sico saudi telecom company (stc)...

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July 27, 2007

Saudi Telecom Company (STC)

• Saudi Arabia is a key market in the MENA region with nearly 26 million inhabitants, characterized by a young population, a robust underlying economy, rising affluence levels, and increasing liberalization of the sector.

• Saudi Telecom Company (STC), the incumbent operator, has seen stiff competition from the second mobile operator Mobily, which has put pressure on revenue and profit growth. This is likely to increase with a third mobile operator and three new fixed-line operators in the pipeline.

Optg Net Profit EPS ROE ROASAR bn Profit Income chg (%) (SAR) (%) (%)CY06A 33.8 12.6 12.8 2.8 6.4 38.2 28.2CY07E 34.1 12.4 12.3 -3.9 6.1 35.6 24.9CY08E 35.1 13.0 12.7 3.3 6.4 35.5 23.6CY09E 35.7 13.1 13.0 2.5 6.5 34.4 23.2CAGR (06-09E) 1.9 1.2 0.6 NA 0.6 NA NA

Key Financials

Revenues

• STC is tacking competition by expanding and leveraging its infrastructure and coverage and bundling services to retail and enterprise customers. Saudi Mobile Market Penetration is forecasted to exceed 100% by end of 2008. While we expect STC’s market share to fall to 52% by 2011, we forecast STC’s customer base will grow at a CAGR of 7.4% over the horizon, benefiting from the expanding Saudi market.

• STC’s attempts to expand outside Saudi finally seem to be paying off. We estimate STC could raise as much as $14 billion of debt to pursue its international acquisitions towards its objective of generating over 10% of revenues from outside KSA by 2010. STC’s recent SAR 11 bn (US$3 bn) acquisition of a 25% stake in Malaysia’s Maxis provides it access to over 14 mn customers in Malaysia, India and Indonesia. We estimate the deal will be value accretive and add ~5% to growth.

• Our analysis suggests that markets are being overly pessimistic with regards to STC’s earnings potential and that downside potential on the stock is limited. We believe that scope for positive surprises are high and could come from change of perception about STC, improvements in core earnings as a result of cost optimization programs, better performance in domestic market, and incremental earnings from possible acquisitions.

• At current prices STC trades at a P/E ratio of 11.0x on 2007’s forecasted earnings - a steep discount to both Regional and Emerging market Telcos as also to Saudi equities (despite a significantly higher dividend yield and profitability).

Company P/E (07E) RoE % D/Y %STC 11.0 35.6 8.5Saudi Equities 14.8 25.5 3.3MENA Telcos 12.6 32.4 5.9EM Telcos 12.8 14.6 2.2

• Our DCF provides a fair price of SAR 91.20, while a blended valuation arrives at a price target of SAR 76.35 (factoring in a 15% discount to peers, which could diminish as the tide of investor pessimism turns). STC provides investors an attractive 8.5% dividend yield and our fair price has a further upside of SAR 5.4 if the company can demonstrate that this discount to peers is unwarranted.

• We initiate coverage of STC with a target of SAR 76.35 per share (12.7% upside potential) and a BUY recommendation. We believe that the possibilities of positive surprises and further upsides are high, with downsides limited by the attractive dividend yield.

BUY (Initiation of Coverage) – ‘The Giant Awakes’

www.sico-bahrain.com

SICO Research

Sector Telecom

Market Cap: US$ 36.1 bn

Primary Exchg Tadawul (KSA)

Other Exchg -NA-

Price: SAR 67.75

Target Price: SAR 76.35

Reuters: 7010.SE

Bloomberg: STC AB

VALUATION RATIOS

2007E 2008E

P/E x 11.0 10.7

P/BV x 3.9 3.7

EV/EBITDA x 8.2 7.8

Div Yld x 8.5 8.1

TRADING DATA

Daily Vol (6M Avg mn) 1.46

Daily T/o (6M Avg US$ mn) 26.2

Issued Shares (mn) 2,000

GCC Equities

Jithesh K. Gopi Tel. (973)1751 5000 (ext 5065) [email protected]

Bryan D’Aguiar, CFA

Tel. (973)1751 5000 (ext 5021) [email protected]

SICO 2007 All Rights Reserved

Attention is drawn to the disclaimer and other information on Page 37

STC versus Tadawul Index

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STC - Rebased

INDEX - Rebased

STC SICO RESEARCH

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Contents

Investment Arguments................................................................... 3

Inorganic growth becomes a reality.............................................. 5 Analysis of Maxis Deal........................................................................................... 6

Detailed Valuation Methodologies ............................................. 10 Discounted Cash Flow Method........................................................................... 10 Comparative Valuation based on Industry Multiples ....................................... 11 Blended Valuation............................................................................................... 12 Valuation Evolution............................................................................................. 13 Valuation versus Saudi, Regional & EM Peers ................................................... 14

Recent Developments .................................................................. 15 Hikes Stake in AwalNet to increase internet market share ............................. 15 STC in talks to secure debt facility for future acquisitions............................... 15

STC’s Q2 FY07 Results................................................................... 16

Business Background.................................................................... 17 Description of Current Business.......................................................................... 17 Group Operations ................................................................................................ 17

Business Segments........................................................................ 18

Saudi Telecommunications Sector Overview............................... 20 Set to become fully competitive......................................................................... 20 There is still plenty of room for expansion in Wireless .................................... 20 Internet and broadband poised for growth ..................................................... 22

STC Business Strategy................................................................... 25 Moving F-O-R-W-A-R-D ....................................................................................... 25 Preparing for fixed-line competition… ............................................................. 25 Broadening range of services and pricing is key to mobile market................ 26 STC concentrating on improving Internet, Data businesses ............................ 27 STC considers regional expansion as domestic competition increases............ 27 Wholesale business to benefit from competition............................................. 28

Corporate History......................................................................... 29 Key Developments............................................................................................... 29 Current Ownership .............................................................................................. 29 Dividend Policy..................................................................................................... 30

Financial Performance and Analysis ............................................ 31 Key Profit and Loss Account Data and Ratios ................................................... 31 Balance Sheet and Cash Flow ............................................................................. 34

Financial Statements & Forecasts................................................. 35

STC SICO RESEARCH

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Investment Arguments

Investment Case

Ability to provide bundled services is a key competitive advantage - Saudi Telecom Company (STC) is the only player in Saudi Arabia offering fixed, mobile and data services. This unique positioning provides the company a competitive edge to offer bundled services and comprehensive service offerings to both retail and enterprise customers. STC is now focusing on expanding its physical coverage as well as its Internet and Data services businesses by upgrading its infrastructure and introducing WiMax. Contrary to perception, STC’s wholesale business will benefit from increased competition, though the impact will not be significant given its relatively minor contribution to STC’s financials.

Well placed to capitalize on new inorganic growth plans - STC is changing its approach towards inorganic growth and is now looking to acquire stakes in carriers operating in multiple geographies with a subscriber base of 15–20 million. STC is well placed to follow such a strategy given its lack of leverage (currently zero debt on books) and significant cash flow generation potential (in 2006 alone, STC generated SR 16 bn ($4.3 bn) from operations).

Excessive pessimism built into price - Recent M&A deal may signal a turn in the tide - STC’s recent acquisition of a 25% stake in Malaysia’s Maxis Communications and 51% direct stake in Maxis' Indonesian unit Natrindo for US$ 3.04 bn, heralds the company’s first aggressive move outside the region. We view the deal positively as it provides STC a much needed growth impetus. STC’s current share price, in our view, reflects an excessive level of pessimism. This deal could possibly signal the turning of the tide as STC aggressively ramps up its inorganic growth plans, given its access to significant funding and a strong domestic franchise.

Competition set to increase but impact expected to be less dramatic on market share and ARPU assumptions - Competition in STC’s home market is set to intensify, with news flow likely to impact sentiment. Following the launch of Mobily’s (Saudi’s second mobile operator) services in 2005, STC’s market share declined to 69% in 2006. In Mar ‘07, a third mobile license was granted to a consortium led by Kuwait’s Mobile Telecommunications Co (MTC).

STC’s monopoly in the fixed-line market will shortly be broken as three new fixed-line licenses are in final stages of being awarded. Going forward, we expect growing competition to weaken STC’s market share and competitive position in its home market. None the less, Saudi Arabia’s large population base (25.3 mn) and its young demographic profile, should enable competition to drive penetration levels higher and lead to demand for higher end services, enabling STC to hold on to a market share of 52% by 2011 with decline in ARPUs significantly less severe than in recent years. Furthermore, we do not expect the third mobile operator to launch an aggressive price war and weaken the overall market in the longer term due to the significantly higher license fee (US$ 6.1 bn) it paid and the pressures it will face to break even once the entity gets listed.

Business / Broadband segments to cushion pressures on growth - STC’s wholesale business will benefit from the increasing competition. We believe that growth in STC’s wholesale business and broadband services will alleviate the pressures on growth in revenues and margins from other services.

