KHCB 2020 Financials - A Look at the New AT1 Capital and Capital Reorganization

 

Link to KHCB FY2020 Audited Financials.

As you will remember, following losses in FY 2019, KHCB needed to raise additional capital to comply with the CBB’s requirement that it have BD 100 million in equity.

KHCB decided to issue AT1 (Additional Tier One) capital rather than additional common equity. Presumably, because there was little appetite for the latter. This would also prevent dilution of existing shareholders.

It also decided to “regularize” some 15.788 million in accumulated negative retained earnings by writing these losses against Paid in Capital. 

This is essentially an accounting entry. 

No cash is involved except for the legal work to amend the bank’s articles and memorandum of association and for the share registrar to amend its records of individual shareholders’ number of shares, issue stock certificates where required, etc.

BD 72 Million AT1 Issue (Subordinated Murabaha)

The issue was “successfully” raised, due to GFH “buying” the entire issue.

Let’s look at the details as outlined note 35 of KHCB’s 2020 audited financials.

The issue was for a nominal BD 60 million plus a BD 12 million premium. Total BD 72 million.

GFH “underwrote” the issue for an underwriting fee of BD 12.1 million and then subsequently “bought” the entire issue. IN GFH’s FYE 2020 financials, this fee is referred to as a “subscription fee”.

Whatever it’s called it is an extremely high fee: 16.67% of the total proceeds of BD 72 million.

GFH paid cash of BD 23.6 million (roughly 35% of the BD 72).

It contributed the remaining BD 48.4 million as follows:

1. BD 24.5 million in the form of 50% of the interests in the AlAreen Hotels WLL (note 13)
2. BD 5.5 million in property
3. BD 18.4 million in financing assets.

Some additional  comments.

First, the issue was primarily in kind (76%) not in cash. The real value of the issue depends on the value of these assets.

Second, while we see these entries in KHCB’s financials, we don’t see them in GFH’s consolidated report because of the "exigencies" of consolidation. There are some adjustments (to GFH’s financials) which I’ll discuss in a forthcoming post on GFH's 2020 financials.

Third, given the BD 12.1 million underwriting/subscription fee KHCB owed to GFH, the actual net cash contribution by GFH to KHCB was BD11.5 million.  

You will see BD 11.477 million in KHCB's Consolidated Statement of Cashflows as "AT1 Proceeds".  That's the net of BD 23.6 million contributed in cash by GFH less then BD 12.1 million "subscription"/"underwriting" fee paid by KHCB to GFH.

That’s the firm to firm transfer. 

But GFH owns 55.41% of KHCB so its share of the fee paid to GFH is roughly BD 6.7 million so one can say it paid a BD 12 million premium for the issue and received back BD 5.4 million (the NCIs share). 

You'll see this amount USD 13.311 million attributed to the NCIs in GFH's annual report in the Consolidated Statement of Shareholders' Equity.

In  KHCB’s financials the AT1 instrument is carried at BD 47.22 million. Not BD 60 million.

How did that happen?

First, the BD 12 million premium was “booked” to KHCB's retained earnings.

Second, the BD 12 million underwriting fee plus an additional BD 778 thousand of other issue expenses were deducted from the AT1 proceeds of BD 60 million ex premium reducing it to BD 47.22 million.

Write-off of Accumulated Losses Against Paid in Capital

KHCB reduced its issued shares from 1,050,000,000 (par value BD0.10) to 892,481,190.

Each shareholder’s number of shares was accordingly reduced by roughly -15%.

During the period 11 August 2020 through 9 November and following the 15% reduction in the number of its shares, Goldilocks sold 1,945,547 shares reducing its holding in KHCB from 9.96% to 9.78%.

One final observation.

KHCB has been showing Emirates Islamic Bank (EIsB) as shareholder with some 8.41% of shares and GFH with 47%.  

In its FYE 2020 annual report, KHCB shows GFH holding 55.41%. EIsB doesn’t appear as a shareholder. 

There is no explanation of the change.

By contrast GFH has been showing its holding in KHCB as 55.41% since FY 2017 (note 18).

Back in 2016 GFH had floated the idea of acquiring 100% of KHCB.

Later it decided not to, but got a special exemption from the tender offer rules in Bahrain to allow it to only acquire Emirates Islamic Bank’s stake. 

Normally tender rules require that over a certain threshold, the acquirer has to tender for all shares it does not own. This to ensure that all shareholders are treated equally.

Unclear why GFH's acquisition of EIsB's shares wasn’t reflected in KHCB’s financials until FY 2020.

What is a Consolidated Financial Statement and Why You Should Care

Arqala Minor with the Prep School's
Beloved Accounting Teacher Mr. Debits
I studied hard then so I could answer your questions today.

