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.

See related blog posts:

• Is Keppel Corp's Provision for Sete Brasil's Orders Adequate?
• Keppel Corp – A Good Captain Sailing Through Rough Waters
• Understanding Shipbuilders' Balance Sheets