Conscious decoupling

On June 8, both companies jointly announced a demerger that will result in the cessation of Sembmarine as a 61%-owned subsidiary of Sembcorp. This will come after a recapitali­sation exercise of Sembmarine.

Sembmarine plans to undertake a $2.1 bil­lion renounceable rights issue to strengthen its cash position and balance sheet. This fund-rais­ing exercise will see the issuance of five rights shares for every one Sembmarine share held at a rights issue price of 20 cents a share. The rights price represents a 31% discount to the theoretical ex-rights price based on a five-day volume weighted average price of 74 cents. The five-day period comprises up to and in­cluding the June 3 closing price.

Sembcorp plans to subscribe up to $1.5 bil­lion of rights shares by setting off the $1.5 bil­lion outstanding under its subordinated loan extended to Sembmarine. The remaining $600 million will be subscribed by Temasek Hold­ings, the parent company of Sembcorp, and indirectly via Sembcorp, Sembmarine.

The deal marks yet another occasion where Temasek is playing an active role in its port­folio companies. For years, it has maintained that the long list of GLCs are managed by their own boards. Last year, it made a partial offer to lift its stake in Keppel Corporation (see facing page), it recently backstopped the $15 billion rescue package for Singapore Airlines. It is now doing the same for these two companies.

See also: Hong Kong investor and EPF pare stake in Interra Resources, Riverstone respectively

Upon completion of the rights issue, Sem­bcorp plans to hive off its stake in a recapi­talised Sembmarine via a distribution in spe­cie to the former’s shareholders. Sembcorp shareholders will receive between 427 and 491 Sembmarine shares for every 100 Sembcorp shares owned, with no cash outlay required.

After the completion of both exercises, Te­masek could emerge as the biggest sharehold­er in Sembmarine, with a stake of between 29.9% and 58%. Sembcorp’s public share­holders, meanwhile, could emerge with a stake of between 30.9% and 35.4% in Semb­marine. Sembmarine’s existing public share­holders could emerge with a stake of between 6.5% to 39.1%.

At a joint briefing, Sembcorp group presi­dent and CEO Neil McGregor admits that both corporate exercises were undertaken in response to two challenges. For one, the Covid-19 pan­demic has caused many countries around the world to initiate a lockdown, forcing the clo­sure of many industries. The reduced econom­ic activity led to an unprecedented destruction of oil demand.

See also: DBS and Sea: Two ends of a barbell?

As a result, crude oil prices have continued to remain low, persisting an industry-wide glut. Although the United States, Saudi Arabia and Russia — three of the world’s biggest producers — eventually agreed to cut production, crude oil prices have not moved high enough to re­turn optimism to the oil industry. “Essentially, the outlook for energy has changed. That re­quires both companies to look at adapting to more sustainable business models,” he says.

With the demerger, McGregor says Semb­corp will be able to focus on its core business­es of energy and urban development without the challenges and constraints of Sembmarine. “It’s really for us to deepen our capabilities and to reshape the portfolio. This is because the change and demand that we are seeing from both Covid-19 and the supply and demand sit­uation for oil and gas, new patterns are emerg­ing in the energy sector. That is something that we would like to be able to move and focus on to compete effectively and win new busi­ness,” he says.

At the same time, the rights issue will pro­vide Sembmarine with much needed cash flow. “That is [the certainty] that we are looking to provide before [the] distribution [in specie of Sembmarine shares]. We would like to see Sembmarine be sufficiently capitalised so that they can continue [their] business and see out the current downturn in the oil and gas cycle,” McGregor says.

Asked whether the privatisation of Semb­marine was considered, McGregor says it was one of many options on the table. However, that move does not solve the need to recapi­talise the company, he says. “Whereas the pro­posed transactions we have now [will] address that [need] completely,” he explains.

From crown jewel to millstone

For many years, Sembmarine was the crown jewel of Sembcorp. When global demand for oil surged in the pre-Global Financial Cri­sis boom, Sembmarine benefited immensely from the massive demand in rig building and offshore platform fabrication. Sembcorp, in turn, rode high on the success of Sembmarine.