At first blush this topic no doubt sounds like it will be a recitation of arcane accounting principles and standards complete with multiple examples of journal entries and the tracking of matching debits and credits.

I promise you it won’t be. Can’t promise much on length though.

The real point of this post is the second part of the title.

You may be thinking why should I care?

After all the accountants will do their job and “account”. 

“Why should I care anymore about this than the recipe the hummus chef at Hummus Express uses?

The reason you should care is that consolidated financials are not the financials of a legal entity rather they are the financials of an “economic entity”. 

An economic entity that the accountants have “constructed” according to certain (accounting) principles. 

From a legal standpoint, this entity exists solely on the pages of a financial report.

Consolidated financials are designed to give a picture of the position and performance of the economic entity or group.

But they can also be misleading, if one doesn't know what they represent.

In the real world, one conducts business with legal entities not accounting constructs.

One buys the stock or debt of a legal entity. One signs other contracts with a legal entity.

Contracts with legal entities are enforced against legal entities and their assets.

Not against economic entities.  

One only gets protection from the "group" if subsidiaries of the parent guarantee the obligations of their parent.

What are the benefits from understanding consolidated financials?

First, the “ships” of many a credit officer or “wise” investor have floundered on the conflation of “consolidated” financials with legal entity financials. Legal entity financials look much different than those of a consolidated group.

Assets (including cash) that appear in the consolidated financials that one thought were available to the Holding or Parent Company are not.  Because they are  assets that belong to a separately incorporated company.

One which is likely to have other shareholders (NCIs) whose permission would be required to "use" them for the Holding Company. And whose reluctance/refusal to give permission to use their "money"   to bail out the Holding Company is probably a safe bet.

Absent a guarantee from the operating subsidiaries, if you lend to the parent company or invest in its securities, you have a claim against the parent company and its assets and cashflow as reflected in its legal financials.

Second, if you understand what you’re looking at, you will be able to get a better sense of the performance of the legal entity whose stock or debt you own. And whether you should accumulate or divest. 

Sometimes you can get an insight into problems in the "group" merely by looking at the NCI share of income.  

In 2019 the NCI share of income at GFH was minus $13 million.  If we assume a 50% split between GFH shareholders and NCIs, this means that GFH also experienced a similar loss. But in GFH's case there was other income that absorbed that loss. The size of the total loss would suggest that there were problems in a major subsidiary.  KHCB would be a likely candidate.

How does consolidation work?

Consolidated financials include not only 100% of the assets and liabilities of the subsidiaries and associated companies that meet the accounting tests for consolidation, but also 100% of their revenues and expenses (thus, their net income). 

Any transactions between the "group" companies are eliminated, i.e., removed from the financials.

When subsidiaries are not 100% owned by the Holding Company, two adjustments are made to reflect the non controlling shareholders’ interests (NCIs).

On the balance sheet a single line adjustment is made on the liability side by creating a component of total equity called Non Controlling Interests. 

No adjustment is made for assets and liabilities of the NCIs on the balance sheet. If you're looking to the consolidated financials as an indication of the assets the "group" has you should not "count" those belonging to the NCIs.  But you have no idea what assets and liabilities "belong" to the NCIs.

A similar approach is taken on the income statement. A single line adjustment is made in net income for the 100% of NCI revenues and expenses by distinguishing a component called “net income attributable to NCIs” from “net income attributable to shareholders of the group”.

Keep in mind that this is a single adjustment across all the subsidiaries. If NCIs have net income of $104 in some subsidiaries and a net loss of $100 in other subsidiaries then the amount shown will be $4.  Again the absence of detail is not particularly helpful for analysis.

Also keep in mind that NCIs are unlikely to be exactly the same parties across all subsidiaries.

Let's turn to Citigroup to get real life examples of these key points with the intent to make them more concrete.

To be very clear there is no negative connotation in the choice of Citigroup.

Rather there is a rich vein of information in their 2020 FY annual report. (Form 10K) 

Compare this to Note 33 in JPMorgan’s FY 2020 Annual report. (Form 10K) which has less detail.

2020 Revenues (Page 301)

Citi Parent’s net income is shown on the extreme left. Citi consolidated on the extreme right with adjusting entries in the middle.

There are wide differences in amount in each revenue or expense category.

In the end the net income for both Citi Parent and Citi consolidated is equal at $11.047 billion. 

But the details show that there are two critical differences between the two sets of financials.

First, Citi Parent does not conduct significant business on its own as reflected in the individual revenue and expense items. Its cashflow is largely secondhand and dependent on payments from the subsidiaries.

Second, subsidiary dividends drive Citi Parent’s cashflow. And, thus, are (a) volatile and (b) subject to constraints on payment.

In 2020 Citi Parent did not receive $9.894 billion of that year’s net income in cash (roughly 90%).

And will not until the subsidiaries pay it dividends.  Until it receives the cash it cannot use it to settle obligations, make investments, etc.  

