Friday, August 11, 2017

Qatar Banking Sector: How "Grim" is Grim?

Sure Sounds Much Scarier Than Subdued

AA was in grave danger of slipping further into his monomania on Dana Gas, until Gulf News (Dubai) rode to his rescue with this timely 8 August article:  Qatar banking system faces grim outlook as sanctions bite”.

“Grim outlook” sure sounds serious.  If Indian banks are facing “subdued” prospects, then Qatar has to be in even worse shape.   

The article’s argument appears based on the following: 

  1. Moody’s has placed Qatar’s banking sector on ratings watch negative, a change from stable.  The other rating agencies have taken steps as well.  S&P bumped Qatar’s sovereign rating to AA-.  Fitch has placed Qatar’s AA sovereign rating on its watch list.  In case you don’t know, investment grade extends all the way to BBB- or Baa3. Qatar banks are more dependent on external funding than earlier. 

  2. External funding may be withdrawn and the Qatar government’s ability to support its banks has weakened.

  3. Qatar’s banks have a “lot” of cross border assets in the GCC and MENA.  AA isn't sure if this is a credit warning about these borrowers ability to repay or about government action to prevent payment.

  4. Moody’s expects non-performing assets to increase from 1.7 % at FYE 2016 to 2.2% by FYE 2018. Moody’s also expects ROA to decline from 1.7% for fiscal 2016 to 1.4% for fiscal 2017.

GN’s assessment seems to be based on two things.

  1. First, some negative things might occur, e.g., external funding withdrawal, ratings drop, etc. At its current rating Qatar could drop a notch or two and still comfortably be investment grade.  More importantly, things that might occur do not necessarily occur.  Or when they do, there may be solutions. Those with long memories or mentors who lived in exciting times will remember that when international banks cut off funding for the Kuwaiti-owned banks in Bahrain following the Iraqi invasion of Kuwait, the KIA rode to the rescue.   

  2. Second, there is negative trend in two metrics:  ROA and ROE. It’s not clear to AA if GN believes that the change in NPA (a 30% increase) or ROA (an 18% decrease) is driving Qatar banks to “grim” territory or whether it is the absolute levels of these figures. 

Let’s put those metrics—ROA and NPLs— into context with a chart drawn from  pages 10-11 in the KPMG report on GCC 2016 banking performance. 

Two things to note about that report. 

  • It covers listed banks and not all banks.  Despite the sample composition, the report should provide a directional idea about relative performance. 

  • That presumably explains much if not all of the difference between KPMG’s figures and Moody’s who are including unlisted banks in their calculations. 

GCC Banking Performance


Based on the above data, it would seem that using GN’s definition things are at least somewhat grim in the UAE and even more so in Bahrain, Oman, and Kuwait. 

Perhaps, this is Qatar’s way of re-integrating itself into the GCC?

But there’s more. 

Notice that the chart in the GN’s story shows a decline in ROA since 2011 well before sanctions on Qatar had been “born” or had molars to bite, though this may be a testimony to the wise leadership's ability to position for necessary future action.

A January GN article quotes Moody's projections for GCC aggregated banking performance in 2017.  Using that projection as a baseline, it would appear that the "grim" Qatar banking sector will outperform the average GCC bank. 

As to the health of GCC country finances in a low energy price environment and thus their ability to support their local banking sector and economy, there’s a Fitch 5 April report that provides some insights. 

Based on its forecasts for the average 2017 oil price and country projected spending, among the GCC states only Kuwait (USD 45) and Qatar (USD 51) have a break-even price below Fitch’s estimated USD 52.50 barrel price for oil.  Kuwait’s break-even price was influenced by its “high investment income”. 

Bahrain is at USD 84, Oman at USD 75, KSA at USD 74, and Abu Dhabi at USD 60.   Details here. 

Mark AA as skeptical on GN’s assessment which seems more like foreign policy advocacy in search of a “victory” than hard analysis. 

It's a bit early to make a call on the effectiveness of sanctions or of Qatar's workarounds.

