Shipyards - DBS Research 2017-07-20: Creating Global Champions


Shipyards - Creating Global Champions

Time to reform, restructure and reposition.

  • We explore possibilities of a merger of Keppel Offshore &Marine (Keppel O&M) and Sembcorp Marine (SMM).
  • Sembcorp Industries (SCI) could re-rate if it divests SMM.
  • Keppel Corp could swap infrastructure assets for SCI’s stake in SMM.
  • Upgrade Keppel Corp to BUY (Target Price S$7.60), raised target prices for SCI (BUY; Target Price S$4.10) and SMM (BUY; Target Price S$2.30).

Time to reconsider a rationalisation of the three industrial entities?

The idea of rationalising the businesses of Keppel and SCI was sparked 15 years ago. 

  • On 24 Oct 2001, the management of SCI and Keppel made a joint statement that they are holding discussions on the rationalisation of the local shipyard industry and the possibility of other collaborations between the two groups. 
  • The discussions were held with the understanding that all arrangements must make business sense and create value for shareholders. However, the discussions ceased after almost a month, "as both management could not reach mutually acceptable terms”. 
  • Subsequently, the O&M business picked up, and Keppel and SCI successfully spread their wings overseas to expand their property and utilities businesses respectively. 

In early 2016, market chatter implied that Temasek revisited the possibility of rationalisation. 

  • On 26 Jan 2016, Bloomberg reported that Temasek Holdings was discussing various options for Keppel and SCI, ranging from divesting non-core assets to selling shares, to brace for a prolonged sector downturn, during a regular portfolio companies review meeting. However, the news was unverified and there was no further update.

Recently, SCI’s strategic review adds another piece to puzzle.

  • The recent announcement of a strategic review of SCI, following the appointment of new CEO, Mr Neil McGregor, has led to further market speculation of more restructuring for Keppel and SembCorp groups. 
  • On 3 May 2017, SCI indicated that the Group will be undertaking a complete review of businesses and strategic direction, focusing on performance, sustainability and value creation, the outcome is expected in six months’ time. 
  • While it is premature to shed more light on SCI’s future direction, it revives market speculation of a rationalisation of the three home-grown industrial plays, namely SCI, SMM and Keppel.

Prolonged structural downturn presses case for global shipyard consolidation – even in Korea and China. 

  • The collapse of the shipping super boom in 2009 has wiped out a majority of the small shipyards especially in China. We are approaching the advance stages of consolidation - mergers of the industry leaders. 
  • In China, rumours of a merger between China Shipbuilding Industry Corporation (CSIC) and China State Shipbuilding Corporation (CSSC) has surfaced as the two groups swapped senior executives in Mar 2015. 
  • In 2016, Yoon Jeung-Hyun, the former Strategy and Finance Minister of South Korea, the world’s second largest shipbuilding nation, had suggested that its Big Three shipbuilders – Hyundai Heavy Industries (HHI), Samsung Heavy Industries (SHI) and Daewoo Shipbuilding & Marine Engineering (DSME) - should consider merging.

Shipyards see glimpse of recovery but likely to proceed at a moderate pace. 

  • The bottoming out of O&G and shipping industries is expected to stage a recovery for shipbuilding. Contract flow should have hit a trough and is trending up. However, the recovery pace is likely to be moderate as shipyards continue to grapple with overcapacity. 
  • Keppel O&M and SMM are barely profitable at the current activity level (down 50-60% from peak) despite being one of the more cost efficient shipyards, and with all the cost reduction measures in place. Hence, it seems logical consolidation of the two Singapore rig-builders will further increase competitive strength to lead on a global basis.

Rationalisation could be a multi-stage process. 

  • The potential rationalisation of Keppel and SCI can be rather complex, and may involve multiple stages. The key challenge is to have a comprehensive proposal with fair asset valuations that is beneficial to all parties. In this report, we delve more deeply to analyse various scenarios involving the major assets in O&M and Infrastructure, as divestments of non-core assets are less material.
  • In this report, we have detailed three possible scenarios involving Keppel, SCI, SMM and Temasek.
  • This is an extension to our Thematic report – “Sea of Change : Does Consolidation Make Sense?” issued on 6-Aug-2015 that discussed the rationale, and pros & cons of a shipyard consolidation.


Merger giving birth to a power house. 

  • We believe merging Keppel O&M and SMM will give rise to a stronger and more competitive rig-building giant in the longer run. A global power house will be created by combining the competitive strength, world class facilities, and branding of both rig-builders. 
  • In addition, there is room for further cost rationalisation in this structural downturn.

