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UAE May CPI inflation rose 0.2% (1.4% annually) following five consecutive months of deflation, though as the breakdown goes, housing deflation persists (housing and related services such as utility prices constitute 39.3% of the UAE CPI basket) and thus price levels remain at the lower end of the GCC spectrum–a phenomenon which should continue to normalize through the remainder of the year but which will likely keep monetary policy accommodative.  Against this backdrop, Barclays notes, the once maligned banking sector continues to show improvement as interbank rates remain on their steadfast downward trend, “reflecting improving liquidity.”  That said per 1Q11 results the loan-to-deposit ratio fell to a 4 year low (99%) with “growth in credit to the private sector (3.2% y/y in April) [is] still in recovery mode” and appearing destined to remain that way for the near-term given recent restrictions on lending volumes and associated fees generated (historically ~2 – 4%/annum on retail portfolios) which should pinch those banks with the greatest retail exposure comparatively profoundly (per Kuwait’s Global Investment House, “for personal loans, ‘aggressive’ banks were lending at an average of 180 – 240x while ‘conservative’ ones were at 72 – 84x the monthly salary; analysts there note that First Gulf Bank (FGB) would be most exposed given 34% retail/total loan and 20% retail fees/total income ratios, roughly double those of the peer group median).  Admittedly, pundits note, “these rules will benefit the banking system in the long run, the impact in the short-term will stifle credit growth and come at the worst time when banks are already struggling with corporate defaults and restructuring eating into the bottom-line.”  On a relative value scale the industry as a whole thus continues to lag the GCC universe, trading at [2012e] ~.95 p/b despite a ROE (~16%) that would imply some 30-40% upside (to that end, Kuwait’s sector looks rich in comparison at ~1.95p/b, 14% ROE).  This, however, is likely testament to hitherto opaque nature of certain imminent restructurings–Dubai Holding holds around USD9.1bn (AED33bn), while the Al Jaber Group (AJG) of Abu Dhabi holds roughly USD1.6bn (AED6bn) worth of debtthat needs to be renegotiated–and the possibility of meaningful exposure.  That said on average the estimated impact on total income for 2011 is likely to be, on aggregate, under 2% for every AED500 of exposure, per analysts, meaning the three cheapest banks on an RV-scale (Abu Dhabi Commercial Bank, Emirates NBD and Union National Bank) could be especially ripe to converge, both within the domestic sector and the greater GCC region as a whole.  Yet others point out that overall elevated non-performing loans (NPL) are likely to persist (6.67 percent at the end of April, up from 6.25 last December, versus the GCC average range of 1.5 per cent in Qatar to 8.1 per cent in Kuwait at the end of 2010), a theory in part linked to the commercial property market per Raj Madha of Rasmala, an investment bank: “The commercial property market is taking a double hit from falling rent and falling occupancy levels, so even if occupancy levels on new buildings reach 50 percent, that would still mean cash flow to owners is down about 75 percent from expectations,” he noted in late May.

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Those looking for convergence between du (Emirates Integrated Telecommunications Company), MENA’s top telecom YTD at +10.5% through end-May (20.1x 2011e P/E and 7.1x EV/Ebitdba) and Etisalat (-5.1%; 7.8x and 2.9x, respectively), which was recently ranked the GCC’s second most valuable portfolio brand (USD3.622bn) by Brand Finance, a consultancy, may have to hold on.  Analysts with Egypt’s CI Capital Research recently noted for instance that risk averse capital and bank deposit flow into the UAE from relatively unstable regional geopolitical backdrops “should in turn boost subscriber growth and limit average revenue per user (ARPU) erosion.”  To this end, it wrote, “driven by mobile services, du continued to deliver a positive performance in 1Q11, where earnings more than doubled [y/y].”  Moreover both players should benefit via the impending introduction later this year of long-term evolution (LTE, or “4G”) and voice over internet protocol (VoIP) services (i.e. the ability to make phone calls over the internet), as well as mobile number portability (MNP) which mark a paradigm shift within the sector towards liberalized, revenue diversification outside of the traditional fixed-line and mobile voice segments.  Etisalat’s agreement with France’s Alcatel-Lucent in mid-February to help develop its LTE network, for instance, which will enable high-speed access to multimedia content such as video conferencing, was predicated on said shift: “Over the last year we’ve witnessed a 200% growth in data roaming traffic.  There is an exploding demand for new technologies and large bandwidth to support and enable the surging data traffic,” commented Marwan Zawaydeh, Etisalat’s chief technology and information officer at the time.  Yet to date du has been more aggressive in its rollout: this spring it successfully conducted and completed its first LTE pilot, a move which followed the launch of the latest 42Mbps mobile broadband services, currently the fastest in the country, after having recently upgraded its network to next-generation DC-HSPA+ technology.

