Analyzing GFH's 1Q2021 “Incredible” Performance

Whether It is Counting or acCounting
AA Helps You Keep the Numbers Straight
(Professional Actor - Not AA)

According to the headline numbers from GFH’s short form press release on its 1Q2021 performance, GFH had an “incredible” quarter.

Net profit including Non Controlling Interests (NCI) share was some US$ 19.3 million compared to US$ 6.8 million for the comparable period last year.

Profit attributable to GFH’s shareholders (excluding NCI) was some US$ 16.1 million versus US$ 5.1 million the year earlier.

That’s 3.2x last year!

Wow!

But strangely GFH’s equity attributable to its shareholders only increased US$ 4 million from FYE 2020.

Similarly total equity including NCI was up US$ 8 million from FYE 2020.

What happened?

What accounts for the “missing” US$ 11 to 12 million?

Normally we would begin by looking at the Statement of Comprehensive Net Income which usually follows the Statement of Net Income.

Examples from Conventional Banks in Bahrain.

BBK 1Q2021. 

Investcorp 3Q2021. (Recall the Investcorp’s FYE is June for no doubt some excellent reason which I was told was to prevent having to issue audited financials some years back when the results would have been “mighty disappointing” to use a technical financial term.)

But it seems that Islamic Banks in Bahrain are not obligated to provide a separate Comprehensive Income statement.

See Al Baraka’s 1Q2021 report here. And note their auditors are a different firm than GFH’s.

So what to do?

Off we go to the Consolidated Statement of Changes in Shareholders Equity where those sort of entries would be recorded.

There you will notice two amounts US$ 4.479 million (fair value changes) and US$ 8.280 million (disposal of sukuk) for a total of $12.759 million being deducted from net income.

You will notice that after these transactions there is a line labeled “Total recognized income and expense”.

This is the equivalent of “comprehensive income”. But “buried” where you might miss it.

That is why as I have argued before it is critically important to look at Consolidated Statement of Changes in Shareholders’ Equity. 

Not only to catch “comprehensive income” when there is no separate income statement for that. But also to see what other entries are affecting equity which are the economic equivalent of “income” and “expense”.

What’s behind these entries?

For those assets that are carried on the balance sheet at “fair value” as opposed to historic cost, accounting standards allow banks to recognize changes in fair value of those assets in two ways:

• The first is to recognize the change in value (whether plus or minus) in the income statement (FVTIS)

• The second is to recognize the change directly in equity (FVTE). So the change does not appear in the income statement.

In 1Q2021, the assets that GFH holds as FVTE had an aggregate net “loss” of fair value prompting a US$ 4.479 million charge to equity. This charge is non discretionary. It is an “expense” in "comprehensive income".

However, the US$ 8.280 million was discretionary.

GFH decided to sell the sukuk

When a FVTE asset is sold, the profit or loss on the sale must be recognized in the income statement.

In order to prevent “double counting” of profit or loss already recorded in the fair value reserve when an asset is sold, the previously recorded profit or loss must be subtracted from the fair value reserve.  

As hopefully is clear from these entries, the impact on shareholders' equity is nil when those two amounts are equal.

When the profit or loss on sale differs from that already recorded in the fair value reserve, then the impact on equity will reflect that difference. 

For example, let's suppose GFH sells an asset for a US$ 8 million profit but has (already) recorded only US$ 7 million increase in the fair value reserve.  

In this case, GFH's equity will increase by US$ 1 million.  If the situation is reversed, GFH's equity will decrease by US$ 1 million.

To be fair by selling the asset, GFH has “locked in” the profit on the sale.

Removing the US$ 8.280 million from the reported US$ 16.1 million in net income lowers net income attributable to GFH shareholders to some US$ 7.8 million.

But what’s the point of all this?

Income is income, isn’t it?

Yes, but.

As noted above, GFH has the “discretion” to decide when to sell an asset. And thus when to declare a profit.

Even though moving the profit to income has no real impact on shareholders’ equity. The needle doesn’t move as they say.

Having that option can be quite handy.  Particularly if one expects that one's shareholders aren't bright or industrious enough to see that the "profit" has already been booked.

To be fair, we don’t know if GFH was taking advantage of particularly favorable market circumstances that might not occur again to sell the sukuk.

Or if it was seeking to manage its earnings upwards.

