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.

Discovery Gardens: Where Wonders Never Cease

Discovery Gardens' Residents Cool Off

Seems the folks at Discovery Gardens had another unhappy discovery of late.  No air conditioning.  

A Palm District Cooling System official said the “company is addressing the problem that arose due to technical problems. About 14 buildings in Discovery Garden are having problems and we are trying to rectify it soon.”

It seems the manifold through which the money flows isn't working.  Unclear if it's a problem with the manifold or a lack of money.  PDC engineers are reportedly on the scene though.

They say that there are three things important in real estate:  location, location and location.

Of course, when "they" say that, they're assuming that basic infrastructure and services are in place.

There's no substitute for dealing with first class firms!

DIC Asks for More Time

According to the Khaleej Times DIC has asked the lenders on its US$1.25 billion facility to extend the maturity until the end of November. Earlier it had been extended from the end of June until the end of September.  The article also states that the Company has circulated a draft rescheduling plan that envisions asset sales over a five to seven year plan.  

“They [DIC] are buying some time because markets go in cycles and currently assets are stressed and below their value,” said Haissam Arabi, chief executive and fund manager at Gulfmena Alternative Investments.

“We are on our way to reach a new cycle as soon as the fourth quarter...when we will see valuations and share prices expanding,” he said. DIC had already extended the $1.25 billion loan, which matured in June, to September 30. 

Sadly we learn that markets often undervalue assets from their true value (the value imagined by the holder) for long times.

And equally sadly, while it appears the Obama Administration's stimulus plan is working, it seems that tangible effects won't be felt until after the November elections.

Earlier post here.

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 World: 99% of Creditors Agree Rescheduling

According to Asa Fitch at The National DW has issued a statement that roughly 99% of creditors have agreed the terms of the restructuring.

An outcome never much in doubt once the steering committee representing 60% of the amount of the debt agreed the terms.  The remaining banks knew that it would take just a few of their number to reach the "magic" special DIFC Court threshold for a potential cramdown.  So why not sign up and get the early bird bonuses?  Also the rescheduling represents the better alternative for recovering the maximum amount of money.

An accomplishment for DW.  But now comes the more difficult bit.  Meeting the terms of repayments.  And in order to do so, probably parting with some of the "Vision's Dreams" at a loss.

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: Athens on the Creek?

Photograph by Tbc  Released to Public Domain

Martin Dokoupil at Reuters has a rather negative report on Dubai's financial condition quoting a Bank of America Merrill Lynch report that 

1. Dubai state owned companies are "sitting" on US$100 billion of debt of which US$30 billion comes due through 2012
2. Dubai's debt is 170% of GDP compared the article notes to Greece's 103%.

That last statistic sounds quite alarming.  But before you plunk down that deposit for an off plan villa at Palm Athena, recall that much of the US$100 billion was debt incurred by corporations not the sovereign itself.  In many cases entities with real businesses.  Emirates Airlines.  Emirates NBD.  Dubai Ports.   In several cases businesses that are incorporated outside of the Emirate.  Or whose main theaters of business activity are outside of the Emirate.

That doesn't mean that everything is just fine.  But rather as always one needs to look behind the headline or headline ratio to the details.

Kabul Bank, Mohammed Karzai, Sherkhan Farnood and Palm Jumeirah

Photograph Ivanlo  Released to the Public Domain 

How often do you hear about companies that advertise services that they really don't offer?  Where managements talk the talk but don't walk the walk?

Well, that's not the case at Kabul Bank where management takes seriously the slogan "The Easiest Way to Earn Millions" as we learn from Bradley Hope over at The National.

And what could be easier than real estate investments in Dubai, particularly in the prestigious Palm Jumeirah development.

One chap made a quick AED3 million, though he can't remember what he did with it.

And what can you say about a Chairman who's so solicitous of his bank's investments that he registers them in his and his wife's name?  No doubt in order to keep a close personal eye on them?  Sadly now, the former Chairman due to some onerous new banking regulations in Afghanistan. 

16 or so villas on Palm J and two plots of land in Business Bay reportedly worth some US$150 million.

As per KB's 31 December 2008 financials (the latest posted on its website), that amount being twice the Bank's shareholders' equity and 21% of total assets (assuming of course that the properties are reflected in the balance sheet). 

Dubai Debt Maturities Through 2012

 Eiger Nordwand

Copyright Kurt Ritschard 

Creative Commons Attribution-Share Alike 2.0 Generic License

 

Reuters has posted a list of debt maturities (bonds and loans) for Dubai through 2012 by issuer.