The strong push is somewhat characteristic, however, and EFG Hermes, an investment bank, wrote in April that unlike its rival, which maintains a presence in multiple frontier markets, du is a pure play on the various Emirates and moreover “has managed to cement its position in the [UAE] market over the past two years, strongly pressuring  Etisalat’s operational and financial performance to its own benefit.  Operationally [it has] reached a 36% share of the mobile market and a 31% fixed-line market share only four years after its launch.”  Plus, room for growth remains ample: UAE population and mobile penetration rates should rise from 4.9m and 245% in 2010, for instance, to 5.6m and 301% respectively in the next five years per analysts, and du’s higher-than-average expected growth (2010-2012 earnings before royalty growth 28.5% versus regional -1.1%) make it best in class, per a spring research note.  In fairness, some observers wonder to what extent du’s high multiple is merely a product of artificial subsidy: it paid a 15 percent royalty fee to the government in 2010, while its rival, Etisalat , paid 50 percent of its annual net profit as royalties.  Analysts with EFG admit that “there is little clarity on whether the Ministry of Finance will soon inform du of the royalty charge starting in 2011 or not,”  and its sensitivity model indicates a fairly dramatic (~25%) increased intrinsic value per share if the royalty is cut even by as little as 10% this year.  Etisalat’s shares would theoretically have even more to gain, however, given its hitherto under-performance as well as the thesis that the government is priming it for its own royalty cut in advance of allowing  non-local ownership of shares which in and of itself should be a huge liquidity boon for an already attractive country and sector.

A new corporate governance code comes into effect this April in the UAE and attempts to “introduce internationally accepted corporate governance rules into the realm of commercial companies” in the emirate.  For instance, listed companies will be compelled to disclose more details about their board members, such as whether or not they are concurrently serving on the boards of other joint stock companies.  Analysts note that the new legislation may ultimately help realize higher market valuations by improving disclosure standards and thereby addressing one form of investor uncertainty.

Sharjah-based Dana Gas, the Gulf’s first privately run natural gas firm, reported a 31% increase in gross profits compared to the same period last year. Concurrently, net profits grew more than eleven-fold. As usual, the firm’s Egyptian operations played a central role to its financial results; in fact, during the second quarter alone two new fields there came on stream, the firm made a new gas discovery, and it realized three successful appraisal wells–all adding to gas reserves. However, according to CEO Mr Ahmed Al-Arbeed, condensate sales stemming from its operations in the Kurdistan Region of Iraq were just as pivotal to the firm’s recent success. Dana Gas signed strategic partnership agreements with both an Austrian and a Hungarian-based integrated oil and gas group during the second quarter, the beginnings of the culmination of a $400 million investment in the region made in 2003 when the company became the first Middle East firm to venture into the Iraqi energy sector post U.S.-invasion.

Dana Gas makes a wonderful long-term play, in my view, based not only on the fundamentals of natural gas and the expanding role I expect it to play in global energy markets, but more broadly speaking as a proxy on MENA growth. I’m adding it to this site’s long-only, mock frontier portfolio, which will be used to manage and grow a mythical basket of capital. Dana Gas will be our first holding, as of today.

Sharjah-based Dana Gas announced two new gas finds over the weekend in Egypt with reserves totalling an estimated 76 billion cubic feet, leading its CEO Ahmed Al-Arbeed to note that the discoveries would boost the firm’s production and profitability and “take us closer to achieving our target production of 40,000 barrels of oil equivalent/day by the end of the year–a target that we are already well on the way to achieving.” Per news reports, the company’s “aggressive drilling campaign” in Egypt, a country that accounts for the lion’s share of its income, began in 2008 after management announced a plan to invest roughly $500 million in Egypt and Iraq’s Kurdish region in 2009 in order to boost natural gas output.

Per its recently published quarterly results, du, a Dubai-based integrated telecom services provider, reported an increase of 156,000 new subscribers (giving it a total of 2.9 million active mobile customers), in addition to a 12% increase in revenues on the previous quarter and a greater than doubling of profits. With an estimated 30% of the UAE’s mobile market, du is competing chiefly with Etisalat, which presently reports 7.26 million subscribers (though it just disclosed a loss of around 80,000 customers over the past three months). According to its chairman Osman Sultan, du hopes to gain an addition 5% market share over the next year, as well as grow usage of mobile broadband on its network–i.e. the BlackBerry mobile e-mail handset and also the launch of Apple’s iPhone.

Once considered the mere low-cost, low-quality network compared with Etisalat, du’s surging customer base is testament to the brand’s perceived value, as well as its growing competitiveness in a market where the cost of a new mobile line today is a third of what it was a year ago, and mobile data rates and fixed-line internet costs continue to fall as well. However, some analysts wonder whether the company’s edge will disappear once protection originally granted to it (in order to shepherd in competition) from the UAE’s Telecommunications Regulatory Authority (TRA) subsides, and/or a third operator joins the fray? For instance, reports allege that Etisalat has previously complained that it would like to lower some prices, but has not been given regulatory permission.

