STX OSV - Positive outlook reiterated during road show (OCBC)

OUTPERFORM Maintained

S$1.56 Target: S$1.88

Mkt.Cap: S$1,841m/US$1,530m

Orders on track with possible margin surprise

Higher target price of S$1.88 (from S$1.70). The order momentum for STX OSV could strengthen in 2H11, according to Head of Investor Relations, Mr Holger Dilling, whom we accompanied on a 2-day non-deal road show in Kuala Lumpur and Singapore. Other issues raised were its recent ownership change; its yards’ capacity; updates on Brazil; and the sustainability of margin improvements. As our margin assumptions could be over-conservative, we have raised our assumptions. This lifts our earnings estimates for FY11-13 by 11-15% (partially offset by lower revenue projections). Accordingly, our target price climbs to S$1.88 (from S$1.70), still based on 11x CY12 P/E (15% discount to rig builders’ 5-year mean). Despite its recent runup, the stock is trading at 9x CY12 P/E, still below the 5-year 11x P/E mean for smallmid-cap industrials. We see catalysts from stronger-than-expected orders and quarterly results.

Takeaways

Reiterating a positive outlook. The company sees a faster-than-expected recovery in the North Sea. Farstad’s recent two AHTS orders with STX OSV have broken an 18-month dry spell when no large AHTS orders had been placed. With Farstad deemed as an early mover, there could be comparable AHTS orders as owners seek to capitalise on future demand. Going by project negotiations, the order pipeline should be diversified and we could hear of a variety of orders including AHTSs, OSCVs and other specialised vessels (icebreakers, coast-guard and fishing vessels) vs. the series of PSV orders announced over the last 18 months.

Estimated order book of NOK15.6bn as at 1H11, with progressive deliveries stretching out to 2013. YTD, we estimate that STX OSV has secured around NOK4.7bn of orders or 47% of our FY11 order target of NOK10bn (excluding Transpetro orders).

Ownership change: business as usual. STX Europe remains committed as a strategic shareholder and its shares have been locked up till Nov 12. On the other hand, the shares of new strategic shareholder, Och-Ziff, have not been locked up. At this juncture, there is no communication on whether Och-Ziff will get board representation. Generally, investors agreed that the removal of the share overhang is positive and believed Och-Ziff’s entry price could signal share-price upside.

Yards still able to accommodate deliveries for 2012. Though well utilised, yards are able to squeeze out 10-15% more capacity; and could accommodate a few more PSV deliveries for 2012 or OCSV deliveries for 2013. The only bottleneck is to be found at its existing Niteroi yard in Brazil which is fully booked until 2013. Should demand be stronger than expected, existing yards can scale up swiftly at low costs. For instance, STX OSV can add staff to its Norwegian operations (currently employing 300+ personnel in each of the five yards vs. 1,000 employees during boom times); debottleneck its Romanian operations (by enhancing yard layout, work processes and facilities to handle larger vessels); and ramp up its Vietnamese operations (yard is delivering 2.5 vessels/per year vs. a planned capacity of 3-4 vessels/year).

Update on new Brazilian yard. Construction of its new yard at Suape, Pernambuco is expected to begin in August and be completed in 2013. Development is expected to cost US$105m or NOK570m. Of this, 75% would be funded by a loan from FMM; 50.5% of the remaining 25% (NOK70m) will be funded by STX OSV. The new yard is expected to deliver 6-7 vessels/year, tripling its Brazilian capacity or increasing its total yard capacity by 25%. This is estimated to add NOK3bn to its current production run rate of around NOK12bn in 2014.

On the other hand, although Brazil is expected to spur growth in the mid-term, management cautioned that inflationary pressures, increasing lead times for equipment and materials, and a skilled-labour crunch could heighten project execution risks (potential margin risks) and delay the development of the new yard.

Transpetro orders could be effective by year-end. Following the grant of environmental licences and financial approval from Brazil’s Merchant Marine Fund (FMM), the effectiveness of the contract for eight LPG carriers with Transpetro (worth US$536m or NOK3bn) now lies in STX OSV’s hands. However, management is delaying signing of the contract until the initial development of the new yard, so that it would have greater clarity on delivery schedules. Nonetheless, management guided that the contracts should be effective by year-end.

Project risks for Transpetro orders mitigated; LPG orders not expected to dilute margins. Management considers the orders as a good start-up project for the yard even though the carriers do not fall into the group’s core competency. As the carriers are more labour-intensive and less complex, they would enable the company to train up its Brazilian labour force. Execution risks are also lower as top sides for the eight LPG carriers have been sub-contracted to UK oil & gas specialist equipment provider, Hamworthy. Hence, STX OSV is only responsible for constructing the hulls and integration of the vessels. Lastly, steel and labour cost-escalation clauses in the Transpetro contract should mitigate cost pressures. Management guided that project margins would not dilute the group’s blended margins.

Improvement in EBITDA margins sustainable. Better integration in the Romania-Norway value chain and overall good project execution had improved FY10’s EBITDA margins to 11.2% from the historical 8-9%. Meanwhile, EBITDA margins were 13.8% in 1Q11. Though yearly forward EBITDA margins are unlikely to stay at the 1Q11 high, we believe EBITDA margins in the near term could actually improve, based on the yards’ improvements and the slack in suppliers’ capacity.

Lifting earnings estimates for FY11-13 by 11-15%. Our EBITDA margin assumptions could have been too conservative. Raising our margin assumptions to 12% (from 11%) for FY11; and 11% from (9.5%) for FY12-13, though partially offset by lower revenue projections for FY11-13 by 6%, our earnings estimates for FY11-13 have been lifted by 11-15%. Our DPS estimates accordingly rise to 4.5cts for FY11 (from 4.0cts); and 5.0cts for FY12-13 (from 4.3-4.5cts), based on a payout of around 30%.

2Q11 results preview. STX OSV will be releasing its 2Q11 results on 13 Aug. We expect core earnings of NOK197m (consensus NOK206m) on revenue of NOK2,959m. This implies EBITDA margins of 10.5%.

Valuation and recommendation

Maintain Outperform with higher target price of S$1.88 (from S$1.70). We came away from the road show positively, concurring with management that the rebound in the OSV sector is intact. In addition, we expect margin improvements in the mid-term. Following our earnings upgrade, our target price climbs to S$1.88 (from S$1.70), still based on 11x CY12 P/E (15% discount to rig builders’ 5-year mean). Despite its recent run-up, the stock is trading at 9x CY12 P/E, still below the 5-year 11x P/E mean for small-mid-cap industrials. We see catalysts from stronger-than-expected orders and quarterly results.