The shipyard sector has been driven by bullish investors in recent time due to the spike in Brent crude prices.
Run-up in valuations to be short-lived
However, not all is rosy and smooth sailing for the shipyard industry as UOB Kay Hian Research (UOBKH) warns investors that these bullish runs are expected to be short-lived.
There are still no clear signs to indicate that the industry earnings are recovering.
In fact, the shipyards in Singapore are still finding it difficult to secure orders from the traditional oil-related product lasses.
In their efforts to diversify and source for other income, orders come with lower profitability and hence reducing the profits of the firms.
Rising Brent crude oil price
Those observing the price of Brent will realise that the recent spike in price is mainly due to the tension rising between Turkey and Iraq.
Turkey has threatened to shut down on oil shipments coming from Kurdistan region in Iraq to oppose the independence referendum happening in that region.
In addition to the political conflict happening, major producers have also made positive comments on oil rebalancing progress.
These developments have resulted in bullish sentiments amongst the investors and have driven the Brent up.
However, it is noteworthy that despite the surge in oil prices, the consensus has kept their forecasts of the future oil price at US$56 to 57 per barrel for 2018.
Analysts are expecting that further investment will only be pumped into the oil sector if Brent is able to push past the US$60/barrel mark.
Therefore, investors who are eager to jump right into the oil sector or even investing in the shipyard sector should wait and observe for further increases in prices.
UOBKH highlighted that oil majors will require “price stability of six to nine months before revising their assumption”.
That means we will still have to wait for at least a year before we will be able to observe any significant offshore CapEx recovery.
Intensifying competition reducing margins
A factor that is slowing down the earnings recovery for the shipyard sector is the low prices that the shipyards have to accept in order to remain competitive.
According to UOBKH, “securing tenders now is a matter of being the lowest cost supplier” and competition is intense, which drives down profit margins for the yards.
In Singapore’s context, our yards have little pricing advantage as compared to the Chinese and South Korean yards due to our limited financial capabilities and lower risk appetite to compete aggressively.
As mentioned above, shipyards have started to diversify in search for other sources of income to boost profits.
Keppel Corp’s diversification into gas-related products has been beneficial as they have won more than $650 million in gas-related orders.
Sembcorp Marine has also gotten a letter of intent for more than $530 million worth of contract with at least two gas carriers.
EBIT margins significantly lower than historical norms
However, the firms also had to put up with lower earnings before interest and tax (EBIT) margins of 6.0% to 8.0% as compared to the historical average of about 11% to 12%.
Analysts are rather dissatisfied with the low EBIT margins of the new contracts secured by the shipyards as profits will certainly be lower.
In addition, though Sembcorp Marine has signed a letter of intent with SeaOne Holdings, the latter may not be able to secure funding to cover the cost of both of its orders with Sembcorp Marine considering that they also have other orders with Samsung amounting to US$1.5 billion.
In view of that, Keppel Corp seems to be more attractive especially so since current valuations have placed Keppel Corp at 0.3 times price to book ratio for the offshore and marine business.
UOBKH opines that such low valuation is underserved since Keppel has largely met with contract win expectations set.
Keppel won $850 million worth of contract in comparison to an expectation of $1.5 billion, whereas Sembcorp Marine only won $250 million worth of contract in contrast to a $2 billion expectation.
Reduced target prices
Regardless, as the shipyard industry still does not seem to have recovered, UOBKH has lowered the contract win assumptions for both firms, expecting the shipyards to each win about $1.2 billion to $2.5 billion worth of contracts over 2017 to 2019.
Investors should also take note that UOBKH has lowered its target price for both firms, reducing Keppel Corporation Limited’s (SGX: BN4) target price to $6.71 from $6.85, and Sembcorp Marine Limited (SGX: S51) is valued at $1.77 from a previous $1.80.
Our local shipyards are likely to be still sailing in rough waves for the time being and investors should be cautious of diving into this sector without safety precautions.