ROTARY ENGINEERING

UOBKayhian on 8 May 2014

VALUATION

• Maintain BUY and target price of S$0.88, based on a 3-year average PE of 10.6x on 2015F EPS of 8.3 S cents. At the current share price, the company is trading at 9.4x 2014 consensus PE, a 61.3% discount to its peer average of 24.3x. 
• We also expect the company to pay out a dividend of 2.9 S cents/share providing investors with a dividend yield of 3.9% for 2014.

FINANCIAL HIGHLIGHTS

• Rotary’s 1Q14 net profit rebounded to S$14.4m from S$2.5m in 1Q13, mainly due to higher revenue and improved gross profit margin. Total revenue rose 94% yoy to S$199.2m (1Q13: S$102.8m) as the company recognised revenue from ongoing project in Singapore and the Middle East. Gross profits grew 90% yoy to S$33.6m with gross profit margin improving to 17% (1Q13: 15%) due to increased productivity and reduction in costs.
• Orderbook fell to S$535m as at 31 Mar 14, of which 74% is from Singapore and the rest in Asean and Middle East. Balance sheet is also healthy with the company recording a net cash of S$147m, 35.2% of the current market cap.

OUR VIEW

• Although this quarter’s net profit exceeded expectations with higher revenue and improved gross profit margin, we maintain our earnings forecast for the year at S$40.8m due to a lack of contract wins for the first 4 months. Unless the company is able to win contracts soon, we are likely to see revenue peak in the next 6 months.
• Awarding of the Petrona’s Rapid project likely delayed. Petronas has recently approved the development of the Refinery and Petrochemical Integrated Development (RAPID), which will cost US$16b, and other associated facilities, which will cost US$11b. Although Rotary has already submitted a bid for one of the packages with a contract size of approximately US$700m-1b, management shared that the client has gone quiet so far and thus Rotary will be focusing on other projects in Malaysia instead.
• Outside of Asean. Rotary sees opportunities in the Saudi Arabia to focus on tankage, electrical and instrumental services and fabrication work as well as exploring other Build-Operate-Own opportunities.

ROTARY ENGINEERING

UOBKayhian on 28 Feb 2014

VALUATION

•  Maintain BUY and target price of S$0.88, based on a 3-year average PE of 10.6x on 2015F EPS of 8.3 S cents. We also expect the company to pay out a dividend of 2.9 S cents/share providing investors with a dividend yield of 4.6% for 2014.

FINANCIAL HIGHLIGHTS

•  Rotary reported a stronger set of results for 2013. Net profit rebounded to S$20.7m from a loss in 2012, mainly due to higher revenue and lower profit recognition from the negative-margin SATORP project. Total revenue rose 34% yoy to S$595m (2012: S$444m) and gross profit improved to S$68.5m (2012: S$110m gross loss). Gross profit margins also grew to 12% which was within management's guidance.
• Orderbook remained strong at S$694m as at 31 Dec 13, of which 69% is from Singapore and ASEAN and 31% from the Middle East. Balance sheet is also healthy with the company recording a net cash of S$134m, 37.5% of the current market cap. Rotary is also proposing a dividend of 1.5 S cents, providing investors a dividend yield of 2.4%.

OUR VIEW

•  Keeping a tight control on current projects. Rotary is confident of delivering a very strong set of results for 2014 as most contracts in the current orderbook are in Singapore, where control is tight and execution risks are a lot lower. Gross margins are also expected to normalise after the Group handed over the SATORP project last year. Rotary has also put in place several initiatives to improve productivity and reduce costs such as shifting its production to its Indonesian yard and investing in barges to transport prefab components across the Straits.
• Oil and gas projects outlook remains robust While Petronas is still evaluating the tenders for the RAPID project and will probably announce the results only in 2H14, Rotary re-iterated that there are also several projects out for tender in 2014 such asMalaysia’s petrochemical hub in Pahang, Thailand’s EPC, tankage project in Map Ta Phut and even Fujairah oil terminal phase 2. Chairman Mr Roger Chia urged investors to remain patient as contract wins will come.
• Earnings to double in 2014. Getting off a low base in 2013 and with the current orderbook of S$694m, we expect the company to record a revenue of S$700m and profit of S$40.8m, doubling from the last financial year.

