What are GFH’s Motives for Acquiring KHCB Shares?

لولا اختلاف النظر، لبارت السلع  

 Summary of key points in this post.

• 45% premium over market on 13.64% of shares from Shuaa and Goldilocks.

• Tender offer proposed for remaining 30.95% of shares

• Favorable Impact on GFH’s Consolidated Shareholders’ Equity

Background

On 6 June GFH announced it had increased its shareholding in KHCB from 55.41% to 69.05% as part of the “Group’s strategy to increase its ownership in KHCB.”

On 7 June GFH provided further details as follows:

With reference to GFH Financial Group’s announcement dated 6th June 2021 pertaining to the subject matter, GFH would like to announce that the increase of ownership in Khaleeji Commercial bank was pursuant to a sale and purchase agreement between GFH along with Shuaa Capital and Goldilocks Investment Company, to acquire their stake of 121,726,795 shares for a total of BD 8,764,329.240 equating to BD 0.072 per share.

On 8 June GFH announced that pursuant to Central Bank of Bahrain requirements regarding takeover and mergers, it had approached KHCB’s Board to make a proposed voluntary takeover offer for the remainder of KHCB’s shares.

Deal Analysis

According to the trading data from the Bahrain Bourse, during the period 4 January through 3 June 2021, the average price of a KHCB share was BD 0.050 (rounded to 3 decimal places). Typically the share trades at roughly 50% of book value.

The BD0.0720 acquisition price represents a 45% premium to the average trading price.

Since the GFH acquisition, the price has increased to just below BD 0.070 perhaps in anticipation of GFH offering the same BD 0.0720 price to remaining shareholders.

Apparently, KHCB is quite a valuable asset.

Though one might not have thought so from the fact that

• KHCB required an additional BD 60 million in capital to meet CBB requirements

• GFH had to buy the entire AT1 instrument

Or maybe you read Fitch Ratings comment on KHCB in their reaffirmation of GFH’s B credit rating. (That rating is below investment grade, if you didn’t know)

Following a balance sheet clean-up exercise in recent years KHCB's asset quality has been improving but is still weak and lags higher-rated peers'.

In any case I hope you are confident that the fact that Shuaa and Goldilocks are related parties had no effect on the 45% premium.

That being said, the size of the premium is perhaps perplexing. 

Neither Shuaa nor Goldilocks were inclined to participate in the AT1. That would seem to evidence a lack of faith in KHCB's future.

One might think of them as perhaps motivated sellers of KHCB. 

It is perhaps also difficult to imagine that there were other serious bidders interested in acquiring a minority stake in company where a single shareholder had control.

But then the ways of the market are mysterious and magical. Especially in the land of flying carpets.

Despite the premium, if you look at this earlier post on Goldilocks, you will see that Goldilocks acquired its stake in KHCB from Shuaa for BD0.096 a share. You will also note that KHCB didn’t pay any dividends since Goldilocks’ purchase.

So on this transaction Goldi has a roughly 25% loss from original cost.

No wonder Shuaa doesn’t publish data on Goldilocks’ performance, contrary to previous years.

In the post referenced above I also wondered if Shuaa had held on to its then 3.88% stake.

It certainly appears so because GFH says it bought shares from both Shuaa and Goldilocks and Goldilocks shareholding was 9.76% according to KHCB’s announcement.

Motives for the Transaction

So what is motivating GFH’s acquisition of KHCB?

Only GFH knows for sure but we can explore some possible rationales. 

I've selected two for discussion:

• Overlooked gem
• Increase in GFH equity beyond the purchase price

Other possible reasons for the transaction could be “civic duty”, etc. And more than one motive may be operative.

As you read, you can decide for yourself which, if either, is the more compelling one.

Overlooked Gem

The market has fundamentally undervalued KHCB.

The canny folks at GFH are about to get KHCB “on the cheap”.

Thereby reaping rich rewards long into the future.

Accounting Magic

The key drivers of the appeal of this motive are two “facts”:

• KHCB’s book value per share exceeds the acquisition price

• GFH uses the book value—not the market or fair value—of KHCB’s assets and liabilities (and thus by the process of subtraction also KHCB’s equity) to prepare its consolidated financials.

As of 1Q 2021 KHCB’ s Book Value was roughly BD 0.160

By acquiring the shares GFH stands to benefit from the difference between book value (BD 0.16) and the purchase price (BD 0.072) and the happy application of rules for consolidated financial statements.

121,726,795 shares at BD 0.088 equals roughly BD 10.7 million or US$ 28.4 million.

Compare that to the BD 8.8 million purchase price. 

A not inconsiderable gain on purchase.

You might well ask:

“How can that be? The P/B ratio is well below one. This can’t make economic sense.”

As I’ve posted here before, accounting does not always reflect economic reality.

Here’s how it would work in detail.

Recall that in its consolidated financials GFH records 100% of KHCB’s assets and liabilities in its (GFH”s) balance sheet using the values appearing in KHCB’s balance sheet. Their book values.

Therefore, net assets (equity) are also reflected in GFH’s financials at book values.

As the final step GFH allocates those net assets between shareholders in the Group and Non Controlling Interests (NCI) in the Consolidated Statement of Changes in Shareholders’ Equity based on their respective ownership/voting rights.

With the acquisition of an additional 13.64% in KHCB shares, GFH’s share of the net assets (total assets minus total liabilities) in KHCB will increase.

This increase in equity attributable to shareholders of GFH will be accompanied by a corresponding decline in equity attributable to NCI in GFH's financials.

If its tender offer for the remaining shares is accepted and completed, an additional increase in Group shareholders’ equity will occur.

Depending on the percent take up on the take over offer, the component in NCI related to KHCB may disappear from GFH’s financials.

