May2012

Research DivisionCompany Reports

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SaudiTelecom Sector

Aljazira Capital is a Saudi Investment Company licensed by the Capital Market Authority (CMA), License No. 07076-37

RESEARCHDIVISION

AGM - Head of ResearchAbdullah Alawi+966 2 6618275a.alawi@aljaziracapital.com.sa

Senior Analyst Syed Taimure Akhtar +966 2 6618271 s.akhtar@aljaziracapital.com.sa

AnalystSaleh Al-Quati+966 2 6618253s.alquati@aljaziracapital.com.sa

BROKERAGE AND INVESTMENT CENTERS

DIVISION

General Manager - Brokerage DivisionAla’a Al-Yousef+966 1 2256000a.yousef@aljaziracapital.com.sa

AGM-Head of international and institutional brokerageLuay Jawad Al-Motawa +966 1 2256277lalmutawa@aljaziracapital.com.sa

Regional Manager - West and South RegionsAbdullah Al-Misbahi+966 2 6618404a.almisbahi@aljaziracapital.com.sa

Area Manager - Qassim & Eastern ProvinceAbdullah Al-Rahit+966 6 3617547aalrahit@aljaziracapital.com.sa

MAY2012

Table of Contents

Executive Summary 1

Strong secular growth, led primarily by mobile services 3Relatively moderate growth in fixed line segment 3Saudi telecom sector remains attractive 4

Data – a promising pillar of growth 6Voice market saturating fast 6Data, the most logical step forward—tremendous potential 9Saudi Arabia on the verge of a broadband boom 11Enterprise segment, an untapped area of growth for data services 14Increasing usage of mobile beyond basic services 17

Transition to next-generation network becomes inevitable 19

Focused growth strategy, strong balance sheet hold key 21Geographic expansion at the core of STC’s strategy 22Mobily among frontrunners in wireless data segment 22STC and Mobily better placed to fund growth 24Capital restructuring, the top priority for Zain KSA 25

Managing costs efficiently holds significant importance 26

Saudi Arabia Telecom Sector Evolution 31

Regulations in Saudi Arabia’s telecom sector 32

Key Investment Risks 33Stiff competition to continue exerting pressure on ARPU 33Competition effect to services quality 33Liquidity risk 33Economic and geopolitical risk 33

Valuation analysis 34

Companies that look attractive 35

Saudi Telecom Company 36

MOBILY 40

Appendix 1: Saudi telecom sector— Key metrics 43

MAY2012

1

The Saudi telecom sector is the largest in the Middle East, with over 56.0 mn mobile subscribers and over SAR77.0 bn in consolidated revenues. After staying dormant until 2000, the sector recorded supernormal growth in the past decade, thanks largely to liberalization of the sector since 2003. Today, the sector is highly competitive, with private players vying for market share by aggressively cutting tariffs—in fact, this has been the trend for five years now. The voice market is fast approaching maturity, with total mobile penetration reaching 198.0% during 2011. We expect the traditional Voice segment to grow moderately, given that penetration is already high and competition is intense. However, there is scope for penetration to increase beyond 200.0%.

The Data segment is expected to emerge as a new area of growth for Saudi telecom operators, especially since the traditional voice market is maturing fast. The Kingdom’s young and tech-centric demographics, the rising craze for smart devices, and relatively high income levels should drive data consumption. Demand for smartphones is also catching on rapidly in Saudi Arabia, with penetration increasing from 17.0% in 2010 to 25.0% in 2011. Another key impetus for growth in the Data segment is the rising demand for broadband services. Despite strong growth, broadband penetration continues to remain comparatively low in Saudi Arabia. Standard mobile broadband penetration in the Kingdom stood at 9.7% in 2010, significantly low compared to the developed markets average of 56.6% and the global average of 17.0%. Fixed broadband penetration was also low at 6.3% compared to developed markets (25.7%) and the world (8.5%). Strong growth in broadband usage coupled with a surge in 3G and 4G services is likely to increase demand for high-speed data consumption and (consequently) drive data revenues. Data revenue is expected to constitute 25.0% of Saudi telecom operators’ total revenue by 2014 compared to 15.0% in 2011. We expect Mobily to be the clear market leader in this segment primarily due to its focused strategy aiming at capturing fast growing mobile broadband market. STC would remain competitive in the fixed broadband market primarily owing to its strong fixed line network infrastructure.

The Enterprise segment is quickly emerging as a new area of focus for Saudi telecom operators. The segment is currently highly underserved compared to some European and developed countries. Saudi Arabia’s robust macroeconomic fundamentals and stable growth outlook are likely to spur the establishment of new businesses. This coupled with the growing need for sophistication and better operational efficiency amongst Saudi companies, especially SMEs, bodes well for the Enterprise segment. Operators providing one-stop solutions stand a better chance of gaining a competitive advantage in the Enterprise segment, especially while catering to large corporate accounts. We expect STC to have competitive advantage over other operators in the enterprise segment. The company’s ability to cater larger corporate account via fully integrated and bundled offerings that include fixed and mobile voice, fixed and mobile broadband, internet, data and ICT services could prove to be a key differentiating factor.

To support the increased data potential, telecom operators are investing heavily to upgrade their technological infrastructure. STC launched 4G mobile services in partnership with Nokia Siemens Networks and Huawei for commercial use in Saudi Arabia in late 2011. Zain also signed partnership agreements with Motorola, Ericsson, and Huawei to offer LTE services in Riyadh, Jeddah, and Dammam. It plans to expand to other major cities by the end of 2012.

Executive Summary

MAY2012

2

Mobily has signed up with Samsung and Huawei to deploy its network, and also has plans to upgrade its WiMax network. A targeted growth strategy and healthy balance sheet are key focus areas for Saudi operators, given the rising competition and significant investment in infrastructure. Both STC and Mobily have a strong balance sheet and are well capitalized to fund growth.

Commoditization of the mobile voice market and stiff competition in the domestic market have encouraged telecom operators to reduce tariffs for both standard and bundled services. STC’s blended ARPU plunged 47.3% during FY2006-11 to SAR72.0. Blended ARPU is expected to continue declining in Saudi Arabia during 2012-14 due to growth in subscriber base and price reduction amid aggressive competition. However, the growing demand for mobile broadband and Value Added Services (VAS) services should help operators to partially offset the deterioration in ARPU. The rate of decline in ARPU in Saudi Arabia should fall by 2.0%-2.5% over the next three years. Hence, operators would do well to manage variable costs efficiently as a means to gain competitive advantage. Initiatives such as infrastructure sharing with existing operators, optimizing spectrum utilization, and technology optimization could help operators control variable costs and protect margins.

We initiate coverage on three Saudi Arabian Telecom companies – Saudi Telecom (STC) and Etihad Etisalat (Mobily), both with Overweight rating. We are considering STC (potential upside of 31.4%) due to its strong presence in the fast-growing fixed broadband and enterprise segments. International expansion in high-growth markets also provides potential to unlock value in the long term. In the case of Mobily (potential upside of 28.1%), its advantage in the mobile broadband segment and focus on achieving operational efficiency through cost minimization are key positives.

Figure 1: Our picks from the Saudi Telecom Sector

Unit STC Mobily

12-Month Target Price SAR 55.7 87.4Potential Upside % 31.4 28.1Current Market price SAR 42.4 68.3Market Capitalization SAR mn 84,200 47,775YTD price change % 25.1 31.9P/E (12E) X 9.6 8.3P/B (12E) X 1.4 2.2EV/ EBITDA (12E) X 5.8 7.1Dividend Yield (12E) % 4.7 4.8

Source: Zawya, AlJazira Capital

MAY2012

3

Relatively moderate growth in fixed line segment

Growth in KSA’s fixed line market has not kept pace with the mobile market, partly due to a higher established base and the fact that competition in this segment is not very intense. Fixed line subscriptions increased at CAGR of 3.6% to 4.5 mn since 2001. With 3.3 mn residential fixed line subscribers, household density stands at 73.9% (in other words, 73.9% of Saudi households have fixed lines). Past trends indicate that over the last four years, household density for fixed lines averaged 73.5%, and has declined from 74.5% in 2006.

Teledensity of fixed lines may increase marginally as a significant proportion of the population lives in areas that are too remote, or prefer to rely solely on mobile phones. In fact, in our opinion, 18% of Saudis live in outlying/remote villages, where establishing fixed line telephony may be not feasible in terms of both cost and implementation.

The Saudi telecom sector has been a model of brisk growth in the past decade. The sector has come a long way in its transition from a slow, government-owned monopoly to a fiercely competitive market. The total domestic telecom services revenue grew at a robust CAGR of 13.2% to SAR60.6 bn during 2005-10. Total sector revenue (comprising of mobile/GSM, fixed and data and international operations), increased at a CAGR of 17.7% to SAR77.2 bn during the same period. This can be ascribed to the strong growth in subscriber base (primarily mobile subscribers) since 2004, when the sector was liberalized, making mobile services more affordable in the Kingdom.

The government’s efforts to open up the telecom sector 2004 onwards proved to be the key trigger for the phenomenal growth in the mobile segment. The Communications & Information Technology Commission (CITC) was established in 2003 to promote competition and provide optimal telecom services in a transparent regulatory environment. As a first step in this direction, in August 2004, the government awarded a mobile license to UAE-based Etisalat to compete against and break the monopoly of Saudi Telecom Company (STC). Competition in the industry intensified with issuance of more mobile licenses in 2007. The entry of new players encouraged companies operating in the sector to ramp up scale and adopt new technologies. In fact, telecom operators have invested SAR31.0 bn over the last three years (2008-2011) to upgrade and develop technological infrastructure. The outcome of this has been beneficial for consumers. ARPU levels have fallen by more than 50.0% since 2005, and companies have been launching attractive packages since 2005. The mobile segment’s growth can also be ascribed to strong demand side factors, such as attractive demographics (population growth of 2.5% per annum) and rising income levels in the last decade.

Strong secular growth, led primarily by mobile services

MAY2012

4

Saudi telecom sector remains attractive

The Saudi telecom market witnessed relatively strong growth in 2010 in comparison to other developing economies in Asia and developed markets in Europe and North America. Telecom revenue in Saudi Arabia grew 16.0% in 2010 compared to Asia (4.0% growth), Europe (9.0% growth) and North America (12.0% growth). The overall GCC telecom market grew 17.0% in 2010.

Another contributing factor to the robust performance of the Saudi telecom industry is the growth of broadband penetration at an average CAGR of 123.0% during the last five years. In 2010 alone, the number of broadband subscriptions increased to 4.4 mn from 2.8 mn in 2009. However, broadband penetration remained low in comparison to developed markets, indicating there is further room to grow. Overall broadband penetration in Saudi Arabia stood at 15.6% in 2010, less than the 24.6% average for developed countries, but higher than the global average of 8.0% and the 4.4% average for developing countries.

The Saudi telecom sector benefits from a favorable demographics profile and relatively high income levels. Approximately 57.0% of the population is under 30 years of age. Additionally, the GDP per capita income of Saudi nationals (USD19,890 per person in 2011) is much higher than other developing economies such as India (USD1,527 per person) and China (USD5183 per person). Therefore, ARPU levels in Saudi Arabia (USD20.8 in 2010) are higher compared to other emerging markets like India (USD2.8). Saudi Arabia’s relatively younger demography and high income levels bode well for the telecom sector.

The Saudi telecom sector’s contribution to GDP was relatively low compared to developed economies, but better than developing countries such as India, China and Russia. The telecom sector contributed just 2.7% of Saudi Arabia’s GDP. In comparison, the telecom sectors of developed economies such as UK and Spain contributed 4.3% and 4.1%, respectively, of the GDP. Nevertheless, the Saudi telecom sector has potential to grow further, especially considering that income levels are expected to increase at a healthy CAGR of 3.5% during 2011-16.

