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

UAE
Egypt
KRG
Total
2016
23
154
78
255
2015
4
125
142
271
2014
4
225
247
476
2013
5
225
230
460
2012
5
237
258
500
2011
5
290
226
521
2010
4
264
82
350
2009
4
192
42
238

 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?


2 comments:

Arkad said...

With Dana Gas now repealing their offer to re-issue the sukuk on more favorable terms, and instead pursuing a court determined outcome, one presumes no sane investors will lend to the firm or subscribe to any new equity it issues.

We struggle to see how DG can remain a going concern at this rate, unless these KRG receivables are literally on the cusp of being paid.

Abu 'Arqala said...

Arkad

Nice to hear from you.

I puzzled as well. DG seems to have gone from "clever boots" to "clever socks" with its strategy.

Unless for example, ....

the legal structure of the deal is unsound. That is, rights to the trust assets are not enforceable.

legal procedures in the UAE regarding corporate insolvency/bankruptcy are such that creditors' rights are largely imaginary. Or that procedures can be made to proceed at a glacial pace. Two unrelated points: (1) NBUQ and Global Kuwait were in an epic legal battle in the UAE. (2) The DIFC exists because the Dubai Govt believes that the UAE onshore legal system is unsatisfactory.

As to payment by the KRG, there were some press reports in 2016 that the KRG was pushing Washington for funds to fight ISIS claiming their finances were tight. I recall seeing figures being thrown around in the press that the KRG was $18 billion in debt then. Plus the usual problems with corruption.

The "problem" then was ascribed to Baghdad tightening the financial screws on the KRG by withholding funds. A key issue related to KRG revenues is the volume of their direct sales to/through Turkey versus those through SOMO. If they sell through SOMO, then Baghdad decides how much they get paid and when they get paid. Direct sales were (are?) at lower than market prices and there is a limited customer base. Turkey no doubt likes the greater energy independence that KRG sales represent but perhaps not enough to see the KRG become independent. In any case for DG to get paid in full, the KRG has to cut a check for roughly USD 2 billion. That's no small amount.

Have you heard anything more recent about KRG? Any thoughts about the accuracy of press reports I mentioned above.

Best AA