Offshore & Marine

Kim Eng on 29 Nov 2012

Drilling in on margins. Margin expectations have become a key determinant of rigbuilders’ share prices. The street was spooked by Sembcorp Marine’s (SMM) purported “10-13%” operating margin guidance, which is a sharp reduction from the previous 14-15% range. While concerns on lower margins are valid, we expect margins to stay near the 13-14% range in the near term, which is above consensus expectations. We argue that scope for margin surprises above street expectations exist. While we agree that Keppel has the potential to turn in higher operating margins than SMM, we think that the latter offers a better pure-play exposure during a positive rigbuilding cycle.

Where does scope for margin expansion lay? To state the obvious, margin expansion can come from: (1) higher pricing and/or (2) lower cost. However, the dynamics within each factor are not so straightforward.
Two key opposing forces for pricing. We see two opposing forces at work for pricing. The first being tight yard capacities. With record orderbook, rigbuilders’ 2013-2014 delivery slots are almost filled and rig owners who want early delivery may need to pay a premium. Rising dayrates for drilling rigs would incentivise rig owners to ensure early or even timely delivery (by going to established yard). Price competition from Korean and Chinese yard however places downward pressures on prices. These yards have excess capacities due to drought in shipbuilding orders and may seek to secure more offshore orders. Our view is for prices to remain steady. For the rigbuilders, these are subjected to market forces and are generally less controllable.

Singapore yards could surprise with better execution. Cost factors would be more yard specific, some of which are likely more controllable. Determinants could be (1) raw material/equipment cost, (2) labour cost, (3) efficiency gains, (4) depreciation cost and (5) product mix. Singapore rigbuilders are well-known for their execution and we believe that this is where opportunities to defend margin lies.

Other notable factors. Forex is another factor as rig contracts are typically dominated in USD while Keppel and SMM reports in SGD and incurs substantial amount of cost in SGD and other currencies. While USD has been depreciating against the SGD, the currency environment does seem to be less volatile now, while we expect steady SGD appreciation in line with MAS’ implicit core inflation target.

Still prefer SMM over Keppel. We stick to our preference for SMM over Keppel as a better pure-play O&M stock. We believe that negativities on margins have been priced in and there may be scope for outperformance above the street’s estimates. Nevertheless, the positive contract win outlook is sufficient for us to keep our Buy calls on both rigbuilders.