But there is indeed more!

You will recall (and if you don’t here’s the link to that post) that in connection with its 2020 purchase of KHCB’s AT1, GFH was required to reduce its consolidated equity attributable to shareholders of the Group by US$ 59.9 million in its FY 2020 financials.

The US$ 59.9 million reflects the excess (positive difference) between (a) GFH’s “contribution”--the amount of the AT1-- and (b) GFH’s share of KHCB’s net assets based on its percentage shareholding in KHCB.

Now that GFH owns 69.05% of KHCB, it is entitled to “recover” some of that amount.

Similarly, it will also have to absorb some of the US$ 14.3 million share of issuance costs levied against the NCI in 2020. Perhaps as much as US$ 4.4 million.

We should see the impact of the 13.64% KHCB share acquisition most likely in GFH’s 2Q2021 financials.

Keep your eye on GFH’s financials to see if my prediction comes true and how the related entries are handled.

Are they disclosed separately as in 2020?

Booked directly to equity?

Or perhaps to income?

DFSA Calls for Audit Improvements

Apparently heeding the comments of  The Rageful Cynic on this blog,  Paul Koster, CEO of the DFSA called for improvements in local auditing as reported by Tom Arnold at The National.

“Are auditors doing enough in that respect? I don’t think so,” said Mr Koster. “I think one of the key areas where auditors right now can gain momentum in the level of trust they provide to the financial market is to increase the level of scrutiny and scepticism in regard to the judgement of management in valuations.”

There's the usual commentary as well about the  need for auditors to get more training so they can understand complex financial instruments.

But the most telling quote of all is at the end of the article.

Auditors speaking to The National have previously accused Gulf companies of using similar accounting practices to mask bad assets and called for greater safeguards to avoid such methods.

Accounting in the GCC is based on IFRS which is a principles and not a rules based approach (the latter being the system in the USA).

Under a rules-based system, the accountant and auditor merely ticks the boxes.  If enough boxes are ticked, the transaction passes the test.  Form may over rule substance.

Under a principles-based accounting system, accountants and auditors are to look behind the form of a transaction to the substance.  The Lehman Repo 105 was a very clear scheme to get around the rules.

That local auditors are whining about violations and doing nothing to stop their clients is a very clear indication that the problem isn't training.  It isn't greater skepticism (or scepticism).  It isn't a lack of scrutiny.  

Very simply put, it's a lack of professional ethics.

CitiGroup and Its Magical US$50 Billion in Deferred Tax Assets

While many in the Developed West are liable to ascribe magical powers to those from the East, the Hindu Fakir, a guru at an Ashram, a bank in Bahrain, there is magic aplenty - particularly of the accounting sort- all over the world.

Today we look at one of the USA's major banks with US$50 billion worth of  DTAs (roughly one-third its capital).  Under accounting standards, Citi has to earn some US$99 billion in taxable income over the next 20 years to fully utilize the DTAs.

Like me I'm sure you're thinking surely there must be an "Islamic" equivalent.  Perhaps a Deferred Zakat Asset.  I'll be watching my favorite financial institutions in Bahrain and Kuwait to see if this shows up in their financials.

In response to a comment from Chapter 11, I'd note that of Citi's US$50 billion in tax credits, approximately US$31.5 billion are disallowed from computation of regulatory capital.  See Note #4 on page 36 of its 2Q10 10-Q.

Gulf Finance House - 1H10 Financials: Now You See It Now You Don't -- The Magical US$137 Million Provision

GFH has finally posted its 2Q10 interim report.

Let's get straight to the heart of the analysis and our headline, Note 15:

"During the period, the Group's credit enhancement amounting to US$ 102 million issued to financial institutions against credit facility arrangements for a project managed by the Group were enforced by the lenders due to contractual defaults by the project company.  Further, based on the Group's assessment of the likelihood that another project will be able to meet the financing when they fall due, the Group has estimated that its financial guarantee of US$ 35 million may be enforced.  In accordance with the requirements of IAS #37, Provisions, Contingent Liabilities and Contingent Assets, the Group has recognised a provision of US$ 137 million towards these liabilities until revised/ renegotiated terms are agreed with the lenders of the project companies.  The Group has recognised an equivalent amount of reimbursement right which has been included in other assets (note 8)."

Presto, changeo with a bit of Accounting Magic a potential US$ 137 million addition to 1H10's net loss is transformed into an asset!  What's even more astounding is that these projects that cannot meet their debt commitments (to the apparently impatient lenders) will nonetheless be able to honor GFH's reimbursement claim upon them.  Now that is truly magical!

(Side Note:  According to my copy of KPMG's Third Edition of "Insights into IFRS" page 635 commenting on IAS 37.35 (about the recognition of Contingent Assets), KPMG states:

"When realisation of a contingent asset is virtually certain, it is no longer considered contingent and is recognised.  In our view, virtually certain generally should be interpreted as a probability of greater than 90 percent."

Unfortunately, I don't have the latest edition so I would caveat that there may have been some new thinking on the topic of what constitutes "virtually certain".)

Taking this amount to the income statement would roughly triple GFH's loss.  It would also breach the US$400 million minimum shareholders' equity covenant.  But there's one more adverse effect making this US$137 million truly a "triple threat".

As we learn in Note #2 during the discussion of the going concern issue, GFH's capital adequacy ratio at 30 June was 12.92% - leaving little room for maneuver or in the words of KPMG "which restricts the Group's ability to absorb further losses or undertake additional exposures".   (Note to KPMG:  You need to amend the reference in your report to the matter of emphasis from Note #1 to Note #2.)