ROTARY ENGINEERING

Uobkayhian on 17 Jan 2014

VALUATION

• Maintain BUY and target price of S$0.88, based on a 3-year average PE of 10.6x on 2014F EPS of 8.3 S cents. At the current share price, the company is trading at 14.5x 2013 PE, a 25.6% discount to its peer average of 19.5x. 
• We also expect the company to pay out a dividend of 1.7 S cents/share providing investors with a dividend yield of 2.6%.

INVESTMENT HIGHLIGHTS

• Award of the RAPID contract will be later than expected. According to management, Petronas is still evaluating the tenders for the RAPID project but will probably announce the results only in 2H14, later than the 1Q14 as initially expected. As a recap, the Petronas RAPID project has a contract size of approximately US$700m-1b and will significantly bump up Rotary’s orderbook if they manage to secure it. In addition, the internal engineering and design department has already started work on the tank design and as a contingency plan, is able to offer their service to the main contractor if they fail to secure this project.
• Competition remains keen but Rotary will not compromise on margins. Gross margins in 2010 to 2013 were impacted by the SATORP project and company is likely to maintain its guidance of 10-12% for 2013. But as the company hands over this negative margin project to its client, the gross margin should recover and normalise to the 14-15% range. Further margin improvement can be achieved by increasing productivity and efficiency, lowering costs by shifting its production to its Indonesian yard and investing in barges to transport prefab components across the Straits. 
• Positive on 2014. As revenue is progressively recognised over the 18-24 months’ project period, management is positive on the earnings outlook for this year. At the same time, the company will also be aggressively seeking new projects to replenish its orderbook. We conservatively expect the company to secure S$700m worth of order wins for this year, a tad below the S$1b secured in 2013.

Rotary Engineering

UOBKayhian on 18 Jul 2013

Investment Highlights

• Rotary provides fully integrated engineering design, procurement, construction and maintenance (EPCM) services to the oil and gas (O&G), petroleum, petrochemical and pharmaceutical industries.
•  The group has projects in Malaysia, Thailand, Indonesia, India, China,  Australia, Saudi Arabia and the United Arab Emirates. Some of the major projects that Rotary has undertaken include the Universal Terminal in Singapore and SATORP JERP package 6 in Saudi Arabia. 

Our View

• Bottoming out, silver lining along the horizon. Rotary has gone through a really rough patch in 2012 with the company reporting an S$80.4m loss attributable to shareholders in 2012 compared to a S$31.0m profit a year ago. This is largely due to a major cost over-run in the SATORP project that led to the recognition of negative gross margins. Despite the loss in 2012, the company dished out a dividend of 0.5 S cents to reward shareholders, giving a yield of 1%. The company has since regained its footing having clinched several contract wins in 1H13, such as the S$300m oil terminal in Pulau Busing and a total of S$102m for a few projects on Jurong Island. As at 31 March, the company had an order book of S$756m to be completed within 18-24 months.

• Chairman and MD Mr Chia remained confident on outlook despite keen competition. According to the Chairman, there is still a strong pipeline of O&G projects in the region and UAE. Only recently, Petronas has called for a tender under Package 8 of the Refinery and Petrochemicals Integrated Development (Rapid) project in Johor, Malaysia. Although the contract value is not mentioned, the package 8 is for the engineering, procurement, construction and commissioning (EPCC) of the cumene, phenol and bis-phenol A production units of the project. Rotary has been pre-qualified for this project.

• S$82m deficit remains a risk. Rotary has this non-controlling deficit sitting on its balance sheet as the 51%-owned SATORP JV has run into steep losses in the SATORP project. Although the auditors are convinced that Rotary did not have to make this impairment in 2012, recovering this amount from the JV partner may also take a while.

Rotary Engineering

OCBC on 11 Apr 2013

Rotary Engineering Ltd (Rotary) had a difficult year in 2012, as it battled escalating cost over-runs on its US$745m SATORP mega-project and repeated delays on its S$260m Fujairah Oil Terminal project. In 4Q12, the group appeared to be making progress on its SATORP project, although the non-controlling deficit is still a thorny issue. The group recently secured S$42m of project work in Singapore’s Jurong Island, and S$300m of EPC work in Pulau Busing. However, the tighter foreign labour market in Singapore could mean lower project margins over the medium term horizon. Coupled with the uncertainty at its SATORP JV, it may still be too early for investors to buy its shares, which are currently trading at 1.4x PBR. Meanwhile due to a reallocation of resources, we have decided to CEASE COVERAGE.

