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Hyflux: 6% perpetual Class A preference shares.

Wednesday, April 13, 2011

I owned units in Hyflux Water Trust in the past. That investment did very well for me and, unfortunately, the Trust was privatised not too long ago. Read blog post here.

Back in 2009, I was also considering between Hyflux and E-pure as beneficiaries of a global search for solutions to water problems. I went with E-pure simply because of valuation reasons. I have no doubt that Hyflux is a strong company in a strong industry too except that its valuation has always been too rich for me.

However, the news that Hyflux is issuing preference shares with an annual dividend rate of 6% is somewhat surprising to me. In an environment of low interest rates, isn't paying a 6% interest a bit expensive? It would only make sense to do this if borrowing from a financial institution would be costlier and it would only be costlier if the company and/or its business is perceived to be high risk.

The only preference shares that I have ever owned is DBS NCPS 6%. This was something I bought 10 years ago. Intuitively, and we won't be too wrong to say this, DBS is less risky compared to Hyflux. Indeed, if DBS should default, I think that's the end for Singapore.

In a nutshell, if I were to invest in Hyflux, it would not be for income, it would be for growth. To invest for growth, I would not invest in Hyflux preference shares. To me, it is that simple.



Data said...

Expensive capital and also quite substantial relative to their debt. Their non-current liabilities as of the latest financial statement is about $529m. With these preference shares they are asking for $200m, uppable to $400m. Am I missing something? Looks like common stockholders should worry...

AK71 said...

Hi Data,

Thanks for sharing the numbers. Raises a red flag, perhaps?

T.T said...

my virgin post here haha..

Hyflux has secured some contracts recently and it has a proven track record over the years in pay decent dividends. However, issuing cumulative preference shares is a very bold move in my opinion. It goes the show that the management is very certain that they can meet the dividends repayment. Also, considering that this is a perpetual issue, the move to step up to 8% pa after 2018 will certainly attract many investors.

I won't be concerned over the preference shares issue. I will be more concerned with the current shareholders. It certainly looks like it is much better buying the preference shares compared to the common stock.

Musicwhiz said...

Hi AK71,

When I first read the announcement and press release by Hyflux, my eyes were growing wider and wider. It would seem the yield on these CPS is a little high at 6%, but the fact that they are cumulative and rank above ordinary shareholders in payout should tell you something about Hyflux. In their (great) desire to raise money for their new projects, they might be short-changing their ordinary shareholders. Someone pointed out on another forum that ordinary shareholders get a yield of just about 2%, while CPS holders get a fixed 6%, triple the yield on Ordinary shares!

To further add to this, I looked at Hyflux's Balance Sheet and it was pretty heavily geared. This would imply that banks would not fund them anymore based on their Balance Sheet, and probably only on very expensive terms which would not be attractive to Hyflux. Since debt was out of the question, why not bonds or debentures to the public? This would further strain their gearing ratios and may interfere with some of their current covenants with their banks, I believe. Banks would typically require companies to comply with certain requirements for their Balance Sheet or else loans can be recalled or there may be interest-reset clauses (depends on the banking facilities letter).

So debt is out of the question, and this also rules out convertible bonds. For equity, a logical method would be a secondary offering (placement) at a discount to market price. Since this did not materialize I would have to assume that Hyflux could not get anyone to purchase additional new ordinary shares as the risks were either too high or the yield too low (or both lah). Hence, their resident financial engineer must have thought of this method of CPS, after seeing the blue chip banks like DBS issue RNCPS. Problem though, is that these are perpetuals and Hyflux has to buy them back some day, at par value or discount to market price. In the meantime, the Company will be coughing up 6% in interest twice yearly, and up to 8% after 2018 (I am assuing the company is still around by then). This is extremely expensive and the fact that it is cumulative also means ordinary shareholders may get nothing if the cash isn't in the kitty.

Hyflux must have a lot of confidence in its cash generation ability to dare to issue CPS with a 6% yield. Currently, the balance sheet (as at Dec 31, 2010) has about $600 million debt and just $222 million cash. This fund raising will raise up to $400 million, which means they just manage to be in a small net cash position. However, looking at the CFS, cash used for operations was $50 million, investing drained $95.7 million while the bulk of the inflows ($213 million) came from borrowings. Stripping the loans out, you would see interest paid on loans of $16.3 million and dividends paid of $34.2 million. This all adds up to about $196.2 million, which scarily is the amount the CPS hopes to raise (assuming no option to increase the number of shares issued). The Company had clinched some major contracts announced just recently and thus would need huge capex to fund these projects. Assuming strong competition and depressed margins, it remains to be seen if these new projects will bring about the desired cash flows which Hyflux is hoping for.

It also noteworthy that final dividend has been REDUCED to 3.5 cents from 5 cents per share a year back, even as the Company supposedly reported a 20% rise in net profit and a 9% rise in revenues. The key is to watch that Cash Flow Statement.

