Sunday 31 July 2016

The Type of Debts O&G Companies Have Matters

Swiber shocked the stock market on Thu by announcing that it had applied to wind up the company. This is unexpected because based on latest financial results for 1Q2016, Swiber is still generating a positive operating cashflow. Anyway, the latest on this episode is that Swiber has applied to withdraw the winding-up application and apply for judicial management instead. The issue in this episode is the high indebtedness of the company. However, the nature of the debts also matters. Swiber has both bank loans and bonds. Had its debts been solely bank loans, the outcome might have been different.

To understand why, it is useful to look at DBS' announcement of the financial impact of Swiber's potential winding-up. DBS announced that its total exposure to Swiber, which comprises loans, bonds and off balance sheet items, is about SGD700M. The exposure is partially secured and it expects to recover half of the exposure. Of the estimated SGD350M of bad debt, DBS will tap on its general surplus allowances and book a loss of about SGD150M.

Given a choice, would DBS want the company to be wound up? If Swiber is kept afloat, the worst thing that could happen to DBS for now is Swiber does not repay its loans and interest on time. However, if Swiber is wound up, DBS would receive collaterals of SGD350M that are used to secure the loans and immediately realise a bad debt of SGD350M. What is the nature of the collaterals? If it is properties, it might be easy to sell them off quickly for a reasonable price at an auction. However, if it is Oil & Gas (O&G) vessels, then it might be hard to sell them off. Swiber's financial results for 1Q2016 listed the types of collaterals used to back the bank loans:
"The bank loans and finance leases are secured by:
(i) First legal mortgage over certain vessels and equipment.
(ii) Assignment of all marine insurances in respect of the vessels mentioned above.
(iii) Assignment of earnings/charter proceeds in respect of the vessels mentioned above.
(iv) Lessors’ title to the lease assets.
(v) Charge on certain trade receivables."
Among the items above, Item (v) trade receivables is most easily converted into cash, but it is not clear how much of the collaterals is in trade receivables. For Item (iii) charter earnings/ proceeds, Swiber reported charter hire income of USD74.6M but chartering expenses of USD168.9M in FY2015, so it is not clear how much cash this item can provide. It is likely that DBS will end up with some O&G vessels which cannot be liquidated quickly for a reasonable price. For the duration that the assets are on its books, DBS will have to spend some money to maintain those assets until sellers can be found.

On the SGD350M bad debt, even though DBS is able to tap SGD200M from its general surplus allowances and reduce the loss to SGD150M, that allowance must be replenished in subsequent quarters from increased provisions. The purpose of a general surplus allowance is to set aside some money every quarter to absorb potential losses so that the impact is more manageable. Earnings in subsequent quarters will be impacted. 

Thus, DBS has much to lose and little to gain from the unexpected winding-up of Swiber. Judicial management will be more beneficial for DBS, since Swiber is still able to generate a positive operating cashflow, as that will allow Swiber to continue operating, collect cashflow and hopefully, over time, it will be able to pay down the loans to DBS. The important corollary is this: banks will not pull the plug from O&G companies. When bank loans come due, banks will just let the O&G companies refinance, because if they do not, O&G companies will default on the loans and the issues discussed above will happen. In 1Q2016, Swiber repaid bank loans of USD137.6M but borrowed USD128.3M at the same time.

For further proof that banks will not pull the plug on O&G companies, you can refer to EMAS Offshore's 2Q2016 financial statement, which stated that it "had breached certain financial covenants relating to its borrowings. As at announcement date, the Group had rectified the breach by way of obtaining covenant waiver and/or amendments to the financial covenants by the lenders." Also, shipping trusts have been facing difficulties due to the shipping glut since the Global Financial Crisis. After 9 years, they are still around, because most of their debts are bank loans. Banks are financial institutions; they are mostly interested in getting back their money rather than owning illiquid assets. Having said the above, banks will also not blindly refinance O&G debts. If the company is not expected to generate positive cashflow and pay down the loans over time, banks will have no choice but to pull the plug at an appropriate time.

Bonds are different from bank loans. When bonds come due, there are usually only 2 choices: repay in full or default. There is no option to roll-over the bonds. Thus, prior to the bonds coming due, the company would have to find ways to raise cash in advance, so that there is money to repay the maturing bond. In the case of Swiber, it did not manage to complete the issue of USD200M of preference shares in end Jun, thus putting strains on its cash resources. As at end Mar 2016, Swiber had USD130.0M in cash. On 6 Jun and 6 Jul, it redeemed bonds totaling SGD205M (approximately USD153.0M). After repaying these 2 bonds, there is no much cash left. On 8 Jul, Swiber announced the receipt of the first letter of demand for USD4.8M, which triggered the chain of events that we have seen.

