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Does consolidation make sense? Merger of two Singapore MRO providers can create a

global giant

Container shipping industry also provides recipe for consolidation

Keppel O&M + SMM = A Powerhouse

Top picks: STE, NOL, SCI and Yangzijiang

Merger of two Singapore MRO providers can create a global giant. While the global airline maintenance, repair and overhaul (MRO) industry is in steady growth mode supported by the increase in aircraft fleets, structural challenges in airframe MRO has dented premier operator SIA Engineering (SIE)’s earnings in the recent past. ST Engineering (STE)’s aerospace arm has been more resilient as it focuses on older models and narrowbody aircraft, but it has not made efficient use of its balance sheet to pursue accretive inorganic growth opportunities. This sets the stage for STE and SIE to consider a merger funded by STE’s balance sheet to better exploit complementary capabilities and create synergies in terms of cost savings to consolidate Singapore’s position as an aviation hub. Following the steep share price decline, we upgrade SIE to HOLD with TP of S$3.70, as a potential M&A target play. STE remains a BUY with TP of S$3.80.

Container shipping industry also provides recipe for consolidation. With carriers still stuck in market share wars, we believe scale and cost efficiency will be the keys to success in the liner industry. We believe liners outside the top 3 should look to consolidate further to enhance their competitiveness through improved cost efficiencies, access to a broader global network and more financial flexibility. This creates potential M&A interest in Neptune Orient Lines (NOL). Fundamentally, things have just started to look up a bit for NOL, with cost control measures yielding fruit in 2Q15, and creating a realistic chance of better earnings performance. Its recent share price under-performance and valuation of just 0.6x P/BV also improve the allure of NOL to potential suitors. Maintain BUY with a TP of S$1.08.

Offshore and marine – down but not out. Singapore shipyards are bracing for tough times ahead – absence of new rigbuilding orders, dwindling order book, low book-to-bill ratio, high fixed cost, project cancellations and deferments - will place rising pressure on shipyards to restructure or merge to derive cost benefits and create a formidable player against global competition. However, there are roadblocks to a merger, as revenue synergies are not clear and there exists integration challenges. We prefer to HOLD Keppel Corp and SembCorp Marine given the challenging industry outlook and have upgraded Sembcorp Industries (SCI) to BUY with TP of S$4.10 on attractive valuation. We expect SCI’s power plants in India to ramp up contributions, offsetting decline in earnings from Singapore power plants. BUY Yangzijiang, (TP$1.62) as we expect it to emerge as a leader in the consolidation of Chinese shipbuilding industry. The stock offers an attractive dividend yield of 4%, we see potential re-rating from a possible dual listing in Hong Kong to fund M&A activities.

STI : 3,196.66

Analyst HO Pei Hwa +65 6682 3714; [email protected] Suvro SARKAR +65 6682 3720; [email protected]

STOCKS

Source: DBS Bank; Bloomberg Finance L.P. Cosco Corporation : Cosco Corp's core businesses include ship repair, shipbuilding, offshore and marine engineering, dry bulk shipping and shipping agency.

Keppel Corporation : Diversified conglomerate with core businesses in offshore marine, property investments and development and infrastructure-based activities.

Neptune Orient Lines : NOL is a container shipping company.

Sembcorp Industries : Focus on Integrated Utilities and Energy, Marine Engineering, Environmental Engineering, Logistics & Engineering & Construction Services.

Sembcorp Marine : Principal activities are ship repair, shipbuilding, ship conversion rig building and offshore engineering.

SIA Engineering : Provision of aviation maintenance, repair and overhaul services.

ST Engineering : An integrated engineering group providing solutions and services in aerospace, electronics, land systems and marine sectors.

Yangzijiang Shipbuilding : The largest private containership builder in China who specialises in medium-sized containerships and bulk carriers.

DBS Group Research . Equity 6 Aug 2015

Singapore Industrials - Thematic Report

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Refer to important disclosures at the end of this report

Price Mkt Cap Target Price Performance (%)

S$ US$m S$ 3 mth 12 mth Rating

Cosco Corporation 0.385 623 0.42 (28.0) (45.4) HOLD Keppel Corporation 7.62 10,018 8.14 (13.4) (29.4) HOLD Neptune Orient Lines 0.905 1,705 1.08 (20.3) (4.2) BUY Sembcorp Industries 3.76 4,846 4.10 (16.4) (30.8) BUY Sembcorp Marine 2.69 4,060 2.55 (11.2) (34.4) HOLD SIA Engineering 3.49 2,839 3.70 (16.7) (24.3) HOLD ST Engineering 3.26 7,342 3.80 (8.9) (12.3) BUY Yangzijiang Shipbuilding 1.275 3,530 1.62 (9.9) 19.2 BUY


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Table of Contents

Does consolidation make sense? 3

- Case study 1 : Shell acquires BG Group 4

- Case study 2 : Consolidation in the US Airline Industry 6

Aircraft maintenance, repair and overhaul industry (MRO) 9

- A growing industry 9

- But facing structural and cyclical challenges 11

- Possible merger in the Singapore MRO landscape? 12

Container Shipping 19

- Any light at the end of the tunnel? 19

- NOL and the case for M&A 22

Shipyards and rigbuilders 28

- Struggling at the deep end 28

- Any more room for consolidation? 32

Company Guides

Cosco Corporation 38

Keppel Corporation 44

Neptune Orient Lines 50

Sembcorp Industries 56

Sembcorp Marine 62

SIA Engineering 68

ST Engineering 74

Yangzijiang Shipbuilding 80


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DOES CONSOLIDATION MAKE SENSE?

When does consolidation make sense? In the last decade, there were 210,000 M&A deals completed, averaging a whopping US$2.17tn annually. Managers have undoubtedly seen value in pursuing size through inorganic means, albeit not always to the benefit of shareholders. Below we discuss some of the commonly cited benefits of consolidation, the hurdles faced in realizing those benefits, as well as motivations for keeping a company small – in other words, resisting consolidation. Benefits of consolidation: For a consolidation to make sense, the value of the enlarged entity post-consolidation must be more than the combined value of the two stand-alone companies. There are many avenues for such value creation in a successful consolidation exercise: Cost savings via economies of scale. When two companies combine, economies of scale are often realised. These can come in the form of wielding greater bargaining power in purchasing or higher margins due to spreading fixed costs thinner. In general, one would expect to see greater economies of scale in horizontal mergers – where two companies engaging in the same business combine. The magnitude of economies of scale can be substantial. Cost savings via streamlining operations. Often, a marriage of two companies involves the shedding of some weight; headquarters are amalgamated, overlapping jobs are cut, administrative functions are centralised and facilities are consolidated. Essentially duplications in operations are eliminated, which reduces costs. Process improvements. Consolidation can facilitate a transfer of expertise or best practices from one company to another. For example, an acquirer may want to inject better management into a struggling target company. Alternatively, a company may be acquired for its expertise in a key industry segment. Stronger top-line growth from complementary competencies. It is possible for two combined companies to achieve a higher total level of sales growth than both companies could have attained independently. For example, this can occur when a company with an attractive product line merges with a company with strong sales and marketing abilities. Firms with complementary products can also realise cross-selling opportunities, boosting revenues.

Financing synergies. The financial benefits of consolidation comes in various forms: i) Value can be created by combining a firm with cash slack with a firm with high-value projects but lacking access to capital markets. Deploying excess cash to attractive projects generates positive NPV, adding value to the combined firm. ii) Debt capacity of the combined firm can increase as a result of better access to credit markets, or avoiding a downgrade in credit rating of the higher-geared firm by consolidating. Higher use of debt in the capital structure generates a greater interest tax shield, creating value for the combined firm provided a significant risk of bankruptcy does not result. iii) Occasionally, a profitable company will acquire a company with a net operating losses (NOL) which it will be able to use to offset taxes immediately, hence capturing the time value of applying those NOLs sooner rather than later. iv) If the combined entity is able to write-up depreciable assets on the balance sheet in the process of consolidation, this would increase depreciation and reduce taxable income, hence creating value. Better equity research coverage and investor focus due to scale. An often overlooked benefit to consolidation, this applies especially to listed companies. Buy-side fund managers often have minimum market capitalisation requirements for investing in stocks due to liquidity concerns and the need to match investments with the size of their funds, which can be gargantuan these days. As a result, sell-side equity analysts also tend to focus on the larger companies that will generate more interest. Consolidation will help companies garner greater attention from the market, facilitating easier access to capital when needed. Hurdles to a successful consolidation: Failing to realise synergies. Integration of two companies is by no means a simple task; organisations are resistant to change and massive amounts of willpower and effort are often required to achieve success. Failure to integrate the two companies is a possibility which can erode value, especially after considering hefty transaction costs such as advisory fees. Overpaying for a target company is another common scenario that destroys value, as evidenced by the fact that an acquirer’s stock price tends to decline upon the announcement of an acquisition. Motivation for remaining small: Certain companies prefer not to participate in the upsizing game, choosing to avoid M&A as a strategy, at least for now. But that action in itself can be counter-productive – it invites takeover interest from potential acquirers who see those untapped synergies as a means to bolster their growth. So why do some companies shy away from consolidation?


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Complexity of managing a huge organisation. Managers have to spread their time thinly acrossmany divisions when the company is large and complex. Further, when size and growth take priority, quality can be affected. This happened at Toyota, which targeted to become the largest carmaker in the world in 2002, and subsequently sacrificed managerial oversight and talent development in the pursuit of growth, resulting in a massive recall of 8.5m vehicles in 2009 due to faulty accelerator pedals and brake systems. Investors may occasionally prefer smaller, more transparent firms. Although we said earlier that large companies are often rewarded with greater coverage by equity research and investors, on the multinational conglomerate level, size could sometimes be a weakness. This is true especially when a complex company has opaque disclosure of its segments and their respective financial and operational performance – the company becomes a black box. Case study 1 : Shell-BG deal Background: Shell is one of the largest global oil majors with over 100 years of operating history. It operates in over 70 countries and hires 94,000 employees on average, and engages in activities across the energy value chain, from upstream exploration to downstream refining and sales & marketing. In 2014, Shell recorded US$421bn in revenue and US$28bn in pre-tax income. Its two primary segments – Upstream and Downstream – represent 11% and 89% of revenues respectively. Shell produced 1,124mmboe of oil and gas in FY14. [Source: Annual Report 2014] Background: BG Group is an international E&P and LNG company. BG Group is noticeably smaller than Shell, recording ~US$19bn in revenue and pre-tax income of ~US$6.3bn before loss on disposals (which, when included gives rise to a net loss of US$2.3bn) in FY14. The company has two segments, namely ‘Upstream’ and ‘LNG Shipping and Marketing’. Its Upstream segment engages in E&P activities and liquefaction operations for integrated LNG projects. This segment reaped a total operating profit of US$3.95bn in 2014, and produced 384kboe/day of gas, which accounted for 64% of total production volumes. The LNG Shipping and Marketing segment recorded a total operating profit of US$2.54bn and has a wide presence in LNG markets: It purchases from 15 out of 19 LNG supplying countries and sells to 27 out of 28 LNG importing countries. Share price reaction: textbook scenario - acquirer’s shares declined while target’s shares appreciated. Rumours of the acquisition started spreading on 7 April 2015 causing BG’s share price to rise 6.7% on that day. When the deal was formally announced on 8 April, BG’s share price jumped a further 26.6% to 1,153p. Despite having come off from its highs, we can say that BG’s share price reaction to date has

been positive overall. Shell’s share price on the other hand is down 8.6%, perhaps reflecting the market’s view that the acquisition premium was too high. Strategic rationale #1: Widening Shell’s lead in the LNG space. LNG is one of the two growth priorities for Shell (the other being deepwater). BG’s focus on LNG is thus a strong strategic fit for Shell, which explains its interest in BG for some years. Shell’s current capacity of 26mtpa of LNG liquefaction capacity, combined with BG’s 7mtpa capacity gives the enlarged entity 33mtpa of capacity as of end-2014. Shell’s management expects the combined entity to add another 13mtpa of capacity by 2018, which will bring the total to 46mtpa – roughly double the capacity of the nearest competitor, ExxonMobil. Additionally, as both Shell and BG are also aggregators – buying third-party LNG and on-selling to a global buyer base – there are economies of scale that can be realised from the combination, as well as cost synergies from shipping and trading operations.

Source: Bloomberg Finance L.P., Companies Finally, both companies have overlapping projects planned, and this creates value by bringing optionality into the combined company; a fresh look at strategic partnering and the timing of investment decisions could help optimize returns. An example of this would be both companies’ plans to begin exporting LNG from the west coast of British Columbia.

Dea l Summary

Announced: 8 April 2015

Expected completion: Early 2016

Cons ideration: 0.4454 Shell B Shares and 383p in cash per BG share

Premium: 52% premium, based on 90-day VWAP

Rationa le : Strengthen Shell's growth priority areas: LNG and Deepwater

Synergies : ~US$2.5b per year synergies identified

Accretion/Dilution: Mildly accretive to 2017 EPS; strongly accretive from 2018

She ll and BG s hare prices pre and pos t-announcement

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Shell estimates of LNG liquefaction capacity

Source: Company Strategic rationale #2: Addition of BG to broaden Shell’s operations in deepwater Brazil. Shell has identified deepwater as its second growth pillar, and has been positive on the economics of deepwater E&P in pre-salt Brazil, citing an attractive 12% return on capital employed on its deepwater operations. BG’s extensive interest in the area therefore creates a good fit. As of end-2014, Shell had about 50kboe/day of production underway in deepwater Brazil, supported by 2 FPSOs; BG produced 78kboe/day from its non-operating interest in 5 pre-salt deepwater fields. The ~130kboe/day of combined production is expected to ramp up to 550kboe/day by the end of the decade, boosted by the 15 FPSOs scheduled to be delivered to support BG’s production operations, which would make Shell a leading player in deepwater Brazil. Synergies: US$2.5bn per year in synergies identified. According to Shell, in April 2015, pre-tax synergies that are expected to reach US$2.5bn in 2018 have been identified, comprising US$1.0bn in operating cost savings and US$1.5bn reduction in exploration expenditure. Operating cost savings of US$1.0bn can be broken down into: i) US$870m of reduced duplication in support functions and corporate costs, and the merging of the two company’s IT systems; ii) US$140m from economies of scale in procurement spend, marketing and shipping. The reduction in exploration expenditure of US$1.5bn arises from Shell’s ability to shift focus to BG’s discovered but relatively undeveloped resource base, particularly in Brazil, rather than investing heavily in exploration – so termed ‘high-grading’. However, Shell also said that US$980m in one-off costs relating to the implementation of these synergistic cost savings will be incurred from 2016-2018, which will detract from the benefits in the near term.

Geographic fit of Shell and BG’s upstream operations

Source: Company Why now? In an interview with CNBC, Shell’s CEO Ben van Beurden said that the oil behemoth had been eyeing BG for a number of years, and that the shift in macro environment made the deal “…a very compelling one from a financial perspective”. He may be right. Price-to-book ratios of the 72 Exploration & Production (E&P) firms that are constituents of the S&P Oil & Gas E&P Index have fallen in tandem with the oil price – a result of strong correlation between oil prices and the share prices of oil & gas companies. The aggregate P/B ratio of the index was 1.3x at end-June 2015, compared to the lofty ~2x valuations seen just one year prior. Valuations have tracked oil price

Source: Bloomberg Finance L.P., DBS Bank Deal Valuation We examine BG Group’s Price-to-BOE (barrel of oil equivalent) and EV/EBITDA on the day before the announcement (7 April 2015) and find that both metrics were at reasonably cheap levels: BG’s P/BOE stood at 13.5x, equal to 1.5 standard deviation below its 10-year average of 23.5x. Its EV/EBITDA was 7.3x, representing 0.3 standard deviation below its 10-year average of 7.8x.

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The consideration offered by Shell to BG represented a 52% premium over BG’s 90-day volume-weighted average price (VWAP) as of 7 April 2015, or 1350p per BG share. By our calculations, this equates to a transaction multiple of about 9.7x EV/ TTM EBITDA and 18.9x P/BOE. BG Group historical valuations

Source: Bloomberg Finance L.P., DBS Bank Conclusion For Shell, a confluence of strategic fit, identifiable synergies and cheap valuations likely formed the rationale behind the acquisition of BG. Will we see more giant M&A deals like this one in the oil & gas sector? Many pundits seem to think so, and we tend to agree. Smart managers of well-capitalised companies would see opportunity in crisis and snatch up cheap deals. Case Study 2 : US Airline Industry Global airlines have endured dismal returns for the past twenty years, with US carriers suffering a similar fate – that is, until a wave of consolidation across the industry altered its competitive dynamics, spurring a paradigm shift towards profit-focused management. The largest four US airlines are now enjoying returns above their cost of capital – a marked improvement over the last decade. Airlines have been shortchanged as the rest of the industry makes profits. A report issued by the International Air Transport Association (IATA) in 2013 concluded that global airline companies had consistently earned returns on invested capital (ROIC) less than their weighted average cost of capital (WACC) over the last 20 years – in other words, destroying value for their investors. The US was not exempted. Ironically, while airlines – the cornerstone of the aviation industry – earned consistently inadequate ROICs, firms operating in other parts of the value chain such as Maintenance, Repair and Operations (MRO) companies, freight forwarders, travel agents, Computer Reservation Systems (CRS) providers and airports were making ROICs equal to or greater than their WACCs.

Global airline ROIC vs. WACC – poor man’s land

Source: McKinsey & Company for IATA Reasons the report gives for airline’s diminished profitability: i) Degree of rivalry amongst airlines was high, given the

high fixed cost nature of the business. Hence seat price erosion was common as airlines jostled for market share.

ii) Consequently, even though airlines halved their unit operating costs in real terms since 1970, these efficiency gains were substantially all passed through to the end customer.

iii) Crude oil producers and labour captured the bulk of aviation industry profits.

The US airline industry began consolidating in 2001, reducing the number of carriers from 10 to 4. In 2014, the top 4 airlines – American Airlines, Delta, United and Southwest – accounted for 82% of domestic capacity compared to only 63% in 2000.

US domestic seat capacity – market share

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American Airlines Delta United Southwest Other

Source: US Department of Trade Form 41 High labour costs catalysed US airline bankruptcies and eventually, consolidation. Labour costs accounted for ~40% of airline operating costs at its peak in 2002, as a result of the strong bargaining power of unions in the US. High jet fuel prices and the 9/11 incident exacerbated the moribund outlook, weakening demand for air travel and causing a

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Merger Hist o ry leading up t o mergerTo t a l Predict ed Effic ienc ies (annua l)

Net work Benefit s vs. Cost Savings

TWA-American (2001)

TWA's third bankruptcy in 10 years, as a result of poor management decisions and stripping of profitable assets by corporate raider Carl Icahn. American siezed the opportunity to integrate TWA's St. Louis hub into its network as well as fully utilize TWA's excess maintenance capacity. N/A N/A

US Airways-America West (2005)

US Airways suffered 5 consecutive years of operating losses totalling US$3.6bn due to high labour costs negotiated in the boom years and a slowing economy, later worsened by the 9/11 terror attacks. Merger with America West was part of its Plan of Reorganization to emerge from bankruptcy. US$600m

~50-60% Network~40-50% Cost

Delta-Northwest (2008)

Both airlines filed for bankruptcy in '05. The cause: Delta overinvested in jumbo-jets, started a discount airline that tanked and grossly overpaid its pilots. Northwest faced high labour and fuel prices as well as a burgeoning pension deficit; bankruptcy was a means to force unions to accept pay cuts. Both carriers emerged from bankruptcy pre-merger; the '08 deal was more directed at network synergies. US$2.0b, beginning 2012

~70% Network~30% Cost

United-Continental (2010)

United filed for bankruptcy in 2002, having been impacted by the slowing economy and facing one of the highest labour costs in the industry. It emerged from bankruptcy in 2005. A series of negotiations with Continental Airlines starting in 2006 resulted in the eventual merger in 2010. US$1.0-1.2b, beginning 201

~75-80% Network~30% Cost

Southwest-AirTran (2010)

Southwest's acquisition of AirTran was primarily a result of its expansion objectives and the two carrier's routes being complementary; both carriers served about 70 airports but only had 19 overlapping routes. US$400m+, beginning 2013 N/A

US Airways-American (2013)

AMR (American Airline's parent) filed for bankruputcy in late-2011 after four years of consecutive pre-tax losses and the lowest operating margins in the industry. Bankruptcy filing provided the airline with the option to reject its union's collective bargaining agreements and dramatically lower labour costs - its main objective. The 2013 merger was part of its Plan of Reorganization. US$650m, beginning 2015

~75-85% Network~15-25% Cost

temporary drop in both load factors and yields. This triggered a wave of bankruptcies which then provided ammunition for many of the mergers and acquisitions that shaped the industry. From 2001-2011, half of the ten largest US airlines filed for bankruptcy. In these consolidation years, labour costs fell substantially as a percentage of operating expenses, reaching proportions as low as 20% for the network carriers in 2008. Labour’s proportion of Opex has almost halved

Source: US Department of Trade Form 41

Bankruptcies cut costs; mergers added network synergies. Interestingly, in the six mergers/acquisitions that occurred since 2001 (see table on next page), we find that the bulk of labour cost savings were generated during the bankruptcy protection and restructuring process, not as a result of synergistic cost savings from M&As. Instead, network benefits formed the bulk of merger efficiencies (or synergies), showcasing just how potent network optimisation – which encompasses things like improved gauge allocation, expanded hubs, and more efficient and diversified connections – as a profit driver can be. These network efficiencies amount to billions of dollars and have undoubtedly contributed to the industry’s return to profitability.

US airline mergers and acquisitions since 2001

Source: Bloomberg Finance L.P., Newswires, American Antitrust Institute

Industry consolidation also resulted in capacity discipline and a re-prioritisation of profitability. Just as crucial in the road to recovery: fewer competitors in the skies have led managers to shift focus away from price competition and towards profits, no longer engaging in the irrational capacity expansions of the late 1980s and early 1990s. This has helped propel the industry into resurgence. Since 2001, the supply-demand gap for US carrier’s capacity has narrowed. Although both available seat miles (ASM) – a measure of supply – and revenue passenger miles (RPM) – a measure of

demand – have increased in nominal terms, the difference between the two has shrunk by 41%, from ~240b seat miles in 2001 to ~142b seat miles in 2014. As a result, load factors are at an all-time high of about 85% and yields have soared to the 15UScts per mile level for network and low-cost carriers alike. Passenger revenue per available seat mile (PRASM), a key barometer of industry earnings that accounts for both load factors and pricing (yield), is therefore also at its highest level in 20 years.


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US airline industry key statistics – never been better

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ROICs have been substantially higher than WACC since 2013. The net effect of cost cutting, capacity rationalisation and network synergies brought about by mergers has been an airline industry that is once again creating value for its investors. The average ROIC for the US airline industry reached a twenty-year high of 16.6% in 2014 by our estimates, considerably higher than its average WACC of 8.3%. EBIT margins have improved in tandem, crossing 10% for the first time in recent history. The lesson here: in a competitive industry, consolidation can provide an expedient means of restructuring, cutting excesses and forcing management to focus on key objectives. US airline industry Return on Invested Capital (%)

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Average WACC = 8.1%


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US Airline Industry EBIT Margins (%)

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AIRCRAFT MAINTENANCE, REPAIR AND OVERHAUL INDUSTRY (MRO) Still a growing industry

Sustained increasing trend for air traffic. Facilitated by rapid economic growth, there has been increasing demand for air travel for the past 20 years. The air travel industry has weathered various major external shocks over the years and for the last 4 years, industry traffic has grown above 5% p.a.

Going forward, increasing per capita income, rising affordability and propensity to travel and emergence of low cost carriers (LCCs) will continue to drive traffic growth, especially in emerging markets and drive the need for more aircraft and aircraft maintenance. Global passenger traffic is forecast to grow at close to 5% per annum over the next twenty years. Growth within Asia is likely to be the largest contributor, driven by China, as seen below.

Air traffic outlook

Source: Boeing Current Market Outlook 2015 Aircraft fleet to double over next 20 years. As a result of above factors, manufacturers like Airbus and Boeing expect approximately 38,000 aircraft to be delivered over the next twenty years, of which around 22,000 are required to fulfil new demand generated by passenger traffic growth, while the rest will replace aircraft presently in service that will be retired from passenger service in the next ten years. This represents a fleet growth CAGR of about 3.6%. Low Cost Carriers (LCCs) is now an important segment. It is estimated that 70% of the new airplanes needed over the next twenty years will be single-aisle or narrrowbody aircraft. LCCs are increasingly dominating short and medium-haul markets. LCCs have increased their penetration of the market and are currently operating about 30% of the total passenger single-aisle aircraft fleet. LCCs also hold more than 30% of the firm backlog of commercial jet airliners on order. Airlines in Asia-Pacific hold the largest backlog. While some of these orders may be scaled down or delayed in future, it is representative of the growth trends expected in the region. This is also reflected in STE’s customer mix, with LCCs growing from 3% of Aerospace sales to 10% currently.

Fleet developments

Source: Boeing Current Market Outlook 2015 Stable fuel prices likely to drive better airline profits in FY15. The International Air Transport Association (IATA) has been consistently upgrading airline profit projections in 2015. According to its latest estimates, industry profits are expected to reach US$29.3bn in 2015, representing a net profit margin of about 4%. This is significantly better than the US$16.4bn net profit recorded by the industry in 2014,


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and the expectations of better results are driven by good load factors, lower fuel prices and US$ appreciation. More than half of the profits are expected to be generated in North America, where airlines are enjoying better profitability post-consolidation of the industry. Airline profit projections

Source: International Air Transport Association (IATA)

All this bodes well for overall MRO growth. Industry consultant Team SAI expects the global MRO market to grow at a CAGR of 4.1% from US$67bn in 2015 to about US$100bn over the next 10 years. Engine MRO will remain the largest segment, with highest CAGR of around 5% over the next 10 years, while airframe MRO will be growing at the slowest pace, at around 1.5% CAGR. 2015 – 2025 Global MRO market size forecast

Source: Team SAI Engine MRO is the biggest segment. Global engine fleet will likely grow at a rate of 3.4% CAGR over the next 10 years, according to Team SAI forecasts. Today, the top 3 engine manufacturers are CFM Int’l, GE, and Pratt & Whitney. CFM International will continue to increase its market share over time, as it dominates the single-aisle market.

Asia will drive MRO growth. In line with the fleet additions in the region, as well as the fact that most of the aircraft are still within their first few maintenance cycles and are far from retirement – unlike in the US – Asia is expected to drive the growth of the global MRO market, with market share expanding from 27% to 34% over the next 10 years. 2015 – 2025 Global MRO market size forecast by region

Source: Team SAI Recovery in air cargo traffic a positive. In 2014, the air cargo market built on the recovery that began in 2Q13. Global traffic volume growth was close to the long-term average, and segment profitability began to improve aided by lower oil prices. Capacity metrics also improved as utilisation of large freighters returned to recent highs. Boeing expects demand for 920 new and 1420 converted freighters over the next 20 years. PTF conversion demand for 2014-34: 1420 conversions

Source: Boeing Current Market Outlook 2015

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Air line Aggregate Net Profit (US$bn)

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40

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80

100

120

2015 2020 2025

Airframe Engine Component Line

CAGR 4.4%

CAGR 3.8%

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Asia Africa/ ME Latam Europe N. America

AsiaCAGR6.1%


Sea of Change

But structural changes may cause rethink of strategies

as challenges emerge

There are three main structural issues affecting aviation MRO services in our opinion. These include: 1) Aircraft aftermarket services are becoming more MRO-

centric 2) Airframe and engine maintenance cycles are

lengthening with higher reliability of new models 3) Man-hour rates in Asia are converging towards those in

developed economies as cost pressures rise, especially in Singapore

4) Narrowbody maintenance will overtake widebody New generation aircraft and engines are more reliable. New generation aircraft like the A350, B787, A320neo, B737 Max will generally require less maintenance and check intervals will be further apart, based on approvals from the OEMs and the regulators. As airlines seek to replace ageing aircraft with these new generation fuel efficient aircraft, it could result in a double whammy for MRO operators : i) loss of revenue from ageing aircraft which typically require higher maintenance and ii) deferral of revenues from new aircraft types due to the lengthened intervals between checks. Singapore Airlines is generally at the forefront of renewing its fleet and ensuring its average fleet age remains below 10 years or so, and hence its MRO subsidiary SIA Engineering has begun to feel the pinch of this trend already, as shown in the decline in the number of checks in recent years. Declining number of heavy checks – C and D checks – in recent years

Source: SIA Engineering, DBS Bank Increase in man hour costs at Singapore operations. Historically, Asian MRO providers enjoyed significant cost advantage of up to 20-25% over MRO providers in North America or Western Europe. This resulted in attracting outsourced work from these developed countries. However, rising wage levels and controls on labour inflows in Singapore have eroded most of the cost advantages over the years. Singapore MRO providers also risk losing business to

other emerging countries in Asia, including the Middle East and China. Convergence of widebody airframe man-hour rates between North America and Asia

Source: ICF SH&E Analysis SIA Engineering staff costs on upward trend before downsizing in 2014

Source: SIA Engineering, DBS Bank Life in an OEM-centric world. The aircraft MRO market is becoming more OEM-centric in recent times with increasing focus from Airbus and Boeing. For new aircraft types, airframe OEMs are now competing for full support maintenance packages with third party maintenance providers. Thus, independents are increasingly under threat with OEMs seeking to protect the aftermarket and it seems reasonable that they will seek to partner with OEMs rather than compete outright as OEMs will have access to data for new airline types. The key questions for independent MROs are thus: 1) To co-operate or not to co-operate with OEMs? 2) In case of co-operation, how is the revenue shared? 3) Which OEM to partner with?

0

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FY10 FY11 FY12 FY13 FY14 FY15

D checks C checks A checks

1015202530354045505560

1995 2000 2005 2010 2015 2020

US$/ man hour

North America Mature Asian MROs Emerging Asian MROs

50,000

55,000

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65,000

70,000

75,000

80,000

85,000

10

1010

2010

3010

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2010 2011 2012 2013 2014

# employees (LHS) Cost per employee (S$) (RHS)


Sea of Change

Manhours for single aisle aircraft projected to exceed widebodies by 2023. According to analysis from industry consultant ICF SH&E, total airframe heavy maintenance manhours for widebody aircraft will grow at a much slower pace in Asia-Pacific than that for narrowbody aircraft. This is evidently due to the huge growth of LCCs in the region, which focus exclusively on narrowbody aircraft for short and medium-haul travel. Also, average widebody labour hours for heavy checks are expected to reduce by about 20% over the next 5-10 years, owing to greater reliability of new generation aircraft. Airframe heavy maintenance labour hours (millions) forecasts in Asia-Pacific

Source: ICF SH&E Analysis Possible consolidation in the Singapore MRO

landscape?

Thus, SIA Engineering had faced some tough times in the recent past. Earnings performance for SIA Engineering has steadily deteriorated over the last 4-5 quarters, dragged by weak core operating margins as well as declining contributions from JV/ associates. In its recently released 1QFY16 (Mar FYE) results, net profit was down 23% y-o-y to S$41.3m. 1QFY16 operating margin of 7.5% was lower than the 8-9% range reported in the last two quarters, thus maintaining a negative trend. Higher costs of operations, due to high staff costs and sub-contract costs and slowdown in heavy maintenance activities for its widebody aircraft clientele were the key reasons for the weak performance.

