Oil & Gas sector (OCBC)

Overweight

Downstream EPC firms

Recovery in sight. Compared to a year ago, the outlook for the oil and gas (O&G) sector is more positive now. Oil companies are ramping up capex investments, and downstream engineering, procurement and construction (EPC) firms would benefit from increased business volume and higher margins. In Singapore, there are several large O&G infrastructure projects, including plans by PetroChina and Chervon to upgrade their Jurong Island refinery, construction of a rubber plant by Lanxess, and the resumption of a stalled ethylene cracker by Shell. Although the bulk of the engineering and construction contracts are likely to be taken up by the bigger firms, parts of these jobs are likely to flow down to downstream EPC firms such as Rotary Engineering (Rotary), PEC, Hiap Seng Engineering, Mun Siong Engineering and Tiong Woon Corporation.

Low orderbook visibility. Despite the improved outlook, the orderbooks of local EPC firms remained at a low level as compared to a year ago (see Exhibit 1). We believe it would take time for these large engineering/construction projects to flow down to downstream players. In addition, our channel checks indicate that competition for projects within Singapore's Jurong Island remains stiff and margins are thin. As such, it may take a while before the outlook for smaller EPC firms improves.

Overseas operations and geopolitical. Rotary and PEC have substantial overseas exposure, which helps the companies sustain their profitability margins in the face of stiff competition within Singapore. However, some investors may be concerned about geopolitical risks. For FY10, Rotary derived 72% of revenue from overseas, mainly in the Saudi Arabia (64%). As mentioned in our earlier report dated 31 May 2010, Rotary's operations have not been affected by civil unrest. The share prices of Rotary and PEC have fallen by 22% and 21% YTD, while its peers have fallen by between 24% to 33% YTD.

Focusing on value; BUY on Rotary. While the outlook for the O&G sector is positive, we remain cautious on the overall outlook for the smaller EPC companies. Orderbooks for these companies remained at a low level and competition within Singapore remains stiff. We continue to like Rotary for its large orderbook and overseas operations, which should help to sustain its margins. We also think that concerns about its Middle East exposure may be overblown because its operations are mainly in Saudi Arabia and UAE, which are less affected by civil unrest. We have a BUY on Rotary with a fair value estimate of S$0.99.