Shipyard Singapore - UOB Kay Hian Research 2015-12-03: A Paradigm Shift In Valuations; 2008-09s Trough Levels Are Not A Realistic

Offshore & Marine SEMBCORP MARINE LTD S51.SI SEMBCORP INDUSTRIES LTD U96.SI EZION HOLDINGS LIMITED 5ME.SI TRIYARDS HOLDINGS LIMITED RC5.SI

Shipyard – Singapore A Paradigm Shift In Valuations; 2008-09’s Trough Levels Are Not A Realistic Guide

We see a potential paradigm shift in rig builders’ valuations. 2008-09’s trough levels are not a realistic guide.
SMM has issued a profit warning, flagging a 4Q15 loss. We had earlier flagged cancellation risks for six jack-up contracts.
MPM’s cancellation has come to pass. The West Rigel semi also faces cancellation risk.
We lower our target prices for SCI to S$4.05 and SMM to S$1.69 after factoring in SMM’s 4Q15 loss.
Maintain MARKET WEIGHT.

WHAT’S NEW

• SMM’s profit warning: A loss for 4Q15…

Sembcorp Marine (SMM) issued a profit warning on Tuesday night. It expects to make a loss in 4Q15. For 2015, net profit is expected to see a significant decline.
The loss for 4Q15 is attributed to a "challenging operating environment and customers deferring or seeking to defer their rig orders".

• … and terminates rig contract with Marco Polo Drilling (MPD).

SMM has announced its termination of MPD’s jack-up rig contract on 1 Dec 15, and it will seek payment of the 2nd disbursement of US$21.4m from MPD’s guarantor Marco Polo Marine (MPM).
Simultaneously, SMM took legal action against MPM in the Singapore High Court on 1 Dec 15.

• Standstill agreement with NAD.

In an early morning announcement SMM said it and NAD had arrived at a standstill agreement until June 2016. Under the agreement NAD will continue to market the rig, but SMM retained the right to sell the rig.
Upon expiry of the agreement, both parties will form a 23:77 (NAD:SMM) Joint Asset Holding Company to market / sell the rig.

STOCK IMPACT

• More deferred deliveries.

SMM’s profit warning announcement suggests that additional deferred deliveries are the cause behind its 4Q15 loss. At this juncture, details are scant.
Deferrals reduce revenue recognition. In the case that a customer cannot pay, it may warrant a profit reversal, as seen in 3Q15.
We highlight nine orders that can potentially be deferred, might even be cancelled or have been cancelled.
1. 1 semi-submersible (semi) – the West Rigel - for North Atlantic Drilling (NAD)
2. 3 jack-ups for Oro Negro
3. 2 jack-ups for Perisai
4. 1 jack-up for MPD (now cancelled)
5. 1 jack-up for Hercules Drilling
6. 1 accommodation semi – the Safe Zephyrus - for Prosafe
Of these nine contracts, we have earlier flagged the risk of seven jack-up rigs for Oro Negro, Perisai, MPD and Hercules Offshore. MPD’s cancellation has now come to pass.
West Rigel is likely to suffer deferral or cancellation too. This is based on NAD’s parent Seadrill’s comments at its 3Q15 results briefing last week. Safe Zephyrus has been completed on time and budget, and with delivery deferred to next year, it will impact SMM’s cashflow only, not earnings.
As such, we think 4Q15’s expected loss is likely due to a write-down and profit reversal relating to MPD’s contract, with the possibility of a negative impact from West Rigel.

• MPD’s profit reversal and write-down are estimated at S$68.4m.

We had earlier highlighted that profit reversal and mark-to-market (MTM) loss relating to the MPD rig would result in a profit reversal of S$32.4m and a MTM loss of S$36.0m, totalling S$68.4m. Our estimate of the MTM loss was based on an assumption of a 50% decline in rig values, net of the 10% customer deposit. Given the current poor rig market and potentially steeper-than-expected decline in rig values, SMM might have opted for a full write-down of the rig’s US$214.3m (S$289.3m) contract value. A successful sale of the rig at a later stage would reverse part of this write-down. The large quantum of this initial write-down would result in a 4Q15 loss.

• Possible profit reversal for West Rigel.

