GFH: A New and Improved Strategy

Not Proof of a Successful Strategy, Hard Work, or Integrity

If you’ve read GFHFG’s press release regarding 2016 net income, you’ll see that GFH has declared success in implementing the strategy it announced in December 2014--a scant two years after announcing what was described as a "long-term" strategy--and the  need for a new strategy.

Let’s let GFH’s top management set the stage for this post.

Commenting on the results, Dr. Ahmed Al Mutawa, Chairman of GFH, said, “We are extremely pleased to have delivered great performance for 2016. These results are a testament to the success of the strategy that GFH has adopted since 2014, and the commitment and integrity of the Board and management team. Our results were supported by the significant recoveries that saw $460 million of assets restored back to the Group, a major benefit for shareholders and one that will allow us to deliver stronger results for the years to come.

Building on the successful achievement of our strategy for 2014-2016, GFH’s Board of Directors has also approved and recommended a new strategy for 2017-2019, which focuses on accelerating growth by way of acquiring financial institutions, infrastructure investments and strategic assets. The new strategy will be presented for shareholder approval at the next General Assembly Meeting and are subject to final regulatory approvals.

Mr. Hisham Alrayes, CEO of GFH, added, “2016 was a year of significant progress across the Group and we are proud of the transformation that has been accomplished as demonstrated by our results.  During the year, we have delivered on our promise to shareholders and the market with regard to recoveries, which will effectively return to the Group all past accumulated and written-off losses of the last eight years.

We have also set the group foundations for the future by further strengthening our Investment Banking, Real Estate and Commercial Banking activities, and have taken sufficient provisions to make the Group’s balance sheet more efficient for future value extraction.

As a prelude to my comments, a recap of GFH’s 2014 strategy.

1. stable and recurring income, profitability and cashflow 
2. reduce holdings in “land-based” business  (real estate) from 50% to 40% in the midterm and to around 30% in the long term
3. ensure greater stability from global financial issues

You’ll find an excellent analysis of GFH’s strategy in this earlier post.

Now to my comments.

Chairman al Mutawa:

1. “Delivered great performance” -- According to my analysis GFH had an operating loss of some US$ 192 million for 2016.  The windfall earnings from litigation settlements do not reflect underlying performance or any fundamental change in GFH’s ability to generate income.  Operating earnings do.  And they evidence dismal performance and no substantial change. 
2. “Testament to the success of the strategy” -- Looking at the above key pillars, I don’t see that any of these were achieved.  Nor does the equivalent of buying a winning “lottery” ticket validate that strategy.  
3. “Commitment and integrity of the Board and management team” -- Frankly AA is puzzled how these two factors influenced the litigation settlement.    Since this was an out-of-court settlement, I suppose one could read this statement to mean that in conducting the negotiations GFH’s board and management team looked out for the interests of GFH and not the payees.  A strange comment to make. 
4. “Results supported by significant recoveries” – Excuse me.   The litigation settlement was the entire cause of the results.  As noted above without the settlement, GFH had a net loss from ongoing operations in 2016. 

CEO Al Rayes

1. “Proud of the transformation” -- What precisely has been transformed?  Certainly not the underlying business (see 2016 results from ongoing operations).   The windfall litigation settlement reflects nothing more than the successful conclusion of legal actions.  
2. “Laid the foundation”  -- One would expect a firm whose main business is real estate development to know that laying foundations and actually completing buildings are two different things.  Though I’m told GFH’s historic forte has been marketing.  There is I am told a lot of unfinished construction at the BFH – Villawhere as local wags have it.  Foundations laid buildings not completed.  Hardly a demonstration of anything except perhaps difficulties in persuading one’s lender to advance more funds. 
3. “Demonstrated by our results” – This is an even further stretch than “laid the foundation” as proving success of the earlier strategy. 
4. “Taken sufficient provisions to make the Group’s balance sheet more efficient for future value extraction” – Since impairment provisions are only to be taken to reflect the impairment of assets, this is indeed a puzzling statement.   Is Al Rayes admitting that GFH has overprovisioned in order to build up a “hidden reserve” to use to boost lower operating revenues in the future?  This could of course "demonstrate" the success of whatever strategy GFH claimed to be following at the time.  And as well the integrity and commitment of the Board.  Or is he admitting that GFH was severely underprovisioned?  

