We have recently seen a flurry of reports regarding the financials for the first quarter of this year.
Despite happy headlines, the fundamentals are not good. I will use some examples to show how to dig under the rosy announcements to get a better idea of the situation.
Let’s start with the banking sector, the blood flow of the economy. In their publicly presented financials there is a wealth of information from the two largest domestic banks in the UAE, First Abu Dhabi Bank (FAB), the merged FGB-NBAD, and from Emirates NBD.
Consolidated FAB net interest and financing income was year-on-year (y-o-y) for Q1 4.9 per cent lower – ie, Q1 2017 showed a decline of 4.9 per cent over Q1 2016. This is the income predominantly generated from the core business of a bank – lending and borrowing.
Similarly y-o-y Q1 2017 fee income, also core business, was 14.7 per cent lower, while other income was up 145.5 per cent (mostly investments and derivatives), with operating expenses up 5.7 per cent and impairment charges down 3.9 per cent. Other income is non-core, and if you make 145 per cent return on investment in a single year, accounted for properly, then you took an extremely large amount of risk and it is unlikely that you could repeat this. The size of risk necessary to generate 145 per cent is far greater than any commercial bank should take.
Impairment charges are amounts you hold aside for bad loans, but it is a non-cash item, your cash flow does not improve. As GE’s legendary former head Jack Welsh said, free cash flow is the most important financial number to look at. Overall this equates to an increase in earnings of 2 per cent. The headline sounds great, but the underlying fundamentals do not.
For Emirates NBD we have net interest income down 3 per cent, other income down 16 per cent, operating expenses down 11 per cent (good) and impairment down 23 per cent (also good), resulting in a 3.6 per cent increase in net profit. Again, we see the same trend of positive headlines but deteriorating fundamentals.
Is this a problem only for banks? Let’s look at the huge operations of Etisalat. It reports: “Etisalat has delivered a strong performance in the first quarter, a reflection of its strategy demonstrating the group’s ability to sustain momentum in spite of vastly changing global industry trends.” Income was up y-o-y for Q1 by 5 per cent, but revenue was down by 3.1 per cent. Normally when revenue is down you would expect profits to be down as well. It only makes sense.
So how did its profit increase? Operating expenses dropped by 7.5 per cent, a considerable amount but not a sustainable way to grow earnings. You can’t keep cutting expenses forever. Etisalat’s statement of “ability to sustain momentum” does not appear to be entirely consistent with the financial numbers that it reports. It is also not clear if the operator adjusted, if necessary, the income growth for the cut in government royalty payments so that we avoid comparing apples to oranges.
More worrisome is the source of cuts in the operating expenses, which are described as “lower network costs and lower depreciation and amortization expenses”. The problem is that two of those three have nothing to do with cash savings, it is simply an accounting adjustment. Again, cash flow is not improving as much as earnings.
Bottom line, any time revenue is down but profits are up, be sceptical. If the savings on the expense side are non-cash based, such as impairments, amortization and depreciation, be extremely sceptical.
These tactics are not positive for our markets or our economy. They give the impression that boards and management are saying one thing when the financials show something completely different. Maybe they all have chief financial officers who don’t know how to work with the financials. Maybe they simply don’t understand corporate governance.
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This article was originally published in The National.