Hyflux: Clearer visibility, stronger funding

We have upgraded our price target to S$3.50, as we raised FY09/10 earnings forecast to account for higher margin. The recent hike in water tariffs in China's main cities, and an improving investment climate, has also resulted in a higher valuation for Hyflux's BOT portfolio. We maintain our BUY call on Hyflux with 22% upside to TP. We believe recent developments have raised the company to a whole new level, as outlined below.

Firstly, earnings visibility is clearer than ever. This is underpinned by a firm orderbook of S$952m to be realized over the next 18 months. This is excluding the potential S$1.1bn worth of projects from Libya pending finalization and financial close. When these are officially awarded by early 2010, earnings visibility will extend to 2013. In the meantime, Hyflux is actively bidding for jobs in new markets such as India and more countries in the Middle East including Tunisia and Morocco. As such, we expect Hyflux to impress the market with yet more contracts from new locations.

Secondly, Hyflux's financial backing has grown stronger especially after its collaboration with the Japan Bank for International Co-operation (※JBIC§). Funding is not only critical for project executions; the ability to monetize completed projects is imperative for further growth. As more plants are being completed in China, we believe Hyflux would have a critical mass of water plants by next year, ready for divestment. It also helps that HWT with a lower cost of capital following the market recovery is in a better position to acquire yield accretive projects. Divestments will provide an instant lift to earnings in 2010.

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Hyflux - Collaboration with Japan Bank for International Cooperation

Hyflux and JBIC signed a Memorandum of Understanding (MOU) for global collaboration on water projects. The two parties will look to identify areas in the future where JBIC will provide financing for Hyflux’s water projects which involves the participation of Japanese equipment suppliers or investors.

JBIC is keen to have Japanese firms gain international exposure to the growing water industry, where it already has advanced technologies in water treatment. Hyflux, which has already been purchasing equipment from Japanese suppliers, only stands to gain from having a strong financier for its water projects.

JBIC is a policy-based financing institution which has a current capital of JPY985.5 billion. Its mission is to contribute to the international economy and promote Japanese industries. Under its recent initiative to support environmental sectors, it is committed to provide finance support of 5 billion USD for the next two years.

Hyflux will potentially be able to replicate globally the financial models for its Algerian projects, whereby JBIC will provide the project financing and equity for its water projects while Hyflux executes and profits from the EPC and O&M portions. Such a model suits Hyflux since it reduces its equity contribution, and removes its balance sheet constraints when taking on new projects.

We await further development on this front. Should this be materialised further, contracts win momentum could accelerate again in China where Hyflux has been hesitant to pick up new projects due to balance sheet constraints. We maintain our SOTP target price.

Hyflux: Resurgent 2Q09 results

Resurgent 2Q09 results. Hyflux Ltd posted its 2Q09 results last night, where revenue jumped 24.4% YoY to S$134.5m, while net profit climbed 14.7% to S$25.9m. The better performance was due to the progressive completion of higher-valued projects, especially from the MENA region, with continued active project execution driving improved gross profit margins. More importantly on a sequential basis, revenue shot up 52.4%, while earnings surged >400%, but this comes as no surprise as we had already noted the seasonality factor in our 1Q09 report (also see Exhibit 1). And for 1H09, revenue climbed 12.7% to S$222.7m, meeting 36.4% of our FY09 forecast, while net profit rose 9.6% to S$31.0m, or 50.4% of full-year estimate.

Municipal business continues to drive growth. On a segmental basis, we note that growth continues to be driven by its municipal business, which jumped 34.5% YoY and 54.6% QoQ to S$116.6m in 2Q09, aided by progressive EPC recognition of the Tlemcen and Magtaa projects in Algeria. While industrial business fell 17.4% YoY to S$17.6m, it was up 41.9% QoQ, where there have been signs of a business recovery in China. Going forward, management notes that municipal sector's fundamentals remained strong and expects the MENA and China markets to remain key contributors to its revenue.

Key MENA and China markets. Its current order book stands at S$1646m as at end-Jun, up further from the S$1480m at end-Dec (see Exhibit 2);more importantly, Hyflux pointed out the increase came mainly from its Operations & Maintenance segment, which surged 1.1% to S$694m following the completion of several China plants - this would translate into stable income over the next 20-25 years. While its S$952m EPC orders will progressively be recognized over the next two years, we expect this "shortfall" will be replenished by its two potential contracts in Libya - we had earlier estimated that the project value of the two projects should easily exceed S$1b (to as much as S$1.5b) but the actual deals may take up to 1.5 years to conclude. Hyflux is also looking at new markets like India but for the moment, it prefers to remain more of a technology provider.

