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.