Quarterly earnings and operating margin trend

Source: Company, DBS Bank Engine shops continue to stutter. SIE’s engine centres – Eagle Services and SAESL, which contribute the bulk of JV/ associate profits – saw profit contribution slip by 41% y-o-y from c.S$19m in 1QFY15 to c.S$11m in 1QFY16. SIE’s engine centres continue to be dragged down by the structural trend of older engine models being retired on an accelerated basis and newer models requiring less engine shop visits, thus lowering utilisation rates. Associate/ JV contributions

Source: Company, DBS Bank

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Sea of Change

Consolidation in the Singapore MRO industry may be

one way to address these challenges

Given the structural challenges, how does Singapore maintain leadership position in the MRO space? In the following pages, we examine the potential of consolidation in the Singapore MRO space, specifically the rationale, benefits and risks of a merger between the two key players – ST Engineering and SIA Engineering. We examine various scenarios and conclude whether SIA Engineering, in particular, is a beneficiary of the M&A theme. The key rationale of a merger scenario can be worked out as: 1) Keeping pace with consolidation trend and positioning

itself firmly as the world’s largest airframe MRO provider

2) Benefiting from increased scale and service breadth 3) Cost synergies

Opportunity to re-establish as clear leader. The aerospace industry in Singapore is an important cluster. Backed by a large pool of over 100 aerospace companies, Singapore has garnered about a quarter of the Asian MRO market. As the most comprehensive aerospace MRO hub in Asia, it has close to 6% of the global MRO market. Under such circumstances, key players like ST Aerospace (wholly-owned subsidiary of ST Engineering) will be encouraged to maintain their leadership positions. Any potential decline in market share of ST Engineering and SIA Engineering will not be beneficial to the city state’s fortunes as

i) Singapore needs to retain its aviation hub status in Asia;

ii) Changi Airport needs to maintain service excellence, which depends on line maintenance activities provided by both SIE and STE; and

iii) aviation is closely linked to the tourism industry in Singapore, which is a significant growth driver.

HAECO-TIMCO merger has lighted the path. In late 2013, TIMCO – a leading MRO services provider in the US – was acquired by HK-based MRO provider HAECO for approximately US$389m, to create the second largest MRO provider globally by airframe man-hours, just behing ST Aerospace. HAECO has facilities in Hong Kong, China and Singapore and the addition of TIMCO gave HAECO entry into the North American market and broadened the set of capabilities offered by the integrated entity.

ST Aerospace can retain its position as world’s largest third-party MRO provider, while benefiting from SIA Engineering’s premium branding. ST Aerospace has grown to become the largest independent MRO provider in the world, with capabilities across military and commercial aircraft, and global presence with hangars in Singapore, US and China. Currently, it has 28 widebody and 39 narrowbody hangars. SIA Engineering, though smaller in scale, brings a full spectrum of MRO services and caters to a wider audience of widebody fleet operators globally, with expertise in the latest fleet types. With HAECO-TIMCO now breathing down ST Aerospace’s neck in terms of capacity, these two Singapore companies can benefit from an expanded scale via a merger. In terms of numbers, the combined entity would have revenues of close to S$3.2bn and net earnings of S$400m, compared to HAECO’s revenue of about S$2.2bn and earnings of about S$100m in FY14. Ranking of airframe MRO providers by man-hours

Rank

2014 3rd Party Airframe Hours

(millions)

2015 Total Airframe Hours

(millions)

1 ST Aerospace 12.0 12.0

2 HAECO 9.4 11.7

3 AAR 4.9 4.9

4 SIA Engineering N/A 4.2

5 AFI KLM E&M 0.7 3.6

6 Lufthansa Technic N/A 3.0

Source: AviationWeek, DBS Bank The merged entity can offer an expanded range of services to a broader range of customers. SIA Engineering derives 40% of its revenues from line maintenance, a segment that ST Engineering has almost no exposure to. SIA Engineering also derives about half its profits from JV/ associates, largely engine MRO services. To compare, STE derives about 55% of revenues from heavy maintenance, 30% from component services and 15% from engine MRO. STE is a major player in the passenger to freighter conversions and modifications market, where SIE does not have a significant presence. The type of aircraft and engines served also vary widely for the two MRO providers. While there is some overlap in customers, it is natural to expect that the primary customer focus of the two MRO providers is different and they are not competing in the same categories. Hence, a merger scenario should be beneficial in enhancing the depth and breadth of offerings.


Sea of Change

Complementary service offerings of STE and SIE

ST Engineering SIA Engineering Heavy (airframe) maintenance - Locations Singapore, US, China Singapore, Philippines - Hangars 28 widebody, 39 narrowbody 9 bays in Singapore + 3 bays in Philippines - Key aircraft types B737 series, A320 series, A330, A340,

B747/757/767/777, DC10, MD10/11 B747, B777, A330, A380

Line maintenance No major exposure Major player in Singapore Changi Aiport JVs in HK, Indonesia, Philippines, USA,

Australia, Vietnam Engine maintenance Fully-owned engine centre in Singapore JVs with Rolls Royce, Pratt & Whitney - Main engine types CFM-56 series Rolls Royce Trent 500, 700, 800, 900

P&W JT8D, Rolls Royce Allison 501, GE J85, Honeywell T53/55, Turbomeca Makila

P&W JT9D/ PW400, IAE V2500, GE90-115B

- Locations Singapore, China Singapore, Hong Kong

Passenger to Freighter conversions

Leading provider, capabilities in B757/767, A330 conversions

Capability in B747 P2F conversions

Source: Companies, DBS Bank estimates Share manpower resources and technical expertise to reduce costs. SIA Engineering boasts strong technical expertise and is usually ahead of the competition in maintaining the newest and large aircraft, a benefit from servicing SIA’s fleet. As SIA owns a fleet of new-generation aircraft, SIA Engineering has the distinct advantage of acquiring the latest aviation technology from training programmes and technology transfer provided by Boeing and Airbus. For example, it was the first to conduct heavy checks on A380 aircraft. While SIA Engineering was among the first in the world to have B747-400 passenger to freighter (PTF) conversion capabilities, STE is a Boeing-certified conversion centre for MD-11, B767-300 aircraft and has delivered proprietary engineering packages (STC) for B757-200. STE is also developing A330 P2F in partnership with Airbus. The two companies would also benefit from sharing of engineers and technicians, which form the bulk of their highly skilled workforce. A merger would eliminate

competition for scarce resources amid tight labour conditions and help manage wage rises. A surplus of skilled workforce at SIA Engineering resulting from longer maintenance intervals of new aircraft could be utilised at STE’s hangars as they would also be trained in older aircraft. Given that engineers need extensive multi-year training to be certified and licensed for a particular aircraft type, access to a highly trained workforce will also reduce the need for STE to invest heavily in building up expertise for some of the new aircraft types.

Savings can also be realised from overheads and administrative expenses. Overheads (excluding sub-contract costs) account for about 15% of sales for SIA Engineering, while SG&A expenses were roughly 7% of sales for ST Engineering. Total overheads for the two outfits together are roughly around S$300m per year. Realising cost savings of say S$50m, would represent a significant proportion of the estimated combined profits of S$400m.


Sea of Change

Personnel data for SIA Engineering

SIA Engineering 2010 2011 2012 2013 2014

Revenue (S$m) 1,106.9 1,169.9 1,146.7 1,178.2 1,120.6

Staff Costs (S$m) 452.9 471.2 498.2 508.4 476.7

# employees 6,152 6,149 6,272 6,405 6,315

Revenue per employee (S$) 179,925 190,259 182,828 183,950 177,451

Cost per employee (S$) 73,618 76,630 79,432 79,375 75,487

Value added per employee (S$)

126,450 130,619 132,346 131,085 114,841

Note: FYE March Source: Company, DBS Bank estimates Personnel data for ST Aerospace

ST Aerospace 2010 2011 2012 2013 2014

Revenue (S$m) 1,871.0 1,920.0 2,019.0 2,079.0 2,061

Staff Costs (S$m) 591.2 608.3 657.4 648.1 607.3

# employees 7,323 7,303 7,307 7,370 7,314

Revenue per employee (S$) 255,496 262,906 276,310 282,090 281,788

Cost per employee (S$) 80,732 83,295 89,974 87,939 83,031

Value added per employee (S$) 127,681 131,341 141,249 140,499 133,384

Source: Company, DBS Bank estimates So what could the merger scenarios look like?

In the case that SIA and/ or its principal shareholder Temasek (who is also the main shareholder of ST Engineering) decides to pursue value-accretive strategies for SIA Engineering amidst the structural changes in the MRO landscape, we come up with three scenarios of how the transaction could be structured:

iv) ST Engineering buys out 100% of SIA Engineering in an either an all-cash deal or cash + stock deal

v) SIA decides to retain majority control over SIA Engineering and divests part of its shareholding to ST Engineering in a move aimed at increasing co-operative strategy between the two MROs

vi) The two companies merge in an all share deal Let us consider these scenarios and the expected accretion to the parties involved (no synergies assumed at this stage): Scenario 1: Direct takeover of SIA Engineering by ST Engineering. At current prices, SIA Engineering is valued at roughly S$4bn by the market. Assuming an acquisition premium of about 10%, ST Engineering would need to cough up about S$4.4bn to acquire 100% shareholding in SIE. STE would need to invoke a general offer for the rest of the shares once it agrees to acquire SIA’s c.80% shareholding in SIE.

All cash deal. While STE will require close to S$4bn of funding to close the deal in this case, we believe its AAA-credit could come in handy. In any case, even a AA-credit rating would not hinder STE’s ability to tap the financial markets. An all-cash transaction would be ROE-accretive and EPS-accretive to STE, but gearing would increase to 1.62x, and STE will incur additional almost S$120m of interest expenses, which may not be an ideal situation. Part cash, part share deal. In this scenario, we assume STE needs to maintain gearing at around 1.0x post acquisition, and hence, will need to issue around US$600m worth of new shares to SIA Engineering, with the remaining in cash. ROE would be maintained but EPS accretion will be a more modest 9% compared to the all-cash situation. If STE decides to go down any of these routes or any other suitable combinations of cash and shares, we believe it will be making optimal use of its balance sheet, which remains under-levered in our opinion, owing to the lack of decent investment opportunities.


Sea of Change

How scenario 1 would look like – all cash option

SIA Engineering market cap (S$m) 3,965 Acquisition premium 10% Acquisition price paid by STE (S$m) 4,362

Funded by: Cash (S$m) 562 Debt (S$m) 3,800

Impact to STE Net gearing pre transaction Net cash Net gearing post transaction 1.62x

ROE pre-transaction 26% ROE post-transaction 29%

EPS pre-transaction (S$) 0.181 EPS post-transaction (S$) 0.202 EPS accretion 12%

Source: DBS Bank estimates How scenario 1 would look like – cash + share option

SIA Engineering market cap (S$m) 3,965 Acquisition premium 10% Acquisition price paid by STE (S$m) 4,362

Funded by: Cash (S$m) 562 Debt (S$m) 3,200 New shares (S$m) 600

STE share price (S$) 3.28 STE existing share cap 3,110

No of shares in STE to be issued to SIE 183

STE share cap post-acquisition 3,293 SIA stake in enlarged STE 4%




Source: DBS Bank estimates

Scenario 2: Partial divestment of SIE stake by SIA to ST Engineering. SIA management has usually maintained the stance that SIA Engineering – unlike SATS, which it divested through distribution-in-specie a few years ago – is part of its core operations and SIA would not prefer to lose control over the MRO outfit owing to the oversight it allows over the airline’s reliability, safety and punctuality. If such a stance is maintained, a complete divestment to “third party” operator like ST Aerospace could be difficult. However, SIA could still consider enhancing co-operation with STE through a partial divestment of stake. If SIA retains 51% majority control in SIE, it can choose to divest about 29% stake to STE. STE will thus enjoy associate contributions from SIE following the transaction. In such a scenario, STE will have to arrange for lesser financing and will end up with a much more conservative gearing than previous scenario – of around 0.25x. ROE and EPS accretion still occurs, though to a more muted extent. We do not expect any control premium to be paid in this case though by STE. While this scenario does have benefits to both STE and SIE, it remains to be seen whether any revenue and cost synergies would materialise effectively in such a scenario without direct merger or takeover. How scenario 2 would look like

SIA Engineering market cap (S$m) 3,965 % divested by SIA 29% Acquisition price paid by STE (S$m) 1,150




Source: DBS Bank estimates Scenario 3: Merger with share swap. We consider this the most unlikely scenario for STE to pursue as it would be EPS and ROE dilutive in the near term, while there is no improvement in balance sheet utilisation. Given that SIE is currently trading at a higher PE ratio of close to 25x forward earnings, compared to STE at 20x, a share swap merger would be unfavourable to STE shareholders. SIA stands to gain, of course, in this scenario, as it ends up having a 22% stake in a diversified conglomerate with arguably more stable earnings profile than a pure-play MRO provider. This situation is only beneficial to both sets of shareholders if there are immediate synergies of S$50m or more to be reaped from the merger.


Sea of Change

How scenario 3 would look like

STE share price 3.28 No of shares 3,110 STE market cap (S$m) 10,201

SIE market cap (S$m) 3,964

No of shares in STE to be issued to SIE 1,209

Total no of shares in STE post merger 4,319 SIA stake in enlarged STE 22%

Combined market cap post merger (S$m) 14,165

Impact to STE Net gearing pre transaction Net cash Net gearing post transaction Net cash


EPS pre-transaction (S$) 0.181 EPS post-transaction (S$) 0.174 EPS accretion -4%

Source: DBS Bank estimates In conclusion, the best scenario for a merger situation would be for STE to finance a full or partial takeover of SIE through a combination of cash and shares. The critical criteria for STE should be to: i) ensure effective use of currently under-levered balance sheet, ii) enhance EPS and improve ROE, iii) reap merger synergies. On the other hand, SIA, as the major shareholder of SIE, could consider :i) ensuring SIA Engineering continues to thrive in collaboration with STE to keep Singapore at the forefront of airline MRO, ii) retaining some degree of control over SIE and iii) ensuring payout is favourable in terms of its own shareholder returns. One last thought – will SIA Engineering be privatised by SIA? The under-performance of SIA Engineering stock also opens the door for another possibility in our view. SIA currently has close to 80% stake in its MRO unit, and the benefits of keeping SIA Engineering listed is not entirely apparent, given the low liquidity of the stock and the fact that SIE does not really need to tap the equity capital markets for financing as it is a cash rich company, and has not had any significant acquisition track record. However, the listed status does provide SIA Engineering an aura of independence. It can be argued that it is important for SIA Engineering to retain the perception of being an independent MRO provider as it has to bid for work from other airlines in addition to parent airline jobs. Roughly 35% of SIE’s revenue is driven by non-SIA customers. But the question remains how independent the market perceives it to be currently anyway

and whether it continues to wins work despite its parent airline affiliation owing to its superior capabilities and facilities. Pros and cons of SIA Engineering’s listed status

Pros Perception of independence from parent airline group important to win 3rd party MRO work

Retains ability to tap markets for future investments needed to survive in changing MRO landscape

Cons Low free float and low trading liquidity Separate Board of Directors but 3 of 10

members from parent; shares same Chairman as parent SIA

Absence of capital market transactions since listing

Have to incur listing related costs Loss of dividends to minority shareholders

Source: DBS Bank estimates Buying out the minority shareholders in SIE would be ROE and earnings accretive to SIA. Based on current market prices and applying a 10% premium, SIA would need S$881m to buy out minority shareholders – not a very big dent to its c.S$4bn cash hoard. In addition to ROE and EPS accretion as shown below, SIA would also be able to keep 100% of cash generated at SIE to itself. SIA gains from SIE privatisation

SIA Engineering market cap (S$m) 3965 % free float 20% Acquisition premium 10% Acquisition price to be paid by SIA (S$m) 881

Impact to SIA Net gearing pre transaction Net cash Net gearing post transaction Net cash

ROE pre-transaction 4.7% ROE post-transaction 4.9%


Source: DBS Bank estimates


Sea of Change

We maintain our BUY call on ST Engineering. Fundamentally, ST Engineering’s orderbook of S$12.2bn as of end 1Q15 provides good visibility on revenues and underpins our projection of steady c.6% growth in earnings over FY15/16. Order wins by Aerospace and Electronics divisions in 2Q15 have been encouraging. Targeted investments in Aerospace division provide further upside in medium term. Most importantly, we believe STE’s M&A potential remains untapped. The Group sits on a very healthy balance sheet with a cash hoard of more than S$500m. We believe it should make use its balance sheet more efficiently to target ROE and EPS accretive acquisitions. As discussed, an attempt to boost its leadership position in the airframe MRO market by merging with compatriot SIA Engineering should be beneficial to both, and yield substantial synergies. Maintain BUY with a target price of S$3.80.

Upgrade SIA Engineering to HOLD. Operationally, SIE continues to face challenges owing to the structural issues discussed earlier. However, given the steep 26% fall in SIE’s share price since our downgrade last November, we believe downside is limited at these levels. In order to tackle some of the structural issues, we continue to believe in the merits of a combination of SIA Engineering and ST Aerospace to better consolidate Singapore’s credentials as an aviation hub as synergies are realised in the form of bigger scale, cost efficiencies and breadth of offerings. Upgrade SIE to HOLD on the back of decent dividend yields (>4%) and potential M&A activity, as discussed above. Our TP of S$3.70 is based on a blended valuation framework (PE, dividend yield and DCF) to factor in both earnings growth and the cash-generative nature of the business.

SIA Engineering’s share price performance relative to broad STI Index since 2014

Source: Bloomberg Finance L.P., DBS Bank

60

70

80

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120

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14

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14

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SIE STI


Sea of Change

CONTAINER SHIPPING

Any light at the end of the tunnel?

Market has not been great for a while now. Container shipping volumes grew at close to double digit levels in the two decades leading into 2008, before the financial crisis. Since 2010 however, the demand-supply gap has been almost consistently unfavourable as structural changes in demand coincided with a glut of ultra large containership orders. Container demand growth has slowed as a result of a slowdown in global growth patterns, especially in developed countries of Europe and the US as well as flattening out of trends like containerisation and outsourced manufacturing. Thus, the new normal in container demand growth is closer to 4-5% per year, with intra-regional trade driving most of the growth. The main lanes of Asia-Europe and Asia-US are expanding more slowly, with Asia-Europe volumes showing negative trend in 2015 so far. Fleet growth will continue to outstrip demand growth. Containership fleet currently stands at around 19.4m TEUs and is expected to expand to around 20.0m TEUs by end-2015, 21.0 TEUs by end-2016 and 21.7m TEUs by end-2017, according to Alphaliner estimates. This takes into account a certain degree of slippage and scrapping. This implies containership fleet growth of about 8.8% in 2015, and 5.1% in 2016, and 3.5% in 2017. Average growth in fleet over this 3-year period is estimated at around 6% per year, if no further orders are taken into account. Fleet growth projections from Aplhaliner

Capacity (TEUs) as at 2015F 2016F 2017F

Starting 18.3 20.0 21.0

New deliveries 1.9 1.2 1.0

Slippage/ scrapping -0.1 0.1 0.0

Scrapping -0.2 -0.3 -0.3

End-year total 20.0 21.0 21.7

Growth 8.8% 5.1% 3.5%

Source: Alphaliner, DBS Bank Mega vessels will account for a large chunk of this growth. The more worrisome aspect of this new supply is the skew towards ultra large container ships above 13,000 TEUs, and in particular, vessels above 18,000 TEUs – which can only find gainful employment on the Asia-Europe route. And as we discussed earlier, the Asia-Europe route is probably the weakest in terms of demand fundamentals in the near to medium term.

Mega containerships of >13,000 TEUs make up more

than half of overall containership orderbook

Source: Alphaliner, DBS Bank

Fleet to orderbook ratio of ultra large containerships

looks imposing

Containership Size Existing Orderbook % of existing

<10,000 TEU

15,141,568

1,236,585 8%

10,000 - 13,000 TEU

2,082,356

568,240 27%

13,000 - 18,000 TEU

1,326,060

816,128 62%

18,000 - 20,000 TEU

482,268

1,199,330 249%

Total

19,032,252

3,820,283 20%

Source: Alphaliner, DBS Bank The race for the biggest continues even today. Maersk Line has for long been the pioneer in upping the game as far as containership sizes are concerned and it is no surprise that it now operates 20 of these ultra large container vessels – the 18,000 TEU Triple-E Class, having placed orders back in 2011. In 2013, four other liners followed suit, including the second and third largest liner companies, MSC and CMA CGM respectively. In 2015, some of the smaller Asian companies took the plunge too, with Japanese carrier MOL, Chinese carrier OOCL and the conservative Korean container carrier Evergreen lining up for ship sizes of up to 20,000 TEUs or more.

<10,000 TEU

32.4%

10,000 -13,000

TEU14.9%

13,000 -18,000

TEU21.4%

18,000 -20,000

TEU31.4%


Sea of Change

New orders are not really slowing down. The industry saw very few orders in 2010 and 2012, as freight rates were weak in previous periods. But, since 2013, orders have been sustained at above the 1.0m TEU mark per year despite the relatively poor freight rate environment, as liners sought to cut costs by investing in scale. Quarterly new containership orders trend – new orders

have already crossed 1.0m TEU mark YTD in 2015

Source: Clarkson Research, DBS Bank Thus, freight rates are not likely to show a strong positive swing anytime soon. Industry freight rates, especially on the main lanes – Asia-Europe and Asia-US – continue to see high volatility since the last highs in 2012, as the supply-demand situation is still not favourable. General rate increases (GRIs) have become more frequent and the quantums higher, but these rate increases have not stuck beyond a few weeks owing to the influx of capacity and pricing wars to retain market share. 2015 could turn out to be one of the worst years for freight rates, as savings from lower oil prices have been more than passed on to customers through removal of surcharges. The spot container freight rate index SCFI is currently hovering close to multi-year lows, as can be seen below. The SCFI remained volatile in 2014

Source: Clarkson Research, DBS Bank

Asia – Europe routes the worst hit owing to oversupply

Source: Clarkson Research, DBS Bank US trade lane faring better than Europe, but not by much. Asia-US Transpacific cargo has been growing at around 2-3% p.a., better than the Europe lane. Carriers in the Transpacific Stabilization Agreement have recommended minimum rates for trade lanes between US West Coast and East Coast from all North Asia ports this year. But spot rates have not been spared from the recent carnage. Asia - US freight rates

Source: Clarkson Research, DBS Bank Even the decline in fuel prices has not helped. Crude oil prices have fallen more than 50% from Sep-14 levels, and in turn, bunker fuel prices are averging around US$350/ mT in 2015, down from US$650/ mT in 2014. This resulted in some short-lived margin boost in 1Q15, but liners have given back all the gains in form of lower freight rates. Therefore, the benefits of lower oil prices are unlikely to be visible on margins from 2Q15 onwards.

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11

Jan/

12

May

/12

Sep/

12

Jan/

13

Ma y

/13

Sep/

13

Jan/

14

Ma y

/14

Sep/

14

Jan/

15

May

/15

S hanghai Containerized Freight Index

0

500

1,000

1,500

2,000

2,500

Oct

/09

Feb/

10Ju

n/10

Oct

/10

Feb/

11Ju

n/11

Oct

/11

Feb/

12Ju

n/12

Oct

/12

Feb/

13Ju

n/13

Oct

/13

Feb/

14Ju

n/14

Oct

/14

Feb/

15Ju

n/15

Europe Med

-

1,000

2,000

3,000

4,000

5,000

Oct

-09

Jan-

10A

pr-1

0Ju

l-10

Oct

-10

Jan-

11A

pr-1

1Ju

l-11

Oct

-11

Jan-

12A

pr-1

2Ju

l-12

Oct

-12

Jan-

13A

pr-1

3Ju

l-13

Oct

-13

Jan-

14A

pr-1

4Ju

l-14

Oct

-14

Jan-

15A

pr-1

5Ju

l-15

USEC USWC


Sea of Change

Price trend for Brent, Jet Fuel and Bunker since 2006

Source: Bloomberg Finance L.P., DBS Bank Also, the oil price decline is not just supply led. While market attention has been overwhelmingly centred on the increase in the supply of crude oil, especially from US shale production, part of the oil price decline has been also caused by falling demand growth. While oil price decline is good news for

container shipping operators, a decline in demand for oil is not so, as it seems to indicate falling economic activity, especially in European countries, which led the decline in demand for oil in 2014, along with Japan. Industry profitability has been very weak since 2011. As a result of the volatile and weak freight rates, and wide differences in slot costs between the more efficient players and the less efficient ones, industry profitability has been lacking since 2011. As can be seen from the chart below, the average operating margin for 15 of the main liner companies was negative in 10 of the last 16 quarters, and the trend towards slightly better numbers in recent quarters has been due to the fact that more of the cost-efficient larger ships have hit the waters in recent times, and cushioned the impact of low freight rates. Even in periods where margins were positive, it has been nothing to write home about, and returns on capital do not make for good reading. In such a scenario, we believe scale and cost efficiencies through consolidation may be the only way out for the industry.

Average operating margin of 15 main liners by quarter (2009-14)

Source: Alphaliner

0

50

100

150

200

250

Jan-

09

Jul-0

9

Jan-

10

Jul-1

0

Jan-

11

Jul-1

1

Jan-

12

Jul-1

2

Jan-

13

Jul-1

3

Jan-

14

Jul-1

4

Jan-

15

Jul-1

5

Bunker Fuel Price Brent Crude Oil Price

Base 100 at Jan 2009


Sea of Change

NOL and the case for consolidation

NOL has lagged the industry in terms of profitability. With its legacy positioning as a premier operator, especially on the Transpacific lane, with complementary logistics services, NOL has had a high fixed cost base. However, in recent years, NOL has not benefited in terms of pricing for the high reliability of these premium services and hence, margins have suffered as industry freight rates tumbled.

Having a high proportion of chartered-in fleet also turned out to be negative. Back in the good days of 2006-07, and even up to 2011, NOL had a fleet mix comprising more than 70% chartered-in ships. This asset-light strategy allowed NOL to earn good returns during the market upturn, but it meant that it was stuck with expensive chartered-in ships when freight rates sank from 2011 onwards.

NOL (APL) comes in close to the bottom of the pile in terms of operating margins in recent years

Source: Alphaliner

NOL has been losing market share in a bid to reverse this high cost base. Over the last three years, NOL has added 34 new vessels to its fleet, with sizes in the range of 8,000 – 14,000 TEU. But it has also returned more capacity to lessors to control costs, as these expensive charters were mostly struck at the height of the container shipping boom in 2006-07. At the end of 2011, NOL’s fleet capacity was around 610,000 TEU. Today, after almost 4 years and 34 newbuildings, it stands at around 560,000 TEU, or a reduction of almost 10%. Owned vessels now constitute 70% of fleet. NOL is one of the few liners that has shed market share over the last 5 years. From being the 4th largest liner company in the world in 2010 (and 7th at the end of 2011 as seen alongside), it is now outside the top 10 of the league table of the world’s largest liners. Its market share has slipped from 4% at end-2011 to less than 3% now. With the loss of market share, NOL has also been losing pricing power in its strongholds like the Transpacific route.

Container shipping operators – ranking by market share

Liner As of end-2011 As of Aug-2015

Rank Mkt share Rank Mkt share

Maersk 1 16.5% 1 15.9%

MSC 2 13.6% 2 13.7%

CMA –CGM 3 8.9% 3 9.2%

COSCON 4 4.2% 6 4.4%

Hapag-Lloyd 5 4.2% 4 5.0%

Evergreen 6 4.1% 5 4.9%

APL 7 4.0% 12 2.9%

CSCL 8 3.5% 7 3.6%

Hanjin 9 3.2% 8 3.2%

MOL 10 2.9% 10 3.0%

OOCL 11 2.7% 11 3.0%

NYK Line 12 2.7% 14 2.6%

Hamburg Sud 13 2.7% 9 3.2%

Source: Alphaliner


Sea of Change

NOL is also one of the very few liners without any orderbook. Since NOL placed its last batch of newbuild orders back in 2010-11, it has been straddled by continuous losses, and an ever stretched balance sheet as it funded the deliveries of these new ships right up to 2014. After four consecutive years of losses from 2011-14, NOL ended 2014 with a net gearing ratio of 2.3x, which effectively tied management’s hands as far as contemplating further newbuild orders, to match the pace with the rest of the industry. As a result, NOL does not have any orderbook for newbuilds, and is the only liner within the top 15 without a pipeline. Even though its balance sheet has improved post the divestment of the logistics business, management has not divulged plans of any capex. Hence, it can be argued that NOL is lagging behind in the so called “arms race” of bigger and bigger containerships, which promise higher efficiencies and better margins even in the face of weak freight rates.

Losses and existing capex commitments led to weak

balance sheet by end-FY14


Container shipping sector – top 20 operators by capacity

Source: Alphaliner Most of the top carriers have ordered the 18,000+ TUE behemoths. The investment cost for these ships have fallen significantly over the last 2 years, with 18,000-TEU vessels now costing between US$135m and US$150m, down from US$170m that Maersk paid when it pioneered the trend back in 2011. This has seen more liners jumping onto the bandwagon. The latest to join the ordering spree are NOL’s G6 alliance partners MOL and OOCL. When these ships are delivered between 2015 and 2017, rates could be subject to more pressure and liners like NOL without the advantage of these mega vessels may struggle to remain in the black.

Liners in the elite club of 18,000+ TEU ships

Liner No of orders Size

Ordered in

Scheduled delivery

Maersk 20 18,000 2011 2013-15

CSCL 5 19,000 2013 2014-15

UASC 6 18,800 2013 2014-15

MSC 20 19,000 2013 2015-16

CMA CGM 6 18,000 2013 2015-16

Evergreen 11 18,000 2015 2018-19

MOL 6 20,100 2015 2017

OOCL 6 21,100 2015 2017

Source: Companies, DBS Bank

0.00

0.50

1.00

1.50

2.00

2.50

(600.0)

(500.0)

(400.0)

(300.0)

(200.0)

(100.0)

0.011 12 13 14

Core Net Profit (US$m)(LHS) Net Gearing (x)(RHS)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

APM

-Mae

rsk

MSC

CM

A C

GM

Hap

ag-L

loyd

Ever

gree

n Li

ne

CO

SCO

N

CSC

L

Han

jin S

hipp

ing

Ham

burg

Süd

MO

L

OO

CL

APL

Yan

g M

ing

NY

K L

ine

UA

SC

K L

ine PIL

Hyu

ndai

M.M

.

Zim

Wan

Hai

Lin

es

million TEUs Existing capacity On order


Sea of Change

This thus creates enough incentives for NOL to consider being acquired or merged. As evident from the discussion so far, NOL could find itself in a position of lesser and lesser prominence in the global liner space, and may also find it hard to achieve consistent profitability amid a muted industry outlook. Consolidation may be beneficial to both parties in

our opinion, as we list down the key rationale for any deal below. According to Wall Street Journal in July 2015, Temasek is reportedly looking to divest NOL.

Rationale for consolidation with another liner

Why NOL will find it increasingly tough to stand alone

Low market share NOL has slipped down the league table of top liner operators owing to its recent strategy of sacrificing

volumes in favour of profitability. While beneficial in the short term, long term relevance in terms of

industry presence could diminish.