Figure 2: KSA telecom—robust revenue growth

Source: Bloomberg, AlJazira Capital

Figure 3: Healthy operating margins as well

Source: Bloomberg, AlJazira Capital

36 . 224 . 2

18 . 516 . 6

14 . 2

0. 0 10 . 0 20 . 0 30 . 0 40 . 0

IndiaUAE

BrazilSaudi Arabia

ChinaMalaysia

IndonesiaBahrain

South AfricaKuwait

CAGR ( 2006 - 10 )

5.1

9.89.8

12.612.7

31.2

26.6

23.4

21

19.1

13.3

12.7

10.2

8.1

0.00 10.00 20.00 30.00 40.00

Oman

Saudi Arabia

Indonesia

Kuwait

South Africa

UAE

Brazil

India

China

Average ( 2006-10)

MAY2012

5

Figure 4: Our picks from the Saudi Telecom Sector

Qatar

UAE

Australia

US

Canada

Japan

France

Germany

Kuwait

UK

Italy

Spain

Bahrain

Oman

Saudi Arabia

Brazil

Russia

China

India

Singapore

1.5

2

2.5

3

3.5

4

4.5

0 10,000 20,000 30,000 40,000 50,000 60,000

Tele

com

Rev

enue

(% o

f GDP

)

GDP per capita (USD)

Source: Zawya, AlJazira Capital; Note:

MAY2012

6

Most of the supernormal growth in Saudi Arabia’s mobile segment in the last decade came from the voice segment. However, high-end data services, including broadband internet, are expected to lead the next wave. We believe the stage is set for Saudi telecom operators to capitalize on the Kingdom’s immense potential in the Data segment. Saudi Arabia’s young and tech-centric population, the growing popularity of smart devices, and the improved technical capabilities of operators would enable use of richer media content and drive data consumption. Furthermore, the Kingdom’s significant potential in broadband, given its current underpenetrated nature, also augurs well for the Data segment. Wireless broadband, in particular, is likely to receive significant impetus with the introduction of 4G services. We expect the number of 3G and 4G subscribers to increase significantly over the next five years, especially with the introduction of mid- and low-end smartphones.

The Enterprise segment is expected to emerge as another growth avenue for Saudi telecom operators. Currently, the segment is highly underpenetrated with SIM penetration less than 1%. However, Saudi Arabia’s robust macroeconomic fundamentals are likely to spur the establishment of new businesses. The growing need for sophistication and a cost-effective ‘one-stop-shop solution’ would also encourage telecom operators to tap this segment and offset saturation in the voice market.

Voice market saturating fast

The voice market is fast approaching maturity with significantly high penetration rates. As reported by the CITC, the number of mobile subscribers in KSA increased at an exponential CAGR of 34.0% during 2001-11 to reach 56.1 mn. This pushed total (including in active subscribers) penetration to 198.0% in 2011 compared to just 12.0% in 2001. The speed at which penetration increased from 100% to over 140.0% is remarkable. Total penetration increased from 12.0% to 138.0% in eight years (2001-2008). It took just three years (2009- 2011) for penetration to advance from 167.0% to 198.0%. Very few emerging and developed countries in the world have witnessed a penetration spike as rapid as this. Our analysis suggests that the penetration rate in most developed countries already exceeded 50.0% in the early part of the decade. However, these markets currently lag Saudi Arabia in terms of penetration.

Another factor that has emerged as a driving force for penetration over the last five years is the so-called “double-SIM (Two SIM cards/accounts per individual) effect. In our view, this trend has been induced by factors such as the relatively high number of foreigners/expatriates using prepaid connections in Saudi Arabia—roughly 87.5% of customers in the Kingdom use prepaid connections. Expatriates account for approximately 30.0% of the Saudi population, significantly higher than OECD average of 5.0-7.0%. Foreign workers and expatriate businessmen living in the Kingdom generally hold more than one SIM/account. In fact, most businessmen use a smart phone besides their standard phone at the high end of the market. Furthermore, the propensity of Saudis to spend more has increased in tandem with rising income levels. Backed by high oil prices during the decade—prices reached USD147 in 2008 compared to USD23 in 2002—per capita income doubled to around SAR80,000 (USD19,890) from SR32,900 (USD8,785).

Figure 5: Voice market fast approaching maturity with robust growth in mobile market

Source: CITC, AlJazira Capital, * AlJazira estimate

9.5 15.1 23.6 30.5 38.7 45.3 49.1

4.64.6

4.85.5

6.16.3 7.0

2.5 5.0 7.2 9.214.1

19.7

28.536.0

44.851.6

56.1

12% 23% 32%40%

60%81%

113%

138%

167%186% 198%

0 %

50 %

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250 %

0 .0

20 .0

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 *

Sub

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ers (

mn)

Pre -paid subscribers (LHS) Post -paid subscribers (LHS)

Total subscribers (LHS) Penetration (RHS)

Data – a promising pillar of growth

MAY2012

7

It is important to consider the active penetration (excluding inactive accounts), while analyzing the mobile penetration rates in Saudi Arabia. This is due to the presence of sizeable number of inactive accounts in Saudi Arabia which may give a misleading picture with reference to mobile penetration. This can be gauged from the fact that penetration of active mobile subscribers (SIMs which have been in use in the last 90 days) stood 165.4% in 2011 compared to total penetration of 198.0%. In our opinion, the large number of inactive accounts can be ascribed to significant number of religious and business travelers visiting Saudi Arabia who require access to temporary SIMs. According to Kingdoms’ Ministry of Hajj on an average 2.5-3.0 mn religious tourists visits Saudi Arabia each year for pilgrimage. Massive flow of religious tourists visiting Saudi Arabia for Hajj coupled with temporary business travelers play a key role in influencing inactive mobile accounts.

Outlook for voice segment: Moderate growth expected

We believe the traditional voice market is fast approaching maturity and saturation, with overall penetration reaching 198.0% during 2011. The growth would be moderate and difficult to come by with ever increasing competition, especially when CITC is planning to issue licenses to Mobile Virtual Network Operators (MVNO), which, thus far exist only in Oman within the GCC region.

We believe that with such high penetration levels and the likely entry of MVNOs, the traditional voice market would take a breather in terms of growth in subscriber base/penetration. However, there is still room for penetration to increase beyond 200.0%. This, in our view, can be attributed to the potential for use of multiple SIMs by low-income Saudis and expatriates. Another key potential driver of penetration in the voice segment is the growing demand for smart phones. This would be complemented by the anticipated healthy growth in population. IMF expects KSA’s population to grow 2.2%-2.5% during 2011-2016, which, in our opinion, would add 7.9 mn new subscribers by 2014. Consequently, we expect mobile penetration in KSA to reach 211.0% in 2014 after increasing to 209.0% in 2013. We further anticipate active penetration rate to increase to 175.4% and 177.1% in 2013 and 2014, respectively.

Figure 6: Active penetration is high as wellSource: CITC, AlJazira Capital

Figure 7: Comparatively high penetration*Source: CITC, ICT, AlJazira Capital, *Active penetration

3.0 5.0 7.2 9.0 13.4

17.9 23.9

29.8

36.4 42.2

37.8

0%

40%

80%

120%

160%

0

10

20

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2001

2002

2003

2004

2005

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*

Sub

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mn)

Active subscribers (LHS)Active penetration (RHS)

196

165 161145 132 131 127

101 9064 61

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MAY2012

8

Extracting further value from subscribers will be pivotal

Over the last five years, Saudi telecom operators focused on capturing market share in the Voice segment by aggressively adding new subscribers. However, this came at the expense of declining ARPU levels, as operators lured subscribers by reducing voice tariffs. According to our estimate, Saudi Arabia’s blended ARPU plunged 56.7% during 2005-10 to SAR78.0, as both STC and Mobily reduced mobile tariffs to add subscribers. However, now that penetration has reached as high as 198%, these operators need to revisit their strategy and focus on deriving additional revenues from existing customers by increasing usage per subscriber. In other words, operators need to shift focus from gaining market share to being competitive. One such strategy adopted by players, such as STC and Mobily, is to increase the proportion of postpaid subscribers in the total subscriber base. This can be evinced from the fact that growth in postpaid subscribers (11.0%) outpaced the growth in prepaid subscribers (8.4%) for the first time during 2011. Mobily’s management claims 12.0% of its subscribers currently hold postpaid connections, and this is expected to grow further in the coming years. Around 25.0% of STC’s subscribers have postpaid connections. With the traditional Voice segment reaching maturity, operators would need to derive additional value from existing customers by increasing usage per subscriber.

Figure 8: Moderate growth in mobile penetration (2012F-2016F)

Source: AlJazira Capital

Figure 9: Growth in prepaid Vs post paid subscribers

Source: AlJazira Capital

37.8

40.241.2

42.3

43.4

44.5

155%

160%

165%

170%

175%

180%

185%

34.0

36.0

38.0

40.0

42.0

44.0

46.0

2011

E

2012

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MAY2012

9

Data, the most logical step forward—tremendous potential

Given the limited growth prospects in the traditional voice market, the Data segment has emerged as logical option for Saudi operators to seek alternative revenues and mitigate slowdown in the Voice segment. The Data segment holds tremendous potential for growth, given that internet is fast achieving mass market exposure in Saudi Arabia. Value-added services (VAS), which is typically reported under the Data segment, is set to surge as a percentage of total revenue for Saudi telecom operators. Data revenue in Saudi Arabia is still low at approximately15% of the total revenues when compared to 40.0% for the developed markets of the world. We believe strong underlying growth drivers are in place to drive data consumption.

Young, tech-centric population

Saudi Arabia is the most populous country in the GCC. The Kingdom’s population (around 28 mn 2010) has been growing at an average rate of 2.5% each year during the last five years. The population is expected to continue growing at the same rate in the coming decade. In addition, the population of Saudi Arabia is one of the youngest in the world, with 57.0% below the age of 30 compared to UAE (49.6%), Kuwait (54.4%), Bahrain (49.5%), and Qatar (44.8%). In terms of the ratio of population below the age of 30, Saudi Arabia also compares well with other emerging countries such as China (43.2%), Brazil (50.9%), Russia (37.1%), and Malaysia (56.2%). This is a crucial factor for growth in mobile services, especially for the Data segment, as the youth are generally more tech-savvy and adopt new products and services quickly. Besides, with around 8 mn expatriates, this segment accounts for 30.0% of the total population. We believe the expatriate population is another important contributor to growth in the mobile data segment.

Smart devices catching on

Saudi Arabia’s young population demographics, rising income levels and an expanding electronics retail sector have fueled demand for smart devices like notebooks, smartphones, 3D technology, PDAs and 3G handsets, and high-end gaming and digital solutions. Smartphones are catching on fast in Saudi Arabia, given the enhanced user experience, superior technical capabilities and support for various applications and services. Since the launch of Blackberry in 2006, the Saudi market has been flooded with new devices by leading handset manufacturers. Apple’s i-phone 3G made its first appearance when Mobily launched it in 2009. Google Android smart phones, currently led by Samsung and HTC products, have also entered the Saudi market in the last two years. Consequently, the smartphones segment exhibited rapid growth in Saudi Arabia, with penetration increasing to 25.0% in 2011 from 17.0% in 2010. According to Informa, a leading telecom data provider, the penetration of smartphones in Saudi Arabia is expected to reach 44.8% by 2015. With increasing demand for smart devices, demand for data services is likely to increase significantly in the coming years.

Figure 10: Saudi Arabia’s young population base

Source: United Nations Population Department, AlJazira Capital

57.0 49.6 54.462.9

49.5 44.857.9

43.2 50.937.1

59.3 56.236.8

43.0 50.4 45.637.1

50.5 55.242.1

56.8 49.162.9

40.7 43.863.2

0 %10%20%30%40%50%60%70%80%90%

100 %

Sau

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Kuw

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Om

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Bra

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Sou

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Mal

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S.K

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15 -29 age group Other age groups

28 8 3 3 1 2 1,233 1,360 198 147 50 29 49

Tota l population (mn)

MAY2012

10

Evolution of mobile devices

Figure 11: Growth in smartphones penetration to drive demand for data

Source: Informa, AlJazira Capital l

Voic

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SM

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Cam

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Mid income bracket ( Young population)

High income bracket ( Young/af f luent/ corporates/

25.0%

75.0%

2011 2015E

44.8%

55.2%

Smartphones share

Basic and feature phones share

MAY2012

11

Saudi Arabia on the verge of a broadband boom

Development of the internet and broadband market plays a crucial role in influencing the demand for the data segment as it complements high-speed data provisions, applications and high-end gaming, and digital solutions. Although a recent phenomenon in Saudi Arabia, broadband internet has grown significantly over the last five years. The Kingdom is currently on the verge of a broadband boom with subscribers increasing at a CAGR of 133.5% to 4.4 mn during 2005–10. The number of standard broadband subscribers grew 31.3% Y-o-Y in 9M 2011, resulting in an overall penetration rate of 20.6%. The growth in the number of users can be ascribed to wider internet access, higher public awareness, and improvement in technological infrastructures. However, majority of this growth has come from wireless (Wimax & Mobile HSPA) broadband, the growing use of which enables customers to use a variety of data packages. Wireless connection accounted for 60.8% of total broadband connection in 2010, up from 47.6% in 2009.