And I suppose -- to add a fourth reason -- such a loss and such consequent events might make a difficult capital raising exercise just a "wee bit" more difficult.

Where there is a need and a will, there is a way -- as the old saying goes.

Turning to the rest of the financials:

1. Note #5: US$115.4 million (95%) of 1H10's US$121.4 million of Placements with Banks and Other Financial Institutions is pledged against commitments and facilities of projects of the Group.   And so should be excluded from liquidity.  You'll notice it is in the Cashflow Statement.  Some might suggest that proper presentation would be to have these amounts in Other Assets.  And well they might but to no apparent avail.   Some of this cash may be pledged to those adversely affected projects discussed in Note #15.
2. Financing Receivables US$14 million decline (which took place between FYE09 and 1Q10) is still a mystery to me.  It's not in the cashflow statement so it must have been offset against something else?
3. Receivable from Investment Banking Services declined from US$85.3 million at 1Q10 to US$40.5 million at 2Q10.  I can find a provision of US$20 million but am unable to locate the remaining US$25 million in the cashflow statement.  Another magical offset?
4. Note #6:  Assets held for sale include Bahrain Financial Harbour Company (US$175 million), $50 million of GFH's long outstanding Receivable from Sale of Investments (now reduced to US$44.5 million and carried in Other Assets) plus US$35 million of Financing to Projects.  The first two items will be settled "against receipt of consideration in the form of cash and land plots."  Well, when you can't pay cash why not settle your obligation with a highly valuable piece of (no doubt) blank land.  The upside potential is, well, enormous, especially at current depressed prices! 
5. Other Assets - As noted above there are reductions of some US$85 million (See Point #4 above), against the introduction of reimbursement rights of US$137 million whose collection is no doubt at least virtually certain if not certain to a much higher degree.
6. Note 9 updates on the financing.  The LMC US$100 million facility (US$80 million outstanding) carries a "profit rate" (read interest rate of 8.5%!).   The rescheduled West LB facility a 3.75% profit rate (reduced from 5%).  This facility is now secured by GFH's shares in Khaleeji Commercial Bank, which no doubt explains why the promised sale of this asset suddenly was postponed.  Perhaps, the collateral will be sufficient cover to prevent an impairment under IAS #39. Also of note during 2Q10 some "wise" and brave lender has provided a US$16.64 million Murabaha financing due in November 2010.
7. Note #10:  Some 69% of Other income (1H10: US$8.6 million) is composed of income declared because certain liabilities were no longer payable (US$4.2 million) and from recoveries of project expenses (US$1.7 million).  

All in all quite a performance in 2Q10.  For those curious that's not a reference to financial performance but the magic of accounting.

Gulf Finance House - 1H10 Financials: Reports of a Turnaround Greatly Exaggerated

On Friday I was quite excited to see that GFH had posted its 1H10 financials and press release thereon.  That is until I printed out the 2Q10 report and found it was actually that for 1Q10.  While the First Quarter was much much better than the Second, I'm assuming this is just a technical glitch, and not a desire to focus on relatively happier days of 1Q.  Hopefully by the time you use the link  above to the financials  all will have been corrected.

In the interim, here are some preliminary observations on the summary 1H10 financials printed in the newspaper, sans as is customary the all important notes thereto.  More detailed comments will follow when the full report is released. 

Income Statement

Revenues

1. GFH doesn't really have much to report for 2Q.  Like Global, GFH's first quarter was much better.  The second for both is rather disappointing to use a charitable term.  
2. GFH had US$7.4 million in revenues during 2Q10 (28.5% of 1H10's US$25.9 million).  In 1H09 the comparable revenues were US$68 million.  A decline of 61% for 2010.
3. 77% of 2Q's revenue was due to FX earnings. I don't believe that GFH has an active Treasury function and so this is probably FX translation gains - a non cash non business revenue. 
4. The US$5.2 million in revenue from "Investment Banking Services" was earned entirely in 1Q10 and as per that Quarter's report US$5.0 million was earned from related parties (Note #11).  That's  96%.  You can tell the economy's bad when when your own "relatives" have no business for you.
5. US$5.1 million in placement, arrangement and management fees, of which 79% was earned in 1Q10.  From the Cashflow Statement it seems that GFH has only collected US$0.2 million during 1H10.

Expenses

1. Staff costs at US$8.8 million are 34% of 1H09's!  Though there is an interesting spike in staff costs in 2010.  In 1Q10 staff costs were US$3.6 million and in 2Q10 US$5.2 million.
2. GFH took a US$20 million impairment provision in 2Q10 as opposed to zero in 1Q10.  This is down from 1H09's US$80 million.
3. The bottom line is that GFH's remarkable improvement in 1H10 versus 1H09 is due primarily to the reduction in expenses from 1H09's US$160.1 million to 1H10's US$73.6 million.  Chiefly reductions in impairment provisions and staff expenses.
4. You'll recall AA's test for a real turnaround in a business is the revenue line.  There is no evidence of any turnaround in the Company's core business. In fact compared to 1H09 core businesses are doing worse.  

