Saturday, May 22, 2010

Global Investment House – Review of 1Q10 Financials & Analysis of Future Prospects


GIH released its 1Q10 financials last week. 

Most of the commentary I've seen (and I certainly haven't seen it all) has focused on the headline numbers, a net loss of KD15.5 million versus KD69.9 million the year earlier period.

For its part the Company touts the underlying revenue stream from its Asset Management Business, a 9% reduction in "General Overheads" and the fact that it made a USD28.9 million first payment on its rescheduled debt. On 28 April so technically outside the 1Q. But when you're looking for good news, it's important to look hard.

Let's look a bit behind these headlines. And, as well, peer into the future. 

As one poster noted, it's all well and good to speak about the past. But what about the future of GIH? How does it chart a course to viability?

As a basis for looking to the future, let's ground ourselves in 1Q10 performance. This earlier post may also be useful in setting the context.

1Q10 FINANCIAL PERFORMANCE AND COMMENTS

Auditors Report

There is a matter of emphasis regarding the US$250 million deposit that GIH placed with National Bank of Umm AlQaiwain. NBUQ has blocked this deposit asserting that GIH committed to buy convertible securities. GIH holds it was merely an expression of interest not a binding contract. The courts of competent jurisdiction in the UAE are currently adjudicating the matter. This amount – roughly KD72.3 million – is significant in relation to GIH's total equity of KD177.3 million and even more to its KD 145.8 million in equity excluding minority interests – a truer measure of the capital available to the firm.

Convertible securities issued by firms in the UAE seem to pose a recurring significant danger to both investors and issuers. If legal matters (proper drafting and law) can't be resolved, I'd suggest local authorities consider banning these.

You might be wondering why the auditors have not referred to GIH's ability to make payment on its rescheduled debt. Generally, the test is ability over the next year to make payment. Apparently, they're comfortable the Company will be able to do so. We'll discuss cash needs for 2010 in the "future" section.

Income Statement

Net operating revenues were a loss of KD0.4 million compared to a loss of KD45.8 million in 1Q09. The bright spot in both quarters was Fee and Commission Income at KD5 million and KD6 million respectively – mostly driven by GIH's asset management business. 

Jumping to the Cashflow statement, Net Cash from Operations is KD9.4 million and KD0.4 million respectively. If one adjusts for changes in assets and liabilities (removing these) and including interest actually paid (that's the KD3.1 million and KD11.7 million at the very end of the Operations section), cash flow from ongoing operations is negative KD7.2 million versus a negative KD40.8 million the year earlier. An improvement but still problematical. Something that shows the critical need to increase revenues to pay the light bills. Debt repayments are another major cash outflow.  And discussed in Financing Activities below. 

On the expense side, for analysis I  add Personnel Expenses and Other Operating Expenses to get ongoing "Core Operating Expenses" (ignoring for a moment interest expense).  Expenses independent of the financing structure of a firm.  It's also a good cash proxy for the amount that GIH needs to pay to keep the store open. 

In 1Q10 the total is KD7.53 million. In 1Q09 KD7.52 million.  Despite talk of a 9% improvement, overall there is none.  What's not explained is why Personnel Expenses have increased roughly 18.6% to KD2.9 million from KD2.5 million. Presumably, if these were one time payments (perhaps connected with downsizing), GIH would have highlighted this fact. Since they did not, then the presumption has to be that they are not. (Hint to GIH:  A little more disclosure could be useful, particularly if you've a good story to tell).

Interest expense was KD6.7 million though as the Cashflow Statement shows only KD3.6 million was paid. You'll note (if you care to trawl through GIH's website) that in the past interest expense and cash interest paid have closely tracked each other. I suspect the difference here has to do with the timing of the payments on the restructuring – which now appear to quarterly timed off the January signing of the rescheduling, viz., April, July, October, January.

Balance Sheet

Cash and Banks at KD92 million includes KD31.8 million (34.6%) at subsidiaries. That amount is not automatically available to GIH to meet its cashflow needs. The subsidiaries would have to either dividend the money to GIH or could, I suppose, lend it to GIH. The latter something we've seen before. 

Medium Term Borrowings have increased by some KD8.6 million. Since it's unlikely that new creditors are advancing funds, what could account for this? The restructuring fee of 1% flat and the time proportional fee of 0.25% p.a. which are to be capitalized. A rough estimate is KD5.5 million. With the unpaid interest of KD3.6 million – we're within the ballpark of the change. Though one would expect unpaid interest to be in Other Liabilities. Perhaps FX movements account for the difference? Also in Note 14 there's an intriguing but unexplained shift of some KD10.6 million from "Islamic" to "conventional". A voluntary shift by creditors for the rescheduling?