Lesser bargaining power Smaller fleet does not give NOL better pricing power with suppliers such as bunker fuel and port

operators and other land based costs

Financial bandwidth Balance sheet has improved post divestment of APL Logistics. Net gearing has fallen to c. 1.0x, which is

still reasonable but not a fully comfortable level. As a pure play liner with higher exposure to freight

volatility, costs of funds may increase.

Growth opportunities Without any orderbook, NOL will risk losing further market share in future and any upcycle

Cost controls Without progressing to bigger ships, NOL may find it difficult to cut costs further and could be at the

receiving end of further structural decline in freight rates

Benefits for acquirer/ merging entity

Cost efficiencies – fixed Lower SG&A expenses through sharing of office space and reduction in overheads. Most liner companies

tend to have significant presence in Singapore as the port is the second busiest in the world.

Cost efficiencies – variable Can lead to better network planning, and greater bargaining power when dealing with suppliers such as

bunker fuel and port operators and other land side costs

Better global presence/

complementary trade routes

NOL has been a key player on the Asia-US route and also provides close connectivity to its erstwhile

logistics arm, which has a strong legacy presence in the US. NOL also has significant presence in Intra-Asia

and is thus, a good fit for European operators.

Financial synergies Access to NOL’s bankers and banking relationships as a government-related entity. Debt capacity of the

combined firm could improve. Absorbing NOL’s losses could provide some tax savings as well.

Bigger scale and market cap The combined entity could leapfrog to the Top 5 container liner category; bring more visibility and

bargaining power. If listed, bigger market cap will be beneficial to liquidity and investor coverage.

Source: DBS Bank Big mergers are rare in the container-shipping industry. The industry is dominated by family-owned businesses and sovereign-wealth funds, who do not want to give up control and are also typically better equipped to endure years of losses during long down cycles without going bankrupt.

2014-15 saw the first major consolidation attempt since 2005, when APM-Maersk acquired P&O Nedlloyd and Hapag-Lloyd acquired CP Ships. In 2014-15, there were two significant deals in the market – both German carriers acquiring Chilean players – a clear case of achieving scale and global reach through complementary trade routes


Sea of Change

Container shipping sector – industry consolidation trends since 1997

Date Acquirer Acquirer nationality Target Target nationality

1997 Hanjin Shipping Korea DSR-Senator Linie Germany

1997 Neptune Orient Lines Singapore American President Lines USA

1998 CMA CGM France Australian National Lines Australia

1999 Maersk Denmark Sealand USA

1999 Maersk-Sealand Denmark Safmarine Container Lines South Africa

2003 Hamburg Sud Germany Kien Hung Taiwan

2005 Maersk-Sealand Denmark P&O Nedlloyd Dutch-British

2005 Hapag Lloyd Germany CP Ships Canada

2005 Hamburg Sud Germany Ybarra Sud Spain

2005 CMA CGM France Delmas France

2007 Hamburg Sud Germany Costa Container Lines Italy

2014 Hamburg Sud Germany CCNI Chile

2015 Hapag Lloyd Germany CSAV Chile

Unsuccessful/ rumoured bids

2006 CMA CGM France Wan Hai Korea

2008 Neptune Orient Lines Singapore Hapag Lloyd Germany

Source: Companies, DBS Bank Case study – how the Hapag-Lloyd CSAV merger propelled the merged entity onto greater heights

Existing Hapag Lloyd +

CSAV = New Hapag LLoyd

Revenue (US$ bn) ~8.8 ~3.2 ~12.0

Container Volumes (m TEUs) ~5.5 ~2.0 ~7.5

Vessels ~147 ~44 ~191

Fleet capacity (TEU) ~775,000 ~265,000 ~1 million

Rank 6th 20th 4th largest

Note: 2013 financials Source: Companies, Alphaliner, DBS Bank estimates The merger of Hapag-Lloyd with the container business of Chilean shipper CSAV, is expected to result in annual savings of at least US$300m. The merged company will have around 200 vessels with a total capacity of approximately 1m TEUs, transporting some 7.5m TEUs every year and will set up its fourth regional headquarters in Valparaiso. With revenue of around US$12bn, the combined entity joins an elite group of international shipping companies and is also propelled to the spot of the 4th largest liner company in the world.

Merger of Chinese shipping companies on the cards? Chinese state media had reported earlier in 2015 that the government was planning to consolidate the operations of state-owned shipping giants including China COSCO, CSCL, Sinotrans and China Merchants. This sent the shares of the liner companies soaring on a few occasions, but so far China COSCO and CSCL have denied these rumours and chances are remote that they would voluntarily merge, given the potential job losses involved.


Sea of Change

Fundamentally, things are just starting to look up a bit for NOL. NOL reported better than expected results for 2Q15, with core net profit of US$3m, excluding US$887m of disposal gains from the divestment of APL Logistics. Stripping out the contribution from discontinued logistics operations, the liner division posted a net loss of about US$11m in 2Q15, which was better than our expectations and also an improvement over the US$36m net loss recorded in 1Q15. Liner core EBITDA margin of 8.3% in 2Q15 was the best in several quarters. This was despite a further 6% q-o-q drop in average freight rates, led by a steep fall on the Asia-Europe lane.

Cost control was the key. Liner opex fell to US$2,242 per FEU, down 6% q-o-q and 14% y-o-y. While the c.40% y-o-y drop in average bunker fuel prices was a factor, NOL was also able to record significant cost savings (around US$223m) in 2Q15 from better network planning, return of expensive charters and more targeted cargo selection strategy. In fact, the drop in bunker fuel prices was more than neutralised by removal of bunker surcharges and freight rate declines, and the actual improvement in profitability was driven by other cost efficiencies.

NOL’s liner business posted improvement in core EBITDA in 2Q15

Source: Companies, DBS Bank Valuations for NOL not reflecting this. NOL share price has been quite flattish YTD in 2015 and is down about 20% since the beginning of 2015. Even the disposal of the APL Logistics business at quite attractive valuations did not make a significant dent to sentiment. The improvement in core EBITDA in 2Q15 was also not fairly reflected in share price performance in our opinion. Currently, NOL is trading at about 0.7x P/BV, which is an attractive level compared to its mid-cycle valuation range of about 1.1-1.2x P/BV in the past. While the logistics unit was responsible for part of the valuation premium in the past, we believe NOL should trend towards the 0.9x P/BV range, which is the median valuation for peer group, as shown on the following page. With net gearing below 1x now, NOL does not compare unfavourably with peers on that count as well.

NOL’s P/B trading range


-0.7%

1.6%

4.6%

-0.9%

0.7%

3.6%

5.7%

3.9%

7.2%

8.3%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

-

500

1,000

1,500

2,000

2,500

1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15

Revenue (US$m) (LHS) EBITDA (US$m) (RHS)

-

0.5

1.0

1.5

2.0

2.5

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

Jan-

15

(x)

+1sd: 1.3x

+2sd: 1.7x

-2sd: 0.3x

Avg: 1x

--1sd: 0.6x


Sea of Change

Share price performance of SG/HK container liner stocks – NOL has been the worst performer since 2014

Source: Bloomberg Finance L.P., DBS Bank Trading at just 0.6x P/B, NOL presents an attractive case for potential M&A activities

Company Price

(Local $) Mkt Cap (US$b) FY15 P/E (x) FY16 P/E (x) P/B (x)

FY15 EV/EBITDA(x)

FY16 EV/EBITDA(x)

Est ROE (%)

Net debt/ equity (%)

Global liners AP Moeller Maersk 11490 35.9 9.3 8.3 1.0 4.4 3.9 N/A 17.8 CSAV 20.08 0.9 29.9 10.0 0.4 N/A N/A N/A 6.9

HK-listed container liners CSCL 2.48 10.7 26.1 16.4 0.9 29.0 24.2 N/A 59.4 OOIL 37.9 3.1 8.7 7.0 0.7 6.4 5.8 7.6 33.9 SITC 4.57 1.5 9.2 8.0 1.9 7.6 6.2 18.6 Cash

Other Asian container liners Hyundai Merchant 6160 1.1 N/A N/A 1.7 16.7 14.7 N/A 672.4 Evergreen Marine 15.2 1.7 13.5 10.8 0.8 9.1 7.8 N/A 96.8 Yang Ming 10.9 1.0 16.5 11.0 0.9 9.0 7.8 N/A 175.4 Hanjin Shipping 5010 1.0 20.7 10.5 1.3 9.6 8.8 N/A 745.2 Wan Hai Lines 24.6 1.7 8.7 9.0 1.5 5.3 5.2 N/A 19.1

Japanese carriers (multi-sector) Mitsui OSK Lines 380 3.7 10.5 8.8 0.6 12.4 11.3 N/A 117.9 NYK 342 4.7 10.9 9.7 0.7 7.8 7.3 N/A 88.1 KKK 269 2.0 10.4 8.4 0.6 5.6 5.2 N/A 63.0

Average 15.8 9.8 1.0 10.1 9.0 13.1 174.6

Median 13.5 9.3 0.9 8.3 7.5 13.1 75.5

NOL 0.90 1.7 115.7 46.8 0.6 8.3 6.8 0.4 110.0


60

80

100

120

140

160

180

200

220

240

260

Jan-

14

Feb-

14

Mar

-14

Apr

-14

May

-14

Jun-

14

Jul-1

4

Aug

-14

Sep-

14

Oct

-14

Nov

-14

Dec

-14

Jan-

15

Feb-

15

Mar

-15

Apr

-15

May

-15

Jun-

15

Jul-1

5

Aug

-15

NOL OOIL CSCL SITC


Sea of Change

SINGAPORE SHIPYARDS AND RIGBUILDERS Struggling at the deep end Depressed oil price adds fuel to fire. Even if oil prices rebound to US$70/bbl, order win momentum will likely lag, in view of the rig order backlog and keen competition, in our view. Lacklustre order momentum

Oil price correlation may break. Singapore rigbuilders' stock prices traditionally have had a strong correlation with oil prices, with a coefficient of 0.8-0.9x. Oil price is a leading indicator for order momentum, which is the key catalyst for rigbuilders’ stock performance. However, the correlation may not hold this time round. Rigbuilders could lag oil price recovery, given that order flow may remain slow as the market needs time to digest the massive supply coming onstream.

Huge order backlog... There are 195 drilling rigs under construction, for delivery in 2015-2018, representing book-to-bill of 22%. In particular, the orderbook-to-fleet ratio is higher for drillships at 30% due to a low base and long-term shift towards ultradeepwater <explorations?>, and 24% for jackups in anticipation of replacement demand as half of the fleet is >30 years old. Meanwhile, the ratio for semi-submersibles is more benign at 15%, partly because of the preference towards drillships. … but weaker demand outlook. Near-term demand for rigs took a turn for the worse since oil prices collapsed as oil majors push back capex and rig count heads south. Global E&P spending is expected to fall by around 20% this year with a greater cut in exploration activities.

Mobile rig deliveries, 1969 – 2018+

Source: Clarkson, DBS Bank

0

20

40

60

80

100

120

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

20

1120

1220

1320

1420

1520

1620

1720

18

No

. of

del

iver

s

Jackup Semisubmersibles Drillships


Sea of Change

US rig count showed signs of recovery, registering more increases than declines in recent weeks

Source: Baker Hughes, DBS Bank Downtrend in new orders since the big bang in 2012. There were only three jackup rig orders YTD, of which one was awarded to Lamprell yard in Middle East and two by a domestic player to a Chinese yard. New order trends for Singapore rigbuilders hit a peak of S$21bn in 2012, boosted by the Petrobras orders, and have been trending down since. This trend will be exacerbated by current headwinds, led by the sizeable global rig orderbook and the depressing low oil price outlook. Declining order wins for Singapore rigbuilders. We have trimmed our FY15 order win assumption for Singapore rigbuilders twice from S$9bn to S$5bn. This is lower than the 10-year average of S$9bn secured by Singapore rigbuilders, and close to the post-GFC levels of S$2.9bn/S$6.2bn in 2009/2010. Slower contract wins will lead to a declining orderbook in the next two years and affect earnings from 2H16 onwards. We expect new contracts to come from production platforms such as FPSOs, FLNG vessels, specialised vessels (for instance, pipelay vessels, semi-submersible accommodation vessels and semi-submersible crane vessels).

New orders heading south

Source: Companies, DBS Bank Estimates

4.4 5.1

10.7 10.4 12.8 11.5

2.9 6.3

13.6

21.0

11.1 9.2

5.0 7.0

0

20

40

60

80

100

120

0

5

10

15

20

25

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015F2016F

US$/bblS$ bn Annual order wins

Singapore Rigbuilders' order wins (LHS) Oil price (RHS)

-160

-140

-120

-100

-80

-60

-40

-20

0

20

40

60

0

500

1000

1500

2000

2500

04-Jan-08 02-Jan-09 01-Jan-10 31-Dec-10 30-Dec-11 28-Dec-12 27-Dec-13 26-Dec-14

U.S. rig count

Land Offshore w-o-w chg

Post GFC, US rig count fell 57% from the peak of 2031 on 12-Sept-2008 to a low of 876 over the course of 9 months

In the recent downturn, US rig count dropped 56% from 1929 on 21-Nov-2014 to 857 on 19-Jun-2015


Sea of Change

Orderbook of Singapore rigbuilders on a downtrend

Singapore rigbuilders S$ m Orderbook 23,900 Orderbook – Petrobras* 11,662 Orderbook - Other Rigbd & conversion* 12,238 Revenue (Rigbdg + Conversion) 12,877 Revenue – Petrobras* 3,337 Revenue - Others Rigbg & conversion* 9,540 Book to bill * 1.9x Book to bill (Excl Petrobras)* 1.3x

Source: Companies, *DBS Bank Estimates Asset prices going downhill

Softening utilisation rates and charter rates. The average utilisation for drilling rigs have declined to <80% since Apr-2015, from >90% a year ago. Semi-submersibles suffered the least, with only a 6-ppt drop, with utilisation still hovering above 90%, probably due to lesser supply pressure. Meanwhile, drillships and jackups saw greater declines of 10ppt/14ppt to 80%/75%. The average charter rates can be misleading because of the additions of newer and more advanced rigs to the fleet. We observe that charter rates for jackups and drillships of similar specs have fallen around 20-30%. Asset prices to follow suit. While there were no newbuild orders for drilling rigs YTD, our channel checks suggest that the secondhand market prices for newbuild rigs under construction has dropped by some 10-15%. However, we believe there is more to go. Market players are monitoring for opportunities to bargain hunt assets on fire sale from shipyards that are desperate to recoup construction costs for owner-initiated cancellations or asset liquidations by creditors of rig-owners that have gone belly up.

Petrobras scandal a can of worms…

Petrobras corruption scandal is dragging the Brazilian O&G sector, deferring exploration and well development (thus delaying rig deliveries and award of FPSO orders), resulting in funding issue of Sete Brasil, and closure of Brazilian O&G players. The Singapore rigbuilders were implicated as the agent/consultant appointed in Brazil were said to be involved in bribery, but both have refuted the allegations. The corruption investigations are ongoing in Brazil and may take awhile. This would create an overhang on Singapore rigbuilders’ share prices, given that Petrobras-related projects account for almost half of their current order backlogs. So, what’s the impact? The rigbuilders were supposed to receive monthly milestone payments but these have been suspended since Nov-2014 pending Sete Brasil’s project funding. We believe deliveries of the 13 rigs awarded to Singapore rigbuilders could be pushed back. In the worst case scenario, if Petrobras decides to cancel the rig contracts, the rigbuilders could suffer significant financial losses as these rigs had a price tag of over US$800m each, which is 30-40% higher than current market prices, adjusting for higher cost local content requirement. However, we believe this is unlikely to happen as Petrobras has already terminated the remaining 16 rig contracts with Brazilian yards, partly due to the yards’ incapability to deliver the rigs on time or meet their working capital requirements with delayed payments.

Orderbook set to decline on the back of lower order intakes 0

5,000

10,000

15,000

20,000

25,000

30,000

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

F

S $ m Outstanding orderbook of Singapore Rigbuilders

Boosted by S$14.2bn Petrobras orders in 2012

Ideal book-to-bill ratio would be 1.5-2.0x.


Sea of Change

What could drive the rigbuilding recovery?

Catalyst #1: Retirement of old rigs. After the rigbuilding boom in 1980s, the sector went through a 20-year gloom till 2005 when we entered a new era of high oil prices. Hence, half of the current rig fleet is >30 years old and would gradually be retired. We believe the reality of lower oil prices will accelerate the replacement cycle. Rig owners are retiring older rigs and making plans to cold stack others in an effort to reduce costs in the current market climate. In general, most future rig attrition can be identified from the existing fleet of cold-stacked rigs, although in some instances a rig owner may opt to retire a rig immediately after contract completion. In the past few months, Hercules Offshore, Diamond Offshore, Noble Corporation and ENSCO have cold stacked a combined total of eight jackups and four semisubs. On the retirement front, since 4Q14, Transocean (11) and Diamond Offshore (6) have scrapped 17 floating rigs. Most recently, Noble Corp. (3) and Atwood Oceanics (1) announced the retirement of four floating rigs. All were older, shallow and mid-water units that were either not likely to work for some time or they were going to require substantial capital expenditures to remain competitive. The pace of old rig attribution plays a critical role in restoring supply/demand equilibrium as the recent rigbuilding boom in 2012-2014 was fuelled by replacement demand. Catalyst #2: Cancellations at Chinese yards. Chinese yards benefitted most from the latest rigbuilding boom, raising their market share to a third of global orderbook of drilling rigs, from <10% previously. However, the

bulk of the orders came from new players or speculators who were lured by the attractive payment terms of 1:99 or 5:95 and easy financing. This makes the Chinese yards particularly vulnerable to contract cancellations in the current climate. The opportunistic and cash-rich players are monitoring the secondhand market for opportunities to acquire distressed assets. Buyer and sellers are in a price impasse. Based on our channel checks, the speculators who have yet to secure charter contracts for vessels delivering in 2015 have dropped prices by 10% or so, leaving themselves some margins to be made. From the buyers’ standpoint, they have the upper hand given the supply glut, and are expecting more downside. If speculators fail to flip the rig, they could forego the 1-5% downpayment and eventually walk away from the contract. But, before that, we believe there will be massive rescheduling at Chinese yards and eventually some cancellations. This will help to mitigate the supply pressure in the near term. The best scenarios will be cancellations of projects that have yet to start, which will “remove” supply completely. Catalyst #3: Sharp recovery in oil prices. A sharp rebound in oil price will incentivise investments into deepwater and ultra deepwater spaces and re-activate some of the higher-cost projects. As a result, it might raise demand for newbuild rigs especially drillships and harsh-environment jackups, and benefit Korean and Singapore rigbuilders. However, we do not think order win momentum could head towrds the 2012-2013 levels.


Sea of Change

ANY MORE ROOM FOR CONSOLIDATION? Singapore rigbuilders : survival of the fittest

The Singapore marine industry underwent a phase of consolidation to compete against lower cost and emerging countries. Prior to year 2000, the Singapore landscape was dotted with 5 major shipyards – Keppel FELS, Keppel Shipyard, Jurong Shipyard, Sembawang Shipyard, Hitachi Zosen. The downcycle in shiprepair industry during the 90s pushed these yards into consolidation. Keppel group privatized its shipyards – Keppel FELS and Keppel Singmarine and acquired Hitachi Zosen to form Keppel Offshore and

Marine. Sembawang Shipyard merged with Jurong Shipyard and S.M.O.E to form the current SembCorp Marine group. Both groups have survived the industry consolidation in the past few cycles since the 1960s. Keppel Corp (KepCorp), with its “Near Market, Near Customer” strategy, has established a global network of over 20 yards in the key O&G regions spanning Asia Pacific, Middle East, North Sea, Gulf of Mexico etc, through merger and acquisitions in most cases.

Keppel’s global expansion through M&A

Source: Company, DBS Bank Sembcorp Marine (SMM) has also adopted the globalisation approach, operating around 11 yards across Singapore,

Indonesia, China, India, US Gulf of Mexico, North Sea (UK sector) and Brazil.

SMM’s global expansion through M&A

Source: Company, DBS Bank Looking ahead, the marine industry will remain as a key sector in Singapore, leveraging on the existing good infrastructure and critical mass already built up by the shipyards and supporting companies. Nevertheless, Singapore players will

have to continuously find ways and means to stay competitive and sustain its positioning as a global hub for ship repair, ship conversion, offshore construction and specialised shipbuilding in the face of rising global competition.

1968: Inaugurationof Keppel Shipyard

Pte Ltd

1971: Expansion into Offshore via the acquisitionof 39% stake in listed Far East

Shipbuilding Ltd (renamed FELS in

1972)

1975: First Overseas

Venture; Set up Keppel

Philippines Shipyard in

partnership with Filipino investors

1976: Expansion into Marine via a cquisition of Singmarine Shipyard

1986: Incorporation of Keppel Corporation; Acquisition

of ex-Mitsubishi

Yard during the offshore

re cession

1990: Acquiring Yard in

GoM for US market

(renamed Keppel

AmFELS in 2004)

1991: Foray into the

Middle East with

acquisition of 20% stake in

Arab Heavy Industries

(now 33%)

1997: Set up Caspian

Shipyard in Baku,

Azerbaijan

1999: Consolidation of Marine

Operations with the acquisition of Hitachi Zosen (renamed to

Keppel Hitachi Zosen)

2000: Foray into Brazil through

acquisition of BrasFELS

2002: Foray into the

Netherlands, acquired Dutch

Offshore Shipyard (Keppel

Verolme BV)

2011: Acquired

27.8% stake in topside modules

fa bricator -Dyna-Mac

1963: Incorporation

of Jurong Shipyard - JV between EDB

and IHI

1968: Incorporati

on of Jurong

Shipbuilder s

1976: Merger of Jurong

Shipbuilder with Jurong

Shipyard

1997:Acquisitionof Sembawang

Shipyard along with PT

Karimun Sembawang

Shipyard (Indonesia) and Bohai

Sembawang Shipyard (China)

1999:Acquisition of SML Shipyard

2001 Acquisition of 50%

of PP L Shipyard; 35% of Maua Jurong (Brazil)

2004:Acquisition of 30% of Cosco Shipyard Group (China)

2006:Acquisition of SMOE Pte Ltd and PT

SMOE Indonesia

2007: Invest 3.31% stake in

Pipavav Shipyard (India);

Acquisition of Sabine Industries

2008: S trategic Alliance

Agreement w ith Rio

De Janeiro-

ba sed Mc La ren

Shipyard to operate a shipyard in Brazil

2009: Development of Integrated New Yard at

Tuas (completed in

2013); Acquisition of

20.1% of Sembmarine

Kakinada (raised to 40%

in 2011)

2010: Developm

ent of E staleiro Jurong Aracruz (EJA) in Brazil

2012: Investment of 20% stake in

E cospec Global

Technology; a cquisition of

S LP Engineering

2014: Acquisition of SSP Of fshore (renamed

to Sembmari

ne SSP)


Sea of Change

Case study: Consolidation of Chinese shipyards

Over 95% of Chinese shipyards have closed down (by number of yards) post-GFC. During the shipping industry's superboom in 2007-2008, China had more than 3,000 big and small yards spread across the country. Post-GFC, China's shipbuilding industry has undergone drastic consolidation as orders have dried out. Uncompetitive small yards were phased out while the bigger yards have been merged or acquired. Thus, there are now just a little more than 100 shipyards with active day-to-day operations in China, a figure that has dwindled from about 400 during mid-2014. China will eventually be left with only 20 to 30 shipbuilding companies with active operations when the severe, ongoing consolidation period of the industry is completed over the next few years, according to Ren Yuanlin, Executive Chairman of Yangzijiang Shipbuilding. Rumours on the merger of the two largest private Chinese shipyards – Yangzijiang and Rongsheng. Earlier last year, the local government in Jiangsu attempted to rope in CSSC’s subsidiary - Shanghai Waigaoqiao Shipbuilding (SWS) - to take over the Rongsheng yard but this was unsuccessful. According to an Upstream article in Mar-15, Yangzijiang is in advanced talks to take as much as a 20% stake in troubled HK-listed shipbuilder – RongSheng - while the remaining 80% interest will be held by a number of Chinese banks including China Minsheng Bank, China Everbright Bank and China Development Bank and other small investors. Yangzijiang has clarified that it is evaluating the opportunity and has yet to firm up its decision. If the offer price is attractive and the restructuring plan is clearly mapped out, it may not be a bad idea to consolidate and eliminate the potential threat that RongSheng poses, considering its strategic location within Yangzijiang’s close proximity. In addition, RongSheng has one of the largest and most advanced shipyards in China, which would allow Yangzijiang to expand its capacity in the construction of sophisticated vessels.

Consolidation in the Chinese rigbuilding space? In China, there are probably around 10 rigbuilders with orders on hand. Since Chinese yards started jumping onto the offshore bandwagon in 2005, we observed that there are only a handful of pioneering yards, namely Dalian Shipbuilding, Cosco Corp, CIMC Raffles Yantai, Shanghai Waigaoqiao and China Merchant Industry Holdings, which have survived and retained their focus on rigbuilding. Many smaller yards have kind of “tried-and-given-up”, realising that offshore projects were more complex than initially thought, and making profits was almost impossible without economies of scale. Merger between China’s two largest shipbuilding SOEs – CSIC and CSSC? State-owned shipbuilding conglomerates, China State Shipbuilding Corporation (“CSSC” or 南船) and China Shipbuilding Industry Corporation (“CSIC” or 北船), have swapped top management in Mar-2015. Former CSSC president Hu Wenming has moved to CSIC as the new president, while former vice general manager of CSIC, Dong Qiang, has become the new president of CSSC. The move is seen as a harbinger of a merger between the two groups, paving way for a smoother integration later on. While both CSSC and CSIC have subsequently denied ongoing talks, rumours continue to run rife. We believe such a major consolidation, if it happens. like the merger of the world's two largest train makers - China CNR Corp and CSR Corp, requires the push from top government. In our view, by merging CSSC and CSIC, China will create a giant shipbuilder and sharpen the competitive edge of the combined entity by:

1) Enhancing R&D capabilities; 2) Streamlining operations; 3) Broadening product offerings; and 4) Completing the military vessels supply chain


Sea of Change

Possible restructuring of Singapore shipyard groups?

In the previous downcycle, Singapore shipyards went through a major consolidation during the late 1990s, where various mergers resulted in the formation of the two giant Singapore government owned shipyard groups today. In 2001, the two Singapore shipyard groups – Keppel Corp and SembCorp Industries embarked in preliminary talks to rationalise their shipyard operations but the deal fell through as they failed to agree on certain terms. This time round, Singapore shipyards are bracing for even tough times ahead compared to the downcycle in early 2000 – absence of new rigbuilding orders, dwindling order books, low book to bill ratio, project cancellations, project deferments, high fixed cost and the need to keep shipyards at high utilisation. This may force the yards to look for ways to restructure. We do not rule out restructuring, mergers and acquisitions possibilities, as any cost rationalisation exercises will boost competitiveness of Singapore yards amid rising competition from Korea and China, and the added burden of operating shipyards in Brazil. We examine the benefits and hurdles of a potential merger of Keppel and SembCorp Marine from the perspective of a)cost synergies, b) revenue synergies c) strengthening competitiveness, d) leadership issues, e) job losses and integration issues.

Cost synergies?

Merging the two rigbuilders will help to streamline the cost structure, and therefore strengthen the competitiveness of the merged entity (“KepSMM”) on the international front. Cost synergies in general, refer to the ability to cut costs of the combined entities due to the consolidation of operations. Potential sources of cost synergies for KepSMM include: Reduced overheads especially non-production staff strength

(e.g. consolidate support functions such as HR, finance, accounting, IT and marketing). This is usually reflected in General and Administrative expenses, which typically account for 2.5-3.5% of revenue. Assuming 20% cost savings post merger, this could boost EBIT margins by 0.5 – 0.7 ppt.

Elimination of surplus facilities and headcount reduction

(redundancies), where there is an overlap and facilities which are underutilised. We do not have the breakdown of utilisation of the individual yards. However, Singapore yards remain the key operating facilities while most of the overseas yards serve as supporting facilities, capturing less complex fabrication / conversion and repair jobs in the region. SMM acquired a 30% stake in Cosco Shipyard Group (CSG), a subsidiary of Cosco Corporation, to tap the lower labour cost in China. However, we have noted that there have been lesser and lesser jobs channelled to CSG in recent years. KepSMM could divest its stake in CSG to re-invest elsewhere. In addition, CSG has posted several quarters of losses due to challenging operating environment, dragging down associate income for SMM.

Increased purchasing power, ie greater bargaining power

with suppliers due to greater purchasing volume and value, yielding larger bulk discounts with suppliers such as steel and raw material procurements.

Keppel and SMM’s yard locations at a glance

Region Keppel Corp SMM Asia Pacific Singapore (HQ) Singapore (HQ)

China China Indonesia Indonesia Philippines India Japan

Latin America Brazil Brazil

North America USA USA

NW Europe Netherlands UK

Mediterranean Azerbaijan Kazakhstan

Middle East Qatar UAE

Source: Companies, DBS Bank


Sea of Change

Branding + World Class facilities + Efficiency – A

powerhouse

Keppel’s branding…While both Singapore rigbuilders have established excellent track records for on-time and on cost deliveries over the past 10-15 years, KepCorp is deemed to have a stronger market positioning and edge over SMM with its innovative R&D, comprehensive product range, global network of yards raising efficiency ratios, longer track record and higher number of rig deliveries. … and SMM’s world class facilities. Keppel has adopted the strategy to expand and maximise utilisation of existing facilities in Singapore, while SMM has taken a different approach to design and build a new facility from scratch. On this front, we opine that SMM’s new yard enhances its efficiency and sharpens its competitive advantage. The modern new yard allows SMM to serve a wider range of vessels and rigs, including VLCCs, new generations of mega containerships, LNG carriers, passenger ships, and ultra deepwater semisubmersible rigs/drillships. Key advantages include:

1) The widest drydock in Singapore - YST D2, measuring 89m wide, is designed to accommodate jackups and semi-submersible rigs.

2) The longest and deepest ship repair drydock in Asia – YST D3, with a length of 412m, is capable of docking the world’s largest containerships of up to 18,000 TEU.

3) The natural deep waters at the new yard enable the

installation of thrusters for semi-submersibles without towing the rig to sea, enhancing productivity and efficiency with reduction of logistic and mobilisation time and costs.

4) Three finger piers and a basin (12 quays in total)

ranging from 210m to 400m with maximum draft from 9m to 15m allows ultra deepwater semi-submersible rigs

Illustration of SMM’s new Integrated Yard @ Tuas

Source: Company A powerhouse with one-third share of the global offshore rig market. A potential merger of KepSMM will create a global champion with a powerful combination - Keppel’s market leadership, branding, and greater overseas experience plus SMM’s world class facilities in Singapore and Brazil, which

complement Keppel’s older facilities. KepSMM will account for almost one-third of the global market share for drilling rigs by orderbook!


Sea of Change

Revenue synergies : will 1+1 = >2?

