The Accounting for Hyflux's Water Treatment Plants

Hyflux develops and operates various types of water treatment plants for municipals and industrial companies in concessions of 20 to 30 years. It has a strong order book of $3,187M as at Dec 2016, of which $1,916M is related to future revenue from the operations & maintenance (O&M) of the water treatment plants over the concession periods. Fig. 1 below shows Hyflux's order book.

Fig. 1: Hyflux's order book

Yet, despite the strong O&M order book, Hyflux lost money in recent quarters from the operations of the Tuaspring Integrated Water and Power Project. In 1H2017, Hyflux lost $25.4M, of which $47.9M was due to Tuaspring. The reason given for Tuaspring's loss is the continuing weak power market for Singapore and losses are expected for the next 2 quarters. Accounting-wise, why did Tuaspring lose money, despite it having a 25-year concession from the Public Utilities Board (PUB) to sell water and excess power from the plant?

Firstly, some background on Tuaspring. Tuaspring is a Design-Build-Own-Operate-Transfer (generically called BOT) project with a 25-year concession from PUB. The plant generates desalinated water and power, some of which is used for the operation of the plant. The excess power can be sold to the National Electricity Market. During the concession period, Hyflux will receive guaranteed minimum payments from PUB. It will also receive additional revenue from the sale of water and excess power. At the end of the concession period, the plant will be transferred to PUB's ownership.

Traditionally, when companies build plants, there is no revenue and there is investment in the Property, Plant and Equipment (PPE) account in the balance sheet during the construction phase. When the plant is operational, the company generates revenue from the sale of goods/ services produced by the plant and depreciates the PPE until the plant reaches the end of its economic life. 

Due to the nature of the BOT arrangement and concession payments from its water treatment plants, Hyflux adopts Interpretation of Financial Reporting Standard (INT FRS) 112. Under INT FRS 112, there is no investment in the PPE account during the construction phase. Instead, all the projected payments during the concession period are discounted to the present value and considered as financial receivables (for guaranteed payments) and intangible assets (for non-guaranteed payments). During the construction phase, these 2 accounts are progressively increased in the balance sheet instead of the PPE account.

Correspondingly, in Hyflux's cashflow statements, negative cashflows show up in "changes in financial receivables/ intangible assets arising from service concession arrangements (SCA)", which we do not usually find in other companies' cashflow statements. Traditionally, it is the PPE line under the Cashflow from Investing that is negative during plant construction. In the case of Hyflux, it is these 2 numbers in Cashflow from Operations that are negative.

Fig. 2: Hyflux's Cashflow Statement

There is another major difference between Hyflux and other companies. Traditionally, when a company builds the plant, it is recorded on the balance sheet at cost, i.e. the cost that the company pays for the plant. However, Hyflux does not pay other companies to construct its plants; it builds them itself. Hence, it is able to recognise a construction revenue for the plants during the construction phase. Since concession grantors like PUB do not pay for the construction of the plant, the construction revenue is the financial receivables and the intangible assets arising from SCA described above. Note from the earlier discussion that the financial receivables and SCA intangible assets are computed as the present value of the projected payments over the concession period. Thus, by the time the plant is completed, all the projected payments over the 20- to 30-year concession period would have been largely accounted for.

When the plant is completed and operational, Hyflux generates revenue from the guaranteed payments from PUB and the sale of water and excess power. On the other hand, it has to amortise the financial receivables and SCA intangible assets over the concession period. Thus, if the actual payments match the projected payments, what Hyflux earns during the operational phase is the interest from the financial receivables and SCA intangible assets, based on the discount rate used to compute the present value. If the actual payments exceed the projected payments, Hyflux earns more profit. Conversely, if the actual payments fall below the projected payments, Hyflux earns less profit or loses money. In the case of Tuaspring, due to the weak power market, actual payments came in below projected payments and Hyflux lost money on it.

Thus, contrary to conventional wisdom, the 20- to 30-year operational phase of a water treatment plant may not be the most profitable phase for Hyflux. A lot will depend on whether the actual payments exceed the projected payments. In contrast, the construction phase of the water treatment plant can be quite profitable.