Despite strong growth in the broadband market, penetration levels continue to remain comparatively low in Saudi Arabia. Standard mobile broadband penetration1 in the Kingdom stood at 9.7% in 2010, lower compared to the developed market average of 56.6% and world average of 17.0%. Furthermore, it remains low compared to some of the regional counterparts such as Bahrain (25.0%) and Oman (14.0%). At 6.3%, fixed broadband penetration was also lower compared to that of developed markets (25.7%) and the world (8.5%). Low broadband penetration, especially mobile broadband, provides an attractive opportunity to boost data revenue and offset the likely slowdown in the traditional voice segment. The uptrend in the number of broadband users is expected to continue; the Kingdom is likely to add 7.2 mn new standard broadband users by 2016. We believe the broadband growth cycle in Saudi Arabia would peak in 2012 with total subscribers increasing 32.4% Y-o-Y to 7.7 mn.

Figure 12: Broadband market growing fast in Saudi Arabia

Source: CITC, AlJazira Capital, as of 9M 2011, Note: Broadband subscribers for 2011 does not include Dedicated Mobile Data

Subscriptions classified by CITC

1. Excluding subscriptions to dedicated data services over a mobile network which are purchased separately from voice services as a stand-alone service

0.22 0.62 1.04 1.44 1.74 2.13

1.3

2.7

3.7

0.3% 0.9%2.6% 4.1%

10.3%

15.6%

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Fixed subscribers (LHS) Mobile subscribers (LHS)

Total broadband subscribers (mn)Total broadband penetration (RHS)

0.064 0.220 0.646 1.075 2.750 4.440 5.830

CAGR (2005-10)-133.5%

Figure 13: Low fixed broadband penetration Source: ICT, AlJazira Capital

25.721.0

10.58.58.2

6.34.8

1.81.71.6

0.0 5.0 10.0 15.0 20.0 25.0 30.0

Developed marketsBahrain

UAEWorldQatar

KSADeveloping markets

EgyptKuwaitOman

MAY2012

12

Wireless broadband (Wimax & Mobile HSPA) to drive growth in data

Although both mobile and fixed line broadband subscriptions are expected to surge, the former is likely to lead. Our rationale is based on the growing demand from the youth, increased affordability and growing popularity of smart/lifestyle mobile devices, and limited entertainment avenues in Saudi Arabia. With regard to supply side drivers, lack of technological infrastructure is no longer a hindrance as 3.5G/HSPA mobile services have emerged as an alternative to traditional copper-based fixed line DSL technology. Faster HSPA broadband is further supported by 21Mbps speed that would fuel broadband growth. Both STC and Mobily are well equipped, with 3.5G Wimax network, to support high-speed broadband. In addition, operators such as Mobily and Zain are aggressively investing in the acquisition of 4G and LTE (Long-Term Evolution). (The same has been discussed in detail in the following section on technological development and mobile infrastructure in Saudi Arabia.)

We believe the following factors would also prove to be the key triggers for mobile broadband growth outpacing fixed line broadband.

• Operators may not find it economically feasible to cover the entire Kingdom through landlines given its huge land mass.

• There is a probability of multiplicity of connection in case of HSPA subscriptions as they are sold to individuals and not distributed among an entire household.

Launch of 3G and 4G services provides further impetus for data consumption

Demand for 3G and 4G services would be a key growth driver for the data segment, in our view. Our rationale is based on the fact that the data consumption level of 3G subscribers is 45% higher than that of 2G subscribers. Furthermore, owners of 4G-enabled smartphones (such as i-Phone 4) use around 1.5 times more data than 3G owners. Hence, demand for 3G and 4G services would be crucial for sustaining growth in the data segment. In light of this, we present below our analysis of how the 3G and 4G market in Saudi Arabia is likely to progress in the next five years.

The 3G subscriber base in Saudi Arabia has grown significantly in the last couple of years largely due to surging demand for high-speed internet amid increasing craze for devices such as smartphones and tablets. The 3G subscriber base has increased more than 50.0% during the period, and currently accounts for approximately 14.0% of total subscribers. While this would support the increasing data consumption, extension of 4G services in the Kingdom is likely to boost growth further. As discussed earlier, major players have invested in the acquisition of 4G technologies, and have tested LTE (commercially known as 4G) networks.

Figure 14: Low mobile broadband penetration

Source: ICT, AlJazira Capital

56.625.0

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MAY2012

13

Figure 15: Growth in 3G & 4G subscribers Source: AlJazira Capital

Figure 16: Share of 3G & 4G subscribers % Source: AlJazira Capital

We believe the strong growth in mobile broadband usage and the surge in demand for 3G and 4G services are likely to boost the demand for high-speed data consumption. This, in turn, would boost the VAS revenue of telecom operators which is typically reported under data revenues. Data revenue’s contribution to total revenues is low for Saudi Arabia (accounting for approximately 15.0%) compared to that for developed markets (40.0%) and emerging markets such as China (22.0%).

We expect data revenues to rise quickly in the coming years with increased data consumption and usage of VAS. Accordingly, we project data revenue, as percentage of total revenues, for Saudi Arabia to increase to 25.0% in 2014.

Telecom operators in Saudi Arabia are likely to increasingly adopt 4G technologies to meet the surge in demand for data services. However, demand for 4G is highly influenced by factors such as consumers’ acceptance of high-tech technology, income levels (4G services would be expensive vis-à-vis 3G) and demand for sophisticated services. Historically, Saudi Arabian consumers have not been very flexible with regard to acceptance of high-tech technology (3G was launched only in 2010) compared to some of the developed and emerging markets. However, the trend is quickly reversing as the younger generation is becoming tech-savvy. This can be gauged from the significant growth in the 3G subscriber base within just two years of its launch in the Kingdom. This coupled with rising income levels of the younger generation hold significant latent potential for 4G services in Saudi Arabia.

In the near to medium term, demand for 3G is expected to continue outpacing 4G as the market is still highly underserved compared to few developed markets. Also, 4G service in the Kingdom is in its infancy as operators continue to tackle the challenges of revamping the technological infrastructure needed to support it. We expect the 3G subscriber base to increase at a CAGR of 14.6% to 27.7 mn during 2011–16. On the other hand, growth in the 4G subscriber base is expected to accelerate post 2013; it is expected to expand at a CAGR of 51.3% to 11.8 mn during 2013–16. Accordingly, we expect 3G and 4G penetration in Saudi Arabia at 87.7% and 37.5%, respectively, by 2016.

7.2

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MAY2012

14

Figure 17: Low share of data revenues (%) Source: AlJazira Capital

Figure 18: Data revenues expected to surge Source: AlJazira Capital

Enterprise segment, an untapped area of growth for data services

The enterprise/corporate segment holds significant growth opportunities for telecom operators in Saudi Arabia that are yet to be tapped. According to Booz & Company, enterprise SIM penetration in MENA countries, including Saudi Arabia, stands at less than 1.0% relative to 6.5% in European nations. Also, Information and Communication Technology (ICT) spending in Saudi Arabia is currently less than one-fifth of that in Western Europe and just one-tenth of that in the US. Furthermore, revenue from the enterprise segment accounts for 17.0% (on average) of the total revenue for major European operators. This provides ample opportunity for Saudi telecom operators to tap this market, especially considering that the Kingdom’s macroeconomic fundamentals are sound. This, in our opinion, is crucial as demand for telecom services from the corporate sector is highly correlated to the economy’s performance.

The Kingdom’s economy proved its resilience during the financial crisis of 2008 and emerged relatively unscathed from global economic slowdown. After remaining flat during 2009, the Saudi Arabian economy grew a healthy 4.1% in real terms during 2010. Provisional numbers indicate that the Kingdom’s GDP is likely to expand 6.1% in 2011, where listed companies combined earnings grew 24.0% Y-o-Y during 9M 2011. The IMF expects Saudi Arabia’s economy to grow at an average annual rate of 4.7% over the next five years. KSA, which was ranked 11th among 183 economies and the first in the MENA region in terms of ease of doing business in 2011, is expected to witness a substantial flow of new businesses.

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The Kingdom’s economy is fast moving from being traditionally oil-based to service-oriented, largely due to the government’s diversification efforts. This, in turn, would require businesses to become more sophisticated in their infrastructure need. Saudi businesses would need advanced telecom services that can improve their efficiency and competitiveness. Enterprise demand for high-end telecom services (such as data services) holds significant potential in Saudi Arabia, given the increased need for mobility, seamless integration of communication functionality and web-based technologies. In addition, government initiatives are contributing to the growing need for advanced telecom services. The government has launched several e-projects that require major development of the telecommunication sector under the National Communications and Information Technology Plan (NCITP). Development of the King Abdullah Science Park (KASP) and Information & Communications Centre (ITCC) are two examples of the initiatives undertaken by the government.

Figure 19: High proportion of enterprise revenue for European operators (2010)

Source: GOSI, AlJazira Capital

SME segment lucrative

The number of business establishments in Saudi Arabia increased at a CAGR of 15.7% during 2004–09. This growth is largely driven by small and medium enterprises (SMEs), which are an integral part of the business environment in KSA. The number of SMEs in Saudi Arabia rose at an average annual rate of 20.0% during 2004–09, accounting for more than 97.0% of the total business establishments. SMEs are also increasingly acquiring sophistication with the growing need for mobile and data services. SMEs are looking for integrated and customized cost-effective solutions to meet their mobile and data services needs. Furthermore, as SMEs in Saudi Arabia do not have in-house IT capabilities, there is ample opportunity for telecom operators to provide services that would help these businesses meet their specific objectives such as reduction in costs, increase in productivity and improvement in customer satisfaction.

The number of business establishments as well as their telecom expenditure is expected to increase substantially, considering the positive macroeconomic outlook for the Kingdom and its improving business environment. Number of business establishment Saudi Arabia is expected to register a healthy growth of 12.0% during 2010-2014. Robust increase in the number of enterprises in Saudi Arabia presents a key growth opportunity for telecom operators.

25.3%15.9% 17.0% 14.2%

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Figure 20: Growth in business establishment to boost demand for corporate telecom services

Source: GOSI, AlJazira Capital

85.6117.5 133.6

159.1187.8

213.2 230.3 253.3283.7

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MAY2012

16

How to target SME segment effectively?

• Identify customers based on key indicators such as telecom expenditure and service sophistication.

• Design customized and bundled solutions that would provide “under one roof” experience. For instance, STC’s Flex plan is a postpaid plan that works with prepaid recharge vouchers. This allows SMEs to control their budgets by setting a fixed credit amount, which employees can access on monthly basis.

• Provide high-end SMEs solutions that would require minimal investment upfront (for instance, software-as-a-service (SaaS) and cloud computing services).

In our opinion, the following business areas offer attractive opportunity in the broad enterprise segment:

• Net working services that are seamless and improve productivity; operators can offer integrated platform for voice, video, internet, messaging and other data services.

• Services providing comprehensive connectivity across branches, regions and nations.

• Management and maintenance of corporate network, cloud computing, and ancillary services such as implementation and management of network security.

• Real time services such as Internet Protocol telephony (IP) telephony, e-mail, and instant messaging, among others.