If its debts were solely bank loans, the outcome might have been different. Also, it is good to pay attention to companies with bonds that are maturing soon.

See related blog posts:

Sunday 24 July 2016

Keppel Corp – A Good Captain Sailing Through Rough Waters

If you had read my previous post on How Will Keppel Corp Navigate the Oil Crash?, you would know that I am ready to sell Keppel Corp before the full force of the storm hits it. Yet, I have to admit that Keppel Corp's management is doing a pretty good job in steadying the ship given the circumstances which they have not much control over. The recently released financial results for 2Q2016 reaffirms my belief that Keppel Corp has a chance of surviving the harsh winter, and if it survives, it will come out much stronger.

It has been said that the Oil & Gas (O&G) industry is facing a long and harsh winter. But how long and harsh will it be? A glimpse of Keppel Corp's order book for the Offshore & Marine (O&M) segment provides an indication of how harsh the winter is going to be. In 1H2016, Keppel Corp booked a revenue of $1.54 billion, which is 56% down from a year ago. Over the same period, it has only managed to secure new orders of $0.36 billion (I excluded the recent order of $0.1 billion because it was announced after the close of 2Q2016). This means that for every $1 of revenue that Keppel Corp delivered, it only managed to secure $0.23 of new orders. From another perspective, the book order is decreasing rapidly at a rate of $1.18 billion every 6 months, or $2.36 billion per year. As at Jun 2016, the net order book stands at $4.28 billion after excluding Sete Brasil's orders. Assuming the same rate of depletion of order book, Keppel Corp's O&M segment will effectively run out of business in less than 2 years' time (note: the last delivery is in 2021, but there is not much business to sustain high utilisation of the yards). Currently, Keppel Corp's O&M segment is still turning out a profit (its 2Q2016's net profit is $61 million, a 65% drop from a year ago), but it will not be long before the segment incurs losses. I do not have any information on how badly the losses are going to be, but I believe the depreciation and manpower costs are not going to be small. 

For Keppel Corp's O&M business to recover, its customers, i.e. the oil drilling companies, have to recover first. Below is a figure of the utilisation and day rate for semi-submersibles from IHS, the ones Keppel Corp is building for Sete Brasil.

Fig. 1: Utilisation & Day Rates for Semi-Submersibles

The utilisation is down by nearly 50% from its peak 3 years ago while the day rate is down by almost 60%. The trend is the same with other types of oil rigs. Multiplying the utilisation by the day rate, you will see that the revenue of drilling companies has fallen by more than 70% from the peak! It is no wonder that drilling companies are not placing new orders for oil rigs. Even North Altantic Drilling, which ordered a semi-submersible from SembCorp Marine, has deferred taking delivery of it until a drilling contract is found. Looking at the steep decline in utilisation, it will be a fairly long time before utilisation bottoms out and recovers. Even when utilitisation and day rate recover, it will still take some time for the benefits to trickle down to the shipbuilders, as drilling companies need several years of profit to repair their balance sheets. I think it will be faster for Britain to recover from Brexit than it is for O&G companies to recover from this severe slump.

Yet, despite the extremely challenging conditions facing Keppel Corp, its management has done a pretty good job in steering the ship. On the corporate side, Keppel Corp is leveraging on the expertise within its various business segments to maximise revenue. One of the key planks of this strategy is to strengthen its asset management segment by consolidating individual REIT, business trust and fund management units into a newly set up unit known as Keppel Capital. The figure below provides an example of how the various business segments will work together to maximise revenue for Keppel Corp.

Fig. 2: Different Business Segments Working Together to Maximise Revenue

From the set-up of a new fund, to developing new data centres to managing data centres, Keppel Corp's business units are involved in every step of it. And when the data centre is sold to Keppel DC Reit, the capital is recovered and the entire process can be repeated. In the meanwhile, Keppel DC Reit continues to derive asset management fees from managing the data centres. The strategy is not confined to data centres only. It works with any operating assets that are capable of generating regular stream of income, including O&M assets (when utilisation and day rate recover). Below is an extract from Keppel Corp's CEO speech when he released the 2Q2016 financial results:
"Established institutional investors have told us that they want to get closer to the coal face to own 'real assets', including those in the offshore and marine, real estate and infrastructure industries."
This new corporate strategy has the potential to rapidly expand its assets under management and generate good revenue for Keppel Corp in the years to come.

