GFH 2018 Earnings – A Closer Look At Debt Settlement Gains – AA is Stumped

After Today's Post, I've Removed this Sign from my Desk

By some accounts (pun intended) GFH had a good 2018.  USD 115 million in net profit, of which USD 114.1 million was for shareholders of GFH.  This compares to USD 103.2 million for FY 2017, of which USD 104.2 million was for GFH’s shareholders.  That year Non-Controlling Interests’ share in profit was a negative USD 1 million.  In 2018 it was just under USD 1 million.  

GFH’s 2018 revenue includes USD 113.1 million from “settlement” of liabilities. This single item is 99% of net profit.  It’s also not what one would commonly consider recurring income.  Hence it merits a closer look. 

To start a glance at the Consolidated Statement of Cashflows show this was a non-cash item.  That is, GFH did not receive any cash from the settlement in 2018.  

Now that’s not uncommon.  Under accrual accounting revenues are booked when earned.  Collection may and often does follow in future accounting periods.   

Note 22 to FYE 2018 Annual Financial Statements discloses that USD 35.3 million of this amount represents the reversal a previously accrued provision (itself a non-cash item) for settlement of liabilities of AHC.   So a non-cash reversal of a non-cash charge.  No cash to GFH in 2018 or in the future.  

Let’s let GFH describe the second larger amount of USD 77.8 million in its own words. 

“During the year, the Group agreed to settle sukuk liability with a financial institution of US$ 203 million at a lower amount, resulting in a gain of US$ 77.8 million (net of associated costs). The settlement was in the form of cash and other non-cash assets.” 

Interestingly, GFH’s October 2018 press release on this issue uses a different formulation: “agreed to acquire circa US$200 million of Villamar Sukuk Company Limited, Sharia Compliant Sukuk Certificates from Al Rajhi Bank”.  

You’re probably wondering why AA is quibbling over the language and parsing press releases.  Well, the manner in which the sukuk was settled has an impact on the net income accruing to GFH.  

Typically, an obligor on an instrument (that would be GH Kuwait in this case) can recognize a gain when it settles a liability for less than its face value. 

But, GFH only owns 51.18% of GH.  So, if GH repaid the Villamar Sukuk (probably with the proceeds of a new loan to GH by GFH as GH is cash poor), on an economic basis, GFH can only claim 51.18% of the USD 77.8 million or USD 39.8 million of this income.  The other USD 38 million belongs to the other shareholders of GH. 

However, if this is the case, under accounting principles for consolidations, GFH is entitled to show the entire amount USD 77.8 million in revenue.  Once again we see a divergence between accounting and reality.  Remember a consolidated statement is a construct which purports to show how the economic reality of a group.  It does not show reality in terms of legal ownership of assets and revenues. 

But under those same principles for consolidation GFH would then have to reflect the share of that profit on the transaction which is due to other GH shareholders via a deduction of US 38 million in the line “Profit of the Year Due to Non-Controlling Interests” from total net income.  You’ll notice in FY 2018, the deduction for NCIs is just under USD 1 million.  

That would seem to indicate (note that word) that another form of transaction was used.  But, it could be that there were offsetting losses for the NCIs of USD 37 million and so the net would only be USD 1 million.  (USD 38 million in GH profits less USD 37 million in losses on other transactions for NCIs).  

If this is not the case and that seems likely, could GFH structure this transaction in another way to allow it to keep the entire USD 77.8 million for its own account? 

AA is not a CPA or CA.  What follows are some conjectures or more precisely speculations. Note that word well.  

1. Having acquired the sukuk certificates, GFH as the owner of the debt engaged in a restructuring agreement with GH.   
2. Under the restructuring, GH remained liable for the full USD 203 million.  
3. Because GFH acquired this debt (the Sukuk) at a discount its cost for the restructured loan is USD 125.2 million.  To balance its books, it needed another debit on the balance sheet to bring the restructured loan to USD 203 million which was offset by a credit to income.
4. Hence, the possible USD 77.8 million profit, arising in the transaction with AlRajhi and not GH and thus fully GFH's and outside of consolidation as it is a transaction with a third party.  In this case GFH would not need to have been a majority owner of GH to recognize this profit which would be "all" its own.

Recognizing profit assumes that GH repays the loan in full.  If this is the transaction that was used, if GH does not for some reason repay the debt in full, GFH will have to take a write-off in the future.  And the future is far away.  

As AA understands IFRS 9 (remember the caveat above about AA's accounting credentials or lack thereof) when a debt instrument is acquired at a deep discount due to credit reasons then an assessment of Expected Credit Loss (ECL) must be made.  In this case, the ECL then would reduce the immediate profit recognized. 

Clearly, the roughly 38.3% discount on the Villamar Sukuk is due to credit distress not current market rates being above the coupon on the debt. 