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.

DEPA 1H10 Loss: The AED185 Million Burj Al Khalifah Claim

If you've seen DEPA's 1H10 financials, you know they declared a loss of some AED117.5 million of which AED103.7 million is attributable to the shareholders of DEPA.  The firm bills itself as the third largest interior contractor in the world.

You've also seen their earnings press release that this loss relates to expenses incurred on a contract at Burj al Khalifah (but not with Emaar the project developer).  Apparently, a large portion is for overhead expenses incurred over a couple of years.  As per the press release, were the claim paid, DEPA's 1H10 results would have been a net profit of AED81 million, making the size of the claim AED185 million.

That seems a rather large amount.  Unclear what this represents as a percentage of total project cost.  And what the likelihood of getting the full amount is.  As well as the identity of the project owner (obligor).

Perhaps, The Real Nick can weigh in with an observation.  And certainly anyone else out there with something to contribute is welcome as well.

Dubai World: No Assets Ring Fenced From Sale

Reuters has published an exclusive report that they have a document circulated among DW's creditors which states that:

1. Total DW debt is some US$39.9 billion instead of the mid US$20 billions.
2. Though there is an apparent US$11 billion non recourse debt at Istithmar subsidiaries and US$2 billion at Infinity.  These amounts are important because they will affect the net proceeds from the sales of those assets.  Debt at the subsidiaries will have to be either assumed by the buyers or repaid by the seller (Istithmar).  
3. DW warned that if it sold its assets quickly it could only raise US$10.4 billion.  It's a safe bet that DW is being conservative as it doesn't want to give the lenders incentive to push for a quick sale.
4. Rather it needs 5 to 8 years to realize the assets at higher prices - the midpoint of which is US$17.6 billion.  The highpoint of which is US$19.4 billion.
5. Heretofore strategic and ring fenced assets are now on the table:  DP, JAFZA, Barneys, Atlantis Hotel, etc.   Though one might question whether this is more a negotiating tactic.  It's hard to imagine the Emirate parting with these assets.  So the hope may be that a recovery in markets will lead to higher values recognized on other assets.  Or that bankers' and investors' ADD will kick in and Dubai World will be able to refinance after five or so years.  Either case obviating the need to part with the "crown jewels".  And, thus, any sale would be an absolute last resort.
6. In an attempt to get banks to sign on to the rescheduling, DW is offering a signing bonus / consent fee.

Quite a remarkable turnaround.

But with roughly US$40 billion worth of debt and US$20 billion from asset sales, there is quite a "financing gap" to fill.  Even more so, when one considers the fact that as the prize assets are sold, DW's right to their earnings and cashflow will end as well.  Is the gap to be funded by the Emirate?  If so, quite an expensive admission ticket to a relatively short ride on the "leveraged assets express".

Anyone out there who would like to share any creditor documents with me can contact me using the Contact Form.

Lost in Transmission: AlBoom's US$20 Million

Boom!

Abid al Boom's slow moving US$20 million lands him in jail.

Al Mazaya Kuwait - The Villa Project Dubai

When Global floated the subsequently "ill-fated" AlThourayia Project Management Company to invest in Mazaya Saudi Arabia, it noted on page 25 in the Private Placement Memorandum that one of the attractive features of that transaction was the involvement of Mazaya Holding (in which Global has presciently acquired a stake earlier, though Global's stake in Mazaya was not mentioned directly in the PPM):

Mazaya Saudi will be positioned to leverage on Mazaya Holding’s competitive market edge, an absolute advantage against competition. As a new entity, Mazaya Saudi will enter the real estate market backed by Mazaya Holding’s respective expertise. The Company will gain from Mazaya Holding’s breadth of practice,  which has materialized through the 18 projects Mazaya Holding has on hand. Such projects range from megascale residential communities, to high rise mixed-use towers, to BOT projects. Mazaya Saudi will benefit from the know-how of Mazaya Holding, and will seek to develop similar scale projects, which shall be backed by Mazaya Holding’s vigorous methodology.

One of the projects touted as evidencing Al Mazaya's absolute advantage (and if you know the Economics definition between comparative and absolute advantage, you'll know just how remarkable a claim that is) was The Villa Project in Dubai, which involved the construction of 500 villas scheduled for completion in mid 2009. (PPM Page 28).

Gulf News recently ran an update on the project's progress.

