Disclaimer

First of all, little bit of disclaimer, as there are very little details provided in the announcement, what I’m about to share is what I understand. Eventual recognition may turn out to be different. Please interpret it with your own discretion.

What we do know

From the little details we do know from the announcement are:

1. the contract is a concession, not pay per transaction like what MYEG or SCICOM usually earn. Prestariang does the job and government pay them, period.

2. SKIN will be a build, operate, maintain and transfer model. In layman’s term, Prestariang build the system for operations in the first 3 years, maintain it for the next 12 years (total 15 years) and eventually ownership will be transferred back to government at the end of the concession period

3. payment will be deferred whereby Pres will build and implement the system for first 3 years without receiving payment but government will pay them in 12 subsequent annual payments of RM294.7m.

What does the deferred payment mean?

Just imagine say your friend hire you to build a house for him, but instead of paying you upfront or by progress, he negotiated a deal so that he can pay you by instalment over certain number of years. Of course by now even the most naïve of you would be wondering why should I do him such a favour? So for him to broker such deal, he has to compensate me by including interest in the annual payments over the repayment period. Only then it’s fair. So RM294.7m x 12 years or RM3.54b in total is government’s payment to Prestariang not just for the SKIN contract but also the interest for the concession period.

What’s the effect on company’s financials?

Now comes the tricky part. I will try to apply my own accounting understanding on IFRIC 12: Service Concession Arrangements which explains accounting treatment for concession biz. I will try to make it as simple as possible. But certain essential parts may be difficult to understand by those who are unfamiliar with accounting in which case, you can simply choose to believe it or not. If you don’t, you can stop reading because the numbers below would be essentially garbage for you.

Key accounting questions

Key question 1: Should revenue and costs be recognised in the first 3 years, next 12 years or evenly over 15 years?

Accounting 101: accruals concept means that revenue and costs are recognised as and when they are incurred, not when cash payment is received or paid. So my interpretation is revenue and costs should be recognised in the first 3 years when work is done, not when payment is received in the next 12 years while maintenance revenue will be recognised in the 12 years maintenance period. In other words, my take is that the development revenue for the build and deployment phase should be recognised by progress for the first 3 years while maintenance revenue will be recognised when maintenance works are carried out.

Key question 2: If revenue and costs are to be recognised, how much of the amount?

Costs are straightforward where the exact amount should be recognised. Revenue is a bit trickier. We have established earlier that the RM3.54b includes both the contract value and interest element. So what should be recognised in the revenue would be the contract value without interest element/the fair value of the contract. Calculations will be shown later.

Key question 3: What about the interest element?

Yes, the government is also paying for the interest over the 15 years concession period so interest element should also be recognised as other revenue over the concession period with “unwinding of discount” method. Details to be provided later.

Key question 4: Impact on balance sheet and cashflow?

One big item will show on balance sheet which is receivables. Receivables will blow up in the first 3 years as government continues to avoid paying. By the end of 3^rd year, the receivables amount should be equal to the fair value of revenue recognised and subsequently adjusted.

First 3 years there will be cash outflow without cash inflow (specific to SKIN). Logically speaking, it’s not sustainable, which means Prestariang will need to raise equity or debt financing.

Simply said, just imagine a credit sale with extremely long credit period. So your revenue is recognised when you make the sales (in this case, you need 3 full years to complete the sales), customers doesn’t pay you yet so you don’t get cash but there will be receivables. And because this is long term, so you are going to charge your customers for paying you in deferred terms.

For those who are interested in further reading, all the above is based on my understanding of IFRIC 12: Service Concession Arrangements. Concession companies like Menang Corp, Triplc are examples of companies who were awarded government concession to build government universities and they do adopt IFRIC 12.

So how much exactly is the revenue?

So now we have established the above, first on revenue. We know that we should recognise fair value so how much is it? Fair value is essentially the present value of the future payments aka contract value without interest element. So we need to establish a discount rate. Government payment should be relatively low risk so I think 7.5% is fair. If we discount the 12 payments by 7.5%, we get a fair value of RM1.83b. But if we discount it based on 6% or 10%, the fair value would be RM2.07b or RM1.5b.

