To trust Hyflux or Hyflux's Trust?

 

Matthew Phan

Extracted as below:-

3 December 2007    

 

Business Times Singapore

 

(c) 2007 Singapore Press Holdings Limited

 

WITH Hyflux Water Trust (HWT) listing on the SGX today, investors might be asking themselves whether to buy the sponsor or the trust.

Despite the plunge from a peak of nearly $4 in 2005 after it aborted joint ventures in Dubai, Hyflux has regained popularity this year, with recent ventures into oil recycling, water treatment in Algeria, and, of course, the listing of its water trust.

Founded by award-winning entrepreneur Olivia Lum, it is seen as a pioneer and brand name in Singapore's water treatment sector, with advanced technology and strong growth potential in a theme that will only grow more urgent. The thing is, you can now say practically the same for HWT. So why buy Hyflux? After all, the trust offers growth potential with less volatility.

HWT's initial portfolio has a capacity of 245,000 cubic metres per day, which could grow to 760,000 cubic metres per day by 2009. It does not bear the risk of executing projects, nor will it see the quarterly volatility of earnings associated with engineering, procurement and construction (EPC) firms, as they book revenues from completed projects in one period but not the next.

Instead, HWT will earn stable revenues over the 25-30 year concessions for its plants. Minimum offtake agreements cover the operating costs. Hyflux, which will operate and maintain the plants, has promised to increase operations and maintenance (O&M) fees only if tariffs also rise, so the trust has less downside on margins. Given China's precarious water shortage and the strategic location of the plants in industrialising areas, utilisation and tariffs are likely to go only up. But don't forget Ms Lum's oft-repeated comment that HWT's listing is a strategic move that strengthens Hyflux. Financial management is key for water treatment firms, which sink large amounts of capital upfront into build-operate-treat contracts. They get a cut up front as EPC fees, then recover the remaining cost over several years of selling water.

According to Sam Ong, Hyflux's chief investment and chief financial officer, 'payback on a typical water project with a concession is about seven to 10 years if we were to keep ownership of the plant'.

By selling the plant into HWT, Hyflux recoups the money upfront and can invest in new projects - what Mr Ong calls 'capital recycling' and 'accelerating gains for a shorter payback period'. Further, Hyflux can sell the plants for more than book value (which reflects only construction cost), thereby booking capital gains, says Mr Ong. This is because cost of capital for HWT - which will trade at a FY2008 yield of 5.7 per cent - is much lower than the internal rate of return (IRR) that Hyflux earns on the plants, which, assuming a 10-year payback period, is by definition 10 per cent.

Investors might correctly worry that Hyflux's revenues and earnings will now be more volatile, after it divests the completed plants, which provide a stream of recurring revenues. Though Hyflux still gets a cut of the plants' earnings, its share falls from a direct 80 per cent to an indirect 31.5 per cent.

But besides dividends from the trust, Hyflux will also earn O&M recurring income as well as trustee-manager fees, which represent new recurring income streams. Also, the business trust structure means that HWT can pay out depreciation on the plants assets, which Hyflux would previously record as expense on its income statement. Depreciation can be significant; it would be $7.9 million in FY2008 and $9.8 million in FY2009, according to HWT's prospectus. In switching depreciation expense to dividend income, Hyflux could earn more from its reduced share in HWT than from its direct 80 per cent stake in the plants themselves.

In listing the trust, Hyflux has clearly defined itself as a service provider in water treatment (and other fields), with associated high margins, growth potential and relative volatility. HWT, on the other hand, functions more like a utility in charge of O&M, paying stable dividends from long-term plant operation. It's up to investors which they prefer. As long as water remains scarce, neither looks half-bad.