In our last report on MIIF (link) 3 weeks ago, we highlighted a mispricing in MIIF's shares and a potential arbitrage opportunity arising from the company's intention to redeem its remaining outstanding shares at 8.25 S cts per share following the close of its disposal of South China Highway Development (H.K.) Ltd.

As anticipated, on 14 September 2015, the company announced that the Proposed Divestment had achieved a financial close. Trading in its shares will be suspended from 18 September 2015, and the share redemption will be effected on 21 October 2015.

We further note that MIIF traded between 7.8 and 8.0 S cts from 24 August to 14 September 15. Investors who had acquired the shares during this period would have effectively locked in unlevered gains of between 3.1% and 5.8% for what would be a maximum holding period of 2 months while taking what we deem as very low risk. 

Investors can refer to the company announcement for more details and key dates. 

Amidst the current carnage in the equity markets, interesting opportunities in the space of arbitrage and special situations are beginning to emerge owing to the widespread and indiscriminate selling. MIIF is one such opportunity that has caught our eye.

MIIF, an entity listed on the mainboard of SGX but structured as a closed ended fund, had announced on 15 May 2015 the sale of its sole remaining asset, an 81% effective interest in Hua Nan Expressway Phases 1 and 2 (HNE) to Topwise Consultants Limited, an existing minority shareholder in HNE, for a total cash consideration of S$110 million (the “Proposed Divestment”). Post completion, MIIF intends to distribute the net proceeds and any excess cash it holds by way of a share redemption, following which it will be delisted from SGX.

The share redemption is expected to take place by 30 October 2015 provided that the Proposed Divestment is completed by its long-stop date of 15 September 2015 and investors will be returned around 8.25 S cts per share based on MIIF estimates which we deemed to be reasonable. This gives investors a potentially low risk return on investment (ROI) of 3.1% over what is likely to be a maximum two-month holding period or an equivalent return of close to 20% annualized.

Brief Background

In December 2012, MIIF made the decision to initiate the disposal of all its then existing assets following a strategic review. In subsequent years since, MIIF successfully completed the divestments of Taiwan Broadband Communications, Changshu Xinghua Port and Miaoli Wind and returned 54 S cts per share to its shareholders. HNE is currently the sole investment held on its books.

MIIF’s interest in HNE is held through its 90% owned subsidiary, South China Highway Development (HK) Ltd (“SCHK”), which in turn holds a 90% interest in HNE. This gives MIIF an effective interest of 81% in HNE. Topwise Consultants Limited (“Topwise”), the proposed buyer owns the remaining 10% of SCHK. The proposed transaction involves the sale of MIIF’s 90% share of SCHK to Topwise for a total consideration of S$110 million. Little is known and has been announced of the buyer except that in 2007, Topwise, together with Precise Management Ltd, sold the same equity stake to MIIF for $295.7 million[1].

Figure 1: HNE's existing ownership structure

HNE is a dual-carriage urban toll road in the city of Guangzhou, China and acts the city’s main artery for north-south traffic. The interest in HNE comes with the exclusive rights to operate and collect tolls up to 2026. In the last two full financial years, namely FY2014 and FY2013, HNE contributed S$12.3 million and S$12.1 million in dividends respectively.

Figure 2: Hua Nan Expressway, Guangzhou. (Source: MIIF)

Investment case

3.1% returns over a two-month period sufficiently attractive under current market conditions

We believe that MIIF would make for a sensible arbitrage opportunity returning around 3.1% based on the last traded price per share of S$0.08 over an estimated period of 2 months or about 20% annualised. While a 3.1% return may not be much to shout about under normal circumstances, we think that this would be a sufficiently attractive opportunity for investors seeking short term stable returns with excellent downside protection especially given the current turmoil in the stock markets.

Low execution risks and high probability of deal completion

While the completion of the Proposed Divestment was originally envisaged to be on 5 August 2015 and has since been delayed, we still believe that there is a high likelihood that the transaction would be completed in due course and before the long stop date of 15 September 2015:
                

1. The key condition precedent for the transaction is the approval of MIIF shareholders, which has already been obtained on 27 July 2015. 
2. As a long time existing shareholder of HNE, Topwise does not require any due diligence and accordingly, the Proposed Divestment will not be subject to conditions typically expected from other third party purchasers and includes only limited representations and warranties.
3. As one of the two previous owners of the HNE stake, we expect that there will be little or no regulatory risks regarding the transfer of the ownership to Topwise as is sometimes the case for Chinese acquisitions.
4. While little is known or has been announced of Topwise and their financial standing, we believe that financing is unlikely to be an issue given that Topwise, together with Precise Management, had received a much higher consideration of S$295.7 million when they sold the stake to MIIF in 2007. In addition, Topwise has remained as a minority partner in HNE since the original sale and MIIF is likely to have done its part in ensuring that Topwise has the necessary financing lined up before entering into the sale and purchase agreement. 
   

MIIF's manager has 17.4 million reasons to see through transaction

MIIF’s manager, Macquarie Infrastructure Management (Asia) Pty Limited (MIMAL) stands to enjoy a big windfall of S$17.4 million upon successful completion of the transaction as the total cumulative proceeds from all its divestments including HNE will exceed the minimum S$694.9 million threshold thereby triggering the success fee. This gives MIMAL extra motivation to see through the transaction.

Excellent downside protection even if deal falls through

In the unlikely event that the Proposed Divestment falls through at this late stage, MIIF would still be able to continue benefiting from the stable cashflows HNE generates going forward. For FY2014 and FY2013, HNE contributed  S$12.3 million and S$12.1 million respectively in dividends to MIIF.  This helped MIIF maintain a dividend payout of 0.9 S cts for FY2014. We believe that MIIF should be able to pay out a similar amount going forward even if they were forced to retain the HNE stake. This is supported by KPMG's view as the Independent Financial Adviser to the MIIF for the Proposed Divestment that "based on an 85.0% dividend payout ratio of MIIF’s estimated dividends on an undiscounted basis, it would take approximately seven to eight years for Shareholders to realise the estimated net proceeds of 8.25 S cts per share."

Our Recommendations

We believe that MIIF shows all the characteristics of a good short term arbitrage opportunity: high probability of deal completion, decent returns over a two month holding period with potential to be magnified with leverage, and excellent downside protection even if the deal fails at this late stage.  For investors seeking a respite from the current carnage in the equity markets, we would recommend this as a viable investment opportunity and are buyers at at S$0.08 and below.

Risks

A prolonged closing of the Proposed Divestment could negatively affect the risk-return dynamics although at the moment we would assign a low probability to this happening given the background of the buyer.

(All preceding amounts in SGD unless stated)

[1] Actual amount paid. The original consideration of S$329.5 million included a contingent payment S$33.8 million which was never paid as conditions for payment were not met.

Recap

As our readers would recall, we have made multiple warnings beginning from January 2015 (reports 1, 2 and 3) regarding what we see as unsubstantiated optimism over Memstar's proposed US$420 million RTO of Longmen Group Ltd ("Longmen"), a private developer of coal bed methane ("CBM") resources in Shaanxi Province, China. Over the course of the past 5 months, the proposed deal has seen the deadline for Longmen to satisfy its conditions precedent lapsed no less than three times, the last of which fell on 31 March 2015. 

