Sembcorp Industries Ltd - Phillip Securities 2017-05-29: Enjoy Your Yield As Catalyst Unravel

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SEMBCORP INDUSTRIES LTD U96.SI

Sembcorp Industries Ltd - Enjoy Your Yield As Catalyst Unravel

• Multiple re-rating catalysts possible, in particular India.
• Under-priced optionality from pending strategic review.
• We initiate Sembcorp Industries (SCI) with an Accumulate rating and a target price of $3.50. This implies an upside of 13.7% (including forecast dividends of 8 SG cents) from the last closing price of S$3.15.

Company Background 

• Sembcorp Industries Ltd (SCI) is an investment holding company mainly engaging in three segments of business, utilities, marine, and urban development. Its foot print reaches across five continents worldwide.
• The utilities segment is involved in development and operation of facilities of various types of energy including thermal, wind, solar, biomass, natural gas, water, and electricity. In addition, it provides on-site logistics and solid waste solutions and management.
• The marine segment is separately listed as a subsidiary, Sembcorp Marine, and SCI holds a 61% of interest. It provides offshore engineering and construction such as rigs, floaters, and platform building and repair.
• Urban development segment specialises in land development and property development on landmark catalytic growth projects.

SEGMENT UPDATE 

India: Underdeveloped electricity conditions are improving 

• According to World Energy Outlook 2016 from International Energy Agency, the population without electricity totalled 244mn with national electrification rate of 81% in India. The urban electrification rate is 4% shy of full access level while the rural rate is 74%. The imbalance of power distribution is severe across states and regions in India. 
• In the Load Generation Balance Report 2016-17 published by Central Electricity Authority (CEA) in India, all regions in India suffered from power shortage in varying degrees for the year 2015-16. The northern states where have second largest amount of electricity demand are subject to respective c.5% energy and c.7% peak deficit. Though CEA expected such a situation will be improved, deficiency of electricity in relatively underdeveloped regions such as eastern and north-eastern states could worse off for the year 2016-17.
• The Indian government has been actively expanding the development of infrastructure for electrification. The installed capacity across the country has grown to 302.1 GW with a compound annual growth rate of 9.6% from 2007 to 2016. As of Apr-17, the installed capacity was recorded at 329.2 GW according to Ministry of Power in India. 
• In the National Electricity Plan 2016, the total capacity addition during 2017 to 2022 is expected to be 187.8 GW, tantamount to 57% growth from the current amount. However, the CAGR of actual electricity generation was only 5.9% from 2007 to 2016, which translated to a relatively low plant load factor (PLF), a measure of average capacity utilisation. Though electricity generation was recorded at a new high of 1,107.4 BU in 2015-16, the PFL arrived at a new low of 42%. We can see a downtrend of PLF over the past 10 years.
• There are several major factors resulting in lower PLF and power shortage.
  1. Some power plants suffer from insufficient or intermittent feedstock supply to fuel the operation. As of Mar-2016, the coal, hydro, and gas installed capacity took up respectively 61%, 14%, and 8% of total capacity. Lacking cheaper domestic coal and gas supply, India relies on the more expensive imported feedstock. Moreover, some plants are forced to shut down due to lack of water. As of Apr-17, the total water available in live storage of 91 reservoirs in the country being monitored by Central Water Commission was 42.7bn cubic meters, which is 27% of the total live storage capacity of these reservoirs.
  2. Some power retailers refused to supply power to poor rural areas due to thin usage and below-cost tariffs. Power distributed to households under the property line is sold lower than market rates amid deferred subsidies from stat governments.
  3. Power theft issues remain. More than 20% loss of electricity during power distribution and transmission was a result of poor technical facilities and commercial regulations.
  4. The weak financial position of distribution companies resulted in recurrent deferment of payment to power generation companies or default on off-take agreements or power purchase agreements.
• The India government has plans to improve the scale as well as efficiencies of the power industry. Besides “Power for All” scheme to electrify all households, industries, and commercial establishment by Mar-19, elimination of coal dependency over the next couple of years is on track. We can see the ambition of Modi’s administration, and expect a promising long-term outlook in India’s power sector. 

