We upgrade Zain to overweight with a TP of SAR11.4. We believe Zain’s turnaround story is materializing, driven by 1) reduction of royalty fees, 2) royalty fees reversal and 3) tower sale. This will be further supported by Zain’s inclusion in EM indices. We expect Zain to report a net income of SAR592mn in 2019f growing by 78.1% yoy. We expect a CAGR growth in sales of 3.4% between 2018-2022f, with a CAGR 1.2% growth in net income during the same period. The stock is trading at 2019f PE and EV/EBITDA of 9.0x and 3.8x, lower than the peer group average of 15.4x and 6.1x respectively.
- New services to support top-line growth: We expect Zain’s revenues to grow 4.2% yoy in 2019 to SAR7.8bn. This compares to a growth of 3.1% in 2018 and 5.5% in 2017. We believe the growth will be driven by 1) growth in enterprise segment supported by government projects, 2) change in the client mix toward post-paid customers which represent 40% of the total customer base, 3) growth in FTTH, and 4) introducing new services. According to management, Zain expects to benefit from Dawiyat (FTTH infrastructure partner) to reach 180,000 homes. The company is also introducing new products such as cloud services, e-pay services and specialized new packages for Hajj and Umrah visitors. These factors are expected to offset the decline in mobile users in Saudi. Based on CITC Q3 18 data, mobile subscribers declined 3.5% yoy to 42.5mn, with a penetration rate of 131%.
- Tower sale is key to reducing debt levels: Zain’s BoD approved the sale and leaseback of its 8,100 towers to IHS for a total value of SAR2.43bn. The lease period is 15 years with an option to extend it for an additional 5 years. The offer also includes building 1,500 towers over the next 6 years. The average price/tower is US$80,000 which is lower than the last 4-year average of US$121,000. Proceeds from the transaction will be used to reduce debt levels, which currently stand at SAR10.2bn. We have not incorporated this transaction in our models as Zain awaits regulatory approvals and details about the leasing terms are not yet available. Although the debt level is expected to decline after the transaction is completed, the impact in the P&L is expected to be limited as the decline in financing charges will be offset by higher lease back expenses for the towers.
- An overview of royalty fee revision: Saudi telecom operators (STC, Mobily and Zain) signed agreements with the Ministry of Finance (MoF), the Ministry of Communication and Information Technology (MCIT) and CITC to settle the outstanding dispute related to royalty fees charged during 2009 to 2017 in addition to the amounts paid in 9M 18. The agreements aim to support the telecommunications sector and to stimulate investment in infrastructure, in-line with the National Transition Program (NTP) and Vision 2030. According to the agreements, royalties will be unified at a rate of 10% of net revenues, compared to 15% for voice, 8% for data and 10% for landline revenues. In return, companies will invest in their networks over the next 3 years. However, the details were not disclosed.
- Royalty fee revision expected to be a game changer: The impact of change in royalty fee will vary across companies, with Zain being the main beneficiary with an estimated cost reduction of SAR293mn/annually and a provision reversal of SAR1.7bn over 3 years. Actually, Zain reversed SAR300mn in 2018 with the outstanding amount of SAR1.4bn to be revised in 2019-2020, subject to meeting certain undisclosed requirements set in the agreement within 3 years. We believe this is a game changer for Zain, expanding its gross margins to 74.3% in 2019-2020 from 65.6% in 2017, based on a conservative reversal estimate of SAR1.3bn. The ability of the company to meet the requirements will further support margins in 2019-2020.