STC SICO RESEARCH

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Savings on recent cost control initiatives are yet to be built into forecasts - STC has launched a cost optimization program aimed at sustaining margins at current levels. This includes significant reduction in manpower and an organization wide rollout of shared services. We have not factored in the savings potential from these initiatives and any positive developments on this front would provide upside potential.

Recent results reflect our views on likely pressures on margins and profitability in the medium term - In 1H FY07, the company’s top line declined 2.2% to SAR16.8 bn. The decline in revenues coupled with higher costs led to a 14.5% decline in the net income during 1H FY07. Profitability is under pressure since the second half of 2006 when the company’s net income declined 8.3% (y-o-y) due to lower pricing and higher costs. However in 2Q-07, the net income improved 14% sequentially (after four continuous quarters of decline) benefiting from cost savings (though it fell 8.6% y-o-y). Going forward, we expect pricing to come under pressure in key markets including Mobile, Internet and Data services resulting in pressure on margins and net income.

Market price is overly pessimistic and provides investors with a high reward for any positive surprises - Our analysis suggests that the current price fully reflects (and even overstates to some extent) the pessimism related to STC’s domestic earnings potential. We have modeled STC’s declining profitability versus peers by factoring in discounts to STC’s base case valuations. We believe that scope for positive surprises are high and could come from sources such as operational improvements in STC (e.g. its cost control measures), delays in roll-out by competition, quicker market penetration of telecom services in the Kingdom, better than expected market position of STC in domestic markets and any further M&A activity by STC.

Key Risks

Pricing of M&A deals & impact on dividend payouts - In its bid to aggressively expand its reach to regional markets, STC may end up paying steep prices for licenses or/and acquisitions. This could be detrimental in the medium term. Another risk is the lack of a track record for STC’s management in integrating large acquisitions.

Note that significant M&A deals could impact cash flow requirements of STC putting pressure on the company to reduce dividend payouts to conserve cash. While this may be in the best interests of shareholders (in cases where acquisitions are earnings accretive in the long run), this could impact sentiment in the short term.

Speed of Competitors roll-out in Saudi - We have already factored in the presence of a third mobile operator in Saudi Arabia from 2008, and the addition of three other fixed line operators – two wireless fixed operators from 2008 and one wire line operator from 2009. Any acceleration (to this base case) in roll outs by competitors could negatively impact STC’s prospects and profitability.

Regulatory risks - As the dominant player in Saudi, STC may require regulatory clearance for new products. Any unfavorable decisions aimed at promoting competition could impact STC negatively.

News flow may result in short term volatility in STC’s share price - Announcements from new operators about major developments in their operational plans can cause temporary negative sentiment in the market about STC, though most of these factors are already priced in our forecasts and valuation.

STC SICO RESEARCH

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Inorganic growth becomes a reality Recently STC had become more vocal about its acquisitions plans to boost growth by leveraging its strong balance sheet. STC has set its sights on bigger carriers operating in multiple geographies with a subscriber base of 15–20 million (as small operators will not have a significant impact on STC’s consolidated operations). STC recently announced the first such deal by acquiring a 25% stake in Maxis Communications which has foothold in three geographies (Malaysia, India and Indonesia) with about 14 mn subscribers. We believe STC still has the potential to make further acquisitions to reach its target of generating 10% of revenues from overseas markets by 2010.

Domestic competition forces STC to look outward

STC has largely remained a domestic operator even as its regional peers expanded beyond their home markets. Over the past decade countries in the Middle East and North Africa (MENA) region have opened-up their markets to competition. Incumbents, faced with rising competition and stagnating markets in their domestic countries have expanded aggressively outside their home markets through acquisitions and new licenses in new geographies. By adopting aggressive inorganic growth strategies Etisalat (UAE), MTC (Kuwait), Orascom (Egypt), and Q-Tel (Qatar) have emerged as large regional players. These operators have successfully mitigated falling market share in their domestic markets through growth in external markets. Etisalat and MTC for instance now aim at becoming not just regional but international players.

STC, in comparison, awoke late to the necessity to grow outside its home markets. Perhaps in part due to the fact that competition was introduced late in Saudi Arabia (only in 2005) and in sharp comparison to its neighbors, penetration rates are yet to hit the 100% plus levels that characterize the region. Other regional operators had very little choice but to expand beyond their home markets. After Mobily’s entry in to Saudi market, STC made several attempts (though unsuccessful) to grow beyond its domestic borders. In March 2006, it withdrew prematurely from its bid for a 35% stake in Tunisie Telecom. Later in June 2006, STC’s bid for the third mobile license in Egypt was rejected.

We believe acquisitions are likely to emerge as an important source of growth for STC going forward.

Balance sheet strength to enable regional expansion

STC is considering inorganic growth opportunities in Asia, Africa and the Middle East. STC officials have indicated that they are looking at carriers operating in multiple geographic areas with subscriber base in the range of 15–20 million.

STC, which currently has no debt on books, has the ability to make sizeable acquisitions by leveraging its balance sheet. STC recently announced plans to borrow SAR 6 bn (USD 1.6 bn) from a consortium of banks. We believe that STC could potentially raise a war chest of as much as SAR 52 bn ($ 13.8 bn) to fund acquisitions given its current zero-debt structure and the levels of leverage by its peers in the region.

In the section that follows we look at the extent of leverage of six telecom operators in the region (who aggressively expanded their geographic reach). Qatar Telecom has the highest leverage on its balance sheet whereas Etisalat has resorted to least proportion of debt to fund expansion. Qatar Telecom (Q-Tel) took on additional debt in Q1-FY07 to fund its 51% stake in Wataniya Telecom.

STC SICO RESEARCH

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Etisalat* 8.5 19.2 NA 14 44%Orascom Telecom 24.0 11.6 51.7 7 207%MTN 33.0 38.7 40.0 21 85%Q-Tel 4.8 19.0 1.3 2 394%Wataniya Telecom 0.3 0.2 9.9 6 79%MTC 1.4 1.4 24.9 20 101%Average 152%

44%

** 2006 figures except for QTel which is based on 1QFY07

Source: Company reports, SICO Research*Etisalat does not disclose group subscriber numbers

Least multiple (Etisalat)

in reported currencies

Debt Position of MENA's Aggressive Telecom Operators

D/EWireless

Subscribers (mn)

No of countries present

Total Equity**

(bn)

Total Debt**

(bn)

In 2006, STC’s net worth stood at SAR 34.1 bn. Based on the average debt / equity multiple, STC can potentially leverage its balance sheet by as much as SAR 52 bn (US$13.8 bn). On a conservative estimate assuming the lowest multiple (Etisalat), STC could still raise SAR15.2 bn which is still significantly higher than its proposed borrowing of SAR 6.0 bn. The potential of leverage coupled with substantial free cash flow generation capacity and a possibility to retain earnings (rather than paying out dividends, if a lucrative deal comes its way) provides STC with the ability to look at large acquisitions in the coming years.

Analysis of Maxis Deal

Described as "a deal of a lifetime" by the STC Chairman, this acquisition marks STC’s foray outside Saudi Arabia. Even though we do not expect the contribution from this acquisition to be significant in terms of earnings and valuation, the deal demonstrates STC’s seriousness in finding opportunities outside its home markets to boost growth and we expect this will help reduce (the perhaps excessive) pessimism lingering on the company’s share price. On June 26, 2007 STC announced a deal to buy 25% of Malaysia's Maxis worth SAR11 bn (US$3.04 bn) that would give STC access to Malaysia, Indonesian and Indian markets. STC would fund the deal using a debt facility of SR 6 bn while the rest would be met from internal funds. STC would buy the stake by investing in Malaysian tycoon Ananda Krishnan's firm Binariang (Maxis Communications' largest shareholder). Binariang had recently teamed up with other Maxis shareholders to buy the 41% of Maxis they did not own in a successful $4.7 bn bid which took the group’s holding to 98%. Binariang is expected to take Maxis Communications private (currently listed in Malaysia) by acquiring the remaining 2%. As part of the deal, STC will acquire a 51% stake in Maxis' Indonesian unit Natrindo. STC and Binariang's other shareholders will together underwrite a US$ 900 mn loan to expand in India where Maxis operates through its Aircel unit. As of Mar’07 Maxis had a subscriber base of 14.04 mn (8.5 mn in Malaysia and 5.5 mn in India). This would value the deal at about US$ 841 per subscriber. The blended ARPU in Malaysia was about US$ 37 while in India ARPUs were much lower at US$ 14.8 The acquisition consists of two transactions: a 25% stake in Maxis’ parent and a 51% stake in Maxis’ operation in Indonesia.

