Sunpower Group - UOB Kay Hian 2018-06-06: Explosive Growth On China’s Environmental Sunrise

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SUNPOWER GROUP LTD. SGX:5GD

Sunpower Group - Explosive Growth On China’s Environmental Sunrise

• As China’s Xi has vowed a war on pollution, Sunpower is on the cusp of explosive growth. Gearing up for this sunrise industry, this aggressive approach is an opportunity for Sunpower to gain the first-mover advantage in order to maximise returns. 
• With Rmb3.4b of projects and Rmb2.0b in its orderbook, top investment funds have validated this company with its technology advantage and proven track record. 
• Initiate coverage with BUY and SOTP-based target price of S$0.77,with 59.7% upside. 
• Conservatively assuming only Rmb400m of future investments for Sunpower’s Green Investment (GI) arm and valuing its manufacturing & services (MS) business with a 10.5x peer multiplier, we have a SOTP value of Rmb3.65/share (on full dilution).

COMPANY ANALYSIS: Proven Track Record With Top Investors Onboard

> 20 years of proven track record.

• Established in 1997 and listed in 2005, Sunpower is a company with a proven track record of more than 20 years. Its technology is tested and proven by global MNC clients across the globe in over 30 countries.

International clientele with ~1500 customers worldwide.

• Sunpower’s clientele includes not only Chinese state-owned enterprises such as CNOOC (China National Offshore Oil Corporation 中国海洋石油总公司) and Sinopec (中国石化) but also international blue chip firms such as Shell, BP, BASF, DOW and Saudi Arabic Basic Industries Corporation (SABIC). 
• To date, Sunpower has served approx. 1,500 customers worldwide.

Steady contract wins and improving revenue and profit throughout the years.

• Ever since its 2005 IPO, Sunpower has continued to make contract wins throughout the years with the most recent being eight new wins totalling Rmb508.6m in 2018. 
• It has also been steadily improving both its revenue and profit over the years, from Rmb1.3b and Rmb54m in 2013 respectively to sales of Rmb2.0b and net profit of Rmb146m in 2017, as it builds its business further into the environmental, petrochemical, steel and transport industries.

More than 300 R&D staff leads to five national standards, 143 patents and national prominence.

• Sunpower’s technology R&D is a major strength of the company, leading to its arsenal of proprietary technologies. It hires 306 researchers and design engineers, which has allowed it to set five national standards and register 143 patents. 
• Sunpower is also committed to future R&D, having acquired Shandong Yangguang Institute in Aug 17 to provide support for its long-term development and expansion in the GI business of centralised steam and electricity cogeneration.

Brought to national prominence for solving permafrost obstacles amongst other awards and accolades.

• Sunpower’s technology has also won it numerous honours and qualifications. Seen as one of the best amongst its peers, its technology is valued amongst its clients. For instance, Chairman Guo Hongxin and Sunpower was boosted to national prominence when their innovative heat transfer technology solution was able to resolve the permafrost issue that was causing major obstacles to the construction of the Qinghai-Tibet railway for over 40 years.

Top investors such as CDH/DCP have done their due diligence and are on board the Sunpower ship with latest tranche of CB convertible at S$0.60.

• Sunpower is also trusted by top investors such as CDH Investments (鼎晖投资) and DCP Capital Partners. The due diligence of CDH/DCP adds credibility and viability to Sunpower’s business and the potential it possesses.
• Coming in more than one tranche, their latest tranche of US$70m convertible bonds (CB) is convertible at S$0.60 and US$30m warrants exerciseable at S$0.70 by 2019, or S$0.80 in 2020. The latest adjusted profit performance targets (applicable to the previous tranche) are Rmb370m for 2020 and Rmb460m for 2021.

CDH Investments (鼎晖投资) is the best PE fund in China.

• CDH is the best PE fund in China according to Qingke’s China VC & PE Annual Ranking 2016 with about US$19b of AUM, and is known as ‘The Blackstone of China’ for its savvy deal making. Its performance has attracted world leading institutional investors into its funds, including Singapore’s GIC, California Public Employees' Retirement System and Canada Pension Plan Investment Board.

DCP Capital Partners headed by former CEO of KKR Greater China.

• DCP is headed by the former CEO of KKR Greater China, Mr David Liu, who was responsible for successful investments in companies like PingAn Insurance (world’s largest insurer in as of Jan 18) and Haier (global leader in home appliances).

