Quantifying sentiment
Stock prices of Keppel and SMM have risen 87% and 100%, respectively, YTD. Much of
this price movement is explained by changes in broader market indices. However, stocks
are riding high due to positive sentiments over oil prices driving expectation of new rig
building demand and higher earnings. While there are reasons for optimism, our analysis
shows that the magnitude of expected change is unrealistic and is likely to cause
disappointment. We are downgrading our sector weighting from Market Weight to
UNDERWEIGHT, while retaining our relative preference for Keppel over SMM.
From high growth to ex-growth
We believe both Keppel and SMM are at or past peak earnings. Keppel needs to win S$6
bn in annual new orders (S$4 bn for SMM) just to maintain O&M revenue and keep
earnings flat, let alone show any growth. Anticipated contracts from Brazil or production
systems will not be sufficient to reverse the net order book and revenue contraction trends.
Positive surprises on margin in the recent quarterly results were partially based on shortterm
fiscal measures (i.e. jobs credits) and may not be indicative of a long-term trend.
Current valuation also suggests that for further upside, both new order wins and forward
earnings growth expectations need to rise above the previous record highs, which may be
unrealistic.
Structurally lower new rig demand
On average, rig building orders comprise 65-75% of Singaporean yards’ annual order
intake. Following five years of steadily rising demand, new rig building orders have come
to almost a standstill in 2009. YTD aggregate demand of US$2.4 bn pales compared with
over US$25 bn worth of offshore rigs ordered in 2008 (net of cancellation). While newbuild
activity should pick up from current lows, there may be a potential 30-50% structural loss
in global new rig demand from its 2008 peak due to: 1) lower jack-up rig demand (20-40%
of historical demand), 2) a collapse in contracts from ‘new entrants’ (40-70% of historical
demand) and 3) demand centre shifting from Norway to China and Brazil, with higher
‘national content’ requirement.
Demand catalysts still elusive
Expectation of energy prices is the ultimate driver of rig building demand, although higher
oil prices or Global IP growth do not always lead to an immediate pick-up in newbuild
activities. Rig demand is ultimately a complex mix of economic, regulatory and political
motivations, the cumulative effect of which can be observed in rig utilisation rates. History
shows that rig building activity picks up every time rig utilisation rates hit 95%, a
surprisingly consistent result across all offshore rig categories. With the present offshore
rig utilisation rate dropping to 85%, the theoretical trigger for broad-based demand may be
six to12 months away.
Stock picks
While we believe that valuation for Singapore O&M companies are stretched, at present,
we maintain our relative preference for Keppel with a NEUTRAL rating over SMM, which is
given an UNDERPERFORM rating. We remain concerned about SMM’s customer
concentration risk – two customers account for 40% of its outstanding net order book –
and its continued exposure to Larsen Oil & Gas related assets. We like Keppel O&M’s
relatively diversified order book, ‘closer to customer’ business model and wholly owned
yard in Brazil. Positive sentiment in the physical property markets and cash war chest
raised from the sale of SPC further strengthens Keppel Corp’s position, in our view.