NCB is special in more ways than one. It is the largest bank in the Arab world in terms of assets, capital and profits. It is the only unquoted Saudi bank. And it has undergone a massive restructuring process - in ownership, management and strategy - over the last four years. For these reasons alone, NCB’s results command attention, but the fact that these are the first complete balance sheet and income statements to be released since 1998 makes them particularly interesting.

Not only do the figures tell the full story of the bank’s turnaround, but they also act as an important milestone in its future. With the results published, a major legal hurdle on the path to listing the bank has been negotiated. And it could be only a matter of months before the government offers a proportion of its stake in an initial public offering (IPO).

That such an event should come to pass would have seemed extraordinary five years ago. Back then, NCB was the fiefdom of the Bin Mahfouz family, with Khalid back in position as general manager and chairman after the hiatus induced by his indictment in the US over alleged involvement in the Bank of Credit & Commerce International (BCCI) affair.

In May 1999, the first step in the restructuring of the bank’s ownership was taken, with the acquisition by the state’s Public Investment Fund (PIF) of a 50 per cent stake from the Bin Mahfouz family. The new board that was formed made two essential appointments: Abdullah Bahamdan took over as chairman and managing director and Abdulhadi Shayif was appointed general manager. Their arrival marked for the first time the segregation of the bank’s management from its owners. Months later, the PIF offloaded 10 per cent of NCB’s shares to the General Organisation for Social Insurance (GOSI), which is expected to be a long-haul investor in the bank. Negotiations continued between the government and some of the remaining Bin Mahfouz family shareholders - among them Khalid’s wife, Naila Abdulaziz Kaaki, and his sons Abdulrahman and Sultan - over the possible transfer of a further block of NCB stock. A deal was struck late last year for the PIF to acquire a further 29.3 per cent of the bank’s equity, in a transaction that was reported as being worth between SR 6,700 million-6,800 million.

If the lower estimate is correct, MEED estimates that the PIF paid about 2.5 times book value for the additional shares. Such calculations are not academic. It is the PIF’s intention - stated back in 1999, when it first entered NCB’s shareholder structure - to take the bank public. Given the bank’s dominant position in the domestic market, and its spectacular return to financial health over the past three years, any IPO will undoubtedly attract considerable attention. The crucial questions will revolve around how much of NCB’s stock will be sold and at what price. If past practice is an indicator of future intentions, there are some clues as to the government’s thinking. The privatisations of Saudi Basic Industries Corporation (Sabic) and Saudi Telecom (ST) were both limited: a total of 30 per cent in Sabic was offered to the public in 1983; and 20 per cent of ST was sold in January 2003.

The more recent example offers some possible insights into how an NCB IPO might be structured. The ST deal was priced to go: offered at SR 170 a share, the stock price has appreciated relentlessly to peak at SR 278 in late April. Given the company’s unique position in the local market, it is difficult to estimate a fair value for ST stock, but there can be no doubt that the IPO was deliberately priced at a heavy discount to generate demand.

For a potential IPO of NCB stock, the existence of nine other quoted banks provides a number of pricing benchmarks. On a price/book value model, the multiples of the quoted banks range from about 2.5 times to over 4 times. On a price/earnings (PE) basis, the spread is considerably tighter. Taking end-2002 figures, Riyad Bank, Saudi British Bank, Saudi American Bank and Saudi Investment Bank had trailing PEs of 15.4, 14.8, 15.3 and 14.6 respectively. Based on NCB’s 2002 net profits, a move to sell a 20 per cent stake at a price of 15 times earnings would raise a total of SR 7,200 million for the government. However, the likelihood is that the IPO would be priced at something of a discount. At a 20 per cent reduction on the PE of 15, the 20 per stake would raise SR 6,000 million, or, at a PE of 10.5, the equivalent of a 30 per cent discount to the prevailing market view of domestic banking stocks, the stake could raise SR 5,100 million. If the estimates of what the PIF paid for its purchase of the most recent 29.3 per cent stake are accurate, it stands to make a healthy return on its investment.

The ST IPO should serve to dispel concerns over potential demand: total subscriptions for that offering reached SR 36,000 million. This wall of liquidity might encourage the government to offer more than 20 per cent of the bank’s stock, but the likelihood is that it will maintain a majority position. The timing of any potential NCB placement is also open to wide debate. Investment bankers in Riyad say that it could be brought to market before the end of the year, if rushed, but a more likely schedule would see it staged next year.

