Dana Gas: Deep Dive on Performance

As the picture above indicates, AA is suited-up and ready to embark on a “deep dive” into DG’s performance.  Despite the diving suit, the chap next to me—one of our firm’s analysts—will not be joining as this exercise isn’t client related.  Pity he’s a superb modeler.  

This excursion should be of interest to current and potential equity investors.  It will as well provide creditors some useful insights for the restructuring negotiations. 

As will become evident as we proceed, the reference to “deep” dive has two meanings. While the ultimate fate of the equity and sukuk holders who have "dived" into DG is unclear, AA has surfaced financially sound and whole.

What this analysis shows is that absent unlikely fundamental changes to its underlying business DG’s ability to deliver appropriate returns to shareholders is limited. That means as well limited probability of improving its ongoing cash flow. 

DG’s “clever boots” strategy for renegotiating the Sukuk is likely to exacerbate this problem by diminishing whatever scant market access it had to debt capital prior to that “wise” move, which has increased the market pricing on its debt. The latter is important we shall see because if DG is use leverage to its benefit, it needs to be able to borrow below its return on average assets (ROAA).

As explained below, this problem is not directly related to the failure to collect the trade receivables, but is more fundamental.   

We’ll look at historic performance as our “best” guide to the future for the reasons I outlined in my earlier post with “sage” advice for DG’s creditors. 

Our analytical “tool” will be return on average equity (ROAE). 

DG ROAE ANALYSIS - NET INCOME
	NI	AVE EQUITY	ROAE
2016	-88	2,827	-3.1%
2015	144	2,791	5.2%
2014	125	2,627	4.8%
2013	156	2,480	6.3%
2012	165	2,321	7.1%
2011	138	2,199	6.3%
2010	43	2,137	2.0%
2009	24	2,035	1.2%
2008	33	1,955	1.7%
Last 9 Years	740		3.5%
Last 5 Years	502		4.0%

  Source:  DG Annual Reports  

Technical Notes:   

• Net income as reported. Amounts in USD millions.
• Average equity is the sum of current and past year closing balance of total equity divided by 2.
• 9 and 5 year averages are simple arithmetic means of individual years’ ROAE.

Why did I select these two periods?

• The first roughly corresponds to the period of time DG has had use of the Sukuk certificate holders’ funds. 
• The second period (the last five audited years) strips away the negative effects of the initial low return “building out” of the business in the "early" years and thus probably gives a better picture of the future. 

Observations:  

• ROAE for both periods would not be acceptable for a firm with a better risk profile than DG. When one factors in DG’s risk profile (concentration in sub investment grade customers in “challenged” markets, etc.), the ROAE is dismal.   
• But there’s more “bad news”.  This is DG’s best case because it doesn’t include any adjustments (present value or impairment) of the Trade Receivables (TR).  In this analysis, I am treating TR as received on time and in full. Making what are necessary adjustments would diminish ROAE.  Perhaps, taking it to “subdued” level to use a financial “term of art”. 
• Not only are return on average assets (ROAA) and ROAE low, but they also exhibit high volatility.  The Standard Deviation Sample (STDS) of Net Income (NI) for 9 and 5 years slightly exceed the Mean indicating high volatility.  For 9 years the STDS is USD 85 million and the MEAN USD 82 million. For 5 years STDS is USD 111 million and the MEAN USD 100 million.  Not surprisingly ROAE follows a similar pattern: the STDS are close to the MEAN.   
• ROAE on Comprehensive Net Income (CNI) isn’t much better. Over the last nine years aggregate CNI was USD 782 million and ROAE 3.8%.  Over the past five years CNI was USD 500 million and ROAE 4%.  Still in the “dismal” range. 

What is causing this disappointing performance? 

One way to analyze ROAE is to break it down into constituent components:  Return on Average Assets (ROAA) and Leverage (Average Assets/Average Equity).  According to the “Dupont” equation, ROAE = ROAA x Leverage. 

Purists among analysts out there may object that there are more sophisticated analytical methods.  AA does not disagree. The Dupont equation is also descriptive not prescriptive. But DG’s case is such that simplified analysis will give us the information we need.  Increased precision, if obtained, will not change the fundamental conclusions. 

To start a look at DG’s average balance sheet.   