In Memstar's last significant update released on 6 March 2015, it announced that it had gotten a conditional approval from SGX for a 6-month extension of time to meet the requirements for a new listing, i.e. from 11 April 2015 to 11 October 2015. 

However, on 6 April 2015, the Company suddenly suspended the trading of its stock and has since then remained largely silent over both developments on the proposed RTO and its own listing status. 

Our Views and Recommendations

The Company's lack of response so far has been disappointing. Given that the stock has been suspended for more than 2.5 months, we can only surmise that the Company had fallen short of the conditions imposed by SGX for its continued listing.

One can imagine the dismay and anguish that minority shareholders are currently going through over the uncertainty of their investments. We feel strongly that the Company owes it to these shareholders to provide an immediate update of the situation at the very least. Likewise, shareholders should consider taking a proactive approach to seek answers from the Company and its management.

This unfortunate episode should also serve as a warning to investors in other companies with similar profiles: cash companies, which may or may not have announced an RTO deal, with rapidly approaching deadlines for them to meet conditions to continue their listings and trading at levels far above the value of their net tangible assets including cash. Jaya Holdings Ltd and E2-Capital Holdings Ltd are two such companies that come to mind. While the situation with Memstar might not manifest itself with these two counters, investors would do well not to be overly optimistic when pricing in potential upside from RTO deals, especially when completion is far from certain. 

There has been a buzz surrounding the latest IPOs of small healthcare stocks on the SGX with investors tripping over one another to try to land some coveted but often paltry amount of shares available for public subscription. When you consider the amazing performance of these IPOs, the excitement they generate is understandable.

For instance, Singapore O&G Ltd, a healthcare group operating a small chain of Obstetrics and Gynaecology specialist clinics, surged 154% from its IPO price of S$0.25 per share on its first day of trading on 4 June 2015 after its public tranche was 332 times subscribed. This was one of the best first-day IPO performances on SGX we have seen in recent years, bettered only by the stunning 310% gain recorded by Talkmed Group Ltd on 30 January 2014. Talkmed Group is, as you might have already guessed, another healthcare group but one providing primarily oncology related services.

While one might argue that the reason for the outstanding first day performances of these two IPOs is the strong fundamentals of their respective businesses, we believe that the outperformance can be attributed to two simple, yet key factors: generous dividend guidance and low relative valuation vis-à-vis industry peers.

Talkmed Group

In its listing prospectus, Talkmed provided for a rather generous dividend guidance of 75% of its annual profit after tax which at the time of its listing would have translated to a prospective yield of around 18%! This was largely due to the company pricing its IPO shares at a rock-bottom post money price to earnings (PE) ratio of just 4.1x historical earnings.

Singapore O&G

Similarly, Singapore O&G took a leaf out of Talkmed’s book and opted for the strategy of low relative valuation and generous dividends, guiding a payout of up to 90% of its profit after tax for FY2015. Using its FY2014 earnings as an indication, this would translate to a lower but still attractive prospective dividend yield of 7.3%. While its post money PE ratio of 12.8x appears rich compared to Talkmed's and indeed most other SGX IPOs in recent months, it is still at a huge discount off its Singapore-listed peers in the healthcare sector.

This brings us to the next question, is the healthcare sector in Singapore overpriced as a whole?

Healthcare stocks enjoys supernormal valuation but it is hard to see why

The healthcare sector is traditionally recognised as a defensive sector. Proponents of the Singapore-listed healthcare stocks often point to a number of seemingly compelling factors driving their valuations: ageing population, strong overall reputation for quality, rising consumer awareness, etc.

While all these qualitative factors may indeed contribute greatly towards investors' confidence in the sector, the only question that ultimately matters is if the hard numbers, i.e. earnings, growth, dividends, etc support the valuations.

If we look at the group of SGX-listed healthcare stocks below in Figure 1, which we feel broadly represents the sector, we can see that the average SGX-listed healthcare stock as represented here trades at an astounding trailing-12 months (TTM) PE of 44.5x, 7.5x TTM sales, and 6.0x its book value while paying very little dividend (1.4%). 

Figure 1: Relative valuation of SGX-listed healthcare stocks as at 19 June 2015 (Source: Morningstar, Company)

For comparative purposes, the corresponding median[i] values of companies on the FTSE ST All-Share Index, which broadly represents about 98% by value of the universe of stocks listed on SGX are about 12.9x PE, 1.1x book and 3.4% dividend yield. By any of these metrics, therefore, there is little doubt that SGX-listed healthcare stocks trade at an unusually high premium to the rest of the market.

To understand if this premium valuation is warranted by strong fundamentals or a result of over exuberant market optimism, we examine a few factors that might offer some clues: historical growth, resilience of the sector’s earnings and trading performance in a downturn.

Positive topline but patchy earnings growth

We note from Figure 1 that the healthcare stocks registered consistent topline growth across the board over the last 3 financial years with an average of 11.5% per annum. This is roughly in line with a Frost & Sullivan report in 2014 estimating healthcare expenditure per capita to grow at 9.7% per year in Singapore and total healthcare expenditure to grow at 10.5% per year in the Asia Pacific region from 2013 to 2018.

Bottom line growth is a lot less uniform with only 4 stocks having generated positive growth, of which Singapore O&G alone registered a double-digit earnings growth at 21.3% although it should be noted that as the smallest player on the list, it had the benefit of a lower base to start off with.

Overall, the growth rates do not compare favourably with the sector's high PE ratios. As legendary investor Peter Lynch noted in his book, One Up on Wall Street, that “The P/E ratio of any company that's fairly priced will equal its growth rate”. If we apply this measure as a rough gauge for value, we can see that none of the healthcare stocks are trading anywhere close to a PE ratio that would suggest that they are under or fairly valued.

Earnings has proven defensive for certain stocks

If growth is insufficient to justify the valuations, how about the supposedly defensive qualities of the healthcare stocks' earnings? To measure how defensive the earnings of these stocks might be, we look back to a period spanning the most recent global financial crisis (GFC), specifically from FY2007 to FY2010. As only two of the six companies on our list, namely Raffles Medical Group ("RMG") and Health Management International ("HMI"), were listed back then, we look each of their performances individually.

From Figure 2 below, we can see that RMG's earnings proved to be rather resilient throughout the financial crisis as both revenue and earnings were generally on the uptrend with just a minor dip in earnings in FY2008. It also maintained a healthy net profit margin of above 15% throughout even though there was an initial drop from FY2007 to FY2008.

Figure 2: RMG's revenue and net earnings after tax for FY2007 to FY2010

The same cannot be said for HMI as its earnings took a dive during the GFC. We note that FY2007 earnings were boosted by one-off net gains of about S$5 million. This was further exacerbated by start-up costs booked in FY2009 attributable to its then newly established Regency Specialist Hospital in Johor, causing the earnings downtrend look more pronounced than it actually was.  

However, even after taking these adjustments into account, HMI's earnings growth trend during this period would still have been slightly negative despite it registering consistent topline growth. 

Figure 3: HMI's revenue and net earnings after tax for FY2007 to FY2010

The operational performances of RMG and HMI during the GFC suggest that healthcare earnings could well be defensive for a well managed company like RMG but it is not a given for others within the sector like HMI. The more recently listed healthcare players have yet to be tested in this regard.

