Dana Gas: Three Additional "Things" to Watch Plus "Bonus" Features

The Underwriting Phase is the Best Time for Scrutiny 

Given the company’s weak financial condition and the behavior of management, those with a financial interest in the firm—creditors and equity investors— need all the help they can get in monitoring DG’s performance.  

As always AA has your back.

In addition to keeping an eye on macro financial performance, here are a few relatively quick things that sukuk holders and equity investors can do to make sure they don’t miss problems organized around three topics:  

• Current performance
• Receivables collection
• Financial liabilities 

These aren’t the only indicators. 

They certainly are not replacements for looking at the financials carefully particularly aggregate cashflow, but can be helpful in identifying performance problems.  At times information in the consolidated income statement or statement of condition can be used to trigger a deeper look.  For example, declines in overall net revenue, a sudden large write-off of exploration costs, etc. should send you looking for more information.  You’d expect to find explanations in the various management reviews in annual and interim financial reports. These tools will hopefully help you look deeper.  If management omits to highlight a problem, these tools may help you discover incipient problems as well. 

Current Performance

DG operates in three separate locations.  Looking at aggregate performance obscures what’s happening on the individual level. That could be quite important if the level is a critical "bit" in the overall business.

DG does provide some information on individual operations in its “segment reporting” note (typically note 4).  Here you'll find total assets and liabilities.  Not enough to go on.

Starting in 2013 DG began providing more information on Pearl's balance sheet in the note Interest in Joint Operations (note 15 in 2016 and 13 in 2014) than in note 4.  One can create a rudimentary balance sheet from this information back to 2012.  That still leaves a significant information gap on the balance sheets of Egypt and the UAE.  

But there is another more important problem with DG's segment disclosure.

The Company does not disclose net income and net comprehensive income for the UAE, Egypt, and Iraq.  It only discloses net revenues and gross profit (net revenue – depreciation and operating expenses) with some additional limited disclosure about elements of the income statement.  Sadly this falls short of what would be ideally useful to users of its financial statements.

With this limited additional information, one can try to construct a rudimentary income statement. But more than some assembly is required. Unlike IKEA not all the parts are in the box, so it’s generally hard to determine whether these entities are profitable before allocation of expenses at the holding company (DG) level or the nature of at least two of the three main operating entities' balance sheets.  

In some cases where there is an extraordinary expense, e.g., a substantial write-off of exploration expenses, it’s a bit easier.  For example, in 2009 it’s pretty clear Egypt had a net loss.  As did Zora in 2016.  One doesn’t even need a calculator to see this.   

What’s a quick but not complete fix to this lack of information?  

Tracking the top line for an indication of ability to generate earnings and cashflow and looking at the disclosed expenses is the easiest.  It's also not a bad starting point. But this is an imperfect "fix".

Revenue declines or increases can reflect changes in prices or volumes.  One would expect prices to be largely out of DG’s control.  Volume declines could reflect operating or reserve problems. 

One can also scan the disclosed expenses for surprises.  These should be visible in the consolidated income statement but looking at the segment information note (note 4) will identify which of the three businesses took the "hit". 

Here’s a starting point for the investors out there who hold DG paper.   

DG Top Line Revenues Millions of USD
	UAE	Egypt	KRG	Total
2016	23	154	78	255
2015	4	125	142	271
2014	4	225	247	476
2013	5	225	230	460
2012	5	237	258	500
2011	5	290	226	521
2010	4	264	82	350
2009	4	192	42	238

 Source:  Note 4 DG Annual Reports

Trade Receivables (“TR”)

As discussed in earlier posts, collecting TR is key to repayment of the Sukuk and to eventual cash returns to shareholders. (AA is indulging in extremely optimistic fantasies today).  The TR are “whisker-growing” stale.  Cash conversion is glacially slow.  On a present value basis, the value of TR is being eroded when one considers the appropriate risk-adjusted discount rate. 

Those with a financial interest in DG’s financial performance should be watching trends in collection or further accumulation of the TR. 