Total Equity is down some KD45.5 million from 31 December 2009. and roughly KD100 million from 31 March 2009.  For the 1Q10/FYE2009 change  KD17 million of  the decline is in Controlling Interests' share – the core equity of GIH.  Chiefly as a result of the loss for the Quarter.  Non Controlling Interests' share is down some KD28.4 million due to disposal of subsidiaries.  (I'm guessing the impact of Al Thouraia).  

Note 13 discloses that GIH holds some 89 million of its own shares (6.78% of equity).  These Treasury Shares were bought for KD59 million and have a market value of  KD9.3 million at 31 March 2010 (15.7% of the purchase price).

Cashflow Statement

In connection with the Income Statement above we looked at the major cashflow  items  in Operating Activities. 

One other item that jumps out is the KD18.2 million cash loss on disposal of subsidiaries. You'll recall from the Income Statement that GIH reported a KD1 million gain on disposal of subs. Since GIH needs cash to pay its light bills and its hungry creditors, this is quite perplexing. Why would the Company incur a net cash loss of KD18 million? Why not just hang on to the asset?

Note 5 provides the explanation. On 14 March 2010, GIH liquidated Al Thouraia recognizing a KD0.824 million accounting profit, while experiencing a KD18.725 million cash outflow. The liquidation extinguished GIH obligations in the amount of KD125.6 million. The rationale for KD18 million tradeoff is suddenly a lot clearer. It also inters the corpse of Al-Thouraia – a matter which GIH no doubt wishes itself and the market to forget. The company had already taken some preliminary (burial) steps in that regard. After the announcement with great fanfare in June 2008 of its private placement of Al-Thouraia, GIH appears to have gone silent on the topic. No mention in its 2008 annual of the great success in raising KD180 million. No press release. But then I may have not looked hard enough. The only GIH driven publicity I could find was a Bloomberg press item referring to advertisements that GIH placed in the Kuwaiti press in November 2009 noting that the Appeals Court had ruled it was not guilty in a civil case brought by a Japanese real estate firm regarding this transaction. Earlier that year in May GIH acquired effective control of Al-Thouraia in a non-cash asset swap transaction which allowed it to proceed with the removal of the life support tube.

GIH: THE FUTURE

Cashflow

Expenses

Let's start here. This is the "nut" that GIH needs to crack to get back to sustained profitability. As mentioned above, GIH's 1Q10 Personnel Expenses were KD2.9 million for a yearly run rate of some KD11.6 million. This is pretty much the level it ran for 2009 – KD11.9 million. 

Other Operating Expenses were KD4.6 million or an annual run rate of KD18.4 – which is 10.3% below 2009's KD20.5 million. 

Core Operating Expenses are therefore roughly KD30 million per year.

Interest Expense was KD6.7 million or an annual run rate of KD26.8 million. In 2009 GIH was subject to penalty interest so a comparison to 1Q10 is not useful. That being said, GIH's 2010 run rate is based on current low interest rates. Rates will eventually increase and so will GIH's interest bill. Normally, interest expense is included in operating expenses. 

Summing these up, GIH has annual "light bills"  (Core Operating Expenses and Interest Expense) of roughly KD50 million per year - the sum needed to keep its store open before any principal repayment of its debt. 

In the analysis below I'm going to use Core Operating Expenses to look at the long term since GIH's current strategy would eliminate the need for large amounts of debt .  Its chosen lines of business not being capital intensive. That gives a more long range view. Then we'll look at Core Operating Expenses plus interest when looking at the nearer term – the critical next 3 years.

Debt Service

In 2010 GIH is obligated to pay 10% of principal under its restructuring. KD50.1 million. Curiously, short term debt in its 31 December 2009 financials was KD61.8 million – some KD10.7 million more. To give GIH as much benefit as possible, we'll use KD50 million. In 2011 the amount is 20%  = KD100 million In 2012 it's 70% =  KD350 million.  In addition GIH owes KD40.9 million on Bonds for a total of KD390.9 million that year.

A table is probably the best way to summarize and present estimated Cash Outflows. To give GIH the best possible scenario all expenses are held constant. No inflation. No salary or operating expense increases. No change in interest rates. That means both the margin (even though it steps up) and the base rate. All in all a very "good" case.

All amount in KD Millions.

