Focus on municipal business. Increasingly, Hyflux has also turned its attention to the municipal sector for growth. This comes as no surprise as most major environmental projects are initiated by the public sector. In addition, governments typically use these major projects as means to pump prime their economies during recessions; China has already launched a massive RMB4t aid package to stimulate its economy where a large portion will be spent on environmental protection. However, due to the lower risk associated with these projects, gross margins are typically much lower (as much as 10 percent points less).
Growing order book but lumpy revenue stream. Currently, Hyflux is sitting on an impressive order book of S$1.5b (end 2008), up from the S$1.1b as of end 2007. Going forward, management remains confident that it can continue to grow its order book by some 20% this year. It is also cognizant of the fact that its EPC business, which contributes some S$1.1b to that order book, can be lumpy in terms of revenue recognition, and is thus working to increase its O&M business, which is more stable as it provides recurring revenue over the projects. However, funding for these projects could remain a concern, given the tight credit situation. Fortunately, management is able to alleviate this by adopting an "asset light" strategy where it constantly monetizes its completed projects to finance future projects.
Initiate with BUY and S$2.03 fair value. While the outlook for the water treatment industry has improved, we believe that not all companies will benefit equally - only those with superior technology, proven track record and strong financial position would emerge victorious. We see Hyflux as one of these victors. We initiate coverage on Hyflux with BUY and a DCF-based fair value of S$2.03.
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