GSS Energy - RHB Invest 2018-03-06: Ideal Proxy To The Tech Boom And Oil Price Recovery

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GSS ENERGY LIMITED 41F.SI

GSS Energy - Ideal Proxy To The Tech Boom And Oil Price Recovery

• With new projects in the auto and consumer space, we expect FY18 to be even better for GSS. Trading at 9x FY18F ex-cash P/E, valuations just account for the PE business. 
• With oil & gas discovery affirmed in Dec 2017, 1P reserves already conservatively estimated at SGD0.29/share, and oil & gas revenue to come in 1H18, we think GSS Energy is significantly undervalued and provides a unique opportunity for investors to ride on the manufacturing boom and oil price recovery. 
• As a result, we initiate coverage with a BUY and with an SOP Target Price of SGD0.25 (56% upside).

COMPANY BACKGROUD

• GSS Energy has two core operating businesses: oil & gas and precision engineering (PE). Previously known as Giken Sakata (S) Limited (Giken), the company was listed on the Singapore Stock Exchange in Feb 1993. The listing status was transferred to GSS with effect from 12 Feb 2015 and Giken became a wholly-owned operating subsidiary of GSS.
  • The Precision Engineering business segment, which started in 1979, now comprises electronic manufacturing services in Indonesia, and precision shafts and machining businesses in both China and Singapore. The group has a diversified customer base, operating in a spectrum of industries such as automobiles, healthcare, banking, vending, electronics, motors, communications, aerospace and others. Its clients include multinational companies such as Panasonic, Philips, Canon and Mitsubishi.
  • Under the electronic manufacturing services, GSS produces a range of high precision components, such as plastic injection moulding parts and printed circuit board (PCB) assembly. As for precision shafts, the group delivers a full range of precision turned-parts, including motor shafts and customised turned components for various industries. Its machining business unit specialises in producing high precision machining parts of all kinds.
  • In 2014, GSS ventured into the energy business. Today, GSS is operating a twin business model (PE and oil & gas), which has allowed the company to be more resilient to meet the increasing uncertainty in the business environment and global economy.

INVESTMENT MERITS

Tech manufacturer with a free oil production business. 

• The stock is trading at 2018F P/E of 11x, which is still lower compared to the peer average of 12.6x. However, if we take a closer look, the company has minimal debt – and has amassed a reasonable net cash pile of SGD5.38m despite spending the capex to drill wells and explorations for its oil & gas arm. Its precision engineering arm is riding on the manufacturing boom (along with its listed peers), and has generated SGD7.3m of profits as of 9M17. 
• Management also expects new customers and projects to fuel more growth into FY18F. Meanwhile, its oil & gas arm has announced hydrocarbon discovery in its Trembul operating area. GSS would continue to drill more wells, aiming to harvest, produce and sell oil by 1H18 and gas by 4Q18.

USD110m of 1P oil & gas reserves vs market cap of SGD79m. 

• GSS Energy’s total estimated 1P reserves totals 18.36 million barrels of oil. We assume an oil price of USD60.00/bbl and apply a 15% risk discount to the oil price, as well as a 50% discount to its 1P (proved reserves) reserves to be more conservative. The total value of the oil reserves, after accounting for the GSS entitlement split of 23.5%, would still be worth about USD110m, or rather SGD0.29 per share, much higher than its current share price of SGD0.16. 
• Investors are thus actually getting the oil & gas production business and its oil and gas reserves for free, while at the same time buying the manufacturing business at valuations lower than that of listed peers.
• All in, the stock is trades at an effective ex-cash 2018F P/E of 9.4x, which is much lower than the peer average of 12.6x.

Looking to monetise a portion of their old field.

• GSS management plans to look into monetising a portion of their old field through either selling a stake in the oil field or by selling part of the oil field away. This would enable it to substantiate the value of the asset immediately and also for it to recognise a sizeable one-off gain and boost its cash pile significantly. 
• This could then be used to further expand the business or reward shareholders with an attractive one-off dividend.