Revenue synergy refers to the opportunity of a combined corporate entity to generate more revenue than its two predecessor standalone companies would be able to generate. This is probably debatable in the case of KepSMM. Well, logically, KepSMM should be more competitive and garner more orders. However, KepCorp and SMM individually already command a significant market share in the global

rigbuilding orderbook. It is arguable if oil majors and rig operators would give: 1) more orders to KepSMM post merger for better economies

of scale and cost competitiveness; 2) the same number of rig orders it would have given to Keppel

& SMM on standalone basis pre-merger; or 3) lesser orders to KepSMM post merger for risk diversification

and probably competition reasons. Market share of Singapore rigbuilders in jackup rigs has moderated in recent years; but still at a high level of 50%

by deliveries

Source: Companies, DBS Bank Potential job losses and integration challenges

It is almost inevitable to have job losses when it comes to merger. KepSMM is no exception, though we do not expect drastic layoffs as both yards are sitting on reasonable orderbooks at this juncture. Having said that, post the oil price collapse since mid-2014, we have started to see the downsizing of sub-contract work force as orderbook drawdown slowed on project deferments. So, even without any merger, we will continue to see cost savings initiatives and potentially job cuts if more projects are pushed back. KepCorp has c.38k staff while SMM has c.13k employees globally. Post-merger integration is always difficult and challenging. The success depends largely on how well managers can persuade all divisions to believe in a vision and act together to realise it. Barriers include the difference in corporate culture, management style, strategic approach as well as the lack of mutual trust. While both KepCorp and SMM are homegrown shipyards which share similar macro, regulatory and historical backgrounds, each group’s corporate culture, vision, strategy and R&D, is likely to be different.

Who will steer the enlarged ship?

Both KepCorp and SMM are reputable shipyards with quality management in the eyes of international operators and oil majors. Who would take the lead in KepSMM post merger? Prior agreement has to be reached on a new leader and management team for the KepSMM yard. This has become particularly challenging with the retirement of most of the old guards. We are certainly not in the position to comment on this but we reckon it might be a critical issue that needs to be considered before any merger.

26 7

139

73 4

22

70

2

5

9

4 7

35

5

8

67%

89%

75%

81%

46%

61%

40%

64%61%

52%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0

5

10

15

20

25

30

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

No

. of

del

iver

s

Ja ckup rig deliveries by Singapore Rigbuilders

Keppel SMM Singapore rigbuilders % global deliveries


Sea of Change

Company Guide

ASIAN INSIGHTS VICKERS SECURITIES www.dbsvickers.com ed: JS / sa: JC

HOLD (upgrade from FULLY VALUED) Last Traded Price: S$0.385 (STI : 3,196.66) Price Target : S$0.42 (10% upside) (Prev S$0.49) Potential Catalyst: Higher oil prices, order wins with better terms Where we differ: We are more conservative in margin assumptions Analyst HO Pei Hwa +65 6682 3714 [email protected]

Price Relative

Forecasts and Valuation FY Dec (S$ m) 2013A 2014A 2015F 2016F Revenue 3,508 4,261 3,655 3,477 EBITDA 311 253 286 339 Pre-tax Profit 61 17 0 16 Net Profit 31 21 2 10 Net Pft (Pre Ex.) 31 21 2 10 EPS (S cts) 1.4 0.9 0.1 0.4 EPS Pre Ex. (S cts) 1.4 0.9 0.1 0.4 EPS Gth (%) (71) (32) (92) 478 EPS Gth Pre Ex (%) (71) (32) (92) 478 Diluted EPS (S cts) 1.4 0.9 0.1 0.4 Net DPS (S cts) 1.0 0.5 0.0 0.2 BV Per Share (S cts) 59.7 61.1 60.7 61.1 PE (X) 28.2 41.3 518.8 89.8 PE Pre Ex. (X) 28.2 41.3 518.8 89.8 P/Cash Flow (X) nm nm 5.0 nm EV/EBITDA (X) 11.1 20.3 17.9 16.4 Net Div Yield (%) 2.6 1.3 0.1 0.4 P/Book Value (X) 0.6 0.6 0.6 0.6 Net Debt/Equity (X) 0.8 1.5 1.5 1.7 ROAE (%) 2.3 1.5 0.1 0.7 Earnings Rev (%): (95) (78) Consensus EPS (S cts): 1.0 1.3 Other Broker Recs: B: 0 S: 10 H: 2

Source of all data: Company, DBS Bank, Bloomberg Finance L.P

NEGATIVES PRICED IN Upgrade to HOLD; operational challenges reflected in the price. After losing c.40% in 3 months, Cosco is now among the cheapest shipyards in the region, trading at 0.6x P/BV. We believe sector headwinds and operational challenges have been largely reflected in the price. Looking ahead, the shipping segment could return to profits in 3Q15 taking cue from the surge in BDI from 600 points to 1100 points since June. Most importantly, we believe Cosco will pull through this downturn with the strong backing of its parent. Parent - Cosco Group - restructuring could deliver upside surprises. Parent – Cosco Group owns 53% stake in Cosco. With Cosco facing challenges from multiple fronts and its share price falling to its lowest levels in over 10 years, if these may provide impetus for privatisation by its parent, who may hold a longer-term view of Cosco’s potential. The privatisation would help to streamline Cosco’s cost structure and allow it to enjoy SOE benefits. Earnings revisions. As guided in its profit warning, Cosco reported a net loss of S$4.8m in 2Q15, after booking S$34m provision for cost overrun, partially mitigated by tax benefits and share of losses of minority interests. We are concerned with the alarmingly high net gearing of 1.8x as of end June-2015, arising from deteriorating payment terms and profitability. We have cut our PATMI forecast for FY15 to breakeven level and FY16 to S$10m profit after lowering margins for shipbuilding and offshore segments each by 1.5ppts. Valuation:

We have lowered our target price to S$0.42 (Prev: S$0.49), pegged to a lower FY15 P/BV multiple of 0.7x (Prev: 0.8x) in the light of deteriorating earnings. P/BV is a more appropriate valuation metric than PE, given the low earnings visibility and profitability. We believe the low valuation has priced in the negatives and hence, we upgrade the stock to HOLD. Key Risks to Our View:

An earlier-than-expected recovery in the oil price could catalyze an industry recovery with Cosco securing more orders at attractive prices. Sharp improvements in productivity could also cause its shares to re-rate. At A Glance Issued Capital (m shrs) 2,239 Mkt. Cap (S$m/US$m) 862 / 623 Major Shareholders China Ocean Shipping (%) 53.4 Free Float (%) 46.6 3m Avg. Daily Val (US$m) 1.0 ICB Industry : Industrials / Industrial Engineering


Singapore Company Guide

Cosco Corporation Edition 1 Version 1 | Bloomberg: COS SP | Reuters: COSC.SI Refer to important disclosures at the end of this report

22

42

62

82

102

122

142

162

182

202

222

0.3

0.5

0.7

0.9

1.1

1.3

1.5

Aug-11 Aug-12 Aug-13 Aug-14 Aug-15

Relative IndexS$

Cosco Corporation (LHS) Relative STI INDEX (RHS)

ASIAN INSIGHTS VICKERS SECURITIES

Company Guide

Cosco Corporation

CRITICAL DATA POINTS TO WATCH

Earnings Drivers:

Orderbook is a key driver of revenues. As of 30 Jun 2015, Cosco had 87 vessels on its gross orderbook, of which 50 were from the offshore segment. Its US$8.1bn orderbook will bolster revenues until 2017. However, offshore vessels are facing a clear oversupply situation on a global scale – which heightens the risk of delivery deferments in the quarters to come. Furthermore, its shipbuilding contracts are of low value while the higher-value offshore contracts face a steep learning curve resulting from a diversified product range.

Order wins keep the orderbook going. YTD, Cosco has secured 12 orders (of which 7 are lower-value 3,600 TEU container ships for MAERSK) totaling US$550m, making up 37% of our assumption of US$1.5bn for this year. In 2014, Cosco secured 30 contracts worth US$1.6bn with a majority of these for higher-end offshore vessels and platforms that typically carry larger contract values. Continued order wins of high value amid a lackluster environment would be encouraging.

Contract pricing impact the bottom line. Chinese offshore yards have historically made low single digit EBIT margins, considerably lower than the low teens earned by their Singaporean peers. Cosco, though among the pioneer offshore yards in China with more established track record, also reported uninspiring EBIT margins of 2-4% in 1H15 and 2.3% in FY14. We believe this has been largely due to aggressive pricing of its contracts and execution hiccups, exacerbated by a wave of delivery deferments upon client requests. Cosco is gaining recognition and thus pricing power should provide uplift to margins.

Conquering the learning curve quickly is essential. Labour is 30% cheaper in China than in Singapore but 50% less productive. Consequently, Chinese yards face higher labour costs that exacerbate the downward pressure on margins. Cosco’s ability to quickly ascend the learning curve is therefore important for improving its net margin in the longer-term. However, Cosco’s tendency to accept a very diverse range of product orders inherently makes swift improvements to productivity difficult.

Industry recovery is the long-term driver of earnings. Cosco’s dry bulk fleet and its shipbuilding and repair segments have been hit by the downturn in the shipping industry, where supply of vessels continues to outstrip demand. Meanwhile, offshore oil & gas players’ capex budgets have taken deep cuts, on the back of languishing oil prices, which does not bode well for order wins for the offshore segment; the segment has seen 4 order wins in FY15 YTD versus 19 in FY14. A meaningful recovery in the shipping and offshore oil & gas markets would signal earnings recovery for Cosco.

Sales Trend

Profitability Trend

Margin Trends (%)


-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2012A 2013A 2014A 2015F 2016F

S$ m

Total Revenue Revenue Growth (%) (YoY)

0

50

100

150

200

250

2012A 2013A 2014A 2015F 2016F

S$ m

Operating EBIT Pre tax Profit Net Profit

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2012A 2013A 2014A 2015F 2016F

EBITDA Margin % EBIT Margin % Net Income Margin %


Company Guide

Cosco Corporation

Balance Sheet:

Net Gearing is high at 1.8x as of end-June-15. More aggressive payment terms have necessitated higher working capital investment by Cosco, which has led to more debt on the balance sheet. There is ~S$3.3bn of debt due within the year which, in the event of an inability to secure refinancing, would likely result in cash-flow issues, although Cosco’s strong parentage may help mitigate this risk.

Share Price Drivers:

Rebound in oil prices would provide support to share price. Offshore & Marine stocks have tracked oil prices closely, as the market views the oil price as a proxy to the industry’s health. A recovery of oil prices at least to above the US$70/bbl level should see Cosco’s share price rise in tandem.

Visible margin improvement should boost the share price. Margin uplift from more favourable contract terms as well as productivity improvements in its workforce would send a positive signal to the market and likely cause Cosco’s share price to rise.

Cosco Group restructuring could deliver upside surprise. Cosco’s share price has corrected c.40% since May, which we felt has priced in the sector headwinds and operational challenges, and is now trading at its lowest levels in over 10 years. Its rock-bottom share price could thus provide the impetus for privatisation by parent company Cosco Group, who may hold a longer-term view of Cosco’s potential.

Key Risks:

Concerns remain over the drillship and cylindrical rig. The cancelled drillship unit, having been substantially completed and up for sale since 3Q13, has yet to find a buyer. Meanwhile the 4th Sevan cylindrical rig unit has had its delivery date extended by 12 months with options on a maximum of an additional 36 months in place. However it remains at risk of being cancelled, as Sevan Drilling has yet to find a charterer for the asset.

Competition risk from Chinese yards remains salient. Many of the leading Chinese shipbuilders jumped onto the offshore bandwagon amidst shipbuilding overcapacity. With the offshore industry facing headwinds as well, price wars amongst the Chinese yards remains a key risk.

Cost overruns continue to plague the business. Provision for cost overruns has been a major swing factor on earnings, blamed on execution hiccups, longer than expected man-hours, and underestimation of project costs.

Deferment and cancellation risk is heightened. Chinese offshore yards are more susceptible to deferments and cancellations in the light of a weaker customer profile of less established players/speculators, and balloon payment terms of at least 90% upon delivery.

COMPANY BACKGROUND

Cosco is amongst the leading offshore yards in China. Starting off as a ship repair yard, Cosco ventured into offshore and shipbuilding via a series of yard acquisitions in 2003-2004. Its business can be classified into four segments - offshore, shipbuilding, repair & conversion and shipping.

Leverage & Asset Turnover (x)

Capital Expenditure

ROE (%)

Forward PE Band (x)

PB Band (x)


0.3

0.4

0.4

0.5

0.5

0.6

0.6

0.00

0.50

1.00

1.50

2.00

2.50

2012A 2013A 2014A 2015F 2016F

Gross Debt to Equity (LHS) Asset Turnover (RHS)

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

2012A 2013A 2014A 2015F 2016F

Capital Expenditure (-)

S$m

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

2012A 2013A 2014A 2015F 2016F

Avg: 125.1x

+1sd: 262.5x

+2sd: 400x

‐1sd: ‐12.3x

-134.7

-34.7

65.3

165.3

265.3

365.3

465.3

565.3

665.3

765.3


(x)

Avg: 1.37x

+1sd: 1.73x

+2sd: 2.09x

‐1sd: 1.01x

‐2sd: 0.65x0.5

1.0

1.5

2.0

2.5

3.0


(x)


Company Guide

Cosco Corporation

Segmental Breakdown FY Dec 2012A 2013A 2014A 2015F 2016F Revenues (S$ m) Shipping and Agency 54 56 53 57 60 Shiprepair and Conversions*

699 587 592 633 705

Shipbuilding* 1,251 449 445 624 895 Offshore* 1,730 2,417 3,171 2,341 1,819 Total 3,734 3,508 4,261 3,655 3,477

Income Statement (S$ m)

FY Dec 2012A 2013A 2014A 2015F 2016F Revenue 3,734 3,508 4,261 3,655 3,477 Cost of Goods Sold (3,249) (3,187) (3,970) (3,343) (3,121) Gross Profit 485 321 291 312 357 Other Opng (Exp)/Inc (195) (195) (192) (187) (187) Operating Profit 290 127 99 125 169 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 1 0 0 1 1 Net Interest (Exp)/Inc (61) (66) (82) (125) (154) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 230 61 17 0 16 Tax (60) (8) 9 0 (3) Minority Interest (64) (22) (5) 2 (3) Preference Dividend 0 0 0 0 0 Net Profit 106 31 21 2 10 Net Profit before Except. 106 31 21 2 10 EBITDA 469 311 253 286 339 Growth Revenue Gth (%) (10.3) (6.1) 21.5 (14.2) (4.9) EBITDA Gth (%) (0.1) (33.8) (18.7) 13.3 18.5 Opg Profit Gth (%) (5.0) (56.3) (21.6) 25.4 36.0 Net Profit Gth (Pre-ex) (%) (24.3) (71.0) (31.8) (92.0) 478.1 Margins & Ratio Gross Margins (%) 13.0 9.2 6.8 8.5 10.3 Opg Profit Margin (%) 7.8 3.6 2.3 3.4 4.9 Net Profit Margin (%) 2.8 0.9 0.5 0.0 0.3 ROAE (%) 8.2 2.3 1.5 0.1 0.7 ROA (%) 1.5 0.4 0.2 0.0 0.1 ROCE (%) 4.6 2.0 1.5 1.4 1.8 Div Payout Ratio (%) 42.4 73.1 53.6 40.0 40.0 Net Interest Cover (x) 4.8 1.9 1.2 1.0 1.1



Company Guide

Cosco Corporation

Quarterly / Interim Income Statement (S$ m)

FY Dec 2Q2014 3Q2014 4Q2014 1Q2015 2Q2015 Revenue 1,147 1,159 916 991 854 Cost of Goods Sold (1,055) (1,102) (869) (918) (794) Gross Profit 92 57 47 73 59 Other Oper. (Exp)/Inc (32) (29) (79) (39) (39) Operating Profit 60 28 (32) 34 20 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 0 0 0 0 0 Net Interest (Exp)/Inc (23) (19) (25) (27) (32) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 37 8 (57) 7 (12) Tax (7) (1) 23 (3) 2 Minority Interest (16) 0 21 (3) 6 Net Profit 14 7 (13) 1 (5) Net profit bef Except. 14 7 (13) 1 (5) EBITDA 96 66 10 70 58 Growth Revenue Gth (%) 10.3 1.1 (21.0) 8.2 (13.9) EBITDA Gth (%) 18.5 (31.7) (84.9) 611.5 (17.8) Opg Profit Gth (%) 38.8 (54.0) nm nm (40.5) Net Profit Gth (Pre-ex) (%) 13.3 (50.0) (284.4) (105.8) (721.7) Margins Gross Margins (%) 8.0 4.9 5.1 7.4 6.9 Opg Profit Margins (%) 5.3 2.4 (3.5) 3.5 2.4 Net Profit Margins (%) 1.2 0.6 (1.4) 0.1 (0.6)

Balance Sheet (S$ m) FY Dec 2012A 2013A 2014A 2015F 2016F Net Fixed Assets 2,226 2,228 2,267 2,256 2,237 Invts in Associates & JVs 4 5 5 5 6 Other LT Assets 275 291 301 301 301 Cash & ST Invts 1,693 2,028 1,561 1,821 1,649 Inventory 445 1,047 1,042 1,218 1,159 Debtors 2,739 2,912 4,564 4,568 4,968 Other Current Assets 12 224 206 0 0 Total Assets 7,394 8,735 9,945 10,170 10,320 ST Debt 1,468 1,926 2,430 2,552 2,679 Creditor 2,244 2,696 2,632 2,610 2,484 Other Current Liab 66 81 110 119 122 LT Debt 1,559 1,856 2,542 2,670 2,803 Other LT Liabilities 7 1 1 1 1 Shareholder’s Equity 1,282 1,336 1,368 1,358 1,367 Minority Interests 768 839 862 860 863 Total Cap. & Liab. 7,394 8,735 9,945 10,170 10,320 Non-Cash Wkg. Capital 885 1,406 3,069 3,057 3,521 Net Cash/(Debt) (1,334) (1,754) (3,412) (3,400) (3,833) Debtors Turn (avg days) 232.1 294.0 320.2 456.0 500.5 Creditors Turn (avg days) 293.7 300.2 254.8 300.7 315.0 Inventory Turn (avg days) 64.5 90.7 99.9 129.6 147.0 Asset Turnover (x) 0.5 0.4 0.5 0.4 0.3 Current Ratio (x) 1.3 1.3 1.4 1.4 1.5 Quick Ratio (x) 1.2 1.1 1.2 1.2 1.3 Net Debt/Equity (X) 0.7 0.8 1.5 1.5 1.7 Net Debt/Equity ex MI (X) 1.0 1.3 2.5 2.5 2.8 Capex to Debt (%) 3.8 1.4 2.0 2.9 2.7 Z-Score (X) NA 0.9 0.9 0.9 0.9



Company Guide

Cosco Corporation

Cash Flow Statement (S$ m)

FY Dec 2012A 2013A 2014A 2015F 2016F Pre-Tax Profit 230 61 17 0 16 Dep. & Amort. 179 184 153 161 169 Tax Paid (82) (12) (6) 9 0 Assoc. & JV Inc/(loss) (1) 0 0 (1) (1) Chg in Wkg.Cap. (957) (543) (1,887) 3 (467) Other Operating CF 51 180 295 0 0 Net Operating CF (580) (130) (1,428) 173 (283) Capital Exp.(net) (114) (51) (97) (150) (150) Other Invts.(net) 0 0 0 0 0 Invts in Assoc. & JV 0 0 0 0 0 Div from Assoc & JV 0 0 0 0 0 Other Investing CF 35 35 49 0 0 Net Investing CF (79) (16) (49) (150) (150) Div Paid (67) (45) (22) (11) (1) Chg in Gross Debt 965 562 1,100 249 261 Capital Issues 0 0 0 0 0 Other Financing CF (55) (35) (68) 0 0 Net Financing CF 842 482 1,009 237 260 Currency Adjustments (75) 77 53 0 0 Chg in Cash 108 412 (414) 261 (172) Opg CFPS (S cts) 16.8 18.4 20.5 7.6 8.2 Free CFPS (S cts) (31.0) (8.1) (68.1) 1.0 (19.3)


Target Price & Ratings History

Source: DBS Bank

S.No. Da teClos ing

Pri c eTa rge t Pric e

Ra ting

1: 04 Aug 14 0.71 0.69 Fully Valued2: 20 Oct 14 0.60 0.62 Fully Valued3: 04 Nov 14 0.62 0.62 Fully Valued4: 04 Dec 14 0.58 0.50 Fully Valued5: 17 Feb 15 0.52 0.49 Fully Valued6: 04 May 15 0.58 0.49 Fully Valued7: 18 May 15 0.52 0.49 Fully Valued8: 22 Jun 15 0.51 0.49 Fully Valued

Note : Share price and Target price are adjusted for corporate actions.

1

2

34

5

6

7

8

0.34

0.39

0.44

0.49

0.54

0.59

0.64

0.69

0.74

Aug-14 Dec-14 Apr-15 Aug-15

S$

ASIAN INSIGHTS VICKERS SECURITIES www.dbsvickers.com ed: TH / sa: JC

HOLD (Reinitiate coverage)

Last Traded Price: S$7.62 (STI : 3,191.39) Price Target : S$8.14 (7% upside) Potential Catalyst: Order wins, oil price recovery, strong housing sales Where We Differ: Lower revenue estimates Analyst HO Pei Hwa +65 6682 3714 [email protected]

Price Relative

Forecasts and Valuation FY Dec (S$ m) 2013A 2014A 2015F 2016F Revenue 12,380 13,283 10,074 9,960 EBITDA 3,017 3,155 2,155 2,168 Pre-tax Profit 2,794 2,889 1,962 1,938 Net Profit 1,846 1,885 1,531 1,504 Net Pft (Pre Ex.) 1,412 1,444 1,291 1,504 EPS (S cts) 102.1 103.7 84.2 82.7 EPS Pre Ex. (S cts) 78.1 79.4 71.0 82.7 EPS Gth (%) (18) 2 (19) (2) EPS Gth Pre Ex (%) (27) 2 (11) 16 Diluted EPS (S cts) 101.2 103.3 83.9 82.4 Net DPS (S cts) 40.0 47.9 42.1 41.4 BV Per Share (S cts) 536.6 571.1 607.3 648.0 PE (X) 7.5 7.3 9.1 9.2 PE Pre Ex. (X) 9.8 9.6 10.7 9.2 P/Cash Flow (X) 22.1 635.8 3.2 9.2 EV/EBITDA (X) 6.3 6.2 7.7 7.5 Net Div Yield (%) 5.2 6.3 5.5 5.4 P/Book Value (X) 1.4 1.3 1.3 1.2 Net Debt/Equity (X) 0.1 0.1 0.1 0.1 ROAE (%) 19.5 18.8 14.3 13.2 Earnings Rev (%): (5) (8) Consensus EPS (S cts): 81.7 81.9 Other Broker Recs: B: 9 S: 3 H: 12


MORE VALUE UNLOCKING ACTIONS? HOLD for decent dividend yield and potential value-unlocking corporate actions. Keppel remains committed on paying out 50% of its earnings to reward shareholders. Although DPS could moderate with earnings decline, yields remain fairly attractive at 5-6% based on our forecasts. Upside surprises could come from gains from disposal / divestments. In addition, infrastructure should recover with the delivery of all EPC contracts, mitigating the weakness from O&M. Offshore & Marine business weighing the group down. Order wins in 1H15 stood at S$1.5bn, less than half of 1H14’s S$3.2bn and considerably lower than FY12 and FY13 full-year wins of ~S$10.0bn. Keppel O&M’s net orderbook is shrinking, implying declining top-line and earnings ahead. In 2Q15, Keppel O&M saw its PATMI fall 36% y-o-y and 15% q-o-q due to revenue declines of 23% y-o-y and 18% q-o-q, led by deferments in Transocean and Petrobras projects. Property business is a mixed bag; infrastructure should bottom out. Singapore home sales remain muted, but the Chinese market seems to be picking up. YTD GFA sold across developers in China is up 24.2% over 2014’s slump, although ASP pick-up has been varied, with mainly Tier 1 cities seeing pricing gains. Overall, Keppel sold over 1,800 homes in 1H15, with 1,170 coming from China alone, marking an improvement over the 1,300 total sold in 1H14. For infrastructure, with the handover of both phases of the Greater Manchester EPC project and the Doha North sewage treatment project having incurred its final provision of just under S$200m in 2Q15, Keppel Infrastructure should see its profitability improve. Valuation: Our TP of S$8.14 is based on sum-of-parts : (1) O&M segment is valued at 10x price-to-earnings (PE) ratio on FY15 earnings, (2) infrastructure is valued at 10x PE on FY15 earnings, and (3) market values/estimated fair values are used for listed subsidiaries and directly-owned property projects. Key Risks to Our View: O&M segment could fare worse than expected. We forecast revenues from Keppel O&M falling to the ~S$6.5bn and S$6.9bn levels in FY15 and FY16 respectively, from S$8bn previously. Continued depletion of the order book coupled with deferments could pose downside to our forecast. At A Glance Issued Capital (m shrs) 1,816 Mkt. Cap (S$m/US$m) 13,835 / 10,018 Major Shareholders Temasek Holdings Pte Ltd (%) 21.0 Aberdeen (%) 6.8 Blackrock (%) 6.0 Free Float (%) 66.3 3m Avg. Daily Val (US$m) 28.7 ICB Industry : Oil & Gas / Oil Equipment; Services & Dist



Keppel Corporation Edition 1 Version 1 | Bloomberg: KEP SP | Reuters: KPLM.SI Refer to important disclosures at the end of this report

60

80

100

120

140

160

180

200

220

6.4

7.4

8.4

9.4

10.4

11.4

12.4


Relative IndexS$

Keppel Corporation (LHS) Relative STI INDEX (RHS)


Company Guide

Keppel Corporation


Earnings Drivers:

Order book the key driver of Keppel O&M’s earnings;

FLNG provides potential upside. Keppel O&M secured S$1.5bn in order wins in 1H15, making up half of our FY15 assumptions. This represents only 27% of full-year 2014’s order wins and is dismal-looking compared to its 2010 and 2011 full-year peak of S$10.0bn. Meanwhile, a declining net orderbook means revenue recognition should be stretched over a longer period, impacting earnings. Weak order wins have resulted from Keppel being assailed on three fronts: i) an oversupply of rigs, particularly jackups, as we enter the peak of the rig delivery cycle; ii) low oil prices; and iii) competition from Chinese yards. Scrapping of old rigs (>30 years old), estimated to constitute ~15% of the current fleet, could help push the market back into balance and drive order wins. An oil price rebound would also improve rig utilisations, hence spurring capex spend and order wins. In terms of growth potential, Keppel’s first-mover advantage in the FLNG conversion market could provide earnings upside; customer Golar has already awarded a 3rd FLNG project.

Residential home sales in China and Singapore are the

main drivers of Keppel Land’s revenue and earnings. Keppel Land’s property trading (i.e. development) segment accounted for the lion’s share of revenue and earnings in FY14, at 85% and 54% respectively. The macro trends in these countries should have a strong influence on earnings. In China, further relaxation of cooling measures, combined with low mortgage rates resulting from central bank easing, seem to be encouraging residential property sales. Singapore unit sales should be dampened by weak buyer’s sentiment due to the continuing effects of government tightening measures, a flood of completions in 2015-2017 and slowing government land sales (GLS) – factors which signal falling ASPs. Infrastructure division earnings buoyed by handover of

problematic assets. The bad apple situation with Keppel Infrastructure’s EPC projects has improved. The handover of the two Greater Manchester EfW Plants was announced in 2Q15, while the Doha North plant’s S$200m of provisions in 2Q15 due to delays and cost overruns is said to be the final round of adjustments; the Doha project should achieve significant completion this year. Thus, lower EPC provisions going forward should give a boost to earnings in the short term. Value-unlocking divestments can provide earnings

upside. Divestments can free up cash to be invested in more profitable areas or to pay down debt. In Keppel’s case, it may also reduce the conglomerate discount on its stock. M1 is a possible candidate for sale; its fundamentals are uninspiring and our telecom analyst has a FULLY VALUED call on this stock as of this report’s writing. We estimate Keppel Corp’s stake in M1 to be ~S$440m. Injection of Infrastructure assets such as the Woodlands Wafer Fab Park into KIT, to whom Keppel Infrastructure acts as sponsor, could be another alternative.

O&M order wins (S$ m)

Offshore & Marine Revenues (S$m)

Property Revenues (S$m)

Infrastructure Revenues (S$m)


9,966

6,754

4,974

3,0003,500

0

1,300

2,600

3,900

5,200

6,500

7,800

9,100

2012A 2013A 2014A 2015F 2016F

7,963

7,126

8,556

6,4606,925

0

1,700

3,400

5,100

6,800

8,500

2012A 2013A 2014A 2015F 2016F

3,018

1,768 1,729

1,477 1,531

0

600

1,200

1,800

2,400

3,000

2012A 2013A 2014A 2015F 2016F

2,832

3,459

2,933

2,073

1,433

0

400

800

1,200

1,600

2,000

2,400

2,800

3,200

2012A 2013A 2014A 2015F 2016F


Company Guide

Keppel Corporation

Balance Sheet:

Following the privatisation of Keppel Land in 1Q15, Keppel Corp’s net gearing has increased to 0.42x as of 2Q15 versus 0.11x at year-end FY14. However, the increase in gearing stems from a lower shareholder’s equity and cash balance due to a largely cash funding of the privatisation. Nominal debt levels remain at very reasonable levels of ~S$7.4bn, translating into a gross gearing of 0.62x as of 2Q15. Share Price Drivers:

Recovery in oil prices would support the share price. Keppel O&M would benefit if oil prices recover to at least above the $70/bbl level, we think, which would trigger more offshore oil & gas capex spend.

Announcement of new order wins. Strong order wins announcements could push up the share price, as investors reward greater visibility on revenues and earnings. Key Risks:

Competition from foreign yards. Keener competition from Chinese yards, which are usually aggressive in their pricing and lax with payment terms, as well as Korean peers, may affect order wins and profitability, especially if Keppel starts to offer concessions to protect market share. Further deferments may result if oil prices remain subdued. Since the oil price started declining in mid-2014, we have seen oil majors and asset owners slash capex spending substantially, which has hit the yards hard. Meanwhile, deliveries of newbuilds and conversions already under construction are being delayed – a situation which could worsen if oil prices remain low. COMPANY BACKGROUND

Keppel is a diversified conglomerate with its core businesses in offshore marine (O&M), property investments and development, and infrastructure-based activities in Singapore and the region. O&M is the largest segment that typically contributes about two-thirds of Group revenue. It possesses strong market leadership positions in rigbuilding, particularly for jackups and semi-submersibles, FPSO conversion, repair and construction of high-end specialised vessels.