Balance Sheet

1. Cash Positions -  Cash increased US$7.8 million largely it seems (though money is indeed fungible) from the sale of US$29.1 million of Treasury Stock for US$7.6 million.  That's a loss of US$21.4 million.  You'll see these numbers reflected in the changes in Treasury Stock and Statutory Reserve in the Equity Account.  An interesting transaction.  I wonder if this was through the market (presumably on the KSE) or a private placement to a wise investor?  Or to a related party?
2. Placements with Banks are down to US$121.1 million at 1H10 from US$156.7 million at 1Q10 and US$455 million at FYE09.  The large drop between FYE 09 and 1Q10 is due to  largely to debt repayments during the first three months of 2010.  In any case, as noted earlier the bulk of the remaining funds are pledged to secure GFH's commitments to make investments.  And so should (unless the 1H10 financials reveal otherwise) not be considered as part of the Bank's liquidity.
3. There was an approximate US$45 million decrease in the Receivable for Investment Banking Services from 1Q10, which I cannot find in the Cashflow Statement.  This may be responsible for the increase in Other Assets by a similar amount?
4. An intriguing new category "Assets Held for Sale" ("AHAS") with a balance of US$260 million makes an appearance in 2Q10.  Apparently a shift of assets from "Investment in Associates".  It will be very interesting to see the basis on which these are carried on the balance sheet versus Investment in Associates ("IIA").  If I remember correctly, IIA are carried at Fair Value Through Profit and Loss.  A change to a different basis for AHAS could have income statement implications., e.g. fair value through equity for one.  As well if they are no longer fair valued but carried at cost, that could potentially - but not necessarily - provide some relief on the recognition of changes in value as "impairments" have a different set of rules than "fair value changes".   The reason my antennae are up on this is because GFH chose 2Q to make this change at about the same time it has signalled that it wants to slow asset sales down.  So I'll be taking a close look at the note on this category in the 2Q10 report  when it is available to see if there is any potential Accounting Magic at work here.
5. Other Liabilities have dramatically increased from 1Q10 and from FYE09.   By US$124 million!!  Hopefully, unlike 1Q10, GFH will provide a note with a breakdown of this category for 2Q10.
6. 1H10 Equity was at US$416.5 million uncomfortably close to the US$400 million net worth trigger in GFH's Sukuk.  Without the 1Q10 remarkable conversion of the Deutsche Bank Murabaha which added US$25 million to Equity, GFH would have breached the covenant.  I use the term "remarkable" because I find it hard to understand why a rational investor would be converting debt in GFH to shares at this point.  Or why there would be a market to purchase GFH's Treasury Shares for that matter.  As I've written before, this transaction's structure allows capital to be infused into the firm without the time consuming process of an Ordinary General Meeting of Shareholders, a Rights Issue, etc.   With the selection of the amount and timing discretionary.  Then again perhaps a wise investor saw and continues to see something here that I don't.

As usual, GFH's Chairman and Group CEO have many favourable things to say about their  imagined turnaround.  And I suppose one would expect them to make these statements.  

However, to attempt to blame GFH's predicament on factors outside its control or to portray GFH as being in the same condition as every other "global investment bank" is a bit much.

First, GFH is not a global investment bank.  It was and is a regional investment bank.  Just as TID, Global, or Shuaa were and are.  In the grand scheme of things looking across the world, rather modest sized shops all of them.  

Second, the list of global investment banks in serious trouble is rather shorter than the list of all global investment banks.   Even if we were to grant GFH temporary hypthetical membership in the ranks of global investment banks, the Goldmine, Morgan Stanley, JP Morgan, Deutsche Bank et al may have tinkered with their strategies.  But they are not fighting for their lives.   Make no mistake GFH is in serious trouble.  Its rating, its share price and its financial condition clearly indicate that.

Gulf Bank: How "Improved" Are Their Financials?

One of our newest readers  raised two interesting questions via our contact page:  

1. He's heard rumors that GB is engaged in restructuring of several large exposures and wondered if I had any insights.
2. Indirectly he asked about the seeming improvement in GB's financials.

Gulf Bank Loan Restructuring

I have no special insight into what's going on at GB.   Perhaps some of our regular readers/commenters - Laocowboy2, The Rageful Cynic, Advocatus, or anyone else out there - may.  If so, please post a comment.

In the interim some speculation. 

Banks restructure loans for a variety of reasons:

1. To agree a repayment schedule with a distressed borrower that provides a reasonable probability of repayment.  The rationale here is to avoid legal proceedings unless absolutely necessary as these generally result in "wastage" of the debtor's estate, particularly in those jurisdictions where creditors' rights are weak.
2. As a pre-emptive strike to keep a loan from falling into the NPL category. 
3. To surgically remove NPLs from the distressed column and transfer them to "restructured" and eventually "performing" loans.  This lowers the total of NPLs and improves the provisions/NPLs ratio.  At FYE09, GB's Specific Provisions covered 43% of NPLs versus 63% a year earlier.  Between FYE08 and FYE09, GB's NPLs increased 138% from KD482.5 million to KD1,148.6 million.  2009 Annual Report here.

The last two can be largely cosmetic - to "manage" problems or at least the appearance of problems.  

Certainly, GB has a sufficient stock of NPLs that it should be busily restructuring away for the substantive first reason mentioned above.  Whether it is engaged in any cosmetic restructuring is not known.

Gulf Bank's Financials - Improved or Not?

Many have noted that for 1H10, GB reported  KD2.1 million in net income versus a loss of KD7.5 million for 1H09.   That certainly looks like an improvement.  But is it?

Two factors were responsible for this apparent improvement:  an increase in the net interest margin of KD11.2 million and an increase of KD22.7 million increase in Operating Income (excluding interest).  Let's take a look at each of them to see where the improvement arises - and if it is due to improvement in the business or to other factors.

The improvement in the net interest margin can I think be explained by three factors.  

