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.

Dana Gas Restructuring: Not So Current (Assets) Trade Receivables -- UPDATED

Not Snow Not Sugar

They say that "even Homer nods".  If a comparison is to be made with Homer and AA, it's more likely Homer Simpson not Homer. 

In my haste to release this post, I failed to include one very key detail.  

The KRG trade receivables are payable to Pearl Petroleum Limited not DG.  The use of the word "share" in DG's financials Note 17 and 28 is crystal clear. 

What does that mean?

• DG's is unable to sell the TR because it does not have title. There could be restrictions imposed by PPL's contract with the KRG on transfer of title or assignment of proceeds by PPL to a third party, here DG.  As noted elsewhere, certain unspecified actions by PPL require 100% shareholder agreement.  It is not clear if this is one of those decisions.  If it is, then another shareholder--perhaps from among the three 10% shareholders--OMV, MOL, and RWEST--might frustrate a transfer.
• As PPL is the payee/owner of the TR, any payments from the KRG go to PPL.  As such, there is the theoretical possibility that such proceeds could be trapped at PPL.  Presumably, PPL has been structured to avoid third party debt with shareholders providing any needed debt financing.  But there ae other liabilities that could interfere with the transfer of funds from PPL to DG.  For example, claims of environmental damages by the KRG, other contractual liabilities, or other third party damage, etc. 
• As I read Note 28, the aggregate KRG TR owned by PPL are some USD 2.04 billion.  What that suggests is that if the KRG pays $100 to PPL, DG's share is $35.  Meaning in effect that for DG to collect the entire USD 713 million, the KRG will have to pay PPL USD 2.04 billion.  That certainly seems to lower the probability of a prompt payment and perhaps even payment. 
• And to state the obvious, sukuk holders' do not have direct access to PPL's assets including the TR, but have access through DG's equity stake in PPL.  Not  a particularly comfortable place to be in. 

One other note and that's Note 28.  PPL is charging the KRG interest.  Contrary to an earlier erroneous statement by AA, DG is accruing interest to income but is not increasing the balance of TR.  Rather it is deducting this amount from Provisions on its balance sheet.  

DG’s ability to repay its creditors depends on the company’s ability to generate cash.  

In this post we'll look at Trade Receivables.  These are accrued amounts owed by customers that have yet to be paid, that is, converted from receivables into cash. 

DG is having a problem (first euphemism of the post) converting TR to cash.  If you bill your customers and they don't pay promptly or don't pay at all, you have a problem. 

Dana Gas Trade Receivables - USD Millions
	1Q2017	2016	2015	2014	2013	2012	2011
Total Receivables	999	982	950	992	795	599	475
KRG	712	713	727	746	515	365	247
Egypt	283	265	221	233	274	234	228
% Total Equity	36%	35%	33%	37%	31%	25%	21%
% Retained Earnings	163%	163%	137%	172%	165%	172%	216%

  Source:  DG Annual Reports.

1. DG income is dependent on two customers – the Kurdish Regional Government (“KRG”) in Iraq and Egypt.  As AA learned in business school, a successful business needs a good product and a diverse and credit worthy base of customers who actually pay.  In baseball a 50% average (for a hitter) would be outstanding.  In business, however, it isn’t good enough!
2. Recently Zora UAE has begun generating revenue but only about 5% of the total.
3. Total receivables have more than doubled since FYE 2011 largely concentrated in KRG “paper".

Dana Gas Trade Receivables - Past Due Analysis
	Total Amount	Current	Past Due Not Impaired
Year	USD Millions		<120 Days	>120 Days
1Q2017	999	7%	5%	88%
2016	982	5%	14%	81%
2015	950	8%	8%	85%
2014	992	11%	19%	70%
2013	795	16%	18%	67%
2012	599	17%	17%	66%
2011	475	23%	33%	45%

DG Annual Reports Note on Trade Receivables.

