Tuesday, June 15, 2010

Dubai Holdings: Detailed Comments on DHCOG 2009 Audited Financials


Further to my post of 5 June, it's time for a closer look at DHCOG's 2009 audited financials.

Before getting into my usually overly detailed analysis, I'd like to highlight some big picture themes that emerge from a review of the Company's 2009 financials.
  1. Most commentary has focused on DHCOG's AED15.2 billion in Borrowings. But as with Nakheel, Trade Payables (AED32 billion) and Customer Advances (AED14.2 billion) are more critical obligations. Both in terms of amounts as well as their greater direct impact on the future of the company and the local economy. When various expenses of AED4.7 billion associated with the restructuring/reduction of its projects in process (termination payments, legal claims, etc) and AED1.7 billion in Contractor Retentions (primarily due in the next 12 months)  are added in, it's clear where the potential cashflow stress really is. 
  2. As noted earlier, the Company is heavily dependent on Government Subsidies for its profitability. 
  3. Severe deterioration in Trade Payables – only 31% of gross receivables are fully performing as compared to 73% the year earlier. In itself this is a relatively minor problem since these represent a small "slice" of total assets. What's more important is that they reveal the profound distress in local markets. 92% of DHCOG's Receivables are denominated in AED and so are with local companies. If you think about it, the last company a local debtor is likely to "stiff" is this Company which is owned by the local Shaykh. Either DHCOG was reaching for business – doing marginal business or these companies are in very dire straits. 
  4. DHCOG also seems to have engaged in a rather large amount of investment activity unrelated to its core activities. And with significant amounts committed to other entities within the Group. A clear sign that the companies were not managed in a disciplined fashion but rather as part of a "Group" – similar to the pattern in Kuwait.
Now to the detailed comments. (Warning:  A cup of caffeine may be required to remain awake as you read what follows).
 
Balance Sheet

Investment Property (Note 6) (page 45) is carried at AED56.5 billion in 2009 down from AED60.3 billion the year earlier. In 2009 DHCOG recognized an AED27.2 billion impairment charge against Investment Property. AED6.9 billion of this was reflected in the income statement. The remaining AED20.3 billion was reflected as a reduction in Government Grants. Thus, bypassing both the income statement and equity. (More on that topic a bit later).

While DHCOG carries its Investment Property at cost less impairment, it also provides details on fair value. Based on an open market valuation, the fair value of Investment Property at FYE 2009 is reported as AED 81.6 billion down from AED141.8 billion at FYE 2008. Clearly, there is a very serious disconnect between the value of the property calculated using discounted cashflow ("DCF") (which is the basis for the impairment) and the market price (based on what some "wise" investor is believed to be willing to pay for the property). That gap is AED25.1 billion. 

The "market" price is 144% of the price determined using discounted cashflow. Even allowing for the impact of some conservatism in the DCF, the gap is too large. What that suggests is that market price remains high. Essentially when market values like this occur, the implied "capitalization rate" ("cap rate") of the rental streams is very low.   Unrealistically low.

Turning to the liability side of the balance sheet, it's clear that Borrowings (Note 28) (page 69) at some AED15.2 billion are not the Company's major liability problem. Current and non current payables of AED32.1 billion are more than twice Borrowings (Note 32 (a) page 74). Customer Advances of AED14.2 billion (Note 33) (page 75) represent much more significant and potentially critical demands on cash. Of particular note is that all Customer Advances are carried as Current Liabilities – meaning DHCOG has to complete projects within the 2010 to satisfy its obligations to customers. As it builds and hands over properties, then these obligations are extinguished. If it fails to do so, there is potential (note that word) requirement to reimburse customers or renegotiate with them.  And these are not all the liabilities towards the "trade" that the Company faces.  There's an additional AED4.7 billion for Provisions and Other Charges - largely related to termination of contracts.

Another key liability account is the AED36.8 billion in Government Grants (Note 29) (page 72). As discussed in my earlier post (referenced above), DHCOG's profitability and cashflow is essentially based on generous subsidies from the Emirate of Dubai. Strip these out and the Company's performance is much diminished. Notes 2.22 (a) and 6 also discuss Government Grants.

Income Statement

Here the role of Government Subsidies is directly obvious. In 2008, the Company had AED19.2 billion in subsidies and had net income of AED9.8 billion. In 2009, subsidies were only AED0.6 billion. That and substantial provisions led to a loss of AED23.6 billion.

As a side comment, I'd note that there are provisions of some AED2.2 billion included in "General and Administrative" expenses (Note 38) for trade and other receivables as compared to a mere AED0.1 billion in 2008. A strong indication of the distress in the local market.

Consolidated Statement of Cash Flows

See the comments in my earlier post. Cashflow generation is constrained. And to flog a downed horse highly dependent on government subsidies.

Detailed Comments

Here are some items that caught my eye.

Note 2.1 (page 8) – The auditors did not raise a matter of emphasis on management's assumption that DHCOG as a "going concern" because of the availability of external support from the Holding Company and the DFSF.

