Cosco Corporation (Singapore) Limited - How did its order book rise so much?

Q3 revenue up 17%, net profit up 69% but operating margin dips below 5%. Separately, we wonder how its order book is calculated.

14/11/2014 - COSCO Corporation (Singapore) Ltd maintains a cautious outlook for the rest of the year.

The shipbuilder warns that sliding crude oil prices have forced major oil companies to cut budgets for deep water rigs.

Moreover, a number of deep water rigs delivered this year are already struggling to get leased.

As a result, new orders in the offshore space have declined.

Also, there are challenges in the offshore space that are specific to COSCO Corp.

As it moves up the value chain, it is likely to face technical challenges that would to impact its efficiency and profitability.

However, the company says it is determined to build its expertise to cater to a broader customer base in the long-term.

In the dry bulk shipping space, it feels the new tonnage accumulated over the last few years mean the recovery will be a 'slow process with uncertainty'.

The company just announced earnings for Q3 FY2014:

Revenue: +17% to S$1.16 bln
Profit: +69% to S$7.2 mln
Forex gain/(loss): S$5.1 mln vs (S$0.2 mln)
Cash flow from operations: (S$227.5 mln) vs (S$316.3 mln)
Dividend: Nil
Order book: US$8.9 bln with deliveries up to 2016

Shipyard revenue was by far the biggest revenue generator. It increased by 17.2% to S$1.1 bln while dry bulk shipping and other business revenue increased by 11.2% to S$13.4 mln.

Interest on borrowings was higher by 12%.

However, the depreciation charged during Q3 was 19% less than that in the same quarter last year.

During the quarter, it made an S$10.6 mln allowance for expected losses on construction contracts, against an allowance of S$33.9 mln last year.

It also made a S$1.6 mln allowance for impairment of receivables and a S$1.6 mln allowance for inventory write-down.

Analyst Low Pei Han at OCBC Research finds Q3 earnings to be in-line with estimates – but that didn’t stop her maintaining a SELL rating.

COSCO Corp's nine months' profit of S$60.7 mln accounts for about 76% of the broker's full-year target.

The broker adds the drop in gross profit margin to 4.9% in Q3 from 7.4% a year ago was due to execution of lower margin contracts.

It also points out that three offshore projects of the company have already been cancelled, or are at risk of being cancelled.

These three projects are: Sevan 650 drilling unit (worth about US$525 mln) which has been deferred for up to 3 years, Dalian deepwater drilling contract (worth about US$630 mln) for which the arbitration is still going on in London, and Octabuoy hull and topside module (worth about US$240 mln) which will likely be cancelled in the near future.

The broker reiterates COSCO Corp's outlook statement in which it highlighted further erosion of its operating margins as it continues to execute orders won in recent years due to the weak shipping market.

Despite improved efficiency and productivity at its shipbuilding operations, OCBC Research warns a further erosion of operating margins doesn’t augur well for a company which has a net gearing of 1.3 times against just 0.6 times a couple of years ago.

The broker cites COSCO Corp’s 'weak execution abilities, relatively poorer quality clientele, and deteriorating balance sheet amidst a slowing offshore market', as key reasons for lowering its price-to-book-value estimate to 0.8x from 1x earlier.

As a result, OCBC Research maintains a SELL rating on the stock with a fair value estimate of S$0.50.

In the words of Analyst Ho Pei Hwa at DBS Group Research, COSCO Corp reported 'a disappointing set of results' as its Q3 net profit fell to a 'miserable' S$7.1 mln.

The third consecutive quarter of margin decline is worrying, adds the broker.

According to the broker, COSCO Corp's 'hefty' gross order book of US$8.9 bln is a 'double-edged sword' as the shipbuilding orders are of low values while the offshore segment continues to see a 'steep learning curve'.

The broker is also worried that the shipbuilder might not be able to sell the cancelled drillship units due to 'weak market sentiment and abundant supply of new drilling rigs'.

The broker also reveals that the 4th Sevan cylindrical rig unit is near completion and it faces the risk of cancellation as the customer has failed to secure a charter contract for the rig and COSCO Corp might be held responsible for the delay in delivery.

DBS Group Research reiterates FULLY VALUED rating on the stock with a target price of S$0.62, having potential downside risks.

Investor Central. Asian insights for global investors. We ask the tough questions of Asian companies which global investors need answers to.

Question

1. On what basis did the management revise the useful lives of its assets?

According to page 8 of its Q3 earnings report, COSCO Corp revised the estimated useful lives of certain assets within leasehold land and buildings, plant and machinery and docks and quays, after conducting a review on January 1.

As a result, the company has increased the estimated useful life of its assets which has the consequence of reducing the depreciation expense in its earnings report.

Therefore, its profit before tax for Q3 has increased by S$9.3 mln whereas the profit before tax for the first nine months has increased by S$27.5 mln due to the lower depreciation charge.

It is noteworthy that in the absence of the lower depreciation charged so far in 2014, COSCO Corp would have recorded a 24% drop in pre-tax profit for the first nine months, compared to the 20% rise it actually did.

Had it charged the depreciation at the same rate as in the previous year, it would have recorded pre-tax loss in Q3 instead of a profit figure.

The net book value of its property, plant and equipment as at September 30 was also higher by about S$27.5 mln.

According to page 90 of its 2013 annual report, COSCO Corp estimated the following useful lives of its assets for 2013:

Buildings on freehold land: 50 years, leasehold land and buildings: 10 to 50 years, office renovations, furniture, fixtures and equipment: 3 to 5 years, plant, machinery and equipment: 3 to 10 years, motor vehicles: 5 to 10 years, motor vessels: 20 years and docks and quays: 30 years.

In the absence of clarity, we wonder which of the above estimates were tweaked in the review on January 1.

Also, on what basis did the management decide to stretch the useful lives of the assets?

Question

2. How much more is it willing to borrow?

COSCO Corp had a cash balance of S$1.8 bln on September 30, which was down from an S$2.03 bln on December 31.

At the same time, its trade and other receivables have increased from S$2.91 bln on December 31 to S$4.74 bln on September 30.

The company's total debt stood at S$4.66 bln on September 30 compared to S$3.78 bln on December 31.

Its net debt to equity ratio has shot up to 1.29 times on September 30 from 0.8 times on December 31.

In all likelihood, COSCO Corp's profitability will decline further as it executes more of low value contracts and climbs up the learning curve in the offshore segment.

Therefore any reasonable investor would wonder how it plans to serve its debt obligations in the coming quarters.

Moreover, how else does it plan to raise funds to finance its working capital?

Just like it has done so far this year, will it borrow more to meet its working capital needs?

In that case, how much more would it be?

(Read the full story to get all 8 questions)

We have invited the company (liman@cosco.com.sg) and its IR agency (michael@spin.com.sg) to an on-camera interview, and/or to reply to our questions in writing.

At the time of publication we have not received a reply (which is why you are seeing this message).

We will update this report if we do.








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