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Is Keppel Corporation Limited Taking A Big Risk To Privatize Keppel Land Limited?

Earlier today, the conglomerate Keppel Corporation Limited (SGX: BN4) announced that it wants to take its real estate subsidiary Keppel Land Limited (SGX: K17) private.

Rumours of the privatization first surfaced on Wednesday when both companies in question asked for a trading halt on their shares.

Although Keppel Corp has a strong suite of reasons for wanting to get the deal done, investors should keep a close watch on the firm’s finances if the privatization is pushed through. There’d be more on this later, but first, here’re some details on the offer.

A golden handshake

Keppel Corp, which is involved in offshore & marine, infrastructure, and property businesses, intends to offer S$4.38 per share for shares for Keppel Land that it does not yet own (Keppel Corp currently owns 54.6% of Keppel Land).

But in the event that 90% or more of Keppel Land’s minority shareholders accept Keppel Corp’s deal by the date the offer closes, the offer price will then be bumped up to S$4.60 per share.

At the lower offer price, Keppel Corp’s valuing the entire Keppel Land at around S$6.768 billion; at the higher offer price, Keppel Land’s being pegged to have a value of S$7.1077 billion. Keppel Corp intends to fund the purchase “through a combination of internal cash and borrowings.”

The benefits

There are a number of reasons for Keppel Corp’s desire to privatize Keppel Land.

Keppel Corp believes that Keppel Land’s core and growth markets (Singapore and China for the former; Indonesia and Vietnam for the latter) are able to enjoy growth-tailwinds over the next 10 to 15 years coming from (1) rising urbanisation, (2) growing infrastructure development, and (3) significant growth in the number of new consumers appearing in emerging markets.

Keppel Corp also sees the buyout as an opportunity to help unlock value for its own shareholders. Based on its number crunching on a pro-forma basis for the year ended 31 December 2014, Keppel Corp pointed out that the acquisition can help improve its earnings per share by 13% and bump up its return on equity from 18.8% to 21.0%.

A takeover of Keppel Land will also enable Keppel Corp to become more diversified with a larger equity base, in the process improving its access to financing from different sources. A more streamlined organization was also highlighted by Keppel Corp as a benefit the privatization can bring.

Last but not least, Keppel Corp also sees the takeover as a way for it to achieve synergies between its diverse businesses.

Increasing risks

But despite the potential benefits, investors might want to keep a close watch on Keppel Corp’s balance sheet.

As I noted previously:

“Keppel Corp’s last reported financials (for the quarter ended 30 September 2014) had it carrying S$4.91 billion in cash and short-term investments and S$7.24 billion in borrowings. That balance sheet could possibly finance Keppel Corp’s possible purchase of the other 45.5% of Keppel Land given that it would cost “only” around S$2.57 billion [at a price of S$3.65 per share for Keppel Land].

But doing so would weaken Keppel Corp’s balance sheet pretty drastically. Given declining oil prices, and with the offshore & marine segment being Keppel Corp’s most important profit contributor over the past few years, increasing its leverage now would seem like a risky move for the company to make.”

On a pro-forma basis assuming Keppel Land is fully privatized, Keppel Corp’s net debt (total borrowings net of all cash) and net gearing ratio (net debt over equity) would both increase by quite a fair bit. You can see this in the table below:

Keppel Corp's balance sheet

Source: Keppel Corp’s presentation

Besides the aforementioned potential negative impacts to Keppel Corp’s business as a result of declining oil prices (though it must be said that the firm has been historically resilient even when the price of oil has tanked in the past), there is also the spectre of the possible weakening of the Chinese and Singapore real estate markets to contend with.

As an example of the potential problems in China, a Chinese real estate developer had failed to meet interest payments for its loans earlier this month. A few weeks later, the company in question, Kaisa Group, then failed to repay a RMB2.5 billion trust. These may well be shrugged off by the Chinese real estate market, but it would still pay for investors to keep a watchful eye on any storms which may appear in the horizon.

A Fool’s take

Even for a company the size of Keppel Corp, the multi-billion deal to acquire Keppel Land is still a huge undertaking.

The acquisition has its benefits, but at the same time, it would amplify the financial risks that Keppel Corp is taking on due to the increased leverage. It doesn’t help either that Keppel Corp has not been able to consistently generate free cash flow from its business operations over the past few years.

As a result, investors of Keppel Corp might want to keep a close watch on the company’s finances to ensure that it’s not biting off more than it can chew.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in companies mentioned.