Dubai: More Pain to Come

Tom Arnold over at The National has an article on the pain likely to come from Nakheel and Dubai Holding restructurings.

As well as a few quotes from the ratings downgrade of ADCB.  Sounds like Brother Eiraqat already needs more than two 1000 mg Dolgit.

Dubai World: The Impact of the Fixed Interest Rate on Secondary Debt Prices

FOR SALE 

 

Great Price.  One Owner Only! 
Carefully Underwritten and Maintained

Asa Fitch over at The National has a report on secondary loan sales of DW debt.  As per his report only US$25 million has been sold so far by an unnamed Asian bank at US$0.55 of par.

Traders are quoted as saying there is a disconnect between the bid and offer prices with sellers looking for modest discounts and buyers thinking more in the range of 30 to 60% discounts.  That's an extremely wide range - which indicates the lack of real demand.  Also it may be reflective of differing discounts for the five-year and eight-year paper.

For a potential buyer there are two key risk issues with a purchase:

1. Repayment Risk - Will DW settle its debt in full?  So there is a premium added to the "risk free" yield to compensate for this risk.
2. Interest Rate Risk -  DW's debt is at a fixed not floating interest rate.  The price of financial instruments with fixed interest rates moves inversely to the current market level of interest rates.   If you think about that it makes perfect sense.  If the market if offering to sell you a new bond with a fixed 5% coupon, why would you pay the same amount for an equivalent credit risk bond with a fixed 2% coupon and the same repayment profile? You'd be willing to buy the 2% bond only if its price were less than par.  Sufficiently less so that you earned 5% on  the bond. The extra bit of yeild coming from capital appreciation.  This price risk exposure is measured by duration and convexity. Duration estimates the price change using a linear approximation of the price change function (equation).  Since the actual function is not linear, a second approximation, convexity, (technically the second derivative) is used to correct the first. Bond sensitivity to interest rates can work both ways.  If market interest rate levels decline, then one's bond is worth more.  That is, reversing the example above, one has the 5% coupon bond in the 2% market coupon environment.  As noted above in the original example, if market interest rates increase, one's bond is worth less.  Since DW's bonds are at below market rates and since market rates are at historic lows, there is little upside potential.  Any buyer will be focused on pricing the downside risk into it's bid.  Compounding the pricing will be the credit risk element.  Just to complete the discussion, floating rate instruments are less much sensitive.  Their duration is generally equal to the length of the repricing period not a function of maturity.  With, for example, a quarterly interest payment reset one can ignore interest rate risk.

These two factors affect the discount.  The bigger the required yield on the instrument the bigger the discount.

Since I haven't seen much discussion of interest rate risk, and since I think it's an important factor affecting the secondary pricing of DW debt, I'm going to focus on it in this post as you may have guessed from my "succinct" discussion of this topic immediately above.  

This is a structural issue.  As the restructuring was crafted, lenders had two options to reflect the economic value of the debt.  

1. Haircut the debt and get a market or near market rate on the debt. 
2. Maintain the fiction that the debt was worth par and take a below market interest rate.

Why did they choose the structure they did?

Some potential explanatory factors:

1. The importance of cashflow to DW.   DW is cash strapped.  A higher interest rate will impact them more now than reduced principal repayments which in traditional restructuring style are going to be backended.  DW's overriding goal is to delay as long as possible the sale of assets, hoping that an economic recovery will allow them to realise more value.  Or that  a refinance will become possible.  Particularly important because a lot of these were purchased at the top of the market with more than modest levels of leverage. 
2. The wise lenders in the steering group who have the remarkable accomplishment of being responsible for 60% of DW's debt (Another great moment in banking!) are probably not going to be selling because the pain would be too great.  It's much easier to absorb say an US$11 million loss on one's US$25 million stake than say a US$2+ billion loss.  So they have no burning incentive to  create a more seller friendly structure.  They're holding at cost not marking to market.  Assuming DW performs under the restructuring, their "haircut" will be the IAS#39 mandated one time present value difference using the new interest rate versus the older higher one.
3. Forgiving principal sets all sorts of dangerous precedents and raises all sorts of dangerous ideas in the minds of borrowers.  
4. Also since interest rates can't go negative, an interest rate reduction has an absolute bound in terms of the haircut.  
5. Additionally, many folks don't understand the concept of present value so an interest rate reduction is not considered as serious as a principal reduction.  You might be surprised (and maybe some of you dismayed) to learn that in many institutions a principal reduction requires a more stringent approval than an interest rate reduction - even when the present value impact is the same.   With the financial press and the average investor the awareness appears to be even lower.

 As usual,  let's begin with the assumptions:

1. A market-demanded discount of 50% of par.   Roughly in the midpoint of the mentioned discount rates.
2. An average 5 year life for the 8 year DW restructured loans.  Since we don't know what the principal repayment schedule is, we have to assume an average life.  I think five years is a good guess. DW's repayments probably mirror the pattern typical for restructurings:  low payments in the first years with the largest in the latter years.  If equal amortization would result in a bit over 4 years average life, then 5 years should be on the safe side. Use of 5 years then sets what I think is a reasonable upper bound to the YTM.  In any case hopefully enough for a directional analysis.  Hint:  I will gladly receive a copy of the  restructuring term sheet if anyone wants to send it to me.  Use the Contact Form to make the initial contact to agree transmission details.
3. A 2% (fixed) coupon.
4. Repayment in full on schedule assumed.

