Sunday, 7 August 2016

Is Keppel Corp's Provision for Sete Brasil's Orders Adequate?

When both Keppel Corp and SembCorp Marine announced their financial results for FY2015 earlier this year, they made provisions of $230M and $329M for Sete Brasil's orders respectively. SembMar's provision is 43% higher than Keppel Corp's, even though SembMar's orders ($7.0B) are only 13% higher than Keppel Corp's ($6.2B). The big question is whether Keppel Corp's provision for Sete Brasil's orders is adequate and whether further provisions are likely in future quarters. 

I have not attempted to answer this question earlier, mainly because it requires a lot of information to do so. Furthermore, the margin of error is large due to the imprecise nature of the information. Compared to the total contract value of $6.2B, a rounding error of $0.1B is only a 1.6% error, however, it can mean $100M in provisions! Thus, I can only hope to be generally right rather than precisely right in this post.

In the 2Q2016 financial results released 2 weeks ago, Keppel Corp has reiterated that its provision of $230M is adequate. It also, for the first time in its financial results, disclosed that its outstanding order book for Sete Brasil's orders is about $4.0B, rather than the $3.7B estimated in my earlier post on How Will Keppel Corp Navigate the Oil Crash? With this additional piece of information, there is better clarity on whether the Sete Brasil's provision is adequate.

The total contract value of Sete Brasil's orders is $6.2B. After deducting the outstanding contract value of $4.0B, Keppel Corp has carried out works worth $2.2B. In the briefing on FY2015 financial results, Keppel Corp disclosed that $1.8B (the Q&A mentioned $1.3B, likely to be in US dollars. You can download the Q&A here.) has been collected from Sete Brasil prior to it stopping progress payment in Nov 2014. This leaves it with a contract value of $0.4B for which work has been carried out but payment not collected yet. There is a need to understand whether this $0.4B of contract value appears in the balance sheet as Work-in-Progress, for which profits have not been booked and therefore requires lower provisions, or trade receivables, for which profits have been booked and need to be reversed out. Assuming the worst case scenario that it is a trade receivable, the full $0.4B needs to be provided for. Keppel Corp has made provisions for $0.23B, which leaves another $0.17B of potential provisions. Note that this figure assumes that Keppel Corp's liabilities to its suppliers have been fully accounted for, because it is possible for Keppel Corp to receive materials from suppliers but not carry out work using these materials yet. Keppel Corp will have to pay suppliers even if no work has been carried out using them. If this has not been accounted for, the potential provisions will increase further.

The above additional provision of $0.17B assumes that no further work is carried out on the Sete Brasil rigs. It is possible that Keppel Corp will complete some of the rigs already in advanced stages of completion and sell them in the open market. However, given the depressed market for rigs, Keppel Corp might not fetch a good price for the completed rigs. If the selling price is lower than the cost to complete them, further losses are likely. Let us examine this scenario.

The rate of completion for the 6 rigs is estimated to be 92%, 70%, 40%, 21% and less than 10% each for the remaining 2 rigs (see Sete Brasil is not the only thing Keppel needs to worry about, say analysts). Let us assume that Keppel Corp will complete the first 4 rigs. Assuming the price of each of the 6 rigs is the same, the total contract value will be $4.1B. In FY2014, when times were good, Keppel Corp could generate an operating margin of 14%. That means the profit from these 4 rigs is $0.6B and the cost to complete them is $3.5B (For now, please ignore the fact that the rigs are partially completed and there is no need to spend the full $3.5B to complete the rigs). I do not know how much the rigs will fetch in the open market. Let us assume they can fetch only 70% of the original contract price of $4.1B, or $2.9B, which means Keppel Corp will lose $0.6B on these rigs.

In a normal transaction, if a buyer and a seller agree to a price of $100 for a goods, but the buyer could not fork out the money and the seller could only resell it at $80 in the open market, the buyer is still liable to the seller for the shortfall of $20. Depending on what are the terms of the contracts with Sete Brasil, Keppel Corp might have remedies to get Sete Brasil to top up the $1.2B difference between the market price of $2.9B and the contract price of $4.1B. However, Sete Brasil has now gone into backruptcy protection and cannot fork out the money. Thankfully, Keppel Corp has collected $1.8B in progress payments from Sete Brasil for the 6 rigs. That will be used to top up the difference. Thus, no further provisions are required when the rigs are sold. In fact, the previous provision of $230M could be written back and Keppel Corp could book a profit on the rigs. Just take note that it will be a fairly long time before the market for oil rigs can recover and Keppel Corp can sell the rigs.

In conclusion, Keppel Corp's provision of $230M for Sete Brasil's orders is generally adequate for now. Further provisions are possible, but the provisions can be written back when the market recovers and the rigs are sold.

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  1. Hi. I dont think so its enough because the provision is only just 4% of the contracts. Using my experience as a Business Manager for 2 decades to make a guess. Hope I am wrong though.
    Also borrowed from DBS / Swiber case. What the CEO said last Q was overturned when Swiber incident surfaced. Amount doubled. Haha.
    More to come...

    1. Hi, DBS / Swiber case might not be comparable to this case. Before Swiber annnounced the unexpected winding-up, the probability of Swiber closing down is less than 100%, so provisions made are less than 100% of the loans. But when Swiber announced winding-up, 100% of the loans need to be provided for.

      In the case of Keppel / Sete Brasil, Sete Brasil shareholders were already debating whether to seek bankrupcty protection when Keppel made those provisions. Thus those provisions had already considered Sete Brasil going into bankruptcy protection.

  2. Hi CW,

    One thing is the $1.3b usd received as down payment is for 6 rig contracts! In fact as far I know the first two were having lots of work in progress and the 4 balance rigs very little work done. So if we consider that Keppel had conservative gross margin of 15% of each rig this means the cost of the first two rigs will be (6.2/6) x 0.85 for 2 vessels (x2) = $1.76b.

    So assuming their WIP for first two rigs are average 80% = 1.4b incurred.

    So the provision of $200mil plus the down payments is probably how this is derived from!

    Because u do not know how many rigs had been completed w/I insider info, it's difficult for u to estimate!

    I think this is why Keppel corp CEO is quite confident. He is a finance guy with CFO background normally more conversative.

    The problem now with Kep corp is not sete brasil, but with other rigs that cannot be delivered n the overheads in kep as shipyards worldwide is really too high if they have not enough order intake!

    1. Hi Rolf,

      Yes, a lot of insider info is needed to estimate the provisions accurately.

      Agree with you Sete Brasil is not the main issue for Keppel Corp. The main issue is the lack of orders!