Distressed capital arbitrage: Hyflux (Part 1)

Hyflux Ltd: a Singaporean champion in distress

Singapore recently amended its insolvency laws as part of a broader competitive move to attract capital, with the US model of Chapter 11 as inspiration.

Hyflux Ltd, ostensibly a waste water and desalination business but in reality an infrastructure investment company with a construction business attached, has recently taken advantage of the new Singapore restructuring legislation in an effort to survive a sever liquidity crisis.

In a series of posts I will take a closer look at Hyflux as a distressed investment opportunity.

This is part 1 on the business and capital structure.

What does the company do?

Hyflux Ltd is a Singaporean public company listed on the Singapore stock exchange with ticker 0600. In the company’s own words (from the 1Q18 results presentation):

As a global provider of sustainable solutions, Hyflux is committed to resource optimisation and sustainable development. A specialist in water treatment and among the top global desalination plant providers, Hyflux is distinctive in its ability to address the challenges at every point of the water value chain. The Group has expanded its offerings to include power generation and waste-to-energy. It also entered into the wellness industry with the ELO brand to broaden its consumer market portfolio.

Headquartered and listed in Singapore, the Group employs more than 2,500 employees worldwide. Hyflux’s track record spans across Asia, the Middle East and Africa. It includes one of the world’s largest seawater reverse osmosis desalination plants in Algeria and Asia’s first Integrated Water and Power Plant in Singapore.

Cutting through the management speak, Hyflux builds different types of water treatment plants. It has patented various membrane technologies which allow it to better treat salt and waste water to make it usable and, ideally, drinkable. This is the basic idea:

water membrane
A simple membrane filter

While there is some technological edge to the filtering technology used, the real expertise is in designing, constructing and then operating the large facilities that treat the water. The revenue and cashflow drivers can be broken down into a startup phase (where the plant is in construction mode and so is non-revenue generating) and operation phase (which has relatively low capital demands and high margins).

In its most recent annual report, Hyflux makes a clear distinction between:

  1. A construction business (Engineering, Procurement and Construction or EPC). This business has high cyclicality with high cash demands.
  2. An operating business (Operations and Maintenance or O&M). This has durable and defensive characteristics with low cyclicality.

There is also a consumer business that develops an “oxygen-rich” water and therapy centre. According to 2017 Annual Report, however, the consumer business revenue was negligible and, in any case, was in February 2018 – just a few months before the restructuring filing – majority divested by way of distribution by in specie dividend to shareholders.

It is the aggressive growth in the cash consuming EPC business that has resulted in Hyflux’s current liquidity crisis, although we will later query whether Hyflux has had free cash flow in any of its businesses.

The revenue breakdown for the year to 31 Dec 2017 was as follows:

Hyflux_revenue breakdown FY17

The variability of the EPC segment (construction) vs the O&M segment is stark.

Despite the use of EPC and O&M as distinct business lines in the management discussion and analysis, the financial statements report on different business lines, in a municipal segment and an industrial segment. From note 25:

Municipal: Supplier of comprehensive range of infrastructure solutions including water, power and waste-to-energy to municipalities and governments.

Industrial: Supplier of comprehensive range of infrastructure solutions for water to industrial customers.

The rationale is that the business units offer different products and services, and are managed separately because they require different technology and marketing strategies. EPC and O&M work are included in both segments. The segment breakdown for the year to 31 Dec 17 (the last date for which the breakdown is available) is as follows:

Hyflux_segment reporting FY17

Geographically, revenue generation has recently been concentrated in Singapore (some 60% of revenue) but significant contributions are also made from the Middle East (especially Oman) and Africa (primarily Algeria).

Company History

To better appreciate and analyse the difficulties Hyflux now faces, I find it helpful to go back 10+ years in the annual reports to see how the capital structure and liabilities evolved.

Beginning at the beginning (as the King said to Alice in Wonderland), the business that is now Hyflux was founded by Ms Olivia Lum in 1989 with 2 employees. According to the Hyflux website, Ms Lum was inspired to focus on the water treatment business as a “sunrise” industry given the increasing “pollution of waterways with rising urbanisation and industrialisation”. No doubt the water security needs of Singapore, which otherwise relies for its fresh water on its northern and much larger neighbour (Malaysia), were also influential. With a chemistry background Ms Lum began by selling “water treatment products and systems using traditional technologies”. This, you will agree, is a noble goal that has only become more pressing with time.