Even in the O&M segment, Keppel Corp has taken the right steps. It acquired the LeTourneau rig business to provide aftermarket sales and services. Even though drilling companies are not ordering new rigs, they still have to maintain their existing rigs, so that business provides a steady revenue stream to supplement the rapidly slowing revenue stream from ship and rig building.

It has also partnered Shell Eastern Petroleum to provide Liquefied Natural Gas (LNG) bunkering business. This might yet open more doors in the LNG area, such as building/ retrofitting LNG vessels. Given the concern over climatic changes and resulting search for cleaner fuels, LNG might gain greater prominence in future.

Although the above 2 actions might not yield immediate results as oil majors are still cutting costs wherever possible, it demonstrates that Keppel Corp knows what it needs to do. In the 2Q2016 speech, Keppel Corp's CEO said that if necessary, they might mothball yards with low work volumes. If implemented, this will reduce the depreciation cost of its yards. 

If there is any action that can be reconsidered, it is Keppel Corp's privatisation of Keppel Land in Jan 2015 for $3.1 billion in cash. Keppel Corp's net debt is $7.3 billion, with a net gearing ratio of 0.62 as at Jun 2016. Imagine how nice it would be to have an additional $3.1 billion in cash. Having said that, the privatisation decision is more bad timing rather than bad decision. Sete Brasil had just stopped progress payment on its rigs 2 months earlier in Nov 2014, and it was not clear at that time if it would be temporary or permanent. Given the sharp fall in oil price, it was reasonable to diversify earnings away from O&G by privatising Keppel Land. The decision cannot be faulted given the circumstances at that time.

In conclusion, Keppel Corp is sailing into the full force of the storm. However, the captain (i.e. its management) has demonstrated that he is a very capable captain. Even if I do not manage to sell Keppel Corp at above my purchase price and have to ride through the storm with it for 5 years, with such a capable captain at the helm, I can relax, knowing that it is in good hands.

Sunday 17 July 2016

How Will Keppel Corp Navigate the Oil Crash?

Keppel Corp is a favourite stock among Singapore investors, given its strong earnings and good dividends (prior to the oil crash in Jun 2014). I have it in my portfolio too, after it came off its high 6 months later. Having held it for 1.5 years and sitting on paper losses, I am beginning to reach a conclusion over whether I should continue to hold or sell the stock. Do note that this post involves some speculation over how Keppel Corp would navigate the oil crash, which might not turn out to be correct. After all, stock investments are about predicting the future rather than knowing the present.

The headlines hogging Keppel Corp this year has been the bankruptcy of Sete Brasil and its failure to take delivery of the 6 semi-submersibles (semi-subs) on order from Keppel Corp. However, in my opinion, Sete Brasil is a much smaller problem that can be managed. If you understand the corporate structure of Keppel Corp, you will notice that for every business segment, there is always a REIT or a business trust. For properties, there is Keppel Reit. For infrastructure, there is Keppel Infrastructure Trust. For data centres, there is Keppel DC Reit. The REITs/ business trusts provide avenues for Keppel Corp to recycle capital. The only exception to this is the Offshore & Marine (O&M) segment, which builds ships and rigs for customers and therefore does not hold any operating assets that can be put into a business trust. But with Sete Brasil saddling it with as many as 6 semi-subs worth a total of $6.2 billion when completed, putting all these assets into a business trust might be a solution to recover the capital. After all, Keppel Corp is an expert when it comes to recycling capital with REITs and business trusts. Fig. 1 below is taken from Keppel Corp's presentation of its financial results for 2015. If it cannot sell and service the rigs (upper branch of the tree), it might as well choose the lower branch of the tree and own, operate, stabilise, monetise and eventually inject the rigs into a trust or fund.

Fig. 1: Keppel Corp's strategy

Given investors' penchant for yields in the current low interest rate environment, investors might buy into the idea of a business trust. Even if an O&M business trust IPO is not well received by the market, Keppel Corp could always distribute the business trust in specie to shareholders. Simplying hiving off the non-performing assets (together with the corresponding debts) will do a lot of good for Keppel Corp's balance sheet. 