STC SICO RESEARCH

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The Indonesian operation is not yet fully operational and reported losses during 2006. In April 2007, Maxis acquired 44% of the Indonesian subsidiary (PT Natrindo Telepon Seluler) for US$ 123.92 mn increasing Maxis’ stake to 95%. This deal implies a valuation of US$ 281 mn for the Indonesian subsidiary and values STC’s 51% stake at US$ 144 mn (less than 5% of the deal). We have chosen not to consider separately the impact of the Indonesian operation because of its small contribution. Note the subsidiary is already embedded in the valuation (and earnings estimates) of Maxis.

in US$ millionConsideration paid by STC 3,040 Stake bought by STC 25%Implied Valuation 12,160 Ratios 2006A 2007E

EV/Subscriber (US$) 841Price/Revenue 5.4 4.6Price/Earnings 20.0 21.0Price/BV 5.8 5.7EV/EBITDA 10.5 9.1

Source: SICO Research, Reuters, Bloomberg, Company Reports

Note: Susbcriber base as on 1Q 2007, 2007 estimates from Reuters

Impact of Indonesian subsidary not included seperately

Analysis of the Deal

STC’s offer for Maxis (MYR 16.6 / share) represents a 9% premium to the last traded price of MYR 15.2 and a 6% premium to the take-over offer price of MYR 15.6 offered by Maxis’ parent company Binariang. Note that the price paid by Binariang already included a 20% premium over Maxis’ trading price prior to their take-over deal, implying STC’s total premium at about 25%. This deal compares favorably to Q-Tel’s acquisition of Wataniya where Q-Tel paid 11.8x EBITDA and 28.9x earnings for a 51% stake in Wataniya. Excluding the Iraqi operation (which is now under liquidation) the multiples increase to 17.4 and 39.8, respectively. A key distinction is that Q-Tel acquired a majority stake, which would attract a premium for control. Going by recent deals such as the acquisition of Investcom by MTN (US$ 950 per subscriber), Umniah by Batelco (US$ 800), Celtel by MTC (US$ 594), Wataniya by Q-Tel (US$ 1,325 per proportionate subscriber) STC’s consideration for Maxis of US$ 841 per subscriber seems reasonable. A sweetener to the deal is Maxis’ strong foothold in India, which is considered to be the fastest growing telecom market in the world. Impact on STC We expect that STC’s stake in Maxis will be treated as an “Investment in associates’ while the stake in Indonesian operation will be fully consolidated. The Indonesian operation will not have any significant impact in the near term as the operation is yet to become fully operational. In order to consider the financial impact we have taken the earnings estimates available for Maxis (it is a well researched company listed on the Kuala Lumpur Stock Exchange). Based on consensus estimates (average of between 10-15 broker estimates) provided by Reuters, we estimate that the incremental increase in STC’s earnings from this deal will be about 5%.

STC SICO RESEARCH

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STC also stands to gain from the higher growth rate of Maxis (CAGR of 16% during 2006-2009) thus increasing contribution to incomes (6% in 2009 compared to 4.7% in 2007). Since STC plans to use a mix of debt and internal funds (50:50 – i.e. about SAR 6 bn debt) to finance the deal, the net benefit would depend on the financing cost. We estimate the net benefit would be about half of the total projected contribution from Maxis.

in US$ mn 2005A 2006A 2007E 2008E 2009ERevenue 1,846 2,233 2,647 3,041 3,464

% Growth 21% 19% 15% 14%EBITDA 1,010 1,125 1,237 1,360 1,501

% Growth 11% 10% 10% 10%Margin (%) 55% 50% 47% 45% 43%

Net Income (GAAP) 485 609 580 632 704% Growth 26% -5% 9% 11%Margin (%) 26% 27% 22% 21% 20%

STC's Share of Profit (25%) 121 152 145 158 176STC's Current Profit* 3,319 3,413 3,120 3,121 3,221 Incremental Contribution (Pro) 3.7% 4.5% 4.6% 5.1% 5.5%Incremental Interest Cost 20 80 70 Net Increase in Earnings 40 78 106 Source: SICO Research, Company reports, Reuters estimates

Note: *based on SICO forecasts excluding share of income from Maxis, 2007 considered for 5 months

Impact of consolidation of Indonesian operation not considered

Results for 2005 and 2006 are given for comparative purpose only

Interest expense based on SR 6 bn debt @ 5.5% annum

Performance of Maxis based on Analyst Forecasts and Impact on STC

In addition to the above STC can also derive cost savings in their international operations in Saudi Arabia. India and Indonesia are two of the top three international calling destinations from Saudi Arabia. STC now with direct footing in these countries through Maxis is in a better position to get attractive rates in these countries thus saving on STC’s costs in Saudi Arabia.

STC SICO RESEARCH

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Our Views on Valuation

Limited Downside with high potential for positive surprises

We believe that the market has already priced in the worst case scenario as far as STC’s share price is concerned. Our valuation which is based on a ‘worst-case scenario’ indicates that the current price level of STC almost fully reflects STC’s earnings potential as a domestic player facing rising competition and the significant risks associated with a market which is changing as new operators commence their operations.

Scenario analysis indicates limited downside risks

We have assumed STC’s market share will drop from the current 66% to about 52% by 2011 while the ARPU is forecasted to drop to SAR 105 per month (US$ 28 per month) by 2011 from the current SAR 133 per month. According to our scenario analysis if STC’s market share drops by another 10% (to 42% by 2011) the DCF valuation will drop by only 7%. Similarly a SAR 10 drop in ARPU (to SAR 95 by 2011) will also have a similar 7% decline on DCF valuation. A combination of these factors will reduce DCF valuation by about 13%. This analysis shows the limited downside for STC from the current valuations.

In our comparative valuation method, we have assigned a discount of 15% to STC’s target multiples from peer group averages in both 2007 and 2008 in order to reflect its weakening position in the Saudi market and lack of diversification outside the domestic market. However if we were to remove this discount as a result of re-rating of STC’s opinion in the market, our fair value will increase to SAR 81.7, an upside of 21% from the current level. This translates to an increase of 7% from our current fair value target price for STC.

We believe that the above two examples represents the worst case scenarios for STC and note that our fair price for STC is only marginally higher from the current price. Also note that at current price STC offers an attractive dividend yield of about 8.5%. We believe the market has already priced in a worst case scenario for STC with limited downside possibility from the current level.

Positive Surprises to provide Upside

Possible upsides to STC can come from three sources, a change of perception about STC, improvement in core earnings as a result of cost optimization programs and better performance in the domestic market, and incremental earnings from possible acquisitions. We expect that any positive surprise from STC can lead to a change in perception of STC and an improvement in target multiples as a result of lower discounts from peers.

We believe that that the downside potential is limited due to the company’s high dividend yield (about 9%) which we believe is sustainable, assuming there are not further M&A deals that would provide the company a reason to conserve cash or repay debt.

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Detailed Valuation Methodologies We valued STC using the Discounted Cash Flow (DCF) and relative valuation methodologies. In the relative valuation method, we use the EV/EBITDA, PER and P/BV multiples to derive a fair value. We arrived at the target price by considering both valuation methods and weighing them appropriately.

Cost of Equity

Since STC has zero debt, its weighted average cost of capital equals the cost of equity. We calculated STC’s cost of equity as below:

Beta: STC’s raw beta using weekly returns for the last one year compared to the Tadawul All Share Index is 0.72. The adjusted beta (assuming the company’s beta will tend towards the market beta over a longer term) is calculated as 0.90.

Risk Free Rate: Given the peg of the Saudi Riyal to the USD we use the US 10-year Treasury yield as the benchmark Risk Free Rate. As of 24th July 2007, the US 10-year yield stood at 4.93%.

Equity Risk Premium: We have assumed an equity risk premium of 6.1%.

Based on the above STC’s Cost of Equity is calculated as 10.4%. Weighted Average Cost of Capital (WACC): We have assumed a debt of SR 6 billion to finance the Maxis deal (assumed interest rate of 5.5% per annum) resulting in a weighted average cost of capital (WACC) of 10.2%. In the long run, STC is expected to further leverage its balance sheet which provides the potential to lower WACC further (depending on level of leverage) and increase our estimate of the fair value.

Discounted Cash Flow Method

Given STC’s ability to generate relatively stable cash flows in the coming years, DCF would be the most appropriate valuation method. Our DCF model is based on a detailed five-year forecast period, which in our view is a reasonable period of analysis for this region. We have assumed a perpetual growth of 3% to derive the terminal value of the company to reflect the weakening position of STC in the home market. This represents a discount to both the expected 3-4% population growth rate in Saudi Arabia which will be a key driver of growth in the segment, and the longer term real GDP growth of the Kingdom (which is yet another margin of safety from a potential investor’s view-point).

Based on these assumptions, the equity value of the company stands at SAR 182.3 billion, translating to SAR 91.2 per share (35% higher than its current price).

(Figures in SAR billion unless specifiedValue

as a % of Total

Present Value of next 5-yrs Cash Flow 49.8 27.3%Cash and Cash Equivalents 8.5 4.7%Present Value of Terminal Value 122.7 67.3%Debt -6.0 -3.3%Year End Adjustment 7.3 4.0%Total Equity Value 182.3

STC - Details of DCF Valuation

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About 67% of STC’s value comes from the terminal value (based on a terminal growth rate of 3.0%). We thus believe it is important to focus our sensitivity analysis to changes in our assumption on perpetual growth rates and cost of equity (as provided in the table below).

Our valuation is more sensitive to change in the terminal growth rate and less sensitive to change in the cost of capital. The valuation ranges from a low of SAR 67.3 per share to a maximum of SAR 148.8 per share validating our contention that downsides in STC are limited. The possibility of upside potential is higher in case of drop in cost of equity due to leverage or increase in growth rates due to change in perception about the prospects of the company.

