Sembcorp Marine (SMM SP) - UOB Kay Hian 2017-11-01: 3Q17 Buoyant Contract Pipeline Obscuring Short-term Blips

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SEMBCORP MARINE LTD S51.SI

Sembcorp Marine (SMM SP) - 3Q17: Buoyant Contract Pipeline Obscuring Short-term Blips

• Sembcorp Marine (SMM)’s headline net profit of S$2.7m was below expectations, impacted by revenue reversals and inventory write-offs. Net gearing remains elevated but is expected to taper down to 1.0x with the receipt of US$500m from Borr. 
• While the positive contract outlook for SMM will drive share price, valuations will be tempered by low profitability as margins are sacrificed. 
• We adjust 2017-19 earnings accordingly and roll forward our target price to S$2.10 (previously S$1.90), based on 2019 valuation. 
• Maintain BUY.

RESULTS

Headline net profit of S$2.7m below expectations. 

• Sembcorp Marine (SMM) reported headline net profit of S$2.7m in 3Q17, down 51% qoq but an improvement from 3Q16 loss of S$21.8m. In 3Q17, two rig contracts were terminated, which resulted in revenue reversal of about S$300m. Excluding one-offs including S$31.3m forex gains and S$12.7m inventory write-off, and without accounting for the impact of revenue reversal, we estimate core net loss at S$13m. 
• Either way, 9M17 net profit was below expectations, at 55% of our full-year estimate.

Net impact of Borr transaction recognised in 3Q17. 

• SMM recognised the net loss arising from the Borr transaction in 3Q17, via a S$12.7m inventory write-down. According to management, accounting standards require the recognition of the financial impact immediately despite the transaction being announced in 4Q17.

Gross margins likely to be depressed for next 5-6 quarters. 

• Due to accounting rules, SMM will first de-recognise revenue associated with terminated rig contracts and rerecognise them on delivery. No additional profit or loss is expected to be recognised from these contracts as the net impact has been accounted for in 3Q17. With gross profit remaining unchanged but revenue inflated as a result of the accounting treatment, headline gross margin will likely be depressed until the delivery of the last jack-up unit in 1Q19. 
• SMM said it could eke out some profit from cost optimisation on the three spec-build rigs, but highlighted it only as a possibility, not a certainty.

Core gross margin estimated at low-single-digit. 

• SMM was reluctant to discuss its core gross profit excluding revenue reversals. Our stab at it, netting out the impact of the inventory write-off, points to a core gross margin probably comparable to 1Q17 levels.

Two rigs’ revenue reversed in 3Q17, three more to be reversed in 4Q17. 

• The quarter saw the revenue reversal for the two Perisai rig contracts. Another revenue reversal will occur in 4Q17 for the three Oro Negro rigs. Marco Polo’s rig was understood to have been reversed out earlier.

Net gearing unchanged at 1.31x, expected to decline to 1.04x. 

• Net gearing as of 3Q17 stood unchanged qoq at 1.31x. With the receipt of Borr’s initial US$500m payment in late-October, SMM expects net gearing to decline to 1.04x.

STOCK IMPACT

Market likely to look beyond short-term earnings blip. 

• The market will likely look beyond this earnings blip as SMM carries out kitchen sinking in 2017. With S$1.2b-1.8b worth of contracts secured (but not formally awarded) for 2018, share price is likely to trend upwards with the positive newsflow on contract awards vs its earnings.

Valuations likely to be tempered by low contract margins. 

• That said, the extent to which valuations will rise is likely be tempered by SMM’s low profitability as margins are sacrificed to secure more contracts and keep utilisation up.

Ytd contract wins of S$2.0b. 

• These include the jack-ups that were re-sold to Borr Drilling (Borr) for S$1.77b. Excluding the Borr rigs, ytd contract wins is S$270m.

EARNINGS REVISION 

Slash 2017 earnings by 37%. 

• Taking into account lower margins in 3Q17, we slash our 2017 core net profit by 37% to S$55m.

Adjust 2018-19 earnings. 

• Given the pipeline of known contract wins in 2018, we bump up our contract wins assumption for 2018 from S$1.5b to S$2.0b. We also revise down our margin assumptions. 
• Our 2018-19 net profit estimates are now S$111m (-23%) and S$138m (-2%) respectively.

VALUATION/RECOMMENDATION

Maintain BUY with a revised target price of S$2.10. 

• Sembcorp Marine's share price has risen 11% since our upgrade. 
• SMM is a long-term recovery play and investors will have to look beyond the likely knee jerk sell-off. With that in mind, we are rolling our target price to 2019, pegged to 1.6x forward P/B. 
• SMM currently rests at an inflexion point where the likelihood of positive developments outweighs the negatives. Given the sizeable pipeline of projects that SMM is likely to secure in 2018, we see upside from this juncture. 
• Downside risks such as impairment have taken a backseat as:
  1. the recent transaction with Borr drilling points to likely sufficient provisions for West Rigel, and
  2. the improving sector outlook means provisions at Sete Brasil are probably sufficient. Maintain BUY.

RISKS

• Execution risks from existing orderbook and future orders.
• Unforeseen impairment risks.

Foo Zhiwei UOB Kay Hian | Andrew Chow CFA UOB Kay Hian | http://research.uobkayhian.com/ 2017-11-01

UOB Kay Hian SGX Stock Analyst Report BUY Maintain BUY 2.10 Up 1.900