If it is able to pull this off, the impact will be significant. If you read my earlier post on Understanding Shipbuilders' Balance Sheets, the uncompleted rigs have resulted in elevated levels of inventory and Work-In-Progress (WIP) in the balance sheet. Keppel Corp has stopped work on the Sete Brasil rigs, which means that they remain stuck in the balance sheet as inventory and WIP and cannot move on to receivables (upon rig delivery) and cash (upon customer's settlement of invoices). A lot of capital is locked up in this state. By completing the rigs and hiving them off into a trust, inventory and WIP can come down significantly, cash will go up and debt will come down.

Although this strategy sounds workable, the feasibility of it depends a lot on finding drilling companies willing to charter the rigs. Fig. 2 below shows the current utilisation and day rate for semi-subs from IHS.

Fig. 2: Utilisation and Day Rates for Semi-subs

The current utilisation for semi-subs is 50%, which means now is still not the right time to execute this strategy. Keppel Corp will need to be very patient and wait for the utilisation to recover before executing this strategy. Even so, there is no need to wait for a full recovery to the point that drilling companies start to order new rigs. At some point in the recovery, there will be demand but uncertainty over how long the demand will last. It is at this stage that drilling companies might be willing to lease rigs instead of owning them outright. That is the time the strategy can be executed. Thus, there is a solution to the Sete Brasil issue, but it will require a lot of patience.

In my opinion, the far bigger problem is the dwindling of orders for the O&M segment. Although each succesful delivery of a rig means there is no further deferment, it also means that the order book is reduced correspondingly. As at Mar 2016, the order book stands at a respectable S$8.6 billion. However, this figure includes the Sete Brasil rigs. The order completion rate for the 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). This means that of the S$6.2 billion order for the 6 semi-subs, there is approximately another $3.7 billion still on the order book. Removing the $3.7 billion worth of orders, the order book reduces significantly to $4.9 billion. In Q1 2016, Keppel Corp received only $0.2 billion in new orders. This is hardly sufficient to replenish the depleting order book. Fig. 3 below shows the uncompleted contract value of Keppel Corp's O&M order book according to year of delivery.

Fig. 3: Keppel Corp's O&M Orderbook

For comparison purpose, I have added the $3.7 billion attributed to Sete Brasil's orders. Most of Sete Brasil's 6 rigs are pushed to 2019-2020 for delivery. After removing Sete Brasil's orders, there is not much business left for Keppel Corp after 2018, assuming that new orders continue to remain weak. Given the low utilisation and day rate for rigs as shown in Fig. 2, it is difficult to see how new orders can recover strongly in the next 2 years.

Although Keppel Corp has reduced headcounts significantly to cope with the slump, there is a point at which core competencies start to be affected. Keppel Corp has to decide whether to further cut manpower to save costs in the short term or maintain core competency in anticipation of recovery in the long term. I believe Keppel Corp will choose the latter, which means high depreciation and manpower cost for the O&M segment in the short term. Having chosen to retain core manpower, Keppel Corp will also not let its facilities and staff idle. Remember the 6 uncompleted Sete Brasil rigs? Keppel Corp will go ahead and complete them in 2019-2020, even if it does not receive further payment from Sete Brasil.

Besides hoping for new rig orders, Keppel Corp also recently acquired Letourneau's rig business so that they are able to provide aftermarket sales and services. Although drilling companies are not in the mood to place new rig orders, they still have to maintain their existing rigs, so that business provides an additional revenue stream for the O&M segment. Recently, Keppel Corp has also diversified into Liquefied Natural Gas (LNG) business to reduce reliance on the oil sector. How much help these moves provide is uncertain.

Finally, please note that although I wrote a lot about the O&M segment, Keppel Corp is not a pure O&G company. It also has properties, infrastructure and investments. The reason why I did not write about them is because I do not have insights in these segments. For a complete assessment of Keppel Corp, you need to assess these segments as well.

Sunday 10 July 2016

Is Brexit Just Noise?

And so, Brexit fears went as quickly as they came. Within 4 trading days, the Straits Times Index had recovered all of its losses from news of the Brexit referendum, giving very little time for investors to either buy or sell. Does the speed at which Brexit fears came and went and the relatively limited damage to the stock market make Brexit a non-event and noise to be ignored by investors of all stripes?