Figure 21: Strong potential for end-to-end enterprise solutions

Source: AlJazira Capital

WAN

Internet

E-MailERPVOIP

Video Calls

Branch Offices

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MAY2012

17

STC competitively positioned in enterprise segment; Mobily playing catch up

STC dominates the enterprise segment of the Saudi telecommunication industry, with more than 435,000 corporate accounts. The company has significant presence in SME segment, which accounts for 98.6% of its total corporate accounts. This indicates that STC must tap large business accounts to maintain its dominant position and generate more value from the enterprise segment. Mobily, although a late entrant, is increasingly capturing large corporate accounts. The company’s deployment of the LTE infrastructure as well as its recent strategic partnership with Google Inc to provide high support for enterprise computing would help it in this regard. It has already secured some big-ticket corporate clients. For instance, Mobily was selected by SABIC for its IP VPN project, and chosen by the General Organization for Social Insurance (GOSI) for the Wahat Ghurnatah business park.

We believe providing one-stop solutions would be the key to gain competitive advantage in the enterprise segment, especially while catering to large corporate accounts. STC offers fully integrated offerings that include fixed and mobile voice, fixed and mobile broadband, internet, data and ICT services. The company is engaged in developing the telecom infrastructure in new economic cities, focusing on services such as broadband, fiber-to-the-factory, Wifi, WiMAX and VAS. The product roadmap includes managed as well as advanced services such as cloud computing and M2M-based services. We believe STC has the scale as well as the advanced infrastructure required to grow in the enterprise segment. The company was the first operator to launch a cloud-based eHealth solution, Easy Clinic. In addition, STC’s experience in serving big-ticket corporate accounts would give it a competitive edge, in our opinion. Its corporate clientele includes top Saudi Arabian organizations such as government ministries and major companies.

Increasing usage of mobile beyond basic services

• Mirroring the trend in developed as well as emerging markets, consumers in Saudi Arabia are using mobile phones for several services beyond basics. Some of these are mobile financial services (MFS), e-commerce and healthcare-related services. MFS, particularly, has been gaining rapid traction over the last few years due to the dominant role of capital and financial markets in the Kingdom’s economy. Although the service is in its nascent stage in Saudi Arabia, the potential for growth is significant, considering that financial institutes are looking to provide innovative and cost-effective banking solutions to customers through mobile phones. Internet and mobile banking services are rapidly emerging as major sources of information, sales and service; and efficient channels to interact with customers. In our view, Saudi Arabia is at an advantageous position to capture the MFS opportunity due to the following key factors:

• Established electronic platforms, such as the SADAD payment system, in the Kingdom provide a strong foundation. SADAD, a national electronic billing and payment (EBP) service, facilitates faster and more efficient centralized electronic billing and payment for consumers and business customers.

• Strong regulatory bodies such as the SAMA and CITC in KSA seek to create a standardized system.

• The Kingdom has a large expatriate population compared to other emerging markets. This opens up avenues for services, such as fund transfer, through mobile phones.

• Policies and legislative reforms by the SAMA ensure a strong legal framework for financial services.

We believe MFS offers telecom operators the opportunity to complement and expand current offerings, and differentiate themselves from competitors in the long term.

MAY2012

18

A PEEK INTO 3G and 4G technology

3G technology

3G refers to the third generation mobile telephony and wireless technology. It facilitates the transfer of voice and non-voice data (music downloads, emails and instant messaging) over the same network simultaneously. The 3G technology helps in increasing the bandwidth, facilitates multiple mobile applications and ensures clarity of digital signals. It transmits packet switch data efficiently at better and increased bandwidth, and offers more advanced services to mobile users. The spectral efficiency of 3G technology is better than that of previous mobile technologies. It can facilitate several multimedia services. Compared to earlier technologies, 3G:

• Offers several times higher data speed

• Enhances audio and video streaming

• Supports video conferencing

• Facilitates web and WAP browsing at higher speeds

• Supports Internet Protocol television (IPTV)

Key features and technical specifications of 3G:

• The transfer rate of 3G networks is between 128 kilobits per second (kbps) and 144 kbps for fast moving devices, and 384 kbps for slow moving. For fixed wireless LANs, the speed goes beyond 2 Mbps.

• 3G technology standards include W-CDMA, WLAN and cellular radio

4G technology:

4G is a fourth generation mobile telephony and advanced wireless technology. It is a successor of the 3G 4G, the fourth generation mobile telephony and advanced wireless technology, is a successor to the 3G and 2G families of standards. 4G is not one defined technology or standard, but a collection of technologies and protocols aimed at creating fully packet-switched networks optimized for data. The technology, still in its infancy, is projected to provide speeds of 100 Mbps while moving and 1Gbps while stationary.

Benefits of 4G over 3G

• High speed video streaming, TV broadcast, video calls and video clips

• Enhanced gaming, chat and location services

• Less complex, faster transmission

• High speed teleworking/VPN access, sales force automation, video conferencing and real time financial information for companies

MAY2012

19

The Saudi telecom sector has transformed significantly over the last decade in terms of technological capabilities. With just a single player providing basic GSM services and internet facilities on dial-up and fixed line (PSTN) network, the telecom infrastructure in Saudi Arabia was well behind that in developed and some developing economies at the start of this period. However, liberalization of the sector in the latter half of the decade, which resulted in the entry of new companies, inflow of large investments and faster adoption of new technology, helped it to surpass some of the developed economies.

A latecomer in technology adoption, the Saudi telecom sector has avoided issues associated with large legacy systems that could have been a bottleneck in upgrading to the new network infrastructure. KSA’s telecom sector currently offers full capacity 3.5G HSPA services for mobile applications in addition to limited long-term evolution (LTE, also known as 4G) networks. Furthermore, industry players such as STC are exploring the option of offering triple play services with the convergence of IPTV, internet and phone services into one package following the implementation of the next-generation network (NGN) technology.

Although the fixed telephony market has been on a decline of late, the fixed line technology is getting a new lease of life with STC (dominates the fixed line market in Saudi Arabia) investing in the NGN technology. STC would replace the existing fixed line infrastructure in a phased manner between 2009 and 2012. This is expected to result in operating cost savings and higher broadband speeds up to 100 gigabytes per second. The increased internet speed due to the improved fixed line technology is expected to enable STC to facilitate high bandwidth applications such as video and television through its triple play offerings.

Figure 22: Saudi Arabia’s telecom sector – industry life cycle of technology adoption Source: CITC

Stages of Industry Cycle

Market Introduction Growth Mature Saturation Decline

IPTV FTTH Services

ERP Solutions Internet Video Conferencing MMS Mobile Broadband (3G) Mobile broadband (WIMAX/ LTE) ADSL Broadband WIMAX Broadband Managed Security Services Mana ged CPE Services IP -VPN Services

Mobile telephony

Fixed telephony

Frame relay services

Transition to next-generation network becomes inevitable

MAY2012

20

In Saudi Arabia, telecom operators have switched rapidly from 2G mobile networks to 3.5G, while some such as Mobily, Zain KSA and STC offer 4G networks. STC launched 4G mobile services in collaboration with Nokia Siemens Networks and Huawei for commercial use in Saudi Arabia in late 2011. Ericsson would continue to be STC’s leading vendor for the deployment of 4G networks across Saudi Arabia, besides managing its 2G and 3G networks. Zain has signed a partnership agreement with Motorola, Ericsson, and Huawei to offer LTE services in Riyadh, Jeddah, and Dammam; it also plans to expand to other major cities by the end of 2012.

Mobily’s strategy is the exact opposite of Zain’s—the company would launch 4G services in smaller cities before expanding to major ones. Mobily has tied up with Samsung and Huawei to deploy its network. Furthermore, it plans to upgrade its WiMAX network to LTE in the near future through the Bayanat al Oula acquisition.

Saudi Arabia is expected to surpass European countries in LTE adoption—it is estimated to reach 12.5% of all subscriptions in KSA by 2015 relative to just 3.4% in 2012. This implies the Saudi telecom sector would need considerable investments in either network upgrades or maintenance of ongoing operations. According to Saudi Arabia’s economy minister, investments in the telecom sector would reach around SAR37 bn in 2013 and SAR50 bn in 2015.

MAY2012

21

Since the liberalization of the Saudi telecom sector in 2004, operators have focused on capturing market share. Players such as Mobily and Zain KSA have captured significant share from market leader Saudi Telecom over the last five years. STC continues to lead the pack with 45.0% share (in terms of total subscriber base) in the domestic market in FY2011. Mobily commands 38.3% and Zain KSA 16.7%. Hence, vying for market share by reducing ARPU levels and offering attractive packages has been at the core of the strategy pursued by these telecom operators since 2005. However, with the domestic voice market fast approaching maturity, operators have shifted focus to increasing revenue from alternative streams such as mobile data (VAS in particular), a largely untapped segment in the Kingdom. This requires significant capital expenditure (capex) on improving the technological infrastructure (upgrading existing legacy network and moving towards 4G/LTE) to stay ahead in the competition. As discussed earlier, Saudi Telecom, Mobily and Zain have already committed significant capital expenditure in upgrading their technological infrastructure. In this scenario, we believe an operator with a targeted growth strategy and healthy balance sheet would lead the market.

In the following section, we discuss the growth strategy of Saudi telecom operators and assess how they are placed against each other:

Figure 23: STC continues to lead the marketSource: Company filings, Tadawul, AlJazira Capital

Figure 24: However, market share on decline Source: AlJazira Capital

45.0%

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MAY2012

22

Geographic expansion at the core of STC’s strategy

With the domestic telecom market nearing maturity and amid increasing competition, expanding footprint in international markets is becoming a key aspect of the strategy of telecom operators. However, of the telecom operators in KSA, only STC has successfully expanded in international markets. The company has increased operations abroad with around USD6.0 bn of foreign investments since 2007. Starting with the acquisition of Binariang, the private parent arm of Malaysian mobile operator Maxis, STC today operates in 10 countries. In another significant move, STC acquired 35% stake in Oger Telecom, a private company with assets that include majority holdings in Turk Telekom and Cell C of South Africa.

As things stand, international business has become an integral part of STC’s overall strategy. Revenue from international operations contributed 32.3% to the company’s total revenue in FY2011. STC plans to increase the share of revenue from foreign markets to 50.0% by FY2014.

This would require substantial capital expenditure and commitment on the part of the management. STC’s international expansion gives it a competitive advantage—the company is able to diversify its revenue stream, hedging against saturation in the domestic market. Major competitors Mobily and Zain are yet to explore the overseas market; this leaves them vulnerable to domestic market dynamics. In addition, STC may benefit from early mover advantage, given its large international operations.

However, STC is yet to unlock value from its international operations. Despite international revenues coming in at a significant 32.3%, their contribution to the bottom line is negligible. This can be primarily ascribed to the high initial cost of setting up operations and capex. Although operations in Malaysia, Turkey and South Africa have already started generating returns, those in countries such as India and Indonesia would require significant investments. Besides, market dynamics in most of these geographies (intense competition, falling ARPUs, high capex requirement primarily to upgrade the technological infrastructure) are similar to those in KSA. Moreover, STC’s minority stake in these operations remains a cause for concern as it may lead to a potential mismatch of strategy with majority shareholder. Thus, while international operations have a significant upside potential in the long term, scaling up their contribution to the bottom line is an issue for STC. Generating attractive returns from the international market after incurring heavy capex is expected to pose a key challenge to the company.

Mobily among frontrunners in wireless data segment

As discussed earlier, the mobile data segment has emerged as a fast growing market over the last couple of years. The segment has tremendous growth potential, considering the increasing demand for smart devices and the Kingdom’s underpenetrated broadband market. The segment is expected to play a crucial role in offsetting the likely slowdown in the traditional voice market. Competition in KSA’s broadband market is increasing with operators rolling out innovative data plans to lure customers. All three operators – STC, Mobily and Zain KSA – offer competitive broadband packages. In addition, they are constantly introducing new services and combinations or “bundled” services. The latter also help in reducing the churn rate as it would be inconvenient for consumers to shift all services from one provider to another. In addition to innovative services, operators are increasingly offering discounts on new data packages. (We have discussed about bundled services and innovative packages offered by the Saudi operator at length in the sections below.) Furthermore, all three operators have invested heavily in shifting to the LTE technology. KSA already has a 4G operator, Etihad Atheeb, which offers WiMAX services and broadband packages with speeds up to 2Mbps as well as VoIP services.

