Sunpower Group - DBS Research 2019-12-16: Full Steam Ahead

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SUNPOWER GROUP LTD. (SGX:5GD)

Sunpower Group - Full Steam Ahead

• First mover advantage leveraging on environmental protection trend and backed by stable recurring revenue.
• Steam plants expansion buoyed by defensive textile industry.
• Further RMB2.3b injection into green investments to cement dominant position; Manufacturing & Services (M&S) segment is group’s backbone.
• Initiate coverage on Sunpower Group with BUY rating.

Green Investments (GI) offers a perfect blend of growth and stability.

• SUNPOWER GROUP (SGX:5GD)’s new Green Investments (GI) business offers resilience with its large exposure to defensive industries. The segment is also aided by supportive government regulations and a global push for environment protection.
• Green Investments revenue is also recurring in nature, backed by long concessions of around 30 years. As a first mover equipped with proprietary technologies, Sunpower is able to demand prepayments from its customers and generate high flows in Green Investments.

Margin improvement in traditional manufacturing and services (M&S) driven by peak factory utilisation.

• Sunpower’s M&S factory is operating at close to full utilisation on an order book of RMB2.5b. The group is in a good position to cherry pick higher margin projects while keeping its order book steady.

Sunpower Group - Company Background

• SUNPOWER GROUP (SGX:5GD) is a China-focused steam, electricity and heat solutions provider that manufactures energy saving and environment protection products. The group was listed on the Singapore Exchange in 2005 and has two main business segments, Green Investments (GI) and Manufacturing & Services (M&S).

Share of revenue contributed by GI segment has been increasing steadily.

• The Green Investments segment constituted 23% and 46% of Sunpower’s revenue and operating profit in FY18 respectively. Supported by the Manufacturing & Services segment, the Green Investments segment will be the earnings driver going forward. The group intends to invest RMB2.5b in equity on Green Investments assets by 2021 which can be realised either through accretive M&As or project developments.
• Additionally, Sunpower’s business is geographically concentrated in China with 91.0% of revenue derived from China. Revenue generated from other geographies remain small with the US being the most significant at 5.2% of total revenue.

The Green investments segment deals in investment, development and operation of centralised steam, heat and electricity generation plants.

• The Green Investments segment first generated steam and electricity in 2017. The focus of the segment is the production of steam, with electricity as a by-product of steam production. Steam is produced in the plants using coal as fuel and then distributed to customers via pipelines. Industries that require steam in their business operations include the food, garment and paper production industries. For example, the food industry may utilise steam in their sterilization process. Sunpower is given the right to operate these plants under concession agreements for a typical period of 30 years. At the end of the concession period, ownership and operation of the plants may be transferred to the state.

The Manufacturing & Services segment leverages on its patents to manufacture energy saving and environment protection products.

• With a library of 160 patents as at 3Q19, the Manufacturing & Services segment manufactures products such as high efficiency heat exchangers & pressure vessels, pipeline energy saving products and flare & flare gas recovery systems. The segment has served over 1,500 companies such as Sinopec, Shell and Bayer and sees repeat orders from 70% of its customers.

Manufacturing & Services order book has soared since 2014, with factory utilisation at nearly 100%.

• The order book has grown from RMB1.1b in Feb-14 to RMB2.5b in Oct-19, representing c.15.0% CAGR. As a result, Sunpower is only selectively taking in orders for Manufacturing & Services products as factory utilisation is almost full.
• See attached report for information on Sunpower Group's key management team.
• See also Sunpower Group Analyst Reports; Sunpower Group Dividend History; Sunpower Group Announcements; Sunpower Group Latest News.

Sunpower Group - Investment Summary

Initiating coverage with BUY; DCF-based Target Price of S$0.81.

• We believe Sunpower’s Green Investments business is resilient with its large exposure to defensive industries. The segment is also aided by supportive government regulations and a global push for environment protection. Revenue is recurring in nature, backed by long concessions of typically 30 years. The Manufacturing & Services segment should remain robust with both local and global demand for petrochemicals driving orders. Margins are likely to improve as Sunpower shifts toward higher margin contracts and as it approaches peak factory utilisation. Overall, Sunpower’s robust outlook backed by solid capital partners could propel its share price to levels seen in early 2017.

Green Investments segment is a potential cash cow in the mid to long-term.

• Sunpower’s Green Investments segment has the potential to generate steady earnings with strong cash flows in the mid to long-term. The group’s Green Investments plants burn coal for fuel to supply steam to end-sector customers in a diverse range of industries. Based on our analysis, Sunpower’s Green Investments plants are mostly exposed to the defensive textile industry (printing and dyeing). This should enable the segment to maintain stable earnings growth even in times of uncertainty.

Sunpower enjoys a natural monopoly in Green investments.

