Why Hyflux Went Kaput I Lessons Learned From Hyflux I Kristal.AI
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The High Flux Story of Hyflux (And the Lessons From the Deep)

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Carl Sagan (American Astronomer): “You have to know the past to understand the present” 

Arun Pai (aspiring value investor/entrepreneur) “.. and to even begin gauging the future”.

 

Sticking to our theme of ‘Water Quality Month’, and having lived in Singapore for over a decade now, no company brings up extreme emotions like Hyflux. A visionary founder, a home-grown unicorn success story, a business that had a social cause, pillaging money from retail investors who did not understand better, banks turning a blind eye … the Hyflux story has it all.

Ever striving to be better investors/business people (as Warren Buffett says: “ … my experience in business helps me as an investor and that my investment experience has made me a better businessman) we shall attempt to dissect the company both from a financial and strategic angle and see where it all went wrong and if salvation is possible.

I will try my level best to refrain from taking advantage of the one phrase that has stuck with me from my trading days “hindsight is 20/20” – this is not to find fault with a singular person or entity, but more to check if there were there any tells, and if any action to remedy the situation could have been undertaken (from the perspective of an investor/operator of the business).

 

As It Began….

Our rags to riches story starts with Olivia Lum. Abandoned at birth in a town called Kampar in Malaysia, she overcame all odds and courtesy her studious demeanour managed to get admission into the prestigious National University of Singapore, with a major in Chemistry. After just 3 short years, in 1989, she took a leap of faith and left a cushy job at Glaxo Pharmaceuticals to fulfil her dream to set up her own business. Hydrochem (S) Pte Ltd (what has now morphed into Hyflux) was incorporated on 20 June, 1989, by Olivia with the $20,000 she raised by selling her apartment and car.

Her inspiration to start up was an educated macro call that the pace of industrialisation and urbanisation is only going to speed up leading to polluted waterways, and hence a water treatment business will always be in high demand. Singapore was a tough market to crack as clients did not want to experiment with anyone new, but armed with a Singaporean ‘Tampines Industrial Park’ office address, a smart pivot to target factories across the border in her mother land Malaysia bore fruit. She started with JB, which is right on the border, and given her stretched finances and the consequent inability to bear flight costs to target deeper cities, this was a smart beginner move.

The 90’s saw Lum – and Hyflux – setting up a strong foundation, investing in the right membrane technology, and ramping up business and client numbers (ergo revenue) in Malaysia and beyond. The company further expanded into China in 1994 and began opening its doors to foreign investments.

 

**Fun Fact – In 1999, an R&D team was set up at Hyflux with the aim of manufacturing its own range of membranes. The first generation of hollow-fibre ultrafiltration (UF) membranes was called Kristal.

 

While like any founder sales were her ultimate priority, and important to strengthen the long-term viability of the business, the only department she personally micro-managed was the R&D wing of Hyflux – Olivia was, after all, a chemist at heart.

 

The Glory Period

The company went from strength to strength, ending up with the coveted title of being the first water treatment company to be listed in Singapore in 2001. This emboldened Hyflux to take on large-scale projects such as supplying and installing the process equipment for Singapore’s first NEWater plant.

Source: Hyflux website

Post winning a number of other PUB contracts, 2003 brought the next big milestone with Hyflux beginning work on owning and operating the first seawater reverse osmosis (SWRO) desalination plant  in Singapore, using patented membrane technology.

It was not just Hyflux’s first desalination plant, but the project value of approximately S$200 million was larger than the company’s market capitalisation at the time. This of course made headlines in a good way back then, but contrary to Hollywood, not all publicity is good publicity. The hype thus created pushed the decision makers at Hyflux to take on a lot more risk, even as the economy neared a precipitous fall.

 

Oil Crisis.. GFC .. Pfft – The Strategy Shift

All this while, the management was more focussed on EPC (Engineering, Procurement and Construction) method of deliverables which in lay terms basically means: build the required project and pass it back to the owner to operate.

While, depending on the credit terms, it’s a lower leverage method of doing business, the revenue can be lumpy given the variable nature of contract closing dates and being one-off projects – but as can be seen by the spectacular growth rate this was not an issue for Hyflux.

Around the time of the GFC in 2008, things changed – the company placed greater emphasis on an Operations and Maintenance (O&M) business model which involves not handing off the project but keeping it on its books (for the tenure of the contract – typically 20 to 30 years). This, of course, evened out revenues and earnings, but increased leverage and operational liability – something that would come back to haunt them later.

 

hyflux-key-financial-data

hyflux-key-financial-data-2

hyflux-key-financial-data-3
Hyflux revenue, profit after tax, shareholder eq, total assets, ROE and from Bloomberg total debt, free cash flow line items (2004-2017)

 

Water Purification Electricity Generation Company

As Hyflux recovered, along with the rest of the world, from the GFC (Hyflux’s market cap peaked in 2005 at close to 2 Bln USD, and post a 50% correction came back to the same levels in 2011), it took on even larger projects; winning a contract  for the Tuaspring Integrated Water & Power plant project in 2011 – its crown jewel at the time.

Hyfux-market-cap-graph
Hyflux market cap graph 2000-present

At a project price tag of 1.4 Bln USD, approximately, this was a massive factory to set up; especially given it was Hyflux’s first foray into the power generation space. The rationale that was put to the board was seemingly sound – energy costs are the largest component of desalination plants; hence, combining both would lead to tremendous synergy and operational efficiency.

The only issue was the amount of energy required for purified water output: the plant would utilise only about 40 MW; instead the capacity created was 411 MW – over a 10X multiple. It was decided that the excess would be sold off on the energy market which on paper looks like a great deal; but which essentially turned out to be Hyflux’s undoing. 

