Shipyards – Singapore - UOB Kay Hian 2018-01-02: Dealing With The Kickbacks

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KEPPEL CORPORATION LIMITED BN4.SI SEMBCORP INDUSTRIES LTD U96.SI SEMBCORP MARINE LTD S51.SI

Shipyards – Singapore - Dealing With The Kickbacks

• The last week of 2017 saw a tumult of good and bad news. The global settlement for Keppel Corp, while hefty, provides a cleaner proxy to the growing rig market recovery. A divestment of its stranded rig assets will be a re-rating catalyst. 
• Meanwhile, the possibility of a similar fine for Sembcorp Marine is estimated to have a negative 17% impact to its book value. Sembcorp Marine finds a new overhang even as it clears one from West Rigel. 
• We adjust Keppel Corp’s target price to S$8.75, while that for Sembcorp Marine and Sembcorp Industries remain unchanged. Maintain MARKET WEIGHT.

ESSENTIALS

Surprise Christmas fine, delays to Keppel Cove divestment. Talk about a tumultuous Christmas week. 

• Over the Christmas week, Keppel Corporation (KEP) announced a surprise US$422m fine for corrupt payments made in Brazil. This was followed by a setback to its divestment plans for Keppel Cove, Zhongshan (Keppel Cove). The transaction has been delayed and is likely to materialise in 2018.

Acquired Wuxi site for Rmb2,533m. 

• Keppel had also over the Christmas holiday announced the acquisition of a 18ha site in Wuxi, China, for Rmb2,533m (S$517m). This is understood to represent only the land cost, and the deal is expected to be completed within the next five years.

West Rigel sold for US$500m, as expected. 

• On the other hand, Sembcorp Marine (SMM) revealed the expected sale of West Rigel for US$500m. While the buyers were not identified, industry sources indicated them to be a partnership between British capital managers Hayfin Capital Management and Breakwater Capital, with an established rig operator likely to come in as rig manager. 
• The deal remains subject to conditions precedent, with an unspecified long-stop date.

STOCK IMPACT

Sembcorp Marine

West Rigel divestment sees net gearing declining to ~70% in 2018. 

• As highlighted in our 4 Dec 17 note (Sembcorp Marine - Potential Sale of West Rigel On Horizon), we expect Sembcorp Marine’s net gearing to decline to 72% in 2018 as a result of the influx of cash from the divestment of West Rigel.

Fine for KEP raises questions for SMM. 

• Given that allegations were made against an agent of Sembcorp Marine for contracts obtained in Brazil, this has created a fresh overhang for Sembcorp Marine, even as the overhang from West Rigel is removed. 
• Sembcorp Marine had on 30 Mar 15 announced it had initiated an internal investigation. Unlike Keppel Corp, it has neither disclosed whether any suspicious activity was found, nor announced any self-reporting as was the case for Keppel Corp. 

Hypothetical fine of S$441m-1,764m for SMM. 

• A back-of-the-envelope calculation of the potential fine for Sembcorp Marine ranges US$327m-1,307m (S$441m-1,764m), assuming the same Culpability Score of 8 as Keppel’s, and no discount given. The assumptions are presented at the back, alongside a brief overview on Keppel Corp’s fine.

A fine at the low end sees our target price falling to S$1.68. 

• A fine at the lower end of S$441m translates into a 17% decline to Sembcorp Marine’s net book value. Accordingly, our valuation for Sembcorp Marine will fall from S$2.10 to S$1.68, based on 1.6x 2019F P/B. Sembcorp Industries’ (SCI) valuation would fall from S$3.87 to S$3.57. 

Keppel Corp

No foreseeable impact to businesses in the US or Brazil. 

• We foresee Keppel Corp being able to comply with the requirements of the Deferred Prosecution Scheme, which ends in three years from 22 Dec 17. 
• In the interim, we do not foresee any impact to its businesses in the US or Brazil. This was demonstrated by the awarding of projects by Pasha Hawaii on 24 Aug 17 and hull carry-over work for the Petrobras P-69 project on 11 Dec 17, despite ongoing proceedings in those jurisdictions.

Clean proxy to growing rig recovery. 