Singapore: Fierce competition in electricity sector until 2019/20 

• According to Energy Market Authority (EMA), electricity glut has been consistent over the past decade. As of 2015, the power supply and demand was recorded at 47,843.8 GWh and 47,513.8 GWh respectively. The power surplus was reported at 330 GWh in 2015 though it has trending down from 2006 to 2015. During the period, the total licensed generation capacity and peak demand delivered respective CAGR of 3.6% and 2.9% moderately.
• Looking ahead, EMA projected power demand will grow modestly to 53,950 GWh with CAGR of 1.5% from 2017 to 2020, according to Singapore Electricity Market Outlook 2016. In 4 years, the projected installed capacity will reach 13,700 MW, and 700 MW of it will be retired thereafter. The current oversupply condition could subside by 2019.
• In Singapore, electricity generated through CCGT/Co-Gen/Tri-Gen plants took up 97% of total units as of 2016, and CCGT is the major operating plant in the category. At the moment, the contracted LNG is flooding the power sector. The “take-or-pay” structure leads power companies to take in the excess gas to generate electricity. The long-term pipeline natural gas (PNG) contracts are expected to expire after 2020. Thus, the glut of feedstock may only decline gradually with the exit of PNG so that excess LNG can fill in the gap. By then, the power supply and demand is forecasted to be more balanced.
• According to Energy Market Company (EMC) and Singapore Power Desk (SPD), the Uniform Singapore Energy Price (USEP) which is the price retailers pay power generation companies fell to or even below the level of short-run marginal cost of steam turbine and CCGT. Therefore, the overall power sector was subjected to thin margin or even loss-making in recent years.
• Furthermore, the decline in the vesting contract level in recent years, has increased generation companies’ exposure to USEP, the proxy of spot market price. This further suppresses margins. It is expected that existing 20% of vesting contact level as of Dec-16 to be wiped out since Singapore Minister of Trade and Industry aimed to fully liberalise the power market in 2018 to 2019. In retrospect, the vesting contract reference price (VCRP) aligned with USEP and trended downward.

China: Strong demand for waste water treatment 

• Total waste water discharge volume has been ascending from 2006 to 2015 with the expansion of the proportion of household side and the shrinkage of industrial side. The shift was in line with the gradual industrialization and urbanization of China. As of Dec-2015, the total waste water discharge volume grew by a CAGR of 4% to 73.53bn tonnes, out of which 72.8% was from the household segment.
• The corresponding infrastructures construction has been catching up to cater to the huge demand from urban waste water treatment (WWT). Within a decade, the number of urban WWT plants surged from 939 in 2006 to 6,910 in 2015. Meanwhile, the designed capacity tripled up from 64million tonnes/day to 190milion tonnes/day, recording a CAGR of 12.9%.
• China has been increasingly concerned with the water pollution issue. Not only has it enacted policies and regulations to supervise harnessing of water discharge, but it also promotes investment and cooperation within the WWT sector. We are optimistic on the WWT market expansion in terms of scale and scope in China in the mid-to-long term.
• Electricity supply maintain a positive growth in China According to National Bureau of Statistics of China, the growth of the total volume of domestic power output has trended down but maintained a positive growth from 2011 to 2015. Thermal power (mainly coal-fired) still dominated the overall output, taking up 73.8% as of Dec-15. Though wind power, as sort of supplemented energy, has not been popularised across wide areas so far, it enjoyed the highest growth with CAGR of 27.6% during the period.
• China has been gradually transformed the structure of the power supply, turning to renewable and green energy, but it is a long-term progress. In the foreseeable future, the thermal power supply is still the main pillar support to the consumption, and wind power and nuclear power are expected to have at least double-digit growth.
• In May-17, Bloomberg reported eight state-owned power generation companies under State-owned Assets Supervision and Administration Commission may be consolidated into three groups: 
  1. Shenhua Group, CGN Power Group, and Datang Group; 
  2. Huadian Group, Guodian Group and China National Nuclear Corporation; 
  3. Huaneng Group and State Power Investment Corporation.
• The consideration is to favour power tariff pricing in the liberalising market. If the option is achieved successfully, these three conglomerates with more than 50% market share in PRC will have strengthened bargaining power to will direct the tariff pricing, which is expected to rise.