The villas were to have a garage and vary in size starting from four bedrooms. "The whole attraction for the project was that you could customise the villas with swimming pools and the landscaping would be included in the fee. We were promised courtyards, water features, a school, mosques, shops and a medical centre, but there is none of that," said the businessman.

According to him, the original location for the development was supposed to be near Global Village, but it was moved by seven kilometres to the current location.

"The big thing at the moment is that [Al] Mazaya are expecting us to pay the Dh25,500 cost of connecting the sewage and Dewa [Dubai Electricity and Water Authority] lines even though its not our responsibility, that's the job of the developer. The frustrating thing is that my neighbour who has Dubai Properties as the developer doesn't have to pay."

The businessman had bought his villa in 2005. "It does say in the contract that they have leeway of a year on completion, but even with that it's two years behind schedule and most of us are still paying rent when we should have moved in," he said.

Other issues concern the poor workmanship and finishing, no boundary demarcation, landscaping or community facilities.

These are some rather serious charges.  But AlMazaya is not shy about taking responsibility for its actions as this quote from the CEO of Al Mazaya Dubai evidences:

"The problems with ‘The Villa' have been due to circumstances beyond our control," he said.

It seems even an  absolute advantage cannot overcome the actions of others.  Unclear if the global financial crisis (lower case "g" on global) is the culprit here.

And a tip of AA's massive tarbouche to Laocowboy2 for calling this article to my attention.

Shuaa Capital Turns the Corner or Does It?

Following the announcement of its 2Q10 financials, there have been several articles on Shuaa. From this one Shuaa Capital Improves Financial Stability Despite Downturn to more nuanced articles like this one over at The National Cautious Investors Leave Shuaa in Lurch.

The question on everyone's mind seems to be: Has Shuaa turned the corner?

SUMMARY

At this point, the simple fact is that it's not possible to say one way or another. One swallow does not a summer make. Nor six months' performance a turnaround, particularly after the last two dismal years. What has happened is that there has been material improvement in net income. But that was primarily due to improvement in a single line of business, proprietary investments. The LOB primarily responsible for Shuaa's past problems. The LOB that Shuaa is therefore de-emphasizing/exiting.

Most of Shuaa's other LOBs are underperforming. No surprise here. These are highly market sensitive. The markets in which the Company operates have been very, very difficult: significant reductions in trading volumes on local exchanges (down 45%) and declines in market indices.

Right now it appears that the current market slump is likely to be prolonged with a less than vigorous recovery. If that's the case, Shuaa with its high correlation to markets has a real problem. Can it staunch the bleeding, return to profitability (even if only modest) and generate sufficient cashflow from operations to meet its cash expenses? Doing this in the next two to three years is likely to be critical.  During that period, external sources of finance (for debt rollovers, expenses as well as expansion) are probably going to be very difficult to come by and very expensive if obtained. Expensive in terms of direct cost (margins and fees) as well as collateral requirements. 

At the worst, continued bleeding could be fatal. And if only modest profitability is achieved, the Company may slowly fade into irrelevance. On the other hand, with the distress at other regional firms, this might be the opportunity of a lifetime.

ANALYSIS

Let's take a close look at Shuaa's financials. The key documents for this excursion are Shuaa's Earnings Press Release and its 2Q10 Financials.

Income Statement

Net Income

Yes, there is a dramatic improvement in the bottom line. The AED37.2 million loss for 1H10 is roughly one-third of 1H09's AED113.7 million.

But the improvement is largely within one line of business.

The Net Loss Before (Losses)/Gains from Other Investments for the first six months of 2010 is AED 52.6 million almost spot on the AED52.9 million loss for 2009. The difference between the "bottom lines" (Net Income) of the two periods is Other Investments. An AED15.4 million gain in 2010 versus a loss of AED60.9 million in 2009.

The nice thing about write downs is that at some point they stop because one cannot write an asset below zero. But all this does is stop the bleeding. It doesn't generate new revenues. And unless it's accompanied by improvement in other LOBs' performance, the Company can "stabilize" at a loss or modest income. A bit later we'll take a look at Shuaa's other LOBs. For now let's concentrate on the macro picture.

Comprehensive Income

Comprehensive Income is more favorable: AED17.2 million loss in 1H10 versus AED88.2 million in 1H09 due to net revaluations of some AED20 million in 2010 and AED25.5 million in 2009. Both of these are non cash items – in a situation where cash generation is key. And largely related, it seems, to the business Shuaa will exit.

Cashflow

The gross operating cash flow is weak. AED18.4 million negative in 2010 versus AED10.6 million positive in 1H09. Also the Company is reducing/selling assets (chiefly Other Investments and Loans) to fund reductions in debt. A pattern they followed last year as well.