1. First, interest expense in 1H09 driven by the aftermath of GB declaring a KD359.5 million loss for FY2008.  If you look at FY2009, GB had total interest expense of some KD119.4 million for the year.  From the comparatives in the 1H10 report, we see that interest expense for the 1H09 was KD72.1 million - 60.4% of the full year total.   Once GB had successfully recapitalized itself, its cost of funds declined in 3Q and 4Q09.  So is the improvement here an improvement in market sentiment due to the raising of KD376 million in new equity? And not a fundamental improvement in the underlying business.
2. Second, pricing increases.  There was an interview with Michel Accad in which he mentioned that GB had repriced (upwards) its facilities.  For some reason, GB no longer breaks out interest income by LOB which would allow an approximation of the gross yield on its loan portfolio.  It stopped with its FYE2009 Annual Report.  Wonder why the change?  With this info we could attempt to quantify the impact of any pricing change between 1H09 and 1H10. to see if indeed  margins had improved.  Using that method for 1H09, we get a gross annualized yield of about 5.6%.  Using this method through 3Q09, the yield is about 5.4%.   If we use the same split between Commercial Banking and Treasury interest as in 2009 (83% as of 1H09 or 84%  for the first nine months of the year 2009) for 1H10,  the 1H10 yield on the loan portfolio is actually lower:  4.9% (1H09 interest split) or 5.0% (Full 3Q09 split).  But that may be an incorrect assumption.  Note to Regulator:  More transparency rather than less is highly desirable.  Note to GB:  Unless you've got something you'd like to hide disclosing this information would be very helpful. Final Note:  This analysis is not conclusive.  The missing step is to see what happened at other Kuwaiti banks'  gross yields to get an idea about the macro environment.
3. Third, as GB continues to aggressively provision for loans (some KD108.5 million so far this year) it reduces its funding cost.  One would expect that the NPLs were already on non accrual so that the provisioning would affect interest expense primarily. One might say that provisioning is inversely related to problems.  On that score, there really doesn't seem to be a fundamental improvement in  the business.

The improvement in Operating Income (excluding Net Interest Margin) is largely explained by "Realised Gains on Disposal of Available for Sale Investments" of KD22 million roughly KD18.2 million over 1H09's earnings for the same category.  A decrease in "Impairment Losses on AFS Investments" of 3.8 million accounts for the rest.

Some observations.

1. Without the AFS asset sale (not a core constituent of GB's commercial banking franchise but a Treasury activity), GB would have recorded an Income Statement loss of KD20 million for 1H10 as compared to the KD7.5 million loss it recorded for the comparable period in 2009.
2. But there's more.  Since GB had already recognized KD20 million of profit on these assets in its fair value reserve (Statement of Comprehensive Income), its Comprehensive Income  for 1H10 was  a KD18.5 million loss versus a KD11.4 million gain for 1H09.  Looking at the Balance Sheet, you'll notice that Shareholders Equity declined KD21 million between FYE09 and 1H10.   And that's the bottom line on financial health - growing equity.  If you're wondering, the extra bit (KD2,5 million) is movement in GB's Treasury Share Reserve.

On a segmental basis, GB's commercial banking division did not make a profit in 2008, 2009, or 1H10.  And I'd note that GB was unable to allocate KD246 million of its 2008 "expenses" to either segment.  Perhaps, they properly belonged as "management overhead"?  

So at this point taking all these factors into consideration, I'd suggest a pause before speaking about "improved" financials.  

There's still a way to go.  To determine when real progress has been made keep your eye focused on:

1. Comprehensive income, looking for a positive number and an increase in Shareholders' Equity from "income" from one period to the next.
2. NPLs and provisions, looking for both to decline.  For provision coverage ratios to increase.
3. Meaningfully positive results in GB's core commercial banking franchise.  As Michel Accad said in part in the 2009 Annual Report in discussing GB's strategy:  "We have redefined our Vision; we seek to dominate the local retail and commercial banking space ..." If commercial banking/retail banking is the key, then GB will be healthy when those businesses are healthy.  Today they're not.

Damas - Auditors' Report

The Auditors' Report has been posted on NasdaqDubai:

This report is being released again due to technical difficulties experienced by some parties in downloading the Auditor’s Report.

Let's be crystal clear here.  This was definitely not due to a failing by the Company, nor its media consultant, nor NasdaqDubai.  Obviously, it's the fault of the downloader.  I apologize for my manifest error and lack of technical skills. 

In any case, Damas' auditors have issued an "emphasis of matter" report.  And that is muted by the language of Note  2 - which avoids such words as "material uncertainty" in reference to "going concern".  Clearly, it's smooth sailing.

Update:  It's been pointed out to me by a kindly reader that the Audit Report itself does contain the sentence:  "“In the event that the financial restructuring plan is not signed as envisaged or the standstill agreement is not extended further, there could be significant uncertainty over the ability of the group to continue operating as a going concern.”

Fair enough.  I stand corrected.

The Curious Case of UAE Banks

Roula Khalaf at the Financial Times:

What’s going on at the banks in the United Arab Emirates? It is an open secret that the deterioration in their asset quality is worse than suggested by the size of problem loans, which credit rating agency Moody’s puts at 4.9 per cent of total loans at the end of last year.

Some accounting magic keeps the amount of reported troubled credits lower than actual.  Renegotiation of troubled credits another way that numbers are managed.   More distress on the way in terms of the full knock-on effects of the crisis.  

But fundamental support for the banking system posited.

No doubt.  

But weakness in the banks will lead to lower loan growth.  Those loans granted will have stricter terms.  And thus there will be an economic price to pay.

The Investment Dar – Review of 2008 Financials

Further to my earlier post, in which I discussed primarily the auditors' report on TID's financials, here are some additional comments.

Treasury Shares

The Consolidated Statement of Changes in Equity and Note 18 (Page 30) shows that TID and its associates owned 60,708,612 in Treasury Shares with a cost of KD45.224 million and a market value of KD6.192 million (13.7% of cost!). 

This is significantly larger than the holdings disclosed in TID's 3Q08 financials of KD9.820 million or 14,097,720 shares. 

Two reasons for the change. 