Perhaps the most interesting aspect of any potential sale is the analysis of what potential participants would be buying. The recently-released financial results paint a portrait of a high-performing, well-structured and well-focused large bank. But this is the result of a radical restructuring programme.

The most interesting of the annual statements are those for 1999. Attention has focused on the massive hike in provisioning induced by the discovery by the new management team of extensive additional non-performing loans (NPLs). The gross NPL position was raised from SR 5,816 million at the end of 1998 to SR 9,802 million at the end of 1999. The situation was made worse by the fact that the year-end 1998 provisioning position was a mere SR 3,329 million. The tough decision was taken to opt for a one-hit solution and, in 1999, provisioning for possible credit losses of SR 6,568 million was made.

The dramatic move swamped annual profits and severely eroded shareholders’ equity: in fact, the equity/assets ratio fell to as low as 3 per cent at the end of 1998. However, the shareholders accepted the medicine and have taken no dividends since to allow a rebuilding of the capital base. Operating performance has been so strong that the rebuilding process has not taken long, as figure 2 shows. Even more impressive is that the return to strength has been managed alongside a conservative NPL coverage approach, which, as figure 3 demonstrates, rose to 108 per cent at the end of last year from a probably-exaggerated 57 per cent at the end of 1998.

There is a case for arguing that the rebuilding of NCB’s equity base remains a work in progress. The equity/asset ratio stood at 8.4 per cent at the end of 2002, some way below the 10.6 per cent unweighted average of the rest of the Saudi banking sector. If NCB’s ratio were brought into line, fresh equity of SR 2,382 million would have to be added (assuming total assets remained flat). But, on current performances, this would account for less than one year’s profits.

The adoption of the one-hit provisioning solution was undoubtedly brave - and a decisive point in the transformation of the bank - but it is only part of the story. Massive balance sheet re-engineering has also been conducted. As figure 4 shows, the loan book was effectively rebuilt: in the months after their appointments Bahamdan and Shayif reduced it from SR 56,600 million to SR 34,700 million. The reduction was matched by a SR 10,500 million increase in exposure to fixed-rate government bonds, the bulk of which were domestically issued. The loan/deposit ratio was slashed from 86 per cent at the end of 1998 to 51 per cent at the end of 1999, and since then it has hovered around the 50 per cent mark. The move stands as a crucial shift in the bank’s strategy: it jettisoned its past as a money renting operation and moved the focus to fee-generating products and services.

As the rapid growth in the bank’s bottom line shows (see figure 1), the strategy has worked. Net profits have soared since 1999, increasing some two-and-a-half times on the 1998 performance. As any prospective shareholder in NCB will be told, it is, by a number of measurements, one of the best performing banks in the country. Even taking into account its comparatively low levels of capitalisation, returns on year-end equity of 27 per cent last year are impressive.

The main driver of this strong growth was an early recognition of the attractions of the retail banking market in general and the Islamic retail market in particular. NCB has built a formidable domestic franchise. A network of 248 branches, 760 ATMs and effective internet and phone banking operations have facilitated its growth. Last year, NCB controlled 47.5 per cent of all mutual funds, 26.4 per cent of the consumer finance, 23.1 per cent of the customer deposits, 27.2 per cent of the fee income, 22.8 per cent of the net income and 21.5 per cent of the assets in the kingdom’s banking sector.

For once, the figures really do tell an interesting story.

Turnaround

3 May 2002

Jeddah-based The National Commercial Bank (NCB) has spent the past two years undergoing a painful restructuring that is now approaching its culmination. Tom Everett-Heath talks to the bank’s top executives about one of the most remarkable recovery stories in Middle East banking

Picture the scene. It’s late 1999 and the management team of Saudi Arabia’s largest financial institution are preparing themselves for a difficult conversation. They have just completed a rigorous examination of their bank’s balance sheet that identified an additional SR 3,000 million of non-performing loans (NPLs), bringing the total to SR 8,789 million. The problem faced was that provisioning levels - already horribly inadequate - would have to be dramatically raised. To make matters worse, there were also a substantial amount of other non-bankable, low-yielding assets on the bank’s books. The solution? Seize the initiative and restructure the balance sheet.