However, the 2014 crash in crude oil prices changed all of that. Exploration and produc­tion projects were slashed by oil majors. As a result, fewer jobs were up for grabs in the mid­stream segment, leading many companies to suffer cash flow problems or go bust.

Sembmarine’s fortunes fared for the worst as contracts to build rigs and offshore platforms dried up. The company recorded its first ever full-year loss in 2015. It also sunk into the red in 2018 and 2019. There were sporadic phases of recovery in crude oil prices but the indus­try remains in a prolonged slump.

As a result, Sembcorp’s own bottom line had dramatically been eroded since then. From recording full-year earnings of $801.1 million in 2014, Sembcorp’s bottom line tumbled 31% to $548.9 million in 2015. Last year, the com­pany’s earnings fell further to just $247 mil­lion, though this was not solely due to Semb­marine’s poor performance.

To offset the drag from Sembmarine, Semb­corp had three years ago embarked on a strat­egy to expand its energy business that was formerly known as the utilities business. The aim was to transform itself into an integrated energy player to take advantage of the global transition towards renewable energy.

However, Sembcorp was not ready to give up on Sembmarine just yet. Last year, the com­pany provided a lifeline to its subsidiary via a five-year $2 billion subordinated loan facility. About $1.5 billion of the subordinated loan was deployed to retire a majority of Sembma­rine’s short-term borrowings and reprofile debt from short-term to longer term. The remaining $500 million was earmarked for working capi­tal and general corporate purposes.

On its part, Sembmarine has been focusing on securing more liquefied natural gas (LNG) projects to diversify its revenue stream. The company tried to win over new customers in the wind energy market by making offshore platforms for them. These are on top of its ef­forts to reduce costs and streamline its operations.

Meanwhile, there is plenty of uncer­tainty in the oil market. “The path to stronger oil prices will depend on how quickly demand recovers, and high crude and fuel inventories will delay a recovery until 2021,” says Moody’s In­vestors Service analyst Elena Nadtotchi. “Even as oil prices are recovering, finan­cial risks will remain high,” she adds.

Improving cash flow, balance sheet

With the proposed demerger and rights issue, Sembmarine will be able to re­pay the loan for Sembcorp without any cash outlay. Part of the remaining pro­ceeds of $600 million will be utilised for working capital purposes.

Sembmarine’s director of finance William Goh says the amount should enable the company to meet its imme­diate and foreseeable cash flow needs. This is crucial as the reduction in work order has tightened the company’s cash flow, he points out.

According to Goh, Sembmarine’s yard has been “standing down” for “a period of time” owing to Singapore’s “circuit breaker” measures to curb the spread of Covid-19. “This totally impacted the ongoing execution of our projects. Nat­urally, we also try to manage our cost and payables. But in all likelihood, it will result in negative operating cash flow at least for 2Q,” he says.

Secondly, part of the proceeds will be used for essential capex. Goh says the company had already suspended all new capex. “We’re proceeding only with essential maintenance capex that are needed to ensure safety and oper­ability of our assets,” he says.

Finally, part of the proceeds will be used to service Sembmarine’s debts. Goh says the company has significant loans that will mature in the foreseea­ble future. But the company cannot as­sume that the banks will refinance its loans as and when they fall due, he ex­plains. Therefore, a contingency meas­ure is needed.

“Naturally, we hope with the completion of the [proposed] transactions, where our imme­diate and foreseeable liquidity needs are met, [coupled with the] strengthening of [our] bal­ance sheet, we are hopeful that our banks will be more supportive and will be able to have a certain level of debt headroom to allow us to seize new opportunities as the industry recovers,” says Goh.

When asked what Sembma­rine’s long term plan to return to profitability were, Goh says the immediate priority is to ensure that the company has sufficient liquidity to sustain its operations. The company will also “right size” its resources according to the industry outlook, he adds.

Strategically, Goh says Semb­marine will continue to diversi­fy into non-drilling products and solutions. This includes focusing on gas-related projects, such as LNG powered vessels and LNG liquefaction plants. The company also intends to grow its provision of renewable energy solutions.