BUSINESS OUTLOOK: Explosive Growth Ahead

Sunpower will see explosive growth ahead with attractive double-digit IRR GI projects.

• We believe that Sunpower see explosive growth ahead as they ride on this huge wave of boiler replacement. They are currently bidding to construct/retrofit and operate these boilers through a Build-Operate-Own/Transfer (BOO/BOT) scheme (usually 30 years’ concession period with right of first refusal to renew) as their new GI business. These GI assets are expected to command an attractive double-digit IRR and generate long-term, recurring and high quality cash flows.

1Q18 core profit surges 52.4% yoy.

• Even as only five of its GI projects contributions kicked in in 1Q18 (including a 49%-owned Rmb52m Jining project), Sunpower reported attributable net profit of Rmb82.4m (1Q17: Rmb83.5m loss). 
• Excluding the financial effects and forex loss of its convertible bonds, underlying core net profit (which represents its true operating performance) of Rmb46.3m surged by 52.4% y-o-y.

1Q18 is just the beginning of Sunpower’s explosive growth potential.

• Sunpower has further noted that the long-term net present value of GI project cash flows is expected to far exceed 1Q18’s EBITDA contributions. With such performance despite the weak seasonality caused by Chinese New Year, we believe this is a solid testament of Sunpower’s explosive growth potential. Rmb3.4b of committed projects is only the beginning, with 28 more projects in the deal pipeline. 
• Currently, Sunpower has four projects in operation (not including the 49%- owned Jining project), another five projects in the construction or design phases, and three more to be constructed, making up more than Rmb3.4b in their GI project portfolio. With a deal pipeline of 28 projects under evaluation, we note that their project win momentum has started to build and opine that this is only the beginning where success of these projects will act as demonstration projects which will allow them to capture more opportunities across China. 

High quality cashflow built on the back of strong fundamentals and technology.

• Sunpower believes that it holds a valuable and realizable portfolio of GI assets. With captive customers and steam being a non-discretionary input for its industrial customers, such cash flows are of high quality. In time, the GI business is likely to be emerge as Sunpower’s primary value creator and growth driver. 
• Sunpower is working to establish healthy, long-term, recurring cash flows through GI on the back of strong fundamentals and technology such as:

Demand will be huge while supply more limited.

• Demand is highly assured, driven by mandatory closure of small “dirty” coal-fired steam boilers in favour of centralised integrated “clean” boilers. For the Hebei Changrun projects, management has shared that all productions whereby the boilers do not meet the requirements are to be ceased.

Sunpower’s exclusive GI cogeneration plans enjoy multiple benefits.

• Sunpower’s GI cogeneration plants supply steam, heat and/or electricity to exclusive industrial areas under 20-30-year concessions. Other than exclusivity to operate a centralised facility, some of Sunpower’s GI projects are granted rent-free use of government land to build its steam distribution pipelines in some areas. 
• Sunpower also receives an additional 2.7 Rmb cents/kwh incentive for its electricity supplied to national grid because of its low- emission power generator.

Attractive double-digit IRRs with lower cost than competitors thanks to technology.

• While management has stated that they have attractive double-digit IRRs for their projects, this may not be the case for all such projects (ie their competitors). 
• Management has shared that some other projects may make far less economic sense and we opine that this may be because of political necessity (ie to create enough “clean” energy). This means that their cost of generating the required steam (the central boiler will sell steam to its customers) is lower than their competitors.

Competitive pricing edge due to core advantages of technology and experience.

• Furthermore, as these projects are typically bidded based on the selling price (adjusted for the price of raw materials), Sunpower enjoys a significant competitive pricing edge over its competitors. 
• We attribute its price edge to the following two core advantages, project execution experience (its own experienced EPC team has a proven track record of execution within the cost constraints set out) and their proprietary technology, particularly their heat transfer technology.

Heat transfer is crucial to central boiler theme.

• Sunpower’s patented heat exchanger is one of the best in the world, allowing the company to become crucial to the “central boiler” theme as transfer of steam heat is a critical part of operating such a project and better transfer results in greater profits. 
• Also, another advantage that Sunpower’s industry leading heat transfer offers clients is the ability to locate facilities in suitable locations further away.

One of the best in the world, three times better than the standard design.