Is there a turnaround soon? 
Rotary Engineering Ltd (Rotary) had a difficult year in 2012, as it battled escalating cost over-runs on its US$745m SATORP mega-project and repeated delays on its S$260m Fujairah Oil Terminal project. In 4Q12, the group appeared to be making progress on its SATORP project, although the non-controlling deficit is still a thorny issue. The group recently secured S$42m of project work in Singapore’s Jurong Island, and S$300m of EPC work in Pulau Busing. However, the tighter foreign labour market in Singapore could mean lower project margins over the medium term horizon. 

SATORP JV deficit a thorny issue
As a brief recap, Rotary encountered several issues on its SATORP in-kingdom project, including design flaws, escalating costs and substantial re-work. After two quarters of steep cost over-runs, it now aims to achieve project commissioning by Oct-2013. However, the financial deficit at its 51%-owned SATORP JV is still unresolved. Rotary’s non-controlling interest showed S$82m of deficit as of Dec-2012. In our view, if Rotary decides to continue participating in projects in Saudi Arabia under the same operating entity, the JV would need a capital injection. Alternatively, if the JV is no longer relevant after the SATORP project ends, there is a risk of an impairment for the deficit amount owed by its minority JV partner. 

Tight labour market in Singapore
Another concern is the tight labour market in Singapore, which accounts for 50% of Rotary’s order-book. While there is no change in the dependency ratio (for the construction sector), the increase in worker levies and reduced man-year entitlements would likely to lead to lower margins. Coupled with the uncertainty at its SATORP JV, it may still be too early for investors to buy its shares, which are currently trading at 1.4x PBR. Meanwhile due to a reallocation of resources, we have decided toCEASE COVERAGE.

Rotary Engineering

OCBC on 4 Mar 2013

Rotary Engineering Limited (Rotary) reported a second consecutive quarter of losses with 4Q12 net losses to shareholders of S$18.4m (3Q12: S$66m). Last quarter was marked by additional provisions made for its SATORP project and lower volume of work due to the late start of Fujairah Oil Terminal (FOT) project. FY12 revenue was down 16% to S$444m, while loss attributable to shareholders was S$80m, compared to profit of S$31m in the previous year. While the SATORP execution issues may be largely behind, the deficit at its JV remains unresolved. In a worst case scenario, Rotary – being the controlling shareholder – may need to take an impairment loss. Another concern is the tight labour market in Singapore, which represents about 50% of Rotary’s order-book. Maintain SELL with an unchanged S$0.34 fair value estimate.

Another loss-making quarter
Rotary Engineering Limited (Rotary) reported a second consecutive quarter of losses with 4Q12 net losses to shareholders of S$18.4m (3Q12: S$66m). Last quarter was marked by additional provisions made for its SATORP project and lower volume of work due to the late start of Fujairah Oil Terminal (FOT) project. FY12 revenue was down 16% to S$444m, while loss attributable to shareholders was S$80m, compared to profit of S$31m in the previous year. The group proposed a 0.5 S cent dividend for FY12. 

SATORP JV deficit remains unresolved
While SATORP execution issues appear to be largely resolved, the deficit at its JV remains a potential risk to shareholders. As a brief recap, Rotary had encountered several issues relating to its SATORP in-kingdom project, including design flaws, escalating costs and substantial re-work. After two quarters of steep cost over-run, it now expects to complete all the major works by Apr 13 and commissioning by Oct 13. However, the financial deficit at its 51%-owned SATORP JV is still unresolved. (Note: Rotary’s non-controlling interest showed S$82m of deficit as of end Dec-12.) In our view, if Rotary decides to continue participating in projects in Saudi Arabia under the same operating entity, the JV would need a capital injection. Alternatively, if the JV is no longer relevant after the SATORP project ends, there is a risk of an impairment loss for the deficit amount owed by its minority JV partner. 

Tight labour market in Singapore
Another concern is the tight labour market in Singapore, which represents about 50% of Rotary’s order-book. While there is no change in the dependency ratio (for the construction sector), the increase in worker levies and reduced man-year entitlements would likely depress project margins. Maintain SELL with an unchanged S$0.34 fair value estimate.

Downstream Oil & Gas

OCBC on 27 Nov 2012

The shift in oil demand growth from OECD countries to non-OECD countries, coupled with an increasing refining overcapacity has put pressure on global refinery utilization rates and refining margins. Against this backdrop, Singapore said that it has no plans to attract any more green-field refinery investments, and will focus on getting existing refineries to upgrade or expand their facilities to produce higher-value petrochemicals, fuels and lubricants. We believe the net effect will be fewer jobs and even stiffer competition for the EPC contractors. As such, we maintain our UNDERWEIGHT on the sector. We like PEC (BUY; FV: S$0.76) for its attractive valuations, but would avoid Rotary (SELL; FV: S$0.34) as we believe the risk of further cost over-run is still relatively high.

