Ordinary shareholders were last paid a final dividend of 0.25 cents for FY2016 last May. No interim dividend was announced for FY2017. Since 2010, ordinary shareholders’ dividends have fallen sharply as dividends to preference shareholders and perpetual security holders climbed dramatically (see chart).
Perpetual securities are meant to be less volatile than ordinary shares, as they have a fixed dividend that shareholders are not entitled to. Yet, after tumbling sharply and then rebounding, Hyflux’s perpetual security holders are asking themselves whether they should hang on to this investment.
Since the issuance in May 2016, the holders of these perpetual securities would have received a full year’s coupon of 6%, and a half-year coupon. Someone who invested $10,000 would own securities valued at $7,900, and would have received $900 in coupon payments. The investor would be out of the money. Of course, the perpetual securities can rebound. But if a perpetual security holder were to hold on to the perpetuals, would he still get his full 6% by May this year? (See accompanying story for more information on perpetual securities.)
How perpetual securities should be viewed
The finance manager of a locally listed real estate investment trust (REIT) once said she was not keen on perpetual securities because she viewed it as expensive debt. Yet, Hyflux is treating both its preference shares and perpetual securities as equity. One of the advantages for an issuer is that perpetual securities are viewed as being cheaper than core equity.
In effect, perpetual securities are hybrids. They act like debt in that they tend to have low or no volatility. And, to incentivise the issuer to redeem the securities, there is a step-up in the coupon. Local perpetual securities act like five-year bonds because their first call date is usually at the five-year mark. However, their coupons are usually higher than similar tenor bonds. They are subordinated to debt instruments but rank above ordinary shares.
Perpetual securities can defer coupons
One of the equity-like features — and this is clearly set out in the prospectus — is the possibility of deferring or not paying the coupon. This was stated in the prospectus of Hyflux’s 6% perpetual capital securities issued on May 26, 2016. It was also stated that the perpetual securities were to be redeemed at the issuer’s discretion. “The issuer is under no obligation to redeem the securities at any time,” the prospectus states. “The issuer may defer the payment of distributions for an indefinite period of time by delivering the relevant deferral notices to the securityholders. Any such deferral of distribution shall not constitute a default for any purpose.” This is unlike bonds, where failure to pay the coupon at the appointed date represents a default.
It is worth keeping in mind that investment-grade companies are loathe to defer or cancel a coupon because of a well-founded fear that doing so will affect their credit profile and access to capital in the future. Thus, issuers of perpetual securities are unlikely to defer or cancel a coupon unless they are in severe financial distress.
Also, if the preference share or perpetual security has passed its first call date, ratings agencies may not assign equity value to the issuances and consider 100% of the hybrid as debt.
Hybrid characteristic popular
Perpetual securities are useful tools. Take REITs, for example. They are bonded by a debt-to-asset ratio of 45%. When they are very close to this ratio, the only way to continue to grow by acquisitions without equity fundraising is to issue perpetual securities. They are considered as equity by regulators and do not dilute unitholders’ share. REITs that have issued perpetual securities include Ascott Residence Trust, Keppel REIT, Mapletree Logistics Trust, Lippo Malls Indonesia Retail Trust and Frasers Hospitality Trust.
Interestingly, while perpetual securities are considered to be equity for accounting purposes, they are similar to debt in that they can contribute to the issuer’s becoming overlevered. Ratings agencies such as Moody’s Investors Service do not consider perpetual securities as 100% equity because there comes a point when issuers have to either pay it off or refinance it. Different agencies have different maximum levels that they recognise as equity. For REITs, Moody’s applies a 50% equity treatment for perpetual securities, that is, only half of the issuance is viewed as equity.
Moody’s also sets a limit on the amount of equity credit from the issuance of perpetual securities or other hybrid securities within an issuer’s capital structure. A rough rule of thumb is the ratio of hybrid equity credit to equity should not exceed 30%. Any additional hybrid equity credit above that will be treated as debt by Moody’s. The rationale is that common equity is a more predictable source of funding, and should be the dominant component of an issuer’s capital structure.
Hyflux breaches 30% rule
As such, Hyflux has breached the 30% rule. Based on its total shareholder equity of $1.1 billion, preference shares and perpetual securities comprise a large portion of shareholder equity. If the remaining 70% of preference shares and perpetual securities is treated as debt, shareholder equity could fall to below $500 million. In this event, Hyflux’s debt would rise, raising its gearing ratio noticeably and lowering its net asset value. The company’s stated plans to divest $1.7 billion of assets should improve these ratios and assuage liquidity fears.
Consistent payments for capital securities
Yes, it looks like the perpetual security holders are safe. “Hyflux has consistently made semi-annual payments for all our capital securities. We also recently announced the payment of dividend for the 6% Cumulative Non-Convertible Non-Voting Perpetual Class A Preference Shares on Oct 25, 2017 and the 6% Perpetual Capital Securities on Nov 27, 2017,” a Hyflux spokeswoman says.
According to Hyflux’s 3QFY2017 announcement, it paid $13.5 million in dividends to its preference shareholders on Oct 25. On Oct 27, the company announced it was paying $15.1 million to its perpetual capital security holders. It had also paid $14.9 million to perpetual security holders on May 29. Both preference shareholders and perpetual security holders are paid twice a year.