MAY2012

23

Our analysis of competition in KSA’s data segment suggests that Mobily is a clear leader. Mobily’s revenue from the data segment increased 53.1% during FY2011 (accounting for 22.0% of its total revenue compared to 18.0% in FY2010) due to higher usage rates in terms of minutes of traffic and data transmission—data transmitted over its network averaged 163 terabytes per day in FY2011 compared to 85 terabytes in FY2010. Mobily dominates the mobile broadband market with a staggering 75.7% share in FY2011. The company’s dominance in the mobile data segment can be ascribed to its focused strategy. In contrast to STC, Mobily does not focus on international expansion. This is primarily because it lacks the scale of operations that STC has, and operates as an international subsidiary of Etisalat of UAE (hence, its expansion strategy is decided by the parent company). Mobily’s strategy centers on strengthening its position in the domestic market by expanding presence in the fast growing data segment, especially mobile broadband. Another important aspect of the company’s strategy is that it concentrates on customer management, which it believes is its core strength. In line with this, the company has outsourced network operations and many distribution and support functions.

We believe most telecom operators in KSA would focus on fast growing data segment, considering that the market is underpenetrated and consumers are becoming more tech savvy. While Mobily is likely to face tough competition from Zain KSA and STC in the wireless data segment, it would continue to dominate the market. Our belief is based on the company’s ability to offer WiMax in the area where coverage is still weak. In our opinion, Mobily should be able to offer a diverse range of data services at higher speeds as it continues to invest in direct fiber-optic connections to companies. We expect revenue from the data segment to contribute 25.0% to Mobily’s total revenues by 2014.

As huge capital expenditure on upgrading the technological infrastructure and expanding in international markets becomes imperative to stay ahead in the race, it is important for telecom operators to manage cash flows and liquidity prudently. Companies with a healthy balance sheet, access to funding and targeted growth strategy are expected to gain a competitive edge, in our view. In the following section, we have assessed STC, Mobily and Zain KSA in terms of their balance sheet strength, and how they are placed against each other.

Figure 25: STC dominates fixed broadbandSource: Company filings, Tadawul, AlJazira Capital

Figure 26: Mobily leads in mobile broadband Source: Company filings, Tadawul, AlJazira Capital

STC, 90%

Atheeb, 10%

Mobily, 75.70%

Combined STC & Zain

KSA, 24.3%

MAY2012

24

STC and Mobily better placed to fund growth

Our assessment of the balance sheet strength and liquidity positions of Saudi telecom operators (STC, Mobily and Zain KSA) suggests that STC and Mobily have strong balance sheets to fund growth. Though STC has the second largest debt level among our selected universe of telecom operators2 in the Middle East and North Africa (MENA) region, at 0.56x, the company’s debt to equity ratio (D/E) is lower than the MENA telecom average of 0.68x. STC’s net debt to trailing twelve months (ttm) EBITDA after capex, an important measure of liquidity for telecom operators, declined from 5.93x in FY2008 to 1.70x in FY2011. Net debt to EBITDA also fell to 1.08x from 1.18x during this period. STC’s debt profile is in line with its scale of operation—the company has the largest revenue and EBITDA among telecom operators in the MENA region.

However, considering STC’s massive overseas expansion strategy, we believe its capital structure would tilt towards borrowings at subsidiaries level. On the other hand, given the uncertainty and competition in its international markets, STC may not immediately derive value from operations here. Focus on international markets exposes the company to a more volatile capital structure and liquidity risks due to increased financial obligation. However, we are optimistic about STC’s ability to generate sufficient operating cash flows, given its strong position in the domestic market. Furthermore, in light of its healthy balance sheet, we are confident the company would be able to tap the debt market and secure funding, if required.

Mobily has a much stronger balance sheet than STC and Zain KSA. Higher EBITDA and lower debt pushed the net debt/EBITDA after capex to 1.43x in FY2011 from 8.9x in FY2008. This is favorable relative to 1.70x for STC and 65.83x for Zain KSA. At 0.38x, the company has one of the lowest D/E ratios among MENA operators. Furthermore, Mobily’s growth strategy, which centers on consolidating the company’s position in the high growth region, reduces the risk of overleveraging the balance sheet and volatility in the capital structure. With healthy finances, Mobily is well poised to continue investing in growth.

2. Please refer appendix for our universe of MENA telecom operators

Figure 27: STC and Mobily has low D/E ratio Source: Company filings, AlJazira Capital

Figure 28: Declining net debt/EBITDA Source: Company filings, AlJazira Capital

0.0%50.0%100.0%150.0%200.0%250.0%300.0%350.0%

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25

Capital restructuring, the top priority for Zain KSA

Zain KSA is struggling to get its finances in order. The company’s D/E ratio was as high as 3.04x during FY2011. High finance charges are eroding Zain KSA’s profits—accumulated losses reached 69.0% of its paid-up capital. The company is facing a severe liquidity crunch with approximately SAR9.75 bn of Murabaha facility maturing in July 2012. Hence, capital restructuring has become a top priority for Zain KSA for the near term. The company has chalked out a two-stage restructuring plan. In the first stage, Zain KSA plans to reduce its capital by cancelling 66% of issued capital. In our opinion, this would help it to erase accumulated losses that totaled SAR9.66 bn as of FY2011. Capital reduction would increase the stock’s implied market price. This would help it to raise capital, as the Saudi Capital Markets Law does not permit fresh issue of shares at a discount. We expect restructuring to conclude before the Murabaha facility matures in July 2012. However, the company faces the risk of being delisted as according to the Capital Markets Authority (CMA), a company could be delisted if its accumulated losses reach 75.0% of its paid-up capital. We believe this could severely cripple Zain KSA’s ability to raise finances and fund its growth plan.

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Telecom operators are aggressively reducing tariffs and offering bundled services at reduced prices in light of the commoditization of the mobile voice market and stiffer competition in the domestic market. For instance, STC launched “InVision”, a triple play marketing strategy, which offers telephony, broadband internet and TV/video-on-demand services in one package to the consumer. The bundled service would help to reduce the churn rate as it would be inconvenient for consumers to shift all three services from one provider to another. In addition to innovative services, operators are increasingly offering discounts on new data packages. For instance, Mobily offers a 50.0% discount on 1GB and 5GB data plan “Connect” upon renewal. Mobily also launched “e life”, a new data plan offering 200Mbps speed, to compete with STC’s “FTTH” plan.

The decline in ARPU levels during the last five years can be ascribed to the reduction in tariffs and offering of services at discounted prices. During FY2006–11, STC’s blended ARPU fell 47.3% to SAR72.0, while that of Mobily tumbled 44.8% SAR65.0. On the other hand, increased focus by operators on capturing market share and upgrading network during the period led to a spike in expenses. Declining ARPUs and increased expenses have dented profitability of Saudi Arabia’s telecom operators.

Falling ARPU, rising costs exert pressure on profitability; STC impacted the most

Over the last few years, a constant decline in ARPU levels has been one of the key trends with regard to telecom operators worldwide. Among our universe of sample countries, ARPU for most declined at a compounded annual rate of 2.0–8.0% during 2005–10. Among mature markets, Germany and Italy’s ARPU declined the most (i.e., at a compounded annual rate of -7.8% and -6.7%, respectively) during 2005-10. Blended ARPU in Saudi Arabia also fell at a compounded annual rate of 14.8% during the same period to USD20.8 (SAR78.0). The significant pace of decline in ARPU levels in the Kingdom can be ascribed to the fact that the sector was liberalized only in 2005, eventually breaking STC’s monopoly.

Figure 29: Declining ARPU levels in KSA and select developed countries

Source: Federal Communication Commission, IBM Teleco 2015 “five telling years” report, AlJazira Capital

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Managing costs efficiently holds significant importance

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Figure 30: Current KSA mobile broadband tariffs, discounts and offerings

STC’s “QUICKnet” plan

Old plan Revised plan

Plan Price (SAR/month) Plan Price (SAR/month)

1GB 100 5GB 99

5GB 200 10GB 199

Unlimited 350 Unlimited 350

Mobily’s “Connect” plan

Old plan Revised plan

Plan Price (SAR/month) Plan Price (SAR/month)

1GB 100 2GB 60

5GB 200 5GB 100

Unlimited 350 Unlimited 350

Zain Broadband

Old plan Revised plan

Plan Price (SAR/month) Plan Price (SAR/month)

2GB 60 2GB 30

5GB 100 5GB 60

10GB 200 10GB 100

Unlimited 350 Unlimited 200

Source: Company websites

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ARPU to exhibit downtrend in near to medium term

Despite a significant fall in ARPU levels during the last five years, mobile pricing in Saudi Arabia has remained high vis-à-vis the standards in developing markets. For instance, ARPU levels in China stands at around USD9.6, while it is just USD2.2 in India. However, blended ARPU in Saudi Arabia (at SAR78 or USD20.6) is not high compared to the standards in developed countries and other GCC nations. At USD33–54, blended ARPU in various GCC and developed countries such as France, Spain and the UK is substantially higher than that in Saudi Arabia. Higher level of ARPU in GCC and developed countries partially reflect the high GDP per capita of these countries.

We have analyzed the relationship between ARPU levels and GDP per capita in select developed and developing countries as part of our effort to determine the ARPU levels in Saudi Arabia, going forward. We observed that ARPU/GDP per capita ratio in emerging markets ranges from 1.08% for Russia to 2.63% for China. As for developed markets, the ARPU/GDP per capita ratio ranges between 0.63% for Germany and 1.35% for France within our universe of selected countries. Based on ARPU levels for 2010, Saudi Arabia’s ARPU/GDP per capita ratio stands at 1.52%, above Qatar, the UAE, Oman and other developed countries in our universe. We believe this indicates further scope for a fall in ARPU levels, albeit moderately, in Saudi Arabia. We expect ARPU/GDP per capita ratio for the Kingdom to be at 0.90–1.10% over the next five years, in line with markets such as Italy and Spain. Italy and Spain are currently at the lower end of the developed European market with ARPU and income levels lower than other developed European countries.

Figure 31: Significant decline in blended ARPU

Source: CITC, AlJazira Capital

Figure 32: ARPU Still high Vs. emerging mkts.

Source: IBM Teleco 2015 “five telling years” report, AlJazira Capital

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We believe blended ARPU in Saudi Arabia would continue its downtrend during our forecast period (2012–14) due to growth in the subscriber base and price reduction amid aggressive competition. However, growth in demand for mobile broadband services would help operators control the fall in ARPU. Consequently, the rate of decline in ARPU in Saudi Arabia is likely to slowdown to 2.0–2.5% over the next three years from more than 15.0% during 2005–10. We expect blended ARPU in Saudi Arabia at SAR73.8 in 2012, and a further decline to SAR70.8 by 2014. With regard to operators, impact of the fall in ARPU levels would be limited for Mobily vis-à-vis STC and Zain. This is primarily due to Mobily’s strong presence in the mobile broadband segment. The company is also actively focusing on converting prepaid customers to postpaid accounts, which have greater value. However, STC would stay ahead of its peers in terms of ARPU levels given its diversified and bundled service offerings.

Figure 33: ARPU/GDP per capita for Saudi Arabia to decline

Qatar UAE

Oman

Saudi Arabia

China

Brazil

India

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S.Africa

France

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USEmerging markets

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Source: CITC, Federal Communication Commission, IBM Teleco 2015 “five telling years” report, AlJazira Capital

Figure 34: ARPU to remain under pressure (2012F-16F)

Source: AlJazira Capital

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It is difficult to control fixed cost in an environment wherein operators plan to upgrade technological infrastructure with investment in 4G network. Hence, managing variable costs to maintain profitability would continue to be the key strategy for Saudi Arabia’s telecom operators. Mobily plans to control variable costs through initiatives such as sharing infrastructure with existing operators, optimizing spectrum utilization and technology optimization. STC has also been focusing on achieving overall efficiency through a cost optimization program. The company outsourced its call center and formed a joint venture with Aegis to reduce workforce by around 20%. Subsequently, STC entered into talks with Mobily to share infrastructure to moderate the CAPEX program in its domestic market. The company has also undertaken employee reduction measures such as the early retirement program, which is expected to gain traction in the short to medium term. Additionally, STC can realize synergies in areas such as product development. For instance, the company’s latest “Xband Jood Premium” bundle catering to the whole household needs for SAR 346/month has garnered significant momentum in KSA.