Possible teething problems but can be resolved. 

  • Initial integration issues are inevitable but should be ironed out over time. One key concern is the potential negative revenue synergies after the merger, which we don’t think is profound as global shipyards are consolidating amid sluggish contract flow. 
  • While product offering does overlap, the Singapore rigbuilders have strategically positioned themselves towards different market segments especially for non-drilling rig solutions. For instance, Keppel expanded into Floating Liquified Natural Gas (FLNG) vessels while SMM has developed the modularized LNG platform for close to shore applications. SMM, leveraging on its competency in ship-type products, has made a foray into the drillship market.
  • Please refer to our Thematic report – “Sea of Change: Does Consolidation Make Sense?” for more details on rationale and hurdles of a shipyard merger.

Injection of Keppel O&M into SMM. 

  • We believe housing the two shipyard groups under SMM is probably one of the simplest routes. Keeping SMM’s listing status will leave open the option for future equity fund raising exercises. The acquisition of Keppel O&M can be funded through new share issuance to Keppel. 
  • Arriving at a valuation of privately held Keppel O&M assets will be the main challenge. For illustration purpose, we are using our fair value in the calculation of potential post-merger ownership structure.


  • We value SMM based on 1.8x PB, in line with the recovery valuation of 1SD below mean since 2004. Taking our cue from that, we are ascribing a similar valuation to Keppel O&M given the converging ROE, orderbook and order wins profile.


Setback of joint-ownership. 

  • The joint ownership structure may be less than ideal when there is divergence in management style and strategy. The party with a higher stake in the joint- entity, i.e. Keppel based on our valuation, might have an upper hand in decision making. 
  • If SCI were to be less involved in the yard operations, would a spin-off of SMM be a more feasible option for SCI? 

Strategic Review: Performance, Sustainability and Value Creation - how does SMM fare? 

  • SCI, under the leadership of newly appointed CEO, Mr. Neil McGregor, has embarked on a strategic review of its businesses. He has stressed that with the challenging macro environment and rapidly changing market dynamics, SCI will need to focus on cost discipline and strengthening its operating performance. 
  • As SCI is reshaped, it will continue to build businesses that are durable and sustainable. It is open to options – to divest non-performing assets as well as to acquire new businesses that are synergistic or offer diversity to existing businesses. Its review of its current businesses - Utilities, Marine and Infrastructure - will undergo a review of its strategic relevance based on three criteria, which are performance, sustainability and value creation.
  • Sustainability: In our view, SMM remains an important part of the offshore and marine industry in Singapore, notwithstanding the structural challenges and cyclical downturn, as Singapore retains its strategic position as the major transportation and trading hub in Asia. Singapore yards have demonstrated cost efficiency over their global peers, and has one of the highest margins for oil-based engineering projects historically.
  • Performance: Marine business has traditionally been cyclical. This time around, we believe the industry is in a prolonged structural downturn due to global overcapacity and lower long-term oil prices that are affecting demand for O&G facilities. As such, the unit is facing challenges and may be a drag to SCI’s profitability and ROE in the near to medium term.
  • Value creation: While the worst could be over for the Marine business, recovery will be patchy and likely to be moderate. We expect ROE to normalise to mid-single digit in the next two years, compared to disappointing results and core losses recorded in the past few quarters. Potential upside stems from SMM’s product innovation, for instance, its new Gravifloat technology (modularised LNG terminal), and stronger than expected recovery in the O&G market.

SMM divestment could well create value for SCI. 

  • Will divesting SMM free up resources for SCI to focus on expanding along the utility value chain to create more value to shareholders? One key hurdle of spinning off SMM is that SCI will “downsize” to a smaller entity. Although this is true from the business and asset perspectives, this move will however enhance shareholder return. 
  • SCI’s utility segment is undervalued in our view, due to a conglomerate discount attached and that it has also been overshadowed by the cyclical marine business in this downturn. We believe the spin-off will re-rate SCI as a pure, stable, defensive utility play. 
  • While gearing levels for both businesses are similar at close to 1x, we see opportunities for capital recycling in the utilities business. A potential listing of its India power business once its income stream stabilises would free up capital for reinvestment.

Potential buyers of SCI’s stake in SMM? 

