Wednesday, September 16, 2015

Swiber Holdings - When Cheap is not Cheap and Perpetual is not Perpetual

Share price of Swiber Holdings has fallen more than 60% in the past 1 year due to the sharp fall in crude oil prices which has caught many investors off-guards. At the current share price of SGD $0.136, Swiber Holdings is only trading at a price to book ratio of only 0.156x (based on 2Q15 NAV of USD 0.621 and exchange rate of 1 USD to 1.4 SGD). Is it considered cheap?

When Perpetual is not Perpetual

Perpetual bond is an attractive financing tool for company as they are able to treat the security as an equity to lower gearing ratio. The rationale behind the accounting treatment is that 1) the company can choose not to repay the perpetual bond indefinitely 2) the interest paid can be deferred.

However, financiers are known to creative in the way that a security can be structured. In the case of Swiber, the perpetual bond is structured such that Swiber is likely to redeem the security 3 years from the issuance date of 25 Sept 2012 (which they have announced that they have the intention to redeem). A step-up margin of 3% is imposed on the perpetual bond every 3 years. This signifies that Swiber will have to pay an interest rate of 12.75% if Swiber don't redeem the perpetual next month. If Swiber don't redeem in 2018, the interest rate will jump to 15.75%.

Given such onerous step-up margin every 3 years, it is questionable whether these securities meet the accounting treatment of equity. Swiber is not the only company that issues perpetual bond that has high step-up margin and a short reset date of 3 years. Ezra did a dilutive rights issue recently so that it can redeem its S$ 150 million 8.75% perpetual bond issued on 18 Sept 2012 with a similar step-up margin of 3% every 3 years. Ezion also has a S$ 125 million 7.8% perpetual bond issued on 14 Sept 2012 with a step-up margin of 3% every 3 years again. If you have noticed, all 3 perpetuals were issued in Sept 2012 with the same step-up margin every 3 years.

We will do the relevant adjustment for the perpetual later.

When Cheap is not Cheap

The issues that many investors have with Swiber is that it is highly geared and a persistently high receivables outstanding. These are certainly valid concerns and a look at its balance sheet shows a high liquidity risk.

The reported debt to equity ratio for Swiber is 1.45x as of 2Q 2015. The gearing went down slightly after the rights issue early in the year. Gearing ratio gives us a clue of the extent of indebtedness and default risk for a company. However, it is only when a company is unable to repay (default) on a bond/loan, that equity value will be threatened.

Swiber is likely to repay the S$ 80 million perpetual security on 25 Sept 2015 (they have started buying from the open market). Therefore, if the company don't generate any free cash flow or get additional loans from the bank, the cash level for Swiber will dwindle down to USD 60 million.

Next year, Swiber will have 3 bonds with a total principal amount of SGD 305 million to be redeemed upon maturity. It is highly unlikely that Swiber will be able to repay the bonds with its current cash level. What alternatives are available?

1) Issue another bond - With the yield to maturity at more than 30% (look at the column - Evaluated Bid Yield) for most of its bonds, Swiber is effectively shut out of the bond market. Swiber will need to offer a bond yield of close to 30% for its new bond issuance, else an investor will be better off to invest in the current bonds which offers higher yield and shorter maturity (lower default risk).

2) Raise equity - Swiber has a current market capitalisation of SGD 136 million. At the current huge discount to book value, a rights issue will only destroy more shareholder value. It is highly probable that Swiber will do another rights issues or share placement, but the amount of equity that can be raised will be highly limited.

3) Sell assets - Swiber has USD 748 million of PPE as of 31 Dec 2014. However, USD 241 million of it is finance lease, which means Swiber don't have ownership of the assets. In addition, Swiber has pledged USD 221 million of assets for bank borrowings. These assets are secured and will be difficult for Swiber to sell (or if sales happen, likely that money will be used to repay the secured loan). This leaves the company with USD 286 million of PPE that can be sold. With the current downturn in O&G industry and the lower charter rates, Swiber will have to sell the remaining salable assets at a discount to its carrying value.

4) Collect trade receivables - Swiber has current trade receivables of USD 443 million, other receivables of USD 377 million. Of the trade receivables , USD 76 million arise from "unbilled receivables arising from variation claims on construction contracts submitted to customers amounting to US$76,447,000". The sum is unbilled and arising from variation claims does not sound good. In addition, 1 debtor represents 50% of the trade receivables in FY 2013 and FY 2014. Who is this debtor and does the debtor has the ability to pay the receivables? There might be a need for further impairment.

As for the other receivables, USD 75 million are capitalised vessel cost which is capitalised expense that is more like prepaid expenses. The rest are mostly receivables and loans from joint venture and associates. The bulk of the other receivables are likely to be in its 27% owned Vallianz Holding. However, if one take a look at the balance sheet of Vallianz, it is doubtful how Vallianz will be able to repay the loans.

Swiber's Annual Report 2014

5) Borrow from bank to refinance bond - Swiber has a current bank borrowing of SGD 209 million which will be up for repayment. It is possible for Swiber to do a refinancing of its borrowing, but it will be tough to raise additional bank loan since banks will be looking to reduce their oil and gas exposure at this moment. This option will depend heavily on Swiber's banking relationship and the bank's risk management policies. 

As an equity investor, we benefit from higher upside when the company reports higher profit. However, when a company is in distress, it is always the holder of the loans and bonds that get the priority claim over the assets of a company. With the limited options that Swiber has, even a successful repayment of the loan is likely to further destroy shareholder value.