1. Over the period FYE 2011 through 1Q2107, the proportion of past due receivables has almost doubled, while the amount of current receivables has declined dramatically.
2. While DG’s presentation is technically “true”, that information does not convey the extent of the past dues. 
3. Yes, some 88% of TR are past due by more than 120 days.  But that's akin to the difference between saying “I hit Jimmy” and “I hit Jimmy and killed him”.  Both are technically true statements about the same event.  Yet, the first is misleading.  (Second euphemism of the post.)
4. Reading DG’s financials one might think that because TR are classified as “Current Assets”, the outward limit would be one accounting cycle or 1 year.  So no TR would be past due more than 365 days. That’s clearly not the case.  
5. From Slide 11 in DG’s 1Q2017 Investor Presentation, it’s clear that a good portion of TR date from 2014 and earlier.   
6. Side Note: DG charged the KRG past due interest at 9% according to its no doubt “Shari’ah” interpretation of its contract beginning in 2013.  In 2016 following an arbitration award, some USD 121 million in accrued interest for 2015 and 2016 was reversed, being the difference between the accrued amount and the Arbitration approved rate of Libor plus 2%.  If you use the amounts of billing and collections shown in the slide, you will have an unexplained difference (even when including the 2015 and 2016 interest reversals) which likely is the effect of other interest transactions.   There's only a minimum problem of USD 4 million constant difference on the Egyptian TR.
7. As per Slide 11, KRG collections over the period 2015 through 1Q2017 were USD 175 million and billings were some USD 246 million.  Note  
8. For the purpose of this analysis, we’ll apply collections on a LIFO basis (against current billings) and FIFO (against the oldest billings).  Billings are actually applied as per contract terms, which are unknown, but this exercise will give us a range of possible outcomes. 
9. If the USD 175 is applied on a LIFO basis, then some USD 700 million plus is more than 2 years past due.
10. If the USD is applied on a FIFO basis, then some USD 500 million is more than 2 years past due. 
11. Either way that’s a dismal picture.  
12. As the table immediately above indicates, at FYE 2014 there were substantial past due amounts from prior years.  Given the KRG’s share of TR, there are likely to be substantial amounts of KRG receivables past due for many years.  AA is guessing 5 or more years.  Some clear present value implications.  
13. Collections from Egypt over the same period were some USD 217 million and billings USD 267 million.  Note Egypt TR at FYE 2014 were USD 233 million.  
14. On a FIFO basis, Egypt receivables would be more current with substantial amounts close to 2 years past due. 
15. On a LIFO basis, the past due tenor would lengthen out to more years. 

The presentation of past due receivables in DG’s financials raises some interesting questions for the Company and its auditors. 

1. As per DG’s financials, TR are generally contractually due between 30 to 60 days.  At what “time” point does a receivable that is past due cease to be a current asset?  AA would think that receivables past due over 1 year would no longer be “current” assets to say nothing of those overdue for multiple years. 
2. If receivables are overdue an inordinate amount of time, when does an allowance become necessary?

Let’s turn to DG’s 2016 Annual Report for their “case”. 

1. Accounting Policies Note 2 Page 58 "Loans and Receivables Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. They are included in current assets, except for maturities greater than 12 months after the end of the reporting period. These are classified as non-current assets. The Group’s loans and receivables comprise ‘trade and other receivables’."  
2. Accounting Policies Note 2 Page 59 "Trade and Other Receivables Accounts receivable are stated at original invoice amount less a provision for any uncollectible amounts. An estimate for doubtful accounts is made when collection of the full amount is no longer probable. Bad debts are written off when there is no possibility of recovery."  
3. Financial Risk Management Note 32 Page 81 "(i) Trade Receivables The trade receivables arise from its operations in UAE, Egypt and Kurdistan Region of Iraq. The requirement for impairment is analysed at each reporting date on an individual basis for major customers. As majority of the Group’s trade receivable are from Government related entities no impairment was necessitated at this point." 

AA’s observations: 

1. Despite stated maturity, the Trade Receivables haves whiskers on them like the old undisposed of items in your refrigerator (see picture above) that start stirring around when the door closes and the light goes out.  Including them (the TR) in current assets on the basis of dishonored contractual maturities does not seem appropriate. (Third euphemism of the post).  Any more than referring to the feral food inhabiting the dark corners of your refrigerator as “fresh”.  At the very minimum, the “time” buckets in the aging should convey more accurately the extent of past dues, e.g., past due 1 year, 2 to 3 years, 4 to five years, and over five years. 
2. DG’s non-impairment argument based on obligors being "government related" is laughable.  Assuming DG are correct, then there is no need for provisions or worry about Puerto Rico. It’s not only government-related, it’s government.  No one seriously thinks that PR is a solid credit.  
3. But there's more. No one should be mistaking the KRG or Egypt for investment grade or even BB borrowers.  Both Iraq and Egypt are rated B (non-investment grade).  There is a world of credit quality difference between say Switzerland and Iraq. 
4. When a B credit does not pay for a prolonged period, provisions are not just a good idea.  They’re required. Even if the obligor is a government related. 
5. What makes the argument even more absurd is it application to the KRG.  Not only is the KRG a sub-sovereign, but at some point in the (near) future, Baghdad is likely to reinforce that sub-sovereign status with vigor, perhaps with the help of two neighboring countries.  Then DG may face an argument similar to the one it is making about the Sukuk: that the existing contract with the KRG is illegal and unenforceable and thus the debt is void.  