DG  AVERAGE BALANCE SHEET
	ASSETS	EQUITY	ACCR	DEBT	D/E	LEV
2016	3,839	2,827	158	855	30.2%	1.36
2015	3,762	2,791	160	812	29.1%	1.35
2014	3,567	2,627	156	784	29.8%	1.36
2013	3,521	2,480	155	886	35.7%	1.42
2012	3,414	2,321	153	941	40.5%	1.47
2011	3,268	2,199	155	914	41.5%	1.49
2010	3,170	2,137	149	884	41.4%	1.48
2009	3,029	2,035	130	864	42.4%	1.49
2008	2,953	1,955	112	886	45.3%	1.51
9 Year	3,391	2,374	147	869	37.3%	1.44
5 Year	3,620	2,609	156	855	33.1%	1.39

Technical Notes: 

• As before averages are computed using current period and previous period ending balances divided by 2. 
• ACCR are non-interest bearing liabilities. For the analytically "pure" of heart, I'd note that I have not included ACCR as "debt" when calculating interest or the D/E ratio.  Making this adjustment results in a minor change to ROAE.
• LEV is the “Dupont” leverage ratio, i.e., Assets/Equity.  However, I have not deducted AACR from Average Assets.
• D/E is a more “traditional” measure of leverage.  A D/E ratio of 1.0x would indicate that debt was equal to equity.
• As the above table discloses, DG is funded primarily by equity.

Now to ROAA based on Net Income. 

DG ROAA ANALYSIS - NET INCOME
	NI	AVE ASSETS	ROAA
2016	-88	3,839	-2.3%
2015	144	3,762	3.8%
2014	125	3,567	3.5%
2013	156	3,521	4.4%
2012	165	3,414	4.8%
2011	138	3,268	4.2%
2010	43	3,170	1.4%
2009	24	3,029	0.8%
2008	33	2,953	1.1%
9 Years	740	3,391	2.4%
5 Years	502	3,620	2.9%

Technical Note: 

• Net Income is as reported by DG.  It includes interest expense and taxes. 

At first glance it appears that leverage is working in DG’s favor.  2.4% (ROAA) x 1.43 Leverage has raised ROAE to 3.5%. 

But appearances are deceiving.    

As noted above, ROAA includes interest expense.  Changes in the interest rate will change NI. Changes in NI will change equity.  That’s why one cannot simply use Dupont equation results based on one set of variables (interest and leverage) to analyze another case using different variables without adjusting NI/ROAA and the leverage ratio (equity).    

To judge whether debt financing (leverage) is working we need to look at the unlevered case. 

DG UNLEVERED ROAA ANALYSIS – NI
	NI	INT	ANI	AASSETS	ROAA
2016	-88	97	9	3,839	0.2%
2015	144	77	221	3,762	5.9%
2014	125	73	198	3,567	5.6%
2013	156	78	234	3,521	6.6%
2012	165	86	251	3,414	7.4%
2011	138	87	225	3,268	6.9%
2010	43	56	99	3,170	3.1%
2009	24	55	79	3,029	2.6%
2008	33	72	105	2,953	3.6%
9 Years	740	681	1421	3,391	4.3%
5 Years	502	502	1004	3,620	5.1%

The levered return for the 9 and 5 years periods is 56% and 57% respectively of the unlevered return. 

Not good news for shareholders who have scant, if any, good news on their investment. 

What’s going on? 

For leverage to be beneficial, a company needs to borrow funds at less than the ROAA. 

During the period 2008 through 2016, DG borrowed funds at roughly twice its unlevered ROAA based on reported interest expense.  For 2012 through 2016, it borrowed funds at 1.9x its ROAA.  Thus, instead of leverage working to the shareholders’ benefit, leverage actually reduced their return. 

DG has three potential ways out of this strategic cul de sac: 

• Obtain debt financing at an interest rate lower than its unlevered ROAA. 
• Repay the debt. 
• Increase ROAA. 

Let’s analyze the likelihood of these providing an acceptable solution and the extent of that solution. 

Lower Interest Rates on Debt Financing 

AA finds it hard to imagine a scenario in which lenders or investors willingly provide debt capital to DG as rates substantially below ROAA. 

• DG business has a weak credit profile. 
• It has two major customers who are rated sub investment grade.  It operates in “challenging” markets. 
• It has a backlog of uncollected receivables. 
• It is a serial defaulter and seems likely to continue this path in five years' time.. 
• Its latest default has been accompanied by legal maneuvering that reasonably gives or should existing and potential creditors concerns about integrity. 

As part of the restructuring, DG may be able to obtain (force) some concessions on the interest rate to below market levels.  For Sukuk holders return of principal may be a more important goal than return on principal. 

Such a move is also a “neat” way for the Sukuk holders to take a “haircut” on principal without formally agreeing to one. 

Let’s assume the certificate holders agree.  

What would that mean?

Net Income would clearly increase.  How much?

