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

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1 December 2015 Value Creation and Market Valuation: Measuring Performance in the Banking Sector of the Gulf Region

2 Banks in the Gulf region have been gaining in importance in recent years both locally and in foreign markets. Yet, as this growth takes place, it is valid to ask how well Gulf banks are doing on value creation, both on an absolute and relative basis. It is equally valid to ask whether the share price movement of these banks in recent years accurately reflects the internal value creation taking place at these institutions. This HCM study provides a comparative overview of 45 Gulf banks. It finds that value creation has increased in general in recent years in the Gulf banking sector, though not at all banks. Further, it finds a plausible correlation between internal value creation and share price change for most banks. For others, however, stock returns cannot be fully explained by internal value creation. The goal of this study is not to provide any definitive performance evaluation of any bank or of the sector but to illustrate alternative and complementary methods for measuring performance. It also aims to help each bank in its internal discussion on what key performance indicators (KPIs) are most relevant to it. As an international consulting firm, HCM supports board of directors and senior management in all regions on determining the right approach to performance measurement. We use a range of financial and non-financial methodologies. Measuring performance is of benefit not just for knowing where one stands (ex post value capturing), but perhaps more importantly for driving the desired value creation (ex ante). HCM s financial stewardship work goes hand in hand with its principal work of supporting banks and other companies in all sectors to establish compensation, governance, and compliance systems that support their fundamental business strategy. Value Creation: External and Internal Metrics Value creation can be measured using external and internal factors. As depicted in Figure 1, the market value in 2014 of the 45 Gulf region banks 1 covered by this study lies between USD 0.8 and 41 billion. This represents more than 25% of the overall stock market capitalization of these countries. From an external perspective, one way to capture value is using total shareholder return (TSR). In this study, we use TSR relative to Thomson Reuters synthetic GCC index. We find that using this metric many banks in the Gulf region have significantly increased their market value in recent years, particularly those from the UAE. However, the median value in our sample for of TSR relative to the GCC index actually shows a negative return (-1.3%). From an internal perspective, a widely used performance measure is economic profit (EP). Because it also reflects risk, EP can have certain advantages over other measures of performance. However, EP still provides investors with an incomplete picture of business results, particularly on a comparative basis. First, EP does not allow ready comparison of companies of different sizes without applying additional calculations and making potential necessary adjustments. Second, EP has a past-looking bias. It accumulates past success (for example, strong brand) or past failures (for example, inefficient retail banking network). As an example, EP does not capture sufficiently the efforts of a bank that has moved from a situation of negative economic profit to a breakeven point. Under an EP angle such bank will still be seen as performing poorly when compared to a bank that started with a positive EP. The latter would be perceived as more successful when in fact it may only be harvesting its past successes. In order to mitigate these drawbacks, we use in this study Economic Profit Dynamic rather than a common EP measure. This approach has been gaining support among economic professionals. HCM has successfully used EP Dynamic with its clients, making in each case relevant adjustments. In this study, we have slightly modified the formula to reflect certain changes in value creation 2. 1 This study uses as basis the Top 50 GCC Banks compiled by the Gulf Business magazine. However, this study does not include five banks for which no comprehensive data was available for the period. 2 A common way to calculate EP Dynamic is to divide absolute yearly changes in the economic profit by trailing sales HCM International Ltd. All rights reserved.