Figure 35: STC—Margins under pressure Source: Company filings, AlJazira Capitall

Figure 36: Net margin under pressure as well Source Company filings, AlJazira Capital

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Cutting on variable costs is vital

As discussed earlier, declining ARPUs and rising cost pressure have impacted profitability of Saudi Arabia’s telecom operators. Our analysis suggests that STC has been impacted the most. This can be evinced from the fact that STC’s EBITDA margins contracted to 36.0% in FY2011 from 48.8% in FY2006. Operating margins also tumbled to 20.1% from 37.4% during the same period. On the other hand, Mobily’s EBITDA margin expanded to 37.2% in FY2011 from 34.3% in FY2006. Although the decline in ARPU levels for both STC and Mobily is comparable (STC‘s 47.3% Vs. Mobily’s 44.8%) during the last five years, Mobily’s operating performance has been better vis-à-vis STC. This can largely be ascribed to Mobily’s focused cost strategy aimed at reducing variable costs. While Mobily’s expenses related to selling and promotion, as a percentage of sales, declined 70 basis points (bps), STC’s selling and marketing expenses grew 510 bps during FY2006–10. Furthermore, STC’s international operation dragged down overall profitability due to higher initial set up cost. Thus, effective cost management has placed Mobily ahead of its peers.

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Prior to 1998 2001

2005 2008 2010/11

20031998

Sector was regulated by Ministry of Post, Telegraph and Telephone (MoPTT)

• STC was established•Primary body responsible for the telecoms sector in KSA

Telecoms commission was established

• Privatization of STC; established as a joint stock company

• Introduction of DSL services by STC• Establishment of the

Communications and Information Technology Commission (CITC)

•Launch of services by Etisalat under brand name Mobily • Subscriber base cross 10 mn•Launch of 3G and 3.5G mobile technology by STC

2004

2007

•Issuance of 3 f ixed licenses•STC acquires stake in Maxis and its operation in India, Indonesia

Saudi Zain starts operation

2009

License to Etihad Atheeb (Atheeb), the main shareholder being Batelco of Bahrain

•STC’s monopoly was broken new license was awarded to Etisalat•Start of new era with increased competition and rising subscribers

•Launch of IPTV and triple play by operators•STC launched fastest Internet package in the MENA region (speed: 100Mbps)

History of Saudi Arabia’s telecom sector

The Kingdom’s telecom sector has transformed from a state-owned monopoly to a highly competitive market over the last decade. This can be primarily ascribed to the government’s efforts to promote liberalization and competition in the sector.

Pre-1998 period—A period of stagnation

• The sector was highly regulated and administered by MoPTT• It attracted limited investment due to the government’s interference and limited budget • STC was formed as a primary entity responsible for the sector’s development

1999-2005 period—Stepping stone was laid for growth

• The Telecom Commission was established in 2001 to regulate the sector • Saudi Telecom became public through an IPO in 2002• STC introduced DSL services in 2003• CITC was established in 2003 to replace the Telecom Commission in order to regulate

the sector, promote investment and safeguard consumer interest through healthy competition

• STC’s monopoly was broken with the issuance of license to UAE-based Etisalat in 2004. This marked the beginning of a new era for the Saudi Arabian telecom sector

• Etisalat launched commercial services under the brand name Mobily• STC launched 3G and 3.5G mobile technology for the first time in the Kingdom in 2005• Subscriber base crossed the 10 mn mark in 2005

2006-2011 period—Sector on an upward curve

• Issuance of three fixed licenses in 2007 is likely to increase competition and promote investment in the sector.

• Saudi Arabian operators went global—STC acquired a stake in Maxis and its operation in India and Indonesia in 2007.

• Saudi Zain commenced commercial operation.• License was issued to Etihad Atheeb (Atheeb), in which Bahrain-based Batelco is the

main shareholder.• Operators increased their focus on the data segment with the launch of IPTV and triple

play. STC launched the fastest broadband internet package (speed 100Mbps) in the MENA region.

Saudi Arabia Telecom Sector Evolution

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Regulations in Saudi Arabia’s telecom sector

As discussed earlier, MoPTT regulated the telecom sector in Saudi Arabia until 1998. The sector was characterized by monopoly of the government-owned STC and lack of investment. However, with the establishment of CITC in 2003, the sector witnessed liberalization. Competition in the sector started to intensify after Etihad Etisalat launched a service under the brand name Mobily in 2004. Additional mobile licenses and three fixed licenses were issued in 2007, attracting investment to the sector. Despite increased liberalization efforts, CITC continues to guard the Kingdom’s telecom sector. CITC plays an active role in the sector’s development by providing a transparent and just regulatory environment, promoting fair competition, and attracting new technologies in the ICT sector to provide end-users with the latest and most reliable services.

CITC Roles and Responsibilities:

• Implement ICT sector policies, plans, and programs

• Issue licenses for ICT provisioning

• Liberalize and regulate the telecommunications market, while attracting local and international investments in the sector

• Protect consumer interest, rights, and ensure safety and security within the ICT environment

• Encourage reliance on market forces and promote healthy competition

• Establish the basis for telecom services tariff regulation

• Manage the radio frequency spectrum resource, including development of the National Frequency Plan, and propose a spectrum usage fee structure

• Promote IT services, increase awareness and usage of the internet

• Encourage research & development in the ICT sector, and encourage modernization of networks and services

• Establish and manage the National Numbering Plan

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Stiff competition to continue exerting pressure on ARPU

ARPU would continue to fall due to the saturating voice market and intense competition. This would exert pressure on the top line. However, the rate of decline is expected to slowdown to 2–2.5% during 2012–14 from over 15.0% during 2005–10. We believe STC would remain ahead of its peers in terms of ARPU levels given its diversified offerings and bundled services. As indicated earlier, at the operator level, impact of the fall in ARPU levels would be limited for Mobily compared to STC and Zain as its strong presence in the mobile broadband segment would help offset a decline in voice ARPU.

Competition effect to services quality

As competition heats up between Saudi Arabia’s largest two operators, STS and Mobily, both companies will head to gain more subscriber base in a manner that may add pressures to technical and administrative capacities of both companies, which will affect the quality of services provided. In this context, the degradation of services on the short and medium terms, will provide the opportunity for virtual operators to easily enter the communication market with advanced services and better response rate to customer complaints compared to existing operators.

Liquidity risk

Over the last five years, there has have seen significant surge in variable costs of telecom operators in Saudi Arabia due to a rise in expenses such as selling and general expenses. Furthermore, with operators increasingly looking to invest in new technologies, managing working capital and liquidity requirements efficiently poses a significant challenge.

Economic and geopolitical risk

Although the Kingdom is one among the most resilient economies, it is exposed to the risk of the ongoing global slowdown. Furthermore, despite the initiatives taken by the government to diversify the economy, Saudi Arabia remains highly dependent on oil, which accounts for over 80% of the government’s revenues. Although the Kingdom has a strong diversification plan, development has been focused on the hydrocarbon sector and related industries, so far. This coupled with the persistent weak social infrastructure has rendered the benefits of diversification somewhat ineffective. Despite the global economy showing signs of recovery and oil prices rebounding to over USD100 per barrel, the Kingdom’s economy continues to face several external risks. Any fresh fall in oil prices could severely dent business and market sentiment, derailing potential economic recovery.

Saudi Arabia’s economy is also exposed to elevated geopolitical risk in the MENA region. The ripple effects of the Arab Spring have spread in varying degrees to oil exporting countries in the region. This coupled with increasing threat from Iran could potentially reduce business and weigh on investor sentiment.

Key Investment Risks

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Valuation analysis

The Saudi telecom sector currently trades at relatively lower valuation multiples compared to emerging markets and other nations across the globe. The price to earnings (P/E) multiple of Saudi telecom companies currently averages 9.7x compared to 12.5x in UAE, 11.4x in Qatar, 23.5x in India, 23.9x in Brazil, 19.5x in Malaysia and 12.2x in South Africa. The P/E multiple of Saudi telecom companies is also higher than the 12.3x average of the top five global players (AT&T, Vodafone Group, Telefonica, Verizon, and France Telecom). The EV/EBITDA multiple of Saudi telecom companies averaged 5.1x compared to 5.9x for UAE, 5.2x for Brazil, 9.3x for India, 8.3x for Malaysia, 5.5x for South Africa and 6.3x for global peers.

P/E(x)EV/

EBITDA (x)EV/

SubscribersEBITDA

margin (%)Subscribers

(mn)Dividend yield (%)

Saudi ArabiaSaudi Telecom Company 10.4 4.8 1,144 36.0 25.2 5.5Etihad Etisalat (Mobily) 9.1 5.4 642 37.2 21.5 6.1ZAIN Saudi Arabia N/A 22.3 749 13.4 9.4 N/AAverage 9.7 5.1* 36.6* 5.8UAEETISALAT 12.0 7.3 2,426 30.5 7.7 8.0Emirates Integrated 13.0 4.6 739 32.1 5.2 5.0Average 12.5 5.9 31.3 6.5KuwaitMobile Tele. Co (Zain) 10.2 6.4 291 44.5 40.3 9.4National Mobile Teleco 3.1 4.1 248 36.6 17.8 2.3BahrainBahrain Telecom 8.0 3.9 130 38.5 11.0 9.1Average 8.0 3.9 38.5 9.1OmanOman Telecom. 8.7 4.5 1,316 44.8 1.8 7.8Nawras 8.3 4.6 536 49.6 2.0 6.3QatarQatar Telecom 11.4 4.7 240 45.8 83.0 1.8Vodafone Qatar N/A N/A 2,593 N/M 0.8 N/AAverage 11.4 4.7 45.8* 1.8BrazilTele Norte 20.3 4.5 531 34.9 39.3 4.0Telemar 41.3 4.7 292 30.9 69.7 2.0Telef Brazil 10.1 5.9 404 35.6 86.9 3.2TIM Participações S.A. 21.2 5.3 136 27.1 114.7 1.9Embratel 26.8 5.4 N/A 25.8 N/A N/AAverage 23.9 5.2 30.9 2.8IndiaBharti Airtel 20.7 9.9 111 33.8 243.3 0.3Idea Cellular 36.7 8.8 139 24.3 63.8 0.0Reliance comm. 13.1 6.8 70 37.3 150.0 0.6Tata comm N/A 11.7 43 10.4 69.2 0.9MTNL N/A N/A 367 N/M 5.4 N/AAverage 23.5 9.3 31.8* 0.4MalaysiaMaxis BHD 18.1 N/A 1,184 49.5 14.0 6.6Axiata Group 19.6 N/A 84 54.0 199.1 3.6Digi.com BHD 24.2 10.8 1,112 46.4 8.8 4.5Telekom Malaysia 16.1 5.8 N/A 36.9 3.6Average 19.5 8.3 46.7 4.6South AfricaMTN Group Ld. 12.1 5.0 214 41.4 141.6 5.8Vodacom Group 15.8 6.0 407 33.6 52.9 3.4Telekom SA Ltd. 8.6 N/A 4,522 27.4 0.5 6.3Average 12.2 5.5 34.1 5.1GlobalAT & T 14.5 7.9 2,412 24.1 103.2 5.7Vodafone Group 12.3 6.2 489 32.0 370.9 5.3Telefonica 9.9 6.2 648 32.2 238.7 N/AVerizon 17.8 7.0 1,840 26.5 108.7 5.1France Telecom 7.2 4.3 469 33.2 167.4 13.2Average 12.3 6.3 29.6 7.3

Figure 37: Comparable valuation analysis

Source: Bloomberg, AlJazira Capital, Respective company filings, Note-*Excluding Outliers

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Companies that look attractive

The lower P/E and EV/EBITDA multiple of Saudi telecom companies can be ascribed primarily to their limited exposure to international markets, especially to high-growth emerging markets. Despite the higher EBITDA margins and dividend yield of Saudi telecom players, investors are placing high premium on emerging market counterparts due to their ability to diversify risk and the fact that they operate in high growth markets.

