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| You Should Have |
A shareholder's relationship with the board of a company in which he or she has invested in is similar in several ways to the relationship of a younger sibling with an elder brother.
This isn’t the
first time I’ve posted on this topic.
Earlier posts here
and here
have focused on quantifying the costs to shareholders.
Today I want
to step back and offer some hopefully informed
speculation
on what might be going on.
See if you
agree
Treasury
Share Transaction Basics – Not an Income Statement Event
To
provide a framework for this post, some basics on Treasury Share
transactions.
Under generally accepted accounting principles, gains
or losses on Treasury Share transactions are reflected directly in
shareholders’ equity in the Consolidated Statement of Changes in
Owners’ Equity.
That is, they do not appear in the Income
Statement.
And because of this some shareholders might miss them!
However, when a firm engages in these transactions, there
is an economic gain or loss to shareholders, particularly because
most of the time these are cash transactions.
Thus, it's proper to
consider them as "income" or "loss" as I will in
this post.
And it's important for shareholders to be aware of them as these transactions affect the value of their firm.
History
of GFH Treasury Share Transactions
As
the chart below demonstrates, it’s only since 2017 that GFH has
become very active in Treasury Share transactions.
Both the volume
and value of transactions has increased dramatically during this
period as have FYE holdings, shown here in USD terms (EOP Value) and
as a percent of total issued shares (% TIS).
| GFH Treasury Share Transactions |
| Millions of US Dollars |
| FYE |
Buy |
Sell |
Cancel |
EOP Value |
% TIS |
| R2014 |
$0 |
$0 |
$0 |
$1 |
0.11% |
| 2015 |
$5 |
$2 |
$0 |
$4 |
1.09% |
| 2016 |
$7 |
$11 |
$0 |
$0 |
0.10% |
| 2017 |
$83 |
$25 |
$0 |
$58 |
2.89% |
| 2018 |
$161 |
$134 |
$0 |
$85 |
6.94% |
| 2019 |
$215 |
$177 |
$51 |
$73 |
8.05% |
How
did GFH fare on these transactions?
Over
the period FY 2017 through FY 2019, GFH has incurred losses on
Treasury Share transactions totaling USD 58 million.
USD 3 million
in FY 2017
USD 27 million in FY 2018 and
USD 28 million in FY
2019.
Beyond that in FY 2019 GFH canceled Treasury Shares that it
had purchased for USD 51 million.
In
FY 2019, it acquired USD 32 million in Treasury Shares for a “share
incentive scheme”. No economic gain or loss but a use of GFH shareholders' funds.
It also obtained OGM approval to use 140
million of Treasury Shares for an acquisition or acquisitions,
subject to CBB approval.
That’s a quite a lot of expensive
Treasury Share transactions –none of which appear in GFH’s
Income Statement.
Let’s take a closer look to try and understand
what is going on and why.
2019
Treasury Share Cancellation
After
having acquired 207,547,170 shares of its own stock for USD 51
million, the Bank with the approval of shareholders and its regulator
canceled these shares of stock.
Instead of canceling them, the
Bank could have retained these shares or sold them back to the market
and obtained cash. Perhaps, not USD 51 million in cash but likely a
substantial portion of that amount.
Why
then would it cancel the shares?
There is a theory that share
buybacks and subsequent cancellation of the shares can improve both
the book value and market value of a stock because reducing the
number of shares increases earnings per share (EPS).
This assumes
that the cost of acquiring the shares, including future earnings on
those foregone assets, is less than the value
created by cancelling them.
Disclosure:
AA doesn’t believe this theory.
Increasing
the price of an individual share does not increase the value of the
firm.
If a company wanted to increase the price of a share, it could simply do a reverse stock split. Number of shares reduced, EPS increaased, no large amount of cash spent.
Buying and then cancelling shares may in fact decrease the value
if the purchase of the shares removes cash or other assets that the
firm needs to increase its value or maintain its ongoing earnings
stream.
There is in AA’s view one possible exception. When a
company has cash but no compelling investment opportunities, then a
share buyback may make sense if tax laws favor capital gains over
ordinary income.
Absent that, these transactions tend to amount to
spending real assets to achieve an accounting gain.
But let’s
assume the theory does work.
After all as Madame Arqala could tell
you, AA is not always right.
The quantum of shares extinguished
needs to be significant to have a significant effect.
GFH
extinguished roughly 5.6% of its existing shares.
It’s hard to see
this having a material effect on the per share price.
According to
AA’s rough calculations and assuming this theory has validity, the
price of a GFH share would have increased USD 0.01 in 2019 assuming a
P/E of 10x.
But there’s more that makes this transaction
baffling.
Having extinguished the shares, GFH proceeded to issue
bonus shares equal to the number of the shares it cancelled.
In
effect undoing whatever value enhancement the cancellation may have
had.
