Wharton Partners Inc.

There is great uneasiness among the Pakistani business community regarding the massive failure of industries in Pakistan. Several factors have been blamed ranging from government policies to a liberalizing economy to over capacity in industries. These factors have resulted in significantly lower earnings for business, however we think perhaps the most significant factor is not yet been realized by any of the parties involved. We have come to the conclusion that during the whole liberalization process, the Pakistani banks have refused to evolve with the changing business environment. Although equity and asset returns have dropped substantially and are now not larger than those in the international capital markets, the bankers still are financing projects in terms of intermediate maturity amortizing loans of maturities from 5 to 10 years. We show by our analysis that in this evolved market, with substantially lower returns, businesses cannot possibly sustain the principal repayments associated with short duration amortizing loans. This is made so difficult due to the high debt to equity ratio given on these loans, typically 60:40 (D:E). We go on to discuss market opportunities arising from this analysis of the Pakistani market.

Pakistan has faced a budget deficit problem compounded with a current account deficit problem. This factor has lead to new taxation. In addition the economy is being liberalized. This has resulted in a tremendous drop in equity returns over the past few years. Return on equity are coming in line with returns in the rest of the world, perhaps lower. Certainly the days of putting up a turnkey project and printing cash are gone.

The important implication is that the debt servicing ability of business have been hit drastically. A 5 to 10 year loan which was considered payable 10 years ago is unserviceable nowadays. We make this claim and we shall back it with facts.

We are going to take data about US companies for different credit ratings and see the effect on their debt servicing ability should the loan be an amortizing loan of maturities between 5 to 10 years. Furthermore, we will try to recalculate the free cashflows from operations with a 60:40 debt equity ratio and see the effect of the amortizing loans on the companies.

For reference we will need to know the annual principal payback as a percentage of the initial principal of debt. If a loan is to be paid back in 5 years from start of production that implies a 20% (100/# of years) payback of principal annually (in addition to the interest charges). Similarly for 7 years this number is 14.28% for 10 years 10%. These numbers are going to be important.

The following data is from Frank J. Fabozzi & T. Dessa Fabozzi's The Hand Book of Fixed Income Securities (4th edition) . Chapter 18 is a paper by Jane Tripp Howe, CFA, Vice President Pacific Investment Management Company. She list the factors for measuring credit risk. She presents data for US companies of different credit ratings from 2 three year periods(1990-1992) and (1989-1991). These facts are quoted from "Great Comments", Standard & Poor's Credit Week, November 8, 1993 (page 41-42) .

Exhibit 18-1 in the article states Key industrial financial ratios regarding long term debt for median numbers for companies of various credit ratings. Here are some of those numbers.

The free operating cashflow/Total debt represents how much cash is left for things such as debt principal repayment (a capital restructuring process and not an expense). We compare these numbers with the principal repayments for various loans given out by Pakistani Banks in order to see the effect of the typical intermediate maturity amortizing loan on the US sectors by credit ratings. These are for industrial companies. One note, when we say AAA companies will survive or default we mean the median and above the median companies as the data is median data. Below median companies for that ratings will do worse.

According to a 5 year repayment schedule only the AAA and AA US companies would manage well. The AA companies may just squeeze through for the (1989-1991) time period. Of course below average AA companies may default. The average A rated companies and below will default according to such repayment schedules which were the norm in Pakistan (these are 7 year loans with a two year grace period for step up and start of production so 5 years is the relevant period to compare with). This comparison is done by comparing the principal repayment rate (as a percentage of debt) of 20% with the Free operating cashflow/total debt for that rating (e.g. 4.1 for BBB for the 1990-1992 period). This implies that the average BBB company could only pay 4.1% of principal instead of 20% i.e. short by 15.9%.

For a seven year repayment schedule the principal repayment rate is 14.28%. For such repayments again only the AAA and AA companies will do well. A rated and below will all default.

For a ten year repayment schedule a 10% payback of principal on debt. For such AAA, AA will definitely do well. A rated companies will also survive. BBB companies and below will default. Remember the loan maturity of 10 years should be 10 years from start of production and not disbursement of loan as the free operating cashflow numbers are for established companies which are operating in steady state for substantial amounts of time. Note here that companies whose debt is rated AAA and AA are few compared with the rest of the US Corporate Universe. All these results are in tables in Appendix 1.

By now you may have an idea that the Pakistani banker makes it impossible for anyone but the best and most established to survive by giving short time amortizing loans. This is a hidden deterrent to servicing debt as the industrialist know they can't possibly keep up with this kind of a principal repayment schedule. The fact is for 7 year loan and below only the AAA and AA rated companies will survive in the Pakistani environment. This will exclude some of the most famous companies in the US such as GM, Merrill Lynch, most if not all airlines, the list is endless. In fact most of the best companies with high debt will default under the Pakistani scenario. Only very diversified companies such as General Electric will survive in this environment.