Here are the numerical results.

We can bound the yield to maturity on the 8 year tenor loan between two  points.

Yield to Maturity ("YTM")

1. Assuming a straight bond with a bullet repayment of principal at the end of Year #8, the YTM is roughly 12%.  While interest payment frequency affects the YTM, the difference is minor.  For our directional analysis, I'm therefore going to ignore it.  12% represents the minimum YTM because the restructured loans provide for principal repayments during the life of the loan not just at the end.
2. Using a 5 year average life, the rough YTM is 17%.

Modified Duration

1. For the straight 8 year bond, duration is very roughly 7 times.
2. For the straight 5 year bond, duration is very roughly 4.5 times. Recall that as above we're guesstimating that the average life of the loan as 5 years.
3. What that means is that if  interest rates increase 1% with no change in default risk (credit rating of DW) and no change in credit spreads (the margin demanded for a specific credit grade), then the DW debt will lose roughly 4.5% of its market value. I've chosen to ignore convexity here because it's not likely to be a significant decrease of the duration impact for  the range of likely market interest rate levels.  Since over the next five to eight years, interest rates are more likely to go up than further down, this is a real risk.  A modest 2% hike in interest rates and there is a 9% loss - which will more than outweigh the coupon earnings.
4. Of course, for an investor who intends to hold the bond to maturity, the price loss will be a mark-to-market event and not necessarily a cash flow loss.  Unless of course the investor sells the bond.  However, a fund or a trader will be marking to market and thus performance will be affected.    With a direct impact on such personally important things  for a fund as fees and reputation for the next fund sale. Or for a trader his bonus and perceived trading skills. You can probably easily imagine how these might increase reluctance to increase one's bid, particularly when demand is minuscule in relation to supply.

Other Factors Affecting Demand

1. Secondary Play:  There is no secondary play here.  Often in distress situations, buyers of debt may be motivated by the chance to acquire a company cheaply (buy the debt wipe out the existing shareholders) or other factors.   Emirates Airlines or Emirates NBD are not on offer.   The restructuring is "done and dusted" so there's no negotiating leverage over deal terms.  And one would have to make quite an investment to acquire a blocking vote on the chance there would be a future covenant hiccup that one could take advantage of.    One of our regular commentators, Laocowboy2 mentioned a time-honored sovereign debt settlement mechanism - using the debt as the currency for investing in a new project in the country.  Often with the debt being exchanged at par (not its purchase price) and sometimes at a favorable FX rate which effectively lower the cost of the investment.  Many an savvy investor in Latin American tourism reaped a bonanza return using this framework.  Others who invested in more brick and mortar enterprises less so.  Hint:  An investor's return in such transactions depends more on the creative use of imaginative transfer pricing than one's ability to run a business, though the latter is important.  In any case,  I suspect it is unlikely that Dubai will offer such a program.  The sovereign debt "hole" here is not that deep. Nor the distress that acute at present.
2. Credit Rating Upgrade:  While the "hole" is not that deep, there is still a hole.  Assuming good performance, at some point DW will be upgraded.  However, this is unlikely to happen in the near term.  By the time significant debt is repaid, it may be so close to final maturity that the impact on YTM may be relatively modest. As well, the structural fact that the debt is at a below market fixed rate is going to work against any significant increase in the price.   
3. Credit Spread Compression:  Usually this occurs in times of irrational exuberance.  Judging by the state of the world economy, a near term return to such giddy days is perhaps not a bet a savvy investor would make today.  And again the very low fixed rate is a negative.
4. Prepayment:  It's unlikely that DW is going to prepay the loan in the near term. If it did,  the YTM could dramatically improve. With a rate this low there is an incentive to ride to maturity. Presumably, the desire to "repay" the restructuring and remove a living blot from its escutcheon would be a motive to refinance (when that was possible).  More importantly, it could alleviate cashflow demands, including the requirement to dismantle its expensively acquired empire of  "core" investments.  The unknown is when banker and investor ADD will kick in and permit a refinance.  A good guess is probably more than 3 years out, particularly as the upcoming US$30 billion of new maturities over the next 2 years will remind the apparently congenitally forgetful and heedless of the "hole".

Dubai Holding: Some Creditors Selling Debt

Asa Fitch over at The National reports that some creditors are looking to exit their exposure to Dubai Holding - DHCOG and DIC - through secondary sales at a hoped for modest discount.

This makes eminent sense in view of the many indirect costs associated with carrying distressed debt.  Costs of additional internal reporting and monitoring for credit purposes as well as for accounting purposes (both book keeping and disclosure).  

On top of all of this, if a creditor feels there is the possibility of an impairment, the decision to close the file  now, recognize the loss and move on may be highly appealing, particularly if there is no long term relationship.  Or if such a relationship is not perceived as being sufficiently profitable in the future.

Clearly, this strategy does not work with banks holding sizable shares.  Unloading a $5 million or US$10 million "bit" is a lot less painful than $50 million or US$100 million.

Dubai Holding Commercial Operations Group - Delays Payment Again Until 30 November

As per an announcement on Nasdaq Dubai, DHCOG is delaying payment on its US$555 million revolving credit facility until 30 November 2010.

In July it announced a two month delay in order to finalize legal documentation.   Perhaps, the drafting is being done by hand?

You'll recall that last January, DHCOG excoriated S&P for downgrading it, claiming in effect that the rating agency didn't know what it was doing.  This may indicate who was right in that debate.