Basically the lower the discount rate, the higher the fair value. But why is there such difference? Recall earlier we establish that RM3.5b includes fair value revenue and interest revenue. So if discount rate/interest rate is lower, which means interest revenue is lower while fair value revenue is higher. For example, if fair value revenue is RM1.8b, interest revenue is RM1.7b. If fair value is RM1.5b, interest is RM2b. Eventually, a total revenue of RM3.5b will be recognised over the 15 years period and match with cashflow, it’s just a matter of apportionment.

How much are the costs?

This we do not know. We would need to assume a pre-tax IRR for the project. For university concession usually it’s implied 12%, of course software development may carry much higher IRR compared to traditional university construction but let’s be conservative and just apply a slightly higher IRR of 13%. This means implied costs is around RM1.5b to be incurred over 3 years.

Interest element

The interest revenue will be dependent on what discount rate you use. For illustration purposes, if you use 7.5% to derive fair value revenue, so after first year you recognise RM610m fair value revenue (RM1.83b/ 3years), interest revenue would be RM46m (RM610mx 7.5%). If 10%, you recognise RM500m (RM1.5b/ 3 years) and RM50m interest (RM500m x 10%). Interest will continued to be charged on cumulative amount net of payment received, i.e. second year will be (RM610+610-0 payment received) x 7.5% so on and so forth until the whole receivables is cleared and entire RM3.5b revenue is recognised.

Plucking in the numbers

If we assume 7.5% discount rate:

Assumptions:

1. The above fair value and interest revenue is dependent on discount rate used (7.5% for illustration).

2. Costs to be incurred is dependent on IRR. If IRR is higher, then costs actually should be lower, vice versa.

3. Progress is assumed to be even, in reality it may not.

4. 100% borrowings are assumed to undertake the costs. 6% is used because Prestariang can easily issue a bond with the underlying backing of the 12 annual instalments by government. These type of bonds don’t carry high interest because payment is almost “guaranteed”.

Has market priced in the contract?

At closing price of RM2.45, the market cap is around RM1.19b. The current profit is around RM15-20m pa since its peak in 2013, which means a PE of above 60 times. But what we know from examples like MYEG or even Prestariang itself a few years back, market is willing to pay high PE for these government software stocks in anticipation for high growth.

Assuming current year ends up with RM20m net profit, once the SKIN project kickstarts, the net profit will multiply to around RM140m (RM120+20m) by the 3^rd year or a CAGR of 91%.

For a combined (current biz + SKIN) forward EPS of 14.6c, target price will be dependent on how many times PE you think it’s fair. 20 times PE would be RM2.92 or 30 times would be RM4.38 and it could still be arguably not expensive if earnings indeed are growing at 91% 3-year CAGR.

Even after the 3 years “explosion” period, RM1.8b receivables at 7.5% would still give you RM135m EBIT pa in the 4^th year (which will slowly go down as government pay the instalment over the years). In the most optimistic scenario, from what we have seen from MYEG’s case, after the end of concession, government may even extend the concession for the company to operate the system.

Alternatively, some may argue that concession is best evaluated based on discounted cashflow. If I apply same 7.5% discount rate, NPV of the project after full repayment of interest and borrowings is around RM340m or adding RM0.70 per share to the current value.

All the above are done without evaluating the existing projects of Prestariang as well as other potential future projects. If you are interested in the company’s prospects, please refer to the annual reports or analyst reports. All I tried to illustrate here is how huge this SKIN contract is to Prestariang. So I believe the market has priced in the award of SKIN to a certain extent (since it was announced last year) but haven't fully appreciate its magnitude (as award value is just announced and bottom line impact unclear).

Conclusion

SKIN is easily a game changer for Prestariang regardless of the eventual accounting recognition. Earnings and cashflow will definitely kick in, just depends on the point of time. Until the management provides guidance to the analyst, I believe sticking to IFRIC 12 would be the safest bet to gauge the impact of the contract. The assumptions I made on the discount rate, IRR, implied cost, financing etc. could be different when company eventually implement the contract but I believe they are not too optimistic or overly conservative.

If you have any alternative views on the above, please feel free to share.