THERE must be good reason why no less than former prime minister Tun Dr Mahathir Mohamad is calling for a special audit on 1Malaysia Development Bhd (1MDB), which has expanded aggressively using expensive debt these past five years.

And while 1MDB supporters say the Ministry of Finance’s 100%-owned sovereign development fund would not require any government bailout as it has some RM10 billion worth of assets in excess of its RM41.9 billion debt, is that really the case?

A closer look at 1MDB’s books for the past four financial years (FY2011 to FY2014) shows there is cause for grave concern. 

Here’s why.

For one, 1MDB’s borrowings and total liabilities have climbed faster than the growth in its asset base (see Chart 1). While the fund’s total asset value of RM51.41 billion as at March 31, 2014, was about 5% more than its total liabilities of RM48.97 billion, the excess of RM2.44 billion would be wiped out if one excluded paper gains from its asset base.

Big-ticket paper gains over the past four fiscal years include some RM5.03 billion in land revaluation gains that largely resulted from 1MDB buying land cheap from the government. Another sizeable paper boost to its asset base is the RM3.3 billion goodwill from its overpayment for power assets it bought, of which RM2.11 billion is still carried in its books (RM1.19 billion goodwill was written off in FY2013).

In short, instead of a RM2.44 billion surplus, 1MDB’s shareholders’ equity would show a RM4.7 billion deficit without these two big-ticket paper gains that do not generate any actual cash flow.

Companies with negative shareholders’ funds cannot be doing well, can they? (See Table 1)

This adjusted negative  shareholders’ equity position corresponds with the fact that 1MDB relied on revaluation gains to show paper profits between FY2011 and FY2013 and would have reported twice as heavy a loss without revaluation gains in FY2014 ended March 31.

1MDB would have been loss-making in all past four fiscal years without RM5.03 billion worth of land revaluation gains. 

While there are still cookies to be had in the revaluation jar, the RM896.8 million land revaluation gains in its latest FY2014 accounts only managed to reduce its net loss from RM1.56 billion to RM665.36 million (see Chart 2).

The problem with paper profits is there is no actual cash flow. This is compounded by the fact that 1MDB needs sizeable cash flow as it relies on borrowed money to fund acquisitions — expensive debt that cost RM4.81 billion to service over the past four financial years.

Yet, 1MDB does not generate enough cash from operations to service its ballooning interest costs and has been borrowing more money to pay interest on existing debt (see Table 2).

And because there are zero returns from money spent on servicing debt cost, 1MDB needs to start generating cash fast. One of the ways is by raising cash from floating its energy asset — whose initial public offering is slated for next year — but returns may not be as large as expected due to pre-IPO promises to private guarantors.

While 1MDB’s supporters may say its operating cash flow will improve once its assets mature and start raking in cash, the chances are the compounding effect of its growing debt servicing cost will hit faster and negate the longer-term growth potential of its investments.

Already, based on 1MDB’s reported numbers for the past four years, the returns on investments made with the expensive debt raised are 0.26% to 5.21% below the implied borrowing cost of four of the seven tranches of corresponding debt totalling RM37 billion, as seen by The Edge (see Table 3).

It does not help that 1MDB’s RM2.4 billion finance cost for RM41.9 billion of debt in FY2014 implies a 5.73% borrowing rate — nearly 200 basis points above the 3.8% coupon for 10-year Malaysian Government Securities. But its actual financing cost is likely higher as 1MDB sold several tranches of debt paper at a discount, which means its implied debt cost is higher than the bond coupon rate because 1MDB gets lower upfront cash proceeds due to the discount but pays interest based on the full nominal value.

Factoring in the discount, which simply means getting between RM90 and RM95 cash upfront while being charged interest for borrowing RM100, the implied cost for 1MDB Energy Ltd’s 10-year US$1.75 billion debt, for instance, is actually 7.61% versus its coupon rate of 5.99%. Similarly, the implied cost for the 10-year

US$3 billion 1MDB Global Investments Ltd bonds with a 4.4% coupon rate is actually 5.65%, The Edge’s calculations show.

An appreciating greenback also means servicing US dollar-denominated debt with ringgit-denominated cash flow is about to get more expensive.

The weakness in 1MDB’s cash flow, fast-rising debt pile and debt servicing needs could be why banks, including Goldman Sachs, insist on charging 1MDB high interest on its borrowings and the rates rise with every new debt it takes.

It remains to be seen how much longer 1MDB will rely on a boost from fair value gains from prime freehold land at the gargantuan 70-acre Kuala Lumpur international financial district, dubbed the Tun Razak Exchange, and the

495-acre redevelopment of the former Royal Malaysian Air Force base in Sungai Besi, slated for the Bandar Malaysia mixed-use development.

And because development profits and any potential recurring cash flow from these planned real-estate developments will be long term, even foreign investors are keeping a close watch because the implied government support for 1MDB’s debt mountain could potentially have a broader impact on Malaysia’s tight fiscal balance.

“1MDB is no longer just a financial and systemic concern. It has become a heated political issue,” says Chua Hak Bin, head of emerging Asia economics at Bank of America Merrill Lynch, who describes the fund as an atypical sovereign entity that “can readily tap the government’s balance sheet and guarantees” and competes directly with the private sector as it invests heavily in power assets and real estate.

The certainty of rising debt service charges and its sizeable leverage means 1MDB might be forced to cash in the land it bought cheap from the government. And if the only way it can sustain itself going forward is by selling the land, isn’t that already a government bailout?

This article first appeared in The Edge Malaysia Weekly, on November 17 - 23, 2014.

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