Compounding the problem is the fact that the State Bank of Pakistan's prudential regulations, as interpreted by the Pakistani banker, stop the working capital (in terms of short term liabilities) for companies based on the above mentioned archaic principal repayment schedule. This creates a vicious cycle and we now have the recipe of an economic disaster.

If what has been presented above is not considered unreasonable, lets try the following analysis. We see the total debt over capital ratio in the table above. We notice its quite low for AAA and for AA. We observe that maybe that's the reason these companies survive our Pakistani standards. So what we do is convert the free cash flow from operations / Total debt and lever it up to a more typical 60 to 40 debt to equity ratio. 60:40 or 50:50 are not atypical for loans by Pakistani Banks. We also subtract the incremental interest (only at a 7% rate to minimize our failure numbers in the interest of being conservative) on the new additional debt from the free cashflow. We repeat the experiment for a 50:50 debt equity ratio. The results are that now AAA and AA companies also default for loans up to 8 years repayment schedules. For 60:40 D/E AAA and AA may survive the 10 years but only by a small margin. Well we see the imposition of short duration amortizing loans typical of Pakistani banks effectively shut down almost all businesses in America except some with exceptional cashflow.

The fact that amortizing loan of small durations were serviceable 10 year ago in a protected economy growing due to foreign aid and drug money does not mean under a more liberalized economy it will work. Our bankers are unaware of the changing economic situation and the relevant implication for debt servicing.

Our return on equity is not that much higher in dollar terms than other markets. Our stock market index does not outperform the S&P500 index like other growth markets even over an extended period of time. The significant number of industrial failures (quoted in newspapers to be on the order of 3000) in the past few years, and the continuing shutdowns implicitly provide us data regarding the inadequate return on asset relative to loan conditionalities. Thus the ratio comparison is valid. It may be argued that the repayments are in rupees and that its depreciating visa vi the dollar. Well the depreciation part of the loan is captured more than adequately in the higher interest rates that these financial institutions charge.

An alternative and much simpler look is to see what return on assets is required for a company to be able to service a 5 year amortizing repayment schedule associated with a 7 year loan. Lets look at a 60:40 debt to equity ratio industrial company. Supposing the company comes into production after 2 years. It has to pay its interest lets say 18%, add the principal to be repaid 20% (100/5 years to maturity) to it. i.e. you have to pay 38% of 60% of your assets. Thus you have to generate a return on assets of 22.8% just to service your debt. Also you will not have any money left over for any capital expenditure or working capital increase. You had better generate these asset returns in your initial years of production or you will default and get your working capital shut off. 22.8% is a high return on assets for initial years of production. If you take the tax deduction for interest then this required ROA drops to 18.91(with a 36% corporate tax rate)..

A more interesting approach is to see what excess return on assets or equity is required to meet the principal repayment part of the loan. For this case we ignore the interest as it is paid irrespective of the maturity of the loan. We come up with the following results.

Repayment
schedule	Extra ROA	Difference	Extra ROE
in Years	required		required
5	12.00%	6.00%	30.00%
10	6.00%	2.00%	15.00%
15	4.00%	1.00%	10.00%
20	3.00%	0.60%	7.50%
25	2.40%	0.40%	6.00%
30	2.00%		5.00%

For a 5 year repayment schedule a company has to generate 12% extra return on assets to just meet its principal repayment obligations. for a 10 year schedule this rate becomes half. Note these returns are in addition to any equity returns that the equity holder requires in form of dividends or what may be the capital expenditure needs or new working capital needs of the company. Looking in terms of return on equity, the company needs to generate 30%! extra ROE to meet this repayment requirement. We notice this requirement for extra ROA or ROE to service the principal repayment is much severe for 5-10 year repayment schedule than 15-30 year ones. Also between having a 15 year repayment schedule compared with a 30 year schedule the additional ROA required to service principal is only 2% (4-2). However between a 5 and 15 year loan this difference is 8%(12-4). This exhibit clearly shows the severity of a 5-10 year repayment schedule. This places an unnecessary and potentially fatal burden on the industry. Given the liberalized economy and new taxation, requiring a company to generate 8-12% extra return on assets to just meet the principal repayment schedules of the typical Pakistani bank loan leads to a high probability of default. Appendix 2 has details about this analysis.

