GFH Treasury Shares – More Shareholder Value Destruction on the Horizon

It’s hard to understand the “logic” being applied by GFH’s board and management with respect to Treasury Shares, particularly given GFH's weak state.

On 16 February 2021 GFH announced two proposals:

1. The cancellation of 141,335,000 in Treasury Shares.
2. The issue of 94,339,623 in new “bonus” shares.

I’ve written before that the cancellation of Treasury Shares is a direct waste of shareholder funds. One buys shares from the market paying cash and then one cancels them and receives nothing. A dead loss.

The first proposal will result in the cancellation of 45% of GFH’s Treasury Shares (total value of USD 69 million). So USD 29 million. 

A large amount for a bank like GFH that has reported net income of USD 50 million the past two years.

If approved, the first proposal will bring the total of shareholders money “whistled” away in Treasury Share transactions to some USD 161 million before 2021's TS trading losses:

1. USD 3 million in losses on 2017 TS sales
2. USD 27 million in losses on 2018 TS sales
3. USD 28 million in losses on 2019 TS sales
4. USD 51 million in losses on 2019 cancellation of TS shares
5. USD 23 million in losses of 2020 TS sales
6. USD 29 million loss on the proposed 2021 cancellation of TS shares

As I noted in my most recent post on this “strategy” it does not make sense nor does it appear to have resulted in any benefit to shareholders in general.

Imagine instead that GFH had not “spent” (or more appropriately mis-spent) shareholder money on TS. 

Instead of borrowing USD 300 million at 7.5% per annum, it would only have needed to borrow USD 140 million resulting in an annual saving on interest of some USD 12 million a year. 

An amount equal to 24% of reported FY 2020 net income!

I’ve argued that cancellation of TS is unlikely to have a material impact on GFH’s share price given the relatively small percent canceled.  And that there are other less costly ways to increase the per share price of GFH. 

But note those would not increase the value of GFH.

Once again via the second proposal GFH will undo what little effect there is by issuing 94 million new bonus shares.

GFH is a weak institution.

Low quality of earnings. Subpar ROAE. Concentration in illiquid assets. A sub investment grade debt rating. 

Poor market performance of its stock, now trading at a P/BV ratio of 0.6X

All this would seem to argue for a more careful stewardship by the Board and management of the bank.

Given all that, it is also hard to understand how the CBB allowed these proposals to be put forward.

That leaves the decision in the hands of the shareholders.

Based on the past the probability of shareholder action to reject these proposals seems low. 

GFH Bahrain - Less to 3Q2020 Reported Income than Meets the Eye

For the first nine months of 2020, GFH reported net income of roughly USD 30.3 million down roughly 50% from the comparable period last year.

That’s not surprising. COVID-19 is casting a pall over many firms’ financial results.

But, neither is the full story.

That’s why one has to read the entire financial report and not just the Income Statement.

By my calculation the true economic performance of GFH over the period was a loss of roughly USD 66 million.PPA “swing” of some USD 96 million from the reported number!

Where does AA’s performance number come from?

The Consolidated Statement of Changes in Owners’ Equity page 4 in GFH’s Third Quarter 2020 interim financials.

The Retained Earnings column is the appropriate locus of focus for our attention.

Why?

Because it’s where economic gains and losses that are not required to be included in the Income Statement appear.

Despite their being excluded from the Income Statement, they are as real a loss as the charges that appear in the Income Statement. And, at times, gains are recorded here that are not included in the Income Statement.

To be very clear there is nothing inherently wrong with these entries.

Equally at times company management may use the discretion allowed under accounting principles to shift a “loss” from the Income Statement to the Statement of Changes in Shareholders’ Equity in order to present a “better” picture of performance.

Motives might be the desire to pay dividends, particularly for a regulated firm like a bank. Management bonus. Share price.

That’s why looking a comprehensive income or loss over a period is a better measure of the firm’s performance. 

