Friday, July 21, 2017

Dana Gas: Deep Dive on Performance



As the picture above indicates, AA is suited-up and ready to embark on a “deep dive” into DG’s performance.  Despite the diving suit, the chap next to me—one of our firm’s analysts—will not be joining as this exercise isn’t client related.  Pity he’s a superb modeler.  
This excursion should be of interest to current and potential equity investors.  It will as well provide creditors some useful insights for the restructuring negotiations. 
As will become evident as we proceed, the reference to “deep” dive has two meanings. While the ultimate fate of the equity and sukuk holders who have "dived" into DG is unclear, AA has surfaced financially sound and whole.
What this analysis shows is that absent unlikely fundamental changes to its underlying business DG’s ability to deliver appropriate returns to shareholders is limited. That means as well limited probability of improving its ongoing cash flow. 
DG’s “clever boots” strategy for renegotiating the Sukuk is likely to exacerbate this problem by diminishing whatever scant market access it had to debt capital prior to that “wise” move, which has increased the market pricing on its debt. The latter is important we shall see because if DG is use leverage to its benefit, it needs to be able to borrow below its return on average assets (ROAA).
As explained below, this problem is not directly related to the failure to collect the trade receivables, but is more fundamental.   
We’ll look at historic performance as our “best” guide to the future for the reasons I outlined in my earlier post with “sage” advice for DG’s creditors. 

Our analytical “tool” will be return on average equity (ROAE). 

DG ROAE ANALYSIS - NET INCOME

NI
AVE EQUITY
ROAE
2016
-88
2,827
-3.1%
2015
144
2,791
5.2%
2014
125
2,627
4.8%
2013
156
2,480
6.3%
2012
165
2,321
7.1%
2011
138
2,199
6.3%
2010
43
2,137
2.0%
2009
24
2,035
1.2%
2008
33
1,955
1.7%
Last 9 Years
740

3.5%
Last 5 Years
502

4.0%

  Source:  DG Annual Reports  
Technical Notes:   
  • Net income as reported. Amounts in USD millions.
  • Average equity is the sum of current and past year closing balance of total equity divided by 2.
  • 9 and 5 year averages are simple arithmetic means of individual years’ ROAE.
Why did I select these two periods?
  • The first roughly corresponds to the period of time DG has had use of the Sukuk certificate holders’ funds. 
  • The second period (the last five audited years) strips away the negative effects of the initial low return “building out” of the business in the "early" years and thus probably gives a better picture of the future. 
Observations:  
  • ROAE for both periods would not be acceptable for a firm with a better risk profile than DG. When one factors in DG’s risk profile (concentration in sub investment grade customers in “challenged” markets, etc.), the ROAE is dismal.   
  • But there’s more “bad news”.  This is DG’s best case because it doesn’t include any adjustments (present value or impairment) of the Trade Receivables (TR).  In this analysis, I am treating TR as received on time and in full. Making what are necessary adjustments would diminish ROAE.  Perhaps, taking it to “subdued” level to use a financial “term of art”. 
  • Not only are return on average assets (ROAA) and ROAE low, but they also exhibit high volatility.  The Standard Deviation Sample (STDS) of Net Income (NI) for 9 and 5 years slightly exceed the Mean indicating high volatility.  For 9 years the STDS is USD 85 million and the MEAN USD 82 million. For 5 years STDS is USD 111 million and the MEAN USD 100 million.  Not surprisingly ROAE follows a similar pattern: the STDS are close to the MEAN.   
  • ROAE on Comprehensive Net Income (CNI) isn’t much better. Over the last nine years aggregate CNI was USD 782 million and ROAE 3.8%.  Over the past five years CNI was USD 500 million and ROAE 4%.  Still in the “dismal” range. 
What is causing this disappointing performance? 

One way to analyze ROAE is to break it down into constituent components:  Return on Average Assets (ROAA) and Leverage (Average Assets/Average Equity).  According to the “Dupont” equation, ROAE = ROAA x Leverage. 

