Cosco Corporation - Hit by lower margins all round (DBSVickers)

FULLY VALUED S$1.695 STI : 3,215.27

(Downgrade from BUY)

Price Target : 12-month S$ 1.60 (Prev S$ 2.86)

Reason for Report : Downgrade TP and recommendation

Potential Catalyst: Offshore contract wins, earnings recovery

DBSV vs Consensus: Earnings disappointed even on our below consensus net earnings

• 2Q11 net earnings fell 53%, below expectations.

• Key disappointment came from lower margins across all divisions, and higher effective tax rate.

• Cost overrun in offshore projects, low earnings visibility, weak margins are key concerns.

• Downgrade to Fully Valued; TP cut to S$1.60 as earnings lowered by 28%(FY11F) and 18%(FY12F).

Second round of disappointing earnings. 2Q11’s net earnings fell by 53% y-o-y to S$31.8m, below our and street estimates. While 2Q10 was buoyed by exceptional gain of S$28m from lumpy profit recognition of Super M2, 2Q11 suffered from lower margins across all divisions (gross margin -5ppt y-o-y and -4ppt q-o-q to 7.5%) and higher effective tax rate. If we strip out exceptional gains from last year and adjust for the lower deferred tax benefit, net earnings would be flat yoy.

Déjà vu - execution issues again. Key disappointment came from lower offshore margins, which declined from 13% to 9% due to: a) cost overrun for drillship; and b)higher start up and R&D cost for its offshore turnkey projects. Margins for shipbuilding projects fell to 8% (from > 10%) with recognition of lower priced/ margin shipbuilding contracts kicking in together with rising costs (wages, currency and steel). Shiprepair/conversion margins continued to slide due to intense competition. Shipping revenue fell 31% q-o-q to S$14m as average charter rates fell 20% to US$12.6k/day in 2Q11.

Downgrade to Fully Valued; TP cut to S$1.60. We cut FY11/12F earnings by 28%/18%, assuming lower gross margins of 9-9.5% on its order book. Disappointing results will put pressure on share price performance till visibility improves. Execution risks outweigh potential catalysts. Target price cut to S$1.60 based on average using SOP and P/B on blended FY11/12F earnings.

Results snapshot

2Q11’s net earnings fell a sharp 53% y-o-y to S$31.8m, below our and street estimates. While 2Q10 was buoyed by exceptional gain of S$28m from lumpy profit recognition of Super M2, 2Q11 suffered from lower margins across all divisions – offshore, shipbuilding, shiprepair and shipping. Gross margin fell 5% y-o-y to 7.5%. EBIT margin was flat at 8% vs 1Q11 but down from 9.6% in 2Q10.

In addition, effective tax rate rose to 32%, due to lower tax exempt shipping profits and a deferred tax benefit adjustment on lower deferred tax benefit recognised. As a result, net margin fell to 3.2%. This is a one-off adjustment and effective tax should normalize to 18% and 21% going forward.

Despite a S$20m provision for losses on shipbuilding contracts incurred in 1Q11, the group provided for a further S$7.9m losses this quarter, mainly for heavy lift vessels, special purpose carriers and offshore projects.

Key disappointment came from lower offshore margins - its first disappointment since its foray into offshore engineering. Gross margin declined from 15% in 2Q10 to 9% due to : a) cost overruns on its drillship package; b) higher start up and R&D cost for its offshore turnkey projects.

Margins for shipbuilding projects fell to 8% as recognition of lower priced shipbuilding contracts start to kick in together with a rising cost environment - wages + 10%, material cost +3%.

Shiprepair and conversion margins continued to slide due to lower ASP stemming from intense competition and excess shipyard capacity in China. Shipping revenue fell q-o-q to S$14m as average charter rates fell 20% to US$12.6k/day in 2Q11.