8.2% 9.2% 10.2% 11.2% 12.2%2.0% 108.4 93.9 82.9 74.3 67.32.5% 115.9 99.2 86.8 77.2 69.73.0% 124.7 105.3 91.2 80.6 72.33.5% 135.5 112.5 96.3 84.4 75.14.0% 148.8 121.1 102.3 88.7 78.4

Terminal Growth Rate

Sensitivity of Valuation to Cost of Capital and Terminal GrowthCost of Capital

The contribution of mobile segment is significant to STC’s overall revenue. Accordingly we have performed a sensitivity analysis to ascertain the impact of STC’s estimated mobile market share and ARPU on STC’s valuation. This demonstrates the limited downside risk due to further reduction in STC’s expected market share and ARPU levels.

91.2 42% 47% 52% 57% 62%95 79.1 82.0 84.9 87.9 90.8100 81.9 85.0 88.1 91.2 94.2105 84.8 88.0 91.2 94.5 97.7110 87.6 91.0 94.4 97.8 101.1115 90.4 94.0 97.5 101.1 104.6

Sensitivity of Valuation to Mobile Market Share and ARPUExpected Market Share in 2011

Expected ARPU in 2011

(SR per month)

Source: SICO Research

Comparative Valuation based on Industry Multiples

In order to derive the comparison-based value for STC’s shares, we have used the PER, PBV and EV/EBITDA multiples based on regional companies that have operations in the fixed-line as well as wireless segments.

Company06A 07E 08E 06A 07E 08E 06A 07E 08E

Fixed Line and Wireless OperatorsEtisalat 14.4 12.9 11.1 4.1 3.5 3.0 8.0 8.0 7.8Qatar Telecom 19.7 14.6 10.8 5.5 5.5 4.4 13.1 9.4 7.6Batelco 13.9 11.9 11.0 3.3 3.4 2.9 10.2 9.5 8.8Jordan Telecom 12.5 12.5 12.2 2.7 2.9 2.9 5.0 5.1 5.0Oman Telecom 10.7 9.8 3.1 5.0Maroc Telecom 17.7 15.7 14.7 7.2 7.0 6.8 8.7 8.0 7.6Saudi Telecom 10.6 11.0 10.7 4.0 3.9 3.7 8.0 8.1 7.8

Overall Average 14.2 12.6 11.7 4.2 4.4 3.9 8.8 7.6 7.5Average (excluding STC) 14.8 12.9 11.9 4.3 4.5 4.0 9.0 7.5 7.4Premium/ (Discount) -28.6% -14.7% -10.7% -7.7% -13.4% -7.4% -10.6% 8.1% 6.1%

------P/E------ ------P/BV------ ------EV/EBITDA------Valuation Metrics - Comparable Telecom Operators

Source: SICO Research, Company Reports, Reuters and Bloomberg

The valuation for STC based on peer multiples is provided in the table that follows. As things stand at the moment, we expect STC’s multiples will trade at a discount to the average valuation multiple of its peer group.

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We believe that the discount is justifiable considering the threat to STC’s competitive position in the Saudi market, limited growth opportunities, lack of diversification outside the domestic market and the pressure on margins. Accordingly we have assigned a 15% discount to peer group average while calculating STC’s target multiples. We believe that this discount may diminish as sentiment improves (driven by the three factors we outlined in our earlier section in valuation views). On incorporating this discount, we arrive at target P/E multiples (based on 2007 estimates) of 11.0, target P/BV of 3.8 and target EV/EBITDA of 6.4 compared to peer group averages of 12.9, 4.5 and 7.5 respectively.

2007E 2008E16,370 16,939

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-15% -15%

4.5 4.066.8 62.3

50% 50%Annual weighting

Source: SICO Research

PBV MultiplePremium/Discount

Peer group averagePrice based on PBV, SAR

PER MultiplePremium/DiscountPeer group average

Book Value Per Share (SAR)Price based on PER, SAR

Price based on EV/EBITDA, SAREarnings Per Share (SAR)

EBITDA (mn SAR)EV/EBITDA MultiplePremium/DiscountPeer group average

STC - Valuation Based on Multiples

Blended Valuation

We used a blended approach to derive the target price for STC. Given the greater rigor and suitability of the DCF approach, we assigned it a higher weightage (50%), and assigned equal weightage (16.7% each) to the PER, PBV and EV/EBITDA approaches. Based on our blended valuation approach, the fair value estimate for STC is SAR 76.35 per share, 12.7% higher than the current price.

(price in SAR) Price WeightageDCF 91.2 50.0%Price/ Earnings 65.8 16.7%EV/EBITDA 54.2 16.7%Price/ Book Value 64.6 16.7%STC - Share Price, SAR 76.35 Source: SICO Research

STC - Blended Valuation

STC Fair Value per share, SAR 76.35Current Price, SAR 67.75% Up (Down) Side from Current Price 12.7%

Calculation of Upside (Downside)

Also note that STC currently has an attractive annual dividend yield of about 8.5%.

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Valuation Evolution

As the only operator in the Saudi telecom sector, STC was the only avenue for investors to participate in the Saudi telecom sector. As a result, the stock historically traded at a high P/E multiple of 16x earnings. The company recorded strong growth in its subscriber base between 2004 and 2005 and the valuation soared to abnormal levels during this period. However, the opening up of the telecommunications industry and the changing competitive landscape has led to a fall in valuation multiples. The stock currently trades at a forward multiple of 10.7x earnings, a significant discount to its historical multiples.

STC has been one of the most liquid and highly traded stocks on the Saudi bourse. The recent correction in regional markets led to a contraction in STC’s volume, as evident in the chart below. Average volumes declined significantly in the past few months. Note that GCC investors are allowed to invest in STC directly (while foreigners can invest in the company only through a fund route).

Chart 1: STC – Trading Pattern

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Chart 2: STC – Trading Pattern

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Until 2004, the STC stock moved broadly in line with the market. However, the stock began underperforming the market following the entry of Mobily in July 2005. The reduction in market share and deteriorating operational performance contributed to the negative sentiment surrounding STC. In the past few months, while most shares witnessed a correction, the STC stock declined more than the broader market. Over the past month, however, the stock has outperformed the markets as investors realized that perhaps the markets are being too pessimistic on the outlook for the company. On a relative basis, STC has significantly underperformed the Tadawul All Share Market Index during the last one year. However in the recent months STC outperformed the market.

Absolute Relative Market

1 m 9.7 2.2 7.5

3 m 12.9 8.0 5.0

12 m (32.3) (5.8) (26.4)

STC - Price Performance relative to Index

Valuation versus Saudi, Regional & EM Peers

The table below summarizes STC’s investment merits in comparison to both regional peers and international emerging market Telcos:

Company P/E (07E) RoE % D/Y %STC 11.0 35.6 8.5Saudi Equities 14.8 25.5 3.3MENA Telcos 12.6 32.4 5.9EM Telcos 12.8 14.6 2.2Source: SICO Research, Bloomberg, Reuters

STC represents a steep discount to Saudi markets, peer averages and EM Telco averages in terms of both forward P/E and Dividend Yield (despite having superior levels of profitability).

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Recent Developments

Hikes Stake in AwalNet to increase internet market share

On March 19, 2007, STC purchased a majority stake in local Internet provider, AwalNet. The acquisition, a first for the company in the internet space, aims to boost STC’s share in the internet market. AwalNet has a 20% market share, and is the leading ISP in Saudi Arabia. AwalNet had earlier pulled out of the bidding process for the second fixed-line license.

The acquisition is in line with the STC’s newly established corporate strategy, which prioritizes external growth and greater penetration in the home communications market.

STC in talks to secure debt facility for future acquisitions

STC is in talks with a consortium of local banks to secure a loan facility that will allow it to borrow up to SAR6 bn (USD1.6 bn). A formal agreement on the five-year loan is expected over the next few weeks. According to information currently available, terms of the loan would be drafted under Islamic Banking laws that ban lending on interest, and the deal would be a commodity-linked transaction. We expect the deal would be used to finance the Maxis Communications deal.

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STC’s Q2 FY07 Results STC announced its Q2 FY07 results on July 18, 2007. According to preliminary numbers, the company’s revenues declined 2.1% to SAR8.4 bn in Q2-07. EBITDA margin declined to 49.6% in Q2-07 from 51.2% in Q2-06 (a marked improvement over 46% during Q1-07). Net profit fell 8.7% to SAR 3.1 bn in Q2-07 however increased 14% compared to the previous quarter. STC’s earnings improved sequentially during the second quarter, after four quarters of continuous decline in profits. The results are summarized in the table below.

