Strong Evidence No Discount for Gulf Holdings on Villamar Sukuk Repayment to GFH

AA Solves Another Case by Applying Non-Euclidean Geometry

As you’ll recall, in 2018 GFH purchased the Villamar Sukuk—on which Gulf Holding KSC Kuwait is obligor--from AlRajhi at a discount of some USD 77.8 million from its face value (roughly USD 203 million).

In its FY2018 financials GFH declared a gain of this amount.

In looking closely at GFH’s financials, I thought there were two possible structures for the “settlement”:

1. Option 1: GFH reduced the debt amount, GH to pay USD 125 million
2. Option 2: No reduction in debt amount, GH to pay full USD 203 million.

Based on that June analysis, I assessed that Option 2 was the more likely settlement mechanism. You can read the June blogpost here for the detailed argument for that view.

But as often is the case, GFH’s financials didn’t provide all the information necessary to make a conclusive determination.

An apparent dead end. But not really.

Additional “Evidence”

Gulf Holdings publishes financials.

If GFH offered it a discount on repayment, that should show up in GH’s 2018 annual report.

If it doesn’t, then there is further indication that Option 2 is the settlement mechanism.

As it has done in the past, GH included its financials in the shareholder package for its FY 2018 Annual General Meeting.

According to those financials:

1. The principal amount of the sukuk is unchanged.
2. As per Note 25, there has been no material change since the date of the financials (31 December 2018) and the date of the external auditors’ report (23 April 2019).

If discussions were ongoing for a reduction, then these should be mentioned in the “subsequent events” note. 

That increases my confidence that the sukuk is being “settled” under Option 2: GH to pay full value.

However, it is possible that GFH and GH did not begin negotiations until after 23 April. But again I consider this unlikely.

There was another open question from my June analysis regarding the potential need for a provision. The Sukuk was non-performing and AlRajhi sold it at a 38% discount. That would seem to be a strong indication that the Sukuk was impaired.

So how could GFH be confident enough persuade itself and its auditors to (a) book the entire USD 77.8 million gain in 2018 and (b) treat the Sukuk as unimpaired.

AA overlooked the fact that the sukuk is secured by Villamar Project assets.

GFH is the “natural”--perhaps the only—realistic buyer for these assets. Arguably it is also the potential buyer best placed to extract full value from the assets.

In any sale GFH and GH (controlled by GFH) would enter into “arms length” negotiations to set the price.

Now some out there might be thinking: “But, AA, this gives GFH the opportunity to potentially manipulate the sale price to its advantage to ensure it ‘collects’ 100% of the Sukuk thus justifying the USD 77.8 million ‘debt settlement gain’. It would be able to bury any shortfall in the value of assets acquired where that amount will be hard to detect”.

To those doubters I say that AA is highly confident that GFH will acquit itself in this transaction applying the same standards of ethics for which it is well known.

Regarding a potential sale of GH assets, according to the GH’s 2018 AGM package, shareholders were to be asked to approve the recommendation of the Board of Directors for a strategic sale of Residential South Real Estate Development Company SPC (RSREDC) and the owner of the Villamar project for a total value of US $ 52,466,853 US $ 47,466,853 / cash (US $ 5,000,000) and authorize the Chairman or his designee to take all necessary actions to complete the sale and transfer of ownership.

As I translate the Arabic AGM notice, the sale price appears to have two tranches: a cash tranche of USD 5 million with the remainder non-cash. Perhaps in partial settlement of the Sukuk?

You can check my translation by using the link above to find the AGM Agenda Point 6 on page 5.  If I've missed something, please set me straight.

I haven’t yet found any press release or other announcement about a sale.

But one appears to have taken place.

If I’ve read the information at www.sijilat.bh correctly, ownership in RSREDC (CR 59128-1) was amended in November 2019 from Gulf Holdings Kuwait to GFH Asset Company Cayman Islands.

Anyone out there with info, please post a comment.

GFH Acquisition of Gulf Holdings Kuwait – More Questions than Answers

Not  F. Scott Fitzgerald

Well, AA always thought he had a first rate intelligence, but after reading GFH’s Note 20 to its FYE 2018 audited annual report, AA is having trouble dealing with two fundamentally opposed ideas in his mind at the same time.  

In that Note, GFH discloses that it has become the majority shareholder in Gulf Holdings KSC (Closed) after it purchased 31.39% of GFH in June 2018 for consideration of USD 6.691 million dollars. 