Oil demand has peaked in developed countries
According to some observers, oil demand in the developed countries may have already peaked and is currently on a long-term downtrend (IHS, The Economist). Indeed, oil demand in the OECD countries has been sluggish over the past several years, resulting in massive refining overcapacity. The key reasons for the declines are: (i) aging population and slowing growth rates, (ii) saturated car ownership rates, (iii) tighter fuel efficiency standards, and (iv) use of new technologies like hybrid electric vehicles. 

Developing countries continue to add refining capacity
Meanwhile, the developing world has been adding new refining capacity to meet its growing domestic oil demand. For example, China’s refining capacity jumped by 51% since 2005 to 10.8m barrels daily in 2011, while its oil consumption increased by 41% to 9.8m barrels daily over the same period. In the Middle East, some countries (i.e. Saudi Arabia, UAE) are embarking on refinery projects to produce higher valued derivatives for the export market – a marked departure from its traditional role of just selling crude oil overseas. These new refineries are massive in scale and could easily outperform the older ones in Europe and America. Also, the refineries benefit from significant cost savings due to proximity to the crude oil producing regions (in the case of Middle East) or to the end-market (in the case of China). 

Global margin squeeze
The shift in oil demand growth from OECD countries to non-OECD countries, coupled with an increasing refining overcapacity has put pressure on global refinery utilization rates and refining margins. Against this backdrop, Singapore said that it has no plans to attract any more green-field refinery investments, and will focus on getting existing refineries to upgrade or expand their facilities to produce higher-value petrochemicals, fuels and lubricants. We believe the net effect will be fewer jobs and even stiffer competition for the EPC contractors. As such, we maintain our UNDERWEIGHT on the sector. We like PEC (BUY; FV: S$0.76) for its attractive valuations but would avoid Rotary (SELL; FV: S$0.34) as we believe the risk of further cost over-run is still relatively high.

Rotary Engineering

OCBC on 5 Nov 2012

Rotary Engineering (Rotary) reported a hefty 3Q12 net loss of S$66m, mainly due to “additional costs, including provisions for foreseeable losses of $40m” for the SATORP project. Although the group had earlier warned of net losses for 3Q12 and FY12, the quantum of the loss was far worse than what we expected (we had estimated net loss of S$8m). To put things in perspective, the magnitude of the 3Q12 loss was so steep that it wiped out Rotary’s previous seven quarters of profits. The group has re-assessed the project budget and made the necessary provisions. Despite so, we think it may still be too early to turn positive. One further risk is the need to recapitalize its 51%-owned JV that is currently working on the SATORP project. Maintain SELL with lower fair value estimate of S$0.34, still based on 0.8x FY13F BPS.

3Q shocker

Rotary Engineering (Rotary) reported a hefty 3Q12 net loss of S$66m, mainly due to “additional costs, including provisions for foreseeable losses of $40m” for the SATORP project. Although the group had earlier warned of net losses for 3Q12 and FY12, the quantum of the loss was far worse than what we expected (we had estimated net loss of S$8m). To put things in perspective, the magnitude of the 3Q12 loss was so steep that it simply wiped out Rotary’s previous seven quarters of profits. 

SATORP trouble continues
As mentioned in our previous reports, the SATORP project encountered several difficulties, including design flaws, escalating subcontracting costs, work sequencing issues and harsh working conditions, resulting in the cost over-run situation. Management assured us it is working hard to rectify these issues and “things are now under control”. It is determined to complete the job to maintain its reputation, even if it meant incurring more expenses. Accordingly, it has re-assessed the project budget and made the necessary provisions. Management also believes that the SATORP project is on schedule for completion by end-2012. 

Impairments and restructuring
During the quarter, the group recorded S$12m of impairments relating to its LNG logistic associate as the business had turned unviable. It also trimmed its admin and other operating costs (excluding FX) such that they are at 10% of revenue (previously: 11-14%). Despite these measures, we think it may still be too early to turn positive. One other risk is the need to recapitalize its 51%-owned JV that is currently working on the SATORP project. (Note: Rotary’s non-controlling interests showed S$65m of deficit as of end-Sep 2012). We updated our model for the quarter results and maintain SELL with lower fair value estimate of S$0.34 (still based on 0.8x FY13F BPS).

