The Rise & Fall Of Hyflux
History reminds us to be prudent with debt
It is said that those who cannot learn from history are doomed to repeat it. While history is replete with negative black swan events such as the corporate failure of Lehman Brothers and the fall of a powerful commodity trader called Noble Group, the underlying causes are free for all to see and learn from. Indebtedness when managed inappropriately can cause the demise of a corporate entity and bring down its related stakeholders alongside it. However, stories are alluring and investors will be drawn to powerful narratives that make the most logical of investors take illogical shortcuts in reaching a conclusion. After all, isn’t water supposed to be safe? Aren’t water companies supposed to be good businesses? Water’s essentiality and the story surrounding it have captivated the minds of investors since the founding of a water treatment company by a young entrepreneur named Olivia Lum, whose personal story of hardship and forbearance itself was the very focal point of the media’s attention on her.
The rise of Hyflux began as it was founded in 1989. It was called Hydrochem (S) Pte Ltd and for all intents and purposes was to become the predecessor of what Hyflux is today – a firm with engineering capabilities specialised in the delivery of water treatment solutions to municipal and industrial usage. At its humble beginning, the company had just 2 employees. 11 years later in March 2000, Hyflux had been incorporated and it was to be used as a holding company with Hydrochem (S) Pte Ltd as a wholly owned subsidiary. Understandably, the company had to be structured as such for the preparation of an initial public offering. Shortly after in January 2001, Hyflux launches its initial public offering and starts trading as a publicly listed entity on the secondary board of the Singapore Exchange. From the company’s founding to its eventual listing, it seemed like a long time coming for the company and its related subsidiaries. But this was only the beginning of its journey. Shortly after in 2003, it had cemented its status as a mainboard participant on the Singapore Exchange and it was a feat to behold.
In the years before the subprime financial crisis, the company had been a consistent performer in the stock market. Between 2006 and 2010, the earnings per share racked up growth from 2 cents per share to 10.52 cents per share, growing net asset value from 25.7 to 28.6 cents per share.
Other indicators of the company’s financial performance also pointed in very much the same direction. Return on equity numbers between the years of 2006 to 2010 was usually a double digit figure that ranged from between 7.8% to 17.6% for those years. These were stellar numbers by any means when compared to other companies. As a result of Hyflux’s outstanding performance over those years, market participants were rewarded with capital appreciation and generous dividends. In fact, dividends paid grew by a factor of more than 5 times, from 0.9 cents per share to 4.7 cents per share over the period.
By December 2009 it had reached a price of close to $3, implying a market capitalisation of approximately 1.9 billion, a far cry from its IPO price of $0.32 per share. By then, investors who had held on since the IPO had earned approximately 900% in profit. If it weren’t for the subprime contagion, Hyflux’s share price might very well have soared higher.
By 2010, 60% of the company’s revenues were from the MENA( Middle East & North Africa) region generating approximately $344 million of revenue. The rest of the revenue came from China, Singapore and other countries. However, by 2011, there was a strategic shift in the business direction to procure more projects from Singapore and Asia. This led to a fall in revenue from the MENA region and on hindsight, was perhaps the beginning of a series of poor decisions made by the managers of the company. Hyflux decided to devote much of its debt capacity and resources to a project called Tuaspring, a capital intensive project which never saw the light of day.
Source : Hyflux FY 2011 Annual Report
With its sight back on the Asian region, Hyflux went on to sign a 25-year agreement for Tuaspring Desalination Plant with PUB. A wholly subsidiary, Tuaspring Pte Ltd was incorporated to deliver on the project’s promises of delivering desalinated water from 2013 to 2038. The decision was a poor one as indicated by return on equity figures post 2010. Along with the agreement came a tremendous need for capital for external sources to fund its construction and capital expenditure programs over the next couple of years. As such, Hyflux had to seek funding in the form of an issue of $400 million worth of 6% Cumulative, Non-Convertible, Non-Voting, Perpetual Class A Preference Shares, which was the first successful non-financial, corporate perpetual preference share issued in Singapore. While classified as equity on the balance sheet, preference shares are known to have debt like qualities as it is being required in most cases to make distributions at a certain rate like a fixed income instrument. To savvy investors, preferred stock really should be considered as debt, debt that ranks superior to ordinary shares by the very fact that it has a greater claim on the company’s assets and earnings.