Prior to that GFH held 19.79% to which it ascribed no value, apparently having written down its much earlier purchase--probably originally made in November 2005 when GH was established--to zero.  

Fair enough.  No problem with that.   

The cognitive dissonance occurred when AA noticed a value of USD 6.691 million was being ascribed to the total of GFH’s 51.18% holding in GH.  That appears to have been based on the 30 June 2018 financials of GH which showed "Total Net Identifiable Assets" (hereinafter "TNIA") of some USD 13.1 million.  

What a remarkable coincidence, 51.58% of TNIA just equals the purchase price for 31.39% of GH.  

That was followed by a puzzling accounting on the next page, where GFH's previously owned 19.79% shareholding was shown with a zero value (presumably its book value) with the 31.39% shown at USD 6.691 million with the 51.18% shareholding valued at USD 6.691 million.  

A chart which had in essence two equations valuing the stock of GH. The first: 19.79% x  # shares of GH = USD 0.  The second: 31.39% x # shares of GH = USD 6.691 million.  

AA struggled to hold both these opposing ideas (equations) in his mind as simultaneously true.  There doesn't seem anything about the first group of shares that impairs their rights.  In fact GFH through BSB Ventures voted those shares at GH's delayed FY 2016 AGM and EGM just three months prior to the acquisition of the second batch of shares.  

If USD 6.691 million is the value of 51.18%  of GH’s shares, then that means the purchase price for 31.39% of shares is USD 4.1 million.  Thus, GFH has paid roughly USD 2.6 million more than it should have.  

If USD 6.691 million is the value of 31.39% of GH's shares, then GH's firm value is USD 21.3 million.  Or some USD 8.2 million more than the TNIA identified in the balance sheet. Or in percentage terms roughly 163% of TNIA. 

That is a very wide range of firm value -- USD 13.1 million to USD 21.3 million.  

No doubt some out there are thinking, “But AA this was the purchase of a controlling stake and so GFH would have to pay a "control" premium.”  

Indeed.  

But on the other hand, did the seller have any other potential buyers?  If GFH were to walk away from GH, GH's prospects would be even bleaker than they appeared at the FY 2016 AGM and EGM last March.  And the seller might lose all its investment.  In such a case GFH might be able to pick up GH's choice assets in later fire sale. So GFH had some leverage.  And apparently did not agree to acquire the Villamar Sukuk from AlRajhi until October, some four months after the acquisition.   

Also, there could be hidden value within GH.  Judging from its draft  FYE 2017 financials and the June 2018 presented, very well hidden.  

There is a third potential reason.  That GFH was more focused on completing the acquisition than the price of the acquisition.  

If you’ve read AA’s posts on GH’s financial condition as of FYE 2017, it was in a very sorry state.  Posts here and here. The auditor refused to render an opinion as he had refused for FY 2016. He also remarked that he was unable to determine if GH was keeping proper books of account.  A rather damning indictment on its face.  

Was GH’s financial situation clearer a scant three months after that date?  

Clear enough to justify GFH plunking down some USD 132 million to become majority owner and agree to acquire the Villamar Sukuk? 

I say three months because GH held its FY 2016 AGM and EGM on 1 March 2018 (no doubt delayed for very good reasons) when its woes were many and manifest.  

That doesn’t seem highly likely to AA.  

As noted in FYE 2018 financials:   

“Given the size, geographic dispersion and inherent complexity involved in the acquisition, the Group, as on date of issue of this consolidated financial statements, has not concluded (emphasis AA) on the determination of fair value of tangible and intangible assets acquired, liabilities assumed and residual goodwill arising from the acquisition.“ And further in that paragraph “the estimates of fair values for tangible and intangible assets acquired and liabilities assumed is subject to significant judgement and shall be determined (emphasis AA) by management … “ 

So what did we learn from this quote and the above? 

First, that GFH bought GH apparently without having a clear idea of value.  It didn’t know in June 2018 when it bought the company if it was overpaying or not. However, it did pay 163% over June 2018 TNIA  In its words it didn’t know the fair value of assets or liabilities assumed. Almost seven and one-third months later—11 February 2019 the date of the issue of GFH's audited FY 2018 financials—it still didn’t.  

Second, that any valuation that will be made is an estimate which is subject to significant judgement.  To be fair generally the only certain items on the balance sheet are liabilities for borrowed money.  Everything else is subject to certain risks of varying degrees.  Cash in US dollars or Euros with a AAA rated bank is more certain usually than accounts receivable for investment banking services.  