In FY2016 financial results, Hyflux reported a net profit of $4.8M. It also mentioned that profits from Engineering, Procurement and Construction (EPC) were substantially wiped out by losses from Tuaspring, which amounted to $113.2M. This shows that the EPC profits can be quite substantial.

Fig. 3: Earnings Review for FY2016

Thus, based on current understanding, Hyflux might not generate the most profits from operating the water treatment plants during the 20- to 30-year concession periods. It probably generates more profits from constructing them.

Just a disclaimer, this post is not a recommendation for anyone to buy or sell Hyflux's shares or perps. Please read the accounting policies in Hyflux's annual report and do your own due diligence.

See related blog posts:

• Did Hyflux Make Money for its Ordinary Shareholders?
• Watch Out for Hyflux's Omission of Ordinary Dividends
• Do Hyflux's 6% Perps Have Sufficient Margin of Safety?

Know Your Customers Well!

Ouch! I just lost $33K on Triyards after it got suspended last month. Triyards is a shipbuilder and a subsidiary of Ezra, which is now under Chapter 11 bankruptcy protection. By right, if you read my post on My Upstream Oil & Gas Rescue Operations, ship and rig builders have not seen the worst of the Oil & Gas (O&G) long and harsh winter and I should not have invested in Triyards in Mar this year. However, Triyards has successfully diversified away from the O&G sector. Among its new orders for the financial year ending in Aug 2016 are chemical tankers, research vessel, passenger ferries, river cruise vessel, wind farm support vessels, etc. New contract wins in such non-O&G vessels totalled USD226.2M in FY2016. Including O&G vessels, total contract wins represent 84% of the revenue in FY2016. The orders-to-revenue ratio is an important metric for me when investing in O&G stocks, as described in Oil & Gas, Show Me the Orders!

Given its success in diversifying away from the O&G sector, Triyards is similar to another ship builder, Vard, which has also diversified away successfully and was the subject of a voluntary cash offer by its parent company in Nov 2016. However, unlike Vard, Triyards' parent company, Ezra, is not in any financial position to offer a cash offer. Nevertheless, Ezra had pledged all its 60.9% shareholding in Triyards equally to both DBS and OCBC in Jul 2016. Any sale of the shares to recover the loans by any one bank would have triggered a mandatory cash offer. When I first bought into Triyards at $0.288 in Mar, its net asset value was USD0.673 as at end Feb 2017. Its debts were USD187.9M, translating to a debt-to-equity ratio of 0.86, which was very high. However, most of the debts were used to finance working capital and trade receivables were USD238.6M. When the bills are collected, there will be cash to pay down the debts.

On 19 Mar, Ezra announced Chapter 11 protection under US laws, instead of the usual judicial management under Singapore laws, which means that creditors cannot foreclose and sell the assets pledged to them. In other words, both DBS and OCBC cannot sell Ezra's Triyards shares to a third party except with the approval of the US courts or consent by Ezra. Since the banks could not sell off the shares, there would be no cash offer, at least not in the near term.

Upon Ezra's bankruptcy protection, Triyards disclosed on 21 Mar that it had approximately USD41.5M exposure to Ezra, mostly in the form of joint corporate guarantees. This represents 19% of Triyards' equity, reducing the net asset value to USD0.545. In Triyards' 3Q2017 financial results announcement, it announced another USD45.1M in impairment losses. As at end May 2017, the net asset value was reduced to USD0.478. Including the exposure due to joint corporate guarantees of USD38.5M mentioned above, the net asset value would be USD0.359. Ezra was a huge body blow to Triyards, but not fatal. Triyards itself was not under Chapter 11 bankruptcy protection and continued trading on SGX despite Ezra's troubles and trading suspension, until 4 Sep.

