GFH - Review of FY 2019 Income And Suggested Questions for the AGM

What Better Time than the AGM!

UPDATED TO INCLUDE INFORMATION FROM KHCB'S OGM/AGM ANNOUNCEMENT.

See related posts here and here.



GFH has published its audited FY 2019 financials as well as a very illuminating presentation (hereinafter “Presentation) on FY 2019 results. This latter document is well worth a read as it gives a quick overview of GFH’s performance.

This post discusses those results. Or at least the ones that caught my eye.

As an added bonus, I’ve included a section with questions that interested shareholders might wish to pose at GFH’s Annual General Meeting (AGM) or if you prefer Ordinary General Meeting (OGM) later this year.

That I believe will be the most useful part of this post.

REVIEW GFH FISCAL YEAR 2019 FINANCIALS

Net Income – Significantly Down but “Better Quality”

The “headline” news is that reported consolidated net income for the Group was USD 67.2 million down from USD 115 million the year before – a decline of roughly 42%.

As per GFH’s press release the decline was largely due to increased provisions at KHCB. (See Potential Questions section).

Net income attributable to GFH shareholders was a higher but still disappointing USD 80.1 million versus USD 114.1 million for FY 2018 a decline of only 30%.

I hope the two terms “consolidated net income” and “net income attributable to shareholders” caught your eye as well as the major difference between the two numbers.

How can that be?

The “magic” of consolidated financial statements.

Key takeaway. 

Consolidated financials are an accounting “construct” not the financials of a legal entity.

That’s a very important bit of knowledge for all who use financial reports. 

Previous post here outlining some of the “realities” of consolidated financials.

In the presentation, apparently given by Mr. Surya Hariharan (Head of Financial Control) he noted that the highlight of the operating income was an improvement in quality.

How does a decline in the amount increase quality you ask? 

Page 6 of the Presentation gives the answer. 

Compared to 2018, the quality of income for 2019 has improved substantially with 71% of the profit being cash profit compared to 2018 which did not have significant cash income.

When a firm’s income is largely non cash, you might expect that the board and management would be “mighty careful” (that’s a technical financial term) with shareholders’ cash.

Wouldn’t you? (See Potential Questions).

GFH Investment Banking Revenue

GFH’s Investment Banking Segment (IBS) contributed USD 95.9 million in revenues or some 29% of total revenues. 

A look at at Note 26 Related Party Transactions page 52 discloses that 99.9% of IBS revenues came from placements with Assets Under Management. That is, assets that GFH manages for clients.

One can imagine the difficulties associated with closing the “sale”, can’t one?

“Loss” on Acquisition of Additional Interests in Tunis Bay and RSREDPP

In line with GFH’s continuing “commitment” to “transparency”, if you look at Note 21, you’ll see a somewhat “obscure” accounting (that is a charitable financial term as well as being semi-technical) for the acquisition of additional interests in Tunis Bay and Residential South Real Estate Development Company.

While the word “loss” isn’t used and this amount doesn’t appear in GFH’s Income Statement, you will note that the transaction resulted in a USD 51.4 million charge to Retained Earnings in the Consolidated Statement of Changes in Owners’ Equity. (See Potential Questions Section).

As one of AA’s colleagues used to say, book the gains through the Income Statement and the losses direct to Equity whenever you can.

POTENTIAL AGM QUESTIONS FOR SHAREHOLDERS

This I hope will be the most useful section of this post.

KHCB – Raising of Additional Tier 1 Capital BHD 37.7 Million

Why would GFH shareholders be interested in KHCB? Because GFH owns 47% and has effective control.

More importantly, as indicated above KHCB’s fortunes or misfortunes affect GFH shareholders.

Per KHCB’s FYE 2019 audited financials KHCB took a provision of BHD 20.4 million in the year. It also made a prior period adjustment to retained earnings for another BHD 11.1 million for a total of BHD 31.5 million.

The BHD 20.4 million in provisions--which went "through" the Income Statement-- led to a net loss for the year of BHD 15.0 million. 

The additional BHD 11.1 million is “buried” in Consolidated Changes in Owners’ Equity.

More importantly, as a result of both the provisions and the prior period adjustment, KHCB’s capital is BHD 15 million below the CBB requirement of BHD 100 million.

As per Note 1 to KHCB’s financials, the Board have mandated an “international bank” to raise BHD 37.7 million in additional tier one capital to “help strengthen its equity and meet capital requirements”.

AS PER KHCB'S OGM/EGM ANNOUNCEMENT IT WILL SEEK EGM APPROVAL TO RAISE UP TO USD 200 MILLION IN AT1 NEW CAPITAL.

1. Why is KHCB planning to raise 2.5 x the capital shortfall?
2. The new amount is 5x the capital shortfall! 
3. A potential sign of extremely serious problems at KHCB.  Or perhaps an intended acquisition?
   