If we then remove the US$ 4.479 million change in fair value from reported income, that further lowers  income to US$ 3.321 million.

As you will notice, there were no items in comprehensive income in GFH’s 1Q2020 financials.

On this basis 1Q2021 wasn’t “incredible” at least in the positive sense of that word.

Based on Comprehensive Income, it was actually lower than the previous year.

However, we're not done yet with the analysis.  

If we look beyond “Comprehensive Income” to other items that I have argued are economically income and expense. we will see additional entries in both periods which further affect economic income.

1Q2020 was particularly brutal – net charges of US$ 25.8 million. 

1Q2021 had a gain of US $ 4.8 million.

On that basis, 1Q2021’s positive result looks much better compared to a rather disappointing 1Q2020 negative performance.

“ كل لبيب بالإشارة يفهم “

Why Hasn’t GFH “Grown” Its Equity Since FYE 2016?

Sometime it's the quality of the soil
Sometimes the climate or lack of water
And sometimes the farmer himself

 Key Points

• GFH’s equity has “grown” a mere US$ 5 million between FYE 2016 and FYE 2020, despite GFH having earned US$ 90 million net of cash dividends. US$ 292 million in net income less US$ 202 million (cash dividends).

• Market making activity and Treasury Share Accumulation cost GFH’s shareholders US$ 146 million.

• GFH also canceled US$ 50.5 million in Treasury Shares leading to another economic loss not captured in its financials though the vagaries of accounting.

• Beyond that, other transactions, largely related to losses incurred on acquisitions totaled US$ 88.5 million, not including the US$ 60 million charge related to KHCB’s BD 60 million AT1.

On 22 May GFH announced that its live webcast on 20 May on 1Q2021 results had been successful.

During the Q&A session the moderator read a question from an unnamed shareholder.

The next question is, while the group has managed to increase its assets, liabilities, and AUM, but not its equity, could you shed some light on the declining equity? 

Suryanarayanan Hariharan, GFH’s CFO responded:

There has been a marginal increase in the equity as of 31st March 2021. Despite the profit, there’s also a fair value movement of our treasury portfolio, which is captured on the equity, and for Q1 2021, there was a drop in the fair value movement, and that touched on the equity for the group. 

That didn’t seem like a completely satisfactory answer to me.

It omits the fact that the US$ 8.280 million in profit on the disposal of a sukuk was already reflected in equity. And, so, even though it appeared on the income statement, it did not increase equity. 

And also that the shareholder seemed to be asking a question about more than the change in equity from FYE 2020 which as noted by GFH’s CFO was positive..

But I didn’t “attend” the webcast so perhaps this is summary of a longer exposition with details “lost in condensation”.

In any case, I thought it would be an interesting topic to look at the “evolution” of GFH Group Shareholders’ Equity.

I chose the period 2017 through 2020.

Some methodological notes:

1. GFH’s Consolidated Statements of Changes in Shareholders’ Equity is the primary source document for information.

2. The focus is on changes in the equity belonging to shareholders of GFH Financial Group. To be clear that excludes the NCI.

3. Calculations reconcile to the changes in that equity. And so as outlined below miss one rather large economic loss

So let’s start with an overview of changes in Group shareholders’ equity over the period.

There really has not been much of a change over the period. US$ 5 million only.

Over the four year period, GFH has declared US$ 292 million in comprehensive income and has paid cash dividends of US$ 202 million.

That should lead to a US$ 90 million increase in equity.

From the chart above it clearly has not.

GFH is ’“short” some US$ 85 million.

So what accounts for the difference? 

Let’s go through the categories starting from the bottom.

TS Loss – Is the loss incurred on selling Treasury Shares.

Note this does NOT include the economic loss on GFH’s cancellation of some US$ 50.5 million of Treasury Shares in 2019.

Why not, after all my ranting and raving about this being a totally incomprehensible act that was to the detriment of the shareholders?

It’s not included because this transaction was netted against outstanding shares so the effect on shareholders’ equity was nil. In a master stroke of financial skill, GFH then issued US$ 55 million in bonus shares so that paid in capital remained unchanged. And I am reconciling to the equity as presented.

Despite that, it is still a loss to shareholders because GFH could have sold those shares in the market. It probably wouldn’t have recovered all of the US$ 50.5 million. But it would have recouped a good portion. That would have been of more benefit to shareholders than canceling the shares.