It would therefore seem to AA that some sort of ECL should have been considered and perhaps created.  As well, it seems (to AA) that assuming no loss on a debt that has been in default since 2013 with minimal repayments during that period is a heroic one. 

That being said, GFH is intimately familiar with GH having had leadership positions on the Board and management for years.  As well, perhaps, it acquired collateral which would make an ECL superfluous. 

AA is stumped.  

In the absence of a detailed description of the transaction from GFH so far, we don’t know.  

AA welcomes other conjectures and ideally local accountants’ expert opinions.  

AA also recommends that shareholders and analysts pose this question to GFH management.  The ideal venue for that the 2019 AGM and EGM for FY 2018 have passed without this issue being raised in those fora according to published minutes of the AGM/EGM.  

That doesn’t stop shareholders from exercising their corporate governance rights and responsibilities to pose the question now.  Or for those who analyze GFH’s equity or debt instruments to raise it as well.

GFH --Rebranding Rituals

At Suq Al Mal, we continuously drill down to leverage key learnings to  synergistically align our core competencies and core values to create scalable opportunities to move the needle while maintaining bandwidth capacity best practices .....

Over the years of AA’s imagined illustrious career, he has seen employers, competitors, and clients launch strategic changes.  As a result, AA has developed a keen “appreciation” (euphemism of today’s post) for the rhetoric and corporate rituals associated therewith.  AA certainly cannot let the opportunity pass to comment on GFH’s participation in these customary rites. 

One further introductory note. 

What follows is not so much a criticism of GFH’s new strategy as a commentary on how that strategy was presented. 

Image, morale all have their part to play in corporate success.   As a participant in such exercises, AA always felt that these rituals and the rhetoric that accompanies them need to be controlled to avoid overstatement–which can well undermine their fundamental intent.

  To start things off a headline blurb from GFH’s 2014 Annual Report (AR):

“There are those who prepare for change and grow stronger because of it, while others struggle to come to terms with the inevitable. We believe our remarkable brand needed a bold and considered change and we have been preparing for the right time to make the required transformation.

That time is now.”

“Bold” yet “considered”.  Launched at just the “right time” to make a “transformation”.    

Some initial reflections on the above:

“Come to terms with the inevitable” sounds rather ominous.  Apparently, it wasn’t only a question of business.  GFH didn’t see much of a future as a mere investment bank nor retaining the Gulf Finance House moniker--one element of the “remarkable brand” that unfortunately had to be jettisoned.  Coming to terms has also resulted in a strategic decision to continue what the ill-destined investment bank GFH was doing but not to do so much in real estate.  Luckily GFH’s preparations were finalized in time!  From a more philosophical and perhaps even theological perspective does the new GFH’s change in strategy represent a repudiation of the regional adage that “real estate may get sick, but it never dies”?

“Remarkable brand” – it’s interesting that the focus is on “brand” rather than “business”.   A case of corporate babblespeak?  Or an indication that image rather than substance is the key focus?     Sadly of late, the brand has been remarkable primarily for unremarkable (two euphemisms in a single post!) results.

“Bold and considered change”—what does it entail? 

Besides changing its name, GFH the “financial group” has boldly separated out activities that Gulf Finance House—the apparently inevitably doomed investment bank—undertook. Its new strategy is to develop these businesses under newly created LOBs and thus diversify its portfolio.  

In AA’s opinion this seems less bold than proclaimed. 

Essentially it is largely more of the same in terms of activities. GFH is not entering the insurance business or exiting real estate completely. Either of these would be bold moves.  The plan to diversify the business away from real estate is eminently reasonable given performance.  Sensible rather than bold.  Yet real estate will remain the core business.  Fine-tuning not radical change. 

From investment bank to financial group.  By AA’s reckoning none of the new LOBs are outside the range of investment banking activity. Even the Goldmine and Morgan Stanley are now pitching middle market commercial banking services.   And shudder some are into retail lending!  Diversification is also a concept that is not foreign to most investment banks. 

So why is “GFH transforming from investment bank into a financial group designated to offer a unique financial portfolio and maximize value potential to its shareholders” as we’re told on page 33 of the 2014 AR?  For that matter why is GFH more concerned about maximizing value potential than in maximizing value realization?  Should it be pursuing return of financial portfolios rather than their uniqueness?

Is there a compelling business reason or is this corporate imaging?

From where AA sits, this seems to be either

(1) rebranding: an attempt to create a new corporate persona to put some “daylight” between the new brand and what then is highly likely to be the old tarnished brand and/or

(2) kotodama.   Names have power.  If we change our name, our fate will change.  In earlier days those who perceived the need for a name change consulted religious figures, numerologists, astrologers, etc. to help find appropriate and powerful new names and symbols.  In these imagined more enlightened times, corporations hire corporate image consultants. 