Trading performance may not hold up in a downturn

We next look at how look at how the companies' share prices performed during the period spanning the GFC. Again, only RMG and HMI's trading data are available for this purpose. 

Figure 4b: Share price performance of RMG during the period of 1 July 2007 to 30 June 2010 vs STI Index and FTSE ST All-Share Index. (Source: wsj.com)

As we can see from Figures 4a and 4b above, RMG's share price plunged during the GFC and traded briefly for as low as S$0.550 per share vs around S$1.50 before the onset of the crisis for a decline of approximately 63% from the start of the period to bottom. By comparison, the STI index and FTSE ST All-Share Index declined about 51% and 56% respectively over the same period. This is despite the resilience of RMG's revenues and earnings throughout the crisis as we witnessed. At its lowest point, RMG traded at a mere valuation of 9.5x earnings, or just a quarter of the lofty 38.4x it is at today.

Figure 5b: Share price performance of HMI during the period of 1 July 2007 to 30 June 2010 relative to STI Index and the FTSE ST All-Share Index. (Source: wsj.com)

Similarly, HMI's share price plunged during the GFC with a fall of 74% from the start of the period to bottom vs the respective declines of 52% for the STI Index and 57% for the FTSE ST All-Share Index correspondingly. PE trend was not determined for HMI as it recorded negative earnings for FY09 and FY10.

Thus, it appears that while earnings of selected healthcare companies like RMG might be defensive during a downturn, their valuations and share prices might not hold up as well.

Our Recommendations

It seems obvious to us that the SGX-listed healthcare stocks in general are overvalued by most valuation metrics vis-à-vis the overall market. While the sector's earnings may be relatively resilient even in a major financial crisis like the GFC, the share prices and valuations have shown that they can be just as vulnerable, if not more, compared to the overall market. The sector's fundamentals may well be able to support a moderate growth rate of around 10% a year as suggested by Frost & Sullivan, although we feel that this is not sufficient to compensate for the over-optimistic valuations.  

Investors should think thrice before chasing the hype especially with increased competition from new hospitals both in the public and private sector going forward. Several public hospitals in Singapore have either already been completed or are in the works over the next 10-15 years[ii]. On the private side, highly regarded hospitals such as Thailand's Bumrumgrad Hospital and Bangkok Hospital Medical Centre, both of which rank consistently amongst the top healthcare institutions in Asia alongside IHH Healthcare’s Gleneagles Hospital, provide strong competition for medical tourist dollars. Closer to Singapore, the Iskandar region has also seen the entry of a number of new players including the upcoming Thomson Iskandar Medical Hub, to be managed by Peter Lim's Thomson International group. Prospects going forward may, therefore, not be all rosy as the valuations would suggest.

We see little value to be had in any of the healthcare stocks listed in Singapore at the moment. That said, it is hard to predict when the valuation bubble will burst. Perhaps it will take another GFC-type crisis to bring a leading healthcare stock like RMG down to single-digit PE levels for investors to realise that the sector may not be as defensive as they thought. 

Key developments since our first report:

1. Two weeks after our report published on 16 April 2015, Business Times ran a similar article on 30 April 2015 highlighting the potential delisting of PCRD as well as a possible restructuring of the group:http://business.asiaone.com/news/pacific-century-headed-delisting (note: link is to the said article reproduced on asiaone.com as Business Times operates a paid platform that might not be available to all readers)
2. In the same two-week period, PCRD's share price has advanced more than 28% to close at $0.445 on 30 April 2015. It has since cooled slightly to $0.435 as at 4 May 2015. 
3. On 2 May 2015, PCRD released an announcement clarifying that "it is not aware of, and has not received, any proposal in relation to privatisation of the Company. In addition, the Company is not aware of any restructuring plan involving the Company and its subsidiaries."
4. PCRD has successfully obtained a fresh mandate for share repurchases up to 10% of its shares and gone on to record its first purchase on 29 April 2015 at $0.405 per share, a sharply higher price than its previous purchase at $0.365 per share a week before.   
   

Our Views

We do not see the company's response as anything more than routine and it does not in our opinion reduce the likelihood of a privatisation happening in the future. It merely confirms that an offer or restructuring proposal has not been tabled or discussed officially as at the announcement date. 

Under the current regulatory regime, there are a few ways that PCRD's privatisation could take place: through a general offer, a scheme of arrangement, a voluntary delisting or a forced delisting by SGX due to low free float (<10%) coupled with an exit offer. Based on current circumstances, we see the last two as the most likely options. Both would require a reasonable exit offer to be tabled and the appointment of an independent financial adviser ("IFA") to opine on the fairness of the offer as stipulated in the SGX listing rules. We note that IFAs tend to benchmark fair value of a company's shares to the market prices of its underlying assets where such values are available as in the case of PCRD. As such, we do not expect any exit offer, if it materialises, to deviate greatly from the fair value computed using this methodology in order to obtain a positive recommendation from the IFA. 

Recommendations

We continue to believe that PCRD is undervalued although we note that the valuation gap between the current market price of $0.435 and the implied fair value of $0.542 which we previously computed has closed significantly to 19.7% (vs 36.4%). Downside risks though, should be limited as the Company has reconvened its share repurchases at a sharply higher price of $0.405 per share lending further support to the share price.  

PCRD’s share price has doubled over the last 3 years to a multi-year high of S$0.345 as at 16 April 2015 but yet remains very much undervalued. With the Company aggressively buying back its shares and reducing its public float to just above 13%, we think there is a good chance that this will be the year Richard Li finally privatises the Company.

Background

Pacific Century Regional Developments Ltd ("PCRD") has been an integral part of billionaire Richard Li Tzar Kai's empire ever since he acquired control of the SGX-listed company in 1994. Currently, it serves mainly as an intermediate holding company for Hong Kong listed PCCW Ltd, which in turn controls:

• now TV, Hong Kong's leading Pay TV operator; 
  
• PCCW Solution, an IT services leader in Hong Kong and mainland China;
  
• 70.8% (92.6%*) of HK-listed Pacific Century Premium Developments Limited ("PCPD"), positioned as a premium property developer with projects in Hong Kong, Japan, Thailand and Indonesia; and
  
• 63.1% of HKT Trust and HKT Limited (together "HKT"), Hong Kong’s premier telecommunications service provider and listed in Hong Kong as stapled securities under a business trust structure.
  

*Note: Even though PCCW holds only 70.8% of the ordinary shares of PCPD, it also owns Bonus Convertible Notes issued in 2012 under an unusual bonus share cum bonus convertible note issue specifically executed to restore the public float of PCPD to more than 25%. The notes have been conferred the same economic rights as the bonus shares and give PCCW an effective economic interest in PCPD of 92.6% instead of 70.8%. 

Figure 1. PCRD Group Structure and Services

For FY2014, PCCW recorded total revenue of HK$33.27 billion and a profit after tax (PAT) and minority interests of HK$3.31 billion. However, this includes a gain of HK$1.31 billion on disposal of Pacific Century Place, Beijing by its subsidiary PCPD, without which the adjusted PAT would have been around HK$2.00 billion. Further, we estimate that HKT contributed approximately HK$1.93 billion or almost 97% of the adjusted PAT.