Or alternatively, it could have foregone issuing bonus shares by just distributing the Treasury Shares to its shareholders.

Net +/- TS – Is the net change in the US$ value of Treasury Shares, that is, purchases (a negative) against sales (a positive). Again this doesn’t include the share cancellation mentioned above for the same reconciliation reasons.

Emp Shares – Are purchases of Treasury Shares for GFH’s employee stock incentive program. A negative number is an acquisition of shares, a positive number the issuance of shares to employees.

Other – Is a collection of all other entries to Group Shareholders’ Equity.

As you’d expect this includes recurring items such as zakat and charity contributions. But there are some one-off items.

Let’s step through each year looking at major entries in the Other category to see if anything else catches our eye.

Each year’s total for Other is given should you want to explore for more detail on your own.

2017 (Total for the Year US$ 252 million)

• US$ 293 million in new stock issued. Some shareholders in GFH projects (Tunis Bay and India) gave GFH their shares in those assets in exchange for equally good GFH shares. This is a non cash transaction.

• US$ 37.5 million charge related to acquisition of increased share of the projects acquired in the stock exchange. Not broken down. KHCB and MGIC (Morocco) appear to be responsible. Probably primarily MGIC.

2018 (Total for the Year US$ 20 million charge)

• US$ 17 million in charges (via restatement) for adoption of FAS 30.

2019 (Total for the Year US$ 39 million charge)

• US$51 million charge for acquisition of additional interests in pre-existing investment with no change of control. Related to Tunis Bay and Residential South Real Estate Development Company (RSRED).

• US$ 14 million credit related to FX rate changes.

2020 (Total for the Year US$ 89 million charge)

• US$ 60 million charge related to KHCB AT1 purchase.

• US$ 14 million charge related to revision of financing terms. Likely KHCB related.

• US$ 18 million charge related to FX rate changes.

• US$ 4 million grant from Govt of Bahrain related to Covid and probably to KHCB.

Looking at items in Other, the US$ 88.5 million in charges related to Tunis Bay, RSRED, KHCB, and MGIC have yet to prove their value.

Some general observations;

• It’s not generally considered a sign of success when you wind up buying an incomplete project investment back from a client at a higher price than you sold it. Particularly when there’s no real “market” price.

• If the project has really increased in value since the initial sale, why would the investor want to sell now? Presumably that value will continue to increase as the project completes.

• If the seller is motivated to sell for liquidity or other reasons, wouldn’t that tend to decrease its pricing “power” in negotiations?

• If the buyer alone can unlock the value of the asset, then shouldn’t he or she have some leverage over the purchase price? After all, the buyer hopefully intends to make a profit on the project. If the re-acquisition price is too high, then the profit will be smaller than envisioned.

• The identity of the investor can also play a role in the price negotiations. Big fish or VIS, whatever you might like to call them, probably have more leverage.

• As I’ve noted before when a sale is concluded via the exchange of boot (non cash items), value can be rather hard to “pin down”. But perhaps easier to manage.

• GFH shares are no doubt more liquid that TBC, RSRED, MGIC. Thus, offering an investor a much easier way to exit. Particularly, if attempts were made to keep the share price “stable”. That might also explain why GFH “experienced” a persistent considerable and uncharacteristic loss on its “market making” activities.

Among the remaining items only the US$ 60 million charge related to the KHCB AT1 sticks out. This was probably unavoidable. GFH didn’t have any good options in the situation.

Summary

If we assume that the employee stock incentive is a worthwhile endeavour and not just another way to accumulate Treasury Shares, then the loss on market making of US$81 million and US$ 65 million in net TS purchases—totaling US$ 146 million—were probably not in the best interests of shareholders in general. Though perhaps some big fish may have benefited.

When the 2019 cancellation of the US$ 51 million in Treasury Shares is added in, we’re talking about some real money. Roughly equal to the cash dividends GFH paid over the period.

Adding the items from Other, particularly the US$ 88.5 million that I’ve flagged above, and it’s not a “pretty picture” to use a financial term of art as well as an homage of sorts for a former GFH senior officer.

All that said, the question for shareholders is how they evaluate GFH’s management’s performance.

C'est bien dit, mais il faut cultiver leur jardin.