‘It was not an easy conversation,’ recalls Abdullah Bahamdan, chairman and managing director of NCB. ‘But all the shareholders were supportive and realised that this was the proper course of action.’

And so began arguably the most spectacular turnaround in Middle East financial history.

The last three years have witnessed the almost total transformation of the region’s largest and most controversial bank. NCB’s ownership structure has been radically altered, management has been energised, new technology has been introduced from front office to back and, perhaps most importantly, balance sheet problems that have plagued the bank for more than a dozen years have finally been resolved.

There is more to come. Plans for the listing of the bank’s stock and a selling down of the government’s position are drawing closer to fruition, and NCB is preparing for regional expansion.

The latest chapter in the NCB story began in May 1999 when the state’s Public Investment Fund (PIF) acquired a 50 per cent stake in the bank from its then chairman and general manager, Khalid bin Mahfouz. As part of the deal, Bin Mahfouz resigned from the bank for the second time - he had stepped down from his position of chief executive officer in 1992 after he was indicted in the US in connection with the Bank of Credit & Commerce International (BCCI) affair but the charges were later dropped, facilitating his return to the bank. In the months that followed PIF’s move into the bank - and Bin Mafhouz’s move out - two crucial appointments were made: Abdullah Bahamdan took over as NCB’s chairman, and Abdulhadi Shayif was promoted to the position of general manager.

‘For the first time the management and the ownership of the bank were completely segregated,’ says Shayif. ‘There were no longer any members of Bin Mafhouz’s family in top management.’ The way was cleared for the new senior management team to address the issues. The first step was comparatively straightforward: a thorough, detailed examination of the bank’s loan portfolio was launched, and the NPL level was raised from SR 5,816 million - as booked at the end of 1998 - to SR 8,789 million.

‘Management took the view that we only had one chance to get this right: there was only one opportunity to maintain credibility,’ says Bahamdan. ‘We recommended to the shareholders that a one-hit provisioning solution be adopted. It was difficult to convince them but we committed ourselves to recovering all the losses within three years. And we have done that.’

The one-hit solution came in the form of an additional SR 4,600 million of provisioning for 1999. With operating profits of SR 1,100 million that year swamped, shareholders’ equity was eroded, but stability was restored to the balance sheet. Repeated, but much smaller, doses of the same provisioning medicine came in 2000 and 2001 and by the end of last year the bank had a loan-loss reserve ratio in excess of 102 per cent, a considerable improvement on the 55 per cent coverage inherited in 1999.

The loan book was also sharply reduced in size with major write-offs and some selling down of positions. ‘The loan book was reduced from SR 56,414 million at the beginning of 1999 to SR 34,917 million at the end of the year,’ says Shayif. ‘We cut out the loans that were not attractive to us and those that were not part of our core business.’

Other non-performing assets, such as stakes in local companies and SR 1,631 million of non-producing and non-bankable real estate assets, were also uncovered and addressed. ‘We prepared a strategy for the liquidation of these non-core assets, and have been gradually selling down the real estate portfolio,’ says Shayif.

The balance sheet damage was repaired. Shareholders decided to waive dividends for the years 2000 and 2001 and, with strong operating profits pumped back in, the bank’s capital base was rapidly rebuilt. By the end of 2001, the management team had kept its promise to the shareholders: all the losses had been recovered.

The symptoms - vast, uncovered NPLs - had been dealt with. But there was an underlying illness: how had the balance sheet become so stressed in the first place? ‘There is a big difference between managing a family business and managing an institution,’ says Bahamdan. ‘Every year dividends had been paid, but provisioning levels had not been high enough. There were also undisciplined credit approval processes. We changed the system and introduced discipline.’ Modern risk management techniques, based on a customised Standard & Poor’s (S&P)system, have been installed. Authorised credit officers now operate on step-up approval levels ensuring all lending is carefully scrutinised, and big ticket lending requires board approval.

Even more important than the rewiring of process has been the transformation of NCB’s culture. ‘It has not been just a balance sheet issue: it has also been a management issue,’ says Shayif. ‘We had to get the commitment right through the bank; we had to formulate divisional strategies - which were new; work out how to implement them; and develop balanced scorecards. All this required education within the bank. Everyone in the bank now has an understanding of what the strategy is and everyone is working in the same direction. There is a performance management culture.’