3 Company Country Market Capitalization (USD, thousand) Economic Profit (EP) Dynamic Change in EP (USD, thousand) Relative Total Shareholder Return Qatar National Bank Qatar 40'915'242 13% 538'905 45% Al Rajhi Banking Corporation KSA 22'195'312-6% -227'074-74% First Gulf Bank UAE 18'051'138 16% 391' % National Bank of Abu Dhabi UAE 18'010'203 7% 191'850 95% Saudi British Bank KSA 15'457'606 26% 397'494 48% National Bank of Kuwait Kuwait 14'650'988-14% -337'119-56% Riyad Bank KSA 13'592'026 14% 271'561-3% Emirates NBD UAE 13'258'602 12% 495' % Samba KSA 12'344'758-7% -144'730-62% Kuwait Finance House Kuwait 10'500'222-2% -70'247-52% Banque Saudi Fransi KSA 10'116'065 1% 7'756-30% Abu Dhabi Commercial Bank UAE 9'954'514 33% 859' % Masraf Al Rayan Qatar 9'104'642 18% 114'601 95% Arab National Bank KSA 8'128'565 10% 142'338-14% Dubai Islamic Bank UAE 7'411'594 34% 440' % Qatar Islamic Bank Qatar 6'632'564 3% 19'256-1% Saudi Hollandi KSA 5'686'620 26% 181'371 78% Mashreq UAE 5'615'952 19% 347'887 5% Commercial Bank of Qatar Qatar 5'586'403-3% -32'523-37% Ahli United Bank Bahrain 4'928'117 7% 85'900-1% Bank Albilad KSA 4'754'544 34% 149' % Abu Dhabi Islamic Bank UAE 4'655'722-2% -24' % Union National Bank UAE 4'344'869 5% 62'780 88% Saudi Investment Bank KSA 4'141'571 33% 192'815 8% Doha Bank Qatar 4'044'828-9% -75'055-30% Commercial Bank of Dubai UAE 3'968'041 9% 59'773 86% RAKBANK UAE 3'769'715 5% 40' % Qatar International Islamic Bank Qatar 3'396'552 12% 39'377 41% Bank Muscat Oman 3'299'800 3% 53'662-60% Burgan Bank Kuwait 3'168'597 12% 117'953-37% Commercial Bank of Kuwait Kuwait 3'039'034 0% -2'786-76% Bank AlJazira KSA 2'942'274 24% 111'983 75% Gulf Bank Kuwait 2'755'605 3% 28'540-92% Al Ahli Bank Kuwait Kuwait 2'260'143-20% -103'563-78% Al Khalij Commercial Bank Qatar 2'180'170 6% 21'295-6% Arab Banking Corporation Bahrain 2'177'000-3% -45'183-12% National Bank of Bahrain Bahrain 2'160'541-5% -14'122 29% United Arab Bank UAE 2'027'852 26% 59'206-4% National Bank of Umm AI-Qaiwain UAE 1'715'266-3% -6'145 40% National Bank of Fujairah UAE 1'452'531 22% 57'913-48% Bank of Bahrain and Kuwait Bahrain 1'257'825-2% -9'626-3% Bank Dhofar Oman 1'235'085 0% -1'228-65% InvestBank UAE 1'112'425-1% -1'211 77% National Bank of Oman Oman 1'000'389 13% 43'528-40% Figure 1: EP Dynamic (calculated from USD values). Data source: Thomson Reuters. Analysis: HCM HCM International Ltd. All rights reserved. 3

4 Methodology Insight EP Dynamic = EP 2014 EP 2010 Average Sales EP = Net Income Total Equity * Cost of equity Economic Profit Dynamic is based on two variables: (1) economic profit, which after deducting capital charge, becomes a pure economic measure of net value to investors, and (2) sales, which correct EP for size differences. A deeper look into EP Dynamic sheds light into its two underlying components: change in the economic profit margin (EP divided by sales) and growth in economic profitability. This approach captures how efficiently the value creation took place, rather than the mere fact that EP was positive or negative. This permits looking beyond any advantages that may have been acquired before the performance period in question. It also allows focus on future results. In addition, EP Dynamic captures value internally and is less disturbed by market inefficiencies, which have tended to characterize emerging markets. Some company analysts favor using EP Dynamic as it uses readily available accounting data and does not require sensitive assumptions. However, this convenience can also be a drawback. For example, some inconsistencies can arise when using net income as a proxy for value after debt capital charge. Furthermore, even though all the six countries reviewed in this study require listed financial institutions to use IFRS standards, this does not exclude the possibility of a bank using some form of short-term income management as a way to give the appearance of better performance. Thus we find the EP Dynamic indicator to be more valid when used with a four-year time horizon, where any possible short-term income management has reduced effect. Figure 2 shows cumulated EP Dynamic for the Gulf banks reviewed. The median EP Dynamic is 6.4%. Saudi Arabian, Qatari and UAE banks posted a big range of EP Dynamic values from negative to highly positive. On the other hand, banks from the other countries showed mainly a moderately positive or a negative EP Dynamic during the period HCM International Ltd. All rights reserved.

5 Bank Albilad Dubai Islamic Bank Saudi Investment Bank Abu Dhabi Commercial Bank Saudi Hollandi United Arab Bank Saudi British Bank Bank AlJazira National Bank of Fujairah Mashreq Masraf Al Rayan First Gulf Bank Riyad Bank Qatar National Bank National Bank of Oman Burgan Bank Emirates NBD Qatar International Islamic Bank Arab National Bank Commercial Bank of Dubai National Bank of Abu Dhabi Ahli United Bank Al Khalij Commercial Bank Union National Bank RAKBANK Gulf Bank Bank Muscat Qatar Islamic Bank Al Baraka Bank Group Banque Saudi Fransi Bank Dhofar Commercial Bank of Kuwait InvestBank Abu Dhabi Islamic Bank Kuwait Finance House Bank of Bahrain and Kuwait Commercial Bank of Qatar National Bank of Umm AI-Qaiwain Arab Banking Corporation National Bank of Bahrain Al Rajhi Banking Corporation Samba Doha Bank National Bank of Kuwait Al Ahli Bank Kuwait Median 6.4% -20% -10% 0% 10% 20% 30% Figure 2: EP Dynamic (calculated from USD values). Data source: Thomson Reuters. Analysis: HCM HCM International Ltd. All rights reserved. 5