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The writing was on the wall by 2013. Free cash flows and cash flows from operations were negative year after year, for a total of 8 years till the present. Hyflux was bleeding cash and interest coverage ratios have fallen from between 6 to 8 pre 2010 to 2.76 in 2013 which was dangerously low in my opinion. And not to mention, interest coverage only considers what is reported as balance sheet debt. It did not factor in dividends on the preference shares and interest on the perpetual securities.
By 2014, the debt had ballooned to levels not seen years ago and return on equity figures had fallen to single digit levels. On top of that, the group’s capital structure became increasingly complex. It had $1.13 billion of secured, unsecured loans, notes and bank drafts on its balance sheet. Apart from that, Hyflux had issued 6% perpetual preference shares which have seniority rights over ordinary shares to the tune of a face value of $392.5 million and it also carried perpetual capital securities which was worth approximately $470 million, net of issuance costs, with semi-annual interest payments to service.
According to the 2014 annual report, interest expenses on balance sheet debt amounted to $42.8 million. But if we were to take a closer look at it, we will find that that figure is grossly misstated. What about the dividends and interest which are payable on the preference shares and the perpetual securities?
Inclusive of another $49.2 million in dividends payable to preference shareholders and interest payable on the perpetual securities, the adjusted total interest expenses would have become $84 million. With an operating income of just $99.2 million, the adjusted interest coverage would have been just 1.18 times.
And then this appeared in the 2014 annual report.
“The issuance of S$475.0 million of perpetual capital securities in aggregate, in January and July 2014, contributed to the net financing inflows in FY2014. The inflow was offset by repayment of borrowings including one of our fixed-rate unsecured notes of S$60.0 million; payments of dividends on ordinary shares, preference shares and perpetual capital securities; and interest costs. Proceeds from the issuance of perpetual capital securities are used for continued strategic investments by the Group”.
Source : FY 2015 Annual Report
Read it again if you have to. If a company has to borrow to pay its dividends and interests costs, there must be something that is wrong in its capital allocation strategies. For Hyflux, while the order book was indeed growing, the company was depleting its cash fast and had to rely on debt, not to thrive but to survive. This was the biggest clue of Hyflux’s impending demise. However, I believe that few investors took notice of this. A growing order book does not automatically lead to the improved financial health of a company.
As it turns out, the plans surrounding the Tuaspring project in Singapore had teething issues. The first of which was a lengthy grid connection delay and testing matters. It was also the intention of management to sell excess electricity back to the grid. The announcement of the matter in the 2015 annual report also marked Hyflux’s entry into the business of generating power, which it claims was lacklustre due to low electricity prices. By 2015, the tuaspring project took on a fancier name called “ Tuaspring Integrated Water and Power Project”. But by 2016, the project’s failure became evident as the CEO, Olivia Lum began to discuss the possibility of the divestment of the Tuaspring project.
Source : FY 2017 Annual Report
The results for the following year in 2017 was so bad that an additional row had to be added in the FY 2017 annual report. That line was called “Profit/(loss)(excluding Tuaspring)” to assuage the fear of investors. But by this time, the damage had already been done and the stock’s price was now around $0.55 per share.
The metaphorical nail in the coffin for Hyflux was when the group had trouble collecting its receivables as accounts receivables spiked from $149.1 million in FY 2016 to $291.7 million in FY 2017, nearly doubling in the span of 12 months.
In May 2018, a painful restructuring process began for all stakeholders involved. The court had granted Hyflux a debt moratorium where rescue financing can be arranged. The rescue financing is similar to what is called debtor in possession financing in the US. The restructuring has led to an arrangement whereby Salim Group and Medco Group would inject approximately $530 million into the company and where ordinary shareholders will only receive 2.74% of the restructured entity. Perpetual security holders and preference shareholders will receive $27 million and 10.26% of the reorganised entity while unsecured creditors will receive a $232 million payout and 27% of the reorganised entity.
Due to the complicated capital structure the group has, one thing is for sure – ordinary shareholders remain the last in the pecking order. More recently, the Securities Industries Association Of Singapore had written to Hyflux over several matters regarding the payment of unnecessary dividends and Olivia Lum’s excessive salary even amidst poor operating results. To me the answer is as clear as daylight. Hyflux had to put on a facade of sorts in order to have raised money from investors via the issue of perpetual securities and preference shares. If not, how else would it have survived to May 2018?
© Kingsley Lim