Sembcorp Marine (SMM SP) - UOB Kay Hian 2017-10-09: Borr Deal Likely Clears Concerns Of Additional Provisions; Upgrade To BUY

SEMBCORP MARINE LTD S51.SI

Sembcorp Marine (SMM SP) - Borr Deal Likely Clears Concerns Of Additional Provisions; Upgrade To BUY

Borr Drilling is purchasing nine rigs from Sembcorp Marine (SMM) for US$1,256m, with upfront cash payment of US$502m.
Sembcorp Marine's share price will likely rally on the improvement to balance sheet and reduction in finance expense.

Reverse engineering the deal suggests sufficient provisions were made, with West Rigel estimated to be written down to 50% of revised contract value, in line with recent transactions.
Upgrade to BUY with target price of S$1.90.

Borr Drilling (Borr) is acquiring nine rigs from Sembcorp Marine (SMM) for US$1,256m, translating into US$139.5m per rig. Delivery of the rigs will be made progressively over 14 months from 4Q17 to 1Q19.

The immediate impact of the deal is the improved liquidity to Sembcorp Marine’s balance sheet, which will likely be the market’s focus.
The sale will see Sembcorp Marine’s net gearing fall from 133% as of 2Q17 to about 76% by end-18, and positions Sembcorp Marine as one of the first few yards to have almost all their stranded assets taken off the balance sheet.

Sembcorp Marine had in 4Q15 provided S$280m for problematic rig contracts, as well as a S$85m inventory write-down. Of the S$280m provision, a portion was related to profit reversals on the Marco Polo Drilling (MPD) and North Atlantic Drilling (NADL) rigs.
As the uncovered cash costs for the six rigs (including MPD’s) was discounted enough, there was no need to provide further, while the spec-build rigs were likely covered under the S$85m inventory write-down. This leaves the balance of the S$280m related to provisions for the NADL rigs.
Reverse engineering the figures yields a written-down value of US$374m, a 50% discount to the revised contract price of US$762m. This written-down value seems consistent with market transactions: the semisubmersible West Mira was transacted for US$360m, about half its original contract price.

With this deal, a significant amount of concerns regarding additional provisions for Sembcorp Marine in the downturn should be removed.
Sembcorp Marine was rumoured to be building 3-4 spec-builds, so even assuming a fourth spec-build rig, subsequent losses (if any) will be small. With concerns for provisions largely removed, the stock is likely to re-rate.

Financially, Sembcorp Marine will benefit from a de-gearing of its balance sheet, resulting in an estimated 15-30% decline in finance expense. We have not included any interest income contribution from Borr. While construction of the three spec-build rigs will resume, we expect no profits from them.
Lastly, we have assumed that the S$15m loss will be recognised in 4Q17. Our revised earnings for 2017- 19 are S$87m (-1%), S$144m (+18%) and S$141m (+12%) respectively.

With the uplift to our earnings, our PBROE valuation returns a target price of S$1.90, pegged to 1.5x 1-year forward P/B. It is possible that share price could revert to its historical mean forward P/B of 2.3x, but we opt to maintain our more conservative, performance-driven valuation metric.
Only positive catalysts for Sembcorp Marine (SMM) can be seen at this juncture, namely future contract wins such as PolyGCL and the outcome of Sembcorp Industries’ (SCI) strategic review.
While earnings growth is limited in the near term, prior overhangs on Sembcorp Marine have largely been removed.
Sembcorp Marine is now positioned for growth in the new low-oil price era.

Our valuation for Sembcorp Industries (SCI) rises from S$3.57 to S$3.67 as a result of the revised valuation for SMM.
Sembcorp Industries (SCI) will likely also rally on this Borr deal and on the higher electricity spot prices it is seeing in India.

Foo Zhiwei UOB Kay Hian | Andrew Chow CFA UOB Kay Hian | http://research.uobkayhian.com/ 2017-10-09

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