Crown Jewel HKT

Of all the assets within the PCRD group, the 63.1% owned HKT (previously known as Hong Kong Telecom) is by far the largest and most profitable.

HKT was first acquired by PCCW in August 2000 at the height of the dot-com bubble for over an estimated US$28 billion in cash and shares. Then, PCCW beat out a rival bid from Singtel, amidst rumours of Beijing's concerns over potentially sensitive telecom assets falling into foreign hands. The acquisition did not initially turn out well and saddled PCCW with massive debts. In subsequent years, PCCW tried disposing of various assets to raise cash in order to pare down its debts including ironically that of HKT's assets. Eventually, PCCW managed to spin off the HKT assets into a trust listing on the Hong Kong Stock Exchange in 2011, raising US$1.2 billion in the process.

HKT is the undisputed leader in telecommunication services in Hong Kong. While it has long been the dominant player in the fixed-line and broadband services segments, its acquisition of CSL New World Mobility Ltd (“CSL”) from Australia-based Telstra in May 2014 for US$2.4 billion further catapulted it to the No. 1 position in mobile services as well. In Hong Kong, it has a market share of >60% for both fixed line and broadband segments and a 31% market share in the mobile segment.

Since listing in November 2011, HKT has performed well operationally. For the year ended 31 December 2014, it recorded total revenue of HK$28.8 billion and profit after tax of HK$ 3.1 billion, registering strong growth in both primarily due to a maiden 7.5 months contribution from the newly acquired CSL. Adjusted funds flow (defined as EBITDA minus capital expenditures, customer acquisition costs, license fees paid, taxes paid, net finance costs paid, and adjusted for changes in working capital), which HKT uses as a gauge for dividend distribution, has also grown steadily from FY2011 to FY2014 at a CAGR of 12%. With a first full-year contribution from CSL in 2015, top and bottom line as well as adjusted funds flow are expected to improve further. 

Figure 2. HKT's financial performance from FY2011 to FY2014

Other Business Segments

Although the other business segments such as PCCW Solutions and PCCW Media generated sizeable revenues, their contributions have been dwarfed by that of HKT. For FY2014, all the other business segments outside of HKT contributed just 14% of PCCW's total revenues and less than 1% of the group's EBITDA. This means that PCCW is at present in effect a proxy for HKT. That said, both PCCW Media and PCCW Solutions have continued to grow steadily and offer good growth opportunities.

PCCW Media, which includes the Pay-TV business operated under the brand "now TV", has been increasing its own entertainment production following a successful first TV drama series production "The Virtuous Queen of Han", which reached 38 million viewers in China. now TV's international footprint also continued to widen through affiliate partnerships to distribute now TV channels across countries in Asia and North America, with the latest addition being Taiwan.

PCCW was also recently awarded a 12-year licence to operate two free to air TV broadcast channels, becoming the first in 40 years to be awarded a new licence by the Hong Kong government. However, with the market dominated by a strong incumbent in TVB, we think the free TV licence is unlikely to contribute meaningfully to PCCW in the near future.

PCCW Solutions, an IT services leader in Hong Kong, has grown revenue and EBITDA by CAGR of 17% and 20% respectively over the last 3 years and continues to secure healthy orders. As at 31 December 2014, it has secured orders worth US$730 million (about 1.7x its FY2014 revenue) although we note that this is down slightly from the corresponding secured orders of US$819 million as at 31 December 2013.

PCRD trading at a steep discount to the value of its underlying assets

PCRD has only two significant assets on its books, its 21.8% stake in PCCW and a direct holding of 131,626,804 Share Stapled Units in HKT.

PCRD last traded at S$0.345 per share as at 16 April 2015, giving it a market capitalisation of S$945 million. Although its stake in PCCW is carried on its books at S$645 million, it is worth around S$1.45 billion on the market based on the closing price of HK$5.11 per share. In addition, PCRD's direct holding of Share Stapled Units in HKT is worth S$240 million. This means that at the current price, investors buying into PCRD are practically buying its controlling stake in PCCW as well as units in HKT at a huge 44.2% discount off the market value.  

To further establish that PCRD is indeed trading at a deep discount to its intrinsic value, we look at its key underlying asset, PCCW and compare its valuation against regional peers:

Figure 3. PCCW vs regional peers (Source: Bloomberg, company)

As you can see above, PCCW’s current valuation is in line with its peers based on both PE ratio ("PER") and dividend yield. However, to be conservative, we decided to peg PCCW to its implied valuation based on the highest dividend yield (4.5%, Starhub) and lowest PER (15.7x, China Mobile) of its peer group. 

Figure 4. Fair value computation of PCRD

This resulted in a fair value price for PCCW of HK$4.38 per share. Based on this new fair value price, we established an implied fair value for PCRD of S$0.542 per share. The current price of S$0.345 is thus at a steep discount of 36.4% to its fair value, which we do not think is justified.  

Aggressive share buyback returning value to shareholders in lieu of dividends while concurrently shrinking public float

PCRD has embarked on an aggressive share buyback programme in the last one year, acquiring and cancelling 9.99% of its own shares equivalent to 303,932,200 shares in total and almost maximising the 10% limit allowed under its share purchase mandate approved at last year’s annual general meeting. While share buybacks are not uncommon, we note that this is one of the rare instances in Singapore where any company has actually bought back close to the maximum amount of shares allowable under its annual share purchase mandate. As a result of the aggressive purchases, the public float has shrunk to 13.1%, a level dangerously close to the minimum 10% limit stipulated by SGX.

We note that the Company has proposed a further renewal of the share purchase mandate for its upcoming shareholders' meeting on 24 April 2015. In its latest circular for the shareholders' meeting, it specifically catered for the scenario of a maximum purchase of 3% of its total outstanding shares. We see this as an indication that the Company is prepared to resume buying back its shares aggressively until such time when the public float is close to the minimum of 10%.    

Figure 5. Extract of share purchase mandate from PCRD circular

Delisting imminent?

One other direct effect of the aggressive buybacks has been the tightening of Richard Li and his Pacific Century Group's control on PCRD. 

Figure 6. Richard Li’s control over PCRD on 15 April 15 vs 14 Mar 14

With Richard Li and the Pacific Century Group controlling almost 87% of PCRD’s total shareholdings and with the shares trading at a steep discount to its underlying intrinsic value, we think there is a good chance that this could be the year that Richard Li finally pulls the privatisation trigger. We see little justification now for PCRD as a de facto intermediate holding company within the Pacific Century Group to remain listed and incur unnecessary compliance and listing costs.

PCRD should continue to return sustainable value to shareholders even if privatisation does not take place

While we see a good chance of the Company being privatised, we also considered the possibility of PCRD remaining listed despite the low public float. Under this scenario, we think that the Company could possibly resume paying cash dividends to shareholders.

For FY2014, PCRD returned almost S$76.9 million of capital through share buybacks alone. With the free float at only 13%, it is only a matter of time when the Company maxes out on its share buyback limits. What next then? For a start, we should note that the PCRD is an investment holding company with no other core operations on its own. This means that it does not have much need for capital or operating expenditures other than to maintain its listing and other corporate expenses.