In FY2016, Hyflux announced it paid $24.06 million in dividends to its preference shareholders, and $40.84 million in dividends to its perpetual security holders. In FY2017, dividend payouts on perpetual securities are likely to be lower, as the company bought back some earlier perpetual securities tranches. The current $500 million tranche, which was issued in May 2016, is the only series it has. That would take annual payments for perpetual securities down to around $30 million.
Weak capital structure
In a nutshell, Hyflux’s share capital comprises $128.8 million worth of ordinary shares, $392 million worth of preference shares and $494.8 million of perpetual securities (see Table 4). It also has $120 million of retained earnings and $25.7 million of employees’ options reserve and $14.4 million of capital reserve. Altogether, Hyflux reported $1.1 billion in total equity, which includes reserves, retained earnings and non-controlling interests. In terms of seniority, the preference shares and perpetual securities rank pari-passu, but below collateralised bank loans and unsecured debt securities.
In its 3QFY2017 results statement, Hyflux announced that its shareholder’s equity decreased from $1.5 billion as at Dec 31, 2016 to $1.1 billion as at Sept 30, 2017 because of the redemption of perpetual capital securities of $295 million in January 2017 and the operating loss for the period. It is based on this capital structure that Hyflux’s net asset value was 26.2 cents on Sept 30, down from 45.1 cents on Dec 31, 2016.
Net gearing as at Sept 30 was 1.07 times. The finance cost for its $1.1 billion of loans is $14.4 million for 3QFY2017, or $57.6 million if annualised. Interest expense for bank loans in FY2016 was $62 million. These figures do not include dividends for the preference shares and perpetual securities.
The four million preference shares of $100 each carry a dividend rate of 6% a year and were issued in 2011. Hyflux can redeem these on or after April 25 this year. If the preference shares are not redeemed on April 25, the new dividend rate will be 8%. “The perpetual preference shares are perpetual securities with no maturity date and are not redeemable at the option of the holders of the perpetual preference shares,” Hyflux states in its 2016 annual report.
Ability to redeem preference shares
Although in a net debt position, the company has $222 million in cash. It has also received an inflow of $95 million from ESR-REIT, which bought Hyflux’s property in Tuas. In addition, Hyflux was awarded US$18.8 million ($21.3 million) on Jan 15, following a dispute over a desalination project in Oman. Hyflux will also get a further $4.4 million and additional interest payments. Whether Hyflux gets to the magical $400 million figure in cash holdings by April remains to be seen. Hyflux has the option to roll over the preference shares, that is, issue new preference shares or more bonds.
Hyflux’s assets held for sale were valued at $1.7 billion as at Sept 30. The company announced it is in the process of divesting its full interest in the Tianjin Dagang desalination plant in China, as well as a partial divestment in Tuaspring in Singapore. In the meantime, the company is exploring a separate listing of its consumer business. It has announced a dividend-in-specie of shares in the yet-to-be-listed HyfluxShop Holdings. Every 1,000 ordinary Hyflux shares will entitle shareholders to 100 HyfluxShop shares.
If Hyflux is unable to redeem the preference shares in April, it can well afford to pay the higher dividend rate of 8%, following cash inflows from the sale of assets during 2017. It can then redeem the preference shares after it completes the sale of the Tianjin project and Tuaspring. The $500 million of perpetual securities is callable only in May 2020.
Moving to asset-light strategy
Hyflux reported a loss per share of 5.04 cents for 3QFY2017 and 11.67 cents for the nine months to Sept 30.
This includes the dividend payout for perpetual preference shares and perpetual capital securities. Excluding these dividends, the loss per share would have been lower
at 3.32 cents for 3QFY2017 and 6.41 cents for 9MFY2017 to Sept 30. The lower loss per share translates
into a loss of $26.07 million for 3QFY2017 and $50.35 million for 9MFY2017 as announced in the income statement.
In FY2016, the company reported a Patmi (profit after tax and minority interest) of $4.8 million. If the dividend payout to the preference shareholders and perpetual security holders were included, however, the loss attributable to ordinary shareholders would have been $59 million.
To prioritise returns to ordinary shareholders, Hyflux has embarked on an asset-light strategy. Last March, it completed the sale of Galaxy Newspring, a water project in Yunnan, for $190.8 million, and booked a gain of $16.5 million. When Tuaspring and Tianjin Dagang are sold, the company would be in a better position to lower its debt and strengthen its capital structure.
Though a small unit, HyfluxShop’s revenue has more than doubled in the last two years. At present, its revenue and assets represent about 0.5% and 1% of Hyflux’s FY2016 revenue and assets, respectively. HyfluxShop owns the exclusive rights to manufacture, sell, market and distribute ELO Water and its related products and services in Asia-Pacific, the Middle East and Africa. Its latest offering is the ELO Green range of nutritional products made of natural and non-genetically modified ingredients.
Although Hyflux has a weak balance sheet, it is continually looking at ways to divest assets to pay its dividends, estimated at $54 million in FY2017, and for new growth areas to reinvest. It is likely to announce full-year results on Feb 23.