6 What explains these differences? One possibility is the degree of balance sheet risk taking, with the UAE and Saudi Arabia perhaps having a higher risk tolerance. Another reason may relate to the differences in the relative length of time of being active in the international financial scene or regulatory or policy restrictions. Yet another possibility is the extent of state participation or control. Banks with lower EP Dynamic also tend to have lower-yielding balance sheets, as a significant part of their assets are in government bonds or local murabaha and wakala. Consequently, to better understand Gulf bank performance, one needs to give deeper attention to the composition of a bank s capital and cost of equity. As the focus of this study is overall bank performance, we applied standardized calculations even if they entail certain limitations. Putting it All Together For purposes of analyzing how value is being created by Gulf banks, should one favor the shareholder measure, TSR, or the internal economic measure, EP Dynamic? As regards TSR, clearly it remains of foremost importance to investors. Its main advantage is that it mirrors performance as perceived by the financial markets. In efficient markets, stock appreciation is an outcome of expected future company performance. Inversely, stock price decrease suggests the market views negatively the prospects of a company. The degree of investor satisfaction is thus closely related to increase in company value either in the form of share price appreciation or income distribution (dividends, share buybacks). For this reason, many see relative TSR as a good performance indicator for aligning owners and managers interests. However, assessing bank performance only through TSR can be incomplete or even misleading. This is so since TSR sometimes can be distorted by market conditions. Further to the degree that TSR also reflects future expectations of investors, it can get ahead of or lag the actual value creation taking place at a bank. As regards EP Dynamic, its advantage is that it captures the actual internal value being created. As such, EP Dynamic can also be used to assess the rise or decline in enterprise value. And if true, the EP Dynamic should also be reflected in stock returns when markets are operating efficiently. Thus there should be a correlation between TSR and EP Dynamic. Is this the case for Gulf Banks? Figure 3 presents TSR over the period of 4 years for Gulf banks both in absolute terms and relative to a benchmark the synthetic Thomson Reuters GCC index. As can be seen there, the four-year cumulative return for this index was 49% as of the end of 2014 (approximately 10.4% per year) HCM International Ltd. All rights reserved.

7 Abu Dhabi Commercial Bank Emirates NBD Dubai Islamic Bank Bank Albilad First Gulf Bank RAKBANK Abu Dhabi Islamic Bank Masraf Al Rayan National Bank of Abu Dhabi Union National Bank Commercial Bank of Dubai Saudi Hollandi InvestBank Bank AlJazira Saudi British Bank Qatar National Bank Qatar International Islamic Bank National Bank of Umm AI-Qaiwain National Bank of Bahrain Saudi Investment Bank Mashreq Qatar Islamic Bank Ahli United Bank Bank of Bahrain and Kuwait Riyad Bank United Arab Bank Al Khalij Commercial Bank Arab Banking Corporation Arab National Bank Banque Saudi Fransi Doha Bank Burgan Bank Commercial Bank of Qatar National Bank of Oman National Bank of Fujairah Kuwait Finance House National Bank of Kuwait Bank Muscat Al Baraka Bank Group Samba Bank Dhofar Al Rajhi Banking Corporation Commercial Bank of Kuwait Al Ahli Bank Kuwait Gulf Bank Median -1.3% -100% -50% 0% 50% 100% 150% 200% Figure 3: Total shareholder return cumulated over (calculated using USD values). Data source: Thomson Reuters. Analysis: HCM HCM International Ltd. All rights reserved. 7

8 On Figure 4 we present both indicators in a two-dimensional graph. There we define a trend line. As can be seen, this trend line does show a positive correlation between EP Dynamic and TSR from 2011 to 2014, with 1% change in EP Dynamic translating into 3.4% change in stock returns. It should be noted that some banks are significantly above or below the line. For example, the stock price of many UAE banks increased during this period more than can be explainable by EP Dynamic alone. For Saudi banks the inverse was the case. However, overall the regression confirms a positive relationship between share price increases and EP Dynamic, thus also confirming the validity of looking at bank performance both from an external and internal perspective. As explained earlier, the main difference between EP Dynamic and TSR is that EP Dynamic reflects wealth actually being created by the bank, while TSR reflects the perception of such value by investors. If a bank s stock price grew more than the wealth that was actually created, this would mean that investors are optimistic about the company s future. In this case, TSR will continue to overestimate the bank s actual performance until the bank either increases its internal value creation or the share price decreases. The inverse situation will occur where TSR is disproportionally low vis-à-vis EP Dynamic. In such case, the cause may relate to ineffective communication by the bank to investors, or to the market not having confidence that the company can continue creating the current level of internal value. Getting the Incentives and Governance Right Whatever may explain the gap between value creation and market valuation of a particular bank, what is clear is that each bank needs to understand how it can create value and manage investors expectations. In that connection, many steps can help in addressing the gap. This includes improving the quality of communication with shareholders and analysts but also giving attention to underlying factors that can undermine shareholder confidence, such as uncertainties about corporate culture, corporate governance or compliance. It is a great challenge to identify the right performance indicator that captures all facets of value creation. This study focuses on two possible metrics, TSR and EP Dynamic. Which metric or combination of metrics are appropriate for a particular bank depends on many factors, including its owner strategy, strategic goals, and corporate culture, as well as the external market and country-specific conditions. HCM has deep experience working with companies around the world on these challenges and factoring in each company s individual complexity, such as when there is part or full state ownership. As compensation and governance experts, HCM also supports companies in ensuring that the managerial incentives and the governance system are properly calibrated to promote sustainable financial and corporate success. Do not hesitate to contact us if we can be of help to your institution in addressing any of these areas HCM International Ltd. All rights reserved.