A grim scenario may occur, but Qatar has abundant resources to fight sanctions and at present retains access to world financial markets.  One could the case of other sanctioned countries with less financial resources or access to financial markets to draw some conclusions about ability to weather a storm.  Hufbauer et al "Economic Sanctions Reconsidered" may be a useful entry point to such a review.

There is is a more nuanced less alarmist view on Moody's report--as appears to be the usual case--at Abu Dhabi’s The National. No “biting” no scenarios of doom.

Saturday, August 5, 2017

Dana Gas Strategy From Clever Boots to Clever Socks?

DG's New Strategy May Be Actually More Clever Than Depicted Above

As you’ve no doubt heard, following rejection from its creditors, Dana Gas withdrew its imagined generous offer of an exchange bond stripped of the conversion option and at an “attractive” 3% fixed interest rate compared to the 9% the Company paid until its moral principles “forced” it to withhold payment because “evolving” interpretations of Shari’ah voided the “Islamic” character of the sukuk. 
At that time according to press reports (Reuters here), the Company said it would pursue "litigation-driven outcomes". 
An initial assessment might be that Dana Gas has taken further leave of what scant senses it might have had.  Scant because its “clever boots” first strategy seemed an unnecessary provocation to the creditors and unlikely to succeed.  DG has a perfectly viable argument for a restructuring without resorting to what are almost certainly distortions of Shari’ah. 