Cost recovery model, which would boost cash flow and production capacity. 

• This means that PT Sarana GSS Trembul (SGT, which is GSS’ subsidiary) would be able to recover all its approved operating costs (opex and capex) from the petroleum produced.
• On top of that, PT SGT is entitled to 23.5% of the petroleum and 31.4% of the natural gas produced in the area after cost recovery. It would be beneficial for GSS to drill as many wells as it can, to increase total production output per day. This is because these costs would be recoverable from up to 80% of the sales revenue of the oil produced, and GSS would be able to produce and generate more income from oil at a much faster pace. As a result, we think the company would likely aim to drill 2-3 wells a year and capitalise on this model to its benefit.

Mistakes learned – vital change in operation cooperation agreement. 

• Back in Nov 2016, GSS announced its subsidiary, PT Sarana GSS Trembul (PT SGT), had entered into an operation cooperation agreement with PT Pertamina EP for petroleum production. This current operations cooperation (kerja sama operasi or KSO) agreement is completely different from the agreement that GSS entered into back in Sep 2014. Under this scheme, GSS is the main party to the contract with Pertamina, to assist the state-owned oil and gas company in the production of petroleum, including oil and gas, in the Trembul Operation Area.
• In comparison with the previous arrangement, Cepu Sakti Energy (CSE) (a business unit of GSS) was a service provider to the village cooperative (KUD), which was the contracted party in the agreement with Pertamina. Pertamina has terminated its contract with the KUD. In turn, Cepu Sakti’s contract with the KUD for production services was cancelled. This resulted in GSS writing down SGD33m on its investment in CSE. 
• With GSS directly supplying to Pertamina and payment from Pertamina directly, the risk of default or nonpayment would be lowered significantly, placing GSS in a much better position as compared to before.

Revenue from oil &gas to be expected in 2Q18 and 4Q18 respectively. 

• On 13 Dec 2017, GSS Energy made a hydrocarbon discovery in its Trembul Operating Area. Z Well SGT-01 discovered eight columns of hydrocarbon bearing sandstone reservoir, with 37 metres of total net payzone. Pertamina has agreed to commence commercialisation of two of the eight zones at a depth of 863-869 metres and 910-915 metres respectively within the lower Ngrayong formation. An estimated 1.5 mmscfd of sweet gas (91% CH4 with no H2S and a negligible amount of CO2) plateau production can be expected for 14 years.
• Management has stated that it expects production of gas to come in 4Q18.
• The group would be exploring additional production of oil by commencing workover programmes in some selected potential wells previously drilled by Nederlandsche Koloniale Petroleum Maatschappij (known as Stanvac). From 1935 to 1942 before these oil fields were abandoned, the wells delivered up to 640 bopd.
• The data obtained from Well SGT-01 has opened up uncovered perspective for Well P1, an exploration well previously drilled by Pertamina in 2005, in which three potential zones were left unrecognised at that time. This was due to inconclusive low resistivity wireline readings, which are now supported by discoveries of hydrocarbon at SGT-01. GSS intends to re-enter Well P1 with a dedicated workover program to maximise the commercialisation of the potential oil zones.
• We expect the group to start producing at least 200 bopd by 1H18, which would generate up to SGD4.38m a year in revenue – in which it could obtain the majority of the revenue due to the cost recovery scheme as agreed with Pertamina. This would add to its cash pile and enable drilling of more wells to further increase production capacity.
• Management aims to drill 2-3 wells a year. We conservatively estimate for production to increase to 310 barrels in 2019 and 340 barrels in 2020.

Potential upcoming dividend policy to indicate confidence as to incoming oil revenue. 

• The oil & gas business would likely start producing revenue in 2H18 and generating income. Along with the already profitable PE business – as well as a healthy balance sheet with net cash of SGD10.7m – we could expect the company to start distributing dividends as soon as in FY18F. This could result in a potential dividend yield of 2% for 2018F and 2.5% for 2019F. 
• As the group continues to grow both its PE and oil & gas business segments, we believed such dividends would grow correspondingly, eventually reaching a dividend yield of about 3.8% in FY2022F. 
• We believe a dividend policy would be a strong positive statement by management as to the future profitability of the business and also as a reward its shareholders.

