SINGAPORE (Dec 9): Assessing risk is an everyday occurrence. When approaching a traffic light while driving, should we accelerate as it turns amber or wait for the next green light? Drivers assess risk every day. As investors or traders, should we buy DBS Group Holdings or Oversea-Chinese Banking Corp for exposure to private banking? Should we opt for Ascendas Real Estate Investment Trust or Mapletree Industrial Trust for exposure to business and tech parks of the future economy?
Risk assessment starts getting a little more complicated when shopping for a mortgage. Should you take a longer loan and pay less a month or a shorter loan to be mortgage-free in 15 or 20 years? Is a floating rate better or a fixed rate? That depends on the interest rate environment and the outlook for interest rates. What determines interest rates? Economic growth, unemployment, industrial production, services growth.
When a company assesses risk, the factors a company needs to consider are manifold: economic outlook, sector outlook, interest rate outlook, cost of debt, foreign exchange risk, capital structure, return on equity, return on capital employed, to be overlevered, underlevered, cash flow, interest cover.
Ezion Holdings, which is currently suspended and awaiting a new major shareholder, is a homegrown offshore support vessel owner-operator and was part of the local burgeoning offshore and marine (O&M) sector from 2000 to 2014. OSV operators were a necessary cog in the wheel of the oil and gas sector. OSVs helped maintain oil rigs and platforms as demand for energy grew with the rise of China.
As the offshore oil sector waned, OSVs were used to service wind farms and gas fields. Australian gas fields such as Gorgon, Ichthys and Barossa became familiar names to investors of Ezion as the company bid for and clinched projects. Its big break was a multi-year project in the Gorgon field, one of Australia’s largest in its northwest shelf.
Taking on more risk
While analysts remained positive on Ezion from 2010 to 2015, free cash flow eluded the company. Now, we get to the textbook definition of risk. “The risk management framework-relationship is characterised by two variables: the willingness to take risk and the capacity to take risk. At any given time, the willingness/tolerance to take risk must not exceed the capacity to take risk,” the textbooks say.
To illustrate risk, we have used something we are all familiar with — common equity-to-total asset ratio. Think of it as your own net worth compared with the assets you have such as a property. If your net worth is $2 million, your property valued at $5 million and your outstanding mortgage is $3 million, your equity-to-asset ratio is 0.4 times. This is below Ezion’s level just before it got into problems.
Ezion’s equity-to-asset ratio stayed around 0.5 times for many years. That means it financed the rest of its capital with debt (see Charts 1 and 2). In Chart 1, the equity-to-asset ratio weakened even before the oil price collapse in 2014. The main reason was the additional debt Ezion took on when it invested in a joint venture with Swissco Holdings to own ageing rigs. This represents the company’s willingness to take on risk.
During its willingness-to-take-on-risk period, risk tolerance was high, as it was with most O&M players including capital goods producers such as Keppel Corp and Sembcorp Marine. In Ezion’s case, capital expenditures increased more than five times, while free cash flow turned strongly negative (see Chart 2). In 2013, the company had stated that it would be mostly reinvesting profits into new projects for FY2014.
The flames of risk tolerance were fanned by quantitative easing and low interest rates. OSV providers were encouraged to issue bonds to finance their expenditures, in the hope that charter rates would provide the cash flow and Ebitda (earnings before interest, taxes, depreciation and amortisation) for interest cover.
The capacity to take on risk was far lower than the risk-tolerance levels of the OSV providers. Oil prices fell sharply in 2014 for reasons such as oversupply, falling demand, shale oil and the unwinding of futures contracts in the financial markets. The sudden fall affected charter rates. In addition, OSV oversupply exacerbated the decline in charter rates. Lower charter rates implied lower cash flow than projections had indicated, and lower valuations for the OSVs because shipping assets are valued based on their cash flows.
Oil prices have recovered this year, but charter rates remain in the doldrums. Thus, it has been a challenge for Ezion’s revenue and cash flows to recover. In the meantime, it had to write down the value of the aged Swissco rigs, turning its shareholders equity negative in FY2017.
Restructure and survival
In July last year, Ezion managed to successfully restructure. Its secured lenders agreed to a six-year US$1.5 billion ($2 billion) refinancing plan for their existing facilities, with minimal fixed repayment and reduction in interest rates. Security holders with $575 million on bonds have agreed to an extension in their maturities by six to 10 years and a reduction in the interest rate to 0.25%. Unsecured creditors have an option to exit via an exercise of stapled warrants to convert outstanding amounts (of debt) to equity.
In a letter to shareholders in March, chairman Wang Kai Yuen said: “Ezion is in advanced discussions with a potential strategic investor. The potential strategic investor needs also to agree to terms with the secured lenders. We have received feedback that the discussions between the secured lenders and one particular investor group have been progressing well. However, no conclusive agreement has been reached to date. As the outcome of this discussion will have a very major impact on the group, we have decided therefore to suspend the trading of the company’s shares to avoid any irregular trading activities from price-sensitive discussions that have started and are ongoing.”
Since the letter in March, Ezion has reorganised its management, cut expenses and, when possible, divested assets, including the sale of an Indonesian joint venture company announced on Nov 14 and stakes in JV companies in Singapore announced on Nov 22. These JVs are likely to hold OSVs.
For investors, the fundamentals of sound risk management do not change over time whether it is for a company or their own portfolios. For listed corporates, cash flow, interest cover and debt-to-equity and debtto-asset ratios are readily available through publicly issued financial statements.
Ezion’s net profit, earnings per share and net asset value remained negative for the quarter ended Sept 30. Interestingly, the company managed to generate operating cash flow of US$3.3 million in the quarter and US$18.8 million for the nine months ended Sept 30. In the first nine months of the year, Ezion had free cash flow of US$14.4 million.
Finally, some green shoots have appeared and, the more green shoots that appear, the greater the likelihood of a new major investor.
