By now, it is common knowledge that ship and oil rig builders are going through a difficult period with the low oil price resulting in customer bankruptcies, order cancellations and deferments. How are the balance sheets of ship and rig builders affected by these events? By understanding the effects of these events, you can predict how the balance sheets of ship and rig builders will look like in the coming quarters.
Before that, let us understand how a ship order "sails" through the balance sheet of a shipbuilder. When a new order is received for a ship, a deposit is usually collected. This shows up as an increase in cash on the assets side of the balance sheet. On the other hand, the cash deposit represents a commitment to deliver a ship. The same amount shows up as an increase in "excess of progress billings over work-in-progress (WIP)" (or unearned revenue) on the liabilities side. As work commences on the ship, cash is reduced to buy materials for the ship and pay workers' salaries. The company will also order some materials or services from suppliers on credit terms, leading to an increase in trade payables. It might also borrow money to pay for the materials/ services. Overall, on the assets side, cash will reduce while inventory and WIP will increase. On the liabilities side, excess of progress billings over WIP will reduce while trade payables and borrowings will increase.
Subsequently, the company would recover the cash by progressively billing the customer for work done, which reduces the WIP but increases the trade receivables. When the customer settles the invoice, the trade receivables will reduce while cash will increase. That cash can then by used to pay off suppliers and reduce trade payables and borrowings. It is important to note that when the company bills its customer for WIP, it also includes the profit margin on the WIP. Thus, shipbuilders can progressively book a profit on the ship for the duration of the contract.
What happens when a customer goes into bankruptcy (e.g. Sete Brasil), terminates an order (e.g. Marco Polo Marine) or requests for deferment (e.g. North Atlantic Drilling (NAD))? The ship will remain as a WIP on the balance sheet, resulting in high inventory, WIP and trade receivables but low cash. Likewise, trade payables and borrowings will be at elevated levels while excess of progress billings over WIP will be low. You can compare SembMar's balance sheet as at end Dec 2014 and 2015 to see the impact.
|SembMar FY15 Balance Sheet|
Moving forward, if work continues on the ship with no further receipt of cash from the customer, those items mentioned above will worsen further. On the other hand, if work is stopped on the ship and there is no further order cancellation and deferment on other ships, the balance sheet will slowly improve as cash is received from the delivery from other ships.
If the company takes an impairment charge on the ship, the inventories and WIP will be reduced. In addition, the profit already booked on the ship has to be reversed out via a reduction on the revenue reserves/ retained earnings item.
If the company manages to sell the completed ship to another buyer, the amount in inventories and WIP will be converted to trade receivables. When the buyer settles the invoice, the trade receivables will be converted to cash, which can then be used to reduce borrowings.
If the company manages to find a charter for the completed ship, the amount in inventories and WIP will be transferred to Property, Plant and Equipment (PPE). During the charter period, cash will slowly flow in from the charter but PPE will reduce progressively due to depreciation. Borrowings will not be affected significantly.
Finally, it should be highlighted that not all shipbuilders operate in the same manner. While most shipbuilders build only when they receive an order, there are others that build some ships without receiving orders. If buyers cannot be found for these build-to-stock ships, they are likely to result in a highly leveraged balance sheet for the shipbuilder. To understand why a rising oil price does not translate into better business for ship and oil rig builders, you can refer to The Missing Link Between Oil Price & O&G Profitability.
P.S. I am vested in Keppel Corp, Baker Tech and a host of other O&G companies.
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