What are GFH’s Motives for Acquiring KHCB Shares?

لولا اختلاف النظر، لبارت السلع  

 Summary of key points in this post.

• 45% premium over market on 13.64% of shares from Shuaa and Goldilocks.

• Tender offer proposed for remaining 30.95% of shares

• Favorable Impact on GFH’s Consolidated Shareholders’ Equity

Background

On 6 June GFH announced it had increased its shareholding in KHCB from 55.41% to 69.05% as part of the “Group’s strategy to increase its ownership in KHCB.”

On 7 June GFH provided further details as follows:

With reference to GFH Financial Group’s announcement dated 6th June 2021 pertaining to the subject matter, GFH would like to announce that the increase of ownership in Khaleeji Commercial bank was pursuant to a sale and purchase agreement between GFH along with Shuaa Capital and Goldilocks Investment Company, to acquire their stake of 121,726,795 shares for a total of BD 8,764,329.240 equating to BD 0.072 per share.

On 8 June GFH announced that pursuant to Central Bank of Bahrain requirements regarding takeover and mergers, it had approached KHCB’s Board to make a proposed voluntary takeover offer for the remainder of KHCB’s shares.

Deal Analysis

According to the trading data from the Bahrain Bourse, during the period 4 January through 3 June 2021, the average price of a KHCB share was BD 0.050 (rounded to 3 decimal places). Typically the share trades at roughly 50% of book value.

The BD0.0720 acquisition price represents a 45% premium to the average trading price.

Since the GFH acquisition, the price has increased to just below BD 0.070 perhaps in anticipation of GFH offering the same BD 0.0720 price to remaining shareholders.

Apparently, KHCB is quite a valuable asset.

Though one might not have thought so from the fact that

• KHCB required an additional BD 60 million in capital to meet CBB requirements

• GFH had to buy the entire AT1 instrument

Or maybe you read Fitch Ratings comment on KHCB in their reaffirmation of GFH’s B credit rating. (That rating is below investment grade, if you didn’t know)

Following a balance sheet clean-up exercise in recent years KHCB's asset quality has been improving but is still weak and lags higher-rated peers'.

In any case I hope you are confident that the fact that Shuaa and Goldilocks are related parties had no effect on the 45% premium.

That being said, the size of the premium is perhaps perplexing. 

Neither Shuaa nor Goldilocks were inclined to participate in the AT1. That would seem to evidence a lack of faith in KHCB's future.

One might think of them as perhaps motivated sellers of KHCB. 

It is perhaps also difficult to imagine that there were other serious bidders interested in acquiring a minority stake in company where a single shareholder had control.

But then the ways of the market are mysterious and magical. Especially in the land of flying carpets.

Despite the premium, if you look at this earlier post on Goldilocks, you will see that Goldilocks acquired its stake in KHCB from Shuaa for BD0.096 a share. You will also note that KHCB didn’t pay any dividends since Goldilocks’ purchase.

So on this transaction Goldi has a roughly 25% loss from original cost.

No wonder Shuaa doesn’t publish data on Goldilocks’ performance, contrary to previous years.

In the post referenced above I also wondered if Shuaa had held on to its then 3.88% stake.

It certainly appears so because GFH says it bought shares from both Shuaa and Goldilocks and Goldilocks shareholding was 9.76% according to KHCB’s announcement.

Motives for the Transaction

So what is motivating GFH’s acquisition of KHCB?

Only GFH knows for sure but we can explore some possible rationales. 

I've selected two for discussion:

• Overlooked gem
• Increase in GFH equity beyond the purchase price

Other possible reasons for the transaction could be “civic duty”, etc. And more than one motive may be operative.

As you read, you can decide for yourself which, if either, is the more compelling one.

Overlooked Gem

The market has fundamentally undervalued KHCB.

The canny folks at GFH are about to get KHCB “on the cheap”.

Thereby reaping rich rewards long into the future.

Accounting Magic

The key drivers of the appeal of this motive are two “facts”:

• KHCB’s book value per share exceeds the acquisition price

• GFH uses the book value—not the market or fair value—of KHCB’s assets and liabilities (and thus by the process of subtraction also KHCB’s equity) to prepare its consolidated financials.