The company that has a bigger impact to Triyards has a name that also starts with "Ez", but it is not Ezra, it is Ezion. On hindsight, Ezion is a major customer of Triyards, much more so than Ezra. Ezion subscribed to 29.5M warrants in Triyards at an exercise price of USD0.563 in Jul 2015. One of the conditions for the issue of warrants to Ezion is that Ezion enters into shipbuilding contracts with Triyards worth at least USD150M. Based on outstanding order book of USD422M as at Oct 2016, this represents 36% of Triyards' order book. On 23 Feb 2017, Ezion announced that it had indefinitely deferred delivery of 4 service rigs worth USD270M to reduce capital expenditure. A cross-check between Ezion's and Triyards' announcements of contract wins in 2014 suggests that 3 of these orders worth a total of USD162.5M are Triyards'. That means USD162.5M of the outstanding trade receivables of USD230.0M could not be collected, dealing a serious blow to Triyards' cashflow. Triyards' 3Q2017 financial results also suggest that banks, despite "owning" 60.9% of Triyards, have grown cautious about providing further loans to it. On 6 Sep, Triyards suspended trading of its shares.

Triyard's problem is similar to Keppel Corp's and SembMar's problem with Sete Brasil, which had deferred offers and stopped payments. Keppel Corp and SembMar survived, because of strong backing of their parents, Temasek, and continued support of their banks. Triyards have neither, and its chance of surviving is a lot lower. For Triyards to survive unscathed, either its banks continue to provide financing to complete the ships ordered by other customers, or Ezion takes delivery of some of its ships, so that Triyards can convert the receivables into cash and pay off the debts.

Actually, I also did not expect Ezion to go into restructuring. Ezion's market capitalisation was one of the highest among the mid-cap O&G stocks before it was suspended on 14 Aug. In fact, I had just bought into Ezion warrants just before it was suspended.

Triyards is the biggest loss on a single stock. The lessons I learnt from this episode is to know your customers really well!

See related blog posts:

• Understanding Shipbuilders' Balance Sheets
• My Upstream Oil & Gas Rescue Operations
• Is A Recovery for Oil & Gas Shipbuilders Near?

If You Invest In Fixed Income, Read the Fine Print

After the exertion to read the Offer Information Statement (OIS) of Hyflux's preference shares and perpetual capital securities (perps) in the past few weekends, this week's post will be a lighter one. 

In my post last week, I extracted the relevant portions of the OIS of Hyflux's preference shares and perps to discuss the conditions upon which Hyflux could omit the preference dividend and perps distribution respectively. For me, the most surprising discovery is that the preference shares are ranked pari passu (or have the same seniority) with the perps! See the figure below, which is extracted from the perps' OIS.

Fig. 1: Relative Ranking of Hyflux's Preference Shares and Perps

All along, I had thought that the preference shares would rank lower than the perps, mainly because the preference shares are a type of shares and perps have characteristics of a bond. Conventional wisdom suggests that a bond must rank higher in seniority than a share. It was only until I read the above from the perps' OIS that I realised that I was wrong!

The relative ranking of the preference shares and perps have important implications for their respective holders. If the preference shares were ranked below the perps, the preference shares would serve as a cushion for the perps. Any losses would be absorbed first by the ordinary shareholders, followed by the preference shareholders before the perp holders suffer a loss. As at Jun 2017, the total debt of Hyflux is $1,308.7M. The equity attributable to ordinary shareholders is about $226.9M (corresponding to net asset value per share of $0.289 for 785.3M shares, which is down from $0.451 in Dec 2016). The debt-to-ordinary-equity ratio works out to be 5.77, which is very high. If the preference shares were ranked below the perps, there is another $392.6M of preference equity between the ordinary equity and the perps. The debt-to-(ordinary + preference)-equity would be 2.11, which is a lot less than the original ratio of 5.77.

Unfortunately, that is not the case. Both preference shares and perps are ranked pari passu with each other. This means that both preference shareholders and perp holders share in the loss together if losses exceed the $226.9M equity attributable to ordinary shareholders. 

The key takeaway for me from reading the Hyflux's OIS is never to assume the relative ranking of different instruments based on their names. And if you invest in fixed income instruments, better read the fine print too.

