What are GFH’s Motives for Acquiring KHCB Shares?

لولا اختلاف النظر، لبارت السلع  

 Summary of key points in this post.

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

• Tender offer proposed for remaining 30.95% of shares

• Favorable Impact on GFH’s Consolidated Shareholders’ Equity

Background

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

On 7 June GFH provided further details as follows:

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

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

Deal Analysis

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

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

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

Apparently, KHCB is quite a valuable asset.

Though one might not have thought so from the fact that

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

• GFH had to buy the entire AT1 instrument

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

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

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

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

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

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

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

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

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

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

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

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

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

Motives for the Transaction

So what is motivating GFH’s acquisition of KHCB?

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

I've selected two for discussion:

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

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

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

Overlooked Gem

The market has fundamentally undervalued KHCB.

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

Thereby reaping rich rewards long into the future.

Accounting Magic

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

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

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

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

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

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

Compare that to the BD 8.8 million purchase price. 

A not inconsiderable gain on purchase.

You might well ask:

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

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

Here’s how it would work in detail.

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

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

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

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

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

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

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

But there is indeed more!

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

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

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

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

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

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

Are they disclosed separately as in 2020?

Booked directly to equity?

Or perhaps to income?

KHCB 2020 Financials - A Look at the New AT1 Capital and Capital Reorganization

 

Link to KHCB FY2020 Audited Financials.

As you will remember, following losses in FY 2019, KHCB needed to raise additional capital to comply with the CBB’s requirement that it have BD 100 million in equity.

KHCB decided to issue AT1 (Additional Tier One) capital rather than additional common equity. Presumably, because there was little appetite for the latter. This would also prevent dilution of existing shareholders.

It also decided to “regularize” some 15.788 million in accumulated negative retained earnings by writing these losses against Paid in Capital. 

This is essentially an accounting entry. 

No cash is involved except for the legal work to amend the bank’s articles and memorandum of association and for the share registrar to amend its records of individual shareholders’ number of shares, issue stock certificates where required, etc.

BD 72 Million AT1 Issue (Subordinated Murabaha)

The issue was “successfully” raised, due to GFH “buying” the entire issue.

Let’s look at the details as outlined note 35 of KHCB’s 2020 audited financials.

The issue was for a nominal BD 60 million plus a BD 12 million premium. Total BD 72 million.

GFH “underwrote” the issue for an underwriting fee of BD 12.1 million and then subsequently “bought” the entire issue. IN GFH’s FYE 2020 financials, this fee is referred to as a “subscription fee”.

Whatever it’s called it is an extremely high fee: 16.67% of the total proceeds of BD 72 million.

GFH paid cash of BD 23.6 million (roughly 35% of the BD 72).

It contributed the remaining BD 48.4 million as follows:

1. BD 24.5 million in the form of 50% of the interests in the AlAreen Hotels WLL (note 13)
2. BD 5.5 million in property
3. BD 18.4 million in financing assets.

Some additional  comments.

First, the issue was primarily in kind (76%) not in cash. The real value of the issue depends on the value of these assets.

Second, while we see these entries in KHCB’s financials, we don’t see them in GFH’s consolidated report because of the "exigencies" of consolidation. There are some adjustments (to GFH’s financials) which I’ll discuss in a forthcoming post on GFH's 2020 financials.

Third, given the BD 12.1 million underwriting/subscription fee KHCB owed to GFH, the actual net cash contribution by GFH to KHCB was BD11.5 million.  

You will see BD 11.477 million in KHCB's Consolidated Statement of Cashflows as "AT1 Proceeds".  That's the net of BD 23.6 million contributed in cash by GFH less then BD 12.1 million "subscription"/"underwriting" fee paid by KHCB to GFH.

That’s the firm to firm transfer. 

But GFH owns 55.41% of KHCB so its share of the fee paid to GFH is roughly BD 6.7 million so one can say it paid a BD 12 million premium for the issue and received back BD 5.4 million (the NCIs share). 

You'll see this amount USD 13.311 million attributed to the NCIs in GFH's annual report in the Consolidated Statement of Shareholders' Equity.

In  KHCB’s financials the AT1 instrument is carried at BD 47.22 million. Not BD 60 million.

How did that happen?

First, the BD 12 million premium was “booked” to KHCB's retained earnings.

Second, the BD 12 million underwriting fee plus an additional BD 778 thousand of other issue expenses were deducted from the AT1 proceeds of BD 60 million ex premium reducing it to BD 47.22 million.

