United Envirotech stable flow of recurring income

• Initiate coverage with BUY, +41% to fully diluted TP of S$0.69
• Expect earnings breakthrough as recurring income streams gather momentum
• Attractive at 8x/7xPE for 75%/21% PATMI growth in FY14F/15F, industry averages 13x
• Potential upside from acquisitions & expansion; CB dilution can be potential overhang

>60% of profits coming from long-term recurring treatment income. United Envirotech (UENV), a membrane-based wastewater treatment company, has been shifting to a stable, recurring and more profitable earnings profile with the acquisition of operating water plants in China. By FY14Mar, UENV would have a total processing capacity of 1.18b m3/day to generate S$25m or 60% of group PATMI. This treatment income is recurring for the life of the water concessions (30 yrs).

Key beneficiary of China’s rapid growth in environmental protection. Besides treatment services, UENV should continue to win engineering and construction (EPC) contracts given the growing demand for membrane-based water treatment plants in China to meet stricter discharge limits, which old plants are not equipped to process. We believe UENV can maintain ~Rmb400m of new EPC orders over the next two years.

Earnings CAGR of
46% from FY13F-FY15F. UENV has potential upside from higher utilisation rates. Besides, we have not incorporated the Phase 2 expansion or acquisitions. BUY, TP S$0.69. Our sum-of-parts TP is based on 10x PE for EPC and DCF valuation (8.6% WACC) for treatment. We have also assumed full dilution of the S$136.2m convertible bond to Kholberg Kravis Roberts & Co (KKR).

Valuations

Sum-of-the-Parts valuation and full dilution assumed for convertible bond. We use sum-of–the-parts analysis to value UENV so as to capture the different valuation characteristics of the two businesses. At the same time, we have assumed full dilution impact from the S$136.32m Convertible Bond issued to KKR. Based on the conversion price of S$0.45 a share, a total of 302.9m new shares would be issued upon conversion anytime up to 28 Sep, 2016.

PE valuation for earnings-driven EPC. Here, we apply 10x PE to FY14F earnings. Our assumed PE multiple is lower than the sector average of 13-14x forward earnings, to factor in UENV’s smaller scale of operation.

Discounted Cash Flow valuation for the treatment business. Here, we apply a) risk free rate of 1.8% based on DBS Bank’s forecast yield on a 10-year Singapore government bond b) expected market return of 10% based on Bloomberg’s 10-year average return of the Singapore market c) the company’s adjusted beta of 1.0. Based on these assumptions, we arrive at a weighted average cost of capital of 8.6%. This discount rate applied to the concession’s free cash flow forecast yielded an equity value of S$0.50/share for the treatment business. No terminal value is included given that most projects are on a TOT or BOT basis, implying that these would be transferred to the government at the end of the concession period.

SOTP target price of S$0.70. Summing up both valuations, we derived a target price of S$0.70 for UENV. Our TP implies 12x FY14F and 10xFY15F, which is still lower than the sector average of 13-14x although UENV features stronger than peers EPS CAGR of 28%.

>40% potential return even on conservative assumptions, recommend BUY. Note that our TP is on a fully diluted basis to account for a CB conversion. As the new shares issued will form 38% of the enlarged share capital, a full conversion would trigger a General Offer (based on >30% threshold). While we have assumed full dilution to be conservative, we believe that conversion would likely be phased out and not all at once. Hence, for comparison purposes, we have also presented a fair value scenario based on the existing share capital.

In view of the attractive potential returns of 43% even on a fully diluted TP, and as much as 80% upside if based on existing share cap, we initiate coverage on UENV with a BUY rating.