Strong insider buying from management. 

• Management has been buying shares from the open market in separate occasions throughout 2017. The last two purchases were done at SGD0.171 and SGD0.175 per share, which is higher than the current market price. We believe this shows a strong vote of confidence by management with regards to the fundamentals and outlook for GSS.

Proxy to higher oil price – higher profits and better margins. 

• After the crash in oil prices in 2014, oil prices have rebounded strongly from their lows and now comfortably sit around the USD60.00 per barrel region. The crude oil markets are also fundamentally stronger as a result of the production cut.
• OPEC and other crude-producing nations led by Russia agreed to extend the production cut to the end of 2018. Under the current deal, OPEC members are cutting supply by 1.2 mbpd and participating non-OPEC producing countries are cutting supply by 0.6 mbpd. This deal would keep 1.8 mbpd off the market until the end of 2018. 
• Another factor to look out for is the Saudi Aramco IPO. The oil giant would want to see a high oil price as this would enable the company to have a higher valuation upon listing – hence we think that the OPEC cuts in production would likely continue. This would then add further upward pressure on the oil price.
• GSS would be a key beneficiary of a rise in oil price, as its lifting cost is only estimated to be around USD12-15.00 per barrel. It would sell to Pertamina at the prevailing oil price based on the Indonesia Crude Oil Price (ICP). This also means that a higher ICP price would translate to better margins and profits for GSS. 
• According to management, the sale price of oil follows closely to the Cepu ICP. The ICP is determined by Ditjen Migas (Directorate General of Oil and Gas) and Pertamina would pay the company using ICP published by the Ministry within the first week of the subsequent month upon the deposition of oil into the Pertamina depot. Cepu ICP is calculated on the basis of the ICP formula, in that it tracks one of the eight internationally traded Indonesia crudes, Arjuna.
• Cepu is priced at a discount of USD4.64 per bbl of Arjuna, and Arjuna is priced at a discount to Brent Crude.

Precision engineering (PE) segment to maintain strong growth from new projects.

• The precision engineering arm is riding on the manufacturing boom as experienced across many listed peers, with revenue surging from SGD61.12m in FY14 to SGD94.3m for FY17. In 2018, management also expects new customers and more projects in the automotive and consumer space to fuel more growth. There have been ongoing trials with a new customer in the consumer space, full scale production expected to start by 1H18.
• We expect this customer to contribute to 15% top-line growth for the PE segment in FY18. However, we understand that the margins for this project would be lower, but still beneficial and profitable for GSS. 
• All in all, we expect the outlook to still be positive for its PE arm and for it to continue contributing positively to GSS’ cash hoard.

VALUATION

Initiating coverage with BUY and Target Price of SGD0.25 SOP-based Target Price of SGD0.25. 

• We initiate coverage on GSS Energy Group with an SOPbased Target Price of SGD0.25 which is further backed by our DCF valuation. Our SOP valuation is based on: 
  1. 11x FY2018F net profit;
  2. Conservative estimate of 1P reserves with 45% discount; 
  3. Extra discount of 50% for country/small cap risk.
• Corroborative DCF Target Price of SGD0.25, assuming: 
  1. WACC of 7.5%;
  2. 0% terminal growth rate.

Minimal valuation was given to the oil & gas division. 

