Keppel Corporation - CIMB Research 2018-03-16: Valuation Now More Compelling

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KEPPEL CORPORATION LIMITED BN4.SI

Keppel Corporation - Valuation Now More Compelling

• We find Keppel Corp’s share price more compelling after shrinking c.18% from its YTD peak.
• At current price, KEP’s O&M unit is valued at 0.6x 2018F P/BV (vs. SMM’s 1.8x).
• The c.S$1.8bn book value gap between KEP O&M and SMM is more than double its recent S$619m global settlement for Brazilian corruption charges. This appears steep.
• In addition, the recent unexpected US$425m semi-submersible order is under appreciated. The mid-water market could see some return in interests following this.
• We expect yard operating leverage to improve y-o-y in 2018F.
• Maintain ADD and SOP-based Target Price of S$10.00. Potential catalysts are

1. stronger order wins,
2. sale of undelivered rigs ,
3. redevelopment of its Singapore properties.

Unduly pricing in more fines scenario 

• We think Keppel Corp’s share price de-rating could be due to
  1. subdued oil prices,
  2. weak 4Q17 offshore & marine (O&M) performance,
  3. easing hype on potential SCI/SMM corporate action (this lifted its O&M valuation earlier), and
  4. US$660m alleged lawsuit under US Racketeer Influenced and Corrupt Organisations Act (RICO). 
• Pegging its property unit to Singapore developers’ average valuation of c.30% discount to RNAV would imply the market ascribes S$1.8bn valuation gap between KEP O&M and SMM, pricing in fines ahead.

Semi-sub contract win unappreciated 

• Keppel Corp's recent US$425m semi-submersible order from Norwegian Awilco was a positive surprise, but under-appreciated. The unit is for mid-water operations of 1,500 metres (c.4,900 ft) vs. SMM’s 10,000ft West Rigel (US$500m). We think the price is reasonable and potentially commanding EBIT margin of c.10% (and above if options are exercised).
• The option for three more units could be exercised within 12, 24 and 36 months, respectively. The current weak oil price trend may justify less costly mid-water floaters.

FLNG Hill achieved first gas, expect to start work for Gandria 

• Keppel Corp delivered the world’s first converted floating liquefaction vessel (FLNG) in Jul 2017; the vessel achieved first gas recently offshore Cameroon. The proof of concept could lead to better acceptance of FLNG conversion. This should also push through the startwork order for the next conversion for Golar, of FLNG Gandria. 
• Keppel Corp secured the contract in 2015 for US$684m but it was laid up due to financing and weak market. Gandria is due to start first gas for Ophir-operated Fortuna development off Equatorial Guinea in 2022.

Operating leverage to improve 

• In 4Q17, O&M suffered S$75m core operating loss (excluding kitchen sinking provisions) on S$489m turnover. The cumulative effect of weak order wins over the years caught up with the division and weakened its operating leverage. 
• We expect this to improve in 2018F with leaner operating efficiency from the mothballing of most of its dormant yards as well as execution of the Awilco and Gandria contracts. Keppel Corp’s order book (S$3.9bn) as at end-17 included Gandria and inactive FLNG Gimi contract (US$705m or c.S$950m).

Maintain ADD and SOP Target Price of S$10.00 

• Keppel Corp is trading at 1.2x 2018F P/BV, below its 20-year average of 1.7x. We believe ROE has bottomed in FY17 and set to recover on the back of minimal capex and earnings growth. 
• Upside could come from continuous capital recycling at its property unit. Noises of potential litigation could be a risk. 
• Our Target Price is based on SOP:

1. property (S$3.82; 20% discount to RNAV),
2. O&M (S$1.21; 2.5x 2018F O&M P/BV),
3. Keppel Capital (S$1.29; 18x 2019F net profit), and
4. Tianjin Eco City (S$0.87, discounted surplus).

What caused the 18% decline from YTD peak? 

• Keppel Corp is trading at 1.2x 2018F P/BV, below its 20-year average of 1.7x. We find its valuations now more compelling after the stock plunged 18% from YTD peak. We see a few reasons for the share price weakness:- 

