Saturday, 11 February 2017

GFH Windfall Settlement Masks Operating Loss of US$192 Million for 2016

GFH’s reported US$ 233 million net income is very impressive on its face.
What’s behind the 20-fold jump in reported earnings to US $233 million? 
US$ 465 million in litigation settlements.   The business equivalent of buying a winning lottery ticket.
Because this unlikely to be a recurring event, we need to look at results from ongoing operations to form a proper view of GFH’s 2016 performance, achievement of its strategy, and prospects for the future.
On that basis how did GFH perform? 
Definitely less well (euphemism of the post).  
As outlined below, an operating loss of US$ 192 million.
Follow along referring to the bank’s, excuse me, financial group’s 2016 audited financials here.  
Operating revenues—ignoring litigation gains—were some US$ 114 million versus US$ 88 million the year before.  A 30% gain or US$ 26 million driven by the sale of some investment and development property.
Operating expenses were at US$ 125 million versus US$ 62 million the year before. 
But I don’t think it is necessarily fair to subtract this full amount from 2016 revenues –which results in an operating loss of US$ 11 million before impairment allowances.
Why?  Some of the increase in these expenses is related to the costs of pursuing the legal settlement or as a result of the legal settlement, i.e., accrued staff bonuses
Let’s look a bit closer at the reasons for the increase in operating expenses.
Roughly US$ 26 million in additional staff expense (note 21) which appears to be increased bonuses for staff (see Other Liabilities note 14) and US$14 million in additional legal costs.   It seems fair to consider these as not part of ongoing operating expenses.  
That leaves an increase of US$23 million –US$ 10 million in undescribed “other expenses” (both in note 22) and $10 million for “investment advisory expenses” (income statement).  That would make 2016 adjusted operating expenses some US$ 85 million, leaving net operating profit before impairments at US $29 million.
In 2016 impairment allowances jumped to US$221 million in 2016 versus US$ 17 million the year before (see note 23). 
Deducting the full amount, GFH’s net income from operations before the windfall gain is a loss of US$ 192 million. 
You can also see a very similar though larger figure in note 32 page 56, i.e. US$ 206 million.   GFH--less generous or perhaps rigorous than AA--did not allocate the US$14 million in legal expenses to the unallocated segment to “match” the litigation settlement revenues.  However, it did allocate the US$25 million bonus accrual to this "segment".
Side Note:  Proving to GFH’s Reported Results:  When the additional $40 million in litigation related expenses is netted from the US$ 465 in litigation “gains” and added to the US$ 192 million operating loss, the result is net income of US$233 million which “foots” to the net income figure in GFH’s income statement.
Let’s look in depth at impairment allowances.  
  1. Financing Assets (note 5) were US$ 38 million.  I’m inclined based on my   earlier posts on KHCB’s credit quality, particularly this one on 2015 past due loans to see that as probably a justified “catch-up”.
  2. Other Assets (note 11) US$72—US$45 million in Other Receivables and $26.5 million in Financing Projects.
  3. Investment Securities (note 6) US$61 million.
  4. Equity Accounted Investees (note 9) US$36 million.
The question is whether there is anything that suggests that these impairment allowances are overstated or should be adjusted for any other reason to determine GFH’s net income from operations – that is, excluding the windfall gains from the litigation settlement.
I don’t think there is but let’s start by examining three possible explanations for these provisions and their dramatic increase.
  1. Formerly perfectly good assets that were carried at proper values in GFH’s prior year’s financials deteriorated sometime during 2016.  Thus, the provisions relate to the ongoing business and are a proper deduction from 2016 revenues, justifying the assumption of a US$ 192 million net loss on operations.  Under this scenario, it’s just a “remarkable coincidence” and nothing more that so many different types of assets declined so significantly during a single year. 
  2. GFH is “taking a bath”, that is, writing down good assets below their realizable value to decrease 2016 net income (perhaps to moderate payment of dividends) and more importantly build up a “reserve” to artificially improve future years’ earnings through timely reversals of provisions.  In other words provisions are overstated to create a "reserve" to be used to manage future earnings.
  3. In previous accounting periods the bank did not recognize impairments so it could artificially minimize or avoid losses in these prior periods. In this scenario, the windfall 2016 litigation settlement gave GFH the opportunity to clean its books.  As you may well expect from my 2010 posts on GFH’s financials and my recent analysis of GFH and KHCB financials as well as the “remarkable coincidence” mentioned above, I think there is a strong case to be made for this scenario playing a major role in 2016 allowances for impairment.  That is not to discount the likelihood that the other two scenarios also played roles. 
Note that Scenario #1 above is the only legitimate reason for provisions under generally accepted accounting principles. 

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