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This article first appeared in The Edge Malaysia Weekly on May 22, 2017 - May 28, 2017

AS a rule of thumb, investors do not like cash calls. They like large ones even less, and they especially dislike cash calls by property developers.

Thus, it should not have been a surprise that the share price of Malaysian Resources Corp Bhd (MRCB) dipped as much as 12% last Thursday after announcing a one-for-one rights issue to raise up to RM2.8 billion.

The cash call itself, however, came as a complete surprise for many retail investors and fund managers. After all, MRCB had been doing really well — both in terms of its share price (up 48% y-o-y) and the group’s balance sheet restructuring.

In fact, it could be argued that the company has never been in better shape since 2013, when Tan Sri Salim Fateh took the helm after his vehicle, Gapurna Sdn Bhd, took up a substantial stake in MRCB.

After asset disposals, some debt restructuring, a few sizeable private placements and the recapitalisation of properties into the group’s real estate investment trust, MRCB’s net gearing has been reduced to only 0.73 times as at last December.

For perspective, the group’s net gearing was a whopping 173% in FY2012 before Salim took over.

MRCB’s balance sheet has never been healthier, thus eyebrows were raised when it proposed its largest cash call to date under the new management.

So, what has led to this?

The management says the rights issuance is a strategic move to alleviate some of the structural problems related to the group’s existing capital structure — too much debt and not enough shareholders’ equity.

However, sceptics say the rights issue has come about due to pressure from a number of circumstantial problems that arose recently. The first was an unexpected delay in the disposal of the Eastern Dispersal Link Expressway (EDL) in Johor. The second was the massive ramp-up in development costs at the KL Sports City public-private partnership (PPP) development in Bukit Jalil — from RM499 million to RM1.2 billion.

“There is never a right time for a rights issue [from an investor’s perspective]. But this is something that we have to do to complete the reorganisation of MRCB’s capital structure,” chief financial officer Ang Wan Tee tells The Edge.

He argues that MRCB’s capital base has always been undersized, given the amount of assets the group has — land with an estimated gross development value of RM49 billion and construction order book of RM7 billion.

In contrast, MRCB’s shareholders’ funds is relatively small at only RM2.9 billion.

The rights issue is meant to address this imbalance. More importantly, it will create tangible value by reducing debt on land slated for long-term development — 20 to 30 years from now.

Ang says the rights issue has always been part of MRCB’s long-term strategy.

“We could have gone to the market for funds a year ago, before we had completed some of the land acquisitions … asked for money to acquire land. Instead, we chose to first acquire the land with borrowings so that we have something to show the shareholders — that this is what we want the money for,” he explains.

MRCB will utilise an estimated RM826.3 million of the funds raised to refinance its borrowings. Ang says this will remove debt encumbrances from nearly 200 acres of land.

 

Did EDL and Bukit Jalil force the rights issue?

On the other side of the coin, analysts have raised concerns over the circumstances that may have pushed the group into triggering the massive cash call.

In a report last week, Macquarie Capital Securities says the delay in the EDL sale is at least partially responsible for the rights issuance.

“We understood that in 4Q2016, MRCB was confident of completing the sale of the EDL highway concession to pare down its debt by at least RM1.06 billion. However, the potential sale to Projek Lebuhraya Utara Selatan (PLUS) did not go through as expected due to valuation disparities,” it explains, giving the EDL a valuation of RM175 million.

Divesting the EDL would have freed up MRCB’s balance sheet, allowing it to borrow fresh funds to finance ongoing developments and construction projects, says Macquarie. Instead, the group now has to tap shareholders for cash.

A separate report by Kenanga Research highlights that MRCB is seeking a 15 to 30-year extension for the EDL — one way to boost the valuations for the loss-making highway before a sale.

However, industry observers say such extensions are difficult to secure without more investments into the highway — something that MRCB would be reluctant to do. Highway concessions are simply a non-core business that the group has consistently tried to dispose of.

However, it is challenging for the government to extend a concession without consideration, especially with an election pending.