  • We have ruled out the option of foreign buyers, considering the importance of shipyards as part of the value chain of Singapore maritime and protection of technology know-how we have developed over the years. With that, potential candidates are narrowed to parent Temasek or peer Keppel.
  • If we were to make another wild guess, homegrown global defence and engineering group, ST Engineering, who also has a marine business may offer some form of synergy in terms of utilisation of yard capacity and joint-development of new products. However, ST Engineering’s marine business is relatively niche with a focus on defence contracts and low exposure to oil and gas, very different from rig-builders.

Temasek to play a mezzanine role. 

  • While Keppel appears to be a strategic buyer in our opinion, increasing exposure to O&M at this juncture may not be well received by shareholders till there is more clarity of a recovery in the sector. Temasek, holding c.50% stake in SCI, could step in to play a mezzanine role by holding it given that it holds a 50% stake in SCI.

Dividend-in-specie to shareholders. 

  • Dividend-in-specie of SCI’s stake in SMM to shareholders would enhance the return to SCI’s shareholders. Alternatively, SCI could dispose off its SMM stake to Temasek. 
  • While a Temasek buyout will augment SCI’s balance sheet for organic expansion and acquisition of new synergistic businesses, this mode would involve funding of more than S$2bn before transacting to Keppel at an appropriate time, which doesn’t seem to fit into Temasek’s investment strategy.


Swap Keppel’s infrastructure business for SCI’s stake in SMM.

  • Similar to previous scenarios, we assume Keppel is injecting Keppel O&M into SMM for new shares in SMM. However, the asset swap between Keppel and SCI will be more complex.
  • Keppel’s management has been advocating its multi-pronged strategy involving Property, O&M, Infrastructure and Investment, and has attempted to demonstrate synergies across segments. Of these, we think that the least critical among the four segments could be Infrastructure, and these assets seem to be a good fit to SCI’s utilities portfolio. 
  • Keppel may choose to keep Keppel T&T in view of this unit’s strategy to grow the data centre business.

Well within Keppel’s means. 

  • We value Keppel’s stake in Keppel Infrastructure Trust (KIT), remaining 49% interest in Keppel Merlimau Cogen (KMC) plant and other Infrastructure assets (excluding Keppel T&T) at S$1.3bn. If Keppel were to swap these infrastructure assets for SCI’s 61% stake in SMM, which is valued at approx. S$2.8bn, Keppel would need to top up an additional S$1.5bn. This is well within Keppel’s means; Keppel’s net gearing stood at 0.6x as at end Mar-2017 and has over S$6bn debt headroom before it hits 1x net gearing.

Keppel Infrastructure Trust (KIT). 

Keppel Merlimau Cogen (KMC) 

  • Keppel Merlimau Cogen (KMC) plant is a top-tier 1,300MW gas-fired power plant. Strategically positioned at the Tembusu sector of Jurong Island off the south-west coast of Singapore, it is well-equipped to support the surrounding industries with their electricity, steam supply and demineralised water requirements. The KMC Plant is connected to the electricity transmission network of Singapore, and has been operational since 2007 with a good track record of reliability and efficiency. 
  • KMC was valued at S$1.7bn back in 2015 based on KIT’s acquisition cost. This implied EV/EBITDA of 15.7x and EV/capacity of 1.0x, in line with peers. Based on our back-of- the- envelope calculation, we estimate the plant to be worth approx. S$1.5bn, factoring in two-year decline in useful life (S$735m for 49% stake).


Back to fundamentals. 

  • While the focus of this report is to explore the possible scenarios of M&A possibilities for the Keppel and SembCorp groups, we note that M&As are unpredictable and crucial financial details will only be released when an offer is made. Hence, our recommendations on the three industrial giants remain purely on fundamentals.

Positioned for recovery. 

  • The share price of Keppel, share price of SCI and share price of SMM have slid from their recent highs in early March, with the culprits being uninspiring 1Q17 results, softened oil prices, and slow contract flow. 
  • Nonetheless, we think that investors should look beyond the upcoming quarterly results, which tend to be lumpy and likely to remain weak given the low order wins in the past two years. We see catalysts stemming from potential oil price recovery to US$50-55/bbl in 2H and order flow gaining momentum going into 2018.

Remains positive on oil rebalancing in 2H17. 

  • Brent has averaged around US$52.8/bbl YTD – up from the 2016 average of US$45.1/bbl, as prices held up well around the US$50-55/bbl mark in the early months of 2017. However, oil prices have been weak of late, hovering around US$45-50/bbl on renewed concerns in the market regarding the oversupply situation as global inventory levels have remained stubbornly high and US shale production has rebounded. 
  • We expect a move towards the US$55/bbl mark by the end of 2017, thus implying an average of US$50-55/bbl for the full-year 2017. We expect prices to average at US$55-60/bbl in 2018, with the mild y-o-y recovery in oil prices driven by accelerated inventory drawdowns as we move into another year where demand will continue to outstrip supply. 
  • Our long-term oil price forecast of US$60-65/bbl remains unchanged and is based on a marginal cost curve analysis.