Key Highlights – Q2-07 results & CY 2006 Results

Q2 FY07 Q2 FY06 % Change Q1 FY07 % ChangeY-o-Y Q-o-Q

Revenues 8.4 8.6 -2.1% 8.3 1.4%EBITDA 4.2 4.4 -5.2% 3.8 8.9%Net Income 3.1 3.4 -8.7% 2.7 14.1%EBITDA Margin 49.6% 51.2% -1.6% 46.2% 3.4%Net Income Margin 36.8% 39.4% -2.6% 32.7% 4.1%Source: SICO Research and Company Report

(Figures in SAR billions unless specified)

STC Consolidated Results (3-Months ended June 2007)

STC’s FY06 and subsequent Q2-07 results reflect the competitive pressure faced by STC after Mobily’s entry (and the subsequent end of the company’s monopoly in the wireless segment). Revenues grew 3.8% to SAR33.8 billion in FY06. Price cuts and rising marketing expenses dented profitability. In our opinion, the decline in EBITDA margins and net income is likely to continue.

Key highlights of STC results for FY06

• Revenues increased 3.8% to SAR33.8 bn in FY06 from SAR32.5 bn in the preceding year. Fixed line revenues increased 8.2% y-o-y to SAR9.8 bn in FY06 driven by broadband and wholesale services. However, wireless revenues increased a modest 2.2% y-o-y to SAR24.0 bn in FY06.

• STC’s subscriber base is estimated to have grown 12.7% to 13 mn in FY06. However, the overall market size is estimated to have grown 26.4% in FY06. The company’s market share declined to 69% in FY06 from 83% in the earlier year.

• Reductions in tariffs, increased promotional discounts and increasing penetration have led to lower Average Revenue per User (ARPU). Wireless ARPU declined 14.8% to SAR158/month in FY06.

• Higher marketing expenses coupled with lower ARPU dented profitability. The net income grew 2.8% to SAR12.8 bn in FY06. This compares to a CAGR of 52.0% between FY02 and FY05 and a y-o-y growth of 33.6% in FY05. On a q-o-q basis, STC’s net income declined for three straight quarters in FY06 – Q2, Q3 and Q4 reflecting the challenge faced by the company. However we expect the earnings to marginally improve in FY07 as they have already fallen in corresponding quarters in FY06.

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Business Background

Description of Current Business

Saudi Telecom Company (STC) is the leading telecom service provider in Saudi Arabia. Until 2005, STC was the sole telecommunications provider in the country. In 2005, Saudi Arabia granted a second GSM license to Etihad Etisalat (Mobily), thus ending STC’s monopoly. STC is still, however, the monopoly provider of wireline telecommunications in Saudi Arabia. It is also the sole provider for internet connectivity to all local ISPs.

STC’s subscriber base comprises 4.3 million fixed line users and over 13 million mobile subscribers, making it one of the largest telecommunications providers in the Middle East. STC is set to lose its monopoly over the fixed line market very shortly with the regulator (CITC) in final stages to grant three additional wireline licenses. CITC granted a third GSM license this year to Kuwait based MTC paving way for increased competition in the wireless segment.

Group Operations

STC’s operations can be broadly classified into wire line and wireless services. Services such as telephone calls (local, national, and international), public telephone services, prepaid card calling, directory services, internet, and business services are provided under the wireline business. Wireless services relate to GSM services such as pre-paid and post-paid connections, SMS, MMS and WAP. The wireless segment contributed 71.1% to total revenues in FY06, while the balance 28.9% came from wireline services. Usage charges contributed 79.3% of STC’s revenues, subscription and activation fees contributed 15.2% and 1.7%, respectively and other revenues accounted for the balance 3.7%.

Chart 3: STC Revenue trend

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Business Segments STC conducts its operations through four divisions, each catering to one part of the telecommunications business. These divisions are outlined below:


ALHATIF

This division caters to the fixed-line business. Apart from the main landline telephone service, ALHATIF offers value-added services such as call hot line, voice mail, caller id, and conference call services. Internet and data services are also provided through the landline network. To its business customers, ALHATIF offers services such as toll-free numbers and direct dialing. Currently, ALHATIF is the monopoly provider of landline telecommunications in KSA. STC’s network, comprising fiber optic and copper cables, is spread across the nation. Global links are established via submarine cables. Fixed-line penetration has remained steady at approximately 16% for the past five years.

ALJAWAL

The ALJAWAL division is the leading GSM services provider in KSA. ALJAWAL offers both prepaid and post-paid connections. Most plans include basic bundled services such as call alerts, call divert, and call waiting. ALJAWAL also offers special packages such as Family ALJAWAL, and the SAWA Friends and Family service to its retail customers and ALJAWAL Business Discount, ALJAWAL Banking, and Bulk SMS to business customers. Through platforms such as WAP and Jawalnet, the company provides data services.

SaudiNet

STC provides internet services to corporate customers, small and medium businesses in Saudi Arabia through SaudiNet, its internet service provider division. SaudiNet developed its IP network and systems jointly with Telia and currently provides dial-up and ADSL services. Post the acquisition of AwalNet, STC offers direct internet access through approximately 38% of the country’s connections. The balance is provided by 21 private Internet Service Providers (ISP). For all practical purposes, these ISPs can be looked at as a connecting link between customers, as the ISPs’ customers pay an ADSL access charge to STC in addition to connection charges paid to the ISP.

Chart 4: STC Group Chart

STC

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Saudi Data

IP-VPN enables customers to connect multiple sites through the creation of virtual private networks (VPNs) that facilitate interconnection of sites through the STC infrastructure.

It also offers communications technologies such as data framework relay and digital leased lines to enterprise customers.

The company also participates across the telecommunication value chain through equity stakes in three companies – Arab Satellite Communication Organization, Arab Submarine Cables Company, and Tejari Saudi Arabia.

Arab Satellite Communication Organization (36.7% stake) – Arabsat, established in 1976, offers a number of services in the Middle East. These services include regional telephony (voice, data, fax and telex), broadcasting (television and radio), and capacity leasing.

Arab Submarine Cables Company (44.3% stake) – This company constructs, leases, manages and operates a submarine cable between KSA and Sudan.

Tejari Saudi Arabia (50.0% stake) – Tejari was formed in November 2006 with the aim of providing electronic platforms and services related to e-commerce dealings.

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Saudi Telecommunications Sector Overview The Saudi telecommunications sector is one of the most attractive in the Gulf Cooperation Council (GCC) region and, in our opinion, offers significant potential for growth. Rising economic prosperity coupled with the positive demographics of a young growing population and large number of expatriates is driving the demand for telecommunication services in the Kingdom. Furthermore, Saudi Arabia, the most populous GCC country, is one of the most under–penetrated markets in the region.

Set to become fully competitive

Saudi Arabia is on its way to becoming one of the most competitive and liberalized markets in the GCC region. The mobile market was opened-up in 2004 when Etihad Etisalat won a license to operate the second GSM service. CITC continued its liberalization agenda by awarding MTC the third GSM license and is expected to grant three new fixed-line licenses in 2007. MTC is expected to begin operations in 2008. Of the three new wireline carriers, two will offer fixed-line services through radio spectrum and are expected to begin operations by end of 2008. The third fixed-line carrier will operate a cable network in select cities and is expected to start operations by mid-2009.

There is still plenty of room for expansion in Wireless

Although rising, mobile penetration is still low

Liberalization has led to an expansion in mobile subscription in Saudi Arabia. Demand improved as consumers were offered choice in service providers, plans, and pricing. Rising economic prosperity also contributed to higher consumer spending on mobile services. The mobile subscriber base grew by 37.1% (y-o-y) to 19.6 million subscribers in 2006. Mobile penetration was 78% in 2006 compared to 58% in 2005 and 39% in 2004.

The use of multiples connections has inflated the actual penetration level in the Kingdom. Based on conservative estimates, the actual penetration may be 15-25% lower than the reported population penetration.

Chart 5: Mobile subscriber base and penetration (2002-2006)

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Despite an average subscriber growth of 40% over the past two years, the Saudi mobile market remains under-penetrated. Yet, this compares well with Saudi Arabia’s GCC peers.

The currently under-penetrated Saudi Arabian mobile market is likely to register robust growth in subscribers, going forward. Three factors likely to drive expansion in subscriber base, in our opinion, are as follows:

• Positive macroeconomic dynamics of a large, young and relatively wealthy population are expected to result in higher spending on wireless services.

• The demand for advanced mobile offerings such as 3G and 3.5G services is increasing.

• Higher competition is leading to improvement in services and reduction in tariffs. The implementation of Mobile Number Portability (MNP) is likely to ease the difficulties in switching between carriers and enhance competition.

Chart 6: Saudi Arabia’s mobile market is under-penetrated

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Chart 7: Saudi Arabia’s very lucrative demographic profile

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Fixed line market to have four operators by 2009

In April 2007 CITC announced it has approved three applicants – Optical Communication Company Consortium (led by USA’s Verizon), Al-Mutakamilah Consortium (led by PCCW of Hong Kong) and Atheeb Consortium (led by Bahrain’s Batelco) – to receive fixed-line licenses. The multiple licenses will, subject to approval from the Council of Ministers, result in the fixed-line market opening from a monopoly to full competition with four carriers within a span of two years.