Raising fair value to S$2.96. Due to the better-than-expected recovery in gross margins, we have bumped up our FY09 net profit estimates by 17.9% (FY10 by 17.5%), while keeping our revenue estimates unchanged. This in turn raises our fair value from S$2.52 to S$2.96, still based on 20x blended FY09/FY10 EPS. Maintain BUY

Hyflux Water Trust Results Highlights

Earnings highlights. 2Q revenue fell 60% YoY to S$6.6m, due to the lack of construction revenue. This has no impact on the bottom line or distributable income. Moving forward, the manager says construction revenue will become an insignificant part of HWT's revenue as HWT only intends to acquire completed projects. If construction revenue is stripped out, 2Q adjusted revenue rose 76% to S$6m (O&M and finance income only). Net operating income rose 27% to S$2.7m.

Unitholders will receive 2.56 S cents for 1H09, versus 2.17 S cents a year ago (+18% YoY). This is after the subordination to the sponsor, who will receive 1.77 S cents per unit (no distributions received a year ago).

Outlook. Utilization was flat QoQ at 44% as HWT's capacity grew but investments in industrial parks slowed. The manager said that the unused capacity will stand HWT in good stead when the Chinese economy "powers back to life again". HWT said it has seen signs of recovery in the PRC market but the manager does not expect this to translate into a "sudden surge" in the next two quarters. HWT is positive on the fundamentals for the PRC water sector in the mid-to-long term.

Growth depends on credit availability. HWT says that, from a Singapore perspective, the credit market seems to be easing but not on a broad basis. HWT's bankers are telling the trust that debt is available to sovereign institutions and "super-blue-chips". But the bankers say credit availability should improve in 2H09. From a PRC basis: there is still a lot of liquidity both generally and for the water sector. Currently, HWT's acquisition plans are on a two-year framework, but this could be accelerated if the market improves.

HWT has guided for a 2H09 DPU of 2.86 cents per unit. This is equivalent to an annualized trailing yield of 8.4%.

Hyflux - Searching for growth in Libya

Hyflux’s fast-growing gearing had been a market concern, which may counter future growth ahead. Net debt-to-equity rose 28pp q-q to 82% in 1Q09, approaching our expected 113% for end-FY09. However, management reiterated that: 1) it can repay trade payables by cash from EPC revenue generated by the Algerian projects on percentage of completion, 2) Algeria has no restriction in capital repatriation, so liquidity is not a concern despite aggressive capex, and 3) the Middle East projects, the main growth driver going forward, are less capital intensive than China’s projects.

While building the world’s largest membrane-based desalination plant in Algeria, Hyflux entered into a MOU to build two desalination plants in Libya, in Tripoli and Benghazi. The plants would cost S$1bn, with a combined capacity of 900k m3, and planned to be financed by an 80:20 debt-to-equity ratio. The signing of these projects would substantially lift the orderbook and operational income from current levels.

China’s water market is still at a development stage and existing capacity is far behind the government’s target as per the Eleventh Five-Year Plan. Management indicated Hyflux’s revenue contribution from the Middle East and North Africa would continue to expand beyond its current proportion of 40% in FY08, due to the upcoming Tlemcen and Magtaa projects in Algeria, but it believes Hyflux remains a major beneficiary of China’s growing water market. Given that Hyflux has already shown a successful record of penetrating into the Chinese water market (China accounts for 54% of total revenue in FY08), with its proprietary membrane technology as a competitive edge, growth in China can be a potential surprise on the upside, in our view.

The orderbook looks healthy (S$1.15bn in end-FY08). Hyflux would focus its attention in delivering projects already in the pipeline, which would continue to deliver strong growth in FY09-10F.

Hyflux - No rights issue and share placements

The recent spate of rights issues and share placement deals has prompted some market talk of Hyflux being the next in line, given the relatively high gearing ratio of the Group. However, in our recent discussion, management has stated categorically that there will be no such development in the near future as they do not see the need for it.

We agree with management that despite a net gearing ratio of 0.8x currently, there is no cause for concern. Even with a $300m Medium Term Note programme in place since June 2008, the Group has only drawn down $23m so far in the previous two months at the bankers’ request. The rates were at 4-5%, which we believe is favourable.