Back to the question of whether Swiber is cheap, let's do some adjustment:

Adjustment for associates
Carrying value of its 27% owned associate Vallianz is USD 95.9 million (equity of USD 73.4 million and perpetual securities of USD 22.5).
Market value is 27% * SGD 163 million = SGD 44 million or USD 31 million
Adjustment: USD 42 million

After adjustment, Swiber is trading at around 25-30% of book value. However, this has yet taken into account 1) potential impairment of trade and other receivables of USD 871 million 2) potential impairment in market value of vessels. Swiber will be able to sustain a positive equity as long as it does not impair a maximum of 25% of trade and other receivables and its property, plant and equipment.

Do your own impairment adjustment and it is your call on the value of the equity. This is certainly a highly leveraged play!

Sunday, August 30, 2015

Reflection on Silverlake Axis

Sooner or later, the markets always humble people. I believe in it and have my fair share of being humbled. While I was not hurt in monetary terms as I sold it off 2 years ago on price discipline, it will be good to do a personal reflection.

My mistakes were

1) I failed to pay attention to the related party transactions
2) The past deals action did not come across as red flags to me as I thought I had invested in the new entity where the whole Silverlake Group is inside the listco.

I tend to be bias to the short seller and will be glad to have more short report in the market as it improves the market process and mechanism. Who is razor99? razor99 called a short on Longtop months before Citron launched a successful attack on the company. Longtop specialises in software catered to the financial institutions, an area similar to Silverlake. Both his experience with Longtop and the release of a fraudulent claim in May probably led razor99 to look into Silverlake.

The most damaging claim

Razor99 made many claims in his 42 pages report, including concerns of bribery. However, only 1 claim was truly critical. According to razor99's claim, margin at Silverlake was inflated through related party transactions. The evidence was a jump in revenue and margin at to-be-acquired entities. Another evidence was the losses suffered at Goh's private co such as Sprint.

Legally, it might be hard to accuse Silverlake of fraud as the company has followed the proper procedures:
1) The mandate for IPT was approved by shareholders annually since 2008 and had always been disclosed since the 2003 IPO
2) The details of the IPT was disclosed in the annual circular (inclusive of pricing)
( )
3) Auditors will review every IPT transactions every year

What are the related party transactions (RPT)?

The IPT mandate approved by shareholder annually holds the critical information to understand the RPTs. In addition, lets take a look at Silverlake listco after 2011 since that is the current corporate structure.

Source: razor99 report

The bulk of the RPT revenue is from software licensing while the bulk of the RPT expense is from service fees paid.

RPT Revenue % per segment

To put the information in another perspective, it will be to view the segment revenue and determine how % of segmental RPT revenue against the actual segment revenue. It can be seen that the bulk of the software licensing revenue (more than half of it) comes from RPT. This deserves a deeper look since software licensing has the highest margin (90%) and account for at least 40% of Silverlake's profit.

Master License Agreement

Everything is properly accounted for under the MLA, inclusive of the minimum fee of US$20 million and how the points are allocated. Under the Master License Agreement (MLA), the interested person is granted the right to "resell, implement, copy, customise or use the software" and to "sub-license the right to use the Software to End-Users". Essentially, when the interested person wins a new software contract, Silverlake will earn a license fee while the implementation and employee costs are borne by the interested person. This explains the 90% profit margin for the software licensing revenue. You don't expect to pay any cost other than your R&D amortization and expenses.

Master Services Agreement

Under the Master Services Agreement (MSA), this deals with the receipt of "Customisation, Implementation and Maintenance services by the Group from the Interested Persons". The MSA explains the 50 million service fees paid, which is almost all of the expenses paid out to the related party. With the MSA, Silverlake sub-contracts or outsources part or whole of the implementation and maintenance job to the interested party for a fee. Once again, everything is properly accounted for with the use of "Man-Day Rates" and "estimated man-days required to complete the work"

Peer Analysis, Source: razor99's report

With an understanding of the MLA and MSA, it is a lot clearer why the peer analysis results in Silverlake having a low employee expenses %, much higher profit margin and much higher revenue per employee. A huge portion of a new software contract implementation is outsourced to the Interested Person. An unknown portion of the costs for maintenance and enhancement is also outsourced to the Interested Person.

Legally correct but still a governance concern

Being right legally is not equivalent to being right in principle to the shareholders though it is highly debatable in this case. Inevitably, the question in shareholder's mind will be what kind of profit is Mr Goh's private entity making from these MLA and MSA contracts. 
  1. If it is a loss, Mr Goh runs the risk of being accused of hiding expenses and inflating margin (although everything is properly and legally accounted for, so it is a false accusation).

    And a subsequent question will be how long is he willing and able to sustain the loss on his own account? Ans: For as long as he continues to be generous. (With regards to the ability, high dividend payout creates a feedback loop and share sales can top up the remaining amount)
  2. If it is a profit, why not share it with the shareholder to show an alignment of interest?
  3. Even if it break-even, why not consolidate all the private co into the listco and nobody can accuse you of anything in the future?
There are of course numerous clues that point to 1 particular scenario above if one read razor99's report and understand what have been written so far on the MLA and MSA.

In any case, for proper corporate governance, it is still best to consolidate the private co into the list co as the Nash Equilibrium. Shareholders can recommend to Mr Goh and they also have the right to vote against the IPT.