On that score the uncharitable out there among you might say why should there be a difference between overall management of the business and financial management.  AA who fancies himself a charitable sort would of course never make such a comment. 
According to the report by Bloomberg, DG’s “evolved” strategy is based on successfully litigating one of the two following outcomes: 
  1. Unwind the sukuk transaction from origin, repay the outstanding principal (roughly USD 690 million) but offset the allegedly now non-Shari’ah compliant “profit” (interest) payments made over the life of the sukuk (some USD 635 million over the life of the transaction). 
  2. Convert the sukuk to equity in the Trust Assets (note the potentially fatal limitation agreed by the Sukuk holders in their initial irrational exuberance).  Based on profit earned by the Egyptian assets and the value of these assets now, DG reportedly believes that the sukuk holders owe it USD 150 million.  Details in the Bloomberg article.   
Abu Yusuf certainly has been a busy chap parsing the law.
Some observations. 
At first hearing a litigation-driven strategy sounds like a crackpot idea.
But there have been rulings in the past by UAE courts (Abu Dhabi based) that support such an approach, though AA understands that judicial precedent is not binding in the UAE. Back in the 1980s or thereabouts, UAE banks’ practice of lending on an overdraft basis and capitalizing interest “came a cropper” when borrowers couldn’t or wouldn’t pay.  NBAD took one such borrower to court.  The borrower noted he had recently “seen the light” and as a good Muslim could not pay interest as it would violate Shari’ah.  Producing bank statements he “proved” that on a cash-on-cash basis he had already repaid the original principal amount of his borrowings and more.  The learned judge ruled in his favor.  NBAD had to issue a check to the borrower for some million AED (the “overpayment”) and cancel the balance of his loan on its books.  One would hope that there has been change in judicial thinking in the Emirates since then but one doesn’t always get the “hope and change” wished for.   
As I read DG’s initial announcement, a key point of DG’s strategy is the assertion that evolving interpretation of Shari’ah made the transaction non-compliant. 
One could argue that that means that at some point the transaction was Shari’ah compliant.  If that is the case, then the date the transaction became non-compliant becomes very important in terms of the legality of profit payments.  Those before the new interpretation were perfectly halal.  Those after not. 
One might argue that the date of DG’s announcement of non-compliance is prima facie the date of non-compliance.  If DG were aware of non-compliance before that date but were silent, then should it be subject to paying damages to the sukuk holders perhaps equal to or greater than the profit payments they received between the end of Shari’ah compliance and the date of announcement?  Does Shari’ah impose a greater obligation on a mudarib with respect to rab al maal than a conventional loan arrangement would?
If Shari’ah holds that a change of interpretation is retroactive back to the inception of the transaction—which AA doubts--, then despite their best intentions the parties did not actually agree to a Shari’ah based transaction but instead agreed to conventional (non-Shari’ah) bond.  If so, then shouldn’t the non-Shari’ah terms as negotiated and agreed by the parties bind the parties?  Indeed with this development, might the sukuk holders be entitled to insist on a non-Shari'ah bond?
A telling point could well be if DG has engaged in non-Shari’ah based transactions.  This would establish that they do not only finance on a Shari’ah basis. As to the first point, on page 78 of its 2016 annual report Dana refers to the “Shari’ah tranche” of the Zora financing which clearly means there was at least one non-Shari’ah tranche to this financing.  That indicates to AA that DG’s conversion to “Islamic” principles is of recent date and no doubt feigned. 
As regards Scenario #2, the Bloomberg article contains an assertion ascribed to the Company that the Egyptian assets only generated USD 60 million during the life of the sukuk.  If the Bloomberg report is true, this is a rather shocking admission by DG’s management of failure.  Equity holders may want to take note.
More to the point, sharp-eyed creditors, pardon me, the creditors have demonstrated scant sharp eyes so far so let AA rephrase. The creditors’ advisors will no doubt parse this calculation carefully.  Presumably it does not include “profit” (interest) payments because the determination of profit is before the sharing of profit between mudarib and investors. 
As regards the USD 450 million valuation for the Egyptian assets, Section 3.2 of the offering memorandum refers to the distribution of the “realisation of the net proceeds” the Trust Assets.  AA is no lawyer but that would seem to argue that DG cannot merely give the sukuk holders shares in the Egyptian venture based on its own valuation, but rather that the Egyptian assets have to be sold.  If the proceeds are not enough to repay the sukuk, other of the Trust Assets have to be sold.  Since this is a limited recourse transaction, if all the Trust Assets are sold and the sukuk is not redeemed in full, then the creditors have no further recourse.  Requiring sale of the assets could upend DG’s strategy of claiming funds back from the creditors.  It is not without danger to the creditors given the limited recourse nature of the sukuk.  But since the creditors have a weak hand given that feature of the deal, a credible threat to “wreck” the Company might bring it to its senses.  If not the sukuk holders might take comfort in making DG share their pain. 
That DG has adopted this highly risky second strategy suggests to AA that DG believes it has a good chance of winning the case, plans to beat creditors into submission though interminable court action in the UAE, or has run out of viable alternatives.  That is, this is a desperation play:  the Company sees no other option.  That implies that DG’s management has assessed that DG’s value is minimal.  The rejected four-year deal would have given breathing space for a miracle in the form of the receipt of a substantial arbitral payment, collection of receivables, etc.  With that deal off the table, the state of the emperor’s clothes or lack thereof will become obvious. 
As regards, victory in the courts or prolonging the legal battle, perhaps the “fix” is already in the home town court.  As noted in other posts at SAM, the December hearing date is one indication.  Another is the complex but highly convenient requirements of the Sharjah court to lift its injunction frustrating DG’s ability to comply with the London court’s requirements.
Alternatively, DG may be hoping to drag matters out in the lengthy judicial process in the UAE’s fine courts similar to the roughly six-years of legal to-ing and fro-ing  between the National Bank of Umm al Quwain and Global Investment House Kuwait, hoping that this will wear the creditors down. Some details here on that epic legal battle which was finally “settled” via an out of court settlement. 
AA hopes that Emirati courts and rulers understand the impact a court decision in DG’s favor would have on the legal credibility of the UAE judicial system, local companies’ access to cross-border financing, and more widely on “Islamic” finance beyond the UAE.   
AA notes, however, that “hope” isn't really a basis for investments or for correcting problems with investments.  As to AA's judicial "hope", “change” may as well prove elusive.   

