OCBC's review on Hyflux: SELL TP S$0.75 — 6 Nov 2014
Hyflux Ltd posted an uninspiring 3Q14 showing, with revenue down 46% YoY to S$101.0m, reflecting the timing of project commencements so far; gross profit also slipped 48% to S$60.2m. As a result, reported net profit fell 55% to S$11.3m, which also included a tax credit of S$5.2m. Still, we did see some sequential improvement, as we estimate that core earnings came in around S$6.6m, versus a net loss of S$23.1m in 2Q14. YTD, revenue fell 40% to S$270.0m, meeting 63% of our full-year forecast, while reported net profit jumped 117% to S$110.6m, estimated core loss came in around S$20.8m, or about 39% of our FY14 forecast. But the company warned that the last quarter is likely to be slow, given the mixed global economic outlook. While the group continues to actively pursue municipal and industrial projects in select markets in MENA, Asia and Latin America, we note that Hyflux has not announced any new contracts this year. In fact, management does not expect to achieve financial close for the Dahej project before year end. We will be speaking with management to get more clarity shortly; but we are likely to keep our SELL rating and DCF-based S$0.75 fair value intact. (Carey Wong) .
Hyflux Ltd has sold its Hyflux Innovation Centre to Ascendas REIT for S$170 million in cash.
Located at 80 Bendemeer Road, Singapore, the Hyflux Innovation Centre is the registered office of Hyflux.
Hyflux has agreed to lease back about 50 per cent of the property from Ascendas REIT for 15 years on ‘customary terms and conditions’.
At present, the property has an occupancy rate of 83.9 per cent.
Apart from the rental for the space it occupies, Hyflux will also pay Ascendas REIT for any vacant space at the property for the next three years.
Hyflux plans to use the S$170 million sale proceeds for R&D, expansion and automation of membrane manufacturing operations at Tuas Hub, and for financing its infrastructure tenders.
Hyflux estimates a gain of S$84 million on the divestment of the 10-storey property.
Analyst Tan Ai Teng at DBS Group Research says the sale of the Hyflux Innovation Centre will reduce the company’s gearing ratio to below 0.5x.
Despite revising its FY14 PATMI estimate to S$156 million from S$44 million previously, the broker remains sceptical about a turnaround in its core operations.
According to the research report, Hyflux is aggressively bidding for projects in Oman, Nigera, India and Singapore, but it hasn’t secured any orders yet.
DBS Group Research believes the divestment proceeds will help it execute the new projects.
However, the broker feels Hyflux’s stock will remain range bound in the absence of an operating turnaround, major order wins and a fast-track execution of its Indian project.
DBS Group Research maintains a HOLD rating on the stock with a revised target price of S$1.33, compared to S$1.23 earlier.
1. Why did it sell the Hyflux Innovation Centre for less than its market value?
According to Hyflux’s announcement, the S$170 million price tag for Hyflux Innovation Centre was arrived at on a ‘willing buyer willing seller’ basis.
Ascendas REIT was more specific.
On slide 3 of its presentation, it revealed that DTZ Debenham Tie Leung (SEA) Pte Ltd estimated the property to be worth S$197 million.
That means, Hyflux sold the property at a 14per cent discount (or S$27 million) to its market value.
That seems like a fairly steep discount which, at face value, raises the question why it sold the property so cheaply.
But there's more to it than that: the so-called land premium.
In February last year, Business Times reported that industrial REITs can no longer avail a monthly land rental facility of JTC.
Instead, they have to pay an upfront land premium for the remaining period of the lease.
Only end users of the land could pay the land lease on a monthly basis.
According to the news report, the monthly rental scheme is attractive as the rent is payable every month in advance and the rental rate is revised annually subject to a 5.5per cent escalation cap.
Moreover, the rent would fall if the property market goes down.
That means, had Hyflux not sold the property, it could have continued to pay the land rental on a monthly basis to JTC.
But because Hyflux sold the property to Ascendas REIT, the Trust has to pay an upfront land premium for the remaining 24.5 years of lease to JTC.
That works out to S$21.2 million.
So, excluding the transaction costs, the acquisition of Hyflux Innovation Centre will cost Ascendas REIT about S$191.2 million.
Based on that, one can argue that Hyflux sold the property at an effective discount of about 3per cent to the market value of S$197 million.