GFH now ventures forward as a self-identified “financial group” under a somewhat new (brand) name with a new and no doubt more powerful logo and apparently new corporate colors—all part of the customary and sacred corporate rituals that accompany this exercise.  AA sadly did not notice if the preferred corporate font had changed—a step that some consultants say irrevocably seals the transformation. 

In case you’re wondering given the apparent cynicism of the remarks above, AA bears his employer’s logo and corporate colors proudly by day with pitchbooks (yes, we have a preferred font and font size!) and by night with specially made pajamas.  Pinstripe of course!    And a more casual pair but only for use on nights of officially sanctioned casual dress days.

Before closing one further quote, this from GFH’s 2015 Annual Report cover which is a nice collection of corporate babblespeak favorite terms  Boldface and comments are AA’s.

GFH Financial Group is on course to achieve steady and sure financial growth by following a clearly defined strategy [AA’s practical business experience suggests clearly defined is a key element in a good strategy, but while necessary, not sufficient].  As our 2015 Annual Report & Accounts illustrates, our brand’s vision to discover, innovate, and realise value potential [perhaps proof not that any is needed of corporate personhood.  It’s unclear though if “vision” relates to imaginings of things that never were or of things that might be, etc.  Special kudos for linking “vision” to action verbs.], has empowered us to diversify our sectors of excellence, as well as expand our geographical footprint.

I was hoping for “one-stop shopping”, “leverage”, “best of breed”, “best practices”, “global architecture”, and maybe even “evisculate”. 

Something perhaps for 2016. 

GFH –A “Bold” and “Considered” New Strategy

Out With the Old

In With the Powerful New

As outlined in my previous post, GFH’s performance has been disappointing since 2008.

In 2014 GFH announced what they touted as a “bold” and “considered” strategy. They also changed the “brand” name from Gulf Finance House to GFH.  No longer a mere Shari’ah compliant investment bank, GFH became a self-described Shari’ah compliant financial group.  

Let’s let GFH speak for itself to set the stage.

GFH’s Chairman’s Report page 29 FYE 2014 AR.

It is the beginning of a new era where GFH adopts a new strategy and transforms from an investment bank into a financial group.  This transformation began during the year when we announced a new structure, which has seen us embark upon a path to further diversify our activities to include the full spectrum of Asset Management, Wealth Management, Commercial Banking and Real Estate Development.

2014 AR -- Page 23. 

A strategic shift.   Historically GFH has been a real estate-centric investment bank, whereby a large proportion of its holdings was centred on landbased investment dealings. With its strategic shift towards finance, the bank is looking to reduce its holdings in this class from its current position of 50%, to a more even distribution of under 40%, in the mid term, and closer to 30% in the long term.

Sometimes though you have to reclaim the own land!

2014 AR – Page 19

GFH’s interest in its key commercial banking asset Khaleeji Commercial Bank is part of it’s (sic) strategy to ensure greater stability from global financial issues. The group will undertake to grow this asset through operational and brand developments.

2014 AR – Page 37

GFH launched a revised business strategy during the year, targeting various operating parameters; prime amongst them is to evolve as a ‘Financial Group’ having operations across a range of financial service businesses, thereby having a stable and recurring income, profitability and cash flows.

To summarize diversification away from over dependence on real estate, more stable income and cash flows with a key focus on Khaleeji Commercial Bank (KHCB) and commercial banking.

AA has prepared three charts using info from KHCB’s and GFH’s annual report to analyze the impact of KHCB on GFH over the past five years.

Impact on Net Income

GFH Net Income Shareholders Only 2011-2015  USD Millions
	2011	2012	2013	2014	2015	Total
GFH	$0.38	$10.03	-$17.66	$14.98	-$5.52	$2.21
w/o KHCB	-$0.27	$9.09	$6.35	$11.23	-$14.29	$12.11

Over the past five years, if KHCB had not been part of GFH, net income would have been roughly US$10 million higher. 

Impact on Volatility of Net Income 

GFH Net Income Statistical Analysis 2011-2015
		Mean	STDV Pop	STDV Sample
GFH		$0.44	11.55	12.91
AA w/o KHCB		$2.42	9.21	10.29

Technical notes:  STDV=Standard Deviation.  STDV Pop=Standard Deviation of the Population.  Amounts in millions of US$s.

Without KHCB the distribution of net income would have been tighter (smaller but still large STDV relative to the mean) and around a relatively higher—but by no means (pun intended) adequate—mean.  Volatility would have been somewhat less.

