Friday, July 22, 2016

Global Investment House - 2015 Financial Performance Reveals Structural Problems with Earnings

It's a small world after all, and for some even smaller

It’s been five years since Global signed its first restructuring agreement and three years since its final settlement with creditors.

How is Global doing?   What are its prospects for the future?   
The first question is the subject of this post.  I’ll cover the second in a companion post.
Catching Up with Global
 
When last I posted, Ms. Maha was Chairman, GIH had published financials showing about KD 1 billion in assets, and the firm was touting its first rescheduling deal with its creditors.
At that point, commenting on the deal’s principal repayment terms—10 percent the first year, 20% the second year and a whopping 70% the third year—I noted that:
“It's highly unlikely that Global is going to be able to meet the repayment schedule even with one or two small miracles coming its way.   With the short fuse and the extensive trip wires (by way of covenants below), the spectre of a second default has to be haunting Global's management and shareholders.”
Not surprisingly in mid-2013 GIH negotiated a second rescheduling deal that gutted the firm: almost all of GIH’s “fine” assets were transferred to creditors in settlement of the debt.  Because the assets weren’t that “fine”, the creditors took a 70 percent stake in the “rump” GIH.  For a variety of reasons, the firm focused its business strategy on fee-based not balance sheet intensive business.  Ms. Maha was replaced as Chairman, though she remains on the Board as Vice Chairman and retains a role in management.
Review of 2015 Performance and Financials
Overview
The structure of GIH’s revenues and expenses indicates a high probability of future earnings volatility. Normalized expenses are 140% of AUM related revenues.  Non AUM LOBs can’t consistently generate enough revenue to cover the remaining expenses and generate a meaningful profit. They are market sensitive (volatile) themselves and more importantly lack scale.  They are more “hobbies” than substantial LOBs.
Besides these structural earnings problems, I noticed a few things in the loan portfolio and murabaha receivables worthy of comment.  Nothing that is life threatening.
Income and Expense
Net Income:
Global earned KD6.5 million in 2015 versus KD6.4 million the year before.  However, 2015 net income was bolstered by a (non-cash) write back of KD4.3 million of loan provisions.   Without this “timely” reversal, net income would have been a much lower KD2.2 million.
Revenues:
Fees and Commission Income accounted for 89% of total revenues in 2015 and 66% in 2014.   Within this category, AUM related fees account for some 80% of revenues, and represent a relatively stable revenue stream.  The other key fee-generating LOBs-- brokerage and investment banking-- each generate about one tenth of the AUM fees but are more volatile.
In 2015 Global benefited from KD 1.8 million in FX translation gains (KD 2.2 million in 2014) due to depreciation of the KD against the US dollar.  Not a stable core revenue source.
Net interest income contributed KD 1.6 million.
Fair Value Through Profit and Loss a loss this year of KD1.5 million vice KD0.8 million in positive revenue the year before.
Expenses:
Excluding loan provisions and impairment losses, Global’s average expenses are about KD 14 million a year – 140% of its stable AUM related earnings.
Structural “Problem” with Earnings
That’s a problem because Global’s other fee-generating LOBs (chiefly brokerage and investment banking) are market sensitive and more importantly lack the scale to  consistently generate significant revenue  to both cover expenses and generate a profit.   Growing earnings by growing assets is constrained by policy and no doubt as well by limited market access. 
Global then is forced to rely on one-offs such as continued depreciation of the KD or provision write backs to turn a reasonable profit.  Note that if there had been no FX translation gain in 2015 and no write back of the provision, Global would have had a modest profit.   
Balance Sheet
As mentioned above, a couple things caught my eye in the loan portfolio and murabaha receivables.
Loan Loss Provision Write Back
According to GIH’s 2015 annual report note 13, the write back provision for credit losses “for the year include KD 3,292 thousand (2014: KD 130 thousand) written back as a result of settlement agreement with a borrower.” 
