This is part of a series of posts on the Singaporean-listed Hyflux Ltd.
For Post 1 on the company background and capital structure, see here.
In this post, I will take a closer look at the Hyflux financial statements to try to discern the source of the current distress.
We have already seen how the liability side of the balance sheet is misleading because of the subordinated obligations which the company often represents as “equity” (and indeed for accounting purposes that is how they are treated because of the depth of the subordination). However, these obligations are claims on the company and should be considered in the context of any analysis of recoveries to the firm.
The asset side of the balance sheet also raises red flags about the quality of the assets figure. Consider the below balance sheet, the latest reported by the Company.
Of the Total Assets figure of S$3.6bn, S$1.45bn relates to receivables (both trade and “service concession”) and S$1.47bn relates to assets held for sale, being the Tuaspring waste-to-energy plant in Singapore that has experienced persistent losses. If either of these very large figures are compromised, then the net asset buffer of $1bn begins to look very thin.
Service concession receivables
Accounts receivable is the money that a company has a right to receive because it has provided customers with goods and/or services. It represents a transaction taking place but no cash changing hands. Therefore the higher the accounts receivable, the higher the revenue and the higher the right to receive cash at some point in the future.
The trends from one industry to another will radically differ as to payment practices and therefore the amount of accounts receivables on company balance sheets. While there is nothing wrong with accounts receivable per se, in general the lower the better or otherwise companies can suffer from sever shortages of cash (an IOU is all very well, but they will not pay wages).
Hyflux has significant receivables figures on the balance sheet, indicating difficulties with cash collection. Its contracts are long term (20-30 year) construction and then operation of desalination or other plant contracts. They are recorded on the basis of the ‘stage to completion’ method, which recognises revenue as progress is made towards completion. This means revenue is recognised even before the service is formally delivered and is based on costs incurred as a percentage of total estimated contract costs. This requires significant management judgment and either an increase of costs incurred on a contract or an underestimation of total contract costs will make the completion percentage appear higher, allowing accelerated recognition of contract revenue. (see Mulford & Comiskey, The Financial Numbers Game pp183-184.)
This method of accounting therefore can be easily manipulated.
Indeed, in an affidavit dated 31 August 2018, the Company stated that it had experienced increased costs in the Tuas One waste to energy project due for completion in 2019 (not to be confused with the Tuaspring waste to energy project), leading to an overstatement of revenue by S$71.2m out of total revenue of S$636m at the parent company level!
Note 9 of the 2017 annual report relating to this asset is extracted below.
This line item is really an expense reported as an asset. It is flagged in the auditors’ report as a key risk issue because “the accounting for long term service concession receivables is complex and involves significant judgment”, but the auditors signed off on the figure on the basis that “the judgment exercised by the Group in the recognition of construction revenue and the service concession receivables is fair” (see page 54 of the 2017 AR). The note further explains, “on inception of the arrangements, management exercises judgment in the estimation of the fair value of the construction service contract and the service concession receivables”, and “construction revenue is recognised progressively based upon management’s estimation of the value of project activities completed.
Note 27 of the 2017 AR details that of the $1.4bn service concession receivables at 31 December 2017 (this figure is higher than that in note 9 because of the additional service concession receivables related to Tuaspring which were held for sale) none was considered impaired despite having no collateral and $137m of the receivables being greater than 180 days owing. The figure is a level 2 asset, meaning it requires management judgment to determine the figure. They are discounted at a rate of 2.38%-5.44%, which seems very low in light of the uncertainty of the asset over 20+ year periods.
As the above reveals, there are likely to be serious questions about this line item, particularly in any distressed scenario where counterparties are much less likely to pay promptly (if at all), monies owed when construction work may not even be complete.
Tuaspring integrated water and power plant held for sale
Tuaspring has capacity of 318,500 cubic metres and 411 MW. The difficulty is that Singapore is currently in a chronic oversupply of electricity and the take or pay generation contracts signed by the Company are reported to have been locked in at levels where it supplies power at significantly lower prices to the grid than generation cost. Tuaspring made losses of S$81.9m in 2017 and S$114.5m in 2016. It was put up for sale by the Company in February 2017. According to the FY17 report (p24), weakness in the Singapore electricity market is expected to continue in 2018.
While held on the balance sheet with an asset figure of S$1.47bn, the sale process has still not progressed in August 2018, and reports are that offers have been barely enough to cover the project level debt (Maybank being the sole financier) of $515m (at book value).
Even if there is some surplus above the liabilities at Tuaspring level, it looks highly unlikely that recoveries from this asset will be sufficient to make a dent in the broader debt repayment requirement.
The cash flows
Supplemental to the balance sheet analysis, it is interesting to note the large cash drain the company has faced over an extended period. In Part 1 I related the history of the Hyflux business. Up until 2009 it showed volatile but impressive growth in reported cash flow and earnings. It is notable that after 2009 there was a divergence between (1) reported net profit after tax (NPAT), which is reported on the profit and loss statement (the statement many first look at and focus on) and (2) operating cash flow (OPCF), which appears on the statement many look at last. This was also around the time the capital structure of the business became increasingly complicated as the company found raised capital to fund the operating cash outflows.
As you can see from the chart, since 2009, OPCF has been consistently, and often significantly, negative. This is because the company has gradually become much more of a project construction company, which requires significant capital outlay up front and the cashflows are much further away. NPAT has been positive because of the increase in receivables.
Divergence in NPAT and OPCF for a period or two are nothing to be concerned about and can be readily explained in a large-scale projects business such as Hyflux, but when the differences persist over longer periods they signal misjudgment about cash collections, insufficient returns on capital investments obfuscated by inaccurate depreciation assumptions, or blatant earnings manipulation.
The OPCF divergence also confirms the cash collection issues faced by the Company, and the current liquidity crisis.
The above is even before we subtract capital expenditures, which almost since listing show that the Company has never had free cash flow. This is a capital intensive business that has consistently barely earned an adequate return on its assets.
In further writeups we will look at analysis of the data we have now set out.
Note: nothing in this analysis is to be taken as an investment recommendation.