Write-off of Accumulated Losses Against Paid in Capital

KHCB reduced its issued shares from 1,050,000,000 (par value BD0.10) to 892,481,190.

Each shareholder’s number of shares was accordingly reduced by roughly -15%.

During the period 11 August 2020 through 9 November and following the 15% reduction in the number of its shares, Goldilocks sold 1,945,547 shares reducing its holding in KHCB from 9.96% to 9.78%.

One final observation.

KHCB has been showing Emirates Islamic Bank (EIsB) as shareholder with some 8.41% of shares and GFH with 47%.  

In its FYE 2020 annual report, KHCB shows GFH holding 55.41%. EIsB doesn’t appear as a shareholder. 

There is no explanation of the change.

By contrast GFH has been showing its holding in KHCB as 55.41% since FY 2017 (note 18).

Back in 2016 GFH had floated the idea of acquiring 100% of KHCB.

Later it decided not to, but got a special exemption from the tender offer rules in Bahrain to allow it to only acquire Emirates Islamic Bank’s stake. 

Normally tender rules require that over a certain threshold, the acquirer has to tender for all shares it does not own. This to ensure that all shareholders are treated equally.

Unclear why GFH's acquisition of EIsB's shares wasn’t reflected in KHCB’s financials until FY 2020.

KHCB Announces OGM and EGM Dates and Agenda More Questions for the OGM and EGM

KHCB has issued the announcement that its FY 2019 OGM and EGM will be held on 25 March 2020.

If a quorum is not reached, the second meeting will be held 1 April. 

If a third meeting is required, the date is 8 April.

Time for shareholders to take another look at AA’s earlier post with questions for KHCB’s Board and Management.

This post adds some new questions on the proposed meeting agendas.

Ordinary General Meeting

1. Item 10 Authorize Board to appoint a “market maker” who will use up to 3% of GFH’s shares. 
2. Item 11 Authorize the Board to take necessary steps to delist from the DFM.

It’s pretty well known that as a general rule, the BSE has liquidity issues so appointing a market maker makes sense.

Shareholders, however, should make certain that “market making” doesn’t become a cover for costly transactions designed to prop up the share price as is the case at GFH. 

A cautionary tale here.

KHCB’s shareholding is concentrated: four shareholders hold just over 75% of shares and would likely have to trade their shares in “off market” transactions (BSE Special Order Market). 

What then is the appropriate amount of Treasury Shares that the market maker needs to provide liquidity to retail shareholders?

Extra-ordinary General Meeting

1. Item 2- Approve capitalization of losses via a reduction in paid-in-capital to BHD89,211,948 from BHD105,000,000.
2. Item 3: Approve issuance of Sukuk in an amount up to USD 200 million as Additional Tier 1 Capital.

Shareholders should probe on why the amount being raised is roughly 5 times the BHD 15 million capital shortfall. 

Is this a sign of an extremely serious problem at KHCB?  Recall that as of FYE 2019 the CAR was a respectable 16.5%  

Or is KHCB planning a major acquisition?

If fully issued, the impact on existing shareholders ability to receive dividends and the market price of shares is going to be significantly adverse because given its size and required tenor to quality as AT1 capital, this is going to be a very costly instrument.  

There may be very little left of net income for ordinary shareholders.

Given the pattern and concentration of shareholding, retail investors are going to have no real say in the outcome, unless they can persuade representatives of the Bahraini authorities that their rights are being ignored. 

However, GFH shareholders may have more ability to influence things because GFH has more diverse shareholding. That is, there are not one or two shareholders who control a majority of the shares.

Goldilocks Investment Fund “The Midas Touch” – Khaleeji Commercial Bank

As Legendary Investor Fred C. Dobbs Can Tell You Not Only Have to Have 

the Golden Touch, But You've Got to Know How Hold On to Value

Continuing our fairy tale theme, another instalment on Goldilocks Investment Fund.

In doing a bit of research on GFH, I just happened to discover that Goldilocks owned some 9.98% of the shares of Khaleeji Commercial Bank Bahrain.

From a quick look at previous years KHCB financials, their ownership first emerged in the FYE 2017 report and has been consistent since then.

What changed was that as of FYE 2016 Shuaa Capital owned 14.01% of KHCB.

In the FYE 2017 report it “disappeared” from the list of major shareholders – 5% and above.

According to the Bahrain Stock Exchange, on 26 September 2017, Shuaa sold 100 million shares to Goldilocks at BHD 0.096 per share on the Special Order Market.

