This article first appeared in The Edge Malaysia Weekly on July 24, 2017 - July 30, 2017

AFTER four long year, Prestariang Bhd last week finally closed the deal for the coveted immigration and border transformation project, SKIN, worth RM3.5 billion.

An acronym for Sistem Kawalan Imigresen Nasional (National Immigration Control System), SKIN is a 15-year concession that was supposed to be the key catalyst that would help to justify the group’s lofty valuations.

But the market does not appear to be convinced.

Following the announcement last week, Prestariang’s share price tumbled almost 12.2% to close at RM2.09 last Thursday, down from the RM2.38 close pre-announcement.

Even the group’s bullish outlook on its existing core businesses did not seem to sway investors.

“We expect revenue from our software and services segment to grow by 25% in FY2018,” president and group CEO Dr Abu Hassan Ismail told the press last week.

Furthermore, he says the group’s training and certification business is expected to see revenue double, fuelled by the Prestariang Skill Training Institute (PSTI) in Petronas’ Refinery and Petrochemical Integrated Development (Rapid) project in Pengerang, Johor.

Abu Hassan also assures investors that the group’s loss-making education arm, UniMY, would break even this year.

Last but not least, he made sure to play up educloud — Prestariang’s venture into shared cloud services. But even with partners like Alibaba, Microsoft and Amazon Web Services, market response has been tepid.

Why the poor response?

For starters, it is important to note that analysts concur Prestariang’s profits should improve going forward, from the third quarter at least.

A report by CIMB Investment Bank anticipates core earnings to expand by 143% year on year to 17 sen per share in FY2018. Even the more conservative estimates by AmInvestment Bank forecasts core earnings per share to rise 80% y-o-y to 11 sen.

The trouble is, the earnings upside simply aren’t enough to justify the stock’s lofty valuations. As at last Thursday’s close, Prestariang was valued at a whopping 112 times earnings. Of course, this is expected to fall once the earnings growth trickles in.

The fact that Prestariang will only control 70% of the SKIN project did not help matters either.

70% — not enough skin in the game

For context, it is important to remember that back when news first broke that Prestariang was bidding for the SKIN project, the expected value of the contract was much higher — as much as RM6 billion.

This helped to drive Prestariang’s share price to over RM3.20 in early 2016. However, uncertainty over whether it could actually bag the contract brought the share price back down to the RM2.20 level over the past year.

The company’s tumbling earnings (see chart) could not have supported such a high share price either. Investors long in the stock at this point were largely betting on the upside potential of SKIN.

Thus, it was a relatively nasty surprise that Prestariang only has a 70% stake in the concession.

Recall that the actual concession has been awarded to Prestariang SKIN Sdn Bhd, a wholly-owned subsidiary of Prestariang Services Sdn Bhd. However, Prestariang only controls 70% of Prestariang Services. Another 30% of the company is controlled equally by Muhammad Nagib Gopal Abdullah, Raja Azmi Adam Nadarajan and Faisalludin Mohamat Yusuff.

When asked why a 30% stake was given to these three individuals, Abu Hassan simply says, “These are the original founding members.”

“They are not somebody else. They were actually physically with us from day one, and they continue to be with us to add value to make sure they deliver SKIN as part of their commitment to the government.”

Note that Raja Azmi is the CEO of Prestariang SKIN.

Whatever the reason however, the financial impact of giving away 30% of the project has not gone down well with investors. Not only will this dilute the earnings from the concession, but Prestariang is expected to bear the entire cost of funding the project’s construction, approximately RM1billion over 36 months.

Assuming the project is 80% financed by debt, a 6% interest rate translates into RM95 million in accrued interest over the first three years of the project.

To make matters worse, the exact returns on the project are rather opaque since the internal rate of return (IRR) is not disclosed.

“We have signed a non-disclosure agreement with the government. We are not allowed to reveal the project’s IRR,” Abu Hassan tells The Edge.

Instead, he simply guides that the project would reap about RM3.5 billion in revenue from year 4 to year 15 of the project.

