SITTING across the negotiation table from 1Malaysia Development Bhd, any party with the financial muscle to acquire its power assets can be forgiven for thinking it has more bargaining power than the cash-strapped strategic investment fund, which incurs multi-million-ringgit interest expenses a day.

After all, besides facing a tight cash-flow problem, the value of 1MDB’s power purchase agreements (PPAs) is depreciating fast as some of them are not that far from expiry, for example, Telok Gong 1 Power Station.

Tenaga Nasional Bhd is one party across the negotiating table, although 1MDB’s plight has attracted a number of local and foreign companies hoping to buy the assets at fire-sale prices.

According to industry sources, YTL Power International Bhd and Malakoff Corp Bhd have expressed interest in the power assets, although YTL Power’s indicative bid is one of the lowest while Malakoff is only interested in acquiring specific power plants.

Several foreign parties, including from the Middle East and China, are also said to be keen on the power assets and are backed by their respective governments.

Currently, TNB is conducting due diligence on the assets. But as a government-linked company, can it get a good deal from 1MDB? However, the more pragmatic question is, can 1MDB afford to sell cheap?

TNB and 1MDB can be considered sister companies, given that the former’s largest shareholder, Khazanah Nasional Bhd with a 29.66% stake, is wholly owned by the Ministry of Finance (MoF) — just like 1MDB. But Khazanah will be barred from voting on the proposal should an acquisition materialise.

As the next largest shareholder (with a 12.22% stake), the Employees Provident Fund will have a big say in the proposed transaction.

Judging from the deal in which TNB took over 1MDB’s 70% stake in Project 3B, the national utility company has demonstrated its capability to negotiate a “fair price”. It paid RM47 million to take over the project, which is to build a 2,000mw power plant in Jimah, Negeri Sembilan. The utility has been granted a tariff hike on the power plant.

However, if TNB’s share price is anything to go by, investors lack confidence in it this time around. The stock has fallen 3.6% since the non-binding proposal to acquire 1MDB’s power assets was announced last month. It closed at RM12.20 on July 31.

In fact, bailout fears have been weighing on the stock, which has fallen more than 16% in the past six months.

Such concerns are understandable, considering that 1MDB is desperate for fresh funds to service its mountain of debts; thus, the investment fund will have to get maximum value for its assets.

Furthermore, 1MDB had paid a hefty premium for its power assets — RM3.3 billion in goodwill. In fact, goodwill on acquisition made up 28% of the total amount of RM12.05 billion it paid.

Worse still, 1MDB borrowed nearly RM18.2 billion to acquire the power assets. This could mean that the investment fund cannot afford to offer even a sen of discount.

What could be the price?

1MDB’s power assets are parked under its subsidiary, Edra Energy Global Bhd, and TNB is keen to buy the five local and eight foreign power plants it owns.

Edra’s assets are in decent shape but there is simply too much debt weighing down its earnings. On top of that, the group has a substantial RM2.1 billion worth of goodwill on its books, which may need to be written off soon.

Looking at Edra’s draft prospectus for the now-defunct initial public offering, 1MDB was hoping to value Edra at RM18 billion to RM21 billion in terms of enterprise value. It sought to raise US$3 billion by selling down its stake to around 30%.

Bluntly put, it is a pipe dream for 1MDB to value its power assets at more than RM18 billion. Industry executives estimate that the assets might be worth around RM14 billion in fire-sale circumstances.

One of the most drastic changes between the draft prospectus and Edra’s circumstances today is the fact that it has lost its “growth story”, which was its ability to secure and execute new power projects.

Edra has already “let go” of Project 3B to TNB because it lacked the capital to undertake the project. Now, the government might even withdraw the 2,000mw combined cycle gas turbine power plant known as Project 4B.

Adjusting for these facts could have an adverse effect on Edra’s balance sheet, specifically its goodwill on acquisition, which still stands at RM2.1 billion.

It is learnt that Deloitte is just wrapping up an audit of Edra’s accounts.