According to Bahrain Stock Exchange data, the closing price on that day in the regular market was BHD 0.1113 so Goldilocks bought at a 15% discount.

Goldilocks already owned some 3,950,000 shares as of that date and apparently acquired another 829,110 shares prior to FY 2017 end.

Shuaa retained 40,779,824 shares or 3.88 % of its holding then.

It’s not clear if it still does.

What was Goldilocks’ return on its investment?

KHCB paid no cash dividends since Goldilocks’ acquisition.

So the return is change in the market value of stock.

KHCB closed at BHD 0.052 on 2 May 2020.

ROI is negative 46% (based only on the cost of the 100 million shares purchased from Shuaa).

That’s before consideration of the likely negative impact on Goldilocks and other KHCB's existing shareholders of KHCB’s need to raise BHD 37.1 million in new Tier 1 equity. 

See that discussion here. 

But save some of your pity for KHCB which is sitting on a similar size block of Treasury Shares at an average cost of BHD 0.1138 and facing a much lower ROI – negative 54%.

You’ll recall and if you don’t AA will remind you that Shuaa bought AlImtiaz's 14% stake in KHCB in December 2006 for BHD 0.065 per share. Approximately one month after ADFG bought a little over 48% of Shuaa.

Shuaa’s ROI on its investment in the 100 million in KHCB shares it sold Goldilocks was roughly a positive 48%.

Side note:  Ending of film pictured above presents an unrealistic scenario when atomic weight is considered, though it has a nice cinematic effect.

Khaleeji Commercial Bank – Dismal FY 2019 Results & Suggested Questions for Shareholders for the AGM

UPDATED FOR INFORMATION CONTAINED IN KHCB'S OGM/EGM ANNOUNCEMENT. 

Comments below in boldface red font.

Link to new post here.

Some quick comments on KHCB’s FYE 2019 financials.

Plus an additional section with suggested questions for shareholders for the AGM.

The bank reported a net loss of some BHD 15 million due to BHD 20.4 million in provisions for FY 2019.

But if you’ll look a bit closer you’ll see that actually provisions for troubled debt were really more than BHD 20.4 million. 

They were just called something else.

As often occurs with the adoption of new accounting standards financial institutions are allowed to make prior period adjustments.

That is, they do not have to include the amount of the total adjustments or provisions required in current year’s income, but only the current year's portion.

So they "pretend" that they made the adjustment in the previous financial year (hence the need to restate that year's numbers) and only have to book the "catch-up" since then in current year's income.

This is the case with AAOIFI’s FAS 30.

Sometimes there is an added benefit. The new standards do not require a formal restatement of the prior period financials.

What that means is they make the change in the prior year's financials but do not have to label that year as "restated".  

This is the case with FAS 30 as outlined in Paragraph 63.

This isn’t idiosyncratic behaviour on AAOIFI’s part. IAS and FASB do allow this on some of their new standards.

What this means is that you don’t see the word “restated” above the comparative numbers for FY 2018 in KHCB’s FY 2019 financials.

Why is that a potential problem?

The word "restated" alerts you to the fact that a material change has been made in the financials. 

When it's not there, you might overlook a significant development.

Usually prior period adjustments are not positive events, though sometimes they are.

That’s why you can’t just look at the Balance Sheet and Income Statement. You also need to look at the Cashflow Statement and the Changes in Equity Statement and read the notes.

Looking at the Statement of Changes in Consolidated Equity in KHCB’s FY 2019 report, you’ll notice a BHD 11.1 million prior period adjustment for FY 2018 associated with FAS 30.

What this means is that the provisions required were actually BHD 31.5 million.

Why care?

That is roughly 33% of shareholders’ equity.

As a result of these provisions, KHCB’s equity fell to BHD 85.7 million as of 31 December 2019.

As their auditor points out in Note 1, this is below the minimum capital of BHD 100 million required by the Central Bank of Bahrain.

Further in that note, you will “note” that

The Board of directors has mandated an international bank to assist it with issuing additional tier 1 capital (AT1) of BHD 37.7 million to help strengthen its equity and meet the regulatory requirements.

Suggested AGM Questions for Shareholders

In light of these developments some suggested questions for shareholders to raise at KHCB’s AGM.