You can use the tags "Dubai Holding" and "DHCOG" to access earlier posts.

DHCOG Secures Two Month Extension on US$555 Million Loan

This morning DHCOG reported on Nasdaq Dubai:

Dubai Holding Commercial Operations Group LLC (DHCOG) confirms that all parties have agreed to extend the existing Revolving Credit Facility (RCF) of $555 million under commercial terms for an additional 2 months. 

 The extension is required to facilitate the finalization of the documentation to renew the facility .

Moody's Downgrades DHCOG

Asa Fitch at The National has an article on Moody's recent downgrade of DHCOG.

"The credit ratings agency downgraded Dubai Holding Commercial Operations Group (DHCOG) by one notch on its rating scale to “B2” from “B1”and kept it on review for another drop. DHCOG, which has large holdings in the hospitality, business parks and property sectors, was unavailable for comment. The group was downgraded to “B1” last December, a rating already considered below investment grade."

You'll recall that last January, Dubai Holding had excoriated S&P for its:

1. manifest "lack of understanding of DHCOG's business, its operations and relationship with the Government of Dubai." 
2. "inaccurate statements coupled with factual errors that are misleading."  

While it may be unclear to some if Moody's is suffering from the same affliction or if S&P was indeed right after all, there's no confusion here at Suq Al Mal.

Dubai Holdings: Detailed Comments on DHCOG 2009 Audited Financials

Further to my post of 5 June, it's time for a closer look at DHCOG's 2009 audited financials.

Before getting into my usually overly detailed analysis, I'd like to highlight some big picture themes that emerge from a review of the Company's 2009 financials.

1. Most commentary has focused on DHCOG's AED15.2 billion in Borrowings. But as with Nakheel, Trade Payables (AED32 billion) and Customer Advances (AED14.2 billion) are more critical obligations. Both in terms of amounts as well as their greater direct impact on the future of the company and the local economy. When various expenses of AED4.7 billion associated with the restructuring/reduction of its projects in process (termination payments, legal claims, etc) and AED1.7 billion in Contractor Retentions (primarily due in the next 12 months)  are added in, it's clear where the potential cashflow stress really is. 
2. As noted earlier, the Company is heavily dependent on Government Subsidies for its profitability. 
3. Severe deterioration in Trade Payables – only 31% of gross receivables are fully performing as compared to 73% the year earlier. In itself this is a relatively minor problem since these represent a small "slice" of total assets. What's more important is that they reveal the profound distress in local markets. 92% of DHCOG's Receivables are denominated in AED and so are with local companies. If you think about it, the last company a local debtor is likely to "stiff" is this Company which is owned by the local Shaykh. Either DHCOG was reaching for business – doing marginal business or these companies are in very dire straits. 
4. DHCOG also seems to have engaged in a rather large amount of investment activity unrelated to its core activities. And with significant amounts committed to other entities within the Group. A clear sign that the companies were not managed in a disciplined fashion but rather as part of a "Group" – similar to the pattern in Kuwait.
   

Now to the detailed comments. (Warning:  A cup of caffeine may be required to remain awake as you read what follows).
 

Balance Sheet

Investment Property (Note 6) (page 45) is carried at AED56.5 billion in 2009 down from AED60.3 billion the year earlier. In 2009 DHCOG recognized an AED27.2 billion impairment charge against Investment Property. AED6.9 billion of this was reflected in the income statement. The remaining AED20.3 billion was reflected as a reduction in Government Grants. Thus, bypassing both the income statement and equity. (More on that topic a bit later).

While DHCOG carries its Investment Property at cost less impairment, it also provides details on fair value. Based on an open market valuation, the fair value of Investment Property at FYE 2009 is reported as AED 81.6 billion down from AED141.8 billion at FYE 2008. Clearly, there is a very serious disconnect between the value of the property calculated using discounted cashflow ("DCF") (which is the basis for the impairment) and the market price (based on what some "wise" investor is believed to be willing to pay for the property). That gap is AED25.1 billion. 

The "market" price is 144% of the price determined using discounted cashflow. Even allowing for the impact of some conservatism in the DCF, the gap is too large. What that suggests is that market price remains high. Essentially when market values like this occur, the implied "capitalization rate" ("cap rate") of the rental streams is very low.   Unrealistically low.

Turning to the liability side of the balance sheet, it's clear that Borrowings (Note 28) (page 69) at some AED15.2 billion are not the Company's major liability problem. Current and non current payables of AED32.1 billion are more than twice Borrowings (Note 32 (a) page 74). Customer Advances of AED14.2 billion (Note 33) (page 75) represent much more significant and potentially critical demands on cash. Of particular note is that all Customer Advances are carried as Current Liabilities – meaning DHCOG has to complete projects within the 2010 to satisfy its obligations to customers. As it builds and hands over properties, then these obligations are extinguished. If it fails to do so, there is potential (note that word) requirement to reimburse customers or renegotiate with them.  And these are not all the liabilities towards the "trade" that the Company faces.  There's an additional AED4.7 billion for Provisions and Other Charges - largely related to termination of contracts.

Another key liability account is the AED36.8 billion in Government Grants (Note 29) (page 72). As discussed in my earlier post (referenced above), DHCOG's profitability and cashflow is essentially based on generous subsidies from the Emirate of Dubai. Strip these out and the Company's performance is much diminished. Notes 2.22 (a) and 6 also discuss Government Grants.