Let’s review the pertinent charges to Retained Earnings.

There are three significant “losses” disclosed here.

First up is a USD 59.9 million charge arising from GFH’s underwriting of the entire BD 72 million (equivalent to USD 191 million) AT1 capital increase at Khaleeji Commercial bank. Note 1 on page 9 contains a detailed explanation if you’re interested.  GFH's carrying value of equity in KHCB is based on its share in the net assets of KHCB.  Not the purchase price.     

Next USD 13.9 million arising from “modification of terms” of financiing GFH has provided. That is, an easement of repayment terms on the debtor which decreases the amount GFH will ultimately receive (assuming the debtor pays) and thus the value of the related asset. Think of this as the recognition of a likely loss on the related financing.

Following that USD 22 million which represents the difference between the cost of Treasury Shares GFH sold (USD 108.7 million) and the amount it received (USD 86.7 million).

I’ve heard of “buy low sell high”, but not the opposite. Perhaps, an alternative investment strategy?

These transactions result from what GFH calls “market making” and AA calls a failed attempt to prop up its share price.

Not much evidence of a positive prop for the price of GFH’s shares. They began the year at USD 0.23 per share and were at USD 16.0 as of end of 3Q. As of 16 November trading at USD 14.9.

Of course, COVID has depressed markets.

But a look at previous posts analyzing this activity over several years suggest that GFH shareholders receive scant benefit from these “market making” activities.  

You'll find these using the search tool on the right hand side of the page and the words "treasury shares".

As noted above, if we adjust GFH’s reported Net Income for these three items, GFH had an economic loss for the period of some USD 66 million.

What’s Behind GFH’s Treasury Share Transactions?

You Should Have

A shareholder's relationship with the board of a company in which he or she has invested in is similar in several ways to the relationship of a younger sibling with an elder brother. 

This isn’t the first time I’ve posted on this topic.

Earlier posts here and here have focused on quantifying the costs to shareholders. 

Today I want to step back and offer some hopefully informed speculation on what might be going on. 

See if you agree

Treasury Share Transaction Basics – Not an Income Statement Event

To provide a framework for this post, some basics on Treasury Share transactions.

Under generally accepted accounting principles, gains or losses on Treasury Share transactions are reflected directly in shareholders’ equity in the Consolidated Statement of Changes in Owners’ Equity.  

That is, they do not appear in the Income Statement.  

And because of this some shareholders might miss them!

However, when a firm engages in these transactions, there is an economic gain or loss to shareholders, particularly because most of the time these are cash transactions. 

Thus, it's proper to consider them as "income" or "loss" as I will in this post. 

And it's important for shareholders to be aware of them as these transactions affect the value of their firm.

History of GFH Treasury Share Transactions

As the chart below demonstrates, it’s only since 2017 that GFH has become very active in Treasury Share transactions. 

Both the volume and value of transactions has increased dramatically during this period as have FYE holdings, shown here in USD terms (EOP Value) and as a percent of total issued shares (% TIS).

GFH Treasury Share Transactions
Millions of US Dollars
FYE	Buy	Sell	Cancel	EOP Value	% TIS
R2014	$0	$0	$0	$1	0.11%
2015	$5	$2	$0	$4	1.09%
2016	$7	$11	$0	$0	0.10%
2017	$83	$25	$0	$58	2.89%
2018	$161	$134	$0	$85	6.94%
2019	$215	$177	$51	$73	8.05%

How did GFH fare on these transactions?

Over the period FY 2017 through FY 2019, GFH has incurred losses on Treasury Share transactions totaling USD 58 million. 

1. USD 3 million in FY 2017
2. USD 27 million in FY 2018 and 
3. USD 28 million in FY 2019.

Beyond that in FY 2019 GFH canceled Treasury Shares that it had purchased for USD 51 million.

In FY 2019, it acquired USD 32 million in Treasury Shares for a “share incentive scheme”. No economic gain or loss but a use of GFH shareholders' funds.