Note to DG’s auditor: Transparent disclosure of just how past due the TR would be helpful. 

Provisions for Surplus Over Entitlements

But there’s something new to watch. 

That is the above mentioned provision which is money that DG owes the KRG.

Why is this important? 

AA suggests you read Note 28 in full, but here is a sentence that caught AA’s eye and summarizes the issue: 

“Furthermore, Pearl has a right under the terms of the Authorisation to offset this Surplus, when payable, against any other outstanding payments due from the KRG.” 

Given its current cashflow generation problems, it’s likely that if the TR are settled, the amounts owed to the KRG will be offset against the TR. The KRG may have a similar right to offset.  But we don't have confirmation of that.

AA would expect that those who depend on collection of the TR for their repayment or dividends would want to track whether this offset is growing and just how fast.  Is this liability threatening to seriously diminish their source of repayment?  

Side comment:  Though none is really needed in AA’s view, perhaps this is another compelling argument that sukuk holders should reject a five-year bullet structure and insist on amortization of the sukuk in the rescheduling negotiations.  As you will recall and if you don’t, AA will repeat his earlier advice.  Principal payment should be in the form of both scheduled repayments and a cash sweep structure to hoover up prepayments if there is excess cash. 

Bonus Indicators

In addition to the operational indicators mentioned above, some "bonus" tips. 

If you missed the reference in DG’s Annual Report 2016 CEO Review, there seems to be a problem of some sort at Zora.

“In the UAE, despite full year average production of 2,744 boepd, total production from the Zora Gas Field has declined throughout the year from production start-up in February.”

This may be a technically solvable problem or it may not. 

Those with a financial interest are likely to have an interest in knowing, though Zora is a rather small fish in DG’s operations.  It clearly is not showing a profit based on DG’s Annual Reports Note 4.

This information may also temper optimism about Zora as additional collateral until the cause of the decline is known. 

For Pearl there are other sources of information (more on that point in a post to come) in the financial reports of three of DG’s partners in the joint operations. 

Here are some examples from MOL Hungary’s 2016 annual report.

• MOL took provisions equal to its share of 2016 net income in Pearl Petroleum (note 6).
  

  “Given the current economic situation impacting the Group’s associate in the Kurdistan Region of Iraq a provision has been made in 2016 against the Group’s share of profit.”

• MOL also announced that it has changed its revenue recognition for sales in the KRG from an accrual to a cash basis.  That’s generally not a sign of robust credit standing of the buyers.  (AA’s first understatement of the post). And may be related to the 2016 provisioning against MOL's profit in Pearl.

Note 3:  “Having assessed the probability of receiving economic benefits from sales activities in Group’s operations in Kurdistan the management decided to recognise revenue on a cash basis on sales in Kurdistan Region of Iraq.”

• MOL has also taken some additional steps in the KRG which appear to reflect a serious concern about economic conditions.  You can easily find them by searching MOL’s 2016 annual report using the search term “Iraq”.  Pearl isn’t MOL’s only KRG asset so some of these steps relate to other companies. But the message seems pretty clear.  MOL is concerned about KRG ability to repay. 

AA Rant

If you read this blog on a semi-regular basis, you’re familiar—perhaps more than you’d like—with AA’s frequent complaints about "shortcomings" financial reporting. 

This rant is about the quality of DG’s segmental information. I’ve noted the deficiencies above. In short DG isn't providing enough information to understand it's underlying business.

Why isn’t DG providing more detailed information?

Others do.  The nearest I can find to an “explanation” is in DG’s 2016 annual report notes 2 and 4.  The below quotes basically repeat what they’ve said in previous years.

“Note 2: Operating segments are reported in a manner consistent with the internal reporting provided to the Chief Operating decision-maker.  The Chief Operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as the Chief Executive Officer who makes strategic decisions.”  

“Note 4:  Management has determined the operating segments based on the reports reviewed by the Chief Executive Officer (CEO) that are used to make strategic decisions. The CEO considers the business from a geographic perspective which is divided into three geographical units.  The Group’s financing and investments are managed on a Group basis and not allocated to segment.” 