As regards the new strategy, mark AA as unconvinced. 

There seems to be nothing new here.   The touted potential acquisition of an Islamic bank in Bahrain and infrastructure development are fundamentally exposures to real estate. 

A glance at the Chairman’s report in GFHFG’s 2016 financials bears this out. 

Mentioned in quick succession are: 

1. Acquisition of a US-based  industrial real estate portfolio and discussion of existing US industrial real estate 
2. Jeddah Mall 
3. Villamar aka Villawhere? 
4. Harbour Row and Harbour Walk (also at BFH)
5. Tunis Financial Harbour
6. Gateway to Morocco
7. Mumbai Economic Development Zone

 A following post will take a look at the assets received in the litigation settlement. 

What is the quality of these earnings, a key issue for the Financial Group going forward.

GFH Windfall Settlement Masks Operating Loss of US$192 Million for 2016

GFH’s reported US$ 233 million net income is very impressive on its face.

What’s behind the 20-fold jump in reported earnings to US $233 million? 

US$ 465 million in litigation settlements.   The business equivalent of buying a winning lottery ticket.

Because this unlikely to be a recurring event, we need to look at results from ongoing operations to form a proper view of GFH’s 2016 performance, achievement of its strategy, and prospects for the future.

On that basis how did GFH perform? 

Definitely less well (euphemism of the post).  

As outlined below, an operating loss of US$ 192 million.

Follow along referring to the bank’s, excuse me, financial group’s 2016 audited financials here.  

Operating revenues—ignoring litigation gains—were some US$ 114 million versus US$ 88 million the year before.  A 30% gain or US$ 26 million driven by the sale of some investment and development property.

Operating expenses were at US$ 125 million versus US$ 62 million the year before. 

But I don’t think it is necessarily fair to subtract this full amount from 2016 revenues –which results in an operating loss of US$ 11 million before impairment allowances.

Why?  Some of the increase in these expenses is related to the costs of pursuing the legal settlement or as a result of the legal settlement, i.e., accrued staff bonuses

Let’s look a bit closer at the reasons for the increase in operating expenses.

Roughly US$ 26 million in additional staff expense (note 21) which appears to be increased bonuses for staff (see Other Liabilities note 14) and US$14 million in additional legal costs.   It seems fair to consider these as not part of ongoing operating expenses.  

That leaves an increase of US$23 million –US$ 10 million in undescribed “other expenses” (both in note 22) and $10 million for “investment advisory expenses” (income statement).  That would make 2016 adjusted operating expenses some US$ 85 million, leaving net operating profit before impairments at US $29 million.

In 2016 impairment allowances jumped to US$221 million in 2016 versus US$ 17 million the year before (see note 23). 

Deducting the full amount, GFH’s net income from operations before the windfall gain is a loss of US$ 192 million. 

You can also see a very similar though larger figure in note 32 page 56, i.e. US$ 206 million.   GFH--less generous or perhaps rigorous than AA--did not allocate the US$14 million in legal expenses to the unallocated segment to “match” the litigation settlement revenues.  However, it did allocate the US$25 million bonus accrual to this "segment".

Side Note:  Proving to GFH’s Reported Results:  When the additional $40 million in litigation related expenses is netted from the US$ 465 in litigation “gains” and added to the US$ 192 million operating loss, the result is net income of US$233 million which “foots” to the net income figure in GFH’s income statement.

Let’s look in depth at impairment allowances.  

1. Financing Assets (note 5) were US$ 38 million.  I’m inclined based on my   earlier posts on KHCB’s credit quality, particularly this one on 2015 past due loans to see that as probably a justified “catch-up”.
2. Other Assets (note 11) US$72—US$45 million in Other Receivables and $26.5 million in Financing Projects.
3. Investment Securities (note 6) US$61 million.
4. Equity Accounted Investees (note 9) US$36 million.

The question is whether there is anything that suggests that these impairment allowances are overstated or should be adjusted for any other reason to determine GFH’s net income from operations – that is, excluding the windfall gains from the litigation settlement.

I don’t think there is but let’s start by examining three possible explanations for these provisions and their dramatic increase.