Income Statement

Here the role of Government Subsidies is directly obvious. In 2008, the Company had AED19.2 billion in subsidies and had net income of AED9.8 billion. In 2009, subsidies were only AED0.6 billion. That and substantial provisions led to a loss of AED23.6 billion.

As a side comment, I'd note that there are provisions of some AED2.2 billion included in "General and Administrative" expenses (Note 38) for trade and other receivables as compared to a mere AED0.1 billion in 2008. A strong indication of the distress in the local market.

Consolidated Statement of Cash Flows

See the comments in my earlier post. Cashflow generation is constrained. And to flog a downed horse highly dependent on government subsidies.

Detailed Comments

Here are some items that caught my eye.

Note 2.1 (page 8) – The auditors did not raise a matter of emphasis on management's assumption that DHCOG as a "going concern" because of the availability of external support from the Holding Company and the DFSF.

"As a result of the sudden and sharp downturn in the Dubai real estate market, the Group's cash flows have come under severe pressure. The Group is currently considering various means to manage its cash flows which include roll over of maturing loans, sale of certain assets and renegotiation of trade and contractors balances. The holding company has confirmed its willingness to provide such financial support as may be required to manage the process and has confirmed that it has access to funds from the Dubai Financial Support Fund for the specific purpose."

Note 2.23 (a) (page 28): DHCOG primarily recognizes revenues from land and building sales on a "completed" contract basis as opposed to a "percentage of completion basis". What this means is that there is likely to be a greater mismatch between the timing of cash receipts and the recognition of revenues. When cash is received before the contract is completed, the contra entry to the receipt of cash is "Deferred Revenues". As per Note 32 (a) (page 74) DHCOG has some AED17.1 billion of Deferred Revenues as of FYE 2009. When these revenues are recognized in the Income Statement, there will be no accompanying cashflow. Something a careful creditor should have his or her eye firmly fixed upon.

 

Note 3.1 (c) (page 34): Of some AED24.7 billion in liabilities due within the next twelve months, repayment of borrowings represents only AED3.7 billion. Roughly 15%.

 

Note 4.2 (b) (page 39): Management has estimated its liability for contractor claims for termination or delay of contracts for construction and consultancy, demobilization of contractors, staff repatriation costs, etc., at AED4 billion. Up AED1.4 billion (54%) from 2008.

 

Note 12 (page 56): The Company recognized AED1.5 billion fair value loss in 2009 for its investment in a fund managed by a related party Dubai International Capital. This is in addition to AED1.9 billion fair value loss on the same investment in 2008. Also see Note 20 (a) page 65.

 

Note 15 (page 60): There is clear distress in DHCOG's Trade Receivables. At FYE2008 AED1.9 billion (83%) of DHCOG's AED2.3 billion in Trade Receivables and Advance Payments were "fully" performing. At FYE2009 AED0.8 billion (58%) of AED1.4 billion were. At year end 2009 AED0.8 billion of AED2.6 billion in gross Trade Receivables were fully performing. That's 31% fully performing. At 2008 the comparative numbers were AED1.9 billion out of AED2.6 billion. Or 73%. Past due but unimpaired receivables also showed a jump from AED0.4 billion at FYE 2008 to AED0.6 billion at FYE 2009. This is significant deterioration in a single year. And reflects widespread distress given DHCOG's comment that it "has a broad base of customers with no concentration of credit risk within trade receivables". Looking at currency composition of receivables, some 92% are denominated in AED. That indicates most of these are to local counterparties. So the distress is local. And it must be significant since it's highly unlikely that a local company would "stiff" a company owned by the Ruler. Generally, when there is a serious sudden deterioration in receivables, the suspicious banker takes a look for an APP scenario. Sales or other transactions against receivables can be a highly convenient way of spiriting value out of a company. Since there is no concentration in the receivables, this probably can be ruled out.

 

Note 28 (page 71): DHCOG failed to comply with 2 of 3 financial covenants as of 31 December 2009. It bankers waived these breaches. That means the covenants remain in place. Given the Company's financial condition, they are likely to be breached again. And the creditors will have another chance to use these to apply pressure.

 

Note 30 (page 72): AED1.1 billion of AED1.7 billion in Contractor Retention payments are due within one year. Two observations. The first is the contractual cashflow demand this represents – though contracts may be renegotiated. The second is that this shows that there have been no significant new construction activities undertaken. Another sign of the slowdown.  (Note:  These liabilities are included in Trade and Other Payables).

 

Note 32 (a) (page 74): AED17.1 billion of Deferred Revenues. As discussed above, when these are recognized, there will be no accompanying cashflow.

 

Note 32 (b) (page 75): Provision for Liabilities and Other Charges is at AED4.7 billion up from AED3.0 billion (2008). Important as another potential cashflow demand. As well, this amount has grown rather significantly in one year. Future trends in these provisions should be watched. Note 46 (page 82) has additional information.

 

Note 38 (page 77): General and Administrative Expenses of AED4.7 billion include AED2.2 billion for impairment provisions on Trade and Other Receivables.

 

Note 40 (page 77): Other Operating Expenses provides details on the composition of provisions.

 

Note 42(a) (page 82): The Company eliminated its commitments to invest in private equity funds from AED259 million in 2008 to zero in 2009. It's unclear why an Operating Company like DHCOG is investing in private equity funds. Nor why it was investing rather substantial sums in the DIC fund on which it has lost some AED3.4 billion.