First of all, whether Brexit is a noise or not depends a lot on the investor's investment strategy. For a passive investor, Brexit (and most other events) is just noise. Regardless of Brexit or not, an investor using Dollar Cost Averaging would continue to put in the same amount of money at the same fixed time intervals. Likewise, an investor relying on Portfolio Rebalancing would rebalance his portfolio at fixed intervals or when the asset allocation moves away from the target allocation by a pre-defined threshold. For a long-term active investor with an investment horizon of 5 years or more, Brexit is also irrelevant as UK would have completed its exit from EU and established new relationships with the EU and other trading partners. However, for active investors with a shorter investment horizon of 2-3 years, Brexit is not without impact. Just because the stock markets recovered rapidly after the Brexit news does not make it irrelevant and just a noise.

As news of the Brexit referendum results broke out on 24 Jun, Japan's Nikkei index crashed 7.9%, Germany's DAX index dropped 6.8%, France's CAC index fell 8.0% while UK's FTSE index declined by a much smaller 3.1%, despite being the protagonist of this episode. When I wrote my initial thoughts about Brexit in What's Next for Brexit?, I was still wondering why UK's FTSE index fell much less than the other European stock markets. It turns out that the answer lies with the forex markets.

Over the same period, British Pound (GBP) declined by 8.1%, from USD1.4877 to USD1.3679. EUR also declined, but by a smaller 2.4%, from USD1.1385 to USD1.1117. On the other hand, JPY rose by 3.9%, from JPY106.16 to JPY102.22 per USD, as investors fled from GBP to safe havens such as JPY. The implication of these currency fluctuations is that UK's goods have suddenly become 8% cheaper while Japanese goods have become 4% more expensive. It is no wonder then that Japan's (and other European) stock markets dropped more than the UK stock market! To a global investor, should Brexit be considered economically irrelevant and just noise to be ignored?

Now, 2 weeks after the Brexit referendum, GBP has declined further to USD1.2954, EUR stayed relatively flat at USD1.1051 while JPY rose further to JPY100.54. From just before the Brexit referendum till 8 Jul, GBP has declined by 12.9%, EUR by 2.9% while JPY rose by 5.6%. Over the same period, in the stock markets, UK's FTSE index has not only recovered all of its Brexit losses but also gained 4.0%, Germany's DAX index is still losing 6.1% while Japan's Nikkei index is still down by 7.0%. The economic effects of Brexit are just beginning.

A major reason why global stock markets did not fall off the cliff after the Brexit news was the realisation that central banks around the world would loosen monetary policies to stave off any economic fallout from Brexit. The impending US Fed interest rate hike went from near certainty in Jun/ Jul to being postponed at least until the end of the year. This has pushed up stocks that are sensitive to interest rates like REITs. On the other hand, bank shares have been relatively flat, ranging from -1.5% for DBS to 1.9% for OCBC during the 2-week period. If you think about it, if interest rate sensitive stocks are gaining from lower interest rate expectations, why are banks not suffering from it? Banks make money from the interest rate differential that they charge on the loans and pay on the deposits. Since the begining of this year, the 3-month Singapore Interbank Offered Rate (SIBOR) has declined from approximately 1.25% to 0.93% as at end Jun. They have also reduced the interest rate charged on housing loans recently. Coupled with lower loan growth and no improvement on Non Performing Loans from the Oil & Gas industry, banks are likely to see lower profitability moving forward, until US Fed decides to raise interest rates. To a local bank investor, should Brexit be considered a non-event and just noise?

If local banks are going to see reduced profitability from lower interest rates, imagine what would happen to European banks which had shown signs of stress even without the threat of Brexit in early this year, due to increased regulations, global economic slowdown, commodity price collapse, etc. (see Why investors are freaking out over European banks (again)). With Brexit, there is further economic slowdown in Europe, reduced cross-border business, forex losses at UK operations, and now, reduced profitability from lower interest rates. European banks are a major cause of concern (see Italy eyes €40bn bank rescue as first Brexit domino falls). Having said that, it is unlikely that there would be a repeat of the Lehman Brothers incident as central banks would step in to rescue any banks deemed as systematically important.

In conclusion, even though stock markets have recovered quickly from news of the Brexit referendum, it does not mean that Brexit is economically irrelevant and can be treated as noise and ignored, at least not by active investors with shorter investment horizons. It is akin to leaving the door unlocked and no thief came in. Does it mean that it is safe to leave the door unlocked? We might just be plain lucky.

See related blog posts:

Sunday 3 July 2016

Understanding Shipbuilders' Balance Sheets

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.

See related blog posts: