In a research note, NBK Capital MENA said, "We are revising our stance on the UAE construction industry and raising our fair values significantly as a result. We are thus now buyers of DSI, and holders of Arabtec and Depa , with sharply raised target prices. "Our stance on UAE construction stocks was negative for most of FY2013, and our fair values implied significant downside from actual prices. As a result, we missed the rally in the sector completely. We believe there are two reasons for this: We underestimated the industry's capacity to grow its backlog. Although we were anticipating a pick-up in construction activity in the MENA region, the scope and pace at which this has happened, has surpassed our expectations. We relied too heavily on our discounted cashflow (DCF) models. These were showing that in order to justify current market prices, very optimistic assumptions had to be made in terms of activity, margins and working capital requirements (WCR). "Our DCF valuations still show the industry to be fairly valued to slightly overvalued. However, we believe that, with underlying industry fundamentals still very healthy, longer-term considerations (which underpin our DCF valuations) will tend to be overlooked at this point in the cycle. "The underlying fundamentals of the industry remain positive in the GCC, buoyed by strong government spending on infrastructure, housing and industrial diversification. This is underpinned by the need for social stability in the wake of the Arab Spring, as well as by continuing shortages in housing (Saudi Arabia) and infrastructure (all GCC countries with the exception of the UAE ). We believe construction activity will remain at very high levels in the UAE and Saudi Arabia (despite short term issues for the latter), and we are seeing signs of an acceleration in awards and activity in Qatar , Kuwait and possibly Egypt . "Looking back at FY2013, the correlation between share price performance and backlog growth has been very strong for Arabtec and DSI, with the EV/Backlog hovering about 0.3x. We believe share prices will continue to follow backlog growth in FY2014 at least, and that the EV/Backlog ratio should remain around the 0.3x level. "We believe Depa should show the greatest growth in backlog, as the cycle in interior contracting lags general contracting by 18 months, and is thus about to turn. Depa should also benefit from upcoming large contracts in Abu Dhabi on projects where its largest shareholder Arabtec is the main contractor. However, the share price has largely anticipated this (in parts also supported by speculation about an Arabtec buy-out of minorities, unfounded in our view), with the EV/Backlog ratio currently at 0.65x " Arabtec is in our view next best-placed in terms of backlog growth potential. The company should continue to benefit from the strength of its underlying general construction markets, but will also start seeing contributions from its new joint ventures in oil & gas and infrastructure. We believe Arabtec's backlog will grow 25 per cent from the current levels (close to AED 40 billion after the latest awards in Jordan ). However, the recent surge in the share price (+44 per cent in the past two weeks) has partly priced this in, with the current EV/Backlog ratio now slightly above 0.35x. "Finally, we believe DSI will grow is backlog 20 per cent in FY2014. This is the lowest growth rate in the sample: DSI is not a late cyclical like Depa , and although it is expanding in new sectors and geographies, we do not expect the potential contributions from these diversifications to yield as significant benefits as Arabtec's new joint-ventures. Nevertheless, with DSI currently having the lowest EV/Backlog ratio, we believe the share price has the best appreciation potential. "We are therefore buyers of DSI with a Fair Value of AED 1.86/share (21 per cent upside). We are holders of Arabtec after the recent surge in the share price, with a Fair Value of AED 4.62/share, and would be looking to add to holdings should the share price correct from here. Finally, we are holders of Depa , with a Fair Value of $0.65 /share, as we believe the current share price already prices in the expected late cyclical recovery."
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