This might be charitably described as manifest garbage.   

DG’s segments are independent companies that prepare their own financials.

What this means is that DG has this information.

Preparation of the segmental information would be a simple matter of reproducing summaries of the income statement and balance sheet.

AA wonders if the CEO really does not look at these reports or condensed versions of them to make decisions. How can he run the business and make investment decisions if he isn't tracking the profitability of major lines of business based on an allocation--imperfect as it is likely to be--of all expenses?  How does one track risks?

If indeed the CEO is not using a methodology similar to this, then perhaps DG needs a new CEO. 

AA also wonders DG’s auditor’s apparent acceptance of this explanation. Some uncharitable souls might say questions about auditor credulity have already been conclusively answered: the auditor has accepted DG’s decision to carry the Trade Receivables as “current assets”.

When important information is missing from financials or other statements by a firm's management, one should wonder why.  Is it that they don't have the information (which is a troubling question in its own right)?  Or that they don't want to release the information (an  even more troubling question)?  That leads to AA's golden rule of providing capital.  If the firm doesn't trust you with information, why should you trust them with your money?

Dana Gas Restructuring: Creditors, What Then Is To Be Done?

As outlined in previous posts, the creditors face two key issues with the restructuring:

1. Obligor Attitude:  If there are not already serious concerns about the obligor’s integrity and willingness to pay, then there should be.  The situation is similar to that of The Investment Dar Kuwait.  Back when it became evident that TID was headed for a restructuring, if not the shoals, its creditors petitioned the Central Bank of Kuwait to appoint an official “minder” to keep an eye on—or more accurately to “control”— TID’s management.  CBK did not.  By contrast creditors did not ask for one in the Global Investment House (Kuwait) restructuring a similarly uncertain large ticket exercise.  As DG is a commercial company and not a financial institution, there’s not even the extremely slim possibility of CBUAE intervention.  Creditors are “on their own”.  That has important consequences for what they should do.
2. Obligor Aptitude: Glacially slow collection of receivables and an apparent chronic weakness in operating cashflow indicate that the obligor is unlikely to repay principal and interest within the proposed five-year tenor. Factors largely outside DG’s control.  The path was cast when DG embarked on its business in Iraq and Egypt.  Given these facts, creditors are likely to find themselves in another restructuring “adventure” with DG in five years’ time.  Therefore, minimizing that future exposure should be a key goal. 

Что делать? 

In framing this post, AA looked to inspiration from other authors who wrote similarly titled pieces, though hopefully this post is free from excessive utopianism.  As you'll notice one such author is missing.  I believe he was in heated exchange on call-in program with the Governor of New Jersey when I called.

In any case, here's are potential steps that AA believes creditors need to take based on the assessment that protection of creditor interests requires measures beyond the usual ones in a restructuring. 

1. Legal steps –recast the deal or elements of the deal to reduce/eliminate exposure to Abu Yusuf-ery legal maneuvering by the obligor.  While this is an important step, it will not be sufficient to protect creditors’ interests.
2. Collateral – get more and to the extent possible, take possession now rather than relying on the exercise of legal rights to deliver it later when Abu Yusuf may have come up with even more clever arguments.
3. Amortization – use interim scheduled principal repayments plus a cash sweep to achieve reductions.  With DG’s weak/uncertain cashflow getting dollars now is wiser than waiting five-years as the past ten years unequivocally demonstrate. 
4. Tenors – Shorten to keep DG’s and your minds focused on repayment.  A five year bullet moves the payment far enough into the future that focus is lost: repayment is a lower priority, particularly for DG.

Legal

Transaction documents are meant not only to set forth the obligations and rights of both parties so there is no ambiguity, but also to provide protection by providing recourse through court ordered enforcement of the agreement if one party cannot fulfill its contractual obligations or decides not to.  DG’s maneuver in Sharjah and other courts to declare the Sukuk contract “illegal and unenforceable” shows the practical limits of that strategy. 