Financial liabilities (debts, loans) also increased 50% from $400 million to $600 million. Says a lot about their working capital management. The continual need to raise money would indicate that this round of CPS fund raising may probably not be the last.

So, in a nutshell, I'd avoid this as the high yield seems to be a veil which is hiding the true extent of debt and negative cash flows which the Company is reporting in its financial statements.


P said...

For me, a high capex business with a history of stingy dividends suddenly offering 6% cummulative preference shares just sounds too fishy.

Perhaps they will let the dividends "accumulate" and only pay a lump sum years down the road... logically that would be making the most out of the issue ;>

The risks of default is akin to a high income earner, who spends alot and suddenly comes up to you wanting to borrow $ with promise of high interest rates.

AK71 said...

Hi T.T,

Looks like the high yield is a major attraction for you since you feel that buying the preference shares is a better option compared to the common stocks. ;)

Yes, if I were a shareholder of the company now, I would be concerned at the cost of debt and how it would impact EPS and dividend payout for me in future. It will have an impact on common stock price.

AK71 said...

Hi MW,

Thank you very much for the thought provoking points you have raised and in great detail too. :)

I also believe that the reason why Hyflux is issuing such preference shares is because they are not able to get funding from financial institutions at a lower or similar cost. A heightened risk profile? I suspect so.

I also agree that ordinary shareholders should be very concerned with this exercise for the reasons you raised.

The water industry has been one that has enjoyed much limelight and it is possible for investors to grow complacent thinking that everything is OK.

AK71 said...

Hi P,

Your analogy of a high income earner with very high expenses suddenly coming to us to borrow money promising high returns is very apt! I smiled when I read this. :)

Your suspicion as to how Hyflux might not pay out the dividends regularly but accumulate them for a few years before paying a lump sum could happen, you think? It does make sense since they could use the money meant for the dividend payout first without extra cost. Another fish to chew on, perhaps. ;-p

la papillion said...

Hi AK,

Likewise, I'm not so in favour of it. I like to get preference shares below par value for the almost guaranteed capital value plus the higher yield.

But most importantly, I do not want to worry about the instrument at all after I get it. It MUST be fuss free and maintenance free, otherwise I might as well get other instruments. Hyflux, being not of pedigree birthright unlike the banks, make me think twice, despite the very good terms offered on paper.

My shameless advertisement of my article is put here for your perusal:


AK71 said...

Hi LP,

Thank you for sharing the link. I have read your blog posts on preference shares before and I feel that you are quite the expert on the subject.

It seems that there are more nays than yeas in response to this exercise, at least amongst readers who have commented in my blog. ;)

la papillion said...

Hi AK,

Posted part 2 in my blog already :)


Actually I think from cna, I've a feeling that more pple wants to get it than not. Remember, we are just the minority here, haha :)

Anonymous said...

Hyflux has not paid fat dividends, of course the story is growth.

AK71 said...

Hi LP,

I will pop by later tonight to read part 2. ;)

Well, I am not saying that people are shallow or anything but we tend to become complacent in good times. Of course, I hope that we are being too cautious and all who are getting the preference shares would make good money. :)

AK71 said...

Hi Anonymous,

Indeed, it should be a growth story. ;)

Could you include your name or initials in future comments? Thanks.

Anonymous said...

This Hyflux CPS is cumulative but not guaranteed. Does it mean that they could continue to pay dividend to ordinary shareholders and to accumulate the CPS dividend until they have sufficient funds.

I thought it would be like the Banks' where dividend of Preference share would be honor with priority over Ordinary share. If it is the same as Banks', then I would wonder if Hyflux would want to break its consistent dividend payout records (regardless how stingy they had been).

With higher debt, it is reasonable Hyflux to offer higher dividend to offset investment risk, quite similar to the model of REITs (i think), higher returns for higher yields.


AK71 said...

Hi TC,

Although the dividend is not guaranteed for the preference shares, it is not guaranteed for common shares as well.

If a dividend were to be paid to common shareholders, by definition, preference shareholders should be paid first. If a dividend were not paid to preference shareholders, then, I do not expect common shareholders to be paid any either.

It only stands to reason. :)

As for comparing Hyflux to REITs, we cannot even begin to think of a comparison as they are fundamentally different. For example, Hyflux pays dividends out of their earnings while REITs distribute income out of their cashflow. I also do not feel that REITs have higher (distribution) yields because their business risk is higher.

If I have misunderstood you, please let me know. :)

Anonymous said...

Hey AK71,

Thanks for the clarification. :)

The comments from the others were also informative and relevant. I suppose I shall reduce my exposure to just buy the minimum, betting that Hyflux would still around to provide the treated water much needed in Singapore. The 6% dividend is quite attractive to ignore.


AK71 said...

Hi TC,

I just put up a new blog post on the subject. Yes, I think being cautious is a good thing. Good luck on this one. We always need some luck. :)

JL said...

Same feeling here. My Wifey was asking me can buy or not and I spent some time looking at its AR 2010.

