THE CURRENT CONCERN: CORPORATE DEFAULTS
The expected dip in GDP growth during 2009, coupled with the repercussions of the global financial crisis, lead us to adopt a cautious stance on the short-term asset quality of Saudi banks. This is mainly due to the significant increase in bad corporate debts and the lack of transparency as to the banks’ exposure to defaulting groups.
The two major cases of default that the Saudi banks face today concern the Al Gosaibi and Al Saad Groups. According to Bloomberg estimates, these Conglomerates have an outstanding total debt of around USD 15 billion, 30% of which is owed to Saudi banks. However, on September 17, 2009, Zawya reported that an agreement has been reached between Saad Group and local banks to settle about SAR 9.7 billion (USD 2.6 billion) in outstanding loans.
Despite this recent positive development, and due to the lack of details surrounding this agreement, we prefer to stay conservative in our forecasts of non-performing loans (NPLs) and the subsequent provisioning, as we see this case as a sample of other companies who might have similar problems though at a smaller scale but a higher frequency.
As a result, we expect the NPL ratio for the Saudi banks to increase to 2.27% in 2009 and to 1.94% in 2010, but remaining well below the expected average of 2.8% and 3.0% for global banks due to the more favorable macro and microeconomic conditions in the Kingdom.
 
MORE RESILIENT AFTER THREE CONSECUTIVE SHOCKS
Having adjusted successfully to two previous shocks, Saudi banks have emerged as more resilient from the current global crisis. The first of these shocks was the stock market correction in 2006. Though the banks had very little direct exposure to local equities, they generated high fee revenues from margin lending, brokerage and asset management services. After the correction, the banks reduced their margin lending and re-focused on core banking activities, resulting in a Y-o-Y drop of 14.4% in the sector’s net income in FY 07. The second shock came in 2008, when due to the severe correction in the global financial markets, Saudi banks suffered from massive write-downs on their investment portfolios. This was another blow to profitability, as the banking sector’s net income dropped 14.1% during FY 08. 2009 is expected to be another challenging year, during which Saudi banks will go through the process of cleaning up their credit portfolios. Rising NPLs, accompanied by large provisions for credit losses, will continue to negatively affect the sector’s profitability, which is expected to drop by 4.9% Y-o-Y. Going forward into 2010, we expect Saudi banks’ earnings to rebound from a relatively low base in 2009 as they benefit from a steep yield curve and better macro-economic conditions, sustained by strong balance sheets and an enhanced risk management framework. We believe the successful management of the current and of the past two crises has enhanced the immunity of the Saudi banking sector, putting it in a better position to ride the next curve.
 
VALUATIONS AND STOCK PICKS:
CORPORATE DEFAULT FEARS CREATE A BUYING OPPORTUNITY
Given the latest price correction, evidenced by the drop in the Banking All Share Index of 12.4% between May 09, 09 and September 16, 09 we believe the Saudi banks are currently trading at attractive valuation levels. Among the seven banks we cover, we favor Samba for its attractive valuation, as well as its high upside potential.
Saudi British Bank and Riyad Bank are also expected to have significant upside potential, supported by their well-diversified funding, solid balance sheets and sufficient levels of liquidity.