As for Sembcorp, the compa­ny will no longer need to con­solidate Sembmarine’s finan­cial performance and position. This will improve Sembcorp’s balance sheet. For instance, the company’s borrowings will fall by $2.9 billion to $8.7 billion as at Dec 31, 2019. With cash and cash equivalents of $1.7 billion, that translates to a net debt posi­tion of $7 billion. The company’s FY2019 return on equity will also rise by 4.4 percentage points to 7.9%. In terms of financial per­formance, Sembcorp’s FY2019 earnings per share will rise 22% to 14.38 cents.

Contrasting views

So, what should investors do?

Shares of Sembcorp have risen 29.4% to close at $1.98 on June 11 since the announcement of the demerger and rights issue. How­ever, the stock is down 15.5% in the last 12 months. At that price level, the stock is trading at 16.8 times earnings. It has a dividend yield of 2.5%.

In contrast, shares of Sem­bmarine have fallen 31.2% to close at 59 cents on June 11. This has extended its 12-month decline to 61.3%. At this price level, the stock is trading at 0.6 times its book value.

Most analysts say the proposed demerger is a positive for Sem­bcorp. According to CGS-CIMB Research, the demerger could un­lock value at Sembcorp as it be­lieves the market has underval­ued the company’s energy and urban development businesses. “Having a cleaner structure as energy and urban development could rerate [Sembcorp],” CGS-CIMB’s head of research Lim Siew Khee writes in a June 9 report.

OCBC Investment Research agrees. “The marine segment has been a drag on [Sembcorp] for some time, and the demerg­er would allow SCI to focus on providing its suite of energy/ utilities and urban solutions. Indeed, there may be potential for a re-rating of the stock as the market’s concern of a privatisa­tion of [Sembmarine] is now re­moved,” the research team says in a June 9 report.

CGS-CIMB has upgraded the stock to an “add” rating from “hold” and raised its target price to $2.49 from $1.76, previously. OCBC has a “buy” call on the stock and has raised its fair val­ue estimate to $2.00 from $1.63, previously.

However, most analysts are bearish on Sembmarine. Despite the rights issue, UOB KayHian says the lack of new orders in the near to medium term will weigh on the company. It warns that securing new orders remains extremely difficult, while its re­pairs & upgrades business has been affected by disruptions in global shipping and cruises. “As a result, we believe that 1HFY2020 results, to be released at the end of July, will be extremely weak,” UOBKH analyst Adrian Loh writes in a June 9 note.

OCBC concurs, saying that a recovery is still a long way off, given the challenging environ­ment in the industry. Moreover, the change of control – because of the demerger – could impact loans with financial institutions, though it concedes that this may be offset by Temasek’s entry as a significant shareholder.

UOBKH has maintained its “hold” rating for the stock and reduce its cum-rights fair value of to 54 cents from 81 cents pre­viously. OCBC has a “sell” rat­ing for the stock and cut its fair value estimate to 55 cents from 75 cents previously.

Going forward, sharehold­ers will need to vote on three resolutions before the proposed merger and rights issue can be undertaken. The extraordinary general meeting is expected to take place between late August to early September.

Shareholder approvals will be needed for Sembcorp to distribute its Sembmarine shares in specie and for Sembmarine to under­take the rights issue. Sharehold­er approval will also be needed for a whitewash resolution to waive their rights to receive a mandatory takeover offer from Temasek. This is because the latter may end up with a stake in Sembmarine beyond 30%. All three resolutions are inter-condi­tional and will need to be passed for the transactions to proceed.

While the future of Sembma­rine does not look as bright, all is not lost. In May 2004, the then CapitaCommercial Trust (since renamed CapitaLand Commer­cial Trust or CCT) was listed via a distribution-in-specie to Capi­taLand shareholders at the rate of 200 CCT units for every 1,000 CapitaLand shares Similarly, in April 2006, the then K-REIT Asia (now Keppel REIT) was given to Keppel Land’s shareholders. Every five Keppel Land shares would get you 1 K-REIT Asia unit.

Since their listings to date, CCT and Keppel REIT have returned 395.4% or 10.45% a year and 135.8% or 6.26% a year respective­ly, both assuming their DPUs are reinvested. Who knows, Sembma­rine might enjoy the same fate.