Its main sources of cash income are derived primarily from its stake in PCCW and its holdings in HKT. 

Figure 7. PCCW's EPS and DPS from FY2010 to FY2014 (^Note: Payout ratio and EPS for FY2014 has been adjusted to account for the one-time gain from the disposal of Pacific Century Place, Beijing by PCCW's subsidiary PCPD)

PCCW has consistently paid out a good chunk of its earnings as dividends (payout ratio >70%) over the last 4 years. In FY2014, its full year dividend payouts amounted to HK 20.2 cents per share. This translates to S$57.5 million worth of dividends for PCRD. In addition, PCRD also received S$8.9 million in dividend income from HKT directly. This gives it a potential cash income of S$66.4 million annually if the dividend payments are sustained. As an illustration, if all these cash were to be paid out as dividends to PCRD shareholders, it would translate to an annual dividend yield of about 7.0%.

As we previously indicated, the bulk of PCCW's earnings come from HKT and HKT's earning should continue to grow in the near future with the full consolidation of CSL in FY2015. Hence, we believe that both HKT and PCCW's dividend payments are sustainable.

While there is no assurance that PCRD will elect to receive its dividends from PCCW in cash (it opted for scrip dividends in FY2014 and cash in the preceding two years), or that it will resume paying cash dividends in future, the benefits from the cash income from PCCW and HKT should eventually accrue to shareholders in one form or the other. 

Recommendations

We believe PCRD to be deeply undervalued. Based on its latest closing price of S$0.345 per share as at 16 April 2015, it is trading at a steep discount to the market value of its underlying stakes in PCCW and HKT. Even if we were to peg the value of its stake in PCCW to the lowest valuation metrics within its peer group, PCRD would still be trading at a discount of 36.4% to the conservative implied fair value of S$0.542 per share.

With the Company also aggressively buying back its shares and boosting Richard Li's control to 86.7% while simultaneously reducing public float to 13.1%, we also believe this year to be an opportune time for Richard Li to finally pull the privatisation trigger.

Should Richard Li elect not to privatise the Company, shareholders would also benefit, in one form or the other, from PCRD's stake in PCCW and cashcow HKT. Sans share buybacks, if the Company elects to pay out its cash income derived mainly from the dividends collected from PCCW and HKT, we think that the Company would be able to sustain an attractive dividend yield of about 7.0% based on the last traded price of S$0.345 per share, further reinforcing our conviction that the stock is selling at far below its fair value.

Key Risks

Further share buybacks will heighten trading liquidity risks going forward. This is somewhat mitigated by the fact that the Company has at present a sizeable share base of more than 2.7 billion, such that even a minimum 10% float amounts to more than 270 million shares. This should be able to sustain some healthy trading activity going forward.

PCRD has high asset concentration risks as its prospects are predominantly tied to HKT. However, HKT's business model has proven to be resilient over the years especially given its market leadership position in Hong Kong. This should help to ensure that PCRD's earnings going forward remain relatively stable.  

(SGD:HKD X-rate of 5.70 assumed)

KSTB has recently been the subject of a takeover attempt by its co-founder, Dato' Chee Peck Chia, an oil and gas industry veteran who together with his concert parties, announced a conditional voluntary takeover  offer (the "Offer") on 23 March 2015 for all remaining shares not owned by them. The offer price of RM0.48 per share is at a small premium to the last traded price of RM0.46 a share before the takeover announcement and a significant discount to its last reported NTA of RM0.67 per share as at 31 December 2014. However, taking into account the timing of the offer and the adjusted NTA per share of RM0.44, we do not think this is necessarily a bad development for KSTB shareholders.

Background

Up until 2014, KSTB had been engaged in the core business of providing tubular handling equipment and running services as well as tubular inspection and maintenance services for companies in the oil and gas industry. It was also in the business of providing land rig services. 

However, that began to change in November 2013 when it entered into an agreement with Bursa-listed Destini Berhad to dispose of its entire interest in Samudra Oil Services Sdn Bhd ("Samudra Oil"), through which it had been conducting its tubular handling equipment business, for RM 80 million. The consideration was satisfied fully in new Destini shares to be disposed of via a placement exercise. The disposal of Samudra was subsequently completed in April 2014 following which the Destini consideration shares were placed out at RM0.35 each[1].

Concurrently with the disposal of Samudra Oil, KSTB also entered into two separate agreements with Indonesian drilling services provider, PT Duta Adhikarya Negeri, to dispose of its 2 land rigs for a total consideration of US$10.5 million.

Figure 1. Part of KSTB’s tubular inspection & maintenance services

With the disposals, KSTB effectively exited both the tubular handling and land rig businesses, leaving it with a relatively small tubular inspection and maintenance services business which is currently operated by its wholly owned subsidiary Samudra Timur Sdn Bhd. As a result, the Company triggered Practice Note 17 ("PN17") of the Bursa listing rules giving it until 2 April 2015 to acquire a new core business in order to maintain its listing status. The Company subsequently triggered Practice Note 16 of the Bursa listing rules as a cash company on 27 February 2015. On the basis of its PN16 status, it has applied to seek an extension of the deadline to acquire a new core business to 26 February 2016. The outcome of this application is currently pending.

For the half year ended 31 December 2014, the group recorded after-tax profit (PAT) of approximately RM3.67 million, translating into a fully diluted EPS of 1.61 sens per share[2]. PAT was up from RM0.13 million in the previous corresponding period in 2013 with the increase largely attributed to foreign exchange gains of RM2.45 million and interest income of 1.65 million. Revenue was RM5.85 million.

Conditional Voluntary Takeover Offer by Dato' Chee and Concert Parties

On 23 March 2015, Dato' Chee Peck Kiat, his son Chee Cheng Chun and Darmendran a/l Kunaretnam (collectively "Joint Offerors"), an Executive Director of the Company, made a conditional voluntary offer for all outstanding shares not held by the Joint Offerors amounting to 76.72% of the total outstanding shares of the Company.  The all cash offer was  RM0.48 per share. Concurrently, the Joint Offerors[3] also made an offer of RM0.18 for all outstanding warrants of the Company not held by them amounting to 69.92% of the total warrants in issue. The Offer is conditional upon the Joint Offerors achieving a minimum shareholding percentage of at least 50% by the close of the Offer. In addition, the Joint Offerors have indicated their intentions to keep KSTB listed.

Our Views

Success of the Offer lies in the hands of a few shareholders

With sizeable stakes in the Company concentrated in the hands of a few key shareholders (We will call them “Key Shareholders” here), the success of the Offer depends very much on their willingness to accept the Offer terms.

Figure 2. A few significant shareholders hold the key to the Joint Offeror’s success in the takeover Offer. Joint Offerors are shaded blue and key shareholders highlighted yellow.

These Key Shareholders include long time shareholders, Innoteguh Sdn. Bhd.  and Trance Equity Sdn. Bhd. (not to be confused with Trance Rex Sdn Bhd) as well as Sterling Honour, Seamless Excellence and Oval Triangle, all of whom became shareholders by virtue of converting their ICULS[4] holdings. The Key Shareholders altogether hold 39.50% out of the 76.72% shares not owned by the Joint Offerors and have yet to give any indications as to their intentions with regards to the Offer.