1. Crude oil price retreated from its high of US$70/bbl to current US$64/bbl. This could be one of the reasons for Keppel Corp’s share price weakness. However, we also note that Keppel Corp’s correlation to oil prices has diminished to 0.84 since the oil crash in Jan 2016 vs. c.0.95x previously.
2. Peer pressure bubbled. SMM's share price had surged ahead of a strategic review by its major shareholder SCI as the market expected some form of corporation actions (privatisation, or divestment of SMM). We believe this had helped to lift KEP’s O&M valuation, up until the completion of SCI's review which somewhat disappointed the market.
3. Weak O&M in 4Q17. O&M ran into a core operating loss of S$75m in 4Q17 as a result of cumulative slow orders over the past few years. We think Keppel Corp also kicked the ball rolling in kitchen sinking provisions of up to S$140m (S$81m further provisions for Sete Brasil, S$10m for Caspian yard closure, and S$49m in doubtful debts) resulting in reported operating loss of S$215m. This marked one of the worst quarters in KEP’s O&M since 2015.
4. More litigations noises. Following the group's global settlement of a S$619m fine to resolve investigations on alleged corruption involving Brazilian officials, EIG (one of the shareholders of Sete Brasil) and eight of its managed funds in the US served KEP O&M with a summon, pursuant to the Racketeer Influenced and Corrupt Organisations Act (RICO) in the United States District Court, Southern District of New York. This new lawsuit came after an earlier civil action commenced by EIG and eight of its managed funds in the United States District Court, District of Columbia was dismissed on 30 Mar 2017.

Valuation gap unduly pricing in more fines for Keppel Corp 

• Pegging Keppel Land’s valuation to Singapore developers' 30% discount to RNAV would imply that the market only ascribes S$1bn of equity value to KEP O&M or at 0.6x CY18F P/BV. This is a steep discount to SMM’s 1.8x, even if we apply a conglomerate discount of 20% to Keppel Corp. 
• The c.S$1.8bn valuation gap between KEP O&M and SMM is more than double the S$619m settlement described above, implying the market unduly expects more fines ahead for KEP O&M.

Semi-sub contract win unappreciated 

• We believe no one had expected any rig order for Keppel Corp in 2018. It managed to win one already YTD and yet the market under-appreciated the US$425m semisubmersible contract from Norwegian Awilco. Perhaps reference was unfairly drawn to SMM’s 10,000ft semi-submersible that is pending a re-delivery and sale at a higher US$500m. However, one should not forget that SMM’s unit is a deepwater harsh environment unit while Keppel Corp’s a mid-water rig.
• Compared to the history of all the mid-water rigs ordered globally since 2001, we think the price tag of US$425m is reasonable and potentially commanding EBIT margin of c.10% (and above if options are exercised). The option for another three units could be exercised within 12, 24 and 36 months, respectively. The current weak oil price trend may justify the use of less costly mid-water floaters rather than deepwater units.

Mid-water in a better position vs. deepwater floaters 

• Globally, there are 26 mid-water floaters that are drilling currently with only three other newbuilds (by Yantai China for delivery in Nov 2018). Therefore, newbuild/drilling ratio currently stands at 15%. Conversely, deepwater newbuild/drilling ratio stands at 51% with 26 units under construction. These floaters were largely ordered during the peak rig cycle years (2012-13), mainly at the Korean yards. 
• Orders for mid-water rigs are more likely than for deepwater given the oversupply situation of the latter, in our view.

Walking the gas talk 

FLNG Hill achieved first gas 

• Golar LNG recently said its first FLNG, Hilli Episyo (converted by Keppel Corp, delivered in Jul 2017), has successfully commenced first production for IOC, Parenco off Cameroon. 
• The converted FLNG is the first in the world, with the ability to produce 1.2m tpa of LNG. The proof of concept could lead to increased acceptance of FLNG conversion in the future for Golar LNG and Keppel Corp, in our view.

Expects to start work for Gandria 

• The above should also push through the start-work order for Golar LNG’s second FLNG, Gandria, which has been stalled since 2015. According to Golar, the LNG carrier has arrived at Keppel Corp for conversion work. 
• The unit will be operated by Ophir for Fortuna development off Equatorial Guinea in 2022. The conversion of FLNG Gimi is still being evaluated, pending a new charterer.

Yards to be busier in 2018F 

• We expect operating margin to improve in 2018F on the back of busier yard utilisation, from the execution of Awilco semi-sub and Gandria FLNG conversion as well as c.S$1.2bn of orders secured in 2017. Our FY18-20 EBIT margin forecasts ranged from 7-9%. 
• End-FY17 order book was S$3.9bn, which included the inactive FLNG Gimi (c.S$950m). We estimate KEP O&M to clinch S$3bn of new orders p.a. in 2018F and 2019F.

Valuation and recommendation 

• Maintain ADD and target price of S$10.00. We find Keppel Corp’s share price more compelling now and see opportunity to accumulate. At 1.2x 2018F P/BV, Keppel Corp seems undervalued vs. its historical multiple and peers'. It has strong fundamentals and multiple re-rating catalysts including
  1. strong balance sheet (no equity raising despite being slapped with a hefty fine),
  2. improving ROEs and margins, and
  3. potential for higher DPS (from more capital recycling in its property division).

LIM Siew Khee CIMB Research | http://research.itradecimb.com/ 2018-03-16

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