks offer relatively low risk in relation to their peers in similar market and earnings growth is expected to remain strong in the medium term.

“Given their profitability and growth outlook, they should trade at a premium to peers,” the report said, which calculated that UAE banks are trading merely in line with banks in new markets.

Banking profits have bounced back strongly in the UAE against a backdrop of high oil prices, robust economic growth and a resilient real estate sector, Goldman said in its research note.

Goldman initiated on five banks in Abu Dhabi and four banks in Dubai with a ‘Buy’ rating on First Gulf Bank and Union National Bank, and a ‘Sell’ rating on Mashreq bank.

Goldman added First Gulf Bank and Union National Bank to its Pan-European ‘Buy List’ and said growth and profitability for the banks would be supported by solid funding trends, growing participation in Islamic finance, rapidly expanding international operations and potential to increase their exposure to Abu Dhabi’s real estate sector.

INFLATIONARY PRESSURE

Growing inflationary pressure could ultimately result in higher operating expenses, deteriorating asset quality and slower retail loan growth, the report warned.

Due to the UAE’s high economic concentration in the oil industry and the real estate sector, any developments resulting in sharp weakening of oil and real estate prices will negatively affect banking activity. The UAE’s strong economic links with Iran could result in slower trade finance growth and higher cost of equity (CoE), should geopolitical tensions in the region emerge, the report said.

“Based on net asset value (NAV), we value UAE banks on 14.5x 2009E earnings. We reached this conclusion by using a 10 per cent cost of equity (CoE) and five per cent long-term growth rate. The 12-month price targets suggest significant upside from current levels for most banks in its UAE coverage universe with the exception of Mashreqbank, which offers only 10 per cent upside.

“We believe that as domestic exchanges mature and economic diversification broadens, lower levels of volatility will justify UAE’s relatively low CoE when compared with most of its developing markets peers, thus providing strong support for UAE bank valuation,” the report said.

Justifying the valuation premium, Goldman said the 12-month NAV-derived price targets indicate that on an average the UAE banks under its coverage offer an attractive 35 per cent potential upside.

“We screen banks for exposure to real estate and Islamic finance, corporate relationships and liquidity. As a result, we added First Gulf Bank and Union National Bank to our ‘Buy List’ and Mashreq bank to our ‘Sell List’,” the report said.

Returns in the UAE banking sector will be closely linked to three key drivers: exposure to real estate, corporate relationships and Islamic finance. Goldman’s valuation methodology captures these aspects through company-specific estimates, which it uses to derive its valuation of the banking business.

“Volatility in global capital markets is mostly to blame for the unjustified convergence in multiples. Indeed, as recently as the beginning of February, UAE banks traded at more than a 20 per cent premium to the same group of banks based on 2009E P/Es.

“We believe that as external factors normalise, investors should find the UAE bank valuations compelling based on stronger fundamentals and attainable growth expectations,” the note said.

REAL ESTATE OPPORTUNITY

Goldman said real estate represented a substantial opportunity for banks in the UAE. Mortgage and housing finance has only been a small part of UAE banks’ participation in the real estate sector. Tamweel and Amlak, two large Islamic mortgage finance companies, control around half of the market. Nonetheless, mortgage penetration is low at around eight per cent of GDP.

“Our forecasts suggest that this could be as high as 15 per cent by 2010, based on demographic changes, expectations of property delivery and mortgage take-up.

“We quantify this at around Dh60bn incremental lending for UAE banks in the next three years, representing a meaningful opportunity for growth.”

Banks are also likely to continue benefiting from the real estate boom directly, as most of them have real estate subsidiaries, own significant investments in land and properties and/or have close links to the government and members of the ruling families. With a total project pipeline hovering at the $400bn level this will continue to have a material impact on earnings.

CAPITAL LEVELS

The report said UAE banks’ capital levels remain adequate but doubts for how long.

Even though profitability in the UAE banking system is in line with the average for banks included in its new markets universe, asset growth has been significantly higher. This has translated into a constant need for additional capital.

