KFH and AUB’s Board of Directors have agreed, in principle, a share swap ratio of 2.326 (shares of AUB for 1 share of KFH). Almost eight months after KFH disclosed that it had invited Bahrain’s AUB to explore a merger between the two banks, the Board of Directors of both AUB and KFH agreed in principle a share exchange ratio of 2.326 (1 share of KFH for every 2.326 shares of AUB). This implies valuing AUB at a 15.5% premium to Thursday’s closing share price and at a price to book of 2.0x based on AUB’s September 2018 book value. This looks almost like a fair multiple given AUB’s ROE (9M18 annualised) of 17%. 
 
What is a reasonable timeline for the deal? The disclosures issued by both KFH and AUB state that the two banks will start their due diligence process after obtaining the needed regulatory approvals. The deal will also need the shareholders’ approval of both banks as well as the nod from the Central Bank of Kuwait, Central Bank of Bahrain and capital market authorities of both countries.  We think the overall process and exchange of shares may take a minimum 4-5 months from now. 
 
Does this deal make sense for KFH? KFH has had for more than twenty years a monopolistic position as the sole provider of Islamic banking services in Kuwait. That leading position in Islamic banking continues, but it no longer enjoys a monopoly as the CBK granted Islamic banking licenses in the mid-2000’s. Moreover, some of the new Islamic banking names have come to the market with a very innovative, digital based product offering (particularly from Boubyan Bank, second largest Islamic bank in Kuwait) and there are other Islamic banks such as KIB and Warba Bank that are being revamped or more ambitious in their expansion plans and market share gains and growth for KFH in its domestic market is becoming more challenging. Management has said that they have screened for takeover candidates and have found AUB to be the best fit for KFH. M&A in Kuwait is difficult because of the shareholding structures of the banks (different families control different banks). AUB and KFH have common shareholders, as AUB was the merger several years ago of a Kuwaiti banks and a Bahraini bank.
 
AUB will give further scale to KFH in Kuwait, as well as an entry to new markets where it is not currently present, including Egypt, the UK and the UAE. AUB has its headquarters in Bahrain, but 51% of its loan book is in Kuwait. We estimate that the merged KFH-AUB entity would have a lending market share of 23% (15% for KFH, 8% for AUB), compared to 27% for NBK (including its subsidiary Boubyan Bank), although it would create the largest bank by assets in Kuwait, slightly ahead of NBK.  KFH current footprint is mainly in Kuwait and Turkey; it has also a presence also Bahrain and Malaysia but these are relatively small.
 
Scope for costs synergies in Kuwait; we do not have a precedent in the domestic market. We factor in cost synergies of 20% of AUB Kuwait expenses in year 1 after the merger (2020). The benchmark is around 30% of the target entity. Unlike in the UAE, we do not have a precedent for synergies in Kuwait as there has not been consolidation in the banking sector. On our estimates, the ROE of the merged entity of c12% would be lower than KFH pre-deal of c14% in 2020 but we note this is subject to synergies and we may have been fairly conservative on this. 
 
Kuwait Finance House: KWD0.62 as of 24 January 2019, Rating: Neutral, TP: KWD0.63/share, MCap: USD13,171, KFH KK/KFH.KW