 Impact on ROE

GFH ROE 2011-2015
	2011	2012	2013	2014	2015
GFH	0.22%	3.26%	-4.00%	4.79%	1.80%
AA	0.22%	3.26%	-4.01%	2.62%	-0.83%
AA w/o KHCB	-0.15%	2.96%	1.44%	2.59%	-3.68%

Technical note:  “AA w/o KHCB” GFH's share of KHCB's net income has been eliminated for the entire period.  Since consolidation of KHCB only took place in 2015 with an accompanying restatement of 2014, KHCB equity only needed to be removed for those two years. 

Here the picture is more mixed.   In 2013, ROE would have been higher.  In 2015 lower. 

Recent legal victories promise to provide GFH additional “dry powder” to fund diversification efforts, particularly those involving the UAE defendant.  It’s really too early to pronounce on the overall strategy.  Time will tell. 

But, a key element of that strategy—commercial banking—depends on KHCB. 

As indicated above, there is a credible case that GFH might be better off without KHCB. 

Past performance is no guarantee of future performance.  Thus, GFH’s strategy depends on KHCB’s future prospects and performance. 

A separate post on that topic will follow.

GFH Bahrain: What’s Changed Since 2010?

Heading Up But Still Lots to Climb

I last posted about GFH in 2010. 

At that point, its financials were a mess.

Along with Global Investment House and The Investment Dar it was part of the trio of once high-flying regional investment banks that hit the wall at high speed. 

What’s happened since then?   

On a positive note, GFH escaped the fate of Global Investment House.  Its shareholders remain in control, cases have been lodged to recover funds, additional capital has been raised, and assets have not been stripped off to creditors. 

Nor is GFH in what would appear to be the nearly persistent vegetative state of The Investment Dar –a chronic condition punctuated by infrequent bouts of apparent lucidity in which TID announces yet another restructuring plan. Sadly during those periods TID is insufficiently lucid to issue financials, the last to see daylight being from FYE 2009, or to even update its website.  Love the Board members’ pictures.  Despite the difference in surnames, three of them look remarkably similar.

So how has GFH performed since 2010?  

Short answer:  not so well. 

On page 36 of its 2015 Annual Report, GFH kindly provide five years of financial highlights.     

GFH ROE 2011-2015
	2011	2012	2013	2014	2015
GFH	0.22%	3.26%	-4.00%	4.79%	1.80%
AA	0.22%	3.26%	-4.01%	2.62%	-0.83%

As you see from the above, AA has a different analysis of the last two years’ ROE.

1.      For 2014 and 2015 GFH used total net income— both GFH shareholders and those of non-controlling interests (NCI)—and equity attributable only to shareholders of GFH (excluding NCI’s share of equity) to determine ROE. 

2.      AA used net income—actually a loss of US$5.5 million—attributable only to shareholders of GFH and like GFH used equity attributable only to GFH shareholders.   Why? Because the point is GFH’s ability to generate income for its shareholders.  Also this choice is related to the nature of consolidated statements as outlined in #5 below. 

3.      As consolidation only affected 2014 (restated) and 2015 results, those are the only two years where there is a difference in calculation methodology.  

4.      Both GFH and AA used beginning and end of period equity to determine a year’s “average” equity to calculate ROE.  Because there were significant capital increases over the five year period (an almost three times increase), this method overstates ROE for certain periods because it understates average equity.  But what’s important here are trends, directional rather than locational statistics.

5.      One very important note:  consolidated financials are an accounting construct.  They are designed to provide a way to analyze the economic performance of a “group”.   But the consolidated "group" is not a legal entity.  That is, the group does not really (legally) directly owns the assets or receive the income shown.  Parent only or individual financial statements show the legal status ownership of assets, cash flows, etc.  Take a look at note 34 in JPMC’s 2015 AR and compare the data to the consolidated financials.  Parent revenues are largely dividends and assets are largely investments. This fact has important implications for investors and creditors that buy holding company equities or unsecured debt securities. Or for lenders to holding companies.  Access to cashflow, access to assets, priority in bankruptcy, responsibility for subsidiary/affiliate debt (absent parent guarantees) are some of these. 

Whether you take GFH’s or AA’s calculations, performance has been “disappointing” (euphemism of the post).  Earnings have been volatile.  ROE has been subpar.

Some of this is economic:  a “weak” (second euphemism) legacy portfolio, the cyclical nature of GFH’s businesses, etc. 

Some of this is a function of internal management: legacy leadership—responsible for the high risk portfolio—was only conclusively removed in late 2013, no doubt delaying remedial action.  GFH has also conducted successful legal actions against “two of its ex-Chairmen for bonuses illegally obtained during the period 2005-2008”  which some readers may interpret as indicating less than the ethics one might hope to find in a self-described Shari’ah compliant institution.   الله اعلم

A coming post will take a look at GFH’s attempt to address its problems.