According to sources, Edra has not impaired any of the RM2.1 billion in goodwill on consolidation in its FY2015 financial statements, which 1MDB is due to submit to Companies Commission Malaysia by end-September.

This would be the second consecutive year in which Edra did not impair goodwill. The first and only time it impaired goodwill was in FY2013, which resulted in a RM1.2 billion

writedown loss.

So far, 1MDB has not tested the goodwill (for impairment) of each acquisition separately. Instead, it has consolidated the goodwill of all its power acquisitions and tested the “recoverable amount of cash generating unit expected to benefit from the synergies of the combination giving rise to goodwill” against the carrying value.

This means that 1MDB expects the synergy of the power assets to help Edra generate future income through new projects. However, this assumption is not realistic because the company lacks fresh capital to undertake new projects since most of the cash generated goes to the creditors.

If TNB acquires the power assets at less than the carrying value of the goodwill, 1MDB will have to book substantial losses. At this juncture, it remains to be seen if 1MDB is prepared to sell the power plants at a loss.

Pros and cons

The acquisition, should it materialise, will boost TNB’s generation capacity by 3,112mw, giving it a 68% share of capacity in Peninsular Malaysia. But should the country allow one player to control more than two-thirds of the electricity generation capacity?

National security aside, the acquisition could well be a prelude to an initial public offering of TNB’s power generation assets — something that 1MDB wanted to do but was not able to.

The acquisition would also give TNB equity in and operational control over a number of plants abroad, opening the door for it to venture abroad. Currently, TNB only has an investment stake in power plants overseas.

On the flip side, there is a high opportunity cost for TNB to acquire 1MDB’s power assets. Besides the miniscule profit contribution, the purchase of several power plants is expected to lift the utility’s net gearing to about 0.61 times from 0.45 times at present. TNB’s net debt currently stands at RM21.3 billion, including RM2.73 billion in cash..

On top of that, Project 3B, which TNB is taking over, will add about RM10 billion of debt to its balance sheet. All in, the utility’s net gearing would approach 0.8 times. This would affect TNB’s ability to pay dividends. The group currently has a dividend yield of about 2.4%. Not only that, the company would not have spare financial resources to take on new projects when the opportunities arise.

Decent assets but too much debt

That said, the heavy debts tied to the power plants might not be a major issue for TNB because the utility has the ability to refinance the inherited borrowings, given its AAA rating.

If TNB were able to refinance Edra’s debts, it would be able to create value in the acquisition.

Edra’s total debt as at FY2015 is estimated at RM11.5 billion. Of this, RM8.1 billion is in project financing and TNB will definitely have to acquire it. The bulk of the project financing debt — some RM5.7 billion — stems from the Jimah power plant. This can be broken into two parts — RM4.267 billion in Islamic medium term notes with an interest rate that ranges from 7.25% to 9.85% and RM1.018 billion of junior Islamic debt with an interest rate of 18.06%.

If TNB can convince the bondholders to refinance the debt, that would bring the interest rate down to around 6%.

At the acquisition debt level, which TNB is trying to avoid taking over, there is a 10-year term loan of RM3.15 billion that has an interest rate of 10%. Again, there is huge savings potential for TNB if it can refinance the debt.

That said, the assets are not without risk. The 440mw Teluk Gong 1 Power Station, whose PPA is expiring next year, is in the process of bidding for an extension. Over in Bangladesh, the group’s 110mw barge-mounted power plant’s PPA expired in June. It is understood that negotiations for an extension are ongoing but in the worst-case scenario, the barge can always be relocated to a new site that needs power.

It is understood that Edra has virtually no free cash as almost all of it is restricted for debt-service accounts. This means that TNB will not be able to use cash in the acquired company to reduce its net acquisition cost.

It now falls upon TNB’s management to undertake thorough due diligence of 1MDB’s power assets and decide if they are worth acquiring. However, the real test for the utility will be to convince its shareholders that it can buy the assets at the best possible price.

This article first appeared in digitaledge Weekly, on August 3 - 9, 2015.