In commenting on valuation of such assets, GFH has disclosed for some time most recently in Note 5 (iii) Impairment of Investment Properties to its FY 2018 audited financials that:   

“Given the dislocation in the local property market and infrequent property transactions, it is reasonably possible, based on existing knowledge, that the current assessment of impairment could require a material adjustment to the carrying amount of these assets within the next financial year due to significant changes in assumptions underlying such assessments.” 

Thus, any valuation on GH would probably be subject to the same caveat.  It could change the next year. Side Comment:  Prospective investors in GFH projects may want to reflect on the inherent uncertainty disclosed by GFH regarding valuation of real estate projects prior to making commitments. 

To summarize having bought GH in June 2018 as of 11 February 2019, GFH had not made a determination of the value of GH.  And it has pointed out that any such value it does assign is subject to assumptions which might change within one year.  

Given the uncertainty of the value of GH expressed in these two quotes, AA wonders how GFH determined whether GH was a good investment to say nothing of what to pay for it.  As per GFH’s own words, there might be “negative” good will.  

Also if GFH did not know GH’s value, was it a wise idea to agree to acquire Villamar Sukuk from AlRajhi for some USD 125.2 million in October 2018?  Or should this have been postponed until GFH had made such a determination?  

GFH spent a total of some USD 132 million on GH-- more than GFH’s 2018 net income. Or for another comparative GFH could fund a lot of trading in Treasury Shares with an amount like that and then cancel the shares bought.  

Let’s compare the June 2018 GH financials presented in GFH’s Note 20 to those as of 31 December 2017 for more insights in GH and potential value.  As a reminder, GH’s FY 2017 financials are drawn from the “shareholder package” for the FY 2017 AGM and EGM.   

Gulf Holdings Unaudited Financial Statements
USD Millions
ASSETS	30 June 2018	31 Dec 2017		DIFF
Investment Property	$40.4	$48.1		($7.7)
Development Property	$387.3	$433.8		($46.5)
Cash and Banks	$1.5	$1.7		($0.1)
Other Receivables and Assets (A/R)	$26.3	$6.0		$20.3
TOTAL ASSETS	$455.5	$489.5		($33.9)
LIABILITIES	30 June 2018	31 Dec 2017		DIFF
Sukuk	$202.8	$202.5		$0.3
Advances from Customers	$168.9	$134.5		$34.3
Related Party	$0.0	$9.9		($9.9)
Other Liabilities	$70.8	$69.3		$1.6
TOTAL LIABILITIES	$442.4	$416.2		$26.2
NET IDENTIFABLE ASSETS	$13.1	$73.3		($60.2)

  

What a difference six months apparently makes.  

So how do we perform an analysis of the changes in its financials without notes and more information?  AA thinks the "key" is the decline in equity.  An eye-popping USD 60.2 million equivalent.  

What could cause this?  A spin off of assets into a new firm, return of capital to shareholders, dividends, realized or unrealized losses.  

The first three are unlikely. 

Why? 

No sign of these in either GFH's or GBCorp's FY 2018 financials.  GBCorp in particular is in need of good earnings news and so would be expected to highlight any positive development no matter how small.  

GH has negative retained earnings and no cash, so cash dividends are unlikely.  Spinoff or return of capital are unlikely too because as you'll notice GH is still carrying the full USD 203 million sukuk as of June 2018.  Spinning out good assets in such a condition could subject GH to fraudulent conveyance claims.  

AA thinks it most likely that the decline in Development Property assets is due to write-offs or impairment charges on these assets.  You’ll recall E and Y were unable to value GH’s land parcel in Morocco as of FYE 2017.   It's less likely that these are sales of these assets at a loss.  

If the increase in Other Receivables and Assets (henceforth "A/R") reflects uncollected sales portions from the Development Property assets and there has been no material increase in cash, that would imply a loss of USD 26.5 million. If we include the Investment Property decline a loss of USD 35 million.  Not enough to explain the decline in equity. 

It’s more likely the USD 20 million increase in A/R is the unpaid portion of the USD 34 million increase in Customer Advances than sales proceeds on Development Property.  We'll discuss the "missing" USD 10 to 14 million from Customer Advances a bit later which AA assumes was collected and spent.  

The equity decline could be due to provisions for  contingencies, legal claims, etc.  If the decline in equity were due to these sort of provisions, we would expect to see an increase in Other Liabilities. We do not.  

So it's most likely that the equity decline is due to impairment provisions on Development Property and as well perhaps on Investment Property.  These would be reflected in a contra account to Development Properties netted directly against Development Properties on the balance sheet and thus "invisible".  

