|By Matein Khalid|
The merger of Abu Dhabi banks First Gulf Bank and NBAD creates the largest bank in the Middle East, a regional colossus with $170 billion in assets, competitive funding cost in the global interbank/capital markets and a market value greater than Credit Suisse, Standard Chartered Bank (SCB) and Deutsche Bank. This is the biggest game changer event in UAE banking and finance since the merger that created Emirates NBD in Dubai in 2007.
I cannot understand the reason First Gulf Bank shares soared 8% on the stock market after merger announcement as if it is paying a 15% takeover bid premium for NBAD. The shares of an acquirer that pays such a premium falls, not rises. NBAD shares rose 15% so a premium valuation is the consensus of the stock market. The merged megabank would be the biggest bank in the Arab world, bigger even than Qatar’s QNB, Saudi Arabia’s SAMBA, Jordan’s Arab Bank or Lebanon’s Banque du LIban et Outre Mer (BLOM).
The FGB-NBAD banking colossus will have a composite return on equity of at least 15% and a market capitalization near $30 billion. In comparison, Oman’s megabank Bank Muscat is only valued at $2.6 billion in Muscat, the reason for my recurrent deep value rhapsodies in this column. True, I know it is dangerous to compare apples and oranges but $30 billion in Abu Dhabi and $2.6 billion in Muscat has a persuasive resonance to me, with the ghost of Graham and Dodd smiling at the 5.4 times earnings, 0.85 times book value and 6.2% dividend yield that characterize Bank Muscat.
I could never understand how First Gulf Bank could earn a 21% ROE in a world where Goldman Sachs earns 5%. It must be the alchemy of an ex Citibank Dubai corporate banking team from the 1990’s which bought global finance to the titans of the Bur Dubai textile market. The ROE of NBAD is much lower at 14% due to its role as the flagship government bank with a low spread public sector loan book. It is significant that this merger culminates a period that witnessed an oil price crash, withdrawal of government deposits in the banking system and credit stress in the money market, as exemplified by a three month EIBOR that is double the three month London interbank offered rate (LIBOR). Cost synergies motivated the merger. This means the loss of hundreds of highend executive “duplication” positions, not exactly a positive omen for the property market. The strategic rationale for the merger will, of course, determine the valuation, profitability and cost of risk of the megabank. My guess is that this merger is based on cost, not revenue, synergies.
The financial metrics of the merger will also determine its strategic rationale. NBAD has both the balance sheet and the $35 billion in excess cash to acquire a controlling stake in First Gulf. The math does not add up in reverse though a share swap with FGB as the acquirer bank would generate a post merged bank with higher returns on equity.
The bigger macro and policy question is that the UAE is a hyper-competitive, over banked market as 50 banks scramble to serve just a 9 million population in an oil economy with high consumer and corporate debt loads. Many banks have neither the scale nor the credit underwriting sophistication to compete in the markets. Lending on turnover to expat gold or food merchants who abuse their bank lines, to say, speculate on Kerala land prices or upscale clubs and then skip town hurts the UAE economy. This shell game of loan, load, cut and run will not survive the latest business cycle slump.
As an equity investor, I am highly tuned to the merger wave in the UAE, as in Wall Street banking. Who could be next? UNB is a corporate bank owned by the Abu Dhabi and Dubai government that could unquestionably generate economies of scale. A ADCB-UNB merger would make strategic since as Abu Dhabi Investment Council owns 50% of the shares of both banks. No wonder UNB soared 7% on the merger news. Will the endgame of the merger wave mean Abu Dhabi will boast two and not one magacbank? This will have a major impact on loan pricing and credit growth in the UAE banking market. It will also make the existence of at least a dozen sub-scale small UAE banks unviable. As Godzilla put it, size matters!
Macro Ideas – An Iraqi Eurobond new issue will not happen
Iraq has serious financial, political and even legal impediments to its first sovereign Eurobond new issue in almost a decade. The Standard and Poors investment rating for Iraq is single B minus, six levels below investment grade, the same as Egypt. Yet the Egyptian state, unlike Iraq, is strong and allied to both Washington and regional financial superpowers Saudi Arabia, Kuwait and the UAE. The Iraq state is weak and fragmented, with Mosul under Daish occupation, Anbar Province in a sectarian ferment, Basra (the home to 95% of Iraqi oil exports and its only oil ports on the Shatt al Arab) dominated by rival Sadrist, Badr. Brigade and other pro-Iran militias.