Sunday, July 30, 2017

Dana Gas: Three Additional "Things" to Watch Plus "Bonus" Features

The Underwriting Phase is the Best Time for Scrutiny 

Given the company’s weak financial condition and the behavior of management, those with a financial interest in the firm—creditors and equity investors— need all the help they can get in monitoring DG’s performance.  
As always AA has your back.
In addition to keeping an eye on macro financial performance, here are a few relatively quick things that sukuk holders and equity investors can do to make sure they don’t miss problems organized around three topics:  
  • Current performance
  • Receivables collection
  • Financial liabilities 
These aren’t the only indicators. 
They certainly are not replacements for looking at the financials carefully particularly aggregate cashflow, but can be helpful in identifying performance problems.  At times information in the consolidated income statement or statement of condition can be used to trigger a deeper look.  For example, declines in overall net revenue, a sudden large write-off of exploration costs, etc. should send you looking for more information.  You’d expect to find explanations in the various management reviews in annual and interim financial reports. These tools will hopefully help you look deeper.  If management omits to highlight a problem, these tools may help you discover incipient problems as well. 
Current Performance
DG operates in three separate locations.  Looking at aggregate performance obscures what’s happening on the individual level. That could be quite important if the level is a critical "bit" in the overall business.
DG does provide some information on individual operations in its “segment reporting” note (typically note 4).  Here you'll find total assets and liabilities.  Not enough to go on.

Starting in 2013 DG began providing more information on Pearl's balance sheet in the note Interest in Joint Operations (note 15 in 2016 and 13 in 2014) than in note 4.  One can create a rudimentary balance sheet from this information back to 2012.  That still leaves a significant information gap on the balance sheets of Egypt and the UAE.  
But there is another more important problem with DG's segment disclosure.

The Company does not disclose net income and net comprehensive income for the UAE, Egypt, and Iraq.  It only discloses net revenues and gross profit (net revenue – depreciation and operating expenses) with some additional limited disclosure about elements of the income statement.  Sadly this falls short of what would be ideally useful to users of its financial statements.
With this limited additional information, one can try to construct a rudimentary income statement. But more than some assembly is required. Unlike IKEA not all the parts are in the box, so it’s generally hard to determine whether these entities are profitable before allocation of expenses at the holding company (DG) level or the nature of at least two of the three main operating entities' balance sheets.  
In some cases where there is an extraordinary expense, e.g., a substantial write-off of exploration expenses, it’s a bit easier.  For example, in 2009 it’s pretty clear Egypt had a net loss.  As did Zora in 2016.  One doesn’t even need a calculator to see this.   
What’s a quick but not complete fix to this lack of information?  
Tracking the top line for an indication of ability to generate earnings and cashflow and looking at the disclosed expenses is the easiest.  It's also not a bad starting point. But this is an imperfect "fix".

Revenue declines or increases can reflect changes in prices or volumes.  One would expect prices to be largely out of DG’s control.  Volume declines could reflect operating or reserve problems. 

One can also scan the disclosed expenses for surprises.  These should be visible in the consolidated income statement but looking at the segment information note (note 4) will identify which of the three businesses took the "hit". 

Here’s a starting point for the investors out there who hold DG paper.   

DG Top Line Revenues Millions of USD


 Source:  Note 4 DG Annual Reports

Trade Receivables (“TR”)

As discussed in earlier posts, collecting TR is key to repayment of the Sukuk and to eventual cash returns to shareholders. (AA is indulging in extremely optimistic fantasies today).  The TR are “whisker-growing” stale.  Cash conversion is glacially slow.  On a present value basis, the value of TR is being eroded when one considers the appropriate risk-adjusted discount rate. 

Those with a financial interest in DG’s financial performance should be watching trends in collection or further accumulation of the TR. 

Note to DG’s auditor: Transparent disclosure of just how past due the TR would be helpful. 
Provisions for Surplus Over Entitlements
But there’s something new to watch. 

That is the above mentioned provision which is money that DG owes the KRG.
Why is this important? 
AA suggests you read Note 28 in full, but here is a sentence that caught AA’s eye and summarizes the issue: 

“Furthermore, Pearl has a right under the terms of the Authorisation to offset this Surplus, when payable, against any other outstanding payments due from the KRG.” 
Given its current cashflow generation problems, it’s likely that if the TR are settled, the amounts owed to the KRG will be offset against the TR. The KRG may have a similar right to offset.  But we don't have confirmation of that.