See related blog posts:

• Watch Out for Hyflux's Omission of Ordinary Dividends
• Do Hyflux's 6% Perps Have Sufficient Margin of Safety?
• Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form

Watch Out for Hyflux's Omission of Ordinary Dividends

Hyflux announced its half year financial results last month. For holders of Hyflux preference shares and perpetual capital securities (perps), perhaps the most noteworthy point is that it did not declare an interim dividend on its ordinary shares. Why is this important? It is because the payment of a preference dividend or perps distribution is discretionary. If certain conditions are met, the company can choose not to pay or only pay partially any preference dividend or perps distribution. One of these conditions is that a dividend on the ordinary shares is not paid out. The conditions for preference shares and perps are different, so let's discuss these separately.

Preference Shares

There are 2 conditions upon which Hyflux can choose not to pay or only pay partially its preference dividends. The 2 conditions are:

1. If it does not have sufficient Distributable Reserves; or
2. If it does not pay its next dividend on its ordinary shares.

See Figs. 1 and 2 below for extracts of the Offer Information Statement (OIS) for the preference shares.

Fig. 1: Conditions for No/Partial Preference Dividend (Extract)

Fig. 2: Definition of Distributable Reserves

For Condition 1, if Hyflux does not have sufficient Distributable Reserves, it will not be able to pay its preference dividends in full. The definition of Distributable Reserves is shown in Fig. 2 above. I interpret it to mean that Hyflux must have sufficient retained earnings to pay dividends, regardless of whether they are ordinary dividends or preference dividends. As at Jun 2017, the retained earnings are $146.9M. The retained earnings have been dropping recently. In Dec 2015 and Dec 2016, the corresponding figures are $284.2M and $210.3M. See Did Hyflux Make Money for its Ordinary Shareholders? for more information.

For Condition 2, if Hyflux does not pay its next dividend on ordinary shares, then it can choose not to pay or only pay partially the preference dividend. Nevertheless, this does not mean that Hyflux will definitely not pay its next preference dividend in full. It only means that Hyflux can choose not to if it wishes.

In addition, the preference dividends are cumulative. If a preference dividend is skipped, it will continue to accumulate until it is fully paid out or the preference shares are redeemed.

Perpetual Capital Securities

For perps, the condition upon which Hyflux can choose not to pay or only pay partially its perps distribution is if it does not pay a dividend on, redeem or buy back any of its Junior Obligations in the preceding 6 months. The ordinary shares are considered as Junior Obligations. In addition, Hyflux can defer part of the perps distribution if it pays a dividend on, redeem or buy back its Parity Obligations on a pro-rata basis with the perps in the preceding 6 months. The preference shares are considered as Parity Obligations. See Figs. 3 and 4 below for extracts of the OIS for the perps.

Fig. 3: Conditions for No/Partial Payment of Perps Distribution (Extracts)

Fig. 4: Ranking of Hyflux Preference Shares and Perps

The last ordinary dividend was paid on 25 May 2017 and the last preference dividend was paid on 25 Apr 2017. As Hyflux did not declare an interim dividend on its ordinary shares in its latest financial results, if Hyflux chooses not to pay the next preference dividend scheduled on 25 Oct 2017 in full, Hyflux can defer part of the next perps distribution scheduled on 27 Nov 2017.

And like the preference dividends, the perps distributions are cumulative. If a distribution is skipped, it will continue to accumulate until it is fully paid out or the perps are redeemed.

Just a disclaimer, this post is not a recommendation for anyone to buy or sell Hyflux's preference shares or perps. It is also based on my interpretation of the terms in the OIS. You can find a copy of the OIS/ prospectus in Bondsupermart. Please read the OIS and do your own due diligence.

See related blog posts:

• Did Hyflux Make Money for its Ordinary Shareholders?
• If You Invest In Fixed Income, Read the Fine Print
• Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form

The Small Cushion That Warrants Provide

I have a small, speculative strategy affectionately called the "minion strategy", which involves throwing a small amount of money into certain depressed stocks that have the potential for a turnaround. The money is mentally written off the moment it is invested. The strategy is described in more details in Meet The Minions. Since the money will be written off anyway, if the stock has a warrant, I would choose the warrant over the mother share, as warrants are cheaper and rise (or fall) proportionally more than the mother shares. 