1. First, the inclusion of holdings of associates. 
2. Second, some minor 4Q08 buying by TID itself. 

Of the two, the associates' holdings were the most important factor. 

1. As at 31 December 2007, they held 35,019,092 shares at a cost of KD21.630 million and at 31 December 2008, 45,135,892 shares at a cost of KD34.993 million. 
2. As of the end of 2008, TID itself held "only" 15,572,720 shares.
   

Let's take a look at trading activity. Unfortunately, TID has not restated its interim financial reports for 2008 so we cannot determine quarterly trading patterns for the associates. 

1. In 4Q08 TID purchased net KD0.411 million. And for the entire year actually sold some KD1.2 million worth of Treasury Shares.  
2. For all of 2008, TID's associates purchased 10,296,800 shares for KD13.363 million. That would mean an average purchase price of KD1.321 per share. When I look at the KSE records for 2008, it seems that March 16 and 17 are the only two trading days with a price of KD1.320 when some 12 million or so shares traded.

Assuming that TID's associates bought their 2008 shares at market and looking at TID's own trading position, it seems there were no significant 4Q08 share transactions by the Group to influence its price – a time when one might have expected an effort to prop up the market value. 

Notable high volume days were 25, 26, and 27 November when 31.4 million, 14.4 million and 15.2 million shares traded roughly in the KD0.220 range. And then again on 17 December when 31.4 million shares traded at KD0.203. And finally on 23 December when 42.3 million shares traded at KD0.157.

Investments at Fair Value through Profit or Loss

In Note 5, Page 19 we learn that "Unquoted local funds with a fair value of KD55,575,647 as of 31 December 2008 (200&7: KD60,710,023) are in funds managed by the Group. Approximately, 52% of the assets of these funds of KD65,287,835 are held by the Group under Murabaha and Wakala payables."

Murabaha and Wakala Placements

Note 7 Page 20. A couple of points here. 

First, as you'll see M&WP with non financial institutions jumped from KD12.7 million in 2007 (7.3% of all M&WP) to KD43.3 million in 2008 (37.6%). From the Note these do not appear to be with related parties. However, TID has some KD51.2 million placed with a related party as of FYE2008. 

We also learn that as of 31 December 2008, it did not hold any collateral on these placements but subsequently acquired KD33.9 million of collateral (exact nature unspecified). 

KD51.2 million represents 44.4% of M&WP which seems a "bit" excessive in terms of risk concentration, especially since collateral seems to have been an afterthought. This amount is roughly 25.4% of FYE08 equity, though year end equity has been depressed by losses and fair value declines so it may be fairer to look at 30 September 2008 equity when the ratio was 11.3%. This analysis assumes of course that TID had no other exposure to this same related counterparty.

Financing Receivables

Note 8 Page 21. TID advises that subsequent to 31 December 2008, it acquired 8.7% of the equity in Bahrain Islamic Bank (an associated company) as settlement of a finance receivable of KD21,237,253. The market value of the shares was KD12,256,833. 

Somehow TID determined that it should recognize KD10,706,237 in goodwill on the transaction. 

And somehow TID's auditors signed off on this. When AA learned his accounting, a transaction was valued by the "boot" received. When there was a market price, that was the "boot" (value). So it's unclear what the basis was for recognizing this rather substantial amount of goodwill.  I guess it's a stark lesson of the need to stay current.  Back to the books for AA!

Investment Properties

Note 10 Page 22. TID advises the subsequent to 31 December 2008, it settled an outstanding Murabaha of KD16,763,386 by transferring property worth KD15,797,730. As a result it recognized a profit of KD965,656 on the transaction! The identity of the "wise" lender in this exchange was not disclosed. Perhaps, the "discount" was the price of an early exit and an excuse from the restructuring. It's unclear how the property was valued.

Investments in Associates

Note 12 Pages 23 -26.

Stehwaz Holding and Rehal Logistics

Page 23. During the year, TID reclassified investments in Rehal Logistics and Stehwaz Holding from investments available for sale to investments in associates where it could use the equity method of accounting instead of the previously used fair value (market price in this case). This reclassification magically created provision goodwill of some KD73.5 million which TID notes it wrote down to KD23.0 million. You may recall from an earlier post of mine that 47 shareholders in Stehwaz had raised some serious charges against TID and the management/board of Stehwaz.  Related to, if I remember  correctly, allegations of manipulation of fair values.  Allegations I'd hasten to note are not judicially proven. Also if I haven't mentioned it before Mr. AlRabah - the peripatetic director at Commercial Bank of Kuwait elected in what was portrayed at the time as a successful campaign to enhance corporate governance was Chairman at Stehwaz during this period.

Boubyan Bank Shares

Page 24. The Note also contains TID's side of the Boubyan Bank share dispute with Commercial Bank of Kuwait. 

Let's let TID speak for itself here.

"The Group's investment in Boubyan Bank (KSC) was transferred to a local bank under a repurchase agreement as part of an agreement with that bank to act as an advisor for restructuring of the Group's debts. The Group revoked the repo agreement when the local bank terminates the advisory agreement. However, the bank did not transfer title of these shares back to the Group but set off its value of KD94,103,965 against amounts due from the Parent Company of KD74,616,098 which is included in Murabaha and Wakala Payables as of 31 December 2008. The Group is pursuing legal action for recovering ownership of these equity shares. The Group carries the investment at its adjusted acquisition cost under equity method of accounting. The fair value of this investment as of 31 December 2008 was KD88,311,406. Subsequently, the Group ceased to have significant influence over Boubyan Bank since it is no longer represented on its Board of Directors when it was reconstituted in April 2009, and has reclassified it as investment available for sale from that date. On 16 June 2009 the court issued a verdict to suspend dealing on those shares temporarily, pending a ruling on the dispute."