Order wins were deferred but not deterred. 

  • YTD new orders have been disappointing, with Keppel and SMM securing merely S$308m and S$75m respectively, lagging behind our expectation of S$1.5-2bn. The finalisation of potential FPSO and LNG projects has taken longer than expected, partly because of the oil volatility and difficulty in securing project financing. 
  • However, with our optimism on oil price recovery and the trend shifting towards cleaner energy, we believe these projects will eventually come through over the next 6-12 months for both SMM and Kep.

Order wins driven by non-drilling solutions, diversifying into LNG. 

  • In addition to their production-related facilities such as FPSOs, Singapore rigbuilders have made forays into the LNG market with Keppel Corp (Keppel) delivering its first FLNG vessel (in early July 2017) while Sembcorp Marine (SMM) is on the verge of securing orders for its first-of-its-kind modularised LNG terminal. These are high value-add products, project value ranging from a few hundred millions to US$1bn.
  • For comparison, the contract value for a jackup rig was approximately S$280m while that for drillships was c.S$700m prior to the recent oil crisis. 
  • Keppel’s FLNG vessel orders from Golar were priced at over S$900m each. FLNG orders currently account for over 50% of Keppel’s orderbook (S$3.5bn as of end-March 2017). 
  • For SMM, a modularised LNG-importing terminal is expected to be worth S$200-300m while an exporting unit could be almost S$1bn. This is a strategic move to reduce reliance on drilling solutions and tap on the robust demand growth for natural gas as cleaner energy. 
  • We believe LNG solutions will be a major order driver for Singapore rigbuilders moving into 2018.

Lifting SMM’s valuation from 1.5x to 1.8x P/BV, in line with 1SD below mean since 2004 in anticipation of sector recovery and stronger order flow ahead.

  • The high correlation of SMM’s valuation and order wins is illustrated in the following chart, where red line represents SMM’s P/B while grey area represents its annual order wins.
  • We observe that SMM’s valuation hovers around 1.5x P/B in early 2009 due to the weak order outlook, which declined from S$5.7bn in 2008 to $1.2bn in 2009; similarly, current valuation at 1.3x P/B reflects the lack of confidence in view of the sluggish order flow thus far. Subsequently, in 2010-2011, SMM was re-rated to almost 4x P/B, in tandem with order win recovery to S$3.0-3.7bn. Hence, If SMM could deliver S$1.5- 2.0bn pa order wins that market is expecting, re-rating from current 1.5SD below mean to 1.0SD below mean seems fair taking into consideration the normalized margins and ROE. 
  • Further re-rating to mean of 3x P/B is not impossible if order wins leap to S$3-4bn pa level and profitability improves.

Keppel to ride on sentiment turnaround in the property sector; raising valuation peg to 1.0x P/BV. 

  • Our property analysts believe that we are at the start of a multi-year government relaxation cycle in Singapore, which presents a multi-year re- rating potential for developers. Management remains optimistic of stronger home sales in China and Vietnam with 19,000 launch-ready homes in its pipeline through 2019, representing 3.3x of home sales in 2016. 
  • We are raising our valuation peg for Keppel’s property segment from 0.85x to 1.0x P/BV, in line with the other large-cap Singapore developer peers.

Recommendation and TPs. 

  • Following the upward revisions in valuation multiples for marine and property, we are raising SMM’s TP from S$1.78 to S$2.30 and Keppel's TP from S$6.00 to S$7.60; upgrade Keppel to BUY with 17% upside potential. SCI’s TP is adjusted to S$4.10 after factoring in SMM’s higher TP.
  • SCI offers a unique value proposition, as a proxy to ride the cyclical O&M upturn and has a defensive utilities business. The ongoing strategic review could be positive to drive ROE improvement in the longer term.
  • SMM benefits as a pure play to ride on sector recovery. Securing modularised LNG terminal contracts is a key catalyst.
  • Meanwhile, Keppel looks set to tap on the property sector's re- rating in the near term.

Company Profile

Pei Hwa HO DBS Vickers | Janice Chua DBS Vickers | http://www.dbsvickers.com/ 2017-07-20
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