Amount of New Capital

1. CAR remains a very acceptable 16.5%.
2. Why is KHCB raising BHD 37.7 million 2.5x its capital shortfall of BHD 15 million?
3. KHCB have announced they will seek EGM approval for up to a USD 200 million sukuk as new capital.
4. Why is KHDB now raising potentially 5x its BHD 5 million equity shortfall?
5. Does the Board or management anticipate the need for further provisions or the occurrence of other problems?
6. Is the CBB requiring that KHCB have more than the minimum BHD 100 million in shareholders’ equity? Admittedly a difficult question for the Board for a variety of reasons.
7. Is KHCB planning any acquisitions?
8. Have existing major shareholders advised whether they intend to participate in the new equity?
9. Hint: It’s not a good sign if they are not interested.

Form of New Capital and Impact on Shareholders

1. Is the AT1 Capital going to be in the form of preferred stock or a similar instruments, e.g. cocos?
2. KHCB will ask shareholders at the EGM to approve up to a USD 200 million Sukuk as the instrument.
3. That’s a more likely scenario than additional common equity because the potential direct dilution of existing shareholders would be significant unless they contributed additional equity.
4. Assuming the new equity is in the form of preferred stock or similar preferred instruments, what will be the impact on shareholders’ ability to receive dividends?
5. Usually these instruments have preference over common equity so payments to the new AT1 Capital will reduce the amount available for common dividends.
6. It’s likely that the new AT1 Capital will lead to a reduction in the market price of common stock given its size relative to existing equity, its likely pricing and privileges vis-a-vis common equity.
7. If on the other hand, it is going to be issued as common equity, what is the dilution impact on existing shareholders? 
8. It would appear to be rather large because of the amount required.
9. AT1 Capital of this size is not going to be cheap.

Alternatives – Treasury Shares?

If you’re like AA, you will have noticed the BHD 11.79 million in Treasury Shares and wondered if these were an alternative that would spare the existing shareholders some pain.

But note this is "efficient" only if KHCB has to raise BHD 15 million not BHD 37.1 million in new Tier 1 capital.

Treasury Shares are deducted from equity. Somehow removing these from the balance sheet would increase equity and thus reduce the amount of new capital required.

If KHCB could sell them at its cost (BHD 11.79 million), it could reduce its BHD 15 million capital deficit to roughly BHD 3 million.

Perhaps, the CBB could even be persuaded that the amount was so small that KHCB could be given the “grace” to cover it from profits over a couple of years.

That would obviate the need for new capital and prevent loss of value of the existing shareholders.

Alas, KHCB’s average cost per Treasury Share is BHD 0.1138.

If it could sell all its shares at market price – not a likely scenario given the size of the “block” and less than enthusiastic appetite for KHCB shares--, it would as a best case raise about BHD 5.4 million based on the closing price of its shares on 2 March  2020. 103.6 million Treasury Shares* BHD 0.052.

However, selling such a large block of shares would decrease the realized price. So the actual amount would be less.

The BHD 6.4 million “loss” on the best case sale (=103.6 million TS * (BHD 0.052-BHD 0.1138) would be a transfer of BHD 6.4 million from the Treasury Shares sub-account in equity to Retained Earnings in Equity.

So it would not affect the total for shareholders’ equity.

And thus not increase or decrease the amount of funds KHCB has to raise to “cover” the BHD 15 million shortfall. Only the cash received would decrease the amount needed to be raised.

Now, if KHCB were to cancel its Treasury Shares, it would recognize a loss of par value (BHD0.10) less average price (BHD0.1138) times 103.6 million shares or roughly BHD 1.5 million.  

That would mean that the BHD 15 million deficit would reduce to about BHD 5 million. The same logic for grace might apply, thus eliminating the need for any new capital.

The question would be the trade off.

Is the benefit to existing shareholders (quantified in BHD terms) of avoiding the issuance of new equity worth more than the cost of canceling the shares and wiping out forever the BHD 11.79 million spent on Treasury Shares.

One would probably want to analyze this in terms of various presumed "recovery" rates (selling prices) of the Treasury Stock. 

If, however, KHCB must raise BHD 37.1 million, then this method would be of limited utility.

As an aside, shareholders might want to ask their Board to remind them again of the compelling business logic of KHCB acquiring roughly 10% of its shares as Treasury Stock.

This may also be a topic that KHCB’s regulator should consider though sadly retroactively.

There’s not much that can be done about past purchases, but KHCB could be required to gradually decrease its holdings of Treasury Shares to a much lower level.

It may also be a 'wise" move for the CBB to ask all regulated entities with significant holdings of Treasury Shares to report to the CBB if the average cost of the holdings is materially different than the current market price.