Capital Expenditure

ROE (%)

Forward PE Band (x)

PB Band (x)


0.3

0.4

0.4

0.5

0.5

0.6

0.6

0.00

0.10

0.20

0.30

0.40

0.50

0.60

2012A 2013A 2014A 2015F 2016F


0.0

100.0

200.0

300.0

400.0

500.0

600.0

700.0

800.0

900.0

1,000.0

2012A 2013A 2014A 2015F 2016F


S$m

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

2012A 2013A 2014A 2015F 2016F

Avg: 10.1x

+1sd: 11.3x

+2sd: 12.5x

‐1sd: 8.9x

‐2sd: 7.6x

5.2

6.2

7.2

8.2

9.2

10.2

11.2

12.2

13.2


(x)

Avg: 2x

+1sd: 2.29x

+2sd: 2.58x

‐1sd: 1.71x

‐2sd: 1.42x

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9


(x)


Company Guide

Keppel Corporation

Key Assumptions

FY Dec 2012A 2013A 2014A 2015F 2016F O&M order wins (S$ m) 9,966 6,754 4,974 3,000 3,500

Segmental Breakdown FY Dec 2012A 2013A 2014A 2015F 2016F Revenues (S$ m) Offshore and Marine 7,963 7,126 8,556 6,460 6,925 Property 3,018 1,768 1,729 1,477 1,531 Infrastructure 2,832 3,459 2,933 2,073 1,433 Investments 152 27 64 63 72 Others N/A N/A N/A N/A N/A Total 13,965 12,380 13,283 10,074 9,960 EBIT (S$ m) Offshore and Marine 1,089 1,059 1,224 967 997 Property 1,353 981 667 449 449 Infrastructure 46 69 466 232 215 Investments 124 18 18 16 18 Others 10 7 0 0 0 Total 2,621 2,134 2,375 1,664 1,679 EBIT Margins (%) Offshore and Marine 13.7 14.9 14.3 15.0 14.4 Property 44.8 55.5 38.6 30.4 29.3 Infrastructure 1.6 2.0 15.9 11.2 15.0 Investments 81.6 64.3 28.4 25.0 25.0 Others N/A N/A N/A N/A N/A Total 18.8 17.2 17.9 16.5 16.9


FY Dec 2012A 2013A 2014A 2015F 2016F Revenue 13,965 12,380 13,283 10,074 9,960 Cost of Goods Sold (9,507) (8,604) (9,245) (6,818) (6,708) Gross Profit 4,458 3,777 4,038 3,256 3,253 Other Opng (Exp)/Inc (1,837) (1,642) (1,665) (1,592) (1,574) Operating Profit 2,621 2,134 2,373 1,664 1,679 Other Non Opg (Exp)/Inc 7 14 12 10 10 Associates & JV Inc 603 626 504 300 300 Net Interest (Exp)/Inc 26 19 (1) (12) (51) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 3,256 2,794 2,889 1,962 1,938 Tax (501) (397) (462) (333) (329) Minority Interest (518) (551) (541) (98) (105) Preference Dividend 0 0 0 0 0 Net Profit 2,237 1,846 1,885 1,531 1,504 Net Profit before Except. 1,914 1,412 1,444 1,291 1,504 EBITDA 3,441 3,017 3,155 2,155 2,168 Growth Revenue Gth (%) 38.5 (11.3) 7.3 (24.2) (1.1) EBITDA Gth (%) (1.8) (12.3) 4.6 (31.7) 0.6 Opg Profit Gth (%) (7.2) (18.6) 11.2 (29.9) 0.9 Net Profit Gth (Pre-ex) (%) 28.4 (26.2) 2.3 (10.6) 16.5 Margins & Ratio Gross Margins (%) 31.9 30.5 30.4 32.3 32.7 Opg Profit Margin (%) 18.8 17.2 17.9 16.5 16.9 Net Profit Margin (%) 16.0 14.9 14.2 15.2 15.1 ROAE (%) 26.4 19.5 18.8 14.3 13.2 ROA (%) 8.2 6.2 6.1 5.1 5.3 ROCE (%) 11.7 8.6 9.1 6.5 6.8 Div Payout Ratio (%) 36.2 39.2 46.2 50.0 50.0 Net Interest Cover (x) NM NM 2,579.8 133.3 32.7



Company Guide

Keppel Corporation


FY Dec 2Q2014 3Q2014 4Q2014 1Q2015 2Q2015 Revenue 3,176 3,185 3,925 2,814 2,563 Cost of Goods Sold (2,149) (2,239) (2,803) (1,803) (1,920) Gross Profit 1,028 946 1,122 1,011 643 Other Oper. (Exp)/Inc (560) (381) (196) (613) (229) Operating Profit 467 565 926 398 414 Other Non Opg (Exp)/Inc 1 7 4 1 5 Associates & JV Inc 122 62 255 61 90 Net Interest (Exp)/Inc 4 9 (24) (5) (11) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 593 643 1,161 455 498 Tax (124) (105) (136) (81) (88) Minority Interest (63) (123) (299) (14) (13) Net Profit 406 414 726 360 397 Net profit bef Except. 385 342 382 357 160 EBITDA 655 701 1,254 526 575 Growth Revenue Gth (%) 6.0 0.3 23.3 (28.3) (8.9) EBITDA Gth (%) 20.3 7.0 78.9 (58.0) 9.2 Opg Profit Gth (%) 12.6 21.0 63.8 (57.0) 4.0 Net Profit Gth (Pre-ex) (%) 14.8 (11.2) 11.6 (6.3) (55.2) Margins Gross Margins (%) 32.3 29.7 28.6 35.9 25.1 Opg Profit Margins (%) 14.7 17.7 23.6 14.2 16.2 Net Profit Margins (%) 12.8 13.0 18.5 12.8 15.5

Balance Sheet (S$ m) FY Dec 2012A 2013A 2014A 2015F 2016F Net Fixed Assets 3,337 3,798 2,673 2,842 3,011 Invts in Associates & JVs 5,267 5,482 4,988 5,238 5,486 Other LT Assets 5,934 2,818 2,706 2,930 2,930 Cash & ST Invts 4,472 6,010 6,107 6,042 6,489 Inventory 7,661 8,995 10,681 6,947 6,869 Debtors 1,839 1,916 2,510 2,056 2,033 Other Current Assets 697 1,037 1,889 1,889 1,889 Total Assets 29,207 30,056 31,555 27,945 28,708 ST Debt 1,006 517 1,796 1,796 1,796 Creditor 5,466 5,409 5,581 5,037 4,980 Other Current Liab 2,593 3,416 3,597 2,749 2,726 LT Debt 6,202 6,583 5,587 5,587 5,587 Other LT Liabilities 362 442 266 266 266 Shareholder’s Equity 9,246 9,701 10,381 11,041 11,779 Minority Interests 4,332 3,988 4,347 1,469 1,573 Total Cap. & Liab. 29,207 30,056 31,555 27,945 28,708 Non-Cash Wkg. Capital 2,138 3,123 5,902 3,106 3,085 Net Cash/(Debt) (2,736) (1,090) (1,275) (1,341) (894) Debtors Turn (avg days) 50.5 55.4 60.8 82.7 74.9 Creditors Turn (avg days) 219.4 237.4 223.4 292.0 280.0 Inventory Turn (avg days) 280.1 363.5 399.9 484.8 386.2 Asset Turnover (x) 0.5 0.4 0.4 0.3 0.4 Current Ratio (x) 1.6 1.9 1.9 1.8 1.8 Quick Ratio (x) 0.7 0.8 0.8 0.8 0.9 Net Debt/Equity (X) 0.2 0.1 0.1 0.1 0.1 Net Debt/Equity ex MI (X) 0.3 0.1 0.1 0.1 0.1 Capex to Debt (%) 11.1 12.7 (5.1) 4.7 4.7 Z-Score (X) NA 2.0 2.1 2.0 2.0



Company Guide

Keppel Corporation


FY Dec 2012A 2013A 2014A 2015F 2016F Pre-Tax Profit 3,256 2,794 2,889 1,962 1,938 Dep. & Amort. 211 242 265 181 179 Tax Paid (225) (585) (328) (463) (333) Assoc. & JV Inc/(loss) (603) (626) (504) (300) (300) Chg in Wkg.Cap. (1,480) (492) (340) 2,924 26 Other Operating CF (152) (709) (1,960) 0 0 Net Operating CF 1,007 625 22 4,305 1,509 Capital Exp.(net) (801) (903) 379 (350) (349) Other Invts.(net) 0 0 0 (3,200) 0 Invts in Assoc. & JV (366) (473) 231 (150) (149) Div from Assoc & JV 157 267 410 200 201 Other Investing CF (60) 431 (144) 0 0 Net Investing CF (1,069) (678) 877 (3,500) (297) Div Paid (1,001) (843) (1,029) (870) (765) Chg in Gross Debt 2,331 2,130 272 0 0 Capital Issues 82 40 34 0 0 Other Financing CF (134) 201 (47) 0 0 Net Financing CF 1,277 1,528 (769) (870) (765) Currency Adjustments (180) 35 42 0 0 Chg in Cash 1,035 1,509 171 (66) 447 Opg CFPS (S cts) 138.3 61.8 19.9 75.9 81.6 Free CFPS (S cts) 11.5 (15.4) 22.0 217.5 63.8



BUY

Last Traded Price: S$0.905 STI : 3,191.39 Price Target : S$1.08 (19% upside) Potential Catalyst: Turnaround in earnings, M&A Where We Differ: More positive on cost-reduction trajectory Analyst Suvro SARKAR +65 6682 3720 [email protected]

Price Relative

Forecasts and Valuation FY Dec (US$ m) 2013A 2014A 2015F 2016F Revenue 8,831 8,617 6,367 5,719 EBITDA 142 284 579 637 Pre-tax Profit (16) (217) 908 38 Net Profit (76) (260) 902 36 Net Pft (Pre Ex.) (277) (258) 15 36 EPS (S cts) (4.1) (13.8) 48.0 1.9 EPS Pre Ex. (S cts) (14.7) (13.7) 0.8 1.9 EPS Gth (%) 82 (241) nm (96) EPS Gth Pre Ex (%) 18 7 nm 147 Diluted EPS (S cts) (4.0) (13.6) 47.3 1.9 Net DPS (S cts) 0.0 0.0 0.0 0.0 BV Per Share (S cts) 110.7 93.3 141.3 143.3 PE (X) nm nm 1.9 46.7 PE Pre Ex. (X) nm nm 115.6 46.7 P/Cash Flow (X) 53.8 24.7 1.5 3.3 EV/EBITDA (X) 39.7 20.5 8.3 6.8 Net Div Yield (%) 0.0 0.0 0.0 0.0 P/Book Value (X) 0.8 1.0 0.6 0.6 Net Debt/Equity (X) 1.8 2.2 1.1 0.9 ROAE (%) (3.6) (13.6) 41.0 1.4 Earnings Rev (%): 4 302 Consensus EPS (S cts): (0.6) 0.8 Other Broker Recs: B: 8 S: 1 H: 11


ON A BETTER FOOTING No sharp improvement in industry outlook. Supply continues to be an issue with container fleet expected to expand by almost 7% in FY15, while demand growth is expected to be more sedate at 3-4%. Though bunker fuel prices have declined from US$600/MT in 2014 to about US$350/MT now, liners are increasingly passing on the savings to customers in a bid to win market share.

But delivering on cost control. Liner opex fell to US$2,242 per FEU in 2Q15, down 6% q-o-q and 14% y-o-y. NOL was able to record significant cost savings (around US$223m) in 2Q15 from better network planning, return of expensive charters and more targeted cargo selection strategy. Liner core EBITDA margin of 8.3% in 2Q15 is the best in several quarters. With the expected return of nine more chartered-in vessels in 2H15, we can expect further cost reductions to materialise.

Minor profitability looks achievable. Though freight rates, especially on the Asia-Europe lane, are still bouncing near multi-year lows, NOL’s strategy to sacrifice market share and focus on restoring profitability seems to be slowly yielding fruit. With the peak season coming up in 3Q, we see hopes of the liner returning to the black. Valuation:

Though core ROE will still be nowhere near desired levels in the near term, NOL’s competiveness is on the rise and a healthier balance sheet puts NOL on a better footing. With valuation at an attractive level of 0.6x P/BV, we believe NOL looks ripe for M&A activities as consolidation is surely the way forward for the container shipping industry. Maintain BUY with a TP of S$1.08 (0.8x P/BV). Key Risks to Our View:

Big mergers are rare in the container-shipping industry. The industry is dominated by family-owned businesses and sovereign-wealth funds, who do not want to give up control and are typically better equipped to endure years of losses during long downcycles without going bankrupt. At A Glance Issued Capital (m shrs) 2,601 Mkt. Cap (S$m/US$m) 2,354 / 1,705 Major Shareholders Temasek Holdings (%) 66.9 Free Float (%) 33.1 3m Avg. Daily Val (US$m) 6.0 ICB Industry : Industrials / Industrial Transportation



Neptune Orient Lines Edition 1 Version 1 | Bloomberg: NOL SP | Reuters: NEPS.SI Refer to important disclosures at the end of this report

46

66

86

106

126

146

166

186

206

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6


Relative IndexS$

Neptune Orient Lines (LHS) Relative STI INDEX (RHS)

ASIAN INSIGHTS VICKERS SECURITIES Page 50

Company Guide

Neptune Orient Lines


Earnings Drivers:

Container volumes and rates are the key revenue drivers. Post-divestment of the logistics business, all of NOL’s revenue will be derived from its container shipping arm under the APL brand. The Transpacific (Asia-US) route is the biggest for NOL owing to legacy reasons, contributing around 50% to revenues. NOL is also fairly well entrenched on the Intra-Asia routes, but a relatively small player on the Asia-Europe route. It is now part of the G6 liner alliance, which allows it to share slots with five other liners. Currently, NOL operates about 90 ships, with an 80/20 owned/ chartered-in ratio. Over the last three years, the liner has added around 34 new ships in the 8,000-14,000 TEU capacity range, while returning expensive charters back to owners. To focus only on more profitable routes, volumes have dropped by around 6% in FY14 from FY12 levels. Volumes might drop further in the future if more chartered vessels are returned to owners. Freight rates have been dropping as well, as evident from the chart alongside, which is a function of market conditions, as explained below.

Container shipping demand-supply equation the main driver for freight rates. Container demand growth is a function of global GDP growth and after a couple of strong decades of close to double-digit growth leading up to 2008, it has leveled off at around 3-5% since 2011, as structural drivers have weakened. In contrast, containership supply growth has consistently outstripped demand growth, with a glut of high-capacity fuel-efficient ships ordered in the recent past. With cost efficiencies being passed on to customers, freight rates are stuck in a structural downturn and have affected premier carriers like NOL – with high cost bases – to a greater degree.

Capacity discipline is a major issue in the industry. While we have seen efforts like the alliances between the top global container liners and some M&A activity to better consolidate the industry, there have been no major cuts in capacity or idling of ships. Carriers are still very much focused on maintaining market share by competing on price, and this ensures that general rate increases do not stick for any period of time and rate volatility is a permanent feature of the liner market.

Cost control has thus become increasingly important. With no control over market-determined freight rates, NOL has had to institute big cost-saving initiatives over the last two years, and very recently in 2Q15, achieved efficiency-related savings of around US$223m. A large part of this is driven by lower bunker consumption with better network planning and newer ships. However, NOL will have to continue cutting down on costs as it still lags most of its peers in terms of operating margins.

Volume ('000 FEUs)

Average Rate/FEU (US$)

Fleet Utilisation

Average Cost/FEU (US$)


3,020 2,9462,827

2,529 2,566

0

400

800

1,200

1,600

2,000

2,400

2,800

2012A 2013A 2014A 2015F 2016F

2,509

2,318 2,265

1,979 1,972

0

500

1,000

1,500

2,000

2,500

2012A 2013A 2014A 2015F 2016F

0.850.91 0.91 0.91 0.91

0.00

0.19

0.37

0.56

0.74

0.93

2012A 2013A 2014A 2015F 2016F

2,7592,556 2,522

2,208 2,182

0

300

600

900

1,200

1,500

1,800

2,100

2,400

2,700

2012A 2013A 2014A 2015F 2016F


Company Guide


Balance Sheet:

Life beyond the logistics business. NOL recently divested the APL Logistics business for a good value of US$1.2bn, and reaped c.US$900m one-off gains in the process. While this resolves its near-term balance sheet stress to an extent – with net gearing declining from 2.3x to 1.1x – NOL will also lose around US$80m of EBITDA contribution per year, or around 30% of FY14's EBITDA level. This makes its earnings somewhat more vulnerable to swings in container shipping market and a potentially lower valuation peg as a pure-play liner. Unlikely to order new vessels immediately. NOL is among the very few top liners not to order the ultra large containerships with carrying capacity of 18,000 TEU or higher. This will seemingly put it at a disadvantage on the Asia-Europe route in the future where these ships will have a cost advantage. However, despite the recent boost to its balance sheet, NOL seems intent not to join the “arms race” as of now and could look to charter in these ships if necessary from its alliance partners like MOL and OOCL. Share Price Drivers:

Better earnings performance. The reduction in cost base for NOL over the past few quarters is encouraging, and could set the base for an improved earnings performance in the coming quarters. 3Q is typically the peak quarter for container shipping volumes and if rates react favourably, NOL’s liner division could return to the black. M&A activity. NOL, with its access to cheap financing, strong base in the world’s 2nd largest container port, and its legacy dominance on the Transpacific trade route, could shape up to be an attractive partner for liners looking to consolidate their operations. Trading at just 0.6x P/BV, acquisition premium will be affordable to any potential acquirer.

Key Risks:

Big mergers are rare in the container-shipping industry. The industry is dominated by family-owned businesses and sovereign-wealth funds, who do not want to give up control and are typically better equipped to endure years of losses during long downcycles without going bankrupt. COMPANY BACKGROUND

Neptune Orient Lines Limited (NOL) is a Singapore-based global container shipping company, with operations across Asia, North and South America, Europe, the Middle East, the Indian subcontinent and Australia.


Capital Expenditure

ROE (%)

PB Band (x)


0.7

0.8

0.9

1.0

1.1

1.2

1.3

0.00

0.50

1.00

1.50

2.00

2.50

3.00

2012A 2013A 2014A 2015F 2016F


0.0

200.0

400.0

600.0

800.0

1,000.0

1,200.0

1,400.0

2012A 2013A 2014A 2015F 2016F


US$

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

2012A 2013A 2014A 2015F 2016F

Avg: 1.01x

+1sd: 1.13x

+2sd: 1.24x

‐1sd: 0.9x

‐2sd: 0.78x

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5


(x)


Company Guide


Key Assumptions

FY Dec 2012A 2013A 2014A 2015F 2016F Volume ('000 FEUs) 3,020.0 2,946.0 2,827.0 2,529.4 2,566.3 Average Rate/FEU (US$) 2,509.0 2,317.6 2,264.6 1,979.5 1,972.2 Fleet Utilisation 0.8 0.9 0.9 0.9 0.9 Average Cost/FEU (US$) 2,759.3 2,556.0 2,522.1 2,207.8 2,181.9

Segmental Breakdown FY Dec 2012A 2013A 2014A 2015F 2016F Revenues (US$ m) Liner 8,054 7,329 7,039 5,757 5,719 Logistics 1,555 1,586 1,659 643 0 Elimination (97) (84) (81) (32) 0 Total 9,512 8,831 8,617 6,367 5,719 Operating Profit (US$ m) Liner (279) (231) (143) 92 120 Logistics 67 64 67 26 0 Others 18 (14) (17) 10 11 Total (194) (181) (93) 128 131 Operating Profit Margins Liner (3.5) (3.2) (2.0) 1.6 2.1 Logistics 4.3 4.0 4.0 4.0 N/A Total (2.0) (2.1) (1.1) 2.0 2.3

Income Statement (US$ m)

FY Dec 2012A 2013A 2014A 2015F 2016F Revenue 9,512 8,831 8,617 6,367 5,719 Cost of Goods Sold (8,988) (8,247) (7,946) (5,623) (5,009) Gross Profit 523 584 671 745 710 Other Opng (Exp)/Inc (737) (769) (764) (617) (579) Operating Profit (213) (185) (93) 128 131 Other Non Opg (Exp)/Inc (32) 1 (27) (21) (18) Associates & JV Inc 9 8 12 4 4 Net Interest (Exp)/Inc (38) (41) (106) (89) (78) Exceptional Gain/(Loss) (77) 200 (2) 887 0 Pre-tax Profit (351) (16) (217) 908 38 Tax (56) (56) (35) (2) (3) Minority Interest (6) (4) (8) (4) 1 Preference Dividend 0 0 0 0 0 Net Profit (412) (76) (260) 902 36 Net Profit before Except. (335) (277) (258) 15 36 EBITDA 68 142 284 579 637 Growth Revenue Gth (%) 3.3 (7.2) (2.4) (26.1) (10.2) EBITDA Gth (%) nm 108.6 99.9 103.7 10.0 Opg Profit Gth (%) 45.2 13.5 49.6 nm 2.2 Net Profit Gth (Pre-ex) (%) (30.0) (17.5) (6.9) (105.7) 147.3 Margins & Ratio Gross Margins (%) 5.5 6.6 7.8 11.7 12.4 Opg Profit Margin (%) (2.2) (2.1) (1.1) 2.0 2.3 Net Profit Margin (%) (4.3) (0.9) (3.0) 14.2 0.6 ROAE (%) (17.4) (3.6) (13.6) 41.0 1.4 ROA (%) (5.4) (0.9) (2.9) 10.7 0.5 ROCE (%) (3.6) (2.7) (1.3) 1.8 1.8 Div Payout Ratio (%) N/A N/A N/A N/A N/A Net Interest Cover (x) (5.6) (4.5) (0.9) 1.4 1.7


Reduction in operating costs key to achieving profitability

Divestment of logistics business at end-May 2015; no contribution thereafter

Divestment gains from sale of APL Logistics division


Company Guide


Quarterly / Interim Income Statement (US$ m)

FY Dec 2Q2014 3Q2014 4Q2014 1Q2015 2Q2015 Revenue 2,050 2,060 2,228 1,985 1,552 Cost of Goods Sold (1,882) (1,854) (2,040) (1,758) (1,391) Gross Profit 168 206 188 227 161 Other Oper. (Exp)/Inc (186) (190) (211) (198) (126) Operating Profit (18) 15 (24) 29 35 Other Non Opg (Exp)/Inc (6) (3) (10) (6) (6) Associates & JV Inc 3 2 5 1 1 Net Interest (Exp)/Inc (25) (30) (28) (35) (24) Exceptional Gain/(Loss) 1 1 (7) 0 887 Pre-tax Profit (44) (14) (64) (11) 893 Tax (7) (7) (19) 2 (2) Minority Interest (3) (2) (2) (2) (1) Net Profit (54) (23) (85) (11) 890 Net profit bef Except. (55) (25) (78) (11) 3 EBITDA 73 107 80 127 121 Growth Revenue Gth (%) (10.0) 0.5 8.2 (10.9) (21.8) EBITDA Gth (%) 205.9 46.6 (25.3) 58.8 (4.8) Opg Profit Gth (%) 73.7 nm nm nm 19.6 Net Profit Gth (Pre-ex) (%) (45.0) (55.3) 217.8 (85.7) (126.4) Margins Gross Margins (%) 8.2 10.0 8.4 11.4 10.4 Opg Profit Margins (%) (0.9) 0.8 (1.1) 1.5 2.2 Net Profit Margins (%) (2.6) (1.1) (3.8) (0.5) 57.3

Balance Sheet (US$ m) FY Dec 2012A 2013A 2014A 2015F 2016F Net Fixed Assets 5,229 6,098 6,012 5,618 5,172 Invts in Associates & JVs 138 170 182 186 190 Other LT Assets N/A N/A N/A N/A N/A Cash & ST Invts N/A N/A N/A N/A N/A Inventory 267 254 175 179 161 Debtors 1,092 1,073 1,080 731 656 Other Current Assets 268 158 128 128 128 Total Assets 8,220 9,029 9,100 7,804 7,705 ST Debt 429 599 615 615 615 Creditor 1,249 1,252 1,178 707 572 Other Current Liab 475 460 435 305 306 LT Debt 3,547 4,267 4,676 3,076 3,076 Other LT Liabilities N/A N/A N/A N/A N/A Shareholder’s Equity N/A N/A N/A N/A N/A Minority Interests 54 54 58 62 61 Total Cap. & Liab. 8,220 9,029 9,100 7,804 7,705 Non-Cash Wkg. Capital (96) (227) (229) 26 68 Net Cash/(Debt) N/A N/A N/A N/A N/A Debtors Turn (avg days) 41.0 44.7 45.6 51.9 44.3 Creditors Turn (avg days) 53.0 57.6 58.7 66.8 52.0 Inventory Turn (avg days) 12.5 12.0 10.4 12.5 13.8 Asset Turnover (x) 1.3 1.0 1.0 0.8 0.7 Current Ratio (x) 1.2 1.1 1.2 1.0 1.4 Quick Ratio (x) 0.9 0.9 1.0 0.9 1.2 Net Debt/Equity (X) 1.4 1.8 2.2 1.1 0.9 Net Debt/Equity ex MI (X) 1.4 1.9 2.3 1.1 1.0 Capex to Debt (%) 25.2 25.1 5.8 2.0 2.0 Z-Score (X) NA 1.1 1.1 1.2 1.1


Sequential improvement in operating profit continues despite freight rate decline and partial loss of logistics contribution

Gearing issues resolved to a large extent with sale of APL Logistics


Company Guide


Cash Flow Statement (US$ m)

FY Dec 2012A 2013A 2014A 2015F 2016F Pre-Tax Profit (351) (16) (217) 908 38 Dep. & Amort. N/A N/A N/A N/A N/A Tax Paid (33) (161) (69) (132) (2) Assoc. & JV Inc/(loss) (9) (8) (12) (4) (4) Chg in Wkg.Cap. (60) (3) (88) (125) (43) Other Operating CF 136 (98) 61 0 0 Net Operating CF (12) 32 69 1,116 510 Capital Exp.(net) (1,002) (1,221) (308) (74) (74) Other Invts.(net) 0 0 0 0 0 Invts in Assoc. & JV (8) (25) 0 0 0 Div from Assoc & JV 0 0 0 0 0 Other Investing CF 111 337 (9) 0 0 Net Investing CF (898) (910) (317) (74) (74) Div Paid 0 0 0 0 0 Chg in Gross Debt 1,588 966 499 (1,600) 0 Capital Issues 1 0 0 0 0 Other Financing CF N/A N/A N/A N/A N/A Net Financing CF 1,580 962 493 (1,600) 0 Currency Adjustments 0 0 0 0 0 Chg in Cash 669 84 245 (558) 436 Opg CFPS (US cts.) 1.8 1.3 6.0 47.9 21.3 Free CFPS (US cts.) (39.2) (45.9) (9.2) 40.2 16.8



Source: DBS Bank

S.No. Da teClos ing

Pric eTa rge t Pri c e

Ra ting

1 08 Aug 14 0.95 1.00 Hold

2 03 Nov 14 0.82 0.88 Hold

3 16 Jan 15 0.95 1.10 Buy

4 16 Feb 15 0.99 1.10 Buy

5 18 Feb 15 1.02 1.10 Buy

6 15 May 15 1.09 1.07 Hold

7 31 Jul 15 0.92 1.08 Buy


1

2

345

6

7

0.70

0.80

0.90

1.00

1.10

1.20

Aug-14 Dec-14 Apr-15

S$

Capex levels not expected to be significant unless further newbuilding plans are announced in future

We are not expecting any dividends from one-off divestment gains for now

ASIAN INSIGHTS VICKERS SECURITIES www.dbsvickers.com ed: JS / sa: JC

BUY (Upgrade from HOLD)

Last Traded Price: S$3.76 (STI : 3,196.66) Price Target : S$4.10 (9% upside) (Prev S$4.30) Potential Catalyst: Oil price rebound, strong order wins, land sales momentum Where we differ: We are conservative in our revenue growth and margin assumptions for 2016 Analyst HO Pei Hwa +65 6682 3714 [email protected]

Price Relative

Forecasts and Valuation FY Dec (S$ m) 2013A 2014A 2015F 2016F Revenue 10,798 10,895 8,896 9,489 EBITDA 1,619 1,612 1,482 1,537 Pre-tax Profit 1,214 1,246 1,134 1,114 Net Profit 820 801 733 705 Net Pft (Pre Ex.) 820 801 679 705 EPS (S cts) 45.6 44.9 41.1 39.5 EPS Pre Ex. (S cts) 45.6 44.9 38.0 39.5 EPS Gth (%) 9 (2) (8) (4) EPS Gth Pre Ex (%) 9 (2) (15) 4 Diluted EPS (S cts) 45.6 44.5 40.7 39.2 Net DPS (S cts) 16.9 16.0 14.4 13.8 BV Per Share (S cts) 290.7 314.8 339.9 365.0 PE (X) 8.2 8.4 9.1 9.5 PE Pre Ex. (X) 8.2 8.4 9.9 9.5 P/Cash Flow (X) 4.6 nm 3.3 6.0 EV/EBITDA (X) 4.8 7.1 7.3 7.2 Net Div Yield (%) 4.5 4.3 3.8 3.7 P/Book Value (X) 1.3 1.2 1.1 1.0 Net Debt/Equity (X) CASH 0.4 0.3 0.3 ROAE (%) 16.9 14.8 12.6 11.2 Earnings Rev (%): (5) (6) Consensus EPS (S cts): 40.5 41.2 Other Broker Recs: B: 7 S: 2 H: 8


TIME TO REVISIT Upgrade to BUY; India growth to mitigate weakness in Singapore. SCI has corrected 28% since end-April following disappointing 1Q15 results and uninspiring outlook guidance. 2Q15 was decent. While the Singapore power business remains under pressure, we could expect the ramp-up in India power plants to drive sequential improvement. Valuation is undemanding, with 19% upside potential to our new TP of S$4.10. Upgrade to BUY. India a new growth engine. The first unit of TPCIL’s power plant in India, operational since April, incurred S$9m startup losses in 2Q15. The plant is likely to breakeven this year and contribute to SCI’s bottomline from 2016 onwards with better economies of scale after the second unit is operational towards the end of 2015. This would mitigate earnings decline from Singapore power plants. Elsewhere, other overseas utilities businesses are expected to be stable this year. Revised down marine earnings. SCI’s 2Q15 results were largely in line. Stripping out one-off gain of S$54.7m arising from divestment of Sembcorp Bournemouth Water Investment, core PATMI grew c.20% q-o-q to S$169m, bringing 1H15 figures to S$311m or 43% of our full year estimate. We are keeping our utilities earnings largely intact but revising down marine earnings to reflect adjustment in SMM earnings forecast. As a result, FY15-16 PATMI forecasts are trimmed by 5-6%. Valuation:

Given its diverse earnings stream and various listed assets, we derive our fair value on SCI based on the sum of its different parts, which include market valuations of its stakes in listed companies Sembcorp Marine (SGX-listed, 60.6% stake), Gallant Venture (SGX-listed, 11.96% stake) and Salalah (Muscat stock exchange, 40% stake) and earnings from utilities and urban development. For its holding company position, we have applied a 10% conglomerate discount to the reappraised net asset value (RNAV). Our TP is adjusted slightly lower to S$4.10 following revision in SMM’s earnings and TP. Key Risks to Our View: Key risks to earnings are further deterioration of Singapore power’s spark spread, execution hiccups in India power plants and deferments in marine projects. At A Glance Issued Capital (m shrs) 1,784 Mkt. Cap (S$m/US$m) 6,708 / 4,846 Major Shareholders Temasek Holdings Pte Ltd (%) 49.5 Mondrian Investment (%) 5.0 Free Float (%) 50.5 3m Avg. Daily Val (US$m) 11.4 ICB Industry : Oil & Gas / Oil Equipment; Services & Dist



Sembcorp Industries Edition 1 Version 1 | Bloomberg: SCI SP | Reuters: SCIL.SI Refer to important disclosures at the end of this report

59

79

99

119

139

159

179

199

219

3.0

3.5

4.0

4.5

5.0

5.5

6.0


Relative IndexS$

Sembcorp Industries (LHS) Relative STI INDEX (RHS)


Company Guide

Sembcorp Industries


Earnings Drivers:

Utilities projects pipeline should progressively add to earnings. New facilities will add to SCI’s power generation and water treatment capacities, which should increase earnings assuming the operations are profitable. A total of 2,588MW of power generation capacity (excluding the 660MW TPCIL Unit 1 plant in India, already online), 140tph of steam capacity and 1.6million m3/day of water treatment capacity is expected to be added from now until 2017. This roughly translates to a 31%, 3% and 17% increase in power, steam and water treatment capacities respectively.