Deleveraging does improve the Company's risk profile. Usually the intent is to sell only the underperforming assets. But that doesn't always work especially in a down market. Often such assets can't be moved. Or if they can, only at fire sale prices leading to losses – which even if only paper losses  will erode market confidence and capital. As a result, the firm winds up selling good assets with a pernicious effect on future ongoing cashflow and earnings. Whatever the case, this is a limited strategy. Limited because there are only so many assets one can sell. At some point, if Shuaa doesn't have sufficient operating cashflow, it won't be able to continue.

Balance Sheet

Total Assets decreased from AED3.6 billion at 30 June 09 to AED2.4 billion at 30 June 10 due to a roughly AED710 million reduction in liabilities plus an AED469 million decline in equity (primarily 2H09 losses). The Company has also been able to improve its liability maturity profile via a secured (AED300 million of collateral versus an AED240 million facility) medium term loan from Abu Dhabi Commercial Bank. Quarterly repayments commence in December 2010 and end March 2013. The rate on this loan is not disclosed. Spreads on the Company's short term borrowings are at 3.5% to 4.0%.

From Macro to Micro

As mentioned above, we need to understand performance at the level of individual lines of business.

Let's turn to Note 17 in the 2Q10 Financials for Segmental Results.

One very important caveat, the allocation of revenues and expenses among segments is more an art than a science. Different definitions of LOB, different management assumptions on how best to allocate revenues and expenses can result in quite different allocations. Accounting and reporting system limitations are another factor. From Shuaa's description of its segments, it seems that there are significant management and administrative items (probably including shared or cross LOB revenues and expenses as well as Treasury functions) in its Corporate Segment which haven't been allocated to LOBs. As such, at the segmental reported net income level, we may be dealing more with gross operating margins than net operating margins. If the LOB numbers aren't fully allocated, and I don't think they are, this exercise is likely to be more "directional" than precise.

With that caveat let's begin with LOB revenues. LOB figures are based on Net Income and expressed in AED thousands.

LOB	1H10	1H09
Private Equity	8,571	21,885
Asset Management	7,280	16,835
Investment Banking	7,499	2,239
Brokerage	19,155	30,527
Finance	32,874	49,029
Corporate	18,848	34,662
Total	93,837	155,177

Revenues were down across the board except for Investment Banking. For many of the LOBs this isn't surprising as they are highly market sensitive and markets have been dismal. 

Asset Management revenues declined due to (a) an almost halving of fees and commissions which were down from AED10.1 million to AED5.37 million and (b) gains on Shuaa managed funds were down from AED6.8 million to AED1.9 million. You'll note that from the latter that asset management is not solely client related fees but includes gross performance on the portion of the funds that Shuaa owns.   In most firms I've worked in, holdings of own funds do not "belong" to Asset Management but to Treasury based on the idea that they do not fundamentally differ from holdings of other third party funds. On that basis Shuaa's Asset Management Revenues and Operating Margin are probably inflated. 

Next net profit (before Minority Interests) in AED thousands.

LOB	1H10	1H09
Private Equity	811	13,137
Asset Management	(491)	11,185
Investment Banking	(2,321)	(6,536)
Brokerage	2,038	12,378
Finance	16,071	14,332
Corporate	(53,289)	(158,219)
Total	(37,181)	(113,723)

The Corporate Segment (which seems to be the "warehouse" for the legacy assets) is allocated the lion's share of assets and expenses. Though it should be noted that as described above this LOB is also a central administrative and management unit as well. The amount of assets in Corporate indicate just how much "non strategic" business the Company developed. 

If we assume that this business is largely being wound down, there are two key conclusions: 

1. The future is in the other LOBs. 
2. The "new" Shuaa is likely to be a much slimmer (in balance sheet terms) entity with a more modest income stream than it was in its heyday. 

Turning to the remaining, LOBs, in absolute income terms, the most profitable LOB is "Finance".  The Press Release describes this as "vehicle finance", though the FYE2009 financials  identify it as primarily "construction equipment finance". The lending focus makes a critical difference in terms of future prospects – at least over the next 3 to 5 critical years.  Renting construction equipment probably doesn't have a bright future in the near term. While not investment banking or broking, lending (assuming the right economic segment) could deliver an annuity cashflow to offset Shuaa's more volatile market sensitive revenue streams. It is one, however, that is asset intensive and requires leverage to generate the ROE that investors require. 

