SINGAPORE (March 6): About two years ago, Sembcorp Industries unveiled a bold, new strategy to reduce its dependency on the oil services industry. Its key focus was to expand its utilities business (now known as the energy business), and thereby, transform itself into an integrated energy player.
This strategy — as the company hopes — would allow it to benefit from the global transition towards renewable energy. At the same time, it would offset the drag by Sembcorp Marine (SembMarine), its 60.9%-owned listed subsidiary, which continues to be bogged down by the downturn in oil prices.
To achieve that, Sembcorp invested in several companies involved in thermal power, gas importation and retail as well as regas infrastructure. It also invested in companies that focus on renewable energy, and water and wastewater treatment. In addition, the company divested some of its prior investments that were not in line with its new strategy.
Neil McGregor, who was appointed group president and CEO of Sembcorp three years ago, reckons that the new direction has made the company more resilient. “Several years ago, our profit engines were only marine and Singapore. Today, we have five profit engines that are contributing over $100 million. These are Singapore, China, India and the rest of the world as well as our urban business. So you can see that we are much more diversified from where our profit pools are coming from,” McGregor said at the company’s FY2019 ended December results briefing on Feb 21.
Still, Sembcorp’s new strategy has produced some hiccups. In particular, the company’s UK Power Reserve (UKPR) was forced to make an impairment of $158 million, owing to challenging market conditions in the UK. UKPR is a flexible energy generation operator, which was acquired by Sembcorp in 2018 for £216 million. It has a portfolio of small-scale, fast-ramping power generation assets and rapid response batteries that is connected at the distribution level.
In Chile, Sembcorp also recorded an impairment of $64 million. This was the result of the $49 million divestment of its water business there, which is expected to be completed by mid-2020. The company says the divestment is part of its capital recycling efforts and portfolio rebalancing strategy of deepening its presence in key markets while divesting peripheral assets.
Moreover, in China, Sembcorp registered an impairment of $23 million for its wastewater treatment assets. This was because the company expected existing facilities would not be able to meet new and more stringent effluent discharge standards that will come into force in Jiangsu province in January next year.
As a result, Sembcorp recorded a total impairment loss of $245 million. This resulted in the company reversing into a loss of $15 million in 4QFY2019, compared to earnings of $106 million in the same quarter the year before. For the full year, the company registered earnings of $247 million, down 28.8% from $347 million a year ago. The company also saw double-digit declines in revenue to $2.32 billion and $9.62 billion in 4QFY2019 and FY2019, respectively.
Is Sembcorp’s bet on being an integrated energy business misplaced? Or are these pains part and parcel of the company’s journey to become a major player in that sector?
Difficult forecasting
McGregor admits that it is quite difficult to make capacity forecasts in the UK. The capacity market there comprises both the energy market and imbalances market. The energy market supplies capacity from fossil fuel power plants and renewable energy sources. On the other hand, the imbalances market tops up any remaining capacity caused by intermittency gaps from flexible energy generation operators.
According to McGregor, the complexity lies in forecasting capacity shortages in the short term. To do this, one needs to look at the supply and demand balance of the entire UK market, he says. This requires the construction of models that are based on many assumptions.
Unfortunately, some of these assumptions did not hold true. For one, the retirement of coal and older gas power plants did not occur as quickly as anticipated, McGregor says. Secondly, other flexible energy generation operators added capacity to the market too, he adds. Also, the UK experienced one of its warmest winters last year, on top of improvements in forecasting by the National Grid Electricity System Operator. In addition, energy demands fell thanks to better energy efficiency and lower levels of industrial production.
“That gives you some idea of the complexity and moving parts of the mechanics of the flexible business. Directionally, I believe we have got this right, but in the short term, there have been impacts that I have already outlined. The underlying assumptions for the investment case have not met expectations,” he says. “So we didn’t have the volatility spikes.”
Does this mean that there could be more impairments from UKPR in the future? Well, that depends on the company’s forward view of the market, says McGregor, noting that the company conducts impairment tests on UKPR’s assets each year. “So all I can say is that this is a business that is variable in nature, [hence], its profitability will be variable as a result,” he says.
In any case, McGregor assures that this incident has taught Sembcorp to make better forecasts ahead. “We brought in more capability to farm the national grid and the markets so that we can model and understand the market better,” he says.
McGregor still thinks that the flexible power generation business is an attractive one because of the UK’s aim to achieve net zero carbon emissions by 2030. “That means there is going to be a lot more renewable [energy sources] that are going to come onboard. With additional renewable capacity, there will be increased volatility because there are fewer base load and intermediate load plants on the margin,” he says.
Analysts mixed
Meanwhile, Sembcorp’s energy business elsewhere is showing a mixed performance. During the quarter, the company’s India operations received insurance claims and settlements of $44 million, which was booked by the company as part of its core earnings. As a result, India’s headline earnings for FY2019 received a boost to $100 million, according to DBS Group Research. “The power market in India seems to be recovering with the current peak surplus expected to reverse by FY2020, according to independent research house CRISIL, and drive up tariffs,” says DBS.
In Singapore, the energy business posted record low earnings of $2 million, down 95% q-o-q and 93% y-o-y, according to CGS-CIMB Research. This was due to the loss of income from the shutdown of power assets for maintenance, in addition to higher purchase cost from contract for differences (CFD) to fulfill customers’ demand. The Jurong Aromatics Corporation (JAC) utilities assets that were divested in 3QFY2019 also resulted in a loss of income of about $6 million in 4QFY2019, says CGS-CIMB.
One bright spot however, was Sembcorp’s urban business. The segment reported earnings of $117 million, up 36% y-o-y from a year ago. This was boosted by profit recognition from completion of residential development Riverside Grandeur in Nanjing China, which DBS estimates to be $70 million.
The company continues to develop new residential projects. It expects to see revenue from The Habitat Phase 2 (launched and sold out in 2019; 3A soft-launched in October 2019) and Sun Casa in 2020. Sembcorp has a net order book comprising 423ha to be recognised as land sales over the next two-to-three years.
For now, shares of Sembcorp have continued to decline, amid a wider market slump triggered by the Covid-19 outbreak. The counter is down 19.7% year to date, bringing it to a five-year low of $1.84 on March 4. At that price, Sembcorp is trading at 15.6 times earnings and 0.54 times book. The stock has has a trailing 12-month yield of 2.2%.
Analysts are mixed on Sembcorp’s prospects. DBS has maintained its “hold” rating for the stock with an unchanged target price of $2.20. “While Sembcorp is already trading at a steep 50% discount to book, re-rating hinges on return on equity enhancement (from current 5–6%) stemming from earnings recovery of utilities businesses in India/ UK and marine segment,” DBS analyst Ho Pei Hwa writes in a Feb 24 note. She adds that a potential restructuring between Sembcorp and Keppel Corp — much talked about for years — remains a wild card.
RHB Securities, however, is maintaining its “buy” call for the stock, albeit with a lower target price of $2.33 from $2.68 previously. “We remain positive on Sembcorp with expectations of its energy and urban segments underpinning performance going forward,” RHB analyst Leng Seng Choon writes in a Feb 24 report.
Nevertheless, RHB has cut Sembcorp’s FY2020 earnings forecast by 14% to $404 million, as management guided a competitive energy business environment in Singapore and India’s 2020 energy performance to be flat y-o-y. It has also cut its FY2021 earnings forecast by 14%.