We do not think any of the Key Shareholders holding significant shares have any compelling reason to put up a competing offer with the offer price already at a premium to adjusted NTA per shares. Should they wish to thwart the takeover attempt by the Joint Offerors, inaction may be the best course of action as the Joint Offerors still need to acquire another 26.72% of shares just to make the Offer unconditional. Furthermore, the board of KSTB had also announced on 25 March 2015 that it does not intend to seek an alternative offer.

Offer Price is at a premium to adjusted NTA representing a decent valuation of the remaining tubular inspection and maintenance business  

The offer price of RM0.48 per share is only at a small premium of 4.3% over the last traded price of KSTB prior to the Offer announcement. It is also at a significant discount of 28.0% to its last reported NTA of RM0.67 per share as at 31 December 2014.

However, taking into account adjustments from shares issued arising from conversions of the ICULS issue and warrants as well as its recent dividend payout of 4.5 sens per share, we estimate that the offer price is actually at a premium of 9.8% to KSTB's adjusted NTA of RM0.44. See Figure 3 below for computation.

Figure 3. Computation of adjusted NTA of KSTB

For the past 5 financial years, the remaining tubular inspection and maintenance service segment has contributed between RM 8.77 million to RM11.11 million in revenue and RM 0.72 million to RM 2.78 million in profit before tax, or an average of RM 1.53 million equivalent to a fully diluted pre-tax earnings per share of just 0.6 sens. 

Figure 4. Historical segmental results of the remaining tubular inspection & Maintenance Service business

As such, the offer premium over NTA of RM0.04 per share implies a valuation of approximately 7 times profit before tax for the tubular inspection and maintenance services business, which is neither too expensive or cheap in the current environment.

Takeover timing needs to be taken into consideration too

Further taking into consideration that the Company is already past the first deadline of 2 April 2015 for submission of a regularisation plan to Bursa Securities to continue its listing status and with the further extension of such deadline to 26 February 2016 uncertain, we believe existing KSTB shareholders should see the Offer as a welcome insurance in the event that the Company is forced to delist. According to the Malaysian takeover rules, the offer document has to be sent to shareholders within 21 days of the takeover announcement on 23 March 2015 and the Offer will need to be open for acceptance for at least another 21 days after the offer document has been despatched. This should buy some time while shareholders await Bursa's response to the Company's request for extension of time to acquire a new core business.

Recommendations

We believe shareholders should wait and see if the application by KSTB to extend the deadline to acquire a new business to 26 February 2016 is approved before making a decision on the Offer. As the Offer will be open for a minimum of 21 days after the Offer document has been despatched to shareholders, they will likely have between 3-4 weeks time while awaiting Bursa's decision. In the event that the extension is rejected by Bursa and the Company faces the prospects of being delisted, we believe that the RM0.48 cash offer provides an adequate compensation for shareholders to exit their investments. Should the extension be approved, KSTB will have until 26 February 2016 to acquire another new business to stay listed. In this case, even if shareholders decide to hold on to their shares, we believe that the downside will be limited given that the bulk of KSTB's assets consist of cash.

For investors not vested in the Company as yet, there is little risk but limited upside in buying in at the current price of RM0.48 per share pending acquisition of a new core business.

[1] Although the Destini consideration shares were placed out at the same consideration of RM0.35 at which they were issued, we note that this price was at an unusually large discount to the then prevailing share price of between RM0.57 and RM0.69 during the placement period even if we account for the low trading liquidity.
[2] Adjustments include interest and interest savings from the warrants conversion proceeds and ICULS conversion.
[3] On an unrelated but interesting note, we noticed that Chee Cheng Chun and Darmendran had also amassed a sizeable 18.64% stake in another Bursa listed company, Rex Industry Bhd, from 23 February 2015 to 5 March 2015 just prior to the Offer announcement. There are no indications as of now that the two transactions are related though.
[4] KSTB issued RM12.0 million worth of 5-year Irredeemable Convertible Unsecured Loan Stocks ("ICULS") to Maybank Berhad as part settlement of debt pursuant to a Debt Settlement Agreement dated 3 September 2013. It is not disclosed if Sterling Honour Sdn Bhd, Seamless Excellence Sdn Bhd and Oval Triangle Sdn Bhd are entities related to Maybank.

Developments since our last update on 25 January 2015 (link)

1. On 27 February 2015, ABRIC announced that it had recorded a profit after tax of RM69.3 million for the FY ended 31 December 2014.
2. Substantial shareholder, Pui Cheng Wui, has been steadily increasing his stake through open market purchases. As at 13 March 2015, Pui owned about 18.4% of ABRIC's total outstanding shares, almost doubling his stake in 2 months.

Our Views

The profit after tax of RM69.3 million is largely due to a one-time gain from the sale of its security seals business. As ABRIC is currently a cash company (PN16), the profit recorded from this sale is immaterial going forward.

Based on the latest announced balance sheet, the Company has cash of RM126.1 million. Adjusting for dividend payments of RM42.1 million, full proceeds from warrant conversion of RM13.8 million (RM1.1 million had been recognised as at balance sheet date), and conservatively subtracting all borrowings of RM8.1 million and payables of RM14.8 mil, net cash is around RM74.8 million or RM0.50 per share, substantially the same as we previously estimated. Revised NAV estimate is slightly lower at RM 0.62.

Note that some variations in subsequent quarters to these two estimates are to be expected due to ongoing corporate expenses, rental and interest income.

As for Pui, we do not wish to speculate on his intentions. However, we note that with him holding a 18.4% stake in ABRIC and stepping up his interests rapidly, any future use of the company's large cash reserves such as for an acquisition may eventually require his buy-in. For comparison, the controlling Ong Family holds around 35% of ABRIC's total outstanding shares.

Recommendation

At the closing price of RM0.505 on 19 March 2015, ABRIC's share price is already up by 25% since our first report 2.5 months ago, adjusted for the special dividend of RM0.30. While the margin of safety at this level is considerably lower than at RM0.405, we still see ABRIC as a low risk value play. We expect good support at its net cash level of RM0.50. Further upside will depend very much on what happens over the next 9 months. If ABRIC does not acquire a new business within this period, shareholders will likely be returned an amount close to its estimated NAV of RM0.62. Any potential acquisition could boost the returns even more.

Events since last update on 10 February 2015 (link)

Memstar Technology Ltd announced on 6 March 2015 that it had entered into a 2nd supplemental agreement to extend fulfillment of key conditions precedent, that were supposed to have first been fulfilled by 31 January 2015 and then by 28 February 2015, to 31 March 2015. These conditions include Longmen Group Ltd (or "Target") successfully completing Tranche 2 Fundraising of US$15 million and the Target entering into an off-take agreement with Petro China and/or CNPC for the purchase of the Target’s coal bed methane.

Memstar also announced that it had successfully obtained a 6-months extension of time to meet the requirements for a new listing, i.e. from 11 April 2015 to 11 October 2015. The extension is, however, subject to the following conditions:

1. The submission to SGX of the Proposed RTO application of Longmen by 30 April 2015; and
2. Memstar providing quarterly updates of key milestones, via SGXNET, on its progress in completing the Proposed RTO by September 2015.