At this point in time, we are bullish on two telecom companies: Saudi Telecom Company (STC) and Etihad Etisalat (Mobily).

• We initiate coverage on STC with a target price of SAR55.7, representing a potential upside of 31.4% from the current price. The company is well-placed to maintain its dominant position, primarily due to its strong presence in the fast-growing fixed broadband and enterprise segments. International expansion in high-growth markets also provides potential to unlock value in the long term.

• We initiate coverage on Mobily with a target price of SAR87.4; this implies an upside potential of 28.1% at current levels. The company is strategically positioned to benefit from the fast-growing data segment. Its advantage in the mobile broadband segment and focus on achieving operational efficiency through cost minimization are key positives.

Note: Our target price is based on the Discounted Cash Flow (DCF) methodology and comparable valuation. In the DCF models, the income statement, balance sheet and cash flow statements have been forecasted until 2015. Cash flows are then discounted using WACC in order to arrive at the target price.

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Figure 37: P/E Valuation of telecom players

Source: Bloomberg, AlJazira Capital

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Saudi Telecom Company

Established in 1998 as a government-owned entity, Saudi Telecom Company (STC) is the largest telecom operator in Saudi Arabia in terms of revenue as well as mobile subscribers. The integrated telecom service provider offers services such as fixed-line telecommunications, leased circuits, telex and telegraph, internet access, mobile telecommunications and website hosting. STC entered the international market with the acquisition of a stake in Malaysia’s Maxis Telecom. The company had operations in 11 countries as of 2011 and a combined subscriber base of over 160 mn.

Stock Details Stock Performance

Rating: Overweight

Current Price (SAR) 42.4Target Price (SAR) 55.7Upside (%) 31.452 week H/L (SAR) 43.1/33.0Shares Out. (mn) 2,000Market Cap. (SAR mn) 84,200

TASI

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STC

• During FY2011, revenue increased 7.5% YoY to SAR55.7 bn. The top-line was primarily driven by a surge in data revenue, which increased 31.5% YoY to SAR9.4 bn. Revenue from the international segment also increased 10% YoY to SAR18.2bn.

• Despite top-line growth, the net income declined 18.1% YoY to SAR7.7 bn, as service costs grew 13.4% YoY during FY2011.

• We expect STC’s net profit to increase 14.4% YoY in FY2012, translating into a net margin of 13.5% compared to 15.0% in FY2012.

Financial PerformanceShareholding Pattern

Investment Summary

• STC dominates the Saudi telecom market, accounting for 59.0% of the industry’s total revenues during FY2011. In terms of mobile subscribers, STC has 45.0% market share. However, the company’s domestic revenue grew at a CAGR of just 2.8% during FY2005-11 due to intense competition.

• STC leverages its position as a primary provider of fixed line services to gain advantage in the fixed broadband segment. The company’s unique selling point is its ability to deliver superior internet download speeds through fixed lines and offer attractive bundled packages.

• STC has invested heavily to expand its presence beyond the domestic market. Share of revenue from the international segment increased from 28.8% in FY2009 to 32.7% in FY2011. However, its contribution to the bottom line is negligible due to high initial cost of setting up operations. The company would need to expand the bottom line to extract value from international operations.

• We arrived at a 12-month target price of SAR55.7 for STC, representing a potential upside of 31.4% from current levels.

GOSI7% PIF

70% PPA7%

Public16%

Source: Zawya, AlJazira Capital, PIF- Public Investment Fund, GOSI- General

Organization for Social Insurance, PPA- Public Pension Agency

QUARTERLY FINANCIALS

Source: Zawya, AlJazira Capital

Indicator 2011A 1Q 2012A 2Q 2012E 3Q 2012E 4Q 2012E 2012E

Total Revenue 55,662 14,679 14,659 14,838 14,750 58,926YoY change (%) 7.5% 12.3% 5.6% 5.9% 0.4% 5.9%

EBITDA 20,025 5,374 5,462 5,603 5,570 22,009YoY change (%) 2.1% 11.6% 7.4% 7.8% 13.1% 9.9%

Net Income 7,729 2,521 1,944 2,196 2,181 8,842YoY change (%) -18.1% 60.3% -13.8% 40.5% -6.7% 14.4%

EPS (SAR) 3.9 1.3 1.0 1.1 1.1 4.4

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Investment Overview

• Maintains dominant position despite stiff competition: Despite liberalization of the telecom sector and the resultant entry of new players, such as Mobily and Zain KSA, Saudi Telecom Company continued to maintain its dominant position. The company held 45.0% market share in the GSM segment with 25.2 mn subscribers in FY2011. In terms of revenue, the company dominates the local market with 59.0% market share in FY2011. While it plays catch up to Mobily in the wireless broadband segment, it has a strong hold on the fixed broadband segment (2.1 mn subscribers towards the end of FY2011). Although STC’s dominance will continue to remain under pressure, factors such as the highest ARPU in the sector and presence across all verticals provide the company an edge.

• International business gaining traction; exposed to risk: With the domestic voice market fast approaching maturity, STC is diversifying operations to sustain the momentum. The company has already invested USD6.0 bn in international markets since 2007. As international operations gain momentum, the international segment’s contribution to revenue increased from 28.8% in FY2009 to 32.7% in FY2011. Expansion in international markets would help STC to diversify its asset portfolio and create a hedge against saturation in the domestic market. STC plans to increase the share of revenue from foreign markets to 50.0% by FY2014.

STC would need to incur substantial capital expenditure (not to mention a solid commitment from the management team) to meet its target of generating 50.0% of total revenue from the international segment by FY2014. In our opinion, this target is highly unrealistic. At best, we expect the international segment to contribute 32.3% of total revenue by FY2014. The international segment’s contribution to the bottom line is negligible due to the high initial cost of setting up operations and capex. Although operations in Malaysia, Turkey and South Africa have already started generating returns, countries such as India and Indonesia would require significant investments. International operations do carry a high upside potential in the long term; however, scaling up contribution to the bottom line would be a challenge for STC.

• Robust network provides edge in fixed broadband market: STC enjoys a superior position in the DSL business due primarily to its robust network (more than 150,000 km of fiber cable line is already operational). This has enabled STC to provide superior internet download speeds through fixed lines, thereby strengthening its position in the fixed broadband segment. In our opinion, STC’s focus on implementing cutting-edge technologies, such as FTTH, will continue to give the company a competitive advantage in the fixed line broadband segment. We expect STC’s fixed broadband subscriber base to increase at a CAGR of 10.4% during FY2011-15 and reach 3.12 mn by the end of 2015. This is expected to contribute significantly to the company’s top-line growth.

• Competitively positioned in high-growth Enterprise segment: The Enterprise segment is quickly emerging as a new area of focus for Saudi telecom operators. The Kingdom’s robust macroeconomic fundamentals and stable growth outlook are likely to spur the establishment of new businesses. STC is competitively positioned in the fast-growing Enterprise segment due to its experience in catering to big-ticket corporate clients. Besides, the company has the ability to offer fully integrated offerings, a critical factor for success as enterprises increasingly look for one-stop solutions. We believe STC’s strong position in the rapidly growing Enterprise segment should help the company consolidate revenue in the domestic market.

• Valuation: We used the blended valuation approach based on DCF and comparative methods to value STC. Based on this, we arrived at a 12-month target price of SAR55.7 for the company’s stock, implying a potential upside of 31.4% from current levels.

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Risk Factors

• The ripple effects of the Arab Spring coupled with increasing threat from Iran could potentially reduce business and weigh on investor sentiment.

• With ever increasing competition, we expect STC’s voice ARPU to fall by an average 1.0% until FY2014. However, ARPU may decline further as players wage an aggressive battle for market share based on pricing.

SWOT Analysis

STRENGTH WEAKNESS

• Largest telecom service provider in Saudi Arabia, despite competition

• Only Saudi player with significant presence in high growth international market

• Integrated telecom service provider with presence across segments

• Strong balance sheet and liquidity position

• Limited presence in fast-growing mobile broadband segment—playing catch up to Mobily

• Dividend yield to decline; STC may need cash to meet its aggressive international expansion target

OPPORTUNITIES THREATS

• Significant opportunity in mobile broadband and enterprise segments

• International markets, such as Malaysia, Turkey and India, hold potential

• Entry of new players following liberalization may dent market share

• Rapidly evolving technology may render existing infrastructure obsolete

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39

Financial Data

Income Statement (SAR million) 2011A 2012E 2013E 2014E

Total revenue 55,662 58,926 62,074 63,880

Growth YoY (%) 7.5% 5.9% 5.3% 2.9%

Cost of Services (24,334) (24,918) (26,777) (27,647)

Gross Profit 31,328 34,008 35,298 36,233

Selling and marketing exps. (7,424) (7,770) (8,186) (8,368)

General and administrative exps. (3,879) (4,229) (4,345) (4,472)

EBITDA 20,025 22,009 22,767 23,393

Depreciation and amortization (8,854) (8,925) (9,567) (9,824)

Operating profit 11,171 13,083 13,200 13,568

Finance cost (2,238) (2,357) (2,095) (1,789)

Provision for Tax / Zakat (118) (135) (140) (143)

Net Profit 7,729 8,842 9,150 9,357

Balance sheet (SAR mn)

Cash and cash equivalents 6,589 10,906 11,097 6,585

Accounts receivable 8,755 9,653 11,219 12,426

Prepayments and other current assets 4,177 4,776 5,266 5,575

Total current assets 21,967 25,335 27,582 24,586

Property, plant and equipment 55,085 56,295 58,577 61,547

Intangible assets 29,318 29,318 29,318 29,318

Total Assets 111,402 116,167 121,015 121,223

Accounts payable 5,190 3,806 4,020 4,123

Murabahas and loans – current portion 5,972 7,659 7,955 7,542

Total current liabilities 25,263 27,201 28,551 28,547

Murabahas and loans 23,960 21,804 19,978 14,816

Share Capital 20,000 20,000 20,000 20,000

Retained earnings 19,516 24,358 29,507 34,864

Total Equity 54,082 58,738 63,695 68,854

Total Liabilities & Shareholders’ Equity 111,402 116,167 121,015 121,223

Cash Flow Statement (SAR mn)

Cash Flow from Operating Activities 16,488 19,238 17,902 18,205

Cash Flow from Investing Activities (8,264) (10,265) (11,989) (12,945)

Cash Flow from Financing Activities (7,686) (4,655) (5,722) (9,773)

Net Change in Cash 538 4,318 191 (4,512)

Cash at the Start of the Year 6,051 6,589 10,906 11,097

Cash at the End of the Year 6,589 10,906 11,097 6,585

Ratios

P/E (x) 11.0 9.6 9.3 9.1

P/BV (x) 1.6 1.4 1.3 1.2

EV/EBITDA (x) 5.9 5.8 5.2 5.1

Dividend Yield (%) 5.3% 4.7% 4.7% 4.7%

ROaA 7.0% 7.8% 7.7% 7.7%

ROaE 14.4% 15.7% 14.9% 14.1%

Diluted EPS (SAR) 3.9 4.4 4.6 4.7

DPS (SAR) 2.3 2.0 2.0 2.0

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MOBILY

Established in 2004, Etihad Etisalat (Mobily) provides wireless telecommunication services, mobile voice and broadband, home broadband and business consultancy services. The company operates primarily in Saudi Arabia and enjoys a strong hold on the mobile broadband segment. Mobily also generates revenue from the sale of mobile handsets and smartphones. Mobily is an associate of UAE-based Etisalat, which owns 27.5% stake in the company.

Stock Details Stock Performance

Rating: Overweight

Current Price (SAR) 68.3Target Price (SAR) 87.4Upside (%) 28.152 week H/L (SAR) 70.3/49.8Shares Out. (mn) 700Market Cap. (SAR mn) 47,775

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TASI Mobily

• During DY2011, Mobily’s revenue grew 25.2% YoY to SAR20.1 bn as data revenue increased 59.0% YoY. The contribution of data revenue to total revenue increased from 18.0% in FY2010 to 22.0% in FY2011.

• Mobily’s net income increased 20.7% YoY to SAR5.1 bn during FY2011. This was supported by strong top-line growth.

• We expect Mobily’s net profit to increase 13.2% YoY in FY2012, translating to a net margin of 26.1% compared to 25.4% in FY2011.