Note the term “settlement agreement”.  GIH did not restructure the loan. The amount was not repaid in cash. Rather the bank took securities to settle the loan as is clear from an analysis of the firm’s cashflow statement and note 11.  The absolute increase in assets in note 11 is much more than the amount shown on the cashflow statement.
A single customer was responsible for 77% of the write-back.   A quick scan of annual reports back to 2012 suggests--but does not prove--that GIH has held this provision since at least 2011. 
The same note states:  “Loans are granted to GCC companies and individuals and are secured against investments in the funds and securities held in fiduciary portfolios by the Group on behalf of the borrowers.”
Why didn’t GIH seize and realize the collateral long ago?  Why hasn’t done the same with the borrowers representing the KD 5.9 million in unused provisions?
One explanation might be that legal processes in Kuwait are painfully slow.  Thus, GIH was legally unable to seize the collateral and extinguish the loan, but rather forced into prolonged negotiations with the borrower. 
That the reversal came at just the “right” time to protect earnings is certainly a remarkable coincidence.  Perhaps difficulties in 2015 caused management to redouble its efforts to collect.  Perhaps a long period of negotiation finally came to a close.  From the financials, it does not appear that GIH gave the borrower a discount on the asset swap.
Loan Portfolio:
Is there room for more earnings positive settlements with borrowers?
Net loans are KD 1.6 million = gross loans KD 7.5 million less provisions of KD 5.9 million (note 13). 
That KD 5.9 million would appear to be able to fund a few “timely reversals”.  
Particularly because Global holds KD17.8 million (fair value) collateral as per note 25.2.2 page 57.  That’s 240 percent coverage of the gross amount of the portfolio.  One might argue and AA certainly would that there doesn’t appear to be a compelling reason to hold a loss reserve when collateral coverage is so high.   
But there’s more.
Global is accruing interest on the gross portfolio because KD 490K in accrued interest in 2015 equates to a whopping 21% per annum yield on the average net loan portfolio. (Simple average of 31 December 2015 and 2014 amounts).  It’s a more reasonable 4.8% on the average gross portfolio. 
To accrue interest, Global would either have to be receiving cash or have almost certain assurance of payment of the interest. 
The cashflow statement shows that Global did not receive cash payments in 2015 for about KD 500 million of interest accrued that year, an amount very close to the interest accrued on these loans.  Of course, the KD 500 difference could well relate to other interest bearing assets.  It could relate primarily to the loans but be due to timing difference:  the interest payment was received after 31 December 2015.  If cash is being received and Global holds such an excess of collateral, how does it justify maintaining the reserve to its auditors? 
On the other hand, if Global is accruing interest—but not receiving cash—, its justification is likely based on asserting that collection of interest is almost certain given the collateral it holds. If the interest is secure and again the collateral so much larger than the principal, then it would seem the principal is also secure and no provision is needed.
All this suggests to AA that Global has some “dry powder” for future contingencies.
Murabaha Transactions
Global is earning a princely 5.28% per annum on these one year transactions (note 12).  Not many good investments offer such a return for a one year tenor.  Kudos to GIH for finding this consistently attractive opportunity—5.24% in 2014, 5.3% in 2013, and 5.45% in 2012.
One would think that such rates would come at the cost of higher risk, but the provision is a modest KD 123K on some KD 3.1 million. 
One thing did catch my eye.  Note 25.2.2 page 57.   The murabaha receivables were more than 180 days past due (but not classified as impaired) as of 31 December 2015 and as well at 31 December 2014.  I didn’t see a reference to collateral for these transactions.  Of course, AA has been around the block a few times on “Islamic” banking transactions and knows that in addition to careful structuring (technically حيل) “Islamic” finance is one area of the faith where miracles occur with a dazzling regularity.
Notwithstanding the above, perhaps a provision of some sort would be warranted.  And could be accomplished by a simultaneous reversal of some of the loan provisions and booking of an equivalent amount as provision for the receivables.  But of course الله اعلم

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