• As a first mover, Sunpower’s Green Investments segment reaps the benefit of a captive customer base. Specifically, we think competitors are prevented from building new plants situated near Sunpower’s existing plants due to direct competition, regulatory hurdles and poor economics. Sunpower is effectively able to achieve a natural monopoly in the areas that its plants serve.
• Additionally, Sunpower’s steam distribution pipeline networks are highly efficient, possessing the ability to cover a wide radius with lower temperature loss relative to the industry. This technology complements its first mover advantage and enables the group to have high bargaining power with its customers. As a result, Sunpower is able to obtain prepayments from its customers and generate high Green Investments operating cash flows.

New Green investments plants to boost segment revenue by 65.9% by FY21F.

• Sunpower’s upcoming two plants - Shantou Phase 1 & 2 and Xintai Zhengda - are expected to be completed in 2020.
• Shantou Phase 1 will begin trial production by the end of FY19 while works for Shantou Phase 2 are in progress. The plants are expected to expand active steam capacity by 820 tons/hour (t/h) and 260t/h respectively. This should translate to top line and operating income contribution of RMB497.3m and RMB124.9m by FY21F.

Future equity investments of RMB900m into Green Investments segment to provide more upside.

• As of 3Q19, Sunpower has made equity investments of c.RMB1.6b, on track to hit its target of RMB2.5b by 2021. While we have not accounted for Sunpower’s pipeline of projects that are not under construction in our valuation, we estimate that the additional equity investments could increase Sunpower’s revenue by c.RMB970m (c.25%) and operating income by c.RMB275m (c.58%) respectively from FY19F levels.

Manufacturing & Services segment forms the backbone of the group.

• Sunpower’s traditional Manufacturing & Services business remains a bulwark against economic fluctuations, with factory utilisation almost full and order book at a record RMB2.5b as at end-3Q19. While capacity for the Manufacturing & Services segment is not expected to grow any further, we believe that order book value still has room to rise as peak factory utilisations enable the group to cherry pick higher margin orders.

Petrochemicals to sustain order book momentum.

• Petrochemical demand in China and rest of Asia is expected to see continued growth, driven by demand for petrochemical products as an intermediate material for production of finished products such as plastics. Indeed, OPEC is forecasting Chinese demand for petrochemical products to rise to c.2.6m barrels per day (b/d) in 2040 from c.1.8mb/d in 2018. This is positive for Sunpower’s Manufacturing & Services order book, with the segment largely serving Chinese petrochemical companies such as Sinopec.

Proprietary technologies and favourable regulatory environment an investment moat.

• Sunpower’s products produce lower emissions and work at a more efficient rate compared to current standards in the industry. We believe this bodes well for the group given the green push by the Chinese government that is increasingly being reflected in the government’s policies. For example, China has increased its environmental protection budget to c.1.2% of GDP (similar to Western European countries). More relevant to Sunpower however is the government’s mandate that outlawed the usage of small boilers.

Capital recycling options on the cards.

• Sunpower aims to hit RMB2.5b in Green Investments equity by 2021. Thereafter, we think the group will explore options to pare down debt. This may include sourcing for co-investments or a partial stake sale of assets.
• Alternatively, the group could be the subject of a takeover similar to the one seen at United Envirotech. United Envirotech issued convertible bonds to KKR in 2011 before receiving a further equity injection in 2013. A year later, United Envirotech was jointly taken over by KKR and CITIC and renamed CITIC Envirotech shortly after. The current Executive Chairman of Sunpower’s capital partner (DCP Capital Partners), was the CEO of KKR Greater China and co-head of KKR Asia Private Equity. Clearly, the links point to such a possibility.

Supported by strong and reputable capital partners.

• Private equity (PE) firms DCP Capital Partners (DCP) and CDH China Management (CDH) have invested in Sunpower through their respective convertible bonds (CB1 and CB2). The former is led by ex-partners of KKR, one of the largest PE firms in the world, while the latter manages over US$17b of assets. PE firms are known to provide a wide range of support to their partners that may include funding, advice and a network to tap on. Indeed, we think Sunpower is supported by understanding capital partners as evident in their willingness to renegotiate the performance targets set in the convertible bond deal.

A Deeper Dive into Green Investment

Sunpower’s Green investments plants are regulated private monopolies.

• Barriers to entry in this industry are high due to the high start-up costs in building a plant and its distribution network.
• Additionally, the local government might not approve of having duplicated networks from a competitor. As a result, Sunpower’s Green investments plants are natural monopolies with a captive customer base to tap on. That said, the plants face regulation by the government in the form of price caps set.

Green investments segment counts the defensive textile industry as a major customer.

• Based on our analysis, the defensive textile printing and dyeing industry form Sunpower’s largest Green Investments customers. According to the World Trade Organisation (WTO), China was the world’s largest exporter of textiles with US$119b exported in 2018. The country is strongly embedded in the textile value chain serving many apparel-focused countries such as Vietnam. Even as China is engaged in the trade war with the US, the country still managed to grow exports of textiles yarn, fabrics and make up articles by 0.3% y-o-y for 10M19.

China’s green push has led to a favourable regulatory environment.