The graph shows the exponential nature of decay of excessive burden of servicing principal of the debt. The debt repayment burden reduces substantially for loans with repayment schedules greater than 12 years. The graph also shows the enormous principal repayment burden on Pakistani companies with loan repayment varying from 5-10 years. This results is a very high probability of default for companies as generating such excessive returns consistently is very hard. It would be optimal to structure loan at a relatively flat part of the curve formed by the bars in the graph above (such as the 12-15 year time period).

This process of loan structuring is responsible for people only putting up relatively commodity like plants in Pakistan as the risks associated with delays for any truly differentiated project in Pakistan with a long gestation period leads to default. As a result non assembly oriented engineering industry in Pakistan in particular faces a severe crisis. Also a natural deterrent to putting up of such differentiated products manufacturing projects has been instituted by the structure of debt in Pakistan. A table of various ROA required various interest rates and maturities to just service debt i.e. principal and interest are presented in Appendix 2. One can look at the large ROA's required to just break even from debt servicing of these amortizing loans. It is doubtful that such ROA's could be achieved in the initial years of an industrial project as a result an early default will occu1r and compound the problem by cutting off the working capital and thus the vicious cycle.

Additional Burden of Amortizing Loans Denominated in High Depreciation Currencies

Keeping in view that the Rupee is Depreciating versus the dollar at a rate ranging from 7-8% annually over the past several years, we look at another problem. The problem as illustrated in appendix 3, is that since payments in the amortizing loans are equal in terms of the rupees, we see that payments in terms of a more stable currency like the dollar are actually higher in the initial years and go down later on. The depreciation is incorporated into the repayment in terms of higher interest rates. The net effect is that the burden on the industrial project is actually more in the initial stages than the later, where as it should be the exact opposite in order to give the project enough time to gestate. Thus a front loaded repayment schedule in Rupees is even more detrimental to industrial projects than an ordinary amortizing loan in a country with low inflation and interest rates.

A Sector-wise Analysis of ROI's of Pakistani Industries and Implications for Defaults

We have started an analysis of different sectors of the Pakistani Stock Market and done some analysis on data to see the future debt repayment ability of Pakistani companies. We are trying to determine if the typical loan structure of a 5-10 year amortizing loan at 60:40 debt equity ratio is serviceable or not.

Our analysis which is described in detail in appendix 4, involved ROI numbers for various sectors. We have the average ROI's, debt leverages, and standard deviations of the ROI's. We also have the median ROIs. We take these numbers and convert the ROI's into Profit/Long Term Debt numbers corresponding to 60:40 debt to equity ratios. We go on to add various levels of Depreciation minus Capex and new working capital numbers to see how many companies would default assuming a normal distribution of ROI's. Effectively we convert the ROI's into several free operating cashflows/Investment and see if they are sufficient to repay a 5 year amortizing repayment schedule loan. For sectors with fewer data points, this analysis has less significance, however this yet again gives support to our arguments. Unfortunately until now we have had data only for the following sectors. We will present an update to this report which will include the other sector analyses.

To interpret the graph we need to decide what should be a reasonable number for (depreciation-capex-..)/debt. Appendix 5 describes this in detail. We have done the analysis in the above fashion so that the reader can decide what he considers reasonable for this value and then picks the appropriate value. If reader thinks capex should be 0. i.e. the most conservative scenario from a default point of view, even then 28% of the companies in the Fuel & Energy sectors would default at a 60:40 debt to equity ratio. For a more reasonable value of Capex of 10% of debt, 60% of companies would fail in this sector. We strongly recommend reading Appendix 4 if the reader is interested in this analysis to be familiar with the assumptions are made in this analysis.

A similar analysis of 4 other sectors for various (depreciation - capex ... ) rates is included in appendix 4. Right now we present a summary analysis of the results based on 0 depreciation - capex assumption and compared a 5 year repayment schedule with a 15 year one. For understanding our reasons for selecting 0 as the depreciation - capex rates please refer to appendix 4 and 5.

We see the extremely high default rates under the 5 year repayment schedule for 60:40 D to E ratios across the sample sectors.

We clearly see that the default probabilities drop from the 80-90% range to 20-30% range with a long maturity amortizing loan. This is clearly illustrative of the severe burden put on new industries in Pakistan due to the inappropriately structured short duration amortizing loans.

Our explanation for using a 0% depreciation - capex rate is explained in detail in appendix 4 and 5. These appendixes illustrate the default probability scenarios in much more detail. We have even more analysis with even more conservative numbers presented in the appendixes.

We believe we have presented empirical evidence that the Pakistani banker is behind a lot of the default and sick industries problem by not evolving with the changes in the business environment of the country.

