Regional picture will shine brighter in 2010

Analysis Companies across the Middle East should see profits return next year and this, coupled with a recovering global economy, will prove good news for investors.

DUBAI, UNITED ARAB EMIRATES – May 18: View of the Jumeirah Lake Towers in Dubai.  (Pawan Singh / The National) *** Local Caption ***  PS02-JLT.jpg
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Companies across the Middle East should see profits return next year and this, coupled with a recovering global economy, will prove good news for investors. Next year will be a recovery year for the Middle East and North Africa. Higher oil prices, government spending, stronger banks and a gradual improvement in the global economy will all combine to boost activity across the region.

That's good news for profit at many regional companies - but not all. Some industries will be quick out of the blocks, while others will take longer to regain momentum. In particular, we expect rapid earnings growth at banks and oil and gas companies next year, while real estate profits will recover more gradually. We'll get to the reasons behind our thinking later. First, it's important to understand a bit of history about the profits of regional companies.

Earnings fell sharply in the first half of this year. On average, profits were down some 40 per cent from a year earlier. That's a steep decline, but some industries performed better than others: oil and gas fell 87 per cent; real estate fell 92 per cent; banks fell 20 per cent; telecommunications fell 9 per cent; and transport and logistics fell 9 per cent. Telecoms and transport and logistics proved relatively stable during the downturn and in broad terms we expect that trend to continue next year. The more exciting opportunities are in the sectors more severely affected by the downturn.

Here, we explain our relatively bullish thinking on banks and oil and gas companies, and our more cautious view on property firms. Oil and gas companies took a hit earlier this year as the oil price collapsed, from almost $150 a barrel last summer to nearly $30 early this year. That is a dramatic fall for governments selling crude oil and firms selling spin-off products, such as the giant Saudi petrochemical firm SABIC. Profit at SABIC fell 94 per cent in the period.

But the very factors that hurt SABIC on the way down should help it on the way back up. Oil has since recovered and is trading at about $70 a barrel. The consensus among analysts is it will hover around this level next year (although, of course, there are never any guarantees when it comes to forecasting oil prices). Crucially for SABIC, and some regional peers such as Industries Qatar, they pay a more or less fixed price for raw materials, mainly gas. That can hurt them on the way down, because they get no respite from the falling cost of inputs. But on the way up, bottom-line profit climbs even more steeply than top-line revenue.

This earnings "kicker" should see profits climb sharply next year, putting regional oil and gas companies in a strong position to benefit from the expected economic recovery. Meanwhile, the weak performance of banks, both regionally and globally, has been well documented this year. They have increased provisions for bad loans as some consumers and companies have gone under. At the same time, the cost of funding for banks is higher because wholesale debt markets are clogged. We believe regional banks will continue to make significant provisions for bad loans for the rest of this year and, to a lesser extent, next year.

It is true that bad loans will probably rise next year as more companies and individuals feel the heat of the downturn. Typically, bad loans peak some 12 to 24 months after a recession. But two factors give us comfort. The first is that many banks have been aggressively provisioning for bad debts this year, so they should have cash set aside to cover non-performing loans as and when they arise. Second, don't forget that aside from credit cards and personal loans, most bank loans are secured against collateral such as a car, property, machinery or a consignment of imports.

So when someone defaults on a car loan, for instance, the bank takes back the vehicle, sells it and recovers some or all of the cash. Similarly, if a company defaults, the bank takes possession of whatever collateral was used to secure the loan. So next year banks will benefit from a growing economy, which should stimulate borrowing by companies and individuals. And the downside from bad debts will be largely taken care of from money already set aside "for a rainy day".

As such, the modest bank profits this year should be relatively easy to beat. When it comes to real estate, profits at regional property companies will show some improvement - but they still face significant headwinds. Looking at the positives, many projects in key domestic markets will be finished and handed over to clients next year, which will boost earnings. Land sales can hardly get any worse and may even pick up slightly after grinding to a halt this year.

And we don't expect a repeat of this year's huge write-downs, such as Emaar booking Dh1.7 billion (US$463 million) against its US unit John Laing Homes, for example. Still, we remain cautious. The completion of those domestic projects may be a double-edged sword; a flood of new properties could contribute to oversupply in markets such as Dubai, sending prices even lower. We'll be keeping a watchful eye on demand, but at present the outlook is weak: end users are cautious about investing in real estate and confidence will return gradually, especially as banks also remain nervous about mortgage lending. Some developers may reposition themselves as landlords, renting out property they cannot sell, but this will struggle to replace income from land sales and sales of completed properties.

Then there are issues on the balance sheet. Many developers have taken on significant debt, much of which matures in the next year or two. They're also stretched by outstanding payables such as bills to contractors and suppliers, just as more people are defaulting on off-plan property deals they signed up to in happier times. Some developers may get government support, extending debt maturity and helping them ride out the current downturn, but there's no escaping the fact that many balance sheets are under huge strain.

Overall then, regarding investment strategy, what does this mean for investors like ourselves? We believe the bright prospects for banking and oil and gas profits next year will boost shares of these companies. Many investors, local and foreign, are waiting on the sidelines looking for a signal to get back into the market. Rising profits could provide the catalyst. We are also cautiously optimistic on real estate stocks. These stocks have fallen more sharply than other sectors and so trade at attractive valuations, such as price-to-book ratio.

Thus, investors may be prepared to buy these shares even before profit returns. If they see the feared "expat exodus" has failed to materialise in Gulf cities such as Dubai and populations continue to rise, they'll see a strong case for buying cheap property stocks. Yong Wei Lee is a fund manager at Emirates Investment Services