• Air pollution is a major problem in Chinese cities.
• For example, in Beijing, the annual mean PM2.5 was at 89.5µg/m³, far higher than the World Health Organization’s recommended level of 10µg/m³. Air pollution is just one example of the many environmental concerns faced by China. China has been active in tackling these issues, implementing policies such as the mandatory closure of small boilers and relocating pollutive industries to specialised industrial parks.
• We think these policies are positive for Sunpower, generating more demand for steam while cementing the group’s dominant position in the industry.

Sunpower Group - Financials

Strong top line expansion to continue.

• In FY18, total revenue was up 66.0% y-o-y on the back of a strong performance in both Manufacturing & Services and Green Investments. Manufacturing & Services revenue improved 39.3% y-o-y to RMB2.5b while Green Investments revenue leapt 384.4% y-o-y to RMB736.8m as the new Green Investments plants ramped up. Going forward, we expect the revenue growth momentum to be sustained driven by new plant acquisitions and construction in the Green Investments segment. Revenue growth for Manufacturing & Services however may plateau as M&S factory utilisation is operating at peak capacity. That said, Manufacturing & Services revenue from service concession arrangements may improve if Green Investments plant construction activity continues.

Hollow nature of service concession arrangements (SCA) revenue.

• While SCAs may arise from Green Investments plants may operate under SCAs, revenue from SCAs is classified under Manufacturing & Services by Sunpower. Revenue from SCAs are “hollow” primarily because they are not directly associated with a subsequent inflow of cash. Under the accounting standards, revenue from SCA is recognised when the performance obligations in the arrangement are fulfilled. Typically, a major performance obligation is the completion of construction of the plant. This leads to a significant amount of revenue being recognised upfront when the plant is completed. As such, revenue from SCAs is “hollow” due to the disconnect between revenue and cash flows. Consider an extreme situation where a newly completed plant does not serve any customers. The plant will not receive any inflow of cash even though revenue has been recognised for plant completion.

Gearing has risen with Green Investments segment’s expansion.

• Since the announcement of the first Green Investments project in Dec 2015, Sunpower’s net debt-equity has risen steadily as the group invested in more Green Investments projects. The nature of the business model requires large upfront investments while cash inflows from the projects are spread over a long period of time. As a result, gearing has risen steadily, reaching a high of 1.17x in 3Q19.
• Gearing is expected to continue to trend higher as Sunpower expands its Green Investments segment. Sunpower is expected to invest an additional c.RMB900m in equity on Green Investments projects in a 40:60 equity-debt proportion. This translates to Sunpower taking on an estimated additional debt load of RMB1.35b.

Net cash flow from operations.

• Given Sunpower’s high gearing and hollow nature of revenue (where a significant amount of revenue is recognised a few years ahead of cash flows), we would need to examine the company’s net cash generated from operations. Net cash flow from operations available for interest payment appears to be on a rising trend, increasing to RMB286.4m in FY18.
• Moving forward, we think cash flow from operations available for interest payment will continue to rise, supported by the highly cash flow generative Green Investments business. Interest payments will rise in tandem with the additional GI Investments that Sunpower is expected to make before decreasing from FY22F onwards as Sunpower looks towards capital recycling.

Intangible assets.

• Service concession arrangements (SCAs) that give Sunpower the right to charge users of its Green Investments plants form a large portion of intangible assets. Such intangible assets are usually recognised as the plant is constructed on a cost of construction incurred plus margin basis. The intangible assets are then amortised over the life of the concession (usually 30 years). As Sunpower has taken on more plant projects over the years, the group’s intangible assets have swelled, rising to RMB2.3b in 3Q19.
• Going forward, intangible assets are expected to continue rising as more Green Investments projects are clinched.
• See attached report for Sunpower Group's SWOT analysis, critical factors and key risks.

Sunpower Group - Valuation

Initiate with BUY and DCF-based Target Price of S$0.81.

• Sunpower’s strong future cash flow generating ability justifies the use of discounted cash flows as a valuation methodology.
• Additionally, valuation multiples such as PE may be skewed by SCA revenue where periods of heavy construction activity may result in temporarily higher earnings which may not be repeated in the following years.
• Our DCF model assumes cost of equity of 12.5% based on a risk-free rate of 3.2%, market return of 11.8% for the China market, and beta of 1.1. As Sunpower is partially financed by convertible bonds, we calculated the cost of convertible bond financing to be 5.7% by dividing the convertible bond into two parts i.e. straight bond and conversion option. Additionally, we obtained an after-tax cost of debt of 4.5% based on an effective tax rate of 25% and cost of debt of 6.0%. Based on WACC of 7.9%, and terminal growth rate of 1%, we derived an equity value of RMB4,885.4m. This translates to an equity value of S$950.2m and share price of S$0.81. See Sunpower Group Share Price; Sunpower Group Target Price.
• Our Target Price has yet to include c.RMB900m equity investment relating to pipeline projects under consideration by Sunpower.
• The successful award of these projects would represent further upside for Sunpower’s earnings and valuation.
• See attached 27-page coverage initiation report for complete analysis on Sunpower Group.

Lee Keng LING DBS Group Research | Singapore Research Team DBS Research | https://www.dbsvickers.com/ 2019-12-16

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