Khaleeji Commercial Bank – Dismal FY 2019 Results & Suggested Questions for Shareholders for the AGM

UPDATED FOR INFORMATION CONTAINED IN KHCB'S OGM/EGM ANNOUNCEMENT. 

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Some quick comments on KHCB’s FYE 2019 financials.

Plus an additional section with suggested questions for shareholders for the AGM.

The bank reported a net loss of some BHD 15 million due to BHD 20.4 million in provisions for FY 2019.

But if you’ll look a bit closer you’ll see that actually provisions for troubled debt were really more than BHD 20.4 million. 

They were just called something else.

As often occurs with the adoption of new accounting standards financial institutions are allowed to make prior period adjustments.

That is, they do not have to include the amount of the total adjustments or provisions required in current year’s income, but only the current year's portion.

So they "pretend" that they made the adjustment in the previous financial year (hence the need to restate that year's numbers) and only have to book the "catch-up" since then in current year's income.

This is the case with AAOIFI’s FAS 30.

Sometimes there is an added benefit. The new standards do not require a formal restatement of the prior period financials.

What that means is they make the change in the prior year's financials but do not have to label that year as "restated".  

This is the case with FAS 30 as outlined in Paragraph 63.

This isn’t idiosyncratic behaviour on AAOIFI’s part. IAS and FASB do allow this on some of their new standards.

What this means is that you don’t see the word “restated” above the comparative numbers for FY 2018 in KHCB’s FY 2019 financials.

Why is that a potential problem?

The word "restated" alerts you to the fact that a material change has been made in the financials. 

When it's not there, you might overlook a significant development.

Usually prior period adjustments are not positive events, though sometimes they are.

That’s why you can’t just look at the Balance Sheet and Income Statement. You also need to look at the Cashflow Statement and the Changes in Equity Statement and read the notes.

Looking at the Statement of Changes in Consolidated Equity in KHCB’s FY 2019 report, you’ll notice a BHD 11.1 million prior period adjustment for FY 2018 associated with FAS 30.

What this means is that the provisions required were actually BHD 31.5 million.

Why care?

That is roughly 33% of shareholders’ equity.

As a result of these provisions, KHCB’s equity fell to BHD 85.7 million as of 31 December 2019.

As their auditor points out in Note 1, this is below the minimum capital of BHD 100 million required by the Central Bank of Bahrain.

Further in that note, you will “note” that

The Board of directors has mandated an international bank to assist it with issuing additional tier 1 capital (AT1) of BHD 37.7 million to help strengthen its equity and meet the regulatory requirements.

Suggested AGM Questions for Shareholders

In light of these developments some suggested questions for shareholders to raise at KHCB’s AGM.

Amount of New Capital

1. CAR remains a very acceptable 16.5%.
2. Why is KHCB raising BHD 37.7 million 2.5x its capital shortfall of BHD 15 million?
3. KHCB have announced they will seek EGM approval for up to a USD 200 million sukuk as new capital.
4. Why is KHDB now raising potentially 5x its BHD 5 million equity shortfall?
5. Does the Board or management anticipate the need for further provisions or the occurrence of other problems?
6. Is the CBB requiring that KHCB have more than the minimum BHD 100 million in shareholders’ equity? Admittedly a difficult question for the Board for a variety of reasons.
7. Is KHCB planning any acquisitions?
8. Have existing major shareholders advised whether they intend to participate in the new equity?
9. Hint: It’s not a good sign if they are not interested.

Form of New Capital and Impact on Shareholders

1. Is the AT1 Capital going to be in the form of preferred stock or a similar instruments, e.g. cocos?
2. KHCB will ask shareholders at the EGM to approve up to a USD 200 million Sukuk as the instrument.
3. That’s a more likely scenario than additional common equity because the potential direct dilution of existing shareholders would be significant unless they contributed additional equity.
4. Assuming the new equity is in the form of preferred stock or similar preferred instruments, what will be the impact on shareholders’ ability to receive dividends?
5. Usually these instruments have preference over common equity so payments to the new AT1 Capital will reduce the amount available for common dividends.
6. It’s likely that the new AT1 Capital will lead to a reduction in the market price of common stock given its size relative to existing equity, its likely pricing and privileges vis-a-vis common equity.
7. If on the other hand, it is going to be issued as common equity, what is the dilution impact on existing shareholders? 
8. It would appear to be rather large because of the amount required.
9. AT1 Capital of this size is not going to be cheap.

Alternatives – Treasury Shares?

If you’re like AA, you will have noticed the BHD 11.79 million in Treasury Shares and wondered if these were an alternative that would spare the existing shareholders some pain.

But note this is "efficient" only if KHCB has to raise BHD 15 million not BHD 37.1 million in new Tier 1 capital.

Treasury Shares are deducted from equity. Somehow removing these from the balance sheet would increase equity and thus reduce the amount of new capital required.

If KHCB could sell them at its cost (BHD 11.79 million), it could reduce its BHD 15 million capital deficit to roughly BHD 3 million.

Perhaps, the CBB could even be persuaded that the amount was so small that KHCB could be given the “grace” to cover it from profits over a couple of years.

That would obviate the need for new capital and prevent loss of value of the existing shareholders.

Alas, KHCB’s average cost per Treasury Share is BHD 0.1138.

If it could sell all its shares at market price – not a likely scenario given the size of the “block” and less than enthusiastic appetite for KHCB shares--, it would as a best case raise about BHD 5.4 million based on the closing price of its shares on 2 March  2020. 103.6 million Treasury Shares* BHD 0.052.

However, selling such a large block of shares would decrease the realized price. So the actual amount would be less.

The BHD 6.4 million “loss” on the best case sale (=103.6 million TS * (BHD 0.052-BHD 0.1138) would be a transfer of BHD 6.4 million from the Treasury Shares sub-account in equity to Retained Earnings in Equity.

So it would not affect the total for shareholders’ equity.

And thus not increase or decrease the amount of funds KHCB has to raise to “cover” the BHD 15 million shortfall. Only the cash received would decrease the amount needed to be raised.

Now, if KHCB were to cancel its Treasury Shares, it would recognize a loss of par value (BHD0.10) less average price (BHD0.1138) times 103.6 million shares or roughly BHD 1.5 million.  

That would mean that the BHD 15 million deficit would reduce to about BHD 5 million. The same logic for grace might apply, thus eliminating the need for any new capital.

The question would be the trade off.

Is the benefit to existing shareholders (quantified in BHD terms) of avoiding the issuance of new equity worth more than the cost of canceling the shares and wiping out forever the BHD 11.79 million spent on Treasury Shares.

One would probably want to analyze this in terms of various presumed "recovery" rates (selling prices) of the Treasury Stock. 

If, however, KHCB must raise BHD 37.1 million, then this method would be of limited utility.

As an aside, shareholders might want to ask their Board to remind them again of the compelling business logic of KHCB acquiring roughly 10% of its shares as Treasury Stock.

This may also be a topic that KHCB’s regulator should consider though sadly retroactively.

There’s not much that can be done about past purchases, but KHCB could be required to gradually decrease its holdings of Treasury Shares to a much lower level.

It may also be a 'wise" move for the CBB to ask all regulated entities with significant holdings of Treasury Shares to report to the CBB if the average cost of the holdings is materially different than the current market price.