The new licenses will improve the telecommunications infrastructure in the nation. Al-Mutakamilah and Atheeb have applied for radio spectrum licenses which will allow the two consortia to operate wireless fixed-line networks. Such networks take less time and are more cost effective to set up. We expect Al-Mutakamilah and Atheeb to begin operations in 2008. The Optical Communications Company, which plans to operate a wireline network, is expected to begin operations only by 2009.

We believe, in the fixed-line market demand for voice has reached stagnation in Saudi Arabia and fixed-to-mobile substitution is likely to gain momentum. Fixed line penetration was 70% of households (about 16% of the population) in 2006. Although this is relatively lower than penetration in the GCC region, Saudi Arabia’s terrain, low population density and large household size limit the potential of household penetration reaching 100%. In our opinion, going forward, demand for fixed-line is likely to come mainly from demand for internet and data services and business users.

Internet and broadband poised for growth

We expect the broadband market to grow rapidly given the renewed focus from CITC and STC, coupled with the entry of three new operators. Mobile broadband is also expected to gain ground in Saudi due to the difficulties in providing wire line broadband access across the kingdom.

Low internet and broadband penetrations

At the end of 2006, internet penetration in Saudi Arabia stood at 18.6%. Internet users have grown from 1 million in 2001 to 4.7 million in 2006.

Chart 8: Fixed-line penetration GCC (as % of households)

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Meanwhile DSL broadband uptake has been very low in the country, due to weak infrastructure. DSL broadband requires user to be within a five-kilometer radius of a telephone exchange to connect to broadband as signals tend to get weaker beyond that. In a country like Saudi Arabia (with a large geographical area and low population density) this has proved to be a big challenge. Additionally, broadband prices are prohibitively high. There were 220,000 broadband users in 2006 (14,000 in 2001). Broadband usage increased 240% annually in 2006, primarily due to pricing cuts implemented by the incumbent in the early part of the year.

ADSL, WiMax to drive broadband usage

The entry of new fixed–line operators is likely to ease the infrastructural bottlenecks associated with broadband usage in Saudi Arabia. The two wireless fixed-line carriers will be able to offer broadband services over their networks and could target locations that cable networks have not yet serviced. The wireless backbone may be supported by platforms such as WiMAX. However, Al-Mutakamilah and Atheeb are likely to be less competitive in the Data Services market. For STC, the Optical Communications Company is likely to compete in the Internet, Broadband as well as the Data Services markets. We expect pricing competition to bring down the tariffs further in Saudi Arabia.

Chart 9: Internet subscriber base, Penetration

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Chart 10: Broadband penetration

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Conclusion

The telecommunications sector is likely to see growth coming from the Mobile, Internet and Data services segments. Growth in subscriber base will continue to remain strong as the young, growing and increasingly prosperous Saudi population spends on mobile communication, especially advanced 3G services, and the internet. However, mobile tariffs are likely to decline as the market pre-empts the third mobile operator in 2008. Internet and Data services are expected to pick-up momentum with the introduction of fixed-line competition improving access, service levels and reducing costs to customers.

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STC Business Strategy

Moving F-O-R-W-A-R-D

In January 2007, STC launched a new corporate strategy to direct its business in the new environment of increasing competition. Named ‘FORWARD’, the strategy will guide the business with seven key priorities:

Fulfill Mobile Potential by launching 3G services throughout the Kingdom Offer Wholesale Services to both national and international customers Re-invent Home Communications by deploying DSL and triple play services Win Enterprise Customers by offering customized business solutions Achieve External Growth Re-organize Internal Structure to become more customer-centric Derive Operational Efficiencies by implementing shared services throughout the organization and by implementing a total cost transformation program which includes manpower optimizing

The first five priorities are aimed at sustaining the revenue growth momentum, while the last two seek to improve cost efficiency at STC in an effort to ease pressure on margins.

Preparing for fixed-line competition

CITC moved ahead in its liberalization policy by inviting bids for the second fixed-line license in 2006. Ten consortia expressed interest in the license. This year CITC announced plans to issue three fixed-line licenses (instead of the original plan of offering one license). As a result, CITC short-listed three consortia who, subject to cabinet’s approval (which seems more like a formality), could be granted licenses.

We expect once approvals are received from the Cabinet, Saudi Arabia will have four fixed line companies comprising STC, Bahrain’s Batelco, Hong Kong's PCCW and USA’s Verizon Communications. Of these STC and Verizon will operate traditional wireline networks. The Verizon consortium’s company is expected to set up its network and could begin operations by 2009. On the other hand, consortia led by Batelco and PCCW have won spectrum licenses to operate wireless fixed line networks. Since such networks involve physical network only for the last-mile connections, they involve lower capex and a faster roll-out. We expect these two wireless fixed line players to begin operations in 2008.

The addition of new players in the fixed-line business could boost penetration levels (as was the case when Mobily entered the wireless market). While the Verizon consortium’s company is likely to concentrate on the densely populated cities, wireless fixed line should help improve penetration in less densely populated regions. For STC its established network could offer it a competitive advantage and is likely to help the company withstand competition better than was the case in the wireless segment.

STC is likely to see the most impact in its international voice and broadband services. In view of the impending threat, in Sep ‘06, ALHATIF cut local and national calling tariffs by up to 50%. ALHATIF also made pricing simpler by eliminating the peak, off-peak and distance bands. We estimate that STC could loose up to 15% market share by 2009.

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Broadening range of services and pricing is key to mobile market

MTC recently received cabinet approval for its third mobile license enabling it to proceed with plans to commence operations in 2008. The third operator’s entry is likely to further intensify competition, since penetration rates are much higher than when the market became a duopoly. We estimate that mobile penetration rates (currently at 78%) are likely to exceed 100% by 2008, when MTC is expected to begin operations. The three players may therefore resort to further competitive pricing and the market is likely to see a further decline in rates. Competition between STC and Mobily has already resulted in lower ARPU. As can be seen from the chart below, STC’s mobile ARPU/month has decreased significantly over the past few years. However the significant license fee paid by MTC and the large capital requirement to launch a nationwide operation would restrict MTC’s ability to induce a fierce price war in the market. We expect that the regulator may also take necessary steps to avoid fierce price wars as this may affect the long term sustainability of the sector.

In today’s scenario, ability to provide a broader range of services is a key factor for each operator. Mobily, which currently uses STC’s network, is investing heavily in building a fiber-optic cable network throughout the kingdom along with Integrated Telecom Company and Bayanat Al-Oula. STC is also investing in its network. The company completed the installation of its fibre-optic network and implemented 3.5G services in 2006. 3G and 3.5G enable users with compatible handsets to download content (such as music), multimedia messaging, high-speed internet access and data transfer. These value added services carry higher revenues and can ease pressure on ARPUs.

STC has not been as successful as Mobily in pushing through its 3G and 3.5G offerings. Of the estimated 600,000 3G customers in Saudi Arabia, 500,000 use Mobily services despite both companies launching 3G within months of each other in mid-2006. STC is now collaborating with various providers in order to enhance its 3.5G HSDPA offerings and increase the demand for 3G services. For example, STC recently launched an on-device portal to allow menu-driven access to the nearly 150 services it now offers. STC is targeting two market segments with the new 3.5G services – the youth and enterprise customers.

While the high speed of data transfer is likely to attract business customers, STC launched a new prepaid mobile card (LANA) for customers aged 18-25 years.

Chart 11: STC’s Mobile ARPU has declined significantly

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LANA offers access to a number of 3G services at very economical rates. Extensive promotions and advertising would be important in gaining market share in this high-margin segment in coming years.

STC concentrating on improving Internet, Data businesses

At approximately 10%, internet penetration in KSA is among the lowest in the region. Majority of internet connections are through dial-up services which often fail to meet customer expectations. Broadband connections account for just 1% of all internet connections. Weak Infrastructure deployment has been the main cause for broadband penetration.

STC is strengthening its infrastructure to grow the internet and data services businesses. It upgraded its main public data network by implementing new data routing systems in the fourth quarter of 2006. The state-of-the-art systems will enable STC to provide a wider range of data services. The company is also aiming to improve its coverage by implementing WiMax technology. Technologies such as WiMax and Ethernet provide a fast and cost effective approach to increasing the network’s reach in places where the point of access is far away from telephone exchanges. STC has also signed a MOU to lay a submarine international communication cable that will link Europe and India through the Middle East with Etisalat, Telecom Egypt, Telecom Italia Sparkle, and VSNL Telecom (India). Furthermore, STC plans to deploy one million DSL lines. STC is not the only company that could benefit from the improvement in broadband penetration. STC’s competitors Bayanat Al Oula for Network Services and the Integrated Telecom Company (ITC), in the data services business, are building a country-wide fiber optic network in collaboration with Mobily. The network is likely to aid Bayant and ITC expand their data services offering.

STC considers regional expansion as domestic competition increases

External growth is now emerging as an important part of STC’s corporate strategy. The company is aiming to generate at least 10% of its revenue from foreign markets by 2010. This is a significant shift in policy for a company which remained a domestic operator even though it had the resources to expand abroad.

As discussed earlier in this note, STC recently delivered the first such deal by way of its US$ 3 billion acquisition of a 25% stake in Malaysian based Maxis Communications. STC is in the lookout for other targets to reach its revenue target by 2010.