The business grew significantly enough that by 2001 it had listed on the Singapore stock exchange as a Singapore success story. Its reported revenue and profits quickly grew along with aggressive targets, including a target sales and profit compounded annual growth target of 30% per annum for the period 2003 to 2008 (page 9 of the 2004 Hyflux results release dated 23 February 2005).

Milestones fell. The timeline on the Hyflux website reports that Ms Lum “made history when she became the first Singapore and the first woman to win the prestigious Ernst & Young World Entrepreneur of the Year in June 2011”. A new global headquarters was bought in 2012, projects in Oman and Saudi Arabia agreed in 2014 and new sectors entered (power generation) in 2015.

Difficulties begin

However, by the end of 2016, the share price had lost over half to SGD0.40 from its level  above SGD0.90 only the year before. By the end of November 2017, the Singaporean daily newspaper the Business Times, was reporting the “fall of water treatment star Hyflux, which is trading near a 15-year low” of SGD0.30.

Even as some credit analysts were querying Hyflux’s credit profile, for example this insightful negative report from Bond Supermart in September 2017, the public perception (or some cynics might say, the Hyflux marketing team) were so unwilling to acknowledge issues that the Bond Supermart team were forced to acknowledge and respond in their follow up note on 1 March 2018.

The section is worth quoting in full:

After the publication of our credit report on Hyflux in September, we have received many inquiries and comments from our readers, clients, and the media. Some of them took issue with our bearish stance on the company. We are grateful for the feedback and we have been thinking about the points they raised.

Here are some of the perspectives we gathered:

  • Water is a matter of national security and of strategic interest to Singapore. The government won’t allow Hyflux to go bust.
  • There is so much retail money in the perpetual securities; it would be a massive public uproar if securityholders don’t get their money back. The regulator and government won’t just stand still and let that happen.
  • Hyflux is a household brand name in Singapore, and has a demonstrated track record of tapping capital markets. It will find a way to refinance the bonds.

The response from the analyst, Ang Chung Yuh, CFA, is commendable:

All of the above bear at least some validity, but we think they are also mostly unpredictable. This author is not smart enough to speculate on these matters. Therefore, we will stick to the fundamentals and focus on things that are knowable and important.

The liquidity crisis quickly came to a head. In its 2017 full-year results released on 27 Feb 2018, Hyflux reported that it would not redeem its S$400m 6% preference shares in April, which meant they would step-up by 2% p.a.

Court filing

On 22 May 2018, Hyflux announced that it and 5 subsidiaries had filed with the Singapore High Court pursuant to Section 211B (1) of the Singapore Companies Act. The Company retained Wong Partnership as its lawyers and Ernst & Young as financial advisers. The result of the filing was that a moratorium was automatically imposed for 30 days on any action against the company to recover debts. The company subsequently applied for, and was granted, on 19 June an extension of the moratorium for 6 months, until 19 December 2018.

The entities that filed were:

  1. Hyflux Ltd,
  2. Hydrochem (S) Pte Ltd,
  3. Hyflux Engineering Pte Ltd,
  4. Hyflux Membrane Manufacturing (S) Pte Ltd,
  5. Hyflux Innovation Centre Pte Ltd, and
  6. Tuaspring Pte Ltd (although the Tuaspring application was subsequently amended after agreement with its primary secured creditor, Maybank, so that the moratorium no longer applies).

The filing was made prior to the impending 28 May coupon payment due on a tranche of its issued notes, the HYFSP 4.250% 07Sep2018 Corp (SGD).

I will explore the legal implications of the filing in a separate post, but first, a look at the liabilities the company owes.

Corporate and capital structure

The capital structure of Hyflux is complex due to its multiple projects, voracious funding needs and global operations. Here is a simplified structure chart from the helpful news and intelligence service, REDD Intelligence :

Hyflux structure chart

A full list of Hyflux subsidiaries is at the back of each year’s annual report.

The debt profile

The chart below shows the debt profile of the Group as 31 March 2018, although a detailed breakdown is not available in the 1Q18 release so FY17 figures are used where available (the total debt figures are substantially the same for 31 Dec 2017 and 31 March 2018).  The court filings did not include the liabilities of the whole group but only the 5 companies (excluding Tuaspring) that filed. Therefore, although more up to date (filed with the Singapore court on 31 July 2018), they do not provide the whole picture.

Hyflux debt profile

Even from the above, the situation looks perilous. As we shall see in further posts, as we take a closer look at the assets and cash flows that support the debt, the situation will appear even more dire.

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice in any shape or form.



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