Sembcorp Industries: Delay In Achieving ROE Target Justifies Undervaluation

Summary

• Sembcorp Industries announced in February 2020 that the company will recognize S$245 million in impairments with respect to its Energy segment, and the unexpected asset write-downs raise questions about acquisitions.
• The earnings outlook for Sembcorp Industries in FY2020 is murky with potentially lower energy demand and a decline in oil price as a result of the current coronavirus outbreak.
• Sembcorp Industries currently trades at 0.48 times P/B, representing a new 15-year historical low, but this is justified by an expected delay in achieving the medium-term, double-digit ROE target.
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Elevator Pitch

I maintain my "Neutral" rating on Singapore-listed conglomerate Sembcorp Industries (OTC:SCRPY) (OTCPK:SCRPF) [SCI:SP].

This is an update of my prior article on Sembcorp Industries published on November 30, 2019. Sembcorp Industries' share price has declined by -17% from S$2.21 as of November 27, 2019, to S$1.83 as of February 28, 2020. Sembcorp Industries currently trades at 0.48 times P/B, which represents a new 15-year historical low P/B for the stock. Sembcorp Industries is also valued by the market at 8.5 times consensus forward FY2020 P/E versus the stock's historical five-year mean forward P/E multiple of 11.0 times. The stock offers a consensus forward FY2020 dividend yield of 2.7%.

The stock's undervaluation and "Neutral" rating are justified by its mid-single-digit ROE for FY2019, which is significantly below the company's five-year double-digit ROE target set in February 2018 following a strategic review. More importantly, Sembcorp Industries acknowledged at the company's recent FY2019 earnings call that it will take a longer-than-expected amount of time to deliver ROEs in the double digits.

In addition, unexpected asset impairments in 4Q2019 and a murky earnings outlook for FY2020 are key negatives. Sembcorp Industries announced in February 2020 that the company will recognize S$245 million in impairments with respect to its Energy segment, and the unexpected asset write-downs raise questions about past and future acquisitions. The earnings outlook for Sembcorp Industries in FY2020 is uncertain, given potentially lower energy demand and a decline in oil price as a result of the current coronavirus outbreak.

Readers are advised to trade in Sembcorp Industries shares listed on the Singapore Stock Exchange with the ticker SCI:SP where average daily trading value for the past three months exceeds $4.5 million and market capitalization is above $2 billion. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers, Fidelity, Charles Schwab or local brokers operating in their respective domestic markets.

Unexpected Impairment For Energy Segment

On February 6, 2020, Sembcorp Industries announced that the company will recognize impairments amounting to S$245 million in relation to its Energy segment in 4Q2019. The unexpected asset write-downs comprised S$158 million for UK Power Reserve's (UKPR) assets, S$23 million for the company's China wastewater treatment assets and S$64 million in relation to the disposal of its water business in Chile.

In the company's announcement, Sembcorp Industries' impairment of China wastewater treatment assets was attributed to "new and more stringent effluent discharge standards" implemented in Jiangsu, China, where its wastewater treatment facilities were located. Separately, Sembcorp Industries' impairment with respect to the company's water business in Chile was a result of the business being sold below its book value. The water business in Chile was negatively impacted by currency depreciation and regulatory headwinds in terms of lower regulated returns.

However, the focus of the S$245 million in impairments is UKPR. UKPR is the largest flexible distributed energy generator in the U.K., and the company was only recently acquired by Sembcorp Industries for approximately S$385 million in May 2018. The S$158 million in asset write-downs for UKPR's assets is equivalent to 40% of Sembcorp Industries' original acquisition price.

Although UKPR was adversely affected by the suspension of the capacity market in the U.K. since late-2018 and became loss-making in 2Q2019, it was anticipated that UKPR will see a turnaround soon. The European Commission approved the U.K. government's Capacity Market scheme in end-October 2019 which implied that the suspension of the capacity market in the U.K. was expected to be lifted soon.

As a result of the unexpected impairments, especially with regards to UKPR, Sembcorp Industries' share price fell by -6% from S$2.16 as of February 6, 2020, to S$2.03 as of February 7, 2020, following the announcement.

At the company's FY2019 earnings call on February 21, 2020, Sembcorp Industries acknowledged that "this is disappointing, and it has been only 1.5 years since the acquisition." Apart from the suspension of the capacity market in the U.K., other factors contributing to the asset impairments for UKPR included milder-than-expected weather, and existing coal & gas capacity in the U.K. market being reduced at a much slower pace than expected. As a result of these factors, flexible energy demand in the U.K. was depressed and that hurt UKPR.