There is also clear direction. ‘Our goal is to be the premier consumer bank in Saudi Arabia, and to achieve this we have to dominate,’ says Bahamdan. ‘We have raised the proportion of net profit generated by consumer banking activities to 65 per cent from 55 per cent in 1999: our target is to get it up to 75 per cent.’ NCB has clearly targeted the Islamic retail market as being its core growth area. By the end of 2001, 85 per cent of its consumer finance was sharia compliant; some 75 per cent of the SR 23,700 million of funds NCB has under management was in sharia-compliant vehicles and 72 of its branches were fully dedicated to sharia-compliant services. ‘Islamic consumer products will lead the way,’ says Bahamdan. ‘Although growth rates are likely to slow, it will still be the fastest-growing segment of the business.’

The drive for dominance in consumer banking has been backed by a full technology upgrade over the last three years. ‘In 1999 we were seen as one of the most traditional banks in Saudi Arabia. Now we are at the cutting edge in terms of systems, delivery platforms and our approach to market,’ says Shayif. Full internet banking, phone banking, ATM banking and wireless application protocol (WAP) banking services are available, taking transactions out of NCB’s branches and facilitating a more customer-focused approach. The facts speak volumes: in 2001, NCB handled 57 million transactions, 37 million - or 65 per cent - of which were conducted through the bank’s full range of electronic distribution channels. ‘Branch managers used to spend 80 per cent of their time in their offices and 20 per cent with customers,’ says Shayif. ‘Since 1999 we have reversed this.’

NCB’s plans for regional expansion will be built on the same foundations as its domestic strength. ‘The first phase of our plan was to get our own house in order and focus on the domestic market. The second phase is to build a regional bank,’ says Bahamdan. ‘Our expansion criteria are simple: we will stick to our strengths - consumer banking - and enter poorly served markets in the Arab world that have been deregulated.’

This does not preclude moves into the region’s more mature markets, where NCB might seek to flex its powerful Islamic banking muscles. The first geographical step is likely to be in Bahrain where a licence is close to being granted for the establishment of a branch. Where NCB moves next is less clear.

Be it at home or abroad, the combination of improved systems, innovative products and motivated staff have allowed definitions of success to be formulated. ‘Our overriding concern is for our shareholders,’ says Bahamdan. ‘Our target is to be among the top three Saudi banks in terms of ROE [return on equity], and that means aiming for about 25 per cent.’

And the target has defined the strategy. ROE of 25 per cent will not be easy to generate from low margin corporate lending and this is something the bank has pulled away from. The sector as a whole has moved on from the time when it lived from renting money, and NCB is leading the way. The focus is on fee-generating products and services that complement lending activity and generate the desired returns. ‘The history of the bank is in lending, but we are interested in returns and our focus on the corporate market is on non-funded revenue and cross-selling,’ says Bahamdan.

The future identity of the shareholders who will benefit from these strong returns remains an unresolved issue. When the PIF bought its 50 per cent stake in the bank from Bin Mahfouz it was made clear that it had no intention of being a long-haul investor. In the months that followed the purchase, the PIF offloaded 10 per cent of NCB’s stock to the General Organisation for Social Insurance (GOSI), which is expected to hold its position indefinitely. Of the remaining stock, about 30 per cent is still held by Bin Mahfouz family members, among them his wife Naila Abdulaziz Kaaki and his sons Abdulrahman and Sultan.

There is growing speculation that the shareholder structure will change further with the government agencies likely to raise their collective stake in the bank to around 80 per cent. Even this is seen as a precursor for further change. The expectation is that NCB will list - it is currently the only unquoted bank in Saudi Arabia - and that the PIF will sell down its stake.

‘It is entirely up to the shareholders if they wish to sell their shares and when they choose to do so,’ says Bahamdan. ‘However, an IPO [initial public offering] cannot be staged until the bank is listed and that cannot take place until two years of full financial figures have been published.’ The figures are expected to be released during the second quarter and are certain to paint a strong growth picture. Operating profits before provisions improved from SR 1,450 million in 1999 to SR 1,626 million in 2000 before leaping to SR 2,271 million last year. It remains to be seen whether the PIF - or other shareholders - will choose to get to market quickly or await further confirmation of the growth story to be delivered by the full-year 2002 financials. Either way, NCB’s journey from private company to well-structured institution is going to culminate in public joint stock status.

That this will have coincided with its transformation into a truly modern and effective full-service bank is far from being a coincidence.