AA can understands why the DG has adopted its stance on the TR: self preservation.    

But AA does not understand their external auditors’ position, though I will give them credit for noting in their 2016 FYI audit report page 41: "Considering the uncertainty around recoverability of trade receivables from KRG, we have included an emphasis of this matter in this audit report."   

AA will be taking a look at DG's ability to generate cashflow in a coming post.  

Perhaps this post and that one will suggest reasons why DG have thought it “wise” to adopt their “clever boots” maneuver on the Sukuk.

Dana Gas Restructuring: Friendly Fire - Sharjah and the UAE

DG has placed the courts of Sharjah in a difficult place.  But the uncomfortable situation won’t stop there. Creditors are almost certain to appeal any Sharjah ruling in favor of DG in UAE Federal courts. 

The Sharjah courts are in a proverbial “pickle”.  The Sharjah ruler is Honorary Chairman of DG.  His son sits on the Board.  DG is also a “home-town” company.    

Do they rule with these considerations in mind?  Or do they rule in view of the impact on the UAE, “Islamic” finance?  Or do they rule in DG’s favor and kick the can to the Federal level?

Hard to tell.  Perhaps, though, there’s an indication:  the 25 December date for the hearing on the injunction granted earlier this month. 

AA would think that a highly visible case involving a USD 700 million restructuring and touching on the fundamental validity of “Islamic” finance would warrant a higher priority waiting six months. 

Perhaps, Sharjah Courts are occupied with even larger and more significant cases.  Who would have thought?  Not AA.

If local courts including the Federal Courts uphold DG’s assertion, the reputation of these courts and the UAE’s system of law will suffer, though as an Emirati banker once said to AA.  “By creating the DIFC and the DFSA the Government of Dubai have expressed their opinion on the state of our onshore laws and courts.” 

An assessment shared as well by other parties, I might note.  I'd end by noting that DG is not the only UAE entity to have issued Murabaha based Sukuk

Dana Gas Restructuring: Collateral Damage - "Islamic" Finance

By asserting that changing Shari’ah interpretations can void a borrower’s existing legal obligation to pay principal and “profit” as well as adhere to covenants, DG’s strategy strikes directly at the heart of “Islamic” finance by creating fundamental uncertainty about the legal validity of “Islamic” transactions. 

Simply put, the result of a DG victory is that “Islamic” legal documentation couldnot  be relied on.

Who is affected? 

Here are three potential key affected parties along with some idea of potential injuries. 

• Existing investors whose Sukuk become subject to fundamental uncertainty.  If the market in general were to mark down these transactions due to the uncertainty, investors (including financial institutions that hold Sukuk as investments) could suddenly lose substantial amounts.  For those investors unlucky enough to be holding the Sukuk of DG or a copycat obligor, value loss could be more substantial as debts and interest are repudiated. 
• Existing and potential borrowers who prefer or depend on this form of financing could well find it much more expensive (higher required profit rates, additional collateral, etc.), assuming that finance were available at all.   In some cases skittish investors may decide to exercise rights to accelerate repayment rather than forebear to avoid being caught by a surprise alleged re-interpretation of Shari’ah.  
• Shari’ah experts, commercial and investment banks, legal firms, and other entities who structure and place “Islamic” finance transactions could well see a significant drop in business.

All of the above have a strong motive to oppose DG’s maneuver as well as individuals and entities with primarily religious and not economic reasons for promoting “Islamic” finance. 

At least three parties have already spoken out.