The share price of Hyflux Water Trust has risen 47% year-to-date to $0.52 currently. With the implied dividend yield moderating to a more realistic 10.7%, the trust is now in a better position to absorb yield accretive BOT projects from Hyflux. This continues to be important to Hyflux’s capital recycling strategy.

Following the cessation of its Middle East joint venture with its Dubai partner, Istithmar in 2006, the latter has been selling down its 9.7% stake in Hyflux. Management believes Istithmar has exited completely, following some private placement deals recently. We believe this removes a major share price overhang. In its place, Japan Gas Corporation, whom similarly has a presence in Algeria, now owns 2-3% of Hyflux.

We have rolled forward our SOTP valuation to FY10, lifting our target price to $2.63 in the process. Valuation for its international peers such as Veolia has improved substantially since our initiation report in April. Despite its smaller, we continue to believe Hyflux should be traded at a premium with its better growth potential and lower cost base.

Hyflux - Agreement to develop two mega desalination plants in Libya

Hyflux has signed a memorandum of agreement (MOA) with the General Desalination Company (GDC) of Libya to jointly invest into and develop two reverse osmosis desalination plants in the Libyan cities of Tripoli and Benghazi. These two plants will have capacities of at least 500,000m3 and 400,000m3 respectively.

The structure of these projects is likely to be similar to Hyflux’s current Magtaa desalinationproject in Algeria. This allows Hyflux to undertake the entire EPC portion of the work and part of the O&M work subsequently without an over-exposure to equity risk, which is capped at 10% of total projected value. Our preliminary estimates suggest the EPC contracts could be worth a total of S$1.2b.

Libya, which is situated in Northern Africa, has the 2nd highest GDP in Africa, largely due to its 12th largest oil reserves in the world, and has financial reserves of US$59b. Hyflux’s presence in the country will be preceded by large multi-national companies such as Shell and Exxon Mobil. While we recognize there is still an element of political risk, we believe this is mitigated by the structure of the projects.

Prior to this, Hyflux has not announced any major contracts for the past 12 months, which we believe has led to sceptism about earnings sustainability for the Group. This agreement affirms our investment thesis that with the successful execution of its Algerian projects, Hyflux is becoming a major global player, with many potential opportunities.

We expect more details of the contracts to emerge in about three month’s time and the construction to start in the 2nd half of FY10. These contracts could add earnings visibility till FY14. We are likely to raise our FY11 once contract details are ironed out. In the meantime, we are keeping our target price of $2.63 based on SOTP.

Hyflux: A bigger victory in MENA

Going bigger and faster in MENA. The MOA is to develop in Libya (1) one 500,000m3/day capacity desalination plant in Tripoli, and (2) one 400,000m3/day desalination plant in Benghazi. Compared to Hyflux's biggest win in Algeria ? 500,000 m3/day in Magtaa, these potential contracts totaling 900,000 m3/day is almost twice as big in terms of capacity. It is anticipated that Hyflux will undertake the EPC portion while the 49/51JVCOs with its state-owned Libyan partner would be responsible for O&M throughout the 25 years concession period.

Projects worth S$1.1b potentially. While financial details are still in the works, we estimated these contracts could add S$1b to Hyflux's EPC orderbook, which is currently about S$700-800m. Assuming financial close for both projects are completed by 2010, projected completion duration of 36 months implies that Hyflux's earnings visibility will be extended to 2013.

Upgrade to Buy, TP S$2.82. We have raised FY10 forecast marginally in anticipation of minor contribution next year when the contracts are officially awarded. In addition, the expected receipts from these projects have also boosted DCF value of Hyflux's BOT projects. Consequently, our SOTP fair value was raised to S$2.82, translating to 24x FY09 PE, which is still below historical average PE of 26x.

Hyflux - Positive on water tariff hike in China

Company Overview — Using its own propriety membrane technology, Hyflux provides water and wastewater treatment services. It has expanded to other applications including separation requirement for various industrial manufacturing processes and recycling of used oils and solvents. The market expects its 09 revenue to grow ~20%, on the back of 3 big projects in China and Africa. Based on 9% consensus EPS growth, Hyflux trades at 18x 09 P/E,

Business Strategy — Focus on municipal projects in China and MENA (Middle East and North Africa), particularly water projects. Municipal projects represent >85% of total revenue. China now accounts for >35% of total rev, and MENA represents >55%.