Aramex, the Dubai-listed logistics and transportation provider, launched yesterday its “Value Express” service for express shipments within the Middle East, North Africa and South Asia regions. The company has contracted with budget carrier Air Arabia to transport parcels at economical rates. The service allows customers the option to transport less urgent parcels at more economical rates, and was developed to support the region’s commercial sector in achieving greater cost efficiencies in the current downturn. According to Aramex Gulf Chief Executive Hussein Hachem, the demand for cheaper freight transport has naturally increased during the recession. Moreover, he expects that the new service will particularly benefit small- and medium-sized enterprises (SMEs)–which represent 75% of total operating companies in the Middle East and which are looking for reliable and cost-efficient solutions.

Both Aramex and Air Arabia are considered two of the stronger “defensive” plays in the UAE, a concept that could one again garner fancy assuming the World Bank’s recent dire forecast for the global economic recession is anywhere on point. Other defensive picks include telecoms Etisalat and du, and foodstuff and mineral water firm Agthia (which back in March announced 90% net profit growth).

Defensive stocks are considered to provide relatively more stability in earnings than high growth companies, and moreover do not experience high volatility quarter-over-quarter in terms of losses, write-downs or uncertainties coming from investments or provisions. That said, defensive plays are not primed for long-term growth, and thus many portfolio managers may still prefer the better risk adjusted opportunities offered by real-estate and financial firms, should markets correct.

A recent report issued by Fitch Ratings concludes that the more challenging operating environment has negatively affected prospects for retail banking in the Gulf Cooperation Council (GCC, consisting of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE), although the degree of severity will vary.  Fitch views the potential risks from retail lending as high in the UAE (particularly Dubai) and Oman, moderate in Bahrain, Kuwait and Qatar, and low in Saudi Arabia.

The report notes further that the most negative impact could be realized in the UAE, particularly in Dubai, because the UAE retail sector is the largest in size and UAE retail loans grew the quickest in the GCC.  Dubai’s economy has been hit especially hard by the global recession, as the UAE has an exceptionally high proportion of expatriates, at more than 80% of the population (90% in Dubai).  Expatriate residence visas are nearly always linked to employment in the GCC; rising redundancies are therefore likely to result in higher defaults as expatriates leave, Fitch notes.  Furthermore, the regulation of retail loans is not as tight in the UAE compared with certain other GCC markets.

Risks is also high for Omani banks as their relative exposure to retail lending is the highest in the GCC, at 38.5% of end-2008 banking system loans.  In addition, Fitch views the levels of leverage available to retail customers as among the highest in the GCC, and regulation of the retail sector as not as tight compared with certain other GCC states.  Finally, the negative impact from retail lending will be least severe in Saudi Arabia, where the market is relatively strictly regulated; demand is sustained by a large, growing young indigenous population rather than expatriates; and the local economy has been more insulated from the impact of the global recession than many other GCC states, though declining energy prices are of concern.

Less than a month after the UAE central bank, based in oil-rich Abu Dhabi, the capital, subscribed up to half of a $20bn five year bond program launched by the Dubai government–news that caused the Dubai Financial Market index to jump 5%–Standard Chartered predicted that inflation levels will fall to 2-3% this year in the UAE as rents and commodity prices ease, and as liquidity dries up.  The new projection is considerably lower than the 20% calculated in 2008.  In fact, inflation accelerated to record highs in all six Gulf Cooperation Council (GCC) states during the past year, fueled by higher government spending and a falling dollar, to which most of the regions currencies are linked.

Yet the bank’s inflation projection is in contrast with that of the government.  UAE Minister of Economy Sultan bin Saeed Al Mansouri, for example, estimates inflation for the year in the range of 5-8%, adding that the government plans to cap prices on 16 basic items and offer discounts at state-owned supermarkets.  However, he lamented, “it is very difficult to have an inflation target when you have a dollar peg.  Policy makers don’t have the tools – the ability to use the currency and the interest rate – to achieve this target because interest rates are set by the U.S. Federal Reserve.”  That said, Mansouri expects inflation to fall because “the supply side will continue but prices will come down especially in the real estate sector due to the drop in demand.”

Finally, Standard Chartered also warned that the country needs a significant increase in liquidity.  The bank believes there is a Dhs110bn liquidity shortfall, despite the recent measures to inject money into the system.  Measures like an additional liquidity injection and a permanent repo window would help plug it, according to Shayne Nelson, the bank’s Regional CEO of the Middle East and North Africa.

Memon Investments, a Dubai-based property developer, predicts a recovery in UAE’s real estate sector within 8-12 months, citing the federal government’s $20 billion bond program that will help to ease liquidity and to alleviate debt burdens shouldered by cash-strapped property firms. Moreover, Memon also notes that construction costs per square foot in the UAE have declined by an average of 30% since the start of the credit crunch, a decline which should make prices for completed projects more affordable and ultimately help to stimulate demand. Such decreasing costs include the prices of steel and other materials including aluminum, wood, glass and diesel, as well as the declining cost of labor and supervision.

JGW

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