One of the recently added minions is Ezion warrant. As luck would have it, on the day I bought the warrant, Ezion called for a trading halt (later changed to a suspension). I literally had to write off the amount the moment it was invested. Later announcements by the company mentioned that it was in discussion with lenders to secure additional funds for working capital. On some investor forums, there were comments that Ezion might need to call a rights issue again to raise funds.  

When a company calls a rights issue, shareholders either have to cough up more money to subscribe to additional shares, or sell the rights (if the rights are renounceable) to collect some money back. Because a rights issue dilutes the amount of shares a warrant can be converted into, there are adjustments made to the conversion terms of the warrants. For example, each Ezion warrant is currently convertible into 1 Ezion share at an exercise price of $0.45. If Ezion were to call a rights issue and increase the no. of shares outstanding, the shares that warrant holders get would be worth less if the conversion ratio and the exercise price stay the same. Hence, there is an adjustment to the conversion ratio and/or exercise price. 

The Ezion warrants were issued in Apr 2016 as bonus warrants to all shareholders. Each warrant was then convertible to 1 share at an exercise price of $0.50. In Jun 2016, Ezion called a 3-for-10 rights issue at an issue price of $0.29. Adjustments were made to the warrants such that holders got 0.113 free warrants for every existing warrant (in lieu of changing the conversion ratio of 1 share for every 1 warrant). In addition, the exercise price was adjusted from $0.50 to $0.45.

Ezion is not the only company that adjusted the conversion terms of its warrants after a rights issue. Viking did the same after its rights-cum-warrant issue in May this year. Innopac also issued free warrants (but did not adjust the exercise price) after its rights issue in Jun this year.

Perhaps the most generous adjustments are made by Olam, which adjusts the conversion terms of its warrants even for ordinary dividends. For example, in Aug this year, Olam declared an interim dividend of SGD0.035. The exercise price was adjusted from USD1.12 to USD1.09 and the no. of warrants was increased by 1.8%.

Thus, there is a small cushion that warrants provide in the event of a rights issue.

See related blog posts:

• Meet The Minions
• The Minions (Millions) Mentality
• Structured Warrants

It Is Possible to Survive a Currency Depreciation

Since that fateful day when Britons voted for Brexit a year ago, the British Pound (GBP) has fallen by 11.8% against US Dollars. Worries about Singaporean companies' investments in UK were raised in the aftermath of the vote. However, the fall in GBP was small fry to one Singaporean company which faced much larger currency depreciation in the countries it invested in. The company is Food Empire, which derived 58% of its revenue from Russia and 13% from Ukraine in 2013. 

In Mar 2014, Russia annexed Crimea from Ukraine. International sanctions on Russia followed suit. Both the Russian Ruble (RUB) and Ukraine Hryvnia (UAH) fell against major currencies. Fig. 1 below shows the fall in RUB (blue line), UAH (red line) and GBP (orange line) against USD since Mar 2014. At the lowest point in Feb 2016, RUB fell by 60% while UAH fell by 70% against USD. In comparison, GBP's fall of 24% against USD over the same period appears mild. 

Fig. 1: Fall of RUB and UAH against USD

Food Empire, which derives the majority of its revenue from Russia and Ukraine, saw its earnings fell from a gain of USD11.3M in FY2013 to a loss of USD13.6M in FY2014. However, despite the continued depreciation of RUB and UAH, earnings began to recover for Food Empire. In FY2015, it narrowed the loss from USD13.6M to USD0.1M. By FY2016, it had recovered to a gain of USD13.8M, which was even more than in FY2013, even though neither RUB nor UAH had recovered to their previous values against USD.

Likewise, Food Empire's share price also followed its earnings. The share price fell from $0.535 in Dec 2013 to a low of $0.205 in Jan 2016 before staging a spectacular recovery to a high of $0.765 in May 2017. 