As of 1Q 2021 KHCB’ s Book Value was roughly BD 0.160

By acquiring the shares GFH stands to benefit from the difference between book value (BD 0.16) and the purchase price (BD 0.072) and the happy application of rules for consolidated financial statements.

121,726,795 shares at BD 0.088 equals roughly BD 10.7 million or US$ 28.4 million.

Compare that to the BD 8.8 million purchase price. 

A not inconsiderable gain on purchase.

You might well ask:

“How can that be? The P/B ratio is well below one. This can’t make economic sense.”

As I’ve posted here before, accounting does not always reflect economic reality.

Here’s how it would work in detail.

Recall that in its consolidated financials GFH records 100% of KHCB’s assets and liabilities in its (GFH”s) balance sheet using the values appearing in KHCB’s balance sheet. Their book values.

Therefore, net assets (equity) are also reflected in GFH’s financials at book values.

As the final step GFH allocates those net assets between shareholders in the Group and Non Controlling Interests (NCI) in the Consolidated Statement of Changes in Shareholders’ Equity based on their respective ownership/voting rights.

With the acquisition of an additional 13.64% in KHCB shares, GFH’s share of the net assets (total assets minus total liabilities) in KHCB will increase.

This increase in equity attributable to shareholders of GFH will be accompanied by a corresponding decline in equity attributable to NCI in GFH's financials.

If its tender offer for the remaining shares is accepted and completed, an additional increase in Group shareholders’ equity will occur.

Depending on the percent take up on the take over offer, the component in NCI related to KHCB may disappear from GFH’s financials.

But there is indeed more!

You will recall (and if you don’t here’s the link to that post) that in connection with its 2020 purchase of KHCB’s AT1, GFH was required to reduce its consolidated equity attributable to shareholders of the Group by US$ 59.9 million in its FY 2020 financials.

The US$ 59.9 million reflects the excess (positive difference) between (a) GFH’s “contribution”--the amount of the AT1-- and (b) GFH’s share of KHCB’s net assets based on its percentage shareholding in KHCB.

Now that GFH owns 69.05% of KHCB, it is entitled to “recover” some of that amount.

Similarly, it will also have to absorb some of the US$ 14.3 million share of issuance costs levied against the NCI in 2020. Perhaps as much as US$ 4.4 million.

We should see the impact of the 13.64% KHCB share acquisition most likely in GFH’s 2Q2021 financials.

Keep your eye on GFH’s financials to see if my prediction comes true and how the related entries are handled.

Are they disclosed separately as in 2020?

Booked directly to equity?

Or perhaps to income?

She Just Can't Get Any Respect

At Least She Got a Seat in Istanbul
Not Even a Mention in the FT

 

Robert Armstrong had an absolutely brilliant article in Saturday’s FT: Rumpled Boris, Macron's mistake and other G7 sartorial missteps.

But one very glaring flaw.

He failed to mention one of the nine leaders at the summit.

At least President Erdogan had a seat for Ms. Von Leyden, albeit not in the front row.

But a seat nonetheless.

Ransomware Prioritize Prevention Then Pursue Prosecution – Part 2

When You're This Far Gone
It's No Wonder You Don't Hear the Wake-Up Call
And a "Sobering Fact" Is Likely to Have No Effect

In Part 1, I outlined (yet again) the above point: hardening the target should be the priority.

In this post, I will hit that downed horse several more times. 

Hopefully demonstrating that with respect to prevention there is quite a bit of low hanging fruit.

Please note that only the first point below directly relates to Mr. Younger’s opinion piece in the FT.  

Russia

Mr. Younger had and perhaps still has access to secret information that makes him better placed than me to make an assessment about the links between ransomware hackers and the Russian Federation.

And as well to draw the conclusion that securing the cooperation of the RF will be a key element in stopping attacks.

His comment may be read to imply that the Russian Government

• is more capable of controlling crime originating inside its borders than other countries are within theirs (that, I’d note, would be a remarkable achievement), or

• that there are bonds between the hackers and certain organs of RF state security or

• perhaps both

In any case, if the hackers were expelled and are motivated by profit, wouldn’t they simply pack up and go elsewhere?

Or in a demonstration of the intense competition in the “free market”, wouldn’t other countries’ enterprising hackers step up to fill the void?

From time to time, countries are “ranked” for the amount of “malevolent” internet traffic they originate.  