Marine: Recovery in oil market is expected in 2017, but less likely from offshore sector 

• The downturn in oil market has persisted more than two years since mid-2014, resulting from supply glut flooding every corner of the world. In retrospect, crude oil price experienced substantial fluctuations, falling from c.$115/bbl in mid-2014 to below c.$30/bbl in early 2016, and bottoming out until current c.$50/bbl. 
• Since the operating costs of onshore drilling (excluding shale oil) are much lower than those of offshore, the current oil price level is expected to arouse the dormant exploration and production (E&P) CAPEX in the onshore sector but offshore. 
• According to Douglas-Westwood, the overall CAPEX in oilfield equipment is forecasted to decline YoY till 2020. The growth of spending in the onshore sector is offset by a drain in expenditure offshore. The projection from IHS Energy, shows an upward total spending YoY growth from 2017 to 2020, which is attributed to onshore expansionary CAPEX. However, the market may not see a significant turnaround in next 5 years. Since upstream spending is the main driver to propel the cyclical upturn, we shall expect the offshore sector to have a longer recovery with lower growth.

Investment Merits 

May see turnaround next year in India 

• As of Mar-17, SCI is operating two thermal power plants in India, Thermal Powertech Corporation India Limited (TPCIL) and Sembcorp Gayatri Power Limited (SGPL). 86% of 1,320MW of capacity has been contracted under long-term power purchase agreement (PPA). The first-year tariff of 570MW contracted to Telangana Power Distribution for 8 years was Rs4.15/KWh, and that of 500MW contracted to Andhra Pradesh and Telangana Power Distribution for 25 years was Rs3.7/KWh. Comparatively, the average spot tariff was Rs2.8/KWh in 2016 and Rs3.0/KWh YTD respectively in the region where the two units of TPCIL are located. Therefore, these two PPAs’ competitive prices are the moats for positive profitability within the contract periods. 
• TPCIL fully operated in FY16 and generated a net profit of S$2.5mn. We believe TPCIL’ onward performance will be relatively stable since only 14% of the capacity is subjected to spot market.
• The second plant, SGPL, located in the same area closed to TPCIL, just commenced commercial operation in Feb-17 with total capacity is 1,320MW. However, the plant is confronting to start-up issues, as the plant failed to secure any long-term PPA while two short-term PPAs for total 388MW will be expired in May-17. The operation of the plant merely covers the cash cost but depreciation in 1Q17. 
• Since the current weak spot tariff may prevail, the next short-term PPAs that SCI succeeds in securing in near term may not have a favourable price. As of now, SCI is working hard to secure other short-term PPAs or other alternate supply contracts. We expect good news from long-term ones may only come in 2018. 
• On the other hand, SCI aims to refinance the debt undertaken by SGPL. It is expected to lower the interest rate to 13% or below. The current interest burden weighs more than 25% of the full year expenses for SGPL. The refinancing is expected to be completed by 2Q17.
• In nutshell, we believe SGPL’ performance will be gradually better off but still possibly drag down the profit contribution from India segment. Once SGPL secures long-term PPAs, we shall see a good turnaround and stable contributions for a mid-term period.