UAE banks have recently raised capital through rights issues (eg Abu Dhabi Islamic Bank, Dubai Islamic Bank), subordinated debt (eg National Bank of Abu Dhabi, Mashreqbank), and convertible debt (eg Abu Dhabi Islamic Bank, First Gulf Bank).

The latter has become particularly popular with banks. National Bank of Abu Dhabi, First Gulf Bank and Abu Dhabi Commercial Bank have all recently announced their intention to issue significant amounts of convertible debt this year.

A combination of high market volatility and increasing demand for bonds in the region has made this choice a relatively low cost and practical alternative. Unless profitability increases, dilution risk will continue to be a tangible possibility, especially on the back of significant operating cost pressure, the report warned.

With the exception of Dubai Islamic Bank, capitalisation levels as of year-end 2007 were comfortably above the minimum required level of 10 per cent under UAE standards.

As banks will need to comply with Basel II guidelines in 2008, there has been much speculation about the impact on capitalisation. For instance, after accounting for market and operational risk, Turkish banks registered a drop in total capitalisation in the region of 200 bps last year.

Lack of disclosure in the UAE makes it nearly impossible to calculate the estimated impact with accuracy.

RETAIL LENDING

Goldman finds that retail lending is not in the driving seat yet for the UAE banks.

Excluding lending to high net-worth individuals, consumer loan penetration to be around five per cent of GDP as of the end of 2007. This low level is not surprising given the UAE’s economic structure.

Domestic economic growth is mainly driven by real estate,
construction, trading flows and oil production.

Nonetheless, fast population growth, which is estimated at around eight per cent in 2007, is fuelling demand for retail banking products. Convergence may be an important driver of loan growth in the future, given that banking assets penetration in the UAE is estimated to be around half that of Europe’s today, based on banking assets to GDP
in PPP terms.

However, this process may be delayed by significant differences in demographics with UAE nationals only representing about one-quarter of the population.

Low participation of women in the work force and higher levels of inequality, as measured by wealth distribution when compared with Europe, may also contribute to a slower development of the retail banking sector.

Therefore, in the medium term, corporate banking and lending to high net-worth individuals will continue to claim the lion’s share of asset growth in the sector, highlighting the importance of corporate relationships.

The risk factors

Goldman has cited the following risks, which could lead to lower earnings growth and profitability estimates and higher levels of cost of equity, all of which could negatively affect UAE bank valuations.

ECONOMIC DEPENDENCY ON THE OIL INDUSTRY: Although we expect oil prices to remain supported at high levels, any developments leading to a sharp fall in oil prices would negatively affect earnings growth and valuations.

REAL ESTATE CONCENTRATION: Even though we have a constructive view on the real estate sector, any developments negatively affecting asset prices in this segment would put pressure on earnings growth and valuation multiples.

STRONG TRADE FLOWS WITH IRAN: Strong economic links with Iran could result in a sharp deterioration of trade finance and higher cost of equity, should political tension in the region emerge.

DEPOSIT CONCENTRATION: Due to the structure of the economy and a small retail sector, banks exhibit a high concentration of deposits among a few large accounts.

MARGIN PRESSURE ON THE BACK OF WHOLESALE FUNDING COSTS: Although we expect deposit growth in local currency to remain robust, banks rely mostly on international markets for long-term financing and for debt in foreign currencies. This could put pressure on margins in certain segments.

HIGH INFLATIONARY PRESSURE: Resilient inflationary pressure may ultimately result in asset quality deterioration and operating cost pressure.

ACQUISITION RISK: Exceptionally high levels of liquidity due to high oil prices, increasing domestic competition and a relatively small retail market may encourage banks to look abroad for inorganic growth opportunities which, depending on acquisition multiples, could lead to earnings dilution.

MARGIN PRESSURE FROM INTERNATIONAL COMPETITION: International banks could initiate competitive pressure in certain segments including corporate finance and wealth management.


LACK OF DISCLOSURE: Publicly available financial information is in some cases insufficient to determine deposit concentration, adequate levels of capitalisation and asset quality.

REGULATION: In some aspects like real estate exposure, the regulatory framework has not been reviewed and may not provide banks with guidance to operate in a fast-changing environment.