Published August 18, 2008

A way out for the unhappy Hyflux investor

By CHEW XIANG
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HAPPY Investor, who put 32 cents into Hyflux at its initial public offering seven years ago, is now sitting on impressively hefty gains - around $6 in capital gain (including a number of bonus share issues), plus about 15-odd cents in dividends.

Unhappy Investor, who bought into Hyflux three years ago, at $3.20 in mid-August 2005 (it hit a year-high of $3.92 on July 26 before tumbling), has instead received just 4.6 cents in dividends and on paper is down roughly 20 per cent.

Why? Since 2005, Hyflux, a pure play water treatment firm, has come on strongly. For the whole of that year, it reported revenue of $131.5 million, and net profit of $46.3 million, or 9.21 cents a share.

That's not far off the results it recently reported for just one quarter - $22.6 million net profit on record turnover of $108.1 million. In 2007, the company earned $33 million, with $192.8 million in sales. EPS was 6.32 cents.

So despite the recent strong results, the company has been comparatively niggardly in rewarding shareholders in the past few years. That's even though Hyflux, in its latest half-yearly results, said it held $93.6 million in cash and had generated strong operating cashflow for the quarter.

But Hyflux, in any case, has never been a dividend stock. Analysts and investors have always seen it as a growth stock benefiting from global water shortages, rewarding shareholders through appreciating share prices.

The company prefers to retain earnings for capital expenditure and that's reflected in its comparatively lower dividend yield - 0.8 per cent last year, by most estimates, compared to around 2 per cent for similarly-sized water companies worldwide.

The problem with that story, at least recently, is that the company's stock performance has been lacklustre. Part of the problem is the meteoric rise in Hyflux's share price in its first few years on the exchange - not too long ago, it was priced at over a hundred times earnings.

So the market probably sees recent results as the fulfilment of early potential, rather than a reason to hike prices even higher. That's reflected in sobering valuations - about 14 times forecast earnings in 2009 and 2010, according to JPMorgan, while CIMB's Jessie Lai sees forward price-earnings ratios at between 17 and 20 times for the next two years. A far cry from just last year, when the stock was priced at 40 to 50 times earnings.

So what is Unhappy Investor to do? Analysts are setting price targets of between $3.30 and $3.80 - that means he won't gain much even if the most optimistic forecasts are met.

And even though analysts are seeing record earnings ahead on contract wins and divestment gains to Hyflux Water Trust, dividends are likely to stay relatively slim as the company gears up for more expansion. A $300 million medium-term note programme is in the works, and more debt through bank lending is likely. What cash is likely to be disbursed will be through its listed business trust.

So is Unhappy Investor forced to take the hit and switch to, say, Hyflux Water Trust? The trust recently reported above forecast half-year distribution per unit of 2.17 cents, an annualised yield of 6.7 per cent and is predicting 7.7 per cent this year - a fair return in turbulent times.

Yet there could be another way out. In 2005, Hyflux's seemingly strong earnings were boosted by one-time items. Core earnings declined 18 per cent, as analysts were quick to point out. But the most recent quarter's results showed surprisingly good margins - gross of 36 per cent, compared to 23 per cent in the year-ago period - and steady net operating cash flow of $16.7 million, compared to just $422,000 a year ago.

So at one end the company has proven itself capable of reining in costs for its water treatment projects despite record construction costs and soaring inflation; at the other end, it has by its own account been extraordinarily adept at negotiating tariff increases to relieve the pressure. These were issues that bedevilled it three years ago, when some were sceptical about its ability to deliver on its strong order book.

It's not entirely clear how the recent improvement was achieved. Chief executive officer Olivia Lum credits the massive build-up in human capital over the past few years - personnel expenses have doubled year-on-year - for helping to mitigate the increase in input prices. How exactly this is achieved is a mystery. The company, naturally, wouldn't give too much away.

But if the change is a genuine and persistent improvement in the company's ability to execute projects, then the stock should see its earnings multiple re-rate to more bullish levels. Admittedly in today's investing climate, that doesn't look too likely, as wary investors put more cautious valuations even on growth stocks. But that could be the only profitable way out for Unhappy Investor.