Looking ahead, Sembcorp Industries is guiding for flat YoY earnings growth for UKPR in FY2020; UKPR delivered earnings of S$10 million and S$1 million for 4Q2019 and FY2019 respectively. Putting earnings disappointment aside, the asset impairments for UKPR raise questions about Sembcorp Industries' past and future acquisitions. Sembcorp Industries has divested approximately S$600 million worth of non-core assets in the past two years in FY2018 and FY2019, so the market is likely to keep a close eye on how the company recycles divestment proceeds into new investments and acquisitions, and whether these will be value-accretive for shareholders.

On the positive side of things, Sembcorp's dividend payout has not been affected by the asset impairments. In fact, the company's dividends per share increased from S$0.04 in FY2018 to S$0.05 in FY2019, as its core net profit, excluding exceptional items, increased by +17% YoY to S$395 million last year.

Murky Earnings Outlook For FY2020

The earnings outlook for Sembcorp Industries is murky. Apart from the fact that UKPR is expected to contribute minimal earnings in FY2020, the company's Energy and Marine segments could potentially be affected by the current coronavirus outbreak.

Sembcorp Industries highlighted at its FY2019 earnings call on February 21, 2020, that there has already been "a slight decline in demand" for the company's China wastewater business, while "a decline in trade and industrial activities" could also potentially hurt demand for its Energy businesses in other markets like Singapore, India and the U.K. China accounted for approximately 24% of the Energy segment's net profit before exceptional items and corporate costs in FY2019.

On the other hand, Sembcorp's Marine business could suffer from a declining oil price. The price of Brent crude dropped below $50 a barrel on Sunday March 1, 2020, and this could result in a slower pace of new order wins for the Marine business. New order wins of S$1.49 billion in FY2019 and S$1.18 billion in FY2018 for the Marine business were significantly lower than prior new contracts wins of S$3.18 billion and S$2.74 billion for FY2015 and FY2017 respectively. The Marine business had earlier guided for continued losses in FY2020.

Stock Remains Cheap Due To An Expected Delay In Achieving ROE Target

Sembcorp trades at 0.48 times P/B based on its share price of S$1.83 as of February 28, 2020. This represents a new 15-year historical low P/B for the stock. The prior historical trough P/B multiples were 1.16 times and 0.60 times in 2008 and 2016 respectively. The stock's historical five-year and 10-year average P/B multiples were 1.3 times and 1.8 times respectively.

Sembcorp is also valued by the market at 8.5 times consensus forward FY2020 P/E and 6.9 times consensus forward FY2021 P/E. As a comparison, the stock's historical five-year and 10-year mean forward P/E multiples were 11.0 times and 11.3 times respectively.

The company offers consensus forward FY2020 and FY2021 dividend yields of 2.7% and 3.3% respectively.

The stock's cheapness is justified, when one considers Sembcorp's current ROE and its ROE target. The company set a five-year double-digit ROE target in February 2018 following a strategic review. The FY2019 ROE (adjusted for exceptional items) was 5.9%. The Energy segment's adjusted ROE was 9.8% in FY2019, which represented an improvement from 8.6% in FY2018, but the Marine segment remained loss-making which dragged down the company's overall ROE. FY2019 ROE would have been an even lower 3.5% if exceptional items such as the impairments mentioned above were included.

At the company's FY2019 earnings call on February 21, 2020, it acknowledged that "it is going to take us a longer period of time to have a consistent return on equities that is in the double-digit range." The timeline for Sembcorp Industries achieving its medium-term, double-digit ROE target is dependent on the turnaround for the Marine segment, which the company highlighted at the earnings call that this is "going to take some time."

Furthermore, Sembcorp remains highly leveraged with a net debt-to-equity ratio (excluding perpetual securities) of approximately 1.3 times as of end-FY2019. This could potentially affect the company's ability to either maintain or increase dividend payout going forward.

Risk Factors

The key risk factors for Sembcorp include further unexpected impairments going forward, weaker-than-expected earnings for the Energy and Marine segments as a result of the current coronavirus outbreak, and a longer-than-expected time for the company to achieve its medium-term, double-digit ROE target.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.