• We upgrade FGB and NBAD to Buy from Neutral We turn positive on FGB/NBAD’s merger, as we believe it offers a compelling theme underpinned by i) cost & revenue synergies; and ii) superior credit discipline, in an environment characterised by weak growth, tight liquidity and credit quality pressures. We estimate a pro-forma ROE of 16% for FGB/NBAD on a recurring basis, which is attractive in a regional (2017e: Rajhi: 15.5%; QNB: 19%) and EM context (MSCI EM banks: 10%), and it trades at 2018e P/B of 1.4x, which is undemanding in our view. We believe FGB/NBAD would be well positioned, in terms of liquidity (3Q16 LDR: 94%) and in terms of capitalisation (2016e CET1: c14.0%), and we do not see any capacity constraints capping its growth potential and its ability to pay dividends. We raise FGB’s FV to AED14.0 (from AED13.7) and NBAD’s FV to AED10.8 (from AED9.0) and upgrade the stocks to Buy from Neutral.
• The right step: challenging environment calls for focus on efficiency Against a backdrop of low oil prices with limited volume growth and pressure on spreads, cost efficiency is likely to be the key driver of operating profit for the sector, in our view. FGB/ NBAD have already embarked in this direction as their merger should yield cost savings of AED500mn/annum (8% of merged entity’s operating costs) from 2019. These savings would primarily stem from the closure of overlapping branches and elimination of duplicate administrative costs. While revenue synergies are less tangible, there is scope for improvement in cost of funds (beneficial for spreads from 2017) and increased product penetration (volume growth).
• A winning formula: FGB’s dynamism & NBAD’s solid credit culture The management structure that is taking shape suggests that FGB’s managerial ethos is likely to dominate in the merged entity. This is advantageous, as FGB will infuse a culture of efficiency and increased shareholder orientation in NBAD. NBAD, in return, would bring a strong credit risk culture that we believe is unmatched in the UAE. While both NBAD and FGB have demonstrated that their credit underwriting abilities are robust relative to the sector, NBAD’s credit discipline, visible in its below-sector-average NPL formation, NPL ratio and cost of risk, is superior.
• Catalysts and risks Playing this merger theme will require patience, as there could be some volatility in the stocks coinciding with the payment of dividend & effective merger date (see pg. 18 for our strategist’s view). That said, we see short- to medium-term catalysts. Mgmt. should unveil detailed guidance for the post-merger synergies and dividend policy early next year, which should reassure investors. Cost and revenue synergies should start emerging from 2017. FGB/NBAD’s credit quality should also hold up better than the sector, in our view. Key risks to our investment thesis include higher-than-expected integration costs and delays to the effective merger date.

Shabbir Malik
Murad Ansari
Mohamad Al Hajj