Rotary Engineering Ltd

OCBC on 25 Sept 2012

Rotary Engineering Ltd (Rotary) issued a profit warning of net losses for the coming quarter and FY12F. According to management, losses were mainly due to the SATORP project. This should not come as a total surprise as Rotary had previously reported that it faced “major challenges” in its execution and warned that “additional costs … will be incurred to rectify” certain issues. The group’s ability to manage the cost over-run issue may be limited given the shortage of subcontractors in Saudi Arabia market and the tight deadline for completion. We now project a net loss of S$2.5m in FY12F and a subsequent recovery in FY13F. We also lowered our P/B peg to 0.8x (previously 1.0x) and fair value estimate to S$0.43 (previously S$0.50). Downgrade to SELL.

Profit warning
Rotary Engineering Ltd (Rotary) announced yesterday that it expects to record net losses for the coming quarter and FY12, although no guidance was given on the quantum. According to the management, losses were mainly due to the SATORP project. This should not come as a total surprise as Rotary had previously reported that it faced “major challenges” in its execution and warned that “additional costs … will be incurred to rectify” certain issues. 

Cost over-run at SATORP
As a brief recap, the group had reported cost over-run of S$46m relating to SATORP in 2Q12. As the losses were mainly incurred on its 51%-owned joint-venture, Rotary’s share of losses was effectively S$23m. The cost over-run situation stemmed from several inter-related issues. The original civil subcontractors responsible for the construction work were unable to cope with the schedule, and additional subcontractors had to be appointed at higher costs. There were also changes to engineering design that resulted in major civil re-work. In addition, piping and electrical and instrumentation activities were also affected due to work sequencing. The latest profit warning implies that these issues may have worsened. Indeed, work sequencing issues can be severe and delays along a project “critical path” can quickly cascade downwards resulting in multiple logjams. 

The clock is ticking…
Rotary’s ability to manage the cost over-run issue may be limited given the shortage of subcontractors in Saudi Arabia market and the tight deadline for completion (Dec 2012). In addition, it may also need to inject more capital into the JV company. We now project a net loss of S$2.5m in FY12F and a subsequent recovery in FY13F. We also lowered our P/B peg to 0.8x (previously 1.0x) and fair value estimate to S$0.43 (previously S$0.50). Downgrade to SELL.

Rotary Engineering

OCBC on 10 Aug 2012

Rotary Engineering Limited (Rotary) was hit by an unexpected S$46m cost over-run for its SATORP project, resulting in a 90% YoY fall in net profit attributable to shareholders to S$1.0m (2Q11: S$10.2m). Its original civil sub-contractors were not being able to cope with the SATORP schedule, leading to additional costs for hiring new subcontractors. Excluding the SATORP cost over-runs, management said that its gross margin will still be lower at 15% (2Q11: 21%) due to margin pressure from recent contracts. We factored in another quarter of cost over-run and cut our FY12F EPS by 40%. However, as the stock is already at depressed valuation (1x P/B, -1 SD below 5-year average), we maintain our HOLD rating with unchanged fair value estimate of S$0.50.

2Q results below expectations
Rotary Engineering Limited (Rotary) was hit by an unexpected S$46m cost over-run for its SATORP project, resulting in a gross loss of S$5.9m for 2Q12. As the losses occurred mainly on its 51%-owned joint venture company, Rotary’s 2Q12 net profit after deducting minority interest was S$1.0m, down 90% YoY from S$10.2m in the year-ago period. Excluding the SATORP cost over-runs, management said that its gross margin will still be lower at 15% (2Q11: 21%) due to margin pressure from recent contracts.

SATORP’s S$46m cost over-run
The S$46m cost over-run for the SATORP project resulted from several inter-related issues. The original civil subcontractors responsible for the construction work were unable to cope with the schedule and more subcontractors had to be appointed at higher costs. There were also changes to engineering design that resulted in major civil re-work. In addition, piping and electrical and instrumentation activities were also affected due to work sequencing. Rotary is currently rectifying the issues but gave no guidance on additional cost going forward.

Order-book running low
The group’s order-book is down 12% QoQ to S$527m as of Jun 2012 and will need to replenish its order-book urgently or risk a fall in operating efficiency. Its Fujairah project was again delayed by its client and the likely start date is now Sep/Oct 2012.