• According to management, they are among the top choices competing with Shanghai Morimatsu, with Nanjing Baose ranking third. With its patented heat transfer tech, Sunpower is able to achieve heat loss that is one third of the usual design, making it three times better.

Clean coal offers all of the emissions benefit of gas but at half the cost.

• In terms of emissions, Sunpower has opted for clean coal energy or coal powder. Pulverised coal has a combustion efficiency of 98%, comparable with the full combustion of natural gas. In contrast, the combustion efficiency of crushed coal is only 60-70%. Chemical agents are added to remove harmful residuals that would otherwise cause air pollutions. 
• Lastly and perhaps most importantly, the cost of its steam power is half of that of natural gas which makes it far more attractive to customers.

Other tech advantages come into play in circular economy design.

• Sunpower also has other tech advantages which come into play when considering the circular economy design. This includes its own in-house ultra-low temperature economiser (低低温省煤) designed to recover exhaust heat, thereby reducing the usage of coal; its own patented desulfuriser (氨法脱硫) that is able to convert waste to fertiliser to provide further economic benefits.
• Sunpower will thus be able to utilise other industries’ outputs (eg wastewater, sludge) to reduce its use of coal and water while selling its own outputs, such as ammonium nitrate and ashes to makers of fertilizer and building materials respectively. It is also able to generate its own electricity (eg Hebei Changrun plant), which leads to off-grid cost savings.

CDH/DCP enters with US$210m of bonds and warrants….

• One constraint that was previously holding Sunpower back was funding. Thankfully, some of China’s top PE funds, CDH Investments and DCP Capital Partners (acquired through CDH) had entered as stakeholders with US$210m of convertible bonds and warrants. 

…validating Sunpower’s business and technology, funds expansion and open doors.

• We view this as a positive as it not only funds the initial stages of expansion but also opens doors for future fund raising and project bidding. Due diligence from the top funds in China affirms the value of Sunpower’s technology bank, the viability of its business and the company’s huge potential.

Deep synergies between Sunpower’s business segments to create both short-term and long-term profits.

• There are also deep synergistic relationships between Sunpower’s existing business segments, 
  1. Environmental Equipment Manufacturing (EEM) and Engineering, 
  2. Procurement and Construction (EPC) and 
  3. the new Green Investment (GI) arm 
  (note: EEM and EPC are now classified as Manufacturing & Services (M&S)). 
• Sunpower not only manufactures required components through EEM but also performs the EPC for the boilers. As such, this will create both explosive short-term profit growth and a stable base of long-term recurring income.

Record high orderbook of Rmb2.0b as Sunpower rides on oil price recovery.

• 70% of recurring incomes in MS (EEM & EPC) segments are from repeat customers and we saw strong growth in that segment in 1Q18 with a revenue increase of 44.6% y-o-y. Its orderbook of Rmb2.0b as at 31 Mar 18 is at a record high, as Sunpower rides on the recovery and growing stability in crude oil prices. 
• With a proven track record of over 13 years, Sunpower has built long-term partnerships with renowned conglomerates such as BASF, BP, Shell, CNOOC, CNPC and SINOPEC etc. Strong R&D capabilities will enable Sunpower to continuously expand into new industries and countries. 
• Manufacturing capacity utilisation for EEM segment remains at 100% in full-year 2017.

FINANCIALS: Record-high Orderbook, GI To Drive Growth

Steadily building up an orderbook of Rmb 2.0b.

• Subsequent to its repositioning as an environmental protection services provider, Sunpower had ramped up its operations to undertake GI projects which had met with early success. We expect Sunpower to capitalise on the enormous market opportunity in the anti-smog services sector in China and continue to develop a robust pipeline of projects. 
• Our 2017-20 estimates will see Sunpower’s revenue double to Rmb4,765 m (34.3% CAGR).

Solid portfolio of GI projects promising ~15% IRR.

• Even after taking into account the cost of capital, the payback period for these projects is short (8-9 years). According to our estimates, Sunpower’s portfolio of projects should yield an IRR of ~15% with 60% gross utilisation as breakeven, inclusive of depreciation and interest expense. This is much higher than those of the other traditional environmental projects (<10%). 

Conservative estimates of GI projects running into 2021.

• Despite management’s proposed 28 pipeline projects amounting to Rmb1,338.8m in equity investments, we conservatively accounted for Rmb200m in equity investments for 2020 and 2021 (total Rmb400m). 

