Thursday, May 21, 2009

Offshore and Marine Sector - Overweight by DMG (21 May 09)

Return of the drill for black gold

We are upgrading our offshore & marine sector from Neutral to Overweight.

Macro environment appears to turn for the better. With general strengthening in commodity and rally in global equities markets, oil prices have climbed 70% from the Feb lows. We believe crude oil price will trend higher, driven by OPEC production cuts and signs of recovery of consumer demand. In addition, the US stress-test results, released two weeks ago, was more benign than expected and ascertained the US banks’ increased lending capacity. These improved changes in the fundamental outlook should augur well for the O&M sector recovery.

Risk-reward now looks attractive in the long run. We are turning buyers on the O&M sector with a 12-month forward outlook. The oil industry takes a long-term view on its investments, given that it takes years to develop oil fields. Previously, depressed oil prices had led to capex cuts and a slowdown in E&P activities, which in turn, resulted in a deflationary drilling cost environment. A low cost environment encourages more drilling. As such, we believe this may mark the start of another secular growth cycle, as new orders start to flow, especially for the capacity constrained production floating systems. We believe the yards, which are highly leveraged to the cycle, with proven track records, competitive edge and strong balance sheets, will be able to garner these new contracts. Hence, we raise our new order assumptions to S$3.0b and S$3.5b for Keppel Corp (Keppel) for FY09 and FY10 respectively. As for Sembcorp Marine (SCM), we have previously revised up our new orders to S$2.0b for FY09 and S$3.0b for FY10 in our SCM’s report dated 11 May 09. We are keeping our SCM’s assumptions.

We have changed our valuation methodology to mid-cycle P/E-based vs. P/B in anticipation of economic recovery and stronger new orders momentum. In our Jan 09 “Alarming bells from drilling dwells”, we used a P/B-based valuation framework as we believe a deteriorating earnings outlook (protracted downturn, potential order cancellations and slower order momentum) will misprice earnings multiples and discount the risks associated. However, with decreasing risk aversion, credit conditions easing and E&P activities rejuvenating, we anticipate stronger earnings momentum and hence, change our valuation methodology to P/E-based.

Valuations still not expensive vs. historical mid-cycle P/E; upgrade Keppel to BUY, Cosco to NEUTRAL and reiterate BUY on SCM. We peg the Singapore yards to P/E of 16x (in-line with the industry’s historical average) on FY10F EPS, and the Chinese yards to P/E of 12x on FY10F EPS. Our target prices are raised by 1-52%. While both Keppel and SCM have outperformed the STI (+29%) YTD, we believe that there is further upside, especially from secular earnings growth and strong new order momentum. We also note that both Keppel and SCM are currently trading at undemanding valuations (as compared to average historical P/E), even after the recent price rebound.

Key risks to our more optimistic investment thesis include a sharp downward reversal in oil price and weaker-than-expected economic recovery.

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