Offshore & Marine - Maybank Kim Eng 2016-01-19: How Low is Low Tide?

Offshore & Marine - Maybank Kim Eng 2016-01-19: How Low is Low Tide? KEPPEL CORPORATION LIMITED BN4.SI  SEMBCORP INDUSTRIES LTD U96.SI  SEMBCORP MARINE LTD S51.SI 

Offshore & Marine - How Low is Low Tide? 

  • Rigbuilding de-rating to continue 
  • Sete Brasil’s potential bankruptcy and oil’s unending rout have brewed extreme pessimism on Singapore rigbuilders. We see no respite over the next six months, given: 
    1. weak rig orders; 
    2. contract cancellation risks; and 
    3. potential asset writedowns. 
  • Factoring these in, we cut Keppel (TP SGD4.24) from HOLD to SELL with de-rating catalysts expected from potential contract cancellations and a broken dividend-yield support. 
  • Maintain SELL on SMM (TP SGD1.00) with no visibility of a bottom. 
  • Maintain HOLD on SCI (TP SGD2.30) which appears most oversold but has no catalysts for a re-rating. 

1. Rig-order drought in FY16-17 

1.1 Rig orders abruptly dried up in 2015 

  • After years of strong orders on anticipation of sustained high oil prices and rig replacements, order wins screeched to a stop in 2015. No drilling rigs were ordered in 2015. 

1.2 No need for more rigs even if oil rebounds 

  • Other than weak drilling demand due to low oil prices, 68 floaters and 115 jackups were under construction as of Dec 2015. These formed 26%/30% of the world’s active floater/jackup fleets. Only 50%/7% of these newbuilds have secured contracts. 

1.3 Cut new orders for Keppel O&M and SMM 

  • We now assume no new drilling-rig orders for Keppel and SMM in FY16-17. 
  • Our FY16-17 assumption of SGD1.6b new orders per yard per year now consists entirely of offshore and conversion jobs. This number is down from SGD2.8b/3.9b for the two years for Keppel and SGD2.5b/3.7b for SMM. 

2. Cancellation risks 

2.1 Slippery slope from deferment to cancellation 

  • Many clients have delayed deliveries and yards have accommodated. Delays range from three to 24 months. There are a few risks: 
    • Many rigs are contracted on backend-loaded payment terms such as 20% downpayment and 80% payment on delivery. Yards finance their construction with working capital and do not get paid unless clients take delivery. 
    • While clients could still take delivery in the end, deferment carries the risk of order cancellation. A continued downbeat market for oil and depressed asset prices could pile the pressure on clients to forgo deposits. 
    • Keppel and SMM may be unable to re-sell contracted rigs at their original prices. They may have to mark down book values and already-recognised profits. 

2.2 Removing future recognition of high-risk orders 

  • In our attempt to call a bottom for stocks, we analyse yet-to-be-delivered rigs on Keppel O&M’s and SMM’s orderbooks. 
  • We assume that clients may continue to delay and eventually refuse delivery, forcing the yards to mark down WIP to market values and write off receivables. 

2.3 FY16-17E EPS cut by 14-53%; that’s not all 

  • The removal of revenue recognition and lower order-win assumptions cut our FY16-17 EPS by 14-53%. 
  • Keppel Corp should still be able to maintain positive FCFs in FY16-17E, thanks to its diversified income sources. 
  • On the other hand, we expect SMM’s FCF to turn negative in FY16 and only slightly positive in FY17. 

3. Up to SGD1b at risk of writedowns, for each 

3.1 Difficult to be precise 

  • Assessing the potential writedowns is complicated and requires multiple assumptions. Details of cash collected, progress billings and WIP are not readily available. We make certain assumptions.
    • Progress billings refer to the amounts that yards have billed their clients. These may not correspond to physical completion. The numbers are based on our own judgement, guided by rigs physical completion status This applies for those under milestone payments. 
    • For backend-loaded contracts, we assume that yards have only charged and collected downpayments. 
    • We assume that asset prices have to be marked down by 20% from their original contracted prices for non-Sete Brasil contracts. 
    • Sete Brasil contracts were secured at c.USD800m a piece when market prices for similar units were going for c.USD600m in 2011/2012. We thus mark down their market values by 20% from USD600m. 
    • Amounts collected from Sete Brasil are based on Sete’s FY14 audited financial statements. We believe that these are reflective of the amounts paid to date as the yards have not been paid since Nov 2014. 