One response would be to change the form of the replacement contract.  If “Islamic” transactions are uncertain, then a conventional (non-Shari’ah) transaction would seem preferable.  If a starving Muslim may eat a ham sandwich in order to avoid death, then it seems to me that if confronted with an obligor that may not be trustworthy as originally assumed and uncertain protection from the courts, a Muslim creditor could legitimately change the form of contract to a non-halal one.  This is important because as shown with the English and BVI courts actions, non-GCC courts are likely to show deference at least initially to areas beyond their competence, e.g., the Shari’ah.

A less severe approach would be to recast the debt obligation into another form of “Islamic” transaction as discussed below.  Perhaps, the transaction could be split into two?  One tranche for only principal repayments in which case Shari’ah or non-Shari’ah distinctions might not apply. Or in other words, the first tranche would be both.  The second an Islamic structure for "profit" (interest), hopefully limiting opportunities for future Abu Yusuf-ery.  Dealing with default interest could be difficult, but creditors are going to have to make some hard tradeoffs following their initial and unfortunate underwriting decision. The ability to ensure cross default would be another key consideration with this no doubt utopian strategy. 

Other actions would be to ensure that entities critical to the success of repayment were incorporated and active in jurisdictions believed to be more likely to give the creditors a fair shake rather than relying on the uncertain existence of a  fair shakyh in local GCC jurisdictions.  Reducing as much as possible the impact of local law on the transaction would be ideal. 

Alternatively, could the DIFC be the jurisdiction for the restructuring suitably structured as an offshore transaction?

But such steps are unlikely to be definitive, even if they are theoretically possible. 

In particular, Argentina’s or the Arab Bank’s recent unhappy experiences in US courts should suggest more than abundance of caution is warranted with reliance on legal jurisdictions as providing a “fair shake”. 

Collateral

On the theory that the “old” deal is dead, then a new deal needs to be struck.  So the door is potentially open to new terms. 

It’s often said that possession is nine tenths of the law.  This should be a guiding principal for the creditors.

A wise move would be what is in effect a pre-emptive exercise of collateral/security rights. That argues for the creditors getting possession/ownership of collateral now to be returned upon full repayment. Transfers of ownership would take place at the inception of the transaction not after a default occurs and potentially lengthy and uncertain legal proceedings are concluded.

A potential replacement structure is a sale/leaseback with DG responsible for operations, capex, insurance, third party liabilities, etc.    DG would sell these assets (by selling the stock in the companies) to the existing Sukuk holders.  The holders would then lease the assets to DG for an x-year period.  No cash would change hands as the “proceeds” of the sale/leaseback would serve to retire the existing obligation.  Sukuk repayment would come from lease payments where perhaps a fixed profit rate would pose less of a problem if Shari’ah structures were chosen.  Upon its successful retirement of the sale/leaseback transaction, DG would have a bargain purchase option to reacquire the assets.

Additional collateral.   Zora is now free from debt and generating cash. It is perhaps the most saleable of DG’s assets.  More (stale) receivables, assignments of proceeds from arbitral awards, ownership of the holding and operating companies for Egypt and the KRG. But unless Dana Gas Ventures BVI owns shares in Pearl, then the KRG operations are not part of the Trust Assets. 

Creditors can expect a robust reaction from DG based on the Trust Assets (TA) being the only security offered. So obtaining new collateral not related to the original TA will be extremely difficult.

If no new collateral can be obtained, then the creditors should take possession of the Trust Assets as outlined above.  If the lessee fails to pay, then the bargain purchase option would be invalid. The assets could be sold to third parties in whole or part.Or investment “adventure” in Egypt or the KRG. Bon chance!  Of course, DG or its shareholders could be given pre-emptive rights in any asset sales. 

Principal Reduction – Amortization

As indicated in my earlier post, the Company’s cashflow is highly unlikely to enable it to retire the debt over the mooted five-year tenor. Creditors could rely as they have over the past ten years on the Company’s promise for principal payment at the end of the next five-years bolstered by no doubt a rosy projection. 