SCENARIO #2 – 3% INTEREST RATE
	DEBT	AINT	OINT	ONI	ANI
2016	855	26	97	-88	-17
2015	812	24	77	144	197
2014	784	24	73	125	174
2013	886	27	78	156	207
2012	941	28	86	165	223
2011	914	27	87	138	198
2010	884	27	56	43	72
2009	864	26	55	24	53
2008	886	27	72	33	78
9 Years		235	681	740	1,186
5 Years		128	411	502	785

Explanatory Notes: 

• OINT and ONI are the “original” interest expense and net income as reported in DG’s financials. 
• AINT and ANI are the “adjusted” interest expense (at 3% p.a.) and resulting net income. 
• ANI = ONI + OINT - AINT

This looks promising. 

NI is up 60% for 9 years and 56% for 5 years.

What does the "new" average balance sheet look like?

DG  AVERAGE BALANCE SHEET -3%
	ASSETS	EQUITY	ACCR	DEBT	D/E	LEV
2016	4,249	3,237	158	855	30.2%	1.31
2015	4,111	3,139	160	812	29.1%	1.31
2014	3,864	2,924	156	784	29.8%	1.32
2013	3,768	2,727	155	886	35.7%	1.38
2012	3,606	2,513	153	941	40.5%	1.43
2011	3,401	2,333	155	914	41.5%	1.46
2010	3,259	2,226	149	884	41.4%	1.46
2009	3,088	2,095	130	864	42.4%	1.47
2008	2,976	1,978	112	886	45.3%	1.50
9 Year	3,591	2,575	147	869	37.3%	1.41
5 Year	3,919	2,908	156	855	33.1%	1.35

Technical Note:

• In line with my earlier comment, I have adjusted average equity to include the increased NI due to the lower interest rate and then average assets to include the increase in equity.
• Note the impact on LEV.

Now to ROAE.

ROAE SCENARIO #2 (3%)
	ANI	AAA	ROAE
2016	-17	3,648	-0.5%
2015	197	3,488	5.6%
2014	174	3,222	5.4%
2013	207	2,974	7.0%
2012	223	2,705	8.2%
2011	198	2,467	8.0%
2010	72	2,315	3.1%
2009	53	2,155	2.5%
2008	78	2,000	3.9%
9 Years	1186		4.8%
5 Years	785		5.2%

Observations:

An improvement. 

But while the ROAE has increased substantially from the 9% interest rate scenario, it still falls below an acceptable return for DG’s risk profile.

Repay the Debt

This would have to be funded with new equity. 

AA finds it hard to imagine shareholders rushing to “double down” on their bet on DG. 

Yes, ROAE would improve by de-leveraging the firm. But the resulting increase from this step is probably not enough to outweigh the risk of loss on substantial new investment in DG. There are no doubt many other less risky investments out there that beat a 5% or so ROAE.  Additionally, the new money invested would not go to expand the business but to repay existing creditors.   

Cash from the foregone interest expense might be used for dividends.  Eliminating debt would eliminate constraints on dividends. DG’s shareholders have had a long drought on their initial investment – not a penny of cash returned. Sukuk holders have at least seen interest.  No doubt cold comfort for the latter and insult added to injury for the former. 

Or for capital expenditures.  The latter unlikely to dramatically change DG’s business because the amounts would be modest on a yearly basis. 

Improve ROAA

With limited access to debt or equity capital DG’s opportunities to make substantial investments in new businesses to bring ROAE up to a level required for its risk profile appear constrained.  Substantial payment of arbitral awards could provide DG with the capital to expand its business.  This seems like a low probability event.  And if funds were received, could suitable new ventures with better risk profiles be secured?  

There are other constraints on DG's ability to improve ROAA.  First, DG has a 35% share of Pearl Petroleum Company which holds the concession in the KRG.  Significant changes in the business there would require funding from other shareholders in Pearl. Also if you've read the financials of MOL and OMV, you'll have noticed a reference to their ability to exert significant influence on decisions.  A bit surprising statement for 10% equity holders.  OMV provides the answer in its financials - 100% shareholder agreement is required for certain (unspecified) decisions. (Note:  I am not advocating that DG double-down its "bet" in the KRG).  Second, at the macro level weak or declining energy prices could also frustrate the best laid plans.  AA isn't placing any bets on a boom in energy prices these days.

As always comments criticisms, and alternative views are welcome.

IMF Managing Director Less Sanguine About Financial Stability Than Federal Reserve Chairwoman

As per CNBC, The International Monetary Fund's Managing Director, Christine Lagarde, has said that she would not rule out another financial crisis in her lifetime, indicating that comments made recently by Federal Reserve Chair Janet Yellen may have been premature.

"I plan on having a long life and I hope she (Yellen) does, too, so I wouldn't absolutely bet on that because there are cycles that we have seen over the past decade and I wouldn't exclude that," Lagarde said.

In this debate AA's money is on CMOL.  Hope yours is too.

Tip of AA's tarbush to CNBC for the phrase "may have been premature".

Previous post on Ms. Yellen here.

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.