Diversified portfolio offset power losses in Singapore 

• SCI’s utilities operation has competitive edges over other peers, especially those pure power generation companies. Though it is expected the power losses continue in next few years, the portfolio is capable of buffering the losses and contribute stable cash flows and net profit to the Group. Centralised utilities systems are providing power, steam, natural gas, waste water treatment, and on-site logistics on Jurong Island with 15-20 year contracts that are renewable every 1 to 5 years. Since the most feedstock’ prices are pegged to crude oil, whose price still hovers around US$50/bbl. The relatively low cost will enhance profitability.
• Highly regulated operation in China provides margin safety China has been the third largest profit from operation (PFO) contribution region. Its PFO grew from S$46.8mn in 2012 to $S140.1mn in 2016. The volume power supply and the tariff are totally directed by the local government (Shanghai and Chongqing). The cost of feedstock, coal, is subject to market price, which is also substantially impacted by policies.
• However, profit margins are protected and relatively visible. We can see a similar pattern in waste water treatment business.

Marine business has been burdensome 

• As of 1Q17, Sembcorp Marine (SMM) secured S$75mn new orders that were from nondrilling segments (Offshore platforms and Floaters). Net order book excluding repairs and upgrades totalled S$7.1bn. The drillship contracts from Sete Brasil valued at S$3.1bn out of S$7.1bn remained frozen. Though some enquired for near shore gas solutions (floating LNG) increased, and the Group may secure new contracts from the segment this year. The profitability is expected to be weak unless large size contacts fall into the pocket. 
• As we mentioned above, the global CAPEX on offshore has not bottomed out due to the dim outlook of oil price recovery, SMM would continue to suffer from shrinking order books. Therefore, the marine side is dragging SCI’s growth.

How Do We View SCI? 

Utilities and marine, are the main business driver of SCI’s portfolio. 

• The former generally performs defensive or countercyclical characteristics while the latter is highly correlated to oil cycle. Since SCI diversified the business foot print across various regions worldwide, the operation is well exposed to global economic growth, which trends up in the long run.
• Furthermore, SCI has been actively involving in renewable energy development such as wind and solar energy and participating higher potential economic growth in developing countries such as India and China. We think utilities side will have moderate growth with improvement from existing projects and more new projects being added. However, we are cautious on the recovery of marine business, since it is totally order-book driven, and we think SMM may have trouble securing large size contracts in the near term.
• Oil price is facing hurdles to climb up due to the structural change of the sector rather fundamental imbalance (supply and demand). The revolution of shale oil development has gradually broken the monopoly of oil market by major oil producers (OPEC). Long-term glut is inevitable because there will be more pumping from once oil price reaches the favourable level identified by shale oil producers. Therefore, the offshore E&P expenditures are expected to be flattish at a low level. It is difficult for SCI to lift the profitability from marine side due to weak macro circumstances.
• During 1Q17 results briefing, the new CEO of SCI signalled that a strategic review will be underway over 6 months to improve the growth of the Group. Though no details are given, we think the marine business will be core taken care of with high probability. 
• We believe SCI’s valuation is suppressed due to SMM’s underperformance and volatile earning. If the marine business is stripped off, the valuation of rest business of the group will be freed up. Therefore, the market is looking forward to the review and contingent corresponding restructuring. It could be the catalyst to favour higher valuation of the group.

Valuation Methodology 

• Our primary valuation method is using sum-of-the-parts. We derive the valuation of S$4,065mn for utilities segment based on the weighted average P/B ratio of 1.2x, which is the peers’ average in power sector. We believe SCI utilities segment should even trade at higher premium due to its superior ROE of 7.0%.
• Our valuation of SMM (S$1.69, Accumulate, Target Price: S$1.58) is based off our target price of S$1.58, which translates into the valuation of S$2,014mn (61% ownership from SCI). The valuation for other segments is based on 1x P/B ratio and for Gallant Venture is based on current market cap respectively. 
• We derive TP of S$3.50 after a 10% conglomerate discount.

Investment Action

• We initiate SCI with an Accumulate rating and a target price of $3.50. This implies an upside of 13.7% (including forecast dividends of 8 SG cents) from the last closing price of S$3.15.

Chen Guangzhi Phillip Securities | http://www.poems.com.sg/ 2017-05-29

Phillip Securities SGX Stock Analyst Report ACCUMULATE Initiate ACCUMULATE 3.50 Same 3.50