Hyflux (HF)could be in a tight cash flow position. More than 70% ($500M +) of their long term liabilities is expiring in 2011 to 2013. Exactly the same period they need the cash to fund their new contracts just closed.

At a gearing of 0.7+ it is unlikely banks will still lend at low interest (unless they can convince banks they can clear their current to be expired loans now.) Do note that a lot of loans are currently unsecured and only a few are secured. Problem of companies like Hyflux is a lot of projects are built for govt with a lot of T&C attached, hence using it to raised funding by "secured loans" is out of the question.

I do foresee quite a huge amount of the $ raised will be to funded so to be called loans. Hyflux must be confident of getting $ from their new projects to continue its cash flow.

Again is a catch 22 situation. For companies like Hyflux, once that start to default dividend, reputation is going to suffered greatly.

So catch 22 here. High risk, high gain.

The Preference share will cost Hyflux $24m a year. Which based on their net profit, means about 30% of profit will be wipe off (assuming EBITA around $100+M next year again).

You are right, common shareholder should worry if share price don't go up. Of course Hyflux could offer share bonus again which will lead to share dilution.

Previously brought DBS, OCBC and UOB shares (around 4-6% returns) and none gives me this headache. This is because banks has a long term direction of 10 years whereas companies like Hyflux direction can change rapidly due to economics changes.

I may just

a) buy 1 lot and let go part of it to minimize the risk (assuming it rise after a few days haha)

b) But some at open market later. Looking at other preference share OCBC UOB e.t.c.it is unlikely that hyflux PF will trade beyond 5 % premium. Of course, if you can go for 1% less dividend, go for bank share. Much more secure. Forget about cumulative. Companies give cumulative guarantee if they are worried that investors scared they default. All the banks never issue cumulative PF cos for the last 30+ years, they never default a single dividend payout. If SG banks default, PAP xiao liao. SG banks security speak a lot of the current finance minister ability. Do you think it can default???

b) Option 2 is to buy at open market later if you fear PF $ drop after issue. Assuming it trade 2-5% above par, the 6% dividend is still better than bank interest. It also allows you to buy in smaller trench to reduce your exposure.

WHy squeeze 1% extra dividend for that kind of risk? Hyflux has a total close to $300M of loans maturing in 2011 which about $240M is unsecured and unlikely banks will not recall back unless Hyflux prepared to borrow at higher interest rate. So make sense to raise $400M right?? I am not sure if their current cash flow + balance left over of PF (est 300M) can fund the future 2 billion contract without raising extra liquidity in future.

AK71 said...

Hi JL,

Many thanks for the very detailed analysis. :)

I kept nodding my head as I read your points. Agree, agree, agree.... and agree. ;)

Well, many still went ahead to apply for the preference shares despite the concerns. It is either they are very confident of Hyflux's future or choose to ignore the high risks.

Like you said, why live with all the risks for an extra 1% of potential dividend. Yes, "potential". ;)

WL said...

April 19, 2011 9:57 PM: JL said... "Same feeling here. My Wifey... I am not sure if their current cash flow + balance left over of PF (est 300M) can fund the future 2 billion contract without raising extra liquidity in future...."
Is it really $2B in total? Me wonders if they have a pay in stages option- i.e. gradual payment scheme according to work completion so that geo-political risk can be spread both ways- this would be the wiser way to do these big projects. I do hope tt Hyflux has such minimum foresight i n the conduct of these deals.

AK71 said...

Hi WL,

You might want to send an email to Hyflux's Investors' Relations Department if it worries you sufficiently, especially if you are vested. ;)

Anonymous said...

One of my frd manage to get some. But funny, he got only 30 out of 100. How to sell that in future ? As mostly preference share is 100.


la papillion said...

Hi TN,

The preference shares are traded in board lots of 10 shares. So if you want to sell it, just sell 3 lots of it.

AK71 said...

Hi TN,

"Hyflux 6% CPS 10", it says. So, I guess there is no problem selling the shares for your friend since the shares are traded in 10s. :)

AK71 said...

Hi LP,

You are an early bird. Thanks for the corroboration. :)

Dolly & Zoopy said...


What is your opinion on bank's NCPS like DBS, OCBC?
They pay dividend like 5.1%. Are there risks? Pls advise

AK71 said...

Hi Dolly and Zoopy,

The banks' NCPS are great investments for income, I feel. However, at the current prices, the yields are somewhat lower.

The most obvious risk for any investor is if a dividend payment is missed, he would never receive it. This is what is meant by non-cumulative.

However, the risk of a missed payment should be quite low.

Personally, I was vested in DBS NCPS 6.0% for 10 full years and not a single dividend payment was ever missed. :)

AK71 said...

Water treatment firm Hyflux has launched an offer for up to $300 million in perpetual capital securities, paying out 6 per cent a year.

The bulk of the perpetuals - up to $230 million - will be offered to the public, the group announced yesterday.

Of the remaining, up to $20 million will be offered to directors, management and employees of Hyflux and its units, and up to $50 million will be set aside in placement to institutional and other investors.


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