It also obtained OGM approval to use 140 million of Treasury Shares for an acquisition or acquisitions, subject to CBB approval.

That’s a quite a lot of expensive Treasury Share transactions –none of which appear in GFH’s Income Statement.

Let’s take a closer look to try and understand what is going on and why.

2019 Treasury Share Cancellation

After having acquired 207,547,170 shares of its own stock for USD 51 million, the Bank with the approval of shareholders and its regulator canceled these shares of stock.

Instead of canceling them, the Bank could have retained these shares or sold them back to the market and obtained cash. Perhaps, not USD 51 million in cash but likely a substantial portion of that amount.

Why then would it cancel the shares?

There is a theory that share buybacks and subsequent cancellation of the shares can improve both the book value and market value of a stock because reducing the number of shares increases earnings per share (EPS).

This assumes that the cost of acquiring the shares, including future earnings on those foregone assets, is less than the value created by cancelling them.

Disclosure:

AA doesn’t believe this theory. 

Increasing the price of an individual share does not increase the value of the firm. 

If a company wanted to increase the price of a share, it could simply do a reverse stock split. Number of shares reduced, EPS increaased, no large amount of cash spent. 

Buying and then cancelling shares may in fact decrease the value if the purchase of the shares removes cash or other assets that the firm needs to increase its value or maintain its ongoing earnings stream.

There is in AA’s view one possible exception. When a company has cash but no compelling investment opportunities, then a share buyback may make sense if tax laws favor capital gains over ordinary income.

Absent that, these transactions tend to amount to spending real assets to achieve an accounting gain. 

But let’s assume the theory does work.

After all as Madame Arqala could tell you, AA is not always right.

The quantum of shares extinguished needs to be significant to have a significant effect.

GFH extinguished roughly 5.6% of its existing shares.

It’s hard to see this having a material effect on the per share price.

According to AA’s rough calculations and assuming this theory has validity, the price of a GFH share would have increased USD 0.01 in 2019 assuming a P/E of 10x.

But there’s more that makes this transaction baffling.

Having extinguished the shares, GFH proceeded to issue bonus shares equal to the number of the shares it cancelled. 

In effect undoing whatever value enhancement the cancellation may have had.

The cost of this apparently pointless exercise? One that had no apparent positive impact on its shares, save for an accounting “gain” of USD 4 million? 

In case you’re wondering that gain was also refected directly in equity.

A mere USD 51 million in cash in exchange for USD 4 million in non cash “income”.

What are some comparable amounts?

It’s roughly 45% of FY 2018 reported net income attributable to GFH shareholders! 

Or 64% of that in FY 2019.

What would motivate GFH to do this?

AA believes that GFH wanted to make “room” to buy more Treasury Shares because the Central Bank limits the number of Treasury Shares GFH is allowed to hold.

To do this GFH would have to find a "way" to remove the Treasury Shares from its balance sheet.

That means a sale or cancellation.

It almost certain that GFH couldn’t find a buyer for a block sale or block sales in “off market” transactions because there just wasn’t appetite given GFH’s condition and prospects.

That would mean GFH would have to sell those shares “in the market” almost certainly lowering the price of GFH stock.

Thus offsetting the effect of GFH’s purchases and undoing all its previous "good" work. The stock has been in slow decline for some time now.

So cancellation was the one remaining option if GFH wanted to continue Treasury Share purchases to "support" its share price.

I can’t think of another good reason for this bizarre economic transaction.

Keep that thought in mind as we take a look at GFH’s Treasury Share purchases and sales.

Treasury Share Purchase and Sales

Why would a bank be buying and selling its shares?

There are several reasons.

Market Making

One reason is to provide liquidity to the market so that shareholders can buy and sell their shares without causing temporary demand/supply imbalances that move the price dramatically.