Cash Outflow201020112012
Personnel11.9  11.9  11.9
Other Operating18.4  18.4  18.4
Core Operating 30.3  30.3   30.3
Interest26.8  24.1  15.0
Debt Repayment50.0100.0350.0
Bond Repayment---------   40.9
Financing 76.8124.1405.9
TOTAL OUTFLOWS107.1154.4436.2
 
Some quick observations. 
  1. Reductions in Core Operating Expenses are marginal in terms of making the mandated payments. A 50% cut in Core Operating Expenses – if such were possible – will not meet the cash outflow needs. 
  2. Sales of assets or creditor rotation (replacement loans or new equity) are key to fulfilling obligations. 
  3. A KD100 million Rights Offering provides only a near term "relief". It does not solve the problem. And, if made this year or next, the investor is making a bet on the potential conversion of GIH's assets. 
  4. Refinancing in the debt markets looks problematical because the "wise" banks have bunched up 70% of the maturities into a single year. If the deal were say five years, GIH might be able to reduce its debts to a more comfortable level while hopefully building up retained earnings if management's view proves to be more correct than mine.  Both factors plus time for debt markets to recover would facilitate bank refinancing. The logical conclusion is that the current lenders are the most likely source of loans in the next three years.
Cash from Operations

The key to understanding GIH's potential for revenue generation is understanding the economics of  its professed new business model. It is essentially service / transaction based focused on three lines of business ("LOBs"): asset management, investment banking, and brokerage. Commonly, these businesses have fairly modest fees – in the range of 2% to 5% levied against volume of transactions or assets under management. 

Contrast that with the principal investment model. And its close cousin the investment sales model. In the pure proprietary investment model a firm buys an asset for its own account. Representative profit margins range from 20% to 25% per annum. In the investment sales model, a firm buys and asset and places all or part of it with investors. In this business, while the firm earns placement, management and performance fees, the real money usually is in the mark-up over cost. The firm buys something for US$1.00 and sells it to its clients for US$1.30. Think Investcorp, Arcapita, etc. So a 25% to 30% one time up front fee on the amount placed along with the placement fee (1 to 2%) plus any later ongoing performance or management fees. Quite attractive margins.

As you can see from the relative profit margins, there is a clear implication for the volume of deals needed to deliver the same revenue stream.

There is also another key difference. In the pure proprietary investment business the firm does not depend on clients. It therefore does not have to worry about securing or maintaining client confidence. Its profitability is driven from the IRR on its investments. To secure returns, it merely needs access to capital and the ability to select good deals on average. Client confidence and marketing expenses only are important to such a firm if it intends to follow an investment placement model.

GIH's historical performance provides a bit of context on revenues for looking forward.

LOBs20062007200820092001E
Asset Mgmt18.720.721.117.617.5
Investment Bkg12.96.724.91.00.7
BrokerageNM0.74.42.92.1
Other 02.00.60.00.0
TOTAL31.630.151.021.520.3

Two quick notes:
  1. Immediate caveat re 2010E. GIH is the Bharti's advisor on Zain. While no doubt the fee will be larger than the KD0.7 above, it's unlikely that Bharti is paying GIH a "Goldman" fee (otherwise they would simply have hired Goldman). Supporting that analysis is the fact that Bharti is from a rather thrifty country that doesn't like to pay fees unless money is being raised – like another thrifty country to their East. 
  2. Also note that Asset Management includes management, placement and performance fees. Of the three, management fees have historically been the largest.
So how does GIH meet the KD30.3 million Core Operating outflow assuming that KD20 million in Fee Income represents its ongoing base? 
  1. Increasing AUM by 50% seems a bit of a stretch given the state of markets and the state of investors' pocketbooks. Unless Ms. Maha's friends at the Haya are predisposed to lend a helping hand. 
  2. Generating KD10 million in brokerage seems a stretch as well. The markets are subdued. Even if markets suddenly become buoyant, it's hard to see this reaching more than KD5 million over the next three years. 
  3. That leaves Investment Banking to raise between KD5million to KD 8 million (no change in brokerage). 
Two variables affect GIH's ability to offer Investment Banking services.

First, debt or equity issuance.
  1. Macro conditions in the market. Are investors in a buying mood? Do they have the cash?  Do they have access to debt?
  2. On the micro level GIH's appeal to issuers depends fundamentally on GIH's placement power. Before it selects a firm, an issuer has to believe that that firm can place the paper. And of course to earn the fee one has to actually place the paper. 
Second, advisory work.
  1. As above macro conditions are key.  Do market conditions encourage asset buying?  Is financing available?
  2. At the micro level, what is the perceived value added by the investment bank.  For regional deals, GIH boasts a fairly good reputation for research as well as local knowledge.
At a 5% fee for either, GIH only needs to generate KD100 million to generate KD 5 million in revenues.  KD 200 million if the fee is half.  It would seem that this is doable - given the right macro (market) conditions.