Depressed valuation, maintain HOLD
Given the shortage of subcontractors in the Saudi Arabia market and the tight deadline for SATORP (Dec 2012), Rotary’s ability to manage the cost over-run situation may be limited. Therefore, we factored in another quarter of weak results and cut our FY12F EPS by 40%. However, as the stock is already at depressed valuation (1x P/B, -1 SD below 5-year average), we maintain our HOLD rating with unchanged fair value estimate of S$0.50.

Downstream Oil & Gas

OCBC on 24 Jul 2012

DOWNSTREAM oil and gas companies under our coverage (Rotary Engineering and PEC) will report their Q2 calendar year 2012 results next month and we expect a relatively weak financial performance from both companies. The industry has been experiencing severe pricing competition amidst a shortage of local large-scale petrochemical project works. In our view, a quick turnaround is unlikely.

Recent comments from the Economic Development Board (EDB) - the lead government agency responsible for attracting energy investments - have also been telling.

When asked for an update on a refinery plan, EDB's deputy director of energy and chemicals said, "EDB does not have a specific aim of attracting a green-field refinery investment at the moment ... the focus is on upgrading the complexity of these refineries."

We believe the sector's profitability will continue to remain depressed. In the last quarter, operating margins for Rotary and PEC were 0.83 per cent and 1.82 per cent, respectively. Outside our coverage, Hiap Seng Engineering and Mun Siong Engineering reported Q1 calendar year 2012 operating losses of $1.2 million and $180,000, respectively. Although margins may recover over the medium-term horizon, we have yet to see any meaningful catalyst. For now, the companies still lack the scale and bargaining power (against oil companies) to push prices upwards.

Investors should also watch out for any unexpected delay in Rotary's Fujairah project and PEC's unresolved claim on its Rotterdam joint venture. To-date, PEC has taken $11.2 million of provisions against $18.3 million of outstanding claims. Depending on the outcome of its negotiations with Verwater (its joint-venture partner), PEC may need to write off further losses. As we feel that there are more downside risks than upside risks, we keep our "underweight" rating for the sector. We also maintain our "hold" ratings for Rotary (fair value: $0.64) and PEC (fair value: $0.50).

Downstream oil and gas companies

OCBC on 6 June 2012

DOWNSTREAM oil and gas companies reported weak results for the first three months of calendar year 2012 (Q1 2012) that were below expectations. Rotary Engineering disappointed with lower gross margins and a steep $4.6 million foreign exchange loss.

PEC Limited barely broke even with net profit of just $1.3 million against revenue of $106.7 million. Outside our coverage, Hiap Seng Engineering and Mun Siong Engineering reported quarterly net losses of $2.2 million and $0.1 million, respectively.

Rotary, PEC, Hiap Seng, and Mun Siong are mainly involved in engineering and maintenance services for the downstream oil and gas sector. They are highly dependent on the pricing and volume of work it secures.
As we have discussed in earlier reports, the recent shortage of project and maintenance work has resulted in severe pricing pressure. With the dismal results, we now fear that some downstream companies are operating at near or below break-even rates.

We are not expecting a quick recovery for the downstream oil and gas sub-sector. First, uncertainty over the eurozone situation may continue to discourage investments by oil companies. Second, the downstream companies lack the scale and bargaining power (against oil companies) to push prices upwards.

In addition to that, Rotary and PEC will require time to fine-tune their overseas operations. To date, Rotary has encountered unexpected delays on its Fujairah project and PEC has unresolved claims on its Rotterdam joint venture. As long as the companies continue to pursue overseas projects, such risks cannot be ruled out.
Meanwhile, the share prices of Rotary ("hold", fair value: $0.50) and PEC ("hold", FV: $0.64) have fallen to near historical lows.

While we have an "overweight" rating on the broad oil and gas sector, we think that investors should wait for clearer signs of a recovery before buying into downstream counters such as Rotary or PEC.
Rotary Engineering - HOLD
PEC Limited - HOLD

Rotary Engineering

OCBC on 5 June 2012

Rotary Engineering Limited (Rotary) share price has fallen by 22% in May and is now at a three-year historical low of S$0.50, representing almost 1x P/B (one standard deviation below its 5-year average). We believe that this was mainly due to its disappointing 1Q12 results, continued uncertainty in the global economy and investors’ preference for defensive non-cyclical counters. That said, we do not see any clear near-term catalysts. Moreover, we believe that there could be more downside than upside risks at this juncture. Therefore, we lowered our valuation peg to 1x (previously 1.2x) and fair value to S$0.50 (previously S$0.61). Maintain HOLD.