The harsh-environment semi West Rigel is being built for NAD, a subsidiary of Seadrill. The rig was ordered in Apr 12 for US$568m and is based on a 20:80 payment structure. While SMM’s announcement for a standstill agreement points to neither a cancellation or delivery deferral, it is clear that both parties are trying to settle with a win-win solution. It appears NAD is unable to finance the final payment since banks are not likely to lend without a charter contract, whilst SMM wishes to collect the remaining payment. As such, SMM is likely to reverse recognised profit in its 4Q15 financials on prudent accounting.

• We provide the following estimated provisions:

Oro Negro cancels1 : S$205.0m, S$0.07/share
Perisai Petroleum cancels: S$119.8m, S$0.06/share
NAD cancels: S$318.2m, S$0.15/share
Total impact if all cancel: S$643.0m, S$0.28/share 1: Assumes 50% profit reversal in 3Q15

VALUATION

• A paradigm shift in valuations; 2008/09’s trough is not a realistic guide.

Keppel and SMM currently trade at 2016F P/B of 1.1x and 1.4x respectively. Against an average 2016F P/B of 0.6x for South Korean and Japanese offshore heavy-engineering shipyards, SMM’s significant premium makes it the most expensive offshore heavy-engineering shipyard stock in the region.
Keppel’s and SMM’s premium valuations started in 2004 on the back of the oil super-cycle.
Keppel had always been involved in rig building while SMM had just diversified into rig building. Both their P/B valuations shifted to higher levels because of a massive earnings uplift, good balance sheet management and decent dividend yields.
Worth noting is prior to 2004, SMM - a pure shipyard - traded at a lower average P/B of 1.26x (1997-2003). Then, it was primarily a ship-repair yard.
While its earnings capability was lower, SMM’s ship-repair business was low risk. Its current offshore heavy-engineering business is inherently higher risk.
During the Asian Financial crisis, SMM’s P/B valuation crashed to 0.85x.

• Maintain SELL on SMM, and lower target price from S$1.72 to S$1.69.

We value SMM at 1.2x 2016F P/B which is below the 2008-09’s trough P/B of 1.4x. This is due to:
1. a high probability of further contract cancellations,
2. a high valuation vs peers’, and
3. a prolonged downturn in the oil & gas industry.
Our P/B valuation is based on SMM’s average P/B level of 1.2x prior to 2004. We cut our target price marginally from S$1.72 to S$1.69 after factoring in a loss in 4Q15 and a steeper 50% - instead of 40% - decline in rig values. However, if we were to impute a cancellation of the West Rigel contract, our target price for SMM would be lowered further to S$1.50 (S$1.07 at AFC’s P/B trough of 0.85x).
Our forecast has been reduced from S$290m to S$225m, taking into account the reversal and write-down on the MPD unit. We expect SMM to report a loss of S$22m for 4Q15. The effect from NAD’s unit is not taken into account.

• Lowering our target price for SCI from S$4.07 to S$4.05.

Factoring in our lower target price of S$1.69 for SMM, our revised SOTP valuation for SCI is S$4.05, based on a 2016F PE of 12x for its utilities business. Including a cancellation on West Rigel, our target price would be reduced to S$3.92 (S$3.61 if SMM is valued at AFC’s trough P/B of 0.85x). Maintain BUY on SCI.
Keppel Corporation: Maintain HOLD and target price at S$7.60 (S$6.39 at AFC trough P/B of 0.85x for its marine business). Entry price is S$6.10.

ASSUMPTION CHANGES / CATALYSTS / RISKS

• Oil price the key risk.

Two key risks in the sector are:
1. protracted low oil prices, and
2. another sharp fall in oil prices.
Both would significantly impede future capex spending, which needs to rise in order to return activity levels to pre-crash levels.

Nancy Wei UOB Kay Hian | Foo Zhiwei UOB Kay Hian | http://research.uobkayhian.com/ 2015-12-03

UOB Kay Hian Analyst Report BUY Maintain BUY 4.05 Down 4.07

SELL Downgrade HOLD 1.69 Down 1.72

BUY Maintain BUY 1.01 Same 1.01

BUY Maintain BUY 0.88 Same 0.88

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