Taking GIH's revision in strategy as a long term commitment,  the long term path is much easier. - in terms of meeting expenses.  But see below.   Assuming there are no future significant principal investments, in the future GIH won't need a lot of debt. 

But we're three years away from that future.  In the critical next three years, it's hard to see this roughly KD20 million per year in interest expense being covered from operations.  

So it's likely that on an income statement basis GIH will incur losses. A very rough guess is somewhere around KD 20 million per year – with a fairly wide standard deviation maybe KD10 million or so. 

New loans are unlikely. As is new equity for the reasons discussed above.  And note that new capital wouldn't address the income statement though it would provide the critical cash needed to pay the interest bills.   Given GIH's condition cashflow is more critical than numbers on the income statement - though as I'll discuss below they are interrelated.

And here let's retrace our steps back to the long term view.  It  won't do for GIH to break even going foward.  It will have to earn a fairly decent return on capital.  Let's say 10% is fair.  That means earning another KD15 million or so.  It's hard to see Investment Banking making up the difference.  So there is a long term profitability issue for GIH's management to grapple with.

All this leads back to the topic of revenue and cash generation.

In client oriented businesses such as GIH is focusing on, client confidence is key to keeping existing business and obtaining new business. And given GIH's margins, significant volumes are required.

So now's an appropriate place to review client confidence.

It's a sad fact that clients tend to simple-mindedly associate the bottom line of a firm with that firm's management's skills. When profits are good, management is smart. When losses are incurred, management is dumb and perhaps even dishonest. Little consideration appears to be given to the overall trend in markets. It's very easy to be a clever boots when the markets are booming.   One finds the real clever boots  - like Abu Shukri - in down markets.

GIH has incurred significant losses over the past two years. On the positive side, at least  these losses are not unique. A lot of other "players" in the market had losses. Going forward, the key to damage control is closing the chapter on red ink as soon as possible. Based on my above analysis, that may be difficult as GIH attempts to build increased scale in their chosen LOBs.

More importantly, GIH distinguished itself from other serious market participants by getting into a rescheduling. And here just to be clear, I don't consider the abundance of Kuwaiti "investment" firms in trouble serious market participants. It was only their managements and perhaps a few other misguided parties (some shareholders and some credulous customers) who envisioned them as sophisticated investment banking power houses.  They weren't HLHZ or Stephens much less Goldman. 

By its very nature a rescheduling raises profound concerns about the viability of a firm. It takes many years to shed the aroma of near death. And where management has not been changed, there is a concern that the same captain and crew may run the ship aground - if not on the same shoals, similar ones.  GIH may have won an award for its rescheduling, but the fact the market notes is that it rescheduled.  Investcorp, Arcapita, NBK Capital have not.

Beyond that, if a client feels that a firm is ethically challenged, it is likely to be reluctant to do more business. Clients react rather negatively when they lose money on an investment that underperforms. And much more intensely when they lose money and feel something was not halal in the investment manager's conduct. The "funding episodes" involving Global MENA Financial Assets and Al Thouraia may be weighing on some market participants' minds. To be very clear on this point, GIH has not been convicted of any wrongdoing on these or other matters. 

However, client reactions are driven by perception not necessarily by reality. At one point, many "serious" investors believed that Mr. Madoff had a secret but sure fire way to beat the market. They acted upon that perception.

So a large part of GIH's efforts have to be directed to restoring market confidence. That explains the public relations campaign. It's apologia for the past, largely focused on its conduct during the rescheduling as opposed to how it got there.  Awards.  Accolades.  And its current visibility campaign ("We're Back and Better than Ever") - touting fund awards, issuing research and market commentary. Worthy of note is that Kuwait's two main papers – AlWatan and AlQabas which generally represent different political tendencies – have been largely supportive of GIH of late. 

All this suggests to me that GIH doesn't have an easy slog. 
  1. Its economics are difficult both on the operating side (business model) and financing side (the short-sighted restructuring imposed by its "wise" lenders.)
  2. And it still has work to do on its market reputation. 
These two factors are interlinked in a feedback loop. An "event" in one area affects the second which in turn affects the first.  One of GIH's tasks is making sure that as many of the events that occur are positive while focusing the lions' share of management time on asset sales.  Failure to meet obligations under the rescheduling is the critical danger.  What that may mean is that GIH won't be able to devote the resources  and management attention to building for the post three year period. 

1 comment:

Laocowboy2 said...

A very thorough analysis of what is still a very problematic situation. Most other commentaries have emphasised the financial aspects, glossing over the reputational damage to the "brand". The simple question remains for anyone choosing to either award an investment banking mandate or place assets to be managed - "Why GIH?". And I faile to see a coherent answer.