Government agencies or regulators have the right to restrict the amount of dividends that a regulated firm—think primarily FIs--may pay under various measures to "protect the financial system". 

In all firms shareholders must approve the payment of dividends through formal processes, e.g. AGM.  So one can't simply ring up the subsidiary and ask for $1 billion in dividends by tomorrow.

As to volatility, in 2019 and 2018 (pages 302 and 303), Citi Parent received dividends 10x those in 2020.  In both of those cases the dividends were more than 100% of those years’ net income.

Also look at the penultimate column on the left "consolidating adjustments".  That will give you an idea of intragroup transactions "eliminated" on consolidation.  You will also see this on the balance sheet, statement of cash flows. 

2020 Balance Sheet (Page 304)

Here the difference is even more stark.

Citi Parent had total assets of $386.134 billion, while Citi consolidated had assets of $2,260.090 billion (almost 6x Citi Parent).

Even more telling, 95% of Citi Parent’s assets were equity in subsidiaries (55%) and advances to subsidiaries (40%). Probably most holding companies look like this. They after all are “holding” equity in subsidiaries.

Compare that to the consolidated financials where there is a greater range of asset types and a greater range of liquidity as well as much larger amounts..   

That has implications when there is corporate distress.

Distress at the subsidiary level is usually but not always the cause of distress at the Parent. 

At this particular time the Parent will be even more dependent on the subsidiary for cash because it most likely has no significant operations of its own. In such a case dividends are unlikely.  Selling the equity in the subsidiary or pledging it as collateral is unlikely.  

The most likely scenario is that the Parent will have to wait for its share from the liquidation of the subsidiary's assets.

Because the Parent holds equity in the subsidiaries, it is last in the priority of payments. Senior creditors get paid first, subordinated creditors next, and equity holders get what’s left. Usually that’s nothing or close to nothing.

There is also a risk that Parent extensions of credit to the subsidiaries may be equitably subordinated to other subsidiary creditors or recharacterized as equity. This of course depends on jurisdiction and the specific circumstances/form of the extension of credit.  

If this happens, the cash flow from the subsidiary to the Parent will be even less.

Even if it doesn't,  Parent Company creditors and investors are likely find themselves at the very end of the cash "waterfall".  

Not where they thought they would be when they extended credit or invested. 

GFH Treasury Shares – More Shareholder Value Destruction on the Horizon

It’s hard to understand the “logic” being applied by GFH’s board and management with respect to Treasury Shares, particularly given GFH's weak state.

On 16 February 2021 GFH announced two proposals:

1. The cancellation of 141,335,000 in Treasury Shares.
2. The issue of 94,339,623 in new “bonus” shares.

I’ve written before that the cancellation of Treasury Shares is a direct waste of shareholder funds. One buys shares from the market paying cash and then one cancels them and receives nothing. A dead loss.

The first proposal will result in the cancellation of 45% of GFH’s Treasury Shares (total value of USD 69 million). So USD 29 million. 

A large amount for a bank like GFH that has reported net income of USD 50 million the past two years.

If approved, the first proposal will bring the total of shareholders money “whistled” away in Treasury Share transactions to some USD 161 million before 2021's TS trading losses:

1. USD 3 million in losses on 2017 TS sales
2. USD 27 million in losses on 2018 TS sales
3. USD 28 million in losses on 2019 TS sales
4. USD 51 million in losses on 2019 cancellation of TS shares
5. USD 23 million in losses of 2020 TS sales
6. USD 29 million loss on the proposed 2021 cancellation of TS shares

As I noted in my most recent post on this “strategy” it does not make sense nor does it appear to have resulted in any benefit to shareholders in general.

Imagine instead that GFH had not “spent” (or more appropriately mis-spent) shareholder money on TS. 

Instead of borrowing USD 300 million at 7.5% per annum, it would only have needed to borrow USD 140 million resulting in an annual saving on interest of some USD 12 million a year. 

An amount equal to 24% of reported FY 2020 net income!

I’ve argued that cancellation of TS is unlikely to have a material impact on GFH’s share price given the relatively small percent canceled.  And that there are other less costly ways to increase the per share price of GFH. 

But note those would not increase the value of GFH.

Once again via the second proposal GFH will undo what little effect there is by issuing 94 million new bonus shares.

GFH is a weak institution.

Low quality of earnings. Subpar ROAE. Concentration in illiquid assets. A sub investment grade debt rating. 

Poor market performance of its stock, now trading at a P/BV ratio of 0.6X

All this would seem to argue for a more careful stewardship by the Board and management of the bank.

Given all that, it is also hard to understand how the CBB allowed these proposals to be put forward.

That leaves the decision in the hands of the shareholders.

Based on the past the probability of shareholder action to reject these proposals seems low.