Purists among analysts out there may object that there are more sophisticated analytical methods.  AA does not disagree. The Dupont equation is also descriptive not prescriptive. But DG’s case is such that simplified analysis will give us the information we need.  Increased precision, if obtained, will not change the fundamental conclusions. 
To start a look at DG’s average balance sheet.   
DG  AVERAGE BALANCE SHEET

ASSETS
EQUITY
ACCR
DEBT
D/E
LEV
2016
3,839
2,827
158
855
30.2%
1.36
2015
3,762
2,791
160
812
29.1%
1.35
2014
3,567
2,627
156
784
29.8%
1.36
2013
3,521
2,480
155
886
35.7%
1.42
2012
3,414
2,321
153
941
40.5%
1.47
2011
3,268
2,199
155
914
41.5%
1.49
2010
3,170
2,137
149
884
41.4%
1.48
2009
3,029
2,035
130
864
42.4%
1.49
2008
2,953
1,955
112
886
45.3%
1.51
9 Year
3,391
2,374
147
869
37.3%
1.44
5 Year
3,620
2,609
156
855
33.1%
1.39
Technical Notes: 
  • As before averages are computed using current period and previous period ending balances divided by 2. 
  • ACCR are non-interest bearing liabilities. For the analytically "pure" of heart, I'd note that I have not included ACCR as "debt" when calculating interest or the D/E ratio.  Making this adjustment results in a minor change to ROAE.
  • LEV is the “Dupont” leverage ratio, i.e., Assets/Equity.  However, I have not deducted AACR from Average Assets.
  • D/E is a more “traditional” measure of leverage.  A D/E ratio of 1.0x would indicate that debt was equal to equity.
  • As the above table discloses, DG is funded primarily by equity.
Now to ROAA based on Net Income. 
DG ROAA ANALYSIS - NET INCOME

NI
AVE ASSETS
ROAA
2016
-88
3,839
-2.3%
2015
144
3,762
3.8%
2014
125
3,567
3.5%
2013
156
3,521
4.4%
2012
165
3,414
4.8%
2011
138
3,268
4.2%
2010
43
3,170
1.4%
2009
24
3,029
0.8%
2008
33
2,953
1.1%
9 Years
740
3,391
2.4%
5 Years
502
3,620
2.9%

Technical Note: 
  • Net Income is as reported by DG.  It includes interest expense and taxes. 
At first glance it appears that leverage is working in DG’s favor.  2.4% (ROAA) x 1.43 Leverage has raised ROAE to 3.5%. 
But appearances are deceiving.    
As noted above, ROAA includes interest expense.  Changes in the interest rate will change NI. Changes in NI will change equity.  That’s why one cannot simply use Dupont equation results based on one set of variables (interest and leverage) to analyze another case using different variables without adjusting NI/ROAA and the leverage ratio (equity).    
To judge whether debt financing (leverage) is working we need to look at the unlevered case. 
DG UNLEVERED ROAA ANALYSIS – NI

NI
INT
ANI
AASSETS
ROAA
2016
-88
97
9
3,839
0.2%
2015
144
77
221
3,762
5.9%
2014
125
73
198
3,567
5.6%
2013
156
78
234
3,521
6.6%
2012
165
86
251
3,414
7.4%
2011
138
87
225
3,268
6.9%
2010
43
56
99
3,170
3.1%
2009
24
55
79
3,029
2.6%
2008
33
72
105
2,953
3.6%
9 Years
740
681
1421
3,391
4.3%
5 Years
502
502
1004
3,620
5.1%
The levered return for the 9 and 5 years periods is 56% and 57% respectively of the unlevered return. 
Not good news for shareholders who have scant, if any, good news on their investment. 
What’s going on? 
For leverage to be beneficial, a company needs to borrow funds at less than the ROAA. 
During the period 2008 through 2016, DG borrowed funds at roughly twice its unlevered ROAA based on reported interest expense.  For 2012 through 2016, it borrowed funds at 1.9x its ROAA.  Thus, instead of leverage working to the shareholders’ benefit, leverage actually reduced their return. 
DG has three potential ways out of this strategic cul de sac: 
  • Obtain debt financing at an interest rate lower than its unlevered ROAA. 
  • Repay the debt. 
  • Increase ROAA. 
Let’s analyze the likelihood of these providing an acceptable solution and the extent of that solution. 
Lower Interest Rates on Debt Financing 
AA finds it hard to imagine a scenario in which lenders or investors willingly provide debt capital to DG as rates substantially below ROAA. 
  • DG business has a weak credit profile. 
  • It has two major customers who are rated sub investment grade.  It operates in “challenging” markets. 
  • It has a backlog of uncollected receivables. 
  • It is a serial defaulter and seems likely to continue this path in five years' time.. 
  • Its latest default has been accompanied by legal maneuvering that reasonably gives or should existing and potential creditors concerns about integrity. 
As part of the restructuring, DG may be able to obtain (force) some concessions on the interest rate to below market levels.  For Sukuk holders return of principal may be a more important goal than return on principal. 
Such a move is also a “neat” way for the Sukuk holders to take a “haircut” on principal without formally agreeing to one. 
Let’s assume the certificate holders agree.  
What would that mean?
Net Income would clearly increase.  How much?
SCENARIO #2 – 3% INTEREST RATE