 

Note 42 (b) (page 82): As DHCOG has scaled back its projects, Commitments for Projects in Progress have declined dramatically from AED34.2 billion in 2008 to AED10.9 billion in 2009. The trade-off is increased Termination Claims.   Clearly, one does not shrink oneself to greatness.  Reduction in contracts is a necessary step given the state of the real estate market in Dubai.  All well and good.  But the question then is what is the future for DHCOG.  If its real estate business is reduced to a more modest level what does this mean for the Company - particularly since its profitability was basically driven by selling real estate it acquired at zero cost due to the kindness of the good Shaykh.

Dubai Holdings: Review of DHCOG 2009 Financials – The Business Model

DHCOG's 2009 audited financials as well as the CEO's commentary are available at this link at NasdaqDubai. Earlier audited financials are in the "Related Documents" section here.

Before I get into detailed comments on the 2009 annual report, I'd like to start by looking at DHCOG's business model, particularly its ability to generate cash. This will provide context for understanding DHCOG's ability to address the issues it faces.  A robust cashflow can pay bills directly.  And, if they are lumpy, a sound cashflow provides a basis for accessing finance to pay bills immediately.

In that regard, DHCOG is heavily dependent on Government Grants for both income and cashflow.

Let's start with net income

All amounts in AED billions. Percentage = Government Grants/Net Income.

	2009	2008	2007	2006	2005
Net Income	(23.6)	9.8	13.9	7.6	1.5
Govt Grants	0.7	19.2	10.0	6.6	0.7
Percentage	NM	196%	72%	87%	47%

 

Notes 2.22 (page 27) and 29 (page 72) in the 2009 financials discuss respectively the accounting treatment of subsidies and the amounts involved. 

With respect to the first, when the Government gives DHCOG land, the Company records the land as an asset with the contra entry to the liability account "Government Grants". Upon sale of the land, DHCOG recognizes profit based on the cost of the land. It then also recognizes the gain on the Grant as a separate item. This enables readers of the financials to determine the value added by DHCOG  through its own efforts by separating out the subsidy it has received.

A hypothetical example illustrates the point. 

Let's assume that the Emirate gives the Company a piece of land fair valued at AED100 on 1 January 2009. DHCOG books an addition to Land of AED100 and reflects a liability of AED 100 under Government Grants.  Then assume a sale on 1 July 2009 for AED 110. The Company's total profit is the sale price AED110 since it paid zero for the property.  In its accounting, DHCOG splits the AED 110 into two components:  AED10 in "Revenues" and AED100 in Government Grants.  In this case the Company is only responsible for 9% of the profit. The subsidy for 91%.

That was a hypothetical example.  Let's look at actual profitability.  Over the period 2005 through 2009, the Company earned AED9.2 billion. During the same period, Government Subsidies  were AED37.2 billion. Or 4.04 times net profit! In fact without the subsidies, DHCOGwould have had a net loss of AED28 billion.

As a side comment, the subsidies result in an interesting transfer of wealth from the Emirate to the private company owned by the Ruler of the Emirate.

The pattern is the same when we examine Cashflow From Operations (2009 Note 47).

Again all amounts are in AED billions.

	2009	2008	2007	2006	2005
Gross Operating CF	2.1	5.4	4.7	2.1	0.6
Net Operating CF	0.8	10.0	16.9	4.6	1.3
Govt Grants	0.7	19.2	10.0	6.6	0.7
Govt Grants/NOPCF	88%	192%	59%	143%	54%
Customer Advances	(4.2)	0.5	2.7	8.2	4.5
Deferred Revenues	3.3	7.0	6.4	0.3	NM

 

Not surprisingly, the above table shows a similar critical dependence on Government Subsidies, this time for cashflow. In four out of the five years, Government Grants were larger than Gross Operating Cashflow – that is Cashflow before changes in long term assets and liabilities and short term assets and liabilities (e.g., Working Capital).   By way of explanation, Gross Operating Cashflow is a better measure of the ability of a firm to generate cash from its operations than Net Operating Cashflow as the latter involves transient sources and uses of cash not resulting from the basic business process.

Another key component of cashflow has been customer advances (deposits) on purchases. As the real estate sales machine slows down so will the pace of new investments by clients.  As the Company's CEO, Ahmad Bin Byat, noted in his commentary on 2009, "The real estate market is expected to continue to face challenges in 2010 and 2011 until the excess supply of the existing and expected inventory is absorbed by stronger demand." That likely means no real meaningful additions to Customer Advances. Rather these will be drawn down. And if the recovery in 2012 is delayed or tepid, the situation will continue.

Also the Deferred Revenues point to another issue for the future.  The Company has been receiving cash for projects underway. These cash receipts have been booked as deferred revenues.  That is cash  is received but income is not recognized.  When the projects are completed and handed over, DHCOG will book substantial revenues. As of 31 December 2009, the amount of outstanding Deferred Revenues was some AED17.1 billion. However, when it does, these revenues will not be accompanied by cashflow of this amount.   To the extent that liabilities have increased during this period, a creditor would have to ask where the Company will get the funds to settle these obligations.

As hopefully this analysis makes clear creditors face two issues with DHCOG. The first largley trivial. The second critical. 