Share prices near historical lows
Rotary Engineering Limited (Rotary)’s share price plunged by 22% in the last month (May 2012) against STI’s 7% and FSTOG (STI Oil & Gas Index)’s 9% declines. We believe that this was mainly due to its disappointing 1Q12 results, continued uncertainty in the global economy and investors’ preference for defensive non-cyclical counters. As of 4th June 2012, Rotary’s share price has again fallen to a three-year historical low of S$0.50, representing almost 1x P/B (one standard deviation below its 5-year average).

Headwinds from all directions
Rotary’s business model is highly dependent on the profitability and volume of the project work it secures. Recently, it faced severe headwinds from several fronts: (i) fewer contracts awarded by oil companies, (ii) rising political risks in the Middle East, and (iii) a severe pricing competition. This has resulted in falling gross margins (1Q12: 14.5%; FY09-11: average gross margin of 22.2%) and net order-book (1Q12: S$0.6b; FY09-11: average order-book of S$0.9b).

More downside risks
We also see more downside risks for the group, arising from (i) additional costs on the SATORP project due to stricter-than-expected requirements, and (ii) further delays on the Fujairah project due to engineering design variations. For the Tanjung Piai oil terminal project, we note that it is still at a preliminary stage (i.e. feasibility studies) and is unlikely to be cash generative over the near and medium term horizon.

Lower fair value of S$0.50
Although Rotary’s share price is near historical lows, we do not see any clear near-term catalyst. Moreover, we believe that there could be more downside than upside risks at this juncture. Therefore, we lowered our valuation peg to 1x (previously 1.2x) and fair value to S$0.50 (previously S$0.61). Maintain HOLD.

Rotary Engineering

OCBC on 7 May 2012

Rotary Engineering (Rotary) reported a dismal set of 1Q12 results and this came in below our and the street’s expectations. Although net revenue increased by 2% YoY, profit attributable to shareholders fell by 41% to S$3.2m on lower gross margins (1Q12: 14%; 4Q11: 18%) and a steep foreign exchange loss of S$4.6m. On a positive note, Rotary’s net cash position has improved to S$46m as of end-Mar 12 (end-Dec 11: S$6m). We lowered our FY12-13F gross margin assumptions to 15-16% (previously 20%) and our P/B valuation peg to 1.2x (previously 1.3x). This in turn lowered our fair value estimate to S$0.61 (previously S$0.72). Maintain HOLD.

Dismal 1Q results
Rotary Engineering (Rotary) reported a dismal set of 1Q12 results and this came in below our and the street’s expectations. Although net revenue increased by 2% YoY to S$133m, profit attributable to shareholders fell by 41% to S$3.2m on lower gross margins (1Q12: 14%; 4Q11: 18%) and a steep foreign exchange loss of S$4.6m. On a positive note, Rotary’s net cash position has improved to S$46m as of end-Mar 12 (end-Dec 11: S$5m).

Margin pressure
Rotary explained that its gross margins dipped due to (i) additional cost incurred during the construction phase of the SATORP project and (ii) greater margin pressure due to stiffer competition. On the first point, management explained that it had incurred additional subcontracting costs to meet the stricter-than-expected regulations. The second point – stiffer competition – was unsurprising as oil companies push back their capital investments due to the global uncertainty. Looking ahead, we expect continued margin pressure over FY12-13F.

Foreign exchange loss of S$4.6m
The group suffered a foreign exchange loss of S$4.6m, arising from the weakening of the US dollar and an unexpected increase in net USD assets due to better billing and collection from SATORP. Given the magnitude of the losses, we feel that Rotary’s treasury management could have done better, for example, by tightening its hedging policies.

Maintain HOLD with lower fair value of S$0.61
Although Rotary is seeing intense business activity in enquiries and bids, its order-book has declined to S$597m as at end-Mar 12 (end-Dec 11: S$646m). We also fear that its Fujairah project could be further delayed due to engineering design variations. Therefore, we lowered our FY12-13F gross margin assumptions to 15-16% (previously 20%) and our P/B valuation peg to 1.2x (previously 1.3x). This in turn lowered our fair value estimate to S$0.61 (previously S$0.72). Maintain HOLD.