DEBT
AINT
OINT
ONI
ANI
2016
855
26
97
-88
-17
2015
812
24
77
144
197
2014
784
24
73
125
174
2013
886
27
78
156
207
2012
941
28
86
165
223
2011
914
27
87
138
198
2010
884
27
56
43
72
2009
864
26
55
24
53
2008
886
27
72
33
78
9 Years

235
681
740
1,186
5 Years

128
411
502
785
Explanatory Notes: 
  • OINT and ONI are the “original” interest expense and net income as reported in DG’s financials. 
  • AINT and ANI are the “adjusted” interest expense (at 3% p.a.) and resulting net income. 
  • ANI = ONI + OINT - AINT
This looks promising. 
NI is up 60% for 9 years and 56% for 5 years.
What does the "new" average balance sheet look like?

DG  AVERAGE BALANCE SHEET -3%
ASSETS
EQUITY
ACCR
DEBT
D/E
LEV
2016
4,249
3,237
158
855
30.2%
1.31
2015
4,111
3,139
160
812
29.1%
1.31
2014
3,864
2,924
156
784
29.8%
1.32
2013
3,768
2,727
155
886
35.7%
1.38
2012
3,606
2,513
153
941
40.5%
1.43
2011
3,401
2,333
155
914
41.5%
1.46
2010
3,259
2,226
149
884
41.4%
1.46
2009
3,088
2,095
130
864
42.4%
1.47
2008
2,976
1,978
112
886
45.3%
1.50
9 Year
3,591
2,575
147
869
37.3%
1.41
5 Year
3,919
2,908
156
855
33.1%
1.35

Technical Note:
  • In line with my earlier comment, I have adjusted average equity to include the increased NI due to the lower interest rate and then average assets to include the increase in equity.
  • Note the impact on LEV.
Now to ROAE.

ROAE SCENARIO #2 (3%)
ANI
AAA
ROAE
2016
-17
3,648
-0.5%
2015
197
3,488
5.6%
2014
174
3,222
5.4%
2013
207
2,974
7.0%
2012
223
2,705
8.2%
2011
198
2,467
8.0%
2010
72
2,315
3.1%
2009
53
2,155
2.5%
2008
78
2,000
3.9%
9 Years
1186
4.8%
5 Years
785
5.2%
Observations:
An improvement. 
But while the ROAE has increased substantially from the 9% interest rate scenario, it still falls below an acceptable return for DG’s risk profile.
Repay the Debt
This would have to be funded with new equity. 
AA finds it hard to imagine shareholders rushing to “double down” on their bet on DG. 
Yes, ROAE would improve by de-leveraging the firm. But the resulting increase from this step is probably not enough to outweigh the risk of loss on substantial new investment in DG. There are no doubt many other less risky investments out there that beat a 5% or so ROAE.  Additionally, the new money invested would not go to expand the business but to repay existing creditors.   
Cash from the foregone interest expense might be used for dividends.  Eliminating debt would eliminate constraints on dividends. DG’s shareholders have had a long drought on their initial investment – not a penny of cash returned. Sukuk holders have at least seen interest.  No doubt cold comfort for the latter and insult added to injury for the former. 
Or for capital expenditures.  The latter unlikely to dramatically change DG’s business because the amounts would be modest on a yearly basis. 
Improve ROAA
With limited access to debt or equity capital DG’s opportunities to make substantial investments in new businesses to bring ROAE up to a level required for its risk profile appear constrained.  Substantial payment of arbitral awards could provide DG with the capital to expand its business.  This seems like a low probability event.  And if funds were received, could suitable new ventures with better risk profiles be secured?  