1. Continuance of Government Subsidies. A slowdown in real estate may mean an inability to utilize the remaining Government Grants, AED36.8 billion at 31 December 2009, in line with the "Master Plan's" timing. Theoretically, this could result in termination of the grants or a change in the their cost basis. However, since the good Shaykh is giving himself land, he is probably inclined to revise the terms of those grants to accommodate any slowdown. The maintenance of subsidies is the key to the Company's ability to generate significant net income and more importantly the cash necessary to repay debts. With a zero cost of land, the Company is uniquely positioned even  if real estate prices are sharply lower.  It also benefits because it does not have to finance the land prior to sale. No need to raise debt, leaving "spare" borrowing capacity, assuming it has access.  And no interest expense, improving both the bottom line and cashflow.
2. The overall state of the real estate market. While it's highly likely that the Shaykh will continue to see the wisdom of granting land to DHCOG, the real question is whether there will be significant demand for new projects. Property in the Company's "land bank" will do creditors little good if it cannot be sold. As noted above, Byat does not expect a recovery in the next two years. And there are some critical amounts due in that period.  And if he is wrong about the vigor or timing of the recovery, the situation will be even more difficult.

With this the stage is set for a second post on the 2009 financials.
 

Dubai Debt Rescheduling Watch: DHCOG AED23.6 Billion Loss

DHCOG's 2009 audited annual report is out.  AED23.6 billion loss.  Equity at AED14.6 billion versus AED37.1 billion.

More commentary hopefully later today.

Dubai Debt Rescheduling Watch: Dubai Holdings Commercial Operations Group Misses Doctor's Appointment

Following up on Frank Kane's earlier article at The National, I was eagerly anticipating reading DHCOG's financials at Nasdaq Dubai.  Sadly they weren't posted.  Seems DHCOG missed its appointment.

Dubai Debt Rescheduling Watch: Check-Up Time for Dubai Holdings

Photographer’s Mate 2nd Class Johansen Laurel - Picture in Public Domain

As Frank Kane at The National reports, DHCOG's financials are supposed to be out "later today".  And when released will give an insight into Dubai Holdings' financial position.

Moody’s, another one of the other large ratings agencies, still issues reports on DHCOG and recently issued a relatively upbeat assessment.

Nonetheless, Moody’s also confirmed that it rated DHCOG at “B1 and under review for downgrade”. 

Dubai Holdings Commercial Operations Group - Still No Financials

Well, "bukra" is in the official slogan of the Holding Company so this isn't a surprise I suppose.

DHCOG announced today on the Nasdaq that it still didn't have its financials finalized.

"Dubai Holding Commercial Operations Group LLC (“DHCOG”) has further extended the publication date of its 2009 consolidated financial statements, due to the complexities of consolidating the financial results of its various operating businesses across multiple geographies. In accordance with the rules and regulations set forth by the listing authority at Nasdaq Dubai, the voluntary suspension of listing on the exchange of DHCOG’s Medium Term Notes remains in force until DHCOG issues its Audited 2009  Financial Statements and Annual Report on or before May 31, 2010".

Remind me, did DHCOG buy a lot of new foreign subsidiaries in 2009?

Dubai Holdings Commercial Operations Group - Delay in Financials

From today's Nasdaq Dubai.

29 Apr 2010 - 09:34:26

Dubai Holding Commercial Operations Group LLC (“DHCOG”) has extended the publication date for its 2009 consolidated financial statements by two weeks until 16 May 2010 as DHCOG has extensively realigned its operating businesses, undertaken a conservative revaluation of its real estate portfolio, and has conducted a thorough impairment testing exercise across all its projects.

These steps have resulted in a slight delay in completing the consolidation process of its financial statements.

The expressions "conservative revaluation of its real estate portfolio" and "thorough impairment testing exercise across all its projects" are unlikely to be accompanied by bumper earnings for 2009.

Fitch Downgrades Dubai Holdings Commercial Operations Group

You'll remember a while back there was quite a "war of words" between S&P and DCHOG when S&P downgraded them to B.   Among one of the countercharges levied by DCHOG was that S&P really didn't understand what it was doing.  That it had a  "lack of understanding of DHCOG's business, its operations and relationship with the Government of Dubai."

Yesterday Fitch weighed in with a downgrade to B+ - marginally higher than S&P's,  However, their comments will give cold comfort to DCHOG.

1. The rating action reflects Fitch's amended rating approach for DHCOG. The agency now rates DHCOG on a standalone basis rather than a top down parent and subsidiary basis. This is due to a continuing lack of substantive information on the government's ability to support the group in case of need.
2. DHCOG is on ratings watch negative.  The resolution of the RWN could result in a downgrade of DHCOG's ratings by more than one notch.  
3. A resolution of the RWN will be contingent upon the receipt of DHCOG's audited 2009 annual accounts, confirming the group's ongoing ability to generate cash flow, retain adequate liquidity and avoid a potential covenant breach at the December 2009 test date. The removal of the rating watch will also be contingent upon DHCOG successfully refinancing the upcoming July 2010 facility, or obtaining additional government funds to repay the facility.

In terms of the basic standalone credit analysis, the two rating agencies are in broad agreement.  The difference between their two ratings is immaterial.

DHCOG can take comfort from the fact that there is no harsh criticism about information flow and adequacy of documentation.  Otherwise Fitch seems to be pretty much on the same page as S&P.  And as well perhaps from Fitch's apparent willingness to factor in government support.  It's question mark seems to be "ability" not "willingness".