This particular disclosure is intriguing, though its wording is obscure. My understanding was that that repo was a new transaction. In 4Q08 CBK bought the shares and gave TID some US$250 million. TID was supposed to buy the shares back in early 2009. On that basis, it's unclear to me how this transaction is related to the restructuring assignment. TID could retrieve the shares (at least theoretically) by giving CBK the cash on maturity. It did not. To be fair, it could not due to lack of funds. 

One other potential reading of this paragraph is that TID gave the shares to CBK in a non cash transaction. That is, it made CBK a secured creditor so it would lead the restructuring. That would seem to be what I'd call a preference (though careful readers aware from my above comment that I lack familiarity with the intricacies of Kuwaiti accounting standards may have drawn a similar conclusion about my knowledge of Kuwaiti laws).   Since this has not mentioned in anything I've seen, I am discounting this second explanation and not as TID did using a 3% perpetual growth rate in my valuation.

Taking the relative share prices of BB at 31 December 2008 of KD0.400 per share and the current price of KD0.540, the shares should be worth roughly KD127 million. If we assume CBK and TID settle for CBK's principal plus additional interest since the setoff, TID should get roughly KD49 million or so in return.

Prodrive

Page 24. During 2008, TID exercised an option to acquire 40% of Prodrive for KD11.2 million of which KD7.1 million is payable and the remaining KD4.1 million is a liability. TID has provisionally recognized some KD8.7 million in goodwill on the transaction. It's unclear what the timing is for TID's payment of these amounts is. Presumably, failure to pay might affect its ownership rights or the acquisition price.

Various "Investment Properties"

Page 25. Again another quote from TID. 

"The underlying assets of certain associates carried at KD237,502,699 in these consolidated financial statements are investment properties in Bahrain and Dubai carried at fair value. The Group's share in associates' results, includes gains on revaluation of these investment properties of KD60,657,096 based on the average of the range of values of independent valuation experts. Subsequent to the balance sheet date, these associates have reported a significant decline in the carrying value of these investment properties. Consequently, the carrying value of the investment in these associates has declined by KD60,622,492 as of 30 September 2009. The associates have not yet determined the impact of change in market values after that date and up to the date of these financial statements."

Impairment Testing

TID has recognized some KD61,560,335 for impairment in associates. It is unclear to me if this amount includes the KD60.6 million related to Various Investment Properties referred to above. Or whether it is before this number? Meaning that additional fair value decreases may be required.

Murabaha and Wakala Payables

Note 16 Page 28-29. This note is interesting for what it tells us about The Investment Dar Bank Bahrain (in which TID has roughly 79% shareholding and so therefore effective control). It seems TIDBB placed some KD253 million with TID on an unsecured basis. This seems a rather large amount / risk concentration by TIDBB with TID. 

Earlier press reports suggest to me (but don't prove) that some of these funds may have been customer investment accounts – in effect Islamic "trust" accounts either RIA (Restricted Investment Accounts where the client designates the investment) or URIA (Unrestricted Investment Account the client does not).

If I'm not mistaken the Central Bank of Bahrain amended one of its regulations for Islamic Banks to limit exposure to a single counterparty of the Islamic Banks own funds, RIA and URIA to 35% of regulatory capital. Often (but not always) when a Central Bank amends a regulation it is dealing with a problem that has occurred. No way to know for sure here. Post hoc does not necessarily mean propter hoc.

Final Comments

After reading TID's 2008 financials, I have some questions about he valuation of  some assets. As later financials are released, this topic will hopefully become clearer.

Global Investment House –Commentary on 2009 Financials & Rescheduling

Earlier yesterday when I saw that GIH had posted summary 1Q10 financials, I decided to do a quick comment while waiting for the full report. 

That reminded me that I had not taken a close look at their audited 2009 annual report. So as a way of preparing to comment on 1Q10 I did. 

Now instead of commenting on 1Q10, I've decided it's preferable to first make some comments about 2009 FYE as a way of providing a basis for later comments. And, as you quickly see, spouting off on a topic or two along the way.

Cash and Banks  - Less Than Appears

Note 12 Page 48: At year end, Cash and Banks was a robust KD101.2 million. A closer look at Note 12 discloses that KD55.1 million was cash at subsidiaries. That is, this cash is in separate legal entities (at least KD28 million at Al Thouraia) and not necessarily at the disposal of GIH. 

AlThouraia -A Strange Saga

Note 24 Page 57: It seems that a KD43.3 million deposit that AlThouraia Properties placed with a local bank was offset by that bank against a loan made by that bank to the Parent, GIH. It's unclear to me what the legal basis for this offset is. Did AlThouraia guarantee the loan made by the bank to GIH? If not, how does the bank cross legal entity lines? 

Particularly, when GIH only owns about 83.36% of AlThouraia, what is the basis for stiffing the minority shareholders on the offset? By the way GIH "recognized" the offset in its financials.   No skin off its nose as they say.

Note 25 Page 57: This discusses the acquisition of Al Thouraia through an asset swap – non cash. The assets are described on Page 58. In effect through this transaction, GIH acquired control of this company, added KD28 million or so to its cash balance, and removed KD83 million in borrowings (from Al Thouraia) from its balance sheet on consolidation. Note GIH does not necessarily have control over the new cash. And it's likely that the KD83 million in debt remains a legal obligation of GIH so that impacts GIH's (the Parent's) cash position contrary to the impression from the consolidated numbers.  It's not only down KD28 million but another KD83 million.  This transaction may also be a very convenient way of dealing with a troublesome issue as discussed below - Saudi Mazaya.