Perhaps, these reports may identify potential candidates?  

I didn't include all the countries named. 

You can look at the reports cited below for additional country names.  

One point to keep in mind. 

It’s unclear if these reports are based solely in IP addresses or if there are other metrics.

Like VPNs proxy servers can make one appear to be in a country when one is not. Proxy server chains can create even more difficulty in locating a person or entity.

Matthew 7:7  Just one day after I posted this, Auntie answered.  Still a great deal even at GBP 159 a year!  https://www.bbc.com/news/technology-57504007

According to this report in 4Q2012, the PRC was responsible for 41% of “global attack traffic” on the internet, the US second with 10%, and the RF in fourth place with 4.3%.

According to another report, in 2016 China led the pack with 27.2% of cyber attacks (this is a subset of malicious traffic) the US with 17.12%, Turkey 10.24%, Brazil with 8.6%, and Russia with 5.14%.

According to this report for May 2019, “China, Russia and Ukraine appear to be active in a wide variety of hack attempts, including root kits, ransomware, brute force attacks and a wide variety of malware.”

State Intelligence Operations versus For Profit Criminal Hacking

It’s important to keep this distinction in mind when looking for solutions.

While finance is my provenance, I’d venture to guess that eliminating spying is even harder than eliminating organized crime.

According to what I read in the media, even allies spy on one another.

I’d also venture that countries are not going to allow the extradition of their intelligence operatives to a foreign country. 

What about criminals?

The definition of “criminal” can be tricky—to use a shared finance and legal term --particularly when it comes to matters of state security.

Unauthorized access to state secrets, secret internet or communications systems and physical sites is a crime.

In such a case one might revise the statement about “terrorists” and “freedom fighters” to: 

One country’s cyber spy is another country’s cyber criminal.

So what is to be done?

Prevention may offer a higher prospect of reducing risk than after the fact prosecution. Though prosecution should not be abandoned.

The Sophisticated “Hacker”

There seems to be a general perception that hackers are an incredibly brilliant lot.

Think of an evil twin from a soap opera.

A “rogue” Bill Gates, Linus Torvalds, or Larry Page.

That’s not always the case.

Much of the hacking takes place by the equivalent of opening an unlocked door or open window.

Those tools are fairly simple to program.

And for the lazy available for purchase on the web, or so I am told.

Here is a CISA alert from 6 May of this year.

More sophisticated hacking software is often developed from undisclosed flaws in existing software or systems that the hacker has purchased from someone else clever enough to discover them.

Here’s an article these “flaws” or zero day exploits.

Here’s another on how these sort of exploits were used to hack IOS in February 2020.

And there are other ways.

According to security experts the WannaCry ransomware attack was made possible by using information from some NSA software that Shadow Brokers illegally acquired and then put up for sale.

The Somnolent/Negligent Target

Here’s where we get to the really uncomfortable part – taking responsibility.

Lot of attacks are successful because targets left their doors unlocked and windows open.

WannaCry was facilitated because many users hadn’t upgraded from Windows XP.

As is common practice, after a certain amount of time, software vendors stop “supporting” old software. That includes providing security patches for known vulnerabilities.

You’ll see that same failure mentioned regarding some of the 2018 ransomware attacks in the USA.

Another is failure to install patches and updates that are provided by the vendor. 

That is, perhaps even more egregious. One doesn’t have to plunk down money for a new bit of software, but merely install a “patch” from the vendor.

Pulse Secure VPN appears to be our poster child here.

First, an article from AP about breaches this year.

Here is a CISA alert from 15 April 2020 which is an update from 10 January 2020. 

Take a look at the timeline outlined in this report.

You’ll notice the vendor made its first wake-up call in January 2019. That was followed by several “sobering facts” from a variety of sources.

Both of these incidents may be a salutary caution to those whose mobile phones no longer receive software updates or security patches. Or those who have ignored a message to update their phones.

I’ll upgrade this comment later to “a wake-up call” or “sobering fact" later.

As you will notice from the FT article cited above, WannaCry was described as a “wake-up call”.

That the somnolent didn't and don’t answer.

Perhaps the solution is a louder ring tone? Voice mail?

Not bloody likely! (See picture at the head of this post).

Stricter government requirements and robust penalties for failure to adhere to them are likely to get more attention and responses.