Narrowing spark spreads in Singapore have hit power generation earnings. Growth in supply of electricity outpacing the growth in consumption led to Uniform Singapore Energy Price (USEP) falling by 22.1% y-o-y in 2013 and by further 20.8% in 2014, shrinking the generator’s spark spread – a barometer of profits on electricity sales. However, the impact will not be significant, as Singapore power generation only makes up 6-7% of SCI’s net income. Nonetheless, an increase in USEP prices going forward will help earnings. Greater contribution from non-Singapore power generation facilities would also alleviate the pressure on profitability. Marine business (SMM) earnings are orderbook-driven. Sembcorp Marine’s (SMM) orderbook has declined to S$10.9bn as of end-2Q15, in tandem with the downturn in the offshore oil & gas industry. Order wins of S$1.4bn in 1H15 were weak but respectable amid the current environment; 2013 and 2014 saw full-year order wins of S$4.2bn. The current orderbook stretches until 2019, but there is risk of order deferments – which would spread revenues and earnings thinner – given that drilling units account for 76% of its value. It has primarily been the low oil prices that saw oil majors and asset owners defer capex spend. Hence, a rebound in oil prices would likely trigger more order wins for SMM, which would be positive for earnings.

Urban Development business provides growth opportunities. Urban Development accounts for c.5% of SCI’s bottomline. Thus, a strong performance of this segment will not move the needle too much for now, but represents an avenue for growth. SCI has about 3,500ha of saleable land remaining across China, Indonesia and Vietnam, which it can develop. However, headwinds in the form of delays in China land sales have proven to be a stumbling block recently; better sales momentum, which we are seeing a glimmer of, would give some earnings uplift.

SMM contract wins

SCI Group Net Profit 1H15 – Total S$366m

Utilities 1H15 Net Profit by Geography - Total S$216m

Utilities in Singapore 1H15 Net Profits - Total S$67.3m


4,193 4,192

3,000 3,000

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2013A 2014A 2015F 2016F

59%36%

4%

5% -4%

Utilities

Marine

Urban Development

Other Businesses

Corporate

S$216m

31%

10%

21%10%

7%

3%

-8%

25%

Singapore

Rest of ASEAN, Australia & IndiaChina

Middle East & Africa

UK

The Americas

Corporate

Significant Item

37%

28%

35%

Energy

Water

On-site Logistics & Solid Waste Management


Company Guide

Sembcorp Industries

Balance Sheet:

SCI’s gearing continues to rise, with net gearing at 0.5x as of 2Q15 – a stark contrast to a net cash position in 2013; increasing leverage at SMM has been the main reason for the increase in debt levels. The slight uptick in 2Q15 was a result of SCI acquiring a 60% stake in Green Infra, which was partly funded with debt. Overall though, gearing remains at palatable levels. Share Price Drivers:

Oil price rebound would drive the share price higher. Investors would have greater confidence in order win potential of the Marine business, as a more robust orderbook gives better visibility on revenues. Order wins in the Marine segment and land sales from Urban Development would bode well for SCI’s share price. While the oil price rebound would be an early indicator, securing contract wins is a more tangible indicator. More momentum in land sales would signal more hope for growth, and be positive to share price. Widening spark spreads at Singapore power plants. Signs of a positive and widening spark spread in Singapore would alleviate a key concern of investors and provide support to the share price. Key Risks:

Increasing competition in the Singapore power market. Total power generation supply in Singapore rose 9.3% y-o-y in 2014, marking the biggest y-o-y jump since the electricity market started. The risk is that 2015 may herald a similar growth in supply, depressing prices further and hurting SCI’s bottomline. Execution of Indian power plants. The availability of coal supply and power purchase agreements for SCI’s power plants in India have been of concern. The first unit is up and running on a 500MW purchase agreement and operating on both domestic and imported coal. Execution risk remains for the second unit as it has not won a purchase agreement yet and is due for completion in 3Q15. COMPANY BACKGROUND

Sembcorp Industries (SCI) is a trusted provider of essential energy and water solutions to both industrial and municipal customers. It has facilities with 5,900 megawatts of gross power capacity and over eight million cubic metres of water per day in operation and under development. It is also a world leader in marine and offshore engineering (via Sembcorp Marine) as well as an established brand name in urban development (comprising industrial parks as well as business, commercial and residential space) in Vietnam, China and Indonesia.


Capital Expenditure

ROE (%)

Forward PE Band (x)

PB Band (x)


0.5

0.6

0.6

0.7

0.7

0.8

0.8

0.9

0.9

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

2013A 2014A 2015F 2016F


0.0

200.0

400.0

600.0

800.0

1,000.0

1,200.0

1,400.0

2013A 2014A 2015F 2016F


S$m

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

2013A 2014A 2015F 2016F

Avg: 11.1x

+1sd: 12.2x

+2sd: 13.3x

‐1sd: 10.1x

‐2sd: 9x

7.0

8.0

9.0

10.0

11.0

12.0

13.0

14.0


(x)

Avg: 1.82x

+1sd: 2.12x

+2sd: 2.42x

‐1sd: 1.52x

‐2sd: 1.22x

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2.5

2.7


(x)


Company Guide

Sembcorp Industries

Key Assumptions

FY Dec 2012A 2013A 2014A 2015F 2016F Marine contract wins 10,979 4,193 4,192 3,000 3,000

Segmental Breakdown FY Dec 2012A 2013A 2014A 2015F 2016F Revenues (S$ m) Utilities 5,615 5,138 4,850 3,846 3,922 Marine 4,428 5,526 5,831 4,877 5,425 Industrial Parks 12 13 7 7 9 Other Businesses and 134 122 208 166 133 Others N/A N/A N/A N/A N/A Total 10,189 10,798 10,895 8,896 9,489 Net Profit before EI (S$ m) Utilities 375 450 408 338 363 Marine 327 337 340 288 306 Industrial Parks 41 50 44 45 45 Other Businesses and 11 (17) 9 1 1 Total 753 820 801 672 715 Net Profit before EI Utilities 6.7 8.8 8.4 8.8 9.3 Marine 7.4 6.1 5.8 5.9 5.6 Industrial Parks 354.3 401.4 678.1 639.8 496.6 Other Businesses and 8.1 (13.6) 4.2 0.5 0.8 Total 7.4 7.6 7.4 7.6 7.5


FY Dec 2012A 2013A 2014A 2015F 2016F Revenue 10,189 10,798 10,895 8,896 9,489 Cost of Goods Sold (8,809) (9,510) (9,480) (7,653) (8,174) Gross Profit 1,380 1,287 1,415 1,243 1,315 Other Opng (Exp)/Inc (320) (339) (352) (280) (323) Operating Profit 1,060 948 1,062 962 993 Other Non Opg (Exp)/Inc 43 212 77 39 39 Associates & JV Inc 163 155 158 150 158 Net Interest (Exp)/Inc (111) (101) (51) (72) (76) Exceptional Gain/(Loss) 0 0 0 55 0 Pre-tax Profit 1,155 1,214 1,246 1,134 1,114 Tax (122) (117) (162) (211) (205) Minority Interest (280) (277) (283) (189) (203) Preference Dividend 0 0 0 0 0 Net Profit 753 820 801 733 705 Net Profit before Except. 753 820 801 679 705 EBITDA 1,548 1,619 1,612 1,482 1,537 Growth Revenue Gth (%) 12.6 6.0 0.9 (18.3) 6.7 EBITDA Gth (%) 2.7 4.6 (0.4) (8.1) 3.7 Opg Profit Gth (%) (0.6) (10.5) 12.0 (9.4) 3.1 Net Profit Gth (Pre-ex) (%) (6.9) 8.9 (2.4) (15.3) 3.9 Margins & Ratio Gross Margins (%) 13.5 11.9 13.0 14.0 13.9 Opg Profit Margin (%) 10.4 8.8 9.7 10.8 10.5 Net Profit Margin (%) 7.4 7.6 7.4 8.2 7.4 ROAE (%) 17.5 16.9 14.8 12.6 11.2 ROA (%) 6.1 6.2 5.2 4.3 4.0 ROCE (%) 11.1 9.5 8.3 5.9 5.8 Div Payout Ratio (%) 35.6 37.0 35.7 35.0 35.0 Net Interest Cover (x) 9.5 9.4 21.0 13.3 13.1



Company Guide

Sembcorp Industries


FY Dec 2Q2014 3Q2014 4Q2014 1Q2015 2Q2015 Revenue 2,534 3,069 2,664 2,338 2,388 Cost of Goods Sold (2,200) (2,725) (2,241) (2,050) (2,035) Gross Profit 334 345 424 289 353 Other Oper. (Exp)/Inc (80) (47) (63) (75) (102) Operating Profit 254 297 360 214 251 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 44 25 35 40 59 Net Interest (Exp)/Inc (12) (8) (37) (26) (50) Exceptional Gain/(Loss) 0 0 0 0 55 Pre-tax Profit 286 315 359 228 314 Tax (41) (52) (26) (40) (41) Minority Interest (66) (66) (92) (45) (50) Net Profit 179 197 241 142 224 Net profit bef Except. 179 197 241 142 169 EBITDA 298 322 396 254 310 Growth Revenue Gth (%) (3.6) 21.1 (13.2) (12.2) 2.1 EBITDA Gth (%) (0.8) 8.2 22.7 (35.9) 22.3 Opg Profit Gth (%) 2.8 17.0 21.2 (40.7) 17.6 Net Profit Gth (Pre-ex) (%) (3.1) 9.8 22.6 (41.0) 18.9 Margins Gross Margins (%) 13.2 11.2 15.9 12.3 14.8 Opg Profit Margins (%) 10.0 9.7 13.5 9.1 10.5 Net Profit Margins (%) 7.1 6.4 9.0 6.1 9.4

Balance Sheet (S$ m) FY Dec 2012A 2013A 2014A 2015F 2016F Net Fixed Assets 5,158 5,127 7,725 8,395 9,048 Invts in Associates & JVs 1,506 1,852 2,074 2,155 2,242 Other LT Assets 1,026 1,085 1,246 1,246 1,246 Cash & ST Invts 2,060 2,257 1,663 2,459 2,386 Inventory 1,887 2,241 3,205 1,779 1,898 Debtors 1,176 1,140 1,200 980 1,046 Other Current Assets 73 53 64 64 64 Total Assets 12,885 13,754 17,176 17,074 17,925 ST Debt 115 414 1,086 1,086 1,086 Creditor 2,833 2,692 2,745 2,242 2,391 Other Current Liab 1,218 1,796 1,526 1,291 1,341 LT Debt 2,205 1,485 3,649 3,649 3,649 Other LT Liabilities 870 837 938 938 938 Shareholder’s Equity 4,503 5,230 5,616 6,064 6,512 Minority Interests 1,141 1,300 1,616 1,805 2,008 Total Cap. & Liab. 12,885 13,754 17,176 17,074 17,925 Non-Cash Wkg. Capital (916) (1,054) 198 (710) (725) Net Cash/(Debt) (260) 358 (3,071) (2,276) (2,349) Debtors Turn (avg days) 40.6 39.1 39.2 44.7 39.0 Creditors Turn (avg days) 119.4 109.5 108.3 124.3 108.0 Inventory Turn (avg days) 63.5 81.8 108.4 124.2 85.7 Asset Turnover (x) 0.8 0.8 0.7 0.5 0.5 Current Ratio (x) 1.2 1.2 1.1 1.1 1.1 Quick Ratio (x) 0.8 0.7 0.5 0.7 0.7 Net Debt/Equity (X) 0.0 CASH 0.4 0.3 0.3 Net Debt/Equity ex MI (X) 0.1 CASH 0.5 0.4 0.4 Capex to Debt (%) 48.2 61.3 27.4 21.1 21.1 Z-Score (X) NA 2.2 1.7 1.7 1.7



Company Guide

Sembcorp Industries


FY Dec 2012A 2013A 2014A 2015F 2016F Pre-Tax Profit 1,155 1,214 1,246 1,134 1,113 Dep. & Amort. 282 303 315 331 347 Tax Paid (128) (125) (119) (258) (211) Assoc. & JV Inc/(loss) (163) (155) (158) (150) (158) Chg in Wkg.Cap. (670) 141 (1,414) 954 21 Other Operating CF 146 92 73 0 0 Net Operating CF 620 1,470 (57) 2,010 1,113 Capital Exp.(net) (1,119) (1,164) (1,298) (1,000) (1,000) Other Invts.(net) 9 16 4 0 0 Invts in Assoc. & JV (133) (284) (280) 0 0 Div from Assoc & JV 93 95 122 70 70 Other Investing CF (80) (21) 11 0 0 Net Investing CF (1,230) (1,358) (1,441) (930) (930) Div Paid (546) (413) (539) (286) (257) Chg in Gross Debt 320 392 392 0 0 Capital Issues 0 0 0 0 0 Other Financing CF (84) 82 1,049 0 0 Net Financing CF (310) 62 903 (286) (257) Currency Adjustments 0 0 0 0 0 Chg in Cash (919) 174 (596) 794 (74) Opg CFPS (S cts) 71.7 73.9 76.1 59.2 61.1 Free CFPS (S cts) (27.7) 17.0 (76.0) 56.6 6.3



Source: DBS Bank

S.No. Da teClos ing

Pric eTa rge t Pric e

Ra ting

1: 07 Aug 14 5.34 6.00 Buy2: 16 Sep 14 5.16 6.00 Buy3: 07 Nov 14 4.54 5.40 Buy4: 04 Dec 14 4.21 4.70 Buy5: 05 Dec 14 4.21 4.70 Buy6: 18 Feb 15 4.24 4.80 Buy7: 08 May 15 4.37 4.30 Hold


12

3 4

5

6

7

3.19

3.69

4.19

4.69

5.19

5.69


S$


HOLD Last Traded Price: S$2.69 (STI : 3,191.39) Price Target : S$2.55 (-5% downside) (Prev S$2.89) Potential Catalyst: Order wins, margin expansion Where We Differ: Market is generally bearish on rigbuilders Analyst HO Pei Hwa +65 6682 3714 [email protected]

Price Relative

Forecasts and Valuation FY Dec (S$ m) 2013A 2014A 2015F 2016F Revenue 5,526 5,833 4,877 5,425 EBITDA 744 829 793 868 Pre-tax Profit 665 707 622 658 Net Profit 556 560 485 515 Net Pft (Pre Ex.) 538 560 485 515 EPS (S cts) 26.6 26.8 23.2 24.7 EPS Pre Ex. (S cts) 25.7 26.8 23.2 24.7 EPS Gth (%) 3 1 (13) 6 EPS Gth Pre Ex (%) 7 4 (13) 6 Diluted EPS (S cts) 26.7 27.0 23.4 24.8 Net DPS (S cts) 13.0 13.0 11.6 12.3 BV Per Share (S cts) 128.1 141.9 152.1 165.2 PE (X) 10.1 10.0 11.6 10.9 PE Pre Ex. (X) 10.4 10.0 11.6 10.9 P/Cash Flow (X) 6.0 nm 7.5 11.9 EV/EBITDA (X) 6.5 7.8 8.3 7.8 Net Div Yield (%) 4.8 4.8 4.3 4.6 P/Book Value (X) 2.1 1.9 1.8 1.6 Net Debt/Equity (X) CASH 0.2 0.2 0.3 ROAE (%) 21.7 19.9 15.8 15.5 Earnings Rev (%): (15) (10) Consensus EPS (S cts): 22.3 21.4 Other Broker Recs: B: 3 S: 12 H: 10


NAVIGATING ROUGH SEAS Maintain HOLD; decent dividend yield. We reckon order momentum will likely lag any oil price recovery amid rig supply glut and keen competition. Nevertheless, SMM offers decent dividend yield of 4-5% on the back of 40% dividend payout. More deferments. Brazilian projects are likely to be pushed back as Petrobras has slashed its 5-year capex by 41% and production target by 30%. Transocean recently deferred delivery of the pair of drillships under construction at SMM's yard by two years. There could be more of such deferments which pose a risk to earnings, but this should be partially mitigated by compensation from customers. Slow order momentum. YTD win of S$1.4bn was driven by the sizeable contract with Heerema Offshore Services to build the world’s largest semi-submersible crane vessel. SMM’s orderbook had dwindled to S$10.9bn by end-Jun 15, from S$11.4bn in Dec-2015. Valuation:

Our SOTP target price of S$2.55 is based on 11x SMM’s FY15F earnings (excluding Cosco Shipyard Group, CSG), 8x CSG’s FY15F earnings and fair value of its 4.97% stake in Cosco Corp.

Key Risks to Our View:

Key risks are sustained low oil prices which affect rig count and newbuilding activities, execution risks at protected markets especially Brazil and further deferments / cancellations. At A Glance Issued Capital (m shrs) 2,089 Mkt. Cap (S$m/US$m) 5,619 / 4,069 Major Shareholders Sembcorp Industries Ltd (%) 61.0 Franklin (%) 5.0 Free Float (%) 34.0 3m Avg. Daily Val (US$m) 4.0 ICB Industry : Oil & Gas / Oil Equipment; Services & Dist



Sembcorp Marine Edition 1 Version 1 | Bloomberg: SMM SP | Reuters: SCMN.SI Refer to important disclosures at the end of this report

44

64

84

104

124

144

164

184

204

2.3

2.8

3.3

3.8

4.3

4.8

5.3

5.8


Relative IndexS$

Sembcorp Marine (LHS) Relative STI INDEX (RHS)


Company Guide

Sembcorp Marine


Earnings Drivers:

Declining orderbook. Order wins and orderbook trend are often the key leading indicators of rigbuilders’ share price and earnings. Singapore rigbuilders’ order flow has been slow, securing S$531m worth of new orders YTD or 11% of our full-year expectation of S$5bn (down from S$9.2bn in 2014). Based on existing capacity, SMM requires S$4-5bn worth of order replenishment every year. We expect new orders to be half of those levels in the coming two years amidst sector headwinds, a harbinger of declining orderbook and earnings ahead. SMM’s orderbook has dwindled to S$10.6bn by end-Mar-15, from S$11.4bn a quarter ago. This translates into a book-to-bill ratio of approximately 2.0x. (or 1.6x if stripping out Petrobras’ revenue recognition from 2017 onwards). Asset deflation underway. Post-GFC crisis, newbuild prices for drilling rigs tumbled 20-30% from 2008-2010. Prices have The 5-15% price gain over the past few years could all be given back, if not worse. In this downturn, China plays a bigger role in global rig market, garnering one-third of global orderbook. Over 90% of these contracts are built on speculation without back-to-back charters and on 5:95 balloon payment terms, making it vulnerable to cancellations. We expect fire sales to suppress rig prices as shipyards would be desperate to recoup their construction costs if ship owners walk away. Rig utilisation and dayrates remain under pressure. Low oil price adds fuel to fire, aggravating the already challenging rigbuilding market that is suffering from a massive order backlog and keen competition. New rig supply is projected to be 5-7% a year while rig demand is expected to contract by 3-5% y-o-y in 2015, before returning to positive territory in 2016. As a result, day rates and utilisation have fallen around 20% from June-2014 levels. It may get worse before it gets better. We believe gradual recovery in rig market towards 2016 will set the stage for rising newbuild demand thereafter. Pace of rigbuilding recovery is dependent on oil price rebound, retirement of old fleets and cancellations at Chinese yards. An oil price rebound above US$80/bbl will stimulate E&P activities and thus rig demand while rig attribution and cancellations will soothe the supply pressure and eventually bring the sector back to equilibrium.

Order Win

Sales Trend

Asset Trend

Profitability Trend

Margin Trends (%)


4,193 4,192

2,000

3,000

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2013A 2014A 2015F 2016F

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0

1,000

2,000

3,000

4,000

5,000

2012A 2013A 2014A 2015F 2016F

S$ m

Total Revenue Revenue Growth (%) (YoY)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

2012A 2013A 2014A 2015F 2016F

S$ m

Net Fixed Assets (Tangible) Total Current Assets

485

535

585

635

685

2012A 2013A 2014A 2015F 2016F

S$ m

Operating EBIT Pre tax Profit Net Profit

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2012A 2013A 2014A 2015F 2016F



Company Guide

Sembcorp Marine

Balance Sheet:

Net gearing has crept up from 0.3x in 1Q to 0.5x as of end-Jun. The rising trend should eventually reverse with the completion of the Brazilian and New yard by 2016, reducing capex to more a normalised level of S$100m+. Share Price Drivers:

Recovery in oil prices. Rising oil prices could lift sentiment on rigbuilders, though it might lag behind the asset owners. We believe SMM would benefit if oil prices recover to at least above the $70/bbl level, which would trigger more offshore oil & gas capex spend.

Order win momentum. Shipyards are orderbook driven. Strong order flow could push up the share price, as investors reward greater visibility on revenues and earnings. Restructuring of Sete Brasil. The successful restructuring of Brazil will allow Sete Brasil to get financing for its rigbuilding programme. This will eliminate an overhang on the rigbuilders. Key Risks:

Sustained low oil price. Brent crude oil price below US$60/bbl would defer investments into deepwater, and higher cost of oilfield projects. Execution risks in protected market. Cost pressure, lack of skilled labour, potential project delays faced in emerging markets like Brazil is a lingering concern. Rig supply glut and competition . Slower order flow is expected as the market takes time to absorb almost 200 rigs scheduled for delivery in the next two years, representing >20% of existing fleet. Competition is intensified with the low order backlog of Korean yards and emergence of Chinese shipyards in the offshore space. COMPANY BACKGROUND

Sembcorp Marine (SMM) is a pure play in the offshore & Marine sector. Its principal activities are rig building and offshore engineering, ship conversion, ship repair and shipbuilding of specialised vessels.


Capital Expenditure

ROE (%)

Forward PE Band (x)

PB Band (x)


0.5

0.6

0.6

0.7

0.7

0.8

0.8

0.9

0.9

0.00

0.10

0.20

0.30

0.40

0.50

0.60

2013A 2014A 2015F 2016F


0.0

100.0

200.0

300.0

400.0

500.0

600.0

700.0

800.0

900.0

2013A 2014A 2015F 2016F


S$m

0.0%

5.0%

10.0%

15.0%

20.0%

2013A 2014A 2015F 2016F

Avg: 15.9x

+1sd: 18.1x

+2sd: 20.3x

‐1sd: 13.7x

‐2sd: 11.5x

9.6

11.6

13.6

15.6

17.6

19.6

21.6


(x)

Avg: 3.31x

+1sd: 4.05x

+2sd: 4.8x

‐1sd: 2.56x

‐2sd: 1.82x1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0


(x)


Company Guide

Sembcorp Marine

Key Assumptions

FY Dec 2012A 2013A 2014A 2015F 2016F Order Win 10,979 4,193 4,192 2,000 3,000

Segmental Breakdown FY Dec 2012A 2013A 2014A 2015F 2016F Revenues (S$ m) Rig Building (newbuilds) 2,356 3,564 3,779 2,173 2,488 Offshore & Conversion 1,395 1,204 1,353 2,040 2,175 Ship repair 642 681 622 625 722 Shipbuilding (newbuilds) 0 0 0 0 0 Others 37 77 79 38 40 Total 4,430 5,526 5,833 4,877 5,425


FY Dec 2012A 2013A 2014A 2015F 2016F Revenue 4,430 5,526 5,833 4,877 5,425 Cost of Goods Sold (3,736) (4,818) (4,989) (4,123) (4,609) Gross Profit 695 708 844 754 816 Other Opng (Exp)/Inc (140) (78) (137) (119) (132) Operating Profit 554 630 707 635 684 Other Non Opg (Exp)/Inc 1 2 1 0 0 Associates & JV Inc 56 16 10 22 23 Net Interest (Exp)/Inc 18 0 (11) (34) (49) Exceptional Gain/(Loss) 38 18 0 0 0 Pre-tax Profit 668 665 707 622 658 Tax (100) (77) (106) (109) (112) Minority Interest (29) (33) (41) (28) (31) Preference Dividend 0 0 0 0 0 Net Profit 538 556 560 485 515 Net Profit before Except. 500 538 560 485 515 EBITDA 702 744 829 793 868 Growth Revenue Gth (%) 11.9 24.7 5.6 (16.4) 11.2 EBITDA Gth (%) (21.0) 6.0 11.4 (4.3) 9.4 Opg Profit Gth (%) (24.8) 13.6 12.3 (10.3) 7.8 Net Profit Gth (Pre-ex) (%) (28.2) 7.5 4.1 (13.4) 6.1 Margins & Ratio Gross Margins (%) 15.7 12.8 14.5 15.5 15.0 Opg Profit Margin (%) 12.5 11.4 12.1 13.0 12.6 Net Profit Margin (%) 12.2 10.1 9.6 9.9 9.5 ROAE (%) 22.2 21.7 19.9 15.8 15.5 ROA (%) 9.9 8.5 7.2 5.9 5.9 ROCE (%) 16.3 15.9 13.2 9.7 9.6 Div Payout Ratio (%) 50.4 48.9 48.5 50.0 50.0 Net Interest Cover (x) NM NM 62.9 18.4 13.9



Company Guide

Sembcorp Marine


FY Dec 2Q2014 3Q2014 4Q2014 1Q2015 2Q2015 Revenue 1,341 1,712 1,445 1,304 1,208 Cost of Goods Sold (1,147) (1,507) (1,170) (1,135) (1,009) Gross Profit 194 205 275 169 199 Other Oper. (Exp)/Inc (39) (33) (38) (31) (52) Operating Profit 154 171 236 138 147 Other Non Opg (Exp)/Inc 1 0 0 0 0 Associates & JV Inc 10 3 (11) 4 (3) Net Interest (Exp)/Inc (1) (3) (7) (7) (9) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 165 172 218 135 136 Tax (25) (33) (21) (26) (23) Minority Interest (9) (7) (19) (3) (4) Net Profit 132 132 178 106 109 Net profit bef Except. 132 132 178 106 109 EBITDA 194 205 255 173 176 Growth Revenue Gth (%) 0.4 27.7 (15.6) (9.8) (7.4) EBITDA Gth (%) 5.7 5.7 24.2 (32.1) 1.8 Opg Profit Gth (%) 3.8 11.0 37.9 (41.5) 6.4 Net Profit Gth (Pre-ex) (%) 7.5 0.3 34.7 (40.5) 3.2 Margins Gross Margins (%) 14.5 11.9 19.0 13.0 16.5 Opg Profit Margins (%) 11.5 10.0 16.4 10.6 12.2 Net Profit Margins (%) 9.8 7.7 12.3 8.1 9.0

Balance Sheet (S$ m) FY Dec 2012A 2013A 2014A 2015F 2016F Net Fixed Assets 1,476 2,394 3,009 3,472 3,712 Invts in Associates & JVs 417 446 470 493 516 Other LT Assets 252 189 192 192 192 Cash & ST Invts 1,409 1,695 1,093 1,123 1,201 Inventory 1,731 2,084 3,005 2,567 3,014 Debtors 468 442 469 406 452 Other Current Assets 32 0 0 0 0 Total Assets 5,786 7,250 8,238 8,253 9,087 ST Debt 33 166 434 434 434 Creditor 1,687 1,781 1,826 1,626 1,808 Other Current Liab 998 1,583 1,189 1,012 1,109 LT Debt 300 600 1,308 1,458 1,708 Other LT Liabilities 221 310 350 350 350 Shareholder’s Equity 2,439 2,677 2,965 3,179 3,451 Minority Interests 109 132 167 195 226 Total Cap. & Liab. 5,786 7,250 8,238 8,253 9,087 Non-Cash Wkg. Capital (453) (838) 459 336 548 Net Cash/(Debt) 1,076 929 (648) (769) (941) Debtors Turn (avg days) 36.6 30.1 28.5 32.7 28.9 Creditors Turn (avg days) 173.5 134.1 134.9 158.0 140.9 Inventory Turn (avg days) 133.1 147.5 190.4 255.1 228.9 Asset Turnover (x) 0.8 0.8 0.8 0.6 0.6 Current Ratio (x) 1.3 1.2 1.3 1.3 1.4 Quick Ratio (x) 0.7 0.6 0.5 0.5 0.5 Net Debt/Equity (X) CASH CASH 0.2 0.2 0.3 Net Debt/Equity ex MI (X) CASH CASH 0.2 0.2 0.3 Capex to Debt (%) 155.1 104.0 42.4 31.7 18.7 Z-Score (X) NA 2.4 2.2 2.2 2.1



Company Guide

Sembcorp Marine


FY Dec 2012A 2013A 2014A 2015F 2016F Pre-Tax Profit 668 665 707 622 658 Dep. & Amort. 94 101 115 137 161 Tax Paid (90) (54) (19) (121) (109) Assoc. & JV Inc/(loss) (56) (16) (10) (22) (23) Chg in Wkg.Cap. (396) 243 (1,267) 136 (216) Other Operating CF (12) (2) (34) 0 0 Net Operating CF 208 937 (508) 751 471 Capital Exp.(net) (516) (797) (738) (600) (400) Other Invts.(net) 0 0 (27) 0 0 Invts in Assoc. & JV (14) 0 0 0 0 Div from Assoc & JV 1 1 0 0 0 Other Investing CF 2 (2) (5) 0 0 Net Investing CF (527) (798) (770) (600) (400) Div Paid (529) (283) (285) (272) (243) Chg in Gross Debt 300 438 964 150 250 Capital Issues (3) (20) (11) 0 0 Other Financing CF 0 0 0 0 0 Net Financing CF (232) 135 668 (122) 7 Currency Adjustments (30) 11 (7) 0 0 Chg in Cash (581) 286 (618) 30 78 Opg CFPS (S cts) 28.9 33.2 36.3 29.5 32.9 Free CFPS (S cts) (14.8) 6.7 (59.7) 7.2 3.4



Source: DBS Bank

S.No. Da teClos ing


Ra ting

1: 05 Aug 14 4.03 4.82 Buy2: 20 Oct 14 3.69 4.00 Buy3: 06 Nov 14 3.59 3.80 Hold 4: 04 Dec 14 2.93 2.89 Hold 5: 13 Feb 15 3.02 2.89 Hold 6: 31 Mar 15 2.92 2.89 Hold 7: 28 Apr 15 2.94 2.89 Hold 8: 22 Jun 15 2.88 2.89 Hold


12

3

45

6

7

8

2.44

2.64

2.84

3.04

3.24

3.44

3.64

3.84

4.04

4.24


S$


HOLD (Upgrade from FULLY VALUED) Last Traded Price: S$3.49 (STI : 3,191.39) Price Target : S$3.70 (6% upside) Potential Catalyst: Earnings improvement, M&A activity Where We Differ: Earnings estimates largely in line with consensus Analyst Suvro SARKAR +65 6682 3720 [email protected]

Price Relative

Forecasts and Valuation FY Mar (S$ m) 2014A 2015A 2016F 2017F Revenue 1,178 1,121 1,163 1,205 EBITDA 315 233 241 251 Pre-tax Profit 294 205 207 218 Net Profit 266 183 186 196 Net Pft (Pre Ex.) 265 177 186 196 EPS (S cts) 23.8 16.3 16.5 17.2 EPS Pre Ex. (S cts) 23.8 15.8 16.5 17.2 EPS Gth (%) (2) (31) 1 4 EPS Gth Pre Ex (%) (3) (33) 4 4 Diluted EPS (S cts) 23.3 16.1 16.4 17.1 Net DPS (S cts) 25.0 14.5 15.0 15.0 BV Per Share (S cts) 122.0 118.1 121.2 124.4 PE (X) 14.7 21.4 21.2 20.3 PE Pre Ex. (X) 14.7 22.1 21.2 20.3 P/Cash Flow (X) 34.5 40.7 29.9 29.2 EV/EBITDA (X) 10.8 15.0 14.6 14.0 Net Div Yield (%) 7.2 4.2 4.3 4.3 P/Book Value (X) 2.9 3.0 2.9 2.8 Net Debt/Equity (X) CASH CASH CASH CASH ROAE (%) 20.0 13.6 13.8 14.1 Earnings Rev (%): (5) (5) Consensus EPS (S cts): 15.7 16.9 Other Broker Recs: B: 1 S: 7 H: 0


KEEP YOUR SEATBELTS FASTENED Things should be more exciting hereon. The share price under-performance in recent months looks to have largely priced in the weak earnings performance in recent quarters. We believe it could be time to watch out for signs of operational improvement as well any potential corporate activity triggered by the decline in share price.

