Shipyard Sector Singapore - UOB Kay Hian 2016-06-02: Lower Overhang On SCI As SMM's Cash Call Risk Abates

Shipyard Sector Singapore - UOB Kay Hian 2016-06-02: Lower Overhang On SCI As SMM's Cash Call Risk Abates Offshore & Marine SEMBCORP MARINE LTD S51.SI  SEMBCORP INDUSTRIES LTD U96.SI 

Shipyard - Singapore: Lower Overhang On SCI As SMM’s Cash Call Risk Abates

  • A calculation of SMM’s cash flows in 2016-18 points to a cash shortfall of S$712m. With debt headroom of S$1.5b, a cash call appears unnecessary. Even if SMM does one, the issuance may come from SCI instead, given the latter’s reluctance to inject additional equity into its subsidiary. Dilution is expected at 3-13%, depending on the discount used. 
  • We switch our valuation benchmark for utilities from 12x to a blended PE of 9.5x. 
  • Upgrade SMM to HOLD and raise target price to S$1.27. Maintain BUY on SCI with a lower target price of S$3.60. 
  • Maintain MARKET WEIGHT on the sector.



WHAT’S NEW


Market rife with a possible cash call by SMM. 

  • The high net gearing in Sembcorp Marine’s (SMM) balance sheet had earlier caused concerns that a cash call might be necessary. This has caused an undue overhang on Sembcorp Industries’ (SCI) share price, with it being the 61% owner of SMM.

Estimating cash inflows/outflows over 2016-18. 

  • To determine whether or not SMM will indeed require a cash call, we estimate the cash shortfall for each year over 2016-18. This was cross-checked against the financial lines at SMM’s disposal, to find out if equity raising is required to meet the shortfall. 
  • Our analysis will purely focus on operational cash flows, and assumes no debt drawdown over the period. Capex over the period is assumed at S$450m, S$225m and S$225m respectively.

Net cash shortfall of S$712m over 2016-18. 

  • In a base-case scenario where we assume non-delivery of five rig orders (3x Oro Negro and 2x Perisai), the cash shortfall over the period is S$712m. 
  • For 2016, SMM faces a net cash inflow of S$93m, making a cash call within this year unlikely. This reverses into a shortfall over 2017-18, with SMM facing a steep shortfall in 2018, at S$640m. 
  • Given the likelihood of a sector recovery by then, additional new orders (and the requisite upfront cash deposit) would help mitigate part of the shortfall.

No cash shortfall if Oro Negro and Perisai take deliveries. 

  • In the bull-case scenario where Oro Negro and Perisai both take delivery of their orders, SMM will receive a cash inflow totalling S$1.1b. This far exceeds the shortfall of S$712m over 2016-18, with SMM set to recognise a net cash inflow of S$359m at the end of the period. 
  • In an alternate scenario where only Perisai takes delivery, the cash shortfall would be S$292m. If only Oro Negro takes delivery, the cash shortfall would be S$61m. In either case, SMM has sufficient debt headroom.

By all accounts, a cash call seems unnecessary. 

  • Assuming no order surprises, or a special directive to raise cash, a cash call for SMM seems unnecessary. The financial covenant on its MTN requires SMM to maintain a net gearing of 175% or lower, implying debt headroom of S$1.5b based on its 1Q16 financial position. This easily covers the shortfall of S$712m in our base case scenario. 
  • An alternative way to breach the 175% net gearing limit would be to lower shareholder’s equity. This would mean losses/impairment of S$1.1b. Our estimate of asset impairment is at most S$663m, and the risk of asset impairment lessens as the oil market recovers. Sete Brasil is sufficiently provided for now at S$329m. 
  • Either way, SMM is unlikely to record a large loss/impairment that lowers equity sufficiently and breach its financial covenant. Thus, with sufficient debt headroom to meet shortfalls, and a low likelihood of breaching its debt covenant, a cash call hardly seems necessary.

A cash call for SMM could be done through SCI. 

  • For the sake of completeness, if SMM were to do a cash call of S$700m, methods for an equity infusion could either be conducted via a strategic placement, a rights issue from SMM, or a rights issue from SCI. 
  • The last option would be more likely than a rights issue at SMM’s level as it allows SCI to tap into the resources of its major shareholder, and this would be consistent with SCI’s stance of not wanting to inject further equity into its subsidiary. The raised monies could then be directed to SMM via a shareholder loan.

Rights issue dilution to SCI’s/SMM’s book value is 12-13% at most. 

  • In a scenario where SCI/SMM does a rights issue, the dilution to book value is at most 12-13%. Depending on the discount to share price, a rights issue at SCI would be between 3- 13%. 
  • Interestingly for SMM, no dilution to book value occurs until a 20% discount is used, after which it dilutes up to 12%. 



STOCK IMPACT


Cash call really a tail-end risk. 

  • From the exercise, it appears that the likelihood of a cash call is low, barring a forced directive. SMM has ample financial lines to meet its cash shortfalls. 
  • While rig values remains depressed, the improving oil market removes some of the earlier risk of order cancellations and asset impairments for SMM, which were part of the reasons warranting a cash call.

Singapore utilities earnings at a likely trough. 

  • While earnings from Singapore utilities remain lacklustre, it appears that a trough has been reached. With Hyflux's power plant having already come on stream in 1Q16 and being the last capacity addition to the Singapore grid, electricity prices appear to have stabilised, hovering at an average of S$40/MWh since Feb 16. SCI’s utilities earnings is thus at an inflexion point, and is likely to pick up with earnings from its two India plants coming fully on- stream by end-2016.

Unwarranted apprehension on SCI’s share price. 

  • With a cash call being a tail event, and Singapore utilities earnings at a trough, we reckon the lacklustre share price of SCI to be undue. Excluding the marine business, we value SCI at S$2.71/share. 
  • Current share price of S$2.77 implies a S$0.06/share valuation to SMM, which is unjustifiably low.



VALUATION


Switching utilities’ PE valuation yardstick to reflect geographical risks. 

  • Our PE valuation yardstick for SCI has been adjusted to the respective countries’ PE valuations. 
  • Given each country’s unique political, regulatory and business risks, the use of a single PE multiple fails to capture the inherent risk from each market. Use of a country’s PE multiple adjusts for this risk, and is more representative of the value of the business if it were to be sold piecemeal in their respective countries. 
  • Our utilities PE valuation falls from 12x to an implied 9.5x as a result, and our target price for SCI is accordingly reduced from S$4.00 to S$3.60.

Upgrade SMM to HOLD. 

  • With the oil market improving and the risk of cancellations diminishing in our view, we revert to our base-case target price of S$1.27, and upgrade the stock to HOLD
  • However, we maintain our bear-case target price of S$0.90 in the unlikely event that SMM makes asset impairments on rig orders at risk. Entry price is S$1.20.

Maintain BUY on SCI 

  • Maintain BUY on SCI but lower target price to S$3.60 (from S$4.00), using a blended PE of 9.5x 2017F for its utilities business. Excluding the marine business, SCI’s valuation falls to S$2.71/share. 
  • SCI’s current price gives the investor the marine business for less than a dime. Barring unforeseen circumstances, the India power plants are primed to drive strong earnings growth. 
  • Maintain BUY.



ASSUMPTION CHANGES/CATALYSTS/RISKS

  • No change to our earnings forecasts for SCI or SMM.




Foo Zhiwei UOB Kay Hian | Andrew Chow CFA UOB Kay Hian | http://research.uobkayhian.com/ 2016-06-02
UOB Kay Hian Analyst Report BUY Maintain BUY 3.60 Down 4.00
HOLD Upgrade SELL 1.27 Up 0.90


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