A simple back-of-the-envelope calculation shows that works out to RM204.2 million per annum over the 12-year period. According to analyst reports, Prestariang’s management is guiding for a net profit margin of up to 38% a year. That works out to about RM77.6 million a year for the company or 16 sen a share.

No cash call?

At the press briefing, Abu Hassan made a bold claim — that the entire project could be funded entirely with debt and internally generated funds alone.

“We have already secured the guarantees from the banks. The government would not award this project to us unless we show proof that we could finance it,” explains Abu Hassan.

An 80:20 debt to equity structure is entirely plausible given that Prestariang is debt free, with RM38.6 million in cash and another RM51.9 million in short-term investments. Assuming the short-term investments can be liquidated at book value, the company has net cash of RM90.5 million.

Thus Abu Hassan tells The Edge, “As things stand, we do not need to undertake a rights issue or a private placement for this project. Of course, if something happens and we need to raise funds we will.”

However, it is interesting that Prestariang will not be cutting back on dividend payouts. Abu Hassan insists that the group will maintain its 50% dividend payout policy.

Assuming the group manages to book the 11 sen to 17 sen earnings per share that analysts forecast, that works out to a payout between RM26.5 million and RM41 million a year. That’s a pretty sizable cash flow drain.

Keep in mind that the SKIN concession has zero cash flow in the first three years. The government only begins to make payments from 2021 onwards.

In fact, some analysts are a little more sceptical. AmInvestment Bank’s report prices in a potential dilution of 18.6% or 90 million new shares issued at RM2 apiece to finance the project.

AmInvestment actually downgraded its call on Prestariang to “hold” with a target price of RM2. Previously, it had made a “buy” call with a target price of RM2.60. This makes AmInvestment’s call the most conservative on Prestariang.

The good news is that the project should have minimal operational risk. Unlike highway concessions for example, which have uncertainty over traffic projections, SKIN’s revenue projections should be fairly accurate.

This would allow the group to borrow at competitive rates. The flipside of course, is that there is minimal earnings upside.

“Right now, the concession includes a provision for us to resize the project at regular intervals, and this has already been priced in. This ensures the system is always able to cope with fluctuations in [immigration] volumes,” explains Abu Hassan.

The only way the RM3.5 billion figure can increase is if the scope of the project grows due to the government adding new border entry points in the future, he explains.

Educloud gets a mixed response

Anyone who had the opportunity to sit in on the presentation by Abu Hassan and his team last week would notice immediately that more than half of the slides were dedicated to Prestariang’s transformation.

Key to this transformation, will be educloud — a shared cloud services provider targeted at local educational institutions.

In simple terms, educloud will enable Malaysian universities to migrate their products, services and data to the cloud. This could range from administrative areas like student enrolment to the education side of the business, like study materials and lectures.

In the long run however, educloud’s vision is to introduce standardised student IDs that the group hopes to monetise through other means like e-commerce or ride-sharing services.

Thus far, Prestariang claims it has no trouble soliciting interest from the universities.

“Our problem isn’t getting interest. Our problem now is making sure we can deliver. The universities see the value in what we are proposing. It can save them millions in costs,” explains Farad Alhusaini, the cloud system orchestrator for Prestariang Digital Sdn Bhd.

Clearly, educloud is on a completely different tack from Prestariang’s other businesses.

Not surprisingly, there are some sceptics.

“It sounds great, but the immediate worry is whether educloud will be a drag on earnings. How quickly will it start turning a profit?” one fund manager asks.

He points to Prestariang’s education venture, UniMY, which has been a drag on the group’s earnings.

The good thing about the shared cloud services however, is the fact that it does not require massive capex.

“We will rely on our partners to build the cloud storage for us — Alibaba and Amazon Web Services. We are more like brokers,” explains Farad.

On a positive note, this simply means educloud could achieve scale very quickly. If anything, educloud has the most potential to surprise on the upside going forward.

But just like SKIN, this will be new territory for Prestariang and investors will be watching closely to see how well the group can execute such projects.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.