The retail sector has been one of the best performing sectors in the Saudi market in 2013, outperforming the other major sectors by a significant margin, showed a recent report.

The sector has delivered a year-to-date (YTD) return of more than 55 percent, followed by the Agriculture and Petrochemical sectors, which delivered YTD returns of 38 percent and 27 percent respectively, Al Rajhi Capital said in its latest “Saudi Retail Sector” report.

The other sectors which significantly outperformed the broader market were hotel (118 percent YTD) and real estate (42 percent YTD).

The sector also garnered a lot of investor interest in the early part of 2013, as trading volumes jumped multi-fold, although they have reduced in the last couple of months.

The retail companies have also reported strong earnings growth, with the net income growing by 16.2 percent y-o-y in the last two quarters.

Nevertheless, the sharp jump in stock prices has led to a significant PE expansion. The forward PEs for the four retail companies under our coverage has increased to an average of 18.7x (current year), from 14.1x at the beginning of June 2013.

“We believe the sector’s fundamentals remain strong, and is likely to continue witnessing robust growth going forward, as consumer spending rises on the back of improving employment among locals (supported by the Nitaqat law), and sustained government spending.

Moreover, with consumer preferences shifting to large store formats, the organized sector will be the major beneficiary of rising disposable income in the Kingdom.”

The valuations for the Saudi retail sector appear expensive with the companies under our coverage trading at an average forward PE of 16.7x times FY14E earnings.

The report said the scope for further PE expansion is limited at the current valuations, while there can be volatility, in case the companies are not able to meet the high expectations, which are already built in to stock prices.

Further, with 2013 coming to an end, we are rolling forward our valuation to 2014. “We have upgraded Al Hokair to Overweight, despite the sharp run-up in its stock price, while we remain Neutral on Jarir, Extra and Al Othaim. Extra’s stock has corrected sharply and is now at a more reasonable valuation, whereas Jarir’s strong stock performance has been justified by its earnings growth, and future growth potential.”

The report forecast that the young Saudi population will continue its spending ways, supported by favorable government policies. As a result, the Saudi retail sector is expected to grow by more than 9 percent annually over the next five years. The major beneficiaries of the spending spree will be the organized, large retail formats like supermarkets and hypermarkets, which are expected to capture an increasing share of the retail sector pie due to changing consumer preferences.

The report noted though that the sector has been witnessing declining investor interest in the last few months, as despite its strong performance, trading turnover fell sharply. The sector’s trading turnover fell to 4 percent as a percentage of the total turnover on the Tadawul, from a high of 15 percent during the second quarter of 2013.

The disposable income has been growing at a rapid rate, supported by government spending (e.g. the Hafiz program, which paid unemployment benefits and ended in December 2012), and favorable government policies (implementation of the minimum wage rate).

Given the rising disposable income and the continued expansionary fiscal government policies, the retail spending is expected to remain strong over the near-term.

According to the EIU, personal disposable income is expected to grow at a CAGR of around 10.3 percent to $10,800 per head over 2011-2017.

The Saudi retail sector significantly outperformed the major sectors in 2013, delivering a return of more than 55 percent during the year, followed by the food sector, which was the second major sector with a 38 percent YTD return, apart from hotel (118 percent YTD) and real estate (42 percent YTD) sectors.

As a result, all the retail companies under our coverage are trading at historical highs, in terms of valuation multiples.

At the current levels, most of the retail companies are trading at a premium to their peers in other emerging countries, and to other domestic demand-driven Saudi stocks.

The Saudi retail sector index jumped more than 50 percent in the first nine months of 2013 to reach a peak of 11,883. Post that, the sector, though volatile on a daily basis, has not moved up, even though the broader market has performed well.

The sector’s sluggish performance in the last few weeks coupled with a drop in trading turnover indicates that the sector is seeing a decline in investor interest. Moreover, some companies are also struggling to meet the aggressive investor expectations.

The Nitaqat law has helped reduce unemployment in the Kingdom (which is currently more than 10 percent), further improving the disposable income among the Saudi population.

According to reports, 600,000 nationals have received employment under the Nitaqat program till the first half of 2013.

According to Saudi Labor Minister Adel Fakeih, the Nitaqat program was instrumental in reducing unemployment rates from 12.4 percent to 11.7 percent in the third quarter of 2013 and led to more than a million Saudis getting their salaries raised by SR3,000 and more.

These recently-employed nationals will have a higher propensity to spend in the Kingdom, as compared to expats, who are more likely to save money and send it back to their home countries.

Although the implementation of the law may lead to higher wage expenses for retail companies, we believe overall it would be beneficial for the retail sector, as it increases the spending power.

The Kingdom in addition to the prospering domestic population, also attracts more than 7 million religious tourists through the year, which is a significant contributor to the Saudi economy.

Saudi Arabia earned around $16.5 billion in 2012, accounting for around 3 percent of the Kingdom’s GDP. The number of religious visas issued has been cut this year due to the construction activities at the holy sites (meant to scale up capacities), which has negatively impacted the earnings of some companies. The reduction in visas for Haj and Umrah are likely to continue for the next two years.

However, once these construction activities are completed, the number of religious tourists visiting the Kingdom is likely to rise sharply, which will positively impact the retail sector, Al Rajhi said in the report.

“We believe the organized retail sector will be the major beneficiary of the growth in the retail sector, as customer preferences shift toward large store formats like supermarkets and hypermarkets.”

Source: Al Arabiya