4. Does GFH anticipate more provisions will be required by KHCB?
5. In posing this question, recall that GFH controls KHCB and should be in a position to know. They certainly were when they prepared the prospectus for the USD 300 million Sukuk issued this February. Earlier post here.
6. Or is the Central Bank of Bahrain requiring this additional amount?
7. Will the new capital be in the form of common equity thus resulting in dilution of existing shareholders?
   
8. Or will it be in the form of a debt-type security that enjoys preference in payment over dividends to shareholders? YES.  A Sukuk.
9. Note well that regardless of the form of the new equity, existing shareholders of KHCB-including GFH-are likely to see the value of their shares decline.
10. Because GFH owns 47% the impact on GFH will be significant.  The value of the KHCB's shares it holds are likely to decline significantly.  GFH shareholders won't see that because KHCB is consolidated into GFH. 
11. But it will affect dividend (cashflow) to GFH in a major way as the Sukuk holders will get paid from Net Income first.  And they are unlikely to price their Sukuk cheaply.  
12. KHCB is also asking shareholders to approve appointment of a market maker.  If KHCB begins engaging in expensive Treasury Share transactions similar to GFH, KHCB and GFH shareholders will be negatively impacted.
    
13. Will GFH be participating in the new AT1 equity?  
14. If so, will it be using any of the 140 million Treasury Shares it obtained shareholder approval to use for acquisitions to participate in the new capital raising for KHCB?
15. If so, how many? 
    
16. If you’re interested, here’s a link to a more detailed discussion of KHCB’s 2019 financial performance.

Management of Shareholder Cash

As noted above, GFH’s FY 2018 earnings were substantially non cash.

Yet, in FY 2019 the Board approved substantial discretionary expenditures of cash equal to roughly USD 140 million. 

And then went on in FY 2020 to raise USD 300 million in debt at 7.5% per annum.

Was this prudent?

1. How does the Board justify paying cash dividends of USD 30 million when income was non cash?
2. Courageous shareholders may consider asking representatives of the Central Bank of Bahrain present at the AGM if it is common practice for the CBB to approve cash dividends when net income for a year is substantially non cash.
3. GFH canceled USD 50 million in Treasury Shares which could have been sold back into the market for cash. Why was this done?
4. GFH also continued its Treasury Share transactions resulting in a cash loss of some USD 27 million in the year.
5. It also purchased some USD 32 million of Treasury Shares for a “share incentive scheme”.
6. Did the bank really need to purchase all these shares in one year?
7. GFH is perhaps anticipating fantastic performance in 2020 and the need to pay out large bonuses?

Treasury Share Transactions

What is behind the continued costly-to-shareholders purchase of Treasury Shares?

1. Are purchases in these amounts really required to provide liquidity to the market? To enable shareholders to more easily buy and sell GFH shares?
2. If this is the case, how does the Board explain the continued losses – USD 27 million in FY 2019; USD 25 million in FY 2018?
3. In general “market making in shares” for liquidity purposes should result in a small net gain or a small net loss.
4. Why isn’t this the case with GFH?
5. Since it isn’t, it suggests that perhaps the reason is not providing “market liquidity” but is really something else. 
6. As noted above, in FY 2019 the bank bought USD 32 million of its own shares for a “share incentive scheme”.
7. As hinted above, it doesn't seem that It really need to buy this amount in one year.
8. As AA argues in a separate post it certainly appears that GFH is using Treasury Shares and cash dividends to attempt to maintain its share price.
9. If that analysis is correct, is the expense worth the effort? And for whose benefit?

2020 USD 300 Million Sukuk

As discussed above and in an earlier post, in early 2020 GFH issued a USD 300 million 5 year sukuk at a fixed interest rate of 7.5% per annum.

If GFH has avoided the discretionary spending referred to above, its need for the borrowing would have been reduced by some 47%.

That would result in savings of USD 10.5 million per year in interest.

Or USD 52.5 million over the five year life of the sukuk.

Update:  GFH is proposing USD 50 million in cash dividends for FY2019.  That is roughly 63% of FY2019's net income attributable to GFH's shareholders. 

It also raises the question about the prudence of GFH's cash management.  Did it borrow an additional USD 50 million it didn't need to?

That increases the interest cost on the sukuk over its life another USD18.75 million.

Shareholders may want to probe a bit to understand the Board's rationale for its cash and debt management "strategy". 

It’s also important to put this borrowing into the context of two statements from the FY 2019 Presentation (page 6). 

Interest expense has increased 181.8% since 2019.

This appears to be a reference to GFH Treasury interest expense. Note that KHCB’s interest expense is included in GFH’s Income Statement under the “Commercial Banking” heading.

And more importantly 

Compared to the previous year, the Bank [GFH] has reduced its negative spread significantly.

That means the Bank still has a negative spread.

It earns less on Treasury Assets than it pays for the money to finance these assets.

Easy to see that because GFH as per the Presentation is paying 4.84% for money market funds (page 4)! 

Adding a fixed 7.5% per annum debt doesn’t seem like it will help on the negative spread.