Brokerage depends on the tone of markets as well as the perception of market participants about Shuaa's longevity. With other brokers shuttering their doors, Shuaa may have an opportunity for growth. The trick here will be driving volumes – largely dependent on market recovery -- to offset what appears to be a rather high (perhaps somewhat fixed) expense base of roughly AED17 million in annual G&A. Further extension of the platform would make business sense though the capital to fund might be difficult to attract. Thinking ambitiously, a single firm able to offer its own brokerage services in more than one GCC market (as opposed to working through local firms) might be a compelling value proposition.

Asset Management could be another promising venture. Success will depend on Shuaa's reputation (largely based on its performance and favorable market perceptions of firm longevity) as well as like Brokerage the all important market tone. This is another volume business given generally modest margins. For a comparable, Global earns about 1% in gross fees and commissions (excluding performance related compensation) on its KD1.5 billion in AUM.

Investment Banking and Private Equity are perhaps more "long shots". Despite higher gross margins, these are likely to be even more hit and miss than Asset Management or Brokerage because of the uneven timing of transactions. Investment Banking requires deal flow – a function of markets, the firm's reputation, and pricing. Private Equity is more equity intensive (on a risk basis) with highly volatile cashflow and income. With this LOB there's always the danger of becoming the "lender of last resort" to a failing investment under the sunk cost fallacy: investing just a few more dirhams to protect all the ones you've already invested. 

Clearly there are opportunities for Shuaa.

But to make a success of its business, Shuaa needs to convince lenders and shareholders that it is viable. To a large extent that means having a reasonable prospect of delivering a meaningful ongoing revenue stream as well as an attractive ROE. It needs both. A 50% ROE on AED100 is unlikely to excite anyone. AED100 million of net income with a 0.5% ROE is likely to be similarly unattractive.

At this point, logically, an ROE analysis of Shuaa's individual LOBs makes sense. Unfortunately, the Segmental Results really don't contain the data I think is necessary for such an analysis. Revenue and expense do not appear to be fully allocated. Determining LOB equity is similarly troublesome. Shuaa's own data has some seems too volatile for Private Equity. Allocated assets don't seem to have a logical pattern. They were AED123 million at FYE2008, AED155 million at 1H09, AED93 million at FYE09 and AED172 at 1H10. Determining required equity for Shuaa's Asset Management and Investment Banking is more than just a matter of the very slim amount of assets these LOBs carry. One needs to consider the equity required to cover operations and risk absorption. While it's possible to construct models to calculate all these, that would require a lot of work and be well beyond the intended remit for this blog.

So we'll end with some general observations.

1. The road in front of Shuaa is difficult. 
2. By their nature its major LOBs are market sensitive and/or volatile. 
3. Markets are difficult and may remain so for some time. 
4. LOBs offering good prospects (Asset Management and Brokerage) are generally low margin requiring significant sustainable volumes to deliver acceptable ROEs.
5. External financing - debt or equity capital - is likely to be difficult to obtain and when obtained costly.

While this analysis does not definitively answer the question about Shuaa's future, it provides some insight into the key challenges and as well some key milestones to watch for progress. 

The exercise of determining whether they can realistically develop the ROE and quantum of earnings to be a meaningful player has been left to the student.

DIFCI to Divest Non Core Assets and Assure Robust Streams of Liquidity

Photo Jimmyjazz Released to Public Domain

 

Today's Gulf News carried a report that DIFCI had decided to get rid of its non core assets.  It has some US$1 billion of them.  Some of which are pictured above.

In the words of Shahli Akram, Acting Managing Director:

"DIFCI may divest certain of its investment portfolio to create robust liquidity streams across the business, whilst maintaining very strong focus on augmenting returns from our core business lines and also creating operational efficiency across the board," he said.

There's a lot of this going around lately.  Sort of like SARS.  The GCC is beginning to look like a US suburb with all the jumble and yard sales going on.  Adnan and  Ms. Maha up in Kuwait -  are selling so many "non core" assets that in three to five years they may have no assets left.  Not a one.  A Pretty fellow in Bahrain with a load of non core assets - real estate focused.  And now even DIFCI.

Ever wonder how a competently managed careful firm gets loaded up with non core assets? 

