After the first quarter's results apparently indicated that Lev Leviev's Africa-Israel Investments (TASE: AFIL) had emerged from the crisis, the second quarter financials were released at the beginning of the week and showed that the joy was premature.
Profits with the aid of accounting and with property assessors' stamps of approval are nice; improved results thanks to exchange rate fluctuations are also important; but the most important question is, are Africa-Israel's businesses profitable? Are they generating cash? Can they service debt repayments?
In the first quarter, Africa-Israel recognized a gross profit of NIS 1.9 billion as a result of revaluations of properties under construction. That looked dodgy even then. How could it be that real estate markets around the world are collapsing and Africa-Israel's Russian real estate portfolio actually appreciates? The explanation is an accounting one. Africa-Israel simply applied an amendment to the accounting standard on property under construction which came into force from the first quarter's financials.
The amendment in effect gave equal treatment to investment property and investment property under construction. Until then, only completed investment property could be assessed and recorded at fair value on the books. Now, it is possible to assess even property construction of which is not complete. If you have built the first of three floors of a mall, or if you're in the middle of constructing a 40-floor office tower, you can put these assets on the balance sheet at fair value. The fair value of property under construction is even harder to assess than that of completed buildings, because the construction costs to completion and other costs that will be incurred until the property is let have to be estimated. The holes in the valuation are therefore larger, but despite the reliance on estimates, the accounting standard was amended, bringing smiles to the faces of several local property tycoons, and many overseas ones.
The problem with fair value is that it isn't always proper. You can do anything on the books, but in reality, it's by no means certain that the book value is the price at which the company can realize the assets. Africa-Israel's first quarter paper profits were added to the direct growth in shareholders' equity thanks to the translation of the balance sheets of the overseas subsidiaries and associated companies. Africa-Israel holds several companies overseas, each of which operates in the local currency. Each quarter, Africa-Israel translates the financials of these companies into shekels, so that if the exchange rate of the foreign currency against the shekel has fallen during the quarter, the shekel value of the overseas company's assets will rise. This is exactly what happened in the first quarter a rise in value that totaled NIS 580 million.
Incidentally, according to the accounting standard, this rise in value is not posted to the profit and loss account. It is not classified as finance income, but is accounted for directly as a rise in shareholders' equity. Overall, Africa-Israel's shareholders' equity rose from NIS 1.7 billion to NIS 2.7 billion in the first quarter certainly good news for the company's shareholders and bondholders. Nevertheless, even then it was possible to see that in its day-to-day operations, Africa-Israel was struggling, because when the profit on revaluations of property under construction was stripped out, the routine activity was revealed as making a loss. And if the revaluation profit and the currency translation differences were excluded, shareholders' equity could be seen to be continuing to fall. But in the meantime, Africa-Israel radiated optimism, and realized assets at an accelerating, though not sufficient, rate.
1-25 leverage
Then came the second quarter results. They exposed the joke that was the property revaluation in the first quarter. After it raised the value of property under construction by NIS 1.9 billion in that quarter, revaluation wrote off NIS 1.3 billion in the second quarter. This yo-yo, the company explained, derived from "updating of the projected cash flow of the assets being constructed."
In other words, in the first quarter we estimated that construction costs would be x and revenue would be y, and we capitalized the cash flows according to interest rate z. Now, three months later, it turns out that the cost will be different, revenue will be lower, and the capitalization rate has changed.
All these changes cost the company NIS 1.3 billion. What is astonishing is that billions flow in and out of the balance sheet under the cover of accounting standards and with the backing of learned valuations.
Because this write-off, plus operating losses and translation differences that this time went against the parent company to the tune of some NIS 260 million, Africa-Israel's shareholders' equity fell from NIS 2.7 billion to NIS 1.2 billion. Africa-Israel's balance sheet total is NIS 30.5 billion, meaning leverage of 1-25. That is to say, for every shekel of the owners' capital, the company took on commitments of 25 shekels. In the first quarter, thanks to the higher shareholders' equity as a result of the revaluations, the leverage was about 1-10 high, but still much lower than the current leverage.
Because of the quarterly report and its financial position, the company, as mentioned, reported its intention of reaching a debt arrangement with its bondholders. But is this the solution that is called for? Did Leviev, who stressed that he himself works twenty hours a day, not think for a moment of introducing an investor into the company, or of selling some of Africa-Israel's important holdings, such as Africa-Israel Residences, Africa-Israel Properties, Africa-Israel Industries, Negev Ceramics, and others. He works twenty hours a day, and never managed to find an hour or two to pop into the bank and ask for financing based on the unmortgaged holdings and it turns out that there are holdings like these amounting to some NIS 4.7 billion?
True, he would not receive finance to the full value of these assets, but a billion or two, and on a good day even three, would seem to be possible. It is also possible to sell more assets. Although Africa-Israel has been focused on realizing assets in the past six months, mainly real estate, but also here and there companies like Gottex. But it could do more, it could realize more assets, particularly overseas. It won't be at the prices of two years ago; Africa-Israel would have to bend on price, and the buyers will exploit its weakness, but what will one not do to survive? Wait a minute, actually there is something.
Before really trying hard to introduce a partner; before injecting more cash; before realizing holdings and assets at what look like low prices, you can turn to the public and say: you gave us money, we invested it, things didn't go our way because of the crisis in the markets, and we need to change the loan terms. That is the easiest solution and the quickest solution. Selling an asset here and there means another few hundred million at best, but reaching a settlement on the public's loans that's a solution worth billions, and it can be done fast.
The institutions that manage the money strike tough poses, but Leviev and Izzy Cohen are no capital market tyros. They apparently believe that after the headlines die down, it will be possible to sit around the table and cut a deal, a belief based on two facts and one assumption. The assumption is that Africa-Israel really did all it could to generate profit for its shareholders and to service its debts, and that this is not a case of management failure. In retrospect it can be said that the decisions to invest, particularly in the US, were at prices divorced from reality. But at the time, when the markets were hot, Africa-Israel demonstrated that it buys high and sells higher. Africa-Israel was always faithful to its business strategy of high financial leverage.
Leviev said last week that a lot of people made money on Africa-Israel, and that's true. Africa-Israel grew 20-30 times in a decade only thanks to financial leverage, and in the past two years it has shrunk by 80%, only because of the leverage. This double-edged sword was known to all. It was built into the company's DNA. In the past, everyone made money and kept quiet; now, they are all losing and complaining. The truth is somewhere in the middle: Africa-Israel is not entirely to blame, but nor are the institutions.
The assumption that it was not management failure that brought Africa-Israel to its present position together with the following facts should speed up an arrangement. The first fact is that, in the end, the institutions manage other people's money, and important as that might be, it isn't their money. The second fact is that, a moment before the intention of reaching an arrangement was reported, the market already knew or estimated that there would be some kind of arrangement. The evidence is that debts totaling NIS 7.4 billion were traded at a value of NIS 4.4 billion. Now that debt is worth NIS 3.5 billion on the market, and it's hard to believe that the institutions will dig in their heels if Africa-Israel offers the original debt with repayment rescheduled over two years. They may ask for a further cash injection from the owners, but, on the whole, they will agree. Some will even agree to some kind of haircut.
Published by Globes [online], Israel business news - www.globes.co.il - on September 8, 2009
© Copyright of Globes Publisher Itonut (1983) Ltd. 2009