But that’s not the case.
Had it sold the property to another end user, the buyer could have continued to avail the monthly land rent payment facility.
Therefore the argument that Hyflux agreed to a S$27 million discount as a goodwill gesture because Ascendas REIT had to pay an upfront land premium to JTC seems unjustified.
In other words, another end-user, who could have availed the monthly rental scheme, might have paid a higher price for the property.
JTC owns a 17.17per cent deemed interest in Ascendas REIT.
2. Why didn’t Hyflux disclose the market value of the property in its announcement?
We are curious to know why Hyflux didn’t disclose the market value of Hyflux Innovation Centre in its announcement, but Ascendas REIT did.
After all, companies just don’t sell properties for any amount of money without finding out the market value of it.
Also, why was the property carried on the books at such a steep discount to market value?
3. Should it have sought shareholder approval for the sale?
Had Hyflux disclosed the market value of the property, the relative figure under Rule 1006 (a) of the Listing Manual might have been different.
Rule 1006 (a) states the relative figure which comes after comparing the net asset value of the assets to be disposed of with the group's net asset value.
In its announcement, Hyflux said that net asset value of the property to be disposed of, when compared with the Group’s net asset value of S$1.19 billion on March 31 works out to be 4.8per cent.
While calculating the relative figure, the company used the book value of the property, which was S$57 million on March 31, as its net asset value.
But Rule 1003 (2) of the Listing Manual clears states that the market value of the asset, if available, should be used in determining the basis of valuation of such a transaction.
We already know that the independent valuer estimated the market value of the property to be S$197 million.
So, the relative figure under Rule 1006 (a) should have been about 16.6per cent.
Now that’s significantly higher than the relative figure mentioned in the announcement.
But it is still less than the 20per cent threshold which would have made the disposal of the property a ‘major transaction’ as per the Mainboard Listing Rules.
The disposal of Hyflux Innovation Centre didn’t qualify as a ‘major transaction’, thanks to the company’s perpetual capital securities issue in January.
Hyflux had an audited net asset value of S$886.3 million on December 31 (refer page 2 of its 2013 annual report).
But because of a S$300 million 5.75per cent perpetual capital securities issue in January and a S$37.9 million profit in the first quarter of 2014, Hyflux’s net assets value surged to S$1.19 billion on March 31 (refer its Q1 2014 earnings report).
So, the surge was almost entirely due to the classification of perpetual capital securities as equity on the company’s balance sheet.
This is one of those situations which reignites the debate about equity classification of perpetual instruments.
In March last year, Grant Thornton released a guide on classification of financial instruments under International Accounting Standard (IAS) 32.
On page 7 of Section B of the guide, Grant Thornton clearly states that ‘A perpetual debt instrument which has mandatory interest payments (but no equity components) is a liability in its entirety.’
After reading Hyflux’s offer document for the perpetual capital securities issue last year, it appears the interest payment to the perpetual security holders is, indeed, mandatory in nature.
Therefore we wonder if Hyflux can classify 5.75per cent perpetual capital securities as equity on its books.
In the larger context, the question is about the rights of the equity shareholders.
Had Hyflux’s perpetual capital securities not been classified as equity, the relative figure under Rule 1006 (a) of the Listing Manual would have been more than 20per cent in the case of Hyflux Innovation Centre’s disposal.
As a result, Hyflux couldn’t have sold the property without seeking shareholders’ approval.
4. How did it arrive at the profit attributable to the property?
In its June 26 announcement, Hyflux said the relative figure under Rule 1006 (b) of the Listing Manual was 5.7per cent.
Under Rule 1006 (b), it compared the ‘net profits attributable to the property’ with the ‘group’s net profits before tax, minority interests and extraordinary items’.
However, it didn’t disclose the absolute figures of ‘net profit attributable of the property’ and ‘group’s net profit before tax, minority interests and extraordinary items’.
Assuming that Hyflux used its audited 2013 net profit before tax of S$51.6 million for the purpose of calculation under Rule 1006 (b), the net profit attributable to the property works out to be S$2.94 million.
But that doesn't tally with what Ascendas REIT thinks that figure should be.
According to Ascendas REIT’s presentation (slide 4), the Trust expects a net property income yield of 6.98per cent from the property in the first year of acquisition.
