Cosco disappointing Quarter-Expected Losses

PhillipCapital - target price of $0.82

3Q11 Results Cosco Corp reported 3Q11 revenue and PATMI of S$970 mil (+2% Y-o-Y) and $32 mil (-42% Y-o-Y). PATMI fell sharply mainly due to
1) lower profits from dry bulk shipping
2) lower margins from shipyard ops (expected losses on construction contracts)
3) higher selling expenses (distribution expense) in a difficult operating environment.

Another Disappointing Quarter-Expected Losses Escalates
Cosco 3Q11 results came in below expectations (Actual PATMI: S$32 mil vs. PSR PATMI estimate: S$39 million). The main culprit was higher expected losses on construction contracts of S$47 mil. We understand from management that the bulk of these expected losses originate from its offshore projects where it experienced cost overruns. The expected losses also provides for penalties stemming from a probable late delivery of one of its vessels currently under construction. The company also mentioned that they might have to recognize further losses in subsequent quarters if they experience further cost overruns or negotiate new shipbuilding/offshore projects at a loss, which we think is highly possible given
1) as it embark on the construction of model/class of rigs not built previously (Letourneau jackups, DP3 drillships) and
2) current shipbuilding market remains weak with little signs of improvement (current rates on construction of bulk carriers not profitable). Hellanic Shipping News quoted NDRC saying on Tuesday that 30% of China’s 1,526 shipbuilding enterprises received no new orders in September, forcing some to shut or stop production.

Shipbuilding and offshore margins remain weak
Management guided that gross margins for shipbuilding in 3Q11 lies somewhere between 8 to 9%. The company is working on improving its delivery lead-time as well as efficiencies in the construction of its dry bulk carriers but conceded that there may be a limit to it. Going forward, current margins might not be sustainable due to lower value of shipbuilding contracts in the market now. Cosco currently has enough shipbuilding contracts to keep its yard busy till 2H2012.We note that Cosco has not won any order for dry bulk carrier construction since December last year and if the shipbuilding market does not improve, Cosco may have to accept shipbuilding orders at a loss to cover its fixed costs.

For its offshore projects, management guided that gross margins for its offshore projects lies near the region of 5% and added that it is “ not so promising” as the company is mindful of the potential costs of scaling the “learning curve” when executing its offshore orderbook.

No signs of order cancellations yet
Other than the order cancellation of a dry bulk carrier in March, the company has not yet received any request for order cancellation or postponed delivery. The company also guided that about half of its current shipbuilding orderbook comes from European customers, of which Greek customers make up the highest proportion of its European customers with the rest made up of Netherlands, UK, Belgium and Norwegian customers.

Valuation:
We downgrade Cosco from Hold to Sell with a revised target price of $0.82 as we lower our FY11e and FY12e EPS to 6cts and 5.8 cts from 7.2 cts and 6.6 cts previously, taking into account possible losses from its marine engineering projects as well as a weak dry bulk market that is expected to persist at least till 2012. Our target price of $0.82 is based on 14x FY12e EPS, in-line with mid-cycle valuations. SELL.


CITI - - target price of $0.82

COS’s disappointing 3Q11 PATMI of S$32mn (flat QoQ; -42% YoY) came in >30% below both our and consensus expectations. Excluding strong forex gains of S$19.5mn during the quarter (vs 3Q10: S$2.1mn), we estimate earnings at a paltry S$17mn. The dismal set of results was underpinned by i) renewed execution problems on several offshore projects (3Q11 provisions of S$47.4mn; +72% YoY); and ii) lower turnover from its dry bulk shipping division (-55% YoY; ave BDI in 3Q11:1533 vs 3Q10: 2352).

Although revenue from bulk shipping has declined, it remains profitable. Contributions from ship repair and offshore conversion remain steady but shipbuilding margins continue to face headwinds.

Management is upbeat on offshore orderbook prospects and believes 2012 order wins can be comparable vs 2011. Enquiry levels for rigs/fpso remain healthy and impact from on-going Europe crisis has not completely dampened demand. Potential contract wins in the near future include Heavy Lift Vessels from Sapura Crest worth more than US$200mn. On the other hand, ship building is expected to remain poor and prices have started to decline by ~5% over the past month. At this rate, Cosco may turn loss making at the ship building level

YTD the group has secured order wins of ~US$2bn (inclusive of two jackups and two semisubs). Current order backlog stands at US$6.4bn, with deliveries into 1H14. Rig orders now account for ~55% of backlog, while ships contribute ~45%, with the remainder arising from fpso conversion jobs.

Maintain Sell. We reiterate our view that COS’s diverse offshore product mix (jackups, tender rigs, drillship, semisubs) continually presents fresh execution challenges to the group in the foreseeable future. Recurring provisions necessary to scale the learning curve is likely to result in earnings volatility in coming quarters, which we believe will hamstring any prospects of a strong sustained rally for the stock.


Deutsche Bank - TP 1.10 HOLD

Target price based on 1.8x FY12E P/B; Hold We peg COS’s target multiple at 1.8x P/B (FY12E), which derives a target price of S$1.10. Our target price implies 15x FY12E PER, below its 2005-11 average of 20.2x but above its 2009 trough PER of 10.4x. Upside risks: a decline in steel prices, RMB depreciation,easing credit markets. Downside risks: a sustained fall in the BDI, a slowdown in offshore orders, execution issues, and a tightening of credit markets

Upside risks
- Steel accounts for about 15-20% of Cosco's costs. A ship plate price decline would positively affect the group's earnings.
- Most of Cosco's shipbuilding orders are in dry bulk vessels. The group's earnings could benefit if there is any unexpected increase in demand for bulk carriers.
- Cosco has experienced execution problems in vessel construction over the past few years. Any better-than-expected project execution would be positive for profit margins.
- New orders for Cosco are dependent on its customers' ability to obtain financing. If the credit markets improve significantly, this could have a positive impact on new orders.

Downside risks
- Most of COS's orders are in dry bulk vessels. If the BDI experiences a sharp and sustained fall, this may affect the group's new order prospects.
- The group has secured several offshore-related orders over the past year. COS's earnings would be affected if customer demand declines in this area. 􀂄 Cosco is targeting an improvement in execution in the coming months. Any further execution issues would be negative for the group's margins.
- Any unexpected worsening of the credit markets would have a negative impact on the group's new orders.