Well, Abu Arqala has a theory based on his experience at the university.  I had a friend let's call him "Sam".  Sam had a legendary refrigerator.  It all began innocently enough.  A clean refrigerator.  Some food items - fruit, vegetables, etc.  Over time these were augmented with left over pizza, Chinese food..  As new items were added, the old ones were all pushed further and further to the back until a critical mass and pressure sufficient for a chain reaction occurred.  One month thereafter,  some of the fruit had  developed whiskers - stubble to be sure, but growth nonetheless.  At two months, the Chinese food eyes.   At three months the pizza a proto hand or claw.  After 9 months, many swore they could hear vague stirrings from deep within the  refrigerator - nameless unthinkable shapes moving at night.  After 18 months, voices were heard. but in an unknown guttural language.   A new form of  life had been created.  After a while, the door was kept closed.

At the 24 month mark, during one summer, a "roomie" temporarily subletting opened the refrigerator.  A hardy soul not particularly prone to squeamishness he took charge of the situation.  Robust liquidity streams were mopped up from the floor.  And in some cases scraped from the interior.  Most of the non core assets were disposed of, except for one legendary orange with a long black beard that eluded capture.   They say (and who am I to doubt them) that it has until today and that if one listens carefully, its plaintive cries can still be heard at night. 

I'm guessing the same sort of thing happens in the financial world.  One starts with a collection of perfectly good assets.  New assets are added to the portfolio pushing the earlier ones to the back.  As they sit  there, some of them begin to fester.  Soon infecting others,  Before you know it, you're loaded up with non core assets.

One can well imagine how Shahli feels having opened DIFCI's rather large refrigerator.

Dubai: The Emirati Goldfinger

Fancy expensive car proving honesty and sincerity.

Dubai is known as an important gold trading center.  Apparently the story of Damas is just one of many.

This is another.

An Emirati identified solely as AA, was taking gold from an Iranian woman, FH,  promising her he was selling to Russians at a "higher price".  Presumably because the Russians in the UAE are not sharp traders.  In one example, she gave him gold worth DH850,000 and he gave her a check for DH500,000.  

One could make a small fortune in such exchanges - though starting with a large fortune would be a prerequisite.

In any case the woman was sure this chap was on the "up and up". 

FH said that each time the accused, who addressed her as 'mother' visited her he used a different car. And, therefore, she believed whatever he said and never suspected him.

As Ken over at Wall St WTF can testify, justice has both a long arm and is swift in the Emirate of Dubai.  Interpol arrested the chap in Thailand and he's been arraigned in Dubai.

The accused has denied the accusation and the Dubai Misdemeanor Court has adjourned the case until August 9.

A couple of further notes.

Despite the similarity of names (AA), like a certain prominent Kuwaiti-Saudi businessman, I continue to deny any wrongdoing.  Mother, why won't you believe me?

And for Ken at Wall St WTF:

1. You've expressed some concern at your blog as to the  vigor (or lack thereof) in the legal pursuit of the Flying Abdullah Brothers.  Perhaps the judicial venue for this case  - the Misdemeanor Court - is an indication of the seriousness with which such crimes are viewed in the Emirate?
2. Also as one who has worked with the DIFX/DFSA, perhaps you can  advise whether Iranians are working there in senior management.  That potentially could explain a lot of things.  He called me "mother" when he signed his Enforceable Undertaking.

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 Sweet Smell of Err .... Sky Gardens Tower

From The National - the downside of upkeep.  Or perhaps an indication of the quality of construction.

But he has been told by the building’s maintenance staff that the pipes running through the tower have likely sprung a leak, which is allowing sewage odours to permeate through the walls.

The issue has persisted for about nine months and he says there are no plans at the moment to permanently fix the problem.

Next time don't use the cardboard pipe.  It has a short service life.

Further Pressure on Rental Rates in Dubai

Gulf News has an article about continuing declines in the Dubai residential and commercial real estate market.  And how this is causing an influx from other Emirates where the supply of "affordable" housing is currently constrained.

New supply is anticipated to exacerbate conditions.

Two sentences in the article caught my eye:

The main concentration of upcoming office supply will come from the Business Bay development. However this is expected to happen in 2011. "There are various infrastructure issues with a lot of completed towers sitting there," said Green.

Perhaps, The Real Nick can comment on what these are.   Utilities, especially electricity?  Or transport.  And of course any reader with a comment is encouraged to weigh in with a comment.   In general the more informative bits of info on this blog come from reader comments.

Continued weakness in real estate suggests issues for lenders on their existing portfolios.  And for developers fewer new projects and perhaps some customers' walking away from previous commitments - as lower rent rates imply a lower value of properties.

There's more to come on this topic.  CB Richard Ellis 2Q report on Dubai should be available on their website shortly.  When it is, I'll post again with the link.