Industry Overview — Amid economic growth and urbanization, mgt sees tremendous potential for water treatment in China and MENA, and sustainable in next few years. Hyflux views increasing commitment from China on environmental control. Hyflux sees good growth in water plant operations as it believes water tariffs in China will rise for years. Mgt targets at 8-10% IRR in China and >10% in MENA.

Competitive Analysis — Competition is keen in waste water treatment. Mgt sees limited threat in other service areas like desalination and recycling, thanks to its membrane technology. While pricing is important in bidding process, track records, brand names and design & engineering are more critical, mgt views.

Recent Results — Despite 1Q rev reducing 2% to S$88, pretax profit grew 23% to S$6.8m, backed by 9ppt GM improvement. Net profit however dropped 11% to S$5m due to tax credit in 1Q08.

Strengths — Propriety membrane technology; in-house production facilities for membrane; good scale of operation; long track records in China; good R&D.

Weaknesses — 82% net gearing; volatile nature of revenue; tariff hike subject to gov’t approval; surge in receivable days.

Hyflux – All major projects are sailing along

While both 1Q revenue and profit attributable were below our expectations, the underlying profit for the period was encouraging, with EBIT increasing 23% yoy. The two main deviant items from our expectationswere China municipal revenue and the effective tax rate. However, 1Q has historically been the weakest quarter and not a good reflection of the full year.

We believe the lower than expected China municipal revenue will be rolled forward to the next quarter when a few BOT projects are due to be delivered. Effective tax rate for the quarter was 25.7%, higher than FY08’s 11.6%. However, management expressed that effective rate for the full year is still likely to be within previous guided range of 10-15%.

Cost of goods sold decreased 9% due to lower commodity and material costs. This lifted gross margins from 23% to 33% on a qoq basis and is also higher than FY08’s 30.7%. This positive development alleviates some of our worries that cost overruns could develop at its MENA (Middle East and North Africa) projects due to the competitive bid for the Magtaa project.

All three key desalination projects are running on schedule, with preliminary groundwork on the Magtaa project underway. With the investments into its projects, net gearing has increased from 0.4 to 0.8. This is within our expectations, as highlighted in our 1st april 09 report where we forecasted net gearing to increase to 81.5%.

We maintain our BUY call on Hyflux and lift our SOTP target price from $2.13 to reflect the higher market value of its stake in Hyflux Water Trust. We believe the Group will remain selective on capital-intensive BOT projects due to the tight credit market. However, if credit markets continue to ease, the Group’s appetite for winning new projects may return.

Hyflux: Still upbeat about the water sector

Seasonally weaker 1Q09 results. Hyflux Ltd posted its 1Q09 results last night. Revenue fell 1.6% YoY at S$88.2m, mainly due to the continued weakness in industrial sales in China (down 35.1%), hit by the challenging economic conditions. But municipal sales managed to grow 7.3% YoY, driven by its still strong order pipeline in that segment. Gross margin also improved from 23.3% in 1Q08 to 33.2%, largely aided by lower raw material prices as well as subcontractor's costs. Nevertheless, due to the absence of a tax credit in 1Q09 (versus S$1.1m in 1Q08), net profit slipped 11.5% to S$5.1m. On a sequential basis, revenue tumbled 50.8%, while net profit tumbled 62.0%, highlighting the usual seasonality of its revenue stream; the first quarter typically records the lowest revenue due to the long Chinese New Year holiday in China.

Upbeat about Algeria, China prospects. Going forward, management believes that the outlook for the water industry remains upbeat, especially in Middle East & North Africa (MENA). Hyflux is particularly bullish about its growth potential in Algeria, as it has just achieved financial close for the US$443m Magtaa Desalination Plant - touted to be the largest in the world with a capacity of 500k m3/day. Construction of the US$200m Tlemcen Plant is also progressing well and is expected to be operational by end 2009. Meanwhile, management is also equally upbeat about its prospects in China, where the company is building and/or operating as many as 30 water treatment plants. One area that Hyflux sees potential is in the growth of water tariffs in China, which are still extremely low by international standards. Although tariffs have grown some 60% between 2003 and 2007, the average is around US$0.20/m3 versus global average of US$3.00/m3.

