The Straits Times / The Business Times News on Hyflux

Consider new-look Hyflux for longer term gain

Hyflux, whose application of membrane technology to wastewater treatment once made it a stock market darling, could look like a different company in a year's time. The company in June acquired a majority stake in a used-oil collection company and intends to use its membranes to clean and recycle the oil.

At a recent results briefing, Olivia Lum, Hyflux's founder and CEO, further detailed the company's plans in this direction, saying Hyflux has the only proven, industrial-scale technology in the world. As long as crude oil prices remain above US$30, the venture will be profitable, she said, and if prices remain above US$50, it will be 'very profitable'.

Should investors buy into the potential growth?

Oil, of course, is a very attractive card to play right now, given high prices amidst geopolitical tension, not to mention leaking pipelines in Alaska. Ms Lum, an experienced businesswoman, probably knows this, and acknowledges the venture will not be profitable until at least 2007, if ever.

Meanwhile, the group's core operations in water treatment have seen the cost of sales and of staff shoot up, causing profits to fall below analysts' expectations and in spite of rapid revenue growth.

Rising costs

Hyflux reported last week that first-half revenues went up 65 per cent year on year to $71.2 million, while second-quarter revenues nearly doubled to $37.5 million, thanks to high industrial sales and a strong project pipeline in China. But costs of raw materials and consumables rose 85 per cent for the half year and 186 per cent for the quarter, while staff costs rose 111 per cent and 76 per cent for the half year and quarter respectively. Profit margins sank as a result. Earnings before interest and tax (Ebit) margin was only 10.4 per cent for Q2 06, compared with 31.4 per cent in Q1 06 and 35.4 per cent in Q2 05. Excluding gains from sale of assets and from financial instruments in 2005, net profits grew 117 per cent for the half year to $12.6 million and 25 per cent for the quarter to $3 million.

But this is not good enough for analysts like Christina Hee and Rick Loo of Goldman Sachs, who said 'the results were still below our and consensus expectations of about $20 million for H1 06'.

The higher cost of sales is due to a large proportion of booked revenues from smaller projects, which have a lower value-added, Ms Lum said, while a CLSA report said 'rising competition in China is likely to be the chief cause' of lower margins. Poor gross margins represent an ongoing risk for investors.

But Ms Lum gave sound reasons for rising staff costs, saying Hyflux is building up new human capital in advance of tapping business opportunities. These include the recycled oil venture, as well as the Indian water treatment market, where Hyflux won a small contract for the first time last week.

Hyflux's headcount has grown 17 per cent from 682 at the beginning of 2006 to 800 at the end of June, according to UOB KayHian. But staff costs rose 76 per cent, perhaps signalling that more expensive but higher-skilled workers have been hired, beefing up Hyflux's knowledge base as a precursor to the ventures.

Further, the plan to make money from selling recycled oil is plausible, even if the numbers show nothing yet. Hyflux will collect oil used as lubricant or other purposes in various industries from steel mills to aircraft component shops and power plants. Within South-east Asia, China, India, the Middle East and Africa, Hyflux estimates about 3.5 million tonnes of used oil is generated every year.

Hyflux said it can restore used-oil to the same quality as virgin oil but sell it 20 per cent cheaper, and estimates the potential market value for recycled oil in the above areas at $2.1 billion a year. Competitors around the world have only managed to prove their methods in the laboratory, while Hyflux has done so in a pilot plant and is now building a processing plant in Singapore, it said.

New growth areas

Hyflux has also broken into India, which analysts agree is a potential growth area, even if the $17 million value of its first contract is puny. Still, investors will be wary of promises of new profits from new areas, given Hyflux's aborted expansion into the Middle East and the uncertainty of project wins in China. The reality of such risks is being reflected in Hyflux's stock price, which has drifted downwards from its high of $3.92 in July 2005 to hit $2.06 on Friday. But has the market fully priced in the risk? Hyflux remains one of the more expensive SGX-listed stocks on a price-earnings basis; according to UBS, it trades at about 19.8 times its FY2007 earnings, against the market's 14.3 times.

Nonetheless, the company's ventures into recycled oil and India, and its decisive action to rechannel resources away from the tough Middle East market, reflects a management that, armed with a track record at commercialising membrane applications, is actively strategising for growth in new areas. Investors with an appetite for risk might consider adding the stock to a longer-term portfolio.