The following discussion is for readers not familiar with debt and debt/equity management in the United States and is meant as a comparison to highlight the differences and to point to possible solutions.

The question arises what are the loan maturities in the US and how do their companies deal with the principal repayment question. There is simple answer to that. Most US companies keep the Debt/Equity ratio constant i.e. in net they do not pay back any principal. They do by refinancing the debt at newer interest rates when the principal on their bonds is due. Lets look at this.

Pakistani bankers don't realize the negative implications of a short duration amortizing loan (loans where principal and interest is paid back in equal installments). The Pakistani banker is unaware of the fact why bullet loans (bullet bonds are bonds where you only pay interest and the principal is due as a lump-sum at maturity) are preferable. The fact is that International Corporations keep a relatively stable debt equity ratio. The purpose of debt is not just to raise money but also to enhance equity returns. These companies issue short term, medium term and long term debt. When the debt matures they replace it with new debt. The purpose is to keep a constant capital structure(Debt to Equity ratio). The question of whether to issue long term or short term bonds rests with their opinion about the term structure of interest rates and which rates are cheaper. Companies like Disney and Coca Cola have issued 100 year bonds and the Tennessee Valley Authority has issued 40 year bonds. 30 year bonds are quite common. The point being that in the US you refinance your loan (or bonds) with other loans (or bonds) or keep really long duration bonds, which then again are refinanced. In Pakistan due to an undeveloped capital market refinancing or rescheduling a loan is very difficult. Thus the debt crisis due to inadequate refinancing of debt in view of the data presented. What must be realized that as long as the bankers can step up their interest rates they should not call back their principal. Also amortizing loans are extremely detrimental for industrial financing specially for such highly leveraged projects. If you buy a car in the US you have 3-5 years to payback the loan. If you have a home you have typically 30 years. Liberalized and taxed economies mixed with short duration amortizing loans are a recipe for economic disaster.

Another common sense way to think about this problem is that industrial companies do not necessarily go to 100% capacity immediately nor can they necessarily develop markets so quickly. As a net result loans should be structured so as to take advantage of the fact that earnings will grow with time and not have large amortizing debt payments so that the company defaults in the initial years because paying the principal is too much. For a car loan amortizing loans are fine as other than a few professions such as investment bankers, peoples salary tends to grow with moderation and thus amortizing loans tied to a persons regular salary make sense.

The only objection the bank can have (to long maturity loans) is about higher interest rates due to changing economic environment. It has the right to charge a higher interest rates for longer loans or on restructuring but if a companies agrees to higher rates then it is in the banks interest to reschedule the loan. Not doing so without any project analysis is negligent and shows severe incompetence.

A few more point to ponder for which We shall not give empirical evidence in this paper are as follows.

1) Pakistani bankers generally lack in Project finance and valuation skills. This is noted by the fact that even though so many defaults are occurring the Bankers have not bothered to reevaluate the projects. Nor have they tried to analyze if the sudden increase in bad loans is due to any other factor than corruption. The FPCCI and its sick units committee is desperately trying to sort out the business communities problems. This ties in directly with a lack of expertise. This gives origins to the banks not evolving the amortizing loans problem. Furthermore, a lack of this ability results in the bank not being to differentiate genuine and fraudulent defaulters.

2) Lack of strategic or Market Vision. Not realizing the Textile and Cement profitability collapse should have been obvious to the Pakistani bankers. Returns in commodity like business with no differentiation will fall eventually with a liberalizing economy. It was imprudent that so many loans were sanctioned despite this fact causing severe problems to the banks as well as the industries. The bankers strategic vision along with the entrepreneurs is responsible for the growth and prosperity of a country by setting up appropriate industries which capture the comparative advantages of a nation. This lack of strategic vision and project valuation can result in introverted import substitution based industry. Banks should realize the coming shrinkage in profits for industries based on local Pakistani markets and the importance of export oriented industries due to the mounting current account deficit problem. If they do not broaden their vision past import substitution based industries of the past, they will hamper industrial growth very significantly.

In our opinion we are opening up a new chapter in Pakistani Capital Market and Industrial development. If the government realizes the problem created due to this flawed methodology of project financing then there may be great hope for a growing Pakistani economy. We now look at the opportunities created if the government and the banking system accept this criticism as valid or they reject it. In either case the investor should be prepared for appropriate steps.

