BOT (Build Operate Transfer) Question

[Nick]

Over the past decade, there are numerous companies investing in BOT projects around the world as governments encourages the private sector to finance public works in return for rights to operate these assets over a fixed period of time. Currently, such BOT assets are very popular investments among listed companies due to their high moat, stable cash-flow and defensiveness. This assumes that they can secure the financing since the cost of the investment is paid upfront during the construction phase. At the moment, there are numerous SGX companies dealing with BOT projects: Hyflux in BOT water plants, KGT deals with concession based assets in Singapore, MIIF & CM Pacific owns BOT toll roads, HPHT owns port concession rights, United Envirotech & Sound Global has extensive investments in water BOT plants etc. Most of these concession rights will expire in the next 2-3 decades - the earliest would MIIF's HNE toll road which expires in 15 years time.

i) Are there any provisions/precedents of renewal of concession rights ?
ii) Will renewal come with 'forced' capex for the asset ?
iii) If there is no provision, why do business trust (KGT, HPHT, MIIF) pay out all of the cash-flow from these assets ?

[d.o.g.]

i) Are there any provisions/precedents of renewal of concession rights ?

I do not know of any renewals. I would think they are quite rare since the whole idea of BOT is that the private company builds it and then gives it to the government, hence the "T" part of BOT. It would be highly unusual for the government to decline to take possession of a cash-generating asset, especially for free or a nominal cost.

ii) Will renewal come with 'forced' capex for the asset ?

Normally the utility is planned for maximum loading, so that when the government takes over it is operating optimally and generating lots of cash. If there is a need to expand the utility perhaps a new BOT contract may be awarded - but that would be separate from the old contract.

Of course, the company may negotiate with the government, but the government ALWAYS holds the upper hand since the company cannot just pack up the plant and bring it home.

iii) If there is no provision, why do business trust (KGT, HPHT, MIIF) pay out all of the cash-flow from these assets ?

Limited-life infrastructure trusts are basically a form of knowledge arbitrage. Smart people sign the contracts and build the asset, then they sell it off to ignorant "investors" via an IPO. If the price declines enough they can be a profitable speculation or a special-situation investment. But such entities are clearly not going concerns, because at some point the concessions expire and the cash flows vanish.

For example, take KGT. There are only 3 assets, Senoko, Ulu Pandan, and Tuas, and they run out in 2024, 2029, and 2034 respectively. So obviously the cash flows have a life of 13, 18 and 23 years respectively. Each asset's cash flow is independent and can be easily modeled since it comes from the Singapore government (no credit risk) and is mostly fixed (low variability).

Senoko pays $42.5m a year and lasts 13 years. Capex assumed to be zero. Breakeven price at 0% discount rate is $552.5m. Assuming 5% discount rate, the NPV is $399m.

Ulu Pandan pays $7m a year and runs out in 18 years. Capex assumed to be zero. Breakeven price at 0% discount rate is $126m. At 5%, NPV is $82m.

Tuas pays $11.5m a year for 23 years. Capex assumed to be zero. Breakeven price at 0% discount rate is $264.5m. At 5%, NPV is $155m.

Add the three NPVs and you get: $636m.
Units outstanding: 639m
NPV per unit: $0.995

Does this mean the fair value of KGT is $0.995 per unit? No. It only means that if you are willing to earn a 5% IRR over the next 23 years, you should not pay more than $0.995 per unit.

So why are some people paying $1.075 for KGT today?

1. They don't understand how to use DCF;
2. They are willing to earn less than 5% IRR over the next 23 years;
3. They believe they can resell their units for a profit; or
4. They believe KGT can make acquisitions that will meaningfully improve the IRR

Would I pay $1.075 for KGT today? I would have to be out of my mind.

Similar analysis can be applied to Hyflux Water Trust (RIP), Cityspring Infrastructure Trust, the various HKSE-listed expressway companies etc.

[Nick]

Thank you for the very clear explanation about the pitfalls on BOT investments. I guess such companies are only capable of paying out the profits from the BOT assets instead of all the cash-flow in order to be sustainable. This is why the companies (not trust) dealing with such investments experience NAV growth while the Trust keeps declining. KGT, HPH Trust etc are self liquidating investments in that regard ? I was quite wary of KGT initially as well. If they took on debt to buy asset and keep on a 100% payout ratio, they might be in trouble. On another note, are Cityspring assets concession based or are they the real owners ?

[Drizzt]

i wonder what about utilities in general overseas like Hua Neng Power, Dominion or consolidated edison. They seem to be very sustainable and do not pay out so much yet still very much leverage.

[mrEngineer]

Hmm one question that popped up from reading this thread is when we see the P&L, it will usually state the interest costs/expenses. How about the prepayments or amortization of the debt? Is it included in the P&L item interest expense or COGS or administrative expenses or others?

[d.o.g.]

when we see the P&L, it will usually state the interest costs/expenses. How about the prepayments or amortization of the debt?

Debt repayment is reflected in the balance sheet (reduction in liabilities) and cash flow statement (under financing activities). It does not affect the income statement and will not appear there.

[mrEngineer]

Debt repayment is reflected in the balance sheet (reduction in liabilities) and cash flow statement (under financing activities). It does not affect the income statement and will not appear there.

I see. Its kinda strange when there are impairment and depreciation of assets counted in the P&L and nothing for the liabilities. It seems like P&L are popular statements that are unable to fully explain the adjustments in balance sheet. Let say in theory, if your long term debt reduces as a matter of goodwill from the borrower, liabilities decreases and equity increases, this transaction does not pass through P&L at all..

[d.o.g.]

Let say in theory, if your long term debt reduces as a matter of goodwill from the borrower, liabilities decreases and equity increases, this transaction does not pass through P&L at all..

If you are referring to debt forgiveness by the lender it would be counted as an extraordinary gain and be reflected as a one-off gain in the P&L. Similar to how discount purchases (below fair value) have to reflect an immediate gain in the P&L.

[Musicwhiz]

I see. Its kinda strange when there are impairment and depreciation of assets counted in the P&L and nothing for the liabilities. It seems like P&L are popular statements that are unable to fully explain the adjustments in balance sheet. Let say in theory, if your long term debt reduces as a matter of goodwill from the borrower, liabilities decreases and equity increases, this transaction does not pass through P&L at all..

Warning: Technical

This is tied the accounting entries behind such transactions. The reduction of debt is taken up as a Debit (Dr) against liabilities, so the corresponding Credit (Cr) must go somewhere. It can either be recognized as an income in the Income Statement, or as Equity in the Balance Sheet. The treatment depends on the nature of the transaction and requires an assessment of substance over form, a fundamental accounting concept.

As d.o.g. mentioned, debt forgiveness by lender frees a company of liability to pay and thus the entry is reversed back to P&L again:-

Dr Liability
Cr Income

For purchase of companies below net asset value, the difference is recorded as negative goodwill and amortized to Income Statement over a number of years.

Dr Investment
Cr Negative Goodwill (Balance Sheet item)
Cr Bank

Then:-

Dr Negative Goodwill
Cr Other Income (reversal of -ve goodwill)

[mrEngineer]

Thanks everybody for your answers! I think Nick has shared with me the answer for my question previously that assets are financed by debt and the depreciation of asset can be seen as repayment of debt in a certain way and if the debt principal payments are still expensed in P&L, it will be double counting.