Now to the other side of the balance sheet.  

Total liabilities increased some USD 26 million largely due to a jump of USD 34 million in Customer Advances.  

AA is puzzled.  Are customers rushing to place money with GH? And have placed USD 34 million in six months?  Perhaps, Villamar sales?  

USD 9.9 million in Related Parties (mostly due to GFH) is not shown.  Was GFH repaid? That seems most likely as GFH is using the balance sheet it presented as value of the firm for both GFH and the other shareholders.  Not just what the consolidation effect on GFH would be. In a consolidated scenario inter company transactions would be eliminated.  So, if this is the case, it’s likely the amount was repaid.  

AA guesses that GH received some of the funds from the increase in Advances from Customers.  Probably something like USD 10 million to USD 14 million and used those funds to repay GFH and for other worthy purposes.  That would fit with the USD 20 million increase in A/R (Other Receivables and Assets).  

Where did the other cash collected go?  Well, construction at Villamar is chugging along and some of the previously recorded prepayments to contractors and consultants that were carried in A/R probably have been expensed. As well, the increase in construction would require some additional new payments.   But AA now is the very thin ice of sheer conjecture. 

Total equity is down some USD 60 million.  As argued above, since the major movement on the asset side is in Development Properties that suggests impairment charges or losses on sale of these properties.  

Changes of these magnitudes in GH’s financials in six months must be based on a fairly thorough investigation of GH's books and valuation of assets. 

As part of the purchase transaction, GFH would have to agree with the 30 June financials. One would expect that there was more substantial work and thought given to this transaction than to the basis for US tax policy which was reportedly sketched out on a cocktail napkin after a few glasses in the local pub.  AA wonders if the Presidential Medal of Freedom mooted for the inventor of this economic "truth" will be bestowed at the same stool? 

Now as of 1 March 2018, GH was in a right proper mess financially. Thus, there is good reason to suspect that these changes were worked out in the roughly 3 months to the purchase. 

Why? 

If changes of this magnitude were known at that point, wouldn’t the auditor have known and commented about them?  The auditor was not shy in compiling a laundry list of reasons why he couldn’t render an opinion.   And certainly the board would not have withheld this information from the auditors.  Would it? 

If the changes were made within the 3 month period between March and GFH’s acquisition, why weren't they finalized to the point that GFH could determine the fair value of assets both tangible and intangible?  

In its FYE 2018 annual report GFH asserts that GH’s “size, geographic dispersion, and inherent complexity” made them unable to make a determination of the value of the firm some 7.5 months post acquisition.   

Yet, even if we believe the comment above and AA sure hopes you do, some very significant determinations were made.  As of June GH's shareholders' equity was 4% of its original value down from 24% only a scant three months earlier (FYE 2017).  

AA encountered another conflict of opposing ideas from GFH's explanation about the difficulties in assessing GH's assets.  GH's major three projects are in Bahrain (two) and Morocco.  Does this mean GFH is not that familiar with these markets? And apparently sadly lacks knowledge of and contact with local experts who might assist in this task?  Or that analyzing major (sizeable) real estate projects is an area where GFH is admitting a lack of skill?  Apparently, as well, is GFH disclosing that it did not obtain any special insight into GH from its significant role in GH's board or management over more than a decade?  

Here is yet another instance of AA struggling to hold two opposing ideas in his mind at the same time.  The one above.  A second one in which GFH is an expert in real estate across diverse geography from Morocco to India with stops in between.  A master of the mega project.  A structurer par excellence of complex deals.  

More suspicious minds than AA’s might wonder if the fact that becoming majority owner of GH and “settling the sukuk” was the likely but not the only ticket to GFH recognizing USD 77.8 million in revenues in Fiscal 2018,  an amount which the preponderant component of GFH’s FY 2018 net income.  And that "matters" were rushed in order to accomplish the transactions during FY 2018 to generate this income.  

Other observers may feel that this reflects another yet masterstroke by GFH management in the area of "intrinsic" value identification and exploitation.    Similar to its trading in treasury shares and then cancelling them.  

If you know your financial history of Bahrain, you know that Bahraini investors are highly suspicious of Kuwaitis who many Bahraini investors believe over provision companies in order to buy their Bahraini shareholders out on the cheap.  It would appear that this case doesn't apply because the selling shareholder is a Kuwaiti firm with Bahrainis conducting  the buy out. 

In any case AA has his own view but will stay silent so as to not prejudice your conclusion.