Our Views

The conditional extension granted by SGX effectively means that the latest extension of time by Memstar for Longmen to fulfill the conditions precedent may well be the final one. Should Longmen fail to meet these conditions precedent by 31 March 2015, Memstar is unlikely to be able to meet the conditions set by SGX to extend its own listing status to 11 October 2015.

Such a scenario would pose a major setback to existing shareholders as we have previously warned. Recall our estimates that the Company only has an NTA backing of S$0.003. In the event that it is forced to delist, shareholders would probably not be able to monetise their shares for much more than this amount.

As we have also highlighted previously, the valuation of Longmen appears rich compared to that of its larger LSE-listed competitor, Green Dragon Gas Ltd. The most ideal scenario for Memstar shareholders would therefore be for a cut-price deal to be negotiated and consummated with Longmen. However, given the dire  circumstances, a deal based on the current price is still better than none for shareholders. Indeed, Memstar may well choose to waive the existing conditions precedent just to push the deal through.

Share price of Memstar is $0.015 as per close of market on 17 March 2015, down 25% from $0.020 from our first report issued on 21 January 2015 warning investors that the price then was unjustified. (See chart below)

Recommendations

Even though the share price has declined to $0.015, where it was at before the RTO announcement, we would still caution investors to stay away given the uncertainties surrounding the deal and Memstar's own listing status. We do not discount any positive news or developments from the RTO giving a temporary boost to Memstar's share price. However, any potential gain has to be weighed against a likely loss of 80% in value (share price of S$0.015 vs S$0.003 NTA backing) should the deal fall through.

In our report on Chuan Hup, we suggested that Falcon Energy Group Ltd’s (“FEG”) successful takeover offer for CH Offshore Ltd ("CHO"), which resulted in CHO becoming its 86.7% owned subsidiary, could be a win-win-win situation for all three companies involved. In this report, we take a closer look at FEG and assess its options with respect to its newly acquired CHO stake.

Introduction to FEG

History

FEG has come a long way ever since it morphed from the then Sembawang Music Holdings Ltd ("SMH"), a small music retail business listed on SGX SESDAQ (n.k.a Catalist), via a 2-stage reverse takeover process into an established Oil and Gas ("O&G") services provider.

The transformation began in May 2006, when Tan Pong Tyea, the current majority shareholder of FEG and a long-time veteran of the oil and gas industry, acquired a 55.0% stake in SMH, triggering a mandatory takeover offer and gaining control of the listed entity. SMH subsequently became known as Falcon Energy Group Ltd. With Tan at the helm, FEG began its initial foray into the new core business of Marine and Oil and Gas services.

The new business gained steam when Tan injected his privately held Oilfield Services Company Limited, a well-established company started in 1983, into FEG. The consideration of S$229 million was paid entirely in newly issued FEG shares, further tightening Tan's grip on FEG. The legacy music business was also disposed of along the way to SMH's former controlling shareholder.  

This series of moves laid the foundation for what FEG is today. 

Core Businesses

FEG currently has 5 main business divisions catering to customers in different stages of the exploration and production phase in the upstream O&G sector. The services offered under each division can either be offered individually or integrated and customised to cater to each customer’s specific requirements. The 5 divisions are listed below:

• Marine Division: Owns and operates a fleet of 22 offshore support vessels ("OSVs") that mainly service customers in the production phase of O&G projects. These include one of the largest fleet of Accommodation Work Barges (13) in the region alongside 3 Multi-functional Support Vessels, 1 Anchor Handling Tug and 5 other OSVs.  The Marine division provides a wide range of platform supply and engineering services. 
• Oilfield Services Division: Provides services such as agencies, logistics, procurement and other general support activities to customers like O&G majors, national oil companies (NOCs), contractors and shipyards globally. This division also provides engineering and consultancy services for the construction of oil rigs and OSVs.  
• Oilfield Projects Division: Provides O&G project related services of varying nature such as building and leasing of specialised seismic vessels and marketing agency for oil companies, ranging from small facilities to multi-million dollar heavy oil facilities. 
• Drilling Services Division: Relatively new division started in 2011 to provide drilling and related services to the O&G majors, NOCs and O&G contractors. Through this division, the group has been building up a modern fleet of high specification jack-up rigs via joint ventures (“JVs”) with its strategic partners. The JVs currently have a total of 5 rigs on order: 4 GustoMSC CJ50 and a Keppel FELS Super B Class jack-up. All 5 rigs were ordered in 2013 and are expected to be delivered between mid-2015 to mid-2016. FEG has an effective ownership stake of 25% in these rigs. The Group previously also held stakes in 2 more GustoMSC CJ46 rigs ordered in 2011 but both were sold to China Oilfield Services Limited before they were delivered, netting FEG substantial gains for FY2014. 
• Resources Division: Set up in 2010 to create another energy-related stream of revenue for the group. FEG has acquired the commercial rights to three coal-mining concessions in East Kalimantan, Indonesia. According to FEG's annual report, production of coal was expected to commence in 2014 although we have not seen evidence of this happening as yet: in its latest Profit & Loss statement for the 9 months ending 31 December 2014, 100% of FEG's revenue came from Marine, Oilfield Services and Oilfield Projects divisions. FEG remains on the lookout for further coal acquisitions.   

Figure 1: FEG's services cover the full spectrum of exploration and production phase in the upstream O&G sector. Source: FEG

Recent Financial performance

FEG has in recent years managed to successfully execute its multi-prong expansion plans with both top and bottom line growing more than 4 times since the downturn in FY2010 to US$350.8 million and US$60.8 million respectively in FY2014. We note though, that revenue and earnings for FY2014 were boosted by the disposal of the two GustoMSC CJ46 rigs, without which they would still have been approximately US$222.4 million and US$30.5 million respectively. Although FEG does not appear to have a consistent dividend policy, they have paid dividends of between 0.5 to 1.5 Singapore cents in 4 out of the last 5 years. 

^FEG changed its financial year from December to March resulting in a 15-month financial period straddling FY2012 and FY2013. Profit After Tax and MI adjusted for FEG’s share of a one-off writedown on CHO’s receivables of US$43.95 million during FP2013 of which the outcome is still pending.


Figure 2: FEG's performance in recent years has been on the uptrend. Source: FEG

At the current share price of S$0.27 and implied market capitalisation of S$218.6 million, FEG is trading at a valuation of 5.2 times FY2014 earnings adjusted for gains from disposal of the two rigs, with an above average dividend yield of about 5.6%.  As with all other oil and gas services companies, we expect operational environment going forward to remain challenging although the effect of lower oil prices have yet to manifest itself in the latest reported financial period of 9M2015 ending 31 December 2014 with profit after tax and minority interests already at US$34.2 million. 

CHO shareholders' deadlock finally broken- expect more synergies

FEG had not been able to exert any meaningful control over CHO ever since it acquired its initial 29.1% stake from Scomi Marine Berhad (n.k.a Scomi Energy Berhad) back in 2010, as witnessed by it not having any representatives in a key executive role on board of CHO- FEG Chairman Tan and CFO Gan Wah Kwang are both non-executive board members. This was largely due to Chuan Hup and its associates controlling a higher 35.1% stake in CHO. Now that Chuan Hup is no longer in the picture, we should start to see more integration between CHO and FEG's operations.