3.2 Keppel may need to write down as much as SGD1.0b. 

  • On our estimates, Keppel may need to write down as much as SGD1.0b: SGD361m of receivables and SGD648m of WIP. We assume that all Sete Brasil rigs and our selected list of 14 other high-risk contracts could be written down. We have also removed revenue recognition for those contracts in our forecasts. 
    • For Sete Brasil rigs 5 & 6, we think there may be writebacks if they are cancelled as Keppel has not started much construction but has collected downpayment. We suspect, though, that this may partly be offset by equipment purchases intended for the rigs. 
    • Other than Sete Brasil, potential writedowns for other high-risk rigs are quite substantial, at SGD568m. 

3.3 SMM may need to write down as much as SGD0.9b. 

  • On our estimates, SMM may need to write down as much as SGD0.9b: SGD299m of receivables and SGD567m of WIP. We assume that SMM writes down all its Sete Brasil rigs and our list of high-risk contracts. We also remove revenue recognition from our forecasts. 
    • SMM has actually collected more cash from Sete Brasil than Keppel. 
    • For Sete Brasil’s rigs 6 & 7, we think that there may be writebacks if they are cancelled as SMM has not started much construction but has collected downpayments. That said, we suspect that this may partly be offset by equipment purchases intended for the rigs. 
    • Other than Sete Brasil, potential writedowns of other high-risk rigs are quite substantial, at SGD486m. 
    • We have not considered writedowns for its Brazilian yard in which it has invested about SGD1b. 

3.4 Not about the technicalities of writedowns 

  • Ultimately, it is not about the technicalities of whether a writedown or provision is required based on accounting principles. What is important is the true cash value that the yards can derive out of these assets when clients cannot pay up. We believe that our exercise in Fig 11 & 12 give investors a sense of the amount at risk. 

4. Valuing the stocks by their assets 

4.1 Turning to asset-based valuations 

  • Our EV/backlog valuations for yards are irrelevant now that order wins are nonexistent and backlogs face risks of writedowns and cancellations. 
  • Earnings-based valuations are also not suitable as delayed deliveries will hurt profitability and cash collections. 
  • We switch to book values but discount these through asset writedowns. 

4.2 Pricing in extremities 

  • We use 3Q15 NTA for the yards and adjust for asset writedowns, instead of forward book values. This is conservative as it would not even consider future earnings. 
  • Arguably, it also ignores potential future losses, but our earlier calculations suggest that both yards could still generate profits and positive FCF in FY17. 
  • While we have built in more extremities than may actually unfold, we gain greater confidence in calling a bottom for the stocks when its there. 

4.3 Is Keppel O&M really worth less than SMM? 

  • What is glaring from the above is Keppel O&M’s lower net asset value than SMM’s. Why should this be so, given its higher earnings base and larger yard presence? The main reason is, Keppel O&M has been paying out most of its earnings as dividends to parent Keppel Corp. Its net asset value does not accrue most of its earnings. 
  • Moreover, since FY14, Keppel O&M’s book value has been declining QoQ while Keppel Land’s has been climbing. 
  • We suspect that other than dividend payouts to Keppel Corp shareholders, much of O&M’s cash has been channelled to property, especially after the privatisation of Keppel Land. 

4.4 Net gearing could spike for SMM 

  • With the writedowns in net assets, equity values will shrink. This would result in higher net gearing. 
  • WE estimate that SMM’s net gearing could spike to 1.33x in FY16, after our adjustments.

Yeak Chee Keong CFA Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2016-01-19
Maybank Kim Eng SGX Stock Analyst Report SELL Downgrade HOLD 4.24 Down 7.70
SELL Maintain SELL 1.00 Down 1.53
HOLD Maintain HOLD 2.30 Down 3.53