GFH have engaged SICO to make a market in GFH shares on the DFM and BSE. Until recently the KSE did not allow market making.

What does a market maker do?

The canonical answer is that a market maker supplies liquidity to the market, filling in transient gaps on the demand side (purchases) or supply side (sales) as needed.

How does that role help the market in a company’s shares to run smoothly?

Buyers or sellers can conduct their transactions without having to conduct transactions at prices significantly different from the “fair” value of the shares.

Two simple examples.

Shareholder Abdullah wants to sell his shares on the BSE but there are not any or not enough interested buyers close to his desired price to fill out the buy side of his ticket.

The market maker steps in to supply the missing demand at what the market maker believes is a fair price.

Brother Abdullah can sells his shares to the market maker without having to reduce his price dramatically, conduct his sales over a prolonged period, or not sell all the shares he wants.  

The market maker now owns the shares.  He either holds them in "inventory" so he has sufficient shares to fulfill his responsibility on the sell side.  Or if he has "too many" shares he gradually sells shares into the market to reduce to the appropriate level.

On the other hand, suppose Brother Jassim in the UAE wants to buy GFH shares at the DFM but no one is selling in the amount he wants to buy. The market maker steps in to save the day, selling from his (the market maker's) inventory of GFH stock.

The market maker of course keeps a sharp eye on price trend in the stock and generally holds no more "inventory" than he needs to in order to fulfill his role.  The last thing he wants to do is hold shares that lose value.

If, by a happy circumstance as appears to be the case here, the stock issuer bears the risk of price declines, then the market maker may take a more relaxed approach to inventory valuation.

Over time one would expect that the market maker to earn an appropriate profit or break even.

If market making results in continued large losses, then this is a sign that the “problem” with the particular stock is not liquidity but rather fundamental value. Or a system wide lack of liquidity in the market. That would be noticeable across more than one stock though. Or the market maker is an idiot.

Two years seems to be more than an adequate time frame to make the call on GFH shares. 

It’s not liquidity. 

It’s lack of demand, fueled no doubt by investors’ ratings of the stock.  

SICO is a professional shop. It acts as market maker in the BSE and DFM for other shares and seems to be doing quite well.

Because it's not one of the two latter cases, then what's happening is that GFH is trying to support its share price.

A completely different goal. 

And one that perhaps should not be called “market making” so much as “share support”.

If shares continue to decline, then it seems that all that is being accomplished is delaying the inevitable and spending shareholder money on a futile quest.

Let’s look at some “performance” data.

During FY 2019, GFH sold Treasury Shares with a cost of USD 177 million for USD 150 million.

That works out to a gross margin of roughly negative 15%. That is, for every USD 1 GFH “invested” via a TS purchase, it received USD 0.85 on sale.

During FY 2018, GFH sold USD 134 million for USD 106 million, a gross margin of negative 21%. For each USD 1 invested, GFH received USD 0.79.

This doesn’t look like “market making” it looks like an attempt at price support as do the dramatic increases in the volumes of transactions.

Less charitable folks that AA might say given the volumes of transactions and losses involved it looks like market manipulation.

As noted in an earlier post, during 4Q18 GFH was responsible for almost 40% of the trades on the three markets in which it is listed (Bahrain, Kuwait, and DFM). To be clear that’s GFH Treasury Share transactions as a percent of total trading on all three markets. Not that GFH was trading in the KSE.

That, as you know, is a critical time of year, when firms and funds prepare their annual audited financials. A time of year when auditors get serious about the numbers they are asked to audit.

What other reasons might a company buy back its shares?

Opportunistic Investments

The market is underpricing a company’s shares. The company can buy them “cheap” and then later sell them “dear”.

 

Given the secular decline in GFH’s share price over years and its weak condition and prospects, this doesn’t seem to be a likely scenario.

Rather it seems that GFH is buying “cheap” and then selling “cheaper”.