The three Kurdish provinces are a de facto sovereign statelet, the legacy of President George HW Bush’s humanitarian intervention in establishing the “nofly zone” in the Kurdish northwest after Saddam Hussein’s defeat in the first Gulf war. The KRG is in constant conflict with Baghdad, whose parliament is dominated by rival sectarian/ethnic political blocs. The malign shadow of Iran’s Revolutionary Guards and the Mehdi Army prevents the emergence of a strong, credible, unitary Iraqi state, as proven by the recent mob storming of the Green Zone by the followers of Muqtada Al Sadr. President Sisi rules Egypt. Prime Minister Abadi does not even rule southern Iraq, let alone Anbar, Mosul and the three Kurdish provinces. A single B in Egypt does not equate to a single B in Iraq in my geopolitical risk paradigm. Standard and Poors sovereign credit analyst desperately need a crash course in the real world realities of the Middle East if they equate Egypt risk with Iraq.
Even though Iraq had selected, Citigroup, J.P. Morgan and Deutsche Bank to conduct the roadshows in New York, London, Paris and Zurich last autumn, institutional investors demand yields as high as 11 – 12% in US dollars to invest in Iraqi debt. proves my point that financial markets are a far more subtle interpreter of sovereign risk than rating agencies. Pakistani Eurobonds are single B but yield barely 6.3%.
Iraq’s financial metrics are truly horrific. The 2016 budget passed by a Parliament (so dysfunctional it makes the US Congress seem the epitome of harmony) projects a $25 billion deficit on a $100 billion spending base. This level of draconian state borrowing will “crowd out” the private sector and exacerbate the cash crunch in the local Iraqi dinar money market. In any case, the World Bank, the Iraqi central bank has $75 billion in hard currency reserves. Yet Iraq’s financial metrics in 2016 are surreal.
The Iraqi state has a payroll of 7 million, five times the payroll in the twilight of Saddam’s Baathist rule in 2003. Salaries consume 70% of public spending at a time the battles of Fallujah and Mosul rage against Daesh, oil and gas capex with foreign joint ventures is going to surge and Brent has plunged from $115 to $48. Life in Baghdad, Basra and Mosul is medieval in its Hobbesian brutality a decade after the execution of Saddam Hussein Al Tikriti. If the global loan syndications and Eurobond/sukuk markets do not finance Iraq, Baghdad has no choice but to go to the Bretton Woods twins in Washington, to become the latest Arab ward of the IMF and the World Bank.
A new issue market desperate to lend ten year money to Argentina at 7.5% will not lend money to Iraq at even a loan shark’s 12% or 1000 basis points above the Uncle Sam note. The geopolitical and fiscal risks, in my opinion, guarantee default and debt restructuring would be impossible if the Kurds do not hand over 550,000 barrels of crude to the Baghdad government in exchange for 17% of state revenues, which they will not as smuggling via Turkish trucks/pipeline is more profitable for a near bankrupt KRG in Erbil.
Even Finance Minister Hoshyar Zebari has conceded international investors will not finance Iraq since the Daish renegade “caliphate” and rule of terror in the northwest and eastern Syria has devastated Iraq’s economic infrastructure and regional trade. Iraq cannot even export 3 million barrels of Basra Light due to its debt shocks and Oxy has requested Baghdad to divest from its concession in the Zubair elephant oilfield. Shell has slashed its Iraqi capex by $1 billion. The oilfields of Basra devastated by bombs, war, sanctions, sabotage, neglect and corruption since the 1980’s “tanker war” with Iran, are no longer Iraq’s financial lifeline. Since I can predict neither the price or volume of Iraqi oil exports, I cannot price Iraqi country and balance of payments risk. An Iraqi Eurobond new issue, tragically, is just not credible and will not happen.
Stock Pick – Goldman Sachs have not yet bottomed in New York!