S&P Final Rating on Emirates Bank International and National Bank of Dubai

Earlier this week, Emirates National Bank NBD announced that it was terminating S&P's rating services.  The market assumption is that this was in response to S&P's downgrade of DHCOG and the rather negative comments S&P made about DHCOG and transparency in the local market.

Whenever a rating agency stops rating an obligor or an issue, it updates its view on the ratings of that entity so that it leaves the market with an accurate read of its credit opinion.

Today S&P reaffirmed its ratings of BBB/A-2 (long term and short term respectively) for Emirates Bank International and National Bank of Dubai with negative outlooks on both  At this point both EBI (which was formed from the rescue of several failed or near failed banks in Dubai) and NBD (which was the previous Ruler of Dubai's personal bank and which was run very conservatively but a canny old Scot at one time) have merged to form a new bank, Emirates NBD.  

The ratings of the two banks benefit substantially (three notches to be precise) based on the assumption that as a systematically important bank, ENBD would receive extraordinary support from the UAE authorities (meaning the Federal Government and the Central Bank of the UAE). Other positive factors were the bank's leading commercial position and its adequate preprovision earnings capacity.  On the negative side were depressed financial conditions in Dubai and high exposure to weakened Dubai government related entities.

ENBD has some AED 7 billion (US$1.9 billion) of debt maturing in 2010. 

As of 30 September 2009, the bank had total assets of AED291 billion (US$79.3 billion), equity of AED 32.2 billion (US$8.8 billion) and medium term debt (bonds and syndicated loans) of AED25.7 billion (US$7 billion).  When adjusted for debt payments due in 4Q09, the adjusted medium term debt total is AED23.4 billion (US$6.4 billion). 78% of that amount matures in the period 2010-2012 as follows:  AED7 billion  (US$1.9 billion) in 2010, AED3.5 billion (US$1 billion) in 2012 and AED7.8 (US$ 2.1billion) in 2013.

The Emirate Strikes Back: Emirates Bank NBD Drops S&P

"What is thy bidding, my master?"
"There is a great disturbance in the Ratings".
"I have felt it".
"We have a new enemy, the rating agency who downgraded DHCOG."

Here's the press release.  I trust the Death Star is ready.

Another Own Goal for Team Dubai in the S&P/DHCOG Ratings Dispute

You've probably seen the press articles that Standard and Poor's lowered the rating on DHCOG from BB+ to B.  A weaker cash flow and lack of information are cited as the reasons along with some background on the Emirate and Dubai Inc.  These reports also note that S&P has withdrawn its rating.

What I want to focus on in this post is the proverbial "war of words" that they have launched.

Was this war necessary? Who stands to win? Who will be the most damaged?

As you might guess from the title, I have my own view. Team Dubai has roundly booted yet another one into its own net. And when it comes to scoring, it seems that just about everyone on the Team is capable.  To be clear here I am referring to DHCOG's reaction to the ratings downgrade and withdrawal by S&P.

Let's start by reviewing each's press release – where better to wage a war of words.

First, S&P. Their press releases, including rating actions, are password protected (though all you need is an email address and the willingness to give it to them to get access). If you can't or don't want to do that, Bloomberg has a more complete account than many of the reports in the press. 

S&P states that:

1. Materially weaker cash flow and a resulting negative impact on liquidity as well as lack of clarity on potential government support (that famous "implicit guarantee" rears its head again) is the basis for the ratings decline. 
2. Because of "inadequate timeliness of information and insufficient documentation (emphasis mine) to maintain their surveillance" they have decided to cease rating the company.  (You might ask why they didn't just withdraw quietly with no fuss and no downgrade.  It's common practice that a rating agency doesn't simply withdraw without either reaffirming or changing the rating.   This is especially the case if they have negative information and conclusions. Since this will be their last word, to do otherwise might leave the market with the wrong impression of their opinion. As to the fuss, it either came as a reaction to what I expect were rather sharp discussions between the two parties. The other less favorable interpretation is that there are significant shortcomings in the information that S&P cannot let pass without comment.). 
3. Three further important negatives. First, the rating trend is negative: more erosion in credit quality is expected. Second, the rating and the negative future view reflect their base case. In other words they are not basing their rating and view on the future on the "downside" case. Third, a broad criticism of "lack of market transparency, reliable market data, and the level of financial information" (Ouch).
   

Now over to DHCOG's press release.

Their view is clearly and starkly stated.

1. They dropped S&P as a rating agency due to S&P's "lack of understanding of DHCOG's business, its operations and relationship with the Government of Dubai." 
2. They have been "sharing adequate information frequently and in a transparent manner" with S&P. 
3. S&P has made "inaccurate statements coupled with factual errors that are misleading." 
4. Therefore, they "discredit and disagree with the content of the latest S&P report". 
5. They will continue to work closely with other rating agencies and directly with investors in full transparency".
   

Now let's look a bit deeper.

Not so long ago, November 2008 to be precise, DHCOG was rated investment grade with "A" or an "AA-".  A "B" rating is a bitter pill, though DHCOG has had prior tastes from earlier downgrades. At any time, a downgrade isn't welcome.  Given Dubai's current difficulties, the downgrade – dangerously close to CCC territory – was probably seen as a direct threat to the company, the parent, and the Emirate itself. Add on top of that a rather broad and sharp criticism of market transparency and reliability and DHCOG's strong reaction isn't surprising.  Another concern might as well be the potential adverse affect on the main shareholder's attitude to the management of the company. What I suspect is the proverbial straw on the camel's back is that S&P signaled that it was likely to further downgrade the company, probably into CCC territory.