9 240% Size of the bubbles corresponds to the market capitalization as of Abu Dhabi Commecial Bank 190% Emirates NBD Dubai Islamic Bank 140% National Bank of Abu Dhabi First Gulf Bank Relative TSR % 40% -10% National Bank of Kuwait Qatar Islamic Bank Banque Saudi Fransi Qatar National Bank Riyad Bank Arab National Bank Masraf Al Rayan Mashreq Saudi Hollandi Saudi British Bank -60% Samba Kuwait Finance House -110% Al Rajhi Banking Corporation -20% -10% 0% 10% 20% 30% EP Dynamic Bahrain KSA Kuwait UAE Qatar Oman Figure 4: Relation between EP Dynamic and TSR measures. Data source: Thomson Reuters. Analysis: HCM 2015 HCM International Ltd. All rights reserved. 9

10 ABOUT HCM HCM is a leading independent international advisory firm specializing in the strategic aspects of Governance, Finance, and Compensation, including financial stewardship and compliance. HCM has a deep experience across various industries (including banking) and in the advising of boards, board committees, senior management, and control functions. HCM s clients come from the private as well as the public sectors. Headquartered in Switzerland, HCM is active across the globe, including in the Gulf region. Through its global partners in the US, UK, Australia, Singapore, and China, HCM supports companies of all sizes, from large multinationals and public institutions, to mid-sized and smaller companies, including those preparing for an IPO. Our mission is to support companies and other organizations tackle the ever important question: «How to measure, steer and allocate value creation?». We also cover risk and compliance as these also affect value. The «value question» is of core interest not only to Owners, Board of Directors and Senior Management, but also increasingly to institutional investors, proxy advisors, HR and control functions, regulators, and international standard setters. HCM is Chair of the Global Governance and Executive Compensation Network (GECN) HCM International Ltd. All rights reserved.

11 ABOUT THE AUTHORS Olga Beregova Senior Manager Olga Beregova has over 12 years of professional experience in consultancy. She has successfully steered extensive compensation and governance changes for private companies, national and international public companies in different industries. As Senior Manager at HCM, Olga Beregova also leads a team of research analysts and consultants, who provide economic research, company performance analysis, corporate valuation, and calibration of short- and long-term variable compensation plans. Olga Beregova holds a Master degree in Finance and Capital Markets from University of Zurich and in Linguistics from Kyiv State University of Foreign Languages. olga.beregova@hcm.com István Lajtai, CFA Consultant István Lajtai specializes in the valuation technique-related aspects of long-term incentive plans. Before joining our team, István carried out financial analyst roles in the energy and pharmaceutical industries. Mr. Lajtai has a Master s double degree in Corporate Finance and CEMS International Management from the Corvinus University of Budapest and is a CFA Charterholder. istvan.lajtai@hcm.com Anastasiia Medianovska Analyst Anastasiia Medianovska is a research analyst primarily dealing with analysis and evaluation of executive compensation frameworks, including assessment of risk/payout profiles and calibration of short- and long-term variable compensation plans. Ms. Medianovska holds Master of Science in Finance from the Universities of Neuchatel, Lausanne and Geneva, as well as Master s degree in International Economics from Kyiv National Economic University. She is also enrolled in the CFA program and has completed two CFA levels. anastasiia.medianovska@hcm.com For further information on HCM services for Gulf Countries, please contact the HCM Partner responsible for the Gulf region: Gabe Shawn Varges Senior Partner Tel gabe.shawn.varges@hcm.com 2015 HCM International Ltd. All rights reserved. 11

12 HCM International Ltd. Mühlebachstrasse 23/25 CH-8008 Zurich Phone HCM Schweiz AG Mühlebachstrasse 23/25 CH-8008 Zurich Phone HCM Compensation Insights & Technology AG 8 rue des Charmilles CH-1203 Geneva Phone geneva@hcm.com