Page 58 reveals that Al Thouraia Project Management Company was established in 2008. Having raised a large amount of capital for no doubt worthy investments, it decided to place most of it with a single financial institution – which technically was not a bank but a entity with an investment firm license. Now why would Al Thouraia's highly responsible board do something like that?   Of course, some out there asked similar impertinent questions about the placements by Global MENA Financial Assets with GIH.

Well, it knew the credit of GIH intimately as this press release shows. And as we learn there: 

"Global announced the launch of Al-Thouraia Project Management Company's capital increase to KD180 million.  Al-Thouraia shall be utilized as a Special Purpose Vehicle (SPV) to invest its whole capital in Mazaya Saudi for Commercial Investment Company "Mazaya Saudi", which has been incorporated in the Kingdom of Saudi Arabia, and will be managed by Mazaya Holding Company "Mazaya". Global Acts as Lead Manager Al-Thouraia Project Management Company." 

If you've been reading the readers' comments to this blog (where you will often find more informed comment than in the main articles), you have seen The Rageful Cynic's link to a post on the saga of Saudi Mazaya.

Debt Rescheduling - "The Most Short-Sighted Unrealistic Deal of 2009"

Note 29 Page 61-62 details the debt rescheduling.  To put my comments in context, note that this US$1.7 billion equivalent deal is secured by US$1.4 billion in principal investments and US$0.3 billion in real estate.  All conveniently hived off into separate companies so that that the lenders should have an easier time of taking ownership.  They merely have to take the equity in the holding companies.  No need to re-register a plethora of individual assets in their own name.

This transaction, as GIH constantly reminds us, won the "Most Innovative Deal" by Euromoney for the Islamic tranche. And you can read more praise on pages 20 and 21 of GIH's 2009 annual report.  Earlier GIH also issued a brochure full of self praise.

After looking through the terms of the deal, I'd like to belatedly award the entire transaction "The Most Short Sighted Unrealistic Deal of 2009". 

A charitable soul would be likely to give GIH's management the benefit of the doubt – that they were coerced into signing this deal.   In evaluating this it would be useful to know just how hard they fought these terms, if at all.

I'm at a loss to find even a single kind word to say about financial institutions that would impose such a deal on a borrower. Banks are not to be faulted for trying to get back the amounts they loaned. But the terms of a rescheduling should be designed to minimize the damage to the borrower.  Milk the cow don't kill it.  

This deal, as you'll see from the details below, does not do this but sets a thoroughly unrealistic repayment schedule and then couples it with interest rate step ups and other onerous clauses. 

Repayment Schedule:

1. Year 1: 10% 
2. Year 2: 20%. 
3. Year 3: 70%. 15% in the first six months, 20% in the next six months and 35% at year end. 

Did anyone in their right mind think this was achievable without causing great damage?  That markets would recover that fast?  Did anyone notice that GIH has almost KD41 million in bonds maturing during Year 3 on top of this debt service? Even if markets have recovered a sale of that size - a literal fire sale - is likely to burn a lot of value up.

Interest Rate: 

1. Year 1: 1.5% plus Libor, EIBOR or Central Bank of Kuwait discount rate). 
2. Year 2: An additional 1% on the margin, taking it to 2.5%. 
3. Year 3: An additional 1 % on the margin, resulting in 3.5%. 

The interest rate step-up is designed to put pressure on GIH to meet the unrealistic repayment schedule. It's hard to see the rational rationale for this.  If the term were longer, say 7 to 10 years, this might make sense (though with the step ups a little more spread out).  But with the short tenor, it doesn't make a lot of sense. How many whips do you need to apply to the horse?   And, if GIH can't sell its assets, another 1% is not going to suddenly cause them to do so.

Fees: 

1. A 1% flat fee on the amount of the rescheduling.
2. Plus 0.25% of the amount rescheduled starting on 15 December 2008 to the date of signing. Both amounts to be capitalized. 
3. Then 24 months after signing another 1% flat fee on the amounts outstanding. Also to be capitalized.   A third whip?  Same comment as above.  If GIH is in a tough spot, an extra 1% on the debt isn't going to move them one way or the other.

Covenants:  

GIH commits to maintain: 

1. Asset value to debt outstanding of .75x. 
2. From 30 June 2010 a minimum Capital Adequacy Ratio of 5% increasing to 7% from 1 July 2011 through final repayment 9 December 2012. 
3. If GIH fails to repay 40% of the original facility amount by the second anniversary, the banks have the right to convert the shortfall into GIH shares. 
4. Finally, the proceeds of any new equity raised must be used to prepay the rescheduled debt. Funny I must have missed that point in previous discussions about GIH's approval of its Rights Offering. Did anyone (including GIH's wise creditors) think that potential shareholders are going to be excited about buying new equity in a firm that can't pay dividends and where the proceeds of the offering will not be used to build the business but to pay back apparently rather greedy lenders? Might it not have been a better idea to let GIH raise capital without requiring that it be used for debt prepayments? On the theory that additional capital would build the business capacity which would strengthen the banks' position.  And of course once the cash was in the till, it could be used for cash shortfalls on debt repayments?  Looks like a case of "wise" bankers shooting themselves in the foot.  One wouldn't use the expression "shoot themselves in the head" here as it's pretty clear there would be more damage caused by a bullet in the foot than one in the head to this wise collection of lenders.

No wonder the lenders were besides themselves with effusive praise for GIH and its management. It seems that GIH gave them everything they asked for. Or perhaps just about everything.  Whether this is all achievable or makes the best sense for the banks is debatable.

The only thing I can think of that would justify such terms would be a profound lack of faith in management - probably based on an adverse assessment of fundamental ethics.  That clearly can't be the case here.  Can it?