Based on the USEP (Uniform Singapore Energy Price) of SGD 220 MwH (in 2011) the projections could have been quite rosy; but the oil crash of 2013, along with the deregulation of the electricity supply market in Singapore, caused prices to crash to a low of 63 MwH in 2016.

Suddenly, electricity generation was a hassle. And things started to look bad on the water purification side, too. Hyflux’s contract explicitly stated that the PUB would decide how much purified water would be purchased. The plant running at full capacity could generate a bit under 320,000 cubic meters in 2016, which was the expected requirement for Singapore’s population for 25 years in the future!

Price chart of oil showing percentage drop from end 2014, to beginning 2016

Seems like during this period, contrary to the first decade of the new millenia, nothing could go right for Hyflux. Internationally, the unexpected oil crash from 2014-2016 led to many of the Middle East clients cancelling or putting on hold the MOUs signed with Hyflux due to their own financial imbalance.

 

The Beginning of the End… 

But given the asset-heavy (and hence liabilities) business model Hyflux had now undertaken, they were saddled with the debt of the existing projects. Free cash flow had been negative since 2009, and it did not help their cause when a chunk of their tertiary offerings which were subscribed to by retail customers (all 34,000 of them) ended up attracting high headline interest rates.

This brought Hyflux’s woes into the spotlight along with the banks who potentially mis-sold the instruments by not adhering to their fiduciary responsibility. Even Temasek was not spared with many retail investors (incorrectly) believing Hyflux was coat tailing off the former’s investment and that the holding company would not allow Hyflux to go under. Temasek was an investor in Hyflux, but for a very short period of time from 2003 to 2006 – guess the smart money did manage to get out in time.

 

The Now… 

Attempts to sell the Tuaspring project have been easier said than done. Given clean water is a scarce commodity the world over and especially in Singapore, the contract signed with PUB was ironclad – they were given right of refusal as to who can operate the plant in case Hyflux wants out.

Even with five extensions, Hyflux’s inability to find another show-runner shows the difficult spot it is in now – market conditions are difficult for a new owner to attain a decent ROI, PUB’s various stringent requirements to ensure security and safety in their ability to provide water to the public, minority investors demands for disposal but only at a fair price – fair, of course, being a number that doesn’t lead to them getting diluted or receiving cents on the dollar of their investment to even asking for a government bailout. 

Dealing with so many stakeholders is a slow and treacherous process with everyone incentivised to only look out for themselves. While this is an ever fluid situation with some external investors seeing value in the business (SM Investments the primary one), and Olivia offering her stake of 267 million shares as a show of good faith to try and push a restructuring deal through; all efforts so far have been of little or no no avail.

The latest and greatest in this saga is the company agreeing to engage exclusively with Utico until August 26,2019 – as it stands currently though, the deal would see Utico take an 88 per cent equity stake in Hyflux for S$300 million as equity and S$100 million as a shareholder loan: a far cry from the 2 billion market capitalisation the company once supported. Where it ends is anyone’s guess – but rest assured it’ll be at a huge haircut to the holders of any Hyflux paper.

 

Lessons Learned .. If Any

Sadly investors did not heed Horace when he said He who is greedy is always in want.” The high headline yield (the preference shares provided a yield of 6%, which stepped up to 8% if it was not called i.e bought out by the company after a certain period of time) led to many retail investors infusing their life savings in this home-grown Goliath. 

When Hyflux failed, the blame game that ensued caught many in its net – financial intermediaries accused of not adhering to their fiduciary responsibility by enabling investors to buy these ‘risky’ instruments, and the government whose approval meant retail investors could purchase Hyflux shares via ATMs, and big gorilla Temasek who reportedly owned a stake in the business; however small. Lum has also been blamed for committing her company to a high-priced gas supply contract without having a buffer mechanism in place.

One can argue that no business analyst can anticipate changes in domestic policies leading to a market crash – vesting contracts given by the Singapore contract to gencos in return of take-or-pay gas supply contracts from LNG terminals played a huge role in the electricity prices dropping – but it is also true that Hyflux received no help from the Energy Market Authority in the early days of the market collapse. None of these reasonings, however, help investors taking a hit of anywhere from 80-95% of their investment.

At the end of the day heeding Warren Buffet’s first criteria of evaluating a businessdo you understand the business (ergo the inherent risks), would have proven wise for Hyflux investors. Instead of blindly following your neighbour who has invested in the latest, it is best to undertake the required amount of effort and due diligence to truly understand what you are purchasing. Else, purchasing a well diversified index through the vagaries of the market cycles consistently over time would be the best way forward.

The hope now is that with public dissension and the government’s push, there will soon be a resolution to the Hyflux conundrum. What we know for sure though is that there are now inners in this story of hyperbolic ambition and corporate greed. As of writing this article, there’s news of differences within the Hyflux core team holding up a rescue deal with Ultico. We will be keeping an eye on developments on our blog as well.

Water is one of the most precious resources to sustaining life and as it occurs in every industry there will be some businesses that succeed and some that fail. Now, this is not an attempt to end on a bullish or happy note – as a proud card carrying capitalist, I would like to add that every savvy investor just needs to sift through the noise and identify the hidden gem to earn a satisfactory rate of return! Hyflux or high flux, the trick is always to analyse the risk-return parameters and invest in fixed income strategies that do not promise outlandish returns (anything above 5% in bonds, perpetuals, preference shares warrants deeper investigation).

If the alarm bells are ringing, do heed the warning!   

 

Disclaimer

The materials and data contained herein are for information only and shall in no event be construed as an offer to purchase or sell or the solicitation of an offer to purchase or sell any securities in any jurisdiction. Kristal Advisors does not make any representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of the materials and data herein. All opinions, forecasts or estimation expressed herein are subject to change without prior notice. Kristal Advisors and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.