MRCB’s management has vehemently denied that the unexpected delay in the EDL’s sale has anything to do with the rights issue. After all, the EDL’s debt is ring-fenced, argues Ang.

On a more positive note, the rights issue will give MRCB more time and breathing space to sell the EDL — possibly on better terms and at a better price.

Over at Bukit Jalil, Ang concedes that the increased development cost at KL Sports City played a part in the rights issue.

“We were prepared to finance half a billion ringgit internally for the first phase,” he explains.

But the RM701 million increase in cost for Phase 1 threw MRCB’s financing plans out the window.

Recall that the group has an 85% stake in Rukun Juang Sdn Bhd, which is involved in the development of KL Sports City — primarily to get the stadium and the supporting amenities ready for the Southeast Asian Games later this year.

The other 15% stake is controlled by former federal territories and urban wellbeing minister Datuk Raja Nong Chik Raja Zainal Abidin via his vehicle Rasma Corp Sdn Bhd.

As the KL Sports City is a PPP project, Rukun Juang has to bear the costs upfront. In turn, the government will provide land as compensation. Last month, the company signed a supplementary agreement with the government, which — among other things — increased the cost of Phase 1 to RM1.2 billion.

It is noteworthy that the original value of the project, including the second phase, was RM1.6 billion, in exchange for a gross land area of 92 acres. The supplementary agreement reduced the overall value of the project to RM1.34 billion in exchange for a net land area of 76 acres.

However, it also increased the construction cost of Phase 1 by RM522 million to RM1.02 billion. This was the result of an increase in the scope of work for Phase 1, and the accelerating of some of Phase Two’s work by moving it into Phase 1’s timetable.

“Initially, we were only supposed to refurbish the stadium first. But the government decided that some of the surrounding facilities like the plaza needed to be completed in time for the SEA Games,” explains Ang.

Unfortunately, due to the confidentiality agreements, MRCB cannot provide more details.

On top of that, Rukun Juang also had to reimburse the government RM179 million in cash due to a reduction in scope, bringing the total development cost of Phase 1 to RM1.2 billion.

The reduced work scope pertains to the supply of equipment such as digital scoreboards, which MRCB wanted to exclude from the project.

While it is a little disconcerting that the group will have to pay the government in a PPP project, note that the government will have to use the money to procure the said equipment that MRCB is no longer supplying.

 

Earnings need to catch up

Looking ahead, is the rights issue a good move?

After all, the major shareholders are certainly prepared to plough more money into MRCB — at least RM728 million from the Employees Provident Fund and RM364 million from Gapurna.

In fact, the duo may even subscribe for the excess unsubscribed shares.

Other major shareholders — Bank Rakyat and Lembaga Tabung Haji, which have stakes of 7.89% and 7.69% respectively — are expected to fully subscribe for their portion as well to enable MRCB to retain its bumiputera status.

Including the fact that the entire exercise is underwritten, the exercise has little chance of failing, unless the minorities vote to reject it outright.

Realistically, what MRCB could have done differently is a purely academic question. Instead, it is more interesting to consider how the rights issue will affect the group’s valuation going forward.

On the positive side, it will reduce MRCB’s net gearing to near-zero levels. However, it is unrealistic to assume the group will remain unleveraged.

Ang says it is willing to gear up to 0.5 times going forward. Post-rights issuance, MRCB will have an estimated shareholders’ equity of RM5.1 billion, debt of RM2.11 billion and cash of RM2.06 billion.

On paper, that means that the company could easily tap the debt markets for another RM2.5 billion to reach an undiluted net gearing of 0.5 times.

Keep in mind though that this does not take into account the disposal of EDL, which could allow MRCB to borrow even more. This means that the group will have ample ammunition for future growth.

A major downside of the rights issue, however, is dilution. MRCB will see its revised net asset value diluted by about 15%, CIMB Research says in a report. Meanwhile, earnings per share is expected to be diluted by 24%, taking into account some RM46.7 million in interest savings each year.

To justify the dilution, management will have to prove its ability to drive earnings growth. With MRCB’s balance sheet woes resolved, all eyes will be on its bottom line.

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