Financial PerformanceShareholding Pattern

Investment Summary

• Mobily is a frontrunner in the rapidly growing data segment primarily due to its strong presence in mobile broadband. The company’s strategy is fully focused on consolidating its position in the data segment. In our view, Mobily has both delivery capabilities and the brand image to unlock further potential in this segment.

• Mobily is focusing on achieving operational efficiency by cutting costs. This could also enhance margins moderately. The company’s strategy of deriving more value from existing customers by increasing the proportion of postpaid subscribers should also improve margins.

• We expect Mobily to maintain a dividend payout of 39.5% in FY 2012, given its healthy free cash flow generation capabilities. This implies a dividend yield of 4.8% over the current price of SAR68.3.

• We arrived at a 12-month target price of SAR87.4 for Mobily, representing a potential upside of 28.1% from current levels.

GOSI11.2%

Emirates Telecom27.5%

Public61.3%

Source: Zawya, AlJazira Capital, GOSI- General Organization for Social Insurance

QUARTERLY FINANCIALS

Source: Zawya, AlJazira Capital

Indicator 2011A 1Q 2012A 2Q 2012E 3Q 2012E 4Q 2012E 2012E

Total Revenue 20,052 5,009 5,391 5,754 5,924 22,077 YoY change (%) 25.2% 11.7% 5.2% 24.0% 2.1% 10.1%

EBITDA 7,454 1,811 2,048 2,188 2,273 8,319 YoY change (%) 20.9% 14.8% 16.4% 20.7% -1.4% 11.6%

Net Income 5,083 1,207 1,407 1,536 1,605 5,755 YoY change (%) 20.7% 21.0% 20.8% 25.5% -5.4% 13.2%

EPS (SAR) 7.3 1.7 2.0 2.2 2.3 1.7

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Risk Factors

• The ripple effects of the Arab Spring coupled with increasing threat from Iran could potentially reduce business and weigh on investor sentiment.

• Although Mobily has a strong presence in the wireless segment, it lags STC in the fixed line segment.

• With ever-increasing competition, we expect Mobily’s voice ARPU to fall by an average 1.5-2.0% until FY2015. However, ARPU may fall further as players compete aggressively on pricing.

SWOT Analysis

STRENGTH WEAKNESS

• Market leader in fast-growing mobile data segment

• Strategy focused on wireless segment, with strong infrastructure and brand image

• Strong balance sheet and liquidity

• Lags STC in fixed line segment• No geographic diversification;

complete focus on Saudi market

OPPORTUNITIES THREATS

• Significant opportunity in enterprise segment

• Opportunity to expand beyond Saudi Arabia

• Entry of new players following liberalization could dent market share

• Rapidly evolving technology may render existing infrastructure obsolete

Investment Overview

• Data segment holds key: The mobile data segment has grown rapidly over the last couple of years. Mobily is a clear leader in the Data segment, primarily due to its strong presence in mobile broadband—revenue from mobile data and value-added services accounted for approximately 22.0% of the company’s total revenue in FY2011, higher than the industry average of 15.0%. The segment has tremendous growth potential, considering the Kingdom’s youth demographic profile and the (consequent) increasing demand for smart devices. We believe Mobily would continue to maintain its leadership in the mobile data segment, which, in our view, would be a key catalyst for top-line growth in the near to medium term. The company has robust infrastructure, brand image (appealing to youth), focused strategy (weaved around data segment), and delivery capabilities to maintain its leadership in this high growth segment.

• Operational efficiency through cost-control measures: Mobily is increasingly focusing on improving operational efficiency by managing costs. This would enable the company to protect margins in a highly competitive environment. Mobily plans to control variable costs through initiatives such as sharing infrastructure with existing operators, optimizing spectrum utilization and technology optimization. This coupled with the company’s strategy of deriving more value from existing customers by increasing the proportion of postpaid subscribers should support moderate margin growth. We expect EBITADA margins to increase 70 bps to 38.4% during FY2012-15.

• Healthy divided yield: Under the new dividend policy introduced in FY2011, Mobily plans to pay quarterly dividends FY2012 onwards—it currently distributes dividends semi-annually. In FY2011, Mobily has maintained a high dividend payout ratio of 44.8%, translating into an average dividend yield of 4.9%. We expect the company to maintain a dividend payout of 39.5% in FY 2012, considering its healthy free cash flow generation capabilities. This would translate to a dividend yield of 4.8% over the current price of SAR68.3.

• Valuation: We have used the blended valuation approach based on the DCF and comparative methods to value Mobily. Based on this, we arrived at a 12-month target price of SAR87.4 for the company’s stock, implying a potential upside of 28.1% from current levels.

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Financial Data

Income Statement (SAR million) 2011A 2012E 2013E 2014E

Total revenue 20,052 22,077 23,963 24,451

Growth YoY (%) 25.2% 10.1% 8.5% 2.0%

Cost of Services (9,728) (10,602) (11,697) (11,752)

Gross Profit 10,324 11,475 12,266 12,699

Selling and marketing exps. (1,086) (1,194) (1,246) (1,247)

General and administrative exps. (1,784) (1,963) (2,085) (2,115)

EBITDA 7,454 8,319 8,935 9,337

Depreciation and amortization (2,149) (2,390) (2,618) (2,746)

Operating profit 5,305 5,929 6,317 6,591

Finance cost (213) (178) (142) (111)

Provision for Tax / Zakat (54) (61) (66) (69)

Net Profit 6,589 10,906 11,097 6,585

Balance sheet (SAR mn)

Cash and cash equivalents 1,690 968 1,977 4,180

Accounts receivable 6,323 6,937 7,529 7,683

Prepaid expenses and other assets 1,399 436 385 386

Total current assets 9,893 10,268 12,010 14,387

Property, plant and equipment 16,412 17,868 18,900 19,745

Total Assets 37,501 38,797 41,036 43,724

Accounts payable 7,808 6,719 5,499 5,231

Current portion of long-term loan 4,895 1,072 1,058 1,388

Total current liabilities 18,046 13,606 12,850 12,935

Long-term debt 977 3,216 2,470 1,388

Share Capital 7,000 7,000 7,000 7,000

Retained earnings 9,810 12,715 15,828 18,863

Total Equity 18,388 21,868 25,600 29,283

Total Liabilities & Shareholders’ Equity 37,501 38,797 41,036 43,723

Cash Flow Statement (SAR mn)

Cash Flow from Operating Activities 6,673 6,448 7,335 8,813

Cash Flow from Investing Activities (3,408) (3,312) (3,115) (3,056)

Cash Flow from Financing Activities (3,237) (3,859) (3,211) (3,553)

Net Change in Cash 28 (722) 1,009 2,204

Cash at the Start of the Year 1,661 1,690 968 1,977

Cash at the End of the Year 1,690 968 1,977 4,180

Ratios

P/E (x) 9.4 8.3 7.7 7.4

P/BV (x) 2.6 2.2 1.9 1.6

EV/EBITDA (x) 8.6 7.1 6.4 5.9

Dividend Yield (%) 4.8% 4.8% 5.1% 5.9%

ROaA 14.3% 15.1% 15.5% 15.3%

ROaE 29.9% 28.6% 26.0% 23.6%

Diluted EPS (SAR) 7.3 8.2 8.8 9.3

DPS (SAR) 3.3 3.3 3.5 4.0

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Appendix 1: Saudi telecom sector— Key metrics

2007A 2008A 2009A 2010A 2011E 2012F 2013F 2014F

Total Subscribers (mn) 28.4 36.0 44.8 51.6 56.1 60.1 62.1 64.0

% Growth 44.4% 26.8% 24.4% 15.2% 8.7% 7.2% 3.3% 3.1%

Prepaid subscribers (mn) 23.6 30.5 38.7 45.3 49.1 52.0 53.4 54.7

Post paid subscribers (mn) 4.8 5.5 6.1 6.3 7.0 8.1 8.7 9.2

Total Penetration % 113.0% 138.0% 167.0% 186.0% 198.0% 207.0% 209.0% 211.0%

Active penetration % 95.0% 114.1% 135.7% 152.1% 165.4% 173.9% 175.4% 177.1%

2G subscribers (mn) - - - 44.4 42.1 37.0 35.1 33.6

% of Total - - - 86.0% 75.0% 61.6% 56.5% 52.5%

3G subscribers (mn) - - - 7.2 14.0 21.0 23.6 25.6

% of Total - - - 14.0% 25.0% 35.0% 38.0% 40.0%

4G subscribers (mn) - - - 0.0 0.0084 2.04 3.41 4.80

% of Total - - - 0.0% 0.02% 3.4% 5.5% 7.5%

Fixed line subscribers (mn) 4.0 4.1 4.2 4.2 4.5 4.5 4.6 4.7

Fixed broadband subscribers 0.62 1.04 1.4400 1.74 2.13 2.8 3.4 3.9

% Growth 181.8% 67.7% 38.5% 20.8% 22.4% 29.8% 21.6% 15.6%

Mobile broadband subscribers* 0.1 0.3 1.3 2.7 3.7 5.0 6.1 7.0

Blended ARPU (SAR) 115.1 98.3 80.4 78.0 75.7 73.8 72.3 70.8

VAS revenue (% of total revenue) 8.4% 10.6% 12.6% 15.0% 17.0% 21.0% 25.0%

Source: AlJazira Capital, CITC, *Standard broadband subscribers

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Overweight: This rating implies that the stock is currently trading at a discount to its 12 months price target. Stocks rated “Overweight” will typically provide an upside potential of over 10% from the current price levels over next twelve months.

Underweight: This rating implies that the stock is currently trading at a premium to its 12 months price target. Stocks rated “Underweight” would typically decline by over 10% from the current price levels over next twelve months.

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Disclaimer

The purpose of producing this report is to present a general view on the company/economic sector/economic subject under research, and not to recommend a buy/sell/hold for any security or any other assets. Based on that, this report does not take into consideration the specific financial position of every investor and/or his/her risk appetite in relation to investing in the security or any other assets, and hence, may not be suitable for all clients depending on their financial position and their ability and willingness to undertake risks. It is advised that every potential investor seek professional advice from several sources concerning investment decision and should study the impact of such decisions on his/her financial/legal/tax position and other concerns before getting into such investments or liquidate them partially or fully. The market of stocks, bonds, macroeconomic or microeconomic are of a volatile nature and could witness sudden changes without any prior warning, therefore, the investor in securities or other assets might face some unexpected risks and fluctuations. All the information, views and expectations and fair values or target prices contained in this report have been compiled or arrived at by AlJazira Capital from sources believed to be reliable, but AlJazira Capital has not independently verified the contents obtained from these sources and such information may be condensed or incomplete. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on the fairness, accuracy, completeness or correctness of the information and opinions contained in this report. AlJazira Capital shall not be liable for any loss as that may arise from the use of this report or its contents or otherwise arising in connection therewith. The past performance of any investment is not an indicator of future performance. Any financial projections, fair value estimates or price targets and statements regarding future prospects contained in this document may not be realized. The value of the security or any other assets or the return from them might increase or decrease. Any change in currency rates may have a positive or negative impact on the value/return on the stock or securities mentioned in the report. The investor might get an amount less than the amount invested in some cases. Some stocks or securities maybe, by nature, of low volume/trades or may become like that unexpectedly in special circumstances and this might increase the risk on the investor. Some fees might be levied on some investments in securities. This report has been written by professional employees in AlJazira Capital, and they undertake that neither them, nor their wives or children hold positions directly in any listed shares or securities contained in this report during the time of publication of this report. This report has been produced independently and separately and no party (in-house or outside) who might have interest whether direct or indirect have seen the contents of this report. It should be also noted that the Research Division of AlJazira Capital had no information at the time of issuing this report regarding any conflict of interest between the company/companies mentioned in this report and any members of the board / executives / employees of AlJazira Capital or any of Bank AlJazira Group companies. No part of this document may be reproduced whether inside or outside the Kingdom of Saudi Arabia without the written permission of AlJazira Capital. Persons who receive this document should make themselves aware, of and adhere to, any such restrictions. By accepting this document, the recipient agrees to be bound by the foregoing limitations.

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