Or they could more wisely include binding (such as one can bind DG) requirements for principal repayments.

With DG’s uncertain cashflow, it’s hard to come up with repayment scenarios.  But that doesn’t mean that the new deal cannot contain some required interim principal repayments before the final principal balloon payment at maturity.  

A key problem with this approach is that it requires faith in DG’s compliance.  Fool me once shame on you. Fool me thrice – we’ll you know the rest. 

A more prudent option would be to include a cash sweep with the required principal payment structure.  As cash came into a newly established concentration account controlled by the security agent (both account and security agent located in a more reasonable jurisdiction), the cash would be divided by the security agent according to a pre-agreed formula.  This mechanism ensures (subject to there being a cashflow) that creditors are not forgotten. Cashflow for the creditors under the sweep would be directed first to scheduled principal payments and then to prepayments.  That is, the sweep should not be limited to only the scheduled payments, but to as much as can be taken limited only by the outstanding debt amount. The point is get the cash now not later.  Creditors would be wise to eliminate prepayment penalties as debt collection is the key issue they face.   

There is another very real benefit to this arrangement.  Just as taking ownership of collateral at the inception of the deal makes it difficult for DG to frustrate creditor rights so does a cash sweep. Under the cash sweep cash would be given to creditors on an ongoing basis as soon as practical after it were received in the concentration account.  Creditors would immediately apply the cash against principal due.  It should be more difficult for DG to later clawback the cash already “swept” to the creditors compared to making some bogus assertion about the transaction becoming invalid due to changing interpretations and then not paying.  

Shorter Tenor

Restructuring at the same or a longer tenor defers the day of reckoning far into the future, particularly if an inadvisable bullet structure is used.  Far enough so that it’s not a priority for either. To avoid this unhappy outcome the maturity of the debt should be shortened.  The debt could be divided into tranches (cross default protected) with a maturity ladder, i.e., 1, 2, 3, 4, 5 years.  Or left as a single amount with 2 or 2.5 year maturity.  This would keep the pressure on DG and hopefully prevent the creditors from lapsing into unwarranted somnolescence. 

The shorter maturities would offer creditors the opportunity to reopen the debt to impose additional terms more frequently as it is highly likely that DG will require more than five years to repay the debt, absent a miracle.  And as AA was once told by a local GCC banker, the only "miracles" in Islam occur in the financial statements of Islamic financiers.

  

Dana Gas Restructuring: Full Repayment of Sukuk Threatened by Weak Cashflow

Looking for the Flow

In a previous post I looked at DG’s stale Trade Receivables, today let’s take a look at the company’s ability to generate cash. 

If the title hasn’t given away the plot, AA’s analysis is that it is likely to be insufficient to repay the Sukuk within five years absent a non-operating event. 

We’ll base the analysis on the “Consolidated Statement of Cashflows” in DG’s annual reports in lieu of developing a more formal model because the intent is to provide a directional rather than locational result.  

This is historic information.  

Why on earth is AA using past data? 

Well, there's nothing on the horizon to suggest a fundamental change in DG's existing business, collection of receivables, etc.  Zora would have to grow exponentially to make a difference.  If new business with better paying customers could be found in other countries, DG probably would be hard pressed to secure financing for a variety of reasons and such business, if finance were available, would take time to develop.

To set the stage a few words about accounting cashflow statements. 