Structural headwinds posing challenges. Despite overall steady growth trends in MRO industry, SIE’s heavy maintenance business has been affected by the induction of newer aircraft, especially in parent SIA’s fleet. Newer aircraft are increasingly more reliable, with longer maintenance cycles. Concurrently, SIE’s engine MRO JVs are also facing the reality of older engine models being retired on an accelerated basis, and new models requiring fewer shop visits.

Is consolidation the way out? In order to tackle some of the structural issues, SIE may consider merging with or partnering third-party MROs with complementary business models. Given its share price decline in recent months, valuations are more amenable to a merger or takeover situation. We believe the merits of a combination of SIA Engineering and ST Aerospace will better consolidate Singapore’s credentials as an aviation hub as synergies are realised in the form of bigger scale, cost efficiencies and breadth of offerings. Valuation:

Given the steep 26% fall in share price since our downgrade last November, we believe downside is limited at these levels. Upgrade to HOLD on the back of dividend yield support (>4%) and potential M&A activity. Our TP of S$3.70 is based on a blended valuation framework (PE, dividend yield and DCF). Key Risks to Our View:

OEMs getting more aggressive. As OEMs increasingly take a bigger share of the airframe MRO market for new generation aircraft, SIE will need to adapt and stay relevant by forming JVs with the right OEMs in the right market, in order to secure future workload. However, new ventures will take time to ramp up and share of market could effectively be lower. At A Glance Issued Capital (m shrs) 1,123 Mkt. Cap (S$m/US$m) 3,920 / 2,839 Major Shareholders Singapore Airlines Ltd (%) 77.5 Free Float (%) 22.6 3m Avg. Daily Val (US$m) 1.4 ICB Industry : Industrials / Industrial Transportation



SIA Engineering Edition 1 Version 1 | Bloomberg: SIE SP | Reuters: SIAE.SI Refer to important disclosures at the end of this report

79

99

119

139

159

179

199

219

3.0

3.5

4.0

4.5

5.0

5.5

Jul-11 Jul-12 Jul-13 Jul-14 Jul-15

Relative IndexS$

SIA Engineering (LHS) Relative STI INDEX (RHS)


Company Guide

SIA Engineering


Earnings Drivers:

Close to 60% of topline is driven by parent SIA. This is mainly due to legacy reasons, as SIE was born as the in-house MRO operations of SIA before being independently listed in 2000. The growth and maintenance cycle of SIA's fleet therefore strongly impact SIE’s core businesses of line maintenance, heavy maintenance and fleet management. Line maintenance division largely driven by Changi Airport traffic. SIE already captures the majority of line maintenance market share (we estimate this to be ~90%) at Changi Airport, which means incremental gains in revenues are driven by the pie getting bigger. We estimate flights handled by SIE to grow by 2% annually in FY16 and FY17. In the longer term, continued growth of Singapore as a tourism hub to the region and the addition of capacity via the upcoming Terminals 4 and 5 should help drive line maintenance revenues and earnings. Heavy maintenance headwinds prevail in near term. The heavy maintenance segment saw revenues decline sharply by 15% in FY15, which was largely attributed to the phasing in of newer aircrafts with longer maintenance cycles and less need for maintenance by virtue of just being new. A persistence of this trend would weigh on SIE’s heavy maintenance business. SIE’s ability to adapt to an OEM-centric environment will impact earnings. How SIE responds to the trend of OEMs, like how Boeing is encroaching on the aftermarket services space, is important. In mid-2014, SIE entered into a fleet management JV with Boeing – its first with an airframe OEM. The deal allows SIE to penetrate new markets in Asia but poses the risk of cannibalisation of currently managed Boeing planes. Entrance into similar partnerships in the future could thus boost earnings but must be weighted carefully against their risks. JVs/associates contribute roughly 50-60% of the bottomline. SIE has 26 associates and JVs in nine countries, with engine overhaul centres comprising the bulk of JV/associate revenues. However, the phasing out of older generation engine models and extended maintenance cycles for their successors continue to dampen contributions from the company’s key engine MRO centres Eagle Services Asia and SAESL, and consequently on SIE’s profits. Slump in oil price is a positive. The slump in fuel prices since September 2014 means airlines across the world are starting to benefit in terms of their bottomlines, and this should encourage more MRO spending in the medium term if oil prices stay benign. Management has indicated earlier that the aircraft MRO cycle should start to turn again over the next 2-3 years, as maintenance cycles cannot be deferred forever, even for new aircraft types.

Base maintenance revenue

Line maintenance revenue

Fleet management revenue

Profit from associates & JVs

Margin Trends (%)


552579

490510

533

0

73

146

219

292

366

439

512

585

2013A 2014A 2015A 2016F 2017F

421 435 442 456 465

0

95

190

285

380

474

2013A 2014A 2015A 2016F 2017F

174165

188198

207

0

42

85

127

169

212

2013A 2014A 2015A 2016F 2017F

150

163

106101

106

0

21

41

62

82

103

123

144

164

2013A 2014A 2015A 2016F 2017F

0%

5%

10%

15%

20%

25%

30%

2013A 2014A 2015A 2016F 2017F



Company Guide

SIA Engineering

Balance Sheet:

Strong balance sheet gives headroom for expansion. SIE has very low leverage at only a 0.02x gross debt-to-equity ratio, and is in a net cash position with ~S$500m of cash reserves on its balance sheet. The company therefore has ample room to take on additional debt to fund attractive projects, should they arise. Share Price Drivers:

Contract wins should benefit the share price. The inking of long-term contracts with airlines provides greater visibility and upside to revenue and earnings, and increases confidence in SIE’s medium-term sustainability. M&A and other corporate activity is a catalyst. In order to tackle some of the structural issues, SIE may consider merging with or partnering third-party MROs with complementary business models. Given its share price decline in recent months, valuations are more amenable to a merger or takeover situation. We continue to believe in the merits of a combination of SIA Engineering and ST Aerospace to better consolidate Singapore’s credentials as an aviation hub as synergies are realised in the form of bigger scale, cost efficiencies and breadth of offerings. Under such a scnaerio, the target company – in this case, SIA Engineering – usually sees a positive reaction in share price, as other party may need to pay a premium over market prices. Key Risks:

Slow growth at certain associates and joint ventures (JVs). Some of the engine MRO JVs cater to older widebody models, which are being phased out. Demand may be negatively affected as a result. Risk of cannibalisation remains salient. New JVs and associates, such as the Boeing fleet management JV, carry the risk of cannibalising some of the group's existing revenue lines, which could slow growth. COMPANY BACKGROUND

Leading regional aircraft maintenance, repair and overhaul (MRO) company with bases in Singapore and Philippines. A comprehensive cluster of JVs with renowned OEMs allows it to provide a full suite of MRO services.


Capital Expenditure

ROE (%)

Forward PE Band (x)

PB Band (x)


0.6

0.6

0.6

0.7

0.7

0.7

0.7

0.7

0.8

0.8

0.8

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

2013A 2014A 2015A 2016F 2017F


0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

2013A 2014A 2015A 2016F 2017F


S$m

0.0%

5.0%

10.0%

15.0%

20.0%

2013A 2014A 2015A 2016F 2017F

Avg: 22.1x

+1sd: 27.2x

+2sd: 32.3x

‐1sd: 17x

‐2sd: 11.8x10.6

15.6

20.6

25.6

30.6

35.6

Aug-11 Aug-12 Aug-13 Aug-14

(x)

Avg: 3.71x

+1sd: 4.08x

+2sd: 4.45x

‐1sd: 3.33x

‐2sd: 2.96x

2.5

3.0

3.5

4.0

4.5

5.0


(x)


Company Guide

SIA Engineering

Key Assumptions

FY Mar 2013A 2014A 2015A 2016F 2017F Base maintenance 552 579 490 510 533 Line maintenance revenue 421 435 442 456 465 Fleet management 174 165 188 198 207 Profit from associates & JVs

150 163 106 101 106


FY Mar 2013A 2014A 2015A 2016F 2017F Revenue 1,147 1,178 1,121 1,163 1,205 Cost of Goods Sold (1,019) (1,063) (1,037) (1,066) (1,104) Gross Profit 128 116 84 97 102 Other Opng (Exp)/Inc 0 0 0 0 0 Operating Profit 128 116 84 97 102 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 150 163 106 101 106 Net Interest (Exp)/Inc 18 15 9 9 10 Exceptional Gain/(Loss) 1 1 6 0 0 Pre-tax Profit 297 294 205 207 218 Tax (23) (23) (20) (19) (20) Minority Interest (4) (5) (2) (2) (2) Preference Dividend 0 0 0 0 0 Net Profit 270 266 183 186 196 Net Profit before Except. 270 265 177 186 196 EBITDA 313 315 233 241 251 Growth Revenue Gth (%) (2.0) 2.7 (4.9) 3.8 3.6 EBITDA Gth (%) (4.0) 0.7 (26.0) 3.2 4.2 Opg Profit Gth (%) (1.2) (9.8) (27.3) 15.2 5.2 Net Profit Gth (Pre-ex) (%) 0.7 (1.7) (33.1) 5.0 5.1 Margins & Ratio Gross Margins (%) 11.2 9.8 7.5 8.3 8.4 Opg Profit Margin (%) 11.2 9.8 7.5 8.3 8.4 Net Profit Margin (%) 23.6 22.6 16.4 16.0 16.2 ROAE (%) 21.1 20.0 13.6 13.8 14.1 ROA (%) 16.7 15.9 10.9 11.1 11.2 ROCE (%) 8.9 7.6 5.3 6.1 6.3 Div Payout Ratio (%) 90.1 105.0 88.7 91.0 87.2 Net Interest Cover (x) NM NM NM NM NM



Company Guide

SIA Engineering


FY Mar 1Q2015 2Q2015 3Q2015 4Q2015 1Q2016 Revenue 294 285 265 276 277 Cost of Goods Sold (273) (269) (241) (253) (256) Gross Profit 21 16 24 23 21 Other Oper. (Exp)/Inc 0 0 0 0 0 Operating Profit 21 16 24 23 21 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 31 29 25 21 24 Net Interest (Exp)/Inc 3 2 2 2 2 Exceptional Gain/(Loss) 6 0 0 0 0 Pre-tax Profit 60 47 52 47 47 Tax (5) (4) (5) (6) (5) Minority Interest (1) (1) (1) 0 0 Net Profit 54 42 46 41 41 Net profit bef Except. 48 42 46 41 41 EBITDA 62 55 61 55 56 Growth Revenue Gth (%) (5.6) (3.0) (7.0) 4.0 0.5 EBITDA Gth (%) (23.3) (10.2) 9.4 (9.1) 0.9 Opg Profit Gth (%) (39.5) (23.2) 52.8 (4.9) (9.5) Net Profit Gth (Pre-ex) (%) (26.2) (11.5) 9.2 (11.0) 0.5 Margins Gross Margins (%) 7.0 5.6 9.2 8.4 7.5 Opg Profit Margins (%) 7.0 5.6 9.2 8.4 7.5 Net Profit Margins (%) 18.2 14.8 17.5 15.0 14.9

Balance Sheet (S$ m) FY Mar 2013A 2014A 2015A 2016F 2017F Net Fixed Assets 306 337 344 351 359 Invts in Associates & JVs 427 436 464 478 492 Other LT Assets 64 69 76 76 76 Cash & ST Invts 523 536 464 489 518 Inventory 108 107 125 129 134 Debtors 87 117 96 99 103 Other Current Assets 119 106 89 89 89 Total Assets 1,633 1,707 1,657 1,712 1,770 ST Debt 6 8 9 9 9 Creditor 246 242 227 236 245 Other Current Liab 26 26 20 21 22 LT Debt 0 14 24 24 24 Other LT Liabilities 25 27 27 27 27 Shareholder’s Equity 1,302 1,361 1,325 1,369 1,415 Minority Interests 27 30 25 27 29 Total Cap. & Liab. 1,633 1,707 1,657 1,712 1,770 Non-Cash Wkg. Capital 41 61 62 60 59 Net Cash/(Debt) 517 514 431 456 485 Debtors Turn (avg days) 31.0 31.5 34.5 30.5 30.6 Creditors Turn (avg days) 94.7 86.9 86.2 82.6 82.7 Inventory Turn (avg days) 41.8 38.2 42.5 45.3 45.3 Asset Turnover (x) 0.7 0.7 0.7 0.7 0.7 Current Ratio (x) 3.0 3.1 3.0 3.0 3.1 Quick Ratio (x) 2.2 2.4 2.2 2.2 2.3 Net Debt/Equity (X) CASH CASH CASH CASH CASH Net Debt/Equity ex MI (X) CASH CASH CASH CASH CASH Capex to Debt (%) 798.2 338.5 161.1 150.6 150.6 Z-Score (X) 10.6 10.2 10.3 10.1 9.9


Profits from associates/JVs up q-o-q but still down 22% y-o-y

Operating margins remain depressed

Net cash position gives headroom for leverage and growth


Company Guide

SIA Engineering


FY Mar 2013A 2014A 2015A 2016F 2017F Pre-Tax Profit 297 294 205 207 218 Dep. & Amort. 35 37 43 43 43 Tax Paid (27) (24) (23) (17) (19) Assoc. & JV Inc/(loss) (150) (163) (106) (101) (106) Chg in Wkg.Cap. (4) (21) (5) 0 0 Other Operating CF (18) (11) (17) 0 0 Net Operating CF 134 113 96 132 136 Capital Exp.(net) (46) (74) (54) (50) (50) Other Invts.(net) 0 0 0 0 0 Invts in Assoc. & JV 0 2 0 (20) (20) Div from Assoc & JV 138 157 112 107 112 Other Investing CF 19 16 19 0 0 Net Investing CF 111 101 78 37 42 Div Paid (242) (245) (269) (163) (169) Chg in Gross Debt 3 16 9 0 0 Capital Issues 23 30 17 20 20 Other Financing CF (2) (3) (8) 0 0 Net Financing CF (219) (202) (251) (143) (149) Currency Adjustments 0 0 5 0 0 Chg in Cash 25 13 (72) 26 29 Opg CFPS (S cts) 12.4 12.0 9.0 11.6 11.9 Free CFPS (S cts) 8.0 3.5 3.8 7.2 7.6



Source: DBS Bank

S.No. Da teClos ing


Ra ting

1: 06 Nov 14 4.42 3.80 Fully Valued2: 14 May 15 4.02 3.70 Fully Valued


1

2

3.42

3.62

3.82

4.02

4.22

4.42

4.62

4.82

5.02

Aug-14 Dec-14 Apr-15

S$


BUY Last Traded Price: S$3.26 (STI : 3,191.39) Price Target : S$3.80 (17% upside) Potential Catalyst: Strong order wins, M&A activity Where We Differ: More optimistic on order wins and margins Analyst Suvro SARKAR +65 6682 3720 [email protected]

Price Relative

Forecasts and Valuation FY Dec (S$ m) 2013A 2014A 2015F 2016F Revenue 6,633 6,539 6,683 6,846 EBITDA 893 835 882 937 Pre-tax Profit 730 651 702 752 Net Profit 581 532 565 606 Net Pft (Pre Ex.) 581 532 565 606 EPS (S cts) 18.7 17.1 18.1 19.4 EPS Pre Ex. (S cts) 18.7 17.1 18.1 19.4 EPS Gth (%) 0 (9) 6 7 EPS Gth Pre Ex (%) 0 (9) 6 7 Diluted EPS (S cts) 18.7 17.1 18.1 19.4 Net DPS (S cts) 15.0 15.0 15.0 15.5 BV Per Share (S cts) 68.1 68.4 71.5 75.9 PE (X) 17.4 19.1 18.0 16.8 PE Pre Ex. (X) 17.4 19.1 18.0 16.8 P/Cash Flow (X) 10.9 16.3 15.0 14.0 EV/EBITDA (X) 10.7 11.6 11.0 10.4 Net Div Yield (%) 4.6 4.6 4.6 4.8 P/Book Value (X) 4.8 4.8 4.6 4.3 Net Debt/Equity (X) CASH CASH CASH CASH ROAE (%) 29.0 25.0 25.9 26.4 Earnings Rev (%): - - Consensus EPS (S cts): 17.5 18.8 Other Broker Recs: B: 5 S: 2 H: 7


M&A COULD FAST TRACK GROWTH Outlook remains healthy. ST Engineering’s orderbook of S$12.2bn as of end-1Q15 provides good visibility on revenues and underpins our steady c.6% growth in earnings over FY15/16. Order wins by Aerospace and Electronics divisions in 2Q15 have been encouraging. A combination of low oil prices and positive outlook for US and Asian airlines – ST Aerospace’s key customers – bodes well for MRO revenues and margins in the near to medium term.

Targeted investments provide potential upside in medium term. The aerospace business’s investments into cabin interiors and VIP completions and configurations business in the US, as well as new partnerships with OEMs across the value chain, create new avenues for growth amidst a broadly stable industry environment.

M&A potential remains untapped. ST Engineering sits on a very healthy balance sheet with more than S$500m cash hoard. We believe it should make use of its balance sheet more efficiently to target ROE and EPS-accretive acquisitions. Among other ideas, an attempt to boost its leadership position in the airframe MRO market by merging with compatriot SIA Engineering should be beneficial to both, and yield important synergies. Valuation:

Maintain BUY with a target price of S$3.80, based on a blended valuation framework (blend of price-earnings, dividend yield and discounted cash flows) to factor in both earnings growth and cash-generative nature of the business. Key Risks to Our View:

The structural changes facing the aircraft MRO industry could hit harder than expected, as newer airframe and engines reduce maintenance spend and lengthen the cycle for checks and OEMs take a larger share of the aftermarket services. Also, continued lack of action on the M&A front could lead to inefficient use of balance sheet and lower ROEs in the future. At A Glance Issued Capital (m shrs) 3,110 Mkt. Cap (S$m/US$m) 10,139 / 7,342 Major Shareholders Temasek Holdings Pte Ltd (%) 51.2 Aberdeen Asset Management (%) 8.0 Capital Research (%) 5.0 Free Float (%) 35.8 3m Avg. Daily Val (US$m) 5.2 ICB Industry : Industrials / Aerospace & Defense



ST Engineering Edition 1 Version 1 | Bloomberg: STE SP | Reuters: STEG.SI Refer to important disclosures at the end of this report

90

110

130

150

170

190

210

2.2

2.7

3.2

3.7

4.2

4.7

Jul-11 Jul-12 Jul-13 Jul-14 Jul-15

Relative IndexS$

ST Engineering (LHS) Relative STI INDEX (RHS)


Company Guide

ST Engineering


Earnings Drivers:

Conglomerate with diverse interests in defense and commercial spheres. STE started out life as a defense contractor but has over the years, leveraged its technical knowhow to penetrate the commercial market. Currently, it boasts multinational operations with global presence in 23 countries and 41 cities, and hires more than 22,000 employees. The group has reduced its reliance on the defense sector over time from 57% of revenues in 2002 to the current 37%, with another 33% from government agencies and the balance from commercial businesses. ST Engineering’s four key business divisions bring diversification benefits. Its Aerospace, Electronics, Land Systems and Marine businesses contributed 32%, 24%, 21% and 21% respectively to revenues in FY14, thus allowing the company to avoid reliance on any particular sector. This has engendered relatively stable revenues and earnings over the years, weathering even crisis periods. Acquisitions have been a key driver, accounting for around 40% of revenue growth over the last decade. However, the dampening effect of a weakening US$ and addition of lower-margin businesses meant earnings growth has not kept up with topline growth. Utilisation of its strong balance sheet and steady cash-flows to undertake acquisitions of high ROE assets could boost future earnings. Healthy order book drives visibility. As of 1Q15, the order book stood at S$12.2bn, down slightly from a high of S$13.2bn in FY13 but nonetheless giving visibility on revenues into FY16 at a c.1.8x book-to-bill ratio. Aerospace MRO primed for steady growth. Continued initiatives by ST Aerospace to broaden its capabilities should propel its growth in the longer term. These include a recently inked partnership with Airbus for passenger-to-freighter conversion of its A320 and A321 jets, marking a diversification of its conversion portfolio; a continued expansion of its cabin interior service solutions business, particularly for VIP aircraft completions; and an aircraft seating solutions JV with Tenryu Holdings set up in 1Q15. Other businesses have select growth opportunities. The Electronics business is looking to capitalise on the trend towards ‘Smart Nation’ solutions in Singapore. The Land Systems business remains a proxy for steady defense spending in the region, although slowing demand for specialty vehicles in China poses some worry. Proxy to a recovery in the US. Around 24% of ST Engineering’s business is derived from the US, which has seen its currency surge by 20% over the past year against a basket of other currencies. ST Engineering is thus poised to benefit from USD-denominated orders.

Aerospace sales growth (%)

Electronics sales growth (%)

Land Systems sales growth (%)

Marine sales growth (%)


5.16

2.97

-0.87

2.71

3.48

-0.95

-0.30

0.35

1.00

1.65

2.30

2.95

3.60

4.26

4.91

2012A 2013A 2014A 2015F 2016F

6.55

4.56

-4.06

7.35

5

-4.47

-2.97

-1.47

0.03

1.53

3.03

4.53

6.03

2012A 2013A 2014A 2015F 2016F

2.23

-2.51

-5.29

3.14

4.55

-5.82

-4.89

-3.96

-3.03

-2.10

-1.18

-0.25

0.68

1.61

2.54

3.46

4.39

2012A 2013A 2014A 2015F 2016F

15.4

22.5

8.3

-5.7 -5.4-6.3

-3.4

-0.6

2.2

5.1

7.9

10.7

13.6

16.4

19.2

22.1

2012A 2013A 2014A 2015F 2016F


Company Guide

ST Engineering

Balance Sheet:

Healthy balance sheet can drive M&A ambitions. ST Engineering was in a net cash position of about S$713m as of end-1Q15. It thus has ample ammunition to undertake attractive acquisitions in growth areas. Dividend payout should remain steady. Strong operating cash flows and a strong balance sheet provide support to healthy dividend yield levels of around 4.6% currently. ST Engineering has cut its payout ratio in recent years from 100% to around 80% owing to cash locked up in overseas locations, which it prefers to invest for growth rather than pay withholding taxes on repatriation. Share Price Drivers:

Strong order wins. While order wins were sluggish for most of 1H15, recent announcements of ST Aerospace securing S$920m and ST Engineering securing S$424m worth of contracts in 2Q15 are encouraging. More announced wins to that tune should boost the share price. Recovery in the Marine sector. The Marine sector is arguably facing the strongest industry headwinds on the commercial front, with low offshore oil & gas spending and broad overcapacity in shipping. Cost overruns in the US exacerbate the situation. An industry recovery, as well as better productivity in the US, would provide more confidence in the medium-term earnings of the business. Key Risks:

Declining defense budgets in the West. Austerity programmes in Europe and planned US spending cuts create the risk of delays to some defense programmes that STE may be bidding for. Some businesses face headwinds. STE may have to restructure more of its aerospace MRO operations in Europe. Meanwhile, the growth of STE’s commercial vehicle operations in China has been affected by tight lending conditions in the country, which is affecting the customers' ability to invest in new construction projects. COMPANY BACKGROUND

ST Engineering (STE) is an integrated engineering group in the aerospace, electronics, land systems and marine sectors. Starting out as a defense contractor, ST Engineering has over the years diversified its businesses and geographies. It is now the largest 3rd party aerospace maintenance, repair and overhaul (MRO) facility worldwide in terms of man-hours.


Capital Expenditure

ROE (%)

Forward PE Band (x)

PB Band (x)


0.7

0.7

0.7

0.8

0.8

0.8

0.8

0.8

0.9

0.9

0.9

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

2012A 2013A 2014A 2015F 2016F


0.0

50.0

100.0

150.0

200.0

250.0

300.0

2012A 2013A 2014A 2015F 2016F


S$m

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

2012A 2013A 2014A 2015F 2016F

Avg: 18.9x

+1sd: 21.8x

+2sd: 24.8x

‐1sd: 15.9x

‐2sd: 12.9x11.6

13.6

15.6

17.6

19.6

21.6

23.6

25.6


(x)

Avg: 5.3x

+1sd: 5.87x

+2sd: 6.44x

‐1sd: 4.74x

‐2sd: 4.17x

3.7

4.2

4.7

5.2

5.7

6.2

6.7

7.2


(x)


Company Guide

ST Engineering

Key Assumptions

FY Dec 2012 2013A 2014A 2015F 2016F Aerospace sales growth (%) 5.16 2.97 (0.87) 2.71 3.48 Electronics sales growth (%) 6.55 4.56 (4.06) 7.35 5.00 Land Systems sales growth (%) 2.23 (2.51) (5.29) 3.14 4.55 Marine sales growth (%) 15.4 22.5 8.32 (5.71) (5.40)

Segmental Breakdown

FY Dec 2012A 2013A 2014A 2015F 2016F Revenues (S$ m) Aerospace 2,019 2,079 2,061 2,117 2,191 Electronics 1,578 1,650 1,583 1,699 1,784 Land Systems 1,513 1,475 1,397 1,441 1,506 Marine 1,011 1,238 1,341 1,264 1,196 Others 259 191 157 162 168 Total 6,380 6,633 6,539 6,683 6,846 PBT (S$ m) Aerospace 304 319 283 298 316 Electronics 152 170 184 196 200 Land Systems 115 112 56 77 94 Marine 128 146 123 124 133 Others 25 (18) 5 8 10 Total 723 730 651 702 752 PBT Margins (%) Aerospace 15.0 15.4 13.7 14.1 14.4 Electronics 9.7 10.3 11.6 11.5 11.2 Land Systems 7.6 7.6 4.0 5.4 6.2 Marine 12.6 11.8 9.2 9.8 11.1 Others 9.5 (9.5) 3.0 5.0 6.0 Total 11.3 11.0 10.0 10.5 11.0


FY Dec 2012A 2013A 2014A 2015F 2016F Revenue 6,380 6,633 6,539 6,683 6,846 Cost of Goods Sold (4,924) (5,201) (5,221) (5,246) (5,340) Gross Profit 1,456 1,432 1,318 1,437 1,506 Other Opng (Exp)/Inc (750) (712) (711) (775) (788) Operating Profit 706 720 608 662 718 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 33 31 57 52 47 Net Interest (Exp)/Inc (23) (21) (14) (12) (12) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 715 730 651 702 752 Tax (131) (138) (114) (126) (135) Minority Interest (8) (11) (5) (10) (11) Preference Dividend 0 0 0 0 0 Net Profit 576 581 532 565 606 Net Profit before Except. 576 581 532 565 606 EBITDA 876 893 835 882 937 Growth Revenue Gth (%) 6.5 4.0 (1.4) 2.2 2.4 EBITDA Gth (%) 6.7 1.9 (6.4) 5.6 6.2 Opg Profit Gth (%) 8.4 1.9 (15.5) 8.9 8.4 Net Profit Gth (Pre-ex) (%) 9.2 0.8 (8.4) 6.3 7.2 Margins & Ratio Gross Margins (%) 22.8 21.6 20.2 21.5 22.0 Opg Profit Margin (%) 11.1 10.8 9.3 9.9 10.5 Net Profit Margin (%) 9.0 8.8 8.1 8.5 8.8 ROAE (%) 31.5 29.0 25.0 25.9 26.4 ROA (%) 7.5 6.9 6.2 6.7 7.1 ROCE (%) 13.6 12.4 10.3 11.5 12.1 Div Payout Ratio (%) 90.0 80.2 87.9 83.0 80.0 Net Interest Cover (x) 30.2 34.4 42.7 56.0 59.9



Company Guide

ST Engineering


FY Dec 1Q2014 2Q2014 3Q2014 4Q2014 1Q2015 Revenue 1,552 1,586 1,553 1,848 1,511 Cost of Goods Sold (1,226) (1,245) (1,220) (1,530) (1,219) Gross Profit 326 341 333 318 292 Other Oper. (Exp)/Inc (174) (184) (190) (163) (149) Operating Profit 151 157 144 156 143 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 21 9 12 15 11 Net Interest (Exp)/Inc (5) (2) (4) (4) (4) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 168 164 152 167 151 Tax (30) (30) (32) (22) (19) Minority Interest 0 (1) 1 (5) (2) Net Profit 137 133 121 140 130 Net profit bef Except. 137 133 121 140 130 EBITDA 213 207 196 203 199 Growth Revenue Gth (%) (20.1) 2.2 (2.1) 19.0 (18.2) EBITDA Gth (%) (12.2) (2.9) (5.1) 3.5 (2.1) Opg Profit Gth (%) (30.5) 3.6 (8.5) 8.5 (8.0) Net Profit Gth (Pre-ex) (%) (18.1) (3.0) (8.9) 15.6 (7.3) Margins Gross Margins (%) 21.0 21.5 21.5 17.2 19.4 Opg Profit Margins (%) 9.8 9.9 9.2 8.4 9.5 Net Profit Margins (%) 8.8 8.4 7.8 7.6 8.6

Balance Sheet (S$ m)

FY Dec 2012A 2013A 2014A 2015F 2016F Net Fixed Assets 1,202 1,520 1,578 1,659 1,737 Invts in Associates & JVs 306 462 478 500 517 Other LT Assets 1,088 963 937 937 937 Cash & ST Invts 1,738 2,065 1,590 1,578 1,614 Inventory 1,922 1,808 1,802 1,842 1,886 Debtors 1,159 1,222 1,319 1,348 1,381 Other Current Assets 617 667 615 615 615 Total Assets 8,032 8,707 8,319 8,480 8,687 ST Debt 211 434 75 75 75 Creditor 1,694 1,605 1,667 1,704 1,745 Other Current Liab 1,985 2,055 1,974 1,990 2,008 LT Debt 1,069 939 944 944 944 Other LT Liabilities 1,060 1,414 1,395 1,395 1,395 Shareholder’s Equity 1,895 2,116 2,132 2,230 2,366 Minority Interests 118 144 132 143 154 Total Cap. & Liab. 8,032 8,707 8,319 8,480 8,687 Non-Cash Wkg. Capital 18 37 95 111 129 Net Cash/(Debt) 458 692 571 560 595 Debtors Turn (avg days) 67.1 65.5 70.9 72.8 72.8 Creditors Turn (avg days) 129.1 119.0 118.2 121.2 121.8 Inventory Turn (avg days) 134.0 134.5 130.4 131.0 131.7 Asset Turnover (x) 0.8 0.8 0.8 0.8 0.8 Current Ratio (x) 1.4 1.4 1.4 1.4 1.4 Quick Ratio (x) 0.7 0.8 0.8 0.8 0.8 Net Debt/Equity (X) CASH CASH CASH CASH CASH Net Debt/Equity ex MI (X) CASH CASH CASH CASH CASH Capex to Debt (%) 17.5 20.5 22.0 24.5 24.5 Z-Score (X) NA 2.4 2.5 2.5 2.6


