Going Short On SembMarine Corp

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TheBearProwl is going short on SembMarine Corp. TheBoringInvestor has also previously given his take on whether Keppel Corp will buy over SembMarine Corp.

Disclaimer: this is not an enticement to invest. DYODD. Caveat Emptor.


Any content should not be relied upon as advice or construed as providing recommendations of any kind.

Following up from the short initiation on Sembcorp Marine (SMM:SP) on 15 Jul 2019 at $1.42 with an intrinsic value of $0.70, we now explain the rationale in greater detail. SMM is currently trading at $1.18 which represents a Price to Book ratio of 1.07.

Investment Thesis

#1 – Business underperformance

In 1H19, SMM recorded $1.5b of revenue as compared to $2.8b in 1H18. This was due to a significantly lower revenue from the Rigs & Floaters and offshore platform segments. The Company also recorded higher finance costs due to increased borrowings that was secured in 4Q18.

#2 – Low order book, High operating leverage

The Company has a $2.14b order book which is a 5 year low. YTD contract wins is about $600m which is also lower than most years.

There is a severe underutilisation of the integrated yard and we think it is likely to be below 50% utilised. The integrated yard has a carrying value of around $4b and $170m in depreciation along with other overheads. Due to the overall low business volume, overhead costs have not been fully absorbed as part of project costs. This has not been material. If volumes continue to decline, it may lead to significant levels of overhead expenses being recognised when incurred.

We think further accounting charges are unlikely at this juncture but will advise our readers to look out for gradual changes in management’s commentary.

We think management has also already rightsized its manpower where possible, and accelerated and implemented most cost reduction plans and are unlikely to further reduce operating leverage significantly from where the business stands today.

#3 – Weakening balance sheet

The Company currently has a debt to equity ratio of 1.755 with net gearing at approximately 1.42.

While the Company currently still generates operating cashflow, it has been recording losses which will lead to a shrinking equity base. The Company may also reach a point where it may not be able to generate positive operating cash flow. While we have no doubt about the Company’s ability to obtain funding, we caution on that the cost of additional funding may be higher.


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#4 – Others

(a) Fundamental shift in supply and demand

As a consequence of USA increasing oil production at the expense of OPEC and a fundamental shift into LNG and renewables, there is a change in the mix of energy production and also of onshore/offshore oil production. USA has became an oil powerhouse and are now a net exporter of oil.

We have still not seen any significant uptick in capital expenditure by the European E&P players which have been major customers of SMM.

The Chinese and Korean yards have also successfully competed for contracts on many occasions

(b) Overhang from corruption probe and Sete brasil contracts

The corruption probe by the Brazilian authorities continues place uncertainties relating not only to risk exposure, but also the ability to secure further contract wins in that region.

We note that there is already a full provision for costs incurred for the 7 Sete Brasil drillships. SMM made a S$329m provision in 2015 for the costs incurred for which there were no payments received.

On 7 Oct 2019, SMM released an announcement noting the settlement of all 7 drillship contracts. For 5 of the 7 drillships, the Group will keep all works performed. In respect of 2 of the 7 drillships which have the most advanced construction progress, the titles to such works will be apportioned between the Group and Sete Brasil in proportion to payments made by Sete Brasil. Sete Brasil has identified a purchaser for the companies of Sete Brasil which own the 2 drillships. The purchaser is expected to negotiate with the Group to enter into new contracts to complete the drillships. This will be positive for the orderbook and cashflow if successful.

SMM will continue to carry the 5 drillships on its books and is unlikely to continue construction until they find a purchaser.

Notwithstanding the current supressed environment, we note that the main upside potential for this settlement is that SMM is now free to enter into contracts for the completion of all 7 drillships, should they be able to secure buyers.

(c) Support from substantial shareholder

SCI has recently provided a $2 billion loan facility to SMM which SCI has funded via a bond issuance to investors such as Temasek. Without this facility, the duration and cost at which SMM secured borrowings may not be as favourable. We

(d) IMO 2020 clean energy & asset renewal program of customers

The IMO 2020 clean energy requirements will lead to an increased order book for the SMRU segment in the form of retrofits and installation of scrubbers. Some companies may also choose to retire their current vessels earlier as it may be costly for some existing vessels to comply with IMO 2020.

As part of a capital expenditure cycle, there is also no doubt that many drillships and offshore platforms are due for scrap and/or refurbishments in the coming few years which should provide some support to the order book. However, we do not think we will see a >$10b peak order book (last seen in 2012) in the near future.

(e) Low likelihood of merger or delisting

There has been speculation about a merger with Keppel O&M, we think that it is unlikely to happen for the following reasons:

  • Unlikely to lead to a rerating of valuations as both segments are underperforming. Where there is a macro-level impact, the valuations may actually rerate down.
  • SMM has just consolidated its yard in Benoi and is accelerating the Admiralty yard closure, as such it does not make sense to consolidate yards again in this capital cycle. Some analysts view the merger as something that will happen eventually, our view is that if both SMM & KOM continue to shrink, there may come a point where there is a need to merge to obtain economies of scale.

On the topic of delisting, while there is no doubt that as the share price drops, SCI will be able to delist SMM at a good valuation, it may be challenging to obtain the support of the minority shareholders.

(f) The immediate impact of oil price as a result of Saudi supply shortage and potential political escalation

While we are wary of oil prices spiking in the event of any political escalation, we note that companies tend to avoid making capital expenditure decisions from such political situations. Further, any escalation leading to oil price increase may also further impact global macroeconomic conditions.

Conclusion

Overall, we are negative on Sembmarine due to the many factors mentioned. We also unable to identify immediate turnaround plans or any near term positive catalyst for the share price.

We have seen SMM continue to spend on R&D and improve its core offerings which will position them to capture any uptick in the industry and we also have no doubt that the Company will be able to continue operating, with the continued support of the major shareholders.

We expect the business to continue to try to capture a higher level of orders via various opportunities and also to manage its cost base. As such, the key criterion is to build up the order book, without which, will be inadequate to support the share price.

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