Who dropped who?

A tricky question. 

Usually such disputes are settled in such a way that no excessive dust is raised.  The company tells the rating agency it isn't happy with the rating. The rating agency advises that it cannot change the rating. So they find a way to part – an amicable divorce. That wasn't the case here.  Both parties have kicked up quite a bit of dust and it seems more than a few rocks.

My guess would be the company made the decision to prevent further downgrades. S&P could have maintained coverage and just marked the company down further if it felt the information were inadequate or delivered too late unless of course it felt the situation was so bad that to continue would violate its integrity and potentially cause severe damage to its reputation. The question that can be posed to S&P is how does this lack of market transparency and reliability affect its ability to rate other companies. Is the situation so severe that it needs to withdraw from other rating engagements?

Just how serious is the dispute?

Both have levied fundamentally serious charges against one another that go to the heart of the other's competence. And a hint of criticism of integrity.

1. S&P contends that the company was not providing information on a timely basis and that when supplied the documentation was inadequate. 
2. DHCOG claims that S&P is unable to understand its business or its relationship with the Dubai Government – in effect the rating agency doesn't have the skills to perform its job. But more than that, compounding its deficient critical skill, S&P is making factually incorrect and misleading statements – a direct attack on its integrity.
   

Whose story is the market more likely to find credible?

In a dispute like this, outsiders are unable to conclusively determine whose story is true.  They don't have the facts so they rely on the reputation of the parties, their presumed motives, and their conduct in the dispute. Dubai is at a disadvantage on all three except perhaps in the region.

While the folks back home will probably quite naturally take DHCOG's side, the wider market will tend to believe the rating agency.

Why?

S&P enjoys a better market reputation than DHCOG. It is a "household name" and has built a perception in the market that it is a smart thorough institution.

The central reason though will be the perception that the company is motivated by defensive self interest. The downgrade affects the company's access to debt markets as well key deal terms, e.g., tenor, pricing, security and covenant packages.  It may also affect the price of the company's stock since shareholders are legally subordinate to all creditors. Faced with these potential outcomes, it's expected that the company will fight to prevent them from happening. Given the negative outlook, it's likely that S&P would have downgraded the company further. While DHCOG would prefer to avoid the "company" of single "B" rated companies, consorting with those in the "CCC" class has to be an even more distasteful prospect.  Also complicating DHCOG's sales story is the fact that many a company in this sort of situation has claimed that credit or stock analysts didn't understand their businesses or the real worth of the company. But, generally, history has vindicated the analysts.

On the other hand, the market finds it hard to believe the rating agency has a hidden agenda or gets great benefit from the downgrade. It is seen as doing its job in delivering the bad news.

So what does a smart company do in this situation?

The first is to realize that not much can be done.  The rating has been lowered.  No amount of protestation will cause the rating agency to change it. Trying to convince the market that you're right and the rating agency is wrong is difficult, if not impossible, for the reasons outlined above. And a variety of parties are locked into using the rate whether or not they believe it is correct.  Entities subject to Basel II. for their capital adequacy calculation.  Investment companies who are limited to investments of a certain credit grade.  Banks who translate external credit grades into internal models for underwriting decisions and pricing purposes, etc.

The second is to choose one's battles carefully. There is truth and there is the appearance of truth. The market does not have the facts. It will judge on appearance. Even assuming that the rating agency is dead wrong, the company has to think carefully if a bitter public dispute will help or harm it. One does not want to wind up in a worse position after the battle than before.

The third is to reply appropriately if one chooses to fight. What arguments are most likely to be plausible? As hurt and perhaps outraged as they were, the wiser thing for DHCOG to have said would be that S&P doesn't understand our business and hasn't given sufficient weight to certain factors. We disagree with the assumptions in their economic model. Their interpretation is therefore wrong. This is much better than saying that the rating agency has the facts wrong, that it lacks the requisite skills or that it is making inaccurate misleading statements. It will be very hard to convince the market that this is the case with a firm with S&P's reputation.  

Compounding DHCOG's position is that other rating agencies have been downgrading it. So in a sense DHCOG is not just fighting one agency, it is fighting the Big Three. An even larger credibility disadvantage. What the company can hope for is that there will be differences among the agencies and it can therefore discredit the lower rating. But, last December Moody's downgraded the company to "B1" – the same as S&P. Fitch's rating is "BB" – higher but by only one level. All three agencies have assigned negative future trends. This certainly takes the wind out of DHCOG's argument. Where there may be hope is that other agencies will not be so negative about the company's timeliness and quality of information and may not wield as broad a brush in criticizing the local market.  Perhaps, apparently small victories but important victories particularly in this climate.

Perhaps, in drafting its press release, DHCOG's target audience was the regional market, that in the UAE or one rather important shaykh in Dubai. And for this audience, their approach may have been the right one. But in terms of the wider market, the one that actually matters for financing, it is not. The press release is unprofessional. It sounds too emotional. It looks like it was drafted in a fit of pique. All that is missing is the sound of the foot stomping.

In the midst of a very challenging refinancing process Dubai Inc. can't seem to avoid scoring own goals.  This isn't the first.  And this isn't the only player (Dubai Inc entity) to do so.  Team Dubai needs to get a better hand on its play (public relations).  The task is difficult enough as it is without needlessly making it worse.   

Not only for the good of today but as well for the good of tomorrow.