A number of new licenses in the region, including in Iraq, Yemen and Qatar, are likely to be up for grabs in the coming year or two. On the other hand, the number of licenses available is on a decline and those on offer are seeing bids at steep premiums. At US$ 6.1 billion, MTC’s bid for Saudi Arabia’s third mobile license is more than double the US$ 2.9 billion that Etisalat paid for Egypt’s third GSM license. With greenfield opportunities on a decline, consolidation is expected to pick-up pace even further. Q-Tel’s acquisition of a 51% stake in Wataniya (Kuwait) in March 2007 is the most recent of such deals.

As mentioned earlier, we believe, STC is well positioned to finance an aggressive acquisition strategy given its zero leverage and strong cash flow generation potential.

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Wholesale business to benefit from competition

STC’s wholesale business is expected to benefit from the increasing competition and new operators in the Saudi market. However the lower contribution of this segment caps the impact on overall revenue. According to our estimates this service would have contributed close to 10% of the total wire line revenue (2-3% of the total revenue) during 2006. We expect this service to grow faster (in the range of 15-25%) in the coming years, increasing its contribution t overall revenues.

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Corporate History The Saudi Telecom Company was established in May 1998 following the decision of the Council of Ministers to deregulate the communications sector. Under this program, the telecommunication division, previously operated by the Government, was transferred to a joint stock company with an issued capital of SAR12 billion. As a part of its negotiations to become a member of the World Trade Organization (WTO), the Saudi government permitted private ownership of telecom companies by offering 30% of STC’s outstanding shares through an IPO to Saudi nationals and pension funds in 2002. Until 2005, STC was the only telecom operator in KSA. This changed when Mobily launched its mobile service in 2005. A third GSM license has been granted to MTC while three winning bids are awaiting cabinet approval for fixed line licenses.

Key Developments

1998: STC established through transfer of the Government’s telecommunications division to a joint stock company.

2002: The Saudi government offers 30% of STC’s capital to Saudi nationals and pension funds through an IPO.

2005: Mobily begins operating in KSA as the second GSM operator.

March 2007: STC acquires a majority stake in AwalNet.

May 2007: STC acquires a 25% stake in Malaysia’s Maxis Communications and 51% in its Indonesian unit Natrindo.

Current Ownership

The Saudi government owns approximately 60% of STC. While 30% of the remaining shares are held by the public. General Organization of Social Insurance (GOSI) and Pension Fund Organization – own the balance (5% each).

Chart 12: STC ownership

Government60%

Public30%

Org of Social Insurance

5%

Pension Fund 5%


Social responsibility

Apart from STC’s commitment to enhancing the telecommunications industry in KSA, the company has invested heavily to developing the telecommunications infrastructure in the holy places of Makkah Al Mukarama and Al Madinah Al Munawwara with an aim to serve pilgrims.

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The company actively supports and participates in many social activities and a variety of charitable initiatives, aiding a diverse and ever-widening range of cultural, educational and social programs, including the Janadriyah Festival, Traffic Week, Blood donation Week. Over 90% of STC employees are Saudi nationals.

Dividend Policy

STC has maintained a healthy dividend payout history. The company began paying dividends in FY02 and generally pays a significant portion of its earnings as dividends. The company’s current dividend yield of 9.4% is one of the highest in the region. During the past three years, STC’ paid out ratios have been 83.4% (FY04), 84.4% (FY05) and 89.9% (FY06). STC also distributed a 1:3 bonus share issue in 2006, increasing its share capital to SAR20 billion.

We believe that at the very least, STC will aim to keep the absolute amount of dividends paid out at current levels. Pressures on margins and a decline in earnings in the short term can lower the dividend marginally. We expect that the dividend payout policy could change substantially if STC leverages its balance sheet significantly in-order to finance acquisitions in line with its strategy. In the long run, the dividend is likely to move in tandem with the forecasted decline in net income. Our current forecasts suggest a marginal decline in dividends in the short term (which we expect to improve towards the end of our forecast period) but will still provide a very healthy dividend yield in excess of 8% every year all the way through to 2011.

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Financial Performance and Analysis

Key Profit and Loss Account Data and Ratios

Subscriber base

We expect STC’s subscriber base to grow in absolute terms (driven by the mobile segment). However, we forecast a loss in market share across all segments as STC will face increasing competitive pressure from new operators and lose its monopoly status in wire line segment.

Services2007E 2009E CAR (07-09) 2007E 2009E

Wireless 16.3 18.0 5.0% 96.8% 119.3%Wireline* 4.2 4.0 -2.5% 16.3% 17.1%

* Does not include Internet and Data

STC - Subscriber ForecastsSTC Subscribers (in mn) Penetration Level

Source: SICO Research, Company Reports

Fixed line subscriber base

Much of the market expansion in Saudi Arabia has been witnessed in the mobile market with fixed line subscriber penetration remaining static over the past few years. We believe that fixed line penetration in Saudi Arabia is constrained by the relatively large average size of each household and the wide geographical area. We, therefore, do not expect the fixed line penetration levels to exceed 20% over our forecast period. We expect penetration to grow more rapidly once the second fixed line operator enters the market in 2009. While overall penetration is expected to increase, we estimate that STC will continue to control the market in FY09 with a market share of 95%. This will decline to about 80% by the end of our forecast period in FY11.

Mobile subscriber base

Chart 13: Changing Mobile Landscape in Saudi Arabia

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STC had 13 million mobile subscribers by the end of 2006. This represents 69% of the total Saudi wireless subscriber base. Mobile penetration in Saudi Arabia stood at 78% at the end of 2006. Factors such as the higher percentage of people in the 15-40 age group, continuing economic growth, and an improvement in services induced by competition are driving the sustained growth in demand for mobile services.

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We forecast mobile penetration to cross 100% in 2008. STC’s subscriber base is expected to grow at a marginal rate once MTC commences its mobile operations in FY08. We forecast a decline in STC’s market share to 52% by 2011.

ARPU and Revenues

We project revenues to remain almost flat in 2007 at SAR34.1 bn compared to the previous year. Thereafter, we expect revenues to increase marginally each year to reach SAR35.7 bn by FY09.

Fixed line business: Following the cut in rates (local, national and international), wireline ARPU is projected to decline in the coming years. Although, fixed-voice usage is likely to continue declining, wireline revenues are likely to receive a boost from Internet and Data services. We expect revenue from wireline services (including Internet and Data) to increase and to become a major contributor. STC’s wholesale business will continue to grow at a faster pace with new operators all set to start operations leading to increased use of STC’s vast network. However the low contribution of this service (we estimate 8-10% of the wire line revenue) will limit the impact on the STC’s overall revenues.

Mobile: In the wireless segment, the decline in rates due to competition and shift in preference for prepaid connections is expected to dent ARPUs. We project STC’s wireless ARPU/month to decline to SAR138 in FY07 and to SAR118 by FY09 as penetration and competition increase in the Saudi market. The fall in ARPU despite an increase in subscriber base is expected to keep the wireless revenues almost constant.

Services2007E 2009E CAGR (07-09) 2007E 2009E

Wireless 24.6 24.8 0.5% 72.2% 69.5%Wireline 9.5 10.9 7.1% 27.8% 30.5%

STC - Revenue ForecastsSTC Subscribers (in SAR bn) as a % of total

Source: SICO Research and Company Report

The following chart illustrates the revenue composition of STC and the expected change during our forecast period till FY11.


Chart 14: Revenue Break-up 2006-2011

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2005 2006 2007E 2008E 2009E 2010E 2011E

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EBITDA Margins

STC’s EBITDA margins declined 4.1% to 48.8% in FY06. We expect this trend to continue for the next couple of years. While ARPUs are declining on one hand, STC is focusing on customer services and increasing marketing expenditure in order to maintain market share. This is likely to increase the company’s selling and marketing expenses. EBITDA margins are expected to decline from 48.8% in FY06 to 48% in FY07.

However, the government may review the current commercial service provisioning fee being charged (15% of the net revenue in case of mobile services) as the third operator starts operation in 2008. We have not factored in the impact of this event which can potentially improve EBITDA margins by 2.5-3% for a 5% reduction (from 15% to 10%) in provisioning fees.


Taxation The company is not required to pay corporate tax and pays only a 2.6% ‘Zakat’. We do not project a change in the taxation structures.

Net Profit We expect STC’s net profit to decline 6.8% to SAR12.3 billion in FY07. We expect the company’s net profit margins to decline to about 36.4% by FY09 from about 38% in FY 2006.


Chart 15: EBITDA and EBITDA Margin 2006-2011

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18

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2006 2007E 2008E 2009E 2010E 2011E

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38%

42%

46%

50%

EBITDA (SAR bn) EBITDA Margin (%)

Chart 16: Net Profit and Net Profit Margin 2006-2011

5

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Net Profit (SAR bn) Net Profit Margin (%)

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We expect the margins to improve marginally from then onwards as the Saudi market will begin to mature with the presence of new operators. The net income margin will be also boosted by incremental earnings from Maxis which we have treated as an associate thus boosting net income and margins leaving revenues unaffected.

