Shipyard Singapore - UOB Kay Hian Research 2015-11-19: Bracing For More Contract Cancellations

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Shipyard – Singapore Bracing For More Contract Cancellations 

• MPM has cancelled its rig contract with SMM, the first salvo in a possible wave of cancellations. Our analysis indicates this reduces SMM’s book value per share by S$0.04, with another S$0.08 on the cards if Oro Negro and Perisai follow suit. 
• Cancellation risks remain elevated for SMM, but not for Keppel. 
• A potential paradigm shift in Singapore rig builders’ valuations may be unfolding. 
• Downgrade SMM to SELL with a lower target price of S$1.72. 
• Maintain MARKET WEIGHT. 

WHAT’S NEW 

• MPM terminates its rig contract with SMM. 

• Marco Polo Marine (MPM) is terminating its rig contract with Sembcorp Marine (SMM) and seeking a refund of its initial 10% deposit (and interest). MPM terminated the rig on the grounds of “cracks found on all three legs of the New Rig during two rounds of test”. 
• SMM refutes receipt of the termination notice, but says that it will terminate the contract anyway on grounds of repudiatory breach of contract, and rejects any claim by MPM. 

STOCK IMPACT 

• Prolonged downturn increasing cancellation risks for Singapore rig builders. 

• The downturn in the drilling rig market has been financially challenging for rig operators who have faced contract cancellations from oil majors and NOCs, and weak job prospects. Rig operators had initially coped by deferring rig deliveries but as the downturn lengthens, owners are now reviewing the economic viability of their newbuild orders with stretched balance sheets in mind. 
• Ytd, South Korean yards have seen eight delivery deferrals, and two order cancellations. Singapore yards have seen 11 delivery deferrals ytd and one cancellation: MPM’s termination marks the first Singapore rig building contract cancellation in the current downturn. 

• Cancellation risks remain high for SMM. 

• Between the two Singapore rig builders Keppel Corp (Keppel) and SMM, the latter faces high jack-up rig cancellation risks given its customers’ profile. During the rig boom of 2012-14, SMM’s saw large order intakes from less established customers, who were newcomers to the offshore drilling market. 

• Delays for Keppel thus far; cancellations are unlikely. 

• To date, Keppel has only received delivery deferrals from clients Transocean (five), Parden Holdings (one) and Grupo R (two). Aside from Parden Holdings, we opine a low cancellation risk given the customers’ long track record in offshore drilling. 
• A cancellation finally comes to pass for SMM. In our 3Q15 results note, we had flagged potential cancellation risks that SMM faced on seven of its jack-up rigs (two for Perisai, three for Oro Negro, one for Marco Polo Marine and one for Hercules Offshore). Now that one jack-up rig cancellation has come to pass, SMM might face a potential wave of similar cancellations. 
• Of the remaining six rigs, five are at risk; Hercules Offshore’s cancellation risk has been rendered moot since it recently emerged from Chapter 11 on 6 Nov 15 with secured funding for its rig. Hercules’ rig had a 5-year drilling contract with Maersk Oil, which substantially lowered its risk. This is compared to the remaining six rigs, which have no contracts backing them. Among them, Oro Negro’s three rig contracts are vulnerable owing to its cash-strapped position. 

• MPM’s cancellation results in a reduction in NAV/share of S$0.04. 

• The contract termination reveals a surprising payment structure of 10:90, unexpected as we had earlier understood that SMM’s contracts were on a 20:80 payment structure. Assuming 90% completion and 15% operating margin, SMM would likely have to reverse an estimated US$24.0m (S$32.4m) of profits already recognised from the project. 
• With rig prices down 30-40% in 2015, we estimate SMM would likely incur a mark-to-market write-down of US$32.2m (S$43.4m) as it assumes ownership of the rig. The total impact to NAV is US$56.2m (S$75.8m), or S$0.04 per share. 

• Six cancellations would reduce NAV by S$0.12/share. 

• MPM’s cancellation might prompt Oro Negro and Perisai to follow suit. In the scenario where all six rigs (Oro Negro’s, Perisai’s and MPM’s) are cancelled, the profit reversal and write-down would be S$131.6m and S$113.9m respectively, thus shaving off S$0.12 in NAV/share. 
• Netting off MPM’s portion, it would imply a NAV write-down of S$0.08 per share for the remaining five rigs. 
• All in all, our target price for SMM would be lowered from S$2.34 to S$1.72, and SCI’s target price from S$4.50 to S$4.07. 

VALUATION 

• A potential paradigm shift in Singapore rig builders’ valuations. 

• Keppel and SMM currently trade at 2016F P/B of 1.1x and 1.4x respectively. Placed in perspective against average 0.6x 2016F P/B for South Korean and Japanese offshore heavy-engineering shipyards, the significant premium on SMM makes it the most expensive offshore heavy engineering shipyard stock in the sector. 
• 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 a higher level because of a massive earnings uplift, good balance sheet management and decent dividend yield. 
• 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. Whilst its earnings capability then was lower, its 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. 

• Downgrade SMM to SELL, and lower target price from S$2.34 to S$1.72. 

• We lower our valuation benchmark for SMM due to: 
  1. high probability of further contract cancellations, 
  2. high valuation vs. peers’, and 
  3. a prolonged downturn in the oil & gas industry. 
• Our valuation benchmark of 2.0x 2016F P/B is based on a regression of Brent oil to historical P/B for large-cap shipyards. Given the rising cancellation risk for SMM, we lower our valuation from 1.5x to 1.2x 2016F P/B. This is around the P/B level that SMM traded at prior to 2004. 
• We have reflected on pre-2004 valuations and current peer valuations. 
• Target price for SMM falls from S$2.34 to S$1.72 for SMM as a result, and we downgrade the stock to SELL. 

• Keppel Corporation: Maintain HOLD and target price at S$7.60. 

• Lowering our target price for SCI from S$4.50 to S$4.07. 

• Factoring in our lower target price for SMM, our revised SOTP valuation for SCI is S$4.07, based on a 2016F PE of 12x for its Utilities business. Maintain BUY on SCI. 

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/ 2015-11-19

UOB Kay Hian Analyst Report BUY Maintain BUY 4.07 Down 4.50

SELL Downgrade HOLD 1.72 Down 2.34

BUY Maintain BUY 1.01 Same 1.01

BUY Maintain BUY 0.88 Same 0.88