• Shari’ah law experts have begun to challenge DG’s position.  Sheikh Yusuf Talal DeLorenzo (USA) and Mohamad Akram Laldin (Malaysia) as per Reuters both not based in the GCC.  For those who don’t know, there is no central Shari’ah authority.  There is no Rome or Pope in Islam. 
• In a 22 June press release Fitch Ratings have in effect stated that they do not accept DG’s interpretation/assertion: “We believe our current assumption that sharia compliance typically does not have credit implications for Fitch-rated sukuk remains appropriate”.  More importantly Fitch have noted the results if DG’s position is legally upheld: “For this reason, if non-compliance had credit implications and such implications cannot be quantified under our criteria for rating sukuk, instruments may not be rateable”.  If instruments are not rateable, the impact is twofold: (1) higher pricing and (2) less demand.  
• On 27 June Moody’s issued a statement (because this is paywalled, I’m using a press report) which quoted it as follows:  “Although Dana Gas is a small issuer in the UAE market, the credit implications of a court decision in its favour would test Sukuk regulatory and legal frameworks beyond Dana Gas as an issuer or the UAE as a jurisdiction.”  And “The implications [of “illegality” voiding responsibility to repay] include concerns about the legality of existing Sukuk and the effect on their issuers, the role and authority of Shari'ah boards, the responsibilities of the lead arrangers’ due diligence on the issuances, our approach to analysing Sukuk structures, and the liquidity of Sukuk markets.

AA suspects that many more third parties will join the chorus.  

Dana Gas Restructuring: Certificate Holders in a Difficult Position

A Clearly Painful Position But Nothing Like the DG Creditors

Sukuk holders are in a weak economic position even though the documents as written give them relatively strong rights.  They are also now into year 10 of their planned 5 year adventure with DG and the obligor would like another 5 years!  But there is little to suggest that another 5 years will be sufficient to repay the debt.

Obligations are repaid by cash not covenants.  DG’s cashflow is uncertain. Creditors may well strike a deal and impose their terms on DG.  But unless there is a sea change in attitude or aptitude of Egypt and the KRG, creditors face a long and uncertain path to full recovery of their funds.  They also find themselves in "bed" with an obligor whose integrity may be questionable.

The simple fact is DG’s cash flow is insufficient to repay the debt as scheduled this October. Creditor huffing and puffing no matter how extensive is not going to change that fact.  The debt needs to be rescheduled.

But how can realistic terms be set?  Given the KRG’s and Egypt’s inability/reluctance to pay and no apparent way to force them to, it is difficult to develop reasonable cashflow forecast scenarios.  How does one design a restructuring when 95% of the obligor’s cashflow is uncertain? 

But sadly there’s more.

Back in 2007, the original Sukuk holders cleverly “signed up” for what was a limited recourse type project, funding it through a bond instead of a loan.  Horses for courses:  a loan probably would have been more appropriate because in general bonds are covenant light. Or in other words:  don't saddle up a cow if you're going "jumping".

The original “security” (such as it was/is truly “security”) consisted of equity (dead last in the legal priority of payments) in companies undertaking what was a new venture for DG.  The Sukuk holders accepted a structure which limited their repayment to the proceeds from these assets (the Trust Assets).  If the “Trust Assets” are insufficient to repay the Sukuk, the creditors have no claim against DG or its other assets.  Contrast that with the security package for the Zora project (described in my last post). Not an identical transaction but instructive for how risks can be better managed. 

They also agreed to a bullet repayment structure.  With a bullet instrument of any size one is generally relying on a refinancing for repayment. If there’s no market for a refinancing from other creditors/investors, then unless collateral is sufficient and legally accessible, the “bullet” is pointed at the heads of the creditors who must reschedule – either directly or via a disguised rescheduling, i.e., a bond exchange.   

With the (first) earlier restructuring, the Sukuk holders improved their position by adding USD 300 million of Egyptian receivables to the “security” package. If we assume a scenario in which the Sukuk holders get ownership of the collateral, what’s likely to happen?  If Egypt isn’t clearing up past due receivables by paying DG, what would be their motive for scrambling to make the creditors whole?  They have an ongoing commercial relationship with DG who generate cash for them.  A relationship with creditors would be a one-sided outflow of precious hard currency.

Similarly, if the Sukuk holders manage to access the KRG receivables by realizing the collateral, i.e., acquiring shares in the operating companies in the KRG, the situation is likely to be the same as with Egypt. And here the relationship between the KRG and DG has been strained by claims and counterclaims. 

One might expect these two obligors to delay even more and perhaps inspired by DG find or invent reasons to challenge the original amounts of the receivables or to reduce them based on asserted failures to provide ongoing contractual services. 

At that point what is DG’s incentive to assist the creditors collect the receivables if it has been shorn of its two "crown" jewels?