Balance Sheet and Cash Flow

Working Capital

STC’s working capital increased significantly in FY06 however going forward, we expect the company’s working capital requirement to be modest.

Fixed Asset Investments

Our assumptions regarding investment in fixed assets are based on the planned and expected capital expenditure on network and technology up gradation and expansion. The major part of fixed assets investments will be made for expanding and upgrading its fixed line and DSL networks, including laying fiber optic cables. Over the next two years, we expect capital expenses to aggregate about SAR 7 billion. Beyond this period, capital expenditure is likely to be for maintenance purposes only as we don’t expect any major deployments. We believe that the maintenance capex level (which we expect to be around 10% of revenues) will be sufficient to meet potential upgrades and other capex requirements.

Long-term Debt

STC has no debt on its books since FY03. However, in line with its plans to pursue large acquisitions in region, the company has availed of a credit facility with Al Rajhi Bank, National Commercial Bank and Banque Saudi Fransi under which it may borrow up to USD1.6 bn (SAR6.0 bn) to fund potential acquisitions. STC made it clear that its recent acquisition of Maxis will be partly financed by debt. Hence we have assumed this level of debt in our forecasts at an estimated cost of 5.5% per annum.

Cash and Bank Balance

We do not expect a major shift in STC’s investment policy. The company is expected to invest in short-term deposits to maintain a good liquidity position. Higher operating cash flows are expected to improve the cash balance.

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Financial Statements & Forecasts Income Statement and Balance Sheet

Income Statement (Consolidated)Year ending 31 Dec (SAR bn) 2002A 2003A 2004A 2005A 2006A 2007E 2008E 2009ENet sales 12.0 16.2 18.4 21.0 20.8 20.8 21.4 21.7 growth (%)Operating expenses 4.0 3.1 3.7 3.8 4.3 4.4 4.5 4.6 Operating profit 8.1 13.1 14.7 17.2 16.5 16.4 16.9 17.1 Other income* (Interest and Invst) (0.1) (0.5) (0.9) (0.6) 0.5 0.3 0.4 0.5 EBITDA 8.0 12.6 13.8 16.6 17.0 16.6 17.3 17.6 Depreciation & Amortization 3.3 3.8 4.3 3.8 3.8 3.9 4.0 4.0 EBIT 4.7 8.8 9.6 12.7 13.1 12.7 13.3 13.6 Interest expense (Implied) - - - - - 0.1 0.3 0.3 Non-recurring items (1.1) - - - - - - - Pre-tax profit 3.6 8.8 9.6 12.7 13.1 12.6 13.0 13.4 Tax (current + deferred) 0.1 0.2 0.3 0.3 0.3 0.3 0.3 0.3 Profit after tax 3.5 8.5 9.3 12.4 12.8 12.3 12.7 13.0 Note: The above statement may not match with the published financial statements due to adjustments/changes made by usInterest expense denotes the implied cost of funds which may be treated differently in an Islamic finance deal

Balance Sheet (Consolidated)Year ending 31 Dec (SAR bn) 2002A 2003A 2004A 2005A 2006A 2007E 2008E 2009ECurrent assets 7.9 8.9 10.3 12.0 13.4 8.8 11.1 13.7Investments 0.9 0.2 0.2 1.0 1.1 12.7 12.8 13.0Net fixed assets 32.0 31.9 30.8 30.5 30.1 29.9 29.6 29.1Net intangible assets 0.0 0.8 0.8 0.8 0.7 0.7 0.7 0.6Other non-current assets 0.1 0.0 0.0 0.5 0.8 0.8 0.8 0.8Total assets 40.9 41.8 42.1 44.7 46.1 52.9 54.9 57.3Current liabilities 13.2 9.4 8.6 9.5 9.5 9.3 9.5 9.7Total Debt 0.7 0.0 0.0 0.0 0.0 6.0 6.0 5.5Other Liabilities 3.1 3.0 2.7 2.4 2.4 2.6 2.7 2.9Total liabilities 16.9 12.4 11.2 11.9 12.0 17.9 18.3 18.1Share capital 15.0 15.0 15.0 15.0 20.0 20.0 20.0 20.0Reserves & surplus 9.0 14.4 15.9 17.9 14.2 15.0 16.7 19.2Shareholders' funds 24.0 29.4 30.9 32.9 34.2 35.0 36.7 39.2Total equity & liabilities 40.9 41.8 42.1 44.7 46.1 52.9 54.9 57.3Note: The above statement may not match with the published financial statements due to adjustments/changes made by us

Source: SICO Research, Company reports

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Cash Flow Statement and Key Ratios

Cash Flow Statement (Consolidated)Year ending 31 Dec (SAR bn) 2002A 2003A 2004A 2005A 2006A 2007E 2008E 2009ENet Income 3.5 8.5 9.3 12.4 12.8 12.3 12.7 13.0Depreciation and Amortization 3.3 3.8 4.3 3.8 3.8 3.9 4.0 4.0Other adjustments 2.0 0.2 1.0 0.9 0.3 0.1 0.3 0.3Chg in working capital -1.3 -1.1 -1.6 -0.9 -1.1 -0.8 -0.4 -0.5Cash flow from operations (a) 7.5 11.4 12.9 16.3 15.9 15.5 16.6 16.8Capital expenditure -5.8 -4.7 -3.7 -4.4 -3.4 -3.7 -3.6 -3.5Chg in investments 0.0 -1.1 0.4 -1.8 -2.0 -7.6 -0.1 0.0Increase in Intangibles 0.0 0.0 0.0 -0.8 0.0 0.0 0.0 0.0Other investing activities 0.0 0.0 -0.1 0.0 0.0 0.0 0.0 0.0Cash flow from investing (b) -5.8 -5.7 -3.4 -7.0 -5.3 -11.3 -3.7 -3.5Free cash flow (a+b) 1.7 5.7 9.5 9.3 10.5 4.2 12.9 13.2Equity raised/(repaid) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Debt raised/(repaid) -0.7 -1.2 0.0 0.0 0.0 6.0 0.0 -0.5Dividend (incl. tax) -0.9 -3.1 -7.8 -10.3 -11.6 -11.5 -11.0 -10.5Other financing activities 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Cash flow from financing (c) -1.6 -4.4 -7.8 -10.3 -11.6 -5.5 -11.0 -11.0Net chg in cash (a+b+c) 0.1 1.3 1.7 -1.0 -1.1 -1.3 1.9 2.2Note: The above statement may not match with the published financial statements due to adjustments/changes made by us

Key ratiosYear ending 31 Dec (SAR bn) 2002A 2003A 2004A 2005A 2006A 2007E 2008E 2009EAdjusted EPS (SAR) 1.8 4.3 4.7 6.2 6.4 6.1 6.4 6.5Adjusted EPS growth (%) N/A 140.4 9.3 33.6 2.8 -3.9 3.3 2.5EBITDA growth (%) N/A 62.7 12.5 16.7 -4.2 -0.7 3.5 0.9EBITDA margin (%) 34.2 48.0 48.3 52.9 48.8 48.0 48.2 47.8Net profit margin (%) 15.1 31.2 30.5 38.3 37.9 36.1 36.2 36.4ROE (%) 14.8 31.9 30.9 39.0 38.2 35.6 35.5 34.4ROAA (%) 8.7 20.6 22.2 28.7 28.2 24.9 23.6 23.2Net debt to equity ratio 2.7 0.0 0.0 0.0 0.0 17.2 16.4 14.0

ValuationsYear ended 31 Dec 2002A 2003A 2004A 2005A 2006A 2007E 2008E 2009EPER (x) 38.2 15.9 14.5 10.9 10.6 11.0 10.7 10.4PCE (x) 19.9 11.0 10.0 8.3 8.1 8.4 8.1 8.0Price/Book (x) 5.6 4.6 4.4 4.1 4.0 3.9 3.7 3.5Yield (%) 0.7 2.3 5.7 7.7 8.5 8.5 8.1 7.7EV/Net sales (x) 5.7 4.8 4.3 4.0 3.9 3.9 3.8 3.6EV/EBITDA (x) 16.6 10.1 8.9 7.6 8.0 8.2 7.8 7.6

Source: SICO Research, Company reports

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NOTES

Securities & Investment Company BSC Disclaimer This report does not constitute or form part of, and should not be construed as, any offer for sale or subscription of, or any invitation to offer to buy or subscribe for any securities. The information and opinions contained in this report have been compiled or arrived at from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness and are subject to change without notice. Investors must make their on investment decisions. Past performance is not necessarily a guide to future performance. Nothing in this report should be construed as investment or financial advice or as an advice to buy or sell the securities of the company referred to in this report. SICO and/or its clients may have positions in or options on the securities mentioned in this report or any related investments, may effect transactions or may buy, sell or offer to buy or sell such securities or any related investments. Additional information on the contents of this report is available on request. Copyright Notice © SICO Investment Bank 2007. This report is being supplied to the recipient for information and not for circulation and may not be reproduced, redistributed or passed on to any other person or published, in whole or in part.

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