Expect seasonal uptick in 2Q09. Although management did not provide an update of its order book - EPC jobs last stood at S$1.14b (end Dec 08), the ongoing projects to be completed should ensure that revenue and earnings see the seasonal uptick in 2Q09 and the rest of the year. As such, we are leaving our FY09 estimates unchanged despite 1Q09 revenueand earnings meeting just 14.4% and 8.3% of our full year estimates. And given the recent re-rating of the equity market, we correspondingly raise our valuation from 16x (trough) to 18x FY09F EPS and our fair value from S$1.87 to S$2.11. Maintain BUY.

Hyflux - Seasonally weaker 1Q

1Q09 core net profit of S$5.1m (-11% yoy) came in within consensus and our expectations. 1Q is seasonally weaker for the group, and accounted for 6.9% of our FY09 forecast. The decline in profit was due to the effect of a tax credit recorded in 1Q08. PBT was up 22.8% yoy to S$6.8m in 1Q09. Construction of the Magtaa plant in Algeria has commenced and is scheduled for completion in 28 months' time. Our estimates are intact, target price unchanged at S$2.66, still based on SOTP valuation. Hyflux is well-positioned to weather the economic turmoil on the back of its municipal business, which should benefit from government infrastructure projects. Maintain Outperform.

Hyflux Ltd posted its 1Q09 results last night, with revenue seasonally weaker as expected; revenue fell 50.8% QoQ (down 1.6% YoY) to S$88.2m, while net profit tumbled 62.0% QoQ (down 11.5% YoY) to S$5.1m. Besides the usual disruption due to the long Chinese New Year holiday in China, its industrial sales there were also affected by the economic slowdown. Nevertheless, Hyflux continues to remain upbeat about the water industry, and about its prospects in both Algeria and China. Although management did not provide an update of its order book ? EPC jobs last stood at S$1.14b (end Dec 08), the ongoing projects to be completed should ensure that revenue and earnings see the seasonal uptick in 2Q09 and the rest of the year. As such, we are leaving our FY09 estimates unchanged despite 1Q09 revenue and earnings meeting just 14.4% and 8.3% of our full year estimates. And given the recent re-rating of the equity market, we correspondingly raise our valuation from 16x (trough) to 18x FY09F EPS and our fair value from S$1.87 to S$2.11. Maintain BUY.

Hyflux - Maintain BUY recommendation with $2.13 target

Hyflux will be reporting its 1QFY09 results on 7 May. With a firm orderbook in place, we expect our full year FY09 estimates to be quite evenly distributed over the four quarters. Consequently, we believe 1QFY09 results will be substantially stronger on a y-o-y basis but relatively level on a q-o-q basis.

Despite the tough economic conditions, Hyflux is continuing to increase its staff headcount as well as beefing up its management team. Key hires recently include Ms Winnifred Heap (Formerly JP Morgan Head of Research) as Group Executive Vice President, Capital Markets and Mr Lee Soon Eng (Formerly Executive Vice-President Sembcorp Industries) as Senior Managing Director, Global Operations.

Hyflux announced that it has achieved financial close for its 500,000m3/day desalination plant in Algeria in March 09. With this green light to start work, we expect management to shed some light on its progress. This is also in line with our estimated revenue recognition pattern for this project, which we believe will form around 20% and 39% of total revenue in FY09 and FY10 respectively .

In our recent discussions with the Trust’s management, they reiterated their confidence that they will be able to meet their forecasted DPU of 5.26 SG cents and could potentially gain from higher water tariffs in China. Strong performances by HWT would vindicate Hyflux’s capital recycling strategy.

We maintain our BUY call on Hyflux with a SOTP target price of $2.13. With funding for its major projects secured, we believe there could be new contract flows in the near future to replace existing projects in China. We also expect increased market confidence as Hyflux continues to execute its prominent desalination projects.

Hyflux - Crystal Clear Choice

Leading environmental company in Asia. Hyflux Ltd (Hyflux) is one of Asia's leading environmental companies, offering integrated waste-water treatment solutions and services using its proprietary membrane technology. Hyflux has its operations and projects mainly in Singapore, China, the Middle East and North Africa (MENA) and India. Based on its FY08 results, Hyflux derived 54% of its revenue from China, 40% from MENA and 6% from Singapore and other regions. Flagship projects in Singapore include the nation's first S$200m desalination plant; in China, they include a 100k m3/day desalination plant in Tianjin; in Algeria, the company is involved in building a S$632m 500k m3/day desalination plant.

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.