Net cash of ~S$700m provides ammunition for acquisitions


Company Guide

ST Engineering


FY Dec 2012A 2013A 2014A 2015F 2016F Pre-Tax Profit 715 730 651 702 752 Dep. & Amort. 137 142 171 168 173 Tax Paid (85) (110) (133) (126) (135) Assoc. & JV Inc/(loss) (33) (31) (57) (52) (47) Chg in Wkg.Cap. 240 154 (72) (16) (18) Other Operating CF 67 45 65 0 0 Net Operating CF 1,041 930 624 676 725 Capital Exp.(net) (224) (282) (224) (250) (250) Other Invts.(net) 42 71 79 0 0 Invts in Assoc. & JV (4) (19) 6 (5) (5) Div from Assoc & JV 33 40 35 35 35 Other Investing CF (20) (67) (53) 0 0 Net Investing CF (173) (258) (157) (220) (220) Div Paid (476) (521) (499) (468) (469) Chg in Gross Debt (8) 28 (394) 0 0 Capital Issues 42 52 11 0 0 Other Financing CF (64) (31) (44) 0 0 Net Financing CF (505) (472) (926) (468) (469) Currency Adjustments (18) 18 0 0 0 Chg in Cash 346 218 (459) (12) 36 Opg CFPS (S cts) 26.0 25.0 22.3 22.2 23.8 Free CFPS (S cts) 26.5 20.9 12.8 13.7 15.2



Source: DBS Bank

S.No. Da teClos ing


Ra ting

1: 14 Aug 14 3.69 4.00 Hold 2: 10 Nov 14 3.46 3.80 Hold 3: 20 Jan 15 3.31 3.80 Buy4: 02 Mar 15 3.40 3.80 Buy5: 14 May 15 3.59 3.80 Buy


1

2

3

45

3.00

3.10

3.20

3.30

3.40

3.50

3.60

3.70

3.80

3.90

Jul-14 Nov-14 Mar-15

S$

ST Engineering enjoys a strong operating cash flow generation


BUY Last Traded Price: S$1.275 (STI : 3,196.66) Price Target : S$ 1.62 (14% upside) Potential Catalyst: Dual-listing, contract wins, shipping recovery Where we differ: Market expects stable earnings in FY15-16 Analyst HO Pei Hwa +65 6682 3714 [email protected]

Price Relative

Forecasts and Valuation FY Dec (RMB m) 2013A 2014A 2015F 2016F Revenue 14,339 15,354 17,326 17,699 EBITDA 4,998 4,336 4,813 5,042 Pre-tax Profit 4,620 3,953 5,023 5,234 Net Profit 3,096 3,479 3,586 3,849 Net Pft (Pre Ex.) 3,096 3,479 3,226 3,489 EPS (S cts) 18.0 20.2 20.9 22.4 EPS Pre Ex. (S cts) 18.0 20.2 18.8 20.3 EPS Gth (%) (13) 12 3 7 EPS Gth Pre Ex (%) (13) 12 (7) 8 Diluted EPS (S cts) 16.6 18.6 19.2 20.6 Net DPS (S cts) 5.3 6.1 6.1 6.1 BV Per Share (S cts) 103.5 119.1 133.8 150.1 PE (X) 7.1 6.3 6.1 5.7 PE Pre Ex. (X) 7.1 6.3 6.8 6.3 P/Cash Flow (X) nm 2.4 9.6 5.6 EV/EBITDA (X) 3.6 4.3 3.5 2.7 Net Div Yield (%) 4.2 4.8 4.8 4.8 P/Book Value (X) 1.2 1.1 1.0 0.8 Net Debt/Equity (X) CASH CASH CASH CASH ROAE (%) 18.6 18.2 16.5 15.8 Earnings Rev (%): - - Consensus EPS (S cts): 17.2 18.0 Other Broker Recs: B: 10 S: 4 H: 4


CRUISING AHEAD

Potential dual-listing to drive re-rating; decent dividend yield. While the stock has done well, we see potential re-rating from probable dual-listing in Hong Kong to fund M&A. In addition, Yangzijiang offers a decent dividend yield of 4% or 5.5 Scts per share on the back of stable earnings and cash flow.

A clear winner in consolidation of China’s shipbuilding industry. As the largest and most cost-efficient private shipbuilder in China, Yangzijiang is amongst the handful Chinese yards that have waded into the high-end vessel space to battle their Korean rivals, and is well positioned to benefit from the post-consolidation recovery of shipbuilding markets, alongside shipping recovery.

Riding out industry cycles with solid management and healthy order backlog. Yangzijiang has emerged stronger in the past few cycles with Executive Chairman, Mr Ren Yuanlin at the helm. Mr Ren, ranked 82 in Lloyd's List's Top 100 most influential people in shipping, is highly respected for his great foresight, strategic sense and cost/cash management. Healthier order backlog of US$4.6bn at high revenue coverage of 1.9x vis-à-vis global peers do not just provide earnings visibiliy but is also a testament to Yangzijiang’s market leadership.

Valuation: We value Yangzijiang based on sum-of-the-parts (SOTP) methodology to better reflect the valuation for the various segments. We arrive at a target price of S$1.62, after applying 8x FY15F price earnings (PE) on shipbuilding earnings, 0.5x price-to-book value (P/BV) for bulk carriers, 1x P/BV for investments, and a 25% discount to the net present value (NPV) of its property project.

Key Risks to Our View: USD depreciation and hike in steel cost Revenue is denominated mainly in USD, and only half is naturally hedged. Assuming the net exposure is unhedged, every 1% USD depreciation could lead to a 2% earnings decline. Every 1% rise in steel costs, which account for about 20% of COGS, could result in a 1.1% drop in bottomline.

Overhang from oustanding warrants Theare are 330m oustanding warrants (approx. 8.6% of outstanding shares if fully exercised) expiring on 29 Apr 2016. The exercise price is Rmb6.602 or S$1.42 per share based on an exchange rate of Rmb4.65/SGD.

At A Glance Issued Capital (m shrs) 3,832 Mkt. Cap (S$m/US$m) 4,886 / 3,530 Major Shareholders Newyard Worldwide (%) 26.1 Lido Point Investments (%) 10.3 Hongkong Hengyuan (%) 8.2 Free Float (%) 50.4 3m Avg. Daily Val (US$m) 11.5 ICB Industry : Industrials / Industrial Engineering



Yangzijiang Shipbuilding Edition 1 Version 1 | Bloomberg: YZJSGD SP | Reuters: YAZG.SI Refer to important disclosures at the end of this report

53

73

93

113

133

153

173

193

213

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7


Relative IndexS$

Yangzijiang Shipbuilding (LHS) Relative STI INDEX (RHS)


Company Guide

Yangzijiang Shipbuilding


Earnings Drivers:

Healthy order backlog offers revenue visibility. Orderbook stood at US$4.6bn as of end Mar-2015, implying healthy book-to-bill ratio of 1.9x and providing revenue visibility for the next two years. The group secured US$1.8bn worth of new orders in 2014 and targets to secure US$2bn new orders this year, a desirable level for orderbook replenishment and optimisation of operational activities. YTD, Yangzijiang has won US$373m worth of new orders, making up 19% of the goal. While this appears to lag its target, we are keeping our assumption for now as orderflows tend to be patchy and we expect the company to clinch orders from mega containerships and LNG vessels in 2H.

Recognition of deferred income cushions downturn. Post financial crisis, Yangzijiang has adopted more prudent provision and accounting policies. For instance, it extended the warranty provision (1% of sales) from one year to three. The reversal of the warranty provision will be captured under COGS line and bolster margins. We also expect the recognition of Rmb720m exceptional gain for the old yard relocation fee (in the form of government subsidy), and an estimated Rmb500m gain from disposal of cancelled vessels (under other income line) in FY15/16.

Exploring M&A opportunities for long-term growth. The Chinese shipbuilding industry has shrunk from over 3,000 yards to about 100 currently. Further consolidation is underway, probably ending with 20-30 survivors, and Yangzijiang will surely make the list. Yangzijiang is in talks to participate in China RongSheng’s restructuring exercise. We believe it boils down to the attractiveness of the deal, and if this goes through, it would be a strategic investment that propels Yangzijiang's long-term prospects. Yangzijiang’s recent acquisition of a 2.8% stake in Shenzhen-listed system supplier Beijing Highlander Digital Co. Ltd (“Highlander”) could in the longer run, pave the way for Yangzijiang to enter the military vessel space.

Production efficiency and cost control. Yangzijiang garners 5- to 10-ppt higher margins vis-à-vis peers. This is achievable through its premium newbuild prices and better payment terms among Chinese yards, as well as production efficiency and cost control.

Shipping recovery. While the worst for the shipping market is probably behind us with relatively more balanced supply/demand, the recovery path is bumpy. The overcapacity issue is yet to be fully resolved and this will weigh on freight rates for dry bulk and containerships in 2H15. We look forward to a better 2016 shipping market to drive shipbuilding orders.

Order wins (US$ m)

Steel cost (RMB/t)

RMB / USD


295

2,900

1,808

2,500 2,500

0

400

800

1,200

1,600

2,000

2,400

2,800

2012A 2013A 2014A 2015F 2016F

4,3004,042 4,163 4,288

4,545

0

900

1,800

2,700

3,600

4,500

2012A 2013A 2014A 2015F 2016F

6.3 6.2 6.1 6.1 6.1

0.00

1.29

2.57

3.86

5.14

6.43

2012A 2013A 2014A 2015F 2016F


Company Guide


Balance Sheet:

Sound balance sheet. Including Held-to-Maturity (“HTM”) investments, Yangzjiang is in net cash, equivalent to 39 Scts per share or 33% of its NTA. It is expected to churn positive free cash flow in the light of minimal capex requirement, more than sufficient to support its 30% dividend payout. Share Price Drivers:

Potential dual-listing to drive re-rating. We see potential re-rating from probable dual-listing in Hong Kong to fund M&A. The valuation gap has widened over the years, and we observed that A-share listed shipyards are trading at over 80x PE and 7x P/BV on average. While we do not expect Yangzijiang to trade up to those eye-popping levels, a significant re-rating from current levels is likely. Contract wins is traditionally the leading indicator of shipbuilders’ share price performance and earnings. In particular, Yangzijiang is commendably gaining foothold in the “high specs” vessel space, which has long been conquered by Korean peers. Strategic acquisitions / expansion. The investment community generally welcomes the redeployment of the excess cash from Held-to-Maturity (HTM) investments to core business. The strategic acquisition of a good facility like RongSheng’s and foray into military vessels bode well for Yangzijiang's long-term growth. Key Risks:

Prolonged industry downturn. We believe the worst is over for the shipbuilding industry, but in the event of unforeseen circumstances that could lead to a prolonged downturn, Yangzijiang's earnings and share price will be affected. USD depreciation and hike in steel cost. Revenue is denominated mainly in USD, and only half is naturally hedged. Assuming the net exposure is unhedged, every 1% USD depreciation could lead to a 2% earnings decline. Every 1% rise in steel costs, which account for about 20% of COGS, could result in a 1.1% drop in bottomline. Overhang from oustanding warrants. Theare are 330m oustanding warrants (approx. 8.6% of outstanding shares if fully exercised) expiring on 29 Apr 2016. The exercise price is Rmb6.602 or S$1.42 per share based on an exchange rate of Rmb4.65/SGD.

COMPANY BACKGROUND

Yangzijiang is one of the largest, most efficient and most profitable shipbuilders in China. It has moved up the value chain to produce mega containerships and very large bulk carriers, as well as LNG vessels.


Capital Expenditure

ROE (%)

Forward PE Band (x)

PB Band (x)


0.3

0.3

0.3

0.4

0.4

0.4

0.4

0.4

0.5

0.5

0.5

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

2012A 2013A 2014A 2015F 2016F


0.0

200.0

400.0

600.0

800.0

1,000.0

1,200.0

2012A 2013A 2014A 2015F 2016F


RM

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

2012A 2013A 2014A 2015F 2016F

Avg: 5.9x

+1sd: 6.6x

+2sd: 7.2x

‐1sd: 5.3x

‐2sd: 4.7x

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5


(x)

Avg: 1.24x

+1sd: 1.48x

+2sd: 1.71x

‐1sd: 1.01x

‐2sd: 0.77x0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6


(x)


Company Guide


Key Assumptions

FY Dec 2012A 2013A 2014A 2015F 2016F Order wins (US$ m) 295.1 2,900.0 1,808.0 2,500.0 2,500.0 Steel cost (RMB/t) 4,300.0 4,042.0 4,163.3 4,288.2 4,545.4 RMB / USD 6.3 6.2 6.1 6.1 6.1

Segmental Breakdown

FY Dec 2012A 2013A 2014A 2015F 2016F Revenues (RMB m) Shipbuilding 13,487 12,832 13,525 14,009 15,407 Shipping 0 0 140 145 161 Investment 1,312 1,507 1,688 1,209 1,056 Property 0 0 0 1,963 1,075 Total 14,799 14,339 15,354 17,326 17,699 Gross profit (RMB m) Shipbuilding 3,291 3,515 2,752 2,677 3,204 Shipping 0 0 55 59 73 Investment 1,280 1,247 1,336 1,135 988 Property 0 0 0 697 382 Total 4,572 4,762 4,144 4,568 4,647 Gross profit Margins (%) Shipbuilding 24.4 27.4 20.3 19.1 20.8 Shipping N/A N/A 39.5 40.6 45.1 Investment 97.6 82.7 79.2 93.9 93.6 Property N/A N/A N/A 35.5 35.5 Total 30.9 33.2 27.0 26.4 26.3

Income Statement (RMB m)

FY Dec 2012A 2013A 2014A 2015F 2016F Revenue 14,799 14,339 15,354 17,326 17,699 Cost of Goods Sold (10,228) (9,577) (11,210) (12,758) (13,052) Gross Profit 4,572 4,762 4,144 4,568 4,647 Other Opng (Exp)/Inc 35 (49) (238) (148) 1 Operating Profit 4,606 4,713 3,906 4,420 4,647 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 0 0 0 0 0 Net Interest (Exp)/Inc (173) (94) 47 243 225 Exceptional Gain/(Loss) 0 0 0 360 360 Pre-tax Profit 4,434 4,620 3,953 5,023 5,234 Tax (846) (1,542) (472) (1,177) (1,167) Minority Interest (7) 18 (2) (259) (217) Preference Dividend 0 0 0 0 0 Net Profit 3,581 3,096 3,479 3,586 3,849 Net Profit before Except. 3,581 3,096 3,479 3,226 3,489 EBITDA 4,859 4,998 4,336 4,813 5,042 Growth Revenue Gth (%) (5.8) (3.1) 7.1 12.8 2.2 EBITDA Gth (%) (5.5) 2.9 (13.3) 11.0 4.8 Opg Profit Gth (%) (6.4) 2.3 (17.1) 13.2 5.1 Net Profit Gth (Pre-ex) (%) (10.0) (13.5) 12.4 (7.3) 8.2 Margins & Ratio Gross Margins (%) 30.9 33.2 27.0 26.4 26.3 Opg Profit Margin (%) 31.1 32.9 25.4 25.5 26.3 Net Profit Margin (%) 24.2 21.6 22.7 20.7 21.7 ROAE (%) 25.1 18.6 18.2 16.5 15.8 ROA (%) 10.7 8.1 8.3 8.5 8.5 ROCE (%) 15.7 10.9 10.8 10.4 10.1 Div Payout Ratio (%) 25.7 29.7 30.3 29.4 27.4 Net Interest Cover (x) 26.7 50.3 NM NM NM



Company Guide


Quarterly / Interim Income Statement (RMB m)

FY Dec 2Q2014 3Q2014 4Q2014 1Q2015 2Q2015 Revenue 4,274 3,743 3,782 3,044 5,710 Cost of Goods Sold (3,090) (2,679) (2,933) (2,260) (4,680) Gross Profit 1,184 1,064 849 783 1,030 Other Oper. (Exp)/Inc (133) (14) (66) 148 321 Operating Profit 1,050 1,050 783 931 1,351 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc (16) 2 13 0 0 Net Interest (Exp)/Inc 126 (26) (34) (11) (1) Exceptional Gain/(Loss) 0 0 0 0 0 Pre-tax Profit 1,160 1,026 762 920 1,350 Tax 85 (214) (131) (204) (310) Minority Interest (10) (1) 2 (9) (9) Net Profit 1,236 811 632 707 1,031 Net profit bef Except. 1,236 811 632 707 1,031 EBITDA 1,129 1,052 987 1,042 1,467 Growth Revenue Gth (%) 20.2 (12.4) 1.0 (19.5) 87.6 EBITDA Gth (%) (3.3) (6.8) (6.2) 5.6 40.8 Opg Profit Gth (%) 2.7 0.0 (25.5) 19.0 45.0 Net Profit Gth (Pre-ex) (%) 54.7 (34.4) (22.0) 11.8 45.8 Margins Gross Margins (%) 27.7 28.4 22.4 25.7 18.0 Opg Profit Margins (%) 24.6 28.1 20.7 30.6 23.7 Net Profit Margins (%) 28.9 21.7 16.7 23.2 18.0

Balance Sheet (RMB m)

FY Dec 2012A 2013A 2014A 2015F 2016F Net Fixed Assets 4,277 5,793 6,117 6,123 6,129 Invts in Associates & JVs 560 605 809 809 809 Other LT Assets 6,723 8,725 8,090 6,861 6,218 Cash & ST Invts 13,760 17,816 12,046 14,511 18,041 Inventory 985 1,463 2,015 2,688 2,746 Debtors 631 2,682 6,721 2,888 2,950 Other Current Assets 6,267 6,127 4,980 9,400 9,904 Total Assets 33,202 43,211 40,778 43,280 46,797 ST Debt 3,472 12,241 5,414 5,685 5,969 Creditor 2,130 3,418 5,723 4,332 4,425 Other Current Liab 6,298 6,783 4,227 4,927 4,916 LT Debt 3,918 1,133 2,636 2,768 2,906 Other LT Liabilities 1,116 1,363 1,702 1,702 1,702 Shareholder’s Equity 15,510 17,801 20,473 23,006 25,801 Minority Interests 757 472 603 862 1,079 Total Cap. & Liab. 33,202 43,211 40,778 43,280 46,797 Non-Cash Wkg. Capital (546) 71 3,767 5,718 6,260 Net Cash/(Debt) 6,369 4,443 3,995 6,058 9,166 Debtors Turn (avg days) 10.8 42.2 111.8 101.2 60.2 Creditors Turn (avg days) 73.7 109.0 154.8 148.4 126.2 Inventory Turn (avg days) 48.3 48.1 58.9 69.4 78.3 Asset Turnover (x) 0.4 0.4 0.4 0.4 0.4 Current Ratio (x) 1.8 1.3 1.7 2.0 2.2 Quick Ratio (x) 1.2 0.9 1.2 1.2 1.4 Net Debt/Equity (X) CASH CASH CASH CASH CASH Net Debt/Equity ex MI (X) CASH CASH CASH CASH CASH Capex to Debt (%) 14.1 7.5 9.0 4.7 4.5 Z-Score (X) NA 1.8 2.2 2.4 2.4



Company Guide


Cash Flow Statement (RMB m)

FY Dec 2012A 2013A 2014A 2015F 2016F Pre-Tax Profit 4,434 4,620 3,953 5,023 5,233 Dep. & Amort. 252 285 430 393 393 Tax Paid (899) (1,001) (492) (478) (1,177) Assoc. & JV Inc/(loss) 0 0 0 0 0 Chg in Wkg.Cap. (2,450) (7,639) 5,331 (2,651) (531) Other Operating CF 502 67 (140) 0 0 Net Operating CF 1,839 (3,669) 9,082 2,287 3,918 Capital Exp.(net) (1,038) (1,000) (729) (400) (399) Other Invts.(net) 0 0 0 0 0 Invts in Assoc. & JV (71) 0 108 0 0 Div from Assoc & JV 15 21 31 0 0 Other Investing CF 17 (137) (775) 1,611 1,495 Net Investing CF (1,077) (1,116) (1,364) 1,211 1,096 Div Paid (1,058) (938) (960) (1,054) (1,054) Chg in Gross Debt (1,100) 5,206 (5,523) 403 423 Capital Issues 0 91 0 0 0 Other Financing CF 331 (224) (19) 0 0 Net Financing CF (1,827) 4,134 (6,502) (651) (631) Currency Adjustments 0 0 0 0 0 Chg in Cash (1,066) (650) 1,216 2,847 4,383 Opg CFPS (RMB cts) 111.8 103.6 97.9 128.9 116.1 Free CFPS (RMB cts) 20.9 (121.8) 218.0 49.2 91.8



Source: DBS Bank

S.No. Da teClos ing


Ra ting

1: 07 Aug 14 1.12 1.60 Buy2: 07 Nov 14 1.15 1.62 Buy3: 17 Feb 15 1.23 1.62 Buy4: 27 Feb 15 1.23 1.62 Buy5: 10 Mar 15 1.22 1.62 Buy6: 30 Apr 15 1.47 1.62 Buy7: 05 May 15 1.44 1.62 Buy8: 22 Jun 15 1.41 1.62 Buy9: 07 Jul 15 1.40 1.62 Buy


1

2 3

4

5

6

7

8

9

1.01

1.11

1.21

1.31

1.41

1.51


S$


Sea of Change

DBS Bank recommendations are based an Absolute Total Return* Rating system, defined as follows:

STRONG BUY (>20% total return over the next 3 months, with identifiable share price catalysts within this time frame)

BUY (>15% total return over the next 12 months for small caps, >10% for large caps)

HOLD (-10% to +15% total return over the next 12 months for small caps, -10% to +10% for large caps)

FULLY VALUED (negative total return i.e. > -10% over the next 12 months)

SELL (negative total return of > -20% over the next 3 months, with identifiable catalysts within this time frame)

Share price appreciation + dividends GENERAL DISCLOSURE/DISCLAIMER This report is prepared by DBS Bank Ltd. This report is solely intended for the clients of DBS Bank Ltd and DBS Vickers Securities (Singapore) Pte Ltd, its respective connected and associated corporations and affiliates (collectively, the “DBS Vickers Group”) only and no part of this document may be (i) copied, photocopied or duplicated in any form or by any means or (ii) redistributed without the prior written consent of DBS Bank Ltd. The research set out in this report is based on information obtained from sources believed to be reliable, but we (which collectively refers to DBS Bank Ltd., its respective connected and associated corporations, affiliates and their respective directors, officers, employees and agents (collectively, the “DBS Group”)) do not make any representation or warranty as to its accuracy, completeness or correctness. Opinions expressed are subject to change without notice. This document is prepared for general circulation. Any recommendation contained in this document does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. This document is for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate independent legal or financial advice. The DBS Group accepts no liability whatsoever for any direct, indirect and/or consequential loss (including any claims for loss of profit) arising from any use of and/or reliance upon this document and/or further communication given in relation to this document. This document is not to be construed as an offer or a solicitation of an offer to buy or sell any securities. The DBS Group, along with its affiliates and/or persons associated with any of them may from time to time have interests in the securities mentioned in this document. The DBS Group may have positions in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking services for these companies. Any valuations, opinions, estimates, forecasts, ratings or risk assessments herein constitutes a judgment as of the date of this report, and there can be no assurance that future results or events will be consistent with any such valuations, opinions, estimates, forecasts, ratings or risk assessments. The information in this document is subject to change without notice, its accuracy is not guaranteed, it may be incomplete or condensed and it may not contain all material information concerning the company (or companies) referred to in this report. The valuations, opinions, estimates, forecasts, ratings or risk assessments described in this report were based upon a number of estimates and assumptions and are inherently subject to significant uncertainties and contingencies. It can be expected that one or more of the estimates on which the valuations, opinions, estimates, forecasts, ratings or risk assessments were based will not materialize or will vary significantly from actual results. Therefore, the inclusion of the valuations, opinions, estimates, forecasts, ratings or risk assessments described herein IS NOT TO BE RELIED UPON as a representation and/or warranty by the DBS Group (and/or any persons associated with the aforesaid entities), that: (a) such valuations, opinions, estimates, forecasts, ratings or risk assessments or their underlying assumptions will be achieved, and (b) there is any assurance that future results or events will be consistent with any such valuations, opinions, estimates, forecasts, ratings or risk

assessments stated therein. Any assumptions made in this report that refers to commodities, are for the purposes of making forecasts for the company (or companies) mentioned herein. They are not to be construed as recommendations to trade in the physical commodity or in the futures contract relating to the commodity referred to in this report. DBS Vickers Securities (USA) Inc ("DBSVUSA")"), a U.S.-registered broker-dealer, does not have its own investment banking or research department, nor has it participated in any investment banking transaction as a manager or co-manager in the past twelve months. ANALYST CERTIFICATION The research analyst primarily responsible for the content of this research report, in part or in whole, certifies that the views about the companies and their securities expressed in this report accurately reflect his/her personal views. The analyst also certifies that no part of his/her compensation was, is, or will be, directly, or indirectly, related to specific recommendations or views expressed in this report. As of the date the report is published,the analyst and his/her spouse and/or relatives who are financially dependent on the analyst, do not hold interests in the securities recommended in this report (“interest” includes direct or indirect ownership of securities). COMPANY-SPECIFIC / REGULATORY DISCLOSURES

1. DBS Bank Ltd., DBS Vickers Securities (Singapore) Pte Ltd (“DBSVS”), their subsidiaries and/or other affiliates do not have a proprietary position in the securities recommended in this report as of 30 Jun 2015 except Cosco Corporation, Keppel Corporation, Neptune Orient Lines, Sembcorp Industries, Sembcorp Marine, SIA Engineering, ST Engineering, Yangzijiang Shipbuilding.

2. DBS Bank Ltd., DBSVS, DBSVUSA, their subsidiaries and/or other affiliates may beneficially own a total of 1% of any class of common equity securities of the company mentioned as of 30 Jun 2015.

3.

Compensation for investment banking services: DBS Bank Ltd., DBSVS, DBSVUSA, their subsidiaries and/or other affiliates have received compensation, within the past 12 months, and within the next 3 months may receive or intends to seek compensation for investment banking services from Keppel Corporation.


Sea of Change

DBSVUSA does not have its own investment banking or research department, nor has it participated in any investment banking transaction as a manager or co-manager in the past twelve months. Any US persons wishing to obtain further information, including any clarification on disclosures in this disclaimer, or to effect a transaction in any security discussed in this document should contact DBSVUSA exclusively.

4. Danny Teoh Leong Kay, a member of DBS Group Holdings Board of Directors, is a Director of Keppel Corporation as of 28 Feb 2015. Wong Kai Yuan Jeanette, a member of DBS Group Executive Committee, is a Director and Group Executive Committee of Neptune Orient Lines as of 31 Jan 2015

RESTRICTIONS ON DISTRIBUTION General This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or

located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation.

Australia This report is being distributed in Australia by DBS Bank Ltd. (“DBS”) or DBS Vickers Securities (Singapore) Pte Ltd (“DBSVS”), both of which are exempted from the requirement to hold an Australian Financial Services Licence under the Corporation Act 2001 (“CA”) in respect of financial services provided to the recipients. Both DBS and DBSVS are regulated by the Monetary Authority of Singapore under the laws of Singapore, which differ from Australian laws. Distribution of this report is intended only for “wholesale investors” within the meaning of the CA.

Hong Kong This report is being distributed in Hong Kong by DBS Vickers (Hong Kong) Limited which is licensed and regulated by the Hong Kong Securities and Futures Commission.

Indonesia This report is being distributed in Indonesia by PT DBS Vickers Securities Indonesia.

Malaysia This report is distributed in Malaysia by AllianceDBS Research Sdn Bhd ("ADBSR"). Recipients of this report, received from ADBSR are to contact the undersigned at 603-2604 3333 in respect of any matters arising from or in connection with this report. In addition to the General Disclosure/Disclaimer found at the preceding page, recipients of this report are advised that ADBSR (the preparer of this report), its holding company Alliance Investment Bank Berhad, their respective connected and associated corporations, affiliates, their directors, officers, employees, agents and parties related or associated with any of them may have positions in, and may effect transactions in the securities mentioned herein and may also perform or seek to perform broking, investment banking/corporate advisory and other services for the subject companies. They may also have received compensation and/or seek to obtain compensation for broking, investment banking/corporate advisory and other services from the subject companies.

Wong Ming Tek, Executive Director, ADBSR

Singapore This report is distributed in Singapore by DBS Bank Ltd (Company Regn. No. 196800306E) or DBSVS (Company Regn No. 198600294G), both of which are Exempt Financial Advisers as defined in the Financial Advisers Act and regulated by the Monetary Authority of Singapore. DBS Bank Ltd and/or DBSVS, may distribute reports produced by its respective foreign entities, affiliates or other foreign research houses pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Where the report is distributed in Singapore to a person who is not an Accredited Investor, Expert Investor or an Institutional Investor, DBS Bank Ltd accepts legal responsibility for the contents of the report to such persons only to the extent required by law. Singapore recipients should contact DBS Bank Ltd at 6327 2288 for matters arising from, or in connection with the report.

Thailand This report is being distributed in Thailand by DBS Vickers Securities (Thailand) Co Ltd. Research reports distributed are only intended for institutional clients only and no other person may act upon it.

United Kingdom

This report is being distributed in the UK by DBS Vickers Securities (UK) Ltd, who is an authorised person in the meaning of the Financial Services and Markets Act and is regulated by The Financial Conduct Authority. Research distributed in the UK is intended only for institutional clients.

Dubai

This research report is being distributed in The Dubai International Financial Centre (“DIFC”) by DBS Bank Ltd., (DIFC Branch) having its office at PO Box 506538, 3rd Floor, Building 3, East Wing, Gate Precinct, Dubai International Financial Centre (DIFC), Dubai, United Arab Emirates. DBS Bank Ltd., (DIFC Branch) is regulated by The Dubai Financial Services Authority. This research report is intended only for professional clients (as defined in the DFSA rulebook) and no other person may act upon it.

United States

Neither this report nor any copy hereof may be taken or distributed into the United States or to any U.S. person except in compliance with any applicable U.S. laws and regulations. It is being distributed in the United States by DBSVUSA, which accepts responsibility for its contents. Any U.S. person receiving this report who wishes to effect transactions in any securities referred to herein should contact DBSVUSA directly and not its affiliate.

Other jurisdictions

In any other jurisdictions, except if otherwise restricted by laws or regulations, this report is intended only for qualified, professional, institutional or sophisticated investors as defined in the laws and regulations of such jurisdictions.

DBS Bank Ltd. 12 Marina Boulevard, Marina Bay Financial Centre Tower 3

Singapore 018982 Tel. 65-6878 8888

Company Regn. No. 196800306E

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