• GSS’ market capitalisation now prices the PE division at around 11x FY18F P/E (excluding net cash of SGD10.7m as at 3Q17). This essentially means that market has yet to give any valuation to its oil & gas division.
• An alternate valuation approach would be based on the asset transaction. The market value of the assets can be derived by discounting 10-15% off the market price of oil and multiplied by its 1P reserves, then applying a further 50% discount to the estimated market value of reserves. According to the Qualified Person’s Report (QPR), there are the equivalent of 18.36m barrels (low case) in the shallow and deeper reservoirs of the Trembul Operation Area.
• We are cautious of the high volatility in the oil & gas sector. Hence, we are very prudent with the assumptions used in our valuation. We assumed a 15% discount to USD60.00 per barrel, multiplying it by the low case (1P) of 18.36 million barrels, and giving the valuation a further discount of 50%, this would give us a market value of USD468.18m.
• Bearing in mind of the split between PT SGT and Pertamina, we derived GSS entitlement to the asset value of approximately USD110.02m (SGD144.13m).
• In comparison, the market capitalisation currently is about SGD79m, reflecting only the precision engineering business segment.

Peer comparison 

• By peer comparison, GSS is trading only at a 2018F P/E of 11x, which is still lower compared to the peer average of 12.5x as shown below. In addition, the oil & gas reserves appear also not to have been taken into consideration at all.
• We are not putting any comparison between GSS and peers in the oil & gas sector as: 
  1. The oil & gas division has not yet commenced production;
  2. We believe the market has given zero valuation to its oil & gas business segment.
• However, we have compiled a list of the players in the sector for reference: 

KEY RISKS

Foreign currency risk. 

• The group is exposed to foreign currency risk on transactions and balances. The PE business segment bills its clients in USD and SGD; while the oil & gas business segment is billing in USD. It holds the majority of its assets in USD terms, and any weakening of USD against SGD would result in a foreign exchange loss.

Precision Engineering division 

• Failure to innovate and keep up with technology advancement. Innovation has been identified as one of the main drivers of growth, and technological advancement is one of the key factors to remain competitive in the industry, going forward. As we enter industry 4.0, manufacturing companies have to innovate and invest in the development of advanced manufacturing technologies to produce higher-value products and services to stay relevant and increase their competitiveness. If GSS is not able to adapt to change, it may lose its competitive edge and long-standing partnerships with its clients.
• Vulnerable to manufacturing slowdown. Currently, GSS’ profitability is entirely dependent on the PE business, and the manufacturing sector is sensitive to business cycles and economic conditions. Hence, its business is exposed to economic swings, which may affect its financial position.
• Growing cost concern in China. Labour costs in China have risen at a rapid rate in the 2000s. Manufacturing labour compensation rose by an average of 11.9% annually from 2003-2015. GSS generates nearly 15% of its revenue in China and has manufacturing facilities in Changzhou, a city in Jiangsu province of China. The wages in Jiangsu city are higher than the average wage within the manufacturing sector. With the rapid increase in cost, we would expect GSS margins to narrow.

Oil & Gas division Oil & gas sale prices risk. 

• Earnings for companies operating in the oil & gas industry are heavily impacted by falling oil prices. Numerous factors cause oil prices to fluctuate. In the near term, we should keep an eye on factors such as geopolitical risks, US shale production, and the Saudi Aramco listing. 
• As for geopolitical risks, these include – but not limited to – tension in the Middle East, US and North Korea, as well as in Iran. Any downward pressure on oil prices would have a negative impact on oil & gas companies’ profitability. 
• The terms of GSS subsidiary PT SGT’s sales agreement with Pertamina state that Pertamina will purchase from PT SGT at market price, using the ICP index. The ICP index price is about 8-10% away from the price of Brent crude.
• Operational risks. Operational challenges with extraction, cost containment issues and ensuring safe conditions through the drilling process represent major risks throughout the whole production process. Any of the above would not only affect the group’s reputation and profitability, but also future contracts with Pertamina.
• Exposure to government regulations. GSS’ oil & gas business is highly exposed to the rules and regulations set by the Government of Indonesia, due to its operation cooperation agreement with Pertamina subsidiary PT Pertamina EP for the production of petroleum, including oil and gas, in the Trembul Operation Area. For example, an abrupt change in policy, such as in tax rates, could impact GSS’ profitability.

Jarick Seet RHB Invest | Lee Cai Ling RHB Invest | http://www.rhbinvest.com.sg/ 2018-03-06

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