* Government austerity steps hit companies hard
* Loosening of purse strings may now boost earnings
* Analysts expect increase in low single digits
* But fresh austerity expected from mid-2017
* Profit margins destined to shrink in long term
By Celine Aswad
DUBAI, March 7 (Reuters) - Saudi Arabian corporate earnings may finally have bottomed out after two years of falls due to low oil prices and the government austerity which followed, with the petrochemicals sector leading signs of recovery.
But a sharp rebound is unlikely for companies in the Middle East's biggest economy as further austerity looms and they are competing for customers who are no longer flush with cash.
Analysts say stronger oil prices recently and government borrowing have encouraged Riyadh to loosen its purse strings by enough to turn corporate profit growth positive after earnings shrank by 4.1 percent year-on-year in the fourth quarter.
Several analysts told Reuters they expect corporate earnings to grow at a low single-digit rate this year, rising by as much as 10 percent if oil prices climb or stagnating if they fall.
"The earnings picture is starting to improve slightly. But we don't expect an outright recovery because some headwinds that were key drags on the performance of some sectors, such as banks, have not fully abated," Mohammed al-Hajj, senior macro strategy analyst at EFG Hermes, told Reuters.
Aggregate net income of 175 firms on the Riyadh exchange fell 5 percent to 94.1 billion riyals ($25.1 billion) last year, after a 13 percent drop in 2015, Thomson Reuters data shows.
Domestic-focused companies were hardest hit because of price conscious consumers. One of Saudi's largest electronics retailers, Jarir Marketing, saw a 4 percent decline in revenue and analysts at Riyad Capital do not expect a top-line recovery in 2017 due to a cut in civil servant pay packages.
Cost saving strategies have helped bolster the earnings of petrochemical producers, which make up roughly a quarter of the total market value, with National Industrialization swinging back to profitability from a loss in 2015.
Any recovery will be modest, however, as to cut its budget deficit the government plans to hike domestic fuel and electricity prices again in the middle of this year and to introduce a five percent value-added tax in 2018.
Although fourth-quarter net income almost tripled to 5.3 billion riyals at Saudi petrochemical firms, Thomson Reuters data shows, Aljazira Capital analyst Jassim al-Jubran said this was because many slashed costs and became more efficient.
Some, such as Kayan Petrochemical, swung back to a profit from losses but margins began contracting in the fourth quarter even as revenues rose 10 percent. Unless product prices rise significantly in 2017, margins may keep narrowing, preventing anything more than a slight gain in profits.
"Corporate earnings for the sector will improve but further upside potential is now limited,” Alrajhi Capital said.
While Saudi banks, whose fourth-quarter net income dropped a fifth to 8.1 billion riyals, may benefit this year from tighter U.S. monetary policy, many are still heavily exposed to the struggling construction sector and provisions for bad loans may prevent anything more than minor improvement earnings.
Banks such as Alawwal Bank, are heavily exposed to the building industry, which is expected to continue struggling even though the government has resumed paying its debts.
A consumer spending surge later this year to avoid 2018's VAT introduction could inflate earnings of retailers such as United Electronics and Jarir Marketing, but the impact will be temporary, and the outlook for 2018 looks bleak because of the tax.
Tarek Fadlallah, chief executive of Nomura Asset Management Middle East, said companies in Saudi Arabia and the Gulf Cooperation Council had enjoyed unusually high profit margins as they benefited from state patronage and protection.
Listed Saudi firms enjoyed a margin of 15.4 percent last quarter, down from an 18.1 percent peak in 2011, but as state support shrinks, margins will fall, Fadlallah wrote.
"Over the long term Saudi and GCC margins are destined to fall below 10 percent - a decline on this scale would require companies to nearly double their revenues in order to maintain the current level of profits," he added.
Graphic by Jessica Wang; Editing by Andrew Torchia and Alexander Smith