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Monday, May 31, 2010

Coastal Contracts (Current Price: RM2.26; Target: RM3.76): Extermely low PE, High Earnings Growth, Declining Gearing and Strong Orderbook


Valuation:
Coastal Contracts Bhd performance is nothing short of spectacular, chartering a massive annualized growth of 48.2% and 65% for revenue and earnings respectively over the past 5 years. Owing to its huge earnings growth, the company was awarded the "Forbes Asia's 200 Best Under a Billion. Latest quarterly net profit in 1Q2010 was RM43.3 mil. Margins are rising as well owing to increasing sales of high-value vessels. Net profit is expected to touch RM170 mil or 47 sen per share in 2010, its highest ever earnings, making it extremely undervalued at PE of 4.9x. Net gearing has been declining tremendously from 53% in 2006 to a mere 6.2% currently. By attaching PE of 8x only, its fair value should be at RM3.76.

Company business:
The company has been in the marine business for four decades and was listed in KLSE in 2003. It is principally involved in three business segments, namely shipbuilding, ship repair/maintenance and shipping/chartering, therefore providing a one-stop center for shipping activities. Most of its earnings come from shipbuilding, supported by ship repair and chartering businesses.

Their main services include building barges (used to transport goods like palm oil, timber, coal, steel etc), landing crafts (Transport goods from ships to shores/beaches), tug boats (towing and pushing other ships) and OSV (Offshore Supply Vessels: Used for offshore oil and gas industry in areas like anchor handling and transportation). It has two shipyards of more than 90 acres with capacity to build 30 ships at any one time near Sandakan, Sabah. Current utilization rate is 80%, with the remaining area earmarked for upgrading purposes to accommodate future offshore structure fabrication (Due to the possible tie-up with Ramunia?).

It has a large customer base coming from different countries and sectors including oil and gas players, logistics provider, navy, shipping agents and commodities provider coming from Indonesia, Singapore, Australia, China and right up to the Mideast such as UAE, Iran and Egypt. This would help the company to be not overly dependent on a single customer.

There is a substantial portion of construction costs that comes from steel. Nonetheless, we continue to see its earnings grow in the midst of surging steel prices in 2007-08, implying its ability to mitigate rising construction costs. In addition, steel prices are expected to stay on a steady uptrend and will not experience a sudden surge in steel prices like what happened in 07-08, allowing the company to handle rising costs better.

"Build then sell" concept:
As opposed to most industry players, Coastal adopted a 'build then sell' strategy since 2006. The reason behind it is that this concept could eliminate the long and different lead-time in shipbuilding which will complicate shipbuilding schedules. Usually, shipbuilders have to wait to secure contracts from customers and then only determine the yard space and equipments required. With this method, the services provided are more attractive to customers owing to shorter lead-time in new deliveries.

Concern of increasing inventories which might explain the stock's low PER:
I don't understand why this stock has been so undervalued despite its strong earnings growth. Part of the reason could be its increasing inventories due to its build-then-sell model which can be risky if customers default, lack of secured orders and strain on its working capital. To mitigate this, the company requires 30% upfront fees from customers prior to building ships in addition to the choice of customers which are financially strong to mitigate defaults and the increasing demand for OSVs amidst increasing deepwater exploration. Even in the event of default, the company could always sell the ships to other prospective buyers at competitive prices owing to its shorter lead-time. Note that there have been no recorded defaults by its customers till now. This build-then-sell method actually helped the company to decrease its debt tremendously, as shown in its massive cut in debts from 2006 onwards as the upfront fees from customers were used instead of loans to start shipbuilding.


Key drivers:
Among the key drivers to its business are higher oil prices which will support deepwater explorations, fleet upgrades & expansion coupled with ageing fleet (about 48% of AHTS globally aged more than 25 years according to Mantrana Maritime) which could be phased out, thus driving new demand for OSVs. It has about RM1.2 bil worth of orderbook which could last it for the next two years. Its earnings are more or less secured over the next two years.

Diversify into fabrication business:
Coastal Contract had just signed an MOU with Ramunia to undertake tendering, bidding and fabrication of offshore structures for the oil and gas industry. Ramunia is one of the 7 licensed major fabricators for Petronas besides other fabricators such as Kencana, MMHE, Sime Darby and Boustead Heavy Industries Corporation. This will be beneficial for both companies as Coastal could provide the yard space while Ramunia has the license to undertake fabrication projects. This venture could signal a new chapter for Coastal Contracts as it could diversify from shipbuilding business and start bidding for fabrication contracts from Petronas and its PSC contractors, which could potentially chart another spectacular earnings growth going forward.

Market Data:
Earnings for 2010 & 2011: RM170mil and RM200mil
Shares Issued: 362 mil
Market Cap: RM830mil
EPS for 2010 & 2011: 47 sen and 55 sen
PER for 2010 & 2011: 4.9x and 4.2x
Net Gearing: 6.2%
P/BV: 1.7x

Shareholders:
Ivory Asia S/B: 31.3%
Pang Fong Thau: 21.4%
Lembaga Tabung Haji: 6.8%


Disclaimer: The above article does not represent an investment advisory service as no subscription or management fees are charged. The contents of the article are provided as general information only and should not be taken as investment advice or as a recommendation to buy or sell any security or financial instrument. Any investment decisions carried out based on information, analysis, or commentary provided above is solely your responsibility. You should consult your investment adviser before making any investment decisions.

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