The cost of this apparently pointless exercise? One that had no
apparent positive
impact
on its shares, save for an accounting “gain” of USD 4 million?
In
case you’re wondering that gain was also refected directly in equity.
A mere USD
51 million in cash in exchange for USD 4 million in non cash
“income”.
What are some comparable amounts?
It’s
roughly 45% of FY 2018 reported net income attributable to GFH
shareholders!
Or 64% of that in FY 2019.
What would motivate GFH to
do this?
AA believes that GFH wanted to make “room” to buy more
Treasury Shares because the Central Bank limits the number of Treasury
Shares GFH is allowed to hold.
To do this GFH would have to find a "way" to remove the Treasury Shares from its balance sheet.
That means a sale or
cancellation.
It almost certain that GFH couldn’t find a buyer for
a block sale or block sales in “off market” transactions because
there just wasn’t appetite given GFH’s condition and
prospects.
That would mean GFH would have to sell those shares “in
the market” almost certainly lowering the price of GFH stock.
Thus
offsetting the effect of GFH’s purchases and undoing all its previous "good" work. The stock has been in
slow decline for some time now.
So cancellation was the one
remaining option if GFH wanted to continue Treasury Share purchases
to "support" its share price.
I can’t think of another good reason for this bizarre
economic transaction.
Keep that thought in mind as we take a look at
GFH’s Treasury Share purchases and sales.
Treasury
Share Purchase and Sales
Why
would a bank be buying and selling its shares?
There are several
reasons.
Market
Making
One reason is to provide liquidity to the market so that
shareholders can buy and sell their shares without causing temporary
demand/supply imbalances that move the price dramatically.
GFH have
engaged SICO to make a market in GFH shares on the DFM and BSE.
Until recently the KSE did not allow market making.
What
does a market maker do?
The canonical answer is that a market maker
supplies liquidity to the market, filling in transient gaps on the
demand side (purchases) or supply side (sales) as needed.
How does
that role help the market in a company’s shares to run
smoothly?
Buyers or sellers can conduct their transactions without
having to conduct transactions at prices significantly different from
the “fair” value of the shares.
Two simple
examples.
Shareholder Abdullah wants to sell his shares on the BSE
but there are not any or not enough interested buyers close to his
desired price to fill out the buy side of his ticket.
The market
maker steps in to supply the missing demand at what the market maker
believes is a fair price.
Brother Abdullah can sells his shares to the market maker without having to reduce his price dramatically, conduct his sales
over a prolonged period, or not sell all the shares he wants.
The market maker now owns the shares. He either holds them in "inventory" so he has sufficient shares to fulfill his responsibility on the sell side. Or if he has "too many" shares he gradually sells shares into the market to reduce to the appropriate level.
On the
other hand, suppose Brother Jassim in the UAE wants to buy GFH shares at
the DFM but no one is selling in the amount he wants to buy. The
market maker steps in to save the day, selling from his (the market maker's) inventory of GFH stock.
The market maker of course keeps a sharp eye on price trend in the stock and generally holds no more "inventory" than he needs to in order to fulfill his role. The last thing he wants to do is hold shares that lose value.
If, by a happy circumstance as appears to be the case here, the stock issuer bears the risk of price declines, then the market maker may take a more relaxed approach to inventory valuation.
Over time one would expect
that the market maker to earn an appropriate profit or break
even.
If market making results in continued large losses, then this
is a sign that the “problem” with the particular stock is not
liquidity but rather fundamental value. Or a system wide lack of
liquidity in the market. That would be noticeable across more than
one stock though. Or the market maker is an idiot.
Two years seems to be more than an adequate time
frame to make the call on GFH shares.
It’s not liquidity.
It’s
lack of demand, fueled no doubt by investors’ ratings of the
stock.
SICO is a professional shop. It acts as market maker in the BSE and DFM for other shares and seems to be doing quite well.
Because it's not one of the two latter cases, then what's happening is that GFH is trying to
support its share price.
A completely different goal.
And
one that perhaps should not be called “market making” so much as
“share support”.
If shares continue to decline, then it seems
that all that is being accomplished is delaying the inevitable and
spending shareholder money on a futile quest.
Let’s look at some
“performance” data.
During
FY 2019, GFH sold Treasury Shares with a cost of USD 177 million for
USD 150 million.
That works out to a gross margin of roughly
negative 15%. That is, for every USD 1 GFH “invested” via a TS
purchase, it received USD 0.85 on sale.
During FY 2018, GFH sold USD
134 million for USD 106 million, a gross margin of negative 21%. For
each USD 1 invested, GFH received USD 0.79.
This
doesn’t look like “market making” it looks like an attempt at
price support as do the dramatic increases in the volumes of transactions.
Less charitable folks that AA might say given the
volumes of transactions and losses involved it looks like market
manipulation.
