Zain Share Price and KSE Decline - What are the Implications?

There has been a lot of analysis about the decline in Zain shares and the implications for the Kuwaiti market.  Usually along the lines of the importance of Zain's volume.  Here's one from AlphaDinar.  A good explanation of the key role played by the blue chip Zain.

What I'd like to do is look at the implications of a prolonged decline in Zain's share price and in the KSE  on local borrowing and debt service.

First an introduction to set the stage.

Anyone familiar with the term "Kuwaiti investor" also knows that this term is generally associated with the terms  "capital appreciation", "OPM",  "leverage",  and "collateral".   And only rarely with the concept "cashflow from operations".

Let's deal with these one by one.

1. Capital Appreciation - The typical Kuwaiti investor has a unique "appreciation" for the strong potential of his assets to increase in value.   Cashflow is generally a secondary consideration if at all.  The belief is that in the not-too-distant future one will be able to sell one's assets to another party at a substantial premium. A trade sale.  A primary market sale or IPO.
   
2. OPM - Other Peoples' Money - especially bank debt - is always preferable when funding investments. If something unexpectedly goes wrong, one has not committed one's own capital to the  full entry price.
   
3. Leverage - The more that one can lever one's investment the higher the IRR.   And the more one can lever one's equity into multiple investments, the richer one can become  Also, if as is typical one's investments have no appreciable cashflow,  the ability to secure additional borrowings is a lifesaver when it comes time to pay the interest on the original loans.  As you'd expect, this works really well in a rising market.  The lender believes it has extra collateral and so can extend another loan.  Local lenders  too share the appreciation of capital appreciation.   In a small overbanked market like Kuwait, it is also difficult to get new customers.  A bank grows with its existing customers - one way or another.  And what bank does not want to grow its bottom line and balance sheet?  But a key risk is overlooked:  cash funded debt is being based  primarily on paper increases in value  - which are subject to negative as well as positive investor sentiment.   
   
4. Collateral - The way to get leverage is to pledge one's assets.   And to the extent that the same asset can be used to support more than one loan the higher one's leverage.   As the asset increases in value, one gives a second lien to another hungry banker and then builds a whole new pyramid of investments. And this brings us back to another virtue of using OPM:  in the event of a problem  with an investment, the investor (borrower) can simply walk away surrendering the asset to the lender. 
   

The result is an inverted pyramid of investments fundamentally supported by growing debt.

Second, now to the analysis.

What could go wrong?

1. In 4Q07 the Central Bank of Kuwait tightened the calculation for 80% loans to deposits ratio moving from a month-end basis to a daily average basis.  (Page 36 here).  In 1Q08, in an effort to control inflation, the CBK pushed banks to lower commercial and consumer lending.  The money tap was turned to a trickle.
2. In 3Q08, the global financial crisis hit.  Foreign banks began restricting loans.  As the tide of liquidity flowed out, asset values declined.  
3. A double barreled effect.  Not only were new funds cut off.  But as asset values declined, collateral values for existing facilities eroded.  Lenders began demanding reductions in principal of loans.  And banks might demand that interest actually be paid.
   

Where to get the cash?

One turns to one's best asset.  One that actually generates cashflow.  For example, Zain.

Plan A was to try to sell off a division or two (initial focus Africa).  Sales proceeds could be dividended to "needy" shareholders. 

That didn't work out. 

So Plan B is to sell a stake to a strategic investor.  Recently Zain shareholder(s) announced the sale of 46% of existing shares to a collection of  Indian investors "Vivasi Group".   Note:  Zain is not issuing new shares to fund expansion.  Existing shareholders are cashing out to get needed cash.

The problem is with Zain's share price down to KD0.960 (Market Cap KD3.93 billion US$13.8 billion - down 50+%) Plan B gets more difficult.  Just this week, BSNL announced that it saw the need to renegotiate the price.  As you might guess, they're not offering to pay more.

The problem is further compounded because as the market drifts lower more investors' collateral is worth less.  Lower collateral cover is generally accompanied by higher banker anxiety and demands for additional collateral or cash.  This affects not just individuals but corporate entities - like the investment companies.  Or the "industrial" companies in the country many of whom only had profitable years in the past because of their investment portfolios.   Let me emphasize that point to make sure it's clear:  their actual business operations did not turn a profit.  They only made a profit because of   (paper) investment income.

With that as background the import of the decline in Zain and the KSE is outlined in stark fashion.