A negative spread is generally considered by Treasurers that AA knows not to be a good position for a bank.

More importantly, it often leads a bank to venture further out on the risk spectrum to get a higher return.

Usually but not always with less than “happy” outcomes.

In FY 2019 GFH acquired some USD 240 million in “structured notes” in its Treasury Portfolio. This is a new asset class within the Portfolio. 

Shareholders may want to ask the Board about this new endeavor particularly the risks such instruments typically pose and whether GFH is in a financial position to assume these risks, how risks will be controlled, etc.

Some tuition from the folks at the USA’s SEC on structured notes.

Those with long memories (probably not most investors or bankers) will remember the banks in Bahrain that had problems with “structured notes” in the past, though it wasn’t just Bahraini banks whose hopes were dashed by this type of asset.

Those like AA also remember less than an honest and transparent sales pitch on these notes from major international investment banks when AA went over to the Dark or Buy Side.

I once called out a representative of a marquee international IB by pointing out that what he had just said contradicted what was written in their prospectus. 

Apparent “Loss” on Acquisition of Additional Interests in Tunis Bay and RSRED

The transaction resulted in a USD 51.4 million charge to Retained Earnings which certainly looks like a “loss” though it did not pass through the income statement.

1. How does GFH Board and management explain/justify this transaction?
2. In other words, what were the good reasons for buying these interests if it resulted in a charge to Retained Earnings of this magnitude?
3. Does the USD 51.4 million charge relate solely to Tunis Bay?
4. That seems to be the case given the statement on page 4 in the Presentation. But good to confirm.
5. If not, how much related to RSRED?
6. Regardless of the answer to that question, what was the consideration “paid” by GFH for the acquisition of RSRED?
7. Did GFH acquire all or part of RSRED in return for reducing the principal of the Villamar Sukuk? That is, it acquired RSRED shares which it “considered” to be a repayment (unlikely to be a full repayment) of the Sukuk? In effect a non cash repayment of part or all of the Sukuk.
8. Why should shareholders care?
9. GFH bought the sukuk from AlRajhi largely for cash. 
10. If it is now treating the acquisition of assets from Gulf Holdings as repayment, the value of the assets acquired would be very important.
11. If GFH is now booking charges to equity based on the RSRED assets acquired being lower in value that the consideration “given”, that would raise questions about the USD 77.8 million in restructuring income on the Sukuk booked in FY 2018.
12. See earlier post on Villamar Sukuk for more details on why valuation of any non cash assets received to “repay” the Sukuk matters. Note the linked post has a link to an earlier post.

Goldilocks Investment Fund “The Midas Touch” – Khaleeji Commercial Bank

As Legendary Investor Fred C. Dobbs Can Tell You Not Only Have to Have 

the Golden Touch, But You've Got to Know How Hold On to Value

Continuing our fairy tale theme, another instalment on Goldilocks Investment Fund.

In doing a bit of research on GFH, I just happened to discover that Goldilocks owned some 9.98% of the shares of Khaleeji Commercial Bank Bahrain.

From a quick look at previous years KHCB financials, their ownership first emerged in the FYE 2017 report and has been consistent since then.

What changed was that as of FYE 2016 Shuaa Capital owned 14.01% of KHCB.

In the FYE 2017 report it “disappeared” from the list of major shareholders – 5% and above.

According to the Bahrain Stock Exchange, on 26 September 2017, Shuaa sold 100 million shares to Goldilocks at BHD 0.096 per share on the Special Order Market.

According to Bahrain Stock Exchange data, the closing price on that day in the regular market was BHD 0.1113 so Goldilocks bought at a 15% discount.

Goldilocks already owned some 3,950,000 shares as of that date and apparently acquired another 829,110 shares prior to FY 2017 end.

Shuaa retained 40,779,824 shares or 3.88 % of its holding then.

It’s not clear if it still does.

What was Goldilocks’ return on its investment?

KHCB paid no cash dividends since Goldilocks’ acquisition.

So the return is change in the market value of stock.

KHCB closed at BHD 0.052 on 2 May 2020.

ROI is negative 46% (based only on the cost of the 100 million shares purchased from Shuaa).

That’s before consideration of the likely negative impact on Goldilocks and other KHCB's existing shareholders of KHCB’s need to raise BHD 37.1 million in new Tier 1 equity. 

See that discussion here. 

But save some of your pity for KHCB which is sitting on a similar size block of Treasury Shares at an average cost of BHD 0.1138 and facing a much lower ROI – negative 54%.

You’ll recall and if you don’t AA will remind you that Shuaa bought AlImtiaz's 14% stake in KHCB in December 2006 for BHD 0.065 per share. Approximately one month after ADFG bought a little over 48% of Shuaa.

Shuaa’s ROI on its investment in the 100 million in KHCB shares it sold Goldilocks was roughly a positive 48%.

Side note:  Ending of film pictured above presents an unrealistic scenario when atomic weight is considered, though it has a nice cinematic effect.