• Low multiples warranted given risks; cut FV & turn Neutral We reduce our FV by 27% to SAR110 mainly as we lower our earnings estimates to reflect recent disappointing revenue trends. We downgrade the stock to Neutral with our FV implying only 12% upside to the current market price. While trading multiples appear low (2016e P/E of 14x, dividend yield of 7%) compared to recent peaks (P/E of over 20x), we believe this is warranted given a weaker earnings growth outlook (2016e -11% Y-o-Y) triggered by slower top-line growth and margin pressures. Also, second largest shareholder SCCL continues to reduce its stake in the company (-c2% YTD, -c11% since 2015), which is a downside risk to share price performance.
• Slowing revenue growth alarming but could improve In-flight catering (c72% of 2015 revenue) has been flat to declining for four consecutive quarters with recent weakness (total meals served down c9% Y-o-Y in 1Q16) mainly due to less foreign traffic that is offsetting increased capacity at Saudia (order book of 62 planes until 2020e; some will replace ones within its 119-plane fleet). Surprises could come from higher pilgrim numbers as Holy Mosque expansion is completed as well as sealing contracts with new airlines (Saudi Gulf, Al Maha that are both yet to start operations; recently secured three-year cSAR80mn contract with new premium carrier Al Bayraq). Also alarming is the recent decline in non-airline revenue (over 4Q15-1Q16; historically the company’s fastest growing segment) as Catering has been exiting some low-profitability contracts.
• High downside risk to margins for three reasons We believe Catering’s impressive profitability profile will fall over time as: i) margins on its contract with main client Saudia are likely to come under pressure as the flag carrier aims to be profitable by 2020e via cost efficiencies (altering meal configurations, discounts, etc.); ii) sales mix shifts to the lower-margin non-airline segment; and iii) an end to receivable provision reversals that have been deflating G&A costs. We expect EBITDA margin to drop c3pp Y-o-Y in 2016e and c1pp per annum thereafter. There is also a risk of longer collection periods from Saudia, which have already been increasing over the past two years.

Hatem Alaa, CFA
Nada Amin