AA would expect that those who depend on collection of the TR for their repayment or dividends would want to track whether this offset is growing and just how fast.  Is this liability threatening to seriously diminish their source of repayment?  
Side comment:  Though none is really needed in AA’s view, perhaps this is another compelling argument that sukuk holders should reject a five-year bullet structure and insist on amortization of the sukuk in the rescheduling negotiations.  As you will recall and if you don’t, AA will repeat his earlier advice.  Principal payment should be in the form of both scheduled repayments and a cash sweep structure to hoover up prepayments if there is excess cash. 
Bonus Indicators
In addition to the operational indicators mentioned above, some "bonus" tips. 
If you missed the reference in DG’s Annual Report 2016 CEO Review, there seems to be a problem of some sort at Zora.
“In the UAE, despite full year average production of 2,744 boepd, total production from the Zora Gas Field has declined throughout the year from production start-up in February.”
This may be a technically solvable problem or it may not. 
Those with a financial interest are likely to have an interest in knowing, though Zora is a rather small fish in DG’s operations.  It clearly is not showing a profit based on DG’s Annual Reports Note 4.
This information may also temper optimism about Zora as additional collateral until the cause of the decline is known. 
For Pearl there are other sources of information (more on that point in a post to come) in the financial reports of three of DG’s partners in the joint operations. 

Here are some examples from MOL Hungary’s 2016 annual report.
  • MOL took provisions equal to its share of 2016 net income in Pearl Petroleum (note 6).
    Given the current economic situation impacting the Group’s associate in the Kurdistan Region of Iraq a provision has been made in 2016 against the Group’s share of profit.”
  • MOL also announced that it has changed its revenue recognition for sales in the KRG from an accrual to a cash basis.  That’s generally not a sign of robust credit standing of the buyers.  (AA’s first understatement of the post). And may be related to the 2016 provisioning against MOL's profit in Pearl.
Note 3:  Having assessed the probability of receiving economic benefits from sales activities in Group’s operations in Kurdistan the management decided to recognise revenue on a cash basis on sales in Kurdistan Region of Iraq.”
  • MOL has also taken some additional steps in the KRG which appear to reflect a serious concern about economic conditions.  You can easily find them by searching MOL’s 2016 annual report using the search term “Iraq”.  Pearl isn’t MOL’s only KRG asset so some of these steps relate to other companies. But the message seems pretty clear.  MOL is concerned about KRG ability to repay. 

AA Rant
If you read this blog on a semi-regular basis, you’re familiar—perhaps more than you’d like—with AA’s frequent complaints about "shortcomings" financial reporting. 
This rant is about the quality of DG’s segmental information. I’ve noted the deficiencies above. In short DG isn't providing enough information to understand it's underlying business.
Why isn’t DG providing more detailed information?
Others do.  The nearest I can find to an “explanation” is in DG’s 2016 annual report notes 2 and 4.  The below quotes basically repeat what they’ve said in previous years.
“Note 2: Operating segments are reported in a manner consistent with the internal reporting provided to the Chief Operating decision-maker.  The Chief Operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as the Chief Executive Officer who makes strategic decisions.”  
“Note 4:  Management has determined the operating segments based on the reports reviewed by the Chief Executive Officer (CEO) that are used to make strategic decisions. The CEO considers the business from a geographic perspective which is divided into three geographical units.  The Group’s financing and investments are managed on a Group basis and not allocated to segment.” 
This might be charitably described as manifest garbage.   
DG’s segments are independent companies that prepare their own financials.
What this means is that DG has this information.

Preparation of the segmental information would be a simple matter of reproducing summaries of the income statement and balance sheet.
AA wonders if the CEO really does not look at these reports or condensed versions of them to make decisions. How can he run the business and make investment decisions if he isn't tracking the profitability of major lines of business based on an allocation--imperfect as it is likely to be--of all expenses?  How does one track risks?
If indeed the CEO is not using a methodology similar to this, then perhaps DG needs a new CEO. 
AA also wonders DG’s auditor’s apparent acceptance of this explanation. Some uncharitable souls might say questions about auditor credulity have already been conclusively answered: the auditor has accepted DG’s decision to carry the Trade Receivables as “current assets”.
When important information is missing from financials or other statements by a firm's management, one should wonder why.  Is it that they don't have the information (which is a troubling question in its own right)?  Or that they don't want to release the information (an  even more troubling question)?  That leads to AA's golden rule of providing capital.  If the firm doesn't trust you with information, why should you trust them with your money?