Oil & Gas - Downstream

Kim Eng on 19 Mar 2012

Downstream oil & gas companies under coverage reported a mixed set of 4QCY11 results. Rotary Engineering (Rotary) met our 4QCY11 forecasts, but PEC disappointed due to higher-than-expected costs on its Rotterdam project. Rotary’s SATORP project is on track for completion by Dec 12 and we expect its Fujairah project to commence soon. On the other hand, PEC suffered delays on its Rotterdam project and made S$5.6m of provisions on unclaimed variation work during the quarter. That said, the project is substantially completed and we do not expect further provisions going forward. Outlook for downstream oil and gas companies remains cloudy, and we prefer PEC over Rotary for its undemanding valuations.

Mixed bag of results 

Downstream oil & gas companies under coverage reported a mixed set of 4QCY11 results. Rotary Engineering (Rotary) met our 4QCY11 forecasts, but PEC disappointed due to higher-than-expected costs on its Rotterdam project. Rotary proposed a 2 S cts final dividend, bringing its FY11 total dividend to 3 S cents. PEC’s year-end is in June, and we are expecting final dividend of 2 S cents.

Review of major projects
With most of the construction work completed, Rotary’s SATORP project (contract value: US$745m) remains on track for completion by Dec 12. We also expect its Fujairah project (contract value: US$250m) to commence soon. On the other hand, PEC had encountered several difficulties in its Rotterdam project, including execution delays and claims on variation orders, resulting in S$5.6m of provisions in 4QCY11. That said, the Rotterdam project is substantially completed and we do not expect further provisions going forward.

Uncertain 2012 outlook
The outlook for downstream oil and gas companies remains cloudy. Within Singapore, competition is stiff and project margins are low. The other key market - the Middle East region – is facing increasing political risks (Israel-Iran conflict, Arab Spring). Nonetheless, Rotary hopes to bag another big EPC project in the region, and is currently pre-qualified for the Jizan refinery project. For PEC, it is currently working on a US$82.5m ENOC EPC project in the UAE.

Strong balance sheet
Despite headwinds in the operating environment, both Rotary and PEC possess strong balance sheets with net cash positions of S$6m and S$147m respectively as of end Dec 11. We value PEC at 1x PBR (BUY, FV: S$0.93), and Rotary at 1.3x PBR (HOLD, FV: S$0.72) for its stronger track record. Between the two, we prefer PEC as valuation is undemanding and its share buyback mandate may limit downside risk to share prices.

Rotary Engineering

OCBC on 23 Feb 2012


Rotary Engineering Ltd (Rotary) reported a 19% and 69% YoY decreases in its revenue and net profit to S$130m and S$8m respectively for 4Q11, mainly due to fewer projects executed in the quarter. FY11 revenue of S$531m (down 25%) and net profit of S$31m (down 51%) were within our expectations but below the street’s expectations. Rotary’s current order-book has also decreased to S$690m from S$758m as end-Sep 11. Meanwhile, the group has proposed a 2 S cts final dividend. We maintain HOLD rating but increased our fair value estimate to S$0.72 on 1.3x PBR.

Results within expectations

Rotary Engineering Ltd (Rotary) reported 19% and 69% YoY decreases in its revenue and net profit to S$130m and S$8m respectively for 4Q11, mainly due to fewer projects executed in the quarter. 4Q11 gross profit margin declined to 20% from 30% (4Q10) due to the absence of major project closures. On a full year basis, FY11 revenue of S$531m (down 25%) and net profit of S$31m (down 51%) were within our expectations but below the street’s expectations. FY11 gross margins remained flat at 21% (FY10: 22%), but net margins fell to 5.8% (FY10: 9.1%) on the back of lower revenue. Rotary has also announced a 2 S cts final dividend, bringing its FY11 total dividend to 3 S cts (or a payout ratio of 55%).

A leaner order-book
Rotary’s order-book has declined to S$690m (as of 14 Feb 2011) from S$758m (as of end-Sep 11). The downward trend in its order-book, as seen over the past 12 months, mainly reflects the financial and economic uncertainties in the global environment. However, management is seeing some momentum in project enquires. It continues to participate actively in tenders and hope to capitalize on its presence in Jubail to win further contracts.

Margin pressure persists 
In view of the uncertainties in the operating environment, management has guided for lower gross profit margin of 12-18%, in contrast to the typical 15-20%. There may be some upside from the release of risk contingencies on project completions. In this regard, we believe that the SATORP mega-project (due for completion in end-Dec 12) may provide 2-3% upside. In line with the recent re-rating of the oil-and-gas sector, we are increasing our fair value estimate to S$0.72 (S$0.61 previously) based on 1.3x PBR (1.1x previously). Maintain HOLD.