Water: Of timing and pricing

Edge Daily, 19 February 2009
by Fong Min Hun

KUALA LUMPUR: CIMB Research said yesterday the water sector was still an attractive investment option even though investors had sold down the shares of water-related stocks earlier this week.

The Selangor state government recently made the headlines after it formally made an offer to buy up the state’s water assets through its investment arm, Kumpulan Darul Ehsan Bhd (KDEB), as part of a restructuring exercise.

However, the lower-than-expected RM5.7 billion offer sent the share prices of key water players, which include the likes of Puncak Niaga Holdings Bhd, Gamuda Bhd and Kumpulan Perangsang Selangor Bhd (KPS), tumbling.

CIMB Research has nonetheless maintained a trading buy on water stocks signalling its bullishness on their prospects over the near term. The research house said it was likely that the Selangor concessionaires would unilaterally reject the offer, which would prompt KDEB to come back with an improved offer.

“Although the offer prices for the Selangor water assets are disappointing... we think there is a good chance of a more attractive offer,” CIMB said in its report yesterday.

“Furthermore, the potential intervention by the federal government via PAAB (Pengurusan Aset Air Bhd) to take over the physical assets and liabilities could lead to favourable alternative valuations for the concession assets.”

To recap, the Selangor state government is looking to acquire the state’s water assets in a bid to improve efficiency and prevent tariff hikes as stipulated in the concession agreements.

For example, Puncak Niaga is expected to hike tariffs by as much as 37% by April this year if the KDEB takeover is unsuccessful.

Presently, Selangor has the highest water tariff average in the country, CIMB Research said. If KDEB is successful in its acquisition, the research outfit said KDEB might propose a tariff cut of up to 14% from the current average of RM1.39 per cubic metre.

Selangor’s water assets are owned by four companies — Puncak Niaga Sdn Bhd (PNSB), Syarikat Bekalan Air Selangor (Syabas), Syarikat Pengeluar Air Sungai Selangor Sdn Bhd (Splash) and Konsortium ABASS Sdn Bhd.

PNSB is a wholly owned subsidiary of Puncak Niaga Holdings, which also owns 70% of Syabas. The other 30% ownership of Syabas is divided equally between KDEB and KPS.

Splash is 30% owned by KPS, 40% by Gamuda and 30% by The Sweet Water Alliance (TSWA), a company linked to Tan Sri Wan Azmi. Lastly, ABASS is 55% owned by KPS (through its 55% owned subsidiary Titisan Modal Sdn Bhd) and 45% by Operasi Murni Sdn Bhd.

Earlier this week, KDEB offered RM1.6 billion for PNSB, RM1.5 billion for Syabas, RM2.1 billion for Splash and RM525.7 million for ABASS.

The offer has been universally declared unattractive, as the offer did not take into consideration the liabilities of the companies. KDEB’s decision to value the companies through their respective capitalised values rather than through their expected cash flows also came under criticism.

“The offers did not disclose the debt/liability and cash components of the concession assets, which should have been accounted for in arriving at the effective acquisition costs. Factoring this in, the valuations in the offer are significantly lower than our DCF (discounted cash flow) estimates for PNSB, Syabas and Splash,” CIMB Research said.

“Effectively, Puncak’s 100%-owned PNSB is valued at RM308 million (75 sen/share) while Syabas’s equity value is negative. The offer price for Splash works out to RM464 million, translating into 10 sen/share for Gamuda’s 40% stake.

“ABASS is valued at RM334 million, lower than the RM529 million price tag it had fetched when KPS took over in Apr 2006. The effective offer price would slip into negative value if we consider Titisan Modal’s outstanding bonds of RM572.3 million. KPS’ 55% effective stake via Titisan Modal is worth 40 sen/share.”

As a result, the concessionaires are expected to unilaterally reject the offer, which means that either KDEB will have to come back with an improved offer, or the concessionaires will deal with federal-owned PAAB.

Should KDEB succeed in taking over the assets, the concession agreements would be converted into licensing agreements subject to various key performance indicators (KPI) to qualify for tariff increases. KDEB has until the end of March to finalise the acquisitions.

In the other scenario where KDEB fails in its bid to acquire the assets, PAAB would then step in as per the legislated requirement.

“Under this scenario, the federal government will intervene via PAAB and acquire the physical assets and liabilities of all water operators, which will take some time to conclude,” CIMB Research said.

“We gather that Puncak Niaga’s delayed 37% tariff hike will be enforceable by Apr 2009. All water operators will eventually be asset-light carrying zero debt in their balance sheets, with future capex to be managed by PAAB.”

The research house added that it expected PAAB’s valuations of the water assets to be higher because it was using the DCF method to value the assets.

“We gathered from our channel checks that PAAB uses the DCF valuation methodology which implies that its offer prices could be more attractive than the Selangor state government’s offer. Furthermore, PAAB will take over the liabilities of the concession assets,” CIMB Research said.

News reports are also suggesting that the concessionaires could fare better by dealing with PAAB, which is willing to pony up to RM9 billion for the assets. However, this is still significantly lower than the concessionaire’s expectations of between RM12 billion-RM13 billion.

So far as consumers are concerned, the silver lining in this scenario is that the proposed hike by Puncak Niaga could be lower than the expected 37% because the company did not meet the requirement to lower non-revenue water (NRW) to the 28% mark.

CIMB Research said Puncak Niaga has lowered NRW to 30%, which meant it could only hike tariffs by 29.6%.

Also upcoming is the deadline for the transfer of all water assets in Peninsular Malaysia to federal-owned PAAB by the end of 2009, as stipulated in the Water Services Industry Act 2006. The transfer will go on regardless of who owns the water assets.

Elsewhere in the peninsula, PAAB has managed to recently secure assets in Melaka for RM889 million and Negri Sembilan for RM1.2 billion. The goal is to ultimately streamline water operations to make them profitable.

“Consolidation remains the key catalyst for the sector,” CIMB Research said.

As for PAAB’s acquisitions elsewhere, CIMB Research said next in line were Pahang and Johor.

“We gather that PAAB has been in active negotiations with Syarikat Air Johor (SAJ) which is the main water concession holder in the state with a 30-year concession ending 2030. SAJ is a subsidiary of the recently privatised Ranhill Utilities. Although the total acquisition cost is still not known, we gather that SAJ has outstanding debts of RM597 million,” it said.

The research house added that expectations of new water infrastructure projects, particularly the award of a 45-kilometre water transfer tunnel between Pahang and Selangor, could also serve to stimulate the water sector in the near term.

The project is expected to be awarded to a consortium that includes local construction players IJM Corp Bhd and the UEM Group.

Should the tunnel project take off, CIMB Research said it could be the catalyst for the development of a RM5 billion water treatment plant in Langat, which is lead by KPS. Financing has already been secured for the tunnel, it added, but the financing plans for the water treatment plant is still unknown.