• Upgrade to Neutral; higher credit costs remain a risk We upgrade our rating on Bank Dhofar to Neutral from Sell, with our adjusted fair value implying 8.8% downside to the current stock price. We also tweak our earnings estimates marginally to incorporate the 2Q16 results and changing trends, as loan growth has slowed Y-o-Y, while credit costs have risen sharply – doubled Y-o-Y in 1H16. We cut our fair value to OMR0.220 (adjusted for the 10% stock dividend). Higher credit costs and compression in net interest spreads are key risks to our earnings estimates.
• Proposed rights issue to augment capital levels Bank Dhofar raised OMR115.5mn via a Tier I perpetual bond issue last year, which boosted capital levels, and created headroom for growth. However, a year later the majority of this capital has been consumed by strong loan growth. The bank’s total CAR was 13.8% at end-2Q16, marginally higher than its pre-Tier I bond issue level of 13.4%. While capital levels remain above the minimum CAR required by the central bank, we believe the cushion is too small to maintain loan growth momentum. The bank recently announced plans to raise up to OMR40mn through a rights issue, which is awaiting regulatory approval. We expect loan growth to remain sluggish in 2H16 as the bank is likely to focus on preserving its capital level.
• Spreads were boosted by stronger retail loan growth Net interest spreads have been a bright spot for the bank compared to peers. Bank Dhofar’s net interest spreads have improved 13bps since the end of 2015 compared to a decline at its peers. This improvement was driven by the strong expansion in the higher yielding retail loan book, which has grown at an average of 20% over the past six quarters. However, funding costs rose sharply in 2Q16, which dented some of the improving spread momentum.

Murad Ansari