1. Formerly perfectly good assets that were carried at proper values in GFH’s prior year’s financials deteriorated sometime during 2016.  Thus, the provisions relate to the ongoing business and are a proper deduction from 2016 revenues, justifying the assumption of a US$ 192 million net loss on operations.  Under this scenario, it’s just a “remarkable coincidence” and nothing more that so many different types of assets declined so significantly during a single year. 
2. GFH is “taking a bath”, that is, writing down good assets below their realizable value to decrease 2016 net income (perhaps to moderate payment of dividends) and more importantly build up a “reserve” to artificially improve future years’ earnings through timely reversals of provisions.  In other words provisions are overstated to create a "reserve" to be used to manage future earnings.
3. In previous accounting periods the bank did not recognize impairments so it could artificially minimize or avoid losses in these prior periods. In this scenario, the windfall 2016 litigation settlement gave GFH the opportunity to clean its books.  As you may well expect from my 2010 posts on GFH’s financials and my recent analysis of GFH and KHCB financials as well as the “remarkable coincidence” mentioned above, I think there is a strong case to be made for this scenario playing a major role in 2016 allowances for impairment.  That is not to discount the likelihood that the other two scenarios also played roles. 

Note that Scenario #1 above is the only legitimate reason for provisions under generally accepted accounting principles. 

Khaleeji Commercial Bank Poor "Fit" with New GFH Financial Group Strategy

As promised in an earlier post, a more detailed look at KHCB.

Key Points of GFH’s 2014 Strategy

To set the stage, a recap of the key elements of GFHFG’s new strategic focus:

1.     “stable and recurring income, profitability and cashflow”—while they didn’t use the term “annuity business” that seems an appropriate characterization

2.     reduce its holdings in “land-based business” (real estate) from 50% to 40% in the midterm and to around 30% in the long term

3.     “ensure greater stability from global financial issues”  

For citations for above, see the 1 December posted linked to above.

In a series of posts to follow, I’ll explain in typical-AA excruciating detail why I think that KHCB is a poor fit with GFH’s new strategy.  Here’s a summary of my main conclusions:  

1.     Historically KHCB’s earnings have been highly volatile probably as a result of some of all of the following:  the nature of its business (long term fixed rate lending), underwriting standards, the limited size of its national market (note KHCB is only 3% or so of the Bahrain bank market by assets), possible earnings management catching up with management, etc.

2.     As a long-term fixed rate lender, KHCB is exposed to significant “profit (interest) rate risk” which threatens future earnings because KHCB’s long dated fixed rate portfolio offers less opportunities for repricing than say a shorter tenor portfolio like that of Qatar Islamic Bank. As well, if rising rates squeeze KHCB’s income, it may be forced to pay lower profit rates to depositors increasing the risk of depositor flight.  Both outcomes are particularly a threat because interest rates for the US dollar—to which the BHD is pegged—appear poised for more increases.  

3.     KHCB’s portfolio has weak credit quality metrics that suggest credit related problems will weigh on future earnings, e.g., consistent renegotiation of significant amounts of its portfolio; the sudden dramatic increase in 2015 in loans classified as “past due but not impaired”, particularly in the 90 day plus past due category; and declining loan loss provision coverage.

4.     Substantial indirect exposure to real estate—an interest rate sensitive asset class—through reliance on real estate collateral.  While direct real estate exposure may be under KHCB’s 40% limit for assets, the indirect exposure through collateral is at 55%.  To the extent that loans may have been made to marginal borrowers based on real estate, the indirect nature of this risk will become more proximate.

So with all these negatives why did KHCB become a key pillar of GFH’s new strategy?

AA thinks the answer is in GFH’s AR 2014 Report by Executive Management page 39. 

“During the year, our sale transaction for Khaleeji Commercial Bank (KHCB) fell through. However, with the revised strategy of evolving as a wider financial group, GFH is now looking to retain its investment in and grow the operations and businesses of KHCB.”

What this seems to say is that if the sale had gone through KHCB wouldn’t be a pillar.  Looks like a third party (the prospective buyer) played a critical role in developing GFH’s new strategy.  

Or in other words “If life gives you chickpeas, make hummus.”