The last half decade has been five separate “annus horribilis” for Goldman Sachs, the New York investment bank once hailed on Wall Street as the most leveraged, most profitable hedge fund in the world that just happened to be listed on the New York stock exchange. Goldman’s proprietary trading desk’s $5 billion bet against the housing markets, its Abacus CDO scandal that led to savage losses for clients but profits for the firm, draconian regulations like the Volcker Rule that limited trading/market making with its own capital, the post Lehman shrinkage of balance sheet leverage, eroded profitability (a 5% return on equity for the best and brightest of global finance? I would rather invest in far more profitable Ajman Bank!).
Goldman’s fabled “culture of success” (excess?) and political links to world leaders were mocked in a Vanity Fair article by Matt Tebbi in which he described Goldman as “giant vampire squid” sucking blood from humanity. Chairman and CEO Lloyd Blankfein drew global scorn when he said the investment bank did “God’s work”. In any case, if even a divine mandate could only produce a dismal 5.2% return on equity is a sad testament to the fate of the fabulous investment bank where so many of my friends worked on 85 Whitehall (deathstar) and Peterborough Court in the Strand, that great temple of money.
Goldman Sachs is a natural loser in Brexit since its scaled up in London after Big Bang in the 1980’s. I used to love hanging out with Goldman bond traders in Broadgate in the 1990’s over long, liquid lunch discussing investments, currencies and Third World money politics (we traded, sold and invested in Brady bonds and emerging market Eurobonds) in multiple languages. Goldman’s brilliant chief economist Jim O’Niell was a friend and I loved his macro-economic conclaves where I learnt so much. Even now, I consider Peter Oppenheimer my guru on Europe, David Kostin in the US and Kathy Mitsui in Japan.
Goldman Sachs shares have been slammed from their 220 peak in April 2015 to only 148.25 now. Brexit and a global bear market mean the shares could easily fall by another 20% by Christmas. Yet somewhere near $100 a share, Goldman Sachs once again, to paraphrase the Top Gun theme song, enters the highway to the value zone!
Goldman Sachs has scaled down its proprietary FICC business and exposure to capital intensive structured derivatives since 2011. Goldman’s asset management business has now achieved global scale. True, commodities, fixed income trading and sales and block trading in equities has mediocre profits while the subprime/Lehman legacy haunts mortgage backed securities. Goldman Sachs was a vocal proponent of Remain, a sensible strategy since London is so mission critical to its global empire. Yet, like David Cameron, Goldman spectacularly lost its Brexit vote bet. Can Goldman Sachs fall below 100? Sure. It traded at 80 – 100 in both 2012 and 2013. Yet the discount to tangible book value below 100 would be so staggeringly large, it could provoke accelerated share buy-backs. Even now, Goldman offers a 1.9% dividend yield, a price/earnings ratio of 9.6 and a price to book value of 0.8%.
Brexit has choked debt/equity underwriting “animal spirits in investment banking and could well hit merger deal pipelines, an area where Goldman excels. The fall in trading volumes and funds exodus from stock markets is bearish for institutional services and Goldman Sachs Asset Management (GSAM), 60% plus of global revenues. Principal investing is hit by the $2 trillion fall in global markets after the Brexit vote. Commodities are in junk since Goldman is one of the world’s largest oil and gas traders, though Blankfein was the only Harvard Law School graduate I know who sold gold at J. Aron. The IPO window is shut for now other than for private equity Ponzi schemes from the Gulf.
It is a given fact that Goldman Sachs revenues are now only $6 billion, a 40% hit last year. Earnings fell a shocking 56%. The bank has fired hundreds of obsolete ex rain makers. It will stop on campus recruiting at Harvard, Wharton and Yale and go to more modest colleges where graduates do not expect the GNP of Albania as a sign on bonus.
Notice the 40% fall in compensation costs at a bank that once paid its managing directors a Pharoah’s ransom. For now, I see a big chill in IPO, underwriting volumes, cross-border mergers, prime brokerage, high yield, fixed income trading, energy trading, merchant banking and asset management. There is no case for a valuation rerating – for now. But times pass, wounds heal, animal spirits return, new bull market emerge. Sometime this winter, I expect to accumulate Goldman Sachs at 90 – 100 for a $180 strategic target.