Ascendas REIT calculated the NPI yield on the total cost of acquiring the property and assuming 100per cent occupancy (as Hyflux would pay for the vacant space for the next three years).
Ascendas REIT’s total cost of acquiring Hyflux Innovation Centre is S$193.86 million.
So, its NPI from the property in the first year works out to be S$13.53 million.
To see whether this tallies with the 5.7per cent figure stated by Hyflux we must ask how much of the S$13.53 million will the Trust earn in rent from Hyflux alone?
Here's our back-of-the-envelope calculation:
We already know that the occupancy rate of the property is 83.9per cent.
So, as per the announcement, Hyflux will pay the rental for the remaining 16.1per cent space at the property.
But we still don’t know how much of the occupied space at the property is leased back to Hyflux.
That’s where Ascendas REIT’s announcement comes in handy.
According to page 2 of its announcement, Hyflux has leased-back about 50per cent of the space at Hyflux Innovation Centre.
The remaining 33.9per cent space is leased to third-party tenants.
In short, Hyflux will pay to Ascendas REIT the rental for about 66.1per cent space at the property in the first year (50per cent occupied and 16.1per cent vacant).
Which means, out of Ascendas REIT’s NPI of S$13.53 million from the property in the first year, S$8.94 million will be paid by Hyflux.
Moreover, after selling the property, Hyflux has foregone a net property income of S$4.59 million which it earned from third-party tenants.
As we are talking about the net property income of the property, that is to say, the net profit, the property-related costs have already been accounted for.
Which is why we can say that Hyflux’s profit will take a hit of about S$13.53 million in the absence of Hyflux Innovation Centre.
In other words, the profit attributable to Hyflux Innovation Centre should be about S$13.53 million.
And compared to Hyflux’s audited 2013 net profit before tax of S$51.6 million, the relative figure under Rule 1006 (b) works out to be about 26.2per cent - not 5.7per cent.
That would classify it as a major transaction as per Rule 1014 of the Mainboard Listing Rules.
Therefore that makes us wonder the basis on which Hyflux arrived at a relative figure of 5.7per cent under Rule 1006 (b).
We stand to be corrected if Hyflux can show us how it arrived at the profit attributable to the property.
5. Why will it pay for any vacant space at the property?
Hyflux’s announcement doesn't explain why it will pay for the vacant space at the Hyflux Innovation Centre for the next three years.
After all, Ascendas REIT didn’t pay an exceptionally high price for the property.
In fact, Hyflux seems to have sold it to the Trust for a discount.
After selling the property, isn’t it Ascendas REIT’s business to find tenants for the property?
Then why did Hyflux agree to pay for any vacant space at the property in the next three years?
Unless it was keen to sweeten the deal for Ascendas REIT.
Certainly, the shareholders would want to know the management’s reasoning for that.
6. How much more rent will it pay to Ascendas REIT every year?
Hyflux said it has leased-back the property for 15 years on ‘customary terms and conditions’.
But it didn’t elaborate what these customary terms are.
For example, how much the rent will rise every year.
7. What are its S$29 million costs related to the sale of property?
On page 2 of its June 26 announcement, Hyflux said “The estimated excess of the sale proceeds over the net book value, rental support, estimated directly attributable expenses and other charges is approximately S$84 million.”
We already know that it sold the property for S$170 million.
We also know that the property’s net book value was S$57 million on March 31.
So, that leaves a difference of S$29 million for “rental support, estimated directly attributable expenses and other charges” related to the disposal of property.
Hyflux already sold the property at an S$27 million discount to its market value.
With another S$29 million being spent on costs related to the disposal, the effective consideration for the property works out to be just S$141 million.
Remarkably, Ascendas REIT’s transaction costs related to the acquisition are just S$2.66 million.
Therefore any reasonable investor would want to know the breakdown of S$29 million costs related to the disposal of Hyflux Innovation Centre.
8. What, or who, brought Hyflux and Ascendas REIT together?
The announcements of Hyflux and Ascendas REIT don’t explain what, or who, made them sit across the table to negotiate the sale of Hyflux Innovation Centre.
Did Hyflux invite bids for its property?
Why did it choose to seal the deal with Ascendas REIT?
We have invited the company (firstname.lastname@example.org, email@example.com) to an on-camera interview, and/or to reply to our questions in writing.
At the time of publication we have not received a reply (which is why you are seeing this message).