1. There are two methods for preparing / presenting a statement of cashflows.  One (the “direct” method) is based on actual cashflows both inflows and outflows.  This provides better information for analysis. 
2. The second is (the “indirect” method) which begins with reported net income and then makes adjustments for certain non-cash items (e.g., depreciation, allowances for impairment, etc.) producing Gross Cash Flow from Operations (“GCFO” or “GO” in this post).  Then a set of further adjustments for changes in the balances of non-cash current assets and current liabilities, resulting in Net Cash Flow from Operations. (“NCFO” or “NO”).   An increase in a current account is a “use” of cash a decrease a “source” of cash.  It’s the opposite for current liabilities where an increase is a “source” of cash and a decrease is a “use” of cash.   Another issue net changes in account balances are used.  This masks actual cashflows, e.g., for receivables it’s the net of new unpaid billings and cash collections on all outstanding receivables.  It’s important to understand that GCFO does not represent cash collected by the company which it then “spends” to increase current assets (e.g., receivables).  What has happened instead is, for example, that some revenue included in accounting net income has not yet been collected.   
3. There is a way to refine the information from an indirect cashflow using notes to try and disaggregate the “net” changes in accounts.  I haven’t done that for the reason noted above.  

The chart below shows DG’s cashflow over an eight-year period.  Note the “traditional” approach to presentation has been adapted to fit the margin constraints on the blog.  That is, years are vertical rather than horizontal. 

Dana Gas Cashflow Analysis  -  Amounts USD Millions
	GCFO	WC + Tax	NCFO	Invest	Finance	Net CF		NO/GO
2016	145	-63	82	-111	-120	-149		57%
2015	345	-142	203	41	13	257		59%
2014	386	-284	102	-55	-67	-20		26%
2013	358	-233	125	56	-141	40		35%
2012	408	-231	177	-57	-67	53		43%
2011	434	-335	99	-93	-53	-47		23%
2010	285	-154	131	-126	-59	-54		46%
2009	176	-71	105	-31	-78	-4		60%
Total	2,537	-1513	1,024	-376	-572	76		40%
Average	282	-168	114	-42	-64	8		40%

Source:  DG Annual Reports

Some observations on the cashflow. 

1. Over the period 2009-2016, DG has converted only 40% of its Gross Cashflow from Operations to “cash”.  The main culprit over the period is a USD 847 million increase in Trade Receivables.
2. If the future is like the past, then NCFO is unlikely to be significantly different than the USD 114 million average over the past eight years.  Note:  NCFO does NOT include finance costs, e.g., "profit rate" (interest).  
3. So USD 570 million is a reasonable estimate of NCFO over five-years.  That's before investments and finance.  
4. If DG needs to maintain investment at average levels—USD 42 million per year—that leaves USD 360 million for debt service.    
5. Assuming annual level principal payments of USD 138 million a year at a 9% p.a. interest rate total payments are some USD 876 million over the five years.  At a 3% interest rate total payments of USD 752 million. 
6. At 9% the shortfall is USD 516 million (roughly 60% unpaid) and at 3% USD 392 million (52%).   
7. Full repayment of the USD 690 million in outstanding sukuk principal and interest therefore appears unlikely (first euphemism of this post) absent significant new developments.
8. One such development would be a fundamental change in cashflow generation from operations, e.g., Zora generating significant cash, Iranian gas sales finally occurring, highly profitable business in a new market.  
9. Another would be a non-operating event or events that change this unhappy picture.  The KRG and Egypt could pay their past due receivables.  The KRG or IRI might pay DG all or some of the USD billions they owe DG according to arbitral decisions.   DG could sell some of its assets with the proceeds directed to creditors. AA is ruling out—perhaps prematurely—DG purchasing a winning El Gordo ticket given DG’s steadfast self-proclaimed adherence to Shari’ah.  Though I suppose a providential re-interpretation of   الميْسِر  and 2:219 by the Company's modern day Abu Yusuf might occur.  An event perhaps more likely than the others outlined in this paragraph.

With this as backdrop, AA is preparing a “What Then Is to Be Done?” post for the creditors chock full of "sage" advice. 

Because AA suspects that the probability of fundamental changes in operations or the occurrence of a non-operating event is low, AA is reaching out for readers' assistance.. 

Readers who know of an Islamic equivalent to St. Jude Thaddeus Patron Saint of Lost Causes or suitable دُعَاء‎‎ are invited to post details.  All five mathhabs are welcome. 

This could be an important pillar of the creditors’ recovery plan.  It would be shame if it was not included.