• The hefty fine aside, Keppel Corp now represents the cleaner proxy to playing the growing recovery in the rig market, alongside the up-cycle in its property business going into 2019. The sole overhang remains the stranded rig assets on its balance sheet, which has a growing probability of being cleared as the rig market improves. 
• While current prices remain unfavourable, we note prices have improved 8% from the bottom of the downturn. A divestment would see significant deleveraging of its balance sheet, and a re-rating to its share price.

EARNINGS ADJUSTMENTS

SMM financial impact: 2018-19 core earnings to rise 3-4%. 

• A one-off loss provision of S$24m will likely be made in 2017, and does not impact our core earnings forecast of S$54m. Earnings in 2018-19 will, however, see a 3-4% rise due to the lower interest expense as Sembcorp Marine further deleverages with receipt of its share of monies for West Rigel. 
• Our revised 2017-19 core earnings are S$54m (-1%), S$115m (+3%) and S$143m (+4%) respectively.

KEP financial impact: Core earnings largely unaffected. 

• The delay in the divestment of Keppel Cove largely leaves our core earnings estimates unchanged (0-1%) from our 8 Dec 17 note, having earlier assumed completion in 2018. Interest expense for 2018 rises by 9% due to the higher net gearing of 45%, and our core earnings dip slightly by 1%. 
• Our revised 2017-19 core earnings are S$784m (-1%), S$902m (-1%) and S$1,174m (0%) respectively. We still see Keppel Corp able to deleverage despite this setback, with further scope for improvement if it is able to divest its stranded rig assets.

ACTION

Maintain MARKET WEIGHT; prefer Keppel Corp. 

• While the market is picking up, several key overhangs remain for both Keppel Corp and Sembcorp Marine. 
• Earnings are recovering but likely to remain soft in the near term as margins are sacrificed for new order wins. This is especially so for Sembcorp Marine, with the coming quarters likely to provide clues on the margins of its recent contract wins. 
• Within the space, we now prefer Keppel Corp to play the recovery, given that it represents the cleaner of the names within the sector and has its earnings recovery supported by its property business going into 2019.

Maintain BUY on Keppel Corp, target price revised to S$8.75. 

• Our revised target price, taking into account the events in end-Dec 17, has been revised to S$8.75. This represents a 3 S cent increase from our earlier email update on the Brazil settlement case, which saw our target price lowered to S$8.72. The increase is due to the incorporation of the new Wuxi acquisition into our RNAV. 
• Our target price is premised on:
  1. the O&M segment at 0.9x 2019F P/B and,
  2. RNAV of S$5.69/share for its property division.

No change to our valuations for Sembcorp Marine or Sembcorp Industries. 

• Both Sembcorp Marine and Sembcorp Industries remain as BUY, with unchanged target prices of S$2.10 and S$3.87 respectively. 
• Sembcorp Marine’s valuation remains pegged to 1.6x 2019F P/B, representing -0.5SD of its long-term P/B.

OTHER ESSENTIALS

Computation of the fine. 

• According to the Deferred Prosecution agreement, the fines are computed according to the guidelines set in the United States Sentencing Guidelines (USSG), Chapter 8, Part C (§8C). We defer to this methodology over the account provided by the Brazilian MPF, which was stated as “twice the bribe amount and a “majority” of the profits made”. The considerations are complex, and one can refer to the manual for greater detail (link). We present below, the simplified concept to compute it.
  1. Determine the base fine, which is the higher of the pecuniary gain to the organization from the offence or the base fine derived from the Offense Level. For Keppel’s case, the base fine was derived from the US$351.8m in profits made, being the higher value than the maximum base fine of US$150m based on an Offense level of 42.
  2. Determination of culpability score, which is on a scale of 0-10+. This score starts from 5 points, and is scaled according to various factors, including the size of the organisation, and the level of cooperation in the investigation. The resultant score determines the minimum and maximum multiplier to the base fine. The multipliers range from 5-20% to as much as 200-400%. In Keppel’s case, it was a score of 8, translating to a range of 160-320% (US$563m-1,126m).
  3. For simplicity, Keppel’s fine of US422m was 1.2x the profits made.

Foo Zhiwei UOB Kay Hian | Andrew Chow CFA UOB Kay Hian | http://research.uobkayhian.com/ 2018-01-02

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