As noted in an earlier
post, during 4Q18 GFH was responsible for almost 40% of the
trades on the three markets in which it is listed (Bahrain, Kuwait,
and DFM). To be clear that’s GFH Treasury Share transactions as a
percent of total trading on all three markets. Not that GFH was
trading in the KSE.
That, as you know, is a critical time of year,
when firms and funds prepare their annual audited financials. A time
of year when auditors get serious about the numbers they are asked to
audit.
What other reasons might a company buy back its
shares?
Opportunistic
Investments
The
market is underpricing a company’s shares. The company can buy them
“cheap” and then later sell them “dear”.
Given the secular
decline in GFH’s share price over years and its weak condition and
prospects, this doesn’t seem to be a likely scenario.
Rather it
seems that GFH is buying “cheap” and then selling
“cheaper”.
Currency
for Acquisitions
A
company buys its shares in order to use as “currency” in an
acquisition. You’ll recall that GFH obtained shareholder approval
to use up to 140 million of Treasury Shares for acquisitions, subject
to CBB approval
This doesn't seem a realistic scenario..
Why?
It’s
hard to imagine that potential sellers of assets to GFH on
an “arms length” basis
have a substantially different view than the market about the worth
of any shares to be proferred.
However, this method can work in special cases.
A seller who knows that his “fine” assets are worth less than
the asking price, may well sell his overpriced assets for overpriced stock as long as he achieves his goal of getting a certain value for those assets, avoiding a loss, declaring a profit, etc..
Having been around the proverbial IB block multiple times, AA
has seen more than a few valuation miracles.
Ones where buyer and
seller agree values divorced from reality to mutually assist one
another in achieving each other's goals.
You may be familiar with some “round-trip” asset
sales in the GCC where the same assets passed between two parties at
increasing prices over the years with such sales justified by
offsetting changes in the buyer’s and seller’s “strategies”
that promote a transaction.
U wants a pan MENA network of banks and
then it doesn’t.
B wants to sell its network and then it wants to
buy it back.
AA’s smarter brother has even seen one where a
considerable “gift” was given to a debtor in a rescheduling.
Instead of taking 70% of the debtor’s equity as all reasonable
models determined, a compassionate creditor took only 30%.
Thankfully, AA’s brother was not asked to “fix” his model to
show that valuation.
AA’s
“Call” - GFH’s Treasury Share Transactions are Designed to
Support the Price of Its Shares
There
seems to be no reasonable
business rationale for the amounts spent by GFH on Treasury Share
transactions – the USD 51 million in share cancellation and the USD
58 million losses on Treasury Share sales.
Nor any compelling reason
why GFH would suddenly find the need to buy USD 32 million in
Treasury Shares for a “share incentive scheme” in a single
year.
The proposal to use 140 million Treasury Shares for an
acquisition also seems a bit far fetched at least for one on a true
arms-length basis.
It seems to AA that GFH is using the latter two
transactions to provide rationale for acquiring more Treasury Shares.
The goal certainly seems to be to prop up the
price.
The question is for whose benefit?
Well, if a shareholder
borrowed funds to buy GFH shares and pledged the shares to a lender, it would be mighty inconvenient for that shareholder if the
price of GFH shares declined.
The shareholder might have to provide
additional cash to top up the collateral or reduce the loan principal. In extremis, he might have to sell shares at a loss to reduce or repay the loan.
Neither very
appealing.
Declines in the value of unpledged shares can also be
mighty inconvenient if one has to mark them to market.
One’s performance
record is tarnished, hampering new business generation.
One’s own shareholders might ask embarrassing
questions.
A truly uncomfortable position particularly if the
shareholders are VIPs or, as they’re sometimes known locally, VISs.
This may
also explain why GFH declared a cash dividend for FY 2018 despite the
fact that it had no real cash income that year. See post
here.
Dividends help defray interest on a loan.
Dividends also
provide a return on one’s investment. Just the thing one might need if the stock
price is trading down instead of up.
One would expect that
expenditures of this amount would be taken for an important
shareholder.
Who might that be?
The 7,464 Abdullahs with holdings
less than 1% each in GFH- some 62% of all shares-- probably don’t
have the “wasta” or the “weight” to command such
largesse.
That leaves just 15 other shareholders.
14 of whom own
20% of the shares and appear not to be related to one another.
Leaving just 1 shareholder with 10% who no doubt by mere coincidence became a
shareholder one year before the Treasury Share transactions began in
earnest.
Is there incontrovertible proof this is the case and that GFH is trying to prop up its share price?
No.
Just a pattern of behaviour that AA assesses is the most likely
explanation for GFH’s actions.
It may well be the case that
GFH’s Board has heard of problems among the Abdullahs who hold its
shares and is trying to mitigate their troubles.
Or is undertaking
these transactions for solid business reasons that AA isn't clever enough to discern.
As
we say in the region “ الله
أعلم “
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