Currency for Acquisitions

A company buys its shares in order to use as “currency” in an acquisition. You’ll recall that GFH obtained shareholder approval to use up to 140 million of Treasury Shares for acquisitions, subject to CBB approval

This doesn't seem a realistic scenario..

Why?

It’s hard to imagine that potential sellers of assets to GFH on an “arms length” basis have a substantially different view than the market about the worth of any shares to be proferred. 

However, this method can work in special cases.

A seller who knows that his “fine” assets are worth less than the asking price, may well sell his overpriced assets for overpriced stock as long as he achieves his goal of getting a certain value for those assets, avoiding a loss, declaring a profit, etc..

Having been around the proverbial IB block multiple times, AA has seen more than a few valuation miracles.

Ones where buyer and seller agree values divorced from reality to mutually assist one another in achieving each other's goals.

You may be familiar with some “round-trip” asset sales in the GCC where the same assets passed between two parties at increasing prices over the years with such sales justified by offsetting changes in the buyer’s and seller’s “strategies” that promote a transaction. 

U wants a pan MENA network of banks and then it doesn’t. 

B wants to sell its network and then it wants to buy it back.

AA’s smarter brother has even seen one where a considerable “gift” was given to a debtor in a rescheduling. 

Instead of taking 70% of the debtor’s equity as all reasonable models determined, a compassionate creditor took only 30%. 

Thankfully, AA’s brother was not asked to “fix” his model to show that valuation.

AA’s “Call” - GFH’s Treasury Share Transactions are Designed to Support the Price of Its Shares

There seems to be no reasonable business rationale for the amounts spent by GFH on Treasury Share transactions – the USD 51 million in share cancellation and the USD 58 million losses on Treasury Share sales.

Nor any compelling reason why GFH would suddenly find the need to buy USD 32 million in Treasury Shares for a “share incentive scheme” in a single year.

The proposal to use 140 million Treasury Shares for an acquisition also seems a bit far fetched at least for one on a true arms-length basis.

It seems to AA that GFH is using the latter two transactions to provide rationale for acquiring more Treasury Shares.

The goal certainly seems to be to prop up the price.

The question is for whose benefit?

Well, if a shareholder borrowed funds to buy GFH shares and pledged the shares to a lender, it would be mighty inconvenient for that shareholder if the price of GFH shares declined. 

The shareholder might have to provide additional cash to top up the collateral or reduce the loan principal.  In extremis, he might have to sell shares at a loss to reduce or repay the loan. 

Neither very appealing.

Declines in the value of unpledged shares can also be mighty inconvenient if one has to mark them to market. 

One’s performance record is tarnished, hampering new business generation.

One’s own shareholders might ask embarrassing questions.

A truly uncomfortable position particularly if the shareholders are VIPs or, as they’re sometimes known locally, VISs.

This may also explain why GFH declared a cash dividend for FY 2018 despite the fact that it had no real cash income that year. See post here.

Dividends help defray interest on a loan.

Dividends also provide a return on one’s investment. Just the thing one might need if the stock price is trading down instead of up.

One would expect that expenditures of this amount would be taken for an important shareholder.

Who might that be?

The 7,464 Abdullahs with holdings less than 1% each in GFH- some 62% of all shares-- probably don’t have the “wasta” or the “weight” to command such largesse.

That leaves just 15 other shareholders.

14 of whom own 20% of the shares and appear not to be related to one another. 

Leaving just 1 shareholder with 10% who no doubt by mere coincidence became a shareholder one year before the Treasury Share transactions began in earnest.

Is there incontrovertible proof this is the case and that GFH is trying to prop up its share price?

No. 

Just a pattern of behaviour that AA assesses is the most likely explanation for GFH’s actions.

It may well be the case that GFH’s Board has heard of problems among the Abdullahs who hold its shares and is trying to mitigate their troubles.

Or is undertaking these transactions for solid business reasons that AA isn't clever enough to discern.

As we say in the region “ الله أعلم “