Evaluate the potential risk of the market and companies with this information in perspective. If the status quo persists then two types of companies will benefit. Firstly the ones with very low debt. Secondly, the established large corporations with lesser competition from new growing companies. Faced with unserviceable debt companies may resort to capital restructuring such as massive rights offerings at low prices as we have seen in the case of Maple Leaf Cement. Companies with a high local debt component will represent a substantial credit risk. Commodity like products producing companies will do better than they would have under an open and liberalizing economy. Manufacturing factories producing truly differentiated products such as high quality engineering products will be a substantial investment risk unless all equity financed. Established companies with extremely good relations with the commercial banks will be the only ones to be able to do substantial refinancing of loans by rolling over their long term debt. Smaller and also newer companies will find it difficult to raise additional debt financing to meet their principal repayments ( as effectively practiced by some of the larger Pakistani corporations).

Old is Gold will take on a new meaning and industries which have been operating for a very long time may be in a better competitive position from avoiding amortizing loan point of view. However, care most be take in investing in companies who may require new capital infusion due to older plants. Equity rights offerings will be realized to be a better financing option than the debt markets. Development of funded debt may be given a boost to fulfill this growing market need for debt at favorable terms.

Under this scenario agricultural related companies may be a relatively better value than the rest of the market. The fertilizer companies may offer significant value. Certainly from a relative value point of view they should offer good value.

If banking policy changes, one may be able to find excellent companies in distress caused by this self created problem. We have specific companies in mind which could produce tremendous returns if they have capital constraints removed from them. Owing to increased competition, new companies with differentiated products will do significantly better in the new environment. Overall, the sick industries problem and defaulted loan problem will improve and the business environment will be much better as a large hidden cost of doing ventures in Pakistan will be removed. In our opinion the Pakistani stock market will then do significantly better than if the status quo was maintained. Long term prospects of larger consumer oriented companies such as PTC, pharmaceutical etc. could look much better than the status quo scenario.

Although reason dictates that policy makers and bankers cannot ignore this problem and will take the appropriate steps once the problem is presented to them, we are not convinced of this. The issue of loan defaults has been much politicized and it is a question whether the government which has made loan recoveries a key issue can afford to back down. The bankers are also in a tight corner as any rescheduling by them is regarded as having paybacks associated with them. The question of whether anything conclusive will occur is therefore not certain. One does foresee that loans where industries agree to pay interest may be allowed to operate and the principal repayments to be rescheduled appropriately. For this reason we would suggest you to ask your Pakistani country analyst for his estimate of the chances of the government taking action in this regards. Our more conservative strategy may be to keep asset allocation for point 1) i.e. the conservative companies and increase exposure to newer companies if new policies develop and market conditions change favoring the smaller companies. One can follow this methodology as the market is slow in responding or analyzing the newer factors and their influence to various subsectors of the economy. A lot of empirical and fundamental research needs to be done in this area.

Impact on the local banking stocks will be most interesting. One suspects that it would be prudent to underweight them in the short run. Perhaps foreign banks will outperform the local institutions on this analysis being made public. If reforms are not introduced soon, there is a possibility of a severe banking crisis due to two factors. Firstly, banks portfolio of bad loans will grow significantly. Secondly, there may be a large switch from Rs. deposits to US Dollar deposits as will be illustrated in analysis that we will publish regarding real returns on various assets in Pakistan. The State Bank has implicitly shown concern about this factor by pressuring the commercial banks to give higher returns on Rupee accounts and has advised commercial banks and investment banks to deal primarily with Rupee and $ accounts respectively and minimize walks across this wall. This can potentially shift a substantial amount of assets from commercial to investment banks in Pakistan. In this context a strategy of shorting the Banks and going long the index may be an interesting trading strategy. Local commercial banks, most actively involved in project finance should be underweighted the most. Care must be taken in regards to the project financing done particularly in the past 5 year as these industrial companies represent the most substantial default risk as they have benefited the least from a protected economy and suffered the most due to non-evolution of banking policies.

We are working on an analysis of services industries and particularly PTCL based on the effects of this debt structuring problem. In our opinion service oriented business have done well in Pakistan due to external sources of income such as foreign aid, worker remittances, drug money, afghan war aid for the past 40 years. In addition due to industrialization services have had the opportunity to flourish. The external or abnormal sources of income have dried up considerably. Pakistan's economic growth is dependent on competitive industry. If most industry is going to get sick due to inappropriately structured debt, then services will follow as peoples cash reserves dry up. Pakistan faced with a budget and trade deficit problem can ill afford a stoppage in this industrial growth. If the status quo persists one can anticipate an accelerating deterioration of standard of living compounded with a rapidly devaluing Rupee. This will have the most adverse effect on the earnings growth potential of PTCL and such companies. Under such a scenario PTCL cannot be valued a high P/E multiple or with a high growth rate. This question of economic growth is essential for any such investment decision in Pakistan.