Fig. 2: Food Empire's Share Price Performance

When a currency depreciates in value relative to other currencies, there are usually 2 impacts -- accounting and economic. The accounting impact means that all assets, liabilities and cashflows denominated in that currency are worth less. However, such impact on assets and liabilities are usually one-off, unless the currency continues to depreciate.

The economic impact means that the real purchasing power of consumers in that country reduces and consumers are not able to afford as many as before the products that companies sell. However, such effects will also readjust themselves over time. When a currency depreciates, imports become more expensive and the real purchasing power of its consumers reduces. However, at the same time, exports also become cheaper and exporters can sell more products overseas and increase their earnings. The net effect of a currency depreciation is that imports will decrease while exports will increase, thus increasing the current account surplus of the country. Over time, a part of these surplus will be spent within the country, leading to a recovery of the real purchasing power of its consumers. Hence, eventually, the profits of companies selling products in the country will also recover.

Having said the above, not all companies will survive a currency depreciation. Those companies with large debts denominated in foreign currencies would have difficulties repaying the debts which have become much more expensive in local currencies. To avoid such situations, companies need to hedge their foreign currency exposure, either by entering into a currency swap, or by holding foreign assets denominated in the same currency. For example, if you take a GBP-denominated loan to buy a property in UK, the effect of the currency depreciation on the property and the loan will offset each other if the loan quantum matches the property price.

Thus, although a currency depreciation will lead to immediate losses for companies invested in a particular country, eventually, prices within the country will readjust and the companies could make normal profits again.

See related blog posts:

• Is Brexit Just Noise?

Did Hyflux Make Money for its Ordinary Shareholders?

Hyflux is an interesting case. In FY2016, it reported a net profit attributable to owners of $4.8M but a loss per ordinary share of 7.51 cents. Its net asset value correspondingly dropped from $0.56 in Dec 2015 to $0.45 in Dec 2016. The main reason? There are a few different types of owners of the company. Besides the ordinary shareholders, there are preference shareholders and perpetual capital securities (perps) holders. The net profit attributable to owners of $4.8M has to be shared among these different types of owners. Both preference shareholders and perps holders have prior claims over ordinary shareholders. In total, they were paid $63.8M in preference dividends and distributions in FY2016. Thus, ordinary shareholders ended up with a loss of $59.0M after accounting for the preference dividends and distributions instead of the reported $4.8M. Divided over 785.3M ordinary shares, the loss per ordinary share was 7.51 cents.

In order to make money for its ordinary shareholders, it has to make a net profit attributable to owners that is more than sufficient to cover the preference dividends and distributions payable to preference shareholders and perps holders. In FY2016, this amount was $63.8M. In the last 12 months, Hyflux has begun to redeem some of its perps. In July 2016, Hyflux redeemed $175M perps bearing interest of 4.80%. In Jan 2017, it also redeemed $295M worth of perps bearing interest of 5.75%. The remaining perps left are $500M bearing interest of 6.00%. In addition, there are outstanding preference shares of $400M bearing a dividend rate of 6.00%. These preference shares are callable on 25 Apr 2018, failing which the dividend rate will step up to 8.00%. Thus, Hyflux needs to make a net profit attributable to owners of between $54.0M and $62.0M every year, before ordinary shareholders get to enjoy the profits.

Since Hyflux made less money than is sufficient to cover the preference dividends and distributions of its preference shares and perps in FY2016, the money has to be drawn from its retained earnings. Its retained earnings thus dropped from $284.2M in Dec 2015 to $210.3M in Dec 2016. In 2H2017, the figure dropped further to $146.9M after reporting a loss attributable to owners of $24.3M. Preference shareholders and ordinary shareholders have to watch this figure very carefully. If the retained earnings drop to zero, there will be no more reserves to pay dividends, including the 6% preference share dividend.

Thus, at this point in time, Hyflux is not making any money for its ordinary shareholders.

See related blog posts:

• The Accounting for Hyflux's Water Treatment Plants
• Watch Out for Hyflux's Omission of Ordinary Dividends
• If You Invest In Fixed Income, Read the Fine Print