We expect CHO's fleet of 15 AHTS, including seven of the 12,240 bhp variety built in Japan, to complement FEG's fleet of mainly Accommodation Work Barges nicely by significantly expanding the scope of services its marine division provides and increasing its fleet capabilities. For more on the 2 types of OSVs, see Figure 3 below. There should also be increased service cross-selling opportunities going forward with the enlarged clientele base as well as geographical coverage. 

Figure 3: FEG's AWBs vs CHO's AHTS. Source: Intership, FEG, CHO.

FEG's gearing ratio likely to have risen significantly- room to optimise capital structure

As at 31 December 2014, FEG had cash of US$88.9 million vs total debts including notes payable of US$239.4 million, giving it a gross gearing and net gearing of about 0.82 and 0.51 respectively. The debts are mostly secured[i] against its existing vessels and leasehold office properties.

FEG had also previously disclosed its intention to fund the CHO takeover using bank borrowings and internal cash resources. Assuming a Loan to value ("LTV") ratio of 70%[ii], we estimate that an additional US$106.7 million of debts would have been added to date and the gross and net gearing would have ballooned to 1.10 and 0.80 times respectively despite the larger equity base due to consolidation of CHO's accounts. This is on par with its peer companies:

Figure 4: FEG's estimated proforma gearing is in line with its peers.

However, despite the seemingly manageable consolidated gearing, we note that all the debts (estimated at US$347.6 million) are now being carried on FEG's books. On the other hand, a large portion amounting to US$69.5 million of the combined cash balance is carried on CHO's debt-free books.

It is important to make this distinction, as while CHO is now majority controlled by FEG, they are fundamentally two separate listed entities each managed by its own board of directors. Cash carried on CHO's balance sheet for example could not be used to pay FEG debt or service FEG interest unless distributed upwards to FEG via say dividends. Thus, we believe that there is room for FEG to carry out a capital structure optimisation exercise and lower its own gearing, especially with the market expecting an interest rate hike later this year.

Strategic options for FEG

We believe FEG may undertake the options put forth below to optimise its capital structure:

Option 1: Gear up CHO’s balance sheet to repay borrowings at FEG

One possible option is for CHO to take on borrowings against its balance sheet and distribute the loan proceeds as well as excess cash on its books to its shareholders in the form of a special dividend. FEG can then use the dividends it receives to reduce its own borrowings, particularly those arising from financing the CHO offer.

As an illustration, we estimated that if CHO were to borrow an amount of US$75 million, secured on its fixed assets of US$196.6 million (taking into account revaluation of its vessels), it would be able declare a special dividend of almost US$125.0 million or S$0.24 per share, out of which US$108.4 million would go to FEG for it to repay its entire projected acquisition loan as well as associated costs.  Even with the special dividend payment, CHO would still be able to retain approximately US$19.5 million in cash as working capital. This would however lead to a cash leakage of US$16.6 million to minority shareholders of CHO.

Option 2: Inject FEG’s marine division into CHO

FEG’s marine division's operates a fleet of 22 offshore support vessels ("OSVs"), including accommodation work barges and multi-functional support vessels, that mainly service customers in the production phase of O&G projects. It has traditionally been a major contributor to FEG in terms of revenue and profit. See charts below:

Figure 5: Marine division is a major contributor to FEG's revenue and operating profits

The division is also FEG's most capital intensive and contributes the majority of the fixed assets in the group:

Figure 6: Marine division contributes the bulk of FEG's fixed assets.

We thus see scope for the division to benefit from a separate listing which would give it ready access to capital markets. In this aspect, FEG can take advantage of CHO's existing listing by injecting its marine assets into CHO. The consideration can be satisfied partly by cash and shares so as to maintain CHO's mandatory free float while freeing up capital at FEG to reduce its borrowings and to invest in other segments of its core businesses.

We note though that this proposal would be subject to higher execution risks: CHO minorities would have to approve the transaction given that it is an interested persons transaction and FEG would not be eligible to vote. 

Option 3: Privatise CHO by buying over remaining stake held by CHO minorities, possibly via a share swap

As opposed to Option 2, FEG management may feel that there is no need for FEG and CHO to both maintain their listing statuses. Indeed, having two listed entities would lead to additional unnecessary compliance costs, especially when FEG already controls 86.7% of the total outstanding shares of CHO. While CHO's existing free float is only 13.3%, buying out the remaining minorities may cost at least US$38 million even if FEG were to stick to the same terms of S$0.55 cash for each CHO share as per the recently concluded offer. With the estimated gross gearing levels of FEG already at 1.10, any additional borrowings used to fund this would not be ideal.

Hence, we think that it may make more sense for FEG to propose a full or partial share swap instead, effectively paying for the CHO shares held by minorities with new FEG shares. As an illustration, if we were to effect the share swap based on the current FEG price of S$0.27 per share and an CHO offer price of S$0.55 per share, Tan Pong Tyea would still be able to retain his controlling stake at above 50%. 

Figure 7: Tan PT would still retain majority control even with a full share swap to acquire CHO's remaining shares.

Other variants to the share swap option include those based on NAV, which could cost less for FEG as it is currently trading below its NAV of 33 US cts as at 31 December 2014.

A follow up privatisation offer though may need to be sufficiently more attractive that the previous offer to entice the remaining minorities to accept. This is, however, unlikely to take place within 6 months after the CHO offer closed on 27 February 2015 as the Singapore takeover code forbids a second offer to be made within this period on terms better than the preceding offer.  

Alternatively, FEG may acquire more CHO shares in the open market before it makes the follow up offer to acquire the remaining shares.

Other key developments to note

On 11 October 2013, CHO announced that it had commenced legal proceedings  in London against PDV Marina S.A. and Astilleros De Venezuela C.A. to recover outstanding charterhire amounting to approximately US$56 million. The  trial is set for 20 April 2015. As CHO had previously written down US$44.0 million worth of related receivables in FY2013, a positive outcome from the trial would provide a boost to both FEG and CHO's financial positions and share prices.

Recommendations

We think the successful takeover of CHO by FEG will be positive to both CHO and FEG in the long run in view of the potential operational synergies. FEG's share price, despite trading at just 5.2 times historical adjusted earnings, may continue to be depressed due to the current challenging operating environment in oil and gas. FEG's gearing could also potentially be a drag on earnings in an environment of rising interest rates.

As for CHO, any potential capital optimisation exercises by FEG to reduce its borrowings may lead to short or medium term price catalysts in the form of a special dividend or a further privatisation attempt by FEG. Both CHO and FEG could also benefit from a positive outcome in the impending trial taking place on 20 April 2015. We are positive on FEG's long-term prospects particularly if it manages to successfully integrate CHO's operations into its own but would prefer an exposure to CHO in view of both long term and short term potential upside.

Key Risks

Further deterioration in the O&G sector will negatively impact both CHO and FEG. FEG will be the more vulnerable of the two with the 5 jack-ups owned by its JVs set to be delivered over the next 1-1.5 years. With total debts likely to have hit US$347.6 million, FEG is also susceptible to rising interest rates.
Investors and CHO shareholders may also not be able to trade CHO shares freely with its free float currently at only 13.3%.