Robust orderbook and GI projects to drive EBITDA growth.

• With its Rmb2.0b orderbook recording new highs and multiple GI projects coming online in 2018, Sunpower is on the cusp of an explosive growth. 
• Based on estimates, Sunpower is set to register EBITDA of Rmb445.8m, Rmb542.5m and Rmb780.1m in 2018-20 respectively.

Net profit CAGR of 48.6% for 2018-20.

• Recurring income from GI provides a foundation for steady growth in EEM and EPC business segments to fall through into the bottom-line. 
• We forecast net profit to reach Rmb246.8m, Rmb279.6m and Rmb383.0m in 2018- 20 respectively.

High gearing means execution is key.

• In order to gain the first-mover advantage and capture market share, Sunpower’s management has adopted an aggressive approach in gearing up its balance sheet. We expect net gearing to peak at 141% in FY19 before coming down. 
• While the business concept is sound with favourable industry outlook, we opine that the company’s successful execution is a crucial part in ensuring that the high borrowings will not threaten the survival of the company. Nevertheless, the group's early GI project has already shown good potential with robust cash inflow.

Improving interest coverage and bolstering operating cash flow.

• Despite adopting a typical capital structure of 60% debt to 40% equity, interest coverage ratio is expected to improve from 2017’s 4.75x to 5.5x by 2020 through quality cash flows. Management shared that it had installed a prepaid system with strict credit limits for its GI projects. 
• Rather than focusing on growth through receivables, Sunpower will look to generate attractive operating cash flows every year. We estimate operating cashflow to post incremental increases to Rmb207.1m, Rmb290.5m and Rmb329.4m in 2018-20.

VALUATION: Initiate Coverage With BUY And Target Price Of S$0.77

• Initiate coverage with BUY and SOTP-based target price of S$0.77. 
• Riding on the back of favourable regulatory environment, we like Sunpower for its:
  1. solid market positioning (through its industry-leading heat transfer technology) in the explosively growing China environmental industry,
  2. profitable high IRR GI projects that have begun contributing to Sunpower’s bottom-line,
  3. track record of more than 20 years partnering with oil majors such as BP and Shell, and
  4. validation and opportunities provided by top investment funds, CDH Investments (CDH)/DCP Capital Partners (DCP).
• We value Sunpower at S$0.77, based on a SOTP valuation where its Manufacturing & Services (M&S) business is valued on a PE basis while Green Investment (GI) is valued based on discounted cashflow methodology.

RISK FACTORS

Higher leverage ahead may increase interest costs and related risks as it temporarily puts the balance sheet in a worse position.

• As Sunpower moves to capture the enormous opportunities ahead, it is inevitable that the company will face higher leverage and the related risks. However, with successful execution, this is beneficial in the long term as the projects generate profits beyond the payback period.

Execution risk.

• While Sunpower has “proof of concept” and contributions have already begun to pour in, we note that it is still nevertheless a rather new business for Sunpower. As with all new business, there will be execution risks involved. 
• Nonetheless, we do believe that these risks are partly mitigated by Sunpower’s existing business knowledge in EPC and EEM.

Macro risk impacts such as end clientele problems.

• A macroeconomic challenge would impact Sunpower in many ways. One such impact is through the current end clientele of its GI projects. As they are largely dye and print clients, they are subject to volatility of market forces, and a major crisis for the industry would mean problems for Sunpower as well. However, individual client risk is offset by prepaid tariffs and the ability to turn off steam (like an electricity utility) in the event of non-payment.

Forex risk of bonds.

• Sunpower’s bonds (and coupons) to CDH are denominated in US dollars so there is a foreign currency risk for Sunpower as it primarily derives its income in renminbi (as seen in 2017 when the US dollar weakened against the renminbi). This works both ways as a stronger US dollar would be positive for Sunpower. The recent US dollar recovery against the renminbi is an example.

Dilution risk.

• While we opine that it is highly unlikely that management will let Sunpower be diluted at low prices due to its convertible bonds (given that management has a major stake in the company), it is nonetheless a real risk. However, given Sunpower’s performance and the fact that it managed to negotiate an extension, we are confident that it will achieve the desired performance targets.

Edison Chen UOB Kay Hian | Yeo Hai Wei UOB Kay Hian | https://research.uobkayhian.com/ 2018-06-06

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