There are other constraints on DG's ability to improve ROAA.  First, DG has a 35% share of Pearl Petroleum Company which holds the concession in the KRG.  Significant changes in the business there would require funding from other shareholders in Pearl. Also if you've read the financials of MOL and OMV, you'll have noticed a reference to their ability to exert significant influence on decisions.  A bit surprising statement for 10% equity holders.  OMV provides the answer in its financials - 100% shareholder agreement is required for certain (unspecified) decisions. (Note:  I am not advocating that DG double-down its "bet" in the KRG).  Second, at the macro level weak or declining energy prices could also frustrate the best laid plans.  AA isn't placing any bets on a boom in energy prices these days.
As always comments criticisms, and alternative views are welcome.

4 comments:

Anonymous said...

Fact that they went down this road clearly tells me that they have no future plans to tap debt markets, or some really bad advisors... Whether they could pull off a rights issue is also questionable, maybe its all part of a plan to take it private

Arkad said...

Insightful. We wonder if Goldilocks did similar math before building a stake in the stock.

Note the period in question is one of falling interest rates (to record lows). Assuming that a bottom is forming/has formed in rates, the return hurdle to justify use of leverage is only going to increase from here.



Abu 'Arqala said...

Anonymous

Thanks for your comment.

DG's strategy is puzzling.

Without debt financing, they are fated to offer shareholders a return equal to their ROAA. I don't see their being able to significantly increase ROAA to make the stock attractive in the market or to private investors. Debt is also the usual ingredient to grow a business.

As I noted earlier, DG has a perfectly "good" reason to restructure. The KRG isn't paying them they can't pay the sukuk holders. I can't see a reason why they needed the "clever boots' maneuver.


So what are other explanations for the strategy?

(1) DG is in real trouble and this is a desperation play. They perceive a "life or death" situation. Take the experimental drug that kills patients 10% of the time because you've got a 90% chance of dying from the disease.

(2) There's something else going on and like the President of a once great nation DG is seeking to divert attention elsewhere by creating controversy.

(3) DG is employing what used to be called "Soviet" negotiating style. Make an outrageous demand in the hopes that the natural tendency to compromise will get them to their real goal. Say they want 5% or 6%.

Let me know if you have any comments on the above. And more importantly continue posting.

Interchange of opinions is always beneficial.

Abu 'Arqala said...

Arkad

Nice to hear from you. Thanks for your gracious tweet highlighting this post.

Goldilocks.

(1) An interesting "investor". GFH and DG. Maybe running a kennel instead of an investment fund? I suppose if you believe in fairy tales, you might believe in these two firms. But Goldi should be careful that bears don't eat it.

(2) Maybe trading on inside information? Misinformation? DGs PE is some 90X which puts it in "hard to justify" territory and it's not even a tech firm or Amazon (PE around 200x). Maybe the KRG is going to pay up?

(3) Or perhaps Goldi's mission is to boost stock prices? If DG stock has been pledged for loans, then a borrower might want to make sure the price doesn't trigger a margin call.

(4) Don't know much about Goldilocks. Do you have any insights?

Interest rates.

(1) Spot on. As interest rates rise, COF will go up.

(2) With DG's risk profile the margin plus the higher COF will raise the cost of debt placing downward pressure on stockholder's returns because ROAA is unlikely to move much. It's also a problem for sukuk holders assuming they not only want an appropriate return for the risk, but also don't want to be underwater on the rate.

(3) Interest rate impact on commodity prices. As interest rates go up, will commodity prices (oil, gas included) go down?

Private/Public

One lesson AA learned from his brother was that when there is a private company and a public one that have common ownership, it's good to make sure that there is no "transfer pricing" going on to shift profits or losses between the companies. I haven't been able to find Crescent audited financials to check on how their KRG business is doing.

Cheers