"As a result of the sudden and sharp downturn in the Dubai real estate market, the Group's cash flows have come under severe pressure. The Group is currently considering various means to manage its cash flows which include roll over of maturing loans, sale of certain assets and renegotiation of trade and contractors balances. The holding company has confirmed its willingness to provide such financial support as may be required to manage the process and has confirmed that it has access to funds from the Dubai Financial Support Fund for the specific purpose."

Note 2.23 (a) (page 28): DHCOG primarily recognizes revenues from land and building sales on a "completed" contract basis as opposed to a "percentage of completion basis". What this means is that there is likely to be a greater mismatch between the timing of cash receipts and the recognition of revenues. When cash is received before the contract is completed, the contra entry to the receipt of cash is "Deferred Revenues". As per Note 32 (a) (page 74) DHCOG has some AED17.1 billion of Deferred Revenues as of FYE 2009. When these revenues are recognized in the Income Statement, there will be no accompanying cashflow. Something a careful creditor should have his or her eye firmly fixed upon.
 
Note 3.1 (c) (page 34): Of some AED24.7 billion in liabilities due within the next twelve months, repayment of borrowings represents only AED3.7 billion. Roughly 15%.
 
Note 4.2 (b) (page 39): Management has estimated its liability for contractor claims for termination or delay of contracts for construction and consultancy, demobilization of contractors, staff repatriation costs, etc., at AED4 billion. Up AED1.4 billion (54%) from 2008.
 
Note 12 (page 56): The Company recognized AED1.5 billion fair value loss in 2009 for its investment in a fund managed by a related party Dubai International Capital. This is in addition to AED1.9 billion fair value loss on the same investment in 2008. Also see Note 20 (a) page 65.
 
Note 15 (page 60): There is clear distress in DHCOG's Trade Receivables. At FYE2008 AED1.9 billion (83%) of DHCOG's AED2.3 billion in Trade Receivables and Advance Payments were "fully" performing. At FYE2009 AED0.8 billion (58%) of AED1.4 billion were. At year end 2009 AED0.8 billion of AED2.6 billion in gross Trade Receivables were fully performing. That's 31% fully performing. At 2008 the comparative numbers were AED1.9 billion out of AED2.6 billion. Or 73%. Past due but unimpaired receivables also showed a jump from AED0.4 billion at FYE 2008 to AED0.6 billion at FYE 2009. This is significant deterioration in a single year. And reflects widespread distress given DHCOG's comment that it "has a broad base of customers with no concentration of credit risk within trade receivables". Looking at currency composition of receivables, some 92% are denominated in AED. That indicates most of these are to local counterparties. So the distress is local. And it must be significant since it's highly unlikely that a local company would "stiff" a company owned by the Ruler. Generally, when there is a serious sudden deterioration in receivables, the suspicious banker takes a look for an APP scenario. Sales or other transactions against receivables can be a highly convenient way of spiriting value out of a company. Since there is no concentration in the receivables, this probably can be ruled out.
 
Note 28 (page 71): DHCOG failed to comply with 2 of 3 financial covenants as of 31 December 2009. It bankers waived these breaches. That means the covenants remain in place. Given the Company's financial condition, they are likely to be breached again. And the creditors will have another chance to use these to apply pressure.
 
Note 30 (page 72): AED1.1 billion of AED1.7 billion in Contractor Retention payments are due within one year. Two observations. The first is the contractual cashflow demand this represents – though contracts may be renegotiated. The second is that this shows that there have been no significant new construction activities undertaken. Another sign of the slowdown.  (Note:  These liabilities are included in Trade and Other Payables).
 
Note 32 (a) (page 74): AED17.1 billion of Deferred Revenues. As discussed above, when these are recognized, there will be no accompanying cashflow.
 
Note 32 (b) (page 75): Provision for Liabilities and Other Charges is at AED4.7 billion up from AED3.0 billion (2008). Important as another potential cashflow demand. As well, this amount has grown rather significantly in one year. Future trends in these provisions should be watched. Note 46 (page 82) has additional information.
 
Note 38 (page 77): General and Administrative Expenses of AED4.7 billion include AED2.2 billion for impairment provisions on Trade and Other Receivables.
 
Note 40 (page 77): Other Operating Expenses provides details on the composition of provisions.
 
Note 42(a) (page 82): The Company eliminated its commitments to invest in private equity funds from AED259 million in 2008 to zero in 2009. It's unclear why an Operating Company like DHCOG is investing in private equity funds. Nor why it was investing rather substantial sums in the DIC fund on which it has lost some AED3.4 billion.
 
Note 42 (b) (page 82): As DHCOG has scaled back its projects, Commitments for Projects in Progress have declined dramatically from AED34.2 billion in 2008 to AED10.9 billion in 2009. The trade-off is increased Termination Claims.   Clearly, one does not shrink oneself to greatness.  Reduction in contracts is a necessary step given the state of the real estate market in Dubai.  All well and good.  But the question then is what is the future for DHCOG.  If its real estate business is reduced to a more modest level what does this mean for the Company - particularly since its profitability was basically driven by selling real estate it acquired at zero cost due to the kindness of the good Shaykh.

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